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

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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

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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

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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

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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