The rupee Depreciation

The Pakistani rupee traded at 115.4 rupees to the dollar this Tuesday from 110.5 rupees to the dollar a day earlier - a depreciation of 4.5 percent. It will stabilize at around 115 rupees to the dollar - the level that Advisor to the Prime Minister on Finance, Revenue and Economic Affairs Miftah Ismail stated on record that he and the State Bank of Pakistan (SBP) are comfortable with.
Ismail and Abid Qamar, spokesman for the SBP, maintained that Tuesday's depreciation was market driven - a claim that is being dismissed as spurious as the rupee is not a free float or driven solely by market conditions; but is a managed float which is defined as interventions by SBP to influence the exchange rate (through sale or purchase of currencies). The objective of such interventions in the more than 80 managed float countries is to safeguard the economy against shocks associated with widening current account deficit and/or depleting foreign exchange reserves.
The question is what prompted 20 March 2018 depreciation three months after the 5 percent depreciation in December 2017? The answer is fairly simple: the December depreciation was not enough to arrest the widening trade deficit or the declining foreign exchange reserves. The SBP's website shows that July-December 2017 trade imbalance was negative 17.93 billion dollars while in July-February, or in the next two months notably January and February, the balance of trade deteriorated further to negative 24.25 billion dollars or an addition of 6.3 billion dollars was added after the depreciation of December.
On February 23 this year, foreign currency reserves held by the central bank were 12.3 billion dollars, down 358 million dollars or 2.8 percent compared to 12.7 billion dollars in the previous week. This amount is not enough to fund three months of imports, the minimum reserves recommended by economists. In other words, foreign exchange reserves have reached a critical stage. However, Miftah Ismail told Bloomberg this week past that reserves would decline further in June 2018 when a debt repayment of 2.5 billion dollars is due - a statement that implies he is not hopeful that Tuesday's depreciation would strengthen the reserve position; Ismail's statement to Bloomberg is therefore inexplicable as such statements by anyone responsible for the finance portfolio are bound to have a severely negative impact on market perceptions.
Be that as it may, it is doubtful that the depreciation would reduce the trade imbalance. Export revenue is unlikely to increase significantly because exporters lament the presence of three elements that impede export growth and that continue to persist: (i) higher input costs relative to other countries particularly electricity cost; (ii) delays in refunds by the Federal Board of Revenue that compel them to borrow to meet their liquidity needs which again raises input costs; and (iii) issues of law and order have improved but continue to impede visit by buyers. Imports are unlikely to be contained given that our major importing items - fuel and China Pakistan Economic Corridor related imports - are unlikely to decline.
The question then is why did the government depreciate the rupee two months before its sixth and final budget and two and a half months before it completes its tenure? Could it possibly be due to donor pressure? An International Monetary Funf (IMF) staff mission was in Islamabad from December 5-14, 2017 to conduct the "first post-programme monitoring discussions" since the end of Extended Fund Facility (September 2013-16). On the fourth day of the Mission's arrival the government capitulated and on 8 December the rupee was allowed to depreciate by 5 percent. On 7 March 2018, the IMF uploaded the full report of its first post program discussions on its website in which it appreciated that "in December 2017, the authorities allowed a 5 percent depreciation of the rupee/dollar exchange rate. Nonetheless, reserve losses have continued pointing to a limited effectiveness of these measures to date....while the depreciation allowed in December was a step in the right direction further steps to phase out foreign exchange interventions and allowing greater exchange rate flexibility on a more permanent basis will be critical to contain the external pressures and improve competitiveness." It took the government twelve days this time to depreciate the rupee as recommended by the Fund.
However, donor pressure in an election year and when the country is not on an IMF programme would be minimal unless the government intended to go back on another programme loan from the Fund which, in turn, would raise the comfort level of other donors thereby generating loans for budget support.
In this context, it is relevant to note that Ishaq Dar, the country's non-functional Finance Minister since October 2017 when he left the country, supported two extremely flawed policies. First, accumulation of foreign exchange reserves that were almost entirely debt enhancing. The IMF's March 2018 report notes that "the authorities success with contracting external borrowing (over 10 billion dollars in fiscal year 2016/17 and more than 6 billion dollars so far in fiscal year 2017/18) has been instrumental in softening the impact of rising external imbalances on foreign exchange reserves....(but) continued mobilization of external financing at favourable rates could become more challenging in the period ahead, against the background of rising international interest rates and increasing financing needs." Ismail is scurrying around trying to borrow at better rates (he publicly acknowledged that he withdrew the summary for approval of one billion dollar tap issuance of Eurobonds because of the higher rate of return). While Miftah Ismail blamed external factors for the rise in Eurobond rates yet it is relevant to note that Fitch rating agency downgraded Pakistan's long-term foreign and local currency issuer default ratings to negative from stable a week before the end of January this year. This prompted Ismail to rely on an overly optimistic rise in export revenue and remittance inflows as well as projecting 5 billion dollars from the amnesty scheme for those Pakistani nationals with assets held abroad. However Ismail has also indicated that Pakistan is considering issuing Chinese currency bonds though it is unclear at what rate these bonds would be issued. In other words the policy of heavy reliance on external borrowing is continuing.
Secondly, because of ever rising reliance on external borrowing which led to ever rising costs associated with such borrowing (annual interest as well as payment of principal as and when due) Dar kept the rupee over valued which in effect understated Pakistan's annual debt payments in dollars. An exchange rate driven by market conditions would have raised this expenditure item to levels that would have led to an unsustainable budget deficit - a deficit that unlike an overvalued rupee had a phased time-bound reduction plan as an IMF condition during the three-year Extended Fund Facility (EFF) programme (September 2013-16). Thus Dar refused to acknowledge that the rupee was overvalued and he consistently ignored the steady decline in exports (as our goods and services became uncompetitive in the world market) as well as the rise in imports (as they became more attractive compared to domestic products); and therefore did not accept the IMF's recommendation to allow for 'greater exchange rate flexibility'. Disturbingly the Fund never made this a time bound structural benchmark though it did state in a footnote in one of the quarterly reviews under the three-year EFF that the rupee was overvalued from between 5 to 20 percent - a margin so wide that it compels one to challenge the econometric expertise in the Fund. In its March 2018 report on First Post Program Monitoring Discussions the Fund stated that Pakistan's external financing needs are expected to rise from 21.5 billion dollars (7.1 percent of GDP) in 2016-17 to around 45 billion dollars by 2022/23 (9.9 percent of GDP). These are extremely worrying statistics.
Thus the recent depreciation would no doubt add a sizeable amount in rupees to markup payable in dollars (including multilateral/bilateral loans, Eurobonds and sukuk) which, in turn, would increase the deficit to unsustainable levels; inflation would rise not only due to a higher deficit but also due to higher price of petroleum and products and the consequent considerable impact on price of transport and consumer items. The ideal solution would have been to take a holistic approach and ensure that exporters concerns are addressed while massively reducing heavy reliance on external borrowing and focus instead on reducing expenditure and rationalizing the tax structure to make it more equitable. But a government in its final days and with a looming election is not likely to do so.
So why did the government decide to depreciate the rupee at this time? The only answer that fits all the facts is that it was a pre-programme condition by the multilateral donors, including the IMF.