PKR's profound woes

There has been a lot of confusion about the recent slide in the exchange rate of the rupee on the currency market. Some of the analysts have attributed the free fall of the rupee, which touched a record low of Rs 93.70-80 to a dollar on the open market in the morning session of 24th May before improving to about Rs 93.40 in the evening, to the massive purchases by two large private sector banks, apparently on behalf of the State Bank to pay the IMF instalment of dollar 394 million due on 25th May, while others were of the view that Pakistan's reluctance to allow resumption of Nato supplies and the consequent threat of blockade of US assistance were the primary reason to drive down the rupee rate.
In order to clarify the situation, the State Bank on 24th May through its spokesman, Syed Wasimuddin, denied such conjectures and rejected the impression that the central bank was aggressively mopping up dollars from the market for making timely payments to international financial institutions. To emphasise his point, he added that the SBP had not made any market forays in recent weeks, including the current week and the exchange rate movement as "somewhat sentiment driven", instead of being influenced by excessive demand and supply mismatches. Pakistan's gross foreign exchange reserves increased by dollar 207 million to 16.3 billion dollars during the week ended May 18, 2012 and the rise in reserves was due to some multilateral inflows and home remittances.
During the FY12 so far, Pakistan had made debt payment amounting to dollar 2.53 billion (inclusive of dollar 809 million to the IMF) and other miscellaneous payments of dollar 1.52 billion, while receipts from multilaterals and other sources had amounted to only dollar 1.21 billion. As far as Stand-By Arrangement facility was concerned, Pakistan had paid dollar 399 million on this account on 24th February while dollar 394 million was paid on 25th May, 2012. Pakistan's remittances at dollar 10.88 billion during the first ten months of 2011-12 were up by 20.2 percent and had helped country's balance of payments (BoP) position despite a widening trade deficit.
The State Bank's statement that there was hardly a solid reason for the recent slide in the rupee rate as it was sentiment driven and most of the factors relevant to the situation did not call for such a level of depreciation may prove to be a kind of balm to cool down the market sentiment for a little while but would not be enough to reassure the market about the stability in the exchange rate of the rupee on a long-term basis. Such a rebuttal to the State Bank's statement could easily be made because the State Bank's spokesman has referred to all the positive points to make his case while negative factors driving down the rupee rate have been conveniently ignored. For instance, it is not enough to say that overseas Pakistanis have sent dollar 10.88 billion remittances which have helped the BoP position despite a widening trade gap. The SBP must be aware that these aggregates are only a part of the whole story and it is the overall current account balance of the country, which is the main determining factor for dictating the direction of the value of a currency. Unfortunately, however, Pakistan's current account deficit has reached dollar 3.4 billion during the first ten months of FY12 and is likely to be around dollar 4.0 billion for 2011-12 in sharp contrast to a surplus of dollar 542 million in the preceding year.
Also, the SBP has boasted about the increase in foreign exchange reserves during the week ended 18th May but has forgotten to mention that these reserves have declined by more than dollar 2.0 billion during the year so far. The State Bank's remark that it was not mopping dollars aggressively from the market to pay for the IMF loan instalment is also very interesting. Obviously, there is no proper definition of aggressive buying in terms of the level of transactions and such a statement could mean that the SBP was buying foreign exchange in handsome amounts from the market but its behaviour "in its own judgement" was not aggressive enough to destabilise the market.
In our view, whatever the statement of the SBP, the issue of rapid depreciation of the rupee should not be taken lightly and its analysis should not be confined to the trends of a limited period of few weeks. There is no doubt that factors like the depletion of reserves, BoP trends and market sentiment at a particular point of time are important for determining the behaviour of exchange rate, but most crucial variable in this context is the relative behaviour of prices in different countries. According to well-known purchasing power parity theory, the equilibrium in exchange rate is disturbed when the two countries have different inflation rates. Currencies of the countries experiencing higher inflation will depreciate and vice versa due to a change in their purchasing power over a period of time.
Judged from this criterion, Pakistan's currency is likely to depreciate by about 8-9 percent or so every year if the difference in inflation rate in the country and the rest of the world continues to be the same. There are also a host of other factors which could come into play while determining the exchange rate of a currency in a free floating regime. Economy's prospects, the likely behaviour of current account and fiscal management of the country are also taken into account to take positions in the foreign exchange market and mould the market sentiment. Unfortunately, however, most of these factors are unfavourable at the moment for Pakistan and if deadlock on Nato supply routes persists, multilateral financial institutions continue to be wary and economic fundamentals of the country do not improve in the near future, Pak rupee could come under renewed pressure.
Keeping in view foreign exchange reserve position of the country, the State Bank could only intervene in the market to even out excessive fluctuations in the exchange market but cannot inject enough liquidity to stabilise the market for a reasonable period of time against heavy odds. As such, it would be better for the SBP to refrain from taking untenable positions and concentrate only on advising the authorities to take steps which could help stabilise exchange rate of PKR on a sustainable basis.