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Balance of Payments Constrained Growth in Pakistan
While there are many positive and negative aspects of Pakistan's economy, the one thing that no observer of the economy can deny is its predictability. A balance of payments crisis forced the government to enter into an IMF stabilization package a decade ago as did another crisis five years ago. Now, again, the country is faced with an unsustainable balance of payments crisis and is on the brink of another stabilization program.
While there is a tendency to blame the different policy makers, we feel that this ignores the fact that the problem is not simply one of policy-making. Rather, the problem is a structural issue in the economy which if left unaddressed will lead to a continuation of the cycle of balance of payments crises. In order to address this issue, the researchers at the Lahore School of Economics conducted research on the theory that Pakistan is trapped in a situation of balance of payments constrained economic growth. The idea behind this research is that because of the structure of Pakistani exports and imports, there exists a maximum growth rate in the country above which Pakistan always faces a balance of payments problem.
More specifically, because of the narrow Pakistani export base (concentrated on low value-added textile exports) and a relatively inelastic import base, as the GDP growth rate of Pakistan exceeds a threshold value imports rise to unsustainable levels while exports only increase marginally. This leads to a balance of payments crisis which is addressed by the usual troika of policies: devaluation, monetary contraction and fiscal contraction. While the narrow export base and the composition of imports provides an explanation for the reoccurring balance of payments crisis, the objective of this research was to calculate the balance of payments constrained growth rate of Pakistan. In order to do this, one must estimate the Pakistani export and import functions and also decompose the Pakistani growth rate.
The Lahore School researchers found that Pakistan's exports were relatively sensitive to foreign income but less so to the real exchange rate which leads to the conclusion that export demand has come more inelastic with respect to foreign income which may reflect the fact that Pakistan exports tend to be lower value-added goods whose demand may respond less to changes in foreign income. Also, their results reflect the relative inelasticity of exports with respect to prices, which may again reflect the low-value added nature of Pakistan's exports. So the researchers concluded that the recent rounds of devaluation will not significantly increase exports. The researchers also estimated the import demand function for Pakistan which indicated that Pakistan's imports have become less sensitive to changes in domestic income over time, and have remained as sensitive as before to changes in prices. Again this shows that only extreme devaluations will increase impact of imports.
Next, the researchers used the estimated import and export demand models to forecast what will happen to imports, exports and the current account under different exchange rate and growth rate scenarios for the next 2 years. This simulations showed an improvement in the current account due to a significant decrease in imports and not a significant increase in exports. This makes sense because the combined effect of an economic slowdown in Pakistan with the fall in the value of the rupee leads to a much higher impact of imports than on exports which are relatively price inelastic.
In the end the researchers presented an argument that there is a major structural problem in the Pakistani economy that relates to the export sector. In particular, the researchers believe that the less sophisticated, low value-added exports that Pakistan has focused on has led to a threshold growth rate in the economy. If the growth rate in Pakistan exceeds this threshold then imports rise to unsustainable levels while exports only increase marginally, which in turn leads to reoccurring balance of payments crises. The empirical results from this study point to a deeper point: Only if Pakistan fundamentally change the nature of the goods it exports will it be able to break out of this cycle of balance of payments crises. A shift towards higher value-added exports characterized by greater income and prices elasticities are the only realistic way for Pakistan to realize sustained levels of higher economic growth.
This research was carried out by Dr. Azam Chaudhry, Dean & Professor, Faculty of Economics, Lahore School of Economics and Gul Andaman, University of Malaya.