Pakistan appears to be in the midst of an economic crisis as the rupee seems to be in free fall with foreign exchange reserves depleting in the backdrop of a high and unsustainable current account deficit.
This is perhaps a logical outcome of a bad policy. Maintaining an over-valued exchange rate and defending it through the use of foreign exchange reserves has resulted in the current impasse. The out-going PML-N government pursued this policy for the better part of their four year term under Finance Minister Ishaq Dar. This was all the more tragic since the Musharraf regime made the country pay a heavy price for the same flawed policy less than a decade ago.
An over-valued exchange rate is bad policy simply because it incentivises imports, discourages exports and ultimately depletes reserves as the trade deficit widens to a point that it leaves foreign exchange reserves in a vulnerable situation, putting the onerous burden of containing the current account deficit on remittances and portfolio inflows. This is a particularly dangerous policy in a country where the export base is narrow.
The current Caretaker Finance Minister thus inherited a difficult trade-off. She could either defend the currency and let the reserves deplete to an alarmingly low level or she could let the rupee slide and defend the reserves. She chose to do the latter and sensibly so. However, the manner in which she has done it demonstrates a lack of nuanced understanding of Pakistani market behaviour.
Economic agents in Pakistan (be it traders, bankers, forex dealers, exporters, industrialists, etc) have come to expect a fixed exchange rate or a discrete devaluation through a managed float and not the constant drip and drab in the value of the rupee on a daily basis. This is creating uncertainty in the market and leading to panic amongst economic agents. What should be done is to devalue the rupee to a fixed level, whatever is considered reasonable to defend the reserves, and then announce that there will be no further devaluation under the tenure of the caretakers. The new government will inevitably have to negotiate with the IMF and fix a new rate.
*This article was originally published in Jinnah Institute's 'Take one. Preventing an Economic Meltdown: Priorities for an Incoming Government'