The last few months have been a roller coaster for the Pakistani Rupee (PKR) and there is a lot of talk about market determined rates, artificially strong rupees and manipulation. Unfortunately, understanding of how foreign exchange markets work in Pakistan is limited to fewer people than you might expect.
How the Developed Market Works
Take Sterling (GBP) as an example. It is a free currency with a huge float. You can find buyers and sellers at any time of the day, at any price level, for almost any realistic trade size. Consumers, investors, businesses, day traders, arbitrageurs, risk and hedging managers can buy or sell without complex or time-consuming procedures, providing a large pool of liquidity.
This is why both bid and bid point to a fair value for the currency and are considered market driven, a great case for effective price discovery. When daily trading volumes are so large, central bank intervention is often seen as a gesture rather than a market-defining event. And its purpose may be to change volatility rather than direction.
We saw it in 1992 when the BoE (Bank of England) spent over £10 billion to influence the market, but ran out of reserves and eventually had to give up. This is why developed countries favor intervention policies rather than direct intervention to influence the market.
An example of intervention policies could be quantitative easing/tightening to influence or compress growth. Of course, black swan events or a sudden shift in sentiment will derail the fair price argument (like how the GBP traded at 1.03 recently), but this has attracted a new pool of investors. , speculators and opportunists, and the GBP climbed above 1.13. A gain of 10% in 10 days! This is the kind of incentive traders seek if something is mispriced, causing market prices to gravitate toward fair prices.
Market determined prices
When an economy driven by markets rather than governments emerges, the ramifications are endless, as taking pricing out of the hand of government and into the invisible hand of markets has ripple effects on economic incentives – when entrepreneurs rather than officials determine how to allocate resources, economic rationality permeates all spheres of economic life.
But when markets are overly regulated, in few hands, and lack liquidity, price discovery can be a challenge. This is the case of PKR. While sentiment-changing events like falling reserves, adverse changes in ratings or a large increase in the current account deficit (CAD) can quickly impact PKR rates, giving the impression of a free market , in reality, this may not be entirely true.
To explain this further, a squeeze by sellers (e.g. sellers holding back dollars for profit when rates are expected to rise), does not create a new flow of sellers for the dollar, so the price change may be exaggerated if no one takes any action.
In another example, if the outflow of dollars is greater than the inflow, this can only be resolved if the State Bank steps in and fills the void, where will the dollars come from? How quickly the central bank acts will impact sentiment and volatility.
At such times, the regulator can persuade the banks not to buy above a certain level and that’s it. Of course, that’s oversimplifying a more complex scenario, but it’s absolutely true of a real-life scenario. We have seen this many times when our reserves have dropped to almost non-existent levels.
When miscellaneous or fresh buyers and sellers are limited, any price anomalies are not quickly corrected (as was the case with the GBP above). It also results in price volatility due to illiquidity rather than fundamental changes, and demand supply levels cannot be changed by changing market prices.
Longer term pricing
However, over the long term, exchange rates eventually align or approach their fair prices. For example, an overvalued currency hampers export growth and provides an unsustainable import subsidy (through cheaper dollars). While an undervalued currency reduces demand and erodes purchasing power. A good example would be when the rupee fell from 110 to 160 against the dollar in a few months after being held back for years.
Intervention, unfortunately, is happening, even lately. Japan stepped in to strengthen the yen for the first time in 24 years as a trio of European central banks raised interest rates sharply, to support their currencies. It was the first time Japan had sold dollars since 1998, official data showed. The Bank of England bought Gilts worth £63 billion to support the financial market. India has spent around $90 billion to prop up its already stable currency. Thailand, Malaysia, Colombia, this list is long.
However, intervention objectives can vary from reducing volatility to managing systematic risk or influencing other areas such as inflation, trade and growth.
In recent years, developed economies have resorted to intervention policies rather than direct intervention, as they are more effective and more sustainable. In a later study of the 1992 sterling crises mentioned above, it was estimated that it cost the UK Treasury a loss of £3.3 billion, when it would have gained £2.4 billion. pounds if he hadn’t done the surgery.
In recent times, a multitude of frameworks have emerged to derive fair prices, but there is no magic formula yet. Of all these REER (Real Effective Exchange Rate) has been introduced as the benchmark method as it uses inflation to target monetary stability.
Although it provides insight into the relative progress of a currency, it is still far from perfect. For example, Bangladesh increased its export volumes when its currency was slightly overvalued. The REER for Turkey and Argentina is around 50 (or undervalued by half), but that doesn’t solve any of their currency problems, in fact, the deterioration of their currencies has fostered a deep-rooted dollarization of their savings.
Therefore, striking a balance between growth, inflation and fiscal space requires someone with an entrepreneurial mindset and the ability to sift through large volumes of data, with some trial and error.
Considering the above, the Pakistani forex market is still quite underdeveloped and first world standards cannot be imposed arbitrarily. Unfortunately, the Pakistani forex market has not progressed at all for decades. It’s not just about making the forex market nearly perfect, but it’s about overhauling the entire economic system. As the opening of the foreign exchange market will only be maintained if other long-term reforms are taken simultaneously. And now is the time to do it.
Until then, market determined prices as promoted by Muhammad (PSL) are still a distant dream.
Copyright Business Recorder, 2022