How to Explain Floating Exchange Rate in Pakistan

There are different currency management regimes used in Pakistan from the start to control inflation rates like Fixed Exchange Rate, Floating Exchange Rate, and Managed Exchange Rate. After Independence, the Government of Pakistan used Fixed Currency Exchange Rate regime which pegged PKR with the Pound. After collapsing Bretton Woods, Pakistan pegged its currency with US dollars.

What is the Fixed Currency Exchange Rate Regime?

In the Fixed Exchange rate system, Currencies are pegged with foreign currency at a special exchange rate to measure the value of imports and exports.

What is a Floating Currency Exchange Rate Regime?

The Value of a currency is based on the demand and supply of that currency in the international market. The International Monetary Fund uses different tactics to force Pakistan to its implementation but still has not been successful.

What is Managed Currency Exchange Rate Regime?

When the value of a currency is partially allowed to flow on demand & supply and partially fixed to give balance in the market, the State Bank typically intervenes market to give stability and confidence to investors.

Which Exchange Rate policy Should be used?

In 2019, according to the reports of the tribune, Pakistan hinted at shifting away from a managed currency regime and toward a more flexible exchange rate policy as it seeks an early agreement with the International Monetary Fund (IMF).

Federal Minister for Planning Khusro Bakhtyar said, “The government is willing to commit political capital for much-needed structural reforms and it would embrace a flexible exchange rate policy.” The IMF demanded that Pakistan adopt a free-float currency rate regime as part of the 22nd rescue package negotiations.

Former finance minister, Dr. Hafiz A Pasha, said “An optimum free float exchange rate is an ideal scenario,”.“The problem is that Pakistan’s currency market is very thin and could be manipulated due to a complete free float,” he added.

Because Pakistan’s economy is primarily reliant on imported products, fluctuations in the currency rate have significant inflationary repercussions. The budget is imbalanced, with too little taxation chasing too much expenditure. Then there’s our Balance of payments (BOPs), where we have too few exports chasing too many imports.

However, these deficits were repaid by depleting the State Bank’s foreign currency reserves, increasing borrowing and debt, and inflating the economy. The government of Pakistan (GOP) addressed the issue by placing restrictions on Foreign Currency Accounts (FCAs).

Pakistan appeared to be turning its back on kleptocracy and spendthrift development two years ago. Imran Khan, the then Prime Minister, was widely acknowledged as having the best intentions for the economy.

However, the ancient regime’s profligacy has resulted in Current Account and Budget deficits of 7% of GDP each, a $40 billion for the current Financial year required for Balance of Payments and other obligations makes it very difficult for the Government of Pakistan.

Why Floating Exchange Rate is not a suitable choice for Pakistan?

A free float establishes the expectation of continued depreciation of the exchange rate for a troubled economy like Pakistan’s. People wage against the Rupee for speculative and value preservation reasons.

This causes valuable capital to flee to other countries. As a result, the Rupee loses even more value. Downwards in a vicious circle. These are known as depreciation expectations. Inflationary expectations are analogous.

A free float makes the price environment for investors completely unpredictable. To determine their rate of return, investors want clarity in the prices of their inputs and outputs. However, downward pressure — more accurately, a free fall in the exchange rate – brings inflation into domestic pricing.

A pressured exchange rate lost value from 150 to 230 in just 6 months due to political instability and weak democratic institutions. a reduction of reserves to $10 billion. The value of all imports in rupees has skyrocketed.

Most importantly, a free float and declining exchange rates can have a large inflationary influence on domestic prices. The inflation rate of June 2022 is recorded at 21.3 % from the previous year. Consider the rising cost of imported energy, which is utilized to make all commodities, particularly low-wage ones. You can’t control market prices with fiat, no matter how well-intentioned you are.

Tackling the Underlying Problem of Inflation

The main problem lies in sustaining a market-based exchange rate at the heart of the problem. If there is anything that needs to be revised, it is the IMF agreement and the free float of the exchange rate. As in the past, a peg of the Rupee to a foreign currency or basket of currencies had to be sought.

Furthermore, there should not be a reliance on a single policy instrument to solve Pakistan’s external account problems. It would be preferable to deploy three policy instruments judiciously.

One option is to negotiate a peg with some depreciation. But not another major devaluation, which would bring with it all the expectations of more depreciation, as well as the concerns of domestic and foreign speculators betting against the Rupee, resulting in outflows. The Rupee has suffered a significant depreciation as a result of the float.

Secondly, preserving the peg while relying on interest rates to some extent. However, balancing support for the peg with keeping borrowing costs low enough to keep the economy growing.

Lastly, and most critically, capital controls will be required to fight the depreciation expectations that have been established, as well as betting against the Rupee and capital flight overseas. Otherwise, capital will flee economies such as Pakistan, Argentina, and Turkey, where capital flight is always a concern.

Conclusion

Pakistan’s economists should focus purely on the need to preserve three macro principles. In open markets, the exchange rate is already under pressure. With huge deficits and low growth, inflation is on the rise. And there’s the interest rate, which needs to be raised to keep inflation under control and the currency peg from sliding further.

The restriction on luxury imports will ease the BOP crisis. The rich have to consider it again and think about the country. Pakistan has the option to save $10 Billion annually by just banning the import of FMCGs and nonessential items.

Work-from-home encouragement for companies will also ease the exchange rate and reduce fuel demand. After Covid-19, we have experience working from home. This will promote technology more and grow the telecom sector.

A drive for Made in Pakistan can have positive effects on the country. Imports will come down and local manufacturing flourishes from it.

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