EXCHANGE RATE AND STOCK PRICE INTERACTION

IN MAJOR ASIAN MARKETS: EVIDENCE FOR

INDIVIDUAL COUNTRIES AND PANELS
ALLOWING FOR STRUCTURAL BREAKS
HOOI HOOI LEAN
*
,
, PARESH NARAYAN

and RUSSELL SMYTH

*
Economics Program, School of Social Sciences
Universiti Sains Malaysia, Malaysia
hooilean@usm.my

School of Accounting, Finance and Economics

Deakin University, Australia

Department of Economics
Monash University, Australia
This article examines the relationship between exchange rates and stock prices in eight Asian
countries. We test for cointegration and Granger causality for both individual countries using the
Gregory and Hansen cointegration test that accommodates a structural break in the cointegrating
vector, and for a panel using the Westerlund panel Lagrange multiplier (LM) cointegration test that
allows for multiple structural breaks in the level of the individual cointegrating equations. Our results
for individual countries suggest that the only country for which exchange rates and stock prices are
cointegrated over the entire period is Korea where there is a weak long-run unidirectional Granger
causality running from exchange rates to stock prices. Employing the panel LM cointegration test
with multiple structural breaks, we find that exchange rates and stock prices are not cointegrated. We
conclude that for the eight Asian countries, exchange rates and stock prices primarily have only a
contemporaneous effect on each other that is reflected in the short-run intertemporal comovements
between these financial variables.
Keywords: Exchange rates; stock prices; structural break; panel.
JEL Classification: F31, G15
1. Introduction
There are two competing perspectives on whether exchange rates Granger cause stock
prices or vice-versa. The traditional approach states that exchange rates Granger cause
stock prices. This approach postulates that changes in the exchange rate will affect the
competitiveness of a firm, which in turn will influence the firms earnings and net worth
and stock prices in general (see, e.g., Dornbursh and Fischer, 1980). The portfolio
approach states that stock prices Granger cause exchange rates. The portfolio perspective
suggests that rising (falling) stock prices influence capital flows from foreign investors who
substitute local (foreign) currency for foreign (local) currency (see, e.g., Frankel, 1993).

Corresponding author.
The Singapore Economic Review, Vol. 56, No. 2 (2011) 255277
World Scientific Publishing Company
DOI: 10.1142/S0217590811004250
255
Thus, a rise (fall) in stock prices will lead to an appreciation (depreciation) of the exchange
rate due to an increase in the demand (supply) of foreign currency.
There is a growing empirical literature that examines the interaction between exchange
rates and stock prices. There are studies for advanced market economies (see, e.g.,
Bahmani-Oskooee and Sohrabian, 1992; Ajayi and Mougoue, 1996; Nieh and Lee, 2001);
countries in Central and Eastern Europe (Bahmani-Oskooee and Domac, 1997; Grambo-
vas, 2003); countries in South Asia (see, e.g., Smyth and Nandha, 2003; Mishra, 2004;
Narayan and Smyth, 2005; Venkateshwarlu and Tiwari, 2005) and countries in North and
East Asia (see, e.g., Yu, 1996; Abdalla and Murinde, 1997; Ajayi et al., 1998; Granger
et al., 2000; Ibrahim, 2000; Wu, 2000; Hatemi-J and Roca, 2005; Ramasamy and Yeung,
2005).
Overall, the existing literature is inconclusive regarding the causal relationship between
exchange rates and stock prices. This is true for the subset of studies on this topic for
countries in Asia. For example, Abdalla and Murinde (1997) examined the relationship
between exchange rates and stock prices in Korea, Philippines, India and Pakistan using
monthly data over the period from January 1985 to July 1994. They found that there was a
long-run equilibrium relationship between exchange rates and stock prices in India and the
Philippines only and that exchange rates Granger caused stock prices in India, while stock
prices Granger caused exchange rates in the Philippines. Granger et al. (2000) examined
the relationship between exchange rates and stock prices for nine Asian countries during
the Asian financial crisis and found that exchange rates and stock prices were not coin-
tegrated in any of the countries. Ibrahim (2000) considered the relationship between
exchange rates and stock prices in Malaysia using monthly data from January 1979 to June
1996. He found that exchange rates and stock prices were not cointegrated when examined
in a bivariate context, but, in a multivariate setting, exchange rates, foreign reserves, stock
prices and the money supply were cointegrated and that the money supply and foreign
reserves Granger caused the exchange rate. Hatemi-J and Roca (2005) used bootstrap
causality tests with leveraged adjustments to examine the links between exchange rates and
stock prices in Malaysia, Indonesia, the Philippines and Thailand in the periods immediately
before and during the Asian financial crisis. They found that prior to the crisis, exchange
rates Granger caused stock prices in Indonesia and Thailand, while the reverse was true in
Malaysia, but during the crisis there was no significant link between the variables.
The purpose of this article is to provide further evidence on the relationship between
exchange rates and stock prices for eight emerging and developed Asian markets, namely,
Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore and Thailand,
over the period from 1991 to 2005. Standard and Poors (2004) classifies Hong Kong,
Japan and Singapore as developed markets and the others as emerging markets. One reason
for using a mixture of developed and emerging markets is that causality may be stronger in
countries with developed foreign exchange and stock markets. The main contribution of
the article is that in addition to using the Gregory and Hansen (1996) test and Granger
causality to examine the relationship between exchange rates and stock prices for indi-
vidual countries, for the first time in the literature on exchange rate stock price interaction
we examine the relationship between exchange rates and stock prices in a panel
256 The Singapore Economic Review
cointegration and Granger causality framework. Because of the possibility of structural
breaks, we use the panel Lagrange multiplier (LM) cointegration test proposed by
Westerlund (2006) that can accommodate multiple structural breaks in the level of the
individual cointegrating equations.
One possible reason for conflicting results for single country studies is that for many
countries, we have data with a maximum span of only 15 to 20 years and often less. The
problem is that the power of traditional unit root tests, such as the Augmented Dickey
Fuller (ADF) test and traditional cointegration tests, such as the Johansen (1988) test, can
be distorted when the span of data is short (see, e.g., Campbell and Perron, 1991). Some
studies use monthly or quarterly data to increase the number of observations, but this
makes little difference in this context because with standard cointegration tests what
matters is the time frame rather than number of observations (see, e.g., Perron, 1991).
Employing a panel-based cointegration and Granger causality approach has several
advantages, compared with focusing on a single country. First, using panel data provides
additional measurement precision by matching responses from one time period to another.
Second, panel data allows us to observe changes in individual behavior over time as well as
monitor behavior of cohorts over time. Third, panel data is generally more accurate than
cross-sectional data. Specifically, cross-sectional studies cannot address unobserved het-
erogeneity that often underpins large and persistent unexplained differences in exchange
rate and stock price movements across countries. A disadvantage of using panel data is that
the findings can be overgeneralized without sufficient regard to the heterogeneous nature of
the panel in terms of development and size.
The remainder of the article is set out as follows. In the next section, we provide an
overview of the exchange rate regimes and stock markets in each of the eight Asian
countries and describe the data used in the study. Following this, we begin by considering
the interaction between exchange rates and stock prices in a cointegration and Granger
causality framework for individual countries. We then proceed to examine the interaction
between stock prices and exchange rates for the eight Asian countries in a panel coin-
tegration and Granger causality framework. Foreshadowing our main findings, we find that
exchange rates and stock prices primarily have only a contemporaneous effect on each
other, reflected in the short-run interaction effects between these financial variables.
2. Overview of the Markets
We use weekly stock market indices and nominal exchange rates in terms of local currency
relative to the US dollar for Hong Kong, Indonesia, Japan, Korea, Malaysia, the Phi-
lippines, Singapore and Thailand.
1
Weekly data are used to avoid representation bias from
some thinly traded stocks. Using local currency per US dollar is important to avoid
rounding-up errors, which is particularly pertinent for countries with large denominations
1
Annual data on the Real exchange rate (from the World Bank, WDI) and the stock price index is only available for four of
the countries in the sample (Japan, Malaysia, the Philippines and Singapore) and only for 19912005 (15 observations). This
sample is not long enough to test for unit roots, cointegration and Granger causality for the individual countries or do the
panel test, allowing for structural breaks.
Exchange Rate and Stock Price Interaction in Major Asian Markets 257
such as Indonesia and Korea (Ramasamy and Yeung, 2005). The sample is from January 1,
1991 to June 30, 2005, which means that there are 757 observations in total. All data are
extracted from DataStream and transformed into logarithmic scale prior to analysis.
Table 1 provides some key indicators of the stock markets in these countries. Japan,
Hong Kong and Korea have the three largest stock markets of the countries based on
market capitalization, value traded and the number of listed companies. Malaysia,
Singapore and Thailand sit behind these three in terms of size with the stock markets in
Indonesia and the Philippines being much smaller according to all indicators. Table 2
shows the exchange rate classification for each of the countries over the timeframe of the
study. Singapore, Korea, Indonesia, Japan and the Philippines had a floating or managed-
floating exchange rate over the entire period. The Hong Kong dollar was pegged to the US
dollar. The Thai Baht was fixed to a basket of currencies until the Asian financial crisis and
has been subject to a managed float since July 1997. The Malaysian ringgit was subject to
a managed float until the Asian financial crisis and has been pegged to the US dollar since
September 1998.
3. Cointegration and Granger Causality for Individual Countries
3.1. Methodology
3.1.1. Univariate LM unit root test
We begin through examining the stationary properties of the exchange rates and stock
price series. Most existing studies of the relationship between exchange rates and stock
prices use the ADF or PhillipsPerron unit root tests to ascertain the order of integration of
the series. A problem with these tests is that neither allows for the possibility of a structural
break. Perron (1989) showed that the power to reject a unit root decreases when the
stationary alternative is true and a structural break is ignored. Perron (1989) developed
an ADF-type unit root test with one exogenous structural break and Zivot and
Andrews (1992) developed an ADF-type unit root test with one endogenous structural
break. Granger et al. (2000) and Hatemi-J and Roca (2005), which are two studies that
examine the relationship between exchange rates and stock prices that use a unit root test
with a structural break, employ the Zivot and Andrews (1992) and Perron (1989) unit root
tests, respectively. However, both of these tests have the limitation that the critical values
are derived while assuming that there is no break under the null. Nunes et al. (1997)
showed that this assumption leads to size distortions in the presence of a unit root with
a break. As a result, utilizing ADF-type tests one might conclude that a time series is
trend stationary, when in fact it is nonstationary with a break, meaning that spurious
rejections might occur. To examine the stationarity properties of the data for individual
countries, we employ the LM unit root test with one structural break proposed by Lee and
Strazicich (2004). In contrast to the Perron (1989) and Zivot and Andrews (1992) ADF-
type unit root tests, the LM unit root test has the major advantage that its properties are
unaffected by the existence of a structural break under the null (see Lee and Strazicich,
2001, 2004).
258 The Singapore Economic Review
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Exchange Rate and Stock Price Interaction in Major Asian Markets 259
The LM unit root test can be explained using the following data generating process
(DGP):y
t

0
Z
t
e
t
, e
t
e
t1

t
. Here, Z
t
consists of exogenous variables and
t
is an
error term with classical properties. Lee and Strazicich (2004) developed two versions of
the LM unit root test with one structural break. Using the nomenclature of Perron (1989),
Model A is known as the crash model, and allows for a one-time change in the intercept
under the alternative hypothesis. Model A can be described by Z
t
1, t, D
t

0
, where
D
t
1 for t T
B
1, and zero otherwise; T
B
is the date of the structural break, and

0

1
,
2
,
3
. Model C, the crash-cum-growth model, allows for a shift in the inter-
cept and a change in the trend slope under the alternative hypothesis and can be described
by Z
t
1, t, D
t
, DT
t

0
, where DT
t
t T
B
for t T
B
1, and zero otherwise.
The LM unit root test statistic is obtained from the following regression:
y
t

0
Z
t
c

S
t1
j
t
,
where

S
t
y
t

^

x
Z
t
^

t
, t 2,, T;
^
are coefficients in the regression of y
t
on Z
t
;
^

x
is given by y
t
Z
t
; and y
1
and Z
1
represent the first observations of y
t
and Z
t
,
respectively. The LM test statistic, ~ t , is given by t-statistic for testing the unit root null
hypothesis that c 0. The location of the structural break T
B
is determined by selecting
all possible break points for the minimum t-statistic as follows:
inf ~ t

i
inf

~ t , where T
B
,T.
The search is carried out over the trimming region (0.15T, 0.85T), where T is sample
size. To select the lag length, we used the general to specific procedure proposed by
Hall (1994). We set the maximum number of lags equal to eight and used the 10%
asymptotic normal value of 1.645 to ascertain the statistical significance of the last first-
differenced lagged term. After deciding the optimal lag length for each breakpoint, we
determined the break where the endogenous LM t-test statistic is at a minimum. Critical
Table 2. Exchange Rate Classification of Countries in the
Sample
Country Currency Exchange Regime Classification
Thailand Baht FB until 07/97 then MF
Singapore Dollar MF
The Philippines Peso F
Malaysia Ringgit MF until 09/98 then FU
Korea Won MF until 12/97 then F
Indonesia Rupiah MF until 08/97, F until 2000 then MF
Hong Kong Dollar FU
Japan Yen MF
Notes: F is freely floating; MF is a managed float; FB is fixed to a
basket, FU is pegged to the $US. Sources: IMF http://www.imf.org/
external/np/mfd/er/index.asp and the Chinese University of Hong
Kong, http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?
cid=8.
260 The Singapore Economic Review
values for the LM unit root test with one structural break are tabulated in Lee and
Strazicich (2004).
3.1.2. Cointegration
Once the order of integration of each variable is ascertained, we test for cointegration.
S
t
E
t
u
t
, 1
where S
t
and E
t
denote the natural log of stock index and exchange rate and u
t
is the error
term. Gregory and Hansen (1996) propose three models for testing cointegration where
they allow for the existence of a structural break in the cointegrating vector.
The first model contains a level shift (Model C):
S
t

1

2
D
t
t
E
t
u
t
, t 1,, n. 2
The second model contains a level shift and trend (Model C/T):
S
t

1

2
D
t
t

0
t
t
1
E
t
u
t
, t 1,, n. 3
Here D
t
t
0, for t < t and D
t
t
1 for t t. The intercept before the level shift is denoted
as
1
, while
2
is the change in intercept due to the level shift.
The third model allows for a regime shift (Model C/S):
S
t

1

2
D
t
t

0
t
t
1
E
t

t
2
E
t
D
t
t
u
t
, t 1,, n. 4
Here,
1
and
2
are as in Equations (2) and (4).
t
1
denotes the cointegrating slope
coefficient before the regime shift and
t
2
denotes the change in the slope coefficient. In
order to test for cointegration between S
t
and E
t
with structural change, i.e., the stationarity
of u
t
in Equations (2)(4), Gregory and Hansen (1996) propose a suite of tests. These
statistics are the commonly used ADF statistics and extensions of the Z

and Z
t
test
statistics proposed by Phillips (1987). These statistics are defined as:
ADF
*
inf
t2T
ADFt
Z
*

inf
t2T
Z

t
Z
*
t
inf
t2T
Z
t
t
As the break point, t, is unknown a priori, the model is estimated recursively allowing the
break point to vary between (0.15T, 0.85T), where T is the sample size. The null hypothesis
of no cointegration is examined using the three statistics with interest in the smallest values
for the three statistics across all break points required to reject the null.
3.1.3. Granger causality
Once it is established whether or not there is a long-run relationship between the series, we
test whether there is Granger causality between exchange rates and stock prices. If
exchange rate and stock price are cointegrated, an error correction term should be included
Exchange Rate and Stock Price Interaction in Major Asian Markets 261
in the bivariate autoregression model as follows (Granger, 1988):
rS
t

0

X
n
i1

1i
rS
ti

X
m
i1

2i
rE
ti

1
ECT
t1

1t
, 5
rE
t

0

X
m
i1

1i
rS
ti

X
n
i1

2i
rE
ti

2
ECT
t1

2t
. 6
Here rE
t
is changes in the exchange rate and rS
t
is changes in the stock price. ECT
t1
,
which is S
t1
E
t1
, is an error correction term derived from the long run cointegrating
relationship in Equation (1). The error correction term can be estimated by using the
residual from a cointegrating regression. The estimated
1
and
2
denote the speed of
adjustment. If cointegration does not exist, the error correction term is dropped from the
bivariate autoregression model. The decision rule is reject (accept) H
0
:
21

22

2m
0, meaning exchange rates do (do not) Granger cause stock prices, and reject
(accept) H
0
:
11

12

1m
0, meaning stock prices do (do not) Granger cause
exchange rates. The lag structure is determined with the minimum final prediction error
criterion.
3.2. Results and discussion
The results for the LM unit root test with one structural break are presented in Tables 3
and 4. In both Model A and Model C, the exchange rate and stock price index in each of
the countries is integrated of order one (I(1)) at the 5% level or better. We briefly discuss
the location of the breakpoints. In Model A, the break in the intercept is statistically
significant at the 5% level or better for both the exchange rate and stock index for each of
the eight countries. In Model C, except for stock prices in Indonesia and Korea, the break
in the intercept and/or slope is statistically significant at the 5% level or better in each case.
With the exception of stock prices in Hong Kong and Japan in Model A and stock prices in
Indonesia and exchange rates in Japan and Hong Kong in Model C, the structural break is
associated with the Asian financial crisis. The structural break in stock prices in Hong
Kong and Japan in Model A occurs at the time of the September 11, 2001 terrorist attacks
in New York and Washington. The structural break in exchange rates for Hong Kong in
Model C occurs a few months prior to the collapse of the internet bubble. The structural
break in Indonesian stock prices is nestled between the Enron and WorldCom collapses as
well as the September 11, 2001 and Bali bombing terrorist attacks.
Given that exchange rates and stock prices are I(1) for each of the countries, we proceed
to test for cointegration with a structural break in the cointegration vector using the
Gregory and Hansen (1996) test. The results are presented in Table 5. There are a range of
break points across the test statistics and models. We begin by discussing the location of
the structural break. In general, the break occurs in either 1993/1994 when there was a bout
of investor profit taking from these markets despite generally positive economic conditions
and strong corporate earnings growth throughout the region; during the Asian financial
crisis or in the period between 2000 and 2002, which was a period of global economic
downturn precipitated by a slowdown in the US economy. This period contained a number
262 The Singapore Economic Review
of events that drove stock prices lower including revelation of fraudulent practices at Enron
and WorldCom, the end of the internet bubble and terrorism and wars.
Turning to the findings for cointegration, for Hong Kong, Indonesia, Japan, Singapore
and Thailand, the null hypothesis of no cointegration between exchange rates and stock
prices is not rejected with any of the test statistics for any of the three models (C, C/T and
C/S). For Korea and Malaysia the null hypothesis of no cointegration between exchange
Table 3. LM Unit Root Test, Model A
TB k S
t1
B
t
Hong Kong 9/5/2001 4 0.0071 0.1394
***
Stock Index (1.6883) (4.1187)
Hong Kong 10/15/1997 5 0.0093 0.0014
**
Exchange Rate (1.5906) (2.1133)
Indonesia 11/5/1997 4 0.0131 0.0815
**
Stock Index (2.7313) (2.3903)
Indonesia 12/31/1997 6 0.0151 0.6095
***
Exchange Rate (2.4151) (15.2351)
Japan 9/5/2001 0 0.0201 0.1025
***
Stock Index (2.7734) (3.4530)
Japan 3/25/1998 2 0.0101 0.0387
***
Exchange Rate (2.0706) (2.6384)
Korea 12/17/1997 7 0.0183 0.1776
***
Stock Index (2.9282) (4.2098)
Korea 12/3/1997 8 0.0148 0.2735
***
Exchange Rate (2.7565) (18.2783)
Malaysia 12/10/1997 8 0.0115 0.1143
***
Stock Index (2.4497) (3.0960)
Malaysia 12/31/1997 8 0.0087 0.1254
***
Exchange Rate (2.0188) (11.2545)
The Philippines 12/2/1998 8 0.0032 0.0882
**
Stock Index (1.2439) (2.3819)
The Philippines 12/10/1997 8 0.0068 0.1388
***
Exchange Rate (1.6185) (10.5677)
Singapore 8/26/1998 8 0.0094 0.0941
***
Stock Index (2.1430) (3.2258)
Singapore 6/3/1998 2 0.0049 0.0388
***
Exchange Rate (1.4670) (5.5894)
Thailand 7/22/1998 3 0.0038 0.0929
**
Stock Index (1.3735) (2.2774)
Thailand 2/11/1998 4 0.0087 0.0717
***
Exchange Rate (2.2671) (4.7404)
Notes: Critical values for the LM test at 10%, 5% and 1% sig-
nificant levels 3.211, 3.566, 4.239; critical values for
other coefficients based on standard t distribution 1.645, 1.96,
2.576;
*
,
**
and
***
denote statistical significance at the 10%, 5%
and 1% levels, respectively.
Exchange Rate and Stock Price Interaction in Major Asian Markets 263
rates and stock prices is rejected with the ADF
*
statistic using Model C/T at the 5% and
10% levels, respectively. For the Philippines, the null hypothesis of no cointegration
between exchange rates and stock prices is rejected with the ADF
*
statistic for all three
models at the 5% level and with the Z
*
t
statistic with Models C and C/T at the 10% level.
Table 4. LM Unit Root Test, Model C
TB K S
t1
B
t
D
t
Hong Kong 11/26/1997 7 0.022 0.0697
**
0.0113
***
Stock Index (3.0240) (2.0020) (2.9604)
Hong Kong 1/5/2000 5 0.0515 0.0002 0.0004
***
Exchange Rate (3.8332) (0.2619) (3.5324)
Indonesia 6/19/2002 4 0.0181 0.0655
*
0.0028
Stock Index (3.2664) (1.9255) (0.8926)
Indonesia 12/10/1997 7 0.0278 0.2496
***
0.0120
**
Exchange Rate (3.3658) (5.9187) (2.4183)
Japan 12/13/2000 0 0.0252 0.0812
***
0.0037
Stock Index (3.1060) (2.7338) (1.4012)
Japan 9/6/1995 2 0.0194 0.0363
**
0.0034
**
Exchange Rate (2.8549) (2.4817) (2.5662)
Korea 8/27/1997 5 0.0236 0.0573 0.0062
*
Stock Index (3.3290) (1.3763) (1.6849)
Korea 11/5/1997 6 0.0311
*
0.0164 0.0063
***
Exchange Rate (4.2912) (0.9969) (3.1000)
Malaysia 10/8/1997 8 0.0270 0.0426 0.0131
***
Stock Index (3.7040) (1.1801) (3.1281)
Malaysia 10/15/1997 8 0.0255 0.0744
***
0.0044
***
Exchange Rate (3.2360) (5.7949) (2.6993)
The Philippines 6/25/1997 8 0.0214 0.0165 0.0215
***
Stock Index (3.1550) (0.4507) (3.5362)
The Philippines 9/10/1997 7 0.0301 0.0235
*
0.0077
***
Exchange Rate (3.4372) (1.7046) (3.4616)
Singapore 8/6/1997 8 0.0212 0.0347 0.0086
***
Stock Index (3.1696) (1.1908) (2.7546)
Singapore 8/6/1997 2 0.0174 0.0215
***
0.0028
***
Exchange Rate (2.7215) (3.0600) (3.1349)
Thailand 7/16/1997 3 0.0136 0.0681
*
0.0126
**
Stock Index (2.6187) (1.6586) (2.2501)
Thailand 8/13/1997 6 0.0222 0.0247
*
0.0047
***
Exchange Rate (3.4091) (1.7614) (2.7111)
Critical values
Location of break, 0.1 0.2 0.3 0.4 0.5
1% significance level 5.11 5.07 5.15 5.05 5.11
5% significance level 4.50 4.47 4.45 4.50 4.51
10% significance level 4.21 4.20 4.18 4.18 4.17
Notes: The critical values are symmetric around and 1 ;
*
,
**
and
***
denote statistical
significance at the 10%, 5% and 1% levels, respectively.
264 The Singapore Economic Review
Thus, a clear finding for Hong Kong, Indonesia, Japan, Singapore and Thailand is that
exchange rates and stock prices hold no long-run equilibrium relationship, meaning they
do not move together and may drift apart in the long-run. The results for Korea, Malaysia
and the Philippines are inconclusive, but we proceed to conducting the Granger causality
testing on the basis that there is a long-run equilibrium relationship between exchange rates
and stock prices in Korea, Malaysia and the Philippines.
2
Table 6 shows the results for Granger causality between stock prices and exchange rates
over the whole time period. The F-test indicates the significance of the short-run causal
effects. For Indonesia, Korea and Thailand there is short-run bidirectional Granger caus-
ality between exchange rates and stock prices. For Hong Kong, Malaysia and Singapore
Table 5. Gregory and Hansen (1996) Test for Cointegration with a Structural Break
Country Model ADF
*
k TB
Z
*
t
TB
Z
*

TB
Hong Kong C 3.9649 3 06/16/93 3.6605 06/09/93 23.50 06/09/93
C/T 4.0918 2 11/14/01 3.8197 09/26/01 28.24 09/26/01
C/S 4.2964 2 07/07/93 4.4660 07/19/95 39.02 07/19/95
Indonesia C 2.7780 4 01/29/03 2.1248 03/05/03 10.17 03/05/03
C/T 4.6871 6 12/20/00 3.7377 06/21/00 26.77 06/21/00
C/S 3.4392 3 02/19/03 2.9652 03/05/03 17.54 03/05/03
Japan C 4.0416 3 04/04/01 3.7856 03/14/01 26.88 03/14/01
C/T 3.9460 3 04/04/01 3.6968 03/14/01 28.30 02/14/96
C/S 4.1375 7 05/02/01 3.8666 03/14/01 28.09 03/14/01
Korea C 4.2127 7 12/30/98 3.2467 01/20/99 20.67 01/20/99
C/T 5.0100
**
7 09/25/02 3.4587 04/28/93 23.51 04/28/93
C/S 4.5935 7 10/01/97 3.3086 01/20/99 21.22 01/20/99
Malaysia C 3.9179 6 02/16/94 3.4324 10/08/97 23.35 09/08/93
C/T 4.7449
*
7 07/21/93 3.9223 09/08/93 30.08 09/08/93
C/S 3.9417 6 02/16/94 3.4719 11/12/97 23.06 09/08/93
The Philippines C 4.8352
**
3 05/26/93 4.4506
*
08/11/93 34.82 08/11/93
C/T 5.2978
**
3 05/26/93 4.7301
*
08/11/93 39.78 08/11/93
C/S 4.9671
**
3 05/26/93 4.5205 08/11/93 37.47 06/09/93
Singapore C 4.0738 0 02/03/99 4.1580 01/27/99 33.49 01/27/99
C/T 4.2186 0 02/03/99 4.3115 01/27/99 35.96 01/27/99
C/S 4.1959 8 01/27/99 4.2424 01/27/99 34.69 01/27/99
Thailand C 4.0441 2 04/23/03 3.7952 04/23/03 25.75 04/23/03
C/T 4.5345 2 10/23/96 4.2376 08/07/96 34.53 08/07/96
C/S 4.1395 2 06/26/02 3.8229 06/26/02 28.25 07/02/97
Note:
*
,
**
and
***
denotes statistical significance at the 10%, 5%, and 1% levels.
2
Given that the results of the Gregory and Hansen (1996) test were not conclusive across all three test statistics and models
we also conducted the Granger causality tests for Korea, Malaysia and the Philippines without the ECT. The con-
temporaneous results for exchange rates and stock prices for these three countries, which are available on request, are
quantitatively the same as those reported.
Exchange Rate and Stock Price Interaction in Major Asian Markets 265
there is a short-run unidirectional Granger causality running from exchange rates to stock
prices. In the Philippines, there is a short-run unidirectional Granger causality running from
stock prices to exchange rates and in Japan there is neutrality between the exchange rates
and stock prices. For Korea, Malaysia and the Philippines the t-statistic for coefficient on
the lagged error correction term indicates the significance of the long-run causal effects. If
exchange rates and stock prices are cointegrated, there must be Granger causality in at least
one direction, but it does not indicate the direction of temporal causality between the
variables (Granger, 1988). For Malaysia and the Philippines, the t-statistic on the long-run
disequilibrium terms are statistically insignificant, suggesting there is no long-run
co-movement between exchange rates and stock prices in these countries. This finding
reflects the inconclusive results from the cointegration tests. For Malaysia, this result could
reflect the fact that the implementation of capital controls in September 1998 has
segmented the exchange rate and stock markets (see Kaplan and Rodrik, 2001). However,
we actually find that there is long-run bidirectional Granger causality between stock
prices and exchange rates in Malaysia after the financial crisis, as discussed below.
In Korea, in the long run there is a weak causal effect with unidirectional Granger
causality running from exchange rates to stock prices at the 10% level, consistent with the
traditional view.
Table 6. Granger Causality of Stock Indices and Exchange Rates
(Full Sample Period)
Country Granger Cause n M F-statistic
a
t-statistic
b
Hong Kong E!S 4 3 2.48
*
n.a.
S !E 5 1 0.05 n.a.
Indonesia E!S 3 2 8.77
***
n.a.
S !E 6 5 4.04
***
n.a.
Japan E!S 1 1 0.60 n.a.
S !E 3 1 0.79 n.a.
Korea E!S 3 6 3.13
***
1.71
*
S !E 5 1 20.64
***
0.54
Malaysia E!S 5 2 4.15
**
0.52
S !E 3 1 0.66 0.99
The Philippines E!S 5 1 0.05 0.77
S !E 5 6 2.43
**
0.36
Singapore E!S 5 5 5.60
***
n.a.
S !E 3 1 0.00 n.a.
Thailand E!S 4 5 2.66
**
n.a.
S !E 4 3 5.24
***
n.a.
Notes: n and m are the optimal lag lengths; ! implies Granger cause,
e.g., E!S implies exchange rate Granger causes stock index;
a
F-statistic for testing H
0
:
21

22

2m
0 or H
0
:
11

12

1m
0;
b
t-statistic for testing H
0
:
1
0 or H
0
:
2
0
in ECM model;
*
,
**
and
***
denotes statistical significance at the 10%,
5% and 1% levels respectively.
266 The Singapore Economic Review
We also divided the entire sample period into two subsample periods based on the break
point with the Z
*
t
test using Model C/S, which Gregory and Hansen (1996) argue estimates
the break point most accurately with the smallest standard deviation. Subperiod 1 is from
January 1, 1991 until the break point date, while subperiod 2 is the period from the break
point date until June 30, 2005. The Granger causality results for the two subperiods are
presented in Tables 7 and 8.
3
In subperiod 1, in the short-run, exchange rates and stock
prices are independent in Hong Kong, Japan and the Philippines and there is bidirectional
Granger causality in Indonesia, Korea, Malaysia, Singapore and Thailand. In subperiod 2,
in the short-run, there is bidirectional Granger causality between exchange rates and stock
prices in Hong Kong, Malaysia, Singapore and Thailand and unidirectional Granger
causality running from stock prices to exchange rates in Indonesia, Japan, Korea and the
Philippines. In subperiod 1, the t-statistic on the error-correction term for Korea, Malaysia
and the Philippines is statistically insignificant, indicating there is no long-run equilibrium
relationship, although in subperiod 2 there is long-run bidirectional Granger causality
between stock prices and exchange rates in Korea and Malaysia. The break dates between
subperiods 1 and 2 in these cases occur around the time of the Asian financial crisis,
Table 7. Granger Causality of Stock Indices and Exchange Rates
(Sub-Sample Period 1)
Country Granger Cause n m F-statistic
a
t-statistic
b
Hong Kong E!S 1 1 0.45 n.a.
S !E 5 1 0.02 n.a.
Indonesia E!S 3 2 9.39
***
n.a.
S !E 6 5 3.59
***
n.a.
Japan E!S 1 1 0.27 n.a.
S !E 3 1 0.02 n.a.
Korea E!S 3 6 3.57
***
0.98
S !E 5 5 4.47
***
0.50
Malaysia E!S 1 5 7.32
***
0.49
S !E 6 6 4.85
***
0.89
The Philippines E!S 5 1 0.01 0.83
S !E 1 1 1.56 1.54
Singapore E!S 5 5 6.96
***
n.a.
S !E 4 6 2.35
**
n.a.
Thailand E!S 4 3 3.28
**
n.a.
S !E 2 3 4.11
***
n.a.
Notes: See notes to Table 6.
3
After dividing the sample into two sub-sample periods we first examined the order of integration for each series using the
LM unit root test with one structural break for both subperiods and found all variables to be I(1). We then tested for
cointegration for each country in each subperiod using the Johansen (1988) and Gregory and Hansen (1996) cointegration
tests and found ambiguous evidence that exchange rates and stock prices were cointegrated in both sub-sample periods for
Korea, Malaysia and Philippines. Thus, we included an error correction term in Equations (5) and (6) for both sub-sample
periods for these three countries.
Exchange Rate and Stock Price Interaction in Major Asian Markets 267
suggesting that the exchange rate and stock market in these two countries became more
integrated as a result of financial restructuring in the fallout of the crisis.
This result is not surprising for Korea, which followed a conventional approach after the
Asian financial crisis. A common view is that financial markets became more integrated in
Korea after the crisis (see, e.g., de Brouwer, 1999). However, this result is more con-
troversial for Malaysia, which implemented capital controls to address the crisis. On the
face of it, capital controls should have led to less integration. The extent to which capital
controls were effective in segmenting Malaysian financial markets from international
capital markets is debatable (see, in general Kaplan and Rodrik, 2001). On the one hand,
the increased sophistication of financial markets and, in particular, the spread of derivatives
has heightened scepticism about a governments ability to restrict particular types of
Balance of Payments flows (Garber, 1998). On the other hand, there is evidence that the
Malaysian capital controls were effective in choking-off speculative activity against the
ringgit and reducing the co-movement of Malaysian overnight interest rates and regional
interest rates (see, e.g., Edison and Reinhart, 1999). Kaplan and Rodrik (2001) find that
compared with IMF sponsored programs, Malaysian policies produced faster economic
recovery and more rapid turnaround in the stock market.
Overall, we find little evidence of a long-run significant causal relationship between
exchange rates and stock prices in the eight Asian countries. Instead, we find that changes
in exchange rates and stock prices generally only have a contemporaneous effect on each
other reflected in short-run intertemporal co-movements between these financial variables.
This result is generally consistent with previous multicountry studies for Asian countries
Table 8. Granger Causality of Stock Indices and Exchange Rates
(Sub-Sample Period 2)
Country Granger Cause n m F-statistic
a
t-statistic
b
Hong Kong E!S 4 3 2.66
**
n.a.
S !E 1 2 3.52
**
n.a.
Indonesia E!S 1 2 2.09 n.a.
S !E 1 1 5.84
**
n.a.
Japan E!S 2 1 0.18 n.a.
S !E 1 6 2.22
**
n.a.
Korea E!S 1 1 0.25 1.93
*
S !E 1 1 5.06
**
1.89
*
Malaysia E!S 5 6 8.16
***
1.99
**
S !E 6 4 5.23
***
3.31
***
The Philippines E!S 4 4 1.58 0.93
S !E 5 6 2.85
***
0.35
Singapore E!S 1 6 1.93
*
n.a.
S !E 3 1 4.21
**
n.a.
Thailand E!S 1 4 2.84
**
n.a.
S !E 1 1 3.23
*
n.a.
Notes: See notes to Table 6.
268 The Singapore Economic Review
such as Abdalla and Murinde (1997), Granger et al. (2000), Smyth and Nandha (2003)
and Narayan and Smyth (2005) and studies such as Bahmani-Oskooee and Sohrabian
(1992) and Nieh and Lee (2001) who reach similar conclusions for the G7 countries. Our
results are also generally consistent with the finding of Hatemi-J and Roca (2005) that
during the Asian financial crisis there was no significant link between the variables.
Over the entire period, except for Korea, exchange rates and stock prices were not
significantly related in the long run. This result could mean that the transmission of
information between these markets was efficient or that the markets were segmented except
for short-run contemporaneous co-movements in the markets other than Japan. Figure 1
plots the behavior of exchange rates and stock prices in each country. Apart from Korea,
the two variables appear to be diverging, rather than converging, giving credence to the
notion that the markets were segmented. This finding indicates that it would only be
possible to use the foreign exchange market as a hedge for investments in the stock market
and vice-versa in the short-run except for Korea. The result also suggests that except for the
short-run, for countries other than Korea, the stock market could not be used as a policy
base for intervention to stabilize the foreign exchange market and vice-versa. The only
country for which there is a long-run equilibrium relationship is Korea, where the
relationship between exchange rates and stock prices is consistent with the traditional view.
This finding suggests that in Korea, stock prices could be used to hedge foreign exchange
investment and that intervention in the exchange rate could be used to stabilize stock
prices.
4. Panel Cointegration and Granger Causality
4.1. Methodology
4.1.1. Panel LM stationarity test
We first implemented the panel stationarity test suggested by Hadri (2000), which is an
extension of the Kwiatowski et al. (1992) test. The Hadri (2000) test is based on the
residuals from the individual ordinary least squares (OLS) regressions:
y
it
:
i

i
t j
it
. 7
Given the residuals ^ j from the individual regressions, the LM statistic is:
LM
1

1
N
X
N
i1
X
t
SR
i
t
2
,
T
2
,

f
0
!
, 8
where SR
it
are the cumulative sum of the residuals,
SR
i
t
X
t
s1
^ j
it
. 9
Exchange Rate and Stock Price Interaction in Major Asian Markets 269
Hong Kong
0
2
4
6
8
10
12
s
t
o
c
k
i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
Indonesia
0
2
4
6
8
10
12
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
Japan
0
2
4
6
8
10
12
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
Korea
0
1
2
3
4
5
6
7
8
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
Figure 1. Movements in Exchange Rates and Stock Prices, 19912005
270 The Singapore Economic Review
Malaysia
0
1
2
3
4
5
6
7
8
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
s
t
o
c
k

i
n
d
e
x
,

e
x
c
h
a
n
g
e

r
a
t
e
The Philippines
0
1
2
3
4
5
6
7
8
9
Singapore
0
1
2
3
4
5
6
7
8
9
Thailand
0
1
2
3
4
5
6
7
8
Figure 1. (Continued)
Exchange Rate and Stock Price Interaction in Major Asian Markets 271
The notation

f
0
is the average of the individual estimators of the residual spectrum at
frequency zero:

f
0

X
N
i1
f
i0
,
N. 10
Hadri (2000) shows that under mild assumptions,
Z

N
p
LM

! N0, 1. 11
4.1.2. Panel LM cointegration test
We employ the panel LM cointegration test with multiple structural breaks proposed by
Westerlund (2006). Consider the following stock price-exchange rate long-run model:
S
it

ij

i
E
it
e
it
,
e
it
r
it
j
it
, 12
r
it
r
it1
c
i
j
it
,
The index j 1,, M
i
1 denotes structural breaks. One can allow for at most M
i
breaks
or M
i
1 regimes, that are located at dates T
i1
,, T
iM
i
, where T
i0
1 and T
iM
i
1
T. The
location of the structural breaks are specified as a fixed fraction
ij
2 0, 1 of T such that
T
ij

ij
T and
ij1
<
ij
for j 1,, M
i
. Westerlund (2006) determines the structural
breaks endogenously from the data using the Bai and Perron (1998) technique, which
globally minimizes the sum of squared residuals to obtain the location of breaks:
^
T
i
arg min
T
i
X
M
i
1
j1
X
T
ij
tT
ij1
1
y
it
z
0
it
^
ij
x
0
it
^

2
, 13
where
^
T
i

^
T
i1
,,
^
T
iMi

0
is a vector of estimate break points, ^
ij
and
^

i
are the estimates
of the cointegration parameters based on the partition T
i
T
i1
,, T
iMi

0
and t is the
trimming parameter such that
ij

ij1
t. We consider Case 2 in Westerlund (2006)
which is a cointegrated regression with an individual specific intercept as the deterministic
component. The null hypothesis for all countries of the panel is
H
0
: c
i
0 for all i 1,, N,
versus
H
1
: c
i
6 0 for i 1,, N
1
and c
i
0 for i N
1
1,, N.
The alternative hypothesis allows c
i
to differ across the cross-sectional units.
The panel LM test statistic is defined as follows:
ZM
X
N
i1
X
M
i
1
j1
X
T
ij
tT
ij1
1
T
ij
T
ij1

2
^
2
i1.2
S
2
it
,
272 The Singapore Economic Review
where ^
2
i1.2
^
0
i1.1
^
0
i21
^

1
i22
^
i21
and S
it

P
t
kT
ij1
1
^ e
*
ik
, where ^ e
*
it
is any efficient
estimate of e
it
. We use the fully modified ordinary least squares estimator (FMOLS)
suggested by Phillips and Hansen (1990) to estimate e
it
. The test statistic is written as a
function of breaks to denote that it is constructed for a certain number of breaks.
4.1.3. Panel granger causality
Once it is established whether exchange rates and stock prices are cointegrated, we
examine the direction of causality between exchange rates and stock prices within a panel
data framework. The panel Granger causality test regression models are as follows:
rS
it

i

X
n
j1

ij
rS
itj

X
m
j1

ij
rE
itj

i
ECT
it1

it
, 14
rE
it

i

X
m
j1

ij
rS
iti

X
n
j1

ij
rE
iti

i
ECT
it1

it
. 15
All variables are as defined above. If exchange rates and stock price are found not to be
cointegrated using the panel cointegration test, the error correction terms will be omitted.
4.2. Results and discussion
The results of the Hadri (2000) panel LM stationarity test are reported in Table 9. The
panel LM stationarity test statistic for stock prices in the panel of eight countries is
22.4011, while the panel LM stationarity test statistic for the panel of eight countries for
exchange rates is 50.7661, which are both significant at 1%. Thus, the joint null hypothesis
of stationarity for both series is rejected, implying that both series are panel nonstationary.
The results of the panel LM cointegration test are reported in Table 10. The panel LM
cointegration test indicates that there are five structural breaks. The first structural break
occured in either January or November 1993, the second structural break occured in
January 1996, the third structural break occured in March or April 1998, the fourth
structural break occured in May 2000 and the fifth structural break occured in July 2002.
These dates correspond broadly with the breaks identified in the Gregory and Hansen
(1996) test for individual countries and are associated with investor profit taking in 1993/
1994, the Asian financial crisis in 1998 and global economic downturn in 20002002. We
examine whether exchange rates and stock prices in the full panel as well as a smaller panel
excluding Korea are cointegrated. In the smaller panel, we exclude Korea given the earlier
Table 9. Hadris (2000) Panel LM Stationarity Test
Panel LM Stationarity Test
Hadri z-statistic Stock Prices 22.4011 ( p 0.000)
Hadri z-statistic Exchange Rates 50.7661 ( p 0.000)
Exchange Rate and Stock Price Interaction in Major Asian Markets 273
finding suggesting there is a long-run relationship between exchange rates and stock prices
in that country. The panel test statistic is 9.888 for the full panel of eight countries and
13.993 for a panel of seven countries. The bootstrapped critical value at the 1% level is
2.218. These results suggest that we are able to reject the null hypothesis that all the
countries of the panel in the panel of eight or panel of seven (excluding Korea) are
cointegrated. Thus, even allowing for multiple structural breaks in the panel cointegration
model, we find there is no long-run equilibrium relationship between exchange rates and
stock prices.
Given the panel cointegration test did not reveal any evidence for a long-run relationship
between stock prices and real exchange rates, in specifying the panel Granger causality
model, we use a VAR framework. We obtain a panel F-test statistic of 7.2 for stock prices
Granger causing exchange rates and a panel F-test statistic of 3.8 for causality running
from exchange rates to stock prices. Both test statistics are statistically significant at the 1%
level. Taken together, the panel Granger causality results suggest bidirectional short-run
causality among stock prices and exchange rates in the eight Asian countries.
5. Conclusion
The traditional and portfolio approaches represent competing hypotheses concerning the
relationship between exchange rates and stock prices. We find little support for either
hypothesis based on the long-run results. There is little evidence that a long-run equili-
brium relationship between exchange rates and stock prices exists in the Asian markets
studied for individual countries and no evidence of cointegration for the countries as a
panel, even allowing for structural breaks in the cointegrating equation. Most investors
believe that exchange rates and stock prices represent avenues to predict the future path of
each other. Our findings, though, indicate that the predictive power of the two financial
assets is restricted to the short-run and even then it does not hold for all countries and
subperiods.
Table 10. Panel LM Cointegration Test with Multiple Structural Breaks
Panel LM Statistics Location of Structural Breaks
9.888 (Full Panel) 13.993 (Excluding Korea)
TB1 TB2 TB3 TB4 TB5
Hong Kong 12/1/1993 1/31/1996 4/1/1998 5/31/2000 7/31/2002
Indonesia 12/1/1993 1/31/1996 4/1/1998 5/31/2000 7/31/2002
Japan 12/1/1993 1/31/1996 4/1/1998 5/31/2000 7/31/2002
Korea 12/1/1993 1/31/1996 4/1/1998 5/31/2000 7/31/2002
Malaysia 11/24/1993 1/24/1996 3/25/1998 5/24/2000 7/24/2002
The Philippines 11/24/1993 1/24/1996 3/25/1998 5/24/2000 7/24/2002
Singapore 11/24/1993 1/24/1996 3/25/1998 5/24/2000 7/24/2002
Thailand 11/24/1993 1/24/1996 3/25/1998 5/24/2000 7/24/2002
Notes: The bootstrapped critical value at the 1% level is 2.218.
274 The Singapore Economic Review
In this respect, our results are similar to findings by studies such as Granger
et al. (2000) for Asian countries and Bahmani-Oskooee and Sohrabian (1992) and Nieh
and Lee (2001) for advanced market economies. We go further than these studies in that
we seek to exploit the extra power in the cross-sectional dimension of the data in testing for
panel cointegration and still fail to find evidence of a long-run equilibrium relationship
between exchange rates and stock prices. The lack of a causal relationship in this study, as
in past studies, could be due to the omission of important variables. Given our failure to
find cointegration, one direction for future research could be to examine whether exchange
rates and stock prices are cointegrated with other potentially important variables such as
foreign exchange reserves and the money supply and consider causality between these
variables, similar to the approach adopted by Ibrahim (2000) for Malaysia.
Acknowledgment
We thank an anonymous referee for helpful suggestions on an earlier version of this article.
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