Exchange Rate Policy

Markets are strange animals. If sufficient number of people can be deluded into thinking that fundamentals in the future would be better, it can start of a self fulfilling prophecy of asset value improvement. Around the world, the bubbles in the stock market, currency markets and housing markets have been a result of this.

The State Bank of Pakistan (SBP) has been successful in leading people to believe that hard currency is pouring into the economy. And if they had not played a role to build reserves and to check the appreciation of the Rupee, the value of the Rupee would have stood at PKR 55 to an USD or lower.

Obviously, while the stringent foreign exchange restrictions are in place, one can not but agree with this analysis. This article tries to analyze whether there is truly a radical change in demand and supply condition or whether the rate appreciation is merely lack of regulatory revision to permit a change in the composition of participants to maintain the demand for hard currency.

Before September 11, 2001, the SBP was able to stabilize the exchange rate by meeting the trade and services payments by purchases from the non-bank market. It is interesting to note that while the current account deficits may no longer be there, yet the pace at which the foreign exchange reserves with the SBP have grown are at best misleading.

While it is not the object to discredit or to take anything away from the Exchange and Debt Management Department at the SBP, it should be pointed out there has been a change in composition of the demand and supply of foreign exchange.

The sentiment before June 2001 for the Pakistani Rupee was either bearish or at best neutral. The exporters were cautious in booking their hard currency sales in the forward and the importers continued to buy hard currency forward for meeting their foreign currency need in the future.

Assuming that the exporter cycle is four months then for an annual export of USD 9.2 billion, the exporters were effectively invested in hard currency to the extent of USD 3.0 billion.

At the same time, the importers, taking forward cover, would have effectively built up foreign currency reserves to the extent of about USD 2.3 billion, again on the assumption of 4 month cover excluding POL which cannot be covered.

SBP, in June 2001, had about USD 1.6 billion of foreign exchange reserves. Combined the foreign exchange reserves between the central bank, the exporters and importers would effectively work out to be about USD 6.9 billion with another USD 2.1 billion with the banks.

Subsequent to the mere change in sentiments, the importers and exporters have liquidated their reserves, with exporters aggressively selling hard currency forward and the importers abstaining from booking forwards. This caused SBP to the increase the size of their kitty by USD 5.3 billion, to USD 6.9 billion.

Aggressive selling by the exporters has been to such an extent that there is anecdotal evidence there have been hard currency sales in anticipation of export orders. Where previously the exporters at best were selling four months forward, now are selling up to one year forwards. While should be the objective that exporters should play their role in providing adequate supply of hard currency, this supply should not merely predicate on the direction of the PKR. As such by providing a more relaxed foreign currency environment, the movement of the PKR would provide relevant information to the market and the policy makers.

The increased flow in unilateral transfers from non-resident Pakistanis and reverse capital flows has helped defray the hard currency demands arising out of trade deficits, old commercial high rate loans repayment, etc. It is difficult to attribute the build up to anything other than a change in the sentiment of the PKR.

SBP has used this change in the sentiment very effectively by playing the market against itself as the exporters are falling over themselves to sell hard currency as soon as possible.

The ulterior motives that drives SBP to lead exporters and importers take undue risks (by speculating rather than hedging) is to establish credibility of PKR as a currency and at the same time benefit from lack of demand for hard currency to build its own reserves.

Let’s evaluate the current rules in the Foreign Exchange Manual that continue to suppress foreign currency demand and supply from the economic participants that are end-users.

1) There are a number of hard currency loans that have been contracted by local companies in the wake of projects put up between the years 1995 and 1997. These projects were in the power production, cement and fertilizer sectors. And were contracted subsequent to the demise of foreign exchange cover that was being provided by the SBP. In a number of instances these loans contracted under Chapter 19 of the Foreign Exchange Manual were prohibited from early repayment. Given that at the time when these loans were contracted the borrowers had to pay a high rate of interest due to the prevailing economic condition, would now like to take advantage of the cheaper source of financing available locally. However, the SBP is concerned about the drain of its reserves to repay these loans rather than the possibility of reducing the debt servicing costs being incurred annually. On the other hand, the SBP is looking for avenues to invest its surplus reserves.
2) Another avenue to increase demand for foreign currency would be to let Petroleum, Oil and Lubricant importers, so far prohibited from taking forward exchange cover (under Chapter IV), to allow it to hedge its foreign exchange risks. While the petroleum prices are being deregulated the Oil Market Companies have their hands tied in managing the market risks confronted by it.
3) It is interesting to note that critics have noted that edible oil prices have increased in the local market albeit due to increase in international market prices. SBP should look into allowing business to hedge price risk of commodities internationally, including edible oil, crude and refined oil products, wheat, and cotton that not only affect the profitability of companies but create significant volatility in Pakistan’s exchange position.
4) The SBP should permit the creation of new classes of participants in the hard currency markets by relaxing the rule that prohibits the exporters from holding foreign exchange for only 3 days.
5) In addition, similar to Bank’s net open position limits, it should allow the importers and borrowers also to build hard currency positions that would enable them to minimize the volatility in exchange rates on dates for oil and debt payments.
6) The exporters and importers should be allowed to buy and sell hard currency from their account similar to that of the Banks NOP to the extent of, say, 20% of their annual hard currency transaction in the previous year. SBP should also enable the importers and exporters who have previously booked forward transactions to undertake another transaction in the opposite direction to square its position.
7) Finally, the restriction that prohibits customers from taking a foreign exchange cover for a period less than one month is hardly in the interest of the country.

Another thing that has to be clear that the SBP while claiming that the Exchange Rate system is now market driven should stop imposing administrative circulars on Banks. This is in specific reference to the recent circular that restricted Banks from displaying rate sheets in the Branches that did not have more than 20 paisas (or pips in FX jargon) per equivalent USD between the bid and offer prices of currencies.

This showed lack of appreciation on the part of SBP as to the international practice and objective of these rate sheets for the banks. Any international traveler who may have visited the Canada or the UK will attest to the fact how much of local currency you receive in exchange for the USD. One can expect to pay between 350 pips to 1000 pips between the bid and ask prices in addition to their commissions for getting money converted.

The question is why do those banks offer such atrocious rates. The answer is that these rates are not applicable to all customers, only those that do not have a commercially viable amount. This means that if a Bank has a treasury in Karachi and the customer in Peshawar wants to convert foreign currency, it would be extremely costly for the branch in Peshawar to call for a rate on an amount say USD 5,000. The 20 paisa spread would only cover the cost of the telephone call and would not even take into account the costs related to personnel, premises or the volatility in exchange rates. SBP’s rationale was that PKR is not volatile these days, but it should be noted that banks do not trade USD 5,000 between each other but multiples of USD 500,000. As such a number of such transactions have to be gathered to bring it to a tradable amount. During this time USD rate may well have moved adversely.

But USD is not the only rate on the rate sheet. There are a number of currencies on the rate sheet and while the SBP may have been able to contain the volatility of USD versus PKR, the same cannot be said for any of the G4 major currencies or exotics.

It should be noted that even the stockbrokers charge a commission that would be higher than the bid / offer spread that Banks are being forced to tie themselves down to for operational purposes.

But we don’t see other Central Banks imposing any such administrative measures to “protect” the consumer. Nor do we see SBP issuing administrative circulars that force banks’ to pay 3 month Treasury Bill rate, with a margin of 20 basis points, on its deposits to the customers.

These administrative measures, rather than creating a competitive environment, is causing an exodus of foreign banks trying to get out of banking business in Pakistan. These banks have been unable to justify doing business in Pakistan due to lack of return on equity and growth in business opportunity. The SBP needs to balance the banks’ ability to make a profit and the rights of the consumer and the government.

It would be nice for once if SBP would try and lead the emerging markets in its efforts to manage exchange policies using developed countries as a benchmark rather than trying to emulate those that emulate the developed countries. Furthermore, any policy guidelines issued should be preceded by its rationale for issuance with sunset timeframe as to when these policies would be redundant.