The Impact Of The Free-falling Rupee

The Impact Of The Free-falling Rupee
Pakistan has made key progress in reviving the stalled IMF programme as a state level agreement has finally been reached. However, the programme will only resume once approval is sought by the Fund’s Executive Board which could take several weeks. Once approval is secured the revival of the bailout is expected to help stabilise the economy and mitigate the risk of a sovereign default.

Currently, Pakistan continues to grapple with the economic crisis which Imran Khan's opponents, now in government, accused him of failing to manage. As of end-June State Bank’s foreign exchange reserves stood at USD 9.8 billion, barely adequate to cover five weeks’ worth of imports. The most significant development has been the fall of the Pakistani rupee to a historic low against the US dollar.

This is despite the coalition government already having taken some very difficult and politically damaging economic decisions including the removal of fuel subsidies, phasing in a petroleum and the imposition of other one-time taxes on industries and the rich.

However, the fresh prospect of a change in government in Punjab and center - following the results of the by-polls on the province’s 20 seats - has brought in uncertainty in the financial markets. Thus, one cannot deny that in the face of continued political and economic uncertainty Pakistan’s economy remains on the brink of a financial crisis, with foreign exchange reserves drying up fast and the Pakistani rupee at record low against the US dollar.

After a brief recovery following the staff level agreement with IMF last week, the rupee closed at 224 to a dollar last Tuesday during interbank trade, shattering all previous records. This was highest day-on-day depreciation since June 2019 where the dollar rose in one day by Rs 6.80. This is mainly attributed to panic buying of the dollar essentially by banks in the inter-bank market. A massive capital flight is expected as stock market plummets and Pakistan’s credit ratings take a nosedive. The rupee may remain under pressure until foreign inflows under various commitments start reaching the country.

When the dollar goes up so drastically, it shakes the very foundations of what holds the economy together. It fuels further inflation, already having reached double-digits and the highest in 14 years, makes debt re-servicing more expensive and further eats into the nation’s foreign reserves as even essential imports become expensive.

A key thing to note is that the dollar is getting stronger against all currencies in the global market and Pakistan is no exception. The second thing to acknowledge is that the exchange rate is a symptom of a disease that needs to be cured not managed.
To resolve the foreign exchange crisis, the government needs to have a long-term approach that focuses on structural changes and not just make-shift ad-hoc measures

The most important realisation should be that there is little room for quick-fix solutions to structural problems. To resolve the foreign exchange crisis, the government needs to have a long-term approach that focuses on structural changes and not just make-shift ad-hoc measures such as raising discount rates, imposing one-time taxes, or curtailing imports. Bolstering the exchange rate through exchange and import controls serves only to disrupt supply chains and eventually weaken the domestic economy. At best it is a short-run painful solution.

A more sustainable approach requires we pay close attention to what is putting a pressure on our exchange rate. A few things stand out:

  1. Whatever feeble strength of the rupee there is today, just hangs on by a thread - remittances. They touched a record high of USD 31.2 billion in FY22. While exports also surged in FY22 by 25%, it is mostly a reflection of post-covid recovery and declining export competitiveness remains a key factor behind Pakistan’s persistent trade imbalance.

  2. The demand for the dollar is also going up. Pakistan is using up its foreign exchange reserves more quickly than previously anticipated because prices of foreign goods are going up – owing to the global financial crunch, Ukraine -Russian war and volatility in the oil market. Pakistan is heavily dependent on imported fuel and cooking oil, but also on machinery and food grains from overseas.

  3. Risk to food security is also increasing. A more expensive dollar makes fuel more expensive, and quickly impact the prices of daily essentials. Given that an average Pakistani spends more than 40% of their income on food, inflation makes significant chunks of the population marginalised and vulnerable.

  4. At this point even though the central bank is desperate to stabilise the exchange rate, it is choosing not to intervene to let market forces determine the exchange rates. However, another reason for not intervening are the low forex reserves that give central bank no leeway. Instead the State Bank of Pakistan (SBP) is checking outflows of dollars to avoid a further reduction in reserves and has decided to continue with the ban on imports.

  5. In Pakistan imports exceed exports. To preserve foreign currency, an early measure taken by the newly appointed government was to ban many types of imported goods deemed non-essential luxury items. This has impacted industries which are running out of raw materials and facing serious supply constraints.

  6. Moreover, we also tend to stick to the old ways of doing things. That is borrowing extensively from friendly countries. The exchange rate was recently bolstered by Chinese bank lending but that did not last long as the fundamentals remain weak.

One thing is for sure which political instability will always put economic reforms at the backseat and encourage speculative behaviour especially with regards to the IMF program. On top of that, even after two months of being in power, amidst unprecedented macro-economic instability and lifeline negotiations with the IMF, the government has still not been able to assign a governor for its central bank. The political leadership is providing no economic guidance but instead engaging in a blame game.

Hina Shaikh is the Country Economist at the International Centre for Growth (ICG), Pakistan Office.