Exchange Rate, Debt Burden and Balance of Trade

By: Atiq-ur-Rehman

Consider a realistic example; the current total external debt of Pakistan is about US$61 billion. At the exchange rate of 106, this amount is equivalent to PKR 6466 billion. Suppose the value of dollar goes up by one in exchange of Pakistani rupee, the debt would be come PKR 6527 billion with an increase of PKR 61 billion. These 61 billion rupees we have never borrowed. If this additional burden is divided on 180 million citizens of Pakistan, the loan burden on every individual (including women and children) would increase by 338 rupees. While 22% individuals in Pakistan have earning below 40 rupees a day, this a drastic burden to be faced by the individuals. The total amount of debt on Pakistan during 2007 was $44 billion which is equal to PKR 2860 billion with the exchange rate prevailing in 2007. Excluding the input/output of debt during next 6 years, this amount rose to PKR 4664 billion by end of 2013 due change in the exchange rate. Hence average burden per individual rose by 10022 rupees which is 27% of the total debt today. These figures imply that it is necessary to critically evaluate the process of currency depreciation and to take steps for controlling it.

What is the benefit of Exchange Rate Depreciation?

Value of Pak rupee against US$ has been on continuous decline since last three decades. Official exchange rate of PKR declined from PKR10/$ in 1980 to PKR84/$ in 2010. The strongest argument of economist in favor of currency depreciation is so called J curve phenomenon. Economist believe that when value of local currency goes down compared to foreign currency, the exports become cheaper and imports become expensive. This causes trade deficit in the short run since the import bill increases by expensiveness of foreign currency. However eventually the domestic goods become more competitive in the international market, therefore foreign demand of local goods increases which causes improvement in the trade balance.

Does the J-curve exist?

The existence of J-curve has been challenged on the basis of empirical evidences. For example, value of US$ decreased by about 40% during 1985-1987 compared to G-7 countries, but the trade deficit of US remain increasing. US faced record trade deficit of $110 billion in 1987. If the J-curve was functional, 2-years gap was sufficient period to recover from the initial deficit hypothesized in J curve and US should have trade surplus but it does not happened . Similarly several people have investigated existence of J curve between Pakistan and its trade partners and found no evidence of the existence of J-curve phenomenon.

Why J curve does not exist?

In fact there are various reasons to believe ineffectiveness of J curve phenomenon. Like other economic theories, J curve theory is based on several assumptions. I would not go into technical details of these assumptions. However the elasticity of imports is the basic thing to determine the trade balance. Major imports of Pakistan include Petroleum, Machinery, Chemicals, Drugs and Fertilizers. These items have generally inelastic demand. No matter what the price of petroleum is, we must purchase it to continue economic activities in the country. A cut in the imports of chemicals, machinery and fertilizer would also result loss to productivity of the country. Therefore no improvement in trade balance is expected by the depreciation of rupee. On the other hand, the exports of Pakistan are facing very tough competition by the China and India, the two neighbours of Pakistan. In addition, energy crisis in Pakistan has created a big hurdle in exports. Handling the problems created by energy crisis with exchange rate policy will be quite senseless decision. A policy of introducing incentives for the investors and insuring smooth supply of energy should be more effective than the exchange rate policy.

Is the J curve argument Plausible to support depreciation?

The empirical evidences do not support existence of J curve. However if the J curve exists, this does not support depreciation policy in case of Pakistan. This is because the increase in debt volume due to depreciation is much higher than the expected benefit of improvement in the trade balance. The historical record shows that maximum improvement in trade balance was during 1990-91 which is about $2.7 billion, whereas the depreciation during this year has increased burden by about $3 billion. So where are the gains of depreciation?
It would be interesting to cite that the total improvement in trade balance during 2000-2005 is negative, indicating deficit of about PKR 60 billion. Meanwhile the amount total debt of Pakistan in 2000 rose by about PKR 200 billion during the same period. This happened despite the fact that average depreciation of PKR compared to US$ remain slow during 2000-05. The net result of depreciation is obvious.

Ethical aspect of Depreciation

The immediate expected beneficiaries of depreciation are the persons involved in import-export business who belong to upper cohort of the society. The people who suffer due to depreciation are all citizens of country especially the tax payers. So the question remains: is it morally justified to depreciate the currency given the scenario stated above?

Final Words

I would summarize the discussion by saying that the depreciation of exchange rate is incapable of improving trade balance with its trade partners. The evidences are present in several research papers published in PDR. Most of our import items are inelastic to exchange rate and their demand does not by expensiveness of foreign currencies. Exchange rate policy is incapable to improve exports because we are facing tough competition by our neighbours. Therefore the net result of devaluation of currency is the increment of foreign debt on Pakistan. Therefore the exchange rate policy should be reviewed so debt burden over Pakistan would not increase.

Note: The data source is mainly the World Development Indicators except mentioned otherwise. One of my students recently completed a MS thesis on the same issue and found that loan repayment we have made so far is more than what we borrowed. The loan burden of $61 billion that exist today is only because of depreciation. If you want more technical details on this topic, visit the following link:http://pu.edu.pk/images/journal/pesr/PDF-FILES/3%20REHMAN%20Exchange%20Rate%20J%20Curve%20and%20Debt%20Burden.pdf

Date posted: January 3, 2014
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