ECONOMIC VARIABLES AND FOREIGN EXCHANGE RATEFOREX

RAMIZUR REHMAN AND SHOAIB MANSOOR,

(feedback@pgeconomist.com)

Jan 31 - Feb 6, 2011

ABSTRACT

A simple statistical technique is used to find the magnitude of impact of economic variables that affect the foreign exchange rate of Pakistan. Secondary data of last twenty five years (1985-2010) from State Bank of Pakistan for Pound is used. For Euro, data of ten years (2001-2010) is considered (Scrutinized only two main variables for Euro). Workers remittance is proved as most significant factor, but in both cases CPI (Inflation) shows no relation with Pound and Euro when analyzed together with other variables of last twenty five years.

Keywords:Fix exchange rate, CPI (Consumer Price Index), Forex (foreign exchange rates)INTRODUCTION

Intrinsically six factors are considered as influencing factor for Forex (foreign exchange) Rates. They are political stability, interest rates, inflation, FDI (Foreign Direct Investment), productivity, and balance of payments.

Political stability is also thought as important factor in some developed countries. It has been studied in Japan and Korea against Forex rates with variables like number of protests and strikes in cities but Pakistan has different situation. All political changes are sheer unpredictable in the country.

Considering the law & order situation (country risk) and risk of exchange rate of Pakistani rupee are de-motivating factors for investments in financial institutes despite high interest rates returns.

In 1964, a model introduced about relation of country net productivity and Forex rates called "Balassa-Samuelson Model" which demonstrates that country Forex behaves according to output of production, higher the productivity healthy the rates and we can see it is still applicable in new economies.

HISTORY ANALYSIS AND LITERATURE REVIEW

In history all economic variables are studied in different times on different economies but no model remains successful ever to predict the exchange rates. Forex rates have strong influence on business (scenario in spot and future rates) as companies and brands try to become multinational. It affects people expectations especially speculators, also in developing countries speculator used to adopt business of financing in foreign currency.

On levels of monetary policy, some times countries try to decrease value of currency to increase FDI in country, inviting large investors to boost economy, and some try to over value its currency, which later on proved as very poor strategies.

In 2010, paper by Ramizur Rehman and Awais Rauf on casual relationship between macroeconomic variables proved a significant but positive relation between inflation and exchange rate while a negative and significant relation between interest rate and exchange rate.

Now, analysis is done for other variables like political instability, FDI, workers remittances and CPI index of last twenty five years with exchange rates of Pound and Euro. These variables are considered as effecting variables for exchange rate all over the world.

METHODOLOGY

The Multiple Regression Model is applied to check the relationship of independent variables i.e. FDI, CPI (inflation), productivity and workers remittances against dependent variable Pound/ Euro. Sound value of R Square shows the strength of model in statistical terms, Beta (coefficient of correlation) in model among variables also prove the results.

ANALYSIS TABLES

The Multiple Regression Analysis is at Significance F "0.05".

GBP exchange rate is analyzed with four independent variables in table 1, and with two independent variables to test the significance in table 2.

Workers Remittances are most significant with lowest P-value. In the both tables, CPI proved to be insignificant as the exchange rate behavior moves according to demand and supply factors in country.

BETATABLE 1COEFFICIENTSSTANDARD ERRORT STATP-VALUEIntercept 71.41 13.54 5.27 0.000 Prod. Growth -2.35 0.88 -2.66 0.015 Workers Rem. 0.09 0.03 3.43 0.003 FDI 0.01 0.00 3.11 0.006 CPI -1.08 1.10 -0.98 0.338 R Square 0.71 . . .

TABLE 2COEFFICIENTS (BETA)STANDARD ERRORT STATP-VALUEIntercept 50.0024 12.7534 3.9207 0.0007 FDI 0.0175 0.0045 3.8425 0.0009 CPI 0.7394 1.3415 0.5512 0.5871 R Square 0.4284 . . . Euro exchange rates are analyzed in table 3, here again CPI is insignificant and workers remittances P-value is near to the Significance F 0.05, here sample size is reduced to give strength to the model.

BETATABLE 3COEFFICIENTSSTANDARD ERRORT STATP-VALUEIntercept 43.20 5.71 7.57 0.00 CPI 1.68 1.07 1.56 0.16 Worker Rem 0.38 0.20 1.95 0.07 R Square 0.88 . . . In tables 4 and 5, CPI of India and Pakistan is analyzed with exchange rate of USD for last ten year, it is clear that P-Value of Pak CPI is 0.0010 highly significant and Beta is higher than Beta of Indian CPI. High Beta means that its Forex rate of USD in Pakistan highly responded to CPI index of Pakistan.

INDIAN CPI ANALYSIS WITH INDIAN RUPEE VALUE IN TERMS OF USDTABLE 4COEFFICIENTSSTANDARD ERRORT STATP-VALUEIntercept 44.9474 2.1288 21.1141 0.0000 IND CPI 0.1086 0.3507 0.3097 0.7647

PAKISTAN CPI ANALYSIS WITH PKR VALUE IN TERMS OF USDTABLE 5COEFFICIENTSSTANDARD ERRORT STATP-VALUEIntercept 51.6774 3.2264 16.0171 0.0000 PAK CPI 1.5934 0.3181 5.0084 0. 0010 CONCLUSIONS

Pakistan Forex is denominated by balance of payments mainly of foreign debt and trade deficit. Next year, Pakistan has to face more troubles in term of balance of payments and Forex rates as schedule of paying back loan of IMF will be started in 2012. Workers remittance is more significant variable, than FDI and productivity (CPI is not significant in case of Euro or GBP but Significant in case of USD), so we can say after balance of payment, workers remittance is significant factor.

Since PPP (Purchase Power Parity) is curbed by a huge factor of demand/supply (balance of payment), that's why it does not hold in case Euro and GBP.

CPI of Pakistan is more significant as compared to CPI of India against USD for last ten years, with a lot of difference in P- Value which clearly demonstrates that India central bank has enough foreign reserves to control the fix exchange rates and they do so.

REFERENCES

[1] Ramizur Rehman and Awais Rauf (2010), Causal Relationship between Macroeconomic Variable and Exchange Rate, International Research Journal of Finance and Economics ISSN 1450-2887 Issue 46, pp 58-62

[2] Simpson, M. W., Ramchander, S (2005), The impact of macroeconomic surprises on spot and forward foreign exchange markets, Journal of International Money and Finance, Vol. 24, pp. 693-718

[3] Laurence Copeland.2007. Exchange Rates and international Finance. Forth Edition; Pearson Education

Ramizur Rehman is Assistant Professor, Lahore Business School, University of Lahore, Pakistan.

Shoaib Mansoor is student of M-Phil, Lahore Business School, University of Lahore, Pakistan. He can be contacted at email shoaib_mealu@hotmail.com