The effect of Devaluation on Economic growth in Fiji

Transcription

1 The effect of Devaluation on Economic growth in Fiji Samuela Draunivudi (s ) Masivou Mocevinaka (S ) Abstract This paper discusses the relation devaluation has on economic growth. It looks at the expansionary effect that has been the tradition dominant view as opposed by the empirical studies conducted on developing economies that have a contractionary effect on growth. The paper discusses the economic bust cycles which results in positive growth after devaluation. It also looks at a simple econometric model with exchange rate being the variable and is significance at 95% level of confidence. The paper concludes that devaluation of the Fiji dollar has a positive effect on growth. Finally, Fiji needs to increase its level of investment and encourage the Fijian people to consume more local produce instead of relying on import items. Introduction In most recent years, devaluation has become a major growth issue to consider in most economies particularly for developing ones. Developing economies are usually characterized by (I) Lower per-capita income, (ii) Predominance of agriculture accompanied with low levels of industrialization, (iii) low level of urbanization but rapid rural-to-urban migration and (iv) dominance of informal sector as a result of underdeveloped labor, financial and other markets (Kumar, 2010). Developing countries also rely heavily on imports for consumption as trade makes efficient use of the world resources which foster economic growth (Konandreas, 2013). The extent in which trade reaches can also hinder growth if trade deficit becomes prolonged thus the exchange rate is change to improve such deficit hence devaluation. Devaluation is the weakening of domestic currency in terms of foreign currency in a fixed exchange rate system by the Federal bank. It can also indicate the rise in the domestic currency price of foreign exchange (Rode, 2012). Most economies used devaluation as an instrument of policies to reduce trade deficits, boost domestic demand hence attain economic growth. However, the trade balance may not improve by making imports cheaper than imports unless the Marshall-Lerner condition (ML) is met. This Keynesian framework view of growth due to devaluation as according to (Acar, University of the South Pacific, 2014 Semester 2 Page 1

2 2000) has been particularly true up to the early 1970 s and numbers of empirical studies has since then signified that devaluation does not always result in an expansionary effect. On the contrary, (Krugman & Taylor, 1978) concurred that devaluation have a negative impact on GDP if Firms propensity to save is more than its employees. Together, as mentioned by (Kim & Ying, 2007), countries with heavy foreign currency liabilities, improved information technology and with existing financial liberalization will have a more contractionary effect as it worsens the balance of payments (BoP). Regardless, (Ratha, 2010) ascertained that contractionary or expansionary effect of devaluation depends on the relative shifts of the aggregate demand and aggregate supply curve. Fiji as developing nation depends mainly on the agriculture and tourism sector as main contributor to exports has devalued its currency a total of four times since gaining independence from Great Britain. Toppled with political instability, Fiji devalued its currency twice in 1988 by the Rabuka-led government, again in 1998 as a preemptive measure for the Asian Crisis and for the fourth time in April 15, 2009 by 20 percent (Sada Reddy: Fiji s economic situation, 2009). So the important question arises on whether devaluation has an expansionary or contractionary effect on growth in Fiji s economy. In an Empirical study conducted on Fiji, it concluded that devaluation of the domestic currency has an expansionary effect on GDP (Narayan & Narayan, 2007). Therefore, this piece of paper will (i) review growth and the economic condition that led to devaluation since independence, (ii) relay on the theoretical framework and reflect on a few literature studies conducted on Devaluation. The paper will also try to prove that devaluation has a significant expansionary impact on growth by developing a simple econometric model that looks to study the relationship between the exchange rate (FJD/USD) and GDP per capita in Fiji from A model developed on the basis of simplicity but is open for modification in future to better capture the effect of devaluation. University of the South Pacific, 2014 Semester 2 Page 2

3 Review: The Fijian Economy Economic Growth and devaluation in Fiji Table 1: Gross Domestic Product per Capita Growth measured in Percentage, GDP per Capita growth % (Source: World Development Indicator) From the Data collected between year 1970 and 2013, the highest percentage growth ever recorded was in 1970 with 12.70% whereas the least growth (-6.612%) ever recorded was in the year 1987; an economic bust which is believed to be the impact of the first coup in Fiji. The first negative growth experienced by the Fijian economy was in 1980 whereby the economy felt the effect of the worldwide recession caused by the US recession as toppled by Oil Price Increase (Stone & Sawhill, 1984). The impact of 1987 led to a sharp fall in confidence, a fall in tourist arrivals and a spike in capital outflows which caused the largest deficit growth in Fiji s History (Browne, 2006). The economic condition in 1987 led to the Fiji dollar being devalued twice that same year which was considered by former Governor for Reserve Bank of Fiji as a pretty hefty devaluation (Sada Reddy: Fiji s economic situation, 2009). However, the devaluation may have improved the trade balance for triggering a positive growth of 0.96% in GDP per capita in 1988 and the following two years as exports becomes cheaper and imports University of the South Pacific, 2014 Semester 2 Page 3

4 expensive, increasing domestic demands for local produce fostering an aggregate increase in output (Rukmani, 2002) In year 1998 after the approval of the Ministry of Finance, the Central Bank devalued the Fijian dollar by 20 percent as a preemptive measure towards the Asian Financial crisis. This measure was to make sure that any significant effect the Asian Financial Crisis would have on Fiji was damped. This may have caused the GDP growth for 1998 and 1999 to remain positive at 1.3 percent and 8.8 percent respectively. However, this was not enough to stabilize growth in 2000 as Fiji entered another coup which set of chain of events that affected the nation. As the result of the coup, most shops and businesses were looted and damaged so business suffered a set- back. With curfew in place, there were limited movements instigating traders and investors to lose confidence (Senibulu, 2005). After the year 2000, the Fijian economy remained positive and grew quite sturdily especially in 2003 to 2004 as the result of a boom in construction and building Industry. The positive growth lasted through out 2006 despite the staging of another military coup that year end. The reason was due to the fact that the 2006 coup occurred late in December and thus the effect was felt mostly in Another reason why Fiji experienced negative growth in later in 2007 was due to the Global Financial Crisis that had a catastrophic effect worldwide. A crisis which according to Reddy in 2008 reduced financial flows from the major trading partner economies putting Fiji macroeconomic on the downside (Fiji's Employer Federation, 2008). The devaluation of the Fiji Dollar on April 15, 2009 was acted upon by the Reserve Bank after the Ministry of Finance gave the green Light. The level of foreign reserves had rapidly started to fall in recent months leading to the devaluation whereby reserves declined drastically from6-7 months to even below 2 in 2009 mainly due to the global crisis and massive floods in January that year. University of the South Pacific, 2014 Semester 2 Page 4

5 Table 2: Official Exchange Rate (FJD per USD) for FJD/USD (Source: World Development Bank Indicator) The Above graph portrays the movement of the FJD against the USD from 1970 to The Time series graph also shows the time lag in which the devaluation of the Fijian dollar occurred as denoted in RED. The general form of the graph slopes upwards indicating that the USD has appreciated over the observed period by %. Theoretical Literature Review The dominant view of Keynes is that devaluation has an expansionary effect on output and employment whereby the mechanism behind the expansion was the improvement in trade balance. The framework considers the switch of demand from imported goods and services to locally produced outputs which stimulates growth in the domestic industry hence switching expenditures to domestically produced goods (Charusheela, 2013). In a study conducted on the effect of changes in exchange rates by a multinational corporation on innovation by Paul in 2006, it was concluded that when devaluation occurs, output increases in both domestic and foreign market. The increase was the result of decrease in price in both markets leading to a rise in aggregate income and employment (Paul, 2006) University of the South Pacific, 2014 Semester 2 Page 5

6 However, few began to oppose the predominant role after 1970 signifying the alternate that the effect could be contractionary especially for Less Developed Countries (LDCs). The approach that considered the structural problems of LDC s and at times referred to as structuralist (Acar, 2000). Such view considers the contractionary effect on two fronts which are: 1. The demand side channels looks at the negative effect of devaluation on aggregate demand through a) import cost which cause a short negative effect on total demand b) Real Balance channel which looks at how real money decreases which in turn decrease expenditure c) Income distribution channel which looks at how fall in real wage rate declines demand d) External Debt channel where countries with external debt will have to pay more e) Speculative Demand channel where an expected devaluation cause by an increase speculative demand for good; demand declines after devaluation f) Tax channel where devaluation increases amount of tax revenue which has a contractionary effect 2. The supply Side Channel looks at the contractionary effect of devaluation on the aggregate supply side through a) Imported Input cost Inflation channel which looks at how local industries cost increase as imported inputs cost increases leading to a decline in output b) Wage Indexation Channel where inflation may cause workers to demand for increase in real wage increasing cost for productionoutput reduced Ching-Chong et.al in 1996 conducted an extensive research on the relationship between effective bargains and currency devaluation in trying to shed ideas on the possibility of contractionary impact of devaluation. The research used a new route called efficient bargaining between firms and unions about employment and wage in trying to agree to an efficient wage-employment contract. The conclusion was that such negotiation University of the South Pacific, 2014 Semester 2 Page 6

7 would suppress domestic supply goods which negate the effect on growth (Ching- Chong, Chang, & Chang, 1996) The Marshall Lerner condition and J- Curve The Marshal-Lerner condition was named after two the two economists who discovered it separately namely; Alfred Marshall ( ), Abba Lerner ( ). The condition states that unless the sum of the price of elasticity of demand for exports and price elasticity of demand for imports is greater than one, trade balance can never improve. Hence: Exports ped + Imports ped > 1 The J Curve effect after devaluation is such that trade balance does not immediately improve after the change in exchange rate. The rationale of the mechanism behind the J-curve effect is such that the volume of Exports and Imports remain unchanged as existing contract trades are to be honored. Hence, the price elasticity demand for both exports and imports remains inelastic in the short run but becomes less inelastic as time grows. Figure 1: J- Curve J Curve 0 Time The desired result of devaluation as depicted above, comes into effect over the long run starting at point A as demand for domestic goods increases due to imported goods becoming expensive than domestically produced goods. Initially after devaluation, trade University of the South Pacific, 2014 Semester 2 Page 7

8 deficit worsens in a short while before the ML condition kicks in at point A which marks the turning point of the J- Curve hence trade balance starts to lessen (Gowland, 2010) Empirical Literature Review Over the years, the number of empirical studies focused on finding the effect of devaluation on economic growth has itself increased. Some of the studies conducted supported the traditional view that devaluation has an expansionary effect as consumption expenditures are switched from traded to non-traded goods which doesn t only improves trade balance but stimulate growth where as others state otherwise (Acar, 2000). Therefore, most economies have since then employed devaluation as an instrument in improving trade balance. Some of the studies conducted have significance evidence that the devalued economy initially have contractionary effect in the short run but expansionary in the long run. (Yilanci & Hepsag, 2011) on the Empirical evidence from Turkey showed that Real devaluation is contractionary in the short run but is expansionary in the long term. Another study by Kushneel and Diyendu on the J- curve disparity in the goods and services sector in the Pacific region by using a Vector Error Correction Model concluded that after devaluation, only the goods trade follows the j-curve phenomenon and not Exportable services over period ( (Prakash & Maiti, 2014) P. Narayan and S. Narayan in 2007 on the other hand conducted a study on the expansionary or contractionary effect of Devaluation in Fiji and came up with an empirical evidence that output increased by 2.3 percent in the short run while 3.3% in the Long run. The Impact of devaluation has a contractionary effect if devaluation is expected to happen. Mr. Sada Reddy in 2009 acted on the swift devalue of the FJD as speculation has started that the value of the currency was expected to weaken causing outflows of capital. On a study sample of 23 developing countries, (Agenor, 1991)related that even though demand increase in the short run before devaluation; there was significance evidence that speculation may cause a contractionary impact in the intermediate term. University of the South Pacific, 2014 Semester 2 Page 8

9 The Empirical study The Regression Model The main motive of the regression is to shed light into the relationship between Fiji s exchange rate per foreign currency (independent variable) and Fiji s level of GDP per capita (Dependent variable). For simplicity, other factors that may have a significant effect on GDP per capita growth are ignored. GDP per capita Growth = f( Exchange rate) Equation Log-linear Cobb-Douglas Production Function was used which gives an econometric equation lngdppc t = lna + lnβ 1 ER + ε t Where; A= Constant term β 1 Slope of the regression ER Exchange rate per foreign currency ε t Error term Time series and Data sources The time period being incorporated is from 1970 to 2013 and the data was obtained from the World Development Indicator. University of the South Pacific, 2014 Semester 2 Page 9

10 Regression Results While running the regression, the problem of positive 1st order autocorrelation AR(1) hence HAC (Newey-West) Method was used to solve the problem yielding such result: Dependent Variable: LNGDPPC Method: Least Squares Date: 10/31/14 Time: 04:29 Sample (adjusted): Included observations: 31 after adjustments Weighting series: LNER Weight type: Standard deviation (average scaling) HAC standard errors & covariance (Bartlett kernel, Newey-West fixed bandwidth = ) Variable Coefficient Std. Error t-statistic Prob. LNER C Weighted Statistics R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob(F-statistic) Weighted mean dep Unweighted Statistics R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Sum squared resid Durbin-Watson stat University of the South Pacific, 2014 Semester 2 Page 10

11 Equation: lngdppc t = lna + lnβ 1 ER + ε t lngdppc t = ER + ε t Variable Coefficient Std. Error t-statistic Prob. LNER C R-squared Interpretations: The magnitude of the effect of Exchange rate on GDP per capita is such that a 1% change would result in a.44% change in the same direction in output per capita (GDP pc). The significance of the model is that given the p value for the t-statistic of the estimated slope coefficient of being less than 5% of the significance level, we could say that the probability of accepting the null hypothesis (Ho: β_1=0) is close to zero, or, we are 100 percent confident that the alternative hypothesis (HA: β_1 0) will be accepted. The Goodness of Fit of the error term is as measure by R-squared value of shows that approximately 78.13% of the variability of the dependent variable (GDP per capita) is explained by changes in Exchange rate of FJD/USD. University of the South Pacific, 2014 Semester 2 Page 11

12 Conclusion The issue of devaluation and its effect has been a focus in this paper on its contributions to economic growth. Devaluation is certainly an important tool that economies all over the world gradually employ when trade balance worsens and that the balance of payments are not being able to be ascertained on the main focus that devaluation has an expansionary effect. The traditional view of has been opposed as number of empirical studies increased after 1970 s stating that developing economies suffer a contractual effect of devaluation. Therefore it was important to determine which one of the views hold true for the Fijian economy as a developed nation since Fiji has so far devalued its currency four times since To support the views related by the literature reviews conduction, data was collected from WDI for 1970 to 2013 and analysis performed using a simple econometric model. First of all the economic growth analysis which depicted the boom bust cycle of Fiji s economy showed that positive growth was experienced immediately in the year after devaluation for all the devaluation years. The devaluation in 2009 also supports the study conducted by (Narayan & Narayan, 2007) that devaluation has an expansionary effect on growth. The Literature review showed that the negative effect of devaluation was largely on two fronts which are the demand and supply channel. The J-Curve effect is particularly true for some developing economies after devaluations as trade deficits increases in the short run but gradually improves once the ML condition sets in. Finally, the regression analysis conducted showed that exchange rate per USD is statistically significance at 5% level as the p-value is less than the significance level. The relationship is such as that a percentage change in the value of FJD would significantly induce a.44% change on GDP per capita hence an expansionary effect University of the South Pacific, 2014 Semester 2 Page 12

13 Policy Recommendation Trade balance improvement hence growth due to devaluation can only be effective if real devaluation is achieved. Because devaluations have contractionary effect on growth there is a need to relook and adjust policy instruments to employ instead of devaluation to allow for a self-sustainable economy. Firstly I would encourage the economy and the public to increase investments in our economy whether in the public or private sector. This investments would help creates employment stimulating growth internally. The government should invest mostly in tourism and agricultural sector as they have the highest employment base in Fiji. Also the government should encourage policies apart from devaluation that will improve trade balances like import substitutions. Reserve bank to encourage commercial banks to increase their engagement in Micro finance which will increase level of savings that can be transferred to as investments. Such initiative like Micro Finance would also increase the populations that are financially inclusive. Governments to Implement workshops to educate and inform people especially those in the rural areas to make use of their natural endowments and try to be sustainable in producing their own foods. Initiatives to be given to the tourism industries to encourage the inclusion of domestically produced foods that the pacific is known for in their hotel meal menus. Bibliography Abu-Lila, Z. M. (2014). Price and Income Elasticities of International Trade: Case of Jordan. International Journal of Economics and Finance 6.10, Acar, M. (2000). Devaluation in Developing Countries: Expansionary or Contractionary? Journal of Economic and Social Research, Agenor, P. R. (1991). Output, devaluation and the real exchange rate in developing countries. Weltwirtschaftliches Archiv, Browne, C. (2006). Pacific Island Economies. Washington D.C: International Monetary Fund publication Services. University of the South Pacific, 2014 Semester 2 Page 13

14 Charusheela, S. (2013). The "Contractionary Devaluation Debate" in Development Economics. Routledge. Ching-Chong, L., Chang, J.-J., & Chang, W.-Y. (1996). Efficient bargains and currency devaluation. Economic Record, Fiji's Employer Federation. (2008). Sada Reddy: Impact of the global crisis on Fiji s economy. Suva: Fiji's Employer Federation. Gowland, D. (2010). International Economics. Fyshwick: Taylo & Francis e-library. Kim, Y., & Ying, Y.-H. (2007). An empirical assessment of currency devaluation in East Asian countries. Journal of International Money and Finance., Konandreas, P. (2013). Trade and Food security: Options for Developing countries. Retrieved October 30, 2014, from Food and agricultural Organisation of the United Nations: Krugman, P., & Taylor, L. (1978). Contractionary Effects of Devaluation. Journal of International economics, Kumar, A. (2010). Major Characteristics of Deloping Countries. Victoria: University of Victoria. Ministry of Information, Communications and Archives. (2009). Sada Reddy: Fiji s economic situation. Suva: Ministry of Information, Communications and Archives. Narayan, P. K., & Narayan, S. (2007). Is devaluation expansionary or contractionary? Empirical evidence from Fiji. Applied Economics, Paul, S. (2006). Devaluation, Innovation, and Prices. The International Trade Journal, Prakash, K. A., & Maiti, D. S. (2014). J - curve disparity in the goods and services sector in the Pacific region: evidence from devaluation in Fiji. Suva: Unspecified. Ramesh, S. (1993, December 15). Power and Politics in the Fiji Islands. Suva, Suva, Fiji. Ratha, A. (2010). Does Devaluation Work for India? Economics Bulletin, Rode, s. (2012). Advanced Macroeconomics. Mumbai. University of the South Pacific, 2014 Semester 2 Page 14

15 Rukmani, G. (2002). Political and economic freedom, fiscal policy, and growth nexus: some empirical results for Fiji. Contemporary Economic Policy. Senibulu, L. (2005, August 16). Professionalism in the Military: A Case Study of the Fiji Military Forces. Suva, Suva, Fiji. Stone, C. F., & Sawhill, I. V. (1984). Economic Polocy in the Regan Years. The Urban Institute. Yilanci, V., & Hepsag, A. (2011). The Contractionary and Expansionary Effects of Devaluation: Empirical Evidence from Turkey. Journal of Economic Cooperation & Development, University of the South Pacific, 2014 Semester 2 Page 15