Cointegrating rank test for VARX (4, 3) trade model.
China appears as the biggest trading partner for ASEAN economies, but it is inconclusive whether the complementarities between China and regional economies offset China’s competitive threat. This study tries to assess if real exchange fluctuations and the demand-supply channels determine the Malaysia-China trade balances in the global crises era, 1997–2010. The finding generally supports the complementary role of China in the Malaysia-China bilateral trading. However, despite the long-run effect of real exchange on trade balances, the Keynesian demand channel was not uphold during and after the global financial crisis—due to the contractionary effect on Malaysian output. The Chinese inflation impact is also not evident following the foreign exchange shocks. Meanwhile, currency devaluation for exports gains is insufficient to sustain Malaysia output expansion against China. Further productivity growth in real and tradable sectors is essentially needed.
- trade balances
- contractionary effect
- global crises
China has become the largest trading partner for many of the East Asian nations in the aftermath of Asian financial crisis 1997/1998. For Southeast Nations (ASEAN-10), China accounted for 12.9% of the regional trade, surpassing the USA (8.1%) and Japan (10.6%) in 2012. The figure was only about 2.2 and 1.9%, respectively, for total exports and imports of ASEAN-China, a decade ago (ASEAN Statistical Yearbook). A number of recent studies have thus documented the complementary effects of China for its trading neighbors in line with the improved economic link [1–4]. Multinational corporations are incorporating China into the global production system along with earlier entrants and hence promoting regional trading . China’s own enterprises are specializing, in coordination with regional counterparts, and so raising intraindustry trade in differentiated products. In other words, the emergence of China as a global economic power has resulted in an increase of labor diversification and intraregional trading, which, in the long run, may lead to regional economic integration similar to the European Union or the North American Free Trade Agreement [6, 7].
Yet, others have also pointed out the conflicting (competing) features of China’s economic rise. China appeared as the world’s leading exporter since 2007, and its current account surplus amounted to about $260 billion (Ministry of Commerce, China),1 which ranked top globally in 2013. There are worries that China’s yuan regime, investment magnetism, and low labor costs, as well as its accession to the World Trade Organization (November 2001), may have positioned the country as a formidable economic competitor that threatens to crowd out other developing Asian countries [5, 8–10]. Malaysia, for instance, has suffered a continuous seven-year trade deficit with China since 2002—which peaked at $4.2 billion in 2007, before the major correction in 2009. Some observers have also, directly or indirectly, related the resurgence of China since the late 1980s and the devaluation of the renminbi (or, Chinese yuan) in 1994 to the Asia financial crisis2 [11, 12]. Such issues have gravely challenged the consensus of sustainable trade competitiveness at the regional level. Up to now, no conclusive consensus has been reached concerning the economic emergence of China. It is still difficult to assess whether the complementarities between China and regional economies offset its competitive threat [5, 13–15].
This study focuses on the Malaysia-China case to assess if the real exchange fluctuations as well as the demand and supply channels determine the performance of bilateral trade balances in the global crises era, 1997–2010. Among the ASEAN-10 members, Malaysia is presently the largest trading partner with China. In 2009, the Malaysia-China trade reached $59 billion—about 18.9% of Malaysia’s global trading, surpassing the Malaysia-US trade share (10.9%). The figure for Malaysia-China trade was only $4.7 billion in 1990 or about 8% of Malaysian total trade.
To the best of our knowledge, previous studies have worked on the Malaysian or the Chinese case but not for Malaysia vis-à-vis China after the major adjustment of yuan and ringgit in July 2005. Likewise, no updated studies have assessed the period of postsubprime crisis.3 Yet, it was noted in the literature that time period of the study being selected would have resulted in dissimilar results. Malaysia, for instance, has practiced various exchange rate regimes in the past four decades—the Bretton Woods system, managed floating, free floating, and basket of currency-floating eras. Different regimes have reflected varied policy responses, and the empirical results could be irreconcilable with the theoretical prediction, over time. As for China, the open policy started in 1978, but the progress of trade and exchange rate liberalization was slow prior to the 1990s. Both nations, however, share a similar exchange rate regime since 1998. Though claimed as managed float by the Chinese authority, Chinese yuan was
The study contributes to expand the literature by taking concerns of several distinguished empirical issues. First, instead of measuring the trade balance as a function of the real exchange rate, domestic income and foreign income in the conventional way, we also incorporate domestic and foreign prices in our empirical model. The consideration emphasizes on the China’s role in the supply and value chain of Malaysian economics and the assessment of potential imported inflation effect (or, deflation), which is of important issue to stabilize domestic economy.
Second, Malaysia is a small and open economy, with the exchange rate regime playing an important role in economic development. When compared to the Chinese population of 1.35 billion people with GDP (at PPP) amounted to US$11,347 billion, the Malaysian market size is relatively small, with only 28 million residents and GDP (at PPP) of US$464 billion. Though Malaysian trade openness is now among the highest in the world (about 200% of its GDP), its total trade volume is relatively still small. It is necessary, in the methodological sense, to develop an econometric model that allows the possibility of drawing a distinction between endogenous and exogenous variables, which are integrated of
In addition, the compilation and analysis of macroeconomic data of both nations by previous studies are also limited by the unavailability of higher frequency series—monthly data. We, therefore, focus on the post-liberalization period (January 1997 to March 2010) where both Malaysian and Chinese series are more valid and reliable. We reconstruct the series that sourced from Datastream, in consider of the seasonal and based-year effects. Our data are also cross-checked with the GVAR database provided by Smith and Galesi . Then we conduct a preliminary test of endogenous break(s)4 on each series and impose the break dates as dummy variables in the VARX and VECMX models.
What follows involves the estimation issue for small sample size, particularly, in regard to the size and power properties of time series analysis. Though with 159 monthly observations, our study only covers a 13-year length of time. Given this, we employ the nonparametric bootstrap method, an alternative to the large sample data tests based on asymptotic theory. It was well noted in the literature that bootstrap’s ability to provide asymptotic refinements often leads to a reduction of size distortions in finite sample bias and it generally yields consistent estimators and test statistics [28, 29]. This method is later applied to test the number of VARX cointegrating ranks and to test the significance of log-likelihood ratio (LR) statistics of the overidentifying long-run restrictions. This method is also applied in the measures of estimation uncertainty and confidence intervals for generalized IRF and persistent profile.
Our study reveals that, despite the long-run effect of real exchange on trade balances, the Keynesian demand channel was not uphold during and after the Asia financial crisis—due to the contractionary effect on Malaysian output. Though a potential depreciation of the Malaysian ringgit would have resulted in an overall surplus for Malaysia against China, the domestic and foreign income variables are only significant through lagged effects in the short run but not in the long-run model, suggesting that the demand side effects are temporal. In other words, ringgit devaluation for exports gains is insufficient to sustain output expansion for Malaysia against China. Further productivity growth in real and tradable sectors is essentially needed. On the other hand, the inflation impact is not evidently observed following the foreign exchange shock, implying that China has yet to be Malaysia’s main source of imported inflation. Meanwhile, the dummy of subprime crisis is excluded from the trade balance model as insignificant statistic was reported during the restriction test. Having the empirical facts being considered, our study generally supports the complementary role of China in the Malaysia-China bilateral trading.
To this end, our study is designed in the following manner. Section 2 shows the theoretical representation of the trade-exchange rate-output-price model that forms the basis of our empirical model. This is followed by the estimation procedures and data description. Estimation results are discussed in Section 3. Finally, in Section 4, conclusion and policy implications are drawn.
2. Research methodology
2.1. Trade-exchange rate-output-price model
The model expresses the trade balance as a function of the real exchange rate and the levels of domestic and foreign incomes. Taking the natural logarithm of both sides, we have the following model, with a stochastic term added to capture short-term departures from long-run equilibrium:
where ln represents the natural logarithm and
2.2. The VARX and VECMX estimation
Pesaran et al.  modified and generalized the approach to the problem of estimation and hypothesis testing in the context of the augmented vector error correction model. Garratt et al. [23, 24] extended the idea and developed the VECMX model along the same lines. They distinguish between an
where there are
2.3. Data description
The analyses are all based on monthly series, spanning from January 1997 to March 2010. Real exchange rates (
3. Empirical discussion
The preliminary examination of the data properties is conducted using the unit root tests by Lumsdaine and Papell  and Saikkonen and Lütkepohl . The data are overwhelmingly integrated of
3.1. Dynamic long-run relationship and error correction modeling
Before proceeding to the cointegration test of long-run relationship, we first have to determine the lag orders of endogenous and exogenous variables outlined in Eq. (3). For this purpose, the Akaike information criterion (AIC) and the Schwarz Bayesian criterion (SBC) are applied to the underlying unrestricted VARX model. SBC has selected the lag orders of 3 for both conditional and marginal models, whereas AIC selected a higher and same order lag for the endogenous (4) and exogenous (3) variables, respectively. According to Garratt et al.  and Affandi , underestimating the lag orders is generally more serious than overestimating them. As such, the subsequent analyses are based on the VARX (4, 3).
Next, we need to determine the number of cointegrating relations given by
|Trace statistics||Bootstrapped critical values|
In order to exactly identify the long-run relationship, we then impose a normalized restriction to produce the long-run estimate of the Malaysia-China trade model (Table 2). The log-likelihood ratio (LR) statistic for the normalized (exactly identified) restriction is identical to the value reported in the value of maximized log-likelihood function for the cointegration test. However, the dummy for the subprime mortgage crisis is excluded from the model, as insignificant statistics are reported during the restriction test. Then again, we are aware that for domestic coefficients (
|ln || − 0.4720ln||+ 3.0446ln||− 1.1416ln||− 0.3078|
|95% Bootstrapped CV for LR: 22.9725||LR test: 22.5245 [0.001]|
|90% Bootstrapped CV for LR: 19.5385|
Long-run estimates reported in Table 2 show that the trade balance is significant and responsive to changes in the real exchange rate of RM/yuan. Recall that the Marshall-Lerner condition implies that a real devaluation of domestic currency (RM) will improve the trade balance only if the sum of the price elasticity of demand for exports and imports is greater that unity. Since the ln
The modeling of VECMX short-run dynamics is presented in Table 3 and several points are noteworthy.9 First of all, the lagged error correction term (ECT
|Conditional model (endogenous variables)||−0.4096b||0.1897||−2.1588 (0.033)|
|Marginal model (exogenous variables)||Δln||0.8014a||0.4192||1.9117 (0.058)|
|0.46||1.233 (0.27)||0.183 (0.67)||3.475 (0.18)||0.026 (0.87)|
A subsequent and important inspection of model stability is to apply the cumulative sum (CUSUM) and cumulative sum of squares (CUSUMSQ) tests to the residuals of the error-correction VECMX model and the long-run VARX coefficient estimates. For the CUSUM test, the recursive residuals are plotted against the break points, while the CUSUMSQ plots the squared recursive residuals against the break points. As a graphical presentation, these two statistics are then plotted within two straight lines, which are bounded by 5% significance level. If any point lay beyond this 5% level, the null hypothesis of stable parameters is rejected or otherwise. Clearly, Figure 1 shows that the stability of estimated coefficients for our Malaysia-China trade model as both statistics is within the critical lines.
3.2. Shock responses and speed of convergence
A good way of measuring the speed of convergence of the cointegrating relations to equilibrium is to examine the dynamic responses of the endogenous variables to various types of shocks, in particular shocks to the real RM/yuan, Malaysian output, and prices. We first consider the effect of system-wide shocks on the cointegrating relations using the persistence profile developed by Pesaran and Shin . On impact, the persistence profile is normalized to take the value of unity, but the rate at which it tends toward zero provides information on the speed with which the equilibrium correction takes place in response to shocks. In addition to the point estimates, the 95% confidence bounds—which are generated by employing the nonparametric bootstrap method using 1000 replications—are also illustrated as dotted lines (Figure 2). The system-wide shock has affected all long-run relations significantly in the beginning, before the effects eventually disappear in the long run. The half-life is about 2 months, and the whole effect takes around 6 months to complete. The result seems to be consistent with the error correction process of the VECMX model.
Next, to analyze the effect of a shock to a variable on the expected future values of the endogenous variables, we employ the generalized IRFs, which measure the change to the
As shown in Figure 3, a unit shock (depreciation) of the real RM/yuan is followed by the response of an expansion in trade balance series. The impact lasted about a year and stabilized in the 13th month. When there is currency devaluation, we generally expect that the trade balance deteriorates at first, because the price change occurs quickly, while trade quantities (volume) change more slowly. After a moderate time period, the volume effect becomes large enough to offset the price effect and the trade balance improves to exhibit the so-called J-curve phenomenon. However, in Figure 3, a 1% depreciation of the Malaysian ringgit brings about a 6% gain in the trade balance almost immediately—in the first 2.5 months—which lowers to a 3% gain in the following months. In other words, depreciation of the RM/yuan resulted in an overall trade surplus for Malaysia against China, where the price effect failed to dominate the volume effect even in the early stage. Perhaps, this is the result of Chinese imports growing faster than exports (against ASEAN) in recent years. Though there is no clear pattern of a J-curve for Malaysia-China bilateral trade, the finding is consistent with the long-run estimation that the bilateral trade is sensitive to real exchange rate changes.
The generalized IRFs of the trade balance to a unit shock in output and producer prices are given in Figure 4. The result indicates the extent to which demand and supply channels affect the bilateral trade balances. The trade balance series depicts a V-shape adjustment to Malaysian output (industrial production) shocks. Domestic consumers may increase their demand for Chinese goods due to the income effect, resulting in temporal trade balance deterioration, but this effect gradually ends within a year. Response to foreign (China) output demonstrates a similar magnitude effect, though the impact lasts longer, about 15 months. This could be due to the substitution effect under which Chinese consumers shift their demand for Malaysian exports to other goods and services. Conversely, IRFs of trade balance responses to Malaysian and Chinese producer prices follow an increasing path. The impacts remain positive and stabilize within a year. The figure seems to indicate some early signs of trade expansion following the producer price shocks.
The effects of real exchange rate shock on output and producer prices are shown in Figure 5. The point estimates are bounded by the 95% bootstrapped confidence intervals using 1000 replications. Clearly, Malaysia shows a greater response to the foreign exchange rate shock, perhaps due to the greater openness of the Malaysian economy. However, a positive unit shock (depreciation) of real RM/yuan is contractionary for Malaysian output. An initial 1% depreciation of the Malaysian ringgit results in a 1.2% reduction in industrial production in the first 2 months. The impact stabilizes after 8 months at approximately 0.8% below its base value. Such a finding of the contractionary effect due to devaluation is along the lines of studies by Rajan and Shen , Ahmed et al. , and Bahmani-Oskooee and Miteza
Likewise, Chinese output responds negatively to the positive shock of RM/yuan (in which the yuan appreciates), but the impact is minor. The deterioration of production (about 0.2%) is observed in the second and third months and the impact stabilizes after 9 months at approximately 0.1% below its base value. Keep in mind that China practices an export-led growth policy based on maintenance of an undervalued yuan. The finding may partly justify China’s rigid policy of keeping the yuan from appreciating against world currencies in the past decade. On the other hand, the response(s) of producer prices to foreign exchange shocks are muted and are generally insignificant statistically. As for the Malaysian producer price shock, the impact could be slightly inflationary, but the scale is small. It is still inconclusive whether devaluation has inflationary or deflationary effects.
Subsequent analysis uses the variance decompositions (VDCs) in an attempt to gauge the extent of shocks to a variable that can be explained by other variables considered in the VARX model. Table 4 presents the generalized VDCs for our VARX model. VDCs can be considered as an out-sample causality test, which provides a quantitative measurement of how much the movement in one variable can be explained by other variables in the VAR system in terms of the percentage of forecast error variance. However, the results based on conventional orthogonalized VDCs are found to be sensitive to the number of lag lengths used and the ordering of the variables in the equation. The errors in any equation in a VAR are normally serially uncorrelated by construction, but there may be contemporaneous correlations across errors of different equations. To overcome this problem, the generalized VDCs of forecast error are applied .
|Horizon||% of variance explained by innovations in|
In Table 4, the Chinese variables (industrial production and producer price) seem to be the most exogenous variables among the six variables in the system. Most of the shocks are explained by their own innovations (87–97%) over the horizon of 24 months. Such a finding provides the methodological support for the VARX and VECMX modeling approach employed in this study. On the other hand, trade balance and real foreign exchange rates are found to be endogenous. In line with the long-run estimates, innovation from the real foreign exchange rate explains a substantial portion of the forecast error variance in the trade balance (about 20%). As for the foreign exchange rate, the major innovation comes from Chinese producer price. Yet, the Malaysian producer price is relatively exogenously determined, though it was included in the conditional model as an endogenous variable.
4. Conclusion and policy implications
The present study explores the dynamic relationship of trade balance, exchange rates, outputs (demand), and producer prices (supply) for Malaysia-China in the era of global crises, e.g. Asia financial crisis, subprime crisis. The empirical framework was constructed based on the VARX and VECMX modeling procedures. In addition, the application of persistent profile and IRFs shows how the core variables (
First of all, the Marshall-Lerner condition holds for Malaysia against China in the long run. The short-run J-curve pattern is not visible through the IRF analysis but noticeable in the error correction modeling. This would suggest a potential gain in Malaysian balance of payment if ringgit depreciated against the yuan. Theoretically, in a Keynesian economy with excess capacity, devaluation boosts net exports and, through the multiplier effect, fosters economic growth. Such demand channel, however, does not work well in the Malaysia-China case during and after the Asia financial crisis. Based on the generalized IRFs, a positive unit shock of real RM/yuan (in which RM depreciates) results in a contractionary effect for Malaysian output. If we refer to the generalized VDC analysis, the percentage variance of industrial production is not well explained by the innovations in variance of the real foreign exchange. Moreover, domestic and foreign incomes are only significant through lagged effects in the short-run model but not in the long-run model, suggesting that the demand side effects are temporal. In other words, devaluation for export gains is insufficient to sustain output expansion for Malaysia against China. It is worth noting that the success of currency depreciation in improving the trade balance largely depends on switching demand in the suitable direction and amount, as well as on the capacity of the home economy to fulfill the additional demand by supplying more goods. Since the trade expansion due to currency shock is temporal and the short-run adjustments are slow, productivity growth in real and tradable sectors is essentially vital to enhance the external competitiveness and hence economic growth.
From the supply side’s viewpoint, Malaysia is a typical semi-industrialized nation, where inputs for manufacturing are still largely imported and not produced domestically due to deficiency in economy of scale; for instance, the automobile, the chemical and allied industry production and textile manufacturing. Firms’ input cost may increase following currency devaluation. However, our analysis of IRFs has not shown clear inflationary or deflationary effect following the shock in real Malaysian ringgit. And, the lagged variables of the producer price were statistically insignificant in the error correction modeling of VECMX. Both the Malaysian and Chinese producer prices are also relatively exogenously determined, as indicated by the VDC analysis. At the outset, the results suggest that negative impact from the higher cost of imported inputs from China (due to ringgit depreciation) does not dominate the production stimulus from lower relative prices for domestically traded goods. In other words, China has yet to be Malaysia’s main source of imported inflation.
At the present stage, China has shown complementary features and been supportive of regional trading. In mid-August 2010, China began the trading of Malaysian ringgit against the yuan on its domestic foreign exchange market to promote bilateral trade between the two nations and to facilitate the use of the yuan to settle cross-border trade. Yet, the potential conflicting (competing) aspect of the trade relationship cannot be ignored. Manufacturing accounted for 92.4% of China’s merchandise exports in 2006, and the trend persists. Malaysia remains competitive in machinery, electronic equipment, and energy supply, but not competitive in clothing and textile manufacturing, food, agricultural and leather-related products, and transportation. Malaysia needs to upgrade its export structure and reduce low-end and labor-intensive manufacturing. Malaysia’s focus should be on high value-added production, design, and service sectors, before China overtakes it in these areas. Since both nations are now promoting the respective services sectors, further bilateral liberalization and strategic collaboration in services trading should be an important focus of Malaysia-China trade. These services may include education, medical tourism, transportation, and construction, as well as financial services. The two nations could experience economic gains in market structure and product diversification as well as economies of scale from regional trade integration. In addition, both nations have committed to bilateral trade integration, in addition to support for the multilateral framework within the ASEAN+6 regimes. Despite the strong competition in manufacturing exports, China recognizes Malaysia as an influential player within ASEAN and various ASEAN-driven collaboration platforms, such as the ASEAN Regional Forum and the East Asian Summit. The trade expansion is likely to accelerate with the formalization of a bilateral trade liberalization pact on track under the ASEAN-China Free Trade Agreement.
This research was supported by a research university grant from Universiti Sains Malaysia (grant no: 1001/PPAMC/816241). The usual disclaimer applies.
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- Available at http://english.mofcom.gov.cn/article/statistic/BriefStatistics/201401/20140100466521.shtml
- The fall of the renminbi implied a real exchange rate appreciation for the dollar-pegged currencies in East Asia, which their fragile financial systems were unable to absorb. Some of them were thrown into prolonged current account deficits and forced to devalue their currencies in order to regain their export market share, which eventually led to the Asia financial crisis in 1997.
- For example, Baharumshah  studied cases of Malaysia-US-Japan and Thailand-US-Japan for the period of 1980Q1–1996Q4; Ahmad and Yang  studied China against G7 during 1974–1994; Bahmani-Oskooee and Harvey [18, 19] studied Malaysia vis-à-vis 14 trading partners for 1983Q1–2002Q1 and 1973Q1–2001Q3, respectively; Bahmani-Oskooee and Wang  then studied China and 13 major trading partners during 1983–2002, but without Malaysia.
- To determine the potential endogenous break(s), we follow the structural break tests of Saikkonen and Lütkepohl .
- Results of unit root tests are not presented here but are available upon request.
- In this chapter, our priority is given to the trade balance model. Hence, only the error correction results for trade balance are presented and discussed. However, estimations for other endogenous variables when taken as independent variables (e.g., Yt, Qt, Pt) are available upon request from the corresponding author.