By Mohiuddin Aazim

Copyright dawn

Pakistan’s economy continues to face competing domestic and globalw pressures. The World Economic Forum’s latest report warns of structural economic shifts from US tariffs, while diplomatic efforts continue toward resolving the Israel-Hamas war.

Domestically, challenges are sharper: the World Bank confirms rising poverty levels, and recent flood damage has prompted urgent requests for International Monetary Fund (IMF) benchmark revisions. In this volatile environment, three issues demand immediate focus: revenue generation, inflation, and a seemingly stable interest rate structure that conceals deeper contradictions.

Financial markets highlight this paradox. Both bullion (the classic safe haven) and equities (the ultimate risk asset) are rising in tandem.

This is not confusion but a calculated response to an anticipated rate cut by the State Bank of Pakistan (SBP). For equities, lower rates reduce discount factors on future earnings, instantly boosting valuations. Cheaper credit also stimulates investment and consumer demand, supporting corporate profits. For gold, the logic is rooted in opportunity cost. When interest rates fall, the income forgone by holding non-yielding assets like gold shrinks, making it more attractive. This dual rally thrives in an environment of moderated inflation and currency stability, reflecting a hedged strategy: growth through equities, protection through gold.

In theory, high net interest rates should attract foreign capital and strengthen reserves; in practice, inflows remain weak, with forex reserves of SBP hovering just above $14.3bn as of Sept 19

Available data reinforces this view; the KSE-100 index stood at 162,257 points on Sept 27, up a remarkable 98.7 per cent year-on-year. At the same time, global gold prices climbed to $3,791 per ounce, a 41pc increase over 12 months, reflecting a similar price hike in local markets where gold touched Rs400,000 per tola last week. Together, these trends reveal investor confidence in domestic equities but also caution through global safe-haven demand.

Superficially, the monetary policy appears steady, with the SBP holding its policy rate at 11pc since September. Yet, this stability is misleading. Headline inflation has plunged to 3pc (in August), far below the SBP’s 5–7pc target. Ordinarily, this would justify a further interest rate cut to stimulate growth. But the SBP remains cautious.

Officials point to potential food price spikes from extreme weather, the risks of premature easing under the IMF programme, and the need to align with global monetary conditions where major central banks, though easing, still prioritise inflation risks. The outcome is a punishing mismatch: an 11pc policy rate against 3pc inflation, leaving a real interest rate of 8pc — extraordinarily high for a developing economy growing at only 2.7pc.

Transmission mechanisms show additional strain. While the policy rate is fixed at 11pc, key rates misalign; the overnight reverse repo ceiling is 12pc and the repo floor is 10pc. Such gaps expose weak policy passthrough to banks and borrowers.

Nevertheless, private sector credit offtake is set to grow in the next quarter, backed by seasonal credit demand plus additional demand created by the massive economic losses in the aftermath of this year’s monsoon floods, mainly in Punjab and Khyber Pakhtunkhwa but also in Sindh and Balochistan. Banks may also see some liquidity unlocking if the government releases Rs560 billion sovereign guarantees under a recently signed agreement with 18 banks for restructuring and financing of Rs1.225 trillion of notorious energy sector circular debt.

Externally, the contradictions are stark. In theory, high net interest rates should attract foreign capital and strengthen reserves. In practice, inflows remain weak, with forex reserves of SBP hovering just above $14.3bn (as of Sept 19).

Structural risks — political instability, security concerns, and a tightly regulated capital market — outweigh interest rate incentives. Net foreign direct investment was only $364 million in July-August 2025, down 22pc year-on-year, showing that investors judge Pakistan’s governance and stability rather than yields alone.

Fiscal dynamics complicate the SBP’s room for manoeuvre. The government projects 4.2pc growth for FY26, but this looks ambitious against double-digit borrowing costs. A stronger primary surplus, achieved this year, should normally give space for monetary easing. However, the limited impact of the surplus instead suggests deeper concerns over debt sustainability or a lack of policy coordination between the SBP and the government. Recent flood losses, estimated in billions, have worsened fiscal pressures. The government’s reliance on Rs1.225tr bank finance package to manage power sector debt further narrows options for policy flexibility.

Globally, Pakistan is not isolated. Central banks from Washington to Jakarta face similar dilemmas: cutting rates risks currency depreciation and capital flight, while keeping them high stifles fragile growth. For the SBP, the problem is more acute because of Pakistan’s reliance on external support, modest reserves, and persistent structural weaknesses.

In this light, Pakistan’s interest rate stability looks less like a sign of resilience and more like a surface-level calm.

Building a more resilient interest rate structure requires greater fiscal discipline from the government and a more independent stance from the central bank. The government must prioritise innovative non-bank borrowing to deepen the capital market. Concurrently, the central bank should gradually curtail its practice of injecting excessive liquidity into the banking system ahead of government debt auctions.

Published in Dawn, The Business and Finance Weekly, September 29th, 2025