Fragile stability

The exchange rate developments in the last two days have had deeply disturbing effect on the economy. Economic agents are exasperated as to how the expectations they had formed a few days ago based on SBP governor's assurances, about the orderly conduct of exchange rate policy and completion of 'prior actions', can turn out to be false within a few days. More importantly, this massive volatility bodes ill for the economy as it would ensue a series of price effects leading to added inflationary pressures and further adjustments in the policy rate.
In his press conference on 17 June 2019, the governor was unequivocal in assuring the nation that the SBP was not following a free-floating exchange rate policy, rather it would be a market-based policy. He further elaborated it by saying that if there was an unusual volatility in the market, the SBP would intervene in the market to remove it. He also announced that the 'prior actions' for the IMF programme have been met and that the IMF Board would consider Pakistan request on 3 July 2019. These were welcoming remarks.
In our last article (BR: 21-6-2019), impressed by these assurances, we had made the following remarks: "The clarification regarding the nature of exchange rate regime should lead to removal of market's misgivings about the floating exchange rate regime which was viewed as great source of market volatility and uncertainty. The free-floating exchange rate regime was hotly debated since the time it became known that the IMF was strongly advocating such a regime as part of its conditionality for the new programme. This is a regime that prevails in those countries which are not facing foreign exchange constraints and their currencies are powerful enough to be used in global trading or act as reserve currencies, freely convertible to other currencies. In a developing country's context a central bank cannot sit idle when currency movements witness a major volatility. The cost of frequent and unpredictable changes in the exchange market is prohibitive. The removal of this doubt by none other than the governor is a very positive development. He has further clarified that the exchange rate would be market based, not market-determined, giving full role to market conditions yet keeping a window ajar for SBP to intervene when it considers that the market may have been affected by non-economic factors. The stability in the forex market would therefore remain a goal of the central bank".
It was further stated that "the most important piece of information the governor shared is the completion of all prior actions for the Fund programme. He also mentioned that the Fund Board is likely to approve the programme on 3rd July 2019. The prior actions from the SBP were basically two: exchange rate and policy rate. We may be reasonably sure that these two variable would remain stable at least for the next quarter when the programme implementation results would be out and need for further fine-tuning would be in order". [Emphasis added]
Markets have been jolted and investors' confidence shaken. This loss of rupee was unforeseen, unexpected and unanticipated. There was nobody from SBP or the government to explain what had gone wrong in the market which led to this awful outcome. In its absence, all kinds of speculative explanations were offered. In background interviews, some bankers and their customers told reporters that unlike in the past, as the pressure built and help was sought from the central bank, the answer was that the market has to find its own balance. This was a carte-blanche which led to such a high increase in the exchange rate. Some analysts, on the other hand, have speculated that this rupee depreciation was also a part of the prior actions. This is inconsistent with governor's categorical statement that the prior actions were completed. Therefore, there is no reason to doubt that claim. Yet another explanation is that the country has to meet stringent reserves targets and the available level of reserves with the SBP was barely sufficient to meet that requirement. With no buffers beyond the required level, the SBP was not in a position to iron out the spike in the exchange rate. This seems more credible but it begs the question as to how the determination expressed in the press conference was to be shown if the SBP had no reserves to use for this purpose? There is also an issue whether the SBP had anticipated that such a surge is imminent and what its response would be? In either case the episode has not inspired market's confidence.
With such volatility, who would even think of making investment as cost of plant and machinery has gone up at least 17 percent in the last six weeks. In the short-run, at least, it would act as an entry-barrier for the new entrants and thus strengthen the monopolistic forces in the industries. This aspect alone would induce inflationary pressures.
What economic effects would result from this development? Frankly, a lot. At the outset, there is a huge increase in the rupee value of foreign debts. The debt servicing on foreign debts would entail extra burden. Even if international oil prices remain constant, the value of imports would increase requiring an upward adjustment in the petroleum products prices, which, if not done, would adversely affect the budget. With rising oil prices, all prices would be affected either in the first round or the second round. The inflation outlook was already gloomy, as reflected in the monetary policy statement at the time of policy rate increase. This additional inflation is over and above the anticipated inflation and, therefore, yet another policy rate increase could be on the cards in the next MPC meeting next month.
On the other hand, the interest rates are already heading to surpass the rates that prevailed on the turn of the millennium. The PIB auction held on Wednesday was priced at close to 14 percent for all maturities. A further rate increase could take it to as high as 14 percent and then PIB yields to about 16 percent. Once again, at such high interest rates there would be a sharper decline in the private sector credit.
The deeper one looks at the horizon, the more troubled outlook is seen.
The growth of 4 percent now looks harder than it seemed when the annual plan was announced. The promised expansion in jobs, housing scheme, increased social spending all look difficult to achieve. To conclude, we are constrained to say that a promising build-up to a Fund programme is losing steam before it begins.
(The writer is former finance secretary)
[email protected]