Quantitative Exchange Rate Economics in Developing Countries

Quantitative Exchange Rate Economics in Developing Countries

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

M. Rusydi and Sardar M.N. Islam 2007 Foreword Stephen Martin 2007 Softcover reprint of the hardcover 1st edition 2007 978-0-230-00481-8 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 1988. First published 2007 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 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 978-1-349-28151-0 ISBN 978-0-230-59248-3 (ebook) DOI 10.1057/9780230592483 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. 10 9 8 7 6 5 4 3 2 1 16 15 14 13 12 11 10 09 08 07

Contents List of Tables List of Figures List of Abbreviations Foreword Preface, Summary and Acknowledgement ix x xi xiii xv 1 Introduction 1 1.1 Introduction 1 1.2 The Indonesian exchange rate prior to 1997 3 1.3 Issues and debates on the 1997 Indonesian currency crisis 5 1.4 Issues post 1997 Indonesian financial crisis 7 1.5 Exchange rate determination: a social choice approach 9 1.6 Limitations of the existing literature 10 1.7 Aims of the research 10 1.8 Research contributions 11 1.9 The social choice approach: New 3 Welfare Economics 12 1.10 Methodologies 13 1.11 Data and computer programs 14 1.12 Structure of the book 14 2 Exchange Rate Economics: Issues, Regime Choice and Modelling 16 2.1 Introduction 16 2.2 Part A: Concept and issues in exchange rate economics 17 2.2.1 Exchange rate concept 17 2.2.2 Real exchange rate in macroeconomic adjustment 18 2.2.3 Real exchange rate and trade 19 2.2.4 Capital mobility 20 2.2.5 Export and import factors 20 2.2.6 Exchange rate behavior 21 2.2.7 Shadow exchange rate 22 v

vi Contents 2.3 Part B: The choice of an exchange rate regime 24 2.3.1 Issues of the exchange rate regime choice 24 2.3.2 Fixed exchange rate regime 25 2.3.3 Floating exchange rate regime 25 2.3.4 Managed floating regime 26 2.3.5 Mechanism of exchange rate determination 27 2.4 Part C: Exchange rate models 28 2.4.1 Monetary model 28 2.4.2 Purchasing power parity (PPP) model 29 2.4.3 Uncovered interest parity model 30 2.4.4 Currency substitution model 31 2.4.5 The choice of a model and a regime 32 2.5 Conclusion 33 3 Exchange Rate Economics in Developing Countries: Indonesian Exchange Rate Analysis 34 3.1 Introduction 34 3.2 Exchange rate crisis in Indonesia 35 3.3 Exchange rate behavior in Indonesia 37 3.4 Exchange rate policies in Indonesia 38 3.5 Monetary policy prior to the 1997 currency crisis 39 3.6 Exchange rate competitiveness for the Indonesian economy 40 3.7 Indonesian exchange rate issues 41 3.8 Conclusion 43 4 Market Models and Applications 45 4.1 Introduction 45 4.2 Modeling purchasing power parity (PPP) 46 4.3 Monetary model of exchange rate determination 49 4.4 Econometric methodology 52 4.5 Testing the PPP and monetary models 54 4.6 Conclusion 61 5 Shadow Price of Exchange Rate 63 5.1 Introduction 63 5.2 SPER models 64 5.3 Shadow price of exchange rate factor 68 5.4 The shadow price of exchange rate for Indonesia 70 5.5 Data requirements and adjustments 70 5.5.1 Price responsive imports 70 5.5.2 Price responsive exports 70

Contents vii 5.5.3 Import tariffs 70 5.5.4 Quantitative restrictions on imports 71 5.5.5 Export taxes and subsidies 71 5.5.6 Quantitative restrictions on exports 71 5.5.7 Shadow price of exchange rate estimation 71 5.6 Conclusion 73 6 Time Series Analysis and Misalignment 75 6.1 Introduction 75 6.2 Krugman analysis 76 6.3 Estimated parameters and empirical findings 77 6.4 Cointegration analysis 78 6.5 Exchange rate overshooting 80 6.6 Time series analysis for exchange rate determination 81 6.7 Stationarity condition testing 83 6.8 Univariate time series 84 6.9 Exchange rate misalignment (ERM) 84 6.10 Empirical results 86 6.11 Conclusion 90 7 Policy Regime Choice and Implications 91 7.1 Introduction 91 7.2 Overview of the exchange rate regime 92 7.3 Determinants for the choice of exchange rate regime 93 7.4 Alternative choices for exchange rate regime 97 7.4.1 Currency unification 97 7.4.2 Financial dollarization issues 98 7.4.3 Full dollarization 99 7.4.4 De facto dollarization 100 7.4.5 Currency board 100 7.4.6 Currency board for Indonesia 101 7.4.7 Managed floating regime 102 7.5 Exchange rate policies in Indonesia 103 7.5.1 Open market operation (OMO) 103 7.5.2 Minimum reserve requirement (MRR) 104 7.5.3 Bank Indonesia as lender of the last resort 104 7.6 Exchange rate stability in Indonesia 104 7.7 Efficiency in the Indonesian foreign exchange market 105 7.8 Exchange rate policy cooperation in Asia 106 7.8.1 Collective exchange rate regime 106 7.8.2 Southeast Asian monetary system (SAMS) 109 7.9 Policy implications for Indonesia 110

viii Contents 7.10 Policy suggestions 111 7.10.1 The appropriate exchange rate regime for Indonesia 112 7.10.2 Choice of the shadow price of the exchange rate model 113 7.10.3 Supportive measures 114 7.11 The choice of a regime and a model: the new approach 116 7.12 Conclusion 116 8 Summary and Conclusion 119 8.1 Introduction 119 8.2 Exchange rate economics: major findings and implications 120 8.2.1 Exchange rate modeling 120 8.2.2 Exchange rate regime 120 8.2.3 Central bank s role 121 8.2.4 Exchange rate volatility 121 8.3 Exchange rate policy implications 121 8.4 Significance 122 8.5 Limitations 123 8.6 Future research 123 8.7 Conclusion 123 Appendices 126 References 133 Index 150

List of Tables 3.1 Outstanding Loans Indonesian Banking Sector 37 3.2 Funds Flow Indonesia 40 3.3 Characteristics of Rupiah/USD Market, 1992 1997 42 4.1 Deviation from ECM-Derived Rupiah, 1992Q1 1997Q2 (%) 48 4.2 Engle-Granger Test 58 4.3 Tests for Unit Roots 59 4.4 Cointegration, Rupiah and Fundamental Variables 59 4.5 ECM for the Relative PPP and Monetary Models 60 4.6 Cointegration Test Results, 1990Q1 2000Q4 60 4.7 Johansen Test for Indonesia 60 4.8 Stationarity 61 5.1 Economic Price of Rupiah/USD, 1997 (monthly average) 69 5.2 Tariffs Equivalent to Quantitative Restrictions, 1990 1997 (average) 72 5.3 Export Tax Equivalent to Trade Restrictions 73 5.4 SPER Factor, Rupiah/USD, 1997 (monthly average) 73 6.1 Contemporaneous Relations of Rupiah 77 6.2 Estimation of the Cointegrating Relationship 79 6.3 Overshooting of Southeast Asian Currencies, 1997 (%) 80 6.4 OLS Estimation of Long-Run Equilibrium: January 1992 July 1997 86 6.5 Real Exchange Rate Index: 1992 1997 87 6.6 OLS Estimation January 1992 July 1997 87 6.7 Deviations from the PPP by PPI and CPI-Deflated Real Rates 88 6.8 Exchange Rate Misalignments (ERM), January 1992 July 1997 89 7.1 Exchange Rate Regimes 94 7.2 Trade-Offs in Choosing an Exchange Rate Regime 97 ix

List of Figures 3.1 The Indonesian Exchange Rate, 1997 36 4.1 Nominal Exchange Rate 52 4.2 Money Supply (M2), Indonesia 55 6.1 ERM of Rupiah, 1992 1997 88 x

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

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

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

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

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

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

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 &