For Pakistan: Devaluation an ineffective tool to address imbalances

Economy needs structural transformation that is a painful and enduring process

LAHORE: Media commentators, especially government officials, are of the view that economic stability has been achieved and the economy will start creating jobs in the days to come.

These statements are making headlines owing to weekly improvement in the foreign exchange position and monthly improvement in the current account balance.

The current account deficit of Pakistan turned out to be 5.5% of gross domestic product (GDP) in fiscal year 2018-19. Based on this figure, the International Monetary Fund (IMF) and independent economists reached a simple conclusion that the rupee was overvalued and there was a need to devalue the currency to achieve equilibrium.

Multilateral institutions, media commentators and even economists came up with a simple prescription of rupee devaluation to improve the complex balance of payments problem.

The balance of payments problem in Pakistan is structural in nature as the economy is unable to diversify exports owing to the faulty composition of exports, and hence terms of trade become unfavourable.

Additionally, the industrial structure is poor and not in line with the world pattern of wants and demands. Under these settings, the devaluation could not solve the persistent structural problem.

Although successive governments had to devalue the currency on various occasions due to the balance of payments crisis, yet the structural problem remained in place.

For instance, the rupee was devalued by around 30% in 2008 to achieve the balance of payments equilibrium. Similarly, the rupee has been devalued by around 47% in the past two years, yet the export growth remained negative in fiscal year 2018-19 and was close to negligible in the first five months of fiscal year 2019-20.

The currency devaluation is normally done to make imports expensive to lessen the balance of payments problem. In the context of Pakistan, the devaluation brings imported inflation, which takes inflation to a higher-than-desired level, making the workers demand higher wages because their consumption basket gets expensive.

Since the onset of devaluation, the country has witnessed a series of protests in major cities where people demanded an upward revision in their pay structures and salaries. As a result, the benefits of devaluation would translate into a higher general price level in the economy.

Again, the increase in the general price level would make exports expensive and the economy will attain the equilibrium at a lower GDP level. This implies that the economy is constrained by the balance of payments equilibrium and it can maintain GDP growth rate of around 4.5% without reducing the foreign exchange reserves. A recent study by the Asian Development Bank (ADB) has shown that Pakistan’s economy can achieve a stable GDP growth rate of 3.8% without incurring balance of payments crisis.

One can have a few reservations about this low number since the sample size of this study is 37 years. Despite the reservations, one can argue that the sustainable GDP growth rate is not achievable unless the balance of payments constraint is relaxed.

In the last financial year, the economy achieved the GDP level of 3.4% and achieved stability to some extent. In order to maintain stability, the current account deficit has to be scaled down and the GDP growth will dip further. This low GDP growth rate will be a bitter pill for the low-income strata of population to swallow.

Concisely, the lesson of history is that devaluation has been an ineffective tool to address the structural balance of payments disequilibrium in Pakistan. The economy needs a structural transformation that is a painful and enduring process.

This structural transformation requires an active role of the government along with the cooperation of private sector to achieve export diversification and sophistication. However, the dominance of global finance has made the task of structural transformation very challenging for the governments in developing economies.

The writer is the Assistant Professor of Economics at SDSB, Lahore University of Management Sciences (LUMS)

 

Published in The Express Tribune, December 23^rd, 2019.

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