Quantitative Exchange Rate Economics in Developing Countries

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1 Quantitative Exchange Rate Economics in Developing Countries

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3 Quantitative Exchange Rate Economics in Developing Countries A New Pragmatic Decision-Making Approach M. Rusydi and Sardar M.N. Islam

4 M. Rusydi and Sardar M.N. Islam 2007 Foreword Stephen Martin 2007 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act First published 2007 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress

5 Contents List of Tables List of Figures List of Abbreviations Foreword Preface, Summary and Acknowledgement ix x xi xiii xv 1 Introduction Introduction The Indonesian exchange rate prior to Issues and debates on the 1997 Indonesian currency crisis Issues post 1997 Indonesian financial crisis Exchange rate determination: a social choice approach Limitations of the existing literature Aims of the research Research contributions The social choice approach: New 3 Welfare Economics Methodologies Data and computer programs Structure of the book 14 2 Exchange Rate Economics: Issues, Regime Choice and Modelling Introduction Part A: Concept and issues in exchange rate economics Exchange rate concept Real exchange rate in macroeconomic adjustment Real exchange rate and trade Capital mobility Export and import factors Exchange rate behavior Shadow exchange rate 22 v

6 vi Contents 2.3 Part B: The choice of an exchange rate regime Issues of the exchange rate regime choice Fixed exchange rate regime Floating exchange rate regime Managed floating regime Mechanism of exchange rate determination Part C: Exchange rate models Monetary model Purchasing power parity (PPP) model Uncovered interest parity model Currency substitution model The choice of a model and a regime Conclusion 33 3 Exchange Rate Economics in Developing Countries: Indonesian Exchange Rate Analysis Introduction Exchange rate crisis in Indonesia Exchange rate behavior in Indonesia Exchange rate policies in Indonesia Monetary policy prior to the 1997 currency crisis Exchange rate competitiveness for the Indonesian economy Indonesian exchange rate issues Conclusion 43 4 Market Models and Applications Introduction Modeling purchasing power parity (PPP) Monetary model of exchange rate determination Econometric methodology Testing the PPP and monetary models Conclusion 61 5 Shadow Price of Exchange Rate Introduction SPER models Shadow price of exchange rate factor The shadow price of exchange rate for Indonesia Data requirements and adjustments Price responsive imports Price responsive exports 70

7 Contents vii Import tariffs Quantitative restrictions on imports Export taxes and subsidies Quantitative restrictions on exports Shadow price of exchange rate estimation Conclusion 73 6 Time Series Analysis and Misalignment Introduction Krugman analysis Estimated parameters and empirical findings Cointegration analysis Exchange rate overshooting Time series analysis for exchange rate determination Stationarity condition testing Univariate time series Exchange rate misalignment (ERM) Empirical results Conclusion 90 7 Policy Regime Choice and Implications Introduction Overview of the exchange rate regime Determinants for the choice of exchange rate regime Alternative choices for exchange rate regime Currency unification Financial dollarization issues Full dollarization De facto dollarization Currency board Currency board for Indonesia Managed floating regime Exchange rate policies in Indonesia Open market operation (OMO) Minimum reserve requirement (MRR) Bank Indonesia as lender of the last resort Exchange rate stability in Indonesia Efficiency in the Indonesian foreign exchange market Exchange rate policy cooperation in Asia Collective exchange rate regime Southeast Asian monetary system (SAMS) Policy implications for Indonesia 110

8 viii Contents 7.10 Policy suggestions The appropriate exchange rate regime for Indonesia Choice of the shadow price of the exchange rate model Supportive measures The choice of a regime and a model: the new approach Conclusion Summary and Conclusion Introduction Exchange rate economics: major findings and implications Exchange rate modeling Exchange rate regime Central bank s role Exchange rate volatility Exchange rate policy implications Significance Limitations Future research Conclusion 123 Appendices 126 References 133 Index 150

9 List of Tables 3.1 Outstanding Loans Indonesian Banking Sector Funds Flow Indonesia Characteristics of Rupiah/USD Market, Deviation from ECM-Derived Rupiah, 1992Q1 1997Q2 (%) Engle-Granger Test Tests for Unit Roots Cointegration, Rupiah and Fundamental Variables ECM for the Relative PPP and Monetary Models Cointegration Test Results, 1990Q1 2000Q Johansen Test for Indonesia Stationarity Economic Price of Rupiah/USD, 1997 (monthly average) Tariffs Equivalent to Quantitative Restrictions, (average) Export Tax Equivalent to Trade Restrictions SPER Factor, Rupiah/USD, 1997 (monthly average) Contemporaneous Relations of Rupiah Estimation of the Cointegrating Relationship Overshooting of Southeast Asian Currencies, 1997 (%) OLS Estimation of Long-Run Equilibrium: January 1992 July Real Exchange Rate Index: OLS Estimation January 1992 July Deviations from the PPP by PPI and CPI-Deflated Real Rates Exchange Rate Misalignments (ERM), January 1992 July Exchange Rate Regimes Trade-Offs in Choosing an Exchange Rate Regime 97 ix

10 List of Figures 3.1 The Indonesian Exchange Rate, Nominal Exchange Rate Money Supply (M2), Indonesia ERM of Rupiah, x

11 List of Abbreviations ADF AIC CBS CIF CPI DF DW ECM ECT EERM EMH EMS ERM FDI FOB FPM GDI GDP GNP IFS IMF ITCC LOP MM MRR MTM OECD OER OLS OMO PPI PPP RID SAMS SBI SCF Augmented Dickey-Fuller Akaike information criteria Currency Board System cost including insurance and freight consumer price index Dickey-Fuller Durbin Watson error correction mechanism error correction term European exchange rate mechanism efficient market hypothesis European monetary system exchange rate misalignment foreign direct investment free on board flexible price monetary gross domestic income gross domestic product gross national product International Financial Statistics International Monetary Fund international tariff and customs code law of one price monetary model minimum reserve requirement monetary transmission mechanism Organization for Economic Co-operation and Development official exchange rate ordinary least squares open market operations producer price index purchasing power parity real interest differential Southeast Asian monetary system Sertifikat Bank Indonesia (Bank Indonesia Certificate) standard conversion factor xi

12 xii List of Abbreviations SIC SER SPER SPFE STCC TCC UIP VAR WPI Schwarz information criteria shadow exchange rate shadow price of exchange rate shadow price of foreign exchange standard trade commodity classification tariff and customs code uncovered interest parity variance wholesale price index

13 Foreword The objectives of this book Quantitative Exchange Rate Economics in Developing Countries: A New Pragmatic Decision Making Approach are to examine the issues in exchange rate economics in developing countries; options for adopting normative and prescriptive models suitable to developing countries, with a case study Indonesia; and to determine the suitable model or modeling approach. To achieve this objective, this book discusses the exchange rate issues in Indonesia; develops and tests market-based, equilibrium and shadow price exchange rate models; and suggests a modeling approach which is based on the consideration of all these three types of models and the appropriate exchange rate regime for Indonesia. Exchange rate determination is a crucial policy problem for any nation and it is considered to be a social choice problem in the economy irrespective of its social and economic organization. This book makes positive advances in the area of international empirical finance as it provides a new and comprehensive analysis of foreign exchange rate and foreign exchange market behavior in developing countries. It also presents an exposition of how modern econometric and other quantitative techniques can be utilized to understand and model exchange rate determination. The global nature of the exchange rate market has made our understanding of the exchange rate determination in a broader context more critical. This is particularly so in developing countries where imperfections in market infrastructure and the lack of integrated policies are major issues. One such developing country is Indonesia. The Indonesian foreign exchange market is of particular interest given the fact that it was the hardest hit by the 1997 Asian currency crisis. An understanding of the Indonesian exchange rate determination through the study of the pre- and post-crisis periods enables us to determine the causes of major currency crises in recent times. This book provides a quantitative analysis of exchange rate determination in Indonesia using some very useful and recent econometric techniques and follows the following structure: Chapter 2 presents a critical literature review of exchange rate economics with a focus on the concepts, issues and methods for the determination of a socially desirable efficient exchange rate. Chapter 3 reviews the issues in exchange xiii

14 xiv Foreword rate economics in developing countries. Chapter 4 overviews market models and their application to the exchange rate determination in Indonesia. Chapter 5 introduces the shadow price exchange rate model and its application in producing the standard conversion rate required to determine the efficient exchange rate for the Indonesian rupiah. Chapter 6 discusses modeling time series analysis and misalignment of the Indonesian rupiah in order to better understand its behavior. Chapter 7 analyzes the policy and regime options available in terms of the implementation of the chosen exchange rate model. Lastly, Chapter 8 summarizes and concludes the research on exchange rate economics with limitations and areas for further research. This book makes a significant contribution to the literature since this type of normative and prescriptive modeling study of the foreign exchange market and behavior for developing countries, has not been undertaken previously. This book will be of special interest to university students, researchers, academics, practitioners and policy makers in the areas of finance, banking, economics and financial planning. I believe that the authors have developed an excellent approach in the determination of exchange rates in developing countries, therefore I strongly recommend reading this book. Melbourne, July 2006 Professor the Honourable Stephen Martin Pro Vice-Chancellor (International), Victoria University, Melbourne, Australia & Former Speaker, Parliament of Australia, Government of Australia

15 Preface, Summary and Acknowledgement The objectives of this book are: (1) to examine the emerging and enduring issues in exchange rate economics such as options of adopting normative and prescriptive quantitative models suitable to exchange rate determination in developed and developing countries; and (2) to develop a new modeling approach for determining the exchange rate, which is suitable especially to developing countries, such as Indonesia, within a framework of welfare economics and normative social choice perspective (Broadway and Bruce, 1984; Arrow et al. 2003). To achieve these objectives, this book: (1) examines the exchange rate issues in a typical developing country Indonesia; (2) develops and tests market-based, equilibrium and shadow price exchange rate models for Indonesia; (3) discusses the issues and mechanism for choosing an exchange rate regime (a social or public choice problem); and (4) suggests an approach for exchange rate determination based on the consideration of all three types of models and the issues in the choice of the appropriate exchange rate regime which is suitable to a developing economy such as Indonesia. Exchange rate determination is a quantitative social choice problem in any economy, irrespective of its social and economic organization. For a typical developing country analysis, the question of what is the best form of exchange rate regime and policy for a country can only be answered by analyzing the underlying socio-economic institutions, conditions and policies of that country. To analyze a typical developing country, this book discusses the exchange rate policies adopted prior to the 1997 Asian currency crises, as well as the current policies post-1997 in Indonesia. The analysis shows that a credible exchange rate regime and policy, which reduces uncertainty in the exchange rate market, may mitigate the flight of domestic currency, and ensure stability and certainty for the economy especially in terms of export competitiveness. Given the historical background of the exchange rate economics in Indonesia, an enduring crucial question that needs to be addressed is how to determine the appropriate exchange rate for Indonesia. To answer this question, market-based purchasing power parity (PPP) xv

16 xvi Preface, Summary and Acknowledgement models and equilibrium models are developed and tested in this book. Since none of these models performs well in econometric tests, an approach is advocated that considers elements of each of these models in determining the exchange rate for developing countries such as Indonesia. This necessitates the development, testing and application of a shadow price model (for these arguments, see Pearce and Nash, 1981; Chao and Yu, 1995), along with certain market-based modeling applications which revise the rate determined by the shadow price model as time progresses. This book argues that the choice of a model also depends on the choice of an appropriate exchange rate regime for a country. The choice of an exchange rate regime is a social choice problem (Arrow et al., 2002) that depends on the underlying socio-economic and institutional conditions, social value judgments and preferences of that country. For Indonesia, the official exchange rate policy of the government is an attempt to make the rupiah more market driven, though previously on many occasions, the central bank, Bank Indonesia, intervened in the foreign exchange market in order to maintain the stability of the currency. This book also reviews the possibility of an alternative currency regime namely a currency board system with a managed floating regime, which remains as a feasible alternative (see Fry, 1995; Stiglitz, 1988 and 1994; Thirlwall, 1989) to the floating exchange rate regime currently adopted by Indonesian government. This exchange rate regime is justified (for these arguments, see Stiglitz, 1988 and 1994; Thirlwall, 1989) by the historical and institutional nature of the Indonesian economy which exhibits market failures, non-existence of some financial markets, underdeveloped financial and regulatory systems and controls. From the findings of this research a new approach to exchange rate determination is proposed. It is argued that for a developing economy like Indonesia, a managed floating regime is appropriate (Stiglitz, 1994). Also shadow price models can be adopted to determine the appropriate exchange rate (Chao and Yu, 1995). These shadow price models should also incorporate underlying market conditions of the national and global economy. The initial exchange rate derived from the shadow price model should be adjusted according to the market, economic and institutional conditions which change over time. In other words, in choosing the appropriate exchange rate, a rate should be chosen which is not overvalued or undervalued it should be the socially desirables efficient (or shadow) rate, which should be adjusted dynamically over time according to the changes in the market, the

17 Preface, Summary and Acknowledgement xvii economy and the society, both national and global. It is obvious that an overvalued currency has several disadvantages such as its adverse impact on export, the balance of payment and economic development. On the other hand, an undervalued (an inappropriately and highly devalued) currency can have a more serious consequences for the economy through inflation, macroeconomic instability, and the ultimate balance of payment problems caused by weaker currency due to its impact on the country s purchasing power and business confidence, etc. An appropriately determined strong currency can overcome these problems of a highly devalued currency. The authors would like to thank Dr. Abdullahi Ahmed, Dr. Ruchi Gupta, Dr. Susan Zeidan, Margarita Kumnick for their relevant comments, extensive editorial and proof reading assistance. The authors appreciate all the research facilities and assistance provided by the Center for Strategic Economic Studies, Victoria University and the School of Accounting, Economics and Finance, Deakin University. Dr. M. Rusydi Lecturer School of Accounting, Economics and Finance, Deakin University Australia Dr. Sardar M. N. Islam Professor, & Director, Decision Sciences and Modelling Program, Victoria University Australia &