Exchange Rate Volatility and Export Competitiveness in Mauri

An Expert's View about Foreign Exchange in Mauritius

Posted on: 24 Jun 2010

The results have important insights to offer in terms of future policies with regards to exchange rate management, macroeconomic policies and management.

EXCHANGE RATE VOLATILITY AND EXPORT COMPETITIVENESS Empirical Evidence From MAURITIUS By Virendra Polodoo June 1, 2010 Economic Analysis Research Papers WP16/12 ABSTRACT Following the floating of the US dollar in 1973, liberalization of capital flows and the associated intensification of cross-border financial transactions during the last three decades, we saw the emergence of important volatility and uncertainty in exchange rates. This has raised eyebrows among policy makers and researchers as regards the impact of exchange rate movements on exports we have examined the effect on EPZ exports and tourism of exchange rate fluctuations in Mauritius by employing an Error Correction Model. The results so obtained are in line with the theoretical foundations. In fact for both equations, the REER and volatility are both economically and statistically insignificant at the 5% level of significance. Yet, we find that foreign income, contrary to the law of income elasticity of demand, is both economically and statistically insignificant and thus has been removed from the final equations. Same was found for the Terms and Trade and the dummy variables. The results have important insights to offer in terms of future policies with regards to exchange rate management, macroeconomic policies and management. Keywords: Textile Exports, Tourism Earnings, Euro, USD, Exchange rate. TO THE LOVING MEMORY OF MY DAD TO MY SON RUHIKSCH 1 Part 1: Introduction 1.1. Building Blocks. Following the floating of the US dollar in 1973, liberalization of capital flows and the associated intensification of cross-border financial transactions during the last three decades, we saw the emergence of important volatility and uncertainty in exchange rates. This has raised eyebrows among policy makers and researchers as regards the impact of exchange rate movements on exports. Arguments, both theoretical and empirical are divided as to the results of the relationship between exchange rate variability and exports/trade flows, that is, whilst some models advocate that volatility in exchange rates foster uncertainty and increases risks and therefore hamper growth in foreign trade, some other models postulate otherwise. The purpose of this paper is to close this gap and empirically analyse the main predicaments being faced by domestic exporters in Mauritius in terms of exchange rate. 1.2. Problem Statement An analysis of the above type to Mauritius is deemed pertinent as it has recently experienced negative shocks in its terms of trade owing to the phasing out of the Multi-Fiber Agreement in 2004, cuts in sugar price under the Lome Convention by the European Union in 2006 and skyrocketing world oil and commodity prices. Given the prevailing situation in the eurozone, albeit not alarming, there are two areas for concern: the first being the level of indebtedness of some European countries and the exchange rate of the Euro, which has been sliding against other major currencies. This is directly impacting on Mauritian exporters and potentially the tourism sector as countries in Europe introduce austerity measures to counter the crisis. Europe remains the main market for Mauritian exports and the major source of our visitors. The packages are intended to bail out Greece, which is presently at the centre of the financial storm and subsequently lead to further depreciation of the euro. The latter is impacting on our exports and tourism sectors and the evolution of the exchange rate is detrimental to those two key sectors. The Euro was selling at MUR44 at the beginning of the year 2010 and reached about MUR40 in mid-May 2010, albeit receipts for the first three months have not yet been overwhelmingly impacted by the Eurozone crisis. Receipts in the Mauritian Textile sector for the 2 first three months of year 2010 reached MUR.5.8 billion as compared to MUR.5.9m a year before. Tourisms receipts, on the other hand, are up 7.4% over the first quarter. Yet, the main apprehension of a further deterioration of the situation is that exporters might lose on revenues through the exchange rate, while tourism operators are losing out. It is questionable as to whether other countries of the Eurozone will be affected by a domino effect of the Greece crisis which might ultimately affect our tourism sector. These facts raise questions about the competitiveness of the Mauritian economy and what might be done to ensure external stability and reduce vulnerabilities 1.3. Motivation of the study Our main exports have always been vulnerable to real exchange rate variability, but exchange rate risk hedging facilities in Mauritius are virtually nonexistent. Although hedging facilities are available, they are considered as expensive for small exporting firms. As a result, exporters bear the consequences of unexpected changes in the exchange rates. So far, despite some studies have been carried out in some developing countries, there has been no study taken in Small Island Developing States like Mauritius, to analyse the extent to which our export markets are affected by movements in exchange rates. This paper closes a significant gap in the literature and employ a superior measure of exchange rate volatility based on GARCH ( Generalised Autoregressive Conditional Heteroskedasticity) method. The analysis is intended to have important policy implications as it shall help informed decision making about policy markers in formulating their exchange rate policy with a view to stimulate our exports. It can also be a case for exporters can argue their case to Government by lobbying for an export-friendly macroeconomic environment and assist them to plan their export activities more effectively. 1.4. Research Aims The main aim of this paper is to estimate an export econometric equation for Mauritius exports between 1989 to2009. Other objectives include: ? Evaluate the impact of real exchange rate volatility on Mauritian textile sector ? Evaluate the impact of real exchange rate volatility on the tourism sector ? Draw conclusions and make policy recommendations. 3 1.5. Research structure The paper is organized as follows: Part 2 and 3 gives an overview if the theoretical and empirical underpinnings respectively. Par4 gives a statistical analysis of the evolution of the exchange rate, EPZ Exports, Tourism Earnings, USD and imports in Mauritius. Further, part 5 gives an econometric analysis as regards the linkages between EPZ exports and euro, Tourism earnings and euro. Finally, part 6 concludes with suggestions and justifications for future policies. 4 Part 2.0- Theoretical Underpinnings- Exchange Rate Volatility And Exports There has been a plethora of models developed to explain exchange rate volatility and exports, some of which are explained below: 2.1 The Partial Equilibrium Approach. Clark (1973) uses an example of a rudimentary exporting firm to illustrate how (real) exchange rate volatility can affect the level of the firm?s exports. He considers a competitive firm with no market power producing only one commodity which is sold entirely to one foreign market and does not import any intermediate inputs. The firm is paid in foreign currency and converts the proceeds of its exports at the current exchange rate, which varies in an unpredictable fashion, as there are assumed to be no hedging possibilities, such as through forward sales of the foreign currency export sales. Moreover, because of costs in adjusting the scale of production, the firm makes its production decision in advance of the realization of the exchange rate and therefore cannot alter its output in response to favorable or unfavorable shifts in the profitability of its exports arising from movements in the exchange rate. In this situation the variability in the firm?s profits arises solely from the exchange rate, and where the managers of the firm are adversely affected by risk, greater volatility in the exchange rate ? with no change in its average level leads to a reduction in output, and hence in exports, in order to reduce the exposure to risk. This basic model has been elaborated by a number of authors, e.g., Hooper and Kohlhagen (1978), who reach the same conclusion of a clear negative relationship between exchange rate volatility and the level of trade. However, this strong conclusion rests on a number of simplifying assumptions. First, it is assumed that there are no hedging possibilities either through the forward exchange market or through offsetting transactions. For advanced economies where there are well developed forward markets, specific transactions can be easily hedged, thus reducing exposure to unforeseen movements in exchange rates. But it needs to be recognized that such markets do not exist for the currencies of most developing countries. Moreover, even in advanced economies the decision to continue to export or import would appear to reflect a series of transactions over time where both the amount of foreign currency receipts and payments, as 5 well are the forward rate, are not known with certainty. Moreover, there are numerous possibilities for reducing exposure to the risk of adverse exchange rate fluctuations other than forward currency markets. The key point is that for a multinational firm engaged in a wide variety of trade and financial transactions across a large number of countries, there are manifold opportunities to exploit offsetting movements in currencies and other variables. For example, there is a clear tendency for exchange rates to adjust to differences in inflation rates, and recent evidence suggests that such adjustment may be quicker than indicated by earlier studies. Thus, if exports are priced in a foreign currency that is depreciating, the loss to the exporter from the declining exchange rate is at least partly offset by the higher foreign-currency export price (Cushman, 1983 and 1986). In a similar vein, as noted by Clark (1973), to the extent that an exporter imports intermediate inputs from a country whose currency is depreciating, there will be some offset to declining export revenue in the form of lower input costs. In addition, when a firm trades with a large number of countries, the tendency for some exchange rates to move in offsetting directions will provide a degree of protection to its overall exposure to currency risk. Finally, as analyzed by Makin (1978), a finance perspective suggests that there are many possibilities for a multinational corporation to hedge foreign currency risks arising from exports and imports by holding a portfolio of assets and liabilities in different currencies. One reason why trade may be adversely affected by exchange rate volatility stems from the assumption that the firm cannot alter factor inputs in order to adjust optimally to take account of movements in exchange rates. When this assumption is relaxed and firms can adjust one or more factors of production in response to movements in exchange rates, increased variability can in fact create profit opportunities. This situation has been analyzed by Canzoneri, et al. (1984), De Grauwe (1992), and Gros (1987), for example. The effect of such volatility depends on the interaction of two forces at work. On the one hand, if the firm can adjust inputs to both high and low prices, its expected or average profits will be larger with greater exchange rate variability, as it will sell more when the price is high, and vice versa. On the other hand, to the extent that there is risk aversion, the higher variance of profits has an adverse effect on the firm and constitutes a disincentive to produce and to export. If risk aversion is relatively low, the positive effect of greater price variability on expected profits outweighs the negative impact of the higher variability of profits, and the firm will raise the average capital stock and the level of output and exports. In a more general setting analyzing the behavior of a firm under uncertainty, Pindyck (1982) has also shown that under certain conditions, increased price 6 variability can result in increased average investment and output as the firm adjusts to take advantage of high prices and to minimize the impact of low prices. One aspect of the relationship between trade and exchange rate volatility that needs to be mentioned is the role of ?sunk costs.? Much of international trade consists of differentiated manufactured goods that typically require significant investment by firms to adapt their products to foreign markets, to set up marketing and distribution networks, and to set up production facilities specifically designed for export markets. These sunk costs would tend to make firms less responsive to short-run movements in the exchange rate, as they would tend to adopt a ?wait and see? approach and stay in the export market as long as they can recover their variable costs and wait for a turnaround in the exchange rate to recoup their sunk costs. Following the finance literature on real options (e.g., McDonald and Segel, 1986), Dixit (1989) and Krugman (1989) have explored the implications of sunk costs in the context of an ?options? approach, which has been applied by Franke (1991) and Sercu and Vanhulle (1992). The key idea is that an exporting firm can be viewed as owning an option to leave the export market, and a firm not currently exporting can be regarded as owning an option to enter the foreign market in the future. The decision to enter or exit the export market involves considering explicit fixed and variable costs, but also the cost of exercising the option to enter or leave the market. The greater the volatility in exchange rates, the greater the value of keeping the option, and hence the greater the range of exchange rates within which the firm stays in the export market, or stays out if it has not yet entered. This suggests that increased exchange rate volatility would increase the inertia in entry and exit decisions. It is useful to note that in most theoretical models, what is being studied is the volatility of the real exchange rate as opposed to the nominal exchange rate. The two are distinct conceptually but do not differ much in reality: prices of goods tend to be ?sticky? in local currency in the short- to-medium run. In this case, real and nominal exchange rate volatilities are virtually the same for practical purposes. 7 2.2. The General Equilibrium Approach So far the discussion of the impact of volatility on trade has been within a partial equilibrium framework, i.e., the only variable that changes is some measure of the variability of the exchange rate, and all other factors that may have an influence on the level of trade are assumed to remain unchanged. However, those developments that are generating the exchange rate movements are likely to affect other aspects of the economic environment which will in turn have an effect on trade flows. Thus it is important to take account in a general equilibrium framework the interaction of all the major macroeconomic variables to get a more complete picture of the relationship between exchange rate variability and trade. Such an analysis has recently been provided by Bacchetta and Van Wincoop (2000). They develop a simple, two- country, general equilibrium model where uncertainty arises from monetary, fiscal, and technology shocks, and they compare the level of trade and welfare for fixed and floating exchange rate arrangements. They reach two main conclusions. First, there is no clear relationship between the level of trade and the type of exchange rate arrangement. Depending on the preferences of consumers regarding the tradeoff between consumption and leisure, as well as the monetary policy rules followed in each system, trade can be higher or lower under either exchange rate arrangement. As an example of the ambiguity of the relationship between volatility and trade in a general equilibrium environment, a monetary expansion in the foreign country would depreciate its exchange rate, causing it to reduce its imports, but the increased demand generated by the monetary expansion could offset part or all of the exchange rate effect. Thus the nature of the shock that causes the exchange rate change can lead to changes in other macroeconomic variables that offset the impact of the movement in the exchange rate. Second, the level of trade does not provide a good index of the level of welfare in a country, and thus there is no one-to-one relationship between levels of trade and welfare in comparing exchange rate systems. In their model, trade is determined by the certainty equivalent of a firm?s revenue and costs in the home market relative to the foreign market, whereas the welfare of the country is determined by the volatility of consumption and leisure. Obstfeld and Rogoff (1998) also provide an analysis of the welfare costs of exchange rate volatility. They extend the ?new open economy macroeconomic model? to an explicitly stochastic environment where risk has an impact on the price-setting decisions of firms, and hence on output and international trade flows. They provide an illustrative example whereby 8 reducing the variance of the exchange rate to zero by pegging the exchange rate could result in a welfare gain of up to one percent of GDP. Bergin and Tchakarov (2003) provide an extension of this type of model to more realistic situations involving incomplete asset markets and investment by firms. They are able to calculate the effects of exchange rate uncertainty for a wide range of cases and find that the welfare costs are generally quite small, on the order of one tenth of one percent of consumption. However, they explore the implications of two cases where risk does matter quantitatively, on the order of the effect in the example cited above by Obstfeld and Rogoff (1998): first, where consumers exhibit considerable persistence in their pattern of consumption, such that welfare is adversely affected by sudden changes in consumption, and second, where asset markets are asymmetric in that there is only one international bond, such that the country without its own bond is adversely affected. Finally, Koren and Szeidl (2003) develop a model which brings out clearly the interactions among macroeconomic variables. They show that what matters is not the unconditional volatility of the exchange rate as a proxy for risk, as used in many empirical papers in the literature, but rather that exchange rate uncertainty should influence trade volumes and prices through the covariances of the exchange rate with the other key variables in the model. In this general equilibrium context, they stress that it is not uncertainty per se in the exchange rate that matters, but rather whether this uncertainty magnifies or reduces the firm?s other risks on the cost and demand side, and ultimately whether it exacerbates or moderates the risk faced by consumers. In addition, they analyze the extent to which local currency vs. producer currency pricing by exporters affects the risks facing the firm; their empirical evidence suggests that risk is higher with the former pricing rule. 9 Part 3- Review of Empirical Literature. Most of the earlier papers (1978 to the mid-1990s) employ only cross-sectional or time-series data and the empirical evidence of these earlier studies is mixed. For example, Hooper and Kohlhagen (1978), Bailey and Tavlas (1988), and Holly (1995) use time-series data to examine the impact of exchange rate volatility on exports of industrialised countries and find essentially no evidence of any negative effect. Cushman (1986), De Grauwe (1988) and Bini-Smaghi (1991) also examine samples of industrialised countries using time-series data and, in contrast, find evidence of a significant negative effect. Cross-sectional studies, such as Brada and Mendez (1988) and Frankel and Wei (1993) find also a negative impact of exchange risk on trade volume, but the effect is, in most cases, relatively small. More recent panel data studies have tended to find evidence of negative impact of exchange rate volatility on bilateral trade. There are apparent advantages of using panel data. Dell?Arricia (1999) notes that unobservable cross-sectional specific effects which may have impact on the trade flows - such as cross-country structural and policy differences ? can be accounted for either via fixed effects or random effects specification. Using fixed effects, Dell?Ariccia (1999) estimates the impact of exchange rate volatility on the bilateral trade of 15 EU member states plus Switzerland over the 20 years, from 1975 to 1994, and finds that exchange rate volatility has a small but significant negative impact on trade; eliminating exchange rate volatility to zero in 1994 would have increased trade by 3 to 4 percent. Rose (2000), Clark et al., (2004) and Tenreyro (2007) also employ panel data containing over 100 countries. In the benchmark result of Rose (2000), the impact of exchange rate volatility on trade is significantly negative; increase in exchange rate volatility by one standard deviation around the mean would reduce bilateral trade by 13 percent. Tenreyro (2007) finds a small negative effect similar to Dell?Ariccia (1999); reducing exchange rate volatility to zero raises trade by only 2 percent. 10 Using fixed effect estimation, Clark, Tamirisa and Wei (2004) find a negative and significant impact of exchange rate volatility on trade; a one standard deviation increase in exchange rate volatility would reduce trade by 7 percent. Empirical studies focusing on emerging and developing countries and using time-series data support the hypothesis of a negative impact of exchange rate volatility on trade. For instance, Arize et al. (2000; 2008) and Dognalar (2002) investigate the relationship between exports and exchange rate volatility in emerging and developing economies. However, these studies focus on the impact of real effective exchange rate volatility on total exports of a country, not on bilateral trade. Only Chit (2008) examines the bilateral exports among five ACFTA countries, and finds that total elimination of exchange rate volatility, in 2004, would have increased the intra-regional trade of ACFTA by 5 percent. Chit, Myint Moe, Rizov, Marian and Willenbockel, Dirk(2008) Studies that have found a negative impact include Grobar (1993) for a number of developing countries, Gonzanga and Terra (1997) for Brazilian exports, and Sekkat and Varoudakis (1998) for a panel study of sub-Saharan African manufactured exports. According to Ogun (1998) and Adubi and Okumadewa (1999), there is a negative effect on Nigeria?s non-oil and agricultural exports, respectively. Furthermore, Darrat and Hakim (2000) found a significant negative effect for Moroccan exports with the GARCH-based measure of nominal exchange rate volatility, but not with the standard deviation version of volatility. Other developing country empirical evidence in support of the negative effect of exchange rate volatility on trade flows includes Kumar and Dhawan (1991) for Pakistan?s exports to the developed world, Savvides (1992) for a combined sample of developed and developing countries, and Hassan and Tufte (1998) for Bangladesh?s exports. Others are Asafu-Adjaye (1999) for Fiji export growth, Ozbay (1999) for Turkish exports, Hook and Boon (2000) for Malaysian exports, and Arize et al. (2000) for exports by 13 developing countries. In addition, Sauer and Bohara?s (2001) comparative study of developed and developing countries on exchange rate volatility and aggregate exports found a negative effect for developing but not for developed countries. 11 In developed countries, other evidence in support of the adverse effect of exchange rate volatility on trade flows includes, among others, Hooper and Kohlhagen (1978) for the United States (US) and German bilateral exports, and Gotur (1985) for a number of developed countries. Maskus (1986) used sectoral analysis of exchange rate risk to study US trade and Kenen and Rodrik (1986) looked into the effect of short-term real effective exchange rate volatility. Koray and Lastrapes (1989) applied a VAR model to US bilateral imports from European countries, Chowdhury (1993) used a multivariate error correction model for the G-7 countries, and Arize (1997) studied seven industrialized countries. Other studies were those by De Arcangelis and Pensa (1997) for Italian export data; Fountas et al. (1998) for Irish exports; Arize and Malindretos (1998) for Australian and New Zealand exports, Fountas and Aristotelous (1999a/b) in the model of exports for the European Monetary System (EMS); and Dell?Ariccia (1999) with panel data for volatility-trade flows in the European Union. On the other hand, Sauer and Bohara (2001) found a positive relationship between aggregate exports and volatility for industrial countries. Clearly, a large number of studies have found a negative effect of exchange rate volatility on trade flows, but others point to a positive relationship. Therefore, the theoretical ambiguity of real exchange rate volatility effect on exports is also evident in empirical work. Cote (1994) reviewed some studies, mostly for industrial countries and observed the effect of exchange rate volatility on trade flows was mixed. Overall, however, a larger number of studies appeared to favour the conventional assumption that exchange rate volatility depresses the level of trade. 12 Part 4: Statistical Analysis. 4.1. Evolution of the exchange rate in Mauritius Exchange rate regimes have undergone marked changes since the British colony days. By not having its own currency, the Currency Board like system was created in the 19th Century- 1848, being regarded as the first in the world. The various shifts in exchange rate policies may be represented in the following table: Table 1: Exchange Rate Policy shifts Period Exchange Rate Policy 1870 Switch between Pound Sterling(gold) and Indian Rupee (Silver) Between 1878 and 1934 Common Monetary Union with India with the INR as the legal tender Throughout the 19th and 20th Century Almost linked to GBP through currency boards 1934 Introduced its own currency but still pegged to GBP through currency board 1967 Pegged to GBP but dual forex market separating capital account transactions from current account transactions. 1972 Left GBP in June 1972 of the back of weakening GBP and establishment of a central exchange rate with Special Drawing Rights (SDRs) 1976 Pegged to SDRs with a 2% band 1979 and 1981 Devaluation of MUR 1982 Delinked from SDR and pegged to trade weighted exchange rates of its major trading partners? currency. De facto pegging to USD. Capital Account Control 1992 Exchange Rate restrictions removed 1994 Capital Account fully liberalised Source: Mauritius, A Competitive Assessment, IMF Working Paper WP/08/212 by Patrick Imam and Camelia Minoiu (2008) 13 In addition to the above, Since 1994, Mauritius has maintained a managed float, whereby the Bank of Mauritius intervenes only to prevent high deviations from normal path of exchange rates within certain bands. Post-Bretton Woods the nominal exchange rate (NER) continuously depreciated against the US dollar (Figure 1) because inflation was higher in Mauritius than in its trading partners. Monetary policy accommodated the higher inflation differentials by letting the NER depreciate to achieve a stationary REER. Source: Mauritius, A Competitive Assessment, IMF Working Paper WP/08/212 by Patrick Imam and Camelia Minoiu (2008) In addition, on a nominal effective basis, the rupee depreciated against the currencies of its important trading partners over the years. MERI1, which uses the currency distribution of trade as weights, showed a rupee depreciation of 8.12 per cent while MERI2, which uses the currency distribution of trade combined with the currency distribution of tourism receipts as weights, showed a depreciation of 9.23 per cent for the period 2001-2009. The real effective exchange rate of the rupee depreciated by 8.12 per cent over the period under review. 14 A Micro analysis reveal that the USD appreciates against the MUR over the period 2001 to 2010 from below MUR30/USD to above MUR30/USD- MUR34.3133 on 28 May 2010 on the back of increased imports, being paid in dollars, which increased the supply of MUR vis-à-vis the USD on the forex market. As far as the Euro is concerned, despite an appreciating trend since its inception vis-à-vis the MUR, it has started to depreciate recently owing to the Debt crisis in emanating from Greece. 4.2. Evolution of our EPZ Exports. From a monocrop economy, Mauritius embarked on an outward-looking export-led growth strategy. With the EPZ Act in the 1970?s, the first industrial zones were set up in the early 1970s. Owing to the world oil price crisis and adverse world macroeconomic setbacks, the EPZ sector was rather gloomy in the 1970?s. The real take off of the EPZ occurred in the mid 1980s with an exceptional period of economic growth and development. The success of the development of the EPZ may be attributed to a number of factors including the selection of business friendly policies provided by the government, the stable industrial relations and the availability of a competitive labour pool, which help to attract investors. Undoubtedly, being a small open island economy, international events were and remain of significant importance for Mauritius. Henceforth, the unique advantage Mauritius had under the home convention also played an important role in attracting investors in the EPZ sector as the Mauritius exports benefited from the duty-free and quota-free access to the European market while other developing nations had quotas and tariffs imposed on their exports. In addition to this, the retrocession of the Hong Kong to China also led to some of the last investors to invest in Mauritius. So, a multiple of local factors and international developments led to the creation of mass employment and boosted exports enormously, thereby providing economic betterment and prosperity. For example, AGOA, The Africa Growth and Opportunity Act which was enacted on 23 May 2000, is being regarded as a panacea for the Mauritian apparel industry. AGOA is supposed to provide eligible countries from Sub Sahara African (SSA) exporting to the US to get the advantage of an average of 17.5% customs duty compared to non-African suppliers. But, to reap the benefit of AGOA, it is imperative to adhere to the strict rules of origins. With stiff competition in the European market, AGOA can boost up the apparel exports in Mauritius. 15 Having been satisfied the criteria rules of origin, Mauritius can enjoy the duty-free and quota from export possibilities to remain competitive and ensure the survival of the textile and clothing sector. Kenya, Lesotho, Madagascar and Swaziland benefit from LDC status and can thus, obtain their yarn and fabrics from any part of the world until September 2004. As a result of this, they have an advantage on Mauritius because in order to have the duty-free access to the US market, yarn and fabric must be sewed in eligible SSA countries on US. It is very difficult for Mauritius to purchase yarn and fabric from US because of high transportation cost. Usually, Mauritius producers buy yarn and fabric from Asia and thus, AGOA may foster more regional integration in SSA. Also, the Multifibre Agreement was established in 1974 by developed countries to protect their own textile and garment industry preventing large exports from Less Developing Countries (LDCs). LDCs had an abundant pool of labour and were hence, able to supply the European (EU) and United States (US) markets at a lower cost. As a safeguarding measure, the US and EU came up with quotas on the exports of the LDCs. Each year countries agree on quotas, that is, the quantity which can be traded between them. The Marrakech meeting in 1994, decided to phase out the MFA over a period of 10 years. One of the main features of the MFA it provokes a shift in production within LDCs, whereby some lose at the expense of others. With the quota system some reengineering process in the textiles production took place. Countries like Korea and Hong Kong profited from the unused quotas of other countries or their LDC status. Illegal transaction, like the transhipment, sewing of false ?made in? labels or falsification of documents occurred. Thus, in 2002 containers of goods made in Sri Lanka were found with the ?made in Mauritius? label. Such a case represents a threat to undermine the privileges Mauritius have under the AGOA since the products destined to the US. The MFA has been a great importance in the development of the EPZ. As a major beneficiary under the MFA, Mauritius will be a loser in the future since it has to face stiff competition from low cost producers. According to analysts in textile and clothing, in the post-MFA era, the ability of a country to compete would be influenced by factors such as: wage costs, supply of yarn, fabric and other raw materials, Infrastructure for transport and marketing, Nearness to markets. It has to be reckoned that the EPZ has to meet big challenges. The island has to face competition from low cost producers from Asia and emerging markets of South East Africa and thus, under such auspices, the capacity of Mauritius to compete is low. 16 However, some foresighted Mauritian producers resist the challenge to export to the EU and US markets by air and thus, reducing the delivery-time from four to two weeks by using air freight. Moreover, the introduction of AGOA has sped up the process of vertical integration in the textiles industry, urging Mauritius to supply yarn and fabric locally. Furthermore, an infrastructure for transport and marketing already exist in the country, reducing the constraints faced by other countries like Bangladesh and Sri Lanka. Nevertheless, the competition from India, China and Pakistan remain unavailable as they already have a textile base and their cost of labour is very competitive by international standards. Similarly, Korea has a very high productive and efficiency while Thailand and Phillipines are expected to lose as they do not have an industrial base compared to Vietnam which is expected to emerge as a major producer. It is also very obvious that the phasing out of the MFA Act as a spur to trade liberalization. Undoubtedly, Mauritius which has developed its textile and garmenting industry on the basis of the MFA stands to lose out. Significantly provided it can review its trade strategy or renegotiate preferential trade agreements for the medium term. A complete reengineering of trade results since buyers in the US and EU have more options to choose from. This may curtail prices when producers in developing countries compete with others in the developed market. Thus, many small or inefficient producers have to close down. On the contrary, producers in developed countries may provide big contract to lower wage economies, exerting big pressure to lower costs in the developing world. Recently, the path of the EURO has had raised eyebrows among various stakeholders about the future of the EPZ sector in Mauritius. 4.3. Statistical Linkage between the Euro and Textile Export Earnings. Here, we provide an evolution of the Euro vis-à-vis the Mauritian rupee (MUR) as well as Mauritian Textile Export Earnings and assess whether there is a linkage between them. For the period of study, that is from 2001 to 2009, the euro generally appreciates from MUR.27.0487/EUR1 in 2001 to reach MUR45.9063 in 2009. Note that after reaching a highest value of MUR.47.2215/EUR1, the euro starts to depreciate and recently (in May 2010) reach about MUR.40/EUR. 17 Our Textile has faced many challenges in the recent years. Back from a boom in that industry in the 1980?s, 1990?s and the early 2000?s on the back of massive influx of Foreign Direct Investment from Asian and European Countries and International Agreements such as the Africa Growth and Opportunity Act and Multi Fiber Agreements, today our Textile sector is on the brink of collapse. The phasing out of the MultiFiber Agreement and heavy competition from low cost producing emerging economies of the like of BRIC Countries (Brasil, Russia, India and China), Sri Lanka, Pakistan and other Asian countries, Mauritius is gradually losing its comparative advantage in Textiles. In addition to the above challenges, Mauritius is presently is on the dawn of a severe collapse of its industry with the ongoing depreciation of the euro vis-à- vis the MUR which means that exporters are not immune from their transaction exposure, that is, their export revenue might be hit severely. The link between the Euro and Textile Export Earnings may be explained by use of the following diagrams: 18 From the above diagrams, we note that the euro depreciates three times against the MUR; in the years 2005, 2007 and 2009. However, we note that despite the depreciation of the euro in the years mentioned, only in 2007 and 2009 that Mauritian Textile Exports fell, indicating that depreciation of the Euro is not the prime factor explaining falling exports in the Textile industry and that our Textile sector is being affected other factors. 4.4. Statistical Linkage between the Euro and Tourism Earnings. Since the late 1970?s, the government has always poised to make Mauritius a tourist paradise. Despite problems like the 1999 riots and Chikungunya (a disease) hitting Mauritius, Tsunami risks, the tourism sector remained one of the most promising engines of growth in real GDP for the period studied. Tourist arrivals skyrocketed from a low of 67,994 in the early 1970?s to reach above MUR.900,000 in 2009. The share of the tourism sector as a percentage of GDP also increased from about 1%-2% in the 1970?s to 18% in 2009. As far as earnings are concerned, we note that tourism earnings, generally kept on increasing save in the year 2009 when earnings fell as the world went into recession and demand for our tourism services fell slightly from our main markets from Europe. We append below diagrams that will enable us to show the link between tourism earnings and the evolution of the euro. 19 From the above diagrams, it is clear that tourism earnings are rather insensitive to changes in euro. Despite the fall in euro in 2005, 2007 and 2009, which was expected to make travelling and holiday in Mauritius dearer, we note that tourism earnings increased in the years 2005 and 20 2007 with the exemption of the year 2009, which is considered as an exception as the world was experiencing the financial crisis and demand fell slightly for our tourism services from our main markets (Europe). 4.5. Statistical Linkage between the USD and Imports. Mauritian imports have traditionally been paid in US dollars. Generally, the USD has appreciated against the MUR from MUR.27.76/USD in 2001to MUR.30.2902/USD in 2009, which partly explains the increased import expenditure over the years. We append below diagrams showing the evolution of imports as well as the US dollar/ MUR exchange rate. 21 In addition to improved standard of living, the rising trend in imports expenditure in Mauritius is also explained by the weakening of the rupee vis-à-vis the US dollar over the years. This meant increased cost of production for our exporters, chiefly for those in the textile industry. The latter explains why our competitiveness for Textile is gradually being eroded by low cost producing economies of BRIC, Sri Lanka, Pakistan and others and the balance of trade deficits experienced in the years under review. 22 Part 5: ECONOMETRIC ANALYSIS 5.1. Methodology and data. The data were obtained from Bank of Mauritius Annual Reports, and monthly bulletin and website, from The Central Statistical Office and from the Bank of Mauritius Annual reports, International Monetary Fund, World Bank database and www.oanda.com. The sample date starts in 2001 and ends in 2009 for the simple reason of data unavailability. We make use of yearly data and Time series analysis shall be made. Many models have been used in the literature as regards the effect of exchange rate movements on exports, albeit the findings depend on sample period, frequency and disaggregation of data, measures of volatility as well as whether the economy is developed or developing. 5.2. The Baseline Model Inspired by the model developed by Saviddes (1992), a two country model of international trade, we model the impact of exchange rate movements on exports. The latter model assumes that the demand for exports are a function of real foreign income and relative prices (foreign prices) as follows: DD = DD Y f P fX X ( , x ) 1 Where DDx is the demand for exports, , Yf is the level of real foreign income, Pfx if the relative prices of exports abroad where P f fx = PE / EP 23 depicts the domestic price of exports; E depicts the exchange rate in nominal terms which pertains to the amount of local currency per unit of foreign currency and Pf is the price level in foreign currency. On the other side of the spectrum, the supply of exports are a function of domestic relative prices, exchange rate volatility and the terms of trade and is given by: SS X = SS X ( Px , V , TOT ) 2 Where SSX is the supply of exports; Px is the relative price of exports given by P x = PE / P P is the domestic price level; V is the exchange rate volatility and TOT is the terms of trade. Besides, P f x = Px / Q is the relative price of exports where Q = EP f / P Denotes the real exchange rate. Converting the above equations into log form with the exception of V, which may take negative values and replace Pfx by Px/Q, equations 1 and 2 above are as follows: 24 DD = ? 0 + ? 1 y fx ? ? 2 p x + ? 3 q + ? 3 SS x = ? 0 + ? 1 p x + ? 2V + ? 3 tot + ? 4 Where ? and ? are stochastic error terms and are uncorrelated. If equilibrium is assumed in the export, market ? 1 1 P 0 ? 2 ? x = + x ? V ? 3 tot ? ? 5 ?1 ?1 ? 1 ? 1 ? 1 Replacing equation 5 into equation 3 and solve for x to obtain a reduced form equation, we have ? x = 0 ? 1+ ? 2? 0 ? 1?1 ? 3? 1 ? 2? 3 ? 2?+ y f ? q + 2tot + V + ? 6 ? ? ? ? ? Where ? = ? 2 + ?1 and ? = ? + ?1? / ? Equation 6 tells us that there a country?s exports is a linear function of its trading partner?s real income, real exchange rate, terms of trade and exchange rate volatility. 25 5.3. Our model. Based on the foregoing model, we formulate a behavioural model of exports for Mauritius that shall be a linear function of its trading partner real income, real exchange rate in Euro and USD as most export revenues are in Euro and raw materials purchased meant for exports are in US dollar, the terms of trade and exchange rate volatility. Our model pins down to the following: ? x 0 ? = 1+ ? 2? 0 ?+ 1 ?1 ?y f 3 ? 1 ?q 2 ? 3 ?o 2 ? ? + 2t t + V + ? 6 ? ? ? ? ? Where ? = ?2 + ?1 and = ? + (?1? ) / ? Equation 6 depicts that exports are a linear function of trading partners? real income, real exchange rate, terms of trade and exchange rate volatility. To obtain a function showing a system of behavioural demand and supply functions, we reformulate equation 6 as follows: E x = ? 0 + ? 1Y f ? ? 2 q1 ? ? 3 q 2 + ? 3 tot + ? 4V + ? 7 Equation is estimated two times as follows: E T = ? 0 + ? 1 y f ? ? 2 q1 ? ? 3 q 2 + ? 3 tot + ? 4 + ? 8 where ET shows receipts from tourism earnings and E p = ? 0 + ? 1 y f e ? ? 2 q1 ? ? 3 q 2 + ? 3 tot + ?z 4V + ? 9 where EPZ shows receipts from Export Processing Zone. 26 Where q1 represents- REER in EURO and q2 represents REER in USD, TOT is the terms of trade, V is volatility. 5.4. Definition of variables The following variables are employed in this analysis: Exports as depicted by receipts from tourism earnings and Export Processing Zone, Trading partners? real income, Terms of Trade and real effective exchange rate volatility. The period average nominal exchange rate is employed to compute real effective exchange rate. We also use annual weighted trade for three main trading partners FOR Mauritius to immune ourselves from misleading inferences pertaining to the evolution of Mauritius? extent of competitiveness and to take into account the dynamic nature of trade patterns between Mauritius and its trading partners. Following Patrick Imam et al (2008), Real Effective Exchange Rate (REER) is defined as follows: 3 REER ? ? ?= w e p* it * it it ? ? p i ? dt ? Where eit depicts the bilateral nominal exchange rate, wit is the ith trading partner trade weight and pit and pdt are the trading partner?s and domestic index of retail prices respectively. 5.5. Econometric Analysis. In this section, we carry out Augmented Dicker Fuller and Phillips ?Perron tests for unit root. We then proceed with an brief introduction of the GARCH model of exchange rate volatility, perform some cointegration tests as per Johansen (1991) procedure. Several hypotheses are made and we conclude this part by analysis of our results and interpretations. For estimation purposes, we shall make use of Eviews 4.1 software. 27 5.5.1. Unit Root Tests Augmented Dicker Fuller and Phillips-Perron tests are carried out using Eviews 4.1 to detect the presence/absence of stationarity in our data series. The results are appended in the table that follows. We note that the data were non-stationary for the period 1989-2009 considered at the 5% significance level. As a result, the data is differenced once to obtain a stationary data set. Table (a) Unit Root Tests Results for EPZ Exports Equation a). Augmented Dicker Fuller (ADF) Without trend With Trend Levels Log Ex -1.49 -2.76 Log q1 -1.87 -2.67 Log q2 -0.63 -3.12 Log Yf -1.77 -1.52 Log TOT -1.65 -1.67 Log V -1.21 -1.33 First Difference Log Ex -4.27** -4.28** Log q1 -4.69** -4.88** Log q2 -4.83** -4.61* Log Yf -4.23** -4.93** Log TOT -4.53** -4.54** Log V -4.65** -4.32** Source: Eviews4.1 output 28 Table (b) Unit Root Test Results for EPZ equation a). Phillips-Perron results Without trend With Trend Levels Log Ex -2.39 -3.65 Log q1 -2.67 -2.43 Log q2 -0.54 -2.29 Log Yf -1.57 -1.59 Log TOT -1.56 -1.72 Log V -1.71 -1.66 First Difference Log Ex -8.88** -9.78** Log q1 -5.87** -7.76** Log q2 -3.94** -3.46* Log Yf -6.73** -5.98** Log TOT -6.93** -5.76* Log V -7.80** -7.06* Source: Eviews 4.1 Output From the above output, * indicates the absence of stationarity at the5% significance level while ** indicates same at the 1% significance level. 29 Table (c )- Unit Root Tests for Tourism Earnings Equation a). Augmented Dicker Fuller (ADF) Without trend With Trend Levels Log Ex -1.24 -2.65 Log q1 -1.73 -2.71 Log q2 -0.60 -3.09 Log Yf -1.73 -1.41 Log TOT -1.59 -1.70 Log V -1.20 -1.31 First Difference Log Ex -4.11** -4.09** Log q1 -4.01** -4.00** Log q2 -4.32** -4.11* Log Yf -4.30** -4.38** Log TOT -4.36** -4.47** Log V -4.58** -4.24* 30 Table (d) a). Phillips Perron Tests Without trend With Trend Levels Log Ex -1.59 -2.67 Log q1 -1.71 -2.72 Log q2 -0.67 -3.32 Log Yf -1.71 -1.52 Log TOT -1.54 -1.78 Log V -1.59 -1.62 First Difference Log Ex -4.31** -4.39** Log q1 -4.58** -4.62** Log q2 -4.63** -4.68* Log Yf -4.32** -4.86** Log TOT -4.12** -4.42** Log V -4.50** -4.31* From the above output, * indicates the absence of stationarity at the 5% significance level while ** indicates same at the 1% significance level. 31 5.5.2. The Lagrange Multiplier ARCH Test Results. The Lagrange Multiplier ARCH test is employed to test the ARCH effects in the real effective exchange rate process. The latter is a requirement of using the GARCH method for this purpose.The REER is assumed to follow a first order autoregressive process, depicted by AR(1) and displayed in the following equation, which is thereafter run. ? log( REER ) = ? 0 + ?1? log( REER ) + ? Equation 10 t t ?1 Where ? is the error term, assumed not to be correlated and REER is the real effective exchange rate. The LM ARCH is found to be significant at the 5% significance level with Chi2 statistic of 4.98 as opposed to a critical value of 4.12. The significance is confirmed with a F- statistic of 7.19 against a critical value of 3.21. Therefore, the REER follows an ARCH (1,1) process, which enables us to produce the GARCH (1,1) dataset as a measure of REER volatility. Given that we have assumed that the error terms are not correlated, the GARCH process of equation 10 is as follows: h 2 2t = ? + ? ? 20 1 t ?1 + ? 2 h t ?1 Equation 11. From equation 11, h2t is the time variant conditional variance of the REER, ? 2t?1 is the squared residuals obtained from equation 10 and the ? s are parameters to be estimated. The results for the GARCH model of REER is shown in the following table. 32 Table (e). GARCH Model Results Mean Equation of the real exchange rate rate process (? Log (REER)) Variable Coefficient t-statistic Constant 0.75 1.46 ? Log (REER)t-1 0.77 5.23 GARCH equation of the real exchange rate volatility Variable Coefficient t-statistic Constant -0.099 0.83 ? 2 ?1 1.78 2.45 t h2t-1 0.43 1.83 Source: Eviews4.1 output From Table (e), the mean equation is synonymous to equation 10 wherein the REER is a function of its lagged value. On the other hand, the GARCH equation is for the equation 11. In essence, we may interprete the above results as prediction of the current Real exchange rate variance by the Mauritian exporters by producing a weighted mean of a long term mean (the constant in the GARCH equation), the forecast variance from last period (the GARCH term) and the information about volatility of the REER observed in the previous period( the ARCH term). As such, the forecast series h2t from the GARCH function provides a suitable measure of REER volatility. 33 5.5.3. Johansen Cointegration Tests and Estimate of the Error Correction Model (ECM) In the absence on non-stationarity in the series, we conduct Johansen (1991) cointegration tests and same are appended in the tables that follows: Table f: Johansen Cointegration Results for EPZ equation -Cointegration analysis (2001-2009) Eigen Values Trace Statistic 5% critical value 1% critical value Hypothethised number of cointegrating equations 0.5647 69.7831 62.28 70.56 None* 0.6849 35.1287 40.79 56.29 At most 2 0.3359 15.8282 22.35 30.23 At most 4 0.1724 7.3097 9.23 18.79 At most 1 0.0325 5.3627 8.72 17.67 At most 3 0.2837 0.8724 4.32 4.18 None* Table g: Johansen Cointegration Results for Tourism Earnings equation -Cointegration analysis (1989-2009) Eigen Values Trace Statistic 5% critical value 1% critical value Hypothethised number of cointegrating equations 0.4235 69.3256 66.74 74.05 None* 0.3678 42.2093 45.19 52.34 At most 4 0.2707 19.7829 27.46 33.53 At most 3 0.1498 3.5425 13.29 17.96 At most 1 0.1765 4.3290 12.78 16.78 At most 2 0.0314 0.6523 2.64 5.52 None* 34 The series in Table f is of Exports of Textile Products depicted as Export Processing Zone(EEPZ), Foreign Income (Yf), Real Effective Exchange Rate (REER), Terms of Trade (TOT), Exchange rate volatility (V). The series in Table g is of Tourism Earnings (ET), Foreign Income (Yf), Real Effective Exchange Rate (REER), Terms of Trade (TOT), Exchange rate volatility (V). * shows that the null hypothesis has not been accepted at the 5% significance level. The trace test indicates 1 cointegrating equations at the 5% level for both cases. Wald Test from the Eviews output gives a Chi2 statistic of 106.26, depicting the presence of cointegration. Given that cointegration exists, we estimate an Error Correction Model in the following equations to take into account of spurious regression. The advantage of the Error Correction Model is that it helps to institute relationships between the short run and long run approaches to econometric modeling. n n n ?Log(EEPZ ) = ? 0 + ?? ? log(E ) ?1 + ?? ? Y flog( ) ?1 + ? ? log(EUREER) - i EPZ t i t ? i t?1 i=0 i=0 i=0 n n ?? ? log(USDREER) +i t?1 ?? ? log(TOT ) 1 -i t? i=0 i=0 n ?? ?V ?1 +?ECM ? + ?DUM 1 + ? Equation 12 for EPZ i t t i i i=0 n n n ?Log(ET ) = ? 0 + ?? ? log(ET ) ?1 + ?? ? log(Y f ) ?1 + ? ? log(EUREER) ?1 - i t i t ? i t i=0 i=0 i=0 n n ?? ? log(USDREER) +i t?1 ?? ? log(TOT ) 1 -i t? i=0 i=0 n ?? ?V ?1 +?ECM ? + ?DUM 1 + ? Equation 13 for Tourism Earnings i t t i i i=0 In both equations, ? on the Error Correction Model provides the speed of adjustment to long run equilibrium. In fact, reform to the exchange rate system to a managed float and other measures in the 1990?s in Mauritius were designed to provide a stimulus to our export sector. Also, various changes relative to the performance of the sector were in place, viz, various bilateral agreements and extensive marketing of the tourism sector, data of which are not 35 available, which substantiate the inclusion of a Dummy- DUM1 , in the equation ( which takes value of 1 in the 1990?s and zero otherwise). 5.5.4. Formulation of the Hypotheses The link between export of EPZ sector and exchange rate movements as well as exchange rate and Tourism may be determined through the following hypotheses. (i) Negative relationship between EPZ Exports and exchange rate movements such that REER Volatility tends to curtail exports in EPZ exports in Mauritius. Similarly, same relationship is expected between tourism earnings exchange rate and tourism earnings, providing a negative sign for the volatility coefficient in both equations. (ii) The effect of a real depreciating Mauritian rupee is to boost export earnings both in the EPZ and tourism sectors as the domestic price of exports become relatively more attractive. Also, a sound macroeconomic environment will also help boost exports in both the EPZ and tourism sector. We, thus expect a positive the REER to have a positive impact on both EPZ exports and Tourism earnings. (iii) The level of foreign income is also a factor influencing exports such that an increase in income in Mauritian trading partners? economy will increase demand for goods and services not only in their own country but also our exports. Hence a positive coefficient is expected between real foreign income and exports of both EPZ products and tourism services. (iv) A favourable Terms of Trade is expected to promote international trade, and thus we expect a positive coefficient for the TOT in the ECM equation 36 5.5.5. Econometric Results and Interpretation for EPZ Equation. Equations 12 and 13 are run using Eviews4.1. We append below an abridged version of the results obtained. Table h: Parsimonious error correction mechanism( Error Correction Model of EPZ Exports Dependent variable ?EPZ Exports Variable Coefficient t-statistic Prob Constant 0.034 0.412 0.822 ?log(Ex)t-2 0.243 2.873 0.094 ?log (EUREER)t 1.497 3.423 0.002 ?log (USDREER)t -1.546 2.961 0.001 ?Vt -2.871 -2.234 0.045 ECMt-1 -0.793 -3.234 0.000 Adj R2=0.53 D-w=1.87 AIC= 1.73 SIC=1.93 S.E= 0.61 F-Statistic= 8.92 (0.00) Diagnostics Normality=0.797 ARCH= 2.48 (0.12) LM(2)=0.73(0.82) White=13.21(0.08) Chow=4.25 (0.63) RESET(1)= 0.15(0.76) Source: Eviews4.1 output 37 The above table shows results obtained from Eviews4.1 output. Note that TOT and, Real Foreign Income and the Dummy Variable do not form part of the regression results for the simple reason of their joint insignificance and has thus been eliminated. The Adj R2 means that the model explains 53% of the parsimonious equation, which is considered acceptable when first differenced. We also note that there is a very strong negative relationship between volatility and EPZ exports with the coefficient for ?Vt at -2.871 at the 5% significance level, consistent with the findings of Sauer and Bohara (2001), Clark, Tamirisa and Wei (2004).This means that for Mauritian exporters are adversely affected in terms of export earnings in case of high volatility of real exchange rates as they are unable to immune themselves from the adverse movements in real exchange rates for the reasons that they do not engage in hedging transactions. The results convey that the exporters might adversely react to maintain their margins by incomplete pass through, raising their prices by the equivalent depreciation of the real exchange rate but they may face the risk of losing fully their competitiveness from emerging economies like the BRIC ( Brazil, Russia, India and China). The speed of adjustment to equilibrium is also significant at 5% significance level and shows a negative sign, as anticipated. The coefficient of ECMt-1 is -0.793 means that, 79.3% of adjustment to equilibrium occurs during the first period. Also, the REER for both Euro and USD are significant at the 5% significance level and positive as expected. The coefficient of EUREER means that the contemporaneous effect is important in boosting exports as shown by the size of the coefficient of about 1.5% adjustment response of exports to the incentive structure of real exchange rate depreciation. The positive sign for the EUREER is 1.497, which means that there is a positive link between the price of euro and EPZ exports. In other words, the result also shows that a real appreciation of the Euro will boost EPZ export while a real depreciation of the Euro adversely affects exports. This has always been the case in Mauritius. For example, presently, the Textile Sector is in the brink of a severe blow and possible collapse. The real depreciation of the Euro vis-à-vis the Mauritian rupee is posing problems for local exporters. It has been estimated by Mauritian Economists that local textile exporters might forego £1 per unit for their products for some enterprises. Similarly, the coefficient of USDREER is negative and at 1.546 suggesting that a real appreciation of the USD vis-à-vis the Mauritian rupee makes imports in USD dearer and raises the cost of 38 production of firms in the EPZ sector. As a result of increased cost of production, competitiveness is eroded on the world markets characterized by fierce competition from emerging players from China, Pakistan, Sri Lanka, India, Brazil and other Asian economies. Thus, a real appreciation of the USD vis-à-vis the dollar adversely impact on Mauritian exports. 5.5.6. Econometric Results and Interpretation for Tourism Earnings Equation. Table h: Parsimonious error correction mechanism ( Error Correction Model of Tourism Earnings) Dependent variable ?Tourism Earnings Variable Coefficient t-statistic Prob Constant 0.042 0.523 0.729 ?log(Ex)t-2 0.436 2.431 0.046 ?log (EUREER)t 1.253 2.987 0.099 ?log (USDREER)t -1.234 2.873 0.088 ?Vt -2.276 -2.017 0.037 ECMt-1 -0.631 -2.987 0.000 Adj R2=0.47 D-w=1.45 AIC= 1.63 SIC=1.23 S.E= 0.53 F-Statistic= 5.87 (0.00) Diagnostics Normality=0.812 ARCH= 2.21 (0.17) LM(2)=0.76(0.815) White=13.21(0.08) Chow=4.12 (0.64) RESET(1)= 0.11(0.69) Source: Eviews4.1 output 39 The above table shows results obtained from Eviews4.1 output. Note that TOT and, Real Foreign Income and the Dummy Variable do not form part of the regression results for the simple reason of their joint insignificance and has thus been eliminated. The Adj R2 means that the model explains only 47% of the parsimonious equation, which is considered acceptable when first differenced. We also note that there is a very strong negative relationship between volatility and Tourism earnings with the coefficient for ?Vt at -2.276 at the 5% significance level. This means that Mauritian tourism operators are adversely affected in terms of earnings in case of high volatility of real exchange rates as despite the fact that arrivals may remain unchanged/ do not decrease earnings may fall following a real appreciation of the Mauritian rupee. However, in the long run, foreigners may find that our local currency is overvalued and may switch to alternative cheaper destinations, which suggests that given the elasticity of the demand for the tourism services, operators cannot raise their prices and suffer in terms of their earnings. The speed of adjustment to equilibrium is also significant at 5% significance level and shows a negative sign, as anticipated. The coefficient of ECMt-1 is -0.793 means that, 79.3% of adjustment to equilibrium occurs during the first period. Also, the REER for both Euro and USD are significant at the 5% significance level and positive as expected. The coefficient of EUREER means that the contemporaneous effect is important in boosting tourism earnings as shown by the size of the coefficient of about 1.2% adjustment response of non traditional exports to the incentive structure of real exchange rate depreciation. The positive sign for the EUREER is 1.253, which means that there is a positive link between the price of euro and Tourism earnings. In other words, the result also shows that a real appreciation of the Euro will boost tourism earnings while a real depreciation of the Euro adversely affects the earnings. However, in practice, this has not always be the case. During the first quarter of 2010, it has been noticed that despite the euro depreciation, tourism earnings were on the rise, albeit the full effects on the tourism sector is yet to be seen. Mauritian analysts from various sectors are of the view that the clientele shift towards the mid-market will continue, and a weakening euro will add additional pressure but the faltering euro rubs salt in the wound. However, per the Central Statistical Office, is backing a 12,5% hike in revenues, relying on Bank of Mauritius figures. According to them, the receipts for the current year will be around Rs 40,15 billion. As regards tourists arrivals, the CSO predict that they will grow by 5% reaching 915 000 on the back of the forthcoming world cup in South Africa. 40 Part 6: Conclusions and Suggestions for future policies As an overall recapitulation, we have examined the effect on EPZ exports and tourism of exchange rate fluctuations in Mauritius by employing an Error Correction Model. The results so obtained are in line with the theoretical foundations. In fact for both equations, the REER and volatility are both economically and statistically insignificant at the 5% level of significance. Yet, we find that foreign income, contrary to the law of income elasticity of demand, is both economically and statistically insignificant and thus has been removed from the final equations. Same was found for the Terms and Trade and the dummy variables. The above results have important insights to offer in terms of future policies with regards to exchange rate management, macroeconomic policies and management. It is clear that unstable exchange rates shall impede the Mauritian competitiveness both for the EPZ sector and the Tourism sector. We have seen that Mauritius is a price taker for its exports on the international scene as it is facing fierce competition among emerging economies like the BRIC, Pakistan, Sri Lanka and other Asian economies. As such trade policy should be geared towards overall macroeconomic stability and elimination of anti-export bias constraints. It is also to important to point out that a devaluation of the rupee at this stage is not appropriate as we are unsure about the future path of the euro and whether the devaluation will help to sustain long run comparative advantage. I do not believe as well that devaluation should be a last resort measure to be taken when all the measures discussed below fail to improve the situation. Indeed, a devaluation of the currency would shake foreign and local investor confidence in Mauritius, which can badly affect investment levels in the country. Why risk the f
Posted: 24 June 2010
Presenting the contributor

Virendra Polodoo, Consultant

Financial Analyst/Economist