Download Prospectus Defense - AIPRG -- Armenian International

Annual Conference | May 17-18, 2008
Exchange Rate Dynamics in Armenia:
How predictable are they?
Vahé Heboyan
PhD Candidate, International Economics & Development
Outline
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Motivation
Theoretical background
Methodology
Data and series
Preliminary results
Future steps
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 2
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
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International competitiveness
Inflation
Output and FDI
Currency crisis
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 3
Exchange Rates in Armenia
170.000
160.0
160.000
140.0
150.000
120.0
140.000
100.0
130.000
120.000
80.0
110.000
60.0
100.000
40.0
90.000
20.0
80.000
70.000
0.0
1996
1997
1998
1999
NEER
2000
2001
REER
2002
$/AMD
2003
2004
€/AMD
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
2005
2006
2007
RR/AMD
Slide 4
Motivation
 Increasing controversies over the factors behind appreciation
Non-Government
 Those opposing Gov. policies

authorities engineered
appreciation to pocket hard
currency and benefit govconnected importers
 Price increases for most goods

Government
 Rapid growth in remittances
from abroad
 Economic growth
 Weakening US$
 Price increase in world markets
Monopolized imports?
(Smbat Nasibyan, Chairman,
Converse Bank)
 Exporters have articulated for
more intervention
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 5
Central Bank’s Position
 Monetary policy priority: Inflation management
 3-4±1.5 % annually 
 Appreciation has helped to prevent complete passthrough 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 6
PhD Dissertation
Exchange Rate Dynamics and Macroeconomic Impact in
Transition Countries: An Empirical Investigation of Armenia’s
Exchange Rate
 Objective: survey, adapt, and extend empirical models to the benefit of
understanding and practically analyzing exchange rate dynamics and
behavior in Armenia
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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 longrun 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 macroeconomic performance
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 7
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 8
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 9
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 10
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 stockpoint equilibrium is achieved for all agents of the economy
(Driver and Westaway,2004)
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 11
Empirical Approaches to Equilibrium ERs
BalassaSamuelson
Monetary
Models
Purchasing
Power
Parity
BalassaSamuelson
The
expected
change in
the
exchange
rate
determined
by interest
differentials
Constant
Equilibrium
Exchange
Rate
Relevant
Time
Horizon
Short run
Statistical
Assumptions
UIP
PPP
CHEERs
ITMEERs
BEERs
FEERs
DEERs
APEERs
PEERs
NATREX
SVARs
DSGE
Name
Uncovered
Interest
Parity
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
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
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
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
Source: Driver and Westaway 2004
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 12
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 13
Basic Model Structure
 Real exchange rate

 

 log et   log et*  log et 1   Zt  Zt* 
   log St  log St 1    PMPRt  PMPRt 1 
 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.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 14
Basic Model Structure
 Equilibrium Real Exchange Rate (ERER)
log e  0  i  FUND t   t
*
t
 FUND - set of fundamental variables that are assumed to
have a determining effect on the ERER
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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 nontradable goods.
Market openness (OPEN). A proxy for trade controls/ restrictions.
Technological progress/productivity (TECHPRO). Allows capturing the famous BalassaSamuelson 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.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 15
Basic Model Structure
 Equation to be estimated using conventional methods.
log et   i log  FUNDit   1    log et 1  i  POLICYit    NOMDEVt   t
 POLICY - single notation of macroeconomic policy variables
 NOMDEV - stands for nominal devaluation
 γ’s are combinations of β’s and θ.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 16
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 17
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 18
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 19
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
py
n
px
yt    i yt i    ji x j ,t i  c
i 1
j 1 i 1
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 20
Error correction model
n
p y 1
n
j 1
i 1
j 1 i  0
px 1
yt   yy yt 1    yx , j x j ,t 1   i yt i     ji x j ,t i  c
 Bounds test (Pesaran, Shin, and Smith, 2001)
 F-stat for existence of the level relationship
 Hypothesis


 yy
 yx , x
H 0 yy :  yy  0 and H 0 yx ,x :  yx , x  0'
H1 :  yy  0 and H1
:  yx , x  0'
 Joint hypothesis
 yy
 yx , x


H0  H0  H0
H 1  H 1 yy  H 1 yx ,x
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 21
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 22
Data and Series
 1996:Q1 – 2007:Q4
Variable
Description
REER
Real equilibrium exchange rate. Is a multilateral CPI based real effective exchange rate. It is Yes
defined in terms of Armenian Dram per unit of foreign currency, so that an increase
(decrease) in REER represents depreciation (appreciation).
ToT
Terms of trade for Armenia is defined as the ratio of export price index over import price Yes
index.
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 No
the lagged rate of growth of real GDP.
PROD
Measure of productivity. Proxied by per capita real GDP relative to that of the trading Yes
partners.
DS
Debt service as a share of exports.
MONDEV Nominal devaluation. Nominal effective exchange rate is used.
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Log
No
No
Slide 23
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 24
Two best models – Model A
ERER  0.48 GOV  0.80 NFA  0.05 INV  0.63 EXCRE
4.5
3.8
5.0
2.3
5.0
4.9
4.8
4.7
4.6
4.5
4.4
4.3
4.2
4.1
19961
19971
19981
19991
20001
ERER
20011
20021
REER
20031
20041
20051
20061
20071
ERER_smoothed
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 25
Two best models – Model B
ERER  0.28 GOV  1.61 NFA  0.88 EXCRE  0.03 NOMDEV
 7.3
3.5
8.5
4.6
5.4
5.2
5.0
4.8
4.6
4.4
4.2
4.0
19961
19971
19981
19991
20001
ERER
20011
20021
REER
20031
20041
20051
20061
20071
ERER_Smoothed
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 26
Misalignment
50%
Model A
40%
30%
20%
10%
0%
-10% 19961
19971
19981
19991
20001
20011
20021
20031
20041
20051
20061
20071
-20%
-30%
-40%
Misalignment
Misalignment_smoothed
Model B
60%
40%
20%
0%
19961
19971 19981 19991 20001
20011 20021 20031 20041
20051 20061 20071
-20%
-40%
-60%
-80%
Misalignment
Misalignment_smoothed
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 27
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 28
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 29
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”
AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan
Slide 30
Thank You 
Comments and suggestions are gladly welcome !!!