A strong dollar is not just a problem for Pakistan, it is a global macroeconomic risk
Rupee depreciation cannot be repaired by simply changing the political regime.
The Pakistani rupee is not the only currency losing value against the US dollar. The Dollar Index (DXY), which measures the value of the dollar against six world currencies, is at its highest level in 20 years, up 10% since the start of the year (YTD) and 15% in course of the last 12 months.
The main driver of a stronger dollar is the US Federal Reserve raising interest rates to control inflation. Last week, the Fed raised the rate by 75 basis points to the 2.25-2.5% range and it is expected to rise further.
Federal Reserve Chairman Jerome Powell has made it clear that the Fed will continue to raise rates until inflation is brought under control. The Fed has a policy mandate to keep inflation at around 2%. Currently, it is at 9.1 pc.
The last time the United States faced double-digit inflation, the Fed rate had to be raised to 20%. The DXY index hit a high of 128 back then, up from 102 now.
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A more optimistic scenario is that the Fed will have to abandon its inflation target as the US economy begins to slow. Last week’s economic figures showed that US GDP fell 0.9% in the second quarter. This is the second consecutive contraction in US GDP, generally considered a sign of recession.
However, Powell focused on inflation because he believes other indicators, particularly the labor market, show the economy is not bad enough to drop the target.
Eurozone economies will also raise their policy rates. The euro has reached parity with the dollar. Last month, the European Central Bank (ECB) raised rates by 50bp to 0bp (the first hike in 11 years). Inflation in the euro zone is at 8.6 pc while inflation in the United Kingdom is at 9.4 pc.
The greatest impact of a stronger dollar will be felt politically because the political cost of inflation is always high.
Western countries have not experienced such levels of inflation since the World War and the political repercussions are now becoming visible. For example, US President Joe Biden’s approval ratings have fallen to 37.7%. In the UK there is an upsurge in strikes, the latest being a nationwide train strike due to high inflation. Italy has called a snap election after former Prime Minister Mario Draghi resigned.
Similar to the situation in Pakistan, the political implications of high inflation will force central banks to remain hawkish. They will be willing to sacrifice growth to control inflation. The main problem is that, unlike the past few decades, when inflation remained low due to globalization, policy space is now limited due to regionalization caused by Russian-Ukrainian and US-Chinese tensions.
Eventually, this could force other countries to break out of the US economic policy regime and sign bilateral treaties. India’s economic policy is the best example of this. While the United States is strongly aligned with India geopolitically as a counter-power to China, India’s reluctance to follow the American economic regime could also become a popular example for other countries. .
However, emerging markets are the most vulnerable. The World Bank has issued a warning on the risk of a rise in a wave of defaults on sovereign debt. Pakistan is not the only country facing such problems.
Twelve economies, including Turkey, Argentina and Lebanon, are now facing hyperinflation. There are also early signs of hyperinflation in Pakistan. People choose to park their capital in non-cash assets such as automobiles and building materials instead of leaving it in the PKR.
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A strong dollar would make foreign debt repayments unsustainable. Like India, Pakistan will also be forced to switch to non-dollar-denominated trade deals, at least with neighboring countries like China. Support from the International Monetary Fund (IMF) should bring some stability to the moving rupee, but this is a long-term macroeconomic challenge that requires structural changes in the economy.
My fear is that the conversation around the rupee’s depreciation in Pakistan has been trivialized and centered around the IMF and political actors. A stronger dollar is not a problem specific to Pakistan and will not disappear with a simple change in the country’s political regime.