By Khurram Husain
Published in Dawn on August 31, 2023
FOR more than two and a half years now, at least, the country has been seeing relentless and unending pressure on the exchange rate and the price level. The present bout of exchange rate volatility began in May 2021 and has continued unabated since then. The dollar had moved around 150 to the rupee for two years until that month. Less than 30 months later, its value doubled versus the rupee, and still the pressure is refusing to subside. It took 10 years for the dollar to double in value from 75 to 150 rupees, from 2008 till 2019. It took less than two and a half years for it to double again from May 2021 till the present.
As the same time, inflation as measured by the Consumer Price Index skyrocketed only a few months after May 2021, and rose relentlessly till our time, with a few interruptions along the way.
The question to ask is: what is driving this relentless surge for almost two and a half years now, punctuated with brief moments of what seems like stability? Why this persistent surge in pressure on prices over such a long period?
To find the answer, do a simple exercise. This gets a bit technical, so let me explain it first. Take the money supply projections contained in the IMF staff reports of April 2021, February 2022 and September 2022. Take the overall broad money supply, called M2, as well as the aggregates called Net Domestic Assets (NDA) and the Net Foreign Assets (NFA), and put the projections into an excel sheet. Underneath each of these projections, take the data reported by the State Bank for the same period, and calculate the difference between reality and projection.
Why this persistent surge in pressure on prices over such a long period?
The projection represents the path to stability. It tells us how the money supply and its aggregates need to move in order for the mounting external sector pressures on the economy to be dissipated. The real figures, reported by the State Bank, tell you what actually happened in reality. The difference — reality minus the projection — tells you how far the economy moved from its projected path to stability.
When you do this exercise, you will notice something. Overall, broad money growth remains more or less within a narrow band of where it is supposed to be. So far so good. But notice how the compositional aggregates are moving relative to where they are supposed to be. The IMF projected a certain level of money supply growth in each staff report. But in its projections, the bulk of the growth was supposed to come from rising NFAs, with NDAs either growing slowly (as per the April 2021 projection) or contracting slightly (as per the February 2022 projection).
In reality, the exact opposite happened. If you plot the difference (reality minus projection) you will notice that NFAs are falling sharply while NDAs are rising. This is the diametric opposite of what was envisioned in the projected path to stability. And this divergence not only continues in both periods covered by the April 2021 and February 2022 staff reports, it also aggravates. By the time of the September 2023 staff report, the difference between where we are supposed to be by programme end (Q4FY23) and where we actually were is so large that it is difficult to fathom how it is going to be rectified.
Now, look at the staff report for the latest Stand-by Arrangement. You will notice that the projections for the monetary aggregates do not even envision a path back to stability. All they do is arrest the deterioration. The previous three staff reports envisioned NFAs becoming positive within a quarter or two. In the SBA, they remain negative throughout the programme period. All that the government is being asked to do is to go into a holding pattern, arresting further deterioration in the money aggregates.
This is the crux of the matter. Serious malfunctions on the balance of payments and fiscal accounts are throwing the monetary aggregates far from their projected path to stability. This malignant movement in the monetary aggregates, in turn, is fuelling inflation and exchange rate pressure. Endless rounds of devaluation are failing to arrest or dissipate the pressure, because the underlying movements keep producing more pressure even after every devaluation. There is no “market-based exchange rate” at the moment in Pakistan, because the market itself is broken, starved of dollars, and cornered by the state as the largest claimant of all freshly created domestic liquidity. Monetary operations alone — hiking interest rates and devaluing the rupee — will not be enough to arrest this trend, unless they are accompanied by fresh inflows of foreign exchange and a sharp contraction in the fiscal account.
It is extremely difficult now to envisage a path to stability on the back of traditional IMF-mandated adjustment alone. Those typically involve rate hikes, devaluations, fresh taxes and expenditure cuts. But this time, the scale of the adjustment required will be so large it could potentially take a wrecking ball to the integrity of state and economy. I cannot recall the last time I saw a situation like this.
It will take years, but it can still be done. The State Bank will have to build reserves by starving the interbank market of dollars, while the state will have to mobilise a massive tax effort the likes of which it has not done in decades. Or a fresh exogenous event that results in a new shower of foreign exchange coming upon us appears. In the meantime, to get a sense of where things are moving, keep an eye on the broad money, NFAs and NDAs as they shape up, and see whether they are trending towards or away from the projection in the SBA. And best of luck to everyone! The scale of what is coming should not be underestimated.
