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A tale of two currencies

by Muhammad Ragheeb-ud-din
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Pakistan’s complete economic meltdown is in progress with the currency market being the prime indicator of how quickly things are spiraling out of control. Pakistan’s currency has gone from 100 to 1 USD to 305 in a matter of six years with open market trading at more than 340. This has fuelled a storm of inflation with petrol, energy, food, medicine, and cars showing more than triple increases in price which has destroyed the livelihood of a vast majority of the population. Inflation for the past two years has reached the highest level in the recorded history of the country and there is no respite in sight with the currency continuously crashing in the open market as well as consistent decline in interbank. The difference between the interbank and open market is now more than 10% and the month-on-month decline is more than 7% since the current caretaker setup took charge. The increase in interbank is due to the IMF condition of no import restrictions which the previous PDM government had imposed by linking access to dollars for import with export. This had incentivized several industries to increase exports in order to access dollars for imports leading to a continuous current account surplus for four consecutive months until July this year. With import restrictions gone July and August saw roughly 8 billion dollars of imports combined and this created pressure on the rupee leading to its fall from around 280 to 305 in interbank. The situation in the open market however is far more dangerous since the dollar has become a speculative asset now. Everyone is trying to buy the dollar as they believe its price is set to increase since the state bank and finance ministry can no longer intervene directly as they had under the previous government as per IMF conditions. This fuels demand for dollars in open market and hence it becomes a self-fulfilling prophecy leading to another cycle of dollar buying for speculative purpose which again leads to more depreciation. Smugglers are also increasingly buying dollars for the purpose of smuggling sugar, wheat, rice to Afghanistan. With international prices of these commodities increasing, mill owners are interested in exporting their produce abroad both legally and illegally to increase their earnings. This has created a great surge in demand for dollars to carry out these transactions which is further appreciating USD in open market. Simultaneously it has also caused massive surge in prices of sugar, rice and wheat in the local market since most of the produce having been moved abroad, now has to be imported at a higher price for local use. The need to import also increases demand for dollars which again feeds in to the cycle of devaluation and inflation. Lastly both smugglers and speculators have easy access to rupee via the 9 trillion cash currently in circulation in the country. This represents more the 30% of the total money supply of the financial system allowing hoarders and smugglers to pay ever higher rates for dollars thus leading to a complete collapse of the rupee in open market. Increasing interest rates which is what state bank has been using in order to convince people not to buy dollars but keep money in banks is ineffective as a strategy since for a smuggler it doesn’t matter how much banks pay him from savings accounts he needs dollars at all costs for his operations. Same goes for hoarders who believe they can get more return via dollar transactions then banks deposits. Instead this policy of high interest rates has greatly increased debt and interest payments which the government has to make to domestic and international borrowers leading to further government borrowing to plug the gap which in turn fuels more inflation. Increasing interest rates also reduces borrowing by the private sector and increases cost of doing business which in turn leads to unemployment, low wages and further inflation. It hinders expansion of existing businesses which especially in-turn leads to a shrinking manufacturing sector thus decreasing the country’s exports. This again fuels a large current account deficit which in turn leads to further depreciation of currency again trapping the nation in a vicious cycle. Breaking out of this vicious cycle requires concrete steps on an urgent basis. Firstly demonetization of the five thousand rupee currency note needs to be carried out. This will ensure that cash lying outside formal banking channels either enters said channels or is removed from the financial system so that it isn’t available for dollar hoarding and smuggling. Alternatively it will also boost tax collection since the informal sector of the economy will be formalized leading to lower budget deficit for the government which in turn will reduce borrowing and thus the interest rate and boost the private sector . This will lead to increased industrial activity which will boost exports and help maintain current account surplus and prevent further devaluation and inflation. Secondly all foreign currency transactions should be via bank branches rather than currency exchanges. Currency exchanges may bring in foreign USD and take a percentage charge for generating new inflows but all USD should be placed with state bank and commercial banks and they should be responsible for providing dollars to importers and locals within the proscribed limits. This will prevent hoarders and smugglers from accessing dollars and ensure exchange rate stability. Lastly, the old policy of importing equivalent to export proceeds needs to be readopted and the IMF is convinced of its necessity since this ensures we have surplus dollars available with state banks for debt repayments and honoring local demand close to interbank rates. If certain steps are not undertaken at the earliest it is feared that Pakistan may soon see dollarization of its economy much like Lebanon Argentina and Turkey are seeing at the moment with prices of all goods spiraling out of control leading to anarchy and societal collapse. Pakistan will cease to exist as a viable state even though right now it is barely one. The vicious cycle needs to be stopped at all costs and soon.

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