Financial Frictions and Exchange Rate Regimes in the Prospective Monetary Union of the ECOWAS Countries

Transcription

1 Financial Frictions and Exchange Rate Regimes in the Prospective Monetary Union of the ECOWAS Countries Presented by: Lacina BALMA Prepared for the African Economic Conference Johannesburg, October 28th-3th, 213 1

2 Motivation Low-Income Countries are capital scarce with difficult and limited access to the international capital market. Difficult access to the international capital market is partly explained by credit market stress rising finance premium and debt burdens. Besides the difficult access to the international credit market, LICs can not borrow in their own currency. They have foreign currency denominated debt: the original sin Foreign currency denominated debt (liability dollarization) offers a channel through which exchange rate variation can lead to business cycle instability. Should the future Central Bank of the WAMZ adopt a pegged exchange rate regime or floating regime in response to external borrowing constraints? 2

3 In this paper We study the connection between external borrowing constraints and exchange rate regimes for the future Central Bank of the WAMZ. We use a small open economy Dynamic Stochastic General Equilibrium model in which firms finance the accumulation of real capital by issuing foreign currency debt. The model incorporates the financial accelerator channel of Bernanke et al. (1999) where firms cost of capital is a function of the state of their balance sheets. In the model, a currency depreciation damages the balance sheets of domestic firms by making the currency debt more expensive to repay. Key features: Operating cost in firms capital utilization Imperfect capital mobility Inefficiencies in investment Absorptive capacity constraints 3

4 Related Literature Our analysis complements several papers on the study of the single currency in the WAMZ: The Optimum Currency Area theory (Bangaké, 28 ; Dupasquier et al., 25); Trade and Financial integration (Gbetnkom, 26 ; Goretti et Weisfeld, 28 ; Masson, 28 ; Sy, 28); The nature of shocks (common or idiosyncratic) hitting member countries (Bénassy-Quéré et Coupet, 25 ; Tsangarides et Sureshi, 28 ; Xiaodan et Yoonbai, 29 ; Dufrenot, 29a); Coordination of the macroeconomic policies against free rider behavior across member countries (Debrun et al., 25 ; Masson et Patillo, 21, 22) ; Convergence criteria among nominal agregate (Alagidede et al., 28, Dufrenot, 29b) 4

5 Related Literature All of the reviewed study concurrently suggest the feasibility of currency union for African countries; However, they advocate for a progressive enlargement from the existing regional economic groupings; Dynamic Stochastic General Equilibrium framework applied for the choice of Monetary Policy Regimes in the ECOWAS (Diop et Fall. 212): Fixed exchange rate regime without accounting for external shock. Differences: we embody many more frictions in DSGE model including credit market imperfections and the connection between this latter and monetary policy regimes; we assume incomplete exchange rate pass-through; we account for a hybrid Philips curve; Another friction: Habit formation in private consumption utility; 5

6 Monetary Systems within ECOWAS (28) Dollarization Currency Board Other conventional fixed regimes Fixed and floating within a band (horizontal) Crawling peg Crawling band Managed floating Exch. Rate Peg Monetary Policy Dollar Euro Composite others Sierra Leone Liberia Cape Verde and WAEMU Targeting monetary aggregate Gambia Guinea Nigeria Inflation target Ghana Pure floating Euro zone USA Others 6

7 Evolution of Exch. Rate Regimes within ECOWAS 12% 1% De Jure Classification 8% 6% 4% 2% % 12% 1% De Facto Classification 8% 6% 4% 2% % Fixed Intermediate Floating 7

8 The Model Hypothesis: The core model is a new Keynesian small open economy DSGE model with monopolistically competitive firm setting their price on a staggered basis. The model extends on Sangaré (213) which in turn is an extension of Gertler et al. (27). The model accounts for : Incomplete exchange rate pass-through as in Monaceli (25); Imperfect capital mobility; Phenomenon of the original sin ; Financial accelerator mechanism as in Bernanke et al (1999); Habit formation in consumption utility as in Justiniano and Preston (24) Hybrid Philips Curve 8

9 The Model (cont.) Households Households choose the set of sequence of budget constraints. maximize life-time utility function subject to a Habit formation Budget constraints Country borrowing premium (Adolfson et al. 28) with being a random shock Total debt of the country Firms Four types of firm: wholesalers, capital producers, domestic goods retailers and imported goods retailers 9

10 The Model (cont.) Wholesalers and the financial accelerator Production function Hypothesis: Firms are credit-constrained and never accumulate enough fund to self-finance their capital Finite life-time horizon: Each survive with a probability. Expected horizon is Budget constraint Expected return on capital External finance premium, + 1

11 The Model (cont.) Capital Producers Hypothesis: The production of new capital is subject to adjustment costs: Absorptive capacity constraint; There is no possibility of substitution between new and old capital; Production and maintenance of capital is a composite investment good composed of domestic and foreign final goods. Adjustment costs associated with new capital production: Law of motion of capital: Capital producers solve the following programme: yields the Tobin s Q as follows: 11

12 The Model (cont.) Real Exch. Rate, TOT and Incomplete pass-through Hypothesis Monopolistically competitive firms exert some power on price of goods they import and distribute creating a distortion between the domestic and foreign prices The Law of one price does not hold for import goods implying the Law of One Price Gap (LOPG) (Monaceli, 25): and The Law of one price holds for export goods Three types of inflation: (1) domestic inflation; (2) imported inflation and (3) consumer price-based inflation ; The link between the Law of one price gap, the terms of trade and the real exchange rate, 12

13 The Model (cont.) Price setting by domestic retailers Hypothesis: There is a continuum of monopolistically competitive domestic firms buying wholesale goods from producers in a competitive way and then repackage then as final goods without any cost; They set price in a Calvo (1983) type price rigidity: a constant fraction ) of randomly selected domestic retailers set prices optimally, while the other fraction keeps its price unchanged; Hybrid Philips curve: Price setting by import goods retailers Hypothesis: The law of one price does not hold: Hybrid Philips curve: 13

14 The Model (End) Exch. Rate Regimes Floating Exch. Rate Regime: Taylor Rule Pure Fixed Exch. Rate Regime: Target Zone Policy: Expected realignment of exchange rate: Variation around the central parity follows AR(1) process: where Exchange rate realignment becomes: We can define a modified Taylor Rule as follows: 14

15 Estimation Strategies Sate-space representation The complete log-linearized version of the model can be written in the form of linear system with rational expectation: The solution to the system can be written as follows: The two equation can be expressed in a single equation as follows: where is a vector of observable variables and is a deterministic matrix. Bayesian techniques Parameters vector: 15

16 Results Parameters values fall under plausible range for all the set of countries Ghana: Impulse response to a country risk premium shock Output Fixed Exchange Rate Policy Floating Exchange Rate Policy Investment Consumption Net worth Nominal interest rate Real interest rate Inflation Real exchange rate Terms of trade

17 Results (cont.) Gambia: Impulse response to a country risk premium shock 2 Output Fixed Exchange Rate Policy Floating Exchange Rate Policy 2 Investment 2 Consumption 1 2 Net worth Nominal interest rate 1 2 Real interest rate Inflation Real exchange rate Terms of trade

18 Results (cont.) Guinea: Impulse response to a country risk premium shock Output.5 Fixed Exchange Rate Policy Floating Exchange Rate Policy Investment Consumption 1 2 Net worth Nominal interest rate Real interest rate Inflation Real exchange rate Terms of trade

19 Results (cont.) WAEMU: Impulse response to a country risk premium shock.5 Floating Exchange Rate Policy -.5 Output Fixed Exchange Rate Policy 4 2 Investment Consumption Net worth Nominal interest rate Real interest rate Inflation Real exchange rate Terms of trade

20 Results (cont.) Nigeria: Impulse response to a country risk premium shock Output.5 Fixed Exchange Rate Policy Floating Exchange Rate Policy Investment Consumption 1 2 Net worth Nominal interest rate Real interest rate Inflation Real exchange rate Terms of trade

21 Results (End) Sierra Leone: Impulse response to a country risk premium shock.5 Floating Exchange Rate Policy -.5 Output Fixed Exchange Rate Policy 1 Investment Consumption 1 2 Net worth Nominal interest rate Real interest rate Inflation Real exchange rate Terms of trade

22 Conclusion First, negative shock to country risk premium is easy-going for investment through a fall in foreign interest rate; Ghana is more responsive to the balance sheet effects as illustrated by an increase in net worth of firms; Second, there is an offsetting effect since real appreciation makes export goods more expensive relative to import goods with detrimental effect on current account; Third, exchange rate-policy shocks suggest the superiority of the insulating role of a flexible exchange rate regime over that of a peg. 22