Weakness in balance of payments (BoP) can amplify the adverse effect of external shocks on the rest of the economy.

However, under normal situations, a weakness in the BoP should not persist. As is the case with most markets, the exchange rate should adjust in response to imbalances thus stabilising the BoP.

This is not the case when the country is pushed into a currency crisis. Allowing the economy to adjust freely can cause significant welfare losses for households. Therefore, most often governments borrow from international institutions (e.g. the IMF) to meet international financial obligations and to ward off currency speculation by building reserves.

However, while government intervention dampens potential business-cycle fluctuations, hindering the exchange rate adjustment process also results in overvaluation of the domestic currency.

Consequently, by making exports expensive and imports cheaper, the exporting sector suffers at the benefit of the importing sector. This causes weakness in the BoP to persist. The country continues to return to international debt markets in a vicious cycle.

This is precisely what ensued after the currency crisis of 2008. Following an increase in world commodity prices, the current account deficit increased from $6.8bn in FY07 to $13.8bn in FY08. Consequently, the SBP’s gross reserves decreased from $15bn in FY07 to $9.5bn in FY08. Dwindling reserves led to currency speculation thus forcing the then incoming government to negotiate a $7.6bn bailout package with the IMF.

Another spell of increasing commodity prices, together with loan repayments, led to a similar episode between FY11 and FY13. The SBP’s gross reserves fell from $16.6bn in FY11 to only $7.2bn in FY13.

A bailout agreement of $6.6bn was again signed with the IMF by the present government. Since then, the government is reported to have borrowed around $25bn in foreign loans in its efforts to finance international obligations and maintain adequate foreign reserves.

However, there was an unintended consequence. Both these episodes were coupled with appreciation of the real effective exchange rate (REER).

After remaining stable over the preceding few years, REER appreciated by approximately 9pc from FY09 to FY12. The second round of REER appreciation started in FY14. Reflecting the intensity of foreign currency borrowing, REER has appreciated by 25pc since FY14.

It is no wonder that exports have continued to decline. Persistent slowdown in the world economy since the 2008 financial crisis — another factor driving REER appreciation — only made the adjustment process more difficult.

Even though the global economy has now started to show signs of recovery, falling remittances and a rising import bill under CPEC means that the cycle is not yet broken. Trade deficit, during the first half of FY17, has increased by 21.8pc compared to the first half of FY16.

Government intervention to pull the country out of the 2008 currency crisis has resulted in significant redistribution of resources away from the more productive exporting sector towards the less productive domestic economy.

How does one correct for this resource misallocation without letting the economy drift back into a crisis?

Addressing this question is also important for another reason. A resource misallocation which shifts resources away from the more productive sector towards a less productive sector can only be detrimental for the long-run economic prosperity of this country.

There are two broad policy options. The first option is to adopt a loose monetary policy. While a loose monetary policy can be used to dampen the effect of foreign currency borrowing on exchange rate, it cannot do so without compromising the ability to achieve price stability. Worse still, the resulting drop in foreign exchange reserves at domestic financial institutions will be counter-productive.

The most effective way to correct this misallocation of resources will be by facilitating the exporting sector through both financial incentives and trade-related structural reforms (the second option).

Part of the revenue generated from taxing the domestic economy must be spent to restore the competitiveness of the exporting sector in the international market. This can be done in the form of tax incentives, subsidies and ensuring the timely release of tax refunds.

However, focusing on incentivising exports alone is not enough. With the increasing importance of global supply-chains in international trade, imported intermediate materials is an important component of exported goods.

Even small barriers within a given supply-chain can cause large disruptions. An effective export promotion policy will, therefore, facilitate the whole supply-chain which includes incentivising import of export-oriented intermediate materials and production technology.

— The writer is a teaching associate at the University of Bristol, UK.
ajpirzada@hotmail.com.

Published in Dawn, The Business and Finance Weekly, May 22nd, 2017