MY PERSPECTIVE - THE FALLING PAKISTANI RUPEE

On January 26, 2023, the Pakistani Rupee hit USD 254 in the open market. The currency has lost more than 40% of its value in the last year and ~+100% since 2018 (USD 1 = Pakistani Rupee-PKR 127). This steep decline is an important factor in the cost-push inflation hitting Pakistan, which is predominantly dependent on imports. Interestingly, the worst inflation is not costed in, as there is always a time-lagged inventory effect (imports at the old dollar rate still in stock). The full impact will trigger further inflation.?

Couple the devaluation of the PKR with the fact that the world is in the grip of inflation caused by the rising energy costs, and pandemic-related economic dislocation (fiscal and monetary stimulus provided in 2020 and 2021 by governments and central banks in response to the pandemic), unexpected recovery in demand through 2021, supply shortages, geopolitical uncertainty (Ukraine war) and increased consumer demand and we have a perfect storm of the economic crisis in Pakistan.?

The rapid inflation rate is bad because people’s salaries are not growing in line with the prices of utilities and daily necessities. In other words, the Rupee is working less for them. Imagine pensioned people, daily wage workers, or even lower-salaried workers; how would they put food on the table, let alone educate their children or get the best health care for their loved ones? It is a serious issue plaguing even the well-to-do. But unfortunately, the response has been to blame others (IMF and international conspiracy) for years of poor governance and the slow growth of the overall economic pie. ?

Why did the rupee devalue so fast? There are two possible explanations:?

1. Well, simply because the State Bank did not have enough dollar reserves to sell them to stabilize the rupee. Central banks use foreign currency reserves to manage the relative strength of their currencies. Let's look at the case of currencies pegged to a dollar or a basket of currencies. The central bank of such countries holds significant reserves of the currency against which it pegs its currency. When the local currency faces downward pressure due to a lack of demand, the central bank sells foreign currency to buy its currency in the market to stabilize the price equilibrium. Simple economics! The fundamental thing is to have a strong economy based on thriving businesses or abundant natural resources.?
2. The central bank wants to move away from managing the rupee rate to making it free-floating, and in such a case, the supply and demand of currency determine its rate. The inherent weakness in the economy is also reflected in the currency.

Net, Pakistan is short on foreign currency reserves.?So the question is, why are the governments (past and present) not focused on increasing foreign reserves through progressive investor-friendly economic reforms instead of depending on foreign aid and loans? The answer is that it is difficult. Why? Because firstly, it will require democracy to flourish with no random musical chairs every 2-3 years, consistent economic policies for 10-15+ years irrespective of who is in power, elimination of subsidies for political mileage, reducing the spent on large parliament, defense, and bureaucracy, bringing agriculture in the tax net and putting the investors/entrepreneurs at the forefront of economic development by providing incentives and an environment of safety and security.?

Is there willingness to do all this? The problem is that the interests of the country and decision-makers need to be aligned. A whacky idea is changing the reward system to allow a 1-2% percentage of GDP growth beyond certain levels to be given legally to the ruling elite as remuneration for growing the economy. Then, there will be an interest in developing the economy. In parallel, reduce or stop the illegal outflow of dollars by reducing and, over time, eliminating cash transactions.?

Additionally, Pakistan has a huge expatriate population base and it should be tapped methodically. Interestingly Pakistani expatriates cannot even participate in elections through voting from their foreign workplaces/homes.

Imagine whether it would have been better to ask the expatriate Pakistanis to invest in dollar deposit in Pakistan and offer them a higher, for example, +400 basis point interest over LIBOR, guarantee the repatriation of the funds (in the current political uncertainty difficult for people to believe) after a year or so and even providing a Gold Card which can provide to the expats small visible benefits to recognize their contribution. Just a thought!

But did Pakistan receive dollars from friendly countries? Yes, it did. The money was for maintaining the reserves and not spending it. So it's not about keeping the money; it's about using the dollars to buy the local currency, which can restore the currency parity.?

Why did Pakistan agree to a floating exchange rate? About 40% of the world's developing countries maintain a managed exchange or a managed floating rate. This provides exporting and importing countries more stability and keeps interest rates low. Fixed exchange rates work well for growing economies that do not have a stable monetary policy and they bring stability to a country's economy and attract foreign investment. Floating exhange rates work better for countries that already have a stable and effective monetary policy.

Free-floating exchange rates can cause volatility with large influx and outflows of funds. With a small economy, Pakistan chooses to keep a free-floating exchange rate. Contrarians will argue that whenever Pakistan has managed the exchange rate within a narrow band, it has been followed by a significant devaluation. For example, between 2003-2007, the rate remained stable at around 58 rupees to a USD, and then in 2008, the rupee devalued by 33%. Then again, the rupee remained stable at about 105 between 2013-2017, and then it devalued by 30%. It averages 5-7% per annum depreciation over time. The logic is that once the currency is free floating, it will depreciate by an average of 5% p.a. instead of being stable for some time (managed) with a shock of 30% every 3-5 years. For sure, you can argue the timing of the decision, but when is it ever a good time for bad news?

So it is a bitter pill that is for the overall good? No, not necessarily it is good. Unless the business/economic base of the country improves, these changes in themselves cannot put the country on the path of growth. Unfortunately, people look at business people suspiciously and think of them as greedy and evil. Still, without them, there will be no jobs and exports to bring in foreign currency and raise the masses' standard of living. The government was managing everything in the communist world. What happened? Compare it to the free market world of the West, and you will get the point. What Pakistan needs is the prioritization of entrepreneurs and business people and the creation of a conducive investment environment on a war footing that should remain consistent for 10-15 years and not be affected by the frequent political musical chairs, i.e., decoupling economic policy from politics.?

How do we grow investor confidence? Pakistan needs an environment conducive to investments that allow entrepreneurs to make money without administrative complexity. The more money they make, the more will be tax collection plus general prosperity as people will get good jobs. Right now, the effort is to increase the tax net and indirect taxes in an economy where businesses are struggling, compounded by the high-interest rates on borrowing money to do business. Here I am not even talking about the administrative complexity of managing the books of accounts for audits by small businesses that hardly have any documentation but are critical for the economy. Simplifying the tax regime for the SMEs to charge them VAT-like taxes that are easy to assess as these are based on sales and do not require a detailed Profit & Loss statement that professional accounting firms audit.?

Would a market of 220 million people lure outside investors? You would think so. However, the investors are afraid to invest as they see political uncertainty, changing policies, rising taxes, lack of dollars for repatriation, high cost of capital (requires higher returns), cumbersome operating environment, pockets of terrorism, and no incentives. The result is that instead of real capital investment, the market is served through imports and relies on foreign borrowing and economic aid to fund the defense, bureaucracy, and burgeoning parliament needs.

Is inflation bad for the economy? Not necessarily! Inflation means a period of rising prices. It reflects economic activity. Many big economies, like the EU before 2021, wanted to increase inflation to about 2% and found it challenging to achieve it despite the quantitative easing and negative interest rates. Currently, the inflation in the EU stands at 9.2%, and therefore in 2022, the key rates were increased from negative to +2.0%. Further, increases in interest are on the anvil to restrict rampant inflation.?

In the case of Pakistan, the inflation would not be so bad if the businesses were thriving, employment was readily available, and salaries were rising - a case of demand-pull inflation. However, in Pakistan, we are facing cost-push inflation as it is a net importer. In such a case, the rising prices with insufficient salary growth will cause suffering to the people. Moreover, the crisis is accentuated by industries temporarily or permanently closing shops. Furthermore, the cost of gas and other commodities will increase with the devaluing of currency, which will further fuel inflation.?

But the deposit rate on the rupee is raised to +15% (1-year); is it not a great investment return? The interbank rate is 17.0% (Dec 2022). The return on deposits is lower than that rate, and taking a loan will be even more expensive as the banks factor the lending risk on top of the interbank rate.?

For measuring the financial return on the rupee deposit (15% plus), equating it to the Fed interest rate on USD of 4.5% is essential. If you keep your US dollars in treasury bonds, you will get that ROI. In Pakistan, you can get 15.0% on deposits. Important that the interbank rate of 17.0% (including sovereign risk and inflation) is equal to 4.5% in USD. When people say that they made a good profit in the stock exchange or real estate, making 20% in the last year in PKR, they lost +20% in real USD terms behind devaluation. You can earn +4.5% on investment-grade dollar bonds without a sovereign and currency risk.?Net assets in Pakistan have become overweight and need to run fast to become productive. It would be best if you had your assets to make more than 17.0% to stay put- avoid losing the value of the principal. Not easy!

The stock market is a good place to invest but these days it's down. Yes, the stock market is an important part of the economy, and its strength is a sign of a vibrant economy. The whole Pakistan stock market is based on a few key stocks, and the concentration leaves room for big players to move the market up and down behind high influx and outflow of funds to cause volatility. Expanding the economy and allowing newer companies to enter will be a boon for the stock market.?

If I buy dollars and keep them, will I protect myself from the rupee devaluation? Buying dollars and keeping them is an interesting concept that needs to be analyzed. People living in Pakistan have Rupee as their reference currency. The effect of devaluation for those who are not traveling outside of the country is in the form of inflation. If you buy and keep dollars, you will undoubtedly benefit from the devaluation, but its benefit will mitigate as inflation also affects the dollar. In the US, the inflation in 2022 was 6.5%. So net, not only is it not helpful for the country as the buying frenzy on dollars will expedite the rupee devaluation, but it is also not smart for the investors unless they invest the dollars in assets that earn a good dollar return. I suggest always thinking from all angles before making a decision.

So what should be done? Is there a way out??Well, brilliant people are working on the best solutions. I have a few suggestions:

1. Bring visible political stability. If there is political stability, the investors (foreign and Pakistanis) will be willing to invest in Pakistan. The formula applied in the last 75 years has yet to work. A change is needed; why not make Pakistan what it was supposed to be, a true democracy? Try for at least ten years; give it a chance.
2. A robust economic plan. The only way to improve the economy is to grow the business in the country on a war footing. It should be the priority, 1, 2, and 3. Invite the best economic minds (foreign and Pakistani), politicians, and select bureaucrats and develop a 15 years financial plan and follow it irrespective of who is in power. The program should offer investor-friendly policies, ensure staff safety, no restrictions on repatriation of profits, and ease of operations. Another step would be to provide lower interest rates to Pakistani SMEs on rupee loans for their businesses and make taxation on them simple to avoid administrative complexity. It would also be good to select specific sectors like Tourism, IT, FMCG, Automobile, Pharmaceuticals, and Defense and incentivize them to build a strong industrial base.
3. Reduce the cash transactions. The best way to document the economy and stop wealth outflow is to reduce cash transactions. In the interim, don’t use it to bring small businesses into the tax net (it will scare them) but to eliminate the parallel cash economy. It will also reduce corruption by recording the transactions. The point is not about burdening the oppressed small investor but about making life easy for them and stopping the outflow of dollars from corruption.?
4. Keep overheads low by reducing the defense spending, number of ministers in parliament and bureaucracy and removing subsidies. More people are managing a shrinking economic pie than needed. Provide more autonomy to the businesses. Make taxation low and easy, and by reducing the budgets of defense, bureaucrats and ministers, it would be possible to lower taxes, and more will be available to pay back the existing loans.?
5. Leverage the biggest Pakistan's asset, the non-resident Pakistani's. Offer, for example, a +300 basis points higher interest on dollar deposits and request the non-resident Pakistanis to invest in these 12-24 month deposits. Give a guarantee (in the current environment seems difficult) that these accounts will not be frozen and investors will get some recognition for helping the country in these difficult times. There should be a clear accountability of how these funds are used.
6. Seriously curb money laundering as it is the biggest issue for the economy. It has a more significant and worse economic impact than corruption. Imagine if there were no way to repatriate corruption money; the corrupt would have to keep or spend in the country, helping the economy. The outflow of corrupt funds is the worst evil. By stopping the undocumented money flow from the country, it will increase documentation which will be good for bringing more people under the tax net and accountability. It will also reduce the outflow of dollars which will stabilize the rupee.?
7. Educate people on what is happening. An ordinary person needs help understanding economics. Given the country's education system's decline, how many qualified people genuinely understand the economy? Allow and organize educated debates based on facts and logic instead of accusing and weaving conspiracy theories to mislead people.?
8. Work on the mindset. Most importantly, a significant effort must be made to change a mindset. Help people develop habits that can keep their minds calm and free of pollutants like fears, negativity, and stress. Media has to play a positive role here. Pakistan is spreading a culture of conspiracy theories, political victimization, and blame. Thought leaders should lead by example by taking responsibility for the situation to demonstrate positive actions and appreciate whoever in government or opposition is taking meaningful action.?

Conclusion

We are a brave and capable nation and will come out of the crisis strong. However, it will only happen if people take charge of their future, participate actively in quelling political uncertainty, and encourage institutions to retreat from politics. Finally, all parties collaborate in developing a 10-15 years economic plan that is executed despite the change in governments. Consistency, security, stability, and an investor-friendly climate are the cornerstones of a good economy.?