II. Malaysia: Exports and Competitiveness1
1. In the years leading to the Asian crisis, the ringgit faced sustained upward pressure, gradually strengthening by about 15 percent in real effective terms between 1990 and mid-1997 (Chart II.1). Since the onset of the Asian financial crisis in July 1997, the ringgit has depreciated by about 23 percent in real effective terms, exceeding the rate of depreciation of most of the other currencies in the region (Chart II.2). More recently, following the imposition of selective exchange and capital controls in September 1998 and the peg to the U.S. dollar, the ringgit has remained broadly unchanged in real effective terms, while the other regional currencies have continued to strengthen. Against the background of a rapid—albeit tentative and still not broad based—recovery in selected export sectors in Malaysia (primarily in electronics and transport equipment), the result has been a growing perception by market participants that the ringgit has become “undervalued.” Questions of over- or undervaluation of currencies are customarily addressed in the broad context of price competitiveness of exports.
CHART II.1MALAYSIA: EXCHANGE RATE DEVELOPMENTS, 1990–99
Sources: Information Notice System; IFS.
CHART II.2ASIA CRISIS COUNTRIES: EXCHANGE RATE DELOPMENTS AND EXPORT PERFORMANCE SINCE JULY 1997
Sources: Information Notice System; APD database.
1/ Three-month moving average based on US$ values.
2/ Indonesia data exclude oil/gas trade.
2. This chapter addresses the following question: Have currency movements since July 1997 had an impact on Malaysia’s competitiveness and on the outlook for Malaysia’s exports? In particular, the chapter attempts to quantify the extent to which the sharp depreciation of the real effective rate of the ringgit since mid-1997 represents a gain in competitiveness, and the extent to which it reflects a decline in the underlying equilibrium real effective exchange rate (REER). The chapter also covers the period prior to the recent crisis by examining the factors behind the real effective appreciation of the ringgit between 1990 and mid-1997, and by assessing the implications for competitiveness.
3. Assessment of developments in competitiveness is better made when it relies on a broad range of indicators. Recognizing that no single indicator offers a complete and satisfactory assessment of competitiveness, and that, in examining export competitiveness, price-based competitiveness indicators should not be the exclusive focus of the analysis, this chapter assesses international competitiveness in the context of a broader range of considerations from both a technical and econometric point of view. To put recent movements of the ringgit in perspective, Section B provides a historical overview of developments in selected external indicators as well as in Malaysia’s trade and exchange regimes. Section C reviews alternative measures of competitiveness. Section D assesses recent levels of the ringgit by estimating an equilibrium REER, and by deriving the REER consistent with “appropriate” current account positions for Malaysia. Section E examines the likely impact on Malaysia’s exports of recent exchange rate developments. Finally, Section F contains concluding remarks and discusses policy issues.
4. The main results can be summarized as follows:
- Two-thirds of the decline in the ringgit in real effective terms since July 1997 appears to represent gains in price competitiveness, with the remaining third appearing to reflect a shift in the equilibrium REER.
- The ringgit appears to have been undervalued by about 16 percent in 1998. The results, however, should be interpreted with considerable caution given that they are based on backward-looking econometric assessment, which may not fully capture more recent developments in competitiveness.
- Malaysia’s equilibrium REER appears to be responsive to external influences (especially the country’s terms of trade), reflecting the great degree of openness of the Malaysian economy.
- Movements in the REER of the ringgit in the years preceding the crisis reflected to a significant extent the impact of the growing integration of Malaysia with the rest of the world. This integration was manifested in surging capital inflows and fast-rising productivity gains as a result of exposure to external competition (the Balassa-Samuelson effect), which have allowed Malaysia to exploit its competitive advantages.2
- The REER of the ringgit will likely need to appreciate substantially over the medium term to bring the current account balance in line with its medium-run fundamentals.
B. Historical Perspective
Influences on the REER
5. Movements in the REER in the first half of the 1980s reflected primarily the effects of an expansionary fiscal stance in response to a substantial deterioration in the country’s terms of trade. Malaysia was hit by a combination of external shocks in the early 1980s: a drastic deterioration in its terms of trade, primarily in commodity prices, as well as a decline in external demand reflecting a recession in industrialized countries. In response, the Malaysian authorities sought by adopting expansionary fiscal policies to insulate the domestic economy from what was perceived as temporary adverse developments in the external environment. The growing fiscal deficits were financed to a significant extent from external sources to avoid inflationary bank financing. The ensuing inflows of external capital exerted an upward pressure on the ringgit and led to a substantial buildup of external liabilities.3 During the early 1980s, the ringgit was kept stable vis-à-vis the U.S. dollar, which was appreciating against most other currencies. At the same time, government expenditure in the infrastructure sector and a boom in construction activity contributed to an expansion in the nontradables sector that led to price increases, which also contributed to the real appreciation of the ringgit.
6. The authorities embarked on a stabilization program in 1984, when it became evident that the deterioration in the terms of trade was permanent and that the domestic and external imbalances were becoming unsustainable.4 A program of fiscal consolidation was implemented. The exchange rate of the ringgit was allowed to depreciate, and, coupled with the depreciation of the U.S. dollar following the Plaza Accord in 1985, the ringgit fell sharply in nominal effective terms over the ensuing period. With inflation moderating in response to the stabilization effort, the REER also declined sharply. In 1985, the economy was hit by a recession, reflecting a new terms-of-trade shock, and, to a lesser extent, the fiscal contraction.
7. External sector policies also played a role—albeit a relatively small one—in maintaining a strong ringgit in real effective terms in the early 1980s. In the 1970s, and to a lesser extend in the early 1980s, external sector policies were used to promote the objective of industrialization through import substitution. With the resulting subsidization of imports, quantitative restrictions on imports and high import tariffs were maintained to prevent substantial balance of payments deficits. Import restrictions were accompanied by selective price and capital controls. The lack of a more realistic alignment of the exchange rate contributed to distortions in the relationship between domestic and foreign prices that penalized exports.
Exchange and trade regime
8. In the early 1980s, the exchange rate of the ringgit was determined on the basis of a composite basket of the currencies of countries that were significant trading partners with Malaysia. The ringgit was nonetheless not rigidly pegged to the basket. The BNM allowed limited fluctuations relative to the basket, and intervened only to prevent disorderly fluctuations in the exchange rate. BNM intervention intensified in the early 1980s in an effort to mitigate the destabilizing effects of foreign capital inflows, which were partly used to finance the fiscal deficit.
9. In the mid-1980s, a gradual liberalization of the trade and exchange regimes began—largely in an effort to boost the export-oriented sector which was dealing with the effects of the recession in 1985—and Malaysia eventually shifted its emphasis of industrialization strategy from import substitution to export orientation.5 By the late 1980s, Malaysia had adopted a trade policy intended to provide a strong base for improving the competitiveness of its exports, with an emphasis on the liberalization of essential imports of capital goods and intermediate inputs. To support this objective, the ringgit was allowed to depreciate sharply (in nominal and real terms) beginning in September 1984 (Chart II.3).6 With conservative macroeconomic policies in place since 1984, the driving force behind movements in the REER has been the nominal depreciation of the ringgit rather than higher domestic price increases relative to partner countries. The policy of bringing the ringgit to lower levels contributed to rapid export growth (see Chart II.3), which in turn helped expand the tradable-goods sector.7
CHART II.3MALAYSIA: EFFECTIVE EXCHANGE RATES, EXPORTS AND THE CURRENT ACCOUNT, 1980–98
Sources: IMF, Information Notice System; WEO; and staff estimates.
1/ Effective exchange rates from the IMF’s Information Notice System.
2/ Derived from WEO partner-country import prices.
10. Malaysia’s outward orientation expanded during the 1990s. Trade policy focused on across-the-board cuts of import tariffs in a phased manner, and on the gradual elimination of nontariff barriers, in line with Malaysia’s commitment under the WTO.8 A surge in private capital inflows—particularly portfolio and foreign direct investment—that took place in the early part of the 1990s led to pressure on the ringgit to appreciate and to a substantial buildup in reserves. Reflecting the adjustment in the exchange rate that took place in the 1980s and the more open trade and exchange regimes, Malaysia’s share in world merchandise exports rose from ¾ percent in 1990 to over 2 percent in 1997.
C. Alternative Measures of Competitiveness
11. The IMF’s Information Notice System (INS) calculations of Malaysia’s REER point in the direction of a likely gain in competitiveness since the onset of the financial crisis in Asia in July 1997. Despite the significant depreciation of other Asian currencies, the depreciation of the ringgit vis-à-vis the dollar over the same period has brought the REER of the ringgit to a much lower level than prior to the crisis.
12. However, the INS calculations of Malaysia’s effective exchange rates are not without shortcomings.9 Although they account for third-market competition, they rely on a weighting scheme that takes into account trade statistics over the period 1988–90, which may not accurately reflect Malaysia’s current trade patterns.10 In particular, the outdated weights may not fully account for those changes in competitiveness that manifest themselves primarily in intensifying third-market competition and reallocation of market shares. In fact, during periods of rapid structural changes and reallocation of market shares—such as the one experienced since July 1997—INS calculations may not fully capture recent developments in competitiveness. Indeed, gains in third markets may have played a role in the recent pickup in Malaysia’s exports, but they may not be captured adequately in the INS weights.11 Despite this shortcoming, the INS REER is used throughout this chapter mainly because of the absence of recent information on competition in third markets. Motivated by this shortcoming, this section looks at alternative measures of competitiveness.
REER indices based on CPI, PPI, and export unit values
13. In order to assess competitiveness based on a broader set of indicators and to detect any Balassa-Samuelson effects, the following REER measures (which are based on different price indices) are compared: the CPI-based REER computed by INS; a PPI-based REER; and an REER based on relative export unit values. The rationale for using producer prices in the computation of REERs is that they contain a larger traded goods component than consumer prices, and are not as much influenced by price controls and indirect taxes.12 Similarly, export unit values capture a large component of trade in goods.13
14. It appears that the real appreciation of the ringgit between 1990 and mid-1997 (based on INS calculations) may understate the loss of export competitiveness. The divergent trends in the CPI-based REER, on the one hand, and the PPI-based REER and the REER based on relative export unit values, on the other (Chart II.4), point to the direction of relatively slower productivity growth in Malaysia’s tradable goods sector than in other countries during the 1990s (an inverse Balassa-Samuelson effect).14 As a result, relative export prices have risen more rapidly relative to broader price indices in Malaysia than elsewhere, but the trend was reversed in 1998.
CHART II.4MALAYSIA: REAL EFFECTIVE EXCHANGE RATES INDICES, 1980–98
Sources: International Financial Statistics and Information Notice System.
D. The Level of the Ringgit
15. The depreciation of the ringgit in real effective terms since mid-1997 and the lack of an upward adjustment in recent months—in contrast to the exchange rates of the other Asian crisis countries—have been cited as factors behind the recent pickup in Malaysia’s exports in volume terms. The task of isolating the effect of the REER from all other influences on exports becomes particularly difficult in an environment of abrupt realignments of exchange rates and market shares. The task can be further complicated when the performance of exports reflects nonprice factors. Looking back, this task is also complicated by the gradual liberalization of the trade and exchange regimes that has taken place during the last two decades.
Long-run equilibrium REER derived from its fundamental determinants
16. Against this background, this section examines whether the ringgit was undervalued in 1998 by measuring the extent of its misalignment in real effective terms in relation to an estimated equilibrium REER.15The long-run cointegrating relationship between the REER and its determinants was estimated to assess the extent to which the depreciation of the ringgit since mid-1997 has been an equilibrium phenomenon, and to measure the extent of misalignment (if any) of the ringgit in 1998. Regressions using annual data for 1979–98 found an empirical long-run link between Malaysia’s REER and the following fundamental variables:16 (i) trade policy (proxied by the sum of exports and imports over GDP), capturing the impact on Malaysia’s REER of the shifts in the trade regime as well as the growing openness of the economy;17 (ii) the external demand environment (proxied by Malaysia’s terms of trade); (iii) capital inflows; and (iv) domestic supply factors (productivity differential between the tradable and nontradable goods sectors compared to partner countries). The statistical evidence suggests that: (i) two-thirds of the depreciation of the ringgit since 1997 appears to have resulted in a gain in competitiveness, with the remaining third being an equilibrium phenomenon reflecting movements in economic fundamentals; and (ii) the ringgit was undervalued by about 16 percent in 1998 (Chart II.5).
CHART II.5MALAYSIA: EQUILIBRIUM REAL EFFECTIVE EXCHANGE RATE AND DEGREE OF MISALIGNMENT, 1980–98
Sources: IMF, Information Notice System; and Fund staff estimates.
1/ Defined as the deviation of the actual REER from its estimated equilibrium level.
17. The patterns of misalignment capture reasonably well the two episodes of turbulence in the foreign exchange market over the last two decades; the sharp depreciation of the ringgit in 1986, and again from mid-1997 to September 1998. Moreover, in most instances the misalignment of the ringgit has been confined within 6 percentage points around its equilibrium value.18
18. With the REER of the ringgit being currently broadly at the level of September 1998 (see Chart II.2), and with the equilibrium REER typically showing a smaller variation than the actual REER, the implication is that currently the ringgit could be undervalued by a similar order of magnitude.19 Against the background of a rebound in the REER of other Asian currencies since mid-1998, the pegging of the ringgit in September 1998 has prevented the exchange rate from correcting the overshooting that has taken place since the beginning of the crisis.
Medium-run REER derived from macroeconomic balances
19. Deviations of exchange rates from their long-run equilibrium levels do not always reflect exchange rate misalignments; they could also reflect cyclical factors or inappropriate policies. As a complement to the methodology of assessing the exchange rate of the ringgit based on an equilibrium REER derived from its fundamental determinants, the macroeconomic balance methodology is used in this section to increase the degree of confidence in the findings. The macroeconomic balance methodology allows quantitative assessments of exchange rates when viewed against benchmark current account positions.20
20. Assessments based on this methodology involve four steps. First, the calculation of an “underlying current account position,” which is the current account balance that would arise when domestic and foreign output gaps fall to zero and the lagged effects of past REER movements have been folly realized. Second, the calculation of an “equilibrium current account” (the saving-investment norm), defined as the current account balance that in the medium run would be consistent with the fundamental determinants of saving and investment. Third, the use of elasticity estimates to calculate how much the REER would have to change (other things equal) to close the gap between the underlying current account position, and the equilibrium current account from the saving-investment norm. Finally, assessment of the degree of currency misalignment based on the required change in the REER derived in step three.21
21. The results suggest that the Malaysian economy was in significant disequilibrium in 1998, with a large current account surplus and a possibly undervalued exchange rate. The estimated degree of undervaluation of the ringgit was about 19 percent (Chart II.6), implying that either other variables (including policies) will have to change or, other things constant, the REER of the ringgit will have to appreciate by this amount over the medium term, to bring the current account balance in line with its medium-run fundamentals. The estimated pattern of misalignment of the ringgit is broadly similar to the one estimated using the long-run cointegrating relationship between the REER and its fundamental determinants.
CHART II.6MALAYSIA: CURRENT ACCOUNT BALANCE AND MISALIGNMENT, AND DEGREE OF REER MISALIGNMENT, 1985–98
Sources: Information provided by the Malaysian authorities; and Fund staff estimates and projections.
1/ Defined as the difference (in percent of GDP) between the underlying current account and the equilibrium current account derived from savings-investment norms.
2/ Defined as the (negative of the) change in the REER required to equate the underlying current account position with the equilibrium current account.
22. These results should be interpreted with considerable caution given that the margin of error is substantially higher than in the previous methodology, owing to a large degree of uncertainty about output gaps, equation specifications and estimated parameters that underlie the saving-investment norms, as well as assumptions on model specifications and lag structures that may not be fully supported by the data. With these limitations in mind, the results nonetheless offer support to the earlier finding that the ringgit was likely significantly undervalued in 1998, thus allowing a higher degree of confidence in the judgement about the level of the ringgit in 1998.
23. Looking ahead, Malaysia’s equilibrium current account will likely remain in modest deficit over the medium term. Such a medium term path for the current account is typical for a country at Malaysia’s level of development. Under the assumption that output gaps (both domestic and foreign) gradually close over the medium term, the appreciation of the REER required to restore macroeconomic balances over the period may be substantial.
E. Impact on Export Performance
24. The likely impact on Malaysia’s exports of the undervaluation of the ringgit appears to be significant over the long run. Using available estimates of exchange-rate export elasticities,22 if the undervaluation of the ringgit persists at the estimated level of just over 16 percent, it would imply a small immediate pickup in export volumes (by only 1 percent), but a more substantial increase (by 9 percent) over the longer run, relative to where the export volumes would otherwise have been.23 When put in the proper context of a relatively high ratio of exports to GDP for Malaysia, the overall impact on activity of such a pickup in export volumes (even after accounting for the high import content of exports), could be very substantial, other things constant.
25. Third-market effects of currency depreciations are notoriously difficult to quantify. An attempt was made to identify countries in the region that Malaysia could challenge with increased competition in third markets. To this end, the composition of Malaysia’s exports was compared against the composition of exports of a number of competitor countries in the region, including Indonesia, Korea, the Philippines, and Thailand. In particular, detailed trade data (based on 3-digit Standard International Trade Classification data) were used to compute the correlation between the commodity shares of the total exports of Malaysia and those of each of these countries. The magnitude of the estimated correlation coefficient—which in effect measures similarities in the structure of exports—was then used as an indication of the degree of competition for exports between Malaysia and these countries. The analysis suggests that Malaysia competes in the same commodities primarily with Singapore, Taiwan Province of China, Thailand, the Philippines, and Korea. In view of regional currency movements since mid-1997, and assuming no major regional currency realignments in the near term, it appears that Malaysia could gain market shares at the expense of mainly Thailand, the Philippines, and Korea.
F. Concluding Remarks and Policy Implications
26. This chapter examined the impact of recent currency movements in the region on Malaysia’s competitiveness and the outlook for exports. A number of alternative indicators of competitiveness as well as methodologies were used to gain a better understanding of developments and to increase confidence in the findings.
27. The results suggest that the ringgit was undervalued by about 16 percent in 1998. Based on available empirical estimates of export elasticities, the undervaluation of the ringgit in real effective terms in 1998 could potentially have a substantial impact on export performance if the undervaluation persists over a long period. However, the results, based on a backward-looking assessment, should be interpreted with caution given the inherent imprecision of econometric estimates, the reliance on a single indicator of competitiveness (namely a CPI-based REER), and the fact that more recent events that could have affected competitiveness—most prominently developments in third-market competition—are not yet fully captured in the data.
28. The empirical evidence confirms that the modest appreciation of the ringgit in real effective terms between 1990 and 1997 was to a great extent an equilibrium phenomenon reflecting movements in economic fundamentals, namely trade policy (the degree of external openness), the external environment (the country’s terms of trade), capital inflows, and domestic supply factors.
29. External sector variables are by the far the most important determinants of Malaysia’s REER: in decreasing order of importance, the external environment, capital inflows, and trade policy are the three most important determinants of movements in Malaysia’s equilibrium REER. Fiscal policy was not found to belong in the long-run cointegrating relationship between the REER and its determinants. While this result may seem to downplay the role fiscal expansion played in the appreciation of the ringgit in the early 1980s, it is nonetheless consistent with the more prudent use of fiscal policy since then. As a result, the estimation was not able to establish a statistically significant influence of fiscal policy on the REER over the entire period examined.24
30. The econometric results provide sufficient support to the hypothesis of Balassa-Samuelson effects over the entire sample period.25 However, the limited degrees of freedom in the estimated equation did not allow direct testing only of the 1990s, where there are indications of the effect dissipating (as mentioned in Section C; see also Annex I). The results suggest that productivity gains in the tradable goods sector stemming from the structural reforms implemented over the past decades exerted an upward influence on Malaysia’s REER, and may have played a role in the appreciation of the REER in the 1990s.
31. The likely response of Malaysian exports to the estimated undervaluation of the ringgit could be significant over the long run. Maintaining the peg to the U.S. dollar at the current rate—and in the absence of major realignments in the exchange rate of the U.S. dollar against other currencies—could generate a robust response of exports in the long run, other things constant. While an export-led recovery (or an export recovery complementing the effects of the fiscal stimulus planned for 1999) would be desirable in the current circumstances, there are significant risks to allowing the undervaluation to persist past the point of providing an initial boost to exports.26 Indeed, a surge of demand for Malaysia’s exports could quickly lead to economy-wide price pressures given the great degree of openness of the country.
32. The results have important implications for exchange rate policy. Competitiveness gains stemming from undervalued currencies tend to be short-lived and, in the absence of adjustment in the exchange rate, are followed by domestic price pressures. Thus, failure to adjust the peg at the first signs of a strong and broad-based recovery in the export sector could potentially lead to an erosion of competitiveness through adjustments in domestic prices. While the current undervaluation of the ringgit may provide a welcome boost to exports, the large exposure of the economy to the external sector would necessitate, sooner rather than later, an adjustment of the peg or a move to a more flexible exchange rate. The adjustment of the exchange rate could prevent either an upward spiral in domestic prices or the need for tighter fiscal and monetary policies to rein in inflationary pressures, thus putting at risk prospects for sustained robust growth. Persistent undervaluation of the ringgit could also invite complacent behavior with adverse long-term implications, as incentives to improve competitiveness through productivity-enhancing measures remain weak.
33. Given that the competitive edge from an undervalued exchange rate cannot be sustained for long, a policy of promoting productivity-enhancing measures should lead efforts to improve the competitiveness of Malaysia’s exports. Such measures could include programs for investments and training in new technologies, and incentives to shift the composition of Malaysia’s exports in favor of higher value-added products. These measures would allow innovation in product design and production methods that would help enhance competitiveness. Acknowledging the importance of such measures, the Malaysian authorities have provided, among other things, incentives to improve skills and to promote research and development and the use of advanced technologies. Improvements in competitiveness could also be achieved through other nonprice factors, including by addressing any short-term structural factors affecting export performance, such as problems in credit availability to viable export activities. Indeed, during the crisis, small- and medium-scale export industries found it particularly difficult to access credit—or had their credit lines cut—as banks were reassessing risks in their portfolios.
This chapter was prepared by Dimitri Tzanninis (ext. 34114) who is available to answer questions.
The Balassa-Samuelson effect describes the process by which higher productivity growth in the tradable- than in the nontradable-goods sector (relative to partner countries) eventually leads to wage and price increases in the nontradable goods sector, and to a real appreciation of the currency. Thus, a seemingly paradoxical situation could arise, in which a real appreciation of the currency may in fact reflect gains in a country’s competitive position. This situation points directly to the limitations of REERs based on price indices that include nontradables, such as the consumer price index (CPI) or the producer price index (PPI). The issues are explored more extensively in Section C.
The federal government’s foreign liabilities increased sharply from RM 4.9 billion (US$2.2 billion) in 1980 to RM 20.8 billion (US$8.6 billion) in 1984.
The devaluation of the currencies of Thailand, the Philippines, and Indonesia in 1983–84 prompted bouts of speculative attacks on the ringgit. With the attacks intensifying in October 1984, Bank Negara Malaysia (BNM) abandoned the policy of maintaining relative stability of the ringgit against the U.S. dollar (and the Singapore dollar) and allowed a greater role for market forces in the determination of the exchange rate.
In fact, the export-orientation of Malaysia’s manufacturing sector had begun in the 1970s, responding to incentives—gradually put in place since 1968—designed to promote export-led industrialization.
The rate of depreciation peaked in 1986, when the ringgit was allowed to depreciate by about 14 percent against its composite basket.
However, it is difficult to detect any Balassa-Samuelson effects during the 1980s due to the overvaluation of the currency and the prevailing price and trade controls.
The effective import-weighted tariff rate was lowered from 11.2 percent in 1992 to 9.4 percent in 1997.
For a description of the methodology and the data used to compute the effective exchange rate indices in the INS, see Desruelle and Zanello (1997).
There has been a gradual increase in the share of Asian countries in Malaysia’s exports during the 1990s. The IMF’s Direction of Trade Statistics point to an increase of the share of all Asian countries in Malaysia’s exports from an average of 40 percent in 1985–89 to 47 percent in 1996, with the trend abruptly interrupted in 1997 reflecting falling exports to the countries primarily affected by the financial crisis. In 1997, exports to the rest of Asia declined sharply to 26 percent of Malaysia’s exports, while the share of imports from those countries remained broadly unchanged from previous years at around 35 percent of total imports.
Malaysia’s exports rebounded strongly in volume terms in the last quarter of 1998, rising by about 15 percent over the same quarter of the previous year. Such strong growth is likely to reflect mainly gains in marker shares rather than increased partner demand, as evidenced by the more sluggish performance of exports from the rest of the Asian crisis countries (see Chart II.2).
Administered and supervised prices account for about 15 percent of the weights in Malaysia’s CPI basket.
Nevertheless, Chart II.4 suggests that the effect might have been present in the second half of the 1980s, when more drastic changes in Malaysia’s trade and exchange regimes took place. Such an effect is more likely to be important when examining countries at different levels of development, such as Malaysia and its major trading partners (the G-7 countries, which account for close to 60 percent of the INS weights). The existence of the Balassa-Samuelson effect over the entire sample period is directly tested in Section D.
The measurement of the extent of misalignment is complicated by the fact that the “equilibrium” REER is an unobservable variable. In this chapter, misalignment is defined as the deviation (in percent) of the actual REER from its estimated equilibrium level. In interpreting the results, it is worthwhile noting that the notion of equilibrium used refers to a statistical estimate of a macroeconomic relationship rather than a description of an unobservable macroeconomic balance as defined by economic theory.
Lack of higher frequency data for a number of explanatory variables for Malaysia’s REER prevented the empirical analysis from assessing short-run movements of the REER. See Annex I for a detailed discussion of the statistical tests and the estimation results.
Malaysia’s merchandise exports rose from 49 percent of GDP in 1985 to 101 percent of GDP in 1998; merchandise imports rose from 37 percent of GDP to 76 percent of GDP over the same period. Part of the rise in imports has reflected an increase in the import intensity of exports.
The estimated undervaluation in 1998 is large relative to past deviations of the REER from its equilibrium (with the exception of 1986, when the ringgit was allowed to depreciate sharply to help correct external imbalances). Historically, misalignments of the ringgit have tended to correct themselves within two to three years.
Estimates of the degree of misalignment need to be interpreted cautiously, given the inherent imprecision of (backward-looking) econometric estimates, and the limitations of price-based indicators, which cannot capture the impact on competitiveness of nonprice factors.
For a description of the macroeconomic balance methodology see Isard and Mussa (1998). The methodology is often called the CGER methodology after the Coordinating Group on Exchange Rates.
Annex II presents a detailed discussion of the statistical tests and the estimation results using the macroeconomic balance approach.
Using an error-correction model on annual data, Bayoumi (1996) estimated the following elasticities of Malaysia’s exports with respect to the REER: -0.06 in the short run and -0.53 in the long run.
Standard trade models assume that it takes, on average, three years for export volumes to respond fully to changes in the REER.
In contrast, Montiel (1997) found that fiscal policy (proxied by the ratio of government investment to GDP) had a statistically significant influence on Malaysia’s long-run equilibrium REER. However, the direction of influence was counterintuitive as increases in government investment were associated with equilibrium appreciation.
Chinn (1997) provides statistical evidence in support of the Balassa-Samuelson hypothesis for Malaysia. Montiel (1997) tested the same hypothesis with a time trend and argued that the observed path of Malaysia’s REER could be consistent with the Balassa-Samuelson effect.
Admittedly, the peg of the ringgit to the U.S. dollar in September 1998 was not intended to provide a competitive advantage for Malaysian exports. Nonetheless, since the establishment of the peg, the ringgit has become more competitive compared to the currencies of the countries in the region.
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1. This annex describes a model of Malaysia’s long-run equilibrium REER based on annual data for 1979–98, and examines the issue of misalignment of the ringgit from an econometric point of view.
2. A number of factors are expected to affect the REER in the long run. Taking into account data availability, the treatment of these factors in this chapter is discussed below:
- Trade policy is proxied by the sum of exports and imports over GDP (the degree of openness). Import controls and high tariff barriers can support an overvalued exchange rate.1 Downward adjustments of the REER to more realistic levels have been accompanied by relaxation of controls over imports (especially of imports of essential capital goods and intermediate inputs). The relaxation of controls promotes export competitiveness and leads to a rise in both imports and exports.
- The external environment is proxied by Malaysia’s terms of trade (defined as the ratio of Malaysia’s export unit values to import unit values derived from the WEO database). An improvement in the terms of trade (shown as a rise in the ratio) would have a positive impact on the current account and would lead to an appreciation of the REER.
- Domestic supply factors are defined as the productivity differential between the tradable and nontradable goods sectors for Malaysia and its major trading partners proxied by per capita real growth in manufacturing less per capita real growth in services. This term measures the Balassa-Samuelson effect: that is, higher productivity growth in the tradable- than in the nontradable-goods sector (relative to partner countries) eventually leads to rises in wages and prices in the nontradable goods sector, and to a real appreciation of the REER.
- Fiscal policy is defined as the ratio of government consumption to GDP. Higher government consumption relative to GDP would put upward pressure on the price of nontraded goods, leading to an appreciation of the REER. Implicit in this argument is the assumption that government spending is concentrated on nontraded goods.
- Capital inflows are defined as the ratio to GDP of the sum of the following: net direct investment in Malaysia; net inflows of portfolio investment; net increase in other investment; and errors and omissions.2 Higher capital inflows would exert an upward pressure on the REER.
3. Estimation of the long-run cointegrating relationship between Malaysia’s REER and its fundamental determinants is complicated by a number of factors: (i) the low frequency of data for some of the explanatory variables prescribed by theory complicates analysis of policy variables and short-term factors and reduces the precision of econometric estimates due to the smaller number of degrees of freedom; (ii) the existence of nonprice controls for the early part of the sample period lowers the information content of the data; (iii) there are no available data on sectoral productivity that could potentially help explain a significant part of the appreciation of the ringgit in real terms between 1990 and mid-1997; and (iv) the gradual change in the exchange and trade regimes over the last two decades complicates the identification of structural breaks in the data and weakens the relation between policy variables and the exchange rate.
4. The long-run determinants of Malaysia’s REER were estimated using annual data over 1979–98 for: trade policy (proxied by the sum of exports and imports over GDP; all expressed in U.S. dollars); a proxy for the external environment (Malaysia’s terms of trade obtained from the WEO database); net capital inflows as a share of GDP (from IFS, expressed in U.S. dollars); and domestic supply factors (productivity differential between the tradable and nontradable goods sectors for Malaysia and the U.S.—representing its trading partners—proxied by per capita real growth in manufacturing less per capita real growth in services).3 All data were expressed in natural logarithms, except for the variables for net capital inflows and the domestic supply factors, which included negative values.
5. To determine the appropriate estimation procedure, tests for nonstationarity of the above variables were carried out using the Augmented Dickey-Fuller (ADF) method, which looks for the presence of unit roots in the series. Table 1 lists the up-to-third-order ADF statistics for the REER, trade policy (EXIM), terms of trade (TOT), net capital inflows (CAP), and domestic supply factors (B-S). According to the tests, the null hypothesis of nonstationarity—that is, each variable has a unit root, or equivalently, is integrated of order one: I(1)—cannot be rejected for any of the variables. All variables are thus stationary in first differences, and cointegration analysis among the level variables is required.
6. The Johansen procedure is used for the cointegration analysis.4 The Johansen procedure is a full information maximum likelihood estimate for vector autoregressive systems, and, as such, it is not concerned about the endogeneity of the explanatory variables. Nonetheless, the procedure imposes a heavy toll on the degrees of freedom and on the precision of the econometric estimates in small samples because it uses a lag structure. The procedure searches for the existence of one or more long-run cointegrating relationships between the selected variables. Table 2 reports the statistics from the Johansen procedure. Only the final specification is reported. The procedure found evidence of the following long-run relationship between the fundamental variables:5
|λ-max 1/||Trace 1/|
|Standardized feedback coefficients|
Double asterisks denote significant test statistics at the 1 percent level.
Double asterisks denote significant test statistics at the 1 percent level.
7. The estimation found evidence of a long-run cointegrating relationship between Malaysia’s REER and its fundamental determinants. All estimated coefficients have the anticipated signs. The coefficient for the terms of trade is relatively large, reflecting the large degree of openness of the Malaysian economy.6 The feedback coefficients suggest a relatively slow adjustment from disequilibrium (indeed, Chart II.5 reveals that it takes on average two to three years for a misalignment to correct itself).
8. The estimated equation is used to derive the equilibrium REER. Misalignment is then defined as the difference between the actual REER and the anti-logarithm of the fitted value of the REER (that is, the equilibrium REER) derived from the equation above, expressed in percent of the equilibrium REER. Chart II.5 reveals that only one-third of the depreciation of the ringgit in real terms since mid-1997 has been an equilibrium phenomenon. The estimated misalignment of the ringgit in 1998 was just over 16 percent.7
1. This section describes the first three steps involved in the macroeconomic balance approach; namely, calculation of: (i) the underlying current account; (ii) the equilibrium current account from saving-investment norms; and (iii) the change in Malaysia’s REER required to equilibrate over the medium term the underlying current account and the equilibrium current account.
Underlying current account
2. A reduced-form equation for the current account (based on a standard trade model) was estimated and subsequently used to derive the underlying current account for Malaysia and the elasticities required in step (iii) above. Using annual data for 1979–98, the following equation was estimated:1
where: M, X, and Y are the nominal domestic-currency values of imports, exports, and GDP, respectively; E is the weighted average of past and present REERs (0.6Rt+0.25Rt-1+0.15Rt-2), and R is the logarithm of the REER defined so that an increase is an appreciation; YG is the logarithm of the ratio of real output to potential output for Malaysia, with potential output estimated using a Hodrick-Prescott filter; and YGF is a trade-weighted average of output gaps for Malaysia’s largest trading partners accounting for two-thirds of Malaysia’s trade (namely, Singapore, the U.S., Japan, Germany, and the U.K.), with output gaps for partner countries obtained from the IMF’s WEO database.2
3. The results suggest that Malaysia’s underlying current account balance was substantially larger (by 4½ percent of GDP) than the actual current account balance in 1998, indicating the possibility of serious misalignment of the exchange rate (see Chart II.6). The results also suggest that Malaysia’s current account is more responsive to foreign rather then domestic output gaps. This may reflect the large import intensity of exports, which may tend to reduce the sensitivity of imports to domestic output gaps.
Equilibrium current account
4. This section describes the calculation of an equilibrium current account balance, defined to be the balance that in the medium-run would be consistent with fundamental determinants of saving and investment. Estimates of the equilibrium current account were based on parameter estimates presented in Debelle and Faruqee (1996), with the constant adjusted to set the average error over the sample period to zero. Annual data for 1985–98 were used, obtained from the IMF’s WEO and World Bank databases. The equilibrium current account balance for Malaysia was defined as:
where CAEQM is the equilibrium current account (expressed in percent of GDP); GGB is the general government balance; DEP is the age-dependency ratio; and YPC and YPCSQ are income per capita relative to the U.S., and its squared value, respectively.
Estimated degree of REER misalignment
5. Following Bayoumi and Faruqee (1998), the term –[0.1886(M/Y) –0.1896(X/Y)] governs the long-run volume effects of REER changes, and the separate term (M/Y)—after having imposed a long-run elasticity of one for import volumes—expresses the price effect of an exchange rate change in the first year. After substituting the values of (M/Y) and (X/Y) in the chosen base year 1998, the resulting elasticity (in absolute value) of the current account with respect to REER changes is ε = 1.05, implying that a 10 percent appreciation of the REER would lower the underlying current account by 10.5 percent of GDP over the medium term, relative to the base year current account.
6. The change in the REER required to equilibrate the underlying current account and the equilibrium current account is then derived from the expression (CAUND – CAEQM)/ε, where ε is the elasticity described above. After substituting the values for CAUND = 17.3, CAEQM = –2.5, and ε = 1.05 in the base year, the appreciation of the REER over the medium-term required to equilibrate the underlying current account and the equilibrium current account is 18.8 percent, other things constant.
Reliable data on the extent of quantitative restrictions on imports, as well as on other nontariff barriers, are not available for the full sample period.
Capital inflows rather than a real interest rate differential was chosen as a fundamental determinant of Malaysia’s REER. This choice was dictated by the fact that in the case of a relatively closed capital account, as was the case in the early part of the period under examination but most critically since September 1998, prevailing high interest rate differentials cannot manifest themselves in large-scale capital flows.
Preliminary regressions did not find evidence of fiscal variables (federal government operating expenditure as a share of GDP) belonging to the long-run relationship. This result may be consistent with fiscal policy having only a short-run effect on the REER. Moreover, fiscal policy in Malaysia has traditionally been exercised prudently, thus not exerting significant pressure on the exchange rate through its impact on demand.
Estimation and testing were carried out in PcFiml. The small sample size (19 annual observations) was sufficient for the Johansen procedure to be conclusive despite the loss of degrees of freedom owing to the lag structure of the estimated system. Given that the fewer the degrees of freedom there are, the harder it is to reject the null hypothesis of no cointegrating relationship, the reported results are thus relatively powerful.
Given that REER, EXM, and TOT entered the equilibrium relationship in logarithmic form, the coefficients for EXIM and TOT represent the elasticities of the REER with respect to these variables. For comparison, the elasticities (estimated at the sample means) of REER with respect to CAP and B-S were 0.6702 and 0.2164, respectively.
It is unclear to what extent the large misalignment of the ringgit in 1986 (also around 16 percent) reflects actual misalignment or a statistical error in the standard econometric sense (that is, the combined effect of temporary and random factors). This period coincides with a sharp depreciation of the ringgit in nominal terms that might have overshot the long-run equilibrium rate.
Estimation and testing were carried out in PcGive. Absolute values of the resulting t-statistics are in parentheses. Single asterisks denote significant statistics at the 10 percent level; double asterisks denote significant statistics at the 5 percent level.
Model specification follows closely Bayoumi and Faruqee (1998), with the following exceptions. First, instead of imposing the various elasticities exogenously, data for Malaysia were used to derive the required elasticities. Second, the ratios of imports-to-GDP and exports-to-GDP were introduced separately in the regression, rather than in a single trade-to-GDP term, to derive an estimate of the underlying import and export elasticities for Malaysia. Finally, the term (M/Y)(R) used in Bayoumi and Faruqee (1998) was not introduced in the regression to avoid the multicollinearity problem arising from the correlation of this term with the term (M/Y)(E). However, following Bayoumi and Faruqee (1998), a unit elasticity was imposed on the term (M/Y)(R), which was subsequently used in the calculations of the underlying current account.