Need to study medium-term effects of rupee devaluation

It provides oxygen to the ailing patient, but it cannot cure the disease

LAHORE: The economy experienced a second round of devaluation in a short span of three months.

The media commentators and notable analysts rejoiced over this step since they kept on stressing that rupee is overvalued. The bout of devaluation is being associated with the report released by the International Monetary Fund (IMF). These commentators even provided an evidence that the stock market reacted to this positively and an upward movement in the KSE-100 Index can be observed.

Since July 2017, there has been a lot of discussion in the media regarding devaluation. The current account deficit has ballooned to 4.8% of GDP in the first eight months of FY 2017-18, which has been and is being sighted as the main reason of devaluation since imports are outstripping exports and high trade deficit is contributing to the current account deficit. Now we may turn to its effects.



The usual argument is that exporters would benefit and they would be able to increase exports since exports become cheap in the international market. This argument requires qualification. First, there is a lot of consumption of intermediate goods in our exports which means that our exports are even import dependent. Second, the effect of devaluation on exports comes with a lag since export orders are booked in advance and exporters factor this effect after some time. Third, imports would become expensive and they start to nullify the effect on exports.

The financial analysts look at the effects of devaluation on the bottom line of companies. For instance, devaluation would enhance the dollar denominated returns of sectors like oil and gas exploration and independent power producers, though textiles would be the major beneficiary.

Another cited impact is that devaluation will stoke inflation which is a general comment. There is hardly any talk what would be the level of inflation going forward. The first round of devaluation couldn’t bring inflation in our economy and now the expectation is that second round will bring it quickly.

As far as the case of inflation is concerned, it all depends on international crude oil prices. The current prices are around $66 per barrel. If oil prices cross $80 per barrel then inflation may be in the double digits. Otherwise, inflation will remain benign.

The commentators further link inflation with the hike in interest rate and state that the State Bank of Pakistan (SBP) may increase the rate in the next monetary policy announcement. If inflation remains benign, then SBP should avoid raising the interest rate since it would negatively affect the real economy, which has started to show signs of broad based recovery.

Another sensation is created that devaluation will increase the external debt and liabilities of the economy. There is hardly any doubt about this effect. In order to mellow down the effect, the governments have to avoid taking external debts which they think a necessity when they contract out for them in the past.



In a nutshell, the effects of devaluation are quite far reaching in our economy. Most of the arguments discuss the effects of devaluation in the short term and there is hardly any analysis which talks about what will happen to the real economy in the medium term. The lesson of history is that devaluation provides oxygen to the ailing patient, but it couldn’t cure the disease. The disease in our case is structural in nature since the above mentioned short run effects ignore the structural characteristics of the economy. Did the devaluation of 2008 solve our structural problems? The answer is no. The result of this devaluation would not be much different from the earlier ones.

The writer is an Assistant Professor of Economics at SDSB, Lahore University of Management Sciences

 

 

Published in The Express Tribune, March 26^th, 2018.

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