Spearhead Analysis – 12.12.2017

By Farrukh Karamat
Senior Research Coordinator, Spearhead Research

In early July 2017 the financial markets in Pakistan witnessed a sudden and unexpected 3.1% decline in the value of the Rupee against the US dollar, leading to somewhat of a panic situation in the market, and sparking a shortage as dealers opted to hold the currency rather than sell. The dollar rose to Rs.108.50 against the Rupee, before settling at a level of Rs.108.25 by close of trading hours. This was the largest single drop in the value of the Rupee against the dollar in a nine-year period.

In the immediate aftermath rumours and conspiracy theories surfaced about what had triggered the decline, as individuals and institutions started coming up with alternative scenarios. The Central bank stated that this was a controlled devaluation, which had become necessary due to the rising external account deficit. As per the State bank of Pakistan (SBP), “The exchange rate adjusted in the market and ….. this depreciation in the exchange rate will address the emerging imbalance in the external account and strengthen the growth prospects of the country …… the current exchange rate is broadly aligned with the economic fundamentals.”

The move drew a conflicting reaction from the Finance Ministry, which stated that this was an “artificial” decline which had “negatively affected … foreign exchange markets”. As per the then Finance Minister one explanation was that the ongoing politically uncertain situation in the country had led to the decline. This was later changed to a communication gap, which led to the fall in the Rupee value. The Minister categorically stated that the market finds its own value and there is no need for intervention, contrary to his own claim and actions which had maintained the level of the Rupee within pre-determined bounds over the last four years.

This was, however, not an isolated event. It was planned and there was more to come. Perhaps this was the start of a rift between the SBP and the Finance Ministry. Leading Economists, Academics and Professionals had also been writing for some time about the imminent decline of the Rupee in view of the unsustainable fiscal deficits.

Since that fateful July ‘adjustment’ the trade deficit has increased by 29% to a level of US$15.03 Billion in the first five months of FY2017-18 as per Pakistan Bureau of Statistics (PBS). In November it was up by 19.5% on a YoY basis and the Government has been unable to arrest the declining trend through measures such as increased regulatory duties.

Imports are up 21.12% to US$24.06 Billion in the period July-November FY2017-18 over the same period last year. The country continues to rely on imports for petroleum, LNG, food and capital products, which are unlikely to decline in the wake of devaluation as there are limited local substitutes available.

Exports rose by 10.49% till November of FY2017-18 to US$9.03 Billion compared to the same period last year. It remains to be seen whether devaluation would increase exports long term or would it be just a fleeting blip.

Come December 2017, the political and economic landscape has changed dramatically. A Prime Minister has been sent home and is facing a trial over corruption allegations, the Finance Minister has been removed and the country is operating without a regular Finance Minister. The Law Minister has been forced to resign under pressure from the right-wing religious parties and there could be more political casualties in the wake of the Model Town report being made public. The political rhetoric continues to decline, not just from the ruling PML-N, but also from the other mainstream political parties.

Amid all this the Government after a meeting on the economy with the International Monetary Fund (IMF) has taken a policy decision to devalue the Rupee, and to let the currency exchange rate adjust to market conditions. IMF has been expressing concerns over the health of Pakistan’s external sector and it is believed that the currency adjustment would help shift foreign currency holdings from commercial banks towards reserves and divert remittances to official channels with a reduced gap between the interbank and open market rates.

A clean chit on economic health from the IMF is important for Pakistan and the country continues to remain under the IMF’s post-programme monitoring (PPM) until about 2023 for borrowing significantly higher than its quota. It seems that all the predictions about the devaluation of the Rupee and the possibility of Pakistan approaching the IMF again in 2018 could be materializing. It is unfortunate that relatively shallow reforms have been carried out, which have not helped improve the structural weaknesses in the economy and here we are again looking towards devaluation as a solution for what ails the Pakistan economy.

With the policy decision on devaluation the dollar has been trading within a range of Rs.108.40-50, higher than the Rs.107 benchmark provided by SBP under a devaluation termed as a “market-driven adjustment”. With uncertainty over the level of devaluation there is a trend towards dollarization as people hold or hoard the US currency for short-term potential gains.

The All Pakistan Textile Mills Association (APTMA) has been quick to endorse the devaluation route as a means for exports ‘becoming competitive’. In the short term there may be a price advantage, but the fundamental issues around being uncompetitive persist. The 2017-18 Global Competitiveness Report, which compared 137 countries, ranked Pakistan at 115th – 22 places from the bottom. Also, past devaluations have not really helped the long-term growth in exports as the country has reverted time and again to low export growth or decline after a period of devaluation. As in the past the Government kept insisting till the very last moment that there would be no devaluation, and within days the scenario has changed as the Rupee continues to fall while finding its ‘market-driven’ value.

The IMF had earlier hinted that measures such as the imposition of Regulatory duties on Imports would not provide the required results, similarly it has been witnessed in the past that devaluation does not really resolve issues. It takes much more than devaluation to restrict imports and increase exports. What devaluation will do is reduce purchasing power parity, raise inflationary pressures and increase the debt per capita. The imports are not likely to be curtailed and the exports are not going to double, neither are inward workers’ remittances; and with Pakistan holding a high level of external debt, the ramifications of devaluation are considerable. For an import-based country like Pakistan devaluation could actually raise the specter of inflation and higher financial burden, in the absence of real structural reforms for revenue enhancement. The price impact of food imports (Imports of US$5.4 Billion in 2016-17) and petroleum products will translate into higher costs not just for imports but also for exportable products.

Devaluation is a necessity given the misguided policies of the Government and the resultant deficits that the country faces. The fact that the Government had been holding back the gradual market driven depreciation of the Rupee over the past four years, might actually result in a huge devaluation, unless the Rupee is being allowed to slide to a certain level and once again an intervention would maintain that level. There is a need to come clean on the objectives of devaluation, as another knee-jerk reaction for achieving partial objectives through managed adjustment will not serve the purpose and not infuse the required confidence in the economy.