What does and does not determine the value of the rupee 20

What does and does not determine the value of the rupee

By Yousaf Nizami

What is the money in your name and your wallet really worth? One way of arriving at a number is calculating what all it can buy today as compared to a month back and perhaps what it will be able to purchase a month later. Another less tedious way that would provide a more absolute number, which changes almost daily and is a more approachable concept for most is how many dollars it can buy today, a month back and a month later.

This is important information for investors looking to spend, save or invest and businesses to formulate budgets, strategize and plan. It is therefore important to understand what does and does not have an effect on the value of the Rupee against the USD.

The conventional stuff

One of the most talked about macroeconomic indicators of the direction and health of Pakistan’s perpetually struggling economy is the value of the Rupee against the US dollar. This is understandable as it directly and indirectly, determines the prices of most, if not all, goods and services and therefore the inflation rate. The most obvious explanation, as with any currency or commodity, is its domestic demand and supply. If the supply for USD is lower than demand in the interbank market, the Rupee will lose value against the greenback. If demand is lower than supply, the Rupee appreciates. The same applies in the open market for physical USD. Various factors determine how much USD is available in the market at any given point in time. In normal circumstances, the unavailability of USD in the interbank owing to heavy payments (imports and/or loan repayments), will put downward pressure on the value of the rupee against the greenback. Similarly, if individual investors strongly feel that the value of the rupee will be falling in the short term, they will buy and hold more physical USD for longer for more capital gain, thus creating a shortage in the open market causing the rupee to depreciate.

Additionally, macroeconomic indicators such as the current account deficit, inflation and policy level changes such as the discount rate or specific policy changes aimed at the local foreign exchange market will also influence the USD/PKR parity. There are some artificial measures that the government and SBP take to stabilize the Rupee that disrupt the process of market forces accurately valuing the rupee against USD. Flooding the interbank market with USD from foreign exchange reserves with the central bank is one way, which has had disastrous effects on the long term stability of the currency, as is being witnessed currently. Then there are administrative measures such as restricting banks from retiring import LCs and issuing of fresh LCs and making it tougher for individuals and businesses to buy physical dollars in the open market. Of late, in some instances, customers have been unable to withdraw cash from their USD bank accounts.

Oft mentioned, but meaningless

If you read the sort of content produced by us or other business journalism publications out there, you may have come across a piece or two about the Rupee in which the author casually slips in the proposition that the strength or weakness of the USD internationally has strengthened or weakened the Pakistani Rupee. This, dear reader, is pure hogwash! Yes, if you speak in terms of third currencies such as Pound Sterling (GBP) or the Euro (EUR), the global value of the USD against the aforementioned, will have an effect on the value of the Rupee against third currencies. But that is only because of the GBP/USD or EUR/USD component of that conversion changing. Nothing is happening to the USD/PKR leg of the conversion that is necessary to arrive at a EUR/PKR or GBP/PKR rate. Even if there is a change in the USD/PKR, coinciding with a change in the EUR/USD or GBP/USD, that is solely owing to domestic factors in Pakistan, not the even or data that has strengthened or weakened the USD internationally.

An example

Let’s say on Monday, the USD/PKR is trading at 227. The GBP/USD is trading at 1.22. Anyone looking to buy GBP in Pakistan will have to buy at a rate of 276.94 (USD/PKR * GBP/USD). The next day, the US government releases inflation data which is better than expected. This strengthens the USD internationally and the GBP/USD starts trading at 1.18. The USD/ PKR parity is unaffected by Americans being able to buy more food due to lower inflation, and stays at the same rate of 227. Anyone who didn’t buy GBP on Monday, but bought on Tuesday, would get a rate of 267.86. Since third currencies are traded in a substantially lower volume than the USD in Pakistan, it would be intellectually dishonest and frankly lazy to even suggest that international USD strength has any bearing on the value of the PKR against the USD. The rupee does not care about what the international value of the USD is doing. The rupee is not big enough, not important enough. Think about it this way: why do you purchase USD, EUR, GBP etc. before going on a vacation? One reason is possibly because the local currency accepted as legal tender in your travel destination isn’t easily available in Pakistan. But more often than not, because no currency changer other than the ones in Pakistan will accept Rupee as legal tender and exchange it for USD or the local currency of your holiday destination. Another way of putting it is that the traded volume of the rupee as a currency, other than in Pakistan, is practically zero. Why then would any changes in the biggest economies in the world have a direct effect on the value of the rupee? The rupee responds only to changes in the domestic market!