With rupee fall, economy slows

SBP cautious about raising policy rate despite massive currency devaluation

LAHORE:

The external sector has started to lose steam. From July to February FY22, the trade deficit remained around $30 billion. Although the growth in merchandise exports was 28%, the import growth of around 49% aggravated the trade deficit. Despite 7.4% growth in remittances, the current account deficit came in at $12 billion.

As a result, Pakistan became a net borrower of around $12 billion from the rest of the world. The foreign exchange reserves held by the State Bank of Pakistan (SBP) are declining despite the proceeds of Sukuk and the resumption of Extended Fund Facility (EFF) of the IMF. In the week ended March 18, 2022, the foreign currency reserves were hovering around $15 billion covering almost two and a half month of imports.

The nominal exchange rate of the rupee is hovering around 182. There is a gradual decline in the nominal value of the rupee in the last couple of months. When there is a gradual decline, the currency remains protected from the speculative attack. On the other hand, a fast decline in the value of the rupee manifests a speculative attack as the movement of currency depends on the capital flows. When there is a large capital inflow, the rupee will appreciate as has already happened around the middle of last year.

The rupee appreciated from 165 to 152 in a short span of time. However, it has kept on depreciating since then. Although a fixed exchange rate regime brings economic stability for a short period of time, it is a prelude to the competitiveness challenge in the medium run. In addition, the speculators become confident about the direction of the currency and try to assert their position, which brings volatility to the currency market.

The lesson of history of that fixed exchange rate shows that it has created competitiveness problems for the developing economies. When a developing economy is growing, dollars are required to finance the necessary capital goods and raw material. The demand for dollars increases with the growth of economy. Therefore, the dollar earning capacity becomes significant along with economic progress. In the case of Pakistan, exports and remittances provide dollars to finance the desirable foreign exchange needs.

Statistics of the last five years show that exports cover around 53% of imports in the stabilisation phase of the economy. In this phase, fiscal austerity and a tight monetary policy slow down the economy. On the contrary, exports cover 43% of imports when the rate of economic growth is around 5%. The devaluation of the rupee also affects the policy rate. The State Bank has increased the policy rate from 7% to 9.75% in the last six months. The slow adjustment in the policy rate is linked with the upcoming election cycle.

The State Bank is cautious about raising the policy rate despite a massive devaluation of the rupee. Had the government been in the first year of its rule, the adjustment in the policy rate would have been abrupt. Keeping in view the high inflation rate, the central banks in advanced countries have started to raise the policy rate.

The US Federal Reserve has already increased the rate and has hinted at a further increase in the coming months owing to elevated prices in the country. The central banks in other advanced countries will adjust their rates accordingly. In a nutshell, the inflation in Pakistan is structural in nature. The upward adjustment in the policy rate will decelerate prices at the cost of slowdown in the economy.

The devaluation of the rupee has started to slow down the economy. Taking the emerging situation into account, the probability of upward adjustment in the policy rate is high.

THE WRITER IS THE ASSISTANT PROFESSOR OF ECONOMICS AT SDSB, LAHORE UNIVERSITY OF MANAGEMENT SCIENCES (LUMS)