Rupee Over-Valuation

Published in  Dawn, May 19th 2019 . On similar theme, see: “Burning Billions“ and “Fear of Floating“. Post explains why the elite classes of Pakistan have chosen to keep the Rupee over-valued, even though it has had disastrously bad effects on the domestic economy.

The popular demand to ‘control’ the slide of the rupee ignores fundamental economic realities. The equilibrium rate is one at which the market arrives at naturally, without government interference. The only way for the government to keep the value of the PKR above equilibrium is to sell dollars at a cheaper rate, which artificially adds to the supply of dollars, and lowers the equilibrium price. The policy of over-valuation of the PKR 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 PKRs, while $10 comes from the government, which 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 subsidize 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 over-valued Rupees, effectively borrowing dollars to subsidize 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 over-valuation is the establishment of negative value-added industries, which make profits only due to the existence of government subsidy on imports. For example, subsidies make it cheaper for our oil czars to import oilseeds from Brazil and Malaysia, rather than growing our own sunflowers! Worse, over-valuation 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 over-valuation makes it extremely difficult to produce competitive products. India is able to produce domestic cars and mobiles because the Indian Rupee is under-valued making imports expensive. Pakistani efforts have failed because over-valuation makes imports cheap. China, Japan, and East Asian countries followed the opposite policy of under-valuation to industrialize. When dollar imports are expensive, due to over-valuation, 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 under-valuation is a key step on the path to industrialization. Under-valuation occurs when the government purchases $10 for every $100 imports purchased by 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 to 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 PKR was set by market forces (not the IMF!). More generally, the wealthy classes enjoy the subsidies on luxury imports.  But over-valuation 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 cheaper PKR.  However, it is costly and risky to setup 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 over-valuation lobby, it would be hard for anyone to have such confidence, in order to setup the industry. The domestic economy will never learn to produce if it is cheaper to import goods at prices subsidized by government borrowing. The long run health and prosperity of the economy requires either fair or under-valuation. The present policy of overvaluation works by borrowing dollars to subsidize imports, and cannot be sustained in the long run.