There is growing pressure on the central bank from the authorities in the twin cities to lower interest rates and simultaneously appreciate the exchange rate.
Meanwhile, the State Bank of Pakistan is working hard to build foreign exchange reserves by buying from the market. In economic theory, these three objectives are impossible to achieve simultaneously, and any forced effort could lead to another crisis. According to one of the most senior bankers in the country, they are trying to defy gravity.
The PKR has slightly appreciated against the USD in recent weeks, while authorities are attempting to control exchange rate stress through negotiations with exchange companies and banks. However, this is not the right strategy and may not be sustainable.
The PKR/USD exchange rate was 284 in March 2023, and after more than two years, it stands at 282. There has been no depreciation in the currency during this period, mainly due to the SBP increasing the policy rate to 22 percent and maintaining positive real rates for most of the time. This attracted capital to the PKR and reversed capital flight.
This policy also reduced the demand for currency in circulation (CIC), which fell to zero in FY24 but has recently started growing again at worrying levels. The incentives to keep PKR in banks are decreasing.
Like water, capital finds its way. When real rates were positive, there was no incentive for companies to build inventories or for traders to hoard commodities like sugar and wheat, which helped tame inflation and stabilize the currency.
However, as the SBP halved the rates, CIC has begun growing again at a faster pace. Foreign currency availability in the open market has almost dried up. Non-essential economic demand has started picking up, and there are signs of commodity hoarding by traders, which may lead to price spikes in the future. The SBP’s decision to keep the policy rate unchanged in the last review was prudent.
In the interbank market, banks manage their supply and demand for foreign exchange. Banks adopted a strategy of attracting home remittances by offering a premium, competing with each other and diverting flows from the informal market. This is why remittances broke all records last year, supported by a government subsidy.
The subsidy allocated in FY24 was around Rs 80 billion, while banks billed around Rs 200 billion. The subsidy was rolled back in FY25. The SBP has altered the incentive structure and is urging the federal government to restart the subsidy. So far, banks are unclear about the subsidy’s fate.
Despite the subsidy, banks incurred losses in the remittance business. Large banks reported losses between Rs 5–10 billion in the first half of CY25. Senior executives from several banks conveyed that they are unwilling to incur further losses, even as import demand grows. This suggests banks might become selective about opening Letters of Credit (L/Cs), as they were in FY23, if the central bank does not adopt the right policy measures.
Multiple implied exchange rates exist, with banks and exchange companies offering varying rates to clients, which could exacerbate the situation. The SBP must assert its independence in managing the exchange rate and monetary policy. It should not cater to pressures for currency appreciation.
The hard-earned stability, built by buying $12–14 billion over the last eighteen months, could be squandered away quickly.
It is best to let market forces determine the currency’s value. If the central bank desires a stronger currency, it must keep real interest rates significantly high. If the goal is to lower interest rates, the currency should serve as the first line of defence.
The objective must be to avoid a repeat of the 2022–23 crisis, whose memories are still fresh. The SBP should maintain clear policies and provide forward guidance. The finance minister should refrain from making public comments on interest rate levels and instead focus on creating a conducive environment for lower rates through steps aimed at achieving greater fiscal consolidation.
The bottom line: interest rates have already been halved within a year, and the impact on demand and currency is evident. The SBP should continue to monitor data and maintain high real rates until capital flows, such as investment and market-based debt, start to pick up.
Copyright Business Recorder, 2025
Ali Khizar is the Director of Research at Business Recorder. His Twitter handle is @AliKhizar