Summary

During the last 10 years, exchange rate volatility increased worldwide as a result of global financial crisis (2008) and the decline in commodity prices including oil price (2014). In addition, several central banks, including FED, ECB, Bank of England, Czech National Bank, Central Bank of Japan,People's Bank of China, started to use exchange rate as a monetary policy instrument to amplify economic growth and achieve their inflation target. Current episodes of exchange rate volatility confirmed that exchange rate is one of the important tools, which can affect country’s economic situation, financial stability and social welfare. Taking into account current events, review of existing literature about exchange rate impact on macroeconomic environment and in-depth analysis of exchange rate effect is becoming significant, in order to inform policy makers and implement correct economic policies.

The aim of this research is to analyze whether exchange rate depreciation is expansionary or contractionary in Georgia and quantify its impact on macroeconomic variables that are important to policy makers. Georgia, as a high dollarized economy with high share of imported inputs, is an interesting case to analyze contractionary depreciation hypothesis and will provide valuable insight for policy makers. In February, 2017 up to 65% of total loan portfolio and 70% of total deposits were in US dollars. In addition, imports used as inputs of production in agricultural, manufacturing, transportation and communication and financial intermediation sectors are as high as 36% in Georgia, which are therefore exposed to currency fluctuations. So, the nominal exchange rate depreciation could directly lead to a negative supply shocks. Moreover, exchange rate risk is one of the main issues that financial sector in Georgia faces. Banking sector is very vulnerable with respect to exchange rate depreciation, because it increases credit risk and rises financial stability concerns.

In standard small-open economy models (e.g. Svensson, 2000), a nominal exchange rate depreciation has an expansionary effect on output through promoting export and reducing imports. This impact is mostly valid in traditional Mundell-Fleming-Dornbusch (MFD) models and in the new open economy macro (NOEM) models. However, this impact can be reversed in an economy with high dollarization and high share of imported inputs. Various researchers, Krugman (1999), Aghion, Bacchetta, and Banjeree (2000), Kamin and Rogers (2000), found out that exchange rate depreciation can have contractionary impact on output. When liabilities are denominated in foreign currency, while income is in local currency, exchange rate depreciation increases debt burden, deteriorated balance sheet position increases risk premium and subsequently causes drop in investment. So, exchange rate depreciation is contractionary if this negative impact outweighs positive impact on net export.

Literature about contractionary depreciation includes paper by Diaz-Alejandro (1965), who examined Argentina’s devaluation in 1959. He claims that contractionary depreciation happened due to income distribution in favor of people with low-propensity to consume. Another important paper in this subject is by Cooper (1971), who evaluated 24 periods of devaluation and concluded that improvement in external position can potentially be outweighed by higher debt service and income redistribution. As Bahmani-Oskooee and Miteza (2003) summarized, the main reasons behind contractionary depreciation is income redistribution towards people, with low marginal propensity to consume, a drop in investment, increased debt service, decrease in real wealth and possible increase in interest rate, increase in imported input prices, wage indexation based on price levels and increase in cost of capital. However, there is also wide literature, that could not confirm contractionary depreciation hypothesis. For example, Kruegel (1978) examined 22 major devaluations of different countries and could not find evidence of contractionary depreciation. Similar result was achieved by Gylfason (1987), who examined 32 devaluation periods. Overall, evidence on the contractionary devaluation hypothesis is quite mixed and results depend on adopted methodologies of the different studies.

Effect of exchange rate differs from country to country, according to the structure of the economy, so it is crucial to take into consideration country’s characteristics for implementation of correct exchange rate policy. To analyze impact of exchange rate on macroeconomic variables research is conducted using structural vector autoregression (SVAR). SVAR (proposed by Sims, 1980) is an extension of traditional vector autoregression (VAR) analysis. It combines economic theory with time series data to quantify impact and response of variables on different shocks or economic policies. Main advantage of SVAR analysis is that it needs a minimum of identifying assumptions. Reduced form model can be estimated using restrictions that are based on economic theory. To identify structural shocks in reduced form SVAR model cholesky decomposition is used, which is one of most often used approaches for this analysis. After recovering structural shocks, they can be used to perform impulse response and variance decomposition. Afterwards, it is possible to evaluate impact of shocks to different variables.

To conduct vector autoregression analysis quarterly data from the 1st quarter of 2004 to the IV quarter of 2016 has been used. The model consists of 5 endogenous, 1 exogenous and 1 structural change variables. Endogenous variables are: annual growth rate of real GDP, annual inflation rate, monetary policy rate, interest rate on loans issued in national currency and annual growth rate of nominal effective exchange rate. The exogenous variable is change in the net international investment position that reflects the difference between foreign assets and liabilities of the country. Increase in foreign liabilities is expected to have a positive impact on the economic growth in the short term. While the variable of structural change corresponds to the period of financial crisis, after which the potential growth of the economy decreased (Podpiera, Jiri et al. 2017).

In cholesky decomposition order of variables is important to reflect which variables react to exogenous shock to other variables in the same period. Growth rate of gross domestic product is located on the first place, because it does not adjust to the change of other variables in the same quarter. Respectively, on the following positions are inflation, monetary policy rate, interest rate on domestic currency loans and on the last position is the exchange rate, because it reacts to changes to all other variables in the same period.

According to the obtained results, appreciation of the nominal exchange rate by 1% leads to a gradual reduction in inflation. Inflation in the third-fourth quarter decreases by 0.3 percentage points. As a result of reduction in expected inflation, the monetary policy rate is reduced by 0.15 percentage points in the short term, which in turn decreases interest rates of domestic currency loans by 0.1 percentage points. The impact of exchange rate appreciation on economic growth is negative in the medium term (0.1 pp), but in the short term it is statistically insignificant. It should be noted that the result obtained from alternative models, where variables are sorted in a different order, are not statistically different compared to the results obtained from the baseline model, which confirms the robustness of attained results.

To sum up, obtained results showed that the nominal exchange rate appreciation leads to decline in inflation rate, monetary policy rate and interest rate of domestic currency loans, while impact on economic growth is negative in the medium run, but statistically insignificant in the short run. Therefore, it is possible to reject the contractionary depreciation hypothesis in Georgia in the medium term, but in the short run, there is not enough evidence to reject this hypothesis.