annual conference | may 17-18, 2008 exchange rate dynamics in armenia: how predictable are they?...
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Annual Conference | May 17-18, 2008
Exchange Rate Dynamics in Armenia:
How predictable are they?
Vahé HeboyanPhD Candidate, International Economics &
Development
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 2
Outline
Motivation Theoretical background Methodology Data and series Preliminary results Future steps
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 3
Importance of Exchange Rates
The most important relative price in international finance
Getting the right exchange rate is a key objective for international investors, MNCs, and scientists.
Poor exchange rate policies were blamed for economic crisis in the developing world
Exchange rate directly affects economic performance International competitiveness Inflation Output and FDI Currency crisis
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 4
70.000
80.000
90.000
100.000
110.000
120.000
130.000
140.000
150.000
160.000
170.000
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
160.0
NEER REER $/AMD €/AMD RR/AMD
Exchange Rates in Armenia
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 5
Motivation
Government Rapid growth in
remittances from abroad
Economic growth Weakening US$ Price increase in
world markets
Non-Government Those opposing Gov.
policies authorities engineered
appreciation to pocket hard currency and benefit gov-connected importers
Price increases for most goods Monopolized imports?
(Smbat Nasibyan, Chairman, Converse Bank)
Exporters have articulated for more intervention
Increasing controversies over the factors behind appreciation
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 6
Central Bank’s Position
Monetary policy priority: Inflation management 3-4±1.5 % annually
Appreciation has helped to prevent complete pass-through of increasing world oil prices to the domestic market
Appreciation creates unique opportunities for local businesses to invest in advanced foreign technologies as they become cheaper Increased productivity Increased competitiveness
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 7
PhD Dissertation
Objective: survey, adapt, and extend empirical models to the benefit of understanding and practically analyzing exchange rate dynamics and behavior in Armenia Understand the behavior and determinants of
exchange rate in Armenia Understand the factors behind rapid appreciation of
Armenia’s currency Examine the dynamics of the real exchange rate and
its variation from its long-run equilibrium path Examine adequacy of theoretical models in ER
determination and policy decision making in Armenia Analyze the exchange rate pass-through into prices
and impact on macro-economic performance
Exchange Rate Dynamics and Macroeconomic Impact in Transition Countries: An Empirical Investigation of Armenia’s Exchange Rate
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 8
Paper Objectives Find the ‘best’ modeling approach that
helps to explain exchange rate dynamics and determinants in Armenia
Scientifically explain ER dynamics and appreciation Market vs. non-market forces Stop different speculative theories
Examine applicability in monetary policy decision making process How stable is the model?
Series Time span
Out-of-sample prediction ?
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 9
Exchange Rate Determination Random Walk: ERs evolve according to
a random walk, thus cannot be predicted
UIP: expected change in ER determined by interest differentials
PPP: constant equilibrium ER Balassa-Samuelson: PPP fails as a result
of international productivity differentials Mundell-Fleming: a standard for
understanding the role of monetary and fiscal policies in an open economy
Monetary Approach: Flexible-price monetary model Dornbusch’s “overshooting” model
Portfolio Balance Approach Other
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 10
Overall Consensus There is no “best” model Long run: based on economic fundamentals Short run: expectations and capital
movements
Choice depends on data frequencies, time span, degree of country’s development, and even the particular pair of bilateral exchange rates (Rosenberg, 2003).
Selection criteria Assumptions reflecting reality in the country(s)
of interest Explanatory power
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 11
Concept of Misalignment and ERER
Edwards (1989, 1994) Sustained deviations of the actual
real exchange rate from its long-run equilibrium level.
What is the Equilibrium RER? Long-run equilibrium is achieved at
the point when stock-point equilibrium is achieved for all agents of the economy (Driver and Westaway,2004)
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 12
Empirical Approaches to Equilibrium ERs
Source: Driver and Westaway 2004
UIP PPP Balassa-Samuelson
Monetary Models
CHEERs ITMEERs BEERs FEERs DEERs APEERs PEERs NATREX SVARs DSGE
Name Uncovered Interest Parity
Purchasing Power Parity
Balassa-Samuelson
Monetary and Portfolio balance models
Capital Enhanced Equilibrium Exchange Rates
Intermediate Term Model Based Equilibrium Exchange Rates
Behavioural Equilibrium Exchange Rates
Fundamental Equilibrium Exchange Rates
Desired Equilibrium Exchange Rates
Atheoretical Permanent Equilibrium Exchange Rates
Permanent Equilibrium Exchange Rates
Natural Real Exchange Rates
Structural Vector Auto Regression
Dynamic Stochastic General Equilibrium models
Theoretical Assumption
The expected change in the exchange rate determined by interest differentials
Constant Equilibrium Exchange Rate
PPP for tradable goods. Productivity differentials between traded and non-traded goods
PPP in long run (or short run) plus demand for money
PPP plus nominal UIP without risk premia
Nominal UIP including a risk premia plus expected future movements in real exchange rates determined by fundamentals
Real UIP with a risk premia and/ or expected future movements in real exchange rates determined by fundamentals
Real exchange rate compatible with both internal and external balance. Flow not full stock equilibrium
As with FEERs, but the definition of external balance based on optimal policy
None As BEERs As with FEERs, but with the assumption of portfolio balance (so domestic real interest rate is equal to the world rate)
Real exchange rate affected by supply and demand (but not nominal) shocks in the long run
Models designed to explore movements in real and/ or nominal exchange rates in response to shocks
Relevant Time Horizon
Short run Long run Long run Short run Short run (forecast)
Short run (forecast)
Short run (also forecast)
Medium run Medium run Medium run/ Long run
Medium run / Long run
Long run Short (and short) run
Short and long run
Statistical Assumptions
Stationarity (of change)
Stationary Nonstationary Nonstationary Stationary, with emphasis on speed of convergence
None Nonstationary Nonstationary Nonstationary Nonstationary (extract permanent component)
Nonstationary (extract permanent component)
Nonstationary As with theoretical
As with theoretical
Dependent Variable
Expected change in the real or nominal
Real or nominal
Real Nominal Nominal Future change in the nominal
Real Real effective
Real effective
Real Real Real Change in real
Change relative to long-run steady state
Estimation Method
Direct Test for stationarity
Direct Direct Direct Direct Direct Underlying balance
Underlying balance
Direct Direct Direct Direct Simulation
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 13
Behavioral Equilibrium Exchange Rate
Popularized by Edwards (1989, 1994) MacDonald (1997)
Assessing whether movements in the RER represent a misalignment or movements are results of changes in economic fundamentals.
Edwards’ (1989, 1994) model is tailored to developing countries with an aim to understand the relationship b/w RER and economic fundamentals.
Has been used extensively by IMF and others.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 14
Basic Model Structure Real exchange rate
e* - ERER, in turn a function of fundamentals Zt - an index of macroeconomic policies (i.e.
the rate of growth of domestic credit) Zt*- sustainable level of macroeconomic
policies (i.e. the rate of increase of demand for domestic money)
St - nominal exchange rate PMPR - spread in the parallel market for
foreign exchange θ,λ, φ and ψ are positive parameters that
capture the most important dynamic aspects of the adjustment process.
* *1
1 1
log log log
log log
t t t t t
t t t t
e e e Z Z
S S PMPR PMPR
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 15
Basic Model Structure Equilibrium Real Exchange Rate (ERER)
FUND - set of fundamental variables that are assumed to have a determining effect on the ERER Terms of trade for goods (TOT). Is defined as the price ratio
of the country’s exports over imports. Government spending (GOV). Usually defined as the
government consumption of the non-tradable goods. Market openness (OPEN). A proxy for trade controls/
restrictions. Technological progress/productivity (TECHPRO). Allows
capturing the famous Balassa-Samuelson effect. Investment (INV). Debt service (DS). Is defined as a share of exports. Net foreign assets (NFA). Is a proxy for the country’s net
external position and is defined as a share of GDP. Aid flows (AID) as a share of exports. Controls over capital flows (CAPCTRL). Similar to the
market openness liberalization will have impact on the ERER.
*0log t i tt
e FUND
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 16
Basic Model Structure Equation to be estimated using conventional
methods.
POLICY - single notation of macroeconomic policy variables
NOMDEV - stands for nominal devaluation γ’s are combinations of β’s and θ.
1log log 1 logt i it t i it t te FUND e POLICY NOMDEV
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 17
Methodology
Issues of stationarity in time series
Co-integration & error-correction Chudik and Mongardini (2007)
Determination of variables’ order of integration becomes uncertain due to poor performance of unit root tests for small samples
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 18
Methodology Gregory and Hansen (1996)
“the standard tests for cointegration are not appropriate, since they presume that the cointegrating vector is time-invariant under the alternative hypothesis (p. 100)”
if there exists a cointegration, the standard ADF test may not reject the null, thus wrongly concluding that there is no long-run relationship.
Gregory, Nason, and Watt (1996) the power of standard ADF test decreases
sharply when a structural break is present. technological progress, economic crises, changes in
the people’s preferences, policy or regime shifts, and institutional developments,
very typical to developing and transition countries.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 19
Methodology Traditional econometric cointegration
approaches (e.g. Johansen’s) require the series to be integrated to the same order => introducing a further degree of uncertainty
into the analysis of level relationships especially in a transition country setting.
Pesaran, Shin, and Smith (2001) – Bounds Testing testing for the existence of level relationship
between variables irrespective of whether the underlying variables are stationary, integrated to the order of one, or a mixture of the two.
this approach has been successful and superior to the traditional Johansen cointegration test in a small sample.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 20
ARDL
Autoregressive Distributed Lag Modeling by Pesaran and Shin (1999) estimation is independent of the
order of integration in the variables => provides statistically better
results (Mongardini, 1998). General structure ,
1 1 1
y xp pn
t i t i ji j t ii j i
y y x c
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 21
Error correction model
Bounds test (Pesaran, Shin, and Smith, 2001) F-stat for existence of the level
relationship Hypothesis
Joint hypothesis
'0:0: ,00, xyxyyxyxyy HandH
1 1
1 , , 1 ,1 1 1 0
y xp pn n
t yy t yx j j t i t i ji j t ij i j i
y y x y x c
'0:0: ,11, xyxyyxyxyy HandH
xyxyy
xyxyy
HHH
HHH,
,
111
000
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 22
Estimation
Econometric Tamplate developed by Chudik (2006) Estimates using ARDL User friendly, Windows based interface Modified to fit our purpose
Data selection Small sample size requires variable
selection Potential 9 explanatory variables Up to 4 commonly used in the
empirical literature
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 23
Data and Series
1996:Q1 – 2007:Q4Variable
Description Log
REER Real equilibrium exchange rate. Is a multilateral CPI based real effective exchange rate. It is defined in terms of Armenian Dram per unit of foreign currency, so that an increase (decrease) in REER represents depreciation (appreciation).
Yes
ToT Terms of trade for Armenia is defined as the ratio of export price index over import price index.
Yes
GOV Government consumption as a share of GDP relative to that of foreign trading partners.
Yes
OPEN
Openness to trade: exports plus imports as a share of GDP. Yes
NFA Net foreign assets as a share of GDP. No
INV Direct investments in rep. economy as a share of GDP relative to that of the trading partners.
Yes
EXCRE
Excess supply of domestic credit. Measured as the rate of growth of domestic credit minus the lagged rate of growth of real GDP.
No
PROD
Measure of productivity. Proxied by per capita real GDP relative to that of the trading partners.
Yes
DS Debt service as a share of exports. No
MONDEV
Nominal devaluation. Nominal effective exchange rate is used.
No
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 24
Preliminary Results
126 models in various specifications
Selection criteria existence of a long-run cointegration
using the bounds testing; the number of statistically significant
variables at 5 percent significance level; and
the number of correct signs of the parameters as predicted by the economic theory.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 25
Two best models – Model A
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
5.0
19961 19971 19981 19991 20001 20011 20021 20031 20041 20051 20061 20071
ERER REER ERER_smoothed
3.8 4.5 2.3 5.00.48 0.80 0.05 0.63ERER GOV NFA INV EXCRE
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 26
Two best models – Model B
NOMDEVEXCRENFAGOVERER 6.45.83.75.3
03.088.061.128.0
4.0
4.2
4.4
4.6
4.8
5.0
5.2
5.4
19961 19971 19981 19991 20001 20011 20021 20031 20041 20051 20061 20071
ERER REER ERER_Smoothed
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 27
Misalignment
Model A
Model B
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
19961 19971 19981 19991 20001 20011 20021 20031 20041 20051 20061 20071
Misalignment Misalignment_smoothed
-80%
-60%
-40%
-20%
0%
20%
40%
60%
19961 19971 19981 19991 20001 20011 20021 20031 20041 20051 20061 20071
Misalignment Misalignment_smoothed
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 28
Conclusions
Preliminary results confirm RER misalignment
However, very sensitive to set of fundamentals
Both models have statistically strong and yield similar misalignment trends, however they differ in the magnitude.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 29
Future research is needed
Further analysis are necessary to study the sensitivity of the results to the choice of the variable set.
Given theoretical ambiguity of the signs of majority of variables, additional work is required to make the right inference about the results.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 30
Additional studies Short run volatility as a function of
expectations (incl. political dummy) and monetary aggregates
Pass through into important price of important products will be examined critical policy implication in order to
determine the appropriate monetary policy response
can influence the future direction of the economic, social, as well as political developments in the country.
IMF (2007): “Look for ways to reduce monopolistic practices in the import business, with a view to increasing the pass-through of exchange rate changes to domestic prices”
Thank You
Comments and suggestions are gladly welcome !!!