On Mo-nday, the Gove-rnor of SBP, Dr Reza Baqir, held his first press conference and covered a range of issues related to monetary and exchange rate policies as well as the IMF Programme. Since the staff level agreement with the Fund, this was the first occasion when a key member of the economic team addressed matters that have been agitating the minds of the markets, investors and people.
For us, there have been at least four takeaways from the press conference. First, a clarification was given that the country has not adopted a free-floating exchange rate. In its place, the concept market-based exchange rate policy was elaborated. Second, the recent volatility in the exchange rate was the result of seasonable movements in the flow of remittances and that it has now smoothed out. Third, with respect to the monetary policy, it was explained that SBP monetary policy committee has decided, for the first time, to adopt a forward looking stance to counter the threat of inflation. This means that unless the inflation goes beyond the predicted level, the policy rate would not require any further adjustment. Third, he exchange rate. Fourth prior actions have been completed.
Let us explain the significance of the above messages. The clarification regarding the nature of exchange rate regime should lead to removal of market's misgivings about the floating exchange rate which was viewed as great source of market volatility and uncertainty. The free-floating exchange rate regime was hotly debated since the time it became known that the IMF was strongly advocating such a regime as part of its conditionality for the new programme. This is a regime that prevails in those countries who are not facing foreign exchange constraints and their currencies are powerful enough to be used in global trading or act as reserve countries, freely convertible to other currencies. In a developing country's context a central bank cannot sit idle when currency movements witness major volatility. The cost of frequent and unpredictable changes in the exchange market is prohibitive. The removal of this doubt by none other than the governor is a very positive development. He has further clarified that the exchange rate would be market based, not market-determined, giving full role to market conditions yet keeping a window ajar for SBP to intervene when it considers that market may have been affected by non-economic factors. The stability in the forex market would therefore remain a goal of the central bank.
The governor was not entirely convincing when he alluded to a hike in remittances as the reason for relative appreciation of the rupee during the days leading up to Eid holidays and subsequent slowdown when, soon after Eid, there was a steep depreciation. It would be useful to let the people know that there are targets in the programme that envisage that SBP would also be a purchaser of dollars from the inter-bank market. In principle, the market has been set for this very purpose. But in the past SBP was never hesitant in using reserves and foreign borrowings for supporting the local currency. This is waste of resources and their misallocation, particularly when have been passing through a difficult economic time. To the extent a given 'net foreign assets' target has to be met, there's no room for the SBP to play a supportive role as it would not have the necessary buffers. Indeed, it would be a net-purchaser to the extent of meeting the target and beyond that if it finds opportunities to build buffers, so that it can play a stabilizing role as well, it should seize such opportunities. Let it be plain that when SBP is making purchases, there would be pressure in the market and exchange rate would be vulnerable.
On the policy rate, the governor has clarified that the SBP is giving due weight to future outlook of inflation and in case there is more inflation in store; they would act to fight it today than to react after its occurrence. This is an aggressive policy and there is no settled theoretical basis to answer this question. The issue is inflation forecast and selection of a given index (headline, average or core inflation) would be matters of judgement rather than science. There is also the question of whether this strategy works only under a rising inflation scenario or would be equally applicable when inflation is falling. Finally, there is the question of the optimal size of real interest rate that one would like to target. Presently, with respect to headline inflation of 9.2% and policy rate of 12.25%, the real interest rate is more than 3%, which is very high and is a leading source of skyrocketing debt servicing payments in domestic debt and contributing to low investment demand.
The most important piece of information the governor shared is the completion of all prior actions for the Fund programme. He also mentioned that the Fund Board is likely to approve the programme on 3rd July 2019. The prior actions from the SBP were basically two: exchange rate and policy rate. We may be reasonably sure that these two variables would remain stable at least for the next quarter when the programme implementation results would be out and need for further fine-tuning would be in order.
The press conference was the first comprehensive exposition of IMF programme and its usefulness in economic stabilization from a senior member of the economic team. More such interactions are needed and should be undertaken at the highest levels. Markets, investors and people all need more information so that they could better appreciate government's predicaments and the time it would take for things to turn around.
The assertion of economic stability is somewhat premature. The 11-month current account (CAD) data should be a cause for concern as the current account deficit remains elevated. With a decline in dollar GDP due to depreciation, the CAD is nearly 5% of GDP, which is only one percentage point decline from 6% last year. Even this decline owes, in significant measure, to increased remittances and not due to a marked correction in the trade account. Imports have declined by 6% but exports have also declined by 2%, not sufficient to make a difference in the CAD. The key to stabilization of external account is fiscal deficit. The government has only given a blueprint (and a good one) of how it plans to do during the next year. The effective reduction in aggregate demand would be realised only when new tax measures and expenditure reduction are implemented and results are in line with the projections. The earliest we would know about this would be when the results of the first quarter are available. Until then a judgement on the state of stability would not be in order.
(The writer is former finance secretary)
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