The Dollar: Buy, sell or hoard?

For any new government in Pakistan that comes to power, either through force or through a constitutionally mandated process, there is a reboot period where almost all teething problems can be blamed on its predecessor. Perhaps the area where this excuse is used the most is the economy. This period ends within two years, which is when there is enough stability in the system that the new setup can start weaning off the ‘it’s their fault’ mantra. PTI’s reboot is taking longer to end because that stability in the system that should have come around by now has not, inflation and unemployment has the general public up in arms and mostly because of the lack of direction in an economic team that is overflowing with massive egos of multiple players who can’t seem to effectively work together. The coronavirus pandemic has exacerbated the situation and will eventually completely erode the progress that has been made.

In the midst of all the chaotic politics, response to Covid-19 and all the bad press associated with it there seems to be one economic policy that was working; the FX policy. The dollar is no longer being discussed as it was at the start of PTI’s government. Rupee depreciation makes better headlines, especially if it’s aggressive, which it was in PTI’s case. Currency appreciation, which has also taken place recently, is boring and lack of volatility in the market even more so.

In this story, Profit will explain the flaws with the old FX policy and the damage it inflicted, what measures the PTI took to control the market and keep it relatively stable and where the USD/PKR parity is headed in the short to medium term.

Dar-ism

In June of 2013 the PML-N took over from the PPP. The rupee was hovering at a level of 98.50 on the back of a total liquid foreign exchange (FX) reserves- net reserves with SBP plus net reserves with banks-figure of approximately $10.28 billion; not great, not terrible. By December, USD/PKR steadily depreciated to peak at 108.20 in December. Although a $6 billion IMF EFF (Extended Fund Facility) had been finalized in September, it would take some time for the first tranche to be released. FX reserves were still bleeding, dropping to a dangerously low $7.98 billion in January 14’; there was desperation for dollars.

That much needed FX reserves support kicked in during the first quarter of 2014 enabling Finance Minister Ishaq Dar to set out on his ill-conceived quest to overvalue the Rupee against the dollar to stupendous levels, using borrowed IMF dollars to maintain excess liquidity in the interbank and open markets. By March 14’ the rupee was at 104.90, by June it was 98.80 only to settle at a more maintainable 100.50-100.80 by December. FX reserves continued to climb to reach $15.26 billion as IMF and other bilateral donors kept the tap open.

By August 15’ however it started to become clear that the underlying pressures resulting from an unsustainable exchange rate policy had started to penetrate the surface, with the exchange rate jumping to 104.30 in a matter of days; the first of many upward spikes. Apart from a patch of volatility in December, the 104 ‘big-figure’ was maintained throughout 2016 and up till June 2017. By this time the 3-year IMF package had also expired. In October 16’ FX reserves reached their highest level at $23 billion with two more years of PML-N’s tenure to go. Dar was adamant to continue pumping dollars into the market all the while piling on supply side pressure and reversing the trajectory of FX reserves.

On 5th July 2017, an intraday spike of Rs4/dollar depreciation exposed more fault lines. On July 28th Nawaz Sharif was disqualified by the SC in the Panama Papers case. A new level of 105.00 – 105.50 was maintained until the start of December 17’ when it jumped to 110.60 within two days; by this time reserves had depleted to $19.5 billion. The PML-N government’s exchange rate policy had finally reached a point where market forces could no longer be controlled from Jati Umrah’s drawing room. By March 18’ USD/PKR reached 115.00 by June 18’ it was 121.40. And these were by no means incremental changes; they were massive spikes that neither the market nor the central bank and definitely not Dar had the capacity to correct.

Another major factor in all this was the very public spat between Dar and the SBP’s top management of the time. As finance minister, he had taken over the central bank’s policy making, even announcing the monetary policy statement at times, before the SBP governor had a chance to do so as was his prerogative. This was despite an IMF condition to make the central bank autonomous.

These spikes were a result of a central bank unwilling to accept the finance minister’s instructions any longer and letting market forces play out rather than injecting already scarce liquidity into the currency market. The 16th of July 18’, for example, was particularly brutal, with the Rupee closing at 121.55 on Friday and opening at 128.00 on Monday, a Rs. 6.5 fall over a weekend. This level continued for the next seven days, only to start gradually correcting itself, settling at around 124 by election time. 

All told, Dar’s interference in FX policy, something that he should have had nothing to with in the first place, left the incoming PTI government with the USD/PKR at 123.90, FX reserves at $16.39 billion and a current account deficit at an eye-watering 5.7% of GDP.

Khan makes some changes

PTI’s FX policy has more sanity than Dar’s but because it initially involved rapid depreciation, it was widely unpopular. This was compounded by the fact that a major expectation from Imran Khan’s economic team was to have a plan, some years in the making, to take the bull by the horns on day one and within 90 days, tame it. The inflationary pressures that came along with the Rupee depreciation did not help matters either, taking headline inflation to above 15%.

Then there were the less tangible changes that had more to do with optics. Asad Umar was fired within eight months of becoming Finance Minister, a position he had been promised and was apparently the best man for, as propagated by Imran Khan himself, for years. One of the many reasons he was shown the door was because he wasn’t playing ball with the IMF. Within a month of Umar’s departure, the new SBP governor, Reza Baqir, whose previous job was IMF’s country representative for Egypt, was installed by the fund as ‘their man’, to strictly execute the new FX policy among other key objectives.

Some of the depreciation had already taken place, before the economic team shake-up, in order to demonstrate to the IMF that Pakistan was willing to take tough measures that would expose them to a significant amount of backlash. This also had to be done due the external account situation that was out of control with the fiscal deficit at around $18 billion in FY 2017-18. Imports had to be discouraged in order to bring this figure down drastically, and that is exactly what the higher exchange rate achieved.

In the second week of October 18’, the rupee depreciated by over Rs 9, bringing the parity to the new level of 133.60 from 124.00. In December another hike of Rs5 took the rate to 138.60. Since precious FX reserves were not being released into the currency markets, they kept hovering around $13 – $15 billion, well into 2019, which is when the bilateral and multilateral donations from ‘friends of the country’ really started kicking in.

Rupee depreciation continued, with the next series of depreciation that would take the Rupee-Dollar parity to where the SBP wanted it, in a relatively more gradual and incremental method. By mid-May the new level was at 141.40 and then came the real volatility; a Rs. 10 depreciation to 151.00 and another similar jump to arrive at 160.00.

With the IMF’s first tranche released, a second on its way and external debt piled on, FX reserves steadily increased to a more comfortable $18.8 billion. By January 2020, the current account deficit, due to a significant drop in imports, had decreased by a massive 75% to a respectable $2.65 billion from $9.48 billion a year ago. This allowed the rupee to appreciate by over Rs5 to a level between 154.50 and 155.00, a range where SBP felt comfortable.

Covid-19 hits hard

We spoke to FX dealers at the treasuries of various banks to get a view of where the market was headed in the mid-term. The Coronavirus had not done so much damage to the markets at the time and there was definitely less uncertainty. Things have changed since but for the sake of perspective, this was what the general consensus was:

The rupee will appreciate further as FX reserves get more support in the coming months and there is more improvement in terms of the external account. It could go as low as 145.00, not more than that, and also no higher than 155.00 in the medium term. A range bound USD-PKR parity would be maintained by the SBP.

This was then, suggesting that all that talk of the dollar hitting 180.00 or 200.00 was unrealistic, unless, and this is the important part, “there was a severe global economic crisis that would deliver a shock to the system”, as quoted by one interbank dealer at one of the top 5 banks’ treasury.

Covid-19 is that shock! It has obliterated economies across the globe. While the population of a country can reduce the risk of getting it or infecting others by practicing social distancing, there is no way to defend markets against it. As a nationwide lockdown continues in Pakistan with only essential industries operational, that too at minimum capacity, the economic fallout is going to be severe. Sindh, the hub of economic activity in the country went into a lockdown in mid-march, other provinces and especially the center reluctantly followed soon after. The rupee also began faltering under the pressure. On the 9th of March it broke the 155.00 barrier, and for the remainder of that week it started testing the critical psychological barrier of 160.00. That was breached on the 25th. The next level to watch was 165.00 that the central bank was not able to protect as it was broken a mere five days later.

Speaking to Profit on condition of anonymity, a currency dealer at one of the top treasuries in Pakistan explained how a bulk of rupee depreciation, apart from the panic caused by the coronavirus, is due to the outflow of hot money parked in the country. SBP Governor Reza Baqir, by maintaining the discount rate above 13 percent over an extended period of time, built up a sort of parallel reserve of dollars amounting to $3.25 billion parked in fixed income securities and equity in the form of Special Convertible Rupee Accounts (SCRA) that facilitate foreign investors to park their money in Pakistan’s financial markets.

That money started to flow out in March at the first hint of a discount rate cut. So far close to $2.5 billion of that cushion has flown out of the country, as was expected, after the rate was cut by 225 basis points in two separate Monetary Policy decisions within two weeks. A third cut of 200 basis followed with the discount rate now at 9%. 

By exercising a limited and controlled form of currency market intervention, the return on investment that would have been booked by foreign investors has been significantly eaten up by rupee depreciation.

A week ago USD/PKR was at 166/167, and the market was looking at the 170.00 level. But two key events stopped that level from being reached. G20 Nations were able to agree on a one-year debt freeze for the poorest countries in the world, a list that includes Pakistan and the IMF approved a $1.4 billion loan as emergency balance of payment support, which will be in addition to the ongoing $6 billion EFF. This has helped the Rupee gain significant ground, around Rs 6 against the greenback and at time of writing the rate was stable between 160.50 and 161.50.

A 30% decrease in oil prices will also provide considerable relief to the balance of payments in the coming days and should help somewhat offset a  fall in worker’s remittances that is bound to take place as Pakistani labourers across the world are laid off as an imminent global recession starts to set in and cause joblessness.

In the short to medium term, it makes more sense now to buy and hold dollars in the current market. The country’s two major dollar outflows i.e. debt repayment and oil import will virtually be nil for at least a year. This will also relieve pressure from foreign exchange reserves that have inched back to a comfortable $17.3 billion. Once the country slowly crawls out of the Coronavirus pandemic, the fiscal deficit will be a much more serious challenge facing it than the current account deficit.

*All historical data is sourced from SBP M2M currency revaluation rates and month-end FX reserve figure archive.