Volatility of Exchange Rate and Export Growth in Pakistan

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“Volatility of Exchange Rate and Export Growth in Pakistan: The Structure and Interdependence in Regional Markets” Khalid Mustafa Assistant Professor Department of Economics, University of Karachi and Mohammed Nishat, PhD Professor and Chairman, Finance and Economics Institute of Business Administration, Karachi

Abstract The study empirically investigates the effect of exchange rate volatility on exports growth between Pakistan and leading trade partners. The countries are selected to determine the bilateral relationship between Pakistan and the other countries under various regional economic blocks such as SAARC, ASEAN, European, and Asia-Pacific regions. Cointegration and Error Correction techniques are used to establish the empirical relationship between exchange rate volatility and exports growth, using quarterly data from 1991:3 to 2004:2. The result indicates that the volatility of exchange rate has negative and significant effects both in the long run and short run with major trade partners namely UK and US. Similar pattern was observed in case of Australia, Bangladesh, and Singapore, where the volume of trade with Pakistan is comparatively consistent and less volatile. The relationship between exports growth and exchange rate volatility for India and Pakistan is observed only in long run perspective. However, of countries like New Zealand and Malaysia no empirical relationship is observed between export growth and exchange rate volatility. Key words: Exchange Rate, Volatility, Export growth, Regional integration

1. Introduction. The impact of exchange rate volatility on the volume of international trade has been studied intensively since the late 1970’s when the exchange rate moved from fixed to flexible exchange rate, means facing a volatile real exchange rate. The theory says that higher exchange rate volatility will reduce trade by creating uncertainty about future profit from export trade. By using the forward markets and by managing the timing of payments and receipts the firm can reduce the uncertainties in the short run. In the long run, exchange rate volatility may also affect trade indirectly by influencing firm’s

investment decision. However, the commercial investors have limited possibilities of trading claims to future operational cash flows. Thus they are forced to shift away from risky markets. According to these arguments, traders are risk averse, and hedging is expensive or impossible; therefore, exchange rate volatility will reduce risk adjusted profit from foreign trade.1 The high degree of volatility and uncertainty of exchange rate movements since the beginning of the generalized floating in 1973 have led policy makers and researchers to investigate the nature and extent of the impact of such movements on the volume of trade. However, these studies deals with the effects of exchange rate volatility on trade flows have yielded mixed results. On one hand, a number of studies have argued that exchange rate volatility will impose costs on risk averse market participants who will generally respond by favouring domestic to foreign trade at the margin. The arguments views traders as bearing undiversified exchange risk; if hedging is impossible or costly and traders are risk averse, risk adjusted expected profits from trade would fall when exchange risk increases. Pakistan follows the flexible exchange rate system since 1982. At the initial stage the fluctuation of exchange rate is very nominal. However, exports evolved broadly in line with total world imports. Pakistan’s share in world imports was stable during the last 24 years, ranging between a minimum of 0.12 percent in 1980 and a maximum of 0.18 percent in 1992. In 2002-2003 the share was 0.17 percent. This suggests that Pakistan’s exports performance was based on the volatility of exchange rate. Only one empirical study is available regarding to Pakistan’s context. Kumar and Dhawan (1991) estimated the exchange rate volatility on...
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