Financial Crisis and Exchange Rates in Emerging Economics: An Empirical Analysis using PPP-UIP-Framework

Transcription

1 MPRA Munch Personal RePEc Archve Fnancal Crss and Exchange Rates n Emergng Economcs: An Emprcal Analyss usng PPP-UIP-Framework Abdul Rashd and Mashael Saedan 14 August 2013 Onlne at MPRA Paper No , posted 16 September :39 UTC

2 Fnancal Crss and Exchange Rates n Emergng Economcs: An Emprcal Analyss usng PPP-UIP-Framework Abdul Rashd Internatonal Instute of Islamc Economcs (IIIE), Internatonal Islamc Economcs (IIU), Islamabad, Pakstan Emal: Abdulrashd@u.edu.pk Mashael Bn Saedan Dar al Uloom Unversy, Ryadh, Saud Araba Emal: Mesho1040@me.com August 2013 Abstract Ths paper emprcal nvestgates the effects of 2008 fnancal crss on exchange rate determnaton n PPP-UIP framework for four emergng countres, usng monthly date over the perod The results suggest that the mpact of recent fnancal crss led to change the role of determnes of exchange rates n exchange determnaton. The fndngs also reveal that the effects of fnancal crss on the exchange rate are dfferent n all the four emergng economes. The fndngs of the study are of sgnfcant for polcy makers n desgnng effectves polces n order to reduce the effects of fnancal crss on exchange rates.

3 1. Introducton Globalzaton makes the world more correlated through many channels such as exports, mports, and net capal flows. More economc and fnancal ntegraton makes the mpact of 2008 fnancal crss speared faster globally. Ths fnancal crss was one of the worst dsasters n the hstory snce the crss of 1929, whch causes a huge fall n the household wealth and the whole fnancal market (Brunnermeer, 2008; Crotty, 2009; Galbrah, 2009; Hekk, 2009). Moreover, caused many serous effects n the global exchange rate regme (Fratzscher, 2009). Therefore, s sgnfcant to nvestgate the mpact of 2008 fnancal crss on exchange rate determnaton. The foregn exchange market s consdered as one of the hghest treadng value n all fnancal markets. Thus, the fluctuaton n the exchange rate mght lead to a sgnfcant mpact n the underlyng economy, n partcular when the rsk and uncertanty s growng n the fnancal markets. The recent fnancal crss causes several doubts and uncertanty regardng the sustanably of exstng fnancal system across the world. Along wh numerous other socoeconomc effects, the fnancal crss also affects determnaton of exchange rates n both short and long run (Keblowsk and Welfe, 2011). The am of ths paper s to examne how 2008 fnancal crss affects exchange rate determnaton n purchasng power pary (PPP) and uncovered nterest rate pary (UIP) framework. Snce several prevous emprcal studes, such as (Refshal, 2010) and (Rashd, 2009), have provded sgnfcant evdence that the exchange rate s determned by jontly through PPP and UIP. We therefore also study the mpact of fnancal crss on exchange rates n PPP-UIP framework. We also examne whether the mpact of fnancal crss on the exchange rate dffers across countres wh dfferent economc and socal backgrounds. Thus, the emprcal analyss s curred for four emergng economes, namely Egypt, Inda, Turkey, and Thaland, usng monthly data coverng the perod from 1981 to The rest of the paper s organzed as follows. Secton 2 revews the lerature related to PPP, UIP, and fnancal crss. Secton 3 explans the PPP, UIP, and the combned form of PPP and UIP. Secton 4 descrbes data and presents the emprcal fndngs. Secton 5 concludes the paper.

4 2. Lerature Revew Several researchers, such as Blanchard et al. (2010), Keblowsk and Welfe (2011), Refshal (2010), Wong and Wa L (2010), Tsangardes (2012), and Fratzscher (2009) examne the mpact of the subprme fnancal crss upon the global exchange rate usng dfferent method. Most of these studes eher the PPP or UIP whle testng fnacal crss effects. However, other studes, such as Rashd (2009), Jaramllo and Servanb (2012), and Keblowsk and Welfe (2011) test the jont form of the PPP and the UIP. These studes provde strong evdence that both PPP and UIP condons play a sgnfcant role n the determnaton of exchnage rate. Refshal (2010) examnes the factors that affect the fluctuaton of Australan dollar n the tme of the fnancal crss. Specfcally, he ames to answer the queston as to why Australa has handeled the most recent fnancal crss so much better than most other developed naton?. Specfcally, the author tests the PPP, UIP, and the real nterest pary (RPI) by usng contegraton approach and provdes evdence that there s a strong relatonshp between the Australan dollar and world commody prces whch assstances to stablze domestc economc actves. Jaramllo and Servan (2012) usng trade-weghted exchange rates test whether the PPP and UIP hold for the Peruvan economy. Ther study covers the perod They document that the mxture of PPP and UIP sgnfcantly explans the dynamcs of the nomnal effectve exchange rate n Peru. They also argue that although the central bank s nterventon s sgnfcant for smoothng the exchange rate short term volatly, dose not have a long term nfluence on the exchange rate. Keblowsk and Welfe (2011) propose a new modellng of exchange rate that enhances the capal enhanced equlbrum exchange rate (CHEER) model, whch s the combnaton of the PPP and UIP. Specfcally, they nclude a ndependent cred default rsk nto ther specfcaton to take nto account the decsons of fnancal nvestors. They use contegrated VAR system and monthly data from Poland and Euro area. Ther results suggest that the soveregn cred rsk s an mportant factor that determnes the exchange rate along wh the prce and the nterest rate dfferentals. As a result of the fnancal crss, there was uncertanty n the fnancal market, whch may affect the determnatons of exchange rates (Keblowsk and Welfe 2011). The recent fnancal crss caused abrupt fluctuatons n the global exchange rate regme (Fratzscher, 2009) that had an nverse mpact n the emergng countres manly

5 through external shocks; mostly by two channels: net capal flows and export (Blanchard et al., 2010). Consequently, the experence of recent fnancal crss left several lesson for emergng economes, partcularly, regardng the choce of the exchange rate regme (Tsangardes, 2012). Most of the emergng countres have constructed consderable posve holdng of US dollar treasury blls from the tme of the crses of the late 1990, whereas they face a boom n the FDI capal nflows at the same perod (Devereux and Sultherland, 2009). Nonetheless, Fratzscher (2009) hghlghts that the subprme fnancal crss breakdown the dea that the US dollar plays a val role n the nternatonal adjustment process because of the sharp declne n the assets prce and the huge deleveragng procedure amd fnancal organzatons. Thus, the economes went to recesson, whch led to huger hazard to human secury that becomes from global fnancal nsecury and had seres effects upon the emergng countres especally the poorest (Fukuda- Parr, 2008). Fratzscher (2009) analyzed the data from 50 advance and emergng countres to nvestgate the change n the global exchange rate durng the recent fnancal crss perod. He states that a sharp fluctuaton n the global exchange rate confguratons has caused by the recent fnancal crss. He strongly recommends the mportance of the macroeconomc fundamental, n specfc suffcent foregn exchange reserves and sound current account posons to pawn capal flow reversal. Blanchard et al. (2010) nspected the mpact of the crss n the emergng countres dong a case study of three emergng countres (Latva, Russa, and Chle). They toke a smple of cross-country specfcaton, connectng unexpected trade and fnancal varables over two quarters. Ther results do not support the hypothess that holdng more foregn reserves helps lm the drop n output n the dsaster. Fukuda- Parr (2008) also observed that even though some developng countres ncreased the reserves and surpluses, they badly affected from the recent fnancal crss. Revewng prevous emprcal studes, we fnd that there are not enough emprcal evdence how the recent fnancal crss affects exchange rate determnaton n the PPP-UIP framework. Therefore, n ths paper, we study the mpacts of fnancal crss on the exchange rate n four emergng economes after takng nto account factors related to both PPP and UIP.

6 3. Economc Theory 3.1 Purchasng Power Pary (PPP) Under the PPP, the change n the prce levels between any two countres determnes the exchange rates for these countres when expressed n same currency, whch s the assumpton of low of one prce (Mshkn, 2010; Plbeam, 2006). The relatve form of PPP s as: e = α + β p d f ( p t ) +ε t t =1,..,T (1) e = log nomnal exchange rate for domestc country s defned as the number of domestc currency uns needed to purchase one foregn currency un. p d = log domestc prce level p f t = log of foregn country prce level at tme ε t = trade shock wh zero mean and fne varance α = constant T = the number of observatons over tme. 3.2 Uncovered nterest rate pary (UIP) Ths theory allows the capal movements and s state that the change of the nterest rate between any two countres determnes exchange rates for these countres (Plbeam, 2006). The UIP can be expressed as: Δe +1 = λ +δ d f ( t ) + µ (2) d = log domestc nterest level f t = log foregn nterest level 3.3 Combnng PPP and UIP MacDonald and Taylor (1992) and Rashd (2009) state that there s not enough emprcal evdence supportng the PPP and UIP separately as many researchers faled to found. They also argue that there are several factors that caused the falure of PPP; for nstance, trade barrers, relatve prce level, mperfect market, and transport cost. Whle the lmed capal mobly and the rsk premum are examples of the factors that cause the falure of UIP. Therefore, the two models mght not be evaluated ndvdually when explorng the determnants of exchange.

7 The man advantage n the combned PPP and UIP s that both pary condons complete each other. The approach, whch combned PPP and UIP, s the capal enhanced equlbrum exchange rate (CHEER) model. A key dea of the CHEER model s that a statonary connecton relable wh the assets and good markets nterdependence adjustment n to equlbrum s shaped by non-statonary devaton from PPP and UIP ( Stephens, 2004; Rashd, 2009). Hence, PPP s a long-term crcumstance, whch supposed that the PPP forms n the expectatons foundaton n the UIP crcumstance. So, ths lnk s transferred to equaton by pluggng equaton (1) nto equaton (2), whch yeld the followng equaton: d f d f ( p pt α e ) = λ + δ ( ) µ η + (3) Rearrangng: e = p d + p f t δ + η d f ( ) + Ψ λ µ where Ψ = α + + η η Fnally, to examne the mpact of fnancal crss, we augment equaton (4) by addng the nteractons between explanatory varables and fnancal dummy. The equaton takes the followng form. d f crss d crss f δ crss d f ( ) + D. p + D. p + D ( ) + Ψ d f δ e = p + pt + t. η η 4. Econometrcs framework 4.1 Data The monthly data coverng the perod from are taken from the Internatonal Fnancal Statstcs (IFS) database for four emergng countres. We select dfferent emergng countres, frst a bg Asan economy (Inda), second an economy heavly reles on toursm (Thaland), thrd a country (Turkey), whch s closet to Europe geographcally, and fnally one Mddle East ol produced country that s Egypt. The selecton of these countres allows us to make an nterestng comparson. (4) (5)

8 The varables ncluded n the analyss are the exchange rate, the nterest rate, consumer prce ndex (CPI), producer prce ndex (PPI), and share prce ndex (SPI). All varables are n log form. Addonally, we create a dummy varable (takng value 1 for post crss perod (11/2007 untl 12/2012) and 0 for pre crss perod) n order to dentfy the mpact of the fnancal crss. Table 1 presents the summary statstcs. Table 1: Summary Statstcs Varables Mean S.D Mean S.D Mean S.D Mean S.D Mean S.D Exchange rate Egypt Inda Turkey Thaland Panel Interest rate CPI PPI Emprcal Results Ths secton presents emprcal fndngs that examne the mpacts of fnancal crss on exchange rate determnaton under two well-know pares (PPP and UIP) for four emergng economcs. To test the effect of fnancal crss on exchange rate determnaton, we run several specfcatons followng prevous emprcal studes, such as Refshal (2010), Jaramllo and Servan (2012) and Rashd (2009). In ths paper, we consder USA as a foregn country. We begn our emprcal analyss by testng the order of ntegraton of each varable. Specfcally, we apply the augmented Dckey-Fuller (hereafter ADF) un root test on both levels and frst dfferences of the varables and test whether they are ntegrated of order zero or one. We also apply the panel un root test, namely Fshertype tests. Ths test s based on the ADF test. Specfcally, Fsher-type tests conduct un root tests for each ndvdual ncluded n the panel and combne the p-value from these tests to produce an overall test. The hypothess for these tests s that all panels contan un roots, whle the alternatve hypothess s that at least one panel s statonary. The results from the ADF tests for levels and frst dfferences of the varables are presented n Tables 2 and 3, respectvely.

9 Table 2: Un Root Results: At levels Varables Constant Constant + trend Egypt Exchange rate (0.7196) (0.9433) Interest rate (0.5457) (0.3515) CPI (0.0277) (0.7945) PPI (0.4284) (0.8030) Inda Exchange rate (0.2483) (0.9247) Interest rate (0.9547) (0.366) CPI (0.7443) (0.6589) PPI (0.6714) (0.9158) SPI (0.6358) (0.5348) Turkey Exchange rate (0.0958) (1.0000) Interest rate (0.8772) (0.8017) CPI (0.0516) (1.0000) PPI (0.7139) (0.0000) SPI (0.1970) (0.8167) Thaland Exchange rate (0.3390) (0.7138) Interest rate (0.5377) (0.2265) CPI (0.7637) (0.9083) PPI (0.9871) (0.1165) SPI (0.5229) (0.0344) US A Interest rate (0.9745) (0.9312) CPI (0.9905) (0.6530) PPI (0.0074) (0.1430) SPI (0.5639) (0.8940) Note: The fgures gven n parentheses are p-value. The null hypothess for ADF un root test s that the seres s non-statonary, whle the alternatve hypothess s that the seres statonary.

10 For Egypt, both exchange rate and nterest rate are non-statonary at ther levels. These results hold regardless we estmate the ADF equaton whout and wh a lner tme trend. However, consumer prce ndex s statonary when the ADF equaton s estmated whout trend. It appears non-statonary when the trend s ncluded n the equaton. Lookng at results for Inda, the result suggest that only the nomnal exchange rate s statonary at s level when only constant s ncluded n the ADF equaton. However, when the trend s added nto the equaton, becomes non-statonary. All others varable are non-statonary regardless of whether a lnear tme trend s ncluded or not except the nterest rate, whch s non-statonary whout the trend, and become statonary wh the trend. Turnng to Turkey we observe that shares prce ndex s statonary when the ADF equaton runs whout the trend but all the other varables are non-statonary. However, the consumer prce ndex, prce producton ndex, and exchange rate are statonary when the trend s accounted but the SPI turns non-statonary. The nterest rate n both cases appears non-statonary. For Thaland, all the underlyng varables appear non-statonary at ther levels, as we do not reject the null of un root. These fndng hold for all varables except share prce ndex even when we nclude a lnear tme trend n the ADF equaton. Share prce ndex appears statonary when we consder a lnear tme trend. Fnally, n case of the USA, the un root test results provde evdence that all the underlyng varables also are non-statonary at ther levels. The results from the ADF un root tests for frst dfferences of the varables are gven n Table 3. It s clear from the table, for all varables, we reject the null of non-statonary n favor of the alternatve hypothess of statonary for all countres. Ths mples that all the varables are ntegrated of order one.

11 Table 3: Un Root Results: At frst dfferences Varables Constant Constant + trend Egypt Exchange rate (0.0000) (0.0000) Interest rate (0,0000) (0.0000) CPI (0.0000) (0.0000) PPI (0.0000) (0.0000) Inda Exchange rate (0.0000) (0.0000) Interest rate (0.0000) (0.0000) CPI (0.0000) (0.0000) PPI (0.0000) (0.0000) SPI (0.0000) (0.0000) Turkey Exchange rate (0.0000) (0.0000) Interest rate (0.0000) (0.0000) CPI (0.0000) (0.0000) PPI (0.0000) (0.0000) SPI (0.0000) (0.0000) Thaland Exchange rate (0.0000) (0.0000) Interest rate (0.0000) (0.0000) CPI (0.0000) (0.0000) PPI (0.0000) (0.0000) SPI (0.0000) (0.0000) US A Interest rate (0.0000) (0.0000) CPI (0.0000) (0.0000) PPI (0.0000) (0.0000) SPI (0.0000) (0.0000) Note: The fgures gven n parentheses are p-value. The null hypothess for ADF un root test s that the seres s non-statonary, whle the alternatve hypothess s that the seres statonary.

12 Table 4 presents the results for panel un root tests for the underlyng varables at levels as well as the frst dfferences. Most of the varables appear nonstatonary when a lnear trend term s ncluded n the equaton. However, the results from estmatng the Fsher-type tests for frst dfferences of the varables show that all varables are statonary. These results hold when we even nclude a lnear tme trend n the equaton. Overall, the results from panel un root tests suggest that all varables are ntegrated of order one. Table 4: Panel un root: at level Varables Constant Constant + trend Exchange rate (0.0001) (0.9807) Interest rate (0.0369) 0.033(0.5131) CPI (0.0000) 1.479(0.9305) PPI (0.0434) (0.0351) SPI (0.0019) (0.3160) Panel un root frst dfference Varables Constant Constant + trend Exchange rate (0.0000) (0.0000) Interest rate (0.0000) (0.0000) CPI (0.0000) (0.0000) PPI (0.0000) (0.0000) SPI (0.0000) (0.0000) Note: The fgures gven n parentheses are p-value. The null hypothess for ADF un root test s that the seres s non-statonary, whle the alternatve hypothess s that the seres statonary. After confrmng the order of the ntegraton of the varables, we apply the Johansen (1995) contegraton test to dentfy whether the varables ncluded n the exchange rate model are contegrated n the long run. Specfcally, we apply the trace statstc to examne the number of contegrated vectors. The results are presented n Table 5. The astersk ndcates the maxmum sgnfcant number of contegrated vectors.

13 Table 5: Results from Contegraton Tests Rank Egypt Inda Turkey Thaland * * * * As can be seen from the table, there s only one contegrated vector for all countres accept Turkey. In Turkey, there are two contegrated vectors. However, I select the frst one when I estmate the vector error correcton model to examne the mpact of fnancal crss on the determnaton of the exchange rate. The exstence of the contegraton between the exchange rate and domestc nterest rate, foregn nterest rate, domestc prce levels, and foregn prces suggest that these varables have a co-movement n the long run. In other words, there s a unque long-run equlbrum. After confrmng the exstence of the long-run relatonshp between the exchange rate and s determnants, I estmate the vector error correcton model for each country to examne the mpact of fnancal crss on the exchange rate. The results are presented n Table 6.

14 Table 6: Results from Vector Error Correcton Model; Dependent Varable: Log (Exchange Rate) Varables Egypt Turkey Thaland Inda Coef P > z Coef P > z Coef P > z Coef P > z Error term Log(exchange rate) t Log(nterest rate)t Log(CPI) t Log(foregn nterest rate) t Log (foregn CPI) t Dummy crss Log (nterest rate) t Dummy crss Log (CPI) t Dummy crss Log (foregn nterest rate) t Dummy crss Log (foregn CPI) t Log (exchange rate) t Log (nterest rate) t Log (CPI) t Log (foregn nterest rate) t Log (foregn CPI) t Dummy crss Log (nterest rate) t Dummy crss log (CPI) t Dummy crss log (foregn nterest rate) t Dummy crss Log (foregn CPI) t Log (exchange rate) t Log (nterest rate) t Log (CPI) t Log (foregn nterest rate) t Log (foregn CPI) t Dummy crss Log (nterest rate) t Dummy crss Log (CPI) t Dummy crss Log (foregn nterest rate) t Dummy crss Log (foregn CPI) t Trend constant

15 Lookng at the coeffcent of error term, we observe that the sgn of the estmated coeffcent s negatve for three countres, namely Egypt, Inda, and Thaland. The negatve sgn s consstent wh the theory. Ths mples that there s a sgnfcant convergence to the long-run equlbrum. The p-values ndcate that ths convergence s statstcally meanngful only for the case of Inda. Interestngly, the estmated coeffcent of the error term for Turkey s posve and statstcally sgnfcant at 10% level of sgnfcance, ndcatng that there s dvergence from the long-run equlbrum. The results also ndcate that the one-perod lagged value of exchange rate has posve and statstcally sgnfcant mpact on the current level of exchange rate for Turkey and Thaland. Nonetheless, for remanng two countres, whle the estmated mpact s posve, s not sgnfcant statstcally. Based on the vector error correcton model, we derve the long-run estmates that are presented n Table 7. Table 7: Varables Egypt Inda Turkey Thaland Coef P > z Coef P > z Coef P > z Coef P > z Log (exchange rate) Log (nterest rate) Log (CPI) Log of foregn nterest rate Log or foregn CPI Dummy crss Log(nterest rate) Dummy crss Log (CPI) Dummy crss Log (foregn nterest rate) Dummy crss Log (foregn CPI) trend constant Consstent wh the theory, domestc nterest rate s negatvely and statstcally sgnfcantly related wh the exchange rate for only Egypt. For Turkey, s sgnfcantly posvely related to the exchange rate. Nevertheless, for remanng two countres, there s no statstcally sgnfcant relatonshp between domestc nterest rate and the exchange rate.

16 Lookng at the nteracton between domestc nterest rate and fnancal crss dummy, we observe that the coeffcent s posve and statstcally sgnfcant for Indan and Thaland. On the other hand, s negatve and statstcally sgnfcant for Turkey, whle for Egypt the estmate s posve but appears statstcally nsgnfcant. It should be noted that n Egypt, the nterest rate mpact on exchange rates becomes nsgnfcant after fnancal crss. In contrast to the case of Egypt, the role of domestc nterest rate has become sgnfcant n the determnaton of the exchange rate after fnancal crss n Inda and Thaland. Surprsngly, for case of Turkey, the mpact of nterest rate on the exchange rate was posve before fnancal crss, whle turns negatve after fnancal crss. The mpact of domestc prces on exchange rate s statstcally nsgnfcant for all countres except Inda. For Inda, s negatve and statstcally sgnfcant at acceptable level of sgnfcance. However, after the fnancal crss, the mpact of domestc prces s sgnfcant for all the four countres. Specfcally, s negatve for Egypt, whereas s posve for remanng three countres. Turnng to the mpact of foregn nterest rate and prce levels, we fnd that the mpact of foregn nterest s statstcally sgnfcant after fnancal crss, whle was statstcally nsgnfcant before fnancal crss for all the four countres. Specally, after fnancal crss, the exchange rate s posvely affected by the foregn nterest rate n the case of Egypt and Thaland. Nonetheless, the exchange rate s negatvely affected by the foregn nterest rate for the remanng two cases. The foregn prce level s negatvely related to exchange rate for Egypt and Inda, whle s posvely related to exchange rate for Turkey and Thaland. However, the relatonshp s statstcally sgnfcant only for the Egypt and Turkey. The estmated coeffcent of the nteractons between foregn prces and fnancal crss dummy s posve and sgnfcant for Egypt, whle s negatve and sgnfcant for remanng three countres. Overall, the results presented n Table 7 suggest that the role of exchange rate determnants has been sgnfcantly changed n terms of both ther sgn (mpact) and statstcal sgnfcance after 2008 fnancal crss. These fndngs are consstent wh the prevous emprcal evdence that ndcate the sgnfcant mpact of fnancal crss on exchange rate determnatons. These results also confrm the dea that the mpact of fnancal crss on exchange rate sgnfcantly dffers across countres wh dfferent economc and socal backgrounds.

17 5. Conclusons Ths study examnes the mpact of 2008 fnancal crss on the exchange rate n PPP-UIP framework for four emergng countres, namely Egypt, Inda, Turkey, and Thaland. The study uses monthly data coverng the perod from The results reveal that the mpact of recent fnancal crss led to change the role of determnes of exchange rates n exchange determnaton. Moreover, we show that the effects of fnancal crss on the exchange rate are dfferent n dfferent emergng economes. The fndngs of the study are of sgnfcant for polcy makers n desgnng effectves polces n order to reduce the effects of fnancal crss on exchange rates. The fndngs are also sgnfcant n decsons for the exchange rate regme; especally n the rsky tme n order to mgate the adverse effects of fnancal crss.

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