A floating exchange rate? | Pakistan Today

A floating exchange rate?

  • Addressing the elephant sitting on the economy

By: Moazam Mahmood and Shamyla Chaudry

We have a crisis of growth, felled by the pandemic. So does much of the world.

But our growth was felled prior to that, by huge and increasing imbalances. Imbalance in the budget, with too little taxation, chasing too much expenditure. And then in our Balance of Payments (BOPs), with too few exports chasing too many imports. But these deficits have to be paid for. Which they were, by running down the foreign currency reserves of the State Bank and contracting higher borrowing and debt. By stoking up inflation.

Now, we have always in time honoured fashion, tried to muddle through. But is the Government of Pakistan (GOP) beginning to address the elephant sitting on the economy, squeezing the life out of it? Which is arguably the floating exchange rate. We have high hopes, based on observing just the tip of the elephant, being addressed by GOP, in the restrictions now placed on Foreign Currency Accounts (FCAs).

The tax filing restrictions just placed on FCAs, logically should begin to address two problems. First, presumably to correct the historic drop in revenue below 10% of GDP, the idea is to bump up taxation, by hitting the FCAs.

But second, and of more immediate import, FCAs, both tax declared and undeclared, are also a source of large capital outflows. Not just small outflows for consumption, like education and health. But larger outflows for investment and speculation. So a significant proportion of these large scale outflows must be through undeclared FCAs. Which the new restrictions should lower, if not scotch.

Focus on just the need to maintain just three macro fundamentals. The exchange rate, already pressured downwards in open markets. The inflation rate stoking up with high deficits and low growth. And the interest rate, which has to be raised to control inflation and keep the exchange rate peg from falling further. But this rise in the interest rate is also the cost of borrowing and so reduces investment and growth.

Further, conversion of Rupees into forex, say US Dollars, and parking them in FCAs, leads to Dollarisation of the economy. Which is weakening the exchange rate. Restricting conversions and parking them in undeclared FCAs, should also reduce Dollarisation and its resultant weakening of the exchange rate.

But if GOP is very encouragingly beginning to recognize the tip of the elephant’s head, it needs to logically recognize the rest of the elephant’s body, weighing down on the economy.

The weighty elephant is arguably, and oxymoronically, the floating exchange rate.

Two years ago, a lifetime in economics, Pakistan looked to be turning its back on kleptocracy and spendthrift development. The new Prime Minister, Imran Khan, had been largely credited with the best will in the world.

But the profligacy of the ancien regime had spawned Current Account and Budget deficits, each of 7% of GDP, a due Balance of Payments bill of $15 billion, a pressured exchange rate, halving of reserves to $10 billion, and capital outflows of $6 billion in the last year alone.

Which required a by now classic recourse to the IMF. Without this multilateral bail out, the external payments could not be met. Nor confidence restored in the macro fundamentals of the economy, to allow faltering investment and growth to resume.

Focus on this need to maintain macro fundamentals.

Focus on just the need to maintain just three macro fundamentals. The exchange rate, already pressured downwards in open markets. The inflation rate stoking up with high deficits and low growth. And the interest rate, which has to be raised to control inflation and keep the exchange rate peg from falling further. But this rise in the interest rate is also the cost of borrowing and so reduces investment and growth.

In macro policy, you cannot have your cake and eat it too. You cannot control all three macro fundamentals, the exchange rate,  the interest rate and the inflation rate. Macro policy can come in the flavor of trilemmas. We are caught in Flemming’s.

Unfortunately, back at the ranch, the IMF SBA/EFF was negotiated belatedly, after a critical slipping in macro fundamentals over a year. For which a much higher price had to be paid. And the higher price was the surrendering of the exchange rate. The peg of the Rupee was abandoned for a free float. This was just bad economics for a country in Pakistan’s fragile economic position.

Why? Because only a few high income countries have full free floats. Think US., UK., and Canada. Predominantly countries have pegs of some sort, also called managed floats. Why? For four major reasons.

One, for a beleaguered economy like Pakistan’s at the moment, a free float sets in expectations of further depreciation of the exchange rate. People rationally bet against the Rupee, for motives of speculation and preserving value. This leads to flight of precious capital abroad. Which in turn weakens the Rupee further. In a vicious circle downwards. Call these depreciationary expectations. Analogous to inflationary expectations.

Two, a free float, with a depreciating exchange rate, increases the Rupee price of Pakistan’s external commitments, payments that have to be made abroad, repayments of loans, debt, future credit. So the country cannot be any forwarder.

Three, a free float brings complete uncertainty into the price environment that investors face. Investors need certainty in the prices of their inputs and outputs to determine their rate of return. But a downwards pressure – more a free fall of the exchange rate – imports in inflation into domestic prices. Making the Rupee value of all imports sky rocket. It is not just the upper classes that have to forgo their French cheeses, but the price of imported capital equipment, plant and machinery, that becomes prohibitive. And Pakistan produces hardly any capital equipment domestically. So the rising cost of imported capital goods further inhibits an already weak domestic investment and growth rate.

And most important of all, the inflationary effect on domestic prices through a free float and depreciating exchange rates, can be huge. Just imagine the rising price of imported energy, used to produce all goods, especially wage goods for the poor. No matter how well intentioned, you cannot control market prices by fiat.

So what is the alternative to muddling through? It is, to address the whole weight of the elephant sitting on the economy, squeezing the stuffing out of it. The floating exchange rate.

The heart of the problem lies in the difficulty, if not the impossibility for us, of maintaining a market based exchange rate. If anything needs revising then, it is the agreement with the IMF, it is the free float of the exchange rate. A peg of the Rupee to a foreign currency or basket of currencies must be sought as of yore.

And there should not be reliance on just one policy instrument to sort out Pakistan’s predicament on its external account. A judicious use across three policy instruments would be better.

One, a peg with some depreciation can be negotiated. But not a further massive depreciation which ushers in all the expectations of further depreciation, and the entailed problems of domestic and foreign speculators betting against the Rupee, with outflows. The float has depreciated the Rupee plenty.

Two, maintaining the peg with some reliance on interest rates. But balancing support for the peg with keeping down this cost of borrowing to keep some growth in the economy.

And three, and most importantly, to counter the depreciationary expectations that have been set in, to counter the betting against the Rupee and capital flight abroad, some form of capital controls will be needed. Certainly if economies like China with a $3 trillion in reserves or India with half a trillion Dollars resort to capital controls, can Pakistan with barely $10 billion afford not to. Otherwise capital, always a flight risk in beleaguered economies like Pakistan, but also Argentina and Turkey, will hemorrhage out. Indeed the IMFs Asia Director admitted that under these circumstances of stalled growth projected for Asia for 2020, capital controls may not be a bridge too far.

The writers are members of the economics department at Lahore School Of Economics.

One Comment;

  1. sheephead said:

    A floating exchange rate? Squeeze all blood out of all common pakis and enrich mily muscles to eat more and more proteins and meaty stuff?

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