When you can fix a problem using two options and opt for both, then you have to wait and see what happens. That is what the State Bank of Pakistan (SBP) has been doing these days. It is waiting. How the economy behaves this year and in the next year will reveal how effective the rupee depreciation and interest rate tightening are going to be in fixing economic woes.

Usually whenever there is a foreign exchange crisis, the monetary authority either lets the rupee fall or raises interest rates. Or it uses both options.

Between January 2018 and April 2019, the SBP has let the rupee depreciate by about 28 per cent. The central bank also raised its key policy rate from 5.75pc to 10.75pc during this period.

This massive rupee depreciation and such a big hike in the policy rate should theoretically help stem the foreign exchange crisis and keep the exchange rate stable for some time. But it all depends on how successful the central bank is in materialising underlying assumptions of both moves. How exports are responding to the rupee depreciation and how much fiscal prudence we see after the interest rate tightening are no secret.

The central bank cannot leave the exchange rate at the mercy of market forces, which will take a long time to become favourable for sustainable economic growth

On the other hand, how inflation has skyrocketed after the rupee’s fall and how contraction in domestic demand due to higher inflation as well as interest rate tightening has slowed down industrial activity are also no secret.

The problem with achieving targeted objectives of monetary moves is that it triggers a series of responses — some desirable and others less desirable.

Pakistan’s economy, particularly its political economy, is passing through a challenging phase: geopolitical pressures, the trade-off between meeting requirements of national security and those of development, fulfilling external debt obligations of the present and the past and benefiting from the CPEC without falling into a debt trap are some of the challenges that are too complex. Avoiding the exchange rate volatility or steep interest rate movements seems too difficult in the face of such serious challenges.

The central bank cannot leave the exchange rate at the mercy of market conditions that would take a long time to become favourable for sustainable economic growth. But at the same time it cannot continue to intervene in the market as aggressively as our political leadership would like for two key reasons. First, we have experienced the bad effects of keeping the rupee artificially stable during the PML-N government. And second, the IMF is insisting that both fiscal and monetary authorities should go by the book.

Going by the book for the SBP means it cannot keep the rupee artificially strong and upset other variables of the economy in the medium term. By extension it also means that the central bank cannot intervene in the foreign exchange market only to emerge as a net seller of dollars.

So how to walk the proverbial tightrope for balancing the two sets of demands: the ones originating from our peculiar requirements rooted deep in the political system and the ones that are logical and significant from the viewpoint of short-term functionality of the economy?

The call becomes even more difficult when the IMF comes into play and begins to make these logical demands.

As we are close to entering an IMF balance-of-payments support programme, the management of the foreign exchange regime is bound to see some changes and the central bank’s intervention in the foreign exchange market is under the spotlight. Some quarters are speculating that the IMF might suggest — or has already suggested — that the SBP should have a separate fund for this purpose.

Whether the central bank intervenes in the market using a separate fund or continues this practice without it is significant on several counts. First, relying on a dedicated fund for this purpose would hopefully make the whole exercise transparent enough for international lenders like the IMF. Second, if such a fund is fed partly with the deposits of the government, the drawdown would have direct implications for fiscal management. And third, if the proposed fund is fed with the occasional funds deposited with the SBP by friendly nations, the central bank would likely have to justify to them if its interventions in the foreign exchange market lead more often to seek a certain exchange rate level instead of curbing short-term volatilities.

Fiscal and monetary authorities are already examining the pros and cons of switching from multiple treasury accounts to a treasury single account with the SBP. This proposal has reportedly originated from the IMF. If the authorities finally decide to opt for it and if a separate fund is created for the SBP to intervene in the foreign exchange market, the twin moves might help in bringing more discipline to both fiscal and monetary management.

But as far as the central bank’s intervention in the foreign exchange market is concerned, one thing is very clear. Regardless of the instruments used for and the resources relied upon, these interventions should not seek to obtain an unjustifiable level of exchange rates — as had been the practice during the PML-N government. The interventions should rather aim at curbing volatility in the foreign exchange market and neutralise speculative attacks. The central bank of a country like Pakistan where the foreign exchange market is quite thin and where external-sector dynamics are transforming cannot be expected to avoid the temptation of keeping the exchange rate artificially stable for a brief period.

Such an artificial stability can emerge as a by-product of interventions primarily aimed at thwarting strong, repeated or prolonged speculative attacks on the rupee. But on the other hand, keeping the rupee artificially stable for an extended period of time is never helpful for the economy in the long run as it masks some structural problems in fiscal and external sector management and delays their solutions. Once we restart borrowing from the Fund, the international lender would likely ensure this does not happen.

Published in Dawn, The Business and Finance Weekly, May 6th, 2019