The Currency Devaluation And Its Effect

Published Date: 02 Nov 2017

INTRODUCTION

Background of the Study

According to many economists, weakening of the currency could actually strengthen economy, since a weaker currency will increase the production, which in turn will uplift employment and raising the economic growth. The increase in the demand for domestic goods and services increase their production, triggering the economic growth. Hence in order to keeps the economy going, economic policies must improve the aggregate demand. And the demand for domestic products originates from outside the country, termed as exports. Likewise, local residents demand for the imported goods and services. Therefore the increase in exports increase the overall demand for domestic output, and increase in imports decreases the demand. Hence exports are the determinants of economic growth, while imports detract the growth of the economy.

International demand for a country's goods and services is an important for boosting the economic growth. And to increase the demand of domestically produced goods in the foreigner market. Attractive prices of these goods should be set, making them more attractive.

Traditionally there are three main approaches to devaluation or currency depreciation: the elasticities approach, the absorption approach and the monetary approach. According to the elasticities framework, devaluation improves a country’s balance of trade when the Marshall-Lerner condition is satisfied, when the sum of the import demand elasticities of the two trading partners exceeds unity. In the absorption methodology, however, the elasticities do not matter, and the trade balance improves only if the nation’s GDP increases faster than domestic spending. In the monetary approach, by contrast, only money demand and supply matter, and devaluation always improve the trade balance. According to the monetary approach to the exchange rate, a devaluation or depreciation decreases the real supply of money, resulting in an excess demand for money. This leads to hoarding and an increase in the trade balance

Currency Devaluation and its effect:

Devaluation is an official change in the value of a country's currency relative to other currencies under the phenomenon of fixed exchange rate. Whereas in floating exchange rate system, currency depreciation result as changes in market forces.

Loosening of the monetary policy results in the increase of selling the domestic currency for other currencies, this leads to domestic currency devaluation. And domestic producers and exporter are the main beneficiaries of this action.

There are two implications of devaluation.

First, devaluation makes the exports of the country cheaper for foreigners.

Second, it makes imported goods expensive for domestic consumers, which discourages the imports.

Depending on consumer and producer responsiveness to price changes (known as supply and demand elasticities), an effective devaluation should reduce a nation's imports and raise world demand for its exports. Improvement in a country's balance of trade will cause an increase in the new inflow of foreign currency; this, in turn, may help strengthen a country's overall balance of payments account. The total effect of a currency devaluation depends on the actual elasticities of the supply and demand for traded goods. The more elastic the demand for imports and exports, the greater the effect of the devaluation will be on the country's trade deficits and, therefore, on its balance of payments; the less elastic the demand, the greater the necessary devaluation will be to eliminate a given imbalance.

Devaluation often is criticized as an inflationary monetary policy because it raises the domestic price of imports. The underlying cause of inflation is not devaluation, however, but rather excess money creation. Nonetheless, devaluation is an unpopular policy, especially in small countries that are extremely dependent on imports as a source of food and other necessities.

When the prices of imports are increased it results in the increase of the demand for domestic products, devaluation results in inflation. If this is the situation, the government should have to increase the interest rates to control inflation.

Devaluation may discourage the investment in the country's economy and may affect the foreign investment of the country.

Devaluation might negatively affect the export industry of the country. Countries in the neighbor may devalue their own currencies to reduce the effects of their trading partner's devaluation.

‘J-curve’ Phenomenon:

Exchange rates have different effects in long run and short run of the economy. One reason for the difference is that quantities traded are often slow to adjust to exchange rate movements. Many economists believe that the trade balance in domestic currency terms should drop first in response to a depreciation (or devaluation) of the domestic currency since initially export and import quantities will change little but the price of imports will increase. Over time, however, more will be exported and less imported due to the cheaper value of domestic currency, so the trade balance rises, resulting in what is known as a trade ‘J-curve’ when the path of the trade balance is plotted over time.

Value Determination:

The value of anything is determined by what you can get in exchange for it. Or, on the other hand, what you have to give up obtaining and keeping it. So in effect, the value of anything is its opportunity cost. This holds true for money itself. It is worth what you can get for it... and, what you're willing to give up, in order to get it. Thus, money itself is a commodity and can be used as barter in exchange for other commodities.

Purchasing Power Parity (PPP) is the relationship between the currencies of two or more countries and the commodities that can be purchased. Parity suggests that, products that are substitutes for each other in international trade should have similar prices in all countries when measured against the same currency.

The basic idea that supports PPP is that (Ceteris Paribus) any deviation from parity would leave room for arbitrage. An entrepreneur could continuously buy an item in one country, and then sell the same item in another country, making a fortune on the price differential. Because of this profit potential, eventually everyone would get in on this action, until the price differential was eliminated and there were no more profits to be had. This results in the Law of One Price.

Any deviations from this parity value should be due to changes in the ratio of imports/exports and/or capital inflows/outflows. These ratios represent changes in demand for the country's currency and will cause the exchange rate to fluctuate above or below parity value.

Devaluation and Economic Well-Being

Currency depreciation affects the social welfare as well, which depends upon real GDP and the rate of unemployment. If there is unemployment along with a high trade deficit, then currency depreciation unambiguously raises welfare, even though the price level rises and inflationary pressures escalate. This is because in this case outputs as well as employment go up, while the trade deficit disappears.

On the other hand, if the nation is already at full employment, devaluation simply raises the price level, lowers aggregate spending, improves the trade balance, but has no impact on overall welfare. However, the weakest sections of society, the retirees, the minimum-wage earners, the older workers, etc., suffer, because their nominal incomes remain fixed while prices go up.

Objectives of the Study:

It is aimed to achieve the following objectives:

To find the need for Devaluation of the currency.

To find the effect of Devaluation of the currency on the domestic exports.

To find the effect of Devaluation of the currency on the domestic imports.

To find the changes in the trade balance, when Devaluation is observed.

To find the impact on the balance of payments, when Devaluation is observed.

Organization of the Study:

To achieve the above-mentioned objectives the study is organized as under. The second chapter consists of the literature, on the effect of devaluation of the local currency, on the domestic exports, domestic imports, trade balance and the balance of payments. While in the third chapter an econometric model is developed, which explains the channel thorough which relationship between devaluation of the local currency and the international trade, in which domestic exports, domestic imports, trade balance and balance payments are included, has been described. Chapter four takes care of the issue of variable construction and also describing the data sources. Chapter five is the one, which is exhibiting the empirical results, based on the methodology, developed in chapter three. The chapter six provides conclusions and policy implications.

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CHAPTER - 2

LITERATURE REVIEW

2.1: Introduction

In this chapter we will furnish a brief critical analysis of the previously conducted studies. Moreover, we will try to take into account the impact of "Devaluation" on "Imports and Exports" by the previous studies. The existing literature depicts that there exists significant relationship between "Devaluation" and "Imports and Exports".

Exchange rate policies to improve the competitiveness have become the centerpiece of any adjustment effort. Mostly it is expected that a nominal devaluation will change expenditure pattern, increased production of tradable goods and services, and increase export. Many authors argued that devaluation can be counterproductive as exports and imports are relatively insensitive to price and exchange rate changes, especially, in developing and semi-industries countries.

2.2 Historical Background:

In the last four decades, Third World countries have lurched from one development paradigm to another: from industrialization to import substitution, to export promotion, to structural adjustment programming. Recently, Sub-Saharan Africa has increasingly embraced the latter approach, including the accompanying removal of trade restraints and currency devaluation.

Economic theory posits that devaluation will likely improve a nation's trade balance. However, there are two schools of thought with divergent explanations of how this comes about. The Elasticities Approach contends that by reducing the real value of the currency, devaluation improves the global competitiveness of a nation's tradable goods. According to the Monetarists, devaluation exerts a negative impact on real balances, thus reducing real expenditures, which force an improvement in the trade balance.

The disagreement is therefore not with the results but over the transmission mechanism. A clear statement on the exact role of relative prices in transmitting the effect of devaluation in a Sub-Saharan1 economy is quite important, as more and more of these countries resort to currency realignment as the key corrective policy initiative in an adjustment package, often implemented at the behest of the I.M.F.

1Eukina Faso, Cameroon, Central African Republic, Cote d'lvoire, Gabon, The Gambia, Ghana, Kenya, Madagascar, Mauritius, Niger, Nigeria, Rwanda, Senegal, Sierra Leone, Tanzania, and Togo are included in Sub-Saharan economy

In the recent years several papers have appeared which have tried to analyze empirically the effect of devaluation on the trade balance and balance of payments. There are three basic objections that one can make to these previous studies:

They examine only the impact effects and fail to show whether any apparent improvement is temporary or permanent.

They do not compare post-devaluation levels of the accounts with pre-devaluation levels.

They have not accounted for the effect of other variable such as the government's monetary or fiscal policy. Only the improvement or worsening of raw account figures following devaluation is reported.

While all three objections do not apply to each of the previous studies, each study fails to deal properly with at least one of them.

2.3 Theoretical Evidences

Different studies by various authors have been conducted according to which devaluation improves the balance of payments not the trade balance. In this context many authors have argued that a trade deficit is due to weak monetary policy and cannot be corrected by devaluation (exchange rate policy) or the use of fiscal policy.

The exchange rate changes (primarily devaluations) in developing countries have been the subject of considerable debate in recent years. Researchers at various international monetary organizations, especially the IMF and World Bank, have generally maintained that devaluation plays a positive and important role in stabilizing balance of payments, while academic researchers have focused mainly on the newly discovered concretionary and otherwise perverse effects of exchange rate adjustment.

Kamal and Alvie, (1975) are of the view that devaluation in the local currency effect both imports and exports of a country. To keep their view they conducted a research and took the case of 1972's devaluation as a case study, according to which Pakistan Rupee was devaluated from Rs.4.76 to Rs.11.00 per U.S dollar.

The effect of devaluation has been estimated, on both, Pakistan's imports and exports respectively. Before describing effect of devaluation on the imports, first import requirements of a developing country like Pakistan have been described in a short way, then, to calculate effect, different import demand functions for different requirements have been estimated. Imports of consumer goods, food grains, raw material and capital goods have been included in the main -imports requirements and then separately demand functions of these imports have been estimated. The effect on exports has only been observed through the comparison between domestic price level and world price level.

Mainly the effect of devaluation in both cases (imports and exports) has been observed through Effective Devaluation, which is measured by comparing exchange rate in pre and post devaluation periods.

The main conclusion, which emerge from the study is, that, imports are influenced by factors other than prices as devaluation is expected to have very substantial effect on the import bill. Both the import functions and the import data in the post devaluation period reflect this. Due to export duties and domestic pricing polices, the relative pieces of Rice, Cotton and Sugarcane have remained somewhat the same. However, export duties and increase prices of agriculture inputs have played a major role in checking an increase in production and introduction of new products in exports has increased the exports substantially.

Grubel (1976) has argued that a country's persistent payments imbalance could be the result of wrong monetary policy and cannot be corrected by either devaluation or the use of fiscal policy. Miles (1979) claims to have provided the requisite evidence to support Grubel's argument.

Thus, it may be concluded that although it cannot expected that import would decline, there are other beneficial effects, and thus the devaluation is a right step in the right direction.

Laffer (1976) eliminates the first two objections in test of 15 postwar devaluations. He examines the time path of the trade balance over seven years, from three years before devaluation until three years after. He finds that although the trade balance "improves" in the years following devaluation for eight of the fifteen cases, in one-half of those cases the trade deficit is still worse than the average balance of three years prior to devaluation. Furthermore, ten of the fifteen countries have the largest deficit of the seven years period in three years following devaluation, and two more have the largest deficit in the year of devaluation. Ten of the fourteen countries with data for the third year following devaluation have a larger deficit in that year than in the year after devaluation. Thus, there is little evidence of devaluation causing significant or sustained improvement in the trade balance.

Salant (1976) did a similar analysis to Laffer on 101 devaluations, for both the trade balance and balance of payments. Salant finds that in about three-quarters of the cases (75 of 101) the average balance of payments for the three years following devaluation is improved as compared with the average in three years preceding devaluation. In contrast, in less than one-half the cases (46 Of 101) does the average of the trade balance improve?

Miles (1979) examines the statistical relationship between devaluation and both tirade balance and the balance of payments for sixteen devaluations of fourteen countries in the 1960s; in this study above described objections have been taken into account to make the study more complete than the previous studies. Using several tests involving both the seemingly unrelated and pooled cross-section time-series regression techniques, the paper tests the effect of devaluation while standardizing for other variables that may affect the foreign accounts.

As effects of devaluation are explored through several statistical techniques. Testing the exchange rate directly through seemingly unrelated regression provides no overwhelming evidence of an improvement in either account. Examining the residuals of the equation without the exchange rate, however, provides a different result. The residuals indicate a small improvement in the trade balance in the year following devaluation. But this improvement is small compared with the deterioration of the trade in the year of devaluation or succeeding years. On the other hand there is clear evidence of balance of payments improving following devaluation. This pattern of contrasting behavior is reinforced by the succeeding tests. Pooling the data across time and countries does not create a significant positive coefficient for the trade balance of payments. Finally, constraining only the exchange-rate coefficient across countries and introducing lead and lag values further reinforces the pattern. The balance of payments, however, has a clear, significant pattern, worsening in the years preceding devaluation and then improving in the year following devaluation.

These results have at least two implications. First, they generally support the position of Laffer (1976) and (1976) that devaluation does not improve the trade balance but improves the balance of payments. The residuals of the trade balance equations excluding the exchange rate are on average positive in the year following devaluation. In isolation this results implies that the trade balance "improves" but the positive residuals in that years are smaller in magnitude than the negative residuals in that year of devaluation. The second implication is the essentially monetary nature of the adjustment to devaluation. While many have suggested that devaluation will be accompanied by change in real variable such as the trade balance, the present test can find little evidence of such changes. In particular, the behavior of the trade balance, combined with the tests on the monetary variable, provide little evidence of a real balance effect affecting trade. This result can be explained either by the assumption that Fiat money balance are only a small fraction of total wealth, or that there are only small reactions to changes in the value of monetary wealth.

The main result of this study is that in any case devaluation does not improve the trade balance but improve the balance of payments, by definition the capital account must be improving, because devaluation seems to cause only a simple portfolio adjustment. According to the monetary approach devaluation causes a simple excess demand for money and excess supply of bonds. The ratio of money to bond holding is then returned to its desired level through a capital account-balance of payments surplus.

Sargent (1983) considers that the fundamental reason for the exchange-rate crisis was the budget deficit. More recent works show that the problems resulted more from the accumulated debt than from the budget, since the deficit decreased sharply in the last years and equilibrium was almost reached in 1925 thanks to the 20% rise in taxes.

(Krueger, 1983) suggests that transactions completed at the time of devaluation or depreciation may dominate a short-term change in the trade balance. That is, there is an initial deterioration in the trade balance during the ‘contract period’ before quantities of exports and imports adjust. Over time, elasticities of exports and imports increase, quantities adjust to the altered effective prices, and the trade balance improves.

Williamson (1983), however, points out that higher import prices, caused by devaluation, can contribute to higher domestic prices of non-traded goods. The resulting overall inflation raises the effective real exchange rate, perhaps eliminating the potential for increasing the trade balance.

Giovannini (1988) argues that traded manufactured goods are imperfect substitutable, that's why; the idea of traded goods price equalization has been altered radically. According to the author the "law of one price" within a given industry is not expected to be held, between domestic production and foreign imports, but it might hold between the same production for domestic market and foreign market.

In this study author concentrates on the optimal pricing polices according to which, price level is predetermined. In this study, also, model is used to analyze the effect of increasing exchange rate risk, the choice of the currency of denomination of export prices, responses of traded goods prices to exchange rate changes and deviation from the "law of one price". Also, a discussion, on the effect of exchange rate uncertainty, which describes that how exchange rate risk effects both the level and the currency denomination of traded goods prices, and on the determinants of correlation between prices of traded goods nominal exchange rate has been made. In the model, the sale of output has been distributed into domestic and foreign markets. According to which there two demand functions have been estimated, for domestic and foreign markets respectively. Where total costs are an increasing function of the total output.

Main results of this theoretical analysis are, that co-movements of prices of traded goods and the exchange rate depend not only on the demand and cost parameters, but also on the stochastic process followed by the exchange rate and exchange rate makes surprise because of predetermination of the price level of traded goods. In the empirical exercise, some tests have been carried out, which isolate the role of price predetermination and ex ante discrimination in the observed deviations from the "law of one price".

There is another strong point of view, according to which large exchange rate swings (overvaluation or undervaluation) can cause hysteresis in trade when foreign firms can enter the domestic market only by incurring a sunk cost and to remain in the market only a fixed maintenance cost is required each period. In this case a temporary rise in the exchange rate, if sufficiently large, would induce foreign firms to enter the domestic market. Since entry costs are sunk, not the entire new entrants exit when the exchange rate returns to its original level and this persistent change in the market structure shifts the relationship between the exchange rate and imports.

The earlier literature that modeled trade in developing countries commonly found evidence that relative prices play a role in the determination of trade flows, buttressing policies of devaluation as a way to correct trade imbalance. Their evidence often came in the form of significant t-statistics on the relative price variable in static or "long-run" specification of Import demand or export supplies (see, for instance, Khan (1974), Ritteiiberg (1986), Bond (1987) and Marquez and McNeilly (1988)).

Edwards (1989) finds that, in most instance (the real effects in chronic high inflation countries appear to be much less), there are significant real effects one year after the devaluation; the effects, however, appear to erode completely the third year.

Baldwin and Krugman (1989), examine the feedback from entry and exit decisions to the exchange rate itself. They argue that macroeconomic constraints imply that a temporary exchange swings cannot lead, to a permanent trade surplus or deficit. The exchange rate must adjust so as to preserve intertemporal balance of payments and also according to one view might be that a temporary overvaluation will automatically be followed by a corrective undervaluation that restores the initial market position.

But according to authors this is not necessarily the case, in a particular model they consider, that a temporary overvaluation is followed by a persistent reduction in the equilibrium exchange rate, that is enough to restore trade balance but not enough to regain lost markets. The purpose of this paper is to further formalize and extend the idea that large shocks to the exchange rate can have persistent effects on international trade. The aggregate behavior of imports when there are many industries subject to potential foreign entry has also been examined.

Here a simple model of two-country framework, which considers an industry in which there is a single foreign firm capable of supplying the home country market and it is assumed if the foreign firm chooses to enter it, will be a monopolist, having a constant marginal cost in terms of the foreign currency. Large movements in the real exchange rate have been considered where the foreign firm might at some point find it advantageous to shift production to the home country and the firm's strategy depends crucially on the behavior of exchange rate. We can see from the models that there is a reasonable case to be made for persistent trade effect of large exchange rate shocks, and that this kind of trade persistence is not simply a kind of lag in the response to the exchange rate. To make the analysis more operational three main tasks have been involved. The first task is to make the models more reasonable at a micro level and the second task is to get the macroeconomic linkages better specified, according to which a decision to enter a market is a kind of investment and a decision to abandon a market is a kind of capital consumption. Finally, there is need of some ideas of how important these effects really are in practice. Here the problem is one of both technique and data. The dynamic effects are not captured by econometric assumption that behavior can be represented by continuous functions and fixed structure of leads and lags. Thus, unconventional statistical techniques may be necessary.

More recent empirical work (see Rose (1990) and (1991); and Ostry and Rose (1992)), however, has suggested that, once the time-series properties of the variables are properly taken into account in the estimation, there is little evidence that relative price have a significant and predictable impact on trade. While Rose (1990) does not model imports and exports separately, using data for 30 developing countries he finds that changes in the real exchange rate do not have a significant effect on changes in the balance of trade.

So far as the inconsistencies of stabilization policies and exchange rate policies are concerned, let us take the devaluation in case of Pakistan. It is profoundly argued on the part of policy makers' whenever they devalue, that devaluation is the most important instrument to correct external sector of the economy and especially to boost the exports (Hasan and Ashfaque (1994)).

This policy is persistently followed and used in our case but the situation is another way round because elasticities of our exports are low and imports are almost inevitable. It usually results in an increase in imports bill and decrease in exports bill due to volume effect and Marshall-Learner conditions in case of low elasticities. It is not an effective measure especially in the long run. Rodriguez (1989) questions the justification of use of a single instrument (nominal exchange rate), as it is the problem of too many targets and only one variable.

Hassan and Khan (1994), argue that if it is valid that trade balance cannot be corrected by devaluation, then, this result has an important policy implication. If exchange rate changes (devaluation) do not improve the trade balance then various IMF stabilization packages that include some exchange rate re-alignment cannot be justified.

The main objective of the study is to examine the validity of the argument exchange policy (devaluation) does not improve the trade balance using Pakistan's data. The issue of the impact of devaluation on the trade balance has been examined by specifying export and import functions along with a price equation. Because devaluation causes the domestic prices level to raise through higher import prices in rupee term.

According to the prevailing practice exports have been taken into account according to two different functions, export demand and export supply functions respectively and also have been specified simultaneously on the grounds that the relationship between quantities and prices is simultaneous in nature. Three functions in which export demand, export supply and import demand, have been estimated by using Cobb-Dougles Production function. Where export demand function includes foreign income2, relative price 3 (which is the ratio of the index of domestic prices of exports to world export prices) and nominal exchange rate and export supply function includes the domestic production of exportable 4 and relative price index 5 as explanatory variables. In the import demand

2World GDP index.

3 Ratio of the index of domestic prices of exports to world export prices.

4Gross Domestic Product.

5 This is the ratio of Pakistan's export price index to domestic price index. (Implicit GDP deflator)

domestic economic activity (GDP) relative price6 and exchange rate have been included as independent variables. Finally a price equation depending upon money Supply (M2 definition), import price and ratio of potential GDP to the last years' actual GDP is estimated. Where last variable potential GDP to the last year's actual GDP is included to capture the supply side effect.

The model has been estimated through 3SLS technique in both linear and log linear form. In case of exports of manufactured product, both (WGDP) and RP are not statistically significant with expected signs ER has positive and significant sign implying that, a devaluation of exchange rate has a positive impact on both primary and manufactured exports. In the case of supply the persistent lagged effects of price are supposed to dominate the estimated results and also the export are seemed to be influenced by the implicit price deflator. The impact of RP on manufactured goods import is negative and for raw material import is positive. An increase in the foreign exchange reserves is also having positive effect on the import demand. Parameter estimates of the general price have the expected signs with statistically significant coefficient in most cases.

6 Ratio of import price index to domestic price index.

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This paper re-examined the role of relative prices in affecting trade and therefore, implicitly, the effectiveness of devaluation policies in light of the recent time-series literature that deals with variables that have unit roots and no well-defined limiting distributions.

Ariel Burstein at.al (2003) argue that the primary force behind the large fall in real exchange rate that occurs after large devaluation is the slow adjustment in the price of non-tradable goods and services. Their empirical analysis is based on data from four large devaluation episodes: Mexico (1994), Korea (1997), Brazil (1999) and Argentina (2001).

They argue that that slow adjustment in price of non-tradable goods and services is not the failure of PPP for goods that are actually traded. They constructed an open economy general equilibrium model that can account for the slow adjustment in non-tradable good prices after large devaluation. To simplify their analysis they focus on rationalizing a post devaluation equilibrium in which non-tradable good prices do not change.

In reality prices do change these prices do change, albeit by far less than the exchange rate, the price of imports and exportable, or the retail price of tradable goods. Modeling the detailed dynamics of non-tradable good prices is a task that they leave for future research.

CHAPTER – 3

METHODOLOGY

Introduction:

Adequate and reliable data is very important for a consequential analysis. So, there should be some reliable data source for these purposes because precise and most relevant form of the data is the basic part of the research. Furthermore, the data must be thoroughly checked to ensure its adequacy and consistency before performing the intended analysis. We have done our utmost effort for the collection of reliable and consistent data set for our desired research. As the nature of our study depends on macroeconomic variables so those variables are used which are aggregative in nature. We have used time series data set for Pakistan and rest of the world for the time period (1972-2010).

Effect of Devaluation:

Appropriate methodology is important to draw meaningful result. Therefore keeping in view the literature, a model has been developed to analyze relationship between devaluation, exports and imports. So, in order to examine the impact of devaluation on the trade balance we need equation for exports and imports. However, it is generally argued that devaluation causes the domestic price level to rise through higher import prices in rupee terms. We, therefore, also need a price equation, which will feed into the export and import equations.

3.3 DATA SOURCES

For the present study, data has been taken from the various sources that provide Information on economic variables. These sources are International Financial Statistics (IFS)1, September 2005's issue, Economic Survey2, 2006’s issue, State Bank Annual Report3, Year Book of International Trade Statistic4, 2005's issue and some data series on general indices from the World Development Indicators (WDI)5 2006's issue.

3.4 VARIABLE DESCRIPTION.

Definition of the Variable and the description of their construction according to which they have been constructed are given below:

3.5 Index Number:

"Index Number is a quantity which shows by its variations, the changes over time or space of a magnitude, which is not susceptible either of accurate measurement in itself or of direct valuation in practice"

1(IFS) "International Financial Statistics", is published annually by International Monetary Fund.

2 Economic Survey is published annually by Ministry of Finance, Pakistan

3 State Bank annual report is published by State Bank of Pakistan.

4 Year Book of International Trade Statistic is published annually by United Nation Development Program.

5 (WDI) "World Development Indicators", is published by World Bank.

Many of the variables have taken in the form of indices or unit value.

3.6 Indices or Unit Value:

Indices of some variable have been calculated by taking year 1995 as base year. In the Variables which have taken in the form of indices, World Gross Domestic Product, World Exports, World Imports, Pakistan Imports, and Pakistan Exports are included.

3.7 Relative Prices:

Relative Price for domestic export demand function has been estimated by taking ratio of the unit value of the prices of domestic exports to the unit value of the prices of world exports, for domestic export supply function by taking ratio of the unit value of the prices of domestic exports to the implicit GDP deflator and for domestic import demand function by taking ratio of the unit value of the prices of domestic imports to the implicit GDP deflator.

Structural adjustment in most developing countries has been built on the twin application of economic liberalization and currency devaluation. Since currency devaluation may create inflationary pressures even as it may provide some positive effects on a country's trade balance, the critical issue is what effects dominates.

3.8 Real GDP, World GDP (WGDP) and Money Supply:

Variable of real GDP, WGDP and money supply has been estimated by deflating the nominal values of GDP, Money Supply by implicit GDP deflator and world GDP has been taken as an index from IFS, which is deflated by world inflation rate.

To improve external competitiveness, exchange rate policy is considered as an important tool of any adjustment effort. It is considered that a nominal devaluation in the exchange rate will result in less expenditure on the imports and an increase in the domestic production. As a result of which exports are increased and an improvement of external accounts of the country is observed.

Using a standard econometric model, we estimate these effects for Pakistan.

3.9 Model Specification:

The Marshall-Lerner condition brought about by Alfred Marshall and Abba Lerner in the early 1950s has been one of the most used approaches in both traditional and contemporaneous international trade literature. This famous condition postulates that if the initial trade balance is zero and if supply elasticities are infinite, then, the absolute values of both import and export demand elasticities must be at least high enough to sum to unity in order to have a devaluation generate a surplus in the balance of payment. In other words, if the absolute values of the demand elasticities of import and export add up to more than one, then an exchange rate devaluation would lead to an improvement of the Trade balance.

In this same context, if a country’s currency is devalued (depreciation) relative to its partners currencies, then its export prices become cheaper, while its import prices rise. Initially, since consumers take time to adjust their preferences from imported to domestically produced goods, we could expect little change in import and export demanded. Foreign consumers will also take time to adjust from domestic to exported goods. Hence, if this was the case, then we would expect the trade balance to worsen as the value of exports would decline while the value of import would rise. In other words, after devaluation, in the short run, the trade balance worsens as deficit increases; in the long run, when preferences are adjusted, the trade balance improves as the deficit shrinks: this reflects the J-curve phenomenon.

According to the elasticities framework, devaluation improves a country’s balance of trade when the Marshall-Lerner condition is satisfied, i.e., when the sum of the import demand elasticities of the two trading partners exceeds unity. In the absorption methodology, however, the elasticities do not matter, and the trade balance improves only if the nation’s GDP increases faster than domestic spending. In the monetary approach, by contrast, only money demand and supply matter, and devaluation always improves the trade balance.

In specifying an export function the prevailing practice has been to specify an export demand or export supply function. However, following Goldstein and Khan (1978); Balassa et al. (1989); Khan and Saqib (1993); Khan and Khanum (1994) and Hassan and Khan (1994) we specify export demand and export supply functions simultaneously on the grounds that the relationship between quantities and prices is simultaneous in nature.

The export demand (Xd) function is specified to depend upon foreign income, relative prices Rp(xd) and nominal exchange rate variables (OER). The world GDP index (WGDPI) is used to represent foreign income while the relative price variable is defined as the ratio of the index of domestic price of exports (UvPx) to world export prices (UvWx).

Rp (Xd) = UvPxi/UvWx

Where Rp(xd) is relative price of export demand function, (UvPx) is Unit value of Pakistan exports and (UvWx) is Unit value of world exports.

Using the Cobb-Douglas functional form export demand function is specified as:

Xdi=A WGDPI1 UvPxi/UvWx2 OER3 ev………………………….(1)

Where Xdi real value of exports demanded; and A is efficiency parameter.

By taking logarithmic transformation to linearise Equation (1) we have

ln Xdi=ln A +1 ln WGDPI+2 ln UvPxi/UvWx +3 lnER +V ………(2)

Where 1 , 2 and 3 are respectively foreign income, relative price of exports and exchange rate elasticities. It is expected that 1 > 0, 2 < 0 and 3 > 0.

The supply function of exportable (XS) is specified to depend upon domestic production of exportable and relative price variable. The real gross domestic product (RGDP) is used to represent domestic production of exportable and relative price of exportable is supply function Rp(xs) defined as the ratio of unit value of Pakistan's export price to domestic price index (implicit GDP deflator).

Again Using the Cobb-Douglas functional form export supply function is specified as:

Xsi=B RGDP1 Uv Px/P2 ew. …………………………..…………….(3)

Where Xsi real value of exports supplied; and B is efficiency parameter.

By taking logarithmic transformation to linearise Equation (3) we have

ln Xsi=ln B + 1ln RGDP+2 lnPxi/P+W .…………………..……..(4)

Where 1, and 2 are respectively real domestic income and relative price elasticities. It is expected that 1 > 0 and 2 > 0. Assuming equilibrium in the export sector we have

Xdi= Xsi=XI

The import demand function (Md) is specified to depend upon domestic economic activity, relative prices (Rp), foreign exchange reserves (FERC) and exchange rate (OER). Domestic economic activity is represented by real gross domestic product (RGDP) and we expect that higher economic activity would lead to higher demand for imports.

The relative price variable of Import demand function Rp(Md) is defined as the ratio of unit value of Pakistan's imports (UvPM) to domestic price index (Implicit GDP Deflator). A priori, we expect that higher relative price would discourage imports. As regards foreign exchange reserves, it is well known that in a developing country like Pakistan import restrictions are usually imposed depending upon the country's foreign reserves position. An improvement in the foreign exchange reserves is likely to lead to a relaxation of import controls and consequently results in higher imports. Finally, the exchange rate depreciation (devaluation) would increase the price of imports and consequently imports would decline.

By Using the Cobb-Douglas functional form import demand function is specified as:

Md = Y RGDP 1  Un PM /P  2 FER 3 OER 4 ek………………..…5)

Where Md real value of exports demanded; and Y is efficiency parameter.

By taking logarithmic transformation to linearise Equation (6) we have

ln Md = ln Y +1 ln RGDP + 2 ln  Un PM /P  +3ln FER +4 ln OER +K….(6)

Where 1, 2, 3 and 4 are respectively real gross domestic product, relative price, foreign exchange reserves, and exchange rate elasticities. It is expected that 1 > 0, 2 < 0, 3 > 0 and 4<0.

Finally, we need a price equation such that the impact of devaluation through higher import prices can increase the domestic price level which may, then, alter the relative prices in the import and export equations. The price equation is specified to depend upon money supply (M2 definition), import prices and the ratio of potential GDP to last year's GDP. The last variable is included to capture the supply-side effect i.e. an improvement in the supply of goods would put downward pressure on the price level.

P = Z M21 Uv PM2 (RGDP / RGDP(-1))3 eq ……………………….7)

Where P is the domestic price index (Implicit GDP Deflator); and Z is efficiency parameter. By taking logarithmic transformation to linearise Equation (7) we have

ln P = 0Z+ 1 ln M2+ 2 ln Uv PM +3 ln (RGDP / RGDP(-1)) + q……8)

A priori, we expect 1 >0, 2 > 0 and 3 < 0.

Thus, to examine the impact of devaluation on the trade balance we estimate equations (2), (4), (6) and (8).

3.10 Marshall/Lerner Condition

According to it, currency devaluation to have a positive impact in trade balance, if the sum of price elasticity of exports and imports (in absolute value) is greater than 1. This principal was given by Alfred Marshall and Abba Lerner.

If the price elasticity of export goods is high then their demand will also increase and it will increase the exports revenue. Similarly, if goods imported are price elastic, total import expenditure will decrease. Both will improve the trade balance. So, the net effect on the trade balance depends on price elasticities. Empirically, it has been found that goods tend to be inelastic in the short term, as it takes time to change consuming patterns. Thus, the Marshall-Lerner condition is not met, and devaluation is likely to worsen the trade balance initially. In the long term, consumers will adjust to the new prices, and trade balance will improve. This effect is called J-Curve effect.

In order to understand the implications of devaluation policy and its impact on the trade deficit in Pakistan; we test the validity of the Marshall Lerner condition (MLC) in the context of Pakistan’s economy. MLC simply implies that the sum of total export (εx) and total import (εM) elasticities must be greater than one if the initial trade gap (TG) is to be balanced. In the event, if TG is non-zero then Marshall Lerner condition simply requires that the weighted sum of these two elasticities exceeds unity and thus mathematically it may be written as:

ε X.+(- εM) >1............(9)

Where weight is defined as:

=(X/M)......……........(10)

In the context of this study, the coefficients of the exchange rates in export demand Equations (2) and import demand Equation (6) represents the estimated elasticities.

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HAPTER - 4

RESULTS AND DISCUSSION

4.1 Introduction

This chapter presents the results of our estimation. The results are obtained by estimating equation (2), (4), (6) and (8) stage least squares (3SLS) 'technique based on E-views version 3.1. In genes techniques are preferred over OLS and 2SLS because we estimated equation simultaneously. Although there is deficiencies of 3SLS like if the model is misspecified, the error from one equation may over flow to other equations in the system and estimated coefficient may be biased. The other technique is Generalized Method of Moments (GMM), which have the same properties as 3SLS estimator1.

We estimated equations using log linear form. The estimated 3SLS regression results of the model and the instrument set used are reported in Tables below:

4.2 Effects on Exports Demand and Supply:

Table (5.1) shows the results of export demand while Table (5.2) represents export supply. The estimate coefficient for the index of World GDP has negative sign and is insignificant. This shows that WGDP increase may increase the demand for our exports, however this increase is insignificant. The coefficient of relative price is positive and highly significant which is contrary to the expected negative sign. This may be due to Value added commodities in our exports, which are demanded even at higher prices when exported in manufactured form like export of garments instead raw cotton and raw fabrics. Exchange variable in the export demand function has positive but insignificant coefficient implying that a devaluation of exchange rate has a positive impact on total exports of Pakistan. In terms of actual value of the coefficient, it indicates that one percent depreciation in the exchange rate may lead to a 0.02 percent increase in export demand, which is very low and insignificant.

Table 4.2: Estimates of 3SLS regression results of Equation 2, Dependent Variable LNXD

Variable

Coefficient

t-value

Constant

1.14

11.26

LnWGDP

-0.05

-1.39

LnRp(Xd)

0.91

9.39

LnER

0.02

1.42

R-Square = 0. 99 D. W = 1.38

4.3 Effect on Export Supply:

Table (5.2) presents the export supply equation. An increase in the real GDP has positive and significant impact on overall export supply. An increase in implicit GDP Deflator has positive and significant impact on export supply. This shows that the export supply seems to be influenced by the implicit price deflator. The lag effect of export supply is positive and significant, it means, that overall export supply is consistent and follows the trend pattern based on past.

Table-4.3: Estimates of 3SLS regression results of Equation 4, Dependent Variable LNXS

Variable

Coefficient

t-value

Constant

-4.86

-4.35

LnRp(xs)

-0.60

-10.85

LnRGDP

1.06

6.27

LnP

0.54

4.61

LnPX(-1)

0.25

2.58

R-Square = 0. 97. D.W = 0. 64

4.4 Effect on Import Demand:

Table (5.3) shows the estimates of Import Demand function. It is observed that GDP have negative and insignificant impact on overall import demand, which is quite contradictory to general economic theory. Similarly foreign exchange reserves have negative and insignificant effect on import demand. The impact of relative price index of imports is positive and significant. This positive impact may appear to be contrary on theoretical grounds; however, it can be justified on a more pragmatic base. Imports of essential commodities like petroleum, edible oil, machinery and tea etc. are major part of our imports even if their prices are increasing overtime. The estimated coefficient of exchange rate is negative and significant implying that a devaluation of the Pakistani rupee may have decreased the overall demand for imports.

Table-4.4: Estimates of 3SLS regression results of Equation 6, Dependent Variable LNMD

Variable

Coefficient

t-value

Constant

2.79

2.14

LnRGDP

-0.26

-1.45

LnRp(Md)

0.49

6.36

LnFER

-0.04

-1.35

LnER

-0.36

-4.35

R-Square = 0.59, D.W = 0.99

4.5 Effect on the Domestic Price:

Parameter estimates of the general price in equation (8) are presented in Table (5.4). These results show that one percent increase in money supply brings about 0.29 percent increase in the general price level. The relative prices of imports have positive and insignificant effect in the general price level in Pakistan. The low value of coefficient of relative price of imports shows that import prices do not contribute much in the overall increase in general price level of Pakistan. Past behavior of prices as shown by the variable InP (-1) is positive and highly significant. This shows that instead relative price of imports or in general the trade balance having any effect on general price level in Pakistan, the domestic trend influences more the general price level.

Table 4.5 Estimates of 3SLS regression results of Equitation 8, Dependent Variable LNP

Variable

Coefficient

t-value

Constant

1.46

4.17

LnM2

0.29

5.97

LnPM

0.006

0.26

LnUnPM

0.09

2.68

LnP(-1)

1.10

6.14

R-Square =0.99, D. W = 0.57

4.6 Marshal Lerner Condition:

In order to find Marshal Lerner Condition the coefficient of the exchange rate in the export demand equation and import demand equation represents the elasticities of exports and imports. As in the event, if the trade gape is non-zero then MLC requires that weighted sum of these two elasticties exceed unity as written in equation (9). Given the estimated export and import elasticities, we compute MLC for the year 2004 as follows:

MLC = ε X.+(- εM) >1where = (X / M); X and M shows the value of exports and imports (for the year 2004 for our purpose).

MLC = (0.02) (12.94/13.133)+ (-0.36)

MLC = 0.01+-(-0.36)

MLC = 0.37 < 1

Thus, the above estimated results do not support MLC for Pakistan in the year 2004 Implying that a policy of-devaluation may result in a deterioration of balance of trade.

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HAPTER – 5

SUMMARY & CONCLUSION

The purpose of this study has been to examine the impact of devaluation on the exports and imports of Pakistan. The policy of devaluation is generally criticized in the less developed small open economies on the ground that both imports and exports of small open economies are less elastic and devaluation may not improve the overall trade balance in theses countries. We tested this notion using Pakistan’s time series data for the year 1972 to 2004. Our results show that both the exports and imports elasticities with respect to exchange rate are low and sum of theses elasticities is also less than one, thus not fulfilling the Marshal-Lerner condition in term of improvement in the balance of trade through devaluation. We used export demand function; export supply function and general price level equation to examine the effect of devaluation. It is observe, through the estimation of these equations, that devaluation does not improve the trade balance of Pakistan. The elasticities of exports and imports are estimated and found to be low during the period of analysis. The Marshal Lerner condition has been tested and found to be less than one, thus not fulfilling the purpose of devaluation i.e. improvement in the trade balance. Further results suggests that an increase in the relative prices of imports do not discourage imports of Pakistan, as Pakistan is being a small open economy is dependent on the imports of some essential items like oil, edible oil and some food items. Also an increase in the real GDP and foreign Exchange reserves have no contribution in affecting the imports of Pakistan and signs of their coefficient are found quite contradictory to the general economic theory. The reason may be given in term of stagnant behavior of importers even if GDP and foreign exchange reserves are changing in case of Pakistan economy.

The demand of our exports is influenced by the relative prices of exports and this is justified on the basis of Pakistan being a small open economy. Also the change in the world GDP index does not influence much the exports of Pakistan as Pakistan‘s exports commodity composition as well as market diversification is stagnant is over the last years as there is no improvement in these sectors.

These results are important and may be crucial policy implication in term of exchange rate policy of the government.