Why are some exchange rates more volatile than others? Evidence from middle-income countries R Havemann and C Kularatne September 2007: DRAFT FORMAT Abstract To better understand why some currencies are more volatile than others, this paper considers the cross-country determinants of exchange rate volatility for a set of middle-income countries. Overall, the paper …nds that higher levels of reserves reduce volatility, and it is estimated that an appropriate level of reserves is approximately 4 12 months of imports. Volatility is increased by increased uncertainty and loose …scal policy. In addition, a volatile terms of trade spills over into a volatile currency. From a policy perspective, whilst it is clear that prudent macroeconomic policy is the best course of action to reduce exchange rate volatility, the in‡uence of external volatility on the exchange rate (over which the authorities have no control) should not be underestimated. JEL Codes: F31, C23 1 Introduction Floating exchange rates are an increasingly common feature of monetary policy regimes, often in combination with an in‡ation-targeting framework. The bene…ts of a fully ‡oating exchange rate were set out as early as Friedman (1958). In particular, many countries rely on the currency to absorb external shocks. Notwithstanding the strong theoretical case for fully ‡oating exchange rates, Calvo and Reinhart (2002) still …nd a pervasive ‘fear of ‡oating’–many countries are reluctant to allow their exchange rates to freely ‡oat, due in no small part to the Strategic Finance & Strategy, Deloitte Consulting; School of Economics, University of Cape Town 1 fact that ‡oating exchange rates can be extremely volatile. In addition, all real exchange rates, pegged or ‡oating, are characterized by currency volatility. In the literature, ‘dirty ‡oats’, where the central bank intervenes to manage the value of the currency, are not found to be necessarily less volatile than ‘free ‡oats’. Indeed, some researchers have found that central bank intervention increases volatility. Of the set of middle-income countries, since the end of 2005, the South African Rand recorded the biggest depreciation (14,8 percent) against the dollar. One of the factors behind rand depreciation is ongoing concern about the widening current account de…cit (4,2 percent of GDP in 2005 and 6,1 per cent in the …rst half of 2006). Figure 1 illustrates that, except for the Chilean peso, every economy among the ten worst-performing currencies against the dollar this year is expected to record de…cits on their current accounts in 2005 (and eight of the ten worst currency performers were emerging markets, including South Africa). Three of the ten worst-performing currencies could record double-digit current account de…cits this year: Iceland (13,8 per cent of GDP), Nicaragua (16,7 per cent) and Guyana (27,9 per cent). New Zealand, the only developed country among this group apart from Iceland, could also record a substantial current account de…cit at 8,9 per cent of GDP in 2006. Turkey, which recorded the third biggest depreciation, is expected to record a current account de…cit of 6,5 per cent of GDP this year. These …gures imply that there may exist some association between currency volatility and changes in the current account de…cit/surplus. Furthermore, middle-income emerging market economies with widening current account de…cits appear to be more prone to currency volatility. In contrast, Figure 2 shows that three countries among the ten best-performing currencies this year is expected to record surpluses on their current accounts in 2006, namely Indonesia, Brazil and Sweden. The de…cit countries in this group could also record relatively low or modest de…cit-GDP ratios ranging between 0,6 per cent of GDP (Haiti) and 8,3 per cent (Romania). Hausmann (2005) has argued that this volatility may be due to commodity price volatility. To assess this empirically, this paper extends the econometric framework of Canales Kriljenko and Habermeier (2004) and Hviding, Nowak and Ricci (2004) to incorporate commodity prices. It is found that the Hausmann predictions are indeed empirically correct: After controlling for other macroeconomic variables, term of trade volatility does contribute to exchange rate volatility. The deteriorating current account balance in some of the emerging-market economies has been mitigated by net equity portfolio in‡ows. For example, in South Africa’s case, net non-resident equity portfolio in‡ows averaged US$0,7 2 billion per month in 2005, helping to fund an average monthly current account de…cit of US$0,8 billion. However, the dependence of South Africa on non-resident portfolio in‡ows has raised a potential dilemma: if equity in‡ows suddenly stop or are reversed, the loss of this rand stability anchor could put downward pressure on the rand and upward pressure on in‡ation via the exchange rate pass-through to prices. A deteriorating current account balance may increase rand volatility as the country’s dependence on capital in‡ows (which are relatively mobile) increases. Fluid capital ‡ows will adversely a¤ect rand volatility. The South African government should attempt to ensure good governance, e¢ cient institutions and strive to create an enabling environment in order to in‡uence the risk-adjusted return on investment in order to reduce the volatility of capital ‡ows and in turn, reduce currency volatility. The evidence provided labelling the SA rand as the worst performing currency in the …rst half of 2006 forms the basis of this study to examine the determinants of the volatility of the rand. Although the SA Rand is not the most volatile amongst the set of world currencies for the period 1980-2000,1 this is the period (1980-2003) over which this study is conducted. In this period, the rand is the eighteenth most volatile out of a sample of …fty developed and developing countries. South Africa ranks near Hungary (17), Mexico (19) and Paraguay (20). These countries are also in South Africa’s peer group for many other indicators, not least of which their international credit rating. [INSERT FIGURE 1 ABOUT HERE] [INSERT FIGURE 2 ABOUT HERE] [INSERT FIGURE 3 ABOUT HERE] This paper proceeds as follows: Section 2 provides a brief overview of the theoretical and empirical literature on the relationship between macroeconomic fundamentals and exchange rate volatility; Section 3 discusses the econometric methodology employed in the analysis; Section 4 provides a brief overview of the data; Section 6 discusses the results; and lastly Section 7 concludes with some policy implications of this study. 2 Empirical Literature Firstly, it is important to realize that all countries experience real exchange rate volatility, regardless of the exchange rate regime. This is because the real exchange rate measures both internal prices and external prices (tradables and non-tradables). A country with a …xed exchange rate and high in‡ation will experience a rapidly depreciating currency. Indeed, a ‡exible exchange rate may bring about real exchange rate 1 See Figure 3. 3 stability, by reducing the likelihood of speculative attacks against the currency. Clark et al (2004) collected data for almost all IMF-member countries, and found that less ‡exible exchange rate regimes do not necessarily guarantee reduced real exchange rate volatility. It could be argued that pegged currencies have a greater likelihood of becoming ‘freely falling’, as speculators may force the central bank to abandon a peg when reserves dry up (see, for example, Krugman 1996). The role of exchange controls is also an area of debate. Canales-Kriljenko and Habermeier (2004) …nd that prudential limits on banks’foreign exchange positions may reduce volatility, by reducing speculative position taking. Glick and Hutchinson (2005) argue that reducing capital ‡ow restrictions may reduce the likelihood of currencies being prone to speculative attacks and currency crises by reducing foreign exchange market distortions. After decomposing daily and intra-daily exchange rate volatility into a continuous and jump components, Beine et al (2006) investigate the e¤ect of intervention on realized volatility. After controlling for the impact of macroeconomic announcements on volatility, they …nd that co-ordinated exchange rate intervention may be a ‘primary’ cause of discontinuous jumps in the exchange rate, suggesting that intervention may exacerbate exchange rate volatility, rather than reduce it. As shown in Table 1, commodity-exporting countries such as Australia and New Zealand also experience amongst the highest levels of volatility. A similar …nding is made by Hausmann (2005) and in the data set compiled below. There is a large literature2 on the link between commodity-exporting countries and the level of the exchange rate, so it would follow that volatility in commodity prices may also …lter through to volatility in exchange rates. [INSERT TABLE 1 ABOUT HERE] Turning to the recent empirical literature, it is clear that exchangerate volatility is often due to poor macroeconomic fundamentals. Using a model selection algorithm, Canales-Kriljenko and Habermeier (2004) found that the following variables were signi…cant determinants of volatility in the nominal exchange rate: In‡ation; Real GDP growth; Fiscal de…cit (% of GDP); and External trade (% of GDP) 2 See, for example, Clinton (2001), Cashin et al (2002) and Chen and Rogo¤ (2002). 4 Subsequent research by a former South African IMF team (Hviding, Nowak and Ricci, 2004) has shown that after controlling for macroeconomic conditions, increasing the level of reserves (relative to short-term debt) also reduces the volatility of the real e¤ective exchange rate. Hviding et al (2004) argue that although theoretically freely-‡oating exchange rates do not require large reserve holdings, in practice the level of reserves may be an important signal for outside investors, for example, a low stock of reserves may re‡ect a history of populist monetary policy. Engel et al. ( 2001) and Mark et al. (2001) …nd evidence that with the increased e¢ ciency from panel estimation, with the focus on longer horizons, implies that the macroeconomic models consistently provide forecasts of exchange rates that are superior to the “no change”forecast from the random walk model. 3 3.1 Econometric Methodology Dynamic Heterogenous Panel Model The natural advantage of using a panel data set and panel estimation is that the number of data points available becomes su¢ ciently large to draw meaningful results. Furthermore, using dynamic heterogenous panel models we can allow for heterogeneity to exist in the short-run dynamics and test for homogeneity in the long-run, between the individual countries. Following Pesaran, Shin and Smith (1999), we base our panel analysis on the unrestricted error correction ARDL(p,q) representation: 4yit = i yi;t 1 + 0 i xi;t 1 + p 1 X j=1 ij 4yi;t j + q 1 X j=0 0 ij 4xi;t j + i + "it (1) i = 1; 2; ::N , stand for the cross-section units (the countries that compose the middle-income countries) and t = 1; 2; :::T denote time periods. Here yt is a scalar dependent variable, xit (k 1) is the vector of (weakly exogenous) regressors for group i, i represents the …xed e¤ects, i is a scalar coe¢ cient on the lagged dependent variable, i ’s is the k 1 vector of coe¢ cients on explanatory variables, ij ’s are scalar coe¢ cients on lagged …rst-di¤erences of dependent variables, and ij ’s are k 1 coe¢ cient vectors on …rst-di¤erence of explanatory variables, and their lagged values. We assume that the disturbances "it ’s are independently distributed across i and t, with zero means and variances 2i > 0. We also make the assumption that i < 0 for all i. This implies that there exists a long run relationship between yit and xit : 5 yit = 0 i xit + it , 0 i = i is the (2) i = 1; 2; :::; N; t = 1; 2; :::; T where i = k 1 vector of the long-run coe¢ cient, and it ’s are stationary with possible non-zero means (including …xed e¤ects). Then (1) can be written as 4yit = + i i;t 1 p 1 X ij 4yi;t j j=1 q 1 X + j=0 0 ij 4xi;t j + i (3) + "it where i;t 1 is the error correction term given by (2) and thus i is the error coe¢ cient measuring the speed of adjustment towards the long-run equilibrium. Using the general framework described above,we consider the following three approaches: 1. The Dynamic Fixed E¤ects (DFE) Model imposes the homogeneity assumption for all of the parameters (across all of the countries in the middle–country set viz for i = 1; :::; N ) except for the …xed e¤ects: = ; i = ; ij = j , j = 1; :::p 1; 2i = 2 ij = j , j = 1; :::q 1 i (4) The …xed e¤ects estimates of all the short-run parameters are ob^ tained by pooling and denoted by pooling and denoted by ^ ^ ^2 ^ DF E , DF E , j DF E , DF E and DF E . The estimate of the long-run coe¢ cient is then obtained by: ^ DF E = 0^ @ ^ 1 DF E A (5) DF E 2. The Mean Group (MG) Model estimates allows for heterogeneity of all parameters and gives the following estimates of short-run and long-run parameters: ^ MG = ^ jMG = PN i=1 ^ i N PN i=1 N ^ ; ^ ij MG = PN ^ i i=1 N ; ^ , j = 1; ::; p 1; 6 jM G = PN i=1 N ^ ij , j = 1; ::q (6) 1 ^ ^ ^ ^ where i , i , ij and ually from (1), and ij are the OLS estimates obtained individ- ^ MG 1 =N 0^ 1 N X @ i=1 ^ iA (7) i 3. The Pool Mean Group (PMG) model advanced by Pesaran, Shin and Smith (1999) provides an intermediate case. This estimator allows the intercepts, the short-run coe¢ cients and error variances to di¤er freely across groups but the long-run coe¢ cients are constrained to be the same; that is, i = , i = 1; 2; :::N (8) The common long-run coe¢ cients and the group speci…c shortrun coe¢ cients and the group-speci…c short-run coe¢ cients are computed by the pooled maximum likelihood (PML) estimation ^ technique. These PML estimators are denoted by ^ i, ^ i, ij and ^ ij and . We then obtain the PMG estimators as follows: ^ P MG = ^ jP MG = ^ PN i=1 ^ i N PN i=1 N ^ ; ^ ij P MG = PN i i=1 N ; ^ , j = 1; ::; p 1; ^ P MG ^ jP M G = PN i=1 N ^ ij , j = 1; ::q (9)1 = This depicts the pooling implied by the homogeneity restriction on the long-run coe¢ cients and the averaging across groups used to obtain means of the estimated error-correction coe¢ cients and other short-run parameters. Under long-run slope homogeneity, the PMG estimators are consistent and e¢ cient. The Hausman (1978) test3 will be applied to examine the extent of the panel heterogeneity mainly in terms of the di¤erence between MG and PMG estimates of long-run coe¢ cients. It should be noted that the MG estimator provides consistent estimates of the mean of long-run 3 Hereafter we shall refer to the Hausman test as the h-test. 7 coe¢ cients but will be ine¢ cient if slope homogeneity holds. Under longrun slope homogeneity, the PMG estimators are consistent and e¢ cient. One of the advantages of this estimation approach is that the dynamics are explicitly modelled. Furthermore, we can test whether long run, homogeneity exists across the countries: i.e. that is that the countries are su¢ ciently similar to justify arguing that they can be used together in a panel data set. 3.2 Threshold Autoregressive Estimation (TAR) The model incorporates Threshold Autoregressive Estimation technique to investigate the presence of a nonlinear relationship between reserves and exchange rate volatility.4 We now include an indicator term, which we use when testing for the existence of a non-linearity. This technique suggests the estimation of: yt = 0 +( 11 + 12 I(Pt 1 ))Pt (10) where yt the log of the coe¢ cient of variation of the real exchange rate„ P is the policy variable and I(Pt 1 ) is an indicator variable. The indicator variable is created by selecting a potential optimal level of the policy variable denoted by . is then subtracted from the original data series denoted Pt 1 . All values of the new series that are greater than zero are set equal to one and all values less than zero are set equal to zero such that I(Pt 1 ) is a dummy variable with values of zero and one. In order to determine what the threshold level might be, we add the 11 and 12 coe¢ cients. The highest level of reserves in which any further increases in reserves will either lead to an increase or have no e¤ect on exchange rate volatility.5 4 The Model Standard models of exchange rates, based on macroeconomic variables such as prices, interest rates and output, are thought by many researchers to have failed empirically. However, Mark et al. (2001) provide evidence of exchange rates incorporate news about future macroeconomic fundamentals. We demonstrate that the models might well be able to account for observed exchange-rate volatility. These models examine the response of exchange rates to announcements of economic data. 4 Canning and Pedroni (2004) discusses a separate methodology using the Granger Represenatation Theorem to test if infrastructure capital stock has a positive or negative e¤ect on per capita GDP. 5 See Potter (1995) and Koop, Pesaran and Potter (1996). 8 From Engel et al. ( 2001), suppose the exchange rate is determined by: Coef f (st ) = xt + t + E (st+1 j t) + "t (11) where Coef f (st ) denotes the coe¢ cient of variation of the nominal exchange rate, xt a macroeconomic fundamental, a measure of risk/uncertainty and E (st+1 j t ) expected nominal exchange rate based on the information set t . Now suppose we observe only some subset of the fundamentals that drive the exchange rate, xt . The above implies that the current exchange rate is a¤ected by both observable and unobservable variables a¤ect the volatility of the currency. 5 Data The data set consists of a panel of 11 macroeconomic indicators for 19 countries between 1981 and 2003. There are a number of di¤erent approaches to measuring exchange rate volatility and as a result, there is no generally accepted measure. Most countries do not publish monthly real exchange series, so this paper creates a real exchange rate series in the standard way, by de‡ating the nominal exchange rate relative to the United States using that country’s consumer price index relative to the US consumer price index. However, the disadvantage is that this is not a trade-weighted measure, although for a signi…cant proportion of countries in the sample most trade is denominated in US dollars, suggesting this not a particularly important problem. The coe¢ cient of variation6 of the currency was calculated based on this monthly real exchange rate for each country in the sample. A number of interesting observations emerge from the data. In terms of volatility against the US dollar, South Africa is ranked with approximately the same level of volatility as Paraguay, Mexico and Hungary. In this particular sample, Brazil and Turkey are the two most volatile currencies, whilst Canada is the least volatile. Figure 4 depicts SA rand volatility from 1980 to 2003. Rand volatility tends to rise in periods of uncertainty. For example, in 1985 and 1994 (Rubicon Speech and …rst democratic elections, respectively), rand volatility rose. [INSERT FIGURE 4 ABOUT HERE] The macroeconomic fundamentals investigated for having an e¤ect on exchange rate volatility are:import cover, budget surplus-to-GDP ratio, 6 The coe¢ cient of variation is the standard deviation divided by the mean and is a more appropriate measure of volatility if data series have signi…cantly di¤erent means. 9 debt-to-GDP ratio, GDP growth rate, a measure of openness of the economy,7 a measure of uncertainty,8 oil price volatility, change in the current account and dollar-euro volatility. 6 Estimation Results During the process of estimation, two groups of variables were found to have a signi…cant in‡uence on real exchange rate volatility. The …rst group is the country’s macroeconomic fundamentals, i.e. variables that carry speci…c information about the country itself. The second group of variables – commodity price volatility – captures the e¤ect of volatility in international markets. [INSERT TABLE 2 ABOUT HERE] 6.1 6.1.1 Macroeconomic variables (‘fundamentals’) Reserves Import cover, measured in number of months, is found to be a signi…cant determinant of exchange rate volatility. It is estimated that an increase in foreign reserves by 1 month reduces real exchange rate volatility by 4 per cent. This result is robust across speci…cations. Hviding et al (2004) argue that this result may be non-linear, with ‘decreasing returns to reserves’. Testing for this, we …nd that the optimal level of reserves South Africa should hold (in terms of import cover) is 4and-a-half months. South Africa currently has approximately 3 months of reserves. Thus increasing the amount of reserves further should aid in reducing rand volatility. Furthermore, Hviding et al (2004) argue that although theoretically freely-‡oating exchange rates do not require large reserve holdings, in practice the level of reserves may be an important signal for outside investors, for example, a low stock of reserves may re‡ect a history of populist monetary policy. 6.1.2 Fiscal policy Two di¤erent variables were used to measure the …scal policy stance - the budget balance-to-GDP ratio and debt-to-GDP ratio. A better budget balance-to-GDP ratio (i.e. a narrowing of the budget de…cit or increase in the budget surplus) reduces real exchange rate volatility. Referring to regression (1) (in Table 2) it can be seen that a one percentage point improvement in this ratio leads to a 0.8 percent decrease in real exchange rate volatility. Similarly a higher debt-to-GDP ratio is associated with 7 Openness is measured as the ratio of the sum of exports and imports-to-GDP. The measure of uncertainty used in this model is the di¤erence between the real long-term interest rate in the US and the country in question squared. 8 10 higher real exchange rate volatility. As indicated in regression (2) a one percentage point increase in the debt-to-GDP ratio leads to a 0.27 percent rise in exchange rate volatility. Both variables are signi…cant at the 5 per cent level. Note that the number of countries in the sample falls from 25 to 19 if the debt-to-GDP ratio is used rather than the …scal balance variable. This is due to a lack of a consistent debt data set across countries. 6.1.3 GDP growth This is found to be only weakly signi…cant and not robust to di¤erent speci…cations. One regression that did include this variable is reported – regression (4). It suggests that a one percentage point increase in growth leads to a 2.7 percent decrease in real exchange rate volatility. However, it cannot be overemphasized that this variable is problematic in this context. It is not robust across di¤erent speci…cations. There is also an inherent endogeneity problem with it not being theoretically or empirically clear if exchange rate volatility reduces growth or if growth reduces exchange rate volatility (for example, a strongly growing country may be at less risk of a currency crisis as it able to attract su¢ cient capital in‡ows). 6.2 Terms of trade shocks Given the small and open nature of most of the middle-income emerging markets in the data set, a priori there is reason to believe that the terms of trade may in‡uence the exchange rate. By extension, terms of trade volatility should in‡uence exchange rate volatility. To the knowledge of the authors this has yet to be incorporated in the empirical literature, although Hausmann (2005) provides a strong theoretical case for how terms of trade volatility may in‡uence the exchange rate. Intuitively, under a ‡exible exchange rate regime, countries experiencing volatile terms of trade will also experience volatile exchange rates; whereas under …xed regimes, the consequences of a sharp increase in commodity prices (such as the oil price) will be re‡ected in higher in‡ation. As a result, in‡ation will be volatile and hence the underlying real exchange rate will become volatile too. Due to data constraints, it was not possible to construct a direct measure of the term of trade volatility as this data is not available for all countries at a high frequency and as the terms of trade measure is highly correlated with the exchange rate. Second best is thus to proxy this volatility. This paper chooses oil price volatility as the measure best suited to proxy terms of trade volatility. This is because the oil price is an important part of either the import or export basket for almost all 11 the countries in the sample. 6.2.1 Oil price volatility It is found that a one percent increase in the volatility of the oil price leads to a 0.06 to 0.07 percent increase in the volatility of the exchange rate depending on the speci…cation. Table 2 reports two of the regressions, one with the budget-balance measure and one with the GDP growth measure.9 [INSERT FIGURE 5 ABOUT HERE] 6.2.2 Current account balance The research conducted found that the level of the current account balance did have a statistically signi…cant e¤ect on rand volatility. A one percent improvement in the current account will lead to 4 per cent decrease in rand volatility. In addition, improvements in the current account reduce rand volatility at an increasing rate, i.e, the more the current account improves, there are rising gains in terms of reduced rand volatility Thus continuous improvements in South Africa’s current account balance, continuously reduces rand-dollar volatility. 6.3 World volatility There is a strong argument that there are time-speci…c factors at play when considering exchange rate volatility: i.e. one can identify periods such as the Asian crisis for example. Although the e¤ects of the sudden devaluation of the Thai bhat during the 1998/9 Asian crisis were initially only felt in south-east Asia, …nancial contagion quickly spread throughout global …nancial markets. This is a good example of a case where the poor fundamentals of one country (in this case Thailand) led to exchange rate volatility in other (emerging) countries. There are a number of approaches that may be used to capture this type of e¤ect. As indicated in Figure 1, the measure of terms of trade volatility may also be a good indicator of world volatility. An alternative measure, the volatility in the dollar-euro exchange rate, is also found to be signi…cant in some speci…cations (see regression 4 in Table 2) for an example. However, in most speci…cations it is found to be not statistically signi…cant. A one percent increase in dollar-euro volatility leads to a 2.31 percent increase in a country’s real exchange rate volatility. 9 Consider regressions (1), (3), (6) and (8) in Table 2. 12 7 Conclusion & Policy Recommendations The literature and the results in this study suggest that prudent macroeconomic policy (a combination of low in‡ation, health budget balance and reserves accumulation) lowers exchange rate volatility. Particularly, results in other studies underscore the role of reserves in reducing volatility, even if this is merely as a signal to market participants. This study extends the literature to consider the role of the terms of trade. It is found that terms of trade volatility (proxied by oil price volatility) increases exchange rate volatility for the countries in the sample. This is not surprising as many of the countries are either signi…cant importers or exporters of oil. The relationship between GDP growth and exchange rate volatility appears complex and raises a number interesting puzzles: Does GDP growth lead to lower exchange rate volatility as capital in‡ows are strong and stable? Or, does lower exchange rate volatility lead to higher GDP growth? Or, controversially, does a volatile exchange rate bu¤er the economy from external shocks? There is a large literature on the relationship between trade and exchange rate volatility (see, for example, Clark 2004). However, in general the results are mixed and it is not clear what the nature of this relationship is. Clearly more research is required regarding the impact of exchange rate volatility on GDP growth in the South African case. The policy recommendations from this study are as follows: 1. Prudent …scal management will not only have a direct impact on exchange rate volatility via the impact on the budget de…cit and government-debt ratio, but also indirectly via the impact on the current account; 2. Current account balance is of far greater importance than reserve levels as far as exchange rate volatility is concerned; 3. Even though reserves has been rising as the current account balance has weakened, the bene…ts from increased reserves will not make up for the increased uncertainty (volatility) emanating from the worsening current account; and 4. Government needs to continue to engage with the public by being even more transparent and sincere in its policy objectives and goals in order to reduce uncertainty. This study concentrated on the cross-country determinants of exchange rate. Future research may need to concentrate on country-speci…c 13 models. In particular, the relatively concentrated market structure raises questions about whether or not participants have su¢ cient power to ‘move’the market, or whether large transactions create temporary exchange rate misalignment, which then is corrected after a period of relative volatility. 14 8 References References [1] Beine M., J. Lahaye, S. Laurent, C. J. Neely and F. C. Palm. (2006). ‘Central Bank Intervention and Exchange Rate Volatility’. Federal Reserve Bank of St Louis Working Paper 2006-031A. [2] Calvo, G. A. and C. M. Reinhart. (2002). ‘Fear Of Floating,’Quarterly Journal of Economics, v107 (May), pp379-408. [3] Canales Kriljenko, J. I. , K. F. Habermeier. (2004). ‘Structural Factors A¤ecting Exchange Rate Volatility: A Cross-Section Study’. IMF Working Paper No. 04/147 [4] Cashin, P. L. Céspedes and R. Sahay. (2001). ‘Keynes, Cocoa and Copper: In Search of Commodity Currencies’. IMF Working Paper WP/02/223. Available online http://www.imf.org [5] Chen, Y. and K. Rogo¤. (2002). ‘Commodity Currencies and Empirical Exchange Rate Puzzles’. IMF Working Paper WP/02/27. Washington D.C.: Own publication. [6] Clark, P. B., N. T. Tamirisa, S-J Wei, A. M. Sadikov L. Zeng. (2004). ‘A New Look at Exchange Rate Volatility and Trade Flows’. IMF Occasional Paper No. 235 [7] Clinton, K. (2001). ‘On Commodity-Sensitive Currencies and In‡ation Targeting’. Bank of Canada. Working Paper 2001-3. [8] Glick, R. and M. Hutchison. (2005). ‘Capital controls and exchange rate instability in developing economies’. Journal of International Money and Finance, Elsevier, vol. 24(3), pages 387-412. [9] Engel, C., Mark, N., and West, K. (2007). ‘Exchange rate models are not as bad as you think’. NBER Working Paper No. 13318. [10] Friedman, M. (1958). ‘The Supply of Money and Changes in Prices and Output’ in Relationship of Prices to Economic Stability and Growth. [11] Hausmann, R. (2005). ‘Ensuring a Competitive and Stable Real Exchange Rate in South Africa’. Mimeo: Preliminary research from South African Treasury Economic Research Programme. [12] Hviding, K., Nowak, M.and Ricci, L. A. (2004). ‘Can Higher Reserves Help Reduce Exchange Rate Volatility?’ IMF Working Paper WP/04/189 [13] Krugman, P. (1996). ‘Are Currency Crises Self-Ful…lling?’, in Ben S. Bernanke and Julio J. Rotemberg eds. NBER Macroeconomics Annual 1996, MIT Press, Cambridge Mass. and London [14] Mark, Nelson A., Sul, D. (2001). ‘Nominal Exchange Rates and Monetary Fundamentals: Evidence from a Small Post-Bretton Woods Sample’, Journal of International Economics 53, 29-52. 15 A Appendix Ten-worst performing currencies v/s US$ SA Rand Iceland Kro na Turkish Lira M auritius Rupee Nicaragua Co rdo ba Guyana Do llar Chilean P eso Co lo mbian P eso Co sta Rican Co lo n New Zealand Do llar Current acco unt, % o f GDP , 2006 % change since 31Dec 2005 -28.0 -24.0 -20.0 -16.0 -12.0 -8.0 Figure 1: T en worst Indonesian Rupiah Brazil Real Slovakian Koruna Swedish Krona UK Pound Haiti Gourde Czech Koruna Thai Baht Paraguay Guarani New Romanian leu Figure 2:T en best 0.0 4.0 perf orming currencies in the f irst Ten best performing currencies v/s US$ -12.0 -4.0 -7.0 -2.0 3.0 Current acco unt, % o f GDP , 2006 % change since 31 Dec 2005 8.0 13.0 perf orming currencies in f irst 16 half of 2006 half of 2006 Canada Malaysia Australia United_Kin Bolivia New_Zeala Norway Sweden Germany Italy France Austria Netherlands Slovakia Sri_Lanka Belgium Iceland Denmark Thailand Korea Portugal Switzerland Finland Spain Japan Gabon Israel Greece Chile Pakistan India Paraguay Mexico SOUTH_AF Hungary Argentina Egypt Slovenia Columbia Indonesia Algeria Poland Kenya Ghana Uruguay Venezuela Ecuador Peru Bulgaria Turkey Brazil 0 0.1 0.2 0.3 0.4 0.5 0.6 Figure 3.Average exchange rate volatility against U S dollar; 1980 2000: Most and least volatile exchange rates, 1970 to 2002 Five most volatile currencies Advanced Japan, Australia, Israel, New Zealand, United Kingdom Emerging Argentina, Uruguay, Turkey, Chile, Indonesia Developing Congo (Dem Rep of), Sudan, Angola, Bolivia, Ghana Five least volatile currencies Advanced Austria, BenLux, Canada, Netherlands, Denmark Emerging Panama, Singapore, Malaysia, Venezuela, Mexico Developing Martinique, French Guiana, Réunion, Netherlands Antiles, Bahamas Source: Adapted from Clark et al (2004) Table 1. M ost and least volatile exchange rates (1970 17 2002) Ra nd-D ollar ex chan ge ra te 0 .18 12 Re al Ra nd /Do llar vo la tility Re al Ra nd /Do llar Exc h ang e rate 0 .16 Ra nd colla pse Ru bicon spe ec h an d sa nc tion s 10 0 .14 Arg en tin ia n/ Me x ic a n/R ussian crises 0 .12 0.1 8 A s ia n c ri s is 6 0 .08 0 .06 4 P re-1 99 4 e le ctio n jitters Ma nd ela' s relea se 0 .04 2 0 .02 0 0 19 81 1 98 2 1 98 3 19 84 19 85 1 986 1 98 7 1 98 8 198 9 19 90 19 91 1 99 2 1 99 3 1 99 4 19 95 19 96 1 997 1 99 8 1 99 9 200 0 20 01 20 02 2 00 3 Y e ar Figure 4:Rand Dollar exchange rate f rom 1980 0.35 Gulf war Oil crisis 2003: Asian crisis Coefficient of variation (annual) 0.30 0.25 0.20 0.15 0.10 0.05 02 00 Gold price volatility Figure 5:Oil and gold price volatility (1970 18 20 98 20 96 19 94 19 92 Oil price volatility 19 90 19 88 19 86 19 84 19 82 19 80 Volatile periods 19 78 19 76 19 74 19 72 19 19 19 70 0.00 2002) Variables Macroecon omic variables Import cover (weeks) mpco Budget surplus to GDP ratio dfgd Log debt-to GDP ratio ldgp GDP growth dgdp Openness Log Uncertainty lunc Terms of trade volatility Log Oil volatility loiv Change in Balance of Payments (current account) World volatility Dollar/euro volatility Φ Joint Hausman test (pvalue) Regress ion (1) Reserve s, Budget surplus -toGDP, uncertai nty, oil volatilit y N = 25 T = 15 Regress ion (2) Regress ion (3) Reserve s, GDP growth, uncertai nty, oil volatilit y Regress ion (4) Regress ion (5) Regress ion (6) Regress ion (7) Regress ion (8) Regress ion (9) Reserve s, GDP growth, uncertai nty dollar/e uro volatilit y Budget surplus -toGDP, opennes s, uncertai nty Openne ss, uncertai nty, oil volatilit y Change in the current account, import cover, uncertai nty Inflatio n rate, change in the inflatio n rate, oil volatilit y Debtto-GDP, inflatio n rate, change in inflatio n rate N = 19 T = 22 N = 19 T = 21 N = 19 T = 20 N = 19 T = 21 N = 19 T = 23 N=19 T=23 N=19 T=22 N=19 T=22 0.043** (-2.98) 0.044** (-3.09) 0.037** (-4.45) 0.044** (-3.64) n/a n/a 0.022** (-2.78) n/a n/a -0.008* (-1.89) n/a n/a n/a 0.013** (-2.36) n/a n/a n/a n/a n/a 0.279** (2.90) n/a n/a n/a n/a n/a n/a 0.398** (4.04) n/a n/a -0.574 (-1.50) n/a n/a n/a n/a n/a n/a n/a n/a 2.378** (-4.33) n/a -0.221* (-1.72) n/a n/a n/a 0.103** (9.65) 0.100** (9.10) 0.117** (16.20) 0.132** (9.25) 0.105** (8.392) 0.122** (-2.14) 0.096** (9.29) 0.100** (8.97) n/a n/a 0.062** (2.44) n/a 0.074** (3.94) n/a n/a 0.064** (2.79) n/a 0.060** (2.20) n/a n/a n/a n/a n/a n/a 0.068** (-3.95) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 0.858** (-13.27) 1.80 (0.77) 0.842** (-12.46) 0.53 (0.91) 0.915** (-7.24) 7.10 (0.13) 2.309** (2.82) -0.827 (-8.85) 0.908** (-17.90) 4.08 (0.25) 0.985** (-10.56) 4.14 (0.25) 0.913** (-7.55) 6.15 (0.10) -0.86** (12.90) -0.79** (-12.87) 5.99 (0.11) 5.35 (0.15) Reserve s, Debtto-GDP, uncertai nty 5.39 (0.25) Table 2. Estimation results 19 Number of Rand cents above the average2 Macroeconomic variables Current values Scenario Difference First half of 2006 Scenario result Difference3 Import cover (months) 3* 2 1 month 29 cents 30 cents 1 cent Budget surplus to GDP ra tio (%) -0.59* -1.59 1 percenta ge point 29 cents 49 cents 20 cents Debt-to GDP ratio (%) 35.8* 36.8 1 percenta ge point 29 cents 59 cents 30 cents 29 cents 31 cents 2 cents Uncertainty Rise by 50 basis points Terms of trade volatility Oil volatility Openness (%) Current account balance Standard deviation rises by US$ 1** 29 cents 30 cents 1 cent 56 55 1 percenta ge point 29 cents 30 cents 1 cent -4.10* -5.1 1 percenta ge point 29 cents 59 cents 30 cents 29 cents 34 cents 5 cents World volatility Dollar/Euro volatility Standard deviation rises by 1 US cent ** Table 3. Scenarios 20
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