Exchange Rate Misalignment in Pakistan: Evidence from Purchasing Power Parity Theory

Transcription

1 The Pakisan Developmen Review 43 : 4 Par II (Winer 2004) pp Exchange Rae Misalignmen in Pakisan: Evidence from Purchasing Power Pariy Theory ABDUL QAYYUM, MUHAMMAD ARSHAD KHAN, and KHAIR-U-ZAMAN 1. INTRODUCTION Exchange rae provides a key link beween he domesic and world markes for goods and asses. Therefore, a proper and deailed analysis of he behaviour of exchange rae is required. There is also growing agreemen ha prolonged and subsanial exchange rae misalignmen can creae severe macroeconomic disequilibria and he correcion of exernal balance will require boh exchange rae devaluaion and demand managemen policies. Thus he policy-makers have used PPP heory as a guide o represen he exernal compeiiveness of a counry, and as a benchmark agains which floaing exchange raes are judged o be misaligned. Developmens in 1990s and 2000s show ha cos associaed wih exchange rae misalignmen is very high. Hence, he analysis of exchange rae deerminaion in he presence of exchange rae misalignmen is crucial for he policy purpose because of is role as a componen of an early warning sysem [Berg, e al. (2000)]. I is no easy o se nominal exchange rae in is inended pah. There are concepual and empirical issues ha wha exacly he value of long-run equilibrium exchange rae. In he lieraure, here are a leas hree broad definiions of misalignmen [Williamson (1994); Miles-Ferei and Raziun (1996) and Hinkle and Moneil (1999)]. Firs, Price-based crieria, such as purchasing power pariy (PPP) and is varians. Second, model-based crieria, based on he formal models of nominal exchange raes. Third, solvency and susainabiliy-based crieria, which make reference o rends in he curren accoun and he exernal debs o GDP raio. I urns ou ha he economic relevance of each crierion is inversely relaed o he difficuly of implemening i. Price-based crieria are relaively easy o implemen Abdul Qayyum is Associae Professor, Pakisan Insiue of Developmen Economics, Islamabad. Muhammad Arshad Khan is Associae Professor, Governmen Pos-graduae College, Muzaffarabad, Azad Jammu and Kashmir. Khair-u-Zaman is Professor, Gomal Universiy, D. I. Khan.

2 722 Qayyum, Khan, and Zaman and has srong operaional advanages. 1 Therefore, in his sudy a more modes goal of implemening he price-based crieria is se forh. Purchasing power pariy consiues one of he fundamenal building block in modeling he modern heories of exchange rae deerminaion. 2 This heory was originally advanced by Cassel (1916, 1918), assers ha under he condiions of free rade 3 he nominal exchange rae beween wo counries is equal o he raio of he wo counries price level. This approach assumes ha equilibrium real exchange raes remain consan over ime and herefore, he nominal exchange rae movemen ends o offse relaive price movemens. 4 The PPP hypohesis posulaes ha exchange raes adjus o price differenials in open economies o resore inernaional commodiy marke equilibrium. Basically, PPP heory relies on law of one price (LOP) 5 in an inegraed, compeiive produc marke wih an implici assumpion of a risk-neural world. The concep is based on a flow heory of exchange raes 6 where he demand for currency is o pay for expors and he supply is o pay for impors. Despie he fac ha he heory has been known for cenuries, PPP remains conroversial as ever. 7 An exensive research has been carried ou, iner alia, by Taylor (1988); Giovannei (1989); Pael (1990); Nachane and Chrissanhaki (1991); Crowder (1992); Saranis and Sewar (1993); MacDonald (1993); Cooper (1994); Corbae and Ovliaris (1988); Ardeni and Lubin (1991); Dornbusch (1988) and Moosa and Bhai (1996) invesigaing he validiy of PPP heory during he curren sysem of floaing exchange raes. Bu hese sudies have no found evidence in suppor of he 1 The implemenaion of model-based and susainabiliy-based crierion requires more deailed analysis. Especially, he susainabiliy-based measures are very difficul o calculae, as hey require a fully fleshed ou macroeconomic model. PPP-based analysis can be used o make iniial diagnoses and for idenifying hypohesis for analysing more deailed models. 2 The flexible-price moneary exchange rae model developed by Frenkel (1976) and Bilson (1978) presumes ha PPP hold coninuously, he Dornbusch s (1976) Sicky-price and he Frankel (1979) real ineres rae differenial models assumes ha PPP hold in he long-run only. However, he poor performance of hese models required he analysis of heir underlying componens, including PPP, o be esed for validiy [Bhai (1996)]. 3 Transacion coss, capial flows and speculaive expecaions are absen. 4 Alhough he assumpion of free rade, absence of ranspor coss and speculaive flows are unrealisic in he real world and he exchange rae may deviae from is PPP level and real exchange rae from is mean values. 5 Law of one price saes ha when measured in a common currency, free raded commodiies should cos he same everywhere under perfec marke seing assumpion (i.e. no ransacion coss, no ax, homogeneous goods and complee cerainy). If he prices deviae from each oher, hen he commodiy arbiragers would capialise by buying in one marke and selling in anoher unil he profiable opporuniies cease o exis. 6 PPP is called he flow model since i races he flow of goods and services hrough he curren accoun o deermine he exchange rae. 7 Much of he heory is reviewed and discussed by Officer (1984); Dornbusch (1988) and Levich (1998).

3 Exchange Rae Misalignmen 723 hypohesis as a long-run hypohesis. 8 As far as Pakisan is concerned, Bhai (1996); Liew, e al (2004); Tang and Buiong (1994) and Ahmed and Khan (2002) found supporive evidence while Chishi and Hasan (1993) found evidence, which does no suppor he PPP hypohesis. The main objecive of he sudy is o es he validiy of PPP heory of exchange rae deerminaion and o evaluae wheher PPP is valid crieria for calculaing misalignmen in Pakisan for 1982Q2 o 2002Q4. The sudy is organised in he following manner. In Secion 2, he price-based measure of misalignmen is described. Secion 3 discusses he heoreical model of PPP. Daa, economeric mehodology and empirical evidence are discussed in Secion 4. Exchange rae misalignmen is calculaed in Secion 4, while some concluding remarks are given in he final secion. 2. PRICE-BASED CRITERIA OF EQUILIBRIUM EXCHANGE RATE Purchasing power pariy heory of exchange rae deerminaion assers ha he exchange rae beween wo currencies over any period of ime is deermined by he changes in he wo counries price levels. This heory signals ou changes in price levels as he overriding deerminan in he deerminaion of exchange rae. According o his heory, exchange rae may diverge from is PPP level in he shorrun. There are several reasons ha why deviaions from PPP occur. Firsly, here may be resricions on rade and capial movemens, which will disor he relaionship beween home and foreign prices. Secondly, speculaive aciviies and official inervenion may creae a PPP dispariy. Thirdly, he produciviy bias when here is a relaively faser produciviy growh in he radable secor han he nonradable secor will resul in sysemaic divergence of inernal prices [Balassa (1964) and Chinn (2000)]. Fourhly, he prices are sicky and do no move rapidly enough o offse frequenly changes in nominal exchange raes. Lasly, he apparen nonsaionariy of real exchange rae will be consisen wih prevalence of real shocks in he economy. Moreover, an imporan shocks during he pas wo decades include large commodiy price changes, innovaions in he financial secor, imbalance in governmen budge, differenials in produciviy growh among major indusrial counries, ec. [Arnd and Richardson (1987)] also generae shor-run deviaions from PPP. 3. PURCHASING POWER PARITY: THEORETICAL MODEL The purchasing power pariy heory serve as equilibrium condiion in he heory of exchange rae deerminaion and in exchange rae policy. This heory is 8 I mus be noed ha he majoriy of sudies conduced o daa have been on developed counries and a limied number on high inflaion developing counries.

4 724 Qayyum, Khan, and Zaman sill frequenly used o deermine he link beween exchange rae and relaive prices. 9 The building block of PPP is he law of one price. For any good, in he absence of quoas, ariffs and oher impedimens o rade, rade and effecive arbirage in goods markes should ensure idenical price across counries. The law of one price is saed as: i i P = S. P (1) Here P i is he price of good i expressed in domesic currency, P i is he price of good i expressed in foreign currency and S is he nominal exchange rae expressed in uni of local currency per one uni of foreign currency. When aggregaed over all goods, he law of one price yields he purchasing power pariy, which is saed as. P P = S (2) Here P is he price level in he home counry and P is he price level in he foreign counry. Equaion (2) is known as absolue PPP. I is known ha ransporaion coss, ariffs and non-ariff barriers will enail marke segmenaion and creae a wedge among price across counries. However, if hese facors remain consan over ime, PPP can be resaed, using a posiive consan B 10, as: P = B( SP ) (3) In logarihmic form i can be expressed as 0 + s + p = β p (4) Rearranging Equaion (4) gives he srong or absolue form of he PPP 0 + ( p p + (5) s = β ) µ 9 Many counries underake correcive measures of heir exchange raes based on inflaion differenials wih parner counries. While fundamenal equilibrium exchange raes (FEERs), derived from medium erm inernal/exernal macroeconomic balance condiions, are becoming more and more aracive for deecing misalignmen in a counry s real exchange rae [Clark, e al. (1994)], PPPs remain much easier o compue. Moreover, deviaions beween FEERs and PPPs have no ye been analysed in empirical sudies. 10 In conras, relaive PPP refers o he relaionship beween relaive change in nominal exchange s p p rae and he differenial in relaive changes in price levels, ha is, =, or in logarihmic s p p form s = p p.

5 Exchange Rae Misalignmen 725 Where s, p and foreign price indices respecively while p are he naural log of nominal exchange rae, domesic and µ is he error erm. 11 This version of PPP is based on he law of one price, which saes ha he price of a common baske of goods in he wo counries, measured in a common currency will be he same a all ime because of cosless spaial arbirage. The esable version of PPP is expressed as: 0 +β1( p p + (6) s = β ) µ Where β0 is he logarihm of he exchange rae observed in he base period. In Equaion (6), he presence of a consan erm β 0 is jusified by Krichene (1998) on wo grounds. Firs, since ransporaion coss, ariff and non-ariff barriers enail markes segmenaion and creae a wedge among prices across counries. Second, he use of a consan also necessary when prices are in erms of indices. PPP holds in he long-run if he resricions ( β0, β1) = (0,1) canno be rejeced. Moreover, an equilibrium relaionship exiss when exchange rae and relaive prices are coinegraed. Furher, if exchange rae changes over ime bu is saionary ARIMA (p, q) process, hen he deviaions from pariy are largely emporary and are expeced o disappear hrough ime. Alhough, one-o-one proporionaliy resricions seem o be implausible and unrealisic in pracice when ranspor coss, oher rade impedimens and measuremen errors are allowed. Taylor (1988) and Sercu, e al. (1995) demonsraes ha in he presence of ranspor coss and measuremen errors in he price variables, he proporionaliy may sill hold, bu i will no necessarily equal o uniy (i.e. β 1 1 ). 4. DATA, ECONOMETRIC METHODOLOGY, AND EMPIRICAL EVIDENCE We uilised quarerly daa ranging from 1982Q2-2002Q4. The exchange rae (s ) was he end of period nominal rae measured in erms of unis of domesic currency per US dollar. Daa on relaive prices (p p) were calculaed on he basis of wholesale price index 12 and were obained from he IFS CD-ROM. Before conducing he analysis of long-run relaionship beween exchange rae and relaive prices, we firs es he order of inegraion of he sochasic variables by employing he augmened Dickey-Fuller (1979) uni roo ess. Table 1 repors he augmened Dickey-Fuller es resuls Logarihm of consan B is β We used (WPI) whole sale price indices (1995=100) for boh Pakisan and U.S. because he relaive prices based on he consumer price indices (CPI) seems o be I (2) i.e. (p p) I (2) while he exchange rae s I (1). 13 These uni roo es resuls carried ou by including linear rend and consan and consan only.

6 726 Qayyum, Khan, and Zaman Table 1 Uni Roo Tess Log-Level Log-firs Difference Series C C & T C C & T s (0) 2.443(0) 8.485(0) 8.432(0) (p p) (3) 1.502(3) 3.743(2) 3.570(2) Criical Values 1% % and indicae significan a 1 percen and 5 percen levels respecively. C&T are respecively represens consan and rend. These resuls indicae ha he series s and (p p) are I (1) in heir log-level and I (0) in heir log-firs difference. Since boh series, which would ener he PPP formulaion, are inegraed of he same order, hence i is possible o es for he presence of coinegraion. The es for he presence of coinegraion is performed using Johansen (1988) and Johansen and Juselius (1990) mulivariae coinegraion mehod. Two lags were seleced for VAR following he Likelihood raio saisic adjused for degrees of freedom. Moreover, he VAR model includes resriced inerceps and no rend. Table 2 repors he maximal eigenvalue ( λ max ) and race ( λ race ) saisics of he underlying VAR. Table 2 Coinegraion Analysis of he PPP Hypohesis Series [s, (p p) ] and Lags = 2 Eigenvalues Hypohesis r=0 r<=1 λ max 31.06(0.000) 4.24(0.388) λ race 35.31(0.000) 4.24(0.389) λ max( T nm) (0.000) 4.04(0.418) λ race( T nm) (0.000) 4.04(0.419) Panel B: Sandardised Eigenvecor (β ) S (p p) Consan Panel C: Sandardised Adjusmen Coefficien (α) S (p p) Indicae 99 percen level of significan. The criical values are aken from Pesaran, e al. (2000). + The λ max and λ race are maximum eigenvalue and race saisics, adjused for degrees of freedom.

7 Exchange Rae Misalignmen 727 I may be noed ha he exchange rae and price series reveal srong evidence of coinegraion using eiher of he wo saisics. The resuls also indicae he exisence of a unique coinegraing vecor. The presence of a single coinegraing vecor confirms he long-run relaionship beween he nominal exchange rae and relaive prices over he sample period 1982Q2-2002Q2. Thus, we se a considerable suppor for he so-called weak-form PPP, which purpors ha exchange rae, and price levels are coinegraed o produce saionary residuals. In order o examine he srong form of PPP, he maximum likelihood esimaes of he normalised coinegraing vecor was obained by imposing exacly-idenifying resricions on he idenified coinegraing vecor. Moreover, imposing over-idenifying resricions on he parameers has also esed he proporionaliy resricion. 14 The resuls are presened in Table 3. Table 3 Tesing for Coefficiens Resricions ( s = β0 + β1( p p ) + µ ) Panel A: Coefficiens and Coefficien Resricions β (0.0615) β (0.0844) Log-likelihood Raio χ 2 (β 0 = 0) χ 2 (β 1 = 1) χ 2 (β 0, β 1 ) = (0, 1) Panel B: Coefficien Resricions and Weak Exogeneiy (Sandardised β eigenvecors and α = Aθ coefficiens) s (p p) consan β α ( ) LR-Tes of Resricions, Rank=1: χ 2 (3)= (0.0010) Indicae significan a he 99 percen level. Figures in parenheses indicae sandard errors. 14 These resricions have been esed by employing Johansen (1988, 1991) maximum likelihood raio es.

8 728 Qayyum, Khan, and Zaman These resuls indicae ha all he coefficiens possess expeced signs and are significan a he 5 percen level of significan. Furhermore, he resuls of he coefficien resricions es reveal ha PPP hold reasonably well; lend srong suppor for he validiy of PPP hypohesis as a long-run relaionship. Our resuls are consisen wih he previous resuls obained by Bhai (1996) and Tang and Buiong (1994) for Pakisan. Furher, he adjusmen coefficiens (panel C, Table 2) for nominal exchange rae and he relaive price level are negaive and significan, indicaing ha boh variables adjus o correc he deviaions from long-run equilibrium posiion. However, exchange rae is adjused faser han he changes in relaive prices owards he long-run equilibrium. Panel B of Table 3 presen he resuls of esing joinly he exisence of a single coinegraing vecor and long-run weak exogeneiy of he variables s and (p p) for he parameers in he PPP equaion, which are consrained for he long-run proporionaliy of he exchange rae and relaive prices. This implies a single row in he β ' marix and a single column in he α marix of he form (, 0, 0). The resricions do no acceped by he daa a he 5 percen level of significan. This resul implies ha boh variables adjus o correc he deviaions from long-run equilibrium posiion. 5. AN ESTIMATION OF EQUILIBRIUM EXCHANGE RATE Recenly, a huge lieraure has been developed around esing equilibrium exchange rae relaionship [see Williamson (1994); MacDonald (1995); Hinkle and Moneil (1999) and MacDonald (2000)]. Increasingly, boh praciioners and policy-makers have been using such relaionship o address he issue of exchange rae misalignmen. Chinn (2000); Hused and MacDonald (1999) and La Cour and MacDonald (2000) assessed wheher some currencies are overvalued or undervalued agains US dollar or Japanese Yen before he 1997 Asian crisis. In his sudy, he exchange rae misalignmen is calculaed as deviaions of he nominal exchange rae from he level implied by PPP. If he acual rae is above (below) he level implied by PPP hen he domesic currency is overvalued (undervalued). Figure 1 repors he implied misalignmen for he period 1995Q1 o 2002Q4. These resuls indicae ha hroughou he period Pak-rupee appeared o undervalue agains US-dollar. However, he magniude of under-valuaion varies over ime and depending upon he esimaion of equilibrium rae. As of 2002Q4, he Pak-rupee is seemed o be undervalued abou 2.3 percen. The average percenage deviaions over he period 1982Q2-2002Q4 are 0.08 percen, which means ha he misalignmen is correced in abou 3 years, while he maximum and minimum values of he deviaions are respecively percen and 5.11 percen.

9 Exchange Rae Misalignmen 729 ) Fig. 1. WPI-based Exchange Rae Misalignmen ( s s ) ( VLerae Le rae FLerae

10 730 Qayyum, Khan, and Zaman 6. CONCLUSIONS In his sudy we have esed he validiy of purchasing power pariy hypohesis and exchange rae misalignmen for Pakisan over he period 1982Q2-2002Q4. From he empirical analysis we can say ha nominal exchange rae is coinegraed wih WPI raio. The coinegraion coefficien beween nominal exchange rae and he WPI-based price raio is close o one. Furhermore, he coefficien resricions are esed using maximum likelihood raio saisic, lend suppor for he validiy of he long-run PPP. Pakisan has been pursuing rade and exchange rae liberalisaion policies from he lae 1980s. Through hese reforms, Pakisan has successfully eliminaed mos price conrols and liberalised rade. These rade and exchange liberalisaion policies allowed he law of one price o work more efficienly as shown by he supporive evidence of PPP. Moreover, he shor-run deviaion from PPP has frequenly occurred, bu he long-run validiy of absolue PPP could no be rejeced. The adjusmen coefficien is negaive and significan. However, he size of his coefficien is small indicaing ha he speed of adjusmen is very slow. Even hough long-run PPP holds, he speed of adjusmen is raher slow, implying ha misalignmen is eliminaed in he absence of shocks bu only afer a subsanial period of ime. The exchange rae remained undervalued vis-à-vis US dollar since he adopion of managed floaing exchange rae sysem. Finally, he predicive power of hese findings implies ha exchange rae misalignmen relaive o PPP would evenually be correced hrough commensurae movemens in nominal exchange raes. From he above discussions we can derive he following policy implicaions. Firs: macroeconomic and srucural policies should help o converge along he same line as hose of is parners. The economic reforms help o enhanced economic efficiency and rade. Moreover, he eliminaion of ariff and non-ariff barriers also helps o foser privae secor developmen and enhance economic growh. Second: here is a close relaionship beween he moneary approach o he balance of paymens and PPP. By managing real exchange raes and reesablish inernaional compeiiveness reversing losses in foreign exchange reserves and even rebuild hese reserves o comforable levels. Third: he findings end o confirm he noion of WPI-based PPP as a long-erm anchor; namely, nominal exchange rae will end o adjus o inflaion differenials. Hence, he apparen validiy of long-run PPP migh warran esing more elaborae exchange rae models ha allow for a well-specified role of main macroeconomic variables, including real income and money supply. In order o conrol he exchange rae misalignmen, he auhoriies should ake appropriae measures o conain he inflaion raes.

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