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Policy rate v exchange rate

Bleak economic scenario

Huzaima Bukhari, Dr. Ikramul Haq & Abdul Rauf Shakoori

Our current grim economic condition is a result of multiple factors—undoubtedly some decisions/inactions by the previous coalition government of Pakistan Tehreek-i-Insaf (PTI) have played a negative part. It is a fact that in its four years, the PTI government failed to undertake fiscal reforms agreed with the International Monetary Fund (IMF) in July 2019 while signing the staff-level 39-month extended agreement under the Extended Fund Facility (EFF) for an amount of SDR 4,268 million (about US$6 billion or 210 percent of quota) “to support the authorities’ economic reform program” [hereinafter “the agreed reform programme”].

PTI government was under obligation to execute the agreed reform programme within a specified time framework—ideally within three years starting from the date the then Finance Minister, Dr. Abdul Hafeez Shaikh, signed it and that was approved by the Executive Board of IMF on July 3, 2019 and which was to be completed by 2022. However, after signing the agreement, PTI government did not initiate fiscal reforms execution process till the date of their departure in April 2022. Unfortunately, at all stages when the IMF team reviewed our progress regarding this aspect in order to release a new tranche, we failed to show any progress. Resultantly, power circular debt reached the alarming level of Rs. 2500 billion and that of gas to Rs. 1500 billion with overall budget deficit recorded at their highest in our history. 

Due to financial mismanagement, leakages of our resources have brought us to a position where global lenders are dictating us in transactional as well as legislative matters and the rulers, without realising the gravity of the situation of the common man, are bowing in obeisance to their directions/dictation. The result of not implementing fiscal reforms triggered policy rate from 5.75% to 13.75%, dollar rate from Rs. 115 to 211 till date, huge taxation, both direct and indirect through mini-budgets, fuel prices that were below Rs. 100 crossed the figure of Rs.230. We are also forced to impose a ban on imports. Citizens are facing heavy power shortage in June as well. Traders are forced to close their businesses early just to save electricity without evaluating its impact on growth.

On the legislative front, Pakistan amended the State Bank of Pakistan Act, 1956 under the direction of IMF to increase the functional and administrative autonomy of the central bank so as to restrict the government’s role in managing policy and exchange rates.

It is a fact that IMF and independent lenders have always advocated for driving exchange rates through market forces as this can ease the pressure on foreign exchange reserves especially when the government starts pumping dollars into the market to artificially maintain rupee parity. The State Bank of Pakistan (SBP) works as the custodian of the country’s external reserves and has the responsibility for foreign exchange reserves management and servicing of external debts.

The direct contributing factor to the exchange rate are the inflows and outflows through Foreign Direct Investments (FDI), Foreign Portfolio Investments (FPI), home remittance, exports, imports, and debt payment and receipts. SBP has established a department to consolidate treasury-related activities and foreign currency payments/transactions handled by its different departments for ensuring efficiency and control in treasury operations in line with international best practices.  

As per the SBP exchange rate regime and forex reserve management, Pakistan is following a market-based flexible exchange rate system since May 1999, where the exchange rate is determined by the demand and supply conditions in the domestic interbank foreign exchange market and the inter-bank rate applies to all foreign exchange receipts and payments both in the public and private sectors. The foreign exchange requirements for approved purposes, including but not limited to imports, services, and debt repayment are met by authorised dealers that form the inter-bank market and unless specified otherwise, these dealers can release foreign exchange for any purpose without approaching SBP—they are also not required to surrender receipts to the central bank.

Though modern economists and global lenders discourage intervention by the central bank in exchange markets and suggest a floating exchange rate system where the exchange rate is determined at par with demand and supply mechanism. However, in economies like Pakistan, there is a need for intervention to avoid speculative pressures and ensure smooth functioning by preventing disorderly market conditions.

Though the IMF’s agreement permits purchases in the FX interbank market to rebuild reserve buffers in favourable market conditions, yet in the current economic scenario and due to limited buffers on account of the level of reserves the floating rate policy seems to be the only option. This free float-in has evolved into a “free fall” of the rupee which is rapidly losing its value.  

In economies like Pakistan, the regulator, and other government institutions must be cognisant of the fact that certain forces in the market manipulate the exchange rate, and in such circumstances, the central bank cannot simply alienate itself.  In an import-based country like us falling value of the currency directly affects the common man, and inflation starts gearing up.  We are witnessing that in a brief span of two months the rupee has lost more than 13% of its worth, and the government is unable to stop this downhill slide. Moreover, the recently-amended SBP Act assigns the task of domestic price stability as the primary objective.

Inflation has been a big challenge and brings severe criticism to any government. Even though the central bank can play a limited role vis-à-vis food and energy inflation which is the result of tariffs, duties, international market prices, local prices, and demand/supply challenges, still, SBP needs to ensure domestic price stability. The variation in inflation leads to the tightening of monetary policy by taking steps like increasing policy rates. In its last meeting held on May 23, 2022, the Monetary Policy Committee (MPC) decided to raise the policy rate by 150 basis points to 13.75%.

This monetary tightening is critical to support much-needed disinflation and SBP undertook this action with the objective of fiscal consolidation, and moderating demand at a reasonable pace while keeping inflation estimates affixed.

The current government of Pakistan Democratic Movement (PDM), as an opposition, was a strong critic of the recently-amended State Bank Act. They termed it as an economic surrender to IMF and claimed that now “foreign lenders will be dictating terms compromising national interests. Rupee’s falling value and increasing rates were ferociously opposed, even termed as “recipe to disaster”. However, to date, no workable plan of action is presented by the incumbent government, which can determine direction for futuristic and sustainable growth. Markets are unable to gain momentum being skeptical of aggressive steps taken by the government to resume the EFF funded facility by the IMF.

The rupee devaluation and local inflation have triggered a snowball effect where every item of domestic, commercial, and industrial use is facing inflationary pressures. Most businesses are now focused on business retention rather than looking for growth opportunities. The government has started taking desperate measures like moving hundreds of items under import restrictions and imposing 100% cash margin requirements.

The overall business environment is looking bleak as uncertainty increases. The government is desperately struggling to sourcing funds from global lenders and friendly countries to avert any adverse economic situation. This has significantly raised the cost of doing business and the current exchange rate and policy rate of 13.75% has adversely impacted the country’s overall economic situation and if this persists, there is a risk that businesses will lose their competitiveness and financial viability, which can trigger a local economic recession.


Huzaima Bukhari & Dr. Ikramul Haq, lawyers and partners of Huzaima, Ikram & Ijaz, are Adjunct Faculty at Lahore University of Management Sciences (LUMS), members Advisory Board and Visiting Senior Fellows of Pakistan Institute of Development Economics (PIDE). Abdul Rauf Shakoori is a corporate lawyer based in the USA and an expert in ‘White Collar Crimes and Sanctions Compliance’. They have recently coauthored a book, Pakistan Tackling FATF: Challenges and Solutions      

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