Before I discuss the prevailing foreign exchange situation, I begin by giving an overview of the foreign exchange (forex) market in Pakistan, to develop a better understanding of the subject. Overall the forex market has three main segments: Inter-bank market, Open market, and Hundi/Hawala or Parallel market. The first two markets are legal, while the third market is illegal.
All approved foreign exchange transactions take place within the banking system through the inter-bank market, where outflows of foreign exchange include: import payments, profit repatriation by foreign firms working in Pakistan, disinvestment, and funds transferred abroad through foreign currency accounts (FCAs). On the other hand, inflows of foreign exchange include export earnings, profits earned by Pakistani firms working abroad, remittances, and foreign investment inflows, etc. The demand and supply of foreign exchange in the inter-bank market determine the inter-bank or official exchange rate. The size of inter-bank market covering all of its transactions is around $500 million a day.
Government transactions do not affect the inter-bank market because they are directly managed by using the State Bank of Pakistan (SBP) foreign exchange reserves. For instance, foreign debt repayments do not affect the inter-bank market. However, the size of the SBP foreign exchange reserves and government transactions affect inter-bank exchange rate through market sentiments. The SBP uses its reserves to intervene in the inter-bank market when exchange rate movements become volatile. But when reserves are low then the SBP cannot effectively intervene in the forex market, consequently, exchange rate is left at the mercy of market forces, and rupee also comes under speculative attack. When the SBP does not intervene to defend exchange rate, then it virtually follows floating exchange rate policy for which it does not need foreign exchange reserves. Having said this, it does not preclude the SBP to maintain reserves for some other official purposes.
Open market is the second segment of forex market. This market comprises exchange companies. Inflows to this market include remittances and dollars purchased from private individuals. Outflows include sale of foreign currency for the purpose of travel, education, and pharmaceuticals, etc. Exchange companies are required to sell 15% of their inward remittances to the inter-bank market, and deposit 25% of their foreign exchange in their FCAs held with commercial banks, out of which they are also required to sell 10% of this amount in the inter-bank market. It is mandatory for exchange companies to submit daily reports on their transactions to SBP, yet a portion of their activities remains undisclosed. The open market exchange rate is determined by the supply and demand of foreign exchange in this market. The size of the open market is around $25 million per day, but this does not cover its undisclosed part, which is much bigger.
Hundi/Hawala is the underground forex market based on networks of brokers spread over developed and developing world. This system basically works on mutual trust and social networks and is unregulated. Under this system, physical movement of currency does not take place across countries, as claims are settled by netting-out opposing transactions. It is a major source of money laundering and capital flight. Due to its very nature, it is difficult to determine the actual size of this market, however, household surveys report that, for instance, about 40% to 45% of households in KP still receive foreign remittances through this system. Roughly, a total of $4 billion of remittances comes from this source.
Factors Conceding to Currency Crisis
Why has the fear of devaluation emerged and what has caused the recent currency crisis? Fear of devaluation arose because the SBP’s foreign exchange reserves kept falling despite recent borrowing from some friendly countries. The cause of currency crisis is mainly the outcome of ill effects of inconsistent policies used to manage the exchange rate.
In the past, Pakistan built its reserves by international borrowing and purchasing of dollars available in the open market (brought in by expatriates on their home visits and smuggled from Afghanistan). This assisted in maintaining an overvalued exchange rate, which made our exports expensive for foreign buyers and imports cheaper, resulting in a very high trade deficit. Now with very low foreign exchange reserves, Pakistan was left with no other choice but to leave the rupee at the mercy of market forces, this is also a pre-condition of the IMF program. This is because: (a) the SBP foreign exchange reserves have depleted fast due to unprecedented current account deficit; (b) smuggling of dollar is drying up from Afghanistan; and (c) occurrence of technical delays in concluding the IMF program. This move, nevertheless, has a silver lining as neutrality would prevail for both exports and imports provided overvaluation is removed ultimately. I do not endorse the views of some experts who have recently argued that the rupee should deliberately be kept undervalued, as is done by China for RMB, without realizing that China also used some compensatory policies for sectors badly affected by undervaluation. Pakistan doesn’t have resources to emulate China and should avoid introduction of another distortion. If overvaluation of currency is a bad policy, so is undervaluation. The best policy would be to keep the exchange rate at or near the equilibrium, so that a level playing field is given to both exports and imports.
When on May 12 IMF press statement was released, it stated, “This agreement is subject to the IMF management approval and to approval by the Executive Board, subject to the timely implementation of prior actions and confirmation of international partners’ financial commitments”, the forex markets did not react harshly. No change in the inter-bank market exchange rate took place until May 16. Although, some movements were seen in the open market from May 14. On May 16, inter-bank market took the lead by depreciating rupee against dollar from 141.7 to 148, then the open market followed this lead by depreciating to 148 from 144.15 a day earlier. So clearly, the signal came from the inter-bank market, which was picked up by the open market. But when open market reacted harshly by depreciating rupee to 155 then perhaps the SBP tried to calm it down through the inter-bank market by using various instruments available to it and rupee now (on May 21) came down to 148.5 in the inter-bank market and 153.3 in the open market. As it appears, the SBP experimented with IMF’s condition of prior actions. Speculators also played their role in the open market. The IMF program will be signed by its Executive Board after a few weeks, only then full details of the program will be available. But until then speculators and the SBP will keep on playing their respective roles to influence the exchange rate.1
Exporters are also exploiting this situation and are holding their export earnings outside the country with expectations that the currency will further depreciate. In addition, there is evidence that exporters are also under-invoicing exports. For China only, I estimated that exports worth $213.1 million were under-invoiced in 2018.
Remittances data show that on monthly basis Pakistan recorded the highest remittances of $2.018 billion in October 2018 that have come down to $1.818 billion in April 2019 but that are higher than $1.721 billion recorded for March 2019. So there is no evidence of expat workers holding back their foreign savings or speculating.
In the first 9 months of current fiscal year, FDI outflow has increased to $1241.8 million from last year’s $560 million. This may be an indicator of consciousness of foreign firms about the prevailing situation. In addition to this, there is a large sum (over $9 billion) of debt repayments due for this year. All of these outflows along with large current account deficit are fast depleting reserves held by the SBP, putting immense pressure on the value of rupee.
The government tried to cut down imports by devaluing currency and using higher tariffs, and as a result total imports paltry decreased from $41 billion to $39 billion over the past 9 months. On the other hand, exports fell by $254 million instead of rising, and now stands at $18 billion. The country lost export earnings while depreciating the rupee, because the required compensatory policy measures remained out of the sight of policymakers. Large trade deficit has thus become one of the biggest drains on foreign exchange reserves, thereby affecting the exchange rate.
All in all, Pakistan has reached a situation where speculators and forex market players have been anticipating the rupee to depreciate fast. The SBP has intervened on many occasions to control the fall in the value of rupee, which has resulted in fast depletion of the foreign exchange reserves. With high current account deficit, falling GDP growth, and rising indebtedness, Pakistan is evidently facing very serious forex problems.
The Way Forward
The traditional measures used by the SBP to manage the exchange rate are no more available to it since it has chosen the path of market determined exchange rate to meet the IMF conditionality. Under this situation, the government may use the following prudent measures to build foreign exchange reserves and manage the misaligned exchange rate:
• The government at the highest level must publicly acknowledge the overvaluation of rupee and the SBP should give credible signals to forex market that its current moves are transparent. In this regard, disclosure of details of the new IMF program at the earliest would give confidence and assurance to the market that it will not receive any surprises. Otherwise, the damage to credibility will have dire consequences for the forex market and economy.
• A passionate appeal should also be made to the nation to buy (only) Pakistani goods with high content of domestic raw materials and inputs, at least for the next 3 years.
• Appeal should also be made to industries to cut down their wastage, it will improve their competitiveness. It is pertinent to note that in the manufacturing sector 10 to 12% of production is wasted on average.
• Imports cannot be significantly reduced by small increase in tariffs because consumers with high purchasing power will in any case buy imported goods even if they have to pay a higher price. Therefore, government needs to introduce prohibitive tariffs on non-essential products to eliminate imports. WTO allows this for up to 3 years, if the country faces BOP crisis. There is a caveat to this suggestion, i.e., whenever Pakistan adopted such a policy, smuggling increased, which also reduced remittances through banking channels. So government must take effective enforcement measures to make such a policy successful. Implementation of this suggestion will also be a boon for domestic import-competing industries.
• Under the prevailing situation, Pakistan can use a modified version of Export Bonus Scheme that was used in the 1960s, at least for some time. It was then considered an effective export promotion measure which also reduced imports. Moreover, to encourage exports, link credit availability to non-exporting firms with export of a certain proportion of their production. I recommend the readers to read my article published in Hilal Magazine’s May 2019 issue for a comprehensive set of suggestions to address the trade deficit, which can assist in building the foreign exchange reserves.
• Make it mandatory for foreign firms working in Pakistan to export their goods and services to the level of their rebound/repatriated profits and dividends, at least for the short to medium run. It is worth noting that in 2018, foreign firms repatriated over $6 billion while their foreign earnings were negligible. So it was a big drain of scarce reserves.
• ‘Transfer Pricing’ is a well-known practice of foreign firms through which they transfer their profits overseas to evade domestic taxes and other regulations. This also raises import bill. Customs department should stop conniving with foreign firms to keep the import bill within reasonable limits.
• Incentivize expats to ‘save in Pakistan’ rather than overseas by introducing savings and investment schemes exclusively for them.
• A large proportion of expats send remittances through the Hundi system because it gives them some premium over the inter-bank market. Besides, this system is efficient and reliable. To motivate remittances through the inter-bank market, government must ensure that expats get competitive exchange rate and that the banking system is efficient and corruption-free.
• Exchange companies are required to sell 15% of their inward remittances to inter-bank market and sell 10% of their deposits in foreign currency accounts in the inter-bank market. Government should raise these limits for some time and not let exchange companies under-report to avoid changes in these limits. This action would raise SBP’s foreign exchange reserves.
The writer is a Professor of Economics at the School of Social Sciences and Humanities at NUST, Islamabad.
E-mail: [email protected]
1 Note: At the time of the publication of this article, any misinformation may unleash the market forces to affect the on-going rupee-dollar exchange rate.
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