Lahore School of Economics

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A low value-added export trap
June 22, 2019

Dr Azam Amjad Chaudhry

While there has been much debate about the strengths and weaknesses of Pakistan’s economy, the one thing that no observer of the economy can deny is its predictability. A balance-of-payments crisis forced the government to enter into an IMF stabilisation package a decade ago as did another crisis five years ago. Now, again, the country is faced with an unsustainable balance-of-payments situation and has entered another stabilisation programme. While there is a natural tendency to blame various economic managers, the fact is that the problem is not simply one that can be solved by minor policy adjustments. Rather, Pakistan is facing fundamental structural problems and while policymakers are making serious attempts to deal with some of these long-term issues, such as low savings and investment, they are reluctant to accept the fact that, even after an almost 40% devaluation, exports have failed to rise. The simple reason for this is that Pakistan is mired in a low value-added export trap.

In order to fully grasp the problem of low exports, one has to understand the current structure of Pakistan’s exports: To start with, the Pakistani export sector has been heavily reliant on textile exports and in particular low value-added textile exports. While many developing countries have started out by exporting low value-added goods, ones in which they have a comparative advantage, the problem in the Pakistani case is that it has failed to move beyond this narrow range of low value-added goods.

Also, while there was much optimism about the expected impact of the recent devaluation toward making the prices of our goods attractive to foreign buyers, the reality is that economic theory is much more nuanced in terms of its predictions about how devaluations affect the balance of payments (and exports and imports in particular). More specifically, while devaluations do increase exports, the actual magnitude of this increase depends on how much more of Pakistani goods will be bought by foreigners as their prices fall; so, if Pakistan exports low value-added textiles whose demand is less sensitive to price, there is a good chance that exports won’t increase by much after devaluation. At the same time, Pakistani imports do tend to respond to higher prices, which means that they fall significantly as the value of the rupee falls. This results in exactly what we see today: a current account deficit that is contracting mainly because of a large fall in imports, but no significant increase in exports.

If Pakistan wants to break out of this trap, it desperately needs an industrial policy that targets higher value-added exports. And critically, policymakers need to understand that any successful industrial strategy needs to move beyond simple incentives for manufacturers. Rather, an industrial policy that is geared toward structural transformation must combine a wide range of elements, including the creation of incentives for innovation that builds on collaborations between industry and academia, the development of technical education and training that is targeted towards industrial growth, and the coordination of industrial investment activities based on the infrastructure and demographic characteristics of specific geographical areas.

Policymakers also need to move beyond the idea of providing simple, across-the-board price and cost incentives to exporters towards more targeted policies, such as strategically reducing tariffs on those specific imported inputs that go into the production of higher value-added exports. But instead of following inward looking recommendations from industrial lobbying groups, policymakers need to look at countries that have moved into higher value-added exports (starting with higher value-added textiles) and see the goods that these countries now produce and the inputs they use for these goods. Pakistani policymakers have tried to use tariff policy and export subsidies to promote exports, but have failed do so in a systematic way.

Finally, Pakistani policymakers need to understand that countries that have successfully pursued export-led growth have always started by identifying new products with significant export potential. In Pakistan’s case, this could be done by analysing those countries that initially exported the same types of goods as Pakistan but graduated into higher-value added sectors, and use their example to determine new goods that Pakistan could potentially export. An example would be to empirically analyse the export basket of a country like Turkey and use its export expansion path as a template for the growth-oriented sectors into which Pakistan could expand. One could even use cross-country data to empirically determine how sophisticated these exports are and target an integrated package of incentives towards developing those higher value-added export products.

The question that many may ask is: why should the government worry about this during the current adjustment period? The reason is that the evidence shows that every five years or so, Pakistani growth rates exceed 4.5% which results in imports rising far more than exports, and in turn leads to a significant deterioration of the current account. This leads to a balance-of-payments crisis that is consistently addressed by the usual troika of internationally-recommended economic policies: devaluation, higher interest rates and expenditure cuts.

As policymakers worry about stabilisation, they also need to start thinking about a coherent industrial strategy that supports a robust export policy. If this is ignored, the historical cycle of a balance-of-payments crisis occurring every five years is bound to continue regardless of which government is in power.

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Labels: Dr. Azam Chaudhry, Publications, Research