ELSEVIER Japan and the World Economy 9 (1997) 109-114

~ R a n d the LD

ECONOMY

The cointegration of Asian currencies revisited a *

Y.K. Tse ' , L.K. N g b

a Department of Economics and Statistics, National University of Singapore, Kent Ridge, Singapore 119260, Singapore

Monetary Authority of Singapore, Singapore 079117, Singapore

Received October 1995; accepted May 1996

Abstract

This paper examines the cointegration of the currencies of the following seven Asian countries: Japan, Malaysia, Philippines, Singapore, Thailand, South Korea and Taiwan. We find that if the Korean won and the new Taiwan dollar are excluded from the system, the remaining currencies are not cointegrated. Otherwise, there is cointegration among the currencies. Thus, there is evidence in support of the formation of a yen-dominated Asian exchange rate system, or the 'yen bloc.'

Keywords: Cointegration; Exchange rate; Managed float; Market efficiency; Yen bloc

JEL classification: C22; G13

I. Introduction

Recent papers on the cointegration of nominal exchange rates generally support the proposition that foreign exchange markets are efficient, and exchange rates are not cointegrated. In a study on a system of nine currencies, MacDonald and Taylor (1989) concluded that there is no strong evidence of cointegration among the exchange rates. While Baillie and Bollerslev (1989) argued that exchange rates are cointegrated, their results have been refuted by Diebold et al. (1994). In a rejoinder, Baillie and Bollerslev (1994) concurred that exchange rates show little evidence of cointegration. Nonetheless, they contended that exchange rate processes have a long memory and may be fractionally cointegrated.

* Corresponding author. Tel: 7723954; fax: 7752646; e-mail: ecstseyk@nus.sg. IOther studies on exchange-rate eointegration include Hakkio and Rush (1989) and Sephton and Larsen

(1991). These authors did not find cointegration among the currencies they examined. It is noted that MacDonald and Taylor (1989) and Hakkio and Rush (1989) used the Engle and Granger (1987) methodology, while other works cited used the more powerful Johansen (1988) methodology.

0922-1425/97/$17.00 © 1997 Elsevier Science B.V. All rights reserved. PII S0922- 1 4 2 5 ( 9 6 ) 0 0 2 3 9 - 3

110 YK. Tse, L.K. Ng/Japan and the World Economy 9 (1997) 109-114

The papers mentioned above are studies on the currencies of developed economies, for which the exchange rates are free to move with minimal government intervention. In a study of the currencies of five Asian economies, Aggarwal and Mougoue (1993) concluded that there is cointegration among the currencies. 2 Their finding is said to provide supporting evidence for the formation of a yen-dominated Asian exchange rate system, known as the 'yen bloc.' The notion of a yen bloc has been suggested by Frankel (1992). He found evidence of an increased role of the yen in the financial markets of the Asia-Pacific region. As argued by Melvin and Peiers (1993), the role of the yen as a regional reserve currency depends on two factors, namely, a transactions motive as determined by trade and capital flows and a portfolio motive based on risk and return considerations. However, the analysis by Melvin and Peiers from a transactions demand perspective using the stochastic dominance approach shows that a yen bloc cannot be supported. The evidence indicates that the yen is not a dominant reserve currency. In addition, the Japanese government does not seem to have actively pursued a yen bloc for the Asia-Pacific region. Also, research by Fukuda (1996) shows that the invoice ratios of the yen have been low and would remain low in the near future. In view of these findings, there seems to be a need to re-examine the evidence in support of a yen bloc provided by tests for currency cointegration. 3

There are some characteristics of the Asian economies which may explain the existence of cointegration not found in the major currencies. First, except for Japan, the exchange regimes of most industrializing and developing Asian economies are characterized as a managed float. The central banks of these economies frequently intervene in the foreign exchange market in order to direct the exchange rates in line with the governments' policies to promote export competitiveness and/or control imported inflation. Second, there is growing evidence that intra-Asian trade and investment are gaining importance. Tradi- tionally, Japan has been the main source of direct investments in the Asian region. Toward the second half of the 1980s, however, the newly industrialized Asian economies became major investors in Southeast Asia, resulting in Asia being the source of about 60 percent of direct investments in the Southeast Asian countries. This development underpins the possibility of a cointegrated system of Asian currencies.

Although Aggarwal and Mougoue (1993) argued that Asian currencies are cointegrated, their results are weakened by some shortcomings. First, the Hong Kong dollar, which was pegged to the U.S. dollar for most of the period under their study, was included in the system. 4 Thus, a cointegrating vector can be obtained by assigning a value of 1 to the Hong Kong dollar exchange rate and 0 to the exchange rates of other currencies. The fact that Aggarwal and Mougoue found only one cointegrating vector further weakens the case for a

2The five economies included in the Aggarwal-Mougoue study are: Japan, Hong Kong, Malaysia, Singapore and Philippines.

3Apart from the economic significance of the yen bloc some interest has been focused on the political implications of the establishment of a yen bloc. For example, Kim (1992) argued that the yen bloc, if it exists, would not be conducive to world peace and prosperity. In this paper, we shall not be concerned with the desirability of the yen bloc from the political point of view.

4The Hong Kong dollar has been pegged to the U.S. dollar since October 1983 (Freris (1991)), while the Aggarwal-Mougoue data set covers the period 27 September 1982-22 December 1989.

YK. Tse, LK. Ng/Japan and the Worm Economy 9 (1997) 109-114 111

cointegrated system. 5 Second, some economies with close trading relationships with Japan, notably South Korea and Taiwan, have been left out of their study. It is noted that South Korea and Taiwan obtain about one third of their imports from Japan. In comparison, Malaysia, Singapore and Philippines obtain about 20 percent of their imports from Japan. Thus, certain regularities may be missing for a system of Asian currencies which excludes South Korea and Taiwan.

In this paper we re-examine the cointegration of the Asian currencies. The following seven currencies are considered: the Japanese yen (JY), the Malaysian ringgit (MR), the Philippines peso (PP), the Singapore dollar (SD), the Thailand baht (TB), the South Korean won (KW) and the new Taiwan dollar (NT). 6 Our data set consists of the nominal exchange rates covering the period from 27 September 1982 to 30 June 1994 (2893 daily observa- tions). 7 We consider the subperiod, 27 September 1982-22 December 1989 (1770 daily observations), which coincides with the sample period of Aggarwal and Mougoue. This subperiod is designated as Period I, while the full sample period is called Period II. In Section 2 we report the results of our analysis.

2. Results

We first proceed with testing whether the exchange rate data contain unit roots. Denoting the exchange rate as rt, we run the following regression for each of the seven currencies:

Alnr t = 3o + 31t + 321nrt-1, (1)

where Alnrt = l n r t - lnrt-l . The well-known Dickey-Ful le r (DF) test for the null hypothesis that A In rt is nonstationary is based on the t-ratio of the estimate of/32. In the case that the residuals of the above regression are serially correlated, the right hand side of Eq. (1) may be supplemented by ~ = 1 0 l i Alnrt_i for sufficiently high value o f k so that the residual autocorrelation is removed. The resulting t-ratio of the estimate of/32 in this augmented regression is called the augmented Dickey-Ful le r (ADF) statistic. To test for the existence of two unit roots, we rerun Eq. (1) with ,42 In rt as the dependent variable, and In rt-1 replaced by Alnrt_1. The results of the DF/ADF tests are reported in Table 1. 8 It

can be seen that the logarithmic nominal exchange rates of each of the seven Asian

5Aggarwal and Mougoue used the Johansen (1988) methodology and did not report the estimates of the cointegrating vector.

6Kim (1992) suggested five scenarios for the future of the Asia-Pacific region. The yen-bloc scenario includes Japan, South Korea, the ASEAN countries, Australia and New Zealand. In this paper we only consider four ASEAN countries. The other two ASEAN countries not included in this study are Brunei and Indonesia. Brunei, however, has a currency interchangeability agreement with Singapore. We have also excluded Australia and New Zealand for the purpose of narrowing the focus to Asia. Unlike the currencies considered in this paper (with the exception of the yen), the Australian and New Zealand currencies are under free-float systems. Furthermore, the developing economies in this study (with the exception of Philippines) have enjoyed high growth during the period of this study, with phenomenal expansions in trade and capital flows.

7The nominal exchange rates are quoted against the U.S. dollar. The data were collected from various issues of the Asian Wall Street Journal. It should be noted that exchange rate data based on the effective rates of exchange or the SDRs could also be used. The nominal exchange rate, however, has the advantage that the data are easily obtainable and the results can be compared against other studies in the literature.

8The critical value of the DF/ADF statistic is calculated from Table 1 provided by MacKinnon (1991).

112 Y.K. Tse, L.K. Ng/Japan and the World Economy 9 (1997) 109--114

Table 1 DF/ADF tests for unit roots

Currency Number of unit roots Period I Period II

t k t k

Japan (JY) 1 -0.7483 0 - 1.6268 0 2 -22.4508 2 -54.1759 0

Malaysia (MR) 1 -2.6575 0 - 1.7098 1 2 -41.0631 0 -50.8660 0

Philippines (PP) 1 -2.0891 0 -2.9228 1 2 -44.4584 0 -56.2707 0

Singapore (SD) 1 - 1.5068 0 - 1.8153 4 2 -31.4419 1 -26.2238 3

Thailand (TB) 1 - 1.6112 3 -2.2281 2 2 -28.2444 2 -44.7742 1

Korea (KW) 1 - 1.2528 0 -0.8487 0 2 -43.5127 0 - 54.6499 0

Taiwan (NT) 1 -2.1241 2 0.2789 5 2 -34.7512 1 -28.0989 4

Note: t is the DF/ADF t-statistic for the null hypotheses of one unit root (i.e. A In rt is stationary) or two unit roots (i.e. A 2 In r t is stationary), k is the number of lags of the dependent variable in the DF (k = 0) or ADF (k > 0) regression. The critical value of t at 5 percent level is -3.41.

currencies contain one unit root. This finding is in line with the findings for other major currencies.

Next we adopt the Johansen (1988) procedure to examine the cointegration of the currency system. 9 The Johansen procedure expresses the data as a finite-order p-dimen- sional vector autoregressive (VAR) process, where p is the number of variables in the system. The existence of cointegration imposes certain restrictions on the parameters of the VAR process. Johansen suggested two test procedures for the restrictions using the maximum likelihood approach. First, the trace statistic was suggested to test the null hypothesis that the rank of the impact matrix (i.e. the number of cointegrating vectors in the system) r is less than or equal to ro, where r0 < p, versus the alternative that the impact matrix is of full rank. Second, the A-max statistic was suggested to test the null hypothesis that there are ro cointegrating vectors versus the alternative of r0 + 1 cointegrating vectors. We calculated both statistics for systems of various combinations of the seven Asian currencies. The results are summarized in Table 2. l°

We first consider the following system of currencies: JY, MR, PP and SD (System A). This system is the Aggarwal-Mougoue set minus the Hong Kong dollar. We observe that there is no evidence of cointegration in the system in both Periods I and II. This conclusion remains unchanged with the addition of TB (System B). Thus, JY together with four of the

9johansen's procedure is based on the likelihood ratio statistic. It provides a statistically efficient test for the presence of cointegration. Unlike the Engle--Granger (1987) two-step procedure, it does not suffer from the ambiguity arising from the normalization of the cointegration vector and the dependence on the nuisance parameters. See Cuthbertson et al. (1992) for a detailed discussion of the advantages of the Johansen procedure.

1°The critical values of the trace and A-max statistics can be found in Osterwald-Lenum (1990).

Y.K. Tse, L.K. Ng/Japan and the World Economy 9 (1997) 109-114

Table 2

Cointegration tests for sys tems of Asian currencies

113

System of currencies Sample period Trace statistic A-max statistic

Ho: r = 0 H o : r < 1 H o : r = 0 H o : r = 1

A: 1--4 I 37.07 20.06 17.02 9.88

II 38.64 19.18 19.46 15.03

1 3 : I - 5 I 58.35 38.22 20.13 17.38

II 67.41 40.79 26.62 20.43

C: 1 -6 1 156.07 * 66.28 89.79 * 21.35

1I 134.00 * 86.54 * 47 .46 * 31,68

D: 1-5, 7 I 91.12 55.66 35.46 19,67

II 110.57 * 70.29 * 40.29 * 27.29

E: 1-7 I 198.46 * 88.61 109.85 * 34.57

II 182.01 * 106.82 * 75 .20 * 40.41 *

F: 1, 6, 7 I 107.42 * 11.65 95.77 * 9.25

II 54.70 * 12.37 42.33 10.04

Note: The currency codes are: 1 -- JY, 2 = MR, 3 = PP, 4 = SD, 5 = TB, 6 = K W and 7 = NT. r is the dimension of the space o f the impac t matrix, that is, the number o f cointegrating vectors in the system. The trace

statistic tests for 140: r _< r0 agains t H~: r = p , where p is the number o f currencies in the system and r0 < p. A-

max tests for Ho: r = r 0 agains t Hi: r = r0 + 1.

* Signif icance at 5 percent level.

ASEAN currencies forms a system that is not cointegrated. With this base system we introduce KW and NT separately. The results are remarkably changed. For the base system plus KW (System C), there is evidence of one cointegrating vector in Period I and two cointegrating vectors in Period II.Xt In the case of the base system plus NT (System D), there is evidence of two cointegrating vectors in Period II but no cointegration in Period I.~2 When all seven currencies are included (System E), the evidence for two cointegrating vectors in Period II becomes even stronger. Both the trace statistic and the A-max statistic are significant. As for Period I the conclusion that there is only one cointegrating vector remains unchanged.

To highlight the relationships among the Japanese yen, the South Korean won and the new Taiwan dollar, we consider a system of these three currencies only (System F). The results show that there is only one cointegrating vector in this system for both Periods I and II.la Thus, although the Japan-ASEAN bloc of currencies is not cointegrated, the inclusion of the ASEAN currencies in the bloc of Northeast Asian currencies provides a richer pattern of cointegration.

1All sys tems in Table 2 have been tested for at most two cointegrating vectors (trace test) and for exactly two cointegrating vectors (A-max test). The results o f these tests, not reported here, are insignif icant at 5 percent

level. ~2Note that the existence of two cointegrating vectors in Systems C and D for Period II is supported by the

t race test but not the A-max test. ~3We did not pursue fur ther investigation o f sys tems of two currencies. For reasons explained in Alexander

and Johnson (1992), a bivariate exchange rate sys tem is not expected to be cointegrated.

114 Y.K. Tse, L.K. Ng/Japan and the World Economy 9 (1997) 109-114

3. Conclusion

We have examined the cointegration of the exchange rates of seven Asian currencies. Although Hong Kong plays a major role in international trade, it is not included in our study as its currency has been pegged to the U.S. dollar. We found that if the South Korean won and the new Taiwan dollar are excluded from the system, the remaining currencies are not cointegrated. Otherwise, there is cointegration among the currencies. While we found only one cointegrating vector for the system in the 1980s, there is evidence in support of two cointegrating vectors for the full sample that extends to 1994. This finding may indicate the deepening interdependence of the economies in the Asian region.

References

Aggarwal, R. and M. Mougoue, 1993, Cointegration among Southeast Asian and Japanese currencies, Economics Letters 41 161-166.

Alexander, C.O. and A. Johnson, 1992, Are foreign exchange markets really efficient?, Economics Letters 40 449-453.

Baillie, R.T. and T. Bollerslev, 1989, Common stochastic trends in a system of exchange rates, Journal of Finance 44 167-181.

Baillie, R.T. and T. Bollerslev, 1994, Cointegration, fractional cointegration, and exchange rate dynamics, Journal of Finance 49 737-745.

Cuthbertson, K., S.G. Hall and M.P. Taylor, 1992, Applied Econometric Techniques (Philip Allan, Hertfordshire).

Diebold, EX., J. Gardeazabal and K. Yilmaz, 1994, On cointegration and exchange rate dynamics, Journal of Finance 49 727-735.

Engle, R.F. and C.W.J. Granger, 1987, Cointegration and error correction: Representation, estimation and testing, Econometrica 55 251-276.

Frankel, J.A., 1992, Is Japan creating a yen bloc in East Asia and the Pacific?, National Bureau of Economic Research Working Paper 4050.

Freris, A.E, 1991, The Financial Markets of Hong Kong (Routledge, London). Fukuda, S., 1996, The structural determinants of invoice currencies in Japan: The case of foreign trade with East

Asian countries, in: T. Ito and A.O. Krueger, eds., Financial Deregulation and Integration in East Asia (University of Chicago Press, Chicago) pp. 147-163.

Hakkio, C.S. and M. Rush, 1989, Market efficiency and cointegration: An application to the sterling and deutschemark exchange markets, Journal of International Money and Finance 8 75-88.

Johansen, S., 1988, Statistical analysis of cointegration vectors, Journal of Economic Dynamics and Control 12 231-254.

Kim, D.C., 1992, Open regionalism in the Pacific: A world of trading blocs?, American Economic Review 82(2) 79-83.

MacDonald, R. and M.P. Taylor, 1989, Foreign exchange market efficiency and cointegration, Economics Letters 29 63--68.

MacKinnon, J.G., 1991, Critical values for cointegration tests, in: R.F. Engle and C.W.J. Granger, eds., Long Run Economic Relationships: Readings in Cointegration (Oxford University Press, Oxford) pp.267-276.

Melvin, M. and B. Peiers, 1993, On the possibility of a yen currency bloc for Pacific-basin countries: A stochastic dominance approach, Pacific-Basin Finance Journal 1 309-333.

Osterwald-Lenum, M., 1990, A note with quantiles of the asymptotic distribution of the maximum likelihood cointegration rank test statistics, Oxford Bulletin of Economics and Statistics 54 461-472.

Sephton, P.S. and H.K. Larsen, 1991, Tests of exchange market efficiency: Fragile evidence from cointegration tests, Journal of International Money and Finance 10 561-570.