Capital Flows and Real Exchange Rate Overvaluation - A Chronic Ailment: Evidence from Pakistan

Abstract

The objective of this study is twofold: (i) to estimate the equilibrium real exchange rate (RER) from a long-run perspective and calculate the degree of overvaluation for the period 1972–2007, and (ii) to test the Dutch Disease hypothesis concerning the effect of capital flows on the RER in Pakistan. Based on various macroeconomic fundamentals suggested in economic literature by Edwards (1988, 1989, 1994), Elbadawi (1994), and Montiel (1997), the equilibrium RER is estimated as a function of the terms of trade, government spending, degree of openness, workers’ remittances, foreign direct investment (FDI) flows, and foreign economic assistance. In view of this study’s long-term focus, all unsustainable and temporary flows are filtered out to obtain an accurate misalignment index. Estimation results are in line with theoretical postulations: an increase in capital flows, government spending on nontradable goods and terms of trade improvement are consistent with an appreciation of the RER, while an increase in the degree of openness is expected to depreciate the RER. Findings suggest that the RER suffers from chronic overvaluation in Pakistan. In spite of filtering out unsustainable and temporary flows, overvaluation increased from 0.75% in 2001 to 22.9% in 2007. A sharp rise in FDI flows (between 2005 and 2007) and an increase in remittances (between 2002 and 2007) are among the main factors that have contributed to this persistent overvaluation. Results also suggest that the Dutch Disease hypothesis holds in the case of Pakistan.