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Misinterpretations regarding exchange rate
By: Dr. Sajid Amin Javed
Movements in exchange rate have far-reaching socio-economic impacts. Exchange rate fluctuations not only affect the export competitiveness, imports and debt profile of the country but also the spending on health and education as well as long-term saving and investment decisions of households. Furthermore, movements in exchange rate, through affecting labour wages and cash deposits, may also contour patterns of income inequality and poverty. Despite this diverse range of effects, movements in exchange rate are seldom noticed in Pakistan and the associated debates, if any, are predominantly limited to the macro level effects of it. On the policy side, a perception prevails among the majority including highest levels of policymakers that a strong rupee points to a better economy. Exchange rate policy of the country, therefore, remained motivated to ensure a strong rupee. So is the case presently.
The State Bank of Pakistan (SBP) has a stronger role to play to ensure an informed exchange rate policy. The SBP, as the custodian of exchange rate, must act not only to ensure the stable exchange rate for rupee avoiding large fluctuation but also guarantee that the exchange rate for rupee is reflective of economic fundamentals of the country and does not hamper the international competitiveness of local goods and services. SBP needs to initiate the awareness that a strong rupee is not necessarily good for the economy.
A currency overvalued artificially (through non market forces)may initially sound good as it increases the purchasing power of common man because one rupee can now buy more goods. However, it might halt the country’s exports, as they are now more expensive in foreign markets. This may result in the gap being filled by another country supplying the same good but at lower prices resulting in loss of exports for the economy with overvalued currency. Another implication is increased imports to the country, which will further increase the current account deficit.
Governments may overvalue a currency artificially by interfering with market forces and managing the supply and demand of Rupee or US dollar (or any other currency) for political or economic motives. These may include the ability to influence purchasing power of people to lower or avoid debt accumulation or to showcase strong economy through strong rupee. Such behaviour generates political gains in the short run as the government may claim improved purchasing power of citizens, which makes goods and services less expensive for domestic consumers. This also favours importers as it makes imports cheaper. The incentives are particularly higher for businesses selling the final products in local market. Exporters, unable to compete internationally with more expensive goods, lose out however.
An appreciation in the currency, therefore, increases trade deficit. Pakistan presents an example. According to the IMF, with 17% increase in the value of rupee against dollar, Pakistan’s trade deficit had widened to $ 2.1 billion in December 2015 due to 16.8% reduction in exports and 0.3% growth in imports. The recent fall in exports from US$15.98 billion in first eight months of 2016 to US$14.3 billion caused a fall in trade balance (which is one of the components of current account aside from primary and secondary income balance). One of the major reasons behind this fall in exports is roughly 17% appreciation in the value of rupee during the period.
On the other side, depreciation may sound unwanted in the short run but it benefits to the country in the long run. For example, it increases exports, decreases imports and thus reduces trade deficit. However, debt accumulation is a powerful deterrent to this action. Countries ridden with huge debt face this problem. According to a news report published in a section of press on 20th July 2013, PML-N government increased national debt by Rs 160 billion due to rupee depreciation of about two to three rupees (the dollar appreciated to Rs 100.8 from 98.50) in a single month.However, a devalued currency can lower debt to GDP ratio in the long run through lowering the current account deficit outweighing the short run loss from debt accumulation.
Increased exports, in turn, generate income and employment opportunities. The impact may vary across countries, but, in general, the demand increasing impact of depreciation is stronger. People get jobs; earn more and real purchasing power increases. An overvaluation of currency may sound good initially but it hurts the domestic buyers through relatively higher increase in prices of non-durables say clothing and food because of higher demand in local market. This raises the cost of living. At the same time, it lessens the job opportunities through reduced exports and may lower the income of people.
Exchange rate movements are also strongly linked with the level of domestic savings through affecting saving behaviour of households. An increase in the value of local currency(appreciation) encourages domestic residents to spend abroad which lowers the domestic savings. Conversely, higher domestic savings are associated with depreciation of local currency. This leads to higher profits in tradable goods and services resulting in higher investment in the export sector.Similarly, a fall in the value of currency increases demand for exports. Additional investment is made in the production of exports to accommodate stated demand. In this context, exchange rate fluctuations can and do alter level and patterns of investments.
Depreciation increases exports, which generate demand for additional labour and thus jobs and, by extension, generate additional economic activity. Let’s not forget that a fall in the value of currency may also reduce employment as real wages of labour decline, which reduces aggregate demand, slowing the economic activity. Demand expansionary effect of depreciation is however stronger. It is important to note that if the new employment opportunities are created more for low skilled or unskilled labour, income shifts to poor households, decreasing income inequality. The case may be other way round also. In either case, exchange rate movements affect patterns of income inequality.
Social effects of exchange rate movements are unevenly distributed and need a careful examination. For example, depreciation of currency, increases exports which may increase the demand for labour. But this increase in demand for labour may be higher in one particular sector of economy as compared to other sectors. For example, if the country exports industrial products, the demand for labour in this sector increases. Wages of the labour working in this sector increase while those of working in other sectors such as agriculture remain unchanged. Consequently, wage inequality rises. The same effect may also be based on currency held with households. Rich households may keep deposits in foreign currency such as US dollar. Depreciation of rupee will increase the value of deposits as US$1, while the value of deposits held in local currency erodes. It is in this context that exchange rate fluctuations have far reaching social implications.

Source: http://tribune.com.pk/story/1211220/misinterpretations-regarding-exchange-rate/ 

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The opinions expressed in this article are the author's own and do not necessarily reflect the viewpoint or stance of SDPI.