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Grappling with adverse terms of trade

February 12, 2018


PAKISTAN’S economy has suffered from deterioration in terms of trade (ToT) that has reduced growth below its potential.

A study carried out by Nishat Fatima of the Pakistan Institute of Development Economics (PIDE) shows that deterioration in ToT leads to a substantial fall in gross domestic product (GDP). In the 17-year period covered by the research, the ToT index declined from 100 points in the 1990-91 fiscal year to 55 points in 2007-08.

On average, the ToT-adjusted GDP was 1.6 per cent per annum less than the actual GDP. That also resulted in a loss in gross domestic savings. The annual ToT index dipped for 11 years and increased only for six years.

Pakistan has to swiftly adjust its exchange rate policy in a rapidly changing global currency market scenario to improve its terms of trade

Economic literature shows that the ToT index deteriorates owing to: depreciation of the national currency against major currencies, unfair trade practices, depressed global market prices of the bulk of exportable commodities, and a shortage of goods that are less susceptible to international price fluctuations.

To quote from an updated and revised edition of the book Aid or Trade by Yusuf H. Shirazi: “the terms of trade have never been favourable to Pakistan since imports have always been higher than exports. And there has always been demand on foreign exchange.”

The author, who is the chairman of a leading industrial group, sets a single criterion for assessing the impact of foreign aid required to bridge the foreign exchange resource gap: development of productive forces and the consolidation of economic independence of the recipient country (including Pakistan). Because of negative balance of trade, he argues that loans and grants keep rising.

The real problem lies in the structural nature of the economy. Low diversification in production and export makes the domestic economy vulnerable to external shocks and adverse price fluctuations in the world commodity markets. According to the PIDE study, there is a need to diversify production of goods which ‘are less susceptible to wide price fluctuations.’

Another major structural problem is that the domestic industry depends heavily on imported machinery, equipment, engineering goods, chemicals and raw materials, etc. For this the only solution is a substitution of imports by local production wherever feasible.

Some views emerging from less-developed markets tend to challenge the prevailing view in the West that currency depreciation leads to a reduction of imports in all cases.

A research report by Ahmet N. Kipici and Mehtab Kehriyell of the Central Bank of Republic of Turkey shows that “depending on the share of intermediary and investment in total imports, the real depreciation of the exchange rate might not lead to a reduction in imports as expected by theory.”

The real depreciation may also have short-term adverse effects on balance of foreign trade because of ‘lagged influence of changed exchange rate in price and quantity components in terms of domestic economy’

According to the PIDE study, a big depreciation of the exchange rate leads to a fall in export price and a rise in cost of import. It is only when the prices of a country’s exports rise relative to the prices of its imports, that it receives more imports for each unit of goods imported, resulting in better terms of trade.

The exchange rate problem is becoming more complex as the dollar loses its unique position in the international currency market. The greatest challenge facing the greenback is that it is an international as well as a national currency, with the growing divergence of US interests and President Donald Trump ’s ‘America First’ policy running counter to the rest of the international community’s points of view.

This divergence is providing further space for hard currencies like the yuan and euro to expand their global reach both as a medium of exchange of goods and services and a reserve currency of central banks.

Barring short-term fluctuations, the greenback is likely to weaken over time as the US tries to boost its exports and reduce its trade deficits.

One can get a glimpse of how global currency movements affect the balance of payments from SBP’s first quarterly report of the current fiscal year.

The report records that favourable currency movements likely played a role in recently pushing inflows of remittances, particularly from the UK and other EU countries, as the sterling appreciated by 2.1pc and the euro gained 3pc against the dollar.

Revaluation losses of around $438.2 million inflated the public debt stock by 1.5pc, especially as the greenback depreciated against the euro and IMF’s Special Drawing Rights.

In sum, Pakistan has to swiftly adjust its exchange rate policy in a rapidly changing global currency market scenario to improve its terms of trade.

Published in Dawn, The Business and Finance Weekly, February 12th, 2018