There are many people these days who are advocating a free floating exchange rate for Pakistan. We have to understand that there is no best answer when it comes to which economic policy is better or worse in absolute terms. Economic policies should be based on ground realities and specific situation of each economy/country. Contractionary policy or expansionary policy, promoting growth or reducing inflation, controlling FX or free float; there are costs and benefits of each policy measures. Even the wackiest of economic policies which don't make any sense to most, like the Modern Monetary theory (MMT), are still recommended by some economists based on their theoretical arguments.
We have already seen the devastation caused by a free floating FX exchange rate in a country like Pakistan since 2018 when Rupee was around 115 level till mid 2018. It depreciated significantly since then on an overall basis that resulted in abnormally high inflation. On top of that, the volatility or fluctuations in Rupee was even more devastating for the investors and businessmen due to lack of clarity about the rate in future. PKR depreciated to 167 by mid June 2020, however due to Corona lockdowns and resultant slowdown in economy, PKR appreciated back to 152 by March 2021. Since then, as the economy started picking up, it's all going downhill for FX rate with PKR declining to 189 by March 2022 and then to 240 before Dar came back with his strong views on restraining the FX rate.
Theoretically, currency parity rate is determined by market forces of supply and demand. That's what we learn in economics 101. However practically there is a strong case for economies benefitting from a stable, or in some cases, a fixed pegged FX rate. Following are some reasons for keeping our PKR rate within a particular range against USD and not allowing it to depreciate significantly through market interventions:
Confidence of businessmen and traders (both importers and exporters) on the exchange parity in future. This is vital for every businessman to have clear view of USD/PKR rate for next few months before opening an LC or making an investment. Without this, they do not want to invest a heavy amount in business expansion or working capital due to fear of loss as a result of unfavorable rupee movement.
Pakistan has a very high level of annual trade deficit with imports significantly higher than exports. Our whole economy is running on imports and even majority of goods we export, we need imported raw materials to prepare them (such as raw cotton is imported and then with value addition at mills, we export fabric or yarn). In case FX rate is left to market forces, since every importer needs USD to pay for their import needs and they know that this imbalance means Rupee will depreciate further in future, they start buying more dollars today in order to import and hoard goods at better rates now which leads to demand supply imbalance in USD causing Rupee to depreciate way more than what it should be. When all big importers start doing this, that creates a run on USD causing its shortage and rate to balloon up. That also leads to volatility in FX rate and lack of direction. Govt/central bank role is critical in such situations to discourage that hoarding.
In Pakistan, USD is seen not just as a currency which is a means of payment. It is also seen as a valuable investment option, to provide a better return on our Rupee investments as we all know rupee will depreciate in future. Hence this phenomenon leads to dollar hoarding and additional demand for USD again leading to run on the currency.
Due to speculation and USD hoarding, PKR exchange rate goes down even more than fundamentals and that directly leads to significantly higher inflation as all imported goods becomes even more expensive. Also, due to higher import bill in rupee terms, more rupee has to be printed by central bank leading to further inflation. It's a vicious cycle.
To manage the above issues, fixing PKR USD rate at a certain level mitigates the risk of speculation and satta on USD. Musharraf Govt kept USD/PKR rate at around 60 for around 7 years, PPP kept it around 80 and Ishaq Dar kept it around 100 for around 4 years that somewhat helped controlled the inflation rate. It's true that once the Govt changes, USD/PKR is bound to depreciate substantially to cover up the years it was fixed and it goes back to its parity level based on fundamentals. In Musharraf case, PKR depreciated to 80 from 60 by 2009, PPP kept it at around 80 for 4 years and it went to 100 by 2013 and then Dar kept it at 100 and it went to 125 by the time PTI came in. However if we calculate the average depreciation per year during those years, it was on average 6-7%, which was in line with what's expected from fundamentals i.e. our twin deficits and huge debt.
But if the PKR is kept at free float, PKR depreciation would be significantly higher as along with fundamentals, speculative elements and run on the USD would make the FX market crash and the result is huge inflation spike that we saw in last few years. For Pakistan's economy, keeping PKR free float is disastrous for the economy and would likely lead to hyperinflation. I'm all for keeping it around a range, such as between 200-210 for a couple of years at least and central bank to intervene and stop volatility/speculations whenever needed.
