DEVALUATION AND ITS IMPACT ON ECONOMIC GROWTH OF ETHIOPIA

DEVALUATION AND ITS IMPACT ON ECONOMIC GROWTH OF ETHIOPIA ODA BULTUM UNIVERSITY COLLEGE OF BUSSINESS AND ECONOMICS DEPARTEMENT OF ECONOMICS A Research Paper Conducted and Prepared By: Abdella Mohammed Ahmed (M.Sc.) And Submitted to Department of Economics TITLE: DEVALUATION AND ITS IMPACT ON ECONOMIC GROWTH OF ETHIOPIA JULY, 2024 CHIRO, ETHIOPIA ACKNOWLEDGEMENT My outstanding thank goes to Allah since He did great things for me throughout all my life progression. I am thankful for my advisor Assistance professor Debala Bonsa and Dr. Leta Sera for their tireless reading and commenting me starting from the proposal writing of this thesis which enabled and directed me to the completion of this paper. Without their intellectual comments and guidance this paper would not have such good shape. I’m also grateful for Mr Dawit Abdisa, And Dr. Yekin Ahmed. for assisting me when I working this paper in providing information of E-view software running, for helping me in providing some necessary material of reading, and intellectual comments. Moreover I am grateful for all my friends those who helped me in writing this thesis and other essential support. Lastly I am thankful for my mother Khadija Mohammed as her support and moral throughout my previous life time really enabled me reach on this achievement. My today level attainment is one of the realizations of what she had been envisioned for me at my early age and guided me through this triumphant life. 1 Acronyms ADF: Augmented Dickey Fuller BOP: Balance of Payment DCs: Developed countries DF: Dickey Fuller DGP: Data Generating Process DW: Durbin Watson ECM: Error Correction Model EPRDF: Ethiopia People Revolutionary and Democracy Front LDCs: Least Developed Countries IMF: International Monetary Fund MEDAC: Ministry of Economic Development and Cooperation MOFED: Ministry of Finance and Economic Development Ms: Money Supply NBE: National Bank of Ethiopia OLS: Ordinary Least Square REER: Real Effective Exchange Rate RGDP : Real Government Investment RPI: Real Private Investment TOT: Terms of Trade TGE: Transitional Government of Ethiopia 2 Abstract This paper uses annual data for the period 1980-2009 to investigate the impact of devaluation on economic growth of Ethiopia using time series econometrics techniques. According to the traditional theory, it is expected that devaluation of domestic currency generally decreases the relative price of domestically produced goods and thereby stimulate demand for domestic export. Hence, the devaluation of currency can be expected to have expansionary effect on real output in Ethiopia. So this study uses more rigorous empirical model and econometric methodology and examines the impact of currency devaluation on economic growth of Ethiopia. The empirical result finds it devaluation exerts negative impact on economic growth of Ethiopia. Key Words: Devaluation, Impact, Economic Growth 3 CHAPTER ONE 1. INTRODUCTION 1.1 Background of the Study Ethiopia is mainly known with her natural environments and the size of its population stands third in the continents. Nevertheless, the economic and the social indicators show that it is at last bottom in the world. It is significantly attributed to the man-made calamities (Such as civil war and poor economic policy), natural calamities (recurrent appearance of the drought) and external shocks (Sentayehu, 1996). The GNP per capita of the country was birr 217.97 in 1994 which was the lowest in the world. Infant mortality is 111 per 1000 and life expectancy is 16 years, health service covers only 45 percent of the population. Malnutrition is rampant with daily per capital claries of 1000 only, about 12 percent of the rural and 80 percent of urban population have access to the safe drinks water. The average growth rate of the real gross domestic product (RGDP) was about 2.21 percent from 1964-1995. The growth of population which was about 2.9 percent per annum was higher than of the real GDP. It indicated that the growth rate of per capita income is decelerating. It also depicted that the performance was less than the average developing and African countries (Getachew, 1995). The major underlying cause for decelerating of the growth rate of aggregate output was the poor performance agricultural sector that dominates the Ethiopian economy. It was the largest employer and foreign exchange earner. In contrast to its size the state of development of agricultural sector was abysmally low. It was characterized by large subsistence sub sector and extremely low productivity. The system did not implement high yield seed, fertilizer, and pesticides, etc and coupled 4 with backward agricultural land tenure system (Eshetu, and Mekonnen, 1992). If the process had continued without appropriate macroeconomic policy, its exports would have been declined and its reserved would have debited. The contractionary macroeconomic policy could be considered as remedy for overviewed currency, however, it entails casts i.e. reduction of output and employment. The other remedy for those outlined problem is to devalue the currency. The government adopted the second remedy as a solution in October 1992. In the post 1992 period was a period of a recovery and stabilization for the economy one of the major economic aims of the EPRDF regime, which come to power in May 1991, was the stabilization and adjustment of the distorted economic structure. In an attempt to cushion the escalating economic problems, the government declared a new economic policies and structural adjustment program component embracing a substantial correction of the overvalued nominal exchange rates, decontrol of any prices, liberalization of the foreign trade, autonomy of state owned enterprise and privatization of small and medium enterprises, financial market reform, liberal investment code with an investment authority that is organized as “one-stop shop” as opposed to command economic system to the previous regime. The private sector is presumed to play a leading role in the growth and development process of the country while the state is to be the facilitator and regulator of these activities (Befekadu, 1999). With such changeable policy environments, the growth rate of GDP had been positive for the periods 1991/92-2002/03 after the politically unstable year of 1991/92, it was only in the year 1997/98 and 2002/03 that a negative growth of -1.4% is and -3.8% was recorded respectively on average, the economy has been growing at about 4 percent for the 5 same period. However, the gains in growth of per capita terms during this period were just recoveries in fact the level of per capita real GDP did not repeat the highest level which had been achieved in 1982/83 (Berhunu and Seid, 2001). Therefore the concern of this study is to assess the impact of the second remedy: devaluation on the Ethiopian economy. 1.2 Statement of the Problem Like many African countries Ethiopia faced serious economic crisis in the mid 1970‟s and the entire decade of 1980‟s. This economic crisis has manifested itself in various forms such as social growth rate of GDP was (2.4 percent per annum in the period 1973 to 1985), negative growth rate of per capita income and increasing balance of payment deficit. Agricultural output growth rate was lower than population growth rate. Hence the country had to either in part basic necessities or to depend on external donations (Asmorem, 1992). However, after the fall of “Derge” a new government came to power in May 1991. The Transitional Government of Ethiopia (TGE), to mitigate the general economic problem, began implementing the comprehensive macroeconomic and structural reforms. Devaluation of the Ethiopian birr against the standard currency (dollar) was one of the under taken measure in order to stabilize the economy in October 1992, the birr was devaluated by about 142% in dollar terms i.e. from birr 2.07 /USD to birr 5.00/ USD. Since then, in the process, the exchange rate of birr has been depreciated overtime and reached to birr/USD=13.63. On September 1, 2010, for the second time, the birr was devaluated by about 20% in dollar term i.e. from birr 13.63/USD to birr 16.35/USD. The objective of devaluation, according to the TGE, stated to improve the current account balance. The rationale for the said objective was set as 6 most of the Ethiopian exportable items unlike other Africa countries can be used in domestic consumption (coffee, oil seeds and oil nuts) by making foreign markets more attractive than domestic market, the volume of export increase, to encourage the production of exportable by shifting resources from non-tradable to tradable by making exportable items cheaper (Sentayehu, 1996). There is hot controversy weather devaluation would result in improving the current account balance and make competitive in the external trade by increasing the volume of export, decreasing the import bills, eliminating market distraction and to have economic growth (MEDAC, 1997/8). Most studies revealed that devaluation will improve the balance of payment. But it has little ability to further objective of reducing inflation and stimulating growth (Killick khan and the world bank, 1993). Mostley, Harrigan and Toye undertook a study on the impact of devaluation in 1991. Their finding indicated that devaluation had no measurable impact on the real GDP, positive impact on export growth, and the balance of payment and negative impact on investment levels. The study conducted by Edward (1986), show that devaluation is contractionary in the first year and the effect is completely reversed in the second year. According to these estimates, devaluation is neutral in the medium to long run. Therefore the studies described above show that there is divergence in effectiveness of devaluation on the growth of the economy. Thus this study will attempt to examine the contribution of devaluation in the trade balance and the impact of devaluation on economic growth. 7 1.3 Objective of the Study The general objective of the study is to evaluate the impact of devaluation on the growth of the Ethiopia economy. The specific objectives of the study are: To identify the contribution of devaluation on trend of trade balance.  To examine the relationship between devaluation and GDP growth.  Based on the results it tries to provide important recommendation and to predict about the impact of current devaluation on Ethiopian economic growth. 1.4 Methodology and Data Source Data Type and Sources To achieve the above mentioned objectives of the study, the paper employed only secondary data which are obtained from various publications of National Bank of Ethiopia (NBE), Ministry of Finance and Economic Development (MOFED), Central Statistical Authority (CSA) and Ethiopia Investment Authority. The data on Gross National Product (GDP) and terms of trade are obtained from National Bank of Ethiopia (NBE) and Central Statistical Authority (CSA). National Bank of Ethiopia (NBE) and ministry of Finance and Economic Development are the source for data on Export, Import, money supply (Ms) and Real Effective Exchange Rate (REER). The data on Real Private Investment and Real Government Investment are collected Authority. 8 from Ethiopia Investment Method of Data Analysis The data collected from those sources can be analyzed by using both descriptive statistics and time-serious econometrics. The descriptive method of data analysis is based on the empirical data using percentage, tabulations and graphs. In addition to the descriptive method, the time serious data will be used to analyze the impact of devaluation on economic growth and to choose a set of variables that determine Ethiopian economic growth. 1.5 Significance of the Study It is known that the performance of the external economic sector was less competitive during the military regime. This can be attributed to the bad policies followed by the then government. Fixing the exchange rate without taking into account the value of birr (over valuation of currency), and restriction of the private sector from taking part in the foreign trade sector are some of the major bad policies. To avert bad condition created by these policy instruments, the government of Ethiopia has taken much reform. Among which, devaluation is one which aimed to promote the external balance via promoting export and discouraging imports. Now some years have passed after the introduction of devaluation and an assessment is necessary to be made so as to evaluate the impact of devaluation on economic growth of Ethiopia. Having this in mind a brief discussion is going to be made on the chapter that follows. 1.6 Limitation of the Study The major limitation from this study is, since the study is entirely depend on those secondary data which are collected from different 9 organizations, the process has faced some challenges due to luck of timely published essential documents and even availability of the existed one. In addition to this, the financial and time constraints are another limitation to the study. 1.7 Organization of the Paper The remaining part of the paper is organized in six chapters. Chapter two reviews the theoretical and empirical aspects about the relationship between devaluation and economic growth, particularly in the Ethiopian economy. The third chapter will be about result of the study, which covers descriptive method. The forth chapter is about the result of a study, which covers econometrics method. The fifth chapter, which covers econometrics analysis. The last chapter will be the conclusion and recommendation. 10 CHAPTER TWO 2. LITERATURE REVIEW 2.1 Theoretical Literature Review 2.1.1 Theory of devaluation There are three approaches to see the effect of devaluation on the current account. These are the elasticity approach, the absorption approach and the monetary approach. 2.1.1.1 The elasticity approach The elasticity approach is the change in the trade balance resulting from a depreciation or devaluation and depending on the price elasticity of demand for the nation‟s exports and imports. In this approach, only relative commodity prices were considered important to determine the possible effectiveness of devaluation. All that was considered necessary to know the price elasticity of the demand for and supply of goods and services imported and exported by a country (Mannur, 1983). The elasticity approach makes use of the Marshal Learner condition i.e. Ex + EM > 1, where Ex is the elasticity of demand for the devaluating country‟s export and Em is its elasticity of demand for imports. But using the elasticity approach to see the impact on export and import of a devaluating country is not without limitation. First, it assumes point elasticity; however there may be a non-marginal devaluation care which improves the balance of payment. Second, the marshal-Lerner condition uses fixed demand and supply curves contrast to this, the income effect of marginal devaluation are not negligible (Sodersten and Reyree, 1994). The above mentioned limitations may not inhibit form using the elasticity approach. That is some adjustment is possible by assuming arc rather 11 than point elasticity and through the action of government to neutralize the income effects. It is argued that elasticity of both demand and supplies arc responsive in the long run than in the short run. This implies trade volumes will take some time to adjust to their new equilibrium position. Thus it seems that the Marshall Lerner condition is satisfied in the long run than in short run. In other words, devaluation may worse the condition of the balance of payment initially. This can be clearly showed using what is called the J-curve effect (Ibid). Surplus Time Deficit J – Curve effect Table 2.1 If Marshall-Lerner condition is not satisfied in the long run either, then the graph shown above fatten out at a deficit greater than that before devaluation. 12 2.1.1.2 The monetary approach The monetary approach says that any improvement in the balance of payment brought by devaluation is transitory and disequilibrium in the money market is a prime cause for the disequilibrium settled in the balance of payment (Sodersten and Geoffreyree, 1994). This can best explain in the diagram that follows. Money PPP Price As1 M (D1) M2 P2 P2 M1 P1 P1 M (D1) R1 R2 Reserve Y1 Real Income E1 E2 Exchange rate Table 3.2 Devaluation under the monetary approach Suppose the domestic currency is devalued, so that the exchange rate becomes E2, as a result domestic goods become competitive and hence the demand for domestic currency bids up both domestically and abroad. That calls for the demand for money to shift to M2. This also created a surplus of balance of payment that causes domestic currency to appreciate but to reserve such trends concerned parties may like to purchase foreign currency. But that increases the level of reserve and hence the money supplies. The increment in the money supply will shift prices upward and such trend continues till price equals to P2 where money supply and demand are equal at M2. 2.1.1.3 The absorption approach The absorption approach, developed by Sidney Alexander, takes a macro approach to the question of devaluation. Alexander thought that the 13 conventional micro approach is in adequate in so far as it ignores the income effect of devaluation. Devaluation affects domestic economic variables such as consumption, investment and national income, and this has to be taken into account predicting the results of devaluation on the Bop situation of a country. This is denoted algebraically as follows. Y= C+Id+G+X-M ………. National income equation ………. (1) Equation (1) can be rewrite as X-M=Y - (C+Id+G) ……. (2) Where G= government budget deficit C= consumption expenditure Id= Investment expenditure X= Export M= Import (X-M)= Trade balance (net export) Equation (2) can further be written B= Y-A Where- B-denotes trade balance (net export) - A- absorption of the economy (C+Id+G) Some components of absorption will be affected by output indirectly through the act of devaluation while other components are directly affected by devaluation. Such components are denoted in equation directly affected by devaluation. This is algebraically shown by da= ady+dD But the change in current account due to devaluation is given by dB= dydA. Then dB = dy – ady – dD = (1-a) dy – dD. NB: “a” = Marginal propensity to absorb lies between “o” and “1” 14 2.1.2 The link between devaluation and economic growth There was no serious controversy over the possible effect of devaluation or economic growth until the Late 1970s. The dominant view up to that period was that devaluation would improve trade balance, alleviate balance of payment difficulties and accordingly expand output and employment. The mechanism behind these positive effects is that devaluation switches demand from imports and makes export industries more competitive in international market by stimulating domestic production of tradable goods and inducing domestic industries to use more domestic inputs (Christopoulos, 2004). The most traditional argument in favor of negative effect of real appreciation up on economic growth it based on the assumption that real exchange rate appreciation deteriorates the competitiveness of enterprises vis-avis their foreign competitors and therefore and therefore decrease exports. This deterioration diminishes thus the profit of the export sector in favor of service and agriculture, largely protected from foreign competition. It decreases industrial self-financing and the will to invest in the industrial sector and more generally in the tradable good sector. If the tradable sector is the most efficient and innovating, real appreciation may act negatively on growth, beyond its impact on mainly exporting firms. Real appreciation is particularly bad for growth in developing countries because it doesn‟t allow promoting the small and in efficient tradable sector, which suffer disproportionately from the institutional and market failure (Rodrik, 2008). The issue of devaluation has long been a major item in the economic and political agendas of LDCs. These countries needed to devalue their currency for a verities of reasons, including correcting the price of distortions and getting the price for the market forces to function properly and changing the relative price of traded to non-traded goods, 15 hence increasing competitiveness in the foreign markets. As a result, it would be possible to decrease foreign trade difficult and improve the balance of payment and above all, to achieve available economic growth. Needless to say, increasing the rate of growth of output is a crucial for economic development output growth is essential for LDCs in order to raise national income per capita, achieve high standard of living for their population and close the development gap between themselves and the industrialized countries (Nwanna, 1994). 2.1.3 The Link between Devaluation and Output There are two views regarding the relationship between devaluation and output. The first one is the traditional view that is optimistic in a sense that it is expansionary rather than being contractionary. The reasons in favor of this argument are devaluation promotes production of tradable, it has expenditure switching effect, higher export and in an improvement of the external position of the country in question. From analytical point of view, devaluation can affect the real sector of the economy through a number of channels. This theory also argues that devaluation will either have an expansionary effect on aggregate output, or in the worst of cases it will leave aggregate output unaffected. If there is utilized capacity, nominal devaluation will be expansionary, and total aggregate output will increase on the other hand, if the economy is operating under full employment, the nominal devaluation will be translated into equiproportional increases in prices with the real exchange rate and aggregate output will not be affected (Sentayehu, 1996). The other view is that, devaluation has contractionary effect through a number of channels one is redistribution of income from those with high marginal propensity to consume to those with high marginal propensity to save. The other way through which devaluation has contractionary effect arises from temporary disequilibrium in the money market. As 16 devaluation entails high inflation, it in turn calls for high demand for money and people prefer to hold financial asset to hold goods. But that had adverse impact in the demand for goods. In contrast to this, devaluation also motivates the production of goods domestically through a number of channels. One instance is the condition of acute shortage of foreign currency, which link domestic production that involves extensive use of imported intermediate goods. However, devaluation can be taken as remedy for the shortage of foreign currency through the promotion of export (Ahamed, 1988). The link between devaluation and output can also be seen from both the supply and demand side of the economy on demand side, devaluation will increase the price at which tradable goods are sold items of domestic currency and decline their price in terms of foreign currency; in short it increases the demand for tradable goods. The effect of devaluation on non-tradable goods is less clear. Demand for such goods emanates from domestic private consumption, private investment and public sector spending (Maria, 1989). Even if devaluation has a contraction effect on non-traded goods, these effects can be offset by a number of contrary factors. The wealth effect would weaken if the privates sector‟s assets were indexed to the price level. In addition, its effect on trade reduces to some extent through a decline in the real value of other taxes because of the rise in prices and a lag into tax collection. With regard to private investment, the effect of devaluation lowers as the price of outputs bid up in the same direction that of the price of imported capital and intermediate goods. The effect will also weaken further as the real wage is likely to fall and that induces and increase in capital expansion (Ibid). On the supply side, devaluation brings about an increase domestic price of imported inputs and in nominal wages in both sectors. The price of 17 imported inputs rises by the same proportion as the devaluation. The net effect of demand and supply are likely to favor products of tradable goods despite the rise in the production cost. But this assumes the increase in nominal wage should not be excessive with regard to its effect on the supply side of non-tradable goods, its outcome is less obvious. It depends on the initial distortions and specific restriction that follows it (Ibid). 2.1.4 Devaluation and investment Devaluation affects investment through many channels. Firstly, devaluation alters the real supply of capital goods. Secondly, it affects the real price of imported inputs, which are used in conjunction with capital goods to produce output. Thirdly, devaluation has an impact on the real product wage and thereby affects profitability and investment. Fourthly, a devaluation produce changes in real income, which affects the demand for domestically, produced goods. Finally, devaluation affects nominal and real interest rates which in turn have an impact on investment (Chibber and Shafik, 1990). The net effects of devaluation on investment will therefore, be a composite of several factors and is theoretically indetermination. The short versus long-term effects of devaluation on private investment can go in opposite directions. Even if the short run effects of devaluation are negative because of increase in the real cost of imported capital and inputs and contractionary demand effects of devaluation. The long run effects on private investment still are positive as the economy respond to increased competitiveness. It is necessary to review the effect of devaluation on private investment in a macroeconomic context. If devaluation is to achieve in primary objectives of improving the trade balance, then for a given level of output, domestic demand must fall 18 Y = Cp + Ip + Cg + Ig + (x-m) Where Y = Fixed output level Cp= private consumption Ip= private investment Cg= government consumption Ig= government investment X= Export and M= Import For fixed output level (Y) an increase in private investment (Ip) is possible only if public expenditure (Cg + Ig) falls by more than the improvement in the trade imbalance (X-M). If aggregate output falls, the short run effect on private investment is likely to be negative. On the other hand if the effect on output of devaluation is positive due to a strong and rapid response. Form the tradable goods sectors; these negative effects can be avoided. Even if these positive effects are not large enough to the short run because of a weak supply response, the long run effects need to be (Gaylor, 1971). Finally the possible outcome of devaluation which is not given much emphasis on many literatures is its psychological risky ness. To the extent that devaluation is viewed as a sign of economic weakness, the credit worthiness of the nation may be jeopardized. Thus, devaluation may dampen investor confidence in the country‟s economy and hurt country‟s ability to secure foreign investment (Davis, 1998). 2.1.5 Inflation and devaluation There is a wide accepted consensus that inflationary situation set in following devaluation. The reason is that it increases the price of tradable goods in terms of domestic currency and the price of local goods manufactured which use imported intermediate inputs. As the price of 19 machines and imported intermediate input bids up in terms of domestic currency, it is no surprise that the price of these manufactured goods goes up. But that calls for the shifts of consumers to non-tradable goods away from tradable and non-tradable goods which uses imported intermediate inputs. To this effect most developing nations are increasingly aware of keeping their external competitiveness via devaluating their currency so as to make their export cheap in the world market. But such targets are possible if a nominal devaluation brings about the desired rate real devaluation of currency. But such act is not always possible mainly because of the inflationary situation set in following devaluation. Such situation are particularly sever for small open economies as it brings inflation as a permanent feature and even under some particularly circumstances leads to hyperinflation (Maria, 1989). Devaluation is inherently inflationary. The impact is transmitted to domestic price both directly through the higher price of imports (consumer goods, fuel row materials and spare parts) as well as indirectly through the higher demand arising from tradable sector. The pass through would be higher the lower the elasticity of demand for imports and import substituting goods (Befekadu and Kibre, 1992). In favor of this Singh (1983) indicated the following. The Chicago and Cambridge schools of economics which normally have very different views about the functioning of the economic system do agree on one point that the general is not a suitable method for structural change and that its major consequence is to generate inflation. The reasoning in each case if off course different (Singh, 1983). 20 2.1.6 Nominal devaluation and aggregated demand Krugman and Taylor (1978), identified three different factors of the contractionary effects of a devaluation on aggregate demand and, therefore, output. a. If imports initially exceed exports, a nominal devaluation causes the foreign currency payment to exceed receipts thus reducing the real income at home and increasing it abroad. The larger the initial trade deficit the greater the contractionary outcome. b. Secondly, they note that if foreign trade is initially in balance, devaluation raises prices of traded goods relative to home goods, giving rise to wind fall profit in exports and import-competing industries. If money wage lag the price increases and if the marginal propensity to save from profit is higher than form wage, national saving goes up thus reducing aggregate demand and therefore output. c. Thirdly, they argue that if there are existing advalorem taxes on export and imports; devaluation redistributes income from the private sector to the government which has a marginal propensity to save close to unity. This reduces the aggregate demand. Bird (1983), in addition to the above factors cites a fourth channel through which devaluation may cause a reduction in aggregate demand. Devaluation raises the domestic currency costs of servicing any given external obligation expressed in foreign currency. In countries with large volume of debt and high interest payment, devaluation may enhance domestic expenditure reducing effect and thus output. 21 2.1.7 Nominal devaluation and aggregate supply Wijinbergen and Edward (1986), identified three channels through which a devaluation can result to contractionary through aggregate supply. Wijinbergen points out that a contraction through the aggregate supply may be worse than the one through the aggregate demand because of inflationary effect while a reduction of the aggregate demand abate inflation. The various channels are:a. Devaluation in the presence of intermediate imports increases the cost of production of local firms. The increased cost of production may force some of the firms to cut their production thus reducing the aggregate supply. b. If devaluation leads to inflation, the real volume of credit from the banking sector is reduced. Whatever the source of working capital, devaluation that is inflationary reduces the real value of working capital and may have adverse effect on output. c. A third channel that may lead to a cut on aggregate supply is if real wage is indexed on imported consumer goods. Since devaluation may cause a rise in the price of such products, it may result in agitation of higher real wages. 2.1.8 Devaluation, current account deficit, and growth One of the most important objectives of devaluation is to improve a country‟s international competitiveness and foreign reserve. Devaluation, by increasing the price of traded goods, i.e. the price of export in domestic market and increasing the price of imports, creates conductive environment to increase the supply of exports and decrease the level of imports. The ultimate result of this depends on the elasticity of import and export demand (Plane, 1990). 22 The significance of variation in elasticity varies from country to country. Developing countries which rely heavily on a single product and the price of which is quoted by a foreign currency, devaluation fails to reduce this price and the export elasticity of demand. Therefore, it is largely irrelevant. Devaluation raises the domestic currency price and the profitability of exporting, there by imposing the importance of the elasticity of supply (Sentayehu, 1996). The impact of devaluation on export depends on slack in the export sector, capacity utilization, investment (including crop expansion, diversification, and gestation period), etc. While the increase in domestic currency price are necessary, they are definitely not sufficient to increase the volume of exportable other factors such as investor uncertainty, expectation formation, availability of modern inputs, etc, are as, if not more important as “getting price right”. Most importantly, the speed of responses is of crucial significance. Where adjustment is not quick, the inflationary impact of devolution undermines the real exchange rate thus invalidating the comparative advantage it is expected to enjoy (Befekadu and Kibre; 1998). Another factor that would affect export prices are international prices. Where the latter are depressed, the domestic currency price increase is likely to be a once-and for-all phenomenon unless the initial devaluation is followed by another and/or policies such as subsidy or tax reduction are instituted to make up for diminishing benefit. But subsidy and tax reduction would have implication for reducing government deficit. In the short to medium run, both imports and import substituting goods are unlikely to respond to changes in prices, given the structure of the economy. If the policy succeeds in decreasing imports this is likely to reduce capacity utilization and therefore output growth. Thus the 23 decrease in current account deficit would be at the cost of the growth of the economy (Ibid). With regard to imports, it is highly improbable that any developing country will be able to influence the foreign price of its imports. Since its demand for particular import will represent only a small fraction of the total world demand for the producer. The domestic price of imports may not rise to the full extent of devaluation if devaluation is accompanied by the removal of import controls that has previously maintained import prices at artificially high levels. Even in a country which has dual exchange rate and the parallel market largely dominates the foreign exchange market; devaluation may not change the imported price in domestic price (Sentayehu, 1996). 2.2 Empirical Literature Review The evidence regarding the impact of devaluation on real economic activity is mixed: while some studies suggest that devaluations have an expansionary effect, other indicates that they generate a contractionary in the economy. 2.2.1 The Effect of Devaluation in Developed Countries R.S Cott Hacker and Abdulnasser Hatemi (2004) tasted the trade Jcurve for three transition central European countries the Czech Republic, Hungary and Poland in their bilateral trade with respect to Germany. They find that three are some characteristics associated with a J-curve effect for each country after a real or nominal depreciation the export ratio briefly drops to below its initial value within a few months and then rises to a long run equilibrium value higher than the initial one. Connally (1983) considers a group of 22 countries and regresses the change in the rate of real growth on the change in the nominal exchange 24 rate. The coefficient obtained was positive and marginally significant providing some support to the hypothesis of expansionary devaluations. Gylfason and Risager (1984) have developed a model for a small country, which stresses the impact of devaluation on interest payments on the foreign debt. Using the imputed parameter data, Gylfason and Risager suggest that while devaluation is generally expansionary in Dcs. Study made by younger (1992) approved that nominal devaluation leads to an equally proportional rise in price in countries which follow free market economy continuing his assertion he said once equilibrium exchange rate is established, nominal devaluation causes price to rise by the same amount of the change in nominal devaluation. While for the case countries where the economy permits only limited competition, he explained that nominal devaluation would not bring an equally proportional rise in price. The reasons for such occurrence are two. First, if the supply side of the foreign currency is considered, official exchange rate are highly overvalued and their market allocation has very little to do with market prices. Second, if the demand side is taken into account, quantity restriction clears the market for foreign exchanges. Hence nominal devaluation of currency may not have direct relation with prices. In addition to the above mentioned reasons, nominal devaluation may not have much impact on domestic price level even if it increases the price of tradable because much of such items for example minerals are not given due attention in local consumption basket. Tumorsky (1981) analyzed the effect of devaluation under the condition of rational expectations. According to this study, real output is responsible to the unanticipated component of change in exchange rate. In the short run devaluation which is under predicted will lead to a less than proportionate increase in the price of domestic output, together with an expansion in the real domestic activity. A devaluation which is 25 over predicted will lead to a more than proportionate increase in the price of domestic output, causing the level of domestic output to fall. A correctly anticipated devaluation will lead to an exactly proportionate increase in the domestic price level, leaving the level of domestic really output unaffected. Thus it is possible for devaluation to have a perverse contractionary effect on the economy and this will be the case if it does not measure up to previously held expectations. Gylfodan and Schmidf (1983) have constructed a small macro model with intermediate goods, where devaluation has two conflicting effects. On the one hand, they generate an expansion through aggregate demand; on the other hand, devaluation results through its effect on the cost of imported intermediate inputs in an upward shift in aggregate supply schedule. The implications of the models are analyzed by importing plausible values to the corresponding parameters for a group of five developed countries and five developing countries with the exception of the United Kingdom and Brazil, these results suggest that, as postulated by the traditional theory, devaluation have a positive effect on aggregate output. 2.2.2 The Effect of Devaluation in Developing Countries Rodrik (2008) provide evidence from 184 countries over eleven 5- year period from 1990-54 through 2000-24 and analyzed the effect of under valuation and over valuation of currencies on stimulating economic growth. He concludes that overvaluation hurts growth while undervaluation is good for growth. For most countries, high growth periods are associated with undervalued currencies. Also he noted, there is a little of nonlinearity in the relationship between a country‟s real exchange rate and its economic growth. He represented that an increase in undervaluation boosts economic growth just as well as a decreasing in overvaluation. But this relationship holds only for developing countries. The relative price of tradable to non tradable (real exchange rate) seems to play a more fundamental role in the growth process. 26 Sheely (1988) found that devaluation have a negative impact on output for 16 Latin American countries while Nunnenkamp and Schweickert (1990) rejected the hypothesis of contractionary devaluation and found a positive relationship between currency devaluation and output expansions. But Upadhyaya (1999), did not find any significant long run effect of currency devaluation on aggregate output for 4 out of 6 Asian countries while he found contractionary effect for two countries. In addition Christopoluos (2004) investigated the effect of currency devaluation on output expansion in a sample of 11 Asian countries over the period 1966-1949. He found that, in the Long run in out of 11 countries and for the panel as a whole, depreciation exerts a negative impact on output growth while for 3 countries depreciation improves growth prospects. Edwards (1988) examined the effect of depreciation on production in 12 developing countries during 1965-1980 using the following regression. Log Y a + Y1 time + B1 Log GE/y + B2 (∆ Lag M – ∆ log Me) + B3 Log ToT + B4 Log REt + Ut In which Y is the real aggregate production, trend rate of real growth rate. GE/Y ratio of nominal government spending, ∆ real rate of nominal money growth, ∆ log Me expected rate of nominal money growth. ToT term of trade, RE real exchange rate and u error term. He concluded that depreciation of money had contracting effect on production in short run, expansionary effect after a year and nothing in long run. The author cited theoretical and logical reasons as follows, undervaluation of currency leads to increase in the price level, decreasing effect on household consumption spending (Pigou effect), and redistribution of income from low to high saving rate, deteriorating trade balance and creating stagnation. All of these caused to reduce aggregate demand production. In addition to these 27 demand side effects, currency undervaluation would influence supply side via increasing import inputs prices, decreasing aggregate supply and finally reduction of production. Kruger (1972) discovered that the effect of devaluation on economic growth depends crucially on what happened to export earnings through she found very little evidence to suggest that devaluation leads to severe recession of prolonged duration. In a study of 8 LDCs, over the period of a two year post devaluation period, Connany and Taylor (1976) found that prices of traded goods rose by an amount approaching the extent of devaluation whilst prices in general rose by less than half as much. In this study, a nominal devaluation was found to be inflationary. Similar results were obtained in the case of Turkey by Bnis and Uzmueur (1990) who employed an interactive three stage least squares procedure using monthly data for the period January 1981 to December 1987. In the case of Turkey the devaluation for 35% of the inflation during the period of study. Bragwat and Onisuka (1974) after having an empirical study in 46 Africa countries which devalued their currencies, conclude that imports continued to grow after devaluation and in majority of cases, the growth rate exceeds the devaluation growth rate i.e. conditions that requires the elasticity of export and import demand to be more than unity is not satisfied. This is because of the very strong demand for imported necessities and inelastic foreign demand for Africa export. Thus, with relatively in elastic demand for export and import, devaluation has little or no effect is changing trade balance in the context of Africa countries. In the world Bank study (1993) essentially using before and after approach, out of twenty-nine sub-Sahara Africa „adjusting‟ countries fourteen had an improvement in GDP growth, whereas fifteen had showed a decline between the period 1987-1991. The World Bank study 28 further confirms that in almost all cases, rate of growth, investment and saving were not at levels required to sustainable development. Using data from the period 1956-89, Balassa (1989) analyzed subSahara Africa (SSA) countries economic performance in general and agriculture exports in particular. He found that a one percent change in the real exchange rate is associated with a 0.8 to 1 percent change in the ratio of exports to output SSA countries. Balassa also found that the response of the export-output ratio to the real exchange rate changes for SSA countries is higher than for other parts of the world. His evidence of an export shares argues against the prevailing pessimistic view export position using a CGE. (Control group approach and econometrics approach) model for two Africa counties, Madagascar and Niger. For Kenya, Branson (1986) has developed a small simulation model which suggests that contrary to the traditional view, devaluation will have important contractionary effects. Bransons model is one picturing an economy with two sectors. One producing agricultural products that are exported and not consumed domestically and has a low output elasticity (this is the case with nearly all of Kenya‟s major export cropscoffee, tea and sisal). The second sector produces non traded export goods using domestic factors and imported intermediate inputs, all of which have low elasticity of substitution among them. In the event of a terms of trade shock such as the one of 1979-1980. Bronson argues that the appropriate policy would have been a reduction in absorption rather than devaluation with low levels of wage indexation, the absorption cut will have a much smaller effect on investment incentives and avoid inflationary consequences associated with a devaluation which will enable the country to maintain non-indexed wages. He concludes that devaluation may not be on appropriate component of a stabilization program in countries such as Kenya with an elastic supply of exports 29 and with intermediate imports. He, however, argues that devaluation would be the appropriate policy for liberalization. According to the study conducted by Abent (2004) using export and import data from 1980/81-2000/01 and found that the long run static media of export function responsiveness of export for a unit change in real effective exchange rate (i.e. export elasticity) highly statistically significant (2.148) while the long run static model of import function the responsiveness of imports for a unit change in real effective exchange rate (i.e. import elasticity) highly statistically insignificant (-1.838) has no strong relation. Thus the sum of the two demand elastics in absolute terms is 0.31 that is devaluation would result in worsening trade balance accordingly marshal Lerner condition (MX+MM>1) to Ethiopia export and import for the period 1980/81-2000/01 does not full filled. Befekadu and Kibre (1994) analyzed the impact of devaluation on the supply of coffee. According to them the supply response of coffee to devaluation is not exciting in the short to medium run because of its gestation period which at the minimum, extended over three years. Second and most importantly, expected increase can materialize only if we assume farmers price expectation to run a head of four years or more. Given the host of uncertainties over hanging in the production process of such perennial crops and experience of farmers regarding price volatility, such an assumption is an over stretched one. 30 CHAPTER THREE 3. EXCHANGE RATE POLICY AND PERFORMANCE OF FOREIGN TRADE OF ETHIOPIA 3.1 An overview of exchange rate policy in Ethiopia Exchange rate policy involves choosing as exchange rate system and determining the particular rate at which foreign exchange transactions will take place. A country‟s exchange rate policy affects its relative price structure in domestic currency terms between goods which are traded internationally (tradable) and goods which are produced, for the domestic market (non-tradable). Moreover, exchange rate policy will affect the overall level of domestic price. For these reasons, the particular exchange rate system and exchange rate level selected will have a widespread impact on the entire economy. In this part, we will attempt to review exchange rate policies and exchange rate premium of Ethiopia. 3.1.1 Exchange rate policy Before 1973 Ethiopian‟s exchange rate policy was in consonance with international monetary fund (IMF) par value system. The exchange rate was 2.48 Eth. Dollar per US dollar from July 23.1945 to December 31, 1963 on January 1st it was devalued to 2.5 Eth dollar per us dollar (Jamin, 1994). During the late 1960‟s, the relevance of the par value monetary system based on us dollar come under question. The US dollar was floated and ceased its convertibility to gold in December 1971. This situation led to the devaluation of the U.S dollar by 79 percent in December 1971 under Smithsonian agreement, gold price rose from $35 to $38 per ounce. The 31 Ethiopian dollar however remained unchanged in terms of gold. This is effect meant a defacto revaluation of birr in terms of dollar. Consequently, the Ethiopian birr exchange rate changed to 1 U.S dollar equal to 2.30 Eth. Dollar (Almost 7.4 percent revaluation in terms of Eth. Dollar). This rate served for the year 1971 and 1972. Not long after, however, the US dollar once again came under pressure and was devalued by 10 percent. The Ethiopian birr was almost revalued by 10 percent against US dollar. The exchange had become 1 US dollar = 2.07 birr (Birritu, 2001). On February 23, 1973 the Ethiopian dollar has been changed to Ethiopian birr. During this time the US dollar once again came under pressure and was devalued by 10 percent; this is done to realign. However, the Ethiopian birr was revalued by 10 percent against US dollar. Therefore, the nominal exchange rate, that is official exchange rate for almost eighteen years was 2.07 Ethiopian birr per US dollar until October 1992, the exchange rate of Ethiopian currency against its reference currency, the US dollar was determined by government decree. Thus, up to the massive devaluation of official exchange rate of 1992 the 2.07 birr per US dollar was issued for external transaction purposes (Ibid). On October 1, 1992 National Bank of Ethiopia (NBE) was devalued the Ethiopian birr by 142 percent in nominal terms or by 58 percent in real dollar terms (Derresse, 1996). As a result of devaluation, exchange rate was increased to 5 birr per US dollar. This rate used for about a year until auction exchange rate was introduced. And also this rate was used for all transaction purpose until May 1, 1993. After the introduction of auction exchange rate, Ethiopia started to follow multiple exchange rate policy. Exchange rates in operation during this time were official exchange rate, auction exchange and the weighted average rate in 32 addition to the illegal parallel exchange rate. The official and weighted average rates were determined by administrative means while the parallel and auction exchange rate have been determined by market and quasi market system respectively. On July 15, 1995 national bank of Ethiopia (NBE) has unified auction and official exchange rate. After unification, one official exchange rate has been applicable to all imports that are auction exchange rate. Auction exchange rate that Ethiopia followed is referred to Dutch auction exchange rate system as it is a descending price auction where the auctioneer calls starting from higher rate and each bidder gets the amount requested at the rate he is willing to pay, until the allocated fund is exhausted several important modification have been put in place to the operation of the auction, the retail auction (where by the National Bank of Ethiopia sells foreign exchange to final users) was replaced by whole sale auction in September 1998. The whole sale auction is in operation up to recent period. The whole exchange rate policy since 1945 up to 2008/09 can be summarized as in the following table. 33 Table 1: Exchange rate policy in Ethiopia (1945-2008/09) Period 1945-1949 Nominal exchange rate 2.48 Policy Rate linked to pound sterling and it was based on IMF per value system 1949-1963 2.48 Rate delinked from pound sterling but still based on IMF par value system 1964-1971 2.5 Fixed IMF par value system 1971-1973 2.3 International monetary fund (IMF) par value system 1973-1992 2.07 Fixed exchange rate system and based on IMF par value system. But in 1976 the Ethiopian dollar has changed to Ethiopian birr. 1992-1993 5.0 Devaluation, but cradling pegs 1993-1995 Different rate Multiple exchange rate policy (Ductch auction exchange rate, official exchange rate and marginal average rate) 1995-1998 Varies from time to time Dutch auction exchange rate system with retail auction 1998-2009 Varies from time to time Dutch auction exchange rate system with whole sale auction. Source: National Bank of Ethiopia 3.1.2 Exchange rate premium Even though there is no consensus among researchers about the inception of the Ethiopian parallel market exchange rate, some are of the 34 opinion that it was non-existent or at its minimal level before the Derg assumed power. Befekadu Degefe (1994) stated that the significance of the illegal parallel market for foreign exchange has grown to the extent of impairing the operation of the official foreign exchange market during the post 1974 and particularly since 1980/81 fiscal years. Hence, the parallel foreign exchange market activities in Ethiopia become important in attracting traders and dealers, especially in the late 1980s, particularly when franco-voluta imports were allowed. The premium between the official and parallel market exchange rates depicted a substantial increase over the years. For example, the premium, which was about 93 percent in 1975/76, moved up to 206.5 percent in 1990/91. Hence, the parallel exchange rate premium continuously expanded over the last two decades before the 1992 reform (See table 3). However, after the introduction of the reform in 1997 in Ethiopia and various exchange liberalization measures (devaluation, adoption of foreign exchange auction system and opening of forex bureoux to engage in retail transactions) took place, the margin of the premium began to narrow. Most importantly, the banning of franco-valuta in late 1996 had contributed much to the small premium in the exchange market. The Ethiopian parallel foreign exchange market is a very volatile market that, at times has showed a drastic fluctuation even after the economic reform program of 1992. This high degree of volatility was due to both social and economic factors. 35 Table 2: The official and parallel exchange rate (1975-2009) Year 1975/76 1976/77 1977/78 1978/79 1979/80 1980/81 1981/82 1982/83 1983/84 1984/85 1985/86 1986/87 1987/88 1988/89 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 Official exchange rate 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 5.00 5.00 5.95 6.25 6.35 6.71 7.12 8.1426 8.3279 8.5425 8.5809 8.6197 8.6518 8.6870 8.7943 9.2441 10.4205 Parallel exchange rate 3.58 4.00 4.71 4.11 3.17 2.82 3.09 3.32 3.52 4.02 4.85 3.80 6.02 6.62 6.62 6.03 6.13 7.40 7.60 7.70 7.75 7.56 7.18 7.21 8.31 8.7914 8.6850 8.7091 8.6751 8.110 9.0258 8.9059 9.5569 11.8102 Premium 1.8261 1.9324 2.0338 1.9855 1.5314 1.3623 1.4928 1.6039 1.7005 1.9420 2.340 1.8502 2.9082 3.1981 3.1981 2.9130 3.0650 1.4808 1.5200 1.2941 1.2400 1.1905 1.0700 1.0126 1.102 1.532 1.67 1.49 0.64 0.68 3.97 1.85 3.38 13.34 Source: National Bank of Ethiopia After the devaluation of 1992 exchange rate premium starts to decrease as it is possible from the above table. But in 2008/09 this situation was 36 changed and the exchange rate premium started to widen. The underlying cause for the flourish of the parallel exchange rate could be cited that major consumer items started to be marked on the parallel market. 3.2 The performance of the export sector of Ethiopia pre and post devaluation The relationship between export performance and economic growth has been a subject of considerable interest to development economists in recent years. Empirical observation across countries tended to demonstrate that developing countries with a favorable growth record tended to enjoying higher rate of growth of national income. Obviously, since exports are a companying of aggregate out put one would expect a positive allocation in terms of the correlation coefficient. Therefore, to see the trends of the export sector of Ethiopia, taking a comparison between the periods of the pre devolution and post devaluation is essential in order to appreciate the likely progress made in this same sector due to devaluation. 37 Table 3: The Growth Rate of Export Year 1979/80 1980/81 1981/82 1982/83 1983/84 1984/85 1985/86 1986/87 1987/88 1988/89 1989/90 1990/91 1991/92 1992/93 1993/94 Growth rate of quantity exported 4.22 -2.54 -1.11 1.32 5.1 -3.41 -9.95 2.6 14.8 -12.8 -5.6 -20.8 -35.5 61.8 64.8 Year 1994/95 1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 Growth rate of quantity exported 10.7 16.7 8.2 -19.13 -16.78 9.7 12.5 44.25 -2.02 6.92 34.5 12.3 10.7 7.0 -1.5 Source: Own Computation from National Bank of Ethiopia On the basis of table 3, the performance of export sector of Ethiopia is analyzed as follows. Before September 1992 of devaluation period (i.e. from 1999/80 – 1991/92), the growth rate of quantity exported was low before the devaluation period except in 1987/88 with growth rate of 14.8 percent. But after the devaluation period of 1992/93, the growth rate of quantity exported was increased by 61.8 and 64.8 for subsequent two years. But this growth was declined for the remaining period as compared to the above two periods showing. But on average the growth rate was high (14.8) as compared to the pre devaluation period (-4.9). Therefore we conclude that devaluation improved the performance of the export sector of the country especially in the first three years after the devaluation period. 38 3.3 The performance of the import sector before and after devaluation It is known fact that during the period of derg regime the growth rate of export was low because the policies followed by that government were hindrance to the development of the export sector. But after the coming of new government and the introduction of devaluation increased the growth rate of export. In the next section we discuss briefly on the import side to determine whether the country is in good situation with regard to the external economic performance. Table 4: Growth rate of import Year Growth rate of quantity Year Growth rate of quantity imported imported 1979/80 6.2 1994/95 37.8 1980/81 -4.4 1995/96 -37.4 1981/82 8.3 1996/97 37.4 1982/83 -4.2 1997/98 -5.8 1983/84 6.1 1998/99 32.5 1984/85 12.3 1999/00 11.3 1985/86 10.1 2000/01 8.4 1986/87 20.4 2001/02 -13.5 1987/88 -12.1 2002/03 25.5 1988/89 -6.1 2003/04 12.7 1989/90 71.5 2004/05 -10.2 1990/91 -24.1 2005/06 6.5 1991/92 -77.0 2006/07 26.14 1992/93 215.68 2007/08 3.44 1993/94 22.56 2008/09 14.17 Source: Own Computation from National Bank of Ethiopia 39 Note. The periods before and after 1992/93 are considered to see how the import sector performance is before and after devaluation. As it is seen form the above table 4, the import sector showed a declining trend between 1979/80 – 1991/92 with an exception of 12.3, 10.1, 20.4 and 71.5 percent growth rate of quantity imported in 1984/85, 1985/86, 1986/87 and 1989/90 respectively. But after the devaluation the growth rate of quantity imported showed an amazing increment (i.e. the growth rate is 215.68% in 1992/93) and this is in contrary to the aim of devaluation. The above table 4 also shows that the average growth rate of quantity imported is 21.9%, which far greater than the pre evaluation period (0.54). Therefore, devaluation is ineffective in reducing the growth rate of quantity imported. To determine the external economic condition of the country we need the aggregate interaction of import and export. Empirical results show that the trade balance (export–import) of the country is deteriorating overtime. However, devaluation is taken to improve the condition of trade balance through promoting exports and discouraging imports. 3.4 Trends of RGDP and REER The ultimate policy objective of any country in general is to have sustainable economic growth. However, the growth rate of RGDP during the military government was low and this low growth rate of RGDP was attributed to the poor performance of agricultural sectors. Agricultural performance during the period not only discouraging in terms of its magnitude, but also it is characterized by large degree of oscillation. The main problems associated to agricultural sector were in appropriate to market policy state determined price policies, politically forced peasant cooperative producer and recumbent drought (Solomon, 2000). 40 Growth rate Graph 1: Trends of real GDP and REER As indicated in the figure 4, after the fall of military government the Ethiopia‟s economy continues to register high growth rate. Ethiopia‟s broad based economic growth continued for the sixty times in a row in 2008/09 putting the country in higher growth trajectory. The real GDP grow at 9.9 percent in 2008/09 making Ethiopia area of the fastest growth economies in the world despite world economic meltdown and global financial crisis. With 42.6 percent share in real GDP, agriculture and allied activities rose by 6.4 percent continuing 27.2 percent to the overall economic growth recorded in the fiscal year. On the above figure 4 the REER observed that there is no big change in the value of the domestic currency. But as the inflation differential with trading partners continued to widen, the real effective exchange rate appreciated by 35 percent in 2008/09. The rate of appreciation however, was slower during the second half of the fiscal year as a result of faster depreciation in nominal exchange rate and lower inflation. 41 CHAPTER FOUR 4. ECONOMETRICS METHODOLOGY OF THE STUDY In this research we emphasize time series analysis and the econometric method concentrate on the discussion of some basic concept of time series data. 4.1 Stationary and non-stationary series When we deal with the stationary of variables we normally deal with weak stationary as the strong stationarity is more of a theoretical concept weak stationary is defined in terms of sample moments (mean and variance). Xt is stationary, if. 1. E(xt)= N, i.e. the mean is independent of time which means as time goes on the mean doesn‟t change. 2. Variance (Xt)- 2 < ∞ i.e. the variance exists or it is finite. The whole idea of dealing with stationary and non-stationary series is to avoid spurious regression which results from regressing non-stationary variable on another. We can describe the spurious regression problem as follows. If we have two random walk I (1) variable, xt and yt. Whose first differences are given as Δyt 2y) Δxt 2x) and are also assumed to be independent by construction, then in their linear regression of the form yt= Bxt +εt we expect the value of B approach to zero as the sample size increase so that tB ~ NID (1, 0). Due to the nonstationary properties of the variable, however, the sample moments will not converge to constant as in the case of stationary variables. Rather, the sample moment coverage to random variables which are functions of wierier process. Therefore, in such regression instead of approaching to zero, the t- statistics will approach two (Gujarati, 1998). 42 Hence we will be misleading if we use the t- distribution by wrongly rejecting the null of no correlation between variables. As a rule of thumb, as suggested by Granfer (1974), we suspect a spurious regression if we have R2 greater than Durbin-Watson (DW) statistics. To avoid the problem of spurious regression, we can either change the data to make it stationary before conducting a regression or use the technique of cointegration. Therefore, in any time series analysis the first thing we have to do is to test the variables involved is a regression for unit roots. 4.2 Tests for unit roots The test has been performed using Dickey fuller (DF) and Augmented Dickey Fuller (ADF) technique. A. The Test for unity root If we assume the data generating process (DGP) to be given by yt= ρyt-1 + …. (1). Where εt~ 2), the DF test is to test on the size of the coefficient ρ. That is, whether ρ=1 or not (Adam, 1992). If we subtract yt-1 from both sides of equation (1), we get Δyt = πyt-1+εt …2 Where π = ρ-1. The null hypothesis is H0: π = 0 (or unit root). If we add a constant in equation (2), we get Δyt = ∂0 If a time trend is further included Δyt = ∂0 + Bt πyt-1 + εt ….4 In (3) and (4) the null hypothesis is H0: π=0 the null, therefore, it means that we have a stationary series. If there are more than one unit root, then testing for a single unit root will be misleading. Therefore, following pantula‟s principle, it is better to 43 start with higher order unit roots by applying the DF test to the first difference of the series. If the result is rejection, then we move to test the given variable at level. If the residuals are serially correlated, which is not unusual for such a DGP, the residual variance not be used (Sjoo, 1997). This is solved by using the ADF test. B. The ADF test for unit root. The ADF test solves the above problem by augmenting the DF test with some log structure of follows Δyt = πyt-1+∑бi Δyt-1 + εt ………5 Δyt = ∂0 + πyt-1+∑бi Δyt-1 + εt ………6 Δyt = ∂0 + Bt + πBt + πyt-1+∑бi Δyt-1 + εt ………7 The ADF test is better than DF test since the augmentation leads to empirical hypothesis there is also H0: π=0 in equation 5, 6, and 7. Choosing the length of augmentation is a typical problem in ADF test. 4.3 Co-integration In order to obtain both the short run dynamics and the long-run relationship, one can appeals to what is known as co-integration. The concept of co-integration implies that even if many economic variables are non-stationary, there linear combination may be stationary. Therefore, the important thing is to rest whether integrated variables cointegrated so that a meaningful long run relationship can be established 4.4 Test to co-integration Though there are different tests for co-integration, we focus on the two step procedure by Engle and Granger. The Engle – Granger two step procedure 44 Given yt ~I (1) and xt ~ I(1), then Step 1: Do OLS on Yt = ∂+Bxt + εt (Regression on levels) which is called co-integrating regression: save the residual from this regression. Step 2: Test whether Êt (the estimated residual) is I (o) or I(1) This can be done by ADF test which is formed as ΔÊt = ∂0 + π Êt-1 + ∑ ΔÊt 1+ ut The null hypothesis here is π=0 (unit root) and the alternative is that the variables are co-integrated. The relevant test statistics used here is different from the usual unit root test on a variable because here we have a derived variable. The major problems in the above procedure are: the assumption of only one co-integrating vector, the choice of logs in the ADF test and the assumption of a common factor in the dynamic of the system. 4.5 The Error correction model While a model in difference of variables gets around the problem of spurious regression, it does so at the cost of not being able to discover the long run relationship between variables of our interest. The error correction model solves this by combining the long run information with a short run adjustment mechanism. k k An ECM can be represented as Δyt = Bi Δxt-1 + ∑ εt ………7 i=0 i=0 Where ECMt-1 is the error correction term which represents the deviation from the long run steady state relation between the two variables ∂ in the above equation represents how change in ∆yt reacts to deviation from the long run equilibrium. The error correction term is one period log of the saved residual from the co-integration relation in the two step procedure. 45 As long as we have co-integration among variables, as noted by Engle and Granger (1987), there is an ECM formulation. We can use the tdistribution to test the significance of the parameter estimate of the ECM as the conventional properties of the distribution hold asymptotically. The choice of appropriate lag structure is a problem in estimating the ECM. 46 CHAPTER FIVE 5. ECONOMETRICS ANALYSIS OF THE STUDY 5.1 Model specification In order to estimate the relationship between devaluation and economic growth, this paper used the model which was presented by Edwards (1992), using gross domestic product (GDP) as an economic growth index. This study hypothesizes that the GDP growth is a function of a set of explanatory variable. So that in this study GDP growth is specified as a function of Real Government investment (RGI) as a variable influenced by fiscal indicator, Real Private Investment (RPI) as a variable influenced by fiscal and monetary policy, money supply (MS) as a monetary fiscal index. In order to investigate the impact of devaluation on economic growth, devaluation was replaced by real effective exchange rate (REER). Also export price index divided by import price implicit index is used as the term of trade (TOT). LGDP = f (LRGI, LRPI, LMS, LTOT, LREER) + ut ……(1) LGDP = a0 + B1 LRGI + B2 LRPI + B3 MS + B4 TOT + B5 REER + ut …(2) L – Represents the logarithm of variables GDP – Gross Domestic product, the real aggregate production RPI – Real private investment PGI – Real Government Investment REERt – ∑aitPit/pht were, ait = the trade shore of the country at time t in the total export and import out of given country. Eit – the bilateral nominal exchange rate country i at time to against home country in terms of country currency 47 Pit – price index of country i at time t Pht – Price index of home country at time t TOT = Export in price index Import price index x 100 Ms = Money supply The expected sign of B1 is positive since government investment has a productive effect for future economic growth of the country. The expected sign of B2 is positive since private investment can have an implication for the sustainability of the external position because of high level of investment implying high future growth through the buildup of large productive capacity. The expect sign of B3 is to be positive since increase in money supply decrease the rate of interest, encouraging investment and thus, expands output. This coefficient captures how monetary policy holds effective in affecting the real variable. The expected sign of B4 is also positive since it is clear that worsening of the terms of trade (i.e. reduction in TOT) will result in real GDP reduction. This implies an extra amount of export is necessary to maintain the previous amount of imports if the terms of trade become worsen. The main interest of this analysis lays in the coefficient of the exchange rate which B5 measures. If devaluation are contractionary (i.e. decreasing real output), it stressed that the value of B4 should be significantly negative. If, however, devaluation is expansionary (i.e. increasing real output), the sign should be positive and statistically significant. 48 5.2 Model Estimation and interpretation 5.2.1 Unit root test of stationarity A stationary test expected to be the first step in time series regression analysis. That is, we must distinguish between stationary and nonstationary variables. Since failure to do so can lead to a problem of spurious regression stationary. Since time series data are employed in this study, a unit root test of stationarity is conducted to know the order of integration of the variable used in the regression. Based on the Augmented Dickey Fuller (ADF) test, which were already discussed in the beginning of chapter 4, the entire variable entering the regression is non-stationary in the original time series data. However, the first difference of all variable is found to be stationary which means that they do not exist a unit root problem. It is therefore possible to say that the original time series is integrated of order one. Table 5.1: Result of unit root test of level of I (0) using augmented dickey-fuller (ADF) test Variables Teststatistics Critical values 1% 5% 10% Ln RGDP -2.866 -3.723 -2.989 -2.625 Ln RGI -0.756 -3.723 -2.989 -2.625 Ln RPI -1.272 -3.723 -2.989 -2.625 Ln REER -1.348 -3.723 -2.989 -2.625 Ln TOT -1.763 -3.723 -2.989 -2.625 Ln MS -2.056 -3.723 -2.989 -2.625 49 One variable LnRGDP is found to be stationary at level and the remaining variables are non-stationary Table 5.2: Result of unit root test for I (1) of the variable using augment dickey – fuller (ADF) test Variables Test statistics Critical values 1% 5% 10% DLnRGDP -5.201 -3.730 -2.992 -2.626 DLnRGI -4.752 -3.730 -2.992 -2.626 DLnRPI -9672 -3.730 -2.992 -2.626 DLnREER -4.294 -3.730 -2.992 -2.626 DLnTOT -4.674 -3.730 -2.992 -2.626 DLnMS -9.054 -3.730 -2.992 -2.626 As shown from table 4.3.2 all the variables are stationary after differencing. 5.2.2 Test of co-integration The existence of co-integrating relationship implies the long run relationship between the variables. There are a number of methods for testing co-integration but this study use the Engle-Granger two step procedures. The Engle-Granger methodology determines whether the residual is stationary or not. If this residual, which is the Linear combination of the variable is stationary, then the variables are said to be co-integrated, that is, they have long run relationship. 50 Table 5.3 Co-integration Test Variable Residual (2) Test statistics -5.873 Critical values 1% 5% 10% -3.723 -2.989 -2.625 According to the above result the residual from the long run model is stationary at level, implying that the variables under consideration have a long run or equilibrium relationship. Thus, the long run structural equation derived from the co-integrating vector is not spurious rather, it is meaningful and it can be presented as. LnRGDP=8.75+0.41 LnRGI+0.325 LnRPI-0.18 LnREER-0.21 LnTOT-0.15 LnMS+ et T: (3.51) (1.76) (2.08) (-2.60) (-0.90) (-1.26) SE: (2.49) (0.235) (0.156) (0.29) (0.233) (0.118) Table 5.4 Estimation results of the long run model Dependent variable: LnRGDP Solved static for long run equation result Variables Coefficient Standard t-value P > /t/ error Constant 8.746191 2.492714 3.51 0.002 LnRGI 0.4139318 0.2351097 1.76 0.091 LnRPI 0.3250898 0.1563899 2.08 0.049 LnREER -0.1769035 0.2928942 -2.60 0.052 LnTOT -0.2091855 0.2334518 -0.90 0.379 LnMS -0.1488969 0.1184947 -1.26 0.221 No. of observation = 30 F (5,24) = 8.43 Prob > F = 0.0001 51 R2 = 0.6372 Adj R2 = 0.5616 DW = 1.66 The estimated model shows that the coefficient of real government investment has got a sign that agrees with the expectation which is positive and the coefficient was found to be statistically significant by looking at the P value which is less than or equal to 10%. The coefficient of real private investment also got the expected sign and statistically significant. The coefficient of real effective exchange rate showed an unexpected sign but the coefficient was found to be statistically significant. The coefficient of terms of trade and money supply are negative which is unexpected sign and they are statistically insignificant. 5.2.2.1 Interpretation of the Econometrics Result of the long run model The coefficient of real government investment (PGI) was found to be significant and showed the expected positive sign. This means that a 1% increase in real government investment will leads to 41.4 percent increase in real GDP. Real private investment (RPI) was found to be significant and showed the expected positive sign. It observed that 1% increase in real private investment (RPI) leads to 52.5 percent increase in real GDP in the long run. This shows that capital accumulations through private investment have productive effort for future capacity of economic growth. The third variable incorporated in the specific model is real effective exchange rate. Unlike the above two variables this variable appeared to have negative correlation with growth in the long run and found to be statistically significant. From table 4.4 a 1% rise of real effective exchange rate (REER) reduces the real GDP by 18% in the long run. This 52 result against what the theory said and it indicates that devaluation has contractionary effect on the growth of Ethiopia‟s economy. This is consistent with the study done by Bronson (1986) in the Kenyan economy. This might be attributed with an absence of export diversification, low elasticity of demand and supply for export, the availability of domestic substitute for imported goods, and the responsiveness of export and import price to the exchange rate depreciation and size and degree of currency depreciation with the link of international market development. Finally, the estimated model show that both terms of trade and money supply showed unexpected sign (i.e. the increase of terms of trade and money supply reduces RGDP growth) and it also found that they are statistically insignificant. 5.2.3 The Error correction model The test of co-integration indicated that the variable under consideration have a long run relationship since every co-integrated non-stationary variable to have error correction representation. An error correction model (ECM) is constructed and estimated in this section as the first difference of the dependent variable is regressed on the first difference of the explanatory variables with their lags and the first lag of the residual obtained in the first step. It indicates the short run dynamics of the OLS estimation result and its adjustment towards the long run equilibrium. 53 Table 5.5 Estimation Result of ECM Dependent variable: DLnRGDP Independent Coefficient variables Standard T – value P >/t/ error Constant 3.796157 0.0929262 40.85 0.000 DLnRGI 0.6544685 0.392272 1.87 0.074 DLnRPI 0.1935162 0.1467967 1.32 0.201 DLnREER -0.358564 0.5466729 -0.660 0.519 DLnTOT 0.5254829 0.3311987 1.59 0.127 DLnMS 0.0639892 0.1111267 0.58 0.571 E lagged -0.4348708 0.2636134 -1.65 0.113 No. of observation = 29 F (6,22) = 1.45 Frob > F = 0.2426 R2 = 0.2827 Adj R2 = 0.0871 The short run model could be DlnRGDP=3.8+0.65 DlnRGI+0.19 DlnRPI-0.36 DlnREER+0.53 DlnTOT+0.064 DlnMS+Et-1 T: (40.85) (1.87) (1.32) (-0.660) (1.59) (0.58) SE: (0.093) (0.35) (0.147) (0.547) (0.33) (0.11) 54 Where D indicates first difference of the logarithm of the variable included in the model and Et-1 is the residual. In addition the model taking a one period lags of the variables. 5.2.3.1 Interpretation of the econometrics result of the short run model (ECM) The short run (ECM) regression result shows that 28% of the variation in RGDP is due to the explanatory variable involved in the model. The coefficient of real private investment, real government investment, terms of trade and money supply shows the expected sign but they are statistically insignificant. The coefficient of real effective exchange rate showed unexpected sign as of the long run and it is statistically not significant in the short run. In the above model, the coefficient of the error-correction term is significant with magnitude of -0.43. This magnitude indicates that deviation from the long run equilibrium is adjusted fairly where 43% of the disequilibrium is removed each period. It has a negative sign implying that any shock in the system in the short term will return back to its long run path. 55 CHAPTER SIX 6. CONCLUSIONS AND POLICY IMPLICATION OF THE STUDY 6.1 Conclusion In this paper, an attempt was made to study the impact of devaluation on economic growth of Ethiopia by using both theoretically and empirically review of different countries and it also assessed the overall macro-economic performance of Ethiopia economic growth for the last three decade and with due emphasis given to foreign trade of the country. The Ethiopia birr was overvalued in the last two decades. The real effective exchange rate had adverse effects on macro-economic performance of the country. The previous government did not take the right corrective measures; rather they pursued a policy of exchange control and foreign exchange allocation. This aggravated the problem of real exchange rate appreciation and depletion of the country‟s foreign reserve. To mitigate the general economic, problem the transitional government of Ethiopia devalue the Ethiopia birr against the standard currency (Dollar) by 142% in dollar terms on October 1992. Even if, the transitional government of Ethiopia (TGE) taken devaluation as an instrument of improving external competitiveness, the country experienced trade deficit after the introduction of devaluation. The reasons are due to absence of export diversification, low elasticity of demand and supply for export and the availability of domestic substitute for import goods. 56 The empirical estimation of the real GDP of the country using OLS estimation in long run and error correction model showed the following results. Real private and government investment showed direct relationship with real GDP and statistically significant in the long run. But in the short run only real private investment is significant. The positive relationship with real GDP is an indication that domestic investments have a great effect to attain a fast economic growth of developing country in order to overcome the misery of poverty. On the other hand real effective exchange rate terms of trade and money supply showed negative relationship with real GDP in long run. Terms of trade and money supply were insignificant in both long run and short run in affecting the real GDP. While the real effective exchange is significant during the long run, turned out to be insignificant during short run. Finally we conclude that, the real effective exchange rate which is the main interest of this analysis results in reduction of real GDP of the country. This result is against what the theory said (devaluation has expansionary effect on real GDP) and it indicates that devaluation has contractionary effect on the growth of Ethiopian economy. 6.2 Policy Implication Based on the findings of this study, the following strategies and measures are suggested for policy implication. - The findings imply that policy makers in developing countries should be cautious when taking a decision on devaluing the currency or using the policy instruments under their control in such a way as to create real depreciation. More particularly, it is 57 not advisable to call for devaluation if the major concern is increasing output in the short run. Along the same lines, we can say that it is not recommended for the LDCs government like Ethiopia implementing a flexible exchange rate system to allow for a major depreciation, since it may hurt economic growth. - Even if devaluation is taken for the reason of improving the trade balance deficit, it failed in achieving this aim. The main argument behind that is the increasing amount of import at a rate that out strips the case for exports. Hence, there is a need for the country to build industries that can produce those commodities, which are imported and demanded at large domestically. 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