There are four aspects of the exchange rate that all Herald readers should understand.*

First, the exchange rate is a price and not a flag. A flag needs to be defended at all cost. Not the exchange rate, which simply tells you how many Pakistani goods foreigners can buy and how many imported goods Pakistanis can purchase for their US dollars and rupees. If the rupee falls, foreigners buy more Pakistani goods as do Pakistanis because imported goods become more expensive. Both create employment in Pakistan and, given the high population growth, employment is our number one challenge.

Second, an overvalued exchange rate makes the economy sick. It is called the Dutch disease. In the late 1950s, the Netherlands discovered natural gas. This raised the value of the guilder (the Dutch currency before the euro) and Dutch manufacturing became uncompetitive and thus declined. In all of South Asia, including Pakistan, the Dutch disease is caused by remittances that prop up the value of currency even though South Asians run large trade deficits (we import more than we export). Thus, manufacturing and exports all over South Asia are weak.

In Saudi Arabia and Iran, both with weak manufacturing exports, the Dutch disease is caused by large oil and gas surpluses. They would be much better off if they managed their energy surpluses to avoid the Dutch disease, and created productive employment in manufacturing rather than fueling sectarian battles.

Third, an undervalued currency (a weak rupee) can be a good thing. By making imports expensive, it discourages consumption and encourages saving and investment. China’s initial growth at the start of this millennium was spurred by a highly undervalued yuan. China was merely emulating East Asian economies that had undervalued their currencies a couple of decades earlier to capture foreign markets. Undervalued currencies reflect that investors/exporters dominate the economy. On the other hand, overvalued exchange rates in South Asia imply that consumers, fed by remittances and politically motivated foreign aid, are king.

One creates factories, the other spawns premature shopping malls. Readers can judge for themselves whether the rupee is over or undervalued based on the relative proliferation of factories and shopping malls in Pakistan. Peshawar is a good example. The appreciating exchange rate policy has further exacerbated problems associated with deteriorating security and distorted taxes. Manufacturing has virtually disappeared while spending on consumption, transport and real estate has gone through the roof.

Fourth, what matters far more for the economy is the real exchange rate than the observed market rate. If the rupee/yuan market rate is unchanged but our inflation is higher than China’s, the real value of the rupee has appreciated. This is a strong indication that our trade deficit with China will rise and the market value of the rupee will come under pressure. In short, the stability of the real exchange rate is more important than the stability of the market rate. Large appreciation of the latter is the main cause of our ballooning trade deficit and depleting foreign reserves because it continues to encourage imports.

To conclude, the real exchange rate has appreciated by about 20 per cent in recent years. This has fueled a huge consumption boom and a large deficit in how much money comes into Pakistan and how much of it leaves the country every year. It is more profitable to invest in shopping malls than in factories and exports. The result is that we are not progressing well towards our number one challenge: creating well-paying, quality jobs for the two million or so young men and women who enter the labour force every year. The recent devaluation of the rupee will correct the real appreciation of our currency’s value and is a step in the right direction.

*For a more technical analysis, read the excellent paper by Naved Hamid and Azka Sarosh Mir, "Exchange Rate Management and Economic Growth: A Brewing Crisis in Pakistan "The Lahore Journal of Economics 22 : SE (September 2017): pp. 73-110

This article was published in the Herald's January 2018 issue. To read more subscribe to the Herald in print.