State Bank seems to be on the defensive. First, it had to justify its policy of building foreign exchange reserves through purchases from the open market and now it is pre-occupied with defending the rupee exchange rate and warning the market participants not to test its resolve to keep the rupee stable.
The first action was a reaction to the widely held view, often aired by the opposition on the electronic and print media, that foreign exchange reserves of the country amounting to over $12 billion were acquired from open market and not earned through genuine sources.
The way it was suggested implied as if the State Bank had acted abnormally or immorally and if the previous hierarchies in the State Bank had resorted to this practice, the same results could have been easily achieved.
The Governor and other officials of the State Bank provided explanations for the shift in policy about the purchase of foreign exchange occasionally but there were hardly any takers and the perception of some hanky-panky business refused to disappear.
Finally, in an effort to end the debate, the Board of Directors of the State Bank had to officially issue a long statement to clarify the position on 21st June, 2004.
According to the Board, accumulation of foreign exchange reserves can take place only when the overall balance of payments of a country (current and capital accounts taken together) is positive.
For the last four years, this happened to be the case in Pakistan and hence reserves had gone up from $1.0 billion in FY 00 to over $12.0 billion by end May 2004.
Tracing the reasons for resorting to purchases from the open market, the statement says that after sanctions on Pakistan due to nuclear test in 1998, the SBP, with the approval of the government, adopted a policy to make all payments in time and build up foreign exchange reserves for debt servicing liabilities by buying foreign exchange from the kerb market.
"The purchases from the kerb market, though at higher than interbank rates, were not debt creating."
Overall, the State Bank purchased $5.654 billion from the kerb market from FY 99 to FY 02 and the practice was discontinued thereafter when the flows in the interbank market improved.
In addition to this amount, SBP purchased $10.838 billion from the interbank market between FY 99 and March, 2004 and sold $3.982 billion during the same period. During the same period, SBP had to make debt service payments totalling $17.413 billion.
Factors contributing to reserve accumulation since 1999-00 were significant reduction in debt servicing payments, increased inflows of workers' remittances, reduced imbalances in trade account, higher disbursements of foreign economic assistance and a modest rise in FDI inflows.
The State Bank has recognised that there was a differential between the interbank and open market rates and because of this it had to suffer a loss of Rs 18.257 billion over a 4- year period.
As the alternative to these purchases was to borrow from external sources at exorbitant interest rates, this modest cost in acquiring non-debt flows was an attractive proposition.
The cost of the whole operation was reported in every audited financial statement of the State Bank.
The rationale offered by the State Bank to buy foreign exchange from the kerb market can hardly be disputed. It is quite clear that Pakistan was at the verge of default after it had exploded the nuclear device.
The freezing of foreign currency accounts and some other desperate measures indicated that the country had actually defaulted and the possibility of a major disruption in external trade with the attendant highly adverse consequences was staring in our face.
The market was fortunately flushed with foreign exchange after the 9/11 events. In this kind of situation, it would have been a folly not to do what the State Bank did. It acted in a way which avoided the default scenario and allowed the country to accumulate adequate level of foreign exchange reserves without incurring debt-creating liabilities.
Of course, there was a cost but this was in rupee terms, small in magnitude and adequately covered by other sources of revenues so as to keep the overall budget deficit within the targeted limits.
As per universally accepted norms, State Bank was perfectly justified to undertake such an exercise.
The SBP does not itself produce and export anything to earn foreign exchange but, in its capacity as the custodian of foreign exchange reserves of the country, buys foreign exchange from the residents of the country and sells it to them for various activities.
The manner in which it operates is rather immaterial. Since the foreign exchange floating in the kerb market also belongs to Pakistanis, there was no harm in tapping that market as well.
It was only coincidence that domestic market was flooded with foreign exchange due to reasons on which the State Bank had no control and at a time when the country needed it badly.
Policy-wise also, the decision turned out to be very correct. Left at the mercy of market forces, Pak rupee would have appreciated to levels which would have affected export competitiveness negatively and encouraged cheap imports.
This would have resulted in widening the trade deficit. During this period, State Bank said so many times that it was deliberately keeping the value of the rupee undervalued with this object in view.
The argument that previous hierarchies did not indulge in this practice due to its undesirability does not hold water because the kerb market in Pakistan at that time used to be very thin and purchases by the State Bank from this market would have resulted in a huge depreciation of the rupee in the open market which the authorities did not want for a variety of reasons.
The State Bank's recent management of exchange rate policy, however, appears to be unclear. During the last few weeks, Pak rupee has depreciated against US dollar by a small margin due to a number of factors including expanding trade deficit, soaring world oil prices and apprehensions about the security situation in the country.
The widening differential in inflation rates between Pakistan and major developed countries also seemed to have played its part.
The State Bank was relatively slow in raising the interest rates which induced the investors to switch-over to other currencies for investment. Some major payments were also to be made during this period.
Since some depreciation of the rupee was more or less obvious, importers are reported to have opened letters of credit abnormally while exporters, sensing a premium, decided to hold back the proceeds by asking the banks to send their documents to the buyers on "collection basis" rather than "payment-on-sight" to delay the inflow of foreign receipts into their accounts with the result that the six-months forward cover rose sharply.
Any other central bank would have allowed the events to take their own course and let the currency depreciate to a new level or adopted neutralising measures without much ado but the State Bank is trying to browbeat the market to toe the line perceived by it to be correct.
The State Bank has sold $700 million in the market during the last three months and according to reliable sources, it is injecting more foreign exchange in the market to stabilise the exchange rate of the rupee.
Probably, the State Bank wants to defend the exchange rate at about Rs 59 to a dollar. Like any other central bank, it has every right to adopt this route but the cost of such an undertaking could be quite enormous if interest rates in foreign countries continue to be high, inflation remains relatively higher in Pakistan and trade gap widens further due to the impact of high oil prices and other factors.
Professor Walter had indicated in the third week of August, 2004, that $12 billion may melt in no time if foreign exchange reserves are not based on sustainable inflows.
Whether the State Bank would be actually prepared to defend the rupee at a particular level without much regard for the market forces and at the cost of sacrificing a major part of reserves could be a matter of conjecture.
However, the present level of foreign exchange reserves has been touted as such an outstanding achievement by the government functionaries that they would not like this shining success to lose lustre and be derided by all and sundry.
Therefore, before there is a serious threat of such an eventuality, the authorities would need to take certain steps.
Since actions like rationing of foreign exchange and rigid control on imports do not appear possible and the country would not like to increase its external indebtedness, only few options would be left to deal with the situation.
As a first option, let us all pray that factors weakening the rupee may somehow disappear. But if our prayers remain unanswered, then the country has to let the rupee depreciate in order to achieve a proper balance between foreign exchange receipts and expenditures.
However, how much depreciation would be enough is difficult to foretell. A reasonable hike in the interest rates would also be helpful to ease pressure on the rupee and contain inflation rate in the economy.
Obviously, the State Bank has to fight a tough battle to maintain a balance between currency stability, inflation and interest rates without disturbing the momentum of growth but delay in tough choices could sometimes be quite risky.
It may also be added that sharp reaction to certain events for no obvious reasons could be counter-productive.
The State Bank Governor is reported to have termed the current movement in exchange rate a result of speculative activity and warned the speculators that central bank would not allow the free-fall of the rupee.
Besides, State Bank officials are reported to make intensive inquiries when a particular bank sells foreign exchange beyond a certain limit.
Clearly, these are early indicators of over-anxiety and may have the opposite effect of what the State Bank intends to create.