Exchange rate misalignment and economic development: the case of Pakistan

Recent findings in the economic growth literature suggest that developing countries need to keep a devalued exchange rate to stimulate their long-run economic growth. In light of this view, we assess the alignment of the real exchange rate of Pakistan, a developing country where sustained economic growth has proved to be elusive during the last two decades. After finding that the Pakistan rupee has been significantly and increasingly overvalued in real terms from 2005 – significantly above the over-valuation detected by International Monetary Fund (IMF) –, we simulate the general equilibrium effects of an eventual re-alignment of the Pakistani real exchange rate with economic fundamentals, and find that realignment would not only lead to a sizable increase in the relative size of the tradable sector - where productivity increases tend to be faster – but also to an associated re-distribution of income in favor of the urban poor and the (relatively disadvantaged) rural households. These findings reinforce recent arguments in the growth literature, and suggest the need for the Pakistani government to achieve – and sustain – a devalued exchange rate to boost its economic development prospects.