A Study on the Relationship Between Real Exchange Rate and Trade Balance_Case of Malaysia, Indonesia, And Thailand

R e a l E x c h a n g e R a t e a n d T r a d e B a l a n c e P a g e | 1

Table of Contents

1. BACKGROUND................................................................................................................2

1.1. Introduction.................................................................................................................2

1.2. Statement of Problem..................................................................................................3

1.3. Objectives of the Study...............................................................................................3

1.4. Organization of the Study............................................................................................4

2. LITERATURES REVIEW.................................................................................................5

2.1. Introduction.................................................................................................................5

2.2. Theoretical Literature..................................................................................................5

2.3. Empirical Literature.....................................................................................................6

3. METHODOLOGY.............................................................................................................9

3.1. Introduction.................................................................................................................9

3.2. Data..............................................................................................................................9

3.3. The Model...................................................................................................................9

3.4. Methods of Estimation..............................................................................................12

4. FINDINGS AND DISCUSSION......................................................................................15

5. CONCLUSION.................................................................................................................15

REFERENCES.........................................................................................................................16


1. BACKGROUND

1.1. Introduction

There is this tacit understanding in devaluation of a currency where it is used as a

mechanism to improve balance of trade. Exports prices become cheaper while imports prices

increase as the value of local currency drops. Consequently, the trade balance improves.

However, the effect of exchange rate on trade balance might vary from a country to a country

due to different level of economic development. One of the notable effects is the Marshall-

Lerner condition. This condition states that when the sum up value of import and export

demand elasticity is equal to, or greater than 1, the devaluation in currency exchange rate will

cause trade balance to increase (Chen & He, 2011).

Malaysia's ringgit had the biggest two-day decline since the 1997-98 Asian financial

crisis recently as reported by Y-Sing and Han (2014). The ringgit fall 2.4 percent to 3.4300

per US Dollar on Monday December, 1st at closing, from 3.3465 per US Dollar on Thursday

November, 27th at closing. The depreciation in ringgit is due to a ripple effect of declining in

world price of oil. The declining in price of Brent crude oil of 38 percent from its June high

thus reducing the country’s revenue as oil is one of Malaysia's main exports. This situation

has made it harder for government to achieve its fiscal deficit target.

Despite shrinking in ringgit, Deputy Finance Minister Datuk Ahmad Maslan said to

Bernama that it will not harmfully affect Malaysia's economy. He mentioned that the ringgit

would remain stable in the long term and Malaysia's economy would grow within

government's expectation in 2015. In addition, this situation is said to be beneficial for

tourism and exports as well as certain sectors. On the other hand, Minister of International

Trade and Industry, Datuk Seri Mustapa Mohamed said to Bernama that currently a joint

study has been conducted between Bank Negara Malaysia, Ministry of Finance (MOF) and

the Economic Planning Unit (EPU) of the Prime Minister's Department to analyse the

advantages and disadvantages of depreciation in ringgit towards the economy. He also

mentioned that there is no possibility to peg the ringgit against US dollar as the move has its

own benefits and drawbacks.


1.2. Statement of Problem

Devaluation in currency would increase the price of imported goods and at the same

time decrease the price of domestic goods. Hence, local manufacturing sector can be

expanded. Besides that, a country's export sector also could be developed as its exports to

foreign countries will be much cheaper. Due to the expansion in export sector, company

profit, salaries, bonuses, manpower, and tax for the government also will increase.

It must be noted that although the currency's devaluation might have positive

influences towards economy, the amount of export and import may not react at initial period

of devaluation. Worse thing to happen is that trade balance may be falling first due to

decrease in value of export and increase in value of import. However, these numbers might

improve after some time. This whole scenario is known as J-curve.

Due to the above situation, it is important for government and related regulatory

bodies to come hand in hand investigating the relationship between real exchange rate and

trade balance and check whether the depreciating currency is good or bad and if it has a

positive effect towards the economy. It is also significant for researchers to determine

whether J-Curve effect exists following the depreciation in currency.

There have been numerous studies focusing on the impacts of exchange rate volatility

on balance of trade; however, none could be found comparing these effects between

Malaysia, Indonesia, and Thailand. Main focus of this paper would be Malaysia while

Indonesia and Thailand will be used to compare their results with Malaysia. Indonesia and

Thailand have been chosen due to the fact that they are Malaysia’s neighbouring countries

and the two countries share similar economic environment.

1.3. Objectives of the Study

The main aim of this paper is to investigate the relationship between the real exchange

rate and trade balance in Malaysia, Indonesia, and Thailand from year 1990 until 2014. In

addition, this study also targets to determine whether Marshall-Lerner condition and J-Curve

exist in these three countries during the study period.


1.4. Organization of the Study

This paper is structured into several sections. After introduction, section 2 discuss

further on theoretical and empirical literature review. Next, section 3 will have discussion on

model and methods of estimation being used in this study. After that, section 4 will be the

findings and discussion. Finally, section 5 will be the conclusion from this study.


2. LITERATURES REVIEW

2.1. Introduction

Despite so many studies done on finding the relationship between real exchange rate

and balance of trade, little studies could be found on comparing the intended results between

the three sample countries, i.e. Malaysia, Indonesia, and Thailand. The next subsections will

discuss on theoretical literature and empirical literature related to the topic of this research.

2.2. Theoretical Literature

Setting all other variables fixed, the trade theory declares that the exchange rate can

affect a country’s imports and exports. A fluctuation in the exchange rate affects both the

value and volume of trade. If the real exchange rate increases for the home country i.e. if

there is a real depreciation, the households in the home country can obtain less foreign goods

and services in exchange for a unit of domestic goods and services. Therefore, less foreign

goods are obtained because of their higher prices.

Lerner (1944) mentioned that lower prices in the domestic country will generally

increase foreign demand for domestic country’s good, but only if the foreign elasticity of

demand is elastic. On the other hand, if the domestic demand for foreign goods is elastic, the

price change in the domestic market will change the domestic consumer’s behaviour. The

consumers will then switch to consume domestic goods rather than foreign goods causing the

value of imports to decrease.

According to Borkakoti (1998), the Marshall-Lerner condition is a condition of

stability. If the elasticity of demand for imports is greater than zero by the same amount as

the elasticity of demand for exports is less than one, then the two elasticity of demand will

add up to one. Therefore, the depreciation will have no effect on the trade balance.

A J-curve as defined by Rose and Yellen (1989) is the combination of a negative

short-run derivative with a positive long-run derivative. A typical J-curve scenario according

to the authors is illustrated as follows: the initial effect of depreciation is to raise the domestic

prices of imported goods, because prices of export goods are sticky in sellers’ currencies.


There is only a small immediate impact on the volume of trade flows. Henceforth, the value

of exports rises only slightly, whereas the value of imports rises substantially due to the

increased cost of an unchanged quantity of imports. As a result, the balance of trade in real

terms deteriorates in the short run. As time passes, the increased price of imports eventually

reduces import volume; export volume and value also rise over time because the price

elasticity of foreign import demand is larger in the long run than in the short run. As a result,

the effect is upturned over time although the depreciation has an initially negative impact on

the real trade balance, resulting to a cumulatively positive effect; thus the short-run response

is ‘perverse’. The graph of the response of the trade balance over time to a once-and-for-all

real depreciation resembles a ‘J’ tilted to the right.

The graph below is author’s own interpretation based on Rose and Yellen (1989).

Figure 1 Sketch of the J-curve effect, t0 is the time of depreciation.

2.3. Empirical Literature

Rose (1990) examined the empirical impact of the real exchange rate on the trade

balance on various developing countries. The author used annual data that covered 30

Trade balance

TB

tt0


countries from 1970 until 1988. Besides that, quarterly data also was used to confirm the

annual results. It was discovered that the exchange rate does not have perverse impact on the

trade balance.

Wilson (2001) studies the effect of real exchange rate on the real trade balance for

bilateral trade in merchandise goods for Singapore, Malaysia, and Korea to the USA and

Japan on a quarterly basis over the period 1970 to 1996. They used partial reduced form

model of Rose and Yellen (1989) (as mentioned in Wilson, 2001) derived from the two-

country imperfect substitute model. He found that there is no significant impact of real

exchange rate on the real trade balance. He also mentioned that there is no evidence for J-

curve on Singapore and Malaysia. Nevertheless, he discovered that there are some J-curve

effects for Korea pertaining to both Japan and the USA. The author mentioned that these

effects might be caused by “small” country pricing of exports in foreign currency, however,

he found no evidence that imports later fell as the lag length on the real exchange rate

increased, which would be required to support a strict interpretation of the J-curve.

Wilson and Tat (2001) studied the relationship between the real trade balance and the

real exchange rate for bilateral trade in merchandise goods between Singapore and the USA

on a quarterly basis over the period 1970 to 1996 using the partial reduced form model of

Rose and Yellen (1989) (as mentioned by Wilson and Tat, 2001). They found that there is no

significant impact of the real exchange rate on the bilateral trade balance for Singapore and

the USA. This is might be due to the fact that there is a weak relationship between changes in

the exchange rate and changes in export and import prices and volumes for Singapore.

Besides that, the authors discovered there is little evidence of a J-curve effect. It was not clear

whether “small country” pricing by exporters in U.S. dollars masked J-curve effect from

initial rise in import values when Singapore dollar depreciated.

Another study has been done by previous researcher that explored the balance of trade

model on Indian data from 1960 to 1995 using a reduced-form specification similar to Rose

(1991) (as mentioned by Singh, 2002). The researcher found that the real exchange rate has

significant impact on the trade balance compared to nominal exchange rate. In addition,

balance of trade in India also being influenced by domestic income. Instead of focusing on

nominal exchange rate, Singh (2002) suggested that policy makers and authorities focus more

on the real exchange rate, specifically the trade weighted real effective exchange rate.


Petrović and Gligorić (2010) were interested in finding whether and how depreciation

in exchange rate as well as its appreciation affects trade balance in Serbia, both in the long

run and short run which covers from January 2002 to September 2007. They used Johansen

co-integration analysis to investigate the long run impact of the exchange rate on trade

balance together with the autoregressive distributed lag (ARDL) approach. The error

correction model is used to determine the short term impact and the related J-curve pattern.

The authors found out that in the long run, the exchange rate depreciation does improves

trade balance, whilst in the short run, the depreciation in exchange rate giving rise to a J-

curve effect.

Yusoff (2010) examined the impacts of changes in the real exchange rate on the real

Malaysian trade balance and the domestic output using quarterly data during the pegged

exchange rate regime, 1977:1-1998:2 and the extended model from 1977:1 to 2001:4 which

includes the period of fixed exchange rate regime. The researcher found that in the long run,

depreciation in real exchange rate improves the Malaysia's trade balance. In addition, there

were similarities of exchange rate impact on the balance of trade as well as the domestic

output. There was a delayed J-curve effect during the 1997:1 to 1998:2, however, no J-curve

effect was found on the short-run analysis.


3. METHODOLOGY

3.1. Introduction

This section discusses the model and methods of estimation that author used in order

to satisfy the objectives of this study; i.e. determining the relationship of real exchange rate

on balance of trade as well as finding the existence of J-curve effects between the three

countries.

1.

2.

3.

3.1.

3.2. Data

The annual data for this study is obtained from International Monetary Fund (IMF) as

well as World Bank. The data used constitutes information from year 1990 until year 2014.

There was some striking adjustment in real exchange rate and trade imbalance. Therefore,

this is one of the reasons that support this research to study whether there is relationship

between real exchange rate and the balance of trade. The trade balance, domestic and foreign

incomes are all in real terms, while the consumer price index (CPI) represents as the price

deflator.

3.2.

3.3. The Model

The modelling on the relationship between exchange rate and trade balance is

discussed by various papers. For this paper, the author specifically refers to research done by

Ng, Har and Tan (2009) as well as Gómez and Álvarez-Ude (2006) which emphasized in

exchange rate on bilateral trade balance evidence.


In general, equilibrium goods market in an open economy can be explained by the

following equations:

Y=C (Y−T )+ I (Y , r )+G−ℑ (Y , ε )+ X (Y ¿ , ε), where:

Y signifies total domestic income, C signifies consumer spending, and T signifies

income tax, I signifies investment, r symbolizes as interest rate, G signifies government

spending, ε signifies real exchange rate, ℑ signifies import, X signifies export, and Y ¿

signifies foreign income.

Consumers spending (C) is derived from total income minus income tax, or in other

words the disposal income(Y−T ). There is positive relationship occurs between total

domestic income and consumer spending due to the fact that higher disposal income result in

higher consumer spending besides to increase total domestic income.

Investment (I) is a function of total income and interest rate. If there is an increase in

total personal income, people would invest more. Hence, there is a positive relationship

between investment and total income.

On the other hand, interest rate (r) imposed might distress investment decision. It is

widely known that lower interest rate attracts more investment as it reduces cost of capital. In

contrast, higher interest rate would decrease total domestic investment. Thus, it can be

concluded that, there is a negative relationship between investment and interest rate.

The real exchange rate (ε ) is obtained by multiplying the nominal exchange rate (E)

with the foreign price level (P¿) and then divide them by the domestic price level (P).

Nominal exchange rate (E) is defined as the number of unit domestic currency exchange for

one unit of foreign currency, giving:

ε=(E P¿)P

(1)

Import (ℑ) is stimulated by domestic income or output (Y ). There is a positive

relationship between domestic income and import as the higher the domestic income, the

higher the imports. On the other hand, there is also a negative relationship between import


and total domestic income as quantity of import depends on the real exchange rate (ε). Higher

ε signifies lower quantity of imports due to the fact that foreign goods become relatively

expensive.

Export (X ) depends on the foreign income (Y ¿¿ and real exchange rate (ε). Foreign

demand for all goods and services will increase when the foreign income is high; thus leads

to an increase in exports. In contrast, when there is an increase in real exchange rate, the

relative price of foreign foods in terms of domestic goods also causes export to be increased.

Therefore, it can be reckoned that there is a positive relationship between trade balance,

foreign income, and real exchange rate.

As the objective of this paper is to observe the trade balance (net export: NX) and the

exchange rate, other variables are assumed constant. The net export is:

EX=I M (2)

By substituting the function of export and import into equation (2), it shows

NX=X (Y ¿ , ε )−ℑ (Y , ε )(3)

After that, substitute equation (1) into equation (3)

NX=X (Y ¿ , E P¿

P )−ℑ(Y , E P¿

P )(4 )

Assume E P¿

P is stationary, we can rewrite the equation (4) as

NX=NX (Y , Y ¿ , ε )(5)

Equation (6) shows below is the balance of trade as a function of the levels of

domestic and foreign income and the real exchange rate.

ln TBt=β0+β1ln Y t+ β2 ln Y ¿t +β3 ln RER t+ut (6)


where ln stands for natural logarithm, ut is assumed to be a white-noise process, and trade

balance, TBt symbolise the ratio of exports to imports allows all variables to be explained in

logarithm form and removes the need for appropriate price index to explain the trade balance

in real term. In this paper, real exchange rate (RER t) is expressed by Malaysian Ringgit

(MYR) against United States Dollar (US$) and Y ¿t is the gross domestic product of United

States.

The sign of β1 could be either positive or negative, following the classical theory.

There is an increase in Malaysian real income, Y t which is increase in import volume if the

estimate of β1 is negative. On the other hand, if β1 is positive, it means that there is an

increase in Y t due to an increase in the production of import-substituted goods. The sign of β2

would depends on whether the supply side factors dominate demand side factors. Marshall-

Lerner theory holds when β3 is positive, it indicates that depreciation leads to the

improvement in the Malaysia’s balance of trade.

This whole process is to be repeated for Thailand and Indonesia data.

3.4. Methods of Estimation

Augmented Dickey-Fuller (ADF) test and Philips-Perron (PP) is the unit root test that

will be used to test the stationary in economic data following the work of Ng, Har and Tan

(2009). Unit root test is used to test of stationary. If ADF test and PP test show different

results, the Kwiatkowski-Philips-Schmidt-Shin (KPSS) test is used as decisive results. Co-

integration analysis is used to determine the long run relationship betweenTBt,RER t , Y tand

Y ¿t in order to solve the spurious regression problem and violation of the Classical

Regression Model. Three methods are used in order to test for co-integration; i.e. Engle-

Granger Test, Error Correction Model, and Johansen-Juselius Test. In order to know the

disequilibrium error, we rewrite equation (6) as:

ut=lnTBt−β0−β1 lnY t−β2 ln Y ¿t−β3 ln RER t (7)

In order to perform Engle-Granger test, the order of integration of the estimated

residual,ut should be tested. If there is any co-integrating regression, then disequilibrium


errors in equation (7) should form a stationary time series, and have a zero mean, the ut

should be stationary, I(0) with E(ut) = 0.

The long run equilibrium may be rarely observed, but there is a tendency to move

towards equilibrium. Thus, Error Correction Model is used to denote the long-run (static) and

short-run (dynamic) relationships between trade balance, real exchange rate, domestic and

foreign income. Vector Error Correction Model (VECM) is suitable to estimate the effect of

exchange rate on trade balance. The equation (8) represents Error Correction Model as:

∆ lnTBt=lagged (∆ TBt ,∆ RER t , ∆ Y t , ∆ Y ¿t )− λ ut−1+v t (8)

where ut−1 represents the residual term at t−1 in long term.

Engle-Granger Test and VECM are tests to check whether the long-run relationship

exists in equation only. Following the work of Ng, Har and Tan (2009) as well as Gomez and

Alvarez-Ude (2006), Johansen-Juselius test will be used to perform hypothesis tests about the

number of the long-run relationship exists in equation. To use Johansen-Juselius’s method,

the Vector Autoregressive (VAR) of the form needed to turn first,

Zt=β1 Z t−1+β2 Z t−2+K+βk Z t−k+v t , t=1 , K , T (9)

into a Vector Error Correction Model (VECM), which can be written as

∆ Z t=Π Z t−k+Γ1 Z t−1+Γ 2 Z t−2+Γk−1 Z t−(k−1)+v t (10)

The test for co-integration between the Z is computed by looking at the rank of the Π

matrix via its eigenvalues. The rank of a matrix is equal to the number of its characteristic

roots (eigenvalues) that are different from zero. The symbol Π shows how many linear

combinations of Zt that are stationary. The vector Zt included of trade balance (TB), real

exchange rate (RER), domestic income (Y ) and foreign income (Y ¿). Thus,

Zt=[TB RER Y Y ¿ ]. The number of lags is selected based on Akaike Information Criterion

(AIC) and Schwarz Criterion (SIC).

Next, the number of co-integrating equilibrium relationship between the logarithms of

trade balance, domestic and foreign national income and real exchange rate should be tested


following the Johansen-Juselius’ approach. Two statistics for co-integration used: the trace

statistic,λ trace, and the maximal-eigenvalue statistic, λmax. Both test statistics are the estimated

value for the ith ordered eigenvalue from the Π matrix. The r set from zero to k – 1, where k

= 4 (k represents the number of endogenous variables in this research).

For trace statistic, the test statistic for co-integration is formulated as

λ trace (r )=−T ∑i=r+1

g

ln (1− λ̂ i)

where T signifies the sample size, r signifies number of long run relationship exist, and λ̂

represents the eigenvalue. For trace statistic, the null hypothesis is the number of

cointegrating vectors is less than equal to r against an unspecified alternative. If λ trace equal to

zero, thus, all λ i are also equal to zero, so it is a joint test.

For maximal-eigenvalue statistic, the test statistic for co-integration is formulated as

λmax (r ,r+1 )=−Tln(1− λ̂i)

The null hypothesis for maximal-eigenvalue statistic is the number of co-integrating

vectors is r against an alternative of r + 1.

There will be various diagnostic tests to be done before forecasting with the final

model in order to confirm the adequacy of representation of the model. To test the parameter,

the t-test is used. Pairwise Granger Causality Test will be used to test the direction of

causality between two variables. Afterward, in order to analyse the residual, Portmanteau

Autocorrelations (Q) test, Autocorrelation LM (LM) test, White heteroskedasticity (White),

and Jarque-Bera residual normality test via Cholesky (JBCHOL) and Urzua (JBURZ)

factorizations are employed. Finally, impulse response analysis will be used for forecast

purpose because the analysis tells the information about interaction among the variables in

the system. The impulse response function is then will be used to verify whether J-curve

effects exist in Malaysia, Indonesia, and Thailand.


4. FINDINGS AND DISCUSSION

Disclaimer: Since there is no econometrical or statistical estimation is needed for this

term paper, the author omits this section.

5. CONCLUSION

This paper will focus on the short run and long run effect of the real exchange rate on

balance of trade of three countries; i.e., Malaysia, Indonesia, and Thailand in order to test

whether Marshall-Lerner condition and J-curve effects exist. The results obtain are expected

to support the empirical literatures on the Marshall-Lerner condition through VECM,

indicating that depreciation does improves the trade balance. In addition, J-curve effects are

expected not to exist during the short run period.

It is hope that the results obtained from this research study will help the government

and other related bodies to create a policy that focusing on the variable of real exchange rate,

which is the nominal exchange rate to aggregate price level. This is to ensure that it achieve

the desired effects on trade balance. In addition, the authorities must cooperate between the

devaluation-based policies (affected through changes in nominal exchange rate) and

stabilization policies (to ensure domestic price level stability) to achieve their targeted level

of trade balance.


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Ng, Y. L., Har, W. M., & Tan, G. M. (2009). Real exchange rate and Trade Balance

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Petrović, P., & Gligorić, M. (2010). Exchange rate and trade balance: J-curve effect.

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Ringgit Slide Won't Adversely Affect Economy: Ahmad Maslan. (2014, December 15).

Official Portal of National News Agency of Malaysia (Bernama). Retrieved from

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Rose, A. K., & Yellen, J. L. (1989). Is there a J-curve?. Journal of Monetary Economics,

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A Study on the Relationship Between Real Exchange Rate and Trade Balance_Case of Malaysia, Indonesia, And Thailand