In 1973, and with that the period

In the world’s
exchange market the developments of economies position financial systems as
leaders. In open economies, foreign exchange rate policies are among the most substantial
macroeconomic indicators, because of the fact that these policies affect the
business world’s investment decisions. This is because the effect of foreign
exchange rates on trade also directly affects the attainment of the policy, in
terms of a decrease in the foreign trade deficit. Today, the trends in the world
economy as well as the movement of goods and services, labor, technology and
capital throughout the world, regardless of the geographical boundaries, affect
the economies of countries. Trade transactions involving more than one region
normally require the conversion of a currency to another currency.

Exchange rate
has significant role in affecting macroeconomic policies in developing and
developed economies. It is one of the policy variables as its systems (fixed or
managed floating) are selected by central banks or governments.  Exchange rate is the price of one currency in
terms of alternative currency.  Throughout the world the influence of exchange
rate has been subject of many discussions among the academicians, researchers
and policy makers since 1970s. The problem was widely debated through the
period to regulate whether to have a fixed or floating exchange rate system.
The Bretton-Woods international monetary system was collapsed in 1973, and with
that the period of fixed exchange rate system ended. Countries adopted floating
exchange rate policies. This floating exchange rate system brought some development
in the economy but it also raises the risk of international trade. Many
countries adopted the flexible exchange rate regime which in turn producedinsecurity
and volatility in exchange rates. After that dispute, policy makers and researchers
have started to examine the impact of exchange rate volatility on trade
(exports and imports). Volatility can be defined as unobservable, stochastic shock.
There are some studies in which researchers have tried to make the exchange
rate volatility variable as an observable variable.

As most of the
countries begin to follow floating exchange rate, it brought policy experts an
opportunity to scrutinize the affiliation between currencies and volume of
trade. In spite of the fact that, several studies have been conducted on the problem
both theoretical as well in empirical studies revealuncertain impacts of
exchange rate volatility on trade. However, no consensus is existing in
theoretical or empirical literature on the impact of exchange rate on trade
flows. Generally, it is an acknowledged that volatility in exchange rate hinders
trade. Since trade agreements are typically signed for distribution of merchandises
in future and in terms of currency, these are denominated either from sellers
or buyers; hence, the risk involved in international trades rises from unexpected
fluctuations in exchange rate and it may lead to decrease trade for those whom
are risk averse traders. There are some theoretical studies which shows a
negative hypothesis. It shows that exchange rate volatility dissuades trade.
Yet, some other studies are in favor of positive hypothesis that trade may be raised
by exchange rate volatility. Similarly, empirical evidence is also unpredictable
as results of empirical work have been inconsistent with a mix results of
significant, insignificant, slight or no effect.

Since
independence in 1947, Pakistan has adopted different exchange rate systems at
different points of time. A fixed exchange rate system has been upheld from
1947 to 1982. The Managed Floating Exchange Rate system was adopted on January
8, 1982 with the particular objective to keep up the intensity of exports in
international markets as the dollar showed appreciation against other
currencies. The Pakistan rupee was attached to a basket of currencies. Changes
in the exchange rate were made by the State Bank of Pakistan (SBP), keeping in
view the objective of protecting Pakistan’s balance of payments positions from
unwanted and unsustainable imbalances. The SBP supplanted the Managed Floating
Exchange Rate system with the New Exchange Rate Mechanism (NERM) on July 22,
1998, as a procedure to face economic sanctions imposed by international financial
institutions and donors after Pakistan conducted atomic tests in May 28, 1998.
The reason of the dual exchange rate was to transfer the benefits of currency
devaluation to exporters, Pakistanis residing abroad who remit money, and to
reduce import of unnecessary goods. It was moreover thought to limit the cost
of devaluation as far as containing cost heightening of key imports, repayments
of foreign debt by limiting the effect of inflation and overall government’s
budget deficit are concerned. The selection of NERM was aligned with multiple
currency practices. This multiple exchange rate system had badly impacted
country’s output and growth as it discriminated among importers and exporters.
Moreover, as per the IMF’s Articles of Agreement, a country is also not
permitted to have different currency practices except for short period of time.

Subsequently,
the two-tier exchange rate system was supplanted with a market-based unified
exchange rate system in May 19, 1999. Under this framework, a floating inter-bank
rate was used for all foreign exchange receipts and payments both for private
and public sectors. Then again, the SBP could intervene in the private sector for
the purpose of selling and buying of foreign exchange at its own rates and
choice of timings as well. Finally, Pakistan adopted the policy of free float
on July 20, 2000.

In a nutshell,
Pakistan has experienced different exchange rate regimes after the separation
of East Pakistan, fixed exchange rate policy (FY1973-FY1981), managed-float
(FY1982-FY1999), multiple exchange rates policy remained functional for a brief
time period after nuclear tests in May 28, 1998, dirty float34 (FY1999) and
finally floating exchange rate policy (since July 20, 2000).

The high degree of volatility and uncertainty of exchange
rate movements since the beginning of the generalized floating system 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
dealing 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 adverse market participants
who will generally respond by favoring domestic to foreign trade at the margin.
The argument views traders as bearing undiversified exchange risk; if hedging
is impossible or costly and traders are risk-averse, risk-adjusted expected
profits from trade will fall when exchange risk increases.

The relationship
between exchange rate volatility and trade flows has been studied in a large
number of theoretical and empirical papers. The main notion, suggested by some
theoretical models, is that a rise in exchange rate volatility increases
uncertainty of profits on contracts denominated in foreign currency and force
risk averse agents to redirect their activity to the lower risk home market.
Other models suggest that higher levels of exchange rate movements offer
greater opportunity for profit and therefore might lead to an increase in
exports. Alternatively, some researchers have suggested that it is possible to
offset potential unexpected movements of the exchange rate by investing at the
forward market causing producers to be unaffected by movements of the exchange
rate. These different ranges of results have been supported by a large variety
of empirical studies causing the effects of exchange rate volatility on exports
and imports to be one of the most controversial topics of international trade.

Pakistan is an
open economy, but still domestic prices cannot remain unaffected by the
external price shocks. These external price shocks can be exchange rate
appreciation or depreciation and any change in the import prices. The increase
or decrease in the currency exchange rate will result in the change of price
level of imported refined goods and imported inputs which are used as the
intermediary goods and that definitely changes the cost of finished goods and
services in the country

China has very
few such opportunities to control exchange rate volatility as compared to the
developed economies. An increase in the volatility results in the increased
exchange rate risk, which must be controlled by the hedging instruments.
Chinese Authorities have maintained the exchange rate stability and
effectiveness of monetary policy on the cost of free international mobility of
capital.

It is an
unsolved dilemma that exchange rate volatility really affects the trade. A lot
of empirical studies have already been conducted on the topic. However, the
results are surprisingly mixed. So the debate is open for the researches. There
are a lot of empirical studies conducted on exchange rate volatility effects on
exports but there are few studies which examine the relation between exchange
rate volatility and imports. These different viewpoints have also been
supported by the empirical literature resulting to a mixed support with regard
to the effects of exchange rate fluctuation on trade. Due to the lack of
extensive literature for the rapidly growing Asian economies, the purpose of
this research is to examine whether there is any significant relationship
between exchange rate volatility and trade (imports and exports) between
Pakistan and China. And also due to the current contract signed between the
countries called Pak-China Economic Corridor in short term and long term.

According to
Pakistan Economic Survey 2014-15, the volume of trade between Pakistan and
China has increased to $16 billion. China’s exports to Pakistan increased by
ten percent during the five years from 2009-10 to 2014-15. As a result, China’s
share in Pakistan’s total exports has gradually picked up from four percent in
2009-10 to nine percent during the fiscal year 2014-15. The most recent
milestone achieved in this bilateral relationship is the signing of the largest
agreement on the construction of Pak-China Economic Corridor due to which it is
important to see how exchange rate volatility will effect Pakistan imports and
exports with China.

The focus of
this paper is on the nature of the relationship between exchange rates and Pakistan’s
imports and exports to China. The overarching research questions are basically:
Do exchange rate volatility affects import of Pakistan from China? And Do
exchange rate volatility affects exports of Pakistan to China? This thesis
examines the impact of exchange rate volatility and exchange rate regimes on Pakistan
exports and imports to the China for the period 1980-2016 in the context of co
integration analysis based on an error correction model.

The analysis is
two-fold. Initially, I will use the study of Backman (2006) as a model for my
analysis to see the impact of exchange rate volatility on Pakistan’s exports to
China and secondly, I will use the study of Cheong (2004) to analyze impact of
exchange rate volatility on Pakistan’s imports from China. Since the data in
this study is time series so initially I will use descriptive analysis
following with the co integration relationship, long and short run relationship
will be studied in context with error correction model (ECM).

The
paper is organized as follows: Section 2 will present a brief historical
background and literature review on the relationship between exchange rate
volatility and Pakistan’s trade with China, Section 3 will present the
theoretical framework, Section 4 contains a description of the data, data
sources and how the variables included in the econometric models are measured,
Section 5 discusses the empirical results and the last section contains a
summary and conclusion.