Dynamics of Foreign Exchange Market in Pakistan

By

Muhammad Arif
Research Consultant to the Financial Daily
Member visiting faculty Master of Islamic Banking & Finance, University of Karachi
BIZTEK on Financial Management

Former Director / Head FSCD, SBP

In recent global world, the importance of foreign exchange market is quite evident.
Objectively they are supposed to perform following three functions:-

1. To facilitate easy inflow and outflow of foreign currencies, mainly reserve

currency in order to meet country’s obligations.
2. Function in a manner to avoid abrupt and large size changes in country’s
nominal exchange rate.
3. Facilitate market players to hedge their risks.

Pakistan is a part of emerging economies and has just reached to the GDP size of $
126-130 billion. Therefore obviously, the size of its foreign exchange market is yet
small as compared to other emerging markets. In FY06, its daily volume was around
$ 200 million that increased to $250 million in 2007 and $ 350 million in 2008. In
2009 and 2010, it has grown to the size of $ 400-600 million. This increase is
significant but there are other important issues that make its activities more vaoltile
as compared to other nations.

The figures provided above, pertain to interbank market which is the official
channel, whereas non official channel known as KERB is also very active and some
time overshadows activities of formal market creating problems for its apex
regulator i.e. SBP. Efforts are under way to streamline this anomaly through
formation of exchange companies, but still SBP has not succeeded in getting control
of this segment to its satisfaction.

Exchange rate policy by definition and practically is part of monetary policy. It

underwent several changes since 1949. The exchange rate of Pakistan remained
fixed in terms of pound sterling up to September 1971 and subsequently in terms of
US$. Since January 1982, the exchange rate regime of PKR was a system of
managed float, based on a basket of currencies. In 1991 with initiation of financial
sector reforms, the direction was set to turn it in to free float that was finally
achieved in 2000-2001. Pakistan uses US$ as its reserve currency. As regards
changes in its nominal value, it also went through various changes. In Sept, 49, the
decision was taken not to devalue PKR while 48 currencies in the sterling area went
in to devaluation in spite of the fact that current account (CA) deficit in 1948-49 was
around 2.5% of its GDP. Luckily, Korean War helped Pakistan to come out of this
crisis and in 1950-51, Pakistan witnessed surplus in its CA. However on ending of
Korean boom, Pakistan again went in to CA deficit. On 31 st July, 1955, first time PKR
was devalued. In 1956-57, the position worsened to such an extent that Governor
SBP in its policy statement singled out balance of payments and inflation as the two
main culprits for the economy. Since that time, the same legacy is hovering over
Pakistan’s economy. Nominal exchange rate remained fixed at Rs 4.76 per US$
since 1955, but since export bonus scheme was in vogue at that time, so effectively
it was a multiple exchange rate. In 1971 it depreciated to RS 7.76 for exports,
however in 1972 it was unified as Rs 11 per US $.

Another issue that confronted Pakistan at that time was significant overvaluation of
Real Effective Exchange Rate (REER) that appreciated by 56% in 1972 and 25% in
1973. To adjust this and in order to make the exports competitive, the PKR was
devalued 56.73% at that time. The main feature of adjustment in feeding CA deficits
has been the aid from donor agencies mainly from the US. The same features still
hold our economy and we have not been able to come out of this mess.

The foreign exchange market in Pakistan gets its inflows through export proceeds,
remittances and FDI. The amount received from IMF is for meeting current account
deficit and does not add up in to FX market activities. Further SBP intervenes some
time to smooth out the market that can come under pressure on account of lumpy
payments or can plunge on receipt of some major amount. Under financial sector
reforms started in 1991, current account has been made totally convertible in 1993,
meaning that any foreign account holder (FE-25) can send its money outward
without any restriction. Likewise this account can receive amount in cash or from
outside without any restriction. In capital market investments, the amount can be
sent in or send out through SCRA, an account maintained with the banks on behalf
of investors. Capital account convertibility is not yet allowed in Pakistan.

The year FY08 remained volatile for the FX market, witnessing huge contraction in
the NFA i.e. around Rs 375 billion. This figure coincided with depletion in the bank
deposits remaining to the same quantum. The outflow mainly went to the Gulf
States for better investment opportunities, however the trend is now on reverse, on
account of recessionary mood in these countries. At that time the rupee
depreciated by more than 18%. However on access of IMF aid, the things have
stated moving towards some improvements, but theses are short term
arrangements. Opportunities exist to encash them on the back of declining inflation
and world coming out of recession. Forward points, an indicator of future trend of FX
market going as high as Rs 3.72 per US $ in June 08 are now softening out. FX
reserves have also improved which is required mainly to support import obligations
and to support FX market in case of its dire need to avoid undue fluctuations in
nominal exchange rate. In wake of these changes, SBP has succeeded in shifting oil
payments to the interbank market. Further KERB market is also showing some
discipline resulting in little spread in between interbank and KERB market.
Another disciplinary arrangement for FX market i.e. Foreign Exchange exposure
limit (FEEL) implemented by the SBP after replacing NOSTRO limits had made the
market more flexible and disciplined to move within some range of banks paid up
capital. Previously they were 10% of paid up capital, however recently they have
been relaxed to 20%. This has made the FX market to arrange their funds by using
somewhat wider space.

Now going forward, let us see what can be the fate of Exchange rate in Pakistan.
One of the questions that dictates the exchange rate parity are the difference in
interest rate on other currencies specifically $ in respect to PKR, the difference of
forward exchange rate from its spot rate and how expected spot rates for $ and PKR
are going to be determined for the next year and what relationship one can foresee
in between inflation in Pakistan with respect to other countries. Apart from these
factors, the paramount factor is the demand and supply position of S with respect to
PKR that some time alters on the basis of government and central bank policies. In
this regard, KERB market has its role as well in shift of market flows and in making
market sentiments

Let us now take first case of interest rate differential. In this regard interest rate
parity theory says that the difference in interest rats must equal the difference in
between the forward and spot exchange rates. In our case the equation becomes
1+rate on PKR/1+ rate on dollar = forward PKR per $/ spot PKR per $. This equation
gives a parity of Rs 92/$ in future, considering PKR interest rate as 12%, $ interest
rate as 1 % and spot rate as Rs 83/$.

Now let us take the case of exchange rate premium that depend on changes in spot
rates of the exchange. The expectation theory in this regard says that percentage
change in between forward rates and today’s spot rates is equal to the expected
change in the spot rate i.e. forward PKR per $/ spot PKR per dollar = Expected spot
PKR per $/ today’s spot PKR per $. In this case, the assumptions are that traders are
not caring about either risk which can not be factually correct.

In case of inflation, the theory of purchasing power parity says that difference in the
rates of inflation will be offset by a change in the exchange rate i.e. Expected (1+
inflation rate in Pak)/ Expected (1+ inflation rate in US) = Expected spot rate of PKR
per $/ todays spot rate of PKR per $. In this case S/PKR parity comes out as Rs 88
considering inflation rate in Pakistan as 10, in US as 3% and current spot rate as Rs
83 per US$.

However apart from above academic exercises, the life is not as simple. Further
studies have established that spot rates calculated as such are most of the times
exaggerated. No doubt, the forward rates seem to contain risk premium but the
sign of this premium swings backward and forward most of the time. However most
probably the nominal exchange rate can stay, if CA deficit remains within control
and committed inflows from multilateral agencies, friendly countries and other
means are ensured. It can move to a mid i.e. at Rs 88/US$ in case of some adverse
movements and can peak at Rs 92 per US $ in FY10 & FY11.

The most important issue in developing FX market right now is to bring hedging
products in the market. SBP has initiated Derivatives market in 2004 with
introduction of FX options and other interest rate derivatives. Forwards and
currency swaps already existed in the market. Sensing huge differential between
LIBOR and KIBOR, market opted for cross currency swaps in FY07 and FY08, but
with significant depreciation in PKR, most of the corportaes burnt their figures.
However since most of them were naturally hedged against their export proceeds,
so in nut shell they landed just on square. Moreover, this experience and others by
using forwards have revealed that most of the corporate players are not aware
about the risks of use of cross currency swap and other derivatives. As for forwards,
they are mostly demand driven and operate in an environment where no price
discovery mechanism exists, so ultimately they also end up without providing future
prices prudently.

These are the hassles of the FX market in Pakistan that can be streamlined with the
initiatives of SBP in collaboration with market players. However market side lacks
capable staff at the moment. This puts an extra responsibility on banks or other
financial institutions or even corportaes to work seriously on capacity building of
their staff working in their treasuries.