Exchange rates, trade liberalization and aid: The Sri Lankan experience

World Developmenl, Vol. 20, No. 10, pp. 1471-1480,1992. 0305-750X/92 $5.00 + 0.00 Printed in Great Britain. 0 1992 Pergamon Press Ltd

Exchange Rates, Trade Liberalization and Aid:

The Sri Lankan Experience

HOWARD WHITE Institute of Social Studies, The Hague

and

GANESHAN WIGNARAJA* Magdalen College, Oxford

Summary. - In 1977 the Sri Lankan government embarked on an extensive program of liberalization, an important element of which was devaluation to ensure a competitive real exchange rate. The 1980s were, however, marked by an increasing divergence between the real and nominal exchange rates, the depreciation of the latter not being matched by similar movements of the former. This paper presents an econometric model of real exchange rate behavior in Sri Lanka. Among other things, it is shown that increased aid inflows have made a significant contribution to the failure of the real exchange rate to match the depreciation in the nominal rate

1. INTRODUCTION

Late in 1977 in Sri Lanka the newly elected United National Party (UNP) introduced a sweeping liberalization program, reversing nearly two decades of almost uninterrupted inward- oriented development. ’ Central to this strategy was the attempt to maintain a competitive exchange rate. As shown in section 2, however, high domestic inflation has meant that continuing depreciation has not been matched by a similar movement in the real exchange rate (RER). The RER actually appreciated during 1980-84, thereafter depreciating to return to approximately its 1978 level toward the end of the decade.

Section 3 considers possible explanations of the behavior of the RER, incorporating these in an econometric model of RER determination. A main finding is that the substantial increase in transfers (both aid and remittances) received by Sri Lanka after liberalization has caused the RER to appreciate (similar to the symptoms of Dutch Disease experienced by countries with commodity booms).* This result lends empirical support to the hypothesis that has recently emerged in the aid effectiveness literature (and elsewhere) that aid inflows may cause Dutch Disease in developing countries (e.g., Michaely,

1981; van Wijnbergen, 1985 and 1986; Levy, 1988; Taylor, 1988; and White, 1992).

Section 4 draws out the policy implications of the analysis and section 5 concludes.

2. REAL EXCHANGE RATE MOVEMENTS IN SRI LANKA, 1974-88

(a) Definitions and behavior

We adopt the trade theory definition of the RER which is the relative price of traded to nontraded goods; i.e. PdPN, where PT and PN are price indices of traded and nontraded goods respectively.’ In practice this is EPT*IP~, where E is the nominal exchange rate and * denotes a foreign variable. Following Harberger (1986), the accepted convention is to use the wholesale

*The authors would like to thank Robert Cassen, Chris Edwards, Ejaz Ghani, Keith Griffin, Peter Sinclair, Frances Stewart, Lance Taylor and two anonymous referees for helpful comments on earlier drafts of this paper. The usual disclaimer applies. Support for one of the authors from the ESRC during preparation of this paper is also gratefully acknowledged. Final draft accepted: December 20, 1991.

1471

1472 WORLD DEVELOPMENT

price index for traded goods and the consumer price index for nontraded. By the conventions adopted throughout this paper, an appreciation corresponds to a fall in the exchange rate and a depreciation a rise.

The construction of RER presents the resear- cher with a number of problems: (i) whether to use a bilateral rate (a nominal exchange rate given by domestic currency against a single foreign currency) or a multilateral rate (i.e., that against a basket of foreign currencies), and, if the latter. the weighting system to be adopted: (ii) the choice of the nominal rate used to construct the index in the presence of multiple exchange rates either because of the existence of a black market or an official dual rate s stem; and (iii) whether to use an effective rate Y. (l.c., one that takes into account the structure of protection).

In the case of Sri Lanka the last two are of less significance, and these arc discussed briefly first. The Foreign Exchange Entitlement Scheme (FEEC, see below), which operated during lY6X- 77. is al example of a dual exchange rate. Some indication of the extent of distortions (not only in foreign exchange markets) is given by the size of the black market premium, which was very high during the IYhOs but fell (with fluctuations) during the IY7Os and has remained low in the IYXOs (Edwards, lYXYb, p. 115). This suggests that the official rate is acceptable for the period covered by our analysis.

Next is the problem of whether to attempt an estimation of the effective rate so that the exchange rate more accurately reflects the relative prices faced by producers. As Faini (IYX6) points out. the data requirements for this arc usually prohibitive. Edwards (IYXYb). however. was able to estimate his equation of RER determination for both the usual RER and the real effective exchange rate (REER). The estimated coefficients varied very little according to which regressand was used (lYX9b. p. 139, Table 5.1 and p. 142. Table 5.2). In the case of Sri Lanka only bilateral (Rs./$) REER data are available. The undesirability of relying upon bilateral indices, combined with Edwards’s evidence just cited are sufficient argument for not taking this aspect into account in the present analysis.

Increasing exchange rate instability has increased the importance of the first issue men- tioned above by making the use of a bilateral rate (usually measured against the US dollar) ever less satisfactory.’ That this is so for Sri Lanka is borne out by our analysis (reported more fully in White and Wignaraja. 19Yl) of three nommal exchange rate indices - a bilateral rate and

multilateral rates based on competitor countries

and trading partners. While reasonably corrc- lated over the whole sample period, the relation- ship broke down during the IYXOs, with the three measures displaying significantly different trends. This trend is shown in Figure 1.

The trends observable in each of the exchange rate indices in Figure I may be explained as follows.” In the postwar period the rupee was closely linked to sterling, except for a brief period from November IY7l to July lY72, when it was pegged to the dollar. From May 1976 to November 1977 a basket of trading country currencies was used as the peg. but with sterling as the intervention currency. A slight depreciation of the rupee from the end of 1074 to the end of lY76 occurred, as sterling weakened against the dollar. From lY68 onward a dual exchange rate system (the Foreign Exchange Entitlement Scheme, FEEC) was operated in which nontradi- tional exports received a preferential exchange rate.

On November 15th. 1977 the new UNP government unified the exchange rate at a new devalued level after which the rupee was floated. The combined effects of the devaluation and flotation resulted in an X8.5% point-to-point depreciation of the trading partner nominal exchange rate index between the end of 1976 and 1077. The free float was continued until mid- 1981 1 at which point the Central Bank began to intervene on an ad hoc basis to avoid excessive instability in the exchange rate. A more formal managed float was adopted from lYX.3, partly at the insistence of the International Monetary Fund (IMF). As we shall now see, however, the depreciation of the nominal exchange rate was not matched by a similar movement in the RER.

Figure 2 shows both nominal and real exchange rate indices.’ Until lY78 the real rate trailed the nominal rate fairly closely. Thereafter they diverged, as the real rate appreciated during 19X&X4. Though the real rate depreciated slight- ly thereafter it did not do so at the same rate as the nominal index, thus the gap between the two grew larger. Why has the government been unable to further improve the competitiveness of the economy through further devaluation? We analyze the reasons for this wedge between the two rates below. First. however. we consider some of the likely implications for the economy of the divergence between the real and nominal exchange rates.

One of the principal objectives of liberalization

AID AND SRI LANKA

I I 1 I I I I -I 1972 1974 1976 1978 1980 1982 1984 1986 1988

cl N$ + NT 0 NC

Fig. 1. Sri Lunkan rzominal exchange rate indices, 197248.

210

200

IQ0

160

170

160

150

8

i

140

K 130

r 120

> 8 100 110

- QO

90

70

60

50

40

1 I I I I I

1974 1976 1978 1990 1962 1964 1986 1989

fJ

0 RER + Nanrnal ER

Fig. 2. Sri Lankan real arld rzomrnal excharlge rate itldrce., (1978 = 100)


in Sri Lanka was to facilitate outward-oriented growth, powered by the expansion of manufactured exports from private firms. The challenge as policy makers saw it was to duplicate the success of the outward-oriented, newly indus- trializing countries (NICs) of East Asia, with which Sri Lanka had been at a comparable stage of development less than two decades earlier (Kelegama and Wignaraja, 1988).

The adoption of outward-oriented policies resulted in some improvement in performance of manufacturing output and exports in Sri Lanka during the post-1977 period. Real average growth rates of manufacturing output accelerated sharply from 1.7% per annum during 197G-77 to 5.6% per annum during 1977788 (Wignaraja, 1991). Faster growth was accompanied by a greater export orientation of manufacturing output and a shift in the composition of total exports from a narrow range of agricultural products toward manufactures. The share of manufactures in total exports rose during 1975-87 from 12 to 40% (World Bank, 1989, Table 16).

Sri Lanka’s manufactured export performance in the outward-oriented period, however, is disappointing in two respects. First, it falls far short of the levels achieved by NICs such as South Korea and Singapore over a comparable period. Second. unlike in the two NICs, the expansion in Sri Lanka’s manufactured exports has been largely driven by simple, consumer goods rather than more advanced intermediate and capital goods. While the textile and clothing sector has displayed impressive growth, account- ing for just under a third of Sri Lanka’s total export value in 1986, other sectors have stag-

nated (see Table 1). The limited diversification into more advanced manufactured products has become a major concern for policy makers.

Many price and nonprice factors contribute to successful export performance in manufactures. The current fashion is to emphasize the importance of outward orientation, the market mechanism and appropriate macroeconomic policy. It is increasingly becoming accepted that a broader range of nonprice factors (such as the removal of infrastructural bottlenecks, the provision of ade- quate human capital and the development of indigenous technological capabilities) are also important to export success.’

We agree that a successful export strategy rests upon efficient management of these interacting factors. Nevertheless, our paper concentrates on a key relative price: the real exchange rate (RER). Policy makers in Sri Lanka were them- selves well aware of the importance of the exchange rate, and it was discussed in many policy documents. One such said of the 1980s that the real exchange rate “could be considered as adverse to exporters during virtually the entire plan period” (Export Development Board, 1990). The unsatisfactory performance of manufactured and other exports in Sri Lanka during 1977-88 may at least partly result from the failure to achieve the desired depreciation in the real exchange rate.

By contrast, services have grown rapidly in the postliberalization period, their growth nearly always exceeding that of the sectors producing traded goods (agriculture, mining and manufacturing, see Table 2). The construction sector experienced a substantial boom during 1977-80,

Table 1. Export structure by selected commodity groups: 1975. 1980 arId 1986

Share of selected manufactures (%) Value of exports Textiles and Metals and Machinery and

(US$ million) clothing Chemicals metal manufacturing transport equipment

Sri Lanka 1975 1980 1986

South Korea 1975 1980 1986

Singapore 1975 1980 I986

557 2.x 1.9 0. 1 0.3 1.043 12.9 3.1 0.1 0.4 1,159 31.5 2.1 0.4 0.X

5,070 36.3 1.5 7.1 13.x 17,446 29.9 4.5 14.3 19.7 34,702 25.2 3.3 10.1 31.2

5,377 4.9 3.7 3.2 22.7 19,376 4.3 7.1 3.8 26.4 22,428 5.0 6.2 3.3 38.0

Source: UNCTAD (1989, Table 4.1).

AID AND SRI LANKA 1475

Table 2. Real sectoral growth rates in Sri Lanka, 1977-87

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

Agriculture 10.4 5.4 2.0 3.1 6.9 2.6 5.0 -0.4 1.6 2.6 -5.8 Mining -9.8 20.2 5.3 4.9 4.2 4.1 7.8 1.5 1.5 5.2 23.2 Manufacturing -0.6 7.8 4.6 0.8 5.2 4.8 5.0 12.3 5.2 8.4 6.8 Construction -9.6 28.3 20.9 11.0 -3.0 -2.0 1.0 -0.1 0.5 1.5 1.8 Services 4.7 7.6 7.8 8.0 6.4 7.0 7.7 6.0 3.8 7.6 2.8

Source: Central Bank of Sri Lanka, various years.

which is symptomatic of Dutch Disease, though it subsequently stagnated.

Liberalization was accompanied by a boom in public investment, especially on the series of large-scale irrigation projects that made up the Accelerated Mahaweli Development Programme (AMDP), but including power and urban development (Levy, 1987). Such an increase in the demand for nontraded goods is a mechanism through which aid inflowS force a real appreciation and decrease the competitiveness of other traded sectors.

The distributional impact of Dutch Disease is often ambiguous. In the Sri Lankan case the main beneficiaries of the aid boom have been the colonists in AMDP and those enjoying rents from aid-associated activity. The main losers have been those that have seen their incomes fall as the tree crop sector has been squeezed by higher taxes and the pressure of transfers on the RER. Through these indirect channels aid may have contributed to the worsening of the welfare of sections of the poor that has been observed in recent years.

3. AN ECONOMETRIC MODEL OF REAL EXCHANGE RATE DETERMINATION IN

SRI LANKA

We turn now to the question of explaining why the RER has behaved as it has. Recent develop- ments in the analysis of RER behavior (see especially Edwards, 1988, 1989a and 198913) have stressed that long-run behavior is determined by fundamentals, such as the trade regime, the terms of trade and capital inflows. The actual value of the RER at any time is also affected by short-run factors such as macroeconomic policies and changes in the nominal rate. This part applies this theory to Sri Lanka in the post-1977 period.

The theory of RER determination tells us that a nominal devaluation will often have only a

temporary impact on the real rate, as it will be eroded by inflation (see, in particular, Edwards, 1988 and 1989a; Bird, 1983). While policies may successfully prevent such an erosion, this has clearly not been the case in Sri Lanka during the 1980s. with continued depreciation having no apparent impact on the real rate.

Assuming no change in fundamentals in Sri Lanka, we should expect the RER to have initially shadowed the nominal rate when the latter depreciated during 1977-78, but thereafter drifted back to its previous level. Despite the growing divergence between the two rates, however, including a period of RER appreciation, this has not happened. There was a clear structural break in the RER during 1977-78. with the real rate remaining permanently above the levels of the earlier period.

The first stage of the liberalization program in November 1977 when all import quotas were abolished and replaced by tariffs seems a likely explanation of this break. Progress’with trade liberalization since 1977 has been slow, with average nominal and effective rates of protection actually rising (Wignaraja, 1992). Subsequent to the initial liberalization in 1977 little impact should, therefore, be expected from changes in trade policy.

If the initial liberalization explains the break (i.e., the failure of the RER to return to its preliberalization level), what is the likely explanation of the subsequent divergence between the real and nominal rates? Why has the real rate not trailed the nominal rate as might be expected? - at times even moving in the opposite direction. A number of changes in fundamentals appear to have occurred that may explain this. First, there was a massive growth in transfers - both public (grant aid) and private (remittances). Official transfers alone rose from around 0.5% GDP in the early 1970s to about 2% by the end of the decade and over 3% during much of the 1980s. During 1978-88 official transfers grew a real annual rate of over 10%. Related to the in-


creased aid, there was a burst of public investment - most notably on the Accelerated Maha- weli Development Project (AMDP), but also in the power sector and urban projects - which may well have put upward pressure on the price of non-traded goods. Borrowing from overseas also increased during this period and this may have had a similar impact.

Second, was a miniboom in tea prices in the early 1980s. that may have been a classic cast’ of Dutch Disease.

Third, it is also possible that the real appreciation has not been the result of fundamental changes at all, but misalignment resulting from inappropriate macro policies, in particular excessive credit creation (excessive being defined in relation to growth of GDP). Except for a peak in 1980, however, excess credit creation has been neither systematic nor particularly excessive. Furthermore, the pattern of excess credit creation does not correspond to what would be expected if it were to play a role in explaining changes in the RER. In particular, it is at its highest when the RER was most depreciated (1980) and its lowest in the postliberalization period at the height of the appreciation (1984).

To examine which of these RER fundamentals has been most important in explaining RER movements in Sri Lanka an econometric model was constructed using general to specific model- ing procedures. These are described in more detail in the appendix. All Sri Lankan data were from the Central Bank (various years) and IMF (various years) was used for the construction of the RER series. The full sample period is l974- 88.

Table 3 lists the variables that, together with the lagged dependent variable, were included in

the most unrestricted form of the model. Testing led us to estimate the following more parsimonious form:

RER, = [3,RER,_, + &TOTTRAN,_, + P,TOT, + P4dNT, + (&dNT,m2 + z, (1)

where the variables are as shown in Table 3 and Z, is an error term.

Some comment is necessary on what has been excluded from equation (1). Total borrowing was found to have no discernible effect on the RER at all: this is consistent with some theoretical views of RER behavior (White, 1990). More controversial is the exclusion of the excess credit creation variable. Our analysis however, at no time found a significant impact from excess credit creation on the real exchange rate. Surprising also is the exclusion of the liberalization dummy. This may perhaps be explained bv its reasonably close correlation with some oi the included variables, especially the change in the nominal exchange rate, making a separate effect difficult to distinguish.

Estimation of equation (1) by ordinary least squares (OLS) yields (t-statistics in parentheses):

RER, = 0.825 RER,_, - 0.006 TO’M-RAN,+, (22.08) (-3.77)

+ 0.121 TOT + 0.8YX dNT, + 0.2X0 dNT,_z (2) (3.47) (10.31) (3.57)

R’ = O.YY F = 2290.43 k = 5 T = I4

The model appears to perform very well. though this statement needs to be qualified by reference to the appropriate specification tests.

EXpWted OhsCrWcl Variablet Symbol sign sign

Real exchange rate Total aid and remittances Total borrowing Terms of trade Liberalization dummy Investment Excess credit creation Change in nominal exchange rate Constant

RER TOTRAN TOTBOR

TOT LlBDUM77

GDKF EDCC

dN7

Dependent variable -VC -VC

-vc or 0 -VC +\,c

+ve -VC

--Ye +ve +vc n/a

*-ve negative; +vc positive; insignificant at the 10% I evel; n/a not applicahlc. tIn text variables have time subscripts and some explanatory vari&lcs arc lagged in the final equation.


Serial correlation. in the presence of the lagged dependent variable, would be especially prob- lematic since OLS would give biased and incon- sistent estimates. The Durbin-Watson statistic is biased toward two with a lagged dependent variable and Durbin’s h turns out to be not defined for this sample. Autocorrelation was therefore tested for by an LM-test, regressing the residuals on their lag and the regressors in the model. The value of the test statistic is 0.46, compared to a critical value of 2.71 so that we may accept the null hypothesis of the absence of autocorrelation at the 10% level.

The sample size is too small to perform a Goldfeld-Quandt test for heteroskedasticity. In- stead a Glejser test was carried out by regressing the absolute value of the residuals on a constant plus each of the model regressors in turn. In no case was the slope coefficient significant at the 10% level. so that the null hypothesis of homo- skedasticity may be accepted. It is therefore valid for us to proceed to interpreting the model estimates.

The coefficient on the lagged dependent variable tells us how quickly the RER responds to changes in its determinants and how much it is dependent upon its previous value: we find evidence of a reasonably long adjustment period, with 13, = 0.825.”

We find an important role for changes in the nominal exchange rate. The RER will reflect about 90% of a change in the nominal rate in the period of the change. Since, as described in the previous paragraph, the RER is strongly influ- enced by its value in the preceding period, changes in the nominal rate can exert a significant “drag” on adjustment of the real rate to its equilibrium level.

Finally, transfers appear to have played an important part in the appreciation of the RER: an increase in one unit of the index of transfers decreases the RER in the following period by 0.006. As this is a dynamic model, this is only the impact effect. The long-run effect will be multi- plied by l/(1-13,), i.e., a factor of just over 5.5. If aid is increased permanently to its new, higher, level. this factor shows the total impact on the RER once equilibrium is restored. While the coefficient on aid is quite low, the rate of increase of transfers in Sri Lanka has been sufficient for a significant impact to have been felt on the RER. The rise in the index of total transfers during 1978-84 was sufficient to cause a change of over seven points in the RER index through the impact effect alone. As these increases have proved permanent thus far, this will have worked through to an increase of over 40 points. Trans- fers have therefore had a dramatic impact in

creating a tendency for the RER to appreciate, thus confirming our suspicion that aid may induce Dutch Disease, and so undermine donors’ concerns that recipients improve their export competitiveness.

4. SOME POLICY OPTIONS

The econometric analysis showed that the failure of the RER to rise with the nominal rate has been the result of changes in fundamental determinants rather than overexpansionary macroeconomic policies. There is therefore no RER misalignment - it is responding to changes in fundamentals, especially higher inflows of aid and remittances. Lal’s (1985) conclusion that attempts to depreciate the RER through nominal devaluation would only result in further increases in the price of nontraded goods is supported by this analysis. Indeed, Gelb (1987) argues that nominal revaluation should be considered during RER appreciation caused by windfalls. Could the Sri Lankan government have sought to avoid the possible adverse repercussions for the balance of sectoral growth, export performance and income distribution that we discussed in Section 2 above?

The history of countries experiencing commodity booms has shown that the government’s response can play a crucial part in mitigating or exacerbating the effects of Dutch Disease. A range of policies can smooth out fluctuations in the RER. These include increasing reserves during a windfall so that the expansion in demand may be spread over time, alleviating likely supply bottlenecks (both through a suitable macroeconomic environment for domestic investment and microeconomic supply-side policies) and adjusting the composition of public expenditure to avoid exacerbating such bottlenecks. As with any expansion in demand, the extent to which multiplier effects benefit the economy rather than push up prices depends upon the availability of resources to meet higher demand. Such resource availability is not, however, a given, but a function of government policy.

The actual actions of the Sri Lankan government were in the opposite direction - policies that may have counteracted the appreciation, in particular the massive expansion in public expenditure. notably the AMDP. What might it have done instead? Some reduction in the extent of the public investment program (or, at least, spreading across time) would have been desir- able, especially given the low return to the investments chosen (again especially the AMDP) and the way in which recurrent costs to maintain


previous investments were sacrificed for the sake of yet more capital investment (Levy, 1987).

Given that substantial capital investment was to take place, government and donor attention should have to be paid to removing bottlenecks in the nontraded goods sector through supporting the development of backward linkages. Failure to do this has been a missed opportunity in terms of failing to increase the aid multiplier and a costly mistake in terms of its impact on other sectors. With aid flows continuing at their current high levels policy intervention along may still be appropriate.

these lines

5. CONCLUSIONS

Attempts to devalue the Sri Lankan rupee during the 1980s were frustrated by higher inflation wiping out nominal changes, so that the RER actually appreciated during the first half of

the decade and then returned to its previous value. This RER behavior is a major factor behind the disappointing performance of manufactured exports since the 1977 liberalization and may have had an adverse impact on income distribution. A key factor in explaining the divergence between the real and nominal exchange rates has been a change in the fundamental determinants underpinning the equilibrium RER. In particular, the spectacular growth in transfers will have required an appreciation of the equilibrium RER. The econometric model presented in this paper demonstrates that aid inflows have, indeed, played a significant part in RER behavior. The divergence between real and nominal rates is thus not a case of RER misalignment caused by an excessively expan- sionary monetary policy. Hence the problem can only be tackled by addressing fundamentals - in particular. a more judicious allocation of public investment across time and the economy and support to the supply of nontradables.

NOTES

1. Details of the earlier period may be found in Karunatilake (1087) and Rajapatirana (1988).

2. The name Dutch Disease comes from the sup- posed adverse impact of the expansion of oil and gas production in Holland on the Dutch manufacturing sector. A boom (in one particular traded goods sector or, as in the case of an aid inflow, a windfall gain to the whole economy) will, through an appreciated RER and higher real wages. decrease the competitiveness ol the traded goods sector.

3. An alternative definition is the purchasing power parity (PPP) RER. For a discussion of the relative merits of these two measures see Edwards (19XYb) and Collier and Joshi (19X9).

4. Some authors. notably the IMF, USC: the term “effective exchange rate” to refer to what is here called the multilateral rate. The convention adopted here is that used by Krueger (lY78) and Edwards (19XYb).

5. This has been demonstrated by Edwards (1YXYb. p. 90) who graphs the US bilateral rate and a

multilateral rate for 33 countries. He shows that the two rates moved quite closely prior to the collapse of Bretton Woods, since when they have experienced increasing divergence.

6. This account draws on Wickramasinghc (19%).

7. Both are multilateral rates, calculated against a basket of trading partner currencies. White and Wig- naraja (19X1) contains an analysis of the behavior of eight alternative measures of the real exchange rate in Sri Lanka during this period. All display broadly similar behavior in relation to the corresponding nominal rate. The choice between trading partners or competitor countries is an important one in determin- ing what is happening to a country’s compctitivcncss.

X. See Chcnery. Robinson and Syrquin (19X6), Lall (1990) and Wignaraja (1991).

Y. The specification of the model assumes a partial adjustment mechanism. Further work might explore alternative formulations, such as the error correction model.

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Wignaraja. G., “The policy environment for industrial exports (in Sri Lanka),” Mimeo (draft D.Phil thesis, not to bc cited without author’s permission) (Oxford, 1990).

World Bank. World Development Report (New York: Oxford University Press, 1989).

APPENDIX: ECONOMETRIC MODEL SELECTION

A three-stage selection procedure was adopted: (a) the model was estimated with all variables inclu-

dcd with a zero lag (except the lagged dependent variable) and the exclusion of each variable tested in turn to allow the elimination of variables with a low explanatory value;

(b)

(cl

the lag structure for each included variable was varied in turn, while maintaining a zero lag on the other variables; the best-fitting lag structures were selected and further restrictions tested to obtain the most parsimonious model.


While postsample predictive testing is an extremely useful tool for evaluating the selected model. its USC was precluded here by the very limited number of observations available.

Following the theoretical discussion of section 3, the following general model was chosen:

RER, = Ij,RER, I + [&TOTTRAN, + (I,TOTBOR, + 13,TOT, + (1,LlBDUM77 + [$,GDKF, + (&EDCC, + Il,dNT, +

1’8 (AI)

where variables arc as defined in the text (see Table 3) and II is an error term.

The residual \um of quart\ Irom estimation ol equation (Al) (RSS,,) was compared with that in various restrictions of the equation (RSS,,). The results for deletion of a single variable arc shown in the first two columns of Table A I. The critical value of the F- statistic at the 5% lcvcl is 5.59 suggesting that TOTTRAN. TOTBOR. GDKF and EDCC arc all candidate!, lor exclusion. Since the first stage of the testing process is at best indicative. only TOTBOR (whose exclusion only causes the RSS to fall hy less than 0.1%) was excluded. (The exclusion of TOTBOR is consistent with theory.) If it wcrc decided to cxcludc further variables at this stage it would he neccsaary to test the restriction jointly.

Restrictions Lag structures

RSS, F (k-2 &I I

RER , 316.X1 15.Yl - - - TO’ITRAN 157.18 4.37 77.46 X9.05 Y2.81 TOTBOR Yh.X6 0.01 - - - TOT 220.87 X.Y7 (1Y.12 6Y.42 120.61 LlBDUM77 212.26 x.35 - - - GDKF 112.40 1.13 - 63.85 I12.80 EDCC 120.23 1.70 - h7.18 118.00 dNT 28X.03 13.x.1 50.44 XY.10 24Y.90

*RSS,, for test of restrictions is Y6.7Y. RSS for lag 0 is Yh.Xh for all variables. The longest lag is not testable for GDKF and EDCC ab the series only start in lY74, leaving insufficient degrees of ircedom.

The model was the reestimated with a barying lag structure (from lero to two years) for each of the included variables. For example. to try the longest lag structure for TOTI’RAN the following equation wa\ estimated:

RER, = lI,RER, I + ~_;,TO’lTRAN, + 13 ,TOTRAN, , + II,TOTl‘RAN, 1 + &TOT + (I,>LlBDUM77 + (I,GDKF, + J-I,yEDC(‘, + Il,dNT, + I’, (A?)

The resulting RSS for each regression is shown fn Table Al. Differencing the data was tcsted where the lag coefficients suggested that this might bc appropriate. but in no case was it supported by the data. On the basis of the results shown this second stage tn the procedure led to the sclcction 01 the following model:

RER, = (I,RER, , + II,TOTTRAN, , + (1,1‘0’1‘ + (1,LlBDUM77 + (I,EDCC, + II,,EDCC, , + [i,dNT, + (i,NT, 2 + II’, (AJ)

The first stage procedure was rcpcated for each 01 the regressors in equation (A3). This analysis show& the two excess credit creation variables to he the mo%t likely candidates for exclusion. Excluding both of them gives F = I .2S: the cvidencc that excess credit crcatlon has played no part in the real appreciation i\ very strong.

The validity of excluding hoth EDCC and either TOTRAN or LlBDUM77 wcrc each tested. It is !ro/ valid to leave out TOTRAN (F = 10.X3) hut in acceptable to eliminate LlBDUM77 (F = 2.Yl). The reason must he in part that LlBDUM77 IS reasonably correlated with some of the included variables (e.g.. 0.34 with dNT and 0.57 with TOTI‘RAN) whereas TOTTRAN is less so (0. IS with dNT) so that the effects from LlBDUM77 may be being picked up by other variables. LlBDUM77 is also more highly correlated with EDCC than is TOTTRAN (0.33 versus only 0.01) making exclusion of both EDCC and TOTRAN less likely to be valid.

The model thus bccomca:

RER, = II,RER, , + (&TOITRAN, , + (i;rOT + (l,dNT, + I),dNT, 2 + z, (A4)

for which the results are reported in the paper.

Exchange rates, trade liberalization and aid: The Sri Lankan experience

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