IS our exchange rate ‘market-determined’ nowadays? Its stability — around Rs280 to one US dollar — appears both amazing and perplexing in the current difficult balance-of-payments situation. This remarkable stability reportedly helped the State Bank of Pakistan purchase billions of dollars from the interbank foreign exchange market over the last few months. Earlier, in the first half of FY2024, the rupee first depreciated from Rs282 to Rs333 within two months, ie, July-August 2023, and then appreciated in the open market back to around Rs280 during September-October. This behaviour brought about by economic and non-economic forces, with few fluctuations since then, helped the SBP increase its dollar reserves through purchases.

During a period of high volatility in the open market, the interbank rate fluctuated much less (between Rs276 and Rs307.) Resultantly, the difference between the open market and interbank rate went up from around zero to about Rs27 in September 2023. The appreciating pressure both in the open and interbank market flooded the former with dollars, causing the open market premium to crash — again close to zero. This much-needed supply helped the SBP purchase dollars to shore up its reserves during the appreciating trend. This purchase is the opposite of the practice of keeping the exchange rate stable by selling from SBP reserves to the interbank dollar market.

Economists usually label a non-moving or little-moving exchange rate as ‘fixed’, ‘pegged’, or a ‘de facto peg’, if the official position runs contrary to the apparent fixity. Economists also use the intelligent term ‘fear of floating’ to indicate a failure to establish a truly market-determined exchange rate. So, what is the reality regarding our current exchange rate regime? Does it exhibit a fear of floating? If it does it would indicate that it is not truly market-determined.

The price of the dollar to the rupee is brought about by the complex interaction between market forces, the regulator of foreign exchange (the central bank), and the government (usually the finance ministry). Dollar demand is influenced through economic incentives given to importers (and outward remitters), and several regulations enshrined in the Foreign Exchange Regulation Act, 1947. Dollar supply is determined by economic incentives to industry, especially export sectors and inward remitters. In terms of ‘wishes’, everyone — consumers of imports (petrol and non-petrol), outward remitters, the government, smugglers, money launderers, etc — would ‘like’ the price of dollar to be extremely low. The only exceptions are exporters (who are not importers) and receivers of inward remittances.

Have our authorities succeeded in inventing a new kind of exchange rate regime altogether?

However, reality does not function on wishes alone. Any price determination regarding demand and supply requires either purchasing power, or another kind of power to influence the price (in the short run). This determines the actual price. A persisting trend of supply being lower than demand will dictate the market regarding price flexibility, with the exchange rate ultimately overshooting.

In our foreign exchange interbank market, those on the supply side are exporters, importers, and the treasury heads of banks who facilitate interbank transactions. The power of facilitators is limited by the supply of foreign exchange they receive daily from exporters and remitters, and partially on their market-making or intelligent price-quoting skills. Rarely, big bankers may collude to dictate a higher price, but this behaviour is unlikely to be sustained as the biggest player is the central bank, which can check manipulative behaviour through regulations, penalties, or a surprise supply of dollars in the interbank market to reduce the dollar’s price.

So, what happened to the exchange rate at the beginning quarter of FY24? According to the SBP’s latest half yearly report, “During Jul-Aug 2023, the external sector was facing several challenges, such as increasing financing gap, high volatility in FX market, tightening of global financial conditions, and heightened domestic uncertainty. These adversely impacted forex reserves and increased pressures on exchange rate. However, crackdown on illegal currency activities like smuggling of foreign exchange, besides exchange company reforms introduced by the SBP in September 2023, reduced pressures on the exchange rate. This combined with sustained improvement in current account balance and reserve position following disbursements from other bilateral and multilateral sources, led to a gradual appreciation of PKR from 5th September 2023 onwards. Supportive regulatory measures, like the imposition of a processing fee on Afghan imports of transit commercial goods via Pakistan and the suspension of B-category exchange companies’ authorisation, further alleviated the strains in the FX market.”

The ‘crackdown’ referred to here became both domestic and international news. Wikipedia now has a page about the 2023 crackdown. Last September, Dawn reported it as ‘The dollar galore in grey market’ and ‘Crackdown restores confidence in rupee’. The ‘crackdown’ on unscrupulous open-market elements rapidly brought down the value of the dollar. The mere news about the crackdown must have reverberated through banking circles deeply affecting the psyche of commercial bank presidents, and appearing to influence treasury officers’ dollar price-quoting behaviour also. Now that the SBP is not supplying dollars in settling their daily trades determining the exchange rate, can we say that it is a market-determined exchange rate? One can say that it seems more like a ‘crackdown-determined’ exchange rate. Have our authorities succeeded in inventing a new kind of exchange rate regime altogether? According to a report on May 7, “A nationwide crackdown on elements involved in hundi and illegal currency exchange persists, as reported by the spokesperson of the Federal Investigation Agency. Over the past four months, 267 raids were conducted targeting individuals engaged in the illegal exchange of hawala, hundi, and illegal currency exchange businesses.”

According to the assessment of the IMF staff published in their May 2024 report, “Gross debt-service obligations remain substantial, and current account imbalances stemming from insufficient exchange rate flexibility and import restrictions may require additional policy adjustment to reach external equilibrium.” Are we about to see a move towards market-determined exchange rates in the near future as we negotiate a medium-term programme with the IMF? If that is so, the future will reveal how long it lasts, given our fixed (and lower) exchange rate-loving authorities and people.

The writer is a former deputy governor of the State Bank of Pakistan.

rriazuddin@gmail.com

Published in Dawn, May 25th, 2024