Pakistan Journal of Social Sciences (PJSS)

Vol. 40, No. 1 (2020), pp. 43-51

Dynamics of Exchange Rate Volatility and Capital Inflows:

A case study of Pakistan
Muhammad Khalid Rashid
Associate Professor, Department of Economics,
Government College of Science, Lahore, Pakistan.
Email: krkhan55@hotmail.com

Abdul Aziz Khan Niazi

Assistant Professor, Institute of Business and Management,
University of Engineering & Technology, Lahore, Pakistan.
Email: azizniazi@uet.edu.pk

Waheed Asghar
Director, Technical Education and Vocational Training Authority, Lahore, Pakistan
Email: waheedasgharpk@gmail.com

Faisal Abbas
PhD Scholar, School of Accountancy and Finance,
The University of Lahore, Lahore. Pakistan.
Email: faisalabbaspcc@gmail.com

Abstract:
Enormous fluctuations inExchange Rates have been observed during
the last three decades as compared to the 1950s and 1960s.Numerous
explanations have been extended to capture the movement of exchange
rates with the help of available theories in hand. But some factors can
be identified which influence the process of exchange rate
determination. By following economic theories, an illustrative model is
developed to test long and short run association among Foreign Direct
Investment, Official Development Assistance, workers
remittance,Exchange Rate movements and Gross Domestic Product in
developing economy like Pakistan. To investigate short and long run
equilibrium, data was collected from different databases covering the
period of 1982 to 2016 and cointegration technique is applied with
desired equation. The results depictthatOfficial Development
Assistance; workers remittance,Foreign Direct Investmentand Gross
Domestic Product influence the Real Exchange Rate in long and short
run. The results further explored that inflow of foreign currency in the
way of official development assistance, workers remittance and foreign
direct investment boosted up exchange rate especially in developing
economies.

Keywords: Real Exchange Rate, Foreign Direct Investment, Official Development

Assistance, Workers Remittance

I. Introduction
The concern of present study is to identify long and short run association among
macroeconomic variables such asOfficial Development Assistance,Real Gross Domestic
Product, Foreign Direct Investment, workers remittance and Exchange Rate.In the last
financial crisis, emerging economies from the glob experienced different aspects of
44 Pakistan Journal of Social Sciences Vol. 40, No. 1

capital flows and in the movement of currency exchange rates.Korinek, A. (2017)found

unexpected results through changes in taxes in regard of debts and foreign direct
investment. They explore that policymakers, financial analyst and decision makers should
consider to decrease higher debts as compared to manipulation of external debts. The
following debts payments directly influence the volatility of exchanges rates in emerging
economies like Pakistan.Habib, M. M., Mileva, E., &Stracca, L. (2017). The findings of
recent studies considering both time series and panel data setting from developing
countries regarding real exchange rate and economic growth depicted revers causality.
The capital flow, trade openness directly influence real exchange rate due to that
economic growth is affected. This means as the exchange rate is increase or decrease the
economics growth is also behaving like but in opposite direction especially in developing
countries.Gabaix&Maggiori (2015)Explore the international currency involvement in
determination of capital flows, taxation, sticky prices and wages in imperfect financial
markets.Hassan & Holmes (2012) explore long and short run association between
remittances and exchange rate and concluded that remittances lead to increase in the
exchange rate in developing economies both in short and long run.

Solimano (2003) stated in his study that remittances received from foreign
countries have positive influence on receiving economies which means remittances
improve savings, investment in different sectors and impact real growth of economy and
consumption.Elbadawi (1999) provided evidence by investigating the inflows in kind of
foreign aids received by developing countries improves exchange rate. On the other hand,
Ogun (1995), Sackey (2001) and Nyoni (1998) in their studies found that inflows of
foreign aid have no relationship with exchange rate.The capital inflows consists of
different categories like foreign direct investment, official development assistance,
workers remittance and investment in stock and bonds (portfolio).Moreira (2002) stated
about official development assistance that these funds are provided by developed
countries to developing countries at lower cost and for long term basis. These kinds of
funds promote the economic growth of developing countries.In early 21 st century,
international business assimilation introduced a new thought of trade openness in
different economies and rapidly increased the volume of capital flows. Plenty of
studieswere conducted to investigate the factors influencing exchange rate fluctuations in
developing countries. Economies facing deficit balance of payment always suffer from
the volatility of exchange rate. Exchange rate fluctuation is normally a problem for
developing economies which is caused by developed Countries. After 1973, most of
economies adopted floating exchange rate to compete with developed nations. Economic
theory and past researcher’s evidences support that Exchange rate effect the international
trade both positively and negatively.Capital inflows, in this study, included workers
remittance, foreign direct investment and other official development assistance. The
general perception regarding capital inflows and outflows have direct relationship with
exchange rate. This is because according to economic theory, increase in inflows boosts
up local currency and decrease in inflows depreciates local currency against foreign
currency.

II. Literature Review

Real exchange rate is basic ingredient in international trade among different
countries in modern age of globalization. The appreciation in home currency is directly
attached with increase in demand for home currency. Korinek, A. (2017)found
unexpected results regarding changes in taxes in regard of debts and about foreign direct
 Muhammad Khalid Rashid, Abdul Aziz Khan Niazi, Waheed Asghar, Faisal Abbas 45
investment. They explore that policymakers, financial analyst and decision makers should
consider to decrease higher debts as compared to manipulation of external debts. The
following debts payments directly influence the volatility of exchanges rates in emerging
economies like Pakistan. The findings of recent studies both considering time series and
panel data setting from developing countries regarding real exchange rate and economic
growth depicted revers causality(Habib, M. M., Mileva, E., &Stracca, L., 2017). The
capital flow, trade openness directly influence real exchange rate due to that economic
growth is affected. This means as the exchange rate is increase or decrease the economics
growth is also behaving like but in opposite direction especially in developing countries.
The inflows of foreign direct investment, workers remittance, and exports become the
cause of appreciation in exchange rate and which directly affects the growth of
economies. However, Miyakoshi, (2003) explained that inflow of foreign exchange
influences the balance of payment. Different researchers like Copeland, (2008), and
Williamson (2009), suggested suitable determinants of exchange rate. Wang and Dunne
(2003) argued that it’s impossible to explain all real variables of real exchange rate
determinant because of several unavoidable reasons.Extensive literature is presented in
past three decades with respect of exchange rate determination like Hinkle &Montiel
(1999), MaesoFernandez, Osbat, &Schnatz, Edwards (1994), Williamson (1994),
Edwards and Savastano (2000), argued that capital inflow have influence in
determination of real exchange rate. They also said that high inflows of capital create
high demand for non-traded products in economy due to which exchange rate will
increase. The different researchers found different results about capital inflow and real
exchange rate relationship where both types of findings are available. Some of the current
studies argue that all types of capital inflows in developing economies have same
influence.While some researchers argued that official flows, FDI and remittances have
impact in movement of exchange rate of one currency into other currencies.In current
researches, different results have found regarding alignment of exchange rate that inflows
of funds have similar influence on changing currency values in respective economies. But
this is just one side of picture .Second view shows the mixed findings regarding capital
inflows. Some researchers argued in their papers with real data that official flows, foreign
direct investment and worker remittances do not behave in same way and differently
influence different currencies according to utilization of inflows in domestic economies.
According to researchers namelyBulir& Lane (2002), Lartey (2007), Kasekende&Atingi-
Ego,(1999);Elbadwi, Kaltani& Schmidt-Hebbel (2008) and Parti, Shahi&Tressel (2003)
foreign inflows increase exchange rate.But research scholars who argued that inflows of
funds do not increase the exchange rate are Hussain, Berg, &Aiyar (2009), Li & Rowe
(2007) Mongardini& Rayner (2009). Cerra, Tekin, &Turnovsky (2008) conducted study
to test the influence of foreign aids on currency exchange rate and they also found that
due to foreign aids,domestic production increases and causes appreciation in exchange
rate. Cerra, Tekin, and Turnovsky (2008) conducted studies in order to find effect of
foreign aids on exchange rate and they also found that foreign aid increases production of
tradable products and appreciates exchange rate. They also explained that investment in
non-tradable products reduces the value of home currency. Capital inflows in shape of
remittances means private transfers have influence on exchange rate and there is one
argument is also about remittances that promotes consumptions of the recipient
economies Chami et al., (2008) and Lueth& Ruiz-Arranz (2007). Due to these inflows
recipient economies are promoted and enable themselves to meet the foreign exchange
deficit. The researchers also argued that counter cyclical remittances have no influence on
real exchange rate of economy. They also argued that remittances for the sake of
46 Pakistan Journal of Social Sciences Vol. 40, No. 1

investment may provide force to macroeconomic variables to drive real exchange rate in
positive manners. In developing counties pro-cyclical inflows of remittance are normally
invested in real estate which increases cost of production. The researchers who have
mixed results areBourdet&Falck (2003), Amued-Dorantes&Pozo (2004), Montiel (2006)
and Saadi-Sedik& Petri (2006). Some of the researchers like Rajan& Subramanian (2005)
and Izquierdo&Montiel (2006) concluded that foreign inflows in form of remittance have
no influence on the appreciation of exchange rate.Aron et al. (1997) conducted study and
concludedthat different variables become the cause of exchange rate deprecation like
capital inflows.Mkenda (2001) conducted study regarding misalignment of exchange rate
and explored that growth in gross domestic product increases real exchange rate.Carrera
&Restout (2008) also concluded in their research that foreign capital flows have
increased exchange rate. The results of Rehman et al. (2010) also favoredincrease in
exchange rate in developing countries due to foreign capital inflows.Hassan & Holmes
(2012) explore long and short run association between remittances and exchange rate and
concluded that remittances lead to increase in the exchange rate in developing economies
both in short and long run. Combes, Kinda& Plane (2011) found same results by using
cointergartion in their study that remittances have influence to appreciate exchange rate
in short and long run.Quttara&Issah (2003) tested hypothesis of official development
assistance and exchange rate relationship in his research and concluded that official
development assistance depreciates real exchange rate.

III. Methodology
The model employed in the study is causality model using the time series data
covering the period from 1982 to 2016. The purpose of this model is to test whether or
not there exists relationship among macroeconomic variables like real gross domestic
product, workers remittance, FDI, official development assistance and real exchange rate.

A. Data Collection and Sources

Annual data of time series were used in this study from 1982-2016 for the
analysis of association between exchange rate and capital inflows. Data forreal domestic
product growth rate were taken from International Monetary Fund Data Base (2016). And
data for FDI and official development assistance were taken from Organization for
economic co-operation and development (OECD) Data Base (2016). Data of REER has
been obtained from Bruegel Data Base (2016). The data for remittances received were
arranged from Federal Bureau of Statistics,Government of Pakistan.

B. Unit Root Test

According to Dickey Fuller Test, there may arise a problem of autocorrelation in
yearly data for macroeconomic variables collected from different sources. To handle and
control the issue of autocorrelation in yearly data , Dickey Fuller provided guide lines to
overcome this by considering following equation:-

∆Yt =B1+ ΖYt-1 + αі + et-----------------------------(1)

The first equation of Dickey Fuller Test has only oneintercept B 1 but there is no
trend in this equation. The second option and shape of Dickey Fuller Test is as under:-

∆Yt =B1+B2t + ΖYt-1 + αі + et-----------------------(2)

 Muhammad Khalid Rashid, Abdul Aziz Khan Niazi, Waheed Asghar, Faisal Abbas 47
The second equation of Dickey Fuller Test has trend and intercept both where
B1is constant like first shape where B2t represents trend which was not included in
equation one.The third and final shape of Dickey Fuller Test has noconstant and no trend
in it.

∆Yt= ΖYt-1 + αі + et-----------------------------(3)

C. Test of Co-integration
ADF results showed the same order of variables means I(I) which is necessary
condition to apply Johansen-Juselius method of co-integration to find out the co-
integrating vector(s). Johansen-Juselius Multivariate model equation is given below.

In above equation Xt ,is the 4x1 Vector ( FDI, ODA, WREMIT, RGDP)
respectively, delta is sign of operator, is representing residuals in equation. The vector
error correction model explored the information regardingshortand long run adjustment
of concernproxies due to the changes in other variables.Error correction term is identified
with sign of which can be classified into different matrices like α and B which
represent error correction parameter and coefficient.The results of Johansen-Juselius
depicted that concerned variables are to be co-integrated and moved together in long run.
The concern variables have common stochastic trend and grow proportionally.

D. Vector Error Correction Model (VECM)

α

The above model equation represents the ECM, where error correction
term and is residual. Where is explaining the short run causality to exchange rate
where represent long run causality running from FDI, official development
assistance, workers remittance and gross domestic product to exchange rate.

IV. Results and Discussion

A. Unit Root Test
The basic condition for Johansen technique is stationarity of data for whichADF
test is applied to find consistent results. The results of unit root test show that all variables
are not stationary at level. After converting into first difference, they become stationary
which is required to run the Johansen technique to test the relationship among variables.

Table 1: Results of ADF test for Unit Root

Variables ADFLevel Coefficient ADF Diff Coefficient Prob.
EXR -0.69233 -0.0638 5.09963 -0.94041 0.0001
FDI -2.7578 -0.33186 5.12107 -6.58828 0.0013
ODA -2.33543 -0.43789 -5.2323 -1.09909 0.0001
REM 2.41362 0.094192 4.15114 -0.72036 0.0131
GDP 0.534384 0.027534 4.63101 -0.8324 0.0004
Note:*indicate 1 % and ** represents 5 % level of significance. The 1%, 5% and 10 % critical values are –3.6394, –2.9511 and
-2.6143 for ADF test.

There are three options or shape or models in Dickey Fuller Test of Unit root
named Constant, constant and intercept and without constant and intercept can be used to
48 Pakistan Journal of Social Sciences Vol. 40, No. 1

obtain decision about the time series data to use in different econometric models. The
results of above all models or options of unit root depicted that all the series are
stationary at first difference and has negative coefficient which should be there for a good
model. All options of ADF depicted in result showed that at first difference, desired
variables do not have unit root. This means that by doing first difference, unit root is
completely eliminated and data can be used for different econometric models. It is
important in time series data to use lag for desired variables for consistent results and for
this need Optimum lag selection Criteria is used which has several options to choose
optimum lag for analysis. According to table 2 results most of the tests favored and
suggested to choose lag three.

Table 2: Results of Lag Order Selection Criteria

Lag LogL LR FPE AIC SC HQ
0 -1305.72 NA 2.6029 81.92005 82.14908 81.99597
1 -1125.33 293.1384 1.6125 72.208 73.58213 72.66349
2 -1071.56 70.5753 3.0224 70.40977 2.92901* 71.24483
3 -1031.91 39.64734* 1.7124* 9.49431* 73.15865 70.70894*

B. Co integration Analysis Result and Interpretation

In this study, to confirm the long run relationship among variables, Johansen
cointegration technique has applied. This technique is more appropriate to test long run
relationship among variables due to several statistical reasons. The results depicted that
there are three co-integration equations to be found in test of Johansen co-integration.

Table 3: Un-restricted Cointegration (Johansen cointegration) results

Hypothesized Trace Max-Eigen
No. of CE(s) Eigenvalue Statistic Prob.** Statistic Prob.**
0* 0.961092 201.1731 0.0000 100.6429 0.0000
1* 0.792986 100.5302 0.0000 48.8241 0.0000
2* 0.710591 51.7061 0.0000 38.43733 0.0001
3 0.288358 13.26877 0.1053 10.54558 0.1785
4 0.084097 2.723187 0.0989 2.723187 0.0989
Trace & Maximum Eigen Value indicates 3 cointegration equations at 0.05 level, *denotes rejection of the
hypothesis at the 0.05 level

The above results show that there are three conintegration equations, which
means that there is long run association among variables. The trace statistic, Max-Eigen
Statistics, Eigen value, critical value and probability depicted that there are three
cointegration equations exist.The negative sign of coefficient represents that when
foreign direct investment, official development assistance, workers remittance and real
gross domestic product increase, the exchange rate decreases which is according to
economic theory.

C. Vector Error Correction Model

Vector Error Correction Models (VECM) incorporated the long run movement
of variables from equilibrium. There are five variables; exchange rate, FDI, official
development assistance, workers remittance and real GDP. In this model exchange rate is
dependent variable and FDI, official development assistance, workers remittance and real
GDPare used as explanatory variables. The results depict that long run causality is
running from FDI, official development assistance, workers remittance and real GDP to
exchange rate of the country.
 Muhammad Khalid Rashid, Abdul Aziz Khan Niazi, Waheed Asghar, Faisal Abbas 49
Table 4: Long Run Coefficients (Dependent variable is EXR)
VECM Estimates Coefficient Standard Error t-Ratio P-value
ECT -0.37772 0.061015 -6.19058 0.0000
D(EXR-1) -0.26662 0.127049 -2.09858 0.0545
D(EXR-2) -0.19664 0.19866 -0.98981 0.3391
D(EXR-3) 0.118467 0.177705 0.66665 0.5158
D(FDI-1) 0.004678 0.001072 4.36384 0.0006
D(FDI-2) 0.00341 0.001201 2.838986 0.0131
D(FDI-3) 0.003404 0.001127 3.020467 0.0092
D(ODA-1) -0.00544 0.000919 -5.92004 0.0000
D(ODA-2) -0.00125 0.001145 -1.09559 0.2917
D(ODA-3) -0.00053 0.001222 -0.43386 0.6710
D(REM-1) -0.00197 0.000812 -2.42577 0.0294
D(REM-2) -0.00203 0.000839 -2.41488 0.0300
D(REM-3) 0.004347 0.001096 3.966984 0.0014
D(GDP-1) -0.00057 0.000128 -4.41964 0.0006
D(GDP-2) -0.00044 0.000119 -3.72917 0.0022
D(GDP-3) -0.00076 0.000137 -5.50052 0.0001
Constant 14.97275 2.625823 5.702117 0.0001

Results of Table 4 consists both long run and short coefficients and probability
values are calculated by using system equation. The target model contained cointegration
equation error term and short run coefficients in above table. The error term means speed
of adjustment toward long run equilibrium. Statistically, for long run the error term of
error correction model should be significant and negative.According to error term long
run causality running from four independent variables such as FDI, official development
assistance, workers remittance and gross domestic product to dependent variables
exchange rate.This means all the independent variables have influence on dependent
variable such as exchange rate in long run. The findings showed that inflow of foreign
currency in shape of workers remittance,FDI and official development assistance
increases domestic currency against foreign currency.

D. Short-Run Analysis
The results of this study also explored the short run causality running from FDIt,
official development assistance, workers remittance and real GDP to exchange rate
movements. The Wald test hasbeen employed to confirm the short run relationship
among variables and results explain that foreign direct investment at optimal lag, as
suggested by lag selection criteria, have short run relationship with exchange rate. The
short run causality is running from explanatory variables to dependent variable. In short
run, whenever variables deviate from equilibrium, they got settled again back to
equilibrium automatically.

Table 5: Short Run Coefficients using Dependent variable is EXR

Wald Test
Variables F-statistic Probability Chi-square Probability
FDI 13.89748 0.0002 41.69245 0.0001
ODA 14.97069 0.0001 44.91208 0.0001
REM 7.310668 0.0035 21.932 0.0001
RGD 10.2977 0.0008 30.89311 0.0001
50 Pakistan Journal of Social Sciences Vol. 40, No. 1

E. Diagnostic checks for the VECMs

It is much important to test reliability and validity of estimated model because
only reliable results can contribute towards effective decision making. There are different
diagnostic tests which confirm the reliability of estimated model with respect to different
aspects like normality of data, autocorrelation and heteroskedesticity. To test the problem
of serial correlation LM test is applied whereas White test is used for heteroskedesticity.
Finally Jarque-Bera is used to test the normality in the model. All tests confirm that there
is no issue in econometric model. The fitness of model is good and model has .80 value
for adjusted R square and F-Statistic value 9.00 and Probability value for F is 0.000
where value for D-Watson are 1.50.

Table 6: Diagnostic Check of Model

Test Prob.
Breusch-Godfrey LM Test: 0.7085
Heteroskedasticity Test: Breusch-Pagan-Godfrey 0.5577
Jarque- Bera (JB) 0.5139
Adjusted R-squared 0.80
Durbin-Watson stat 1.80
F-statistic 9.65
Prob(F-statistic) 0.0000

V. Conclusion
The concern of present study is purely to identify long run as well as short run
association of variables such asofficial development assistance, real GDP, FDI, workers
remittance and exchange rate.Exchange rate has significant influence in international
transactions and in stability of currency movement.The findings confirm both short and
long run relationship among variables. The results shows that the long run causality runs
from FDI, official development assistance, workers remittance and real GDP to exchange
rate. In other words foreign direct investment and exchange rate move together in long
run to capture the equilibrium. The inflows of foreign capital including workers
remittance, foreign direct investmentand official development assistance increase
exchange rate in Pakistan.

References
Amuedo, C., & Susan, P.(2004). Worker’s remittances and the real exchange rate: A
Paradox of gifts.World Development, 32, 1407-17.
Carrera, J. &Restout, R. (2008). Long run determinants of real exchange rates in Latin
America. Grouped’Analyseet de ThéorieÉconomique, Working paper No.142.
Cerra, V., Serpil, T., & Stephen J. T.(2008). Foreign aid and real exchange rate
adjustments in a financially constrained dependent economy.IMF Working
Paper No. 204.
Elbadawi, I. A., Linda K., & Klaus, H.(2008). Foreign aid, real exchange rate, and
economic growth in the aftermath of civil wars.World Bank Economic Review,
22, 113-40.
Elbadawi, I.A. (1999), External Aid: Help or Hindrance to Export Orientation in Africa.
Journal of African Economics, 8, 578-616.
Gabaix, X., &Maggiori, M. (2015). International liquidity and exchange rate
dynamics. The Quarterly Journal of Economics, 130, 1369-1420.
 Muhammad Khalid Rashid, Abdul Aziz Khan Niazi, Waheed Asghar, Faisal Abbas 51
Hussain, M., Berg, A., &Aiyar, S. (2009). The macroeconomic management of increased
aid: policy lessons from recent experience.Review of Development
Economics,13, 491-509.
Habib, M.M., Mileva, E., &Stracca, L. (2017). The real exchange rate and economic
growth: revisiting the case using external instruments. Journal of International
Money and Finance, 73, 386-398.
Kasekende, L. A., & Michael, A.(1999) Uganda‘s experience with aid.Journal of African
Economies, 8, 617-49.
Lartey, E.(2007). Capital inflows and the real exchange rate: an empirical study of Sub-
Saharan Africa, Journal of International Trade & Economic Development, 16,
337-57.
Lueth, E., & Ruiz-Arranz, M.(2007). Are workers‘ remittances a hedge against
macroeconomic shocks? The case of Sri Lanka.IMF Working Paper 07/22.
Maeso-Fernandez, F., Chiara, O., & Bernd, S. (2004). Towards the estimation of
equilibrium exchange rate for CEE ascending countries: methodological issues
and a panel cointegration perspective. European Central Bank Working Papers
No. 353.
Miyakoshi, T. (2003). Real exchange rate determination: Empirical observations from
East-Asian countries. Empirical Economics, 28, 173-180.
Mongardini J., & Rayner, B.(2009). Grants, Remittances, and the Equilibrium Real
Exchange Rate in Sub-Saharan African Countries.IMF Working Paper No. 75.
Nyoni, T. S. (1998).Foreign aid and economic performance in Tanzania. World
Development,26, 1235-40.
Ouattara, B., &Issah, H. (2003). Foreign Aid Inflows And Real Exchange Rate: Evidence
From Syria.Manchester School Discussion Paper 00331.
Rajan, R., & Arvind, S.(2005). What Undermines Aid‘s Impact on Growth?NBER
Working Paper 11657.
Rehman, H., Jaffri, A. A., & Ahmad, I. (2010). Impact of foreign direct investment
inflows on Equilibrium real exchange rate of Pakistan. South Asian Studies,25,
125-141.
Saadi-Sedik, T., &Petri, M. (2006). The impact of grants and remittances on the
equilibrium real exchange rate in Jordan.IMF Working Paper No. 06/257.
Sackey, H. A. (2001).External Aid Inflows and the Real Exchange Rate in GhanaAERC
Research Paper No. 110.
Solimano, A. (2003). Remittances by emigrants: Issues and evidence. WIDER Discussion
Papers No. 2003/89.
Williamson, J. (2009). Exchange rate economics. Open Economies Review, 20, 123-146.
Wang, P., & Dunne, P. (2003). Real exchange rate fluctuations in East Asia: Generalized
impulse–response analysis. Asian Economic Journal, 17, 185-203.