Empirical Analysis of Coexisting Exchange Rate Misalignment & Trade Policies in Pakistan

Abstract

Globalization & trade liberalization is at their peak in the 21st century. It has made balanced coexistence of currency policy and trade policies of critical importance for the external sector of the economy. Persistent real exchange rate misalignment necessitates readjustments of relative prices. In addition, it leads to a significant decrease in economic growth by driving away from the resource allocation from productive activities. One of the key compensatory policy tools with the government is trade policy. Whereas, evidence suggests that trade policy is used by the government to compensate for the misaligned exchange rates. In this context, firstly, this research study examines the equilibrium real exchange rates and exchange rate misalignment for Pakistan by using the Behavioral Equilibrium Exchange Rates (BEER) approach. Secondly, we examine the significance of exchange rate misalignment and bilateral tariffs for the trade flow of Pakistan. Lastly, we investigate the correlation between exchange rate misalignment and the government’s decision to mitigate it by trade policies with a panel data set consisting of 37 trading partners ranging from 2003 to 2019. This research study provides a historical retrospective analysis of exchange rates and trade policies, from FY1982 till FY2020, during different exchange policy regimes. The empirical findings suggest that there have been recurring episodes of overvaluation and undervaluation in Pakistan confirming the existence of exchange rate misalignment. Furthermore, it supports the significance of exchange rate misalignment on the bilateral exports of Pakistan. Lastly, the impact of trade policy tools is reaffirmed, such that, the periods of overvaluation will raise the trade restiveness while the periods of undervaluation will relax the trade-restrictive measure of government. However, under product group analysis the association turns out to be in the opposite direction for some product groups. It shows that inconsistent policies among different sectors might cancel out the impact as a whole for the economy and cause a surge in exchange rate misalignment further.