Estimating Equilibrium Real Exchange Rate And ...

Estimating Equilibrium Real Exchange Rate And Misalignment In An Oil Exporting Country: Libya's Experience Abulhamid Ben-Naser, Keshab Bhattarai, Mohamed M Elheddad The Journal of Developing Areas, Volume 52, Number 4, Fall 2018, pp. 249-267 (Article) Published by Tennessee State University College of Business DOI: https://doi.org/10.1353/jda.2018.0063

For additional information about this article https://muse.jhu.edu/article/678200

Access provided by University of Hull (26 Feb 2018 19:47 GMT)

The Journal of Developing Areas Volume 52

No. 4

Fall 2018

ESTIMATING EQUILIBRIUM REAL EXCHANGE RATE AND MISALIGNMENT IN AN OIL EXPORTING COUNTRY: LIBYA’S EXPERIENCE Abulhamid Ben-Naser Keshab Bhattarai Mohamed M Elheddad University of Hull, UK and Misurata University, Libya

ABSTRACT Exchange rate misalignments has attract a significant attention especially in developing economies; Libyan economy has witnessed a major economic and political changes. Libyan exchange rate has been changed specifically after 2000, and political instability after 2011 .This paper aims to shed a light on the equilibrium real exchange path to obtain the misalignments level (over and undervaluation) periods for the Libyan economy. This problem have not received an adequate intention from the policy makers in Libya. Cashin (2004) model is used to determine the main fundamentals that affect the equilibrium path. After applying time series analysis for a period (1975-2015). This paper utilized annual data covering the period (1975-2015); and the data extracted from Central Bank of Libya (CBL), International Financial Statistics (IFS), Organization for Economic Cooperation Development (OECD, Arab monetary Fund (AMF) and World Bank (WB). After testing stationarity of time series using ADF and P.P, this study applies co-integration technique to investigate long relationship between exchange arte and its fundamentals. Then, it performs the vector error correction model (VECM) to compare between long run and short relationships, supported by impulse response functions. The main findings of this study as follows. First, real oil prices and real relative productivity are found to play a significant role in the real exchange rate. For Libyan case, this study includes the degree of openness to this model because the Libyan authorities applied intensive restrictions to restrict external trade for a long time. Second, the results of VECM technique reveal that the speed of adjustment is 4.5 years for half-life to return to the actual level of exchange rate to the equilibrium path. In addition, the results from the impulse response functions (IRFs) found that the real exchange rate responds positively to the shocks in (rop) and (rrp), whereas responds negatively to the shocks in (open). Finally, the real exchange rate for the Libyan economy is recently overvaluation by more than 40%. This study provides some important policy implications for Policy maker specifically monetary authorities (Central Bank of Libya) should consider misalignments of Libyan exchange rate, and implement a proper policy to keep the exchange rate reasonably close to what fundamentals suggest. Policy makers should reduce money supply and increase exchange rate. A managed floating exchange rate policy could be a choice.

250 JEL Classifications: F31, O24; F31;C01; C22. Keywords: Equilibrium Exchange Rates, Libya, Time Series Estimation, VECM, Co-integration. Corresponding Author’s Email Address: [email protected] ;

[email protected]; [email protected] INTRODUCTION One of the significant issues that caught the attention of the authors, economists and policy makers equally is the issue of real exchange rate misalignment and equilibrium. Edwards (1989) claimed that the wrong level of real exchange rate for long time would have an opposite effect on the competitiveness and economic performance. (Hosni and Rofael 2015). The main causes of the real exchange rate misalignment are inappropriate macroeconomic policies, structural factors in the economy, and internal or external trade shocks (Edwards1988, Nilsson, 1998). It is important to measure the degree of misalignments in the real exchange rate because it helps us to identify the determinants of the real exchange rate (Kalinda Mkenda 2000). Misalignments cause a distortion in the price and allocation of resources in the economy. The overvalued real exchange rate has a strong linkage to low growth rate and productivity; as well as the capital does not move to most lucrative sectors (Chøwdhury and Ali 2012). In developing countries, the real exchange rate misalignments are usually overvaluation, which unfavorably influences the tradable sector by depressing production, decreasing investments, and declining exports volume. Some studies have found that the inactive performance of developing countries leads to imbalanced real exchange rate (Ghura and Grennes 1993). Since Cassel (1921) and Keynes (1923), the debate on real exchange rate has been subjected to many definitions and has become a main source of contradictory economic policies (Krugman and Taylor, 1978; Edwards, 1989). The exact measurement of the real exchange rate has played a crucial role in the specification of real exchange rate misalignments. The real exchange policy is now considered as an important reason for sluggish growth in Africa and Latin America, whereas it has increased growth in Asia (World Bank, 1984; Dollar, 1992; Edwards, 1988; Ghura and Grennes 1993; Rodrick, 1994). This study contributes to ongoing empirical studies into main aspects. First, measuring equilibrium exchange rate and misalignment in developing country: Libya. To the best of our knowledge, there is a lack on empirical studies on exchange rate misalignment in Libyan economy. Second, most of the previous studies related to the Libyan exchange rate focused on the nominal exchange rate and its relationship with some economic variables such as money supply, inflation and economic growth. This study focuses on real exchange rate misalignments. The rest of this article is organized as follows; after this section, an overview about exchange rate policy in Libya will be discussed in the second section, followed by literature review on exchange rate misalignment. Then, Section 4 displays the empirical evidence of exchange rate fundamentals in Libya and estimates equilibrium and misalignment of exchange rate in this economy. Finally, some conclusions and policy implications are presented. EXCHANGE RATE POLICIES IN LIBYA: AN OVERVIEW: Libya is an oil-exporting country, which greatly relies on oil producing for its foreign exchange revenues, more than 90 per cent of foreign exchange resources. Monetary

251 authorities adopted fixed exchange rate during 1973-1986, it was one Libyan Dinner (LYD) = 3.36994 U.SD ($) (Central Bank of Libya, 2006). At the beginning of 1981, the payments balance suffered from a considerable deficit because of a dramatic decrease in oil prices. Consequently, the Libyan authorities had to carry out some policies to tackle that deficit. These policies included a direct policy to restrict imports and foreign exchange controls. In parallel, these policies caused other problems in the economy; the black market became larger and the inflation was at a high level. In 1986, for more flexibility of the exchange rate, the Central Bank of Libya (CBL) pegged the Libyan dinar to special drawing rights (SDR) rather than the U.S. dollar, the exchange rate was at 1 LY D = 2.8 SDR, with its range allowed to increase or decrease at the rate of 7.5%, this margin was changed many times. Additionally, the Libyan monetary authorities applied a new programme during 1999-2001, which allowed the sale of foreign exchange currencies through commercial banks with prices were determined by Libyan central bank. These prices went up increasingly to eliminate the black market of foreign exchange gradually, as well as to realign the domestic price level. The main changes in the nominal exchange rate is in Figure 1. In the period 2002-2010, the CBL adapted its policy to shift the economy towards liberal policies and market economy. On 24.December.2001, the CBL issued the Resolution No 49 for the Libyan dinar exchange rate against foreign currencies. This resolution determined the exchange rate at one LD = 0.77$, or the equivalent of one LD = 0.608 SDR, this rate was implemented on first of January 2002. On 14 June 2003, the CBL issued the Resolution No. 17 for adjustment exchange rate to be one LD = 0.5175 SDR. This rate changes against the foreign currencies according to the volatility of the basket currencies (Central Bank of Libya). This exchange rate policy has been constant until now, but the real exchange rate witnessed many changes due to the lack of foreign exchange due to the political problems that led to lower oil production. Petroleum production decreased from 1.8 million barrels/day in 2009 to between (0.4-0.5) Million barrels/day during 2014-2015 that causes a sharp black market again (Central Bank of Libya 2015). The tables below show the official exchange rate changes. TABLE 1. SUMMARY OF THE EXCHANGE RATE POLICIES IN LIBYA (1970-2015) Episode 1 2 3 4

Period 1970-1985 1986-2001 2000-2002 2003-2015

Policy Fixed Exchange rate policy (Pegged to US dollar). Relatively Flexible exchange rate (Pegged to SDR). Devaluation of national currency Flexible Exchange rate policy

Source: Author’s work

252 TABLE 2. THE MAIN CHANGES IN THE NOMINAL EXCHANGE RATE IN LIBYA (1970-2015) year 1970 1973 1986 1990 2001 2002 2015

Nominal Exchange Rate % Change (US dollar / LY dinar) 2.857 3.370 17.956 3.226 - 4.273 3.571 10.694 1.667 - 53.318 0.791 - 52.549 0.729 - 7.838 Source: Central Bank of Libya (CBL) and International Financial Statistics (IFS).

FIGURE1. THE TREND OF NOMINAL EXCHANGE RATE IN LIBYAN ECONOMY (1970-2015) 1.4

1.2

1.0

0.8

0.6

0.4

0.2 1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

NER LYD/1$

Source: Central Bank of Libya

LITERATURE REVIEW Chøwdhury and Ali (2013) studied the determinants of the real exchange rate for Libya using yearly data from (1970-2007) by employing the Auto Regressive Distributed Lags (ARDL) co-integration method. The mean result of this study is that there is a long-run equilibrium association between the real exchange rate and its fundamentals. The RER was appreciated with terms of trade and was depreciated with government expenditure which is not consistent the Mundell-Fleming impact of fiscal policy. Additionally, RER appreciates with foreign and trade openness while depreciates with interest rate, the structural break variables are found to be positive. As for technology and productivity, they have no significant impact on RER. The speed of adjustment towards equilibrium path was very high in short run, it was 76 percent annually to correct disequilibrium. De Jager (2012) estimated the equilibrium real effective exchange rate using (VECM) for South Africa. The main outcomes presented that a 1 percent rise in the real interest rate differential will cause a 0.8 percent appreciation of (REER). I addition, an increase in real GDP per capita by 1 percent induce a 1.3 percent appreciation of the (REER) in the long term. A 1 percent rise in prices commodity relative to prices of oil was found to cause a 0.1 percent appreciation of the real effective exchange rate in the

253 long term, whereas rose trade openness was linked with depreciation of REER. As for the government deficit as a ratio of GDP, a 1 percent increase in the government deficit as a proportion of GDP caused depreciation of the REER by approximately 1.5 percent. The error correction term was about 0.28, which mean that 28% of the misalignments on average is removed every year. Jansen and Nicholas (2008) determined the equilibrium real exchange rate of the Indonesian rupiah in order to investigate the impact of rupiah exchange rate determinants, and to find out the suitable level for long run trend. The research used quarterly data to cover the period of time (1999Q1-2006Q4) by using co-integrating regression. They explained that relative price of non-traded for traded goods (TNT), and net foreign assets (NFA) have a significant effect on real exchange rate. On the other hand, the term of trade (TOT), openness (OPEN), and financial globalization (FG) do not have a significant impact on real exchange rate of the rupiah. As for real exchange rate misalignment, it was undervalued during (2000Q1-2002Q1) and (2004Q2-2005Q3), and overvalued during (2002Q2-2004Q1) and (2005Q4-2006Q4). Koranchelian (2005) estimated a long run equilibrium real exchange rate level for Algerian dinar. This study found that, the Balassa-Samulson impact moves together with real oil price to elucidate the equilibrium real exchange rate evolution in the long run in Algeria. The half- life of the real exchange rate deviation from the real exchange rate path is approximately nie months; it is very close to that in other commodityproducing countries. The major finding of this study is that, the Algerian dinar was about in the path of equilibrium at the end of 2003. Hosni and Rofael (2015) assessed the real exchange rate (equilibrium and misalignments) in Egypt in the period (1999-2012). This paper used three techniques to estimate the equilibrium real exchange rate (ERER) which are the Purchasing Power Parity (PPP) approach, the Fundamental Equilibrium Exchange Rate (FEER) approach, and the Edward Model (1989). All techniques found that the Egyptian Pound is recently overvalued. REAL EXCHANGE RATE MISALIGNMENT: CONCEPTUAL ISSUES Real exchange rate misalignments refer to the deviation of the actual real exchange rate from its long-run sustainable equilibrium level. The first estimation of equilibrium (rer) in the literature was by Gustav Cassel in 1918 by employing PPP theory (Jongwanich 2009). The theoretical value of (rer) is (Magyari2008): 𝑒 𝑝𝑝𝑝 =

𝑝 𝑝∗

(1)

Where (𝑒 𝑝𝑝𝑝 ) is the theoretical (rer) according to PPP theory, (p), (𝑝∗ ) are national and foreign prices respectively, which will be as follows: 𝜆= 𝜆 =

𝑒𝑛 𝑒 𝑝𝑝𝑝 𝑒𝑛 𝑝⁄𝑝∗

(2) (3)

254 𝜆 =

𝑒 𝑛 . 𝑝∗ 𝑝

(4)

Where (𝜆)the theoretical value of local currency against another currency is, (𝑒 𝑛 ) is the nominal exchange rate as units of national currency per a unit of foreign currency. Therefore, 𝜆 > 1 ⟹ undervaluation. 𝜆 < 1 ⟹ overvaluation. 𝜆 = 1 ⟹ equilibrium. Regarding to formulating the PPP theory, misalignments raise when there is a deviation from the equilibrium level. PPP has many shortages to capture the equilibrium path and misalignments. Actually, the traded goods should cost the same under perfect competition market (no transaction costs and taxes) with homogeneous products and complete information. Furthermore, there are important differences between the compositions of the price basket due to preference of consumers and manufacture production between countries. Another important point is that the PPP approach supposes that the equilibrium real exchange rate stays unmoved for the entire period. It does not take into account (rer) fundamentals. Therefore, the PPP hypothesis proved to be a weak method to estimate the long run real exchange rate, see Dornbusch (1982), Montied, and Ostry (1991). In this respect, the linkage between real exchange rate and main fundamentals should be taken into account to obtain the long run real exchange rate. In doing so, (rer) may define as (Corden 1994): 𝑟𝑒𝑟 =

𝑒 . 𝑝𝑡 ∗

(5)

𝑝𝑛

Where (𝑟𝑒𝑟) is the external real exchange rate, 𝑝𝑡∗ is the world prices level of traded goods, 𝑃𝑛 is the local price levels of non- traded goods, and 𝑒 is the nominal exchange rate in terms of domestic currency per one unit of foreign currency. It is usually used the wholesale price indices to represent foreign prices of tradable goods whereas (cpi) is used to reflect the domestic prices of non-tradable goods. This study will employ proxies because of data limitation on price of tradable and non-tradable goods, the wholesale price index (wpi*) in the united states for the world price level of tradable goods and the domestic consumer price index (cpi) for the local price levels of non- traded goods as follows: 𝑟𝑒𝑟

=

𝑒 . 𝑤𝑝𝑖 ∗ 𝑐𝑝𝑖

(6)

This study will use single equation reduced form model. This method refuses the view of unmoved equilibrium path as in the PPP approach.

255 EMPIRICAL ANALYSIS METHODOLOGY AND DATA: This paper utilizes annual data covering the period (1975-2015). The data extracted from Central Bank of Libya (CBL), International Financial Statistics (IFS), Organization for Economic Cooperation Development (OECD, Arab monetary Fund (AMF) and World Bank (WB). Real oil price (rop) is used to capture the changes in the international economic environment and the impact of external shocks. This variable is calculated as the ratio of Libyan oil prices (average prices of petroleum exporting Libyan companies) divided by consumer price index (Information Authority, CBL). Real Relative productivity (rrp) is measured as a percentage of the real domestic (gdp) to the real foreign (gdp); this variable is use as a proxy for economic performance. Trade openness (open) is employed as a measure of exchange and trade restrictions and the effect of commercial policy. It is accounted as (imports+ exports)/gdp. Real growth rate (rgr) , which is calculated as a growth rate of (gdp) .The data were collected from (CBL) and (WB). By definition, the increase in (rer) in this model explains appreciation in the national currency, while the decrease elucidates a depreciation. From the figure 2, there is a major real depreciation in the national currency after 2002. The (rop) was at a high level between 1980 and 1981, after that it went down dramatically. After 2000, the (rop) was at a high scale, but after 2013, it decreased sharply again. The (open) was at a low level in eighties and nineties, the policy makers in the monetary authorities applied contractionary policies after the dramatic decrease in oil price to restrict imports and reduction of oil exports but between 2000 and 2010, imports and exports increased. After 2013, the (open) went down remarkably because of the reduction in oil production. The (rrp) declined between 1980 and2000 and after 2013 because of the significant decrease in oil revenue in those periods. The (rgr) accounts the economic performance during the study period. This indicator follows the oil sector, as we mentioned before. The model is explained as: 𝑟𝑒𝑟 = 𝛽 ′ 𝐹𝑡 + 𝜇𝑡

(7)

𝑟𝑒𝑟 = 𝑓(𝑟𝑜𝑝, 𝑟𝑟𝑝, 𝑜𝑝𝑒𝑛, 𝑅𝐺𝑅)

(8)

𝑟𝑒𝑟 = 𝛽0 + 𝛽1 𝑟𝑜𝑝 + 𝛽2 𝑟𝑟𝑝 + 𝛽3 𝑜𝑝𝑒𝑛+ 𝛽4 𝑟𝑔𝑟 + 𝜇𝑡

(9)

After estimating this equation, the (rer) misalignment will be obtained by subtracting the equilibrium path from the actual (rer). The equilibrium (rer) is found from the fundamentals equation as a predicted value of (rer) estimation function. The predicted value of (rer) estimation will not be selected as an equilibrium path because they may exhibit a substantial degree of short-term ‘noise’ whereas the long-run (rer) equilibrium will not exhibits this behaviour (Baffes, Elbadawi et al. 1997). Therefore, the study will employ the Hedrick-Prescott (HP) filter to smooth out the predicted values of equilibrium real exchange rate. Moving average is used to eliminate short-run variation in data

256 involves a long time series but this method is not possible for a country like Libya, where all data are non-stationary. For commodity-exporting countries, Cashin, Cespedes and Sally (2002) found that, there are a strong relationship between real commodity export prices and real exchange rate movements. Moreover, Choudhri and Khan (2004) detected the Balassa-Samuelson impacts are related for developing economies as well as the terms of trade also affect the real exchange rate (Koranchelian 2005). Therefore, the difference between equilibrium and actual (rer) determine the (rer) misalignments, which represent an inappropriate economic indicator to obtain over and undervaluation of national currency. This approach starts with computing equilibrium (rer) by estimating a long-run (rer). This article will apply the Cashin et al (2002) model (augmented PPP). Johansen (1988, 1995) and the Vector Error Correction model (VECM) is used to examine this relationship as in table (3): FIGURE2. TREND OF REAL EXCHANGE RATE AND ITS DETERMINANTS IN LIBYA DURING (1975-2015) RER

ROP

350

140

300

120 100

250

80 200 60 150

40

100 50 1975

20

1980

1985

1990

1995

2000

2005

2010

0 1975

1980

1985

1990

RRP

1995

2000

2005

2010

2000

2005

2010

OPEN

160

160 140

120

120 100

80 80 60

40

40 0 1975

1980

1985

1990

1995

2000

2005

2010

2000

2005

2010

20 1975

1980

RGR 160 120 80 40 0 -40 -80 1975

1980

1985

1990

1995

Source: E-views 9 output

1985

1990

1995

257 TABLE3. DESCRIPTIVE STATISTICS Mean Median Maximum Minimum Std. Dev. Observations

OPEN 0.69 0.66 1.46 0.34 0.22 41 Source: E-views 9 output

ROP 55.40 48.51 122.27 12.95 28.25 41

RER 1.88 2.19 3.12 0.69 0.83 41

RRP 0.38 0.26 1.29 0.088 0.32 41

RGR 5.54 0.907 123.3 -54.00 31.84 41

STATIONARITY RESULTS Before applying any empirical analysis, one should make sure that there is no spurious regression through checking the properties of series. Thus, the unit root test have been examined for all variables. Two unit roots were applied - Augmented Dicky-Fuller ADF and Phillips-Perron (PP) - to test the stationarity. If the time series variables are not stationary (have unit root), then the first difference should be taken for that variables to obtain stationary series. The two tests (ADF, PP) reject the null hypotheses a unit root, then the variables are not stationary at level. However, all variables are stationary at first difference at level of significance 1 percent, as in the table 4. This means all variables are integrated at first order I (1). The next step is co-integration test. TABLE4. UNIT ROOT TESTS Variables

Model

ADF test Level

Level

First difference

-1.230305 -5.070316*** -1.051711 -5.070316*** -1.891600 -5.012785*** -1.837881 -5.005056*** -0.993907 -5.087328*** -0.971498 -5.087328*** -0.172229 -8.004624*** -1.865244 -4.513439*** OPEN -0.367285 -9.001835*** -2.093401 -4.422975*** 0.535109 -8.086105*** -0.296192 -4.681209*** -1.704294 -4.667991*** -1.874018 -4.661728*** ROP -1.674395 -4.597591*** -1.848092 -4.603988*** -0.840391 -4.740042*** -0.840391 -4.733665*** -1.508589 -5.636495*** -1.425249 -6.829048*** RRP -1.782928 -5.836897*** -1.736194 -6.873814*** -1.819568 -5.277425*** -1.904110 -6.524985*** -7.078056*** -21.01393*** RGR 7.140179*** -6.916820*** 7.132142*** -20.46654*** -7.216159*** -21.37951*** 7.050416*** 7.049322*** 6.915009*** 6.891999*** Note: */**/*** indicate rejection of null hypothesis of unit root at significance levels 10, 5, 1 percent respectively. RER

Intercept Intercept & trend None Intercept Intercept & trend None Intercept Intercept & trend None Intercept Intercept & trend None Intercept Intercept & trend None

First difference

P.P test

258 Co-integration test results The relationship between (rer) and its fundamentals should cope with the technique of co-integration. When the variables contain unit root and are not stationary at level, but all variables are integrated at order one. Thus, co-integrating procedure proposed by Johansen (1988, 1995) should be applied which tests the existence of a linear cointegration between variables. The trace and maximum eigenvalues statistics is given in Table (5) below. There is one co-integration vector at 5 percent of significance. It is appropriate to employ a Vector Error Correction technique. TABLE5. CO-INTEGRATION TEST Unrestricted Co-integration Rank Test (Trace) Hypothesized No. of CE(s)

Eigenvalue

Trace Statistic

0.05 Critical Value

Prob.**

None * At most 1 At most 2 At most 3 At most 4

0.748768 0.453400 0.253105 0.145462 0.053821

94.61100 42.11866 19.16523 8.075657 2.102288

69.81889 47.85613 29.79707 15.49471 3.841466

0.0002 0.1554 0.4811 0.4574 0.1471

Unrestricted Co-integration Rank Test (Maximum Eigenvalue)

Hypothesized No. of CE(s)

Eigenvalue

Max-Eigen Statistic

0.05 Critical Value

Prob.**

None * At most 1 At most 2 At most 3 At most 4

0.748768 0.453400 0.253105 0.145462 0.053821

52.49234 22.95343 11.08957 5.973369 2.102288

33.87687 27.58434 21.13162 14.26460 3.841466

0.0001 0.1755 0.6384 0.6166 0.1471

Trace and Max-eigenvalue test indicates 1 co-integrating eqn(s) at the 0.05 level.

Since, it is confirmed that, there is a long run equilibrium (rer) among variables, and then various procedures could be applied Fully-Modified Ordinary Least Squares (FM-OLS) approach proposed by Phillips & Hansen (1990). Here we suggest employing (FM-OLS) as in table (6).

259 TABLE 6. FULL MODIFIED ORDINARY LEAST SQUARES Dependent Variable: RER Method: Fully Modified Least Squares (FMOLS) Sample (adjusted): 1976 2014 Included observations: 39 after adjustments Long-run covariance estimate (Bartlett kernel, Newey-West fixed bandwidth=4.0000) Variable ROP RRP OPEN RGR C

Coefficient -1.545929 1.527914 -1.811367 -1.091021 351.6587 0.768210 0.740941 42.90949 3267.320

R-squared Adjusted R-squared S.E. of regression Long-run variance

Std. Error 0.506189 0.347610 0.557895 0.296374 30.30179 Mean dependent var S.D. dependent var Sum squared resid

t-Statistic -3.054055 4.395481 -3.246788 -3.681232 11.60521

Prob. 0.0044 0.0001 0.0026 0.0008 0.0000 189.3851 84.30512 62601.62

According to the definition of the exchange rate in this study (units of foreign currency per one unit of local currency), going up means that there is a real exchange rate appreciation, while going down depreciation. From the table above, an increase in the (ROP), (OPEN)), and (RGR) are associated with (RER) depreciation, a one unit rise in the (ROP), (OPEN)), and (RGR) cause the (RER) to be depreciated by approximately (1.54), (1.81) and (1.09) respectively. As for (RRP) , this indicator are related to appreciation of the real exchange rate, a one unit rise in (OPEN) causes real exchange rate to be appreciated by (1.53).

Vector Error Correction results The (VECM) results including of long and short run are shown in Table 5. The first part of the table presents the long-run outcomes and the second part represents the short-run consequences. The long and short run outcomes in Table (7). (VEC) coefficient in this model is negative (-0.018102) which provides the stability of the co-integrated relation between fundamentals as in table (7). Table (8) for diagnostic tests. TABLE7. VECTOR ERROR CORRECTION ESTIMATION Variables

Long Run coefficients t-statistic

Variables

Short Run coefficients t-statistic

-5.55880

St.d Error 3.98463

∆ROP

0.011468*

1.71776

St. d Error 0.00668

ROP t-1

-22.14976***

RRP t-1

-12.04483***

-6.61844

1.81989

∆RRP

0.018550***

4.88662

0.00380

OPEN t-1

38.00212***

6.28896

6.04267

∆OPEN

0.009776***

3.65970

0.00267

RGR t-1

7.001717

1.03582

6.75958

∆RGR

0.045592***

4.42281

0.01031

Constant

-1083.947

ECt-1

-0.018102

-1.21495

0.01490

260 TABLE 8. VECM DIAGNOSTIC TESTS

Serial correlation

H0 No serial correlation

Test LM test-χ 2 (lag 1)

Probability

Heteroscedasticity

No heteroscedasticity

Breusch-Pagan-Godfrey

Decision No serial correlation

0.0639 No heteroscedasticity 0.2466 Normality

Error terms are normally distributed

Jarque-Bera

Error terms are normally distributed

0.063016

FIGURE 3. IMPULSE RESPONSE FUNCTIONS RESULTS Response to Cholesky One S.D. Innovations Response of RER to RER

Response of RER to ROP

Response of RER to RRP

Response of RER to OPEN

Response of RER to RGR

60

60

60

60

60

40

40

40

40

40

20

20

20

20

20

0

0

0

0

0

-20

-20

-20

-20

-20

2

4

6

8

10

2

Response of ROP to RER

4

6

8

10

2

Response of ROP to ROP

4

6

8

10

2

Response of ROP to RRP

4

6

8

10

2

Response of ROP to OPEN

20

20

20

20

10

10

10

10

10

0

0

0

0

0

-10

-10

-10

-10

-10

-20 2

4

6

8

10

-20 2

Response of RRP to RER

4

6

8

10

-20 2

Response of RRP to ROP

4

6

8

10

Response of RRP to RRP

4

6

8

10

2

Response of RRP to OPEN

10

10

10

5

5

5

5

5

0

0

0

0

0

-5

-5

-5

-5

-5

-10

-10

-10

-10

-10

-15

-15

-15

-15

6

8

10

2

Response of OPEN to RER

4

6

8

10

2

Response of OPEN to ROP

4

6

8

10

4

6

8

10

2

Response of OPEN to OPEN

40

40

40

40

20

20

20

20

20

0

0

0

0

0

-20

-20

-20

-20

-20

-40 2

4

6

8

10

-40 2

Response of RGR to RER

4

6

8

10

-40 2

Response of RGR to ROP

4

6

8

10

Response of RGR to RRP

4

6

8

10

2

Response of RGR to OPEN

40

40

40

20

20

20

20

20

0

0

0

0

0

-20

-20

-20

-20

-20

-40

-40

-40

-40

-40

-60

-60

-60

-60

6

8

10

2

4

6

8

10

2

4

6

8

10

10

4

6

8

10

4

6

8

10

Response of RGR to RGR

40

4

8

-40 2

40

2

6

Response of OPEN to RGR

40

-40

4

-15 2

Response of OPEN to RRP

10

Response of RRP to RGR

10

4

8

-20 2

10

2

6

Response of ROP to RGR

20

-20

4

-60 2

4

6

8

10

Sources: Author’s calculation based on E-views outcomes

2

4

6

8

10

261 Figure3 shows that (rer) in Libya responds positively to the shocks in real oil prices. This positive response is bigger than the trade openness and productivity. One standard deviation increase in (rop) leads to a positive response in (rer); this positive response becomes high after the third period of shocks. It is expected because Libya is oil rich economy; (rop) plays a vital role in (rer) movements. (rgr) has a negative response on (rer) in the first nine years then this impact changes to be positive. EQUILIBRIUM REAL EXCHANGE RATE AND MISALIGNMENT IN LIBYA (1975-2015) Estimating the equilibrium path of the real exchange rate and misalignment is complex issue, they are not observed indicators such as potential output and the non-accelerating inflation rate of unemployment (Magyari 2008). Therefore, setting (rer) path and keeping it at the equilibrium level is a big challenge. It provides a beneficial instrument in assisting the macroeconomic performance (Driver and Westaway 2005) . The equilibrium (rer) is derived by the fitted values of (rer) determinants. The predicted values are computed by employing filtering technique witch called the Hodrick – Presscott filter5. The (rer) is overvalued when it is more appreciated than the equilibrium level, whereas it is undervalued when it is more depreciated than the equilibrium level (Edwards 1989). The equilibrium (rer) is defined as the steady- state (rer)conditional on a vector of permanent values of fundamentals (Olimov and Sirajiddinov 2008). Misalignments of (rer) is expected to provide signals t some economic indicators in the economy. Misalignments is calculated as in this forma: 𝑀𝑖𝑠% =

𝑒𝑟𝑒−𝑒𝑟𝑒𝑟 𝑒𝑟𝑒𝑟

∗ 100

FIGURE4. A. THE ACTUAL AND EQUILIBRIUM REAL EXCHANGE RATE PATH (1975-2015)

350 300 250 200 150 100 50 0 1980

1985

1990 Actual

1995

2000

2005

HP EQUILIBRIUM

2010

262 FIGURE4. B. THE EQUILIBRIUM AND MISALIGNMENT LEVEL OF REAL EXCHANGE RATE (1975-2015).

160

120 Overvaluation↑

80

40

0

-40 Undervaluation↓

↓↓

-80 1980

1985

1990 MIS*100

1995

2000

2005

2010

EQUILIBRUM

CONCLUSIONS This study aims to measure the real exchange rate misalignments for Libya. Utilizing annual data on Libyan exchange rate during (1975-2015) and using time series technique. The main findings are as follows. Firstly, (rop), (rrp), (open) and (rgr) are the main fundamentals of (rer) in Libya. VECM results show that the speed of adjustment towards to equilibrium path is relatively slow; 10.7 percent of this disequilibrium is corrected each one year. It indicates 4.65 years to eliminate 50 percent of deviation of actual real exchange rate towards the equilibrium. Secondly, impulse response functions show that a one standard deviation increase in (rop) (external shocks) leads to a positive response in real exchange rate. Thirdly, there is a high misalignment in Libyan dinner, which over evaluated by more than 120% percent of the equilibrium level in the recent years. These findings have a very important policy implication. Policy maker specifically monetary authorities (CBL) should consider misalignments of Libyan exchange rate, and implement a proper policy to keep the exchange rate reasonably close to what fundamentals suggest. In Libyan economy, sometime misalignment arrived at 120% deviation from the equilibrium path whereas fundamentals suggest 5%. Therefore, to mitigate this misalignment, policy makers should reduce money supply and increase official exchange rate. A managed floating exchange rate policy could be a choice. Further work needed on how government intervene to smooth down exchange rate fluctuations.

263 ENDNOTES *The authors are very grateful for anonymous reviewers for their valuable comments. In addition, We would like to thank Misurata University and Libyan Higher Education Ministry for PhD scholarship. 1- The main reason for employing the US wholesale price index as a proxy for foreign price is that this study focuses on the exchange rate of the LYD against the USD. 2- The Balassa-Samuelson impact is interested in the productivity and price of tradable sector as follows: if there is an increase in the productivity of tradable goods relative to trading partners, the real exchange rate for this country may tend to be appreciated. The interpretation of this assumption is that, when the productivity increases in the tradable sector, this may lead to increase wages in this sector. The wages in the non-tradable sector are may influenced to be increased too. Therefore, the consumer price index will increase compare to trading partners, then the real exchange rate will be appreciated. 3- The smoothed equilibrium real exchange rate is estimated by using the explanatory variables a Hodrick-Prescott filter with a smoothing factor of 100. This method neutralizes the effect of temporary variation in explanatory variable on estimation of equilibrium real exchange rate by taking a proxy variable for the long run- equilibrium path of these indicators 4- Edwards (1988) defined the real exchange rate misalignments as a deviation of the actual real exchange rate from its equilibrium path. APPENDICES THEORETICAL FRAMEWORK A.

Local Production (Domestic Firms) This part represents the supply side in the local economy. The domestic economy has two sectors, exportable sector or primary commodity sector as an export tradable good and non-tradable sector, which consists of a number of firms producing non-traded goods. 𝑚𝑎𝑥𝑙𝑖 𝛱𝑖 = 𝑝𝑖 𝑦𝑞 − 𝑤𝑙𝑞 Subject to 𝑦𝑞 = 𝛼𝑞 𝑙𝑞

(1) (2)

Where (𝑝) the prices, (𝑦) the production, (𝑤) the wages, (𝑙) the labour, (α) the labour productivity, (𝑞) denotes to the total production of none tradable and exportable production (𝑛 + 𝑥). Importantly, due to the labour can freely move, wages (𝑤) equalise across sectors. (𝑤𝑙) the labour costs, and (α𝑙) the technology. 𝑦𝑥 = 𝛼𝑥 . 𝑙𝑥 𝑦𝑛 = 𝛼𝑛 . 𝑙𝑛

(3) (4)

Where, x: the exportable goods, n: the non-tradable goods, l: the quantity of labour is needed for producing exportable and non-tradable goods, a: the labour productivity. Profit optimization in both sectors provide equations of prices; depend on wages and productivity: 𝑝𝑥 = 𝑤/𝛼𝑥 𝑝𝑛 = 𝑤/𝛼𝑛

(5) (6)

264

Then, prices of the non- oil tradable sector: 𝑝𝑛 = (𝛼𝑥 /𝛼𝑛 )𝑝𝑥

(7)

Therefore, the prices of the non-tradable goods 𝑝𝑛 to the prices of primary commodity 𝑝𝑥 is entirely specified by technology and demanded conditions. (𝑝𝑛 /𝑝𝑥 ) = (𝛼𝑥 / 𝛼𝑛 )

(8)

Thus, the productivity differential between the two sectors is the main determinant of the relative price of non-tradable good to the exported good 𝑝𝑛 /𝑝𝑥 . Then a rise in the oil price will increase the wages in the oil sector causing to an increase in the level of wages and prices of the nontradable sector. B.

Local Consumers (Domestic Household). The economy has a continuum of homogenous individuals that supply labour inelastically (𝑙 = 𝑙𝑥 + 𝑙𝑛 ) to consume tradable and non-tradable goods that produced domestically. The tradable (imported) goods are not locally produced and are imported from outside the country, and the primary goods are not consumed locally.

Subject to

𝑚𝑎𝑥𝑐𝑛 ,𝑐𝑡 𝑢 = (𝑐𝑛 )ƴ (𝑐𝑡 )1−ƴ

(10)

𝑝𝑛 𝑐𝑛 + 𝑝𝑡 𝑐𝑡 = 𝑤𝑡ℎ

(11)

Where 𝑐𝑛 the consumption of the non-tradable goods is, 𝑐𝑡 is the consumption of imported goods 1−ƴ ƴ from abroad. Composite consumption 𝑐 = 𝜏 . 𝑐𝑛 . 𝑐𝑡 is the aggregate consumption of imported (tradable) and domestic (non-tradable) goods with 𝜏 = 1/[ƴƴ (1 − ƴ)(1−ƴ) ] being a constant. The household is supposed to cover cost of the aggregate expenditure by using the total wealth 𝑤𝑡ℎ. The consumer price index of the oil exporting economy, which is found by solving the optimization problem. It is a geometric average with weights ƴ and ƴ-1 for prices of tradable and non-tradable respectively. 𝑝 = (𝑝𝑛 )ƴ . (𝑝𝑡 )1−ƴ

(12)

Where, (𝑝) is the consumer price index, 𝑝𝑡 is the prices of a unit of the tradable goods imported from the foreign region in domestic currency. The low of one price is: 𝑝𝑡 = 𝑝𝑡∗ /𝐸

(13)

Where, 𝑝𝑡∗ is the imported goods prices (tradable) denominated in foreign currency, 𝐸 is the nominal exchange rate, defined as units of foreign currency per a unit of domestic currency. C. Foreign Production (Firms) and Consumption (Household)

265 The foreign country involves of three different sectors: a final sector, an intermediate sector, a non-tradable sector. Foreigners using labour as the only one factor to produce and consume the non-tradable good as: 𝑦𝑛∗ = 𝑎𝑛∗ . 𝑙𝑛∗

(14)

For producing the intermediate good, just labour is used as an only factor. In this sector, the production function for all firms will be represents by: 𝑦𝑖∗ = 𝛼𝑖∗ . 𝑙𝑖∗

(15)

The profit maximization problems in the non- tradable and intermediate sectors are equal to the optimization problem of the firms in the oil exporting country. 𝑚𝑎𝑥𝑙∗𝑖 𝛱𝑖 = 𝑝𝑖 𝑦𝑖 − 𝑤𝑖 𝑙𝑖

(16)

Subject to 𝑦𝑖 = 𝛼𝑖 𝑙𝑖

(17)

The foreign non-tradable prices as a relative productivity function between intermediate and nontradable sectors, as well as the prices of the foreign intermediate good is: 𝑝𝑛∗ = (𝛼𝑖∗ / 𝛼𝑛∗ ) . 𝑝𝑖∗

(18)

The production process of final good includes two intermediate inputs. The first one is the primary commodity, which is produced by a group of countries, one of them the local economy. The second input is an intermediate good, which is produced in the rest of the globe. The final production is the tradable goods, which is produced by collecting foreign primary commodity as the following function: 𝑚𝑎𝑥𝑦𝑥∗ ,𝑦𝑖∗ 𝛱𝑡 = 𝑝𝑡∗ 𝑦𝑡∗ − (𝑝𝑥∗ 𝑦𝑥∗ + 𝑝𝑖∗ 𝑦𝑖∗ )

(19)

Subject to 𝑦𝑡∗ = 𝜔( 𝑦𝑖∗ )𝜃 . (𝑦𝑥∗ )1−𝜃

(20)

Where 𝜔 = 1/𝜃 𝜃 (1 − 𝜃)1−𝜃 is a constant. The solution to problem gives the cost of one unit of the traded good, denominated by foreign currency, as geometric average of oil good and intermediate good prices: 𝑝𝑡∗ = (𝑝𝑖∗ )𝜃 . (𝑝𝑥∗ )1−𝜃

(21)

Foreign consumers and local consumers consume the non-tradable good (final good). Thus, the consumer price index (𝑝∗ ) for the foreign country represents in the next equation: 𝑝∗ = (𝑝𝑛∗ )ƴ . (𝑝𝑡∗ )1−ƴ

(22)

Utilizing from functions (20) and (29) as: (𝐸 𝑝 /𝑝∗ ) = 𝑓 (𝛼𝑥 /𝛼𝑛∗ . 𝛼𝑛∗ / 𝛼𝑛 . 𝑝𝑥∗ /𝑝𝑖∗ )

(23)

266

   

Where: (E 𝑝 /𝑝∗ ): the (rer). (𝛼𝑥 /𝛼𝑖∗ ): Productivity differential between the export and import (foreign) sectors or between local and foreign tradable sectors. (𝛼𝑛∗ /𝛼𝑛 ) : productivity differential between the foreign and local non-tradable sectors. (𝑝𝑥∗ /𝑝𝑖∗ ): the price of the primary commodity divided by the price of intermediate goods The last two terms represent the Balassa-Samuelson effect (Cashin, Céspedes et al. 2004).

REFERENCES Arab Monetary Fund, Annual statistics (2017), Stataistics-Arabic database. Baffes, J., et al. (1997). Single-equation estimation of the equilibrium real exchange rate, World Bank, Development Research Group. Central Bank of Libya, Economic Bulletin, different issues. Cashin, P., et al. (2004). "Commodity currencies and the real exchange rate." Journal of Development Economics 75(1): 239-268. Chøwdhury, K. and I. Ali (2012). "Estimating the determinants, dynamics and structural breaks in the real exchange rate of Libya." Corden, W. M. (1994). Economic policy, exchange rates, and the international system, OUP Oxford. Driver, R. L. and P. F. Westaway (2005). "Concepts of equilibrium exchange rates." Edwards, S. (1988). "Real and monetary determinants of real exchange rate behavior: Theory and evidence from developing countries." Journal of development economics 29(3): 311-341. Edwards, S. (1989). "Exchange rate misalignment in developing countries." The World Bank Research Observer 4(1): 3-21. Eita, J. H. and M. M. Sichei (2014). "Estimating Namibia's Equilibrium Real Exchange Rate." The International Business & Economics Research Journal (Online) 13(3): 561. Ghura, D. and T. J. Grennes (1993). "The real exchange rate and macroeconomic performance in Sub-Saharan Africa." Journal of development economics 42(1): 155-174. International Fiancanial statistics database. Hosni, R. and D. Rofael (2015). "Real exchange rate assessment in Egypt: Equilibrium and misalignments." Journal of Economics and International Finance 7(4): 80-97. Jongwanich, J. (2009). "Equilibrium real exchange rate, misalignment, and export performance in developing Asia." Asian Development Bank Economics Research Paper Series(151). Kalinda Mkenda, B. (2000). Essays on purchasing power parity, real exchange rate, and optimum currency areas, Göteborg University.

267 Koranchelian, T. (2005). The equilibrium real exchange rate in a commodity exporting country: Algeria's Experience, Working Paper No.135,International Monetary Fund. Magyari, I. (2008). "Exploring the Correlation between Real Exchange Rate Misalignment and Economic Growth in the CEE Countries." Advances in Economic and Financial Research-DOFIN Working Paper Series. OECD database. World Bank , World Economic Indicators