Academic journal article The Lahore Journal of Economics

Capital Flows and Real Exchange Rate Overvaluation - A Chronic Ailment: Evidence from Pakistan

Academic journal article The Lahore Journal of Economics

Capital Flows and Real Exchange Rate Overvaluation - A Chronic Ailment: Evidence from Pakistan

Article excerpt

Abstract

The objective of this study is twofold: (i) to estimate the equilibrium real exchange rate (RER) from a long-run perspective and calculate the degree of overvaluation for the period 1972-2007, and (ii) to test the Dutch Disease hypothesis concerning the effect of capital flows on the RER in Pakistan. Based on various macroeconomic fundamentals suggested in economic literature by Edwards (1988, 1989, 1994), Elbadawi (1994), and Montiel (1997), the equilibrium RER is estimated as a function of the terms of trade, government spending, degree of openness, workers' remittances, foreign direct investment (FDI) flows, and foreign economic assistance. In view of this study's long-term focus, all unsustainable and temporary flows are filtered out to obtain an accurate misalignment index. Estimation results are in line with theoretical postulations: an increase in capital flows, government spending on nontradable goods and terms of trade improvement are consistent with an appreciation of the RER, while an increase in the degree of openness is expected to depreciate the RER. Findings suggest that the RER suffers from chronic overvaluation in Pakistan. In spite of filtering out unsustainable and temporary flows, overvaluation increased from 0.75% in 2001 to 22.9% in 2007. A sharp rise in FDI flows (between 2005 and 2007) and an increase in remittances (between 2002 and 2007) are among the main factors that have contributed to this persistent overvaluation. Results also suggest that the Dutch Disease hypothesis holds in the case of Pakistan.

JEL Classification: F10, G00, E22.

Keywords: Real exchange rate, capital inflow, overvaluation, Pakistan.

(ProQuest: ... denotes formulae omitted.)

Introduction

The significance of the exchange rate as a crucial policy fundamental with profound implications for the macro-economy, motivates this study. The exchange rate can impact the economy through two potential channels: (i) by influencing a country's macroeconomic stability, and (ii) by affecting the size of its tradable sector. Unfortunately, Pakistan has fared poorly on both counts. In the past, there have been recurrent episodes of dwindling foreign currency reserves, persistent deficits, and severe macroeconomic crises (Table-1). According to the literature, a current account deficit to gross domestic product (GDP) ratio in excess of 5.0 is largely considered unsustainable. During the 1990s, there were two particular instances of a sharp deterioration in the current account deficit: (i) between 1992 and 1993,1 and between 1995 and 1996.2 While there was a significant improvement in Pakistan's external position between 2000/01 and 2003/04, the current account deficit has been deteriorating since 2005. According to the State Bank of Pakistan's annual report, the current account deficit expanded by approximately 104% over the last year (2007 - 2008) and reached a record historical peak of US$14 billion. More than 80% of this increase has been due to an increasing trade deficit which can be attributed to the following factors: (i) a falling export-to-GDP ratio, and (ii) a massive increase in imports as a percentage of GDP due to (a) an increase in domestic demand, and (b) an unprecedented rise in global oil and commodity prices-the expansion in the oil trade deficit alone explains about 38% of the overall deterioration in current account between 2007 and 2008.3

Further, the growth of the tradable sector in Pakistan has been poor relative to the nontradable sector (Figure 1). Traditionally, only commodity producing sectors (agriculture, manufacturing, and mining) were defined as tradable while all others (construction, services, transport, and communications) were classified as nontradables. However, owing to technological improvements, services have now entered the sphere of the tradable sector, thus rendering somewhat abstract the conventional distinction between tradables and nontradables. …

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