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

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  • Hamna Ahmed

    ()
    (Lahore School of Economics, Pakistan.)

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    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 amongthe main factors that have contributed to this persistent overvaluation. Results also suggest that the Dutch Disease hypothesis holds in the case of Pakistan.

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    Bibliographic Info

    Article provided by Department of Economics, The Lahore School of Economics in its journal Lahore Journal of Economics.

    Volume (Year): 14 (2009)
    Issue (Month): Special Edition (September)
    Pages: 51-86

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    Handle: RePEc:lje:journl:v:14:y:2009:i:sp:p:51-86

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    Web page: http://www.lahoreschoolofeconomics.edu.pk/EconomicsJournal/LJEIntro.aspx
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    Related research

    Keywords: Real exchange rate; capitalinflow; overvaluation; Pakistan.;

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    References

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    1. Ofair Razin & Susan M. Collins, 1997. "Real Exchange Rate Misalignments and Growth," International Finance 9707001, EconWPA.
    2. Sebastian Edwards, 1988. "Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence From Developing Countries," NBER Working Papers 2721, National Bureau of Economic Research, Inc.
    3. Usman Afridi, 1995. "Determining Real Exchange Rates," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 34(3), pages 263-276.
    4. Arvind Subramanian & Jonathan David Ostry & Simon Johnson, 2007. "The Prospects for Sustained Growth in Africa," IMF Working Papers 07/52, International Monetary Fund.
    5. M. Ashraf Janjua, 2007. "Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 12(Special E), pages 126-152, September.
    6. Elbadawi, Ibrahim A. & Soto, Raimundo, 1994. "Capital flows and long-term equilibrium real exchange rates in Chile," Policy Research Working Paper Series 1306, The World Bank.
    7. Ofair Razin & Susan M. Collins, 1997. "Real Exchange Rate Misalignments and Growth," NBER Working Papers 6174, National Bureau of Economic Research, Inc.
    8. Salim Chishti & M. Aynul Hasan, 1993. "What Determines the Behaviour of Real Exchange Rate in Pakistan?," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 32(4), pages 1015-1029.
    9. Dani Rodrik, 2008. "The Real Exchange Rate and Economic Growth," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 39(2 (Fall)), pages 365-439.
    10. Simon Johnson & Jonathan D. Ostry & Arvind Subramanian, 2007. "The Prospects for Sustained Growth in Africa: Benchmarking the Constraints," NBER Working Papers 13120, National Bureau of Economic Research, Inc.
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