1.

0 Introduction
1.1 Research Background
In the context of Malaysian exchange rate regime, the currency is regulated by Bank Negara
Malaysia (BNM), the Central Bank of Malaysia, which was established on 26 January 1959
with major goals of promoting economic growth, a high level of employment, maintaining
price stability and a reasonable balance in countrys international payments position,
eradicating poverty and restructuring society. BNM set in to intervene to maintain relative
stability in the value of M$ and orderly market conditions whenever the currency fluctuated
excessively as compared to a basket of Malaysias trading partners currencies.

In the year 1975, Malaysia entered a new exchange rate regime. The Malaysian Dollar was
officially renamed the Ringgit with its external value determined based on a trade-weighted
basket currencies. In 1978, the exchange rates for all other currencies were determined on the
basis of Ringgit U.S. Dollar (RM/USD) rate and the USD rates for those currencies in the
foreign exchange markets. Since then, Malaysian exchange rate was managed within a band
of RM2.50 to RM2.70 (Goh and Mithani, 2000). This managed float was sustainable until the
mid of 1997, when Ringgit started to depreciate excessively following the outbreak of the
Asian Financial Crisis. Within a year, Ringgit fell into 37% as compared to the USD (Hasan,
2001).

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.

Effectively from 2 September 1998, the exchange rate of the Ringgit was no longer
determined by demand and supply in foreign exchange market. Malaysia returned to a fixed
exchange rate system, pegged at a rate against the USD at RM3.80 per unit USD. As a result,
from this action, Malaysian economy had been slowly recovered and improved.

1
 Diagram 1: Exchange rate fluctuations of USD/RM Source : tradingeconomics

Figure above shows that there is a clear trend where the RM has depreciated steadily against
the USD from the year 2015 to 2017.

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 that play an important
role in determining the exchange rates. Therefore, this research study examines the
relationship between exchange rates and macroeconomic variables that are stated above.

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

2
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.

Meanwhile, there are no previous researches that examine the relationship of those four
macroeconomic variables which are simultaneous with Malaysia's exchange rate. Ng Yuen-
Ling (2008) only examine the relationship between trade 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).

1.3 Research Objectives

This main objective of this research paper is to find out the determinants that affect the
exchange rate in Malaysia among the variables such as inflation rate, trade, foreign direct
investment and interest rate.

1. To investigate the long-run relationship between exchange rate and its key
determinants by using econometric methodologies.
2. To investigate dynamic short-run causality between exchange rate and its key
determinants by using econometric methodologies.

1.4 Research Questions

The main question is to find out what are the determinants that affect the exchange rate in
Malaysia among other macroeconomic variables.

The following are sub questions:

1. Is there exist any short-run and long-run relationship between exchange rate and
inflation rate in Malaysia?
2. Is there exist any short-run and long-run relationship between exchange rate and trade
in Malaysia?
3. Is there exist any short-run and long-run relationship between exchange rate and
interest rate in Malaysia?
4. Is there exist any short-run and long-run relationship between exchange rate and FDI
in Malaysia?

3
1.5 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. In order to discover a new knowledge in the field of study of exchange
rate, it is critical to examine whether the independent variables are positively or negatively
related to the exchange rate. Furthermore, policymakers and potential foreign investor will
have a better understanding of the behaviour of exchange rate in Malaysia.

2.0 Literature Review

2.1 FDI and Exchange rate

Yol and Ngie (2009) conclude that FDI inflows in Malaysia are positively affected by
exchange rate as the Ringgit Malaysia (RM) is constantly undervalued. The study of Tokunbo
and Lloyd A (2009) investigated the empirical evidence on the effect of exchange rate
volatility on foreign direct investment (FDI) in Nigeria, using secondary time series data
from1970 to 2004. In doing this, the study utilized the error correction model as well as OLS
method of estimation. The results suggest, among others, that exchange rate volatility need
not be a source of worry by foreign investors. Also, the study further reveals a significant
positive relationship between real inward FDI and exchange rate. This implies that,
depreciation of the Naira increases real inward FDI. Besides that, Lily, Dullak and Lim
(2014) empirically analyses the exchange rate movements and foreign direct investment
(FDI) relationship using annual data on ASEAN economies, that is, Malaysia, the Philippines,
Thailand, and Singapore. By employing ARDL bounds test approach, the empirical results
show the existence of significant long-run cointegration between exchange rate and FDI for
the case of Singapore, Malaysia, and the Philippines with all countries recording negative
coefficient implying that the appreciation of Singapore dollar, Malaysian ringgit, and the
Philippine peso has a positive impact on FDI inflows.

2.2 Inflation and Interest rate on Exchange rate

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. However,
macroeconomic variable and exchange rate are positively correlated but it depends upon the
time duration (Ray, 2008). Accordingly, inflation and interest rate both have negative relation

4
with nominal exchange rate. 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. In addition, Ebiringa, Thaddeus and Anyaogu (2014) models long run
relationship between exchange rate, interest rate and inflation using autoregressive distributed
lag (ARDL)co-integration analysis. The study is motivated by the desire to ensure stability in
exchange regime through a structurally nexus of interest rate and inflation volatility and
targeting. Using historical data on Nigeria (1971-2010), the paper established a significant
short-run and long run positive relationship between inflation and exchange rate. On the other
hand, interest rate exhibited a negative relationship, though insignificant.

2.3 Trade and Exchange rate

Khanom, Emu and Uddin (2014) identify the relationship between the exchange rate and
trade balance in Bangladesh from year 1973 to 2011. This study uses Augmented Dickey
Fuller (ADF) Unit Root Tests, Co-integration techniques, Engle-Granger test, and some other
diagnostics test like Multicollinearity test, Normality test, Chaw test, Lagrange Multiplier
serial Auto-correlation test and Ramseys RESET model specification test and so on. The
main findings of this study is the exchange rate is an important variable to the trade balance,
and devaluation will improve trade balance in the long run, thus consistent with Marshall-
Lerner condition.

Kyereme (2002) main objective is to explore the determinants of trade balance between US
and Australia in the long run. By using co integration test and sample data 1965 to 1998, he
found that there is a positive relationship between exchange rate and trade balance. Besides
that, the regression result conducted that price ratio is a major factor determinant the trade
balance. Other variables such as GDP ratio, money supply, real exchange rate and lending
ration also have significant to influence the trade balance.

A large and numerous studies have focusing their study on the relationship between trade
balance and exchange rate. Similarly, Kale (2001) used co integration method to examine the
relationship for these two variables in the Turkish economy. This study used the quarterly
data from 1984:1 to 1996:2 for his framework model. Furthermore, Bickerdike Robinson
Metzler condition was holds when the devaluation of exchange rate in the long run improves
Turkey trade balance.

3.0 Methodology

5
This study is using exchange rate (ER), FDI inflows (FDI), inflation rate (INF), interest rate
(IR) and trade (TRADE). For this study, I will be using nominal exchange rate to analyze the
impact on the independent variables.

Expected signs: -

ER = f { INF (-), TRADE (+), FDI (+), IR (-) }

The technique to estimate the data are varies vector error correction model (VECM). This
study will base on these approaches to get the best result.

3.1 Conceptual Framework

Independent variables

Inflation Trade (+) FDI inflows Interest

rate (-) (+) rate (-)

Dependent variable Exchange rate

Diagram 2: Conceptual framework

3.2 Hypothesis Statement

6
H1: there is a short and long run relationship between exchange rate and inflation rate in
Malaysia.

H2: there is a short and long run relationship between exchange rate and trade in Malaysia.

H3: there is a short and long run relationship between exchange rate and FDI inflows in
Malaysia.

H4: there is a short and long run relationship between exchange rate and interest rate in
Malaysia.

3.3 Data sources

The data was collected from International Financial Statistics (IFS) and World Bank. The data
was collected from the year 1980 to 2015 annually. It was a secondary data and consist of 36
observations.

3.4 Model Estimation

ER t = f {INF t , TRADE t , FDI t , IR t }

LER t = 0 + 1 LINF t + 2 LTRADE t + 3 LFDI t + 4 LIR t + t

Where,

LER = Nominal exchange rate (RM/USD)

LINF= Inflation rate (%)

LTRADE = Trade (% of GDP)

LFDI = Foreign direct investment inflows (% of GDP)

LIR = Interest rate (%)

t = error term

3.5 Econometric properties

Since
on
should
TDV,
be time
order,
test
the
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used to
the this
stationary
and
Augmented
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for
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find
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variables. be
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having study
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out
or not.
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(VECM)used
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The
allows VEC
us
relationships. toroot
we
the
to
runthe
be
the
Since this study is based on time series data, we should use the unit root test to find out if the
variables LER, LINF, LTRADE, LFDI and LIR are stationary or not. The Augmented
Dickey-Fuller, PP and KPSS tests will be used to test for the stationary of the variables. If all
the variables are found to be stationary of the same order, the cointegration test will be used

7
to determine the long run relationship between the dependent and the independent variables.
After having found cointegration, the vector error-correction model (VECM) will be used
to investigate the temporal short-run causality between the variables. The VEC model
allows us to capture both the short-run and long-run relationships.

1. Unit root tests

Unit root test used to make sure the data used for the study is stationarity. In this study, there
will be using the most common unit root tests which are ADF, PP and KPSS. If the series is
stationary at the level, then it is integrated of order 0, that is yt ~ I(0). However, if the series
at the level has a unit root, we will then take the first difference of the series and repeat
the unit root test. If it is stationary at the first difference then the series is said to be
integrated of order 1, that is yt ~ I(1).

yThe
the
=
tt-1
+ basic
specified
unit
+ equation
yroot
as test is for
follows:
ADF & PP test :-KPSS test :-

H0 : there is unit root (non stationarity) H0 : there is no unit root

H1 : there is no unit root (stationarity) H1 : there is unit root

2. Johansen and Juselius Cointegration

This method sets out a maximum likelihood procedure for the estimation of the co-integrating
vectors presence in Vector Autoregressive (VAR) model. There are two test statistics that can
be used in identifying the number of cointegrating vectors (r) which are maximum eigenvalue
and trace statistics. A rank of zero means that there is no cointegrating relationship. If the
rank is one, there is one, if it is two there are two and so on.

3. Vector Error Correction Model (VECM)

If cointegration has been detected, this already suggests the existence of long run equilibrium
relationship. Thus, VECM is applied to evaluate the long run properties of the cointegrating
series. In VECM, the cointegration rank shows the number of cointegrating vectors. For
instance, the rank of two indices that two linearly independent combinations of the non-
stationarity variables will be stationarity.

4. Granger Causality Test

8
The purpose of this test is to find out any short-run causality relationships among the
variables. The test helps to verify whether changes in any series can be explained by the other
series. A verdict unidirectional causality occurs between two variables if either null
hypothesis of the cross pairs is rejected. Bidirectional causality exists if both null hypotheses
are rejected and there is no causality if both null hypotheses fail to be rejected.

4.0 Empirical Results and Discussion

Table 1: Unit Root Tests Results

ADF Unit Root Test
Levels First Differences
Intercept Trend & Intercept Intercept Trend & Intercept
LER -1.260 -2.165 -.5.688*** -5.570***
LFDI -4.990 -2.903 -1.709*** -2.648***
LTRADE -1.539 0.376 -3.443** -3.548**
LINF -3.895*** -3.827** -4.660*** -4.654***
LIR -2.263 -3.410* -6.074*** -5.977***
PP Unit Root Test
Levels First Differences
Intercept Trend & Intercept Intercept Trend & Intercept
LER -1.253 -2.165 -5.696*** -5.580***
LFDI -4.990** -5.027** -21.081*** -23.329***
LTRADE -1.325 0.098 -3.483** -3.813**
LINF -3.895*** -3.748** -8.848*** -8.811***
LIR -2.134 -2.999 -10.747*** -10.441***
KPSS Unit Root Test
Levels First Differences
Intercept Trend & Intercept Intercept Trend & Intercept
LER 0.644 0.120* 0.070 0.073
LFDI 0.170 0.082 0.500** 0.500***
LTRADE 0.359* 0.175** 0.459 0.205
LINF 0.093 0.055 0.067 0.053
LIR 0.577** 0.091 0.333 0.333***
Notes: Figures in () are the lag lengths. Asterisks (*), (**) and (***) denote significant at1%, 5% and 10%
levels, respectively.

The
show
at
Thisthe
first
be
run
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Lag
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variables
of order
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have that test
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Order
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find
length, all
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and
sensitive
the
Selection
the the
integrated
isbetween
found
at the
the
optimalto at
long
VAR
to
From table 1, the ADF, PP and KPSS test results show that all the variables are stationary at
the first difference at the 1% and 5% level of significance. This means that all the variables
are integrated of order 1, that is I(1).

Johansen and Juselius Cointegration test

9
After all the variables, have been found to be stationary at the first difference, the
cointegration test can be used to find the long run relationship between the dependent and the
independent variables. Since the cointegration test is very sensitive to the lag length, the
VAR Lag Order Selection Criteria will be used to determine the optimal lag length. so, the
optimum lag length for the model of this study is 2 based on AIC.

Table 2: Lag length selection from VAR estimates

VAR Lag Order Selection Criteria

Endogenous variables : LNER LFDI LINF LTRADE LIR
Exogenous variables : C
Date: 02/11/17 Tim e: 22:17
Sam ple: 1980 2015
Included obs ervations : 34

Lag LogL LR FPE AIC SC

0 -59.50004 NA 3.06e-05 3.794120 4.018585

1 26.34765 141.3962* 8.69e-07 0.214844 1.561633*
2 53.36035 36.54659 8.55e-07* 0.096450* 2.565563

* indicates lag order s elected by the criterion

LR: s equential m odified LR tes t s tatis tic (each tes t at 5% level)
FPE: Final prediction error
AIC: Akaike inform ation criterion
SC: Schwarz inform ation criterion

Table 3: Johansen and Juselius Cointegration Tests Results

Trace Test: LER,LINF,LFDI,LTRADE,LIR(k=2, r=2)
H0 H1 -trace 95% CV
r=0 r1 94.259** 68.819
r1 r2 48.116** 47.856
r2 r3 27.083 29.797
Maximum Eigenvalue Test: LER,LINF,LFDI,LTRADE,LIR (k=3, r=1)
H0 H1 -max 95% CV
r=0 r=1 46.143** 33.877
r1 r=2 21.033 27.584
r2 r=3 15.095 21.132

Notes: Asterisk (**) denotes significant at 5% level, k is the number of lag and r is the number of cointegration
Vector.
While table 3 results shows the cointegration test results based on the trace statistic and
maximum eigenvalue statistic. Trace statistic shows there is two cointegrating equations at
the 0.05 level while maximum eigenvalue statistic shows there is one cointegrating equation

10
at the 0.05 level. This indicates there is an existence long run relationship between the
dependent variable LER and the independent variables LFDI, LTRADE, LINF and LIR.

If the cointegration shows there is at least one long-run relationship shared among the
variables, VECM is applied to evaluate the long run properties of the cointegrating series.
Table 4 below shows the normalized cointegrating vector.

Table 4: Implied Long Run Elasticities of Normalized Cointegration Vector

Parameter Constan LER LINF TRADE LFDI LIR ECT

Estimated t
Elasticities -0.238 -1.000 -0.101 0.359 0.171 -0.404 -0.5599
[t- (-3.351) (6.260) (4.845) (-7.139) (-3.1522)***
statistics] *** *** *** ***

From table 4, the long run exchange rate equation can be written as:

Log GDP=Log
1.760109
0.025281INF TDV
LER= -0.238 0.101 LINF + 0.359 LTRADE + 0.171 LFDI 0.404 LIR
0.696099
Table 6
normalized
cointegrating vector.
The cointegration equation shows that the exchange rate is positively related to trade and
FDI and negatively related to the inflation rate and interest rate. All the signs of the
coefficients are correct and satisfy the a priori, theoretical expectations. The coefficient of the
trade shows that 1% increase in trade will increase the exchange rate by 0.36%. This means
that the increase in trade will lead to an increase in Malaysia exchange rate. In addition,
the coefficient of the FDI shows that 1% increase FDI inflows will increase Malaysia
exchange rate by 0.17%. The coefficient of the inflation rate shows that 1% increase in
inflation rate will decrease exchange rate by 0.10%, while the coefficient of the interest rate
shows 1% increase in interest rate will reduce the exchange rate by 0.40%. Thus, inflation
and interest rate have a significant negative impact on exchange rate.

The ECT is statistically significant with negative value and this is correct sign as expected.
The ECT value of -0.5599 implies that about 55.1% of the short-run deviations in the
exchange rate would be adjusted in yearly basis to reach the long run equilibrium state.

Granger Causality Tests

11
After cointegration is found in our model, the Granger causality test based on the VECM will
be used. First, the Granger causality test with LER as the dependent variable will be tested.
Then, the Granger causality for LINF, followed by LTRADE and LFDI and lastly LIR as
the dependent variable will be tested as well.

Table 5: Granger Causality Tests Results

Dependent 2-statistic ECTs
Variables (p-value)
LER LI LTR F LI Coeffici t-
ents statistics
NF ADE DI R
LER - 2.166 10.893 1.401 4.345 -0.5599 -3.1523
(0.3385) (0.0043) (0.4964) (0.1139) ***
***
LINF 4.335 - 0.0217 2.065 0.350 -4.6208 -2.753
(0.0465)** (0.9892) (0.3561) (0.8394) ***
LTR 3.1890 0.0217 - 0.078 0.6304 -0.041 -0.310
(0.2030) (0.9892) (0.9618) (0.7297)
ADE
LFDI 1.0268 2.5069 0.6859 - 0.6574 1.2055 0.4891
(0.5985) (0.2855) (0.7097) (0.7199)
LIR 5.3878 9.1903 0.4903 5.3495 - -1.6194 -2.907
(0.0676)** (0.0101) (0.7826) (0.0689) ***
*** **
Notes: Asterisk (***), (**) and (*) denote significant at 1%, 5% and 10% levels,
respectively. is the first different operator.

All the Granger test results based on the VECM are shown in table 5. The chi-square statistic
results show the significance of the short run causal effects, while the significance of the
lagged error correction term (ect (-1)) shows the long run causal effect.

LIR
LER

LINF

LFDI

LTRADE

Diagram 3: Short run causal link between variables

12
The diagram above shows that there is a short run unidirectional causality between LER and
LIN and LIR. Therefore, the ECT t statistic shows that the burden of short run endogenous
adjustment to bring the system back into its long run equilibrium is solely borne by LER,
LINF and LIR.

Diagnostic Tests

Run the diagnostic tests to check the robustness of this model.

Table 6: Diagnostic Tests

F-statistics (p-value)
97.9882
Jarque-Bera
(0.4245)
AR[2] 28.6512
(0.2788)
ARCH[1] 330.6568
(0.4795)

From the table 6 shows that the model is good and free from autocorrelation and
heteroscedasticity problems.

5.0 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
exchange rate and four macroeconomic variables namely FDI, inflation rate, interest rate and
trade.

To achieve the objective of the study, the cointegration test and the Granger causality test
were used to investigate the short run and long run relationship between exchange rate and
the independent variables of this study such as inflation rate, trade, foreign direct investment
and interest rate.

Based on the empirical results and discussions, trade and FDI inflows have positive long run
relationship with exchange rate in Malaysia. Besides that, inflation and interest rate have
negative long run relationship with exchange rate in Malaysia.

This study also find out that both inflation and interest rate have short run relationship with
exchange rate in Malaysia but for trade and FDI, there is no short run relationship with

13
exchange rate. Conclude that inflation and interest rate have short as well as long run
relationships with exchange rate in Malaysia.

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.

14
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