THE global economy is passing through a perfect storm. The commodity super-cycle has led to record high prices of essential imports. On the other hand, emerging markets face capital flight with rising interest rates in the US and EU markets. Emerging economies are facing stress with rising import bills and depleting central bank reserves. Lebanon, Sri Lanka, Suriname, and Zambia are already in default.

Pakistan has done better as proactive measures taken by the government have averted the threat of default. These include measures to curb imports and budgetary measures to restore the IMF programme. Markets are reacting positively to these policy measures; yields on Pakistan sovereign international bonds have declined sharply to 22pc, from peak levels of 50pc in July 2022. The stock market has rallied 7pc in August, while the rupee has strengthened over 10pc in the last week days.

However, despite the recent improvements in sentiment, the large external financing needs over the medium-term continue to cast a long shadow over the economy. According to the IMF staff report in February 2022, Pakistan’s external financing needs will remain high — around $35bn to $40bn annually — over the medium term.

Stability in the foreign exchange market is crucial for creating a conducive environment for local businesses: attracting new investments, supporting growth, and managing inflation expectations. However, given the large external financing needs, the rupee will likely remain under stress as the demand for dollars remains significantly higher than the available supply in the market, at least in the immediate run.

With overall global sentiment on capital markets being negative, and the rating outlook downgrade by international rating agencies, we are effectively priced out of the international bond markets. This leaves the economy too dependent on borrowing from multilateral agencies and bilateral loans from friendly countries. The large funding requirements in emerging markets have put us in a weak position to negotiate better terms and conditions.

Therefore, other than ensuring that existing forex flows continue to trickle into the country without delays – to avoid any see-sawing of the exchange rate in the market, as recently witnessed – alternative sources of dollar-funding need to be explored and managed in the medium term to ensure stability.

Read: The default response

When the going is good, as is the case in the currency market right now, it is the right time to introduce certain measures so that the exporters and remitters can be incentivised or coerced to bring in the existing foreign currency remittances stuck outside the country, and ensure that they continue to arrive without delay and keep the markets calm.

The central bank requires better engagement with banks, perhaps on a daily basis at the treasury level, and with money changers. Better and aggressive enforcement of discipline is also a need of the hour.

On the other hand, the most significant alternative source of external financing in the last 3 years is the Roshan Digital Account (RDA) initiative of the State Bank of Pakistan (SBP) and the Naya Pakistan Certificates (NPC) of the government of Pakistan. Approximately $4.8bn inflows have materialised under this scheme since September 2020, out of which $3.1bn is investments in NPC.

However, inflows have slowed down sharply in the last few months due to unfavorable global market conditions. While global interest rates have risen sharply – with the benchmark six-month Libor trading around 3.6pc today compared to 0.15pc in the same period last year – the profit rates offered on NPCs have remained unchanged at 5.5pc to 7pc across different tenors.

The profit rates on NPC instruments need to be market-based and linked to Libor rates. Even at a spread of 500 basis points over the Libor, the NPC profit rate of 8.5pc will be significantly lower than the borrowing cost from international bond markets, currently at 22pc. Urgent attention is needed to keep NPC products attractive to incentivise fresh inflows and discourage existing investors from pulling out.

The second area that needs to be addressed is the large and growing onshore holding of foreign currency assets, mostly cash held by individuals for saving or payment needs. No formal estimates exist of the size of these holdings, but their significance can be gauged from the following data points; first of which is the size of the foreign currency deposits of the banking sector. These stand at around $5.8bn today, down from $7.1bn last year. In 1998, before the freezing of foreign currency accounts, the size of these deposits used to be as high as $11bn.

The second data point is currency in circulation: the latest SBP data shows that this has increased to Rs8 trillion ($35bn) and makes up around 30pc of the total money supply in the economy and 40pc of bank deposits.

High currency in circulation is also highly inflationary in nature. In previous episodes of market turbulence, the low deposit base of banks struggled to meet the deficit financing needs of the government, leading to money-printing by the SBP.

During periods of uncertainty and exchange rate volatility, many private investors convert their cash holdings into dollars. The reason investors prefer to hold foreign currency assets ‘under the mattresses’ (in cash or in their bank lockers) is the lack of returns offered by commercial banks and lack of alternate investment avenues. There is also reluctance to declare these assets to tax authorities for obvious reasons.

Therefore, the primary objective should be to cut down on currency in circulation and that is only possible with reduced financing requirements of the government, either by keeping the debt-servicing lower by managing the policy rate at the right levels (as the demand for currency in circulation isn’t amenable to policy rate changes), or by avoiding fresh debt by enhancing tax and non-tax revenues. We need to remind ourselves that we have to borrow to service our existing debt.

The other option is to ensure that the enhanced money supply will be used to meet the mainstream requirements of the economy, which at this stage is dollar inflows – ideally in the form of exports or other sources of investment (bank deposits or otherwise) – to enhance the forex pool in the country and ease-off pressure on the government’s reserves. Today, an investor will get only 0.2pc to 0.75pc on their foreign currency deposits, while big depositors can negotiate a higher rate. In comparison, commercial banks in India offer returns of 2.85pc or higher on foreign currency deposits. The central bank in India has recently waived the Cash Reserve Requirement (CRR) and Statutory Liquidity Requirement (SLR) requirement on incremental foreign currency deposits, incentivising banks to raise them.

The writers are a former governor of the State Bank of Pakistan, and the president and CEO of the Bank of Punjab, respectively.

This is the first of two articles; the next installment will appear in tomorrow’s edition of Dawn.

Published in Dawn, August 18th, 2022