May 19, 2008	Monday	Jamadi-ul-Awwal 13, 1429

Since January 2008, the rupee has been under pressure after nearly 5-6 years of relative stability. The previous government including the State Bank can claim it as a success of managed float backed by strong economic fundamentals, while critics may claim it to be a ‘hard peg’ engineered under the veil of prerogatives of buying and selling foreign exchange in the open market conducted by the State Bank.

The claim of success can be supported by strong growth in exports, remittances and foreign direct investment (FDI) while the failure can be demonstrated by the inflation, at least in the last two years and the undervalued currency in the range of 5-10 per cent.

In spite of moral suasion and some hard actions by the State Bank in the last two weeks, the rupee has declined by eight per cent in value since the last week of April and is touching Rs70 in the open market with no respite in sight.

A major policy question is, that if the rupee fails to stabilise around Rs65-70 range in the next two weeks or even shows wild intra-inter-week fluctuations, along with the decline in the paid-up (real as well as nominal) value of insurance (i.e., foreign exchange reserves) does one seriously need to review the policy of managed float?

In a reactive mode, one can dismiss the need for such a review and regard the current depreciation as ‘self-correction’ for the past sins in the “implicit” management of the currency and weak fundamentals in the shape of rising current account deficit.

To the extent that the rupee value stabilises (without wild fluctuations) in the range of Rs65-70, one would be less inclined for a structural review. However, if the value of the rupee does not stabilise, it is always useful to keep certain options open along a continuum between a “hard” peg and a “free float”, although theoretical ‘free float’ is followed by a handful of countries in the world and most of the countries exchange rate regimes are along this continuum.

The need for a review and change in regime along the continuum depends on the perception of policy managers on what economic and non-economic causes are behind this current downslide, how severe they are and for how long they will continue.

If the current rapid down slide is due to ‘panic’ and ‘euphoria’ magnified by political uncertainties, the slide may stabilise at a higher value, once these political uncertainties are put to rest at the earliest. However if these political uncertainties continue to ‘simmer’ and are interpreted by market players as such, specifically speculators, this ‘panic’ will take the shape of a ‘crisis’ in the exchange market.

Assuming that it will take a full fiscal year or at least the next 7-8 months to return to macro stabilisation, the exchange markets can easily interpret it as a ‘crisis’ environment. In this respect, lessons in exchange rate management learnt from the Asian countries in financial crisis of 1998 and how each country responded to the contagion, panic and the speculators offer useful insights for our economic policy managers.

Although no two countries are alike, and “one size fits all” prescriptions are least desirable, on the basis of generalised similarities one can look into the successful management of one or two countries and modify accordingly.

One model that emerges from the study of Asian countries is the IMF-backed model. There will be political pressure and vested interests to adopt this model--- let there be orderly decline of the rupee, with resultant ‘inflationary tax’ as delayed penalty of lax taxation policy of the previous government.

Of course, the poor will suffer more than the rich and the achievement to MDG goal-1 may reduce it to likes of any other international unfulfilled commitments. The complementary goodies in the shape of conditionalities (even in case of half-hearted implementation, usually the fiscal side is condoned by IMF due to political maneuvering at the time of release of each tranche), higher future debt liabilities and higher interest rates will remain an essential component of IMF-backed model. Moreover, IMF-backed programme may push for lower growth.

The other model, followed by Malaysia was IMF-less model. It pegged its currency to a fixed exchange rate with the dollar and adopted capital controls. This hard peg regime continued from September 1998 to December 2000. At the time it was criticised by western powers and the IMF, but later many economists accepted that its costs of adoption were not as high as initially magnified.

It is interesting to see the remarkable similarities in pre-crisis vulnerabilities of Malaysia to our situation. First, Malaysia was exposed to international portfolio investment flows, following active promotion of this form of finance from the early 1990s.

Second, bank intermediation of domestic and foreign savings was problematic. Much of the credit went to finance consumption, property market investments and stock business. It resulted in a consumption boom and an asset price bubble,

Third, competitiveness was eroded in the face of competition from China, rising real wages (not in our case) and the central bank’s unwillingness to revise its dollar peg exchange rate policy (in contrast weakness of the dollar having depreciated the rupee in respect of other currencies). Moreover, Malaysia’s future export and GDP prospects depended mainly on the continued large scale inflow of foreign direct investment.

Given that the exchange markets may operate under the ‘crisis’ mode for the next few months, this calls for short-term and I repeat, ‘short-term’ regime shift in the exchange management to lend stability, reduce volatility and calmness to the market. In this scenario, can a case be made for fixed peg with capital controls to take us to the ‘hollow middle’ of the continuum?

Critics may react that external environment specifically with respect to falling dollar and commodity prices is entirely different than it was at the times of Asian financial crisis. Moreover, the source is not outflow of ‘hot money’ as foreign exchange handled by exchange companies is small fraction of inter-bank transactions and it’s epicentre lies in the real market.

Countering this argument one would observe that in spite of current account balance being unsustainable in the last fiscal year, there was no run on the rupee. Probably it was the record FDI. I would argue that even if current chaos/panic has originated in the real sector, reinforced by reduced FDI, pegging the rupee at a slightly undervalued level (anywhere between Rs68-70) is justified in crisis period and under weak and lagged response of imports (specifically the essentials) and exports which are resource based (cotton, rice, cement) to exchange rate changes, popularly known as elasticity pessimism. In case, one should be aware that if due to low elasticity exports do not respond to depreciation, they also do not fall rapidly in case of appreciation.

Till January, the main source of imported inflation was rise in dollar denominated commodity prices including oil. The fast depreciation, has added another source of imported inflation which may turn into a runaway phenomena if not stopped in its tracks. Thus one needs a nominal anchor for controlling inflation. Pegging exchange rate will not only reduce speculative imports, but via its feedback, stabilise the cost of imported inputs for export competitiveness and dampen inflationary expectations. Foreign importers of our resource based goods may also ease squeeze on our exporters for passing on the gains in the rupee parity.

One weakness of the Malaysian approach as perceived by the economists was short to long-term negative impact of capital controls on FDI. Whether the FDIs can rise to the levels of 2006-07 in matter of months to support the deteriorating current account balance given the simmering political uncertainties in our case remains a question mark and its short/long- term impact on FDI a million dollar question.

Much depends on how the loopholes in foreign outflow are controlled through capital controls. Moreover, controls should not be designed to shield Pakistan from the world but rather a means of buying time to straighten things out. They should be seen as window of opportunity to get through the crisis.

In conclusion, by looking at the role and the type of fiscal and monetary policy for this short-term regime shift, one cannot be oblivious of their specific tailoring for its success. One hopes, that the current exchange rate turmoil will be short-lived and policy makers will not be confronted with the difficult choices, but in case they are, each option has trade-offs and next round of sustainable growth will be determined by the selection of any one of these two options.

e-mail : sajam2000@yahoo.com