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Managed Exchange Rate: A Double-Edged Sword for Pakistan’s Economy
An analysis of Pakistan’s currency policy and its far-reaching economic consequences.
The News
In a move that has drawn sharp criticism from its export sector, Pakistan has reportedly maintained an artificially appreciated rupee against the US dollar for the past 18 months. This ‘managed’ exchange rate, which has seen the local currency gain approximately Rs4 against the greenback, is increasingly being cited as a significant deterrent to both exports and crucial foreign investment, particularly within the manufacturing sector.
While the government and the State Bank of Pakistan (SBP) contend that a stronger rupee fosters economic stability, exporters argue that this policy is actively undermining growth. The consequences are already visible: a surging import bill, which pushed the trade deficit to an alarming $39 billion in FY26, effectively offsetting substantial remittance inflows. Exporters highlight dwindling international competitiveness due to higher production costs and a Real Effective Exchange Rate (REER) that signals currency overvaluation, prompting fears of business closures and a stunted industrial base.
Background: The Delicate Balance of Currency Management
An exchange rate is often seen as a barometer of a nation’s economic health, reflecting its purchasing power and trade competitiveness. Governments and central banks sometimes intervene in currency markets to achieve specific economic objectives. An “artificial exchange rate” typically refers to a currency’s value being held at a level that does not truly reflect market supply and demand, often through central bank buying or selling of foreign currency.
For a country like Pakistan, which has historically grappled with balance of payments crises and relied heavily on external financing from institutions like the International Monetary Fund (IMF), the temptation to stabilize the rupee through management can be strong. A stronger rupee can initially appear beneficial by making imports, especially essential commodities and raw materials, cheaper, thereby potentially easing inflationary pressures and signaling economic confidence.
However, this stability comes at a cost. The Real Effective Exchange Rate (REER) is a crucial indicator that measures a currency’s value relative to a basket of other major currencies, adjusted for inflation. A REER value above 100 suggests that a currency is overvalued, making a country’s exports more expensive and its imports cheaper compared to its trading partners. The current REER of 106.4 for Pakistan’s rupee serves as a stark warning sign, indicating a significant loss of competitiveness on the global stage, especially when compared to regional rivals like India and Bangladesh, whose currencies have generally depreciated, making their exports more attractive.
Impact on Pakistan: A Cascade of Economic Challenges
The policy of maintaining an overvalued rupee, coupled with other economic factors, generates a domino effect across several critical sectors of Pakistan’s economy:
1. Erosion of Export Competitiveness
Exporters are at the forefront of this crisis. A stronger rupee translates directly into higher prices for Pakistani goods in international markets. With production costs already elevated—reportedly 12% higher than in China—exporters struggle to compete. This rapidly leads to a loss of market share, reduced foreign exchange earnings, and a diminishing incentive for local manufacturers to expand or innovate. The government’s ambitious targets of increasing exports to $60 billion and doubling trade with the US to $20 billion in five years appear increasingly unrealistic when the fundamental cost structure undermines the very ability to export.
2. Widening Trade Deficit and Import Dependency
While remittances provide a vital lifeline, the overvalued rupee encourages an unchecked surge in imports. Cheaper foreign goods become more attractive to domestic consumers and industries, leading to a higher import bill. The fact that a substantial $41.5 billion in remittances is almost entirely offset by a $39 billion trade deficit highlights a critical imbalance. Instead of using remittances as capital for growth, the nation appears to be spending them on consumption, including non-essential items like bulk car imports, further exacerbating the trade gap and making the economy vulnerable to external shocks.
3. Discouragement of Foreign Direct Investment (FDI)
Foreign investors seeking to establish export-oriented manufacturing facilities are deterred by an overvalued currency. A high REER means that setting up production in Pakistan makes their eventual exports more expensive, directly impacting profitability. This disincentive for FDI is reflected in declining investment figures, depriving the country of crucial capital, technology transfer, and job creation opportunities essential for long-term industrialization and economic development.
4. Rise in Smuggling and Informal Economy
An overvalued local currency makes imported goods cheaper, not just through official channels but also for those engaged in illicit trade. Exporters report increased smuggling from neighboring countries like China and Iran, where goods are cheaper relative to Pakistani prices. This influx of cheaper, often under-invoiced, goods not only undercuts legitimate local industries but also feeds the informal economy, depriving the government of much-needed tax revenue and further destabilizing the domestic manufacturing base.
5. Compounding Effect of High Interest Rates
The challenge of an overvalued currency is compounded by high domestic interest rates, currently maintained at 11.5% by the SBP. High borrowing costs directly inflate production expenses for businesses, making it even harder for Pakistani manufacturers to compete globally. Even with incentives like subsidized loans, the combined burden of high interest rates and an unfavorable exchange rate stifles growth, rendering such support measures less effective in stimulating the struggling manufacturing sector.
Analysis: Prioritizing Illusionary Stability Over Sustainable Growth
The current approach to exchange rate management in Pakistan reflects a profound policy dilemma. While the government’s intention to foster stability and potentially curb imported inflation by strengthening the rupee is understandable, the long-term economic repercussions are proving to be far more damaging. True economic stability is not achieved through artificial currency levels but through robust, competitive exports, a diversified industrial base, and a healthy balance of payments.
The disconnect between policy objectives and ground realities is stark. Exporters, who are the engine of foreign exchange generation, are being forced to scale back or close operations, while ambitious export targets remain elusive. The reliance on remittances to mask a widening trade deficit is unsustainable, transforming a potential growth driver into a mere consumption enabler.
For Pakistan to break free from its perennial cycle of economic instability, a paradigm shift is imperative. Instead of resisting market forces, a strategy of gradual, managed depreciation of the rupee could restore export competitiveness without causing a sudden shock. This must be coupled with fundamental structural reforms: reducing the overall cost of doing business, enhancing energy efficiency, streamlining logistics, and improving the regulatory environment. Incentives for exporters need to be part of a broader, coherent strategy to stimulate industrial growth, rather than isolated measures that are negated by overarching macroeconomic policies.
Ultimately, the current policy prioritizes a perceived short-term currency stability over the long-term prosperity derived from a vibrant, export-led economy. Ignoring the clear signals from the REER, the trade deficit, and the cries of the manufacturing sector risks perpetuating Pakistan’s economic vulnerabilities, hindering its potential to become a truly competitive player on the global stage.
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