The exchange rate: a steady hum of discontent

No economic variable captures the popular imagination in Pakistan more than the exchange rate. After Pakistan moved from a fixed to a flexible market exchange rate in the summer of 2019, this fascination has only grown.

Unfortunately, there is a lot of confusion about what the exchange rate is, how it is determined, what the equilibrium value of the Rupee should be, why a fixed exchange rate system is unsustainable and how to make the nascent flexible system work better. This article attempts to demystify these five concepts.

First, let us start with some basic terminology. If you are completely averse to math, you can skip this part and go straight to my second point. The “bilateral exchange rate” is the price of the Rupee against another currency.

For instance, the bilateral exchange rate against the US dollar these days is around 260. This means that 1 US dollar is worth 260 Rupees. Similarly, the bilateral exchange rate against the Euro is 280, against the pound is 320, against the UAE dirham is 70, and so on.

The “nominal effective exchange rate” (NEER) summarizes the bilateral exchange rates against each currency into a single number and is therefore a better representation of the strength of a currency in international markets. NEER is all the bilateral exchange rates of the Rupee weighted by how much trade we do with that country. For instance, if we only traded with the US and UAE, and 70 percent of our trade was with the US and 30 percent with UAE, the nominal effective exchange rate today would be = 260.7 + 70.3 = 203.

In turn, the NEER is converted into an index that is arbitrarily set to 100 at a given point in time. 100 has no special significance other than it being the value of the index at that time. For instance, we could set the index to 100 today. And if next month, the PKR depreciates to 280 against the USD but appreciates to 60 against the UAE dirham, then the nominal effective exchange rate would have depreciated to 280.7 + 60.3 = 214. Since 203 was indexed to 100, the index value of 214 would be (214/203)100=105. So we would say that the nominal effective exchange rate has depreciated by 5 percent, i.e., (105-100)100.

The “real effective exchange rate” (REER) is the best representation of how competitive the Rupee is in international markets. It reflects the cost of our exports abroad by adjusting for any change in their prices in Pakistan. REER is the NEER adjusted for the difference between inflation in Pakistan and that in other countries.

For instance, if Pakistan only traded with the US and our exchange rate depreciated from 260 this year to 300 next year, that would represent a nominal depreciation of 15 percent=(300-260)/260*100. However that would not mean that Pakistan’s goods are now 15 percent cheaper in the US. Say US inflation remained at 2% this year and next but our inflation increased from 5 to 10 percent, then in “real” terms, our goods would only have become 10 percent cheaper in the US = 15-(10-5).

As an aside, this illustrates a very important concept: if your exchange does not depreciate against another currency by as much as your inflation rises relative to that country, you will lose competitiveness, i.e. your goods will become more expensive there. At a minimum, therefore, you should expect the Rupee to depreciate every year by how much inflation in Pakistan has gone up relative to other countries (given historical patterns, this is around 5-10% a year).

Again, the REER (like NEER) is expressed as an index that equals 100 at a given point in time. Again, 100 has no special significance other than it being the value of the index at that time. A common mistake people, including our successive Finance Ministers, make is to assume that a REER value of 100 represents the fair value of the Rupee. This is totally wrong. The REER on its own can tell you nothing about where the Rupee should be. Its fair value could in principle correspond to any index value of the REER. If there is anything you remember from this article, please remember this.

This brings me to my second point. What determines the value of a currency? From a day to day perspective, the bilateral exchange rate is determined by the demand and supply of that currency in the interbank market.

Supply in the interbank market comes from exports, remittances, foreign direct investment (FDI), and borrowing from abroad. Importantly, borrowing from abroad is the borrowing in the form of loans taken by our banks and private companies, as well as foreign portfolio investment (FPI) into our stock market and government bonds (infamously labeled “hot money”). Unlike other mature countries, this is typically relatively small in Pakistan.

As an important aside, note that debt borrowed by our government from commercial banks, multilaterals and other countries goes straight to our foreign exchange reserves and is not part of the supply into the interbank market.

On the other hand, demand in the interbank market comes from imports as well as profit, dividends and debt service repayments to foreigners who have supplied FDI and invested in our debt and equity markets. When supply is higher than demand, the Rupee appreciates (and vice versa). In other words, if total inflows—in the form of exports, remittances, FDI and FPI—exceed total outflows—in the form of imports, profits, dividends and debt service to foreign residents and companies—then the Rupee appreciates that day (and vice versa).

My third point is that the fair value of the Rupee cannot be talked up artificially and is determined by five underlying structural factors: (1) how high inflation is in Pakistan relative to other countries: the higher it is, the more the Rupee depreciates, (2) how productive we are relative to other countries: the less productive we become, the more expensive our goods become and the more the Rupee depreciates, (3) demographics: the higher our population growth rate, the lower our savings and the higher our consumption and imports, and thus the more the Rupee depreciates, (4) the relative return on the Rupee: the lower the domestic interest rate relative to interest rates abroad the more the Rupee depreciates, since Pakistanis will choose to open accounts in foreign currency and purchase foreign currency from the market, and (5) the balance of inflows and outflows of foreign currency in the interbank market, which is determined by the current account, FDI, FPI and repayments to foreign residents and companies, as discussed above.

So if we want a strong Rupee, we must lower our inflation, become more productive, slow down population growth and increase domestic savings (including by running a tighter fiscal policy), maintain appropriately high interest rates, control our current account deficit (notably by increasing exports), and generate more foreign currency inflows into Pakistan in the form of FDI, foreign borrowing by banks and the private sector, and foreign inflows into our government debt and equity markets. There is no other way to sustain a strong currency.

My fourth point is that a fixed exchange rate system is not suitable or sustainable for Pakistan. To run a fixed exchange rate system, you need a lot of foreign exchange reserves so that you can support your currency in the interbank market. Typically, at the fixed rate, there will be excess demand for foreign currency, which the central bank has to meet from its reserves.

However, these reserves are precious. They are primarily to pay for imports and debt servicing and should therefore be used very judiciously. Running out of them is what gets you into trouble and forces you to seek IMF help.

In the past, we fixed the Rupee at an artificially high rate, encouraging imports and discouraging exports. This was a completely perverse policy and completely the opposite of what the East Asian tigers did to propel their growth, which was in large part supported currencies that were kept artificially weak and thus favoured their exports. While our policy artificially lowered imported inflation, it put a penalty on manufacturing and contributed to us running current account deficits that were funded by the government borrowing from abroad, leading to a mushrooming of our external debt.

The only way we could sustain this was by throwing reserves into the market. Eventually we would run out of them, the Rupee would suffer a sudden large downward adjustment and we would have to go to the IMF again.

This was bad policy and is not the way successful countries function. Instead of a fixed exchange rate, mature countries rely on a flexible and market-based exchange rate and only intervene when conditions become disorderly. Pakistan moved to such a system for the first time in 2019.

This should help better regulate our imports and, together with other reforms to lower the cost of doing business in Pakistan, improve the business climate and better link our producers with global supply chains, it should also support a revival in our exports over time.

This brings me to my fifth and final point. While a flexible exchange rate is better than a fixed on in a country like Pakistan, it is still subject to important challenges and our nascent exchange rate system needs to be further developed to help it function better over time. Banks intermediate inflows and outflows in the interbank market. They can contribute to speculation when they to advise their clients to wait to bring their export proceeds onshore because they speculate the Rupee might depreciate.

This can create disorderly conditions in the market and the central bank then steps in to fill some of the emerging gap between the demand and supply of the currency to make sure that the Rupee does not become too volatile. This can also happen when there is unexpected bad news on the international front (like Covid or an unexpected move by the Fed) or domestically (like political upheaval or delays with the IMF).

Intervention is only done by the central bank in those rare circumstances when the gap becomes large very quickly and the market would break down in its absence (called “disorderly market conditions” in the technical jargon). This intervention is also naturally limited by how much foreign exchange reserves the central bank has.

In the final analysis, while moving to a flexible and market-based exchange rate in 2019 was the right thing to do, we need to do two things to make the system work better. First, we need to generate more FDI, foreign borrowing by our commercial banks and private sector, and FPI into our domestic government bond and stock market.

Otherwise, there will always be a structural gap between our foreign exchange inflows and outflows given our current account deficit, and the Rupee will tend to continually depreciate instead of moving both up and down as other mature currencies do on a day to day basis.

Unless we do this, we can only sustain a current account deficit of around 1 percent of GDP—the existing sum of FDI, foreign borrowing by our commercial banks and private sector, and FPI into our domestic government bond and stock market—without the Rupee coming under consistent depreciation pressure.

Second, we need to develop and deepen our interbank market like other countries have done over time, including by adding more hedging instruments (like futures, swaps and options), broadening the players in foreign exchange market to include non-banks, reducing frictions and segmentation among market players, and considering a foreign exchange auction system to allow more foreign exchange to accumulate, curb speculation and facilitate more efficient pricing.

Otherwise, the Rupee will continue to be determined by banks based on daily supply, demand and sentiment, which is inherently volatile. A flexible exchange rate is a better system for Pakistan but it needs supportive macroeconomic policies and reforms to deepen the interbank market.

Copyright Business Recorder, 2023