Pakistan's central bank cut its policy rate by 50 basis points to 9.0 percent, its first rate cut this year, saying it was placing "a higher weight on declining inflation and low private sector credit relative to the risks to the balance of payments position."
The State Bank of Pakistan (SBP) - which at its two previous board meetings in April held rates steady to ensure a competitive return on rupee denominated assets and thus an inflow of needed capital - said there had been a noticeable change in sentiment following the recent political elections and a decline in inflation had helped increase the relative return on domestic assets.
"If the economy is to reap the benefits of evolving positive sentiments and lure the domestic as well as foreign investors, then implementation of a reform oriented and credible medium term fiscal outlook is essential," the SBP said.
But the central bank stressed that the absence of foreign financial inflows and high fiscal borrowing remained "formidable economic challenges, especially for monetary policy," while power shortages and security concerns remained strong impediments to growth.
But the continuous decline in inflation along with moderate aggregate demand has improved the outlook for inflation, and without a cut in the policy rate, real interest rates would have risen and not helped support private investment, the SBP said.
Pakistan's headline inflation rate fell to 5.13 percent in May, continuing the declining trend since hitting 12.3 percent in May 2012, reaching its lowest level since October 2009.
For fiscal 2013, which ends June 30, the SBP expects inflation to be at least two percentage points below its target of 9.5 percent. Last year the SBP cut policy rates by 250 basis points.
A planned one percentage point increase in general sales taxes by the government and possible higher electricity tariffs pose a risk of inflation exceeding the SBP's 8 percent inflation target for fiscal 2014, but the central bank said demand is expected to remain moderate, dampening inflation.
Pakistan's economy continues to be plagued by energy shortages and concern over basic security, with the estimate for Gross Domestic Product in fiscal 2012/13 at 3.6 percent, below the target of 4.3 percent as investments continue to decline.
Despite the improving sentiment following the election of Nawaz Sharif as prime minister, the central bank said it had not changed its assessment of the balance of payments position. While the current account deficit remain manageable, around 1.0 percent of GDP this year, the real challenge remains the lack of financial inflows.
In the first 11 months of the 2012/13 fiscal year, there has been a net capital outflow of $413 million.
"Add this to the ongoing payments of IMF loans and it becomes clear that the pressure on foreign exchange reserves has not abated," the SBP said.
As of June 14, the central bank's foreign exchange reserves were $6.2 billion, down from $6.7 billion as of April 5 and $8.7 billion at the end of January.