EXCHANGE RATE VOLATILITY EFFECT ON MACROECONOMIC FUNDAMENTALS IN THE SIX GULF COUNTRIES

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EXCHANGE RATE VOLATILITY EFFECT ON MACROECONOMIC FUNDAMENTALS IN THE SIX GULF COUNTRIES

M A Djirimu¹, A D Tombolotutu², F M Tuty³

1,3) Department of Economics & Development Studies, Faculty of Economics & Business, Tadulako University, Central Sulawesi

2) Palu Muhammadiyah University, Central Sulawesi E-mail: ahlis.djirimu66@gmail.com

Abstract

At the time, based on the experience of the Southeast Asian and Latino American Countries, rates of investment and capital inflows have been high after the period of low rates of return of capital. However, moral hazard, because of excessive external debt, and the currency and maturity mismatch, remained the main problem in these countries. Regarding the financial dimensions, before the crisis 1994 and 1997, several key issues such as lack of control by the central banks, weak banking regulations, lack of insurance on saving of customers, the collusion between banks and private enterprises, corruption, low capital adequacy ratio, the failure in the institutions of regulatory experts, neglect and application of non-rational criteria in the allocation of the credits handicapping the state. The consequence of the rapid liberalization of current account and the deregulation of financial markets has resulted in increased capital inflows. This extension of the liberalization of capital markets was to support the provision of national institutions and private sector funds at low cost. Similarly, exchange rate policy applied by South-East Asia and Latino American was to reduce the volatility of domestic currency against the dollar, especially the risks of the debt in dollars. Internationally, the moral hazard has led international banks to lend to domestic banking sectors in South-East Asia and Latino American by neglecting the criteria of prudence. However, there was an asymmetry of regional exchange rates.

The Gulf Cooperation Council (GCC) was founded in 1980 by Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE). Since its inception, the GCC main objective of the GCC is to achieve economic integration between the forsaid countries, many steps have been taken out of these are the unified tariffs and a plan to achieve a monetary union by 2010. A successful monetary union requires adopting an effective single monetary policy, financial market integration, and reasonable economic convergence. One of the problem would be faced by the countries toward the economic integration is exchange rates volatility. Based on this reason, we would like to investigate the exchange rates volatility effect on macroeconomic fundamental in GCC countries.

The countries under study are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE). The GCC data cover 40 observations from the 1970 to the 2011. In this study, the exchange rates volatility, reserves minus gold, export, investment, inflation level, crude petroleum production, gross domestic product refers to the CD-ROM International Financial Statistics International Monetary Fund (IFS- IMF) and website of each Central Bank country data and reports of the Central Bank concerned. The approach used in estimating the exchange rates volatility effect on macroeconomic fundamentals in six GCC countries is based on Augmented Dickey-Fuller test (ADF), Granger’s causality test, Johansen’s co-integration test, vector autoregressive (VAR) or vector error correction models (VECM).

According to our hypothesis, in the case of GCC’s macroeconomic vulnerability, this empirical research finds out that in the GCC countries, macroeconomic vulnerability is on track of the relation between exchange rate volatility and reserves minus gold, export, the inflation level by which inflation pass-through plays an important role, investment, the crude petroleum production, GDP. In partially, macroeconomic vulnerability can be proved by linkage between exchange rate volatility and reserves minus gold, by linkage exchange rates volatility and export, between exchange rate volatility and investment, by correlation between exchange rate volatility and inflation level, between exchange volatility and crude petroleum production, and by linkage between exchange volatility and GDP.

(JEL: E00, F30, O53)

Keywords: exchange rates volatility, reserves minus gold, export, investment, inflation level, crude petroleum production, gross domestic product, GCC countries

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Introduction

Until 1996, it is called, about Japan, South Korea, Taiwan, Hong Kong, Singapore, Thailand, Malaysia and Indonesia, a real “miracle of East Asia”. Thus, the great economic growth in these countries for three decades is seen by others. Hong Kong, South Korea, Taiwan, Singapore became known as "four tigers" because of their economic performance.

However, these performances caused a syndrome of success in the form of economic vulnerability whose symptoms are: (i) low competitiveness of the industrial sector because of the facilities granted by governments to protect certain productions of goods, import substitution policy which is favorable to the interior of the country, and operating facilities of inputs available to certain private enterprises; (ii) lack of transparency between the banking system, private sector and government; (iii) an implied warranty given to government debt short term to finance long-term projects. According to the IMF (1997), the success of South- East Asia before the crisis are the result of: (i) the rapid growth of private financial sector and the role of human resources as an engine of growth; (ii) the high level of domestic savings;

(iii) the decrease of the population compared to other developing countries; (iv) development policies; (v) and the stability of macroeconomic performance such as GDP per capita, the inflation rate, foreign exchange reserves, external debt, and the exchange rate. The rapid economic growth in South-East Asia is promoted by government intervention that, in this way creates a climate conducive to sustainable growth. The essential role of the state manifests itself concretely in the form of outward-oriented policies, the rapid growth of savings and investment, the discipline of macroeconomic policy.

Since 1995, many international institutions such as IMF, World Bank, Political and Economic Risk Consultancy (PERC), the World Economic Forum, the Yamaichi Research Institute reminded Thailand and Indonesia as their economies entered a phase of heating. The moral hazard has become the source of financial vulnerability in the South-East Asia region during the process of liberalization of financial markets in the ‘90s. Economic vulnerability and financial shocks correspond strictly to business activity, financial activity and internationally. In terms of business activity, political pressure to maintain the highest economic growth resulted in an implied warranty and specific government grants to support private projects. This phenomenon explains that businessmen and politicians have become closer.

II. Theoritical Analysis

There is little real consensus on either the meaning or the importance of the relationship between exchange rate volatility and trade. Overall, among the studies reviewed, the majority of them concluded that the volatility of the currency tends to lower the level of trade. But, when this is measured, it is relatively minor. The weakness of this link may be explained in several ways (Coté; 1994) : (i) an increased risk does not necessarily lower risk activities even for companies that have a risk aversion; (ii) the hedging techniques enable companies to significantly reduce, at low cost, currency risk; (iii) the volatility of exchange rates may actually offset other types of risks; (iv) the volatility of exchange rates can create conducive conditions to trade and invest profitably. The consequence of the volatility of exchange rates became the center of the debate on the optimality of different exchange rate regimes after the abandonment of the Bretton Woods system in the early ‘70s. Proponents of fixed exchange rate say that since the abandonment of this system, exchange rates are highly unstable, extremely volatile and their values deviate from the equilibrium point. According to their views, the volatility of exchange rates deteriorates international trade. In contrast, proponents of the flexible exchange rate say that exchange rates are driven by macroeconomic fundamentals to fixed parities. A flexible exchange rate results in adjusting the balance of payments to meet the external shocks and to reduce the increase in customs duties, or to control capital flows to macroeconomic equilibrium. In fact, the volatility of exchange rates

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can directly affect foreign trade by the uncertainty and the cost of adjustment and can indirectly affect the structure of the output, through investment and the policy of the state.

Aristotelous (2001), Ariza et al (2000), Ariza et al (2003), Bredin et al (2003), Kasman and Kasman (2005) and Poon et al (2005) show that, except for the study of Kasman and Kasman (2005), other studies use the real effective exchange rate and the same measures of volatility (Moving Average Standard Deviation), the same data exports, the same type of data (aggregated) with the exception of the study Bredin et al, the same frequency data, quarterly data except Aristotelous study, and the same estimation methods, that is to say the test of Johansen co-integration. The results obtained are different and both the studies of Ariza et al (2000 and 2003) and Poon et al (2005), explains with the conventional theory that the volatility of the exchange rate worsens the trade, but the Aristotelous’ study showed that the relationship between exchange rate volatility and foreign trade is not significant and the studies of Bredin et al (2003) and Kasman and Kasman (2005) found a significant positive relationship in all equations.

Choudry (2005), Sukari and Hassan (2001) used the same instruments that previous studies with the exception of the measure of volatility, because they used models generalized autoregressive conditional heteroskedasticity (GARCH). The study by Choudry is current U.S. exports to Canada and Japan, while the study of Sukari and Hassan supports only U.S.

exports. The study shows that Choudry, among four equations tested, three verify the conventional theory that the volatility of the exchange rate worsens the trade. The study by Sukari-Hassan also supports this view.

Doyle (2001), Du and Zhu (2001), Fang and Miller (2004) and Zainal (2004) used the same REER (except to the study of Zainal who applied the NEER) the same measures of volatility namely GARCH models, and the same data types. With the exception of the study who used Doyle exports according to the categories of Standard International Trade Classification (SITC) and Zainal study that used industry data, they used data of different frequencies and samples of different periods and different methods of estimation (the co- integration test of Engle-Granger applied by Doyle, the test applied by Du and Zhu, GARCH models applied by Fang and Miller and testing "Distributed autoregressive lag ARDL bounds" applied by Zainal. Doyle studies showed that among 34 equations, 25 showed a positive relationship between the volatility of exchange rates and external trade, and only 12 of these equations are significant. Seven equations give a negative relationship between volatility in exchange rates and foreign trade, of which five are significant. The study of Du and Zhu showed that among six equations, four are negative but there is only one equation that is significantly negative. The Fang and Miller study also supports the conventional theory. Zainal's study showed that among seven equations, two had a significant positive relationship between the volatility of exchange rates and export sector, while a single equation had a positive relationship between non-significant volatility and export sector.

Vita and Abbott (2004) and Donganlar (2002) used the same instruments with the exception of the estimation method (they used the test of "Autoregressive Distributed Lag", ARDL bound), the same sample period and the same country of study. Vita-Abbot found an ambiguous result that three equations are significantly negative. A single equation between the volatility of exchange rates and external trade was significantly positive. Donganlar found that by using the cointegration test of Engle-Granger, five equations, four of them were significantly negative. According to these, the study Donganlar supports the conventional theory and even the study of Vita-Abbot in three equations.

Rahmatsyah et al (2001), and Bohar-Sauer (2001) and Rajan and Siregar (2004) used different countries of study: trade of Thailand, the United States and Japan, 91 countries, including 22 countries developed and 69 developing countries, trade between Indonesia and Japan, the frequency of different data, and different sample periods. The study Rahmatsyah et al (2002) used the NEER and REER, while the other two studies used the REER. Rahmatsyah et al found that among 16 equations, 12 equations significantly supported the conventional

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theory that the volatility of the exchange rate worsens the trade. Three equations have a positive relationship, but only one is significant. Sauer and Bohars showed that among 108 equations 82 support the conventional theory, 77 are significantly negative; in other words, these equations have show the real exchange rate volatility deteriorating trade. Twenty-six equations indicated no significant positive relationship between the volatility of real exchange rates and foreign trade. While Siregar and Rajan found that among 12 equations, using exports and imports to Indonesia and from Japan, 9 equations support the conventional hypothesis that the volatility of real exchange rate worsens the foreign trade. There is only one significant positive relationship between the non-volatility of real exchange rates and foreign trade.

Bustaman dan Jayanthakumaran (2006), Chit-Rirov-Willenbockem (March 2008), Aliyu (October 2008) and Bredin and Cotter (October 2008) show different results depending on the methods used, the countries studied, data types, and the frequencies of observations.

The Bustaman-Jayanthakumaran studies used 18 data of goods exported from Indonesia to the United States and found that 18 goods had a statistically significant relationship of co- integration in the long run. Among the 14 goods, six had significant coefficients of volatility.

Two commodities had negative relationships between the volatility of nominal exchange rates and quantities of exported goods (raw cocoa and cocoa produced), while four had positive relationship goods, namely the prepared fish, textiles, pulp paper and auto parts. In fact, the results of the study and Bustaman-Jayanthakumaran are ambiguous. The study-Chit-Rizov- Willenbocker-Aliyu and in the case of more than 14 ANSEA5 trading partners (the European Union, the United States, Japan, China) and the case of Nigeria supports the conventional hypothesis. The study Bredin and Cotter also gives an ambiguous result.

Many studies on the determinants of direct investment (FDI) have been made since the

‘90s. These studies found the determinants of the extent of FDI and an update on macroeconomic variables such as exchange rates, the number of telephone lines, the real GDP growth, the ratio between exports and GDP, share of manufacturing in GDP, the costs of labor, rate of inflation, portfolio investment and infrastructure as determinants of FDI. Froot and Stein (1991) analyzed the impact of real exchange rates on FDI from several European countries to the United States using annual and quarterly data for the period 1974 - 1987.

They found that the depreciation of European currencies vis-à-vis the USD has discouraged the flow of FDI into the United States. A similar relationship was indicated by the studies of Klein and Rosengren (1994), Golberg and Klein (1998), Ito (2000), Sazanami et al (2001).

They showed that the appreciation of the currencies of countries of origin of FDI vis-à-vis the currencies of recipient countries has encouraged FDI. Klein and Rosengren (1994) analyzed FDI flows that have passed Canada, Japan and several European countries to the United States during the period 1979 - 1991, while Bayoumi and Lipworth (1998), and Golberg and Klein (1998), Ito (2000), and Sazanami et al (2001) analyzed the impact of exchange rates on Japanese FDI in different periods. Except for the study of Froot and Stein (1991) and the Sazanami et al study (2001) that analyzed FDI in several sectors, most of these studies evaluated the relationship between exchange rates and FDI flows. Some studies have also considered other independent variables in their research. For example, Klein and Rosengren retained the costs of labor and assets. As Sazanami et al retained the costs of labor and the cumulative FDI from countries of origin. Both studies found that the cost of labor rates have discouraged FDI to recipient countries. Sazanami et al reported that cumulative FDI encouraged FDI from countries of origin. Few studies provided an update on the impact of exchange rate volatility on FDI. Golberg and Kolstad (1995) observed volatility of exchange rates on FDI bilateral moving from Canada, Japan and Great Britain to the United States using quarterly data for the period 1978 - 1999. They measured the volatility of exchange rates by calculating the standard deviation of real exchange rates. They found that the volatility of the exchange rate had a positive impact on FDI. Benassy-Quéré et al (2001) observed the impact of volatile exchange rates measured by the coefficient of variation of quarterly nominal

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exchange rates on FDI from developed to developing countries during the period 1984 - 1996.

Using annual data, they found that the increased volatility of exchange rates has discouraged FDI. These two studies give different results from the impact of exchange rate volatility on FDI. We note that both studies get the expected relationship between exchange rates and FDI because they have shown that the appreciation of the currencies of origin FDI countries vis-à- vis the currencies of recipient countries could promote these FDI.

The most recent studies were conducted by Morrisey and Udomkerdmongkol (2008), and Gottschalk and Hall (2008). Morrisey and Udomkerdmongkol (2008) used samples of 16 emerging countries and panel data for the period 1990 - 2002. These countries were three in number in Africa (Tunisia, Morocco, South Africa), five in Asia (Pakistan, China, Malaysia, the Philippines and Thailand), and seven in Latin America (Bolivia, Colombia, Costa Rica, the Republic of Dominican, Paraguay, Uruguay and Venezuela). They used aggregate annual data for 1990 - 2002 and have attempted to test the three hypotheses Chakrabarti and Scholnick assumptions. If ceteris paribus, (i) there is a negative relationship between expected depreciation of national currencies of recipient countries FDI and FDI flows; (ii) FDI increase when the devaluation occurs; and (iii) the volatility of the currencies of recipient countries of FDI discourages FDI. In addition, a better economic condition and foreign investor confidence in the political and economic condition of recipient countries determine significantly the entry of FDI. But in their study, they modified the assumptions of Chakrabarti and Scholnick under which the entry of FDI is a function of the level of exchange rates, volatility in exchange rates and exchange rate shocks due to limits encountered in the data and the availability of frequencies. In short, Morrisey and Udomkerdmongkol justified that the independent variables that affected U.S. foreign direct investment include: (i) the real effective exchange rate (REER, 2000=100) data from IFS-IMF and from the World Development Indicators (WDI 2004); (ii) the bilateral exchange rates official means (the national currencies of recipient countries of FDI compared to USD); (iii) the share of manufacturing in GDP (it is the proxy of the degree industrialization of a country); (iv) the inflation rate, measured as the percentage of the annual GDP growth, it becomes the proxy for macroeconomic conditions; (v) the ratio of exports of goods and services relative to GDP and has become the proxy of export potential; (vi) the GDP per capita was the proxy of the costs of labor; (vii) portfolio investment relative to GDP was the proxy of confidence foreign investment; (viii) the number of telephone lines was the proxy infrastructure; (ix) GDP growth was the proxy of the potential market. Using OLS, the inclusion of fixed effects and random effects, the test Hausmann, the approach of the Hodrick-Prescott and the VAR, the results showed the following:

First, there were strong positive relationships (or negative) between the devaluation (appreciation) of national currencies of recipient countries of FDI inflows and FDI. Second, there was a negative (positive) between the expected depreciation (appreciation) of national currencies of recipient countries of FDI and the entry of FDI. These results indicated that the growth of FDI in these countries is rather intended to cover domestic demand in the financial, telecommunications, wholesale and retail to take advantage of low wages. Third, there was a negative relationship between volatility in exchange rates and the entry of FDI. Fourth, the interaction between changes in the logarithm of the index REER (ΔREER) and the temporary components of bilateral exchange rates (TFXD) are significant. This means that REER are more volatile, the more FDI is affected. Fifth, they found that the economic condition and the confidence of foreign investors are significant. Sixth, the 1997 economic crisis in South-East Asia had no impact on U.S. FDI in emerging markets.

The second recent study was conducted by Gottschalk and Hall (2008) on FDI and uncertainty of exchange rates in South-East Asia. They studied the relationship between exchange rate volatility, diversification of risk levels and location of FDI in manufacturing in the countries of South-East Asia such as Indonesia, Malaysia, the Philippines and Thailand.

They found that the Yen and USD have an important role in the location choices of Japanese

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and American investors. Their study also showed that the volatility of the yen and the correlation between the national currencies of the four countries vis-à-vis the yen significantly determined U.S. and Japanese investments in the region.

An important perspective is one that justifies the relationship between exchange rate regimes and inflation by pegging exchange rate, which contributes to the stability and promotes a low level of inflation. The experience of emerging countries where institutions are weak, the pegging exchange rate provides an important tool to control inflation by means of a commitment to exchange rate stability and discipline in relation to growth in the money supply (Crockett & Goldstein, 1976). With regard to small and open economies, the pegging of nominal exchange rates helped these countries to minimize fluctuations in the level of domestic prices and contributed to economic stability (Mac Kinnon, 1963). In contrast, in countries where institutions are strong, independent central banks and financial markets more efficient, low levels of inflation can be achieved without specific commitment to implement the targeting of exchange rates (Calvo & Mishkin; 2003).

More recently, inflation targeting has become a tool for achieving price stability in developed countries and emerging countries. In most of the relatively closed economies, inflation targeting involves freely floating exchange rate that will not affect the volatility of inflation, since the fraction of the price of goods compared to the aggregate price level is comparatively small. However, in relatively open economies, fluctuations in exchange rates may affect price stability. Then, the exchange rate should remain stable.

A significant number of empirical studies tried to test the relationship between the choice of exchange rate regimes and inflation levels recorded. Edwards (1993) has tried to see if the exchange rate peg allowed inflation to improve performance by introducing a degree of financial discipline. He used a sample of 52 emerging countries for a period from 1980 to 1989 and showed that inflation levels are much lower in countries where exchange rate regimes are fixed. It stresses the possibility of reverse causality in the sense that there is no evidence that these are countries with low inflation that adopt exchange rate regimes or that the regime set in place generates low inflation. Ghost et al (1996) reached the same conclusion that countries with low inflation rates have a pronounced tendency for the fixed exchange rate, but also in the other direction, the fixed exchange rate led to lower inflation.

There are two indepth studies concerning the relationship between exchange rates and inflation in the South-East Asian countries: first, the study of Ito and Sato (2006) who analyzed the evolution of exchange rates and inflation after the crisis using a VAR approach.

They analyzed the direct effect (past-through effect) of the movement of exchange rates on domestic prices in countries such as Indonesia, Malaysia, Singapore, Thailand and South Korea. They made certain variables, such as oil prices, the common variable. They also used country-specific variables, such as the base currency of each country (M1), the nominal effective exchange rate (NEER) index of manufacturing production, the index of consumer prices (CPI), the producer price index (PPI) and the index of import prices. Their results showed that, first, the degree of direct effects of shocks on exchange rates varied across the different indices, the largest effect being felt through the index of import prices, the index of producer prices (PPI) and the lowest effect being felt through the consumer prices index (CPI).

The response of domestic prices to shocks in exchange rate was also high for Indonesia than in the other country. The response of the CPI vis-à-vis the impact of exchange rate was much higher in Indonesia than in any other country. In addition, the CPI will react more sharply to shocks elsewhere in the producer prices index (PPI). This implies that the transmission of shocks passed regularly by wholesale sales to consumers. In addition, the difference in inflation rates between Indonesia and the other four countries after the crisis is attributed to the political reaction of the Central Bank of Indonesia. Since the relationship as

"impulse response" of the variables affected by monetary policy shocks on exchange rates that the relationship "impulse response" variables affected by monetary policy shocks on the

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index of consumer prices is positive and statistically significant. This implies that the domestic inflation rate of Indonesia after the crisis and until 2005 was discouraging in terms of competitiveness with neighboring countries. Finally, unlike the direct effects through the CPI, it became more evident between Indonesia and other countries affected by the crisis.

Second, the study by Chan (2008) attempted to measure the coefficient of exchange rates direct short-term and long term using simple regression models linking the relationship between the consumer prices index and determining variables such as exchange rates of each currency, the PPI, the nominal GDP of Malaysia, Indonesia, the Philippines and Thailand.

The result showed that the ratio remained at 0.3 for the four countries. This implies that the four countries managed to stabilize inflation after the Asian crisis. The intervention on the exchange rate will be less favorable trade balance. The co-integration test indicates that there is a long-term relationship between CPI, GDP, exchange rates and index of producer prices (PPI) of the United States in these four countries. However, this study needs to be developed.

Chan found that the coefficient of the direct effect of exchange rate on inflation in Indonesia was only 11%. While the results using the VAR model was 57%.

There is substantial literature on the effect of exchange rate regimes on economic growth. In more general terms, this literature does not lead to conclusions that it is a positive effect on the stability of exchange rates on economic growth and a negative pegging exchange rate with increasing the output. We can identify two reasons why the stability of exchange rate stimulates increased economic growth.

First, the elimination of risks in foreign trade stimulates foreign trade and international division of labor. Frankel and Rose (2002) found a strong positive impact of fixed exchange rates on trade and income in the context of monetary union.

Second, the fixed exchange rate regimes are able to create a stable macroeconomic environment by lower risk premiums for a real interest rate. Therefore, the real interest rate stimulates long-term investment, consumption and economic growth (Donbusch, 2001). For example, the Baltic countries, Bulgaria, Bosnia and Herzegovina apply a strict agreement on the exchange rate for reasons of macroeconomic stability and to strengthen their economic growth. However, by the flexible exchange rates, a country can easily adjust to real shocks.

Under fixed exchange rate regime, the adjustment of real exchange rates must be made by the change in relative prices, which means costly rigidities. This can cause an excessive burden on the economy, and ultimately result in lower economic growth.

Nevertheless, the experience of the financial crisis shows that the cost of maintaining pegging exchange rate system of full capital mobility is very expensive. The exchange rate with anchor becomes subject to speculative attacks. The experience of Estonia during the speculative attacks on the CEECs in 1998 shows that the rise in interest rates is costly for the country that keeps exchange rates anchored (Fischer, 2001). Therefore, the flexible exchange rate regime may be more appropriate to avoid the crisis and to achieve stable economic growth over time.

The flexible exchange rates can, in principle, reduce the vulnerability of the economy by acting as shock absorbers, but they introduce an important element of volatility. The volatility of the nominal exchange rate is usually associated with a high variability of real exchange rate and thus to macroeconomic volatility. Hausmann and Gavin (1996) provided an overview of different ways that macroeconomic volatility was measured in the literature and the estimated effect of this volatility on economic growth. The IMF (1997) shows that intermediate exchange rate regimes are associated with faster economic growth, while the flexible exchange rate regimes generate growth rates the lowest. However, Reinhart and Rogoff (2002) find that economic growth is best under a flexible exchange rate regime and the intermediate regimes are those who are less well with poor results. Finally, the effects of exchange rate regimes on growth obviously depends on the degree of economic development since the flexible exchange rate regimes are associated with growth rates highest in the industrialized countries while the performance is relatively poor in emerging economies.

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Three recent studies have analyzed the relationship between the volatility of exchange rates and economic growth. First, the study of Azide et al (2005) concerns the impact of exchange rate volatility on growth and economic performance of Pakistan over the period 1973 - 2003. Second, the study of De Grauwe and Schnabl (2006) analyze on the stability of exchange rates, inflation and economic growth in CEE. Finally, the study of Schnabl (2007) deciphers on volatility and growth in emerging European and South-East Asian countries.

The study of Azide et al (2005) explains that the concept of exchange rate is the price of a currency that has a relationship with other currencies. The exchange rate is a conversion factor, a multiplier ratio. It depends on the direction of conversion, while the volatility is defined as an indicator of instability or uncertainty. It is a measure of risk, such as asset prices, portfolio optimization, and the choice of price and risk management. These risks can be the "input" of various economic decisions. The volatility of exchange rate uncertainty described in international transactions in goods and financial assets. Exchange rates are relative prices of financial assets in the future. They reflect an unanticipated change in supply and demand for financial assets and foreign currencies. They are the seeds of optimism in determining the supply of currencies, interest rates and income. Azides et al have used the method GARCH (generalized autoregressive conditional heteroscedasticity) to measure the movements of exchange rates and predict. They also used the co-integration test, Dickey- Fuller Augmented test (stationary/unit root test, 1979, 1981), the VAR approach, the Granger’s causality (1969), the variance decomposition and the impulse response functions to shocks. They used variables measuring economic performance, such as real exchange rates of Pakistani rupee, exports, imports, supply of money, and the output of manufacturing industries as independent variables. They could not measure the effect on economic growth of the uncertainty of exchange rates and found that there was a significant positive relationship between the non-volatility of exchange rates and economic performance. This result was not consistent with the hypothesis that the decline in the exchange rates volatility could promote the production of the manufacturing sector. Previous empirical studies show that there is a negative link between exchange rates volatility and economic growth (Aghevli et al, 1991) and (Obstfeld, 1995). But, the difference between previous studies and the study of Azide et al relates to the data. The study of Azide et al used time series data, while previous studies used cross-sectional data. In fact, the application of different exchange rate regimes also affects the result of the study.

Second, the study of De Grauwe and Schnabl (2006) analyzed the impact of exchange rate regimes on inflation and economic growth in Central and Eastern Europe (CEE) using panel estimates for the period 1994 to 2004. They found that de facto measures of the stability of exchange rates better explain the equations for inflation and economic growth as measures of de jure. In addition, the result shows that there is a significant impact of the stability of exchange rates on low inflation, and there is also a significant positive impact between high stability of exchange rates on real economic growth. When they divided the research period in times of high inflation (1994 - 1997) and period of low inflation (1997 - 2004), they found that the stability of exchange rates resulted in the disappearance of inflation. The relationship between the stability of exchange rates and high real economic growth has been robust. This result indicates that membership of the CEECs to the European Monetary Union has a positive impact on economic growth in these countries.

Third, the study of Schnabl (2007) concerns on the volatility of exchange rates and economic growth in emerging Europe and emerging East Asia countries. He found that: (i) the countries of South-East Asia have maintained the stability of their exchange rates vis-à-vis the USD after the crisis in 1997 and that the emerging CEE countries also maintained stability of their exchange rates vis-à-vis the euro, although some countries such as Poland and the Czech Republic admitted the total float of their currency; (ii) the emerging Europe and South- East Asia continue to have rapid growth when the fixed exchange rate is chosen. He also found that the fixed exchange rate had a positive impact on international trade, interest rates

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and macroeconomic stability; (iii) in emerging Europe, the positive impact of stability on economic growth during the observation period is the process of macroeconomic stabilization at the time of accession of the CEECs to the European Union. In South-East Asia, the negative impact of exchange rate volatility on economic growth was stronger and it could be said the strong tendency of countries in South-East Asia, including Japan, to anchor their currencies to the dollar; (iv) the positive impact of the stability of exchange rates on economic growth was not linear, a situation conducive to international investment has encouraged the entry of speculative capital and economic overheating as it has shown by the experience of the Asian crisis.

III. Data and Method

The countries under study are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE). The GCC data cover 40 observations from the 1970 to the 2011. In this study, the exchange rates volatility, reserves minus gold, export, investment, inflation level, crude petroleum production, gross domestic product refers to the CD-ROM International Financial Statistics International Monetary Fund (IFS-IMF). In the case of Bahrain, Oman, Qatar, Saudi Arabia, United Arab Emirates (UAE), the exchange rate volatility represented by Nominal Effective Exchange Rate (NEER). For the reason of inavailability in the case of Oman’s data, inflation level, investment and gross domestic product could be excluded from the analysis. For the reason of lack data on level of inflation in UAE, the inflation level has been excluded in econometric model.

The approach used in estimating the exchange rates volatility effect on macroeconomic fundamentals in six GCC countries is based on Augmented Dickey-Fuller test (ADF), Granger’s causality test, Johansen’s co-integration test, vector autoregressive (VAR) or vector error correction models (VECM).

The approach used in estimating the exchange rates volatility effect on macroeconomic fundamentals in six GCC countries is based on Augmented Dickey-Fuller test (ADF), Granger’s causality test, Johansen’s co-integration test, vector autoregressive (VAR) or vector error correction models (VECM). Since the employed econometric techniques are quite standard, the detail will not be presented in this paper.

We will firstly analyze the effect of volatile exchange rates of national currencies of the six GCC countries on the characteristics of each country’s macroeconomic fundamentals, namely reserve minus gold (RES), export (EXP), inflation level (INF), crude petroleum production (CRU), investment (INV), and economic growth (GDP). We use time series data from the IMF of each country using the procedure of econometric analysis.

In order to study more thoroughly the effect of the volatility of exchange rates on macroeconomic fundamentals in the six GCC countries, we apply first, the ADF test. This test is designed to analyze the stationarity of each variable. Second, we perform the test of Granger causality. Third, if the ADF test shows that all data are stationary at the order=0 [I (0)], therefore, we apply VAR models. If the data are stationary at the first differences [I (1)], we apply therefore the vector error correction models (the unrestricted VAR). Fourth, before the application of VAR or VECM, we apply the cointegration test of Johansen. Once the data are cointegrated at the first differences, we choose the vector error correction model.

IV. Finding

From a theoretical point of view, the volatility of exchange rates has a negative impact on macroeconomic variables such as, export, inflation level, crude petroleum production, investment, and GDP. In contrast, the exchange rate volatility has a positive impact on reserve minus gold.

Firstly, we will study the positive linkage between the exchange rate volatility and reserve minus gold.

Secondly, we analyze the indirect effect of exchange rate volatility on the balance of trade over the amount of exports and imports. When the exchange rate appreciates, therefore,

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the export volume decreases, vice versa. When exchange rates are stable, imports may increase due to higher income. But, when the exchange rates are volatile, this volatility affects the price of imported goods. When the currencies depreciate, the price of imported goods rises. Therefore, the import volume decreases and vice versa. In this research, we only analyze the exchange volatility effect of export.

Thirdly, we see that the effect of the volatility of exchange rates on inflation can be classified into two categories: (i) first, a direct effect which requires imported products such as consumer products, raw materials and industrial equipment; (ii) second, an indirect effect that involves the application.

Fourthly, we analyze the indirect effect of exchange rate volatility on the crude petroleum production over the oil price.

Fifthly, the empirical studies show the negative effect of exchange rate volatility on investment. The increasing of exchange rates volatility discourages FDI to recipient countries.The appreciation of the currencies of the origin countries of FDI against the currencies of recipient countries of FDI encourages FDI, and vice versa.

Sixthly, we see that more recent studies show that the stability of exchange rates has a positive impact on economic growth.

According to the table 1, in Bahrain, Bahrain volatility of the currency exchange rate is only a positive effect on crude petroleum production. Reserve minus gold is also a positive effect on crude petroleum production. Exports of Bahrain has a positive impact on macroeconomic variables which four reserve minus gold, inflation, crude petroleum production and investment. Crude petroleum production has a positive impact on exports and investment. Instead, the investment has a positive and significant impact on reserve minus gold, inflation, and crude petroleum production. Economic growth in the short term has significantly effect exports.

Table 1

Result of the short-run impact of exchange rate volatility on macroeconomic fundamentals in Bahrain in the 1970-2011 period Dependent

Variables

Independent Variables

∆ER Vol ∆ RES ∆ XPORT ∆ INFLATION ∆ CPP ∆ INV ∆ GDP ECTt-1

∆ER Vol - 1.68250 1.00337 0.49390 0.18714 1.20382 0.29245 0.13902

(0.20241) (0.32283) (0.48648) (0.66775) (0.27946) (0.59181)

∆ RES 0.65138

- 10.2372*** 0.24275 0.14952 4.26799** 0.12491

-0.47046

(0.42464) (0.00278) (0.62506) (0.70115) (0.04570) (0.72572)

∆ XPORT 0.00987 2.62548 - 0.61724 7.59367*** 1.95922 3.38862* -2.13416**

(0.92137) (0.11343) (0.43694) (0.00894) (0.16971) (0.07347)

∆ INFLATION 2.25623 1.78242 4.48803** - 0.000035 4.79336** 0.55654 -0.35745

(0.14134) (0.18980) (0.04073) (0.99530) (0.03478 (0.46025)

∆ CPP 3.24288* 9.29871*** 15.5704*** 0.91444 - 24.7424*** 2.55318 -4.87129**

(0.07968) (0.00416) (0.00033) (0.34498) (0.0000014) (0.11836)

∆ INV 0.00389 0.00216 2.89519* 0.43937 8.05929***

- 1.32775

-1.08306

(0.95057) (0.96315) (0.09701) (0.51143) (0.00723) (0.25640)

∆ GDP 1.76923 0.41298 1.79392 0.00947 0.06606 2.35094 - -0.51699

(0.19141) (0.52432) (0.18841) (0.92301) (0.79855) (0.13349) Notes : (1) The value in parentheses are the p-value. For ECT, the values in parentheses are t-ratio

(2) Asteriks (*), (**), (***) indicate significance at 10, 5, 1 percent level respectively

(3) Two cointegrating vectors are incorporated into the VECM analysis since the trace test has some advantages over the maximum eigenvalues test (Johansen 1994)

Source: result calculated by author.

Just like in Bahrain, Kuwait, exchange rate volatility has a significant positive effect on crude petroleum production (CPP). Reserve minus gold has a positive and significant impact on inflation. Exports provide a positive and significant impact on reserve minus gold and investment. Crude petroleum production has a significant positive impact on investment.

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Investment in Kuwait has a positive and significant impact on reserve minus gold and crude petroleum production. Economic growth provides a significant and positive impact on the reserve minus gold and investment through the acceleration process.

Table 2

Result of the short-run impact of exchange rate volatility on macroeconomic fundamentals in Kuwait in the 1970-2011 period Dependent

Variables

∆ER Vol - 1.13327 1.01056 0.22312 0.00260 1.19113 0.78742 -3.88410**

(0.29380) (0.32113) (0.63937) (0.95963) (0.28197) (0.38046)

∆ RES 0.91869 - 17.2520*** 0.67835 1.73125 8.86615*** 17.4694*** -4.39352**

(0.34388) (0.00018) (0.41530) (0.19613) (0.00504) (0.00017)

∆ XPORT 0.50123 0.07138

- 0.34531 0.05537 0.08149 1.11602

-2.38132**

(0.48328) (0.79078) (0.56025) (0.81523) (0.77684) (0.29745)

∆ INFLATION

0.02263 3.41731* 0.61944

- 0.10207 1.77687 0.55654

-3.04837**

(0.88122) (0.07231) (0.43614) (0.75111) (0.19047) (0.46025)

∆ CPP 8.73159*** 0.66874 0.01773 0.02969 - 24.7424*** 0.21530 2.45358**

(0.00535) (0.41859) (0.89477) (0.86411) (0.0000014) (0.64530)

∆ INV 0.01896 0.08196 3.40478* 0.94366 8.05929*** - 6.55483** -2.02926**

(0.89121) (0.77621) (0.07281) (0.33748) (0.00723) (0.01456)

∆ GDP 0.23702 1.17873 0.63704 0.00947 0.00031 1.73963

- -3.76506**

(0.62916) (0.28445) (0.42974) (0.92301) (0.98605) (0.19508) Notes : (1) The value in parentheses are the p-value. For ECT, the values in parentheses are t-ratio (2) Asteriks (*), (**), (***) indicate significance at 10, 5, 1 percent level respectively

In the case of Oman, exchange rate volatility does not affect positively and significantly on several macroeconomic variables such as reserves minus gold exports, crude petroleum production, investment and gross domestic product. Unfortunately, inflation data is not yet available on CD-ROM IFS IMF. Reserve minus gold has a positive and significant correlation with export at α 1%. Export has a positive and significant impact on reserve minus gold and economic growth. Crude petroleum production and significant positive effectat α 10% on exchange rate volatility. Investments had a positive impact and significant with minus gold reserve, export and economic growth. Economic growth has a positive and significant impact on the gold reserve at α 1% level.

Table 3

Result of the short-run impact of exchange rate volatility on macroeconomic fundamentals in Oman in the 1970-2011 period (Lag order 1)

Dependent Variables

∆ER Vol ∆ RES ∆ XPORT ∆ CPP ∆ INV ∆ GDP

∆ER Vol - 1.49299 1.22776 3.70611* 0.26691 1.71267

(0.22928) (0.27481) (0.06172) (0.60841) (0.19850)

∆ RES 0.07459 - 8.89465*** 0.00662 4.47340** 8.51539***

(0.78624) (0.00497) (0.93559) (0.04104) (0.00589)

∆ XPORT 0.43227 12.5142*** - 0.00446 4.90533** 1.24028

(0.51484) (0.00108) (0.94713) (0.03284) (0.27241)

∆ CPP 0.00067 2.18081 0.76866

- 0.17149 1.49121

(0.97945) (0.14798) (0.38614) (0.68112) (0.22955)

∆ INV 0.36005 0.12201 0.07966 1.62772 - 0.01352

(0.55204) (0.72879) (0.77929) (0.20976) (0.90804)

∆ GDP 0.62988 0.52782 3.15444* 1.46329 12.1123*** -

(0.43233) (0.47198) (0.08373) (0.23388) (0.00127)

Notes : (1) The value in parentheses are the p-value. For ECT, the values in parentheses are t-ratio

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(2) Asteriks (*), (**), (***) indicate significance at 10, 5, 1 percent level respectively

(3) Two cointegrating vectors are incorporated into the VECM analysis since the trace test has some advantages over the maximum eigenbalues test (Johansen, 1994)

In Qatar, like in the United Arab Emirates (UAE), exchange rate volatility does not affect any macroeconomic fundamentals. Reserve minus gold, exports, inflation, investment has a significant positive effect on economic growth. Inflation has also a positive and significant impact on reserve minus gold. Crude petroleum product has a negative effect on some macroeconomic variables such as reserves minus gold, exports, inflation, and investment. The rate of economic growth has a positive and significant impact on macroeconomic variables which three reserves minus gold, inflation, investment.

Table 4

Result of the short-run impact of exchange rate volatility on macroeconomic fundamentals in Qatar in the 1970-2011 period Dependent

Variables

∆ER Vol ∆ RES ∆ XPORT ∆

INFLATION ∆ CPP ∆ INV ∆ GDP ECTt-1

∆ER Vol - 0.56830 0.00073 0.32562 0.00284 0.31643 0.08625

0.25765

(0.4557) (0.9786) (0.5726) (0.9578) (0.5784) (0.7707)

∆ RES 0.96342 - 0.03207 17.1814*** 5.47709** 0.05191 11.8060*** -190814**

(0.3329) (0.8588) (0.0003) (0.0246) (0.8215) (0.0015)

∆ XPORT 0.16392 1.21429 - 1.82015 8.59369*** 0.47949 1.66907 27.1226**

(0.6879) (0.2776) (0.1881) (0.0058) (0.4946) (0.2048)

∆ INFLATION

0.05484 0.71299 0.70601

- 6.40655** 0.05249 5.33577**

16.9075**

(0.8165) (0.4054) (0.4079) (0.0171) (0.8205) (0.0282)

∆ CPP 1.15203 0.00171 1.01086 0.49191

- 0.53842 0.60520

1.24413

(0.2901) (0.9672) (0.3212) (0.4887) (0.4694) (0.4417)

∆ INV 0.38988 0.46242 0.00463 1.68857 5.79354** - 12.0216*** 5.67332**

(0.5376) (0.5023) (0.9462) (0.2048) (0.0232) (0.0018)

∆ GDP 0.01279 29.1701*** 7.45687*** 7.16659** 1.81679 79.6710*** - 3.14734**

(0.9106) (0.0000004) (0.0098) (0.0121) (0.1861) (0.000000002) Notes : (1) The value in parentheses are the p-value. For ECT, the values in parentheses are t-ratio (2) Asteriks (*), (**), (***) indicate significance at 10, 5, 1 percent level respectively

In Saudi Arabia, exchange rate volatility has a positive and significant impact on crude petroleum production and investment. This is reasonable because Saudi Arabia is the second supplier of crude oil in the world after Venezuela and most investments are in sectors Crude oil exploitation. Reserve minus gold, exports and investments have a positive and significant impact on inflation. Crude petroleum production and significant positive effect on the three macro-economic variables on exchange rate volatility, inflation and investment.

The rate of economic growth had a positive impact on the reserve minus gold, inflation, investment.

Table 5

Result of the short-run impact of exchange rate volatility on macroeconomic fundamentals in Saudi Arabia in the 1970-2011 period Dependent

Variables

∆ER Vol - 0.90226 0.02668 1.23005 4.40035** 0.40185 0.69830 -0.09437

(0.3482) (0.8711) (0.2744) (0.0426) (0.5299) (0.4086)

∆ RES 0.61129 - 8.02616 0.03496 1.39095 1.48989 5.29828** 1.77665

(0.4391) (0.0074 (0.8527) (0.2456) (0.2298) (0.0269)

∆ XPORT 1.09680 0.00063 - 0.08034 0.83373 0.34570 2.97147 0.78564

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(0.3018) (0.9801) (0.7784) (0.3671) (0.5601) (0.0931)

∆ INFLATION 2.02633 16.5298*** 11.4856*** - 7.09841** 10.7546*** 10.4158*** -1.51369

(0.1628) (0.0002) (0.0017) (0.0113) (0.0022) (0.0026)

∆ CPP 7.32715** 0.06046 0.72098 0.89125

- 0.31676 0.04461

-3.82048**

(0.0101) (0.8071) (0.4013 (0.3511) (0.5769) (0.8339)

∆ INV 3.22834* 1.11377 8.79138 0.20769 3.91371* - 10.8280*** 2.48161**

(0.0803) (0.2979) (0.0053) (0.6512) (0.0552) (0.0022)

∆ GDP 1.32845 0.36126 1.25952 0.12334 0.25975 0.06117 - 1.27671

(0.2563) (0.5514) 0.2690 (0.7274) (0.6132) (0.8060)

Notes : (1) The value in parentheses are the p-value. For ECT, the values in parentheses are t-ratio (2) Asteriks (*), (**), (***) indicate significance at 10, 5, 1 percent level respectively

In the United Arab Emirates, reserve minus gold positive and significant impact on macroeconomic variables namely three on exports, investment and economic growth. Export has a positive and significant impact on reserve minus gold and economic growth. Crude petroleum production only positive influential reserves minus gold. Investments have a positive and significant impact on reserve minus gold and economic growth. While the rate of economic growth and a significant positive effect on macro economic variables namely three in reserve minus gold, investment and economic growth.

Table 6

Result of the short-run impact of exchange rate volatility on macroeconomic fundamentals in UAE in the 1970-2011 period Dependent

Variables

∆ER Vol ∆ RES ∆ XPORT ∆ INFLATION ∆ CPP ∆ INV ∆ GDP

∆ER Vol - 0.24270 0.00298 na 0.04394 0.01848 0.00531

(0.6253) (0.9568) na (0.8351) (0.8928) (0.9423)

∆ RES 0.42982 - 11.0295*** na 3.25164* 6.79316** 18.2521***

(0.5164) (0.0026) na (0.0800) (0.0141) (0.0002)

∆ XPORT 0.01591 7.51968** - na 0.18297 2.42356 13.2708***

(0.9005) (0.0107) na (0.6719) (0.1321) (0.0012)

∆ INFLATION na na Na - Na na na

na na Na Na na na

∆ CPP 0.87681 1.03040 0.63447 na - 0.36212 0.09091

(0.3550) (0.3170) (0.4320) na (0.5517) (0.7649)

∆ INV 0.00618 6.27457** 1.01366 na 1.61746 - 20.6831***

(0.9378) (0.0179) (0.3237) na (0.2129) (0.000000005)

∆ GDP 0.31111 14.0110*** 8.92102*** na 1.34336 3.97693* -

(0.5807) 0.0007 (0.0061) na (0.2545) (0.0550)

Notes : (1) The value in parentheses are the p-value. For ECT, the values in parentheses are t-ratio (2) Asteriks (*), (**), (***) indicate significance at 10, 5, 1 percent level respectively

(4) Inflation data are not available Source: result calculated by author.

.

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Conclusions

This empirical research finds out that in the GCC countries, macroeconomic vulnerability is on track of the relation between exchange rate volatility and reserves minus gold, trade balance, the inflation level by which inflation pass-through plays an important role, FDI, and the crude petroleum production. In partially, macroeconomic vulnerability can be proved by linkage between exchange rate volatility and reserves minus gold, by linkage exchange rates volatility and balance trade, between exchange rate volatility and foreign direct investment (FDI), by correlation between exchange rate volatility and inflation level, and between exchange volatility and crude petroleum production.

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