The IMF is on board, yet the rupee continues to decline.

Previous assumptions pointed towards a prevailing lack of confidence in economic sustainability as the primary driver behind the consistent and steep deterioration in the rupee-dollar exchange rate. The expectation was that after the Stand-by Arrangement (SBA) with the IMF, the rupee-dollar exchange rate situation would improve.

This did happen, but it was short-lived. Despite significant support from the IMF, the value of the rupee continues to decrease. Most recently, the PKR traded at Rs305 a dollar on August 31 in the interbank, reaching a new low. In the open market — which continues to see a shortage of the greenback — the dollar is trading around Rs315-320. This has prompted valid concerns regarding the local currency’s stability in the foreseeable future.

The situation has left stakeholders baffled because despite taking all the required measures to manage the declining value of the rupee, the currency continues to weaken. The market is now left wondering if the substantial backing of the IMF cannot bolster the rupee, who or what can. This panic is increasing pressure on the local currency, while businesses, investors and global markets are losing confidence in it. Additionally, this loss of value is intensifying the inflation predicament.

What is behind the recent fall?

The rupee has lost more than 8pc to the greenback, dropping to 306 a dollar from 281 in the interbank in just three weeks starting from August 5. In the open market, the rupee traded at 332 a dollar on September 1.

Five primary factors explain the recent dip in the rupee’s value.

Political uncertainty

One major factor is election uncertainty. It is a continuation of rampant political uncertainty on an even larger scale. The market is unable to predict the exact timing and outcome of the elections. And theories about extending the caretaker setup indefinitely are shaking the market.

IMF review concerns

Heightened apprehension about potential delays in the IMF’s review, scheduled for February 2024 if the elections are delayed, and the associated fate of the SBA, are also rattling the market. Memories of the ninth review and the premature ending of the 23rd IMF program are still fresh. The possibility of the IMF review being postponed, which could potentially lead to a lack of confidence in the country’s economic trajectory, is putting pressure on the rupee.

Surging import bill

Another top factor is the increase in the import bill and, consequently, the demand for dollars. The outgoing Pakistan Democratic Movement government managed the dollar demand to arrest the rupee’s fall through import controls for a few months. This decision resulted in another failed IMF programme as Pakistan failed to complete the 9th review.

Pakistan’s import bill remains significantly elevated, especially after the removal of import restrictions, leading to an increase in the demand for the US dollar. Current account surpluses that Pakistan accumulated during April and May quickly eroded due to a significant shortfall in July, recording a current account deficit of $0.81 billion compared to a surplus of $0.5 billion in June. Consequently, the rupee came under pressure.

IMF’s stringent stipulations

The IMF’s stipulation that the dollar rate spread in interbank and the open market should not exceed 1.25 per cent and must be corrected every five days has proved counterproductive. On September 1, the dollar to PKR rate gap in interbank (306) and open market (332) was 8.5pc, which is around six times higher than the 1.25pc ceiling.

To meet this condition, the rupee either has to drop in the interbank or rise in the open market. The latter seems impossible since the State Bank of Pakistan (SBP) doesn’t have the reserves or the space to supply dollars to the market. The PKR would need to slide to 328 a dollar in the interbank to bring this gap to 1.21pc. This IMF condition is continuously destabilising the currency market and needs revisiting.

The process is straightforward. The initiation of Letters of Credit (LCs) leads to a surge in dollar demand, raising the dollar rate in interbank. Anticipating further declines, people rush to purchase more dollars for imports, education, health, and tourism. Resultantly, demand exceeds supply in the interbank, causing the rupee to slide.

The unmet dollar demand spills into the open market, exerting further pressure on the PKR. Speculative demand, dollar smuggling, and hoarding intensify. The interbank, already striving to minimise the open market rate spread, faces additional challenges in accommodating this spike, further widening the gap, and a vicious cycle is created.

It’s crucial for the market to stabilise the rupee’s dollar value. While the rupee’s fate should be market-determined, imposing a weekly condition results in widening the gap beyond the stipulated rate. Fulfilment of this condition has turned into a relentless race between interbank and open market rates, with the latter always outpacing the former.

Inflation’s impact

Inflation is exacerbating the rupee’s decline. Pakistan appears trapped in a cycle where currency depreciation and inflation fuel each other. While there’s ample discussion on how rupee depreciation increases inflation, the contributions of higher inflation to the rupee’s decline are often overlooked. The rupee’s continued slide diminishes its purchasing power daily. Faced with historically high inflation, people tend to hedge against the rupee’s fall by keeping savings and pensions in dollars. This strategy raises the dollar’s demand and value, which, in turn, weakens the rupee. This spiralling dynamic perpetuates inflation.

Moreover, SBP’s policy of converting every dollar to rupee and preventing people from holding dollar accounts has reduced dollar supplies. Businesses and firms keep their proceeds abroad, anticipating local currency depreciation, further pushing the rupee down.

Regarding external factors, the global dollar rise against all other currencies significantly devalues the rupee. This pressure might persist, given the dollar’s expected strength against global currencies. The dollar’s rise on August 23, as investors awaited Jerome Powell’s speech at the Jackson Hole Economic Policy Symposium, underscores this point. The Fed’s policy rate decision is crucial for already vulnerable currencies.

What are the options?

Realistically, the options at hand are very limited and arresting the rupee’s slide does not appear to be on the horizon. The combination of economic and political uncertainty, coupled with low foreign exchange reserves and higher financing needs is likely to continue to push the rupee down.

But, the government has little choice but to make some difficult decisions to address the eroding trust in the rupee. It is crucial to take substantial and strategic measures to effectively manage and rectify the situation, at least to slow down the rupee’s slide.

Addressing election uncertainty

The most difficult and yet most critical assignment is eliminating uncertainty about the elections.

The government, or the election commission, must give a clear election roadmap with a timeline. If there are unavoidable delays, they can be pointed out and clearly communicated to the market. Aiming to achieve economic stability before the elections appears to be an impractical approach. We have seen a similar approach failing in the recent past when we delayed going to the IMF as we intended first to stabilise the economy and pump the power to the rupee by building reserves from friendly countries. It came at the cost of chaos in the economy, panic in the currency market, steep loss of the rupee, unstoppable inflation, and a premature ending of another programme of the IMF.

Engaging the IMF

Also, the government must engage with the IMF to eliminate the condition of keeping the rate difference below 1.25pc. The condition rate of a weekly spread of less than 1.25pc between the two currency markets must be removed or else the vicious cycle of the interbank chasing the open market will continue and further exacerbate the deteriorating conditions. If the IMF sticks to the condition, it is better to stagger the correction of the spread to two to three months, rather than on a weekly basis.

Steps SBP needs to take

Finally, and most importantly, the SBP must act and communicate with the market. Up to this point, the SBP has not been clear about underlying factors exerting significant pressure on the rupee, measures being taken to handle the situation and the approach being adopted to address the increasing disparity between interbank and open market rates.

The open market rates have been allowed to self-adjust without adequate efforts to manage public perception — dominated by bleak views in wake of the rupee’s weakening — effectively.

In the current scenario, it is of utmost importance that the SBP takes proactive measures in effectively communicating to the market that the current pressures on the local currency are transient. This strategic communication can play a pivotal role in mitigating unnecessary panic-driven dollar purchases, assuring stability and instilling confidence within the market participants.

Also, the SBP must allow people to keep dollars in their accounts.