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October 11, 2018

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De facto dollarisation: an economic disaster in disguise

LAHORE: Whenever uncertainty hits rupee, local commercial enterprises lose faith in the national legal tender and start using greenback as benchmark in their business deals, pushing the country towards de facto dollarisation of economy, which might turn out to be a devil’s bargain down the line.

This trend is in line with what entrepreneurs in other troubled economies have been doing for decades. For instance despite US trade restrictions, the informal economy in Cuba primarily relies on the US dollar.

A devaluation of over seven percent is likely to further blow up the inflation rate that may go rogue if the government exercised its option to print banknotes and the central bank waited for the scheduled announcement of next monetary policy.

The fifth devaluation since December, took the rupee losses to about 26 percent, had been expected and seen as a prerequisite for another bailout package. Currently among all other problems faced by the economy, shortage of dollars is the most serious one.

The current account deficit widened 43 percent to $18 billion in the year that ended June 30, while the fiscal deficit ballooned to 6.6 percent. Foreign currency reserves dropped in late September to $8.4 billion, covering less than two months’ imports.

In such cases the banks immediately increase the interest rates to contain expected inflation. High inflation rates result in a more unstable investment climate and a lower rate of economic growth. All creditable global institutions have already downgraded the growth forecast for this fiscal.

Individuals who bring their goods and services to the international marketplace are unfairly punished and rightfully discouraged when currency movements turn legitimate profits into foreign exchange losses. They then look for ways to protect their interests by converting to a stable and reliable international currency.

Unofficial dollarisation at a lower level has in fact existed in the country since the nineties. Many elite schools charge their monthly tuition fee in dollars. The salaries of a number of employees in big corporate sector are pegged to dollar.

The agreements signed with the independent power producers during 1993-1996 were in US cents/unit instead of rupee. The same practice is being followed by all foreign investors that come to Pakistan on sovereign guarantee of the government of Pakistan. This activity has protected them from all types of economic problems in Pakistan. Only the domestic industry suffers.

According to International Monetary Fund (IMF), dollarisation can take multiple forms. Official or de jure (by law) dollarisation occurs when the US currency is adopted as the predominant or exclusive legal tender.

Partial or de facto dollarisation happens when the local currency remains the exclusive legal tender but financial and payment-related transactions are allowed to be dollar-denominated, effectively allowing a bi-currency system to take hold. This de facto dollarisation has sped up in Pakistan during the past one decade.

This de facto dollarization has speeded up in Pakistan during past on decade. Dollar that was worth Rs62 in early 2008 has more than doubled to Rs134 now.

It is useful, in turn, to distinguish between ‘payments dollarisation’ (the use of foreign currency for transaction purposes), financial dollarisation (residents’ holding of financial assets or liabilities in foreign currency), and real dollarisation (the indexing, formally or de facto, of local prices and wages to the dollar).

Some manufacturers, particularly the multinationals are seriously debating on the option of fixing the rates of products in US dollars to bring stability in prices and cushion themselves from ever increasing inflation and volatility of Pakistani currency.

Every time rupee devalues, the foreign investors suffer badly from it because they are forced to remit fewer dollars on their profits back home.

It is highly unlikely that Pakistan would go for de jure dollarisation of its economy because of some substantial drawbacks in adopting a foreign currency.

This would deny the government the option to print its own money, thereby depriving the state of its ability to directly influence its economy, including its right to administer monetary policy and any form of foreign exchange regime.

Moreover the central bank would lose its ability to collect ‘seigniorage’ that is the profit gained from issuing coins and printing notes (the minting and printing of monies costs less than the actual value of the notes or coins). The de facto dollarisation would however continue or even accelerate if economy is not put on right track with transparent and prudent policies.

According to a research paper, when the organizational capability of the government to enforce the laws (financial contracts in particular) is limited, an economy is more likely to suffer from both high (cash) dollarisation and the low level of financial development. Furthermore de facto dollarisation in the face of ballooning twin deficits and an poor macroeconomic conditions would prove to be an economic disaster in disguise.

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