The Falling Rupee is Working
By Nayyer Ali MD
Earlier this summer Pakistan signed off on an IMF package in order to get 6 billion dollars in IMF funding needed to cover a balance of payments crisis. Pakistan was literally out of dollars and had massive loans due, the only choice was the IMF or a catastrophic default.
Why did things come to such a mess? The primary cause was due to the fact that Pakistanis were buying much more from the outside world (imports) than they were selling (exports). In the 2000’s under Musharraf exports doubled from 10 to 20 billion dollars a year, then rose slowly to about 24 billion dollars by 2013. But over the next five years, exports were stagnant, even though India and Bangladesh were experiencing significant export growth. Normally to buy imports, Pakistan needs the dollars it gets from selling exports, and the trade balance should be about even. But Pakistan had two other sources of dollars that allowed its imports to balloon while exports failed to grow.
The first source was foreign direct investment, including inflows from the China Pakistan Economic Corridor or CPEC. The FDI flow amounted to a few billion dollars a year. The other source of dollars was remittances from Pakistanis working overseas in the Gulf, Europe, and the US. The remittance flows exploded in the last 10 years and have reached over 20 billion dollars per year. These two sources allowed Pakistan to import far more than it exported for the last several years. Imports went to almost 60 billion dollars per year, while exports stayed under 25 billion, and the trade deficit peaked at 37 billion dollars in 2017-2018. What made this situation so incredibly bad was the economic policies of Nawaz Sharif and his Finance Minister Ishaq Dar. They kept the exchange rate of the Pakistani Rupee fixed at 105 to the US dollar. This was a terrible mistake and flew in the face of basic economics. As inflation had badly eroded the value of the rupee this decade, its exchange rate had become hopelessly overvalued, meaning that the true economic value of the rupee should have been much lower. But Nawaz Sharif was not going to lower the value of the rupee in 2018 while facing an election he ended up losing anyway.
When a currency is overvalued, it makes imports much cheaper than they should be, while it makes exports that much more expensive. The rupee was 60% overvalued, meaning Pakistanis could buy foreign goods for 105 rupees which really should have cost them 165 rupees, while foreigners looking to buy Pakistan products had to pay 160 dollars to buy products that should have cost 95 dollars. In such a scenario, of course, Pakistan would have massive imports and little exports.
To fix this, the most important action was to devalue the rupee and let it slide to a fair market exchange rate. This happened over the last year, with the PKR now down to about 160 to the USD. Initially a devaluation does very little. It takes several months for buyers to respond to lower export prices and for domestic consumers to cut back sharply on imports and look for substitutes produced internally. In the first few months of devaluation, the press reported that it was not working. Another factor is that even though more exports get sold, because of the lower exchange rate, in dollar terms exports don’t start to rise until there is a huge surge in sales.
We are finally starting to see this policy bear fruit. In July 2019, the monthly trade deficit has tumbled to 2 billion, and will likely continue to fall. Imports fell to 4 billion dollars while exports in dollar terms are up 10% to over 2 billion dollars. With worker remittances up to 22 billion dollars for the year, Pakistan is now able to fully cover its import needs. The overall trade deficit for this fiscal year should come down to under 24 billion dollars.
Going forward, Pakistan needs to prioritize exports. If Pakistan can squeeze imports further and cut the trade deficit to 10 billion dollars, it can then run a total surplus in dollars with the 23 billion in remittances and 2 billion in FDI. Pakistan could actually accumulate foreign exchange reserves of 15 billion dollars every year and more if it keeps its trade deficit small. The key to this is to avoid the mistake of Ishaq Dar. Do not allow the rupee to become overvalued again. When two countries have different rates of inflation, the exchange rate needs to move in the opposite direction to keep fair value. As long as inflation runs higher in Pakistan than in the US, the exchange rate needs to adjust downward every year to keep balance.
Even better than keeping the exchange rate at fair value, for a developing country that wants to have export led growth similar to what the East Asian Tigers did in the 1970’s and 1980’s, and China did in the previous 30 years, keep the exchange rate undervalued. That makes imports even more expensive, without having to police a regime of import duties that lead to smuggling and a black market, and allows your exporters to sell to the world at a discount, which boosts their sales and production. One of the key pieces of the IMF deal is that the exchange rate is no longer under control of the government Finance Ministry but rather under the control of the State Bank of Pakistan, which is independent, and whose head is now a Pakistani who was a former IMF official. If he manages the exchange rate correctly, then Pakistan should have rapid export growth over the next few years, a shrinking trade deficit, and rapidly rising forex reserves.
