Macroeconomic fundamentals and exchange rates in South Asian economies. Evidence from pooled and panel estimations

Publication Date03 Jun 2019
AuthorMuhammad Umar Draz,Fayyaz Ahmad,Bhumika Gupta,Waqas Amin
SubjectEconomics,International economics
Macroeconomic fundamentals
and exchange rates in
South Asian economies
Evidence from pooled and panel estimations
Muhammad Umar Draz
Department of Management and Humanities,
Universiti Teknologi PETRONAS, Seri Iskandar, Perak, Malaysia
Fayyaz Ahmad
School of Economics, Lanzhou University, Lanzhou, China
Bhumika Gupta
Institut Mines Telecom, Telecom Ecole de Management,
Evry, Île-de-France, France, and
Waqas Amin
Department ofManagement Sciences, University of Okara, Okara, Punjab, Pakistan
Purpose This study aims to examine the impact of macroeconomic fundamentalson exchange rates of
selectedSouth Asian economies during 1981-2013.
Design/methodology/approach The authors have usedtwo econometric approaches to the data. For
the pooled sample, estimated generalized least square (EGLS) and the two-stage least square method are
applied. For the panel data, the authors have used the panel generalizedmethod of moments and ordinary
least squares(OLS) methods.
Findings The results suggest that macroeconomic factors have a signicant impact on exchangerates.
The robust ndingshighlight that improvements in domestic economicand political systems are crucial fora
successfulexchange rate policy.
Originality/value The existing literature on exchange rate fundamentals have either focused on
exchange ratesand international trade or investigated the relationshipfor the developed economies. Covering
a period of more than three decades, and using both pooled and panel estimations, our study is unique in
terms of its focuson the South Asian economies.
Keywords Exchange rates, Macroeconomic fundamentals, South Asian economies
Paper type Research paper
1. Introduction
Over the past few decades, the global economic system has gradually transformed from an
abridged nancial design to a compound entangled set of nancial structures. The
international marketsenvironment has experienced considerable variations in the form of
extreme unpredictability in exchange rates, better capital movement and a sequence of
worldwide nancial crises during the past couple of decades. Although the majority
of modern empirical models have neglectedthe possible presence of a long-term association
between exchange rates and nancial fundamentals, both theoretically and empirically
Journalof Chinese Economic and
ForeignTrade Studies
Vol.12 No. 2, 2019
pp. 104-119
© Emerald Publishing Limited
DOI 10.1108/JCEFTS-01-2019-0007
The current issue and full text archive of this journal is available on Emerald Insight at:
exchange rates are still the subject of many controversies in the eld of economics and
international nance(Beckmann et al., 2011). Surprisingly, the connection betweenexchange
rates and macroeconomic variables still remains an imperative problem due to the little
attention paid to investigatingthis aspect, especially in developingeconomies. Over the past
few decades, the Asian economies have transformed enormously and the eruption of the
Asian nancial crisis has stimulated different implementations of exchange rate
arrangements becausedeveloping economies are more exposed to turmoil.
Exchange rate uctuations are signicantly inuential on the various aspects of the
economy and also on the concerned parties. The role of exchange rates is extremely
signicant in the internationalmarket and the variability of exchange rates, both in the case
of appreciation and depreciation, is directly connected with the economic performance of a
country. Exchange rate movements have become excessive subsequent to the
implementation of exible exchange rate regimes and the volatility of developing
economiescurrencies depends on the pegging system and the implied burden of the
currency that a particularnation pegs (Chong and Tan, 2007).
However, currency crises are more frequent in developing markets because the nominal
currencies of these economies might not create xed and anticipated exchange rates and
their equality level might diverge, a agging way for currency speculation passages. Even
though the Asian economies usually favor a managed oating exchange rate scheme, the
exchange rate instability of every currency varies even in the existence of a pegging
arrangement (Warner and Kreinin, 1983;Alba and Papell, 1998). Moreover, exchange rate
constancy, capital mobility with independent policies cannot be accomplished concurrently
and technically there has always been a tradeoff among these three macroeconomic
fundamentals. Therefore, it is worthwhile to investigate the importance of exchange rate
determination factorsfor the sustainable performance of a country.
As a result of neighboring countriesreforms during the previous decade, several South
Asian economies stayed on both internal and external transformations to incorporate with the
international economy during the mid-90s. This, in turn, increased the vulnerability of nancial
turmoil because nancially more integrated and open economies are highly vulnerable to both
external and internal blows. Therefore, an amountofexchangerateelasticity and associated
monetary policy sovereignty turned out to be critical for macroeconomic management. Cavoli
and Rajan (2013) have explained that under the International Monetary Fund (IMF) behavioral
classications of the leading South Asian currency systems, India is characterized as a
managed oater, roughly regular with its ofcial declarations, while Bangladesh and Sri
Lanka are categorized as soft-peg countries. On the other hand, a key component of an exports-
based strategy is balanced exchange rates. In fact, it is sometimes argued that developing
economies can encourage exports by means of an undervalued currency and China is, indeed,
following the same policy stance. Furthermore, stable exchange rates reect lower risks,
which, in turn, lead to the lower cost of capital. However, one size does not t all and different
policies may be required to suit different nations (Edwards, 2011).
Figure 1 shows the instability of exchange rates from 1990 to 2013 for the ve South
Asian economies includedin the sample[1]. The volatilityrates are computed taking the rst
year as a base. Percentage changes from the base year indicate the annual movement of
currencies compared with the US dollar. Over the past decade, a majority of Asian
economies has shifted to the managed oating exchangerate and all Asian economies have
attached substantialsignicance to exchange rate constancy in their policystructure.
The exchange rates of Bhutan and India are the most volatile. Bangladesh preserved a
substantially low exchange rate risk and its exchange rate instability was normally lesser
than Sri Lanka and Nepal after introducing the managed oating classication. Since
rates in
South Asian

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