Since the start of this fiscal year from July 1, the rupee has been on the decline. It lost 80 paisa or 1.4 per cent value against the US dollar between July 1 and August 10, coming down to 58.92 a dollar from 58.12.

This depreciation in the rupee value in less than one-and-a half months is much larger than the 0.5 per cent loss the local currency had suffered against the dollar in the entire fiscal year July-June 2003-04.

There are a number of factors responsible for this decline in the rupee value. They can be easily categorized into two i.e.. the factors directly related to economic fundamentals and the factors not directly related with them.

But it seems too difficult to discuss the two types of rupee-weakening agents separately, as both are closely inter-linked. So, let us examine their combined impact on exchange rate movements.

Higher demand: Bankers say the prime reason for the fall in the rupee value was an exceptionally high demand for foreign exchange from importers. Importers were buying dollars not only on daily basis to pay the import bills but were also making huge forward purchases anticipating a significant fall in the rupee value. In fiscal year 2003-04,

Pakistan saw an all-time high trade deficit of $3.2 billion, more than three times the 2002-03 deficit of $1 billion. What was peculiar about this huge trade deficit of $3.2 billion was that half of it or $1.6 billion deficit had accumulated in the last quarter i.e. between April-June 2004.

Consequently, the rupee that had gained 30 paisa or 0.5 cent value against the dollar in July-March 2003-04, lost 61 paisa or more than one per cent during April-June 2004.

This trend continued and the rupee lost another 42 paisa or 0.7 per cent of its value to a dollar in July 2004, the first month of the new fiscal year. But since the trade deficit in July was $189 million, against the average monthly deficit of more than half a billion dollars in April-June 2004, this big decline in the rupee value needs further explanation.

Though the trade deficit reached $189 million in July, the market was anticipating it to be much higher, keeping in mind the average monthly deficit of more than half a billion dollars in April-June 2004.

This anticipation led many importers to speed up forward dollar buying to avoid exchange rate loss due to the weakening of the rupee as a result of massive trade deficit. Moreover, the monetary policy statement of the State Bank issued on July 21 indicated clearly that the rupee might remain under pressure in July-December 2004.

The policy statement revealed that during July-May 2003-04, the overall balance of payments surplus had fallen by 70.7 percent to $1.2 billion, due to a fall in net capital inflows.

This big decline in BOP surplus coupled with the SBP statement that the rupee might remain under pressure during July-December 2004 strengthened the importers' view that it was time for them to purchase forward dollars to avoid exchange rate loss in future.

Then the trade policy for 2004-05 issued by the ministry of commerce on July 22 also made it clear that achieving the policy objectives would depend, among other things, on "competitive exchange rates".

Besides, the trade policy projected a huge $3 billion trade deficit for this fiscal year, only slightly lower than the last year's $3.2 billion. This also indicated that the rupee would remain under pressure in the current fiscal year and it gave rise to heavy forward dollar buying by desperate importers.

Earlier, on June 12, Finance Minister Shaukat Aziz had also said in his budget speech for this fiscal year that the government would keep the exchange rates competitive.

His statement, supplemented by the trade policy statement and the SBP commentary on the exchange rates in its monetary policy, gave a clear direction to the market on exchange rate movements during this fiscal year. Accordingly, the market started behaving as if a fall in the rupee value was quite inevitable and that there was no question of delaying or avoiding it.

The SBP, on its part, also let the rupee fall gradually throughout July to help exporters remain competitive with their peers in neighbouring countries like India, Sri Lanka and Bangladesh.

But it made it a point to curb volatility in exchange rates and at times intervened in the market, both directly and indirectly to achieve this objective. In July the SBP injected about $400 million for this purpose.

But in August, volatility did hit the exchange rates for a couple of reasons including a planned $100 million payment by Pak-Arab Refinery Co or Parco to a consortium of banks, which was put off at the eleventh hour for the next three months. In the first 10 days of August, the rupee lost 38 paisa or 0.6 per cent value against the dollar coming down to 58.92 a dollar from 58.54 at the end of July 2004.

What was more worrisome from the SBP's viewpoint was that the rupee fell below the psychologically important barrier of 59 to a dollar and even touched a two-year low of 59.40 per dollar on August 4.

The central bank did manage to prop up the rupee through interventions and by convincing Parco to defer the payment of a $100 million instalment out of a $355 million dollar-rupee swap it had contracted with a consortium of five banks.

Parco had entered into this swap in early June to borrow dollars from four local banks and one foreign bank against rupee funds to repay a Japanese loan, almost seven years ahead of schedule. The company had already paid the first instalment of $55 million in July, and on August 4 it was supposed to pay the second instalment of $100 million.

The central bank, though determined to let the rupee slide down smoothly, further injected more than $150 million into the banking system during the first ten days of August to dampen the pro-dollar sentiments and stabilize the rupee.

Its efforts resulted in containing the dollar below Rs59 and it seems that the central bank would defend the rupee at this level for quite some time. It may let the rupee fall further if a really big demand for dollars arises in the market or if the depreciation in the value of regional currencies including the Indian rupee makes it necessary.

Indian Rupee: Whereas Pakistani rupee or PKR lost 80 paisa or 1.4 per cent value to a US dollar between July 1 and August 10, 2004, the Indian rupee or INR also lost 48 paisa or slightly more than one per cent value against the dollar during this period. Thus, PKR depreciated by a much higher margin than the INR did.

Since Pakistan and India follow different financial years, it seems logical to compare their exchange rates on the basis of calendar year. In more than seven months (between January 1-August 10, 2004), the Indian rupee lost 85 paisa or nearly 1.9 per cent value, falling from 45.61 to 46.46 a dollar.

In this period, Pakistani rupee lost 148 paisa or 2.6 per cent value, falling from 57.44 to 58.92 a dollar. Here again, the fall in the PKR value has been much steeper than in the INR.

This would provide the much-needed support to the exporters battling hard, amidst rising cost of production due to oil and gas prices and spiralling inflation, to meet an ambitious $13.7 billion export target during this fiscal year.

But if the PKR is allowed to depreciate at such a fast pace, it would not only increase the cost of imports and external debt servicing in terms of rupees, but would also fuel imported inflation over medium term.

It would also provide incentive for dollarization of bank deposits and shift some investment from the stock market to those areas of economy that lack proper documentation like the real estate.

SBP interventions: That is why the State Bank seems determined to keep the rupee stable for some time. Central bankers say there is no question of letting the rupee fall further in near future, unless the INR and other regional currencies depreciate by a big margin. The SBP is defending the rupee against slipping below 59 a dollar and it would likely maintain this defence level during this quarter.

But in the next quarter, the central bank may have to set another defence level, keeping in mind the then-existing ground realities. Chances are that the rupee would come under pressure in October-December due to pre-payments of government and corporate debts, rising trade deficit and not-so-big inflows of foreign direct investment and workers' remittances.

In the next quarter, the monetary authorities will also have to cope with inflation more aggressively than during this quarter and that would mean further rise in the interest rates. The reason is that the pass-through impact of rupee depreciation and likely removal of a temporary cap on domestic oil prices placed in the wake of soaring world oil prices would push inflation further up.

All this would have an unfavourable impact on exporters' competitiveness and the authorities would have to let the rupee depreciate further to compensate them. Already, the export finance rate has risen by half a percentage point to 4 per cent for August as a result of a 45bps increase in the weighted average yield of six-month treasury bills. A further increase in export financing rate, due to on-going gradual tightening of monetary policy seems inevitable.