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