Nov. 25 (Bloomberg) -- Pakistan’s central bank cut its benchmark interest rate for a third time this year to aid an economy dragged down by war.

State Bank of Pakistan lowered its discount rate to 12.5 percent from 13 percent, according to a statement in Karachi yesterday. The central bank was forecast to reduce borrowing costs by 11 of 12 economists in a Bloomberg News survey.

Pakistan’s campaign against Taliban militants is costing the government more than $8.5 billion a year and has prompted a spate of terror attacks in the Punjab region, which generates more than half of the country’s economic growth. The “risk and uncertainty has increased considerably,” prompting the central bank to “keep a very close watch” according to the statement.

“Sustained improvement in the economy depends on the political situation turning around and on a major easing of security concerns,” said Kevin Grice, an economist at Capital Economics Ltd. in London. “Pakistan’s problems are too intractable to expect a major improvement in these areas any time soon.”

Pakistan is relying on aid pledged by foreign donors to help boost growth in an economy pummeled by the global recession, the war against Taliban insurgents and what the Asian Development Bank describes as a “lingering power crisis.”

“This reduction was already priced into the stock market but will surely help companies reduce their financial costs,” said Habib-ur-Rahman, who oversees the equivalent of $50 million in stocks and bonds at Atlas Asset Management Ltd. in Karachi. The benchmark stock index, which has climbed 57 percent this year, rose 0.5 percent to 9,277.18 as of 9:32 a.m. The rupee, which has fallen 5.1 percent since Jan.1, rose 0.4 percent to 83.16 against U.S. dollar at 9:30 a.m.

IMF Rescue

The International Monetary Fund on Aug. 8 agreed to increase a loan to Pakistan by $3.2 billion, after the country was forced to turn to the Washington-based lender for a $7.6 billion bailout in November 2008. The U.S. Senate on Sept. 24 voted to triple annual economic and social-development assistance to Pakistan to $1.5 billion for the next five years.

Pakistan turned to the IMF for a rescue package to avoid defaulting on its debt, after the country’s foreign-exchange reserves shrunk 75 percent in a year to $3.5 billion and the current-account deficit widened to a record.

The government’s 12 percent local-currency bond maturing in August 2018 yielded 12.43 percent today, versus a record high of 16.68 percent on Dec. 16, 2008, according to data compiled by Bloomberg.

Long-Term Ratings

The nation’s long-term sovereign debt rating was raised to B- from CCC+ in August by Standard & Poor’s Corp. Moody’s Investors Service, which lifted Pakistan’s credit-rating outlook to stable from negative the same month, rates the foreign debt at B3. Both ratings are six levels below investment grade.

South Asia’s second-largest economy has “stabilized” as a result of inflows from the IMF program, though the outlook remains “especially uncertain,” according to Grice from Capital Economics. “The best that can be hoped for is a weak recovery,” he said.

Gross domestic product may expand 3 percent in the year through June 2010, “not much better” than the 2 percent growth of the previous 12 months, Grice said.

Lower interest rates may encourage consumers to borrow and spend more, leading to higher sales for companies like Unilever Pakistan Ltd., the nation’s biggest maker of consumer goods, and Pak Suzuki Motors, the country’s largest car manufacturer.

Demand Improvement

“The decline in interest rates will improve demand, said Asif Qureshi, head of research at Invisor Securities Ltd. in Karachi. “We have already stared to see an impact on car sales and with further cut today it is expected to improve.”

Car sales in Pakistan began rising in July, after declining for 18 consecutive months, according to the Karachi- based Pakistan Automotive Manufacturers Association.

Pakistan’s central bank has been able to reduce interest rates due to slowing inflation.

Consumer prices rose 8.87 percent in October from a year earlier, according to the statistics bureau. That was the smallest increase in 22 months.

“The poor administration in the supply chain of some food items is not helpful in positively altering inflation expectations,” the central bank said in today’s statement. Higher gas and electricity tariffs and a recent resurgence in global commodity prices are also “sources of uncertainty” for the inflation outlook, it said.

Governor Salim Raza, who has been running the central bank since January, on Sept. 29 kept borrowing costs unchanged, after slashing interest rates from a record high of 15 percent earlier in the year.

Economic Expansion

The ADB in August reduced its forecast for Pakistan’s economic expansion in the year to June 2010 to 3 percent and said a revival of growth would require an improvement in the nation’s security environment. The central bank in its Oct. 29 annual report said the economy is showing a “gradual recovery” and is likely to meet the growth target of 3.3 percent.

Yesterday’s rate cut may be the central bank’s last move for some time, according to analysts.

“After this week, we then expect policy rates to stay on prolonged hold far into 2010,” said Grice from Capital Economics. “This is because inflation is likely to bottom out soon in Pakistan even though we anticipate only a weak economic recovery.”

To contact the reporter on this story: Farhan Sharif in Karachi at Fsharif2@bloomberg.net

Last Updated: November 24, 2009 23:36 EST