A relationship analysis
Exchange rates, GDP and KSE index
2.1 Exchange rates (ER) are not autonomous in nature, these are determined by the forces of demand for and supply of major medium of currency (mostly US dollar in Pakistan) used in imports and exports trade. Whereas the volumes of imports and changes therein seem to be the major source to determine demand for US dollar in Pakistan, the value and changes in exports appear to be the major determinants of supply of dollar. In addition, workers’ remittances, foreign direct investment (FDI), foreign portfolio investment (FPI), and government foreign borrowing (and its payments) are some other factors that affect the volumes of supply and demand of foreign currencies, and hence the exchange rates. Studies by Ahmed, Ara and Hyder (2005). Xiaopu (2002), and MacDonald and Ricci (2003) reveal that openness of economy, capital flows and terms of trade are the major factors affecting the real exchange rate in long term. Ejaz, Abbas and Saeed (2002) find budget deficit as an important factor in determining real exchange rate in Pakistan.
2.2 The changes in the exchange rates – depreciation and appreciation - in turn affect the home country’s import and export trade. Appreciation of the country’s currency makes exports expensive and imports cheap, and depreciation makes exports cheap and imports expensive. Consequently, the volumes of exports and imports change, which further affect the consumption and production at national level, the GDP of the country, and its all major related components – the primary sector, secondary/ manufacturing sector and tertiary/services sector. Hussain and Farooq’s (2009) study shows that exchange rate volatility, exports of country and reserve money affect the long term growth of the economy. 2.3 Of the three major components of GDP - the primary sector, secondary/ manufacturing sector and tertiary/services sector, especially the latter two sectors greatly relate to private sector businesses, and the positive and negative changes in GDP may exert profound effects on private sector investments and stock exchange prices. Purpose and objectives of research
2.4 The purpose of this research is to empirically verify whether the changes in exchange rates affect import and export trade, GDP, and investments in KSE listed corporate sector company shares. The stated research would pursue the following specific objectives. 1. To study the impact of exchange rates on Pakistan trade (imports & exports), GDP, and KSE prices. 2. To econometrically estimate and establish the relationship between Pakistan’s exchange rates, imports and exports trade, GDP, and KSE prices. 3. To analyze the stated relationship between exchange rates, imports and exports trade, GDP, and KSE prices, and make recommendations for improvement of the situation wherever seem necessary.
Significance of the study
2.5 This study has specified a model of measuring/capturing effect of exchange rates on stock exchange prices via a logical path of import and export trade, GDP and KSE listed corporate sector stock prices. The study will econometrically measure the specified relationships, and empirically provide the evidence whether such relationship exists and if yes, then how strong the relationship is.
II. Literature Review
It is a well-known fact that poorly managed exchange rates can be a major factor in hampering economic growth.Statistical analysis from different countries showed that the avoiding overvaluation of currency is the most important requirement for economic growth (Razin and Collins 1997; Johnson, Ostry, and Subramanian 2007). It is agreed universally that overvaluation adversely effects the economic growth (Easterly (2005). Aguirre and Calderón (2005) concluded that overvaluation of real exchange rate and devaluation of real exchange rate both hinders...