Exchange Rate Volatility and Its Impact on Commodity Trade Flows between Singapore and Malaysia

(ProQuest: ... denotes formulae omitted.)1.INTRODUCTIONIntroduction of floating exchange rate regime in early seventies has presented exchange rate uncertainty to traders and possibility of negative effects on trade between nations. However, theoretical developments have produced models that predict the effects of exchange rate volatility on trade could also be positive if traders maximize trade today in order to cover part of future loss due to exchange rate uncertainty. Regardless of the outcome, each nation follows its own recourse to meet this challenge. For example, countries may adopt floating exchange rate, pegged rate, managed rate, etc. Exchange rate regimes in both Singapore and Malaysia are fairly similar. Monetary Authority of Singapore (central bank) adopts a managed float regime which allows the Singapore dollar to fluctuate within a band. Similarly, Bank Negara Malaysia (Malaysia's central bank) implements comparable policy. Although both exchange rates float within bands, still the real exchange rate between Singapore dollar and Malaysian ringgit could experience volatility outside a given band due to differential inflation rate in Singapore and Malaysia. Figure 1 highlights the degree of volatility of the real exchange rate between Singapore dollar and Malaysian ringgit.Has this volatility affected trade volume between Singapore and Malaysia? In trying to answer such questions we usually rely upon predictions from past models and estimates. In trying to learn past studies we come across the most recent review articles by McKenzie (1999) and recently by Bahmani-Oskooee and Hegerty (2007) who provide a detail theoretical and empirical review of the impact of exchange rate volatility on trade flows. From these review articles we gather that a few studies have included Singapore in their list of countries. Bahmani-Oskooee and Payesteh (1993) used standard Ordinary Least Square method to investigate long-run effects of exchange rate volatility on import and export volumes of six countries: Greece, Korea, Pakistan, the Philippines, Singapore and South Africa. In the results for Singapore they find no significant effects. Suspecting that the results could suffer from spurious regression problem, they then relied upon Engle and Granger (1987) cointegration method and showed that indeed the variables are not cointegrated. Since Engle and Granger (1987) method does not allow feedback effects among variables, Bahmani-Oskooee (1996) adopted Johansen's cointegration technique which allows feedback effects among variables of a given model. In the case of Singapore, although he finds cointegration among the variables of both import and export demand models, measure of exchange rate volatility carries an insignificant coefficient in the import demand model but significantly positive coefficient in one vector and negative coefficients in two vectors. The negative effects is also confirmed by Poon, et al. (2005) who used, again, the Johansen's method but only export volume of Singapore in addition to exports of Indonesia, Japan, South Korea, and Thailand.The mixed findings by the above studies do suffer from aggregation bias in that they have used trade flows of Singapore with the rest of the world. To reduce the bias another set of studies assess the impact of bilateral exchange rate volatility on bilateral trade flows between two countries. Unfortunately, no study has included Singapore as a trading partner.1 In this paper we try to assess the impact of exchange rate volatility on the trade flows between Singapore and her major trading partner Malaysia. However, following the recent trend we disaggregate the bilateral trade flows between the two countries by commodity and investigate the short-run and long-run effects of real exchange rate volatility on 22 industries in Singapore that import from Malaysia and 26 industries that export to Malaysia.2 These industries in each group conduct more than 84% of the trade. …