Thursday, 20 March 2014

Dar’s Exchange Rate Equilibrium

Article was published in "Money Matters" on March 24, 2014
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March has made history in the literature of exchange rates in Pakistan. I am calling it a historic event since no one expected this to happen with meager foreign exchange reserves, low foreign direct investment, negative trade as well as current account balance and lower GDP growth. While analyzing the data researchers will consider it an outlier.

Writers are trying to explain the behaviour of the exchange rate in numerous ways. Every explanation mentions the $1.5 billion grant or ‘gift’ from two friendly countries. The Coalition Support Fund payments, privatisation, IMF loans and MoUs signed are other major factors which, according to different authors, are the main contributors to the exchange rate appreciation. I tried to relate the appreciation of rupee by seven percent within less than seven working days with the above mentioned fundamentals but failed to relate any variable or combination of these factors, which could explain the meteoric appreciation of the rupee. On the other hand, we also know that our trade balance is negative and the current account has reached $2 billion in eight months, putting pressure on the exchange rate.

In my last article I tried to explain how different variables can affect the exchange rate and what would be the impact of forced exchange rate appreciation. If it is a temporary appreciation, exporters will bear a potential loss for a short period and importers will enjoy paying lower prices for a short period. Further, it is also expected that a temporary appreciation in the exchange rate will eventually result in massive depreciation in the coming weeks. It was also expected that moneychangers (dealers of foreign currency in the open market), assisted by the government creating chaos in the market, will eventually benefit moneychangers when the currency depreciates in the next few weeks. Nevertheless, this does not seem to be the case.

Before I explain further let’s look at the graph below and try to analyse it. It is taken from the central bank’s website which provides “Exchange Rates for Mark to Market Revaluation by Authorized Dealers in Foreign Exchange”. The value of the exchange rate is below Rs98/$ on March 20 2014 and according to the forecast it is slightly increasing above Rs100/$ in the next six months. What does it tell us?

It tells us to take the finance minister seriously. When he said that he would bring down the exchange rate to Rs98/$, no one bought it including me and several other writers/researchers /authors. Moreover, they argued, the exchange rate is artificially controlled by intervention in the market and thus it would not depreciate in a few weeks to Rs.106/$ or Rs.109/$.

Million-dollar question:  How did the value of the exchange rate come down so swiftly in less than seven working days? The answer to me is very simple. They just pulled it down. How?

Finance Minister Ishaq Dar believed and repeatedly said that our exchange rate is depreciating due to speculations and it is not a true equilibrium value of exchange rate. He supposed that Rs.98/$ is the true equilibrium value of the exchange rate. But one may ask that if he wanted to set it at his desired level then he may have announced it. Why did it take 7 days to come to Rs.98/$. The answer is simple once again. It looks more professional this way.

However, one needs to take two agents into confidence before doing this kind of exercise, i.e., SBP and authorised big moneychangers. Were they informed? Did they get the guidelines from the finance on how to pull the exchange rate down? Did the government bailout big moneychangers to overcome their loss?

The bottom line of the story is that Rs98/$ is the new equilibrium exchange rate. Irrespective of whether it is an overvalued exchange rate and exporters will face losses, every exporter will need to set their prices considering the new exchange rate. The exchange rate will probably move around the par value of Rs.98/$ and depreciate little in the next few weeks. SBP will control it by using by direct forex interventions. We can call the current drop the regime shift in the history of exchange rates in Pakistan.
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