Challenging the CW

September 15, 2017

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SOME of the responses to the online version of a recent article I wrote on the PML-N government’s misguided economic policies (Burying Dar-nomics) threw into sharp relief the need for challenging the conventional wisdom (CW) on important aspects of economic policy and management. Over several articles, I will try to address some of these misconceptions, which range from whether Pakistani industry is overburdened with taxation or not, the indirect tax burden on the average citizen, to the effectiveness of a stable exchange rate. In today’s piece I will focus on the exchange rate.

An issue which has generated considerable fireworks (without necessarily the illumination) is the suggestion that the policy of the government since late 2013 to keep the nominal exchange rate stable has been counterproductive. While outlining the reasons on a number of occasions previously, of why, in our case, greater flexibility of the exchange rate may be a more feasible option in the long run, the advocates of such a policy have banked on standard economic theory as well as the development experience of many countries (though admittedly there may have been outliers). In this view, the exchange rate is a ‘fundamental’ price that influences the investment decision — over a period of time — of businesses in an economy. Hence, its effects are ‘strategic’ in nature, and may be one important factor in explaining the long run decline of the share of Pakistan’s export sector in the overall economy to less than seven per cent.

In response, counter arguments have been presented that are mostly ‘tactical’ in nature — the adverse effect on public finances, public debt and inflation. (The inflationary impact of a weakening of the exchange rate can be temporary and ‘one-time’, as the 2008 experience demonstrated). A final counter-argument presented (which is not tactical in nature) has been that the effect on exports of previous episodes of rupee weakening is less than evident. This is a complex issue that also needs to take into account the counterfactual ie what would have been the long-run effect on exports without a depreciation of the exchange rate.

However, at this stage, with Pakistan’s exports declining significantly since 2013 and non-CPEC related imports rising over 20 per cent, with an overall external current account deficit of over $12 billion being posted and pressure on the balance of payments intensifying rather than lessening, many of the arguments on both sides are essentially redundant. Now it’s simply down to avoiding a large, disorderly adjustment of the exchange rate in the months ahead.

Half-baked economic beliefs continue to pervade the discourse.

Discussion regarding the real or imagined impact of exchange-rate flexibility on boosting exports or curbing imports, or getting the relative ‘price’ between the tradable and non-tradable sectors of the economy right, is somewhat irrelevant right now, because whether compelled by the financial markets or forced by the IMF, an adjustment of the exchange rate will happen. It is not a question of if but when, and by how much.

The government, as well as those cheerleading the supposed benefits of a stable exchange rate in the face of a protracted and growing overvaluation, will soon see the misguided policy go down in flames — just like in 2008. Policymakers under Shaukat Aziz’s stewardship back then refused to adjust the exchange rate in the build-up to the macroeconomic crisis for precisely the same reasons given by the current finance minister.

However, in both cases, the flawed policy failed a key test — it was not sustainable. To make the failure of the stable exchange rate policy even more stark, in the current episode of exchange rate misalignment since 2013 international oil prices have barely averaged $50 per barrel. Hence, the blame cannot be laid on any external factor or an adverse terms-of-trade shock. As in the 2005-08 period, current policymakers are scrambling to staunch the decline in foreign exchange reserves by preparations for more external borrowing, making the same mistake of “over-financing and under-adjusting”.

For the cheerleaders in the financial markets of the stable rupee policy who should have known better, but clearly did not, 2008 should have been a lesson. An even bigger lesson should have come from the start of the Asian financial crisis 10 years earlier. Thailand’s central bank had pegged its exchange rate to the US dollar for a decade and was confident that with forex reserves at over $30bn, it had ample firepower to defend the Thai baht. When the sentiment in the financial markets turned against the baht, and large hedge funds like George Soros’ Quantum Fund built up aggressive ‘short’ positions (essentially selling the Thai baht), the central bank spent over $10bn of its reserves in a matter of days in trying to defend the currency. With large positions in the Thai baht being unwinded and investors heading for the exits, this was a losing battle for Thai authorities, and the baht collapsed by 60pc between June and October 2007.

With history rich in examples of how policymakers have repeatedly got it wrong on the exchange rate, the only surprise is why they repeat the same mistakes with such regularity. In our case, judging by some of the arguments made, it seems it is not just policymakers who refuse to learn from history and our own experience but even people working in the financial markets.

Hopefully, in the future, before embarking on a policy of a stable, near-pegged exchange rate for a protracted period in the face of overvaluation pressure, policymakers will ask if this had brought any benefits to the country’s balance-of-payments position in the past — and draw the right conclusion.

The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.

Published in Dawn, September 15th, 2017