Exchange Rate Volatility and Iran's Bilateral Imports from Turkey

Hassan HEIDARI[1], Reza MOHAMMADPOUR[2]*, Vahid KAFILI[3]

Abstract

This paper investigates the effect of exchange rate volatility as well as some other important explanatory variables on Iran's bilateral imports from Turkey during 2003Q1 to 2012Q4 to examine bilateral import elasticity for a specific external supplier in order to improve trade balance. The aim of this paper is to fill the research gap about the mentioned issue particularly for developing countries. The empirical results from ARDL approach indicate that income elasticity is significant and exchange rate volatility is negative and statistically significant for Iran’s bilateral import from Turkey in long run.

Keywords:import demand, real effective exchange rate, time-series, Iran, Turkey.

JEL Classification:F14, F31, C22.

  1. Introduction

To explain the impact of exchange rate volatility on international trade flows many empirical studies have investigated. Most empirical findings, which are primarily concerned with exports, confirm that an increase in exchange rate volatility tends to generate uncertainty which may have a negative impact on trade flows. The current study tends to estimate the impact of exchange rate volatility on demand for bilateral imports for Iran, using bilateral import data from selected external source of Iran.

Although the effectiveness of import policy depends on the magnitude of each country’s import elasticity with respect to income, price, exchange rate and volatility of exchange rate, the current policies might not be more effective unless they meet import elasticity of particular trading partner countries. Hence, the main objective of this study is to offer that different policies should be implemented for trading partners instead of a single trade policy to improve trade balance. For policy perspective, it is important because trade policies based on aggregate import elasticity might be deceptive, if bilateral import elasticity is different from those of aggregate import demand model. (Alam and Ahmad, 2011)

There have been numerous studies carried out across the globe focusing on the relationship between exchange rate volatility and bilateral import. To the best of our knowledge, there is not any study investigating the relationship between exchange rate volatility and bilateral import for Iranian economy. The objective of the present study is to investigate the effect of exchange rate volatility on Iran’s bilateral import from her selected trading partner country, Turkey, during 2003Q1 to 2012Q4. The selection of the country is justified by the fact that Iran’s imports from this neighbor country is increasing and Turkey is one of Iran's major trading partner countries. On the other hand, these two countries are planning to come up 30 billion dollars in their bilateral trade up to 2015. Figure 1 shows the trend of Iran’s Imports from Turkey during the period of 2003-2012.

Figure 1. Iran’s Imports from Turkey.


Source: IMF’s Direction of Trade Statistics.

The reason for sample period started from 2003Q1 is approval of equalization in exchange rate.

The present empirical study differs from previous research for Iran in various dimensions. We employ ARDL approach to detect short-run and long-run impact of exchange rate volatility on aggregate demand for imports. The paper uses real effective exchange rate to construct the measure of exchange rate volatility. We also apply GARCH process for estimating volatilityof real effective exchange rate. Our results show that income elasticity is significant and exchange rate volatility is negative and statistically significant for Iran’s bilateral import from Turkey in long run.

The rest of the paper proceeds as follows: The next section reviews the literature on import demand function particularly for developing countries as well as studies about bilateral import demand function. Section 3 explains the data and methodology. Section 4 provides the results, and finallysection 5 concludes the paper.

  1. Literature review

An expanding number of empirical studies have been investigated the major determinants of import demand function particularly for developing countries. In many different studies, the conventionally used import demand functions has been analyzed for several decades, including Khan (1974) for 15 developing countries, Arize and Afifi (1987) for 30 developing countries, Bahmani-Oskooee (1998) for six less developed countries, and Sinha (2001) for five Asian countries. On the other hand, studies by Dutta and Ahmad (1999) for Bangladesh, Tang (2002) and Sinha (1996) for India, Tang and Mohammad (2000) for Malaysia, Rijal et al. (2000) for Nepal and Sinha (1997) for Thailand are country-specific studies.

Some previous studies for Iran such as Abrishami (2001) assesses the demand function in limited exchange conditions. This study shows that long-run income elasticity of import demand has a precise cointegration at all specifications. It also indicates that short-run income elasticity is more than one. Nasrollahi (2004) shows the determinants of import demand function for Iran using an ARDL modelling approach. He found demanded imports, relative price of imports and real domestic income are cointegrated between 1959 and 2000. Price and income elasticities in long-run which estimated by using ARDL model that are -1.44 and 1.595, respectively. Kazerooni and Feshari (2010) investigate the linkage between non-oil exports and the real exchange rate volatility for Iran over the period of 1971-2007. They estimate a proxy for the real exchange rate volatility by using GARCH model. They also estimate a conventional exports function by Johansen’s multivariate co-integration approach. Their results show that among the explanatory variables, the real exchange rate and its volatility have positive and negative impact on the non-oil exports of Iran respectively. Molaei et al (2012) examined the factors affecting (GDP of two countries, exchange rate volatility and relative prices) on bilateral trade between Turkey–Iran using VAR approaches for annual data from 1980 to 2009. Their results show that Iran’s GDP has a significant positive impact on bilateral exports of Turkey and Iran. This case is also true for the impact ofTurkish GDP on imports. Relative prices have no significant effect on exports and imports and in last, exchange rate volatility have a significant positive impact on bilateral export and import functions, so that the elasticity of exchange rate volatility of Turkish Lira to Iranian Rial on bilateral export and import are 0.003 and 0.002, respectively. Heidari et al (2012) investigate the long-run relationship between exports, imports and economic growth in the Iranian economy using annual data over the period of 1960-2007. They extend the Feder's model (1982) by entering a proxy for human capital. The Bounds Test approach to level relationship developed by Pesaran et al (2001) has been adapted in their study where it can be applied irrespective of order of integration of the variables. Results reveal that while there is significant and positive relationship between exports and economic growth, the effect of imports is insignificant and also human capital has a negative effect on growth both in short and long term periods.

There are only few studies which investigate the impact of exchange rate volatility on import demand with traditional income and price elasticities in case of developing and less developed countries (Alam and Ahmad, 2011). For example, Bahmani-Oskooee (1996) estimates import and export demand functions for seven developing countries (Brazil, Greece, Korea, Pakistan, Philippines, Thailand and Turkey), using quarterly data for the period of 1975-1985. He finds that exchange rate volatility has an adverse effect on the imports of Greece, Pakistan and South Africa, while domestic income and relative price variables have expected signs in case of all sample countries.

The majority of studies in the literature use time series analysis, based on aggregate trade flows. Only few studies investigate the impact of exchange rate volatility on bilateral imports. Cushman (1986) finds mixed results concerning the impact of exchange rate volatility on US import demand using bilateral time series data for the major trading partners of the USA. Caporale and Doroodian (1994) uses monthly data for the period 1974-92; they find that exchange rate volatility has a significant negative effect on US imports from Canada. McKenzie and Brooks (1997 and 1998) include exchange rate volatility variable into import demand function for both Australian and German trade flows to United States of America. For the Australia to US trade, they find a significant but weak relationship between volatility and trade. Mckenzie (1998) investigates the impact of exchange rate volatility on Australian bilateral export and import to USA, Japan, Germany, Hong Kong, New Zealand, Singapore and the UK from 1988Q1 to 1995Q4. He find that out of fourteen bilateral import equations eight provide a positive and six negative coefficients on exchange rate volatility variable, and none of them is statistically significant, while aggregate import equation provides a negative and significant coefficient on exchange rate volatility. Alam and Ahmad (2011) investigate the effect of exchange rate volatility as well as some important explanatory variables on Pakistan’s bilateral import from her major trading partner countries: USA, UK, Japan, Saudi Arabia, UAE, Germany and Kuwaitduring the period of 1982Q1-2008Q2. Their results suggest that income elasticityispositive and significant and exchange rate volatility is negative and statistically significant for Pakistan’s bilateral import from UK in the long run.

  1. Data and methodology

Our data set covers the period from 2003Q1 to 2012Q4. The Data series of bilateral imports were taken for selected importing country of Iran namely Turkey which were collected from the IMF's Direction of Trade Statistics (DOTS). Gross domestic product, consumer price index, unit value index of import and real effective exchange rate for Iran were compiled from the IMF's International Financial Statistics (IFS). All real values are measured on base of year 2005 and all of the series are transformed into natural log form. Log transformation can trim down the problem of heteroskedasticity (Gujarati, 2003). Following Alam and Ahmad (2011) our modified model in this paper is as follows:

(1)

Where represents real bilateral import demand for Iran to Turkey at time t, represents real gross domestic product of Iran at time t, represents relative price of imports at time t, represents real effective exchange rate at time t, represents real effective exchange rate volatility indicator at time t, represents constant for the model, , , , represents the coefficients of the equation, and is error term.

The impact of volatility in the exchange rate on Iran's bilateral imports from selected source is estimated by using the ARDL approach. This paper does not include all dimensions of dynamic relationships between Iran's bilateral imports and real effective exchange rate volatility but limited to the following variables:

Dependent variable

  • Real bilateral imports is a ratio calculated by dividing the bilateral import over unit value index of import.

Independent variables

  • Real gross domestic product is the ratio of nominal gross domestic product to consumer price index. Expected sign for this variable is positive, because an increase in real income, increases domestic demand for import.
  • Relative price of imports is a ratio calculated by dividing the unit value index of import over consumer price index. It is expected to find a negative relationship between real bilateral imports and relative price of imports.
  • Real effective exchange rate measures the changes in the competitiveness of a country by taking into account the changes in the relative prices between the countries involved. (Pelinescu and Caraiani, 2006). This index is expected to have a positive relationship with real bilateral imports.
  • Real effective exchange rate volatility is a measure that intends to capture the risk faced by traders due to unpredictable fluctuations in the exchange rate. The study used GARCH models for this variable. The effect of this variable on the import demand depends on whether the trader is risk-neutral or risk-adverse.
  1. Results

The standard Augmented Dickey-Fuller (ADF) unit root test is employed to check the order of integration of the variables under investigation. The ADF test results are reported in Table 1:

Table 1. ADF Unit Root Test Results

Country / Variable / ADF Test in Level / ADF Test in First Difference
t-Statistic / Prob. / Result / t-Statistic / Prob. / Result
Iran / LRGDP / -2.3341 / 0.4057 / Non- Stationary / -18.8203 / 0.0001 / Stationary
LRPM / -2.3020 / 0.4230 / Non- Stationary / -6.4655 / 0.0000 / Stationary
LREER / -1.7493 / 0.7097 / Non- Stationary / -4.7989 / 0.0004 / Stationary
LV / -10.8171 / 0.0000 / Stationary / - / - / -
Turkey / LRM / 1.0136 / 0.9150 / Non- Stationary / -6.1626 / 0.0000 / Stationary

We also apply Phillips-Perron unit root test. The PP unit root test results is also corresponding with the ADF unit root test.

Banerjee et al (1992) test has been done in order to find the existence of a long-run relationship:

(2)

The result indicates that calculated t-Statistic is greater than critical value of the table. Thus, we reject the null hypothesis and conclude that there is a significant evidence of long-run relationship. (Tashkini, 2006)

The long run ARDL model selected on the bases of different information criteria for selected country, reported in Table 2:

Table 2. The Long run ARDL model Estimates

LRGDP / LRPM / LREER / LV / C
Turkey / ARDL
(1,0,0,0,0) / 1.0093***
(1.8241) / -1.1248**
(1.9859) / 0.6453**
(2.0655) / -0.9026**
(2.0012) / 7.1947***
(1.7990)
Figures in parenthesis are t-statistics. *, ** and *** denote that significant at 1%, 5% and 10% level respectively.

Based on ARDL (1,0,0,0,) for Turkey, long run relationships are examined. Several significant conclusions can be drawn from the results. The income elasticity of imports is found positive and significant for Iran’s bilateral imports from selected country. The results suggest that due to a 100 percent increase in Iran's real GDP, imports from Turkey rise by about 100.93 percent.

The results further explain that import price elasticity is negative and significant for Turkey. This result suggests that an increase in relative price of imports might reduce bilateral import demand from mentioned country. The elasticity of real depreciation (real effective exchange rate) is also positive and significant, implies that depreciation of local currency reduces imports from Turkey. The long run results for bilateral imports of Iran from Turkey, suggest that there is a significant adverse effect of real effective exchange rate volatility on bilateral imports of Iran in case of Turkey. The long run elasticity of real effective exchange rate volatility with respect to Iran’s bilateral imports is negative and significant, implies that real effective exchange rate volatility reduces imports. To summarize the long run elasticity, the present study's results show that real gross domestic product of Iran is positively related to real bilateral import demand of Turkey. The result also shows that income elasticity is a bit greater than and close to one.

After exploring the long run association between Iran’s bilateral imports and its determinants under consideration, we estimate anerror correction mechanism(ECM) model. The results of the short-run dynamic models for Turkey are presented in Table 3:

Table 3. Error Correction Model

Dependent variable: DLRM
t-statistics/F- statistics
Country / Turkey
ARDL → / ARDL(1,0,0,0,0)
ΣLRGDP / 0.6251***
ΣLRPM / -0.6966**
ΣLREER / 0.3997**
ΣLV / -0.5590**
ECM (-1) / -0.6193*
R2 / 0.5343
Adj. R2 / 0.4056
DW-Sta. / 1.9343
Diagnostic Tests
A:Serial Correlation / χ2=3.3052
B:Functional Form / χ2=0.0507
C:Normality / χ2=0.4177
D:Heteroscedasticity / χ2=2.4464
A: Lagrange multiplier test of residual serial correlation
B: Ramsey's RESET test using the square of the fitted values
C: Based on a test of skewness and kurtosis of residuals
D: Based on the regression of squared residuals on squared fitted values
Note: Diagnostic tests show that all classic assumptions are significant at 5%.
*, ** and *** denote that significant at 1%, 5% and 10% level respectively.

The highly significant ECMconfirms the existence of a stable long run relationship (See Banerjee et al, 1993). The estimated coefficients of ECM is negative and highly significant at 1 percent level, implying that part of the changes in imports represents an adjustment to its last-period deviations from its long-run steady-state equilibrium, so that the time paths of these variables do not diverge in long run.

Further, the diagnostic tests reject some noticeable econometric problems. Test for normality confirms residual normality and ARCH test rejects heteroskedasticity in the disturbance term at 5 percent level of significance. The Ramsey’s RESET test passes the specification of functional form for the estimated model at 5 percent level of significance. The LM test results indicate that there is not serial correlation in the residuals.

  1. Conclusions

The dynamic relationship between bilateral import demand for Iran and exchange rate volatility as well as some important explanatory variables withTurkey has been examined by applying the ARDL approach, suggesting a long-run relationship among selected explanatory variables over the sample period for Iran’s bilateral imports from Turkey. The income elasticity of imports is positive and significant which indicates that as real income growth occurs in Iran, it demands more imports from Turkey. The result also shows that relative price elasticity for bilateral imports significantly and negatively affects bilateral imports from Turkey, suggesting that import of goods decrease by increasing import price. The present study also confirms that devaluation has significant contraction effect on Iran’s bilateral imports. The result further suggests that exchange rate volatility reduces the demand for Iran’s bilateral import from selected partner in the long run. This study concludes that short run disequilibrium converges very soon in the long-run.