"The exchange rate has been broadly stable in nominal terms, but, due to rising inflation, the real effective exchange rate has appreciated," so observed the IMF in its just-released fourth review on Pakistans economy.
A similar observation with some detailed numbers was published in the central banks third quarterly report released earlier this week.
"The Nominal Effective Exchange Rate (NEER) depreciated by 4.6 percent during Jul-May FY10 compared to 6.4 percent during the same period last year. This depreciation was more than offset by the increase in the Relative Price Index (RPI) that is due to higher domestic inflation compared to trading partner countries. As a result Real Effective Exchange Rate (REER) appreciated by 3.5 percent," the SBP pointed out.
The argument of both parties is based on the famous equilibrium exchange rate theory, which implies that nominal exchange rate against trading partners tends to adjust to its real value over a period of time.
For simplicity of analysis, let us compare Pak rupee with its biggest trading partner i.e. green back - a parity which is considered a benchmark in the domestic currency market.
After remaining stable against the USD since the start of fourth quarter, rupee crossed the psychological barrier of 85 parity mark lately, after a gap of almost three months. The currency has depreciated by 1.6 percent since March 31, 2010.
One may wonder what is driving the rupees slide when international commodity prices are falling and over $1.3 billion pending external receipts for fiscal support from CSF and IMF have been received in recent weeks.
Well, it can partially be explained by higher demand owing to higher oil prices in April and some other payments. But, unlike, previous months, one has to take into account that SBPs intervention in forex markets was also low.
Pakistans BoP position comes under pressure once oil crosses the threshold of $90 per barrel. The central bank has thus far let the currency adjust through dirty float since the current account balance eased due to higher inflows of home remittances and a lower import bill. However, in case there is misalignment either way, SBP would rethink its strategy.
But it does not necessarily mean that SBP will allow an equivalent fall in the rupee against the appreciation in REER, as central banks across the globe also look at External Sustainability and Macroeconomic Balance approaches.
Both these theories, unlike the equilibrium doctrine, analyze the trends of external current account balance and its direction in the near future.
With current account balance likely to remain in the vicinity of 2.2-2.8 percent of GDP (SBPs estimate) in FY10 against earlier estimates of 3.2-3.8 percent and actual 5.6 percent in FY09, an adequate weight ought to be assigned to these theories.
In the aftermath of Euro Zone crises, international food and fuel prices might remain depressed in the short to medium term - something which can check the growth in imports. This coupled with some external aid and other flows, which traditionally come in the last weeks of fiscal year, may further improve the import cover ratio.
Although, growth in LSM is reflecting in export recovery as well, the energy crisis can be detrimental to export growth.
Yet, standing in policy makers shoes, rupees further deprecation to fully adjust against the appreciation in REER is not the desired policy option in the short to medium term
Hence, if international commodity prices stay low, amid slow but gradual continuation of efforts to resolve the energy deficit and continuation of remittances inflows, the rupee may consolidate at 84-85 levels against the green back.
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