Devaluation – arguments for and against

Introduction:Appendix 9.2 includes 3 articles, 2 of these were written a few days before 28 October 1995’s devaluation, and one immediately after 12 September 1996’s devaluation. These 3 articles examine the pros and cons of devaluation, analyzing its impact on the economy. The following section presents main summary of these 3 articles.

Theme of Articles:Devaluation is a controversial topic for an economy. Some economists speak in favor of it and others says it does not solve problems of an economy, instead it adds fuel to fire and worsen the issues.First few paragraphs are explaining the situation in country, how various rumors and talks about the expected devaluation of Pak rupee against US $. And the behavior of Bankers, Currency analysts, Importers, SBP authorities, and Governor’s towards these rumors. A brief trend of previous devaluation has also been discussed.Most of the analysts gave some reasons, which explained why the devaluation was mandatory. They say that there is a need for devaluation because of the (1) continued widening of the trade gap, (2) the fall in foreign exchange reserves, (3) and mounting inflationary pressures. But the actual figures indicate that the trade and current account deficits, for instance, have both been falling not over the last few years, not widening. These two deficits are closely related with the exchange rate, and there trend has been downward, which signals no need for current devaluation. And foreign exchange reserves are also rising since 1990 not falling, again devaluation is not required.

Inflation is the only reason on which analysts are right but for the wrong reasons.High inflation in one trading country as compared to the other makes the real exchange rate to deteriorate and creates a need to devalue the nominal exchange rate. Because, Real Exchange Rate is the Nominal Exchange Rate times Relative inflation; if inflation goes up, the nominal exchange rate has to be adjusted to maintain the value of Real Exchange Rate. Pakistan’s inflation rate is higher than its trading partners, but devaluation on these grounds would only add fuel to the fire. Pakistan’s inflation is currently around 14.8 and devaluation would prove to be inflationary and further worsen an already bad price situation.The main reason in favor of Devaluation is that it will make our exports more competitive by bringing their prices down and it will ultimately result in an increase in exports, and increased volume of foreign exchange earnings. But many economic analysts think that exports may not be price sensitive and they may b affected by non-price factors. And if in case exports do increase, the price of imports will also rise at the same time… and for a country like Pakistan whose imports are greater than its exports, it can be disastrous. Some analysts gave another argument that the value of Indian rupee has fallen, and this move is done by Indian govt. especially to discourage the Pakistani export commodities in international markets. This claim is illogical; firstly, because Indian goods are not directly comparable to Pakistani exports and nor are they perfect substitutes, and secondly the devaluation seen in Indian rupee was temporary, where rupee fell to 35 per dollar for only a short period and then again stabilized at around 33.80.Most governments hate to devalue because in the short run there are more losers than are gainers. Imports and locally produced import substitutes become expensive after

devaluation hence boosting the inflation. And only a few exporters benefit from devaluation. In Pakistan, Governor of State Bank sets the value of rupee in view of supply and demand for other currencies, if he misreads the signal and devalues the result is inflation and extra debt burden. And if he over values the currency, it overvalues exports and undervalues imports, resulting in a trade deficit. More reliable rates are domestic and international inflation rates and the fiscal and trade deficits. Pakistan’s inflation rate is high and its fiscal and trade deficits are increasing, trade deficit has gone up to $3.5 billion, and reserves are already low. If in this situation Pakistan borrows from international money lenders like IMF or World Bank, they will demand heavy premium, which further increases the debt burden. So a justification in favor of devaluation is that, what a Governor needs is a policy that reduces our expenditures and increases our earnings ad a sizeable devaluation is such a policy measure. It sends a strong signal to domestic buyers that imports are expensive so avoid them. And it sends a message to foreign buyers that Pakistani exports are cheaper, come and buy them. This brings down the trade deficit and releases the pressure on reserves, and now Pakistan can borrow from IMF and World Bank on low rates.The third article provides solid evidence that there is no need for further devaluation and there is no point in saying that Pakistani rupee is currently overvalued. And Pakistan’s current account deficit is consistent with the fact that being a developing country, we are net importer of capital. The formula, relative price index divided by NEER is a measure used for getting Real Effective Exchange Rate, and Pakistan’s NEER is 405 and the Relative price index is 241… which suggest that Pakistani rupee is already undervalued, so there is no need for further devaluation.

Critical Analysis:

Devaluation always has some short run costs such as an increase in the international debt burden and general reduction in the standard of living. The real culprit in Pakistan’s case is high domestic inflation which has raised the costs of production, including the high interest rates.

My Point of View:Yes after reading the 3 articles that devaluation has more demerits than merits. And especially Pakistan who is net importer of capital, devaluation will increase the prices of imported capital, required for industry. Exports are already low, so inflation will further worsen the situation by also increasing the prices of domestic import substitutes and will boost the inflation.

Conclusion:Conclusion after reading the above literature is that no devaluation is required in developing country like Pakistan. Because many analysts believe that exports are not only influenced by price but also heavily influenced by non price factors, such as Quality and etc. so devaluation will not result in increased exports and decreased imports, but it will ultimately result in heavy inflation.