LAST week the rupee saw a small-scale panic sparked by a steady decline in the exchange rate versus the dollar. Here is some background.

Pakistan has two major foreign exchange markets. There is the interbank market, and then there’s the free market, or the open market, or the kerb market as it’s known sometimes.

The open market is where you and I go to buy our dollars whenever we’re travelling abroad to visit relatives. It’s run by money-changers and it’s where you’d buy your dollars if you’re lucky enough to be purchasing property in Dubai, or importing a used car.

If you have a child studying abroad and are in the unenviable position of paying for that child’s education, then again you would buy your dollars from the open market.

When your relatives from abroad come to visit you and bring foreign exchange with them, it’s the open market where they will convert that foreign currency into rupees.

Then there’s the interbank market. You and I never use it because it’s for institutions only. So if you’re an importer, you’ll pay your supplier abroad with funds from the interbank market. If you’re an exporter, then money that you’ve earned abroad will arrive into the interbank market.

Amongst the largest players in the foreign exchange markets in the country are the oil companies, whose total demand for dollars is in excess of $10 billion every year.

Here are a few numbers to give you some perspective of the scale at which things happen in these markets. Every day, something like $300 million are turned over in the interbank market, and about $20m in the open market. With almost 1.5 million students studying abroad, Pakistanis remit close to $5bn every year to pay for their education.

As an aside, imagine if this money could somehow be funnelled into our education system at home.

The interbank market is supplied with dollars primarily through exports, and occasionally the central bank also pumps in some foreign exchange in order to tide over a temporary shortage.

Pakistan’s exports last year were in the range of $23bn, and of the $13bn plus remittances that came into Pakistan last year about $2.5bn came through exchange companies and the remainder through the banks.

The kerb market, by contrast, is supplied primarily through remittances and currency brought in by visitors from abroad, receiving somewhere around $7bn every year.

Both these markets are connected to each other. The exchange companies gather up all the stray amounts of foreign exchange that comes into the country in the pockets of visitors coming from abroad, and ‘export’ this currency in large boxes, inspected and sealed by the State Bank, to their offices in Dubai.

From here, the money is deposited into the banks, and brought back into the country through the interbank market. Why don’t they simply deposit the money into the banks directly in Pakistan? I have no idea.

So when the declines in the rupee happened over the past three months, going from Rs95.7 to a dollar in October to Rs98.7 in December, they were led by declines in the interbank market. These were interbank exchange rates that were being quoted in the press, the open rate at its lowest point hit Rs99.7.

Why did this slide occur, and how was it arrested? That answer gets a little complicated because each party in our foreign exchange markets blames the other.

If you talk to the bankers, they’ll tell you the money-changers are the speculators here, withholding the inflows they control from Dubai and thereby creating artificial shortages to drive the rates up when they perceive demand for the foreign currency increasing in the kerb market.

The exchange companies, for their part, say the banks have made a ‘cartel’ of sorts, since a small number of banks controls such enormous volumes of foreign exchange transactions.

They argue that banks withhold their ‘net open positions’, which is dollar balances held abroad, and again create an artificial shortage, and supplement this shortage by fuelling sentiment, telling their importer clients to ‘buy now at this rate because it looks like further declines are on the way’.

In any case, both versions hinge on the creation of what they call an ‘artificial shortage’ and the manipulation of the currency by a few big players to reap a windfall gain on the forex markets.

But the point is that neither of these versions actually captures the truth. It’s common practice for governments to blame money-changers or speculators for adverse currency movements. But common practice is wrong in this case.

As with many such homely truths, it’s a good idea to ask some simple questions. For instance, why does speculative activity of this sort kick in only when foreign exchange reserves are falling sharply? Perhaps because the shortage of foreign exchange is actually not all that ‘artificial’ and certainly not temporary. Consistent declines in the country’s reserves, with no meaningful inflows on the horizon, are what spark speculative sentiment.

The rupee saw the declines it did last week because our foreign currency markets are weakly held together, and easily manipulated by a few big players who control large flows coming into and out of these markets.

There was clearly a speculative element to the whole story, but speculators only thrive in currency markets when there is insufficient fire power with the central bank to douse the shortages they’re able to create, and that is the real crux of the weakness here.

Short-term, ad hoc administrative measures have succeeded in arresting the declines, but for the speculators to be shut out of the markets properly, what is needed is a revival of inflows, and reform of our forex markets to ensure that a small number of banks do not wield such outsized influence in the supply of foreign exchange liquidity.

The writer is a Karachi-based journalist covering business and economic policy.

khurram.husain@gmail.com