EDITORIAL: The rupee lost 2.8 percent value against the dollar in June before very slightly recovering on news of a dollar one billion package from the World Bank and the International Monetary Fund ($500 million from each). There was no element of surprise in the decline with pundits forecasting a further fall in weeks if not months to come if Covid-19 peak is not reached soon and the significant reversal in the numbers being infected begins.
The PTI government's biggest economic challenge after taking oath in August to early September 2018 was the highest-ever current account deficit in the country's history - close to 20 billion dollars - with foreign exchange reserves of 9.6 billion dollars (on 7 September 2018 as per the State Bank of Pakistan) - not enough to meet three months of imports. With foreign debt repayments coming due in months to come the administration had no option but to seek loans from friendly countries, including China, Saudi Arabia and the United Arab Emirates. In addition, the Asad Umar-led finance ministry then proceeded to deal with the overvalued rupee, a flawed policy supported by the then finance minister Ishaq Dar that enabled him to understate the budgeted debt servicing payments while ignoring the impact of an overvalued rupee on exports. Umar succeeded in bringing the real effective exchange rate (REER) to 98.66 by March 2019 - a period when the REER reflected the rupee value and the discount rate was linked to core inflation instead of the Consumer Price Index (CPI). At the time of Umar's removal from the finance ministry the current account deficit had come down to 11 billion dollars, the discount rate was 10.75 percent while the foreign exchange reserves on 13 March 2019 held by the State Bank were 12.6 billion dollars.
Enter the new economic team leaders and the staff-level agreement with the International Monetary Fund (IMF) on 12 May 2019. Prior conditions agreed and implemented included: (i) delinking of the discount rate from core inflation and linkage with the higher Consumer Price Index (CPI) with the SBP claiming that as per the IMF definition the REER calculated by the SBP does not reflect the true picture; and (ii) a market-determined exchange rate which the Fund argued would 'help the functioning of the financial sector and contribute to better resource allocation in the economy.' These policies together with the contractionary fiscal policies agreed with the Fund led to stifling of economic activity and rising unemployment levels.
Enter Covid-19 into the already deteriorating economic situation in the country and the existing negative trends were exacerbated. The two policies meticulously adhered to by the SBP pre-Covid-19, the high discount rate and the market-determined exchange rate, were no longer politically acceptable to the administration. This is evident from the IMF's staff report on Pakistan's request for Rapid Financing Instrument dated April 2020 where the Fund "cautioned on the need to remain vigilant of potential inflationary pressure arising from rupee depreciation and supply side pressures." It is noteworthy that while the IMF projects 8 percent inflation for next fiscal year the government has understated it at 6.5 percent in budget documents; and the Fund also stressed that intervention in the foreign exchange market should remain limited to prevent disorderly market conditions.
Foreign exchange reserves on 12 June 2020 were 10.1 billion dollars and the argument is that if the discount rate is reduced further it would put pressure on the rupee value. While there is interdependence of macroeconomic indicators yet there is no empirical evidence of exactly how much impact would a discount rate decline have on the rupee value (with available data for other countries revealing that the linkage supports inflationary expectation hypothesis but data shows that a one percentage change in the discount rate motivates an exchange rate change ranging from a low of 0.11 to a high of 0.73).
It is therefore about time the SBP conducted and presented empirical research on the impact of its recent change in linking the discount rate to the CPI instead of the core inflation and the impact of each decline in the rate post-Covid-19, which understandably does not represent a normal situation, on the exchange rate. The central bank is also requested to shed light on the likely impact of its yesterday's decision to cut policy rate by 100 basis points to 7 percent on PKR's parity with USD.
Copyright Business Recorder, 2020
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