Pakistan May Lower Interest Rates by One-Third, Analysts Say

By Michael Dwyer

June 17 (Bloomberg) -- Pakistan may cut interest rates by as much as a third as the government’s fight against the Taliban weakens an already deteriorating economy, analysts said.

The State Bank of Pakistan may lower its policy discount rate by between 400 and 450 basis points from 14 percent by the end of the year to help counter “entrenched recessionary inclinations,” said Asad Farid, an economist at AKD Securities in Karachi. The central bank’s next monetary policy statement is due in late July.

Pakistan’s army is extending its seven-week campaign against Islamic militants in the country’s northwest and is now targeting Taliban commander Baitullah Mehsud in his South Waziristan stronghold. The military campaign is straining the nation’s budget deficit and may force the government to seek further bailouts from foreign donors.

“Government resources are constrained by the ongoing military operations in the North West Frontier Province,” Sayem Ali, an economist at Standard Chartered Plc in Karachi, said in a report yesterday. “The government has had to allocate additional resources to military operations by reducing investment spending, at a high cost to the economy.”

Pakistan’s budget deficit is estimated to widen to 4.9 percent of gross domestic product in the year starting July 1, Junior Economics Minister Hina Rabbani Khar told parliament in Islamabad on June 13. That’s higher than last year’s 4.3 percent and more than the 4.6 percent target set by the International Monetary Fund as part of a $7.6 billion bailout agreed in November 2008.

‘Realistic Cuts’

The fiscal shortfall could end up being as much as 6.4 percent of GDP unless the government makes “realistic cuts in development expenditures,” AKD’s Farid said in a report released after the weekend budget.

Prime Minister Yousuf Raza Gilani’s government is counting on foreign aid to fund almost a third of next year’s budget gap. Pakistan has asked the IMF for a $4 billion stand-by loan as “insurance” if the pledged assistance doesn’t arrive, Shaukat Tarin, finance adviser to the prime minister, said June 14.

International donors including the U.S. and Japan pledged $5 billion at a meeting in Tokyo in April to shore up the country’s ailing finances and fight terrorism.

Governor Syed Salim Raza, who took over as head of the central bank at the start of the year, in April cut the benchmark interest rate for the first time since 2002, reducing borrowing costs from 15 percent to help bolster economic growth.

IMF Bailout

Former Governor Shamshad Akhtar raised the central bank’s policy rate by the most in more than a decade on Nov. 12, a move she described as “the toughest decision of my life,” in order to secure a rescue package from the IMF.

Pakistan was forced to apply for a loan from the IMF in late 2008 after its foreign reserves shrunk by 75 percent in a year, its current account deficit widened to a record and inflation jumped to a three-decade high.

South Asia’s second-largest economy is expected to expand 3.3 percent in the year starting July 1 after growing 2 percent in the previous 12 months, Junior Minister Khar said in her weekend budget speech. Growth averaged an annual 6.8 percent over the preceding five years.

The $146 billion economy slowed after the global recession eroded exports and foreign investment. The situation may get worse as the government intensifies its fight against Islamic extremists in the northwest Swat Valley and struggles to provide food and shelter for people displaced by the war.

“Persistently high inflation, tough measures implemented under the IMF program, and the deteriorating security environment are weighing heavily on the economy,” Standard Chartered’s Ali said. The slowdown “has affected the government’s tax revenues, limiting its ability to increase support for the 3 million people displaced by fighting or to finance military operations.”

Ali expects the central bank to lower interest rates by 200 basis points to 12 percent at its next meeting in July.

To contact the reporter on this story: Michael Dwyer in Singapore at Mdwyer5@bloomberg.net