«The Capital Account and Pakistani Rupee Convertibility: Macroeconomic Policy Challenges Irfan ul Haque* Abstract Pakistan embarked on the ...»
The Lahore Journal of Economics
16 : SE (September 2011): pp. 95-121
The Capital Account and Pakistani Rupee Convertibility:
Macroeconomic Policy Challenges
Irfan ul Haque*
Pakistan embarked on the liberalization of its capital account more than
two decades ago. Today, it is an economy with a capital account that is, by and
large, free of restrictions, and a convertible currency. However, its actual
integration into the global economy in comparison to other emerging market economies has remained rather limited. The opening of a capital account appeared to have improved the country’s access to private foreign capital, but because of domestic security and economic and political concerns, the inflow of private capital has fallen in recent years. Although capital outflows were not a major cause for the decline in foreign exchange reserves during Pakistan’s economic crisis of 2008, the open capital account and rupee convertibility have made it more vulnerable to outside shocks. This article identifies three areas where policymakers in Pakistan face serious challenges, i.e., macroeconomic management; controlling tax evasion, which the Pakistani rupee’s convertibility has made easier; and minimizing the real cost of portfolio investment to the country. The article offers ideas on how these challenges could be met.
Keywords: Capital Account, Covertibilty, Pakistan.
JEL Classification: E22, G11, H26, O16.
1. Introduction Capital account liberalization is a keenly debated issue. On one side, with the support of mainstream economic theory, free capital flows are held to promote efficient allocation of investable resources because investment can move from less profitable (implying less efficient) to more profitable locations. When accompanied by trade liberalization, open capital markets and flexible exchange rates reinforce and facilitate international specialization in trade on the basis of comparative advantage.
* Special Advisor Financing for Development, South Centre, Geneva. The usual disclaimers apply.
Irfan ul Haque However, capital account liberalization1 has also been seen to make economies more vulnerable to international financial crises, especially in the developing world. Reckless commercial bank lending led to the Latin American debt crisis of the 1980s, costing the entire region a whole decade of economic growth. Aggressive trade liberalization and an open capital account brought Mexico to its knees in 1994, when it was made to pay for its over-exposure to short-term capital. Three years later, there was the wrenching East Asian currency and financial crisis, which caused massive economic and financial disruption and thwarted economic growth in Thailand, Indonesia, and Korea, while touching many other countries in the region.
In recent years, emerging market economies have experienced a rather different problem, although still caused by hot money flows. With interest rates falling to near-zero levels thanks to monetary easing in the leading industrial countries, investors have sought opportunities in some of the emerging market economies, where interest rates—because of domestic macroeconomic imperatives—have been significantly higher.
Among others, Brazil, South Africa, India, and Singapore have experienced large capital inflows that have put pressure on their currencies to appreciate. The affected countries have tried to stem this inflow through various measures (notably, taxing short-term inflows) but with limited success. This problem has led the International Monetary Fund (IMF) to recognize that capital controls may be justified in certain conditions.
Pakistan started on the course of capital account liberalization and exchange convertibility in the mid-1980s, quite early compared to other developing countries. Indeed, this process started even before Pakistan took steps to bring down tariff barriers and liberalize its trade regime. The rupee has now been more or less freely convertible since the early 1990s and capital movements face few hurdles. Has this helped or hindered Pakistan’s economic progress? To what extent have these measures facilitated or constrained the design and implementation of macroeconomic policy in Pakistan? This article attempts to address these questions.
The following section explores how open the Pakistan economy really is, since clarity on this question is essential to a discussion of macroeconomic policy. This is followed, in the third section, by an exploration of the impact of capital account liberalization on Pakistan’s “Capital account liberalization,” “open capital account,” and “financial globalization” refer essentially to the same phenomenon, although they have subtle contextual nuances. In this article, they are used interchangeably.
The Capital Account and Pakistani Rupee Convertibility 97 economy. This lays the foundation for a discussion, in Section 4, of the macroeconomic policy challenges that an open capital account and rupee convertibility pose for Pakistan’s policymakers. The final section offers a few concluding observations.
2. How Open is the Pakistan Economy?
The openness of an economy can be looked at in two ways: (i) by tracing the actual measures a country has taken to liberalize and open up its capital account and foreign exchange regime (de jure indicators), and (ii) by examining the economy’s actual integration into the global economy in terms of trade and financial flows (de facto indicators).2 How Pakistan measures up to these indicators is discussed in this section.
De Jure Indicators
Foreign currency accounts (FCAs) were introduced in Pakistan as early as 1973. The intention here was to attract foreign earnings of an increasing number of Pakistanis working overseas by making available to them a reliable, attractive, and safe savings instrument at home. The real motivation behind this step was the government’s pressing need to finance fiscal deficits while gaining access to foreign exchange that was, as always, in short supply (see Mirakhor & Zaidi, 2004).
However, the first major step to liberalize the capital account and exchange rate regime was taken with the introduction of foreign exchange bearer certificates in 1985, which foreigners or Pakistanis could purchase with foreign exchange.3 Six years later, in 1991, all foreign exchange controls were removed and the Pakistani rupee became more or less fully convertible. Within a few months, dollar bearer certificates (DBCs) were introduced, which was a significant development for a variety of reasons.
These certificates, which carried a maturity period of one year, were denominated in US dollars and carried an interest rate linked to the London Interbank Offered Rate (LIBOR), not to domestic money market rates. The certificates could be cashed in Pakistani rupees, US dollars, or any other foreign currency at the prevailing exchange rate. However, more consequential was the government’s foreswearing to ask questions This is a common approach to measuring global integration in trade (see, for example, Dollar & Kraay, 2001). In the context of capital account openness, Prasad (2009) adopts a similar approach.
Much of the factual information in this and the next few paragraphs is taken from Historical exchange rate regime of Asian countries, University of Hong Kong, retrieve from http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=22 Irfan ul Haque concerning the sources of funds used to purchase DBCs or to open FCAs.
This was, in essence, an open invitation to Pakistani residents to evade tax payment and launder money.
Further refinements to the capital account and foreign exchange regime continued in the succeeding years, culminating in early 1998, when banks were allowed to quote their own currency conversion rates within the buying and selling bands fixed by the State Bank of Pakistan (SBP).
However, the process came to a sudden halt just a few months later.
FCAs—which were freely allowed and had become popular with both resident and nonresident Pakistanis—were frozen literally overnight. This was a clumsy and poorly managed response to the imposition of severe economic and financial sanctions on the part of the US, Japan, and European countries, as punishment for the May nuclear tests.
The FCA freeze was accompanied by the introduction of a multiple exchange rate system comprising an official rate, an interbank rate, and a composite rate, although banks could still quote their own currency conversion rates. However, since the IMF generally regards multiple exchange rate regimes with disfavor, the issue became an irritant during negotiations for a standby agreement that Pakistan desperately needed to cope with the financial stringency resulting from the sanctions.
In mid-1999, the system of multiple exchange rates was, however, abandoned, and a unified exchange rate was reintroduced. The rupee was once again declared free to float, but was effectively pegged to the US dollar within a specified narrow range.
The liberalization process continued during the Musharraf era but the focus shifted to making the foreign exchange regime more transparent and efficient, and improving supervision of the institutions involved. The formation of exchange companies was seen as an important step in curbing—and eliminating—unauthorized moneychangers, who had become important players in the liberalized environment. A major goal was to narrow the differential between the open, kerbside rate and the interbank exchange rate and have home remittances channeled through the banking system rather than through the informal system of hundi and hawala. Around the same time, a swap desk was set up at the SBP to ensure liquidity in the foreign exchange forward market, and to rationalize forward premiums, a step seen to help both foreign exchange traders and the interbank market (SBP, 2003).
The Capital Account and Pakistani Rupee Convertibility 99 By 2008, the liberalization process was virtually complete and the
IMF (2008) could conclude:
All current international transactions are conducted in the interbank foreign exchange market. Importers, exporters, and businesses are free to shop around for the best possible rates in the interbank market for all exchange transactions without recourse to the central bank. Banks may purchase foreign exchange from exchange companies (ECs) at freely negotiated rates. Individuals may purchase foreign exchange through the interbank or EC foreign exchange market in accordance with regulatory provisions. Some government foreign exchange transactions (e.g., debt service payments, conversion of privatization proceeds) are conducted directly by the State Bank of Pakistan, at the rates determined in the interbank market (p. 1061).
In brief, the current situation is:
Residents or nonresidents can open FCAs at commercial banks with remittances from abroad, foreign travelers’ cheques, or foreign currency in cash, but not with income from export or similar activities.
Nonresidents or foreign firms may open domestic currency accounts that are fully convertible into foreign currency, so long as foreign funds are channeled through the banking system.
Nonresidents may acquire listed securities with remittances from abroad with no restrictions on the repatriation of capital gains, dividends, or receipts from the disposal of such securities.
Nonresidents are free to trade in registered corporate debt instruments and bonds listed on the stock exchange, federal investment bonds, or Pakistani investment bonds as well as market treasury bills. Branches of foreign banks and foreign-controlled investment banks may also engage in these activities.
Today, the only salient restrictions on the capital account relate to the limits on the amount of domestic currency that a traveler may physically carry overseas (PKR500 to India and PKR3,000 to other countries) and on the amount Pakistani residents may hold in overseas bank accounts (a maximum of USD1,000 in all countries other than India, Bangladesh, Afghanistan, and Israel, where Pakistani residents may not own any bank accounts.) Irfan ul Haque The reform of the domestic financial sector was an essential accompaniment to the opening up of the capital account.4 This process stretched over more than a decade and consisted of granting the SBP autonomy, improving the regulatory and supervision system, privatizing nationalized banks, liberalizing foreign bank entry and operations, moving toward “market-determined” interest rates, and eliminating financial repression (Haque, 2010). The results of these reforms were impressive not only in terms of the growth of bank deposits and advances—which reached 40 and 30 percent of gross domestic product (GDP), respectively, in 2007—but in the rapid growth of the financial sector as a whole, reaching an annual rate of 17 percent between 2003 and
2007. The sector also attracted some USD4 billion in foreign investment.
De Facto Indictors
Global integration takes place through international trade and the movement of capital across countries. Thus, the magnitudes of international trade and international capital flows relative to a country’s GDP provide a fair indication of its integration into the global economy.
Since capital movements across countries are meant to narrow differences in investment returns (allowing for country and exchange rate risk), the behavior of a country’s stock market relative to other leading markets could also provide an idea of its global financial integration.
Table 1 provides the salient indicators of openness during 2004–09 for Pakistan, while Table 2 gives similar indicators for India and a few other Asian economies for 2004–08.5 The ratio of foreign trade (i.e., exports plus imports) to GDP for Pakistan fluctuated between 40 and 45 percent during 2004–08, but fell sharply to 35 percent in 2009 because of the economic crisis. The same ratio for Sri Lanka or Indonesia was considerably higher, close to or exceeding 60 percent (Table 2). However, India’s position was rather different: the trade ratio was initially of the same order of magnitude as Pakistan’s, but it gradually rose to about 50 percent of GDP. In other words, the two countries were more or less similarly placed with respect to openness to foreign trade just a few years ago, but India became considerably more globalized over time.