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FACTORS AFFECTING EXCHANGE RATE MOVEMENTS IN SELECTED ASIAN

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Conference Paper · April 2012

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 1

FACTORS AFFECTING EXCHANGE RATE MOVEMENTS

IN SELECTED ASIAN COUNTRIES

by

Jerson B. Patosa1 and Dr. Agustina Tan Cruz2

. .

Abstract
Exchange rate has a vital role in the country’s level of trade, which in turn is very
critical in a free market economy. Consumer spending is specifically directly affected by
money supply in the agribusiness sector, and vice versa. The main objective of this study
is to determine the factors affecting movements in the exchange rate of selected Asian
countries. The United States is taken as the base country. The real interest differential
(RID) model, supported by the Keynesian and Chicago price theories, is used in the
study. Data on money supply, industrial production, interest rate, and inflation rate were
taken from the World Bank for the period 1977–2010. Both long- and short-run exchange
rates were estimated using ordinary least squares (OLS). Results show that not all
variables included in the model contribute to the explanation of exchange rate
movements. Industrial production is significant in all countries. Results for other three
variables money supply, interest rate and inflation rate are somewhat mixed. China,
Malaysia, Thailand and Singapore have only two significant variables each. For China
and Malaysia, the significant variables are industrial production and inflation rate. For
Thailand industrial production and interest rate are significant and for Singapore money
supply and industrial production. For the Philippines, three variables have significant
contribution to the exchange rate movements, and these are money supply, interest rate
and industrial production. Policy makers therefore must be aware of control mechanics so
that movements of any determinants will not run adverse to the market mechanism.

Keywords: exchange rate movements, ordinary least squares, real interest differential model.
.

INTRODUCTION

Exchange rate is a very important factor affecting economic health. It has a vital
role in country’s level of trade which in turn is very critical in a free market economy.
Consumers spending particularly in the agri-business sector, it is directly affected by
money supply and vice versa.
1
Faculty, Department of Agribusiness, College of Agri-business, Fisheries, Marine and Sciences, Southern
Philippines Agri-business Marine and Aquatic School of Technology (SPAMAST-DIGOS
CAMPUS).
2
Dean, School of Applied Economics, University of Southeastern Philippines (USeP-SAEc)
 2

This is the reason why exchange rate is the most monitored, analysed and
politically manipulated measures of the economy (wiki.answers.com). Like any other
commodity, the value of the currency rises and falls depending on the forces of demand
and supply. Consumer spending is directly affected by money supply and vice versa. The
supply and demand of the country’s money is reflected in its foreign exchange rate
(www.tutor2u.net).The relative demand and supply of money in the country will
determine the exchange rate between countries. A permanent increase of money supply in
home country causes the exchange rate to depreciate. An increase in the home country
interest rate causes the demand for money to decrease followed by an increase in the
price level resulting in home country over foreign country exchange rate depreciation.
Likewise, an increase of interest rate in a foreign country causes the demand for money in
that foreign country to decrease causing an increase in price level in said foreign country,
and the home country over foreign country exchange rate will appreciate
(wiki.answers.com).
The country import and export are also affected by the changes of exchange rate.
An appreciation of home country currency will lead the price of export products to be
more expensive, and import products to be cheaper. Likewise, a depreciation of home
currency will lead the price of import products to be more expensive and export
products to be cheaper.

Rationale of the Study

A poorly–managed exchange rate can be disastrous to economic growth.
Understanding the exchange rate and the factors affecting its movements is very
important, since transactions outside or inside of the country are affected by the exchange
rate. Exchange rate serves as the basic link between the domestic and the foreign market
for various goods, services and financial assets. Using the exchange rate we are able to
compare prices of goods, services and assets quoted in different currencies. The interest
of this study is to investigate which factors really affect movements of the exchange rate.
Among many models used in determining factors affecting exchange rate movements,
Real Interest Rate (RID) model was used in this study. A real understanding of the
mechanism behind the exchange rate movements has always been of great interest for
economists around the world. As a consequence, studies were done about exchange rate
in some countries in Asia but this study used Real Interest Rate (RID) model to determine
which macroeconomic variables affect the exchange rate movements in selected Asian
countries.

Significance of the Study

Movements in today’s exchange rate are affecting tomorrow’s exchange rate level
and, thus, the Central Bank’s loss function. As is the case with price level stabilization,
the forward-looking public understands that deviations from target will be countered by
future policy movements. Consequently, this reduces the discretionary stabilization bias.
The impact of exchange rate to the macroeconomic variables is an essential factor that
policymakers should consider, aside from determining factors affecting exchange rate
movements between countries. Moreover, this will help them in deciding what issues and
policies are to be prioritized, especially in formulating the monetary as well as the fiscal
policy.
 3

Objectives of the Study

The main objective is to determine the factors affecting movements in the
exchange rate of selected countries in Asia. The study aims to present trends of exchange
rate movements in the Philippines, China, Singapore, Thailand and Malaysia, with United
States as the base country and to test the capacity of Real Interest Differential (RID)
model in determining the movements of exchange rate.

Scope and Limitations

In reality, many factors affect exchange rate movements and so-called real factors
or real understanding. The study is limited to secondary data on the following
macroeconomic variables: money supply, industrial production proxied by real GDP,
interest rate and inflation rate of the Philippines, China, Singapore, Malaysia, Thailand
and the United States. Data for the period 1977 to 2010 were gathered from the website
of the World Bank. Among the many models used in identifying the determinants of
exchange rate movements, the Real Interest Differential (RID) model will be adopted.

REVIEW OF RELATED LITERATURE

Using the Real Interest Rate model in identifying the determinants of exchange
rate movements, Peterson (2005) confirmed that variables included in the model used to
explain the changes in exchange rate are not uniform for countries. One country
experiences a different economic situation compared to another country; hence the
movements of exchange rate also differ, and so with the factors affecting them. The
variables that seem to be the most in line with the original RID model among three
countries (Japan, Sweden and UK) are interest rate differential and inflation rate. The
result is somewhat unexpected for industrial production and money supply. The
coefficient for money supply is negative instead of the expected positive sign. All three
economies show this relation and results are also significant at 1% level. Due to a 1%
decrease in money supply, exchange rate increases by 0.65%.
Hua (2011) showed the economic and social effects of real exchange rate. A real
appreciation exerts positive effect on economic growth by exerting pressure on efficiency
improvement and technological progress via worker’s motivation, education and capital
intensity. It exercises negative effect by deteriorating the international competitiveness in
tradable sector, and thus by destructing employment. He used the Generalized Moment
Model (GMM) system estimation approach and panel data for 29 Chinese provinces, over
the period 1987-2008. The study showed that the real exchange rate appreciation had a
negative effect on the economic growth and is higher in coastal than in inland provinces,
contributing to a minimization of the gap of GDP per capita between two kinds of the
provinces. Also, the real exchange rate appreciation exhibited negative effects on
employment.
Dorosh and Valdez (1990) quantify the effects of exchange rate and trade policies
on agriculture in Pakistan. They found out that a trade policy bias to importable goods
leads to an appreciation of the exchange rate, i.e., a decrease in the ratio of the domestic
 4

price of traded goods to non-tradable. The real exchange rate appreciates because tariffs
on imports raise the domestic prices of import goods so that demand shifts to non-traded
goods. The main finding of their paper is that there is a need to analyse the effects of
policy interventions in agriculture in developing countries in an economy-wide
framework. They also found that there is now an overwhelming body of evidence
showing that trade and exchange rate had a greater adverse impact on agriculture
incentives, than policies that are specific to agriculture. The indirect and usually implicit
price intervention also influence private investment and labor employment in agriculture,
and induce substantial income transfer from agriculture to the rest of economy.
Byrne and Davis (2003) estimate the impact of exchange rate uncertainty on
investment, using panel estimation featuring a decomposition of exchange rate volatility
derived from the GARCH model of Engle and Lee (1999). The key result of the study is
that transitory and not the permanent component of exchange rate negatively affects
investment. The permanent volatility will not delay investment as firms act to take
advantage of related permanent shifts in the exchange rate, while a rise in temporary
volatility will reduce investment as firms become more conservative under sensitive
uncertainty and delay their investment. The results imply that to the extent that Economic
and Monetary Union (EMU) favors lower transitory exchange rate, it will also be
beneficial to investment (Byrne and Davis, 2003)
Aydin et., al. (2004) estimates the export supply and import demand for the
Turkish economy using both single equation and vector regression framework. The study
indicated that imports are mostly affected by the real exchange rate and national income.
The analysis reveals that the real exchange rate is a significant determinant of imports
and trade deficit, but not of export. Exports are mostly determined by unit of labor cost,
export prices and national income. The VAR finding that the real exchange rate is
determined by current account indicates that the effect of the real exchange rate on trade
deficit basically works through the imports. On the export side, as the unit of labor costs
and export prices are basic determinants, public and private policy measures toward
productivity increase should be taken into consideration.
Berument and Pasaogullar (2003) investigate the negative relationship between
the real exchange rate and output in Turkey. They first analysed the bivariate relationship
between the set of the variables (interest rate, real exchange rate, government size,
inflation rate, output, capital account and current account). They also analysed whether a
long-run relationship exist between the real exchange rate, inflation rate and output.
Several VAR models were estimated, and the forecast error variance decomposition and
impulse responses obtained from the VAR models were examined. In the bivariate
analysis, for most of the transformations and lags, they found a negative correlation
between output and real exchange rate. However, from the Granger causality test, they
did not find a significant causality between the variables, possibly due to the inability of
the test to remove the effects of other exogenous variables. They also found that a long-
run relationship exists among the real exchange rate, inflation rate and output. After
employing various VAR models for the sample period (quarterly data from 1987-2001),
they found out that real exchange rate movements are very important in the variability of
output. The response of output is negative and permanent after a real devaluation. Their
findings also hold in the alternative settings in which the possible effects of external
variables are controlled.
 5

Kamin and Roger’s (2000) study in Mexico suggest that to limit the detrimental
effects of devaluation, the overvaluation of a currency must be prevented. Further, they
claim that there is no easy way to keep output costs at moderate levels after devaluation.
An overvalued domestic currency may initially result in increased output but may create
the risk of a financial crisis, which in turn, may cause exchange rate depreciation and
subsequent output losses.

METHODOLOGY

Theoretical Framework deliberated

The Keynesian theory and the Chicago price theory are the theories supporting the
RID model developed by Jeffrey A. Frankel in 1979. Keynesian theory is a general
theory of employment, interest and money. Keynesianism is named after John Maynard
Keynes, a British economist who lived from 1883-1946. Keynesians believe that prices
and wages are not flexible but are sticky, downward. The stickiness of prices and wages
in the downward direction prevents the economy’s resources from being fully employed.
Another theory used by Frankel is the Chicago price theory formulated by Milton
Friedman in 1976 and George Stigler 1982, supported by the Department of Economics,
Chicago University. This theory assumes that prices and wages are flexible; a
contradiction to Keynesian theory. It is based on the premise that answering important
economic questions correctly requires the ability to combine theory and data. Peterson
(2005) used the Chicago price theory and included the money supply, industrial
production, interest rate and inflation differential to explain the movements in the
exchange rate between countries.
The Frankel RID model tested the Deutche Mark/US dollar rate between the years
1974-1978 and found that the model helped explain over 80% of the Frankel RID model
exchange rate variations between the US and Germany. The model receives great
enthusiasm around the world for its ability to predict exchange rate movements to a larger
extent. Many economists have re-evaluated the model and tested it in different time
periods. However, support for the model after the 1980’s has been rather poor. In the
study of Isaac and de Mel (1999) they concluded that the Frankel’s validation of the RID
model was pure historical accident. But in the study of Peterson (2005), it was found that
the model seems to be able to explain movements in the exchange rate to a certain degree
up to the present.
The model has the Purchasing Power Parity (PPP) and the Uncovered Interest
Rate Parity (UIRP) as underlying theoretical assumptions, the two main building blocks
of open macroeconomics. When combined, the PPP and UIRP offer a relationship
between changes in exchange rate and the interest rate. Peterson (2005) also claimed that
the model constitutes significant explanatory variables (money supply, industrial
production, interest rate and inflation rate) for exchange rate movements in all countries
included in his study. This study seeks to find out if the variables used in the model of
Peterson (2005) can help identify exchange rate movements in Asian countries with the
US economy as the base.
 6

Purchasing Power Parity

For the RID model to hold, Purchasing Power Parity (PPP) must also hold. PPP is
a generalization of the law of one price, which states that two identical goods must sell
for the same price when converted into the same currency. PPP states that the general
price level should be the same when converted into a common currency.
The PPP equation is expressed as:

=x (1)
where:
= domestic price level
x = spot exchange rate
= foreign price level

Reasons for PPP failure are sticky prices, the existence of non-traded goods and
the fact that the basket of goods used in different countries may differ according to taste
and other social factors. For absolute PPP to hold the real exchange rates which have to
be floating should be equal to one.
In practice, absolute PPP is not very likely to hold (Copeland, 2005). However,
relative PPP can help explain movements in the exchange rate. This hypothesis states that
when the domestic currency experiences higher inflation, there must be an equal fall in
the value of the home country’s currency. According to Copeland (2005) inflation in the
home country is equal to the foreign country’s inflation rate plus the percentage
depreciation. Similarly, home country’s inflation can only be higher to that of the foreign
if its currency depreciates by the same percentage.

Uncovered Interest Rate Parity

The second underlying theory is Uncovered Interest Rate Parity (UIRP), which
states that when the domestic interest rate is higher than that of foreign, there must be a
compensated depreciation of the home currency.
The UIRP equation is written as:

= + (2)
where:
= domestic interest rate
= foreign interest rate
= the expected % depreciation of the
domestic currency

If the domestic country’s currency is expected to depreciate and hence, lose

value, no domestic or foreign agents will hold domestic assets unless they offer a higher
interest that compensate for the lower value of the currency. UIRP assumes that
economic agents are risk neutral. They do not require a risk premium when undertaking
risky investments. In other words, they are indifferent between holding risky assets or not
and hence, they only care about the average return (Copeland, 2005)
 7

Conceptual Framework
Figure 2 shows the conceptual framework of the study. The identified economic
variables that can affect the exchange rate movements are: money supply, industrial
production, interest rate and inflation rate. The variables in this study are the same with
those of Peterson (2005).
• Exchange Rate Movement in:
- Philippines
• Money supply (M2)
- China
• Industrial production
- Singapore
• Interest rate
- Malaysia
• Inflation rate
- Thailand
-U.S. (base country)
Figure 2: Factors affecting exchange rate movements in selected Asian countries with the United States as
the base.

The exchange rate movements are hypothesized to be affected by money supply,

industrial production, interest rate and inflation rate. Of the four economic variables, the
interest rate and inflation rate are generally viewed as standard determinants of exchange
rate movements. Peterson (2005) found that these variables seem to be the most
influential factors in his original RID model.
The domestic currency price of the foreign currency is one of the many prices in
the economy that rises in the long-run after a permanent increase in the money supply. A
permanent increase in a country’s money supply causes a proportional long-run
depreciation of its currency against foreign currencies. Similarly, a permanent decrease in
a country’s money supply causes a proportional long-run appreciation of its currency
against foreign currencies (Krugman and Obstfeld, 2006).A country with a consistently
lower inflation rate exhibits a rising currency value, as its purchasing power increases
relative to other currencies. Those countries with higher inflation typically see
depreciation in their currency in relation to the currencies of their trading partners. This is
also usually accompanied by higher interest rates. Interest rate is determined by the
money market. Higher interest rates offer lenders in an economy a higher return relative
to other countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to
drive the currency down (www.investopedia.com).A rise in domestic industrial
production or output level raises domestic money demand leading by the fall in the long-
run domestic price level. According to the PPP model there is an appreciation of the
domestic currency against foreign currencies. A rise in foreign output raises foreign
money demand, leading to a fall of foreign price level in the long-run.

The Model
The model was developed by Frankel (1979) using different approaches regarding
the relationship between the interest rate and exchange rate. The first approach assumes a
flexible price and is referred to as the Chicago theory. The flexible price assumption
implies a positive relation between the interest rate and the real exchange rate. This is
explained by the fact that when the domestic interest exceeds that of the foreign, the
 8

domestic currency is expected to experience depreciation and inflation in the near future.
This in turn causes demand for domestic currency to fall with depreciation as a
consequence. Hence, we have a positive relationship between the interest rate and the
exchange rate. The second model involves the RID model assuming sticky prices, and is
called the Keynesian theory. This theory has a negative relationship between the
exchange rate and interest rate. With the domestic interest higher than foreign because of
a reduction of the domestic money supply, but without a fall in the price since prices are
sticky, capital inflow is increasing. This will in turn lead to an appreciation of the
domestic currency.
With the two underlying theories explained, the basic assumptions for the RID
model can be revealed. The RID model is considered a combination of the Chicago
theory with flexible price and the Keynesian theory with stickiness in the sense that it has
a negative relation between the exchange rate and the interest differential, but a positive
relation regarding the exchange rate and the long-run expected inflation differential
(Frankel, 1979).

Long run exchange rate:

The long-run exchange rate could be expressed in the following form:

= +φ −λ ,
= −φ +λ
= − = ( −φ +λ ) − ( −φ +λ )
= − − φ( − ) + λ( − ), (3)
where:
= natural log of money supply
= natural log of the price level
= natural log of real output
= interest rate
= short-run exchange rate
= long-run exchange rate
φ = parameter representing intercept term
λ = speed of mean-reversion
= indicates the analogous variables for the
domestic country
= indicates the analogous variable for the foreign
country
* = indicates the analogous variable for the long-run
It follows that an increase in the domestic money supply causes the price to go up
and hence, the exchange rate to depreciate. An increase in income or a fall in the
 9

expected price increases the demand for money and therefore causes the currency to
appreciate.

Short run exchange rate

Assume UIRP and relative PPP, x= − to hold, and also =θ( – ) +
( – , where θ>0 is the speed of adjustment (the greater the gap between the spot and
long-run exchange rate, the faster is the % change in the exchange rate). By combining
the UIRP and PPP, we come up with equation 4, which demonstrates the short run
exchange rate.

− = ( – )+( –
= − ( − )−( – (4)
where:
= speed adjustment
= domestic exchange rate
= foreign exchange rate
= domestic inflation rate
= foreign inflation rate and other variables are as
defined in equation (3)
Real Interest Parity
In the long run, = ; hence:
− = – , (5)

This is known as “Real Interest Parity”, a combination of UIRP and PPP. It states
that the interest rate differential is equal to the inflation differential.

Real Interest Differential Model

Combining equations (3) and (5), we have:

= − −φ ( − ) + λ( – , (6)
= ; = ; = ;
= ; = and =
where:
= money supply differential as % of GDP
= natural log of real output
= inflation rate
φ = parameter representing intercept term
λ = speed of mean-reversion
 10

When combining equation 6 with the short run conditions of equation 4, we end
up with equation 7 below:
= − −φ( − )− ( − ) + (λ + ) – (7)
where:
=spot exchange rate
= speed of adjustment

The model describes the exchange rate as a function of the relative money supply,
the relative income level, the interest differential and the inflation differential. In the
short run, the exchange rate’s speed of adjustment is proportional to the size of the gap
between the spot exchange rate and the long run exchange rate, and in the long run, when
= , by the inflation rate.This can be tested by estimatingto see whether or not it can
help explain any of the variation of the exchange rate with appropriatesigns on the
coefficient estimates. The final model, which serves as the empirical model of the study
is then expressed as:

x = β0 + β1(md – mf) + β2(yd – yf) + β3(rd – rf) + β4(Id – If) + ε (8)

where the variables are as previously defined.

Data and Variables

The data were gathered from the World Bank website. The following variables
were considered:
(a) Money supply– the total amount of money available in an economy at
specific time (M2).
(b) Industrial production –a measure of the county’s economic health judged
by Its output from manufacturing, mining and utility industries, proxied
by real GDP.
(c) Inflation rate –the %age rate of change in price level over time.
(d) Interest rate – the rate at which interest is paid by a borrower for the use
of money that they borrow from a lender.

Empirical Application
This section presents the model for the real interest differential theory. Equation 8
is used to test which variable affect the exchange rate movements in selected Asian
countries (Philippines, China, Singapore, Malaysia, and Thailand) with the United States
as the base.
This study determined the factors affecting exchange rate movements in selected
countries in Asia during the years 1977-2010. Ordinary least square (OLS) and the
unstandardized coefficients have been used to estimate the model (Frankel 1979). In
order for the estimation of the parameters to be BLUE (Best Linear Unbiased Estimator)
the following conditions are to be satisfied:
(i) Each random error has a probability distribution with zero mean.
Some errors will be positive that is; E (t) = 0
 11

(ii) Each random error has a probability distribution with variance of

σ2, E (έ2) = var (έ) = σ2.
(iii) The covariance between the two random errors corresponding to
any two different observation is zero; cov (έsέt) = 0 where ,
t ≠ s.

RESULTS AND DISCUSSIONS

Philippines

Estimates of Parameters: Philippines

Table 1 shows that industrial production, money supply and inflation rate are the
significant variables. The exchange rate elasticity with respect to industrial production is
-0.479, implying that a 1% increase in the industrial production causes the Philippine
exchange rate to depreciate by 0.479%. This jibes with the study of Berument and
Pasaogullar (2003) where the correlation of exchange rate and output is negative. A
permanent increase of money supply in the home country causes the exchange rate to
decrease.
The estimated coefficient of money supply is -0.392, indicating that a 1% increase
in the money supply causes the Philippine exchange rate to decrease by 39.2%. Based on
macroeconomic theory, an increase in money supply causes a decrease in interest rate
followed by an increase in investment and consumption. Aggregate demand will increase,
and consequently, the demand for money will increase. As a result, demand for peso will
increase. Only the interest rate is not significant and this means that movements of
exchange rate in the Philippines are not affected by the changes of this variable.

Table 1.Estimates of coefficients – RID model for the Philippines, 1977-2010.

Variable Estimated Standard P-Value Partial
Name Coefficient Deviation Correlation

Constant 2.121ns 2.003 2.003

_
Money supply -0.392* 0.189 0.046 -0.360
_
Industrial production/real GDP -0.479* 0.070 0.000 -0.787
_
Inflation rate 0.329* 0.146 0.032 0.787
_Interest rate 0.706ns 0.638 0.277 0.202
_ _
R2 adjusted = 60.79,
* = Significant at 10% level
ns
= Not significant

By squaring the partial correlation value, we can get how much each independent
variable is contributing to the dependent variable. Industrial production has a partial
correlation value of -0.787 which gives 0.619 and hence, explains 61.9% of the exchange
rate variability. Money supply differential explains 19.9%, inflation rate differential
explains 14.9% and the interest rate differential only 4.08%.
 12

Figure 3 shows the actual and predicted exchange rate values of Philippine peso
based on the U.S. dollar. The predicted exchange rate was obtained through the result of
RID model. Both predicted and actual data follow the same trend. The differences
between the predicted and actual data are quite small, indicating the capability of the RID
model to predict exchange rate. As we can see in the graph, the Philippines exchange
rates rapidly increase in 1997 due to the Asian economic and financial crisis. All Asian
countries considered in this study were affected by the crisis (Das, 1999).

60
(Philippine peso: US Dollar)

50

40
Exchnage rate

30

20

10
Actual exchange rate Predicted exchange rate
0
1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009
Year

Figure 3. Actual and predicted exchange rate, Philippine peso: U.S. dollar, 1977-2010.
Exchange rate of the Philippines rapidly increase from 2000 to 2004, it was in the
year 2000 that the investors dumped their holdings due to the allegations of Ilocos Sur
Gov. Luius “Chavit” Singson that President Estrada received payoffs from illegal
gambling operations or jueting. The economy also suffered from wage and transport cost
increases that lead investors to cut their investments. In this year also, the Philippines
stock market has lost around 36 % of its value since the start of that year
(www.newsflash.org).

China

Table 2 shows the regression results for China. Inflation rate differential and
industrial production got the expected signs that support the underlying assumption of the
model. R2 adjusted is equal to 68.50% indicating the contribution of the two variables in
forecasting exchange rate. The exchange rate elasticity with respect to the industrial
production is -0.635, representing a 0.635% decrease in China’s exchange rate as
industrial production increases by 1%.
 13

Table 2.Estimates of coefficients – RID model for the China, 1977-2010.

Variable Estimated Standard P-Value Partial

Name Coefficient Deviation Correlation

Constant -4.935ns 4.677 0.300

Money supply 0.437ns 0.115 0.708 0.070
Industrial production/real GDP -0.635* 0.088 0.000 -0.801
Inflation rate 0.267* 0.128 0.047 0.359
Interest rate 0.014ns 0.038 0.724 0.066
_
R2 adjusted = 68.50
* = Significant at 10% level,
ns
= Not significant
The estimated coefficient of inflation rate differential is 0.267, implying that a 1%
increase in inflation rate causes the exchange rate to appreciate by 26.7%. Money supply
and interest rate are not significant, which means that the movements in exchange rate are
not affected by the money supply and interest rate, as far as China is concerned.
Actual and predicted exchange rate values are presented Figure 4, which shows an
increasing trend during the period 1977 to 2010. The rapid increase of China’s exchange
rate in 1995 was accompanied by a high inflation rate of China.
In the same year the Chinese authorities abolished the exchange rate controls on
current account transactions (exporting, importing, interest and dividends) and unified the
exchange rate. From 1994 to 2004, China fixed their exchange rate (Mckinnon and
Schnabl, 2009).

10
9
8
7
(Chinese Yuan: US Dollar)

6
5
Exchange rate

4
3
2
1
Actual exchange rate Predicted exchange rate
0
1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Year

Figure 4. Actual data and predicted exchange rate, Chinese Yuan: U.S. dollar, 1977-2010.
 14

Malaysia
Table 3 shows the regression results for Malaysia. The R 2 adjusted value of
0.6539 is quite comparable to those of the Philippines and China. The result implies that
65.39% of the variability in the exchange rate is explained by the independent
variables included in the model. Figure 9 shows the capacity of the model to predict the
exchange rate. Industrial production has the largest contribution in explaining the
exchange rate movements.
Of the variables included, industrial production and inflation rate are significant.
Exchange rate elasticity with respect to the Malaysia industrial production is -0.615,
indicating that 1% decrease in industrial production causes the Malaysian exchange rate
to depreciate by 0.615%. Money supply and interest rate differentials are not significant
which means that movements of exchange rate in Malaysia are not affected by the two
variables.
Table 3. Estimates of coefficients – RID model for the Malaysia, 1977-2010.
Variable Estimated Standard P-Value Partial
Name Coefficient Deviation Correlation

Constant -5.533* 1.161 0.000

ns
Money supply -0.035 0.111 0.758 -0.057
Industrial production/real GDP -0.615* 0.092 0.000 -0.778
Inflation rate 0.742* 0.364 0.050 0.353
ns
Interest rate -0.018 0.040 0.668 0.080
_
R2 adjusted = 65.39,
* = Significant at 10% level,
ns
= Not significant
Figure 5 shows the actual and predicted exchange rate values of Malaysian ringgit
with the US dollar as the base. The movements of actual and predicted exchange rate
values are almost constant from 1977 to 1989 but from 1989 to 2010, the big differences
between the two values occurred.
4.5
(Malaysian ringgit: US Dollar)

4.0
3.5
Exchange rate

3.0
2.5
2.0
1.5
1.0
0.5
Actual exchange rate Predicted exchange rate
0.0
1985
1977

1979

1981

1983

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Year

Figure 5. Actual data and predicted exchange rate, Malaysian ringgit: U.S. dollar, 1977-2010
 15

Policy in Malaysia has taken as one of its goals some form of exchange rate
stability. This goal can at times come into conflict with the goal of low and stable
inflation. Exchange rate stability can conflict with the goal of low and stable inflation rate
if it leads to inappropriate setting of policy interest rates or if the exchange rate directly
transmits foreign prices in an inflationary or deflationary fashion.
From September 1998 to July 2005, Malaysia opted for bilateral exchange rate
stability against the US dollar that caused a rapid increase of Malaysian ringgit. Malaysia
abandoned its commitment to bilateral exchange rate stability in favour of a commitment
to effective exchange rate stability on July 21, 2005 (McCauley, 2007).

Thailand

Regression results are presented in Table 4. The value of R 2 adjusted is 0.3419,

implying that only 34.19% of the variability of exchange rate are explained by the
variables included in the study. The capacity of the model to forecast the movements of
exchange rate are shown in Figure 10. Industrial production is significant and it has the
biggest contribution when explaining the model. If the industrial production of Thailand
decreases by 1%, exchange rate will increase by 0.834%. The Chicago price theory
supports the positive relation between exchange rate and interest rate. The estimated
coefficient of interest rate is 0.123 following that a 1% increase in the interest rate causes
the exchange rate to increase by 12.3%. The remaining two variables (money supply and
inflation rate differential) are not significant.

Table 4.Estimates of coefficients – RID model for the Thailand, 1977-2010.

Variable Estimated Standard P-Value Partial
Name Coefficient Deviation Correlation
Constant 2.219ns 11.159 0.199
Money supply -0.342ns 2.513 0.893 -0.025
Industrial production/real GDP -0.834* 0.196 0.000 -0.621
Inflation rate -0.146ns 3.433 0.966 0.008
Interest rate 0.123* 0.069 0.080 0.318
_
R2 adjusted = 34.19,
* = Significant at 10% level,
ns
= Not significant

During the Asian crisis in 1997 to 1998, the Thai baht devalued from 25 to 40 to
the dollar, causing a temporary rise in inflation.
 16

50
45
40

(Thai baht: US Dollar)

Exchange rate 35
30
25
20
15
10
5 Actual exchange rate Predicted exchange rate
0

1999
1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

2001

2003

2005

2007

2009
Year

Figure 6. Actual data and predicted exchange rate, Thai baht: U.S. dollar, 1977-2010.

Singapore
Singapore aims to ensure low inflation as a sound basis for sustainable economic
growth. Monetary policy is centered on the management of the exchange rate, rather than
on the money supply or interest rate. This is a reflection that Singapore is a small and
open economy. The exchange rate is the most effective tool in maintaining price stability
of the place (Parrado, 2004).

Table 5.Estimates of coefficients – RID model for the Singapore, 1977-2010.

Variable Estimated Standard P-Value Partial
Name Coefficient Deviation Correlation

Constant 16.328* 6.114 0.012

Money supply 0.379* 2.109 0.083 0.316
Industrial production/real GDP -0.125* 0.126 0.000 -0.880
Inflation rate 0.282ns 2.595 0.914 0.020
Interest rate -0.039ns 0.039 0.320 0.185
_
2
R adjusted = 78.67,
* = Significant at 10% level
ns
= Not significant

In the context of Singapore’s open capital account, the choice of the exchange rate
as the focus of monetary policy would necessarily imply that domestic interest rates and
money supply are endogenous. As such, MAS money market operations are conducted
mainly to ensure that sufficient liquidity is present in the banking system to meet banks
demand for reserve and settlement balances (wiki.answers.com)
Table 5 shows the regression results for Singapore where both money supply and
industrial production are significant.
 17

The R2 adjusted value of 78.67% is the highest value of all countries included in
this study. In the case of Singapore, the differences between actual and predicted
exchange rate are quite small, indicating that the model can forecast the movements of
exchange rate well (see Figure 11). Squaring the partial correlation reveals that industrial
production explains 77.4% of the exchange rate and money supply only, 9.10%. The
exchange rate elasticity with respect to industrial production is -0.125, implying that a
1% increase in industrial production causes the Singapore exchange rate to depreciate by
0.125%.

Figure 7 presents the actual and predicted exchange rate values from 1977 to
2010. Both actual and predicted data follow the same trend. The downward trends of
Singapore exchange rate indicating a strong local currency against foreign currency (US
dollar). Exchange rate began appreciating in 1983 to 1985. This was followed by a
depreciation that lasted till the end of 1996. The onset of the economic crisis is affected
Singapore exchange rate to depreciate against US dollar . Appreciation began in early
2003, and this rise of the Singapore dollar has continued to the present.

3.0
(Singapore Dollar: US Dollar)

2.5
Exchange rate

2.0

1.5

1.0

0.5
Actual exchange rate Predicted exchange rate
0.0
1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009
Year

Figure 7. Actual data and predicted exchange rate, Singapore dollar: U.S. dollar, 1977-2010.

Summary and Conclusion

This study determined the factors affecting exchange rate movements in
selected Asian countries (Philippines, China, Malaysia Thailand and Singapore). It also
presented trends and investigated the determinants of exchange rate movements in these
countries with the United States as the base country. Data were gathered from the World
Bank website. The Real Interest Differential (RID) model was used in this study to
determine the factors affecting exchange rate movements in selected Asian countries.
Industrial production or GDP has a negative coefficient sign in the RID model,
indicating that when the amount of industrial production increases, the local currency
appreciates. This is true for all five countries in the study. A rise in domestic industrial
production or output level raises domestic money demand leading by the fall in the long-
 18

run domestic price level. According to the PPP model there is an appreciation of the
domestic currency against foreign currencies. A rise in foreign output raises foreign
money demand, leading to a fall of foreign price level in the long-run.
In general, macroeconomic theory states that there is a negative trade-off between
the real exchange rate volatility and interest rate differential (Krugman and Obstfeld,
2006). By controlling supply and demand for money through changes in the interest rate,
a Central Bank can stabilize the exchange rate. Both Singapore and Malaysia reveal this
relation, though the values were not significant.
The significant variables in each country vary. Industrial production is significant
in all countries. A decrease in money supply causes a decrease in interest rate and
increase in investment and consumption in the Philippines. This is an important input to
people in agri-business sector especially that we are in the agricultural country.
The results of this study show that not all variables included in the model
contribute to the explanation of exchange rate movements. The significant variables in
every country are not the same. The variables that seem to be the most in line in with the
original RID model among the five countries are the industrial production. Results for the
other three variables, money supply differential, interest rate differential and inflation rate
differential are somewhat mixed. China, Malaysia, Thailand and Singapore have only two
significant variables each. For China and Malaysia, the significant variables are
industrial production and interest rate and inflation rate differential. For Thailand
industrial production and interest rate differential are significant and for Singapore
money supply and industrial production. For the Philippines on the other hand, three
variables have significant contribution to exchange rate movements, and these are money
supply differential, industrial production and inflation rate differential.

Recommendations
Knowledge of exchange rate movements is vital to changes in the general price
levels of commodities, which are commonly expressed in terms of consumer’s price
indices. If indices in the general price level exceed in big proportion compared to the
salaries and wages of consumers, then such situation is detrimental to the welfare of said
consumers.
Each country shows different significant variables affecting movements of
exchange rate. The policymakers in every country must have different objectives in
dealing with the variables. In the Philippines policymakers must focus on money supply,
industrial production and inflation rate in order to control exchange rate movements. In
China and Malaysia, policymakers must give attention to industrial production and
inflation rate, while Thailand must concentrate in industrial production and interest rate.
Singapore must watch money supply and industrial production to control exchange rate
movements.
Hence it is recommended that researchers must also use other models in
determining the factors affecting exchange rate movements. Inclusions of additional
variables are also suggested. It is also recommended that the data bases should be up-
dated, be made more organized and available to researchers
 19

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