25 October 2004	Monday	10 Ramazan 1425

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The rupee has shed four per cent value against the US dollar since the start of the new fiscal year in July. On October 21, it closed at 60.42 a US dollar in the inter-bank market. At end-June 2004 it was at 58.13.

This four per cent fall in the rupee value in less than four months is bound to have multiple effects on various sectors of the economy. The reasons for the rupee depreciation are well known and can be summed up in one sentence: the outflows of foreign exchange have been larger than the inflows. Let us now see the ramifications of this big fall in the rupee value.

External debt: A four per cent rupee depreciation means a four per cent increase in the rupee book value of external debt. At end-June 2004, Pakistan's total external debt stood at $33.3 billion. Converted into rupees, using the end-June exchange rates it translates into Rs1935.7 billion. With a four per cent fall in the rupee value this stock of external debt now stands around Rs2013 billion, showing an increase of more than Rs77 billion!

Debt service: A four per cent fall in the rupee value also means an equal increase in the rupee cost of external debt servicing. The government will now have to spend Rs60.42 billion for servicing a billion-dollar external debt, if we assume that the debt servicing is made at the October 21, 2004 exchange rate. It would have to spend only Rs58.13 billion to service the same amount of external debt had the rupee remained at the end-June level.

Imports: A four per cent rupee depreciation has made imports costlier in rupee terms. For a billion-dollar import, the country now needs Rs60.42 billion. Had the rupee remained intact at the end-June level, it would have required Rs58.13 billion.

Exports: The value of exports in rupee terms has increased as a result of the rupee depreciation. A billion-dollar export now earns Rs60.42 billion. If the rupee had not depreciated, a billion-dollar export would have earned Rs58.13 billion.

But as our exporters use many direct and indirect imported raw materials in manufacturing exportable goods, this increase in exports in rupee terms would be partly offset by the increase in the imports' value.

Remittances: Pakistan looks set to attract $4 billion through workers' remittances or foreign exchange sent back home by overseas Pakistanis, during this fiscal year. If we convert this amount using the October 21, 2004 rupee value these remittances translate into roughly Rs242 billion.

If the rupee were to stay unchanged at end-June 2004 level in the current fiscal year, workers' remittances of $4 billion would have brought in Rs232.5 billion.

Thus, the fall in the rupee value will substantially increase the equivalent rupee funds. Though this would mean increased incomes for those who receive these remittances, it would also slightly raise overall liquidity levels in the banking system with likely increase in inflation if the interest rates are not increased at the required pace.

The above analysis indicates how a further fall in the rupee value that seems almost inevitable may impact on the external sector positively or negatively. Now let us see if the economy as a whole would gain through further depreciation of the rupee.

Export-led growth: An oft-repeated argument in favour of the rupee depreciation is that as the rupee falls it helps in boosting the country's exports that in turn leads to export-led growth of the economy. This is partly true.

But as Pakistan depends heavily on imports for manufacturing of value-added exports and as its energy needs are met more through imported oil than the domestic resources, the end-benefits of the rupee depreciation are too limited. Besides, the very concept of exports-led growth in countries like Pakistan is a subject of debate among independent economists. Many believe that only a balanced mix of export-led and domestic consumer driven growth can be sustained over time.

Inflation: Pakistan is currently facing a complex economic challenge. If it lets the rupee fall freely, and the central bank restricts to checking only periodical volatility in exchange rates, imported inflation would rise. That, in turn, would complicate the challenge of checking overall inflation and have a dampening impact on consumer spending, one of the several engines of a faster economic growth.

Economic growth: But if the central bank decides to defend the rupee it would have to move faster on increasing interest rates besides taking a hit on its foreign exchange reserves. This fast-paced increase in interest rates would have an unfavourable impact on economic growth. Pakistan's economy grew by an estimated 6.4 per cent in the last fiscal year with its large-scale manufacturing sector showing an unprecedented growth of 18.1 per cent, up from 7.7 per cent a year earlier. The economy is targeted to rise by 6.6 per cent this year.

Some economists argue that to achieve this growth rate, the SBP should not allow interest rates to rise too fast. They argue that low interest rates prevailing in the last fiscal year led to a big 18.1 per cent increase in Large-scale manufacturing (LSM) and 10 per cent growth in exports, despite the fact that the rupee depreciated by only 0.5 per cent.

Monthly weighted average lending rates of all the banks combined ranged between 4.6-5.1 per cent throughout last fiscal year and the markup on export loans remained at 3 per cent for ten long months.

But whereas the role of low interest rates in facilitating economic growth cannot be overlooked, interest rates elasticity to investment and growth needs to be reexamined.

Go for the must: One hopes that the government and the central bank would go for the must, in tackling crucial economic challenges that also include maintaining a balance in exchange rates and interest rates.

One also hopes that the State Bank would focus fully on its core function of stabilizing prices.

Inflation was initially targeted at 5 per cent for this fiscal year, slightly higher than the actual 4.57 per cent in the last fiscal. But with international oil prices having touched a twenty-year peak and a lot of liquidity still chasing too few goods, it may rise to six per cent or even beyond. In a recent interview to Reuters, Dr. Husain said that the SBP would give a measured response to inflation "and if the market conditions suggest that there is an increase in inflationary expectations, the central bank will try to neutralize those expectations."

The governor also said that the inflation target of 5 per cent would exceed slightly.

Many in the banking industry are taking this statement as an indication that the SBP would not mind increasing interest rates at a faster pace than in the past. If the cure of the current economic ills really lies in raising interest rates a bit faster, then the sooner the SBP goes for it the better it is. A faster increase in interest rates would also play a role in keeping the rupee somewhat stable.

Rupee defence: Dr. Husain also made it clear that the central bank has "never resisted the rupee depreciation" and that "there was no defence of the rupee at all."

"The central bank comes in when there is too much volatility-in order to tide over and smooth this volatility," he said. "The exchange rate should be seen moving in a smooth manner, either appreciating or depreciating rather than having fluctuations," he added.

The financial market is taking this statement as a clear signal that the SBP would not try to keep the rupee artificially stable and leave it to find its real value through the market forces of demand and supply. But one wonders if leaving the exchange rates entirely up to market forces is a better policy to follow why then the SBP kept the dollar deliberately stable in last two fiscal years. Had it not defended the dollar earlier, the current AND REAL value of the rupee would have been much higher than what it is now, despite the worsening of the current account on the back of a widening trade deficit.

But as is known to all, the central bank was defending the dollar in the last two years primarily to avoid its negative impact on our exports.

Our independent economists need to engage themselves in a serious debate now over what is really good for the economy-leaving the rupee to market forces after having defended the dollar for long or keeping it from falling to unmanageable new lows.

It is a separate issue; however, whether the SBP can support the rupee through meaningful and strong interventions without taking an ultimate hit on its foreign exchange reserves that have now slipped slightly below $10 billion, enough only to cover seven months of imports.