Since the beginning of March’20, Pakistan’s economy witnessed three economic disturbances and one expected policy revision: a) net outflow of US$ 1.3 billion from treasury bills (dubbed as ‘hot money’) out of the total inflow of US$ 3.43 billion inflow of this type during FY20, a reduction of nearly 38 percent in 3 weeks; b) currency depreciation by 2.6 percent during the same period; c) meltdown in the stock market in line with the meltdown in world markets; and d) a 75 basis points cut in policy rate. The trigger for the three disturbances (a) to (c) above is the corona pandemic and for (d) is the falling inflation recorded in Feb’20. Given a single data point regarding the ‘pandemic shock’ it is risky to convincingly establish correlation leave alone causality between expected downward revision of interest rates and the other three disturbances but a stylistic analysis can be undertaken to understand the role of falling interest rates on outflow of ‘hot money’, depreciation of the currency and stock market carnage.

In case of a) above, the foreign investors, for example, those who invested in Dec’19 @ of PKR154/US$ and redeemed 3-month Treasury Bills (TBs) @ PKR158/US$, in March’20 will roughly earn between 3.0-0.7 percent from a 3-month TB against an almost zero elsewhere in the world. So the reduction in rupee denominated domestic debt came at the cost of depreciation of the rupee. The corona pandemic (demand for safe haven US$ shooting-up) and expected beginning of downward cycle of interest rates domestically are the main reasons for this quantitative outflow. The domestic stock market meltdown is an additional reason, including the above two for the extent of depreciation of the rupee as it was reinforced by domestic cash moving from crashing stock market to seeking safe haven in US$. In normal times, stock markets respond positively to cut in interest rates as interest costs come down and expected corporate profits move up. Correspondingly cash/savings move from stable foreign currency to stocks in search of quick and dirty returns. In the following discussion, it is useful to be aware that a) to c) are still being played out due to differentials in intensity and peak times of pandemic across countries including Pakistan. However, since we are interested in the impact of interest rates on a) to c) indicators, its impact may have stabilised in the first round namely in the first 3 weeks of March’20 and the impact of second round of cuts in interest rates will appear in these indicators from the fourth week of March’20.

How much each of the above three reasons contributed to the above outflow and extent of rupee depreciation in the first 3 weeks of March’20 is any body’s guess. Was it a) equally shared? Or b) 75% due to pandemic and 25% due to interest rate cut or c) vice versa?. Given the turmoil witnessed in the international financial system, it is reasonable to assume possibility b) above, for the impact of falling interest rate. Assuming that in coming months no more foreign money is invested in TBs, outflow from Pakistan due to pandemic has bottomed out and expected initiation of a consistent downward cycle of interest rates of 75-100 basis points every two months by SBP, a simple straight line extrapolation of just recent data point evidence reveals that an additional 500 basis points decline in policy interest rate would trigger the outflow of the remaining hot money. Of course, bringing down inflation in the range of 5-7 percent in the immediate future will be manna from heaven, but in normal circumstances may be possible in the next 10-12 months. Sensitivity analysis of the decline in interest rates and its timing required to speed/slow the outflow of hot money under normal circumstances can be assessed by varying the above assumed outflow percentage contributed by the decline in interest rate.

Stylistically quantifying the impact of downward cycle of interest rates on PKR/US$ parity is far riskier and is influenced by many more unknowns than in the case of quantitative outflows. Expected behaviour of current account deficit, foreign currency debt liabilities, multilateral/bilateral inflows, performance of stock market and frictionless functioning of the exchange market are just few of the unknowns. Based on the above assumed contribution of falling interest rate of 25 percent in total outflows in the first three weeks of March, single data point evidence and ‘business as usual’ in the external sector, a 100 basis point decline in interest rate will push up the rupee parity rate by 0.85 percent. An important caveat in the above calculation is that if the stock market resumes its upward march, the above impact of falling interest rate on exchange rate depreciation may be over-stated, as funds in Pakistan may move out (it is not happening in other countries yet in spite of bringing policy rate to zero) from US $ to speculation in the stock market.

Thus for policymakers and politicians there are two policy decisions on the table. The first one is the trade-off between two evils: Faster depreciation of the currency as a result of aggressive and speedier downward cycle of interest rates versus maintaining a gradual CPI synchronized downward movement in interest rates. For the former policy decision, the evidence is that since last one and half year significant depreciation of the currency and previous cycle of low interest rates (in PML-N government) including subsidized export financing facility and LTFF has not paid off in terms of either significant increase in exports or investment in export oriented manufacturing, except speculation in real estate, construction, transportation, speculative imports and wholesale and retail activity leading to non-sustainable and inclusive “GDP growth exuberance”. No doubt there are benefits in terms of reduction in rupee denominated domestic debt to the tune of Rs.350 billion and expected domestic debt servicing costs, but these are marginal given the size of our debt in trillions. These benefits may be outweighed by a second round of inflation fuelled by increase in $ denominated energy prices and thereby increase in circular debt as well as rupee servicing costs of foreign debt. The real issues holding growth are high energy costs, uncertainty in limping documentation of the economy, backlog of sales tax refunds to exporters and domestic supply constraints rather than interest rates.

The second policy dilemma is the policy mix to cushion the economy from corona shock. Given that it is a temporary but an intense shock, should the policymakers adopt targeted, tailor-made and time-bound interventions (not policies) or tinker with macro policies which impact in the medium to long-run on the decisions of economic agents to allocate resources for e.g., in case of interest rates between current consumption and consumption-oriented investment in our heavily populated and undocumented economy. Lack of high frequency macro data and micro data for the targeted groups and sectors in most cases risks ‘poor, political and vested interests’ targeting thus softening their ultimate impacts. Unfortunately most impacts are never monitored, documented and in exceptional cases, ‘lessons learnt’ are presented to the higher authorities to serve vested interests. The plethora of targeted interventions suggested by various ministries and SBP in the last few days for soft landing amidst corona shock should serve well if they are evidence based and implemented effectively and efficiently rather than to drastically change the monetary and fiscal policy mix and put the sustainable growth path at risk for short-term populism.