Economic Challenges in Pakistan
The central bank of Pakistan is facing growing pressure from authorities in the twin cities to lower interest rates and appreciate the exchange rate simultaneously. However, according to economic theory, achieving these three objectives at the same time is impossible and could lead to another crisis.
The State Bank of Pakistan’s Efforts
The State Bank of Pakistan (SBP) is working to build foreign exchange reserves by buying from the market. Despite its efforts, the bank is trying to defy gravity, according to one of the most senior bankers in the country. The Pakistani rupee (PKR) has slightly appreciated against the US dollar (USD) in recent weeks, but this appreciation may not be sustainable.
Exchange Rate and Interest Rates
The PKR/USD exchange rate was 284 in March 2023 and currently stands at 282, with no depreciation in the currency over the past two years. This is mainly due to the SBP increasing the policy rate to 22 percent and maintaining positive real rates for most of the time, attracting capital to the PKR and reversing capital flight. However, as the SBP halved the rates, the demand for currency in circulation (CIC) has begun growing again at worrying levels.
Impact on Inflation and Currency
When real rates were positive, there was no incentive for companies to build inventories or for traders to hoard commodities like sugar and wheat, which helped tame inflation and stabilize the currency. However, as the SBP reduced the rates, CIC has started growing again, and foreign currency availability in the open market has almost dried up. Non-essential economic demand has started picking up, and there are signs of commodity hoarding by traders, which may lead to price spikes in the future.
Remittances and Subsidies
In the interbank market, banks manage their supply and demand for foreign exchange. Banks adopted a strategy of attracting home remittances by offering a premium, competing with each other and diverting flows from the informal market. The government subsidy allocated in FY24 was around Rs 80 billion, while banks billed around Rs 200 billion. However, despite the subsidy, banks incurred losses in the remittance business, and senior executives from several banks conveyed that they are unwilling to incur further losses.
Multiple Implied Exchange Rates
Multiple implied exchange rates exist, with banks and exchange companies offering varying rates to clients, which could exacerbate the situation. The SBP must assert its independence in managing the exchange rate and monetary policy and should not cater to pressures for currency appreciation.
Conclusion
The hard-earned stability built by buying $12–14 billion over the last eighteen months could be squandered away quickly if the central bank does not adopt the right policy measures. It is best to let market forces determine the currency’s value. If the central bank desires a stronger currency, it must keep real interest rates significantly high. The SBP should maintain clear policies and provide forward guidance to avoid a repeat of the 2022–23 crisis. The finance minister should refrain from making public comments on interest rate levels and instead focus on creating a conducive environment for lower rates through steps aimed at achieving greater fiscal consolidation.
