Pakistan Institute of Development Economics


Exchange Rate Dynamics – Overvalued or Undervalued

Publication Year : 2020
Author: M Ali Kemal
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The exchange rate is the price of foreign exchange. It changes with a change in demand and supply of foreign exchange. The price decline is known as appreciation/revaluation of Pak Rupee while the price increase is known as depreciation/devaluation of Pak Rupee. Thus, the recent decline in the price of the exchange rate is an appreciation of Pak rupee. Unexpectedly, Pakistani currency started appreciating form 26 August 2020 not just against the dollar but also against Euro and British Sterling from Rs168 per US Dollar to Rs157.86 per US Dollar. Today the price was around Rs159.45 per US Dollar. During this period, the Dollar index has gone down by 0.7 per cent while rupee gained strength by 6.3 per cent against the dollar; 6.2 per cent against Sterling Pound and 7.9 per cent against Euro.Pakistani rupee became the third best-performing currency in Asia after South Korean and Indonesian currency in recent times. The recent appreciation can be associated to the non-depletion of foreign exchange reserves due to an increase in remittances, deferment of loan repayment and relief aid. However, sustainability is a major question.Alternatively, we witnessed a spike in the exchange rate due to pandemic panic in March 2020 when hot money flew out. If the spike is more than usual it is known as overshooting of the exchange rate. It is a very short term phenomenon which was instantly adjusted in a short time frame. The spike in the exchange rate during March-April 2020 was close to 8 per cent when the exchange rate was depreciated from Rs154.23 per US Dollar on March 7, 2020, to Rs167.5 per US Dollar on April 6, 2020. The overshooting was readjusted during the next 30 days when it reached Rs158.8 on May 6, 2020, i.e., 5.5 per cent appreciation. Whereas it went up to Rs167.6 per US Dollar by June 30, 2020, floated around this par value by the end august and then started appreciating. It is now back to Rs159.45 per US Dollar. Was it overshooting and readjustment or Rs168 per US Dollar is the actual equilibrium exchange rate value and now it is overvalued.Pakistan’s currency was overvalued by as much as 20 per cent according to IMF in 2017. At that time the currency value was controlled at Rs105 per US Dollar. In Jun 2017, IMF calculated Real Effective Exchange Rate, available on the SBP website shows that exchange rate was 21.0086 per cent overvalued. The Real Effective Exchange Rate (REER) index is a nominal effective exchange rate index adjusted for relative movements in national price indicators of the home country and selected other countries (or currency unions). In November 2017 the currency was started depreciating against the dollar and reached Rs124 per US Dollar in July 2018, i.e., 15 per cent depreciation. The REER index also shows that from June 17 to June 18 there was 14.5 per cent real depreciation in the exchange rate. Rupee depreciated further and reached Rs147 per US Dollar by May 2019, i.e., further 15.6 per cent depreciation, a total of 28.5 per cent depreciation since 2017. We can state unambiguously that overall depreciation by then has covered the overvalued part of the currency that was objected by the IMF two years ago because the inflation difference (with world inflation) during the two years was close to 6 per cent.In June 2019, the exchange rate depreciated by 9.9 per cent to Rs163 per US Dollar. Recalculation tells 35.6 per cent depreciation in the last two years. Since inflation difference during 2017-19 was 6 per cent, thus we can fairly say that the exchange rate was overvalued by 9.6 per cent. Similarly, REER index value in June 2019 shows 16.5 per cent real depreciation in exchange rate compared to June 2018 and the index value confirms undervaluation of the exchange rate by 9 per cent.I call this depreciation in the exchange rate by 9.9 per cent in May-June 2019 as overshooting. The readjustment was done by 1.6 per cent in July 2019 and further 2.26 per cent in August 2020. By December 2019 the exchange rate was reached at Rs155 per US Dollar, i.e. readjustment by 5.2 per cent since June 2019. REER index value shows that after readjustment exchange rate was still undervalued by 4.28 per cent. Though, inflation rate during July-Dec 2019 was high; month-over-month accumulated 7 per cent and year on year 12.6 per cent in December 2019. Considering month over month accumulated inflation differential would eventually lead us to conclude contrary to what REER index shows. It was either close to 100 or little higher than 100, implies not undervalued.