Exchange rate blues


Vagaries of Consciousness

  • Need to bring order to the economy

What happened to the exchange rate on Black Monday (16-7-2018) would go down as perhaps the worst day for Pakistan’s economy. Six percent of the value or Rs7 were shaved off in the inter-bank market in a single day. In the open market dollars were simply not available. Curiously, after three rounds of depreciations in the last fiscal year, nothing of this type was apparently on the cards nor the market was expecting such an action. No adverse news by way of unfavourable economic data had appeared.

Since last July, the rupee has roughly depreciated from Rs104 to Rs128, a loss of Rs24 or about 23pc of its value. The last major adjustment in the exchange rate happened in 2008, when starting from November 2007 at Rs61, the rupee depreciated to Rs80 around end of October 2008, showing cumulative weakening of 31pc. In this latest round, between March and July, we have lost Rs18 to a dollar (Rs110 at end February and Rs128 at present), which is 16pc in less than three months, implying more than two-thirds of the depreciation since last July.

Such a massive erosion of rupee, therefore, is unprecedented. It becomes somewhat more baffling when one realises that the Monetary Policy Committee (MPC) of the State Bank had met on 14th July 2018, where it decided to raise the policy rate by 100 bps, highest in nearly three years. Nothing contained in the monetary policy statement, issued after the said meeting, had given any hint that such a move was afoot. The SBP, after these adjustments, has issued a press release, as in the past, stating that the exchange rate movements were reflective of demand-supply position in the inter-bank market.

Although this is a technically correct answer, it doesn’t divulge the entire story. In the inter-bank market, SBP uses both its muscle (reserves) as well as moral suasion to nudge the market in the desired direction. Occasionally, it does decide to let the market find its equilibrium. On each such occasion, since last July, several economic managers had indicated that adjustment decisions were made in consultation with the ministry of finance as well the prime minister. When the first adjustment was made, back in July 2017, the then finance minister was extremely upset saying it was done without his knowledge and ordered an inquiry. At a press conference after meeting the presidents of banks and other officials, he remarked that if there were issues of poor liquidity of forex, ministry of finance would have made the necessary effort to shore up reserves. So with such close interaction, it is difficult to imagine that the Bank was doing it at its own. In the interim administration two major episodes of adjustment have taken place, from Rs115 to Rs121 and from Rs121 to 128, and to assume that there was no consultation that went into these decisions would be hard to accept. Incidentally, the interim finance minister has not hesitated in making a few statements on the exchange rate while she visited Karachi and held meetings. Such statements clearly hinted that the exchange rate should be allowed to move freely. This is a major signal for encouraging depreciation and very likely induced the SBP actions. We have been advocating use of this instrument to bring order in the market but everyone knows that it has to move in line with other policy instruments to achieve the desired objectives (discussed below).

The program framework would provide the appropriate background and environment where such actions would produce the desired results. Otherwise all these isolated actions would not be counted as hard conditions accepted by the government

The consequences of this development are far reaching. First, the monetary policy action of increasing the interest rate by 100 bps was immediately neutralised. Had the MPC known such a large correction was in the pipeline, the need for interest rate correction may not have been felt. However, with such a large correction, the inflationary pressures would soon bring their own consideration on policy rate decisions.

Second, there is a very large loss of capital on the foreign component of public debt. At end-March, the public external debt was $69 billion. In the last quarter, significant borrowing was resorted to for BOP purposes. We estimate that at end-June the debt was at $73 billion. At this level of debt, the loss of capital in rupee terms is estimated at Rs2.2 trillion. The public debt at end-June 2018 was Rs21.4 trillion. With capital loss due to depreciation, that debt stands increased to 23.6 trillion. If we add the estimated deficit of Rs2.5 trillion incurred by the government during last fiscal year, the public debt would go to 26.1 trillion. Since this level of debt is very close to the end of last fiscal year, it would not be inappropriate to use the GDP for 2017-18, which was Rs34.4 trillion. The debt to GDP ratio would thus be a staggering 76pc. No other indicator would reflect more starkly the poor state of the economy than this high debt to GDP ratio. This has happened primarily in the last two years.

Second, the most immediate channel that would affect ordinary people from this disruption is the increase in energy prices. Even if international prices were to remain constant, the depreciation effect of about 6pc would be felt shortly on the next revision of petroleum prices on 1st August. The monthly fuel adjustment on electricity prices was negative for nearly last three years. However, it has finally ended last month when NEPRA allowed a positive Rs1.21 per Kwh as fuel adjustment charges for May. In the new application, the power producers have applied for an increase of Rs0.7 for the month of June. Thus in the months to come, fuel adjustment would continue to rise both because of rupee depreciation and increase in oil prices.

Third, the economic disruption has reached a level where it can no longer be corrected through monetary policy instruments alone. In fact, the last year has seen the highest fiscal deficit in six years of 7.1pc of GDP (excluding circular debt settlement), which is the primary reason behind the unraveling of fiscal discipline. Nothing by way of fiscal correction is in sight. In 2017-18, the tax collections have registered one of the lowest growth rates of less than 10pc in last five years while a grimmer picture is also reported in the collection of non-tax revenues. On the expenditure side, large over-runs are reported in debt servicing, subsidies and defense. Provinces have ended up over-spending rather than giving a surplus of Rs300 billion as was budgeted. With such major departures from even the revised estimates, presented at the time of 2018-19 budget in April, the approved budget, left behind by a government that was not supposed to give that, is completely out of line with the ground realities. The new government has to give its own budget and address these fundamental fiscal issues. Until such time, the interim government, after it had expressed its inability at the outset to do much about the economy, should have avoided actions that aggravate the situation.

Fourth, these so-called corrective measures are now essentially eroding our negotiating position with the IMF, since very soon Pakistan has to approach them for a new program. The program framework would provide the appropriate background and environment where such actions would produce the desired results. Otherwise all these isolated actions would not be counted as hard conditions accepted by the government. More would be demanded to restore stability.

Therefore, there has to be a complete freeze on economic actions, except those that help reduce the aggregate demand (don’t spend except for obligatory expenditures and don’t provide foreign exchange except when absolutely essential). Let the new government apply itself to do what is needed to bring order in the economy.