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Facts about PKR depreciation

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Muhammad Arif

PKR is vacillating around RS 105-Rs 110/- per US nowadays creating doubts about its actual valuation.
This has started a discussion in the media and notable circles that what are the actual reasons of this movement. Mostly circles are blaming and putting its responsibility on mismanagement of the government and SBP.
Exchange rate policy by definition and practically is part of monetary policy. It underwent several changes since 1949 in Pakistan. The exchange rate of Pakistan remained fixed in terms of pound sterling up to September 1971 and subsequently in terms of US$. Since January 1982, the exchange rate regime of PKR was a system of managed float, based on a basket of currencies. In 1991 with initiation of financial sector reforms, the direction was set to turn it in to free float that was finally achieved in 2000-2001. Pakistan uses US$ as its reserve currency. As regards changes in its nominal value, it also went through various changes. In Sept, 49, the decision was taken not to devalue PKR while 48 currencies in the sterling area went in to devaluation in spite of the fact that current account (CA) deficit in 1948-49 was around 2.5% of its GDP. Luckily, Korean War helped Pakistan to come out of this crisis and in 1950-51, Pakistan witnessed surplus in its CA. However on ending of Korean boom, Pakistan again went in to CA deficit. On 31st July, 1955, first time PKR was devalued. In 1956-57, the position worsened to such an extent that Governor SBP in its policy statement singled out balance of payments and inflation as the two main culprits for the economy. Since that time, the same legacy is hovering over Pakistan’s economy. Nominal exchange rate remained fixed at Rs 4.76 per US$ since 1955, but since export bonus scheme was in vogue at that time, so effectively it was a multiple exchange rate. In 1971 it depreciated to RS 7.76 for exports, however in 1972 it was unified as Rs 11 per US $.
Another issue that confronted Pakistan at that time was significant overvaluation of Real Effective Exchange Rate (REER). REER stands for weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country’s currency, with each other country within the index. Real Effective exchange rate of Pakistan in 2016 stands at 122.5% and now around RS 125 in 2017, considering index base as 100 as of 2010. This shows 25% overvaluation of PKR in terms of its export items. To counter this increase in exports, control on imports, lowering down CA deficits and Fiscal deficits with increase in tax revenue are required.
The foreign exchange market in Pakistan gets its inflows through export proceeds, remittances and FDI.
Now in December 2017 State Bank of Pakistan (SBP) has withdrawn its rupee support through a market mechanism, leading to a fall of 4.3 per cent in the currency’s value against the dollar So here it is – a new rate band of Rs110-110.50 per dollar that the SBP may now defend until the full impact of the readjusted exchange rate becomes clear. Another factor can be the US Fed that has increased its policy rate for the third time in 2017 from 1.25% to 1.50% while Fed Chair Janet Yellen is due to retire.
Pakistan’s trade deficit has shot up to $15 billion (with exports at $9bn and imports at $24bn) in the first five months of this fiscal year, And, the current account deficit in the first four months of this fiscal year totaled $5bn, more than double the $2.26bn figure in the year-ago period.
But how well will the rupee depreciation support export growth? Emboldened by an incentive package, less-interrupted supply of energy and growth in the large-scale manufacturing our main exports are under question..
And while a weaker rupee can increase the pace of growth of overall exports, exporters are also required to improve their own manufacturing and marketing capabilities to become more competitive in the world market. For this they require some support in those areas where taxes have been unduly imposed. In fact tax net needs to be broadened and not to raise tax from those who are already paying taxes.
The rupee depreciation is sure to boost the cost of external debt financing. But the prospects of a 6pc economic growth in the current fiscal year and the ongoing fiscal belt-tightening and plugging in revenue losses can offset the cost. Most local bankers and analysts are apparently satisfied with the new exchange rate, some of them insist the rupee is still overvalued.
The real effective exchange rate model suggests the rupee was 14.5pc overvalued in end-November, implying a rate of Rs121 per dollar. (But) whether the rupee will get to Rs121 is only a speculation. FX reserves have also been improved which are required mainly to support import obligations and to support FX market in case of its dire need to avoid undue fluctuations in nominal exchange rate. The reserves were fallen to the ground in FY 2013-14 at less than $ 10 billion. Now at the end of Dec 2017 they are at $ 20.6 billion.
Another disciplinary arrangement for FX market i.e. Foreign Exchange exposure limit (FEEL) implemented by the SBP after replacing NOSTRO limits had made the market flexible and disciplined to move within some range of banks paid up capital. Previously they were 10% of paid up capital and now at 20%. But SBP also remains flexible for some banks on the basis of business transaction.
Going forward, let us see what can be the fate of Exchange rate in Pakistan. One of the question that dictates the exchange rate parity are the difference in interest rate on other currencies specifically $ in respect to PKR, the difference of forward exchange rate from its spot rate and how expected spot rates for $ and PKR are going to be determined for the next year and what relationship one can foresee in between inflation in Pakistan with respect to other countries. Apart from these factors, the paramount factor is the demand and supply position of S with respect to PKR that some time alters on the basis of government and central bank policies. In this regard, KERB market has its role as well in shift of market flows and in making market sentiments.
The market players in this regard have always remained Government, SBP, Interbank market, Parallel market i.e. KERB through money changers, FX dealers of the banks and corporate sector.
As stated its parity between two currencies depends on inflation or interest rate parity basically meaning purchasing power parity. So if we consider Rs 105.7 as parity rate on Oct 2013, than considering USA inflation rate as 1.5% and Pakistan inflation rate as 12% the parity comes out as 105.7*1.12/1.015 = Rs 116.63. In case the inflation of Pakistan inches up than the PKR would have been depreciated further. But this did not happen and conversely Pakistan inflation rate has come down to 4% with USA to edge up at 2.2% than why this happening. Only to the fact of over speculation, with no visible way outs to streamline CA and fiscal deficits.
So what should be the immediate steps to improve PKR status?
1. No buying from the interbank market. Instead they should be asked to surrender dollars to SBP above some stipulated level. They should be asked to pay some premium to the SBP for getting right to procure dollars as and when required.
2. Stringent inspection of interbank market and KERB, where no LC is being honored in time and no export proceeds is coming in time. How one can say that SBP is doing its duties.
3. Curtailing imports rather than focusing on exports. Leaving aside oil and edible oil that are inflexible other imports should be minimized as possible as we can.
4. Keeping focus on increase of revenue through widening tax net.
5. Supporting exporters to increase their export targets.
6. Check on inflation that can increase and hurt common man and overall economy by keeping measures to retain GDP growth around 6-7%.
So these are the basic jobs that government and SBP are required to do to stabilize PKR.

Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), former Head of FSCD SBP, former Head of Research Arif Habib Investments and Member IFSB Task Force for development of Islamic Money Market, former Member of Access to Justice Fund Supreme Court of Pakistan.