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Exchange Rate Pass-Through to Domestics Prices in South Africa

Exchange Rate Pass-Through to Domestics Prices in South Africa. Presented by Francis Chiparawasha [Economics Department, UWC]. Presentation Outline. Background and Motivation Study Objectives Literature Review Methodology Preliminary Results Conclusion. Background.

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Exchange Rate Pass-Through to Domestics Prices in South Africa

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  1. Exchange Rate Pass-Through to Domestics Prices in South Africa Presented by Francis Chiparawasha [Economics Department, UWC]

  2. Presentation Outline • Background and Motivation • Study Objectives • Literature Review • Methodology • Preliminary Results • Conclusion

  3. Background • After the fall of the Bretton Woods system of exchange rate management, many developed economies moved to the floating exchange rate regime. • Emerging and Developing economies followed e.g. South Africa (SA) • SA undertook trade liberalisation measures in 1994 and adopted a unitary floating exchange rate regime under an inflation targeting framework in 2000 (Du Plessis & Smit, 2007; Mtonga, 2011). • A floating exchange rate system & open trade policy > • Lose of power to insulate own economy from external economic shocks such as exchange rate fluctuations. • Exchange rate fluctuations affect imports, exports, capital flows and domestic inflation

  4. . Gill Marcus Motivation • “To date, the pass-through from exchange rate to inflation has been relatively constrained, particularly compared to previous periods of high volatility and currency weakness. Also, it could be that the recent sharp moves in the exchange rate are seen to be excessive and a sign of overshooting. However, the longer these weaker levels persist, the greater the risk that the relatively benign impact on inflation will end.” • SA Commercial Property News, 6 June 2013 • This shows that amongst many, exchange rate variations are a determinant of inflation

  5. Motivation [cont...] • The analysis of Exchange rate pass-through is important to determine a country’s optimal monetary policy mix (Choudhri& Hakura, 2006). • Exchange rate movements have a strong bearing on the stance of monetary policy. • E.g. Low pass-through credits the implementation of inflation targeting and provides a better autonomy to pursue independent monetary policy (McCarthy, 2006).

  6. Research Objectives • The aim of this study is to: • [1] determine the short-run magnitude and speed of exchange rate pass-through to import, producer and consumer prices in South Africa. • [2] measure the long-run degree and speed of exchange rate pass-through to import, producer and consumer prices in South Africa. .

  7. SA Consumer Inflation [All urban areas]

  8. NEER Short-Term Variability [% Change from previous month 1980 -2014]

  9. Literature Review >Aggregate prices vs disaggregate prices >Dangers of inflation -It affects everyone especially the poor

  10. Exchange Rate Pass-Through &Monetary Policy • After experiencing exchange rate crises in the mid to end-1990s, many emerging economies changed their monetary policy regimes from targeting exchange rates in favour of targeting inflation (Nogueira, 2007). • This was a shift from focusing on exchange rate to focusing on inflation > evidence – adoption of inflation targeting by many countries • Criticised as one of the cause of the 2007/2008 Global Financial Crises – Joseph Stiglitz • Central Banks (CB) were obsessed with inflation and ignored developments in the financial system • Nevertheless, knowledge of ERPT still important especially for forward-looking CB

  11. The channels of ERPT • Distribution Channel – Two staged pass-through (McCarthy, 2000; 2006; Gosh & Rajan, 2007) • Foreign Direct Investment Channel – relocation of operation facilities (Ponomarev, Trunin &Uluykaev, 2014) • Direct and Indirect Channels – Laflèche, 1996; Hüfner &Schröder, 2002; Hyder & Shah, 2004; Karoro, 2007 and Tandrayen-Ragoobur& Chicooree, 2013

  12. Exchange rate depreciation Indirect effects via competitiveness Direct effects via import prices Imports of finished goods become more expensive Imported inputs become more expensive Demand for exports rises Demand for substitute Demand for labour increases Production cost rise Wage rise Substitute goods & exports become more expensive Production prices rise Consumer prices -Market structure -Inflationary environment -Pricing policies -Product substitutability --Adjustment of non-tradable prices and wages -Prevailing exchange rate policy - Exchange rate volatility Adapted from Laflèche (1996); Hüfner and Schröder (2002) and Hyder and Shah (2004)

  13. Empirical Literature • Developed countries – extensive literature > Menon, 1995 survey • McCarthy (2000) > US, the UK, Japan, Germany, France, Belgium, Sweden, Switzerland and the Netherlands. – ERPT along the distribution chain modest for most of the economies. • Goldfajn & Werlang (2000) – 71 countries > ERPT depends on the time horizon (17% in 3 months but 73.2% in 12 months • Lower in OECD countries than emerging economies confirms Taylor’s (2000) argument • Cheikh and Louhichi (2014) > consumer prices in 12 Euro zone countries • The results show different degrees ERPT across countries, e.g. Portugal (8.4%), Greece (5.8%) change in consumer prices, Finland, France and Germany (2% ).

  14. Empirical Literature • Emerging and Developing Countries • Mihaljek and Klau (2001) > 13 emerging economies – ERPT is moderate in most of the countries • Ito and Sato (2006) analyse the effect of exchange rate changes on import, producer and consumer prices in East Asia (Korea, Thailand, Indonesia, Malaysia, Singapore ). • The findings indicate that pass-through is largest in import prices and smallest for consumer prices. • Razafimahefa (2012) - comprehensive study of ERPT in sub-Saharan Africa. • The results show an average degree of 40 % • South Africa • Nell (2000) – Data >1973 – 1998 long run pass-through 82%

  15. Empirical Literature • SARB (2002) – Import prices > 10% depreciation lead to a 0.46 percent increase in import prices within a month of the shock • 78% in the long run with 50 percent of adjustment taking place in less than twelve months. • Bhundia (2002) > import prices (almost complete), PPI to CPI 75% , 85% in the long run • Ocran (2010) found an ERPT into import prices peaking of 40% after 8 months, an ERPT into producer prices peaking at 27% after 7 months. • Aron et al. (2012) - the long-run pass-through is 55 percent from the multiple equations analysis compared to 75 percent for the single equation results • Ellyne and Hearn (2014) - import price changes >producer prices is high (89%), but only 18 % of the subsequent change in producer prices is transmitted to consumer prices

  16. Data and Methodology • OLS, VAR, VECM, DSGE models • VAR Model • (g x 1 variables) – g-(crude oil, output gap, nominal effective exchange rate, import, producer, consumer prices, prime rate & m3) • Quarterly data, 1980 – 2013 [StatsSA & SARB] • Transformed to a VECM:

  17. Methodology • Recursive VAR - McCarthy (2000; 2006) > Inflation at each stage-import, producer, and consumer--in period t is assumed to be comprised of several components. • [1] expected inflation at that stage based on the available information at the end of period t-1. • [2] + [3] - are the effects of period t > domestic “supply” and “demand” shocks on inflation at that stage. • [4] the effect of exchange rate shocks on inflation at a particular stage. • [5] effects of shocks at the previous stages of the chain + that stage's shock.

  18. Model –Recursive VAR --non-correlated external shocks .

  19. Preliminary Results • All variables have at least one root except output gap • Trace and eigenvalue test > 2 co-integrated relations @ 5% significance level • The long run results show that a 10% depreciation of the rand will lead to a 7.5% change in import prices which declines along the chain. • Short run about 40% • This is consistent with Karoro et al.(2009), Nell (2000) and Bhundia’s (2002) results who found the ERPT to import prices to be 7.5%, 8.2% and 7.5% respectively. • coefficients of the error correction term in cointegrating equation indicate that consumer, and producer prices and nominal effective exchange rate are significant and correctly signed others insignificant.

  20. Conclusion • Exchange rate fluctuations are determinants of domestic inflation • Understanding the impact of exchange rate variations on inflation is important in formulating monetary policy esp. for forward-looking CB • Using a recursive VAR, quarterly data > 10% depreciation results in a 7.5% change in import prices in the long run and about 40% in the short run • SARB should monitor movements in exchange rate in their monetary policy planning because they have a significant effect on domestic inflation

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