BALANCE OF PAYMENTS AND EXCHANGE RATE POLICY

 

Corrective measures taken to contain adverse impact of economic sanctions and global recession on the economy

From YOUSAF RAFIQ
Sep 13 - 19, 1999

During 1998-99 the external sector remained under pressure. This reflected mainly the impact of economic sanctions and world recession, emanating partly from Asian crisis and partly on account of economic difficulties faced by Japan, Russia and Brazil etc. The position, shortly before the beginning of 1998-99, was that the foreign exchange reserves were low, programmed loans from multilateral organizations were in jeopardy and prospects for the inflow of foreign investment, aid and loans from other sources were dim. Moreover, the appreciation of Pak-Rupee against major currencies, particularly the currencies of European countries, affected the competitiveness of Pakistani products in the international markets. Under these circumstances a number of corrective measures were taken to contain the adverse impact of economic sanctions and global recession on the economy.

The measures included: (a) temporary suspension of withdrawal facility in foreign exchange from foreign currency deposits; (b) adjustment in exchange rate which was supplemented by the introduction of two-tier exchange rate mechanism; (c) adoption of various measures to affect import compression such as imposition of cash margin requirements for opening letters of credit for imports etc; (d) tightening of a number of exchange control regulations on certain service payments like travel, education and health and temporary suspension of interest payments to non-preferred creditors; (e) exemption from maintenance of statutory cash reserve/statutory liquidity requirement against balances held in Special Exporters Account to boost exports; and (f) rationalization of export finance scheme to make small and medium exporters, emerging exporters and indirect exporters eligible for export financing facility.

The policy measures adopted in the post sanctions period had a major impact on balance of payments. The temporary suspension of withdrawal in foreign exchange from foreign currency deposits, though it averted the threat of an immediate run on foreign exchange reserves, eroded the depositors’ confidence with adverse impact on the stock and foreign exchange markets and inflows of remittances. During the crisis period, the gap between official and kerb market exchange rate widened and premium touched the level of 28.48 per cent on July 11, 1998. The imposition of economic sanctions also led the suspension of new bilateral and multilateral disbursements for non-humanitarian assistance and put pressure on resources in the form of reduced availability of commodity and project aid. By the end of October, 1998 foreign exchange reserves fell to as low as US $440.4 million. However, after the conclusion of agreement with the IMF in January 1999, the flow of funds from the international institutions was restored and Paris Club countries also agreed to reschedule external debt, including the pending arrears. Keeping in view the improved prospects of the availability of external financing, augmentation of foreign exchange reserves and the relative exchange rate stability, the exchange and payments regime was gradually liberalized.

Important policy measures taken in the second half of 1998-99, included interalia, (a) the replacement of two-tier exchange rate system with the market based unified exchange rate system with effect from May 19, 1999 whereby the floating inter-bank rate would apply to all foreign exchange receipts and payments both in public and private sectors. The official exchange rate and the surrendering of requirement of 5 per cent of export proceeds were abolished; (b) cash margin requirements for opening letters of credits for imports were gradually eliminated; (c) customs tariff rates were reduced; (d) duty drawback system was rationalized and upward revision of rates for various value added export items were announced; and, (e) restrictions on the sale of foreign exchange for travel, education and health purpose at composite rate were lifted.

Balance of payments (1998-99)

The external sector targets for 1998-99 were originally set on the basis of the trend in 1997-98. At that time it was too early to fully recognize the consequences of post nuclear test developments. In order to achieve the zero trade deficit during 1998-99, the targets for exports and imports were fixed at US $10 billion and US $10.1 billion respectively in the Trade Policy 1998-99. Subsequent developments called for a review of these targets. Exports and Imports were projected at US $8.48 billion and US $9.17 billion respectively. The latest revised balance of payments projections for 1998-99, prepared jointly with the Fund Mission estimated exports (fob) at US $7,558 million and imports (fob) at US $9,043 million, with a deficit of US $1,485 million in trade balance. Meanwhile the deficit under services account was also estimated lower at US $2,572 million. On the basis of estimated inflows of US $1,042 million under workers’ remittances and US $558 million under residents’ foreign currency deposits, the net inflow under private transfers was projected at US $2,256 million. The current account deficit (excluding official transfers) was estimated at US $1,801 million for 1998-99. However, owing to net capital outflows (including errors and omissions) amounting to US $1,974 million, stemming largely from short-term capital outflows (both public and private), the overall balance of payments deficit was projected at US $3,613 million during 198-99, Further, an exceptional financing gap of US $4,168 million was projected for 1998-99.

The latest available data indicate that country’s balance of payments position remained under severe pressures and the effective implementation of Fund program was also affected. The current account deficit (excluding official transfers), although narrowed by 6.7 percent to US $1,792 million during 1998-99 when compared with 1997-98, remained close to the projected level of US $1,801 million. The improvement over the preceding year resulted on account of contraction in the deficits both under services account (-$705 million) and trade account (-$192 million), substantially offset by a marked decline of US $826 million in the net inflow under unrequited transfers. The deficit in services account narrowed by 21.6 percent to US $2,559 million during 1998-99 due entirely to a reduction of US $919 million in payments in the wake of decision to restrict acquisition of foreign exchange in respect of travel abroad for various purposes including official travel, health and education etc at more depreciated exchange rate from the open market instead of composite rate and temporary suspension of repatriation of dividend income and interest payments etc. In absolute terms, the fall was particularly prominent under the category of investment income mainly of interest payments (-$512 million), travel (-$189 million) and other transportation (-$103 million), Meanwhile, aggregate services receipts also declined to US 41,494 million, denoting a fall of 12.5 percent during the period under review. Major drops in receipts were witnessed under other goods, services and income, other transportation and investment income. Under the category of private transfers, residents’ foreign currency deposits depicted a much smaller increase of US $476 million during 1998-99 as against the rise of US $1,476 million in 1997-98. These were adversely affected on account of erosion of depositors’ confidence after the suspension of the facility of withdrawals, in foreign currency, from these deposits in May 1998 and tightening of some exchange control regulations in July 1998. The inflow of home remittances also sharply declined by US 4435 million to US $1,055 million during 1998-99 owing to lower receipts from almost all the major countries particularly Saudi Arabia, USA, Abu Dhabi, Dubai and UK. The decline was due mainly to diversion of workers’ remittances to other than official channels in the wake of sharp rise in the kerb market premium.

According to the latest foreign trade data (based on customs records), exports declined by 10.7 percent of US $7.7 billion during 1998-99 and also stood lower against the latest projections of US $8.48 billion due largely to fall in unit prices of major commodities in the international market in the wake of global recession and economic turmoil in East Asian countries. The major items showing decline in export value included: cotton yarn, synthetic textiles, cotton fabrics, raw cotton, sports goods, ready-made garments, rice, fish and fish preparations, leather and tarpaulin and other canvas goods. Imports also denoted a fall of 8.4 percent to US $9.2 billion during 1998-99 in the wake of sluggish economic activity as well as adoption of various import compression measures. These, however, remained close to the latest projections of US $91.17 billion. The imposition of 30 percent minimum cash margin requirement on all import L/Cs (except certain specified items) which remained in place during the period between July 12, 1998 to January 10, 1999, after which it was reduced to 20 percent and 10 percent before its abolition on February 24, 1999, resulted in containing the import bill. During the period of cash margin requirement, monthly average imports registered a decline of 16.5 percent compared to a smaller decline of 10 percent in the same period of 1997-98. However, immediately after the abolition of this restriction in February 1999 monthly imports showed virtually steady growth and, on average basis, rose by 11.7 percent during March 199-June 1999 compared to the corresponding period last year. When compared with the average imports during the restriction period (August 1998- February 1999), imports depicted a sharp rise of 17.4 percent. The decline in imports during 1998-99 was particularly prominent under "wheat", followed by ‘power generating machinery’, ‘petroleum crude and products’, ‘electrical machinery and apparatus’, ‘other chemicals’, ‘construction and mining machinery’, ‘textile machinery’, ‘sugar’ and ‘iron and steel’. Imports of sugar declined sharply by 92.1 percent to only US $3.1 million. The negligible import of sugar was largely the reflection of bumper sugarcane crop, which resulted in 49.2 percent rise in sugar production during 1997-98. The import value of wheat also declined substantially by US $294.8 million or 42.2 percent under the combined impact of good harvest and lower average import prices. As a result of larger decline in exports than imports, the trade gap expanded marginally to US $1.49 billion during 1998-99 compared to US $1.40 billion in 1997-98 but stood substantially higher than the projected trade deficit of US $0.68 billion.

In the capital account (both long term and short term), net outflow of US $1,703 million (including errors and omissions) was recorded during 1998-99 against the net inflow of US $1,395 million in 1997-98 which was mainly the reflection of enlarged outflows under medium and short term capital, non-resident foreign currency deposits and higher amortization of official long term loans. Break-up of capital account revealed that the aggregate net outflow of US $3,867 million under the medium and short term capital during 1998-99, resulted on account of exceptionally enlarged outflow under non-resident foreign currency deposits (-$2,384 million) and net medium and short term loans, including government bonds (-$1,483 million). Under other official capital the net disbursements of long term loans declined by US $133 million to US $2,484 million during 1998-99 due entirely to fall of US $444 million under food and project aid substantially off set by an increase of US $311 million in program aid. On the other hand, net inflow under private long-term capital declined by US $631 million to US $104 million due mainly to substantial decline of US $420 million in foreign private investment reflecting fall in both direct and portfolio investment. The utilization of private long-term loans/credits including export/suppliers’ PAYEE credits depicted a net outflow of US $307 million in contrast to a net inflow of US $373 million in 1997-98. Under the combined impact of the above developments, the overall balance depicted a deficit of US $3,333 million during 1998-99 compared to the projected deficit of US $3,613 million during 1998-99 compared to the projected deficit of US $3,613 million and the deficit of US $306 million in 1997-98. Meanwhile, owing to an exceptional financing of US $3,333 million on account of rescheduling of external debt and debt relief of US $835 million from commercial banks, the net accumulation of arrears amounted to US $4,168 million during 1998-99.

Balance of payments projections 1999-2000

The balance of payments projections for 1990-00 have been prepared under two different scenarios i.e. (a) with IMF program; and, (b) without IMF program. The balance of payments position (with IMF program) indicate that current account deficit (excluding official transfers) is projected to be at US $1,282 million during 1999-00, reflecting an improvement of 28.5 percent over 1998-99. This improvement is likely to stem almost entirely from reduction in the trade deficit by US $875 million, partly off set by expansion of US $368 million in the deficit under services account. In the trade account exports (fob) are projected to rise by 6.7 percent to US $8,190 million whereas imports (fob) are estimated to decline by 3.8 percent to US $8,990 million. Thus, under the combined impact of a rise of US $516 million in exports and a fall of US $359 million in imports, the trade gap is projected substantially lower at US $800 million during 1999-00, almost half the deficit in 1998-99. However, the deficit under services account is estimated to expand by 14.4 percent to US $2,927 million due entirely to higher payments. Under the head private transfers, inflow under workers’ remittances is estimated higher at US $1,400 million because, after the introduction of a unified exchange rate system, the premium in the open market exchange rate currently around 4 percent is likely to fall further and expected to exert a positive impact on the flow of home remittances through official channels. Under the capital account, the net outflow (including errors and omissions) is projected at US $3,805 million for 1999-00. The long-term capital is projected to exhibit an outflow of US $1,255 million during 1999-00, resulting mainly from lower disbursements of official loans and enlarged outflow under other official capital, as against the inflow of US $1,209 million in 1998-99. However, medium and short-term loans are likely to reflect a net inflow of US $88 million in contrast to a net outflow of US $870 million in 1998-99. After taking into account an amount of US $2,835 million as expected outflow under non-resident foreign currency deposits, the deficit under the overall balance is projected at US $4,830 million during 1999-00 compared with US $3,333 million in 1998-99. Meanwhile, an exceptional financing gap of US $5,746 million is projected during 1999-00 compared to US $4,168 million in 1998-99.

Under the projection for 1999-00 (without IMF program) the current account deficit (excluding official transfers) is also estimated to be lower at US $1,633 million, reflecting an improvement of 8.9 percent over the 1998-99. Exports and imports are not likely to be affected. He services account deficit is likely to expand by 16.4 percent due to larger rise in payments (US $478 million) than in receipts (US $59 million). While unrequited transfers are estimated lower by 7.8 percent to US $2,402 million, the flow of remittances are estimated marginally higher. In the capital account, a substantially enlarged net outflow of US $4,200 million is projected during 1999-00. Under the long-term capital, a net outflow of US $1,650 million is estimated during 199-00 against the inflow of US $1,209 million in 1998-99, reflecting mainly nil disbursements of program loans from World Bank/ADB etc as against US $936 million in 1998-99. Under the combined impact of the above developments, the overall balance is likely to show a deficit of US $5,576 million in 1999-0 compared to the deficit of US $3,333 million in 1998-99. Moreover, the amount representing exceptional financing gap is also estimated higher at US $4,392 million during 1999-00 compared to US $4,168 million in 1998-99.

Foreign exchange reserves: The liquid foreign exchange reserves, which stood at US $930 million at end-June 1998, declined sharply, amidst fluctuations, to US $440.4 million at end-October, 1998. The decline was mainly attributable to freezing of foreign currency accounts, decline in exports and other receipts under current transfers and services account along with disruption of financial flows from donors. After resumption of flow of resources from multilateral institutions these rose to US $1,838.4 million at the end of March 1999. These included mainly the disbursements of Fund assistance under CCFF (US $492.9 million), ESAF (US $53.2 million), EFF (US $26.6 million), IBRD structural adjustment loan (US $346.5 million), and first tranche of ADB loan for trade promotion activities (US $20 million). The reserves, however, stood at US $1,729.7 million as end-June 1999.

Exchange rate policy

A fixed exchange rate regime was followed from 1947 to 7th January 1982. During early 1980s, the dollar started appreciating in terms of major currencies an as the Rupee was linked to US Dollar, this adversely affected the competitiveness of Pakistani products in international markets. In a world of freely floating exchange rate regime, given our widely diversified trade and financial relations, Pak rupee’s peg with a single currency could prove very costly. Thus, with a view to maintaining the competitiveness of exports and thereby to bring a sustainable balance between country’s current receipts and current payments, it was decided to adopt the managed floating exchange rate system with effect from January 8, 1982. Under this, system, the value of Pak-rupee was reviewed daily with reference to a trade-weighted basket of currencies of the country’s major trading partners/competitors. More frequent but generally small adjustments in the value of Pak-rupee were made as and when circumstances indicated a need for such an adjustment, keeping in view the relative changes in exchange rates and prices of country’s major trading partners/competitors as well as major macro-economic indicators of Pakistan. The managed float continued to operate till July 21, 1998 when the rupee stood devalued by 78.5 percent during the period.

Two-tier exchange rate system: Imposition of economic sanctions in the wake of nuclear tests in May 1998 created a crisis like situation. Low level of foreign exchange reserves, coupled with apprehension of disruption of normal financial inflows from multilateral financial institutions and bilateral donors in the face of generally inflexible claims on reserves, created a state of uncertainty specially with regard to country’s ability to meet its external obligations. The foreign exchange reserves, which had declined from US $1,315 million on May 27, 198 to US $930 million at the end of June 1998, fell further to US $415 million on November 12, 1998. Uncertainty led to increase in speculative demand for dollars, intensifying further pressure on Pak rupee and the premium of free market rate over official rate touched the record level of 28.48 percent on July 11, 1998. In order to face the challenge, a number of measures were taken, including introduction of a two-tier exchange rate system, effective from July 22, 1998. The new mechanism comprised: (a) official exchange rate, (b) floating inter-bank exchange rate, and (c) composite rate. The official exchange rate was determined by the State Bank, while the floating inter-bank exchange rate (FIBR) was determined by demand and supply of foreign exchange. The composite rate was based on certain specified ratio of official rate and floating inter-bank rate which was initially fixed at 50:50 (50 percent official and 50 percent FIBR) and was changed to 20:80 on December 21, 1998 and further to 5:95 on March 11, 1999. This system was tantamount to defacto adjustment in the exchange rate. The underlying philosophy was to pass on the advantages of devaluation to exporters and expatriate workers wishing to remit money to Pakistan, and to compress the non-essential imports. It was also intended to contain the cost of devaluation in terms of containing price increase of essential imports (initially comprising seven items, subsequently reduced to only two viz wheat and POL products) and repayments of external debt thereby limiting the impact of inflation and the overall fiscal deficit of the government.

However, the value of Rupee stabilized both in free market and inter bank market after a number of effective measures were adopted. These measures included: timely intervention in the foreign exchange market, curbing of speculative forces through moral support to money changers and issuance of warnings to illegal money changers for getting themselves registered with the SBP, more vigilant monitoring of the outflows of foreign exchange, and changes in the mix of official and floating inter-bank rates etc. In the free market, the value of Pak-rupee improved from a level of Rs 63.75 per US dollar on September 4, 1998 to Rs 52.35 on May 18, 1999. Similarly, in the inter-bank market, it also improved from Rs 57.19 on November 11, 1998 to Rs 50.44 on May 18, 1999. The position of liquid foreign exchange reserves also showed improvement and rose from US $415 million (equivalent to 2.2 weeks of imports) as on November 12, 1998 to US $1,738 million (equivalent to 9.2 weeks of imports) on May 18, 1999.

The introduction of two-tier exchange rate system meant the adoption of multiple currency practice. The acceptance of Article-VIII obligations by Pakistan, among others, makes it obligatory to avoid recourse to multiple currency practice. Moreover, multiple exchange rate system discriminates among different exporters and importers and leads to cost/price distortions thereby resulting in mis-allocation of resources with adverse impact on output and growth. Under Fund’s Articles of Agreement, a member is not allowed, except temporarily and with the Fund’s approval, to engage in multiple currency practice. It was, therefore, GOP’s first priority to move to a unified exchange rate policy as soon as circumstances permit it do so.

Unified exchange rate system: Since the two-tier exchange rate system was a transitory arrangement, a unitary exchange rate was adopted with effect from May 19, 1999. Under the system, the official exchange rate was abolished and the value of the rupee was left to be determined by the supply and demand forces in the inter-bank market. Under the unified exchange rate system, floating inter-bank rate is the effective exchange rate at which all foreign exchange receipts and payments (both in public and private sectors) take place. All foreign exchange requirements for all approved purposes (including imports, invisibles, debt repayment etc) are to be met by the Authorized Dealers from the inter-bank market. The Authorized Dealers neither approach the State Bank for release of foreign exchange for any purpose, nor are they required to surrender it to the State Bank. As a part of exchange rate management policy, the State Bank may intervene in the market for the sale and purchase of foreign exchange on its own account at rates and timing of its choice. The State Bank has recently been empowered to purchase and sell foreign exchange not only from inter-bank market but from any source within or outside the country, thus broadening the scope of State Bank intervention in foreign exchange market. While each Authorized Dealer is free to fix his own buying and selling rates, the spread between the spot buying and selling rate should not exceed Rs 0.50 per US Dollar. State Bank will not provide forward cover to Authorized Dealers. However, Authorized Dealers may provide forward cover for exports, imports and other permitted transactions for any duration, in accordance with the conditions prevailing in the market. Withdrawal in rupees from foreign Currency Accounts and encashment in rupees of various foreign exchange dominated bonds (DBCs, FCBCs, and US Dollar bonds) and profit thereon will be made at average inter-bank closing rate for the previous working day. Since the introduction of unified-exchange-rate system, the value of Pak rupee both in the inter-bank and the free market has been moving within a narrow range of Rs 50.70 - Rs 52.16 and Rs 52.40 to Rs 54.40 per US Dollar respectively.