Equilibrium Exchange Rates in PNG: a new approach to policy- setting in RRDCs Martin Davies Associate Professor, Washington and Lee University Visiting Associate Professor, UPNG Visiting Fellow, DPC, Australian National University Research Fellow, Institute for National Affairs Joint work with Marcel Schroder, thanks to Laura Nettuno for research assistance
Plan for today • New model • Theory • Policy: new policy framework for RRDCs • Empirics • Observations • Forex market • Exchange rate: what if exchange rate floated
Objective of Paper: are standard models useful for understanding policy in RRDCs • Model for macro policy in RRDC • Adjust standard Internal-External balance model to account for key features of RRDCs • What are key features? • Resources sector is an enclave: not linked to the rest of the economy • Net factor income is large and negative • Question: how does policy prescription for RRDC change?
Observation for PNG • resource sector is an enclave • firewalled from rest of economy • 2015 fastest growing economy in the world, unemployment increasing • resources sector: • capital owned by foreigners, few national workers • large share of export income accrues to foreign owners • PNG ownership share low • resources taxes are low
What is a RRDC? • What is a Resource Rich Developing Country (RRDC)? • Definition of RRDC (IMF 2012): • low- and lower-middle-income country • Low: less than USD 1000 • Lower-middle: USD 2000-4000 • exhaustible natural resources comprises at least 20 percent of total exports • New observation / stylised fact: significant difference between GNP and GDP • 29 RRDCs over 20 years: GNP/GDP = 0.93 • range 0.64 (Equatorial Guinea) to 1.01 (Uzbekistan) • PNG is 0.94 (IMF says 0.90) 0.87 in 2000; 0.99 in 1978) • G-7 over last 20 years: GNP/GDP= 1.00
Standard Policy Framework • Standard Internal Balance-External Balance policy framework focuses on • Gross Domestic Product (GDP) • Current Account (CA) measured by Trade Balance: Exports (EX) less Imports (IM) • But net factor income large and negative in RRDCs • need to account for this • Focus on • GNP = GDP + net factor income • Current Account = EX – IM + net factor income
GDP vs GNP • GDP: value of all goods and services produced within a geographic area • GNP: value of all goods and service produced by nationals of a given country • GNP = GDP + net factor income (subtract out parts of GDP that aren’t produced by nationals, add in parts that are produced by nationals overseas) • Modelling Net Factor Income • Resources sector production function; capital K R , owned by foreigners, L R foreign labor Y R = F(K R ,L R ) e.g. Y R =K R .L R (L R =10,K R =20, Y R =200) • Assume that all resource sector output is exported: Y R = EX R • Suppose PNG owns share α of project, then net factor income = - (1- α)EX R • GNP = GDP - (1- α)EX R • With resource taxes, t R , net factor income = - (1- α)(1-t R )EX R (↑ α, ↑t R will ↑GNP)
Model
Model
Policy in PNG • In an open economy, policy has two goals • internal balance: producing at full employment ( Y = Y f ) • over-employment (Y > Y f ): increase in inflation • underemployment (Y < Y f ): decrease in inflation • external balance: current account is near zero: CA = 0 • is large current account deficit : foreign investors question ability to repay debt. Is CA deficit bad? • Two instruments: • exchange rate ( e ) – expenditure switching • Fiscal policy ( G ) – expenditure changing
Internal Balance • Internal balance: Y = Y f : Y f = C + I + G + EX ( e ) - IM aggregate expenditure = full employment consumption (C) + investment (I) + gov’t spending (G) + exports (EX) – imports (IM) = Y f exchange rate = e Devaluation ↑e → our goods cheaper to foreigners → ↑export (EX) • Increase in gov’t spending: ↑ G → Y > Y f (output is above its full employment level) • To restore internal balance: revaluation ( ↓e ) → EP */ P → our goods more expensive to foreigners → ↓exports (EX) → ↓Y returns to Y f
Internal Balance Exchange rate, e Expenditure switching, E Internal balance: Y = Y f IB G Expenditure changing, G
External Balance • External balance (CA = 0): CA = Exports – Import = EX ( e ) – IM(Y) = 0 • ↑ G increases aggregate expenditure → ↑ income (Y) → ↑ imports (IM) decreasing the current account ( ↓CA ) • To restore external balance: devaluation ↑e → our goods cheaper to foreigners → ↑ exports (EX)
External Balance External balance: CA = 0 Exchange rate, e EB G
Macroeconomic Goals Exchange rate, e EB (CA=0) A IB (Y=Y f ) G
Zones of Economic Discomfort Exchange Rate , e EB (CA = 0) IB (Y = Y f )
Result 1 Macro policy should focus only on the Non-Resource sector
Definition 2: CA includes net factor income Net factor income is large so need to include it
New Equilibrium Exchange Rate Concept: RRDC EQUILIBRIUM EXCHANGE RATE (RREER)
Diagram: RREER EB(CA=0) Exchange rate, e A . e RRDC B e S IB RRDC (Y=Y R ) IB S (Y=Y R ) G S G RRDC Govt Spending, G 21
Proposition 1
Export Boom Standard Model e EB 1 (CA=0) Y > Y R CA > 0 EB 2 (CA=0) . A IB 1 (Y=Y R ) C IB 2 (Y=Y R ) G 23
Export Boom: RRDC model EB 1 (CA=0) Exchange rate, e EB 2 (CA=0) A . e 1 B Y < Y R e 2 CA > 0 IB 1 (Y=Y R ) C IB 2 (Y=Y R ) G 2 G 1 Govt Spending, G 24
Export Boom Result
Result: Increase in ownership share or resource tax rate
Increase in t R or α: RRDC model EB 1 (CA=0) Exchange rate, e Y > Y R CA > 0 EB 2 (CA=0) A . e 1 B Y < Y R e 2 CA > 0 IB 1 (Y=Y R ) C IB 2 (Y=Y R ) G 2 G 1 Govt Spending, G 27
Empirical Results (preliminary)
Conclusion
PNG: devaluation ( ↑e ) completing the square e EB 1 (CA=0) Y > Y f CA > 0 EB 2 (CA=0) Y > Y f . . A B CA < 0 Y < Y f . CA > 0 . C D IB 2 (Y=Y f ) IB 1 (Y=Y f ) Y < Y f CA < 0 G 30
Forex Market: Balance of Payments what exactly is going on? • BOP = Current Account + Financial Account = (Exports – Imports) + (Capital Inflows – Capital Outflows) = (Export + Capital Inflow) – (Imports + Capital Outflows) = Supply of Forex (S FC ) – Demand for Forex (D FC ) BOP 2014 = - K861 mn Stock of excess kina (pent up demand for USD) BOP 2015 = - K753 mn BOP 2016 =Current Account (16.65 bn) + Financial Account (-16.62 bn) = K31 mn BOP 2017=Current Account (13.03 bn) + Financial Account (-11.67 bn) = K 1.36 bn (proj) .
Figure from Fox, Howes, Nema, Schröder (2017)
PNG: Market for Foreign Exchange (rationing) Exports + Balance of payments deficit S FC e Capital Inflows = Excess demand for forex / Excess supply of Kina - K861 mn (2014) - K753 mn (2015) A e * = 1 = 3.21 0.3115 D FC True D FC Rationed (Imports Rationed + Capital Outflows Rationed ) Foreign Currency (USD)_ S * D *
PNG: Market for Foreign Exchange: Current Exports + S FC e Capital Inflows Balance of payments surplus = Excess supply of forex / Excess demand for Kina True excess demand for forex / (K1.3 bn proj 2017) excess supply of Kina e * = 1 = 3.21 0.3115 TRUE + RESIDUAL STOCK D FC D FC Rationed D * OF DEMAND for USD FC Foreign Currency (USD) D * + RESIDUAL D * S * STOCK OF DEMAND
Model of Exchange Rate Adjustment • Capital mobility very low • No speculative attack on exchange rate • Standard models of currency crisis don’t apply • Current situation: pent up demand for forex over time • Stock of kina waiting to be converted to forex • Speculative demand for Kina (supply of forex) • Stock of forex waiting to be converted to Kina when the price is right • Won’t convert until Kina falls enough to offset • If you float then stocks may enter forex market
Model of Exchange Rate Adjustment
Model of Exchange Rate adjustment
Model of Exchange rate adjustment D FC . Exchange rate, e S FC e H A * e 2 e L * e 1 D S F S Foreign exchange 38
National Income Accounting GDP = C + I + G + EX – IM • forex restrictions reduce imports ↓M → ↑GDP (growth strategy) BUT • PNG is a developing country: no substitutes for inputs → two effects ↓Investment (I) demand side Y falls ↓Y (direct) supply side • Production is constrained by inability to source key overseas inputs
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