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Econometric Analysis of Croatia's Proclaimed

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Econometric Analysis of Croatia's Proclaimed South East European Journal of Economics and Business Volume 10 (1) 2015, 7-17 DOI: 10.1515/jeb-2015-0001 ECONOMETRIC ANALYSIS OF CROATIA’S PROCLAIMED FOREIGN EXCHANGE RaTE Davor Mance, Saša Žiković, Diana Mance * Abstract The officially proclaimed foreign exchange policy of the Croatian National Bank (CNB) is a managed float with a discretionary right of intervention on the Croatian kuna/euro foreign exchange (FX) market in order to maintain price stability. This paper examines the validity of three monetary policy hypotheses: the stabil- ity of the nominal exchange rate, the stability of exchange rate changes, and the exchange rate to inflation pass-through effect. The CNB claims a direct FX to inflation rate pass-through channel for which we find no evidence, but we find a strong link between FX rate changes and changes in M4, as well as between M4 changes and inflation. Changes in foreign investment Granger cause changes in monetary aggregates that further Granger cause inflation. Changes in FX rate Granger cause a reaction in M4 that indirectly Granger causes a further rise in inflation. Vector Autoregression Impulse Response Functions of changes in FX rate, M1, M4, and CPI confirm the Granger causalities in the established order. Keywords: central bank policies, monetary transmission effects, inflation targeting JEL classification: C22, E52, E58, F42 INTRODUCTION * Davor Mance, MA The Croatian National Bank (CNB) has recently Assistant changed its official policy from a free floating to a University of Rijeka, Faculty of Economics managed floating exchange regime (CNB 2013, CNB [email protected] 2014). The CNB reserves the right to intervene on the currency markets and it did so more than 200 times in Žiković, Saša, PhD an 18 years period (1997-2014). The CNB has not of- Associate Professor ficially determined an a priori upper or lower bound- University of Rijeka, Faculty of Economics ary or intervention point but it claims to maintain the [email protected] stability of the kuna/euro foreign exchange (FX) rate in order to meet its primary objective of price stability. A Diana Mance, PhD similar approach was recently also taken by the Czech Senior Assistant National Bank (CZNB 2014). University of Rijeka, School of Medicine The aim of the paper is to analyze the Croatian [email protected] kuna/euro foreign exchange policy (FX policy) using Copyright © 2015 by the School of Economics and Business Sarajevo 7 Econometric Analysis of Croatia’s Proclaimed Foreign Exchange Rate an econometric approach. The three hypotheses test- the direct assessment of FX - inflation pass-through ed in this paper and based upon CNB statements on effects. Subsequent research shows that the pass- their web pages are: (1) ‘the CNB does not predeter- through effect declines with increasing monetary mine the lower and upper level of the kuna exchange stability and decreasing inflation (Mihaljek and Klau rate it is committed to defend (the upper and lower in- 2008). Monetary stability has, in this regard, a psycho- tervention point)’; (2) ‘the CNB participates in foreign logical memory effect and a non-linear relationship. exchange market transactions in order to prevent ex- For a small open economy such as Croatia, credit cessive exchange rate fluctuations in both directions’, and liability euroization reduces the efficiency of the and (3) ‘the CNB maintains the stability of the kuna/ FX rate as a shock absorber, such that the positive euro exchange rate in order to meet its primary ob- effects of free floating are easily mitigated against jective of maintaining price stability’ (CNB 2014). The (Devereux and Lane 2003). The question of the “fear stated reason for the proclaimed CNB policy is a pre- of floating” (Calvo and Reinhart 2000) may be coun- sumed fast transmission channel between inflationary tered by the question of the “fear of commitment” expectations and exchange rate changes (CNB 2014). in an environment involving the future obligation of This inflation pass-through effect is important as it every EU country (except UK and Sweden) to eventu- prevents the exchange-rate policy from being an ef- ally join the EMU. The question of “either fix or float” fective policy tool for employment and GDP growth. and suboptimal intermediary policies has been dis- This is the reason why we analyze the statistical rela- cussed at great length (Mundell 1961, Friedman and tionships and Granger causalities between Foreign Mundell 2001, Buiter and Grafe 2002). As Friedman Investments (FI), the foreign exchange (FX) rate and and Mundell (2001) concluded, intermediary solutions the consumer price index (CPI) via transmission mon- are suboptimal. With credit and liability euroization etary aggregates M1 and M4. constraints present in Croatia, it might have been op- The paper continues with a literature review with timal in the past to have a formal currency board as in comments, followed by an explanation of our compre- Bosnia and Herzegovina and Montenegro, or, fast-for- hensive data set and methodology. In the results and warding to the present day, beneficial in the short run discussion section, statistical tests are consequently to make an earlier firm commitment to the Economic applied and commented on. and Monetary Union. This may be the principal reason for the change of the FX policy description on the offi- cial CNB web site from free float to managed float. The LITERATURE REVIEW authors’ aim was to put this label to comprehensive econometric testing. During the last 15 years several empirical studies on monetary transmission channels in Croatia have come to different conclusions. The presumed inability DATA AND METHODOLOGY to model the primary FX rate time series because of its non-stationarity, non-normality, heteroscedastic- The time series of kuna/euro FX rate consists of ity, and the presence of frequent structural breaks in monthly observations covering the period from the time series has motivated several other authors to January 1997 to April 2014 (CNB 2014). Consumer model the FX returns instead, and to pursue various price index (CPI), foreign investment (FI), and M1 and ARCH (Autoregressive Conditional Heteroscedasticity), M4 monetary aggregates data were comprehensively TAR (Threshold Autoregression) and VAR (Vector available only on a quarterly basis from Q4 of 2000 to Autoregression) approaches (Posedel 2006, Tica and Q4 of 2013 (CNB 2014). Posedel 2009, Erjavec et al. 2012). Earlier exchange To model the FX time series, a Box-Jenkins meth- rate – inflation pass-through research did not come odology with a truncated Fourier series approach was to converging results regarding the endogeneity of used. Let yt be time series with t = 1, …, N, where N is the exchange and inflation rate (Choudhri and Hakura length of time series. In order to determine the sea- 2001, Cukierman, Miller, and Neyapti 2002, Devereux sonal variations and trend, the time series is divided and Engel 2003, Gagnon and Ihrig 2004, Mihaljek and into two components: Klau 2008). In regard to Croatia, Stučka (2004) found (1) statistically significant J-curve effects with subsequent � � � implications on investment, production, and inter- �where�� Yt�� is a stochastic irregular component and national trade, with the latter having an influence on χt is a deterministic periodic function of the truncated inflation. These are indirect effects that, according to Fourier series form: 2� the envelopment theory, should be disregarded in �� ��� ��� ∙���� ∙ cos � ∙����� � � 8 South East European Journal of Economics and Business, Volume 10 (1) 2015 �� ���� ���� ��� ��� � �� ��� ���� ���� ��� �� ��� � ������ � � � ������ ������� �� ������� ��� �� ��� � ������ � � � ������ ������� � � � ������ ��� �1����√� . �� ��� ����� �� 2� �� � ����� � ����2 ∙ cos � ∙ � � 1����� � 12 ��� � R������2=0.885 ∙ � �� �� ��� ��� �� ��� ��� � � � � 2� � � �� �� ∙��� ∙ cos � ∙��� � 2� �� ��� ��� ∙���� � ∙ cos � ∙����� � � � �� ���� ���� ��� ��� �� ���� ���� ��� Econometric Analysis of Croatia’s Proclaimed��� Foreign Exchange Rate � � �� ��� ��� Granger test is a standard bivariate regression: (2) �� ��� ���� ���� ��� �� ��� ���� ���� 2� ��� �� ��� ��� ∙���� ∙ cos � ∙����� c1 is the mean, c2 is the linear� trend, c3 is the sea- �� ��� � ������ � � � ������ � � � ��� � ��� sonality amplitude,� c4 is the phase correction, T is the � �� � � � � � � � � period and t is time in months. � ��� � ��� � � � ��� � �� � �� ��� �� �To ���model the� stochastic�� component Yt in the equa- � ��� � ��� � ��� �� � �� ��� �� tion (1), ARIMA modelling of time series is used (Box, � � � ��� � ��� Jenkins,� and� Reinsel� 2008). If is stationary one can � �� � � � � � � � � (5) � �� ��� Yt �� ��� � ������ � � � ������ construct a -order autoregressive (AR) model (3) and/ p � ��� � ��� � or -order� � moving average� ��� (MA) model (4): ��for all� pairs� of � � �, � series�� in the group (Granger q�� ������� � � 2� � xt �yt��� � ��� � � �� �����∙��� ∙ cos � ∙��� � �� � � � � � � �� � 1969). The strength of causation is reported according � to the�1���� F-statistics√� based on .the Wald statistics for the �� ��� � ������ � � � ������ (3) joint hypothesis: �1����√� . � � ��� � �� ��� ����� �� � ��� � �� � � � ���������� �� ������� ��� Nonstationary �variables�� ����are tested ��for cointegra- tions. If two nonstationary time series are cointe- � � 2� � � � ��� � ��� (4) grated� � with ����� some � ����2stationary ∙ cos time� series,∙ � � 1���� a causal2�� � re- � �� � � � � � � � � � 12 lationship may be� assumed� �����
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