July 5 was a turbulent day for the Pakistani rupee, which rupee depreciated against the dollar by 3.2 percent and traded at Rs108.25 to a dollar. The news came as a surprise and was immediately associated with political happenings of the day.
Later, it was confirmed that the State Bank of Pakistan’s policy of no intervention was responsible for the fall. Though a step in the right direction, it created a stir and an impulsive response from government circles. At the time of penning these thoughts, a lifeline has been provided by the minister of finance and the rupee has almost been restored to its pre-July 5 position and is trading at around Rs105 to a dollar.
However, this restoration has showcased the fractured approach towards implementing monetary policy in the country. First, it has been confirmed that the rupee is essentially weaker than its present value. Whenever the market is left to work, it will fall down. And there is a strong likelihood that the fall will be steep. The more it is stopped through artificial means, the more the policy will be distorted, thereby increasing the odds for a steeper dip.
Second, the reaction from the finance ministry and its effectiveness in terms of re-appreciating the rupee to its pre-July position in less than 24 hours not only highlights the extent to which the government is obsessed with strengthening the rupee but also shows how it can control a dirty float.
However, the most important concern is the independence of the SBP, which was explicitly compromised through such a response. Who is the custodian of the exchange rate policy? And who is responsible for implementing monetary policy? It is always the central bank. A serious question that arises in this context is: who has the right to control commercial banks? The response to this one-day dip in the rupee can be seen to have challenged the SBP’s independence. It was an explicit show of fiscal dominance with a clear message that central bank independence is not going to go down well in Pakistan.
The finance minister immediately summoned a meeting of the presidents of all banks. This meeting was convened to question how the exchange rate policy of the SBP was being implemented. The present law empowers the SBP to carry out the exchange rate policy independently. It is also worth noting that the then governor of SBP was not invited to this meeting.
The hurried attempts to appoint an ex-finance secretary as the new governor reflect the strong intentions to strengthen the rupee. But they can also call into question the autonomy of the central bank, whose role seems to have been assumed by the ministry instead. Exchange rate management, in particular, seems to have been virtually mandated to the finance ministry. This is in violation of the SBP Act 1956 (amended in 1997) which grants autonomy to the SBP.
If data from the SBP serves as a guide, the real effective exchange rate (REER) – the nominal exchange rate adjusted for difference of prices in trading partners – for the Pakistani rupee has appreciated by more than 25 percent in the last four or five years. More alarmingly, it has appreciated by 22 percent since June 2013.
India, Bangladesh and Sri Lanka have improved their international price competitiveness while Pakistan is losing it. Since 2013, the REER of India, Bangladesh and Sri Lanka has depreciated by 18.8 percent, 21.4 percent and 11.58 percent, respectively. The result is the decline of Pakistani exports and an ever-high trade deficit. It is interesting to note that currencies of other countries – including Malaysia, Indonesia, and India – have been devalued by 47 percent, 38 percent and 30 percent, respectively, since 2013.
The overvalued rupee – which makes exports costly for others – has resulted in a decline of 20 percent in exports (in dollar terms) over the last three years while imports went up as we can buy more with less money. Pakistan’s trade deficit was swollen by 38.8 percent to an all-time high $23.385 billion during the first nine months of the current financial year.
The government’s quest to strengthen the rupee strong seems to be motivated by the 2018 election. A fall in the rupee might indicate bad economic performance.
The show of fiscal dominance highlights that the SBP will need to ponder over its capacity to implement decisions independently and regain credibility in the midst of this tug of war. Regaining lost credibility can take years and further jeopardise the already weak implementation of monetary policy. The short-run fiscal policy horizon – which focuses more on political gains – once again takes over the costs of a bad policy. The grandeur of a strong rupee seems to have continued and the government is committed to strengthen the rupee till the elections.
Monetary policy and the exchange rate remain beyond the control of the SBP – at least for some time. The involvement of government actors in the SBP’s affairs must be reviewed and rethought as it could have huge implications for the country. The responsible authorities need to act now and introduce proper legislation to ensure the de-facto independence of the SBP.
The writer is a research fellow and heads the Policy Solutions Lab at the Sustainable Development Policy Institute (SDPI).