1

An empirical investigation into what determines the behaviour of official exchange rate in Pakistan.

2 Contents Abstract 1. Introduction 2. Research question 3. Research objective 4. Data & methodology 11 4.1. 4.2. 4.3. Data Methodology Justification of method 12-27 28 Page number 3 4 -5 6 7 8-

5. Empirical findings 6. Summary & conclusion 7. Annex -1 Data of variables

Abstract

This paper aims to determine the behaviour of official exchange rate issued by State Bank of Pakistan. What economical factors in short and medium term affect or determine the behaviour of official exchange rate in Pakistan. Domestic currencys value against the major currency dollaris influenced by economic factors like GDP, countrys official interest rate, M2 (money & quasi money), Foreign direct investment and consumer price inflation. This study tests the validity of the hypothesis the short term and medium term factors like GDP, interest rate, M2 (money & quasi money), foreign direct investment & consumer price inflation influence the exchange rate of Pakistan. Besides, among these factors which factor(s) has the most and least affect on the exchange rate. Moreover, how the exchange rate can be stabilised by controlling these factor(s).

Key words: Official exchange rate, GDP, discount rate, inflation, FDI, M2 & Pakistan 1. Introduction

In the era of globalization and financial liberalization, exchange rate plays an important role in international trade and finance for a small open economy like Pakistan. This is because movements in exchange rates affect the profitability of multinationals and increase exchange exposure to enterprises and financial institutions. A stable exchange rate may help enterprise and financial institutions in evaluating the performance of investments, financing and hedging and thus reducing their operational risks (Nieh and Wang, 2005; Rahman and Hossain, 2003). Fluctuations in exchange rate may have a significant impact on the macroeconomic fundamentals such as interest rates, prices, wages, unemployment, and the level of output. This may ultimately results in a macroeconomic disequilibrium that would lead to real exchange rate devaluation to correct for external imbalances (Parikh and Williams, 1998).

Foreign exchange rate is the price of a unit of foreign currency in terms of the domestic currency. In a floating exchange rate mechanism as is the case in Pakistan, the foreign exchange rate is determined in the same way as the price of any other commodity in the free market economy. Appreciation or depreciation of currency thus depends on demand & supply of the Pakistani rupee along with the other factors like level of GDP, interest rate, M2 (money & quasi money), foreign direct investment & consumer price inflation.

Pakistani currency has been depreciating against USD since 1982. According to the secondary data obtained from WDI, geometric mean rate of devaluation of Pakistani rupee from 1981 2009 was recorded as 7.58%. Over a period of 29 years, Pakistani rupee has been depreciated against USD by 725%. Average annual rate of devaluation of Pakistani rupee against USD from 1981 2009 was thus recorded as 7.54%. Depreciation in Pakistani rupee against USD as compared to other East Asian countries like India, china, Iran and Bangladesh is substantial & alarming and calls for an investigation. A detailed study is imperative to be conducted to explore the reasons and factors causing Pakistani rupee to devaluate against USD.

2. Research questions 1. How annual percent increase in GDP, official interest rate, M2 (money & quasi money), Foreign direct investment and consumer price inflation influence the exchange rate of Pakistani rupee against USD? 2. Among these determining factors described above which one has the most or least affect on exchange rate? 3. How the exchange rate can be stabilised by controlling these factors of exchange rate?

3. Research objective

This study aims to investigate the factors that influence of exchange rate in Pakistan in short and medium term. Having investigated and analysed the effects of these determinants, a scale of importance will be assigned to those factors to measure their affects on exchange rate according to their relative importance. Besides, how the determinant factors of exchange rate according to their relative importance can be used to stabilise, maintain and align the exchange rate to the economic policy of Pakistan.

4. Data & Methodology

4.1.

Data

A large sample period of 30 years from 1980 to 2009 has been selected to avoid small sample bias. Secondary data (world development indicators & trading economics) have been used to conduct this study. Six variables have been selected in this study. Exchange rate is used as dependent variable whereas annual percent increase in GDP, official interest rate, M2 (money & quasi money), foreign direct investment and inflation are used as independent variables to measure their effects on exchange rate.

Dependent variable Exchange rate: Foreign Exchange Rate can be defined as the Price of one countrys currency in terms of another currency or we can also say that its the domestic price of a foreign currency. Official exchange rate Annual percent increase is used in this study as dependent variable.

Independent variables

9 1. Gross domestic product: GDP can be defined as the total market

value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. Annual percent increase in GDP (current USD) is used in this study to measure its affect on exchange rate.

2.

Interest rate/SBP discount rate: The discount rate is the

interest rate charged to commercial banks and other depository institutions on loans they receive from their regional State Bank's lending facility--the discount window. Annual percent increase in average interest rate/discount rate declared by State bank of Pakistan is used as independent variable in this study.

3. M2 (money & quasi money ) Money and quasi money comprise the sum of currency outside banks, demand deposits other than those of the central government, and the time, savings, and foreign currency deposits of resident sectors other than the central government. This definition of money supply is frequently called M2; it corresponds to lines 34 and 35 in the International Monetary Fund's (IMF) International Financial Statistics (IFS). Annual percent increase in M2 as percentage of GDP is used as independent variable.

4. Foreign direct investment net

10 FDI stands for Foreign Direct Investment, a component of a country's national financial accounts. Foreign direct investment is investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets. Annual percent increase in FDI net is used in this study to measure its affect on exchange rate.

5. Inflation A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money... Annual percentage of consumer prices inflation is used in this study to measure its affect on exchange rate.
Source: WDI, Trading economics

Quality of data Sources of secondary data (world development indicators and trading economics) are reliable however, the accuracy of the data cannot be absolutely guaranteed as indicators came from a secondary source. Variables measure the concepts which we intend to measure. Given that the data have been collected according to the above definitions of the variables, the data used in this study is valid for the purpose of analysis. It is important to note that the above definitions of the variables have been taken from the user guide of the World development Indicators which is the source of the data used in this study. A few data values are missing from some variable. Data on World Development Indicators and trading economics are drawn from the sources thought to be most authoritative.

11 4.2. Methodology

1. Normality of data is checked to see whether the data is normally distributed or not. normality of data. 2. To check whether the relationship between dependent and independent variables is Linear or not, both graphical and statistical methods are employed. 3. To view the overall picture of the variables, descriptive statistics are used. 4. Major assumptions of parametric statistics were checked. Having conducted Shapiro-wilk test for normality and statistical method to check the linear relationship of dependent with independent variables, we conclude that the data is normally distributed and the independent variables have linear relationship with dependent variable. Since the data is scale and approximately normally distributed, bi-variate parametric associational test like Pearsons correlation test is used to see the association between dependent and independent variables. 5. Major assumptions of multiple regressions were checked before applying OLS linear regression. Multicollinearity, hetro, and autocorrelation were checked. 6. OLS method of multiple linear regression attempts to predict a dependent variable from a combination of several normally distributed independent variables. In this study, we want to see what is the highest possible multiple correlation of these variable with dependent variable. For such a reason, we have used OLS multiple regression. Shapiro-wilk test is conducted to check the

4.3.

Justification of the method

Descriptive statistics is used in this study to show the overall view of the variables. Bi-variate parametric associational test like Pearsons correlation test is used to see the association between dependent and independent variables. OLS method of multiple linear regression attempts to predict a dependent variable from a combination of several normally distributed independent variables. In this study, we want to see what is the highest possible

12 multiple correlation of these variable with dependent variable. For such a reason, we have used OLS multiple regression.

5. Empirical Findings 5.1. 5.1.1 Assumptions of parametric tests Shapiro-wilk test for normality of data

Since the sample size in this study is 30. The most suitable test to check the normality of data up to 50 sample size is Shapiro-wilk test.

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Tests of Normality Kolmogorov-Smirnova Statistic Money & quasi money annual percent increae SBP discount rate annual percent increase Foreign direct investment annual percent increase Inflation annual percent GDP annual percent increase exchange rate annual percent increase a. Lilliefors Significance Correction *. This is a lower bound of the true significance. df Shapiro-Wilk

Sig. Statistic df Sig. .200* .124 .200* .200* .200* .200

*

.114 30 .142 30 .112 30 .124 30 .125 30 .089 30

.966 30 .435 .964 30 .392 .946 30 .128 .932 30 .060 .933 30 .060 .973 30 .610

H = Data is normally distributed H = Data is not normally distributed Sig = 0.05 P values of all variables computed through Shapiro-wilk test are greater than the significance level 0.05, we fail to reject H. Therefore, we conclude that data is normally distributed.

5.1.2. Graphical & statistical methods to check the linearity Graphical & statistical method is used to check whether the relationship between dependent and independent variables is linear or not.

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Since R quadratic - R linear = 0.00 which is < 0.05 significance level. Therefore, we conclude that relationship between dependent variable exchange rate & independent variable- SBP discount rate is linear.

Since R quadratic - R linear = 0.017 which is < 0.05 significance level. Therefore, we conclude that relationship between dependent variable exchange rate & independent variable- inflation is linear.

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Since R quadratic - R linear = 0.023 which is < 0.05 significance level. Therefore, we conclude that relationship between dependent variable exchange rate & independent variable- GDP is linear.

Since R quadratic - R linear = 0.023 which is < 0.05 significance level. Therefore, we conclude that relationship between dependent variable exchange rate & independent variable- M2 is linear.

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Since R quadratic - R linear = 0.004 which is < 0.05 significance level. Therefore, we conclude that relationship between dependent variable exchange rate & independent variable- FDI is linear.

5.2. Pearsons correlation test The Pearsons correlation table is computed in SPSS to see the degree to which dependent variable- exchange rate is related to the independent variables namely - GDP, countrys official interest rate, M2 (money & quasi money), Foreign direct investment and consumer price inflation.

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Descriptive Statistics Mean exchange rate annual percent increase Money & quasi money annual percent increae Foreign direct investment annual percent increase Inflation annual percent GDP annual percent increase SBP discount rate annual percent increase 7.5000 14.3757 25.2587 8.3000 7.5420 -.4032 Std. Deviation 6.25190 6.39877 55.00650 3.86987 7.72520 17.70994 N 30 30 30 30 30 30

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Correlations Money & quasi exchange rate annual percent increase exchange rate annual percent increase Pearson Correlation Sig. (2-tailed) N Money & quasi money annual percent increae Pearson Correlation Sig. (2-tailed) N Foreign direct investment annual percent increase Pearson Correlation Sig. (2-tailed) N Inflation annual percent Pearson Correlation Sig. (2-tailed) N GDP annual percent increase Pearson Correlation Sig. (2-tailed) N SBP discount rate annual percent increase Pearson Correlation Sig. (2-tailed) N **. Correlation is significant at the 0.01 level (2tailed). *. Correlation is significant at the 0.05 level (2tailed). 30 -.049 .796 30 -.475** .008 30 .224 .233 30 -.480** .007 30 .337 .068 30 30 -.041 .830 30 -.161 .397 30 -.165 .382 30 -.337 .068 30 30 -.041 .830 30 .238 .204 30 -.208 .270 30 30 .270 .149 30 -.129 .496 30 30 -.429* .018 30 30 1 money annual percent increae -.049 .796 30 1 Foreign direct investment annual percent increase -.475** .008 30 -.041 .830 30 1 Inflation annual percent .224 .233 30 -.161 .397 30 -.041 .830 30 1 GDP annual percent increase -.480** .007 30 -.165 .382 30 .238 .204 30 .270 .149 30 1 SBP discount rate annual percent increase .337 .068 30 -.337 .068 30 -.208 .270 30 -.129 .496 30 -.429* .018 30 1

Results:

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The correlation table above shows the Pearsons correlation coefficients and the two-tailed significance (Sig.) levels. To investigate if there was statistically significant association between

exchange rate and money and quasi money, Pearsons correlation was computed. Pearsons correlation co-efficient for correlation between exchange rate and Money & quasi money is r=-.049 and the significance level or p value is p=0.796. Using Cohens 1988 guideline, the direction of the relationship between two variables is negative and the effect size too low as r indicates that approximately, 0.2% of the variance exchange rate can be predicted from money and quasi money. The relationship is not significant at 0.05 level of significance. Therefore, we can infer that the money and quasi money are not correlated. To investigate if there was statistically significant association between

exchange rate and foreign direct investment, Pearsons correlation was computed. Pearsons correlation co-efficient for correlation between exchange rate and FDI is r=-.475 and the significance level or p value is p=0.008. Using Cohens 1988 guideline, the direction of the relationship between two variables is negative means increase in FDI will appreciate exchange rate and vice versa. The effect size is moderate as r indicates that approximately, 23% of the variance in exchange rate can be predicted from FDI. The relationship is statistically significant at 0.05 level of significance. Therefore, we can infer that the exchange rate & FDI are moderately correlated. To investigate if there was statistically significant association between

exchange rate and inflation, Pearsons correlation was computed. Pearsons correlation co-efficient for correlation between exchange rate and inflation is r=.224 and the significance level or p value is p=0.233. Using Cohens 1988 guideline, the direction of the relationship between two variables is positive and the effect size is low as r indicates that approximately, 5% of the variance exchange rate can be predicted from inflation. The relationship is not statistically significant at 0.05 level of significance. Therefore, we can infer that the exchange rate & inflation are not correlated. To investigate if there was statistically significant association between Pearsons

exchange rate and GDP, Pearsons correlation was computed.

correlation co-efficient for correlation between exchange rate and GDP is

20 r=-.480 and the significance level or p value is p=0.007. Using Cohens 1988 guideline, the direction of the relationship between two variables is negative means increase in GDP will appreciate exchange rate and vice versa. The effect size is moderate as r indicates that approximately, 23% of the variance in exchange rate can be predicted from GDP. The relationship is significant at 0.05 level of significance. Therefore, we can infer that the exchange rate & GDP are moderately correlated. To investigate if there was statistically significant association between

exchange rate and SBP discount rate, Pearsons correlation was computed. Pearsons correlation co-efficient for correlation between exchange rate and discount rate is r=.337 and the significance level or p value is p=0.068. Using Cohens 1988 guideline, the direction of the relationship between two variables is positive and the effect size moderate as r indicates that approximately, 11% of the variance exchange rate can be predicted from inflation. The relationship is not significant at 0.05 level of significance. Therefore, we can infer that the discount rate are not correlated Out of five independent variables, only two variables FDI and GDP show moderate correlation with exchange rate at 0.05 significance level.

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5.3.

Assumptions of OLS method of Multiple regression

5.3.2.Multicollinearity To find out whether the correlation among independent variables exists or not, Collinearity statistics are computed.
Coefficientsa Unstandardized Coefficients Model 1 (Constant) Money & quasi money annual percent increae SBP discount rate annual percent increase Foreign direct investment annual percent increase Inflation annual percent GDP annual percent increase .548 .249 .339 2.198 .038 .893 1.120 -.038 .017 -.334 -2.184 .039 .911 1.098 .035 .065 .098 .533 .599 .627 1.596 B 7.443 -.050 Std. Error 3.804 .165 -.051 Standardized Coefficients Beta t 1.957 -.304 Sig. .062 .764 .747 1.339 Collinearity Statistics Tolerance VIF

-.371

.144

-.458

-2.573

.017

.669

1.495

a. Dependent Variable: exchange rate annual percent increase

Multicollinearity exists when the tolerance is below 0.1 and VIF is greater than 10 or at an average much greater than 1. In this case, there is no Multicollinearity. 5.3.3. Heteroscedasticity As SPSS does not have the provision to conduct statistical test to detect heteroscedasticity. Therefore, goldfeld quant test was conducted manually to detect heteroscedasticity in the data. The test has revealed the following results. H= There is no hetero in the data H = There is hetro in the data

22 Sig. = 0.05 Df= n-d-4 Df=10 Fcal = ESS/ESS Fcal = 5869.661/11744.52 Fcal= 0.50 Ftab = 2.97 Since Fcal < Ftab, we fail to reject H. Therefore, we conclude that the data is free from heteroscedasticity. 5.3.4.Autocorrelation To find out whether the correlation between error term and time exists or not, Durbin Watson test is conducted.
Model Summaryb Std. Error of the Model 1 R .700a R Square .490 Adjusted R Square .384 Estimate 4.90675 Durbin-Watson 2.235

The Durbin-Watson d = 2.2 which between two critical values of 1.5 < d < 2.5. Therefore, we conclude that there is no first order linear autocorrelation in our multiple linear regression data.

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5.2

Multiple regression

Since the objective of this study is to check the dependence of exchange rate on different factors such as GDP, countrys official interest rate, M2 (money & quasi money), Foreign direct investment and consumer price inflation. In this study, ordinary least square (OLS) method of multiple-regression is used to estimate the effects of those factors on exchange rate. The objective of the regression in this study is to find such an equation which could be used to find the predicted value of the exchange rate for a given set of values of GDP, countrys official interest rate, M2 (money & quasi money), Foreign direct investment and consumer price inflation. The specified multiple regression equation takes the following form: ERt = + M2t + SBPDRt + FDIt + INFt + GDPt + t Where Since all the variables are time series, subscript t denotes the time period. = Y-intercept, , , , , are partial regression co-efficient of independent variables. A partial regression coefficient represents the change in dependent variable, ceteris paribus, due to one unit change in independent variable. Dependent variable ER= exchange rate Independent variables M2= Money & quasi money SBPDR = SBP discount rate FDI = Foreign direct investment INF = Inflation GDP = Gross domestic product E = error term To test the significance of the individual coefficients t-test is also employed in this study. Overall goodness of fit of the model is checked through F-test and the adjusted coefficient of determination (adj. R2).

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Correlations
Money & exchange rate annual percent increase Pearson Correlation exchange rate annual percent increase Money & quasi money annual percent increae SBP discount rate annual percent increase Foreign direct investment annual percent increase Inflation annual percent GDP annual percent increase Sig. (1tailed) exchange rate annual percent increase Money & quasi money annual percent increae SBP discount rate annual percent increase Foreign direct investment annual percent increase Inflation annual percent GDP annual percent increase N exchange rate annual percent increase 30 30 30 30 30 30 .117 .198 .248 .415 . .074 .004 .415 .135 . .415 .102 .034 .034 . .135 .248 .009 .398 . .034 .415 .198 .191 . .398 .034 .004 .117 .004 .224 -.161 -.129 -.041 1.000 .270 -.475 -.041 -.208 1.000 -.041 .238 .337 -.337 1.000 -.208 -.129 -.429 -.049 1.000 -.337 -.041 -.161 -.165 1.000 -.049 .337 -.475 .224 -.480 quasi money SBP discount annual percent increae rate annual percent increase Foreign direct investment annual percent increase Inflation annual percent

25
GDP annual percent increase

-.480

-.165

-.429

.238

.270

1.000

.004

.191

.009

.102

.074

Money & quasi money annual percent increae 30 30 30 30 30 30

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First column of correlation matrix shows the correlation of independent variables with exchange rate. Note that only three dependent variables namely SBP discount rate, foreign direct investment and GDP are significantly correlated with exchange rate.

Model Summaryb Adjusted R Model 1 R .700a R Square .490 Square .384 Std. Error of the Estimate 4.90675 Durbin-Watson 2.235

a. Predictors: (Constant), GDP annual percent increase , Money & quasi money annual percent increae, Foreign direct investment annual percent increase, Inflation annual percent , SBP discount rate annual percent increase b. Dependent Variable: exchange rate annual percent increase

Model summary table shows the multiple correlation co-efficient (R), using all predictors simultaneously, is 0.70. R = 49% and the adjusted R = 38%.

27 Adjusted R is lower than unadjusted R . This is, in part, related to the number of variables in the equation. As we can see from co-efficient table that only three independent variables namely foreign direct investment, inflation & GDP are significant, but other variables add a little to the prediction to the exchange rate. Because several variables were used, a reduction in number of variables might help us find an equation that explains more of the variance in exchange rate, once correction is made. Adjusted R value indicates that 38% of variation in exchange rate is explained /predicted from combination of independent variables. According to Cohen (1988), this is a large effect.

ANOVAb Model 1 Regression Residual Total Sum of Squares 555.671 577.829 1133.500 df 5 24 29 Mean Square 111.134 24.076 F 4.616 Sig. .004a

a. Predictors: (Constant), GDP annual percent increase , Money & quasi money annual percent increae, Foreign direct investment annual percent increase, Inflation annual percent , SBP discount rate annual percent increase b. Dependent Variable: exchange rate annual percent increase

H======0 H=====0 F-ratio is used to test the null hypothesis that all regression parameters except constant term are zero. Alternative hypothesis is that at least one the , , , , is non-zero and has an effect on exchange rate.
ANOVA table shows that F= 4.62 and it is statistically significant as it gives p value .004. We have strong evidence to reject null hypothesis and to accept alternative hypothesis. Significant value of F indicates that combination of these variables significantly predicts the exchange rate- dependent variable.

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Co-efficientsa Standardized Un-standardized Coefficients Model 1 (Constant) Money & quasi money annual percent increae SBP discount rate annual percent increase Foreign direct investment annual percent increase Inflation annual percent GDP annual percent increase B 7.443 -.050 Std. Error 3.804 .165 -.051 Coefficients Beta T 1.957 -.304 Sig. .062 .764

.035

.065

.098

.533

.599

-.038 .548 -.371

.017 .249 .144

-.334 .339 -.458

-2.184 2.198 -2.573

.039 .038 .017

a. Dependent Variable: exchange rate annual percent increase

Exchange rate^ = 7.443 - .05 M2 + 0.35 SBPDR - .038 FDI + .548 INF - . 371GDP Table of co-efficient shows the standardised beta co-efficients which are interpreted much like correlation co-efficient. The t-values and the sig opposite each independent variable indicates that whether that variable is significantly contributing to the equation for predicting exchange rate. The regression results have shown that in the absence of independent variables, exchange rate will change about 7.44%. The t-statistics test the null hypothesis that the corresponding regression parameter is equal to zero, given that the other variable is included in the model. Having seen the t values of all independent variable included in the model, we can determine that the null hypothesis (variables dont contribute to predict exchange rate) is true in case of M2 & SBP discount rate as the t values are not

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significant at 0.05 level. Whereas, the alternative hypothesis (variables do contribute to predict exchange rate) is true in case of FDI, Inflation and GDP as the t values are significant at 0.05 level. Negative value of FDIs un-standardised B co-efficient shows the inverse relationship/correlation between FDI and exchange rate. One percent increase in Independent variable FDI will bring about 4 % decrease in exchange rate means 4 % appreciation in Pakistani rupee against USD and vice versa. Positive value of un-standardised B of inflation shows the positive correlation between inflation and exchange rate. One percent increase in independent variable-inflation will bring about 55% increase in exchange rate means 55% depreciation in Pakistani rupee against USD and vice versa. Negative value of GDPs un-standardised B co-efficient shows the inverse relationship/correlation between GDP and exchange rate. One percent increase in Independent variable GDP will bring about 37% decrease in exchange rate means 37% appreciation in Pakistani rupee against USD and vice versa. While the other two variables, discount rate and money and quasi money dont add much to predict exchange rate. Therefore, FDI, Inflation and GDP are the only variables that are significantly adding to the prediction and the most determent among three is the inflation.

6. Summary & Conclusion

30 This paper aimed to determine the behaviour of official exchange rate issued by State Bank of Pakistan. In this study we aimed to find out what economical factors in short and medium term affect or determine the behaviour of official exchange rate in Pakistan. The objective of this study was to determine how many among five economic factors such as GDP, countrys official interest rate, M2 (money & quasi money), Foreign direct investment and consumer price inflation affect exchange rate. Ordinary least square method of multiple regression was used to predict behaviour of exchange rate. FDI, Inflation and GDP are the only variables that are significantly adding to the prediction when the other two variables namely SBP discount rate and Money & quasi money dont contribute much to predict behaviour of exchange rate. Having conducted the analysis, we found out that independent variables, FDI, GDP and inflation are the factors to predict exchange rate. Among them, the most determinist factor is inflation. Therefore, policy makers can achieve the desired exchange rate by controlling inflation, foreign direct investment and GDP. As we have seen from co-efficient table that only three independent variables namely foreign direct investment, inflation & GDP are significant, but other variables add a little to the prediction to the exchange rate. Because several variables were used, a reduction in number of variables might help us find an equation that explains more of the variance in exchange rate, once correction is made

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References World development indicators WDI data base Trading economics online world development indicators database State Bank of Pakistan online library Basic econometrics Damodar N.Gujrati p 28 - 139 Quantitative data analysis in SPSS Alan Bryman