There is broad agreement that the rupee is overvalued, with estimates of overvaluation ranging from 20-40 per cent. There are, however, two opposing views on how to deal with the problem:
One, devaluation and two, administrative measures, i.e., export subsidies and regulatory duties on imports.
The argument of the anti-devaluation group is that devaluation has never worked in Pakistan and it will only result in higher inflation because there is no surplus to export and most imports are essential items.
Whether export supply and import demand are inelastic is a myth created by the beneficiaries of an overvalued exchange rate: the bureaucracy — the government is the largest beneficiary in terms of cheaper imports, including defence equipment and reduced cost of debt servicing — traders and the rich, who are the main consumers of imported goods.
Overvaluation is generally unnecessary because it leads to fewer jobs, small businesses can’t compete with cheap imports and farmers do not get a fair price for their crops.
To argue on the basis of supply and demand elasticities in Pakistan can be a futile exercise, because economists can produce results that support any argument.
However, by looking at past events shows the myth that ‘devaluation has never worked in Pakistan’ is false. For example, during 1982 to 1988 the government implemented a policy of exchange rate reforms and allowed the rupee to devalue — the rupee/dollar rate virtually doubled from Rs9.91 in 1982 to Rs18.73 in 1988.
Despite this large depreciation economic managers were able to restrict the annual inflation in this period to around six per cent through various measures including sensible management of adjustments in the nominal exchange rate, control over monetary expansion and by maintaining fiscal discipline.
The devaluation effectively reduced the real exchange rate by 43pc and the reduction in overvaluation had the expected positive effects on the economy in terms of impressive growth of GDP (6.5pc), large scale manufacturing sector (eight per cent) and exports (10pc) over the next six years.
In addition, during this period, the trade deficit declined by 40pc as devaluation reduced growth in imports to only two per cent.
The 1980s experience shows that a large devaluation need not lead to high inflation and can have the desired positive impact on manufacturing and agriculture production, economic growth and exports.
However, for devaluation to work it has to be part of a comprehensive, long term, government policy and if devaluation is forced upon a government — because of a balance of payments crisis — it has none of these positive outcomes.
This can be seen from a more recent experience. In 2007, Pakistan faced a growing current account deficit and the government initially kept the rupee/dollar exchange rate stable, but as international reserves declined this became increasingly difficult and in the last quarter of 2007 the government lost control over the exchange rate which depreciated by 25pc in one year, from Rs 60.68/dollar in October 2007 to Rs80.43 in October 2008.
Exchange rate stability was only restored in November 2008 when the new government was forced to sign an agreement with the IMF. Performance over the next six years (2009-2014) was the polar opposite of that in 1980, with GDP growth averaging only three per cent per annum and inflation averaging over 11pc per annum.
The current situation is very similar to 2007. The overvaluation of the currency has led to declining exports and rapidly increasing imports, resulting in a growing current account deficit that increased from just over one per cent of GDP in 2015 to almost four per cent in 2017.
As a result, foreign exchange reserves held by the State Bank of Pakistan are declining at an accelerating rate, falling in the last quarter (July-September 2017) to $13.8bn and this was despite short-term borrowing of over $700 million in this period.
The government has implemented several administrative measures, such as incentive packages for exports and increases in regulatory duties on the import of a large number of items.
However, because of widespread under invoicing of imports and chronic delays in payment of refunds to exporter, such measures have seldom worked.
As in 2007, the elections are due shortly which means that the fiscal deficit is likely to increase this year and the government is publically committed to keeping the rupee/dollar exchange rate stable, thus unless the exchange rate is adjusted, the current account will continue to grow and the foreign exchange reserves will continue to decline.
The window to choose between the policies followed in 1982 as opposed to those in 2007 is closing rapidly and it is important to start the adjustment process before it is too late.
The Government needs to immediately announce that it is going to follow an exchange rate policy aimed at achieving, and then maintaining, a competitive real exchange rate and simultaneously initiate a process of gradual devaluation of the rupee.
The Writers are Professor and Research Fellow at the Lahore School of Economics.
Published in Dawn, The Business and Finance Weekly, October 30th, 2017
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