Pakistani policymakers and politicians learn Econ 101 the hard way

Over the past year, Pakistani policymakers and politicians have had to learn basic lessons taught in Econ 101. Guided by lazy punditry that wrongly claims that fundamental economic principles do not apply in Pakistan, they have chosen to rely on administrative measures rather than markets, ignored the law of unintended consequences, and implemented the misguided policies of fixing the exchange rate, price controls, and import restrictions that have led the country towards an economic meltdown. The resulting scarcity of raw materials and a squeeze in profitability have led to the closure of many factories across different sectors. A large number of layoffs of workers is severely aggravating the misery of households across the country already crushed by rampant inflation. Meanwhile, an increasing section of the population falls into poverty.

The series of egregious policy interventions started under the previous Finance Minister, Miftah Ismael, with the State Bank of Pakistan (SBP) requiring commercial banks to get prior approval before opening letters of credit (LCs) or registration of contracts for certain types of imports like completely knocked down kits (CKD) for assembling cars and cell phones, as well as certain types of machinery. While the SBP denied giving instructions to curb imports, in reality, only those banks that were receiving inflows from remittances or exports were allowed to process import payments. Several other commercial banks struggled to process import documents. Although this was meant to be a temporary measure for maintaining forex reserves, like most administrative actions, once in place, it not only assumed a permanence but also expanded in scope to many more imports than originally stated. 

These included basic raw material inputs for exports and a large array of other manufacturing units across many sectors. 

With the induction of Ishaq Dar as Finance Minister, the folly of rationing LCs was compounded by informal instructions to banks and licensed exchanges to manage the rupee parity price against the dollar. Forex dealers were provided daily guidance by the central bank to transact in the open non-interbank market at SBP-recommended rates. Suppressing the trend movement in the exchange rate against the market-determined mechanism fuelled the growth of an undocumented curb market for currency transactions as volumes at the SBP recommended rates shrunk to negligible levels. This contributed to the reduced inflow of foreign exchange. With a large gap, ranging from 10 to 20 percent, emerging between the curb market rate and the interbank rate, more of the workers’ remittances started being channeled through informal means such as hawala/hundi. The inflow of remittances in Pakistan fell and the uncertainty in currency markets also encouraged exporters to delay the conversion to rupees of export dollar proceeds in anticipation of future depreciation.

The downward spiral in output has been worsened by the administrative controls on Letters of Credits, that will now take considerable time to reverse.

Javed Hassan 

Trying to fix the rupee parity went directly against the agreed-upon policies under IMF’s Extended Fund Facility (EFF) program. Artificially managing the rupee distorts consumer prices and mid-priced state-determined electricity, gas, and petroleum tariffs, which has significant fiscal implications. A breach of the market-determined currency regime signalled to the lender a lack of commitment to structural reform and contributed to the program’s ninth review being stalled. 

The government reluctantly had to abandon its ill-conceived intervention to progress in its discussions with the IMF. Since there had been a buildup in the gap between market and interbank rates, the PKR sharply depreciated by as much as 20 percent against the dollar which unleashed a further round of inflation, already high due to supply chain constraints from the administrative curbs on imports. Year-on-Year CPI is currently over 35 percent, which is the highest seen in the last 50 years with no signs of abating soon. The exchange rate fiasco not only damaged the finance team’s credibility but has added fears that the country could default.

Unfortunately, the SBP has fallen short of using the autonomy that it was granted by the parliament to deliver on its mandate, which casts doubt on its credibility also. The SBP Governor appeared to support the government policy of artificially managing the exchange rate. He had asserted that the true value of the exchange rate was close to Rs230 per US dollar just a few days before it sharply fell. As the independent Economic Advisory Group has alluded, “By preventing the exchange rate from fully adjusting while not backing it with an appropriate interest rate stance, the SBP only contributed to the instability that it was mandated to prevent.”

The Finance Ministry and SBP could have avoided the economic mayhem by allowing a market-based exchange rate and appropriate monetary policy to provide an automatic adjustment mechanism to maintain a balance of payments equilibrium. Similarly, the downward spiral in output has been worsened by the administrative controls on LCs that will now take considerable time to reverse. It is hoped that policymakers have learned the heavy price of ignoring economic fundamentals, albeit the hard way.

– Javed Hassan has worked in senior executive positions both in the profit and non-profit sector in Pakistan and internationally. He’s an investment banker by training.

Twitter: @javedhassan