EXCHANGE RATE STABILITY AND IMPORT PENETRATION: THE CASE OF MALAYSIA AND

SINGAPORE

Tyson Teo Chih Soon

RG 3851 T314 Corporate Master in 2013 Business Administration

2013

Pusat Khidmat Maklumat Akadcmik Ul'.1VERSm MALAYSIA SARAWAK

EXCHANGE RATE STABILITY AND IMPORT PENETRATION: THE CASE OF MALAYSIA AND SINGAPORE

P.KHICMAT MAKL.UMAT AKACEMIK

11111 1lIllli'iiilll II II III 1000246851

TYSON TEO CHIH SOON

This project is submitted in partial fulfillment of the requirements for the degree of Corporate Master in Business Administration

Faculty of Economics and Business UNIVERSITI MALAYSIA SARAWAK

2013

STATEMENT OF ORIGINALITY

The work described in this Corporate Business Project, entitled "Exchange Rate Stability and Import Penetration: The Case of Malaysia

and Singapore" is to the best of the author's knowledge that of the author except

where due reference is made.

(Date Submitted) Tyson Teo Chih Soon 10031694

ABSTRACT

EXCHANGE RATE STABILITY AND IMPORT PENETRATION: THE

CASE OF MALAYSIA AND SINGAPORE

By

Tyson Teo Chih Soon

Q n this research, the relationship of nominal exchange rate stability and import

penetration between Malaysia (developing economy) and Singapore (developed

economy) are being examined. The time series data employed in this research consist

of annual data ranging from year 1980 to 2010. The methodology applied in this

research comprises of Augmented Dickey Fuller (ADF) unit root test, Johansen and

Juselius cointegration test as well as Granger causality test based on Vector Error

Correction Model (VECMY In the cases for both countries under review, the

Co integration test shows that there is an existence of long run equilibrium linkage

between both variables employed. Also, in short run, the Granger causality test

shows a positive bi-directional relationship from the independent variable (nominal

exchange rate stability) to dependent variable (import penetration ratio). Though the

relationship of both variables is similar between both countries, the degree of its

relationship varies.

ABSTRAK

KESTABILAN KADAR PERTUKARAN ASING DAN PENEMBUSAN

IMPORT: PENYELIDIKAN TERHADAP MALAYSIA DAN SINGAPORE

Oleh

Tyson Teo Chih Soon

Dalam kajian ini, hubungan antara kestabilan kadar pertukaran asing nominal dan

kadar penembusan import antara Malaysia (ekonomi sedang membangun) dan

Singapore (ekonomi maju) telah diambil kira. Kajian ini merangkumi tempoh masa

tahunan bermula dari tahun 1980 sehingga 2010. Kaedah-kaedah yang telah

diaplikasikan dalam kaj ian ini terdiri daripada 'Augmented Dickey Fuller (ADF) unit

root test', ujian pengamiran 'Johansen and Juselius' dan juga ujian penyebab

(Granger causality) berdasarkan ujian 'Vector Error Correction Model' (VECM).

Dalam keputusan ujian ke atas data kedua-dua negara yang dikaji, ujian pengamiran

menunjukkan terdapat hubungan keseimbangan dalam jangka panjang antara

pembolehubah-pembofehubah yang diaplikasikan. Juga, dalam jangka pendek, ujian

penyebab 'Granger causality' menunjukkan terdapat hubungan positif satu hala dari

pembolehubah tidak bersandar (kestabilan kadar pertukaran asing nominal) kepada

pembolehubah bersandar (kadar penembusan import). Sehubungan itu, keputusan

ujian yang dijalankan menunjukkan hubungan positif dari pembolehubah tidak

bersandar terhadap pembolehubah bersandar dalam jangka pendek. Walaupun

hubungan antara kedua-dua pembolehubah yang diaplikasikan an tara kedua-dua

negara adalah samar, akan tetapi, tahap kesannya adalah berlainan. \

ACKNOWLEDGEMENT

It would not have been possible for me to complete this study without the

helps from the faculty, family members and friends. Therefore, I would like to

express my gratitude to these individuals for their encouragement, guidance and

support.

I am indebted to my Supervisor, Dr. Evan Lau. He has made available his

support in a number of ways to further enrich my academic life. In reviewing my

study, he is indeed fair reviewer. Along with painstaking comments, he did not

hesitate to give compliments in some parts of my work. What has encouraged me the

most is that he always demonstrates his faith in my ability to complete my work.

Last but not least, thanks to all my seniors and my friends who had directly or

indirectly given their hands in completing my final year project, especially for Thien

Fung Thai and Tan Chiang Ching. Moreover, I would like to express my sincere

"thank you" to my family members. This study could not be successful completed

without your mental and physical support.

Thank you so much to you all! Simply saying "thank you" would never be

sufficient to actually express my heartfelt thankfulness.

- - - - - ~--- --------­pusat Khidmat Maklumat Akadtmik UNlVERSm MALAYSIA SARAWAK

T ABLE OF CONTENTS

LIST OF TABLES

PAGE

x

LIST OF FIGURES x

CHAPTER ONE: INTRODUCTION

1.1 Introduction ..................... ..... ................ .. .. .. .... ............ .. .......................... .

1.2 Concept of Study. . . . . . . . . . . . . . . . . . . . ... .............. .......... ........ .. .......... ........... 3

1.3 Malaysia's Nominal Exchange Rate Stability (MNERS)...... .................. 4

1.4 Malaysia Import Penetration Ration (MIPR)...................... .... ................. 6

1.5 Singapore's Nominal Exchange Rate Stability (SNERS) .... ............. 7

1.6 Singapore Import Penetration Ratio (SIPR) .. ............................... 9

1.7 Problem Statement............. .. .................. ... . .. ..... .. ... .... ........ 10

1.8 Objectives of the Study............ .... ....... .... ........... ...... .. ................. .... ........ 12

1.8.1 General Objective ......... .... ........................... ...... ... .......... ...... ......... 12

1.8.2 Specific Objectives........ .. ....... .... ..................... .. ............................. 12

1.9 Significance of the Study............................................... .. ....................... 13

1.10 Structure of Study . . .................. ....... .. .... ................................................. 14

vii

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction... ..................... .............. .............................. ............ ............. 15

2.1 Reviews on Previous Study...................................................................... 15

CHAPTER THREE: METHODOLOGY

3.1 Introduction ............................................................................................. 26

3.2 Concept ofYariables ............................................................................... 26

3.2.1 Exchange Rate Stability (ERS) ...................................................... 26

3.2.2 Import Penetration Ratio (lPR) ...................................................... 27

3.3 Data Description................................................................ 28

3.4 Augmented Dickey-Fuller (ADF) Test ................................................... 28

3.5 Johansen and Juselius Cointegration Test........ .................................... 30

3.6 Granger Causality Test........ ................................................................. 31

CHAPTER FOUR: EMPIRICAL RESULTS AND DISCUSSIONS

4.1 .Introduction ....... ....................... ................................... ............. ............... 34

CHAPTER FIVE: CONCLUSION AND RECOMMENDATIONS

5.1 Introduction .................................................................................... :........ 38

viii

5.2 Summary of Findings ............ .... ........ ....... ............. .......... .. ....... ..... ......... .. 39

5.3 Policy Implications ...... .... .................. ....... .................... .. ..... .. ................. 41

5.3 Limitation of Study .......................................................... ....................... 42

REFERENCES 43

ix

LIST OF TABLES

PAGE

Table 2.1: Review of Literatures .......... ....... ...................... .. .......... .. ............ ...... . 22

Table 4.1 (a): Augmented Dickey-Fuller (ADF) Unit Root Test Results

Table 4.1 (b): Augmented Dickey-Fuller (ADF) Unit Root Test Results

(Malaysia) ............................. .. ...... .... ... ................. .. ........ ............... 35

(Singapore) ............ ...... .............. ............... ... ........... ....... ................ 35

Table 4.2(a): Cointegration Test and Hypothesis Testing (Malaysia) ................ 36

Table 4.2(b): Cointegration Test and Hypothesis Testing (Singapore) .............. 36

Table 4.3(a): Granger causality Test in VECM Results (Malaysia) ................... 37

Table 4.3(b): Granger causality Test in VECM Results (Singapore) ................. 37

LIST OF FIGURES

PAGE

Figure 1.1: Malaysia's Nominal Exchange Rate Stability from 1980 to 2010 ................. .. ........................ .... .............. .... ........... ....................... 4

Figure 1.2: Malaysia's Import Penetration Ration from 1980 to 2010 ....... ................... ... ........ ............ ..... ............................................. 6

Figure 1.3: Singapore's Nominal Exchange Rate Stability from 1980 to 2010 ........................................................................... 7

, Figure 1.4: Singapore Import Penetration Ratio from 1980 to 2010 .................. 9

x

CHAPTER 1

INTRODUCTION

1.1 Introduction

The study of stability within exchange rate has spawned various economics

concern and views pertaining inflationary level, investment fields, asset management,

political concerns and many more. In terms of sensitivity, the stability within the

value of any currency posses' directs impact on the currency exchange rate. This is

because exchange rates express the value of one country's currency in relation to the

value of another country's currency (Carbaugh, 2008). Hence, stability of the

currency value is of paramount in macro-policy or more specifically, the monetary

conduct of an economy.

The exchange rate stabilization policy plays an important part in not only the

economy's monetary performance, but also various considerations within an

economy. These considerations might range from investment strategies to domestic

demand patterns and so on. The relationship between exchange rate and international

trade has been reviewed on numerous writings before. However, the measurement of

the stability in exchange rate has 'been done on different gauging bases. Few

examples can be seen by literature provided by Aizenman et al. (2009) and Calvo

and Reinhart (2002).1

1 Aizenman el al.(2009) compares the currency's exchange value monthly standard deviation against a base country in his model whilst Calvo and Reinhart (2002) took into account of the percentage changes in foreign reserves and the absolute changes in nominal interest rates. ­

The exchange rate for emerging or developing countries is vulnerable to

external factors for most of the time. For example, the Asian financial crisis has

cause the Ringgit to lose its value at a devastating rate. The reason behind this event

was due to the sudden and enormous capital flight where foreign investors lost

confidence towards Malaysia financial market. Also, the trade sector was not in

favourable situation jUdging from both importation and exportation side of the

industry due to the competitiveness issue. As uncertainty and volatility in currency

exchange reduces the prospect of long run trade agreement, trade activity was being

done mostly by spot-on price and it impairs very much on purchasing power

capability by the locals.

On the other hand, as trade issues have long being associated with the

volatility of exchange rate. Moreover, much of the empirical research has placed

emphasis on usual variables such as trade balance (import and export). In deviation

from most conventional research, this research emphasises on the relationship of

exchange rate stability and import penetration ratio. Such researches are being

performed on numerous occasions, however, their empirical evidence from were far

from collectively unanimous. For example, Trefler (1993) suggest that the effect of

import penetration ratio were not significant, whereas, Finger and Harrison (1994)

and Lee and Swagel (1996) claimed that protectism on local industries from foreign

competition were particularly higher on countries with a higher degree of import

penetration ratio. In addition, Goldberg and Maggi (1996) proposed that the effect

from this ratio on trade protection policy for the political clustered sectors

(government-linked sectors) is negative, but not statistically significant (Maggi and

Andres, 1998).

2

1.2 Concept of Study

Trade is one of the main propellants for a country's economic growth and

eventually its development status. However, only the import component will be taken

into consideration within this study. The direction of the fluctuation for the exchange

rate variable will also have to be taken into consideration in detennining the

relationship between the stability of the exchange rate and import penetration as well.

As fluctuation within the exchange rate variable will theoretically encourage or

discourage domestic demand on foreign goods and services, the direction of the

exchange fluctuation needs to be monitored as well. Given a scenario, a favorable

exchange fluctuation on the home country (i .e., relatively stronger home currency)

increases the purchasing power parity of home country and thus, enabling higher

degree of import penetration on domestic market and vice versa.

An example of such scenario would be the case of China's economy in the

manipulation of its exchange rate by artificially keeping its value low relatively with

its trading partners. This is being done to gain upper hands in view of their

international trade, as being mentioned on previous paragraph. Furthermore, the

Japanese and Brazillian monetary authority has also taken similar measures to

support their trading industries (Sanger and Wines, 20 I 0).

All in, the activity mentioned above engages very much on exchange rates

variable and its stability will impact upon purchasing decision of domestic market for

goods and services from abroad. Hence, this research examines the relationship

between exchange rate stability and import penetration ratio of the economy under

review. In other words, the research takes into consideration the sensitivity of

exchange rate variable and total import values which satisfy domestic demands.

3

1.3 Malaysia's Nominal Exchange Rate Stability (MNERS)

Figure 1.1 Malaysia's Nominal Exchange Rate Stability from 1980 to 2010

3

2

1

~ ~

0

0 -1 :;::; ro a:: -2

-3

-4

-5 1980 1985 1990 1995 2000 2005 2010

Year

1- MNERS 1

Source: InternationaJ Finance Statistics, International Monetary Fund, Various Issues

Figure 1.1 shows the trend of the stability within MNERS from year 1980 to

2010. The stability in the nominal exchange rate is fairly volatile throughout 1980 to

2010. However, such volatility was heightened in the event world economic crisis for

example during the early 1980 and mid 1990.

In the early of 1980, the trend experienced significant instability due to the

effect of global oil shock (see Hamilton, 2011). On the other hand, the period of mid

90s, specifically during the 1997 Asian Financial Crisis highlights a direr drop of

NEER and hence, reflecting higher instability in the trend. However, it starts to peak

up due to the stabilization policy implemented by the Central Bank to counter off

financial speculation activities or commonly being referred to as "currency attack",

4

Pusat Khidmat Maklumat Akademik UNIVERSm MALAYSIA SARAWAK

which was the major cause of the crisis at that time2 • From that point onwards, the

trend of the stability in NEER are relatively more stable than it was before except

during early 2010 where the economy felt a brush of the dot-com bubbles3 (which

caused minor volatility ofNEER) which originated from the western economies.

1 Refer to International Monetary Fund (1997a) 3 Refer to Goh and Lim (2010)

5

1.4 Malaysia Import Penetration Ratio (MIPR)

Figure 1.2 Malaysia's Import Penetration Ratio from 1980 to 2010

4.8 ·

4.4

~ ~ 0

~ a::

4.0

3.6

3 .2

2.8 1980 1985 1990 1995 2000

Year

I-MIPRI

2005 2010

Source: International Finance Statistics, International Monetary Fund, Various Issues

Figure 1.2 shows the trend of the MIPR from year 1980 to 2010. The trends

are quite stable with respect to some minor instability throughout the period.

Nevertheless, the volatility was clearly highlighted during the second quarter of 1980.

This trend might well be the result of economic structural reforms from a heavy

agrarian-based economy to manufacturing economy (see Tang and Haji Alias, 2000).

Furthermore, the Malaysia's economy is moving from a more agrarians based

economy to manufacturing based economy with export orientation (Tang and Wong,

2007). In a more recent scenario, the economic structure has been transformed into a

more service based economy (knowledge, tourism and servicing) 4 and this shows a

differentiated reliance (significantly lower ratio) on importing needs from the period

of 1990 onwards.

~ Refer to Mahadevan (2007) on the transition of Malaysia economic structure and also on Economic Transformation Programme.

6

1.5 Singapore's Nominal Exchange Rate Stability (SNERS)

Figure 1.3 Singapore's Nominal Exchange Rate Stability from 1980 to 2010

2.0

1.5

1.0 ~

:oR ~ 0.50

15 Q::

0.0

-0.5

-1.0 1980 1985 1990 1995 2000 2005 2010

Year

1- SNERS III

Source: International Finance Statistics, International Monetary Fund, Various Issues

Figure 1.3 shows the trend of the stability within SNERS from year 1980 to

2010. The stability in the nominal exchange rate is volatile throughout the timeline

and was heightened especially during the event world economic crisis for example

throughout 1980.

Throughout 1980, the stabi 'lity in SNERS experienced significant instability

due to the effect of global oil shock, much like the effect felt by its neighbouring

Malaysia (see Hamilton, 2011). On the other hand, the economy felt much lesser

effect from the infamous 1997 Asian Financial Crisis though the trend records a

decline of NEER. Such attribute are the results of different monetary conduct of the

Monetary Authority of Singapore. Though the crisis affected the Asian region,

ingapore was particularly cushioned from the effect relatively due to its stronger

fundamental in Monetary Authority of Singapore's monetary practices.

7

Since 1981, the Monetary Authority of Singapore has been practicing a more

disciplined monetary conduct where it is managed float against a basket of currency

(which would have seen much impact if compared to free float exchange regime). On

top of that, their exchange rate policy band is periodically reviewed to ensure that it

remains consistent with underlying fundamentals of the economy. This measure is

the crucial element in systematically assessing the path of the exchange rate in order

to avoid a misalignment in the currency value (Monetary Authority of Singapore,

2012).

8

1.6 Singapore Import Penetration Ratio (SIPR)

Figure 1.4 Singapore lmport Penetration Ratio from 1980 to 2010

5.4

5 .3

5 .2

~ 0- 5 . 1 0 :p co

cr:: 5.0

4.9

4.8

4.7 1980 1985 1990 1995 2000 2005 2010

Year

I-SIPRI

Source: International Finance Statistics, International Monetary Fund, Various Issues

Figure 1.4 shows the trend of the SIPR from year 1980 to 20 10. The trend

shows a more volatile pattern throughout the period compared to Malaysia's case.

However, the period of post millennium records a higher penetration ratio from prior

to it.

All in, the relatively volatile trend might be attributed to trade dependence

(openness) characteristic which the economy posses. However, this does not

necessarily represent true import penetration, but rather the presence of re-exports in

the raw data. This is because Singapore is the type of open economy which revolves

around entrepot activity (importing for exporting purposes) since the dawn of its

existence.

9

1.7 Problem Statement

An exchange rate movement is usually indicator for an economy's

competitiveness judging from the argument from finance to international trade. In

such case, the developing and developed economy like Malaysia and Singapore5 are

relatively sensitive to externality such as exchange uncertainty, which is very much

attributed to their small-open economies.

Though higher degree of stability in exchange movement are being

maintained mainly for the purpose of deterring speculation practices by foreign

investors, especially within the field of finance and investment, it can also iiJustrate

higher degree of trade protectionism policy. As the import penetration issue of a

country is concerned, the self-sustaining issue will not be far behind. A higher degree

of penetration ratio might suggest that a country under review has higher dependency

on importations and this might raise an alarm in some areas on national security (i .e.,

excessive dependency on foreign agricultural products or food products). According

to the MIPR and SIPR (refer to figure 1.2 and 1.4, respectively), the trends are

generally showing lesser penetration ratio that of Malaysia's side compared

Singapore. This brings about the question of viability of sustainabi lity in country's

overall production to satisfy its own domestic demand where is it more prone to the

development of economic status (i.e., developing or developed) or is it weighing

more on the factors of abundance as being illustrated by Heckscher-Olin Model.

Whenever a discussion or study are being performed on variables concerning

exchange rate (in this case, exchange rate stability), the discussion on its impact on

S Classifications are based on information obtained from World Bank (Country and Lending Group) where the Malaysia is categorized under developing economy whilst Singapore is under high income (developed) economy.

10

international trade will not be far behind. The degree of stability in the exchange rate

is correlated to various components within a country's economy. Cases in point,

transaction involving foreign exchange are very much linked to a country's business

activity (especially those involved in import and export industry), gross domestic

product and also the rate of employment. Theoretically, the public will spend less on

goods and services not only from domestic supplier, but from foreign supplier

(import) as well. When this happens, the central banks will interfere to manipulate

their currency's value to their economy's advantage and this are being portrayed by

the degree of stability on its exchange rate.

Furthermore, a more stable exchange rate movement are deemed to be more

favourable to international trading prospect. However, it is this conclusion is far from

evidently conclusive as Malaysia is adopting a more stabilized exchange regime for

more than a decade now and Singapore has been opting for a freer exchange regime.

In all, these two countries might pose different monetary conduct but relatively

similar economic size attributes.

In a nutshell, the viability of exchange stabilization policy practiced by

Malaysia after the infamous 1997 Asian financial crisis is yet to be determined in

handJ ing future financial crisis, as applied to Singapore's monetary conduct too. The

effect of such variable might directly or indirectly impact upon the patterns of

domestic demand for these two economies as well.

11

1.8 Objective of Study

The short run and long run relationship between the nominal exchange rate

stability (MNERS and SNERS) and import penetration ratio (MIPR and S[PR) for

Malaysia and Singapore are yet to be determined. Furthermore, the determinant of

causal relationship between these two variables within these two economies is also

yet to be answered. With this, the objectives to investigate this matter are as follow:

1.8.1 General Objective

• To examine the relationship between exchange rate stability and import

penetration ratio for both Malaysia and Singapore for the period according to

each country's data availability.

1.8.2 Specific Objectives

• To examine the long run relationship between exchange rate stability and the

level of import penetration ratio in Malaysia and Singapore.

• To detennine the short run causality between exchange rate stability and level

of import penetration ratio in Malaysia and Singapore.

12

1.9 Significance of Study

In pursuing higher level of economic status, a country's governing authority

would have to achieve such goal starting from a tactical basis and in this case,

regulating the microeconomic environment via various microeconomic policies. For

instance, formulation of microeconomic (short term) policies must also have in sight

ofa country's macroeconomic (long term) policies. For these two policies to function

in a synergy condition, a study on an economy's microfoundation (for example,

domestic demand pattern) will help in forecasting the needs of future monetary

conduct (macroeconomic policy) of the country.

When a country has achieved or is in the standard of a developed economy,

its next goal is to formulate and execute a long term stabilization policy. This would

then highlight the needs to devise various strategic economic growth policies to

sustain the economic advancement. In such economic phase, an economy relatively

possesses a higher degree of openness (and thus, more liberated exchange regime)

compared to those of a developing economy. In these arguments, the stability of

exchange rate variable plays a significant role in determining the country's long term

capability in regulating its international trade.

This research can be significant in the sense that its findings can provide

important insights and thus, implication on the formulation of not only

macroeconomics policy, but microeconomic policy as well. To pinpoint this claim,

the policymakers can formulate a more effective monetary conduct to gauge

exchange sensitivity whilst addressing domestic consumption demand.

Besides that, a study on the pattern of domestic consumptions which are

being satisfied by products abroad can also be utilized for various indication

13

purposes such as an insight of a country' s purchasing capability, degree of trade

protectionism policy, economic growth direction and so forth. A higher degree of

such consumption suggest that a country's domestic reliance on imports are

significant and thus, gives an idea of the how the trade balance are going to perform

while a lower degree would suggests otherwise. With such measurement, the

fonnulation of various micro and macro level economic policies can be done on a

more effective and surgical basis.

1.10 Structure of Study

The following chapter focus on the review of previous studies, Chapter 3

discuss on the methodology to be applied in this research followed by Chapter 4

focusing on the results and discussion. The last chapter concludes this research with

pol icy implications.

14