EXCHANGE RATE MISALIGNMENTS IN ASEAN-5 COUNTRIES

1. EXCHANGE RATE MISALIGNMENTS IN ASEAN-5 COUNTRIES ECN 4149 Guest Lecture by Lee Chin Department of Economics Faculty of Economics and management University Putra Malaysia

2. Outline • Introduction • Issues & Objectives of the study • Literature reviews • Model & Method • Results & Discussion • Conclusion

3. 1. Introduction • During the 1980s and early 1990s, • the Southeast Asia’s enjoyed rates of growth of nearly 8% a year.

4. 1. Introduction • However, the impressive growth had dramatically changed in 1997. • Massive attacks on Thai baht took place on 14 and 15 May 1997, • forcing the Bank of Thailand to float baht on 2 July 1997. • At first, the economic crisis was limited to Thailand's financial sector, but it quickly grew to engulf Malaysia and Indonesia as well.

5. Causes of Asian Currency Crisis • The “fundamentalist” view • Corsetti et al. (1998) • structural weaknesses - in domestic financial institutions • unsound macroeconomic policies. • “financial panic” • Radelet et al. (1998)

6. Causes of Asian Currency Crisis • A rigidly fixed exchange rate or quasi-fixed exchange rates • Hill, 1998; Nidhiprabha, 1998; Sadli, 1998 and Athukorala, 1998. • effective weight of the US$ in the basket was so high • could be characterized as an implicit peg to the US currency. • It is believed that the pegged to US$ would help to ensure their currencies stability, • however, a robust US economy in recent years had strengthened the $ which had led many investors to believe that ASEAN currencies were overvalued.

7. Objectives • Generally, this paper aims • to determine the exchange rates for ASEAN countries before the currency crisis • to see whether there is any currency misalignment • by using • the monetary exchange rate model & • vector error-correction techniques.

8. 2. Exchange Rate System • After the collapse of the Bretton Woods system • South East Asia countries - evolved into a generalized floating exchange rate system. • Before the onset of currency crisis, • Indonesia peg her currency to US dollar, • Malaysia & Thailand peg their currencies to a basket of their respective trading partners’ currencies. • Singapore practised the managed float system • Philippines adopted an almost fixed nominal exchange rate regime.

9. Following the speculative attacks & abandonment of the baht, the contagion effects swept across the region. • Their currencies depreciated sharply • the exchange rates systems together with a fairly open capitalaccount which they maintained for the past decade was not sustainable. • Malaysia opted to close their capital accounts significantly • the other 4 major Southeast Asian economies have adopted floating regimes.

10. 3. Literature Reviews • Theoretical & empirical literatures on the determinants of exchange rates or exchange rate misalignments. • Regardless of the specific approach in modelling exchange rate determination, to measure misalignment the equilibrium exchange rate must be ascertained.

11. Empirical studies of Asian exchange rate misalignments before the 1997 crisis

16. 4. The Monetary Approach to Exchange Rate Determination • Monetary models of exchange rate determination • were developed after the collapse of the fixed exchange rate system • Its basic rationale • since an exchange rate is the price of one country’s money in terms of that of another, • it is important to analyse the determinants of that price • in terms of the outstanding shocks of & demand for the 2 monies.

17. 4. The Monetary Approach to Exchange Rate Determination • Over the past 3 decades - enormous growth in the literature on exchange rate economics. • Several versions have been put forward giving rise to 2 main types of models: • Flexible-price monetary model due to Frenkel (1976) and Bilson (1978) • Sticky-price monetary model of Dornbusch (1976) and Frankel (1979)

18. Assumptions • All monetary model - rely on: • PPP holds continuously et = pt – pt* (1) • Money markets in equilibrium: mt = 1pt + 2yt + 3rt (2) mt* = 1pt* + 2yt* + 3rt* t (3) where et is the spot exchange rate (defined as domestic/foreign currency) mt is the domestic money supply pt is the domestic price level, yt is the domestic real income rt is the domestic interest rate * denotes the corresponding foreign variables

19. Flexible-price Monetary Model (FPMM) • Solving Eq 2 & 3 for the relative price levels, and substituting into Eq 1 • Flexible-price monetary model: et = (m t - m*t )-  (yt - y* t)+ (r t – r*)t (4) • (mt - m*t)should be +1 • (yt - y*t)should be negative • (rt – r*t)should be positive.

20. Flexible-price Monetary Model (FPMM) et = (m t - m*t )-  (yt - y*t)+ (r t – r*)t (4) • (mt - m*t) should be +1 • (yt - y*t) should be negative • (rt – r*t) should be positive. • ↑ msupply will lead the eto↑ (depreciate) • ↑ y will raise the money demand, causing thee to↓ (appreciate). • ↑ r will result in a depreciation of the e (↑) via a reduction of the demand for money.

21. Sticky-price Monetary Model (SPMM) • An alternative version • prices are rigid, adjusting gradually • so that PPP holds only in the long-run • Sticky-price monetary model: et = (mt - m*t)- (yt - y*t)+ (rt – r*t)+ Et(t+1 –*t+1) (5) • (mt - m*t)should be +1, • (yt - y*t)should be negative • (rt – r*t)should be negative • Et (t+1 –*t+1) should be positive.

22. Alternative hypotheses on the coefficients of the monetary models • The last 2 effects are the opposites • SPMM • ↑ r leads to capital inflows, & hence to an appreciationof the e (↓). • ↑ expected long-run  results in agents switching from domestic currency to bonds. Thus the demand for domestic currency decreases, causing a depreciationof thee (↑).

23. Methodology • We first examine the stationarity of the series using ADF unit root test. • Then we test for the existence of cointegrating relations between the exchange rate & its fundamentals using Johansen cointegration test. • Next, following the general-to-specific methodology, the final parsimonious VECM monetary model are obtained • the resultant model will be checked in terms of diagnostic tests. • Finally, the estimated VECMs are used to determine the exchange rates before the currency crisis • to see whether there is any currency misalignment for ASEAN five countries.

24. Methodology ADF Unit Root Test Johansen Cointegration Test • Vector Error Correction Model • Parsimonious • Diagnostic Tests Estimating Equilibrium Exchange Rate Exchange Rate Misalignment

25. Data • IMF International Financial Statistics yearbook. • 1980Q1 - 2003Q2. • Data 1980Q1 – 1995Q1 - formulate models (except 1985Q4 - 1995Q1 for Thai) • Data 1995Q2 onwards - comparison & out-sample forecasting. • Data: • Exchange rates (ER) - quarterly averages. • Monetary aggregates - broad money stock (M2). • Income - industrial product indices (IPI). • Interest rates - short-term market rates (MR) (except – 3 month treasury bill rates (TB3) - Philippines). • Expected inflation rate - Preceding 4 quarters growth in CPI.

26. 5. Results ADF Unit Root Test Johansen Cointegration Test • Vector Error Correction Model • Parsimonious • Diagnostic Tests Estimating Equilibrium Exchange Rate Exchange Rate Misalignment

31. Equilibrium Exchange Rates • In order to determine the equilibrium exchange rates before the currency crisis to see whether there is any currency misalignment, • out of sample forecast for exchange rates are made • Using the final parsimonious models obtained • in sample and out of sample predictions • Evidences of the goodness of fit are revealed in Figure 1 – Figure 5. • In virtually, the models fit the data very closely. • the models able to track the actual exchange rate well • manage to get a number of correct turning points.

37. Estimated Misalignment • Residuals between the actual and the estimated equilibrium exchange rates

39. 6. Summary & Conclusion • Building upon the theoretical framework of sticky price monetary model • this paper estimates the equilibrium exchange rates of five ASEAN countries. • Using the residuals between real and equilibrium exchange rates, these ASEAN countries’ exchange rate misalignments relative to the USD are derived.

40. It is shown that before crisis • Indonesia rupiah, Malaysia ringgit, Philippines peso & Singapore dollar were overvalued about 1 to 4 % against USD • Thai baht was 2 % undervalued against USD. • The misalignments are quite small. • This suggests that the cause of the ASEAN crash cannot be attributed to traditional fundamentals. • the undervalued Thai baht experienced crashed • the overvalued Philippines peso & Singapore dollar did not. • Thus, the exchange rate overvaluation is not the key factor to the 1997 ASEAN currency crisis.

41. Thank You The End