January 2010 - MCB-Arif Habib Savings and Investments Limited

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Now again claiming no monopoly over wisdom, let‟s see what empirical researchhas been done on the subject. Zulfiqar Hyder and Sardar Shah 2 (2004) studiedthe subject and concluded firstly that exchange rate movements have amoderate effect on domestic price movements as a result of a higher share ofagricultural commodities and energy subjected to government regulation in theConsumer Price Index (CPI) and Wholesale Price Index (WPI). Secondly, thehigher share of tradable in the WPI as compared to the CPI implies a greaterimpact of exchange rate movements in the WPI. Thirdly, the effect spreads outover twelve months but is more pronounced in the first four months. Fourthly, theexchange pass-through to consumer prices has further weakened after the freefloat of the Rupee/Dollar after the year 2000. Fifthly, within the WPI commoditygroups, the pass-through of exchange rate movements is stronger in „Fuel &Lighting‟ and „Manufactures‟ groups while in the case of CPI, pass-through ismore pronounced in‟ Transport & Communication‟ and „Fuel & Lighting‟ group.Finally, the response of exchange rate movements in the food inflation is low inboth the CPI and the WPI.Some very important conclusions can be drawn from the study. First of all, thedepreciation does not have a proportionate impact on all prices. Local agricommodityprices are not really influenced by international prices, thanks togovernment intervention. What is really affected by depreciation is the price offuel, i.e. petrol, diesel etc. This is probably going to be more pronounced sincelocal prices have become fully aligned with international ones. So keeping in viewthe composition of the CPI, which has a much greater proportion in food thanenergy, currency depreciation is unlikely to be a major push factor behind CPIinflation.The REER StoryAnother commonly believed consequence of exchange rate depreciation iscompetitive gain Pakistani exports would enjoy in international markets. Thatwould be true if inflation did not increase substantially making those exports moreexpensive to foreigners and subsequently wiping the gain from the depreciation.Unfortunately in Pakistan, that‟s exactly what happened.A measure known as the Real Effective Exchange Rate (REER) is a tradeweighed and inflation adjusted measure of the price of country‟s currencycompared to those of its trading partners. Despite a severe depreciation of thenominal exchange rate, the REER has changed very little implying that as far asforeigners are concerned, Rupee denominated goods have not really becomecheaper. This was of course due to the high 20.7 percent inflation rate thecountry experienced in the financial year, 2009. An increase in domestic inflation2Zulfiqar Hyder and Sardar Shah. (2004). Exchange Rate Pass-Through to Domestic Prices inPakistan. SBP Working Paper Series.No.5,pg.14 9
appreciates the REER, while an increase in the inflation rate of a country‟strading partners depreciates it.Inflation in Pakistan, save for the short term blips, is on a declining trend as noreal recovery has taken place. With the rest of the world well into a recoveryaugmented with monetary and fiscal stimuli, there is likely going to be an upwardpressure on their inflation. This would then make Pakistan‟s exports morecompetitive by depreciating the REER.The Bottom Line!Coming back to the first question posed earlier i.e. which way the Rupee will go;based on fundamentals there is slight tendency for it to appreciate.However, since stability in the overall balance of payments position rests onfinancing flows with uncertain disbursement tenure, the pressure could be in theother direction if these flows do not materialize or are delayed. The key point tonote is that since the Rupee has been allowed to function as a fully flexibleexchange rate, an appreciation is actually possible (yes I dare to say it) andkeeping everything in view, the arrival of the scheduled flows cause anappreciation. As far as the second question is concerned i.e. does depreciation inPakistan cause inflation? the answer is only to a limited extent due to thedissimilarities between the composition of the inflation indices and thecomposition of traded items. Finally, does Rupee depreciation cause exportcompetitiveness for Pakistan; this would be the case only if inflation do not wipeout the gains. In recent times the depreciation of the Rupee has been offset byhigh inflation causing the REER to remain relatively stable.10
Page 1 and 2: Tariq Ali, AHI Researchtariq.ali@ar
Page 3 and 4: O/N-7 Ds08 -15 Ds16- 30 Ds31- 60 Ds
Page 5 and 6: Some Thoughts on the Exchange Rate
Page 7 and 8: The Economics of it allThe exchange
Page 9: Business CycleKnowing where we are
Page 13: Source: SBP, FBS, AHIL EstimatesAri

January 2010 - MCB-Arif Habib Savings and Investments Limited

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