The Forex challenge

Pakistan suffers from two structural deficits of the budget and the current account of the balance of payments. The budget deficit is being financed heavily by the printing of rupee notes. It is within the power of the State Bank of Pakistan and the government to print and use rupee notes for the purpose, even if it has very serious long-term economic, social and political implications.

However, the SBP and the government do not have the ability to print dollars and have been relying on net capital inflows to finance the current account deficit. Foreign direct investment being erratic due to the political and security situation in the country, large-scale reliance on foreign borrowing has become a norm.

Instead of undertaking policy reforms to narrow or eliminate the current account deficit, every government has taken its begging bowl abroad to borrow on any terms and from every source. It has put the country on a path towards external debt trap.

The only way to avoid frequent balance of payments crises is to adopt a long-term strategy to bring the trade deficit down to a level where current invisible receipts net of current payments can meet the trade deficit, leaving a small or no current account deficit to be financed by net capital inflows. Such a strategy will also enable the SBP to divert net capital inflows towards accumulation of a reasonable amount of foreign exchange reserves, which is needed for several reasons:

First, leads and lags in export receipts and import payments require the cushion of about two months’ imports to avoid trade disruption. Assuming a monthly level of imports of $3.5 billion, there is a need to maintain foreign exchange reserves of around $7 billion for the purpose of trade financing alone.

Second, there is a need to build additional reserves to be used by the SBP both to counter any speculative pressure on the nominal exchange rate and to meet unexpected demand for foreign exchange due to short term non-trade related foreign liabilities.

Third, the SBP should have enough foreign exchange reserves to cover any temporary current account deficit that may emerge in a particular period due to unforeseen international trade developments or unexpected national emergencies/calamities.

While it is difficult to calculate the amount needed for non-trade related contingencies without having access to all the relevant data, an additional amount of about $5 billion may be needed as a minimum, making the total amount of about $12 billion that the SBP should have at its disposal all the time. Considerations of safety and security may require even a higher level of reserves.

It may also be pointed out that these reserves should not be built up by incurring more short-term foreign exchange liabilities but rather by attracting foreign direct investment and relying on long term loans on soft terms. For example, reserves built by taking a short-term deposit from another central bank will not be of much help.

Similarly, if there is a greater dollarisation of the economy and a consequent increase in dollar deposits in the SBP by commercial banks to meet the mandatory reserve requirement on their foreign currency deposits, it should not be counted in the reserves of the SBP. Additionally, the reserves that are already earmarked and purchased in advance by importers for future payments should be assumed to be not available any more for balance of payments purposes.

In the light of the above considerations, let us examine the present adequacy of the foreign exchange reserves of the SBP. In this connection, it is important to first correct a distortion introduced by the SBP in reporting the figures of what it calls “liquid foreign exchange reserves”.

The SBP reported its “total liquid foreign exchange reserves as on November 1, 2013 at $9.5 billion out of which $5.3 billion represented foreign currency deposits of residents and non-residents with commercial banks. The SBP’s inclusion in its “liquid foreign exchange reserves” of foreign currency deposits held with commercial banks by the private sector is legally and operationally invalid.

The government had allowed commercial banks to hold foreign currency deposits of both residents and non-residents under FE Circular number 25 of the SBP dated June 20, 1998. It has a legally binding provision that “the balances of new foreign currency accounts would not be required to surrender to the State Bank of Pakistan” and that commercial banks are “free to keep/invest the same” abroad or in Pakistan. Thus, the SBP has no right of use on the foreign currency deposits with commercial banks. The banks are required to match foreign exchange deposit liabilities with a corresponding amount of foreign exchange asset holdings of their own.

The SBP’s inclusion of these dollar deposits in the tally of “total foreign exchange reserves” amounts to window dressing of reserves. In fact, an increase in such deposits should be treated as flight of capital rather than an increase in reserves. Excluding them, the SBP had no more than $4.2 billion as foreign exchange reserves as on November 1, 2013

Even a part of these reserves represents compulsory deposits in foreign exchange of commercial banks with the SBP to meet the special reserve requirement of the SBP on foreign currency deposits. These deposits are practically owned by commercial banks and should be set aside in a special account and not shown as reserves.

Additionally, there are short-term foreign currency deposits of foreign central banks and governments held by the SBP. These cannot be used without the risk of defaulting on their repayment. Finally, there are forward sales of foreign exchange by the SBP for import financing. All the amounts under these heads should be deducted from reserves in determining the level of ‘free reserves’ at the disposal of the SBP. With all these adjustments, the ‘free reserves’ of the SBP will most probably be negligible or negative on November 1, 2013.

The challenge for economic policymakers is to increase the current negligible amount of free reserves to an amount of about $12 billion over a few years’ time. The first step should be to take further measures to channel home remittances through the banking system and give incentives to Pakistanis working abroad to invest their savings in Pakistan.

Right now most of the remittances are sent by expatriate Pakistanis for family maintenance and consumption financing. Avenues for productive investment with legal and practical protection of property rights can go a long way in increasing remittances for investment in Pakistan.

Second, steps should be taken to promote exports and curtail imports so as to bring down the trade deficit. That would require adoption of a long-term export-led growth strategy in place of the present policies, which discourage savings and exports and encourage consumption and imports. Moreover, effective steps need to be taken to discourage under-invoicing of exports and over-invoicing of imports that has become a source of holding assets abroad.

Third, measures should be put in place to reduce capital flight taking place through the foreign currency deposit scheme and other loopholes in the system. While Pakistan is obliged under Article 4 of the Articles of Agreement of the IMF to avoid restrictions on current transactions, it has every right to stop legal and illegal capital flight. The government should undertake a comprehensive review of the situation in the capital account and take measures, inter alia, to stop capital outflow and bring back the assets that have been kept in foreign countries by citizens of Pakistan.

Briefly, net long-term capital inflows should be systematically diverted from financing of the current account to building up of foreign exchange reserves by gradually reducing the trade deficit and increasing remittances for investment in Pakistan and stopping capital flight from the country.