Currency diary

The currency is in pressure for the past few sessions. Speculations are rife and the market is coming up with one number or the other. Pakistan’s economy is not used to a flexible (market-based) exchange rate and headlines are being based on nominal movements. But such volatility is healthy for the market and one should not confuse this as a crisis.

The question is: what is the equilibrium or fair value of PKR against USD? Well, there is none. Theoretically, analysts and economists can come with a fair value (or band) - like they do for equities traded on stock exchange. But markets have their own way of discovering the price. Usually (in due time) the market price converges to fair value. But in the short run, sentiments (demand and supply) drive the market. Plus, the theoretical value is dynamic – it changes with other factors such as interest rates, inflation, current account and other indictors.

A couple of years back, there was an effective fixed exchange rate regime in Pakistan. At that time, the fundamentals were showing that the currency was overvalued. The key indictors to watch are Real Effective Exchange rate (REER), current account and financial/capital accounts.

REER indicates the currency movement in the medium to long term – like the way REER was moving in 2016-18, a steep adjustment in currency was inevitable.

Current account reflects the currency direction in the short to medium term – if the current account is slipping (like it was in 2017-19), the currency is bound to adjust to taper the deficit. The financial/capital account drives short term currency movement – as day to day flows are on the basis of demand and supply, and sentiments are based on these. Ever since COVID, these capital/financial accounts are under pressure and that explains currency deprecation in the past few weeks.

REER is indicating that currency is slightly undervalued and there is room for 5-7 percent appreciation in the PKR. Current Account is well in control and the deficit could be even lower due to COVID. This is also implying that currency can pull back to 155-160 levels. The real issues are the foreign debt repayments and lack of foreign funding and investment. The reserves decline lately is due to these factors.

The good news is that expected inflows are better than the expected outflows. This means that the currency may pull back. But before doing so, the current sentiments may let it slide further.

There are agreements signed with ADB, WB and AIIB for disbursing $500 million each. This cumulative $1.5 billion is expected in a week or so. Then $1.4 billion from China (commercial borrowing) is expected to reach on June 26. This is a renewal to the loan paid back weeks earlier. There is rescheduling of $2.4 billion debt servicing (due till Dec 2020) to May 2022 under the G20 debt relief package. The IMF second and third tranche is expected in a month or so too.

There will be some debt repayment pressure in the last week of June ($800mn) and right now there is some increase in opening up of LC for oil payments – thanks to mismanagement. Furnace oil, petrol and diesel are all in short supply in Pakistan. This will pass too.

In July, one would see SBP reserves back to $13-14 billion from current $10.1 billion. This will ease the pressure on currency and it may come back to 160-165 level in a few weeks. Having said that, it is important to note that currency movement and its valuation are dependent upon other macro indictors such as inflation and interest rates.

Inflation determines REER and there is no pressure on that and is no more a prime concern for the SBP. Interest rates are to be dealt with care. There is a tradeoff between interest rates and exchange rate. Lower the real interest rate, higher the chance of currency depreciation and vice versa. The SBP has lowered rates by a massive 525 bps in the past three months and that is one reason for the currency to be under pressure. Since the underline fundamentals are strong (Current account and REER), the pressure on currency has remained subdued. However, if there is further aggressive easing, it will be hard to control currency sentiments. There is a clear tradeoff. Tread with care.