Outward Orientation of The Economy: A Review of Pakistans Evolving Trade and Exchange Rate Policy

IJAZ NAB1

Pakistans ongoing policy reform aims to strengthen the competitive foundations of the economy and make it more outward-oriented. This paper reviews the recent trade performance and progress regarding tariff reform. Management of the exchange rate as a principle tool of trade policy is discussed. The paper also explores the potential and modalities of trade with India. (EL.: F31, F12, F13, F14,0.53)

I.

INTRODUCTION

Since the late 1980s Pakistan has put in place a broad spectrum of policies to strengthen the competitive foundations of the economy and make it more outwardoriented. The liberal investment policy passed in 1990 no longer requires government approval for new production units regardless of size, sponsor or location. The govemment is also fully committed to privatizing state-owned enterprises. Of the 51 units identified for privatization, 28 units have been offered for bidding and letters of intent have been issued in 13 cases. In the teleco~unications sector one million vouchers are being offered to the general public in the domestic market and five million in the international market. Private investors have also shown considerable interest in the energy sector in response to a well-designed policy. Perhaps the most significant feature of Pakistans liberalization is the ongoing effort to liberalize trade. The objective is to increase Pakistans share of world merchandise exports from the woefully low 0.2 percent recorded in 1992. Both tariff
ljaz Nabi * Viwing Professor, Lahore University Journal of Asian Economics, Vol. 8, No. ISSN: 1049-0078 of Management Sciences (LUMS), Pakistan. 143- I63 Copyright 0 1997 by JAI Press Inc. All rights of reproduction in any form reserved.

I, I997 pp.

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reform and exchange rate liberalization are taking place. Trade related reforms include reduction of the negative list from 300 to 75 items between 1988 and 1994; a cut of the average statutory rate from 77 to 45 percent with a further reduction to 35 percent by 1997. The highest tariff rate now is 70 percent. Much, however, remains to be done to meet the WTO time table to which Pakistan is committed. A major shift has also taken place in the old import substitution oriented exchange rate regime. Nearly all exchange controls were lifted in 1991; both foreigners and locals can open foreign exchange accounts in any bank and make remittances abroad or bring money in without seeking government permission. Pakistan has shifted from a fixed exchange rate regime to a managed float system. Apart from trade and exchange rate policies, several other trade enhancing initiatives are also being taken. The Karachi Export Processing ZONE has been established with one window operations. A Pre-shipment inspection scheme has been put in place and is currently being fine-tuned to smooth out customs inspection procedures. The duty draw back scheme (whereby exporters of manufactured goods get a refund of the duties paid on imported materials) is also being rationalized to reduce payment time and thus make more funds available to finance exports. Many policy initiatives thus have either been taken or are on the anvil to make the economy more competitive and outward oriented. This paper focuses only on four aspects. In section I, Pakistans current trade profile is drawn and some comparisons made with other countries in South and South-East Asia. The pace of tariff and non-tariff reform is assessed in Section II, in the light of Pakistans WTO commitments. A brief history of Pakistans exchange rate policy and its impact on trade is presented in Section III. Finally, Section IV focuses on regional trade and assesses the prospects and modalities of India-Pakistan trade.

II.

PAKISTANS RECENT TRADE PERFORMANCE

A summary measure of the outward orientation of an economy is the share of traded goods in GDP On this measure, Pakistan is less outward oriented compared to the rapidly growing South-East Asian economies. Pakistans traded goods account for about 35 percent of GDP compared to Malaysias 145 percent and Thailands 66 percent. Within South Asia, Pakistan is more outward oriented compared to India and Bangladesh but far less than Sri Lanka. Pakistans outward orientation has increased only slightly in recent years. In 1983 the share of traded goods to GDP was 32.4 percent. Meanwhile the dynamic ASEAN economies (Malaysia and Thailand) increased their trade share in GDP by more than 50 percent. The increase in Pakistans outward orientation has been moderate despite impressive growth in exports (Tables 1 and 2). In 1980-1993, exports grew, on average, by 10 percent which is more than three times the average growth in 1970-1980. While this export growth is encouraging in the context of South Asia, it is only moderate

Pakistan S Evolving Trade and Exchange Rate Policy

TABLE 1. 1983
Countries Malaysia Thailand Indonesia India Pakistan Sri Lanka Bangladesh Source:

145

The Importance

of Ikade 1993
Import Value (millions of US$) 45,657 46,058 28,086 22,761 9,500 4,227 4,001

Share of Imports plus Share of Imports plus Export Value (millions Exports in G.R Export in G.P oflJS$) 93% 41% 48% 14% 32.4% 58.3% 21.7% 143.96 66.36 42.64 19.66 34.81 75.96 26.16 47,122 36,800 33,612 21,533 6,636 2,896 2,272

World Development Report, 1995

TABLE 2.

Growth in Trade (Annual Average Growth Rate) TABLE

1983 1993 1981-1993 12.6 15.5 6.7 7.0 10.1 7.3 9.8 1970-1980 7.7 6.8 12.1 4.5 5.4 2.6 2.9 1981-1993 9.7 13.8 4.5 4.2 3.0 4.0 4.8

Countries Malaysia Thailand Indonesia India Pakistan Sri Lanka Bangladesh Source:

1970-1980 3.3 8.9 6.5 5.9 3.1 -1.4 -2.4

World Development Report, 1995

compared to Thailands recent average annual export growth of 15.5 percent and Malaysias 12.6 percent. The small increase in outward orientation in recent years is due to a slowdown in the growth of imports. However, the import bill still remains much larger than the export bill and Pakistan has maintained a trade deficit of approximately US $2.5 billion. A first look at the structure of Pakistans exports suggests that this has moved in a desirable direction in recent years (Tables 3 and 4). Primary commodities were 15 percent of total exports in 1993 as compared to 43 percent in 1970, and manufactured goods share has increased to 85 percent in 1993 compared to 57 percent in 1970. However, machinery and transport equipment exports (that reflect the engineering content of exports) has remained negligible compared to the impressive increases recorded by Malaysia and Thailand. Furthermore, the heavy reliance on textiles (which account for 78 percent of total exports) continues unabated. Of the seven counries listed in Table 3, only Pakistan and Bangladesh rely as heavily on textile exports. The narrow range of products exported from Pakistan can be seen in Table 3 . In recent years, eight product categories have accounted for 90 percent of total exports.

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TABLE 3.
Fuel, minerals metals Countries Malaysia Thailand Indonesia India Pakistan Sri Lanka Bangladesh Source: World Developmnt

Structure of Merchandise
Machinery & transport equip. 1970 2 0 0 5 0 0 0 1993 41 28 5 7 0 2

Exports
Other Manufacturers 1970 6 8 1 47 57 1 81 1993 24 45 48 68 85 71 -

Other primary commodities 1970 63 77 54 35 41 98 1993 21 26 15 18 14 27 18

Textilefibers
textiles clothing 1970 1 8 0 27 75 3 1993 6 15 17 30 78 52 78

1970 30 15 44 13 2 1

1993 14 2 32 7

1 1
0
Report. 1995

TABLE 4.

Structure of Merchandise
Other Primary commodities 1993 4 8 8 30 17 9 14 1970 8 7 4 19 7 4 1993 4 7 9 10 6 3 30

Imports
Machinery & Transport Equipment 1970 28 36 40 23 31 18 1993 54 45 42 14 35 21 13 Other Manufacturers 1970 31 43 45 29 35 29 1993 305 36 34 42 27 51 28

Food Countries Malaysia Thailand Indonesia India Pakistan Sri Lanka Bangladesh Source: World 1970 22 5 9 21 21 47 1993 7 5 7 4 14 16 15 -

Fuels 1970 12 9 3 8 7 3

Development Report. 1995

The heavy reliance on cotton based exports in the 1990s is seen in that they account for nearly three-quarters of Pakistans total exports. This heavy reliance is now a serious policy concern. First, world demand for cotton products is declining as opposed to demand for mixed fiber (man-made and natural) products, which is rising. Second, the cotton crop is highly prone to pests and the monsoon cycle. Heavy monsoons cause the relatively flat Indus basin to become a gigantic lake which damages the standing cotton crop. A bad cotton harvest reduces the gross domestic product. Indeed, in the last twenty years, cotton output has perfectly cradled overall GDP growth. Third, the political economy of cotton pricing has resulted in administered prices in the cotton chain, from the grower to the textile manufacturer. Such non-market pricing has made it difficult to ascertain Pakistans comparative advantage in cotton exports. Fourth, tariff and non-tariff barriers imposed by developed countries to protect their high-cost textile manufacturers will make it increasingly difficult for Pakistan to increase exports to developed countries. Thus diversification of exports remains a priority policy agenda for Pakistan (Table 5).

Pakistan S Evolving Trade and Exchange TABLE 5. Pakistans Most Important

Rate Policy Exports in 1994-1995

1991-1992 1994-1995 4,295 (52.8%)

147

(Million US Dollars)
Change 1994-1995 over 1991-I 992 27.7% 22.6% 9.2% 11.7% 284.5% 34.4% -78.2% 25.7%

Commodity Description Textile yarn, made up articles n.s. & elated products Articles of apparel and clothing accessories Rice Leather, leather manufactruing furskins Sugar & honey Fish fresh, frozen Cotton Professional scientific and controlling ments and apparatus n.s. Vegatables & fruit Footwear Total Exports Share of most important items in total exports Source: Annuul Report. Stare Bank of Pokismn. 1994-95. instrun.s. & dressed

3.363.4 (48.7%)

1.362.3 (19.7%) 1669.9 (20.5%) 416.2 (6.0%) 251.7 (3.7%) 56.0 (0.8%) 114.8 (1.7%0 581.5 (8.4%) 91.2 (1.3%) 454.6 (5.6%) 281.2 (3.5%) 215.3 (2.7%) 154.3 (1.9%) 126.8 (1.6%) 114.6 (1.4%)

Petroleum, petroleum products and related 58.3 (0.8%) 40.1 (0.6%) 6912.2 64.2% 56.3 (0.7%) 49.1 (0.6%) 8141.3 92.1% 3.4% 22.4% 17.8%

A concern also is the narrow country concentration of Pakistans trade. The major destinations for exports are Japan, the U.S., Germany and the U.K. (in that order). These are also the major sources of Pakistans imports. The primary change in the trading pattern over the years is the growing importance of Japan, with nearly half of Pakistans trade (exports as well as imports) taking place with Japan (Table 6).
TABLE 6.
1974-1975 CountriesExports USA Japan Germany UAE Saudi Arabia France U.K. Malaysia Kuwait Italy Total
Source:

Pakistan:

Major nade

Partners (RS. In Million)

1993-1994

1984-1985

as 70 of as 70 oj as % of as 70 of as 7% c7f as % of 7: exp. Imports 7: e-up. Exports 7: exp. Imports 7: exp. Exports 7: exp. Imports 7: exp. 3.73 6.80 4.49 4.63 6.04 1.90 6.68 0.63 1.78 2.43 3097 2633 1558 244 1559 501 1230 700 1224 599 20925
Survev, 1994.95.

384 699 462 476 621 195 687 65 183 250 10286
Pakistan

14.80 12.58 7.45 1.17 7.45 2.39 5.88 3.35 5.85 2.86

3965 4573 2163 1936 2627 978 2538 123 392 1564 37979

10.44 12.04 5.70 5.10 6.92 2.58 6.68 0.32 1.03 4.12

11289 12002 5163 4608 9570 1582 5277 4677 7105 2164 89778

12.57 5.75 5.13 10.66 1.76 5.88 5.21 7.91 2.41

29502 16428 12997 7182 8371 16031 1469 788 5582 205499

14.36 7.99 6.32 3.49 4.07 7.80 0.71 0.38 2.72

27367 19971 8500 13965 10374 12657 14207 13734 6224 258250

10.60 7.73 3.29 5.41 4.02 4.90 5.50 5.32 2.41

13.37 111272 54.15 119251 46.18

Economic

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III.

TOWARDS A LIBERAL TRADE POLICY

There are many reasons for the unsatisfactory structure and growth of Pakistans trade. Perhaps the two most critical factors are the tariff and exchange rate policies. Through a series of measures in the late 1980s Pakistan finally announced a clear shift away from the import-substitution development strategy that it had pursued up to that point. Several of these measures were aimed at a more liberal trade regime with the objective of integrating Pakistan into the world economy. At the start of the trade reform, many tariffs were slashed. Between 1988 and 1994, the maximum tariff fell from 425 percent to 250 percent, while the average tariff fell from 77 percent to 45 percent. The government is committed to reducing the average tariff rate to 35 percent by July 1996. This ceiling will include other taxes on imports such as iqra, the import licensing fee and the surcharge for reconstruction following the 1992 floods. Despite the impressive trade liberalization effort, as seen in tariff reduction, much work remains to be done to usher in a truly liberal trade regime. Quantitative restrictions (principally in the form of import licensing but also outright prohibition in some cases) are a case in point. As part of the liberalization effort, the number of items subject to licensing have decreased from 1361 to 970 in 1993, but nearly 10 percent of all commodities are still subject to QRs. The most prominent items on the negative list are textile and clothing items. The negative list actually encompasses nearly 25 percent of manufacturing output, which is high by international standards, if the 34 items subject to health and safety regulations and the 16 products subject to procedural requirements are also accounted for. Exports also remain subject to taxes and restrictions. Export ban, quotas, exclusive public sector export rights, special procedure and minimum prices affect 52 export product categories. Export prohibitions apply to 25 products, some of which may be justified on safety, security and environmental grounds. Multi-Fiber Arrangement (MFA) quotas may have to do with other countries trading policies but restrictions on items such as sugar, meat, grains, edible oils, oilseeds, hides and skins and ferrous and non-ferrous metals need to be evaluated because of their implications for effective protection levels and competitiveness of the economy. A. The Uruguay Round and Pakistan2 The recently concluded Uruguay round has set tariff targets that will help create a liberal trading environment. However, it has important implications for the design of LDC trade policy, not only with respect to the tariff structure but also for streamlining non-tariff measures (such as antidumping measures and countervailing duties, export subsidies, balance-of-payments provisions, import licensing, rules of origin, customs evaluation, pre-shipment inspection), Trade Related Investment Measures (TRIMS), Trade Related Intellectual Property Rights and trade in services. Participat-

Pakistan S Evolving Trade and Exchange Rate Policy

149

ing nations will fully benefit from the more trade liberal WTO setting if they have moved on all these fronts. An evaluation is made below of the salient outcomes of the Uruguay round from Pakistans perspective. An important objective of the Uruguay Round was to substantially improve market access of trading nations. The results for Pakistan are that its exports to OECD countries now face an overall weighted average tariff level of 6.9 percent. This is higher than the average weighted tariff of 4 percent imposed on imports from other countries. Pakistani exports to non-OECD countries face a considerably higher average weighted tariff of 9.1 percent. The Uruguay round has also helped to bring down nontariff measures faced by exports. Such measures on Pakistans exports should eventually fall from about 60 percent to 8 percent. The outcome of the Uruguay round regarding the Multi-Fiber Arrangement (MFA) is of special interest to Pakistan because textiles and clothing comprise 70 percent of its exports. The ten year, four stage end-loaded program under which MFA is to be integrated into WTO has been disappointing (17 percent of 1990 import volumes were integrated into GATT 1994, 34 percent of 1990 import volumes will be integrated after a further three years, and the remaining 49 percent at the end of the ten year period). The schedule for quota growth rates will help in mitigating the lengthy phase-out period for quotas. The bottom line, however, is that tariffs on exports from South Asian countries will fall from 83 to 22 percent, compared to 38 percent and 15 percent for all participants in the MFA. Pakistan has retained the right in the Uruguay round of being a textile import restricting country during the MFA phase out period (in 1993, inputs imported for Pakistans textile sector faced a weighted average tariff of 35 percent while semi-finished and finished items face weighted average rates of 74 percent and 77 percent, respectively). This is not surprising given that Pakistan is an MFA-restricted country. However, Pakistan enjoys proven export competitiveness in textiles, and by maintaining a more open import regime, it could further strengthen its competitiveness, and could take a lead in the dismantling of MFA. Nontariff barriers, anti-dumping measures and countervailing duties are likely to emerge as potential contentious issues in the future, as demands on government increase for protectionist measures following trade liberalization commitments of the Uruguay round. Pakistan has neither been a victim nor a user of these measures, but this may change as Pakistans exports increase. Pakistan should play a more active role in strengthening the WTO to monitor such protectionist tendencies in developed countries. As an importer, Pakistan should introduce clarity in measuring dumping, and transparency in the legal procedures for invoking anti-dumping measures in order to minimize the use of this tool as a protectionist device. The Uruguay round also made progress on the thorny issue of subsidies. These have been defined as financial contributions by governments, foregone revenue that benefits enterprises and the provision of goods and services (free or at less than market prices) other than infrastructure, and price supports from which the producers benefit. Export subsidies are included but not subsidies given to agriculture. How-

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ever, countries with income per capita of less than US$lOOO per annum may retain export subsidies on manufacturers at their 1986 levels. Pakistan has retained export subsidies to mitigate the anti-export bias of past import-substitution policies. These go beyond the allowed limits and will have to be progressively eliminated. On balance-of-payments, the Uruguay round allows developing countries to use import restrictions temporarily to do deal with foreign exchange shortages. However, there is a preference to use price-based measures affecting the whole range of imports rather than quantitative restrictions limited to a few sectors. Pakistan invokes GATT balance-of-payments provisions in 140 tariff lines. With a more flexible exchange rate and improved management of the float, Pakistan now has a more desirable instrument for managing balance-of-payments than the blunt instrument of import restrictions. A summary assessment of Pakistans progress in meeting the GATT requirements for a more liberal trade regime concludes that a large gap still exists between what needs to be done what is actually being achieved. This waning of enthusiasm is partly due to the disappointing outcomes with respect to MFA and agricultural subsidies in developed countries. The speed with which developed countries have moved on their preferred agenda items such as TRIPS has also contributed to this sense of disappointment. However, in order to meet the WI0 deadline and to benefit from the more liberal trade regime, Pakistan needs to move more quickly on trade liberalization.

Iv.

THE EXCHANGE

RATE POLICY

The exchange rate has been a key instrument of Pakistans trade policy. Up to the early 1980s Pakistans exchange rate policy was designed to support the countrys import-substitution industrialization strategy. A fixed exchange rate regime was followed whereby the rupee was over valued vis-a-vis other currencies to maintain the low price imports of machinery and raw material. Since the 1980s the exchange rate has been based on managed float, with international relative prices adjusting smoothly reflecting balance-of-payments performance. In more recent years, the exchange rate has become .more an instrument for adjusting the countrys macroeconomic imbalances rather than for supporting trade policy. A. A Brief History Since the exchange rate policy until the 1980s was an integral part of the overall trade policy, the history of the two is intertwined and is briefly reviewed. In 1952, following the collapse of the Korean war commodity boom, Pakistan faced its first balance of payments crisis. To deal with it the government resorted to licensing and quantitative controls rather than devaluation of the rupee. This paved the way for import-substituting industrialization.

Pakistans Evolving Trade and Exchange Rate Policy

151

The import system adopted in 1952 lasted well into the 1960s. This system allowed the rupee to remain overvalued throughout the period, which in turn created excess demand for imports at duty-paid prices and made rationing of imports through quantitative controls necessary. The result was that stringent quantitative controls on imports along with high tariffs raised the prices of domestic manufactures well above world market levels, while capital goods imports were much more lightly taxed. At the same time the prices of food and raw materials, the latter being the mainstay of the domestic jute and cotton industries, were held below world market prices. This system effectively redistributed income from agriculture to industry, by turning the terms of trade against the former and in favor of the latter. The martial law government of Ayub Khan (1958-1969) began to dismantle the system of direct controls on imports and investment. One important component of this programme was the adoption of the Export Bonus Scheme in 1959. This scheme was essentially a floating multiple exchange rate system under which exporters of manufactured goods received Bonus Vouchers equal to a certain percentage of their export earnings, in addition to the rupee equivalent of their export earnings converted at the official rate. These vouchers allowed the holder to either: (i) purchase an equivalent amount of foreign exchange at the official rate which could be used to import any item on the Bonus list3; or (ii) to sell the voucher in an organized market. Since Bonus Vouchers were generally quoted on the stock exchange at 1.5 to 1.8 times their face value, the effective exchange rate of exports on which the bonus rate was 20 percent was Rs. 6.19 to Rs. 7.62 per dollar against the official rate of Rs. 4.76 per dollar. This to a large extent compensated exporters of manufactured goods for the overvaluation of the rupee, allowing them to successfully compete in international markets. It also made it possible for managers of the economy to pursue an import-substitution strategy of growth along with export expansion. In the Bhutto period (1971-1977), government intervention in the economy took on an entirely new dimension and a series of economic reforms were introduced which included nationalization of commercial banks, life insurance and certain industries, a new labor policy giving security of employment to workers and greater freedom to the trade unions, and land and tenancy reforms. Amidst all this, the government pursued an enlightened foreign exchange policy. In May 1972 the rupee was devalued from Rs. 4.76 to Rs. 11 .OOto the dollar and the Bonus Voucher System was abolished. The rupee/dollar rate was subsequently adjusted to Rs. 9.90. The system of trade controls underwent a fundamental change. The number of items freely importable was greatly increased, and in the first year after the devaluation there were about 300 items on the free list. The list was gradually expanded and by 1976-1977 the number of items had been increased to 4074. Control was, however, exercised by creating obstacles in the licensing process and by altering import duties. It is very difficult to measure the overall impact of these changes as no work has been done on effective rates of protection in Pakistan during this period. It appears that initially nominal rates of protection declined as duties were lowered in response to devaluation. Later duties were adjusted upward each year according to revenue

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needs; e.g., a surcharge was levied on all dutiable imports after the flood in 1973, and when export duties were abolished in 1974, higher import duties were levied on many commodities to make up for the lost revenues. On the export side, varying rates of bonus on exports had previously been used to encourage manufactured exports. However, devaluation combined with the world commodity boom, which improved Pakistans terms of trade, resulted in a temporary undervaluation of the rupee and the government levied export duties on nearly all exports. As world prices rose, export duties were also increased, and in October 1973 they reached a peak of 45 percent on raw cotton, 40 percent on cotton yarn, 25 percent on gray cloth and 15 percent on other finished cotton and leather products. As the boom collapsed, export duties were gradually reduced until all such duties on manufactures were abolished in August 19745. There was some delay in the adjustment of export duties and this may have had some negative impact on exports. In 1976-77 further steps were taken to encourage exports by means of rebates on excise and customs duties, a 50 percent reduction in tax on income from exports, and expansion in the concessionaire finance scheme to all manufactured exports. The military government of Zia-ul-Huque (1977-1988) began a gradual process of reduction of direct government intervention in industry and encouragement of the private sector. Perhaps the most important policy reform affecting exports was the introduction of a flexible exchange rate in January 1982 to increase the competitiveness of Pakistans exports in world markets. Initially the plan was to peg the value of the rupee to an index which was a weighted average of currencies of Pakistans major trading partners. However initially during the first year the rupee was depreciated against the basket of currencies to bring its value to the level prior to the appreciation of the dollar in 198 1. Subsequently, its value was managed with respect to the basket of currencies using a loose form of the purchasing power parity concept. The flexible exchange rate initially allowed the government to reduce other direct export incentives6. For example, in August 1983 compensatory export rebates on both cotton and woolen yarn were eliminated, and those on other manufactured items were substantially reduced. However, the unprecedented rise in the dollar in 1984 was not fully adjusted for, resulting in the overvaluation of the rupee. To correct this, the government in 1985 again expanded the system of export rebates. The government then took advantage of the fall in the dollar in 1985-1987 not only to correct for the overvaluation that had taken place earlier, but also to devalue the rupee against the basket of currencies and eliminate export rebates completely. However, the increase in the rupee/dollar rate without a corresponding adjustment in the nominal tariff rates, tended to increase the level of protection to domestic industry which, along with the elimination of export rebates, increased the bias in favor of import-substitution. The distortions in the exchange rate caused by a trade policy designed for supporting import-substitution industrialization are quantified and discussed in Table 7. First we examine the actual exchange rate E, in column (1). It was constant (fixed by the government) until 197 1-1972 and then fell sharply as a result of the devaluation of 1972. It then remained unchanged until January 1982 when Pakistan delinked its

Pakistans Evolving Trade and Exchange Rate Policy TABLE 7.

EO Years 1960-61 1961-62 1962-63 1963-64 1964-65 1965-66 1966-67 1967-68 1968-69 1969-70 1970-7 1 1971-72 1972-73 1973-74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980-81 1981-82 1982-83 1983-84 1984-85 1985-86 1986-87
Noes:

153

Exchange Rates, 1961-1987

E* (3) 7.45 7.55 7.64 7.72 7.82 7.78 7.73 7.67 7.76 7.87 7.52 8.65 10.31 12.80 13.53 13.98 13.67 13.77 13.36 13.17 13.46 14.41 16.02 17.96 19.20 20.28 20.91 (EO/EPPP)-I (4) -0.4555 -0.4563 -0.45 13 -0.4716 -0.494 1 -0.499 1 -05262 -0.5301 -0.5249 -0.5313 -0.5433 -0.5468 0.0000 -0.1646 -0.2508 -0.2832 -0.3242 -0.3291 -0.3062 -0.2898 -0.2960 -0.28 13 -0.1551 -0.1606 -0.1130 -0.1150 -0.0947 (EO/E*)-I (EPPP/E*)-I

EPPS (US)

(1)
4.620 4.7620 4.7620 4.7620 4.7620 4.7620 4.7620 4.7620 4.7620 4.7620 4.7620 4.7620 10.5880 9.900 9.900 9.900 9.900 9.900 9.900 9.900 9.900 10.5500 12.7500 13.4800 15.1600 16.1300 17.1700
Purchasing

(2)
8.746 8.759 8.679 9.013 9.414 9.507 10.051 10.135 10.023 10.161 10.426 10.508 10.588 11.851 13.214 13.811 14.649 14.757 14.269 13.940 14.063 14.680 15.091 16.059 17.092 18.227 18.965

(5)
-0.3608 -0.3691 -0.3769 -0.3833 -0.3912 -0.3876 -0.3843 -0.3788 -0.3860 -0.3953 -0.3667 -0.4492 0.0272 -0.2264 -0.2684 -0.2920 -0.2758 -0.2809 -0.2587 -0.2484 -0.2642 -0.2676 -0.2040 -0.2496 -0.2103 -0.2047 -0.1788

(6)
0.1740 0.1604 0.1355 0.1672 0.2034 0.2227 0.2994 0.3221 0.2902 0.3865 0.3865 0.2154 0.0272 -0.0739 -0.0236 -0.0124 0.0716 0.0719 0.0685 0.0583 0.0452 0.0190 -0.0579 -0.1060 -0.0197 -0.1013 -0.0930

I. EO is the nominal 2. EPPP = Nominal

exchange rate. Power Parity Exchange Rate = EO (1972-73)/(WPIf/CPIp)

where WPIf CPIP 3. E* = Nominal

= wholesale

price index in the U.S.

= ccmsumer prnce index in Pakistan. Exchange Rate.

Equilibrium

currency from the U.S. dollar and pegged it to a basket of currencies of its trading partners. This allowed the exchange rate to fluctuate against the dollar. The result was a gradual devaluation of the rupee in terms of the U.S. dollar. Another exchange rate reported is the E,,, (column 2 ) which is the purchasing power parity exchange rate. To calculate it, we assumed that in 1972-73, when Pakistan had a small surplus on the trade balance, the official exchange rate was correct. For the all other years, the E,,, is obtained by the 1972-73 exchange rate and the difference in the rate of inflation in Pakistan and its major trading partners. For the

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JOURNAL OF ASIAN ECONOMICS 8(l), 1997

former we used the consumer price index in Pakistan and for the latter the U.S. wholesale price index. According to this exchange rate policy, the rupee should have fallen against the dollar gradually and consistently and in 1987 it should have been less than half its value in 1961. A comparison of the official exchange rate, E,, and the purchasing power parity exchange rate, E,,,, gives a measure of the over-valuation of the rupee during this period (Column 4). It shows that in FY 1966, the rupee was overvalued by 46 percent, and this increased to 55 percent by FY 1972 when the overvaluation was eliminated by the devaluation. As the rupee was revalued the next year and inflation in Pakistan was much higher than in the US, the overvaluation re-emerged and it continued to increase until the delinking of the rupee in FY 1982. Since then the rupee has been steadily devalued in real terms, and as a result the overvaluation has declined by less than 10 percent in FY 1987. A similar story can be told in terms of the equilibrium exchange rate, which is the exchange rate that would have prevailed in the absence of government intervention, i.e., under a neutral trade policy. Trade policy here includes all elements of the commercial policy such as import controls, tariffs and quotas, export taxes or subsidies, and price controls, some of which were discussed in the previous section. This exchange rate would also have eliminated external imbalances, i.e., deficits on the current account which were not sustainable in the long run. Derivation of the equilibrium exchange rate is reported in the Annex. The equilibrium exchange rate E* is given in column 3 of Table 7. A comparison of the equilibrium exchange rate (E*) and the purchasing power parity exchange rate (E,,,) discussed earlier, shows that according to the former the overvaluation was much less than that shown by the latter during the 1960s (column 6, Table 7). This difference probably arises because the Export-Bonus Scheme partly compensated for the overvaluation of the rupee during this period, and it is not possible to take account of that in the calculation of the equilibrium exchange rate. After devaluation and elimination of the Export Bonus Scheme in 1972, the two rates are fairly close to each other (Within plus or minus 10 percent). The overvaluation of the rupee as compared to the equilibrium exchange rate also declined after 1982, but not by as much as shown by the purchasing power parity exchange rate. B. Ikade Retarding Impact of The Exchange Rate Regime Exchange rate distortions can have serious trade retarding effects. An over-valued exchange rate (compared to the equilibrium value) reduces the price received by the exporter. This price disincentive results in lower output, lower exports and reduced foreign exchange earnings. Such disincentives and their balance-of-payments consequences were estimated for Pakistans agricultural exports in 196 1-l 987 (Hamid, Nabi, and Nasim, 1990). The first row in Table 8 shows that rice and cotton prices were substantially lower than they would have been in the absence of exchange

Pakistan S Evolving Trade and Exchange Rate Policy

TABLE 8. Price, Output and Foreign Exchange Effects of Exchange Rate Distortions (Average % Effect 1961-1987)
Effects Price output Foreign exchange earnings Source: Hamid, Nab1 and Nasim,
1990.

155

Earning

Basmati Rice -22% -15% -8%

Cotton -27% -13% -25%

rate overvaluation. The second and third rows show that output and foreign exchange loss associated with lower prices were also considerable.
C. Recent Exchange Rate

Management

The managed float exchange rate regime now prevalent in Pakistan has avoided the kind of distortions that existed up to the late 1980s. There is little evidence that the Pakistani rupee is seriously overvalued. This is clear from the movement in the nominal exchange rate vis-a-vis that of Pakistans major trading partners (the US, Japan, Germany, UK and France), who together account for nearly half of the foreign trade (imports plus exports). Table 9 gives the movement in the nominal effective exchange rate or NEER (which is simply an index of the nominal exchange rates of the five major trading partners weighted by their shares in trade) between 1980-198 1 and September 1995. The calculations show that NEER depreciated from 100 to 405. In other words, the same unit of major trading partners currency now costs nearly four times as much as in 1980-1981, which represents a substantial nominal devaluation of the rupee. But how have the relative prices moved? Table 10 traces the movement of prices in Pakistan and its five major trading partners. The last column of the table shows that the trade-weighted consumer price index of trading partners has increased from 100 to 168, while the index for Pakistan has increased from 100 to 323. To compensate for differences in inflation, the real effective exchange rate (REER) needs to be adjusted,

TABLE 9.
Countries USA France Germany UK Japan 1980-1981 RO 9.91 2.11 4.92 22.68 0.0463

Nominal Sept. 1995

RI 31.55 6.46 22.29 50.4 0.32

Effective Exchange

Rate
NEER 111.4 24.5 86.1 37.8 145.1 404.9

(RI -RO)/Ro Trade Weight 2.2 2.1 3.5 1.2 5.9 35 8 19 17 21 SUM

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TABLE 10. f980- I98f

Cuuntries USA France Germany UK Japan Pakistan PO 100 100 100 100 100 100

Trade weighted 199s

PI 172 204 148 218 125 323

Relative Price Index

Trade Weight 3.5 8 19 17 21 TWCPf 60.2 16.3 28.1 37.1 26.3 167.95 Relative Price Index 241

~P~-P~~/Pl 0.72 1.04 0.48 1.18 0.25 2.23

which is simply the relative price index (calculated in Table 9) divided by NEER (calculated in Table 10). Notice that NEER is 405 and the relative price index is 241. Thus the depreciation in the nominal exchange rate has more than compensated for the higher price level in Pakistan relative to the major trading partners. In fact, there has been a substantial depreciation of the real effective exchange rate. There is one cause for worry in current exchange rate management. The economys outward orientation is taking place at a time when macroeconomic stabilization efforts are also going on. At the root of macroeconomic instability lies the failure to slash the fiscal deficit. The money supply increase during years of slow economic growth (1993-1995) has resulted in double digit inflation (in the range of 12-14 percent). This causes the real effective exchange rate to appreciate, leading to an adjustment in the nominal exchange rate. Frequent adjustments in the nominal exchange rate further fuel the inflationary spiral. Thus avoiding fiscal adjustment results in instability in the exchange rate, which may adversely affect outward orientation of the economy.

V# TRADE WITH INDIA In 1994-1995, Pakistans trade with India was estimated at US $105.6 million (of which imports were worth $64 million). This is negligible compared to Pakistans total world-wide trade of $18.5 billion. Clearly, given tastes and cultural similarities, the potential for trade between the two countries is substantial. One indication is the rough estimate that the value of smuggled and third country imported lndian goods into Pakistan may be as high as US$ 1 billion, and no information on smuggled Pakistani goods into India is available. The anemic trade between India and Pakistan has implications for region-wide prosperity in South Asia. The international experience is that sustained growth is rarely restricted to a single country in a region. In East and South East Asia, for example, liberal trade policies and a consistent fiscal and investment regulatory framework among several countries have expanded market size, created new oppo~unities for

Pakistan 5 Evolving Trade and Exchange Rate Policy

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investment and technology transfer and enhanced labor mobility. This has unleashed competitive energies to fuel long term growth. Arguably, political rivalry and mutual suspicions between the largest two South Asian nations, Pakistan and India, have prevented trade expansion and may have retarded region-wide growth. Opening up of India-Pakistan trade may well be the catalyst that sets the entire region onto the virtuous cycle of mutually re-enforcing economic growth. A. The Potential For Trade It is hard to estimate the trade potential between India and Pakistan where trade is restricted through non-tariff barriers. One approach is to carry out detailed unit cost
TABLE 11.
Code 011 042 057 071 075 081 121 211 263 281 333 334 522 562 611 651 652 653 654 656 657 6.58 659 667 723 842
Source:

Revealed Comparative
CommodiQ

Advantage
India 1.3815 0.1473 1.1560 1.5473 1.3664 1.0185 1.4618 9.6985 0.2435 1.5473 1.5473 2.1652 1.5473 0.7875 0.3382 0.6447 1.1678 1.1709 1.0199 0.3485 0.2494 0.9988 1.4975 0.2618 0.3448

(Average 1984-1986)
Pakistan 5.3367 0.5378 0.3507 0.1500 4.3687 Indicated Speciakation India Pakistan India India India India India India Pakistan India India 0.1862 5.1906 1.8253 3.7598 3.1341 1.3257 0.03 10 1.4038 3.8237 2.7213 1.8995 9.8214 1.407 1 India India Pakistan Pakistan Pakistan Pakistan Pakistan, India India Pakistan, India Pakistan Pakistan Pakistan India Pakistan Pakistan

Meat fresh, chilled, frozen Rice Fruits, nuts, fresh Coffee and substitutes Spices Animal feeds Tobacco, unmanufactured Hides, skins-undressed Cotton Iron ore concentrates Petroleum oils, crude Petroleum products, refined Inorganic chemicals Fertilizers Leather Textile, Yarn Cotton fabrics, woven Woven textile, non-cotton Other woven textiles, fabrics Textile prod, NES Floor cover, tapestry Textile articles, NES Floor covering etc. Pearl, prod. semistone Civil engineering
Bhargava et al. (1994). op. tit

equip.

Mens outwear, non-knit

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estimates of different commodities to identify the products where the two countries would have a comparative advantage. Projections could then be made of the demand for these products in the two countries to estimate the potential for increased trade. The first part of this analysis was done in a recent study (Bhargava et al, 1994). Table 11 shows the products for which India or Pakistan would have a comparative advantage. The results reported in Table 11 must be taken with some skepticism. Both economies have a plethora of distortions (subsidies, tariff and non-tariff barriers, and rationing and managed exchange rates) that they have started to dismantle. Comparative cost estimates, while the reform is in process, are unlikely to be a reliable guide to post-reform trade advantage. Another recent study (Srinivasan, 1994) investigating the trade enhancing potential of forming a South Asia Regional Trading Block (India, Pakistan, Sri Lanka Bangladesh, Nepal) estimated that smaller countries in such a block would gain the most. Nepal and Bangladeshs trade would increase by 270 percent and 122 percent (as a share of their total trade), respectively. Additional trade creation for Pakistan and India would be a modest 3 percent and 7 percent, respectively (Tables 12-14). The reason is that such regional blocks work best if several conditions are met prior to forming the block: average tariffs should be high among would-be members; would-be members should be important trading partners; members should have different economic structures; and different factor endowments. South Asian would-be member countries satisfy only the first of these conditions. Most countries major trading partners lie outside the region, and their economic structures and factor endowments are similar, which result in their economies being competitive rather than complementary. It must be kept in mind that the model underlying the study does not take into account the trade limiting effects of non-trade barriers. India-Pakistan trade liberalization would essentially amount to removal of such barriers, so that the findings of the study may be overly pessimistic. A useful guide to future trading potential may well be the past. Historically, the regions that now constitute Pakistan and North-Western India have traded to mutual advantage. Distance (transport costs) and tastes suggest that with opening up of trade, Delhi-Lahore could emerge as a prosperous trading corridor. Lahore, surrounded by its satellite cities Faisalabad (Lyalpur), Gujranwala, Sialkot and Gujrat, could constitute one node of this corridor and Delhi and its satellite cities the other. Similarly, Karachi, Bombay and Ahmedabad could emerge as another trading triangle. In Pakistan, the two trading zones would be mutually reinforcing because of the strong marketing and communication links that already exist between Lahore, Faisalabad and Karachi. To conclude, the quantum of trade between Pakistan and India after reduction of tariffs and removal of non-trade barriers awaits a proper study. If smuggling is any indication, the value of trade could well be in the region of $2 to $3 billion and could rise quickly.

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TABLE 12.
Iron/Agglomerated Bidu (Tandu) leaves Soybean meal Dyeing. tanning materials Carbon electrodes Cardamom, Tea Books Beta1 leaves Vegetable seed Ginger, undried Zinc ingots Magnesium Coal Sports goods Phthalic Anhydride Taramind, dried Cement Sewing machines, industrial Other Total large

Pak-India

Commodity
1989-1990

Major Pakistani Imports from India

Trade (In millions of Pak Rs) _____.../990-1993 259.8 152.0 152.8 71.i 73.0 48.9 12.0 11.0 16.0 20.6 6.8 1991-1992 252.6 124.0 135.3 150.8 84.7 40.2 23.5 24.9 20.4 17.0 50.1 6.7 59.1 61.4 1992-1993 255.7 102.5 402.6 233.6 80.4 53.9 144.9 20.8 29.2 19.0 25.9 24.1

_~ 1993-1994 321.3 104.9 538.3 319.8 20.8 56.9 58.7 34.3 43.0 35.9 50.9 36.4

202. I 139.6 71.5 90.6 87.8 8.8 23.4 13.6 9.3 13.9 9.9

25.5 2.9 1.5 1.0 84.2 815.6

1989-1990

20.1 0.5 2.1 2.6 125.2 1026.3 1990-1991 328.2 206.5 260.8

15.2 9.3 10.2 11.0 177.3 1212.5 1991-1992 298.5 156.4 79.8 1209.8 982.2

5.4 11.1 15.6 19.3 231.9 1748.4 1992-1993 482.9 110.3 84.4 861.5 210.9 71.2 108.5 23.2 74.0 6.7 12.9 128.5 2175.0

6.6 42.1 20.7 177.6 21.5 235.6 2125.9 1993-1994 462. l1134 63.8 112.7 7.4 27.1 39.0 31.0 37.3 11.0 298.1 84.6 1287.6

Major Pakistani Exports to India

Vegetables & fruits Textile, yarn & fabrics Leather & leather manufactures Petroleum, crude Raw cotton Wool, raw, scoured Other waste wool/fine animal hair Poppy seeds Plants for perfumeslpharaceuticals Copper waste and scrap Rock salt Sugarcane. refined Others Total etc.

243.2 178.4 140.8 1.4 10.9 0.8 49.5 8.6 38.1 18.8 46.1 757.5

3.3 0.2 22.2 6.8 9.9 14.0 81.4 933.3

14.3 0.9 3.3 10.1 10.3 48.6 2814.2

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TABLE 13.
Machinery

Wading Patterns of South Asian Countries

1990-1991 27.2% 22.1% 16.3% 8.4% 5.8% 10.2% 1990-1991 50.2% 17.8% 7.8% 5.7% 4.6% 1990-1991 17.7% 14.4% stones 12.0% 6.5% 5.4% 4.3% 3.8% 1991-1992 36.0% 15.0% 15.9% 14.0% 5.3% 10.4% 1991-1992 48.7% 19.7% 8.4% 6.0% 3.6% 1991-1992 25.0% 15.7% 8.7% 4.9% 3.9% 3.9% 3.3% 1991-1992 16.1% 12.3% 11.9% 7.2% 8.0% 6.5% 1992-1993 36.9% 15.5% 15.0% 12.9% 10.1% 8.6% 1992-1993 51.4% 21.5 n.a. 4.7% 3.5% 1992-1993 27.4% 16.0% 10.1% 4.1% 3.2% 1.9% 2.8% 1992-1993 15.3% 12.3% 12.5% 8.3% 7.1% 7.3%

Imports & transport equipment Petroleum, petroleum products, etc. Chemicals & related products Industy specific machinery Road vehicles and parts Basic manufactures Exports Textile yam, fabrics, etc. Clothing & accessories Cotton fibers & waste Rice Leather, leather manufs, dressed furskins Imports Mineral fuels, lubricants, etc. Non-electric Iron & steel Electrical machinery Transport equipment Organic chemicals Imports Gems &jewelry Ready-made Engineering Chemicals garments products & related products machinery Pearls, percious & semi-precious (excl. footwear)

1990-1991 19.1% 11.7% 11.9% 7.2% 7.0% 5.4%

1994.

Leather & leather manufactures Cotton fabrics

Source: Eumpa Statistical Yearbook,

B. Where Do We Go From Here? Mutually beneficial trade with India is an important agenda item in Pakistans trade policy. This is consistent with Pakistans liberal trade stance that requires competitive purchase and sale of goods and services. Pakistan is also committed to opening up trade with India because of the GATT requirement that all member nations should enjoy MFN status with each other. Nonetheless the political economy of trade liberalization with India is such that Pakistan needs to be well-prepared for such a move. The attempt in the late 1970s at opening trade with India resulted in a large trade deficit and a political backlash that forced the government to clamp down. If this were to happen again, it might hamper the countrys on-going reforms to deregulate and liberalize the economy.

Pakistans Evolving Trade and Exchange Rate Policy

161

TABLE 14.
Pakistan Imports Japan USA Germany

Major Trading Partners of South-Asian

1990-1991 13.0% 11.8% 7.3% 6.3% 4.9% 4.0% 5.1% 2.9% 1990-1991 10.8% 8.3% 8.6% 7.3% 6.0% 3.0% 3.6% 1990-1991 12.0% 8.0% 7.8% 4.1% 8.4% 7.6% 4.1% 5.8% 1990-1991 16.2% 16.1% 9.9% 6.4% 5.8% 4.4% 3.2% 2.6% 2.3% 1991-1992 14.3% 10.5% 7.9% 5.2% 5.5% 4.2% 4.3% 4.7% 1991-1992 12.8% 8.3% 7.1% 6.6% 7.3% 4.4% 4.3% 1991-1992 12.1% 7.5% 8.0% 6.7% 6.7% 6.3% 6.4% 5.9% 1991-1992 14.7% 16.1% 9.3% 7.8% 6.5% 3.9% 3.3% 2.4% 2.4%
1994.

Countries

1992-1993 15.9% 9.4% 7.5% 4.4% 4.8% 5.1% 4.2% 4.2% 1992-1993 13.9% 6.8% 7.8% 7.1% 6.6% 5.9% 4.7% 1992-1993 10.3% 7.1% 8.0% 7.4% 6.2% 7.2% 6.4% 3.8% 1992-1993 16.4% 9.2% 9.2% 7.1% 6.4% 3.7% 3.4% 4.1% 2.4%

Saudi Arabia UK Malaysia China France Exports USA Japan Germany UK Hong Kong UAE Saudi Arabia Imports USA Japan Germany Saudi Arabia UK Belgium UAE USSR/CIS Exports USA USSR/CIS Japan Germany UK Belgium Hong Kong UAE France Source:
Europa Statistical

Yearbook,

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Preparing following:
l

for India-Pakistan

trade liberalization

requires

attending

to the

Estimating the costs of not trading with India. These may arise in the form of higher transportation costs as well as higher manufacturing costs of importing products from third countries. Costs might also arise because third country imports embody sophisticated technologies and are not reproducible locally. Indian imports might create a local market for products incorporating technologies that could be reproduced locally. This may give rise to new industry that competes with Indian imports. Carrying out marketing surveys, holding trade fairs and exploring dis~bution networks in the two counties to minimize disruption to trading patterns. Setting up mechanisms to monitor trade flows on a regular basis and agreeing on measures for voluntary restraint in case the trade deficit crosses agreed upon thresholds. Opening trade with India might affect industry in Pakistan both in terms of possible input cost reduction as well as price competition. Studies must be carried out to assess the net impact of these outcomes on Pakistans industrialization efforts both in the short run and the long run. Tariff reform efforts in both countries would need to be coordinated and martitored. Higher tariffs in one country may attract manufacturers enjoying economies of scale for export to the country with lower tariffs. This would seriously hamper the industrialization efforts of the second country. Coordinated tariff reform would help avoid such outcomes. Mechanisms need to be put in place to study possible dumping. Arbitration procedures must be set up to deal with complaints bilaterally before resorting to expensive and acrimonious battles in Geneva.

To conclude, liberalizing India-Pakistan trade presents many oppo~uniti~s and challenges. However, given the political tensions between the two countries, it would be advisable to be well prepared for such a move lest the political backlash to short term adjustment costs overshadows the certain long-term benefits.
7%~ authnr is Visiting Prqfessor at Luhnre llniversity af Management Sciences Acknowledgments: (LUMS). This paper is written fi)r a conference jointly sponsored by Jawarlal Nehru Universit> Nrw Delhi, and American Committee an Asian Economic Studies at Iuternatinnal Centre, New Delhi (March II -14, 1996). This puper is part of ongoing work an Pakistan :Y trade policy by the Export Research Group at LUMS.

NOTES
1. Although Nan-trad~t~o~a~ exports grew by an impressive 18 percent in 199495, traditional exports grew by almost 20 percent and cotton based exports by 21 percent. The share of no~tradit~~~a~ exports in total exports thus has not increased.

Pakistan S Evolving Trade and Exchange Rate Policy

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2. This discussion is based on Pakistan: The Uruguay Round and Trade Policy Reform Into the Next Century: Background Paper for Pakistan 2010 by Patrick Low (1993). 3. There were over 200 items, including all luxury consumer goods, on the list. 4. The import policy specified fairly broad categories; thus each item covered numerous individual commodities. 5. However, the Government continued to earn large profits through its monopoly in the export trade in cotton and rice. 6. The flexible exchange rate also facilitated the import liberalization process by allowing the government to eliminate restrictions without running into balance-of-payments problems.

REFERENCES
Ali, H.A. 1995. Trade Relations with India. Pakistan and Gu(f: Economist, XfV(24), 17-23. Ministry of Finance, Government of Pakistan. (1994-1996). Economic Survey. Islamabad, Pakistan. Hamid, N., Nabi, I., and A. Nasim. 1990. Trade, Exchange Rare and Agricultural Price Policies in Pakistan. World Bank, Washington, D.C. Low, P. 1993. Pakistan: The Uruguay Round and Trade Policy Reform Into the Next Century: Back Ground Paperfor Pakistan 2010. Srinivasan, T.N. 1994. Preferential Trading Arrangements in South Asia: Theor?; Empirics and Policy. World Bank, Washington, D.C. State Bank of Pakistan. 1995. Annual Report. Islamabad, Pakistan. The Economist Intelligence Unit: Investment, Licensing, and Trading Conditions Report on Pakistan, July 1994. World Bank. 1995. World Development Report. Washington, D. C.

Received March 1996; Revised December

1996