Economic modelling in the caseof oil euphoria

AgMIP seminar

Dr Aziz Hayat

Deakin UniversityAustralia

Introduction• Azerbaijan is a former USSR state and got independence

in 1991.• It witnessed an oil boom, which created an oil euphoria

that led to higher real exchange rate.• When oil euphoria subsided, real exchange depreciated,

provided a further opportunity to invest in Agriculture.• However, its agriculture value added as %age of GDP

declined from 33% in 1994 to merely 5% in 2012 despite having an oil boom.

• I will now focus on as to why real exchange rate appreciated in 1996-1999 period and why it depreciated in 2000-2003 period and what it meant for Agriculture sector in Azerbaijan.

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1. Definitions related to real exchange rate (RER)

2. Features of Azerbaijan economy relevant for RER.

3. Questions we try to address

4. Methodology

5. Findings

6. Discussion

7. Implication

Rest of presentation is organized as follows :

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nPtP

Some Definitions*:

1. Real Exchange Rate (RER)

goodstradableofice

goodstradablenonoficeRER

Pr

Pr

* Dornbusch (1974), Kruegen (1982), and Frenkel & Musa (1985)

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1.1. Measures of RER for Azerbaijan:

where is the share of country i in Azerbaijan’s non-oil trade turnover in 2001, and ,

is the foreign currency of country i per Manat.No. of countries = n= 18.

iw

AZproductsfoodnonFood

AZServices

CPI

CPIRER

&

1

iw

i

AZServices

i

n

i WPI

CPIeRER

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1n

iiw

ie

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1.2. Equilibrium Real Exchange Rate (ERER) :

ERER is the relative price of non-tradable goods to tradable goods that, for given long-run equilibrium values of other relevant variables (fundamentals) results in the simultaneous attainment of internal and external equilibrium.

Edwards (1989)

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1.2.1. Internal Equilibrium :

The non-tradable goods market clears in the current period and is expected to be in equilibrium in thefuture.

1.2.2. External Equilibrium :

The current account balances in the present period and thefuture satisfy the inter-temporal budget constraint that states that the discounted value of the current account balances has to be equal to zero.

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1.3. ERER Fundamentals :

1. Productivity (Balassa-Samuelson (1964)) 2. Real interest rate differential3. Capital flows4. Openness of the economy5. Terms of trade6. Government consumption

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RER Misalignment = Actual RER -- ERER

RER Misalignment:

We measure it. We can estimate it.

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Features of Azerbaijan economy relevant for RER

a. HAS been in transition from a centrally planned to a market based economy since 1992.

b. IS at an early stage of a major oil boom.

2.

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1. Sharp devaluation of the RER at the onset of transition followed by gradual appreciation.

2. Dismantling of old production structures and initiating structural reforms. (Halpern and Wyplosz, 1997)

1. Unanticipated increase in wealth and permanent income.

Characteristic features of transition and oil rich economies relevant for RER:

Transition Oil boom

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3. The liberalization of capital accounts and subsequent capital inflows. (Orlowski, 1998 and Brada, 1998).

Transition Oil boom

Appreciation of RER

2. Capital inflows: Portfolio and foreign direct investment (FDI).

Cont’d (Characteristic features)

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2.1 Evolution of RER fundamentals in Azerbaijan :

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Figure-1: Index of Productivity (ratio of real GDP to total employment, seasonally adjusted,

2001=100)

60

70

80

90

100

110

120

130

1996 1997 1998 1999 2000 2001 2002 2003

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Figure-2: Foreign direct investment (seasonally adjusted, million US dollars)

0

100

200

300

400

500

600

1996 1997 1998 1999 2000 2001 2002 2003

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Figure-3: Govt. expenditures on goods & services (percent of GDP, seasonally adjusted)

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4

5

6

7

8

9

1996 1997 1998 1999 2000 2001 2002 2003

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BUT RER has been depreciating since Mar / Dec 1999!!!

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40

60

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1996 1997 1998 1999 2000 2001 2002 2003

RER1

RER2

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• Why has the RER been depreciating since 1999?

• Will it continue to depreciate and for

how long?

3. Questions we try to address

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3.1 This has helped to achieve rapid growth in the non-oil tradable goods (Manufacturing) sector in 2002-2003:

2000 2001 2002 2003

GDP at market prices 11.1 9.9 10.6 11.2Net taxes on goods and services 74.1 66.0 12.1 11.2

GDP at factor cost 8.5 6.2 10.4 11.2Industry 6.9 7.7 4.9 4.3

Oil and gas extraction and processing n.a. n.a. 3.9 0.6Other n.a. n.a. 9.6 22.2

Agriculture 12.1 5.0 6.4 5.6Construction 2.6 0.9 81.7 61.0Services 9.6 6.2 6.1 8.0

Azerbaijan: Growth Rate of Real GDP by Sector of Origin, 2002-2003: (in percent)

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We argue that it is due to the oil euphoria as reflected in signing of numerous production-sharing agreements (PSA) in the oil sector in 1994-1999, which led to “excessive” appreciation of the RER at the time.

In the later half of the sample, the oil euphoria subsided as some of the PSAs failed or ran into difficulties, which led to the downward revision of future income and hence the depreciation of RER.

The depreciation of the RER in 2000-2003:

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4. METHODOLOGY

a. Basic Approach

• Assume that the prices are determined by the market.• Then, the best guess for the actual RER with no other

information would be:

(1) tt ERERRERE

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• Now suppose we do not know ERER, but we have atheory of how it is determined:

)( tt lsfundamentafERER

• We don’t observe ‘f ’, however we can estimate ‘f ’.

(1) & (2)

ERER could be estimated by simply regressing actualRER on ‘fundamentals’ given (1) holds.

(2)

0)( ttttt lsfundamentaEwithlsfundamentafRER

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4.1 ECONOMETRIC ESTIMATES:

(i) Engel-Granger (1987) designed error correctionmodel (ECM).

(ii) Johanson (1995) designed vector error correctionmodel (VECM)

Estimation Techniques:

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EQUATIONS:

Long-run equilibrium:

ttt xcy EG :

ttttt yyyy 22111JN :

(3)

(4)

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a. Long-run variables:

• Productivity• Terms of trade (ToT)• Country Risk (An index of economic & political stability)• Openness (ratio of the sum of exports & imports to GDP)• Interest rate differential (vis-à-vis US)• Foreign direct investment (as % of GDP)• Cumulative amount of oil to be produced under

existing PSA (measuring expectations of future income).

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Cumulative amount of oil to be produced under existing PSA (billion barrels) :

0

5

10

15

20

25

30

94 95 96 97 98 99 00 01 02 03

PSA PSA_AD

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b. Data

• Frequency: Quarterly

• Sample period: September 1996 to December 2003.

• Sources: ADB database, IMF-online, Intelligence economic unit, National Bank of Azerbaijan, IMF unpublished data.

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4.2 EMPERICAL RESULTSModels 1EG 1JN 2EG 2JN

Log(PSA) 0.204 0.173 0.251 0.201[6.946] 14.752 [6.701] [7.176]

Log(Productivity) 0.531[10.513]

Log(TsOT) -0.110 -0.145 -0.449 -0.683[-2.439]** [-9.463] [-7.802] [-17.813]

Openness 0.004[8.711]

Govt. expnditures 0.022 0.038[7.776] [4.438]

Risk -0.008 -0.008 -0.013 -0.019[-3.519] [-8.157] [-4.351] [-8.872]

Constant 4.415 4.404 4.523 2.658[22.297] [53.122] [17.874] [9.704]

R squared 0.916 0.940Adjusted R squared 0.906 0.933Order of VAR na 2 na 1No. of observations 30 27 30 28Note: t-statistics in square brackets**) Siginificance level at 5%, rests are all siginificant at 1%.

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Oil Euphoria and Overshooting of RER:

Over-shooting= ERER (with successful & unsuccessful PSA’s) minus

ERER_AD (with successful PSA’s)

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Legends of the following graphs:

RER1 = Real exchange rate 1

ERER1EG = ERER using RER1 estimated by Engel-Granger (EG) method.

ERER1JN = ERER using RER1 estimated by Johansen Method (JN) method.

ERER1EG_AD = ERER1 was adjusted for unsuccessful PSA’s before estimating by EG.

2 in other graphs stand for other measure of RER that isRER2.

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Oil Euphoria and Overshooting of RER

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1996 1997 1998 1999 2000 2001 2002 2003

RER1 ERER1JN ERER1JN_AD

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100

110

1996 1997 1998 1999 2000 2001 2002 2003

RER1 ERER1EG ERER1EG_AD

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20

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60

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100

120

140

1996 1997 1998 1999 2000 2001 2002 2003

RER2 ERER2JN ERER2JN_AD

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60

80

100

120

140

1996 1997 1998 1999 2000 2001 2002 2003

RER2 RER2EG RER2EG_AD

Oil Euphoria and Overshooting of RER

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5. FINDINGS:

• The signing of numerous PSA’s in 1994-99 fueled expectations of high future income and increased consumption expenditure on both tradable and non-tradable goods. Since the price of tradable goods is given by the international market, the relative price of non-tradable goods increased. In other words, RER appreciated.

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• Subsequently, some of the PSA’s failed or run into difficulties, which led to a downward revision of expected future income, a reduction in current spending and, thus, depreciation of the RER.

• In retrospective, the oil euphoria of 1994-99 caused appreciation of RER in excess of what we would have observed if the expectations of future income were more realistic.

Cont’d (Findings)

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• The excess appreciation of 1994-99 has been undone by the depreciation of 1999-2003, therefore we expect the RER to start appreciating again.

Cont’d (Findings)

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Our finding of RER movements being caused by changing expectations of future income is not limited to Azerbaijan.

It applies to any country in which exogenous factors (a discovery of oil reserves, an increased global demand for natural resources, a considerable rise in world commodity prices, etc.) can cause substantial swings in the RER through their effects on expectations of future income.

I and Prof Victor have done some work on this with US RER and see a similar phenomena being happening.

6. DISCUSSION

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7. IMPLICATIONS :

• The expected appreciation of RER will have a negative impact on the competitiveness of the non-oil tradable goods sector.

• Therefore the Government of Azerbaijan needs to enhancethe competitiveness of the non-oil tradable goods sector

(especially Agriculture) by improving, in particular, the policy environment, further reducing the tax burden on the sector, its access to bank credits, and rehabilitating and upgrading economic infrastructure, if broad-based growth of last several years is to be maintained.