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Reactions of Exchange Rates Towards Malaysia Stock Market:
Goods Market Approach and Portfolio Balanced Approach
Loh Mun Seong
Abstract: Economists and investors alike have to debated whether exchange rates
have respond to the stock market or vice versa. This study examined the reactions
of exchange rates towards Malaysia stock market during January 1981 to October
2013. This study utilize the Engle-Granger Cointegration and Error Correction
Model to determine long run relationships and speed of adjustment between all
variables. VARs Granger causality to defines causal relation between variables.
The results reveal significant negatively short run and long run associations
between exchange rates and Malaysia stock market which consensus to the Goods
Market Approach by Dornbusch and Fischer (1980) suggests exchange rates
depreciation positively affected to the stock market. The empirical results also
denotes bidirectional causality exists between Malaysia stock market and
exchange rates which consistent to the Portfolio Balanced Approach postulate
negative relationships between stock prices and exchange rates and stock prices
have an impact on exchange rates.
Keywords: Econometrics, Causality, Stock Market, Exchange Rates, Time Series
1. Introduction
For an open economy like Malaysia, the level of the exchange rate has an important
implications for the competitiveness of exports and domestic price inflation. Even more
important is the need to avoid extreme volatility in the exchange rates, which would distort
decision making in international transactions, particularly in trade and foreign investment.
The exchange rates of the Malaysia ringgit Vis-à-vis the United States dollar and Singapore
dollar was very volatile following the floating of the ringgit in July 1997 (Figure 1 and Figure
2). The commodity price shocks that occurred after the transition to a floating exchange rate
regime only served to exaggerate this volatility. Apart from the oil price shocks, economic
recession and currency speculation were the others main shocks influencing the volatility in
the exchange rates. In particular, speculative activity on the ringgit also increase in volatility
during the mid-1997s reflected the effects of several factors, the most important being the
sharp deterioration in the terms of trade that triggered the recession.
The 1997 Asian financial crisis and 2008 U.S. subprime crisis has made a strong pitch for
dynamic linkage between the stock prices and exchange rates (Figure 1 and Figure 2). During
the crisis period, the world has noticed that the emerging market collapsed due to substantial
depreciation of exchange rates as well as dramatic fall in the stock market. The start of 1998
witnessed a sharp increase in the volatility in the both foreign exchange and stock markets.
During this period, the Malaysia Ringgit depreciated further following the depreciation of the
Korean Won and Indonesian rupiah in early 1998. Meanwhile, the outflow of foreign shortterm funds during this period contributed to a progressive tightening of liquidity in the
banking system.
In 1997, central bank of Malaysia was used to influence domestic interest rates to avoid large
capital outflow and the volatile short-term capital flows of the ringgit during the Asian
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financial crisis. Under these circumstances, central bank of Malaysia introduced selective
exchange control on 1st September 1998 while the exchange rate was fixed at US$1=RM3.80.
Objective to executed fixed exchange rate regime is to stabilize the volatile environment in the
international foreign exchange and continue to promoting a stable environment for restoring
investor to revive the Malaysian economy.
Another period of exchange rate volatility occurred during July 2005 following substantial
capital flows during the period. Attempts to central bank of Malaysia to neutralize the impact
of the flows on the exchange rate and domestic liquidity did little to reduce the volatility.
However, sharp increase in volatility experienced during 2008. Such a level of volatility was
unprecedented. The movements in the exchange rates of the ringgit in 2008 were strongly
influenced by the contagion effects of developments in the region and world economic
recession, which resulted in a loss of investor confidence and large outflows of foreign shortterm capital.
Figure 1: United States dollar (USD) against Malaysia ringgit (MYR) towards Malaysia
Stock Market
Index
2,400
MYR
4.4
KLCI
USDMYR
2,000
4.0
1,600
3.6
1,200
3.2
800
2.8
400
2.4
0
2.0
1985
1990
1995
2000
2005
2010
Source: Bloomberg database, October 2013
Figure 2: Singapore dollar (SGD) against Malaysia ringgit (MYR) towards Malaysia
Stock Market
MYR
2.8
Index
2,000
1,600
KLCI
SGDMYR
2.4
1,200
2.0
800
1.6
400
1.2
0
0.8
1985
1990
1995
2000
2005
2010
Source: Bloomberg database, October 2013
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2. Literature Reviews
In this sections will review previous works done by the academicians, researchers and
policymakers on the reactions of exchange rate to the stock market. In recent times, the
relationships between exchange rate and stock prices has attracted considerable attention
among academicians, economists, policymakers and investors. Economists and investors alike
have to be debated whether exchange rates have respond to the stock market or vice versa.
Ajayi and Mougoue (1996), Sheng and Shuh (2004) and Smith (1992) demonstrated exchange
rate fluctuation have a very strong significant impact upon the stock prices of these
economies. However, Franck and Young (1972), Solnik (1987), Chow et al. (1997), Jorion
(1990, 1991), Bodnar and Gentry (1993), Bartov and Bodnar (1994), Naeem and Rasheed
(2002) signify there is no significant relationships between stock market and foreign exchange
rate. On the others hand, Kate and Fabiola (2005), Aggarwal (1981), Giovannini and Jorion
(1987) and Roll (1992) suggested that stock price and exchange rates are positively related but
Soenen and Hennigar (1988) revealed strong negative relationships between stock prices and
effective exchange rates.
In addition, Li and Huang (2009), Bahmani and Sohrabian's (1992), Chien & Cheng (2001)
found that exchange rate granger cause stock market but Pan, Fok & Lui (1999) found that the
exchange rate granger cause stock prices with less significant causal relations from stock
prices to foreign exchange. Contrary with Horobet et al. (2007), Kate and Fabiola (2005) and
Libly (1993) results provide stock prices granger cause exchange rates.
Apart from that, Granger, Huang and Yang (2000) and Mansor (2000) found the
unidirectional causality exists between stock market and exchange rate and the direction of the
causality is from stock market to exchange rates. However, Li and Huang (2009), Bahmani
and Sohrabian (1992), Chien & Cheng (2001) and Yu (1997) found that exchange rates and
stock returns have short run unidirectional causality. Besides that, Bhmani and Sohrabian
(1992) also suggested in the long run there are no causal relationship between stock prices and
exchange rates.
3. Methodologies and Empirical Results
In this study employed monthly time series data ranging from January 1981 to October 2013.
The basic linear function used in this study as stated in equation (1),
=
,
(1)
Where
proxy Kuala Lumpur Stock Exchange,
proxy United States dollar
(USD) to Malaysia ringgit (MYR) e.g. US$1=RM3.80 and
proxy Singapore dollar
(SGD) to Malaysia ringgit (MYR) e.g. SG$1=RM2.50. All data were obtained from
Bloomberg database.
3.1 Unit Root test
As a first step to determine the stationary of each of the variable, I employed the Augmented
Dickey-Fuller (ADF) test. The ADF model is given as follows:
= + t+
+
+
= + t+
+
+
= + t+
+
+
where is a pure white noise error term. The null hypothesis of the unit root test is =0. We
reject null hypothesis of the unit root if the t-statistic of is smaller than 99% Dickey-Fuller
critical value given by Mackinnon (1991).
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Table 1: ADF unit root test
Variables
Augmented Dickey Fuller (ADF)
Level, I(0)
First Difference, I(1)
KLCI
-0.6907 (0.8463)
-11.1295 (0.0000)*
USDMYR
-1.5978 (0.4828)
-17.7728 (0.0000)*
SGDMYR
-0.7971 (0.8184)
-20.3186 (0.0000)*
Note: * denotes 1% significant level. AIC is used to select the lag length.
( ) Numbers in parentheses denotes p-value
The ADF unit root test presented at Table 1 indicate we cannot reject hypothesis in level but
we can reject hypothesis in the first different based on Mackinnon's critical at 1% level of
significance because all variables are stationary.
3.2 Cointegration test (Engle-Granger test)
The Engle-Granger procedure consists of estimating the cointegrating regression by Ordinary
Least Square (OLS), obtain their residuals and applying unit roots test for the residual (Engle
& Granger, 1987). Thus, if the time series is found to be non-stationary and integrated of the
same order from the ADF test, the Engle-Granger cointegration test is performed. To obtain
the residual, the following cointegrating regressions are performed:
= +
+
+
= +
+
+
= +
+
+
and the ADF test is as follows:
=
+
+
where
include
,
or
sequence and with the null hypothesis of
: =0 (no cointegration). The value of optimal lag length p is selected by the smallest
Akaike information criterion (AIC) and Schwartz criterion (SC). Since the residual series is
calculated from a cointegrating equation, an intercept of time trend is omitted from the
equation (Enders, 1995).
Table 2: Engle-Granger Cointegration test
ADF Test Statistic
-4.3097*
1% Critical Value
-3.4468
5% Critical Value
-2.8687
10% Critical Value
-2.5706
Variable
Coefficient
T-statistic
RESIDUAL
-0.0932
-4.3097*
Note: * denote 1% significant level. AIC=10.8232 and SC=10.8434
Table 2 presented Engle-Granger Cointegration test. The result showed that all variables were
cointegrated at 1% significant level. This means that there are long run equilibrium
relationships between stock market and exchange rates. This result conversely with the
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findings of Mansor (2000) and Li and Huang (2009) found there are no long run relationships
between stock prices and foreign exchange.
3.3 Granger Representation Theorem (Engle-Granger Two-Step Error Correction Model)
Though the study adopts Ferson and Harvey (1998) Asset Pricing Model as the theoretical
framework, the Engle-Granger (1987) two-step error correction model procedure was adopted
for the estimation of the models. The models are specified as below:
= +
+
+
= +
+
+
Where ∆ denotes the first difference operation on the respective variables,
and
are the
coefficients showing the short run equilibrium relationships connecting the independent and
dependent variables,
and
are the coefficient showing the long run relationships
connecting the explanatory variables and dependent variable.
is the residual obtained
from the linear regression of the I(1) variables and lagged by one as a requirement of the
granger representation theorem. is the disturbance term for the model.
Table 3: Engle-Granger Two-Step Error Correction Model
Variables
Coefficient
T-statistic
USDMYR
-231.6488
-6.458284*
RESIDUAL
-0.052916
-2.730645*
SGDMYR
-170.7504
-2.238743**
RESIDUAL
-0.037782
-1.874858***
Note: *, ** and *** denote 1%, 5% and 10% significance level
Table 3 demonstrate Engle-Granger Two-Step Error Correction Model. The result exhibit
USDMYR had a significant negative short run and long run relationship with the stock market
at 1% significant level. Besides that, result also show SGDMYR had a significant negative
short run and long run relationship with the stock market at 5% and 10% level of significance
respectively. The long run coefficient was significant implying that stable exchange rates in
the long run would help to improve the performance of the Malaysia stock market.
The long run equilibrium coefficients had a expected a priori negative sign implying that the
model where appropriately specified (Abraham, 2012). This implies that 5.29% and 3.78% of
the short run distortions affecting the performance of Malaysia stock market could be
corrected in the long run.
3.4 VARs Granger Causality test
The VAR can be considered as a means of conducting causality tests or more specifically
Granger causality tests. By using F-test to jointly test for the significance of the lags on the
explanatory variables, this in effect tests for ‘Granger causality’ between these variables. It is
possible to have causality running from variable X to Y, but not Y to X; from Y to X, but not
X to Y and from both Y to X and X to Y. The ‘Granger causality’ test are specified as below:
= +
+
+
+
i
j
=
+
+
j
+
j
+
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Table 4: VARs Granger Causality test
Independent
Variables
KLCI
USDMYR
SGDMYR
Direction of Causality
Dependent Variables
USDMYR
SGDMYR
43.0386
36.7396
(0.0008)*
(0.0057)*
28.0997
42.9690
(0.0606)***
(0.0008)*
38.9302
50.6258
(0.0029)*
(0.0001)*
KLCI
USDMYR
KLCI
SGDMYR
USDMYR
SGDMYR
KLCI
Note: * and *** indicates 1% and 10% significance level
( ) Numbers in parentheses denotes p-value
Table 4 show VARs Granger causality test in all the variables. Based on the empirical results
shows bidirectional VARs causality exists between KLCI and USDMYR and KLCI and
SGDMYR which consensus with Granger, Huang and Yang (2000), Mansor (2000), Li and
Huang (2009), Bahmani and Sohrabian's (1992), Chien and Cheng (2001), Yu (1997),
Horobet et al. (2007), Kate and Fabiola (2005) and Libly (1993). The result also shows
bidirectional causality between USDMYR and SGDMYR.
4. Conclusion
This study examined the reactions of exchange rates towards to Malaysia stock market. The
findings of Mansor (2000) and Li and Huang (2009) found there are no long run relationships
between foreign exchanges and stock prices. But the results contrary reveal there are
significant negatively short run and long run associations between exchange rates and
Malaysia stock market which consensus to the Goods market approach by Dornbusch and
Fischer (1980) and Mao and Kao (1990) suggests exchange rates depreciation it make the
local products more attractive and demand for these exporting goods increases in the foreign
market hence the revenue is positively affected to the stock market.
The empirical results also denotes bidirectional causality exists between Malaysia stock
market and exchange rates which consensus with Granger, Huang and Yang (2000), Mansor
(2000), Li and Huang (2009), Bahmani and Sohrabian's (1992), Chien and Cheng (2001), Yu
(1997), Horobet et al. (2007), Kate and Fabiola (2005) and Libly (1993). The result seems
consistent to the Portfolio balance approach postulate a negative relationships between stock
prices and exchange rates and stock prices have an impact on exchange rates. A rise in
domestic stocks market will attract foreign investors to invest in the stock market and
diversify their portfolios. A rise in stock prices encourages investors to buy more domestic
assets simultaneously selling foreign assets to obtain domestic currency will cause domestic
currency appreciation.
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