KARACHI, Nov 2: The State Bank decision to pay for oil import bills out of its foreign exchange reserves will kill two birds with one stone: it will make the rupee stronger and, in the process, push up interest rates- so necessary to check rising inflation.

Oil importing companies will now pay their banks the rupee equivalent of oil import bills; the banks will pay the bills in foreign exchange and then buy it from the central bank. Earlier, the companies had to buy foreign exchange from banks to pay for oil imports.

Whenever an oil refinery or an oil marketing company had to pay an oil import bill, it used to shop around in the inter-bank market. At the end, it either got the required amount of foreign exchange from the bank that had opened its letter of credit or from another bank. The banker of the oil importing company used to provide foreign exchange from its own kitty or buy the same from other banks.

So, whenever the payment of an oil import bill fell due, it pushed up the demand for dollars.

At times, when foreign exchange outflows outstripped the inflows in the inter-bank market, this practice used to create a big demand for dollars and weaken the rupee.

As the demand for oil imports went up with the start of this fiscal year in Pakistan's growing economy and as international oil prices boomed, the resultant pressure on the rupee was too difficult to manage. Small wonder than that the rupee lost 5.5 per cent value against the US dollar in July-October 2004.

Now as the SBP has started selling dollars to the banks so that they could use the same for financing oil imports of their clients, the rupee is making a smart recovery. On the first two days after this arrangement, the local unit has recovered 79 paisa or 1.3 per cent value against the dollar. But a fast recovery in the rupee value is not the only benefit of the new arrangement.

There are more in store.

Since the central bank is selling dollars to banks for making oil import payments it is sucking in rupee liquidity from the market in the process.

Average monthly oil import is estimated around $350-400m. So, when the SBP would sell this much foreign exchange to the banks every month it would suck in Rs21-24bn from the banking system, this being the rupee equivalent of $350-400m. Such a huge outflow ofliquidity should help the SBP in fighting inflation by containingthe growth of monetary assets and increasing the interest rates.

The beauty of the SBP's new arrangement is that this estimated outflow of Rs21-24bn from the banking system and the resultant increase in the interest rates strengthen the SBP's ongoing tightening of interest rates in a way acceptable for most market players.

Had the SBP drained out Rs21-24 billion from the banking system through a direct measure like increasing cash reserves or liquid reserves requirement it would have annoyed the banks. Similarly, had the State Bank made a sharper increase in interest rates directly it would have caused resentment among the business community.

So, its decision to pay for oil import bills out of foreign reserves would not only strengthen the rupee but would also add muscle to its fight against inflation by containing monetary growth and increasing the interest rates.