Exchange rate pass-through in developing and emerging markets

Janine Aron, John Muellbauer

14 September 2014

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The interest in exchange rate pass-through (ERPT) in developing and emerging market (DEM) countries has burgeoned in the last two decades. By contrast, in the earlier comprehensive empirical survey of ERPT by Menon (1995), the majority of studies covered industrialised countries – largely the US, Japan and European countries – with only a handful of less developed countries, mainly reported in a single cross-country study.

The adoption of inflation targeting by many DEM countries in the past two decades, with its reliance on inflation forecasting, has probably enhanced the interest in ERPT. Many have adopted floating exchange rates and eliminated capital controls. This exposes them to speculative pressures, contagion, and easily reversible capital flows. Monetary policymakers in small, open economies may face challenges with greater imported inflationary pressures and exchange rate volatility.

ERPT refers to the degree to which exchange rate variations influence trade prices and, through them, other domestic prices. Understanding the nature of the adjustment of aggregate import prices to exchange rate changes, and through import prices eventually to other aggregate domestic prices, is important for anticipating inflationary developments and monetary policy responses. Also, the rising share of emerging markets in world trade has been implicated in lowering global inflation (see Figure 1) through the pricing behaviour adopted by many emerging market (especially Asian) exporters, aimed at enhancing their market share.

Figure 1. Decline in headline inflation for sets of countries

Source: World Economic Outlook database, IMF.

ERPT may be measured in both the short run and long run, but even in the long run, the pass-through may not be ‘complete’ in that the change in the exchange rate may not be fully passed through to prices.1 ERPT in practice often displays significant asymmetries (though commonly it is assumed linear and symmetric), for instance when exchange rate depreciation elicits a price response of a different magnitude to an appreciation, or when smaller changes elicit a different proportionate response from larger changes. Much literature on the industrial countries investigates a different nonlinearity – the apparent secular decline in ERPT with structural/regime changes, such as the adoption of a stabilising monetary regime.2

For all its policy importance, the measurement and interpretation of ERPT measures is a complex and highly technical affair. Many published estimates, especially for the DEM countries, are misleading in being from misspecified models; and different published measures are often not comparable. This poses challenges for the policymaker.

Small, open, and trade-dependent economies embody special features that can make it especially difficult to obtain reliable estimates of ERPT. Where the exchange rate has been actively targeted (e.g. in Asia), systems methods with feedback effects on the exchange rate may be more reliable than single-equation models. With extensive structural transformations (e.g. in South Africa and Central and Eastern European countries in the 1990s), secular shifts in ERPT should be tested for. The greater uncertainty facing DEM economic agents also raises the relevance of nonlinearities from threshold effects (menu, hedging, and other transactions costs). Finally, hyperinflation and macro-volatility can make for challenging empirical analysis.

Faced with a plethora of reported ERPT measures in the empirical literature, the discerning policymaker needs to ascertain by which method these were calculated, which controls and restrictions were applied, and the time frame and stability of the estimates. Reported ERPT estimates from different methodologies are not directly comparable as the underlying assumptions differ. Our survey (with Ronald MacDonald) of recent research in DEM countries on ERPT (Aron et al. 2014) categorises and compares the heterogeneous methodologies used to extract ERPT rates to different prices (with detailed typology tables), and it considers what meaning a policymaker could attach to such estimates. We highlight the frequent misspecifications that produce unreliable ERPT estimates in empirical applications. Our survey heavily reinforces Menon’s concern that choice of data and methodology significantly affects the reliability of published ERPT estimates.

Five common misspecifications

In general there are five common misspecifications contributing to the malaise.

  • First, many multi-country studies ignore the country heterogeneity (except in country fixed effects) that arises from different levels of development and trade regimes, different monetary policies and histories of inflation, and differences between commodity exporters and commodity importers.

Thus, before restrictions are imposed that ERPT coefficients are the same across all countries in the sample, these restrictions should be tested. Barhoumi (2006), unusually in this literature, tests and soundly rejects this restriction of homogeneous ERPT across countries.

  • A second common error, particularly in multi-country studies, is to specify a highly restricted bivariate relationship between, for instance, import prices and the nominal effective exchange rate when the relationship is likely multivariate (i.e. it should include domestic costs, such as unit labour costs, and foreign prices, possibly also oil prices).
  • A third common error is to assume very restrictive lag structures without careful testing.

The assumption of short lags and the omission of domestic unit labour costs (which though slow to adjust to shocks do eventually respond to imported inflation) could result in long-run ERPT being substantially underestimated. In countries where powerful unions create domestic wage-push shocks that depreciate the exchange rate, there is a risk of overestimating the impact of the exchange rate on domestic inflation when neglecting domestic labour costs.

  • This leads to the fourth frequent misspecification, which is to ignore the potential endogeneity of the exchange rate and of domestic cost variables (when included).

Active anti-inflationary monetary policy may cause an initial exchange rate shock to be partly offset by an interest rate adjustment. This would lead to a negative feedback from exchange rate shocks, and reduce the longer-term inflationary impact of the initial shock. Such issues are almost invariably ignored in ERPT studies, especially with micro-data. The implication is that equation systems are needed to develop a deeper understanding of ERPT.

  • Changing monetary policy regimes causes a fifth potential misspecification, linked with the importance of such nonlinearities in DEM economies.

Generally it is assumed that there are constant (unchanging) parameters in the ERPT models. But regime changes can shift the coefficients underlying the time profile of ERPT. We are unaware of studies for emerging markets combining a systems approach with tests for structural breaks (these potentially could occur anywhere in the equation system). The possibility of structural breaks explains why many researchers work with quarterly or monthly differences of data in VAR models or single equations. Differencing the data is likely to improve robustness for estimation of short-run ERPT or for short-run forecasting. But to estimate medium-term ERPT robustly – and this is arguably the time frame of most interest to monetary policymakers – model selection strategies that test and control for regime breaks are needed (see Castle et al. 2012).

Guidance for policymakers and future research

Where does this leave the policymaker? Given pervasive empirical misspecifications in the literature on ERPT in DEM countries (see evidence in Aron et al. 2014), one can ask which stylised empirical facts emerge, apart from the obvious ones that short-run ERPT is smaller than long-run ERPT, that ERPT diminishes down the distribution chain from import prices at entry to consumer prices, and that there is considerable heterogeneity among countries. One important fact is that there appears to be little systematic difference between advanced countries and DEM economies as a whole, once inflation history is controlled for. This is consistent with the view that ERPT has declined with more stable, anti-inflationary monetary policy regimes (see Taylor 2000).

There are some indications that higher exchange rate volatility may be associated with higher ERPT in the DEM countries with floating currencies – possibly because exchange rate changes are viewed as more permanent or because invoicing in DEM currencies is discouraged by volatility. However, in countries with occasionally shifting currency pegs, which tend to have lower exchange rate volatility, ERPT appears to be higher – probably again because exchange rate changes are viewed as more permanent. We view the evidence on asymmetries in the response of domestic prices to positive/negative or large/small exchange rate shocks as too inconclusive and too sensitive to the specification errors in the underlying models for broad conclusions to be reached. Similarly, evidence on trade openness (import penetration) analysed using (endogenous) trade flows is ambiguous, though lower trade barriers measured using tariff measures appear to increase ERPT.

Fresh research work on ERPT in DEM countries should concentrate on addressing the empirical deficiencies: comparing single equation and systems methods given their comparative advantages and disadvantages; checking robustness to different empirical proxies and lag lengths in better-specified equations (using general-to-specific approaches), and to variable ordering (in VARs); and taking account of the nonlinearities and regime changes that prove pervasive in DEM economies (monetary and trade regime changes, implying instability in ERPT) and asymmetries of various types.

A high priority for research on aggregate time-series data for DEM countries is to incorporate domestic costs in the form of unit labour costs. Such data for the aggregate economy are often unavailable, but for many countries there are data on wage rates – at least for some sectors of the economy – and on productivity growth – even if only annual data. Unit labour costs could be replaced by hourly or per-person wage or earnings data and the productivity trend, without enforcing the restriction:  But this needs to be studied in at least a three-equation system, in which domestic prices, wages, and the exchange rate are treated as endogenous, and where for small economies, foreign prices (including oil prices) are taken as exogenous. Where highly disaggregated micro-data are available, studies of heterogeneous ERPT can generate insights into the effect of market structure and the economics of inflation.

For wary DEM country policymakers, ‘forewarned is forearmed’ when it comes to the interpretation of ERPT results.

Acknowledgements: This research was supported the British Academy, by grants from the Open Society Foundation and the Oxford Martin School.

References

Aron J, G Farrell, J Muellbauer and P Sinclair (2014),"Exchange Rate Pass-through to Import Prices, and Monetary Policy in South Africa", Journal of Development Studies, Taylor & Francis Journals, vol. 50(1), pages 144-164, January.

Aron, J, R MacDonald, and J Muellbauer (2014), “Exchange Rate Pass-through in Developing and Emerging Markets: a Survey of Conceptual and Policy Issues, and Empirical Findings”, Special Section on Exchange Rate Pass-through, Journal of Development Studies, 50(1): 101–143. 

Barhoumi, K (2006), “Differences in Long Run ERPT into Import Prices in Developing Countries: An Empirical Investigation”, Economic Modelling, 23: 926–951.

Castle, J L, J A Doornik, and D F Hendry (2012), “Model Selection when there are Multiple Breaks”, Journal of Econometrics, 169: 239–246.

Dale, S (2011), “MPC in the dock”, Speech by Executive Director, Monetary Policy, and Chief Economist of the Bank of England, National Asset-Liability Management Global Conference, London, 24 March. 

Menon, J (1995), “Exchange rate pass-through”, Journal of Economic Surveys, 9(2): 197–231.

Obstfeld, M (2002), “Exchange rates and adjustment: perspectives from the New Open-Economy Macro-models”, Keynote speech, Bank of Japan, Monetary and Economic Studies, special edition, December: 23–46. 

Taylor, J B (2000), “Low Inflation, Pass-Through, and the Pricing Power of Firms”, European Economic Review, 44: 1389–1140.

Footnotes

1 For correcting trade imbalances, a high level of pass-through to import prices and to wholesale prices to induce expenditure-switching is helpful, but a low subsequent pass-through to retail prices (e.g. the CPI) is needed to contain inflation and promote competitiveness (Obstfeld 2002).

2 This issue is by no means settled – see Dale (2011) on the underestimation of ERPT to import prices in 2009 in the UK.

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Topics:  Exchange rates

Tags:  exchange rates, exchange rate pass-through, developing countries, emerging markets, model misspecification

James Martin Fellow, Institute for New Economic Thinking; Associate Member, Nuffield College; and Member of the Centre for the Study of African Economies, University of Oxford

Senior Research Fellow, Nuffield College; Professor of Economics, Oxford University; and Senior Fellow, Institute for New Economic Thinking, Oxford Martin School

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