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The free fall of the rupee on July 5 provided an opportunity for Finance Minister Ishaq Dar to reaffirm his vision of a stable and robust national currency in the present ‘expansionary phase of the economy.’

The rupee has remained stable over the past two years as the authorities ignored the IMF‘s repeated advice for exchange rate adjustment.

Dar’s determination to beat back speculative attacks on the widely accepted ‘over-valued’ rupee is further demonstrated by the appointment of former Finance Secretary Tariq Bajwa as the new central bank governor.

There are limits to the excessive use of devaluation to reduce the trade deficit

It is a departure from the current practice to appoint a banker or an economist in the central bank’s top position.

Earlier he held a meeting in Islamabad with banks and State Bank officials to signal the market to observe voluntary discipline.

The finance minister described the plunge of the rupee as an ‘artificial’ move engineered by an individual not competent enough to take any such arbitrary decisions.

The depreciation of the rupee has multiple impacts on the economy and its cost-benefit ratio needs to be examined thoroughly before making any move via the managed float route. For this the proper forum is the Monetary and Fiscal Policies Coordination Board.

The July 5 episode shows that the exchange rate cannot be left to be set by a market afflicted by excessive speculative trading activity.

Any sharp currency devaluation would have at least two serious implications: a surge in the cost of debt servicing as well as on investment based on imported capital goods, particularly for long-term infrastructure projects.

Mr Dar blamed the free fall of the rupee for an almost Rs230 billion increase in public debt within just a few hours.

There is a difference between a weak market exchange rate and strong purchasing power parity of the rupee versus the dollar.

This difference hides a major abnormality: a weaker rupee makes imports costlier and exports cheaper, perpetuates adverse terms of trade and transfer of resources abroad, and aggravates the balance of payments position.

The market value of a national currency does not necessarily reflect the fundamentals of the economy as it is determined by day-to-day or moment-to-moment demand and supply; unless it is subjected to managed float.

For investment purposes, it is common practice to use the purchasing power parity to measure the real size of an economy; apart from using the fluctuating and varying market exchange rates to estimate a country’s GDP.

The free, or managed, float has spurred market volatility since the fixed parity was abandoned.

This is because the free float has been excessively used to promote financialization of the economy while the economy’s core activity of financing remains subdued.

In Pakistan, banks prefer to invest in Treasury bills and Pakistan Investment Bonds, the stock market and currency trading rather than cater to potentially more productive sectors of the economy.

The corporate sector prefers self-financing to borrowing from banks at floating rates to keep financial charges affordable.

The financialization of the economy tends to slow down economic growth. It has resulted in frequent economic crises in countries, finally peaking in a global financial crisis in 2007-08.

The financial crises have tended to reduce the clout of the IMF and central bank’s worldwide but for efforts to keep financial markets afloat.

Looking at the big picture, the continuous depreciation of the rupee since the early 1970s, to boost exports, has delivered an import-oriented and not an exported led economy.

Trade and current account deficits have been a perpetual problem, managed by huge workers’ remittances, ballooning foreign debt and fluctuating capital and financial inflows with worsening external sector imbalances.

For nearly half a century, since the initial years of 1970s, the global financial system has been facing organic failures despite massive international efforts to salvage the faltering system.

And in a fast changing global, trade and investment environment many of the existing policies have been put to a critical test. There are limits to the excessive use of devaluation to reduce the trade deficit.

The rupee depreciation does temporarily help boost exports by making goods and services cheaper for foreign buyers. To cut imports by making them expensive for domestic buyer’s, the external sector has to hit the edge of a precipice.

Since the cost of imported capital goods and other industrial inputs, including raw materials, becomes expensive as a result of currency depreciation, the cost of production of exportable goods ultimately goes up and loses much of its competitiveness.

The problem is that costly imports have not encouraged enough of import substitution nor have external sector pressures convinced the country’s policymakers to mobilise, increase dependency on domestic resources and reduce reliance on foreign money.

This leads to the trade and current account deficits becoming a perpetual problem with the external sector in a virtually unending crisis.

Published in Dawn, The Business and Finance Weekly, July 17th, 2017