This essay makes no pretence to offer a novel concept or a new development strategy and most economists reading it will probably stifle a yawn and turn the page. Yet it is a subject worth talking about. Many countries round the world, most notably the former Asian Tigers, China, Brazil, Turkey and more recently India have followed such a strategy with great success. Pakistan has not and it is well to ask why and what we can do about it.
Pakistan has never had a consistent, coherent and well-articulated export-led growth strategy. Indeed, exports are often treated as a residual, an after-thought, once the domestic market has been filled. This is inexplicable given our persistently large trade deficit which has not been reduced over time and we have difficulty financing it (filling the gap) each year. Economic growth has at various times been driven by either the public or private sector or more recently – and most disastrously in the previous government – by consumption which created dangerous asset- price bubbles in the domestic economy, led to overheating pressures and a surge in inflation and imports. Economic growth has never been driven by exports nor has building a dynamic export sector been at the forefront of any government’s economic strategy.
While the large-scale manufacturing sector in Pakistan is the focus of policy attention not least because it has a powerful lobby, it is the tip of the manufacturing (and export) sector ice-berg. It is the small and medium-enterprise manufacturing (SME) sector in Pakistan that generates four-fifths of our manufacturing output, employment and exports. Sustained and focused policy-driven growth in this sector with its strong forward and backward inter-industry linkages is the kind of “inclusive” growth that Pakistan urgently needs. With labor-input a large component of capital and output, rapid SME growth has important positive implications for wages, employment, living standards and the goal of poverty alleviation.
Why Pakistan has shied away from adopting such a strategy is not clear. Of course every now and then there is much bluff and bluster about boosting exports and grand plans to contain our external deficit and debt. Since the government is busy giving “top priority” to everything, the priority that should be given to exports is drowned amid the “noise” of the many – and often contradictory – pronouncements.
Perhaps the first reason for not paying sufficient attention to the SME sector – and an incredible one at that – is that we don’t know much about the SME sector despite its size and importance in the economy. We have large bureaucracies dealing with SME in all provinces but it is unclear what they do. Surveys of activity this sector are taken in- frequently, sometimes as far apart as 15 years, and a inter-survey growth rate is calculated which is then put into the National Income Accounts and repeated year-after-year until the next survey. The real growth rate of the SME sector has been fixed at as low a figure as 2.5% per annum. The present fixed rate is 7.5% per annum. But what is really happening in the SME sector in the inter-survey years no one knows except through crude methods of linear interpolation. If there is no information and just a fixed assumed growth rate with fixed and outdated coefficients for employment and capital, there can be no meaningful strategy of export- led growth in the SME sector to begin with.
The second reason could be that we don’t like to talk about exchange rate policy except in whispered conspiratorial terms. Maintaining a “stable” exchange rate is always thought to be a reflection of how well economic policies are being managed. Governments frequently interfere with exchange rate management issues and demand that the exchange rate is kept “stable.” An appreciating exchange rate is greeted with applause. Devaluation is always bad. Nominal “exchange rate stability” was one of the highly-touted achievements of the Musharraf years even though no one was noticing that Pakistan’s export-to-GDP ratio was falling (along with our notoriously under-performing and falling tax-to- GDP ratio). This presented prima facie evidence that export profitability was most probably being compressed and the authorities should have done something about it. But given that we were in an era of plentiful aid and other capital inflows there was no pressure on government to do much either on the export or the tax front.
Added to the conspiracy theories, there is a widespread view that exchange rate devaluation which for exporters means more rupees earned per dollar exported, has no effect on export performance. The reality is more nuanced and worthy of some elaboration.
There are fairly long lags between exchange rate depreciation and the response of exports. It takes time to gear up production to the new level of export profitability. Furthermore, for devaluation to impact exports in a positive way, the exchange rate must depreciate in “real,” rather than only “nominal,” terms, that is, the extent of depreciation (or increase in nominal export profitability), of say 10 percent, must exceed the going rate of domestic inflation, say 7 percent.
Exports respond to increases in real profitability (in the above example the real increase in export profitability is 10 percent minus 7 percent = 3 percent, not just the nominal change in profitability, 10 percent). If the extent of devaluation is offset, or more than offset, by higher inflation because macro policies are insufficiently tight and there is cost-push inflation, there will be no stimulus to exports because there is no, or perhaps even a negative, change in real export profitability.
Importantly, any increase in real export profitability needs to be sustained if the stimulus to exports is to be lasting. If exporters see that the improvement in real export profitability is likely to be fleeting and will dissipate through future inflation, or a change in government policy, they will have little incentive to export and would prefer to sell in the domestic market. Given the concentrated, oligopolistic structure of industry in Pakistan and the high-levels of protection afforded to producers in the domestic market from foreign import competition, real profitability in the domestic market can be very high, often a multiple of what can be earned in the export sector. In Pakistan this has been a strong disincentive to produce for exports.
This brings to the foreground a “second-order condition” for a successful export drive. Even if there is a real increase in export profitability, the much higher real profitability levels, or “monopoly rents,” that can be earned in the domestic market will induce firms to sell domestically, eschewing exports. Worse, firms may actually switch back to selling in the domestic market and cease exporting altogether as the differential between domestic profitability and exports rises. Of course, a judicious application of trade, tax and tariff policies and other incentives can help countries achieve an incentive structure more favorable to exports. Many countries that are more aggressive with their export drive actually tilt profitability sharply towards the export sector and ensure it is sustained.
The importance of establishing an incentive structure favorable to exports is underscored by the fact that exporting, per se, is a challenging task. Not only are quality requirements higher, strict adherences to, for example, packaging, labeling, and hygienic standards is essential. One often hears of Pakistani exports being banned in foreign markets because of our failure to adhere to high standards. Competition from other countries selling in the same market is intense; price wars and dumping can be ruinous, and there are tariff and non-tariff barriers and complex procedural regulations in the importing country that have to be negotiated and complied with. These “non-price” determinants of exports can be of significant importance.
While price and non-price factors interact to determine competitiveness, exports also respond to export market income growth. The magnitude of the response of exports to income growth is the “income elasticity of demand for exports” which generally reflects the country’s export mix. Given the commodity composition of Pakistan’s exports, dominated by low-value textiles such as yarn and cloth, the income elasticity of our exports is not large, perhaps even less than unity (or less than one). This means that for every one percent increase in export market income growth, our exports respond by less than one percent. This less than “unitary income elasticity” of our exports explains why Pakistan’s export market share has lagged behind the growth in global income and trade. By contrast, in the more dynamic exporting countries, the income elasticity of exports of their higher-value added products can be as high as four or six and these countries have made impressive strides in expanding their global market share.
Many countries use the exchange rate as a weapon of export competitiveness, most prominently China, where the exchange rate is kept artificially depreciated (by some calculations by as much as 42% but now down to 24%), when China’s massive trade surpluses with other countries, most notably the US, and even more massive foreign exchange reserves (presently $2.6 trillion) would point towards a policy of gradual appreciation of the currency that would slow down the torrid pace of China’s exports and pull in more imports driven by domestic demand. In doing so, China’s massive trade surpluses would start to diminish, and with other surplus countries adjusting in a similar manner, the global economy would be better balanced. According to a recent estimate a 20% appreciation of the Chinese currency would cut $150 billion off the US trade deficit with China and create 1 million US jobs by making US exports more competitive.
Pakistan needs to change the commodity composition of its exports, add new higher value products for export and look for new export markets. After 62 years we still export the same products of largely unchanged quality to the same markets as reflected in the estimated “Commodity Concentration Index” of our exports which has remained broadly unchanged. We have made little progress in moving up the “value-added chain” and getting better unit prices for our exports. One study showed that the unit price our exports can be as low as one-third of the unit price other developing exporting countries earn for the same product. The unit price of our exports of garments, for example, was lower than the unit price received by exporters in Bangladesh for the same garments selling to the same market. This is a distressing fact since it shows the untapped scope of raising our export earnings from the present base. Bangladesh nearly doubled garment exports from 2004 to 2009 from an industry employing three million workers, mostly women. From June to November in 2009, garment exports accounted for more than 80 percent of the country’s total exports. Among developing countries, Bangladesh is the third-largest exporter of clothing after China and Turkey, a distant No.2, according to the World Trade Organization. Pakistan’s garment exports are trivial by comparison.
The non-price determinants of our exports remain poor. There is little research and development in the export industry and a so-called Export Development Fund seems to have no effect on exports or development. The old Export Promotion Bureau has been revamped and re-structured in an effort to make it a more dynamic and forward-looking organization called the Trade Development Authority of Pakistan (TDAP). Although headed by a dynamic individual there seems to be little depth in terms of the skills and experience of persons working in the organization. There is reason to believe that the Export Finance scheme is abused since financing from this scheme has no correlation with exports. The money is probably used for investing in the stock market, gold and real estate. With a few exceptions, our export exhibition stalls in overseas trade fares are dull and unimaginative and our products presented in a poor light.
Does a successful SME-led export drive mean that Pakistan needs to use the exchange rate more aggressively? The answer is conditional. Either Pakistan can recoup lost competitiveness through playing “catch- up” by a constant downward adjustment of the nominal exchange rate as we do now, or we can look at the other side of the equation, namely the rate of inflation, or more precisely our domestic rate of inflation relative to the rate of inflation of our trading partners and competitors. If Pakistan can push its inflation rate down to levels close to that of our trading partners and competitors there would be no need, or very little need, to constantly move the domestic currency downwards just to recoup the loss in real competitiveness. Relative exchange rate stability or an exchange rate that only moves in a fairly narrow band – can go hand-in-hand with sustained (and even rising) levels of real export profitability.
To be sure, getting our domestic inflation rate down to single figures presupposes a macroeconomic setting that is credible and disciplined something that Pakistan has not excelled in recently. Yet it is well to recall that if we were to take a long view and exclude outliers (periods of very high or very low inflation) Pakistan has been a low-inflation country, with inflation averaging about 6.5% per annum over the past six decades. It is only recently that inflation has reached unprecedented heights largely because of the deeply flawed policies of the previous government when growth was consumption-driven – a bizarre strategy in a savings-constrained economy – but also because of the recent surge in the global price of commodities and oil that swelled the economy’s twin-deficits to in excess of 8% of GDP. It is quite possible that despite the sharp devaluation of the nominal exchange rate since 2008, after adjusting for the recent high inflation the real effective exchange rate is still somewhat appreciated discouraging exports while encouraging imports when economic policies including exchange rate policy should be aiming to do the reverse.
Some economists suggest that Pakistan target an equilibrium exchange rate that is slightly depreciated in real effective terms – as in East Asia – and is consistent with a sustainable external current account deficit of 2-3% of GDP and a steadily declining external debt-to-GDP ratio. The viability of such a strategy again presupposes a degree of tightness in the stance of macroeconomic policies that may prove difficult to achieve and sustain. Moreover in the present global environment when Asia is being called upon to use the “second engine of growth,” namely, domestic demand to boost imports, such a strategy could invite opprobrium. Whatever the exchange rate regime the key point is that export price competitiveness needs to be sustained. A brief period of real depreciation followed by several years of real effective appreciation because of insufficient downward flexibility of the nominal exchange rate because of political pressures (and/or higher relative inflation because of poorly managed macroeconomic policies) is inimical to any sustained export drive.
Is there any empirical econometric support to the view that the real exchange rate matters? There have been a surprisingly few studies done in Pakistan given the importance of the subject (most of the studies have been done by the World Bank, Asian Development Bank and the IMF using Pakistani data). These studies do point to a strong and fairly robust relationship between the real exchange rate and exports. Of course, other factors too contribute as explanatory variables such as world income growth. The lags between real exchange rate changes and real exports mentioned earlier need to be carefully specified to get a better “fit” of the predictions of the econometric model to the actual data. Other than these models which are probably out-of-date, the projections that are made each year in the context of our export targets are based on what can be termed “casual empiricism.” The government iterates to a target figure for each export commodity based on discussions with trade bodies and simply extrapolates by using an agreed compound growth rate from a given base-year figure. There is no rigorous forecasting model which specifies explanatory variables that underlies the export targets.
To sum up, Pakistan needs more information and better information on what is going on in the SME sector from which most of our exports emanate. It will be costly since the SME sector is widely dispersed but the benefits would more than justify the cost of more frequent surveys of the full population of the SME sector, say every three years with smaller sample surveys taken each year so as to build-up a time-series profile of the dynamics of the SME sector. External donors would be more than willing to finance such a survey (s) with grant (non-debt-creating) funds if Pakistan can present a credible plan. The decision by the US to give $100 million to the SME sector could portend a new beginning for the sector but one has misgivings about the administrative and technical capacity of the SME establishment and whether they can or will deliver meaningful results.
Discussion of the appropriateness of the exchange rate and how domestic inflation and relative inflation affects export profitability, the difference between nominal and real exchange rate, the overall conduct of exchange rate policy, and different exchange rate regimes followed by more successful exporting countries, needs to be more transparent, up-front and better understood. The point to drive home is that the real exchange rate does matter and is an important – albeit not exclusive determinant of lasting export success. It is the most important price signal in any economy.
The incentive structure needs to tilt towards exports versus selling in the domestic market through judicious adjustment in trade, tax, finance and tariff policies. Special, selective incentives should be given to exporters, especially new exports which should not be available to producers selling in the domestic market within of course the ambit of WTO rules. To prevent abuse of these incentives they should be tied to performance and withdrawn if performance is not forthcoming as measured by, say, actual exports in the previous three years.
If this “tilt” is sustained, new exports will emerge of products and from sectors previously un-thought of. A look at the rag-bag category of “Miscellaneous Exports” in the export data turns up some surprising high-value items that Pakistan exports (some to very sophisticated markets in Europe) but the amounts are small and their year-on-year growth is erratic. Since there is little targeted encouragement given to these new exports, they usually fade out of the export picture altogether. If there is no domestic market that they can turn to, these firms shut down. In both cases, Pakistan has lost a potential export item and valuable foreign exchange something that we can ill-afford. Focusing on fostering growth in these high-value exports which emanate from the SME sector would improve the export mix, diversify the export base, reduce the commodity concentration of our exports and increase the income elasticity of demand for our exports in world markets. The non-price determinants of exports need to be strengthened through emulating “best-practice” techniques employed by the leading exporters of the world. This is not rocket-science since most of the “best-practice” techniques can be gleaned from the internet.
Furthermore, domestic investors and FDI proposals that are aimed at exports should be given the highest priority and placed on a fast-track of approval. FDI inflows offer the best route to securing structural shifts in the technological progress function in the SME sector while at the same time bringing in better managerial and marketing skills which are so critical in exporting. Enhancing productive efficiency in the SME sectors means being able to offer higher wages in line with productivity improvements which would lead to higher living standards and poverty levels dropping to the teens as demonstrated by the remarkable success of other exporting countries. As productivity growth responds to output growth (as in the P.J. Verdoon and Kaldor models which inverts the causality of neo-classical models of Solow and Swan) with output growth being driven mainly by net exports as would be the case in an export-led development strategy, static and dynamic economies of scale can be reaped through the process of “Learning-by-Doing” as espoused by the US economist Kenneth Arrow in his path-breaking work. Such dynamic economies of scale and increasing returns can generate positive cumulative circular causation effects that impact costs, prices and profitability in the export sector.