Why the rupee’s recent winning streak is detrimental to the economy

The Pakistani rupee has seen a remarkable winning streak, appreciating in value by almost 10 percent from an all-time low of PKR 307.09 against the US dollar on September 5, to PKR 277.03 on October 17. This has occurred against the backdrop of a crackdown by state agencies on purportedly illegal foreign exchange trading and the implementation of regulatory reforms within exchange companies by the central bank. Additionally, there has been widespread speculation in the market regarding authorities targeting a parity of PKR 250 against the dollar. While it is impossible to verify the accuracy of these rumors, they undeniably influence sentiment, resulting in the rupee becoming a one-way bet, rising consistently for 28 consecutive trading days.

The uninterrupted daily rise of PKR was even more extraordinary when we consider the absence of significant improvements in underlying fundamentals, such as trade surpluses, balance of payments, inflation, and real interest rates, which would typically support such a dramatic change in the exchange rate. In the absence of such factors, it appears that the sheer determination of authorities to enhance parity through administrative measures was the primary driving force behind the shift in sentiment, and consequently, the value of the currency.

While having a strong currency may have apparent advantages, such as cheaper imports and inflation control, it is crucial to understand that when the state intervenes in exchange rate management, it engages in centralized planning. This approach assumes that the central bank or government possesses the knowledge and ability to determine the “correct” value of a currency. It presupposes that a central authority has access to all the information required to make these decisions. In reality, exchange rates are influenced by countless variables and information scattered throughout the market. No central authority can have access to all this information, and attempts to control exchange rates generally result in distortions, inefficiencies, and ultimately failure. Famously, in September 1992, the UK was unable to keep the value of the pound above a specified limit and was forced to withdraw from the exchange rate mechanism of the European Monetary System.

In Pakistan, the detrimental impact of maintaining an overvalued PKR is well-documented. 

- Javed Hasan

In Pakistan, the detrimental impact of maintaining an overvalued PKR is well-documented. Industries that could have otherwise been competitive failed to reach their full potential due to a skewed exchange rate, and resources were misallocated to less efficient sectors. The reduced competitiveness associated with an overvalued currency can be identified as a major contributing factor to slower economic growth compared to its peers. In the worst case, the exchange rate regime between 2013 and 2018 suppressed exports and boosted imports, resulting in an all-time high trade deficit and a balance of payments crisis.

In the most recent development, the one-way movement of the currency has enticed some market participants to capitalize on what appears to be a sure bet. For instance, exporters are incentivized to forward book their export proceeds, while importers seek to postpone payments to external vendors. After a span of approximately two to three months, these contracts will need to be settled, potentially all around the same time. This is likely to generate a surge in demand for dollars without a corresponding increase in liquidity. Consequently, a sudden sharp depreciation could occur, once again driving up administered prices and fueling inflationary pressures.

The distortions as a result of an overvalued PKR would be further exacerbated if it serves to anchor inflation and, consequently, to ease monetary policy. Effectively, the central bank would be skewing interest rates, encouraging credit expansion when the overall macroeconomic condition does not support sustainability, leading to a temporary economic boom followed by a prolonged bust.

In his essay “The Pretense of Knowledge,” the economist Friedrich Hayek argued against the hubris of central planners who believe they can possess and apply the necessary knowledge to control complex economic systems. He stated, “The recognition of the insurmountable limits to one’s knowledge ought to teach the student of society a lesson of humility that should guard them against becoming an accomplice in men’s fatal striving to control society – a striving that makes them not only tyrants over their fellows but which may well make them the destroyers of a civilization that no single mind has designed but has grown from the free efforts of millions of individuals.”

Hayek’s insight should serve as a guiding principle for policymakers, encouraging them to allow the process of price discovery to unfold naturally, without government coercion to determine the ‘correct’ value of the rupee or interest rates. Centralized decision-making in complex economic systems, such as currency and credit markets, carries inherent limitations. In contrast, decentralized, market-based practices prove more effective in processing and utilizing dispersed information. Attempts to exert undue influence on these markets often result in unintended consequences that can be far more detrimental than the limited short-term benefits they may bring.”

– 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