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Presentations made at the PSSP First Annual Conference - December 13, 14, 2012 - Planning Commission, Islamabad, Pakistan
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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