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Relationship Between Malaysias Foreign Exchange Rate Economics Essay

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In essence, currency exchange rate is defined as the price of one countrys currency when exchanged into another country's currency. The importance of exchange rates in free economy is immeasurable. Nowadays, countless of corporations globalize their businesses all over the world to maximize their respective objectives. The preponderance of investors involved in investment around the globe is to diversify their portfolio. Besides, travellers also need to exchange their currency for journey purposes. All of them simultaneously engage in the activity of exchanging their currencies. However, exchange rate was highly volatile and unstable due to internal and external factors, especially in the post-Bretton Woods era in which the origin of the floating rate exchange rate regime starts here. The purpose of this research study is to examine the factors that trigger the exchange rates in Malaysia. Hence, four independent variables have been chosen, namely foreign direct investment, inflation rate, interest rate and trade balance.

1.1 Research Background

The term 'Exchange Rates' is referred as the relative prices of national currencies. Under a floating-rate regime, exchange rates are largely determined by the market forces, which is the supply and demand in the foreign exchange markets. In a large scale, it determines the relative of economic health of a given countries. Exchange rates always play an indispensable role in a country's level of trade. Due to these reasons, exchange rates hugely analyzed, watched and governmentally controlled economic approaches. But in a smaller scale, they may as well impact the investor's real return in a portfolio. In fact, any analyse attempted to determine or describe the behaviour of the exchange rate would state that it is a complex process which is cumbersome to researcher (Graham, 1983). However, it would be helpful empirically if succeed.

1.1.1 Malaysia

Prior to the notorious 1997 Asian financial crisis, Malaysia has maintained its high growth rates averaging 8.9 percent during 1988 till 1996. In addition, Malaysia attained low inflation rate about 3-4 percent per year. High employments were happening in country as well, rendering Malaysia as one of the miracle economies in East Asia. However, all this fairy tales soon became nightmares when the financial crisis emerged. The crisis originated from Thailand and Thai baht had suffered an intense selling pressure in May 1997. This onslaught had a domino-effect, and finally affected our ringgit in Malaysia.

During the first year of the crisis, the value of Malaysia currency, Ringgit, fell nearly 50 percent while the stock market shrank about 60 percent in value. To be precise, Malaysia Ringgit contracted from an average ratio of RM 2.42 to one U.S dollar in April 1997 to the new low of RM 4.88 to the U.S dollar in January 1998. As a consequent, high inflation, increasing unemployment from business closure led economy to experience a severe recession for the first time since 1985. The property bubble bursts consequently follow by crisis, and to make things worse, a huge capital outflows as investor and markets losses confidence. In the public sector, there is a cut down in both the expenditure and investment. Several infrastructure mega-projects have been postponed or /and cancelled follow by the crisis. With those negative incidents, the government can only depend on the net exports as a source of income (Mohamed and Syarisa, 1999). Depreciation in Malaysian Ringgit reduces the imports of luxury goods as the local demands contracted.

After the crisis permeated, Dr Mahathir imposed selective exchange measures to regain control of its economy from the crisis, so that Malaysia can destined its own fate. There are three measures that are under the selective exchange control: first, offshore ringgit market was extinguished thus speculators have no access to ringgit funds. Second, the government fixed the exchange rate at RM 3.80 to a U.S dollar. Third, a "twelve month rule" was executed to forbid the capital outflows for twelve months. As a result, these measures slowly revive and improved Malaysia's economy.

From the brief history of the Malaysia currency crisis, it able to discovered the importance of foreign direct investment (FDI), inflation rate, interest rate and trade balance that play an important role in determining the exchange rates. Therefore, the research study examines the relationship between exchange rates and macroeconomic variable that are stated above.

1.1.2 Relationship between Malaysia's Foreign Exchange Rate and Foreign Direct Investment (FDI)

Foreign direct investment (FDI) is an international flow of capital that provides a parent company or multinational firms with control over foreign business activities. According to Marial & Ngie (2009), at 2005, inflows of FDI around the world rose to $916 billion, with more than half of these flows received by businesses within developing countries.

Furthermore, foreign direct investment (FDI) is one of the elements that could affect the exchange rates, and thus the FDI activities are either highly active or hibernate. That might be influencing or causing the exchange rates to fluctuate. Making transactions using foreign currency for import or export of goods, foreigners make an investment on production or collaboration project, saving purpose and much more that are relevant to using monetary. Since gaining independence in 1957, Malaysia has taken advantage of tangible assets like natural resources, abundant labour as well as intangible assets like trade status under Generalized System of Preferences (GSP), macroeconomic stability, liberal trade regime, and a resourceful legal infrastructure to bring in FDI. For example, Intel established its Malaysia company located at Penang Island, DELL established a factory at Bayan Lepas Industrial Area, Penang Island and much more multinational company operated in Malaysia. All these can boost up the Malaysia's economic and bring in new technology to production or development.

1.1.3 Relationship between Malaysia's Foreign Exchange Rate and Inflation Rate

Inflation is a sustained increase in the average price of all goods and services produced in an economy. Inflation's effects on economy are various and can be positive and neither negative. However, a consistent of high inflation will depress the value of the exchange rates. As the higher the price rises, the lesser the value of money and hence reducing the people's purchasing power relative to other country. Consumers need to spend and it directly affects the money supply, vice versa. When the value of money decreases, consumers' spending declines and trading sentiment for its currency turns sour, leading a decline in Malaysia's currency against other currencies that have stronger economies. Besides, inflation is usually accompanied by higher interest rates.

1.1.4 Relationship between Malaysia's Foreign Exchange Rate and Interest Rate

Interest rates and exchange rates are highly correlated. By controlling the interest rate, Central Bank can influence both inflation and exchange rates. High interest rates can provide higher return for lenders relative to other countries. As a result, high interest rate will attract foreign investors to invest and will affect the exchange rates to be appreciated as the demand for currency increases.

In contrast, based on the International Fisher Effect theory, the home currency will be depreciated when the home interest rate is higher than foreign interest rate because interest rate reflects an expectation of inflation. In other word, high interest rate in home country indicates high inflationary expectations in the country; hence the home currency will depreciate against the foreign currency with relatively low interest rate.

1.1.5 Relationship between Malaysia's Foreign Exchange Rate and Trade Balance

Exports and imports play an important role in influencing the demand for the currency. A trade surplus (export is more than import) indicates that an increase demand for the country currency by the foreigners. For example, if Malaysia is in the trade surplus, it means that there will be more demand for the Malaysian Ringgit to pay for purchasing goods. Therefore, a trade deficit will have the vice-versa effects.

Malaysia is considered the most trade-dependent country after Singapore in the Association of Southeast Asian Nations (ASEAN) region. In 2011, Malaysia reported a trade surplus of RM8.31 billion. The products that were mainly exported by Malaysia are rubber, palm oil, cocoa, pepper, tobacco and etc. While imports products are electronics, machinery, vehicles, iron & steel products and etc.

1.2 Problem Statement

This main reason to conduct this study is that exchange rates play an important role in the microeconomic and macroeconomic level. For example, at the microeconomic level, the profits of multinational companies depend heavily on the fluctuation of exchange rates as their operation businesses deal with the exchange rates. Besides that, exchange rates can also directly affect the realized return to the investors who invest in the overseas market. Up to the macroeconomic level, exchange rates are clearly important in international trade, foreign direct investment and economic growth of a country.

Over the past, many researches were conducted in order to examine the relationship between exchange rates and macroeconomic variables. However, most of the past researches (Kanas, 2005 & Pontines, 2011) focused only on the developed countries such as US and New Zealand. Malaysia, on the other hand, categorized as developing country is less explored by the researchers due to its less matured financial market. Hence, this study will focus on Malaysia - a developing country in order to examine the relationship between the exchange rate and four macroeconomic variables namely foreign direct investment, inflation rate, interest rate and trade balance.

Yol and Ngie (2009) conclude that FDI inflows in Malaysia are positively affected by exchange rate as the Ringgit Malaysia (RM) is constantly undervalued. Besides that, Achsani, Fauzi & Abdullah (2010) state that the exchange rates significantly affect inflation rate in Asian regions and the sensitivity of inflation rates to the movement of exchange rates in Asia regions is higher if compare to those in North America and Europe Union. Yu Hsing (2007) indicates uncovered interest-rate parity theory is hold in his study as the nominal exchange rate in Egypt is negatively associated by the foreign interest rate. Lastly, main findings of Ng, Har and Tan (2008) paper proposes that exchange rate is an important variable to trade balance in Malaysia and currency devaluation will improve trade balance in long run. Based on these significant results, those four macroeconomic variables will include in the study.

Meanwhile, there are no previous researches that examine the relationship of those four macroeconomic variables which are simultaneous with Malaysia's exchange rate. Ng et al (2008) only examine the relationship between trade balance and exchange rate in Malaysia whereas Yol and Ngie (2009) investigate on how exchange rate affects foreign direct investment in Malaysia. Indeed, beside the four macroeconomic variables, there are other variables that can affect the exchange rates but this research study limit the discussion on those chosen variables because the study model will lose its degree of freedom if too many variables were brought in. (Mohamed, Wisam, Aris and Md, 2009)

Last but not least, a number of researches were done to examine the relationship between exchange rate and macroeconomic variables by employed different research methodologies. Utami and Inanga (2009) employed Ordinary Least Square (OLS) to examine the relationship between interest rate and exchange rate in Indonesia while Ogun, Egwaikhide and Ogunleye (2012) investigate the relationship between real exchange rate and foreign direct investment Sub-Saharan Africa by applying Granger causality test. Lastly, Shirvani and Wilbratte (1997) used the co-integration test to find out the relationship between real exchange rate and trade balance in US and other G7 countries. This research paper employed those research methodologies simultaneously in order to get the result from different perspectives. Unit root test, OLS, Granger causality test and co-integration test are included in this study.

1.3 Research objective

1.3.1 General objective

This main objective of this research paper is to find out the major forces behind Malaysia exchange rate. There are numerous factors determining exchange rates and they are all are related to the trading relationship between two countries. As mentioned, foreign direct investment, inflation, interest rate and trade balance play an important role in determining the exchange rates in Malaysia. Hence, the research objective is to investigate the relationship between these factors and the Malaysia's foreign exchange market.

1.3.2 Specific objectives

In the process of doing so, there are several specific objectives that the study will attempt to answer.

Determine the relationship between Malaysia's foreign exchange rate and foreign direct investment (FDI).

Determine the relationship between Malaysia's foreign exchange rate and inflation rate.

Determine the relationship between Malaysia's foreign exchange rate and interest rate.

Determine the relationship between Malaysia's foreign exchange rate and trade balance.

Determine long run relationship and short run relationship between Malaysia's foreign exchange rate and four macroeconomic variables namely FDI, inflation rate, interest rate and trade balance.

1.4 Research Question

There are two research questions in this research paper:

Does the significant relationship between Malaysia's foreign exchange rate and four macroeconomic variables namely FDI, inflation rate, interest rate and trade balance exist?

Is there any long-run and short-run relationship between Malaysia's foreign exchange rate and four macroeconomic variables namely FDI, inflation rate, interest rate and trade balance?

1.5 Hypotheses of the Study

Hypothesis 1

H10 : There is no significant relationship between Malaysia's foreign exchange rate and foreign direct investment (FDI).

H11 : There is a significant relationship between Malaysia's foreign exchange rate and foreign direct investment (FDI).

Hypothesis 2

H20 : There is no significant relationship between Malaysia's foreign exchange rate and inflation rate.

H21 : There is a significant relationship between Malaysia's foreign exchange rate and inflation rate.

Hypothesis 3

H30 : There is no significant relationship between Malaysia's foreign exchange rate and interest rate.

H31 : There is a significant relationship between Malaysia's foreign exchange rate and interest rate.

Hypothesis 4

H40 : There is no significant relationship between Malaysia's foreign exchange rate and trade balance.

H41 : There is a significant relationship between Malaysia's foreign exchange rate and trade balance.

1.6 Significance of Study

The objective of this empirical research is to examine the relationships between exchange rate and the selected independent variables, namely foreign direct investment, inflation rate, interest rate and trade balance. In order to discover a new knowledge in the field of study of exchange rate, it is critical to examine whether the independent variables is positive or negative to the exchange rate. Furthermore, policymakers and potential foreign investor will have a better understanding of the behaviour of exchange rate in Malaysia.

Exchange rate management is a topic that have been argued and debated in policy making and academic circles. The 1997- 1998 Asian crisis severely damaged both the economic and exchange rate. An overly volatile exchange rate is vulnerable to speculation, thus reducing its competitiveness to invest for long-term purposes (Taguchi, 2009). As a result, it is definite that it will affect the term of trade of nation. Furthermore, it also seeks an answer on how it affects the investment decision abroad. The fluctuation of exchange rate will determine the opportunity to invest or withdraw their capital. Therefore, this research study will provide some suggestion regarding the behaviour of exchange rate, as well the importance of decision making in exchange rate management.

Wise decision making is always the most important part in the investment process, if a wrong decision is made, it may cause the investor to face unbearable losses in the aspect of capital, time, human resourcing and much more. Exchange rates always act as one of the element that foreign investor should consider in the investment process because exchange rate fluctuation may cause an investor to earn very little of profit or might be compensated more than what he had earned. Hence, the results of the empirical research are helpful for those investors as they can further understand the relationship between the macroeconomic variables and Malaysia's foreign exchange rate.

1.7 Chapter Layout

The research paper is structured as follows, Chapter 2: Literature Review will describe the theoretical framework, empirical models which are related to four independent variables and comparison between the models. Chapter 3: Methodology will present the data description and model estimation. Chapter 4: Data Analysis will present the empirical result. Final chapter will conclude and discusses the policy implications of the results.

Conclusion

The main purpose in this empirical research is wished to find out the relationship between the four macroeconomic variables and the Malaysia's exchange rates. Besides that, the research study will examine long run relationship and short run relationship between Malaysia's foreign exchange rate and four macroeconomic variables namely FDI, inflation rate, interest rate and trade balance. In the end, this research study hope can become a foundation for the future research and also can provide the directions to the policy makers.


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