EXCHANGE RATE VOLATILITY AND ITS EFFECTS ON MACROECONOMIC MANAGEMENT IN ZAMBIA
Jonathan M. Chipili[*]
Final Draft Report
December 2014
Abstract
The impact of exchange rate volatility on selected macroeonomic indicators in Zambia is analysed over the period 2007-2013. The extent of exchange rate volatility deemed disruptive on the economy is also determined. A significant role for exchange rate volatility in macroeconnomic management is established: volatility in the kwacha/US dollar exchange rate tends to depress trade, increase inflation, discourage capital flows and dampen output although its impact tends to be temporary; and exchange rate depreciation in excess of 1% tends to generate negative effects on the economy. The results underscore the significance of the exchange rate in trade and monetary policies and the transimission of exchange rate impulses to the rest of the economy. The central bank must therefore seek to stabilize the exchange rate; however, this requires an appropriate currency stabilization strategy that ensures currency flexibility and competitiveness. Interventions in foreign exchange markets should not be undertaken in isolation as this may significantly deterioratethe reserves position and weakenthe country’s ability to respond to adverse external shocks. Thus, complementary policies are recommended to sustain a stable exchange rate.
JEL classification: F31; C22; C32
Keywords: Exchange rate volatility, macroeconomic indicators, GARCH, SVAR
1.Introduction
The study of persistent variability in the exchange rate post-1973 remains an active subject of empirical investigation due to the adverse effects a volatile exchange rate can potentially impose on the economy.Policymakers are interested in exchange rate volatility for formulating suitable macroeconomic policies while corporate entities are concerned about its implications on profitsby designing appropriate risk management tools (Bollen, 2008; Bauwens and Sucarrat, 2006).
Aggregate and sectoral output, price level, international trade and foreign investment are typically affected by a volatile exchange rate (Mirdala, 2012; Arratibel, et al., 2011; Takagi and Shi, 2011; Chipili, 2010). Volatility in the exchange rate introduces uncertainty which in turn generates negative economic welfare effects (Bergin, 2004; Obstfeld and Rogoff, 1998). Further, fluctuations in the exchange rate affect consumer goods prices which in turn affect demand and consequently consumption. Monetary policy is also affected by currency fluctuations especially where domestic growth is underpinned by exports as authorities attempt to support the external sector through exchange rate stabilisation at the expense of inflation stabilisation (Crosby, 2000). Echange rate uncertainty can also create incentives for trade protectionist tendencies and sharp currency reversals which in turn impose further costs on the economy (Sengupta, 2002; Bayoumi and Eichengreen, 1998).
Volatility in exchange rates can also restrict the flow of international capital by reducing direct and portfolio investments. Speculative capital flows may also be induced by exchange rate volatility under the flexible regime that could in turn contribute to instability in economic conditions (Willett, 1982). Further, greater exchange rate volatility increases uncertainty over the return of a given investment. Potential investors are attracted to invest in a foreign location as long as the expected returns are high enough to compensate for the currency risk. In view of this, foreign direct investment tends to be lower under higher exchange rate volatility. Most developing economies are net debtors such that considerable fluctuations in exchange rates may affect the real cost of debt service. Similarly, banks, corporate entities and individuals exposed to foreign denominated debt are negatively affected by exchange rate volatility (Schnabl, 2009).
Central banks globally therefore endeavour to stabilize exchange rates in order to moderate the adjustment and uncertainty costs that a volatile exchange rate imposes on the economy.
While a vast amount of literature on the impact of a country’s exchange rate volatility on macroeconomic variables exists, limited empirical work has been undertaken on Zambia. Notably,Chipili (2013), Musonda (2008) and Tenreyro (2007)have examined the exchange rate volatility-trade link; Aghion et al. (2009)have analysed the impact of exchange rate volatility on productivity growth; and Chipili (2013) examined the relevance of exchange rate volatility in monetary policy setting as well as central bank foreign exchange intervention decision. In all these studies, the revelance of exchange rate volatility is noted with varying degree of impact on the sectors/variables studied. While a number of studies report negligible exchange rate volatility effects on real economic activity, Aghion et al. (2009)find exchange rate volatility to exert significant negative impact on productivity growth subject to a country’s level of financial development: the impact is severe in thin and less developed capital markets.
This study seeks to empirically examine the impact of the kwacha exchange rate volatility on selected macroeconomic variables in Zambia over the period 2007-2013 due to data limitations especially on capital flows at monthly interval. A brief perspective on the macroeconomic policy evolution from early 1990 when economic reforms commenced is provided.Specifically, the study analyses trends in the kwacha/US dollarexchange rate and major macroeconomic variables. Possible causes of exchange rate volatility in the kwacha exchange rate are reviewed from past studies. A formal econometric framework for examining the impact of the kwacha/US dollar exchange rate volatility on the economy and the threshold for exchangerate volatility deemed disruptive to the economy are provided.
The results reveal that exchange rate volatility tends to depress trade, increase inflation, discourage short-term capital flows and dampen output although its impact tends to be temporary. In addition, exchange rate depreciation in excess of 1% tends to generate negative effects on the economy.
The rest of the paper is organised as follows. The next section provides a brief overview of the exchange rate policy in Zambia and discusses the evolution of selected macroeconmic and financial indicators. Section 3 reviews relevant literature on macroeconomic effects of exchange rate volatility on the economy. The estimation procedure and empirical results are presented in section 4. Section 5 concludesand offers policy recommendations.
2.Overview of the Exchange Rate Policy and Trends in Selected Macroeconic
Indiactors
In recent years, the focus of economic policy has been on raising economic growth and reducing poverty by consolidating the stabilisation gains achieved since the commencement of economic reforms in early 1990s. Financial sector and private sector development plus public financial management and accountability reforms are other areas of priority concern to the Government.
Prior to economic reforms, the focus of Government policy was on industrialisation built around import substitution adopted soon after gaining independence in 1964. The main sector of the economy was mining which accounted for about half of GDP and about 90% of total export earnings (UNDP, 2006)[1]. Strong copper revenues initially supported the development strategy as copper prices and output steadily rose. Subsequently, revenue from copper weakened due to the fall in copper prices in early 1970s and the decline in copper output. Oil prices shot up in 19973/74 and again in 1979/80 (oil price shocks) causing the terms of trade to decline.
The Government responded by imposing exchange and trade controls (foreign exchange controls on current and capital account transactions plus import licensing)as well as price controls on goods. Interest rate ceilings were also introduced. The exchange rate was fixed while monetary and fiscal policies were loosened. Attempts to diversify the economy away from copper dependence and limit the dominance of state owned enterprises (SOEs) created to spur the industrialisation development strategy in the late 1980s failed due to underlying distortions created by the policies in place (see Adam, 1995). Negative real GDP growth rates became entrenched by the mid 1990s.
Consequently, the economy was liberalised as market-oriented reforms were adopted in early 1990s with the support of the IMF/World Bank. The reform package included the de-control of product prices, trade liberalisation and elimination of exchange controls in 1994 making both current and capital account fully convertible that subsequently gave way to a market determined exchange rate. The removal of interest rate ceilings in 1991, introduction of Treasury bills auctions in 1993 and adoption of indirect instruments of monetary policy in 1995, privatisation of SOEs including mining companies and rationalisation of expenditures (especially non-essential) and enhancement of domestic revenue collection were other reform measures undertaken.
Zambia has maintained a liberal flexible exchange rate system since 1994. Prior to that, the exchange rate was fixed from the time of independence in 1964. A fixed exchange rate regime existed from 1964 to 1982 and 1987 to 1991 while a crawling peg was adoptedbetween 1983 and 1985. An initial float of the kwacha took place between 1985 and 1987. A more flexible exchange rate regime was adopted in the early 1990s as part of the economic reforms. The decision to choose each of these exchange rate regimes was largely influenced by conventional economic and political arguments. A comprehensive review of the exchange rate policy in Zambia is provided by Chipili (2010), Mungule (2004) and Mkenda (2001).
According to figure 1, the kwacha/US dollar exchange rate exhibited a rising trend over the priod 1994-2013 with some volatility, particularly during the global financial crisisof 2007/8 and the period following debt forgiveness (HIPIC Initiative and MDRI) in early to mid-2000. Over the sample period, remarkable economic improvements have been posted, evidenced by sustained growth in real GDP since early 2000, reflecting strong growth in agricultural output supported by favourable weather and appropriate farmer input support programme by government;recovery in the mining sector following huge re-invetsment after privatising the state owned mining conglomerate; pick-up in tourism due to various promotional activities; and steady growth in the contruction sector owing to the boom in private commercial and housing properties, public investment in health and educational facilities and road infrastucture by the government. In addition, inflation has constitently declined to single digits in the recent past, reflecting the stabilisation programme embarked on by government since the commencement of economic reforms in early 1990. Similarly, commercial bank lending rates have declined in line with the trend in inflation. Money supply growth, though volatile, has slowed down and stabilised around an annual growth rate of 20% in recent years, reflecting the resolve by authorities to contain inflationary pressures while supporting growth.
The current account has recovered since 2000 despite some fluctuations, reflecting strong growth in exports (both copper and non-traditional exports)while imports have been rising in recent years in line with the expansion in key economic sectors such as mining. Despite exhibiting considerable volatility, foreign direct invetsmet has picked up attributed to a stable and robust macroeconomic environment. The size of the capital market has expanded over the years as reflected in the rising stock market index. Fiscal deficits (as a percent of GDP) improved from around 8% in 1994 to around 1% in 2008; however, the trend reversed in recent years reaching around 6% in 2013largely due to the infrastructure investment programme embarked on by Government. Finally, the declining trend in domestic revenue collections was reversed in 2010, picked up sharply and exceeded the 1994 level by 2013, reflecting steady economic expansion and various revenue broadening measures.
Figure 1Selected Macroeconomic Indicators
Note: Exchange_Rate_KUS$=absolute values of kwacha/US$; Real_GDP_Growth=%; Inflation=%;
Money_Supply_Growth=%; Lending_Rate=%; Curr_Acc_Percent_GDP=current account in % of GDP;
Exports_Percent_GDP=exports as % of GDP; Imports_Percent_GDP=imports as % of GDP; FDI_Percent_GDP=foreign direct investment as % of GDP; Stock_Mkt_Index= stock market index (=1000); Revenue_Percent_GDP=revenue as % of GDP; Fiscal_Deficit_Percent_GDP=fiscal deficit as % of GDP.
3.A Brief Look at the Literature
There is no consensus in the literature regarding the factors that influence exchange rate volatility due to divergent theoretical models of exchange rate determination. In addition, the factors are numerous compounded by the inability to predict them and their effect on real exchange rate volatility varies considerably to be quantified with certainty (Canales-Kriljenko and Habermeier, 2004; Dungey, 1999; Korteweg, 1980).
A large body of empirical work has employed fundamentals-based models in modelling exchange rate volatility (see Kočenda and Valachy, 2006; Devereux and Lane, 2003; Bayoumi and Eichengreen, 1998; Pozo, 1992). Most of these studies document real shocks with large permanent effectsas the dominant source of exchange rate volatility. Notwithstanding this evidence, fundamentals tend to explain only a small proportion of exchange rate volatility due to the weak link between the two (popularly referred to as the ‘disconnect argument’), thus lending support for the role of microstructure factors in exchange rate fluctuations in the short-term (see Bjørnland, 2008; De Grauwe et al. 2005; Obstfeld and Rogoff, 2000; Flood and Rose, 1995for an extensive discussion). However, Morana (2009) provides more recent support for fundamentals in terms of linkages (causes and trade-off) between exchange rate volatility and volatility in macroeconomic factors (i.e. output, inflation, interest rate and money supply). Although the direction of causality is bi-directional, it is however, stronger from macroeconomic factors to exchange rate volatility than vice-versa. Thus, stability in the macroeconomic variables is recommended to reduce exchange rate volatility in sharp contrast to Flood and Rose (1995).
In the case of Zambia, the influence of copper price - major commodity export - on the exchange rate like for most developing countries whose currencies are commodity-basedis documented (Cashin et al. 2002). In addition, the positive influences of exchange rate regime, money supply and openness on conditional volatility of the kwacha/US dollar is established (see Chipili, 2010; Bangaké, 2008; Hausmann et al., 2006). Savvides (1990) finds both real and monetary variables to be key determinants of exchange rate variability.
Thus, identifying sources of exchange rate volatility facilitates the design of appropriate policy response. By and large, real (external) sources tend to constrain policy response due to their unpredictability of occurrence and highly differential impact on the exchange rate. This is in contrast to the domestically generated factors such as monetary which authorities have reasonable control over. If the sources are monetary in nature, the policy response is to reduce the trend rate in monetary expansion and/or raise trend rate in real output growth. This entails adopting a predictable monetary policy rule that involves pre-announcement of monetary targets, instruments and their timing.
Empirical evidence regarding the impact of exchange rate volatility on macroeconomic variables is mixed. For instance, Baxter and Stockman (1989) do not find evidence of exchange rate volatility impacting on macroeconomic aggregates under alternative exchange rate regimes. Low exchange rate volatility is associated with greater output growth and lower inflation (Robertson and Symons, 1992).Sapir and Sekkat (1995) find no appreciable impact of exchange rate volatility on trade, investment and growth. On the contrary, Chit (2008) argues that evidence of exchange rate volatility adversely affecting investment, growth and trade exists. Schnabl (2009) finds exchange rate volatility to exert negative effect on growth.
The theoretical prediction of the exchange rate volatility-trade relationship is ambiguous: exchange rate volatility can either stimulate or depress trade (Hooper and Kohlhagen, 1978; Baron, 1976; Clark, 1973;Ethier, 1973). Similarly, empirical evidence is inconclusive (see Ozturk, 2006; Clark et al. 2004;McKenzie, 1999;Côté, 1994). Nonetheless, there is growing and firm evidence that exchange rate volatility imposessignificant effects on the volume of trade(seeOzturk, 2006; Clark et al. 2004;UK Treasury, 2003;McKenzie, 1999;Côté, 1994;IMF, 1984;Farrell et al., 1983).Exchange rate variability affects international specialisation in production which in turn leads to a reduction in the welfare of people as output declines and consequently income and consumption (Clark, 1973). Volatility in the exchange rate can lead to the reduction inthe volume of international trade due to increases in the level of trade riskiness that creates uncertainty about profits. In addition, it causes prices of tradables to rise due to the risk mark-up (risk premium) imposed by sellers in order to protect profits. This tends to affect the competitiveness of exports. In response to fluctuations in the exchange rate, firms shift resources from the risky tradable sector to the less risky non-tradable sector in order to protect their profits. Further, a rise in exchange rate uncertainty increases transaction costs as agents attempt to hedge against exchange rate risk (Schnabl, 2009).
The importance of exchange rate in monetary policy and foreign exchange interventions is established.Most empirical work especially in developed countries is dominated by estimations of the interest rate rule proposed by Taylor (1993) as most central banks typically use the nominal short-term interest rate as the main operating policy instrument (see Eleftheriou et al. 2006;Adam et al. 2005; Claridaet al. 1998). Central banks mostly adjust the nominal short-term interest rate in response to deviations of output and inflation from potential level and target, respectively. In Zambia, exchange rate volatility is found to be an integral part of monetary policy setting and central bank foreign exchange intervention decision (see Chipili, 2013).
4.Estimation Method, Data and Empirical Results
To establish the impact of exchange rate volatility on the economy, we begin by estimating exchange rate volatility using the GARCH model. Thereafter, the structural VAR (SVAR) model that includes exchange rate volatility derived from the GARCH model and selected macroeconomic variables is estimated and impulse responses and variance decomposition results reported. Finally, the threshold for exchange rate volatility deemed disruptive is determined using the non-linear effect apparoch.
4.1Estimation Method
GARCH Model
Volatility in the kwacha/US dollar exchange rate is modelled using the GARCH approachspecified in equations 1 and 2in order to characterise its time-varying conditional variance path. The GARCH models introduced by Engle (1982) and extended by Bollerslev (1986) take into account the distributional form of the exchange rate: leptokurtic, clustering and leverage behaviour typically present in financial time series data(Brooks, 2001; Bauwens and Sucarrat, 2006). The standard deviation, a widely used measure of exchange rate volatility, is not adopted on account of the fact that it tends to overstate total risk, does not distinguish between predictable and unpredictable elements of a variable and lastly assumes normality distribution of a variable which is not always the case especially for financial variables.