March 28, 2025
Image The Financial Daily
Pakistan Crushes Inflation
In February 2025 Pakistan’s inflation over the prior year came in at less than 2%. This has been a dramatic turnaround from 2023 when inflation peaked at over 30%. Meanwhile, the current account has been in balance, meaning that the country is taking in as many dollars as it is sending out to purchase imports. Exports have been rising, and the economy is finally starting to show signs of growth. Vehicle sales reached a 2.5 year high in January, and car sales are projected to reach 160,000 in 2025. This would still not be as high as the late 2010’s but the trend is now in the right direction.
In addition to car sales, the market for solar panels took off in 2024, with 17 gigawatts of panels imported by consumers from China. Solar power is now incredibly cheap, and in a sunny climate like Pakistan can provide power for large portions of the day. The new solar panels added about 33% to Pakistan’s electric grid capacity.
While the panels are great for consumers, they have created headaches for the large scale power sector. Pakistan in the 1990’s and early 2000’s was short of electricity, and in order to attract foreign investment by private investors (so-called IPP’s), they had to offer very favorable terms. Basically, the investors were guaranteed payment in dollars and were paid for the capacity of electricity they could generate, regardless of whether that capacity was being used. With recent bad economic times, electricity demand was much lower than the capacity, forcing the government to pay the IPPs billions of dollars for sitting idle. These costs were passed on to consumers, forcing Pakistanis to pay much higher rates for electricity than in India or Bangladesh. With more consumers switching their daytime power demand to solar they own, this capacity issue is going to be made worse. The IPP agreements were written with 30- or 40-year guarantees, so Pakistan is on the hook for many years to come. The only way out is for there to be rapid economic growth that drives electric power consumption much higher and will allow the IPPs to run their plants and sell power at a lower price.
How did Pakistan whip inflation? The answer is quite simple and basic economics. The State Bank of Pakistan raised interest rates high enough to force the economy into a downturn that reduced demand and brought inflation down. It had to raise interest rates to over 20% (compare that to the 4.5% rate the US Federal Reserve currently has). As inflation dropped over the last year, the SBP has been able to bring interest rates down. But they are still rather high at 12%, and if one looks at the real rate interest (subtracting out inflation), the interest rate is still quite high and has a very large room to come down more. Expect the SBP to continue to cutting rates this year, perhaps as low as 8%.
As interest rates come down, economic activity will pick up. Lower rates mean consumers can afford more large ticket purchases such as appliances, motorcycles, and autos. Lower rates also mean that businesses can finance investments and make profits where before they couldn’t due to the high interest bills any new project would face.
The government has done a good job of macroeconomic management and much of the credit goes to the Finance Minister Muhammad Aurangzeb. He used to be CEO of Habib Bank, so he has a much better understanding of the economy than the hapless Ishaq Dar who had no idea how to deal with inflation. The political economy of Pakistan appears to be that the army will let the PML-N stay in power as long as they let qualified technocrats run the most important ministries, particularly Finance. Democracy is at best “managed”, as most observers believe that the PTI easily won the last election. Whether this arrangement will last for a decade or longer is an open question, but if the economy is growing rapidly, the population will likely go along.
The government needs to do several things to accelerate and maintain Pakistan’s GDP growth rate to 6-7% per year. Privatizing loss-making government owned entities must be a priority. PIA is an obvious example of why the government should not be running a business. The country would be better off if the government sold PIA to a qualified entity for 1 rupee. In general, there is no reason for the government to be running businesses. Businesses should be in ruthless competition with each other. They are not supposed to be overstaffed with patronage jobs paid for by taxpayers. If PIA cannot make it on its own, let private airlines provide air travel to Pakistanis. It’s just not the government’s responsibility.
A second priority is to make sure the exchange rate is not allowed to become overvalued. Right now it appears that the SBP is tightly controlling the exchange rate and keeping it at 280 rupees to the dollar. Pakistan would be better off with a truly floating exchange rate, where the value of the rupee is set by market forces. But if the government is intent on fixing the exchange rate, it needs to adjust it periodically to reflect fair value. The problem with an overvalued exchange rate is that it encourages imports and hurts exporters by making Pakistani goods more expensive than they should be in dollar terms.
Thirdly, the education system in Pakistan needs dramatic investments. At all levels from primary to university level the system needs expanding. There needs to be 100% universal enrollment in primary education, and as many as possible of those children should go on to secondary school. Pakistan must also dramatically increase the number of young people attending university. Educating the workforce is one of the easiest ways to grow the economy because it increases the value of labor.
Finally, Pakistan needs to aggressively court foreign investors to set up production in Pakistan. Doing that will help raise Pakistan’s exports. It will also allow for transfer of technology and know-how to Pakistanis that will allow more indigenous economic growth.
Pakistan can reach the status of lower end developed country in 25 years if it can sustain 7% growth. This is achievable, but it requires good economic management for a generation. Political stability is a must along with the defeat of the TTP (Pakistani Taliban) terror group that has set up safe havens in Afghanistan.
