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