Academic journal article The Lahore Journal of Economics

The Capital Account and Pakistani Rupee Convertibility: Macroeconomic Policy Challenges

Academic journal article The Lahore Journal of Economics

The Capital Account and Pakistani Rupee Convertibility: Macroeconomic Policy Challenges

Article excerpt


Pakistan embarked on the liberalization of its capital account more than two decades ago. Today, it is an economy with a capital account that is, by and large, free of restrictions, and a convertible currency. However, its actual integration into the global economy in comparison to other emerging market economies has remained rather limited. The opening of a capital account appeared to have improved the country's access to private foreign capital, but because of domestic security and economic and political concerns, the inflow of private capital has fallen in recent years. Although capital outflows were not a major cause for the decline in foreign exchange reserves during Pakistan's economic crisis of 2008, the open capital account and rupee convertibility have made it more vulnerable to outside shocks. This article identifies three areas where policymakers in Pakistan face serious challenges, i.e., macroeconomic management; controlling tax evasion, which the Pakistani rupee's convertibility has made easier; and minimizing the real cost of portfolio investment to the country. The article offers ideas on how these challenges could be met.

Keywords: Capital Account, Covertibilty, Pakistan.

JEL Classification: E22, G11, H26, O16.

1. Introduction

Capital account liberalization is a keenly debated issue. On one side, with the support of mainstream economic theory, free capital flows are held to promote efficient allocation of investable resources because investment can move from less profitable (implying less efficient) to more profitable locations. When accompanied by trade liberalization, open capital markets and flexible exchange rates reinforce and facilitate international specialization in trade on the basis of comparative advantage.

However, capital account liberalization1 has also been seen to make economies more vulnerable to international financial crises, especially in the developing world. Reckless commercial bank lending led to the Latin American debt crisis of the 1980s, costing the entire region a whole decade of economic growth. Aggressive trade liberalization and an open capital account brought Mexico to its knees in 1994, when it was made to pay for its over-exposure to short-term capital. Three years later, there was the wrenching East Asian currency and financial crisis, which caused massive economic and financial disruption and thwarted economic growth in Thailand, Indonesia, and Korea, while touching many other countries in the region.

In recent years, emerging market economies have experienced a rather different problem, although still caused by hot money flows. With interest rates falling to near-zero levels thanks to monetary easing in the leading industrial countries, investors have sought opportunities in some of the emerging market economies, where interest rates-because of domestic macroeconomic imperatives-have been significantly higher. Among others, Brazil, South Africa, India, and Singapore have experienced large capital inflows that have put pressure on their currencies to appreciate. The affected countries have tried to stem this inflow through various measures (notably, taxing short-term inflows) but with limited success. This problem has led the International Monetary Fund (IMF) to recognize that capital controls may be justified in certain conditions.

Pakistan started on the course of capital account liberalization and exchange convertibility in the mid-1980s, quite early compared to other developing countries. Indeed, this process started even before Pakistan took steps to bring down tariff barriers and liberalize its trade regime. The rupee has now been more or less freely convertible since the early 1990s and capital movements face few hurdles. Has this helped or hindered Pakistan's economic progress? To what extent have these measures facilitated or constrained the design and implementation of macroeconomic policy in Pakistan? …

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