The volatility in financial markets seen earlier this month has raised issues with potential to impact negatively on the sustainability of foreign exchange reserves and the economic growth rate.
The State Bank of Pakistan(SBP) says that it has injected $700 million into the currency market to beat back speculation. Yet the national currency has depreciated against the dollar from a recent high of Rs57.3 to a low of Rs58.91.
Fearing further depreciation, importers opened letters of credit at a rapid pace, exporters delayed their remittances and banks slowed down sales of foreign exchange, trying to take as much advantage as they could from the free float of the rupee.
The pressure on the rupee's foreign exchange rate is explained by soaring trade deficits and payments of debts. The immediate cause is stated to be the pre-payment of some $350 million debt by the Parco. Trade deficits are however being taken care of by enormous inflow of remittances.
Intervening on a daily basis, the central bank sells dollars to keep the exchange rate stable. The value of the rupee, in the market is determined not by its intrinsic worth, its purchasing power parity with other currencies, but the short-term demand and supply. In global market manipulation, currencies are either presently over-valued or under-valued depending on exchange rate policy of individual countries.
The President of the National Bank of Pakistan (NBP), Syed Ali Raza, says exchange rate and interest rate are the two faces of the same coin. The exchange rate differential is reflected in the interest rate differential.
Yet in the dramatic changes of the past 2-3 years, it has been unusual that the equality has not been followed. There has been a negative rate of return on bank deposits and major corporates get loans at below the inflation rate. In the United States, there is a negative real return on money as the US Fed rate at 1.5 per cent is much lower than the current inflation rate of three per cent.
Linking of a currency's real value to inflation appears to have lost much of its relevance as enormous global stock of excess money, estimated in trillions of dollars, is unable to find avenues for productive investment.
Much of the money flows into speculative investment considered by bankers as a normal business activity.Banking is a risky business and banks tend to shed some of their risks.
Of the record Rs9 billion profits made by the NBP in the calender year 2003, 60 per cent is interest income and 40 per cent is non-interest income, up from 20 per cent about four years ago. Ali Raza says that the ideal ratio is 50-50 which is his target. Non-interest incomes come from fees, currency trading, investment in stocks, etc..
Economists agree that occasionally and in certain circumstances, foreign exchange reserves get dissolved by speculation. The volatility in the exchange market has to be checked effectively to prevent such a disaster.
This has been done in the past by Pakistan through brief interventions by the SBP through managed float of the rupee. China and Malaysia have pegged their national currencies to the dollar and have fixed parity with the greenback.
Although not immune from speculative attacks, Pakistan's foreign exchange reserves cannot get dissolved like dispirin in the water. The situation here differs from that which prevailed in Thailand in 1997. Ali Raza says that there was too much institutional foreign portfolio investment which was pulled out when devaluation of Thai Bhat became imminent.
In Pakistan, portfolio investment is nominal and the volume of foreign direct investment is much larger, far more difficult to shift to new locations. The current account is not convertible and the capital account is partially convertible. The foreign exchange transactions by banks are permissible only against central bank's approved list of transactions.
Exchange companies have no such restrictions but their operations are very small in the overall national exchange market. Yet, any flight of capital can bring pressure on the exchange rate and the role of the exchange companies may be enlarged in the process. This may impact adversely on the foreign exchange reserves.
Pakistan foreign exchange reserves equivalent to one year's imports provide a strong cushion against speculative attacks. It is not the absolute figures that count. Forex reserves amounting to ten months imports are considered to be comfortable and less than two months' imports are viewed as hazardous.
A stable exchange rate and low interest rates have triggered economic growth, reduced debt burden of government and corporates. Much of the improvement in corporate profits are accounted by low interest rates. The issue now is how depreciating rupee and increasing interest rates would impact on economic growth.
The Public Sector Development Programme budgeted at Rs202 billion and Rs200 billion excess money with the banks could ensure high economic growth says the NBP president if governance is improved. It would depend on how the money is spent, how effectively the projects are monitored and how efficiently they are implemented.
But the key issue that determines the exchange and interest rates is the yawning trade deficit. Over the past three decades or more, (except for very brief periods) Pakistan's rupee has been depreciating to make exports of merchandize cheaper and imports costlier.
Devaluation of the rupee compensates the exporters for the high cost imported goods and the government is able to collect more taxes on higher rupee- priced imports. This more than helps the government make up for the cut in direct taxes and lowering of tariffs. The domestic consumer bears the costs.
The devaluation also helps to perpetuate inefficiencies in export-oriented industries and sustains perpetual trade deficit. Despite a much stronger Euro, Europe continues to draw strength from a booming export in a sluggish economic recovery because of industrial efficiency.
In the long term, the euro would continue to remain strong against the dollar. By 2010, Prof\Dr. Norbert Walter, chief economist, Deutsche Bank, estimates that the dollar reserves held by the central banks world over would decline to 50 per cent (against current 65 per cent estimated by Alan Green span), the euros' share would up to 30 per cent and the share of other currencies would be 20 per cent.
Whether it is recession or economic boom, trade deficit is a recurring phenomenon because policy makers forget the imbalance in trade can only be removed by increasing exports and cutting on imports through a policy of national self-reliance.
In the past, trade deficits have been funded by external debts. Foreign trade has been debt-driven and not export-driven. It has been a policy of external dependence not inter-dependence. In fact, the first phase of domestic industrialization was debt driven.
Foreign exchange reserves are often sustained by massive foreign direct investment, not portfolio investment that tends to destabilize the markets. Efforts to manage foreign investment have not been successful, as in the absence of a regional trade bloc, economies of scale in production is not possible. As populous China and India prove, foreign investors preferred bigger markets. The size of the Pakistani market is not growing fast because of rising poverty.