February 17, 2003	Monday	Zul Hijjah 15, 1423

The inflows of dollars, much in excess of the emerging forex market demand, has helped the State Bank build up $9.5 billion reserves and to shore up the rupee against a sinking dollar. So far, so good. But there are increasing risks in continuing to keep on hoarding depreciating greenback. Pakistan maintains all its reserves in dollars.

Similarly, the perception of the market and the authorities on exchange rate policy differs, with many currency experts wanting to see the rupee appreciate faster. The rupee is under-valued.

Currently, the central bank intervenes in the inter-bank forex market to mop up excess dollar and its sales proceeds( surplus liquidity) from the banking system, thus managing the appreciating exchange rate. For all practical purposes, it is no longer a free float of the rupee.

And despite the nominal strengthening of the rupee, the real effective exchange rate(REER) continues to slide( upto December 2002, for which figures are available).

In a working paper circulated for the National Credit Consultative Committee (NCCC) recently, the State Bank says that the REER, an indicator of export competitiveness,has depreciated by 10.3 per cent in December 2002 compared to June 2000 and by 3 per cent in relation to June 2001.

The rupee was quoted at 64.1472 for one dollar in September 2001 and 60.1246 in June 2002.Now, it is just under 58, close to 1999-2000 level.

“The REER is determined by exogenous movements in dollar-rupee parity and the endogenous influence of internal price changes,” says the NCCC document.

The State Bank says:” the strength of the exchange rate is usually gauged, in popular discourse, by the nominal changes in dollar-rupee parity. As the nominal exchange rate had over-shot in the aftermath of introduction of free float in 2001, it would not be correct to take the resulting parity as the reference point for measuring the rupee depreciation. The true indicator of the export competitiness is real effective exchange rate.”

An excess supply of dollars in the inter-bank market has helped the State Bank to build unprecedented level of reserves.

International currency experts say that the risk to high reserves policy is a steep fall in the dollar, with the United States facing the prospect of deflation. “If we do fall in deflation” says Federal Reserve Governor Ben Bernanke,” the logic of printing press example must assert itself.” The printing press has its electronic equivalent that allows the US to produce as many dollars as it wishes at essentially no cost, says the Economist and warns that “Asian central bankers better watch out.”

The Asians are stated to be funding half of America’s current account deficit that is estimated to reach $307 billion in fiscal 2003 and $1 trillion for next five years. A senior treasury manager at a leading commercial bank says how long will Japan, India and China continue to invest in US treasury bonds that are increasingly becoming unattractive because of the depreciating dollar and lower interest rates. The dollar has depreciated 13 per cent against the euro since George Bush took over as the president of the United States and the Fed interest rates are down to 1.25 per cent, with market expectation of a further fall. With rates nearer zero,the interest rate weapon to fight deflation , would have become blunt. Going by the present current account deficit, the market sees the dollar over-valued.

In the past three years or more, Pakistan has focused on foreign sector of the economy. While it was struggling to reduce its external vulnerability,it was persuaded by the IMF to opt for a free float of the rupee in 2001, that brought about a free fall of the national currency. It is not fiscal stability but the excess dollar supply that has strengthened the rupee. The two best performing economies in Asia are China and Malaysia. Their currencies have fixed and stable parities with the US dollar for the past several years. In case, the dollar inflows begin to peter out,Pakistan would need huge reserves to keep the rupee stable.

Of course, the authorities are conscious of the fact that the reserves need to be productively used. Since the pace of investment is sluggish, the ministry of finance and the State Bank are identifying expensive multilateral debts which can be retired or pre-paid. The IMF standby arrangement facility is one of the first targeted to be pre-paid. All the debt rescheduling and debt relief have not yet made the external debt levels sustainable and is keeping Pakistan dependent on donors. Once the expensive debts have been retired, the government may find more fiscal space to enlarge its much-needed development spending programmes to stimulate economic growth and reduce poverty.The focus should shift to making domestic economy prosperous. George Soros, a leading currency and stock expert, says that international finance capital plays a decisive role in individual countries. Like an empire, the global capitalist system has a centre and a periphery and the centre benefits at the cost of the periphery. Finance capital flows to the centre from where it is distributed to the periphery. The United States has been dependent on inflow of foreign money for meeting its current account deficit(5 per cent of GDP) and foreign investment is declining because of recession in the US economy. The Bush doctrine and 9/11 have spurred capital outflows to their places of origin. The trend is likely to be further strengthened by a possible prolonged recession, by American protectionism and Washington’s isolationism in global politics. Going by the historical record,the US economic miracle of the 1990s may be followed by a decade of cyclic depression.

As long as the rupee is strong, stable and enjoys the confidence of both local and overseas compatriots, the dollar inflows are likely to continue at an accelerated pace at least, says national currency experts, for the next 3-5 years.

The State Bank is purchasing dollars whose parity with the rupee is declining and is expected to suffer heavy losses, that may nearly wipe out SBP’s projected revenue for the year.

Secondly, the question arises as to how long can the sterilisation policy last? How long will be exchange rate policy remain hostage to inefficient exporters who need to improve quality and price to compete in the world market.

In the first quarter 2002-03 SBP report, it is stated that REER (competitor) which includes developing countries(excluding Singapore) depreciated. This was largely due to the fact that the inflation rate in those countries with which Pakistan’s exports compete in third market,was higher.

A stronger rupee has meant cheaper imports of industrial raw materials, reduced cost of investment, lower debt servicing costs both for government and corporates, which combined with low interest rates and low inflation, has made exports competitive. It is time to examine how long would the country pay for subsidised exports for the benefit of the industrialized markets.