Misperception about Exchange Rate

By, Dr. Ashfaque H. Khan

Why Pakistan’s exchange rate (rupee-dollar parity) remained stable between October 2001 and March 2008 (78 months) and why it registered a sharp depreciation between April 2008 and February 2012 (47 months) will form the subject matter of this article. Some ‘generalists’ have always argued that the government of that time had ‘artificially’ stabilised the exchange rate between October 2001 to March 2008, and that the prolonged stability in exchange rate was inconsistent with macroeconomic fundamentals.

Only recently (January 26, 2012), the former finance minister Sartaj Aziz was quoted in an English daily, commenting on the recent sharp depreciation in exchange rate. He argued that the “growing pressure on foreign exchange reserves, weak macroeconomic indicators coupled with relatively high inflation rate in Pakistan as compared to its trading partners are major factors for the depreciation of the rupee against the US dollar”.

Sartaj Aziz’s blunt summation says it all. The appreciation or depreciation of exchange rate is dependent on the foreign exchange reserves and the country’s macroeconomic fundamentals. How can any central bank ‘artificially’ hold the exchange rate for such a long period of time in a managed floating exchange rate regime with no predetermined path for the exchange rate?

Foreign exchange inflows on a sustained basis constitute one of the key factors for providing stability to exchange rate. Pakistan’s foreign exchange earnings (exports of goods and services, current transfers including remittances and investment income) stood at $12.8 billion in 1999-2000 but surged to $37 billion by March 2008 – almost a three fold increase in eight years. Such large inflows helped Pakistan to build its foreign exchange reserves from $1.3 billion in 1999-2000 to $16.4 billion by October 2007 – almost a thirteen fold increase in seven years. Three years of surpluses in the current account (2001-02 to 2003-04) helped Pakistan build its foreign exchange reserves as well.

The accumulation of foreign exchange reserves was so excessive during the period that it created serious difficulties for the State Bank of Pakistan (SBP) in conducting its monetary policy. The SBP had to struggle to strike a balance between preventing sharp appreciation of exchange rate and massive increase in reserve money fueling inflation.

The SBP used the sterilization instrument to neutralize the monetary impact of the massive inflow of capital. For example, the SBP injected Rs.257 billion (against net purchase of $4.4 billion) into the banking system in 2002-03, but 70 percent (Rs.181 billion) of that injection was sterilized. Resultantly, the reserve money grew by 13.5 percent instead of 44 percent had SBP not sterilized the inflow. However, despite the sterilization exercise, Pakistan’s exchange rate appreciated by 7 percent during 2001-02 and 2003-04.

Pakistan’s current account balance entered in deficit zone in 2004-05 ($1.75 billion) but widened substantially in 2005-06 ($5.6 billion) and 2006-07 ($7.5 billion). However, the deficit was more than covered by record-high capital inflows, including foreign direct investment (see IMF Article IV Consultation report, November 8, 2007). Thus, despite a relatively large current account deficit in 2005-06 and 2006-07, Pakistan’s exchange rate remained stable at around Rs.60 per US dollar owing to the massive inflow of foreign capital including foreign investment which surged to $8.4 billion and helped in adding $3.5 billion in gross official reserves in 2006-07. Hence, even with a $7.5 billion in current account deficit in 2006-07, Pakistan succeeded in adding to foreign exchange reserves. Such inflow not only helped the rupee to fluctuate within a narrow band (Rs.60.27 to Rs.60.62 per dollar) against the US dollar but the real effective exchange rate remained stable as well (see IMF Article IV Consultation report, November 8, 2007, page 6).

Besides foreign capital inflows, Pakistan’s macroeconomic fundamentals remained strong during 2002-07 with economic growth averaging almost 7.0 percent per annum, investment rate reaching all time high at 22.5 percent of GDP, large-scale manufacturing growth averaging 12.9 percent, inflation averaging 6.0 percent, budget deficit as percentage of GDP averaging 3.7 percent, public debt continuing to decline from 80 percent to 55 percent of GDP and debt servicing as percent of total revenue witnessing a decline from 51 percent to 25.4 percent. Such a performance encouraged the IMF to write in its Article IV consultation report (November 8, 2007) that “Pakistan has experienced a remarkable turnaround in its economic performance since 2001/02” (PP.4).

Thus, massive capital inflows and strong macroeconomic fundamentals were the principal reasons for the prolonged period of exchange rate stability in Pakistan during 2002-07. Weak macroeconomic indicators, relatively high inflation, surging debt burden, persistence of political instability, weak economic management, massive decline in foreign investment and other capital inflows building pressure on foreign exchange reserves, over the last four years are the principal reasons for the recent depreciation of rupee viz. US dollar.

A country can witness appreciation or stability in its exchange rate if foreign capital inflows exceed its foreign exchange requirements hence enabling it to continue to build its foreign exchange reserves. Many countries in the Asia-Pacific region including India have experienced a prolonged period of exchange rate stability, even appreciation in their exchange rates owing to strong capital inflows and strong economic fundamentals. Pakistan can once again experience stability in its exchange rate provided it brings its house in order, attracts foreign investment and other capital inflows, sustains economic growth in the range of 7-8 percent, keeps inflation at low single-digit, enforces fiscal discipline, and reduces the country’s debt burden. Capital inflows are an economic barometer, conveying useful information based on the opinion of large numbers of investors who scrutinize economic indicators. Heavy capital inflows can cause problems for developing economies like Pakistan, pushing up exchange rates.

I hope this writing will clear the misperceptions of those who believed that the exchange rate was ‘artificially’ held during 2002-07.

The author is Principal and Dean, NUST Business School, National University of Sciences and Technology, Islamabad. E-mail: ahkhan@nbs.edu.pk

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