@Jungibaaz Why can terrible economies like Lebanon peg their currencies to the USD, but we cant? Not that I am advocating it, just curious.
Secondly, how would us building our Gold and Silver reserves support PKR?
Thanks Brother!
Brother I'm not entirely sure what the situation is with Lebanon, a rudimentary analysis is probably that they can manage it due to the structure of their trade, they have 36 months of reserves to cover their imports, we over around 3-4 months mostly. But exchange rates are determined primarily by supply and demand for a currency. They can vary according inflation and interest rates of one country relative to another, vary as a result of trade and investment flows, or by pegging and central bank intervention.
Fixed rate (peg) is used to promote stability, but the trade-off is distortions and inflexibility it can cause to trade balance, and underlying price mechanisms that are related to trade and other inflows/outflows, and how much it costs to maintain the peg in terms of reserves. On floating exchange rates, if the market determines the exact value of a currency like ours, the price of PKR can immediately account for macroeconomic trends, interest rates, forecasted events, other news, and you will usually have a (mostly) properly valued exchange rate that doesn't exert too much pressure on other macroeconomic factors. But the price can be volatile and undesirable. And some countries have a policy in between, mostly free floating with minimal central bank intervention, this is called a 'managed float'.
Pegs and fixed regimes are inflexible by their nature, and they can if not properly managed cause big distortions and build up of pressure. In order to combat this, you really need to be either something close to an oil rich currency like Saudi to weather any adverse movement and burn abundant dollar reserves to fight the market whenever you want, or have a good deal of exports to earn those dollars you need to maintain the peg. We don't earn much from exports to begin with, and our pegs tend to be set such that our exports suffer, and then we run short on dollars, which is the very thing you need to maintain a peg.
A lot also depends on WHERE we place a peg. Let's say today we place a dollar peg at 160 PKR, could we sustain it? Sure. Maybe for a few months, a year or two, but the real effective exchange rate will change over time and move against our peg. If we set the value at 125 PKR, then we're really playing with fire, we will need to burn reserves to battle devaluation pressures, we'd run out reserves quite quickly and the peg would fail completely after some time. Why can't we peg to the dollar and keep it there at a reasonable rate? Well, for a variety of reasons, not least uncertainty of economic movements over time. Take the US and Pakistan (PKR/USD) as an example, basic economic and financial theories regarding interest rate parity and arbitrage dictate that since the US is a low inflation, low-ish growth, and very low interest rate economy, while we on the other hand are a higher inflation, and much higher interest rate economy... all else equal over the course of a year, PKR should devalue relative to USD in order to reflect its true price. What happens when we peg is that we prevent that correction in price to occur over time. The more we prevent this, the worse the pressures and distortions become.
The recent case study for this is Ishaq Dar era 'managed float'/peg. This man's cardinal sin was his policy of pegging PKR at 105 per dollar. This was seen as a pro-growth policy, as it preserved the purchasing power of the PKR and thus the purchasing power of ordinary Pakistanis, it made imports cheaper, it helped keep inflation low without resorting to growth limiting interest rate hikes. However, it had several major flaws for a country like ours. The cheapening of imports due to strong PKR simultaneously made our exports more expensive (our exports are already very low value and not too competitive). To put it simply, a german manufactured car could probably sustain a 2-3% higher price and still get export orders, but 2-3% for agricultural commodities of Pakistani origin might make them seriously uncompetitive, or alternatively, the higher and cheaper consumption due to the peg might make those goods that might have been exported be consumed locally.
So the peg worsens the trade balance and reduces your ability to maintain forex reserves. Ordinarily, if trade balance worsens, markets see this and the PKR value will drop to reflect this change. But in Dar regime, SBP used forex reserves to fight the market on PKR valuation, burning those precious reserves to keep the peg. The longer this peg was maintained, the more PKR became overvalued, the more reserves were burned to continue fighting the market, the worse the current account deficit and trade balance became. And in turn, due to a worse deficit, the fewer new reserves we earned to replace those we lost by maintaining the peg. This cycle went on and on until the SBP ran out of reserves and ammo. So the peg fell through, interest rates were hiked, PKR fell off of a cliff and caused shock to purchasing power and inflation, and we came asking for IMF assistance because we had dollar debts due, an unsustainable dollar leakage via the current account, and no reserves to fund ourselves.
In my personal estimation, a free floating currency, or a very sparingly managed float for an economy like ours is best. If we try to go for short term prosperity by pegging PKR high, we'll damage exports. It'll be living beyond our means until the reserves run out. If we peg the PKR low as some countries like China did successfully, it should help us build export competitiveness, but not without its own set of distortions that may cause damage. So that's what I'd like to see, a mostly free floating, properly valued PKR, and an independent SBP to set rates and policies according to the needs of the economy rather than bowing to political pressure.
