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The rupee under pressure

Pakistan and the IMF have reached a staff level agreement for a $5.3 billion bailout programme. Before this programme is presented to the executive board of the IMF for its approval in early September, Pakistan will have to implement certain prior actions. Two of the prior actions pertain to the State Bank of Pakistan (SBP) – namely, pursuing a flexible exchange rate policy and tightening the monetary policy by raising the discount rate within the range of 100-150 basis points.

While the SBP is likely to tighten monetary policy in August, it has already started implementing the prior action pertaining to exchange rate. The SBP has withdrawn itself from intervening in the foreign exchange market.

The SBP, like other central banks in emerging markets (for example, India), has been intervening in the FX market to create a balance between demand and supply of foreign exchange with a view to maintaining stability in the exchange rate. In the absence of sizeable inflow of foreign exchange and continued payment to meet external debt obligations, the SBP has lost almost $10 billion in its foreign exchange reserves in two years. In order to protect its own foreign exchange reserves, the SBP also borrowed from commercial banks in the forward swap market to the extent of $2.35 billion.

The decline in foreign exchange reserves from $14.776 billion in July 2011 to $5.153 billion by July 19, 2013 on the one hand, and heavy repayment to the IMF and other external creditors, on the other – in addition to financing current account deficit amounting to $2.30 billion in 2012-13 – have forced the government to seek a balance of payments support from the IMF. If there is no programme or a delay in the approval of the programme with the IMF, Pakistan is likely to default in its external debt payment obligations by end-December 2013 with attendant consequences for the economy.

It is against this backdrop that implementing prior actions has assumed critical importance for short-to-medium term economic stability. The SBP has withdrawn itself from the FX market for two reasons. First, it has to implement prior action and second, it has lost the capacity to intervene in the FX market as its effective foreign exchange reserves have fallen to $2.8 billion ($5.153-$2.35). Consequently, Pakistan’s exchange rate depreciated from Rs98.5 per dollar on June 1 to Rs101.4 per dollar on July 26.

The open market exchange rates have reacted violently for several reasons. First, as the news spread that the SBP had withdrawn itself from the FX market, unscrupulous elements – as always – took control of the market by indulging in speculation and hoarding of foreign exchange. Second, the finance minister’s statement that the government is seeking heavy upfront payment from the IMF gave an impression that the government had become desperate to build reserves.

Third, the government’s ill-thought decision to allow the tax authorities to get direct access to bank accounts of individuals has created fear among the people. This has encouraged dollarisation in the country as people are withdrawing their money from banks and buying dollars from the open market. This has created an extra demand for the dollar in the open market. Fourth, the currency dealers have indulged in hoarding of dollars to get higher spread. Fifth, the SBP had taken certain measures as part of the anti-money laundering drive – reportedly. The market, however, believed that the government had become nervous and was taking measures to protect its foreign exchange reserves.

All these factors have contributed to the nervousness in the FX market and provided a field day to corrupt elements to play havoc with the exchange rate. Accordingly, the open market exchange rate moved from Rs100 per dollar to Rs104.7 per dollar. However, the actual trade in open market is taking place at Rs106-107 per dollar. The spread between the inter-bank and open market exchange rate has widened to Rs5-6 per dollar. This is a serious development as the spread normally has been in the range of Rs1-1.5 per dollar.

The widening of the spread will encourage expatriate Pakistanis to remit money through non-banking channels. This will adversely affect the flow of remittances from official banking channels. Any slowdown in remittances will have serious consequences for current account deficit as well. If corrective measures are not taken immediately, the rupee will be at the mercy of unscrupulous, dishonest elements in the FX market.

I would urge the finance minister to take this matter seriously and not leave it to the SBP alone. I would also urge the minister to concentrate exclusively on the economy and not spread himself too thinly on political matters. His performance will, after all, be judged by the performance of the economy.

Invariably, exchange rate depreciation has been an essential part of the conventional macroeconomic policies advocated by the IMF. Empirical evidence suggests that exchange rate depreciation has been associated with deceleration in economic growth, increase in unemployment and poverty, undermining of public sector investment and development strategies, increase in cost of living, worsening of income distribution and shifting of the burden of adjustment to low-income groups.

The G-20 leadership has now moved out of the conventional macroeconomic policies pursued by the IMF. Devaluation in the midst of a depressed global economy will not work. A developing economy like Pakistan cannot increase it exports by changing relative price through devaluation in a recession-hit industrialised economy.

Devaluation increases the cost of imported inputs of export-oriented industries. Hence, the larger the share of imported inputs in total inputs of export-oriented industries, the lesser will be the beneficial effect of devaluation on balance of payments. Furthermore, the experience of the 1990s suggests that the benefits of devaluation have always accrued to importers of Pakistani goods. The importers force Pakistani exporters to reduce the unit price of goods to the extent of devaluation. This fact is known to the current finance minister as well.

On the contrary, devaluation will have a far-reaching adverse impact on Pakistan’s economy. It will increase public debt (one rupee loss in the exchange rate will add Rs60 billion to public debt) and interest payment accordingly, thus eroding fiscal space to undertake development projects. More importantly, it will increase the cost of imported fuel used in power generation. Today, the gap between Nepra-determined tariff and actual tariff stands at Rs6 per unit. The government has earmarked Rs150 billion in the budget to take care of Rs2 per unit and it is supposed to increase power tariff by Rs4 per unit as prior action. All this calculation has gone haywire. The gap between determined and actual tariff must have increased by now. It will contribute to building circular debt once again.

This is serious business and requires the complete attention of the finance minister. I would urge him to take serious notice of what corrupt and unscrupulous elements have done in the FX market. It is clear that the minister is not being briefed properly and that the economic policy is being formulated on an ad hoc basis rather than on sound thinking.

The writer is principal and dean of NUST Business School, Islamabad. Email: ahkhan@nbs.edu.pk

Dr. Ashfaque H Khan, "The rupee under pressure," The News. 2013-07-30.
Keywords: Economics , Economic issues , State Bank-Pakistan , Monetary policy , Economy-Pakistan , Economic policy , Foreign debts , Economic growth , Exchange rate policy , Foreign exchange , Macroeconomic policy , Trade-Pakistan , Unemployment , Poverty , Imports , Banks , Pakistan , IMF , BoP , Nepra