EDITORIAL: The PKR has appreciated by a little over 4 percent in the last two months. The currency parity currently is hovering around 160-161. The currency was bound to bounce back, as fundamentally based on valuation methods the currency was undervalued. Since the sentiments were negative earlier for emerging economies, like many other currencies, PKR moved south as well. There was a case of portfolio outflows from developing to developed economies. The newly-opened avenues of debt portfolio (hot money) moved out quicker than it came in. There are various methods to value currency; but in simple words, in short-term sentiments (based on market flows) determine the direction of the currency. In the medium to long term, the current account balance is a prime driver of the currency. The sentiments are currently positive in Pakistan and seeing the mood of the investors, currency may further appreciate.
For longer view a close eye on the current account is imperative. As long as the current account deficit is manageable, the currency is in a good shape. The manageable current account deficit is what can be financed through the market-based and expected other foreign inflows. In an economy like Pakistan’s, certainly a deficit of 6 percent of GDP (as was the case in FY18) should raise alarm. However, a deficit of around 2 percent of GDP can be comfortably financed. In the recent past, current account is in surplus for four out of five months. The persistently high remittances along with buildup of reserves due to current account surplus and mainly financing from multilaterals changed the sentiments. This along with USD depreciation against many currencies in the last month or so became the reasons for currency appreciation in Pakistan.
The question is where would the currency stand in months to come? Nobody can say the exact numbers as it would be anybody’s guess. Any form of valuation is indicative and the real value is determined by the market. The currency in Pakistan since last year is market based. The flexible market-based exchange rate is a landmark achievement of State Bank of Pakistan (SBP). The realization is slowly seeping in as the participants are still living in the hangover of fixed exchange rate regime. The International Monetary Fund’s (IMF’s) broad methodology is to look at three methods to value currency. One is based on current account, the other is on financial and capital accounts flows. The third method is to look at the real effective exchange rate (REER). Based on current account and REER currency was bound to appreciate and it did.
Some say that the currency should be pegged to the REER at 100 ‘so-called’ equilibrium level. Back in 2017, when the REER was 120 plus, it was expected to depreciate, and the movement in 2018-19 is known to all. Now the REER is standing at 91.69. Based on this, some argue that currency to appreciate to reach the level of 100. The important element to understand is that REER at 100 is based on indexation in a certain year. Any changes in the weights of the trading partners or other variables are not fully reflected in the REER. Plus, there are multiple methods to compute REER. That is why REER is an indicative measure; it cannot be followed religiously.
The other factor needs to understand is the currency cannot be pegged to one indictor (such as REER) in a flexible market-based exchange rate. Demand-supply reality in any market determines the price. So is the case of exchange rate. The example can better be illustrated by looking at valuation and market price of any scrip in stock market. There are multiple ways of valuating a company and the fair price is evaluated. The valuation changes with movement in interest rates and all. But the market prices in the short run is mostly based on sentiments while the prices usually converge to the fair value. The currency market is a bit different. Some economies have fixed peg to USD and others have varying buffers. Pakistan is in a process of transiting from fixed exchange rate to market based. But since the market is thin in volume and any shock/surprise can move the market considerably. For that the central bank’s stated objective is to carefully monitor the flows and intervene to curb volatility. That is the key to understand. SBP may not like the currency to appreciate too much or in worse times not to depreciate too much. High volatility is not good. The same argument holds true for interest rates. Interest rates moved between 6 percent and 15 percent in the last decade or so. Recently, the rates moved up from 6 percent to 13.25 percent and came down to 7 percent within three years. SBP is therefore required to look for a stable interest rate policy and that is imperative for having a stable or less volatile exchange rate.
Copyright Business Recorder, 2020
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