The trade deficit elephant is in the room. The room is getting a tad tight, with the burly presence of the energy elephant, plus several baby elephants. More and more guns are getting trained at the hapless mahout, the Accountant, for not providing the needed fodder. With the election season already here, our money is on the leader of the clan worrying more about these elephants than JIT or IK, or even the twitter MOAB from the twin city.
We have always had a trade deficit. So what is new? It is the emerging pattern that makes it different. The dollar inflows -Exports, Remittances and ODA (official development assistance, bilateral and multilateral) -are spiraling downwards, and FDI is almost flat. Barring the miracle of many Pakistanis feeling sufficiently scared (or 'incentivised') to bring their overseas wealth home, more borrowing appears to be the only show in town.
In today's rising (dollar) interest rate scenario accumulating further foreign debt is risky. Our existing debt level is already on the cusp of unsustainability. More foreign borrowing is almost certain to perpetuate the vicious cycle where we will have to borrow more to pay existing debt.
We can have only a limited influence on Remittances, ODA, and FDI. The dynamics of international trade also limit our ability to make exports more responsive to whatever impulses we can muster, but there is some space here, particularly given the mendicancy of our so called strategic trade policy frameworks. Among the multitude of factors afflicting our exports the exchange rate stands out. It is widely believed that PKR is overvalued. It is also held that our competitors are constantly re-aligning their currencies. This, the overvalued camp maintains, denies a level playing field.
The theory - depreciation can help export competitiveness - is well-accepted. The devil is in the detail. The first hurdle is determination of 'equilibrium': the optimal exchange rate. The gap between REER (real effective exchange rate that factors in inflation differentials) and actual exchange rate does not, necessarily, establish if the currency is over-valued or not. There is a whole array of different methodologies, producing varying results. The IMF, for instance, uses three different approaches (macroeconomic balance, equilibrium rate, external sustainability), each throwing up different estimates of 'misalignment'. In simple terms, it is hard to say if PKR is over-valued, and by how much. [One study argues that the rupee could well be undervalued, if SBP interventions are any indication: between July 2013 and April 2015 SBP purchased more than $3.5 billion to prevent the rupee from appreciating!]
The next hurdle, is establishing a co-relationship between (favourable) exchange rate and export growth. Pakistan has had a number of devaluations, (some very large - more than 100% in 1971; around 30% in 2008) as also some revaluations, most notably in March 2014, when over a three day period the rupee strengthened by 5.1% to close at Rs 98 to a dollar (in December 2013 it was trading at Rs 107). Also, before the IMF made us go for the free float we had experimented with all kinds of exchange rate management policies that surely gave us the space to tinker with the market to support exports. Did all or any of this impact our export competitiveness?
The relationship between exchange rate and competitiveness is a heavily populated research field. But despite all the regression analyses, all the co-integration techniques employed, it is at best a split verdict, with most finding little empirical evidence of devaluation helping our exports.
Look at some recent numbers. Between 2003 and 2008, our exports grew at an average of 13% per annum, despite a largely stable exchange rate. Between 2008 and 2014, PKR depreciated at an annualized average of 9% but the exports grew by only 3%, despite the sudden and large spike in cotton prices! The sheer number of variables, dependent and predictors, challenges the development of a satisfactory econometric model. There is too much going on out there for a researcher to capture it all, even if he chances upon reliable tots, trops, and tfpds (terms of trade, trade openness, total factor productivity differentials) configurations.
Let us, for the sake of argument, accept that PKR is overvalued. Let us ignore the caveat that determination of overvaluation on the simplistic basis of difference between market rate and REER can be quite misleading. Let us gloss over the cost (to economic fundamentals) of a sharp depreciation of PKR. Will devaluation, even a large one, take our exports to giddying heights? Have any of our devaluations validated the 'J curve' theory (exports initially decline before ascending)?
Our issues are of a more structural nature. We largely export commodities, with very little value addition. This puts us at the mercy of the buyer, and more often than not we end up competing amongst ourselves rather than with suppliers from elsewhere. This induces a 'pass through' effect: Buyers grab most of the benefits pie. We sell more for less and in dollar terms, there is little export gain.
Our export mix and lack of market diversification render the export growth - exchange rate nexus a spurious correlation. But does that mean we do nothing and just live with the current exchange rate? It is volatility, not alignment, of exchange rates that scares the buyers away. Research is quite unambiguous on the adverse effects of volatility on export prospects. No importer relishes the idea of an inventory loss on account of abrupt exchange rate adjustments.
How real is the volatility risk? How does the market read it and shape the sentiment? During the last nine months, we have borrowed $ 5.27 billion, more than half of it from banks. Despite this substantial injection, SBP's liquid reserves have depleted by $2.4% since the IMF programme ended. We are rapidly moving closer to the risk of having a dominant source (China) for our FX needs. In the unofficial market, there is a 4% premium. Borrowings will become increasingly more expensive, and of a shorter tenor with costly rollover risks.
It is hard to dismiss the threat of a large devaluation, sooner rather than later. It is time to act now. The least cost option will be to let PKR slide - very slowly but most surely. This may not show immediate export gains but could avoid a death foretold.
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