After trading in the tight range of 104-105 per dollar since December 2015, the Rupee plunged to as low as 110 per dollar to settle around 108.40-50 per dollar. Economists and businesses have been urging the government to devalue the rupee, saying it was hurting exports and contributing to the depletion of Pakistan’s foreign currency reserves. A weaker rupee would help the economy grow and ease balance of payments pressures. The recent devaluation will help exportable products become competitive in the international market. The government had no choice as the trade deficit has crossed all limits. While on one hand, devaluation reduces our purchasing power parity, on the other hand, it will increase inflation and swell our debt per capita.
Despite SBP’s claim of market based adjustment of exchange rate, the timing of devaluation is of crucial importance as it coincides with post program analysis meeting with International Monetary Fund) IMF and launch of US$2.5 billion Eurobond/Sukuk bond in the international market. The currency adjustment would help shift foreign currency holdings from commercial banks currently standing at a higher level of around $6 billion back to official reserves and help divert remittances to official channels with declining gap among the official, banking and open market rates.
The ongoing depreciation is seen as a healthy move for the economy as it will make the imports expensive and may help manage the bill while giving a boost to exports. However, it takes more than just devaluing the rupee to restrict imports and increase exports. The recent rate change will have minimal impact either on imports or on exports because the rate is still substantially overvalued to the extent of about 15 percent. A partial rate correction will increase the rupee cost of foreign debt payment, but the government will still enjoy an implicit subsidy in its expenditure on foreign debt payment due to the remaining overvaluation.
The official intervention of monetary authorities in the foreign exchange market to influence the exchange rate fluctuation is a worldwide phenomenon. The monetary authorities intervene with the objective of maintaining orderly market conditions, which ultimately help to achieve the overall macroeconomic goals. Heavy intervention was witnessed in the beginning of 1973 by developed economies to smoothly shift from the Bretton Woods fixed exchange rate system to free float. However, Pakistan, like many of the other developing economies, continued with the fixed exchange rate regime until 1982 when it shifted to managed float. In July 2000, Pakistan shifted to free float which in turn led the PKR/US dollar parity to depict a great deal of volatility. The management of foreign exchange market was indeed not an easy task; especially, when the foreign exchange market was thin and dominated by a relatively small number of agents. The central bank is the biggest player in the thinly traded local foreign exchange market and controls what is widely considered a managed float system.
The State Bank of Pakistan (SBP) started intervening in the foreign exchange market to moderate the exchange rate fluctuations by both managing the mismatch between US dollar demand and supply and by suppressing the speculative moves of a few agents.
Since the free float of the Pak rupee, monetary policy has played a dominant role in stabilizing the exchange rate in Pakistan. Significant ups and down in forex rates are now being monitored through effective instruments of monetary policy. Similarly, whenever speculative activities are observed in the market, they are tackled with proactive monetary policy measures of the State Bank. The Bank uses the instrument of the discount rate to control undue pressure on the exchange rate while Cash Reserve Requirements (CRR) or mopping up of excessive liquidity through purchases from the kerb market, to curb speculative activities in the forex market.
In order to achieve sustainable macroeconomic equilibrium, monetary and fiscal policies must be consistent with the chosen nominal exchange rate regime. Further, the misalignments in the real exchange rate can be used as a guideline for policy interventions by the SBP. Policy measures should be identified and if needed, should be introduced immediately to correct any actual or even potential misalignments of the exchange rate. The exchange rate should be flexible to maintain a competitive position in the world market.