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HUBUNGAN ANTARA KESEIMBANGAN PERDAGANGAN DENGAN
KADAR PERTUKARAN ANTARA MALAYSIA DENGAN RAKAN-RAKAN
PERDAGANGAN UTAMA
YEE CHIN FEE
Projek ini merupakan salah satu keperluan untuk
Ijazah Sarjana Muda Ekonomi dengan Kepujian
(Ekonomi Antarabangsa)
Fakulti Ekonomi dan Perniagaan
UNIVERSITI MALAYSIA SARAWAK
2010
THE RELATIONSHIP BETWEEN TRADE BALANCE AND EXCHANGE
RATE IN MALAYSIA AND HER TRADING PARTNERS
YEE CHIN FEE
This project is submitted as a partial fulfillment of
the requirements for the degree of Bachelor of Economics with Honours
(International Economics)
Faculty of Economics and Business
UNI`'ERSITI MALAYSIA SARA WAN
2010
ABSTRAK
HUBUNGAN ANTARA KESEIMBANGAN PERDAGANGAN DENGAN KADAR PERTUKARAN ANTARA MALAYSIA DENGAN RAKAN-RAKAN
PERDAGANGAN UTAMA
OLEH
YEE CHIN FEE
Kajian ini menguji peranan kadar pertukaran dalam menentukan perdagangan keseimbangan dua hala. Negara- negara sampel yang termasuk dalam kajian adalah rakan-rakan perdagangan utama Malaysia iaitu Amerika Syarikat, Jepun, Singapura, China dan Thailand. Ujian kepegunan, ujian kopengamiran di bawah model "Autoregressive Distributed Lag" (ARDL) dan "Impulse Respond Function" telah dimanfaatkan dalam kajian ini. Bagi jangka masa suku pertama tahun 1991 hingga suku ke-empat tahun 2008, keputusan empirik menunjukkan bahawa "Marshall-Lerner Condition" wujud bagi kes Amerika Syarikat dan China manakala keluk-J hipothesis
wujud bagi kes Amerika Syarikat dan Jepun.
ABSTRACT
THE RELATIONSHIP BETWEEN TRADE BALANCE AND EXCHANGE RATE IN MALAYSIA AND HER TRADING PARTNERS
BY
YEE CHIN FEE
This study examines the role of exchange rate in determine Malaysia's bilateral trade balance. The sample countries had been included are the Malaysia major trading partners, namely United States, Japan, Singapore, China and Thailand. The unit root tests,
cointegration test under the Autoregressive Distributed Lag Model and Impulse Respond Function had been utilized in this study. For the sample period of 1991 quarter I until 2008 quarter 4, empirical results indicated that the Marshall-Lerner Condition hold in the
case United States and China while the J-curve hypothesis existed in the case of United
States and Japan.
ACKNOWLEDGEMENT
I would like to take the opportunity to thank the organizations and the people that
assisted and guided me in completing this paper.
First of all, I would like to thank my university, Universiti Malaysia Sarawak (UNIMAS)
for every support and effort in making sure that all the students will be able to take their
final year project, as it is one of the prerequisites for graduation. I am also thankful to
my faculty, Faculty of Economics and Business (FEB) for their supports and resources
provided to assist me in completing my final year project.
Secondly, I am also grateful to my supervisor, Associate Professor Venus Liew Khim
Sen for his precious time and efforts invested in supervising me to complete this paper.
This paper would not have been completed in time if is not for his advices, guidance and
supervisions.
Not to forget, I am very appreciative to the lecturers of Faculty of Economics and
Business (FEB) for providing me with the fundamental economics knowledge and
concepts needed to complete this final year project.
Lastly, I thank all my friends, course mates and family who have been always on my
side to encourage me whenever I am facing difficulties in completing this paper.
Without their support and encouragement, I would not have completed this paper.
TABLE OF CONTENTS
List of Tables
List of Figures
CHAPTER I
1.1 Introduction
1.2 Concept of Study
1.2.1 Marshall-Lerner Condition
1.2.2 J-Curve Phenomenon
1.3 Overview of Malaysia Trade Balance
1.3.1 Bilateral Trade with United States
1.3.2 Bilateral Trade with Japan
1.3.3 Bilateral Trade with China
1.3.4 Bilateral Trade with Singapore
1.3.5 Bilateral Trade with Thailand
1.4 Exchange Rate
Xlll
xiv
i
4
4
6
II
ii
12
12
13
15
ix
1.5 Motivation of Study
1.6 Problem Statement
1.7 General Objective
1.7.1 Specific Objectives
1.8 Significance of Study
1.9 Organization of Study
CHAPTER 2
2.1 Introduction
2.2 Review of Theoretical Framework
2.3 Review of Model and Methodology
2.3.1 Unit Root Tests
2.3.1.1 Augmented Dickey-Fuller (ADF) test
2.3.1.2 Philip-Perron test
2.3.2 CointegrationTest
18
19
21
21
22
23
24
25
30
31
32
2.3.2.1 Johansen and Juselius Cointegration Test 32
2.3.2.2 Autoregressive Distributed Lag Model 33
2.3.3 Vector Error Correction Model (VECM) 36
X
2.3.7 Impulse Response Function
2.4 Empirical Results
38
38
2.5 Concluding Remark 40
CHAPTER 3
3.1 Theoretical Framework 45
3.2 Data Description 46
3.3 Methodology
3.3.1 Unit Root Test 47
3.3.1.1 Augmented Dickey-Fuller (ADF) 48
3.3.1.2 Kwiatkowski-Phillips-Schmidt-Shin (KPSS) 49
3.3.2 Cointegration Test 50
3.3.2.1 Autoregressive Distributed Lag Model 51
3.3.3 Impulse Response Function 54
CHAPTER 4
4.1 Introduction 56
XI
4.2 Unit Root Test Results
4.3 Autoregressive Distributed Lag (ARDL) Results
4.4 Impulse Respond Function Results
CHAPTER 5
5.1 Introduction
5.2 Findings
5.3 Policy Recommendation
5.4 Direction for Future Studies
5.5 Limitation of Study
5.6 Concluding Remark
REFERENCES
58
61
69
73
73
74
75
76
77
78
xii
List of Tables
Table 2.1: Review of Literatures
Table 4.1(a) ADF unit root test, stationary in level
Table 4.1(b) ADF unit root test, stationary in first different
Table 4.2(a) KPSS unit root test, stationary in level
Table 4.2(b) KPSS unit root test, stationary in first different
Table 4.3 Cointegration Test in ARDL model
Table 4.4 Diagnostic Tests
41
58
58
59
59
61
65
xiii
List of Figures
Figure 1.1: Malaysia's Trade Balance from 1980 to 2007 7
Figure 1.2: Total Share of United States, Japan and Singapore in Total Exports 8
Figure 1.3: The Share of Major Trading Partners in Total Exports from 1980 to 2007 9
Figure 1.4: The Share of Major Trading Partners in Total Imports from 1980 to 2007 10
Figure 1.5: The Exports share to Malaysia's major trading partners from 1980 to 2007 14
Figure 1.6: The Imports share to Malaysia's major trading partners from 1980 to 2007 14
Figure 1.7: Exchange rate in Malaysia in term of I US dollar 15
Figure 1.8: The Exchange rate in Malaysia from 1980 to 2007 17
XIV
List of Figures
Figure 4.1: CUSUM Stability Test for United States 66
Figure 4.2: CUSUM Stability Test for China 66
Figure 4.3: CUSUM Stability Test for Japan 67
Figure 4.4: CUSUM Stability Test for Singapore 67
Figure 4.5: CUSUM Stability Test for Thailand 68
Figure 4.6: Response of Trade Balance to Generalized One S. D. Real Exchange Rate Innovation (Malaysia toward USA) 69
Figure 4.7: Response of Trade Balance to Generalized One S. D. Real Exchange Rate Innovation (Malaysia toward China) 69
Figure 4.8: Response of Trade Balance to Generalized One S. D. Real Exchange Rate Innovation (Malaysia toward Japan) 70
Figure 4.9: Response of Trade Balance to Generalized One S. D. Real Exchange Rate Innovation (Malaysia toward Singapore) 70
Figure 4.10: Response of Trade Balance to Generalized One S. D. Real Exchange Rate Innovation (Malaysia toward Thailand) 71
Chapter 1 Introduction
1.1 Introduction
The impact of real depreciation on the trade balance either in the short run or long
run is important for developing countries in order to pursuing the liberalization of trade
and exchange rate (Hsing, 2009). Therefore, if the real depreciation worsens the trade
balance in short run or long run, monetary and fiscal policy should focus on stabilize
currency value. Besides that, Marshall-Lerner condition, which represents that real
depreciation, leads to increases the trade balance in the long run if sum up value of
import and export demand elasticity exceed one. Real depreciation improves the trade
balance through two different channels. Firstly, increase quantity of export.
Depreciation of the currency reveals the domestic goods cheaper as compared to imports
goods, thus making export more competitive. Secondly, quantity of imports decreases,
as import is relatively more expensive. Alternatively, amount of export and import may
not responsive at initial period of depreciation. Thus, trade balance may be worsening
first due to decrease in value of export and increase in value of import but improves
after some time. This make scenario knows as J-curve.
Hsing (2008) studied the 7 selected Latin American countries fur the existing of
the J-curve by using the impulse response function. Furthermore, he revealed that the J-
curve does exist in Chile, Ecuador and Uruguay. Moreover, he stated that the trade
balance data will be more useful if employ the bilateral data within trading partners
1
rather than using aggregate data. According to the Wilson and Kua (2001), the rationale
behind J-curve is rooted in the elasticities approach to balance of payment adjustment,
or which focuses on the magnitude of the supply and demand price elasticities of
exports and imports. However, Hsing (2005) explained that the J-curve is the trade
volume effect lagged price effect so that import value increase over export value in the
short run in domestic currency. Furthermore, Lai and Lowinger (2002) concluded that
the exchange rate had two type basic effects on trade balance which are price effect and
volume effect. Depreciation in domestic currency increases the cost of imports in
domestic currency units while the exports become less expensive in foreign currency.
Consequently, the price effects on depreciation of domestic currency will increases the
volume of exports rather than volume of imports. He further confirmed that the price
effects are faster than the volume effects when an exchange rate devaluation. Therefore,
the time adjustment of the trade balance following currency depreciation is reminiscent
of the letter "J" and this short run situation is the "J-curve" effect.
The sample countries to be examine is Malaysia and her top five major trading
partners, namely, United States, Singapore. Japan, China and Thailand. These live
countries contributed more than 60 percent of Malaysia's total trade balance. Hence, the
trade balance between Malaysia and these five countries has greater impact to total trade
account and even to the current account. Besides that, these live countries bilateral trade
data with Malaysia are available for the econometrics tests.
2
Afterward, the bilateral trade balance data has been employed in this study while
the other data are Gross Domestic Production domestic (proxy as domestic production
or domestic income), foreign Gross Domestic Production (proxy as foreign production
or foreign income) and real bilateral exchange rate (nominal exchange rate multiply
with foreign price level after that divide by domestic price level). From the studied of
Bahmani-Oskooee and Brooks (1999). a country's trade balance could be improving
with one trading partner and at the same time failing with another. Hence, the aggregate
data on each of these variables could suppress the actual movement taking place at the
bilateral levels. The exchange rate variable is using the real bilateral exchange rate due
to the real bilateral trade balance data been employed in this study. Bahmani-Oskooee
and Ratha (2004) suggested that if the trade balance model is a bilateral model, the
correct exchange rate to be used should be the real bilateral exchange rate.
The Autoregressive Distributed Lagged (ARDL) bound testing model will he
applies in this study to reexamine the relationship between trade balance and exchange
rate in the long run, while the impulse response function employs to find out the
evidence of the existing of the J-curve. Although the ARDL model suggested that all the
variables are either stationary in level or first difference or mixture, the unit root test still
needed. This is because the ARDL model will he crash if the variables are in the order
of second difference.
3
1.2 Concept of Study
1.2.1 Marshall-Lerner Condition
According to Tang and Wong (2007), Marshall-Lerner condition approach argues
that the necessary and sufficient conditions for a country to devaluate its currency to
improve its trade balance. For example, the sum of the elasticity of import demand and
the elasticity of export supply of the country must exceed unity. From the studies of Lai
and Lowinger (2002), the Marshall-Lerner condition required that if the sum of the price
elasticity of exports and imports are more than 1, currency devaluation will improve the
trade balance in the long run.
1.2.2 J-curve phenomenon
J-curve phenomenon is a trend whereby a country's trade balance following
devaluation in home currency. Depreciation in home currency make the import become
more expensive whiles the export sale less in foreign currency. Due to this situation,
trade balance will deficit because the sale in export are less than import. Indeed, the
depreciation will cause the price of imports to rise and therefore total spending on
imports will subsequently increase and worse the trade balance and current account.
However, after a while, the volume of export will start to rises as the lower competitive
price to foreign buyers, simultaneous domestic consumers will buy less from costly
import goods.
4
The J-curve mostly arises due to the high import expenditure. It results in the
increasing in the home currency price where the volume is unchanged owing to
commitment. As time passes, the quantity adjustment effect becomes relevant where the
import volume decrease and the export increase (Carbaugh, 2008). Brooks & Fausten
(1998) had briefly explained trade balance worsen in short run occur by assume the
prices are fixed in suppliers' currencies, and quantity do not respond quickly to price
changes. That are export, import, import price in term of foreign price, and export price
in term of domestic prices are fixed. When export and export price in term of domestic
prices are fixed (i. e. exchange rate is RM4: S2 to RM4: $1), mean the export prices
cheaper than before with the same quantity to export. Meanwhile, import and import
price in term of foreign price are fixed (i. e. exchange rate is $1: RM2 to $1 : RM4),
mean the import prices more expensive than before with the same quantity to import.
Therefore, trade balances worsen.
Another explanation for the J-curve phenomenon is through the price elasticity.
The price elasticity is inelastic in the short run but elastic in the long run. When
currencies depreciate in home country, price for export will he less expensive than
before while price for import will be more expensive than before. For example, the
exchange rate is $l: RM3, after currencies depreciate, it becomes $I: RM4. Therefore,
foreign countries buy our goods by price RM4 (less expensive than before) during we
export while we import by RM4 (more expensive than before). However, since there are
inelastic in the short run, the percentages of quantity changes not much compare to price
5
changes. So, quantity of exports wills increases but the increases are less, import will
decrease but the decreases are less. The quantity of export just increases a bit when we
sold in RM4, but we still import a lot in that time. Therefore, the overall for the trade
balance for export is decrease and import is increase and our country's trades balances
are worsen in the short run. In the long run, price is elastic and the quantity changes are
much more than price changes. The quantity of export will increase much and import
will decrease much. So, the trade balance will improve in the long run.
Magee (1973) who argued theoretically that even thought devaluation improves
the trade balance in the long-run, the short-run trade balance response could he different.
In fact, trade balance will deteriorates first and improving after passage of sometime in
the short run.
1.3 Overview of Malaysia Trade Balance
Malaysia as a traditional export-led country is heavy depends on the exportation
performance to sustain economic growth. Malaysia experiences in transform its
economy from import-substitution industrialisation in 1960s to export-oriented
industrialisation in the 1980s and 1990s. The abundant of' natural resources such as
rubber, tin and other commodity made Malaysia was the major exporters in the world in
1970s and 1980s. Following the commodity crisis, Malaysia government had
transformed the economy structure toward manufactured goods which these goods also
6
became the dominant in the total exportation. Between 1978 and 1988, Malaysia's
exports increased by about 224 percent (about 23 percent average annual increase)
(Buang, 1990) (refer Figure 1.1). Afterward, the exportation was on a stable growing
trend in 1990s. The trade balance was on the downward trend after 1998 and this trend
is continues until 2002 and after that Malaysia trade balance again had a experience of
the upward trend.
Figure 1.1 Malaysia's Trade Balance from 1980 to 2007
Trade Balance of Malaysia from 1980 to 2007
.. ýO ý
ý_
ý
ý
40000-
30000-
20000-
10000-
0
80 82 84'8'6'8'8 90 92 94 96 98 00 02 04 06 Year -1 nnnn
TB
Source: International Finance Statistic. International Monetary Fund. Various Issues
7
Figure 1.2: Total Share of United States, Japan and Singapore in Total Export
Ratio of exports to US, Japan and Singapore in Total Exports from 1980 to 2007 60 .
56
52
ý 48
44
40
361, --ýrr, rr r' ý 80 82 84 86 88 90 92 94 96 98 00 02 04 06
Year
- Share of Export
Source: International Finance Statistic, International Monetary Fund, Various Issues
Besides that, Malaysia's share of world exports has increased from 0.5 percent in
1973 to 0.7 percent in 1987. Those remarkable growth was recorded both in
manufacturing and agricultural exports. During 1988, Malaysia major exportation
markets are from European Community, Japan, United States, Hong Kong, Taiwan, and
Korea which had contributed almost 85 percent of total export share.
From 1990 until 1999, the ratio of exports to GDP was 91.24 percent and it keeps
increasing until 2000s. The exports are important to Malaysia's economy thus it
provided a large number of job opportunities and domestic market is small which unable
to stimulate high economy growth. After the financial crisis, exportation had a high
growth which led to the positive trade balance. At the same time, the total exports to
8
United States, Japan and Singapore are registered more than 40 percent per annual in the
total exports (refer Figure 1.2).
Figure 1.3: The Share of Major Trading Partners in Total Exports fron 1980 to 2007
ý ýO ý_
b ý
2000007
160000
120000
80000
40000
o-
The Share of Major Trading Partners in Total Exports
80 82 84 86 88 90 92 94 96 98 00 02 04 06 year
T Z--I
Total Exports Share of major trading partners
Source: International Finance Statistic. International Monetary Fund. Various Issues
9
Figure 1.4: The Share of Major Trading Partners in Total Imports from 19811 to 2007
ý ý
_ý ý
160000-
140000-
120000-
100000-
80000-
60000-
40000-
20000-
0
The share of Major Trading Partners in Total Imports
80 82 84 86 88 90 92 94 96 98 00 02'64'd6' Year
I Total Imports -- Share of Imports]
Source: International Finance Statistic. International Monetary Fund, Various Issues.
Since 1970s, Malaysia always has a positive trade balance which means that the
exports volumes are always greater than imports volumes. Malaysia' major import
markets are dominant by the few countries since 1990 which are Japan, United States
and Singapore.
In this study, United States, Japan, China, Singapore, Thailand, Philippines and
Indonesia will take as the empirical study countries. The bilateral trade of those
countries had contributed almost 60 percent of the total value of exports since I980s
(refer Figure 1.3). Besides that, those countries also the major imports markets fir
Malaysia which contributed more than 60 percent per annual in the share of total
imports (refer Figure 1.4).
10
1.3.1 Bilateral Trade with United States
The trade flows between Malaysia and United States are closely which the United
States demands for Malaysia exports goods are higher. Moreover, the shares of exports
to United States in total exports in Malaysia are more than 15 percent per annual since
1980. In another word, United States had dominated Malaysia exports market.
Especially among the period in 1990s, exports to United States reached almost 20
percent from total exports. According to figure 6, United States also the largest importer
country for Malaysia. Thus, the trade flows between United States and Malaysia are
highly integrated and as a result, recently the global recession due to the subprime
mortgage crisis is deteriorated Malaysia's bilateral export between United States and it
led to reduce in total exports and Malaysia's economy also been dragged into recession.
However, the demands from United States are remain strong and the negotiation of
Malaysia-United States free trade agreement is still on process. Thus, the trade flows
between Malaysia and United States will increase in the future.
1.3.2 Bilateral Trade with Japan
Japan is the third large exports market for Malaysia's exports and importer
country (refer figure 5 and 6). However, the demand From Japan is reduce gradually per
annual (refer figure5). This showed that Malaysia exports are started diversify her
exports market which compare at 1980s only depend on United States and Japan. In
order to improve the trade relationship with Japan, The Japan-Malaysia free trade
agreement (FTA) was signed in 2005 and implemented from 2006 with the expectation
11
that it would further enhance the trade and investment relationship between the two
countries.
1.3.3 Bilateral Trade with China
China as an emerging economies, the growth of exports from Malaysia are
increase all over the time especially after 2000s, or more correct is after become a
member of World Trade Organization which led to reduce some trade barrier gradually.
According to the figure 5, the export's share to China is on a upward trend which
showed that China is become another important market for Malaysia exports. This large
population country has a very attractive demand for Malaysia exports which can
improve the trade balance. While the existed of ASEAN-China free trade agreement
may be adequate in maintaining the Current economic engagement, the bilateral trade
parts could further stronger this strategic link.
1.3.4 Bilateral Trade with Singapore
Singapore is Malaysia's neighbouring country which the trade relationship is
tightly and closely. Singapore is the second largest exports market for Malaysia's
exports and also the second largest importer country fir Malaysia (refer 5 and 6).
Moreover, due to the strategic geography location, the trade flow among Singapore and
Malaysia are remaining higher since 1980s. However, the export to Singapore was
showed a downward since the Asian financial crisis. The ASEAN free trade agreement
(AFTA) will promote highly integral trade and investment flow among the member
12