SOMETHING quite remarkable has been witnessed of late: the dollar has depreciated significantly against the rupee. As this has been a highly noticeable and largely unexpected event, it has raised a plethora of questions in the minds of citizens, and conspiracy theories have done the rounds.

Yet dollar depreciation against the rupee is not as mysterious as it would appear if one understands the role of foreign currency reserves in deflating speculative sentiments. Why do we need to hold foreign currency reserves in the first place? The short answer is that we need to defend the currency from speculators who bet that the currency will fall in value.

An easy way to do that is to sell the currency in forward contracts. Once a major player starts selling, word would quickly spread in the inter-bank and the open market, prompting more speculators to do the same. If there is no major buyer with pockets deep enough, the currency will crash, with depressing implications.

Imports, that include essentials such as cooking oil, would become very expensive, further adding fuel to the already high inflationary fire, and pushing more people towards poverty.

Holding sufficient foreign currency reserves means that the central bank can become a buyer with deep pockets. The larger the reserves, the deeper the pockets, and the higher the hurdle that speculators need to cross.

If speculators know that the country has sufficient reserves, they are likely to realise that they will not succeed in lowering the value of the currency further via selling pressures in forward trades. So, the primary function of holding foreign currency reserves is to deter speculators from attacking the currency.

Countries typically hold reserves in some other country’s currency for this purpose, and for obvious reasons they prefer to hold the currency of a larger country with deep and highly liquid markets. Hence, the dollar is the currency of choice across the globe.

Naturally, if a country gets a large, unexpected boost, as in Pakistan’s case recently, to its reserves, it deflates the speculative sentiment. So, the recent dollar depreciation comes as no surprise once we take into account the relatively large unexpected inflow.

But what do we do with foreign currency reserves lying idle? There are obvious opportunity costs of having large sums of money tied up in a foreign currency as this money cannot be used for more productive purposes. The country has to pay this cost if it wants to avoid speculative attacks on its currency. However, it should attempt to minimise this cost.

Currently, we are holding all of our reserves in dollars and these reserves are invested in US Treasury debt that pays a very low interest rate because the US dollar is the most popular reserve currency globally, with reportedly over 60pc of all reserves across the globe in US dollars.

These countries mostly buy US Treasury debt with their reserves — the demand for US treasury debt is very high. Consequently, the US Treasury needs to pay very little return on the amount borrowed.

It is true that the US Treasury debt market is the most liquid market in the world, and countries can quickly sell dollar-denominated debt and make dollars available to defend their respective currencies.

However, Pakistan is a relatively small country and markets in the euro or pound sterling should be deep enough for us in our time of need. We should be able to sell euro- or pound sterling-denominated debt quickly, access these foreign currencies, and defend the rupee if such a need arises.

Hence, we should consider diversifying into other foreign currencies, in particular if the return on the euro or pound sterling-denominated debt is higher than the dollar-denominated debt.

As we are a poor country, intelligently managing our reserves by investing in a number of major currencies will minimise the opportunity cost of holding reserves. Furthermore, in recent history, the US has had a budget crisis, a debt ceiling crisis, and a credit-rating downgrade. So, the US market is not as attractive as it used to be from the safety standpoint.

Hence, diversifying foreign currency holdings makes sense both from the risk as well as the return perspective. You may have heard that there are no free lunches in economics. If you lower risk, you lower the return as well.

However, for a country like Pakistan with a small economy, such a free lunch is possible. Diversifying foreign currency holdings could improve the return while lowering the risk. n

The writer is a research fellow at the Risk and Sustainable Management Group, University of Queensland, and an associate professor of economics at LUMS.

h.siddiqi@uq.edu.au