January 2010 - MCB-Arif Habib Savings and Investments Limited

The Economics of it allThe exchange rate or the price of one currency in terms of the other isdetermined like the price of any other commodity, by the meeting point of itssupply and demand. Thus the level of the exchange rate is determined by factorsthat would change the supply and demand. So to put it quite simply, the price ofsomething is lower when there a lot more of it then is required. Some of thesefactors that show how much of foreign currency is likely to go around aregenerally interest rates inflation, net capital flows, business cycles and politicalrisk. In the proceeding table, we have listed the factors that typically affect theexchange rate in Pakistan along with the direction the effect is likely to cause theexchange rate to move (+ means the factor is causing appreciation, - meansdepreciation and N means neutral). Furthermore, we have assigned scores from1 to 5 (5 being the strongest) on how strong the effect is in causing the exchangerate movement. We have discussed each of these factors in some detail.Pakistani Rupee FundamentalsVariable Effect ScoreInterest Rate Spreads - 2Inflation Differential + 3Balance of Payments Position + 4Business cycle N 3Politics - 4Interest Rate SpreadInterest rate spread between different countries would determine how muchreturn one country‟s currency would be giving compared to the other. Increasinginterest rates should then in theory attract more capital. In Pakistan, unfortunatelythis effect is probably muted with country risk factors shooing away any capitalconsidering entry due to higher rates. One of the few plausible cases remainingto support this theory would be of a Pakistani expatriate worker sending some ofhis savings to a deposit account paying relatively higher rates in his Pakistanibank but because this would happen on a limited scale we would give theinterest rate spreads a score of 2 on their ability to cause changes in the Rupee.6