Behavior of inflation volatility in el salvador


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Behavior of inflation volatility in el salvador

  1. 1. Behavior of Inflation Volatility in El Salvador under a dollarization regime Rafael Mata León*† Abstract Complete Dollarization occurs when the inhabitants of a country use theUnited States dollar instead of the domestic currency. Under this regime,domestic nominal interest rate is pegged to the US nominal interest rate. Atpresent time, three countries have adopted this monetary policy strategy,Ecuador, El Salvador, and Panama, in the years 2000, 2001, and 1904respectively. Dollarization, as Reinhart et al mention, is increasingly a definingcharacteristic in many emerging market economies. There are very fewobserved cases of dollarization, and hence history provides little guidance as toits consequences. The purpose of this study is to observe and compare the inflation volatility ofEl Salvador related to the fluctuations in the same index of the United States.As we will observe, there was a cointegration of series between El Salvador andthe US inflation before the US dollar was adopted in 2001 as the main currency. The methodology to follow is to gather monthly data from 1996 to 2010, andwork with the logarithm percent change. The data will be obtained from differentsources such as central banks, IMF, ecowin Reuters, etc. We will observe how the adoption of the US dollar in El Salvador helped tocontrol the volatility of inflation. Consequently, better and more secureinformation became available. Now, the volatility of inflation follows a patternthat can be studied and this is a necessary condition to attract foreign directinvestment to the country. Also, we will observe that the existence of volatility ofinflation in El Salvador is mainly due to a variance in the consumer prices of nontransactable goods.Advisor: Antonio Moreno Ibañez*Department of Economics, Universidad de Navarra, Pamplona, Spain. E-mail :† I would like to thank Carlos Carcach because he showed me the path to be followed. To my advisorAntonio Moreno for all the help and guidance provided. To my director and all my professors of themaster, because they taught me the few things I know about economics. Finally special thanks to myparents, family, and friends who were constantly supporting me.
  2. 2. Content Page1. Introduction 2 1.1. El Salvador 32. Model 63. Data 64. Results 75. Conclusion 96. Tables and Figure 11 2
  3. 3.  Introduction Dollarization is the process by which a country leaves its own currency andadopts a more stable currency as its main legal currency. When a country takesthe decision to dollarize it adopts the monetary policy of the Federal Reserve ofthe United States with the objective of have more stable cycles of devaluationand inflation. To use the US dollar drastically reduces the exchange and marketrisk, it reduces transaction costs for goods and services in the internationalenvironment, and it is easier to accountability evolved in the international ambit.The supposedly reduction in the nominal interest rate will attract more foreigndirect investment and consequently growth. On the other hand the welfare costs of dollarization, relative to the optimalpolicy, are due to both the fixity of exchange rates and the loss of seigniorage.Seigniorage is the difference between the value of money and the cost toproduce it, or in other words, the economic cost of producing a currency within agiven economy or country. If the seigniorage is positive, then the governmentwill make an economic profit; a negative seigniorage will result in an economicloss. For example, if to a central bank the cost of produce a bill of one monetaryunit is 0.05 monetary units, the positive seigniorage resulting of 0.95 monetaryunits. The measured dollar loss of seigniorage may be associated with anincrease in social welfare. The implication is that computed seigniorage lossescan only be unambiguously interpreted as “real losses” to the economy if policycredibility problems are assumed away, a point that seems to have beenmissed in the debate. The fixity of the exchange rate eliminates the faculty of using the realexchange rate to avoid or reduce external shocks, and even the politicalinstability typical from our countries. To adopt a dollarization strategy does not guarantee the economic growthand stability. Have volatility of inflation been reduced with the adoption if the USas the main currency in El Salvador? 3
  4. 4. o El Salvador At the end of November 2000 the Salvadorian government approves theMonetary Integration Law. On January 1st 2001 all ATM’s were programmed togive dollars and all saving accounts were converted to the US currency. Theway to proceed is to peg a rate to debts, contracts, and financial assets. Whena country pegs its currency against another one, its inflation rate must convergetowards the inflation rate of this foreign partner because of the risk of losingcompetitiveness and current account imbalances.1 Additional perceivedadvantages of pegging the exchange rate include the potential reduction of thedevaluation risk and the default or sovereign risk (default or sovereign risk is thepossibility that a country will default on its external debt) of domestic interestrates, thereby lowering the cost of borrowing for both the government and theprivate sector and encouraging greater international trade.2 The decision to adopt the US dollar as the main currency is still in debate tosome economists. As we will observe, the inflation in El Salvador at the momentit dollarized was already below the media by year 1999 (see Figure 1). Theinflation since 1999 began to follow a similar path as the US. By the year thelaw was passed El Salvador’s inflation behave most likely to the US inflation,with the exception that the “shocks” seems to affect more El Salvador. In figure2 we can observe how after the US dollar was adopted as the main currencythe distance between the media is still the same as we can observe in figure 3.The intention of this paper is to try to explain the reason why the distancebetween the media is still the same. The Universidad Centroamericana (UCA) analyzed the economic situation ofEl Salvador during 2007 and they found out that 50.3% of Salvadoriansconsider that dollarization is the responsible for the increase in the cost of life.On the other hand, the next day the US dollar became the official currency rate,1 Hoarau, Jean-François; Blancard, Stéphane; and Jean-Pierre Phillipe. Testing for nominal convergencein the Central America area : evidence from panel data unit-root tests. Applied Economics Letters,16:11, 1171 – 1174 (2009).2 Hoarau, Jean-François; Blancard, Stéphane; and Jean-Pierre Phillipe. Testing for nominal convergencein the Central America area : evidence from panel data unit-root tests. Applied Economics Letters,16:11, 1171 – 1174 (2009). 4
  5. 5. the interest rate to lend money to consumption and mortgages fell from 17% to11%.3 We will observe that the Salvadorian belief about the dollarization increasingthe cost of living is in reality that the prices of non-transactable goods havebeen constantly increasing. Non-transactable are those that can only beconsumed in the economy they are produced; they can not be imported orexported. In other words El Salvador has an “internal inflation” that if removedfrom the calculation of the CPI we will observe how inflation is practically similarto the US inflation. In this matter what the authorities in El Salvador should bedoing is to apply policies that are intentioned to control this internal inflation andfinally achieve the objective of removing the volatility of inflation in El Salvador. In summary, the reasons why El Salvador adopted this monetary policystrategy was because at that moment, it seemed to be the faster way to enterinto the globalization race, a fast technique to leave behind the poverty, and toopen itself to the world. It was a time that coffee, sugar, and cotton, the principalgoods that maintained the economy during the 90’s went down. The economyneeded a reengineering and the manufactured goods came to play. When thelaw was approved, the intention was to create a high aggregated value of themanufactured goods. Since El Salvador is a very small country, with very littlethey could achieve what China has done until now, the problem was the worldcrisis that appeared. We can say that the dollarization was the logical step tofollow same as when a man marries a woman after years of dating. After all thepeg of 8.75 colones for 1 US dollar was done years before the law was passed.3 Tyler Maroney, Dolarización: Iniciativa para el Diálogo Político, International Journalists’ Network 5
  6. 6.  Model The way to proceed is to perform an ADF test to check for unit roots. As wewill prove, the inflation has a unit root and therefore is non-stationary. On theother hand by performing the unit root test in 1st difference we will observe howthe series becomes stationary. When all the variables are integrated of the same order, the second step isto estimate the model, also called a "cointegrating equation," and test whetherthe residual of the model is stationary. The next step is to prove that the inflation is stationary if we eliminate thenon-transactable goods. Take a look for instance a figure 4. The inflation isalmost stationary when we leave out energy. In El Salvador we will show howby applying a unit root test it is stationary at level difference. The last step is to show if there is cointegration between El Salvador and USinflation, even before the dollarization came into play. For this we will apply aJohansen Cointegration Test and this will prove that the dollarization was thelogical step to follow. This will also explain why the distance between the mediaof inflation is still the same even after the US dollar was adopted as the maincurrency. The purpose of the cointegration test is to determine whether groupsof non-stationary series are cointegrated or not. EViews implements VAR-basedcointegration tests using the methodology developed in Johansen (1991, 1995).  Data The data we will be working with consist of 175 variables corresponding tothe monthly inflation from January 1996 to July 2010. The data is obtainedfrom Reuters EcoWin where the logarithmic percent change between each timeperiod is applied. The data for the calculation of inflation in El Salvador bygroups is the logarithm percent change and was obtained from El Salvador’scentral bank. 44 FuenteDirección General de Estadística y Censos (DIGESTYC) 6
  7. 7.  Results When you are estimating a model that includes time series variables, thefirst thing you need to make sure is that either all time series variables in themodel are stationary or they are cointegrated, which means that they areintegrated of the same order and errors are stationary, in which case the modeldefines a long run equilibrium relationship among the cointegrated variables.Therefore, a cointegration test generally takes two steps. The first step is toconduct a unit root test on each variable to find the order of integration. In thisexercise the unit test root will be perform through an Augmented Dickey-FullerTest. As we will observe some variables are non-stationary then we will have toperform a first difference in order to fix the problem of stationarity. The ADF statistic value is -2.540701 and the associated one-sided p-valueis 0.1077. In addition, EViews reports the critical values at the 1%, 5% and 10%levels. Notice here that the t-statistic value is greater than the critical values sothat we do not reject the null at conventional test sizes. As we can observe, all the ADF statistic value is higher than the respectivecritical values at all levels. Then we do not reject the null hypothesis so we saythat the time series variables are non-stationary (see table 1). We must dodifferences of first or second degree until we are able to find stationarity (seetable 2). As we observe in the tables by running the ADF test using the first differencefor each variable the ADF test statistic is smaller than the critical values at alllevels. Then we can say that the variables were integrated of first order. Engle and Granger (1987) pointed out that a linear combination of two ormore non-stationary series may be stationary. If such a stationary linearcombination exists, the non-stationary time series are said to be cointegrated.The stationary linear combination is called the cointegrating equation and maybe interpreted as a long-run equilibrium relationship among the variables. 7
  8. 8. The purpose of the cointegration test is to determine whether groups of non-stationary series are cointegrated or not. EViews implements VAR-basedcointegration tests using the methodology developed in Johansen (1991, 1995). As we can observe in table 3, the first block reports the so-called tracestatistics and the second block reports the maximum eigenvalue statistics. Foreach block, the first column is the number of cointegrating relations under thenull hypothesis. In our case we do not reject the null hypothesis that the seriesare cointegrated. Both, trace test indicates 1 cointegrating eqn(s) at the 0.05level and Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level. 8
  9. 9.  Conclusion The adoption of the US dollar as the main currency in El Salvador was ameasure proposed by the executive power and approved by the legislation inless than 10 days. Historically the country has a trajectory of economic stabilityinterrupted only during the 80s by a social crisis that ended up in a civil war.Nevertheless when in 1992 the peace agreements were signed, the economyhas enjoyed economic and financial stability. In other words, the dollarizationwas presented as a way to participate in the globalization race, leaving backpoverty and was not imposed by market “forces”. As we can observe, there existed a cointegration between the inflation of ElSalvador and the US. In fact, the exchange rate has been pegged for about 7years before the monetary integration law was passed. The dollarization was away to “take the next step”. The economic cycles of El Salvador and the UnitedStates are pretty much the same. As every inflation index, stationality is verysimilar in both countries. The cointegration that existed before the law waspassed led to both inflations to behave similarly. When in January 2001 the USbecomes the official currency, one of the consequences was the supposedlyreduction in the volatility of inflation for El Salvador and consequently, thereduction in distance between the media of inflation for El Salvador and the US,nevertheless by observing figure 3 and 4 we can see how the distancecontinues to be the same. Then we can say the there has not been a structuralchange in the behavior of the volatility of inflation for El Salvador. The reduction in volatility is a necessary condition to attract more foreigndirect investment and more secure and valid information in order to makeprevisions and therefore plans. In figure 4 we can observe how the behavior ofthe inflation in the US without taking into account the energy leads to almost acomplete stationary series. In El Salvador something similar happens. In figure5 we can observe the behavior of inflation by groups in El Salvador. The groupsconsist of: 9
  10. 10. 1 Food and non-alcoholic beverages 7 Transportation2 Alcoholic beverages, tobacco, and 8 Communicationsstupefacient3 Clothing 9 Recreation and Culture4 Shelter, water, electricity, gas, and other fuels 10 Education5 Furniture, articles for the home and ordinary 11 Restaurants and Hotelsconservation of the home6 Health 12 Diverse Services As we can observe in the graph, since the US was adopted in 2001, thegoods that have increase the most in a year have been twice: transportation,communications and education. While alcoholic beverages, tobacco, andstupefacient; shelter, water, electricity, gas, and other fuels; and furniture,articles for the home and ordinary conservation of the home have increased atthe most once. This means that El Salvador in order to have an almost perfectstationary series will need to take out the non-transactable goods in thecalculation of the CPI. In other words, since dollarization appeared El Salvadorhas encountered itself with an “internal inflation” due to the increase in prices ofnon-transactable goods. It could be that the exchange of “colones” to US dollarsis the guilty of this increase in prices, but is a fact that the common feeling ofSalvadorians have about the increase in the cost of living comes from the factthat non-transactable goods are more expensive than before. This is why thedistance of media between El Salvador and US inflation is the same, because insome things dollarization has actually helped to reduce the uncertainty andtherefore the volatility while it has created an internal inflation. It is still early to conclude if dollarization is good or bad. As mentionedbefore, dollarization is something new and it is very few things we know about it.What we can say for sure is that during the actual crisis, El Salvador hassuffered more than others because of the lack of its monetary tool. The lost ofseigniorage is an important loss of income to El Salvador’s central bank and theFED is not willing to share the revenues. Volatility of transactable goods hasbeen reduced while an internal inflation of non-transactable goods hasappeared; which is very harmful to local industry. The information made to doprevisions is now better and more secure. Finally, foreign direct investment hasbeen constantly increasing since El Salvador became dollarized. 10
  11. 11.  Tables and FigureFigure 1. Consumer Price Index of El Salvador and the United States Consumer Price Index 30 27 24 21 18 15 12 9 6 3 0 19 07 19 01 19 01 20 7 20 07 20 01 20 01 20 01 20 7 20 07 20 1 19 1 19 01 19 07 19 7 20 07 20 01 20 01 20 1 20 07 20 1 20 07 20 07 20 7 20 7 20 01 20 01 20 1 20 07 7 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 / / / / / / / / / / / / / / / / / / / 96 98 99 01 05 06 07 08 96 97 97 98 99 00 00 01 02 02 03 03 04 04 05 06 07 08 09 09 10 10 19 SV [log 12 months] USA [log 12 months] SV Media [12.167795] USA Media [7.60054778]Figure 2. Consumer Price Index of El Salvador and the United States after monetary integration law was passed 11
  12. 12. Figure 3. Consumer Price Index of El Salvador and the United States before monetary integration law was passedFigure 4. Consumer Price Index of the United States, total and without energy 12
  13. 13. Figure 5. Consumer Price Index of El Salvador by groups 0.7 0.65 0.6 0.55 0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0-0.05 2001 2002 2003 2004 2005 2006 2007 2008 2009 -0.1-0.15 -0.2-0.25 -0.3-0.35     1.1   Alimentos y Bebidas no Alcohólicas     1.2   Bebidas Alcohólicas, Tabaco y Estupefacientes     1.3   Prendas de Vestir y Calzado     1.4   Alojamiento, Agua, Electricidad, Gas y Otros Combustibles     1.5   Muebles, Artículos para el Hogar y para la Conservación Ordinaria del Hogar     1.6   Salud     1.7   Transporte     1.8   Comunicaciones     1.9   Recreación y Cultura     1.10   Educación     1.11   Restaurantes y Hoteles     1.12   Bienes y Servicios Diversos 13
  14. 14. Table 1. Unit test root in level difference for using ADF for El Salvador’s inflation 14
  15. 15. Table 2. Unit test root in first difference for using ADF for El Salvador’s inflation 15
  16. 16. Table 3. Johansen Cointegration Test for inflation in El Salvador and the United States Date: 09/01/10 Time: 02:53 Sample (adjusted): 2 175 Included observations: 174 after adjustments Trend assumption: Linear deterministic trend Series: SV_CPI USA_CPI Lags interval (in first differences): No lags Unrestricted Cointegration Rank Test (Trace) Hypothesized Trace 0.05 No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None * 0.088868 18.25844 15.49471 0.0187 At most 1 0.011796 2.064683 3.841466 0.1507 Trace test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Hypothesized Max-Eigen 0.05 No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None * 0.088868 16.19375 14.26460 0.0245 At most 1 0.011796 2.064683 3.841466 0.1507 Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values 16