Need for timely currency adjustments

Political pressures are mounting on PM Imran Khan to control inflation and create new jobs. Coalition partners are flexing muscles to get MNAs'/MPAs' funds, seeing that members within PTI clan are voicing concerns now. A government with a razor-thin majority is not left with many options. The fiscal expenditure may increase soon by enhancing PSDP (federal and provincial) releases. This will have an impact on macroeconomic stabilization.

The policy levers to control macroeconomic variables are exchange rate (ER), interest rates (IR) and fiscal. The targets are inflation and growth (job creation). The immediate target is to bring inflation down, but sooner or later growth has to come to the forefront. The central bank might not be thinking of growth revival too soon as this would invariably put pressure on the current account. But the federal government seemingly does not have enough political capital to wait for policies to work out.

There are two ways to attain growth - by boosting public expenditure (PSDP) or by enabling private investment. The latter is better as its more sustainable and efficient. The private sector stimulus can come from lowering IR. Enhancing PSDP can slip the fiscal deficit and would have inflationary consequences. This could delay the ease in monetary policy. From a technocrat perspective, the growth driver should be the private sector. Plain and simple. However, the political economy has its own dimensions. The political government is approaching its limits of austerity. This can be linked to a historic trend.

Optimus Capital in its recent Market Strategy Report, based on historic data, has mentioned that twin deficit contraction is probably bottoming out. 12 month rolling average of ex-petroleum imports yearly decline (lowest point) was 18.5 percent in Jan-99, 20.8 percent in Nov-09 and is now at 15.9 percent in Nov-19. The story of the fiscal side is similar. It's a subject for economists from academia to do papers on linkage of political economy to economic contraction. This could give another dimension to explain frequent balance of payment crises.

Now with fiscal expenditure growth seemingly inevitable, there will be some pressure on current account deficit through growth in imports. There might be inflationary consequences of enhanced fiscal spending. This may delay the IR easing cycle. Market is expecting no change on Tuesday's policy review. And the SBP may remain a hawk in March as well.

There is pressure of the private sector on government to lower the interest rates sooner rather than later. If not March, it will be in May. The policymakers are losing on two levers. This will put further pressure on twin deficit. The ER will come under pressure if the current account starts slipping. Thus, in a few months the market may start anticipating a currency depreciation.

Now take hot money into the equation. The hedge fund managers may start anticipating it, and the portfolio investment might start evaporating in anticipation of expected ER adjustment. This may bring depreciation forward to an earlier date or time. Mind you, currency is a politically tough decision as well. Islamabad might not like it. This may put central bank in a tight spot.

The fiscal side is not SBP's domain. The decision is between choosing IR and ER. The question is which lever to use and when. The ER is moving towards a market-determined phenomenon. This does not mean it is to be free float. The free float currency only exists in the OECD states. In rest of the world, there is some kind of managed ER system. Some peg to a currency or basket of currencies. Some link to a certain level of real ER.

The emerging economies that have moved up the ladder of growth have one common philosophy i.e. to build foreign exchange reserves irrespective of current account deficit or surplus. The reliance is on net reserves (not debt) either by running current account surplus or by attracting FDI.

ER is set to meet the objective by setting some principles and manage accordingly. The principles should be well spelled out, so that everyone should have an understanding of it, and the markets would make decisions accordingly. In case of Pakistan, it could be based on a certain level of real ER. Decide a band and move within it. The currency movement either way should be smooth on regular intervals.

Sudden jump in ER could have higher inflationary consequences. Pakistan had experienced it in 2008 and 2019. A slow graduation in depreciation (if required) would have less inflation. Such policies could mitigate the risk of sudden evaporation of hot money as well.

The inflation differential is high at this point. Keeping nominal ER at one point is actually appreciation in real terms. Without bring down inflation differential, the exchange rate has to adjust at some point. Knee-jerk adjustment is not good. If there is a need, the SBP should start doing it today slowly and gradually, and build reserves in the process.