FY04 was an eventful year for the foreign exchange market in Pakistan. Not only
did it witness the end to the steady appreciation of the Rupee since mid-FY02, the
pressure on the local currency was caused by both a sharp squeeze in the current
account surplus as well as a dip in the differential between Rupee and US$ interest
rates. In fact, the increased sensitivity to interest rates has been a hallmark of the
exchange rate market in both FY03 and FY04.
The impact of interest rate changes on the Rupee movements is particularly visible during H1-FY04. In this period, the Rupee was initially stable as a small weakening of the net external account surpluses was mitigated by the SBP reducing its net inter-bank market purchases. However, as the differential between Rupee and US$ interest rates narrowed by August 2003, traders increasingly sought to retire their foreign currency loans, thus putting pressure on the exchange rate.
It should be noted that during the first half of FY04 the country was still recording substantial current account surpluses, and therefore, a small upward correction in Rupee interest rates and market interventions was sufficient to allow the domestic currency to regain strength. Thereafter, as the monthly current account surpluses first dipped sharply and then turned into deficits, the Rupee began depreciating. As this movement was now driven by deterioration in fundamentals, the larger SBP interventions in this period were less fruitful and only moderated the downtrend of the Rupee.
As a result, in contrast to a 0.61 percent appreciation in H1-FY04, the Rupee witnessed a net depreciation of 0.68 percent by the end of FY04. It is important to note here that in the face of a weakness in the external account, it would have been
inappropriate for the central bank to hold the exchange rate unchanged – this would have only resulted in draining foreign currency reserves, and would have made the eventual corrections for the economy even more difficult. Therefore the SBP market interventions, through both, direct sales of foreign currency as well as through interest rate movements, aimed at striking a balance between adhering to market fundamentals and allowing the economy some time to adjust to the changing economic environment.
