Pakistan's Foreign Exchange Rate and

Control Regimes
Written By: Dr Zafar Mahmood

This is first of the two articles on the exchange rate that I am contributing for the worthy readers of the Hilal.
This article begins by explaining the exchange rate and then delves on to demarcate the evolution of Pakistan's
exchange control regimes. The second article will provide reasons as to why Pakistan is currently experiencing
volatility in its exchange rate.

Exchange rate is the price of a currency at which a country trades it for another country's currency, normally on
the foreign exchange (forex) market. The foreign exchange market exists predominantly among large banks,
domestic and foreign, and among foreign exchange companies. Exchange rate is usually determined in the forex
market through the interaction of supply and demand arising from the forex market transactions. In reality, there
are different rules under which a country's exchange rate is determined, especially the way the monetary or other
government authorities intervene in the forex market or stay away from it. Broadly speaking, the exchange rate
regimes include pegged or fixed exchange rate, managed floating exchange rate, and flexible exchange rate.
Pegged exchange rate is a regime in which the central bank announces an official (par value) of its currency and
then maintains the actual market rate within a narrow band by intervening in the forex market.

Managed floating exchange rate is a regime in which exchange rate fluctuates on daily basis but the central bank
attempts to influence the exchange rate by buying and selling currencies. It is also called a 'dirty float'. A floating
or flexible exchange rate is a regime wherein a currency's value is allowed to fluctuate according to forex market.
In this regime, the central bank does not intervene in the forex market to influence the exchange rate but it does
not preclude the central bank to buy or sell foreign currencies for other purposes. With above understanding of
the exchange rate, let us now turn to delineate different phases of the exchange rate regimes of Pakistan.

Fixed Exchange Rate Regime (1947-1981): After independence in 1947, Pakistan linked its currency to the
Pound Sterling; this link was maintained till 1971. In 1949, the UK government devalued the Pound Sterling and
India followed it by devaluing its Rupee. Both of them pressurised Pakistan to devalue its Rupee. Pakistan was
one of their major suppliers of raw materials and a buyer of their finished products. Pakistan, however, took its
sovereign decision not to devalue its currency at that time. Pakistan took this decision because devaluation of its
currency would have meant our imported plants and machinery becoming expensive to our industries, while
given a small export base there was no guarantee that exports earnings will increase. Later on it turned out to be
right decision because it not only supported our industrialisation drive but it also enabled Pakistan to diversify
its export markets.

Up to August 1955, the rupee-dollar exchange rate was maintained at 3.31 rupees per US dollar. After the Korean
War boom there was a global recession and the world economies including Pakistan faced the problem of scarcity
of the foreign exchange reserves. Consequently, Pakistan had to devalue its currency in 1955. The new rate was
fixed at 4.76 rupees per US dollar; that is, the rupee was devalued by 30 %.This devaluation enabled Pakistan to
realise a growth rate of 44.4% in just one year.

With the increase of economic influence of the USA, Pakistan pegged its currency to the US dollar on 17th
September 1971 but the exchange rate of Pakistan with US dollar was kept fixed at Rs.4.76 per US dollar. By
the end of the 1960s, Pakistan was implementing a very complex system of controls and multiple exchange rates
owing to export bonus voucher scheme. To come out of the clutches of this system, Pakistan opted to devalue
its currency and abolishing the prevailing schemes of export promotion. It devalued its currency by 58% and the
new exchange rate was set at Rs. 11 per US dollar on 11th May 1972.

Pak rupee appreciated by 11% in February 1973 after the devaluation of US dollar by 10%. As the rupee was
pegged to US dollar, Pakistan had to revalue its currency to Rs.9.90 per Us dollar. This exchange rate continued
till 7th January 1982. With rising domestic inflation, large fiscal deficit and decline in remittances, the rupee
once again became overvalued, especially after the appreciation of the US dollar to which the currency was
pegged. To overcome this problem Pakistan abandoned the fixed exchange rate with US dollar and float the
rupee under managed exchange rate regime by delinking its currency with dollar and linking it with the
currencies of 16 major trading partners following the worldwide trend of deregulation of economies and
exchange rates. The exchange rate adjustment allowed Pakistan to experience an export growth rate of 26.8%
per annum during this period.

Managed Floating Exchange Rate (1982-1998): The government fine-tuned the over-valuation of the currency
by adopting the managed floating exchange rate on 8thJanuary 1982 and linking the currency to a basket of
currencies of its major trading partners. The value of the currency started declining after the adoption of the new
exchange rate regime. Since 1991, some new measures to reform the exchange and payments system were
introduced that include: (i) resident Pakistanis were allowed to maintain foreign currency accounts like non-
residents to attract funds held abroad by private citizens, legally or illegally; (ii) restrictions on holding of foreign
currency and on foreign exchange allowances for travel were removed; and (iii) rules governing private sector's
foreign borrowing were liberalised, especially where no government guarantee was required. In addition, host
of other restrictions on foreign payments were removed (e.g., for the purpose of education, royalty payment,
foreign advertisement, and professional institutions' membership).

In 1994, full convertibility of Pak rupee was introduced for current account transactions as part of the trade
liberalisation programme, while for the capital account convertibility a cautious approach was adopted. The
central bank implemented partial convertibility of the capital account by allowing foreign exchange companies
to operate in Pakistan and the corporate sector to obtain foreign equity. Pak rupee was also made fully convertible
for some capital account transactions, e.g., foreign portfolio investment in the country. Aside from allowing 100
% foreign equity participation, no restrictions were in place on the repatriation of capital, profits, royalty, etc.
With all of these measures, Pakistan was able to achieve an annual growth rate of 8% during this period.

Multiple Exchange Rate and Dirty Float Regimes (July 1998-July 2000): This phase was marked with political
instability in the country and economic sanctions by western countries as a result of the nuclear test by Pakistan.
The government froze the foreign currency accounts in order to preserve its official foreign exchange reserves.
These circumstances eroded the confidence of the private sector. Whatever liberalisation achieved on current
and capital accounts in the earlier periods was virtually reversed. To counter the crisis, government adopted the
system of multiple exchange rates consisting of an official rate (pegged to US dollar), a Floating Inter-Bank Rate
(FIBR), and a composite rate (combining official and FIBR rates). During May 1999, Pakistan adopted the
system of dirty floating exchange rate and the currency was pegged to the US dollar by removing the multiple
exchange rate system. The exchange rate was then defended within narrow bands (margins) till July 2000.
Because of the events of this short period, Pakistan faced an annual decline in exports at the rate of -0.34%.

Flexible Exchange Rate Regime (July 2000-2009): Since 20th July 2000, Pakistan de jure is following a flexible
exchange rate regime. Nevertheless, the de facto exchange rate arrangement has managed to float without fixing
pre-determined paths for the exchange rate. The central bank's interventions are limited to moderating and
preventing excessive fluctuations in the exchange rate. The central bank intervenes in the market using the US
dollar. Foreign exchange controls and restrictions are now minimal. Current account transactions are now
unrestricted except for occasionally imposed limits on advance payments for some imports. Foreign investors
can now freely bring in and take out their capital, profits, dividends, royalties, etc. IMF (2010) classifies
Pakistan's exchange rate regime as a de facto conventional peg to the US dollar within a narrow band. During
this period exports grew by 8.8% per annum.

A Volatile Exchange Rate

This article aims to explain reasons behind the current volatility seen in the exchange rate of Pak currency.
Immediate impacts of the fall in the value of the currency can be summed up as: rising inflation, interest rate,
and debt. These impacts will accentuate threats to macro-economic stability.

Global economy was performing well between 2002 and 2008; the Pak rupee during this time period was quite
stable. It may be noted that the rupee-dollar exchange rate was 61.4258 rupees per U.S. dollar in 2002, which
changed to 62.5464 rupees per U.S. dollar in 2008. Thus, in these seven years, the rupee depreciated by merely
0.302% per annum, so nominal exchange rate was more or less stable. Global economic crisis (The Great
Recession) erupted in 2008 and continued till 2012. During this period Pak rupee depreciated by 9.28% per
annum. In other words, the value of Pak currency fell from 62.5464 rupees per U.S. dollar in 2008 to 89.2359
rupees per U.S. dollar in 2012. From these observations, one may jump to the conclusion that perhaps Pakistan's
economy is influenced so much from the global events that its currency acts according to the business cycles in
the global economy.

In reality it is not so. It may be noted that in contrast to above observations, now when the global economy has
started showing signs of improvement our currency has become more volatile instead of becoming stable as was
experienced during 2002-2008. It depreciated to about 108 rupees per U.S. dollar only recently, though some
improvement is seen lately. It, thus indicates that reasons for our currency's recent decline lies somewhere else,
not so much in the performance of the global economy.

Let us see that when the global economy is showing the sign of resurgence then why our currency depreciated
so much? The exchange rate, like commodities, is influenced by the demand and supply situation in the foreign
exchange market. Demand for foreign currencies comes from importers, government who has to service foreign
debt, foreign investors who have invested in Pakistan and want to remit their annual earnings abroad, and foreign
workers who are working in Pakistan and want to remit their savings abroad. Supply of foreign currencies comes
from export earnings, investment income earned by Pakistani investors in foreign countries, workers' remittances
working abroad, foreign grants, foreign direct investment, portfolio investment and private and public sector
loans from abroad.

When supply of foreign currencies increases as compared to demand, our currency appreciates and as demand
for foreign exchange increases as compared to its supply, our currency depreciates. During 2008-2012, when
our currency depreciated, the official statistics indicates that exports grew by 7.61% per annum whereas imports
grew by 9.05% per annum. Import of services as compared with export of services remained high; the size of
this difference was over US$ 3 billion. Similarly, the income taken abroad by foreign investors, as compared
with income brought into the country by Pakistani investors, was higher to the tune of about US$ 4 billion. So
these figures suggest that the size of demand for foreign exchange remained much higher as compared with its
supply. Thus, this large and rising gap between our foreign receipts and payments is one of the major causes for
sharp depreciation of Pak rupee.

Countries do benefit from global crisis. They manage crisis to their benefit; but how? They look at early warning
indicators, which inform them about the likely health of the global economy. They act accordingly. They pursue
policies to strengthen their economies to improve competitiveness in the international market. As a result they
are able to penetrate in foreign markets. Moreover, they benefit from the falling prices of raw materials and other
products. For example, the price of oil was US$ 140 per barrel in 2007, which fell to $40 soon after the global
crisis erupted. So countries were able to reduce their import bill. Contrary to the trade pattern of other countries,
what we experienced in Pakistan was import bill on petroleum products going up. It increased from US$ 7.33
billion in 2007 to US$ 11.58 billion in 2008 and to US$ 15.26 billion in 2012. This implies that we could not
take necessary measures to manage our demand and kept on spending more as petroleum prices were low, as if
they will not increase in the future.

Our exports also came under stress because foreign countries, especially our developed trading partners, lost
their purchasing power to buy export products. Concomitantly, whereas our competitors quickly adjusted their
export policies to face global crisis, our policymakers could not adjust to the situation. Our exporters lost
competitive strength mainly due to energy crisis, loss of productivity due to lack of expenditure on research and
development, rampant corruption and poor governance, all of these factors raised the cost of production and cost
of doing business. Thus, opportunity to earn much needed foreign exchange was lost.

Global economic crisis and crises of security and energy in Pakistan also affected Foreign Direct Investment
(FDI), a source of foreign exchange. It is often argued that the global crisis makes foreign investors averse to
taking risks. This leads to a reduction in FDI. We did see a fall in FDI into Pakistan from US$ 5.4 billion in 2008
to US$ 0.82 billion in 2012. Others argue that with the crisis in developed countries their investors look for
investment opportunities abroad, but Pakistan could not attract foreign investors, whereas its competitors were
able to attract FDI of big magnitudes. Consequently, whereas our competitors piled up foreign exchange reserves
and maintained stable exchange rates, our reserves kept on depleting. Again, the problem is not the global crisis
but it is purely due to our inability to exploit the situation.Thus, with fast depletion of foreign exchange reserves,
our currency came under the pressure. Pakistan's internal problems are not the outcome of just last few years.
These have been brewing for quite some time. Dilemma with our policy-making has been that the capital receipts
are used to finance current expenditures instead of using for developmental purposes. Over the time, we have
accumulated monstrous public debt and used it for wasteful consumption instead of investing in productive
activities. Now as our debt is almost out of proportion, investors are shying away from investing in the country
because they know the implications of debt for an unstable economy.

A glance at the import figures of Pakistan explains that we import only 24% capital goods, which also cover
automobiles and their parts. Our imports also consist of 14% consumer goods and 56% raw materials that are
used in the production of consumer goods. Hence, more than 70% of imports are used for consumption.
Remaining 6% of imported raw materials are used to produce capital goods. So, export earnings and borrowing
from foreigners are primarily spent on import of consumption goods. The country can only become strong and
prosperous if export income or loans are invested in productive activities. Alternatively, the economy is doomed
to fail if foreign earnings are used for pleasure consumption. This is precisely happening in Pakistan.

Since the early 2000s such policies are adopted that resulted into higher but unsustainable growth rates. This
was done by transforming the economy into a consumer economy. Such policies delivered higher growth rates.
But due to lack of sustainable production base, the economy started showing damage done to it. Foreign investors
sensed our economic crisis long time ago and realised that the Pakistan economy is fast losing its international
competitive edge; and that money borrowed from them is wasted in consumption instead of used in productive
investment. Some of them left the country with their investment, while potential investors stayed away. Thus,
the pressure remains on our currency due to the paucity of foreign exchange receipts.

Our currency crisis are internal, they are the outcome of bad domestic policies and not because of the global
crisis. Our policies are biased against exports and they are not investment friendly. Under such a situation Pak
currency will remain volatile, as we recently experienced a plunge in our currency to 107 plus rupees a dollar.
Recent ban on the import of gold enabled the government to partly stem the free fall in the value of the currency
but such measures will not be very helpful in the long run. Such policies lack Gravitas. We should stop blinking
eyes to the real issues and problems and stop taking piecemeal and ad hoc policy measures. We must introduce
prudent policies to create macroeconomic stability (sustained high growth with low inflation) as well as stable
exchange rate. Adopt investment and export friendly policies, stop allocating capital receipts into pleasure
consumption and adopt austerity measures for some good time. The resulting increase in foreign exchange
reserves will automatically stabilise the currency.