EDITORIAL: A few days back, Governor State Bank of Pakistan (SBP) Dr Reza Baqir said that it's the first time ever in the history of Pakistan that forex rate is moving in both directions. That is indeed the case and transition towards flexible exchange rate regime; it is a remarkable achievement. Business Recorder has always advocated for a flexible exchange rate regime and never supported the so-called fixed exchange rate. Unfortunately, historically in Pakistan, exchange rate movement has remained politically sensitive and it is seen as a barometer of the economic performance of any government. That is why sticking with a certain exchange rate at times due to political considerations has come at a huge economic cost. For example, the Shaukat Aziz government did not let the currency depreciate and the Nawaz Sharif's government followed in the former's footsteps. On both the occasions, the currency devalued significantly after the change in regime.
For an economy, that is largely dependent on imports for its raw material, energy and other needs, sudden shocks create long-lasting problems. When the currency is kept overvalued, the imported demand grows artificially and increases the severity of the devaluation shock. This is another issue. In economic terms, an overvalued currency leads to a period of low inflation and that generates imported demand. This balloons current account deficit and to keep currency value intact, central bank burns its foreign exchange reserves. For a country, where reserves are virtually all the time hovering around the critical levels (3 months of import cover), the party is usually short-lived. This partially explains the frequent boom-bust cycle. There is a role of persistently high fiscal deific in it, but for simplicity of the argument, it is not being discussed here.
There is another problem of having a fixed exchange rate regime with sudden shocks at intervals. The economy usually booms, based on demand generated through keeping the currency overvalued. In these times, foreign investment also comes in the domestic sectors. But by the time foreign investors have time to get the payback, the currency depreciates and economy slows down. This happened in telecom, banking and oil and gas sectors during 2003-07. Seeing how these investors burned fingers in the aftermath of the 2008 crisis, fresh investment is far and few. The argument also holds true for domestic investors who have access to global markets.
The other issue investors see is the ease of taking money in and out of the country. It is easy to bring the money in Pakistan; but taking it out for business expansion, repatriation of profits/disinvestment or for any other reason is a painstaking process. SBP is working on making the process fluid. But low levels of reserves is making this transition difficult and slow. Since the foreign exchange reserves of SBP seldom reach a comfortable level, there is always a threat of a balance of payment crisis. This has hindered the investment flows in productive sectors and most savings are parked in speculative assets - such investments have short-term horizon and are less productive.
All the efforts should therefore be on building reserves to comfortable levels. For that, the SBP should not use its arsenal to just keep the currency level at an arbitrary level. The currency movement should be left to market forces based on demand and supply for smooth operation. However, the currency movement is politically sensitive. Any small movement makes headlines. Plus, the market participants are living in the hangover of fixed exchange rate regime. It will take time and efforts to change the mindset and to articulate the right narrative. That is why a gradual transition towards fully market based exchange rate is imperative.
SBP appears to be adopting a policy of flexible exchange rate while keeping a close eye on the expected inflows and outflows; it intervenes in the market to curb volatility. This regime has to continue for certain time before market could really adapt to the new norms. It's been functional for a little over a year and during that time PKR/USD hovered around 154-169 levels. This seems a healthy volatility. What SBP in our view is focusing on is for the parity to be not too far from the fundamental valuation-based on REER, current account balance and capital/financial flows. Based on these three factors, currency should be comfortable around PKR/USD of 150-155. But till the reserves are built up sufficiently, sentiments would keep the currency slightly undervalued. Thus, to have better currency outlook, building up foreign exchange reserves is of utmost importance.
Copyright Business Recorder, 2020
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