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Exchange Rate Management and Economic Growth: A Brewing Crisis in Pakistan

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Abstract

In this article it is argued that Pakistan has had a consistently overvalued exchange rate and the policy with regards to management of the exchange rate has undergone a significant change in recent years. We show that prior to March 2013, the policy target of the exchange management was stability of the real effective exchange rate. However, during the tenure of the current government, the policy target for exchange rate management seems to have been stability of the nominal exchange rate against the US dollar. As the currencies of Pakistan’s major trading partners (UK, Europe and China) have depreciated against the dollar during this period, the real effective exchange rate has appreciated by over 20 percent since the time that the current policy makers took office. Overvaluation in general and the recent reversal in the exchange rate management policy in particular have had an adverse impact on exports and the manufacturing sector. This not only has serious negative consequences for the long term, growth of the economy, but has greatly increased the short-term risk of a balance of payments crisis.

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... Like other developing countries, Pakistan has had an overvalued currency and significant changes have been observed in the exchange rate policy in recent years. Prior to March 2013, the prime objective of the policy was to stabilise the real effective exchange rate (R.E.E.R.) and was shifted to the stability of a nominal exchange rate against U.S. dollars post 2013 (Hamid & Mir, 2017). Another problem in the country is poor management of exchange rate and is often driven by individuals who do not have basic understanding of economics. ...
... Consequently, the exchange rate remains more or less transparent and sometimes subjected to arbitrary changes. Some studies (Hamid & Mir, 2017) claim the overvalued exchange rate and misalignment are the main causes of loss of competitiveness in the international market and declining growth in tradable sector during the last decade. Intuitively, the strategy of making the currency undervalued to get competitiveness in the international market may not work in correcting deficit in external account in Pakistan. ...
... Recently some empirical studies (Hamid & Mir, 2017;Javed & Farooq, 2009;Nawaz, 2012;Shahbaz, Islam, & Aamir, 2012) showed depreciation of Pakistani currency to be growth enhancing. The common feature of these studies is that they all have assumed symmetric effect of exchange rate on growth and therefore seem to miss important insights and unable to distinguish and isolate the impact of appreciation from depreciation on economic performance. ...
Article
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Exchange rate fluctuations play a vital role in influencing macroeconomic variables including economic growth via the channels of net exports and investments. This study claims to be the first in assessing the asymmetric effect of exchange rate fluctuations on G.D.P. in Pakistan whose currency had the title of ‘worst currency of South Asia’ in 2018 after more than 20% depreciation in just three months. In this study, we employ a recently developed technique of Non-linear A.R.D.L. by Shin, Yu, and Greenwood-Nimmo (2014 Shin, Y., Yu, B., & Greenwood-Nimmo, M. (2014). Modelling asymmetric cointegration and dynamic multipliers in a nonlinear ARDL framework. In Festschrift in Honor of Peter Schmidt (pp. 281–314). New York, NY: Springer.[Crossref] , [Google Scholar]) to test for possible asymmetric effect of exchange rate on G.D.P. along with the proxies of fiscal and monetary policies. Both A.R.D.L. and N.A.R.D.L. are applied on annual data range from 1972 to 2014. The results of A.R.D.L. are found poor and co-integration relationship lost when the assumption of symmetry is taken into consideration. On the contrary, Non-linear A.R.D.L. technique carry more rich information related to the issue at hand and co-integration relationship is confirmed. From the results we found that week currency hurts G.D.P. growth, while strong currency adds to growth. Besides these, we confirm asymmetric impact of exchange rate on G.D.P. growth in Pakistan and find the evidence of short-run, long-run and adjustment asymmetry. To achieve the objective of sustained growth, exchange rate management should focus to restore stability and go for more strong currency in Pakistan. Future research needs to consider capital flows and exchange rate regimes in the form of ‘Sudden Stop hypothesis’ when investigating the asymmetric impact of exchange rate.
... The key objective of the strategy before March 2013 was to stabilize the effective real exchange rate (REER) and to move to nominal exchange rate stability against the U.S. dollars after 2013 (Hamid & Mir, 2017). ...
... Pakistan exports are greater than its import, and the deficits have increased since its independence. Recent studies (Hamid & Mir, 2017;Javed & Farooq, 2009;Nawaz, 2012;Shahbaz et al., 2012) have shown that devaluation of the currency is boosting the economic growth in Pakistan. All of these studies are based on the assumption that exchange rate has an asymmetric effect; therefore, these studies seem to be missing important insights and do not lay out the asymmetric effect of exchange rate on economic growth. ...
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In the literature for Pakistan, the asymmetric effect of the exchange rate on the agricultural sector stands ignored. Current research is designed to investigate the possible asymmetric effect of exchange rate fluctuations on the agricultural sector using a nonlinear autoregressive distributed lag (NARDL) framework. The data set comprises a period of 1970 to 2019, which is taken from the Ministry of Finances and handbook of the State Bank of Pakistan. The variables used in the study are real effective exchange rate, agricultural production, inflation, primary export, government investment, terms of trade, imports, and exports. The ADF unit root test confirmed that the research series is a combination of stationary and non-stationary variables. The study, therefore, uses the ARDL approach, but the focus is to investigate the asymmetric effect; thus, the NARDL technique is also applied. The NARDL results suggest that positive movements have lesser impacts than those of negative movements in the exchange rate on the agriculture sector both in short run and in the long run.
... Like other developing countries, Pakistan has had an overvalued currency and significant changes have been observed in the exchange rate policy in recent years (Hamid & Mir, 2017). Bad exchange rate management is another issue in the country and is often driven by individuals who do not have a basic understanding of economics. ...
... Consequently, the exchange rate remains more or less transparent and sometimes subjected to arbitrary changes. Some studies (Hamid & Mir, 2017) claimed that the overvalued exchange ...
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This study aims to forecast the exchange rate by a combination of different models as proposed by Poon and Granger (2003). For this purpose, we include three univariate time series models, i.e., ARIMA, Naïve, Exponential smoothing, and one multivariate model, i.e., NARDL. This is the first of its kind endeavor to combine univariate models along with NARDL to the best of our knowledge. Utilizing monthly data from January 2011 to December 2020, we predict the Pakistani Rupee against the US dollar by a combination of different forecasting techniques. The observations from M1 2020 to M12 2020 are held back for in-sample forecasting. The models are then assessed through equal weightage and var-cor methods. Our results suggest that NARDL outperforms all individual time series models in terms of forecasting the exchange rate. Similarly, the combination of NARDL and Naïve model again outperformed all of the individual as well as combined models with the lowest MAPE value of 0.612 suggesting that the Pakistani Rupee exchange rate against the US Dollar is dependent upon the macroeconomic fundamentals and recent observations of the time series. Further evidence shows that the combination of models plays a vital role in forecasting, as stated by Poon and Granger (2003).
... To ascertain the impact of the exchange rate regime on the success of FA, a categorical variable denoted by D EX is taken to have a value of "1" when the exchange rate regime is flexible and "0" otherwise. The data on exchange rate regimes was obtained from Hamid and Mir's [28] study. Furthermore, to capture the impact of the macroeconomic environment in which FA takes place, average GDP growth and average unemployment rate in the preceding two years of FA are included in the empirical model. ...
Article
This study seeks answers to questions such as: what is fiscal adjustment? Which fiscal strategy will result in a reduction in public debt liabilities? In the pursuit of answers to these questions, the study has defined two objectives. Firstly, the fiscal adjustment episodes must be identified in order to detach the discretionary fiscal stance; secondly, the success of these adjustment episodes in reducing public debt liabilities must be assessed. As a result, attempts will be made to undertake analyses that would simplify the issues underlying Pakistan's practical policy options. A total of eleven adjustment episodes have been observed in a sample, ranging from 1976 to 2017, following Alesina and Ardagna's definition. The descriptive analysis reveals that five episodes succeeded in reducing the public debt, while six episodes failed to reduce the ratio. Out of the five successful episodes, four are found to be spending-based and one is tax-based. To quantify the success of fiscal adjustment, the empirical model has been calibrated on Leibrecht and Scharler's model and estimation is done via both the Ordinary Least Squares (OLS) and Robust Least Squares (RLS) methods. The RLS method produces better outcomes than the OLS method. Under RLS, all variables are significant except GDP growth, whereas in the OLS model, the election year and regime shift, together with GDP growth, are statistically insignificant. The fiscal adjustment's composition reveals that spending-based consolidation boosts the chances of the fiscal adjustment's success. Fiscal authorities should, therefore, adopt spending-based austerity measures to ensure the sustainability of public finances and prevent the negative macroeconomic consequences of unsustainable public debt.
... The possible effects of exchange rate changes on productivity have witnessed extensive investigations, but the findings are mixed and inconclusive. Studies of Hamid and Mir (2017), Javed andFarooq (2009), Nawaz (2012), Shahbaz et al. (2012), Narayan and Narayan (2007), Rodrick (2008) and Rapetti et al. Razmi (2013) reveal that exchange rate depreciation enhances growth. ...
Article
The dynamic relationship between exchange rate movements (appreciation and depreciation) and macroeconomic fundamentals had preoccupied the minds of researchers across the globe. Consequently, extensive research works have been conducted to unravel the puzzle; however, the findings remain inconclusive. The inconclusiveness of these researches may not be unconnected with the choice of model, the omission of key variables and erroneous assumption of symmetric interrelationships of the variables. To mitigate such error and fill the observed research gaps, this study leveraged on the non-linear autoregressive distributed lag to trace the possible asymmetric pass-through of the exchange rate to output growth in Nigeria. The study made use of monthly time series for the period 2000M1–2018M12 for empirical estimations. The empirical findings reveal an asymmetric pass-through from exchange rate to productivity. Exchange rate depreciation led to output retardation in the short run, but neither appreciation nor depreciation of the exchange affected output in the long run. The findings highlight that exchange rate depreciation of the local currency does not improve the country’s productivity. This reveals a disconnection and misalignment between exchange and productivity in Nigeria. The findings call for proper alignment of the Naira exchange rate with the U.S. dollar for improved productivity in the economy.
... Thus, it is evident from the above discussion that the relationship between RER movements and economic growth proves to be an important issue from both positive and normative perspectives. Although, there is ample evidence on estimating the equilibrium real exchange rate (Chishiti & Hasan, 1993;Afridi, 1995, & Siddiqui et al. 1996 and computing real effective exchange rate misalignment (Qayyum et al. 2004;Hyder & Mehboob, 2005;Janjua, 2007;Debowicz & Saeed, 2014;Hamid & Mir, 2017& Bhatti et al. 2018 for Pakistan, these studies are confined only to computation and/or presentation of the trends of RER misalignment in Pakistan over different time periods. These studies conclude, at large, that Pakistan has experienced various episodes of undervaluation and overvaluation. ...
Article
This study endeavours to examine empirically how real exchange rate (RER) misalignment affects economic growth in Pakistan. In this regard, we have not only estimated the direct impact but also the indirect impact of misalignment on economic growth by using the financial development channel. We have used time series data ranging from 1980 to 2016 to carry out the empirical analysis. After testing the time series properties of the selected variables, we computed long run equilibrium RER later used to calculate RER misalignment. Finally, we estimated the impact of misalignment on per capita economic growth, both direct and indirect. Our results reveal an adverse impact of RER misalignment on economic growth. However, we report that financial development helps in minimising the adverse impact of RER misalignment, though not fully eliminating it. Based on the empirical findings, the study suggests that exchange rate policies need to be managed more cautiously. Moreover, the financial sector development needs to be strengthened which may help in fully alleviating the adverse impact of RER misalignment on economic growth. JEL Classification: F31, GOO, O47 Keywords: Real Exchange Rate Misalignment, Financial Development, Economic Growth, FMOLS
... Further result indicates that while undervaluation of the currency significantly improves economic growth in the short-run, it significantly hinders growth in the long-run. More so, Hamid and Mir (2017) investigate the impact of overvalued exchange rate on the economic growth of Pakistan using a contextual analysis by discussing on the various exchange rate regimes and its implications on economic growth. The authors conclude that exchange rate overvaluation has produced an adverse impact on exports and the manufacturing sector. ...
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This study investigates the impact of real exchange rate on economic growth in Nigeria by assessing the long-run and the short-run impacts of the variables using the Johansen cointegration test and the Vector Error Correction Model (VECM). The analysis is based on the annual time series data of real exchange rate and the real GDP covering the sample period of 1980 to 2017. Result shows the existence of long-run and equilibrium relationship between the variables under consideration. In addition, the model established the presence of positive and significant impact of exchange rate on the economic growth in Nigeria. As such, policy makers in Nigeria should be extremely critical in decision makings particularly on matters related to exchange rate in order to benefit from its positive and valuable impact towards generating a sustainable economic growth. A considerable and rational appreciation of the domestic currency is essential in encouraging rapid growth in the long-run period.
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Previous studies that examined the impact of exchange rate misalignment on economic growth were based on the symmetric approach where both overvalued and undervalued exchange rates were supposed to affect the economic growth in a similar way. However, in recent years, a number of studies have established that exchange rate changes affect the trade flows in an asymmetric way. Hence, this study investigates the asymmetric effect of exchange rate misalignment on the economic growth of Pakistan. The findings of the study indicate that in the case of the symmetric approach, exchange rate misalignment has a negative impact on economic growth. However, after applying the nonlinear ARDL approach, the study finds significant evidence in favor of the asymmetric effect of exchange rate misalignment on economic growth. Interestingly, the results indicate that undervaluation spurs while over-valuation hampers the economic growth in Pakistan. The study recommends that though under-valued exchange rate may have temporary relief for the economy, yet in the long run, a market-based equilibrium exchanger rate is imperative for a developing economy like Pakistan.
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Real exchange rate (RER) misalignment refers to a situation in which a country's actual RER deviates from some notion of an implicit "ideal" RER. An exchange rate is labeled "undervalued" when it is more depreciated than this ideal, and "overvalued" when it is more appreciated than this ideal. Such misalignments are widely believed to influence economic behavior. In particular, Overvaluation is expected to hinder economic growth while undervaluation is sometimes thought to provide an environment conducive to growth. But unless the "ideal" is explicitly specified, the concepts of RER misalignment remain subjective. The objectives of this paper are first to develop and construct explicit measures of RER misalignment, and second to explore systematically the relationships between misalignment and economic growth.
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