Revision in forward cover rules

The State Bank's decision on 21st December 2011 to revise the terms of forward cover facility provided to the importers would not be surprising for those who have been watching the behaviour of the rupee, both in the spot and forward markets, closely and with some concern. Apparently, at a time when the rupee was fast losing its value, the central bank had to send a signal to the market that it was monitoring the situation on a regular basis and would not hesitate to take corrective measures, if needed. Maturity of forward contracts against import, according to the SBP circular on 21st Dec, should now coincide with the maturity of the underlying Letter of Credit (L/C). In cases where the import L/C has a tenor of more than 12 months, the tenor of the forward cover facility would be 12 months on a rollover basis or the remaining tenor of the L/C, whichever is less, subject to the condition that the tenor of the forward cover should not be for less than one month. Forward cover facility against foreign loans would also be subject to the same conditions. If the terms of the L/C are amended to extend its tenor in accordance with the regulations, importers can rollover the forward cover on the original maturity date of the forward contract coinciding with new maturity of the underlying L/C. All forward contracts against which the underlying L/Cs are established are cancelled and are required to be negotiated on maturity at prevailing exchange rates. Forward cover already provided to customers prior to the effective date of the circular, would remain effective till the maturity but any rollover would be in accordance with revised instructions. Banks were also instructed to ensure that the facility is availed only for genuine transactions and that customers do not hedge more than the underlying exposure. If during SBP's inspection or at any point of time, it was found that the facility was misused and was against genuine transactions, action would be taken by the SBP under Foreign Exchange Regulation Act, 1947. It is not difficult to understand why the State Bank of Pakistan has attached certain conditions for forward cover booking with the actual letters of credit against imports and private foreign loans. Noticeable in this connection is the fact that forward cover was restored last year when the foreign exchange reserves of the country had touched record high levels due to higher inflows and exchange rate was stable at around Rs 86 to a dollar. The situation, of late, has however, changed altogether. With the widening of trade and current account deficits and shortage of greenback in the currency market, the Pak rupee has now depreciated to around Rs 90 to a dollar in the open market and interbank. The pressure on the rupee is so heavy that dollar is being traded in forward cover for six months at Rs 4 plus current exchange rate. Although the trend in the rupee rate behaviour is determined by the expectations of players in the market, which at present seem to be gloomy, yet the State Bank's decision on 21st December to attach conditions to the forward booking could help curb speculation in the currency market and check the increasing demand for dollars. More specifically, the condition of actual L/Cs for the provision of forward cover facility would automatically exclude contracts and reduce pressure on the rupee. However, it is extremely difficult to gauge the precise impact of the State Bank's decision on the rupee rate in the spot and future markets or the rate of forward cover for various tenors. This is so because the behaviour of exchange rate is determined or projected on the basis of a host of other important factors including the likely outcome in the current account balance of the country and other inflows like foreign investment, bilateral assistance and loans from multilateral institutions etc. In our view, though limiting the scope of forward cover facility for imports and private foreign loans shows the uneasiness of State Bank over the evolving situation in the foreign exchange market, it would, in all probability, make only a marginal difference to the rupee rate or the forward cover fee due to the preponderance of other factors in the determination of rupee value. We are afraid, however, that if the authorities of the country get overly concerned about the current depreciation of the rupee, they may resort to administrative measures like multiple exchange rates, import quotas to check the slide of the rupee. Such measures are not only counter-productive in the long run but may promote corruption and lead to shortages in several cases. Therefore, it would be far better to cure the disease rather than try to curb the symptoms by temporary means. Copyright Business Recorder, 2011