ISLAMABAD, 8 July — Pakistan has adopted a seven-pronged strategy to build up its forex reserves and stabilize exchange rate by eliminating volatility.
The strategy consists of: Unifying the present interbank and kerb market in forex, establishment of Forex Exchange Companies (FECs) and banning money changers, discouraging dollarization of the economy, reducing private dollar deposits of resident and non-resident Pakistanis with commercial banks within the country, increasing the forex inflows both in the form of FDI and holdings of Pakistanis abroad, encouraging home remittances of overseas Pakistanis and prevention of money laundering.
The new policy has started to pay initial dividends. But, its effectiveness will be tested fully in the next six months. That the State Bank of Pakistan (SBP) resorted to such a policy means that this is a warning by the SBP, the country’s central bank. The SBP says, “due to unprecedented improvement in the current account deficit that showed a surplus of $2.1 billion during July-March of fiscal 2002, the enhanced vulnerability of the external sector has been contained, but many of the factors responsible for this upturn are still mired in uncertainty.” The SBP has good reasons to issue this alert to the government. It says, for example, the grants from Washington are “unlikely to be available in the amounts received in fiscal 2002 that ended June 30 and should be discounted from future projections,” because the immediate US purpose has been achieved, although the operation in Afghanistan may linger on at a reduced scale. Washington granted $600 million for balance of payments support and paid $300 million as logistic fees for using its airfields and military facilities for operations against Al-Qaeda and the Taleban in Afghanistan.
The SBP estimates a loss of at least $1.53 billion on account of “vulnerabilities” during fiscal 2003 compared to 2002. In order to encourage FDI flows, the government has reduced corporate taxes and in two years, lowered the customs duty on nearly 6,500 items. These steps are meant to reduce the cost of doing business in Pakistan.
The other vulnerabilities include the fact that the trajectory of oil prices is moving up. The savings from low international oil prices in fiscal 2002 will not be available in fiscal 2003.
Until the market-driven interbank forex rate and the kerb market are integrated, the permanence of the improvement in flows of overseas workers’ remittances will also remain uncertain. The Interbank market determines the forex rate for almost 95 percent of all transactions, including $21 billion in foreign trade, annually. The kerb market in forex, mainly dollars and Gulf currencies, handles between $4 to $6 billion a year.
“This underlines the need to consolidate positive structural changes in the external sector by removing the segmentation of the foreign exchange market. Therefore, the planned introduction of Foreign Exchange Companies (FECs) is an important step forward. Given Pakistan’s established pool of expatriate worker’s abroad, this will help to ensure more dependable flows to formal channels” — regular banks, rather than the present widespread use of ‘hawala’ or ‘hundi’ — the SBP hopes.
But, there is a big “if” in what SBP hopes and what actually may happen regarding the inflow of expatriates’ home remittances, as well as export earnings several businessmen retain abroad. SBP and the government will have to ensure the exchange rate stability. In case the exchange rate turns volatile, the rupee weakens and there is a substantial spread or premium between the interbank and the kerb rates, overseas Pakistanis and businessmen will not like to suffer a loss. They may seek other means to bring money to Pakistan, in spite of establishment of FECs.
SBP’s forex hopes are based on some of the positive pointers, it saw during 2002. The greenback compared to the rupee, for instance, went down 6.25 percent in the interbank market during the fiscal. Out of this, dollar had declined 4.0 percent before Sept. 11, and 2.25 percent afterward.
The dollar’s decline in the kerb market was steeper still where it was down 9.8 percent during the year. Most of the decline occurred after Sept. 11. The dollar that was quoted in the interbank market on June 30, 2001, at Rs. 64.07/64.09 went down to Rs. 60.03/60.05 on June 29, 2002. The kerb market saw the dollar tumble from Rs. 66.70/66.80 on June, 30, 2001, to Rs. 60.20/60.25 on June 29, 2002. Over the weekend interbank rate was Rs. 60.07/60.10, and kerb Rs. 60.28/60.23.
Larger forex inflows, including both remittances sent by expatriate Pakistanis from US, Gulf, as well as Western aid and grants, strengthened the rupee parity against the dollar and other currencies.
SBP intervened in the interbank and the kerb markets on several occasions during 2002. It purchased dollars when the US currency was declining in relation to the rupee. By doing so, the SBP not only added these dollars to its official forex reserves, but it also did not allow the rupee to appreciate to a level where it would have made exports more expensive for foreign buyers. The official forex reserves, as a result partly of dollar buying and larger inflows rose from $3.2 billion as on June 30, 2001, rose to $6.2 billion on June 29, 2002. Both amounts include a third belonging to private resident and non-resident dollar depositors.
The commercial banks have placed these dollars with the SBP. The government is of the view that if SBP did not conduct dollar buying operations during 2002, the Pakistani currency would have appreciated to Rs. 55 to a dollar. A costly rupee would have been injurious to the country’s exports that have stagnated at around $9.0 billion for years. SBP purchased nearly $4.0 billion from the interbank and offshore kerb markets.
At the same time, there were occasions in 2002 when the dollar started rising against the rupee. Then the SBP sold the greenback in the interbank market.
The SBP is discouraging “dollarization” of the economy. It has asked commercial banks to reduce their forex deposits to less than 20 percent of all deposits by no later than Dec. 31, 2002. The banks are also paying a very nominal interest on forex deposits that ranges from 1 to 1.75 percent. This is quite a disincentive to depositors. As of now, Pakistani bankers and government’s economic managers are quite optimistic. One indication: the spread between the interbank and the kerb rates that was Rs. 2.70 on June 30, 2001, narrowed to an all-time low of Rs. 0.20 on June 29, 2002.
One of the elements that encouraged overseas Pakistanis to remit money through official banking channels, rather than the ‘hawala’ or ‘hundi’ was closer monitoring of money movement, following Sept. 11. Fearful of their remittance getting tied up in the monitoring, the expatriates doubled to $2.0 billion the money they sent home through banks during 2002 compared to $1.0 billion in 2001. The government hopes remittances will rise further during 2003. Exports earnings held by Pakistani businessmen abroad were also brought back as the kerb market premium and chances of the dollar appreciating thinned. The narrowing down of the spread between the two markets have encouraged the SBP and the government to unify the forex market, and bring an end to speculative kerb operations. The central bankers hope that formation of Foreign Exchange Companies (FECs) will bring about that unification. Officials of the Ministry of Finance (MoF) say that a law to establish FECs will be on the statute book in the next few days. They also hope that the law regulating FECs will leave very few operators in the market.
Pakistan has nearly 400 money changers, licensed by the SBP, while there are another 400 unlicensed ones. The government’s intention is to ban the unlicensed ones firmly.
The FECs will operate under new and stricter rules, reporting details of all transactions and identification of all buyers and sellers of forex to the SBP. The FECs will also have to abide by SBP’s Prudential Rules for clean banking. Pakistani and foreign-based banks will also be allowed to buy and sell forex, from which they had been forbidden so for.