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Sandwiched Perpetually Between An Overvalued Rupee And A Balance of Payments Crisis, Pakistan Has To Take A Fiscal Decision Long Overdue

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Muhammad Ziauddin explains Pakistan’s 70-year-old dilemma of choosing between an overvalued rupee and a free floating exchange rate that stemmed from the Korean War beginning in 1950 and a brief period of strong exports with overvalued rupee that followed. He believes a loosely managed float might help redeem Pakistan’s economy.

Pakistan has remained all along an importing country. Overwhelmingly so. It would not be wrong to describe our economy being an import-led one. There is not much that we do not import—from machinery to raw materials, intermediaries, oil, finished consumer goods, even food items and cotton despite being essentially an agricultural country whose cotton production is ranked the fifth largest in the world.

Since we do not possess or earn enough hard currency to fund these imports we have suffered from massive trade deficits year after year, covering them with loans leading to an ever mounting foreign debt forcing the country to borrow as well to pay back loans obtained to fund imports.

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On the face of it, we seem to have been consigned to an ever expanding trade as well as current account deficits leading to a perpetually deteriorating balance of payments position as neither our exports nor our foreign remittances seem to be growing at a pace that would help our external earnings overtake in foreseeable future both the galloping import bill and the ever mounting debt, what to talk of meeting just the import bill.

Overvalued exchange rate

The one major element that had turned Pakistan very early in the day into an overwhelmingly import-led economy has been and still is its overvalued exchange rate. It has remained so all along these 71 years except for 1973 when it was depreciated by 133 percent in one go and 1955 when it was depreciated by a little over 33 percent. We are using, without any break an over-valued rupee in our foreign trade transactions since 1980s when General Zia’s super-duper finance minister Ghulam Ishaq Khan took over the reins of country’s economy in his bureaucratic hands that had never touched an economic text book.

Ghulam Ishaq Khan with General Zia

Ghulam Ishaq Khan with General Zia

The first crisis

When the Pakistani policy makers faced the serious crisis in September 1949 in the shape of devaluation by pound sterling along with a host of currencies including the Indian rupee by almost a third, our official economic managers decided not to follow suit because of the fear that devaluation would rise the import bill without an offsetting increase in export earnings. India responded to this decision of ours by suspending trade, thereby damaging the Pakistani economy.

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The Indians felt that Pakistan’s dependence on the Indian economy was too strong and that severing of economic ties would motivate Pakistan to change its decision. But the Korean war of 1950 came to Pakistan’s rescue. There was a huge upsurge in demand for Pakistani export commodities, especially jute and export receipts doubled by 1951. The balance of payments position became very strong in just one year, and the foreign exchange reserves substantially increased.

Since then an overvalued Pakistan rupee has come to be associated in our national psyche with national pride as by maintaining an overvalued rupee we had defeated the move of our enemy number one, India to undermine our economy.

However, within a year the situation changed dramatically. The start of negotiations to resolve the Korean war led to plummeting of the price of jute and cotton, and Pakistan’s balance of payments position was severely affected. Exports fell as imports shot up in 1952 leading Pakistan to a substantial deficit for the first time since 1947. The government did not respond to the crisis by adjusting the exchange rate, which had become clearly overvalued but adopted stringent system of import controls.

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Too little, too late

It was only in 1955 that Pakistan undertook devaluation of the rupee by 33.5 per cent. Unfortunately, the devaluation did not prove strong enough to boost exports. Actually the devaluation was a delayed reaction to the earlier devaluation by the trading partners in 1949, but the circumstances of mid-1950s involved a rapid rise in costs and prices therefore the 1955 devaluation was considered too little too late.

It seems since it’s very inception Pakistan has been suffering from the misperception that a strong currency represents a strong economy, and is a symbol of national pride. That perhaps is the reason why we have tended to maintain an overvalued rupee all through the last 71 years except in 1955 and 1973.

Debt trap

According to Asad Zaman, Vice Chancellor Director General Pakistan Institute of Development Economics (Fear of floating – published in Dawn on March 27, 2019), currency crises result when central banks ‘manage’ the exchange rate at the wrong level. This results in a constant need to pump dollars into the market to cater to the excess demand for FX created by overvaluation. Eventually, reserves are depleted, and new loans are necessary, leading the country into a debt trap.” That is exactly the kind of crises we are facing today.

The International Monetary Fund whom we have approached for a bail-out, therefore, wants us to let the rupee float freely so as to help Pakistan extricate itself from the debt trap.

Free float

In a floating exchange rate regime, the central bank allows the supply and demand for dollars and rupees to determine the exchange rate. This way the domestic economy has to learn to operate in a new type of economic environment, where imports are more expensive and riskier to obtain. The FX risk inhibits foreign competition which allows infant industries greater room to grow.

“These methods were invented and used by East Asian economies to create the miracle of growth which transformed them from agricultural to industrial economies. Also extremely effective was the tactic of systematic undervaluation of currency, which allows the central bank to accumulate foreign exchange reserves, instead of losing them. This creates the surplus required to support domestic industries, to allow them to grow into export tigers. Today, instead of using failed models like the Washington Consensus based on free-market ideologies, we need to learn new strategies from the rising sun in the East.” —From Azad Zaman’s ‘Fear of floating’

Fixed versus floating

Over the years, economists and politicians have often changed their minds about whether it is a good idea to try to hold a country’s exchange rate steady, rather than let it be decided by market forces. For two decades after the World War II, many of the major currencies were fixed under the Bretton Woods Agreement.

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During the following two decades, the number of currencies allowed to float increased, although in the late 1990s a number of European currencies were permanently fixed under Economic and Monetary Union and some other countries established currency boards.

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When capital can flow easily around the world, countries cannot fix their exchange rate and at the same time maintain an independent monetary policy. They must choose between the confidence and stability provided by a fixed exchange rate and the control over interest rate policy offered by a floating exchange rate.

Summary of the arguments for floating and fixed exchange rate systems. (Source: Tutor2u)

On the face of it, in a world of capital mobility a more flexible exchange rate seems the best bet. A floating currency will force firms and investors to hedge against fluctuations. It should make foreign banks more circumspect about lending. At the same time, it gives the policy makers the option of devising their own monetary policy.

But floating exchange rates have a big drawback: when moving from one equilibrium to another, currencies can overshoot and become highly unstable, especially if large amounts of capital flow in or out of a country, perhaps because of speculation by investors. This instability has real economic cost. To get the best of both the worlds, many emerging economies have tried a hybrid approach, loosely tying their exchange rate either to a single foreign currency, such as the dollar, or a basket of currencies.

But the currency crisis of the late 1990s, and the failure of Argentina’s currency board, led many economists to conclude that if not a currency union such as the euro, the best policy may be to have free-floating exchange rate (Economics—An A-Z Guide by Mathew Bishop, pages 111-112).

The good and bad of free float

Advantages of free float as per other sources: floating exchange rates don’t require an international manager like IMF to look over current account imbalances. Under this system, if a country has large current account deficits, its currency depreciates; central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect parity, but such is not the case under the floating regime.

Here there’s no parity to uphold; in a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency; under a fixed exchange rate regime, countries export their macroeconomic problems to other countries.

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Suppose that the inflation rate in the US is rising relative to that of the Euro-zone. Under a fixed exchange rate regime, this scenario leads to an increased US demand for European goods which then increases the Euro-zone’s price level. Under a floating exchange rate system countries are more insulated from other countries’ macroeconomic problems.

Disadvantages: floating exchange rates are highly volatile. Macroeconomic fundamentals can’t explain especially short-run volatility in floating exchange rates; higher volatility in exchange rates increases the exchange rate risk that financial markets face. Therefore, they allocate substantial resources to predict the changes in the exchange rate, in bid to manage their exposure to exchange rate risk; floating exchange rates may aggravate existing problems in the economy.

If the country is already experiencing economic problems such as higher inflation or unemployment, floating exchange rates may make the situation worse. If the country suffers from higher inflation, depreciation of its currency may drive the inflation rate higher because of increased demand for its goods; however, the country’s current account may also worsen because of more expensive imports.

The best way out of our current currency crisis, it seems, is to adopt a managed float but keeping the rupee slightly undervalued.


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