Annual Conference | May 17-18, 2008 Exchange Rate Dynamics in Armenia: How predictable are they? Vahé Heboyan PhD 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 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 Banks 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 Armenias 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 Armenias 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 Dornbuschs 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 countrys 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

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 Z t - an index of macroeconomic policies (i.e. the rate of growth of domestic credit) Z t * - sustainable level of macroeconomic policies (i.e. the rate of increase of demand for domestic money) S t - 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 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 countrys 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 countrys 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 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.

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 peoples 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. Johansens) 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

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

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:Q4 VariableDescriptionLog 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

AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 26 Two best models – Model B

AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan Slide 27 Misalignment Model A Model B

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 !!!