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CHAPTER 1

INTRODUCTION

1.1. Backgrounds

In 1961, Oi was able to explicate an intriguing conclusion. Quoting from

his studies, it is argued that price instability is a virtue rather than a vice.
However, Hooper and Kohlhagen (1978) reveal a justification for the proponents
of stability that exchange rate instability which translates to exchange rate
uncertainty does reduce international trade. The previous research has led
numbers of studies on this topic. However, most of these studies focus on
developed economies and also rarely explicate exchange rate uncertainty’s effects
on different trade sectors. Hence, this research aims to give contribution in
focusing the topic on developing economy. The research’s main objective is also
to describe different impacts that exchange rate uncertainty imposes on different
trade sectors. Indeed, the research will be the first study that reveals sectoral
impacts of exchange rate uncertainty in Indonesia.

Real exchange rate can broadly define a country’s competitiveness

compared to other country. Under the theory of Purchasing Power Parity (PPP),
real exchange rate will remain constant. It means that the theory implies no
changes of competitiveness among countries across times. However, many
evidences lead to the failure of PPP to hold in reality. Therefore, assuming PPP
does not hold, real exchange rate may vary overtime and so does a country’s
competitiveness.

Moreover, fluctuations of real exchange rate may root in fluctuations in

nominal exchange rate and in fluctuations of price level ratios. Changes in
nominal exchange rate are highly determined by the exchange rate regime adopted
by a country. Adoption of fixed-exchange rate regime implies high interventions
of central bank in keeping the currency’s exchange rate at a certain level, while
free-floating exchange rate regime lets the exchange rate to be determined by

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market-mechanism. As we can see from the chart below, nominal exchange rates
of Indonesia’s currency and its main trading partners seem to fluctuate relatively
more rapidly after the adoption of free-floating exchange rate regime in 1997.

Chart 1.1. Nominal Exchange Rate Fluctuations of Indonesia’s Currency with Its
Main Trading Partners

On the other hand, there are several factors that may cause fluctuations in
price level. These factors include condition of macroeconomic such as
government expenditure, employment and technology changes. As we can see
below, price levels of Indonesia and its five main trading partners also vary
overtime.

Chart 1.2. Price Levels of Indonesia and Its Five Main Trading Partners

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Many people argue that fluctuations of exchange rate can affect

international trade. Fluctuations or variability or volatility of exchange rate can
cause uncertainty. Exchange rate uncertainty is argued to have an impact on
international trade that it can cause the profit gained from international trade
activities to be uncertain as well. This research takes more focus on the impact of
exchange rate uncertainty on the volume of bilateral trade.

Reviewing the theories and empirical evidences available, the research a

priori assumes real exchange rate to be more relevant in affecting trade rather than
nominal exchange rate. Given that there are ways in eliminating real exchange
rate uncertainty in short term, the research also focuses on the medium term to
long term real exchange rate uncertainty. However, the research does not a priori
take the level of real exchange rate uncertainty to be different under fixed
exchange rate regime and free-floating exchange rate regime.

Maskus (1986) and Cho et al. (2002) find that exchange rate uncertainty
imposes different impacts on different sectors. On the other hand, there are plenty
of arguments and evidences showing that exchange rate uncertainty can have
dualism influence on trade. In some cases, exchange rate uncertainty can increases
the volume of international trade but in some other cases exchange rate
uncertainty is detrimental to international trade. Moreover, most studies focuses

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on the empirical tests on the case of developed economies and rarely can we find
those for developing economies. Yet, Pick (1990) emphasizes the impact of
exchange rate uncertainty can be larger in developing economies compared to
developed economies since the less-developed condition of developing
economies’ financial market. Hence, this research takes Indonesia, a developing
country, as observation in order to contribute to the development of this topic.
This is also the first research in Indonesia that tries to explicate the impact of
exchange rate uncertainty toward different trade sector.

In order to represent the population of Indonesia’s bilateral trade, the

research takes the sample from Indonesia’s bilateral trade with its five main
trading partners, namely Japan, USA, Singapore, Korea and Germany. Trade
sector classification follows the Standard of International Trade Classification
(SITC) Revision 3 with 1 digit classification. The data is taken annually from the
year 1987 to 2006. This time-series allows for 10 years of the adoption of fixed-
exchange rate regime and 10 years of the adoption of free-floating exchange rate
regime.

In this research, the variable of exchange rate uncertainty is calculated

using the Perée and Steinherr’s exchange rate uncertainty measurement. This
variable is included as one of independent variables in an expanded gravity model.
Gravity model itself is widely used and has been very successful in explaining
behavior of bilateral trade. Other independent variables are real GDP per capita,
population and distance.

The data is formed as a panel data consists of 800 observations and

regressed using various panel-data regression models. The best model is then
taken as default in order to explain the impact of exchange rate uncertainty on
bilateral trade.

The research finds that that exchange rate uncertainty imposes different
impacts on different trade sectors. From 8 trade sectors, exchange rate uncertainty
has significant negative impact on two trade sectors while it has significant

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positive impact on the other six trade sectors. This pattern is concluded in the
table below.

Table 1.1. Impacts of Exchange Rate Uncertainty of Different Trade Sectors of

Indonesia’s Bilateral Trade

Impacts of Exchange Rate Uncertainty on Trade Sectors

Negative Impacts Positive Impacts
Beverages and Tobacco Food & Live Animals
Animal and Vegetable Oil Crude Matter, Inedible
Mineral Fuel
Chemical Products
Manufactured Goods
Machinery and Transportation
Equipments

Differences of exchange rate uncertainty’s impacts on different trade

sectors occur because of the varying level of openness, industry concentration,
foreign direct investment which represents multinational activities and protection
level which prevail in different trade sectors.

1.2. Research Problem

Adoption of different exchange rate regimes may produce different

fluctuations of exchange rate. Therefore, the level of exchange rate uncertainty
may also vary across different exchange rate regimes. Moreover, exchange rate
uncertainty may impose different impacts on trade. The research tries to explicate
the impacts of exchange rate uncertainty on the volume of trade. Specifically, the
research tries to make a sectoral analysis on the impact of exchange rate
uncertainty of Indonesia’s bilateral trade data.

1.3. Research Objectives

The objectives of the research are:

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a) To know the level of exchange rate uncertainty during the adoption of

fixed-exchange rate regime (1987-1997) and free-floating exchange rate
regime (1997-2006) in Indonesia;

b) To know the relationship between Indonesia and trading partners’ GDP

per capita, Indonesia and trading partners’ population and distance
between Indonesia and trading partners to Indonesia’s bilateral trade;

c) To know the impacts of exchange rate uncertainty on different trade

sectors of Indonesia’s bilateral trade.

1.4. Research Significance

The research adds more empirical study on the topic of exchange rate
uncertainty and trade especially taking developing economy as an object of
analysis. This research is the first research that study sectoral impacts of exchange
rate uncertainty in Indonesia. This research finds that exchange rate uncertainty
not necessarily always causes negative impacts on international trade.

1.5. Research Hypothesis

The research hypothesizes:

a) There is no significant difference in the level of real exchange rate

uncertainty under fixed-exchange rate regime and free-floating exchange
rate regime;

b) GDP per capita and population are positively related to international trade
while distance is negatively related to international trade;

c) Exchange rate uncertainty imposes different impacts on different trade

sectors.

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1.6. Research Methodology

The research uses an expanded gravity model in order to explain

Indonesia’s trade between its five main trading partners. Specifically,

ln TRADEijs ,t    1 ln GDPPCt   2 ln POPt   3 ln dist   4sU ij ,t   ijs ,t

(1.1)

The model estimates that trade (TRADE) is influenced by the product of

GDP per capita (GDPPC) of Indonesia and trading partner, product of population
(POP) of Indonesia and trading partner, distance between Indonesia and trading
partner (dist) and exchange rate uncertainty (U). Moreover, since the objective of
the research is to explicate different impacts of exchange rate uncertainty on
different trade sector, the variable of exchange rate uncertainty is formed as a
fixed-effects estimator. This means that the variable of exchange rate uncertainty
is multiplied by dummy-interactive variables each representing a trade sector.

In this research, Indonesia’s main trading partners are Japan, United States
of America (USA), Singapore, Korea and Germany. Trade sectors classification
follows the Standard of International Trade Classification (SITC) Revision 3 with
1 digit classification. From 10 trade sectors available, the research includes 8 trade
sectors to be observed. The excluded trade sectors are the sector of miscellaneous
manufactured articles and the sector of commodities and transaction. The sector of
miscellaneous manufactured articles is excluded from the analysis due to
difficulties in determining the trade sector level of openness and concentration.
Meanwhile the trade sector of commodities and transaction is excluded because it
has relatively small portion in Indonesia’s international trade.

Table 1.2. Trade Sector Classifications

SITC 1-digit DESCRIPTION Code c

0 Food and Live Animals 1
1 Beverages and Tobacco 2
2 Crude Materials, Inedible 3
3 Mineral Fuels, Lubricants etc. 4
4 Animal and Vegetable Oils & Fats 5

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5 Chemical Products 6
6 Manufactured Goods 7
7 Machinery and Transport Equipment 8

The data is formed as a panel data. The time-series variable is year which
covers a period of 20 years. The period observed starts in 1987 and ends in 2006.
This allows for 10 years utilization of fixed-exchange rate regime and 10 years
utilization of free-floating exchange rate regime. The cross section variable is
named as coding1. This variable is a system of code which represents 8 different
trade sectors and 5 trading partners. Having 40 individuals of cross-section and 20
individuals of time-series, the data consists of 800 observations.

1.6.1. Data Collection Technique

Data of Indonesia’s exports to and imports from five main trading partners
is obtained from Badan Pusat Statistik’s data. The research obtains data of Real
GDP, population, price level, and annual exchange year from the International
Monetary Fund (IMF)’s International Financial Statistics (IFS) CD-ROM.
Meanwhile, the data about distance between Indonesia and its five main trading
partners is obtained from the data provided by Andrew K. Rose.

1.6.2. Data Processing Technique

Using the Stata 10.0 software, the data is regressed under the Ordinary-
Least Square (OLS) estimation method. This includes the conditions that the data
should be able to fulfill the basic assumptions of OLS in order to produce best-
linear-unbiased (BLUE) estimators. Moreover, the panel data is regressed under
several panel data regression models. These models are Pooled-Least Square
model, Fixed-Effects Model, Random-Effects Model and Generalized Least
Square (GLS) model. The best result is then chosen under the following
thresholds:

1
The information about the system of formation for the cross-section variable is available in
Appendix.

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a) The method should be able to produce the most credible result under the
assumptions specified.

b) The method should be able to produce a significant model.

c) The method should be able to produce the most numbers of significant

parameters.

1.7. Research Systematic

The systematic of the research is as follows:

CHAPTER I: Introduction

This chapter includes backgrounds of research, statement of problems, research

objectives, research contribution, hypothesis, methodology and systematic.

CHAPTER II: Literature Review

This chapter consists of two parts, summary of theories and review of preceding
researches on the same topic of the research. The summary of theories range from
the theory of pattern of trade, exchange rate, purchasing power of parity (PPP),
and exchange rate uncertainty’s impact on trade. The review of preceding research
includes research about the impact of exchange rate uncertainty of trade in
developed economies and some researches of the same topic in Indonesia.

CHAPTER III: Indonesia and Its Main Trading Partners

This chapter elaborates the condition of Indonesia and its main trading partners by
the independent and dependent variables used in this research. This means that the
chapter gives historical explanations on Indonesia and its five main trading
partners’ real GDP per capita, population, distance from Indonesia to each trading
partner, and bilateral exchange rate between Indonesia and each trading partner.
Moreover, a review of Indonesia’s trade data is also provided. The review of trade
includes aggregate data of Indonesia’s trade with all five trading partners as well

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as explanations on data based on the trade sector classification used in this

research.

CHAPTER IV: Research Methodology

This chapter explains the foundation of the gravity model specified in this
research. Next, the chapter also explains the measurement of exchange rate
uncertainty used in the research which is the Perée and Steinherr’s exchange rate
uncertainty measure. Moreover, the chapter explains the sample and data used in
the research. The chapter ends with explanation on all the regression method used
in the research.

CHAPTER V: Results and Analysis

The chapter has two sections namely the subchapter of results and the subchapter
of analysis. The first subchapter shows all the results obtained from the regression
process of the model using the sample and data. The second subchapter explains
the meaning of the best regression result in economic terms.

CHAPTER VI: Conclusion and Remarks

This last chapter of the research states some conclusions drawn from the whole
process of the research especially the results and analysis. The chapter also
elaborates the caveats of the research. This last part of the chapter states some
remarks of the research based on the information obtain from the research.

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