The State Bank of Pakistan (SBP) is fire-fighting on the forex front knowing well that it is now paying the price for keeping the rupee overvalued in the past.

The tragedy is that the decision to let the rupee put on extra weight was not entirely the central bank’s. In fact, the government of Mian Nawaz Sharif with Ishaq Dar at the finance helm never “allowed” the SBP to independently manage the exchange rate.

In July 2017, when Mr Dar forced the SBP to withdraw its decision of correcting the exchange rate, all came to know who wanted to stretch the duration of the rupee overvaluation.

“But even before that whenever the central bank wanted to let the rupee shed some value, the government resisted the move,” recalls a senior central banker.

Currently, the central bank’s forex reserves are quite low (slightly below $14bn as on Jan 5, insufficient to cover even three months of imports).

Speaking analogically, the SBP does not have enough water to spray on the flames of uncertainty that engulf the rupee. Besides, the SBP’s writ, or in our analogue the fire engines, cannot manoeuvre the entire labyrinth of the open market where the smouldering debris sits.

In inter-bank market too, the SBP’s ambitious fire fighting cannot permit it to supply dollars too generously: there are limitations of low forex reserves along with some market rules.

One of the rules is that the central bank cannot be a net supplier of foreign exchange all the time. That would raise a question in the market over claims of even a quasi-free exchange rate regime.

Speaking analogically, the SBP does not have enough water to spray on the flames of uncertainty that engulf the rupee

Once we keep this detailed view of the exchange rate fire fighting in mind, it becomes easier for us to understand why occasionally the central bank has to eat its words. Just a few days after imposing an otherwise sensible restriction on forex companies, the SBP had to lift it.

The central bank had initially asked these companies to bring back home physical cash equivalent in US dollars only up to 35 per cent of the sales of non-dollar foreign currencies (Euro, Pound Sterling, Saudi Riyal and UAE Dirham) in Dubai.

It had told them to repatriate the remaining 65pc via bank accounts. But within days, it reversed the move and re-permitted up to100pc repatriation in physical cash dollars. The SBP had to do this as the 35pc condition had, according to forex companies, created so much shortage of dollars in the open market that they were unable to transact business.

Obviously, the open market rates also shot up to unmanageable heights widening the gap between these and interbank rates, at one point around Rs2 per US dollar.

After the reversal of the SBP restriction, the US dollar rate in the open market started falling and the wedge between the interbank and open market rates narrowed to Rs1.50 per dollar within three days.

Officials of the Exchange Companies Association of Pakistan hope that the gap between the two rates would narrow further to Re1 per dollar within a couple of days.

So, now we know that if SBP wants to keep exchange rates stable in the open market, the only way is to let forex companies bring back home physical cash dollars equivalent to full proceeds of the sales of non-dollar foreign currencies in Dubai.

“This means one source of cash outflow of non-dollar foreign currencies and inflow of cash dollars would remain open to misdeclaration,” remarked a source close to the SBP.

Customs authorities at airports and officials of the SBP and Federal Investigation Agency (FIA) keep a check on physical movement of foreign currencies by forex companies. That would continue. Why then would the SBP impose the 35pc import of dollars against export of non-dollar foreign currencies condition in the first place?

“There is more to it than meets the eye,” commented a source close to the central bank.

“The SBP’s restriction (announced on Jan 1 and withdrawn on Jan 9) had a noble motive i.e. to make misdeclaration difficult by involving banks in handling 65pc import of dollars against export of non-dollar foreign currencies.

“But this does not suit the interests of the very big, very powerful people involved in currency money laundering, currency smuggling and capital flight,” says a former head of a foreign bank.

“And it is easier for them to manipulate dollar supplies in the open market for a few days to create noise and an impression that a certain decision of the central bank is behind this shortage. The rest follows according to their plan.

“The federal government refuses to listen to the SBP logic and keeps demanding that the open market rates be brought to normal levels and finally the central bank is left with no option but to retract even an otherwise right decision.”

GOING FORWARD: Exchange rate management is expected to remain tough for the SBP throughout this fiscal year.

First, despite improvements in exports and home remittances, filling in the big hole in the current account balance ($6.43bn in five months of FY18) might tempt the central bank to let the rupee fall further.

But letting this happen would not be that easy because fiscal authorities would resist it to avoid a build-up in the rupee cost of foreign debt servicing; that to in the last year of the PML-N term, senior bankers say.

The pressure on the rupee, meanwhile, would abate. Despite deceleration in growth rate, the volume of imports remain huge (about $29bn in 1st half of FY18) and despite a rise in growth rate, export volume is still low ($11bn 1st half of FY18).

Assuming that this pattern continues through the second half, import dollar demand alone might be too strong, to talk about foreign debt servicing and outward remittances of dollars by foreign companies in Pakistan.

“And, banks and importers will take time to get used to a planned use of the yuan instead of the US dollar for financing imports from China.

YUAN COMING: However, with the most recent move by China on Jan 11 to push the use of yuan for its Belt and Road Initiative, of which CPEC is an offshoot, the dream of Pak-China trade in bilateral currencies may come true sooner rather than later.

The People’s Bank of China issued a notice on its website on Jan 11 proposing five measures, all meant to promote the use of yuan for cross-border trade and investment for Chinese companies.

“After studying those measures, the SBP can issue further guidelines to banks here and show them ways for promoting Pak-China trade in bilateral currencies, and even ways for attracting Chinese investment in yuan instead of dollars,” speculated the treasury head of a local bank.

“In that case, the demand for dollars might not be as strong as we thought earlier (before the announcement of the new measures by Chinese central bank for promoting Yuan. But again, it all depends on how soon these things materialise.”

Published in Dawn, The Business and Finance Weekly, January 15th,2018