Real Exchange Rate Behavior under Peg: Evidence ... - World Scientific

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Review of Pacific Basin Financial Markets and Policies Vol. 12, No. 1 (2009) 141–158 c World Scientific Publishing Co. and Center for Pacific Basin Business, Economics and Finance Research

Real Exchange Rate Behavior under Peg: Evidence from the Chinese RMB and Malaysian MYR

Yongjian E Bank of Communications 188 Central Yincheng Road Shanghai, 200120, China [email protected] Anthony Yanxiang Gu School of Business, State University of New York 115 D South Hall, 1 College Circle Geneseo, NY 14454, USA [email protected] Chau-Chen Yang Department of Finance, College of Management National Taiwan University 1 Roosevelt Road Sec. 4, Taipei, Taiwan [email protected] The exchange-rate behavior of the Chinese yuan (RMB) and the Malaysian ringgit (MYR) indicates that the real exchange rate volatility of both the pegged currency/the anchor currency (the US dollar), and the pegged currency/the non-anchor currencies (Japanese yen and British pound) are lower under the pegged regime. The dynamic behavior of the pegged currencies’ real exchange rates is consistent with the anchor currency as the speed of convergence of the Big Mac real exchange rates of the RMB, MYR, and the dollar against the floating currencies are almost identical during the pegged period. This may be due to similar inflation rate movements in the related economies. These results do not support the opinion that China has manipulated the value of its currency. Keywords: Pegged exchange rate regime; real exchange rate; anchor currency; nonanchor currency; China; manipulate. JEL Classification: F31, F41

141

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142 • Yongjian E, Anthony Yanxiang Gu & Chau-Chen Yang

1. Introduction Numerous studies have examined the effects of official exchange rate arrangements on real exchange rate behavior since Mussa (1986) reported that real exchange rates are more volatile under the floating exchange rate system than under the fixed rate system. Grilli and Kaminsky (1991) analyzed a century’s data of US/UK exchange rate and argued that the high real exchange rate volatility under the floating exchange rate system is a phenomenon of a particular historical period rather than a result of the floating exchange rate system. Lothian and McCarthy (2001) examined the real exchange rate behavior of the Irish punt under alternative exchange rate arrangements and found that real exchange rates were less volatile under currency union than under other fixed or floating arrangements. They also report no clear-cut difference in exchange rates behavior across fixed or floating regimes. Engel and Kim (1999) divided real exchange rate into a permanent and a transitory component, and found much higher volatility in the transitory component during the floating period than the pegged period. However, there is no study about the impact of exchange rate regimes on volatility of exchange rates between pegged currencies and the non-anchor currencies that are floating to the anchor currency. Furthermore, there is limited research on deviation of exchange rates from Purchasing Power Parity (PPP) under different official exchange rate arrangements or the impact of different exchange rate regimes on PPP. The only published study we found is by Parsley and Popper (2001) who found faster mean reversion under peg regimes than under floating rate systems. This study investigates the exchange rates behavior of pegged currencies against non-anchor currencies that are flexible to the anchor currency. This is in contrast to previous studies that focused on exchange rates of the pegged currency against the anchor currency or non-anchor currencies that are fixed to the anchor currency. We try to answer two questions: What is the impact of a pegged regime that has a sole anchor currency on the volatility of exchange rates between the pegged currency and the non-anchor currencies? Is PPP between the pegged currency and the non-anchor currencies parallel to PPP between the anchor currency and those non-anchor currencies? Although a hard-peg arrangement eliminates nominal exchange rate volatility between the pegged currency and the anchor currency, it is not clear whether a peg regime decreases the exchange rate volatility between pegged currencies and the non-anchor currencies. We select the Chinese RMB and the Malaysian MYR for our empirical tests because over the last two decades, both currencies were made

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Real Exchange Rate Behavior under Peg • 143

flexible, then pegged to the US dollar, and are currently pegged to a basket of currencies. We use the Big Mac-based real exchange rates to compare the dynamic behavior of real exchange rates of the currencies. There are three advantages associated with the Big Mac approach. First, the Big Mac is a composite good and its ingredients are almost the same across countries, while goods used to compute CPI are different. Second, unlike CPI, Big Mac prices are measured at levels rather than indices. Finally, we do not have to face the product-aggregation bias (Imbs et al., 2002), when analyzing the dynamic behavior of the real exchange rates. The rest of the paper is organized as follows. Section 2 compares exchange rate volatilities of four real exchange rates, i.e., RMB/yen, RMB/pound, MYR/yen, and MYR/pound under different exchange rate arrangements. Section 3 adopts panel data methods to analyze the dynamic behaviors of the Big Mac real exchange rates between the pegged (RMB and MYR) and 11 non-anchor currencies, and between the US dollar and the non-anchor currencies. Section 4 concludes the study.

2. The Pegged Exchange Rate Regime and Real Exchange Rate Volatility The Chinese government frequently adjusted the exchange rate between the RMB and the US dollar from the early 1980s to 1993. From 1994 to July 21, 2005, although the announced official arrangement was managed float, the nominal RMB/dollar exchange rate was almost unchanged. In fact, it was kept at $1 = RMB8.28 from 1998 through June 2005, hence was de facto pegged to the US dollar. Similarly, the MYR was officially announced to be pegged to a basket of currencies from 1975 to 1997, and the MYR/dollar exchange rate was actually variable. During the 1997–1998 Asian financial crises the MYR was extremely volatile and depreciated dramatically against the dollar. Then the MYR was pegged to the US dollar at the rate of $1 = MYR3.8 from 1999 to July 21, 2005. Since July 22, 2005, both China and Malaysia pegged their currencies to a basket of currencies, rather than solely to the US dollar.1 1

Reinhart and Rogoff (2002) used “Natural Classification” to classify the exchange rate regimes. Under their approach, the RMB in the period from 1994 to 2001 and MYR in the period from 1999 to 2005 are both classified as de facto pegs. The RMB is classified as managed float from 1981 to 1992, and, crawling-peg from 1992 to 1994. The MYR is classified as crawling-peg from 1975 to 1997, and freely floating from 1997 to 1998.

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We use the Japanese yen and the British pound as non-anchor currencies, which have been flexible to the US dollar since the collapse of the Breton Woods System, to compare the volatility of four real exchange rates, i.e., RMB/yen, RMB/pound, MYR/yen, MYR/pound, during the pegged and the non-pegged periods. Monthly CPI of China, Malaysia, the United States, Japan and the United Kingdom and their nominal exchange rates are from the International Financial Statistics (IFS) of the International Monetary Fund (IMF). Our observations are from January 1987 to June 2005 as China’s CPI is included in the IFS only since 1987, and the US dollar is not the sole anchor currency after July 21, 2005. Real exchange rates are calculated as: Rt = Nt + Pf t − Pht , where Rt is the logarithm of the real exchange rate at time t, Nt is the logarithm of the domestic currency price of foreign currency, Pht is the logarithm of domestic CPI and Pf t is the logarithm of foreign CPI. We examine the real exchange rates of RMB/dollar, RMB/yen, RMB/pound, MYR/dollar, MYR/yen, and MYR/pound, and define the RMB and the MYR as domestic currencies. We also examine the real exchange rates of dollar/yen and dollar/pound and define the US dollar as domestic currency. Figure 1 illustrates the three real exchange rates RMB/yen, MYR/yen and dollar/yen from 1987 to June 2005, where Rcj represents the real exchange rate between the RMB and the yen, Rmj denotes the real exchange rate between the MYR and the yen, and Ruj is the real exchange rate between the dollar and the yen. As shown in Figure 1, the RMB/yen real exchange rate and the dollar/yen real exchange rate exhibited almost the same pattern of variations from January 1994 to June 2005, the peg period, and the similarity became more obvious and consistent from January 1998 to June 2005, the hard-peg period. The MYR/yen real exchange rate also showed very similar variations to the dollar/yen real exchange rate from January 1999 to June 2005. Figure 2 illustrates the other three real exchange rates RMB/pound, MYR/pound and dollar/pound for the same period 1987–June 2005, where Rcb represents the real exchange rate between the RMB and the pound, Rmb denotes the real exchange rate between the MYR and the pound, and Rub is the real exchange rate between the dollar and the pound. The real exchanges rates showed similar patterns with the pound.2 The similarities result from the peg arrangements because the

2

That phenomenon also appears in the float period, though not very obvious, because the RMB and MYR were not completely freely flexible to the dollar in the period.

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Real Exchange Rate Behavior under Peg • 145 -2.0 -2.5 -3.0 -3.5 -4.0 -4.5 -5.0 88

90

92

94

96

Rcj

Fig. 1.

98

00

Rmj

02

04

Ruj

Real exchange rates of RMB, MYR and dollar vs yen (Rcj, Rmj, Ruj).

3.0 2.5 2.0 1.5 1.0 0.5 0.0 88

90

92

94

Rcb

Fig. 2.

96

Rmb

98

00

02

04

Rub

Real exchange rates of RMB, MYR and dollar vs pound (Rcb, Rmb, Rub).

RMB and the MYR were fluctuating together with the dollar against the yen and the pound. The similarities provide evidence supporting the argument that most of the real exchange rate volatility is caused by nominal exchange rate volatility.3 Note also in Figures 1 and 2 that the RMB/yen, MYR/yen, RMB/pound, and MYR/pound real exchange rates are less volatile in the peg period than in the floating period.

3

The correlations between real and nominal exchange rates of the RMB and MYR against the yen and pound were all above 80% in the peg period.

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In order to compare real exchange rate volatility in different periods, we calculate the standard deviations of the real exchange rates, and the standard deviations of their first difference. T 1 (Rt − R)2 , (1) stdv(R) = T −1 t=1

and

stdv(∆R) =

T

1 (∆Rt − ∆R)2 , T − 1 t=1

(2)

where stdv(·) is the standard deviation, R is the (log) real exchange rate and ∆R = Rt − Rt−1 is the first difference of R. The results are reported in Tables 1 and 2. As shown in Table 1, the standard deviation of RMB/dollar real exchange rates is 0.0653 (0.0401), and the standard deviation of its first difference is 0.0239 (0.0084) for the pegged period 1994–2005 (1998–June 2005), which are significantly smaller than that for the floating period 1987–1993. The standard deviations of RMB/yen and RMB/pound real exchange rates and their first differences are also much smaller in the pegged period than in the floating period. Note that the standard deviations declined even more significantly in the hard-peg period 1998 to June 2005. Table 1.

Standard deviations of the RMB real exchange rates.

stdv(Rcu ) stdv(Rcj ) stdv(Rcb ) stdv(∆Rcu ) stdv(∆Rcj ) stdv(∆Rcb ) 1987–June 2005 1987–1993 1994–June 2005 1998–June 2005

0.1248 0.1404 0.0653 0.0401

0.1700 0.1627 0.1590 0.0759

0.1542 0.1900 0.0978 0.1006

0.0314 0.0306 0.0239 0.0084

0.0428 0.0417 0.0387 0.0295

0.0407 0.0468 0.0304 0.0213

Rcu , Rcj and Rcb are the real exchange rates of RMB/dollar, RMB/yen and RMB/pound, respectively. ∆ represents the first difference. Table 2.

Standard deviations of the MYR real exchange rates.

stdv(Rmu ) stdv(Rmj ) stdv(Rmb ) stdv(∆Rmu ) stdv(∆Rmj ) stdv(∆Rmb ) 1987–June 2005 1987–1998 1987–1996 1999–June 2005

0.1779 0.1168 0.0513 0.0187

0.1305 0.1114 0.0991 0.0397

0.2064 0.1589 0.1136 0.1052

0.0221 0.0273 0.0109 0.0040

0.0316 0.0350 0.0277 0.0239

0.0303 0.0350 0.0281 0.0188

Rmu , Rmj and Rmb the real exchange rates of MYR/dollar, MYR/yen and MYR/pound, respectively. ∆ represents the first difference.

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Standard deviations of the real exchange rates with the Malaysian MYR being the domestic currency and their first differences are also significantly smaller for the pegged period 1999–June 2005 than the previous periods as shown in Table 2. The volatilities in the floating period are magnified because of the 1997–1998 financial crises, the standard deviations are till much higher than that in the pegged period excluding the two-year’s outliers. Comparing standard deviations of nominal exchange rates is also necessary since real exchange rate volatility is mainly caused by nominal exchange rate volatility. The standard deviations of nominal exchange rates are presented in Tables 3 and 4. The two tables show phenomena similar to that in Tables 1 and 2, all the nominal exchange rates and their first differences exhibit significantly lower volatilities in the pegged period than in the floating period. The variation in nominal exchange rates between the pegged currency and the anchor currency should be nearly zero, which is the case for the RMB and the MYR in the pegged period, and the near-zero variation contributed to the much lower volatilities of the real exchange rates shown in Tables 1 and 2 in the pegged period. However, there is a question as to why the volatilities of both the nominal and the real exchange rates between the pegged currencies (RMB and MYR) and the non-anchor currencies (yen and pound) also fall in the pegged period. In theory, there should be no Table 3.

Standard deviations of the RMB nominal exchange rates.

stdv(Ncu ) stdv(Ncj ) stdv(Ncb ) stdv(∆Ncu ) stdv(∆cj ) stdv(∆Ncb ) 1987–June 2005 1987–1993 1994–June 2005 1998–June 2005

0.3119 0.1859 0.0119 0.0005

0.4061 0.2493 0.1060 0.0811

0.2945 0.1957 0.0718 0.0868

0.0298 0.0200 0.0015 0.0004

0.0396 0.0320 0.0283 0.0268

0.0387 0.0392 0.0173 0.0181

Ncu , Ncj and Ncb are (log) nominal exchange rates of RMB/dollar, RMB/yen and RMB/pound respectively. ∆ is the first difference. Table 4.

Standard deviations of the MYR nominal exchange rates.

stdv(Nmu ) stdv(Nmj ) stdv(Nmb ) stdv(∆Nmu ) stdv(∆Nmj ) stdv(∆Nmb ) 1987–June 2005 1987–1998 1987–1996 1999–June 2005

0.1907 0.1256 0.0359 0

0.2376 0.1624 0.1380 0.0681

0.1991 0.1501 0.0951 0.0925

0.0219 0.0272 0.0106 0

0.0308 0.0342 0.0269 0.0231

0.0301 0.0348 0.0276 0.0187

Nmu , Nmj and Nmb are (log) nominal exchange rates of MYR/dollar, MYR/yen and MYR/pound respectively. ∆ is the first difference.

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systematic differences in the volatilities of nominal and real exchange rates of the RMB and MYR against the pound and yen between the pegged and the floating period if the pound and the yen were completely flexible to the dollar. In order to explain the systematic and significant differences, we show the standard deviations of the nominal and real exchange rates of dollar/yen and dollar/pound in the different periods in Tables 5 and 6. A comparison between the standard deviations in Tables 3 and 5 reveals that when the RMB is pegged to the dollar, the volatilities of the nominal exchange rates of RMB/yen and RMB/pound were almost the same as that of the dollar/yen and dollar/pound. But when the RMB is flexible to the dollar, the volatilities of the nominal exchange rates of RMB/yen and RMB/pound are much higher than that of the dollar/yen and dollar/pound. A comparison between the standard deviations in Tables 4 and 5 reveals a similar phenomenon for the MYR. Comparing Table 6 with Tables 1 and 2 reveals the same phenomenon for the real exchange rates between the currencies over the periods. Table 5. Standard deviations of the dollar/yen, dollar/pound nominal exchange rates.

1987/01–2005/06 1987/01–1993/12 1994/01–2005/06 1998/01–2005/06 1987/01–1998/12 1987/01–1996/12 1999/01–2005/06

stdv(Nuj )

stdv(Nub )

stdv(∆Nuj )

stdv(∆Nub )

0.1255 0.0976 0.1007 0.0811 0.1421 0.1526 0.0681

0.0807 0.0804 0.0735 0.0868 0.0722 0.0788 0.0925

0.0279 0.0273 0.0283 0.0268 0.0302 0.0285 0.0231

0.0244 0.0331 0.0172 0.0181 0.0271 0.0286 0.0187

Nuj and Nub are the nominal exchange rates of the dollar/yen and dollar/pound respectively. ∆ is the first difference. Table 6. Standard deviations of the dollar/yen and dollar/pound real exchange rates.

1987/01–2005/06 1987/01–1993/12 1994/01–2005/06 1998/01–2005/06 1987/01–1998/12 1987/01–1996/12 1999/01–2005/06

stdv(Ruj )

stdv(Rub )

stdv(∆Ruj )

stdv(∆Rub )

0.1266 0.0821 0.1459 0.0806 0.1193 0.1141 0.0825

0.0831 0.0906 0.0776 0.0904 0.0758 0.0813 0.0956

0.0285 0.0280 0.0288 0.0278 0.0308 0.0289 0.0238

0.0248 0.0337 0.0174 0.0186 0.0274 0.0290 0.0191

Ruj and Ruj are the real exchange rates of dollar/yen and dollar/pound respectively. ∆ is the first difference.

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These phenomena provide evidence that the yen and the pound were not completely freely flexible to the dollar during the whole sample period. Another reason why the volatilities of the RMB and MYR exchange rates against the yen and the pound are lower during the pegged period is that both the yen and the pound were more stable than the RMB and the MYR against the dollar when the RMB and the MYR were flexible to the dollar. Hence, when the RMB and MYR were pegged to the dollar, the volatilities of both nominal and real exchange rates of RMB/yen, MYR/yen, RMB/pound and MYR/pound declined. 3. Pegged Exchange Rate Regime and the PPP In this section, we examine whether deviations from the purchasing power parity of the real exchange rates between the pegged currency and the non-anchor currency are parallel to those between the anchor currency and the non-anchor currency under the pegged regime, since the pegged regime makes the movements of nominal exchange rates between the pegged currency and the non-anchor currency parallel to those between the anchor currency and the non-anchor currency, and nominal exchange rate volatility is the major source of real exchange rate volatility. We use the Big Mac-based real exchange rates to analyze the dynamic behaviors of the real exchange rates between the RMB, MYR and the pound and yen, and between the dollar and the pound and yen. The Economist magazine started to report the local Big Mac prices and nominal exchange rates for comparison in some countries in 1986. China has been included since 1992 and Malaysia since 1993. Because the Big Mac index has advantages, such as the generally believed same ingredients for the hamburger across countries and the prices are measured in level rather than in indices, many recent studies use it to investigate the relation between exchange rate behavior and purchasing power parity (Cumby, 1996; Lutz, 2001; Parsley and Wei, 2003; etc.). Because the periods when the RMB and MYR were pegged to the US dollar are short, we use panel approach for the examination. In addition to China, Japan, Malaysia, UK and US, we select nine countries’ local Big Mac prices and nominal exchange rates for the study.4 For comparing purchasing power parity between the RMB against those currencies and the dollar against those currencies, the sample (peg) period is 4 Those countries are Brazil, Canada, Chile, Denmark, Mexico, Singapore, South Korea, Sweden, and Switzerland. Currencies of those countries were all flexible the US dollar when the RMB and MYR were pegged to the dollar. See also Reinhart and Rogoff (2002).

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12 years from 1994 to 2005 and there are 132 time series observations. For comparing purchasing power parity between the MYR against those currencies and the dollar against those currencies, the sample (peg) period is seven years from 1999–2005 and there are 77 time series observations. The Big Mac real exchange rate is computed as: Rt = Nt + Pf it − Phit , where Pf it and Phit represents (log) domestic and foreign Big Mac prices, respectively. We begin by looking at whether the Big Mac price and CPI have similar behaviors. As shown in Figures 3 and 4, when China and Malaysia had their currencies pegged to the dollar, both countries’ Big Mac price and CPI exhibited similar variations and trends. Although the Malaysian Big 108 104 100 96 92 88 84 80 76 94 95 96 97 98 99

00 01 02 03 04 05

CPI

Fig. 3.

BM

China’s Big Mac price and CPI.

120 116 112 108 104 100 96 92 1998

1999

2000

2001 CPI

Fig. 4.

2002

2003

2004

2005

BM

Malaysia’s Big Mac price and CPI.

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Mac price was consistently higher than its CPI from mid 2001 to 2005 the correlation coefficients between the Big Mac price and CPI are over 0.8 for both countries.5 3.1. Stationarity test Next, we test whether Big Mac real exchange rates are stationary. The weakness of the standard Augmented Dickey-Fuller (ADF) test is its low power, which means it is very difficult to reject the null hypothesis of nonstationarity for a stationary series that is close to a unit root test process. The problem is worse for short sample time series. We try to overcome the problem by examining the panel aspect of the data and adopt two methods of panel unit root test proposed by Levin, Lin and Chu (2002) and Im, Pesaran and Shin (2003).6 The difference between LLC and IPS is that LLC assumes the same auto-regression coefficients across series, while IPS assumes that the coefficients can be different. Considering the possibility of cross-sectional dependency across the times series we also report the results after controlling for cross-sectional dependency.7 The results of the stationarity tests on the Big Mac real exchange rates of the RMB, MYR and US dollar against the currencies that were floating to the dollar are reported in Tables 7 through 10. Countries of these currencies are listed in Footnote 4. The time periods are 1994–2005 when the RMB was pegged to the dollar, and 1999–2005 when the MYR was pegged to the dollar. The stationarity tests reject the null hypothesis in every case as the estimated coefficients are all far from one whether or not cross-sectional Table 7. Results of panel unit root test on RMB Big Mac real exchange rates (1994–2005). LLC

Coefficient p value

IPS

No Cross-Sectional Dependency

Cross-Sectional Dependency



−3.1152 0.0009

−5.8905 0.0000

−1.7634 0.0389

−3.1132 0.0009

1994–2005. Both statistics of LLC and IPS are normally distributed asymptotically. 5 Big Mac Prices and CPIs of other countries have similar behavior as that of China and Malaysia. 6 Those two methods are called LLC and IPS for short. 7 We add common time dummies to each ADF regression to control the cross-sectional dependency.

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152 • Yongjian E, Anthony Yanxiang Gu & Chau-Chen Yang Table 8. Results of panel unit root test on MYR Big Mac real exchange rates (1999–2005). LLC

Coefficient p value

IPS





−10.0891 0.0000

−5.7912 0.0000

−2.8766 0.0020

−2.0809 0.0187

1999–2005. Both statistics of LLC and IPS are normally distributed asymptotically. Table 9. Results of panel unit root test on US dollar Big Mac real exchange rates (1994–2005). LLC

Coefficient p value

IPS





−3.7644 0.0001

−5.6871 0.0000

−1.6178 0.0529

−2.9611 0.0015

1994–2005. Both statistics of LLC and IPS are normally distributed asymptotically. Table 10. Results of panel unit root test on US dollar Big Mac real exchange rates (1999–2005). LLC

Coefficient p value

IPS





−4.6345 0.0000

−4.8344 0.0000

−1.3836 0.0832

−1.5982 0.0550

1999–2005. Both statistics of LLC and IPS are normally distributed asymptotically.

dependency is controlled and all the estimates are significant at the 5% level except the three estimates in Tables 9 and 10 that are significant at the 10% level. The results of the tests indicate that these real exchange rates are stationary and PPP holds for the sample data. We test whether the series Nt + Pf t and Pht cointegrate by using the panel cointegration method proposed by Kao (1999) in order to account for the common stochastic trend.8 PPP holds if the series are cointegrated. The test results are reported in Table 11. The statistics are all significant at the 1% level, indicating that PPP holds. With this evidence that deviations 8

Lyhagen (2000) pointed out that panel unit root test does not account for common stochastic trend.

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Real Exchange Rate Behavior under Peg • 153 Table 11.

ADFa p value∗ ∗ a

Results of panel cointegration test.

China (Pht ) (1994–2005)

United States (Pht ) (1994–2005)

Malaysia (Pht ) (1999–2005)

United States (Pht ) (1999–2005)

4.3792 0.0000

2.5217 0.0058

−2.3417 0.0096

−3.5543 0.0002

All significant at the 1% level. See Kao (1999).

from PPP are transitory, the next step naturally is to estimate their speeds of convergence. 3.2. Speed of convergence This section focuses on comparing the speeds of convergence of the RMB and MYR real exchange rates with that of the US dollar. We estimate the speed of convergence of the real exchange rates with the following regression: Ri,t = θi + λt + ρRi,t−1 + εi,t ,

(3)

where θi is individual fixed effect9 representing currency-specific effects, λt is common time dummy controlling cross-sectional dependency. The autoregression coefficient ρ measures the speed of convergence. The bigger the ρ, the faster the speed of convergence, and the shorter the half life. The half life can be computed as: log(0.5)/log(ρ). Equation (3) is a dynamic panel with fixed effects for which the OLS estimator of ρ is biased downward when the sample length T is short. In order to reduce the bias, we make the following adjustment following Nickell (1981): 1 − ρT 1+ρ 1− ρ − ρ) = − plim ( T−1 T(1 − ρ) N→∞ 1 − ρT 2ρ 1− . (4) × 1− (1 − ρ)(T − 1) T(1 − ρ) Considering that there may be heteroskedasticity across the time series we also report the GLS (Generalized Least Square) estimators. The results are reported in Table 12. The results in Table 12 indicate that when the RMB was pegged to the dollar, the half-life of deviations from Big Mac parity of the RMB real exchange rates is 1.34 (1.56) years, only slightly longer than the 1.32 (1.53) 9

Fixed effect is selected for Hausman tests on each sample and the null hypothesis can be rejected significantly.

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154 • Yongjian E, Anthony Yanxiang Gu & Chau-Chen Yang Table 12.

Estimated speed of convergence of Big Mac real exchange rates.

RMB (1994–2005) OLS ρb

GLS

US Dollar (1994–2005) OLS

GLS

MYR (1999–2005) OLS

GLS


GLS

0.5043 0.5538 0.5000 0.5482 0.3391 0.3832 0.3370 0.3760 (6.0792) (6.8191) (6.0187) (6.7193) (3.3801) (3.6194) (3.3478) (3.5481)

Adjusted ρb 0.5956

0.6405

0.5918

0.6355

0.4786

0.5173

0.4771

0.5110

Half Life

1.56

1.32

1.53

0.94

1.05

0.94

1.03

1.34

Numbers in parentheses are t statistics and all the estimates are significant at the 1% level.

years of the US dollar. Thus, their half-lives appear to be identical. The half-lives of deviations from Big Mac parity for the MYR and the dollar also appear to be identical during the period the MYR was pegged to the US dollar. These results suggest that the pegged regime makes PPP between the pegged currency and the non-anchor currencies parallel to PPP between the anchor-currency and these non-anchor currencies. All the GLS estimators are bigger than the OLS estimators, indicating the existence of heteroskedasticity across the time series. Compared to the results of previous studies, our GLS estimated speed of convergence in the RMB’s peg period is slightly faster than that of Parsley and Wei (2003), and our GLS estimated speed of convergence in the MYR’s peg period is similar to that of Cumby (1996).10 To test the sensitivity of our estimated results, we add a lag of the dependent variable to control serial correlation to the right hand side of Equation (3): qi,t = θi + λt + ρqi,t−1 + γ∆qi,t−1 + εi,t .

(5)

The results are reported in Table 13. The estimated speeds of convergence are faster with a lag than without one for all the three currencies, the speeds of convergence for the RMB and the dollar are identical, and the speeds of convergence for the MYR and the dollar are also identical. Again, all the GLS estimators are bigger than the OLS estimators, indicating the existence of heteroskedasticity across the time series. These results are consistent with that estimated with Equation (3) and reported in Table 12. The results again confirm that the dynamic behavior of real exchange rates of the pegged 10

The temporal adjustment for our estimators did not eliminate the bias because of the small number of time series. However, it does no affect our comparison as the bias is the same for all.

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Real Exchange Rate Behavior under Peg • 155 Table 13.

Estimated speed of convergence of Big Mac real exchange rates.

RMB (1994–2005) OLS ρb Adjusted ρb Half Life γ b

GLS


GLS

MYR (1999–2005) OLS

GLS


GLS

0.3667 0.3957 0.3625 0.3926 0.1980 0.2431 0.1973 0.2408 (4.3916) (5.1366) (4.3218) (5.0591) (1.8381) (2.1141) (1.8201) (2.0890) 0.4642

0.4925

0.4602

0.4895

0.3492

0.3915

0.3488

0.3894

0.90

0.99

0.89

0.97

0.66

0.74

0.66

0.73

0.2615 0.2620 0.2606 0.2547 0.2976 0.2877 0.2934 0.2759 (3.0992) (3.1572) (3.0879) (3.0728) (2.7815) (26572) (2.7325) (2.5499)

Serial correlation controlled. Numbers in parentheses are t statistics and all estimates are statistically significant at least at the 5% level.

currency against the non-anchor currencies is consistent with that of the anchor currency against the non-anchor currencies. The interpretations may include: First, movements of nominal exchange rate between the hard-pegged currency and the non-anchor currency are the same as that between the anchor currency and the non-anchor currencies, and nominal exchange rate movements are the major source for real exchange rate movement; second, purchasing power parity calculations may underlie official currency peg decisions (Parsley and Popper, 2001); and third, similar inflation rates in the related countries help PPP hold between the currencies during peg period. Inflation in the country of the pegged currency, i.e., China and Malaysia in this case, move closer and along with inflation in the country of the anchor currency, United States. Just like the US was “exporting inflation” under the Breton Woods System, the Chinese and Malaysian inflation rates were close to that of the US during their hard peg periods. As shown in Figure 5, China experienced very volatile inflation before 1997 and very high inflation from 1993 to 1995. As mentioned above, the Chinese government had actually pegged the RMB to the dollar since 1994, and its inflation rate had declined sharply. The Chinese inflation rate was relatively close to the US level during the strictly pegged period of 1998– 2005, and its fluctuation was almost parallel to the US inflation from 1999 to 2003. The lower and stable inflation under pegged regime is consistent to what Ghosh et al. (1997) have noticed. Thus, the similar inflation rate behaviors may explain why purchasing power parity holds during the period. However, our findings on inflation differ from Broda’s (2006) explanation. He reported much higher national price levels in developing countries

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156 • Yongjian E, Anthony Yanxiang Gu & Chau-Chen Yang 26 24 22 20

China

18

Malaysia

16

USA

Rate

14 12 10 8 6 4 2 0 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05

-2

Year

Fig. 5.

Inflation rates of the three countries.

with fixed exchange rate arrangements than those with flexible regimes, and related the high price levels to fixed exchange rate regimes. In our sample, the inflation rate in China was much higher during the managed floating period than during the pegged period, e.g., the average inflation rate was 8.73% during 1990–1997, compared to 0.58% during the hard peg period 1998– 2005, and 7.35% during 1982–1993, and 3.39% during 1994–2005. Malaysia had similar experience, average inflation rate was 3.84% during 1992–1998, compared to 1.87% during the peg period 1999–2005. Figure 5 displays the inflation rates of China, Malaysia, and the United States from 1988 to 2005. Broda’s (2006) report cannot explain how significantly lower inflation rates can be coincident to much higher price levels for years under peg regime. It would be ideal if the Big Mac data were available for China (1990–1997 or 1982–1993, length equivalent to the pegged period) and Malaysia (1988– 1998) so we can test and compare the mean reversion of their real exchange rates both before and after the two countries pegged their currencies to the dollar. 4. Conclusions In this study, we examine the effects of pegged exchange rate regime on real exchange rate behavior. Comparisons of real exchange rate volatilities in different periods reveal that real exchange rates volatilities of the RMB/yen, MYR/yen, RMB/pound and MYR/pound were lower when the RMB and the MYR were pegged to the US dollar than when they were not pegged

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to the dollar. These results suggest that the two countries’ pegging policies reduced volatility in the real exchange rates between their currencies and the anchor currency, and their currencies against the non-anchor currencies.11 Next, we exploit the panel aspect of the data to compare the dynamic behavior of Big Mac real exchange rates of the RMB (MYR) against the currencies that were floating to the dollar and that of the dollar against these floaters. We find that the speeds of convergence for the RMB, MYR and the dollar Big Mac real exchange rates are almost identical during the peg period, which indicates that pegged regime makes the dynamic behavior of the pegged currency’s real exchange rates consistent with that of the anchor currency’s real exchange rates. Thus, nominal exchange rate behavior accounted for most of the real exchange rate behavior, and the peg arrangements did not distort the real exchange rates between the pegged and the anchor currencies for our sample time series. These may be explained by the governments’ making their peg decisions based on purchasing power parity calculations, and by similar inflation rate movements in the countries of the pegged currencies and the anchor currency in the peg period. The evidence from this study does not support the opinion that China has manipulated the value of its currency. Our evidence of inflation challenges Broda’s (2006) opinion that relates higher price levels in developing countries with fixed exchange rate regimes. Further studies are requested for determining whether what we have found is also true for other currencies that have a peg history, and more work is needed to identify unknown factors that affect macroeconomic indicators under different exchange rate regimes. Acknowledgments We thank the anonymous reviewer and Michael Schinski for helpful comments and suggestions. References Broda, C (2006). Exchange rate regimes and national price levels. Journal of International Economics, 70, 52–81. Cumby, R (1996). Forecasting exchange rates and relative prices with the hamburger standard: Is what you want what you get with McParity? NBER Working Paper No. 5675. 11

A stable real exchange rate between their currencies and the US dollar and the nonanchor currencies is very important to China and Malaysia because trade with the US and the non-anchor countries is crucial to the Chinese and Malaysian economies.

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Engel, C and C Kim (1999). The long-run US/UK real exchange rate. Journal of Money, Credit and Banking, 31, 335–356. Ghosh, A, A Gulde, J Ostry and H Wolf (1997). Does the nominal exchange rate regime matter? NBER Working Paper No. 5874. Grilli, V and G Kaminsky (1991). Nominal exchange rate regimes and the real exchange rate. Journal of Monetary Economics, 27, 191–212. Imbs, JH, MR Mumtaz and H Rey (2002). PPP strikes back: Aggregation and the real exchange rate. NBER Working Paper No. 9372. Im, KS, MH Pesaran and Y Shin (2003). Testing for unit roots in heterogeneous panels. Journal of Econometrics, 115, 53–74. Kao, C (1999). Spurious regression and residual-based tests for cointegration in panel data. Journal of Econometrics, 90, 1–44. Levin, A, C Lin and CJ Chu (2002). Unit root tests in panel data: Asymptotic and finite sample properties. Journal of Econometrics, 108, 1–24. Lothian, JR and CH McCarthy (2001). Real exchange-rate behaviour under fixed and floating exchange rate regimes. Unpublished Paper, Fordham University. Lutz, M (2001). Beyond burgernomics and MacParity: Exchange rate forecasts based on the law of one price. University of St. Gallen Working Paper. Lyhagen, J (2000). Why not use standard panel unit root test for testing PPP. Working Paper Series in Economics and Finance, No. 413, Stockholm School of Economics. Mussa, M (1986). Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications. Carnegie Rochester Conference Series on Public Policy, 24, 117–214. Nickell, S (1981). Biases in dynamic models with fixed effects. Econometrica, 49, 1417–1426. Parsley, DC and HA Popper (2001). Official exchange rate arrangements and real exchange rate behavior. Journal of Money, Credit and Banking, 33(4), 976–993. Parsley, DC and S-J Wei (2003). A prism into the PPP puzzles: The microfoundations of Big Mac real exchange rates. NBER Working Paper No. 10074. Reinhart, C and K Rogoff (2002). The modern history of exchange rate regimes. NBER Working Paper No. w8963.

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