PKR has been appreciating against USD for the past two months. One reason is the USD depreciation against other currencies; but PKR has appreciated (though less than USD) against all the other currencies of major trading partners.
The question many have in mind is the currency parity and outlook for the next few months. With a market-based mechanism in place, it could be anybody’s guess. Having said that, there were reasons for currency appreciation, and it is happening. Right now the demand and supply dynamics are driving the market. The current account has been in surplus for four of the last five months. The SBP reserves have kept on building due to this and flurry of flows from multilateral agencies.
There are three main indictors that should be seen for asserting currency direction – current account, capital/financial accounts, and real effective exchange rate (REER). All the three are depicting that currency was supposed to appreciate and it did. REER stood at 91.89 in Aug 20 which is consistently moving down from its high of 97.22 in Feb 20.
Lower the REER, better is the outlook of nominal currency. The REER was 121.0 in June 2017. The currency was bound to depreciate. It did and REER moved to its lowest level to 89.74 in Jul 2019. Do remember that the PKR touched the low of 164 against USD and interest rates peaked at 13.25 percent in July 2019. The currency started appreciating since then and reached of 154.17 on 14th Feb 2020. A similar phenomenon is happening today, despite the fact that policy rate is at 7 percent.
The fact that is important is interest rate differential and that is to be seen against the inflation differential. After COVID, the global interest rate outlook has changed. The near zero global interest rates and better domestic inflation outlook have kept the differential not high, even after lowering interest rates. This is reflected in improvement of REER. Globally, rates are going to remain low as the big economies are on a currency printing spree. Seeing this, the food prices blip in Pakistan might not be a great concern for policymakers and currency market participants.
The question is where would the currency move going forward. Well the movement is sentiment driven. When the PKR was depreciating against USD during Mar- Aug, it was not supposed to fall that much but market sentiments were bearish and the movement followed the mode. Now the sentiments are better, and the mood has changed. With consistent flows of remittances (continued in October) exporters are booking dollar in forward market and importers are waiting (where they can) to convert. The equilibrium in currency would reach where the exporters would stop this forward booking and importers would stop delaying payments.
Form the policy point of view, SBP may not like too much volatility in the currency market. If the currency appreciates too much, it will move fast in the other direction too when the sentiments change. Having said that, based on REER, current account and other flows, currency can pull back to 150-155 levels. But seeing the lower interest rates and pick-up in demand, the import bill can shoot up – already there are signs of imports moving up.
If the current account starts slipping (which might happen) with current level of SBP reserves (marginally covering three months of imports), the pressure would be on currency and interest rates. In flexible exchange rate regime, either currency can appreciate, or interest rates can remain low. To not make interest rate vulnerable, currency cannot be let to appreciate too much. Levels in the range of 155-160 could be a thing in the months to come.
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