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Reforming foreign exchange regime – I

It would be difficult to find another law that could rival the pervasive effect on the economy of Pakistan as did the Protection of Economic Reforms Act 1992. It was an unprecedented law, giving an over-riding effect to its provisions over all other laws. It is not uncommon in legislative practice to use exclusivity clause for a given or some provisions of a law but quite unusual to have such an over-riding effect across the board. The objectives stated in the preamble included (a) promoting a liberal environment for investment and savings; (b) reforms undertaken and are under way for this purpose; and (c) giving legal protection to these reforms to create confidence about establishment and continuity of liberal economic environment.

The law defined ‘economic reforms’ as economic policies and programmes, laws and regulations announced, promulgated or implemented by the government on and after the seventh day of November, 1990, relating to privatisation of public sector enterprises, and nationalised banks, promotion of savings and investments, introduction of, fiscal incentives for industrialization and deregulation of investment, banking, finance, exchange and payments systems and holding and transfer of currencies.

The most far-reaching provisions of the law were given in Section-4 & 5. First, we consider Section-4, which says: All citizens of Pakistan resident in Pakistan or outside Pakistan and all other persons shall be entitled and free to bring, hold, sell, transfer and takeout foreign exchange within or out of Pakistan in any form and shall not be required to make a foreign currency declaration at any stage nor shall anyone be questioned in regard to the same. Second, on the other hand, Section-5(1) says: All citizens of Pakistan resident in Pakistan or outside Pakistan who hold foreign currency accounts in Pakistan, and all other persons who hold such accounts, shall continue to enjoy immunity against any enquiry from the Income Tax Department or any other taxation authority as to the source of financing of the foreign currency accounts.

Taken together, these two provisions have engendered a host of distortions in the forex regime of Pakistan. The law brought an open-ended liberalization of the forex market, which previously was one of the most regulated markets in the country. In any developing country, the forex market was one whose business and conduct was heavily guarded by central banks from speculators, smugglers and money remitters (hundi, hawala). In fact, at the time we had not even reached the stage to allow current account convertibility (making rupee convertible into any foreign currency for the purpose of trade in goods and services), whereas the law implicitly made the capital account convertible, and that too outside the jurisdiction of the central bank.

Let us now discuss the wrongs introduced by the law in the forex regime in the country. A plain reading of the text betrays an abhorrence toward regulation of economic activities irrespective of their type, motive, origin and purpose. Even in the most developed countries, travellers are required to make a declaration regarding cash being carried across the borders. In developing countries, where there is an acute shortage of foreign exchange, it was quite a shocker to allow complete freedom of owning, holding, selling, buying foreign exchange and taking in and out of the country without any limit. This freedom tantamount to allowing residents also to own forex and do whatever they wanted with such forex holdings. It was but natural that the law encouraged residents to convert their rupee savings in dollars to hedge against devaluation and hence a process of dollarization – a term never heard of before – was triggered. This was like creating an environment where the country no longer faces a forex constraint. In fact, it goes even beyond, for it prevents other agencies to inquire into the affairs of the holders of the forex in or outside the FCAs.

Unfortunately, this was the time when the forex regime was highly restricted, and prior to this law, a standing scheme of allowing foreign currency accounts (FCAs) was in vogue, essentially to facilitate non-residents and to help generate some forex also. The said scheme was such that banks would surrender their deposits to SBP, which would guarantee future availability on demand, absorbing the devaluation risk in the process. The new law allowed residents to open an FCA with vast unfettered freedom as noted above. The ensuing wave of dollarization made the FCAs the most cherished investment in the country. In 1998, these deposits stood at a staggering level of $ 11 billion (while our reserves were only a fraction of this level), overwhelmingly accrued since after the law was enacted.

The nuclear tests conducted in May 1998 created panic among the economic managers and they ended up freezing these consecrated deposits, leaving in its wake a legacy that continues to haunt this country. Curiously, the provisions of the law that had provided numerous assurances against such an eventuality were of no use. Section-10 of the law says: All financial obligations incurred, including those under any instrument, or any financial and contractual commitment made by or on behalf of the government shall continue to remain in force, and shall not be altered to the disadvantage of the beneficiaries. But this was not helpful.

Let us also explain how the law amounted to implicitly allowing capital account convertibility. The FCAs were open for both residents and non-residents, and deposits in the accounts could be made both from inward remittance as well as from local sources. This clearly meant that a resident having local rupee funds can convert them into dollars, eg, and then remit them abroad. This is what happens under capital account convertibility. A proliferation of money changers made it easy for residents to purchase forex from the market whenever they so desire. Before the freezing debacle, it was an amusing sight that in the well reputed foreign banks, which spearheaded the dollarization process, reps of money changers were readily available within their premises to provide the forex which was then deposited in the FCAs. With such a flagrant distortion in the forex regime, no rocket science was needed to predict that the process would end in disaster.

Waqar Masood Khan, "Reforming foreign exchange regime – I," Business Recorder. 2018-03-07.
Keywords: Economics , Economic reforms , Liberal environment , Law implicitly , Freedom tantamount , Contractual commitment , Foreign banks , FCA