RINGGIT/YUAN EXCHANGE RATE AND ITS IMPLICATIONS ON MALAYSIA’S TRADE WITH CHINA AND SELECTED TRADING PARTNERS: EVIDENCE FROM INDUSTRY DATA by ABDORREZA SOLEYMANI Thesis Submitted in Fulfillment of the Requirement for the Degree of Doctor of Philosophy February 2014 ACKNOWLEDGEMENT This study would not have been completed without the support and encouragement of several people. First, I would like to express my sincere gratitude to my supervisor, Dr. Chua Soo Yean for his guidance, encouragement and invaluable support and supervision throughout this work. I am also very grateful to my co-supervisor, Associate Professor Dr. Abdul Fatah Che Hamat for his thoughtful comments and advice during the thesis Process. I also would like to thank to my previous co-supervisor, Professor Dr. Datuk Amir Hussin Baharuddin for his helpful comments throughout this Process. The greatest debt of gratitude, however, is owed to my family and my parents. My lovely daughter, Saba who has attention less of me than she deserves. Most importantly, I thank my wife, Behanz Saboori who has endured the completion of two degrees over a period of 6 years. She has supported me and encouraged me along the way. I could not have done this without her. I am also deeply indebted my Mother, Fatemeh Taheri and my Father, Mohammad Hussein Soleymani for their encouragement and support the whole time my life. Finally, especially indebted to my older brother, Ahmadreza Soleymani for his unconditional love and support. Words are inadequate to express my gratitude to my parents and to my family who share in this accomplishment. TABLE OF CONTENTS Acknowledgement ii Table of Contents iii List of Tables vii List of Figures ix List of Abbreviation x Abstrak xiii Abstract xvi CHAPTER 1- INTRODUCTION 1 1.1 Introduction 1 1.1.1 Development Planning, Industrialization Process and Trade Policies 6 1.1.2 External Trade in Malaysia 13 1.1.3 Malaysian Exchange Rate Regime 17 1.1.4 A Snapshot of Malaysian bilateral Trade and Exchange Rate with China 23 1.2 Problem Statement 28 1.3 Research Objectives 29 1.4 Research Questions 29 1.5 Significance of the Study 30 1.6 Organization of the Study 33 CHAPTER 2- LITERATURE REVIEW 34 2.1 Introduction 34 iii 2.2 Literature Related to Currency Depreciation and Trade Flows 34 2.2.1 Theoretical Literature Review 36 2.2.2 Empirical Literature Review 43 2.2.3 Literature Related to Currency Depreciation and Malaysian Trade Flows 51 2.3 Literature Related to Exchange Rate Volatility 52 2.3.1 Theoretical Literature Review 52 2.3.1.1 Basic Uncertainty Trade Models 53 2.3.1.2 Review on More Recent Approaches 54 2.3.2 Empirical Literature Review 57 2.3.2.1 Recent Empirical Literature Review-In General 58 2.3.2.2 Recent Empirical Literature Review-In East Asian countries 69 2.3.3 Literature Related to Exchange Rate Volatility and Malaysian Trade Flows 72 2.4 Literature Review on Third-Country Effect 82 2.5 Summary 87 CHAPTER 3- METHODOLOGY 90 3.1 Introduction 90 3.2 Currency depreciation effects on trade flows 90 3.2.1 Specification of the Model 90 3.2.2 Estimation Technique 93 3.3 Exchange Rate Volatility Effects on Trade Flows 96 3.3.1 Specification of the Model 96 3.3.2 Estimation Technique 99 3.4 Third-Country Effect on Trade Flows 100 iv 3.4.1 Specification of the Model 100 3.4.2 Estimation Technique 104 3.4.3 Real Effective Exchange Rate for Malaysia 105 3.5 Data Description and Sources 106 CHAPTER 4- RESULTS AND DISCUSSION I 113 (Ringgit/Yuan Sensitivity and Industry Trade Flows between Malaysia and China) 4.1 Empirical Results for Outpayment Models 118 4.2 Empirical Results for Inpayment Models 121 4.3 Discussions 123 CHAPTER 5- RESULTS AND DISCUSSION II 126 (Ringgit/Yuan Volatility and Industry Trade Flows between Malaysia and China) 5.1 Empirical Results for Import Demand Models 130 5.2 Empirical Results for Export Demand Models 134 5.3 Discussions 136 CHAPTER 6- RESULTS AND DISCUSSION III 139 (Ringgit/Yuan Volatility as a Third-Country Effect on Malaysian Trade) 6.1 Introduction 139 6.2 Third-Country Effect on Bilateral Trade between Malaysia and Her Six Major Trading Partners 141 6.2.1 Empirical Results without Third-Country Effect 141 6.2.2 Empirical Results with Third-Country Effect 142 6.2.3 Discussions 145 v 6.3 Third-Country Effect and Industry Trade Flows between Malaysia and Japan 147 6.3.1 Malaysia-Japan Industry Trade without the Third-Country Effect 149 6.3.1.1 Empirical Results for Import Demand Models 153 6.3.1.2 Empirical Results for Export Demand Models 157 6.3.2 Malaysia-Japan Industry Trade Including the Third-Country Effect 160 6.3.2.1 Empirical Results for Import Demand Models 163 6.3.2.2 Empirical Results for Export Demand Models 171 6.3.3 Comparing the Results with and without the Third-country Risk Factor 179 6.3.4 Discussions 184 CHAPTER 7- CONCLUSION 187 7.1 Introduction 187 7.2 Summary of Results 187 7.3 Policy Implication 194 7.4 Suggestion for Future Studies 195 REFERENCES 197 APPENDIXES vi LIST OF TABLES Table 1-1: Planning horizon in Malaysia 8 Table 1-‎2:‎International‎trade‎objectives,‎strategies‎and‎policies‎in‎Malaysia’s‎National‎ Plans 12 Table 1-‎3: Malaysian external sector (percentage of total) 15 Table 1-‎4: Malaysian external trade with its seven major trading partners at industry level in 2010 17 Table 1-‎5: The major changes to the Malaysian exchange rate regime 22 Table ‎2-1 The explanatory variables and measurements of exchange rate volatility used by recent empirical literature. 67 Table ‎2-2: Recent empirical literatures on exchange rate volatility effect on trade for East Asian countries 77 Table ‎3-1: list of industries under study classified by SITC product groups revision 2. 108 Table ‎4-1: Industries that responded to real depreciation in the long-run import value (outpayment) model 120 Table ‎4-2: Industries responded to real depreciation in the long-run export value (inpayment) model 122 Table ‎5-1: The responded of import industries to real exchange rate volatility in the long-run 131 Table ‎5-2: The responded of export industries to real exchange rate volatility in the long- run 135 vii Table ‎6-1: Share of total trade for six major trading partners of malaysia in 2010 (in million) 141 Table ‎6-2: Import industries affected by real exchange rate volatility 155 Table ‎6-3: Export industries affected by real exchange rate volatility 158 Table ‎6-4: Import industries affected by real ringgit/yen volatility 164 Table ‎6-5: Import industries affected by real ringgit/yuan volatility as a third-country effect 167 Table ‎6-6: Export industries affected by real ringgit/yen volatility 173 Table ‎6-7: Export industries affected by real ringgit/yuan volatility as a third-country effect 175 Table ‎6-8: Industries affected by bilateral exchange rate volatility and third-country risk factor 180 Table ‎7-1: Industries short and long-run affected by ringgit/yuan changes 192 viii LIST OF FIGURES Figure1-1: Transformation from an agro-based to an industrial based economy (percentage of GDP) 7 Figure ‎1-2: Diversification of Malaysian exports (share of total exports) 14 Figure ‎1-3: Malaysian trade with its seven major trading partners in 2010 (share of total trade in percentage). 16 Figure ‎1-4: The real and nominal value of exchange rate between Malaysia and USA 21 Figure 1-5: Growth index of Malaysia’s‎ bilateral‎ trade‎ with‎ seven‎ major‎ trading‎ partners (based year =1980) 23 Figure ‎1-6: The real and nominal value of the yuan in terms of ringgit 25 Figure ‎1-7: The real exchange rate of the seven Malaysian major trading partners currency in terms of ringgit (based year =1980) 26 Figure ‎1-8: Real ringgit/yuan volatility 27 Figure ‎6-1: The real and nominal value of exchange rate between Malaysia and Japan 148 Figure ‎6-2: Real ringgit/yen volatility 149 ix LIST OF ABBREVIATION A-GARCH Asymmetric Generalized Autoregressive Conditional Heteroskedasticity ADF Augmented Dickey-Fuller AFTA ASEAN Free Trade Agreement AIC Akaike Information Criterion ARCH Autoregressive Conditional Heteroskedasticity ARDL Autoregressive Distributed Lag ASEAN Association of Southeast Asian Nations BNM Bank Negara Malaysia BRM Bickerdike-Robinson-Metzler CAFTA China-ASEAN Free Trade Agreement CFA Communaute Financiere Africaine CNY Chinese Yuan CPI Consumer Price Index CUSUM Cumulative Sum CUSUMSQ Cumulative Sum of Squares DEAC Developed Members of the East Asian Countries DLS Dynamic Ordinary Least Squared DLS- IV Dynamic Ordinary Least Squared and the instrumental variable DOTS Direction of Trade Statistics DUM Dummy E&E Electrical and Electronics ECM Error Correction Model EOI Export-Oriented Industrialization EPU Economic Planning Unit EU European Union EUR EU Currency FTA Free Trade Agreement FDI Foreign Direct Investment x FMOLS Fully Modified Ordinary Least Squared GARCH Generalized Autoregressive Conditional Heteroskedasticity GDP Gross Domestic Product GFC Global Financial Crisis GLS General Least Squares GMM Generalized Method of Moments GMM-IV Generalized Method of Moments and the instrumental variable HKD Hong Kong Dollar IFS International Financial Statistics IMF International Monetary Fund IMP Industrial Master Plan IV Instrumental Variable JPY Japanese Yen KRW South Korean Won LM Lagrange Multiplier MA Monetary Approach MGARCH-M Multivariate Generalized Autoregressive Conditional Heteroskedasticity in Mean MITI Ministry of International Trade and Industry ML Marshall-Lerner MOF Ministry of Finance Malaysia MP Malaysian Plan MTR Mid-Term Review NAICS North Amirican Industry Classification System NDP National