EXCHANGE RATE: IN RETROSPECT
Jan 2 - 8, 2012
Since Pakistan's economy has a considerable degree of openness to foreign trade, the domestic price level cannot remain immune to external price shocks i.e. exchange rate depreciation/appreciation and changes in import prices.
Any appreciation or depreciation of the exchange rate will not only result in significant changes in the prices of imported finished goods but also imported inputs that affect the cost of the finished goods and services.
It is now generally accepted that the real exchange rate is a key relative price in an economy. Changes in the real exchange rate influence foreign trade flows, balance of payments, the structure and level of production, allocation of resources etc. While the real exchange rate is an endogenous variable that responds to both exogenous as well as policy-induced shocks, the nominal exchange rate is usually taken as a policy instruments.
Historically, Pakistan pursued a policy of export-led growth, with the objective of achieving viability in her balance of payments with a view to achieving this objective.
The country had to adopt various exchange rate regimes at different times. As such, since the early 1950s, it has maintained an over-valued exchange rate. The degree of over-valuation, however, has decreased over time. Between the early 1950s and January 1982, Pakistan pursued a fixed exchange rate policy.
In 1960, the Pakistan's economy was working with a fixed exchange rate regime. The nominal exchange rate was officially fixed at Pakistan Rs4.762 against one US dollar. This official rate of exchange remained unchanged till 1972.
In 1972-73, the rupee was devalued from Rs4.76 to 11 to a dollar but subsequently re-adjusted to Rs9.90 against the one US dollar - a total devaluation of 130 percent. This new rate of exchange continued within the context of a fixed exchange rate regime till 1982.
During the early 1980s, the dollar started appreciating in terms of the major currencies and as the rupee was linked to the US dollar, this affected the competitiveness of Pakistani products in international markets. Thus, with a view to maintaining the competitiveness of exports and thereby to bring a sustainable balance between the country's current receipts and current payments, it was decided to adopt the managed floating exchange rate system with effect from 8th January 1982.
Under this system, the value of the Pak-Rupee was reviewed daily with reference to a trade weighted basket of currencies of the country's major trading partners/competitors.
The goal is to achieve a targeted path of the nominal effective exchange rate and hence sustain a desired level of external competitiveness. As a result of this policy, while Pakistan's nominal exchange rate, i.e., rupee - dollar rates, increased by 117 percent between 1980-81 and 1989-90, the extent of the over-valuation of the rupee declined and during the 1980s varied between 10 to 20 percent. Between 1071-72 and 1989-90, while Pakistan's PPP (purchasing power parity) exchange rate increased by more than 138 percent, its budget deficit as a percentage of GDP increased from 3.3 to 6.8 percent. Since 1982, the rupee has been devalued consistently.
The managed float systems of 1982 continued to operate successfully till 21st July 1998. In the wake of economic sanctions by major donors and the restraining stance adopted by multilateral financial institutions as a reaction to the nuclear test on May 28, 1998, Pakistan had to take a number of measures to face the challenge.
As a part of this strategy, the State Bank of Pakistan introduced a new exchange rate mechanism on 22nd July, 1998, replacing the manage floating exchange rate system. The underlying philosophy of the dual exchange rate was to pass on the advantages of devaluation to exporters, expatriate workers wishing to maintain money to Pakistan and compress non-essential imports.
The multiple exchange rate system discriminated among different exporters and importers and led to a misallocation of resources with an adverse impact on output and growth. Further, under the IMF's Articles of agreement, a member is not allowed, except temporarily, to engage in multiple currency practice. The two-tier exchange rate system was replaced with a market-based unified exchange rate system on May 19, 1999.
Under the unified exchange rate system, a floating inter-bank rate was applied to all foreign exchange rate system; a floating inter-bank rate was applied to all foreign exchange receipts and payments both in the public and private sectors.
On 20th July 2000, Pakistan set the Pak rupee on a free float. Continuous up and down of the currency rates was observed in recent years. However, in Musharraf era, currency rate stood at stable position, to some extent.
Due to foreign exchange liberalisation reforms in Pakistan, the depreciation of the currency has accelerated. Pakistan being a small open economy is quite vulnerable to the external shocks in terms of both unfavourable world trade and deterioration of terms of trade with its major trading partners. Being a close competitor in the international market, it will have important ramification on the real exchange rate and as a result on exports, balance of payments, external debt and international competitiveness.
Generally, the exchange rate is influenced through four different channels: differences between domestic and foreign inflation rates; changes in relative prices, i.e., the terms of trade; changes in income and finally difference between domestic and foreign interest rates.
Exchange rate policy influences various parts of the balance of payments. It affects the balance of trade of a country mainly through improving international competitiveness, which affects the supply and demand for exports and imports.
If the price elasticity of imports and exports is sufficiently low, the trade balance expressed in domestic currency may worsen.
An improvement in the foreign exchange reserves is likely to lead to a relaxation of imports controls and consequently results in higher imports.
Finally, the exchange rate depreciation would increase the price of imports and consequently imports would decline. On the other hand, the potentially higher costs of imported raw material and capital goods associated with exchange rate depreciation increase marginal costs and lead to higher prices of domestically produced goods.
In case of indirect effect, the exchange rate depreciation affects the net exports, which in turn influence the domestic prices. In addition, import-competing firms might increase prices in order to maintain profit margins. In fact, the exchange rate policy affects the international competitiveness of domestic product as
* Changes in the cost of production may raise the domestic price level.
* Changes in domestic price may also affect production costs if changes in wages are in line with the changes in cost of living when imports become more expensive with depreciation.
* And, if a large country depreciates its currency, the exports from small countries to the concerned country may be reduced.
The country has been lucky that overseas Pakistanis send billions home and have been and are the largest source of external financing and foreign exchange. Remittances also fall when the exchange rate weakens: a one percent depreciation leads to an acute reduction in remittances. Depreciation of the rupee reduces remittances, as migrants may be able to purchase the same goods basket with fewer dollars.
It is notable exchange rate is also affected by poor government policies. Presently a major concern among the macroeconomists has been the unprecedented growth in government budget deficits and this large budget deficits are found to be associated with, among other things, high interest rates, excessive growth in money supply, high prices etc. Thus, budget deficits are believed to have a direct and indirect impact on the real exchange rate.
A government can finance its budget deficit by either one of the following four methods: increasing money supply, borrowing from the public, borrowing from external sources and drawing on external reserves. The fiscal deficit has no relationship with the nominal interest rate in Pakistan; the government deficit financed through borrowing from the banking system is associated with higher nominal interest rates.
During the present government, the rupee weakened about 4.82 percent in 2011, and 1.53 percent in 2010. Despite devastating flood, which put the economy in bad shape, hitting both the agriculture and manufacturing sector, exchange rate remained unaffected and stable in first half of the year, but emergence of weakness in the external account exerted pressure on the rupee towards the latter half of the year. Recent devaluation of the rupee is the result of government foreign polices too, because the exchange rate comes under pressure due to existing tensions between the US and Pakistan.
Due to devaluation, the country's current account deficit stood at $2.104 billion in July-Nov compared with $589 million in the same period a year earlier.
The deficit is likely to widen further in the coming months because of debt repayments and a lack of external aid. Foreign exchange reserves reduced about $16.77 billion, compared with a record $18.31 billion as of July 30.
On the other hand, government has to start paying back instalments of $8 billion International Monetary Fund (IMF) loan from early 2012.
Without additional sources of revenue, its foreign exchange reserves may come again under pressure. The IMF has already forecast a challenging current financial year for Pakistan, with current account balance turning into deficit and security situation and global risk aversion restricting capital inflows into the country.
There were also concerns about growing tensions with the West in 2011, which could choke off much needed foreign aid. United States is the biggest donor to Pakistan, and has allocated some $20 billion in security and economic aid since 2001, much of it in the form of reimbursements for Pakistan's assistance in fighting militancy.
Government should take short-term steps to address vulnerabilities. Specifically, containing the budget deficit in 2011-12, a cautious monetary policy, and a responsive exchange rate would reduce vulnerabilities, contain inflation and protect Pakistan's dollars stock. Even Pakistan's persistent payments imbalances can be due only to faulty monetary policy and cannot be corrected by either devaluation or the use of fiscal policy.
If exchange rate changes/devaluation do not improve the trade balance then the various IMF stabilisation packages that include some exchange rate realignment cannot be justified.