Pakistan’s central bank has made external stability the organising principle of monetary policy. But with the rupee appreciating in real terms, reserves barely covering three months of imports, and another energy shock unfolding, the institution that rescued the economy from crisis risks becoming captive to the political economy that created it.
The SBP has raised the policy rate by another 50 basis points to 12 percent. Inflation is running above expectations, the Middle East war shows little sign of ending, and global central banks are tightening. Yet Pakistan’s external account remains broadly stable, foreign exchange reserves have reached $21.5 billion, and the rupee continues to hold its ground. For a central bank that has increasingly made external stability the organising principle of monetary policy, there is much to celebrate. Or is there?
Central banks generally concern themselves with price stability, employment, output and financial stability, with different mandates assigning different weights to these objectives.
In Pakistan, however, the balance of payments has acquired an almost singular importance. And understandably so. Nearly every major macroeconomic crisis in recent memory has culminated in an external financing crunch, reserve depletion, currency depreciation and an eventual return to the IMF. Even inflation has frequently been driven by exchange-rate adjustments rather than domestic demand pressures alone.
There is therefore a respectable case for treating external stability as Pakistan’s foremost macroeconomic constraint. But if that is indeed the organising principle, the central bank’s current approach raises some uncomfortable questions. For one, what exactly constitutes external stability? Three months of import cover? A current account deficit contained below one percent of GDP? Or a rupee that has barely moved against the dollar for three years?
Consider reserves. At $21.5 billion, SBP’s holdings now cover approximately three months of imports, a milestone the central bank has understandably highlighted.
The improvement from the depths of the 2022-23 crisis is substantial. But three months is hardly a particularly reassuring buffer for an economy that has repeatedly found itself scrambling for emergency financing. If external vulnerability is the root of Pakistan’s recurring crises, why should the benchmark for success be the bare minimum conventionally associated with reserve adequacy?
For an economy with Pakistan’s history of external financing volatility, six months of import cover would be a more credible ambition. But three months should be a milestone on the way to resilience, not a destination. Especially when a meaningful portion of external support remains dependent on official creditors and rollover arrangements.
But the more fundamental contradiction lies elsewhere. How does a central bank that regards external stability as its overriding concern appear so reluctant to allow the exchange rate to perform its most important function?
The rupee has traded remarkably close to Rs280 against the dollar since late 2023. Indeed, it has appreciated modestly in recent months. This is extraordinary for a currency that has historically depreciated substantially over time, particularly since domestic inflation persistently exceeds that of major trading partners. Meanwhile, Pakistan’s real effective exchange rate (REER) has climbed to nearly 109, its highest level in eight years.
SBP is right to argue that an index reading of 109 does not, by itself, establish that the rupee is overvalued. But the direction of travel is difficult to ignore. With nominal exchange-rate stability and higher relative domestic inflation, the rupee has been appreciating in real terms. That makes imports relatively attractive and places additional pressure on the price competitiveness of domestic production and exports. For an economy supposedly obsessed with external sustainability, it is a peculiar outcome to tolerate.
This is especially striking because SBP’s own stated exchange-rate framework describes currency flexibility as the first line of defence against external shocks.
The exchange rate is supposed to absorb changing external conditions, allowing reserves and monetary policy to perform their respective functions. Yet the exchange rate appears to have become the one macroeconomic variable that policymakers are least comfortable allowing to adjust.
To be clear, the relative stability of the rupee cannot simply be attributed to SBP defending an artificial level through reserve sales. The central bank has been purchasing foreign exchange from the market and rebuilding reserves. That is an important distinction. But it does not settle whether the resulting exchange rate is consistent with medium-term external competitiveness, or whether the broader policy framework has become excessively accommodating of nominal currency stability.
This brings monetary policy into the picture. The familiar impossible trinity holds that an economy cannot simultaneously maintain a fixed exchange rate, unrestricted capital mobility and independent monetary policy. If the exchange rate is politically expected to remain stable, monetary policy, domestic demand, external financing and reserve accumulation must collectively accommodate that preference.
And that appears increasingly close to Pakistan’s policy equilibrium. Interest rates are adjusted to manage inflation and external pressures, official financing provides additional breathing room, and the currency remains remarkably stable.
In the process, the exchange rate’s role as an adjustment mechanism risks being subordinated to its political significance.
The irony is that this strategy may itself be undermining the external stability it seeks to preserve. An appreciating real exchange rate can weaken competitiveness and encourage imports, increasing the burden on monetary policy to restrain demand. Meanwhile, the prolonged absence of nominal adjustment creates expectations of continued stability.
Businesses, households and the government begin treating the prevailing exchange rate less as a market outcome and more as an economic entitlement. The longer that expectation persists, the more politically costly any subsequent adjustment becomes.
The latest monetary policy statement offers little indication that this contradiction is being confronted. Private-sector credit is growing at 14.1 percent, including consumer financing.
Non-energy imports are recovering sharply. Headline inflation has reached 10.3 percent and core inflation remains elevated at 8.4 percent. Yet the central bank continues to see economic growth within its earlier projected range and the current account deficit remaining manageable. The policy rate has been raised, but the broader framework still appears designed to preserve recovery without requiring meaningful exchange-rate adjustment.
There is a political economy to this. For governments, exchange-rate stability is among the most visible indicators of economic competence. Depreciation is unpopular, immediately inflationary and readily portrayed as evidence of economic mismanagement.
Interest-rate adjustments, by comparison, are less visible to the average voter. There is therefore an obvious political preference for keeping the currency stable while using other instruments to manage the consequences.
As the political cycle enters its final stretch, that preference is unlikely to weaken. Pressure to sustain growth, protect purchasing power and avoid politically costly adjustments will only increase.
The danger is not that another external crisis is inevitable. It is that a framework which repeatedly postpones adjustment can allow vulnerabilities to accumulate beneath apparently reassuring headline indicators. Pakistan has encountered that equilibrium before. It rarely ends well.
What makes the present situation particularly unsettling is the leadership at the bank. The incumbents took charge at a time when Pakistan was heading towards one of the worst external crises in its history. Their tenure has since been marked by the restoration of macroeconomic stability, a dramatic reduction in inflation and a rebuilding of foreign exchange reserves. In many respects, Pakistan found its own version of Paul Volcker at precisely the moment it needed one.
But the final year of the five-year term presents a different test. It is one thing to make difficult decisions when a crisis is already unfolding and the alternatives have been exhausted. It is quite another to make them when reserves are rising, growth is recovering, the political establishment wants continuity and the next crisis remains beyond the immediate forecast horizon.
Perhaps that is the Faustian bargain. The central bank that helped rescue Pakistan from external collapse now finds itself accommodating a political economy in which nominal exchange-rate stability has become synonymous with macroeconomic success. The temptation to preserve the hard-won recovery is understandable. But the cost may be the very flexibility needed to make that recovery sustainable.
Pakistan’s version of Volcker may yet be remembered for bringing the economy back from the brink. Whether they are also remembered for helping dismantle the conditions that repeatedly take it there will depend on what happens to the exchange rate before the next committee meeting in seven weeks.