External account stability: Exchange rate defence strategies may prove to be the Achilles’ heel

Remittances and services exports have cushioned the impact of higher oil prices. But a strengthening real exchange rate and reluctance to let the rupee adjust could undermine competitiveness if the war drags on.

Pakistan’s external account has weathered the oil shock remarkably well. Seven months into the Middle East war, there is little evidence of the external financing pressures that accompanied previous episodes of sharply higher energy prices. Domestic consumption is being restrained, energy import volumes are lower, and stronger remittances and services exports have largely absorbed the increase in the import bill.

The numbers are telling. Between March and September 2026, the current account recorded a deficit of $465 million, compared to a surplus of $684 million in the corresponding period last year. The deterioration of $1.15 billion is modest considering that average international oil prices have risen by 46 percent, with an even sharper increase in refined petroleum products. Goods and services imports increased by $4.7 billion, of which petroleum accounted for only $1.5 billion. Much of the remaining increase came from transport, machinery, metals and other non-energy imports.

The offsets have been substantial. Home remittances increased by $2.1 billion, while services exports added another $1.2 billion. Together, these inflows more than compensated for the additional petroleum import bill. Pakistan’s external resilience is increasingly being supported by sources of foreign exchange other than merchandise exports.

The import composition provides further reassurance. According to the Pakistan Bureau of Statistics, the goods import bill increased by 13.2 percent to $19.2 billion in the first quarter of FY27. Petroleum imports grew by just 6.5 percent, while non-petroleum imports increased by 15.1 percent. Transport, machinery and metals recorded growth of around 20 percent. Petroleum product import volumes declined by 21 percent and crude volumes by 7 percent, reflecting weaker consumption in response to higher prices, while domestic refineries continued operating at relatively high capacity.

LNG imports have fallen even more sharply. Pakistan received just 18 LNG cargoes between March and September, including seven spot purchases, compared to 64 cargoes a year earlier. At prevailing international prices, the reduction represents potentially around $2 billion in avoided import expenditure. However, part of this reflects disruptions to contracted supplies from Qatar rather than simply weaker domestic demand. The lower import bill has come alongside gas shortages and supply constraints, limiting the economic benefit.

The rise in non-oil imports is not necessarily a cause for alarm either. Completely built-up car imports increased by 40 percent to $126 million, while kits for local assembly rose by 31 percent to $600 million. Part of this reflects pent-up demand, but rising inventories and discounts in the secondary market suggest that the momentum may not last. Machinery imports are increasing even as mobile phone imports decline, a potentially encouraging shift in composition. Higher metal imports may also point to some recovery in construction activity.

There are reasons to expect import demand to moderate over the coming months. Inflation remains elevated, uncertainty surrounding the war is weighing on consumer and investor sentiment, and secondary market interest rates have risen by around 200 basis points from their pre-war lows. Financial conditions are tightening even without a further increase in the policy rate, which should temper demand for imported consumer durables and other discretionary purchases.

Meanwhile, remittances continue to surprise on the upside. Some of the increase may itself be related to the war, with expatriates potentially repatriating savings amid uncertainty in the Middle East. Services exports are also benefiting from a relatively favourable tax regime and an expanding base. These inflows are providing a cushion that merchandise exports have struggled to deliver on their own.

The more uncomfortable development is the exchange rate. With domestic inflation running ahead of that in trading partner economies and the nominal rupee-dollar parity remaining largely unchanged, the real effective exchange rate has climbed to 108.93, its highest level since May 2018. The index has appreciated by nearly 7 percent over the past year. This does not, by itself, establish that the rupee is overvalued, but it does indicate a steady erosion of relative price competitiveness.

The State Bank has a reasonable defence. It continues to purchase dollars from the interbank market, rather than sell them to support the rupee, while foreign exchange reserves have reached historic highs. There is no immediate evidence of a currency shortage or an external financing crisis. Yet that does not mean the exchange rate can remain largely unchanged indefinitely, particularly if domestic inflation continues to outpace that of Pakistan’s trading partners.

The government is understandably reluctant to allow depreciation. The exchange rate remains politically sensitive, and past experience suggests that even a modest adjustment can generate expectations of further weakness. Policymakers fear the inflationary consequences and the possibility of a self-reinforcing cycle of depreciation. The temptation, therefore, is to preserve nominal exchange-rate stability and rely on tighter monetary conditions to contain demand.

That may explain why a measured increase in the policy rate appears more likely than any deliberate exchange-rate adjustment. The next monetary policy meeting is scheduled for October 26, and secondary market yields have already moved higher. But monetary tightening and exchange-rate flexibility serve different purposes. Higher interest rates can restrain demand and contain inflationary pressures; they cannot, on their own, reverse the loss of external competitiveness resulting from a strengthening real exchange rate.

Much now depends on the duration of the war. A prolonged conflict could eventually weaken remittances, constrain services exports and sustain pressure on the energy import bill. Conversely, an easing of hostilities, alongside higher US oil production and softer global demand, could bring petroleum prices down sharply. With Pakistan largely passing higher fuel prices through to consumers, lower international prices would also provide some relief to domestic inflation.

For now, the external account remains manageable, and there is little reason to expect an imminent balance-of-payments crisis. The greater risk is that policymakers mistake the absence of immediate pressure for evidence that the current exchange-rate approach can be maintained indefinitely. Pakistan has bought itself some breathing space through lower energy consumption and stronger foreign exchange inflows. It should not squander that advantage by allowing a gradual loss of competitiveness to become the next external account problem.

Copyright Business Recorder, 2026