PKR depreciation

This is the second and last part of a two-part series focusing on the reasons for the November 2015 rupee decline.
The rupee declined to 106.60 paisa per dollar interbank and 107.40 in the open market in the first week of November. The question is why and who if anyone can be held responsible? Two factors may be behind the depreciation. First, the inappropriate and ill advised statement by Harald Finger the International Monetary Fund (IMF) mission chief for Pakistan for the 6.64 billion dollar Extended Fund Facility (EFF), and second the flawed policies of Ishaq Dar. Speculative currency trading today may well have been a function of these two factors.
IMF's Harald Finger, like his predecessor Jeffery Franks, has displayed a tendency to capitulate to Ishaq Dar's insistence on a joint press conference in Islamabad even though the mandated quarterly reviews under the EFF are held in Dubai for security reasons. The joint press conference was held on 5th November 2015. Unlike Franks, Finger appears to be unable to out-talk the Finance Minister during these press conferences though he did manage to reveal that the government missed the fiscal deficit target as well as the net domestic assets target. Perhaps to set the record straight Finger called a meeting the next day, on Friday 6th November 2015, with select media personnel and made the ill advised comment that Pakistan's rupee was overvalued by between 5 and 20 percent depending on different scenarios (the scenarios were not highlighted). By Monday 9th November the rupee declined to over 106 rupees to the dollar necessitating a statement by Finger from Washington DC the same day: "Pakistan's nominal exchange rate should continue to be market-determined. Any implied overvaluation of the real effective exchange rate (ie nominal exchange rate adjusted for differences in prices between Pakistan and its trading partners) can be corrected over the medium-term with continued structural reforms, gradual improvement of Pakistan's competitiveness, and supportive monetary, fiscal, and financial sector policies. In the context of the Article IV consultation with Pakistan, IMF staff performed an assessment of the country's external position. As part of this assessment, a number of models were used to assess Pakistan's real effective exchange rate. These model estimates are imprecise and show significant variation, thus being only indicative. They pointed to some overvaluation and, more broadly, a need for continued strengthening of export competitiveness, public finances, and external reserve buffers." This particular statement as well as coverage of the joint press conference with Dar is unfortunately not on the IMF website.
What is however on the IMF website is the statement that the "IMF's primary purpose is to ensure the stability of the international monetary system-the system of exchange rates and international payments that enables countries (and their citizens) to transact with each other." To ensure this stability requires monitoring and the eighth review under the EFF like its seven predecessors refers to the rupee over valuation. Para 16 of the eighth review states that "staff and the authorities agreed that further accumulation of reserves is desirable as the balance of payments position remains vulnerable and reserves are still significantly below adequacy norms (encompassing a broad set of risks including a drop in external demand or terms of trade shock, capital flow drains due to external liabilities stocks example short term, debt or medium or long term equity of debt liabilities and or capital flight risk). Staff noted that further accumulation could also help arrest the recent trend of REER appreciation (real effective exchange rate) which is inconsistent with fundamentals although staff agreed with the authorities that a range of other issues, including electricity shortages, security issues and the business environment also need to be addressed to strengthen competitiveness."
The resolution of IMF concerns is echoed in the Letter of Intent (LoI) dated 15 September 2015 submitted by Dar to the Board of Directors of the Fund for approval to release the next tranche. He noted that the authorities are "continuing to build foreign exchange reserves buffers to strengthen the resilience in the face of external shocks, and creating suitable conditions for higher investment and exports by improving competitiveness and the business climate." Unfortunately though the buffers largely consist of enhanced external borrowing (313 million dollars were borrowed from consortium of commercial banks and Dubai-based Noor bank in September alone) which accounts for, first Bloomberg, and more recently Harald Finger acknowledging that the reserves are not sustainable. In addition, exports fell, FDI fell for the second consecutive year and remittances are expected to flatten out. So much for Dar's claims in the LoI!
In passing, it may interest the readers to know that even though much was made of Prime Minister Nawaz Sharif's visit to IMF headquarters in DC during his official tour of the US yet when asked the Fund's public relations officer Rice stated that "I don't have a read out for you on that meeting. I'm sure as you suggest it was a broad discussion of the status of the economy and reforms and as I mentioned the mission is in the field so when the mission concludes we will be able to give you a further read out of that at the time." Or a waste of time for the country's chief executive!
That Nawaz Sharif and Ishaq Dar support a strong rupee, inexplicable for someone majoring in economics in his/her freshman year was first evident in September 2013 when the rupee fell in the open market to as low as 113. The reasons for the fall were given as threefold: (i) speculative trading fuelled by public panic that the rupee value would further plummet coupled with gold smuggling to India (as India taxed gold). Dar taxed gold and on 27 September the SBP increased the minimum rate of profit on all rupee saving deposits payable by commercial banks to 6.5 percent from the 6 percent previously to arrest the rupee decline apart from undertaking open market operations to stem the rupee fall; (ii) flight of capital and as per SBP sources 9 billion dollars a year was leaving the country. Unfortunately capital flight continues evident from recent heavy investments by Pakistani nationals in Dubai real estate market. The Ayyan Ali case points to a well organised money laundering operation through carriers; and (iii) flawed Finance Ministry economic policies that account for a rising current account deficit (with exports plummeting and remittances as well as low international oil prices providing the only economic safety net) and negative capital balances (decline in Foreign Direct Investment). There is however a heavier than ever reliance on portfolio inflows which are extremely volatile and whose cost is indirectly paid by the general public as Dar has delayed implementation of higher taxes to be imposed on the stock market players as agreed ostensibly to be able to influence the market as a measure of the success of his policies.
What Dar has failed to do which accounts for the rupee being over valued is to improve the business climate which has declined since he took over the portfolio or improve governance through reforms of the Federal Board of Revenue. He, as is usual with him, blames the Board of Investment for the worsening business climate and one can only hope that he acknowledges his own overwhelming contribution to the worsening business climate. His budgets have steadily increased reliance on withholding taxes as a component of direct taxes from between 65 to 70 percent amounting to 862 billion rupees, (which are not strictly direct taxes as they are passed onto the consumers and are not collected by the FBR to boot) and 310 billion rupees from shifting non-tax revenue to other taxes. Thus a total of over 1.1 trillion rupees is accounting jugglery. He has also borrowed heavily from external factors (boasting at one time that given low rates of interest abroad relative to the domestic market he is borrowing at 5 to 6 percent and retiring domestic debt procured at 12 percent and refusing to take account of the rupee erosion) and of course failing to take account of the annual rupee depreciation of even 5 percent - the norm till to-date. In addition, his claims neither support his Eurobond and sukuk returns of over 7.5 percent or the rising trade deficit negatively impacting on our REER. Capital flight too continues unabated.
Economic fundamentals are thus not only weak but are being further weakened. The only redeeming aspect of our macro economic data is low international oil price, high remittances as well as the implementation of the China Pakistan Economic Corridor - neither of these linked to Dar's policies. To conclude, between Finger and Dar growth is unlikely to pick up with the focus on deficit reduction, and any future ill advised statements would simply further erode the REER.