Pakistan Institute of Development Economics

PIDE Knowledge Brief No. 17:2020
Exchange Rate Policy Must Seek Undervaluation!
Publication Year : 2020
Author: Abdul Jalil
Exchange Rate Policy Must Seek Undervaluation!

Abdul Jalil, Professor of Economics, Pakistan Institute of Development Economics, Islamabad.

In Pakistan, the exchange rate policy has always tended towards overvaluation (see Box 1). This policy has led to five major currency crises, an attack on foreign exchange reserves, and an eventual IMF programme, over the last 30 years (Haque and Hina, 2020).
The present knowledge brief reviews literature on the relationship between exchange rate policy stance and economic growth. Besides, an attempt is also made to estimate the misalignment of the exchange rate for Pakistan using an econometric model. The evidence provides overwhelming support for an exchange rate policy that seeks undervaluation to stimulate growth. In Pakistan, however, the State Bank of Pakistan (SBP) continues to adopt the policy of exchange rate overvaluation.
Box 1: Currency Misalignment
Misaligned currency means exchange rate that is inconsistent with satisfactory macroeconomic fundamentals of a country. If the currency is misaligned, then it may be overvalued or undervalued.
Overvaluation: If the currency of a country is overvalued, then it makes the imports attractive and exports hard to sell. Currency overvaluation leads to an unsustainable current account deficit.
Undervaluation: On the other hand, if the currency of a country is undervalued, it results in current account surplus. Undervaluation of currency can stimulate the economy to a higher economic growth level.
The Impact of Misalignment on Economic Growth around the World
As mentioned earlier, there is an extensive literature that tests the impact of exchange rate misalignment on economic growth. Three essential points can be inferred from the literature.
·      There are different concepts of real exchange rate misalignment (see Box 2).
·      Researchers use different sets of explanatory variables to calculate the equilibrium exchange rate.
·      The calculation of the equilibrium exchange rate is sensitive to econometric models and econometric techniques.
Despite all the technical issues, there is almost a consensus that the real exchange rate undervaluation positively impacts economic growth. More specifically, Bhalla (2008) notes that each 1 percent sustained undervaluation may lead to 0.3 percent to 0.4 percent increase in economic growth. On the other hand, the overvaluation of the real exchange rate negatively impacts economic activities (see Table 1).
Box 2: Methodologies for Measuring the Misalignment of Exchange Rate
The difference between the prevailing exchange rate and the ‘equilibrium’ exchange rate is called the misalignment of the exchange rate. The measurement of the equilibrium exchange rate is not a straightforward task. The researchers provide various measures depending on the objective, focus, the conceptual framework, empirical methodology, and assumptions (Isard, 2007). Therefore, the literature suggests several empirical methodologies to measure the equilibrium exchange rate. These may be model-independent or model-dependent. In a nutshell, there is not an ‘equilibrium’ exchange rate. All measures provide different numbers for the equilibrium exchange rate depending on the period, methodology, and underlying assumptions about the macroeconomic variables.

The Channels through which (Mis)Alignment Effect Economic Growth
  • The literature cites the example of East Asian countries’ outward-oriented policies when discussing the positive impact of the undervaluation of currency on economic growth. On the other hand, the overvalued currency hurt the Latin American and African countries’ economic growth following inward-oriented policies.
  • Rodrik (2008) notes that market failures and bad institutions affect the tradable sector in developing countries. Therefore, currency undervaluation might work to correct market distortions and positively impact economic growth.
  • The currency undervaluation may boost the industrial sector through incentives for capital accumulation, technological capabilities, and information spillover. The improved industrial sector will add to the economic growth of the country.
  • Theoretically, Gala (2007) suggests that the real exchange rate’s undervaluation may increase profit margins. These profit margins will induce higher savings, investments, and ultimately increase economic growth.
  • A stable and competitive (undervalued) real exchange rate may boost economic diversification in developing countries.
The Case of Pakistan

As mentioned earlier, the SBP continuously pursuing the policy of keeping the exchange rate parity overvalued by supporting the foreign exchange market through central bank interventions (see Box 3). Therefore, the prevailing nominal exchange rate in Pakistan does not reflect the equilibrium exchange rate. The difference between the prevailing and the equilibrium exchange rate is called the exchange rate misalignment. As mentioned earlier, there are several methods to calculate the misalignment of the exchange rate (see Box 2). However, we follow the IMF’s suggestions[1] and use an econometric model by taking several variables into account, keeping the dynamics of Pakistan’s economy in view. In this regard, we take Rao’s (2019) guidelines to construct a macro model for Pakistan’s case (Box 4). Since the SBP manages the exchange rate parity through interventions, we simulate the nominal exchange rate with and without foreign exchange interventions (see Figure 1).
[1] Almost all the IMF methodologies are based on econometric estimations.

Box 3. Central Bank Interventions
The central banks intervene in the foreign exchange market through buying and selling of the foreign/local currency to support the nominal exchange rate parity. The support could be to reach a specific desired level of exchange rate parity or to reduce the exchange rate volatility in the currency exchange market.
Selling of Foreign Currency: When the local currency is under pressure in the foreign exchange market due to weak macroeconomic fundamentals, the market signals to depreciate the exchange rate. In this scenario, the central bank sells foreign currency and buys local currency to manage the pressure. The exchange rate will be overvalued. Resultantly, the central banks lose foreign exchange reserves. The reserve deficient countries, such as Pakistan, cannot afford this policy for a long time. Whenever the central bank stops the support due to the lack of foreign exchange reserves, the local currency depreciates rapidly to adjusts to its market value. Sometimes, rapid depreciation may lead to currency crises.
Buying of Foreign Currency: On the other hand, the central bank buys the foreign currency when the market forces signal the appreciation of the local currency. The central bank builds the international reserves in this process.

Figure 1 provides a historical evaluation of SBP’s intervention effectiveness in controlling the exchange rate parity.

Our analysis comes up with three main messages, namely:

  • First, if the SBP does not intervene to support the foreign exchange market, the exchange rate would have been around 205 per USD at the end of August of 2020. The support of SBP kept the exchange rate overvalued for a long time.
  • Second, following Rao’s (2019) methodology, our estimates show that the SBP has provided cumulative direct market support of USD 119 billion from January 1991 to August 2020. However, the support of USD 119 billion has yielded management of the exchange rate by only Rs. 36.
  • Third, the overvalued exchange rate largely subsidised imported consumption and distorted the competitiveness of exportable items. This led to a higher trade deficit, balance of payment (BOP) crises, and ultimately the IMF bailout packages. This also suggests that if the SBP adopts a less protective exchange rate regime, we may avoid severe economic outcomes such as the depletion of foreign exchange reserves, BOP crises, and currency crises (Haque and Hina, 2020).

This note provides overwhelming evidence that currency undervaluation is beneficial for economic growth. A macro-econometric model shows that the SBP continually used our scarce foreign exchange reserves to keep the exchange rate arbitrarily overvalued throughout history. This is one important factor that has contributed to our repeated BOP crises and IMF programmes. We hope that this note will inform the exchange rate policy to keep an undervalued target exchange rate and not use reserves to fight overvaluation (see also Jalil, 2020).  


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