Forex troubles

THE spread between the value at which the rupee is traded in the interbank market versus its value in the open market has widened to Rs4, which is the highest it has been in recent memory. In normal times, the State Bank takes note when this spread goes above one rupee, and forces the exchange companies to narrow the gap. Most of the time this demand from the regulator is enough to force a rectification. But this time it does not appear to be working. Despite numerous such meetings between the exchange companies and the central bank, the spread has continued to widen, raising the spectre of black marketing and diversion of large-scale remittance inflows towards illegal hundi and hawala channels. If left unchecked, the widening spread could spur greater dollarisation of the economy, fuel speculation, and create massive distortions in the quantum of foreign exchange inflows.

In short, the large spread might be evidence of a low-intensity foreign exchange crisis that is under way. Based on market players’ perceptions, the crisis appears to have two drivers. First is the continuing fall in the foreign exchange reserves that are currently just sufficient to cover a little over two months’ imports. Any lower and the economy will be in the danger zone. The second driver is the approaching decision at FATF to ‘grey list’ Pakistan’s financial sector for deficiencies in its anti-money laundering and countering of terror-financing framework. The State Bank has been putting in place a raft of regulations designed to curb illegal foreign exchange transactions, which is making the formal foreign exchange markets a more cumbersome place to do business for many. There is little that the State Bank can do to reverse either of these two drivers. But with the political government gone, the space for action available to the central bank has expanded, and restraining the growth of this spread ought to become a main priority, before it triggers any large-scale capital movements.