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Monetary Policy to be aligned in sync with Fiscal Policy and structural reforms

The monetary policy is the key to influence trade/ current account of any country. The extent and the effectiveness of that, however, vary from country to country, given country’s own political and economic dynamics and other realities on the ground. These elements must not be used as ‘one-size, fits-all’ as part of the template to manage the economy, particularly the external account. The effectiveness of monetary policy is already under debate these days, particularly due to the outward flight of ‘hot money’.

If one looks at the relationship strength between interest rate and currency in the context of Pakistan, the convention says that the relationship between these two factors shall be strong and inversely related — i.e., interest rates go up, currency stabilizes or move inversely, and vice versa. However, in the context of Pakistan economy, the direct relationship between the two has been weak to moderate, which means that to play with interest rate to manage the currency is at best moderate but it could be safely assumed as weak looking at the relationship between the other elements of current account. The movement of policy rate remains a strong indicator and message for the market on where the policy-makers see the economy going, but using it as a tool to manage the trade/ current account deficit remains feeble.

Now, if one looks at the influence of exchange rate to manage the trade deficit, the relationship between exchange rate and exports is “strong”. However, given the fact that we have wide trade deficit and there clearly seems to be ‘no relationship’ between the exchange rate and the imports; therefore, there is hardly any effect of exchange rate to manage the overall trade deficit. There is weak to moderate correlation between the exchange rate and the current account deficit due to very large number of remittances, which could be impacted with the change in currency conversion rates. Given the fact, however, that our remittances are largely consumption-driven, the flow of the currency will remain indifferent to the exchange rates, as such.

Devaluation also directly results in contributing to the fiscal deficit as the cost of debt servicing on foreign exchange (FX) debt increases which results in higher borrowing in Pakistan Rupee (PKR) to cough-up more foreign currency as Pakistan is in a debt trap. This also causes cost-push inflation as deficit financing is the sole cause of creating inflation in any economy. This is tantamount to effectively printing currency and results in higher currency in circulation, which has increased over three folds and growing in the last few years. Thus, fueling inflation and hurting common people on this count too, other than making essential and semi-essential items expense due to devaluation.

It has been observed that the exchange rate has virtually no impact and the interest rate has at best a weak influence to manage the trade and the current account deficit in Pakistan. Therefore, the decision-makers shall make a decision to adjust these two key monetary policy tools with extreme caution to manage the pace of the economy and the management of FX reserves through trade. This is also resolved that in order to manage the imports, the best instrument available is the fiscal policy (duties, cash margins, bans all together, etc.) at this stage, while simultaneously working on the import substitution, a medium to a long-term fix. On the other hand, the sustainable growth in exportable flows could only be achieved through a medium to long term solutions with structural changes (value-addition, non-conventional exports, etc.) and exploring new paths, like manpower exports — an area gravely neglected — which must be given the status of an industry and measures must be taken and offer incentives, accordingly. We are sort of left with medium to long term solutions, other than the aggressive fiscal measures, while all other actions, particularly the monetary policy ones, are a temporary respite and may act as a ventilator for the economy and may not be beneficial in the long run.

The writer is a Karachi based freelance columnist and is a banker by profession. He could be reached on Twitter @ReluctantAhsan

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