Popular demand to control the value of domestic currency is highly contradicting with fundamental economic facts.
Equilibrium exchange rate is the one that comes in market without any intervention. It indicates the rate at which price of currencies is justified given that demand for and supply of the currency is equal. In this situation if we demand to keep the rupee overvalued, government would have to artificially increase the supply of dollars in the market.
The policy of overvaluation of the Pakistani rupee is equivalent to an across-the-board subsidy on all imports. Anyone who purchases $100 receives $90 of it from private sources seeking to buy Pakistani rupees, while $10 comes from the government, that borrows dollars and sells them cheaply to keep the price of dollars low. Naturally, this makes imports cheaper, because the government pays part of the bill.
While occasionally it might make sense to subsidise strategic imports, it can never be sensible to provide across-the-board subsidies for all imports. Yet, in Pakistan, this is what has been happening for several decades. Governments have maintained significantly overvalued rupees, effectively borrowing dollars to subsidise all imports.
This is the simple explanation for our need to repeatedly borrow from the IMF, even though pundits pontificating on this matter have incorrectly blamed many other factors. We will examine why this has happened, what the consequences have been, and how the problem can be remedied.
One of the deadly effects of overvaluation is the establishment of negative value-added industries, which make profits only due to the existence of government subsidy on imports.
For example, our oil czars import oilseeds from Brazil and Malaysia, since it costs more to grow our own sunflowers! Worse, overvaluation prevents valuable industries from coming into existence.
Attempts at producing export-oriented silk, olive oil, palm oil, small electronics, and other light industrial products, have all faltered because overvaluation makes it extremely difficult to produce competitive products. India is able to produce domestic cars and mobiles because the Indian rupee is undervalued, making imports expensive.
Pakistani efforts have failed because overvaluation makes imports cheap. China, Japan and East Asian countries followed the opposite policy of undervaluation to industrialise.
When dollar imports are expensive, due to undervaluation, then it becomes profitable to set up domestic industries which can successfully compete with imports. Creating domestic industries which can manufacture substitutes for imports made expensive by undervaluation is a key step towards industrialization.
Undervaluation occurs when the government purchases $10 for every $100 imports purchased by the public, bumping up the price of the dollar by adding to the demand. This allows the government to transparently collect money, avoiding corruption at customs, and creating desperately needed foreign exchange reserves for national benefit.
The question is why, when it is so harmful for local development, have we pursued a policy of mass subsidy for all imports over decades. Billions of dollars in subsidies goes to select industries which profit immensely from cheaper-than-market-value imports. These industries would collapse if the subsidy was withdrawn, and the value of the Pakistani rupee were set by market forces (not the IMF!).
More generally, the wealthy classes enjoy subsidies on luxury imports. But overvaluation is defended on the ground that the poor will have to pay more, even though the subsidy benefits the rich far more.
The imaginative beneficiaries of the billion-dollar subsidies promote another half-truth to support this disastrous policy.
They acknowledge that additional demand will be created by lower prices for Pakistani goods, but argue that our export industries are working at full capacity and will not be able to expand production to meet the additional demand.
What they say is true in the short run — we may not see an immediate response in terms of increased exports.
In the long run, export-oriented industries could come into existence to satisfy additional global demand created by the cheaper Pakistani rupee.
However, it is costly and risky to set up industries. Putting in the required large investments in production capacity requires confidence that the government will maintain its exchange rate policies. Given the power of the overvaluation lobby, it would be hard for anyone to have such confidence, in order to set up the industry.
The domestic economy will never learn to produce if it is cheaper to import goods at prices subsidised by government borrowing.
The long-term health and prosperity of the economy requires either fair or undervaluation. The present policy of overvaluation works by borrowing dollars to subsidize imports, and cannot be sustained in the long run.
Article is written by Dr. Asad Zaman and published in Dawn News on May 19, 2019.
To read more related materials see https://www.dawn.com/news/1472155/fear-of-floating and https://www.dawn.com/authors/8201/asad-zaman