The State Bank of Pakistan (SBP) said on Thursday it had not tried to stop the rupee from falling to three-year lows, but would act on rising inflation which is on track to top its target for this financial year. High prices for imported oil have widened trade deficit, putting pressure on the rupee, and pushed up inflation to nine percent in the year through September.
The rupee has depreciated more than four percent since July 1, hitting a three-year low on Thursday of 61.70 per dollar.
Inflation would surpass the central bank's target of 5.0 percent in the fiscal year to June 30, 2005, SBP governor Dr Ishrat Hussain told Reuters in an interview.
"It will exceed the target slightly," he said. "But it is too early in the year to say where the inflation would be."
He said rising world oil prices, surging food prices and rents were mainly to blame for climbing inflation, which was 4.57 percent in the fiscal year through June 2004.
"If the market conditions suggest that there is an increase in inflationary expectations, the central bank will try to neutralise those expectations.
"Our monetary policy stance is that we will have a measured response according to the market conditions," the governor said.
He said the central bank would check volatility in the currency market but had not tried to set its level.
"We never resisted the rupee depreciation," he said. "There was no defence of the rupee at all."
The rupee recovered a little to end domestic trading on Thursday at 61.20/61.30 to a dollar. Dr Ishrat declined to give a forecast of future levels.
"The central bank comes in when there is too much volatility - in order to tide over and smooth this volatility," he said.
"The exchange rates should be seen moving in a smooth manner, either appreciating or depreciating rather than having fluctuations."
The slide in the currency's value has been mainly due to the widening trade gap on the back of high oil prices, analysts say.
The deficit was $839 million in the three months through September, versus $145 million in the same period last year.
Dr Ishrat said the depreciation of the rupee was not a worrying sign, but reflected a higher dollar demand triggered by growth.
"The reasons are positive," he said. "Once the economy starts growing at 6.0 percent plus, the demand for imports of machinery and industrial raw material goes up," he said.
Non-food and non-oil imports have surged by 38 percent in the July-September quarter of fiscal 2004/05, officials say.
Dr Ishrat said that against the 38 percent growth in imports, growth in exports had been 10 percent.
"The imbalance between the outflows and the inflows is putting pressure on the rupee."
He said the country's growth target remained 6.6 percent.
"Our analysis does not show a need for any revision at this stage," he said. "We stick to our existing forecast - led by industrial and agriculture growth," he said.
He said the current account would not be in surplus this year.
"It will be almost balanced, or slightly in deficit," he said adding that a deficit would be financed by foreign direct investment, inflows from a planned Islamic bond issue and disbursements from international financial institutions.
The governor said high oil prices remained the main concern, because they hurt Pakistan's balance of payments.
"It hurts Pakistan's fiscal position because the burden is not being passed on to consumers to keep a lid on oil prices."
The governor said Pakistan is expected to market its first sovereign Islamic bonds after Eid al-Fitr is over next month.
"After Eid, there will be roadshows," Dr Ishrat told Reuters. They will be held in the Middle East, some other Asian countries and Europe, he said.
Pakistan is expected to sell a $500 million sovereign Islamic bond, called Sukuks, a market source told Reuters in Hong Kong on Wednesday.
But the governor said the government had not yet decided on the size of the bond.
"Everybody has his view, but the government has not taken any position," he said.
Pakistan has selected Citibank and HSBC to jointly lead manage the bond.
"We hope that the market will respond very positively (to the Islamic bond) and we will get good pricing," he said. "There is a big demand (for Islamic bonds) in the Middle East, but we want diversified base. We want to introduce Pakistan in the international capital markets. We do not want to put all our eggs in one basket."