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WHAT FLUCTUATES CURRENCY VALUE?

What Fluctuates Currency Value?


The impact of Net Foreign Portfolio Investment, Net External Trade, Political Instability
and KSE 100 Index on Exchange Rate

Introduction
Background
The relative power of a currency against another is determined through numerous factors.
This power fluctuates with the changes in the determinants, this paradigm is known as currency
depreciation; when some factors tend to decrease the power of domestic currency versus the
other. Pak Rupee is subject to these tantrums. The biggest of all came in 2008 following the
global financial crisis. The main reasons behind such sharp deteriorations are bad economic
condition, level of public external debt, political instability i.e. law and order situation, shrinkage
in foreign portfolio investment and bad performance of stock market in Pakistan.
Foreign inflows in the form of external debt and portfolio investment are among the main
sources of exchange earnings that help in savings and economic growth. Inflow of foreign
portfolio investment increases supply of foreign currency and ultimately helps in reducing
exchange rate.
Problem Statement
For a currencys valuation many economic and non-economic macro factors are
analyzed. Such factors include components of the capital structure of a country, which is equity
and debt, political conditions, and the stock market returns. Previous works have shown
significant impact of stock prices (Rm), external debt, political conditions (Terrorism) and

WHAT FLUCTUATES CURRENCY VALUE?

Foreign Portfolio Investment on Forex Rate. (Aurangzeb & Dilawer, 2012; Aslam, 2002;
Bartram & Dufey, 2001; Drehera, Herz, & Karb, 2006; Hasan & Javed, 2009; Qaiser, Sohail,
Liaqat, & Mumtaz, 2012). There is a need to analyze the impact of Net Foreign Portfolio
Investment, Net External Debt, Government Stability and Stock Market Trends on Pak Rupee
value, considering lag periods and correlation among the predictors.
Research Objectives

To study the impact of foreign portfolio investment on currency value.

To study and analyze the effects of external debt on the exchange rate.

To investigate the implications of political instability on the value of Pak rupee.

To analyze the impact of fluctuations in stock market i.e. KSE on the exchange rate.

To study the predicaments of financing through debt and equity on macro level.

Research Questions

Does change in net foreign portfolio investment cause change in PKR value?

Does external debt inflows cause PKR value to increase?

Does PKR value increase with an appreciation in the KSE 100 index?

Is government stability a predictor of PKR value?

Scope and Limitations of the Study


The scope of this research is restricted to the aforementioned variables, whereas there are
other variables that cause interruptions in the currency value. We limit the scope of this research,
by only studying the behavior of PKR due to changes in FPI, KSE 100 index trends, external
debt and political instability in Pakistan.

WHAT FLUCTUATES CURRENCY VALUE?

Literature Review
The value of currency is the key macro-economic variable that affects the decision
making of the prospective investor, governments, financial intermediaries, exporters, importers,
businesses, policymakers in the developed as well as the developing world. (Malik, 2014).
Exchange rate volatility significantly depends upon the macro fundamentals of a country. There
is a strong relation between the proportions of financial assets; money supply, and foreign
exchange reserves Pakistan to the PKR/USD exchange rate. (Saeed, Awan, Sial, & Sher, 2012)
Foreign capital can work efficiently and its productivity will be high if the quality of
policy making is good. Good governance and foreign aid affect the economic growth positively
while that of external debt has a negative impact, and consequently discourages the portfolio and
direct investment in a country (Qayyum & Haider, 2003). The magitude increases exponentially
if the firm listed on the exchange is involved in foreign trade. (Sulaiman, Hussain, Jalil, & Ali,
2009)
The FP investors are found to be risk averse and FD investors are in pursuit of more
returns in exchange for risk taking. (Goldstein & Razin, 2006). By investing in foreign securities,
investors can hedge their portfolios against exchange rate risk. (Bartram & Dufey, 2001).
Majority owned establishments however enjoy political instability as it decreases the payment to
political connections in the future and decreases the attractiveness of minority-owned
investments. (Durnev, Enikolopov, Petrova, & Santarosa, 2012)
Currency value is also bound to the changes in the external debt and its servicing. (Saeed,
Awan, Sial, & Sher, 2012). This choice of capital structure followed by companies can be

WHAT FLUCTUATES CURRENCY VALUE?

applied to a country. Financial risk can however be hedge while political risks cause instability
that further creates exchange rate risk. (Allayannis, Brown, & Klapper, 2002)
Eichengreen, et al., (2007) found that emerging market economies find it difficult to
translate their debts in to domestic currency. This imbalances the balances as they tend to grow
in the form of foreign dominated debt in response to currency changes but the assets that are
placed by these debt are dominated in the domestic currency led by debt intolerance and inability
to pay. However the equity share in foreign liabilities that is FDI and FPI is quantitatively more
important than whether foreign debt liabilities are denominated in domestic currency or foreign
currency. (Lane & Shambaugh, 2009)
For developing countries bilateral exchange rate changes are of vital importance (Tirole,
2003). Bilateral exchange rate is strongly adversely affected by the volumes of external debt
(Devereux & Lane, 2003). Foreign currency debts must be minimized to eliminate the risk of
financial crisis it creates financial risk which consequently creates a ripple effect upon
currencies, deteriorating every time countries borrow. (Bordo, Meissner, & Stuckler, 2009)
Volitality in exchange rate causes maniflod increase in debts as depreciation in domestic
currency causes appreciation in the value of debt which can only be met with more hard currency
than that of borrowed in the first place. (Bordo & Meissner, 2005)
Central bank independence and fixed exchange rates differ in terms of transparency.
Public can observe the later but not the former as it is of a secrative nature making it easier to
intervene in the market and cause short term influence upon the exchange rates. Such is caused
due to lack of scrutiny at policy level and instability in government. (Broz, 2002)

WHAT FLUCTUATES CURRENCY VALUE?

Correlation exists among the macro-economic and non-economic factors. There paths
intertwine. (Lane & Shambaugh, 2009). Capital structure of a country determines the magnitude
of the impact whenever these crossovers happen. An increase in the currency value can be a
cause for an increase in the portfolio investment as vice versa, whilst deficits when met with
external debts entail an imbalance in the balance sheet of a country leading to unwarranted future
as the value of external debt becomes a function of prevailing Forex rate. (Aurangzeb &
Dilawer, 2012; Aslam, 2002; Bartram & Dufey, 2001; Drehera, Herz, & Karb, 2006; Hasan &
Javed, 2009; Qaiser, Sohail, Liaqat, & Mumtaz, 2012).

Methodology
Variables
Foreign Portfolio
Investment (FPI)

External Debt
(ED)

Exchange rate
(EX)

Political Instability
(PI)

Stock Index changes


(SI)

Hence, our estimation equation is


Exchange Rate (PKR/$) = - 1 (FPI) - 2 (KSE 100 Index) - 3 (External Debt) + 4 (Political Instability) +

WHAT FLUCTUATES CURRENCY VALUE?

Hypotheses
Foreign Portfolio Investment----- Currency Value
H1: Foreign portfolio investment has a positive impact on currency value relative to a
foreign currency.
External Debt----- Currency Value
H2: External Debt has a negative impact upon currency value relative to a foreign
currency.
Political Instability----- Currency Value
H3: Political Instability has a negative impact on currency value relative to a foreign
currency.
Stock Index Changes---- Currency Value
H4: Stock Index Changes are positively related to currency value relative to a foreign
currency.
Data Collection
This study will use quarterly secondary data from 1970 to 2013, making 172 observations
for each variable. Quarterly closing exchange rate of US $ against Pakistani Rupee will be taken
from the official website of State Bank of Pakistan. The data of foreign portfolio investment will
be retrieved from the website of State Bank of Pakistan and Economic Survey of Pakistan.
External debt data is to be retrieved from Economic Affairs Division Pakistan and Finance
Ministrys website. For fluctuations in Stock exchange index, KSE 100 index data will be
retrieved from KSEs official website. For the political instability readings proxy based on the

WHAT FLUCTUATES CURRENCY VALUE?

data from ICRG (International Country Risk Guide) is to be used. The CPI data for the period
understudy will be collected from the SBPs Hand Book of Statistics.
Research Design
Purpose of the study

Sample

Time Horizon

Hypothesis Testing

172 quarterly
observations

1970-2013
Time Series Data

Type of Investigation

Unit of analysis

Data Collection
Method

Correlation
Estimation

Country

Interference

Study Setting

None

Non-contrived

Secondary Data
Observations

Test Design
The data hence collected will be put through E views 7 for data analysis in which three
different statistical techniques for analysis that are descriptive statistics, Correlation method, and
Ordinary least squares regression will be applied. The model proposed for this research will be a
log = log model. Before running the tests the data will be adjusted against Consumer Price Index
to make the nominal data real.
Proposed Schedule
Sr. No

Chapters

Days Required

1.

Introduction

10 days

2.

Literature Review

12 days

3.

Data Collection

16 days

4.

Data Analysis

8 days

5.

Discussion

6 days

6.

Recommendations/Conclusion

5 days

WHAT FLUCTUATES CURRENCY VALUE?


Significance
All the previous works cited here have studied relations between exchange rate, stock
prices, political instability and capital structure in separate studies without acknowledging the
vital and real time impact of these variables as a whole on the exchange rate, however they have
acknowledge the association among them. This research study would take the conversation one
step ahead by proposing and analyzing a model that would fit in the major influences that exist
within the paradigm. This will also enable the policy makers to better understand the dynamics
of currency value as Policymakers must be cautious and careful in designing monetary policies
because they have a direct bearing on cash inflows into the capital market and on the stability of
the capital market.

References
Allayannis, G., Brown, G. W., & Klapper, F. L. (2002). Capital Structure And Financial Risk:
Evidence From Foreign Debt Use In East Asia.
Aslam, Q. (2002). Pakistans Debt Position and the Question of Debt Retirement. The Lahore
Journal of Economics, 6(2), 137-161.
Aurangzeb, D., & Dilawer, T. (2012). Impact of Terrorism on Stock returns: Evidence from
Pakistan. Universal Journal of Management and Social Sciences, 2(8), 73-85.
Bartram , S. M., & Dufey, G. (2001). International Portfolio Investment: Theory, Evidence, and
Institutional Framework (2nd ed.).
Bordo, M. D., & Meissner, C. M. (2005). The Role Of Foreign Currency Debt In Financial
Crises. Cambridge: National Bureau Of Economic Research.

WHAT FLUCTUATES CURRENCY VALUE?

Broz, J. L. (2002). Political System Transparency and Monetary Commitment Regimes.


International Organization, 56(4), 861-887.
Devereux, M. B., & Lane, P. R. (2003). Understanding bilateral exchange rate volatility. Journal
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WHAT FLUCTUATES CURRENCY VALUE?

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Lane, P. R., & Shambaugh, J. C. (2009). The long or short of it: Determinants of foreign
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American Economic Association, 93(5), 1678-1702.

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