Folly of chasing exchange rate

PAKISTAN’S economic debate is trapped in outdated vocabulary. Each time the rupee weakens, headlines scream ‘devaluation’. Anchors ask whether one is imminent, while policymakers debate whether the exchange rate should be defended or strengthened. as if it was simply another policy tool. It’s not. The language belongs to another era. Today, most countries let their currencies move more freely. When an economy gets dangerously out of balance, the currency has to adjust to avoid a more disruptive crisis, as our own history has shown.

The exchange rate is not an administrative decision. It is the market price of one country’s currency in terms of another. This price is shaped by domestic inflation relative to that of the country’ trading partners and the accompanying interest-rate differentials, productivity, government spending more than it earns, external balances, capital flows, adequacy of foreign currency reserves and, above all, expectations of what businesses think will happen to the economy in the future. The rupee doesn’t get weaker because policymakers decide to weaken it. It weakens because the country’s economic choices make the current rate impossible to maintain.

Central banks try to manage this by choosing different systems — a fixed rate, a managed float of the currency or a freely floating rate. Each regime imposes its own discipline but no system allows a government to control the exchange rate without fixing the bigger economic picture first. Pakistan has drifted between these arrangements without consistently committing to any of them — tightly managed at times, allowed to depreciate gra­­dually at others, restrained through administrative controls, or adjusted only under IMF-sup­ported programmes. This is not a coherent strategy; it’s a succession of ad hoc responses to recurring crises.

People often think a weaker rupee is the main reason Pakistan struggles to export. The real determinants of competitiveness lie elsewhere. Exporters here face far greater structural obstacles than the exchange rate itself: expensive and unreliable electricity and energy, high taxes and unpredictable cumbersome regulations, outdated shipping logistics and inefficient customs procedures. Furthermore, a modest depreciation cannot compensate for structural impediments of this scale when high tariffs, non-tariff barriers and regulatory restrictions distort relative prices far more than movements in the exchange rate. While domestic producers remain insulated from global competition whether the rupee appreciates or depreciates, exporters face elevated costs for imported inputs.

The exchange rate is just a symptom of how the economy is being run.

The exchange rate is just a symptom of how the economy is being run. Exchange-rate stability depends on policy credibility rather than administrative intervention. It requires fiscal discipline, low and predictable inflation, sustainable external balances, competitive domestic markets and confidence that macroeconomic policies are internally consistent. Persistent fiscal deficits financed through borrowing fuel inflation, erode confidence and render the exchange rate unsustainable; propping up an artificially strong currency merely postpones adjustment while increasing its eventual cost.

Economists often refer to the fancy term ‘REER’ (real effective exchange rate). This is a diagnostic tool which simply compares Pakistan’s prices with the prices of its trading partners, accounting for inflation, to see if the rupee looks broadly overpriced or underpriced. It does not magically tell you the ‘perfect’ price of the rupee, especially when the government is heavily interfering with trade and import rules. Its utility also depends on the structure of the economy: where trade is open and prices respond freely to market forces, REER is informative; where protection, import restrictions and administrative controls are extensive, its relevance diminishes, since tariffs, licensing requirements, customs delays and regulatory barriers shape competition more than the exchange rate does.

Governments can temporarily influence the measured REER through tariffs, exchange controls, multiple exchange rates or import restrictions. These may ease immediate pressure on currency, but do not improve competitiveness. Instead, they create shortages and widen the gap between official and market exchange rates. The official exchange rate may appear stable even while the underlying equilibrium is drifting away. The State Bank can and should intervene to reduce excessive short-term volatility and maintain orderly market conditions. What it cannot do is permanently offset weak fiscal, monetary and structural policies. Markets eventually prevail.

Pakistan’s experience illustrates this. The country has repeatedly moved through the same cycle: an overvalued exchange rate, declining reserves, import restrictions, IMF support, sharp depreciation and temporary stability before the next crisis emerged. Adjustment then came through panic and sharp devaluation. Each episode was descri­bed as a currency crisis, whereas a market-responsive rate would have allowed gradual correction and reduced crises. The exchange rate merely exposed underlying weaknesses and the failure to undertake timely fiscal and structural reforms.

To be fair, today’s circumstances differ from previous crises. They look admittedly better: the current account is broadly balanced, reserves have stabilised, the gap between official and unofficial exchange rates has largely disappeared, and importers and exporters can obtain foreign exchange without significant rationing. But this stability should not be mistaken for a durable improvement in fundamentals. It has been supported by exceptionally strong remittance inflows, continued external borrowings, and foreign debt rollovers, subdued import demand owing to weak economic activity, high inflation that has compressed domestic demand, and the State Bank directing money changers to surrender remittances into the formal banking systems, factors that ease pressure on the rupee without removing Pakistan’s structural vulnerabilities. More importantly, per capita incomes are not growing and the investment/GDP ratio remains very low.

For lasting exchange-rate stability, the priorities are clear: restore fiscal discipline, reduce inflation, reform SOEs, lower trade protection, rationalise energy pricing, improve productivity, modernise logistics and create a more predictable regulatory environment. These reforms, and not attempts to manage the exchange rate, will determine the rupee’s stability.

The exchange rate is not the disease. It is merely the thermometer. Breaking the thermometer does not cure the fever. Nor does fixing the reading change the patient’s condition. The rupee simply reflects the economy Pakistan has built. Until the economy becomes more competitive and fiscally disciplined, markets will determine where the exchange rate settles.

Nadeem ul Haque is former VC PIDE and deputy chair of the Planning Commission.

Shahid Kardar is a former governor of the State Bank of Pakistan.

Published in Dawn, July 25th, 2026 ...