EMPIRICAL DETERMINANTS OF REAL EXCHANGE RATES FOR SOUTH

AFRICA:1975:Q1-2010:Q4

TERM PAPER: INTERNATIONAL FINANCE

TINASHE BVIRINDI

OUTLINE

Definition and importance of RER South Africa and SADC Literature review Empirical literature findings Empirical model Results Conclusions and recommendations

Real exchange ratesDefinition

Rate which determines the relative prices of goods and services between countries -(Leon-Ledesma and Mihailov, 2011)

At which there is internal and external balance – (Montinel, 1999)

Tradable and non tradable goods market equilibrium (Edwards , 1989)

A function of macroeconomic equilibrium-(Montinel, 2003)

RER is a supply side function and aggregate demand has no effect in its determination-Harrod Balassa and Samuelson

Responds to real variables and monetary disturbances have transitory effects (Edwards, 1981)

However, is complicated by the fact that it is unobservable (Korsu and Braima, 2007)

Importance of real exchange rates

Private investments and growth- Caballero and Corbo (1989), Serven and Solimano (1991), Sosunov and Ushakov (2009)

Exports, imports, investment and savings -Ghura and Grennes (1993)

Domestic food supply – Cotiani et al (1990) Inflation- Kamin (1996) Currency crisis- Xiaopu (2002) Stable real exchange rates lead to

success- Dornbusch (1989)

South Africa- A brief

Emerging market economy, relatively diversified, export oriented (Gold, coal and platinum) and integrated with global economy

At the epicentre of trade in SADC (South Africa Trade Performance Review, 2010) 60% of SADC GDP More than 50% of SADC trade Huge trade links among the Free Trade Area

SACU members (Swaziland, Lesotho, Namibia ) Zimbabwe, Botswana, Mozambique

70% trade occurring with Europe Currency is among 15 of most traded currencies Shocks that cause over or undervalued exchange

rates in SA have adverse and spill over effects in the region

Theoretical Determinants

Determinants Nominal effective exchange rates, internal

relative prices (Leon-Ledesma and Mihailov, 2011)

World price of primary exports (Chen and Rogoff, 2006)

Technical progress (Ricardo and Balassa,1964) Output in the long-run and real interest rate

differentials in the short-run (Dornbusch, 1974) Productivity differentials (Harrod, Balassa and

Samuelson, 1964; and Rogoff, 1996)

Theoretical Determinants …

Government purchases of tradable goods (-), government expenditure on non-tradable good, capital flows and terms of trade result in RER appreciation (Montiel, 1999)

Exchange and trade controls(-), level and composition of government consumption (+/-), capital flows (-), terms of trade (+/-), technical progress and capital accumulation (+) (Edwards, 1989)

The impact of terms of trade, government consumption and tariffs are theoretically ambiguous

Empirical literatureStudy Focus Methodology Motivating model/ studies Findings Kumar (2010)

India 1997 Q2-2009Q2

Autoregressive Distributed Lag Model and ECM

Edwards (1989) Productivity (+), Government consumption (-), Openness (-), Foreign assets (+), Terms of Trade (+)

Sossounov and Ushakov 2009

Russia 1991Q1-2008Q1

Multivariate cointegration

Edwards and Savastano (1999) Montinel (1999)

TOT (+), Productivity (+), Fiscal policy (-)

Korsu and Braima (2007)

Sierra Leone Multivariate Cointegration (JJ), Hendry’s general to specific modelling for ECMs,

Edwards (1989) TOT (-), Level and composition of government consumption (+), capital flows (-), trade controls (+), technical progress (+), capital accumulation (-), real putput (+).

Drine and Rault (2003)

45 developing countries in Africa, Latin America and Asia

Panel Cointegration techniques

Edwards (1989) Investments (+), Government consumption (+/-), Trade policy (-), GDP per capita (+), TOT (+), Capital flows (+)

Mungule (2004)

Zambia 1973Q1-1997Q4

Multivariate cointegration Engle and Granger ECMs

Edwards (1989)

Terms of trade (+/-), Domestic credit (-), Trade policy (-), Capital Flows (-)

Aaron, Elbadawi and Khan (1996)

South Africa 1970-1995

Engle and Granger cointegration and ECMs

Edwards (1989) TOT (+), Gold price(+), Reserves (+), Tariffs (+), capital flows (+), government expenditure (+)

Egert and Revil 2003

5 central and eastern European countries namely Czech Republic, Hungary, Poland,Slovakia and Slovenia 1991-2001

VAR, 3 Simultaneous equation based Cointegration

Williamson Model(1983, 1994) Clarkson and McDonald Model (1998) Basalla and Samuelson model (1970)

Current account balance (+), terms of trade (+/-), openness ratio (-), relative productivity (+) , private consumption (+)

Methodology

Edwards’ Inter-temporal optimisation model Distinguishes between short run and the long-

run Johansen and jesilius cointegration

techniques Single equation error correction modelling-

Engle and Granger techniques to complements analysis

Empirical Long-run model specification)1..(....................

/

65

43

/

2

/

10

ttt

ttt

t

TARIFFGOLD

PRDCTYOPENESSNGDP

GOVEXPTOTLREER

Definition of variablesVariable Explanation Source Terms of trade (TOT) The residual of log (term of trade excluding

gold) regressed on productivity. This is done to purge the impact of productivity on TOT

South Africa Reserve Bank (SARB)

Tariff This variable is the ratio of import taxes to total imports

IMF

Government public expenditure ratio Log (total government expenditure/ GDP) Statistics South Africa

Domestic credit Log of total domestic credit SARBExcess credit growth Quarterly change in total domestic credit SARB

Gold price International price of gold DatastreamOpenness The residual of Log((imports+exports)/gdp)

regressed on terms of trade and the gold price. This is done to remove the effects of trade shocks

IMF Intenational Financial statistics database

Productivity  Measured as the log of (GDP/Total number of employees)

SARB

Real Effective Exchange Rate A multilateral trade weighted index for real exchange rates of 15 trading partners calculated by SARB.

SARB

Preliminary data analysis

-.3

-.2

-.1

.0

.1

.2

.3

75 80 85 90 95 00 05 10

PPTOT

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

75 80 85 90 95 00 05 10

POPEN

4.0

4.2

4.4

4.6

4.8

5.0

5.2

75 80 85 90 95 00 05 10

LREER

4.3

4.4

4.5

4.6

4.7

4.8

4.9

5.0

75 80 85 90 95 00 05 10

LPDCTY

4.5

5.0

5.5

6.0

6.5

7.0

7.5

75 80 85 90 95 00 05 10

LGLD

.00

.02

.04

.06

.08

.10

.12

.14

75 80 85 90 95 00 05 10

ATRDTAXESTMPT

-2.4

-2.2

-2.0

-1.8

-1.6

-1.4

75 80 85 90 95 00 05 10

GRAT

Unit root tests  ADF Phillips Perron Conclusion

Model Trend and Intercept  

  lags Levels 1st Dif Lags Levels 1st Dif  

Trade taxes/imports 4 -2.700 -5.831* 4 -2.613 -19.297* I(1)

Total government expenditure

4 -1.185 -13.504* 4 -2.622 -19.960* I(1)

Government expenditure to GDP

4 -2.287 -12.697* 4 -1.910 -16.615* I(1)

Terms of trade 4 -1.602 -16.415* 4 -1.908 -16.605* I(1)

Domestic credit 4 -2.400 -3.766** 4 -1.724 -11.029* I(1)

Productivity 4 -2.301 -12.228* 4 -2.302 -12.280* I(1)

Reer 4 -2.483 -3.768** 4 -2.838 -10.693* I(1)

Neer 4 -1.958 -5.251* 4 -1.558 -10.352* I(1)

Investments 4 -2.646 -15.523* 4 -2.412 -15.829* I(1)

Gold Price 4 -1.213 -9.326* 4 -1.441 -9.623* I(1)

Real wages 4 -2.692 -13.050* 4 -2.446 -13.358* I(1)

Interest rates 4 -2.752 -7.628* 4 -2.295 -7.591* I(1)

Lag Length selectionVAR Lag Order Selection Criteria        

Endogenous variables: LREER PPTOT POPEN LPDCTY ATRDTAXESTMPT LGLD GRAT   Exogenous variables: C         Date: 04/19/12 Time: 22:58        Sample: 1975Q1 2010Q4        Included observations: 121        

                          

 Lag LogL LR FPE AIC SC HQ                          0  780.9425 NA   6.56e-15 -12.79244 -12.63070 -12.726751  1541.180  1419.948  5.15e-20 -24.54844  -23.25452*  -24.02293*2  1601.321  105.3712   4.32e-20* -24.73259 -22.30649 -23.747263  1638.862  61.43004  5.32e-20 -24.54317 -20.98490 -23.098024  1700.385  93.55532  4.49e-20 -24.75016 -20.05970 -22.845195  1753.020  73.95077  4.51e-20 -24.81025 -18.98762 -22.445466  1808.711   71.79992*  4.45e-20  -24.92085* -17.96603 -22.096237  1855.943  55.42925  5.27e-20 -24.89163 -16.80463 -21.607198  1896.055  42.43268  7.44e-20 -24.74472 -15.52554 -21.00046                          

 * indicates lag order selected by the criterion       LR: sequential modified LR test statistic (each test at 5% level)     FPE: Final prediction error         AIC: Akaike information criterion         SC: Schwarz information criterion         HQ: Hannan-Quinn information criterion      

Cointegration tests - Johansen

Unrestricted Cointegration Rank Test (Trace)                    

Hypothesized   Trace 0.05  No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

                  

None *  0.375617  135.9260  125.6154  0.0101At most 1  0.203497  76.11007  95.75366  0.5024At most 2  0.140776  47.21440  69.81889  0.7528At most 3  0.090909  27.94530  47.85613  0.8161At most 4  0.059984  15.84097  29.79707  0.7234At most 5  0.046108  7.984916  15.49471  0.4670At most 6  0.015546  1.989855  3.841466  0.1584

                  

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)                  

Hypothesized   Max-Eigen 0.05  No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

                  

None *  0.375617  59.81589  46.23142  0.0011At most 1  0.203497  28.89567  40.07757  0.4986At most 2  0.140776  19.26910  33.87687  0.8052At most 3  0.090909  12.10433  27.58434  0.9284At most 4  0.059984  7.856059  21.13162  0.9123At most 5  0.046108  5.995060  14.26460  0.6138At most 6  0.015546  1.989855  3.841466  0.1584

                  

Cointegration model…

Normalised Cointegration model

LREER(-1) LTOT(-1) OPEN(-1) LPDCTY(-1) TARIFF(-1) LGOLD(-1) GRATIO(-1) C

 1.000000  1.963001 -0.730274  0.002122 -6.580808  0.789005 -2.150804 -12.98921

std error (0.44037)  (0.14046)  (0.31087)  (1.64081)  (0.13893)  (0.51615)

t-Stat[ 4.45765] [-5.19929] [ 0.00683] [-4.01071] [ 5.67917] [-4.16701]

               

Error Correction: D(LREER) D(LTOT) D(POPEN) D(LPDCTY) D(TARIFF) D(LGLD) D(GRAT)                              

CointEq1 -0.063774 -0.074516  0.363617  0.025811  0.006844 -0.004894  0.000940

 std error  (0.02886)  (0.01616)  (0.06976)  (0.01686)  (0.00616)  (0.04376)  (0.01563)

 t- stat [-2.20999] [-4.60985] [ 5.21256] [ 1.53113] [ 1.11174] [-0.11186] [ 0.06014]

Cointegration and error correction

Coefficients signs for gold are different from apriori expectations.

Magnitudes of TOT and Gold coefficients different from Aaron, Elbadawi and Khan (1996)

In the long-run Policies targeted at increasing openness, import tariffs and

government expenditure result in real exchange rate depreciation

TOT improvement and an increase in the international gold price result in real exchange rate appreciation. This might mean the income effects are stronger than substitution effects

Productivity has no effect on RER Approximately 6% of any deviation from equilibrium is cleared

in the following quarter, giving the rand a half life of approximately 12 quarters/3years

Productivity, government expenditure, trade taxes, and gold price do not respond to equilibrium error, thus could be weakly exogenous

Impulse response and variance decompositions

Period S.E. LREER GRAT PPTOTPOPE

NLPDCT

Y TARIFF LGLD

1 0.06 100.00 0.00 0.00 0.00 0.00 0.00 0.00

2 0.09 96.52 0.98 1.10 1.00 0.11 0.27 0.02

3 0.11 94.52 0.71 2.05 1.65 0.44 0.62 0.02

4 0.12 93.15 0.55 2.98 1.84 0.57 0.89 0.02

5 0.14 92.02 0.44 3.75 1.94 0.69 1.15 0.03

6 0.15 91.10 0.38 4.40 1.96 0.77 1.35 0.04

7 0.16 90.36 0.34 4.93 1.97 0.83 1.53 0.05

8 0.17 89.74 0.31 5.37 1.96 0.88 1.67 0.06

9 0.18 89.24 0.29 5.74 1.95 0.92 1.79 0.07

10 0.19 88.81 0.27 6.04 1.94 0.96 1.89 0.08 Cholesky Ordering: LREER PPTOT POPEN LPDCTY TARIFF LGLD GRAT

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

.07

1 2 3 4 5 6 7 8 9 10

LREER PPTOT POPENLPDCTY ATRDTAXESTMPT LGLDGRAT

Response of LREER to CholeskyOne S.D. Innovations

Impulse response and variance decompositions…

In the medium-run, about 6% of the variation in REER is explained by TOT while tariff (1.89%) and openness (1.96%)

More than 80% of variation in REER is explained by REER itself

Government expenditure results in a temporary real exchange rate appreciation in the first 2 quarters but will lead to a permanent depreciation

For a better analysis of dynamics i consider the ECM specification in the slides below

  1975:1-2010:4Equation 1

1975:1-2010:4Equation 2

1975:1-2010:4Equation 3

Coef adjust -0.183*** [-4.130] -0.083** [-2.063] -0.096** [-2.547]

Long-run      Tott-1 -0.350*** [-3.636] -0.235** [-2.898] -0.225*** [-2.879]

Opent-1 -0.004 [-0.171] -0.031 [-1.161] -

Productivityt-1 -0.213*** [-3.261] -0.225*** [-3.430] -0.188*** [-3.371]

Goldt-1 0.013 [0.456] 0.034* [1.875] 0.018 [1.555]

Tarifft-1 -0.085 [-0.276] -0.222* [-1.729] -0.090 [-1.518]

Public expenditure ratiot-1 -0.141 [-1.446]    

Constant 1.503*** [3.288] 0.857* [1.971] 1.075*** [2.776]

Short-run dynamics      

D(lreer)t-2 0.037 [0.446] -0.175** [-2.112] -0.154* [-1.910]

D(Domestic credit)t-1 -0.492** [-2.218] -0.568** [-2.604] -0.587*** [-2.723]

D(Gold)t 0.1022 [1.770] 0.111* [1.971] 0.110** [1.996]

D(TOT)t 0.152 [0.886] 0.026 [0.195] -

Dummy (debt crisis 85) -0.079*** [-3.692] -0.074*** [-3.63] -0.077*** [-3.82]

Diagnostics tests      

Adjusted R2 0.261 0.204 0.208Serial Correlation Breusch Godfrey

7.050 {0.029} 2.545 {0.280} 2.874 {0.238}

ARCH test 11.036 {0.001} 1.413 {0.234} 4.078 {0.130}

White Heteroskedasticity 42.162 {0.017} 24.73 {0.259} 21.791 {0.193}

AIC -3.053 -2.931 -2.949SIC -2.738 -2.680 -2.740Normality J-B 35.10 (0.000) 31.43 (0.000) 20.28 (0.000)

Stability of equation 3

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

80 82 84 86 88 90 92 94 96 98 00 02 04 06

CUSUM of Squares5% Significance

Results of single equation ECM

I consider the dummy for the debt crisis between 1983Q3 and 1985Q4 and apply general to specific modelling

Equation 3 explains approximately 21% of variations in REER

Long-run coefficients for gold and tariff are unstable

Only TOT and productivity have consistent signs on coefficients

Results show that a 10% increase in productivity result in an 1.8% real exchange rate appreciation in the long-run (Balassa-Samuelson effect)

Results of ECMs

Approximately 9% of deviations from equilibrium are cleared in the first quarter and half life is approximately 7 quarters

Consistent with Chen and Rogoff (2006) gold prices have short-run contemporaneous effects and no long run impact. However, the magnitude of the coefficient lies outside their 0.2 to 1 suggestion

10% Domestic credit growth results in short-run exchange rate appreciation of approximately 5.8%

There exists some inertia in real exchange rate growth

Policy implications

In the short-run the central bank can speed the real exchange rate adjustment through influencing the pace of domestic credit growth

Policies targeted at improving the terms of trade and increasing productivity will result in real exchange rate appreciation in the long-run

THE END