The recent strengthening of the rupee has baffled independent economists though official sources at the Ministry of Finance and State Bank of Pakistan (SBP) cite positive economic fundamentals as the reason behind the fall of the greenback vis-a-vis the rupee - from a little over 155 in September 2019 to 168.15 on 06-08-2020 to less than 159 today.
The economic fundamentals that impact on the rupee are by and large fourfold. First, a significant rise in remittance inflows - in July-September 2019-20 total remittances were 5452.65 million dollars while the comparable figure for the same period in the current fiscal year is a whopping 7147.04 million dollars - a rise of 31 percent and in total terms a rise of 1.694 billion dollars. The reasons for this increase: (i) the pandemic has all but disabled the unofficial/illegal hundi/hawala system due to lockdowns in countries where the bulk of our remittance income is sourced compelling the remitter to use official channels; (ii) the need for higher remittances by families due to job losses in Pakistan as a consequence of extremely harsh contractionary fiscal and monetary policies since May 2019; and last but not least (iii) a steady rise in inflation specifically food inflation. A rise in remittance inflows, official sources correctly argue, have contributed to a strengthening of the rupee though the World Bank advises caution in relying on this source of foreign exchange earnings and forecasts a decline by 2023.
Secondly, the current account deficit has been massively curtailed since last year. Apart from remittances, another major critical component of the current account is trade account (exports and imports). Exports during July-September 2020 were 912,579 million rupees (against 869,030 million dollars in the comparable period of the year before) showing a rise of 5 percent though in dollar terms, which determines the external value of the rupee, the rise was merely 0.65 percent - 5474 million dollars July-September this year compared to 5510 million dollars the year before. Imports rose from 1,765,972 million rupees July-September 2019 to 1,884,444 million rupees in the comparable period in the current fiscal year hailed as indicative of economic activity picking up though again in dollar terms the rise was significantly lower - from 11.199 billion dollars to 11.311 billion dollars.
This data indicates that in dollar terms which determines the external value of a currency the trade deficit rose in the current year - from negative 5.689 million dollars last fiscal year to negative 5.837 billion dollars in the current year. Thus to claim that the rupee has strengthened against the dollar because exports have risen and/or the trade deficit is down does not hold water.
Thirdly, interest (discount) rates and domestic inflation impact on the exchange rate. From 20 July 2019 to March 2020 the discount rate was a high of 13.25 percent which as expected attracted hot money (around 3 billion dollars) and the rupee strengthened - from 168 rupees to the dollar in August 2019 to 155 in October 2019 to 54.9 on 1 November 2019. The hot money has since left the country as was feared by independent economists. Be that as it may, conventional economic theory argues that a high discount rate's positive impact is mitigated if domestic inflation is high. Pakistan's inflation pre-pandemic was forecast at 13 percent by the International Monetary Fund (IMF) and today inflation is the highest in the region at around 9 percent - with India and Bangladesh registering under 6 percent, Nepal at 6.7 percent, and Sri Lanka registering a low of 4 percent in October 2020. In effect, the decision to have a high discount rate to contain inflation was a double whammy for the people of this country as it not only failed to contain inflation, prompting the economic team leaders to unfairly place the entire blame on hoarders/smugglers/cartels but at the same time also choked off productivity.
Foreign exchange reserves also have a bearing on the currency rate. In November 2019, reserves held by the SBP were 8.3 billion dollars and by April 2020 reserves had risen to 12 billion dollars with a 2 billion dollar injection from multilaterals April and May to enable the country to deal with Covid-19. On 23 October 2020, the SBP website notes foreign exchange reserves of 12.1 billion dollars due to (i) a rise in remittance inflows July-September this year and (ii) 2.7 billion dollar external loan inflows (against 2.1 billion dollars in the comparable period of the year before) with bilateral and multilateral partners contributing 1.58 billion dollars budget support/programme lending/project financing (including one billion dollars of safe China deposits) and 149 million dollars commercial bank borrowing. Pakistan has budgeted a total of 5.8 billion dollars from bilateral and multilateral sources this year though if the IMF programme is not restored this amount would be in jeopardy which may be dealt with through higher commercial borrowing and/or a massive cut in public sector development programme. In other words, reserves have been strengthened by higher remittances (1.6 billion dollars) and external borrowing (reminiscent of how Ishaq Dar strengthened reserves).
The question is: are these the only two factors responsible for a stronger rupee today? Or did SBP intervene in the foreign exchange market? The SBP spokesperson when asked by Business Recorder categorically denied any interference in the foreign exchange market however the SBP has been reluctant to acknowledge interference post 12 May 2019, the day the economic team leaders reached a staff level agreement with the Fund. In June last year foreign currency traders noted that the central bank sold foreign currency in "quite a sizeable amount" to pull the exchange rate back from an all-time low, a claim not denied by the SBP. And again in June 2020 a senior banker claimed that the SBP had intervened in the forex market with a sizeable amount through banks and authorized exchange dealers though the SBP spokesperson, when asked to confirm, did not comment.
An observations is in order. The SBP website indicates a real effective exchange rate (REER) of 93 for June 2020, while Dar's over-valued rupee reached a high of 121 in June 2017. And since early 2019 the REER has been under 100 so one may assume there is ample 'give' to strengthen the rupee as rupee maybe undervalued.
Be that as it may the SBP's decision to keep the discount rate at 7 percent (clearly no longer linked to either the consumer price index calculated at 9 percent or core inflation at a little over 5 percent) and a strengthening rupee indicates the space given to Dr Reza Baqir to take independent decisions with respect to these two critical policy tools has been withdrawn - a space that the IMF is insisting be restored based on the agreement signed by the economic team leaders - Dr Reza Baqir and Dr Hafeez Sheikh - on 12 May 2019 to adopt a "market-determined exchange rate (to) help the functioning of the financial sector and contribute to a better resource allocation in the economy."
This position was reinforced by the IMF in the April 2020 Rapid Financing Instrument documents: "staff stressed that intervention in the foreign exchange market should remain limited to prevent disorderly market conditions."
To conclude, Pakistan is facing two equally undesirable alternatives: not to intervene in the forex market which would satisfy the IMF but have grave political implications or intervene in the market at the risk of the IMF suspending its Extended Fund Facility programme. The Prime Minister would be well advised to acknowledge that it was his own economic team leaders who bear the major responsibility for placing the country in this untenable position which hopefully would lead to revisiting some of the IMF conditions agreed last year and, more particularly, the timeline for their implementation.
Copyright Business Recorder, 2020
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