empirical determinants of real exchange rates in south africa
DESCRIPTION
this presentation is a summary update on the empirical determinats of real exchange rates in south africaTRANSCRIPT
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