A stable rupee ahead

With rupee flirting around 84 per US dollar mark this week, the punters are speculating sharp rupee slide owing to bleak security position and US economic recovery. However, a close investigation of real effective exchange rate movement revealed a different picture. Moreover, improved reserve adequacy indicators are also implying stable local currency movement against green back.
Nonetheless, there is some history to rupee dollar movement. After peaking in October 2007, Pakistans foreign exchange reserves were on a constant decline, but the rupee did not see sharp depreciation until June 2008, following which it continued to weaken till it marked its record low of 83.70 against the greenback on October 17, 2008. It rather improved after that and fell below 81 level by the end of FY09.
In July, however, it depreciated again and ever since then it is flirting around 83 mark. At this point, recall that between June and October last year, our economic managers were busy negotiating with the IMF for its standby facility of $7.6 billion. And in July9, they were busy arranging for the for third tranche of standby facility and bridge financing against FoDP pledges.
Now with our economic managers in Dubai on economic review for the fourth tranche, a slight speculation in currency market could have been a historian guess. But here is the catch,, this time round the economic theory odds are in favour of a stable, rather strong rupee - contrary to the previous two cases where there were fundamental reasons behind rupees southward movement. The basic economic theories on exchange rate mechanism suggest that rate movements endogenously balance the macroeconomic variables.
Real Effective Exchange Rate (REER), reflective of cumulative movements of weighted average exchange rate of basket of currencies of our trading partners and relative price index, governs the direction of currency to keep the system in long-term equilibrium. Pak rupees REER, as computed by SBP, appreciated by 4.6 percent from October 2008 to April 2009. Thus, to attain equilibrium, a slide in rupee was imminent as observed in July when rupee fell against greenback by 3 percent.
However, during April-September period our REER depreciated by 5.1 percent owing to substantial decline in domestic inflation - making goods and services available in Pakistan expensive to its trading partners. With inflation likely to remain in control during October-December period amid global recovery to inflate prices in some of our trading partners, REER is likely to hover around September levels.
Moreover, our reserves adequacy ratio - import cover - which was reduced to two months is now over six months owing to foreign flows in the form of aid and soft loans amid decline in import bill. Even, if international oil prices shoot again, the decline in non oil import bill will not let the similar crises similar to last year repeat.
Solely based on economic analysis, our currency should rather appreciate against other trading partners. However, the bleak security situation shatters the confidence of investors to hold Pak rupee, thus offsetting the impact of decline in domestic inflation. Therefore dollar is likely to hover in the band of 83 - 85 in near to medium term.