Financial globalisation and managed exchange rate

Capital flows increase volatility in financial markets that doesn't bode well for govt, business

LAHORE:

Financial globalisation has increased volatility in the foreign exchange market. If the country experiences huge capital inflows, the rupee will appreciate vis-a-vis the US dollar. These short-term flows affect the value of currency a great deal.

Similarly, a sudden increase in remittances and imports also impact the value of the rupee. However, remittances and imports rise gradually while short-term capital flows quickly cross borders.

Under these set of conditions, if the country adopts a flexible exchange rate regime, it will quickly move the value of the rupee up. In the presence of capital inflows, the rupee will appreciate. If the volume of capital inflows is significant, the rupee will gain value quickly.

On the contrary, if the confidence of investors is rattled in financial markets, capital outflows will take place. The capital outflows will erode the value of the rupee.

The flexible exchange rate normally spurs speculation in the foreign exchange market. In the event foreign exchange reserves go down, speculators become certain that the rupee will depreciate. They will start buying dollars and many speculators join the bandwagon. The rupee will keep going down.

Mainstream economists will favour this situation on the ground that the rupee will get an equilibrium value. They are of the opinion that speculators will experience financial losses, which will deter other speculators from speculating in the currency market.

However, they tend to ignore the cumulative effect of speculation, which may take the rupee away from the equilibrium. The lesson of history is that the speculators take the currency value away from the equilibrium and create difficulties for policymakers.

The flexible exchange rate is suitable for the developed economies. They have a large volume of foreign exchange along with developed financial markets.

In those financial markets, derivative trading and repurchase agreements take place. These markets carry out trillions of dollars of transactions in a day and there is depth in the markets.

Keeping in view all this, a developing economy like Pakistan needs a managed exchange rate regime. Pakistan has been following this since 1982. In this regime, the State Bank of Pakistan (SBP) may intervene in the foreign exchange market, as and when required.

Violent changes in capital flows will require intervention from the SBP, provided adequate volume of foreign exchange reserves is available. If the volume of foreign exchange is low, the SBP will have to buy dollars from the foreign exchange market to defend the rupee.

The downside of this intervention is that the gap between the official rate and the market rate will increase as there is a shortage of dollars in the banking system. If the SBP puts in effort to clamp down on the market rate, a parallel market would develop, which happened in 2023 and the rupee-dollar parity touched 308 in September that year.

The purpose of SBP's intervention in the foreign exchange market is to tame volatility and stabilise the exchange rate. If there is a shortage of foreign exchange reserves, domestic banks will increase the selling price of dollar as the dollar will be bought by importers.

By increasing the selling price of dollar, a wide spread is created with the buying price. Normally, the banks generate profit out of this spread.

The SBP has to reduce the spread by offering banks some alternative liquid asset, which provides an opportunity to banks to earn profit.

In short, the financial globalisation driven by capital flows has increased volatility in financial markets. This volatility neither bodes well for the government nor for the business. Hence, the role of the government becomes pivotal in reducing volatility in the best interest of business.

The writer is an independent economist who worked at SDSB, Lahore University of Management Sciences (LUMS)