A strong dollar is not just an issue for Pakistan, it’s a global macro risk

The rupee depreciation cannot be fixed by simply changing the political regime.
Published August 1, 2022

The Pakistani rupee is not the only currency losing value against the US dollar. The Dollar Index (DXY), which measures the dollar's value relative to six global currencies is at a 20-year high, up 10 per cent year-to-date (YTD) and 15pc over the past 12 months.

The key driver for a strengthening dollar is the rise in interest rates by the US Federal Reserve to control inflation. Last week the Fed raised the rate by 75 basis points to the 2.25-2.5pc range and it is expected to rise further.

Federal Reserve Chairman Jerome Powell made it clear that the Fed will continue to raise the rates until inflation is controlled. The Fed has a policy mandate to keep inflation at around 2pc. Currently, it is at 9.1pc.

The last time the US faced double-digit inflation, the Fed rate had to be raised to 20pc. The DXY Index reached a peak of 128 back then, compared to 102 currently.

Read: How a strong dollar affects the economy — and your wallet

A more optimistic scenario is that the Fed will have to give up on its inflation target as the US economy starts to slow down. Last week’s economic numbers showed that the US GDP declined in the second quarter by 0.9pc. This was the second consecutive contraction in the US GDP, usually considered to be a sign of recession.

However, Powell kept his focus on inflation as he thinks that other indicators, especially the labour market, show that the economic situation is not bad enough to give up on the target.

Eurozone economies will also raise their policy rates. The Euro has reached parity with the dollar. Last month, the European Central Bank (ECB) raised rates by 50bps to 0pc (the first hike in 11 years). Eurozone inflation is at 8.6pc while UK inflation is at 9.4pc.

The biggest impact of the dollar strengthening will be on the political side as there is always a high political cost of inflation.

Western countries have not seen such inflation levels since the World War and the political repercussions are now becoming visible. For example, US President Joe Biden's approval ratings have fallen to 37.7pc. In the UK, there is a spike in strikes, the latest being a nationwide train strike due to high inflation. Italy has called in early elections after the previous prime minister Mario Draghi resigned.

Similar to the situation in Pakistan, the political implications of high inflation will force central banks to remain hawkish. They will be willing to sacrifice growth to control inflation. The primary issue is that, unlike the past few decades, when inflation stayed low due to globalisation, now there is limited policy room due to regionalisation caused by Russia-Ukraine and US-China tensions.

Eventually, this might force other countries to get out of the US economic policy regime and sign bilateral treaties. India’s economic policy stance is the best example. While the US is strongly aligned with India geopolitically as a counter to China, India’s reluctance to follow the US economic regime might become a popular example for other countries as well.

However, emerging markets are the most vulnerable. The World Bank has issued a warning about the risk of a rise in a wave of sovereign debt defaults. Pakistan is not the only country facing such issues.

Twelve economies which include Turkey, Argentina and Lebanon are now facing hyperinflation. There are early signs of hyperinflation in Pakistan as well. People are choosing to park their capital in non-monetary assets such as automotive and construction materials instead of leaving it in the PKR.

Read: The big default? Pakistan among a dozen countries in ‘danger zone’

A strong dollar would make external debt repayments unsustainable. Like India, Pakistan will also be forced to move to non-dollar trade settlements — at least with neighbouring countries such as China. The support from the International Monetary Fund (IMF) should provide some stability to the sliding rupee but this is a long-term macro challenge that requires structural changes in the economy.

My fear is that the conversation around rupee depreciation in Pakistan has been trivialised and centred around the IMF and political actors. A stronger dollar is not a Pakistan-specific issue and will not go away with a simple change in the country's political regime.