By Ariba Shahid and Asif Shahzad
KARACHI, Pakistan (Reuters) -The Pakistani rupee weakened by 1.2% on Wednesday after foreign exchange companies removed a cap on the currency, saying it caused "artificial" distortions for an economy in desperate need of International Monetary Fund help.
The move towards a market-based exchange rate should please the IMF, as that is one of the conditions that the multilateral lender has set before it agrees to unlock a stalled bail-out programme for Pakistan.
Finance Minister Ishaq Dar's attempts to defend the rupee, including currency market intervention, had run counter to the IMF's advice.
Battling the highest inflation in decades, the central bank has raised interest rates sharply, but the country has barely enough foreign exchange reserves to cover three weeks of imports and is struggling to meet its external financing obligations.
The Exchange Companies Association of Pakistan (ECAP) said late on Tuesday it was lifting the cap on the currency in the interest of the country.
"We have decided that we will bring the exchange rate at par (with) what we are supplying to the banks against credit cards," ECAP Secretary General Zafar Paracha said in a statement, adding that level is 255 to 256 rupees to the dollar.
The rupee closed at 240.60 to the U.S. dollar and offered at 243 in early open market trade on Wednesday, ECAP said in a statement, compared with a range of 237.75/240 at the close on Tuesday.
In the interbank market, the rupee depreciated 0.49 rupees or 0.21% against the dollar.
The rupee's official value has depreciated 11.23% against the dollar since the start of the 2022-23 fiscal year, which ends on June 30.
Before the cap on the rupee was removed, markets eyed three different rates to assess its value -- the state bank's official rate, the one assessed by the foreign exchange companies and the black market rate.
"We think the dollar rate in banks may fall by up to 5% in few days," said Mohammed Sohail, chief executive officer at brokerage Topline Securities.
ECAP President Malik Bostan told Reuters that the central bank had given an assurance at a meeting that commercial banks would be instructed to supply exchange companies with dollars within a week.
"We're facing a shortage. We do not have physical dollars," Bostan said. "People aren't selling dollars. They're only buying."
He said the removal of the cap would curb black market trade, though it would take time to bridge the gap.
"The black market rate is still sticky in the range of 260-270. The decision of exchange companies has not had any impact as such," said Fahad Rauf, head of research at Ismail Iqbal Securities.
Stock market investors responded positively to the decision to remove the currency cap, with the Pakistan Stock Exchange's (PSX) benchmark index rising 1.77%. Topline's Sohail said investors hoped the removal of the cap would help to persuade the IMF to resume disbursements.
The IMF is yet to approve its ninth review to release $1.1 billion, which was originally due to be disbursed in November last year. The Fund wants Pakistan to cut subsidies, slash energy sector debt and levy more taxes to reduce the budget deficit, and make the transition to a market-based exchange rate.
Prime Minister Shehbaz Sharif said on Tuesday that his country was willing to discuss all of the IMF's demands.
There was no rise on Wednesday in future rates that are released daily by the central bank. After the sharp fall early in the day, the rupee remained stable till market closing time.
Rauf said exchange companies have become irrelevant in the face of the growing black market.
"The government and central bank need to fasten the pace of the release of currency controls otherwise the black market will continue to thrive," he added.