Equilibrium Exchange Rates in PNG: a new approach to policy- - - PowerPoint PPT Presentation

Equilibrium Exchange Rates in PNG: a new approach to policy- setting in RRDCs

Martin Davies Associate Professor, Washington and Lee University Visiting Associate Professor, UPNG Visiting Fellow, DPC, Australian National University Research Fellow, Institute for National Affairs

Joint work with Marcel Schroder, thanks to Laura Nettuno for research assistance

Plan for today

• New model
• Theory
• Policy: new policy framework for RRDCs
• Empirics
• Observations
• Forex market
• Exchange rate: what if exchange rate floated

Objective of Paper: are standard models useful for understanding policy in RRDCs

• Model for macro policy in RRDC
• Adjust standard Internal-External balance model to account for key features of

RRDCs

• What are key features?
• Resources sector is an enclave: not linked to the rest of the economy
• Net factor income is large and negative
• Question: how does policy prescription for RRDC change?

Observation for PNG

• resource sector is an enclave
• firewalled from rest of economy
• 2015 fastest growing economy in the world, unemployment increasing
• resources sector:
• capital owned by foreigners, few national workers
• large share of export income accrues to foreign owners
• PNG ownership share low
• resources taxes are low

What is a RRDC?

• What is a Resource Rich Developing Country (RRDC)?
• Definition of RRDC (IMF 2012):
• low- and lower-middle-income country
• Low: less than USD 1000
• Lower-middle: USD 2000-4000
• exhaustible natural resources comprises at least 20 percent of total exports
• New observation / stylised fact: significant difference between GNP and GDP
• 29 RRDCs over 20 years: GNP/GDP = 0.93
• range 0.64 (Equatorial Guinea) to 1.01 (Uzbekistan)
• PNG is 0.94 (IMF says 0.90) 0.87 in 2000; 0.99 in 1978)
• G-7 over last 20 years: GNP/GDP= 1.00

Standard Policy Framework

• Standard Internal Balance-External Balance policy framework focuses on
• Gross Domestic Product (GDP)
• Current Account (CA) measured by Trade Balance: Exports (EX) less Imports (IM)
• But net factor income large and negative in RRDCs
• need to account for this
• Focus on
• GNP = GDP + net factor income
• Current Account = EX – IM + net factor income

GDP vs GNP

• GDP: value of all goods and services produced within a geographic area
• GNP: value of all goods and service produced by nationals of a given country
• GNP = GDP + net factor income (subtract out parts of GDP that aren’t produced by

nationals, add in parts that are produced by nationals overseas)

• Modelling Net Factor Income
• Resources sector production function; capital KR, owned by foreigners, LR foreign labor

YR= F(KR ,LR) e.g. YR =KR.LR (LR=10,KR=20, YR =200)

• Assume that all resource sector output is exported: YR = EXR
• Suppose PNG owns share α of project, then net factor income = - (1- α)EXR
• GNP = GDP - (1- α)EXR
• With resource taxes, tR, net factor income = - (1- α)(1-tR)EXR

(↑α, ↑tR will ↑GNP)

Model

Model

Policy in PNG

• In an open economy, policy has two goals
• internal balance: producing at full employment (Y = Yf )
• over-employment (Y > Yf ): increase in inflation
• underemployment (Y < Yf ): decrease in inflation
• external balance: current account is near zero: CA = 0
• is large current account deficit: foreign investors question ability to repay debt. Is CA

deficit bad?

• Two instruments:
• exchange rate (e) – expenditure switching
• Fiscal policy (G) – expenditure changing

Internal Balance

• Internal balance: Y=Yf : Yf = C + I + G + EX(e) - IM

aggregate expenditure = full employment consumption (C) + investment (I) + gov’t spending (G) + exports (EX) – imports (IM) = Yf

exchange rate = e

Devaluation ↑e → our goods cheaper to foreigners → ↑export (EX)

• Increase in gov’t spending: ↑ G → Y > Yf

(output is above its full employment level)

• To restore internal balance: revaluation (↓e) → EP*/P → our goods more expensive

to foreigners → ↓exports (EX) → ↓Y returns to Yf

Internal Balance

G Exchange rate, e IB Internal balance: Y = Yf Expenditure switching, E Expenditure changing, G

External Balance

• External balance (CA = 0):

CA = Exports – Import = EX(e) – IM(Y) = 0

• ↑ G increases aggregate expenditure → ↑ income (Y) → ↑ imports (IM)

decreasing the current account (↓CA)

• To restore external balance: devaluation ↑e → our goods cheaper to foreigners

→ ↑ exports (EX)

External Balance

G Exchange rate, e EB External balance: CA = 0

Macroeconomic Goals

G Exchange rate, e EB (CA=0) IB (Y=Yf) A

Zones of Economic Discomfort

Exchange Rate, e EB (CA = 0) IB (Y = Yf)

Result 1

Macro policy should focus only on the Non-Resource sector

Definition 2: CA includes net factor income

Net factor income is large so need to include it

New Equilibrium Exchange Rate Concept:

RRDC EQUILIBRIUM EXCHANGE RATE (RREER)

21

Diagram: RREER

IBS(Y=YR)

A

EB(CA=0) Govt Spending, G Exchange rate, e IBRRDC (Y=YR)

.

B

eRRDC eS GRRDC GS

Proposition 1

23

Export Boom Standard Model

IB2 (Y=YR)

A

EB1 (CA=0) G e

Y > YR CA > 0

IB1 (Y=YR) EB2 (CA=0)

.

C

24

Export Boom: RRDC model

IB2 (Y=YR)

A

EB1 (CA=0) Govt Spending, G Exchange rate, e IB1 (Y=YR) EB2 (CA=0)

.

B C

Y < YR CA > 0

e1 e2 G1 G2

Export Boom Result

Result: Increase in ownership share or resource tax rate

27

Increase in tR or α: RRDC model

IB2 (Y=YR)

A

EB1 (CA=0) Govt Spending, G Exchange rate, e IB1 (Y=YR) EB2 (CA=0)

.

B C

Y < YR CA > 0

e1 e2 G1 G2

Y > YR CA > 0

Empirical Results (preliminary)

Conclusion

30

PNG: devaluation (↑e) completing the square

IB1 (Y=Yf)

A

EB1 (CA=0) G e

.

Y > Yf CA < 0 Y > Yf CA > 0 Y < Yf CA < 0 Y < Yf CA > 0

IB2 (Y=Yf) EB2 (CA=0)

. .

.

B C D

Forex Market: Balance of Payments

what exactly is going on?

• BOP = Current Account + Financial Account

= (Exports – Imports) + (Capital Inflows – Capital Outflows) = (Export + Capital Inflow) – (Imports + Capital Outflows) = Supply of Forex (SFC) – Demand for Forex (DFC) BOP 2014 = - K861 mn BOP 2015 = - K753 mn BOP 2016 =Current Account (16.65 bn) + Financial Account (-16.62 bn) = K31 mn BOP 2017=Current Account (13.03 bn) + Financial Account (-11.67 bn) = K 1.36 bn (proj) .

Stock of excess kina (pent up demand for USD)

Figure from Fox, Howes, Nema, Schröder (2017)

PNG: Market for Foreign Exchange (rationing)

e Foreign Currency (USD)_ DFC

Rationed

SFC Exports + Capital Inflows

(ImportsRationed + Capital OutflowsRationed )

S* D*

Balance of payments deficit = Excess demand for forex / Excess supply of Kina

• K861 mn (2014)
• K753 mn (2015)

e* = 1 = 3.21 0.3115 A DFC

True

PNG: Market for Foreign Exchange: Current

e Foreign Currency (USD) DFC

Rationed

SFC Exports + Capital Inflows

DFC

TRUE + RESIDUAL STOCK

OF DEMAND for USD

S* D*

Balance of payments surplus = Excess supply of forex / Excess demand for Kina (K1.3 bn proj 2017)

D*

FC

D*+ RESIDUAL

STOCK OF DEMAND

True excess demand for forex / excess supply of Kina

e* = 1 = 3.21 0.3115

Model of Exchange Rate Adjustment

• Capital mobility very low
• No speculative attack on exchange rate
• Standard models of currency crisis don’t apply
• Current situation: pent up demand for forex over time
• Stock of kina waiting to be converted to forex
• Speculative demand for Kina (supply of forex)
• Stock of forex waiting to be converted to Kina when the price is right
• Won’t convert until Kina falls enough to offset
• If you float then stocks may enter forex market

Model of Exchange Rate Adjustment

Model of Exchange Rate adjustment

38

Model of Exchange rate adjustment

A

SFC Foreign exchange Exchange rate, e

.

eH eL FS DS DFC e2

*

e1

*

National Income Accounting

GDP = C + I + G + EX – IM

• forex restrictions reduce imports

↓M → ↑GDP (growth strategy) BUT

• PNG is a developing country: no substitutes for inputs

→ two effects

↓Investment (I) demand side ↓Y (direct) supply side

• Production is constrained by inability to source key overseas

inputs

Y falls