The real effective exchange rate (REER) is getting stable. The number stood at 103.31 in Feb19 and last three months’ (Dec18-Feb19) average is at 102.92. The theoretical equilibrium is at 100, and closer the REER is to it, lesser the need for currency depreciation.
Back in Nov17, the REER was at 124.19 and it was imperative for nominal currency (exchange rate) to adjust significantly to bring it close it is fair or equilibrium value. The currency started depreciating in Dec17, and the REER gradually moved towards its equilibrium. In early days of adjustments, inflation was low and the REER fast adjusted upon nominal currency depreciation (read: "Dollar dairy: Don't go the Dar way" and "Currency equilibrium -almost there").
For instance in Dec17, the rupee dollar parity was down by 3.5 percent while the REER moved up by 4.0 percent - the CPI stood at 4.57 percent in the same month. With nominal currency depreciation, the inflation slowly moved up, and thereafter, the need of currency adjustment increased to let the REER reach its true value.
From Nov17 to Dec18, the rupee dollar parity is down by 31.6 percent while the REER moved up by 17.7 percent to reach 102.27. The rupee dollar parity in Dec18 averaged at 138.78, and since then there was no significant movement till last week. The reason could be that the REER has come close to its desired value and the imperative of currency depreciation diminished.
It is important to note that there is no linear relation of REER with PKR/USD. The real effective exchange rate is a function of nominal exchange rate and inflation of basket of countries one trades with. Higher the trade with a country, higher is its contribution to REER. The USD is taken as a proxy to make the analysis simple as many of Pakistan’s trading partners’ currency is pegged to the USD.
The other variable is Pakistan’s inflation relative to its trading partner. The world inflationary outlook is falling while Pakistan is going through a short term high inflation. The relative price index (RPI) has gone up lately. This is denominator - higher the RPI, lower the impact of nominal exchange rate adjustment on REER.
That is why the REER moved the other way round lately - it is down from 102.27 in Dec18 to 103.31 in Feb19 while the rupee depreciated by 0.43 percent in two months. This is probably making the SBP go for another round of depreciation - depreciate currency slowly day by day.
The SBP seems to have learned from its mistake and did not let the rupee slide in a go by 3-5 percent, but rather let it depreciate slowly on daily basis. However, the market is still panicking. With talks to the IMF and MoF, the SBP has designed a mechanism for managing currency market. They are surely moving away from sticky exchange rate regime, at least for the time being, but the mechanism is not clear.
The apparent method is to create a revolving fund of around $500 million to manage currency and maintain the level on quarterly basis as having a free float currency could be a recipe of disaster in a thinly traded market. The SBP should communicate the mechanism to the market clearly.
The goal should be to define a range of REER between 98-102 or 97 to 103 and stick to it. Whenever, the movement is the other way round, adjust accordingly. Based on current numbers, the fair value or equilibrium is PKR/USD at 147 and at this point of time, the SBP may settle the rupee dollar parity around 145 by June end.