Overinvoicing, Underutilization, and Distorted Industrial Growth

With an artificial exchange rate, a government establishes a set of prices that makes certain transactions highly profitable at the same time that it establishes laws making those transactions illegal. We usually call it “corruption” when people follow the government’s price incentives instead of its contradictory legal incentives. In Pakistan, the dollar sells for 4.75 rupees in the official market but for two to three times that much in the free market. Handsome profits are made by those who can trade in both. This paper describes overinvoicing of capital-equipment imports in Pakistan industry. Moral dimensions of the problem are not at issue. The central question is how overinvoicing affects the allocation of investment and, therefore, the structure of industry — how (and by how much) overinvoicing changes the costs of capital to the men who make investment decisions1. The logic of the problem can be developed with simple equations but an understanding of overinvoicing and its consequences does not depend on algebra. The reader who finds equations more a hindrance than a help can omit them and still get a clear sense of the shape and magnitude of the problem.