Exchange Rate Management: Two Extremes

[AhsanAmin]

One of the most sensitive variables in management of economy of a country and her growth is exchange rate of that country. A change in Exchange rate affects almost every other variable in the economy of a country. Unfortunately the present government has gone from one extreme of artificially controlled exchange rate to the other extreme of totally floating and falling exchange rate. A proper strategy for the growth of the country is that of prudent management of exchange rate between these two extremes and going from one extreme of artificial control to another extreme of totally floating and falling exchange rate is just as equally dangerous for the economy. While considering the strategy for management of exchange rate, a comprehensive criteria has to be adopted that takes into account all benefits of strong exchange rate and costs associated with maintaining a strong exchange rate and a prudent management of exchange rate has to fix the exchange rate where marginal costs of maintaining the exchange rate are equal to benefits from the controlled exchange rate. And decrease of dollar reserves due to maintaining exchange rate have to be taken into account as a cost in this comprehensive criteria. And state bank has to intervene very intelligently in the market so as to make it possible to cause largest possible increase in exchange rate for every dollar spent to buy the rupee. If the present government had intervened intelligently instead of allowing free fall in exchange rates, present exchange rate would have been close to 140 rupees to dollar and it would have taken approximately a billion dollars of intervention.
Huge inflation associated with freely falling exchange rate might cost Imran Khan his government in next elections. Situation would have been far more in his favor if he had followed a policy of prudent and intelligent exchange rate management and state bank had prudently (and not recklessly) intervened in the market from time to time.

 

[insight-out]

The State Bank is not "totally floating" the exchange rate. It is in fact managing the exchange rate very closely and diligently. It may not appear to be the case because the Rupee has fallen to 175. But this is not by accident. It is certainly by design. There are a number of reasons why the government is allowing the market to devalue the Rupee.

• Intervention means using foreign exchange reserves, which it does not want to do. The reason is that a depleted reserve has other implications on things like availability of credit from international agencies, and its own ability to back its imports and liabilities.
• A weaker Rupee helps exports, as it will make our production costs cheaper and more competitive in the international market. This is important because exports are a priority for this government (as they should be)
• A weaker Rupee discourages imports, as it makes them more expensive. This is good for non-essentials.

Of course, a weaker Rupee has its downside, the major one being that essential imports become more expensive too. And given that the biggest chunk of our imports consists of oil and gas, the cost trickles down to everything else, hence upward pressure on prices.

So like most other things, it is a balancing act. The government can keep the Rupee strong, keep prices relatively low, but destroy exports and local industry. Or swallow the bitter pill of high prices and unpopularity with the masses, but support exports and industry. The former option is for short term gains, and what previous governments have done. The latter is for long term gains, and what the current government is doing. Given the state of our economy, the latter option is the only real one we have.

One last note. There is a threshold beyond which a weak Rupee will do more harm than good. That is when the State Bank should intervene. We're not there yet. But if and when we approach that threshold, I am certain the State Bank will intervene.

 

[niaz]

Floating exchange rate is a two edged sword.

Undoubtedly floating currency has many advantages such as automatically making imported goods dearer which reduces their demand and increasing the exports because locally manufactured goods become cheaper. Nevertheless there are also certain disadvantages for a heavily debted country like Pakistan. Firstly the debt repayment requires more Rupees than before thereby partially offsetting the increases in exports. Secondly, because items such as machinery & essential raw materials become more expensive; new investment is reduced.

Any country which now imports even the food items such as wheat, edible oil and sugar devaluation would cause inflation. In my humble opinion, benefit of continued Rupee devaluation is debatable.