May 192008

By A.B. ShahidThe past two weeks witnessed a rapid fall in the exchange value of the rupee triggering a controversy about what should be its realistic exchange rate, and who is fiddling with it.

The way things stand (highest ever trade, current account and balance of payment deficits, inflation), there are plausible reasons why the rupee is falling though the extent of its fall is indeed questionable.

In markets not suffering from aberrations that Pakistan faces, spot and forward exchange rates between two currencies are linked according to the universal formula whereby forward rates are based on the spot rate and the interest rates of those currencies. Presently, this is not the case with rupee/dollar forward exchange rate quoted by banks, which make the rate suspicious.

Based on market’s closing rates on May 13 (per press reports), there is a clear disconnect between what is the spot rate, and what it should be. According to the formula, given the market’s mean spot dollar selling rate of Rs68.38/dollar and 6-month dollar interest rate of 2.83 per cent (LIBOR) and that of the rupee quoted at 10.59 per cent (KIBOR), the forward premium should be around Rs3.58/dollar, and the forward rate should be close to Rs71.96/dollar(i.e. Rs68.38+ Rs3.58).

But, the market quoted the 6-month forward rate as Rs70.35/$. Working backwards, this rate yields a spot rate of around Rs66.96/dollar, and not Rs68.38/dollar. Banks are unable to convincingly explain this disconnect between the spot and forward rate. There are reasons for this distortion though all of them are not plausible; apparently, a bit of speculation is involved.

Bankers say that they are under pressure to supply dollars to importers on spot basis to pay their import bills. Meeting these commitments to beneficiaries abroad if under letters of credit or guarantees, is also binding upon banks that make commitments thereunder on behalf of their importers. Banks operating with the current country profile can afford to breach these commitments only at the risk of losing their credibility in the international banking circles.

On the other hand, expecting further depreciation of the rupee in the coming weeks, with the help of importers abroad, exporters are delaying realisation of export proceeds and aggravating a cash flow problem in banks. This is forcing banks to buy dollars at inflated prices that pull the rupee down. What else do we expect if imports (a large portion thereof luxury goods of no economic value) go on unabated given the ‘trade liberalisation’ that the last regime indulged in?

The arguments make sense. Rising prices of almost all imported items are enticing importers into importing more and as early as possible, but there is another aspect that needs scrutiny – flight of capital. Pakistanis are buying unusually large numbers of properties in the UAE and investing in businesses given the decline in economic indicators and growing uncertainties about the coalition regime’s future.

The fact is that rising current account and trade deficits have shaken bankers’ confidence (despite the promises of future dollar inflows) for two valid reasons. First, the inflows promised as of now ($3.5 billion) are well below the expected rise in trade deficit by end of FY07. By April, it had crossed $16 billion; by year-end it could touch $21 billion even if, by mutual consent, payment for recent oil imports is delayed until early FY08.

Second, while inflows from foreign governments (China, Saudi Arabia and others) may arrive on time, inflows on account of purchase of shares in private sector companies could be delayed by the local share sellers in the hope of making additional capital gains from the rupee’s continued depreciation. Shareholders’ overly profit-oriented mindset triggers this view. Besides, some bankers may know that backstage moves to this end are in progress.

That is why, to meet their spot dollar payment commitments, banks are entering into rupee/dollar swaps (i.e. spot dollar purchase and simultaneous forward sale commitment thereof to offset the resulting exchange exposure). Theoretically, banks can do so but only if, either before or the date on which dollars sold forward are to be delivered, they will be receiving at least the same amount of dollars to meet their commitment under the forward sale contract.

However, if this is not so i.e. no inflow of dollars is expected at the future date agreed in the forward sale contract, that swap will create an exchange exposure. There could be cases wherein dollars bought on spot were sold to importers (who surely will not sell them back at the delivery date of the forward sale contract), and there will also be no dollar inflow at that future date either on account of export proceeds realisation, or under any other definite transaction.

These are the exposures that need to be contained because banks could otherwise go on building large over-sold positions in dollar. SBP is aware of this possibility, and has commenced spot audits of bank treasuries, and has also restricted export of cash foreign currency by the moneychangers. But it needs to do more to contain the flight of capital; intelligently devised incentives could do the job better.

Tactless market deregulation provided market players the clout that frightens regulators. In deregulated economies regulators are discovering new limits to their market disciplining abilities. But in spite thereof, they must go on devising checks that prevent market corruption (by few) without creating an under-privileged class among the market players.

For the moment, rapid depletion of exchange reserves has stunted SBP’s ability to intervene in the market in an effective manner. Except for containing imports with marginal economic value, there is no immediate solution to Pakistan’s woes. SBP can achieve this objective by imposing indirect controls on imports that do not violate WTO restrictions by raising tariff barriers.

What we urgently need is re-building investor confidence. That being the case, SBP must use its regulatory muscle to instil sanity in the financial markets that shift the use of scarce exchange reserves for trading activities that yield maximum economic benefit.
Source: Daily Times 19/5/2008 

 Posted by at 11:33 pm

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