EXCHANGE RATE VOLATILITY AND MACROECONOMIC DETERMINANTS: A COMPARATIVE ANALYSIS FOR MALAYSIA
Kong Cbek Hang
Corporate Master in Business Administration 2010
Pusat Khidm t 1\1 k1 UN}VERSJTI aM ,\ ,a~yumatAkademjk
• ~ SlA SARAWAK
P,KHIDMAT MAKLUMAT AKADEMIK
1IIIIIIIIIIi'~illllllllll 1000246476
EXCHANGE RATE VOLATILITY AND MACROECONOMIC DETERMINANTS: A
COMPARATIVE ANALYSIS FOR MALAYSIA
KONG CHEK HANG
A dissertation submitted in partial fulfillment of the requirements for the degree of Corporate Master in Business Administration
Faculty ofEconomics and Business UNIVERSITI MALAYSIA SARA W AK
2010
APPROVAL PAGE
I certify that I have supervised and read this study and that in my opinion it conforms to
acceptable standards of Scholarly presentation and is fully adequate, in scope and
quality. as a research paper for the degree of Corporate Master in Business
Administration.
Dr. Rohaya Mohd Nor Supervisor
This research paper was submitted to the Faculty of Economics and Business,
UNIMAS and is accepted as partial fulfillment of the requirements for the degree of
Corporate Master in business Administration.
Professor Dr. Shazali Abu Mansor D~ Faculty ofEconomics and Business UNIMAS
DECLARATION AND COPYRIGHT
Name : Kong Chek Hang
Matric Number : 08031523
I hereby declare that this research is the result of my own investigation, except where otherwise stated. Other sources are acknowledged by footnotes giving explicit references and bibliography is appended.
Signature
Date
© Copyright by Kong Chek Hang and Universiti Malaysia Sarawak
ii
ACKNOWLEDGEMENTS
First and foremost, I would like to express my sincere gratitude to my supervisor,
Dr. Evan Lau Poh Hock, for his encouragement, valuable guidance and support in completing
my project. His patience, enthusiasm, immense knowledge, and his willingness to motivate
me contributed tremendously to my research.
Besides, I would like to thank the authority of University Malaysia Sarawak
(UNIMAS) for giving an opportunity to further my studies in my preferred course. Also, I
would like to take this opportunity to thank all of people who provided valuable information
as the guidance of my research include the lecturers and staff of Faculty of Economic and
Business.
Finally, I would like to take the opportunity to thank my family and friends who spent
their time and shared their knowledge for helping me to complete my research with the best
possible result. With their extreme understandings, giving invaluable supports and
encouragement of my chose path in completing this research is very much appreciated.
iii
ABSTRACT
EXCHANGE RATE VOLATILITY AND MACROECONOMIC DETERMINANTS: A
COMPARATIVE ANALYSIS FOR MALAYSIA
By
Kong Chek Hang
( The purpose of this study is to examine the relationship of Exchange Rate volatility and its
determinants from 1976:Ql to 2007:Q4. The ARCHJGARCH techniques are applied to better
capture the time-varying characteristics of volatility and the exchange rate volatility series
were generated utilizing the GARCH mOd0 The empirical results of Philips and Perron test
reveal that all the variables are non-stationary in levels but stationary in first differences
except for volatility which shows stationary in levels. Then, Johansen's co integration test
indicates long run relationships between the variables where two cointegrating vector were
existed and finally, Granger causality in the vector error-correction model is employed to
scrutinize short run relationships between the variables. Hence, investment seems to have
significant influence towards volatility in all macroeconomics factors. The Government's
currency rationing policy tends to lessen the volatility, proving that the policy-induced
changes in exchange rate have stabilizing effect on its determinants.
IV
----~----------------------~-----
ABSTRAK
KOMPARATIF ANALISIS KEMERUAP AN KADAR PERTUKARAN DAN
PENENTU FAKTOR MAKROEKONOMI TERHADAP MALAYSIA
Oleb
Kong Cbek Hang
Kajian ini bertujuan untuk meneliti hubungan antara kemeruapan kadar pertukaran terhadap
penentunya dari 1976:QI hingga 2007:Q4. ARCH/GARCH teknik dipraktikkan bagi
penangkapan masa berselisih kemeruapan yang sesuai dengan coraknya dan satu siri
kemeruapan dijanakan dengan menggunakan GARCH model. Oi dalam kajian ini, Ujian
'Philip' dan 'Perron' mendedahkan kesemua pemboleh ubah adalah tidak pegun pada
peringkat tahap paras tetapi mencapai pegun selepas pembezaan kali pertama kecuali bagi
kemeruapan kadar pertukaran menunjukkan pegun pada peringkat tahap paras. Kemudian,
Ujian Kopengamiran lohanses dijalankan untuk menunjukkan hubungan jangka panjang
antara pemboleh ubah di mana wujudnya dua vektor berintegrasi. Akhirnya, Keputusan Ujian
Penyebab Granger diaplikasikan dalam 'vector error-correction' model digunakan untuk
meneliti hubungan jangka pendek antara pemboleh ubah. lusteru itu, pelaburan seolah-olah
mempunyai pengaruh penting kepada kemeruapan kadar pertukaran terhadap semua faktor
makroekonomi. Oasar Kerajaan pencatuan mata wang cenderung pada mengurangkan
kemeruapan, dasar terse but membuktikan telah membawa kesan perubahan dalam
mengukuhkan kadar pertukaran terhadap penentunya.
v
Pusat Khidmat Maidumat Akademik UNlVERSm MALAYSIA SARAWAK
T ABLE OF CONTENTS
DECLARATION AND COPyRIGHT............................................. ................. 11
ACKNOWLEDGEMENT......................................................................... iii
ABSTRACT............................................... ..... ............... ............ ......... . . iv
ABSTRAK .. .. ........................................................................... .............. v
LIST OF TABLES........ . ..... .. ........................ ... ......................... .................. ix
LIST OF FIGURES................................................................................. x
CHAPTER ONE: INTRODUCTION
1.1 Overall Introduction ................................................ .. ................ .
1.1.1 Exchange Rate Volatility and Risk ............................................ 3
1.1.2 Malaysia Exchange Rate Regime review.... ........................ .... 4
1.1.3 Terms of Trade and Economic performance in Malaysia.... ........... 8
1.1.4 FDI profile in Malaysia.............................................. ........ 10
1.2 Problem Statements ........................................................... ...... . 12
1.3 Objective of the Study ....................................... . ... . .................. . 13
1.3.1 General Objective .......................... .. ... .... .... ................... 13
1.3.2 Specific Objectives............................... .......................... 13
1.4 Significance of the Study . .. ........................................................ . 14
1.5 Scope of Study .......................................................................... . 15
VI
CHAPTER TWO: LITERATURE REVIEW
2.1 Overview ........... ............... . ... .. ... .... .. . ... . ..... . . . ....................... . 16
2.2 Reviews of the Empirical Results on Exchange Rate Volatility towards
Macroeconomic Determinants in Developing Countries....................... 17
2.3 Reviews of the Empirical Results on Exchange Rate Volatility towards
Macroeconomic Determinants in Developed Countries........................ 26
2.4 Reviews ofthe Empirical Results on Exchange Rate Volatility towards
Macroeconomic Determinants in Mixed Countries............................. 35
CHAPTERTHREE:METHOLOGY
3.1 Introduction .......................................................................... . 39
3.2 Theoretical Framework..................................................... .. ...... . 40
3.3 Data Description ....... . ......... .. . .. ......... ........... ......... ... ... ... .... . ... . 41
3.4 Model Formulation ................... . .. .. ............. . ............... .. . . .... .. .... .. 42
3.5 Phillips-Perron Test ......................... . ......... ... .. .. .. .... .. .. ... .. .... . .. . . 43
3.6 Co integration Test ........................... . ... . . .. ... ....... . . .... . .. .. .. ........ . 44
3.7 Causality Test and Vector Error Correction Model (VECM) ........ .... .. .. .. 46
CHAPTER FOUR: EMPIRICAL RESULTS AND DISCUSSION
4.1 Introduction ............ . ..... ..... . ... . . . .... .. . .. ... ... . . . . . . . .. ... .................. . 49
4.2 Phillips-Perron Test: Unit Root Test .... ........ . ....... .... . .. ......... . ..... ...... . 50
4.3 lohansen-.Tuselius: Cointegration Test ...... ... ....... .... . ... . . . .. . . . . . ........ . . . 51
4.4 Granger Causality Test and VECM ... ... . .. . .. . . ..... . . .. . ........ . .... .. ........ . 53
4.5 Conclusion . ........ ... ................................ . ....... ... ..... ....... .. .. . .... . 58
VII
- - _. ----'-------------
----- --- -----
CHAPTER FIVE: CONCLUSION
5.1 Introduction........................................................................... 59
5.2 Concluding remarks ................................................................. . 59
5.3 Policy implications and Recommendations ...................................... . 62
5.4 Limitation of study ............. , .................................................... . 65
REFERENCES 66
VIII
------~--------.~~---- - -- --~ "-- - --'--- -
LIST OF TABLES
Title Page
Table 1: De Facto Exchange Rates Policies of East Asia in 2006 7
Table 2: FDI inflows Malaysia 2000-2008 11
Table 3: Summary of the Exchange Rate Volatility review in Developing Countries 21
Table 4: Summary of the Exchange Rate Volatility review in Developed Countries 30
Table 5: Summary of the Exchange Rate Volatility review in Mixed Countries 37
Table 6: Philips and Perron (PP) Unit Root Tests Results 50
Table 7: Results of lohansen-luselius Co integration Test (Full sample) 51
Table 8: Granger Causality Results in the Vector Error Correction Model (VECM) 54
ix
LIST OF FIGURES
Title Page
Figure 1: Trade Balance (TB) and GOP of Malaysia from 1997 to 2008 9
Figure 2: The relationships between ERV, GOP, FOI and TB 40
Figure 3: Interrelationships causality between variables 55
x
CHAPTER ONE
INTRODUCTION
1.1 Overall introduction
There are increasing numbers of government concerned on the issues re lated to
exchange rate uncertainty in both developed and developing countries. Numerous questions
and challenges have been pointed out regarding these issues. Exchange rate is one of the most
important economic indicators relatives to a country's international competitiveness. It affects
directly on international trade, capital account, foreign direct investment (FDI) and economic
developments in a country. Thus, the impact of exchange rate vo!atiJity on economic
fundamentals is substantially great if an economy does not provide possible tools in hedging
currency risk in its market place.
In recent years, China emerges as a large trading nation and this has increases the
economic power of China in the world. As regional political becomes one of the primary
essentials in Asian region, Malaysia begins to accelerate by moving up its value chain. There
are growing focuses on the relationships between exchange rate volatility and macroeconomic
variables such as interest rate volati1lity, inflation, and money growth. This is proven by
Karras et al. (2005) where there is a significant relationship between macroeconomic
variables and the exchange rate volatility.
Bah and Amusa (2002) defined damage effect relatives to less developed countries
(LDC) on fluctuation of exchange rate caused by changes in market expectations and market
fundamentals. Unpredicted volatility of exchange rate is difficult to forecast with any
precision. In post-Bretton Woods era, the characteristic of exchange rate is much more
volatile than the macroeconomic variables.
The movements of exchange rate will always become a concern for various parties as
the variability of volatility tends to give significant impacts on economy. Developing
countries such as Asian countries preferred a managed floating exchange rate system than
pegging system to reduce the risks caused by underestimated or overlooked in order to
maintain their macroeconomic success. Thus, some countries implement either monetary or
fiscal polices in order to response to the risk of the ever-changing environment.
Generally, in the studies of Wanaset (2008) implied the volatility of exchange rate
stems from numerous factors for instance policy intervention, economic determinants, and
expectations. In some cases, psychological factors also had been implemented regard to
exchange rate movements. The hypotheses showed that if the exchange rate volatility is
higher subsequently it will create uncertainty for the future profit from export.
2
1.1.1 Exchange Rate Volatility and Risk
Characteristic of exchange rate systems probably defined as fixed I or floating 2 •
Exchange Rate Volatility described the degree to which variable change over time, meanwhile
larger of the magnitude of a variable change, or else more quil,;kl~' changes
over time, it become more volatile. Floating exchange rates is free to change over time.
Therefore it is likely to be more volatile. However, fixed exchange rate does not have
volatility because they are fixed. Exchange rate uncertainty tends to affect international trade
and investment decisions which caused higher risk.
The exchange rate volatility caused macroeconomic determinants expose to exchange
rate risk and may lead to inflationary tendencies. Due to these, the government had prepared a
contingency plans by employing fiscal and monetary autonomy.
The unexpected movements on exchange rate volatility tend to decrease export
demand from international trade transactions. Thus, decrease their future profits either in short
term or long term period (Doganlar, 2002). This is because most of the contracts of trade are
not for immediate delivery on goods . They are denominated in terms of currency of either the
exporter or the importer due to the unexpected changes in exchange rate that affecting reaJ
profit.
I Fixed exchange rates, described not supposed to change and idealJ,y remain fixed for a permanent period of
time.
2 Floating rates, float up or down in every period of time and is often difficult to predict real point.
3
-------------- -- -
The relationship between foreign direct investment and exchange rate volatility is
strong if the movements of exchange rate are volatile. However, the relationship is weak
when the movements of exchange rate are stable (Crowley and Lee, 2003). Investor will
consider the volatility of exchange rate as a risk factor that might decreases or has no impact
on the investment in selected countries .
Exchange rate volatility is proved to have a significant relationship with economic
growth. The risk of exchange rate volatility tends to influence the economic growth of a
county. The impacts are either negative or positive which depend on the exchange rate
volatility. As a result, it affects upstream or downstream trends of a country economy growth
performance.
1.1.2 Malaysia Exchange Rate Regime review
Over the years, global economy follows the Bretton Woods system which is flexible
exchange rate systems from 1973 until present. International market had experienced
sustainable changes in exchange rate volatility. Since the outbreak of the Asian financial crisis
in 1997-98, many Asian countries have adopted series of policy to overcome the crisis in
ameliorating their country economy. Thailand, South Korea, and Indonesia agreed to accept
the rescue programme from International Monetary Fund (lMF) except for Malaysia, who had
shied away from the offer.
4
Pusat Khidmat Maklumat Akademik UNlVERSm MALAYSIA SARAWAK
Among South East Asia countries, Malaysia's economy is considered as one of the
most open economies as it upholds an open policy towards investment and trade ever since
year 1980. Therefore, the foreign exchange market plays an important role which contributes
to the economic growth and financial development in Malaysia.
Malaysia currency, which is Malaysian Ringgit (RM), is formerly known as the
Malaysian Dollar (M$) . In June 1967, there were three separate dollars including M$ that
replaced the old Sterling-linked Malaysian/Straits Dollar where the unit of M$ was created. In
the particular year, Malaysia government had changed the exchange rate policy to floating
rate which maintained about RM2.50 to RM2.60 per dollar in 1989, and it was determined by
demand and supply of foreign exchange market. The Bank Negara Malaysia (Central Bank of
Malaysia) administered exchange controls on behalf of the Malaysian Government throughout
Malaysia, where authority had delegated to the authorized banks.
For the pre-crisis period of mid-nineties, RM was considered as a stable and strong
currency which had experienced several years of rapid economic growth. However, it was
slightly undervalued in some fact pointed out in the previous literatures. Bank Negara
Malaysia (the Malaysian central bank) can easily moderate any volatility in the exchange rate
through minimal intervention. As a result, Gross Domestic Product (GOP) grew about 8.5
percent between 1991 and 1997 with per capita income increasing two fold. This tends to
attract large scale of investment inflows into the country. Thus, improve economic prospects
of nations.
5
Subsequently, crisis began when Thai baht was floated on 2 July 1997. Okposin and
Cheng (2001) argued that Malaysia government quickly pointed a finger to currency
speculators who had destroyed the economy and colonizes of the people. The consequences
bring forward the scenario of increasing unemployment, market collapsed and socio-political
instability. Malaysia maintained a large and liquid stock market, and found that examining
how stock prices varied across firms is a reasonable way to measure the effects of policy
changes.
After post-crisis in Sept. 1998, Malaysia had adopted capital control to stabilize RM
which pegged exchange rate at RM 3.80 relatives to the currencies of their major trading
partners. Thus, wide range of capital control and removal of all legal channels of transferring
RM abroad had been introduced with the aim to protect the monetary policy from external
volatility. The International Monetary Fund (IMF) classified Malaysia's exchange rate regime
as a "conventional pegged arrangement", whereby the Ringgit is pegged against the US dollar
at RM 3.8 per $1.
Therefore, in July 2005, Malaysia government announced the changing of exchange
rate policy where Bank Negara Malaysia (BNM) integrated changing system of exchange rate
from fixed exchange rate to manage floating. After recovering from crisis, many economists
believed that Malaysia can wider its economic due to the increasing in consumer demand and
FDI advances.
6
----~--------~ ---- " --- --
Table 1: De Facto Exchange Rates Policies of East Asia in 2006 Country Exchange Rate Policy
Cambodia Managed Float China Crawling Peg
Hong Kong Pegged Indonesia Managed Float
Japan Free Float Laos Managed Float
Thailand Managed Float Taiwan Managed Float
Malaysia Managed Float Singapore Managed Float Vietnam Crawling Peg*
Philippines Free Float South Korea Free Float
Source: International Monetary Fund, De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework. Note *: replicate policy change subsequent to release of the IMF report.
Table 1 represent the categorization of a government's based on their exchange rate
policy in East Asia and the exchange rate poHcy can be complicated if there is an intervention
towards forex markets. As we can see, most of the Asian economies have adopted a variety of
exchange rate policies commonly to managed floats including Malaysia. Before Asian crisis,
Bank Negara Malaysia did not maintain parity for Ringgit Malaysia which determined by the
market. Then, after the ringgit depreciated sharply after the Thai devaluation in 1997
straightly on September 1, 1998, Malaysia fixed its exchange rate at RM 3.8 per u.S. dollar.
Finally in 2003, it had change back to manage floating.
7
1.1.3 Terms of Trade and Economic performance in Malaysia
Generally, changing in terms of trade is said to affect by exchange rate volatility
between countries. Bleaney and Greenaway (2001) pointed out that increasing in terms of
trade tend to create a higher level of investment and finally improves economic growth of
country. Meanwhile, the exchange rate volatility can prevent industries from engage into
international trade cooperation in trade negotiations.
However, exchange rate volatility can influence trade directly, through uncertainty and
adjustment of the costs, and indirectly, through its effect on the formation of output,
investment and on government policy. By examining the impact of Asian financial crisis
(1997-1998) with the implementation of capital control in Malaysia, exchange rate
uncertainty was found to affect trade downwards slopes. The episode of capital control is still
fresh in the discussion of policy makers in Malaysia.
During Asian financial crisis happened in mid-1997, Malaysia exchange rate
misalignment and volatility relative to international trade were seriously affected. Sekkat and
Varoudakis (2000) alleged that misconduct of economic policies in developing countries has
lead to exchange rate misalignment and volatility, which may harm international trade as well
as decelerate economic performance.
Naseem et al. (2009) showed that among the crisis period, exchange rate volatility has
merely promotes Malaysian imports. This implied that exchange rate volatility is an important
determinant to determine Malaysian trade flows with other countries especially during the
8
,
1997 Asian financial crisis. Theoretically, net merchandise export is defined as trade balance
which leads to sensitivity relative to volatility of exchange rate.
Exchange rate volatility has either positive or negative effects in both short run and
long run which leads to Malaysia growth on GOP. On the other hand, based on Masron and
Yusop (2006) studies, they found that there will be a negative impact on the bilateral trade
and gross domestic product (GOP) towards of exchange rate volatility.
Figure 1: Trade Balance (TB) and GOP of Malaysia from 1997 to 2008
RM (U.S Million) 800000~--------------------------------------~
700000
600000
500000
400000
300000
200000
100000
o+=~~~~~~~~~~~~~ 97 98 99 00 01 02 03 04 05 06 07 08 Year
1-TB ---- GOP I
Source: IMF (unit National Currency in U.S million)
Before Asian financial crisis occurred, RM was a convertible currency which was
freely traded around the world at RM2.S0 per dollar. Due to the speculative
activities resulted from the explosion of the Thai baht in Ju ly 1997, the RM was plummeted
by as much as around RMS.OO to the dollar in weeks.
9
Figure 1 shows the Trade balance in Malaysia from 1997 to 2008. Trade balance had
increased from U.S $3509.5 million to U.S $22644.2 million during the year of financial
crisis. However, it decreased from U.S $20826.7 million to U.S $18135 .1 million from 2000
to 2002 since RM had pegged to RM 3.80. In 2003 to 2008, trade balance had: increased
dramatically due to government policy on exchange rate. Volatility had affect on GDP which
showed an increasing number of trades. Thus, increase FDI and other economic indicators.
1.1.4 FDI profile in Malaysia
In 1980s, Malaysia economic transformed to become one of the world's biggest
producer of primary products such as rubber, palm oil and tin. FDI is defined as an important
vehicle to drive Malaysian economy into evolution and integration with world economy.
In 2005, Malaysia FDI continued to be favorable . It strengthened domestic economy
which robust private consumption and investment activity with the transfer of technology to
the recipient countries with the respect that profit is the main investor's interest.
10
Table 2: FDI inflows Malaysia 2000-2008 Years 2000 2001 2002 2003 2004 2005 2006 2007 2008
Volume 3787 554 3203 2473 4624 4064 6060 8401 8053
Source: UNCTAD (Unit National Currency measure in U.S dollar million)
The above table showed For inflows in Malaysia from 2000-2008. There was a drastic
decrease of FDI from 2000 to 200] i.e. U.S $3787 million to U.S $554 million. Then, FDI
inflows fluctuated in 2002 to 2005 from U.S 3203 million to U.S 4064 mi.llion. It was then
increased dramatically from U.S $6060 million to U.S $8053 million from 2006 to 2008.
Exchange rate volatility played crucial role not only in locating the capital inflows but
also in their composition. As a result, it affects corporate decisions on whether they should
invest as it will influence the predicted future profits of international company.
\ 11
1.2 Problem Statements
Among developing countries, Malaysia's economy is considered as one of the most
open economies as it upholds an open policy towards investment and trade ever since year
1980. Besides encourages the inflow of foreign direct investment (FDI), the open policy also
plays an important role in poverty reduction and economic restructuring in Malaysia. Thus
foreign exchange rate and stock market playa crucial role in contributing to economic growth
and financial development in Malaysia. Previous researchers stated that determinants of
macroeconomic indicators played crucial role in affecting exchange rate volatility and its
indicators in both developed and developing countries.
Economic Growth, Foreign Direct Investment, and trade are indicators that affect by
the movements of exchange rate. They influence investor or trader's confident and perception
towards Malaysia. Exchange rate volatility can reflect the sustainability of the economy
growth in the long run, and also the strength and development of Malaysia.
In addition, increasing of exchange rate volatility is extensively which had detrimental
effects towards international trade and hence have a negative economic impact especially on
emerging economies with underdeveloped capital markets and unstable economic policies
(Prasad et al., 2003).
Therefore, the determinants of exchange rate volatility for foreign market currencies
must not be overlooked or underestimated in order to achieve macroeconomics success and
sustainability.
12