Pakistan is always in the quest of interest and exchange rate stability — the two prerequisites for sound economic growth.

Structural issues of the real economy and of the external sector make it difficult to maintain interest and exchange rate stability for even a few years. That keeps economic growth unsteady with all its socio-political consequences.

The PML-N government had maintained artificial exchange rate stability for years. But the caretaker government tasked to hold the general election in 2018 let the overvalued rupee fall. The process continued after the installation of the PTI government.

Both the PPP and PML-N governments used to borrow heavily from banks to bridge fiscal gaps. They would also switch over from commercial bank borrowing to central bank borrowing, and vice versa.

Keeping the local currency artificially strong had left a question mark on the exchange rate stability when it was left completely up to the market forces. And a decade of excessive borrowing from commercial banks had not only crowded out the private sector but also impeded the future development of a market-based interest rate structure.

These things, however, remained less noticeable as GDP growth during the past decade averaged three per cent-plus on the back of strong public-sector spending and better policymaking than those by the PTI.

The rupee’s sustainable rise against the dollar depends on whether the trade deficit will continue shrinking

Maintaining artificial stability in exchange rates is no more an option now because the International Monetary Fund (IMF) does not like it and the State Bank of Pakistan (SBP) had already shunned this practice towards the end of the PML-N government.

The PTI government still has the freedom to borrow massively from commercial banks. But the days are over for switching over from commercial bank borrowing to central bank borrowing. In other words, the central bank is bent upon making both exchange and interest rates more market driven — and reflective of the changes in the fundamentals. The recent gains in exchange rates should be seen in this perspective and projections about their sustainability should be made accordingly.

In the first year of the PTI government, the rupee had to lose 31.7pc value against the dollar as foreign exchange outflows remained thicker than inflows. At the beginning of 2019-20, Pakistan secured a $6.9 billion IMF loan to fix its balance of payments. Instalments of that loans together with foreign exchange funding by friendly countries and foreign exchange commercial loans helped reshape the balance of payments and the rupee lost just 5pc value against the greenback. In two years, the rupee cumulatively shed 36.7pc of its worth vis-à-vis the dollar and plunged to 168.05 at the end of June from 121.50 at the end of 2017-18.

In these two years, the current account deficit that stood at $19.19bn at the end of 2017-18 first fell to $13.43bn at the end of 2018-19 and then to just $2.97bn. With the beginning of 2020-21, the rupee started making modest recovery and this trend is still on.

In July-September, the rupee regained 1.4pc and rose to 165.70 at the end of September from 168.05 at the end of June. In the first six working days of October, it regained more value and closed at 163.72, thus consolidating its total gains between July 1 and Oct 8 to 2.6pc. One key factor behind this recovery is that Pakistan booked a modest current account surplus in both July and August. If the country manages to keep the current account in surplus for months to come, further recovery in the rupee’s value is possible.

But the rupee’s sustainable rise against the dollar depends on whether the trade deficit will continue to shrink — even after the removal of additional import duties on hundreds of items and amidst sluggish demand for exports. In the first nine months of 2020, about 180,000 Pakistanis left abroad for jobs against 625,000 in entire 2019, according to the Bureau of Emigration and Overseas Employment. Official data about overseas Pakistanis who have returned home after Covid-19–triggered global economic slowdown is not available. But their number runs in hundreds of thousands. These two things may potentially decelerate the current handsome growth rate of remittances with a lag of time. Much also depends on the success of Roshan Digital Accounts that the government has launched for overseas Pakistanis enabling them to make foreign portfolio investment into homeland while sitting abroad.

Pakistan’s total external debts rose to $112.8bn at the end of 2019-20. This is naturally bound to increase the external debt servicing requirement in the future. For the exchange rate stability, it is imperative to keep external debt from growing further. If that does not happen then occasional recovery in the rupee’s value may actually prove short-lived.

Political temperature is rising in the country. And, this is happening at a time when the World Bank says the economy can grow just 0.5pc during this fiscal year — far lower than the official target of 2.1pc. If the PTI government and Pakistan Democratic Movement fail to reach a political accord and if the planned street agitations are allowed to happen, the economy will be the first victim. Foreign direct investment and exports will likely suffer. That may dash hopes for exchange rate stability.

What amplifies this fear is the fact that unlike in the past the SBP cannot be expected to pump foreign exchange into the interbank market to keep the exchange rate within a band — except in the case of “extreme volatility”.

The central bank does not have lots of foreign exchange funds to pour into the interbank market in any case. Due to uncertain geo-political conditions prevailing in the region and persisting pressure on our Eastern borders, Pakistan is trying to improve the import coverage of its foreign exchange reserves. Currently, the central bank’s reserves of $12.15bn are enough to meet just over three months of the merchandise import bill.

Published in Dawn, The Business and Finance Weekly, October 12th, 2020