– macroeconomic condition and financial sector in … 1 session...workshop on “supporting...

Workshop on“Supporting Asia‐Pacific LLDCs and Bhutan in mobilizing resources for

the SDGs”

Session 1 – Macroeconomic condition and financial sector in Bhutan

“Diagnosing the Dutch Disease: Are the symptoms present in Bhutan?”

December 11th 2018

Macroeconomic Trends Real Sector Fiscal Sector Monetary Sector External Sector

A primer on the Dutch Disease Diagnosing Bhutan’s condition

The three effects Bilateral Real Exchange Rate

Conclusion

Contents

Macroeconomic Trends Dutch Disease Diagnosis Conclusion

Macroeconomics Trends: The real sector

y = 0.0072x2 - 0.0802x + 3.8029R² = 0.3442

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-5 5 15 25 35 45 55G

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Average resource rents

Resource rents and Growth volatility

• The incontrovertible dependence on the sector• Resource dependent economies are more vulnerable to growth volatilities due to the

low price elasticities of supply and price volatility


Macroeconomics Trends: Fiscal sector

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Contribution to Revenue

Electricity Trade Services Finance Manufacturing Primary Others

• Public finance’s dominant role: 36.5% of GDP• Electricity’s significant but declining role


Macroeconomic Trends: Monetary Sector

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Money supply trends

M2 (Broad Money) M1 M0 (Reserve Money) QM (Quasi-Money)

2008 2009 2010 2011 2012Excess liquidity 3125.6 2598.1 4379.4 ‐1130.8 4500Average 2694.46Standard deviation 2045.81Volatility 0.76

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Hydro Inflows as % of Money Supply

Project inflows % of M2 Export Revenue % of M2


Aizenman and Marion (1999) detect a highly significant and negative correlation between money growth volatility and private investment.

Macroeconomic trends: External Sector

• Current account surpluses are short lived

• An economy that hasn’t reached its long term output potential requires investment and government consumption to exceed their steady state levels (Aristovnik, 2006)


Dutch Disease: A Primer

• Sachs and Warner (1996) in an empirical investigation find a significant inverse relationship that is robust even when controlling for variables like initial per capita income, trade policy, government efficiency, investment rates etc.

• Frankel (2011) explores six channels through which the resource curse occurs: (i) long‐term trends in world prices, (ii) price volatility, (iii) permanent crowding out of manufacturing, (iv) autocratic/oligarchic institutions, (v) archaic institutions, and (vi) cyclical Dutch Disease

• Corden and Neary (1982) pioneered the formulation of a formal framework that captures the dynamics between the traded booming sector, lagging sector and the non‐traded sector


Diagnosing Bhutan’s condition

Three effectsMonetary Effect

Unsterilized inflows cause monetary expansion Short term disequilibrium Inflationary pressures

Spending Effect Increased revenues Consumption and investment increase Demand for tradables and non‐tradables increases Tradables can be imported but non‐tradable production cannot increase overnight

Resource Movement Effect Reinforced by spending effect Changes in relative prices Demand for non‐tradables increase


Diagnosing Bhutan’s condition

Some specificities:

• Fixed exchange rate

• Monopsonistic context

• Insulated from international price swings– Tariffs determined bilaterally

• Transmission channels of a boom are usually the expansion of installed energy capacity as opposed to favourable terms of trade movement.

• Projects are financed entirely by capital inflows from India and undertaken on an Inter‐Governmental basis thereby mitigating some of the capital crowding out effects.

• Significant share of the labour requirements, both manual and technical, is sourced from India and labour is virtually immobile


Diagnosing Bhutan’s Condition

The Spending Effect:

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Composition of Absorption

Power absoprtion govt Power abosrption private

Power absorption invest

Increased revenuesConsumption and investment increaseDemand for tradables and non‐tradables increasesTradables can be imported but non‐tradable production cannot increase overnight



The Resource Movement Effect

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Non TradedO

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T2

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eReinforced by spending effectDemand for non‐tradables increaseChanges in relative prices



The Resource Movement Effect

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Manufacturing and Services

Manufacturing, value added (% of GDP) Services, etc., value added (% of GDP)

Manufacturing, value added (annual % growth) Services, etc., value added (annual % growth)

• Weak empirical evidence

• But there may be underestimation

• Difficult to verify labour movement

• Immobility of labour and the capital intensive nature of the booming hydropower sector that does not employ much labour upon completion.

• Unconventional channel whereby the civil service has been growing exponentially at an average of about 5% over the last 12 years

• “when the two effects combine, we see that both contribute to a real appreciation…However, the resource movement effect tends to lower the output of services whereas the spending effect tends to raise it, and there is no presumption as to which will dominate.” (Cordon and Neary, 1982)


Diagnosing Bhutan’s Condition The Monetary Effect

A temporary disequilibrium Fixed exchange rate regime like that of the Rupee‐Ngultrum the transmission

channels of increased energy export revenues are different from that of a floating exchange rate regime, where the principal channel is an appreciation of the nominal exchange rate spurred by increasing demand for the local currency.

inflationary pressures sparked by an expansion in the money supply leads to an upward pressure on the real exchange rate thereby effecting competitiveness

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Velocity of Money

GDP growth M2 growth Inflation Velocity of money

• Import intensive credit growth

• Significance of monetary effect is debatable

• The effect on the BRER



The Bilateral Real Exchange Rate

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Rea

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RER (WPI) Real Power

Use WPI due to trade integration

While it is challenging to disentangle the determinants of the real exchange rate’s behaviour in the graph but we can infer a broadly inverse relationship between real exchange rate and real power exports



The Bilateral Real Exchange RateDeterminants

Longer run fundamentals and short term disequilibrium

lo g

The model suggests that a 1 percent increase in real power exports leads to a .006 percent appreciation in the BRERThese crude estimates still imply that the 10000 MW initiative which would result in an almost 500 percent increase in power capacity and associated exports would cause a BRER appreciation of 3 percentEarlier estimates which were reported for a shorter time frame : a crippling 20 percent appreciation.most significant impact, despite its unexpected sign, comes through the channel of a monetary disequilibrium effect with a 1 percent increase leading to a .066% depreciation.



The Bilateral Real Exchange Rate

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Misalignment of the BRER

• We apply the calculation suggested by Lebdaoui (2013) wherebythe misalignment is the percentage difference between the BRERand the trend component of the BRER extracted using theHodrick Prescot filter

• Mostly an overvaluation: Perhaps due to the nominal peg?


Deeper rooted causes

Where did the credit demand and supply come from Excess liquidity: unsterilized Hydro inflows, corporate deposits, lead to an expansion of the

money supply Attractive for banks to lend Wealth effect: People anticipate their incomes to rise in the future due to rising asset prices Spending effect: In anticipation they avail more loans

Why did the trends result in a crunch? Inflow and outflow timing mismatches Lack of adequate INR reserves The crunch is a manifestation of a problem that has been building over the years

Macroeconomic Trends Analysis & Rationale SWFs Proposed framework Conclusion

Strategies

Categories of suggestions to deal with the INR crunch Real Sector: Diversification to enable enhancing of exports and containing imports Fiscal efficiency: Alignment with monetary policy Reserve Management: A strategy to optimize returns and restructure reserves Liquidity Management: Reduce volatility and lending to sectors that stimulate imports


Sovereign Wealth Funds

Functions: Take into consideration time horizon and liquidity structure Stabilization

delinking expenditure from revenue Common to commodity exporting countries

Inflation management Sterilization

Social Development Investing in areas of socio‐economic importance

Diversification & Industrial Policy Investing in potential economic sectors

Debt Management Ring‐fencing

Savings vs. Investment Investment horizon Intergenerational Equity USD 830 billion Norwegian Pension Fund‐ 160% of GDP


Objectives

A fund with multi‐faceted purposes

Sterilize inflows from hydro power exports and related loans and grants

Debt Servicing

Enable government to support counter‐cyclical interventions to sustain the desired level of growth in the economy

Reduce volatility in liquidity and credit

Priority sector investments and Private Sector Development

Investing in Foreign Government Bonds


Objectives


Conclusions

A general trend of Bilateral Real Exchange Rate appreciation that is consistent with a Dutch Disease, but cannot unequivocally attribute this to hydropower export revenues

Limited resource movement effect cannot ignore the possibility that the manufacturing sector could have been larger in the

absence of real exchange rate appreciation

Spending effect manifests in the form of increased private absorption of power income.

Unconventional Resource movement effect.

Strategies: stabilization fund, structural reforms that encourage diversification will be critical.

Macro‐prudential policies


– macroeconomic condition and financial sector in … 1 session...workshop on “supporting...

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