a

ELSEVIER

Journal of MULTINATIONAL FINANCIAL

Journal of Multinational Financial Management MANAGEMENT 7 (1997) 333-344

Efficiency of black markets in foreign currencies in Southeast Asia

Ghulam Sarwar * Depurtrnent qf Fimnce, Insurance und Real Estute, Business College, St Clo~td State University, St Cloud,

MN 56301-4498, USA

Abstract

This paper examines the weak-form efficiency of currency black markets in Malaysia, Indonesia, Thailand and the Philippines for the period 1951-1993. Efficiency is examined for individual markets as well as in bivariate and multivariate settings using cointegration tech- niques. Efficiency findings are sensitive to model specification, time period examined, and choice of the cointegration technique. Overall, the results are not supportive of efficiency in bivariate and multivariate systems of the four black-market exchange rates during 197331993. The results have implications for managing exchange-rate risk and for possible arbitrage opportunities in these markets. 0 1998 Elsevier Science B.V.

Keywords: Currency black markets; Market efficiency; Cointegration

JEL cluss$cation: F23; F31; G15

1. Introduction

The efficiency of spot markets in currencies of major industrialized countries has been studied extensively. In some countries of Southeast Asia: however, foreign currencies are actively traded in black markets due to government restrictions placed on the foreign sector. Currency black markets lack established trading institutions, are often thin and segmented, and have high transaction costs (Gupta, 1981; Aggarwal, 1990; Noorbakhsh, 1990). Further, relevant financial information is generally not available on a timely basis in black markets (Gupta, 1981; Booth and Mustafa, 1991). These factors may prevent or delay the efficient adjustment of exchange rates to relevant market information. If black market currencies are inefficient, then international portfolio managers can earn above-average risk- adjusted rates of return from arbitrage opportunities.

Among the few existing studies on currency black markets, Gupta ( 198 1) examines

* Corresponding author. Tel.: 320-255-3231; Fax: (320)-255-3986; e-mail: gsarwar@stcloudstate.edu

1042-444X/97/$17.00 Q 1997 Elsevier Science B.V. All rights reserved. PII SlO42-444X(97)00021-2

the currency black markets in India, South Korea and Taiwan, and finds evidence consistent with weak-form market efficiency. Noorbakhsh ( ! 990) reports similar results for 13 black market currencies from Latin America, Africa and Asia. However, Aggarwal (1990) uncovers little support for weak-form efficiency in seven South American currency black markets, but finds strong support for the semistrong- form efficiency version of purchasing power parity in 13 black market currencies from Africa, the Middle East, South America (Bolivia only), and Asia. Interestingly, Koveos and Seifert ( 1985) show that this semistrong efficiency version does not hold for the Bolivian currency black market, while it holds for seven other Hack market currencies of South America, four of which were shown to violate the same efficiency version over essentially the same period by Aggarwal ( 1990). In a two-currency study, Booth and Mustafa ( 1991) conclude that, using the cointegration techniques of Engle and Granger (1987), the Turkish black markets for US dollars and West German marks are efficient individually and with respect to each other. The literature consensus seems to be that currency black markets are individually weak-form

cient, but that the evidence for semistrong efficiency is at best mixed. None of the foregoing studies, however, have examined efficiency in a two-market

framework, with the possible exception of Booth and Mustafa (1991). and in a multi-market framework. While currency black markets may be individually efficient, it is quite conceivable that a black-market currency has a long-term relationship with one or more currencies from related markets (countries) so that changes in one currency value can be predicted from known values of other currencies. Such bivariate and multivariate aspects of efficiency have received very little attention in the previous research on currency black markets. Our paper aims to address this imbalance in the literature.

The present paper examines the efficiency of currency black markets in Indonesia, Malaysia, Thailand and the Philippines in a two-currency and multi-currency frame- work during 1951-1993. Cointegration techniques of johansen ( 1988) and Engle and Granger ( 1957) are used to examine efficiency. These markets have been pre- viously found to be individually weak-form efficient by Aggarwal ( 1990) and Naorbakhsh (1990). The markets under consideration had active black market transactions for much of the sample period. Furthermore, Indonesia, Malaysia, Thailand and the Philippines have been members of the Association of Southeast Asian Nations (ASEAN) since 1967, which affords more favorable trading terms to member nations than to non-member nations (Wu~/~ Czl~reni:v Yem5ook, 1987). Member nations have been active trading partners (International Monetary Fund, 19843; as international trading partners, there is integration in these countries’ economic activities. Thus, it is appropriate to test for cointegration of black-market currencies in markets where international trading patterns have been established.

The examination of efficiency for these currency markets should be of particular interest to international portfolio managers because the security markets of Indonesia, Malaysia, Thailand and the Philippines have attracted large amounts of foreign capital within recent years (Brauchli, 1995). Because some trade and capital flows take place at black-market exchange rates (Aggarwal, 1990) and changes in

G. Savwar J Journal qf Multinational Financial Management 7 (1997) 333-344 335

black-market rates anticipate changes in official rates in some Southeast Asian countries (Gupta, 1981), a study of the efficiency of black markets has implications for managing exchange-rate risk and for the behavior of exchange rates in these markets.

The remainder of the study is organized as follows: tests of cointegration and efficiency are discussed in Section 2; data are explained in Section 3; empirical results are included in Section 4; and the conclusions are drawn in Section 5.

2. Tests of cointegration and market efficiency

Granger (1986) has shown that two asset prices from a pair of efficient markets cannot be cointegrated. If two prices, X, and Y,, are cointegrated, then an error- correction model for the prices can be specified as follows (Engle and Granger, 1987; Granger, 1986):

x*-x,_, =cx[X,_, -yY,-,1+fl[Y, - Y,_,]. (1)

Eq. (1) implies that a change in the asset price can be explained by a component of asset prices, X, ~ 1 and Y, _ i, available to market agents at time t - 1. Such a price behavior is inconsistent with weak-form market efficiency, according to which past information on prices cannot be usefully exploited to predict subsequent prices. Hence, the absence of cointegration among security prices implies the existence of weak-form efficiency in security markets.

Tests for cointegration of black-market exchange rates are based alternatively on the Engle and Yoo (1987) two-step procedure and the Johansen (1988) maximum- likelihood procedure. Alexander and Johnson (1992) and Dutt (1994) show that cointegration-based efficiency findings are not invariant to the two cointegration techniques. The Engle and Yoo (1987) procedure first estimates the cointegration regression:

X,,=b,+b,X,,+...+b,,X,,+C1, (2)

where Xrt, Xzt,. . , X,, are the m time series (n? different exchange rate series) being tested for cointegration and ,u~ is an error term. The estimated residuals from Eq. (2) are then tested for the presence of a unit root via the augmented Dickey-Fuller (ADF) test by estimating the regression:

A sufficient number of lagged terms is included to ensure that the error term in Eq. (3), qt, is white noise. If the estimate of 6 is significantly differently from zero, then the residuals have no unit root and the original exchange rate series in Eq. (2) are cointegrated.

The Johansen estimation method is based on the error correction representation of a vector autoregressive (VAR) model as follows:

k I AZ, =O+ c r,AZ,_,+hT_, +E,,

where Z, is a vector containing variables integrated of the same order (the two exchange rates in the bivariate case, or multiple exchange rates in the multivariate case) and E, is a Gaussian error term. The Johansen maximum-iikeliho’od procedure estimates Eq. (4) subject to the hypothesis that i7 has a reduced rank r<n?, where nr is the number of variables (spot exchange rates) contained in Zt. Johansen proposes a trace test and a maximum eigenvalue test to determine the exact number of cointegrating vectors in a system. In the trace test, the null hypothesis is that there are E. or less cointegrating vectors, where r = 0,1,2,3 in the present case. For example, the null hypothesis of zero cointegrating vectors (r=O) is tested against the general alternative hypothesis of one or more cointegrating vectors (r> 1). In the maximum eigenvalue test, the null hypothesis of zero cointegrating vectors (r =O) is tested against the specific alternative of one cointegrating vector (I” = I 1, IWO cointegrating vectors (r=2), and so on. The number of non-zero eigenvalues equals the number of cointegrating vectors in the system. If the null hypothesis of zero comtegrating vectors (i.e. no cointegrating relationship) among black-market exchange rates is rejected, then it can be construed as evidence against the weak-form efficiency of black markets.

3. Data

Efficiency tests are carried out on the monthly black-market exchange rates between the currencies of Indonesia (rupiah), the Philippines (peso), Thailand (baht). and Malaysia (ringgit) and the US dollar. The data cover the January 1951 to December 1993 period and provide 516 monthly observations. The black-market rates (i.e. open market rates) are obtained from the B&o:-ill (Pick’s) Cumw~ Y~wn!mok (International Currency Analysis, 1960). The monthly observations are the end-of-the-month price of a US dollar in the domestic currency and are the midpoints of the buying and sefling rates for currency transactions occurring within the country and at major trading centers of the world. The sample period covers both the fixed exchange rate period, 1951-1972, and the floating exchange rate period, 1973-1993.

The four currencies under consideration have experienced difierent ievels of black market activities over the sample period. The World Currwq Ywrbonk has categorized Indonesia and Malaysia as “liberal currency control” countries, and the Philippines and Thailand as “strict currency control” countries from 1973 to 1987.’ Malaysia

I In countries of “liberal control” currencies, ownership of foreign currencies is tolerated. infracrionb oi currency laws are not punishable by jail, and black-market rates often differ substantially from ofiicial rates. Jn contrast, the “strict control” currencies are surrounded by voluminous protecti\,e legislation, have multiple official rates, and cannot be transferred abroad without authorization. Further, ownership? of foreign monies is ilIe@ and punishable.

G. Surwar /Journal of Multirzational Finawcid Manngement 7 (1997) 333-344 337

moved to “free currency” category (i.e. little or no currency restrictions) in 1989, while Thailand and the Philippines both moved to “liberal currency control” category in 1992.

4. Empirical results

Cointegration tests are performed on the natural logarithms of the black-market exchange rates to avoid the so-called Siegal paradox due to Jensen’s inequality. Much of the empirical research is on exchange rates in the logarithmic form (see, for example, Hakkio and Rush, 1989; Tronzano, 1992). The cointegration approach of Engle and Yoo (1987) requires a uniform order of integration for all variables examined. The order of integration of each exchange rate series is determined using the Dickey-Fuller (DF) and augmented Dickey-Fuller (ADF) tests for the entire sample period, 1951-1993, the fixed rate period, 1951-1972, and the floating rate period, 1973-1993. The ADF regressions for the entire sample period included eight lagged terms, and those for the fixed and floating rate periods each contained six lagged terms, following the approach of Said and Dickey (1984).’ The eight/six lagged terms are sufficient to result in white noise in the residuals.3 The robustness of the Said and Dickey approach has been well established by Schwert (1987).

Table 1 presents the results of DF and ADF tests for the level and first-difference of the natural logs of black-market exchange rate series. The hypothesis that each

Table 1 Integration tests for black market exchange rates

Black rate (country/years) Dickey-Fuller Augmented Dickey-Fuller

1951-1993 1951-1972 1973-1993 1951-1993 195lL1972 1973-1993

Exchange rates (in logs) Rupiah/USD (Indonesia) -2.27 -2.30 0.78 -2.50 ~ 1.93 -1.54 Ringitt/USD (Malaysia) - 1.90 -1.81 -2.61 -1.61 -1.91 -2.16 Peso/( USD) (Philippines) 0.88 -0.27 0.196 1.36 0.12 0.76 Baht/USD (Thailand) -2.32 -2.61 -2.38 -1.88 -2.13 -0.56

A Exchange rates (in logs) Rupiah/USD (Indonesia) -15.8 ~ 14.38 - 12.58 Ringitt/USD (Malaysia) - 12.69 -13.32 - 10.56 Peso/( USD) (Philippines) -13.91 - 15.61 - 10.85 Paht/USD (Thailand) - 13.63 ~ 13.23 -9.89

-5.63 -5.99 -4.98 -5.56 -5.27 -4.87 -6.43 -7.04 -4.87 -4.78 -4.66 -4.75

Fuller (1976) provides critical values of - 3.44 and -3.46 for 500 and 250 observations at the 1% level of significance, respectively. Critical values at the 5% level are -2.88 (500) and -2.87 (250).

‘Said and Dickey (1984) show that an unknown ARIMA (p&l) process can be approximated for 7 sample observations as an ARIMA (TL/3,0,0) process. ’ Increasing the number of lags beyond those suggested by the Said and Dickey ( 1984) approach does not materially alfect these or subsequent conclusions.

exchange rate series is nonstationary cannot be rejected based on the DF tests at the 5% level of significance. However, each exchange rate series is first-difference stationary on the basis of ADF tests at the 1% level of significance. indicating that a higher order of differencing is not required.” Thus, each of these series has a unit root, implying that the four currency markets are individually weak-form eficient5 Our results are consistent with those of Aggarwal (1990) and Noorbakhsh ( 1990) for these four black markets.

Cointegration analyses are performed using bivariate and multivariate currency models, following Sephton and Larsen ( I991 ) and Tronzano ( 1992) who argue that bivariate efficiency results may differ from multivariate efficiency findings and that structural instability is a major concern in cointegration-based tests of efficiency. Given that the structural breakpoint in black-market rate series is in year 1973,h a Chow test (F-test) is used to examine the stability of coefficients of cointegration regressions between the fixed and floating rate periods. The calculated F-values range from 21.27 to 879.64 under bivariate models and from 22.84 to 392.05 under multivariate models for alternative dependent variables in cointegration regressions. The critical F-values at 1% level are 4.61 and 3.02, respectively, for the two- and four-currency models. These results do not support the null hypothesis of coefficient stability, suggesting that separate cointegration regressions are appropriate for the fixed and floating rate periods.

Table 2 reports the ADF tests of cointegration for bivariate models. Six possible currency pairs exist for bivariate models with the four exchange rates under consider- ation. Given that each exchange rate can serve as a dependent variable. 12 cointegrat- ing regressions are run for ADF tests. Six lagged residual terms are included in residual-based ADF regressions following the approach of Said and Dickey ( 1984): the six terms are sufhcient to yield white noise in the second-step residuals. The ADF tests find no evidence of a cointegrating relationship in 1 li of the 12 bivariate models under the fixed rate period, and in all 12 cases under the floating rate period. Consequently, the results overwhelmingly support the notion that the four currency black markets are efficient with respect to each other irrespective of the currency exchange rate regime. Booth and Mustafa ( 1991) find similar evidence using daily exchange rates from the Turkish black markets for US dollars and West German marks during 1985-1987.

Table 3 contains the ADF tests of cointegration for three- and four-currency models. Because each exchange rate can serve as a dependent variable in cointegra-

‘These results are unatfected when a constant term is omitted or when a trend variabie is included in the ADF regressions. ‘This interpretation is attributed to Gupta (1981) and Chan et ai. (1992). ‘The exact timing of the one-time structural change in black-market exchange rates is at best unknown. Although the year 1973 marks the beginning of the flexible exchange rate system in most developed countries, the four countries under study did not switch their exchange rate policies to Roaring exchange rates in 1973. The year 1973 was arbitrarily chosen as the possible breakpoint to reflect the impacts on black-market exchange rates of floating exchange rate systems in currencies of major industrialized countries.

G. Somar 1 Jourwl qf Multinational Financial Managenzmt 7 (1997) 333-344 339

Table 2 Bivariate tests of cointegration for currency black markets

Augmented Dickey-Fuller

Currency pair (dependent variable) 1951-1972 1973-1993 Critical Value (5%)

Ringgit-Peso (Ringgit/USD) -3.92 -2.24 -3.25 (Peso/USD) -2.08 -0.37 -3.25

Ringgit-Baht (Ringgit) -3.01 -2.46 -3.25 (Baht) -3.21 -0.49 -3.25

Ringgit-Rupiah (Ringgit) -2.92 -2.12 -3.25 (Rupiah) -2.08 0.85 -3.25

PesooBaht (Peso) -0.01 -2.75 -3.25 (Baht) -3.12 -2.61 -3.25

Peso-Rupiah (Peso) -0.50 -2.03 -3.25 (Rupiah) -2.06 - 1.82 -3.25

Baht&Rupiah (Baht) -3.14 -2.83 -3.25 (Rupiah) ~ I .96 -2.43 -3.25

Critical values of the augmented Dickey-Fuller (ADF) tests come from Engle and Yoo (1987); six lagged terms are included in ADF tests. a Indicates the rejection of the null hypothesis of non-cointegration at the 5% significance level.

Table 3 Tests for cointegration using three- and four-currency models

Model (dependent variable)

Augmented Dickey-Fuller

1951-1972 1973-1993

Critical values

5% 10%

P-G-B

P-G-R

P-B-R

G-B-R

P-G-B-R

(P) (G) (B) (P) (G) (R) (P) (B) (R) (G) (B) (R) (P) (G) (B) (R)

-2.13 -2.82 -3.78 -3.51 -4.03b -2.32 -3.78 -3.51 -3.25 -3.20 -3.78 -3.51 ~ I .98 -2.83 -3.78 -3.51 - 3.80b -3.21 -3.78 -3.51 - 1.98 -2.65 -3.78 -3.51 -0.49 -2.31 -3.78 -3.51 -3.13 -3.22 -3.78 -3.51 -2.07 ~ 1.92 -3.78 -3.51 -2.99 -2.62 -3.78 -3.51 -3.21 ~ 3.72” -3.78 -3.51 -2.07 -2.89 -3.78 -3.51 - 1.76 -2.88 -4.13 -3.83 -2.99 -2.69 -4.13 -3.83 -3.20 -3.65 -4.13 -3.83 -2.09 -2.61 -4.13 -3.83

P = Peso; G = Ringgit; B = Baht; R = Rupiah. P-G-B = Peso, Ring&it and Bdht model; P-G-B-R = Peso, Ringgit, Baht and Rupiah model. Critical values for augmented Dickey-Fuller (ADF) tests come from Engle and Yoo (1987); six lagged terms are included in ADF tests. a Indicates the rejection of the null hypothesis at the 10% level of significance. b Indicates rejection at the 5% level of significance.

tion regressions, 12 ADF tests are presented for the four three-currency models, and four ADF tests are shown for the four-currency model. The ADF tests uncover no evidence of cointegration in 10 of the 12 combinations of the three-currency model under the fixed rate regime, and in 1 I of the 12 cases under the floating rate regime. Furthermore, cointegration does not exist in the four-currency model, irrespective of the choice of the dependent variable and the exchange rate regime. Thus. cointe- gration results show little sensitivity to model specification. The results suggest that the four currency black markets are efficient in a four-currency setting regardless of the exchange rate regime. Further, the markets are also generally efficient in a three- currency context. These results are broadly consistent with those derived earlier from the two-currency model. A direct comparison of OUT efhciency findings with those of earlier studies on black markets is not possible because multivariate efficiency was not examined in those studies.

The foregoing ADF tests examine only the dominant cointegratmg vector. rather than all the possible cointegrating vectors: moreover, little is known about the asymptotic distribution of the ADF tests. The Johansen ( 1988) approach rectifies such deficiencies.

Table 4 reports the Johansen cointegration tests for bivariate currency models. The tests reject the null hypothesis that there are at most zero cointegrating vectors in four of the six currency pairs under the flexible rate period, and in two of the six currency pairs under the fixed rate period. Cointegration exists for the baht and rupiah currency pair and for the baht and ringgit pair regardless of the exchange rate regime. The results suggest the existence of two cointegrating vectors for the baht and rupiah pair and one cointegrating vector for the baht and ringgit pair. The remaining two pairs which exhibit cointegration under the flexible rate regime arc the ringgit and rupiah pair and the ringgit and peso pair; the former pair yields

Table 4 Johansen tests for bivariate models

IHypothesis Test statistics Critical values

Ho: Ha: ?-- G P-B P-R G- B G R B--R 5% 10%

1951-1972 r=O r=l II.17 10.31 15.08 18.39’ 14.52 !5.50” 15.67 13.7 i’ = 0 r>l 15.48 14.47 18.84 23.72” 19.08 25.23b 19.96 17.8 i’l 1_=2 4.31 3.96 3.76 5.43 5.30 9.73b 9.24 7.5

197.3% I993 I’ = 0 r=i 20.w 13.33 12.17 17.3Ob 1 7.39b 14.11 15.67 13.7 i-=0 r21 77 w -. ._ 19.10 15.93 Xl7” 29.92b 24.20b 19.96 17.8 /.<I ,-z2 4.71 6.82 3.40 2.37 10.82b IO.31 b 9.24 7.5

P- Peso; G = Ring&; 5 = Baht: R = Rupiah; P-G = Peso and Ringgit pair. Critical vaiues come from Microfit 3.0. Pesaran and Pesaran ( 1991 ). and I’ is the number of cointegrating vectors. ’ Indicates the rejection of the null hypothesis at the 10% level of significance. bIndicates rejection at the 5% level of significance.

G. Samw / Joumal of’ Multinational Fimncicd Managrnwrzt 7 ( 1 W7j 333-344 341

two cointegrating vectors, while the latter pair displays exactly one cointegrating vector. Since the Thai currency baht is involved in the two commnon currency pairs for which the null hypothesis is rejected under both currency rate regimes, the presence of a cointegrating relationship in these pairs, which implies market ineffi- ciency, may be largely the result of behavior peculiar to Thai currency market. The specific reasons for failure of market efficiency may be established only after a detailed investigation of Thai market’s microstructure and institutional framework.

The latest bivariate findings do not support weak-form efficiency in four of the six currency pairs in these black markets under the floating rate period; these findings are at odds with the earlier bivariate results from ADF tests which support efficiency in all currency pairs under the floating rate period. The differences between the results of Johansen tests and ADF tests are less severe for the fixed exchange rate period.

Table 5 presents the Johansen cointegration tests for the three- and four-currency models. The tests reject the null hypothesis of a zero cointegrating vector for three of the four three-currency models under the floating rate regime, and for the four- currency model under both exchange rate regimes. In these cases, the tests are suggestive of the existence of exactly one cointegrating vector and thus do not

Table 5 Johansen tests for three- and four-market models

Hypothesis Test statistics Critical values

Ho: Ha: P-G-B P-G-R P-B-R G-B-R PPG-B-R 5% PPG-B-R 10% P-G-B

195lLl972 39.38 16.34

23.03 12.05 4.29

197331993 41.20” 18.21

_ 22.59” 12.69 11.52 11.78 6.59 3.69 2.91

30.79 29.92 40.50 15.37 13.62 18.22

_ 15.41 11.20 4.16

43.23 14.89 _

29~l6~ 18.25

16.30 9.79 3.83

31.49 13.23

_

22.28 12.88

5.34

44.92” 19.79 _

25.92” 13.92

6.88

59.39b 53.11 29.48 34.91 15.70 19.96 4.22 9.24

29.90b 28.13 13.77 22.00 11.48 -15.67

59.62b 53.11 20.21 34.91 12.83 19.96 2.93 9.24

29.6Sb 28.13 15.37 22.00 9.10 15.67

34.92 19.96

22.00 15.67 9.24

34.91 19.96

_ 22.00 15.67 9.24

Notes: P = Peso; G = Ringgit; B = Baht; R = Rupiah; P-G-B = Peso, Ringgit and Baht model; P-G-B-R = Peso, Ringgit, Baht and Rupiah model. Critical values come from Microfit 3.0, Pesaran and Pesaran (1991), and r is the number of cointegrating vectors. For each time period, the first four null hypotheses (r=O to r ~3) reflect the trace test, while the last three hypotheses stem from the maximum eigenvalue test. a Indicates the r-ejection of the null hypothesis at the 10% level of significance. b Indicates rejection at the 5% level of significance.

support weak-form efficiency. These results again are at variance with the earlier multivariate findings from the ADF tests which suggest no cointegration for the four-currency model and for most of the three-currency models. Hence, cointegra- tion-based efficiency tests of black market currencies are sensitive to model specifica- tion, sample period under examination, and choice of the cointegration technique. These findings for black market currencies corroborate those of Sephton and Larsen d 1991), Alexander and Johnson (1992), and Dutt ( ! 994); the latter findings, how- ever, are derived using free market currencies of industrialized countries. Our conclu- sions on the sensitivity of cointegration-based efficiency results to model specification (bivariate versus multivariate) and choice of the cointegration technique may apply as well to other black market currencies. Future research can shed light on such eficiency aspects of other currency black markets.

Overall, cointegration results using the Johansen test do not support the notion of weakform efficiency in bivariate and multivariate systems of the four black- market exchange rates under the floating exchange rate period. The same conclusion holds for the four-currency system of these black markets under the fixed exchange rate regime.

Cointegration amongst black-market exchange rates implies the existence of infor- mational market inefficiencies which might profitably be exploited. Such inefficiencies may in part be due to institutional barriers, such as constraints on currency move- ments and transactions, that hamper the interplay of currency black markets, as pointed out by Booth and Mustafa (1991). Although Indonesia and Malaysia have forcefully imposed few constraints on currency transactions since 1973. the Philippines and Thailand have lowered their strict currency controls only since 1990.’ Thus, the existence of restrictions on currency transactions in the latter two markets may have rendered the exploitation of possible arbitrage opportunities difficult.

Gointegration among time series also implies that one or more series are anticipat- ing other series (Campbell and Shiller, 1988), or that common fundamental economic forces are driving the time series into a long-run equiiibrium relationship (Engle and &anger, 8987). Such interpretations suggest that the four black-market exchange rates have a long-run relationship among themselves, so that one black- market exchange rate can be anticipated from its known past values and from known values of other three exchange rates. Consequently, actual or perceived changes in black-market rates of a subset of the four currencies could forewarn concerned financial managers to shield their portfolios from the adverse effects of expected changes in the black-market rates of remaining currencies and of anticipated adjustments in official rates that follow black market rates. Such enhanced a’bility of financial managers to manage currency exchange-rate risk should be of much value because of the lack of actively traded financial instruments to hedge the exchange-rate risk in these emerging markets.

‘See the first footnote. above, and the discussion in Section 3 concerning the level of black market activities in these currency markets over time.

a

G. Sarwar / Journal ~j’Multi11utiona1 Finmcial Management 7 (1997) 333-344 343

5. Conclusions

This paper examines the weak-form efficiency of currency black markets in Malaysia, Indonesia, Thailand and the Philippines for the period 1951L1993. Efficiency is examined for individual markets as well as in bivariate and multivariate systems using cointegration techniques.

Cointegration-based tests of efficiency are sensitive to model specification, time period examined, and choice of the cointegration technique. Overall, the evidence is inconsistent with the proposition that the four black-market exchange rates are efficient in bivariate and multivariate settings during 1973-1993. The market ineffi- ciency also exists for the four-currency system of these markets during 1951-1972. Such findings may not seem surprising given the nature of the black markets examined.

International portfolios invested in security markets of Southeast Asia are highly susceptible to currency exchange-rate risk inherent in these markets. The findings in this research, that these black market currencies are not weak-form efficient, indicate that international portfolio managers may profit from arbitrage opportunities. The evidence for the inefficient use of market information implies the presence of utility enhancing speculation opportunities in these currency black markets.

The results suggest the existence of a predictable long-run relationship among the four black-market exchange rates during the flexible exchange-rate era. Such a relationship could potentially provide useful opportunities to financial managers for managing exchange-rate risk in these markets.

Acknowledgements

I would like to thank an anonymous referee for many helpful comments which improved the paper.

References

Aggarwal, R., 1990. The nature of currency black markets: empirical test of weak and semistrong form efficiency. Int. Trade J. 5, l-23.

Alexander, C.O., Johnson, A., 1992. Are foreign exchange markets really efficient? Econ. Lett. 40,449-453. Booth, G.G., Mustafa. C., 1991. Long-run dynamics of black and official exchange rates. J. lnt. Money

Fin. IO, 392-405. Brauchli, M.W., 1995. Foreign capital holds key in Southeast Asia. Wall Street J., 23 January. Campbell, J.Y., Shiller, R.J., 1988. Interpreting cointegrdted models. J. Econ. Dyn. Control 12, 505-522. Chan, K.C., Cup, B.E., Pan, M.S., 1992. An empirical analysis of stock prices in major Asian markets

and the United States. Fin. Rev. 27, 2899307. Dutt, S.D., 1994. The foreign exchange market efficiency hypothesis: revisiting the puzzle. Econ. Lett.

45, 4599465. Engle, R.F., Granger, C.W.J., 1987. Cointegration and error correction: representation estimation, and

testing. Econometrica 55, 251-276. Engle, R.F., Yoo, B.S., 1987. Forecasting and testing in cointegrated systems. J. Econ. 35, 143-159.

Fuller, W.A., 1976. Introduct!on to Statistical Time Sel-ies. Wiley, New Yol-k. Granger, C.W.J., 1986. Developments in the study of cointegrated economic variables. Oxford Bull. Econ.

stat. 48, 213-228. Gupta, S.. 1981. A note on the cfliciency of black markets in foreign currencies. .i. Fin. 36. 705 710. Hakkio, C.S., Rush. M., 1989. MaI-ket elfciency and cointegration: an application to the stel-iing and

deutschmark exchange markets. .I. lnt. Money Fin. 8, 75-88. International Currency Analysis, 1960-1996. World (Pick’s) Currency Year-book. New York. international Monetary Fund. 1984. Directory of Tl-ade Statistics: I984 Yearbook. Washington. DC. Johansen. S.. 1988. Statistical analysis of cointegration vectors. J. Econ. Dyr?. Control 12, Z-254. Koveos, P., Seifert. B.. 1985. Purchasing power parity and black markets. Fin. Mgmt 14. 40-46. Noorbakhsh, A., 1990. Eflicient market hypothesis and the black market for foreign exchange. J Econ.

IQ, 49-54. Pesaran, M.H., Pesaran. B.. 1991. Microfit 3.0: an interactive econometric software package. Oxford

University Press. Oxford. Said. SE., Dickey. D.A.. 1984. Testing for unit roots in autoregressive-moving average models of unknown

order. Biometrika 7, 599-607. Schwert. G.W.. 1987. Erects of model specificalion on tests for unit roots in macroeconomic data.

.I. Monetary Econ. 20. 73 103. Sephton. P.S.. Larsen, W.I<., 1991. Tests ofcxchange market eficiency: fragile evidence from cointegration

tests. J. Int. Money Fin. Yl ( 10). 561-570. Tronzdno, M., 1992. Eiliciency in German and Japanese foreign exchange markets: evidence from cointc-

gration techniques. Weltwirtschaftliches Archiv 130, I 19.