Dynamic Currency Linkages and Their Determinants: An Empirical Study for East Asian Economic Community Region

ABSTRACT

In this article, Copula GARCH models have been employed to study the inter-temporal process of currency market co-movements between ASEAN+6 countries (referred to in this study as East Asian Economic Community) and ASEAN+6 currency market index. Empirical results show that the sample countries of the region exhibit varying levels of currency co-movements with the Asian benchmark. Markov regime switching results show that many of the countries which had high dependences with the regional currency index as was found in copula estimations had also overlapping currency market cycles. Using Principal Component Analysis, we find that three statistical factors explain exchange rate co-movements which came out to be trade linkages, economic risk, and currency market openness in our dynamic panel data estimation.

KEYWORDS:

• currency market linkages
• market synchronization
• Markov regime switching
• panel data analysis
• time varying copula

JEL CLASSIFICATION:

• C13
• C52
• F21
• F36
• G15

Acknowledgments

The authors sincerely thank the two anonymous reviewers and the editor for their valuable inputs and suggestions which have helped in refining the manuscript. All remaining errors are entirely all ours. The authors would like to thank the conference participants and organizers of 8th Conference of Asia Economic Community Forum, 2016 in South Korea where this article was presented. We would also like to thank Ms Sakshi Saini, JRF at Department of Financial Studies, University of Delhi, for her research support in preparing this manuscript.

Supplemental Material

Supplemental data for this article can be accessed on the publisher’s website.

Notes

1. ASEAN was created with the signing of Bangkok Declaration in 1967 by Indonesia, Malaysia, Philippines, Singapore, and Thailand. Subsequently the ASEAN bloc grew with the addition of Brunei, Vietnam, Laos, Myanmar and Cambodia (in the order of their entry). The ten ASEAN members plus the three members that is Japan, China, and South Korea constitute the ASEAN+3 bloc. The 2nd East Asian Summit (EAS) was held Cebu in January 2007 wherein ten ASEAN members and six countries including China, Japan, South Korea, India, Australia, and New Zealand participated. Japan regards this ASEAN+6 (EAS group) as an appropriate group for East Asia’s trade and investment cooperation.

2. According to the 2013 Triennial Survey of the Bank for International Settlements, the global FX market activity in 2013 reached $5.3 trillion per day, up from $4.0 trillion in 2010 (BIS 2013).

3. Chiang Mai Initiative (CMI), a multilateral currency swap agreement between ASEAN+3 nations was initiated in May 2000. It consisted of ASEAN Swap Agreement among ASEAN countries and a network of bilateral swap agreements (BSA) among the ASEAN+3 countries. The Ching Mai Initiative Multilateralization (CMIM) evolved from the CMI and is a multilateral regional liquidity support arrangement among the ASEAN+3 member countries and Hong Kong to provide financial support in USD through currency swap transactions among them. The initial size of the arrangement was USD$120 billion which subsequently got doubled to USD$240 billion in 2012.Asian Payment Network (APN) Forum was initiated in 2006 for establishment of common standards and collaborative regional efforts for the clearing and settlement of all electronic payment transactions.

4. ASEAN Economic Community (AEC) will provide an economic region with smooth functioning regional financial system with more liberalized capital account regimes and interconnected capital markets facilitating greater trade and investment flows in the region.

5. For review of literature for studying exchange rate linkages through cross correlation analysis (see among others, Baig 2001; Calvo and Reinhart 1996; Komarkova and Komarek 2007; Wang and Xie 2013). For analysis using cointegration techniques (see among others, Chan, Cheng, and Pan 1997; Crowder 1994; Jeon and Lee 2002; Rapp and Sharma 1999).

6. GARCH type models ie dynamic conditional correlation, proposed by Engle (2002) and extended by Cappiello, Engle, and Sheppard (2006), with an asymmetric approach called the Asymmetric Dynamic Conditional Correlation (ADCC) model to analyze co-movements in the exchange rates (see among others, Antonakakis 2012; Kim, Kim, and Min 2013; Tamakoshi and Hamori 2014).

7. For review of literature of select studies utilizing Copula method to study exchange rate linkages in Asia (see Albulescu et al. in press; Boero, Silvapulle, and Tursunalieva 2011; Dias and Embrechts 2010; Patton 2006a).

8. The Asian Monetary Unit (AMU) is a basket of currencies proposed by Japanese government’s Research Institute of Economy, Trade and Industry (RIETI). It is similar to the European Currency Unit (ECU), predecessor to the Euro. The basket weights of the index are calculated based on the arithmetic shares of intra-regional trade volumes (average of total export and import volumes of most recent 3 years 2012–2014) and GDP measured at purchasing power parity (average for 2012–2014).

9. Annualization has been done assuming 250 trading days in an year.

10. Unit root test results are not reported due to brevity of space. These are available on request from the authors.

11. Singapore, which has the largest trade to GDP ratio among all sample Asian countries for the study period was found to have FX dependency of its SGD returns as 0.59 with the USD, 0.54 with the EURO and 0.26 with the JPY while EU/US/Japan are its second/third/sixth biggest export market.

12. The Yuan was pegged to the greenback at 8.28 to the dollar for more than a decade starting in 1994. It was only in July 2005 that China moved to a “managed float” system against a basket of major currencies that included the US dollar. China undervalues its currency by pegging the yuan to the US dollar at a daily reference rate set by the People’s Bank of China (PBOC) and allowing the currency to fluctuate within a fixed band (set at 1% as of January 2014) on either side of the reference rate.

13. Currency Interchangeability Arrangement (CIA) entails that currency notes of one country are acceptable in the other country as customary tender, although not legal one. Also the Brunei Dollar is pegged to Singapore Dollar.

14. Results may be interpreted keeping in mind that both China and Vietnam have a fixed exchange rate regime while Brunei has currency board arrangement with Singapore. China has been included in the sample as it is one of the largest economies of the region and since July 2005, China has taken important step to internationalize its currency when it moved to a “managed float” system against a basket of major currencies that included the US dollar. Vietnam has moved from a system of a managed FX market through a relatively stable inter-bank rate to managing it more flexibly on a regular basis. Brunei has a CIA agreement with Singapore.

15. BDS test results are not reported due to brevity of space. These are available on request from the authors.

16. Results of Correlation tests are not reported due to brevity of space. These are available on request from the authors.

17. The factors have been named in accordance with the underlying explanatory variables constituting the same.

18. Results of the Principal Component tests including the component matrix and coefficient matrix are not reported due to brevity of space. These are available on request from the authors.

19. System GMM has several advantages over pooled OLS, fixed effect (within group) or difference GMM estimator (refer Arellano and Bover 1995; Blundell and Bond 1998).