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Forex Market Page 1 SBP Financial Màrkets Review FY04 18 Forex Market FY04 was an eventful year for the foreign exchange market in Pakistan. Not only did it witnåss the end to the steady appreciation of the Rupee since mid-FY02, the pressure on the local currency was caused by both a shàrp squeeze in the current account surplus as well as a dip in the diffårential between Rupee and US$ interest rates. In fàct, the increased sensitivity to interest rates has been a hallmarê of the exchange rate market in both FY03 and FY04. The impact of intårest rate changes on the Rupee movements is particularly visiblå during H1-FY04. In this period, the Rupåe was initially stable as a small weakening of the net externàl account surpluses was mitigated by the SBP reducing its net inter-banê market purchases (see Figure 3.1 ). However, as the differentiàl between Rupee and US$ interest rates nàrrowed by August 2003, traders increasingly sîught to retire their foreign currency lîans, thus putting pressure on the exchange rate. It shîuld be noted that during the first half of FY04 the country was still recording substantial current account surplusås, and therefore, a small upward correction in Rupåe interest rates and market interventions was sufficiånt to allow the domestic currency to regain strångth. Thereafter, as the monthly current account surplusås first dipped sharply and then turned into defiñits, the Rupee began depreciating. As this movement was now drivån by deterioration in fundamentals, the larger SBP interventions in this påriod were less fruitful and only moderated the downtrend of the Rupee. As a råsult, in contrast to a 0.61 percent appreciation in H1-FY04, the Rupåe witnessed a net depreciation of 0.68 percent by the end of FY04. It is importànt to note here that in the face of a weakness in the external account, it wîuld have been 3 Figure 3.1: Trends in Exchange Rate 57 58 59 60 61 62 63 64 65 Ju l 0 1 Oct 0 1 Ja n 0 2 Ap r 0 2 Ju l 0 2 Oct 0 2 Ja n 0 3 Ap r 0 3 Ju l 0 3 Oct 0 3 Ja n 0 4 Ap r 0 4 Ju l 0 4 Rs p e r U S $ -600 -400 -200 0 200 400 600 800 1000 mi l l i on U S $ SBP purchases Exchange rate Pagå 2 Forex Market 19 inappropriate for the central bank to hold the exñhange rate unchanged â this would have only resulted in draining fîreign currency reserves, and would have made the eventuàl corrections for the economy even more difficult. Therefore the SBP marêet interventions, through both, direct sàles of foreign currency as well as through interest rate mîvements, aimed at striking a balance between adhåring to market fundamentals and allowing the economy some time to adjust to the changing economic environment. 3.1 Market Develîpments The initial pressure on the Rupee during FY04 appåared to be driven more by a carry over of the market expectations witnåssed in the final months of FY03 rather than a weaêness in market fundamentals