Abdul Rashid and Abida Ellahi,
International Institute of Islamic Economics (IIIU),
International Islamic University (IIU), Islamabad,

Dec 08 - 21, 2008

"Policymakers generally prefer to stabilize exchange rate rather than interest rates because exchange rate stabilization provides the economy with a clear-cut nominal anchor, while stabilizing interest rates does not."

Since the last few years, both financial reforms and trade liberalization are at the great concern of economic policies. The principle objective of these policies was and is to contribute to the deepening of the financial sector, and ultimately to the stability and considerable growth of the reforming economies. Forex markets have an immediate and direct impact on an economy. Particularly, economies that rely strongly on remittances of overseas contract workers or tourism on the one hand and on imports (both consumer and capital goods) and foreign debt on the other are quite sensitive to forex rate instabilities.

No doubt, a competitive exchange rate is the sign of growth process via positive impact on foreign investments (both foreign portfolio and foreign direct investment) and international trade activities. While the exchange rate dynamics implied in models of inter-temporal smoothing of traded goods consumption and cross-country wealth redistribution/transfer make the determination of equilibrium exchange rate a meaningful for one to examine.

Moreover, the exchange rate plays a central role in maintaining external (balance of payments) and domestic equilibriums. Interest rate also plays a very important role as an instrument of monetary policy to promote the saving, investment and hence economic growth. Therefore, the role of foreign exchange rate along with interest rates in policymaking has been increasing in emerging and developing economies and understating its response to shocks is not only important to policymakers but also to traders and investors.

Monetary policy is the most important tool that policymakers have to stabilize an economy. However, if policymakers have to stabilize either exchange rate or interest rate, then, in general, they prefer to stabilize the exchange rate. Exchange rate stabilization, no doubt, provides the economy with a clear-cut nominal anchor, while stabilizing interest rates does not (It is worthy to note that the classical instrument for stabilizing the exchange rate volatility is interest rate. A week currency can be strengthened by higher interest rates and a strong currency can be dampened by a lower interest rate). Similarly, policy makers do not allow the exchange rate to become standalone absorber of fluctuations in commodity prices consistent with the view that the exchange rate may not be allowed to adjust in response to terms of trade shocks.

With this sort of theoretical background, in this document an attempt is made to present the historical trends and relationship between exchange rate, price levels and interest rates for four South Asian economies namely Bangladesh, India, Pakistan and Sri Lanka at first. And then, some cautions regarding exchange rate policy are discussed. The exchange rates in Bangladesh showed a gradual increase between the periods 1997 to 2000 and a more stable pattern since 2001 till 2003 and a rapid increase for subsequent period.

In 1999 exchange rates in Pakistan were stable and there was a rapid increase in exchange rates in 2000 and it has been reached its peak in the mid of 2001. However, in the end of 2001, the exchange rates have been started to decline and this declining trend has continued till the end of 2003. Finally, for the following period, the exchange rates showed a more stable pattern. For remaining two countries (India and Sri Lanka), the exchange rates have more or less an increasing trend through the sample period.

In Pakistan, the currency crises appear as spikes in interest rates. The interest rates in Pakistan seemed more dynamic as compared to other countries. It had decreasing trend on average up to mid of 2003 and increasing trend for the subsequent period. Analogously, the interest rates in Bangladesh showed a decline on an average before the mid of 2004 and after that vice versa. On the other side, Indian interest rate had increasing trend between the periods of 1994 to 1996. However, the rate has significantly declined during the period from 1997 to 2003 on an average. For the following period, once again interest had an upward trend. The market interest rates showed a rapid decline on an average after reaching at its maximum level in the end of 2000 in Sri Lanka. It was lowest in the beginning of 2004 and showed a slowing up pattern for the subsequent period.

Exchange Rate 0.144 0.153 0.058 0.134
Prices 0.159 0.239 0.118 0.214
Market Interest Rate 0.076 0.296 0.674 0.331
Corr. b/w Exchange Rate and Prices 0.956 0.925 0.497 0.913
Corr. b/w Exchange Rate and Interest Rates 0.461 -0.597 0.039 -0.579

Table 1 provides some interesting information about relationship and variability of the exchange rates, interest rates and commodity prices. It can be observed from the table that exchange rate is less volatile than interest rate in Indian, Pakistan and Sri Lanka. The higher variability of interest rate relative to exchange rate may be a positive indication of lack of credibility. This evidence suggests that they stabilize exchange rate at the cost of interest rate volatility. However, the interest rate is less volatile as compared to exchange rate in Bangladesh. It suggests that the monetary authority may not frequently use interest rate to prevent the abrupt changes in exchange rates. Similarly, the evidence suggests that commodity prices are more volatile than exchange rate however the difference does not have statistical significance.

Regarding contemporaneous links among exchange rates, interest rates and commodity prices, the correlation coefficients provide evidence that there is highly statistically significant positive correlation between exchange rate and domestic prices. The less volatility of commodity prices and the presence of the significant correlation are consistent with view that the exchange rate may be allowed to adjust in response to terms of trade shocks. Interest rate is negatively correlated with exchange rate in case of Indian and Sri Lanka, which suggests that an expansionary monetary policy (decreasing interest rates) leads to a future depreciation. On the other hand, we observe a positive correlation between interest rate and exchange rate for Pakistan and Bangladesh although the correlation coefficient is close to zero in case of Bangladesh. This indicates credibility problems and interest increases signal future depreciations.


The "pure float" and "perfect capital mobility" are artifacts of economics textbooks. Of course, the South Asian countries do not have perfectly free floating exchange rate regime, however, they are classified as having managed float exchange rate regime. Thus, they have common practice to manage their exchange rates fluctuation within band. However, the exchange rate variability is quite low even in the countries that say they allow their exchange rate to float freely. The low variability of the nominal exchange rate does not owe to the absence of the real or nominal shocks in these economies, nevertheless, it suggests that they be reluctant to allow large swings in their exchange rates there seems to be an epidemic case of "fear of floating". In fact, when countries retain voluntary access to international capital market, lack of credibility will lead to fear of floating, high interest rate volatility and procyclical interest rate policies.

As said earlier, exchange rate stabilization provides a mechanism that prevents the economy from unnecessary nominal dynamics, while stabilizing interest rate does not.

Despite the South Asian countries trade volume is increasing significantly and they are gradually removing, or at least giving relief in, tariffs and other barriers, they have a number of trade barriers. Principally, these trade barriers slow down the process of pass through of the changes in exchange rates to domestic prices of commodities. However, if we look at empirical evidence, the pass through from exchange rate swings to domestic prices is far higher in India and Pakistan than in developed economies. It implies that they are used to stabilize the real exchange rate at the cost of domestic inflation.

As claimed by many researchers since the Asian financial crisis and the two subsequent crises in Russia and Brazil, intermediate exchange rate regimes are on their last legs and most of the countries in the world are moving toward corner solutions at the one end hard pegs such as currency boards, currency unions or dollarization, or at the other end freely-floating exchange rate regimes. However, some observers have argued that there is relatively more chance of speculative attacks and currency crises if countries have either hard pegs or freely-floating exchange rates.

A question that comes up about the South Asian countries is that "is there possibility of a common single currency or dollarization, or fully freely-floating exchange rate regime?" We don't think so. However, we can say taking into account the orderly and balanced development of the economy that the South Asian countries need to balance the forex market intervention and to smooth fluctuations to reduce the estimated misalignment against its potential effects on inflation, financial stability and the economy in general. Appropriate measures taken on the fiscal and monetary fronts would definitely limit the required exchange rate adjustments and provide shelter against currency crisis under the globalization mode.