V.tandrayen-Ragoobur Exchange Rate Pass Through in Mauritius AEID

7/28/2019 V.tandrayen-Ragoobur Exchange Rate Pass Through in Mauritius AEID

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Exchange Rate Pass Through to Domestic Prices: Evidence from Mauritius

by

Verena TANDRAYEN-RAGOOBUR1

and Anjulee CHICOOREE

Department of Economics and Statistics, Uni versity of M auri tius

Abstract

This study examines the impact of exchange rates and external shocks on import prices,domestic producer and consumer prices for the small island economy of Mauritius highlydependent on the external markets. Quarterly data from 1999 to 2010 and the StructuralVector Autoregressive model are used. The impulse response function suggests thatexchange rate pass through to consumer prices is the highest; followed by producer priceswhile exchange rate pass through to import prices is the lowest. Our findings also reveal theexistence of bidirectional causality only for the case of nominal effective exchange rate andproducer prices. Further, the variance decomposition results indicate that the variance ofimport and producer prices is explained mainly by oil price shocks while the variance ofconsumer prices is largely accounted by import price shocks. This study shows that monetary

policy has a determinant role in maintaining price level in the economy.

Keywords: Exchange Rate Pass Through, Inflation, Structural Vector Autoregressive Model,Mauritius

JEL Classification: F31, E31, C32

1Address: Department of Economics and Statistics, Faculty of Social Studies and Humanities,

University of Mauritius, Reduit, Mauritius. Phone Number: +230 7871282. Email:[email protected]
mailto:[email protected]:[email protected]:[email protected]


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1. Introduction

Exchange rate pass through is the percentage change in local currency import prices resultingfrom a per cent change in the exchange rate between the exporting and importing countries(Goldberg and Knetter 1996). Exchange rate pass through can be either incomplete orcomplete and refers not only to the effect of exchange rate changes on import and exportprices but also on consumer prices, producer prices, investments and trade volumes. Theextent and degree of exchange rate pass through points out the importance of exchange ratefluctuations on domestic price inflation and also the extent to which exchange rates andimport prices influence domestic inflation.

Studies on exchange rate pass through investigate the impact of exchange rate fluctuations ondomestic prices or more specifically on consumer price inflation (Choudhri and Hakura 2001,McCarthy 2006). McCarthy (2006) finds that exchange rate pass through to import prices isnegative and particularly large for Belgium and Netherlands while pass through is small inSweden and Switzerland. The exchange rate pass through to producer price index is fairlyweak in most industrialized countries. The response of the consumer price inflation is the

lowest except for Belgium and Netherlands. The variance decompositions results reveal thatdomestic policies are important in controlling domestic consumer inflation. Studies onemerging economies, namely Bhundia (2002) for South Africa shows that pass throughelasticities are highest for import prices, followed by producer prices and consumer pricesthus suggesting that exchange rate shocks have a successively smaller impact as one movesdown the distribution chain. In addition shocks to producer prices have a considerable impacton consumer price inflation, so that policies oriented towards mitigating inflationary pressuresat the producer price level may reduce consumer price inflation. Garcia and Restrepo (2001)show that the pass through to inflation is complete in the long run for Chile. Restrepo (2001)further concludes that exchange rate pass through depends positively on output gap and wagesand that foreign price are positively related to inflation. Rowland (2003) indicates thatexchange rate pass through is incomplete in Colombia even after a year where only 80 per

cent of an exchange rate change is passed onto import prices and for producer and consumerprices exchange rate pass through is 28 per cent and 8 per cent respectively. Ghosh and Rajan(2007) study the evolution of exchange rate pass through into consumer price index for theIndian economy. The results indicate that exchange rate pass through elasticity of the rupee-USD is between 45 per cent and 50 per cent and quite stable over the period under review.There is also evidence that exchange rate volatility consistently has a negative impact onexchange rate pass through. In addition, Sek and Kapsalyamova (2008) indicate that thedegree of pass through is highest on import price, moderate on producer prices and lowest onconsumer prices but on overall exchange rate pass through is incomplete in four East Asiancountries namely, Singapore, Malaysia, Thailand and Korea before and after the financialcrisis of 1997. The effect of import price shock is found to be stronger than an exchange rateshock in determining domestic prices especially in the case of Singapore.

Like many developing countries, Mauritius depends on the rest of the world and the level ofinterdependence has increased in the last decade. Mauritius being a small island economywith a domestic market insufficiently large to support large scale production depends onimports from other countries to supply a large part of domestic consumption and on exports toother countries to provide markets for much of its output. It is highly vulnerable to anyadverse economic changes in other economies. Mauritius has increasingly liberalised its tradefrontiers leading to lower barriers to trade, for both goods and services. This has increasedtrade and intensified international competition. In addition to greater trade and financialliberalisation, two specific changes have impacted significantly the Mauritian economynamely the phasing out of the preferential access obtained on the EU market for sugar exportsand the dismantling of the Multi Fibre Agreement for our textile products in 2005. Inaddition, currency markets show different degrees of volatility, reflecting the particulareconomic circumstances that the country faces through time. Exchange rate volatility is


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another crucial element that needs to be considered for small countries that dependextensively on trade the case of Mauritius. Exchange rate changes have thus importantimplications on both producer and consumer price inflation. To our knowledge, there are nostudies analysing exchange rate pass though for the small island economy of Mauritius whichis highly dependent on trade and where food imports presently consists of 77 per cent of thetotal import bill.

The main aim of the study is thus to investigate the extent and degree of exchange rate passthrough to prices at different distribution levelsfrom import prices, to producer prices up toconsumer prices. The study further focuses on the existence and degree of causality betweenexchange rate and domestic prices and analyses the degree of exchange rate pass through toimport, producer and consumer prices. Lastly, we assess the effect and importance ofexternal shocks in explaining import and domestic prices in the Mauritian economy. Astructural vector autoregressive (SVAR) model is estimated and the impulse responsefunctions are used to calculate exchange rate pass through elasticity and also to analyse theeffect of external shocks on import and domestic prices. Forecast error variancedecomposition is equally obtained from the SVAR to examine the importance of external

shocks in explaining import and domestic prices.

The study is organised as follows. Section 2 reviews the theoretical and empirical literatureon exchange rate pass through. Section 3 analyses the data used for Mauritius. Section 4depicts the methodology adopted. Section 5 presents the econometric analysis and results.Section 6 concludes with policy recommendations.


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2. Literature Survey

The existing literature on exchange rate pass can be viewed from three perspectives. The firstone studies exchange rate pass through into import prices for specific industries (Feinberg1989 and Klitgaard 1999) while the second covers studies relating to exchange rate passthrough into aggregate import prices (Hooper and Mann 1989; Campa and Goldberg 2005)and finally the last one regroups those studies that examine the pass through related towholesale and consumer prices (McCarthy 2006). It is important to note that studies onexchange rate pass through at the macro level investigate exchange rate pass through from themonetary policy view where different prices indices (import price index, producer price indexand consumer price index) are estimated. Our study captures all the three dimensions ofexchange rate pass through for Mauritius.

There are several possible channels through which exchange rate changes may affect prices.Changes in exchange rates have direct and indirect effects on consumer prices. At unchangedforeign currency costs of production, an exchange rate change affects the domestic currencyprice of foreign imports and this is termed as the direct effect. Changes in foreign import

prices may affect consumer prices in two ways. The first effect is from the fact that importsmay be finished goods used for consumption and thus the price level is directly influenced.Second, imports are also intermediate goods used in the production of domestic output. Thus,the appreciation of foreign currency increases domestic currency cost of production and this isin part passed through into higher output prices.

The indirect effects of exchange rate fluctuations are divided into the competition effect andthe wage inflation effect by Sachs (1985). The competition effect takes place when there areshifts in the demand for domestic output due to exchange rate fluctuations. An exchange rateappreciation leads to an increase in exports prices and fall in import prices. Given unchangeddomestic costs, domestic producers have to react to lower import prices by cutting their ownprices and profits margins due to lower competitors prices. On the other hand, exchange rate

depreciation is likely to lead to an increase in the domestic demand for substitutes due to therising import prices, thus putting upward pressure on prices of such products and causingconsumer prices to rise. At the same time depreciation of the domestic currency make exportsmore competitive on the world market. The rising demand of exports leads to an upwardpressure on the price of domestic tradable goods which also contribute to the rise in consumerprices. The last channel is the wage inflation effect. The wage inflation effect works throughthe determination of nominal wages which has a direct impact on production costs. Exchangerate depreciation increases the price of imported consumption goods leading to a fall inpurchasing power of workers. To compensate for the fall in purchasing power, employersincrease nominal wages and this leads to an increase in the cost of production which isconsequently passed through into higher output prices. Laflche (1996) illustrates the directand indirect effects of exchange rate fluctuations on the consumer price level in Figure 1 as

follows.


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Figure 1: Transmission mechanism of exchange rate depreciation to prices.

Source: Laflche (1996)

The extent, speed and magnitude of exchange rate pass through to domestic prices depend onmicroeconomic and macroeconomic factors which may either deepen or lessen the impact ofexchange rate volatility on domestic prices. One of microeconomic factors is the marketstructure (Dornbusch 1987; Menon 1996) as the responsiveness of prices to an exchange ratemovement is determined by the relative number of foreign firms and the ratio of marginal cost

to price of foreign suppliers. An appreciation of the domestic currency is found to lower priceless than proportionally and the decline in the domestic price is larger the more competitivethe industry and the larger the share of imports in total sales. Due to imperfect competition,pricing will no longer be at marginal cost and firms can charge a mark-up on costs to earnabnormal profits even in the long run.

Pricing to market equally influences exchange rate pass through (Krugman 1986) as it is thepricing behaviour of firms exporting their products to a destination market following anexchange rate change. The extent of pricing to market is based on the competitive conditionsin foreign markets. As such, exporters prefer profit margin to fluctuate rather than foreigncurrency prices in response to exchange rate fluctuations. The pricing strategies alsoinfluence exchange rate pass through. Producer currency pricing implies that in the short run

consumers prices change one-for-one with changes in the nominal exchange rate and thus thelaw of one price holds while in the case where nominal prices are set in advance in thecurrency of the consumer, this is referred to as local currency pricing where nominalexchange rate changes do not lead to a change in prices in the short run. Therefore, in theproducer currency pricing case there will be complete exchange rate pass through while in thelocal currency pricing case exchange rate pass through will be zero in the short run.

One of the macroeconomic factors influencing exchange rate pass through is the inflationaryenvironment of a country. Countries with high inflation tend to have more persistent costscompared to countries with low inflation. Thus, a high inflationary environment would tendto increase the exchange rate pass through to domestic prices. A positive and significantassociation between pass through and the average inflation rate may hold across countries(Choudhri and Hakura 2001). Further, firms usually respond more to cost increases if costchanges are perceived to be more persistent (Taylor 2000). Further, exchange rate volatility

Exchange Rate Depreciation

Direct effects

Imported inputs

become more

expensive

Imports of finished

goods become more

expensive

Domestic demand

for substitutes

rises

Indirect effects

Demand for

exports rises

Production costs rise

Wage rises

Demand for

labour increasesSubstitute

goods and

exports become

more expensive

Consumer price rises


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also influences exchange rate pass through (Mann 1986). Due to foreign exchangeuncertainty foreign firms cannot perfectly forecast exchange rate so their profit margins areexposed to exchange rate shocks. For instance, if exporters perceive a shock to be transitory,they would avoid changing prices by shifting the markup thus reducing the pass through.While if firms expect exchange rate shocks to be persistent, they are more likely to changeprices rather than adjust profit margins.

In line with the inflationary environment, monetary policy environment influences exchangerate pass through to domestic prices. From Devereux et al. (2004) model of endogenousexchange rate pass through, countries with successful policy of monetary stabilisation are ableto reduce the variance of their money growth and thus have low rates of exchange rate passthrough. This is explained by foreign exporters who prefer to set their prices in that countryscurrency leading to the producer currency pricing case, thereby reducing the impact ofexchange rate changes on the countrys consumer price index. Low variability of monetaryshocks reduces the predictive power of exchange rate in determining monetary shocks andthis effect therefore suggests another reason for the pass through to be smaller under a lowinflation environment (An 2006).

McCarthy (1999) indentifies openness as impacting on exchange rate pass through. Thegreater the degree of openness, the larger the pass through (Soto and Selaive 2003).Aggregate demand uncertainty where foreign firms cannot perfectly forecast gross domesticproduct or gross national product is another economic variable that affects exchange rate passthrough (Mann 1986). The profit margins of foreign firms are exposed to demand shocks.Exporters usually alter the profit margins when aggregate demand shifts due to exchange ratefluctuations in an imperfectly competitive environment, thus reducing pass through. Thuspass through is likely to be lower in countries where aggregate demand is more volatile.

3. Data Source and Analysis

3.1. Data Source

Data from both the Statistics Mauritius and the Bank of Mauritius are used. Oil price, moneysupply and short term interest rate are obtained from the Bank of Mauritiuss various annualreports and monthly statistics bulletins. Gross domestic product, import price indices,producer price indices and consumer price indices are obtained from the Statistics Mauritius.The nominal effective exchange rate is calculated using data on imports, exports andexchange rate from the Bank of Mauritiuss various annual reports.

3.2. Data Analysis

The nominal effective exchange rate volatility of Mauritius is the standard deviation of the

nominal effective exchange rate characterised by periodical fluctuations where at firstexchange rate volatility increased at a diminishing rate and from 2003-04 onwards thenominal effective exchange rate volatility experienced large swings as illustrated in figure 2below. The increase in volatility in 2004-05 reflects the local market conditions andinternational trends where the rupee depreciated against the currencies of major tradingpartners while the year 2005-06 was subject to a fall in exchange rate volatility. Volatilitypeaked in the year 2006-07 and it stood at 0.21 which reflected local market conditions suchas the increase in the Lombard rate, shortage of liquidity on the domestic interbank foreignexchange market, intervention of the Bank of Mauritius in the foreign exchange market andinternational trends. From 2006-07 to 2008-09 exchange rate volatility had a downward trendbut pick up again in 2009-10 to reach 0.11 and it was due to the central banks nonintervention in the market to reduce volatility of the exchange rate and also because of thelack of liquidity on the spot foreign exchange market.


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Source: Authors Computation

The imports behaviour, consumer and producer price behaviour over the period 1999 to 2010

in figure 3 below shows that imports have been increasing and peaked in the year 2007-08while during the last two fiscal years imports have been declining and the consumer priceindex

2and producer price index had a increasing trend over the years.

Source: Data Bank of Mauritius Annual reports, CSO, Authors computation

There have been considerable changes in the composition of imports over the years as

illustrated in table 1. Most of the ten categories of imports have been rising and the mostnoted rise in food and live animals is found where it increased from 12.43 per cent in 1999-00to 17.76 per cent in 2009-10. However, the proportion of manufactured goods classifiedchiefly by materials and machinery and transport equipment in total imports decreased overthe studied period.

2The CPI is of base year 2006-07 while the PPI is of base year 2007

0

0.05

0.1

0.150.2

0.25

1999-

00

2000-

01

2001-

02

2002-

03

2003-

04

2004-

05

2005-

06

2006-

07

2007-

08

2008-

09

2009-

10

Yearly SD of NEER

SD

Year

Figure 2: Yearly nominal effective effective exchange rate volatility over the period

1999 to 2010

0.0

40.0

80.0

120.0

160.0

0

30000

60000

90000

120000

150000

99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09 09-10

Imports (Rs Million) CPI PPI

Year

Rs millions Index

Left scaleRight scale

Figure 3: Import expenditure, consumer and prodcuer price index over the period

1999-2010

Right scale


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Table 1: Import Composition from 1999 to 2010

Financial Year (per cent)

99-00 02-03 05-06 09-10

Food and Live Animals 12.43 16.45 14.73 17.76

Beverages and Tobacco 0.83 0.85 0.89 1.62

Crude Materials, Inedible except Fuels 2.91 2.51 2.41 2.69

Mineral Fuels, Lubricants and Related Materials 9.55 10.93 17.84 17.61

Animal and Vegetable Oils and Fats 0.85 1.15 0.73 1.02

Chemicals and Related Products 7.46 8.19 7.62 8.74

Manufactured Goods classified chiefly byMaterials

31.57 28.34 19.77 17.89

Machinery and Transport Equipment 25.12 21.78 28.08 22.85

Miscellaneous Manufactured Articles 9.07 9.64 7.59 9.29

Commodities and Transactions not classified

elsewhere in the SITC

0.22 0.18 0.34 0.54

Source: Data Bank of Mauritius Annual reports, Authors Computation

Imports consist of consumer goods and raw materials used in the manufacturing industry,changes in imports expenditures on these products may have an impact on the consumer priceindex and producer price index (manufacturing). Imports expenditure have been increasingover the years where the highest increase of 21 per cent was recorded in the year 2004-05 andit was also noted that consumer and producer price inflation was higher at 5.58 per cent and

7.85 per cent respectively. High energy prices and the depreciation of the rupee are seen tohave led to the rise in imports expenditures and domestic inflation. The highest rate ofconsumer inflation was registered in 2006-07 led by the depreciation of the rupee and hikes infood prices where imports expenditures and producer price inflation equally rose. Producer

price inflation was highest in the year 2007-08 due to high import. 2007-08 saw a stabilisingin the inflation rate as well as a fall in imports expenditures while in the last fiscal year importexpenditures and consumer price inflation were subject to a rise while producer price inflationfell.

4. Methodology

The objectives of the study are first to examine the degree of the pass-through of exchangerates in Mauritius to prices of goods at various distribution levels, from the prices of importedgoods to producer prices and to consumer prices. Second, we analyse the impact and extentof external shocks namely oil prices shocks, exchange rate shocks and import price shocks onconsumer and producer price. Lastly, we investigate the impact and extent of oil price shocks

and exchange rate shocks on import prices.

4.1. Model Specification

Our model derives from McCarthy (2006) which is a model of pricing along distributionchain - import, production and consumer - to track pass through from exchange ratefluctuations at each stage of the distribution chain. The model also considers supply, demandand exchange rate shocks. Furthermore, the model accounts for the reaction of the CentralBank to carry out monetary policy.

The supply shocks are identified from the dynamics of oil price inflation denominated in

US dollars ( . The proxy for demand shocks is the dynamics of output gap ( ) in thecountry after accounting for the contemporaneous effect of the supply shock. Finally the


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exchange rate shocks ( ) are identified from the dynamics of exchange rate changes ( )after taking into account the contemporaneous effect of demand and supply shocks.

Inflation at each stage import, producer and consumer at time period t, is assumed to

contain several components where the first component is the expected inflation at that stagebased on available information at the end of the time period t-1. The next two componentsare the effect of period tdomestic supply and demand shocks on inflation at that stage. Thefourth component shows the effects of exchange rate shocks on inflation at that stage. Thenthe effects of the shocks of the previous stages of the chain are included and finally there isthe stages shock. The shocks at each stage can be considered as the changes in the pricingpower and markups of firms at these stages.

Finally, the Central Banks reaction function is estimated where the short term interest rates

( ) are related to the previously mentioned variables in the model and the money demand

function relates money growth ( to the other variables in the model.

The model is as follows:

) + (1)

= ) + + (2)

+ + (3)

(4)

(5)

(6)

(7)

+ (8)

where and are import price, producer price and consumer price inflation

respectively and , , are import price, producer price and consumer price shockrespectively. is the monetary policy shocks and is the money demand shock.

is the expectation of the variable based on the information set available at end ofperiod t-1.

4.2. Variables

The variables used for the study spans from the first quarter of 1999 to the second quarter of

2010. Oil prices are obtained from the Bank of Mauritius and are the quarterly average ofIPE

3Brent Oil in US dollars per barrel. The output gap is calculated as the deviation of the

log of real gross domestic product from a quadratic trend. The nominal effective exchangerate is calculated as follows:

where

NEERt is the quarterly nominal effective exchange rate at time t.

3 IPE is the international petroleum exchange in London which is now known as ICE, the

Intercontinental Exchange in London.


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is the quarterly weight of trading partner i in total trade at time t. The weight of thefirst ten trading partner which have the highest share in total trade is taken for thecalculation of the nominal effective exchange rate. The ten trading partners on averageaccount for 70 per cent of total trade of Mauritius.

is the end of quarter exchange rate of trading partner i at time t.

The weights of trading partners are calculated using the following formula:

= 1

+ )

where is the quarterly import of the Mauritius from country i at time t, is the quarterly

export of Mauritius to country i at time t, + ) is quarterly total export plus imports

from all trading partners at time t.

The import price inflation is calculated from the quarterly average of IPI on a base year 2007,

the producer price inflation is calculated from the quarterly average of the producer priceindex with the base year of 2007 while the consumer price index inflation is calculated fromthe quarterly average of consumer price index of base year 2006-07. From Frimpong andAdam (2010), the quarterly average of the weighted average yield of 91 days t-bills is used asthe short term interest rate to reflect the central banks behaviour. The money supplyvariables used are the quarterly average M2 from the first quarter of 1999 to the secondquarter of 2006 and from the third quarter of 2006 onwards the Broad Money Liabilities areused4.

4.3. Estimation Technique

To estimate equation (1)-(8), it is assumed that the conditional expectations in these

equations can be replaced by linear projections on lags of the eight variables in the system.Therefore, the model can be expressed and estimated as a VAR using a Choleskydecomposition to identify the shocks.

The structural VAR model is represented as follows:

(9)

where is the N x 1 vector of contemporaneous endogenous variables (oil price, output gap,

nominal effective exchange rate, price indices, short term interest rates and money supply

variable), the matrix is of order N x N and describes the contemporaneous relationships

between the variables. A(L) is the lag polynomial matrix of order infinity, is the

(unobserved) vector of structural shocks of order N x 1.

By multiplying equation (4.9) by an inverse matrix , we obtain the reduced form of theVAR model. It must be noted that this adjustment is necessary because the model given in

equation (4.9) is not directly observable and structural shocks cannot be correctly identified.Therefore,

(10)

4The Bank of Mauritius stopped the publication of M2 as from third quarter of 2006. From the third

quarter of 2006 till date Bank of Mauritius reports broad money liabilities.


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where is a N x 1 vector of serially uncorrelated structural disturbances (errors) of the modeland it is obtained as follows:

or (11)

n(n-1)/2 restrictions are imposed on the matrix A0

based on the Cholesky decomposition ofthe residual variance covariance matrix which defines A as a lower triangular matrix.

The lower triangular matrix implies a recursive scheme among variables and also that somestructural shocks have no contemporaneous effect on some endogenous variables given theordering of the endogenous variables. Following the identification scheme, equation (11) canbe written as:

= (12)

where are the reduced form VAR residuals.

It is important to determine the order of the variables so as to identify structural shocks. Asshown by equation 12, oil prices are ordered first because the reduced form residuals of oilprices are not likely to be affected contemporaneously by any other shocks except oil priceshock itself while oil price shocks affect all the variables in the system contemporaneously.Output gap is ordered next, then the nominal effective exchange rate. The import price indexin ordered next as the exchange rate is at first going to have an effect on import prices. Belowthe import price index is the producer price index because the import prices will have aneffect on producer prices as producers import inputs from abroad.

The next price index is consumer price where it is directly affected by import prices and alsoindirectly affected by producer prices. The last two variables which are short term interestrate and growth in money supply is ordered next to illustrate the reaction of the central bankfollowing inflation and also to maintain the value of the rupee against other currencies.

The exchange rate pass through to domestic prices is calculated from the impulse responsefunction results and the pass through elasticity at t is given by:

0 0 0 0 0 0 0

0 0 0 0 0 0

0 0 0 0 0

0 0 0 0

0 0 0

0 0

0

=per cent change in the price level t quarters after the shock (13)Initial per cent change in the exchange rate at time t=0Pass throughelasticity at time t


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The numerator is the percentage change in the level of the respective price indices betweenthe period zero, when the initial exchange rate shock hits, at time t. The denominator is thepercentage change in the nominal effective exchange rate at time 0.

4.5. Expected Results

From the work of Bhundia (2002), Faruqee (2006) and Sek and Kapsalyamova (2008) amongothers, it can be expected that first exchange rate pass through to import prices is highercompared to exchange rate pass through to producer and consumer prices and secondexchange rate pass through to producer prices is higher compared to exchange rate passthrough to consumer prices. Thus the effect of an exchange rate shock declines along thedistribution chain. Studies carried out by Bhundia (2002), Garcia and Restrepo (2001) andRowland (2003) in developing countries indicate low exchange rate pass through in domesticprices. Although exchange rate pass through is different across countries but the mainsimilarity is that exchange rate pass through to consumer prices is the lowest compared toexchange rate pass through in producer and import prices. Such evidence has also been foundin emerging countries like Brazil where Belaisch (2003) results indicate that exchange rate

pass through to consumer price is 17 per cent after a year while around 100 per cent forwholesale prices.

The effect of external shocks in explaining consumer prices varies across countries where forthe case of industrialised countries, McCarthy (2006) notes that external factors explain afairly small proportion of the variance of domestic consumer prices while Bhundia (2002)shows that shocks to producer prices tend to have a considerable impact on consumer pricesfor the case of South Africa. In four of the East Asian economies selected by Sek andKapsalyamova (2008), it was observed that that import price shocks have a stronger effectthan exchange rate shocks in determining domestic prices.

5. Findings

5.1. Unit Root Tests, Diagnostic Tests and Granger Causality Tests

The unit root tests indicate that all variables are stationary except the short term interest ratevariable which is in our case t-bills yield is found to be integrated of order one. Given theautoregressive nature of the model, the lag order is determined using the maximum likelihoodratio and also such that there is no autocorrelation among residuals. The likelihood ratioresults indicate the inclusion of 3 lags. To determine whether there is a cointegratingrelationship among the variables the Johansen (1995) test is applied. Although evidence ofcointegration for rank 3 is found, it is ignored as no long run relationship among the variablesis studied.

The diagnostic tests on the structural VAR indicate no autocorrelations among residuals,residuals are normally distributed and the model is stable as the characteristic roots have amodulus less than one and all eigenvalues lie inside the unit circle. The granger causality testundertaken to examine the existence of causality from exchange rates to imports and domesticprices and vice versa and also from imports prices to domestic prices and vice versa indicatesthat there is bidirectional causality in one case where producer prices granger cause nominaleffective exchange rate and vice versa while it is found none of the variables; nominaleffective exchange rate, import and producer prices granger cause consumer prices.


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5.2. The Effect of Exchange Rate Shocks on Import and Domestic Prices

Figure 4: Exchange Rate Shocks Impacts on Import, Producer and Consumer Prices

Import Prices

Producer Prices

-4

-2

0

2

0 5 10 15

erpt01, neer, ipi

95% CI cumulative orthogonalized irf

step

Graphs by irfname, impulse variable, and response variable

-4

-2

0

2

0 5 10 15

erpt01, neer, ppi


step



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Consumer Prices

An exchange rate shock at time zero of 9.48 per cent (calculated from the change in exchangerate equation) leads to a fall in the nominal effective exchange rate, indicating an appreciationof the exchange rate. It is thus expected that the negative exchange rate shock will lead to afall in import, producer and consumer price inflation. The cumulative orthogonalised impulseresponses show the impact of an exchange rate shock at time zero on the different prices and

are illustrated in figure 4.

An exchange rate shock leads to a fall (as expected) in import prices, although the impact onimport prices in not immediately felt. At time zero the effect of the exchange rate shock onimport price is 0.64 per cent, in three quarters it is -0.19 per cent and the cumulative effect

increases further to -0.29 per cent in six quarters and by the end of the 12 quarters, theexchange rate shock leads to a decrease in import price of -1.04 per cent. The exchange rateshock has the expected impact on producer prices where the instant impact leads to a fall inproducer prices of -0.11 per cent and increases to -0.32 per cent and -0.77 per cent by the endof three and six quarters respectively. The cumulative impact increases to -1.45 per cent bythe nine quarters while over the 12 quarters the effect of the exchange rate shock increases to-1.34 per cent. The exchange rate shock has a negative impact on consumer prices where at

time zero consumer prices fall by -0.48 per cent and maintain its downward trend. In the caseof consumer prices the effect of an exchange rate shock is much higher compared to importand producer prices where by six quarters consumer prices have fallen by -1.19 per cent andover three years the cumulative impact on consumer prices is -2.26 per cent.

-4

-2

0

2

0 5 10 15

erpt01, neer, cpi


step



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5.3. Exchange Rate Pass Through Elasticity to Import and Domestic Prices

From figure 5 below, exchange rate pass through is incomplete in the three price indices.However, the behaviour of the indices differs. In the case of import prices, the initial passthrough elasticity is negative, implying that there is no immediate impact of an exchange ratechange on import prices. Over 3 quarters, the pass through increases to around 1.97 per centand to 3.04 per cent in 6 quarters following the initial exchange rate shock. By the end of 12quarters the exchange rate pass through to import prices is 10.93 per cent. Thus in the shortterm (3 quarters) exchange rate pass through is low, while in the long term (over 3 years)exchange rate pass through increases slightly. It can be observed that exchange rate shockshave little impact on import prices both in the short and long term.

Figure 5: Exchange Rate Pass Through Elasticity to Import and Domestic Prices

To better understand the reasons behind the low exchange rate pass through to import prices,it is important to know the sources of Mauritian imports. Mauritius imports are from threemain countries namely; the European Union, India and China and these countries accountsrespectively for 21.68 per cent, 18.72 per cent and 12.60 per cent of the total imported goodsfor the year 2009. Another important aspect is that the major imports in 2009 were machineryand transport equipment, food and live animals, manufactured goods classified chiefly bymaterial and mineral fuels, lubricants and related products. Most of the imported machineryand transport equipment are from the European Union, China and Japan. A large proportionof imported food and live animals are from Europe and Australia. The sources of mainimports are India and China where price is expected to be low given the cheap labouravailable in these countries. In addition, low quality products are imported from China and

this further explains the low import prices.

Exchange rate pass through to producer prices is positive at time zero and increases to 3.40per cent over 3 quarters following the initial exchange rate shock and over 9 quartersexchange rate pass through to producer prices amounts to 15.28 per cent, which is the highest

pass through over three years. Over 12 quarters exchange rate pass through to producer pricesfall slightly to reach 14.12 per cent. Exchange rate shocks have an important impact onproducer prices where in the short term exchange rate pass through is 3.40 per cent while inthe longer term the pass through is 14.13 per cent. The exchange rate pass through toproducer prices is explained by the fact that imports consist of machinery and transportequipment, manufactured goods classified chiefly by materials and mineral fuels, lubricantsand related products which are mainly used for production by domestic manufacturing firms.

Thus exchange rate changes are likely to have an impact on the price of these imported goodswhich leads to an increase in the producer price.

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IPI PT Elasticity -6.74 1.97 3.04 4.41 10.93

PPI PT Elasticity 1.14 3.40 8.16 15.28 14.13

CPI PT Elasticity 5.06 8.97 12.56 18.67 23.87

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Exchange rate pass through to consumer prices is considerably higher compared to the othertwo price indices. An exchange rate change at time zero leads to an increase in consumerprices by 5.06 per cent. Pass through in the 3 and 6 quarters after the initial shock is 8.97 percent and 12.56 per cent respectively. The pass through effect to consumer prices is 23.87 percent after three years. Consumer prices are thus more impacted by exchange rate shockswhere the short term exchange rate pass through is 8.97 per cent and 23.87 per cent in thelong term. Therefore, exchange rate shocks have the largest impact on consumer pricesfollowed by producer prices and the lowest impact is felt on import prices.

Changes in exchange rate are found to have the largest impact on consumer prices. The factthat Mauritius imports most of the food products, exchange rate changes have importantimplications on the price of foodstuffs. A higher exchange rate pass through to consumerprices can equally be explained by the change is exchange rate regime from managed float toa flexible system where the Central Bank intervenes in the market only to smooth outfluctuations rather than to maintain the value of the rupee against other currencies within arange. Thus exchange rate changes have an impact on consumer prices. Mauritius being aresource scarce economy, consumer goods are imported and thus despite rising prices, local

consumers will still buy imported consumer goods which are not produced domestically.Thus, an exchange rate depreciation which increases import prices will cause importers topass the high import prices to consumers in the form of higher prices.

5.4. The Effect of External Shocks on Import and Domestic Prices

The Mauritian economy is highly vulnerable to external shocks. Besides exchange rateshocks which affect import and domestic prices, other external shocks such as supply shocksand import price shocks affect domestic prices.

Impact of External Shocks on Import Prices

For the case of import price, the effect of supply shock (proxied by oil price inflation) onimport price is given by figure 6 below

Figure 6: Impact of Oil Price Shock on Import Prices

The initial effect of an oil price shock leads to an increase in import prices of around 0.67 percent and increased further to 2.13 per cent 3 quarters after the initial shock. The impact of theshock decelerated in the next 5 quarters while the impact increased as from 9 quarters afterthe initial shock to reach 2.86 per cent in three years. Thus supply shocks seem to affectimport prices both in the short and long term.

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Impact of External Shocks on Producer Prices

Figure 7 below shows the impact of oil price shocks and import price shocks on producerprices. The positive oil price shock has a negative effect of 0.10 per cent on producer pricesat time zero implying that the impact of an oil price shock is not immediately felt on producerprices. The cumulative impact increases to 0.70 per cent and 1.16 per cent 3 and 6 quartersrespectively after the initial shock and after 3 years producer price increases by 2.04 per centfollowing the supply shock at time zero. A negative import price shock at time zero leads to afall in producer prices by -0.2 3per cent. The impact increases to -0.55 per cent after 6quarters and finally after 3 years the impact of the import price shock leads to a fall inproducer prices by -1.14 per cent.

Figure 7: Impact of Oil Price Shock and Import Price Shocks on Producer Prices

Oil Price Shocks

Import Price shocks

Impact of External Shocks on Consumer Prices

The impact of external shocks on consumer prices is illustrated by figure 8 below. Followinga positive oil price at time zero consumer prices increase. Although a negative effect is felton consumer price from 1 to 3 quarters after the initial shock, the cumulative effect of the oilprice shock after three years leads to an increase in consumer prices by around 1.61 per cent.A negative import price shock at time zero initially leads to an increase in consumer priceswhile the desired impact is felt as from two quarters after the initial shock. Over 6 quartersthe cumulative impact of the import price shock is 0.14 per cent and over 12 quarters

consumer prices have fallen by -0.03 per cent following an import price shock at time zero.

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Figure 8: Impact of Oil Price Shock and Import Price Shock on Consumer Prices

Oil Price Shocks

Import Price Shocks

Oil price shocks have a larger impact on import prices followed by producer prices and thenconsumer prices. In the case of import prices, an import price shock has a larger influence onproducer rather than consumer prices. This analysis therefore puts forward that domesticprices are vulnerable to external shocks and this can be explained by the high degree ofopenness of Mauritius. The impulse response functions indicate the extent of pass through ofexternal shocks to import and domestic prices but do not indicate how important these shocksare in explaining import and domestic prices. Thus the forecast error variance decomposition

(FEVD) is used to analyse the importance of externals shocks in explaining fluctuations in

import and domestic prices.

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5.5. Forecast Error Variance Decomposition of Import and Domestic Prices

From figure 9 below, oil price shocks are important in explaining import price variance wherein the second quarter oil price shocks explain 25.45 per cent of the variance in import prices.In the following quarters the importance of oil price shocks in explaining the variance inimport prices fell and reach 15.07 per cent in three years. Nominal effective exchange rateexplains a smaller proportion of the variance of import prices. In the first quarter 6.31 percent of the variance in import prices is explained by exchange rate shock. By 6 quarters theproportion increased to 8.65 per cent while by the end of three years the variance of importprice explained by exchange rate shock increased to 10.01 per cent.

Oil price shock is more important in explaining the variance in producer prices followed byexchange rate and import price shocks. In the first quarter oil prices explain 0.63 per cent ofthe forecast variance and as the forecast horizon increases the percentage increases to 9.89 percent in 6 quarters and over three years to 11.99 per cent. Initially exchange rate explained afairly small proportion of the variance of producer price around 0.70per cent but as theforecast period increased the per cent increases to 8.33 per cent in 9 quarters and reached

11.62 per cent in three years. Import prices explain very little of the variance of producerprices where initial import prices explains 3.33 per cent of forecast variance and over threeyear the percentage increased slightly to reach 5.97 per cent.

The variance of consumer prices is mostly explained by import prices followed by oil pricesand exchange rate. Initially import price explains 7.84 per cent of the variance in consumerprices and this percentage increases over three years to reach 16.02 per cent. Oil pricesexplain a smaller proportion of the variance in import prices which stand at 0.53 per centinitially and increases to 8.67 per cent by three years. The smallest proportion of the variancein consumer price is explained by exchange rate. Although at first exchange rate explained alarger proportion of the variance of consumer price compared to oil price, but over theforecast horizon oil price overtook exchange rate where over three years exchange rate

explains 4.99 per cent of the variance in consumer prices.


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Figure 9: Forecast Error Variance Decomposition Results

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6. Conclusion

This study examines the degree and extent of exchange rate pas through to import anddomestic prices and also the effect of external shocks such as oil price shocks and importprice shocks on domestic prices. So as to understand which shock better explains the variancein import and domestic prices, the forecast error variance decomposition of each price indexhave equally been studied. Another investigation carried out in this study is on the existenceand degree of causality from exchange rate to domestic and import prices and vice versa.Using a structural VAR model that incorporates a distribution chain, the results from grangercausality test indicate that bidirectional causality exist is one case where producer pricegranger causes nominal effective exchange rate and vice versa while in other casesunidirectional causality is found. It is equally found that nominal effective exchange rate,import and producer prices do not granger cause consumer prices.

The impulse response functions of the structural VAR are used to calculate exchange rate pasthrough elasticity and the results indicate that exchange rate pas through to consumer prices ishighest and not complete. The second larger impact of an exchange rate shock is felt on

producer prices and the smallest on import prices. Therefore pass through increases as onegoes along the distribution chain. The findings especially for the case of consumer andimport prices are not in line with other studies. But this can be explained by the fact that mainsources of imports being China and India, lower import prices can be expected given thecheap labour and the low quality products from China. Moreover, the pricing to marketpractice can explain the low pass through to import prices. As far as consumer prices areconcerned the reason behind the high pass through is the dependence of householdsconsumption on imported consumer goods where most of them are not subsidised. Theincreasing cost of living in Mauritius and the change in the exchange rate regime can alsoexplain the high pass through in consumer prices.

Externals shocks equally have an effect on import and domestic prices. The results suggest

that oil price shocks have a larger impact on import prices compared to producer andconsumer prices while import price shocks have a larger influence on producer prices. Theexamination of external shocks in explaining the variance in the price indices pointed out thatthe variance of import and producer prices are explained mainly by oil price shock while forthe case of consumer prices, import prices explain most of its variance. External shocks thusplay an important role in the Mauritian economy whereby prices are exposed to externalshocks. However, Mauritius being a small island developing state is vulnerable to externalshocks and thus cannot do much to reduce the impact of these external shocks on theeconomy given the extent of openness of the country. The study can be useful for policymakers such as Central Bank, in controlling the price level in Mauritius. The indication thatexchange rate pass through to consumer prices is highest but still incomplete implies thatdomestic policies such as monetary policy have a significant role in controlling consumer

price inflation. Given that import price shocks have an important impact on producer prices,managing inflation at the level of imports could be effective to reduce producer priceinflation. Moreover, the variance of consumer prices is explained mainly by import prices.Thus, managing inflation at import level and the monitoring of pricing technique by importerscan contribute in reducing consumer price inflation.


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