Exchange Rate Misalignment in Pakistan and its

General Equilibrium Distributional Implications

Dario Debowicz and Wajiha Saeed December, 2012

PSSP Working Paper

Motivation

• Exchange rate trends – The nominal exchange rate was flat at Rs. 60 per

US$ for several years (2001 – 2008) – Since 2008, the rupee has been depreciating

nominally • Exchange rate policy is focused on inflation

control, and short-term stabilization goals – But what are the long-term real-side implications

of Pakistan’s exchange rate policy?

Exchange Rate in Growth Literature

• An important determinant of growth • Not just exchange rate regime and exchange rate

stability • The alignment of the exchange rate is important

– Overvaluation harms growth – Associated with stop-go cycles, BOP crisis, rent-

seeking • Furthermore, undervaluation is conducive to

growth – Rodrick (2008)

We ask • Is the exchange rate at it’s equilibrium level in

Pakistan? – The real exchange rate may be overvalued – The IMF calls for greater flexibility in it’s 2012

Article IV report • What would be the real side implications of

allowing the exchange rate to get to its equilibrium level…? – Particularly on the structure of the economy

Structure of the Study

PART 1 • Econometric methods used to assess the

rupee’s alignment PART 2 • A Computable General Equilibrium (CGE)

model is used to assess the impact of correcting the (eventual) misalignment

PART 1 Measuring Misalignment • We take the Behavioural Equilibrium

Exchange Rate or BEER approach – i.e. the “equilibrium” rate is defined in the

behavioral sense – We estimate the “equilibrium” relation between the

real exchange rate and economic fundamentals • Deviation of actual exchange rate from

estimated “equilibrium” one taken as misalignment

Econometric Methodology

• The BEER is derived using (Johansen’s) cointegration technique – Uses a Vector Autoregression (VAR) – Cointegration yields the long run relation – Ensure that results are not spurious

Variable Increase in variable expected to cause:

Real effective exchange rate Real interest rate difference (r – r*) Appreciation

Debt to GDP ratio Depreciation

Relative terms of trade Ambiguous

Net foreign assets to GDP ratio Appreciation

Balassa-Samuelson Effect Appreciation

Economic Fundamentals

Dat

a Tr

ends

(S

ampl

e: 1

982-

2010

) 4.4

4.6

4.8

5.0

5.2

5.4

5.6

1985 1990 1995 2000 2005 2010

LREER

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

1985 1990 1995 2000 2005 2010

RDIFF

2

3

4

5

6

7

8

9

1985 1990 1995 2000 2005 2010

DEFICIT

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

1985 1990 1995 2000 2005 2010

LTNT

-.4

-.2

.0

.2

.4

.6

.8

1985 1990 1995 2000 2005 2010

LTOT

-.08

-.04

.00

.04

.08

.12

1985 1990 1995 2000 2005 2010

NFA

The long-run equilibrium relation or BEER

𝒍𝒍𝒍𝒍𝒍 = 𝟐.𝟕𝟕𝟕 + 𝟕.𝟕𝟐𝟐𝒍𝒓𝒓𝒓𝒓 + 𝟕.𝟐𝟕𝟐𝒓𝒍𝒓𝒓𝒅𝒓𝒅

− 𝟏.𝟐𝟕𝟐𝒍𝒅𝒍𝒅 + 𝟏.𝟕𝟏𝟐𝒍𝒅𝒍𝒅 + 𝟕.𝟕𝟐𝟕𝒍𝒓𝒏

Total Misalignment: Actual REER vs. “Sustainable” BEER

80

100

120

140

160

180

200

220

240

1985 1990 1995 2000 2005 2010

REER BEER (HP Filter)

Total Misalignment: Actual REER vs. “Sustainable” BEER

80

100

120

140

160

180

200

220

240

1985 1990 1995 2000 2005 2010

REER BEER (HP Filter)

Total Misalignment in % Actual vs. “Sustainable” BEER

-20

-10

0

10

20

30

1985 1990 1995 2000 2005 2010

Misalignment & Growth

-20

-10

0

10

20

30

-2

0

2

4

6

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

GDP per capita growth (annual %)Total Misalignment

Tota

l Mis

alig

nmen

t

GD

P G

row

th

• We use a CGE model to study the impact of devaluation

• In CGE analysis, we model the structure and the circular flow of income in the economy

• Allows us to simulate shocks to the economy

PART 2 CGE Analysis

2008 Pakistan SAM Sectors (22)

Agriculture (7): Wheat, Rice-IRRI, Rice-basmati, Cotton, Sugarcane, Other field crops, Other agriculture

Industry (12): Manufacturing, Other food, Wheat milling, Rice milling, Sugar milling, Cotton processing, Textiles, Chemicals, Fertilizer, Cement, Energy, Construction

Services (3): Trade, Transport, Other services

Factors (3) Labor, Capital and Land

Households (7) Rural (5): Large/medium farm, Small farm, Tenants, Non-farm poor, Non-farm non-poor

Urban (2): Urban poor, Urban non-poor

Other Institutional Accounts (4) Government, Rest of world, Saving-Investment, Change in stocks. The government includes separate taxes for import taxes, direct taxes and sales taxes.

Our Simulations

• Simulation 1: Real devaluation of 10%, based on total exchange rate behavioral misalignment for period 2007-2009.

• Simulation 2: Real devaluation of 25%, based

on total exchange rate behavioral misalignment for year 2010.

Expected Structural Implications: Exchange Rate Devaluation • Exports gain competitiveness; imports become

more expensive • However, imported intermediate inputs also

get more expensive… – Hence effective subsidy to sectors with high

portion of imported intermediate inputs changes, increasing their costs

What is the final impact on relative size of exporting sectors; and sector structure of the economy?

Closures/Assumptions • The share of investment in domestic absorption is

fixed, with endogenous propensities to save. • The government has a target deficit, with

endogenous income tax rates. • The real exchange rate is exogenous (flexible

foreign savings), and the numeraire is provided by the consumer price index (fixed CPI).

• Factor endowments are fixed with full employment for every factor .

Out

put P

rices

BASE DEV10 DEV25 Wheat 1.0 0.7 3.9 Rice – Irri 1.0 0.9 4.3 Rice – Basmati 1.0 1.0 4.5 Cotton 1.0 0.7 3.7 Sugarcane 1.0 0.7 4.3 Other field crops 1.0 0.7 4.0 Other agriculture 1.0 -0.6 -0.6 Other Manufacturing 1.0 0.4 1.4 Other Food 1.0 -1.1 -2.9 Wheat Milling 1.0 0.0 0.9 Rice Milling 1.0 -0.7 -0.9 Sugar Milling 1.0 0.1 1.7 Cotton Processing 1.0 -2.9 -7.8 Textiles 1.0 -1.0 -2.9 Chemicals 1.0 1.3 3.4 Fertilizer 1.0 1.2 3.3 Cement and Bricks 1.0 0.6 2.0 Energy 1.0 0.3 1.1 Construction 1.0 1.2 3.2 Trade 1.0 -0.9 -1.8 Transport 1.0 1.0 2.7 Other Services 1.0 -0.1 0.4

Out

put P

rices

BASE DEV10 DEV25 Wheat 1.0 0.7 3.9 Rice – Irri 1.0 0.9 4.3 Rice – Basmati 1.0 1.0 4.5 Cotton 1.0 0.7 3.7 Sugarcane 1.0 0.7 4.3 Other field crops 1.0 0.7 4.0 Other agriculture 1.0 -0.6 -0.6 Other Manufacturing 1.0 0.4 1.4 Other Food 1.0 -1.1 -2.9 Wheat Milling 1.0 0.0 0.9 Rice Milling 1.0 -0.7 -0.9 Sugar Milling 1.0 0.1 1.7 Cotton Processing 1.0 -2.9 -7.8 Textiles 1.0 -1.0 -2.9 Chemicals 1.0 1.3 3.4 Fertilizer 1.0 1.2 3.3 Cement and Bricks 1.0 0.6 2.0 Energy 1.0 0.3 1.1 Construction 1.0 1.2 3.2 Trade 1.0 -0.9 -1.8 Transport 1.0 1.0 2.7 Other Services 1.0 -0.1 0.4

Out

put P

rices

BASE DEV10 DEV25 Wheat 1.0 0.7 3.9 Rice – Irri 1.0 0.9 4.3 Rice – Basmati 1.0 1.0 4.5 Cotton 1.0 0.7 3.7 Sugarcane 1.0 0.7 4.3 Other field crops 1.0 0.7 4.0 Other agriculture 1.0 -0.6 -0.6 Other Manufacturing 1.0 0.4 1.4 Other Food 1.0 -1.1 -2.9 Wheat Milling 1.0 0.0 0.9 Rice Milling 1.0 -0.7 -0.9 Sugar Milling 1.0 0.1 1.7 Cotton Processing 1.0 -2.9 -7.8 Textiles 1.0 -1.0 -2.9 Chemicals 1.0 1.3 3.4 Fertilizer 1.0 1.2 3.3 Cement and Bricks 1.0 0.6 2.0 Energy 1.0 0.3 1.1 Construction 1.0 1.2 3.2 Trade 1.0 -0.9 -1.8 Transport 1.0 1.0 2.7 Other Services 1.0 -0.1 0.4

Valu

e A

dded

(B

illion

PKR

; % C

hang

e)

BASE DEV10 DEV25 Wheat 235.3 0.3 -4.5 Rice – Irri 79.0 0.1 -0.6 Rice – Basmati 71.5 0.1 -0.6 Cotton 125.0 13.1 58.1 Sugarcane 93.0 -4.6 -14.2 Other field crops 161.0 -1.8 -6.4 Other agriculture 1,252.4 -3.0 -9.4 Other Manufacturing 952.7 -1.6 -4.7 Other Food 66.7 -1.4 -3.3 Wheat Milling 295.1 -4.4 -13.1 Rice Milling 419.8 0.5 0.5 Sugar Milling 83.2 -4.8 -15.0 Cotton Processing 140.3 15.9 70.1 Textiles 77.4 5.6 23.4 Chemicals 74.4 1.1 4.5 Fertilizer 34.6 1.9 7.0 Cement and Bricks 108.1 -5.4 -14.9 Energy 145.9 -1.9 -4.7 Construction 260.4 -7.2 -19.5 Trade 1,829.0 -1.0 -3.2 Transport 1,156.0 -1.0 -3.0 Other Services 2,260.6 3.8 9.6 Total 9,921.6 0.0 0.0

Valu

e A

dded

(B

illion

PKR

; % C

hang

e)

BASE DEV10 DEV25 Wheat 235.3 0.3 -4.5 Rice – Irri 79.0 0.1 -0.6 Rice – Basmati 71.5 0.1 -0.6 Cotton 125.0 13.1 58.1 Sugarcane 93.0 -4.6 -14.2 Other field crops 161.0 -1.8 -6.4 Other agriculture 1,252.4 -3.0 -9.4 Other Manufacturing 952.7 -1.6 -4.7 Other Food 66.7 -1.4 -3.3 Wheat Milling 295.1 -4.4 -13.1 Rice Milling 419.8 0.5 0.5 Sugar Milling 83.2 -4.8 -15.0 Cotton Processing 140.3 15.9 70.1 Textiles 77.4 5.6 23.4 Chemicals 74.4 1.1 4.5 Fertilizer 34.6 1.9 7.0 Cement and Bricks 108.1 -5.4 -14.9 Energy 145.9 -1.9 -4.7 Construction 260.4 -7.2 -19.5 Trade 1,829.0 -1.0 -3.2 Transport 1,156.0 -1.0 -3.0 Other Services 2,260.6 3.8 9.6 Total 9,921.6 0.0 0.0

Valu

e A

dded

(B

illion

PKR

; % C

hang

e)

BASE DEV10 DEV25 Wheat 235.3 0.3 -4.5 Rice – Irri 79.0 0.1 -0.6 Rice – Basmati 71.5 0.1 -0.6 Cotton 125.0 13.1 58.1 Sugarcane 93.0 -4.6 -14.2 Other field crops 161.0 -1.8 -6.4 Other agriculture 1,252.4 -3.0 -9.4 Other Manufacturing 952.7 -1.6 -4.7 Other Food 66.7 -1.4 -3.3 Wheat Milling 295.1 -4.4 -13.1 Rice Milling 419.8 0.5 0.5 Sugar Milling 83.2 -4.8 -15.0 Cotton Processing 140.3 15.9 70.1 Textiles 77.4 5.6 23.4 Chemicals 74.4 1.1 4.5 Fertilizer 34.6 1.9 7.0 Cement and Bricks 108.1 -5.4 -14.9 Energy 145.9 -1.9 -4.7 Construction 260.4 -7.2 -19.5 Trade 1,829.0 -1.0 -3.2 Transport 1,156.0 -1.0 -3.0 Other Services 2,260.6 3.8 9.6 Total 9,921.6 0.0 0.0

Valu

e A

dded

(B

illion

PKR

; % C

hang

e)

BASE DEV10 DEV25 Wheat 235.3 0.3 -4.5 Rice – Irri 79.0 0.1 -0.6 Rice – Basmati 71.5 0.1 -0.6 Cotton 125.0 13.1 58.1 Sugarcane 93.0 -4.6 -14.2 Other field crops 161.0 -1.8 -6.4 Other agriculture 1,252.4 -3.0 -9.4 Other Manufacturing 952.7 -1.6 -4.7 Other Food 66.7 -1.4 -3.3 Wheat Milling 295.1 -4.4 -13.1 Rice Milling 419.8 0.5 0.5 Sugar Milling 83.2 -4.8 -15.0 Cotton Processing 140.3 15.9 70.1 Textiles 77.4 5.6 23.4 Chemicals 74.4 1.1 4.5 Fertilizer 34.6 1.9 7.0 Cement and Bricks 108.1 -5.4 -14.9 Energy 145.9 -1.9 -4.7 Construction 260.4 -7.2 -19.5 Trade 1,829.0 -1.0 -3.2 Transport 1,156.0 -1.0 -3.0 Other Services 2,260.6 3.8 9.6 Total 9,921.6 0.0 0.0

Exports (Billion PKR; % change)

BASE DEV10 DEV25 Other Agriculture 24.5 34.1 88.6 Other Manufacturing 264.8 21.8 55.4 Other Food 25.5 26.0 73.0 Wheat Milling 0.4 15.7 33.3 Rice Milling 119.2 23.2 59.8 Sugar Milling 5.6 14.9 28.4 Cotton Processing 314.4 23.4 98.0 Textiles 248.6 30.4 104.3 Chemicals 31.5 19.2 52.8 Transport 223.4 17.5 43.7 Other Services 242.4 14.4 36.4

Imports (Billion PKR; % change)

BASE DEV10 DEV25 Wheat 65.4 -23.2 -45.1 Other field crops 9.9 -24.9 -47.2 Other agriculture 7.9 -28.9 -55.7 Other Manufacturing 1,285.2 -7.8 -18.9 Other Food 139.1 -9.2 -22.4 Sugar Milling 0.7 -21.9 -45.5 Cotton Processing 95.1 5.0 27.5 Textiles 3.9 -5.7 -13.9 Chemicals 107.8 -4.6 -9.1 Trade 16.8 -27.6 -53.0 Other Services 528.7 -24.3 -47.1

• Index for labour and land in base; Assumed rental rate of capital in base; and % changes.

Real Wages

BASE DEV10 DEV25 Labour 1.0 0.7 3.9 Land 1.0 0.6 5.4 Capital 0.2 -1.6 -3.3

Annual Per Capita Income (000 PKR; % change)

BASE DEV10 DEV25

Large & Medium Landlord Farmers 236.4 -0.3 1.3

Small Landlords & Tenant Farmers 63.2 -0.3 0.4

Waged Farmers 46.7 -0.3 0.1

Non-Farm Poor (Quintile 1 & 2) 37.1 -0.1 0.9

Non-Farm Non-Poor 64.1 0.1 1.4

Urban Poor (Quintile 1 & 2) 36.2 0.8 3.5

Urban Non-Poor 152.9 -0.6 -0.8

Total 78.2 -0.3 0.4

Conclusion • Our findings indicate that Pakistan is presently

going through a period of overvaluation • This has potentially large implications for

structure of the economy • Overvaluation runs contrary to export promotion

and economic growth goals • Optimal exchange rate policy needs to consider

these long-term real side implications in addition to short term stabilization and inflation control goals

End