5TH INTERNATIONAL WORKSHOP ON EUROPEAN ECONOMY 22 AND 23 NOVEMBER 2002 CEDIN / ISEG THE PORTUGUESE DISINFLATION PROCESS: ANALYSIS OF SOME COSTS AND BENEFITS António Portugal Duarte (http://www4.fe.uc.pt/portugal/ - [email protected]) FACULTY OF ECONOMICS – UNIVERSITY OF COIMBRA GRUPO DE ESTUDOS MONETÁRIOS E FINANCEIROS (GROUP FOR MONETARY AND FINANCIAL STUDIES – GEMF) Av. Dias da Silva, 165 3004-512 COIMBRA, PORTUGAL http://www4.fe.uc.pt/gemf/ I. Introduction The present study main goal consists in analysing the Portuguese economic policy of disinflation through a nominal stabilization policy of the Portuguese Escudo. We study the pegging of the Portuguese Escudo (PTE) to the Deutsch Mark (DM) taking for granted the anti-inflation reputation of the Bundesbank and the role played by the Deutsch Mark in the stability process of the foreign exchange and of the European price level. This presentation is structured in the following way: Section II presents a historical retrospective of the disinflation process in the Portuguese economy and analyses some costs and benefits of this process. Section III lay out of the data and handling of the series used. Section IV analysis of the existence of a co-integration relation. Section V describes the construction methodology of a Near-Var model for both Portuguese and German economies and it analyses also its main features. Section VI complements the latter section, evaluating the results of a simulation analysis. Finally, section VII concludes this work, leaving some clues for future research. 1 II. The Portuguese Disinflation Process: The Role of the Nominal Stabilization Policy of the Portuguese Escudo The disinflation experience of the Portuguese economy, while a gradual and continued process in the reduction of the inflation rate, began in 1990 when Portugal adopted a nominal stabilization policy of the Escudo in view of other countries currencies with a long tradition related to price stability, where the Deutsch Mark was seen as a reference currency. Figure 1 shows the evolution of the Portuguese and German inflation rates in the periods between 1979 and 1998 and between 1990 and 1998. Figure 1: Portuguese and German Inflation Rates 30 TxInfP TxInfA 20 10 0 1980 1985 1990 1995 2000 30 TxInfP TxInfA 20 10 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: OECD data base Main Economic Indicators, published by Estima, USA, www.estima.com. As it is easily observed, after the rise of the inflation rates in the beginning of the 80s, the Portuguese inflation rate reached a maximum value of about 30% by the end of 1983, recording, too, at that time the biggest differential compared to Germany. Such a high rate inflation, reflected the successive devaluation’s of the Escudo exchange rate in an attempt to maintain the foreign competitiveness of the Portuguese industry. After ten years, Portugal sees its value reduced to about 5%, and continuing this dropping route up until today. This disinflation process is associated to the adoption, by the Portuguese monetary authorities, of a nominal stabilization policy of the Portuguese Escudo, in the context of its participation in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS), as it is illustrated in Figure 2. 2 Figure 2: Nominal variation of the Escudo to the Mark ∆ NomEM 20 10 0 1980 1985 1990 1995 2000 ∆ NomEM 20 10 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: OECD data base Main Economic Indicators, published by Estima, USA, www.estima.com. The exchange rate policy was therefore favouring the anti-inflation goal leaving behind consensus about reinforcing foreign competitiveness of the Portuguese economy. In fact, in the period prior to Portugal adhesion to the European Economic Community (EEC), the exchange rate regime was characterised by the maintenance of a crawling peg regime of the Escudo. However, the success of the integration in the European market was deeply dependent on the capacity of the monetary authorities to reduce the inflation rate to the levels presented by Germany. In this context, in October 1990, the crawling peg policy was replaced by a policy based on a limited floatation of the Escudo in relation to the five main currencies of the ERM of the EMS. Portugal began, then, adopting an exchange rate policy based on the nominal stability of the Escudo. Since the Portuguese inflation rate registered a high convergence rate to the European levels, the Portuguese government decided to propose the incorporation of the Escudo in the ERM of the EMS, becoming effective on the 6th April 1992. The discipline of this mechanism functioned as an anchor of the disinflation policy. Nevertheless, in September 1992 we witnessed a deep crisis in the EMS translated into a succession of some realignments that culminated with the expansion of the foreign exchange floatation bands to fifteen % (15%) in August 1993. In this context, the Escudo ended up by devaluating in 6% and 6,5%. Nevertheless, the Portuguese Escudo realignments didn’t aim at changing the generic option for a foreign exchange stability policy that was being followed. 3 It is now important to analyse some of the costs and benefits associated with the disinflation process. In fact, with the exception of the period between 1992 and 1994, the disinflation process was also characterized by a real appreciation of the Escudo to the Deutsch currency, as illustrated in Figure 3. Figure 3: Real Variation of the Escudo to the Mark ∆ RealEM 10 0 -10 1980 1985 1990 1995 2000 ∆ RealEM 10 5 0 -5 -10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: OECD Data Base Main Economic Indicators, published by Estima, USA, www.estima.com. In face of this evidence, a question a rises about how a small open economy like the Portuguese one, with a weak currency, didn’t experience a financial crisis due to the speculative attacks that were registered against the Escudo? This was due to the fact that the Portuguese economy was involved in a process of European integration, allowing it to benefited from all the credibility, stability and discipline conferred by the tacit acceptance of the anti-inflation monetary policy of the Bundesbank and by the pegging of the Portuguese Escudo to the Deutsch Mark. Due to this strategy, the Portuguese economy was also able to reach successfully the main goal of price stability, that was explicitly assumed by the political authorities. Nevertheless, it should also be mentioned that as a result of the disinflation process there was a loss of Portuguese competitiveness due to the real appreciation of the Portuguese Escudo, limiting, thus, the product growth. In this context, this study tries to clarify the influence that an appreciation of the real exchange rate can have on GDP and price level. 4 III. Data Time series were used with quarterly data covering the period between 1977 and 1998. In general, the data was obtained from the statistical sources published by OECD (Main Economic Indicators), being, preferably, used the most recent ones. For Portugal we also used data from the National Institute of Statistics and from the Bank of Portugal. The price levels and output series were expressed in simple indexes based on the year of 1990. GDP was evaluated at constant prices. Short run nominal interest rates were used. With the exception for the interest rates, all series were used in logs. The majority of the results were obtained by using econometric software PcGive, version 10. IV. Co-Integration The co-integration analysis was developed with the aim of finding out if in the long run it is possible to identify a linear combination between domestic macroeconomic variables that is stationary. The estimation technique used in the co-integration time series consisted in the application of the maximum likelihood method developed by Johansen. Once identified the variables to be included in the system and once defined its nature, number of lags to be used were then chosen, in order to avoid errors auto-correlation problems. We reached, therefore, eight lags for the endogenous variables, and no lags were retained for the exogenous variables. Having as a base the values of the λ max (maximum eigenvalue) and the trace tests for a confidence interval of 95%, the number of the co-integration vectors found coincides with the number of the endogenous variables used, as it can be observed in Table 1. Table 1: Co-integration Analysis (λ max and trace tests) λ r = p λ max λ max (A) 95% Trace Trace (A) 95% 0.458132 p = 0 49.02** 29.41* 27.1 120.8** 72.48** 47.2 0.410487 p ≤ 1 42.28** 25.37* 21.0 71.78** 43.07** 29.7 0.225008 p ≤ 2 20.39** 12.24 14.1 29.5** 17.7* 15.4 0.107651 p ≤ 3 9.112** 5.467* 3.8 9.112** 5.467* 3.8 (A) It was used the correction of freedom grade, the observations number (T) was replaced by T-n.m, where n is the number of variables and m is the number of lags. In this situation, we may conclude that the variables are jointly stationary. It were, therefore, established the conditions that allowed us to move forward to the construction and estimation of a Near-VAR model for both Portuguese and German economies. 5 V. A Near-VAR Model for the Portuguese and German Economies In order to construct the Near-VAR model it was necessary to proceed, initially, to the formulation and estimation of a system that would serve as the base to all the construction process.