ASYMMETRIC EFFECT OF REAL EXCHANGE RATES AND OIL PRICES INTO INFLATION: EMPIRICAL EVIDENCE IN ASEAN-5

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International Journal of Business and Economy (IJBEC) eISSN: 2682-8359 [Vol. 3 No. 1 March 2021]

Journal website: http://myjms.mohe.gov.my/index.php/ijbec

ASYMMETRIC EFFECT OF REAL EXCHANGE RATES AND OIL PRICES INTO INFLATION: EMPIRICAL

EVIDENCE IN ASEAN-5

Jaratin Lily¹*, Mori Kogid^2*, Debbra Toria Nipo³, Sidah Idris⁴ and Imbarine Bujang⁵

1 2 3 4 Faculty of Business, Economics and Accounting, Universiti Malaysia Sabah, Kota Kinabalu, MALAYSIA

5 Faculty of Business and Management, Universiti Teknologi MARA, Kota Kinabalu, MALAYSIA

*Corresponding author: [email protected]; [email protected]

Article Information:

Article history:

Received date : 29 November 2020 Revised date : 5 January 2021 Accepted date : 5 February 2021 Published date : 14 March 2021

To cite this document:

Lily, J., Kogid, M., Nipo, D., Idris, S.,

& Bujang, I. (2021). ASYMMETRIC EFFECT OF REAL EXCHANGE RATES AND OIL PRICES INTO INFLATION: EMPIRICAL EVIDENCE IN ASEAN-5.

International Journal Of Business And Economy, 3(1), 60-74.

Abstract:Inflation is the rate at which the cost of goods and services is rising over time. This study investigates the asymmetric inflationary impact of oil prices and real exchange rates in ASEAN 5 (Indonesia, Malaysia, Philippines, Singapore, and Thailand). The study applies the NARDL (Nonlinear Autoregressive Distributed Lag) method to answer the hypothesis. The data consists of monthly data on consumer price index (CPI), oil prices, real exchange rates from 1979 until 2019. In all sample countries, the findings showed that there is a long-term co-integration between study variables. The findings revealed evidence of a long-run asymmetric inflationary impact of the oil prices in Indonesia, Malaysia, Singapore, and Thailand, whereas short-run asymmetry occurs in Indonesia, Malaysia, and the Philippines. Furthermore, the results showed that an increase in oil prices appears to increase inflation significantly, but the impact of oil prices becomes less or insignificant when oil prices fall in the long run.

Meanwhile, the long-run asymmetric inflationary impact of exchange rates only occurs in Thailand, whereas only Singapore has no evidence of short-term asymmetry.

Surprisingly, in the case of Thailand, further analysis revealed that an appreciation of home currency seems to increase the local inflation implying that the cost reduction of the imported goods and services were not passed through the consumers. These results offer an alternate interpretation of how inflation responds to exchange rates and oil prices that are useful to the relevant parties in developing an effective mitigation strategy to monitor inflation rates. Future research

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1. Introduction

Inflation is defined as an increase in the general price level. In a market economy, prices of goods and services will often change over time. Some prices are rising and some prices are declining. Inflation happens when there is a significant rise in the cost of goods and services in general, not just of individual goods and services. Inflation can be an issue as it makes tommorow’s money saved today less valuable. In other words, inflation reduces the customer’s purchasing power (Choi et al., 2018). For example, if an investor received 5 per cent of investments in shares and bonds, but the inflation rate was 3 per cent, the investor would only receive 2 per cent in real terms.

Over the years, economists have investigated determinant factors affecting inflation on various segments of the economy and on the total output of goods and services but failed to have consensus due to the significance of the factors differ across country (Nusair, 2019). Cost-push inflation is one such form of inflation. Generally, cost-push inflation may occur in the event of an inelastic demand curve, where demand can not easily be adjusted in line with rising prices (Jongwanich et al., 2019). This kind of inflation arises as prices rise due to higher production costs, such as raw materials and wages. The higher production costs have caused decline in the supply of goods and services while the demand for goods and services remains constant (Kandil

& Morsy, 2011). As a result, the increased cost of production is passed on to customers in the form of higher prices for finished products. Increase in oil prices and imported materials, can be seen as one of the signs of potential cost-push inflation. For example, if the price of oil increases, businesses that are directly or indirectly influenced by the increase in oil prices due to increase in energy and transportation costs lead to price increase of their products and services (Long & Liang, 2018). Moreover, the rise in price of imported raw materials due to exchange rates could also cause companies to pass along the additional cost to their customers, resulting in higher prices for final customer’s goods and services (Hemmati et al., 2018)..

needs to include the demand-pull factors in the model with structural break.

Keywords: Asymmetric Effect, Real Exchange Rates, Oil Prices, Inflation, NARDL, ASEAN-5.

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Studies on oil price inflationary effect have received attention since the oil price crisis in the 1970s (Barsky & Kilian, 2004). Previous literature generally have supported the transmission of oil prices towards inflation (Chou & Tseng, 2011; Ibrahim & Said, 2012), though there is mixed evidence in recent years (Chen, 2009; Choi et al., 2018; Gómez-loscos et al., 2011).

Although both studies by Ibrahim and Said (2012) and Chou and Tseng (2011) support the cost push inflation hypothesis of oil prices in Malaysia and Taiwan, respectively, in the long run but the effect is insignificance in the short run. Meanwhile, the declining effect of oil prices towards inflation has been found in some studies (e.g., Choi et al., 2018; Gómez-loscos et al., 2011) mostly because the presence of government intervention to mitigate the oil price inflatonary effect. Meanwhile, Jongwanich and Park (2009) revealed that oil price movements explain less than 30 percent of Asia’s inflation. The exchange rate pass-through theory (ERPT) is an important theory that incorporates the theory of exchange rate and inflation (Amoah &

Aziakpono, 2017). ERPT refers to the transition of changes in the exchange rate of import (export) prices of particular goods to the price of goods in the currency of the destination country. If the percentage in import prices is less than percentage change in exchange rate, the ERPT is said to be partial or incomplete, as exporters (or importers) absorb a portion of the exchange rate adjustment (Ghosh, 2009).

As most of the earlier studies have assumed a linear relationship between oil prices and exchange rates towards inflation, the assumption of the linear model may be too restrictive in the case of oil prices and exchange rates pass-through into inflation, so an extension of this needs to be investigated further (Choi et al., 2018). The linear relationship implies that an increase or a decrease in oil prices or exchange rates tend to have equal effect towards inflation, but in the opposite direction which is not always true. As for oil price case, oil price reduction will not always reduce inflation in a same magnitude or size during the oil price reduction or increment (Davari & Kamalian, 2018). Eventhough a decrease in oil prices are expected to lower cost of production, there is a possibility that domestic firms only reduce the cost of production to a small extent which leads to a smaller decrease of CPI (Atil et al., 2014; Choi et al., 2018). Therefore, there will be only small reduction or no change in prices of goods and services. Besides, with active government intervention in its monetary policy to maintain inflation, there is also possibility of an increase in oil price showing insignificant effect on inflation (e.g., Choi et al., 2018; Gómez-loscos et al., 2011).

In the case of exchanges rates, although a home currency depreciation (appreciation) is expected to increase (decrease) domestic inflation, however, the impact also depends on several factos which are the elasticity of demand, whether firms will pass on the exchange rate costs or benefits into consumers and the fraction of a country's trade denominated in foreign currencies (Gopinath, 2015). For example, when there is home currency depreciation, rather than passing through all the change of exchange rate costs into their imports, firms may absorb some of the costs. In addition, central bank plays a significant role in managing the exchange rates in ASEAN countries (Lily et al., 2014; Parsley & Popper, 2006; Tan & Chong, 2008;

Xing & Wan, 2006). The central bank tends to intervene against the foreign exchange rate if the exchange rates go beyond the desirable rate by buying and selling their foreign reserves or changing the interest rate (Patnaik et al., 2011). This intervention could also influence how exchange rate affect the domestic inflation.

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Thus, these consequence implies that there is an asymmetric oil price and exchange rate pass- through into inflation. From the empirical perspective, most studies have indicated the asymmetric relationship between oil prices and inflation (Bala & Chin, 2018; Davari &

Kamalian, 2018; Lacheheb & Sirag, 2018; Salisu et al., 2017). Therefore, this study revisits the impact of the asymmetric effect of oil prices and exchange rates into inflation in ASEAN-5.

The current study applies nonlinear ARDL approach to capture the asymmetric effects for both factors. Furthermore, NARDL method performs better for small sample size of data. Besides, the NARDL approach can test asymmetric effect of the series in long run and short run simultaneously (Shin et al., 2014). Understanding the asymmetric oil price inflationary effects can assist the monetary authorities to manage the country policy comprehensively.

2. Method 2.1 Data

Monthly data (end of period) from January 1979 until March 2020 were used for empirical analysis which consists of Consumer Price Index (CPI)(2010 basis), Brent crude oil prices, and the real domestic currency vis-à-vis the foreign currency, the US dollar. The sample countries consist of Indonesia, Malaysia, the Philippines, Singapore and Thailand (ASEAN-5). The databases that contain this relevant information are obtained from International Monetary Fund (IMF) and World Bank databases. In this study, the real exchange rates are calculated by using the purchasing power parity (PPP) approach. Thereafter, the real exchange rate (RER) is defined as the nominal exchange rate (NER) of the domestic currency vis-à-vis the U.S dollar multiplied by the ratio of the price level in the USA to the price levels in the domestic currency.

Thus, a rise (fall) in the real exchange rate index indicates a real depreciation (real appreciation) of the local currency. To calculate the RER, the formula from Osinubi and Amaghionyeodiwie’s (2009) study is used in a simple form as follows:

=  ^US =  ^US

H H

P CPI

RER NER NER

P CPI . (1) Where RERare the real exchange rates, NER is nominal exchange rates, P_USis the US CPI, P_H

is the domestic CPI.

2.2 Econometric Models

In this study, firstly, descriptive statistics analysis, and unit root tests were used to analyse the characteristics of the variables. Then, the asymmetric cointegration model of NARDL was utilized to test the asymmetric effects of the exchange rate (RER) risks on FDI inflows over the long run in each country studied.

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2.2.1 Unit Root Tests

Before further analysis, the unit root tests were conducted to check for the stationarity and order of integration of the series variables. In this study, the Dickey-Fuller (DF), Augmented Dickey- Fuller (ADF) (Dickey & Fuller, 1979) and Phillips-Perron (PP) (Phillips & Perron, 1988) unit root tests were adopted. The lag length for the ADF test was chosen by minimizing the Schwarz information criterion. Another alternative approach is the Phillips-Perron (PP) test suggested by Phillips (1987), extended by Perron (1988) as well as Phillips and Perron (1988). The details of the tests will not be further explained since both tests have been extensively discussed in numerous studies.

2.2.2 NARDL Model

The recently developed NARDL approach by Shin, Yu, and Greenwood-Nimmo (2014) which accounts for nonlinear and asymmetric adjustment was employed. The general form of the NARDL model can be shown as:

( )

  ₋  ⁺₋  ⁻₋  ₋ ⁺ ⁺₋ ⁻ ⁻₋

= =

 = ⁰+ ¹ ¹+ ² ¹+ ³ ¹+



 +



 +  +

1 0

p q

t t t t i t i i t i i t i t

i i

y y x x y x x e (2)

At first, the following equation was specified to illustrate the asymmetric long-run equation of inflation (Ibrahim, 2015; Shin et al., 2014):

  ⁺  ⁻  ⁺  ⁻

= ₀+ ₁ + ₂ + ₃ + ₄ +

t t t t t t

cpi oilp oilp realusd real sdu e (3)

whereoilpandrealusdare the oil prices and real exchange rates, respectively, where

( )

=     ₀, ₁, ₂, ₃, ₄ is a vector of unknown long-run parameters to be estimated. Meanwhile the oilp_t⁺and oilp_t⁺represents the partial sums of positive and negative changes in oilp, while

+

realusdt andrealusd_t⁺represents the partial sums of positive and negative changes inrealusd:

( ) ( )

+ + + +

= = = =

=



 =



 =



 =





1 1 1 1

max ,0 ; max ,0

t t t t

t i i t i i

i i i i

oilp oilp oilp realusd realusd realusd (4)

and

( ) ( )

− − − −

= = = =

=



 =



 =



 =





1 1 1 1

min ,0 ; min ,0

t t t t

t i i t i i

i i i i

oilp oilp oilp realusd realusd realusd (5)

To be specific, equation (3) can be framed or reformulated into an ARDL setting (Ibrahim, 2015; Pesaran et al., 2001; Shin et al., 2014) as in equation (6) as follows:

( )

  



   

 

+ − + −

− − − − − −

=

+ + − − + + − −

− − − −

=



= + + + + + +

+ + +  +  +





0 1 1 2 1 3 1 4 1 1

1 5

0

p

t t t t t t i t i

i q

i t i i t i i t i i t i t

i

cpi oilp oilp realusd realusd cpi

oilp oilp realusd a

cpi

re usdl e

(6)

where all variables are previously defined, and p and q are lag orders. The term ⁺



= 0 q

i i

and ⁺



= 0 q

i i

measure the short-run influences of positive changes in the oil prices and real exchange rates (appreciation in USD) while ⁻



= 0 q

i i

and ⁻



= 0 q

i i

measure the short-run influences of negative

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changes in the oil prices and real exchange rates (depreciation in USD). From equations (3) and (6), both₁= − ₂/ ₁ and ₂ = − ₃/ ₁represent the long-run impacts of an increase and decrease in oil prices on inflation. Meanwhile, both₃ = − ₄/ ₁ and ₄ = − ₅/ ₁represent the long-run impacts of an increase and decrease in real exchange rates on inflation. Testing for the presence of cointegration among the variables involves the Wald F test of the null hypothesis ofH₀:₁=₂ =₃=₄ =₅ =0 as in standard ARDL model (Pesaran et al., 2001). If the cointegration exists (the computed F-statistic exceeds the upper bound critical value), then an examination of long-run and short-run asymmetries using the Wald F test can be done. Thus, using Wald test in Equation (6), long run asymmetry test can be done on the null hypotheses of H₀: − ₂/ ₁=− ₃/ ₁ (oil prices) and H₀ : − ₄/ ₁ =− ₅/ ₁(real exchange rates).

Meanwhile, the short run asymmetry tests can be tested on the null hypotheses of

⁺ ⁻

= =

=



=



0

0 0

q q

i i

H (oil prices) and ⁺ ⁻

= =

=



=



0

0 0

q q

i i

H (e.g., Delatte & López-Villavicencio, 2012;

Fousekis et al., 2016).

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3. Results and Discussion 3.1 Descriptive Analysis

CPI across all sample countries show an upward trend (see Figure 1). Additionally, the CPI in all sample countries experienced a significant increase during the periods of the Asian financial crisis (1997-1999) and the global financial crisis (2007-2009).

1 2 3 4 5 6

80 85 90 95 00 05 10 15 20

LOGINCPI

3.6 3.8 4.0 4.2 4.4 4.6 4.8 5.0

80 85 90 95 00 05 10 15 20

LOGMYCPI

1 2 3 4 5

80 85 90 95 00 05 10 15 20

LOGPHCPI

3.8 4.0 4.2 4.4 4.6 4.8

80 85 90 95 00 05 10 15 20

LOGSGCPI

3.2 3.6 4.0 4.4 4.8

80 85 90 95 00 05 10 15 20

LOGTHCPI

Notes: Incpi (Indonesia CPI), mycpi (Malaysia CPI), Phcpi (The Philippines CPI), sgcpi (Singapore CPI) and Thcpi (Thailand CPI)

Figure 1: Consumer Price Index

The RER is the sample countries also showed fluctuations over the sample period (see Figure 2). In this study, the exchange rate was quoted as units of home currency per USD, thus an increase in RER indicates depreciation in local currency against USD. As in the case of CPI, the RER across all sample countries show an upward trend (depreciation) during the periods of the Asian financial crisis (1997-1999) and the global financial crisis (2007-2009).

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8.0 8.5 9.0 9.5 10.0 10.5

80 85 90 95 00 05 10 15 20

LOGINDREALUSD

0.4 0.6 0.8 1.0 1.2 1.4 1.6

80 85 90 95 00 05 10 15 20

LOGMYREALUSD

3.4 3.6 3.8 4.0 4.2 4.4

80 85 90 95 00 05 10 15 20

LOGPHREALUSD

.1 .2 .3 .4 .5 .6

80 85 90 95 00 05 10 15 20

LOGSGREALUSD

3.0 3.2 3.4 3.6 3.8 4.0 4.2

80 85 90 95 00 05 10 15 20

LOGTHREALUSD

Notes: Inrealusd (Indonesia), myrealusd (Malaysia), Phrealusd (The Philippines), sgrealusd (Singapore) and Threalusd (Thailand)

Figure 2: Real Exchange Rates

The oil prices also showed fluctuations over the sample period (see Figure 3) but show an upward trend. Basically, there is sudden change of the downward trend especially during the economic crisis in mid of 1980s, during the Asian Financial crisis and Global Financial Crisis.

2.0 2.5 3.0 3.5 4.0 4.5 5.0

1980 1985 1990 1995 2000 2005 2010 2015 2020 LOGOILP

Figure 3: Oil Prices

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3.2 Unit Root Tests

Both the unit root tests (ADF and PP) indicated that all of the variables were integrated less than I (2) at the 1 per cent significance level (see Table 1). Therefore, the NARDL model is appropriate to investigate the inflationary effect of oil prices and exchange rates.

Table 1: Stationarity Test

Variable Level First Difference

Country ADF PP ADF PP

Indonesia CPI -1.3058 -0.8407 -6.5958*** -13.5359***