It is perhaps for the first time in the history of our country that the Governor of the State Bank is openly discussing national policy regarding exchange rates and reserves.

The Governor is to be congratulated, not only for amassing $5 billion, but also for his candour. An open public debate will lead, possibly, to valuable suggestions, and definitely impart a sense of participation to the public. While the logic, that a reasonable level of foreign currency reserves is vital, is flawless; there are serious objections as to how we have achieved it.

The bank decided to buy its requirements of foreign currency from the open market over the last two years, 2000, and 2001. It used these sums to repay foreign currency dues, and build up the reserves. It bought the dollars from the unofficial kerb, or ‘hundi’ market and not the official inter-bank market, both of which were supposed to be on a “free float”. I suppose the logic was that if they would buy from the inter-bank market, the rate would go up making the imports costlier.

The more dollars the bank bought, the higher went its value, in the unofficial market. At one point there was a difference of as much as four rupees to the dollar between the inter-bank and the kerb rate. Now this had many side effects.

i) The huge demand from the State Bank caused the rupee to slide precipitously against the dollar in the open market.

ii) This sudden slide created nervousness in the market and the inter-bank rate also slid in sympathy with the kerb rate.

iii) The large disparity between the two rates, official and open market, encouraged all persons remitting money into Pakistan to do so through the hundi and not at the inter-bank rate, through regular banking channels.

iv) We the exporters of this country felt that we were being given a raw deal. That the State Bank will not buy a dollar from us at Rs. 61 but will prefer to pay a hundi wala Rs. 64. This signalled to us that the earnings of a tax-paying citizen had a lower value than those who remitted their money through non-taxed, undocumented channels.

V) “In the process,” the Governor State Bank writes, “we paid Rs.11.6 billion over and above the inter-bank rate to acquire this amount of $5.20 billion.” I feel that if the State Bank had purchased its requirements mostly if not entirely, from the inter-bank market, most of this Rs11.6 billion rupees could have been saved. Moreover, exchange rate stability could have been achieved much earlier.

Under normal circumstances the demand for hundi money is limited. These are made up by e.g. some well heeled travellers not satisfied with their normal allowances, others remitting money abroad for their children’s education, or for other dependents. Foreign currency is available from the State Bank for imports of anything under the sun, as almost all import controls are now gone.

So now days there is very little normal demand for foreign currency from unofficial sources, except of course for capital flight or speculation. Demand for both these reasons is highly volatile and based on fears and expectations, rather than the SBP policy. These can be sparked off by political and economic uncertainty.

They can also be caused by a genuine desire to protect savings from being eroded by a rapidly depreciating rupee. So while these factors may be dormant today, they can over whelm us in the future, as they nearly did in the past. If these two demons are unleashed in their full fury no Government can stand up to them. Five billion dollars will be a mere pittance. The recent capitulation of the Malaysian Government to currency speculators is a very good pointer.

While demand for “hundi money is normally small the supply of it is immense. There are drug money flows, which we can only guess at, Dr. Mahbub-ul-Haq as minister estimated them in billions of dollars. Then the immigrant remittances, which are estimated at about $2 billion. These remittances are entirely legal, but can flow in through either channel, official or unofficial.

A rational person will route them through the channel, which will give him a better rate of return. So if the Hundi route is offering a better rate there is a marked preference to remit by that route. If the difference is only nominal then he will prefer the normal banking channel, especially as it is safer, and is also considered more patriotic. In any case both the above inflows are far more than the normal demand for such money especially if it costs more than the official rate. So there is a natural surplus, which is what the SBP was buying up.

Had the SBP bought its requirement from the Inter-bank market the rate of the dollar in the inter-bank would have shot up, possibly to be at par or even above the kerb rate. This may have sounded implausible two years ago, but nowadays this has almost been achieved. When the official and kerb rate is about the same, more and more of the immigrant remittances will flow through the banks, creating a healthy current account surplus. As the exchange rate stabilises this process will accelerate. No doubt this phenomena has been greatly helped by the aftermath of the events of Sept 11.

All concerned are loathe to use the hundi route. If the two rates are close this will continue, and we should continue to see a healthy current account surplus. The moment there is a big difference between the two rates, the remittances will again get diverted to the Hundi route. The subsequent uncertainty will again cause outflows of savings and speculative remittances leading to a repeat depreciation of the rupee.

So much for how we got to our pile of dollars. The fact that we have finally got it, is a great achievement. Many years ago the then finance minister Mr. Sartaj Aziz came to Lahore to talk about the budget. The author raised the question of allowing the rupee to float freely. He replied, “Give me reserves of a billion dollars - and I will float the rupee”. So reserves of five or even three and a half billion dollars are a solid insulation against short-term exchange rate turbulence.

The essential question is what are we to do with this huge pile of money. Just to leave it there, waiting for an emergency, seems an awful waste of resources in a poor country like ours. These days the commercial banks are not giving returns of more than two percent, if that, to dollar deposit accounts. People are still shell shocked by the events of September 11th. and the subsequent decline in the stock markets abroad. The interest rates in the developed world have also been cut sharply by their federal reserves.

However normalcy will return soon. Then the dollar deposits may begin to flow back abroad. If there is any political or economic uncertainty at home, it will accelerate this process, and all the hard work and money spent, will go wasted. We have to find ways to put these precious reserves to good use. If the depositor gets a return of about four percent on dollar deposits, and is reasonably sure that he will be able to encash his dollars when he wants, he is more likely to leave his money in Pakistan. He may even transfer more of his savings from foreign banks to Pakistan, giving us many more billions of dollars. Some imaginative policy options need to be developed which will give us some return on the dollar deposit as well as keep the money liquid enough to be available in case of need.

What are these policy options? This is what the debate must be focused on. I will try to indicate some possible alternatives in this article. While the banks are giving near zero returns on dollar accounts, yet the rupee rate of return is 10% on long-term deposits. In effect they are still expecting the rupee to slide against the dollar by 8% annually. Can the Sate Bank offer a cheap forward risk cover, for short periods at least? Maybe this could be translated into an instrument to replace the export refinance scheme. This would save many billions for the State Bank, which it spends in subsidizing this scheme as well as free money for other investments. It’s an option well worth looking at. Given a bit of ingenuity the dollar deposits can be used to lower local rates of interest, which in turn may help much needed domestic investment to get going.

I know that the conventional wisdom is that the job of the Governor State Bank, like the federal reserve in the USA is to ensure monetary and price stability. So once that is achieved he has done his job. I feel that in Pakistan while the above objectives are commendable yet economic development must take first priority. It is the alleviation of poverty, which must be our prime concern. Its high time all our policy making should now be geared up to promoting development and employment. For the last few years the nation has patiently borne the pain of stiff economic measures and belt tightening, but this cannot go on much longer. Mounting poverty, unemployment, growing economic disparity may set off a chain of events more destructive than we can foresee.

The author is the chairman of the Towel Manufacturers Association of Pakistan.