The need to address systemic economic issues

It will ensure exchange rate stability on a sustainable basis

ISLAMABAD: The erosion of the value of the rupee at a breakneck pace has diverted attention from the bigger and systemic economic issues.

No doubt, exchange rate fluctuations do not augur well for the economy. At the same time, such fluctuations are an indication of the market’s trust or lack of it in the economy and point towards deeper macroeconomic issues.

Since December 2017, when the rupee was allowed to depreciate after nearly four years of managed exchange rate stability, the currency has gone down 43%. So what has happened over the last one and a half year that has driven down the rupee so sharply? To answer this question, let’s begin by looking at relevant economic indicators during the period when the exchange rate exhibited stability.

From July 2013 to June 2014 (FY14), the average rupee-dollar inter-bank exchange rate was 102.85. Month-wise, the average exchange rate varied between 97.49 and 107.54. From July 2014 to June 2015 (FY15), the average rupee-dollar parity improved to 101.29. Month-wise, the average parity varied between 98.65 and 102.74.

Thus, in FY15, not only did the rupee strengthen against the greenback, the exchange rate exhibited far greater stability than the previous year, as evident from a far smaller deviation of the upper and lower values from the mean.

Next year, FY16, the average exchange rate was recorded at 104.23. Month-wise, the average exchange rate varied between 101.71 and 105.37. In FY17, on average one dollar was exchanged for Rs104.69, with monthly average exchange rate varying between 104.53 and 104.77, which is a classic example of exchange rate stability.

Things began to change in FY18. The average exchange rate slid to 109.84. If seen in average terms, it was only a change of 5 percentage points over the previous year’s exchange rate of 104.69. However, the average monthly exchange rate varied from 105.30 to 118.90, representing a 13-percentage-point deviation from the mean value, which brings out considerable exchange rate fluctuations.

It is important to mention that in the first five months of FY18 (July-November), the average exchange rate was 105.35, while in the next seven months (December-June), the exchange rate on average was recorded at 113.05.

The rot started in December 2017, which corresponds with the time when Ishaq Dar stepped down as finance minister, when the dollar appreciated to 108.69. From then onwards, the rupee began to lose its value consistently. FY18 closed with average and month-end exchange rates of 118.90 and 121.28 respectively.

The first 10 months of FY19 (July-April) saw average exchange rate of 152.27, with variations of 145.23 and 158.53 (data source: SBP).

Thus, between FY14 and FY17 and the first five months of FY18, the exchange rate remained relatively stable between 101.29 and 105.39. The important question is how the exchange rate was kept stable. Like a commodity, the exchange rate between two or more currencies is determined by their relative supply and demand.

A country’s demand for and supply of a hard foreign currency, in our case the American dollar, is reflected by its external balance. If the demand (import of goods and services) for dollars exceeds its supply (export of goods and services), the dollar will appreciate and by implication the rupee will depreciate; otherwise the reverse will happen. Did Pakistan maintain a current account surplus during the stable exchange rate period?

The answer is in the negative. In FY14, trade and current account deficits were recorded at $19.82 billion and $3.46 billion respectively. In FY15, the trade deficit went up to $22.16 billion, while the current account imbalance came down by a whisker to $3.12 billion.

In FY16, the trade and current account deficits hiked to $23.9 billion and $5.45 billion respectively and further to $32.48 billion and $12.94 billion respectively in FY17. FY18 closed with all-time high trade and current account deficits of $37.6 billion and $19.89 billion respectively.

Thus, between FY13 and FY17, we had a peculiar situation in which the rupee remained stable despite the increasing current account deficit. The only way it could have been done was by pumping dollars into the market and, thus, pulling down the foreign exchange reserves - a policy which can’t be sustained in the long run.

But why did the economy run substantial trade and current account deficits? To answer this question we need to go back to the elementary economics.

Savings, investment

An economy’s current account balance equals the difference between total savings and total investment. If the savings exceed investment, the economy will draw up foreign savings to fill the gap and thus run current account deficit. If savings fall below investment, the economy will run current account surplus.

Coming back to Pakistan, in FY14, the savings-to-GDP ratio was 13.4%, which increased to 14.7% in FY15, but fell to 13.9% in FY16 and further to 12% in FY17 and 11.4% in FY18. At the same time, in FY14, the investment-to-GDP ratio was 14.6%, which increased to 15.7% in FY15 and remained the same in FY16. In FY17, it increased to 16.1% and further to 16.4% in FY18.

The data highlights two crucial features of Pakistan’s economy. The first is that the investment-to-GDP ratio is very low. In China, India and Bangladesh, the investment accounts for 44%, 31% and 30% of GDP respectively. Second, national savings are even less than the investment and the gap is met through borrowing, which represents foreign savings.

During the years of stable exchange rate, the savings fell and investment increased. Hence, the gap between savings and investment widened, which meant that the current account deficit went up by the same amount. It is the low savings and investment level that lies at the root of Pakistan’s external deficit.

An overvalued rupee didn’t cause this problem, nor can depreciation address it, as borne out by the current financial year’s export performance.

During FY19 (July-April), exports were recorded at $20.01 billion compared with $20.48 billion registered over the corresponding period of last year. Although imports have also declined by nearly $2 billion, this has largely to do with slowdown of the economy.

One of the major determinants of savings is the interest rate. Given a fixed income, the higher the interest rate, the greater is the propensity to save. In Pakistan, as in most other economies, the main source of savings is the household.

It was during the Pervez Musharraf era that the National Savings Schemes’ (NSS) rates were drastically reduced with a view to encouraging real estate and speculative investment as well as to promote consumer financing. The NSS rates remained low during FY14-18, which accounted for the low level of savings during this period.

Other factors that discourage savings include conspicuous consumption, increased availability of consumer financing, low real disposable incomes and low real interest rates offered by commercial banks, which thrive on a high interest rate spread.

Savings represent the difference between disposable income and consumption. Thus, consumption is a drag on savings. Trade deficit occurs when the economy consumes (imports) more than it produces (exports of goods and services). Thus, a massive trade deficit is undergirded primarily by a combination of relatively high consumption and low productive capacity.

In case of Pakistan, productivity constraints are brought by a narrow manufacturing base, reliance on primary and low-value processed products and manufactures to generate export revenue, lack of skilled labour and low marginal productivity of labour due to shortage of capital. It is such systemic problems that should be addressed to bring down the external deficit and, thus, ensure exchange rate stability on a sustained basis.

The writer is an Islamabad-based columnist

Published in The Express Tribune, June 3^rd, 2019.

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