The currency shadow market

There are numerous PKR-USD exchange rates that exist. The rate at which various banks transact and conduct transactions is known as the interbank rate, and it is controlled by the central bank through a variety of means. The central bank is responsible for maintaining that rate’s stability; it can also shut down operations or employ other less subtle strategies to maintain market order when needed. 

There is also a rate known as the open market rate, which is the rate at which exchange firms buy and sell foreign currency to regular people in exchange for a variety of documents, among other things. The difference between the open market rate and the interbank rate is usually only a few rupees in normal, non-volatile times, or around 1 to 2 percent. 

However, the gap widens significantly during volatile times, and in recent memory, it has reached more than twenty rupees, or roughly seven percent. However, the spread—the difference between the two rates—can be tightened by the central bank to maintain some order in this market by controlling the supply and demand of foreign currency. The availability of foreign currency at a particular open market rate is not guaranteed. There may be supply at that rate, but the rate may not exist.

For want of a better term, the “real” open market rate is essentially the marginal rate, also known as the price at which actual transactions take place or supply may be available. In recent times, there has been a difference of as much as thirty rupees, or roughly ten percent, between this rate and the interbank rate. This “real” open market rate has fluctuated between seven and ten percent over the past few months. This is the rate at which a large number of remittances have begun to flow through the informal market and the supply of foreign currency is available.

A broken market is indicated by the existence of three distinct rates and significant spreads in relation to the interbank rate. Since there is insufficient supply of foreign currency on the formal market, wide spreads like these mean that availability can only be guaranteed at a higher rate. The new declaration by the national bank to move Mastercard settlements in unfamiliar cash from open market to interbank implies the very, to such an extent that interest in the open market can be decreased, and the spread can be diminished. Although there has been some narrowing of the spread, the fundamental issue of a lack of foreign currency remains.

The country’s import coverage is at or close to its lowest level in two decades as a result of the restricted supply of foreign currency. This is the signal that our issues with foreign currency are far from over until we are able to stabilize our import coverage and arrange sufficient foreign currency to meet critical requirements. We will continue to observe volatility, wide spreads, and multiple rates for the same currency until that occurs.

The parallel markets that exist for exchange rates can only be eliminated once the sovereign stops interfering in management of exchange rate, and there is sufficient foreign currency liquidity available, whether that is through increased surplus, increased remittances, or fresh loans, or a mix of both.  Furthermore, clamping down on cross-border informal trade that generates demand for foreign currency is also critical for bringing some order into the foreign exchange market.  Any short-term intervention that the government does can only be an interim fix.  Fixing the structure of the market, and availability of sufficient foreign currency liquidity remains critical to ensure stability in the exchange rate.  It may also be noted here that in terms of pure fundamentals, assessed through the Real Effective Exchange Rate (REER), PKR is undervalued related to the USD – the premium that exists largely reflects the liquidity premium.  Ample availability of liquidity can eventually lead to a more balanced exchange rate, and minimize impact of parallel shadow markets.