Preliminary

TSQ Discussion Paper

2001/2002 – No. 9

Exchange Rate Movements before and after the

Currency Crisis in Southeast Asian Countries

- An Error Correction Model Approach Based on Purchasing Power Parity-

March 2002

Shinji YOSHIOKA

* The author is a JICA (Japan International Cooperation Agency) Expert to BAPPENAS (National
Development Planning Agency of Indonesian Government) from CAO (Cabinet Office of Japanese
Government). But the opinions expressed in the paper are derived from the author’s study results and are
not the official views of JICA, BAPPENAS, CAO, or any government. The author is grateful to the
colleagues at BAPPENAS for their insightful feedback to this study and also thankful to Mr. Ramli Ripai,
BAPPENAS, for his assistance in data processing. The author’s contact point is yoshioka@link.net.id.
Summary

This paper explores the exchange rates movements in selected southeast Asian countries
before and after the Asian currency crisis in 1997-98, employing an error correction
model approach based on the purchasing power parity hypothesis. I pick up three
southeast Asian countries, such as Indonesia, Singapore, and Thailand. The unit root
tests are completed for determining the degree of integration of the related data, such as
exchange rates and prices. Both Engle-Granger and Johansen tests are examined for
confirming cointegrating relationship. Empirically estimated error correction models are
then estimated based on pre-crisis data, and simulated for both in- and out-sample terms.
In-sample simulations are for checking the property of models and out-sample
simulations are for calculating the deviations of actual exchange rates from estimated
values.

JEL Classification Numbers: C22 and F31

Key Words: Unit Root, Cointegration, Error Correction
Model, Purchasing Power Parity, Exchange Rate

1
I. Introduction

In 1971, the U.S. stopped changing dollars to gold and many developed countries gave
up the fixed exchange rate regime and adopted the floating system. Approximately a
quarter century later after this moment, southeast Asian countries were deeply damaged
by the currency crisis and continuous economic and social turmoil in 1997-98.
Important economic indicators, including economic growth rate, exchange rate, prices
are fluctuated so much. Also, some countries, including Indonesia, accepted drastic
changes in the economic framework, e.g., adopting floating exchange rate regimes.

The exchange rate played the most remarkable role at the crisis. Before it, many Asian
developing countries had adopted the fixed exchange rate system against U.S. dollar.1
In other words, the exchange rate was not determined at market but by monetary
authorities. Even at present, they also seem strongly restricted. Some might think it is
meaningless to analyze the determination of official exchange rate under the fixed rate
regime or strong influence of monetary authorities. Some argues whether the exchange
rate is a policy tool or market price.2 But I suppose it may make some economic sense
if we can reveal monetary authorities’ behavior for the exchange rate or some elements
of the market determination after the crisis.

For this purpose, I employ an error correction model (hereafter, ECM) approach for the
estimation of the exchange rates. The main features of this approach are as follows:

(1) ECM describes the short run disequilibrium as errors.

(2) ECM keeps useful information in the long run and obtains the long run equilibrium
relationship.
(3) ECM reduces the possibility of “spurious regression” to a large extent.

For estimating ECM, I take the purchasing power parity hypothesis (hereafter, PPP).
Some economists, including Sjaastad (1998), insist that the PPP has a large error. On the
other hand, the latest study, such as Klaasen (1999), finds evidence in favor for the PPP
using a Markov regime-switching model. Among a lot of economists, it is a wide
consensus that the PPP would hold in the long run.

For model analysts of the exchange rate determination, the Plaza accord in 1985 was a
turnover point. In 1980’s, some theoretical developments for exchange rate model were
observed, including a portfolio balance model,3 which explicitly takes other financial
assets than money into account and assumes incomplete substitution among them, but
Frankel (1992) revealed that almost all empirical exchange rate models, including
portfolio balance models and monetary approach models, etc., fail to forecast exchange
rate development in a stable manner and Meese and Rogoff (1983) results that each
theoretical model for the exchange rate does not bring any better ex post forecast results
than a random walk model. Meese and Singleton (1982) shows that it is impossible to
reject the random walk hypothesis for the real exchange rates, which means that the real
exchange rates under the floating system in developed countries are subject to a random
1
For more detailed analysis on Asian exchange rate regimes, see Bénassy-Quéré (1996).
2
See Flassbeck (2001).
3
See Branson (1978) and Rodriguez (1980), etc.

2
walk process.4 These results imply that the PPP hypothesis does not hold for the real
exchange rates.

On the other hand, some partial adjustment models, including Woo (1985) and
Somanath (1986), and variable parameter models, including Schinasi and Swamy
(1989), indicate successful results. Among these results, an ECM approach is the most
employable in my paper. An ECM approach tries to estimate the exchange rate
development with observed exchange rate deviations from the long run equilibrium and
the short run dynamics based on the assumption of the stable long run equilibrium
among fundamentals expressed by the cointegrated relation and the exchange rates.
MacDonald and Taylor (1993) and MacDonald and Taylor (1994) employ ECM
estimated by cointegrated vectors based on Johansen method and report some successful
results that ECM out-sample forecast results are superior to those of random walk
models. And Mark (1995) insists that exchange rate fluctuations are correlated with
differences of observed rates from the equilibrium level and possible to be forecasted in
the medium and long run (1-4 years) to a sizable extent. Although I do not aim to
forecast the exchange rates but to estimate the deviation of them between those actual
and those estimated by ECM, these results encourage my analysis.

The first step to estimate ECM is to test a unit root to confirm the degree of integration
between exchange rates and prices. A Dickey-Fuller test is to be employed. Dickey
(1976), Dickey and Fuller (1979) and Dickey and Fuller (1981) develop this method
and Phillips and Perron (1988) contributes to expand it. The second step is to confirm
the long run equilibrium relation. For this purpose, cointegration test is widely
employed. Granger (1981) introduced this concept and both Engle and Granger (1987)
and Johansen (1991) provide the typical methods. After these tests, the third step is to
estimate some empirical ECMs because of limitations mentioned later. At the fourth
step, these models are simulated for both in- and out-sample periods, which are
correspondent to pre- and post-crisis periods. Here, these out-sample simulations are not
examined for forecasting purpose but for calculating the deviation of actual exchange
rates from ECM-derived values in order to measure the impact of the crisis.

This paper consists of six chapters including this introduction. The second to the fifth
chapters are correspondent to above mentioned four steps. I focus on three southeast
Asian countries, such as Indonesia, which is regarded as the most damaged country by
the crisis in the region, Singapore, which is one of the least damaged countries, and
Thailand, which is regarded as the origin of the crisis. Some analyses on the exchange
rate are executed; the first chapter stresses introduction; the second chapter deals with
unit root tests; the third chapter examines cointegration tests; the fourth chapter reports
estimation results of the empirically estimated ECMs based on the pre-crisis period
data; the fifth chapter completes both in- and out-sample simulations to calculate the
deviation of actual exchange rates from the ECM simulation results; and the sixth and
the final chapter concludes analysis of this paper.

In this paper, all data are quarterly and taken from CD-ROM edition of “International
Financial Statistics” issued by the IMF. I employ TSP of TSP International and Excel of
4
Other than Meese and Singleton (1982), also Adler and Lehman (1983), Huizinga (1987), and Meese
and Rogoff (1988), etc., support these results.

3
Microsoft Corporation for computing.

I. Unit Root Tests

Various economic time series data are not stationary. In this paper, exchange rates and
prices are employed and they also seem non-stationary. We then have to test the degree
of integration of data. Dickey-Fuller test for a unit root is widely adopted for this
purpose, which starts to assume that time series data are subject to following simple
equation at data generating process (hereafter, DGP):

(EQ1-1) yt = α 0 + α 1T + θy t −1 + u t
where T time trend
yt time series data
ut error, subject to stationary ARIMA process

Let yt-1 be subtracted from both left- and right-hands of equation (EQ1-1), and we then
obtain following equation:

(EQ1-2) yt − y t −1 = ∆yt = α 0 + α 1T + (1 − θ ) y t −1 + u t
where ∆ operator for the first difference

Nelson and Plosser (1982) calls the case that θ=1 or θ-1=0 ‘trend-stationary’ and the
case that 0<θ<1 ‘difference-stationary.’ The null hypothesis for unit root is that θ=1.

Other than Dickey-Fuller test, I also employ Phillips-Perron test and weighted
symmetric test for southeast Asian countries’ data, such as nominal exchange rates, real
exchange rates based on WPI and CPI, prices of WPI and CPI, relative prices of WPI
and CPI against U.S. correspondent prices,5 and those differentiated by the first order.
Table 1 reports the results of Dickey-Fuller, Phillips-Perron, and weighted symmetric
unit root tests.

These results might seem rather mixed and inconsistent. The following facts are,
however, confirmed:

(1) At least, one of the tests results examined fails to reject the null hypothesis against
the unit root for level of data at five percent statistical significance.
(2) At least, one of the tests results succeeds to reject the null hypothesis for the first
order difference data at five percent statistical significance.

We can thus result that the economic data related to the PPP, such as nominal exchange
rates, real exchange rates based on WPI and CPI, prices of WPI and CPI, and relative
prices of WPI and CPI against U. S. correspondent prices, seem integrated by the first
order, i.e., subject to I(1).

5
Some economists insist that the PPP is subject to prices of tradable goods, e.g., Balassa (1964) and
Samuelson (1964). In southeast Asian countries, however, these data are not necessarily available.

4
Table 1: Results of Unit Root Tests
level difference by the first order
D-F P-P W-S D-F P-P W-S
p-value lags p-value lags p-value lags p-value lags p-value lags p-value lags
Indonesia
nominal exchange rate 0.13262 3 0.69660 3 0.90365 3 0.01349 4 0.00634 4 0.00269 3
real exchange rate on WPI 0.21323 3 0.64732 3 0.90597 3 0.00175 3 0.00215 3 0.00068 3
real exchange rate on CPI 0.00000 6 0.90849 6 0.95128 3 0.00732 5 0.01368 5 0.00206 3
WPI 0.52098 4 0.36790 4 0.39509 4 0.00956 3 0.00349 3 0.00366 3
CPI 0.35780 3 0.26881 3 0.47851 4 0.03425 3 0.00074 3 0.01536 3
relative WPI 0.00113 7 0.47149 7 0.44653 4 0.03178 3 0.00241 3 0.01086 3
relative CPI 0.91570 3 0.84036 3 0.84484 4 0.13159 3 0.00074 3 0.05362 3
Singapore
nominal exchange rate 0.00507 3 0.21259 3 0.25577 3 0.03727 3 0.00123 3 0.00819 3
real exchange rate on WPI 0.00035 3 0.10890 3 0.03411 3 0.01305 3 0.00368 3 0.00315 3
real exchange rate on CPI 0.33100 5 0.60221 5 0.85681 3 0.17873 3 0.00247 3 0.05181 3
WPI 0.17663 4 0.21078 4 0.14482 3 0.02032 3 0.00302 3 0.00486 3
CPI 0.03423 3 0.69737 3 0.99978 3 0.61894 3 0.02045 3 0.43583 3
relative WPI 0.01360 3 0.09476 3 0.04249 3 0.00751 3 0.00219 3 0.00197 3
relative CPI 0.50687 3 0.92852 3 0.99923 4 0.12923 3 0.00008 3 0.02936 3
Thailand
nominal exchange rate 0.13070 6 0.44248 6 0.98297 5 0.06780 3 0.00020 3 0.04915 3
real exchange rate on WPI 0.00040 8 0.64440 8 0.79543 3 0.01300 8 0.00070 8 0.03105 3
real exchange rate on CPI 0.68804 4 0.43405 4 0.61531 6 0.09456 3 0.00014 3 0.05308 3
WPI 0.40307 3 0.56423 3 0.56454 3 0.05710 3 0.00421 3 0.01720 3
CPI 0.15796 8 0.76728 8 0.99355 3 0.31730 3 0.00017 3 0.15458 3
relative WPI 0.00530 8 0.55645 8 0.14987 3 0.02165 3 0.00220 3 0.00525 3
relative CPI 0.99078 3 0.98792 3 0.99702 3 0.04013 4 0.00043 4 0.01273 4
U. S.
WPI 0.08782 8 0.42553 8 0.84279 6 0.23547 5 0.00574 5 0.13923 4
CPI 0.47234 8 0.94279 8 0.99740 6 0.40776 4 0.00994 4 0.10200 3

Notes: 1. All data are transformed by logarithm.

2. The lag length is determined subject to AIC2 criterion with acceptance of
maximum 8 quarters lag.
3. The estimation period is from the first quarter of 1985 up to the last quarter
of 1996.
4. Both constant term and time trend are included.
5. The results of D-F are those of augmented Dickey-Fuller test, those of P-P
are of Phillips-Perron test, and those of W-S are of weighted symmetric test.
Source: Author.

II. Cointegration Tests

The second step is to confirm the existence of the cointegrated relation. For this purpose,
Engle-Granger test of Engle and Granger (1987) and Johansen test of Johansen and
Juselius (1990) and Johansen (1991) are widely employed.

The concept of cointegration is very simple. Since we have found out that all data
relating to the PPP possibly have unit root and are thus integrated by the first order, then
two time series data6 (let them be y and x and y, x∼I(1)) are said to be cointegrated

6
This assumption of two data series is, off course, easily expanded to three or more.

5
when there exists a β that satisfies y-βx∼I(0)7. Suppose the following equations:

(EQ2-1) y = βx + u or u = y − βx

The most complicated problem here is that u is not observed.8 We then have to examine
a regression for existing data as follows:

(EQ2-2) y t = βˆxt + uˆ t or uˆ t = y t − β̂xt

Engle-Granger test examines the augmented Dickey-Fuller test for unit roots in û .

On the other hand, Johansen test employs the most likelihood method. First, suppose
that the DGP of vectors of two time series data9 are obtained by the following vector
autoregression:

(EQ2-3) Z t = Π 1 Z t −1 + Π 2 Z t − 2 + ... + Π k −1 Z t − k +1 + Π k Z t − k + ε t
where Пi parameter matrix (here, 2x2) (i=1, 2, 3, …, k)
εt disturbance vector subject to normal distribution

The equation (EQ2-3) can be written by the error correction form as follows:

(EQ2-4) ∆Z t = Γ1 ∆Z t −1 + Γ2 ∆Z t − 2 + ... + Γk −1∆Z t − k +1 + Γk Z t − k + ε t

or
k −1
(EQ2-5) ∆Z t = ∑ Γi ∆Z t −i + Γk Z k + ε t
i =1
where Гi = -I + П1 + П2 + … + Пi (i=1, 2, 3, …, k)
I square matrix (here, 2x2)

At the equation (EQ2-4), Гk is correspondent to the root of the equation (EQ2-3) in the
long run. Since Zt is a vector subject to I(1), the first term of the right-hand in the
equation (EQ2-5) is subject to I(0). The final element of the right-hand in the equation
(EQ2-4) therefore a linear integration (or combination) between data subject to I(1).
Johansen test is thus consistent with the most likelihood method to estimate
cointegrating vector, employing the cannonical correlation methods. Johansen and
Juselius (1990) and Johansen (1991) also provide methodology to test statistical
significance of these vectors and to examine likelihood test for cointegrating
parameters.
Table 2 reports the results of the cointegration tests of Engle-Granger and Johansen,
which are examined according to the following equation:10

7
This can be also said that the linear integration between two (or could be three or more) data is
stationary or subject to I(0).
8
In this paper, I employ data with the suffix of ‘t’ that indicates terms as those in the short run and those
without it as those in the long run. In the short run, some deviations from the long run level are allowed
and adjusted to the long run level. In the long run, this kind of adjustment is completed.
9
Same as the footnote 5.
10
Some economists might insists that α=0, β=1, and γ=-1. But this conviction must be empirically tested.

6
(EQ2-6) e = α + βp + γp * +ε
where e nominal exchange rate (local currency per US dollar)
p domestic prices (WPI or CPI)
p* foreign prices (US WPI and CPI correspondent to p)

Table 2: Results of Cointegration Tests

(1) Engle-Granger Test
p-value vector lag
domestic foreign
prices (+) prices (-)
Indonesia (WPI) 0.83902 -2.19889 2.59806 2
Indonesia (CPI) 0.65718 1.88031 -0.02392 2
Singapore (WPI) 0.20775 0.06748 0.20175 3
Singapore (CPI) 0.04684 0.80092 0.28226 8
Thailand (WPI) 0.64922 0.35455 -0.53066 4
Thailand (CPI) 0.16087 -0.76353 0.02547 7
(2) Johansen Test
vector
Hypothesis eigenvalue rH0 p-value domestic foreign lag
prices (+) prices (-)
Indonesia
r=0 0.72976 26.34849 0.28195 0.58820 -0.51244
WPI r≤1 0.55897 10.64700 0.41447 -1.06256 1.26221 8
r≤2 0.00663 0.82326 0.39030 -0.29721 -0.09124
r=0 0.65592 28.92083 0.17062 -1.35795 -1.34425
CPI r≤1 0.62009 16.11822 0.09816 -46.68924 38.25022 8
r≤2 0.31296 4.50427 0.03108 6.77196 3.93292
Singapore
r=0 0.59019 18.22465 0.75474 -0.95729 1.14007
WPI r≤1 0.30147 7.51986 0.68391 0.91260 -0.53424 8
r≤2 0.23500 3.21453 0.06857 1.20491 -1.81024
r=0 0.70846 30.37488 0.12569 -9.01608 6.11206
CPI r≤1 0.61860 15.58397 0.11478 -0.62923 1.51276 8
r≤2 0.28449 4.01716 0.04213 -0.03181 -0.91123
Thailand
r=0 0.85710 32.02192 0.08779 1.03240 -1.28538
WPI r≤1 0.47205 8.67418 0.58889 0.12668 0.17440 8
r≤2 0.08065 1.00908 0.33891 0.12022 -0.58864
r=0 0.65798 22.19818 0.52923 -1.07369 -0.64608
CPI r≤1 0.51333 9.32362 0.53179 -1.15882 0.75934 8
r≤2 0.05522 0.68161 0.43124 -0.02796 -0.56933
Notes: 1∼4. are same as Table 1.
Source: Author.

7
Among the results, both Engle-Granger and Johansen test do not find any effective
cointegrating relationship at five percent statistical significance. The latter, however,
does for Singaporean WPI-based case at ten percent significance with plausible signs of
parameters.

In general, Engle-Granger test shows rather negative results for cointegration while
Johansen test does positive. Some parameters derived by Johansen test, however, seem
too large from the view point of common sense since they are the elasticity of prices to
exchange rates. The results bring up these problems for both tests.

The first problem for Engle-Granger test is deeply related to weakness of the augmented
Dickey-Fuller testing power. Hakkio (1986), Frankel (1990), and Frankel (1991) insist
that Dickey-Fuller test require a large number of observed samples to reject random
walk hypothesis on real exchange rate. Engle-Granger test for cointegration also
employs augmented Dickey-Fuller test and contains the same kind of weakness of
testing power. If the augmented Dickey-Fuller test can not reject the random walk
hypothesis, Engle-Granger test also can not find a cointegrating relationship in nature.

The second problem for Johansen test is, on contrary, related to its oversizing problem.
Podivinsky (1990) and Cushman et al. (1996) reveal that Johansen test for cointegration
has a somehow small-sample bias, i.e., is oversized and sometimes finds out a
cointegrating relationship that is not confirmed by simulation results. Concerning to too
large parameters (or elasticity) obtained by Johansen test, e.g., Cushman et al. (1996)
recommends that the elasticity of money for exchange rate should be more than ten in
absolute. But this figure is far beyond wide consensus among economists.

These weak points of both Engle-Granger and Johansen tests, however, reflect the
presently achieved level of the empirical economics and this is the limit of the science.
Even though there are some problems, these results strongly suggest that the
cointegrating relationship exists between the exchange rates and prices, and we thus
have to estimate and simulate empirical ECM in the following chapter.

III. Estimation of Empirical Error Correction Model

Here, we also employ the same equation that expresses the PPP in the long run as the
equation (EQ2-6) as follows:

(EQ3-1) e = α + βp + γp * + ε
where data without lower suffix are those in the long run

We can also assume a distributed lag relationship with one term (here, one quarter) lag
length between the exchange rates and domestic and foreign prices in the short run as
follows:

(EQ3-2) et = λ + ϕ 0 p t + ϕ 1 p t −1 + ψ 0 p * t + ψ 1 p * t −1 + θet −1 + u t
where data with lower suffix that denotes terms are those in the
short run

8
In the long run, it is assumed that the following relationship holds:

(EQ3-3) e = e−1 = e− 2 = e−3 = ...

p = p −1 = p − 2 = p −3 = ... p * = p * −1 = p * − 2 = p * −3 = ...

Then, the equation (EQ3-2) can be transformed to the following equation in the long
run:

λ ϕ 0 + ϕ1 ψ +ψ1 * u
(EQ3-4) e= + p+ 0 p + t
1−θ 1−θ 1−θ 1−θ

Since the equation (EQ3-4), off course, has to be equal to that of (EQ3-1), we obtain the
following equations:

λ
(EQ3-5) α=
1−θ
ϕ + ϕ1
β= 0
1−θ
ψ +ψ 1
γ = 0
1−θ
or
(EQ3-6) λ = α (1 − θ )
ϕ 1 = β (1 − θ ) − ϕ 0
ψ 1 = γ (1 − θ ) − ψ 0

Substituting the equations (EQ3-6) into the equation (EQ3-2), we obtain the following
equation in the short run:

(EQ3-7) et = α (1 − θ ) + ϕ 0 pt + [β (1 − θ ) − ϕ 0 ] pt −1
ut
+ ψ 0 p * t + [γ (1 − θ ) − ψ 0 ] p * t −1 + θet −1 +
1−θ

Subtracting the exchange rate at the previous term from both hands in the equation
(EQ3-7), we obtain the following equations in the short run:

(EQ3-8) et − et −1 = α (1 − θ ) + ϕ 0 pt + [β (1 − θ ) − ϕ 0 ] pt −1
u
+ ψ 0 p * t + [γ (1 − θ ) − ψ 0 ] p * t −1 + θet −1 + t − et −1
1−θ
or
∆et = ϕ 0 ∆pt + ψ 0 ∆p * t − (1 − θ )(et −1 − α − βp t −1 − γp * t −1 ) +
ut
(EQ3-9)
1−θ

The equation (EQ3-9) is the ECM for the PPP. At this ECM, the exchange rate is

9
explained by domestic and foreign prices and the error correction term. The third term
of the right-hand in the equation (EQ3-9) is the error correction term under the
assumption that θ is less than one (otherwise, this system is instable and has tendency to
diverge since a shock would be accumulated in an expansive manner). When the actual
exchange rate deviates from the long run PPP equilibrium level, error correction term
will adjust this deviation. We can not, however, directly estimate this ECM from actual
data since the parameters of α, β, and γ are those in the long run and unknown. We then
transform the ECM (EQ3-9) to the following equation, which can be estimated with
actual data:

(EQ3-10) ∆et = α (1 − θ ) + ϕ 0 ∆p t + (1 − θ )(β − 1) pt −1 + ψ 0 ∆p * t + (1 − θ )(γ − 1) p * t −1

− (1 − θ )(et −1 − p t −1 − p * t −1 ) +
ut
1−θ

Usually, the equation (EQ3-10) is to be estimated with actual data. The parameter of γ
for the foreign prices in the long run equilibrium equation (EQ3-1) is, however, strongly
assumed negative. The fifth term of the right-hand at the equation (EQ3-10) thus could
not play a role of proxy for the error correction term in the equation (EQ3-9). We then
transform the equation (EQ3-10) once more to the following form:

(EQ3-11) ∆et = α (1 − θ ) + ϕ 0 ∆p t + (1 − θ )(β − 1) pt −1 + ψ 0 ∆p * t + (1 − θ )(γ + 1) p * t −1

− (1 − θ )(et −1 − p t −1 + p * t −1 ) +
ut
1−θ

The equation (EQ3-11) could be also written as follows:

(EQ3-12) ( )
∆et = π 0 + π 1 ∆pt + π 2 pt −1 + π 3 ∆p * t + π 4 p * t −1 + π 5 et −1 − pt −1 + p * t −1 + π 6
where π 0 = α (1 − θ )
π 1 = ϕ0
π 2 = (1 − θ )(β − 1)
π3 =ψ0
π 4 = (1 − θ )(γ + 1)
π 5 = −(1 − θ )
ut
π6 =
1−θ

The unknown parameters for the long run PPP equilibrium, such as α, β, and γ are
derived by the following calculations:

π0
(EQ3-13) α =−
π5
π
β = − 2 +1
π5

10
 π4
γ =− −1
π5

At Table 3, I pick up the most plausible equations that support the PPP among
empirically estimated ECMs subject to AIC.

Table 3: Estimated Results of ECMs

short run estimation
difference lagged difference lagged
error adjusted
constant of domestic domestic of foreign foreign D-W
correct term R-squared
prices prices prices prices
2.39598 0.977218 0.011240 -1.30426 -0.105479 -0.253984
Indonesia 0.32186 1.84209
(1.52669) (3.57433) (0.083200) (-1.48897) (-0.25825) (-2.23118)
1.01844 0.044253 -0.080880 -1.00768 -0.129671 -0.174192
Singapore 0.24023 1.62035
(1.73042) (0.399880) (-1.38421) (-2.83112) (-1.80246) (-1.99027)
2.28417 0.187325 -0.358047 -0.654845 0.239972 -0.538202
Thailand 0.24603 0.84586
(4.35037) (0.583190) (-2.64062) (-1.18577) (1.73188) (-4.29724)
long run PPP
domestic foreign
constant
prices prices
Indonesia 9.43357 1.04425 -1.41530
Singapore 5.84663 0.53568 -1.72891
Thailand 4.24409 0.33473 -0.55412
Note: 1. Estimation periods are from the first quarter of 1986 up to the last quarter of
1996 for Indonesia, and from the first quarter of 1985 up to the last quarter of
1996 for Singapore and Thailand.
2. As prices, ECMs of Indonesia and Singapore employ WPI and that for
Thailand does CPI.
3. Figures in parentheses indicate t-statistics for parameters.
Source: Author

From the results, we can find out the following three points:

(1) The adjusted R-squared are considerably small. This strongly suggests that these
ECMs lack some important elements,11 including the exchange rates against Japanese
Yen and other intra-regional currencies and balance of payment factors.
(2) Relating to the elasticity of prices to the exchange rate,12 those of domestic prices
are smaller than those of foreign prices for both short run estimation and long run PPP.
This might be due to the fact that monetary authorities attached greater importance to
foreign prices than to domestic. This small elasticity of domestic prices brings very little
depreciation or appreciation of ECM-derived exchange rates and a large deviation of
actual exchange rates from ECM-derived level during and after the Asian currency crisis
as ECM simulation results later.
(3) According to the adjustment parameters for the error correction term at the ECMs,
the half-lives to the long run PPP equilibrium is 2.4 quarters for Indonesia, 3.6 quarters

11
Kasuya and Ueda (2000), e.g., reports a favorable results for the PPP employing fractional
cointegration method between U.S. dollar and Japanese Yen, including accumulated current account
balance.
12
Since the ECMs are estimated with data of a difference of logarithm, each parameter of prices
indicates the elasticity of prices to exchange rates.

11
for Singapore, and 0.9 quarters for Thailand. These figures are too short, considering
that Rogoff (1996) insists that the half-lives of the PPP is around 3-5 years and Murray
and Papell (2002) suggests that it is shorter and around one year. But this very quick
response to the deviation from the long run PPP equilibrium level was not from market
but by monetary authorities. It could be plausible that monetary authorities respond
more quickly than market does.

IV. Simulation of Empirical ECM

Above estimated ECMs appear to indicate the pre-crisis relationship between exchange
rates and prices with rather small adjusted R-squared, then, I employ these ECMs for
dynamic simulations for both in- and out-sample periods. 13 The former in-sample
simulation is completed for five years from the first quarter of 1992 up to the last
quarter of 1996 while the latter out-sample simulation begins at the first quarter of 1997
and ends at the third quarter of 2001. Table 4 and Chart 1 report results of in-sample
period while Table 5 and Chart 2 show those of out-sample term. A deep attention must
be paid that in- and out-sample simulations are based on different purposes. The former
are completed for checking the property of models, and the latter for calculating the
deviation of actual exchange rates from ECM-derived values in order to measure the
impact of the crisis on the exchange rates.

Table4: In-Sample Simulation Results

(Unit: Percent Deviation from ECM-derived exchange rates)
Indonesia Singapore Thailand
1992Q1 0.34 -0.55 0.42
1992Q2 1.68 1.80 0.88
1992Q3 0.63 1.59 -0.20
1992Q4 1.42 4.01 0.76
1993Q1 0.43 7.01 1.41
1993Q2 1.71 7.33 0.46
1993Q3 1.95 6.93 0.27
1993Q4 2.39 6.29 0.85
1994Q1 3.15 7.43 1.02
1994Q2 2.97 6.04 0.09
1994Q3 1.08 3.92 -0.76
1994Q4 0.20 2.78 -0.73
1995Q1 -0.69 2.90 -0.81
1995Q2 -1.07 1.89 -2.11
1995Q3 0.04 3.55 -1.30
1995Q4 0.09 5.18 -0.86
1996Q1 -1.20 5.68 -0.31
1996Q2 -0.01 7.51 0.00
1996Q3 -0.52 8.33 0.00
1996Q4 -2.37 9.09 0.62
Source: Author

13
This means that I complete the final tests.

12
Chart 1: In-Sample Simulation Results
(1) Indonesia
2400

Indonesian Rupiah per U.S. Dollar

2200

2000

1800
1992Q1 1993Q1 1994Q1 1995Q1 1996Q1

Actual Estimated

(2) Singapore
1.7
Singaporean Dollar per U.S. Dollar

1.6

1.5

1.4

1.3

1.2
1992Q1 1993Q1 1994Q1 1995Q1 1996Q1

Actual Estimated

(3) Thailand
26.0
Thai Baht per U.S. Dollar

25.5

25.0

24.5
1992Q1 1993Q1 1994Q1 1995Q1 1996Q1

Actual Estimated

Source: Author

13
In in-sample period, the empirically estimated ECMs of Indonesia and Thailand show
fairly good properties while Singaporean model has larger errors.14 In general, it is
obviously observed that the exchange rates in these three countries were managed based
on the long run PPP to a sizable extent since the ECM-derived exchange rates are
calculated as an adjustment process to the PPP level. Among those, Singaporean Dollar
was managed in an under-evaluated manner. This might have promoted Singaporean
export. Indonesian Rupiah and Thai Baht had been managed very well if monetary
authorities wanted to manipulate them subject to the PPP level. We can result that the
managements of the exchange rates in these three countries were almost consistent with
the ECM-derived level and thus, subject to the long run PPP level before the Asian
currency crisis. And this is consistent with the analysis based on the Balassa-Samuelson
hypothesis of Ito et al. (1997).

Table 5: Out-Sample Simulation Results

(Unit: Percent Deviation from ECM-derived exchange rates)
Indonesia Singapore Thailand
1997Q1 14.45 2.84 1.82
1997Q2 11.62 4.35 1.98
1997Q3 19.68 10.27 29.53
1997Q4 45.67 19.83 58.62
1998Q1 119.70 24.49 82.59
1998Q2 108.83 22.27 55.70
1998Q3 103.55 29.19 58.09
1998Q4 39.29 22.26 42.34
1999Q1 43.84 26.53 42.98
1999Q2 30.95 29.52 44.36
1999Q3 27.42 30.59 49.21
1999Q4 21.12 30.22 51.49
2000Q1 21.33 34.20 47.50
2000Q2 32.39 38.15 52.27
2000Q3 34.56 40.63 61.85
2000Q4 41.41 43.32 71.48
2001Q1 47.69 46.89 71.66
2001Q2 55.99 51.00 80.92
2001Q3 32.13 46.01 78.97
Source: Author

14
There remains a possibility that Singaporean monetary authorities has changed its exchange rate
manipulation policy from the second semester of 1995. But it could not be tested because the DGP of
Singaporean Dollar disturbed so much during the Asian currency crisis.

14
Chart 2: Out-Sample Simulation Results
(1) Indonesia
14000

Indonesian Rupiah per U.S. Dollar

10000

6000

2000
1997Q1 1998Q1 1999Q1 2000Q1 2001Q1

Actual Estimated

(2) Singapore
2.0
Singaporean Dollar per U.S. Dollar

1.5

1.0
1997Q1 1998Q1 1999Q1 2000Q1 2001Q1

Actual Estimate

(3) Thailand
50
Thai Baht per U.S. Dollar

40

30

20
1997Q1 1998Q1 1999Q1 2000Q1 2001Q1

Actual Estimated

Source: Author

15
During the Asian currency crisis, off course, these three countries experienced a drastic
fluctuation. Actual exchange rates depreciated far from the ECM-derived level based on
the pre-crisis long run PPP. This depreciation is, off course, caused a sharp decline of
output as Moreno (1999) points out. From the out-sample simulation results, we can
find out the following three points:

(1) In the third and fourth quarters of 1997, the depreciative deviation of Thai Baht from
its ECM-derived level preceded those of other currencies such as Indonesian Rupiah
and Singaporean Dollar. This fact clearly indicates that Thailand was the origin of the
Asian currency crisis. It seemed to diffuse to Indonesia and other southeast Asian
countries later.
(2) Indonesian Rupiah depreciated the most among these three and this resulted in a
social turmoil in mid-1998 at its capital, Jakarta. In 1998, for three quarters, Indonesian
Rupiah kept to depreciate by more than double from its ECM-derived level based on the
pre-crisis long run PPP. Next to Indonesian Rupiah Thai Baht also depreciated by more
than 80 percent. On the other hand, Singaporean Dollar did not depreciated so much
during the crisis compared with Indonesian Rupiah and Thai Baht. During 1998, its
percent deviation of actual exchange rates from ECM-derived level is within the range
of 20-30 percent. This is partly due to relatively large depreciation of ECM-derived
Indonesian Rupiah and very little depreciation or appreciation of those of Thai Baht and
Singaporean Dollar during the crisis resulted by the different elasticity of domestic
prices to the exchange rates among three countries.
(3) More interestingly, after the crisis, actual Indonesian Rupiah showed somewhat a
tendency to regressing to its ECM-derived level based on the pre-crisis long run PPP
around end of 1999 or begin of 2000 while Singaporean Dollar and Thai Baht continue
to depreciate even at present. Indonesian Rupiah, however, once depreciated in the first
semester of 2001 because of the instable political situation. But in general, Indonesian
Rupiah recovers more quickly than other two currencies partly due to strong structural
reform under the IMF leadership.
(4) One of the most remarkable movements of exchange rates in these three countries
after the crisis is that Thai Baht has reached to its ‘crisis level deviation’ from
ECM-derived level in mid-2001, which is around 80 percent.

V. Conclusion

Off course, we have to pay a deep attention that these simulation results contain
considerably large errors since the empirically estimated ECMs indicate rather small
adjusted R-square. We can point out the following facts:

(1) During the pre-crisis period, monetary authorities in Indonesia, Singapore, and
Thailand seem to have manipulated their exchange rates in a consistent manner with the
ECM-derived level based on the long run PPP equilibrium.15
(2) During the crisis, actual exchange rates deviated from the ECM-derived level based
on pre-crisis long run PPP to a large extent. Among countries focused on here, the
relatively large depreciation seemed to start at Thailand and the deviation of Indonesian

15
This could be said for Singapore at least until the first semester of 1995. See footnote 12.

16
Rupiah was the largest and reached to more than 100 percent.
(3) After the crisis, on contrary, Indonesian Rupiah shows somewhat a tendency to
regress to its ECM-derived level partly due to a strong support of structural reform
under the IMF leadership.
(4) Singaporean Dollar and Thai Baht seem to continue to expand the deviation of
actual exchange rates from their ECM-derived level based on the pre-crisis long run
PPP even at present. For the former case, this might reflect a change in the policy stance
of monetary authorities from the second semester of 1995, and for the latter, the
deviation is now reaching to its ‘crisis level deviation.’

17
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