Define a Coherent Exchange Rate Policy

A ‘stable’ exchange rate is a reflection of how ‘well’ the economy is being managed.

Governments frequently intervene in exchange rate management matters and ask that the exchange rate is kept stable in nominal terms or only fluctuates around a tight band.

• An appreciating exchange rate is good.
• Devaluation is always bad.

The reality is more nuanced.

An exporter is interested in the ‘real’ value of the dollars/he earns per unit of exports, not the ’nominal’ amount.

Thus the nominal exchange rate needs to be corrected for inflation-or more specifically, relative inflation-meaning Pakistan’s inflation vis-a-vis the inflation rates of our trading partners and competitors yields a Real Effective Exchange Rate (REER).

Empirical studies show that exports do respond to changes in the REER because it is an important—albeit not the only—determinant of export success.

Historically, and even now, there has been a strong anti-export bias in Pakistan with the REER tending towards an appreciation.

This means the exporter is getting fewer and fewer real dollars per unit of exports. If exporters see that the improvement in real export profitability is likely to be fleeting or dissipate through future inflation or by changes in government policy, they will have little incentive to export and would prefer to sell in the domestic market.

One way of forestalling REER appreciation is to allow for greater downward flexibility in the nominal exchange rate so as to yield a constant on rising REER. A better way is to reduce our adverse relative inflation differential as opposed to our trading partners and competitors.

However, this would require highly disciplined macroeconomic policies (small fiscal deficits and a tight monetary policy stance with positive real interest rates) that can be sustained over time. Unfortunately, this is something that Pakistan has not been able to do. Brief periods of price stability have given way to extended periods of high inflation rooted in lax macroeconomic indiscipline.

Successful exporting countries notably China keep the REER slightly depreciated thus giving their exporters a lasting competitive edge.

By keeping the Renminbi at a significantly lower level than that which would be dictated by market forces and the size of China’s foreign exchange reserves, China has emerged as an unstoppable export juggernaut.

Would Pakistan benefit from a similar policy?

Between January 2007 and July 2010, the Pakistani Rupee depreciated much against the US dollar and other major currencies, eroding by 38.5%.

This was caused by crude oil which shot up from $80 per barrel to $140 per barrel.

Being an oil importing country, the trade deficit burgeoned to $15.3 billion while Forex reserves dropped to just $6.7 billion.

Inflation hit a peak of 25% as the entire consumer basket was jolted by commodity prices and massive deficit financing from the central bank.

During the same period exports grew from $17.3 billion in FY07 to $19.6 billion in FY10, while imports jumped from $27 billion to $31 billion.

In simple terms the increase in oil prices thus fuelled the deficit in the balance of trade and the consequent devaluation of the Pakistani Rupee.

Would a policy of forced and greater devaluation have helped Pakistan in the medium to long term scenario?

The problem with such a strategy is Pakistan’s unfavourable terms of trade.

The terms of trade is the export price index relative to the import price index and helps gauge capital inflow and outflow in terms of 100 indices.

In fact, a dose examination of the terms of trade suggests that Pakistan’s terms of trade are not only unfavourable but also deteriorating for all major categories except food and live animals which improved significantly in FY09.

These have declined from 73.6 in FY05 to 63.8 in January 2007 to 54.9 in nine months FY10. This indicates that in FY05, for every unit of import Pakistan exported 73.6 per cent of the index value, and by nine months FY10 export unit relative to the import unit had dropped to 54.9%.

These figures reveal that if Pakistan devalues its currency, the incremental cost paid for imports will be more than the additional benefit earned from exports on a relative time basis.

The key point is that the Real Effective Exchange Rate (REER) is what really matters to exports rather than the nominal exchange rate.

From January 2007 the Pakistani Rupee has significantly depreciated, in nominal terms, against the USD. This indicates that the PKR has weakened against the USD and thus Pakistan’s exports to the US and other trading partners should have become more competitive, as they had become cheaper in units of foreign currency.

However the REER paints a different picture; it takes the nominal exchange rate, adjusted for foreign price levels and then deflates it by domestic inflation.

This index had during the same period appreciated and the PKR had strengthened by 5.8% since January 2007. As a result instead of Pakistani exports getting cheaper, exports have become more expensive in the international market and hence less competitive.

The primary reason for this is domestic inflation. In FY08, CPI was 12%, which spiked to 20.8 per cent in FY09 before settling down to 11.7% in FY10.

Essentially the domestic cost of manufacturing, transporting and selling our goods abroad has risen to such an extent that it has neutralised the advantage of a weak currency.

The skewed structure of Pakistan’s imports and the infrastructural inefficiencies inherent in the domestic economy prevent Pakistani exporters from benefiting from a weaker currency. This is partly because Pakistan is an oil-importing country with 34 per cent of the total import bill attributed to the import of crude and refined petroleum.

A weaker PKR means a higher import bill, higher prices for transportation (7.5 per cent of CPI basket) and energy (7.5 per cent of CPI basket) not to mention the indirect effect on perishable 237food items, house rent, recreation and other components of the inflation basket.

Higher costs not only erode the margins of exporters who already suffer from power shortages, security threats and high interest rates but force them to pass on the price increase to their international customers. Given that most Pakistani exports are low value added items, they also suffer from demand inelasticity.

This means that a price decrease does not increase volumetric demand by enough to offset the revenue loss from lower prices. While it is tempting to think that a policy of deliberate PKR devaluation would improve export competitiveness, the reality is that domestic inflation, supply bottlenecks and fiscal indiscipline, would result in real appreciation as witnessed over the last three years and, in fact, make exports less competitive.

The solution to increasing exports lies, therefore, in stabilising the macroeconomic environment, providing adequate infrastructure and security, access to credit, investment in product quality and value addition which are longer term policy objectives, all necessary conditions to complement a policy of maintaining a competitive exchange rate.

The converse of this is to keep a stable exchange rate, which is what happened during the period, 2002-2007. During this period, Pakistan saw its exports rise from $9 billion to $17 billion. A stable currency policy allowed a steady build-up of reserves and investment flows. Investment rates climbed to as high as 23 per cent as foreign direct investment felt more confident that future returns would not be eroded by a weak currency.

This allowed the liquidity cycle to ease up leading to a benign interest rate environment, reduced debt servicing. All good news for GDP growth as compared to previous years where low reserves encouraging dollarisation, low investment rates and relatively low growth.

So does a successful export-driven economy mean that Pakistan needs to use the exchange rate more aggressively? The focus has to be the Real Effective Exchange Rate, rather than the nominal exchange rate.

Keeping REER competitive is a necessary but insufficient condition. If Pakistan can maintain a competitive REER, Pakistan can recoup lost competitiveness by focusing on supply side issues which control inflation or it can continue to play ‘catch up’ and do what is being done now which is a constant downward adjustment of the nominal exchange rate hindering export competitiveness.