Since the breakdown of the Bretton Woods system of fixed exchange rate in 1973, much has been said and written about the succeeding floating exchange rate regime and its consequences on various macroeconomic outcomes such as trade. On balance, empirical evidence appears mixed at best, suggesting further investigations to better understand the relationship. At the same time, extant literature seems to have largely ignored the case of a region located on the West of Australia—the Pacific Island Countries (PICs)—small, open, vulnerable, growth and poverty challenged economies. The financial sectors in these economies are also small, bank-centric and not very well developed; in fact, financial development has been relatively slow and mostly inadequate. Given their relatively small share of world trade, most PICs are price takers, making them vulnerable to external shocks. Moreover, since the trade sector comprises a large proportion of domestic economy, shocks from world economy can have large impact on the PICs.
In the case of Papua New Guinea (PNG), for example, to the best of our knowledge, literature is devoid of any scientific investigation. Yet, trade, like for most economies, remains paramount for the country’s growth and development; the country’s total trade value as at December 2017 amounted to USD 3.97 billion, representing about 66.4 percent of the nominal Gross Domestic Product (GDP). Over the period, trade as a share of GDP has declined, on average, from the highs of 80-90 percent in the earlier years. What makes PNG’s, of all PIC’s, case even more intriguing is that it, together with Vanuatu, are among the only two PICs with a managed floating rate regime. It is also the largest of the PICs; its population of 8 million accounts for over 80 percent of all PICs put together and accounts for about 83 percent of the region’s landmass.
Immediately after gaining independence from Australia in 1975, PNG adopted a fixed exchange rate regime with its nominal kina exchange rate pegged to a basket of currencies of its major trading partners, more importantly, Australia and the United States. The kina was floated in late 1994 and since then PNG has operated under a managed floating exchange rate regime. In 2014, BPNG shifted to a ‘crawl-like’ exchange rate arrangement, a soft-peg regime, in response to a foreign exchange shortage and volatility in foreign exchange market price setting mechanism. The ‘crawl-like’ arrangement entailed a fixed trading margin of 150 basis points within which retail exchange rates can trade. While these regime shifts effectively reduced the volatility of nominal and real exchange rates, it attracted some criticisms.
The foregoing scenario begs the question of how have trade flows in PNG been impacted by the shift of exchange rate regimes. More specifically, how does real exchange rate volatility impact trade flows in PNG, which forms the main issue of investigation for this study. As indicated, this is the first study to systematically do so. The paper extends the traditional models of trade, import and export demand, proposed by Goldstein & Khan (1985) and Bahmani-Oskooee (1986) by including real exchange rate level and volatility to examine the relationship. The study employes Autoregressive Distributive Lag Model (ARDL) with the intention of exploring both short-term and long-run relationships between the variables. Quarterly data was collected from various sources such as the Bank of PNG’s Quarterly Economic Bulletin (QEBs), the IMF’s International Financial Statistics (IFS) database, and the World Bank’s World Development Indicators (WDI) database. The sample period span over 13 years from 1995Q1 to 2017Q4.
The study finds that the influence of exchange rate volatility on trade flows is positive and significant, especially in the short term. In the long-term, trade is affected by factors other than exchange rate volatility such as real exchange rate and relative price levels and, domestic and foreign income. An increase in real exchange rate level (appreciation) has a negative effect on both import and export demand. An increase in domestic and foreign demand positively influences import and export demand, respectively, while an increase in relative import and export price levels has a negative impact on the demand for imports and exports, respectively.
Based on these findings, some policy implications may be drawn, including the following. Some degree of exchange rate volatility, especially in the short-run appears to be sound economic strategy. Since exchange rate volatility intrinsically complements a higher flexibility in the exchange rate, exchange rate flexibility may foster positive trade flows. Accordingly, there might be some merit in re-visiting direct policy measures such as the exchange rate trading margin which limits the flexibility of the exchange rate. It may also be useful to investigate other determinants of import and export demand including real exchange rate, relative import and export prices and domestic and foreign demand to enhance trade flows in PNG in the long term. Depreciation in the real exchange rate or a decline in relative export prices may also be considered.
Meson Tumsok Bank of Papua New Guinea, Jen Je Su, Tarlok Singh and Parmendra Sharma, Griffith University.
This paper was presented at the December 2018 South Pacific Central Banks—Griffith University inaugural research conference in Suva. Key stakeholders attending the conference included Reserve Banks of Australia and New Zealand, ADB, World Bank, IMF/PFTAC and DFAT. The views and opinions expressed in this study are those of the authors and do not reflect those of the Bank of Papua New Guinea or its Board.
Please click here to read the full “Exchange rate volatility and trade in Papua New Guinea” working paper