Interest rates are a central part of economic policy, influencing various sectors, including financial markets, households, businesses, and government debt. In the context of Pakistan, changes in the interest rates set by the State Bank of Pakistan (SBP) have a profound impact on the stock market, savings, foreign debt, and current account balance, as well as the general economic environment. Understanding these impacts requires an analysis of the present-day scenario and how future monetary policies are likely to affect Pakistan's financial landscape.

Interest Rates and the Stock Market in Pakistan
Interest rates have a direct and significant effect on the stock market, which is sensitive to changes in the cost of borrowing and investor sentiment. A reduction in interest rates tends to encourage more borrowing by businesses and consumers, leading to increased investment and spending in the economy. This, in turn, can boost corporate earnings and spur demand for shares, resulting in higher stock prices. Conversely, an increase in interest rates typically raises borrowing costs, reduces corporate profitability, and dampens investor sentiment, often causing a decline in stock prices.

On January 27, 2025, the SBP announced a reduction in its key policy interest rate by 100 basis points (bps), dropping it from 13% to 12%. This move reflects a more cautious stance on inflation, signaling the central bank's attempts to stimulate economic growth while carefully balancing inflation risks. Following this rate cut, the stock market saw positive reactions, especially from interest-sensitive sectors like real estate, banking, and automobiles, which benefit from reduced financing costs.

Historically, the Pakistani stock market has exhibited volatility in response to changes in monetary policy, with investors reacting swiftly to rate cuts or hikes. With the SBP’s policy rate now at 12%, the stock market is expected to see further upside momentum, particularly in sectors reliant on borrowing, as businesses may increase expansion plans, fueled by cheaper financing costs.

However, in the longer term, the relationship between interest rates and stock market performance may become more complicated as inflationary pressures may persist and influence investor behavior. In particular, if the SBP continues to lower rates in the upcoming quarters, it might lead to concerns about currency devaluation, which could dampen foreign investor confidence.

Impact of Interest Rates on Pakistan’s Current Account Balance
Underdeveloped economies like Pakistan, which are heavily reliant on imports, are particularly sensitive to fluctuations in interest rates due to their direct impact on exchange rates and trade balances. Changes in interest rates can influence a country's currency value, foreign capital inflows, and subsequently, the current account balance.

A reduction in interest rates, such as the one implemented by the SBP, typically results in a depreciation of the local currency. For Pakistan, this could result in an increase in the cost of imports and a widening current account deficit as the country faces rising import costs and diminishing foreign exchange reserves. At the same time, cheaper local financing could spur domestic consumption, exacerbating import dependency.

For the underdeveloped economies, the impact on current account balances due to monetary policy changes is critical. Countries like Pakistan, which already have persistent trade deficits and borrowing needs, face more significant challenges when interest rates decrease. As the Pakistani rupee depreciates in the aftermath of lower interest rates, importers will have to pay more in local currency for the same volume of imports, potentially worsening the current account deficit further. The current account is an important indicator of an economy's overall external economic health. Pakistan's deficit has already been a concern, with the most recent data indicating a sharp rise in its current account deficit by over 25% in 2024. By 2025, the expected depreciation resulting from a rate cut could lead to further deterioration, with estimates pointing to a widening of the deficit unless supported by export growth or inflows of foreign direct investment (FDI).

Effects of Interest Rate Reduction on Savings Behavior
The impact of interest rate changes on savings behavior is notable. When interest rates fall, the returns on traditional savings instruments (like fixed deposits and government bonds) decline, which can demotivate individuals and businesses from saving. In Pakistan, many households rely on these instruments for income, and lower interest rates reduce the incentive to save money in banks.

The recent cut in interest rates from 13% to 12% is expected to have a more moderate effect on savings in the short run. Historically, Pakistan’s population has tended to hoard savings in cash rather than placing them in formal banking channels, a practice driven by inflationary concerns and a lack of financial literacy. With inflation running high, lower interest rates might not lead to an immediate shift toward higher consumption, as many citizens are likely to retain their savings out of caution.

The general public's view on saving is deeply tied to inflation and the eroding value of money. While a lower interest rate environment may encourage higher consumption in theory, the practical impact on savings in Pakistan may be less pronounced, given the broader socio-economic dynamics of inflation fears and savings habits.

Impact on Public and Foreign Debts
An important consequence of changes in interest rates is the effect on public and foreign debts. Pakistan’s public debt has reached alarming levels, with its external debt alone exceeding $100 billion as of the latest available data. A reduction in interest rates has mixed consequences for countries with heavy borrowing in foreign currencies. On one hand, it lowers the servicing cost of existing debt, making it easier for the government to meet its debt obligations in the short term. On the other hand, a currency depreciation resulting from interest rate cuts means that foreign denominated debt becomes more expensive in local currency terms.

For Pakistan, this policy shift is likely to decrease the domestic cost of government borrowing, as the government may find it cheaper to finance its budget deficit. However, this benefit could be offset by a weaker Pakistani rupee, which would increase the local currency equivalent of external liabilities. Foreign loans, in particular, would become more expensive to service in terms of the rupee, thus threatening the sustainability of the fiscal position.

From an international perspective, the anticipated impacts on the rupee and debt service obligations could dissuade new foreign capital inflows. Any weakness in the rupee – caused by the rate cuts – raises the risk for foreign lenders that their investments could diminish in value. On the other hand, if Pakistan succeeds in maintaining economic stability and inflation control alongside rate cuts, these actions may eventually build investor confidence.

Future Projections: More Rate Cuts?
The recent interest rate cut from 13% to 12% marks a trend towards potentially further easing, with analysts predicting additional rate cuts in the upcoming monetary policy review in the next quarter. There are expectations that the SBP may continue with a cautious easing stance, adjusting rates downward incrementally to balance the need for economic growth without exacerbating inflation.

While analysts project future cuts, the trajectory of these cuts is still a subject of debate. Some experts argue that inflationary risks and an already vulnerable balance of payments might lead the SBP to move cautiously. Others suggest that continued rate cuts are necessary to stimulate growth amidst global economic challenges.

Changes in interest rates have wide-reaching implications for Pakistan’s economy, affecting everything from the stock market to foreign debts and current accounts. The reduction of the SBP policy rate by 100 basis points to 12% reflects a balancing act between stimulating economic growth and mitigating inflationary pressures. While this rate cut is expected to improve stock market sentiment and reduce debt servicing costs, the challenges of a widening current account deficit and currency depreciation remain a concern for underdeveloped countries like Pakistan. As anticipate future monetary policy actions by the SBP, all eyes are on the delicate balance the central bank must maintain between fostering economic growth and safeguarding macroeconomic stability. The trajectory of interest rates, particularly in response to inflation and the state of the external account, will continue to shape Pakistan’s financial landscape in the coming months.