Impact of currency depreciation

The currency has finally started heading south. It depreciated by around 5 percent in the last few trading days. The noise is that the SBP would keep it around Rs110-112 per USD for the time being, and see the impact on macroeconomic variables, and decide accordingly. This seems to be the right approach, and BR Research has been reiterating the same.

The question is the plausible impact of depreciation on other economic variables and what parallels can be drawn from 2008. Intuitively, any fall in the rupee value would bring imported inflation home and in turn the domestic demand would be curtailed.

This implies that the economy could move from low inflation and high growth era to high inflation and low growth period. That is not desirable as this adversely impacts two fundamental objectives of economic management i.e. employment generation (worsens due to low growth) and affordability of goods and prices (falls due to high imported inflation, and high interest rates).

If that is the case, why urgency? The problem is rising balance of payment worries or growing current account deficit, which is taking reserves to uncomfortable levels. Thus, the currency adjustment is to readjust the trade deficit, primarily, and higher inflation is a side effect.

The need is to carefully evaluate the intended and unwanted outcomes of currency depreciation. Apart from inflation adversaries and its impact on growth through curtailed domestic demand, it could hamper fiscal balance by increase in debt servicing- both on foreign loans (direct impact) and on domestic debt by subsequent higher interest rates.

Let’s try to evaluate the impact of 5 percent recent currency depreciation on imports, exports and inflation based on past experiences. In case of inflation, in 2008 when the currency went through a sharp depreciation, inflation impact was a little too much. The question is would the prices respond in similar fashion this time around?

There is a fundamental difference in the prices of basic household goods today than what it was in 2008. At that time, a few key commodities were at steep discount to international prices while today some of them are trading at premium. For example, wheat in March 2008 was at 35 percent discount to international prices and today its 100 percent higher than international prices.

Similar is the case of milk spot prices, which were at 20 percent premium to world prices in 2008 while the premium is 110 percent today. Similar are the results for fertilizer and petroleum prices. There is commodity supply glut both at home and abroad; but the prices are here high due to support prices and its cascading affect, in case of food commodities. For fertilizer, doing away with subsidies and higher gas prices have resulted in higher prices at home. And in case of petroleum, there is room in taxes to nullify the impact of currency depreciation.

The impact of any depreciation this time around would not be too inflationary as domestic prices are already higher than global averages. The good news is that it won’t bring too much imported inflation and in turn its adverse impact on growth through demand adjustment would not be much.

The bad news is it would not curtail essentials’ imported demand unless petroleum prices are revised up. There will, however, be some price increase in automobiles, energy and few other sectors. And imports in these sectors might take a dip.

More important is to see the impact on exports. It is good for the exports as they would get theoretically 5 percent more cushion.

This is in addition to 4-7 percent cash rebate in textile package which should be utilized swiftly. However, there is intense competition to Pakistan exports. It’s a buyer market; and seller would have to share part of increased margins. And imported raw materials would also partially nullify the gains.

Apart from manufacturing exports, it’s time to get rid of wheat and sugar surpluses lying for years before they get rotten. The subsidy requirement would be reduced.

In nutshell, exports would benefit more. However, imports may not fall much. And inflation impact would be still in control. The currency should stick to new levels for a few months to see the actual impact.