The rupee has been sliding down for the past many weeks and dollar is touching Rs170. This wave of devaluation has sparked speculation of further depreciation in the coming days. Should we be panicking and start hoarding dollars?
If anything, this is perfectly in line with market fundamentals. The reasons behind the current spell of depreciation are primarily the rising trade deficit and to some extent, the Afghanistan situation. Our imports have risen sharply in the last few months — predominantly due to rising international commodity prices such as for oil, gas, coal, steel, etc.
Some increase in imports can also be attributed to recovering economy fuelled by fiscal and monetary stimulus. In simpler terms, as the government injected more money into the market through the Covid stimulus package and other means and maintained interest rates at a low level, the demand increased leading to rebounding growth.
But with growth recovery, the demand for imports also increased, widening the trade deficit. Moreover, some of the recent increase in imports can also be attributed to the vaccine imports, the phenomenal increase in demand for automotive, capital imports under Temporary Economic Refinance Facility (TERF), etc.
What impact should the trade deficit and current account deficit have on the exchange rate?
As soon as the current IMF programme started, the government switched to a market-determined exchange rate. Notwithstanding the reports of some intervention by the State Bank in the market, the market-determined regime does not give the flexibility to the central bank to maintain the exchange rate at an artificial level. This in fact is the right strategy for a country like Pakistan, so that its hard-earned forex reserves are not burnt to preserve the exchange rate, indirectly subsidising imports at the cost of scoring political brownie points. The exchange rate, therefore, took the hit, and the rupee devalued.
But for now, the threat of any further significant devaluation is not in sight. The devaluation itself has made the imports expensive. In addition, the government is also considering increasing regulatory duty on luxury imports to further dampen the demand for these items. These measures are complemented by a change in monetary stance — an increase of 25 basis points, which is likely to be followed by further increases in the future — and passing on the energy price increases. All these measures are expected to immediately reign in the rising current account deficit. Hopefully, the current spell of rising international commodity prices should also be over in the next 6 to 9 months, further supporting an optimistic medium-term outlook.
But under this cyclical trend, lies the political economy of devaluation in Pakistan.
What we must understand is that historically the rupee has only gone down against the dollar and that’s the direction it will maintain in the medium-term, notwithstanding any short-term reverse movements. The reason for this perpetual devaluation is the underlying balance of exports and imports. Pakistan is a country with high imports and low exports. The difference is bridged through precious foreign exchange, earned from remittances, foreign direct investment, and external loans. Historically, the rupee has depreciated against the dollar by approximately 7 per cent per annum to account for the perpetual supply and demand gap. This gradual devaluation is in fact absolutely essential for Pakistan until the export composition and volume change significantly.
During PML-N’s tenure, we followed the managed float exchange rate regime. The then finance minister artificially maintained an overvalued exchange rate and pumped in foreign exchange in the market, whenever the demand for dollars increased. An overvalued exchange rate made exports expensive and imports cheaper, thus further widening the trade deficit. The industry suffered but the traders were happy. The citizens enjoyed quality imported goods at cheaper prices, not realising that they would have to pay the price later on. Therefore, as a result of artificially maintaining the exchange rate at an abnormally low level, our reserves took a serious hit, while imports continued to increase. This prompted a balance of payment crisis and necessitated the present IMF programme. Such an approach was economically disastrous.
If we don’t want to repeat the same mistake, we should be open to gradual devaluation depending on the current account balance. To manage the CAD, the fiscal and monetary policies have to work in tandem. It’s prudent to go slow and steady than to overheat the engine and lead to yet another balance of payments crisis.