EXCHANGE RATE RESPONSE OF IMPORT DEMAND IN PAKISTAN

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1 Sarhad J. Agric. Vol. 23, No. 4, 2007 EXCHANGE RATE RESPONSE OF IMPORT DEMAND IN PAKISTAN Mohammad Afzal Exchange rate policy has assumed an added importance in recent years due to changing global economic conditions. This paper has examined the foreign exchange reserves, real and effective exchange rate response of imports demand in Pakistan using both classical and time series econometrics approaches. The real depreciation of the exchange rate has been found to have dampening impact on import demand. Adoption of a realistic exchange rate is highly desirable. Domestic inflation and an unrealistic exchange rate may discourage the investment flows needed to the new incentives. A stable and long-run relationship exists between imports and GDP, effective exchange rate and relative import prices. Cointegration results do not support the long-run equilibrium situation between imports; and foreign exchange reserves and real exchange rate. Keywords: Demand, Exchange Rate, Imports, Johansen Test, Pakistan INTRODUCTION Imports and exports are two sides of the same coin. To study the foreign trade regime of a country, a better picture could be obtained if imports are studied at some length. Imports play an important role in the investment environment and thus industrial development and economic growth of a country. Therefore, study of the behaviour of imports is necessary not only to see the demand for imports that can determine the dependence on the foreign countries supply of raw materials, semifinished and finished goods that have implications for balance of payments scenario but also serves as guide for comparing the purchasing power of exports that is terms of trade. Some countries notably in Latin America and Asia have not been reluctant to use exchange rate policy in a highly active fashion. There is considerable disagreement among economists concerning the desirability of devaluation in developing countries. Economists have paid serious attention to the possibility of contractionary effects of devaluation (Bird 1983, Upadhyaya and Upadhyaya 1999). During early 1990s Pakistan embarked on trade liberalisation programme. Exports growth exceeded imports growth but imports increased in value terms resulting in current account deficit to the tune of 5% of GDP. Therefore, study of imports is highly desirable in order to have a pragmatic picture of the foreign trade situation as that will help in formulating policies. Moreover, exchange rate policy has now become an important element of standard structural adjustment programme requirements to improve external balance. Therefore, it is of paramount importance to examine the response of imports to exchange rate dynamics. Khan (1974), Naqvi et al. (1983), Sarmad and Mahmood (1985), and Afzal (2001) have studied import performance of Pakistan. Except Hasan and Khan (1994), other fore-mentioned studies have not examined the exchange rate response of imports. Hasan and Khan (1994) study period is Moreover, neither of these papers has examined the time series properties, which is highly desirable due to the use of time series data otherwise the results are likely to be spurious. The objective of this paper is to study the real and effective exchange rate response of imports demand in Pakistan for the period 1960 _ 2003 using both classical and time series econometrics approaches that may be of some help to formulate a realistic exchange rate policy. MATERIALS AND METHODS The traditional import demand of a country depends on the real domestic income and real import prices. The aforementioned studies have explored the import behaviour in a traditional way. Keeping in view the importance of exchange rate for imports, we estimate import equations using real exchange rate as well as effective exchange rate for imports. During 1950s and 1960s most developing countries including Pakistan opted for vigorous industrialisation through import substitution (IS). In the following decades (1970s, 1980s) a mix policy of export-promotion and import-substitution was pursued in Pakistan. During 1990s import-liberalisation and exportpromotion policies have been followed in Pakistan. Therefore, study of the impact of liberalisation efforts on imports is desirable and this has been captured by a dummy variable (D0) in this paper. Following, Afzal (2001) and Hasan and Khan (1994), we estimate the following import demand functions, with modifications to the said studies as under: LnM d = φ 0 + φ 1 Ln (PM/WPI) + φ 2 LnY+ φ 3 LnFER + φ 4 Ln REX (1) LnM d = φ 0 + φ 1 Ln (PM/WPI) + φ 2 LnY + φ 3 LnFER + φ 41 LnEERm (2) LnM d = φ 0 + φ 1 Ln (PM/WPI) + φ 2 LnY+ φ 3 LnFER + φ 41 LnEERm +φ 5Do (3) Where, M d = Real value of imports demand PM = Unit value of imports of Pakistan WPI = Wholesale price index (WPI) of Pakistan Department of Economics, Gomal University, Dera Ismail Khan - Pakistan

2 M. Afzal. Exchage Rate Response of Import Demand in Pakistan 1182 Y = Real GDP of Pakistan (1990 =100) Do = to 1990 (Pre- liberalisation) = to 2003 (Liberalisation) REX = Real exchange rate FER = Foreign exchange reserves EERm = Effective exchange rate for imports REX is defined (Dornbusch et al 1989, p.12) as under: REX = NER / CPI * USA WPI (4) Where NER = Nominal exchange rate CPI = Pakistan s consumer price index (1990=100) US WPI = USA Wholesale price index EERm (Krueger 1978, Khan1998) is the effective exchange rate for imports that includes nominal exchange rate (NER), the import tariff (t), import premiums from quantitative restrictions (pr) and other import charges (q). Therefore, we have EERm = NER (1+t+pr+q) (5) φ 1, φ 2, φ 3, φ 4 and φ 41 are respectively relative price for imports, real GDP, foreign exchange reserves, real exchange rate and effective exchange rate for imports elasticities. The expected signs of the coefficients in the above equations are: φ 1 < 0, φ 2 >o φ 3 >o, φ 41 <0 and φ 4 <0 and the sign of φ 5 is uncertain. DATA SOURCES Data on GDP, consumer price index (CPI), wholesale price index (WPI), unit value of imports and aggregate imports have been taken from Pakistan Economic Survey (various issues). The data regarding USA wholesale price index were collected from International Financial Statistics yearbooks (various years). Data on nominal exchange rate were taken from IFS for the early years (1960s and 1970s) and for later years ( ) from State Bank of Pakistan Annual Reports (various reports). Data on reserves in domestic currency have also been taken from State Bank of Pakistan source. Data on effective exchange rate for imports were obtained from Mahmood and Qasim (1992) up to and for from Khan (1998). For the remaining years effective exchange rate values were simulated. All the variables are in natural logarithm and are in constant 1990 = 100 prices. Using annual data, the period of the study is RESULTS AND DISCUSSION OLS (Ordinary Least squares) estimated the abovementioned three models. The estimation results are as under: LnM d = Ln (PM/WPI) LnY+ 0.05LnFER 0.46 Ln REX (1) (3.25)* (-0.71) (2.76)* (0.60) (-2.49)* R 2 = 0.90 DW = 1.50, LM (1) = 5.41* (01) Note: figures within parentheses are t-statistic. * Stands for 5% level of significance in the three equations LnM d = Ln (PM/WPI) LnY 0.07 LnFER LnEERm (2) (0.20) (-0.25)(3.41)* (-0.90) (0.21) R 2 = 0.89 DW = 1.49, LM (1) = 4.51* (0.01) LnM d = Ln (PM/WPI) LnY -0.07LnFER LnEERm -0.08Do (3) (-0.06)(-0.22)(3.22)* (-0.96)(0.21)(-0.42) R 2 = 0.89 DW = 1.50, LM (1) = 4.24*(0.03) In equation 1, all the coefficients have correct signs. Except real GDP (Y) and REX, all other coefficients are not significant. The coefficient for FER is positive but not significant. Hasan and Khan (1994) also got positive but not significant coefficient for FER for their disaggregated import demand functions for the period An increase in FER is expected to have a positive effect on import demand, but it is not significant. Thus FER do play a role in import demand but do not have crucial importance. Since we are dealing with time series data, the problem of autocorrelation will certainly arise. Durbin Watson (DW) statistic is the most celebrated statistic for detecting serial correlation. However, its great drawback is that if it falls in the indecisive zone, it is difficult to conclude whether serial correlation does or does not exist besides other problems. Q-statistic and the Breusch- Godfrey LM test are preferred in most applications. We will use the LM test. The LM test is not only statistically more powerful in large samples but also in finite or small sample (Gujarati 2003). Therefore we also reported LM test for the three equations. We used lag 1 for LM test based on AIC (Akaike information criteria) and SIC (Schwarz information criteria). Since the DW for the above three equations falls in the indecisive zone, we used also LM test. For all the three equations, the LM test is significant. Therefore, there is evidence of serial correlation and the results are interpreted with great caution. The REX expresses the prices abroad relative to those at home. An increase in the REX, or a real depreciation means that foreign prices in rupees have increased relative to prices of domestically produced goods. This implies that foreign goods imports) have become more expensive compared to goods at home. Therefore, REX has the correct and expected sign. Hasan and Khan (1994) also got negative and significant coefficient for REX for their import function for Industrial raw materials. The estimation results show that an increasing REX has dampening effect on import demand. As Pakistan s industry has remained heavily dependent

3 Sarhad J. Agric. Vol. 23, No. 4, on imports (Kemal (1998), devaluation is most likely to adversely affect the industrial sector. This result is according to expectations as devaluation increases the import prices that leads to reduction in import demand even if it is relatively inelastic. When real exchange rate is replaced by the effective exchange rate for imports (equation 2), we get very different results. Except the real GDP, no other variable has significant coefficients. FER and EERm have unexpected coefficients. The coefficient of the EERm is very small. A possible explanation is that domestic income is the principal determinant of imports. The coefficient of GDP is highly significant and exceeds unity implying that imports demand responds tremendously to income supporting our previous results (Afzal 2001).In equation 3 when the dummy is added, we do not get different results from equation 2. The dummy has negative coefficient but is not significant. In equation 1, we also experimented with Do, but also got negative and not- significant coefficient for Do. This may imply that liberalisation has adverse effects on imports but it is not significant suggesting that trade liberalisation and the consequent changes in the exchange rates have not affected Pakistan s imports demand because of massive reliance of the industry on imports. The demand for imports is almost inelastic. Co-integration Since we are dealing with time series data, it is pertinent to examine the data for unit roots and cointegration to see whether imports and other macroeconomic variables have long-run equilibrium or not? To do so we first investigate stationarity of the data employing unit root tests. We use both ADF (Augmented Dickey-Fuller) and PP Phillips-Perron) tests to determine the order of integration. Since these tests are computed routinely in the more recent research on economics the theory underlying these tests has not been mentioned. The lag length was chosen until residual were white noise using AIC and SIC and the optimal lag length was 1. The results of both tests (Table I) in level as well as first difference stationary show that they are integrated of order one with two obvious exceptions (PM/WPI for random walk with drift and drift and linear time trend in ADF and imports for random walk with drift in PP in level form). Now we apply Johansen (1991, 1995) technique of cointegration. Johansen method uses two test statistics for the number of cointegrating vectors: the trace test (λ-trace) and maximum eigenvalue (λ-max) test. We followed general to specific approach (Maddala 2003) to select the lag length and optimal lag length was one. The results of Multivariate and Bivariate Johansen test are given in Tables II and III. Econometrics software Eviews 3.1 derived all the results of unit roots and the Johansen cointegration method. Table II reveals that the null hypothesis of H 0 : r 2 is strongly rejected at 5% level of significance by both the λ-max and λ-trace tests in the multivariate case indicating the long-run relationship between imports and other underlying variables. There are three cointegrating vectors. Now we perform a bivariate Johansen cointegration test to see the long-run relationship of the forementioned variables with imports (Table III). The null hypothesis of no cointegration (H 0 : r = 0) is rejected by both the tests for GDP (Y), EERm and import price ratio (PM/WPI) supporting the strong, stable and long-run relationship between imports and the said variables. However, REX and FER are not cointegrated with imports implying absence of long-run relationship. As a matter of fact accumulation of foreign exchange reserves (FER) is a more recent phenomenon notably post 9/11 and REX and imports have been drifting apart due to relatively inelastic nature of imports. The absence of cointegration in no way implies that the said variables are of little importance for imports. CONCLUSION This paper addressed the important issue of real and effective exchange rates response of imports whose importance has increased in recent years due to changing global economic conditions. To study this aspect we employed both classical and time series econometrics techniques. The impact of the real exchange rate on import demand has been found to be dampening and this is according to expectations. Real depreciation of the domestic currency discourages imports but increases the competitiveness of the exports. Therefore, adoption of a realistic exchange rate becomes highly desirable as the objective global situation demands. Liberal outward-looking trade policies can lead to a higher economic growth through efficient industrialisation if appropriate fiscal, monetary and exchange rate policies accompany them. Domestic inflation and an unrealistic exchange rate may discourage the investment flows needed to the new incentives. An increase in foreign exchange reserves is expected to have a positive effect on import demand and these reserves do play a role in import demand but do not have crucial importance, as it is not the only determinant of import demand. More recent augmentation of foreign exchange reserves has benefited the economy in diverse ways increasing investors confidence, improving Pakistan s creditworthiness and serving as cushion

4 M. Afzal. Exchage Rate Response of Import Demand in Pakistan 1184 against contingency. Effective exchange rate response of imports is not according to expectations. Liberalisation has adverse effects on imports but it is not significant. A stable and longrun relationship has been found between imports and GDP, EERm and relative import prices. However, cointegration results do not support the long-run equilibrium situation between imports; and FER and REX but this does not in any way imply less importance of the said variables. Table I: Variables LnY LnM LnREX LnEERm LnPM/WPI LnFER LnPM LnPd Unit Root Tests: Level form and first difference stationary ADF Level ADF First Difference PP Level PP First Difference τ µ τ τ τ µ τ τ Z (t b1 *) Z (t b ) Z (t b1 *) Z (t b ) Note: The MacKinnon (1991) critical values for rejection of hypothesis of a unit root for both ADF and PP for 1%, 5% and 10% respectively are, -2.62, -1.94, and 1.62 for pure random walk (τ, Z (t a *); -3.61, and 2.60 for random walk with drift (τ µ, Z (tb 1 *) and 4.20, and 3.19 for drift and linear time trend (τ τ, Z (t b ). Table II: Multivariate case: Johansen test results Hypothesis λ-max 95%CV Hypothesis λ-trace 95%CV H 0 : r = 0 H 1 : r = * H 0 : r 1 H 1 : r = * H 0 : r 2 H 1 : r = * H 0 : r 3 H 1 : r = H 0 : r 4 H 1 : r = H 0 : r 5 H 1 : r = H 0 : r =0 H 1 : r * H 0 : r 1 H 1 : r * H 0 : r 2 H 1 : r * H 0 : r 3 H 1 : r H 0 : r 4 H 1 : r H 0 : r 5 H 1 : r Note: Critical values of Table II and Table III are from Osterwald Lenum (1992).

5 Sarhad J. Agric. Vol. 23, No. 4, Table III: Bivariate results of Johansen s method Hypothesis λ-max 95%CV Hypothesis λ-trace 95%CV A. LnM LnY 20.69* * B. LnM LnEERm 18.93* * C. LnM LnREX D. LnM LnFER E.LnM Ln (PM/WPI) 24.35* * REFERENCES Afzal, M Import Functions for Pakistan A simultaneous equation approach, The Lahore J.Econ. 6(2): Bird, Graham Should developing countries use currency depreciation as a tool of balance of payments adjustment? A Review of the Theory and Evidence: A Guide for the Policy Makers, The J. Dev. Studies, 9(6): Dornbusch, Rudiger and F.Leslie C.H. Helmers The open economy: Tools for policy makers in developing countries, Oxford Uni. Press. Govt. of Pakistan, Economic Survey (various issues), Islamabad, Ministry of Finance, Economic Advisor Wing. Gujarati, D Basic Econometrics. McGraw-Hill Inc, New York. IMF, International Financial Statistics (Various issues), Washington D.C. Kemal, A.R Industrial development in Pakistan, Pakistan J.Applied Econ. 14 (1 & 2): Khan, A.H The Experience of trade liberalisation in Pakistan. The Pakistan Dev. Review, 37(.4): Khan, Mohsin S Import and export demand in developing countries. IMF Staff Papers, 21: Johansen, S Estimation and hypothesis testing of cointegration vectors in Gaussian Vector Autoregressive Models. Econometrica, 59, Johansen, S Likelihood-based inference in Cointegrated Vector Autoregressive Models, Oxford Univ. Press. Krueger, A.O Foreign trade regimes and economic development: Liberalization attempts and consequences, Ballinger, Cambridge, MA. MacKinnon, J.G Critical values of cointegration test in R.F. Engle and C.W.J. Granger Eds, Long Run Economic Relationships: Readings in Cointegration, New York, Oxford Univ. Press. Mahmood, Zafar and Qasim Mohammad Ali Foreign trade regimes and savings in Pakistan. The Pakistan Dev. Review, 31(.4): Naqvi. S.N.H., Ashfaq Hasan Khan, Nasir M.Khilji and Ather Maqsood Ahmed The PIDE Macro-econometric Model of Pakistan's

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