The Monetary Policy Committee met last week and decided to increase the policy rate by 100 basis points. Market activity began to respond to this development and the dollar began its rally against the rupee. The dollar had vacillated in the Rs217 to Rs222 range since Ishaq Dar became the Finance Minister.

While that range had been broken through a couple of weeks ago, the intraday change on the 26th of January conveyed an unreal sense of elasticity between the policy rate and the price of the dollar.

While the discipline of economics doesn’t suggest a direct causal relationship between currency valuation and policy rates, the perception was that speculative activity in the exchange markets started as investors saw the policy rate hike as the government’s desperate attempt to put the shaky International Monetary Fund (IMF) programme back on track.

The dollar surged and surged even higher in the intraday to script one of the highest rallies of the US currency against its Pakistani counterpart. The dollar rallied to Rs263 from 230.89 at the close of the previous trading day.

What use is leaving the dollar to the market if it will mean devaluation in any case and no real increase in exports?

While analysts connected this to the policy rate hike and speculations surrounding resumption of the IMF programme, it seemed that dollar surged not because of the rate hike but because of some market signaling and an uncanny use of exchange rate instrumentalisation that the State Bank may have used to unpeg all or some part of the dollar valuation.

In either case, what I argue in this piece is that Pakistan lost, and only lost on that day — Rs33 against the dollar and 100 basis points on the policy rate, which, as analysts claim, translates into around Rs0.3 trillion of additional payments against bonds and commercial loans.

What use is leaving the dollar to the market if it will mean devaluation in any case and no real increase in exports, and what use is the policy rate hike if it will not cause a moderation in the inflation rate?

In fact, as we have seen during previous IMF programmes, deflationary trends somewhat caused by the policy rate hike were offset by inflationary pressures of the rupee devaluation. Are these reforms only needed to put the IMF programme back on track and is this a fair cost of the balance of payments support that Pakistan expects to receive from the IMF?

There is a clear answer to this question, and it brings to light why Ishaq Dar wanted the government’s say in determining the dollar price and initially resisted implementing IMF ordainments in letter and spirit.

You enter the IMF programme and the first thing that its experts tell you to do is to stop intervening in the exchange rate markets and unpeg the local currency against the USD, which is considered to stimulate exports and put brakes on the expanding current account deficits.

Pakistan’s exports are sticky and hardly budge even after many rounds of devaluation stimuli. The proposal to allow markets to determine the value of the dollar is partially understood but partially not, given the many imperfections that exist in how markets are structured and function. Export growth, as a result of devaluation, hasn’t been able to cover the increase in the external debt servicing obligation and energy import bill.

Concurrently, the other proposal the IMF makes is to keep raising the policy rate to the extent that it becomes an effective instrument to subdue inflationary pressures in the market. The idea is to make money so expensive that investors stop going to the banks to buy loans, arrange credit and hence don’t have enough to spend, thereby reducing inflation expectations.

However, the deflationary benefits of such rate hikes haven’t been able to cover the costs of the increase in payment obligation against bonds and commercial loans.

Other than exports being sticky and unresponsive to the devaluation stimulus, inflation in Pakistan is sluggish to respond to policy rate hikes simply because people here don’t buy their cars or their homes and don’t set up businesses with credit from the banks.

Financial markets haven’t matured, and the majority of the public isn’t connected to the financial grid. The contractionary monetary policy, as the economics textbook would have it, doesn’t apply to this part of the world.

Some of our economists have told the IMF this; some haven’t because they believe that the desired maturity would never come to the financial markets if we don’t listen to what the IMF says.

Many others suggest not thinking about what the IMF tells you to do because Pakistan doesn’t have an option outside of the IMF, and there is little value in estimating the effectiveness of their proposals.

In either case, while it’s a no-brainer that the current economic situation mandates returning to the IMF and there are no other options, there is no rationale associated with rendering a blind eye to IMF proposals that don’t work and are a source of certain costs to the economy.

There is a macroeconomic offset associated with the two headline IMF reforms (leaving the dollar to the market and raising the policy rate) and barring the balance of payments support that Pakistan will receive as a result of these reforms, the reforms themselves only present a loss-loss situation for Pakistan’s economy.

Further rate hikes and devaluation of the rupee only have the potential to cause further damage to the economy. There’s every reason for the government to go back to the IMF but also to take these pointers back to the upcoming round of negotiations with the fund.

The writer is an economist based in Islamabad. He tweets @asadaijaz

Published in Dawn, The Business and Finance Weekly, January 30th, 2023