Any aggressive appreciation in PKR will be disastrous for the economy .. (larger the current account deficit, larger depreciation needed to restore things
Trends in current account balance affect the exchange rates through the following three channels:
1. The flow of supply/demand channel
2. The Portfolio Balance Channel
3. The Debt Sustainability Channel
1. The flow supply/demand channel1): It is based on the fact that the supply of domestic currency is driven by the country’s demand for foreign goods and services
while the demand for domestic currency is driven by foreign demand for a country’s goods and services.
• Current account surplus (deficit) implies higher (lower) demand for domestic currency
èappreciation (depreciation) of the domestic currency against foreign currencies.
• However, when the domestic currency reaches some particular level, appreciation (depreciation) of the currency leads to deterioration (improvement) in the trade balance of the surplus (deficit) country.
The change in exchange rates that is needed to restore current account balance depends on the following factors:
1) The initial gap between imports and exports: When the initial gap between imports and exports is relatively wide for a deficit nation, then relatively higher growth in exports than growth in imports is needed to narrow the current account deficit.
2) The sensitivity of import and export prices to changes in the exchange rate: Typically, depreciation of the deficit country’s currency should result in:
• An increase in import prices in domestic currency terms.
• A decrease in export prices in foreign currency terms. However, it has been experienced that changes in exchange rates have very limited pass-through affect on prices of traded goods and services. Thus,
• The limited (greater) the pass-through of exchange
rate changes into traded goods/services prices, the more (less) substantial changes in exchange rates are required to narrow a trade imbalance.
3) The sensitivity of import and export demand to the changes in import and export prices: For a deficit nation, when import demand is more price elastic than export demand, then its currency needs to be depreciated by a substantial amount to restore the
current account balance.
2) The portfolio balance channel: According to this channel, current account imbalances shift wealth from deficit nations to surplus nations that can lead to shifts in global asset preferences.
• For example, countries running large current account surpluses against a deficit country may seek to reduce their holdings of the deficit country’s currency to the desired level; as a result, the value of the deficit country’s currency is negatively affected.
3) The debt sustainability channel: According to this channel, running a large and persistent current account deficit ultimately leads to a continuous rise in external
debt as a % of GDP. Thus, to narrow the current account deficit and to stabilize the external debt at some sustainable level, a deficit country’s currency needs to
be depreciated by a substantial amount; and consequently, the currency’s real long-run equilibrium
