The determinants of ASEAN-5 real effective exchange rate vis-á-vis the UK pound
| Pages | 98-118 |
| DOI | https://doi.org/10.1108/WJEMSD-07-2013-0038 |
| Date | 14 April 2014 |
| Published date | 14 April 2014 |
| Author | Abdalrahman AbuDalu,Elsadig Musa Ahmed |
| Subject Matter | Strategy,Business ethics,Sustainability |
The determinants of ASEAN-5
real effective exchange rate
vis-a
´-vis the UK pound
Abdalrahman AbuDalu
College of Business, Universiti Utara Malaysia, Kedah, Malaysia, and
Elsadig Musa Ahmed
Faculty of Business and Law, Multimedia University, Melaka, Malaysia
Abstract
Purpose – The purpose of this paper is to present an empirical analysis of long-run and short-run
forcing variables of purchasing power parity (PPP) for ASEAN-5 currencies vis-a
`-visthe UK p ound, i.e.
their real effective exchange rate (REER).
Design/methodology/approach – This study uses a recently developed autoregressive distributed
lag (ARDL) approach to co-integration (Pesaran et al., 2001) over the period 1991:Q1-2006:Q2.
Our empirical results suggest that the foreign interest rate (R*) and domestic money supply (M1) are
the significant long-run forcing variables of PPP for ASEAN-5 REERs for the three periods.
Findings – In the short-run, the variables have different impacts during the sub-periods and full
period for ASEAN-5 countries. The results suggest that the domestic money supply (M1) for Malaysia,
domestic interest rate and foreign interest rate (R*) for Indonesia, domestic money supply (M1) and
term of trades (TOT) for Philippines, foreign interest rate (R*) for Thailand, and foreign interest rate
(R*) and net foreign assets (NFA) for Singapore, respectively, have the highest significant short-run
forcing variable of PPP for countries REERs.
Originality/value – In this respect, the outcomes can derive policy implication for the monetary
authorities in these ASEAN-5 countries.
Keywords Economics, Globalization, Finance, ASEAN-5, Purchasing power parity (PPP),
Real effective exchange rate
Paper type Research paper
Introduction
The financial market situation of Southeast Asian Nations (Malaysia, Indonesia,
Philippines, Thailand and Singapore, hereafter ASEAN-5, the initial members of the
economic group when it was first established in 1967) countries is generally thin and
reasonably shallow. This has caused the purchasing power parity (PPP) in each of
these countries to become misaligned among them. For instance, if a country chooses
a floating exchange rate, it is possible that its exchange rate can be excessively volatile
due to speculation. The volatility of exchange rates generates uncertainties that can
affect domestic and foreign investor’s investment decisions. This dilemma continues
to undermine the ASEAN-5 economic growth prospects. In contrast, if a country
chooses a fixed exchange rate, it provides little space for its poli cymakers to
manoeuvre and to realign its exchange rate with ASEAN-5 cur rencies.
The 1997 Asian Financial Crisis (AFC) plunged some of the most successful
economies in the world, particularly ASEAN-5 countries, into financial chaos. This
crisis caused collapse in these economies, i.e. the impact of the financial crisis was very
severe not only on the financial sectors but also on the real sectors in these countries.
Thus, the 1997 financial crisis was a critical point in Asian economic histo ry. It was
empirically and theoretically argued that the AFC caused the ASEAN-5 economies to
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/2042-5961.htm
Received 30 July 2013
Revised 30 July 2013
Accepted 31 July 2013
World Journal of Entrepreneurship,
Management and Sustainable
Development
Vol. 10 No. 2, 2014
pp. 98-118
rEmeraldGroup Publishing Limited
2042-5961
DOI 10.1108/W JEMSD-07-2013-003 8
98
WJEMSD
10,2
become more sensitive to changes and fluctuations in the world economy, particularly
the economy of the UK. Therefore, the issue of the degree of sensitivity of ASEAN-5
to the UK economy will be measured in this study.
The objective of this study is: to determine the long-run and short-r un forcing
variables of PPP on ASEAN-5 real effective exchange rate (REER) over the study
period and sub-periods. The autoregressive distributed lag (ARDL) approach is
employed here because it has several advantages, such as: avoiding the classification
of variable into I(0) or I(1), it is free from problems of endogeneity and yields consistent
estimates of the long-run coefficients. In this study, the emphasis will also be on the
behaviour of the REER. (The term REER is defined as the real price in the domestic
currency of one real unit of another (foreign) currency. Hence, the nominal exchange
rate is part of the REER.) The REER indicates how the weighted average purchasing
power of a currency has changed relative to some arbitrarily selected base period.
The findings of this study should be useful for the ASEAN-5 policy makers. In the
light of the serious implication of the changes and fluctuations of exchange rate s in
ASEAN-5 economies, it is critically important to conduct a study on the PPP of REER
determinants that have important impacts upon the economi c growth of ASEAN-5.
Overview of PPP
The PPP theory was originally developed by Cassel (1919/1923), a Swedish economist,
who stated that the exchange rate of currencies between two countries would move
proportionally to the ratio of the price level in the currencies concerned. There are an array
of approaches and related methodological frameworks available in the PPP literature:
MacDonald and Ricci (2001), Sarno and Taylor (2002), Cheung et al. (2004) and Che and
Mansur (2006). However, there are at least four major competing PPP models that demand
special attention (Cheung et al., 2004). These are: absolute PPP and relative PPP,monetary
model of PPP, portfolio balance of PPP and uncovered interest parity (UIP) of PPP.
Absolute PPP and relative PPP
In the literature, there are two versions of PPP theory, namely, absolute PPP and
relative PPP. While absolute PPP refers to the equity of price levels across countries,
relative PPP refers to the equity of the rates of change in these price levels. The Law of
Comparative Advantage (LCA) theorem of equilibrium exchange rate or the Law of
One Price (LOP) of the capitalist system suggests that the same basket of goods and
services must sell at the same price in different capitalist countries (Cassel, 1919/1923;
Sarno and Taylor, 2002). This measure of the price of the basket of goods and services
is essentially known as absolute PPP and has been repeatedly expressed in the
literature (Sarno and Taylor, 2002; Che and Mansur, 2006) as:
St¼PtP
tð1Þ
where, s
t
is the spot REER expressed as the domestic price of the foreign currency; p
t
is the domestic price level, while p
tis foreign price level and tdenotes the time period.
MacDonald and Ricci (2001) and Sarno and Taylor (2002) asserted that Equation (1),
which represented the absolute PPP theoretical framework, should be specified as a
testable regression equation, expressed as:
st¼b0þbtðptp
tÞþeð2Þ
where bis constant variable and eis a noise error term.
99
Determinants
of ASEAN-5
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