Podcast Review: Macro Hive Conversations With Dr Reza Baqir

We were delighted to have serving Governor of the State Bank of Pakistan (2019-current) and 18-year veteran of the IMF Dr Reza Baqir as our podcast guest this week. We had an insightful discussion around Pakistan’s economy, markets, COVID and EM debt reduction, the thoughts from which we have distilled below.

Pakistan’s Twin Deficits

Our first question was on Pakistan’s macroeconomic state prior to the pandemic. Baqir made it clear that, in the context of an overvalued exchange rate, a historically low savings rate and a state bank with insufficient reserve holdings, twin deficits were impairing Pakistan: a current account monthly deficit that peaked at around $2bn a month, and a deteriorating primary fiscal imbalance that amounted to more than 1% of GDP.

The solution required a radical adjustment of the imbalances, a recognition that the governor admits came right from the top. ‘The stabilisation that we achieved from July 2019 to March 2020 would not have been possible without the ownership at the very highest possible level – the Prime Minister, Imran Khan, recognising the depth of the problem and recognising the need for adjustment.’ This adjustment came in the form of a reform package, supported by the IMF, which began in the middle of last year.

At the heart of the difficult reforms were two things. One, the country needed to transition from a fixed exchange rate regime to a market-based one. Second, they needed to increase the amount of reserve holdings. The latter, according to the governor, has historically been the best predictor of when Pakistan has needed to go to the IMF. Due to the country’s savings/investment gap, the country has had to borrow. In the context of a fixed and overvalued exchange rate, there have been occasions where Pakistan has had insufficient reserves to meet foreign exchange obligations. This is what the governor is hoping to avoid in future…

Communication, Communication, Communication

In a time when uncertainty haunts households and businesses around the world, Baqir was certain about the key to central bank success – communication. There are three contexts in which this cropped up in our podcast:

Moving from a fixed to a market-based exchange rate:

This transition, one that has ultimately proven key to the reform’s success, was necessary to obtain greater control over its reserve holdings. The governor described it as ‘swimming upstream in a river’, indicating that ‘[the] need to sell dollars to prevent a currency from depreciating’ was a never-ending process that causes structural impediments. Moving to a market-based regime (a rate primarily determined by supply and demand, but which does leave room for the state bank to intervene during disorderly market conditions) enables the exchange rate to move both ways and is less costly for the balance sheet.

The key factors that enabled this transition were:

• The macroeconomic backdrop. This comes in four parts: (i) the state bank already halved the deficit prior to the regime change; (ii) the government announced it would not borrow large amounts from the state bank; (iii) the Rupee was allowed to depreciate significantly so that much pent up excess demand for the dollar had already been allowed to be reflected in the exchange rate; (iv) the state bank raised interest rates.
• Good communication with the foreign exchange rate players. This came in the shape of a meeting with corporate banks to discuss the state bank’s stance on filling treasury gaps. The governor was aware some corporate firms may struggle with the resulting exchange rate volatility, but said that, over time, they would learn to manage inflows and outflows themselves (although he emphasised that the state bank would be there if there are disorderly market movements).

Using inflation expectations as a nominal anchor:

Without an exchange rate anchor, the country needed to anchor expectations against inflation effectively. For this, the state bank began to reorient monetary policy statements, placing an emphasis on expected inflation. So far, they believe good communication has successfully enabled the market to make this transition. Surveying inflation forecasters, they have found that market predictions have converged on a range that the state bank had expected.

How did they do it? Firstly, the state bank announced at the start of the fiscal year that they expected inflation to be, on average, 11-12%. Furthermore, at the end of every monetary policy meeting, they held closed door discussions with leading market analysts. This was done to convey trust to the wider business community, which the governor says have, on occasions, had good reason to mistrust public information. The focus of these meetings was to discuss policy decisions, expected inflations and state bank forecasts.

Using informal connections as a good source of information:

Baqir is not the only governor to be navigating his way through turbulent times. In response to a question around communication between central bank governors, he responded: ‘Only one governor can appreciate the pain, the constraints, the challenges of another governor, especially when you’re dealing with such a powerful external shock’. He then continued to say that he has had discussions with other central bankers and that ‘informal communication is the most reliable and biggest source of high-quality information’.

Our Response to the ‘Mother of all External Shocks’ Has Been Measured

Without a doubt, the major transitions Pakistan has had to go through over the last year would have been easier without what Baqir describes as ‘the mother of all external shocks’. Nevertheless, the timing of the adjustments has probably helped mitigate some of the economic downside to COVID. As it stands, several core macroeconomic indicators are improved, which has ‘only been made possible by the difficult reforms’.

Nevertheless, the relatively fragile state of EM countries, which includes Pakistan, has meant the policy responses to the pandemic have been measured. The higher level of public debt and lower foreign reserves mean that if macroeconomic indicators worsen, EMs could be left in a very vulnerable position post COVID.

Innovative Monetary Policy – ‘Focus on Flows as well as Rates’

Given the macroeconomic constraints, there has been a push towards innovative monetary policy measures in response to COVID-19. On this front, the governor emphasises the need to focus on quantities as well as interest rates. Since the onset of pandemic-related economic pressure, the State Bank of Pakistan has done the following:

• On rates:
  • Dropped interest rates by 625bps, the largest cut in EMs, apart from Argentina.
• On flows:
  • Introduced a presumptive one-year extension in principle payments of borrowers to banks.
  • Doubled the period (to 180 days) in which a bank’s clients can restructure their loans.
  • Introduced concessional credit facilities for payroll financing, targeting job savings.

Baqir is positive on the uptake of these schemes, suggesting that the impact of all these measures has been about 3% of GDP.

The Worst of the Financial Turmoil is Behind Us

Altogether, the reforms have moved the macroeconomic landscape in Pakistan towards an environment that is more equitable and supports sustainable growth. In addition, if the country can maintain the current improvement in terms of the health crisis, the governor believes there is room to be optimistic about the future. ‘Today, when we look at the future, I am quite confident, Bilal; one should never say never, but I am quite confident that the worst, in terms of financial turmoil, is behind us’.

Why such optimism? There are a number of indicators that are moving in the right direction:

• The current account deficit has fallen tenfold. In monetary terms, it has reduced to about $200mn a month by December 2019. One of the key reasons for this was the adjustment of the exchange rate.
• In the most recent fiscal year, the primary fiscal balance has moved to a surplus. Exports are starting to recover, but ‘we need to monitor remittances closely’.
• Reserves are up. Since the start of the year, growth reserves grew by about $5bn, and net reserve buffers (growth reserves-short positions) have doubled the amount on the books (from $7bn to $14bn).
• The transition to a market-based exchange rate has been successful. The Rupee is no longer only appreciating, it has two-way movement. Intraday volatility is within the range of other EMs who have similar exchange rate systems. Also, since January, the currency has depreciated 8%, right in the middle of the range of other EMs.

There is Still More to Do

Despite the big strides forward, there are three main priorities that the state bank is striving towards:

1. Increasing exports – exports provide the highest-quality resource for increasing reserves. The transition to a market-based exchange rate has already improved export demand.
2. Financial inclusion – the bank wants to redistribute credit from a few large players to SMEs, women and underserved sectors, such as housing and agriculture.
3. Promoting savings – the country’s domestic savings rate is lower than other EM markets and places a strain on the current account balance.

A Word on Debt Reductions

Asked to remove his ‘governor hat’, Baqir finishes the podcast by comparing the Great Recession and the COVID crisis. His words are complimentary, saying the IMF, World Bank and G20 have acted quickly in providing credit for EMs. He does, however, hope that this remains the case and that official creditors look towards debt reductions to avoid any persistent suffering in borrowing countries.