The last few months have been a roller coaster for the Pakistani Rupee (PKR) and there is a lot of talk about market determined rate, artificially strong Rupee and manipulation. Unfortunately, understanding of how the Pakistan forex markets works is limited to fewer people than one would expect.

How the Developed Market Works

Let’s take Sterling (GBP) as an example. It is a free currency with a huge float. You can find buyers & sellers at any time of the day, at any price levels, for almost all realistic deal size. Consumers, investors, corporates, day traders, arbitrage traders, risk & hedging managers can buy or sell without intricate or lengthy procedures, providing a vast pool of liquidity.

This is why demand and supply point towards a fair value for the currency and is deemed market driven, a great case for efficient price discovery. When the daily trade volumes are so huge, intervention by a central bank is often seen as gesture rather than a market determining event. And its purpose may be to alter the volatility rather than the direction.

We saw in 1992 when BoE (Bank of England) spent more than GBP10bn to influence the market, but ran down its reserves and finally had to give up. This is why developed countries promote intervention policies rather than direct intervention to influence the market.

An example for intervention policies could be quantitative easing/tightening to influence or compress growth. Of course, black swan events or sudden change in sentiment will derail the fair price argument (like how GBP traded at 1.03 recently), but this attracted a fresh pool of investors, speculators & opportunists, and GBP climbed above 1.13. A profit of 10% in matter of 10 days! This is the kind of incentive that traders look for if something is being mispriced resulting in market prices gravitating towards fair prices.

Market-determined prices

When an economy driven by markets rather by governments comes into being, the ramifications are endless, because taking price-setting out of the hand of government and giving it to the invisible hand of markets has ripple effects on economic incentives—when entrepreneurs rather than officials determine how to allocate resources, economic rationality permeates all spheres of economic life.

Closed market

But when markets are excessively regulated, in a few hands and lack liquidity, price discovery can be a challenge. Such is the case with PKR. While sentiment changing events like falling reserves, adverse change in ratings, or material increase in Current Account Deficit (CAD) may swiftly impact PKR rates, giving the impression of free market, in reality, that may not be completely true.

To explain this further, a squeeze by sellers (for example, sellers holding dollars back for profits when rates are expected to go up), doesn’t create a new stream of sellers for dollar, so the price change can be exaggerated if no one takes any action.

In another example, if the outflow of dollars is more than the inflows, it cannot be addressed unless the State Bank steps in and fills the gap, where else will the dollars come? How quickly the central bank does this will impact sentiment & volatility.

In those times, the regulator can persuade the banks to not buy above a certain level and that is that. Of course this is over-simplifying a more complex scenario, but this is very true of a real life scenario. We’ve seen this on multiple occasions when our reserves dipped to almost non-existent levels.

When diverse or fresh buyers and sellers are limited, any price anomaly doesn’t get corrected soon (as it was in the GBP case above). This also translates into price volatility due to illiquidity rather than fundamental changes, and demand supply levels cannot be tweaked by changing market prices.

Longer-term pricing

However, in the long term, currency rates do eventually align to or near their fair prices. For example, an over-valued currency obstructs growth in exports and provides an unsustainable subsidy to imports (through cheaper dollars). Whereas an undervalued currency curtails demand and erodes purchasing power. A good example would be when Rupee plummeted from 110 to 160 against the dollar in a few months after being held back for years.

Intervention

Intervention, unfortunately, happens, even in recent times. Japan intervened to strengthen the yen for the first time in 24 years as a trio of European central banks sharply raised interest rates, to prop up their currencies. It was the first time Japan had sold dollars since 1998, according to official data. Bank of England bought Gilts worth GBP63 billion to support the financial market. India has spent roughly $90 billion in supporting its already stable currency. Thailand, Malaysia, Colombia, this list goes on.

However, the objectives to intervene may vary from reducing volatility, addressing systematic risk or to influence other areas like inflation, trade and growth.

In recent years, developed economies have used intervention policies, rather than direct intervention, as they are more effective and more sustainable. In a later study on the 1992 GBP crises mentioned above, it was estimated that it cost the UK Treasury a loss of GBP3.3bn, where as they would have gained by GBP2.4bn had they not done the intervention.

Fair prices

In recent times, a flurry of frameworks has emerged to infer fair prices, but there is no magic formula as yet. Of all of these REER (Real Effective Exchange Rate) has been touted as the go to method as it uses inflation targeting monetary stability.

While it does give some insight into a currency’s relative progression, it is still far from being perfect. For example, Bangladesh grew their export volumes when their currency was slightly over valued. REER for Turkey & Argentina is around 50 (or undervalued by half), but that does not solve any of their currency woes, in fact their deteriorating currencies promoted deeply entrenched dollarisation of their economies.

So striking a balance between growth, inflation and fiscal space needs someone with an entrepreneur’s mindset and ability to sift through large volumes of data, with some trial & error.

Way forward

Considering the above, the Pakistan forex market is still fairly under developed and first world standards cannot be imposed arbitrarily. Unfortunately, the Pakistan forex market hasn’t progressed at all in decades. This is not just about making the forex market near perfect, but it is about overhauling the entire economic system. As opening up the FX market will sustain only if other long-term reforms are simultaneously taken. And the time to do that is now.

Till that time, market determined prices as promoted by Muhammad (PBUH) is still a distant dream.

Copyright Business Recorder, 2022