Exchange rate and tradebalance in Ethiopia; j curve           effect               February 2013   1
Chapter One Introduction     1.1) Background of the studyForex/Fx:how itworks???Market for currency; biggest and   24 hrs ...
Review of foreign                     currency reservesCertain figures       in Africaon forex             Have got accumu...
Reserve accumulation seen asa tool for maintaining lowexchange rates in order to      Review of reserve inpromote trade   ...
Certain figures on grossforeign Reserves of of NBE  2.0 months of import of goods and non-factor  services(at end of 2008/...
Figures on Export and import               components in EthiopiaExport 1980                              Import 1980   Co...
1.2) Statement of the problemDespite growth in export(mainly from theagricultural sector) , magnitude of trade deficithas ...
The country reported( in 2009) huge deficit even  on agricultural goods :where it has the potential  to narrow the gap suc...
Certain points That DevaluationMight Prove To BeDisappointing    First, the trade balance will correct only if: the sum of...
Because of this market structure, little benefitfor the Ethiopian producers (hence limit supplyresponse)An excess or spare...
There is a doubt about enough availabledomestically (Ethiopian) produced goods whichboth domestic and foreign consumers wi...
There is some support in theory for J Pattern butagain it is up to empirical evidence and that is whythe researcher is int...
Hypothesis of the studyPrevious research has tested the theory of J curve formany developed and developing countries(littl...
Based on the analysis; in 17/19 countries:devaluation improve trade balance though it isnot continuous. For only two of in...
A prominent professor of accountancy who haspublished a number of professional articles onsub-Saharan stated: The J curve ...
Objectives of the studyGeneral objective;  to examine the existence of j curve effect of  devaluation on trade balanceSpec...
Scope and significance   1) Scope of the studyIdea scope: relationship between exchange rate, domestic income,foreign inco...
Methodology of the study  Data type, data description and time series characteristiclogarithms  of trade balance (TB)  Rea...
Model specificationIn general: Three approaches for estimating j curveBahmani-Oskooee(1985) employed an aggregate dataRose...
Model used; a reduced form model employed by Rose and Yellen(1989)and Bahmani-Oskooee (1991)Model assumptions:  both expor...
The standard "two-country" imperfect substitute model is asfollowsDomestic demand for import (Md), and the demandfor impor...
Where Y is domestic income,  PM the domestic currency price paid by domestic importers  and P denotes the overall domestic...
From homogeneity assumption dividing the explanatoryvariables on the right hand side by P.                                ...
the relative price of imports is equivalent to the foreign currency price of foreign exports adjusted for the exchange rat...
Substituting RPm from equation 5 in to equation 3 weobtainMd        Md(RPx*/Q ,Y)…………………………..(6)        ……….(2)Similarly f...
Domestic exports are foreign imports and vice versa  Xs= M*d       X*s= Md ……………………..………………......(8)             ……….(2)  ...
The log-linear functional form approximation isLog TB t α β Log Yd, t γ LogYW, t λ Log REX t ε t (11)Yd (Yw) is a measure ...
First, the main reason to use :regardless ofwhether exports are less than import.Especially good for the case in Ethiopia ...
Third , the form gives direct elasticities forinterpretation: additionally the use of ratio in loggives the MLC exactly ra...
Regarding with the expected sign of parameters used in themodel;β and γ could be negative or positive.  Usually an increas...
Equation (11) represents the long-run relationships. To test the J-Curvephenomenon which is a short-run concept, we must i...
Where k lag length  Applying the familiar F test to determine joint significance of  lagged level variables as a test of c...
Econometrics toolsThe researcher will apply the following tools   Granger causality Method: determining whether one   time...
Impulse response functions: to examine the J curve pattern of the trade balance upon exchange rate shock. Auto Regressive ...
Graphical Methods And Summary StatisticsAll the data are having a time series propertythus in order to show the relationsh...
This is what I amproposing !!!!!!  I Thank U               36
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  1. 1. Exchange rate and tradebalance in Ethiopia; j curve effect February 2013 1
  2. 2. Chapter One Introduction 1.1) Background of the studyForex/Fx:how itworks???Market for currency; biggest and 24 hrs in a day ,7 days incomplex one a weekTrading entirely on computer The “bid” and “ask”Traders, speculators involvedEuro/JPY,USD/CHF and currency quotes; A” bid”CAD/USD are popular and the price at w/c u cancommon pairs sell and “ask” is a price uForex mkt(takes the notion of can buymkt in economic) is justmechanism not a common place No commission charges;….all trading done over brokers make profit Viacomputer ask and bid quotes 2
  3. 3. Review of foreign currency reservesCertain figures in Africaon forex Have got accumulated recently from high export and aid flows Adequacy in reserve allow toLondon mkt borrow and hedge againstlargest(36%) instability in external capital flows but there are forgoneNewyork(18%)Tokyo( costs from investment and6%) social expenditure that could be financed by these reservesUSD accounts 85% rather(Elhiraika andNdikumana;euro 40% Yen 19% 2007) 3
  4. 4. Reserve accumulation seen asa tool for maintaining lowexchange rates in order to Review of reserve inpromote trade Ethiopiacompetitiveness: mercantilist Began depleting Sep 2007motive (Aizenman and Lee By end of Nov 2008 it had2005). reached a record low of just one month of imports(result in rationing(a temporary strategy) foreign currency to rebuild) 4
  5. 5. Certain figures on grossforeign Reserves of of NBE 2.0 months of import of goods and non-factor services(at end of 2008/09) 2.4 months of import(1.5 Billion USD) (On June 2009) 2.2 months of import of goods and non-factor services(on July 7, 2010) 5
  6. 6. Figures on Export and import components in EthiopiaExport 1980 Import 1980 Coffee(62%), leather and leather Capital goods(averaging products(11%),oilseeds(3%) 34%),Export 2008/09 Capital goods37%(1980- Coffee(26%),leather and leather 1990) to 31%(2000-2009) products(5%),Oilseeds(25%)On export 2009/10 Consumer go0ds(29.5%) Coffee(26%), Oilseeds(17%) Raw materials 3.1%(1980- Gold (14%)and chat(10%), 1990) to 2.2%(2000-2009)A shift in share of exports and a A shift of import sources fromshift in destination(south-south trade Europe to Asia(what aw.r.t Asia and Africa) were dramatic import from china!!!)observed(Tewodros Makonnen; 62012)
  7. 7. 1.2) Statement of the problemDespite growth in export(mainly from theagricultural sector) , magnitude of trade deficithas increased(Birr 40,320.7 million in 2005 toBirr 72,822.3 in 2009, with an average growthrate of nearly 16%) .Due to the high cost anddependency on imports and the slow growth ofexports (Samuel and Tarekegn; 2011)Country’s industrial base failed to boost theexport of or to produce substitutes : in order tonarrow the ever widening trade deficit. 7
  8. 8. The country reported( in 2009) huge deficit even on agricultural goods :where it has the potential to narrow the gap such as Soya bean, wheat flour, grain sorghum etc.Does devaluation improve trade balance? A surprise in devaluation of birr in August 31, 2010 from a value of 13.63 to the US dollar to 16.35 as an effort to boost export;. The move ,by itself, might not address the trade problem 8
  9. 9. Certain points That DevaluationMight Prove To BeDisappointing First, the trade balance will correct only if: the sum of the import and export demand elasticities greater than one developing country context :believed to be low at least in SR Market structure :to dampen the impact of the devaluation. A market for developing nations are dominated by a few major international buyers who had market power 9
  10. 10. Because of this market structure, little benefitfor the Ethiopian producers (hence limit supplyresponse)An excess or spare capacity must exist ready tomeet the demanddevaluation affects intermediate and capitalgoods that are imported from abroad hence;affecting domestic production in a negative way.In the unlikely event that other trading partnersfollow suit or take other retaliatory measures.May trigger mini trade war involvingEthiopia, its neighbors and her major tradingpartners (Bienen et.al; 2010) 10
  11. 11. There is a doubt about enough availabledomestically (Ethiopian) produced goods whichboth domestic and foreign consumers wish tobuy(evidence ; the cause of inflation in 2008 andthereafter is due to shortage of food items)The times, how long will it take for both domesticand foreign consumers to adjust their preferencesand switch towards Ethiopian-made goods matteras well.Others ; bring the theory of J-curve to play:though devaluation deteriorate trade balance in SRit could lead to positive result in LR 11
  12. 12. There is some support in theory for J Pattern butagain it is up to empirical evidence and that is whythe researcher is interested to support or rejecttheory in Ethiopia.The study will employ a time series econometrics ondata set available period 1974 – 2011.Lulit Asefa has done impact of exchange rate ontrade balance (1992-2007).This study will fill the gap(2008-2011) and willalso assess the trade balance pattern to the period1974-1991 12
  13. 13. Hypothesis of the studyPrevious research has tested the theory of J curve formany developed and developing countries(littleattention at/to African countries) Glenville Rawlins and John Praveen (1993) have doneon nineteen Sub-Sahara African countries(Burkina Faso,Cameroon, Central African Republic, CôtedIvoire,Gabon, The Gambia, Ghana, Kenya, Madagascar,Mauritius, Niger, Nigeria, Rwanda, Senegal, SierraLeone, Tanzania, Togo, Zaire, and Zambia). 13
  14. 14. Based on the analysis; in 17/19 countries:devaluation improve trade balance though it isnot continuous. For only two of indicate J curvebut based on t-statistics only the J exist inTanzaniaMohsen Bahmani-Oskooee and AberaGelan(2012) had test J curve for nine Africancountries ( Burundi, Egypt, Kenya, Mauritius,Morocco, Nigeria, Sierra Leone, South Africa,and Tanzania ).They were unable to find anysupport for the J-CurveTwo reasons that the researcher don’t expect Jcurve to hold in Ethiopia 14
  15. 15. A prominent professor of accountancy who haspublished a number of professional articles onsub-Saharan stated: The J curve has not beenobserved in many African countries; hence thereis little reason to expect it in Ethiopia.Some others said , the J-curve effect holds trueonly if a country has a balanced BOP position atthe time of devaluation, which is not the case inEthiopia; Right? 15
  16. 16. Objectives of the studyGeneral objective; to examine the existence of j curve effect of devaluation on trade balanceSpecific objective: To investigate the short run and long run relationship between real exchange rate and trade balance To examine the pattern of trade balance during in the two recent regimes; Derg and EPDRF regimes 16
  17. 17. Scope and significance 1) Scope of the studyIdea scope: relationship between exchange rate, domestic income,foreign income with trade balance;Time scope :1974-2011 (the two regimes period)Of course the area scope :is on multilateral trade balance inEthiopia 2) Significance of the study Serve as a road map for policy makers on the short run and long run relationship between exchange rate and trade balance in Ethiopia on a particularly specified period it will contribute to the existing literature in the area. 17
  18. 18. Methodology of the study Data type, data description and time series characteristiclogarithms of trade balance (TB) Real effective exchange rate(RER) and domestic GDP and World Industrial Production Index /US GDP will be used as a proxy variable for foreign income(Y*) export and import values will be used for calculating TB ratio measure 18
  19. 19. Model specificationIn general: Three approaches for estimating j curveBahmani-Oskooee(1985) employed an aggregate dataRose and Yellen(1989) used bilateral dataBahmani-oskooee and Wang(2008) used sectoral dataHowever, the researcher will use only the firstapproach of estimating J curve : employing anaggregate trade data/ multilateral trade model. 19
  20. 20. Model used; a reduced form model employed by Rose and Yellen(1989)and Bahmani-Oskooee (1991)Model assumptions: both exports and imports are imperfect substitutes for domestically produced goods the market clearing condition that equates the domestic demand for imports to the foreign supply of exports. the demand variables are represented only by current income rather than permanent and transitory income. homogeneity of the demand function is assumed, so that the consumer does not suffer from money illusion - demand will remain constant when doubling money income and prices. 20
  21. 21. The standard "two-country" imperfect substitute model is asfollowsDomestic demand for import (Md), and the demandfor import by the rest of the world (M*d), are givenby equations (1) and (2): Md F(Y,Pm,P)……………(1)Md* F(Y*e,P*m,P*)………………………(2) 21
  22. 22. Where Y is domestic income, PM the domestic currency price paid by domestic importers and P denotes the overall domestic price level, Y* represents foreign income, e the exchange rate expressed as the domestic currency price of foreign exchange, P*M denotes the foreign currency price paid by domestic importers and P* the overall foreign price level.In other words, the quantity demand is a function of the levelof money income in the importing region, the imported goodsown price and the price of domestic substitutes. 22
  23. 23. From homogeneity assumption dividing the explanatoryvariables on the right hand side by P. 23
  24. 24. the relative price of imports is equivalent to the foreign currency price of foreign exports adjusted for the exchange rate hence:RPm eP*x/P=(EP*/P)(P*x/P)=(1/Q)RP*x ……….(5) Where P*x is the foreign currency price of foreign exportsQ is the1)real exchange rate defined as the relative price ofdomestic to foreign goods{ i.e Q=P/(EP*)} and RP*x the relative price of foreignexports to foreign produced goods 24
  25. 25. Substituting RPm from equation 5 in to equation 3 weobtainMd Md(RPx*/Q ,Y)…………………………..(6) ……….(2)Similarly foreign country’s demand for importsdepends up on foreign income and domesticrelative export price;M*d Md*(RPxQ ,Y*)…………………………..(7) 25
  26. 26. Domestic exports are foreign imports and vice versa Xs= M*d X*s= Md ……………………..………………......(8) ……….(2) trade balance TB as the following ratioTB= Md / Xs = Md / M*d Md(RPx*/Q ,Y)/ Md*(RPxQ ,Y*) …………(9) ……….(2) Assuming constant or stationary values of RPx and RPx* we can write the above equation in general form: TB=TB(Q,Y,Y*) ……………………….(10) 26
  27. 27. The log-linear functional form approximation isLog TB t α β Log Yd, t γ LogYW, t λ Log REX t ε t (11)Yd (Yw) is a measure of domestic (foreign) income, REXis a measure of real effective exchange rate and ε is an errorterm Following Bahmani-Oskooee (1991) and others such as Gligoric and Petrovic(2009 ) the researcher define trade balance as the ratio of imports over exports The ratio measure of is good for several and important reasons 27
  28. 28. First, the main reason to use :regardless ofwhether exports are less than import.Especially good for the case in Ethiopia thattrade balance as a difference measurebetween export and import takes almost inall periods a negative valueSecondly, The ratio measure is not sensitiveto units of measurement in export andimports (Bahmani-oskooee and Alse(1994)) 28
  29. 29. Third , the form gives direct elasticities forinterpretation: additionally the use of ratio in loggives the MLC exactly rather than approximately(Onafowora 2003).Fourth, the ratio is used to make the measure oftrade balance unit free (Bahmani-Oskooee, 1991).Fifth it allows focusing on what proportion ofimport is financed by exports. 29
  30. 30. Regarding with the expected sign of parameters used in themodel;β and γ could be negative or positive. Usually an increase in domestic income leads to higher imports yielding a positive estimate for β. However, if the increase in domestic income is due to an increase in production of import substitute goods, imports could actually decline yielding a negative β. Higher in foreign income expected to boost domestic export thus a positive effect on domestic trade balance (Bahmani-Oskooee 1986).• Finally, if a decrease in REX or depreciation has also anambiguous result until it is justified empirically 30
  31. 31. Equation (11) represents the long-run relationships. To test the J-Curvephenomenon which is a short-run concept, we must incorporate theshort-run dynamics into the long-run model .Thus the following ARDLrepresentations 31
  32. 32. Where k lag length Applying the familiar F test to determine joint significance of lagged level variables as a test of cointegration, i.e., if 1- 4 are jointly significant, variables are said to be cointegrated. The short-run effects of depreciation are inferred by the estimates of K’s. Specifically, negative values for K’s. at lower lags followed by positive values at higher lags will be consistent with the J-Curve hypothesis in the case when devaluation effect become negative at lower lags and positive at higher lags. The long-run effects are inferred by the estimate of 4 which is normalized on 1. 32
  33. 33. Econometrics toolsThe researcher will apply the following tools Granger causality Method: determining whether one time series is useful in forecasting the other Unit root test :identifying the order of time series and test stationarity of main variables Cointegration Aalysis; explore the existence of long run relationship: Johansen Cointegration test (johansen1996) and Autoregressive distributed lage(ARDL) approach of pesaran,shin and smith(2001) will be respectively used if the variables have the same order of integration 33
  34. 34. Impulse response functions: to examine the J curve pattern of the trade balance upon exchange rate shock. Auto Regressive Distributive Lag Approach(ARDL)ADRL allows to estimate both the short run effects and long run estimates solves the problem of variable endogeniety in small samples is superior (Narayan (2005) works whether unit root exist or not. This method does not require both variables to be integrated in the same order. 34
  35. 35. Graphical Methods And Summary StatisticsAll the data are having a time series propertythus in order to show the relationship easier.And graphical insights will be given onstationary and non-stationary properties ofvariables 35
  36. 36. This is what I amproposing !!!!!! I Thank U 36
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