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

1. Annual Conference | May 17-18, 2008 Exchange Rate Dynamics in Armenia: How predictable are they? Vahé Heboyan PhD Candidate, International Economics & Development

2. Outline • Motivation • Theoretical background • Methodology • Data and series • Preliminary results • Future steps AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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

4. Exchange Rates in Armenia AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

5. 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 Motivation • Increasing controversies over the factors behind appreciation AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

6. Central Bank’s 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

7. 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 • 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 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 AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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

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 • Dornbusch’s “overshooting” model • Portfolio Balance Approach • Other AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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 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

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

12. Empirical Approaches to Equilibrium ERs Source: Driver and Westaway 2004 AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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

14. Basic Model Structure • Real exchange rate • 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, φandψ are positive parameters that capture the most important dynamic aspects of the adjustment process. AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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 country’s 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 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

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

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

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 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

19. 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

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

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

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

23. Data and Series • 1996:Q1 – 2007:Q4 AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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

25. Two best models – Model A AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

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

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

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

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

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” AIPRG Conference | May 17-18, 2008 | Washington DC ¡ Vahé Heboyan

31. Thank You  Comments and suggestions are gladly welcome !!!