An Empirical Analysis of Exchange Rate Pass-Through in Singapore

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1 An Empirical Analysis of Exchange Rae Pass-Through in Singapore MAS Saff Paper No. 50 June 2009

2 AN EMPIRICAL ANALYSIS OF EXCHANGE RATE PASS-THROUGH IN SINGAPORE BY JOEY CHEW SAM OULIARIS* TAN SIANG MENG June 2009 * SAM OULIARIS WAS A CONSULTANT TO THE ECONOMIC POLICY DEPARTMENT OF THE MONETARY AUTHORITY OF SINGAPORE AND PROFESSOR OF BUSINESS POLICY AND ECONOMICS AT THE NATIONAL UNIVERSITY OF SINGAPORE. THE VIEWS IN THIS PAPER ARE SOLELY THOSE OF THE AUTHORS AND SHOULD NOT BE ATTRIBUTED TO THE MONETARY AUTHORITY OF SINGAPORE. THE AUTHORS ACKNOWLEDGE THE SUPPORT PROVIDED BY EDWARD ROBINSON TO THIS PROJECT AND HIS EXTENSIVE COMMENTS AND EDITS ON AN EARLIER DRAFT. THE AUTHORS ARE ALSO GRATEFUL TO CYRENE CHEW, DENNIS TAN AND PETER WILSON FOR THEIR USEFUL COMMENTS. THE MONETARY AUTHORITY OF SINGAPORE JEL CLASSIFICATION NUMBER: E3, E5, F3, F4 KEYWORDS: Exchange rae pass-hrough, Impor prices, Inflaion, Singapore

3 MAS Saff Paper No. 50 June 2009 ABSTRACT This paper provides an in-deph analysis of he exchange rae pass-hrough in he Singapore economy, allowing for he firs ime, asymmeric pass-hrough effecs over he business cycle. We find ha he firs sage exchange rae pass-hrough o domesic impor prices is complee, wih changes in he exchange rae fully refleced in domesic impor prices by he fourh quarer of he shock. The implicaion of his resul is ha he exchange rae provides an imporan buffer agains exernal price pressures a he borders, especially in periods of escalaing global commodiy prices, hereby conribuing significanly o he objecive of medium-erm price sabiliy. In comparison, he second sage pass-hrough, which involves he ransmission of a change in domesic impor prices o consumer prices, is more drawn-ou. Consequenly, he overall exchange rae pass-hrough o consumer prices is fairly modes: a 1% appreciaion in he S$ Nominal Effecive Exchange Rae (NEER) leads o a 0.1% decline in he domesic Consumer Price Index (CPI) in he shor run and a 0.4% decline in he long run. This finding is no unique o Singapore, as economeric evidence also poins o subdued pass-hrough for many oher indusrial counries. Our analysis also suggess he presence of asymmeric pass-hrough effecs across he business cycle. Amids robus economic growh, imporers end o pass on a smaller share of he cos savings arising from a sronger exchange rae han when coss increase as a resul of he weaker exchange rae during a downurn. Reailers also end o be more aggressive in passing on impor cos increases in a phase of srong economic expansion. The inference is ha Singapore s moneary policy needs o lean agains he wind during a robus cyclical expansion ha is accompanied by an increase in impor coss. Moneary Auhoriy of Singapore i

4 MAS Saff Paper No. 50 June 2009 TABLE OF CONTENTS ABSTRACT i TABLE OF CONTENTS ii 1. INTRODUCTION 1 2. LITERATURE REVIEW 3 3. HISTORICAL AND RECENT DEVELOPMENTS IN SINGAPORE S IMPORT PRICE INDEX AND CONSUMER PRICE INDEX 6 4. FIRST STAGE PASS-THROUGH ANALYTICAL FRAMEWORK EMPIRICAL MODELLING AND ESTIMATION RESULTS INTERPRETATION OF THE REGRESSION RESULTS ASYMMETRIC PASS-THROUGH EFFECTS OVER THE BUSINESS CYCLE SECOND STAGE PASS-THROUGH ANALYTICAL FRAMEWORK EMPIRICAL MODELLING AND ESTIMATION RESULTS INTERPRETATION OF THE REGRESSION RESULTS ASYMMETRIC PASS-THROUGH EFFECTS OVER THE BUSINESS CYCLE 27 Moneary Auhoriy of Singapore ii

5 MAS Saff Paper No. 50 June CUMULATIVE IMPACT OF THE TWO STAGES AND IMPLICATIONS FOR MONETARY POLICY CONCLUSION 33 REFERENCES 35 APPENDIX 1 SERIES DESCRIPTION AND DATA SOURCES 38 APPENDIX 2 UNIT ROOT AND COINTEGRATION TEST RESULTS FOR ipi, fwpi AND exr 39 APPENDIX 3 UNIT ROOT AND COINTEGRATION TEST RESULTS FOR cpi, ulc AND ipi 40 Moneary Auhoriy of Singapore iii

6 MAS Saff Paper No. 50 June INTRODUCTION 1.1 Since 1981, moneary policy in Singapore has been cenred on he managemen of he Singapore Dollar-denominaed Nominal Effecive Exchange Rae (S$NEER) o promoe price sabiliy as a sound basis of susainable economic growh. 1 The nominal exchange rae affecs domesic consumer prices hrough wo channels: (i) he domesic prices of impored goods; and (ii) he profi margin of exporers, which in urn affecs he level of resource uilisaion and hence domesic price pressures. 2 The firs channel, commonly known as exchange rae pass-hrough, consiss of wo sages. In he firs, changes in he nominal exchange rae are ranslaed ino he prices of impors in local currency erms. These price changes are passed on in whole or in par o he consumer during he second sage. 1.2 The exen of pass-hrough a each sage was previously examined in wo separae papers by he Moneary Auhoriy of Singapore. (MAS, 2001b and 2001c) A he firs sage, MAS (2001c) finds ha he exchange rae passhrough o domesic impor prices is complee, wih changes in he exchange rae fully refleced in domesic impor prices by he fourh quarer of he shock. In comparison, he second sage pass-hrough is more sluggish, as suggesed in MAS (2001b), wih changes in domesic impor prices having a more mued impac on consumer prices. 1.3 This paper updaes he empirical esimaes, affirms he earlier findings, and combines he resuls from he wo sages o assess he cumulaive pass-hrough impac on he domesic Consumer Price Index (CPI). The resuls show ha he shor- and long-run pass-hrough elasiciies are 0.1% and 0.4%, respecively. I is imporan o noe ha his impac does no incorporae he effecs of he second ransmission channel hrough which he exchange rae affecs consumer prices i.e. he expors earnings channel. A general equilibrium economeric model would be needed o assess he overall impac of he exchange rae on consumer prices. 1.4 This paper also examines how he pass-hrough elasiciy has evolved over he years. The resul deecs a discernible rend of declining pass-hrough effec a he firs sage. This empirical finding is no unlike ha of he oher developed economies. For example, Gagnon and Ihrig (2004) 1 2 MAS (2001a) and Khor e al (2004) provide more informaion on he exchange rae policy regime in Singapore. See MAS (2008a) for a sylised descripion of he price deerminaion mechanism in Singapore. Moneary Auhoriy of Singapore 1

7 MAS Saff Paper No. 50 June 2009 and Liu and Tsang (2008) repored similar resuls for he U.S and Hong Kong economies, respecively. 1.5 To furher he undersanding of he price ransmission mechanism, he paper also invesigaes wheher here are asymmeric pass-hrough effecs over he business cycle. Conceivably, imporers and reailers could vary heir pricing behaviour considerably, depending on he sae of economic condiions. However, such asymmeric effecs have no been examined in he pass-hrough lieraure. To his end, he paper provides an empirical characerisaion of he asymmeric pass-hrough effecs for he wo sages. The resuls sugges ha a he firs sage, imporers pass on a smaller share of he cos savings arising from a sronger exchange rae amids robus economic growh han when coss increase as a resul of a weaker exchange rae during a downurn. A he second sage, reailers end o be more aggressive in passing on impor cos increases during sronger economic condiions. 1.6 Finally, wo inferences for Singapore s exchange rae policy are drawn from he empirical findings. Firs, he exchange rae is an effecive ool in curbing exernal price pressures a he borders, as he effecs of a change in he exchange rae are fully passed on o domesic impor prices wihin a year. This would imply ha in periods of escalaing global commodiy prices, a sronger exchange rae could conribue significanly o he objecive of medium-erm price sabiliy. Second, in view of he asymmeric pass-hrough effecs, moneary policy in Singapore needs o lean agains he wind during a robus cyclical expansion accompanied by an increase in impor coss. 1.7 This paper is organised as follows. The nex secion presens a brief survey of he lieraure on exchange rae pass-hrough, while Secion 3 reviews he hisorical rends in Singapore s impor and consumer price indices. Secions 4 and 5 provide he analyical framework and he empirical resuls for he firs and second sage pass-hrough, respecively. Asymmeric pass-hrough effecs for he wo sages are also separaely modelled and esimaed. Secion 6 combines he wo sages ino a single empirical model and illusraes he overall pass-hrough ransmission via simulaions. Inferences for exchange rae policy are also made. Secion 7 summarises and concludes. Moneary Auhoriy of Singapore 2

8 MAS Saff Paper No. 50 June LITERATURE REVIEW 2.1 The lieraure on exchange rae pass-hrough is exensive, wih he bulk of he research focused on he relaionship beween he exchange rae and impor prices, i.e. he firs sage. The second sage pass-hrough, which involves he impac of a change in impor prices on consumer prices, is seldom sudied in isolaion. 2.2 Firs sage pass-hrough is complee when he change in he exchange rae is refleced fully in domesic impor prices. This phenomenon ends o occur in small, open economies where imporers are price-akers given ha heir demand accouns for a relaively small share of producers oupu. For example, Dwyer and Leong (2001) esimae ha he long-run elasiciy of he exchange rae for Ausralia is no saisically differen from uniy and ha complee pass-hrough is achieved wihin four quarers. MAS (2001c) also obains similar resuls for Singapore. However, no all he small open economies experience complee firs sage pass-hrough; Liu and Tsang (2008) find ha Hong Kong s firs sage pass-hough is incomplee, wih he esimaed long-run pass-hrough elasiciy a 65%. 2.3 More generally, economeric evidence suggess he rae of firs sage pass-hrough ends o be incomplee in he long run for indusrial counries. For example, in heir sudy of impor prices for a sample of 23 OECD counries in he pos Breon-Woods period, Campa and Goldberg (2005) find average pass-hrough elasiciies of abou 64% in he long run. This resul is similar o he esimae for euro-area s pass-hrough elasiciy in Campa, Goldberg and Gonzalez-Minguez (2005). The hypohesis ha he ransmission is complee is also rejeced for a majoriy of counries in boh papers. Furher, several economeric sudies have found evidence of a declining exchange rae pass-hrough in indusrial counries since he 1990s. For example, Marazzi and Shees (2007) find ha a 1% depreciaion in he US$ would lead o a 0.2% increase in US impor prices in he 1990s, down from an increase of 0.5% in he period of 1970s and 1980s. Resuls from Bailliu and Fujii (2004) also sugges a saisically significan decline in firs sage pass-hrough in he 1990s for a panel of 11 indusrial counries including he US, UK and Ausralia. 2.4 A smaller srand of he lieraure focuses direcly on he relaionship beween he exchange rae and he aggregae consumer price index. Similar o he firs sage resuls, cross-panel counry daa and even sudies along he likes of Gagon and Ihrig (2004) and Cunningham and Haldane (2002) sugges Moneary Auhoriy of Singapore 3

9 MAS Saff Paper No. 50 June 2009 ha he pass-hrough of exchange rae movemens ino final consumer prices end o be low in indusrial counries, and ha here has been a general decline in is magniude in he 1990s. Mishkin (2008) also observes ha he correlaion beween consumer price inflaion and exchange rae change is now very low in mos indusrial counries 2.5 Several hypoheses have been pu forward o explain he phenomenon of low and declining exchange rae pass-hrough. Broadly, hey can be grouped ino macroeconomic and microeconomic facors. On he macroeconomic fron, Taylor (2000) argues ha in a sable, low inflaion environmen backed by a credible inflaion-argeing moneary policy regime, firms will reduce he exen o which hey pass on exchange rae-relaed cos increases. In comparison, Devereux and Yeman (2002) link exchange rae pass-hrough o inflaion from a differen perspecive. For counries experiencing relaively high raes of inflaion, hey argue ha he coss of mainaining fixed prices (namely, forgone profis) end o be much greaer han he menu coss of price changes, implying ha exchange rae passhrough should increase wih he rae of inflaion. 2.6 Many empirical sudies have sough o deermine he relaionship beween exchange rae pass-hrough and he inflaion environmen. The majoriy of hese sudies focus on cross-secional counry variaions in passhrough elasiciies. Choudrhi and Hakura (2001) and Devereux and Yeman (2002), for example, invesigae he role of inflaion variables in explaining cross-counry differences in exchange rae pass-hrough in a large sample of counries and find ha hese variables do have explanaory power. Bailliu and Fuji (2004) and Gagnon and Ihrig (2004) ake a differen approach and examine wheher exchange rae pass-hrough has declined in indusrialised counries in response o a shif o a more credible moneary policy regime. Boh sudies find evidence of such a decline. 2.7 Turning o he microeconomic facors, he lieraure has radiionally relied on he compeiive pricing behaviour of firms o explain he presence of incomplee pass-hrough. Dornbusch (1987) sees he decline in he exchange rae pass-hrough elasiciy since he 1980s as reflecing improvemens in compeiive condiions. However, such changes are ypically difficul o model. Unquanifiable facors such as rade liberalisaion and labour marke reforms can also lead o increased marke compeiion in he domesic economy, hus influencing he exen of exchange rae passhrough. Moneary Auhoriy of Singapore 4

10 MAS Saff Paper No. 50 June Oher indusrial economics-based explanaions have more recenly linked declining pass-hrough wih increased compeiion from China and he proliferaion of cross-border producion neworks. According o Marazzi and Shees (2007), he effecs of direc compeiion or he hrea of poenial compeiion wih China has caused exporers from oher counries o be more hesian o shif heir dollar prices in response o movemens in heir exchange raes. Olivei (2002) posulaes ha he larger presence of MNCs has led o a decline in exchange rae pass-hrough, owing o he prevalence of inracompany ransfer pricing, which are less responsive o exchange rae movemens han prices based on arm s lengh rade. 2.9 Finally, he inpu mix of raded goods could also explain he phenomenon of low exchange rae pass-hrough. Engel (2002) idenifies he exisence of local cos componens (e.g. coss for non-raded services such as labour) in raded goods as a source of incomplee exchange rae passhrough o consumer prices. Impored goods conain value added from domesic disribuion services such as ransporaion, wholesaling and reailing. The ransmission from a change in he exchange rae o he final consumer price will hus no be one-o-one even in he long run. More broadly, Campa and Goldberg (2005) observe ha he decline in firs sage pass-hrough could reflec a shif in he impor bundle away from energy and raw maerials owards more differeniaed manufacured goods whose prices are less sensiive o exchange rae movemens. Moneary Auhoriy of Singapore 5

11 MAS Saff Paper No. 50 June HISTORICAL DEVELOPMENTS IN SINGAPORE S IMPORT PRICE INDEX AND CONSUMER PRICE INDEX 3.1 This secion presens a review of he hisorical developmens in Singapore s impor price index (IPI) and consumer price index (CPI). The IPI racks changes in he prices of goods impored o Singapore in domesic currency erms. As a price aker in global markes, foreign price shocks could be ransmied rapidly o domesic impor prices. Given Singapore s high impor dependence, hese swings in he IPI will in urn significanly impac domesic consumer prices. This review will highligh he key facors underlying (i) he rend decline of he IPI in he period and he subsequen urnaround in he las decade; and (ii) he moderaing pace of increase in he CPI over he years despie higher impor prices. 3.2 Singapore s impor price index fell by 1.8% p.a. beween 1980 and 1998, reflecing in par, he fall in global prices of commodiies and elecronics goods as well as he srenghening of he S$NEER. 3 Over he same period, while he foreign wholesale price index (FWPI) 4 increased by 4.0% p.a., he relaively sronger pace of appreciaion in he exchange rae miigaed hese foreign cos pressures and kep impored prices in domesic currency erms low. (Char 3.1 and Table 3.1) Char 3.1 IPI, S$NEER and FWPI 300 FW PI 200 S$NEER 100 Index (Q1 1980=100) IP I Source: DOS, auhors calculaions 3 4 The S$NEER is weighed by he share of Singapore s major rading parners in oal impors. The counries and heir weighs in he S$NEER are no published. See Appendix 1 for he complee lis of daa sources and descripions of he series used in his paper. The Foreign Wholesale Price Index (FWPI) is weighed by he shares of Singapore s major rading parners in overall impors. Moneary Auhoriy of Singapore 6

12 MAS Saff Paper No. 50 June 2009 Table 3.1 Compounded Annualised Growh Raes of Domesic and Global Price Indices IMF Food and Beverages IMF Indusrial Inpus (% p.a.) Global Elecronics FWPI IPI Global Oil Source: IMF, CEIC, auhors calculaions Noe: Global oil price index refers o a simple average price index of U.K. Bren, Dubai and Wes Texas Inermediae. Global elecronics price is proxied by he US producer price index for semiconducors. 3.3 Following he oil shock in 1979/1980, global crude oil prices plummeed and remained relaively low for mos of , aside from he brief spike during he 1991 Gulf war. (Char 3.2) Consequenly, he mineral fuels componen in he IPI which carries a large weigh of 18% reflecing he requiremens of Singapore s oil refinery indusry fell by 4.7% p.a. over he same period. (Table 3.2) Global non-oil commodiy prices were also relaively benign, wih he IMF food and beverage price index and he IMF indusrial inpus price index falling by 1.8% and 1.0% p.a., respecively. Meanwhile, echnological advancemen and globalisaion led o significanly lower prices of elecronics in he lae 1990s as compared o he early 1980s. By he end of 1998, he US producer price index for semiconducors a proxy for global prices of elecronics had fallen by 60% since (Char 3.2) In Singapore, prices of impored elecronics are subsumed under he Machinery & Transpor Equipmen caegory which dominaes he overall IPI wih a weigh of 57%. Reflecing in par he weakness in he prices of elecronics, he subindex has also remained fairly sluggish over his period. Char 3.2 Global Prices of Primary Commodiies and Elecronics Goods 250 Energy 200 Index (Q1 1980=100) Food & Beverage Indusrial Inpus Elecronics Source: IMF, CEIC Moneary Auhoriy of Singapore 7

13 MAS Saff Paper No. 50 June 2009 Table 3.2 Compounded Annualised Growh Raes of Seleced IPI Componens (% p.a.) Food, Animal & Veg Oil and Beverages Crude Maerials Mineral Fuel Chemicals & Chemical Producs Manufacured Goods Machinery & Trans Equipmen Overall IPI Source: DOS, auhors calculaions 3.4 The decline in he IPI levelled off afer he Asian financial crisis. Since 1999, impor prices in domesic currency erms have become more sensiive o foreign cos pressures, as he pace of appreciaion in he S$NEER was more moderae compared o he 3.8% p.a. increase in he FWPI. The Singapore economy was buffeed by several shocks in he pas decade he Asian Financial Crisis in 1998, US-led IT recession in 2001 and SARS crisis in 2003 hus limiing he overall pace of appreciaion in he S$NEER. This was compounded by a rally in global commodiy prices. In , he IPI rose sharply by 13%, almos enirely due o he near ripling in global crude oil prices. I seadied beween 2001 and 2005 before rising sharply again in , in andem wih global price increases across he enire commodiy complex of agriculure, base meals and energy. The persisen fall in he prices of elecronics could no offse hese producion cos pressures and he IPI climbed by 2.3% p.a. beween 1999 and Meanwhile, consumer price inflaion in Singapore can be aribued o wo underlying facors: (i) he prices of impored goods, which follows from he fac ha Singapore is highly dependen on impors for is consumpion needs; and (ii) cos pressures arising from exernal demand, resuling in aendan income spillover effecs on he non-radable secors. The laer affecs inflaion indirecly via derived demand for resources in he producion of expors. This ransmission mechanism is summarised in he relaionship beween he rae of resource uilisaion as proxied by he oupu gap and CPI inflaion. 5 Beyond he full uilisaion rae of resources, he oupu gap urns posiive, and engenders a rise in inflaionary pressures, as he capaciy of he economy is unable o mee he level of demand. Conversely, when he oupu gap urns negaive, he economy experiences a slack in resource uilisaion, hus resuling in an easing of cos and price pressures. Boh series rack 5 The oupu gap was derived from a weighed average of hree mehods a mulivariae saespace model, Friedman (1984) s variable span smooher and a simple univariae HP filer. Moneary Auhoriy of Singapore 8

14 MAS Saff Paper No. 50 June 2009 each oher fairly well, wih an esimaed correlaion coefficien of around 0.8. (Char 3.3) Char 3.3 Oupu Gap and Inflaion Oupu Gap (% of Poenial GDP) CPI Inflaion Per Cen Source: DOS, auhors calculaions The economy was above is poenial rajecory in he early 1980s, as he oupu gap averaged around 4%. Reflecing he reduced slack in capaciy as well as he 1979/80 oil shock, domesic inflaionary pressures inensified during his period. The recession in 1985 brough he economy some respie, wih inflaion averaging -0.1% p.a. in In he ensuing decade, domesic economic aciviy rebounded robusly. Amids he susained posiive oupu gap, inflaionary pressures also srenghened. 3.7 Cyclical weaknesses came o he fore amids he Asian financial crisis, which brough inflaion down o -0.3% in Nowihsanding he srong recovery in 2000, domesic price pressures remained fairly subdued over he period , as he Singapore economy was below is poenial growh rajecory for a record period of five years since 2001 owing o an unprecedened incidence of exernal shocks. 3.8 Shor-erm volailiy in CPI inflaion aside, domesic consumer price inflaion has remained relaively low and sable when viewed over longer periods. Headline CPI rose by 2.5% p.a. in he 1980s, and moderaed o an average growh of 1.9% p.a. in he 1990s, in par reflecing he subdued impored inflaion, as evidenced by he rend decline in he IPI. Subsequenly, nowihsanding he reversal in he downrend in he IPI, CPI inflaion eased furher o an average of 1.3% p.a. in he period of , on accoun of he slack in he domesic economy. The decline in he momenum of price increase since he 1980s had been broad-based across he major CPI caegories. (Table 3.3) Moneary Auhoriy of Singapore 9

15 MAS Saff Paper No. 50 June 2009 G3 CPI Table 3.3 Compounded Annualised Growh Raes of Exernal and Domesic CPI (% p.a.) Domesic CPI AXJ CPI ALL ITEMS Clohing & Foowear Transpor & Communi -caion Educaion & Saionery Healh Care Recreaion & Ohers Food Housing Source: CEIC, auhors calculaions 3.9 Srucural facors could have also affeced inflaion dynamics in Singapore. Noably, he generally benign inflaionary environmen was observed in he G3 economies as well as emerging Asia. Moneary heoriss, including John Taylor and Frederic Mishkin, have since aribued he moderaion in CPI inflaion o increasingly anchored inflaion expecaions arising from a more credible moneary policy regime. There has also been a gradual shif in consumpion preferences oward services-relaed iems, such as educaion, healh care and recreaion, as shown in heir larger CPI weighs, hus rendering he CPI o be less sensiive o changes in impor prices. (Table 3.4) Increased flexibiliy and compeiion in boh he produc and facor markes could have also kep a lid on he pass-hrough of domesic and foreign coss o final consumer prices. Table 3.4 Singapore s CPI Caegories and Weighs Caegories Weighs (%) Food Clohing & Foowear Housing Transpor & Communicaion Educaion & Saionery Healh Care Recreaion & Ohers Source: DOS 3.10 The discussion hus far has focused on he possible qualiaive facors affecing he evoluion of impor and consumer prices. In he nex wo secions, economeric echniques are used o quanify he exchange rae pass-hrough effecs in he wo sages. Asymmeric pass-hrough effecs are also allowed for over he business cycle o furher he undersanding of he price ransmission mechanism. Moneary Auhoriy of Singapore 10

16 MAS Saff Paper No. 50 June FIRST STAGE PASS-THROUGH 4.1 ANALYTICAL FRAMEWORK The sandard pass-hrough lieraure has radiionally relied on a simple modificaion o he Law of One Price o assess he degree of firs sage exchange rae pass-hrough over he long-run. This paper uses he following modified equaion: ( FWPI ) ( EXR) β α IPI = wih 0 α 1 and 0 β 1 (1) In equaion (1), IPI denoes he domesic IPI, FWPI represens a foreign wholesale price index weighed by Singapore s major rading parners and EXR is he S$NEER ha convers foreign prices ino domesic prices Under his specificaion, here is complee firs sage pass-hrough of he exchange rae in he long run if β = 1. Such pricing behaviour is also known as producer currency pricing, given ha he producers of impors se he prices in heir home currency. This could happen, for insance, in an environmen of very high inflaion, or in highly dollarised economies. One would also expec such behaviour o prevail in a small economy, where imporers are price-akers given ha heir demand accouns for a relaively small share of he producers oupu In he even of a zero pass-hrough, domesic prices of impors are independen of movemens in he exchange rae. This implies ha he β coefficien in equaion (1) is zero. The inference is ha he producers pracice local currency pricing, by fixing he domesic prices of impors. This form of pricing behaviour is perhaps more plausible in indusrial economies on accoun of heir large domesic markes The exen of he pass-hrough could also be incomplee in he long run. This could arise on accoun of a monopolisically compeiive environmen, as imporers miigae he effecs of exchange rae changes by varying heir profi margins o mainain heir marke share. In his case, β would fall beween 0 and 1. Moneary Auhoriy of Singapore 11

17 MAS Saff Paper No. 50 June To esimae β, a logarihmic ransformaion is applied o equaion (1), yielding he following equaion: ipi = φ + α fwpi ) + λ( exr ) (2) ( wih λ = β, 0 α 1 and 1 λ 0 where α and λ are he elasiciies of domesic impor prices wih respec o foreign impor prices and he exchange rae, respecively. 6 In a small, open economy like Singapore, firs sage exchange rae pass-hrough is expeced o be complee in he long run, i.e. λ = -1, as imporers are price-akers. 4.2 EMPIRICAL MODELLING AND ESTIMATION RESULTS We proceed o es for he presence of uni roo in he hree series in equaion (2). Appendix 2 repors ha all he hree series in equaion (2) are found o be non-saionary based on he Augmened Dickey-Fuller (ADF) es. The Johansen coinegraing es also affirms he exisence of a long-run relaionship beween he hree variables. Equaion (2) is herefore esimaed using Johansen maximum likelihood coinegraion based on quarerly daa from 1980 o The esimaed coefficiens (Table 4.1) are of he expeced signs and saisically significan. We are ineresed in esing wheher he following resricions hold: (i) α = 1, which implies complee long-run pass-hrough of foreign coss movemens; and (ii) λ = -1, which implies complee firs sage exchange rae pass-hrough in he long run. A likelihood raio es for coefficien resricions confirms ha α is saisically differen from 1 while λ is no saisically differen from -1. Equaion (2) is hen re-esimaed wih λ consrained o -1. (Table 4.2) 6 The variable fwpi can be furher expressed as a mark-up of producers of impored goods under condiions of imperfec compeiion in he imporing counry. See, for example, Campa and Goldberg (2005). MAS (2001b) adoped a similar approach oward modelling he exchange rae pass-hrough relaionship. For his paper, we have chosen he modified Law of One Price specificaion in equaion (1) o model he pass-hrough effecs. Noably, given ha Singapore is a very small open economy, domesic demand from Singapore is assumed o have no impac on impor prices. Moreover, here should be lile impor compeiion from Singapore-based producers o influence he mark-up of he foreign producers. Moneary Auhoriy of Singapore 12

18 MAS Saff Paper No. 50 June / 2/ Table 4.1 Esimaes of he Long-run Coefficiens Q Q Variable Coefficien Sd. Err. -sa fwpi α = exr λ = LR Tes for Binding Resricion Resricions Null hypohesis Resricion is binding Chi-square (1) p-value α = / λ = / The null hypohesis of he resricion being binding is rejeced. The null hypohesis of he resricion being binding is no rejeced. Table 4.2 Esimaes of he Long-run Coefficiens wih λ consrained o -1 Variable Coefficien Sd. Err. -sa fwpi α = exr λ = The esimaed (consrained) long-run equaion in Table 4.2 is subsequenly embedded wihin an error-correcion model (ECM) o capure he shor-run dynamics of domesic impor prices. Specifically, changes in IPI are affeced by deviaions of he IPI from is long-run equilibrium value (as deermined by he preferred long-run model in Table 4.2), and lagged changes in IPI, FWPI and EXR. The shor-run model (ECM (1)) is hus specified as: Δipi = β + β + 0 l i= 1 β Δipi 4i 1 ( ipi fwpi + exr ) 1 i 1 1 k i= 0 + coeff dummy_variables + ε + β Δexr 2i i + j i= 0 β Δfwpi 3i i (3) The number of lag erms is chosen using he sandard general-o-specific modelling approach, yielding he parsimonious model presened in Table 4.3. The coefficiens in he model are of he expeced signs and saisically significan. Moneary Auhoriy of Singapore 13

19 MAS Saff Paper No. 50 June 2009 Table 4.3 Key Resuls of ECM (1) Q Q Dependen Variable : Δ ipi Variable Coefficien Sd. Err. -sa p-value Error-correcion erm β 1 = Δ exr β 20 = Δexr 3 β 23 = Δ fwpi β 30 = Diagnosic Tes/Fi of Model R-squared Adjused R-squared Sd. Err Durbin-Wason sa To assess he srucural sabiliy of he esimaed equaion in Table 4.3, rolling regressions (wih a fixed 12-year window) are esimaed. Chars 4.1 and 4.2 plo he esimaed coefficiens of Δ exr and Δexr 3 and heir p-values, respecively. The changing pass-hrough elasiciies are no inconsisen for a small open economy ha has experienced significan srucural changes, paricularly wih regard o is rade paerns and he compeiion landscape in produc markes. More formally, he issue of parameer sabiliy can be evaluaed using a recursive rolling Chow es, 7 of which he corresponding p-values are shown in Char 4.3. The resuls flag a clear break in he regression specificaion around In view of he srucural parameer shifs, he shor-run specificaion is esimaed wih a reduced sample period from Q o Q4 2007, yielding he preferred shorrun specificaion for domesic impor prices in Table The recursive version of he Chow es is useful for deecing srucural breaks a some unknown dae wihin he sample period. For example, o assess wheher a paricular dae, say Q is he break dae, he whole sample is firs spli ino wo sub-samples, prior and afer Q The same specificaion, wih adjusmen for dummy variables, is esimaed for he wo sub-samples. The null hypohesis of parameer sabiliy is assessed based on he F-es saisics. This procedure is repeaed for he nex dae, Q and so on. Using his es, Marazzi and Shees (2007) deec a saisically significan srucural shif in he firs sage pass-hrough parameers for he US economy in Q Moneary Auhoriy of Singapore 14

20 MAS Saff Paper No. 50 June (a) Coefficien of Char 4.1 Δ exr (b) p-value for coefficien of Δexr 0.04 OLS Esimaed Coefficien p-value Noe: The x-axis shows he end poin of a 12-year rolling-window regression. For example, Q refers o he resuls of he regression, wih a sample period saring from Q and ending a Q Char 4.2 (a) Coefficien of Δexr 3 (b) p-value for coefficien of Δexr OLS Esimaed Coefficien p-value Noe: The x-axis shows he end poin of a 12-year rolling-window regression. For example, Q refers o he resuls of he regression, wih a sample period saring from Q and ending a Q Char 4.3 p-value of he F-es Saisic from Recursive Chow Tes p-value Moneary Auhoriy of Singapore 15

21 MAS Saff Paper No. 50 June 2009 Table 4.4 Key Resuls of he Shor Run Firs Sage Pass-hrough Q Q Dependen Varia ble : Δ ipi Variable Coefficien S d. Err. -sa p -value β 1 Error-correci on erm = Δ exr β 20 = Δexr 3 β 23 = Δ fwpi β 30 = Δfwpi 3 β 33 = Diagnosic Tes/Fi of Model R-squared Adjused R-squared Sd. Err Durbin-Wason sa INTERPRETATION OF THE REGRESSION RESULTS Several characerisics of Singapore s firs sage pass-hrough emerge from he empirical analysis. Firs, here is complee exchange rae pass-hrough in he long-run, similar o he findings in MAS (2001c). An appreciaion of he S$NEER provides cos savings o imporers in he shorrun. Over he long-run, hese savings will be fully passed down he domesic supply chain, as imporers compee for marke share. Conversely, faced wih a cos increase from a weaker exchange rae, and in he absence of excess margins, imporers will ulimaely need o pass on heir increased coss Second, while he conemporaneous firs sage pass-hrough is relaively large a 0.33% for a 1% appreciaion in he S$NEER (Table 4.4), here is a discernible decline in his effec over ime, as evidenced in he ime-varying rolling regression resuls shown in Char 4.1a. Heighened compeiive pressures could be forcing imporers o absorb a greaer proporion of exchange rae movemens Third, he resuls sugges ha imporers sagger he impac of a change in he exchange rae over a few quarers, perhaps due o price ineria arising from hedging conracs. This can be inferred from he coefficien of Δe -3 in Table 4.4, which implies ha domesic impor prices will fall by a furher 0.33% in he hird quarer afer a 1% appreciaion in he exchange rae. Also, he lagged impac appears o have become more pronounced from 2000 (Char 4.2a), alongside he gradual decline in conemporaneous pass-hrough Moneary Auhoriy of Singapore 16

22 MAS Saff Paper No. 50 June 2009 since This could reflec he proliferaion of hedging opporuniies on he back of increased deph and sophisicaion in Singapore s financial secor Fourh, from he empirical resuls, he effecs of a change in he exchange rae are fully passed on o domesic impor prices wihin a year of he shock. Char 4.4 depics he profile over ime of he cumulaive response of impor prices o a 1% appreciaion. Domesic impor prices fall by jus over a hird of a percen in he iniial quarer, and abou 0.6% by he hird quarer. Full pass-hrough is achieved by he fourh quarer. The endency for impor prices o quickly rever o is equilibrium afer an iniial shock is also eviden from he fairly igh co-movemens of he acual and long-erm equilibrium impor prices as implied by he coinegraion equaion. (Char 4.5) Char 4.4 % Deviaion of IPI from a 1% Appreciaion in S$NEER Char 4.5 Acual and Esimaed Long-Run IPI % Deviaion from Baseline Numbers of quarers ndex (Q1 1980=100) Acual IPI Implied Long-run IPI Source: DOS and auhors calculaions Lasly, he pass-hrough of foreign prices o domesic impor prices is incomplee in he long run. For a 1% increase in FWPI, domesic impor prices increases by 0.76%, which is significanly less han one. (Table 4.1) This resul can be aribued o Singapore s well-diversified impor sources. A foreign producer migh be resrained from passing on he full exen of a price increase o he Singapore marke for fear of losing marke share o oher providers. For example, global food prices, as proxied by he IMF food and beverage commodiy price index, increased by 50% beween Q and Q However, domesic food impor prices rose by a more subdued 21% over he same period. Alhough he smaller increase could be due in par o he sronger exchange rae, he diversiy of Singapore s food impor sources migh have also provided a buffer agains exernal price pressures. 8 On a echnical noe, i is also likely ha he composiion of goods in he 8 Using he Herfindahl Index as a measure of impor diversiy, MAS (2007) shows ha Singapore's food impor sources are indeed well-diversified. Moneary Auhoriy of Singapore 17

23 MAS Saff Paper No. 50 June 2009 domesic impor price index is differen from ha of he foreign wholesale price index. Prices should herefore no rise by he same exen. 4.4 ASYMMETRIC PASS-THROUGH EFFECTS OVER THE BUSINESS CYCLE The preceding pass-hrough resuls describe he average pricing behaviour of imporers across a range of differen economic condiions. However, i is plausible ha hey could vary considerably, depending on he sae of he business cycle. For example, amids robus demand, imporers migh pass on a smaller share of cos savings arising from a sronger exchange rae, relaive o he cos increase passed on (owing o a weaker exchange rae) during a downurn. Accordingly, he presence of asymmeric pass-hrough effecs is invesigaed using he following specificaion: cyc _ IMP = δ + δ cyc _ EXR + δ cyc _ EXR dum _ posgap + 0 j i= 0 1 δ cyc _ IMP* 4i i 2 + k i= 0 δ cyc _ IMP 5i 1 i 1 + δ cyc _ EXR dum _ neggap 3 + coeff dummy_variables + ε 1 (4) where he noaion cyc_ refers o he cyclical componens of he variables. 9 The dummy variable dum_posgap -1 akes he value of 1 if he oupu gap in he previous quarer is 1% and 0 oherwise. Conversely, he dum_neggap -1 akes he value of 1 if he oupu gap in he previous quarer is -1%, and 0 oherwise The magniude and saisical significance of he coefficiens {δ 1, δ 2, δ 3 } provide an assessmen of he asymmeric pass-hrough effecs arising from he business cycle. Broadly, hree asymmeric oucomes could be presen: (i) If he oupu gap a -1 is beween -1% and 1%, he variables dum_posgap -1 and dum_neggap -1 ake he value of 0. The coefficien δ 1 is hus inerpreed as he impac of a 1% appreciaion in he exchange rae on domesic impor prices when he economy is a around is poenial oupu level. 9 The cyclical componens are obained by aking he difference beween he acual values of he variables and heir respecive rend componens (esimaed using he Hordrick-Presco procedure). Moneary Auhoriy of Singapore 18

24 MAS Saff Paper No. 50 June 2009 (ii) In he even ha he oupu gap a -1 is 1%, he sum of he coefficiens, δ 1 and δ 2, shows he effecs of a 1% appreciaion on impor prices amids robus economic condiions. (iii) Should he economy ener ino a recession wih he oupu gap a -1 <= -1%, he sum of he coefficiens, δ 1 and δ 3, provides an esimae of he impac on impor prices owing o a 1% appreciaion of he exchange rae In view of he parameer insabiliy resuls for he earlier regressions, he specificaion in equaion (4) is esimaed using he same reduced sample period Q Q4 2007, as ha in Table 4.4. Table 4.5 repors he key resuls of he esimaed specificaion. Of he wo asymmeric dummy variables, cyc_e dum_neggap -1 is omied from he regression as is coefficien was saisically insignifican. In comparison, he oher dummy variable, cyc_e dum_posgap -1, as well as cyc_e are boh saisically significan. These resuls provide evidence for an asymmeric firs sage pass-hrough impac over he business cycle, albei wih only wo separae oucomes. Table 4.5 Key Resuls of Firs Sage Asymmeric Pass-hrough Q Q Dependen Variable : cyc _ IPI Variable Coefficien Sd. Err. -sa p-value cyc _ EXR δ 1 = dum _ posgap 1 cyc _ EXR δ 2 = cyc _ FWPI δ 40 = cyc _ IPI 1 δ 50 = Diagnosic Tes/Fi of Model R-squared Adjused R-squared Sd. Err Durbin-Wason sa Specifically, under robus economic growh, a 1% appreciaion in he exchange rae would lead o a 0.24% fall in domesic impor prices. For imporers, a sronger exchange rae reduces procuremen coss, and hence bolsers heir profi margins. However, i is possible ha hey need only pass on a smaller porion of hese cos savings over he near erm, as impor demand is expeced o remain robus on he back of coninued above-rend growh. In comparison, during sluggish economic condiions, a 1% Moneary Auhoriy of Singapore 19

25 MAS Saff Paper No. 50 June 2009 depreciaion in he exchange rae would lead o a 0.5% rise in domesic impor prices I should be noed ha in boh cases, he reverse argumen does no apply. Specifically, amids srong economic growh, a weaker exchange rae oucome is unlikely o maerialise, as i would furher fuel inflaionary pressures amids srong economic growh. Meanwhile, in weaker economic condiions, domesic inflaionary pressures would be mued given he slack in he economy and as such, a igh moneary policy is unlikely o be pursued under such circumsances. Moneary Auhoriy of Singapore 20

26 MAS Saff Paper No. 50 June SECOND STAGE PASS-THROUGH 5.1 ANALYTICAL FRAMEWORK The second sage of he exchange rae pass-hrough enails he ransmission of he change in impor prices in domesic currency erms o reail prices, and hence o CPI inflaion. A sandard cos mark-up specificaion is used o model his process. The model expresses Singapore s CPI as a mark-up over domesic uni labour cos (ULC) and IPI: ( ULC ) β ( IPI ) γ CPI = α (5) A logarihmic ransformaion is applied o equaion (5) o obain: cpi = λ + βulc + γipi (6) where (i) λ = log(α) and hus (e λ 1) is he reail mark-up over coss; and (ii) β and γ are elasiciies of he CPI wih respec o ULC and IPI respecively Equaion (6) capures he major sources of consumer price inflaion in Singapore: (i) domesic cos pressures, as proxied by ULC; and (ii) exernal price pressures, in he form of prices of impors. 10 In he presence of highly compeiive markes, he mark-up should also be only marginally posiive in he long run, since excess profi margins or losses are no expeced o prevail. As such, consumer prices of goods and services should rise proporionaely wih cos increases for businesses o remain viable in he long run. This is equivalen o uni homogeneiy, i.e. β + γ = Second sage pass-hrough is considered o be complee in he long run if CPI changes by γ% for a 1% change in IPI. This is differen from he firs sage pass-hrough, where a pass-hrough is complee only if he exen of he change in he exchange rae is refleced fully in he domesic impor prices. Effecively, he reail impor is a differen good compared o ha a he poin of impor. In he process of disribuion and sale, value added is conribued by he non-raded secors. Is price should hus no be expeced o move by he same proporion as he price of he impored componen, bu 10 The delineaion of he wo sources ino exernal and domesic is no as precise as heir labels sugges. Movemens in ULC are also heavily influenced by exernal condiions, given ha expor orders accoun for abou 75% of oal demand in he Singapore economy. Moneary Auhoriy of Singapore 21

27 MAS Saff Paper No. 50 June 2009 by a proporion equal o he share of he impored componen in he CPI, as represened by γ. 5.2 EMPIRICAL MODELLING AND ESTIMATION RESULTS Similar o he firs sage, we es for he presence of uni roo in he hree series in equaion (6). All he hree series are found o be nonsaionary based on he Augmened Dickey-Fuller (ADF) es. The Johansen coinegraing es also affirms he exisence of a long-run relaionship beween he hree variables. (Appendix 3) Equaion (6) is herefore esimaed using Johansen maximum likelihood coinegraion based on quarerly daa from he sample period Q Q used in he preferred specificaion for he firs sage. Boh elasiciies β and γ are of he expeced signs and are saisically significan. The likelihood raio es for coefficien resricions finds ha he sum of β and γ is no saisically differen from 1. (Table 5.1) The equaion is subsequenly re-esimaed wih his consrain, yielding he preferred long-run specificaion for consumer prices in Table / Table 5.1 Esimaes of he Long-run Coefficiens Q Q Variable Coefficien Sd. Err. -sa ulc β = ipi γ = consan α = LR Tes for Coefficien Resricions Hypohesis Chi-sq (1) p-value H o : β + γ = / The null hypohesis of he resricion being binding is no rejeced. Table 5.2 Esimaes of he Long-run Coefficiens wih he Consrain β + γ = 1 Q Q Variable Coefficien Sd. Err. -sa ulc β = ipi γ = consan α = The shor-run dynamics for second sage pass-hrough are specified in an ECM. Specifically, changes in he CPI are driven by he deviaion of he CPI from is long-run equilibrium value, as deermined by he mark-up model, as well as changes in CPI, ULC and impor prices in he shor run. Changes in he oupu gap and is level are also included in he se of explanaory shor- Moneary Auhoriy of Singapore 22

28 MAS Saff Paper No. 50 June 2009 run variables o capure he sae of he business cycle. The shor-run equaion (ECM (2)) can hus be expressed as: Δcpi = α + α + 0 l i= 0 4i 1 ( cpi 0.575ulc 0.425ipi ) α Δcpi 1 1 i + m i= 0 5i 1 α gapi i + n i= 0 1 6i + k i= 0 α Δgapi α Δulc i 2i i + j i= 0 α Δipi 3i i + coeff dummy_variables + ε (7) The number of lag erms is chosen using he sandard general-o-specific modelling approach, yielding he model presened in Table 5.3. Table 5.3 Key Resuls of he ECM (2) Q Q Dependen Variable: Δ cpi Variable Coefficien Sd. Err. -sa p-value Error-correcion erm α 1 = Δulc -3 α 23 = Δulc -5 α 25 = Δipi α 30 = Δipi -1 α 31 = gap -1 α 51 = Δgap α 60 = Diagnosic Tes/Fi of Model R-squared Adj R-squared Sd. Err Durbin-Wason sa Rolling regressions (wih a fixed 8-year window) are used o evaluae he robusness of he resuls. Chars 5.1 and 5.2 show he esimaed coefficiens of Δipi and Δipi -1 and heir p-values from he rolling regressions. The resuls sugges parameer insabiliy in he regression across he differen sample periods. In he laer periods, he esimaed coefficien of Δipi, becomes insignifican. In comparison, he esimaed coefficien of Δipi -1 urns saisically significan over ime, wih he sign becoming posiive. A recursive Chow-es suggess a discernible break in he parameers around Q (Char 5.3) Moneary Auhoriy of Singapore 23

29 MAS Saff Paper No. 50 June 2009 Coefficien (a) Coefficien of Δipi Char 5.1 (b) p-value for coefficien of Δipi p-value Noe: The x-axis shows he end poin of an 8-year rolling-window regression. For example, Q refers o he resuls of he regression, wih a sample period saring from Q and ending a Q Char 5.2 (a) Coefficien of Δipi -1 (b) p-value for coefficien of Δipi Coefficien p-value Noe: The x-axis shows he end poin of an 8-year rolling-window regression. For example, Q refers o he resuls of he regression, wih a sample period saring from Q and ending a Q Char 5.3 p-value of he F-es Saisic from Recursive Chow Tes p-value Moneary Auhoriy of Singapore 24

30 MAS Saff Paper No. 50 June Hence, he shor-run specificaion is re-esimaed wih a reduced sample period from Q o Q (Table 5.4) Diagnosic ess indicae ha all he key variables are significan a he 10 percen level or beer and display he expeced signs. Noably, he change in he oupu gap variable, raher han he level of he oupu gap which was dropped from he preferred equaion, affecs domesic inflaion oucomes. This suggess ha inflaionary pressures could emanae from he rapid closing of a negaive oupu gap, even when he rae of resource uilisaion is below poenial. 11 Table 5.4 Key Resuls of he Shor Run Second Sage Pass-hrough Q Q / Dependen Variable : Δcpi Variable Coefficien Sd Err -sa p-value Error correcion erm 1/ α 1 = Δulc α 20 = Δipi -1 α 31 = Δgap α 60 = Δgap -3 α 63 = Diagnosics/Fi of Model R-squared Adj R-squared Sd Error Durbin-Wason sa The long-run relaionship, as esimaed by he coinegraing equaion, is assumed o remain unchanged, given he small sample size A simulaion involving a 1% shock o IPI is inroduced o he equaion in Table 5.4 o assess he shor-run second sage pass-hrough. For comparison purposes, he equaion is also simulaed separaely wih a 1% ULC shock. Char 5.4 depics he response profiles of he CPI. As noed previously, firs sage exchange rae pass-hrough is complee by he fourh quarer of he onse of he shock. In conras, he adjusmen of CPI o is long-erm equilibrium from he IPI shock is far more sluggish and proraced. No only is he response smaller hroughou he horizon, he pace of adjusmen is also slower, paricularly in he ouer years. 11 MAS (2006) also shows ha changes in he oupu gap conain more useful informaion on inflaionary dynamics han he size of he oupu gap iself. Moneary Auhoriy of Singapore 25

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