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Devaluing rupee isn’t worth a dime

Updated September 11, 2017

In the face of a massive trade deficit, the government is under pressure to let the overvalued domestic currency depreciate against foreign currencies.

To what extent can the rupee’s depreciation or devaluation be instrumental in containing the trade deficit? And what are the potential costs of such a decision?

Like most other countries, Pakistan maintains a managed floating exchange rate regime. The exchange rate is largely determined by the supply of and demand for different currencies. However, from time to time, the central bank intervenes in the foreign exchange market to keep the rate stable.

Thanks largely to such interventions the rupee has maintained its value in relation to foreign currencies, particularly the dollar.

This fact itself shows that the domestic currency is overvalued, because an economy facing a substantial current account deficit — which shows that the foreign demand for its goods and services is less than the domestic demand for foreign goods and services — must see its currency depreciate.

Rupee depreciation, the argument goes, will have a double impact: Pakistan’s exports will become cheaper while imports from its trading partners will become expensive. Thus, depreciation will encourage exports and at the same time discourage imports, which will reduce trade and current account deficits.

What are the potential costs of such a decision?

This is what depreciation, or devaluation, in theory is supposed to accomplish. But whether in reality such an outcome comes about is contingent upon quite a few factors.

Take the likely impact on imports. In the wake of depreciation, the domestic prices of imports will go up. The import bill, however, is a function of both prices and import volume. The effect of devaluation on the volume of imports depends on import elasticity of demand.

In case the demand is inelastic, the price increase will not significantly reduce import volume. The elasticity of import demand depends largely on the availability of substitutes. If domestic substitutes are available, imports will go down.

For Pakistan, the likely impact of depreciation on import volume can be estimated by looking at the country’s import profile. According to the State Bank of Pakistan, the country imported goods worth $48.58 billion in 2016-17.

Of this, the biggest share was that of petroleum products, which was $10.60bn (21.82pc of the total), followed by machinery and equipment $7.87bn (16.20pc), and raw materials and inputs $7.12bn (14.65pc). This means that three product groups account for 52.67pc of Pakistan’s total imports.

Petroleum products are necessary as they are used by both industrial and final consumers, while the import of machinery and equipment as well as raw materials and inputs is essential for a developing country like Pakistan.

Besides, the substitutes for these products are either not available or they are available in a crude or substandard form. In other words, the right substitutes for most of Pakistan’s imports are not available, which makes the import demand inelastic.

An increase in prices of imports as a result of devaluation will not significantly reduce total import volume. There is even the possibility that the final import bill may go up due to the increase in prices of imports for which the demand is largely inelastic.

Now take the likely impact on exports. Increase in exports following depreciation will depend on the price elasticity of demand for the products concerned in foreign markets.

Let’s suppose that the demand for Pakistan’s exports is price elastic. Therefore, foreign buyers will increase orders for Pakistan’s exports. The important question, however, is whether Pakistan has the excess capacity to respond to the increased orders.

For a country which is facing severe supply-side constraints — a narrow manufacturing base, energy shortage, lack of commitment to product quality, and production inefficiencies — it is difficult to answer the question in the affirmative.

Even if we assume that depreciation will drive up Pakistan’s exports, we need to bear in mind that depreciation, like most other policy measures, is a double-edged sword.

In the first place, it reduces real incomes of the residents by raising prices of a number of items. In case of Pakistan, given the import basket and dearth of substitutes, the impact on real income is likely to be large.

Secondly, the cost of foreign debt servicing also goes up. Again, the impact will be substantial for Pakistan, where external debt servicing forms a sizeable part of the government’s expenditure.

Thirdly, a fall in the value of the domestic currency increases aggregate demand; therefore, the success of depreciation depends on the ability to hold domestic demand in check through restrictive fiscal and monetary policies.

In the absence of excess manufacturing capacity, the increase in aggregate demand may result in inflation and increased demand for imports thus offsetting any benefits that devaluation may bring.

Pakistan’s problem is that restrictive fiscal and monetary policies will slow the pace of economic growth, which the government can hardly afford.

Published in Dawn, The Business and Finance Weekly, September 11th, 2017