SBD-3
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He is correct in saying that State Bank can manage the market for foreign exchange. However, since state bank is not the sole player in FX market, there is always a room for market players to play on trends and expectations. Pakistan, ironically, has been suffering from twin deficit in most of its financial history (A current account deficit+ a primary fiscal deficit). So not only that the Foreign exchange has been flowing out of the country on net basis every year, the situation is aggrieved by the negative fiscal balance. State bank can and does manage the market, but only to an extent. FX Reserves provide the state bank the teeth to show the market that it can act i.e. if market will create an excessive or speculative demand, it will move in with the FX injections from its own kitty. However, SBP have to add net dollars to market from its FX reserves since the market's natural net position is that of short (i.e. Market will always have dollar outflow greater than inflows due to negative current account balance). Thus, if SBP is to keep the rate stable, it will have to fund the deficit from its own reserves. Thus the cost of stabilizing the USD-PKR is depletion of FX reserves. As the trend continues i.e. SBP providing net injections, SBP's cushion to combat speculative pressures continues to erode. Now consider SBP as a policeman with Bullets (FX Reserves) and the market as a bunch of criminals. The criminals will only obey the policeman until has adequate stock of bullets. As soon as the criminals know that the policeman is either low on stock or has exhausted his bullets, they will rebel. Similar happens when SBP's reserves erode dangerously. The market faces two types of additional pressures in addition to natural outflow due to negative current account 1) Speculative pressure on USD demand side i.e. Dollarization that people start hoarding USD because they see a good appreciation thus returns. 2)A panic increase in genuine demand as people like to buy dollar now than later because of expectations that dollar will be expensive to buy tomorrow. And since they know that SBP will not intervene because it hasn't left with any reserves, the demand pressures multiply. So effectively where the PKR depreciation (devaluation is technically an act by the government to devalue its currency)would have be 20 had SBP left it to the markets and allowed PKR to depriciate naturally, the actual depriciation turns out to be greater than 20 and that too at the cost of loss of FX reserves. This is where IMF has shown their reservations i.e. Why lose FX Reserves when SBP can't stop the inevitable. And interestingly this has happened once before. In 2007, SBP, after a calm period of around 5-6 years of USD-PKR hovering around 60 faced a massive speculative attack on PKR. This forced the government to again seek IMF's support. Resultantly, IMF asked the SBP to stop maintaining the FX rate artificially and allow it to depreciation. If you check the pattern of 10 years FX rate data, you will see that SBP's exchange management regime was hugely modified as a result of 2007's speculative attack. Here's the figure
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