Crazy Rain and the Little Dragon at Europe’s Door

A structural threshold vector autoregressive model for the Moroccan business cycle

Erik Klok1322753

June 25, 2012

Master’s Thesis EconomicsUniversity of Groningen

Department of Economics, Econometrics and FinanceSupervisor: dr. J.P.A.M. Jacobs

Co-assessor: dr. G.H. Kuper

AbstractMorocco has a highly volatile economy which hamper long-term development. This thesis develops a structural vector autoregressive model (SVAR) in order to identify and examine the sources of business cycle fluctuations in Morocco. Block exogeneity restrictions based on the small open economy assumption are imposed to capture the main characteristics of the Moroccan economy like international trade and financials linkages, and its exposure to erratic rainfall. Nonlinearities are allowed to account for threshold effects of rainfall during droughts.

The model reveals that rainfall is the dominant source of business cycle fluctuations in Morocco, even in the absence of a drought. These findings are in sharp contrast with the general believe that the Moroccan economy has become more resilient to rain shocks. International variables also have been a dominant source of business cycle fluctuations in Morocco, in particular trade price shocks. Although Moroccan authorities claim that the economy is resilient to international financial crises, the model shows otherwise. Migrant’s remittances are often praised for smoothing business cycle fluctuations, but they do not play a significant role in the Moroccan business cycle.

JEL classification: C32, Time-series models; C34, Switching Regression Models; C51, Model Construction and Estimation; E32, Business Cycle Fluctuations; E44, Financial Markets and the Macroeconomy; F24, Remittances; F41, Open Economy Macroeconomics; Q54, Climate, Natural Disasters, Global Warming.

Keywords: Small open economy; Structural subset VAR models, threshold effects; Morocco, business cycles; Rainfall, droughts; Financial stress, International linkages, Remittances.

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Preface

Since the introduction of vector autoregressive (VAR) models by Christopher Sims in the eighties of the twentieth century – for which he was awarded the Nobel Prize in Economics in 2011-, they became a popular research area in applied macroeconomics. VARs are excellent frameworks for analyzing the transmission of shocks through an economy. The standard VAR model of Sims subsequently evolved over to time in order to cope with contemporary challenges like nonlinearities and the wish to include a relatively large set of variable while maintaining a parsimonious model.

In this thesis I apply the VAR framework to Morocco in order to identify and analyze the impact of various shocks to which Morocco is exposed. After a severe crisis in the late eighties, the Moroccan economy remained relatively volatile, reducing its long-term growth potential. It is therefore somewhat surprising that there exist no other attempts to identify and examine the sources of business cycle fluctuations in Morocco. A large VAR is constructed by taking advantage of the traditional small open economy assumption which results into block exogeneity restrictions on the model structure. Because of the large share of agriculture and limited available water resources, the Moroccan economy is vulnerable to rain shocks. Therefore, I was more or less obliged to include rainfall as a potential source of business cycle fluctuations in Morocco, which is a little bit controversial in the VAR literature. The constructed model incorporates threshold effects of rainfall in order to distinct the effect of rainfall on the economy under normal conditions for the effect during droughts.

Besides the modeling challenges, the construction of a decent dataset for Morocco was very demanding and several difficulties had to be encountered. For example, meteorologist do not use political borders in their construction of a dataset, in contrast with economists. I therefore construct a rainfall index that is suitable for economic analysis. The construction of the dataset was a task in itself.

This thesis is organized as follows. In Chapter 1 an introduction to the construction of the VAR model for Morocco is given. Chapter 2 contains some background on the Moroccan economy, with a strong focus on climate in its relationship with economic activity. In Chapter 3 the VAR methodology is presented. Chapter 5 presents a description of the construction of the dataset. Chapter 6 provides the structure of the VAR model and a summary of the structural equations. Chapter 7 describes the computational model estimation and provides model diagnostics. In Chapter 8 impulse response functions and dynamic multipliers are provided. Chapter 9 provides an historical composition decomposition of the Moroccan business cycle. Chapter 10 contains a short summary, conclusions, and recommendations for future research and policy makers.

I would like to thank my supervisor dr. J.P.A.M. Jacobs for his endless patience with my inaccessible way of working and inappropriate communication skills. Furthermore, I would like to thank Mr. Younes Zouhar - a researcher at the IMF Middle East and Central Asia Department and former Chef de la Division de la Balance Morocaine des Paiments- who was so kind to provide me with data on remittances and tourism receipts.

Groningen,

Erik Klok

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Contents

1 Introduction 71.1 Morocco’s unfulfilled growth promise 71.2 Vulnerability to shocks 81.3 A VAR model for the Moroccan business cycle 9

2 Background 112.1 The climate in Morocco 11

2.1.1 Rainfall and agricultural production 122.1.2 Household behavior in response to changes in agricultural production 132.1.3 Fiscal and monetary responses to changes in agricultural production 142.1.4 Rainfall and total actual available renewable water resources 14

2.2 Migrant’s remittances 15

3 Methodology 183.1 Dynamic stochastic general equilibrium models 183.2 Vector autoregressive models 193.3 Cointegration: vector error correction models and global VARs 203.4 Hybrid DSGE-VAR models 213.5 Framework for Morocco: the SVAR methodology 22

3.5.1 Impulse response functions and dynamic multipliers 243.5.2 Historical decomposition 25

4 Model specification 26 4.1 Structure of the VAR model 264.2 Summary of the structural equations 31

4.2.1 The foreign economy block 314.2.2 International trading prices block 334.2.3 The domestic economy block 35

4.2.3.1 Export volume 354.2.3.2 Gross national expenditure 364.2.3.3 Domestic output 374.2.3.4 Domestic prices 394.2.3.5 The exchange rate 414.2.3.6 Domestic interest rates 454.2.3.7 Transmission mechanism of monetary policy in Morocco 484.2.3.8 Domestic financial conditions 494.2.3.9 Tourism receipts 514.2.3.10 Migrant´s remittances 52

4.2.4 The domestic climate block: threshold effects 56

5 Data 585.1 International economic and financial conditions 595.2 World trade prices 605.3 Domestic economic and financial conditions 605.4 Rainfall 66

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6 Estimation and stability 71

7 Shock responses: impulse response functions and dynamic multipliers 767.1 Foreign shocks 78

7.1.1 Foreign output shock 787.1.2 Shock to international financial stress 797.1.3 Foreign price shock 807.1.4 Foreign interest rate shock 80

7.2 International trade price shocks 817.2.1 Import price shock 817.2.2 Export price shock 81

7.3 Domestic shocks 897.3.1 Export volume shock 897.3.2 Domestic expenditure shock 897.3.3 Domestic output shock 897.3.4 Domestic price shock 907.3.5 Exchange rate shock 907.3.6 Domestic interest rate shock 907.3.7 Domestic financial conditions shock 907.3.8 Tourism receipts shock 917.3.9 Remittances shock 91

7.5 Rain shocks 98

8 Historical decomposition of the Moroccan business cycle 102

9 Summary and concluding remarks 107

References 100

A Data supplements 122A1. Estimation of export and import prices for 1990 122A2. Estimation of domestic expenditure series 125A3. Principal component analysis of financial conditions 127A4. Rainfall 128

B Excess reserves 130

C Model diagnostics 130

D List of symbols and abbreviations

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List of Figures

4.1 Structure of the VAR model for Morocco 305.1 Graphical representation of the variables included in the SVAR model 68

7.1.A Foreign responses to foreign output, international financial stress and foreign price shocks: foreign output, international financial stress, foreign prices, foreign interest rates, import prices, and export prices 83

7.1.B Domestic responses to foreign output, international financial stress and foreign price shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rate 84

7.1.C Responses to foreign output, international financial stress and foreign price shocks: domestic financial conditions, tourism receipts, and remittances 85

7.2.A Responses to foreign interest rate, import price and export price shocks: foreign output, international financial stress, foreign prices, foreign interest rates, import prices, and export prices 86

7.2.B Responses to foreign interest rate, import price and export price shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rate 87

7.2.C Responses to foreign interest rate, import price and export price shocks: domestic financial conditions, tourism receipts, and remittances 88

7.3.A Responses to export volume, domestic expenditure, and domestic output shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rate 92

7.3.B Responses to export volume, domestic expenditure, and domestic output shocks: domestic financial conditions, tourism receipts, and remittances 93

7.4.A Responses to domestic prices, exchange rate, and domestic interest rate shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rate 94

7.4.B Responses to domestic prices, exchange rate, and domestic interest rate shocks: domestic financial conditions, tourism receipts, and remittances 95

7.5.A Responses to domestic financial conditions, tourism receipts, and domestic interest rate shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rate 96

7.5.B Responses to domestic financial conditions, tourism receipts, and domestic interest rate shocks: domestic financial conditions, tourism receipts, and remittances 97

7.6 Responses to rain shocks under normal and dry regimes 100

8.1 Historical decomposition of the Moroccan business cycle 104

A3.1 Graphical representation of the components of financial conditions in Morocco 127A4.1 Locations of selected WMO stations in Morocco 128B1.1 Excess reserves of the banking system in Morocco 129

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List of Tables

5.1 Individuals measures of financial conditions in Morocco 655.2 WMO stations and their appointed weights in the constructed rainfall index 675.3 List of variables in the SVAR model for Morocco 68

A2.1 Descriptive statics interpolation goodness of fit export and import series 126A3.1 Correlations between individual financial components 127A3.2 Principal component analysis: eigenvalues (components) 127A3.3 Principal component analysis: eigenvectors (loadings) 127A4.1 Rainfall regimes in Morocco 128

C1.1 System residual Portmanteau test for autocorrelation 130

C2.A System residual test: Cholesky (Lütkepohl) orthogonalization 130C2.B System residual normality test: inverse square root of residual correlation

matrix (Doornik-Hansen) orthogonalization 131C2.C System residual normality test: inverse square root of residual covariance

matrix (Urzua) orthogonalization 131

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1 Introduction

After a near-bankruptcy in the early ninety eighties, Morocco successfully implemented a ten year structural adjustment program (SAP) of the IMF. Morocco became even known as ‘the little dragon at Europe’s door’ and was predicted a bright economic future. Unfortunately, the country could never deliver on its promise. One of the reasons for the disappointed growth rate since the ninety nineties is that the economy remained very volatile. Nevertheless, not attempts have been made so far to identify and examine the source of this volatility.

The purpose of this thesis is therefore to develop a model capable of identifying the major shocks to which the Moroccan economy is exposed since the ninety nineties and to understand the dynamic reactions these shocks generate. In addition this thesis measures the relative contribution of each of the shocks to the Moroccan business cycle over the last twenty years. Identification of the major shocks and their dynamic adjustment path is the first and essential step to make the Moroccan economy more resilient to shocks. For these purposes, a structural threshold vector autoregressive model with exogenous variables and block exogeneity restrictions (STVARx) is developed for Morocco.

1.1 Morocco’s unfulfilled growth promiseA temporary boom and subsequent fall in the price of phosphate in combination with sharp rise in world interest rates, almost resulted in Morocco’s bankruptcy in 1983.1 A prolonged period of macroeconomic and financial instability followed. When revenues from phosphate exports collapsed –Morocco’s main export product at that time-, the ‘Moroccanization’ of the economy aimed at promoting agricultural self-sufficiency, discouraging imports and foreign investment, and state control over natural resources, came to an abrupt end. As a condition for new loans from the International Monetary Fund (IMF), the country agreed on a program to restructure its economy.2 The SAP resulted into a more diversified and trade oriented economy, and with country characteristics like its proximity to Europe, political instability, low wages and decent infrastructure, Morocco was predicted a bright economic future.

Morocco however never succeeded to fulfill this promise, mainly because of two reasons. Additional and necessary reforms that were planned for the early ninety nineties were delayed and proceeded far much slower than initially anticipated. In particular, progress on reforms aimed at reducing the role of the state in the economy were only slowly coming into place. Second, the Moroccan economy is still vulnerable to external and domestic shocks making output highly volatile. Because the economy has become more diversified due to the SAP program, it is likely to be more vulnerable to different sources of shocks. Before the reform program volatility arose mainly from two sources only: shocks to phosphate prices and bad harvests. Sekkat (2004) examines the Moroccan growth experience since the 1960 and distinguish three sub-periods according to the behavior of the growth rate. The third sub-period (since the early ninety nineties) shows indeed much more volatile growth rates than the periods between 1960 and 1990.

The fact that high volatility of output hampers the long-term development of an economy has become widely accepted after the apex of the traditional macroeconomic dichotomy between volatility and growth. Lucas (1987) for example argues that the possible returns from understanding business cycle fluctuations are not worth the effort compared to

1 The ratio of external debt to gross domestic output (GDP) reached 87, while the ratio of external debt to exports –Morocco’s main source of foreign exchange earnings at that time- reached an astonishing level of 305 (Reinhart, Rogoff and Savastano, 2003). 2 For an extensive and critical assessment of the Moroccan SAP see Denoux and Maghraoui (1998).

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those from understanding economic growth. The identification and understanding of short-term economic fluctuations in Morocco is therefore of crucial importance for the economic future of the country.

1.2 Vulnerability to shocks Since the reforms of the eighties, the Moroccan economy has become more diversified and less vulnerable to single shocks like fluctuations in the price of phosphate or harvests. At the same time when the economy became more diversified, Morocco gradually exposed itself to more potential shocks. For example, Morocco is today more exposed to international financial markets and the tourism sector strongly developed. The increased international trade and financial linkages between Morocco and the world, particularly Europe, make the country potentially more vulnerable to foreign shocks.

Nevertheless, one of the main risks Morocco continues to face is its exposure to a highly erratic rainfall pattern. Given the high dependency on rainfed agriculture, which typically accounts for some 15% of GDP but employs more than 40% of the workforce, private consumption and output are easily affected by changes in rainfall. In addition, Morocco is listed by the Food and Agriculture Organization (FAO) among the countries that face on average absolute water scarcity; water withdraws from renewable resources are no longer sufficient to satisfy all human demands. The total actual renewable water resources that are available in Morocco fluctuate with the level of rainfall. Rainfall therefore directly increase or decrease pressure on water resources and determines the level of water stress among mining, industry and other purposes. Because water sources are crucial for all socio-economic development, the effect of rainfall on economic activity in Morocco is expected to be much larger than only the effect on rain-fed agriculture. Meanwhile, the rainfall pattern in Morocco is predicted to become even more volatile in the future. Rainfall deviations from normal levels during a year will increase both in magnitude and frequency.3 Or in words of the North- African people: ‘the rain goes crazy’.

Rainfall is often linked to the economy, with an extensive amount of literature focusing on the effects of long-term decreases in rainfall on economic growth (Barrios et al., 2003), the role of intra-annual rainfall variability in explaining growth differences between countries (Brown and Lall, 2006), or on estimating damage functions in order to estimate the effect of extreme rainfall events (e.g. Hallegatte et al., 2007). Meanwhile, in modern business cycle research rainfall has not been included as a potential source of short-run economic fluctuations, despite the fact that many countries like Morocco are particularly vulnerable to relative small changes in rainfall levels during a year and not only to long-term decreases in rainfall trends. Interest in climate as a potential source of short term economic fluctuations in modern macroeconomics is gradually increasing since the work of Buckle et al. (2007) who successfully include a climate variable in their business cycle model for New Zealand.

Although not included in contemporary business cycle research before the work of Buckle et al. (2007), linking climate to economic cycles started already at the end of seventeenth century with the sunspot theory of Jevons (1886). Basically, Jevons (1886) linked the UK business cycle to the eleven-year sunspot cycle based on the relationship between sunspot activity and agricultural production. Although his theory was never taken too seriously, his thoughts on the transmission of shocks and anticipation effects are

3 Fisher et al. (2002) designate the northwestern region of Africa as particularly vulnerable to changing rainfall patterns as a result of the interaction between the structure of the economies in these regions and the magnitude of the change itself.

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interesting.4 Favorable harvests due to increases in sunshine reduce the prices of food and raw materials, thereby changing conditions in the money market. Manufacturing output increased because people have more resources left because food prices decreased. The effect of harvest fluctuations were multiplied by changes in investment decisions induced by self-fulfilling expectations of market participants responding to price signals.

The inclusion of a rainfall variable in the models for Morocco introduces some modeling challenges that emerge from the exogenous nature of rainfall and a potential non-linear relationship with economic variables. Threshold effects of rainfall in Morocco are expected based on Gober et al. (2001) and Baraket and Handoufe (1998) who show that rainfall sufficient to cause dramatic reductions in Morocco’s agricultural production is estimated at 38% below normal values, while below 19.8% there is no fear of any serious impact of rainfall on agricultural production. These threshold values are similar to Ameziane et al. (2007) who show that cumulative annual rainfall less or equal to 263 mm is less than normal water requirements for wheat crops and wheat production is altered drastic. Since the normal long-run average winter rainfall is estimated at 401.2 mm in this thesis, the deviation expressed in percentage points is 138 mm, or 34%. In additions slaughter rates increase more than proportional during droughts; Chaarani and Mahi (2007) for example show that the slaughter rate in Morocco increase to 16% in dry years, from 6% in humid years. A regime dependent binary variable is therefore introduced in the model to allow for some kind of non-linear behavior of rainfall during droughts.

Morocco’s highly erratic rainfall pattern is only one of the characteristics that makes the country vulnerable to shocks. Morocco is for example well known for its large share of diaspora across Europe. Migrant communities emerged since the 1960s from high demand for low-skilled labor in Europe. As the Moroccan people remain strong ties with their home countries, large flows of remittances followed. Remittances are in general considered as a welcome gift for a country because they provide funds for development and may smooth business cycle fluctuations. Nevertheless, remittances actually may amplify business fluctuations when the remitter is not altruistic, but has a portfolio-diversification motive instead. Under an altruistic motive remittances increase during recessions, while a portfolio motivates remitter will decrease its transfers in order to prevent losses. Remittances are also associated with Dutch Disease effects. The literature on the cyclical nature of remittances does not always adequately deal with the endogeneity problem that exists between the state of the Moroccan economy and the level of remittances. The vector autoregressive approach to the Moroccan business cycle as developed in this thesis is an appropriate framework to examine the cyclical nature of remittances without the danger of an endogeneity bias.

1.3 A VAR model of the Moroccan business cycleThe vector autoregression (VAR) model as developed by Sims (1980) has become a standard method in empirical macroeconomics to evaluate the dynamic response of an economy to shocks. Despite its popularity, a standard VAR model is not sufficient to capture the main characteristics of the Moroccan economy and is therefore insufficient for identifying the major shocks and their propagation mechanisms. Several important developments in VAR model specification and estimation since its introduction make it possible to construct a relatively large framework that captures the most important characteristics of the Moroccan

4 Until today, no empirical evidence has been found that there exist a causal relationship between sunspots and economic cycles by their effect on agriculture. Jevons’s theory is therefore used as a classical example of spurious correlations; an apparently statistical relationship between two or more variables that in reality does not exists.

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economy. The VAR model that is constructed for Morocco uses the innovative block exogeneity procedure of Cushman and Zha (1997) and Zha (1999) that makes use of the small open economy (SOE) assumption in order to make it possible to include a relatively large number of variables compared to a standard VAR. A block structure reduces the numbers of parameters that must be solved for at all times. At the same time, a block structure brings some actionable clarity to the complex dynamic relationships and reveals some of the deeper dynamics of a VAR. Block exogeneity procedures are imposed for example by Dungey and Pagan (2000) in order to construct a VAR model for Australia. Buckle et al. (2007) build on the work of Dungey and Pagan by extending a small-open economy VAR model for New Zealand with a climate block in additional to an domestic economy, foreign economy and international trading prices block.

This thesis develops a structural vector autoregressive (SVAR) model to identify and examine the main sources of Moroccan business cycle fluctuations and follows the block structure procedure of Buckle et al. (2007) that arises naturally from the assumption that Morocco is a small open economy subject to external and internal shocks. A key innovation of the VAR model for Morocco is the incorporation of nonlinear effects, in the spirit of Chan et al. (1995). Chapter 4 provides an extensive overview of the model developed in this thesis and the distinctive character compared with previous similar models. Impulse response functions and dynamic multipliers are used to evaluate the dynamic impact of the various shocks that are included in the model. Subsequently, a historical decomposition is performed to estimate the contribution of each individual shock to the Moroccan business cycle over the last twenty years.

Several interesting results emerge from the developed VAR model for Morocco. Despite its developed towards a more sophisticated economy, rainfall remains the dominant source of business cycle fluctuations in Morocco, even in the absence of droughts. This suggest that the Moroccan economy has no become more resilient to rain shocks. As expected, due to reforms, the financial sector has become more important, but impulse response functions suggest that financial reforms should continue. Financial conditions seem to adjust only at a very slow phase when the Moroccan economy is hit by a shock, reducing the recovery speed of the economy. Reforms aimed at increasing the mutual confidence between financial institutions and economic agents should reduce the long-lasting effects of shocks on financial conditions in Morocco. International variables also have been a dominant source of business cycle fluctuations in Morocco, in particular trade price shocks. Despite the claim by Moroccan authorities that the economy is resilient to international financial crises, stress on international financial stress directly affects the Moroccan economy. Migrant’s remittances are often praised for smoothing business cycle fluctuations, but they do not play a significant role in the Moroccan business cycle.

Finally, puzzles that are often find in impulse response functions based on VAR models like the liquidity, price, exchange rate, forward discount bias and interest-ouptut puzzles (see Kim and Roubini, 2000 and King and Watson, 1996) do not emerge in this thesis, which suggest an appropriate identification scheme of the model. The inclusion of the forward looking indicators like rainfall and international financial stress may have contributed to the absence of puzzling outcomes.

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2 Background

This chapter provided some background information on the transmission mechanism of rainfall on the Moroccan economy and migrant’s remittances. Background information on other aspects of the Moroccan economy like the monetary and exchange rate policy, trade patterns, is incorporated in Chapter 4 that provided a description of the structural equations of the model.

2.1 The economic impact of rainfall in MoroccoThe Moroccan economy is not only very vulnerable to fluctuations in rainfall because of its large share of rainfed cereal agriculture, but also because its low balance of total renewable water resources which effect almost all economic activity in the country. Before discussing the basic impact of climate on the economy, a brief overview of the Moroccan climate is provided.

2.2.1 The climate in MoroccoMorocco is located at the northwestern corner of Africa and is surrounded by the North Atlantic Ocean, the Mediterranean Sea, the Atlas Mountains and the Sahara, which makes the country’s climate very different across regions as well as across seasons. There exist a Mediterranean or a dry-summer subtropical climate in the northern coastal regions that is characterized by warm summers and mild and wet winters. The southern interior regions of Morocco have high volatile temperatures and are often hit by droughts. Because of these unfavorable climate conditions in the south of Morocco and in the mountains, economic activity mainly takes places in the coastal areas and their hinterland where climate is more favorable for humans. This is basically the reason why the rainfall dataset that is used in this thesis need to be adjusted to account for the regional differences. The construction of the rainfall index is elaborated in Chapter 5.

Temperatures in regions with economic activity are generally moderate with a small range between winter low and summer high temperatures, while rainfall patterns are much more volatile during the year. Temperature is a rather conservative element of the Moroccan climate with a relatively small annual range, while rainfall is the most defining characteristic (Oliver, 2005). Subtropical high pressure cells during summer makes rainfall scarce, while during winter the polar jet stream brings abundant rain. Although the variation in total winter rainfall is relatively low, monthly variation during the wet season during November-March, is very erratic. This volatile rainfall pattern is directly related to the North Atlantic Oscillation (NOA) and the El Niño-Southern Oscillation (ENSO). NOA is a regular climatic phenomenon in the North Atlantic Ocean of fluctuations in the difference of atmospheric pressure at sea level and controls the strength and direction of westerly winds across the North Atlantic. The magnitude of these westerly winds determine the level of winter rainfalls in Morocco; when winds are strong rainfall is heavy. This rainfall pattern created by the NOA is however on average - but over a period that varies from three to seven years - every five years disturbed by the ENSO. One variant of ENSO is El Niño which is a prolonged warming over the east-central tropical Pacific Ocean and brings in more rain than on average, but is magnitude is varying, from almost zero to extreme cases as in September 2008 when record rainfall levels were denoted. La Niña in contrast, the name for the cold phase of ENSO, coincide with less than average rainfall levels.

The highly volatile rainfall patterns created by El Niño and La Niña is expected to have serious consequences for the rain-dependent Moroccan economy. Rainfall directly affects the economy by altering rainfed crop productions, but is also the main source of the

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replenishment of the available renewable water resources. Water is crucial for all kinds of economic activity. Because water balance are generally low in Morocco, relatively modest changes in rainfall levels may change the level of competition for scarce water resources between agricultural, industry and domestic use. Those effects of rainfall on the economy is like to initiate a dynamic reaction that is described in Chapter 7 by hand of dynamic multipliers resulting from a rain shock. Both channels are explained in this paragraph.

2.2.2 Rainfall and agricultural productionAlmost 90% of agriculture in Morocco consist of rainfed cereal production and although the share of agriculture in GDP is with 18% relatively modest, the sector employs more than 40% of the labor force and is therefore of crucial importance for the Moroccan economy.5 Changes in cereal production levels result in not only rural household behavior, but also urban household behavior. The government of Morocco is also seriously affected by changes in cereal production due to imposed price controls and changes in tariff revenues due to changes in required cereal imports.

The agricultural sector can be divided into a rainfed traditional sector consisting of cereal (wheat, barley and maize) production for domestic consumption and a relatively small irrigated and more modern export oriented sector producing fruits and vegetables. Due to a lack of irrigation systems in the traditional sector in combination with limited soil-water storage capacity, the major share of agriculture in Morocco is exclusively directly depended upon adequate levels of rainfall.6 Cereal production has become particularly vulnerable as a consequence of price controls imposed by the Moroccan government in the late 1980s which resulted in artificially high prices for cereals. As a consequence, cereal production expanded towards unproductive areas with low and volatile rainfall levels. In addition, farmers expanded wheat production at the expense of the less rainfall dependent crops like barley. As a results, the standard deviation of agriculture growth in Morocco increased from 10 percent in the 1970s up to 42 percent in the 1990s as illustrated by Azzam and Sekkat (2005). The same authors also show that total-factor productivity in Moroccan cereal sector in the long and short run is driven by changes in rainfall and technical efficiency and not by government policy, demand effects and technical changes. The effect of rainfall on cereal production is also empirical examined by Heng et al. (2007) who show that in the case of wheat, yields in Morocco during the past twenty years were frequently limited by the amount of - and timing of rainfall. Growing season precipitation amount is the best single predictor of above net primary productivity of grassland or crop production (see for example Nippert et al., 2006 and Cooper et al., 2008). Barakat and Handoufe (1998) define threshold levels for rainfall that are sufficient to cause a significant reduction in agricultural production in Morocco. The security threshold is estimated at 19.8% below normal rainfall during October and May, and indicates a rainfall deficit without fear of a decrease in agricultural production. A significant decrease in agricultural productivity is certain when rainfall is 38.1% lower than average. More information on this kind of threshold effects are given in Chapter 5. Not only the amount of rainfall is important, but also its timing. The cereal growth cycle in Morocco coincides with the rain season during October to May, with seeding occurring typically in October-December, tillering and stem extension during January-February and heading and ripening in March-May.

Gober et al. (2001) indicate that cereal yields in Morocco are linearly related to cumulative rainfall in January through March. This may be explained by the fact that despite

5 Source: UN Statistics Division - National Account Main Aggregate Database.6 Droogers et al. (2001) calculate a worldwide soil-water storage capacity (SWSC) index that shows the Moroccan SWSC is amongst the lowest in the world and exhibit scarce reserves of moisture.

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the typical growing cycle, famers could theoretically wait for the rain up to March making it difficult to readjust production plans in the case of low rainfall before March although this is not desirable (Karaky, 2002).

2.2.3 Household behavior in response to changes in agricultural productionAs a consequence of vulnerability of crops to rainfall, farmers in general tend to respond immediately to changes in rainfall by reducing investment or even stop cropping and focus on livestock management in response to dry spells. Famers cannot postpone seeding, which makes it making it difficult to readjust production plans in the case of low rainfall before March (Karaky, 2002). This point is also indirectly reflected by studies that found that cereal yields are linearly related to cumulative rainfall in January through March (Gober et al. 2001). The response of livestock capital in Morocco to rainfall conditions on livestock capital seems to be in line with other countries with limited access to financial services. Livestock is not only threatened by the absence of drinking water as a result of decreases in rainfall, but several studies (Karaky, 2003 and Lybbert et al., 2009) find that livestock capital in Morocco responds accordingly to changes in cereal production levels. Livestock act therefore as an asset for farmers to hedge against rainfall fluctuations, although farmers often complain that they are forced to sell livestock at difficult times when prices are low.

Lybbert et al. (2009) emphasize the potential limited possibilities in Morocco regarding the mitigation of income deficits by reallocating assets. Due to the possible existence of a critical herd size threshold in the case of livestock, below this value the marginal productivity of livestock falls sharply, the cost of current consumption in terms of future productivity increases. This is reinforced by the fact that for credit-constrained rural households in Morocco, productive assets, in particular livestock, can be difficult to recoup. Hence, household are expected to sell livestock only when it is strictly necessary. In a survey of 250 Moroccan rural households Lybbert et al. (2007) indeed show that households will first draw down stores of agricultural products if possible and, borrow money from family or friends, followed by the selling of livestock and renting out land. There is however a big difference in types of livestock: sheep and goats are rapidly sold after changes in rainfall, while selling of cattle is held as a last resort indicating that a critical herd size exist for cattle and they are difficult to recoup, in contrast of sheep and goats which are not considered to increase to cost of current consumption in terms of future productivity. Buckle et al. (2007) also refer to the existence of a positive relationship between livestock capital and weather conditions in New Zealand as a possible explanation of the observations that export volumes initially increase in response to adverse weather conditions due to a possible increase in slaughter rates.

Secondary effects of changes in cereal production levels in response to rainfall are examined more formally by Karaky (2002) in a general equilibrium model that is based on a social accounting matrix. The model reflects the interaction between production, income, consumption and capital accumulation of Moroccan households, companies, the government and the rest of the world based on 1997 national income values. One of the interesting features is that Karaky makes a distinction between six different types of households in Morocco, that respond differently to changes in cereal production levels. Households welfare is affected by changes in cereal production levels by changes in returns to factors of production, prices and consumption levels. Although all types of households are better off under favorable cereal production conditions, and all are worse off in adverse conditions, they are not effect to a similar extent. This can be for the larger part be explained from the fact that although both wages and returns to factors of production change in response to change in cereal production levels and therefore both landlords and workers gain, the relative

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change in purchasing power is much larger for rural and urban poor. Their purchasing power available for food is directly affected by changes in cereal production levels, while this is not the case for medium and large farmers that are net sellers of food. Urban non-poor households suffer therefore less than poor household although they also face higher food prices, but they are partly compensated by an increase in returns to urban capital as production activity would tend to shift towards urban commodities when cereal production declines.

2.2.4 Fiscal and monetary responses to changes in agricultural productionChanges in cereal production has far more widespread implications than only affecting the income households. Because Morocco is structurally a net importer of cereals, favorable rainfall dramatically declines cereal imports. To maintain the fixed exchange rate, net capital inflows decrease to balance the current account. In addition, tariff revenues fall in line with the decrease in imports and government savings decrease as consumption is assumed to be remained fixed in the short-term. As a consequence of the fall in foreign savings and government savings domestic investment will decrease. The opposite occurs with unfavorable cereal production levels. Finally, Globe et al. 2001 mention that loan default by farmers during adverse climate conditions imposes additional cost on the Moroccan government because of its program of debt relief during times of rainfall deficits.

In addition to the effects of rainfall on cereal production and livestock capital, it also affect pasture growth and everything associated like lambing percentages, cattle slaughter rates and dairy production. And more importantly, the effect of changes in agricultural production in Morocco is particularly large as agriculture is also an important source of intermediate inputs for several manufacturing industries in Morocco, like the flour and pasta, and leather processing industries.

As becomes clear from the work of Karaky (2002), rainfall effects on agriculture in Morocco are likely to spill over to non-agricultural activity like returns to urban capital or fiscal and policy consequences. In addition, there exists in the literature a long history of the the independency of agricultural and monetary factors causing business cycles. In this view, elaborated by for example Andre (1906) movements in agricultural production alters money demand and the associated change in interest rates induce an economy-wide impact. Due to the existence of such a relationship, monetary policy might be effective in mitigating the effect of a rain shock on the economy. However, Morocco has limited scope to pursue an independent monetary policy given its pegged exchange rate regime, as will be discussed in Chapter 5.

2.2.5 Rainfall and total actual available renewable water resourcesIn addition to the relatively large share of rain-fed agriculture that directly dependents on levels of rainfall, rainfall affects the Moroccan economy indirectly by altering scarce water resources needed for industrial, mining, irrigated agriculture and other human demands. Rainfall also drastically changes government expenses due these scare water resources. For example, expenses for programs to protect livestock, forest and adequate water supply for villages as a consequence of the rainfall deficit in the period October 1999- March 2000, were estimated at 6.5 million Moroccan dirham (Gober et al., 2001).

The availability of water from rainfall is limited by the relatively high rates of evapotranspiration in Morocco.7 These water resources consist mainly of so called blue water that originates from rainfall that escapes evapotranspiration and is captured in rivers and aquifers. The other source of freshwater availability, green water, that is formed by infiltrated

7 The amount of water that remains in the soil after what is evaporated and what is transpired by plants as a part of their metabolic process.

15

rain and is of less importance for Morocco due to low soil storage capacity. This also explains the large share of rainfed agriculture. During the past twenty years, Morocco is increasingly suffering from a constant water deficit caused by irregular climate conditions in combination with increased demand from water due to increased economic activity.

Total internal renewable water resources in Morocco are theoretically on average estimated at 29 billion m3 per year8 -although the technically and economically feasible resources are much lower -and with a population of 32.3 million9, Morocco is with less than 1000 m3 per capita per year defined by the Falkenmark Water Stress Indicator (Falkenmark et al., 1989; 2007) as a country that faces physically water scarcity. Water scarcity can lead to water supply collapse, crop failure in irrigated fields, the closure of river basins and increased infrastructure cost to make more water accessible for economic use. For example, Yang et al. (2003) conclude that there is a threshold of about 1500 m3/capita per year below which a country’s cereal imports become strongly inversely correlated with its renewable resources. In addition, the total annual withdrawals from these low levels of water resources exceeds 40% in Morocco which is in the literature a threshold value to indicate high water stress (Raskin et al., 1997 and Alcamo et al., 2000). Water is considered as a constraint on socio-economic development and water supplies are no longer adequate to satisfy all human demands.

Because internal renewable water resources include the average annual flow of rivers and the recharge groundwater generated from rainfall, even slight variations in these on average low water resources induced by changes in rainfall may affect the economy. Rainfall in Morocco therefore directly tightens or weakens the constraint on economic activity imposed by scarce water resources. Although agriculture (mainly irrigated exports) still accounts for 87% of the total amount of water withdraw, municipal (9.7%) and industrial water withdraw (2.9%) are gradually increasing pressure on water resources. Two main water users, phosphate mining and hydro electricity generation are worth mentioning because of their special roles in the Moroccan economy.

The cause of the economic crisis during the 1970s and 1980s were fluctuations in world phosphate prices and although Morocco has become less dependent on phosphate mining since the IMF SAP, phosphate and its derivatives still account on average for 18%of total Moroccan export value.10 Although Morocco is the world’s third largest miner and processor of phosphates and first exporter housing approximately two third of the world’s phosphate reserves, the phosphate industry activity is constrained by scarce water resources in Morocco.11 Phosphate mining requires massive quantities of water: according to the Florida Institute of Phosphate Research, a single phosphate mine pumps on average more than 100,000 gallons of water a minute, and can be evaluated to 57 million m3, or in terms per capita 2 m3, in Morocco. With already scarce water resources, these huge water demands of the phosphate mines and their chemical branches impose heavy burdens on other socioeconomic sectors in surrounding areas like agriculture and the drinking water industry. Phosphate mines increase the pressure on already scarce water resources, and rainfall becomes even more crucial in areas surrounding phosphate activity.

Furthermore, the Moroccan Ministry of Energy aims to expands its hydropower generation from 8% - but even 25% of total energy supply is currently of hydraulic origin - to 20% in

8 Source: FAO AQUASTAT.9 Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2008 Revision. 10 Source: International Trade Center, Trade Competiveness Map. 11 US Geological Survey: Global distribution of Phosphate reserves.

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2020. Hydropower production variability is proportionally related to the precipitation level by altering river flows. River basins have a tendency to amplify precipitation changes by approximately factor 2.6 (Harrison et al. 2006), e.g. runoff changes tend to be greater than the precipitation change causing them. Adequate water balances in basins are needed to guarantee the fall and movement of water during period of insufficient rainfall. Water levels in basins during the year depend on rainfall levels during winter times. When rainfall is insufficient during winter, low water balances in the summer hampers hydropower generation in that period. With sufficient water balance during a year it does not matter if rainfall patters are volatile as long as the total level of rainfall is adequate to fill the water basins to guarantee an equal stream of water is guaranteed during the year. With low water balance as is generally the case in Morocco, a moderate rain shock may already affect the generation of hydropower resulting in fluctuations of energy prices.

To summarize, the Moroccan economy is not only affected by rainfall due to agricultural production, but also by the competition amongst socioeconomic demands for water resources due to low water balances. For example phosphate mines reduces water resources left for irrigated agriculture heavily, making them quite vulnerable to small changes in rainfall that is the indirect source of irrigation. In the future, pressure on water resources will become even larger in line with Morocco’s predicted economic development, making the economic activity even more vulnerable to fluctuations in rainfall.12 Both the direct and indirect impact of rainfall on the economy will trigger a dynamic multiplier effect by altering economic variables like prices and savings. This dynamic path is analyzed in Section 6.

2.2 Migrant’s remittancesMorocco is well known for its large diaspora communities across Europe, that started to settle during the 1960s in response to Europe’s high needs for low-skilled labor. The general belief at that time was that Moroccan guest workers would accelerate the development of their home country’s economy by temporary relieving pressure on the unbalanced Moroccan labor market, providing funds for investment and redistributing knowledge when they returned.13As it turned out, most workers did not return and migration continues until today with already 4 million people of Moroccan decent live abroad, while Morocco has approximately 33 million inhabitants.14

Because Moroccan migrants in general remain close ties with their relatives at home, large remittance flows arose and gradually became an important element of Morocco’s economy. Workers’ remittances currently contribute 7% to GDP -which corresponds with the recent twenty years average- and Morocco is the world’ fourth receiver in absolute terms.15 Remittances are expected to remain substantial in the near future as migration will continue for at least the coming two decades as predicted de Haas and Plug (2006). Their economic impact remains ambiguous, despite that remittances in general are considered as a welcome gift to an economy.

Remittances are in the literature associated with reducing poverty rates (Adam and Page, 2010), increasing investment in education and health care and promote development of financial institutions (Aggerwal et al., 2006) which in its turn fosters growth (Mohamed and Sidiropoulos, 2010), overcoming problems of credit rationing (Edwards and Ureta, 2003) and

12 See for example Taleb (2007) for future scenarios on water demand in Morocco. 13 See de Haas (2005) and Leichtman (2002) for both political and economic history of Moroccan migration. 14 de Haas (2005) and UN World Population Prospects.15 Chami et al. (2008).

17

Yang, 2007), and promoting entrepreneurship (Maimbo and Ratha, 2005).16 There are also several potential negative externalities of remittances on the micro-level like moral hazard problems, crowding out the insurance aspect of wages and thereby sub-optimally shifting risk from risk neutral firms to risk-adverse remitters resulting into higher wage volatility over time and lower work effort (Chami and Fischer 2000), fueling speculative bubbles in unproductive real estate, increasing income inequality, encouraging migration (Van Dalen, Groenewald and Fokkema 2005) and thereby increasing brain drain (Leichtman 2002).

While these are all effects of remittances on the micro level, remittances also have a serious impact on the macro level directly. Remittances act as stable source of foreign exchange which reduce the probability of sudden stops and current account reversals (Bugamelli and Paterno, 2009), provide a collateral for bond issuance which lowers the cost of debt (Ketkar and Ratha, 2010), reduce the volatility of output by smoothing consumption in economic downturns, and may even foster growth (Mohamed and Sidiropoulos, 2010; Berthomieu and Tykhonenko , 2009). Unfortunately, remittances also impose a number of serious threats to an economy that are relatively under exposed, like generating Dutch Disease effects (Amuedo-Dorantes and Pozo, 2004) or amplifying business cycle fluctuations. Negative externalities might even surpass the benefits of remittances, leading some studies to reject the conventional wisdom that remittances are good for growth (Glytsos, 2005; Chami et al. 2003, 2008).

Most of those studies are however based on cross-country samples, rather than individual countries despite the behavior and effect of remittances depend on individual country characteristics. For Morocco only a few country- specific studies are available. In addition several existing studies suffer from a potential endogeneity problem when examine the effect of remittances on economic growth. Most studies focus on the relationship running from remittance to growth; while a reverse causation is also possible. Economic growth in the receiving country determines the level of remittances. Two distinct hypotheses exist on the behavior of remittances in response to economic conditions in the receiving country, and depend on the motivation of the remitter. The most accepted hypothesis is that the remitter is altruistic: he compensates family members in his country of birth during times of hardship. In this case, remittances respond negatively to changes in income of the receiver (Chami et al., 2008; Yang and Choi, 2007). The other view is based on a portfolio-diversification or rent-seeking motive of the remitter and remittances responds positively to changes in income of the receiver (Amuedo-Dorantes and Pozo, 2010).

For the Middle East and North Africa (MENA) region, Glytsos (2005) finds an overall positive long-run relationship between remittances and growth in Morocco. Berthomieu and Tykhonenko (2009) show by hand of a panel convergence framework that for six MENA countries –including Morocco- there exist a positive impact of remittances on growth. Mohamed and Sidiropoulos (2010) also conclude for the MENA region by hand of fixed-effects panel methods that remittances have a positive impact on growth. Interestingly, Sayan (2006) shows that in the short-run remittances in Morocco tend to be procyclical. Remittances amplify business cycle movements, rather than smoothing them.

3 Methodology

16 Docquier and Rapoport (2005) provide an extensive literature overview on the microeconomic impact of remittances.

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Contemporary business cycle research is dominated by two methodologies: structural vector autoregressive (SVAR) and dynamic stochastic general equilibrium (DSGE) models. Both models developed in response to shortcomings of the Cowles Commission structural equation approach (SEMs), which was the main paradigm of empirical macroeconomic research in the 1950s, 1960s and 1970s. Macroeconomist became divided after Lucas’s critique (Lucas, 1976) that questioned the constancy of parameters in SEMs. Rational expectations of forward looking agents result in misspecified SEM models under Keynesian identification assumptions because structural parameters are not invariant to changes in policy rules. Furthermore, identification of SEMs was mainly achieved by imposing restrictions that take the form of exogenous variables that appear in one equation but not in another. The problem with this way if identification is that true exogenous variables are hard to find. Macroeconomists subsequently moved in two directions; one group favoring dynamic stochastic equilibrium models (DSGE), while the other group beliefs in the vector autoregressive (VAR) approach to macroeconometric analysis as introduced by Sims (1980) for which he was awarded the 2011 Nobel Prize in Economics. Today, models tend to incorporate elements of both approaches.

3.1 Dynamic stochastic general equilibrium modelsThe first group of economists continued to follow the Cowles methodology, albeit introducing the assumption that data is generated by a dynamic general equilibrium model in which forward looking agents have rational expectations of future prices. These models evolved into sophisticated dynamic stochastic general equilibrium (DSGE) models reflecting New Keynesian and real business cycle (RBC) paradigms. DSGE models based on the New Keynesian paradigm attempt to provide microfoundations for Keynesian concepts such as nominal price rigidities and non-neutrality of money. In this spirit, Rotemberg and Woodford (1997) were the first to introduce an econometric specification from an explicit model of intertemporal optimization on part of the suppliers and the purchasers of goods and services to evaluate monetary policy rules.

Real business cycle models in contrast build on the neoclassical growth model that assumes flexible prices, to evaluate real shocks to the economy as pioneered by Kydland and Prescott (1982). The benchmark modern DSGE model is a fully micro-founded model with real and nominal rigidities. Basically, each model incorporates households that consume, invest and supply labor which allow them to set wages. They maximize utility that is determined by consumption, leisure and real money balances. Firms on the other hand hire labor, rent capital and are monopolistic suppliers of differentiated goods making them price setters. In other words, DSGE models describe the behavior of the economy as an aggregate using microeconomic decisions made by these firms and households. DSGE models are calibrated where it is assumed that the parameters are known a priori from for example microeconometric evidence or surveys, or are estimated using Bayesian techniques (Smets and Wouters, 2003). DSGE models are by critical economists often considered to be too stylized to be truly able to explain the dynamics of the data. For example, financial market imperfections are often inappropriate modelled because financial markets are assumed to be efficient and self-correcting although recent events like the financial crisis of 2008 painfully proved different. In the words of Sims (2006) – the father of the other alternative school of thought in response to the traditional Cowles methodology - : ‘aggregate DSGE models are story-telling devices, not hard scientific theories that cannot model the dynamics of the data’. Simplifications made in the construction of behavior models are helpful to understand how the economy works, but they cannot fulfill the requirements to match in detail the dynamic behavior of accounting constructs and proxy variables that make up the data. At best, DSGE

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can be used a mechanism for generating a prior (for a VAR), not a model of the data like VARs. See Tovar (2008) for a more comprehensive discussion on the applications and limitations of DSGE models.

Potential misspecification of DSGE models result from using Bayesian techniques with incorrect priors. These DSGE models give less satisfying answers to policy questions than an alternative less perfect fitted model when employed in the estimation of a dynamic shock process. Calibration of DSGE models may therefore be a more successful approach (Kocherlakota, 2007). For Morocco, calibration of an extensive DSGE model is not an attractive option because micro evidence on optimal household and firm behavior is generally unavailable, in particular for large sample periods. Furthermore, the critique on Bayesian estimation of DSGE models and the general concerns on the degree of misspecification, make the construction of such a model for Morocco not attractive.

3.2 Vector autoregressive modelsThe second group of economists that became dominant after the Cowles Commission uses vector autoregressive (VAR) models that were developed by Sims (1980) in response to the shortcomings of the traditional identification of SEM models. According to Sims those restrictions on the short-run dynamics of the model are ‘incredible’. Because true exogenous variables that are required for identification in SEM models are hard to find, Sims proposed to treat all variables in the model symmetrically. He developed an a-theoretical unrestricted system of reduced form equations where each variable depends on its own lags and the lags of all other variables included. This system is known as a standard our educed form vector autoregression (VAR) and treats all variables as endogenous. The data is therefore free to estimate the relationships between the variables without any restrictions.

However, because VARs are reduced form models, some structural restrictions are required to identify the relevant innovations and subsequently impulse responses. Some form of identification is needed because reduced-form errors are generally correlated. Sims (1980) proposed to use a type of recursive system where a Choleski decomposition is used to achieve identification; contemporaneous shocks to higher ordered variables feed through to lower ordered variables but not vice versa. Unless the underlying structural model can be identified from the reduced-form VAR, the innovations in a Choleski decomposition have no economic interpretation. In the end, the model of Sims is subject to the same critique Sims elaborated regarding the identification approach of the Cowles Commission.

In response to the short-coming of recursive VARs that use a Choleski decomposition, Sims (1986) and Bernanke (1986) proposed the use of economic theory to achieve an appropriate identification, resulting into so-called structural vector autoregressions (SVAR). A SVAR uses assumptions based on economic theory to sort out the contemporaneous links among the included variables. Stock and Watson (2001) define SVAR models as reduced form VARs that require identifying assumptions that allow correlations to be interpreted causally. This produces instrumental variables that permit the contemporaneous links to be estimated using instrument variables. For example Bernanke (1986), Blanchard and Watson (1986), and Sims (1986) recover the structural innovations from the residuals by using economic theory rather than an arbitrary Cholesky ordering of the residuals.

SVARs differ from SEMs because their focus is on shocks; structural innovations are assumed to be orthogonal and can therefore be seen as primitive exogenous forces which buffet the system and cause oscillations (Bernanke, 1986); shocks do not have common causes and therefore it is natural to treat them as approximately uncorrelated. SVAR models therefore examine the dynamics of a model by subjecting it to an unexpected shock. SEMs do

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not make a distinction between expected and unexpected changes in one of the included variables. Structural innovations are in SEMs interpreted as errors that reflect the effects of omitted, nonessential variables and are unrestricted. Today, VAR models are widely used in macroeconomics; for example they have been used to examine the effects of monetary policy on output (Sims, 1986), to distinct the relative importance of supply and demand shocks on economic fluctuations (Blanchard and Quah, 1989), to decompose real and nominal exchange rate movements into the components induced by real and nominal factors (Enders and Lee, 1997), and more recently to document the effect of climate on the business cycle (Buckle et al., 2007).

3.3 Cointegration: vector error correction models and global VARsSVAR business cycle models traditionally focus on short-run fluctuations around a long-term trend, where the long-term trend is filtered out in order to work with stationary data. However, it is possible to incorporate nonstationary variables in the model, when variables are cointegrated. Equilibrium relationships assure that variables cannot move independently of each other, which ensures that the dynamic path of such variables must bear some relation to a current deviation from the equilibrium relationship. An ordinary SVAR fails to display such connection between the change in a variable and the deviation from equilibrium as expressed in an error correction. The short-term dynamics of the variables in the system are influenced by deviations from equilibrium. Pesaran et al. (2004) use the apparent synchronization of international business cycles to construct a global vector autoregressive (GVAR) model. Cointegrating relationships allow for interaction amongst different economies and account for the global comovement between various macroeconomic variables like output, inflation, interest rates, equity prices, oil prices, money supply and exchange rates. Country specific vector error-correction models are combined to generate forecasts for all the variables in the world economy simultaneously.

In a similar way, Dungey and Pagan (2009) extend their original structural VAR model for Australia (Dungey and Pagan, 2000) by allowing for both transitory and permanent components in the time series, in contrast with the previous framework that models macroeconomic outcomes as transitionary deviations from a deterministic trend. The resulting structural vector error correction model (SVECM) has a theoretical orientation but also reacts to the nature of the data, specially the evidence for co-integration. Although the inclusion of long-term behavior in a business cycle model is appealing, it becomes very complicated when the number of variable that are included in the model increase. Multiple cointegrating relationships are hard to explain from economic theory and assumptions required to identify the multiple cointegrating relationships are often difficult to justify. The approach of Dungey and Pagan (2009) is to treat the terms of trade, interest rates and prices as variables integrated of order zero [I(0)] after eliminating a deterministic component. Meanwhile foreign output, exports, GNE and GDP are defined as variables integrated of order one [I(1)] and are included in a test for the presence of cointegration between the variables. In these tests, exports and foreign output are treated as exogenous, well the cointegration test is augmented for the I(0) variables – the terms of trade, interest rates and prices. A major drawback of cointegration analysis is its extreme sensitivity to tests assumptions like which variables to include, the lag length specification and the deterministic trend specification (Ahking, 2002, Emerson, 1997; Juselius, 2006). For example in the case of Australia, Baghi et al. (2004) do not regard the terms of trade as exogenous in the cointegration test and find cointegration between the exchange rate, the terms of trade and interest differential. This problem is elaborated by Kennedy (2003) who argues that when testing for cointegration, if a relevant variable has been omitted the test should fail to find

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cointegration. In the context of Dungey and Pagan (2009) this may be a problem as they exclude stock market capitalization in their 2009 compared to its 2000 model, however, the trends of GDP and stock market capitalization are likely to be cointegrated.

With their test specifications and model set-up, Dungey and Pagan found evidence for two cointegrating vectors. In this case when the cointegration rank exceeds one, it is not straightforward to interpret the cointegrating vector because any linear combination of these cointegrating vectors is also a cointegrating vector. Therefore the separate behavioral relationships need to be identified by appropriately restricting the individual cointegrating vectors. This is a major challenge associated with cointegration analysis. Greenslade et al. (2002) show that statistical techniques proposed in the literature for identification in cointegrated systems are almost impossible to implement successfully.17 Therefore they recommend a thorough use of economic theory at an early phase by imposing exogeneity restrictions and restricting the dynamic adjustment of the model to increase the power of tests of overidentifying restrictions on the long run cointegrating vectors. Dungey and Pagan (2009) identify the two cointegrating relationships by imposing zero restrictions that are examined by a chi-squared test for binding restrictions.

Kennedy (2003) however also emphasizes that it is important that arguments form the basis for imposing identification restrictions because of the difficulty of interpreting estimates of the cointegrating vectors. If economic theory tells us that tow variables should be cointegrated (for example relative inflation rates and the exchange rate in the case of purchasing power parity theory), then testing for cointegration is used as a test of that theory. In a model with a relatively large set of variables, it is likely that multiple cointegrating relationships arise that are unexplainable. It is therefore not attractive to incorporate cointegrating relationships in a business cycle model with a relatively large set of variables. Meanwhile, the inclusion of fewer variables increases the misspecification of cointegration relationships due to omitted variables problems. The results of Dungey and Pagan (2009) however are quite similar to their earlier work, except from the impact of monetary policy shocks, which seems to be slightly overstated in the old model. However, the models are not completely comparable because of a different set of variables of the unadjusted 2000 model.

3.4 Hybrid DSGE-VAR modelsSome contemporary research combines both the VAR and DSGE approaches resulting into hybrid DSGE-VAR frameworks, as is done for example by Del Negro and Schorfheide (2006) and Lees et al.(2010). This modelling approach however received heavy criticism. Favero (2007) for example argues that the logic of criticism moved to the Cowles Commission approach of the 1970s might apply exactly to DSGE-VAR models. In fact, Favero claims that the DSGE-VAR approach is looser than the Cowles Commission methodology in that restrictions are not imposed and tested but restrictions are made fuzzy by imposing distributions on them. Hence, an arbitrary amount of uncertainty is added to model based restrictions in order to make them compatible not with the data but with a model-derived unrestricted VAR representation of the data.

3.5 Business cycle framework for Morocco: the SVAR methodology Based on the previous discussion on DSGE, SVAR , DSGE-VAR and SVEM models,

17 Like the widely used Johansen (1988, 1991) procedure that forces all cointegrating relationships to be orthogonal to one another. Although mathematically elegant, its economic justification and interpretation is not clear (Kennedy, 2003).

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the SVAR framework is chosen to be the foundation of the business cycle model for Morocco. Advanced techniques for identification are used to overcome traditional shortcomings of VARs like the relative small number of variables that can be included because degrees of freedom are quickly consumed as the number of variables or lags increases. Nonlinear behavior resulting from climate is also incorporated. The specific design of the SVAR model for Morocco is elaborated in Section 4 below.

Although most economists agree that DSGE models are important for understanding economic behavior, they at least require further development regarding the incorporation of price stickiness and financial market frictions (Kocherlakota, 2010). This requires even more data and understanding of microeconomic agents, which is for a less developed country like Morocco unavailable. Moreover, the main critique on DSGE is how they deal –or neglect- market imperfections, and as I elaborated in previous sections of this thesis, the Moroccan economy is characterized by many market imperfections like labor market rigidities, corruption and credit constraints. Although markets are less complex than in developed countries, the many market imperfections and lack of behavioral data and understanding limit the success of the construction of a DSGE model for Morocco. For example, we do not know how agents in Morocco respond to the receipt of remittances, do they increase consumption or investment? What is the motive of the remitter? Are they altruistic motivated and compensate loss of income at home or are they rent-seeking and increase investment during booms? How do Moroccans respond to changes in rainfall? Do they for example anticipated by reducing their livestock during droughts? We do not know. Since DSGE models start from microeconomic principles of constrained decision-making, instead of given observed correlations, they are difficult to construct for Morocco. To return to the critique of Sims on DSGE models, making assumption on microeconomic behavior in Morocco when construction a DSGE model for Morocco likely cannot fulfill the requirements to match in detail the dynamic behavior of accounting constructs and proxy variables that make up the data. A VAR model therefore likely fits better than a DSGE model when applied to real Moroccan data. Incorporating cointegrating relationships is also not an attractive option as discussed above when the number of variables included in the model is relatively large.

To understand the VAR methodology, consider the k-vector times series {Y t } generated by the k-dimensional structural vector autoregressive process with exogenous variables VARX(p), ignoring a constant term for simplicity of exposition.

Γ A (L)Y t=Γ B ( L ) X t+εt (3.1)

where Y t is vector of endogenous variables, Γ A ( L )=A0−∑i=1

p

A i Li denotes polynomials in the

lag operator L of the endogenous variables, X t is a vector of exogenous variables,

Γ B=B0+∑i=1

p

Bi Li denotes polynomials in the lag operator L of the exogenous variables, and

ε t=(ε1 t , …, ε Kt) ' is a k-dimensional white noise or innovation process; with E (ε t )=o , E (εt ε ' t )=∑εand E (ε t ε ' s )=0 for s≠ t. A0 and B0 contain the contemporaneous relationships between the endogenous and exogenous variables. Respectively. A0 takes the form of a non-singular matrix normalized to have ones on the diagonal. The structural disturbances have zero means, have constant variances, and are individually serially uncorrelated. The reduced form associated with this structural VAR model is:

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ΓC(L)Y t=Γ D ( L ) X t+u t (3.2)

where ΓC ( L )=I−∑i=1

p

A i Li denotes polynomials in the lag operator L of the endogenous

variables, X t is a vector of exogenous variables, Γ D=B0+∑i=1

p

Bi Li denotes polynomials in the

lag operator L of the exogenous variables, and ut is a vector of serially uncorrelated reduced form disturbances. The relationships between the structural equations in (1) and the reduced form in (2) are:

ΓC=( A¿¿0)−1 Γ A ( L )=( A¿¿0)−1[A0−∑i=1

p

Ai Li]¿¿ (3.3)

andut=( A ¿¿0)−1 εt ¿ (3.4)

Hence, the reduced form disturbances are composites of the structural disturbances which give rise to an identification problem. The parameters of the primitive or structural model have to be recovered from the estimated reduced form model, which is done by imposing restrictions on the structural form. As long as the parameters in ( A¿¿0)−1 ¿ are not identified, it is impossible to identify the structural disturbances ε t form the reduced form estimates ut. The parameters in the structural from equation and those in reduced form equation are related by

ΓC ( L )=I−(A ¿¿0)−1(∑i=1

p

A i Li−1)¿ (3.5)

andΣu=E (u tu ' t )=( A¿¿0)−1¿¿¿ (3.6)

When the VAR includes k variables, full identification of ( A¿¿0)−1 ¿ requires k 2 restrictions. The covariance matrix Σu which describes the pattern of variances in covariances underlying the disturbance terms, provides 1/2k(k+1) of these constraints. This implicates that we need 1/2k(k-1) for exact identification of the structural parameters. When economic theory leads to more imposed restrictions the model is said to be overidentified.

Restrictions on the matrix ( A¿¿0)−1 ¿ are known as short-term restrictions because they concern constraints on the disturbances. The most popular restriction is to impose a recursive identification method by assuming the existence of a Wold-causal chain; disturbances are orthogonalized by the Choleski decomposition. The Bernanke –Sims procedure allows for types of identification restrictions that permit non-recursive structures. They come in various forms: coefficient (sign) restrictions, variance restrictions and symmetry restrictions. See Enders (2010) for a discussion on the application of each of those types of restrictions. An alternative to short-term restrictions are provided by Blanchard and Quah (1989) who separate temporary and permanent effects of disturbances. More specific, they identify demand and supply shocks by assuming that only the latter has a long-run effect on output. The Blanchard and Quah (1989) decomposition is known as a long-run restriction.

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Occasionally, a combination of short and long-run restrictions is used in order to achieve identification, see for example Galí (1992).

More recently, the Bernanke-Sims identification procedure has been extended by Zha (1996) by imposing a block structure on the VAR to take advantage of the small open economy assumption. Under a block exogeneity procedure, restrictions are imposed on both contemporaneous and lagged relationships. Recursive blocks have the advantage that these blocks can be treated as independent for the purpose of estimation and inference (Zha, 1997). In the case of a small open economy, both a foreign and domestic economy block is defined. Variables in the foreign block are assumed to affect the domestic variables contemporaneously and lagged, but not vice versa. Originally, domestic and foreign variables were simultaneously included in the VAR model, but by restricting the foreign variables to be unaffected by domestic variables, separate blocks in the VAR emerge. This reduces the number of parameters that need to be estimated at the same time. Block exogeneity restrictions are further developed and applied by amongst others Cushman and Zha (1997), Zha (1999), Dungey and Pagan (2000) and Buckle et al. (2007). This thesis follows the four block structure of Buckle et al. (2007) who specify an international economy block, an international trading prices block, a domestic economy block, and a domestic climate block. The exact modeling strategy for Morocco is elaborated in the next section of this thesis.

3.5.1 Impulse response functions and dynamic multipliers The SVAR framework is very useful for examining the response of one variable to an impulse in another variable in a system that involves a number of other variables as well. The moving average representation of the reduced form VAR model (VMA) is useful to trace out the dynamic path of the various shocks on the variables included in the VAR system. Assuming stationarity and using Eq. (3.2), the reduced form VAR can be written as a vector moving average with exogenous variables in that the variables are expressed in terms of current and past values of the reduced form innovations:

Y t=ΓC ( L )−1 [ Γ D ( L ) X t+u t ] (3.7)

A comparison of the moving average representation in Eq. (3.7) with the reduced form in Eq. (3.2) shows that in the autoregressive representation of the reduced form the variables are expressed as a function of past values of the variables, whereas in the moving average representation the variables are expressed as a function of current and past innovations ut. Since we are interested in the effects the structural innovations rewrite Eq. (3.7) using Eq. (3.4):

Y t=ΓC ( L )−1¿ (3.8)

where Θ(L) and Φ (L) contain the dynamic multipliers to trace out the impulse response functions following innovations to the structural error terms and the multipliers functions following innovations to the exogenous variables respectively.

Restrictions are required to identify the impulse response function to prevent that the error terms correlate and shock become uninterpretable as discussed above. It is important to note that impulse response functions and dynamic multipliers have a different interpretation: whereas impulse response functions reflect responses to unanticipated shocks only, dynamic multiplier functions show the responses to both unanticipated an anticipated shocks because they reflect the response of the system to a change in an exogenous variable. This distinction is particularly important concerning the effects of monetary policy: most monetary policy

25

actions are systematic responses of the central bank to the state of the economy and are therefore not unexpected. Impulse response functions focus only on the effects of unexpected shocks, and do not examine anticipated monetary policy.18 In this thesis dynamic multiplier analysis in the spirit of Lütkepohl (2007) is used to examine the effect of exogenous rain shocks (i.e. not determined within the system) on the Moroccan economy. A distinction between unexpected and expected rain shocks does not exist.19 Meanwhile, impulse response function resulting from other shocks in the system are by definition unexpected.

3.5.2 Historical decompositionAlthough the impulse response functions and the dynamic multipliers provide interesting insights into the dynamic adjustment path following a particular shock, they do not quantify the role of the shocks in the business cycle. The historical decomposition tries to answer the question of which shock caused a particular variable to fluctuate According to Dungey and Pagan (2009) the historical decomposition can be derived by simply recognizing that the VARMA form of Eq. (3.8) allows for any variable to be written as a weighted sum of previous shocks plus the effects of an initial condition. Allowing for exogenous variables, the historical decomposition can be derived by using:

y t=initial conditions+∑i=0

t−1

∑j=1

k

θ ijε j ,t−i+∑i=0

t

φix X t (3.9)

where θij is the ith impulse response associated with the jth structural shock, while φ i is the ith dynamic multiplier response associated with an exogenous shock. There are k structural shocks in the system and x exogenous shocks. Ideally, one would plot the historical contribution of the endogenous variables to GDP throughout the sample period and interpret the relative contributions of the different structural shocks. However, not all structural shocks are available at the beginning of the sample period, because of the inclusion of lagged variables. However, for stationary VARs when t becomes large, the contribution of the initial state becomes negligible. One should keep in mind that for t close to the starting point of the decomposition the initial values may have a substantial impact.

18 For a discussion on the difference and similarities between dynamic multipliers and impulse response functions see Stein and Song (2002).19 Because rainfall is exogenous and non autoregressive, rain shocks are not reinforced by the reaction of other variables or lagged values that include the shocks. Hence, a rain shocks will disappear directly after the moment of the shocks, and the rainfall variables does not display any persistence at all in periods after the rain shock occurred. This is in contrast with the other variable which display some kind of impulse response function themselves following their own shock because of the autoregressive process or feedback through other variables. A rain shocks will therefore die away immediately, well other shocks gradually die away.

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4 Model specification

The SVAR model that is developed for Morocco is based on block exogeneity restrictions that follow for the traditional small open economy (SOE) assumption. This section provides the origins of the structure that is impose on the VAR model and highlights the difference and novelties compared to existing similar models. In the second paragraph of this chapter a summary of the individual structural equations is given. The incorporation of exogenous rainfall and threshold effects are clarified in the last paragraph.

4.1 Structure of the VAR modelThe structural VAR model constructed for Morocco is based on the traditional small open economy (SOE) assumption; the small open economy participates in international trade but is small enough in that it does not affect trade prices or other international economic conditions.This SOE assumption can be translated in a block exogeneity procedure as introduced by Cushman and Zha (1997) to examine the effects of monetary policy in Canada. Dungey and Pagan (2000) applied the block exogeneity restrictions of Cushman and Zha (1997) to identify international and domestic shock to the Australian economy in SVAR business cycle model. The work of Dungey and Pagan (2000) is subsequently extended by Buckle et al. (2007) to construct a large business cycle model with block exogeneity restrictions for New Zealand to take advantage of its small open economy characteristics. I follow and extent the methodology of Buckle et al. (2007) by defining a domestic economy block, a foreign economy block, an international trade prices block, and a climate block.

The model developed in this thesis differs from the modeling approach of Buckle et al. (2007) in several ways. First, due to specific country characteristics, each structural equation of the SVAR model developed for Morocco is quite different from the restrictions that are used in the model for the more advanced economy of New Zealand. Both countries follow different exchange rate and monetary policies, while Morocco undergoes a process of economic and financial reform since the early 1990s which continues until today. Morocco is also famous for its large share of migrants living in Europe and therefore it is interesting to include migrant’s remittances in the model.

Second, I include an indicator of international financial stress in the foreign economy block –to reflect Morocco’s increasing linkages with the international (financial) world- instead of an indicator of stock market capitalization that is used by both Buckle et al. (2007) and Dungey and Pagan (2000). The incorporation of international financial stress above international stock market returns has the advantage that it allows for a richer set of dynamics.20 For the viewpoint of contemporary international financial turmoil and an increasingly integrated financial world, the incorporation of financial stress is interesting. The gradually increasing exposure of Morocco to international financial markets makes the

20 For example, international stress affects interest rates, while stock markets merely follow interest rates.

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incorporation of financial stress an interesting feature of the model, particularly because government officials of Morocco claim that the country is insulated from international financial turmoil. As this thesis shows, this consensus is unfounded and financial stress affects the Moroccan business cycle.

Third, rainfall is assumed to be completely exogenous and non-autoregressive (contemporaneous rainfall does not depend on past values of rainfall), in contrast with the soil-moisture variable that Buckle et al. (2007) use as an indicator of climate conditions in New Zealand. Exogenous rainfall implicates the use of dynamic multipliers instead of impulse response functions to examine the effect of a rain shock on the Moroccan economy. Furthermore, the model allows for threshold or nonlinear effects of different rainfall regimes, which is elaborated below.

The fourth major difference with the New Zealand business cycle model of Buckle et al. (2007) and the model developed for Morocco in this thesis is that the Moroccan model is fully identified which is in more in the line of Dungey and Pagan (2000) who use a recursive scheme to identify shocks in the domestic economy block. In the domestic economy block of Buckle et al. (2007) simultaneity exists between the exchange rate, domestic prices, and domestic real asset returns.21 Although simultaneity occurs more often in VAR models, it generates two potential problems. First, shocks may be not correctly identified. Earlier work of Sims (1986) already proposed an alternative to the Choleski decomposition that is consistent with money market equilibrium, which was based on simultaneity between money and interest rates. However, Sims makes a distinction between the money demand and supply functions: the money supply rises as the interest rate increases, while money demand is negatively related to the interest rate. The approach of Buckle et al. (2007) do not make such distinctions and shock to the exchange rate, domestic prices, and domestic real asset returns seem unidentifiable. This is not a problem as long as it is not the objective to examine these shocks, but the variables are merely included to examine the transmission of shocks to other variables. Although Buckle et al. (2007) limit the discussion of impulse response functions to a selection for domestic climate, domestic interest rates, foreign output, foreign interest rates, and world prices for exports and for import, it is unclear that this is based on the recognition of the existence of a potential simultaneity problem. Meanwhile, the historical decomposition of the New Zealand business cycle is in this view more controversial. The authors use the impulse responses associated with the individual shocks to identify the historical importance to the business cycle, including exchange rate, domestic prices and real asset returns shocks, which are not identified because of the simultaneity problem.

Another problem associated with simultaneous VAR modeling as noticed by Leeper et al. (1996) is that statistical inference derived from a posterior simulator becomes challenging. According to Waggoner and Zha (2003) the common method used for simultaneous VAR models relies on the importance sampling technique (Cushman and Zha, 1997; Kim and Roubini, 2000), while this method can be prohibitively inefficient. To overcome this problem caused by simultaneity in VAR models, Waggoner and Zha (2003) develop a Gibbs sampling method in order to obtain accurate statistical inference from the parameter estimates and the impulse responses. Bhuiyan (2008) for example employs this Gibbs sampling method to estimate a VAR model that examines the effects of monetary policy shocks in a small open economy by allowing the monetary policy variable, the market interest rate, and the exchange rate to interact simultaneously. Buckle at al. (2007) do not address this estimation problem associated with simultaneity in VAR models and therefore

21 Identifying one of those shocks, without the need for contemporaneous restrictions, is theoretically possible by including exogenous contemporaneous climate in one of the equations. This boils down to the old-fashioned method of identification in SEMs, see for example Gottschalk (2001). Nevertheless, Buckle et al. (2007) seem not to make use of this possibility.

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their statistical inference from their model may be inaccurate, despite their use of the Broyden-Fletcher-Goldfarb- Shanno (BFGS) algorithm to estimate the contemporaneous matrix.

In the forthcoming part of this section on the modeling strategy, the functional form of each equation is specified. The equations are the result of three types of restrictions on the system. First, block exogeneity restrictions are imposed to define the system as block recursive between the foreign and domestic economic variables. Domestic variables are absent in the international economy or trading prices block, while variables appearing in the international economy and trading prices may appear in the domestic economy block. Rainfall is restricted to be completely exogenous and does not depend on its own lags.

Second, I follow Dungey and Pagan (2000) by imposing a recursive structure on the domestic economy block in contrast with Buckle et al. (2007) in order to avoid simultaneity within the system. Although this is more controversial, a recursive scheme arises almost natural and did not require unrealistic additional assumptions. The motivation and justification for such a scheme is implicitly elaborated during the description of the structural equations.

Third, some additional restrictions on the lagged structure of the system are imposed, resulting in a so-called subset VAR -or near- or asymmetric VAR. Subset VARs therefore allow variables and lag lengths to differ across equations, while in ordinary VARs lag distributions are perfectly symmetric.22 The number of VAR coefficients to be estimated increase in direct proportion of the square number of variables. This implies that many parameters need to be estimated - including many that are statistical insignificant- which consumes many degrees of freedom.23 A subset VAR makes the model more parsimonious by purging the insignificant coefficients from the VAR which reduces the number of coefficient estimates (Enders, 2010). Lütkepohl and Brüggemann (2001) argue that although response patterns from full and subset VARs are qualitatively identical, confidence bands for the unrestricted model are considerably wider. This thesis follows the procedure of Lütkepohl and Brüggemann (2001) to restrict some lags to zero in the Moroccan VAR model. More estimation details of the VAR can be found in Section 6 below.

The idea of estimating asymmetric VARs quickly emerged after the introduction of standard VARs by Sims (Hsiao, 1981; Ahking et al. 1985) and subsequently never disappeared (Benkwitz, Nuemann and Lütkepohl, 2000; Keating, 2000; Benkwitz, Lütkepohl and Wolters, 2001; Siliverstovs and Bilan, 2005; Hsu et al., 2007). Meanwhile, symmetric VARs are more popular in the literature because they are easily estimated; ordinary least squares yields efficient parameter estimates because the specification of all equations in the model is the same. Symmetric VARs avoid computationally extensive and exhaustive search required for lag exclusion. Most statistical packages have built-in functions for the estimation of standard VARs, but do not allow for different lag lengths across equations.

Before turning to a description of the structural equations, it needs to be emphasized that each variable is detrended. The structural VAR model therefore describes behavior away from a deterministic growth path or short term fluctuations. In Section 6 it is shown that the system has stable roots, and temporary shocks therefore die away and the system returns to its long-term growth path. Outcomes of the structural equations that result from the contemporaneous

22 Strictly speaking, a VAR with block structure is a near-VAR because the variables in each equation are asymmetric. When I refer to a near- or subset VAR I refer to an asymmetric lag structure in addition to the imposed block structure.23 The number of parameters to be estimated in the VAR equals k+ pk 2, which requires are relatively large sample size when the number of lags of variables increases.

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and lag restrictions are presented in Table 1 which provides a schematic overview of the structural threshold subset vector autoregressive model with exogenous variables (STVARx). Threshold effects emerge from different rainfall regimes, which are discussed extensively below. In Table 1 rows indicate the dependent variables, while columns reflect the independent variables. Contemporaneous restrictions are indicated by the dark-grey shaded cells, while Roman numerals show the lagged variables that appear in the equations for each dependent variable. The Roman numeral II (III) indicates that two (three) lags of the independent variable appear in the equation, while the subscript a indicates that only lags subsequent to the first lag of that variable appear in the structural equation. IIIa indicates that only the second and third lags of the variable are present in the equation. This restriction and contemporaneous restrictions stem from economic theory and are determined a priori, while restrictions on the maximum lag length of a specific variables -two or three lags - are the result of the estimation strategy of a subset VAR as recommend by Lütkepohl and Brüggemann (2001) and can therefore be seen as ex ante restrictions. Dotted lines in Table 1 distinguish the four blocks.

The foreign economy block includes an indicator of trade-weighted foreign output (y*), international financial stress (f*), foreign prices (π*) and foreign interest rates (i*). International prices for Moroccan imports and exports (pi and pe) constitute the international trading prices block, while export volumes (x), domestic expenditure (d), domestic output (y), domestic prices (π), the real effective exchange rate (e), domestic interests rates (i), domestic financial conditions (q), tourism receipts (t), and migrant’s remittances (r) give shape to the domestic economy block. The domestic climate block includes precipitation or rainfall (p). A description of each individual variable and their sources can be found in the next Section that discusses the data that is used in the model.

The unshaded cells represent the contemporaneous restrictions in the matrix A0 which is part of Γ A ( L )in Equation (3.1). Without the contemporaneous ‘restrictions’ on the effect of the economic variables on exogenous rainfall, we need 105 contemporaneous restrictions on the system for exact identification, while Table 1 contains 168 contemporaneous restrictions or unshaded cells.24 Therefore, the structural VAR model for Morocco is overidentified.

24 Alternatively, by viewing precipitation as a restricted endogenous variable, 120 contemporaneous restrictions are needed for exact identification, against 193 in the specified model.

30

Figure 4.1 Structure of the subset STVARx business cycle model for MoroccoIndependent variable

y* f* π * i* pi pe x d y π e i q t r p

Dep

ende

nt v

aria

ble

y* II III III IIIa

f* II II II

π * II II II

i* II II II II

pi II II II II

pe II II II II

x III II IIIIII

d

d II II II II II IIIII

aIII III III

y II II II II II III III III

π III II II III II III II

e II II II II II II II II II II II II II II II

i II II II II III IIIIII

d

q II II II II II II II II II II II

t III III II II

r II II II II II II II II II II II II

Contemporaneous relationships are indicated by the dark shaded cells; i.e. the unshaded cells represent the contemporaneous restrictions that are imposed on the model. The dotted lines represent the block exogeneity restrictions. II indicates that the first and second lags of the variable are present in the equation; III indicates that all lags of the variable are present in the equation.Subscript notation: a = only the second and third lags of the variable are included in the equation, d indicates that rainfall affects the variable under consideration only under droughts and not in a normal rainfall regime. Variable definitions: y*,foreign output; π * ,foreign prices; f*, international financial stress; i*, foreign interest rates; pi, import prices; pe , export prices; x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates; q, domestic financial conditions; t, tourism receipts; r, remittances; p, rainfall or precipitation

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4.2 Summery of the structural equationsThis section gives a description of each structural equation included in the VAR model as outlined in Figure 4.1. The functional form of the structural equations are consistent with the block exogeneity restrictions and reflect information from economic theory or previous empirical research.

4.2.1 The foreign economy blockMorocco’s increasing exposure to international economic and financial conditions is captured by a foreign economy block that includes trade-weighted foreign output, international financial stress, foreign prices, and foreign interest rates.

Foreign real output (y*) is taken to be dependent on its own lags and lagged values of foreign interest rates, stress on international financial markets, and foreign prices. Higher foreign prices may hinder economic growth by increasing uncertainty about future prices, creating distortions to economic decisions, and redistributing wealth from borrowers to lenders.25 Shocks to both foreign interest rates and financial stress variables do not contemporaneously affect foreign output. It takes some time before changes in financial conditions are translated into the real economy. Capital investment requires planning and contemporaneous investment depends on financial conditions of the (recent) past. The Federal Reserve Bank of the United States for example states that it typically takes six to twelve months before changes in financial variables affect output. This explains why only the second and third lag of foreign interest rates enter the foreign output equation (a similar restriction is used by Dungey and Pagan, 2000).26

Positive (negative) innovations in foreign interest rates and financial stress are expected to hamper (foster) foreign output, as predicted by the monetarist school of thought (Friedman, 1956). While the negative effect of increased financial stress on output is unambiguous, dynamic business cycle models often fail to disclose an adverse effect of interest rate innovations on output (e.g. King and Watson, 1996). Many models fail to display a negative leading role of interest rates for future real economic activity, the so-called ‘interest rate – output puzzle’ Without the inclusion of foreign prices – the approach of both Dungey and Pagan (2000) and Buckle et al. (2007) in order to increase model estimation efficiency – I also encounter an interest rate output-puzzle. Many solutions for this puzzle are proposed in the literature; separating technology and monetary shocks because they influence the correlation between output and interest rates in opposing ways (Mertens, 2010), including habit preference and frictions to capital accumulation and factor immobility (Beaudry and 25 For example prices may create distortions to behavior of agents because tax payments are often not indexed to inflation.26Adjustable mortgage rates and credit card interest rates based on Libor makes transmission from financial variables to the real economy less sticky, suggest that the first interest rate lag may be included in the domestic output equation. However, contemporaneous and first lagged effects of the foreign interest rate on output are statically insignificant.

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Guay, 1996; Boldrin et al., 2001), or account for liquidity traps (Krugman, 1998). In the foreign economy block constructed in this thesis the inclusion of foreign prices was enough to overcome the positive effect of changes in interest rates on output.27

International financial stress (f*) is modeled on its own lags as well as lagged values of foreign interest rates and prices. Financial stress reflects interruptions to the normal functioning of international financial markets and emerges from drastic and unforeseen events like terrorists’ attacks, earthquakes, loss of confidence or unexpected changes in economic outlooks. Financial stress is therefore a forward looking indicator and does not depend on contemporaneous or lagged vales of economic growth.

Unexpected increases in the interbank rate –potential caused by increased international financial stress- may result in increased interbank stress, which feeds back into the international financial stress index. The interbank rate therefore is assumed to have lagged effects on international stress, while the interbank rate is contemporaneously affected by foreign stress.

Foreign price shocks may result in financial stress when it increases uncertainty in the economy and financial markets. Meanwhile, prices often follow stress rather than being its cause. Financial stress induces economic agents to change prices; increased stress implicates lower future economic activity and therefore lower prices. An exception is the case when stress is induced by oil price shocks which both tend to increase stress and consumer prices, but consumer prices nevertheless have some degree of stickiness compared to the financial stress index.

Foreign prices (π *) are therefore contemporaneously affected by financial stress, as stress proceeds prices. Other contemporaneous and lagged changes in foreign prices stem from output shocks. The contemporaneous effect of both variables is however expected to be limited by a certain amount of price stickiness.

Foreign nominal interest rates (i*) are determined by contemporaneous and lagged values of foreign output, international financial stress, and foreign prices. Foreign interest rates follow therefore a simple Taylor rule – although adjusted for financial stress. Under severe conditions of stress it is possible that the interbank rate moves independently of the key rate of the central bank. The overnight rate is pushed up by increased default risk in the interbank market. The interbank rate will follow the key rate that corresponds to the ordinary Taylor rule only when financial markets stabilize. The interest rate increases (decreases) in response to deviations of output and inflation above (below) target or long-run values. Model estimates of the coefficients are consistent with a Taylor rule. This is contrast with the SVAR models of Dungey and Pagan (2000) and Buckle et al. (2007) which also incorporates a foreign economy block, but do not include a measure of foreign prices as discussed above. As a consequence, the reaction function of the central bank is likely to be misspecified when the central bank follows a Taylor rule. As noted by Dungey and Pagan (2000) including foreign inflation is not attractive as SVAR literature augment the Taylor rule for the forward looking central bank with some measure of commodity price inflation which is used as predictor of future inflation. Adding extra variables to the system to account for such forward-looking effects is according to Dungey and Pagan not an attractive option from the perspective of model efficiency. Unlike Dungey and Pagan, I include financial stress

27 The loss of efficiency of an additional variable in the form of foreign prices is in the model for Morocco implicitly compensated by the specification of a subset VAR, while Dungey and Pagan (2000) and Buckle et al. (2007) do not place restrictions on specific lags resulting in excessive estimation of parameters that are insignificant.

33

rather than stock market capitalization as an indicator for international financial conditions. This has not only the advantage of better capturing financial turmoil - stock markets are only one potential source of stress, see the Data section, for example it does not capture sovereign debt risks directly-, but it is also a future looking indicator of future economic activity and prices.

In other words financial stress replaces Sims’ commodity prices as an forward looking indicator. When the financial stress index increases, growth and inflation will decrease and the index can therefore be seen as a forward looking indicator of inflation (Hakkio and Keeton, 2009). Foreign stress may therefore replace the role of commodity prices as a predictor of future inflation in the Taylor rule. Hence, no additional variables are needed to prevent liquidity puzzles to occur. In addition, the inclusion of foreign prices is also essential for other domestic variables like the real exchange rate, domestic prices and remittances. Hence, the foreign equation is likely not the only equation in the models of Dungey and Pagan (2000) and Buckle et al. (2007) to be misspecified as a result of the omission of foreign prices.

A dummy is included in the foreign policy equation to capture the European Exchange Rate Mechanism (ERM) crisis of 1992, because the international financial stress variable does not capture the ERM completely as it was merely an European affair. This crisis surged the interest rate to repel speculative attacks on the currencies of some countries in the ERM, although to no avail.

4.2.2 International trading prices blockThe set-up of the international trading prices block is similar to Buckle et al. (2007) for New Zealand and is based on a three-goods model of the dependent economy which makes a distinction between import, exports and non-traded goods. Like New Zealand, Morocco is a price taker in international trade and therefore export and import prices are only determined by international conditions. Nevertheless, Morocco has as the biggest producer of phosphate in the world some pricing power regarding this commodity, but the phosphate is not consumed at home and economic conditions as included in this model do on do affect the price of phosphate. Morocco merely adjust its supply of phosphate rather than its price.

Furthermore, Morocco is a structural net importer with intermediate goods that are used in the production process and cereals making up a larger share of total imports.28 Goods that are exported are typically not consumed domestically, like inorganic chemicals, precious metal compound, and isotopes.29 Lahcen (2007) distinguishes a traditional Moroccan agricultural sector used for domestic consumption, from the more modern sector existing of irrigated crops like vegetables and fruit trees.

The three-goods assumption has two implications: first, rising import prices may have a stagflationary effect on Morocco’s economy by increasing consumer and producer prices while decreasing internal demand and output. This import price effect is limited to some extent because Morocco actively imposes import subsidies. Import prices are also one of the priorities of Morocco’s central bank. Second, rising export prices will increase real incomes and output with little effect on domestic inflation as export goods make up only a small proportion of domestic consumption.30 As Buckle et al. (2007) argue these features likely 28 Top five import categories for Morocco according to the WTO representing over 50% of total exports: 1) Boilers and machinery, 2) Electrical and electronic equipment, 3) Vehicles other than railway, 4) Mineral fuel and oils, and 5) Cereals. 29 Top five export categories for Morocco according the WTO representing over 60% of total exports: 1) Inorganic chemicals, precious metal compound, and isotopes, 2) Salt, sulphur, earth, stone, plaster, lime, and cement, 3) Articles of apparel and accessories, 4) Electrical and electronic equipment, and 5) Fertilizers. 30 Second round effects may exist when higher wages in the export sector spill over to the rest of the economy.

34

result in asymmetric behavior of export and import price shocks, which should therefore both be included in the model rather than a single measure of the terms of trade.

In the structural VAR model for Morocco, export and import prices (pe and pi) depend on their previous values, and on contemporaneous and lagged values of foreign trade weighted output, foreign prices, and international financial stress. This is consistent with the assumption that Morocco is a price taker on international markets.31 Foreign consumer prices on European markets probably partly determine the export and import prices Morocco faces as a large part of the imported goods from Europe are also consumed by Europeans. Similar, some of Morocco’s exports like textile faces strong competition and depend on the general price level in Europe. Meanwhile, European inflation is expected to affect export prices to a lesser extent compared to import prices as most of Moroccan imports come from Europe, while exports like phosphate are determined regardless of the European price less because production occurs outside Europe.

The impact of international stress on international import and export prices that Morocco faces is ambiguous. Since Morocco’s imports mainly consist of commodities like petroleum, increased international stress is expected to decrease import prices based on the argument that increased stress reflects deteriorating future economic conditions which is anticipated by decreasing world commodity prices. An exception to this line of reasoning is the case when financial stress is caused by an oil crisis which is expected to both increase stress and import prices for Morocco. Meanwhile, increased international stress may also increase import prices contemporaneously when investors shift away from risky assets to safer commodities. Owing to low or negative correlations with other asset classes and hedging properties, commodities have attracted increasing financial interest in recent years (IMF, 2008). Since an important part of Morocco’s overall export price is based on the price for phosphate, it is not unthinkable that export prices contemporary rise because of hedging properties. Subsequently, export prices will decrease when international income is affected by increased financial stress.32

A dummy in the import price equation for the year 2000 is included to account for the European Union – Morocco Free Trade Agreement which came into effect in March of that year and gradually phased out all import duties or equivalent charges on industrial goods. In March 2000 machinery import tariffs were completely liberalized. This agreement also removed important export barriers that resulted into artificially low export prices for Moroccan goods. Effects of the ERM crisis are also included in the third quarter of 1992, as well as changes in import prices in 1998 resulting from Morocco’s accession to the WTO. Dummies in the export price equation are introduced to capture Morocco’s entrance as a member of the WTO in 1998, the Multifibre Agreement of 2005, the Middle East Crisis of 1990, border peace agreements and conflicts with Algeria in 1991 and 1994 respectively, and the reduction of phosphate exports in the last quarter of 2008 from China, another major 31 Although European inflation is determined by import and export prices it faces, the zero restrictions of export and import prices in the foreign price level equations are imposed because our export and import prices are the ones Morocco faces. It is unlikely that the trade prices Morocco face affect European consumer prices, given the relatively modest size of its economy and tradeable sector in comparison to Europe. Granger causality test clearly confirm this hypothesis. 32 I adjust for the exceptional situation of 2008 and its preamble. The ‘unexpected’ fall of Lehman Brothers on September 15, 2008 initiated tremendous financial panic at the end of the third quarter of 2008. As a consequence, the panic index exploded during the last two weeks of the third quarter of 2008 resulting in an high overall panic index for 2008Q3. Although commodity prices immediately decreased sharp at the end September 2008, this effect is only captured by the export price index in 2008Q4 while 2008Q3 still reflect an increase compared to Q2. Hence a spurious positive relationship emerged between financial stress and commodities in these quarters, while this relationship was negative during this period. This accounting discrepancy is captured by an interactive dummy variable for the second half of 2008.

35

exporter of phosphate. The Multifibre Agreement that went into force in January 2005, exposing Moroccan textile and clothing exports to direct competition with low-cost producers in Eastern Europe and East Asia by ending export quotas, Moroccan textile exports quantities and prices dropped sharply (Walkenhorst and Malouche, 2006).33 The Middle East Crisis in the second half of 1990 also decreased export volumes and prices, see Nsouli et al. (1995).

4.2.3 The domestic economy blockThe domestic economy block contains the domestic reactions to exogenous foreign and rain shocks, as well as the sources of domestic shocks that arise from innovations to monetary policy, the real effective exchange rate, internal demand, domestic financial conditions, merchandise goods export volumes, migrant’s remittances, and tourism receipts. In line with Buckle et al. (2007) there are two main components in our domestic economy block. Five variables represent aggregate real domestic output and aggregate real demand for domestic output: gross domestic product (y), gross domestic demand (d), export volume (x), tourism receipts (t), and migrant’s remittances (r). Prices and financial conditions are presented by the real effective exchange rate (e), domestic interest rates (i), financial market conditions (q), and consumer prices (π). Because GNE includes expenditure on imports, while GDP excludes imports but includes exports, both variables are expected to react different to various shocks like real effective exchange or rainfall innovations. As Dungey and Pagan (2000) notice, whenever both log GDP and GNE are present in the same equation, the two variables are equivalent to log GDP and the balance of trade to GDP ratio. Shocks to the balance of trade are therefore also implicitly captured. This section summarizes the structural equations that make up the domestic economy block.

4.2.3.1 Export volumeThe volume of export (x) is affected by lagged shocks to world prices for Moroccan exports and the real effective exchange rate. According to the small open economy assumption it is is assumed that there exist infinitely elastic demand for Moroccan exports on international markets. Infinitely elastic demand results from the fact that Morocco does not have market power in international markets. In other words, there exist no effective demand constraint and exports therefore determined by supply. Morocco can sell as many tradable goods as it wants at a given world price. Eventually, quantities can be adjusted to this given price for tradables. International stress and foreign output affect the volume of exports through their effect on international prices that Morocco faces for its tradables. Precipitation shocks affect export volumes under drought conditions, but not when rainfall are relatively modest. The distinction between normal rainfall regimes and drought regimes is explained in the next section that discusses the domestic climate block.

The reason that Moroccan exports are not affected by rainfall deviations under normal conditions is that although the export sector uses a lot of water, it is assigned a water priority status by the government. Irrigated agricultural exports and mining activities (phosphate) are examples of water intensive export sectors that have a priority status. Priority sectors are only affected during droughts. In 2000 for example, a severe drought in Morocco prompted authorities to restrict irrigation activities. In addition, because a large share of exports is not directly affected by rainfall (in contrast with rain fed agriculture), those sectors are only affected by secondary effects of rainfall due to water scarcity which unable producers to

33 Although such an agreement results in structural changes in Morocco’s trade pattern, which is captured by the trend, there is also a shock effect when a policy change comes in effect.

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operate at full capacity. It is only under severe drought conditions that Moroccan authorities restrict irrigation in order to guarantee access to drinking water (Ameziane et al., 2007). Rainfall affects exports only when a drought occurs because less severe fluctuations are absorbed by irrigation and other available water balances. Available water buffers also explain the contemporaneous restriction on rainfall in the export equation.

Export prices in foreign currency reflect the degree of substitutability between international export goods, while the exchange rate affect the domestic prices of all export goods. Faini (1994) shows that export prices were a significant determinant of exports in Morocco during the 1980s, although the contribution of relative prices to export growth appears is modest. The contemporaneous restrictions on the world export price, the real effective exchange rate and foreign output is justified by Smith (2004) who argues that in the short-run, psychical constraints and pre-arranged contractual obligations affect the ability of exporters to respond to price or demand changes. For example in the case of agricultural exports, time of seeding and climate conditions make agricultural exports relatively inelastic in the short-run to price changes. Export supply may become less sticky when there is some degree of substitutability between domestic and export markets, and between the export goods themselves, explaining the choice of a lag of only one quarter.

A dummy variable is included to account for several positive outliers in the volume of exports. The sudden surge of exports in September 1991 to Algeria is explained by the UN Peace Plan for Self-Determination of the People of the Western Sahara (Malouche and Walkenhorst, 2006). Other outliers are caused by the announcement of the Moroccan Foreign Trade Law that came into effect on 1 January 1994 and reached an advanced status in 2008. The 1996 announced free trade agreement with the EU that came into effect in 2000 and the free trade agreement with the U.S. announced in April 2002 that went into force in 2006 also resulted in abrupt changes in the volume of exports. In 2008 exports surged because China, the country with the largest phosphorus reserves after Morocco, eliminated exports in response to rising food prices partly caused by rising phosphate-based fertilizer costs. In the second half of 2010 export volumes of phosphate surged in response to a global commodity boom ascribed to the second round of quantitative easing (QE2) by the FED. I also include a dummy for these events.

Another dummy variable is included to take account of sudden drops in export volumes resulting from the following events. The announcement of the Moroccan Foreign Trade Law announced in 1992, resulted in a temporary decline in exports before the law went into force on 1 January 1994. Exports also declined because of the 2005 Multifibre Agreement –see the description of the export price equation- and the closure of the border between Morocco and Algeria in August 1994 following a terrorists’ attack on a hotel in Marrakech that was ascribed to Islamist militants of Algerian origin, resulting in an immediate ban on exports to Algeria.34

4.2.3.2 Gross national expenditureGross national expenditure (d) is interpreted as a measure of aggregate demand, and is contemporaneously affected by international trade prices and rainfall. Domestic output, prices, interest rates, financial conditions, exchange rates, and migrant’s remittances impact demand after one-quarter lag.35 International import and export prices reflect terms of trade

34 Before the Multifibre Agreement Textiles and clothing account for about 34% of merchandise exports.35 Tourism receipts are viewed as income earned by Moroccans and therefore affect domestic demand indirectly. Expenditures on local markets of tourists are included in tourist receipts, but are formally spoken exports of services and therefore affect GDP directly, but not GNE.

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effects of Morocco’s purchasing power and affect the composition of domestic demand. Other foreign variables are assumed to affect domestic demand implicitly by their effect on other domestic variables.

The a priori expected effect of export and import price shocks on domestic demand is ambiguous. On the one hand, a negative import price shock improves the terms of trade, ceteris paribus, which implies that Morocco can buy more imports for any level of exports. On the other hand a rise of import prices reduces the quantity of import demand, but also requires more spending on the quantity of goods imported. The overall effect of import prices on domestic demand therefore depends on the price elasticity of import demand. Because most of Moroccan imports are highly inelastic products like oil and food which have no substitutes, higher international prices for imports is likely to increase rather than to decrease real expenditure. An increase in the world prices for Moroccan exports improves its terms of trade, enabling more imports. However, Morocco’s terms of trade is only for a small part determined by export prices; tourism receipts and remittances are used to finance imports. Export prices may affect domestic prices when they are also consumed at home. In this case, higher export prices fuel domestic inflation. Most of the exported goods are however not consumed at home, as elaborated earlier, and the goods that are both exported and consumed at home can be considered as ‘luxury’ and are characterized by a high degree of substitutability. The direct effect of higher export prices is therefore expected to lower domestic expenditure because of shifting to cheaper goods or simply a reduction of consumption of those goods. Indirect income effects of higher export prices are captured by the inclusion of domestic output in the expenditure equation.

Lagged income and relative effects on domestic expenditure arise from changes in domestic output, consumer prices, the exchange rate, financial conditions, remittance inflows, and the interest rate. Domestic demand is only affected by interest rates after a delay of two periods, consistent with the general view that interest changes do not affect within half a year (Friedman, 1959). As noticed earlier, because both log GDP and GNE are present in the same equation for GNE with symmetric lags –in contrast with the output equation where GNE has a contemporaneous effect on GDP but includes GDP values on the right-hand side are lagged- , the two variables are equivalent to log GDP and the balance of trade to GDP ratio.36 Spending effects resulting from shocks to tourism receipts and export volumes are indirectly captured by their effect on domestic income.

The direct effect of the exchange rate on domestic expenditure is to decrease the price of imports, stimulating expenditure. However, the exchange rare shock also makes Moroccan exports less competitive leading to reduced income from exports and expenditure will fall. The international variables impact domestic expenditure indirectly by their effect on domestic output and relative prices. The interbank rate is expected to be negatively related to domestic (investment) demand. However, because of possible asymmetric bank pricing under the presence of excess reserves this effect may be seriously weakened. As we well see below when the financial conditions equation is discussed, financial conditions may even ease in this case of an interbank rate increase.

Rainfall shocks not only affect domestic spending because of the income effects they generate –which are implicitly captured by their effect on output - but also from anticipation effects of both consumers as well as the government. Lybbert et al. (2009) examine the response of households to drought risk in Morocco. They found that the most common

36 LnGNE−lnGDP=ln ¿¿. Hence, the negative sign of Y in the GNE equation is the result from both including Y and GNE on the right-hand side of the equation. If Y was concluded on its own, the sign is expected to be positive.

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drought responses in Morocco are drawing down stores of agricultural products, selling sheep and cattle, beginning or increasing off-farm work, and increasing informal loans. The Moroccan government pursues a structurally oriented short-term reactive relief program when the risk of drought increases (Amaziane et al., 2007). Funds are available to prevent and compensate the destructive consequences of rainfall deficits in order to solve problems associated with drinking water, livestock protection, jobs creation and agricultural credit relief. Amaziane et al. (2007) characterize this as a crisis-management oriented approach with very high costs in terms of public money investment, time, and human resource needs. During the 1999 drought year, the authors claim that a total of 3.18 billion MDH was allocated to the national drought relief program, which corresponds with 1% of GDP of that year. Stoppa and Hess (2003) notice that in 1999, in addition to the national drought relief program, another 6.5 billion (2% of GDP) was spent to protect livestock and forest, and to provide water for villages and herds in drought-stricken areas. The government has also incurred significant fiscal costs in its support of Morocco’s agricultural bank CNCA and other agricultural lending facilities. Overall, the drought of 1999 led to a rise in Moroccan government’s fiscal cost of at least 3% of GDP.37

Because rainfall affects the domestic wheat production, the government adjusts imports in order to compensate changes in domestic production. For example, the drought of 1999-2000 compelled Morocco to import more than twice as much wheat than in normal years. Similarly, imports of food decrease significantly when rainfall is abundant. This was for example the case in 2003-2004 when imports fell by 11.4% because of favorable climate conditions (Abidar and Laytimi, 2005). Since domestic production is part of GDP, while imports are part of GNE, rainfall fluctuations alter the gap between GNE and GDP.

A dummy variable is included in the demand equation to account for value added tax reforms in 2005 which significantly increased demand at moment of impact, see Cruce (2011).

4.2.3.3 Domestic outputDomestic output (y) is assumed to be contemporaneously determined by domestic expenditure, which implicates that demand precedes supply.38 Foreign stress, interest rates and output do not have a direct impact on Moroccan output. One may argue that lagged foreign output has a direct impact on Moroccan GDP because of the possibility of spillover effects from world productivity shocks, as suggested by Buckle et al. (2007). Meanwhile, these effects likely affect long-term trends while the focus of this thesis is on fluctuations around the long-term trend. Sensitivity analysis justifies the lagged and contemporaneous restrictions on the domestic variables in the domestic output equation. The effect of foreign GDP is indirectly captured by changes in tourism receipts and export volume.

Shocks to import and export prices, the exchange rate, and tourism receipts have a direct effect on domestic output, although not contemporaneously. The output effects of exchange rate movements other than changes in export volumes or tourism receipts are subject to a time lag as they concern output changes induced by changes in the relative price of intermediate goods that are imported. Physical constraints (such as inputs of capital and labor) and pre-arranged contractual obligations limit the reaction speed of suppliers to cost changes. The effect of exchange rate shocks on output is ambiguous; the exchange rate 37 Morocco’s fiscal position is relatively good at 51% of GDP in 2010 (IMF). Its cumulative probability of default is with 8.5% lower than for example of France’s 9.2% (CMA, 2010). Hence, a drought is unlikely to trigger a sovereign debt crisis in Morocco. Nevertheless, in the line of the huge costs associated with drought relief, the inclusion of debt dynamics is interesting in the VAR model, but data is not available for the sample period. 38 In contrast with the much criticized Keynesian formulation of Say’s Law that supply creates its own demand.

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lowers the cost of intermediate imports which stimulates growth, but at the same time decreases the competiveness of Morocco’s export and tourist sectors.

The contemporaneous restriction on the effect of tourism receipts on domestic output originates from the literature that examines the tourism-led growth hypothesis but fails to find evidence for it. In contrast, short-run output causes tourism receipts while in the long-run tourism receipts Granger-cause output (Prasad and Narayan, 2003; Yildirim and Öcal, 2004; Oh, 2005; Lee and Chang, 2008). Tourism enhances economic growth in the long-run, but not in the short-run. Tourism receipts bring in foreign exchange which can be used to finance import of intermediate goods, stimulating economic growth. In the short-run higher economic activity implies more business trips and hotel bookings. Moreover, the contemporaneous restriction on tourism receipts also follows implicitly from the assumption that the exchange rate is a major determinant of tourism receipts, which requires that tourism receipts is placed below the exchange rate in the system – while the exchange rate is already placed in the lowest region in our scheme as most of the variable in the system contemporaneously affect the exchange rate. Although this restriction is the most contentious from a theoretical perspective, it is explainable form the literature as discussed above and confirmed by sensitivity analysis.39 Moreover, such choices are made with all models and unavoidable, as expressed by Dungey and Pagan (2000).

Precipitation shocks are assumed to affect domestic output after one quarter by their impact on rainfed agricultural production, water balances available for industrial usage, and hydropower electricity. See for a more detailed description of the several channels through which rainfall affects the Moroccan economy Section 2 of this thesis. The contemporaneous restriction on the effects of rainfall on output stems from delayed effect of rainfall on harvest, and the existence of water balances that act as a buffer. Nevertheless, because rainfall is the principal source for replenishment of water balances, rainfall eventually have affects economic activity. Furthermore, contemporaneous effects of rainfall on the economy are indirectly captured by anticipation effects that are included in the expenditure equation.

The effect of a negative rain shocks during a drought period on economic activity is unclear a priori as it initially may increase output because of for example increased slaughter rates. For example, Hazell et al. (2001) refer to the extreme drought of 1945 in Morocco to underpin this line of reasoning: at that time 25% of cattle and 39% of sheep either died or were sold prematurely on a glutted market in Morocco. Under more recent drought, similar behavior was observed although not that strong.

4.2.3.4 Domestic pricesContemporaneous shocks to domestic prices (π) arise from foreign inflation, export and import prices, domestic demand, and rainfall. Remittances and tourist receipts impact inflation indirectly through their impact on domestic demand.

According to Dropsey and Grand (2008) the growth rate of money supply is significantly affecting inflation in Morocco. Benbouziane and Abdelhak (2004) also find unidirectional causation from money to prices in Morocco, which is in line with the monetarists’ view that money precedes and causes inflation. I allow for the upward pressure of additional money supply by the inclusion of financial conditions which include a measure

39 Bivariate ordinary least squares regression between output and tourism receipts, causality analysis, and Wald lag exclusion tests do also not display any signs of a contemporaneous effect of tourism receipts on domestic output. More important, the subset restriction procedure by Lütkepohl and Brüggemann (2001) -elaborated in the Estimation and Robustness Section of this thesis- also resulted in no contemporaneous effect of tourism on output/ growth.

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of broad money. The quantity theory of money predicts that given an unchanged income velocity of money, inflation is strongly influenced by monetary growth. The direct channel through which money affects prices is according quantity theorists via a priory effects on demand for goods. Money is only held for transactional purposes and agents want to hold a constant quantity of real cash at the full equilibrium level of the economy. An increase in the money supply will raise real cash balances above the desired level, thereby prompting them to get rid of the excess via additional spending. I take account of the indirect effect of money growth (as part of domestic financial conditions and interest rates) on domestic demand. The inclusion of GNE in the domestic price equation captures that indirect channel of money supply on prices by their effect of interest rates and subsequently spending.

As noted by Buckle et al. (2007) shocks to the domestic price equation cannot simply be interpreted as supply or productivity shocks, because prices are contemporaneously affected by mark-up pricing over costs, foreign prices of tradable and non-tradable goods, and expectations on future prices. Following Buckle et al. (2007) the production costs of firms are determined by prices of imported intermediate costs, labour costs and productivity. The domestic price equation therefore implicitly captures murk-up on cost-pricing by domestic firms. A Phillips curve relates wage inflation to demand pressure (GNE) and expected inflation. Expected inflation is assumed to be affected by a combination of current and lagged price inflation and rainfall.

The exchange rate determines the domestic currency price of imports. A short-run restriction on the contemporaneous effect of the exchange rate on domestic prices is imposed. This is in line with the model structure of Dungey and Pagan (2000) and the finding of McCarthy (2000) who shows that in the U.S. exchange rate has a modest effect on domestic price inflation while import prices have a much stronger effect. Moroccan data reveals a similar pattern. A possible explanation for the contemporaneous restriction on the exchange rate is offered by the Sveriges Riksbank (2004) who suggests that the importer that wants stable developments in the consumer prices of their goods may discard exchange rate changes that are perceived to be temporary. This seems to be plausible for Morocco where exchange rate movements are relatively small because of interventions by the central bank to maintain the fixed regime. However, when their exists some pass-through, positive (negative) exchange rate innovations are expected to decrease (increase) domestic prices by their effect on the prices of import goods. Feinberg (2000) shows that the real exchange rate has a negative effect on domestic prices in Morocco, while the pass-through is less then complete. Furthermore, although that it is expected that exchange rate pass-through increases as the cost-share of imported inputs increases, this is not the case in Morocco. Feinberg suggest that barriers to entry into domestic markets hinder the competitive influence of trade liberalization.

Export prices feed into domestic inflation as some tradable goods are also consumed at home, while in a later stage higher export price may affect earnings in that sector leading to wage changes that spillover to the nontradeable sector – although this is effect is likely to be captured by a long-term trend.

The foreign rate of inflation is included to capture alternative channels for the international transmission of inflation besides trade prices. Darby and Lothian (1983) for example argue that changes in the expected foreign inflation rate may affect the demand for domestic money through a currency substitution channel. Ciccarelli and Mojon (2010) show that in industrialized countries inflation is a global phenomenon. This may be caused by international pressure among or on top of monetary authorities, co-movement in international business cycles which imply through Phillips curve effects co-movement of national inflation

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rates as well. Industrial production, nominal wages, short-term interest rates, long-term interest rates, the Yield curve, and nominal and real money supply therefore may tie domestic to foreign inflation rates. These effects are implicitly captured by the inclusion of foreign interest rates in the domestic price equation for Morocco. Finally, and probably more relevant to Morocco as a country with a pegged exchange rate, Ciccarelli and Mojon (2010) argue that fiscal expansion of the country whose currency is the anchor of the exchange rate system can be expected to have inflationary effect throughout the countries that adopted the peg. More generally, macroeconomic theory suggest that inflation rates are being equalized under fixed exchange rates with the reserve currency causing inflation in the participating country.40 Floating exchange rates in contrast may keep domestic inflation rates isolated from the rest of the world.

Rainfall shocks alter inflation expectations –a major determinant of current inflation-, but it is a priori unclear in which direction. On the one hand, rainfall shocks implicate supply shocks by their effect on agricultural production in the near future, which has its impact on domestic prices when demand is not changed in response -as predicted by a traditional dynamic aggregate demand and supply framework, see for example Gärtner (2009). On the other hand, the same supply shocks are also income shocks to farmers. Rain shortages reduce the domestic supply of food, thereby increasing required imports, resulting in possible changes in the domestic prices level. The net effect of rainfall on domestic prices depends on the relative strength of these forces. Although food has a 40% weight in Morocco’s CPI, the effect of rainfall on domestic prices is limited by active government intervention (subsidies, tariffs, direct price controls) because rising food prices cause great public outcry and potential food riots. Food prices in Morocco are therefore expected to be relatively sticky, especially during droughts. Hence, price pressure on non-food goods caused by changed income of farmers, is likely to be a more important channel through which rainfall affect domestic prices. When rainfall is (un)favorable prices are therefore expected to rise (fall) because the income effect outweighs the supply effect.

The effect of rainfall on domestic prices during droughts is unclear; the drop in farmers’ income may be strong enough to offset the increase in prices generated by the negative supply shock. The government has a priority on stabilizing prices (subsidies program starts), a less on compensating farmers their loss in income. Hence, income effect is expected to offset the supply effect when a drought occurs. To summarize, under normal conditions, the first effect is expected to dominate, while during droughts the loss in income is expected to be strong enough to offset the price increase, the more becomes of subsides programs to offset sharp price increases during droughts.

Dummy variables in the domestic prices equation are included to take care of outliers caused by value added tax reforms in 2005 (Cruce, 2011), the European Union- Morocco Free trade Agreement which came into effect in March 2000 and gradually phased out all import duties or equivalent charges on industrial goods, the introduction of housing subsidies in 1995 (Le Blanc, 2005), the implementation of a drought relief program in the second-half of 1992 to reduce prices (Eur, 2002), and a devaluation of the MHD in May 1990 increasing import prices in domestic currency (Nsouli et al., 1995).

4.2.3.5 The exchange rate

40 Under standard purchasing power parity (PPP) theory, higher foreign prices increase domestic prices when the exchange rate is fixed. See the next paragraph on the exchange rate equation.

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The real effective exchange rate (e) (REER) equation allows for several theories of exchange rate fluctuations. Because of Morocco’s fixed exchange rate regime, these fluctuations are however limited within margins of +/- 3 percent by the central bank in order to maintain its conventional real fix peg arrangement against an undisclosed basket of foreign currencies (El-Achkar and Shahin, 2008). Morocco is targeting the REER rather than the nominal rate in order to maintain competitiveness and avoid currency overvaluation while opening their markets to international capital flows (Dropsy and Grand, 2008). As discussed in Section 2, there is no evidence that the long-run value of the Dirham is misaligned during the sample period used to estimate the model. Because I focus on deviations from a long-run trend, the trend is interpreted as the REER anchor as set by the central bank, while fluctuations upon 3 percent around this trend are determined by market forces as specified in the this structural equation for exchange rate determination.

Two main sources of fluctuations of the REER are the financial market view in which the exchange rate adjusts instantaneously to any change in current financial market condition, while the prices of goods are sticky, making it possible for the exchange rate in the short run to overshoots its new long run value (Dornbush, 1976), and the real economy view where real shocks to for example government spending, labor supply, or productivity result in REER fluctuations. The work of Drine and Rault (2004) is one of the rare attempts to investigate the sources of real exchange rate fluctuations in Morocco (1979.1 to 1998.1) and shows that real shock are a more predominant source than nominal shocks. Their work includes four variables: the foreign interest rate, domestic output, and domestic prices, but provides some primarily directions on exchange rate determination in Morocco.41 Demand shocks account for 94% of REER fluctuations in Morocco, while the contribution of nominal shocks is very low with a share not exceeding 4%. Supply shocks are insignificant in explaining REER behavior in Morocco. Because I include additional variables in the constructed business cycle model, more sources of REER movements in Morocco are possible compared to Drine and Rault (2004). The exchange rate equation constructed in the business cycle model for Morocco therefore includes various theories of exchange rate determination, including purchasing power parity (PPP) which is based on the law of one price. Without trade barriers and transaction costs, homogenous goods will have the same price in different markets when expressed in the same currency. Alternatively, the difference between domestic and foreign prices is equal to the percentage depreciation or appreciation of the exchange rate. When PPP exactly holds, the real exchange rate is equal to the nominal exchange rate adjusted for the differences in price levels between countries. However, PPP does often not hold and in the literature and various explanations are offered, including the famous Balassa-Samuelson theorem (Balassa, 1964; Samuelson, 1964) which states that price differentials between countries depend on inter-country differences in the relative productivity of the tradable and nontradeable sectors. See for an application of the Balassa-Samuelson effect in relationship with Morocco’s structural reforms Eken et al. (2005). The literature on real exchange rate determination often includes work that finds a so-called PPP puzzle (e.g. Taylor et al. 2001): exchange rates often take a long time to converge to the exchange rate predicted by PPP (with estimated half –lives between three to five years), while exchange rates are observed to be very volatile – i.e. they are not sticky in the short run but change very quickly in the short run.42 Furthermore, Sarno and Taylor (1998) found no evidence that the long-run 41 However, the REER includes a structural break in the early 1990s, which is not taken care of, making the results of Drine and Renault (2004) less convincing. Meanwhile the authors briefly notice that econometric tests confirmed the absence of significant breaks in the data. This is surprising given the drastic exchange rate reforms in Morocco since the 1970s as discussed in Section 2.42 A possible explanation is that monetary shocks are transmitted quickly to the exchange rates, whereas prices and wages in the real economy are stickier.

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relationships implied by PPP are generally not cointegrated. The evidence on whether PPP holds for Morocco (against the EU) is generally accepted in the literature (Camarero et al. 2006; Achy, 2003, Laureti, 2001; Sarno, 2000; Bahmani-Oskooee, 1998), although some other studies fail to accept PPP for Morocco (Holmes; 2001; Albak and Park, 2003).

The effect of an increase in domestic prices relative to foreign prices on the REER is under a fixed regime ambiguous as noted by Wang (2005).With a flexible exchange rate a domestic price increase is expected to lower domestic interest rates relative to foreign rates, resulting in capital outflows and a depreciation of both nominal and the real exchange rate. With fixed exchange rates, an increase in the domestic prices level would lead to an immediate appreciation of the REER. Lower real interest rates and a worsening of the current account caused by the initial appreciation could trigger a devaluation of the nominal exchange rate and a subsequent depreciation of the real rate. However, devaluations and revaluations are rare for Morocco during our sample: devaluation occurred once in 1990 while in 2001 there was a revaluation of the Dirham against a basket of foreign currencies. Furthermore, large REER movements are unlikely to emerge from domestic inflation as it has been stabilized at a level comparable to European countries.

Second, the possibility of fluctuations arising from uncovered interest parity (UIP) conditions is captured by the inclusion of the domestic interest rate, the foreign interest rate, and inflation. As Dungey and Pagan (2000) notice, the UIP involves equating the difference between the current real exchange rate and its expected future value with the current interest differential. Therefore, the expected real exchange rate is conditioned upon all variables in the system to capture the information used to determine the expected future value of the exchange rate. Meanwhile, the role of UIP as a source of exchange rate fluctuations in Morocco is likely to be modest because of capital controls imposed by the central banks in order to operate an independent monetary policy under the fixed exchange rate.

Rainfall is a likely to be an important predictor of future economic activity.The expected effect of rainfall on the REER is difficult to predict because of two effects are associated with changes in rainfall, as is the case with supply shocks in general. On the one hand, prices and the therefore REER decrease (increase) with favorable (unfavorable) rainfall because of changed supply of food. On the other hand, the wealth effect results in an opposite movement in prices and the REER: increased income creates upward pressure on prices and the REER. Those two effects are implicitly taken account for by the inclusion of domestic prices, income and expenditure in the exchange rate equation. Hence, the net effect depends on the expectations of the relative strength of both forces. Under normal conditions, the first effect is expected to dominate, while during droughts the loss in income is expected to be strong enough to offset the price increase, the more because of subsides programs that offset sharp increases in prices during droughts. Meanwhile, during drought food imports sharply increase, putting downward pressure on the nominal exchange rate and therefore the REER given unchanged rates of inflation. This effect is limited central bank intervention in order to maintain its fixed peg. The commodity currency theory is the third possibility of exchange rate fluctuations and is captured by the inclusion of export and import prices. I allow for the possibility that the Dirham is a commodity currency as suggested by some evidence in the literature. Camarero et al. (2008) argue that purchasing power parity (PPP) is often not a good approximation of REER behavior, while models that account for real shocks do a better job. The authors suggest that the nonfulfillment of PPP can be explained by the composition of trade between the EU and MENA countries: whereas the EU exports manufactured products to the MENA countries, the majority of these countries sell primary products to the EU. It is therefore

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possible that the behavior of the exchange rate between the two areas could depend on the price of primary products, which are commonly fixed in international markets. Indeed for Morocco, Camarero et al. (2008) find that the commodity terms of trade has a significant effect on the REER, although this effect is positive rather than negative as predicted by commodity currency theory.

A possible explanation for this result is that the main Moroccan commodity exports (fish, lead and phosphate) are relatively demand elastic. When those commodities become cheaper, the revenues from exporting these products increase, appreciating the exchange rate in real terms. The effect of import price shocks on the REER in Morocco is unclear a priori. One the one hand, more expensive imports requires more foreign currency as demand for imports do not sufficient fall (i.e. import demand is relatively inelastic) and the Morocco’s purchasing power decreases, the REER depreciates. On the other hand, increase in import prices might fuel domestic inflation, appreciation the REER (provided that the nominal exchange rate does not change). The resulting effect of an import price shock on Morocco’s REER depends therefore on the effect on the nominal exchange rate, the impact on the domestic inflation rate, and the impact of the import price shock on the foreign inflation rate. For example, Huang and GUO (2006) show that oil price shocks in China would lead to a minor appreciation of the exchange rate due to China’s lesser dependence on imported oil than its trading partners.

Fourth, exchange rate fluctuations may be determined by variables that impact on the current account balance or capital inflows like migrant’s remittances. With flexible exchange rates, remittances put upward pressure on the exchange rate, leading to an appreciation. However, this direct effect on the nominal exchange in Morocco is limited because of its fixed exchange rate. The BAM provides the additional Dirhams that are demanded to maintain its peg against the Euro. In addition, a large share of remittance is transferred into to Euro’s or USDs, and are only transferred in a later stage when remittances are spent, putting upward pressure on the Dirham only at that time.

In the literature remittances are often associated with Dutch Disease effects. Remittances create additional demand, which for exogenous given prices for tradable goods, culminates in higher prices of nontradeable goods –the spending effect- , which corresponds to a real exchange rate appreciation. Subsequently, a resource effect may arise; a shift of resources from the tradable to the nontradeable sector. Lartey et al. (2008) argue that resource movement effect of the Dutch disease effects operate stronger in fixed nominal exchange rate regimes because in this case a country cannot adjust their relative prices after a negative shock to the tradable sector. The nominal exchange rate depreciation that normally results from the shift in spending to nontradeable goods is prevented. Nevertheless the magnitude of Dutch disease effects depends on several other circumstances. Acosta et al. (2009) show for example that countries with deeper and more sophisticated financial systems face a less pronounced currency appreciation because they are better able to channel the remitted capital into new productive investments. Fayad (2010) shows that Dutch disease effects of remittances in the MENA region are only modest, as the appreciative effect of remittances attenuates by productivity –enhancing depreciative effect of simultaneous FDI. For Morocco, this argument makes little sense given the modest size of FDI (1% of GDP), compared to remittances (8%).

However, some studies found evidence against Dutch disease affects associated with remittances. For example Amuedo-Dorantes et al. (2007) show that in small island developing countries the exchange rate depreciates rather than appreciates after an increase in remittances. The authors suggest that this can explained by the possibility that remittances are primarily consumed on traded versus non-traded goods, raising the relative price of traded

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goods and causing a depreciation of the real exchange rate. In Morocco, remittances are mainly used to finance consumption like food imports, but also for real estate The latter is an symptom of the Dutch disease, but this is merely a long-run phenomenon, while in the short run, remittance may actually depreciates the REER whenever they are used to finance the consumption of imported goods relative to domestic goods. Which is plausible, as Morocco is a net importer.

The effect of a domestic interest rate increase on the REER is expected to be positive. Under a flexible exchange rate regime, an increase in the domestic interest rate attracts foreign capital, appreciating the exchange rate. With fixed exchange rate, the central is committed to provide the additional demand for Dirhams, and as predicted by the Mundell-Fleming model, the domestic money supply decreases, making monetary policy ineffective. However, because Morocco has capital controls, the addition demand for its currency resulting from higher domestic interest rates is restricted. The nominal exchange is therefore expected to be unchanged in response to a domestic interest rate shocks. A positive interest innovation is expected to lower inflation and economic activity, depreciating the REER (i.e. the relative competiveness of Moroccan goods increase when the relative inflation rate of its trading partner increases).

Two dummy variables are included in the exchange rate equation to capture to a devaluation of the Dirham by about 9.3 percentages in the second quarter of 1990 and a revaluation in the second quarter of 2002 to diversify the composition of the basket by introducing new currencies outside the European area, it is the British Pound and the Swiss Franc (see for example Bouoiyour et al., 2005).

4.2.3.6 Domestic interest ratesThe interbank rate (i) equation is designed to capture the monetary reaction function of the central bank of Morocco – Bank al-Magrib (BAM). BAM intervenes in the interbank market based on contemporaneous and lagged changes in the foreign interest rate, aggregate domestic demand, and the exchange rate. The objective of BAM is to maintain currency stability, by keeping inflation under control and managing the exchange rate, rather than targeting inflation like the ECB. In this view, BAM is reluctant to raise interest rates in case this lead speculative pressure on the currency. The day-to-day monetary control aims at maintaining the interbank weighted average rate close to the key rate which is set discretionary (Agénor and El Aynaoui, 2008). According to the BAM the key rate is designed to ward off any drop in the currency’s external value or any adverse impact on the competiveness of the Moroccan economy.

BAM has no nominal anchor for inflation and follows no official rule in order to maintain price stability, but the bank judiciously uses discretionary (fiscal and monetary) and indirect (incomes) policies like strong food subsidies and tariffs to achieve price stability. Unlike for example the ECB, BAM is not targeting inflation. Moumni and Dasser (2011) empirical examine the relevance of a Taylor-type rule in the active monetary policy of BAM and find no evidence on the use of such a rule in order to achieve price stability. The authors conclude therefore that operational objective of BAM is to regulate liquidity in the money market by influencing the overnight interbank interest rate, while pursuing the hypothesis of a discretionary monetary policy rather than rule-based policy in order to achieve price stabilization. When domestic prices are included in a monetary rule, they find a negative and insignificant reaction of the interbank rate in response to an increase in inflation, in contrast with a positive reaction recommend by Taylor (1993). García-ortíz and Pizarro-Barceló (2010) also find a negative interest rate response to a positive shock in inflation in a VAR

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including production, prices, interest rates, monetary aggregate, bank credit, and the exchange rate. Boughrara (2003, 2009) also finds that monetary policy following a positive price shock loosens rather than tightens. Unfortunately, both García-ortíz and Pizarro-Barceló (2010) and Boughrara (2003, 2009) do not explain this unexpected result. These results are likely to be spurious; a Taylor rule assumes the central bank to automatically increase interest rates in response to inflation rates above the target level. However, in reality BAM does not follow such a rule, but maintain price stability with discretionary policies rather than mechanically changing interest rates.

All those studies that examine Taylor type of behavior in Morocco include the consumer price index, while BAM is following underlying inflation that excludes state tariffs and volatile prices such as food and oil. The difference between including core and headline inflation is likely to be more important than for example in the EU because food makes up 40% of the CPI in Morocco. Moreover, food prices are extremely volatile, and the BAM does not react with interest rate changes. In words of BAM (2011): the impact of supply shocks on volatile food prices, which is considered broadly neutral over the medium term, remains noticeable on the monthly and quarterly fluctuations of inflation. However, we specifying a Taylor rule with headline inflation for Morocco, one implicitly assumes that BAM does change interest rates too volatile (food) prices. Moreover, the underlying rate of inflation is likely to be largely captured by the long-term trend, which we have filtered out.

Therefore the inclusion of consumer prices in our policy equation would be incorrect.43 Dropsey and Grand (2008) suggest that when Morocco wants to target inflation, Morocco has to be particularly cautious given the importance of subsidized prices in the CPI index, for example food and petroleum. BAM should therefore target core inflation, excluding price they cannot influence like food and energy. In addition the general consensus among policymakers is that, insofar as inflation is caused by supply shocks, then is should be ignored. However, if it is due to demand overheating, then monetary policy should tighten severely (Moorthy and Kolhar, 2011).

An increasing share of literature has emphasized the relevance of the exchange rate in the conduct of monetary policy. For example, Mohanty and Klau (2004) show that in most emerging economies the interest rate responds strongly to the exchange rate and that this response could be stronger than to changes in the inflation or output gap. The exchange rate is an important source of inflation in emerging economies and relative competiveness, and many central banks therefore included them in their in the conduct of monetary policy.

43 Indeed, when including consumer prices in the policy reaction function, I find also a negative reaction of interest rates to changes in consumer prices. There are two possible explanations for the negative reaction of interest rates to changes in prices. First, higher food prices also implicate a loss of income for farmers (when caused by a negative supply shocks) and less income to spend on other goods than food. Hence a scenario of biflation may emerge. The CB may react with lower interest rates to stimulate domestic demand, however this is unlikely as BAM does not react to temporary prices changes like volatile food. Second, price shocks in Morocco are often the result of changes in supply, and can therefore be seen as events of stagflation: prices increase while output and employment fall. Monetary goals as specified in the Taylor rule may therefore conflict: inflation is above target while output is below full employment. Hence the interest reaction depends on the relative weights given to fight inflation versus stimulating output. But again, supply shock in Morocco (food) is perceived to be temporary and BAM is unlikely to respond, at least not mechanically. Incidentally, BAM may respond but according to well considered decision. Another possible explanation of the negative response of interest rates to prices is that the equation does not reflect a policy reaction function, but merely reflect a Fisher hypothesis which states that there is a positive relationship between interest rates and expected inflation. Berument and Jelasssi (2002) find evidence of a weak form of the Fisher hypothesis in Morocco: there is a positive relationship between inflation and nominal interest rates, although less the strength is less than one.

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Central banks generally tend to lean against the wind by raising interest rates when the exchange rate depreciates. Aizenman et al. (2008) show that both inflation targeting (IT) and non-inflation (non-IT) targeting emerging market central banks –including Morocco- respond to real exchange rates in setting interest rates. The response to the REER is much smaller in the IT countries compared to non-IT countries. The IT group attempts to lean against the wind and stabilize the exchange rate by increasing interest rates in response to real exchange rate depreciation, but their actions are more constrained by the commitment to target inflation than the non-IT countries as these objectives are not always consistent. Meanwhile, non-IT central banks place much less weight on inflation in setting interest rates. The real exchange rate stabilization objective does not appear to be influencing central bank interest rate-setting directly because it is a good predictor of future inflation, hence used as currency defense mechanism. However, because Morocco has strict capital flows, and the exchange rate is maintained by foreign reserves, and only limited by domestic interest rates, the REER might be used by the central bank as a predictor of future inflation. This creates the possibility of a positive interest rate reaction to a REER depreciation, which is elaborated below.

Helmi et al. (2011) examines the relevance of a simple exchange rate and foreign interest rate augmented Taylor-rule rather than discretionary policy in reducing the inflation rate for selected MENA countries, including Morocco. Estimated extended Taylor-rules for Jordan, Israel and Turkey are consistent with theoretical predictions, while the results for Morocco are more puzzling because of an unexpected sign of the exchange rate in the policy rule according to the authors. While, this negative rather than positive sign is explainable a more serious problem is the choice of variables included in their model. A difficulty of the work of Helmi et al. (2010) is that they use the U.S. federal funds rate and the exchange rate against the USA dollar. Implicitly, because of its peg against a basket of currencies dominated by the Euro, the authors estimated the reaction of the ECB rather than of the BAM when including the U.S. interest rate and exchange rate as approximates for the foreign variables the BAM follows. Their results may therefore be spurious. Nevertheless, to explain the positive (negative) response of interest rates to an exchange rate appreciation (depreciation), Helmi et al. (2001) follow the view of Calvo and Reinhardt (2000) that many countries do not rely exclusively on foreign exchange market intervention but also use interest rate defenses to smooth exchange rate fluctuations. Exchange rate depreciations increase domestic demand for money, and when supply does not change, the interest rate will increase, generating difficulties in the financial and real sectors. In response central banks increase the domestic money supply lowering domestic interest rates. Obstfled and Rogoff (1995) in contrast recommend that a substantial appreciation of the real exchange rate call for a relaxation of monetary policy. Taylor (2001) explains this reaction by the fact that an appreciation has a contractionary effect on demand; the appreciation makes foreign goods cheaper and domestic goods more expensive, reducing net exports. Monetary policy should therefore ease in order to stimulate domestic demand. However, this line of reasoning assumes that trade and nontraded goods are substitutes to some extent. Morocco’s imports are mainly intermediate goods that are not produced at home, like oil. An exchange rate appreciation decreases the cost of those goods, increasing production and output. In addition, more resources are left for expenditures for other than intermediate goods, fueling inflation for non-imported goods. In response, the central bank might tighten monetary conditions again, i.e. the relationship becomes positive as found by Helmi et al. (2001) for Morocco.

Obstfeld et al. (2005) emphasizes the role of foreign interest rates in the determination of domestic monetary policy under pegged exchange rates. With perfect capital mobility and an exchange rate credibly pegged with a band of zero width, home and base-country interest rates should move one-for-one and the pegging country’s monetary independency would be

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nil. Under capital controls and some band width, the home country could use its monetary independency to offset base interest rate shocks (elasticity of home rate with respect to the foreign rate is smaller than one), or reinforce them (elasticity of home rate with respect to the foreign rate exceeds one).

Financial conditions and remittances are also included in the policy reaction function, as the BAM has not always perfectly controls the interbank rate. From the second half of 1999 onwards a persistence excess of liquidity has appeared due mainly to flow of foreign currencies generated by the privatizations and migrants’ remittances. In 2001, for example the Moroccan authorities failed to soak up the liquidity due to the large flows of worker’s remittances. The subsequent 14 percent broad money growth raised the domestic demand and the inflation rate surged from 0.6 to 6.8 percent (Dropsey and Grand, 2008). In order to mop up the surplus and stop the fall of the interbank rate, BM therefore resorted to liquidity withdrawal operations, almost continuously between October 1999 and December 2002, by selling its entire portfolio of Treasury bills on the secondary market. Nonetheless, the effort seemed insufficient to mop up the liquidity excess; hence, BAM had to raise the monetary reserve ratio in 2002 and in 2003 (Boughrara et al. 2008a). This effect on the interbank rate is captured by a dummy variable.

Another problem associated with interest rates in Morocco is occurrence of droughts. Interest rates typically increase as the government borrows money to fund its drought-relief program which is largely undertaken at market conditions. Nonmarket financing of the budget deficit is rare, but in 1995 –a severe drought year- the Moroccan government nonetheless heavily used central bank credit in the form of a special, although remunerated at market interest rate (Jbili et al., 1997)

Dummy variables are included to account for changes in reserve requirements, key rate changes, and reforms. BAM increased reserve requirement of banks in 1992.4, 1993.1, 2002.3, and 2003.4. Reserve requirement increases were typically imposed to mop up excess liquidity resulting from remittances or privatization revenues, although not always with success, see Dropsey and Grand (2008). Reserve requirements were lowered in 2008.1 and 2009.1 in response to the global financial crisis. The key rate of BAM was increased in 2008.3 and 2008.4, while decreases occurred in 1995.2, 1995.3, 1996.4, 1998.1, 1999.3, 1999.4; 2001.2, 2001.4, 2002.1 and 2009.2. For a motivation of these decisions see the website of BAM.

4.2.3.7 Transmission mechanism of monetary policy in MoroccoAlthough the monetary reaction function of BAM is now specified, it remains the question how policy changes are transmitted to the real economy. In the literature four different channels of monetary transmission are considered and are empirically examined for Morocco by Boughrara (2009). The first is the traditional interest rate channel: monetary policy changes affect cost of capital and yield on savings, which are transmitted to spending decisions and financial resources. The credit view states that that monetary policy not only works through its impact on demand for financial services, but also on the supply-side. Tighter policy will reduce the ability of banks to supply loans, forcing businesses to reduce spending. The credit view can be separated in a bank lending and a balance sheet channel. According to the lending view, expansionary monetary policy increases banks’ reserves and deposits, increasing the total amount of loans available. Under the balance sheet channel expansionary monetary policy increases the net worth of firms and agents and consequently banks, increasing spending and investment. The exchange rate channel is the third channel of monetary transmission. Given unchanged rates of domestic and foreign inflation,

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expansionary monetary policy results in currency depreciation, this simulates exports and therefore aggregate output. The asset price channel is the fourth channel of monetary transmission: expansionary monetary policy decrease the attractiveness of bonds, stimulating demand for equity. According to Tobin’s q, higher equity prices increase the market value of firms relative to the replacement cost of capital, increasing investment. In addition, higher equity price improve household incomes and thereby spending. Boughrara (2009) examines the monetary transmission mechanisms in Morocco and concludes neither the asset price channel or (nominal) exchange rate channel is operative (which is not surprising given Morocco’s pegged exchange rate regime), while both the interest rate and the lending view of the credit channel are operative. In an earlier study, Boughrara (2003) however used the real effective exchange rate and found it to be an important monetary transmission channel. Boughrara (2009) argues that the lending channel does however not function efficiently in the short run, while it is operative in the long run. Moreover, when using a micro economic panel of bank balance sheet data to estimate the response of bank lending to changes in monetary policy, Boughrara and Ghazouani (2008) find evidence for the existence of a bank lending channel in Morocco. In addition, Garcia-Ortíz and Pizarro-Braceló (2010) support this hypothesis of the presence of a bank credit channel in Morocco, but they find evidence that is also works in the short run.

4.2.3.8 Domestic financial conditionsDomestic financial conditions (q) capture returns on financial assets, private credit and the amount of liquidity in the Moroccan economy; see the Data section below for more information on each individual variable and the construction of this index.

Financial conditions in Morocco are affected by contemporaneously and lagged effects of shocks to international financial stress, foreign interest rates, import and export prices, domestic demand, output, prices, the exchange rate, the domestic interest rates, and migrant’s remittances. The effects of export volumes, tourism receipts, and rainfall on domestic financial are implicitly captured by their effect on the other variables. Contemporaneous effects of most of those variables on financial conditions in Morocco arise from their effect on expectations of domestic output performance and therefore future returns to financial assets, the amount of private credit extended by financial institutions, and the amount of liquidity in the economy. The contemporaneous restriction on remittance is explained by the fact that financial conditions proceed remittances in a circular cause and consequence between the two variables. I.e. remittances respond to financial condition in Morocco –being substitutes or complements, elaborated in the next paragraph concerning the remittances equation-, and subsequently alter domestic financial conditions by changing liquidity conditions in Morocco. For a longer term, large capital inflows related to worker’s remittances allow financing of an increasing large number of bank activities.

The inclusion of domestic financial conditions is important for understanding the monetary transmission mechanisms through which the monetary policy shocks propagate in Morocco and are transformed in economic growth or inflation. According to the credit view of monetary transmission, expansionary monetary policy (decrease in the interbank rate) increases the ability of financial institutions to supply loans, improving domestic financial conditions. Financial condition may also be affected by the asset price channel: expansionary monetary policy decrease the attractiveness of bonds, stimulating demand for equity. According to Tobin’s q, higher equity prices increase the market value of firms relative to the replacement cost of capital, increasing investment. In addition, higher equity price improve household incomes and thereby spending. However, as noted by Boughrara (2009) it is

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difficult to interpret a decline in bank loans after a monetary contraction: the credit channel emphasizes a shift in loan supply; the interest rate channel postulates a shift in loan demand, which results from a drop in real activity due to higher interest rates. Boughrara (2009) identifies the demand and supply of loans by holding prices of loans constant and concludes that the credit channel is not operative in the short-run. Because the identification scheme use in thesis assumes only a lagged effects of half a year of interest rates on expenditure, a contemporaneous drop in financial conditions following an increase in the interbank rate suggest that the credit channel is achieve.

Although some strong to weak evidence is found for the credit channel in Morocco as highlighted in the previous subsection, an interesting article of Agénor and El Aynaoui (2010) suggest that asymmetric bank pricing behavior under excess liquidity may hamper transmission of monetary policy. The authors argue that excess liquidity – which is often the case during our sample period, see Figure B1 in Appendix B- may impart greater stickiness to the deposit rate in response to a monetary contraction and induce an easing of collateral requirements of borrowers, which in turn translate into a lower risk premium and lower lending rates. Lebedenski (2007) shows that deposit rates are stickier in the presence of excess liquidity. This corresponds to the balance sheet view of monetary transmission, although with an opposite sign. This line of reasoning leaves the possibility open for an improvement of financial conditions in Morocco following a contractionary monetary shock. Moroccan banks hold most of the time large excess reserves which is likely to be the result of the pegged exchange rate regime in Morocco. Upward pressure on the exchange rate created by large capital inflows (e.g. remittances) requires the BAM to intervene and an accumulation of foreign reserves. In the absence of sterilization, surplus reserves translate into an expansion of the monetary base and rapid accumulation of excess liquidity by commercial banks (Agénor and Aynaoui, 2010).

Traditionally, two general conflicting explanations for reserve accumulation by commercial banks exist. Friedman and Schwartz (1963) argue that banks desire a higher level of reserves following periods of panic in order to increase bank runs. The explanation of the accumulation of excess reserves according to Horwich (1963) is that they are built up because of lack of profitable alternatives to holding cash. The view of Horwich is the most likely explanation of excess reserves given the high level of non-performing loans in Morocco. Moroccan banks generally prefer to restrict their lending activity because of the high default risk, although they could lend more are the current market rate (Boughrara et al., 2008). Deposit rates are less response to increases in the interbank rate under the presence of excess liquidity under these conditions, because banks internalize the fact that raising the deposit rate will induce households to shift more of their assets into bank deposits, increasing the level of liquidity. On the other hand, Agénor and Aynaoui (2010) argue that if excess liquidity is sufficiently high, banks may be inclined to soften collateral requirements in order to stimulate the demand for loans. Because the interbank rate represents the opportunity cost of holding excess reserves, demand for voluntary cash holdings decrease and excess liquidity in the market increase which reduce the risk premium on loans. This imposes upward pressure on output and inflation. The theoretical model of asymmetric bank pricing behavior under excess reserve may therefore be an explanation of the results of Boughrara (2009). The response of output to an increase in the interbank rate appears to be compatible with standard macroeconomic theory; output depresses following an unexpected rise in the interest rate. Boughrara concludes that the overall response of output to a monetary tightening is negligible. The lending channel however displays a very different response to a monetary tightening than output. During the first year following the shock, loan quantity increases in response to a monetary tightening, although not significantly. Afterwards, the quantity of loans subsequently decreases. The lending rate is only operative in the long-run. Boughrara

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does not give a possible explanation for the puzzling results of the initial increase of the quantity of loans provided by banks in response to a monetary tightening, but we expect the answers can found in the high level of excess reserves banks in Morocco generally hold resulting in asymmetric bank pricing behavior as suggested by Agénor and Aynaoui (2010).

Shocks to rainfall are also expected to have an impact on financial conditions in Morocco, although only indirectly. In the finance literature there exist some evidence of weather related psychologically effects on stock market performance, see for example Hirshleifer and Shumway (2003). Basically the theory is that sunshine improves investors’ mood and their by stock returns. To the extent such an effect even exists for Morocco, the effect is probably reversed: Moroccans likely welcome rainfall as it is scarcer than sunshine and will improve their moods. Rainfall is also likely to reduce the credit worthiness of farmers and increasing the share of nonperforming loans because of changed income, which is captured by the inclusion of national output in the financial conditions equation – which is affect by rainfall in the model. During droughts, interest rates on debts to farmers are generally decreased and unpaid loans are cancelled. The decline of farmer’s capacities of loan repayments during droughts has also led to the exclusion from CNCA (Morocco’s farm bank) loans from a significant number of farmers, from 400 to 100 thousand (Abidar and Laytime, 2005). Meanwhile, as stated in the previous section, interest rates in Morocco increase in general because of additional government borrowing to finance its drought relief programs which deteriorate financial conditions.

However, rainfall may affect domestic conditions directly when they are directly related to insurance, rather than income. Although the feasibility of rainfall based insurance programs in Morocco has been confirmed (Stopa and Hess, 2003; McCarthy, 2003; Gober te al., 2001), they are not yet operative although rainfall related derivatives are expected to decrease the reduction of moral hazard and adverse selection of current schemes provided by the government, and attract potential interest of (international) re-insurers and capital markets. Furthermore, rainfall is likely to affect expectations of financial agents (like stock traders) on future economic activity and may alter current actions. Meanwhile, this effect is likely to be limited for Morocco because of relatively less developed stock markets and large firms quote on stock exchanges are likely to be less vulnerable to rainfall shocks; small non-irrigated farmers are mostly affected. Those same people are already credit rationed and loans are only extended to high creditworthiness borrowers and rainfall therefore does not alter their access to loans, despite it alters their incomes.

4.2.3.9 Tourism receiptsTourism receipts (t) are sensitive to foreign output shocks, the exchange rate and rainfall. Domestic income does not affect international tourism receipts. International tourism is an important factor in the Moroccan economy and a significant source of foreign exchange; recently it surpassed remittance in their contribution to GDP (7.5%. versus 8% in 2009 respectively). Nevertheless domestic –or inward- tourism is growing in Morocco –currently more than 20% of total tourism is form domestic origin-, but unfortunately data on inward tourism is unavailable and although it is increasing it would be an insignificant variable in the Moroccan business cycle model. Inward tourism receipts are however implicitly captured by the inclusion of national expenditures in the model.

Because tourists consumes a lot of water – between 300 and 850 liters a day (De Stefano, 2004), while the average Moroccan uses only 50 liters of water per day- and water is already scare under the definition of FAO in Morocco –see Section 1- tourism should be very vulnerable to rainfall, the main source of water replenishment, see Section 1. Golf courses,

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swimming pools, and aquatic centers are top consumers of water in Morocco. Coastal aquifers are already experiencing serious sea water intrusion because of an intensive withdrawal of groundwater to meet the high water demand of tourists (Anfuso and Nachite, 2011). On the other hand rainfall may affect outdoor activities, fees and revenues for local markets, although rainfall is rare in main tourist season, but tourism continues during the whole year in Morocco, including the rain season. Heavy rains for example force tourists to stay in hotels hampering the sale of shopkeepers. See for a more general study on the linkages between water and tourism Eurostat (2009). For many years however, the tourist sector received priority over local uses in times of water shortage. However, the tourist sector thereby increases water stress for citizens. For example, during the drought of 1994-1996, the town of Tangier suffered from a severe water shortage while water supply to tourist facilities had priority over the water needs of the local population (De Stefano, 2004; Plan Blue, 1999). In 1995 a law was enforced to ensure that water resources belong to the public unless they are subject to prior recognized and vested rights. Moreover, Morocco’s 1995 water law assigns priority to potable water over other uses in times of water shortages, giving highest priority to the local population and the watering of livestock (USAID, 2011).

A dummy variable is included in the tourism equation to capture adverse events that significantly decreased international demand for tourism in Morocco, like the Gulf War of 1990-1991, terrorist attack in August 1994 when two Spaniards were killed, the subsequent closer of the Algerian border which caused the number of Algerian tourists in 1995, the aftermath of September 11, 2001, and the Casablanca suicide bombings on May 16 2003. Another dummy variable is included to capture events that positively affect tourism in Morocco: the end of the Gulf War, strong reforms to boosts tourism in 1996 like a decrease of the VAT applicable to tourism activities from 14% to 10% and a government initiative to start 17 hotel projects to increase the capacity and competiveness of Morocco’s tourism sector, and the liberalization of air transportation in 2006 which led to the market entry of several low cost carriers. In addition, some laws regulating tourism-related activities like the guide profession and travel agencies were amended.

4.2.3.10 Migrant’s remittancesThe inclusion of migrant’s remittances (r) is one of the more interesting features of the model because in the literature on remittances there exist much controversy. The discussion concerning remittances centers around three themes: 1) are remitters altruistic or profit-seeking (or in other words are remittances pro-or countercyclical), 2) are remittances substitutes or complements to financial services, and 3) their reaction to exchange rate movements: income versus price effects. The remittance equation is constructed to captures these shocks to domestic income, financial conditions, and the exchange rate. In addition, shocks to foreign financial stress, foreign prices, the foreign interest rate, domestic prices, the domestic interest rate, domestic financial conditions, tourism receipts, and rainfall are also expected have an effect on migrant’s remittances.

Positive (negative) shocks to foreign output are expected to enhance (reduce) the ability of migrants to remit, and the effect of foreign income on remittances is therefore expected to be positive. The effect of international financial stress on remittances is unclear a prior: on the hand had increased stress in the host country reduce the expected future income of the worker which may respond with decreasing the level of remittances. On the other hand, in so far Morocco is isolated from increased international stress, Morocco can be seen as a save heaven and therefore attract additional remittances. An increase in foreign prices leaves less income of the Moroccan migrant left to remitter if his/ her income is not compensated. Indirectly, foreign prices affect the exchange rate and thereby the decision to remit. An

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increase in foreign interest rates makes it more attractive to leave funds on a deposit account rather than to remit them, meanwhile higher interest rates increase future income of savings which can be remit in the future. An increase in the policy rate also may also signal a slowdown of future economic activity which is expected to be unfavorable for the level of remittances. Hence, the effect of foreign interest rates on the level of remittances is ambiguous.

The response of migrant’s remittance to domestic conditions in Morocco is even more controversial. Two distinct hypotheses exist on the behavior of remittances in response to economic conditions on the receiving country, and depend on the motive of the remitter. Unfortunately, little is known about the nature of the motivation of Moroccan remitters.

The first and most accepted hypothesis is that the remitter is altruistic: the remitter compensates family members in their land of birth during times of economic hardship. Among others, Chami et al. (2008) and Yang and Choi (2007) provide evidence in favor of this view for a large panel of countries. The other hypothesis rest on a portfolio-diversification or rent-seeking motive of the remitter. Transfers respond positively to economic conditions in the home country. Remittances are a result of deciding to invest in home country assets and are withdrawn when economic conditions deteriorate. Such self-interested behavior is found by Lucas and Stark (1985) in Botswana and more recently by Amuedo-Dorantes and Pozo (2010) for Spanish migrants. Sayan (2006) examines the behavior of workers’ remittances in twelve developing countries –including Morocco- in a simple bivariate regression using the HP filter in order to focus on short-term fluctuations, and concludes that countercyclicality is not commonly observed across these countries. Sayan shows that remittances are pro-cyclical to Moroccan output in the short-run.

This is in sharp contrast with the long-run findings of Bouhga-Hagbe (2006) that altruism play an important role in the flow of remittances to Morocco. Bouhga-Hagbe focus on the relationship between agricultural output and remittances, excluding the possibility a positive relationship of non-agricultural output and remittances. If such a relationship hold in the short-run I expect a negative effect of rainfall – as an indicator of agricultural output- and a positive (or less stronger, depending if non altruistic behavior outweighs self-interest behavior of the remitter) relationship with overall output. By using co-integration techniques Bougha-Hagbe (2004) finds evidence favors the altruistic motive at cost of the portfolio motive, suggesting that remittances are stable sources of foreign capital. Portfolio motives are approximated by the interest rate differential between the country of residence and Morocco, and are insignificant. This is however a poor measure of portfolio motives of remitters because we know from surveys both for Morocco (Barendse et al. 2006) and other countries that receive large flows of remittances, that asset substitution does not takes the form of money deposits in Morocco, but of real estate. Although Bougha-Hagbe recognizes that remittances are redirected toward real estate, he considers the motive for this is altruism rather that portfolio diversification because the price index for housing in Morocco grew at approximately the same rate as the whole price index over the period 1993-2003. Therefore, Bougha-Hagbe argues that real estate is not an attractive investment opportunity for Moroccan workers living abroad, but because a large part of remittances is invested in real estate this reflects an altruistic motive. This line of reasoning is however incomplete as there exist well known other aspects of real estate that could be profitable besides increases in prices like rents –or expected price increases over a long time period, say thirty years- and moreover that a price of real estate does not increase within a short time period this will not implicate that they will never rise and a general housing index might be stable, while some categories might increase like city real estate. Housing subsidies before 1995 were mainly demand oriented, and changes in policy toward more supply oriented resulted in temporary

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drop in mid 1990s (le Blanc 2005). After 2004, housing price in Morocco started to increase, making it profitable to invest. In additions remitters might to buy a house for themselves to return in holidays and when they retire and this is self-interested motive rather than altruism this is ‘attachment’ which might be plausible. But currently there is housing bubble in morocco, reflecting a portfolios motive. Finally, as Bougha-Hagbe also recognizes it might be worthwhile to investigate other indicators of portfolio diversification than interest rate differentials, like stock markets. Therefore I cannot exclude the possibility of the portfolio motive to play an important role in determining remittances.

Regarding the Moroccan price level, an altruistic motivated remitter may want to compensate Moroccan residents for a rise in prices, but when the remitter is self-interested, a rise in the general prices level can be viewed as detrimental leading to a withdrawal of remittances.

Short-term fluctuations of the exchange rate may affect remittance in two opposite directions: on the one hand a decrease in Morocco’s exchange rate makes the remitter relatively wealthier which is generally favorable for the amount of remittances. On the other hand, negative pressure on remittance is created because under REER depreciation, receivers of remittances get more Dirhams for the same amount of remittances denoted in foreign currency – if the remitter’s goal is to transfer a fixed amount of funds in Dirhams.

Moroccan interest rates also affect remittances in two possible ways. First, when the remitter has a portfolio diversification (or self-interested) motive, higher interest rates increase remittances based on the fact that funds can make a higher return in Morocco relative to their country of residence. Higher interest rates can also be perceived as a future cooling down of the economy, reducing remittance flows. The response of remittances to changes in Moroccan interest rates is more predictable when they are altruistic motivated: remittances are seen as substitute for domestic credit and are sent as a less expensive source of credit. When higher interest rates are interpreted as a future slowdown of the economy, an altruistic remitter may want to compensate.

A similar line of reasoning exists for the relationship between financial condition in Morocco and migrant’s remittances. Although several studies investigates the impact of remittances on financial development in the long run, both the short-run and long-run causal nature of remittances and financial development are rare. Individual studies on Morocco regarding the relationship between financial development and growth do not (yet) exist, while evidence provided by studies on other countries is mixed and mainly focus on the long run. For example, Mookerjee and Roberts (2011), Orozco and Fedewa (2005), show that financial development attracts remittances in the long-run by improving infrastructure that makes it possible to remit (e.g. number of banks), remittances transferred trough official induce recipients to become familiar with financial services, and subsequently start to demand other financial services as well – the so-called ‘’induced financial literacy hypothesis’. The effect of shocks to financial conditions in Morocco on remittance flows is unclear a priori in the short run; remittance may act as a substitute for financial services, like financial institutions, the remitter is a source of liquidity for Moroccans. On the other hand, remittances act as complements to financial conditions at home; a good investment climate and higher return on asset may attract remittances. Remittances can also be seen as insurance against economic hardship and when financial conditions deteriorate it may become harder for Moroccan to get a decent insurance. In a previous study (Klok, 2011) I examined both the short-run and long-run the causal relationship between growth, financial development, and remittances in Morocco using a vector error correction model. Results show that financial conditions in Morocco Granger cause remittance in the short-run unilateral, and that this relationship is positive. The remitter as a substitute for financial resources in the short-run is therefore

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unlikely; they act as complements. Favorable financial conditions attract remittances, possible of associated favorable growth prospects, higher returns on equity. Meanwhile, in the long-run this relationship becomes negative, i.e. remittances are substitutes for financial resources in Morocco rather than complements as in the short run.

International tourism in Morocco generally has a positive effect on the level of remittances. During holidays, migrants from Moroccan descent return to their home country to visit relatives, transferring remittances personally. This explains the same seasonal pattern in remittance and tourism data., for which is corrected in this thesis.

Rainfall may act as a forward indicator of the future state of the economy for the remitter; it implies future changes in harvest and consumer prices. Depending on the motive to remit, remittances are adjusted to anticipate on such effects. Arezki and Brückner (2011) show that rain shocks have a positive significant effect on remittances in a panel of Sub-Saharan Africa countries, but that this effect decreases when the share of domestic credit increases. According to the authors, when domestic financial markets are thin, credit-constrained investors will have difficulties to obtain finance for high-return projects in the presence of positive rainfall shocks that transitorily increase the return to capital. At sufficient high levels of credit to GDP, transitory GDP shocks have a negative effect on remittances. According to the authors, this is consistent with the view that remittances take advantage of unexploited domestic investment opportunity that exists due to domestic credit market imperfections. Since Morocco has a relatively well developed financial market compared to other African countries, rainfall shocks are expected to have a negative effect on remittances following the same arguments. When barriers to financial flows are low, remittances provide insurance against transitory income shocks. Meanwhile, when barriers to financial flows this generally means a developed financial sector which implies more insurance possibilities at home, which weakens the argument that remittances are a source of insurance only when financial markets are relatively less developed. In contrast, less developed financial increase the likelihood of remittances that are sent as insurance.

Yang and Choi (2007) uses rainfall as an instrumental variable for income changes – to correct for possible endogeneity between income and remittances- to show that in Philippines, changes in income are found to lead to changes in remittances in the opposite direction which is consistent with an insurance motivation. More extreme climate events like hurricanes are also associated with substantial increases of remittances (Yang, 2007). In contrast, Amuedo-Dorantes et al. (2007) find that natural disasters trigger a decrease in remittances in developing countries, while for small island developing states –which are particularly vulnerable to natural disaster because of the geographic concentration of their populations in coastal areas- remittances increase following a natural disaster. The authors suggest that the impact if natural disasters are felt harder in small island developing countries and remitters therefore appear more likely to respond to the disaster by raising their remittances. Alternatively, motives of remitters may differ between island and non-island developing states, resulting in pro- and countercyclical remittances.

The distinction between ‘normal’ rainfall regimes and droughts may be important for estimating the effect of rainfall on the behavior of remittances. For example, Moroccan remitters may behave like self-interested agents –making remittance positively related to rain shocks- while under droughts Moroccan remittances may become altruistic – negatively related remittances to rain shocks. A household survey of Devereaux et al. (1993) for Namibia reveals a slight decrease in remittances during drought, rather than an increase, and he attributes this to the existence of a drought relief program. A scenario like this is also not unthinkable for Morocco, where also extensive drought relief programs exists as discussed

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earlier in this thesis. In this case, when remitters are altruistic motivated, they compensate rain shocks during normal rainfall regimes, but not in droughts.

Finally, a dummy variable is included to capture the sudden remittance boom in 2001 which was not only observed in Morocco, but also in other countries that receive large flows of remittances like Pakistan. The cause of this boom remains puzzling but is related to introduction of Euro, concomitant money laundering, tracking and regulating Hawala-type networks in the wake of 9-11 (Barendse et al. 2006; Sayan, 2006; Bougha-Hagbe, 2004 and de Haas and Plug, 2006).

4.2.4 The domestic climate block: threshold effectsPrecipitation (p) or rainfall is exogenous to the system and is not defined as an autoregressive process, in contrast with soil moisture that is used by Buckle et al. (2007) for New Zealand. The absence of nonlinearities is one of the limitations of VAR models because many relationships between variables display some nonlinear behavior (Stock and Watson, 2001). Assuming linear behavior between rainfall and the economy is particular unrealistic in the Moroccan VAR model. Significant differences are expected to be found between ordinary rainfall deficits and extreme deficits, i.e. droughts. Substantial rainfall deviations are expected to have larger effects on the economy than small deviations, i.e. we suspect nonlinear effects of rainfall on the economy insofar that some economic effect only occur when rainfall deviations are sufficiently large. For example, as mentioned above when a drought occur, the government implements a drought relief program when rainfall deficits are sufficiently larger, but not when rain fluctuations are only moderate.

Gober et al. (2001) and Baraket and Handoufe (1998) indeed show that rainfall sufficient to cause dramatic reductions in Morocco’s agricultural production is estimated at 38% below normal values, while below 19.8% there is no fear of any serious impact of rainfall on agricultural production. These threshold values are similar to Ameziane et al. (2007) who show that cumulative annual rainfall less or equal to 263 mm is less than normal water requirements for wheat crops and wheat production is altered drastic. Since the normal long-run average winter rainfall is estimated at 401.2 mm in this thesis, the deviation expressed in percentage points is 138 mm, or 34%.

To incorporate nonlinear or threshold effects of rainfall on the economy in our VAR model, we allow for regime-switching behavior as introduced by Lim and Tong (1980) which allows the behavior of vector Γ A ( L ) in Eq. (3.1), i.e. the other variables in our model, in response to a rainfall to depend on different rainfall regimes. The threshold autoregressive model developed by Tong has become enormously influential in economics because its offers an alternative to restrictive assumption of linear behavior of economic processes which many models, like VARs rely on. For example, TVAR models are used to solve the liquidity puzzle by allowing for different behavior of interest rates in high and low inflation regimes, i.e. the response of interest rates to money changes is a function of inflationary regimes, see for example Shen and Chiang (1999). For an overview of the extensive literature on the development and various application of TAR models see Tong (2011) and Hansen (2011).

Two different rainfall regimes are distinguished; a normal rainfall regime when negative deviations range do not exceed 122.5 mm, and a drought is defined when shortages 122.5 mm44 as suggested by Gober et al. (2001), Baraket and Handoufe (1998) and Ameziane et al. (2007)45. The distribution of the two different regimes during over or sample period is provided in Table A4.1 of Appendix A4.44 I estimate the threshold value at 122.5 mm to include the drought of 1999/ 2004; data shows that this rain season also resulted in significant threshold behavior.

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Incorporating given multiple thresholds in an autoregressive system originates from the work of Chan et al. (1985). An alternative is to estimate the threshold value(s) along with the other parameters in the system, but this leads to several complications. When the threshold value is unknown, the threshold is identified only under the alternative, leading to a so-called nuisance parameter problem. Among others, Chan (1993) and Tsay (1998) provide procedures to obtain consistent estimates of unknown thresholds. Fortunately, rainfall regimes in Morocco are clearly defined by the literature as elaborated above. In addition I exposed some border-line cases to sensitivity analysis by in - and excluding seasons that were close to the predetermined threshold values –like the season of 1998-1999- in the indicator variables to see if they improved the model outcomes.

A two-regime threshold vector auto regressive (TVAR) model can be denoted as:

Y t=β1+ A1Y t+B1 ( L )Y t−1+ I1 t ( τ>γ 1 ) [ β2+ A2 Y t+B2 (L )Y t−1 ]+μ t (4.1)

where β is a vector of constants, A is a matrix with contemporaneous coefficients, B (L ) is a matrix polynomial in the lag operator, μt is a vector of structural disturbances, and I n is an indicator function that takes on the value of 1 if the threshold variable τ is above the positive threshold value in the first indicator function, while the second indicator takes on a value of 1 when the threshold variable is below the negative threshold and 0 otherwise. In other words, the indicator variable represents a dry rainfall regime, or drought. Nonlinear is introduced by allowing the coefficients of the VAR to vary in response to the two different regimes; β1, A1

and B1represent the parameters of the VAR in a normal rainfall regime, β1+ β2, A1+ A2and B1+B2 are the parameters in a dry regime. It is important to note that the threshold behavior of rainfall is restricted to the direct relationship between rainfall and the economic variables only. We do not assume that the relationship between the economic variables themselves change with different rainfall regimes. For example, the relationship between rainfall and output changes in different rainfall regimes, but the relationship between GDP and inflations does not change with different rainfall regimes.

5 Data

This section provides a description of the data that is used in the model. The outline follows the block structure of the model. Sources, symbols, calculations and -if necessary- additional remarks are provided for each variable. The estimation sample covers the first quarter of

45 A third, wet, regime with rainfall deviations exceeding 122,5 mm was also tried but turned out to be insignificant.

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1990 until the third quarter of 2010. This sample size is justified by the structural break that occurred in Morocco’s economy during the late 1980s when an ambitious reform process was launched in order to modernize the financial sector and stabilize inflation rates by the introduction of a pegged exchange rate regime. Reforms continued during the 1990s, resulting in a stronger annual growth of 1.75 percent in the period 1998-2004 (Eken et al., 2005) compared to the early 1990s when average growth was only 0.26 percent. Meanwhile, reforms in the early 1990s where a combination of relatively small improvements in education, governance and public infrastructure. No structural break resulted therefore from those reforms, in contrast to the exchange rate switch and the introduction of price stability by the central bank in the late 1980s.46

In order to focus on short-term fluctuations around a long-term growth path, the Hodrick-Prescott (HP) filter is used to estimate the cyclical component of each variable. In addition, potential problems associated with using non stationary series are prevented. Removing the HP long-term trend to smooth economic time series has become a widely used method since its introduction by Hodrick and Prescott (1997) in order to analyze postwar U.S. business cycles. Although the HP filter is not undisputed and new bandpass filters are developed (Baxter and King, 1999; Christiano and Fitzgerald, 1999), criticism is limited to the application of the HP filter on data with a lower frequency than quarterly. The HP is and will remain one of the standard methods for detrending (Ravn and Uhlig, 2002). The filter or smoothing parameter –which penalizes the acceleration in the trend relative to the business cycle component-, is given a value of 1600.47 The HP filter can however not be applied to the precipitation variable because climatological variables require a longer sample period to estimate their long-term trends , usually 30 years prior the sample period. An alternative is therefore required which is elaborated below. This sections also shortly discuss some other difficulties associated with the precipitation and the remittance variable, like measurement issues, extreme values and seasonal patterns. This explains why the sections regarding the precipitation and remittance variables go into more detail compared to other variables.

Obtaining quarterly time series for all Moroccan variables was not straightforward; many variables that were available at established international databases needed to be complemented with data from local sources. Inconsistencies arose between reported values of different sources or even from different values of the same source. Interpolation methods are used to estimate some missing data points, although the overwhelming majority of the series is complete. In addition, some variables like foreign output are adjusted in such a way that they reflect Morocco’s trade flows.

The main source of the economic variables is the International Financial Statistics (IFS) service of the International Monetary Fund (IMF); otherwise, the source is mentioned explicitly. At the end of this section, the variables and their symbols as used in the model are presented in Table 5.1, whereas Figure 5.1 provides a graphical representation of all time series. The dotted line represents the HP long-term trend, except in the case of the rainfall variables where the dotted line represents the 30 years precipitation normal as defined by the World Meteorological Organization (WMO).

46 Structural breaks may generate nonlinearities and nonnormalities in the residuals of a constant coefficient VAR (Canova, 2004) and therefore a VAR requires that the underlying structure of an economic system does not change over a chosen time period.47 Ravn and Uhlig (2002) demonstrate that the parameter filter should be set according to the following rule:the number of periods per year divided by 4, subsequently raised to a power of 4, and multiplied by 1600. Since I use quarterly time series, the smoothing parameter is therefore set at 1600.

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5.1 International economic and financial conditionsA trade-weighted foreign GDP volume index that reflects Morocco’s main trade flows is constructed to represent foreign real output (y*). Foreign real output is a weighted composite of the GDP volumes of Morocco’s main trading partners: France, Spain, Italy, Germany, the Benelux, the United Kingdom, the United States, India, and Brazil.48 Index weights are based on two-year moving averages of the estimated percentage of individual trading partners in Morocco’s total exports, and are calculated from the IMF Direction of Trade Statistics. These weights for each main export destination are subsequently multiplied by the corresponding GDP volume index of that country. 49

Stress on international financial markets (f*) is captured by the Kansas City Financial Stress Index (KCFSI) provided by the Federal Reserve Bank of Kansas City. Financial stress is defined as interruptions to the normal functioning of markets and is characterized by five key phenomena; increased uncertainty about fundamental value of assets, increased uncertainty about behavior of other investors, increased asymmetric information, decreased willingness to hold risky assets, and decreased willingness to hold illiquid assets (Hakkio and Keeton, 2009). Eleven variables are used in the KCFCI index to capture these key phenomena of financial stress: 3- month LIBOR/ T-BILL spread, 2- year swap spread, off-the run/ on-the-run 10-year Treasury spread, Aaa/10-year treasury spread, Baa/Aaa spread, High-yield bond/ Baa spread, consumer ABS/ 5-year Treasure spread, correlation between returns on stocks and Treasury bonds, implied volatility of overall stock prices (VIX), idiosyncratic volatility of bank stock prices, and cross-section dispersion of bank stock returns.50 For a description of each of the eleven indicators of international financial stress see Hakkio and Keeton (2009).

The Euro area harmonized index of consumer prices (HICP) is used as an indicator of foreign prices (π*) and is obtained from the European Commission’s Eurostat.

Foreign nominal interest rates (i*) are represented by the Euro LIBOR 3 Month Interbank Rate provided by the British Bankers’ Association (BBA). This rate is almost perfectly correlated with the Euribor from 1999 onwards, which is considered to be the benchmark interest rate in the Eurozone. Meanwhile, the Euribor was only introduced in 1999 and the ECB artificially estimated rates until 1994, insufficient to cover the sample considered in this thesis.

5.2 World trade prices

48 One average they account for 70% of Morocco’s exports during the sample period 1990-2010. 49 In the literature, two measures of foreign output are used: GDP (Dungey and Pagan, 2000) and industrial production index (IPI) (Buckle et al., 2007 and Benbouziane et al. 2010). I follow Dungey and Pagan (2000) by using foreign GDP rather than an IPI, because GDP encompasses more than just manufacturing activity, like wholesale and retail merchandise as well as activity in the service sector. Although goods production is a crucial part of the economy, much of this output takes place outside the factory gates (Steindel, 2004). Although IPI might correctly reflect external demand for countries that export industrial inputs, we prefer the more comprehensive GDP index as Morocco does not only depend on input demand from foreign industries, but is more dependent on tourism exports and remittances that depend on income earned in- and outside the factory gates. Nevertheless, discrepancies between movements in GDP and IPI are typically small, with IPI being regarded as a leading indicator for GDP. 50 Off-the-run treasuries refer to bonds and notes issued before the most recently issued treasuries. On-the-run treasuries in contrast are the most recent issued ones.

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The foreign currency prices of Moroccan exports (pe) and imports of merchandise goods (pi) are estimated by multiplying export and import prices of merchandise goods (USD based) series from the World Bank’s Global Economic Monitor (GEM) by the United States dollar / Moroccan dirham (USD/MAD) exchange rate (period average). The resulting export and import prices denoted in domestic currency are subsequently multiplied by Morocco’s nominal effective exchange rate to obtain export and import prices denoted in trade weighted foreign currency.51

Because the GEM does not cover data prior 1991, I estimate export and import prices for 1990 using export and import price series that are available at the IMF IFS. Although the IFS presents discontinued series for export and import prices with only a few observation, it covers values for the year 1990 –which are missing in the GEM.52 Nevertheless, the GEM and IFS use different methodologies regarding export and import prices; the GEM uses value indices while IFS estimated ‘true’ price indices- therefore the IFS values need to be adjust to fit the GEM’s series. I use an interpolation method based on the rate of changes in IFS prices indices to estimate value series; i.e. GEM values are backdated by means of estimated growth rates of the IFS. Appendix A.1 provides a full description of the estimation procedure of import and export price series for 1990, and a more general discussion on the difference between unit value and price indices.

5.3 Domestic economic and financial conditionsReal domestic output (y) is represented by gross domestic product (GDP) divided by the GDP deflator. Because quarterly values of both GDP and its implicit deflator for 2010 were not available at the IMF IFS database at the moment of writing, I estimate these values these by multiplying each quarter of 2009 by the corresponding real quarterly growth rate for 2010 provided by Le Haut Commissariat au Plan (HCP).

From the graphical representation of the real GDP series in Figure 5.1-, the relatively large volatility during the early 1990s is remarkable. The GDP deflator rather than nominal GDP appears to be responsible for this high level of volatility, and therefore I need to be confident that the implicit GDP deflator is the correct variable to deflate nominal GDP. For example, if the Consumer Price Index (CPI) is used as a deflator, volatility during the period 1993-1997 is reduced for a large extent. The discrepancy between the relative movement of the CPI and the GDP deflator can be seen as the development of net export prices - or the terms of trade. The CPI measures only consumer prices (including import prices), while the GDP deflator – defined as the ratio of nominal to real GDP - is a weighted mean of the price of all GDP components: consumption, government expenditure, investment and net exports. Deterioration in the terms of trade decreases the GDP deflator, but might increase the CPI to an extent that depends on the pass-through of cost or prices, for more details see Yasumatsu (2008). The development of the terms of trade explains a large part of the volatility during the early 1990s, although it cannot explain the discrepancy completely because of measurement issues between the CPI and GDP deflator that arise for measurement discrepancies; the CPI is Laspeyres price index while the GDP deflator is a Paasche index, resulting in an upward bias for the CPI and a downward bias for the GDP deflator (Koga, 2003). Because we are interested in the real value of all domestically produced goods and services, rather than a single basket of consumer goods (that includes import prices and does not take account of

51 Export and import prices are denoted in foreign currency in order to distinguish between changes in international prices of traded goods and exchange rate effects that both affect export and import prices Morocco faces. Furthermore, I like to emphasize that GEM’s export and import prices do not include trade in services, although the share of services in total trade in Morocco is steadily increasing. 52 In the IFS database, export and import price indices are available for 1990.1-1992.4 and 1995.3-1997.3.

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export prices), we use the GDP deflator to estimate real GDP and the volatility of real GDP in the early 1990s is justified.

The consumer price index (CPI) is used as a proxy for the domestic prices (π) and measures the rate of price change of a given basket of consumer goods. Food and energy prices are included, contrary to core inflation that is the policymakers’ official target for setting policy. Food and energy are important elements in Morocco’s consumption pattern and should be included in a proxy for domestic prices; however it should be kept in mind that the Bank al-Magrib implicitly follows core inflation when keeping a watch at price stability.53

The real effective exchange rate (REER) is used as an indicator for Morocco’s exchange rate (e) and is defined by the IMF as a period average nominal effective exchange rate (NOER) index that is adjusted for relative movements in national prices or cost indicators of Morocco, selected countries and the euro area. The NOER in turn is an index of a currency’s period average weighted geometric average of exchange rates for the currencies of selected countries and the euro area. In line with Morocco’s fixed exchange rate regime, the NOER fluctuates around the index base of 100. Under this definition, an increase (decrease) in the REER implicates that Morocco’s relative purchasing power increases (decreases) compared to the world, i.e. when the REER increases (decreases), Morocco becomes less (more) competitive.

Data on worker’s remittance (r) flows to Morocco is abstracted from the personal archive of Mr. Younes Zouhar, a researcher at the IMF Middle East and Central Asia Department and former Chef de la Division de la Balance Morocaine des Paiments In my search of quarterly remittance data the covers my sample period, I got a lead from a paper of Bough-Hagbe of the IMF’s Middle East and Central Asia Department (2004) on remittances in Morocco in which he uses quarterly remittances data for the period 1993.1-2003.4. A mail exchange followed in which Mr. Bough-Hagbe redirected me to Mr Younes Zouhar - as his source of data.

Remittances are subsequently deflated by the Moroccan CPI. Remittance inflows that are defined as private current transfers recorded in Morocco sent by Moroccans abroad are used in this thesis. It is important that this definition of remittance inflows is used rather than using an aggregate of three balance of payment concepts: compensation of employees, migrants’ transfers and workers’ remittances, as is commonly done in the literature.54 Including the ‘wrong’ components may lead to drastic biased results concerning the cyclicality of remittance flows as shown by for example Chami et al. (2008). Worker’s remittances are on average countercyclical while employee compensation and migrants’ transfers are on average procyclical. The different concepts of remittances have a different relationship with GDP: employees’ compensation and migrants’ transfers react to

53 Including food prices in the CPI is important for the Moroccan model because food prices are expected to be an important transition mechanism of a rain shock to the economy. The distinction between core and headline inflation should be kept in mind when interpret policy reactions in response to price changes induced by for example rainfall. The CB therefore not respond directly to changes in food prices, but only respond when food price change translate in changes in core inflation because of second-round effects. Lee (2009) for example shows that food prices not only help to forecast future core inflation, but their conditional variance also affects the conditional variance of core inflation. 54 Compensation of employees cover according to the IMF Balance of Payments Manual (1993, fifth edition) wages, salaries, and other benefits, in cash or in kind, and includes those of border, seasonal, and other nonresident workers. In the case of Morocco, compensation of employees covers mainly pensions and family allowances paid by foreign agencies to Moroccan residents. Migrants’ transfers are flows of goods and changes in financial items that arise from the migration (change of residence for at least a year) of individuals from one economy to another. Workers’ remittances are current transfers by migrants who are employed in new economies and considered residents there.

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changes in GDP of the receiving country in a similar way as traditional private capital flows than migrant remittances that may behave as compensatory income transfers.

In additional to the conceptual differences, remittances are known to be measured with error. Unrecorded remittance flows range generally from 20 to 200 percent of official records (Freund and Spatafora, 2005). De Luna Martinez (2005) argues that remittances received via money transfers operators and informal channels like Hawala operators, friends and family members are often neglected when recording remittance flows. Hence, when one should bear in mind that official recorded remittance are likely to be underestimated, despite the fact that Morocco has been relatively successful in channeling remittances through official channels.

Figure 1 shows a sharp increase in remittances during 2001. This surge was not only experienced in Morocco but also in other remittance receiving countries (like Pakistan) and remains puzzling, although it can be partly explained by the concurrence of the introduction of Euro, concomitant money laundering, tracking and regulating Hawala-type networks in the wake of 9-11 (Barendse et al. 2006; Sayan, 2006; Bougha-Hagbe, 2004 and de Haas and Plug, 2006). I adjust for these outliers by including impulse dummy variables in our model. Because remittance series displays a strong seasonal trend, the US Census’ ARIMA-X12 multiplicative method (Bell et al., 1998) is used to smooth the series.

Data on Tourism receipts (t) is also provided by Mr. Younes Zouhar and seasonally adjusted by the Census’ ARIMA-X12 multiplicative method.

Real domestic demand (d) is approximated by real gross national expenditure (GNE) which is estimated according to a simple income identity. Exports of goods and services are subtracted from GDP and imports of goods and services are added. Series for exports and imports of goods and services are interpolated as they are not directly available for the whole sample period. Because a GNE deflator is unavailable, we use the CPI index to deflated nominal GNE, rather than the GDP deflator that includes export prices while excluding import prices.

To estimate the exports and imports of goods and services for the period 2002.1-2010.3 we use the total value of goods and services exported and imported as reported on the quarterly balance of payments presented by the Office du Change (OC). Because observations before 2002 are not provided by the OC and neither by any other source to our knowledge, we interpolate the export of goods and services quarterly values over 1990.1-2001.4 based on the IMF IFS’s imports and export series (1990.1-2010.3) of merchandise goods. Basically, what I do is estimate the share of trade services for the period 1990.1-2001.4 by interpolating missing data points based on three other times series: annual exports of goods and services series from the World Development Indicators (WDI) database, quarterly merchandise goods exports for 1990.1-2009.4 from the IMF IFS, and monthly tourism receipts as provided by Younes Zouhar.

Interpolation is often used for estimating missing values in data series and can take many forms, however when applying these methods to a business cycle context one should be extremely cautious. For instance, one of the simplest forms of interpolation is assuming a constant growth rate between available observations to estimate the missing value(s). While this method might be acceptable form the view of representing -for example- a particularly country’s share of world GDP as for example done by Reinhardt and Rogoff (2009) because this share is relatively stable, it will not capture any cyclical behavior. My method of interpolation does not dismiss cyclical behavior because of the use of the three time series mentioned above which all have a cyclical component. Appendix A.2 provides an exact overview of the used interpolation procedure.

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Resulting series for domestic demand displays some seasonal behavior, which can be explained by the seasonality of both export and import of goods and services. Exports of goods and services peak in each third quarter of a calendar year, which can for the larger part be explained by the large inflow of tourism receipts during the summer holiday. Furthermore, exports of merchandise goods (like clothing or fruits) also exhibit a modest seasonal component. Imports of goods and services peak in the second quarter (explained by imports of winter-wheat) of each year and to a lesser extent in the last quarter (imports of summer-wheat). This seasonal pattern arises solely because of the import of goods; imports of services as well as import prices do not display any seasonality.

Because the seasonal components of exports and imports do not offset each other, net exports also has a seasonal variation that peaks in each third quarter of each calendar year, while in the second and to a lesser extent each fourth quarter net exports are low. The seasonality of net exports is inversely related to the seasonal pattern of domestic demand since. When net exports are low (second and fourth quarter) domestic demand is high due to increase in imports, while in the third quarter demand is low due to the relative high level of net exports. Tourism receipts compensate for loss of export of merchandise goods during summer, while imports are drastically low in comparison with other quarters.

The question remains why GDP does not display any seasonal behavior, in contrast with GNE. The observation that GNE is generally low in each third quarter while this is not the case for GDP can be explained by the fact that imports (wheat) are low compared to other quarters, while export of goods and services are high during summer, increase in tourism receipts outweigh loss in exports of merchandise goods in the summer. Meanwhile the output of other sectors, like agriculture is low during summer which compensates the increase in net exports, leaving GDP on aggregate relatively unchanged. The difference between GDP and GNE regarding seasonal behavior in the second and fourth quarter of each year, can simply be explained by the structural wheat imports in these quarters, which does not alter domestic production.55 The seasonal component of domestic demand is removed by a U.S. Census Bureau X-12-ARIMA multiplicative procedure.

The interbank rate (IBR) is used as a proxy for domestic interest rates (i) and is extracted from the Bank AL-Magrib (BAM) for 2001.1-2010.3 and the IMF IFS for 1994.1-2004. The years 1990-1993 are represented by the one year deposit rate provided by the BAM because until 1997 – before interest liberalization- the IBR and the one year deposit rate were equal. Interest charged on short-term loans between banks is used as a reference rate in the pricing of various financial instruments.

Real exports (x) are represented by GEM’s goods export volume series for 1991.1-2010.3. For 1990, export volumes are calculated by dividing the IFS’ export of merchandise goods (denoted in mil MDH) value series that is adjusted by the USD/MDH nominal exchange rate (period average), divided by the export unit value index.

Different indicators of financial conditions (q) are used in economic analyses to represent the state of the financial sector in a country. Financial conditions may change gradually over time reflecting development towards a more sophisticated system, and may tighten or expand in the short-run along with economic cycles. Another feature of financial markets is that they

55 Remittances also display a strong seasonal trend, but as these are recorded on the capital account they do not directly affect GDP or GNE. A seasonal trend does not implicate a similar seasonal behavior of GDP and GNE. This depends on their usage and time of spending.

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are subjected to panic; a sudden contraction in financial conditions. Financial crises often trigger serious economic recessions, see for example the fall of Lehman Brothers in 2008.

Different individual measures of financial conditions –like M2 to GDP- are used in the literature to represent the state of the financial system in a country. These measures are however only crude measures of financial development because they reflect only a single aspect of the financial system. Each taken alone can easily give false signals in a context of overall financial development. Some aspects of the financial system develop, while other stay behind or even deteriorate. An index is therefore constructed to capture various aspects of the financial system in Morocco by using indicators that measure the size of the financial sector, the relative ease of banks in provide funds, and the amount of credit to the private sector.56 A description of the three selected indicators, their interpretation in a financial context and sources is presented in Table 5.1. Figure A1 in Appendix A.3 provides a graphical representation of each individual component of the state of the financial system.

The idea of constructing a financial development index is not new, Beim and Calomiris (2001) for example construct a single numerical index of financial development for different continents, where six individual measures are simply averaged to give an overall measure.57 Creane et al. (2004) use a different method to construct a financial development index for the Middle East and North Africa (MENA) region. They use principal component analysis (PCA) to construct an index based on broad money, money bank assets to central plus money bank assets, the reserve ratio, and private credit. I follow Creane et al. (2004) by using principal component analysis (PCA) to construct an index that captures the overall condition of the financial system in Morocco.

In an index based on PCA, weights are assigned to each individual financial indicator in the overall index, based on the eigenvalue decomposition of the observed variance matrix. It reduces the dimension of a particular dataset while maintaining as much as variation as possible; similarities and differences in the data are used to compress the data by reducing the number of dimensions with limited loss of information. More formally, PCA models the variance structure of the dataset using linear combinations of the variables, called components. The loadings are the combination coefficients. The principal components (PC) are estimated by calculating the eigenvalue decomposition of the observed covariance matrix of a group of series, while the loadings are determined by the eigenvectors. The first principal component (PC 1) is the unit-length linear combination of the original variables with maximum variance, while PC 2 is the best summary of the variability left over after PC 1, and so forth. Principal component analysis of the original financial indicators dataset consisting of stock market capitalization, private credit and broad money, excess reserves, reveals that the first principal component (PC1) explains 95% of the total variation that is present in the original data.58 The second principal component (PC2) explains another 3.7% of the variation that is not explained by PC1. The third common factor of comovement (PC3) between the three financial variables is like PC2 negligible according to Kaiser’s criterion (1960); principal components with an eigenvalue less than 1 contain less information than a single standardized variable whose variance is one. Eigenvalues can be found in Table A2 of Appendix A3. We interpret PC1 as the state of overall financial conditions in Morocco.

56 I also attempted to included the borrowing spread and the level of excess reserves in the financial condition index, but they are characterized by structural breaks, resulting in spurious insignificant relationships with the other indicators and the overall index, see Figure 2 in Appendix 2.57 The reserve ratio, real interest rates, liquidity, private borrowing, bank lending and stock market capitalization.58 Before the PCA, all series are standardized by subtracting their mean and dividing by the square root of their variance in order to prevent unit value bias.

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In the context of overall financial conditions, all loadings of PC1 –our weights in the financial conditions index- are of the expected sign. The level of stock market capitalization, broad money and private credit are all positively related to the state of the financial system. As financial conditions ease (tighten), broad money, stock markets, and private credit increase (decrease). The loadings or weights that we use in our financial conditions index are 0.568, 0.583, and 0.580, for stock market capitalization, broad money and private credit respectively. Hence, relative weights are approximately equal. All principal components and their loadings can be found in Table A3.1 in the Appendix, while correlations between the three financial indicators are given in Table A3.2. A graphical representation of the resulting financial conditions index is given in Figure 5.1 below.

Table 5.1 Individual measures of financial conditions in MoroccoIndicator Description Interpretation

CFG 25*

Stock market capitalization. Approximated by the

Casablanca Finance Group 25 Index (CFG 25); it comprises

84% of the total market capitalization of all companies listed at the Casablanca Stock

Exchange

Size, liquidity and activity of stock markets enhance economic growth by encouraged savings and

lowering transaction costs, which improves resource allocation while risk sharing reduces the cost of

capital (Beck and Levine, 2004; Cooray, 2010). On the other hand, stock markets may trigger financial

instability and misallocate capital and become detrimental to economic growth (Eichengreen, 2002).

Private credit

Ratio of credit to the private sector by deposit money banks

Measure of financial width; it reflects the level of financial services or intermediation, (Levine et al.,

2000; Beim and Calomiris, 2001).

M2 Short term liquid liabilities as measured by broad money

Measures the overall size of the financial sector, or financial depth. It is positively correlated with the

provision and quality of financial services (Goldsmith, 1969; King and Levine, 1993).

Sources: Casablanca Stock Exchange (CSE) and Bank Al-Magrib (BAM)* The CFF 25 is a price-only market capitalization weighted index, and by definition considers only the prices of the underlying stocks and excludes dividends. Including dividends would give a better measure of total returns on shares and prevents some additional volatility that arises from quoting cum to ex dividends that tend to decrease a share’s price and vice versa. In general, the additional volatility in overall price indices caused by individual dividends is very modest and long-term trends of price and total return indices are comparable.

5.4 Rainfall A new index is constructed to represent rainfall levels in Morocco during the sample 1990.1- 2010.3. Standard climate datasets that are provided by meteorologists are unsatisfactory for two reasons. First, meteorologists traditionally construct their climate datasets on coherent

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climate zones or grids rather than political boundaries that are used by economists. Second, those climate zones or grids include remote areas that have little economic importance to the country. Meanwhile, the climate in those remote areas is often significantly different from the rest of the country and therefore affects country climate averages. Therefore one must be careful when using standard climate data for economic analysis.

Some attempts have been made to transform the domain of climate datasets from grids into political zones, with Mitchell et al. (2003) as one of the few to provide a comprehensive set of climate data collected by meteorological stations which are simply averaged to estimate the total rain that fall within a country’s border.59 However, those datasets still include economic irrelevant zones like mountains and deserts.60 An exception is the national rainfall index (NRI) developed by Gommes and Petrassi (1994) that is defined for areas where water is a severe constraint for agricultural production. Higher weights in this index are assigned to rainfall in more humid areas relative to arid areas, leading to a rainfall index with a good correlation with crop yields. The NRI is unfortunately only available on an annual basis and only covers the period 1961-2002. The Foreign Agricultural Service (FAS) of the United States Department of Agriculture (USDA) provides rainfall data series for countries that are based on their agricultural areas in their commodities intelligence reports, but only on an occasional basis.

In general, meteorologists do not pay attention to the economic relevance of their series, treating all regions equal when averaging by country, whilst some regions are more vulnerable to changing climate conditions than other regions because they display more economic activity. The resulting biased proxy for rainfall in this case does not reflect the actual effect of climate on the economy. In the case of Morocco, meteorologist for example include regions like parts of Saharan Morocco -with a Subtropical climate that is significantly different from the major part of inhabited Morocco- or the Atlas Mountains in their calculation of country averages. Although the climate of Saharan Morocco or the Atlas Mountains does hardly affect average economic activity of Morocco, their extreme climates does affect average climate levels. Applying average climate levels to economic analysis that include regions that do not affect economic activity while they affect average climate levels is misleading and might result into biased results. Saharan Morocco and the Atlas Mountains should therefore be excluded when calculating country averages in order to make them suitable for economic analysis. Implicitly, this follows from assigning appropriate weights to other regions with more economic activity.

To construct a climate dataset that is suitable for economic analysis I therefore assign weights to rainfall data series that are obtained from stations of the World Meteorological Organization (WMO). Weights are based on the relative economic importance of the region a station represents and their expected economic exposure to climate variability. In this view weights for the Moroccan rainfall index are appointed according to Balaghi et al. (2006) who provide average Moroccan provincial wheat yields –the principle crop in Morocco and highly dependent on rainfall levels- for the period 1990-2004. Greater weight is given to WMO stations that are located in regions with relatively high wheat yields. For example, the

59 Its use is however limited. In the Mitchell dataset the last ten year are missing which might impose serious restrictions on empirical models. As economic data for Morocco is only available for the years 1990-2010, but precipitation data only until 2000, this implies a reduction of forty observations, half the total number of observations in the Moroccan VAR model for the period 1990-2010 thereby significantly reducing the scope and validity of the model.60 Meanwhile, it is likely that there exists a relationship between an areas’ severe climate conditions and its low levels of economic activity. However this is often a process of centuries, for our sample we are however interested in changes in rainfall on economic activity; in places with no economic activity, climate changes do not affect economic activity.

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region of Meknès produces about eight times more than the much drier region of Ouarzazate. Absolute rainfall anomalies in Meknès will therefore have more consequences for Morocco than the same anomalies in Ouarzazate.

Table 5.2 provides an overview of the selected WMO stations in Morocco as well as their appointed weights. The original daily precipitation series are abstracted from the Global Historical Climatology Network (GHCN) Version 2.0 data base and the Federal Climate Complex Surface Summary of Day Data of National Climate Data Center of the U.S. Department of Commerce. Figure A4.1 in Appendix A4 provides a geographical illustration of the location of the considered WMO stations.61 The resulting rainfall index is denoted in millimeters and is estimated for the period 1961 – 2010 on a monthly basis. Rainfall anomalies are subsequently calculated by subtracting WMO defined climatological normals from the constructed rainfall index. A precipitation normal is defined by the WMO (1989) as the arithmetic mean of the precipitation element computed over three consecutive decades, which should be updated every decade. A climate normal describes the climate and is used as a base to which current conditions can be compared. In my case, the standard reference periods are 1961-1989, 1971-1999 and 1981-2009 for 1990-1999 and 2000-2009 and 2010 respectively. No significant structural breaks occurred in Morocco’s climate normals during our sample; i.e. I do not find a long-term trend in Morocco’s rainfall pattern, although there exist a clear seasonal pattern. Rainfall anomalies therefore represent deviations from a long-run seasonal pattern.

Table 5.2 WMO stations and their appointed weights in the rainfall index for MoroccoLocation WMO station number Weight*

Tangier/ Boukhalf 601010 1Tetouan 603180 1

Oujda/ Angads 601150 5Rabat/ Sale 601350 1

Midelt 601950 5Meknès/ Bassatine 601500 42Casablanca/ Anfa 601550 42

Safi 601850 11Marrakech/ Menara 602300 11Agadir/ Inzezgane 602500 5

Qourzazate 602650 5

*Source: based on average wheat production 1990-2004 as provided by Balaghi (2001)

Table 5.3 List of variables in the SVAR model for Morocco

Domestic economy blocky domestic real output

Foreign economy blocky* trade weighted real foreign output

61 For more information about the locations of the stations (latitude, longitude etc) or their type (US navy site, public airfield etc) see the International Station Meteorological Climate Summary (ISMCS) developed at the Federal Climate Complex in Asheville, North Carolina (US).

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π domestic prices q domestic financial conditionse real effective exchange rate d domestic demand r real migrant’s remittances ex export volume i domestic interest rate t tourism receipts

π* foreign pricesi* foreign interest rate f* international financial stress

International prices blockpe world export pricespi world import prices

Domestic climate blockp precipitation/ rainfall

All variables except the foreign interest rate, the domestic interest rate and precipitation in centimeters,are denoted in natural logarithms.

Figure 5.1 Graphical representation of the variables included in the SVAR model

Domestic output Domestic prices

Exchange rate Domestic demand

Remittances Tourism receipts

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Export volume Domestic financial conditions

Domestic interest rate Precipitation

Import prices Export prices

Foreign Output Foreign interest rate

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Foreign financial stress Foreign prices

Dotted lines represent long-term trends as estimated by the Hodrick-Prescott filter, except for precipitation where the dotted line represents WMO climate normals. All variables except foreign interest rates, domestic interest rates and precipitation are denoted in natural logarithms.

6 Estimation and stability

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The number of VAR coefficients to be estimated increase in direct proportion of the square number of variables. This implies that many parameters need to be estimated - including many that are statistical insignificant- which consumes many degrees of freedom. As discussed in Section 4 of this thesis, a subset VAR makes the model more parsimonious by purging the insignificant coefficients from the VAR which reduces the number of coefficient estimates (Enders, 2010). Others might use a Bayesian approach by combining a set of prior beliefs with the traditional VAR methods. Subset VARs therefore allow variables and lag lengths to differ across equations, while in ordinary VARs lag distributions are perfectly symmetric. Lütkepohl and Brüggemann (2001) argue that although response patterns from full and subset VARs are qualitatively identical, confidence bands for the standard model are considerably wider. I follow the top-down strategy procedure of Lütkepohl and Brüggemann (2001) to restrict some lags to zero in the Moroccan VAR model. This procedure is for example also used by Bhar and Hamori (2005) to construct a subset VAR model for the linkages between international stock markets.

Lutkepöhl (2007) provides a description of the top-down strategy for subset VAR modelling and is followed in this thesis. First, the VAR order is determined using the information criteria as mentioned above. Second, from this full VAR model parameters are deleted one at a time from the equations separately and each time the model is estimated using SUR and the Akaike and Schwarz information criteria is compared with the previous minimum one.62 If the current value of the criterion is greater than the previous minimum value, the coefficient is maintained otherwise deleted. In other words, in each step a lag of a variable is deleted of the criterion does not increase by that additional constraint compared to the smallest value obtained in the previous steps.63 Meanwhile, an eye is kept on whiteness of the residuals by means of Portmanteau tests. Finally, the resulting set of equations including all lag restrictions is estimated. The structure of the final model including the lag restrictions is provided in Figure 4.1 in Section 4 of this thesis. According to Lütkepohl the advantage of this top-down procedure, starting from the top or largest model) and then working down gradually, is that it permits to check all individual coefficients. The disadvantage of this top-down strategy is that each equation needs to be estimated in the initial selection step which consumes many degrees of freedom. However, this potential problem is eliminated in the Moroccan VAR model by restrictions imposed a priori based on economic theory.

The traditional way of estimating the parameters of a structural (subset) VAR as constructed in the previous section of this thesis is to use a two-step procedure as proposed by Bernanke (1986). This approach first calculates the residuals and the variance-covariance from the reduced form VAR estimates. The reduced form VAR is traditionally estimated by ordinary least squares (OLS) when the model is perfectly symmetric, or by seemingly unrelated regression (SUR) otherwise (see for example Enders, 2010 or Lütkepohl, 2007). The second step is to estimate the contemporaneous matrix in Eq. (3.1) through the sample estimates of the variance-covariance matrix, often by full information maximum likelihood (FIML). FIML maximizes the likelihood function via for example a nonlinear squares Marquardt’s method and assumes normally distributed disturbances. Alternatively, the Broyden-Fletcher-Goldfarb-Shanno (BFGS) algorithm is used to estimate the contemporaneous matrix in the second step of the Bernanke procedure, a second-derivative search method. 62 Alternatively, subset models are estimated by the elimination of the regressors with the highest p-value or the lowest t-stat in absolute order, see for example Kulaksizoglu and Kulaksizoglu (2009). This is not a good option for VARs as t-values are often unreliable as regressors are likely to be collinear. 63As an alternative for this conventional information-based subset method, Hsu et al. (2008) suggest to use the Lasso shrinkage method that avoids computationally intensive and exhaustive search. Although this method is interesting and promising it was not feasible in the setting of this thesis.

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A less commonly used alternative to the two-step procedure of Bernanke is to estimate the estimate the reduced form parameters and the contemporaneous parameters jointly.64 In this view, a VAR system can be seen as a group of equations containing unknown parameters which can be estimated using a number of multivariate techniques that take into account the interdependencies among the equations in the system. This estimation procedure follows the approach by Zellner and Palm (1974) which estimates the model in the tradition of a seemingly unrelated regressions (SUR) system instead of using the standard tow-step SVAR approach of Bernanke and Sims. The ‘system’ approach to VARs is used in an number of papers.

Zhang et al. (2004) for example use a system estimated by Seemingly unrelated regression (SUR) to test the robustness of their VAR results. In a system setting that is estimated by seemingly unrelated regression (SUR), they remove the effects of global shocks in order to examine the correlations of underlying local shocks that effect economies in East Asia. Forbes and Abeysinghe (2005) develop a structural VAR model to measure how a shock to one country can affect the GDP of other countries by using a new specification strategy. In order to capture both direct trade linkages as well as indirect multiplier effects through output fluctuations in other nations, they develop a model in which simultaneously output supply and demand across all countries in the world are equated. The model differs for the Sims-Bernanke type of structural VAR in four ways. First, the model is over-identified, whereas Sims-Bernanke models are exactly identified. Second, the model is extremely parsimonious, whereas the Sims-Bernanke models are highly over-parameterized. Third, the covariance can have non-zero off-diagonal elements, allowing non-zero correlation between error terms, whereas Sims-Bernanke assume diagonality a priori. Fourth, Forbes and Abeysinghe introduce a changing parameter structure in the model. An export share matrix is allowed to vary smoothly over time to reflect changing trade patterns of countries. Three-stage leas squares (3SLS) is used to estimate the SVAR model, while the authors notice that they could not implement a FIML procedure due to the interaction between output and the changing export shares. Wild and Schwank (2008) follow the approach by Forbes and Abeysinghe (2005) which estimates the model in the tradition of seemingly unrelated regression (SUR) to estimate the effect linkages between sectors on sectoral growth performance in South Africa.

Various techniques exist to solve systems consisting of a group of equation containing unknown parameters and can be estimated taking into account the interdependencies among the equations. Well known methods of estimation are ordinary least squares (OLS), weighted leas squares, weighted two-stage least squares (2SLS), three-stage least squares (3SLS), full-information maximum likelihood (FIML), generalized method of moments (GMM), and autoregressive conditional heteroskedasticity (ARCH). A common finding with time series model including systems, is that residuals may be correlated with their own lagged values.In the case of serial correlation, ordinary least squares is no longer efficient. Since prior residuals help to predict current residuals, this information can be used to form a better prediction of the dependent variable by for example using a Marquardt nonlinear least squares algorithm. Nevertheless, system residual Portmanteau tests for autocorrelation reject the presence of serial correlation of the residuals in the model as constructed for Morocco,

64 Because of the nonstandard specification of the structural VAR, like for example the inclusion of exogenous rainfall with threshold effects and asymmetric lag specification, the standard SVAR two-step specification and estimation method used by the computer package EViews is unsatisfactory. Therefore, the SVAR as developed in this thesis had to be estimated using the system estimation interface where the reduced form parameters and the contemporaneous parameters are implicitly determined jointly.

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suggesting that the VAR has sufficient lags to eliminate any remaining serial correlation. Results of the system residual Portmanteau test for autocorrelation are presented in Table C1. of Appendix C. From the perspective of the absence of serial correlation, there is no need to estimate the model using nonlinear techniques.65

Lag length determination is therefore a critical element in the specification of a VAR model. The inclusion of sufficient lags prevent autocorrelation of the error terms but increasing the lag length reduces degrees of freedom quickly, resulting in significance of inefficient estimators. The selection of the appropriate lag length therefore involves a trade-off between bias and efficiency. In the words of Lütkepohl (2007), selecting a higher order lag length than the true lag length causes an increase in the mean-square-forecast errors of the VAR and that under fitting the lag length often generates autocorrelated errors. Lütkepohl discusses various criteria that are used to select the appropriate lag length of a reduced form VAR model: the sequential modified LR test statistic, the final prediction error (FPE), the Akaike information criterion (AIC), the Schwarz information criterion (SC), and the Hannan-Quinn information criterion (HQ). Basically, the information criteria reflect the trade-off between the reflection of the observed process – minimized error terms-, versus the amount of parameters –to many lead to inefficient estimators. Information criteria are therefore a combination of the squared sum of residuals and a penalty term for the number of lags. When estimating the reduced form VAR model for Morocco, the selection of lag length was restricted between one and five. Kilian and Ivanov (2005) suggest that the Hannan-Quinn Criterion (HQ) is the most accurate criterion for quarterly VAR models, whit the exception of sample sizes smaller than 120, for which the Schwarz Information Criterion (SI) is more accurate. I follow Hatemi-J and Hacker (2009) who suggest that combining the sequential modified LR test statistic with the Schwarz information criterion (SC) and the Hannan-Quinn information (HQ) criteria cause a substantial increase in the success rate of choosing optimal lag order. The reduced form VAR was therefore estimated with three lags.

Besides the selection of the appropriate lag length and the presence of serial correlation, the question whether the system is recursive rather than simultaneous is important for the selection of the estimation technique. A potential simultaneous equation bias – where the error term is correlated with the independent variable- should be taken care of. The main way to solve this issue is to use an instrumental variables methodology like 2SLS or 3SLS, which is the approach used by Forbes and Abeysinghe (2005) in their ‘system’ estimation of the SVAR. Full maximum likelihood (FIML) is another approach to overcome simultaneous equation bias. FIML does not require instrumental variables, but assumes that the equation errors have a multivariate normal distribution in contrast with 2SLS and 3SLS.

The SVAR as constructed for Morocco is however recursive rather than simultaneous. A recursive or triangular model is a special case of an equation system where the endogenous variables are determined one at a time in sequence. A system is called diagonally recursive if in addition there is no correlation between the stochastic disturbances. Ordinary least squares (OLS) is in this case an appropriate estimator for each single equation in the system. If a system is recursive but not diagonally recursive, disturbances might be correlated across equations and seemingly unrelated regression (SUR) of Zellner and Palm (1974) is a more efficient estimator. Correlation of the various errors may arise from example common omitted variables. Even if errors are uncorrelated across equations, SUR is a more efficient estimator than OLS when lags are asymmetric (Enders, 2010), which is the case in the model for Morocco.

65 For example, EViews transforms the linear model with serial correlation and estimate the parameters by applying a Marquardt nonlinear least squares algorithm to the transformed equation. The nonlinear least squares estimates are asymptotically equivalent to maximum likelihood estimates.

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The SUR method, or Zellner’s method, estimates the parameters of the system, accounting for potential heteroscedasticity and contemporaneous correlation in the errors across equations.66 The model for Morocco is block recursive and the recursive or triangular property applies to blocks made up of subset of the equations in the model: the foreign economy, international trade prices, the domestic economy, and climate. Each block is solved for in turn. In addition, the blocks themselves contain no simultaneity and each equations is therefore simply evaluated once to obtain values for each of the variables. Therefore the SUR method provides sufficient estimations for the Moroccan model. Because the model does not contain simultaneity biases or serial correlated errors, FIML does not add efficiency. More importantly, as said before FIML is based on the assumption that errors are Gaussian. If the errors are not normally distributed, FIML may provide poor results. Unfortunately, errors of the Moroccan model seem to be nonnormal, as indicated by the system residual normality test that are provided in Appendix C2. For multivariate normality tests, various factorization of the residuals that are orthogonal to each other exist. First, Lütkepohl (2007) uses the inverse of the lower triangular Cholesky factor of the residual covariance matrix. The resulting test statistics depend on the variables in the VAR. Second, Doornik and Hansen (2008) use the inverse square root of the residual correlation matrix. This test is invariant to the ordering and to the scale of the variables in the VAR. Third, Urzua (1997) proposes to use the inverse square root of residual covariance matrix as factorization. Both the Urzua and Lutkepohl test for normality reject the null hypothesis of multivariate normal error. However, the Doornik-Hansen test does not reject the null hypothesis of multivariate normal error. Meanwhile, some equations display non-normal behavior according to the Jarque-Bera statistc and in the Doornik-Hansen test the skewness and kurtosis are not in line with normality either. Because or VAR model has a recursive structure, normality test based Cholesky factorization as proposed by Lütkepohl, are probably the most appropriate and indicate that errors are non-normal. Therefore there exist strong suspicions that the VAR model for Morocco has non-normal errors.

Galvão (2006) relates possible difficulties with maximum likelihood estimation to threshold models. Likelihood estimation assumes that the covariances are the same for each regime, which may not hold when applied to macroeconomic data with time-varying variances. As noticed by Feng and Wongwachara (2009), when a regime indictor is observable –in the Moroccan case rainfall- the classification provides perfect discrimination among regimes. This enables estimation with piecewise linear regression separately as suggested by Goldfeld and Quandt (1973). Using the parameters estimated from the VAR model the impulse response functions and dynamic multipliers are subsequently estimated using the Broyden solution algorithm in EViews. Broyden’s method is a modification of Newton’s method where an approximation to the Jacobian is used when linearizing the model rather than the true Jacobian which is used in Newton’s method, see for more information EViews (2009).

Non-normal errors however may violate some of the assumptions for the variance properties of a VAR. They also may indicate that the linear VAR can be improved upon by taking care of nonlinear effects, particularly as linear forecasts are not optimal in the presence of non-linearity. They also point to outliers or structural breaks. Thus, non-normal errors may sound a warning on VAR results, while they need not necessarily invalidate the VAR.

66 EViews allows for cross-equation restrictions on parameters and therefore estimates a more general form of SUR than is typically described in the literature.

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According to Lütkepohl normality is not a necessary condition for the validity of many of the statistical procedures related to VAR models, by deviations for normality may indicate that model improvements are possible. For example, rejection of normality may reflect the existence of nonlinear behavior in the model which is not captured, outliers, or that the error process is not homoscedastic.67 However, it is in the case of many studies that economic shocks deviate from normality, even after model adjustment.VAR residuals are often found to be nonnormal in applied work (Lütkepohl, 2007). Financial shocks for example often do not follow a normal distribution. Nevertheless, much of the asymptotic theory on which inference in dynamic models is based also work for certain nonnormal residual distributions (Olsen, 2010). Most importantly, in terms of VAR estimation non-normality results in a loss of asymptotic efficiency in (maximum likelihood) estimation. As part of sensitivity analysis, alternative specification were tested to check the robustness of coefficient estimates. The stability condition of the VAR is fulfilled as all the calculated characteristic roots lie outside the unit circle.

7 Shock responses: impulse response functions and dynamic multipliers

67 Taking into account autoregressive heteroscedasticity (ARCH) effects may resolve the problem of non-normal errors. However, SUR estimation of the system already accounts for the possible presence of heteroscedasticity.

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One particular interesting feature of a VAR model is their ability to examine economic response to shocks within the system. As discussed in Section 3, impulse response functions following economic shocks or dynamic multipliers following exogenous rain shocks trace out the adjustment path of the economy. The results can help to inform Moroccan policy makers how economic variables react to foreign and domestic shocks, real and financial shocks, and climate shocks. Claims by the Moroccan authorities that the economy is relatively insulate form world financial turmoil and rainfall and shocks, are examined by the adjustment path following these shocks. Do rain shocks result in a different adjustment path during droughts than under normal rainfall conditions? For example, rainfall during drought may increase slaughter rates –in anticipation to a drought Moroccans for example may slaughter livestock earlier than planned-, resulting in a temporary output boom. Do remittances respond procyclical to Moroccan output or do they dampen the business cycle? In the next section, the relative contribution of each shock to the Moroccan business cycle is assessed. For now the focus is on the dynamic impact of the shocks.

Before turning to the interpretation of the impulse response functions and dynamic multipliers, two caveats need to be mentioned. First, not all shocks are identifiable despite the imposed structure on the VAR. Particularly, we cannot interpret shocks to GDP and GNE as supply and demand shocks respectively despite the inclusion of both variables in the model. The reason is that some components of expenditure simultaneously affect aggregate demand and supply, like infrastructural expenditure.68 Shocks are therefore labeled simply after the equation from which the originate, rather than giving them an interpretation like supply or demand shocks. The sizes of shocks applied to the SVAR model are one standard deviation of the structural error. Exogenous rain shocks are the size of one standard deviation. Value of the roots from eigenvalues of the estimated VAR model and 60-year simulations confirm that all the IFRS converge.

Two standard error confidence bounds around the impulse response functions are presented. Impulse response functions are based on the estimated coefficients of the VAR and since each coefficient is estimated imprecisely, the impulse responses also contain error (Enders, 2010). Confidence intervals are therefore constructed around the impulse responses that allow for parameter uncertainty inherent the estimation process. First-order asymptotic theory based confidence is only one of the various methods that are used to constructed confidence bounds for IRFs, others include The standard bootstrap (Efron and Tibshirani,1993), the bootstrap after bootstrap (Kilian,1998), and Hall’s percentile method (Hall, 1992). The problem with the construction of confidence bounds based on first-order asymptotic theory is that as discussed in the previous section, there are (strong) indications that error are not normally distributed – although the Doornik-Hansen test suggest otherwise. For times series models with nonnormal residuals it is recommend the use a time series bootstrap to obtain the standard errors and confidence intervals.69 Enders (2010) suggest a way to obtain desired confidence intervals that do not assume normality by performing the following Monte Carlo study. Unfortunately, I was unable to implement such a procedure in EViews but as suggested by Enders the Estima RATS or GAUSS program is capable to estimate the bootstrap confidence intervals.70

68 It is however possible to identify demand and supply shocks by for example the Blanchard-Quah (1989) decomposition or better known as long-run restrictions on a VAR. Another possibility is estimating the SVAR by sign restrictions upon the impulse response as a way of identifying demand and supply shocks. See Fry and Pagan (2011) for an review of sign restrictions in SVARs. 69 Note that asymptotic confidence bands are necessarily symmetric while the shape of bootstrapped confidence intervals depend on the bootstrap distribution and may be asymmetric. 70 Basically, I did not succeed to automatize the process as suggested by Enders in EViews to repeat itself for a several thousand times because of the use of the system and model interface to derive the impulse response functions.

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Theoretically, the confidence intervals for the impulse response functions and dynamic multipliers are estimated as described by Enders (2010). First, estimate the VAR coefficients and save the residuals. Let âi denote the estimated values of the VAR coefficients ai and let {ê i } denote the estimated residuals. Second, for a sample size of T, draw T random numbers so as to represent the {e t } sequence by using randomly selected values of ê i with replacement (bootstrapping). This creates a simulated series of length T, {et

s } that should have the same properties as the true error process. Third, these random values can be used to construct a simulated { yt

s } sequence: y ts=â0+â1 yt−1

s +…+âp y t−1s +e t

s. The series has to initialized in order to eliminate the effects of initial conditions. Finally from the constructed, the simulated { yt

s } sequence the VAR is estimated again. Form these newly estimated VAR, impulse response functions are estimated again. This process is repeated several thousand times, thereby generating several thousand impulse response functions. These IFRs are then used to constructed the confidence intervals. To construct a 95 percent confidence interval, exclude the lowest 2.5 percent and highest 2.5 percent. The complicated issue with the construction of confidence intervals of a VAR is that regression residuals are correlated and one should use the imposed structure to construct a simulated series of {et

s }, see Enders (2010) for more details and examples. Note that the bootstrap is still an asymptotic procedure; the bootstrap is a second order refinement in that it is a better asymptotic approximation than the normal distribution. Meanwhile, because of potential non-normal errors in the Moroccan VAR, is a probably better to use an bootstrap procedure as described above than using a first-order asymptotic theory. Therefore, one should keep this in mind when evaluating the constructed confidence bound around the IFRs.

Although, bootstrapped confidence intervals for the IFRs for Morocco are preferable, problems related to standard methods for constructing confidence intervals that are mentioned above (Efron and Tibshirani, 1993; Kilian,1998; Hall, 1992), are likely to be prevented. As emphasized by Benkwitz et al. (2000) confidence bounds based on first-order asymptotic theory and standard bootstrap methods may be unnecessarily large and may have real coverage probabilities quite different from the corresponding nominal levels. These problems cannot be solved by simple bias adjustment which have been proposed in the literature. Benkwitz et al. (2010) cannot recommend to use any of these methods for a large VAR model because the problems of standard methods are for the larger part caused by zero elements in the autoregressive matrices. Therefore, it is recommended to pretest for zero coefficients and specify subset VAR models, which is done in this thesis. If the zero elements are specified correctly, all the standard methods should work asymptotically.

7.1 Foreign shocksAs a small open economy, Morocco is expected to be vulnerable to foreign shocks. Impulse response functions following various foreign shocks raise do not confirm claims by the Moroccan authorities that the country is vulnerable to real shocks rather than financial

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shocks. Impulse responses resulting from the various foreign shocks are presented in Figure 7.1 and 7.2 below.

7.1.1. Foreign output shockA negative foreign output shocks is immediately followed by modest (and insignificant) decrease in foreign inflation and a decrease in foreign interest rates by the central bank.71 Subsequently, financial stress decreases following a lower interest rate and a decrease in inflation. Lower financial stress and interest rates contribute to the recovery of foreign output to trend after one and a half year.

Prices that Morocco face on international markets for its imports decrease following a negative output shock, with a bottom in the fourth quarter after the shock occurred. The negative effect on export prices is smaller and becomes even positive in the second quarter. This suggest that the import prices that Morocco face are more elastic with respect to foreign income shocks than export prices. Remittances immediately decrease following a foreign output shock, suggesting that the income of migrant’s is an important element of the decision to remit. The peak decline is already reached in the second quarter from which remittances recover back to trend in the third quarter. Tourism receipts do not react significantly in response to foreign output shocks, suggesting that foreign income shocks are not an important determinant of tourism receipts in Morocco. Tourism is therefore not an important channel by which innovations to foreign output are transferred to the Moroccan business cycle, in contrast with the general believe that tourism is an important transmission mechanism of foreign shocks. Export volumes, the domestic interest rate, the exchange rate, also do not react significantly in response to a foreign output shocks. The effect of an foreign output shock on the volume of export is expected to work via the effect on the price of exports, but they do not respond to foreign output shocks to a large extent.

Given the nature of Morocco’s exchange rate regime (pegged) the dynamic impact of foreign output shocks on the Moroccan economy is somewhat surprising because theory predicts that a country with a fixed exchange rate regime will adjust to terms-of-trade shocks induced by for example a contraction in foreign demand, will adjust through a contraction of domestic output, while a country with flexible exchange rates will adjust through a currency depreciation that offsets the negative effects on output following a shocks. However, from the impulse response functions it becomes clear that the effect of a foreign output shock on import prices is more pronounced than on export prices. This implicates that Morocco’s terms improves following a shock to foreign output, rather than deteriorates. Since importers are demanding less euro’s, upward pressure on the dirham is created. Because of Morocco’s pegged exchange rate, authorities will be required to intervene in the foreign exchange market to maintain the value of the currency. Hence, they will reduce the upward pressure on the dirham by purchasing euro’s for dirhams. This increases the supply of dirhams in the money market, increasing the amount of money and credit available for investments. Indeed, the impulse response function of domestic financial conditions indeed correspond with this line of reasoning. At impact, financial conditions slightly decrease in Morocco following a foreign output shocks. In the second quarter however financial conditions reaches a peak above trend reflecting possible intervention in the foreign exchange market by the central

71 International financial stress does not respond to output shocks directly as information on output shocks is captured earlier in the stress index than in the output variable which is published with some time lags. Hence, stress causes output and not vice versa. The financial stress index had probably increased already in anticipation of lower output due to an unexpected shock. Sensitivity analysis (like Granger causality tests, and an alternative specification of the model were output is allowed to affect financial stress directly) between the financial stress variable and output confirmed this view.

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bank. An ease of financial conditions contribute to output above from the third quarter onwards, although this effect is likely to be insignificant.

The unequal effects of foreign output shocks on import and export prices and subsequently intervention effects illustrate the importance of including both import and export prices individually in the model, rather than a single measure of the terms of trade.

7.1.2 Shock to international financial stressThe inclusion of financial stress in the model for Moroccan is one of the more interesting features of the model. The Moroccan economy is not as insulated from international shocks as claimed. At impact, a shock to financial stress increases the international interbank rate but the central bank succeeds in the next quarter to control the interbank rate again. Foreign output decrease one quarter after the shock, recovering the next quarters to above trend values for the next three years because of lower interest rates. Foreign prices remain for two and a half year below trend following a increase in financial stress.

The shock to foreign stress directly translate in lower import and export prices Morocco face on international markets. Export prices recover more quickly than import prices, which may result in a modest term of trade gain temporary. Moroccan export volumes are almost unaffected by a shock to financial stress, despite the temporary drop in world export prices. Because export prices recover within a year, this may suggest that Moroccan exporters do not have sufficient time to adjust their volume of exports, or that they simply not chose to reduce their export volumes but simply bear the temporarily lower prices for the export produces. Exporters nevertheless face less revenues which contributes to the loss of Moroccan output and expenditure. Domestic output and expenditure remain below trend for more than six years, suggesting longstanding effects of international financial shocks for the Moroccan economy. In line with the drop in output, expenditure and export and import prices, domestic inflation falls below trend for two years. The exchange rate depreciates following the shock to international financial stress, but recovers the next quarter to overshoots its trend value. An explanation can be found in the Dornbusch overshooting model where the market adjust to a new equilibrium between prices and quantities. Initially, because of the stickiness of prices of goods, the new equilibrium will be first achieved through shifts in financial markets. Financial conditions in Morocco decrease at impact, lasting for more than six years and recover very slowly. Tourism receipt temporary increase following the temporary exchange rate depreciation. Interestingly, remittances decrease following turbulence on international financial markets and remain below trend for one and a half year as a combination of the drop in income of the remitter and an overall deterioration of economic conditions in Morocco. This suggest that the Moroccan remitter is not as altruistic motivated as thought or his reduction in income is that strong that he is forced to reduce his remittances. A reduction in remittances reinforce the deterioration of economic conditions in Morocco on its turn. Finally, domestic interest rates do not react significantly to international financial turbulence, which is not surprising given the limited space for the central bank to intervene given its pegged exchange rate regime. However, it might be worthwhile to reverse the sharp decrease in domestic financial conditions following international financial markets turbulence by for example reducing domestic interest rates, but to be effective the pegged exchange rate might be abandoned. In addition, it remains the question of lowering interest rates is an appropriate measure to ease financial conditions in Morocco as is discussed below. Anyway, the exposure of Morocco to stress on international financial markets reinforces the discussion on a possible exchange rate regime shift in order to pursue an independent monetary policy. Poole’s model (1970) for the optimal choice of monetary instruments recommends that increased financial sector volatility increases the

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desirability of an interest-rate-oriented policy procedure over a monetary-aggregate procedure. But Morocco is not ready for interest-rate based policy given its immature financial structure. On this basis, Morocco should work on its institutions and financial structure to move to a flexible exchange rate system and an interest-rate oriented policy.

7.1.3 International price shockThe central bank tightens its monetary policy by increasing its key interest rate in response to an international price shocks. International output subsequently falls and financial stress increases. In response, interest rates are lowered, even below trend. From the fourth quarter onwards, output gradually recovers, financial stress ease away and inflation returns to normal values.

Import and export prices are hardly affected by a foreign price shock, although international import prices that Morocco faces on international markets temporary increase significantly in the first quarter. Export volumes are therefore also unaffected by foreign price shocks. Following a foreign price shock, the real exchange rate depreciates, i.e. Morocco becomes more competitive. Domestic inflation increases following a world price shock, despite the limited effect on trade prices. This suggest the existence of alternative channels for the international transmission of inflation, as discussed in Section 4.2.3.3, like standard purchasing power parity theory with fixed exchange rates. Nevertheless, the Moroccan economy remains relatively sheltered from foreign prices shocks. Remittances increase slightly in the third quarter following a foreign price shock, reflecting exchange rates effects. This reflect the remitter possible take advantage of a more favorable exchange rate and increase their remittances, rather than remitting less foreign currency to yield the same level of Moroccan dirhams that are remitted.

7.1.4 Foreign interest rate shockA positive foreign interest rate innovation slightly contract output, decrease foreign inflation and give an impulse to stress on financial markets. Import and export prices are hardly affected. The exchange rate appreciates slightly in the second quarter after the shock, reflecting lower foreign inflation rates. From the second quarter to the sixth quarter the exchange rate however depreciates below trend, reflecting some pressure on the exchange rate within the bandwidth of the peg. Capital controls limit this effect. Higher foreign interest rates are translated to domestic interest rates, although only to a limited extent and this is effect is likely to be insignificant. Remittances temporary increase after a positive foreign interest rate innovation in reaction to the cyclical interaction between the exchange rate financial conditions and foreign interest rates.

Domestic financial conditions tighten due to higher foreign interest rates, reflecting some degree of capital outflow because of higher foreign returns. Because of the fixed exchange rate regime, this creates downward pressure on the value of the Dirham and authorities need to intervene in the foreign exchange market by buying dirhams for euro’s. This decreases the supply of dirhams in the money market, decreasing the amount of money and credit available for investments. I.e. financial conditions in Morocco deteriorate following a foreign interest shock. The impulse response functions therefore reveal a similar pattern as predicted by the Mundell-Fleming model where a fixed exchange rate is the cause of adverse domestic economic conditions following positive foreign interest rate innovations. Flexible exchange rates absorb foreign shocks like interest innovations. Nevertheless real variables in the Moroccan economy like output and expenditure are affected only to a limited

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extent by foreign interest innovations, suggesting that the real economy is relatively insulated from foreign interest rate shocks – despite the fixed exchange regime.

7.2 International trade price shocksAs explained in Chapter 4, the characteristics of the Moroccan economy likely result in asymmetric behavior of export and import price shocks, which should therefore both be included in the model rather than a single measure of the terms of trade. IFRS show that import and export prices are more the less mirrors of each other, a part form the effect of the exchange rate and relative magnitudes of the effects the generate.

7.2.1 Import price shockAn import price shock generates a short but sharp recession in Morocco. At impact, higher import prices increase domestic expenditure as a large share of expenditure is on imports. This reflect a low substitutability of imports –which is not surprising giving the large share of imported food and oil- and Moroccans are therefore unable to avoid the higher import prices. Gradually, higher import prices mean less disposable income to spent and domestic expenditure fall. Domestic output increases at impact of the positive import price innovation, but subsequently falls below trend due to higher input costs. The temporary increase in domestic output following higher import prices is somewhat puzzling, but may be explained by that fact that initially there is some degree of substitutability in the short-run between imported goods and domestically produced goods. For example, Moroccans may consume part of their stockpiles of grain in order to evade higher prices of imported grain. Domestic prices initially increase and the exchange rate subsequently appreciates. Financial conditions improve slightly at impact reflecting the existence of credit programs to deal with higher import prices, or the existence of agents raising loans to overcome the temporary higher import prices. Meanwhile, higher import prices and no reduction in volumes implicate that the value of the dirham is under pressure, which obliges the authorities to intervene by buying dirhams for foreign currency which effectively reduces the domestic money supply. Nevertheless domestic financial conditions seem to expand after an import price shocks. Financial market condition in Morocco will further ease until the fifth quarter after the import price shocks. Higher domestic expenditure (on imports) increase the demand for credit at any given interest rate. Because domestic income does not increases -it even decreases- higher temporary expenditure on imports has be financed by credit. Higher interest rate and a higher level of credit result. Higher interest rates may also be partly the result of credit demand of the government in order to finance its import subsidy programs. In addition higher interest rates may be the result of the central bank that reacts to higher expenditure and inflation by raising interest rates as an import price shock leads to a trade-off between inflation and the output gap ad discussed in Section 4.2.3.5. Remittances do not respond to import price shocks, suggesting that the remitter is not altruistic motivated and does not compensate higher import prices in Morocco by increasing the level of remittances.

7.2.2 Export price shockA positive innovation to world prices for Moroccan exports is at impact followed by an increase in domestic expenditure –as income of exporters increase- and output follows. The volume of exports is relatively insensitive to price changes, although a slight but insignificant peak decline is revealed by the impulse response function. Domestic prices increases following the boom in domestic expenditure. Domestic output falls back from above trend to below trend in the second quarter, from which it gradually recovers. This is remarkable, but this may suggest that increased income from higher export revenues is spent

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on imported goods, rather than domestic goods. It may also be a sign of a possible correction as a consequence of overheating. The real exchange rate appreciates slightly in the second quarter, but decrease when inflation domestic inflation falls and some of the additional income for exports is spent on imports. As higher export prices without an decrease in export volume results in upward pressure on the dirham, the central bank is obliged to intervene by buying foreign currency for dirhams. Hence, domestic financial conditions ease, contributing the boom in expenditure. Remittances increase in the first two quarter after the export price shock and the remitter may have a portfolio motive because has wants to profit from higher export prices. Because the exchange rate effect of an import price shock is stronger than for an export price shock, the net effect on remittances is zero in case of an import price shock as remitters decrease their transfers in response to an real exchange rate appreciation. Their money is more worth in the country of residence than in Morocco and remittances are reduced.

Figure 7.1.A

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Foreign responses to foreign output, international financial stress and foreign price shocks: foreign output, international financial stress, foreign prices, foreign interest rates, import prices, and export pricesIRF

Shock

Foreign output International financial stress Foreign prices

y*

f*

π*

i*

pi

pe

Variable definitions: y*,foreign output; π * ,foreign prices; f*, international financial stress; i*, foreign interest rates; pi, import prices; pe , export prices

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Figure 7.1.B Domestic responses to foreign output, international financial stress and foreign price shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rateIRF

Shock

Foreign output International financial stress Foreign prices

x

d

y

π

e

i

Variable definitions: x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates

Figure 7.1.C Responses to foreign output, international financial stress and foreign price shocks:

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domestic financial conditions, tourism receipts, and remittancesIRF

Shock

Foreign output International financial stress Foreign prices

q

t

r

Variable definitions: q, domestic financial conditions; t, tourism receipts; r, remittances

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Figure 7.2.A Responses to foreign interest rate, import price and export price shocks: foreign output, international financial stress, foreign prices, foreign interest rates, import prices, and export pricesIRF

Shock

Foreign interest rate Import price Export price

y*

f*

π*

i*

pi

pe

Variable definitions: y*,foreign output; π * ,foreign prices; f*, international financial stress; i*, foreign interest rates; pi, import prices; pe , export prices

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Figure 7.2.B Responses to foreign interest rate, import price and export price shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rateIRF

Shock

Foreign interest rate Import price Export price

x

d

y

π

e

i

Variable definitions: x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates

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Table 7.2.C Responses to foreign interest rate, import price and export price shocks: domestic financial conditions, tourism receipts, and remittancesIRF

Shock

Foreign interest rate Import price Export price

q

t

r

Variable definitions: q, domestic financial conditions; t, tourism receipts; r, remittances

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7.3 Domestic shocks

7.3.1 Export volume shockAn adverse shock to Moroccan export supply immediately results in a recession that lasts for less than one year. The reduction in export supply puts downward pressure on the exchange,which has to be counterbalance by the central bank in order to maintain the exchange rate target. Normally, one would expect an real exchange rate depreciation after an adverse shock to the volume of export, which results in less demand for the local currency. However, if a decrease in export earnings translates in less spending on imports, it is possible that the exchange rate appreciates. In such a case, we would expect an reduction in domestic expenditure, which is not shown by the impulse response functions. For Morocco it is however possible that under certain conditions a drop in export volume goes in hand with an increase in the price on world markets, for example phosphate. Export earnings may therefore actually increase, putting upward pressure on the real exchange rate. If this is true, the assumption of perfectly elastic demand on world markets and that Morocco has no pricing power may no longer hold. However, phosphate is the only export product for this may be the case, it is unlikely that Morocco has pricing power for its other main export categories like textile or fruit and vegetables. Adverse shocks to harvests that are harvested may well be correlated with harvests in other countries and therefore an global price rise for those products. To fully understand the exchange rate appreciation that follows and adverse export supply shocks a more disaggregated look is required on the potential sources of export supply shocks in Morocco. Except from domestic output and the exchange rate, the economy remains relatively sheltered from adverse export volume shocks.

7.3.2 Domestic expenditure shockIn response to a negative shock to domestic expenditure output falls in its slipstream for one year. Domestic prices and the exchange rate do not initially react significantly in response to a domestic expenditure shocks. As output and expenditure start to recover, prices and the exchange rate start to rise to above trend values. Interest rates immediately drop following a expenditure shock in order to stimulate the economy, but contributes to relatively high inflation levels in the third and fourth quarter after the shocks. Domestic financial conditions start to deteriorate one quarter after the negative expenditure shock and last for almost seven years. Tourism receipts and remittances do not respond significantly to domestic expenditure shocks.

7.3.3 Domestic output shockAn unexpected contraction in domestic output does not reduce domestic expenditure significantly, widening the difference between income and expenditure. This may increase the current account deficient, decrease savings and stock piles, or increase debts. Financial conditions contract significantly for almost six quarters as a result of a reduction in income and in line creditworthiness and return on equity. Remittances do not react immediately in response to an output contraction, but increase when output is recovered in the next quarter after the shock. In the next quarter remittances decrease to below trend values for one quarter, leaving the total level of remittances unchanged.

7.3.4 Domestic price shockThe Moroccan economy is remains relatively unaffected by an unexpected temporary price increase. Output and expenditure do not respond significantly. Because of the domestic price shock, the real exchange rate appreciates immediately and remains above trend for three

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quarters. Domestic interest rates increase slightly in response to higher domestic prices. Tourism receipt decrease in the first two quarter after the price shock because of a higher exchange rate, which is unfavorable for tourists. Remittances increase only in the first quarter due to higher Moroccan interest rates, to adjust gradually to trend levels in the subsequent quarters.

7.3.5 Exchange rate shockAn unexpected and temporary real exchange rate appreciation decrease the volume of exports in the third and fourth quarter after the shock occurred. Domestic prices decrease in the second quarter to revert back to trend in the third quarter. Given its large share of imports, an exchange rate appreciation makes those goods less expensive in terms of dirhams. Tourism receipts decrease because of the exchange rate appreciation in the first two quarters from which its gradually recovers back to trend values. Interest rates increase for three quarters, which is somewhat puzzling, but confirms the results of Helmi et al. (2011) who also find a monetary tightening in response to an exchange rate appreciation, see Section 4.2.3.5. The line of reasoning is based on the large share of imported goods which become cheaper under an exchange rate appreciation, putting upward pressure on production and expenditure which may fuel inflation for non-imported goods. The exchange rate appreciation is likely to force the central bank to intervene in the foreign exchange market in order to reduce the pressure on the dirham by selling dirhams for foreign currency. This will ease domestic financial conditions, although the IFR show that this effect is likely to be insignificant. Immediately when the shock occurs, a peak decline in remittances is observed, lasting for three other quarters. For the remitter, because of the exchange rate appreciation, each foreign currency is worth less, making him to decide to remit less as his income is relatively worth more in the country of residence. See Section 4.2.3.9 for a discussion on possible changes in behavior of remitters in response to exchange rate shocks.

7.3.6 Domestic interest rate shockA monetary policy shock in the form of higher interest rates hardly affect domestic output and expenditure. This may partly be explained by the limited ability to pursue an own monetary policy because of the pegged exchange rate regime, or due a failure of the transmission mechanism of monetary policy in Morocco as discussed in Section 4.2.3.6. Because of the insignificant of interest rates on domestic output, an interest rate-output puzzle where output increases following a positive interest innovation (King and Watson, 1996) also does not emerge. The IFRs do not display a price puzzle either – a monetary tightening is associated with an increase in the price level rather than a decrease-, although domestic prices also do not decrease significantly. Higher interest rates however attract remittances during the first two quarters after the shock, indicating a portfolio-motivated remitter. Financial conditions in Morocco first contract during the first two quarter after the positive interest rate innovation, but subsequently improve to even above trend levels for the next three years. This may partly confirm the asymmetric bank pricing behavior under the presence of excess liquidity theory of Agénor and El Aynaoui (2010), which may results in higher lending rates despite higher interest rates. See Section 4.2.3.7 for more information on this issue. The exchange rate appreciate slightly following a positive innovation in domestic interest rates, although not significantly, which is not surprising given the capital controls imposed by the Moroccan authorities making a forward discount bias puzzle unlikely. Nevertheless, IFRs do not suggest any signs of an exchange rate puzzle where the currency depreciates following a domestic interest rate shocks (Kim and Roubini, 2000). Without such capital controls, when the uncovered interest parity holds, a persistent depreciation of the currency over time after the appreciation following a positive innovation in domestic interest rates.

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7.3.7 Shock to domestic financial conditions An adverse shock to domestic financial conditions generates a deep and long-lasting recession in Morocco. Domestic expenditure start to decrease from the second quarter to find a peak decline in the fifth quarter, from which it very slowly recovers. Expenditure remains significantly below trend for almost four years. The dynamic adjustment path of output follows a similar pattern. Inflation does not react strongly. However one should expect that a severe reduction in domestic expenditure should reduce inflation. However, output also falls eliminating downward pressure on prices. The central bank reduces its key rate in order to counter balance the adverse shock to domestic conditions, contributing to counterbalance the downward pressure on prices and the recovery of output. The real exchange rate depreciates in the second quarter after the shock, from which is subsequently recovers although it overshoots its long-run value temporary. Remittances do not respond immediately, but start to increase above trend as the exchange rate depreciates.

7.3.8 Tourism receipts shockOutput decreases in response to an adverse shock to tourism receipts in the second quarter and subsequently rebound to above trend levels in the third quarter after the shock occurred. Along with the drop in tourists, remittances decrease as many tourist are migrants that bring cash remittances are goods along. The second quarter after the shock remittances are recovered to normal levels. Expenditure is not significantly affected by the temporary drop in remittances caused by an adverse shock to tourism receipts.

7.3.9 Remittances shockSurprisingly, a shock to remittances does not affect the Moroccan economy significantly. This may be explained by the fact that remittances are not direct used to increase expenditure, but are saved. There is a temporary drop in domestic expenditure, but this is rather small and likely to be insignificant. Based on the impulse response functions, remittance are not a source of business cycle fluctuations themselves, but is more a response variable to other shocks. Morocco’s pegged exchange rate regime may also be a reason for the limited effect of a remittance shock on the domestic economy. Under a more flexible exchange rate, decreased remittance flows create downward pressure on the exchange rate, making the country more competitive and the economy may benefit from this point of view from an adverse shock to remittances.

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Figure 7.3.A Responses to export volume, domestic expenditure, and domestic output shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rateIRF

Shock

Export volume Domestic expenditure Domestic output

x

d

y

π

e

i

Variable definitions: x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates

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Figure 7.3.B Responses to export volume, domestic expenditure, and domestic output shocks: domestic financial conditions, tourism receipts, and remittancesIRF

Shock

Export volume Domestic expenditure Domestic output

q

t

r

Variable definitions: q, domestic financial conditions; t, tourism receipts; r, remittances

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Table 7.4.A Responses to domestic prices, exchange rate, and domestic interest rate shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rateIRF

Shock

Domestic prices Exchange rate Domestic interest rates

x

d

y

π

e

i

Variable definitions: x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates

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Table 7.4.B Responses to domestic prices, exchange rate, and domestic interest rate shocks: domestic financial conditions, tourism receipts, and remittancesIRF

Shock

Domestic prices Exchange rate Domestic interest rates

q

t

r

Variable definitions: q, domestic financial conditions; t, tourism receipts; r, remittances

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Table 7.5.A Responses to domestic financial conditions, tourism receipts, and domestic interest rate shocks: export volume, domestic expenditure, domestic output, domestic prices, the exchange rate, and the domestic interest rateIRF

Shock

Domestic financial conditions Tourism receipts Remittances

x

d

y

π

e

i

Variable definitions: x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates

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Table 7.5.B Responses to domestic financial conditions, tourism receipts, and domestic interest rate shocks: domestic financial conditions, tourism receipts, and remittancesIRF

Shock

Domestic financial conditions Tourism receipts Remittances

q

t

r

Variable definitions: q, domestic financial conditions; t, tourism receipts; r, remittances

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7.4 Rain shocksThe inclusion of rain shocks is one of the more interesting features of the Moroccan business cycle model. Due to the distinction between different rainfall regime, it is possible whether rain shocks have different effects because of threshold effects as is discussed in Section 4.2.4.The dynamic multipliers that result from an exogenous rain shock under both regimes are presented in Figure 7.6 below. The dynamic multipliers indeed reveal that the same rain shock generates different economics reactions during drought that under normal weather conditions. An adverse rain shock generates under both regimes a recession, although this recession is during droughts deeper and longer-lasting.

Domestic expenditure immediately decrease following an adverse rain shocks under normal conditions, reflecting anticipation effects for reductions in future income due to for example expected lower harvests in the subsequent quarter. During a drought, the same adverse rain shock will increase expenditure at impact – although not significantly. This may reflect anticipating effects of the government during a drought by increasing cereal imports in order to create a buffer for reductions in next harvests. In the second quarter after the rain shock, domestic expenditure fall to below trend values. The contemporaneous fall of domestic output is not the direct effect of rainfall on production –which only materializes in the next quarter-, but is caused by the contemporaneous reaction of other economic variable to a rain shock like a reduction in expenditure. The peak decline in output occurs in the fourth quarter after the shock, from which it gradually recovers. Surprisingly, and adverse rain shock during a drought results in higher output during a drought, although not significantly. This may be caused by an increase in slaughter rates during droughts; Chaarani and Mahi (2007) for example show that the slaughter rate in Morocco increase to 16% in dry years, from 6% in humid years. Nevertheless, output makes a steep fall in the second quarter after the shock to reach its peak decline already in the second quarter –in contrast with a peak decline in the fourth quarter under normal climate conditions- and subsequently output recovers toward trend values around the tenth quarter after the shock.

Domestic prices react differently under both regimes, but they react immediately to rainfall as they alter inflation expectations which is a major determination of current inflation. On the one hand, reductions in expenditure following anticipated lower future income put downward pressure on inflation. However, if beliefs are sufficiently strong that inflation will rise strongly in the near future due to supply reductions, contemporaneous inflation decreases. During normal times, prices decrease at impact following the contemporaneous reduction in expenditure, while the impact on output has not yet materialized. As output starts to fall and expenditure does not fall further, prices start to increase. During droughts, inflation increases contemporaneously. His may be a combination of the absence of expenditure reductions, and strong beliefs that prices will rise strongly in the near future because of bad harvests despite strong subsidy programs of the government during droughts. As expenditure stars to fall and output recovers, inflation gradually convert back to trend, already within five quarters. The real exchange rate follow the inflation patterns under both regimes.

Domestic interest rate do not react significantly during a rainfall shock during normal weather conditions. In contrast, interest rates sharply rise during droughts. This may be an attempt by the authorities to control the inflation rate, but this is unlikely as the authorities generally do not respond to higher food prices – see Section 4.2.3.5. A more likely scenario is that the interest rate increase because of higher demand for credit by the government to finance it large drought relief programs. This negative external effect of the drought relief program contributes to the depth and length of the recession.

Domestic financial conditions deteriorate under both regimes, although under droughts the peak decline is a little bit stronger, while the adjustment period to normal levels

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is shorter than under normal conditions. An explanations is the launch of special credit programs under droughts.

Tourism receipts increase during the third quarter after the rain shocks, following the exchange rate depreciation. During drought, tourism receipts decline, contributing to the depth of the recession.

Remittances do not respond significantly to an adverse rain shock during normal conditions. During droughts, remittance increase at impact due to take advantage of higher interest rates in Morocco, but quickly fall to below trend values as output decreases. This again indicates that the remitter is not altruistic motivated. Export volumes decrease under droughts, with a peak decline in the fourth quarter, as they also suffer from a water shortages- despite their priority water status, see Section 4.2.3.1.

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Figure 7.6 Responses to rain shocks under normal and dry regimesmultiplier

RegimeNormal Dry

x

d

y

π

e

101

multiplier

RegimeNormal Dry

i

q

t

r

Variable definitions: x, volume of export; d, domestic expenditure; y, domestic output; π, domestic prices; e, real exchange rates; i, domestic interest rates; q, domestic financial conditions; t, tourism receipts; r, remittances

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8 Historical decomposition of the Moroccan business cycle

Although the impulse response functions and the dynamic multipliers provide interesting insights into the dynamic adjustment path following a particular shock, they do not quantify the role of the shocks in the business cycle. To examine the relative contribution of each variable to the Moroccan business cycle, a historical decomposition is used. The historical decomposition tries to answer the question of which shock caused GDP to fluctuate. Burbidge and Harrison (1985) introduced this VAR based innovation-accounting technique for a re-examination of money’s role during the Depression. Gali (1992) use historical decomposition of output series in order to links different business cycle episodes to specific shocks hitting the economy. In a similar way, this section applies the historical decomposition on the constructed SVAR model for Morocco to estimate the contribution of each of the variables included in the model to detrended domestic GDP over the period 1990.1 -2010.3.

As discussed in Section 3.5.2 of this thesis, the historical decomposition can be derived by simply recognizing that the VARMA form of Eq. (3.8) allows for any variable to be written as a weighted sum of previous shocks plus the effects of an initial condition. Allowing for exogenous variables, the historical decomposition can be derived by using:

y t=initial conditions+∑i=0

t−1

∑j=1

15

θ ij ε j ,t −i+∑i=0

t

φi X t (9)

where θij is the ith impulse response associated with the jth structural shock, while φ i is the ith dynamic multiplier response associated with the exogenous rain shocks. This is Eq. 3.7 applied to the specific case of Morocco. There are 15 structural shocks in the system and one exogenous rain shock, which multipliers are regime dependent as discussed in the previous sections. Ideally, one would plot the historical contribution of the endogenous variables to GDP throughout the sample period and interpret the relative contributions of the different structural shocks. However, not all structural shocks are available at the beginning of the sample period, because of the inclusion of lagged variables. However, for stationary VARs when t becomes large, the contribution of the initial state becomes negligible. One should keep in mind that for t close to the starting point of the decomposition the initial values may have a substantial impact.

Figure 8.1 shows the contribution to deviations from detrended domestic output (y) arising from foreign output (y*), foreign prices (π *), international financial stress (f*), foreign interest rates (i*), import prices (pi), export prices (pe), export volumes (x), domestic expenditure (d), domestic prices (π), exchange rates (e), domestic interest rates (i), domestic financial conditions (q), tourism receipts (t), remittances (r) and rainfall (p) during the period 1990.1 to 2010.3. Domestic output is at trend at the zero line in each diagram, the respective shocks do not contribution to deviations in output from trend. The solid lines represent the contribution of each variable to output deviations, while they are plotted against the dotted lines which represent the output deviations. From the domestic output lines, it seems that a structural break occurred around the year 2000, where output is much more volatile before this year. However, this is not attributable to a structural break that occurred in the economy, but merely reflects droughts hold ups, which is merely a coincidence and another drought may occurred in the near future. This becomes also clear from the graph that shows the contribution of rainfall deviations to the Moroccan business cycle.

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Foreign output, domestic expenditure, international financial stress, import prices, export prices, domestic financial conditions and rainfall contributed significantly to fluctuations of Moroccan output from trend. In contrast, remittances, foreign prices, domestic prices, foreign interest rates, domestic interest rates, exchange rates and tourism receipts contributed very little to the deviations to the deviations of output from trend. The modest contribution of domestic interest rates and the exchange rate is not surprising given the fixed exchange rate policy of Morocco. However, the very modest contribution of remittance shocks in output fluctuations is somewhat surprising given the debate in the literature on short-term behavior of remittances. Depending on the motive of the remitter, remittances are expected to reinforce or mitigate output fluctuations in the receiving country. The first and most accepted hypothesis is that the remitter is altruistic and therefore compensates family members at home at times of economic hardship (Chami et al., 2008; Yang and Choi, 2007). The other hypothesis is based on a portfolio-diversification or rent-seeking motive of the remitter; transfers consequently respond positively to economic conditions in the receiving country.

The only work so far that examines the short-run relationship between remittances and economic fluctuations that includes Morocco is Sayan (2006). He finds by hand of ordinary correlations between the two variables and lagged values that remittances follow output with a lag of one year and are procyclical to Moroccan output. His works have several potential limitations; he does not include other variables –leading to potential omitted variable problem, uses annual data –thereby potentially capturing long-run behavior rather than short-run-, and does not correct for potential endogeneity between remittances and GDP fluctuations –resulting in misleading relationships. The quarterly based SVAR framework constructed in this thesis overcomes these potential shortcomings and shows that remittances in Morocco do not appear to contribute to GDP fluctuations in the short-run; neither procyclical or countercyclical. This is line with previous work (Klok, 2011) in which I found no short-run relationship between output fluctuations and remittances for Morocco in a vector error correction model (VECM). A long-run relationship was found, although with a negative nature. The dead-aid hypothesis is also applicable to remittance, contradictory that they are different from aid. Remittances in the long-run may therefore be associated with Dutch Disease symptoms, increased labor market risk and fueling unproductive speculative real estate investments. In other words, it is likely that Moroccan migrants have a long-run horizon regarding sending remittances, rather than being short-sighted. They do not change their level in remittance in response to short-term fluctuations in Moroccan GDP, but rather invest them in long-term projects.

International financial stress also contributed to GDP deviations from trend in Morocco, in contrast with the general consensus that Morocco is insulated from global financial crises. Although the contribution of the global financial turmoil of 2008 was indeed only modest because Moroccan banks don’t contained any subprime assets, global financial stability in the 1990s contributed positively to Morocco’s GDP. International financial turmoil following the Dot.com bubble in the early 2000s contributed to the relative poor performance of the Moroccan economy. Despite claims by officials and capital controls, Morocco is not insensitive to international financial stress.

International import and export prices also contributed for a large part to GDP fluctuations and differ over the sample period. For example, high import prices resulting from world-record commodity price peeks at the end of 2008 contributed for a large part to the economic downturn. However, the negative effect of import prices was partly offset by higher export prices –for phosphate in particular- which contributed to GDP fluctuations in a positive way. Shocks to domestic financial conditions also contribute to GDP deviations from trend. The ease of financial conditions before 2007 contributed to GDP deviations above trend during that period.

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Given the structure of Morocco’s economy, it is not surprising that rainfall fluctuations are the major driver of business cycle fluctuations during the sample period. The droughts of 1991-1993, 1994-1995, 1998-2000 generated significant recessions in Morocco, while excessive rainfall during 1995-1997 resulted in an economic boom. Meanwhile, more modest rainfall also contributed significantly to output deviations from trend, for example in the early 2000s. Rain contribution to GDP deviations from trend during the sample do not show any sign that rainfall became less important as time elapse when the economy becomes more sophisticated and less vulnerable to rainfall fluctuations. More important, since the 2000s no drought occurred, but the contributions from rain to GDP fluctuations remained large. However, it is only a matter of time before Morocco is hit by another drought. Climate can therefore not be ignored in macroeconomic modeling for Morocco, and for other vulnerable countries with a volatile climate.

Figure 8.1 Historical decomposition of the Moroccan business cycle International Domestic

Foreign output Domestic expenditure

International financial stress Domestic prices

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Foreign prices Exchange rates

Foreign interest rates Domestic interest rates

Import prices Financial conditions

Export prices Export volumes

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Remittances Rain

Tourism

The dotted lines represent deviations of Moroccan output from its long term level. The solid lines indicate the contributions of each variable to detrended domestic GDP.

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Summary and Concluding Remarks

Given the highly volatile nature of the Moroccan economy which hampers the long-term development of the country, this thesis develops a structural threshold vector autoregressive model with exogenous variables (STVARx) to identify and examine the main sources of business cycle fluctuations in Morocco. Block exogeneity restrictions based on the small open economy assumption and subset techniques make it possible to include a relatively large set of variables in the model. A novel contribution of this thesis is to allow for nonlinear effects of rainfall on the economy during droughts. Indeed, some economic variables like domestic prices, interest rates, the real exchange rate, and migrant’s remittances behave differently during a drought regime compared to a normal regime. The model produces sensible results that are broadly consistent with a priori theoretical expectations. Results are free of economic puzzles that are often encountered in the VAR literature, like liquidity, price, exchange rate, forward discount bias and interest-output puzzles (see Kim and Roubini, 2000 and King and Watson, 1996). An appropriate identification scheme and the inclusion of the forward looking indicators like rainfall and international financial stress may have contributed to the absence of puzzling outcomes.

Impulse response functions (IFRs) and dynamic multipliers are used to evaluate the dynamic adjustment paths of the economy following various shocks. They provide useful information for policy makers in Morocco on how economic variables respond to changes in policy or other events. For example, the IFRs confirm thoughts that the monetary policy transmission channel does not work appropriately in Morocco. Output and expenditure are hardly unaffected by an interest rate increase, while financial conditions ease – which is in contrast with theoretical predictions. If the Moroccan authorities wish to pursue an interest-rate based monetary policy, they should first improve the institution framework and find a way to reduce the high level of excess reserves of commercial banks.

Domestic financial conditions play an important role in the transmission of various shocks through the economy, making their effects longer-lasting. The increasing role of financial conditions in the Moroccan economy are the results of structural reforms since the eighties aimed at liberalizing the financial sector. However, IFRs confirm the very slow adjustment of financial conditions after a shock, suggesting that financial reforms should continue in order to make the financial sector more efficient and that it becomes more resilient to shocks. This is in line with the view of the World Bank (2006) that the Moroccan financial sector is still relatively inefficient because of high levels of bureaucracy and corruption, giving rise to negative externalities of the financial sector.

In contrast with the general believe, remittances do not appear to be a source of economic fluctuations in Morocco or react strongly to other shocks. From the IFRs, the Moroccan remitter does not seem to be altruistically motivated and does not smooth the business cycle in his country of birth. Despite the weakening of attention for rainfall as a source of economic fluctuations in Morocco, dynamic multipliers show that they both generate a severe recession, both under drought and normal weather conditions –despite the existence of governmental drought relief programs.

Historical decomposition is used to access the contribution of each variable to the Moroccan business cycle over the last two decades. Rain has been the most dominant source of economic fluctuations during the last twenty years, despite the drought hold off during the last decade. These findings are in sharp contrast with the general believe that the Moroccan economy has become more resilient to rain shocks. Lower output volatility since the turn of the century is merely the result of drought hold offs, rather than that rainfall has a smaller

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impact on the economy. Meanwhile, another drought can strike at any moment, since drought are predicted to occur once every four years. Structural measures should therefore be take to make the Moroccan less vulnerable to rain shocks, by improving for example water infrastructure, storage capacity and replacing water-dependent crops. The focus in Morocco currently is on improving institutional quality, the financial system, and diversifying its export sector. Although these measure make a worth the effort and make a lot of sense, one should not forget the fundamental source of volatility: rainfall. By improving its resilience to rain shocks, the Moroccan economy takes the next step in its development toward are more mature economy. Without doing so, the Moroccan economy remains ailing.

International variables also have been a dominant source of business cycle fluctuations in Morocco, in particular trade price shocks. In contrast with claims by Moroccan authorities that the economy is resilient to international financial crises, the model shows proves otherwise. Migrant’s remittances are often thought of smoothing business cycle fluctuation, but remittances do not play a significant role in the Moroccan business cycle.

As with all economic models, there are several possible directions to build on. First of all, confidence intervals should be improved by a bootstrap method as described in Chapter 7. Another interesting possibility is to include potential cointegrating relationships between the variables, although the number of variables has likely to be reduced in order to obtain interpretable cointegrating relationships. In a addition, a separating demand from supply shocks might be interesting to interpreted the impact of fiscal policy.

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Appendix A. Data estimation

A1. Estimation of export and import prices for 1990This appendix provides detailed calculations on export and import prices for the quarters of the year 1990, as they are unavailable at public databases.

Because the World Bank’s Global Economic Monitor (GEM) does not cover import and export prices prior 1991, I estimate export and import prices for 1990 using export and import price series that are available at the IMF IFS.72 The GEM and IFS however use different methodologies regarding export and import prices -the GEM uses value indices while IFS estimated ‘true’ price indices- therefore the IFS values need to be adjusted to fit the GEM’s series.

I use an interpolation method based on the rate of changes in IFS prices indices to estimate value series; i.e. values are backdated by means of estimated growth rates. Calculations can be seen as a way of backdating by means of growth rates obtained from the IFS and can more formally expressed as:

y t=zb/( xb

x t) (A1.1)

where y t is the estimated unit value at time t , zb is the value of the unit value at the base period b and x t is the price index at time t . The base period is the first quarter of 1990. Although the GEM explicitly uses the term export and import prices, export and import price series for Morocco are implicit value indices. Value indices are often used as substitutes for the more expensive survey based price indices that for many countries are unavailable –Morocco is not an exception- , although the IMF IFS database provides price indices for some quarters (1990.1-1992.4 and 1995.3-1997.3). Unit value indices are widely available as they can be calculated by dividing total trade values by their volumes which are standard recorded by customs authorities. Unit values can be seen a unit average value, and is therefore different from a pure unit price.

As the literature on price index methodology emphasizes (Silver 2009, IMF 2009, Von der Lippe 2010), unit value indices cannot be used as true substitutes for price indices.73 The continued use of value indices as substitutes for price indices is misleading for economic analysis regarding inflation, deflators and the terms of trade.74 While I recognize that value indices do not reflect true price changes, the unit value bias might actually be desirable in some economic frameworks when one like to allow for other than only pure price effects. 72 IFS provides discontinued series for export and import prices; only 1990.1-1992.4 and 1995.3-1997.3 are available for Morocco.73 For reasons of clarity, the unit value index considered here is not a Drobisch’s index although the latter is also often referred to as an unit value index, see von der Lippe (2010). 74 An alternative to value indices is to construct an alternative export and import price index for Morocco by defining a geometric weighted average index of nominal main export and import prices. This price index then would be calculated by multiplying -say a two years moving average- of each main export or import good as a percentage of total exports -available at the International Trade Center’s Trade Map- by each corresponding world trade price of each individual goods that are available at the GEM Commodities database. This is approximately the method used by Camero et al. (2008) and Cashin et al. (2004) except they calculate commodity weights based on a normal average and not a moving average that may reflect changes in trade patterns. In addition Camerero et al. (2008) construct a commodity term of trade for Morocco and other Mediterranean countries, while Cashin et al. (2002) construct indices of national commodity-export prices for 58 countries, including Morocco. Data on merchandise trade shares of individual goods in total trade is only available after 2002 and the construction of such a price index would not be possible for our sample, and the question remains on the suitability of a such a price index, which boils down to the general discussion on the discrepancy between price and value indices.

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Unit value indices are better representatives of the purchase or sales for international transactions during a given period because they correspond with the quantity traded during that period. After all, unit value and volume match up during a given period that when multiplied, equals total trade value.75

To understand this, consider the disaggregation of the unit value bias by Von der Lippe (2010) who decomposes the unit value bias into a Laspeyres substitution effect and a structural component due to substituting unit values for prices. The Laspeyres substitution bias is explained by taking an economic approach to price indices: rational agents may adjust quantities in response to price changes. A Laspeyres price index does not capture this effect -while a unit value index does - and therefore represent the true price change. Since quantities are assumed constant in a Laspeyres index, the change in price will neglect changes towards the good when its price changes, i.e. the good with the higher price will increase in magnitude in the overall export basket. On the other hand, when export price of a particular export good decrease, the Laspeyres price index will overstate the true price decrease. For import prices, Laspeyres indices tend to overstate price changes when import prices increase and understate the true price change in case of a decrease in import prices. For this reasons, the IMF prefers a superlative index that captures more realistic revenue- maximizing behavior. The structural component is more worrisome because it may change a unit value index even when price remain constant, which is the reason why unit value indices do not represent pure price evolutions as they cannot be affected by relative changes in quantities by definition.

A classical numerical example that is often quoted in papers discussing the unit value bias (Silver 2009, IMF 2009) that arises from heterogeneous goods rather than homogeneous goods is provided by the United Nations (1981) and considers trade in refrigerators. This refrigerator example shows that even in the case that prices of refrigerators remain constant, unit values will changes as demand shifts to more expensive refrigerators, leaving the total amount of refrigerators constant. Since a price index by definition cannot be affected by changes in relative quantities, a value index is not a true substitute for price indices. Although this is true, it remains the question what we want measure: a price change only or the transactions done in a particular period? A unit value index does not represent the true price change, but it is better measure of what is actually going on: changes in trade value that are not only dependent on price but also on the mix of tradable goods. Returning to the example of the refrigerators and assume Morocco exports both cheap and expensive refrigerators. When there occurs a change in the mix for refrigerators (for whatever reason, say an external demand shift of preferences outside the influence of Morocco) towards more expensive ones while total quantity (cheap plus expensive ones) remains constant. In this case, the export price index remains constant during that period while a unit value index increases due to higher demand for expensive refrigerators. Hence what matters for the Moroccan exporter is the increase in export value due to higher demand for more expensive exports. The exporter in this case experiences an export ‘price’ shock, although prices remained constant. This is what count for our model, and therefore export and import value indices are better representatives from the point of true cost or revenues per unit and reflects reality better than

75 Price indices have the advantage that they have a smaller aggregation bias than unit value indices because they rely on more detailed information. Meanwhile, standard price indices still do not represent true cost of living indices as they also suffer from a lack of detailed stratification, although to a lesser extent than unit value indices as shown by Bradley (2005) and Silver and Webb (2002). In general therefore, detailed stratification at the lowest level is recommended to estimate true cost of living indices. IMF (2009) however notes that in the presence of price discrimination to the foreign countries an economy exports to, stratification by country is undesirable, but stratification by product is recommended for trade price indices.

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price indices which might miss changes in the mix of tradables. In the view of this thesis it is about representativity and not about pure price changes.

Meanwhile, it is not unreasonable that for Morocco, the discrepancies between export and import unit value and price indices are modest relative to more advanced economies, given the structure of its tradable sector. Discrepancies between value and price indices that result from non-price induced changes in the composition of export or imports is according to Silver (2009) and IMF (2009) particularly important in modern markets with increasing differentiation of products with high turnover. Although Morocco has a relatively undiversified export sector compared to more developed countries, it has several export categories, and some of them include products that have high turnover rates like clothing and food –see Section 1 of this thesis-. Only the share of food exports depends on weather conditions, and therefore affect the composition of Moroccan exports regardless the prices for these products. Differences between price and value indices are therefore still expected to exist for Morocco.

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A2. Estimation of domestic expenditure series This appendix explains the interpolation method that is used to constructed export and import of goods and services series for Morocco, which are required in the construction of the domestic expenditure series. I use three available times series for interpolation: 1) from the World Development Indicators (WDI) database we use yearly exports of goods and service denoted in current Dirham for the period 1990-2009. 2) Quarterly merchandise goods exports for 1990.1-2009.4 from the IMF IFS are used.76 3) Monthly tourism receipts provided by Younes Zouhar over 1990.1-2010.10.

IFS Merchandise goods exports together with tourism receipts, capture on average 87% of the total annual WDI goods and services exports over the interpolation period 1990-2001, while after 2001 –the period that is known from the OC-, it captures only 80%, suggesting that the share of service export other than tourism is growing over time. Because tourism and goods exports are also available on a quarterly basis, on average 87% of the movement of quarterly exports of goods and services (goods plus tourism) before 2002 is known, while on average 13% is unknown (i.e., services other than tourism).

The interpolation procedure is defined as follow. First, I calculate the annual share of service export excluding tourism – i.e. services other than tourism- for the years before 2002 by subtracting IFS’s merchandise goods exports and Zouhar’s tourism receipts from the WDI’s exports of goods and services series. The estimated share of service export other than tourism on a yearly basis is divided by 4, assuming for interpolation that the amount of service export excluding tourism does not follow a seasonal pattern (which we known form series of service exports other than tourism from the OC).77 This seems to be reasonable given the fact that the share of services other than tourism accounts for (a modest) 13% of total exports, which is relatively constant during the year and follows roughly the pattern of merchandise goods export. Most of the inter annual variation in exports of goods and services is explained by the highly seasonal pattern of tourism receipts.

The interpolated estimate of services other than tourism is added to merchandise exports and tourism receipts to obtain values for exports of goods and services in general. A robustness check over the period 2002.1- 2010.3 and 2001.1 (quarters for which the OC provides data for exports of goods and services) confirms the strength of the used method of interpolation. Absolute discrepancies expressed in percentages between our interpolated series of exports of goods and services, and the series of goods and services as recorded by the OC show that the average absolute deviation is 1.87% with a standard deviation of 1.07%.Table A2.1 provides descriptive statistics over the period 2002.1-2009.4 for the interpolation goodness of fit of interpolated export and imports of goods and services over the period.78

76 We do not use the series of merchandise export and imports that the IMF provided on a quarterly basis. Instead we aggregate monthly series of the IFS to calculate quarterly values ourselves. There exist a significant discrepancy between the reported quarterly values by the IFS and their underlying monthly values for some years. 77 With the exception of 2001. Exports of goods and services for the first quarter of 2001 is provided by the OC and does therefore not have to be interpolated. The three other quarters of 2001 are interpolated as follow. We subtract the value of goods exports and tourism receipts from the value of export of goods and services provided by the OC. The resulting value is subsequently subtracted from the difference between the WDI’s annual value of goods and services and the combined annual value of goods merchandise export and tourism receipts. Finally this difference is divided by 3 to estimate the interpolation constant that is added to the quarterly values of goods export and tourism receipts to obtain quarterly values for export of goods and services for 2001.2-2001.4.78 Excludes the years 2006 and 2008 because in those years there are quarters (2006.4 and 2008.2) that includes large difference between reported merchandise goods export recorded by the IFS and the OC that cannot be explained , leading to a biased goodness of fit. For our interpolation sample entries of IFS and OC of merchandise exports corresponds expect from rounding and no larger difference as in 2006 and 2008 exist.

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Interpolation estimates are probably even better before 2002, because of the share of services other than tourism is smaller –and therefore the probability of changing the path of development of total exports of goods and services is likely to be smaller- compared to the period we were able to check.

In addition, the estimated series for export of goods and service – from which only the share of service exports other than tourism is missing (on average 13% of total exports is unknown and is therefore interpolated) – itself only accounts for 26.4% of GDP on average during the interpolation sample. Services other than tourism only account for 3.6% of GDP and a small deviation interpolation bias (on average 2.62%) in the relative modest share of exports of services other than tourism in total will therefore not significantly change GNE estimates (defined as GDP -NX).

Imports of goods and services for Morocco are estimated in a similar fashion as exports of goods and services series. First I calculate an interpolation constant by subtracting yearly IMF IFS’ imports of merchandise goods from imports of goods and services provided by the WDI, and divided by four to obtain an quarterly interpolation constant which is added to IMF’s quarterly imports of merchandise goods to estimate quarterly series for total imports with again an exception for 2001.1 because this value of goods and service is provided by the OC. Imports of services account on average over the interpolation period for 12.82% of total imports of goods and services and 3.6% of GNE .

Again, diagnostics confirm the a priori hypothesis that interpolation does a reasonable job; based on that fact the imports of services only with affect GNE modestly and move in the same direction as import of goods. The resulting average absolute deviation from quarterly data of goods and services provided by the OC (2002.1-2010.3 and 2001.1) is 2.27% with a standard deviation of 1.51%; see appendix table A1. The combination of small deviations from observed observations, and the relative small share of the estimated values in GNE justify the method of interpolation.

Table A2.1 Descriptive statistics interpolation goodness of fit

Exports ImportObservations 24 32Mean 2.17 2.28Median 2.09 2.11Maximum 4.74 5.39Minimum 0.27 0.12Std. Dev 1.24 1.51Skewness 0.53 0.49Kurtosis 2.48 2.39Jarque-Bera 1.74 1.79

Probability 0.42 0.40

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Source: own calculation based on data from WDI, IFS and Office du Change.

A3. Principal component analysis (PCA) of financial conditions in MoroccoData sources that are used in this appendix: Casablanca Stock Exchange (CSE) and Bank Al-Magrib (BAM).

Figure A3.1 Components of financial conditions in Morocco (2001.1=100)

Table A3.1 Ordinary correlations between the individual financial components

CFG 25 Private credit M2CFG 25 1.000Private credit 0.905 1.000M2 0.916 0.975 1.000

Table A3.2 PCA: eigenvalues (components)

No. Value Difference ProportionCumulative

Value Proportion

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1 2.864 2.753 0.955 2.864 0.9552 0.112 0.088 0.037 2.976 0.9923 0.0241 … 0.008 3.000 1.000

Table A3.3 PCA: eigenvectors (loadings)Variable PC 1 PC 2 PC 3CFG 25 0.568 0.821 0.060Private credit 0.581 -0.452 0.677M2 0.583 -0.350 -0.733

A4. Rainfall

Figure A4.1 Locations of selected WMO stations in Morocco

Source: own preparation based on ‘Morocco Outline Map’ from Maps of the World.

Table A4.1 Rainfall regimes in Morocco

Season Regime classification

Cumulative rainfalldeviation in millimeters

1990-1991 normal 71.11991-1992 drought -133.91992-1993 drought -152.81993-1994 normal 53.41994-1995 drought -177.71995-1996 normal 227.31996-1997 normal 118.81997-1998 normal -571998-1999 drought -99.51999-2000 drought -122.52000-2001 normal -26

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2001-2002 normal -682002-2003 normal 103.52003-2004 normal 55.92004-2005 normal -552005-2006 normal 126.72006-2007 normal -49.72007-2008 normal -85.42008-2009 normal 198.22009-2010 normal 96.3Source: based on the constructed rainfall index for Morocco as described in the Data section. Regime classifications are based on Baraket and Handoufe (1998), Gober et al. (2001), and Ameziane et al. (2007).

Appendix B. Excess reserves

Figure B1 Excess reserves of the banking system in Morocco

Own calculations based on data of the Bank Al-Magrib: (Dépôts à vue auprés du CCP+ Dépôts à vue auprés du Trésor)/ Dépôts à vue auprés des banques

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Appendix C Model diagnostics

Table C1 System residual Portmanteau test for autocorrelationLags Q-Statistic Probability Adjusted Q-Statistic Probability Degrees of freedom

1 194.46 0.93 196.93 0.91 2252 407.57 0.92 415.49 0.88 4503 634.73 0.86 651.50 0.74 6754 868.45 0.77 897.52 0.52 9005 1083.81 0.81 1127.24 0.48 11256 1287.13 0.89 1347.05 0.52 13507 1508.23 0.88 1589.35 0.39 15758 1710.23 0.93 1813.79 0.41 1800

Null hypothesis: no residual autocorrelation up to lag k

Table C2.A System residual normality test: Cholesky (Lütkepohl) orthogonalizationCom-ponent

Skew-ness

Chi-square

Proba-bility Kurtosis Chi-

squareProba-bility

Jarque-Bera

Proba-bility

1 -1.19 19.12 0.00 7.39 65.32 0.00 84.44 0.002 2.27 69.35 0.00 14.44 441.82 0.00 511.17 0.003 -0.39 2.09 0.15 3.13 0.06 0.81 2.15 0.344 0.24 0.76 0.38 4.47 7.28 0.01 8.04 0.025 0.51 3.54 0.06 3.36 0.44 0.51 3.98 0.146 0.07 0.07 0.79 80.89 20473.04 0.00 20473.11 0.007 -0.24 0.79 0.37 3.59 1.18 0.28 1.97 0.378 0.47 2.97 0.08 4.98 13.18 0.00 16.15 0.009 0.27 0.98 0.32 2.79 0.14 0.71 1.12 0.5710 0.18 0.45 0.50 3.80 2.14 0.14 2.59 0.2711 0.25 0.87 0.35 6.38 38.47 0.00 39.34 0.0012 -0.46 2.80 0.09 4.74 10.27 0.00 13.08 0.0013 0.19 0.53 0.47 4.33 5.98 0.01 6.51 0.0414 -0.08 0.09 0.77 5.71 24.77 0.00 24.85 0.0015 1.84 45.76 0.00 10.93 212.48 0.00 258.23 0.00

Joint 150.19 0.00 21296.56 21446.75 0.00Null hypothesis: residuals are multivariate normal

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Table C2.B System residual normality test: inverse square root of residual correlation matrix (Doornik-Hansen) orthogonalizationCom-ponent

Skew-ness

Chi-square

Proba-bility Kurtosis Chi-

squareProba-bility

Jarque-Bera

Proba-bility

1 -1.25 16.48 0.00 9.80 20.25 0.00 36.73 0.002 2.73 43.71 0.00 18.54 1.41 0.23 45.12 0.003 4.12 65.11 0.00 92.82 460.04 0.00 525.15 0.004 0.01 0.00 0.95 4.51 10.83 0.00 10.83 0.005 2.73 43.62 0.00 51.64 318.83 0.00 362.44 0.006 0.21 0.67 0.41 32.89 413.28 0.00 413.95 0.007 -0.09 0.14 0.70 3.29 1.34 0.25 1.148 0.488 0.22 0.74 0.39 4.42 8.75 0.00 9.49 0.019 0.47 3.26 0.07 3.76 1.09 0.30 4.36 0.1110 1.80 27.16 0.00 18.05 55.61 0.00 82.77 0.0011 -1.69 25.11 0.00 18.03 68.03 0.00 93.14 0.0012 -0.32 1.57 0.21 5.83 21.84 0.00 23.41 0.0013 -0.10 0.16 0.69 7.38 45.22 0.00 45.38 0.0014 -0.68 6.28 0.01 5.99 12.70 0.00 18.98 0.0015 0.55 4.32 0.04 4.07 1.54 0.21 5.87 0.053

Joint 238.33 0.00 1440.77 1679.11 1.00Null hypothesis: residuals are multivariate normal

Table C2.C System residual normality test: inverse square root of residual covariance matrix (Urzua) orthogonalizationCom-ponent

Skew-ness

Chi-square

Proba-bility Kurtosis Chi-

squareProba-bility

Jarque-Bera

Proba-bility

1 -1.19 20.63 0.00 7.80 96.23 0.00 116.86 0.002 2.33 78.87 0.00 14.93 583.77 0.00 662.64 0.003 -0.23 0.79 0.38 5.91 36.19 0.00 36.98 0.004 -0.018 0.00 0.95 3.04 0.06 0.81 0.06 0.975 1.49 32.08 0.00 38.49 5129.53 0.00 5161.61 0.006 0.79 9.09 0.00 34.53 4048.77 0.00 4057.86 0.007 -0.06 0.06 0.81 2.59 0.47 0.49 0.53 0.778 0.24 0.82 0.36 4.07 5.26 0.02 6.08 0.059 0.41 2.49 0.11 3.41 0.94 0.33 3.43 0.1810 0.73 7.83 0.01 7.22 74.63 0.00 82.46 0.0011 0.26 0.95 0.33 6.74 58.96 0.00 59.91 0.0012 -0.41 2.43 0.12 4.20 6.53 0.01 8.97 0.0113 0.09 0.14 0.71 5.38 24.33 0.00 24.48 0.00

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14 -0.5 3.64 0.06 3.79 3.05 0.04 6.69 0.0415 0.49 3.46 0.06 3.59 1.78 0.07 5.24 0.07

Joint 0.00 10070.49 0.00 0.00Null hypothesis: residuals are multivariate normal