Over the past year
and a half, the Fed’s aggressive interest rate hikes have significantly
strengthened the dollar (US Fed rate now stands at 5.25%). A quick peek at the
US Dollar Index would reveal just this. But in lands far away from the USA, aggressive
interest rate hiking by central banks has not translated into an appreciating
or steady domestic currency.
Take Pakistan as
an example. A rather extreme example. The State Bank started monetary
tightening a lot earlier with more hawkish momentum than other central banks.
The State Bank began raising interest rates in September 2021, taking interest
rates from 7% to the present 22% within a period of less than two years. This
implies a monetary tightening spread of 9.75% between State Bank and Fed rates.
Despite this, the
Pakistani rupee has depreciated from Rs 168 to Rs 287 relative to the dollar – since
the start of State Bank’s monetary tightening cycle. What gives? To answer
this, one has to understand why free-floating exchange rates move.
The long run
In the long run, the
exchange rate of a currency is determined by the country’s purchasing power
parity. That is what every macroeconomics course across the world teaches
students. Economist Atif Mian simplifies this by saying, “Exchange rate in the
long run reflects a country’s productivity relative to rest of world”. Other
factors that influence exchange rates in the long run include relative price levels,
trade barriers and net export demand.
But this
understanding of exchange rates in the long run is based on a few assumptions –
as always is the case in economics. And who knows when the long run would
arrive? This is where our buddy short run steps in.
The short run
In the short run,
there are two key economic theories about interest rates affecting exchange
rates. One is called International Fisher Effect (IFE). IFE assumes that
changes in inflation don’t impact real interest rates. Hence, the theory states
that lower interest rates give way to lower inflation rates which translate
into an appreciating currency (through purchasing power parity aka price level
differences). This implies that in the goods market, there is no opportunity
for arbitrage.
The other economic
theory is the uncovered interest rate parity (UIRP) which states that arbitrage
is not possible if there is an interest rate differential between the money
markets of two countries. Assuming like IFE that real interest rates are same, let’s
say USA has an interest rate of 10% and UK has an interest rate of 5% with an
exchange rate of 1 dollar for 1 pound. UIRP says that if British investors perform
a carry trade (take advantage of higher interest rates in USA), there would be
no arbitrage as lower interest rates in UK would mean appreciation of the pound.
Hence, gains from higher interest rates in the USA are cancelled out by
relative depreciation of the dollar.
Empirical
evidence
Unfortunately,
both these economic theories are not supported by empirical evidence. Traders
have been able to make arbitrage profits on interest rate differentials and
usually the exchange rate doesn’t depreciate when interest rates rise, although
not always, due to future expectations.
So, what does practice
tell us? Practice tells us that the exchange rate usually appreciates when the relative
interest rate increases. This is exactly because UIRP fails to hold true in the
short run causing traders to perform carry trades which appreciate the currency
in which interest rates are higher. This flow of capital is what allows appreciation
of the currency with higher nominal interest rates. Note that the key difference
between IFE+UIRP and capital flows is that IFE+UIRP take assumptions in real
interest rates while capital flows are thought of in terms of nominal rates.
An interesting application
of the capital flows phenomenon is that raising interest rates is the dominant strategy
for central banks in a rising inflation environment. For instance, if the Fed
raises interest rates, the US dollar would appreciate causing imports to become
cheaper and leading to lower inflation (lower prices of imported goods). This
would cause inflation to increase abroad, and other central banks would follow
the Fed by raising interest rates to keep inflation in line. So, the Nash equilibrium
is for every central bank to raise interest rates when inflation rises (given central
banks are targeting inflation).
The Pakistani
Rupee
So why doesn’t the
Pakistani rupee appreciate then? Because risk premium also comes into play.
When investors look to invest in a country or profit from arbitrage, they also
add in a risk premium. In Pakistan, this risk premium is currently very high
due to a mix of political instability, balance of payment crisis and government
interventions.
For this same
reason, when a global recession is expected, investors flock to safe haven
currencies like the euro, pound, dollar or Swiss franc and away from emerging
market currencies. The markets tend to give developed economies the benefit of
the doubt at the cost of developing economies which face destabilizing capital flight
in such scenarios.
Another factor
also comes into play: market reflexivity. When the rupee depreciates, it sets
off a chain reaction whereby a weaker rupee causes more investors to sell their
rupees and this feedback loop continues until the rupee depreciates to a low
enough level. So, investor expectations play a huge role in currency markets as
well.
Finally, Pakistan
runs a criminally high current account deficit which is poorly financed. A
current account deficit, by default, implies that the home currency should depreciate.
Why? Because that country is running a capital account surplus – borrowing from
foreigners. Eventually it would have to run a capital account deficit to repay
the foreigners. This would entail Pakistan selling its rupees to purchase
foreign currency to pay the foreigners back – causing depreciation of the
rupee.
On the other hand,
Pakistan’s capital account is heavily financed with debt inflows which tend to
be highly volatile. As Pakistan has seen, international investors are unwilling
to lend to Pakistan right now, except at prohibitively high interest rates,
since investors can earn a high risk-free rate in the USA. Consequently, when the
regular flow of capital stops, the rupee ends up depreciating.
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