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«How did the Malaysian real exchange rate misalign during the 1997 Asian crisis? Naseem niaz ahmad mohd and Zulkornain yusop and Tajul ariffin masron ...»

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How did the Malaysian real exchange

rate misalign during the 1997 Asian


Naseem niaz ahmad mohd and Zulkornain yusop and Tajul

ariffin masron

Universiti Putra Malaysia, Universiti Putra Malaysia, Universiti

Sains Malaysia

Online at http://mpra.ub.uni-muenchen.de/44922/

MPRA Paper No. 44922, posted 23. December 2013 08:26 UTC

IIUM Journal of Economics and Management 18, no. 2 (2010): 161-95

© 2010 by The International Islamic University Malaysia



Mohd Naseem Niaz Ahmad,a Zulkornain Yusopb and Tajul Ariffin Masronc a Department of Economics, Faculty of Economics and Management, University Putra Malaysia. (Email: naseemniaz@econ.upm.edu.my) b Department of Economics, Faculty of Economics and Management, University Putra Malaysia. (Email: zulyusop@econ.upm.edu.my) c School of Management, Universiti Sains Malaysia, Penang, Malaysia. (Email: tams@usm.my)


Currency overvaluation seems to be the prominent explanation for the 1997–98 Asian financial crisis. Although this is the case, the reinstatement to managed float exchange rate regime in mid-2005, as well as the instability of commodity prices and the recent 2008–2010 global economic crisis, leads to the question of how far the fluctuation in the Malaysian ringgit is consistent with the changes in its economic fundamentals. Based on the theory of real equilibrium exchange rate, this paper estimates the NATREX approach to modeling the Malaysian equilibrium exchange rate from 1991 to 2009. The empirical results show that the ringgit took a U-turn from being overvalued during the pre-crisis (1991–1997) to being undervalued in the post-crisis (1997–2002) periods, before fluctuating around its long-run equilibrium for the rest of the period. This corroborated the hypothesis that an overvaluation leads to a currency crisis, which is followed by substantial currency devaluation. The misalignment rates then reduce and remain close to the equilibrium path.

JEL Classification: C32, F31, F41 Key words: Asian crisis, Global financial crisis, Real exchange rate misalignment, NATREX model, Malaysia 162 IIUM Journal of Economics & Management 18, no. 2 (2010)

1. INTRODUCTION In the history of development economics, concern about exchange rate misalignment that is associated with the extent of over- or undervaluation of currencies has been thought of as a key factor, especially for emerging economies, including Malaysia. Over the past decade, Malaysia has managed to develop strong macroeconomic fundamentals as well as a strong financial sector until the 1997-98 financial crisis. In the 1990s, Malaysia exhibited strong economic performance, where the inflation rate was low, unemployment was below 3 percent, the exchange rate remained stable at around RM2.50 per US dollar, the current account improved,, and the international reserves remained high. All these factors led to an impressive real GDP growth of around 8 percent per annum, which was several times faster than the US and other western industrial countries (Lee et al., 2002). This reflected that Malaysia was a well-managed country, both in terms of economic development and political stability. However, in mid-1997 the Malaysian economy was caught in a financial crisis that arose from a regional contagion effect. The crisis swept Southeast Asian countries into dramatic currency chaos and forced the Malaysian ringgit to depreciate by about 80 percent, from RM2.50 to RM4.50 per US dollar. In defeating the crisis, the Bank Negara Malaysia (BNM) had pegged the ringgit against the US dollar at RM3.80 per US dollar.

The continued shackling of the ringgit to the US dollar led to a 38.1 percent depreciation of the ringgit1 The BNM, however, later removed the peg and allowed the ringgit to operate in a managed float in July 2005.

The ringgit depreciation that was caused by the regional crisis can be interpreted as a disequilibrium phenomenon, suggesting that the ringgit was severely affected by exchange rate misalignment.

From the literature, real exchange rate misalignment can be defined as the deviation between the actual and the real equilibrium exchange rates, which is labeled as being overvalued (undervalued) when the actual real exchange rate is below (exceeds) the equilibrium real exchange rate (Richaud, Varoudakis and Veganzones, 2000; Zhang, 2001). Leape et al. (1997) document that an exchange rate misalignment may arise when there is a degree of fixity in exchange rate in terms of managed or fixed exchange rates or in the situation where floating markets are not efficient.

How Did the Malaysian Real Exchange Rate Misalign During the 1997 Asian Crisis? 163 Furthermore, Bouoiyour and Rey (2005) notice that the fixed exchange rate system allows serious misalignment of the exchange rate. It is also acknowledged that a chronic misalignment in real exchange rate was the major source of slow growth in Africa and Latin America (World Bank, 1984 and Gulhati, Bose and Atukorala, 1985).

The findings from the earlier studies imply that the Malaysian exchange rate is at risk of misalignment from actual market rates, which could distort the country’s comparative advantage based on the Ricardian theory of international trade, hence, inhibiting the Malaysian economy as its external sector is the main engine of economic growth. If the ringgit were to remain pegged to the dollar, a depreciating ringgit would cause the cost of imports to rise significantly; fuelling domestic inflationary pressures and forcing the export sector to become less competitive (Ariff, 2005). A dramatic currency devaluation or depreciation is the most likely outcome of a currency crisis that is generated by an “overvalued” exchange rate (Kaminsky and Reinhart, 1999; Goldfajn and Valdes, 1999; Edwards and Savastano, 1999; Chinn, 2000; Edwards, 2000). Stein and Lim (2004) further corroborate that overvaluation of the exchange rate is a vital determinant, which is very costly and has been the cause for most currency or balance of payments crises.

In this respect, the determinants of exchange rates or the misalignment of exchange rates pose a number of questions and challenges to policymakers and researchers in terms of how to measure the misalignment of the real equilibrium exchange rate. The 1997 turmoil is believed to be the cause of the temporal ASEAN exchange rate misalignment. The rise of the global economic crisis of 2008–09 which epicentered in the United States, and the instability in global commodity prices such as food and oil prices have sparked an increase in the number of empirical studies examining the topic of exchange rate misalignment, leading to much debated policy implications and reactions.2 This encourages us to exclusively scrutinize the misalignment of the Malaysian ringgit during 1991–2009, which spans the years of the development of the foreign exchange market and financial opening of the country, the 1997–98 financial crisis, as well as the recent 2008–09 global economic crisis.

164 IIUM Journal of Economics & Management 18, no. 2 (2010) The generalizability of much published research on this issue is problematic and assorted. Among previous studies that have dealt with such matters are: Furman and Stigliz (1998), and Sazanami and Yoshimura (1999), who measure real exchange rate misalignment using the purchasing power parity (PPP) in long-run averaging (“stylized facts” base period) and mean reverting as base period, respectively, and discover that the Malaysian ringgit was overvalued on the eve of the currency crisis. Moreover, Husted and Macdonald (1999), who estimate the equilibrium exchange rate via panel cointegration in the unrestricted version of the flexible monetary model, corroborate that the Malaysian ringgit was overvalued at the end of 1996.

In other major studies, Chinn (1998), Chinn and Dooley (1999) and Chinn (2000) gauge Asian currencies overvaluation through a long-run PPP model, a productivity-based model and a monetary model of the nominal exchange rate, respectively. The results found are conflicting. In a long-run PPP framework, the ringgit appeared to be overvalued. The productivity-based model reveal that the ringgit was undervalued, while the monetary model indicate that misalignment of the ringgit was small or did not imply much deviation from short-run equilibrium at the eve of the currency crisis.

Later, Kwek and Yoong’s (2002) real equilibrium exchange rate model establish that the ringgit was undervalued before the eruption of the 1997 Asian currency crisis. Stein and Lim (2004) find further evidence that the ringgit was misaligned but not prolonged, where the Malaysian ringgit seemed to be depreciated. In addition, Lee and Azali (2005) report that by utilizing the sticky-price monetary exchange rate model, the Malaysian ringgit appeared to be overvalued on the eve of the crisis. A recent study by Sidek and Yusoff (2009), using Malaysian real effective exchange rate, show a persistent overvaluation of the ringgit in the early 1990s until midbut generally close to the equilibrium after the crisis period due to the ringgit's peg to the US dollar.

Given the limited empirical studies on currency misalignment, particularly of ASEAN countries, this study attempts to bridge the gap as well as to shed some light by assessing this issue based from a theoretical framework using the most recent methodology.

Therefore, this study investigates the measurement of Malaysian exchange rate misalignment from two alternative estimates: (a) the bilateral real equilibrium exchange rate (RER) of the ringgit against How Did the Malaysian Real Exchange Rate Misalign During the 1997 Asian Crisis? 165 the US dollar; and (b) the real effective equilibrium exchange rate (REER), where the sample period spans from 1991:1 to 2009:4. In this study, RER and REER are defined as the ratio of domestic consumer price index (CPI) to foreign producer price index (PPI) based (PPI-CPI based), which broadly represents both tradable and nontradable goods. The choice of PPI is due to it being weighted with traded goods, representing a greater proportion of traded goods (Edwards, 1989).3 The Natural Real Exchange Rate (NATREX) equilibrium model is used to estimate whether there is any currency misalignment of the ringgit’s observed real exchange rates with the underlying macroeconomic fundamentals of the Malaysian economy, which may serve as a warning signal for currency crises.

Furthermore, the average total sum of squares due to error (ATSSE) is employed to compute and disentangle the degree of exchange rate misalignment across different exchange rate regimes. This is due to the action taken by Malaysia to switch from managed float to a conventional pegged arrangement under a risk management policy in the midst of the 1997-98 Asian financial crisis, and the reinstatement of exchange rate by scrapping the ringgit’s peg to the US dollar to operate in a managed float in mid-2005. Hence, the findings obtained in this study will bring new dimensions to the literature as it leads to estimating the Malaysian exchange rate misalignment based on the NATREX equilibrium model across different exchange rate regimes throughout the series of financial crises. The estimation process is carried out by incorporating the macroeconomic fundamentals in the form of economic theories and econometric perspectives.

The remainder of this paper is organized as follows. Section 2 explains the development of the Malaysian exchange rate arrangement while Section 3 describes the measurement of misalignment and the NATREX equilibrium model that is used to estimate the real exchange rate misalignment. An econometric formulation and cointegration analysis are carried out in Section 4.

Section 5 reports the empirical results obtained from the econometric analysis and Section 6 concludes with the findings and policy implications.

166 IIUM Journal of Economics & Management 18, no. 2 (2010)


Malaysia implemented two different exchange rate regimes from the 1970s to the present, as shown in Table 1. Malaysia adopted the managed float system with intervention of the government via open market operation from 1978 to September 1998, before deciding to peg its currency to the US dollar as the outcome of the 1997 Asian financial crisis. In July 2005, Malaysia switched back to the managed float system to further boost its economic growth.

–  –  –

The series of Malaysian bilateral and effective exchange rates (in terms of both nominal and real) are illustrated in Figure 1. It seems that the Malaysian exchange rate has turned 180 degrees at the outbreak of the 1997–98 Asian financial crisis. The co-movement of exchange rate in both cases was relatively stable under managed float in the 90s. A rising trend in the RER and REER was apparently observed from 1991:1 to 1997:3, indicating an appreciation of the ringgit. This signifies that the value of the ringgit was increasing faster than the US dollar. Later, the eruption of the regional financial crisis led the RER and REER to become volatile in 1997:3 before dwindling in 1998:3, when the ringgit was tied against the US dollar at RM3.80. Since then the ringgit seemed to have soothed with only a slight fluctuation until mid-2005. Following the reinstatement of the managed float regime in July 2005, the ringgit began to appreciate until the beginning of 2008 before bumping into another episode of global economic crisis, which once more plunged the ringgit into depreciation. Conjointly the appreciation and depreciation lead to a sign of exchange rate alignment for both the RER and REER.

How Did the Malaysian Real Exchange Rate Misalign During the 1997 Asian Crisis? 167

–  –  –

Note: NER is the Nominal Exchange rate and RER is the Real Exchange Rate while NEER is the Nominal Effective Exchange Rate and REER is the Real Effective Exchange Rate.

–  –  –

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