Exchange rate and trade balance a new approach using big mac index for the case of thailand

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Exchange rate and trade balance a new approach using big mac index for the case of thailand

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UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS EXCHANGE RATE & TRADE BALANCE: A NEW APPROACH USING BIG MAC INDEX FOR THE CASE OF THAILAND A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS BY VO THE ANH Academic Supervisor: Dr VO HONG DUC HO CHI MINH CITY, DECEMBER 2014 ACKNOWLEDGEMENTS It is assistance, guidance, and encouragement that contribute to the success of this thesis Therefore, I would like to express my gratitude to those who always stand by me during periods of writing thesis My profound appreciation and sincere thanks must first be expressed to my academic supervisor, Dr Vo Hong Duc, Director of Economic Regulation Authority in Perth, Australia, for his interest, encouragement, and guidance throughout thesiswriting process from initial themes to entire finish, especially during boring time of reading the final draft I would like to express my grateful thanks to Assc Prof Dr Nguyen Trong Hoai, Dr Truong Dang Thuy, Dr Phung Thanh Binh, and Dr Pham Khanh Nam, Lectures at Department of Economics Development at University of Economics (HCMC), for their helpful commands and valuable pieces of advice during the time I write the thesis Special thanks are extended to Dr Le Van Chon for his invaluable econometric guidance Thanks to such academic commands, advice, and guidance, I could finish the thesis on the best way I am be grateful to not only staff members at Department of Economics Development at University of Economics (HCMC) but also my classmates at VNPMDE 19 for their help and support and for offering such a warm and friendly studying atmosphere Most importantly, I am indebted to my parents for financing my study as well as for their constant love and moral support This thesis could not be finished without their comprehension i ABSTRACT This thesis focuses on achieving two main objectives: (i) an evaluation of the Thailand’s currency to confirm whether a currency is over- or undervalued during the period from 1980 to 2013 for the case of Thailand; and (ii) a consideration of the effects of a currency’s devaluation on trade balance for the case of Thailand In this study, these effects are considered in different aspects such as the determinants of a trade balance of Thailand; and the long run relationship between bilateral exchange rate and Thailand’s trade balance In relation to the first objective, the prominent feature of the study is to use the Big Mac Index (BMI), the first ever study of this kind conducted in Vietnam, for evaluating Thailand’s currency and to apply this evaluation in the context of the link between exchange rate and trade balance Nevertheless, the common-used index, the Consumer Price Index (CPI), is also utilized to compare the effectiveness of BMI with that of the CPI Theoretical grounds for evaluating a currency in term of purchasing power parity (PPP) theory are first presented, together with the theory of the link between currency’s devaluation and trade balance Next, the empirical studies associated with such theory are discussed Empirical models and results are reported accordingly To obtain the first objective, the PPP hypothesis is required to be satisfied in terms of panel cointegration tests The fully modified OLS (FMOLS) technique is adopted to determine the equilibrium exchange rate for evaluation process On the grounds of the tests of PPP, the panel-based unit root tests as developed by Breitung (2001) and the panel cointegration tests by Pedroni (1999, 2001, 2004) and Kao (1999) are adopted The empirical results confirm a solid validity of PPP for the case of CPIbased exchange rate and a weak evidence of the PPP for BMI-based exchange rate In the relation to evaluate Thailand’s currency, the results illustrate that (i) the valuation ii of Thailand currency using CPI-based exchange rate is fairly consistent to that of BMIbased exchange rate with an exception of the outcomes during the 1997 Asian financial crisis; and (ii) the Big Mac exchange rate is better when bilaterally evaluating the Thailand Baht to US dollar The second main objective - a consideration of the effects of a currency’s devaluation on trade balance - could be achieved by the two procedures The first procedure is to analyze how changes on exchange rate policy, fiscal policy, and monetary policy affect Thailand’s trade balance In this task, effects of devaluation on trade balance are examined on various scenarios: (i) the entire sample of 62 countries who are trading partners with Thailand; (ii) different geography (between regions and regions of countries); (iii) different income levels; and (iv) during different periods in which Thailand’s currency is over- or under-valued Both OLS method and IV technique are employed because of an endogeneity problems as mentioned in previous studies The empirical findings indicate that the exchange rate policy plays a central role in explaining Thailand’s trade balance and the fiscal and monetary policies are beneficial in some cases The second procedure is to examine the long run relationship between a devaluation of Thailand’s currency and trade balance with the applications of the panel-based co-integration tests by Pedroni (1999, 2001, 2004) and Kao (1999) and the FMOLS model The panel FMOLS estimations illustrate that a devaluation of Thailand Baht could provide positive effects on trade balance in the long run, especially for the groups of country with high income, upper middle income, in America, and Europe The individual FMOLS regressions between Thailand and each of her 62 trading partners indicate that the devaluation of Thailand’s currency would stimulate Thailand’s trade performance with over 20 trading partners, but hurt its performance with the other 10 countries and inconclusive conclusion for the others iii ABBREVIATIONS PPP Purchasing Power Parity BMI Big Mac Index CPI Consumer Price Index M-L Marshall-Lerner OLS Ordinary Least Squares FMOLS Fully Modified Ordinary Least Squares IMF International Monetary Fund VND Vietnam Dong IV Instrumental Variable OECD Organization for Economic Cooperation and Development VAR Vector Autoregressive ARDL Autoregressive Distributed Lag ECM Error Correction Model iv Contents LISTS OF FIGURES viii CHAPTER INTRODUCTION 1.1 Problem Statement 1.2 Research Objectives 1.3 The Structure of the Thesis CHAPTER LITERATURE REVIEW 2.1 Theoretical Grounds 2.1.1 PPP Theory 2.1.2 Alternative approaches to devaluation theory 2.2 Conceptual framework 12 2.3 Empirical reviews 13 2.3.1 Test of PPP Theory 13 2.3.2 Evaluation of a currency 15 2.3.3 Determinants of a Trade Balance 16 2.3.4 Devaluation and Trade Balance 17 CHAPTER 25 THAILAND’S TRADE BALANCE AND 25 v ITS BIG MAC INDEX 25 3.1 Thailand’s Trade Balance 25 3.2 Big Mac Index 27 CHAPTER 31 RESEARCH METHODOLOGY 31 4.1 Panel unit root test 31 4.2 Panel cointegration test 32 4.2.1 Kao’s cointegration test 32 4.2.2 Pedroni cointegration test 33 4.3 Fully modified OLS approach 36 4.4 Empirical models 37 4.4.1 Test of PPP theory 37 4.4.2 Evaluation of Thailand’s currency 39 4.4.3 Determinants of Thailand’s Trade Balance 39 4.4.4 Devaluation and Thailand’s Trade Balance 45 CHAPTER 47 DATA AND RESEARCH FINDINGS 47 5.1 Data description 47 5.2 Empirical results 49 5.2.1 Test of PPP theory 49 5.2.2 Evaluation of Thailand’s currency 52 vi 5.2.3 Determinants of Thailand’s trade balance 56 5.2.4 Devaluation and Thailand’s Trade Balance 63 CHAPTER 73 CONCLUSION 73 6.1 Conclusions 73 6.2 Implications for research and policies 76 6.3 Limitations 77 REFERENCE 79 APPENDIX 86 vii LISTS OF FIGURES Figure 2.1: Conceptual framework for exchange rate effects on trade balance 12 Figure 3.1: Thailand’s trade balance during 1995-2013 periods 26 Figure 5.1: Misalignments of nominal exchange rate based on CPI and BMI 53 LISTS OF TABLES Table 3.1: The structure of Thailand’ trade classified by currency 27 Table 5.1: Data Description 48 Table 5.2: Unit root test for PPP testing 50 Table 5.3: Panel cointegration test for PPP 51 Table 5.4: Results of OLS and IV estimation for determinants of Thai trade balance 57 Table 5.5: Estimation results for undervaluation and overvaluation periods 59 Table 5.6: Estimation results for countries within each of the seven sub-samples 61 Table 5.7: Results of Breitung (2001) unit root test - level and first difference 64 Table 5.8: Cointegration test 65 Table 5.9: Panel results of FMOLS estimation 67 Table 5.10: Individual results of FMOLS estimation 70 viii CHAPTER INTRODUCTION 1.1 Problem Statement Exchange rate is possibly one of the most concerned subjects among academics, exporters, importers, investors as well as policy-makers because its vitally important roles played in the international economics While academics have concerned and developed theories of disequilibrium and equilibrium real exchange rate, the policymakers concentrate more on exchange rate adjustment in order to examine its effects on the economy Additionally, exchange rate risk is a key element related directly to the costs and profits for importers, exporters as well as foreign investors Furthermore, it is argued that developing countries have tendency to devaluate their currency in order to gain the relative competition Given the importance of exchange rate in the economy, issues in relation to exchange rate attract my interest and that this a key reason for my choice to make a topic for the thesis In February 2014, with the opening of the first ever branch of McDonald’s, a giant US fast-food company in Ho Chi Minh City, Viet Nam, the Economists Magazine have added the Vietnam Dong (VND) to its collection of Big Mac Index (BMI) This index provides McDonald’s burger prices in all different parts of the world in terms of local and foreign currencies The index is considered as a lighthearted guide in order to evaluate whether a currency of a particular country of interest is at its correct level The index has been increasingly well-recognized as a global standard with its existence in several international economics books and many academic studies The thesis aims to evaluate the real value of Thailand Baht and to consider the link between Thailand Baht depreciation and Thailand’s trade balance Thailand is opted to study due to several reasons First, according to Bahmani-Oskooee and The first shortcoming is the data The exchange rates of countries in Europe have been quoted in terms of Euro since 1999 and Euro currency is quoted in the central bank of Thailand from 2001 Therefore, the bilateral exchange rate for most European countries is calculated on the application of a moving average technique Chiu (2010) used the fixed numbers to calculate the bilateral exchange rate This raises the problem of measurement errors The second shortcoming is that the trade balance and real exchange rate variables are stationary with the panel-based unit root tests As such, it is not suitable when using FMOLS for the entire data as well as sub-samples All variables including trade balance, bilateral real exchange rate, domestic GDP, and foreign GDP are nonstationary in terms of individual series; these variables should be treated as an individual series rather than panel data However, this paper provides panel evidences in order to gain a consistency, to make it easy for comparison, and to recommend proper policy implications Finally, there are a number of studies analyzing the lengthy effects of exchange rate on trade balance in association with the phenomenon of J-curve and the well-noted Marshall-Lerner condition However, this thesis has not placed an analysis on these issues 78 REFERENCE Alexander, S S (1952) Effects of a devaluation on a trade balance IMF Staff Papers, 2(2), 263–278 Alexander, S S (1959) Effects of a devaluation: A simplified synthesis of slasticities and absorption approaches The American Economic Review, 49(1), 22–42 Arora, S., Bahmani-Oskooee, M., & Goswami, G (2003) Bilateral J-curve between India and her trading partners Applied Economics, 35(9), 1037–1041 doi:10.1080/0003684032000102172 Baharumshah, A Z (2001) The effect of exchange rate on bilateral trade balance : new evidence from Malaysia and Thailand Asian Economic Journal, 15(3), 291– 312 Bahmani-Oskooee, M (1985) Devaluation and the J-Curve : Some Evidence from LDCs The Review of Economics and Statistics, 67(3), 500–504 Bahmani-Oskooee, M (1993) Macro-Economic determinants of Australia’s current account, 1977-86: A reexamination Weltwirtschaftliches Archiv, 129(2), 411– 417 Bahmani-oskooee, M M (1992) What are the long-run determinants of the US trade balance ? 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Kuwait, Nigeria, Oman, Asia Saudi Arabia, South Africa Asia and Oceania Australia, Bangladesh, Brunei,Cambodia, China, Hong Kong, India, Indonesia, Japan, South Korea, Lao PDR, Malaysia, Nepal, New Zealand, Pakistan, Philippines, Singapore, SriLanka, Vietnam High income Australia, Austria, Belgium,Brunei, Canada, Cyprus, Czech Republic, Chile, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, South Korea, Kuwait Upper income middle Brazil, Bulgaria, Colombia, China, Hungary, Iran, Malaysia, Mexico, Panama, Peru, Romania, South Africa, Turkey Lower middle and Bangladesh, Benin, Cambodia, Coted' Ivoire, Egypt, India, Indonesia, low income Lao PDR, Nepal, Nigeria, Pakistan, Philippines, SriLanka, Vietnam 86 Appendix B: Diagnostics tests  Test of multicollinearity As presented in Gujarity (2011, p 71-74), there are five ways to detect multicollinearity phenomenon in the model In this thesis, the variance-inflating factor (VIF) approach is used to check the multicollinearity VIF is a measure of degree to which the variance is inflated in OLS estimation owing to collinearity The VIF is calculated as follows: 𝑉𝐼𝐹 = 1 − 𝑟𝑖𝑗2 where rij is the coefficient of correlation between two variables i and j, respectively The rule of thumb to identify multicollinearity is that the value of VIF is greater than 10 Stata command:  ivvif after ivreg2 command Test of heteroscedasticity This thesis performs heteroscedasticity test by Pagan and Hall’s (1983) for instrumental variable (IV) regression The test also presents the related standard heteroscsedasticity test by White/ Koenker with OLS or IV regression.The null hypothesis is of no heteroscedasticity, the test statistic is distributed as chi-squared with degrees of freedom equal the number of indicator variables If the results fail to reject the null hypothesis, meaning that the disturbance is homoscedasticity Stata command:  ivhettest after ivreg2 command Test of autocorellation This thesis uses autocorrelation test by Arellano-Bond (1991) in panel data The test was originally proposed for a particular linear Generalized Method of Moments 87 dynamic panel data estimator, but it is more applicable than other panel-based autocorrelation tests like Wooldridge (2002) It can be applied in a variety estimation methods such as linear GMM regressions, ordinary least squares (OLS) and two-stage least-squares (2SLS) It can also be made consistent in the presence of various patterns of error covariance Stata command:  abar, lags (number) after ivreg2 command Test of endogenity This thesis applied the endogenity test in which one or more endogenous variables could be implemented The test was first proposed by Durbin (1954) and separately by Wu (1973) and Hausman (1978) The null hypothesis is that the specified endogenous variables could be treated as exogenous ones The test statistic is distributed as chi-squared with degrees of freedom equal to the number of variables tested A rejection of the null hypothesis indicates that effects of endogenous regressors' on the estimation are meaningful, thus IV techniques are required The test is presented when the option of endogtest (regressors) is added after ivreg2 or xtivreg2 command 88 Appendix C: Results of IV estimation for determinants of Thailand’s trade balance  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir  ivvif Variable VIF D.rer 1.19 D.gdpr 1.18 D.govgdpr 1.18 D.m2gdpr 1.08 D.rir 1.02 Mean VIF 1.13  ivhettest OLS heteroskedasticity test(s) using levels of IVs only Ho: Disturbance is homoscedastic White/Koenker nR2 test statistic: 5.138 Chi-sq(5)P-value = 0.3992  abar, lag(2) Arellano-Bond test for AR(1): z = -9.40 Pr > z = 0.0000 Arellano-Bond test for AR(2): z = -0.78 Pr > z = 0.4348  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir, cluster(id) 89 Appendix D: Results of IV estimation for determinants of Thailand’s trade balance Entire sample Undervaluation Overvaluation Undervaluation Overvaluation CPI CPI BMI BMI -0.107 -2.007 0.276 -0.153 -0.0797 (-0.12) (-1.45) (0.27) (-0.22) (-0.12) -1.733** -2.747*** -1.482 -2.649** -1.647* (-2.57) (-3.47) (-1.41) (-2.23) (-2.01) -0.128 -0.144 0.0441 0.107 -0.208 (-0.46) (-0.56) (0.14) (0.46) (-0.56) -0.536* -0.699** -0.402 -0.113 -0.313 (-1.89) (-2.25) (-0.94) (-0.23) (-1.11) 0.0528 0.0270 0.0969 0.0448 -0.0396 (1.13) (0.59) (0.85) (0.74) (-0.97) 0.0520** 0.100** 0.0510* 0.0432 0.0350* (2.60) (2.12) (1.88) (1.66) (1.90) N 1201 681 520 254 214 Endog_test 3.879 5.076 2.021 3.236 0.147 P-value 0.0489 0.0243 0.1552 0.0721 0.7017 D.rer D.gdpr D.m2gdpr D.govgdpr D.rir _cons 90 High income Upper middle income Lower middle and low income Asia and Oceania Europe America Africa and Western Asia 0.367 -0.325 -0.435 0.589 1.468* -0.440 -2.960 (0.71) (-0.21) (-0.27) (0.41) (1.78) (-0.22) (-0.97) -1.555 -1.565 -1.662 -0.349 -1.176 -3.452 -2.432 (-1.53) (-1.54) (-1.05) (-0.47) (-1.15) (-1.32) (-0.96) 0.0906 0.456 -1.178** -0.602** 0.0832 -1.061 0.783 (0.61) (0.84) (-2.62) (-2.25) (0.27) (-0.98) (0.98) -0.253 -0.276 -0.719 -0.153 -0.202 -0.701 -0.259 (-0.42) (-0.69) (-1.12) (-0.40) (-0.72) (-0.49) (-0.19) -0.00175 0.131 0.0736 -0.0227 0.0764 0.212 0.0409 (-0.05) (1.04) (0.51) (-0.79) (0.96) (1.15) (0.22) 0.0560** 0.0426 0.0243 0.0148 0.0258 0.0903 0.116 (2.30) (1.40) (0.61) (1.50) (0.79) (1.07) (1.08) N 616 294 291 426 416 183 176 Endog_test 0.028 0.031 0.044 2.466 1.143 4.231 0.206 P-value 0.8676 0.8604 0.8345 0.1163 0.2851 0.0379 0.6502 D.rer D.gdpr D.m2gdpr D.govgdpr D.rir _cons 91 Appendix E: STATA COMMAND IN THE THESIS  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir  ivvif  ivhettest  abar,lag(2)  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir, cluster(id)  xtivreg2 tb gdpr m2gdpr govgdpr rir (rer= l(1/2).rer m2 thai_m2 reserve thai_reserve ir thai_ir), fd endog(rer) orthog(gdpr) cluster(id) small  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir if under_cpi==x, cluster(id)  xtivreg2 tb gdpr m2gdpr govgdpr rir (rer= l(1/2).rer m2 thai_m2 reserve thai_reserve ir thai_ir) if under_cpi==i, fd endog(realer) orthog(gdpr) cluster(id) small  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir if under_bmi==x, cluster(id)  xtivreg2 tb gdpr m2gdpr govgdpr rir (rer= l(1/2).rer m2 thai_m2 reserve thai_reserve ir thai_ir) if under_bmi==x, fd endog(realer) orthog(gdpr) cluster(id) small  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir if income==i, cluster(id)  xtivreg2 tb gdpr m2gdpr govgdpr rir (rer= l(1/2).rer m2 thai_m2 reserve thai_reserve ir thai_ir) if income==i, fd endog(realer) orthog(gdpr) cluster(id) small  ivreg2 d.tb d.rer d.gdpr d.m2gdpr d.govgdpr d.rir if region==j, cluster(id)  xtivreg2 tb gdpr m2gdpr govgdpr rir (rer= l(1/2).rer m2 thai_m2 reserve thai_reserve ir thai_ir) if region=j, fd endog(realer) orthog(gdpr) cluster(id) small (in which x=0,1; i=1,2,3; and j=1,2,3,4) 92 ... test of PPP and the evaluation of Thailand Baht? iv What factors determine the Thailand trade balance? v Is there any long run relationship between real bilateral exchange rate and Thailand? ??s trade. .. her trade balance to Thailand 24 CHAPTER THAILAND? ??S TRADE BALANCE AND ITS BIG MAC INDEX In this chapter, an overview of Thailand? ??s trade balance during 1980-2013 periods is initially provided Then,... employed the disaggregate data or bilateral exchange rate to investigate the link between trade balances and exchange rate changes Theoretically, devaluation of nominal exchange rate worsens the trade

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