August 2, 2019 (MLN): Whenever the interest rate rises, return on investment increases for both private and public investors and hence, allows the country’s currency to appreciate.
The main reason behind this appreciation is that more and more people come inside the county to invest. If it is the case, then why does this relationship not seem to hold in Pakistan despite rising interest rate scenario? Does interest rate policy really lead to exchange rate stability?
It is not as simple as it seems. In non-bookish world, interest rates and exchange rates do not have a simple one-on-one relationship. However, they do impact each other in important ways.
As interest rates alone do not determine exchange rates and the value of a currency in foreign exchange markets, other factors such as internal political stability, inflation, current account deficit, gross domestic product (GDP) and government debt are equally important.
Pakistan’s economy has been performing poorly over the last year. Thus, in an attempt to stabilize the currency, curb the inflationary pressure and avoid many adverse economic consequences, the government has been adopting tight monetary policy since the beginning of 2018.
High interest rate policy is considered important for a number of reasons. Firstly, it raises the attractiveness of domestic financial assets as a result of which capital inflows occur and thereby limit the depreciation of the exchange rate. Secondly, it not only reduces the level of domestic aggregate demand, but also improves the balance of payments position by reducing the level of imports.
However, despite adopting tight monetary policy, the government is still not able to curb currency depreciation and establish price stability in the economy.
The figure below illustrates the positive relationship between interest rate and exchange rate (USD/PKR) in Pakistan. Historically, from FY03 until FY19, discount rate averaged 8.12 Percent, reaching an all-time high of 15 percent in 2008 and a record low of 6.25 Percent in 2016 and 2017.
By interpreting data from the figure below, it can be observed that Rupee is continuously depreciating against USD, thus, USD is becoming more expensive. From 2003 until 2007 Rupee was depreciating slightly against USD. However, after this moment till 2009 Rupee experienced a sharp depreciation of 34% against USD. In the last fiscal year when discount rate increased to 12.75 percent from 10.5 percent in FY18, Rupee depreciated significantly by 31 percent against USD.
The trend indicates that with the rise in interest rates, rupee continues to depreciate, leading to a rise in exchange rate (USD/PKR). The justification behind this positive correlation between interest rate and exchange rate in case of Pakistan is as economic theory suggests that in a country where inflation is high its domestic currency depreciates.
The rise in inflation increases the demand for foreign goods and decreases the exports, leading to a current account deficit. On the other hand, the exchange rate of the foreign currency increases, resulting in an appreciation of that currency.
Calculations based on the data from FY03 shows that in Pakistan, the association between interest rate and exchange rate (USD/PKR) is not that significant. As in the figure below, the total variations in exchange rate caused by the changes in interest rate which is explained by R2 is only 0.15 percent, moreover, the equation suggests that for every 1 percent rise in interest rate, the exchange rate (USD/PKR) appreciates by only 0.4 percent.
Therefore, increase in interest rate to limit currency depreciation is inefficient because exchange rate (USD/PKR) is affected by many other factors as explained above for which interest rates are one of those macroeconomic variables.
Among other factors, GDP is the most crucial macroeconomic variable as per our calculations that explains most of the exchange rate (USD/PKR) fluctuations i.e. 86 percent of the variations in exchange rate (USD/PKR) caused by the changes in GDP numbers, additionally, for every 1 percent increase in GDP, exchange rate (USD/PKR) appreciates by 11.18 percent.
The rationale behind this relationship is that when the income level of the country increases, people would tend to buy and invest more in the foreign country. This would result in country’s current account (CA) deficits, as a result of higher imports. A negative current account is equivalent with currency depreciation.
The above relationship can also be seen in the figure below, illustrating the strong positive affiliation between GDP and exchange rate (USD/PKR). The trend shows that the exchange rate is rising with the rise in country’s GDP. However, other variables such as CA balance and yearly average inflation are showing the mix trend of rise and fall.
In conclusion, it is apparent from the above analysis that the negative relationship between exchange rate (USD/PKR) and interest rate does not seem to be the case in Pakistan because of the strong counter-impact of other macroeconomic factors such as inflation, CAD, political and economic instability and so on. However, this does not necessarily imply that monetary authorities should not exercise to restraint currency depreciation when regulating interest rates. Nonetheless, interest rate should be monitored and adjusted accordingly because it is a contributing factor in macroeconomic policy making.
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