Article for January 12, 2010

Depreciating Exchange Rate

By

Dr. Ashfaque H. Khan

A country’s current account deficit may deteriorate for a variety of reasons including
expansionary fiscal policy, a deterioration in the terms of trade, higher debt servicing etc. A
deficit in current account can only be sustained if there is a matching inflow of capital to finance
it. In the event of shortfall in capital flows, the country seeks balance of payment support from
outside, including the IMF. Exchange rate depreciation invariably has been an essential part of
the IMF program to facilitate adjustment.

Exchange rate depreciation has been associated with deceleration in economic growth; increase
in unemployment and poverty; undermining public sector investment and development
strategies; increasing cost of living, worsening income distribution and shifting the burden of
adjustment to low-income groups.

The proponents of devaluation (the IMF and the Country’s Central Bank) argue that it improves
external competitiveness, increases exports, reduces imports and thus improves trade and current
account balances. They also argue that devaluation initially worsens but eventually improves
balance of payments with a lag (J-Curve effect) which is hard to specify.

With the contraction in world trade as a result of global economic meltdown over the past two
years, and the associated rise in protectionism in industrial countries, the critics have raised
questions regarding the efficacy of devaluation as an instrument to improve balance of payments.
How come a developing country increases exports by changing relative price through
devaluation in a recession-hit industrialized markets?

The critics also argue that devaluation increases the cost of imported inputs of export-oriented
industries. Hence, the larger its share in total inputs of export-oriented industries, the lesser will
be the beneficial effect of devaluation on balance of payments. Furthermore, the experience of
the 1990s suggests that the benefits of devaluation have always accrued to importers of Pakistani
goods. The importers would force the Pakistani exporters to reduce the unit price of goods to the
extent of devaluation.

Pakistan has witnessed a stable exchange rate for almost eight years in the current decade. The
rupee-dollar parity hovered around Rs. 60-62 per dollar. Exports more than doubled during the
period, rising from $8.5 billion in 1999-00 to $19 billion in 2007-08 or over 122 percent.
Exchange rate nosedived since early April 2008 and Pakistani rupee has lost one-third of its
value vis-à-vis US dollar. When the present government took charge of the state of affairs on
March 31st 2008 the exchange rate was Rs. 62.5 per US dollar and today it has plunged to Rs. 85
per dollar – a loss of Rs. 22.5 per dollar in less than two years. The IMF has also asked Pakistan
to pursue a “flexible” exchange rate policy under its program. Pakistan is religiously following
the dictate of the IMF and as such allowed rupee to lose ground with a view to improving
external payments position.

Has Pakistan achieved these objectives? Have exports increased, and imports reduced? Has
external payment situation improved as a result of devaluation? Exports during 2008-09 declined
to $17.8 billion from $19.0 billion a year ago – a decline of 6.7 percent. Exports stood at $9.2
billion in the first half of the current fiscal year as against $9.5 billion in the same period last
year – down by 3.0 percent. Thus, exports continue to decline in the midst of fast-depreciating
exchange rate. In other words, we have observed a negative relationship between devaluation
and exports – quite contrary to the theory.

With reference to my article, dated December 30, 2009; I had depicted that over 90 percent
improvement in external payments position during the period came from the collapse of
commodity and oil prices as well as surge in remittances for unexplained reasons. Devaluation
has certainly not helped in increasing exports or improving current account balance.

On the other hand, devaluation has done irreparable damage to the economy. The exchange rate
depreciation has alone added Rs.1,125 billion in public debt. In today’s exchange rate it amounts
to $13 billion. The rise in public debt would increase interest payment, reduce fiscal space for
development spending and put enormous pressure on budget. Higher budget deficit would lead to
even more accumulation of public debt.

Devaluation by definition is inflationary. While inflation in many developing countries was close
to zero percent, it remained at higher double-digit level for quite sometime in Pakistan – thanks
to depreciation of exchange rate. Consequently, the State Bank of Pakistan had to maintain tight
monetary policy with adverse consequential effects on investment and growth.

Depreciation of currency is likely to play havoc for sugar prices in a few months time. There will
be a shortage of at least 1.5 million tons of sugar this year for which the government has a plan
to import. Not only the price of sugar in international market will be at its ever highest in 29
years but its landed cost at Karachi would also surge on account of depreciation of rupee.
Similarly, the depreciation of currency will keep POL prices at higher level; higher furnace oil
price will make electricity costly and if it is not passed on to consumers, the issue of circular debt
will continue to hound the government. We may see aggravation of power crisis and stagnation
of industrial growth going forward.

The SBP is requested to conduct the cost-benefit analysis of pursuing “flexible” exchange rate
policy. For the IMF, the textbook approach may not work all the time. Given the current state of
weak global market and the depressed level of economic activity at home, is this the right time to
force the government to pursue a “flexible” exchange rate policy? Please also conduct the cost-
benefit analysis of such policy for the general public of Pakistan. While doing such an analysis,
please also compare the experiences of Indonesia and Malaysia in the events of 1997 financial
crisis. The people of Pakistan wait for the result of your analysis.

The writer is dean and professor at NUST Business School, Islamabad. Email:
ahkhan@nims.edu.pk