How to deal with Pakistan forthcoming currency crisis

There is no way out. There are only compromises. The threat of a currency crisis in Pakistan has been identified by Thomas Sowell Nomura. If there were to be a currency crisis, how should Pakistan respond? First, it's important to know that a currency crisis occurs when selling causes a weak currency, like the PKR, to depreciate significantly.

The majority of currency crises since the 1990s have involved balance sheet effects: A nation's public or private sector, or both, has significant foreign currency external liabilities. In this scenario, depreciation deteriorates balance sheets, resulting in a downward spiral that reinforces itself. That was the case for Asia in the 1990s, and the Argentine crisis of 2001 was a factor in the current situation in Pakistan.

After the dust had settled in Asia, economists discovered a few common factors that contributed to the crisis: The currencies of the region were overvalued; economies relied too heavily on short-term loans from outside lenders; The regulation of private banks and finance companies was weak and fragile; and governments lacked the political consensus necessary to swiftly and painfully adjust the economy and stabilize it.

The exchange rate, monetary, and fiscal responses to the recent currency crises in Asia and Latin America offer valuable lessons. In response to speculative attacks, policy tradeoffs are dire.

Costs are high no matter what governments do. The nature of the shock, the initial conditions of the economy, and the balance sheets of banks, businesses, and the government all play a role in determining the less expensive response to a speculative attack. all around.

Leaving room for the exchange rate to fluctuate If you set your exchange rate too high, you put your country at risk of disaster because any decline will be sudden and catastrophic rather than gradual.

A country has time to correct whatever is causing the exchange rate to fall through slow and steady declines. You don't have much time when you collapse suddenly.

As a result, exchange rate pegs are extremely risky. Pakistan will experience yet another round of inflation in the event of such a sudden collapse. Given that Pakistan already has an inflation rate of 27%, a sudden collapse of the PKR could cause inflation to rise by up to 50%, just like it did for Sri Lanka earlier this year (see graph).

A new monetary framework and a new nominal anchor will be required if a flexible exchange rate regime is implemented. The central bank can use a variety of tools to establish a new monetary framework if the nation does not meet the requirements for inflation targeting.

The standard elements of ceilings on net domestic assets and floors on net international reserves may be included in the framework. The use of reserves to meet current account requirements must be consistent with these limits.

The central bank will need to tighten restrictions on the implicit expansion of base money (the money supply) in the first few weeks after the exchange rate collapse, when financial market conditions and expectations are likely to remain uncertain, in order to control inflation and exchange rate depreciation. On a daily basis, it doesn't work to run monetary policy by targeting a monetary aggregate.

Due to the currency's significant depreciation following a speculative attack, inflation may rise sharply in the months following the currency's collapse (as a result of one-time price adjustments).

Real interest rates on domestic currency debt will fall significantly as a result of this brief rise in inflation. In order to avoid further depreciation and the risk of igniting a spiral of depreciation and inflation, it is appropriate for policymakers to temporarily raise nominal interest rates to offset at least some of this immediate effect.

Fiscal policy A new exchange rate will only be able to last as long as people think it is good for the economy. As a result, restrictive fiscal policies must follow speculative crises. However, fiscal policy shouldn't be too restrictive.

After the collapse of the exchange rate, policymakers may want to avoid cutting spending too much to prevent speculation and inflation. This could result in more contraction and lower tax revenues, making it more difficult to service the public debt.

To move the debt-to-GDP ratio to a level that is sustainable, sufficient time must be given. A program that tries to force the debt-to-GDP ratio to reach its desired long-term level too quickly may not succeed, reducing the credibility of the policymaker.

Instead of being based on unsustainable expenditure cuts and tax increases in the near future, fiscal reform will gain credibility if it is perceived as being sustainable and leading to fiscal balance in the medium term.