During the first half of 2019, we witnessed the continuation of the exchange rate policy introduced by the caretaker government.

The caretaker cabinet questioned the PML-N government’s decision to keep the rupee artificially stable under its tenure. They decided to let the market forces determine the exchange rate.

That is why we saw the rupee depreciating between January and June in line with the trend that persisted throughout 2018. The rupee lost 25.8 per cent value to the dollar in 2018. In January-June 2019, it lost another 15.2pc. A total downward adjustment of 43pc in the rupee’s value did an overdue correction in the exchange rate.

Since July this year, the exchange rate has become truly market-driven. The rupee has gained some of its lost value. Foreign exchange reserves of the State Bank of Pakistan (SBP) that were once depleting fast owing to the central bank’s intervention in foreign exchange markets have started growing again. On Dec 20, the SBP’s reserves rose to about $10.91 billion, up from $7.28bn at the end of June when it finally stopped supporting an exchange rate–band in the interbank market.

Since July, Pakistan is under a $6bn balance-of-payments bailout programme of the IMF and is supposed to let the exchange rate remain market-driven. However, the SBP may intervene in the foreign exchange market to check “extreme volatility” in the exchange rate. To sustain the rupee’s gains in 2020, Pakistan needs larger volumes of non-debt-creating foreign exchange inflows from exports, remittances and foreign investment. It also needs to check outflows as much as possible.

Chief contributors to high interest rates are the rupee devaluation, growing energy prices and scant control over the prices of essential commodities

One way to do this is to sustain the reduction in the import bill. The other is to avoid extra build-up in external debts. But the latter is too difficult because in the past two years total external debt and liabilities have increased. We have become more indebted to service old debts.

On the interest-rate front, we witnessed the continuation of the tight monetary policy of 2018 throughout 2019. It became rather tighter in 2019. That was necessary to contain the inflationary spill-over of the 43pc rupee devaluation between January 2018 and June 2019. The tightening of interest rates was also seen necessary to check a general rising trend in headline inflation.

However, in July-December 2019, inflationary pressures did not subside even amidst the exchange rate stability and tight monetary policy. Independent economists began arguing that one of the reasons why inflation was stubbornly high was that it was not entirely demand-driven in the first place. From their viewpoint, inflation was partly cost-push and continuing with a tight monetary policy was no more desirable. A huge 6.5pc decline in the output of large-scale manufacturing in July-October 2019 and the halving of the consumer finance intake between July and November lent some credence to their line of argument.

Higher interest rates must have been contributing to rising inflation, but greater contributors are rising domestic energy prices, lagged impact of the rupee devaluation and scant controls over price administration of essential commodities.

Phased withdrawals of subsidies on energy and agricultural inputs plus higher interest rates on agricultural finance continue to affect agriculture negatively. As agriculture and industry remain constrained, the services sector alone cannot keep the overall economy in shape. So reining in galloping inflation, containing energy price hikes and managing interest rates at affordable levels are all necessary.

But that calls for walking on a tight rope and making guarded policy trade-offs. Energy prices are up because of not only subsidy withdrawals but also the voluminous circular debt.

If the government transfers that debt on to its own fiscal books, it will lead to a further increase in the fiscal deficit. A higher fiscal deficit necessitates further borrowing from banks and, if interest rates are eased liberally, the government cannot be discouraged from such borrowing. This is just one example of how things are interdependent and complicated. Presently, Pakistan needs out-of-the-box solutions to overcome its complex economic issues. It needs economic wizards, not just ordinary economic policymakers.

The IMF’s advice to the government to stop making fresh borrowing from the central bank and the government’s decision to pay heed to it also played a part in shaping interest rates in 2019. From the beginning of the new fiscal year on July 1, the government began limiting its net borrowing from the central bank i.e. it contained fresh note printing, which is inflationary in nature and has remained a key contributor to high headline inflation. But in order to do so, it started making additional net borrowing from commercial banks, which quite expectedly crowded out the private sector.

Persistently tight monetary policy made it possible for banks to keep a high interest rate spread throughout 2019 and earn higher interest income. The availability of greater room for continuous lending to the government via investment in debt securities made them oblivious to their responsibility of catering to credit needs of the private sector.

All of this cannot be expected to change overnight. But the change must come. How this change will happen depends largely on an ideal fiscal-monetary coordination between the government and the SBP. The IMF’s take on future fiscal and monetary policies will also play a key role as long as we remain under its $6bn lending programme.

Published in Dawn, The Business and Finance Weekly, December 30th, 2019