The foreign exchange reserves of the country have already crossed the mark of $9.5 billion and may exceed the $10 billion mark most probably before the end of the current fiscal year.

The present economic managers of the country have expressed the intention of taking the figure of reserves to the level of the country’s external debts/foreign exchange liabilities within the next 6-7 years i.e. by the year 2010. According to their invented theory, when the reserves reach the level of the foreign exchange debts and liabilities, these debts and liabilities would reduce to zero even though the substance of this theory can always be brought into question on the ground that the debts and liabilities are liquidated either by repayments or write-offs by the lenders.

As per reports, the maintenance of reserves at the current level has caused an expenditure of approximately Rs20 billion as the profit of the State Bank of Pakistan (SBP) transferable to the federal government has reduced from Rs26 billion to Rs6 billion only.

There are valid reasons for maintaining foreign exchange reserves at a certain level to guard against the vulnerabilities in the external sector including the frequent devaluation (of the rupee) shocks which we had witnessed since 1982 when the rupee was placed on the managed float up to the fiscal year 2001-02 (FY-02) when, in consequence of the 9/11 events, the inflow increased by an unprecedented proportion so much so that the rupee appreciated against the dollar to such a level that it became uncompetitive for the exporters and the SBP had to resort to the purchases of dollar from the inter-bank market to keep the dollar/rupee rate at a certain level. In the earlier years the SBP had to make purchases of the dollars from the kerb market to meet the day to day expenditure besides increasing the foreign exchange reserves. The figures of the SBP’s dollar purchases during the last 4 years are as under:

It would be seen from the above table that heavy purchases were made by the SBP during the fiscal year 2001-02 (FY-02) and the first quarter of the current fiscal 2002-03 (FY-03). This no doubt helped the SBP in building up the foreign exchange reserves but the question is what was the other alternative if there were no dollar purchases by the SBP from the inter-bank market. The commercial banks obviously did not have the investment outlets for such huge inflows. They are of course providing foreign currency loans both — pre-shipment and post-shipment — to the exporters where their range of interest earnings may be around 4- 4.5 per cent. They are also offering foreign currency loans to the importers which does not appear to have substantially picked up so far. For foreign currency loaning to the local exporters/importers, the amounts of the foreign currency deposits held by them appear quite sufficient as would be evident from the fact that utilization of the Asian Development Bank’s line of credit made available through the SBP is also reported not to be in an adequate proportion. In case the SBP does not purchase the dollar inflows from the banks, they will be able to earn only 1-1.5 per cent on placement of their foreign assets with the banks abroad which will have serious negative effect on the earnings of the entire banking sector.

Another aspect of the matter is that in case the commercial banks succeed in dollarizing our international trade — imports and exports — in near future, what will happen to the huge rupee deposits? Where the same will be deployed by the banks and what will the fate of return to the depositors which the banks already go on reducing from time to time?

What can, however, be safely concluded from the above discussion is that in the context of the heavy foreign exchange inflows expected through the inter-bank market in coming years — a healthy phenomenon for the country’s economy — as is evidenced by 16 per cent increase in the exports during the first half of the fiscal FY-03 and very high increase in the workers’ remittances which will cross the four billion dollar mark during the current fiscal FY-03 and the banks finding no outlet to deploy these funds, the only option would be heavy dollar purchases by the SBP from the inter-bank market which will become a routine. Consequently, the SBP’s foreign exchange reserve will continue to be built up as a matter of routine.

The foreign exchange reserves build-up has two important aspects: (a) cost to the government (or the SBP) and (b) inflationary impact on the economy. These two matters are rather inter-related. When dollar purchases are made by the SBP, equivalent rupee amount is pumped into the economy and if the production of the goods/services does not increase in the like proportion, such pumping will create inflationary impact. It is, therefore, imperative that the rupee amount so pumped into the economy is taken back. This process been termed as “sterilization” in the SBP’s report for the first quarter of FY-03 (Q 1/FY-03). The methodology so far adopted for the purpose was to liquidate the SBP’s holdings of the government Treasury Bills (TBs) and make good the resultant squeeze in the government funds by the sale of the TBs through auction in the market. The SBP is thus losing income from the TBs which was around 5-6 per cent per annum (p.a.), while its income on investment of dollar assets may be around 1.5-2 per cent p.a., it is taking a loss of about 3.5 per cent p.a. The government is, however, gaining to the extent of the SBP loss. This has been claimed by the government as substitution of the costly domestic debt by the cheaper one. However, since SBP profit is transferable to the government, the process may not have any serious implications either for the SBP or the government so long as the SBP’s holdings of the TBs do not exhaust. The “sterilization” process has reduced the SBP’s holding of the TBs from Rs485 billion as on the June 30, 2001 to merely Rs119 billion as on the June 30, 2002 (page 111 of the SBP’s report for Q 1/FY-03). As purchases of $1,145 million were made by the SBP during Q 1/FY -03, a sum of Rs66 billion approximately at the current exchange of $1=Rs58 would have been required for sterilizing the effect of those purchases which consequently would have reduced the stock of the SBP’s holding of the TBs from Rs119 billion to Rs53 billion. This stock may already have exhausted by December, 2002. The final position would be available to the public if the SBP’s report for the second quarter of FY-03 contains the requisite data.

The analysis of the economic prospects is always subject to the long “ifs” and “buts” because no expert can predict the behaviour of the different variables involved over medium and long terms. The building of the foreign exchange reserves up to the desired level will depend on the continuous heavy inflows and the changes in the exchange/interest rates both for local currency as well as the foreign currencies in which we hold our reserve as also the conditionalities of the IMF etc,.

In case the relative variables remain more or less in the predicted framework, the accumulation of reserves may not pose a problem. For this purpose the SBP will be required to pump Rs1508 billion into the market at the current exchange rate of $1=Rs58. From where the SBP will dish out over one and half trillion rupees? Obviously by creating money. If the position is something else, the SBP may please correct it. But then the question arises how such a huge “sterilization” arrangement will be run by the SBP in the coming years till 2010. Prima facie, the possibility is that by selling the TBs in the market. The government will thus incur additional domestic debt of Rs1508 billion which shall entail an additional cost of Rs38 billion annually (@ 2.5 per cent p.a. as the TBs rate is likely to come down to that extent in a next few months) in/after 2010 (this additional cost will inflate at the ascending annual rate of Rs5.5 billion e.g., Rs5.5 billion say in 2004/ Rs11 billion in 2005 and so on).

Will the contracting of the additional domestic heavy debt burden for “sterilisation” purposes not run contrary to the debt reduction strategy of the previous military regime, the continuity of which has been undertaken by the present government, under which the country’s debt is required to be reduced to 60 per cent of the GDP by 2012, and for the implementation whereof a law was also contemplated to be promulgated ? Will the creation of the additional debt-servicing liability not add to the fiscal deficit and run contrary to the policy of reducing it for which the government is squeezing small investors of the National Savings Schemes (NSS) by reducing the interest rates at half-yearly interval? The government has already reduced the interest rates on the NSS investment by half during the last 2-3 years.

Another aspect of creating such huge debt is whether the IMF will permit it. In this connection, for the present, the government can take shelter under the plea that by 2004 we shall abandon the IMF programmes and consequently, there will be no IMF intervention in our policies.

From the above discussion, it can be concluded that the option of creating additional heavy domestic debt for financing “sterilization” programme is not feasible on many counts. May be that the SBP authorities have in mind some other alternative which they have not made public. If so, the SBP should disseminate that option in its quarterly report for the second quarter of FY-03 ending December 31, 2002.

Yet another dimension of reduction in the TBs rate is its impact on the profitability of the banking sector and its consequences for the “savers”. The excess liquidity in the banking sector/lesser investment opportunities due to slackness in the economic activities/substantial reduction in the TBs rate and high provisioning by the large public sector banks against the defaulted loans has already reduced their profitability and the banks in turn have squeezed the depositors by reducing the deposit rates instead of bringing operational efficiencies and reducing the intermediation costs. Further cut in the TBs rates — bringing it to 2.5 per cent p.a. in the next few months as seems inevitable — will enable the banks to further squeeze the depositors. Do the the SBP/government policies aim at making one side of the financial system i.e. “savings side”, “Riba-free”. It may be mentioned here that in 1998, the SBP policies had effectively made the frozen foreign currency deposits “Riba-free” as 10 per cent p.a exchange risk coverage fee imposed on the banks did not leave any room for the banks to pay any return to the concerned depositors.

While examining various aspects of the “sterilisation” policy, a point which strikes to one’s mind is whether the sole aim of reduction in the TBs rates is simply to provide feasible environment for operation of the “sterilization” policy which is likely to continue for quite a long time? This is because the SBP’s discount rate has not been brought down so low as it currently is 7 per cent p.a., while for 6-month TBs auctioned on the 9th January, 2003 the rate was 3.9468 per cent p.a.

In the article on foreign exchange reserves published in Dawn EBR dated January 20-26,2003 “an opinion has been expressed that the Central Bank can counter the effects of the fall in export earnings by helping run the fiscal deficit.” This does not seem to be a valid opinion. The increase/decrease in exports does not have any direct bearing on the fiscal deficit. The fall in the export earnings does have an impact on the current account in the external sector and consequently on the volume of the foreign exchange reserves. Further, the SBP is also not supposed to interfere in the fiscal management as it is the prerogative of the government.

Another concept presented in this article is that the accumulation of reserves by the SBP help reduce the balance of payments deficits. The balance of payments is the difference between the actual receipts and payments. This can be reduced only by matching/reducing the foreign exchange transactions. The reserves cannot by themselves increase or decrease the balance of payments deficit. The reserves can no doubt help in meeting the deficits.

Now a few words about the contents of the SBP report for Q-1/FY0-3:

(a) On page 59, it has been mentioned: “it is noted that large portion of the banking sector NPLs is rooted in aged loans against which any meaningful recovery seems quite impossible”. In response to my earlier article, the SBP had explained the difference between the non-performing loans (NPLs) and the defaulted loans vice letter published in Dawn dated 13-06-2002. According to the said letter, “the loans that are overdue (principal or mark-up) for a period of 90 days or above are termed as the NPLs, whereas the loans that become overdue by 365 days or more are called defaults.” From that view point, no NPL can become “aged”. Thus reference made in the quarterly report under discussion is for the “defaulted loans and not to the NPLs.

(b) Hitherto, the economic managers have been claiming that the improvement in the economy, particularly in the external sector, is on account of the policies pursued by them. This quarterly report admits the factual position by stating that “the fact that the catalyst for the rise in the foreign inflows was the policies of other countries towards the informal flows (page112)”. Thus it is more transparent.

(c) On page 97, it has been mentioned that “in order to facilitate exporters who have been facing declining forward premium, the SBP established a swap desk in the first week of September, 2002 . The SBP’s sell/buy swap with banks (which also helped in containing reserve money growth) not only strengthened the rupee against the dollar but also pushed up the forward premium”. The exporters’ interest is in the declining rupee. How the strengthening of the rupee can help the exporters or in raising the premium on the forward sale of dollars to the banks by the exporters is beyond comprehension. Prima facie, the SBP interpretation runs counter to the factual position. Unless explained in details with reasons, the swap arrangement is likely to only temporarily affect the NDA/NFA of the SBP and the banks; the reserve money remaining unchanged. A simple statement in this respect may not satisfy the public.

(d) The reports lists the tools of sterilization (pages 112-115) as: (a) open market operations; (b) foreign exchange swaps; (c) increasing the discount rate; and (d) raising the reserve requirement. Foreign exchange swaps are the tools of very short duration and are not expected to be helpful in the longer term. In the scenario where the interest rates are on the decline and the SBP/government are working towards that end, the option of increasing the discount rate is not feasible for quite some time in future. Apart from that, how the increase in the discount rate can act as a sterilization tool is not quite clear. It has also been the policy of the SBP to reduce the reserve requirement, therefore, reversing that the policy does not seem practicable in the near future.

The only option available seems to be to sell the TBs. The chances of using yet another option of using the government deposits given in the report are rather far-fetched because the government is already facing the fiscal deficit and it will not be possible for it to provide huge money required for the sterilization operations. If at all the government does so, it will be by raising money through the sale of the TBs. And consequently, it is not the fifth option.