The article was published in the "Money Matters" on August 26, 2013
There are some possible solutions to stabilise exchange rate. First and foremost is the exchange rate forecast. Different fundamentals are considered to forecast it in the short, medium and long run. The demand and supply of foreign exchange reserves in Pakistan is the most vital determinant, which determines the value of exchange rate in the short run. Another key variable is the interest rate that helps to forecast exchange rate through two channels: impact through change in money supply in the long run and impact through change in capital inflows or outflows.
The possibility of the former channel is more likely to affect the country’s exchange rate in the long run. As there are capital controls in Pakistan; the latter channel may not be feasible in studying movements in the exchange rate. However, if expectations of price changes are included due to changes in money supply then interest rate might be a suitable determinant of exchange rate in the short run.
The relative price (difference between price in home and foreign country) is another important determinant of exchange rate. Technically, it is known as Purchasing Power Parity (PPP). If the exchange rate is adjusted according to changes in relative prices, the PPP holds.
However, due to State Bank of Pakistan (SBP) interventions, delayed response of price increase and speculators creating excess demand and supply of foreign exchange in the market to manipulate movements in the exchange rate, it is not receptive to price changes in the short run. But change in relative prices is an effective determinant of exchange rate in the long run.
In the wake of a balance of payments deficit, it is difficult to control exchange rate depreciation. Nevertheless, the country can do away with the need to borrow if it liberalises its capital account and the current account is financed by foreign direct investment and foreign portfolio investment, along with remittances (part of current account balance). Consequently, external debt will decline.
Due to increase in forex reserves, the exchange rate will be artificially controlled by foreign exchange injections in the market. Can this policy be supported? Judging from the Indian and South East Asian experience, it is a definite yes but with several reforms. A rule-based policy is needed to avoid time inconsistency. Further, the fiscal deficit should be reduced to decline the overall public debt as well as debt servicing.
Operational independence of the SBP is a key prerequisite to stabilise the exchange rate. The government should refrain from any policy intervention. For instance, the SBP should ask to maintain exchange rate within a certain band with specific interventions in the market. Similarly, targets should be set according to expected changes in prices in a particular year, expected trade balance and expected changes in forex reserves position. This would help boost the confidence of domestic as well as foreign investors. This policy would not favour rent seekers.
Monetary stability is necessary to reduce inflation and maintain exchange rate stability. However, this is not possible in the presence of a huge fiscal deficit as the government seeks funds from the central bank or scheduled banks with regular intervals. This causes inflation in the economy, thus contributing to exchange rate depreciation in the long run. In the short run, it overvalues the real exchange rate and makes exports expensive globally. Ultimately, this causes a decline in exports and trade balance, which has a directly impact on exchange rate.
Despite mitigating the current account deficit, remittances are still not among the most favoured policies to curb the deficit. Exports and imports are the two main components of current account. A cut down in imports resolves the problem but what kind of imports and how is the main question of concern? Reducing imports of capital and intermediate goods is not beneficial for the production sector. On the other hand, the end consumer is worse off if imports of consumerable items are reduced.
Another option is to increase exports by increasing production, discovering new potential markets and signing preferential and/or free trade agreements. Is this possible? For the last many years, several export-oriented policies have been adopted. Have those policies, by any means, had a positive impact on the trade balance. The answer to this is a no, as is evident from the situation of trade balance.
In conclusion, there is a fundamental solution to all the problems and that is the growth of the economy. For growth, exchange rate stability is not required. Slight volatility may help the economy to grow faster but higher volatility may dampen growth. Volatility is not the major issue in Pakistan.
Investment – private domestic investment or foreign investment – is required for growth. Reforms are needed to attract investors to the country. The framework of economic growth (FEG) is among the better policy options for the government to move on to the path of growth.
However, researchers have criticised the FEG as no timeframe has been provided in the document. Further, it will probably take 30 to 50 years to implement the FEG’s policies.
Hence, there is a need for short term policy measures to overcome the anomalies in the path of long run growth.
Finally, a few research questions that will further increase the understanding of exchange rate economics of Pakistan: do we need to control exchange rate? What if we have free float exchange rate systems with limited SBP interventions or no interventions at all? As volatility is not a problem for the economy, can we handle the trivial volatility patches in exchange rate? The writer is a research economist at PIDE- See more at: http://magazine.thenews.com.pk/mag/moneymatter_detail.asp?id=6001&magId=10&catId=76#sthash.fpBEahUR.dpuf