ASEAN income gap and the optimal exchange Rate Regime

ABSTRACT

This article investigates the optimal exchange rate regime in a group of ASEAN countries, which minimizes the adverse effects of foreign demand shocks on real output, the real exchange rate, price level and between-country income gap. Using a panel structural vector autoregressive model for small open economies, we show that the extent by which foreign demand shocks influences the between-country income gap depends on the exchange rate regime and the transmission channels through output, the price level and the real exchange rate. Our results show that a fixed exchange rate is better in insulating output and real exchange rates against adverse foreign demand shocks. Nevertheless, a flexible exchange rate regime achieves lower inflation and narrows the income gap across countries. Further, foreign demand shocks explain a larger portion of the forecast error variance of macroeconomic variables under a fixed than under a flexible exchange rate regime.

KEYWORDS:

• Foreign demand shock
• exchange rate regime
• ASEAN
• income gap
• panel SVAR

JEL CLASSIFICATION:

• D33
• E30
• F31
• F41
• F33

Acknowledgments

We are grateful for the constructive comments given by the referee, which have improved the quality of the paper. Any remaining errors are our own.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The income gap in this refers to the difference in income per capita between countries.

² Masron and Yusop (2008) find that with the existence of external shocks, ASEAN countries have a larger income gap between them.

³ See the studies of Broda (2004), Chia, Cheng, and Li (2012) and Zhang, Li, and Chia (2014).

⁴ The IMF’s de jure classification was reclassified into a de facto classification in 1998.

⁵ Due to the accession of Cambodia to ASEAN in 1999, this year is chosen for the starting year of the dataset. In addition, data relating to some variables for Cambodia, Lao PDR, Myanmar and Vietnam are not available for the time period before 1999 and after 2014.

⁶ Levy-Yeyati and Sturzenegger (2005) show that a de jure exchange rate regime is the legal regime that a country commits to apply.

⁷ Levy-Yeyati and Sturzenegger (2005) indicate that a de facto exchange rate regime is classified according to the actual policy rather than the announcement.

⁸ Fixed exchange rate regimes comprise no separate legal tender, currency board and conventional fixed exchange rate regime. Intermediate exchange rate regimes include a peg with bands, crawling pegs, crawling band, stabilised arrangement and other managed arrangements. Floating exchange rate regimes comprise an independent float (or free-floating) and managed float with no predetermined band.

⁹ Export volume shocks are changes in the volume of exports.

¹⁰ Details can be provided on request.

¹¹ Detailed results of the unit root tests are available from the authors upon request.

¹² Details of the cointegration tests are available from the authors upon request.

¹³ Detailed results are available from the authors upon request.

¹⁴ In addition to the AIC, we also use the sequential modified Likelihood ratio (LR) test statistic and the final prediction error (FPE) criterion. The results are similar to the one produced by the AIC.

¹⁵ Detailed results of lag-length, no autocorrelation and stability tests are available from the authors upon request.

¹⁶ Under a fixed exchange rate regime the nominal exchange rate is fixed, so changes in the real exchange rate under this regime are expected to come from movements in the price level. However, given that the price level is sticky in the short-run, the real exchange rate is expected to be more stable in the fixed regime than in the flexible regime.