A section of society has criticised the government for the continuing depreciation of the Pakistani rupee. Although between December 8, 2017 and June 27 this year, the value of the rupee has gone down 18.65 percentage points relative to the American dollar, the depreciation was either unavoidable or could have been averted at a great cost.

The exchange rate is the price at which one currency is exchanged for another. It is determined, just like prices of two or more commodities, by the relative demand and supply of domestic and foreign currencies.

If the demand for a foreign currency, such as the dollar, exceeds its supply, it will appreciate, which means that the domestic currency will depreciate. The greater the difference between the demand and supply, the sharper will be the upward or downward movement of the exchange rate.

A country’s demand for and supply of foreign currency is reflected by its balance of payment account, which consists of two types of entries: debit items and credit items. The former covers payments made to foreigners, such as import of goods and services, and debt servicing; the latter covers payments received from foreigners, such as export of goods and services, investment inflows, and credit.

The demand for a foreign currency arises from debit items in the balance of payments, while the supply of foreign currency comes from credit items in the balance of payment. Thus if a country imports more than it exports, its demand for a foreign currency will exceed the supply thereof and thus the domestic currency will tend to depreciate.

The result will be similar if capital outflows exceed capital inflows. Hence, when an economy is facing an adverse balance of payments position, it is likely to have a weak exchange rate position i.e. its currency will depreciate.

Mounting deficits

Pakistan is running trade and current account deficits for last several years. In the financial year ending 2015, trade and current account deficits were $22.16 billion and $3.12bn respectively, which increased to $23.9bn and $5.45bn respectively in FY16 and further to $32.48bn and $12.94bn respectively in FY17.

Then why did the exchange rate remain relatively stable for more than three years? The answer is that the stability of an actually overvalued rupee was maintained by pumping foreign currencies into the market, which brought down the foreign exchange reserves (forex) available with the central bank. It was only a matter of time when in view of depleting foreign exchange reserves the State Bank of Pakistan would no longer be able to keep an overvalued exchange rate.

Depreciation acts as a self-correcting mechanism, which tends to make exports cheaper and imports expensive. This helps reduce trade deficit. The actual impact on the trade balance is contingent upon relative price elasticity of exports and imports. An overvalued rupee did not allow the self-correcting mechanism to work with the result that a high trade deficit was accompanied by an overvalued exchange rate, which is an unusual as well as an undesirable combination.

Let us now return to the depreciation of the rupee against the dollar during the outgoing fiscal year (FY2018). During FY18 (July-May), current account deficit reached $16.50bn compared with $11.14bn during the corresponding period of FY17.

The current account deficit is underpinned by $27.93bn trade deficit on merchandise account and $4.73bn for trade in services. According to the PBS, merchandise trade deficit reached $34bn for FY18 (July-May). The primary income deficit during the first 11 months of the outgoing fiscal year was $4.83bn, while secondary income account recorded $21.54bn surplus thanks to $18.03bn remittances.

The large trade and current account deficits indicate that the demand for dollars has far exceeded their supply, which has sharply driven down the exchange value of the rupee.

Rock and a hard place

The financial account position has not been rosy as well. During FY18 (July-May), the country received $2.47bn as Foreign Direct Investment (FDI) and $2.28bn as foreign portfolio investment.

During FY18 (July-March), debt servicing, which represents capital outflows, soaked up $4.97bn, while $15.62bn net external borrowing was recorded during the first eleve11 n months of the outgoing fiscal year. As a result of problems on both current and financial accounts, foreign exchange reserves available with the central bank declined from $16.14bn on June 30, 2017 to $10.26bn on June 14, 2018.

The falling foreign exchange reserves constrained the State Bank’s ability to directly intervene in the market by injecting dollars into it. Not only that, the weakening forex position conveyed a negative signal to the market. Speculations were rampant that the dollar would go up further. As a result, the demand for the dollar went up, which actually drove up its price in terms of the rupee – a self-fulfilling prophesy.

The only way the government or the central bank could keep the exchange rate stable was to restrict the purchase of foreign currencies, particularly the dollar, in the open market. But that would have created an acute shortage of dollar leading to its under-the-counter trading at a much higher conversion rate.

What is needed to prevent further depreciation of the rupee is substantial net foreign capital inflows (export receipts, FDI, foreign aid), which will increase supply of the dollar and convey a positive signal to the market thus reducing speculations. As any increase in export receipts is likely to be offset by increased import payments, hefty external assistance, whether bilateral or multilateral (such as from IMF) seems to be the inevitable recipe.

This article first appeared on Dawn.