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Tuesday, January 12, 2010 Add to Clippings Print Story

Depreciating exchange rate

Dr Ashfaque H Khan

A country's current-account deficit may deteriorate for a variety of reasons, including an

expansionary fiscal policy, deterioration in the terms of trade and higher debt servicing. A
deficit in current account can only be sustained if there is a matching inflow of capital to
finance it. In the event of a 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 programme to facilitate adjustment.

Exchange-rate depreciation has been associated with deceleration in economic growth,

increase in unemployment and poverty, undermining of public-sector investment and
development strategies, increasing cost of living, worsening income distribution and shifting of
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 and 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 (the J-curve effect) which is hard to specify.

With the contraction in world trade as a result of the 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 recession-hit industrialised 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 less 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 witnessed a stable exchange rate for almost eight years in the last decade. The rupee-
dollar parity hovered around Rs60 and 62. Exports more than doubled during the period, rising
from $8.5 billion in 1999-00 to $19 billion in 2007-08, or over 122 per cent. The exchange rate
nosedived in early April 2008, and since then the Pakistani rupee has lost one-third of its value
vis-à-vis the dollar. When the present government took charge on March 31, 2008, the
exchange rate was Rs62.5 per dollar and today it has plunged to Rs85 per dollar – a loss of
Rs22.5 per dollar in less than two years. The IMF has also asked Pakistan to pursue a "flexible"
exchange-rate policy under its programme. Pakistan is religiously following the dictate of the
IMF and as such allowed the rupee to lose ground with a view to improving external payments
position.

Has Pakistan achieved these objectives? Have exports increased and imports reduced? Has the
external payment situation improved as a result of devaluation? Exports during 2008-09
declined to $17.8 billion from $19.0 billion the previous year – 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 3.0 per cent. 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.

In my article on Dec 30, I had said that over 90 per cent improvement in external payments
position during the period came from the collapse of commodity and oil prices, as well as a
surge in remittances for unexplained reasons. Devaluation has certainly not helped in
increasing exports or improving the current account balance.

On the other hand, devaluation has done irreparable damage to the economy. The exchange-
rate depreciation has alone added Rs1,125 billion in public debt. In today's exchange rate it
amounts to $13 billion. The rise in the public debt would increase interest payment, reduce
fiscal space for development spending and put enormous pressure on the budget. A 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 per cent, it remained at a double-digit level for quite sometime in Pakistan –
thanks to the depreciation of the exchange rate. Consequently, the State Bank of Pakistan had
to maintain a tight monetary policy with adverse effects on investment and growth.
Depreciation of the currency is likely to play havoc with 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 will the price of sugar in international market be at its ever
highest in 29 years but its landed cost at Karachi would also surge on account of a depreciation
of the rupee.

Similarly, the depreciation of the currency will keep POL prices at higher level; a higher furnace-
oil price will make electricity costly The SBP is requested to conduct the cost-benefit analysis of
the pursuit of a "flexible" exchange-rate policy. For the IMF, the textbook approach may not
work all the time. Given the current 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 a 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 the 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

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