Despite the rupee’s appreciation, businesses cannot afford to be complacent. By Farhan Bokhari in Karachi.

Kamran Mirza, chairman and managing director of Abbott Laboratories in Pakistan, is acutely aware of how much the frequently changing exchange rate of the rupee could affect the profit margin of a multinational company whose eventual returns must be calculated in a hard western currency.

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From 1996 until 2000, the regular depreciation of the Pakistani rupee meant that, while earnings per share in rupees for Mr Mirza’s company fell by half due to weak business conditions, such earnings dropped by two-thirds after conversion to a foreign currency like the US dollar.

The difference in earnings per share was largely the consequence of devaluation of the rupee. In effect, fewer rupees turned in to even fewer dollars by the time that profits were repatriated overseas, thanks to the effect of devaluation. “In the past, we made fewer dollars each year because of the exchange rate,” says Mr Mirza.

However, executives like him, are now encouraged by the unprecedented appreciation of the rupee in the past year. During that time, the currency rose by just under 9%, pushed up in part by the attacks on the US last September. Foreign companies already in Pakistan may find the appreciation to be a source of comfort.

The relatively stronger rupee trades at an exchange rate against the US dollar that is approximately a sixth of what it was in the 1980s, when Pakistan followed a fixed rate of exchange regime before embracing a floating regime in the 1990s. But, unlike in the 1990s when businessmen and other affluent Pakistanis routinely kept part of their savings in foreign currencies as a hedge against devaluation, the relative stability of the recent past has begun prompting many to save in rupees.

The rising fortunes of the rupee have been helped by the large increase in remittances from overseas Pakistanis, which in the last financial year (July-June) soared to $2.4bn, almost double that of the previous year. The increase was prompted in part by Pakistanis sending more funds back, apparently driven by the fear that they would get caught in investigations linked to terrorist financing.

Swollen reserves

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The rising remittances have helped to swell up Pakistan’s liquid foreign currency reserves. At more than $8.5bn in November, these were enough to finance about 10 months of imports. That was in sharp contrast to the situation a few years ago when the reserves sometimes sank to a few hundred million dollars in the midst of periodic balance-of-payment crises.

Last year, Pakistan also received $1bn in grants from the industrialised world, including the US, and it expects a $1bn write-off this year of the debt that it owes to the US. These examples of Western largesse, awarded for Pakistan’s support in the fight against terror, were also in complete contrast to the past when the country suffered under the weight of sanctions, especially following its first nuclear tests in 1998. Before Pakistan chose to become a close Western ally in the fight against terror, such grants were considered out of the question.

Tighter controls

Senior Pakistani officials are convinced that events of the past year have unleashed unprecedented pressures on governments worldwide to tighten controls over the flow of undocumented funds across borders. They say that one consequence would be the rising flow of remittances through regular banks, from where the central bank would be able to continue purchasing foreign currencies to boost its reserves further.

Ishrat Hussain, Pakistan’s central bank governor, is convinced that the use of channels such as the hawala system (a network of money changers used for transfer of funds) is certain to become increasingly redundant.

For the first time in more than a decade, businessmen like Mr Mirza are comforted by the relative stability of the rupee, hoping that the unexpected devaluation of the past will not recur in the foreseeable future.

The rupee’s devaluation often meant that businesses, especially foreign ones, had to increase their rupee earnings at a faster pace each year, even though returns in foreign currencies grew by a relatively smaller margin.

The emerging trend for the first time marks the return to what some describe as the rupeeisation of the Pakistani economy in contrast to the past trend, which was widely known as dollarisation.

“For businesses, for the first time, the thinking process has changed,” says Ali Jameel, a former investment banker and head of a Karachi-based telecom consultancy. He recalls the 1990s, when businesses planning their budgets often included an 8%-10% devaluation expected each year. “The new trend is about going for a large push to earn rupees and to not necessarily think in terms of how many dollars you would be worse off or better off at the end of your financial year,” says Mr Jameel.

But analysts say that the future trend of the rupee could still be influenced in part by events such as a US attack on Iraq, which in turn is bound to affect global oil prices. A larger trade deficit for Pakistan, prompted by sharply increased oil prices is bound to affect economic prospects and damage confidence.

“If there is war and oil prices rise sharply with consequences for Pakistan, the remittances from overseas may begin to fall fast,” says one bank president. “In times of such uncertainty, people would obviously try to look for other safer havens worldwide,” he warns, underlining the short-term threat to remittances from overseas.

Sakib Sherani, chief economist at ABN Amro Bank in Pakistan, says that while there is immediate relief for the rupee, the country must still be on watch for signs of reversing trends. “The momentum of dollarisation has been broken but it may be premature to say it has gone for ever,” he says.

Businessmen warn that one weakness in the appreciating rupee is that it is not necessarily the consequence of a robust economic recovery in a country where growth has remained moribund for the past three years, largely due to a long drought. More than half the country’s population of 140 million relies on farm incomes. Farm incomes have fallen and the sale of many products has been modest, all due to drought, businessmen say.

Weak demand

“The central issue of importance [for investor confidence] is the underlying weak demand after contraction of the economy [in recent years]. There has been a low volume of growth,” says Azhar Malik, chairman and managing director of ICI Pakistan. “If appreciation of the rupee would have come through an economic recovery, such as a turnaround in our international trade performance, that appreciation could have continued to benefit the economy with a wider effect,” he says.

Many analysts conclude that the rupee is likely to remain at present levels for some time to come. The continuous fear of Western investigations into the finances of those suspected of being linked to terrorist financing is bound to help the rupee and to discourage the flight of capital from Pakistan, analysts say. The global environment has prompted Pakistan to take fresh steps to tighten controls on foreign currency dealings inside the country.

Money changers

The search for illegal transfer of funds has prompted Pakistan to tighten controls on its large network of money changers. They have been given up to two years to convert themselves to registered companies, with their accounts subject to regular inspection by the central bank.

In the past, many such money changers operated through the hawala or the hundee system – a worldwide network through which money given to a money changer in one country was quickly transferred to a changer in another country.

“People sending money to Pakistan continue to be influenced by the terrorist financing issue,” says a finance ministry official. “There is every hope now that the remittances should continue coming in through regular banks, which helps our reserves and helps the Rupee,” he says.

While businesses have reason to celebrate the rupee’s rise, some worry that the absence of a fast economic recovery driving up the currency should not be ignored. During the present financial year, Pakistan expects foreign investments to rise to $700m, up from last year’s $500m, a modest figure for a country with such a huge population.

Many prospective investors have been discouraged by the domestic security environment and events such as the attack on the US consulate in Karachi, the suicide bomb attack on a bus full of French naval technicians in Karachi and the kidnapping and subsequent killing of US journalist Daniel Pearl.

Local investors warn that initial signs of a recovery in the large textiles sector, where investors are believed to have invested at least $500m last year, is not enough to become the basis for a large scale recovery in Pakistan’s international trade, which could become the cornerstone of an overall economic recovery.

“This is hardly the time when new businesses would want to invest largely in Pakistan,” says a company chief executive. “Even with the incentives surrounding the rupee, businesses look at many other issues too, and we can not afford to be complacent.”

Shaukat Aziz

Shaukat Aziz has been Pakistan’s finance minister for the past three years since the Pakistani military took charge in October 1999. He is widely believed to have the backing of General Pervez Musharraf, Pakistan’s military ruler, to continue in the next civilian government. Mr Aziz is a former banker with much international experience and last served as the executive vice-president of Citicorp, based in New York. Here, he speaks with Farhan Bokari

How do you measure your government’s economic performance during the past three years?

The last three years have been very challenging but we have made considerable strides in achieving macro-economic stability. In the past, we have had high budget deficit, low economic growth, anaemic trade and external declines, and a broad decline in investor confidence. Our relations with donors were mixed and credibility was low. We have now achieved macro-economic stability, improved investor confidence, and put the economy on a sustained course for further development. To achieve macro-economic stability we initiated fiscal discipline and improved revenue collection.

Tax collection this quarter (July-September) is up 17%. The Central Board of Revenue (CBR) – the main tax collection agency – has begun institutional reforms. Tariffs and tax rates have been reduced and no new taxes are being introduced. For banks we have reduced taxes already and we are aiming for a top rate of 35% in the next few years. Tax reforms have resulted in substantial reduction of duties, to reduce input costs for businesses.

How do you respond to critics who say these improvements have not trickled down to Pakistan’s mainstream population?

The overall macro-economic stability is important to ultimately have the benefits trickle down. When we took over, the economy was historically weak. Our challenge is to transfer the benefits down to the people. Our exchange rate has appreciated and our foreign exchange reserves are high.

If the rupee had continued to weaken as it did before, prices across the board would have been higher. We have increased the public sector development programme (PSDP), which will create projects for health-care, education, construction of dams, water storage and canal systems.

This will create jobs and allow people to spend. At the same time, we are encouraging the development of micro-finance projects. The philosophy here is to make people self-sufficient. By the end of this year, our ‘khushali’ bank (a micro banking initiative to help the poor) will spread to every district of Pakistan. Additionally, we have developed food support programmes for the poor.

The best way to fight poverty is to raise growth levels. The drought of the past few years has abated and there is a recovery in the manufacturing sector. We also hope to contain inflation to below 4% annually.

How concerned are you about Pakistan’s domestic security situation and the extent to which that influences investment decisions?

Security in Pakistan is clearly getting better. Pakistan is committed to fight terrorism and will not allow its territory to be used for terrorism. There are signs of improved investor confidence. The Karachi Stock Exchange is now at an eight-year high, reflecting increased corporate profits, recognition of our reforms and continuous improvement in the macro-economic fundamentals. There continues to be foreign investor interest in our equity markets.

Could poor relations with India undermine Pakistan’s economic hopes?

We hope a dialogue with India will begin, allowing both countries to discuss all issues including the dispute over Kashmir. However, if people were really concerned about relations with India, there would have been a run on the stock market and the rupee would have gone down, and that hasn’t happened, indicating that the overall sentiment remains positive.

Do you have a policy prescription for Pakistan’s next government?

For the new government, the priority will be to maintain continuity and make a dent in poverty. Now that there is macro-economic stability, one can make a difference. One of the key drivers of growth is agriculture and now that the drought is over, we expect an improvement in farm productivity.

What assurance is there that Pakistan will not once again succumb to the political crises seen in the past?

We all have to look ahead and recognise that any government coming in to office will have to work for the benefit of Pakistanis. Going forward, I see the process of democracy consolidating further.

This interview first appeared in The Banker’s issue of December 2002

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