Interest rate tightening and rupee’s health

The recent tightening of the interest rate should help rein in galloping inflation in coming months. However, the rupee may continue to remain under pressure as external-sector fundamentals will take more time to improve even after we enter a loan programme with the International Monetary Fund (IMF).

In March alone, the rupee lost 1.4 per cent value to the dollar as end-quarter external debt servicing peaked, bringing its total loss against the greenback to 15.9pc in the first nine months of 2018-19.

Despite the tightening of the policy rate by 375 basis points so far — from 7pc at the close of the last fiscal year to 10.75pc now — not only the rupee has lost 15.9pc value against the dollar in the first nine months of 2018-19 but also its stability remains uncertain. The reason is that the improvement in fundamentals of the external sector has remained limited. Merchandise exports in July-February totalled $15.1 billion after a year-on -year increase of 1.85pc.

But despite a 6pc decline, the import bill is still at $36.6bn. So we have a trade deficit of $21.5bn. It is down 11pc from a year ago. But in terms of volume, it is still too large — and even home remittances of $14.3bn received in July-February fall too short in fixing this deficit, notwithstanding the fact that at this level remittances show about 12pc year-on-year increase.

The problem is with the volumes of foreign exchange inflows, not of the growth trend. Prime Minister Imran Khan and Finance Minister Asad Umar keep telling us that brighter times are ahead and lots of foreign investment is in the pipeline. Unless that investment actually starts flowing in, the foreign exchange crunch will likely persist not only during this fiscal year but also perhaps in the next few years.

The rupee lost 1.4pc value to the dollar as external debt servicing peaked, bringing its total loss against the greenback to 15.9pc in the first nine months of 2018-19

That’s the view the IMF has also taken. Once we enter into the Fund programme, the government will have to take politically tough measures, like taxing the big and the powerful that are still out of the tax net and containing its development and non-development spending to keep the fiscal deficit in check. Besides, the central bank will have to discontinue the old practice of providing cushion to the rupee through interventions in the foreign exchange market. Meanwhile, the cost of external debt servicing can only be expected to grow further after borrowings of $9.2bn from friendly countries in the first three quarters of this fiscal year. In the first half of the year, Pakistan spent $5.36bn on the servicing of external debt. External debt servicing had consumed $7.49bn in 2017-18, according to the latest data released by the central bank.

When this write-up is published on April 1, prices of petrol and other fuel oils will have gone up. Energy prices have been on the rise because international oil rates have remained higher than last year’s. Besides, even our populist government could not dare reduce the amount of taxes and duties.

The government could not do this to avoid taking a hit on revenue generation. Tax collection is already low.

“In view of the shortfalls in revenue collection and escalating security-related expenditures, it is most likely that the target for the fiscal deficit would be breached,” said the State Bank of Pakistan (SBP) on March 29 when it raised its policy rate by 50 basis points to 10.75pc.

The interest rate hike comes amidst continuing underlying inflationary pressure, a larger fiscal deficit (2.7pc of GDP in the first half of 2018-19 against 2.3pc a year ago) and a high current account deficit despite some improvement. The current account deficit narrowed to $8.8bn in July-February from $11.4bn in the corresponding period of the preceding fiscal year. But it still poses a challenge as the improvement has come in the backdrop of $9.2bn foreign funds from friendly countries — China, Saudi Arabia and the United Arab Emirates.

We had to resort to this foreign exchange funding, which carries both economic and political costs, in our quest to avoid a free fall of the rupee. Despite that, the rupee has lost 15.9pc to the dollar so far in this fiscal year. On March 25, SBP’s foreign exchange reserves stood at just $10.7bn.

Pakistan is likely to sign a balance-of-payments support deal with the IMF in mid-April. Hopefully, the first IMF loan tranche will come in before June. That will help reduce external debt servicing problems in the April-June quarter besides setting the country on the course of prudent fiscal and monetary management for stabilising the faltering economy.

During his visit to Pakistan in the last week of March, IMF Mission Chief Ernesto Ramirez Rigo met several federal ministers and senior officials. In fact, he met SBP Governor Tariq Bajwa and other senior central bankers ahead of the monetary policy committee meeting.

Whenever the IMF agrees to a bailout package, its demands include the tightening of interest rates. This time, too, the Fund is pushing for the continuation of a tight monetary regime.

The Fund also wants to see our central bank more autonomous and foreign exchange regime freer. It is pressing the SBP to even make inflation targeting a core objective of monetary policy. The SBP decision to raise the policy rate by 50bps from April 1 shows it prefers inflation-fighting to facilitating economic growth.

The central bank has projected 3.5-4pc economic growth in the current fiscal year, far lower than the last year’s revised growth of 5.22pc. Lower economic growth means a loss of jobs and a fall in disposable incomes. Both things are going to erode political capital of the PTI.