The 1998 World Investment Report outlines the major determinant of investment and the two most important are macroeconomic stability and the consistency and continuity of the policies.
Seven major elements of the macro economic stability relate to the foreign exchange reserves, stability of the exchange rate, investment to GDP ratio, fiscal deficits, inflation rates, openness of the economy, and the banking system and its supervision. Over the last one year and particularly in the recent months, some of the macroeconomic fundamentals of Pakistan have become quite strong.
The foreign exchange reserves have crossed $5 billion, exchange rate is stable around Rs60 to a dollar, fiscal deficit is showing a declining trend, inflation is around 3 to 4 per cent, the economy has been liberalized and maximum import duty has been reduced to 30 per cent and would go down to 25 per cent and banking reforms have taken place. No doubt, improvements in law and order situation and political environments would also go a long way in promotion of investments the improvements in macro fundamentals have raised the prospect for higher investment levels that had fallen to the lowest levels since the 50s. In this article, we examine one of the main elements, the improvements in the foreign exchange reserves. Foreign exchange reserves of Pakistan have increased to $ 5249 million on 6th May. Of these State Bank reserves are $ 3483 million and of the commercial banks $ 1766 million.
From sustainability standpoint, three questions are being raised. Firstly, it is argued that the reserves held by commercial banks should not be counted towards the reserves of the country. Second, the reserves have increased because of the purchases in the open market and that is unsustainable. Third, reserves have increased because of the 9/11 events and as such the increase in reserves is neither policy-induced nor sustainable. Since there has been a change in the accounting procedures, it has also been suggested that increase in reserves is just due to changes in these procedures. All these elements need to be examined carefully and objectively both because if the policy initiatives are to be taken or the policies need strengthening, they are done and that the investors have the proper perspective and their perception of the economy of Pakistan is well founded. With a view to ascertaining if the increase in foreign exchange reserves is only due to the events of 9/11 or it is also a result of the efforts of the government, it is useful to examine changes in the reserves before the 11th September 2001 separately from the changes in the current year.
The foreign exchange reserves of a nation depend on the situation of the current account and the capital accounts of the Balance of Payments. The foreign exchange reserves increase if both are surplus or if the deficit in one is more than compensated by the surplus in the other. During 2000-01 the current account balance showed a surplus of $ 331 million if the official transfers were considered a part of the current account and in deficit of $ 508 million if official transfers were excluded. In either case this adds to the foreign exchange reserves and because it is unrequited transfers it does not add to the external debt of the country.
The improvement in the current account of the balance of payments has been due to reduction in the trade deficit, though the deficit was still $1,269 million, and the increase in unrequited transfers. The unrequited transfers include three elements viz. the workers remittances, the purchase of foreign exchange by the State Bank Of Pakistan from the open market and the inter-bank markets and the deposits of the residents with the commercial banks. These may also include the transfers on government account.
Let us first look at the definition of reserves. Until last year, the reserves of the State Bank included its own reserves and 20 per cent of the total foreign exchange reserves held by the commercial banks with the State Bank as a requirement on which it paid interest and another 5 per cent on which no interest is paid. According to the definition, the total reserves by 30th June 2001 were $2,087 million out of which the reserves of the State Bank were $ 1,688 million and 25 per cent of the deposits held by the commercial banks amounting to $399 million of foreign exchange reserves.
This is a significant improvement compared to that on 30th June 2000 when total reserves amounted to $1,358 million of which the State Bank held $997 million and $363 were held by the State Bank as a requirement for the commercial banks. However, according to the new definition, all the reserves held by commercial banks are included in foreign exchange reserves. According to this definition, there was an increase from $1,968 million to $3,219 million, an increase of $ 1,151 million. No doubt these reserves were not sufficient if the State Bank had to intervene in the market to support the rupee in the wake of speculation, it was nevertheless significant increase. What factors were responsible for the improvements in reserves position are examined in the following. Three sub-accounts of the current account balance are: trade balance, the invisible account balance and the net unrequited transfers. The trade balance improved by 10.1 per cent; the deficit declined from $1,412 million in 1999-2000 to $ 1,269 million in 2000-01. The exports increased by 7.4 per cent and while imports also increased but at a slower rate of 4.1 per cent. While the growth in exports following a 10.2 per cent growth in the preceding year is commendable it needs to increase at a much rapid rate considering that with the revival of the economy imports of both the machinery and the raw materials and intermediate goods is going to increase at a much rapid rate. To the extent the low growth rate of imports reflects decline in the import of wheat and sugar it is quite welcome but if it reflects recessionary tendencies this is not very desirable.
The machinery group showed a growth rate of just 3.4 per cent and the imports of all other categories except food and petroleum had gone down. Obviously when the economy will be revived the imports would tend to grow and the balance of trade would tend to rise unless major efforts are made to increase the exports. No doubt with the increase in investments productive capacity would increase and new technology would make Pakistani exports competitive and the exports would tend to rise but that may happen only with a lag. That the trade deficit does not become a major stumbling bloc to the further increase in the foreign exchange reserves, special efforts are required to increase the export earnings.
The second sub-account is the net services that also include interest payments, profits and dividends. They have always been in deficit and the deficit has been rising over time. It rose from $2,794 million to $3,137 million in 2000-01 even though there was a somewhat decline in the interest payments. The third sub-account is the unrequited public and private transfers and Pakistan always had surplus in this sub-account. In general, transfers on the public accounts are shown separately and the State Bank provides estimates of current account balance by excluding them and alternately by including them. It has been the sharp increase in surplus of the unrequited transfers of the private and public sector that led to improvements in the reserves both in the year 2000-01 and the current year.
The Pakistani workers outside the country have to make three important decisions: how much to remit, whether to remit through the banking channels or through the ‘hundi’ and whether to keep the savings outside the country or deposit them in the commercial banks in Pakistan. Whatever the decision they may take, one thing is quite clear: these are the earnings of the Pakistanis and it depends on the government to what extent they are able to convert them into the national foreign exchange reserves. The workers remit the money back home depending on the needs of their families and the investment they would like to make in Pakistan. The decision to remit through official channels depends on a number of factors including the differentials in the inter-bank and the ‘kerb’ rate and the efficiency of the banking system. Since the hundi system has been much more efficient, the remittances over time had been increasingly diverted to the hundi system. During 2000-01, remittances through the banking sectors increased by 10.4 percent i.e. from $ 983 million to $ 1,087 million. No doubt it shows an increase from a low base but it does show a movement in the right direction. The major factor behind the growth has been the introduction of various schemes introduced by the banks to make prompt payments.
Since a large amount of remittances moved to the hundi system the foreign exchange available in the kerb market was available to both the private and the public sector. The private demand arises either because the banks may not sell the foreign exchange for certain purposes but more importantly for dollarization in the country and capital flight. On the other hand State Bank of Pakistan my enter the market and purchase the foreign exchange and there is nothing wrong with it. The State Bank has been purchasing the foreign exchange from the market for the last three years; the purchases in the last three years have been $531 million, $1,634 million and $ 2,157 million.
Supposing all the foreign exchange dealers are declared as the banking companies and they are to surrender all the remittances to the State Bank of Pakistan, would it then be any different from what is being done by the State Bank of Pakistan at present? However, it needs to be underscored that when State Bank competes with the private sector to purchase the foreign exchange from the kerb market the differential in the inter-bank and kerb market increased and pushed the remittances towards hundi market. However, at present the intervention by the State Bank of Pakistan is keeping the exchange rate at a level that the exporters are not at a great disadvantage and at the same time government is raising its foreign exchange reserves.
The decision to deposit their asset in banks in Pakistan or keep them outside depends on the confidence of the workers outside in the policies of Pakistan. Whereas up to May 1998 resident and non-residents were depositing around $ 1.5 to $ 2.0 billion every year, it dried out when the foreign exchange deposits were frozen. However, gradually the confidence is being built and foreign exchange account deposits on June 30, 2001 was $1,543 million; $534 million deposits were received in 2000-01 compared to $322 million during the last year. The commercial banks have to deposit 20 percent with the State Bank of Pakistan on which they are paid interest and 5 percent without any interest payments. During the year 2000-01, the current account deficit went down to $ 331 million from $1,143 million in 1999-2000. However, when the official transfers are included then it turns into surplus of $508 million. During 2000-01 the capital account also showed surplus, which is not only reflective of the debt rescheduling but also, the grant and loans made available to the government. One of the factors that the government was able to obtain loans has been the fact that the government implemented almost fully the programmes of the IMF and the World Bank. The increase in reserves by $ 691 million during 2000-01 suggest that a deficit of $331 million (or surplus of $508 million if public transfers are also included) on the current account of the balance of payments has been more than compensated by the surplus on capital account. If all the FE-25 deposits with banks are included then increase in foreign exchange during the year was $1,251 million.
Therefore to the extent government made an effort to increase exports over the last two years and that the banking system has made efforts to make prompt payments, improvement in the current account could be attributed to the government policy. Similarly, the honouring of commitments made to the multilateral agencies did help the capital account. Nevertheless, the level of the reserves by the end of the 2000-01 fiscal year was still low though a clear positive trend could be discerned.
During the current year, the State Bank is in an enviable situation. By intervening in the market it helps the exporters by maintaining an exchange rate that is in conducive for exports and at the same time it increases its foreign exchange reserves. Central banks all over the world intervene in the exchange market to stabilize the currency at an equilibrium level. Trade gap in the first ten months of the current year has shrunk by 34.2 percent i.e. from $1,402 million to $ 921 million. However, the decline is due to fall in the imports by 6.93 percent and not by an increase in exports. As a matter of fact exports declined by 1.78 percent. Whereas in the context of 9/11 events the decline in exports was expected as large number of orders for Pakistani exports were cancelled, to the extent the EU had provided more access to Pakistan.It was expected that exports from January onwards would pick up.
But it did not. Nevertheless, during April exports have increased by 6.8 per cent and one only hopes that it would increase even further in the remaining months of this financial year and the years to come. At the same time the imports have grown at a more rapid rate of 8.7 per cent, which may be indicative of the revival of the economy, but at the same time results in deterioration in trade balance. Therefore efforts at diversification of exports by commodities and market need to be accorded top priority and the investments are basic to that. Over the first 8 months the remittances have increased to $ 1,630 million compared to $ 772 million over the same period of the last year. This is rather important and needs to be examined if these levels are sustainable. The upsurge in the remittances could be decomposed into three parts. Firstly, some of the expatriates have brought their capital to Pakistan, which they earlier had kept outside the country.
However, its proportion in the increase in remittances is not easy to determine. Second, the remittances are coming through the banking channels because of the restrictions on the ‘hawala’ system. This is a permanent source but it would also mean that the supplies in the kerb market would go down. However, if the currency remains stable and there is no demand for dollarization and capital flight stops, then reduction in the supplies may be counterbalanced by reduction in the demand and the foreign exchange may still be available in the open market which the State Bank can purchase. Considering that there is no differential in the inter-bank and kerb market rates, and that the banks have come up with the schemes for prompt payments the increase in remittances would continue.
The State Bank has made outright purchases of $ 917 million over the first eight months compared to $1,261 million of the corresponding period last year. FE-25 accounts in the first six months have been increased by $134 million. The balance of payments has shown a surplus of $1,660 million in the first 8 months.
We may note that the reserves have increased from $ 3,160 million to $ 5,249 million, an increase of $ 2,089 million. Almost four-fifth of this is contributed by the surplus at the current account; the surplus amounts to $ 1,660 million. The remaining is the surplus on capital account composed of grants and the loans. Would the reserves continue to grow? It is a difficult question but one can conjecture on the basis of various policy scenarios. The imports are expected to increase rather sharply with the revival of the economy.
While the exports would also increase, as the machinery imports would result in an increase in productive capacity and as it would be based on the latest technology the competitiveness of exports would rise but with a lag. However, Pakistan has to keep its exchange rate at the equilibrium level, help the exporters to find new markets and the Export Promotion Bureau will have to take lead in that and help in diversification of the product mix. On the other hand, the remittances would continue to rise and the capital inflows would ensure that the capital account is in surplus. With an increase in foreign investments the capital inflows would increase even further and the reserves would rise even further. Reserves have increased and we have to make sure that investment starts flowing in to make the best use of it. With the increase in reserves government will have an option to retire the debt by using the reserves when they are found to be excessive.