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THE LINK BETWEEN EXCHANGE RATE AND TIMBER EXPORT EARNINGS: EVIDENCE FROM MALAYSIA

THE LINK BETWEEN EXCHANGE RATE AND TIMBER EXPORT EARNINGS: EVIDENCE FROM MALAYSIA
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  2 nd  INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (2 nd  ICBER 2011) PROCEEDING   2508 THE LINK BETWEEN EXCHANGE RATE AND TIMBER EXPORT EARNINGS: EVIDENCE FROM MALAYSIA Noor Aini Zakaria 1  and Hafizah Abdul Rahim 2   Abstract Over the years, the relationship between the exchange rate and international trade has been analyzed. Indeed, the 1997 Asian financial crisis has drove policy makers in the region including Malaysia to study the impacts of exchange rate on trade flows which Malaysia considered as the second most trade-dependent country after Singapore in the ASEAN region. For Malaysian timber industry, being one of the most sector that much influenced by the exchange rate volatility, the further analysis on the link of exchange rate and export is considered important. This study uses Granger causality approach to analyze the relationship between exchange rate and timber export. Besides, we used Chow test to examine the structural change of exchange rate regime on Malaysian export of major timber products. The quarterly data from 1997 to 2008 were employed for this study. This study evidenced there is a structural break in the third quarter of 2005 to the fourth quarter of 2008 which real exchange rate is significant and positively correlated to timber export under managed floating exchange rate regime. Field of research:  Exchange rate, timber export, international trade, cointegration, OLS, granger-causality and chow-test. 1. Introduction Over the years, the relationship between the exchange rate and international trade has been analyzed. Indeed, 1997 Asian financial crisis has drove policy makers in the region including Malaysia to study the impacts of exchange rate on trade flows which Malaysia considered as the second most trade-dependent country after Singapore in the ASEAN region. In other words, among all, exchange rate fluctuation is one of the factors that are likely to determine the economic performance of a country. Knowledge of the link of exchange rate on exports is major importance for policy makers in an open economy like Malaysia which depends heavily on its trade with rest of the world. Therefore, it becomes necessary to evaluate the relationship of exchange rate on Malaysian timber export performance as this sector recognized as one of the main foreign exchange earner for national economy. 2. Literature review The relationship between exchange rate and export has received considerable attention from researchers since the collapse of fixed exchange rate in the early 1970s. A variety of theoretical and empirical model attempts to analyze the effects of exchange rate appreciation and depreciation. Theoretically, real exchange rate changes may have an impact on macroeconomics. When the country’s real exchange rate depreciates, it will increase the 1  PhD Candidate, Paris Institute of Technology for Food, Life and Environmental Sciences, France in collaboration with Forest Research Institute Malaysia (FRIM). Email: norainiz@frim.gov.my / ainizack82@yahoo.com  2  School of Business Innovation and Technopreneurship, Universiti Malaysia Perlis. Email: hafizahrahim@unimap.edu.my / fiezarmy@yahoo.com   2 nd  INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (2 nd  ICBER 2011) PROCEEDING   2509 aggregate demand of its products. A fall of the real exchange rate means the country’s product become relatively cheaper in comparison to the products of other countries and hence the demand for the country’s export may increase. However, according to Marshall-Lerner condition, depreciation will only be success if volumes of trade are elastic to price changes (Salvatore, 2004). Besides, the policy maker believed that exchange rate appreciation would be detrimental to exports and encourage import. The Mundell-Flemming model rules for small open economies, an exchange rate appreciation will hurt export and encourage imports of a country. Empirically, Arslan (1993) found exchange rate depreciation has important role to boost the export growth to help Turkey recover rapidly from the debt crisis of late seventies. In addition, Thapa (2002) conducted a study on Nepal and suggested that depreciation of real exchange rate enhances international competitiveness of Nepal’s domestic goods and boost their net export. Nabli and Marie-Ange (2002) conclude from the study on export performance of Middle Eastern and North African countries that the exchange rate overvaluation caused major loss and decreasing their export competitiveness. Saadiah and Kamaruzzaman (2008) make a study on exchange rate and export performance of Indonesia, Malaysia, Thailand and Singapore. They found that the real exchange rate undervaluation can be used to promote export while an overvaluation will tend to reduce export. In contrast, Lai and Miller (2005) on their study in Singapore summarize that the exchange rate depreciation not significantly improve export of the country. Alam (2010) on his study on Bangladesh found that Bangladesh export-price is inelastic and depreciation of the currency does not have much impact on Bangladesh export. For Malaysian timber industry, being one of the most sector that much influenced by the exchange rate volatility, the further analysis on the link of exchange rate and export is considered important. As far as we are concern, there is no specific study deal with the link of exchange rate and Malaysian timber export as such has been carried out. Given the limitation of empirical study on area of timber export and exchange rate in Malaysia, this study deemed to bridge the gap by empirically analyze the link of exchange rate on the Malaysian timber export earnings. The main objectives of this study aim to (i) to study the relationship between exchange rate and export earning of Malaysian timber products. Thus, the findings of this study are expected to bring a new dimension to the literature. This study is structured as follow: section three will provide the literature review on the effect of exchange rate on export. Section four discuss on methodology and data. Section five will be the results and discussion and finally conclusion will summarize this paper. 3. Data This study uses the approach of Alam (2010) to analyze the relationship between exchange rate and Malaysian timber export. An important question is which exchange rate is appropriate for this study, either nominal or real exchange rate? The researchers have different views on the strength and lacks of both types. Nominal exchange rates are accused to overestimate the existing exchange rate uncertainty. However, the nominal exchange rates are preferred in short term analysis compared to long term. The real exchange rate can be defined as the nominal exchange rate that takes the inflation differentials among the countries into the account (Kipici and Kesyireli, 1997). Real exchange rate mainly related to macroeconomic variables such as resource endowments, technology and preference. The important fact is real exchange rate can be used as an indicator of the competitiveness in the foreign trade of a country. Thus, for this study, we used real exchange rate to analyze the impact on the export earnings of timber. The quarterly data covers the period from 1997 to 2008 have been employed for this study. The data for nominal exchange rate was extracted from Central Bank of Malaysia (2010), the total export of Malaysian timber products were compiled from Maskayu Monthly Bulletin of Malaysian Timber Industry Board (1997, 1998….2008) and consumer price index (CPI) was taken from International Monetary Fund (IMF). The nominal exchange rate has been converted to real exchange rate by multiplying the nominal exchange rate of Malaysian Ringgit/US Dollar  2 nd  INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (2 nd  ICBER 2011) PROCEEDING   2510 by the ratio of foreign price level to domestic price level. Consumer price index (index, 2000=100) has been used as proxy domestic price and foreign price as well. RER= NER x (CPI MAS  /CPI US ) In the above equation, RER refer as a real exchange rate, NER is a nominal exchange rate and CPI is consumer price index. Figure 1 shows the nominal exchange rate and real exchange rate of Malaysia. Figure 1: Nominal vs. real exchange rate for Malaysia, 1997-2008 0.000.501.001.502.002.503.003.504.004.500 10 20 30 40 50 60    E  x  c   h  a  n  g  e  r  a   t  e   (   M   Y   R   /   U   S   D   ) Nominal ER Real ER   In between, to reduce the price effects on Malaysian timber export, the nominal export has been transformed into real terms. To obtain the real export for Malaysian timber products, the GDP deflator (index, 2000=100) was used as a proxy to deflate the nominal export. As expected, nominal export grows faster than real export because it includes inflation. Real export growth appears more moderate because the calculation has separated out any pricing effects (Figure 2). Real Export = Nominal export value / GDP deflator  2 nd  INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (2 nd  ICBER 2011) PROCEEDING   2511 Figure 2: Nominal vs. Real export value of Malaysian timber products, 1997-2008 010002000300040005000600070000102030405060    E  x  p  o  r   t  v  a   l  u  e   (  m   i   l   l   i  o  n  s   M   Y   R   ) Nominal export value (RM)Real export value (RM) 4. Statement of the hypotheses   This study expects negative relationship exist between real exchange rate and the export performance of timber. In other words, if the real exchange rate increase (Malaysian Ringgit depreciates), this will increase the competitiveness of the timber products and hence encourages export earnings. 5. Methodology 5.1 Unit Root Test The unit root test is performed to examine the relevant time series for stationarity. The most common tests are known as Dickey-Fuller (DF) or Augmented Dickey-Fuller (ADF) and Philip Perron (PP). An important assumption of DF test is that the error term ε t   are independently and identically distributed. The ADF test adjusts the DF test to take care of possible serial correlation in the error terms by adding the lagged difference terms of the regressand. However, the PP is based on the Philip (1987) Z-test, which involves transforming the test statistic to eliminate any autocorrelation in the model. It uses nonparametric statistical methods to take care of the serial correlation in the error terms without adding lagged difference terms. In this study, both tests have been used to test for unit root. ADF is used for this study because of the power of test which is the (time) span  of the data is based on 40 observations and if there are structural breaks in a time series, the unit root tests may not catch them. The first regression equation (1.1) (OLS model), puts the real exchange rate as the independent variables of total export of timber products.  y t   = α 0  +  β  1  x  t-1 + ε t (1.1)   The above equation shows that y is the real export, x is real exchange rate, ε  is the error term, α  and β  is the parameters.  2 nd  INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (2 nd  ICBER 2011) PROCEEDING   2512 5.2 Granger Causality Granger causality is statistical causality, which based on the premise that information on future value of a variable is contained in its past values. That is, we can predict future value based on past values. Thus,    y t   = α  +  Σβ   j    y t-I + ε t   (1.2) However, if lagged values of x variable (real exchange rate) can improve the forecast of the y (timber export), they are said to Granger cause y:    y t   = α  +  Σβ   j    y t-i  +  Σθ  i    x1 t-i  + ε t    (1.3) The regression (1.3) refers to Granger causality test to analyze the long run relationship between real exchange rate and timber export by looking at the coefficient of error term as long run causality. To test cointegration and causality, the procedures involves three steps. The first step refers to unit root test which is performed earlier in this analysis. The second step is to test for cointegration using the Johansen maximum likelihood approach. The purpose of cointegration test is to determine the cointegration between the groups of series. If such a combination exists, the variables are said to be cointegrated which interpreted as a long run equilibrium relationship among the variables. 6. Discussion of finding To confirm that the results will not generate any spurious inferences, the unit root test is performed (Alam, 2009). Prior to unit root test, both series export and real exchange rate were graphed in log levels to analyze the stationary of the data. The export data was stationary at level and export was non stationary. Export data was integrated at order one (I(1)) and no further differencing of data or unit root testing is required (Table 3). Table 3: Unit root test for export and real exchange rate Method Model Variable t- statistic ADF Constant Ln_ER - 8.2573** Ln_EX - 2.5818* Trend Ln_ER - 2.5507* Ln_EX - 6.6728** PP Constant Ln_ER - 4.3986** Ln_EX - 3.6097** * and ** indicate rejection of null hypothesis of non-stationary at 1% and 5% level of significance. Null hypothesis: the variables are non-stationary.   However, integrated at order 1 does not necessarily mean that the series are cointegrated (Alam, 2009). For granger causality test it is important to know whether the variables are cointegrated, then a vector autogression in first differences will be misspecified. The first differencing of all the non stationary variables puts too many unit roots and any potentially important long-term relationship between the variables will be unclear (Alam, 2009). To straight to the point, we adopt the VAR model as proposed by Alam and test for the Granger Causality. From the equation (1.3), to see the variables are cointegrating by using Johansen test. The results are as follows:
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