SBP Has Enough Room to Cut Key Interest Rate By 6% in FY25: JP Morgan

JP Morgan has projected foreign exchange reserves held by the State Bank of Pakistan (SBP) to increase to $15 billion, the CPI inflation rate down to 9.5 percent, and the key policy rate cut by 500-600 basis points by the end of the current fiscal year (2024-25). This prediction comes on the heels of the recent Staff-Level Agreement (SLA) between Pakistan and the International Monetary Fund (IMF) for a three-year Extended Fund Facility (EFF) deal, worth approximately $7 billion. “We expect further accumulation in foreign reserves (from US$9 billion to US$15 billion) in the next 12 months, supported by the normalization of official creditor inflows, even as the current account (CA) deficit widens slightly, and Pakistan stays on the sidelines of the offshore bond market. The key assumption here is that the EFF program will unlock financing from major bilateral and multilateral partners, which make up almost 80% of Pakistan’s external debt stock,” it stated. JP Morgan surmised that, unlike the previous 9-month SBA program, the EFF is a flagship IMF program that represents a bigger show of confidence in Pakistan’s sovereign credit profile, taking into consideration various factors (e.g., government stability, reform progress, debt sustainability), notwithstanding downside risks. Indeed, major multilateral agencies such as the World Bank and ADB have recently announced policy-based loans, the agency explained. Stronger external stability that comes with a new EFF program removes a key obstacle for the SBP to resume policy easing. Periodic energy price adjustments and rate-based taxation measures (i.e., higher sales and excise taxes) should not materially affect the disinflation trend due to offsetting drags from a weaker domestic demand. JP Morgan expects headline CPI to moderate from 23.9 percent in FY24 to 9.5 percent in FY25. “There is substantial room for easing. As such, we expect the SBP to deliver at least 500- 600bp of rate cuts in FY25, with potentially a front-loaded easing profile in 1H FY25 while external conditions remain benign,” the agency said. Despite the constructive outlook, JP Morgan remains cautious of several downside risks. Political instability, fiscal slippages due to overly optimistic revenue assumptions and ad-hoc spending increases, and the medium-term risk to public debt sustainability due to the elevated debt servicing burden, are highlighted as potential challenges. The SLA agreed upon on July 12, 2024, marks a significant milestone, subject to approval by the IMF’s Executive Board and timely confirmation of financing assurances from other major official creditors. This agreement is a positive surprise, as previous expectations had leaned towards securing an SLA by the end of August 2024, with a risk of protracted negotiations. JP Morgan added that the EFF program if formalized in the next month or so, is a boost to Pakistan’s external stability in FY25. However, the agency warned of some downside risks: The price action, especially in Eurobonds, has been very strong over recent weeks as the relatively smooth election earlier in the year was followed by the successful completion of the SBA, and now topped off with the likely board approval of the EFF over coming weeks. This has resulted in Eurobonds yields moving lower to between 11-12 percent compared to the 15-23 percent range around end-23, while in local markets treasury bill yields have declined by 100bp since the start of the year even though PKR has only marginally strengthened against the USD. “We remain on the sidelines in both local and hard currency Pakistan fixed income assets as we believe the positive trajectory is now fully priced in credit, while we expect better entry points in FX,” the agency added.