The rupee is making headlines again. The currency has depreciated by 3.5 percent against the US dollar in last four weeks, leaving many worried about its future. But as any history professor would say, know your past for it holds a key for tomorrow.
The story of rupee-dollar parity is roughly as follows. After peaking in October 2007, Pakistans foreign exchange reserves were on constant decline, but the rupee did not see sharp depreciation until June 2008, following which it continued to weaken till it marked its record low of 83.70 against the greenback on October 17, 2008.
At this point, recall that between June and October last year, our economic managers were busy negotiating with the IMF for its standby facility of $7.6 billion. And as one would expect history is repeating itself. The currency - which gradually stabilised and remained largely range bound between January and June 2009 - actually started weakening about four weeks ago. This again coincides with a series of negotiations with the IMF to close the $4 billion bridge-financing deal for governments fiscal support.
So whats the connection? Dive into one of the basic economic theories on exchange rate mechanism and you find out that rate movements endogenously balance the macroeconomic variables. Real Effective Exchange Rate (REER), reflective of cumulative movements of weighted average exchange rate of basket of currencies of our trading partners and relative price index, govern the direction of currency to keep the system in long-term equilibrium.
But like in past, Pak rupees REER, as computed by SBP, has not been in equilibrium as nominal exchange rate has been propped up artificially. Our REER appreciated by 4.6 percent from October 2008 to April 2009 - making goods and services available in Pakistan cheaper to its trading partners. So it is more than plausible that IMF is asking SBP to reduce this gap to keep purchasing power at parity and hedge any potentially sudden movement in currency which typically threatens to collapse any system - like in the case of 90s East Asian crises.
But IMFs role as a catalyst does not bode an all that gloomy future for the currency. Rupees depreciation last month amid declining inflation which is likely to be around 11 percent in July appears to have reduced the appreciation in REER up to permissible level. This means the worst is already over for the current, and it is likely to hover in the band of 83 to 85 per USD in the coming few months.
And technical chartists seem to confirm this. "Dollars ten-year bullish cycle versus rupee seems to be nearing its end" says a chartist at a leading brokerage house, adding that the currency is in a technically overbought state, but even if it breaks its previous record, rupees maximum potential would be 85 to 85.40 per US dollar.