How is the exchange rate determined in Pakistan?

Exchange rate of Pak rupee with dollar was fixed up to 1982 when the Central Bank (CB) used to intervene in the market to defend the fixed rate. Afterwards, exchange rate was left to the market to determine as is now in Pakistan, of course with occasional intervention by the CB. Under the flexible exchange rate regime, the exchange rate depends on how the demand-supply balance of foreign currencies moves. When the supply for dollars rises with demand staying constant then each dollar cost less rupees to buy it. If domestic markets get reassured about the future of the economy then private holders of dollars sell them, leading to an increase in the value of local currency. Thus, movements in the exchange rate do not always reflect economic fundamentals, but are also driven by sentiments prevailing in the market.

The Pak rupee was exchanged for dollar in the inter-bank market at 105.5 on 4thMarch 2014, at 104.4 on 6th March, at 103.7 on 7th March, at 102.9 on 8th March, at 98.5 on 12th March, at 97.02 on 26th March, and at 98.17 on April 2nd. Concomitantly, Pakistan's total foreign exchange reserves declined to $7.6 billion on 7th February-2014 from $13.5 billion a year ago because of large repayments to the IMF and others. Foreign exchange reserves held by the Central Bank were even lower, at $2.84 billion. But it started rising after mid-February and rose to $4.8 billion by14th March, went down to $4.42 billion on 21st March, but went up to $5.365 billion. Marked improvement in foreign reserves was mainly due to support from bilateral lenders and remittances inflow. It would be pertinent to note that under the IMF guidelines December-2013, the CB undertook some corrective actions including using higher policy rates, purchases in the foreign exchange market, and greater exchange rate flexibility. In the above context, questions are being asked: What caused sudden rupee appreciation? How the economy is being affected by the appreciation? Will this appreciation last for some time to come? This article attempts to answer these questions one-by-one. Causes of Sudden Appreciation:

The source of sudden appreciation is the information spread about improvement in economic fundamentals and future outlook of the economy, which caused a reversal in market sentiments. Positive developments as described in the latest CB Monetary Policy Statement are: almost all major economic indicators have moved in the desired direction over the past few months. Growth of 6.8% in Large Scale manufacturing improved aggregate supply in the country. The fiscal deficit has been contained during the first half of the fiscal year while the private sector credit has increased. Moreover, positive sentiments in the market are due to a noticeable increase in foreign exchange reserves and a larger than anticipated decline in inflation. Another key factor that induced the sentiments has been the IMF's approval of the government's pace and thrust of reforms. Pakistan's Eurobond now trades at a premium, this strong performance on the existing Eurobond should help placement of the new issue. All those who were expecting continued depreciation were surprised by sudden appreciation and quickly took new positions to off-load their dollar holdings which increased dollar supply in the market further appreciating the rupee.

Having seen through the peak period of IMF repayments, there are now numerous inflows lined up in the next few months. This includes an IMF tranche of about $550 million by the end of May, a 3G/4G auction in April, and Eurobond issuance in about 2 months. Meanwhile, the government's decision to use foreign currency deposits held by commercial banks to the tune of US$500 million has also eased dollar supply constraint in the interbank forex market. It may be noted that during this period, US dollar also fell against pound by 0.85%; so some appreciation of rupee is due to dollar depreciation.

Despite IMF repayments of $692 million are due up until end of June, the expected inflows will raise reserves. This indicates of improved external liquidity, thus reducing impending repayment dangers. All these expectations have enabled market to hold rupee at its appreciated level. After-Effects on the Economy: A sudden appreciation of the Pakistan currency is seen by critiques as no good for the economy. They argue that it will cause tremendous job loss in Pakistan due to loss in international competitiveness. Ask importers who have made forward contract, as they always do in advance. Some of them have lost their fortune. Anyways, imports will rise as with appreciation we have to pay less for imported items. Is this a desired outcome for an economy which is struggling to boost exports to create employment and avert a Balance-of-Payments (BOP) crisis? Doubts are expressed over the stability of the currency at current levels. Our major export industry, textile, which is already facing fierce competition from other textile exporting countries, has come under pressure with appreciation. Provided appreciation is translated into a fall in the prices of non-traded goods in the country along with a fall in the prices of imported inputs used in the export-oriented industries, exporters will benefit. Otherwise, they will face the brunt of appreciation.

In case, this sudden appreciation is without the backing of strong macroeconomic fundamentals then volatility in currency will take place in the near future. Consequently, with rising export prices exports will decimate and import-bill will be higher. Remittances inflow will also slow down. Thus, appreciating currency to the point where the country is no longer competitive in the international market can cause the economy to be in the stagnations and will thus have adverse implications for the BOP.

Some one might think that with appreciation of rupee the import price may go down, which may result into lowering of inflation. The appreciation may not solve the inflation problem at all if it is due to large inflow of capital. Net capital inflows will increase the volume of currency in circulation resulting into increased inflation. So a policy of sterilization, whereby government issues domestic bonds to wipe out increased money supply, would be needed to neutralize the adverse implications of foreign capital on inflation. Pakistani residents holding assets in Pak-rupee have become richer as they can buy more foreign goods with rupee-denominated assets. There will be a fall in public debt servicing to the extent of appreciation at the time of servicing. At the same time customs duty revenues will fall with decline in imports in Pak rupee. Therefore, actual net fiscal implications are ambiguous.

Anticipated Length of Appreciation: It all depends on how accurate and credible information market is receiving from different quarters about turn-around in the economy. Even if the information is partially correct the market will reverse its sentiments and rupee will start depreciating to its original position from where it started gaining strength. Despite strict instructions from the CB to exchange companies to reduce the rupee-dollar exchange rate spread in interbank-open forex markets, it is currently about Rs.2.5. It