The weakening currency dilemma

The rupee has been on steady decline since the past two months, with the exception of the past two days. Most are quite aware of the worsening balance of trade position with exports for 1H-FY12 arriving at $11.24 billion and imports standing at $22.71 billion. Remittances, which were the nation’s pride for keeping the economy out of red, have this time failed to buttress the struggling current account despite registering an unprecedented level over $6 billion during the last six months. In the face inelastic imports, exports have seemed to be the only maneuverable saving grace. However, the general opinion regarding power shortages causing supply deficits, especially with reference to the textile sector, is also a favourite example and ostensibly a significant impediment. It takes the sector only one year of glory for the SBP and other policy makers to start reveling in the idea of its permanence and glorify the fact that the fiscal imbalance did not affect the external account in the days of cotton gains and surpluses.
Reflecting on other interesting correlative developments in the last two months, KIBOR in excess of 12 per cent, ie higher than the discount rate signals impending liquidity constraints in the banking system. The last two T-Bill auctions have also been witness to the low participation levels, extremely unlike the preceding fiscal year, and bid patterns that showed quotation of high rates that led to complete rejection of the earlier bid in Dec-11.
Theoretically this would also imply that banks are either short of funds or unwilling to lend to anyone given that the private sector credit has not ventured further than the Rs3.1-3.2 trillion from the end of FY11, and short-term government bonds seem to hold no spark lately. This implies that the shortage of funds is reflecting itself on the currency as higher interbank exchange rates are being quoted, resulting in the ongoing depreciative phase for the rupee.
Delving into the investigation of the first hypothesis, it seems that banks are most definitely not short of funds. A latest report on liquidity held in excess of the CRR shows, that in the later week of Dec-11 when KIBOR hit the12 per cent high, banks on average held around Rs10 billion/day (Rs70 billion/wk) in excess of the CRR. Similarly, an OMO conducted over the last two days extracted liquidity worth Rs41 billion. Why would SBP further squeeze liquidity if the market was already short?
On the other hand, the ‘unwillingness’ hypothesis may very well hold some truth. During the first half of FY12, the SBP has lent an incremental Rs151 billion (versus Rs80 billion during 1H-FY11) and scheduled banks have lent Rs668 billion (versus Rs206 billion) to the government for budgetary borrowing. This coupled with a decline in Net Foreign Assets of Rs130 billion during the 1HFY12 (Rs127 billion increase during 1HFY11) is presumably rendering a double whammy on the exchange rate. Simple arithmetic would reveal that banks have an incremental hold up of around Rs662 billion, explaining their reservations about money lending and raising the price of the rupee.
On the darker predictive side, the rupee can be expected to go even further down as the date of IMF payment approaches. And touching base with the well known exports and power deficit connection, the slow growth in external receipts can be expected to continue as no resolution of the power and gas supply issue seems to be approaching. Since this is the land of the impure, the rent seeker and the opportunist, I would suggest lets all speculate and thrive! Cheers!!