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The rupee slide in recent weeks suggests that the traditional arguments of elevated current account deficits, selling USD by SBP, REER, rational/adaptive expectations on foreign inflows, geo-politics and begging bowl need a serious rethink. In fact, the only argument that stands valid in this short-run extreme volatility is the unchecked flow of USD to Afghanistan since Sept ’21 and now its weak monitoring in the last few days.

Due to porous borders, rampant undocumented (smuggling) and even under-/over-invoiced documented trade among the locals residing on both sides of the border with the connivance of officials, historically the use of rupee and afghani to settle financial transactions remained benign and largely unrecorded.

Since 2001, cash USD also entered as a third currency. However, it would not be an exaggeration to reclassify Afghanistan and Pakistan as a vibrant rupee currency common area, as de facto reliance on PKR for financial transaction may have increased manifold after dwindling of USD in foreign aid since Afghanistan’s isolation in the world community. It is likely to remain well-knit and ‘cloaked’ common currency area at least in FY22 until sufficient USD flow through trade or aid in Afghanistan.

Once this is accepted as a shock to the regular working of monetary policy in Pakistan, the next challenge is how to manage the possible frequent short episodes of extreme exchange rate volatility in Pakistan, namely sizeable depreciation in matter of weeks and appreciation in matter of days that is likely to be an outcome of this shock.

Given the dominance of Pushto and Darri languages and preference of ‘word of mouth’ over any formal documentation, there is a strong ‘cloak’ over the modus operandi of how the unofficial financial transactions are conducted between the two brotherly nations. Under these behavioural constraints few testable scenarios of financial transactions are discussed. Let me briefly elaborate on a testable hypothesize why it is meaningful to consider Afghanistan and Pakistan as a vibrant common currency area.

Soon after the withdrawal of US troops, the prospects of deep devaluation of afghani and non-availability of USD in the country were apparent. If the afghani had followed an orderly devaluation and USD was available at the new price, its exchange rate may have settled close to PKR/USD rate. Due to its non-availability, true USD market exchange rate in Afghanistan remained anybody’s guess.

Consequently, the previous stock of PKR held by our Afghan brothers and their counterparts/relatives in Pakistan were used to buy USD in Pakistan to protect the undocumented/documented profits and savings and use against future USD transactions. In an analogy of dam holding water, the spillways are opened during flood as the stored water rises above a stated level, the PKR flooded the loosely monitored USD outflows and once the PKR stock tapered-off in Afghanistan with a loss of USD 1.2 billion or even more to the Pakistani exchequer, the water-level receded along with the partial closure of gates.

If SBP (State Bank of Pakistan) had intervened in a timely manner and/or biometric controls were in place as per FATF (the Financial Action Task Force) recommendations, it may have staggered the rise of USD/PKR, but it is doubtful if it could have stopped the excess supply of PKR in bidding up the USD price, as there are many options, including Hundi/Hawala. It is fair to assume that the brotherly nation and its relatives in Pakistan are holding $1.2 billion or even more in cash to meet Afghanistan’s very crucial needs, including trading in goods and property.

From a monetary policy perspective, the objective of SBP is not to allow excessive (how much is ‘excessive’ remains an empirical question) build-up of PKR in Afghanistan in a given period so as not to repeat the above-mentioned episode and reduce the short-term volatility in its exchange rate. In a trading of goods environment it depends on the following dynamics:

At a macro level, it is a simple ECO101 explanation, that in a given period, net positive exports (exports greater than imports) to and from Pakistan will lead to increased supply of PKR relative to its demand in Afghanistan and during off-loading of excess PKR for USD from Afghanistan, pressure will temporary build on rupee’s exchange rate, causing a short-term volatility. If net exports are negative, two possible scenarios arise. Either importers in Afghanistan run down on their cash USD balances as demanded by the Pakistani exporters or if acceptable, pay in PKR to Pakistani traders.

Thus PKR supply will increase in Pakistan, which may or may not build up short-term pressure on PKR exchange rate. If USD is held as an asset, afghani traders may not be willing to part with their limited stock of cash USD. In both cases, it will further strengthen the rupee common currency area.

At a micro level, the impact of trading on short-term volatility becomes more complicated. It depends crucially on the type of bilateral (mostly relatives on both sides of the border) traders engaged in trading. If bilaterally same traders are engaged simultaneously in imports and exports, rupee balances will continue to be held by both individual parties for a longer period on both sides of the border with expectation that they will zero out over an agreed period of time without causing much loss to either party in terms of USD/PKR parity.

If it is a multilateral environment where importers and exporters deal in different commodities, the demand and supply of PKR in Afghanistan will converge to the above macro scenario.

Whether monitoring and biometric controls are effective in eliminating short-term extreme volatility of USD/PKR, only time will tell, but like water cash always finds a way to where it is meant to reach. Theoretically, one has to accept that Afghanistan because of its temporary isolation is compelled to conduct transactions in PKR/afghani.

The sooner it is accepted that both Pakistan and Afghanistan are a rupee common currency area, transactions arrangements in cash PKR and USD be institutionalized accordingly in both areas. A textbook solution is setting up of clearing house in both countries where monthly balances of PKR are cleared and net position is cleared in cash USD or PKR. It will benefit Pakistan more than

Afghanistan as it will formally suck the excess PKR in Afghanistan. Informally, these clearing houses may already exist under the above described bilateral trade or among groups of traders in Pakistan and Afghanistan. Unfortunately, institutionalizing such transparent clearing houses for cash is easily said than done.

The cultural ‘cloak’ mentioned above, the belief that Islam doesn’t recognize territorial borders and ‘word of mouth’ between Muslim brothers is far superior to any other documentation pose serious challenges to the working of institutionalized clearing houses for common currency area in this environment. Traders and others dealing in cash flows may be unwilling to clear their balances on a periodic basis formally because of some legitimate fears, but again it is worth experimenting to reduce short-term extreme volatility in USD/PKR rates.

Copyright Business Recorder, 2021


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