Wednesday, 28 August 2013

Exchange rate economics

The article was published in the "Money Matters" on August 26, 2013

There are some possible solutions to stabilise exchange rate. First and foremost is the exchange rate forecast. Different fundamentals are considered to forecast it in the short, medium and long run. The demand and supply of foreign exchange reserves in Pakistan is the most vital determinant, which determines the value of exchange rate in the short run. Another key variable is the interest rate that helps to forecast exchange rate through two channels: impact through change in money supply in the long run and impact through change in capital inflows or outflows.

The possibility of the former channel is more likely to affect the country’s exchange rate in the long run. As there are capital controls in Pakistan; the latter channel may not be feasible in studying movements in the exchange rate. However, if expectations of price changes are included due to changes in money supply then interest rate might be a suitable determinant of exchange rate in the short run.

The relative price (difference between price in home and foreign country) is another important determinant of exchange rate. Technically, it is known as Purchasing Power Parity (PPP). If the exchange rate is adjusted according to changes in relative prices, the PPP holds.

However, due to State Bank of Pakistan (SBP) interventions, delayed response of price increase and speculators creating excess demand and supply of foreign exchange in the market to manipulate movements in the exchange rate, it is not receptive to price changes in the short run. But change in relative prices is an effective determinant of exchange rate in the long run.

In the wake of a balance of payments deficit, it is difficult to control exchange rate depreciation. Nevertheless, the country can do away with the need to borrow if it liberalises its capital account and the current account is financed by foreign direct investment and foreign portfolio investment, along with remittances (part of current account balance). Consequently, external debt will decline.

Due to increase in forex reserves, the exchange rate will be artificially controlled by foreign exchange injections in the market. Can this policy be supported? Judging from the Indian and South East Asian experience, it is a definite yes but with several reforms. A rule-based policy is needed to avoid time inconsistency. Further, the fiscal deficit should be reduced to decline the overall public debt as well as debt servicing.

Operational independence of the SBP is a key prerequisite to stabilise the exchange rate. The government should refrain from any policy intervention. For instance, the SBP should ask to maintain exchange rate within a certain band with specific interventions in the market. Similarly, targets should be set according to expected changes in prices in a particular year, expected trade balance and expected changes in forex reserves position. This would help boost the confidence of domestic as well as foreign investors. This policy would not favour rent seekers.

Monetary stability is necessary to reduce inflation and maintain exchange rate stability. However, this is not possible in the presence of a huge fiscal deficit as the government seeks funds from the central bank or scheduled banks with regular intervals. This causes inflation in the economy, thus contributing to exchange rate depreciation in the long run. In the short run, it overvalues the real exchange rate and makes exports expensive globally. Ultimately, this causes a decline in exports and trade balance, which has a directly impact on exchange rate.

Despite mitigating the current account deficit, remittances are still not among the most favoured policies to curb the deficit. Exports and imports are the two main components of current account. A cut down in imports resolves the problem but what kind of imports and how is the main question of concern? Reducing imports of capital and intermediate goods is not beneficial for the production sector. On the other hand, the end consumer is worse off if imports of consumerable items are reduced.

Another option is to increase exports by increasing production, discovering new potential markets and signing preferential and/or free trade agreements. Is this possible? For the last many years, several export-oriented policies have been adopted. Have those policies, by any means, had a positive impact on the trade balance. The answer to this is a no, as is evident from the situation of trade balance.

In conclusion, there is a fundamental solution to all the problems and that is the growth of the economy. For growth, exchange rate stability is not required. Slight volatility may help the economy to grow faster but higher volatility may dampen growth. Volatility is not the major issue in Pakistan.

Investment – private domestic investment or foreign investment – is required for growth. Reforms are needed to attract investors to the country. The framework of economic growth (FEG) is among the better policy options for the government to move on to the path of growth.

However, researchers have criticised the FEG as no timeframe has been provided in the document. Further, it will probably take 30 to 50 years to implement the FEG’s policies.

Hence, there is a need for short term policy measures to overcome the anomalies in the path of long run growth.

Finally, a few research questions that will further increase the understanding of exchange rate economics of Pakistan: do we need to control exchange rate? What if we have free float exchange rate systems with limited SBP interventions or no interventions at all? As volatility is not a problem for the economy, can we handle the trivial volatility patches in exchange rate? The writer is a research economist at PIDE 
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Controlling exchange rate

The Article was Published in the "Money Matters" on August 19, 2013

Much has been written recently about the exchange rate movement and the rupee downfall. Interestingly, the exchange rate is forecast based on random market research without using fundamentals in several of these writings. In the presence of balance of payments deficit and its financing through capital account (mainly by taking loans), it is reasonable to believe that the currency will not be appreciating for a long time.

Contrary to popular opinion, the layman also takes a keen interest in the exchange rate movement. It is one of the most talked about economic or financial variables. However, people have several misconceptions about the subject that have nothing to do with economics.

Recently, a newspaper article claimed that the IMF has asked the country to devalue its currency and a few economists believe that imports will rise due to depreciation. While not a single economics text book has explained this relationship, it is likely that these economists have included some aspect of the political economy. Typically, the term depreciation and not devaluation is used in a free float or managed float exchange rate.

Quite simply, exchange rate is the price of domestic goods in the international market. Depreciation implies that the exchange rate in terms of rupee against other foreign currencies increases. Hence, the prices of domestic products increase relative to those of foreign products. If the rise in domestic prices is consistently more than the increase in the prices of foreign countries then the exchange rate keeps depreciating at regular intervals.

On the other hand, if the depreciation rate is more than the increase in the rate of relative prices between two countries then the country’s goods become cheaper internationally. Consequently, the country’s exports will rise and imports will decline.

In the last one month, the exchange rate had depreciated between 99 and 105 against US dollar and then it appreciated to 102.5 in the open market. Either the relative price of the country’s goods has escalated by this margin or exports are getting cheaper in the world market and so is the possibility of increase in exports.

What are the other factors that influence exchange rate? The most significant of these that determines the exchange rate on a daily basis is the demand and supply of foreign exchange (forex) reserves. The increase in exchange rate is due to the excess demand for foreign currency in the market. Market forces push up the price of dollar - known as depreciation in exchange rate - until demand equals supply.

The problem starts when it is not known as to how high the price of foreign exchange (dollar) will go. When the price of foreign exchange exceeds a certain limit, the State Bank of Pakistan (SBP) intervenes in the market to inject foreign currency and close the gap between demand and supply of foreign exchange.

A significant factor that has led to the current rise in exchange rate from 99 to 105 against the greenback is the central bank’s decision not to intervene in the foreign exchange market. However, this has also led to currency speculation and investors opting for more dollarisation.

In the ‘90s, Pakistan’s foreign exchange reserves stood close to $1 billion. A thesis conducted by the Quaid-i-Azam University at that time concluded that whenever the forex reserves dropped below $1 billion, the gap between the open market and official exchange rate started widening. Nonetheless, it created more options for speculators and investors to gain from exchange rate fluctuations, mostly in the form of depreciation.

After 9/11, the situation has changed completely and the forex reserves’ position has started to improve. More foreign exchange is available for international transactions. Consequently, the trade gap has started to expand as more consumer-oriented goods are imported. The inflow of remittances has increased to narrow down the rapid increase in trade deficit. Further, it has also led to surplus balance of payments in the last decade.

Although remittances have increased multifold today as compared to the ‘80s and ‘90s, we have still been witnessing balance of payments deficit for several years due to increase in oil prices in the last five to six years and increase in import of consumer goods. The balance of payments deficit is financed by forex reserves and IMF loans. Until 2007, the exchange rate was controlled artificially by foreign exchange injections in the market. But as soon as the new government came into power, it let the exchange rate move freely and as a result, the exchange rate depreciated from 62 to 78 against the greenback in a few months.

Besides forex reserves and relative prices, there are other determinants of exchange rate, such as interest rate differentials between the home and foreign country. Higher interest rate invites capital inflows and increases foreign exchanges, which leads to exchange rate appreciation or vice versa.

The terms of trade, political and economic stability as well as public debt are the perceptual determinants of exchange rate, which can directly or indirectly affect it through changes in forex reserves, balance of payments or prices.

With regard to exchange rate, there are several issues that need to be addressed by researchers. The first and foremost is whether depreciating exchange rate is a real problem when there is a balance of payments deficit. Other issues include: the problems in artificially controlling exchange rate; if free floating is the answer to all problems; the intervention of SBP in the market; the monetary policy’s role in determining exchange rate; stabilising exchange rate; the benefits and problems of liberalising capital account and whether its liberalisation is a remedy for exchange rate stability.

The writer is a researcher at PIDE