While the soaring current account deficit is eating away the heap of Pakistan’s foreign exchange reserves, the falling rupee is further compounding the inflationary pressure. The rupee has been sliding downward against the dollar for quite some time now and has fallen sharply against the greenback over last four months. The situation has created panic amongst investors who are rushing to buy even more dollars, pushing the price further up.

The State Bank’s recent decision to ban export of foreign currencies coupled with informal warning issued to key foreign exchange market players, has caused some reversal in this trend, but this would just offer a temporary respite.

Dr Shamshad Akhtar, Governor of the State Bank of Pakistan (SBP), has claimed that this volatility in the price of rupee does not reflect market fundamentals and is primarily caused by speculative trading. She has also affirmed SBP’s commitment to stabilise the exchange rate but has warned that any intervention would be ‘calibrated in line with the volatility’ and not with any base price.

Her statement has done little to address the investors’ concerns and in fact has raised many questions. How the State Bank can intervene in the price adjustment process? To what extent the exchange rate policy can help, if at all, in halting this rupee slide? What has caused this sudden speculative trading and what can be the consequences of further rupee depreciation?

The SBP, like any other central bank, can intervene in the foreign exchange market, either directly or indirectly. The direct interventions include selling dollars in the open market to help stabilise the rupee, but such a step would come at the cost of causing a further dent to our shrinking foreign exchange reserves.

The indirect interventions may include tweaking the interest rates, modifying foreign exchange regulations, or influencing the key market players. While an increase in the interest rate runs the risk of hampering economic growth, other interventions – such as compelling the commercial banks to sell the dollars in inter-bank market, restriction on Nostro accounts and imposing limits on capital outflow on exchange companies - only present a stopgap arrangement.

The sliding downward rupee also indicates the worsening macroeconomic imbalances including our widening current account deficit and expansion of our monetary assets to finance overspending by the last government.

Pakistan claims to be following the Managed Floating Exchange Rate Regime. The foreign exchange rate policy defines the way a country manages its currency vis-à-vis foreign currencies and is closely linked with the country’s monetary policy. If the national unit is tied to any international currency, it is called a ‘pegged’ arrangement but if the exchange rate is left for the market forces to decide, based on supply and demand, it falls under the ‘floating exchange rate regime’.

In the case of floating arrangements, the central banks reserve the right to intervene to check excessive volatility in the currency price, and the policy is termed as managed floating exchange rate regime, though these interventions are not supposed to establish a certain target price level or band for the local currency.

The pegged arrangements on the other hand can be divided into two main classes; hard pegs and soft pegs. Hard pegs either eliminate the local currency altogether and the country adopts another international currency, a phenomenon also termed as dollarisation, as observed in European Monetary Union or have currency board arrangements, where the central bank only undertakes the expansion of monetary assets, by ensuring at least 100 per cent backing by the pegged currency reserves.

In some other cases, these hard pegs are also backed by a basket of currencies, based on the country’s trading profile. In such regimes, the exchange rate either remains fixed for a given time or moves within a very tight band. Soft pegs or pegged floats, on the other hand, come in many forms including crawling pegs, crawling bands or pegged exchange rates within horizontal bands, where the central bank manages to keep the price within a certain range.

The exchange rate policies ranging from hard pegs or dollarisation arrangements to floating regimes form the exchange rate policy continuum, providing many policy options for any country to position itself anywhere on this continuum. Many economists, however, promote the use of floating regimes, especially for countries open to international capital flows, quoting the economic crises of many countries with soft pegged regimes, including Mexico, Indonesia and Brazil, which plunged into economic crises, as opposed to other emerging economies, which did not have pegged exchange rate regimes and managed to survive the crises. Therefore, Pakistan, with a managed floating regime, is supposedly towing the right policy.

The IMF officials however, make a differentiation between the de jure and de facto exchange rate policies of a country, as according to them, despite a country’s claim of having a floating regime, sometimes it might have a commitment for a particular price level - a condition which is not allowed in managed or independent floating regimes.

According to IMF’s website, the last report regarding de facto exchange rate regimes of different countries came out in 2007 and, surprisingly, it ranked Pakistan as one of those countries having different claimed and de facto exchange rate policies. According to the report, in actuality, Pakistan falls under the category of ‘other conventional fixed peg arrangement’.

Despite the claims of so-called economic progress during the last five years, one wonders that why there was a difference between our claimed and pursued policies. Were we trying to artificially peg the rupee price with the dollar, throughout the last five years, by somehow managing the market sentiment or through the oxygen of heavy foreign aid inflow? If we were, then what has caused this reversal now - some policy compulsions or the removal of that oxygen mask? Are we also exposed to an economic crisis, in the days to come, as witnessed in East Asia, due to following this pegged float arrangement?

Dr Shamshad Akhtar has expressed hope and indicated that, since she has finalised the negotiations with multilateral agencies and other donors, the dollars would soon ‘start pouring in’, which in other words mean that Pakistan would soon have enough oxygen to keep breathing but unfortunately not enough medication to cure the ailment.

The dangers of further depreciation are looming large on the economy. Not only the devaluation would fuel the already record high inflation but would also further worsen the balance of payment situation. The fuel prices which are already on an unprecedented hike due to the rise in global crude oil prices, will go up further.

According to some international experts, the global crude oil price can go as high as $200 a barrel by the year end. Coupled with such a hike in price, any further fall in rupee can have a devastating effect on our already crippling economy.

Some optimists, or proponents of j-curve theory, are predicting that the depreciation in the rupee will bring the much needed boost to exports and will be beneficial specifically for our textile sector. While that may offer a short-term recipe for marginally increasing our exports, any such measure does not and cannot contribute towards enhancing the overall competitiveness of our exports. Furthermore, the inflationary pressures caused by such devaluation will greatly undermine, if not nullify, any such benefit.

Robert Mundell and Marcus Fleming gave the concept of impossible trinity almost 50 years ago, stating that it is difficult for a country to simultaneously attain three goals of having unhindered capital flow, an independent monetary policy and a stable exchange rate and any country will have to compromise on any one of these three goals to achieve the other two.

While our monetary policy is dominated by our fiscal priorities, the exchange rate is undergoing a volatile price hike and the State Bank is warning to bring in more restrictions on capital flow, one wonders whether our economic managers are moving from the impossible trinity to a three-dimensional impossibility.

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