Dar’s Exchange Rate Equilibrium

Article was published in "Money Matters" on March 24, 2014

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March has made history in the literature of exchange rates in Pakistan. I am calling it a historic event since no one expected this to happen with meager foreign exchange reserves, low foreign direct investment, negative trade as well as current account balance and lower GDP growth. While analyzing the data researchers will consider it an outlier.

Writers are trying to explain the behaviour of the exchange rate in numerous ways. Every explanation mentions the $1.5 billion grant or ‘gift’ from two friendly countries. The Coalition Support Fund payments, privatisation, IMF loans and MoUs signed are other major factors which, according to different authors, are the main contributors to the exchange rate appreciation. I tried to relate the appreciation of rupee by seven percent within less than seven working days with the above mentioned fundamentals but failed to relate any variable or combination of these factors, which could explain the meteoric appreciation of the rupee. On the other hand, we also know that our trade balance is negative and the current account has reached $2 billion in eight months, putting pressure on the exchange rate.

In my last article I tried to explain how different variables can affect the exchange rate and what would be the impact of forced exchange rate appreciation. If it is a temporary appreciation, exporters will bear a potential loss for a short period and importers will enjoy paying lower prices for a short period. Further, it is also expected that a temporary appreciation in the exchange rate will eventually result in massive depreciation in the coming weeks. It was also expected that moneychangers (dealers of foreign currency in the open market), assisted by the government creating chaos in the market, will eventually benefit moneychangers when the currency depreciates in the next few weeks. Nevertheless, this does not seem to be the case.

Before I explain further let’s look at the graph below and try to analyse it. It is taken from the central bank’s website which provides “Exchange Rates for Mark to Market Revaluation by Authorized Dealers in Foreign Exchange”. The value of the exchange rate is below Rs98/$ on March 20 2014 and according to the forecast it is slightly increasing above Rs100/$ in the next six months. What does it tell us?

It tells us to take the finance minister seriously. When he said that he would bring down the exchange rate to Rs98/$, no one bought it including me and several other writers/researchers /authors. Moreover, they argued, the exchange rate is artificially controlled by intervention in the market and thus it would not depreciate in a few weeks to Rs.106/$ or Rs.109/$.

Million-dollar question:  How did the value of the exchange rate come down so swiftly in less than seven working days? The answer to me is very simple. They just pulled it down. How?

Finance Minister Ishaq Dar believed and repeatedly said that our exchange rate is depreciating due to speculations and it is not a true equilibrium value of exchange rate. He supposed that Rs.98/$ is the true equilibrium value of the exchange rate. But one may ask that if he wanted to set it at his desired level then he may have announced it. Why did it take 7 days to come to Rs.98/$. The answer is simple once again. It looks more professional this way.

However, one needs to take two agents into confidence before doing this kind of exercise, i.e., SBP and authorised big moneychangers. Were they informed? Did they get the guidelines from the finance on how to pull the exchange rate down? Did the government bailout big moneychangers to overcome their loss?

The bottom line of the story is that Rs98/$ is the new equilibrium exchange rate. Irrespective of whether it is an overvalued exchange rate and exporters will face losses, every exporter will need to set their prices considering the new exchange rate. The exchange rate will probably move around the par value of Rs.98/$ and depreciate little in the next few weeks. SBP will control it by using by direct forex interventions. We can call the current drop the regime shift in the history of exchange rates in Pakistan.

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DAR’s Exchange Rate Policy

Article was published in the "Money Matters" March 17, 2014.        tweets @malikemal

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While teaching an international finance course to my students at the PIDE, several questions surfaced regarding the gap between the theory we teach and the current scenario of exchange rate of the rupee that has appreciated against the greenback from Rs108.64 on December 3, 2013 to Rs97.88 on 12 March 2014. On the one hand, prominent economists have rubbished the recent appreciation and termed it an overvalued exchange rate, while on the other hand our finance minister, who is currently obsessed with reducing the exchange rate, believes the rupee’s appreciation indicates the revival of public and investor confidence in the economy and the local currency.

Two basic theories which explain movements in the exchange rate in the short to medium run are uncovered interest parity (UIP) and purchasing power parity (PPP). Uncovered interest parity says that movements in the exchange rates are due to the difference between interest rates offered in the home and foreign country. Exchange rate adjusts according to the interest rate differential during the maturity period of bonds.

The purchasing power parity theory says that the exchange rate is the ratio of domestic price and foreign prices. If prices in the home country are more than foreign country then the exchange rate depreciates and vice versa if foreign prices are more than domestic prices. Thus, it clearly states that changes in exchange rate between the two countries is directly proportional to the inflation differential between the two countries.

Daily fluctuations in the exchange rate depends on various factors which are mostly related to the “news”. Some people call it speculation but not every news story is speculative, sometimes it is based “anxiety” and “expectations”. I am using the word “anxiety” because, in general, forex investors have a myopic view and they do not want to take any kind of risk. We can call them over obsessed risk averters.

These news stories or reports are nonetheless related to the availability of forex reserves in the market. For instance, expectations of excess supply appreciate the exchange rate and expectations of excess demand depreciate the exchange rate. These expectations are sometimes correct and sometimes create havoc in the market. The current appreciation in the exchange rate from Rs. 104/$ to Rs. 98/$ is a special case of speculation which is explained by several authors during the last few days but every argument relates it with higher remittances, lower trade balance, better reserves management but it is beyond that. The latest report in the market is that Pakistan received $1.5 billion from the two friendly countries for a special purpose. The news may be true but I don’t buy the argument that $1.5 billion has resulted in the appreciation of rupee by 7.2 percent in 12 days.

Oil imports bill account for one-third of the total imports bill. The government is now using FE-25 facility to finance imports for a 40-day period. This ensures lesser depletion in forex reserves held by the SBP temporarily. More importantly, it gives imports a cover and puts less pressure on the exchange rate due to large inflow of forex reserves held by the SBP. It helps the government manage forex reserves more efficiently.

Although the above stated arguments are important in the exchange rate management but I failed to associate the current appreciation during the last ten days with the actual happenings discussed by the authors in various newspapers. The only logical thing which can be associated with it is political gimmick. But how?

It is surprising to see government officials over joyous about the current appreciation. It is no surprise either that the government has taken credit for the rupee’s rise or conveniently termed it an achievement of the government. Several repercussions are expected due to the appreciation in the nominal exchange rate. On the positive side, the inflation rate will decline due to a decline in the import bill in rupees. Subsequently, the government may also reduce the price of oil – a move that will help industrialists purchase cheaper raw material, intermediate goods and capital for their production. Moreover, imported consumer items will be available at lower cost. But here we are forgetting that prices are sticky downwards. Other than oil prices, which are controlled by the government, prices of other commodities may not decline. Nevertheless, they are not going to increase as well.

Theories of exchange rate determination discussed earlier clearly state that in the presence of inflation differential, which is positive for Pakistan, the exchange rate needs to depreciate. Nonetheless, prices do not affect the exchange rate instantly but with a lag of six months to three years in some cases due to several factors – central bank intervention being the most important among them. Similar behavior was observed in the last decade when the exchange rate was artificially controlled. Some authors call it a stable exchange rate but they ignore that the real effective exchange rate is overvalued, which really matters in terms of policy formulation and competitiveness.

And while the IMF has approved our EFF loan, several prominent economists, including ones in the IMF have been arguing that our exchange rate is overvalued and needs to depreciate thus we should not intervene in the market and try to “stabilise it”. Stabilising the nominal exchange rate implies that we are changing the value of the real exchange rate from its equilibrium.

The current appreciation will increase the import bill (in dollars) because imports are now cheaper and exports will decline (in dollars) because exports are now expensive. Selling one dollar worth of exports in the international market was giving Rs105 at the start of this month but now they will get Rs98 for the same thing. Thus our exporters are bearing potential loss of Rs7. Is it good for the economy? Not at all.  Moreover, if the trade balance gap widens then it will directly affect the current account balance.

Further, one must ask whether the Pakistani currency is appreciating only against dollar or it is appreciating against other currencies as well. The answer is yes, it has appreciated against the Euro by 5.3 percent from March 3, 2014 to March 12, 2014. Similarly, it has appreciated 7 percent against the Chinese Yuan and 8 percent against UK Sterling in the same period.

While communicating with several economists and students of economics, I realised that everyone is expecting the rupee’s revaluation to be short-term, most expecting it to go back to Rs106 or Rs109 against the dollar. Nevertheless, no one knows the time frame, which is the most important thing. Since Finance Minister, Ishaq Dar is expecting $16 billion forex reserves by the end of this year, the government gets a cover by financing imports through banks, Further, the finance minister has asked the US to reimburse Pakistan for the remaining CSF payments, ensuring better forex reserves management while controlling the current account balance. The exchange rate may not depreciate much by the end of the year but this does not imply that our competitiveness is improving or our economy is thriving.

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A Question of Real Growth

The article Was Published in the Magazine "South Asia"

Since a military government is not bound by political exigencies, it can easily formulate and implement policies which may not seem people-friendly – at least in the short term.

In today’s world, military rule is considered the worst form of government as opposed to democratic regimes. It is, however, generally argued that growth is not directly linked to the regime polity. Instead, the economic success of a country lies in higher investments and coherent economic policies. Nevertheless, Pakistan has witnessed a higher growth rate of GDP under military rule as compared to democratic governments. 

Since its inception, Pakistan has experienced several episodes of martial laws as well as democratically elected governments. The 66 years of the country’s existence can be divided into seven regimes; Regime 1 (1947-1958) in which the country achieved 3.1 percent growth per year. During these first 11 years, the sole emphasis of the government was on setting up a base for a sustained growth process. The GDP growth during the second phase (1958-71), in which the country was governed by a military ruler, was 6.8 percent. Regime 3 (1971-1977) was the first pure democratic spell and had a 3.9 percent growth rate. 

General Zia’s martial law, or Regime 4, had a 6.6 percent GDP growth rate, while a slower growth of 4.5 percent was observed during the second democratic regime – from 1988 to 1999. This democratic era that spanned over almost eleven years can be further divided into four short intermittent governments of the late Benazir Bhutto and Mian Nawaz Sharif, both of whom served in office for two incomplete terms. 

On average, the growth rate was 5 percent during Regime 6 (1999-2008). It was the government of General Pervez Musharraf. Although the democratic government of the PML-Q was in power during 2002-2007, it is largely believed that the real power was exercised by General Musharraf. 

Regime 7 was the democratic dispensation from 2008 to 2013 in which the country experienced a very low growth rate on average at 2.9 percent per annum. 
On the surface, it is clear that in Pakistan the growth rate during military regimes was much higher than in democratic regimes. Apart from the GDP rate, several other indicators also improved during military rules. For example, the overall public debt reduced considerably while the position of the foreign exchange reserves improved remarkably during the Musharraf regime. The standard of living increased during all three military rules. It was also observed that since industrial growth was higher during these periods, income disparity widened, which is an integral part of the development process. 

Various factors were responsible for a better GDP growth during military rules. The first was the overwhelmingly high foreign aid. The Ayub Khan government received huge sums in foreign aid. It also received the technology that helped bring about a green revolution in the country. General Zia’s government received foreign aid due to the Afghan war. During his rule in the 1970s, industrial productivity increased manifold due to investments in high-tech industries. 

Similarly, the government under General Musharraf received aid due to the country’s participation in the war against terror. Known as the Coalition Support Fund (CSF), this aid was given without any conditions attached. 

Contrary to this, democratic regimes faced several difficulties: sanctions, repayment of debt and debt-servicing of loans taken out during military regimes. The need to borrow short-term loans from the IMF - on strict conditions – also arose during the rules of democratically elected governments, which negatively affected the overall economy. 

The nature of foreign aid received by military rulers is different from the aid received under IMF programs. For instance, project-specific aid has a multiplier effect on the overall economy. If invested in a project, such aid generates employment opportunities. Moreover, due to the aid-externality effect, public, private and multinational investors are encouraged to invest in the country. 

Sustained economic growth is possible if policies are consistent, investors have confidence in the government and the rule of law is established for long intervals. This is possible if either the same government continues in power for a long period or a change in government does not result in a change of policies of the previous government. It is also observed that economic managers of military governments give special incentives to investors. Although this increases the rent-seeking behavior, yet it leads to higher growth since the investors make long-term investments. Indonesia, Malaysia, Taiwan, Singapore and South Korea are some other countries that prospered under military rule. Unlike a democratic government which functions amid the constant fear of a military takeover and faces criticism of the opposition as well as the public, military governments are hardly answerable to any authority and mainly work without consensus. In short, such governments do not have to face the political and legal hurdles which a democratic government can face in the implementation of its policies. Since a military government is not bound by political exigencies and can afford to look beyond self-serving goals such as getting elected in the next elections, it can easily formulate and implement policies which may not be people-friendly in the short run. Another advantage enjoyed by military governments is that they are less prone to political instability as compared to democratic regimes. Dr Eatzaz, Acting Vice Chancellor of the Quaid-e-Azam University, terms the 1990s as an era “marked by musical chairs of democratic governments” of Benazir Bhutto and Nawaz Sharif. The collapse of one elected regime after another resulted in significantly low economic growth. Ironically, there was political stability during all three military rules and hence the country registered higher growth. It can be said that growth is not linked to the system of governance but instead to the policies adopted by a government. In military regimes there is less confrontation and more freedom to opt for different policies and implement them. This gives positive signals to investors as they hope that their objectives will be achieved without much difficulty. It is thus easier for them to take crucial investment-related decisions. However, the role of foreign aid cannot be ignored as it has vital importance, especially in the context of economic growth of Pakistan.

How big is GSP Plus?

The article was Published in Money Matter, February 10, 2014
   

Energy projects, luring foreign investors to the country, implementing Vision 2025, kicking off the privatisation process and securing GSP Plus status are among the important endeavours of the current governemnt since they took charge in June 2013.

Although securing GSP Plus status is an important achievement for the current government, the benefits of the trade agreement with the EU are exaggerated.

What is GSP Plus? It is a special incentive scheme which provides a complete waiver on the exports of specific products. GSP Plus provides special treatment to developing countries and least developed countries to export their products at a lower tariff rate compared to MFN tariff rates. However, the agreement comes with conditions which have to be fulfilled by the country that is awarded GSP Plus status. These conditions relate to the standard of living and working conditions, implementing the international convention of human and labour rights, good governance and environment.

GSP Plus status, which came into force on January 1 this year, gives Pakistan free trade access on zero duty to the European market for the next ten years. It sounds quite grand but only 75 products are allowed on duty-free access to the European markets with a condition that it must not exceed 6% of the EU’s total imports.

The limited number of products has reduced the scope of potential benefits Pakistan can earn from the agreement but it is still expected that Pakistani exports will increase by $1 billion to     $2 billion. The numbers are not too big but the status will have a possible externality effect through employment generation in upstream industries as well as services sectors. Minister for Commerce and Trade Khurram Dastagir Khan ambitiously assumes that 100,000 people will get employment in different sectors due to the GSP Plus agreement. Nonetheless half of that number would also be satisfactory.

However, there is no free lunch. The EU has placed 27 compliance restrictions on Pakistan which relate to child labour, standard of living of employees, environment and governance. Consequently, the European Union (EU) will closely watch Pakistan’s human and labour rights laws, governance and environment protection laws. Any violation could lead to temporary or even permanent suspension of the agreement. Moreover, ensuring the enforcement of the above mentioned laws would increase the cost of production as well.

And while securing GSP Plus status is being touted as a major achievement of the current government despite it being an initiative of the previous government, there are certain hurdles which still need to be overcome to get the required benefits of the agreement.

The first hurdle is the availability of energy, which is the essential component in the production process, as power outages have led to lower growth in almost all sectors of the economy. An understanding needs to be developed between firms and the government to provide uninterrupted supply whenever necessary, especially to firms involved in exporting commodities to European countries.

The second problem deals with the lack of available exports surpluses. The problem can be addressed through horizontal networks. However, due to lack of clusters and networking among the firms, the overall benefits may not be exploited. Another issue is implementing the 27 constraints which are imposed on Pakistan. Who will ensure that the entire conditions are being met?

Another interesting restriction of GSP Plus is that the share of exports of any product cannot exceed six percent of total EU imports of that product. Who will regulate this process if we are giving free hand to the firms to export? Who will calculate whether we are exporting each product within our limit? Since a violation of these conditions would lead to either temporary or permanent suspension of GSP Plus, the government will have to devise a foolproof mechanism to monitor these dealings.

No doubt our current account balance would improve through additional exports under the GSP Plus incentive scheme. Moreover, we need to borrow $1 billion less if our exports increase by $1 billion. Nevertheless, the expectations to increase exports by more than $2 billion under GSP Plus status are ambitious because (i) few products of leather garments, textiles and carpets are allowed (ii) value added products are not among the major exportable items and (iii) GSP Plus is limited to one segment of the industry.

The role of lobbyists is crucial in the approval of GSP Plus. Therefore it would be great if lobbyists keep negotiating with European countries to allow exports of more products at zero duty as well as if the quota restrictions could be increased from the current 6 percent. Although the latter suggestion is only be beneficial if we have energy to produce as well as exports surpluses to export.

More importantly, in the era of globalisation, we need to reduce our transaction costs and compete in the world market. GSP Plus alone is not the solution. We also need to think long-term and devise an alternate strategy if GSP Plus is not renewed after ten years or suspended due to a violation of conditions. Value addition is the key to increase the value of exports. Branding is also another way to increase value of exports

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