The Pakistan rupee (PKR) was devalued today by 9.6% to 255.43/US$ from 230.89/US$, following yesterday’s announcement by the Exchange Companies Association of Pakistan that it would remove its de facto cap on Pakistan’s exchange rate, which it says it had voluntarily imposed to help ease pressure on the currency. This brings total depreciation to just over 30% over the past year and is the biggest one-day move since 1999.
The decision follows the 24 January 100bps rate hike by the State Bank of Pakistan (SBP). Both moves are necessary to rein in external pressures and get Pakistan’s IMF programme back on track. (See here for our more complete analysis published on 24 January, which we refrain from rehashing here.)
Today’s deval closes the gap with the parallel market exchange rate, which traded around 260/US$ on 25 January (a c10-15% premium to the official rate) and has depreciated slightly to 268/US$ today (narrowing the gap to 5%). Assuming the SBP takes its hands off the wheel, further depreciation is likely, with non-deliverable forwards pricing in another 12% of depreciation over the next three months to 291/US$ (up from 263/US$ yesterday) and 22% over the next year to 326/US$ (from 303/US$ yesterday).
However, it is unclear if today’s move represents a shift towards a flexible exchange rate or if the SBP will intervene to prevent further depreciation. With a backlog of FX demand and US$6bn of imports currently stuck at Pakistan’s ports (per our local partners at IMS in Karachi), the exchange rate is likely to overshoot its fair value in the near term, which will test the SBP/government’s resolve to shift to a market-determined exchange.
With reserves falling by another US$920m to US$3.7bn in the week to 20 January, equivalent to just 0.6 months of trailing goods & services imports and 11% of Pakistan’s gross external financing needs, direct intervention by the SBP is completely untenable. However, it may resort to moral suasion or other regulatory measures, which would limit the near-term reserve drawdown but, ultimately, prevent the needed external adjustment from taking place and result in a balance of payments crisis just the same.
Even if PKR is allowed to float freely, it is not sufficient on its own to prevent a debt crisis. Alongside this week’s rate hike, it moves Pakistan one step closer to securing its IMF programme and associated funding, but further action will be required (including fuel and electricity tariff hikes and passage of a new PKR 300bn revenue package announced this week – see here for a summary from IMS), and, with reserves at such critical levels, it may be too late to put the programme back on track without restructuring.
Overall, we view today’s devaluation as a necessary but not sufficient pre-condition to avert a sovereign default. We will wait to see how PKR trades in the coming days and weeks before assessing whether there has been a shift to a market-determined regime or if it is simply a one-off deval followed by renewed management (like we have seen in Egypt in recent years).
Ultimately, the official and parallel exchange rates must converge and the backlog of FX and import demand must be settled to clear the market, but the parallel exchange rate is itself a moving target and built-up imbalances mean that an overshoot is likely in the near term, which may tempt the government to intervene.
Further, there will be some short-term pain associated with the devaluation, with currency depreciation pushing up import prices at a time of elevated inflation. This may absorb some of the political capital needed to pass the rest of the government’s reform agenda and get the IMF programme back on track.
Nonetheless, with Pakistan’s eurobonds trading below recovery value, we maintain our Buy recommendation on the PKSTAN 7 ⅜ 04/08/2031s at US$43.6 (22.9% YTM) on a mid basis at the time of writing on 26 January on Bloomberg.
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