Rupee: Stable ahead, but not for long

With the rupee touching its new low against the greenback just before Eid holidays, skeptics quickly linked it to Pakistans deteriorating economic fundamentals in the aftermath of the floods.
A close inspection, however, reveals that it was just natural volatility of any currency driven by the demand and supply mechanism. The rupee, which had crossed the 86-mark against USD due to $215-million-plus oil payment amid some hiccups in worker remittance inflows, has now reverted back to the 85.50 levels.
And the Real Effective Exchange Rate (REER) computed by the central bank supports the argument of short term stability. REER, which is computed on the basis of the rupees relation to 22-23 currencies, instead of looking at key trading partners and competitors, has depreciated considerably in the Feb-Jul period.
Though, based on its current computation methodology and the backward-looking static nature, REER cannot be taken as the chief indicator of currency movement; it can, however, be taken as a ballpark figure to assess the rupees movement ahead. Since REER was close to its index level 100 in July, from roughly around 95 in February, a stable currency can be expected in the short run.
This also provides some room to the rupee to stay at current levels. In the post-flood scenario, higher inflation in the coming few months, i.e. high consumer prices at home relative to trading partners, might result in the appreciation of REER. But based on REERs historic band of around 92-95 levels, the nominal exchange rate may eventually remain sticky.
Apart from the fact that no major demand-supply shock is in the pipeline, sanity will likely prevail in the currency market over the next few months. However, in the medium term, like all other macroeconomic indicators, fiscal discipline is imperative for stability in the currency market.
The gap between government revenues and expenditure, which is threatening to lead Pakistan into a debt trap, can be detrimental for the currency market. The fiscal reforms that include the implementation of a reformed GST or VAT, coupled with the energy sector reforms, are imperative to check the fiscal deficit.
To look at the picture the other way, the continuation of IMFs Standby Arrangement is contingent upon the implementation of the above mentioned reforms and the autonomy of State bank of Pakistan. In the absence or further delay of these reforms, chances of derailment of the IMF programme are high. The World Bank and ADB are also linking their assistance to the consent of IMF.
With no significant funds expected from FoDP, and drying FDI inflows, the demand-supply mechanism in the currency market is at the helm of timely flows from multilateral agencies. Since major outflows are not anticipated till December, the rupee is expected to hover around 85-87 levels until then. However, if the required fiscal reforms are not taken in due course, the currency might hit 90 against the greenback.
Amidst all these news of doom and gloom, however, the appointment of well-reputed Shahid Kardar as the Governor of State Bank is a positive surprise. This does not only give a ray of hope as regards SBPs autonomy, but also with respect to timely fiscal reforms.