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

1. PSSP Working Paper
Exchange Rate Misalignment in Pakistan
and its
General Equilibrium Distributional
Implications
Dario Debowicz and Wajiha Saeed
December, 2012

2. 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?

3. 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)

4. 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

5. 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

6. 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

7. 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

8. Economic Fundamentals
Increase in variable
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

9. 5.6 5.0
5.4 2.5
5.2 0.0
5.0 -2.5
4.8 -5.0
4.6 -7.5
4.4 -10.0
(Sample: 1982-2010)
1985 1990 1995 2000 2005 2010 1985 1990 1995 2000 2005 2010
LREER RDIFF
Data Trends
9 .2
8 .1
7 .0
6 -.1
5 -.2
4 -.3
3 -.4
2 -.5
1985 1990 1995 2000 2005 2010 1985 1990 1995 2000 2005 2010
DEFICIT LTNT
.8 .12
.6
.08
.4
.04
.2
.00
.0
-.04
-.2
-.4 -.08
1985 1990 1995 2000 2005 2010 1985 1990 1995 2000 2005 2010
LTOT NFA

10. The long-run equilibrium relation
or BEER
𝒍𝒍𝒍𝒍𝒍 =
𝟐. 𝟕𝟕𝟕 + 𝟎. 𝟎𝟎𝟎𝒓𝒓𝒓𝒓𝒓 + 𝟎. 𝟐𝟐𝟐𝒅𝒅𝒅𝒅𝒅𝒅𝒅
− 𝟏. 𝟐𝟐𝟐𝒍𝒍𝒍𝒍 + 𝟏. 𝟎𝟎𝟎𝒍𝒍𝒍𝒍 + 𝟎. 𝟎𝟎𝟎𝒏𝒏𝒏

11. Total Misalignment:
Actual REER vs. “Sustainable” BEER
240
220
200
180
160
140
120
100
80
1985 1990 1995 2000 2005 2010
REER BEER (HP Filter)

12. Total Misalignment:
Actual REER vs. “Sustainable” BEER
240
220
200
180
160
140
120
100
80
1985 1990 1995 2000 2005 2010
REER BEER (HP Filter)

13. Total Misalignment in %
Actual vs. “Sustainable” BEER
30
20
10
0
-10
-20
1985 1990 1995 2000 2005 2010

14. Misalignment & Growth
6
4
Total Misalignment
2
GDP Growth
30
0
20
10 -2
0
-10
-20
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
GDP per capita growth (annual %)
Total Misalignment

15. PART 2
CGE Analysis
• 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

16. 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.

17. 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.

18. 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?

19. 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 .

20. 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
Output Prices
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

21. 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
Output Prices
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

22. 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
Output Prices
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

23. 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
Value Added
(Billion PKR; % Change)
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

24. 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
Value Added
(Billion PKR; % Change)
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

25. 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
Value Added
(Billion PKR; % Change)
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

26. 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
Value Added
(Billion PKR; % Change)
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

27. 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

28. 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

29. 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
• Index for labour and land in base;
Assumed rental rate of capital in base;
and % changes.

30. 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

31. 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

32. End