15. co-integration tests of purchasing power parity

8/14/2019 15. Co-Integration Tests of Purchasing Power Parity

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Co-integration Tests of Purchasing Power Parity: the Case of the Thai Baht

Co-integration Tests of Purchasing Power Parity: the Case of theThai Baht*

This paper will examine the validity of the purchasing power parity (PPP)hypothesis for the Thai baht vis-d-vis the currencies of Thailand's keytrading partners under the new exchange rate regime using thecointegration technique. The major conclusions obtained from thisempirical analysis may be broadly summarized as follows. First, theempirical evidence, based on the DF and ADF statistics, seems tosuggest that the nominal exchange rates and relative prices are wellcharacterized as non-stationary 1(1) process. Second, the cointegrationanalysis provides no evidence in support of a long-run equilibriumrelationship between bilateral nominal exchange rates for the Thai bahtvis-d-vis the currencies of Thailand's major trading partners and thecorrespdnding relative price ratios. This implies rejection of PPP for thesecountries. If this is the case, considerable care should competitivenessagainst Thailand's key trading partners, of shocks to the nominalexchange rate be taken in assessing the loner run implications for thereal exchange rate, and thus.

1. Introduction

In the pursuit of economic policy, monetary authorities in many developing countries havegiven increasing attention to the use of the exchange rate as a means of achieving andmaintaining external competitiveness or as an anchor for domestic prices. This isparticularly relevant in the case of Thailand where exchange rate policy has been regardedas an important instrument for correcting external disequilibrium problems (Wibulswasdi,1987, p. 40), particularly after the switching of the exchange rate regime from pegging theUS dollar to an undisclosed basket of currencies in November 1984. It has been surmisedthat, under this new exchange rate regime, the nominal exchange rate is adjustedcontinuously in order tc maintain the real exchange rate close to its long-run equilibrium

level as implied by the purchasing power parity (hereafter PPP) doctrine.' Although this newexchange rate regime has given the Thai monetary authorities more room to maneuver theexchange rate in response to developments prevailing at home and abroad, it still remainsunclear whether such a continuous adjustment of the nominal exchange rate is reasonablyconsistent with a differential between domestic and foreign inflation rates as implied by aPPP doctrine. In view of this, an examination of the validity of the PPP hypothesis isimportant since it can serve as a useful guide for Thailand's policymakers in implementingexchange rate management .2Earlier empirical studies of the PPP hypothesis have beencarried out mainly in the context of highly developed or advanced countries. The evidenceobtained so far has been far from conclusive. Some recent empirical studies of PPP areunable to find evidence in support of a long-run relationship between the exchange rate andthe ratio of price levels. For example, Corbae and Ouliaris (1988) use the cointegrationapproach to test for PPP between the United States and her three major trading partners.

They find little evidence in favour of PPP after 1973. Taylor (1988) finds no evidencesupporting the long-run relationship between the exchange rate and inflation differentialsamong five countries of interest, even with an allowance made for transaction costs andmeasurement errors. Mark (1990), employing a cointegration technique, is unable to findempirical evidence to support the presence of PPP between the United States and sixindustrial countries during the 1973-1988 period. Similar findings, also using the techniqueof cointegration, are reported in empirical studies of other countries. For instance, Karfakisand Moschos (1989) observed that there is little evidence in support of the presencee oflong-run PPP between Greece and six of its major trading partners since the adoption of a


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managed floating regime in 1975. Kim and Enders (1991) showed that there was littleevidence in favour of the existence of long-run PPP between Korea and the Pacific Rimnations over the 1973 to 1987 period. Contrary to the findings cited above, some otherempirical studies have found some evidence in favour of the long-run PPP hypothesis (i.e.Hakkio, 1984; Rush and Husted, 1985; Frankel, 1981; Huizinga, 1987; Abuaf and Jorion,1990). On the other hand, some studies report mixed results regarding the validity of the

PPP hypothesis (see, for example, Taylor and McMahon, 1988).

Although the exchange ratehas played an increasing role in macroeconomic management in Thailand, particularly sincethe mid-1980s, little attention has been paid to explicitly modelling the behaviour of the ex-change rate between the US dollar and the Thai baht in recent studies of macroeconometricmodelling for Thailand such as Nijathaworn and Arya (1987) and Deeithinant (1988). Theexception in this regard is the study by Warr and Nidhiprabha (1989).Against thisbackground it is interesting to see whether, and to what extent, PPP is applicable to the caseof Thailand from 1984.M1i to 1992.M6 when the management of the Thai baht became moreflexible.' The validity of PPP is tested within the context of the bilateral nominal exchangerate-price relationship between Thailand and its seven major trading partners: Japan, theUSA, the UK, Germany, Hong Kong, Malaysia and Singapore. These countries are chosen onthe ground that their currencies have been used in the present currency basket of Thailand.

The econometric methodology used for this analysis is based on a cointegration approachdeveloped by Engle and Granger (1987). The cointegration analysis is useful since theexistence of long-run relationships among the economic variables postulated by PPP theorycan be tested for. The plan of this study is an follows. Section II provides a brief discussion ofthe theoretical framework of exchange rate determination based on the PPP approach and ofsome earlier empirical studies based on PPP. This is followed by a brief discussion of theeconometric methodology employed in testing for the PPP hypothesis over the said period.Section III discusses empirical results.

* The author would like to thank Dr Anthony. J. Phipps and Dr Costas L Karfakis for their detailed andvaluable comments on earlier versions or the paper. Thanks are also due to anonymous referees forhelpful comments and suggestions and to Dr Ammara Sripa}ak and Dr Pichit Patrawimolporn forsupplying part of the data for use in this study. Financial support from the Bank of Thailand isgratefully acknowledged. The views presented here are those of the author and do not necessarilycoincide with the Bank of Thailand.1. In a case where the exchange rate follows PPP, the real exchange rate will remain constant. Tounderstand this, the bilateral real exchange rate (RER) of the Thai baht against a currency of one ofThailand's major trading partners is expressed algebraically as:

RER = EPf / P

where E represents the bilateral nominal (e.g. Thai baht/US dollar) exchange rate; P denotes theconsumer price index (CPI) in Thailand: and P is the CPI in the USA. It follows from the above equationthat if PPP prevails, then an increase in Thailand's price levels relative to the price levels of itscorresponding trading partner would be compensated for or reflected in a proportionate fall in E.

Accordingly, the RER would not be altered. See Dornbusch (1987) for more discussion on this.

2. Under the new exchange rate regime, the baht-US dollar rate is the exchange rate which has beennormally used by the monetary authorities as a basis for setting an appropriate level of the baht'sexternal value against Thailand's six major remaining trading partners, namely Japan, the UK,Germany, Hong Kong, Malaysia and Singapore. The daily nominal exchange rate between the Thaibaht and the US dollar appears to have been adjusted in response to three proximate factors, namely,(i) the movements of the exchange rates of major currencies in the international foreign exchangemarket; (ii) the patterns of selling and buying of foreign currencies in the domestic market; and (iii)


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the prevailing conditions and likely outlook of Thailand's economy (Wibulswasdi, 1988). Since theadjustments based on (i) and (ii) have been generally regarded as short term in nature, their effectson the rate setting seem to be minimal. Nevertheless, adjustments in the exchange rate followingdevelopments in these two factors have to be pursued constantly in order to shield the domesticeconomy from the adverse effects of fluctuations in the exchange rates of major currencies in theinternational foreign exchange market. Adjustments in exchange rate based on (iii), on the otherhand, have constantly been implemented with the view to addressing a deterioration in competi-tiveness and in external debt as well as to protecting the balance of payments. This latter adjustment

in exchange rates appears to be of particular importance at times when certain shocks, i.e. monetaryor real shocks, can be identified

3. The evolution of exchange rate arrangements in Thailand can be broadly divided into five distinctphases: (i) the pre par value system (until 1963); (ii) the par value system (19631978); (iii) the dailyfixed system (1978-1981); (iv) the de facto fixed system (1981-1984); and(v) The basket of currency system (1984-present). Exchange rate regimes during the first four periodsmay be broadly characterized as fixed exchange rate systems. This is no longer the case in the fifth

period during which the variability of the bilateral nominal exchange rates of the Thai baht vis-d-visthe currencies of Thailand's seven prime trading partners has increased and the official exchange rate

policy is regarded as an adjustable multi-currency peg regime. More detailed information on this canbe found in Sakornratanakul and Patrawimolporn (1992)

II. The PPP Approach to Exchange Rate Determination: Theoretical Considerations andMethodological Issues

IL1 Theoretical Considerations

Several alternative theoretical approaches to the determination of the exchange rate havebeen put forward in the literature.' One such .an approach is based on the notion of PPP.Although this approach has on occasions been criticized as being inappropriate ontheoretical and empirical grounds, it has remained in use as an important building block inmacroeconometric models and as guidance in choosing an appropriate long-run exchangerate as reflected in the "monetary approach" to exchange rate determination. The theory ofPPP asserts that the bilateral exchange rate between two countries is determined by theirprice ratio, measured by some form of aggregate price indices. This implies that prices of asimilar consumption bundle between countries, when expressed in a common currency,should be equal in the absence of transaction costs and trade barriers. This theoryemphasizes the law of one price by assuming that perfect commodity arbitrage acts as anerror-correction mechanism (ECM) to force the home price of a consumption bundle in linewith the foreign price of a corresponding consumption bundle (Corbae and Ouliaris, 1988).

There are two main versions of the PPP approach to exchange rate determination: one is theabsolute version and the other is the relative version.The absolute version of PPP theorystates that the equilibrium exchange rate between two currencies equals the ratio of twoprice levels (domestic price index to foreign price index). The estimating model based onsuch a version may be empirically formulated as:

et = a0+ a1t + ult (1)

where e, denotes the bilateral nominal spot exchange rate (the domestic currency price(baht) of a unit of foreign currency), and n, is the relative price level, defined as p, - p*,

between Thailand and each of its seven major trading partners, where p, stands for thedomestic price level, p* represents the foreign price level and ul, is the disturbance term. Allthe lower case letters denote logarithms of the variables concerned. Testing the validity ofthis version is equivalent to testing whether ao = 0, a, = 1 and ul, is white noise.

In the relative version of PPP, on the other hand, it is asserted that the rate of change ofthe nominal exchange rate is determined by the inflation :ate differential between the twocountries. Since inflation erodes a currency's purchasing power, a country with a higherinflation rate tends to have its currency depreciated relative to a country with a lower rate ofinflation. The validity of this version can be empirically tested by testing whether aZ = 0 anda, = 1 in the following model:


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et= a2 + a3t + u2t (2)

IN Econometric MethodologyIn testing for the presence of a long-run relationship between the exchange rate and theprice ratio between the two countries such as those specified in Equations (1) and (2),several alternative testing methods have been used in the literature e.g. OLS, TSLQ andcointegration. Since a testing methodology based on the cointegration approach of Engle

and Granger (1987) has been rapidly gaining in popularity in recent empirical studies of thePPP hypothesis, due to its appropriate treatment of endogeneity and non-stationarityproblems, it would be desirable to'apply this testing procedure in this study.' The main ideaunderlying this cointegration analysis is that two (or more) non-stationary 1(1) variables canbe combined to form a stationary 1(0) variable even though each individual variable itself

4. for a detailed review of this see, for example,Mussa(1984);MacDonald and Tailor(1992)

5. It is worth noting that the issue concerning the appropriateness of using a cointegration techniquein testing the PPP hypothesis has received increasing attention in recent empirical studies. As notedin the papers by several researchers such as Hakkio and Rush (1991), the application of thecointegration technique to test for the presence of long-run PPP relationships seems to be moreappropriate in -the case where the total sample length is long enough to capture the fluctuations inthe variables concerned. In their view, the extension of the number of observations by the use ofhigher frequency data appeared to be of little help in increasing the power of the cointegration test.

Mark (1990) also notes that some caution should be exercised in the interpretation of the empiricalresults based on the relatively short period of modern experience with flexible exchange rates (16years). He has surmised that the issue of committing a so-called "type I error" would become morerelevant if the "true" long-run were longer than 16 years. Contrary to this view, Isard (1983) arguedthat the adjustment toward long-run PPP can be fulfilled within two to five years. A similar argumentto this is made in Manzur (1990) who finds that adjustment to long-run PPP can have full effect in fiveyears.

is non-stationary. In the present context, although the two time series (e, and n) in equation(1) are individually non-stationary or 1(1), they may be cointegrated if there exists a non-zero constant (3 such that ul, = e,- P'7


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estimated residuals obtained from Equations (1) and (2) are stationary, 1(0), process usingthe integration test statistics, DF and ADF test statistics; reported in Dickey and Fuller(1981). If the residual terms in Equations (1) and (2) are stationary, the cointegrating vectoramong these variables is said to exist, implying that there is a stable long -run relationshipamong these variables.

This requires testing for HO: -y, = 0 in the regression:

------------------------------------------------------(4)where u, are the residuals from the cointegrating regression. The t-ratio statistics associatedwith the estimated residuals are then compared with those provided in Engle and Granger(1987) and Engle and Yoo (1987). The rejection of the null hypothesis of a unit root for theresiduals from the cointegrating regression implies that e, and n, are cointegrated. TheCointegrating Regression Durbin-Watson (CIRDW) test statistic - the DW ratio in the OLSestimation of the 'cointegrating regression' of Equations (1) and (2) - is also employed as analternative test for the existence of cointegration.IIL Empirical Tests of the PPP Hypothesis IIL1 Data and Integration AnalysisIn this sectior., the null hypothesis that there is a long-run equilibrium relationship between

the exchange rate, e, and relative prices, n,, for Thailand and each of its seven major tradingpartners is tested against the alternative that there is no such relationship, using theeconometric technique of cointegration discussed earlier. The estimation period is' from1984.M11 to 1992.M6. The choice of sample period was dictated by the implementation ofthe new exchange rate regime in which the Thai baht was unpegged from the US dollar. Thedefinitions and sources of data are provided in the Appendix.

There are a number of issues that must be considered in conducting the PPP testing ofEquations (1) and (2) as noted by many researchers such as Boughton (1988) and Laytonand Stark (1990). In this study, the following two related issues are addressed: (i) a suitabletrading partner; and (ii) an appropriate price index. With regard to a suitable trading partnerset, the following seven countries are selected: Japan, the USA, the UK, Germany, HongKong, Malaysia, and Singapore. These countries are selected on the grounds that theircurrencies are accounted for in the present system of Thailand's currency basket. As for the-

selection of appropriate price measures, the following two alternative definitions of the priceindex are utilized: the consumer price index (CPI) and the wholesale price index (WPI). Thechoice of these price indices in this study is dictated by their popularity in the literature onempirical studies of the PPP hyporthesis.b

Before proceeding to test whether the exchange rates are cointegrated with the priceratios, it is necessary first to test for the existence of unit roots in the stochastic processesof the exchange rates and price ratios. The results of these integration tests are reported in

Table 1. As indicated

Table 1 Unit Root Tests of Exchange Rates and Prices

Variable eLevel(s)nc rzw Ae

FirstDifference(s 471w

USA-3.18(2) -1.73(0) -2.17(0) - -8.13(0) -

(20.28] [1833] [12.68] [17.0 [19.15] [S.SO]UK -2.61(0) -2.56(0) -1.92(0) - -8.39(0) -

[S.BSJ [17.40] [18.80] [6.40 [16.50] [10.9a an -1.51(0) -4.41(0) -0.96(0) - -10.95(1) -

[20.51] [18.90] [10.62] [13.6 [17.18] [13.9German -1.44(0) -2.92(0) -1 07(0) - -7.62(0) -

[16.05] [1630] [11.45] [11.1 (18.4-i] [8.09]Sin a ore -2.28(1) -3.40(0) -3.62(0) - -9.39(1) -

[18.12] [21.09] [17.69] [16.1 [17.71] [19.7Mala sia -1.52(1) -3.34(1) -2.87(0) - -8.70(1) -


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[18.38] [2035] [10.23] [18.6 [14JS] [11.0

Notes: Figures in round parentheses represent the number of lagged dependent variables used inthe autoregression to ensure the white noise in residual terms. The selection between zero and non-zero lags was based on the Lagrange multiplier (LM) test for twelfth-order serial correlation of theresiduals. Figures in square brackets refer to the values of the LM(12) statistic. The rest of the entriesare the reported DF and ADF statistics (T,) The critical value at the 5% significant level is -3.45 for N =100 (Fuller 1976, p. 373). Rejection of the null hypothesis that the series in question are /(1) requires r,


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Japan - - -1.93(0) 0.05(13.81)

Germany -1.65(0) 0.05 -2.01(0) 0.08[16.83] 116.921

Singapore 1.38(0) 0.06 - -[13.61]

Mala sia -0.76(0) 0.09 -2.27(0) 0.15

[20.92] (12.731Notes: See notes to Table 1. The critical values of the DF (ADF) and CIRDW tests at the 5%

level of significance are -3.37 (-3.17) and 0386 respectively for sample sizes in the vicinity of100 (Engle and Granger, 1987).

nominal bilateral exchange rates (between the Thai baht and the currencies of Thailand'skey trading partners) are not cointegrated with the ratio of price differentials, when eithernc or nw are used. As is evident from Table 2, the values of the DF or ADF test statistics (1-statistics) are such that the null hypothesis of a unit root for the residuals from thecointegrating regression cannot be rejected in any case at the 5% significance level. Asimilar conclusion of no cointegration of the exchange rates and corresponding spondingprice ratios is obtained from the CIRDW test statistics. The results of this appear to suggestthat a simple notion of PPP did not hold between Thailand and its key trading partnersduring the period under review.' This implies that the nominal bilateral exchange rates forthe Thai baht, vis-a-vis the currencies of Thailand's major trading partners, and thecorresponding price ratios, drifted apart from each other following shocks to the balance ofpayments. That is, any variation in real exchange rates is regarded as being permanent andthe real exchange rate is not expected to return to the equilibrium PPP value.Although theempirical results reported here seem to provide no support for cointegration, these resultsshould be viewed as being preliminary and hence be interpreted with considerable caution.However, the results may be explained in the following ways. First, the failure of a simplePPP approach to model exchange rate determination may reflect the omission of some important variables asadditional regressors from a model.' As noted by many researchers, a variety of factors, such as changes in mon-

etary and/or fiscal policies, differential changes in productivity growth or terms of trade shock, may justify the

departure of the exchange rate movements from PPP (see, inter alia, Frankel, 1981; Adler and Lehmann. 1983;

Edison, 1987). Second, the results may be explained by the relatively short sampling period (approximately eight

years) used in this study. Such a period may be too short to detect any significant movements of exchange rates to

return to PPP following a shock to the economy. However, data over a longer sampling period with no switchingof exchange rate regimes are not readily available. Extension of the data set backwards seems to be

inappropriate, as the econometric technique used here cannot deal with changes in exchange rate regimes. As

noted by many researchers, for example, Mussa (1984) and Mark (1990), the behaviour of real and nominal

exchange rates has differed significantly across periods of fixed and flexible nominal exchange rate regimes and, in

particular, the variance of the changes is much larger under floating exchange rates. Third, the unfavourable

results of the PPP version of exchange rate determination may be attributed to the limited variability of the rate of

inflation in Thailand during the period under. review. As claimed by many researchers (see, for example. Kim

1990), PPP is unlikely to hold when country pairs experience small differentials in price movements.Finally, from a technical point of view, the finding of no cointegration in PPP may be associated with the following

two technical issues.' The first issue is related to the power of the Dickey-Fuller unit root test. As claimed by many

researchers (see, inter alia, Schwert, 1987, Lo and MacKinlay, 1989), the power of the Dickey-Fuller unit root

test is quite low in the sense that it tends to fail to reject the null hypothesis of a unit root against relevanttrend stationarity al ternatives, especially in the case of testing against the local alternative of a root close to, but

below unity. In view of this, the non-rejection of the null hypothesis that the variables of interest are difference

stationarity or I(1) may be due to two reasons. One reason is that the null is, in fact, true. The other is that,

although the null is false. the data do not contain sufficient information to allow the test to statistically reject it.The second related issue is concerned with the formulation of an appropriate testing hypothesis in unit root tests. It

has been claimed that the traditional formulation of the testing hypothesis in unit root tests is more favourable for

the null hypothesis (see Kwiatkowski et al., 1992, among others). As can be seen, the rejection of the null

hypothesis that the variables in question do not contain a unit root requires overwhelming evidence against it. It is


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possible that the conclusions obtained in this study would be different if the null and alternativehypotheses were to be reversed.9

8. I think a referee of this journal for directing my attention to these issues.

9. For more detailed discuss a new approach to testing for a unit root, see Maddala(1992),amongothers

Appendix: Definitions of Variables and Sources of Data

Data on exchange rate series (the baht price of foreign currencies)employed in this study are obtained from the Department of Economic Research, the Bankof Thailand (BOT). Data series on price indices - the consumer price index (CPI) and the

wholesale price index (WPI) - are taken from the IMF's International Financial Statistics (IFS)tape, lines 63 and 64 respectively. Note that price indices appearing in line 64 representsome form of wholesale or producer price indices. All data series cover 1984.M11 to1992.M6, except that of Malaysia's WPI which is available from 1986.M1 onwards. Thevariables used in this study are all measured monthly and defined empirically as follows:

e The bilateral nominal spot exchange rate of the Thai "baht" against thecurrencies of Thailand's seven major trading partners, namely the US dollar, the

Japanese yen, the UK pound stering, the deutschmark, the Hong Kong dollar, theMalaysian ringgit, and the Singapore dollar. All data are expressed in logarithms.


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An increase in the exchange rate depicts a nominal depreciation of the Thai bahtrate. The data on exchange rates are monthlyaverage values and are obtainedfrom the BOT.

pc The log of Thailand's consumer price index.pw log of Thailand's wholesale price index_pcfThe log of the consumer price index of Thailand's key trading partners,

ners, respectively.PwfThe log of the wholesale price index of Thailand's key trading partners,respectively. 'c The log of the ratio of Thailand's CPI to the respective CPI of Thailand's majortrading partners, defined aspc - pcf.wThe log of the ratio of Thailand's WPI to the respective WPI of Thailand's majortrading partners, defined aspw = pw~

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15. co-integration tests of purchasing power parity

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