- Further devaluations likely in the near term regardless of whether an IMF agreement is forthcoming.
- Longer term, further rupee depreciation lies ahead but huge interest rate differential should more than offset the declines.
Short-Term / Tactical Outlook: Reserve Gain Belies Increased External Fragility
The uptrend in USDPKR in place since the SBP devalued in December looks like it has further to run as the central bank’s hiking cycle does little to ease depreciatory pressure amid a tightening Fed, rising inflation, and dwindling import cover.
*Numbers 1-5 reflect order of historical importance in driving the currency pair. **Negative sentiment towards the currency/economy is views as contrarian bullish. See here for a more detailed understanding of short-term currency drivers.
The Pakistani rupee has remained stable around PKR123.75/USD since the last devaluation in mid-June, but fundamental depreciatory pressures have continued to build which suggests further rupee devaluations are likely before year end. While the SBP does not necessarily want a weaker currency, it has little choice but to allow free market forces to play out.
While the SPB has shifted to hiking mode, real interest rates remain near multi-year lows thanks to the pick up in inflation. Reserves have risen over the past two months, coming in at $16.9bn in July, but import cover remains woefully low thanks to the ongoing surge in imports. The ongoing rise in oil prices is likely to further undermine Pakistan’s terms of trade forcing the SBP to continue drawing on its reserves to prevent a more rapid decline in the rupee.
Indeed, the rise in reserves has been entirely the result of increased reliance on financial account inflows as reflected by the fact that the trade deficit hit a new all-time high of USD3.6bn in July. The petroleum import bill rose to a new all-time high in July at USD1.8bn, surpassing the 2008 and 2012 peaks. It would likely take a collapse in oil prices or some major surge in interest rates in order to shift us to a more constructive short-term stance.
Talks are ongoing between Pakistani officials and the IMF over yet another bailout package for the country but given the IMF’s track record of encouraging currency weakness to bolster reserves, there is no reason to expect this to be supportive for the rupee.
Long-Term / Structural Outlook: Interest Rate Differentials to Offset Rupee Depreciation
From a longer-term perspective, rupee weakness in nominal terms looks highly likely but significantly higher interest rates suggest that the currency should actually outperform the dollar in total return terms. Stronger real GDP growth in Pakistan should have a positive direct impact, while positive real interest rates suggest interest rate gains will outweigh currency depreciation over the coming years.
*Assumes a 1 percentage point increase in productivity improves fair value of currency by ~0.5% based on the Balassa-Samuelson effect. See here for a more detailed understanding of the key long-term currency drivers.
Pakistan’s Growth Outlook Weak but Outperformance Vs US Likely: Real GDP growth in Pakistan is likely to outstrip that of the US due do the country’s low base and strong demographic trends which will see the working age population grow in excess of 2% per year. Indeed, even with a relatively modest forecast for productivity growth given the country’s low level of development, we forecast the country to grow at 3.9% over the long term.
Pakistan scores poorly in every area in our Productivity Index, with its Political and Societal scores weighed down by the prevalence of Islamic fundamentalism preventing a shift towards liberalism. The poor score in the External category reflects Pakistan’s increasing reliance on Chinese funding that has taken place since the China-Pakistan Economic Corridor which has saddled the country with a huge external debt load with little promise of sustainable boost in productivity.
The country shows little sign of escaping its low savings-low growth equilibrium. We do not see the PTI government being able to enact the kind of fiscal reform that is needed to raise savings and investment, and ultimately the productivity of labour. Despite these weaknesses, it is difficult to see the economy fail to outpace that of the US given the latter’s own significant headwinds. We therefore see real GDP growth dynamics acting as a slight positive force for the PKR.
Inflation to Average Double Digit Rates: The inflation pressures that are currently showing up in rising headline and core CPI readings have their roots in the loose fiscal and monetary policies seen over recent years, which have resulted in a public and private sector credit boom. We see few signs of improved tax revenue collection necessary to reduce the government’s dependence on central bank debt monetisation. The economy is likely to remain dependent on foreign assistance in the form of loans from China and the IMF to prevent default, but this will likely come at the cost of increased long-term debt repayments which will put upside pressure on inflation and downside pressure on the currency.
PKR is Not Cheap Despite Recent Devaluations: The Pakistani rupee has become slightly more competitive following the bout of devaluations this year but its real effective exchange rate remains slightly above its long-term average. Furthermore, based on the positive correlation between GDP per capita and average price levels, Pakistan score marginally on the strong side. Overall the PKR’s current valuation implies a minor drag to the currency over the long term.
Positive Real Rates to Support Rupee: In total return terms the rupee is likely to fare much better than in spot terms due to significantly higher interest rates meaning that in total return terms the rupee should outperform the dollar. We expect Pakistani rates to average a full 10pp above the US as the SBP is forced to maintain elevated rates due to high external funding needs. High yielding currencies have a history of outperforming in total return terms due to the higher risk in terms of volatility and potential for negative shocks. We expect wide interest rate differentials to more than offset the nominal decline in the rupee.