We will see new things in Naya Pakistan for the next fiscal year, beginning July 1. One of them is a high-powered National Development Council (NDC) will be formulating development and economy-oriented policies of the country—and the chief of our armed forces will be a member of it. The prime minister will head the council.

The federal cabinet that met with Prime Minister Imran Khan on June 17 approved the formation of NDC.

So, we are entering into an era of economic management where civilian and military authorities will jointly prioritise policy actions for economic management. In this era, the central bank may find it quite challenging to discharge its responsibility of ensuring financial stability and managing exchange and interest rates regimes.

Pakistan is not going to free float the rupee, leaving exchange rates completely to demand and supply—no matter who pushes this idea and how hard

Just a day after the federal cabinet approved formation of NDC, governor of State Bank of Pakistan (SBP) said in his maiden press conference that Pakistan’s policy is a “market-based exchange rate system”. But he made it clear that exchange rate management will not be left completely to supply and demand.

“So, if there is volatility, State Bank intervenes. You need to keep a close eye on the market. That is our regime and we want to go with this regime,” he remarked. The message is clear: Pakistan is not going to free float the rupee, leaving exchange rates completely to demand and supply—no matter who pushes this idea and how hard.

The International Monetary Fund’s (IMF) board of directors is likely to approve next month a $6 billion loan to Pakistan for balance of payment support. During negotiations for the loan spread over several months the IMF was reportedly arguing for the rupee’s free float but Pakistani authorities resisted the idea. They, however, agreed to the Fund’s observation that the rupee was overvalued and the SBP let the rupee fall further even though it had already lost much of its value since December 2017.

The rupee has lost 29.2 per cent of its value against the dollar during the current fiscal year, falling to 156.96 a dollar in the interbank market on June 20 this year from 121.50 at end-June last year. Since end of December 2017, when the rupee was at 110.42 a dollar, its value has declined by 42.1pc.

Now, as the SBP has asserted that despite following a market-based exchange rate regime it will continue to intervene in the forex market during times of volatility, the rupee’s depreciation may become more orderly.

Dramatic and massive downward adjustments may hopefully be avoided. When a central bank maintains the exchange rate equilibrium as a policy but intervenes in the forex market when conditions become turbulent, the local currency does not plunge at the drop of a hat.

“An exchange rate that remains fixed for a long time is not in our favour. On the other hand, a free float also is not favourable,” Dr Reza Baqir stressed in his June 18 presser.

This clear-cut policy statement is enough to reassure banks and forex markets that the days of keeping the rupee artificially strong are over—once and for all. And, it puts to rest all speculations about an impending free float of the rupee.

Now, forex markets can operate with confidence and buyers and sellers of foreign exchange should rather keep a close eye on external sector fundamentals. Because, these fundamentals will ultimately be guiding SBP policies and actions in the realm of exchange rate regime.

Any temporary support to be lent to the rupee via SBP interventions will be just that—temporary in nature—and it will come only after the central bank views the market conditions as volatile.

Recently released data shows that Pakistan’s current account deficit has narrowed to about $12.678bn in July-May FY19 from $17.926bn in July-May FY18. Such a big current account deficit at a time when the SBP’s forex reserves are just at $7.604bn (as of June 14) is bound to keep the rupee under pressure.

So, chances for the rupee to avoid further depreciation in the near future are slim. Once we enter an IMF lending programme in early July, the Fund will also start reviewing, among other things, working of our exchange rates regime quite closely.

Thus, those who think that the SBP governor will eat his own words and keep the rupee artificially stable in the name of interventions in forex market should better review their optimism. In addition to the avowed SBP policy of maintaining market-based exchange rates and IMF’s push for ensuring sanctity of this policy, the shallow forex reserves, too, don’t leave logical room for over-optimism about the rupee’s health.

But at the same time, currency speculators and others who make predictions about the rupee to lick a new low day after day should also shun this practice. It’d be naïve to think that the central bank—even with shallow forex reserves—cannot check speculation-driven volatility.

When central banks choose to intervene, they simply do it. Outright selling of dollars is not the only tool they use; they employ several other techniques including forward dollar-rupee swaps and even moral suasion.

Managing exchange and interest rates remained challenging for the SBP in 2018-19 and in all likelihood will remain challenging even in 2019-20. Talking about monetary tightening in the outgoing fiscal year, the SBP chief said in his press conference that this was the only choice for fighting inflation but eventually it will help contain inflation and fiscal deficit.

The federal budget documents show the government has projected a fiscal deficit of 7.1pc of GDP though such eminent economists like Dr Hafiz Pasha and Shahid Kardar have termed it underestimated. In a jointly authored newspaper article both have given good reasons to support their view and have presented examples of underestimated fiscal deficits of the past as well.

But maintaining the fiscal deficit even at the projected 7.1pc means generation of unbelievably high revenue resources and keeping expenses at unbelievably low levels. Slippages look almost certain, more so due to uncertain political environment and in the midst of targeted low economic growth of 2.4pc, lower than 3.3pc of 2019-19.

So, further interest rate tightening on account of the fiscal deficit in the next financial year (on top of the 5.75pc increase in the SBP’s key policy rate in the current year) cannot be ruled out. Besides, despite monetary tightening in 2019-20, the 11-month average CPI inflation stood at 7.2pc—well-above the level of 6pc which begins affecting GDP growth—therefore further interest rate tightening, too, cannot be ruled out.

Published in Dawn, The Business and Finance Weekly, June 24th, 2019