How to deal with Pakistan’s forthcoming currency crisis

“There are no solutions. There are only trade-offs.” ? Thomas Sowell Nomura has warned that Pakistan faces currency crisis danger. How should Pakistan deal with a potential currency crisis - if it did occur? Firstly, it is important to understand that a currency crisis is when a weak currency (in this case the PKR) depreciates significantly as a result of selling.

Since the 1990s, most currency crises have involved balance sheet effects: a country (either public or private sector, or both) has large external liabilities in foreign currency. In that case depreciation worsens balance sheets, creating a self-reinforcing downward spiral. That was the story for Asia in the 90s, the Argentine crisis 2001, part of the problem in Pakistan now.

Economists identified some common characteristics that caused the crisis after the dust settled in Asia: The region’s currencies were overvalued; economies were over reliant on short-term borrowing from foreign lenders; private banks and finance companies were fragile and weakly regulated; and governments lacked the necessary political consensus needed to take swift and painful measures to adjust and stabilise the economy.

Valuable lessons can be learned from the exchange rate, monetary, and fiscal responses to the recent currency crises in Asia and Latin America. Policy tradeoffs in response to speculative attacks are grim.

No matter what governments do, the costs are high. The less costly response to a speculative attack depends on the nature of the shock, the economy’s initial conditions, and the balance sheets of banks, firms, and the government. In general.

Allowing the exchange rate to float

If you peg your exchange rate at a too-high level, you’re setting your country up for disaster, because any decline in the exchange rate will be sudden and catastrophic instead of slow and gradual.

Slow and gradual declines give a country time to reverse course and fix whatever factors are driving down the exchange rate. A sudden collapse gives you no time at all.

Thus, exchange rate pegs are very risky. Such a sudden collapse for Pakistan will bring another round of inflation for Pakistan. Given Pakistan already has an inflation rate of 27%, such a sudden collapse of the PKR could bring about a rapid increase in inflation as it did for Sri Lanka earlier this year for up to 50% (see graph).

Monetary policy

Adoption of a flexible exchange rate regime will impose the need for a new monetary framework and a new nominal anchor. If a country does not have the preconditions for inflation targeting, the central bank can use a combination of instruments to create a new monetary framework.

The framework can include the standard elements of ceilings on net domestic assets and floors on net international reserves. These limits must be consistent with the use of reserves to meet current account needs.

To keep inflation and exchange rate depreciation in check, the central bank will have to tightly constrain the implicit expansion of base money (money supply).The most difficult problem is setting monetary policy during the first few weeks following the collapse of the exchange rate, when financial market conditions and expectations are likely to remain unsettled. Trying to run monetary policy by targeting a monetary aggregate works poorly on a day-to-day basis.

The substantial depreciation of the currency after a speculative attack implies that during the months following the collapse of the currency, inflation can increase sharply (as a result of one-time adjustments in many prices).

This temporary increase in inflation implies a substantial reduction in real interest rates on debt denominated in domestic currency. To offset, at least partially, this near-term effect, it is appropriate for policymakers to raise nominal interest rates temporarily to avoid further depreciation and the danger of igniting a spiral of depreciation and inflation.

Fiscal policy

A new exchange rate will be sustainable only if it is perceived to be fiscally responsible. For this reason, speculative crises need to be followed by restrictive fiscal policies. But fiscal policy should not be too contractionary.

If interest rates are kept high to avoid speculation and inflation following the collapse of the exchange rate, policymakers may want to avoid excessive expenditure cuts, which could lead to more contraction and lower tax revenues, making it more difficult to service the public debt.

Sufficient time must be given to achieve the goal of moving the debt/GDP ratio to a sustainable level. A program that attempts to force the convergence of the debt/GDP ratio to its desirable long-run level too quickly could fail to achieve its goals, thereby reducing the policymaker’s credibility.

Credibility will be enhanced if fiscal reform is perceived to be sustainable and leading to fiscal balance in the medium run rather than based on unsustainable expenditure cuts and tax increases in the near run.

Copyright Business Recorder, 2023