The rupee slide

A misconception doing the rounds in the media is that the rupee is market based with demand and supply determining its value. This is far from the truth.

On 12 May 2019, the International Monetary Fund (IMF) and the then two economic team leaders representing Pakistan notably Dr Hafeez Sheikh the de facto finance minister from 19 April 2019 till his summary dismissal on 29 March 2021 and Dr Reza Baqir appointed as Governor State Bank of Pakistan (SBP) on 6 May 2019 till date, reached a staff level agreement. The Fund website noted that "a market-determined exchange rate will help the functioning of the financial sector and contribute to a better resource allocation in the economy."

A market determined exchange rate is defined when a State Bank does not have a specific exchange path or target and indicators for managing the rate are broadly judgmental for example balance of payments position, international reserves, and parallel market developments; adjustments may or may not be automatic and intervention maybe aimed at moderating the rate of change and prevent undue fluctuations (disorderly market conditions) that may be direct (through purchase/sale of dollars by the central bank) or indirect (exerting its power as the banking sector's regulator). In other words, it is a judgment call by the SBP and this very judgment call should be in question today.

The Monetary Policy Statement on 20 September 2021 notes that "the flexible market-based exchange rate regime has performed well since its introduction in June 2019, including through the Covid shock. It has overseen a healthy modulation of the current account and supported a critical build-up in the country's gross and net FX reserves despite external pressures. Under this regime, the SBP does not suppress an underlying trend in the exchange rate and any interventions are limited to address disorderly market conditions. Since its floatation, the rupee has moved in an orderly manner in both directions and has depreciated by only 4.8 percent to date, much less than many other emerging market currencies over the same period. Since the rupee was floated, SBP's gross foreign exchange reserves have nearly tripled to a record $20 billion, while net international reserves have risen by nearly $16 billion between end-June 2019 and end-August 2021."

One must challenge these claim on four counts. First, yes, the rupee dollar parity in 2019-20 did reduce the trade deficit by throttling imports however ignored was the heavy cost borne by the public in terms of stifling of the economy leading to a pre-Covid 19 projection of 1.5 percent growth, 13 percent inflation and high unemployment.

Second, foreign exchange reserves registered 20.6 billion dollars on 1 October 2021 as per World Bank in its report released last week on Pakistan titled "Reviving Exports" which it maintained is equivalent to only 3.7 months of imports. On 15 October the State Bank of Pakistan (SBP) website indicated reserves were down to 17.4 billion dollars - so at present barely enough to cover three months of imports - the minimum reserves required.

It is also relevant to note that than 50 percent of the reserves are sourced to borrowing - debt equity through issuing Eurobonds/sukuk at rates well above the international level, commercial borrowing at a high rate with a low amortization period and bilateral/multilateral concessional borrowing whose continued flow is dependent on the successful sixth review talks with the IMF. The recent Saudi 3 billion dollar support and the 1.2 billion dollar deferred oil payment - loan and not grant - announced on 27 October 2021 led to the rupee gaining strength - from 175.25 rupees interbank on the day the news hit the market to 171.56 two days later on Friday. However, it is too early to definitively conclude that the rupee will continue to strengthen given that the trade deficit continues to widen, and the reserves continue to dwindle.

The major positive factor in the current account deficit remains remittance inflows that have continued to keep the current account in a non-stressful position in spite of recent worrisome escalation in the trade deficit. Remittances reached a historical high last year of 29.4 billion dollars and data suggests that this rising trend is continuing in the first quarter of 2022. Thus the rise in reserves cannot be sourced to the rupee dollar parity.

And finally, the rupee is not moving in an orderly manner and its decline has been precipitous since May 2021 - around 13 percent if one takes account of the strengthening of the rupee since the Saudi injection. The World Bank report argues that Pakistan's dollar earnings have declined due to the rising trade deficit, lower exports to Afghanistan (previously 870.5 million dollars) post-Taliban takeover, and rising import bill which in turn is contributing to increased outflow of dollars and the dollar's scarcity relative to the Pakistani rupee.

Pakistan is thus on an IMF programme with no predetermined path for the exchange rate and disturbingly has no inflation targeting framework as per the Fund website. Had inflation targeting been its objective there would have been as per the Fund "public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets. Additional key features include increased communication with the public and the markets about the plans and objectives of monetary policymakers and increased accountability of the central bank for attaining its inflation objectives. Monetary policy decisions are guided by the deviation of forecasts of future inflation from the announced target, with the inflation forecast acting (implicitly or explicitly) as the intermediate target of monetary policy." This may partly explain why the State Bank has been disclaiming responsibility for inflation by citing administrative measures, justified to some extent as the country has witnessed rising utility rates and taxes, and to appease the Prime Minister's pet peeve the "mafia", as the major contributors to inflation.

A comparison with other regional countries reveals that India, not on a Fund programme, has no explicitly stated nominal anchor, but monitors various indicators in conducting monetary policy. Bangladesh and Sri Lanka have a monetary aggregate target, and Nepal has a fixed rate arrangement. The recent rupee erosion, sources claim, can be justified by data uploaded on the SBP website on two counts. The real effective exchange rate (REER) for September 2021, provisional, is given as 95.8 down from the previous month's 96.5. In the pre-May 2019 days this would have indicated that the rupee is undervalued to the tune of 100 minus 95.8 or by 4.2 rupees to the dollar - a view shared by previous governors of the SBP. However, the SBP website now notes that "a REER index of 100 should not be misinterpreted as denoting the equilibrium value of the currency." In this context the rupee strengthening post-Saudi injection should reduce the rupee's September undervaluation but the question is for how long especially as trade deficit continues to widen.

And secondly, the discount rate of 7.5 percent is now linked to core inflation (6.4 percent in September), a policy that was abandoned in May 2019 without any corroborating research that would have negated a research paper on the Bank's website arguing in favour of a linkage with core as opposed to Consumer Price Index.

This justification is in marked contrast to policies implemented post-May 2019 till the onset of the pandemic in April 2020 when the rupee erosion continued even when the REER showed it was undervalued and the discount rate was linked to CPI instead of the core inflation. In other words, the SBP management appears to have reversed its 2019 policy thrust to what was prevalent before May 2019.

Be that as it may, the rupee slide has made a mockery of the government's budgeted deficit as each rupee erosion vis a vis the dollar adds 100 billion rupees to debt servicing and considering that the rupee dollar parity was 152 rupees to the dollar during budget formulation therefore in spite of the Saudi injection and the strengthening of the rupee the addition is around 1.9 trillion rupees or, in other words, other things remaining the same the total outlay for the budget would rise from 8.4 trillion rupees to 10 trillion rupees with the addition itemized under current non-development expenditure - a highly inflationary policy which may well fuel further rupee erosion.

Copyright Business Recorder, 2021