Objectives of this short paper are threefold. First is to briefly review the history of exchange rate management in Pakistan. Second is to assess its performance with a view to isolate the weaknesses in exchange rate management. Third is to suggest a way forward, based on removing identified shortcomings.
Brief history of exchange rate management in Pakistan
Pakistan followed a fixed exchange rate regime from August 1947 to December 1981. Pak rupee (PKR) was de jure pegged to pound sterling (GBP) till September 1971, when the peg was de jure linked to US dollar (USD). Initial parity with GBP was set at PKR 13.3507 (equivalent to PKR 3.31/USD). Parity with GBP was changed to PKR 9.2670 in July 1949, when the UK devalued GBP by 30.6%, but PKR was not devalued. Hence PKR appreciated against GBP by 44%. This started the history of keeping PKR overvalued against important currencies. This appreciated PKR/GBP parity continued till August 1955, when PKR was devalued with a new parity of 13.3391/GBP (equivalent to PKR 4.7697/USD). In November 1967, the UK again devalued GBP by 14.3%, but authorities in Pakistan again opted not to devalue. As a result, PKR again appreciated against GBP by 16.7%. PKR parity with USD remained same at 4.7697.
Soon after the failure of Bretton Woods System of Fixed Exchange Rates in August 1971, Pakistan delinked PKR from GBP and pegged it de jure with USD at the same parity of PKR 4.7697/USD to keep its fixed exchange rate regime intact, despite its international demise. In May 1972, parity was devalued to PKR 11.0078, but revalued again to PKR 9.9078 in February 1973. This parity with USD continued till December 1981. Subsequently, Pakistan adopted a managed floating regime in January 1982.
After the failure of Bretton Woods System and start of free floating of international currencies, it became almost impossible, or extremely difficult, for any country to keep following the fixed regime. Managed floating regime was adopted in Pakistan to avoid the extremes of either fixed or floating exchange rates. It was based on the idea of making timely adjustments in the exchange rate keeping in view the inflows and outflows of foreign exchange in the country. These adjustments led to exchange rate rising from PKR 9.9078 in December 1981 to PKR 44.05 in May 1998.
Events subsequent to the nuclear test made the country strong, but its currency weak, with very low reserves and inevitable freezing of resident foreign currency accounts. This difficult period was managed with a temporary dual exchange rate system, consisting of an official exchange rate fixed at PKR 46/USD and a floating rate determined through demand and supply of foreign exchange in the interbank market. Dual rates were unified in May 1999 to establish a market-based floating exchange rate regime. This de jure market-based regime is still in vogue in Pakistan.
Assessment of exchange rate regimes
In order to assess an exchange rate regime, objectives of exchange rate management need to be understood and a suitable indicator, closely connected with those objectives should be available. I presume that a good regime promotes exports in such a way that the rate of growth of exports is higher than the rate of growth of imports. I, therefore, use the simple ratio of exports to imports to track the performance of each regime. Being a ratio, it helps in using nominal values of exports and imports, without causing much distortion in this simplified approach. It should also be noted that one minus this ratio is equivalent to trade deficit to import ratio, therefore, its explicit discussion is not necessary. Whenever export-import ratio goes down, trade deficit in terms of imports widen, and vice versa.
Figure 1 reveals the performance of each regime. During the fixed exchange rate regime, export-import ratio displayed a declining trend. It declined from an average of 112.5% (trade surplus) in FY49-FY58 to 62.5% in FY72-FY81. This initial surplus in trade account was brought about mostly by higher international demand for domestic goods in the aftermath of Korean War. This surplus also concealed any negative impacts of PKR appreciation against GBP in 1949. Negative effects of PKR overvaluation, however, became visible after FY56 with an almost continuous decline in this ratio, except for FY72-73, which was preceded by a devaluation of PKR against USD.
Fixed exchange rate regime is visibly marked by two deliberate nominal appreciations of PKR against GBP. It is almost impossible to understand the economic and financial rationale behind these conscious policy moves, but they seem to have established a policy mind set of keeping PKR over valued against all odds, for most of the times, notwithstanding its impossibility. This is a dangerous approach as it leads to uncontrolled devaluations when export-import ratio declines and reserves start to deplete, subsequent to keeping PKR overvalued for lengthy periods.
Establishment of a managed floating regime was a prudent move by the Ministry of Finance under the leadership of late Mahbub ul Haq as Finance Minister. During January 1982 to June 1998, PKR depreciated, on average, by 0.75% per month. However, median of monthly depreciations was only 0.32%. This indicates reluctance to adjust properly, leading to outlier monthly changes in conditions of external sector distress (i.e., when reserves were declining). During this period, value of USD moved from PKR 9.9078 in December 1981 to PKR 46.24 in June 1998. Export-import ratio increased from 44.2% in FY82 to 85.3% in FY98. This seems to be a commendable performance (in terms of one indicator) with an addition of 2.57 percentage point, on average, each year during this period. Despite this increase, BOP came under distress many times during this period, implying that managed floating regime was not able to counter the BOP vulnerabilities.
Dual Exchange rate mechanism, introduced in July 1998, was a temporary system to manage the BOP crisis in the aftermath of freezing of foreign currency accounts. It helped in managing the difficult period, by containing the demand for foreign exchange. Unification of dual rates paved the way for market-based exchange rate regime. Under this system, exchange rate was supposed to be completely determined by the interbank market. Unfortunately, soon after its introduction, an unofficial cap (ceiling) was imposed by the SBP through selling (intervention) of reserves at the cap level. The period from July 1998 to date is marked with significant phases of ad hoc interventions to keep the exchange rate almost fixed close to cap level. Name of this regime is a misnomer, as it is far from a market-based system. This regime seems to be worse than both the earlier fixed, and managed floating regimes. Export-import ratio declined drastically during this regime from 82.5% in FY99 to 38.2 in FY18 (Figure 1). This means that the trade deficit widened from 17.5% of imports to 61.8% of imports.
Strategy of intervention by central banks is based on the idea that volatility of the exchange rate changes (i.e., standard deviation of exchange rate changes) is bad for the economy, and hence, central banks should intervene to reduce the volatility. This works if intervention is done on exceptional circumstances. If this is done on a day to day basis, it inevitably leads to depletion of reserves, which increases the exchange rate volatility. Whenever reserves depleted significantly, SBP had to forgo the cap to preserve its reserves, but sadly, it was almost always too late. It is well known that exchange rate depreciates significantly under distress. Failure to depreciate timely (at the behest of the market, or at the behest of SBP) makes the PKR appreciate, which makes the imports cheaper, leading to a decline in export-import ratio, rise in trade deficit and compulsory decline in reserves, with further exchange rate instability.
It would be too simplistic to assume that only one indicator will be sufficient to tell us which exchange rate regime promotes sustainable movements in export-import ratio and trade deficit-import ratio. Therefore, another simple indicator, which is the ratio of central bank foreign exchange reserves to its base money (reserve money), is also used to assess the sustainability, in terms of availability of foreign exchange in the economy to finance imports and other foreign exchange commitments. When foreign exchange reserves of SBP are rising in terms of its base money, it means the money creation in the economy is also accompanied by increasing availability of foreign exchange. When this ratio is declining, the money supply in the economy is still rising, but the availability of foreign exchange is declining. In other words, the macroeconomic policies are not helping generate sufficient foreign exchange resources in the economy. This can happen either when export-import ratio is rising or falling.
Foreign exchange reserves to base money ratio tells us to what extent the central bank base money is backed by foreign exchange reserves. Rapidly falling values of this ratio indicate extreme stress on balance of payments, which require immediate remedial measures on many fronts. A rising ratio indicates increasing strength of BOP brought about largely by a credible exchange rate regime. What is also obvious is the fact that borrowed reserves temporarily increase this ratio, but can not necessarily make it rise sustainably. Continued increase in exports (with an increasing export-import ratio, together with a non-falling reserves-base money ratio) is the best way to make trade deficit sustainable. Remittances, while not creating any future repayment liabilities, are not as good as export receipts. This seems paradoxical, but the reason is simple. Rise in remittances tend to make the exports uncompetitive by exerting appreciating pressure on PKR. Through this channel, remittances also tend to promote imports at the expense of exports. This phenomenon is known as Dutch Disease. Therefore, exchange rate management needs to compensate for this factor as well to keep the PKR competitive. Foreign direct investments (FDI), of course help, but these also create future repayment liabilities for dividends and profits (to be paid to foreign investors in foreign exchange).
In light of above discussion, it is important to supplement our assessment by gauging the performance of the ratio between foreign exchange reserves of SBP and its base money. Figure 2 presents the monthly trends in two regimes of managed floating and allegedly market-based system. Managed floating regime was implemented in a manner that exacerbated the financing problem, reflected in a continuous declining trend of SBP reserves to its base money. Most of the rises in this ratio came through borrowed reserves under various IMF programs. Despite these, the government was not able to make BOP sustainable under the managed floating regime.
Figure 2 shows that the allegedly market-based regime has done worse than managed floating. Both export-import ratio and reserves to base money ratios declined in this regime, with a couple of very short episodes of rises with borrowing from IMF. The ratio of SBP foreign exchange reserves to base money ratio is an indicator which captures various macroeconomic, BOP, and fiscal stresses emerging in the economy. Fall in this ratio usually proves very costly to the economy at large, as is apparent in Figure 2. Hence, the exchange rate management in Pakistan (with very high import-export and trade-deficit import ratios), is of paramount importance to keep the PKR competitive for most of the times by making it flexible.
Given a historic mindset of keeping the PKR overvalued, making the PKR flexible seems like an uphill task. However, it is by no means impossible. How much flexibility do we need in PKR on a medium to long-term basis? With the fear of floating, everybody eschews to even ask this question (especially the politicians).
The illusion that a stronger domestic currency makes a country strong is hard to dispel from everybody's mind. Reality is just the opposite for developing countries. A weaker currency helps make a country grow sustainably, by inducing economic agents to invest in export production and dampening import growth.
What sizes of depreciations, say year to year, are needed in our economy to make our BOP sustainable? Let us look at the relationship buried in a simple scatter plot of 442 monthly observations (January 1982-October 2018) between YoY percentage depreciations, and YoY percentage changes in export-import ratios, presented in Figure 3. Trend line of this scatter shows that YoY percentage depreciations higher than 6% help in increasing export-import ratio. An 8% YoY depreciation is associated with a 0.32% YoY increase in export-import ratio. Slightly larger depreciations are associated with much larger additions in export-import ratio. However, depreciations smaller than 6% YoY are not sufficient to increase export-import ratio. Smaller depreciations are associated with declines in export-import ratio. Exchange rate fixation and appreciations are associated with larger and increasing declines in export-import ratio.
Important point here is not necessarily the reliability of these estimates. Better estimates can, of course, be obtained from a sophisticated econometric exercise. However, this simple scatter plot shows that policy makers can always estimate an appropriate level of adjustment, and implement it, at any given point of time. What matters most are the adjustments made when reserves are stable, so that accumulation of reserves and increase in export-import ratio becomes the norm. If adjustments are not made in relatively good times, stress begins to emerge, which becomes larger and larger with the passage of times. This also creates an illusion that depreciations do not help by looking at only those depreciations which resulted in times of distress.
The way forward
In our simple assessment, the allegedly market-based exchange rate regime was found to be far removed from market mechanism. It has decreased export-import ratio significantly and caused the SBP foreign reserves to deplete and borrow externally to stabilize the exchange rate. It is also important to understand that in times of distress, immediate remedies lie in buildup of reserves through a combination of various steps, including external borrowing, restraints on domestic borrowing, and myriad of other adjustments under a reform package. Once the economy is stabilized and reserves are built up, exchange rate management should not be tempered with unofficial or official caps. It should focus more on buying foreign exchange in normal times.
The most important element of exchange rate regime is the trust accorded to the managers by economic agents including the government. The government can decide on the type of regime to be followed by SBP. Once it is decided that a market-based regime is to be implemented by the SBP, then it should also be accorded independence in implementing it. In fact, this is already a part of Foreign Exchange Regulation Act, 1947. Clause 2 of section 4 of this law states that, "Except as may otherwise be directed by the State Bank, authorized dealers, authorized money changers and exchange companies shall be free to determine exchange rates for conversion of Pakistan currency into any foreign currency or any foreign currency into Pakistan currency."
Above legislation clearly wants SBP to implement a true market-based exchange rate system. Language of the law empowers SBP to give directions on exchange rate on exceptional basis. This law does not empower any entity other than SBP to give directions on exchange rate. This seems to be the spirit of this clause. However, exceptions became the rule in SBP, through the interference of Ministry of Finance, which displayed a historic fixation on overvaluation of PKR to the detriment of balance of payments.
A crucial weakness of current exchange rate regime is that the Monetary Policy Committee of SBP is not responsible for supervising it. MPC is reluctant to take on this responsibility because of the weakness in powers and functions granted to it in SBP Act, 1956. According to clause (a) of section 9E of SBP Act, powers of MPC are defined as "formulate support and recommend the monetary policy, including as appropriate, decisions related to intermediate monetary objectives, key interest rates and the supply of reserves in Pakistan and make regulation for their implementation."
Monetary policy, within a central bank always encompasses both interest rate and exchange rate policies. However, MPC of SBP is responsible for managing "key interest rates", but not the exchange rate. Monetary Policy Committee should, therefore, be empowered to supervise the exchange rate regime through a suitable amendment in SBP Act. MPC should review the performance of exchange rate trends as intensively as it does for monetary aggregates and other macroeconomic variables. While this is indeed done in every meeting, but MPC finds itself helpless in conveying its wisdom about the direction of exchange rate, given the weakness in SBP Act.
MPC has competent and credible members. Once it is given this responsibility, government should also accord its trust to MPC about exchange rate directions. Government has already demonstrated its trust on MPC regarding interest rate settings, which are being done independently by MPC, since its constitution in 2015.
I conclude by quoting a sentence from Allama Shaikh Muhammad Iqbal's book "Ilm ul Iqtisad", written in Urdu, and published in 1904:
"...the same first principle of determination of value seems to be correct, i.e., the value of exchange rate is also determined in view of demand and supply of goods between nations."
It is time we apply Iqbal's wisdom in reforming our exchange rate management regime to realize his dream of making Pakistan a strong as well as a prosperous country.
(The writer is former Deputy Governor, State Bank of Pakistan)