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Banking on exchange rate

According to the IMF, rupee is overvalued by 5 to 20 percent – depending upon the estimation methods. Data from State Bank of Pakistan (SBP) also confirm that Real Effective Exchange Rate (REER) for rupee appreciated by 23 percent between 2010 to early 2016. SBP will be announcing its new policy soon and it is high time to remind SBP that it must consider steps to keep already overvalued rupee strengthening further and to restore its actual value. Presently, ensuring fair exchange rate for rupee seems to be a forgotten objective of monetary policy in Pakistan. “Stronger rupee” policy may sound good politically but it falsely signals improved economic conditions. It erodes international competitiveness and woes of exports worsen in particular. The case for substantial but gradual decrease in the value of rupee is therefore overwhelming.

A look into the risks identified by SBP in its monetary policy of 31st July, 2016 clearly highlights that, of the two, current account deficit is significantly related to the overvalued rupee. Particularly, trade deficit driven part of it. Overvalued rupee discourages exports and encourages imports. Starting in about 2003-04, the decline in exports is showing no signs of ease. Exports dropped by 10.3% in September 2016 when compared with the same month in 2015. In the first quarter of fiscal year 2016-17, exports nosedived by an amount of $4.7 billion. On the other hand, imports registered a surge of 10.7% to $11.7 billion in the same period leading to a trade deficit of $7.1 billion in the first quarter of ongoing fiscal year. The deficit is higher by 29% when compared with the first quarter of FY 2015-16.

The government blames fall in commodity prices as primary reason for declining exports. Additionally, narrow export base, low value-addition, higher costs of doing business are some of the reasons highlighted in debates on media and seminars. But the role of real exchange rate appreciation seems missing in mainstream debates. Particularly, government seems unthinking of this. It is interesting to note that the latest episode of declining exports and increasing imports coincides with rupee appreciation. Pakistan’s exports fall by 27 percent “between” January 2014 to September 2016, while during the same period, PKR appreciated against the USD by 9 percent (nominal) and 23 percent [REER].

Along with other factors, historically lower inflation in major trading partners, contributed to REER appreciation of rupee by 23 percent between 2010 to January 2016. A sharp rise in the foreign exchange reserves and capital inflows added further to overvaluation of rupee. In this context, monetary policy decisions can have serious implications. Put simply, contraction appreciates while expansion depreciates the domestic currency.

Obviously, SBP seems reluctant in cutting the policy rate further down for couple of reasons. At one hand, it is not bringing the required pick up in investment and spendings while it has resulted in low cost excessive public borrowing on the other hand. The government borrowings from commercial banks has increased from Rs 1526.3 billion in fiscal Year 2014-15 to Rs 1.152 trillion in fiscal year 2015-16 to finance the budget deficit. Let’s not forget, however, that raising the policy rate may discourage excessive public borrowing but at the cost of further appreciation of rupee. This will further squeeze the international competitiveness.

Not only the overvalued currency creates false sense of “optimism” about the economic conditions of the country but also it causes “misallocation” of resources through wrong price signalling. Adjusting the rupee to its actual value is mandatory not only to regain lost competitiveness but also for effectual economic policy formulation. Many examples exist. China and Japan outright devalued their currencies to fight the ills of global financial crisis while many others including but not limited to India, Turkey and South Africa have ensured depreciation. But Pakistani rupee was not allowed to depreciate. Incumbent government defends strong rupee and presents it as an achievement.

It is obligation of SBP to maintain rupee’s fair value and it has room for policy discretion to correct the exchange rate for rupee through direct and indirect controls. For example, loose monetary policy by SBP can help restore the value of rupee indirectly. Proponents of no-cut in interest rate argue that Pakistan already has the lowest rate in South Asia. It will be, however, interesting to see the trend of interest rate in all these countries. For example, India lowered its repurchase rate by 25 base points in its last monetary policy.

It will not come as a surprise if government defends the overvalued rupee. Faced with the trade-off between “purchasing power” based “political gains” or “competiveness”, governments are inclined to pick the former. In this situation, custodian of monetary policy has to play a crucial role in adjusting the domestic currency to its fair value. For SBP, it means a real depreciation of rupee by 5-20%. SBP has couple of options here. First and foremost, lowering the interest rate – the expansionary policy – as it depreciates the rupee. Second, at least keeping the status quo at 5.75 percent as raising policy rate will further appreciate the rupee. Along with other effects, increased competitiveness, following the depreciation, can provide growth enhancing boost to the economy.

Defence of overvaluation can come here in the name of debt burden impact of depreciation and lower sensitivity of exports to exchange rate. Both the arguments can be challenged. Firstly, depreciation may increase debt burden in the short run but the gains from it in the long run outweigh these costs. Also, the impact is limited to debt denominated in foreign currency which is about 31% of the total debt of Pakistan. Secondly, no matter how low export sensitivity to exchange rates is, depreciation narrows the trade deficit two-fold namely 1) encouraging exports and 2) discouraging imports. Thirdly, given the nature of exports of Pakistan, appreciation of rupee heavily affects their competitiveness. Finally, the call is not for undervaluing the rupee per se, it is simply to bring it to its actual value or closer to it, at least. The long run gains from depreciation outweigh the cost associated with it.

At the same time, SBP must ensure that government observes fiscal discipline. Excessive domestic borrowing by government needs to be discouraged otherwise it may create (or further intensify) liquidity constraints which is already pushing the interest rate upward.SBP should adopt measure other than increasing the policy rate for example setting certain limits as the increase in interest rate will appreciate the rupee further. It must also be ensured that part of public borrowing is not used to accumulate foreign exchange reserves as it hurts the economy threefold. Firstly, it is unproductive use of the debt. Secondly, artificially accumulated reserves further add to trade deficit through increasing imports. Finally, these reserves exert pressure to appreciate rupee further.

It is good news that Global Competitiveness Index of Pakistan improved from 133 in 2013-14 to 126 in 2015-16. At the same time, we need to remember that India is 39th in the list. Also, despite this improvement, exports are falling continuously. Overvalued rupee is one of the major reasons behind this secular decline of exports. It is in this context that, SBP must conduct monetary policy ensuring a fair exchange rate for rupee. The choice of the tools remains with the bank including direct and indirect measures. But the question remains: Is SBP thinking to bank on exchange rate? Presently, the answer to the question seems to be a “no”.

Sajid Amin Javed, "Banking on exchange rate," Business Recorder. 2016-10-30.
Keywords: Economics , Monetary policy , Import credit , Public welfare , International economic integration , Foreign exchange reserves , REER , PKR , SBP , USD