WE often hear assertions by eminent people (including ministers and independent economists) about a fixed value of the US dollar in Pakistani rupees. Can this bluff ever become credible? To answer this question, let us use a line of reasoning known as ‘reductio ad absurdum’ sometimes used by mathematicians to either disprove an assertion by showing that it leads to absurdity, or prove an assertion whose contradiction leads to absurdity.
Now assume an almost impossible bluff — $1 equals Re1. Before laughing it off, just think of a financial situation in which this bluff becomes credible. We print rupees, but dollars neither fall from the heavens nor from helicopters. Our stock of monetary base (ie currency plus deposits of commercial banks with SBP, also known as reserve money) is over Rs8,000 billion. If we, somehow, get $8,000bn dollars as non-borrowed SBP foreign exchange reserves, then this bluff will become credible. Remember that our current foreign exchange reserves stand at $10bn. Now think of the likelihood of this miracle to occur. Would someone doubt the absurdity of this financial condition to ever materialise? Hence the assumed exchange rate is false.
The exchange rate in this situation can be equal to one rupee per dollar if reserves continue to rise with the same speed as the rupee currency stock, or reserves remain fixed and the monetary base never increases (an impossible proposition for our economy.) This system is the most rigid form of the fixed exchange rate known as currency board. Only 11 countries of the world are following this regime including Hong Kong, Brunei Darussalam, and a few small or island economies. Hong Kong pegged its dollar at a parity of 7.80 HKD to one USD in 1983. It maintained its foreign exchange reserves at more than 100 percent of its monetary base since then and, hence, is credible enough to have even withstood political turmoil. Brunei Darussalam is rich in resources as well as in foreign exchange reserves. Brunei dollar is pegged with Singapore dollar with unit parity.
We are neither like Hong Kong nor rich enough to be like Brunei. So let us now use powers of 10 (ie, 10, 100, 1,000, etc) to gradually come back to reality through simple arithmetic division. To maintain a parity of Rs10 to a dollar, reserves should be at least $800bn. Similarly, to maintain a parity of Rs100 to a dollar, reserves should be at least $80bn. Let me not use this example with the numeral 1,000 as it will start giving nightmares to the experts who open their mouth about any specific value of the exchange rate. Luckily, we are not managing a currency board, but unfortunately, we have a fixation about fixing the exchange rate. Readers should have guessed by now that to fix the exchange rate to Rs200 per dollar (through a currency board), we will need at least $40bn in reserves which are continuously rising at the same speed as our reserve money stock at the assumed parity. To maintain a parity of Rs160 to a dollar, we need at least $50bn which should be continuously increasing with our ever-rising currency in circulation.
Foolish statements uttered by officials, past or present, destroy the credibility of economic policies.
Thank Allah no one ever thought of establishing a currency board in our country. Everyone can see the absurdity of fixing the exchange rate except the bluffers. People can easily work through the mesmerising logic of ‘reductio ad absurdum’ without knowing it. Literate or illiterate, ordinary people are numerate and perfectly capable of seeing the absurdities of our past exchange rate policies. They may not be aware about deficits in trade, current or fiscal accounts, but they become aware of falling reserves and are always aware about the exchange rate, which is the simplest price to understand and much simpler than the Laspeyres index on which the concept of inflation is based. As soon as people see the mismatch between the exchange rate and the level of reserves, they immediately see the absurdity of fixing the exchange rate parity or keeping the rupee overvalued.
Bluffers, however, continue to make unsound assertions forgetting that economic policy formulation is not a game of poker. Foolish statements uttered by the officials, past or present, destroy the credibility of economic policies. Even good policies become difficult or more costly to implement when economic agents and investors lose their trust in them due to cacophonous or incredulous statements coming from the policy formulators.
While the ordinary people may not be aware about the balance of payments data, policymakers, economists, financial analysts, businesspeople, and investors cannot brush it aside. Our imports of goods and services has risen at an average speed of $20.7bn per quarter to $62.1bn during July-March FY22; quarterly interest expenses on external debt and net profit and dividend payments averaged $1.5bn; exports $9.6bn; remittances $7.8bn. Outflows from the current account exceeded inflows by about $4.4bn per quarter, with a three-quarter current account deficit of $13.2bn. This deficit was financed by incurrence of net liabilities (through foreign investments and loans net of amortisation) of $7.4bn leaving a hole of $5.8bn, financed through use (depletion) of foreign exchange reserves. Current (last) quarter of FY22 is likely to see rapidity in external sector deterioration.
The risk of not meeting external obligations (ie, default) is rising. If the stabilisation measures (ie, fiscal tightening along with tight monetary conditions) are not undertaken soon, the risk will rise manifold. As Sakib Sherani has recently mentioned in a column in this newspaper, the current situation is a confluence of several crises not experienced earlier by our country. Policymakers at the helm of affairs, therefore, should weigh the risks of default carefully, even if they seem small at this stage. The risk will rise exponentially under political instability. The current situation also represents a crisis of competency. When alleged competency turns out to be more like incompetency and vice versa, it requires immediate installation of a credible interim set-up which can take the blame for needed stabilisation measures. This seems to be the only option to lessen political costs for the existing government and, by holding early elections, allow Pakistan to move forward.
The writer is a former deputy governor of the State Bank of Pakistan.
Published in Dawn, May 20th, 2022
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