where pd = dom. price level & pf = world price level

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2 Study examines:do unrequited transfers: Aid & remittances affect real exchange rates (RER)? Nominal exchange rate (NER): units of foreign currency per unit of domestic currency (DC). RER= NER (pd/pf) where pd = dom. price level & pf = world price level Rise in value of DC & ER rate mean the same Dutch disease: RER appreciates with increasing Aid & REM hurting exports competitiveness PNG : outlier with large resources: excluded 2

3 The term Dutch disease: refers to unintended negative impact of a resource boom on a country s nonresource tradable sector, Term: Rise in the appreciation of the Dutch currency in 1960s: surge in the foreign exchange: Discovery of the North Sea gas fields in the Dutch economy 3

4 Earnings spent within the economy lead to rise in price of non-tradables: water, electricity, land & services Rise in dom.price level & increase in RER hurting competitiveness of exports Term: Dutch disease is extended to cover impact of unrequited capital transfers on export competitiveness as well. 4

5 PICs :price takers: prices of traded goods are fixed in world markets. Increase in domestic expenditure results only in rise in prices of non-traded goods Relative price change leads to change in composition of output Output in traded goods sector contracts 5

6 Two major channels Inflows of aid and remittances are expected to result in a spending effect causing an increase in consumption of tradables and non-tradables Prices of tradables determined outside Relative prices of non-tradables increase Boosting domestic price level. 6

7 Higher RER both fueling and fueled by a resource movement effect Rising non-tradable prices shift resources from production of tradables to non-tradables These shifts exert upward pressures on wages & production costs, & the overall dom price level Resulting appreciation in RER (= NER(pd/pf) hurts export competitiveness 7

8 There is also the effect flowing out of consumption-leisure tradeoff Leisure is preferred as remittances rise Reduction in overall supply of labour Growing demand: higher consumption due to remittance: reduction in labour supply: further price increases in non-tradable sector. Rise in pd result in REER appreciation 8

9 Aid as percent of GDP Year Fiji Samoa Sol. Islands Tonga Vanuatu (Ave) (Ave) (Ave) (Ave)

10 Table 2: PICs: Remittances (percent of GDP): Year Fiji Samoa Sol Is. Tonga Vanuatu (Ave) NA (Ave) (Ave) (Ave)

11 REER Index ( Base: 2010=100) : Year Fiji Samoa Sol. Is Tonga Vanuatu (Ave) (Ave) (Ave) (Ave) Source: IMF(except Tonga and Vanuatu); authors' calculations 11

12 Exports of PICs as (% of GDP) Year Fiji Samoa Sol Is Tonga Vanuatu NA NA

13 Exports of PICs as % of their imports : Year Fiji Samoa Sol Is Tonga Vanuatu NA Source: WDI 13

14 Testing Aid & Rem positively affect REER Trade weighted REER rate from IMF Data constraint: Min. number of variables. Policy variable: capturing effects of fiscal & monetary policies on REER: domestic credit as ratio of GDP Expansionary policies influence REER No a priory conclusion on direction (+ or -) 14

15 Domestic Credit by ( % of GDP) : Year Fiji Samoa Sol.Is Tonga Vanuatu (Ave) (Ave) (Ave) (Ave)

16 Sign of Dom.Credit: positive or negative. If policy measures would lead to rise in supply of non-tradables, there would be fall in domestic inflation That will result in REER. Negative sign On the other hand, if economic policies are inflationary, there would be a rise in REER, given world price level. 16

17 The model for estimation purposes is written as follows: REER i,t = β 0 + β 1 AID i,t + β 2 REM i,t + β 3 DOMCRE i,t + ε i,t where REER: Real exchange rate in index number; AID = aid as percentage of GDP; REM = remittance inflows as percent of GDP; DOMCRE= domestic credit as percent of GDP; ε i,t = white noise error term. 17

18 Panel Unit Root and Stationary Tests: Maddala and Wu (1999), Hadri (2000), Levin et al. (2002) and Im et al. (2003) Panel Cointegration Pedroni (1999, 2001, 2004) and Kao (1999) panel cointegration tests. Pedroni (1999, 2001, 2004) considers seven different statistics 18

19 Panel Fully Modified OLS (FMOLS) Estimates The FMOLS procedure accommodates the heterogeneity that is typically present both in the transitional serial correlation dynamics and in the long run cointegrating relationships. TEST RESULTS ON REQUEST 19

20 Six out of seven Pedroni statistics: establish cointegration The estimated long run estimated panel equation : REER = AID REM DOMCRE (3.651) (4.232) (-6.096) Variables are in logs 20

21 Estimated coefficients: elasticities 1% rise in AID results in 0.2% increase in REER. 1% in rise in REM leads to 0.3%rise in REER Expansionary policies result in rise in non-trables supply: fall in REER: 21

22 A panel study: 5 PIC which have currencies of their own: Fiji, Samoa, Solomon Islands, Tonga and Vanuatu. Many commonalities: A panel study: Variables: REER in Index; aid & remittances as % of GDP; & policy variable: Domestic credit as % of GDP 22

23 Finding: Existence of strong evidence in favour of significant & direct association with aid & remittance inflows and appreciation of domestic currency Phenomenon of Dutch disease hurting the attractiveness of its exports operates 23

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25 Increase output of non-tradables & import substitution wherever possible Focus on dom. production of vegetables, fruits and milk PICs: large areas of arable land unutilized Emphasis should be on lessening domestic inflation. 25

26 THANK YOU 26

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30 It was six men of Hindostan To learning much inclined, Who went to see the Elephant (Though all of them were blind), That each by observation Might satisfy his mind.

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