FeaturedNationalVOLUME 19 ISSUE # 20-21

Assessing economic challenges and policy recommendations

An independent think tank has underscored the detrimental effects of the overvaluation of Pakistan’s exchange rate, which has exacerbated the trade deficit and contributed to the accumulation of external debt.

In its report titled “Pakistan Economic Freedom Audit: The Sound Money,” the Policy Research Institute of Market Economy highlights the urgent need for government accountability in adhering to fiscal responsibility laws and proposes new legislation to prevent currency manipulation. The report also sheds light on the decline in Pakistan’s sound money rating, citing high inflation and monetary expansion as key factors. Additionally, it discusses the Ministry of Finance’s revised projections for borrowing, reflecting a shift towards increased reliance on domestic sources.

It has also criticized the State Bank of Pakistan (SBP) for its involvement in implementing expansionary fiscal policies by indirectly extending loans to the federal government. This action has undermined the effectiveness of changes guided by the International Monetary Fund (IMF) in the central bank law.

The report highlighted the negative consequences of the collaboration between the central bank and the finance ministry. This collaboration has resulted in high inflation and contributed to the accumulation of debt. Although amendments to the SBP Act have restricted the government’s ability to directly borrow from it, monetary expansion has persisted. According to the report, the SBP has infused liquidity into banks through Open Market Operations, enabling these banks to subsequently lend to the government. Consequently, the SBP indirectly provides funds to the government through scheduled banks. Banking industry sources reveal that as of the first week of this month, the central bank had lent Rs10.3 trillion to commercial banks through open market operations.

It commented, “Attempting to control inflation by setting the policy rate while expanding the money supply in response to government borrowing from scheduled banks is counterproductive.” During the last Extended Fund Facility (EFF) agreement, the IMF had prohibited the federal government from borrowing directly from the central bank. However, with the complicity of the central bank, the government bypassed this restriction and engaged in borrowing through indirect channels. Over the past five years, broad money has experienced an average annual growth rate of 14.6%. In the fiscal year 2022-23, Pakistan witnessed a significant surge in its annual inflation rate. While the average annual inflation rate over the past decade stood at 9.6%, the fiscal year 2022-23 recorded a rate of 29.2%, marking the second-highest rate in Pakistan’s history.

The removal of borrowing restrictions has failed to curb the money supply; instead, it has increased borrowing costs for the government. The central bank prints currency notes and sells them to commercial banks, which then lend the money to the government at higher interest rates. The report observed that the SBP recently adopted a reactive approach to inflation and currency depreciation, which proved ineffective. Despite raising the policy rate from 9.75% in January 2022 to an unprecedented 22% in June 2023, the SBP’s monetary policy instrument had limited success in controlling inflation and exchange rates.

During the fiscal year 2022-23, Pakistan witnessed a historically high depreciation of its currency, raising doubts about the effectiveness of monetary policy instruments, as noted in the report. Despite the substantial increase in the policy rate, market perceptions did not reflect a tightening policy stance, leading to prevailing market uncertainty. Consequently, the Pakistani rupee depreciated significantly against major currencies, accompanied by a historically high inflation rate.

The institute has emphasized that the overvaluation of the exchange rate in Pakistan has led to a trade deficit, resulting in the accumulation of external debt. These factors contribute to the current monetary fragility faced by Pakistan. The report suggests holding the government accountable for violating the Fiscal Responsibility and Debt Limitation Act and recommends introducing new legislation to prevent currency manipulation by the government. It recommended that an Act of Parliament be enacted to restrict the deliberate overvaluation of the exchange rate, for which a suitable indicator needs to be developed.

The report highlights that Pakistan’s sound money rating has reached its historically lowest level due to high inflation and double-digit growth in monetary expansion. Recent fluctuations in the sound money rating were driven by inflation and its volatility, while the score on foreign currency accounts remained stable. Recent assessments indicate that Pakistan’s sound money rating for 2023 is 4.6, the lowest in history, primarily due to exceptionally high inflation during the year. Pakistan’s economy’s sound money category was evaluated using the Fraser Institute methodology.

This score reflects a concerning state of affairs regarding the country’s economic freedom. Pakistan’s performance has significantly declined compared to the last two ratings, with a decrease of one quarter. This score represents the country’s lowest in the past four decades.

The value of money has consistently depreciated over time. From 1974 to 2001, its purchasing power for goods and services included in the CPI basket declined by one-tenth, and from 1974 to 2023, by one-sixty-eighths. The Pakistani rupee has also experienced a similar decline in value against foreign currencies. For instance, the value of one US dollar in Pakistani rupees increased from less than 10 in 1974 to 248 in 2023, resulting in a 25-fold cumulative loss.

However, monetary growth during this period exceeded 1000 times, indicating inefficiencies in both monetary and fiscal policies that have contributed to this expansion and, ultimately, the devaluation of money.

The ministry of finance has revised its projections of borrowings from both domestic and external sources. There has been a substantial increase in reliance on domestic sources due to reluctance on the part of foreign lenders to provide new money despite an International Monetary Fund umbrella. The government has reduced its projections of gross foreign loans from Rs7.2 trillion to just Rs3.3 trillion—a reduction of 54% in rupee terms. Correspondingly, there has been an increase in domestic loans—from nearly Rs31 trillion to Rs34.2 trillion.

In dollar terms, the ministry has decreased the foreign inflow projections from $17.7 billion to $11.4 billion—a downward adjustment of $6.3 billion, according to the new Annual Borrowing Plan. The revision has primarily been made on account of projections for Eurobonds and foreign commercial loans.

The findings presented in the report paint a concerning picture of Pakistan’s economic landscape. The overvaluation of the exchange rate and the resulting trade deficit pose significant challenges to the country’s monetary stability. Urgent action is needed to address these issues, including strict adherence to fiscal responsibility laws and the introduction of measures to prevent currency manipulation. Furthermore, the government’s revised borrowing projections underscore the importance of domestic financial resources in navigating the current economic climate. It is imperative for policymakers to heed these recommendations and implement effective strategies to safeguard Pakistan’s economic well-being.