Exchange rate adjustment: a welcome step

For the past many months, we have been voicing our concerns that a rational exchange rate policy is missing that would address increasingly untenable state of external account. Mercifully, in a bold initiative, the State Bank of Pakistan has finally allowed exchange rate to move in accordance with the market forces. After significant volatility in the exchange rate on Friday, where it ranged between Rs 105.55 and Rs 109.5, and finally closing at Rs 107, the SBP, in a statement, pronounced that the movement was due to market forces, which would henceforth be allowed to work freely. The statement said: “SBP is of the view that this market-driven adjustment in the exchange rate will contain the imbalance in the external account and sustain higher growth trajectory. The exchange rate will continue to reflect the demand and supply conditions; and SBP stands ready to intervene, in case speculative and/or momentary pressures emerge, for smooth functioning of the foreign exchange markets.”

This is a historic development. A statement plainly elucidating a shift in policy stance, in an area where until recently the very thought of change was taboo, is a highly welcome step. The Prime Minister and his economic team both in the Ministry of Finance and at SBP deserve appreciation in doing what should have been done during this fiscal year, if not at the beginning of the year when we began to lose foreign reserves. Doing so at a time when a Fund Mission is undertaking a post-program monitoring review, would go a long well in addressing their concerns about the rising vulnerabilities in the economy.

Many critics would say that the move is more due to Fund’s review rather than a realization of its justification. They would cite the latest monetary policy review where neither a concern was expressed on this account nor a need to this effect was acknowledged. Notwithstanding this criticism, those who know the dynamics and realities of political economy associated with this step, the measure is extraordinary and should spawn positive hopes that it may herald a new era of responsible economic management.

Although laudable, we must be mindful of a number of factors that would test the success of this policy. First, the market would assess the credibility of the policy shift as it works through locating its equilibrium. In the process, there would be overshooting of the rate: exporters would hesitate to book orders in anticipation of further depreciation while importers would advance their orders, creating volatility in the market. The vigilance of the central bank should isolate and punish speculative demand and enable real market forces to work toward the equilibrium.

Second, we should brace for a number of adjustments that would inevitably be ensued in the aftermath of exchange rate adjustment. For instance, inflation, debt servicing and fiscal deficit would rise. Inflation would come through higher rupee values for the same international prices. The most significant channel directly affecting consumers would be through the prices of petroleum products and edible oil. The former would also lead to an increase in energy prices (electricity and gas) in the first-round effects. A sizeable uptick in inflation would signal an end to interest rate stability. By the time of the next monetary policy, this equation would be clear. The rupee value of external debt servicing (interest payments) as well as public sector imports would be higher. However, we may see an upside both in customs and sales tax revenues as their rupee valuations would rise. SBP profits would also rise on account of revaluation gains on its foreign reserves. These things would partly mitigate the adverse impact on the budget. The exchange rate adjustment may also have a salutary effect on remittances.

Third, a key factor that would help achieve the objectives of this policy is the control of public sector imports in general. The success of liberalization depends on the elasticity of import demand and export supplies. While exports would take some time to respond, import demand should respond immediately. Here, the key would be government fiscal deficit. To show some response, government would have to undertake a major cut on spending, particularly those requiring use of foreign exchange. Except CPEC and critical defense needs, no use of foreign exchange should be allowed in the public sector, at least for the current fiscal year. We still have time to conserve demand as more than six months are left in the fiscal year. We would also advise that government should release forex revenues of foreign investors, which were help-up due to scarcity of forex availability. A negative signal of difficulties in repatriation would have destabilizing effect.

Fourth, Ministry of Finance and SBP should undertake a realistic assessment of whether the country would be able to sail through the fiscal year without having to seek the support of IMF. Our worry, as many others have expressed also, is the precarious state of SBP reserves, use of commercial bank reserves and the impending external debt servicing obligations. The successful launch of Euro and Sukuk bonds was hardly sufficient to bridge the gap created during the four months of the current fiscal year. There are no major inflows in the pipeline from the IFIs. The current account deficit is rising and would not immediately reverse its course or slow-down in any meaningful way. It seems, therefore, that the country may be facing a major financing gap before the close of the fiscal year.

Given the fact that we are at the fag-end of this government’s five-year term, seeking a long-term programme from the Fund would be unrealistic. It is entirely possible, however, to contemplate a Stand-By Arrangement (SBA) before we reach a tipping point. In the coming days, the effects of the new policy would begin to unfold. It is not infrequent under such circumstances that agents become uneasy and vulnerable to rumors and panic. Thus, it is imperative for the Government to draw up plans for facing the evolving economic scenario. If its assessment of cash-flows points to an unbridgeable gap, it should not hesitate exploring the possibility of seeking an SBA.

An SBA is a flexible arrangement in terms of its length but would carry a higher cost and shorter repayment duration. For instance, Pakistan did a 9-month SBA in 2000-01 before entering into a three-year program during 2001-2004. However, the shorter the duration the more advanced (prior) would be the actions required. In fact, during 2000-01 SBA, all actions were done up-front. This would be necessary to avert an economic crisis just around the time the government would be completing its terms and going for new elections.