Introduction Methodology Results Robustness Conclusion

Monetary Policy, Exchange Rate andAsian Stock Markets

Tim LeelahaphanThe University of Warwick, UK

5 November 2009Bank of Thailand Research Workshop

20 October 2009Internal Workshop, The University of Warwick

6 August 2009Singapore Economic Review Conference 2009

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion

Examine the effect of monetary policy and exchange rateon stock prices

Employ a Bayesian structural vector autoregression modeland impose sign restrictions

Simultaneously and uniquely identify contractionarymonetary policy shocks and depreciation shocks in anintegrated framework

Consider standard VAR analyses including impulseresponses and variance decomposition

Cover Malaysia, South Korea and Thailand stock markets,1989-2008

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion

10 minutes Introduction and Econometric Methodology

15 minutes Results and Robustness

5 minutes Conclusion

Comments and Questions

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion MP/Stock Prices ER/Stock Prices Motivation Objectives

Monetary Policy and Stock Prices

Interest rates are important determinant of stock prices

Affect both the current and the expected future realinterest rate

Changes in expected future interest rate serving as adiscount rate (direct link between MP and the stock market)

Changes in all factors affecting aggregate demand, thepath of profit and the expected dividends (indirect linkbetween MP and the stock market)

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion MP/Stock Prices ER/Stock Prices Motivation Objectives

Exchange Rate and Stock Prices

ER changes could affect the competitiveness ofmultinational firms (goods market hypothesis andtraditional approach)

The value of an exporting firm would increase, following itsdomestic currency depreciation

A fall in firm’s stock prices due to a depreciation, if lots ofimported inputs are used in the production

Movements of ER have effect on firm’s future payables (orreceivables) that are denominated in foreign currency

Compare to MP/stock prices, lesser attention has been paidto ER/stock prices

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion MP/Stock Prices ER/Stock Prices Motivation Objectives

Motivation

After the 1997 Asian financial crisis, ER/stock prices hasreceived higher attention due to turmoil in both markets

I Jul-Sep 97, ringgit (-37.4%), stock market (-31.4%)I End of 97, Korean won (-150%), stock market (-50%)I Begin of 98, Thai baht (lowest point), stock market (-75%)

The primary reason for the Asian financial crisis is attributableto an inappropriate mixture of policies (Rajan, Thangaveluand Parinduri (2008))

ER issues and MP relevant to Asia, especially those relatingto financial issues and asset prices, are in focus ofeconomists and market participants

Whether MP should seek to promote asset price stability

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion MP/Stock Prices ER/Stock Prices Motivation Objectives

Objectives

To examine if there is difference in the influence of the MPactions and of ER developments on the stock market (thesystematic feature in terms of persistence of the impact)

To assess if ER has also played important role in driving thestock market, in addition to MP

To examine and compare the extent to which MP and ERis responsible for the movements in Asian stock prices

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Sign Restrictions Identification Specification

Sign Restrictions Approach

To differentiate monetary policy shocks and exchange rateshocks in the data

Developed by Canova and de Nicolo (2002), Uhlig (2005)and Mountford and Uhlig (2005)

Justify if the signs of the corresponding impulse responsesare accepted by priori consensual considerations regardingthe effects of MP shocks and ER shocks on keymacroeconomic variables

Leave the impact of these two shocks on real stock pricesunrestricted

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Sign Restrictions Identification Specification

Advantages of Sign Restrictions Approach

Require only a minimal set of economically meaningfulrestrictions for identifying MP shocks and ER shocks

Make restrictions which are often used implicitly and are inline with the conventional considerations more explicitly

Results are not altered by reordering the variables and by aconsequent selection of a different Cholesky decomposition

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Sign Restrictions Identification Specification

Identification 1

The VAR model comprises monthly data ofI Real industrial production (GDP)I Annual change in consumer prices (P)I Interest rate (i)I Real exchange rates (e)I Financial sector real stock prices (f )I Market real stock prices (s)

Shocks GDP P i e f sContractionary MP Shocks - - + app

Depreciation Shocks + + + dep

Based on properties outlined by Uhlig (2005) and Mountfordand Uhlig (2005), Monte Carlo simulations are performedIf the range of impulse response satisfies the signrestrictions, we keep the draw, otherwise we discard it,until 1,000 draws compatible with the sign restrictions areacquired

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Sign Restrictions Identification Specification

Identification 2

The restrictions are in line with standard macroeconomictheory and have also been used in the empirical literatureemploying VARs with sign restrictions to identify these shocksfor individual countries

The restrictions uniquely identify contractionary monetarypolicy and depreciation shocks and also discriminate thesetwo shocks from other potential shocks (labor supplyshocks, technology shocks or fiscal policy shocks)

We leave the impact on financial sector and market index realstock prices unrestricted

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Sign Restrictions Identification Specification

Clarification

An interpretation of exchange rate shocks

Following Kim (2002), could be thought of as the disturbance in FX market,due to abrupt shifts in portfolio preference, changes in the way of marketparticipants’ forming expectations on exchange rates and evaluating relativerisks of domestic and foreign assets

An independent monetary policy under a fixed exchangerate regime

Reisen (1993) suggests many Asian countries are successful in achieving the‘impossible trinity’, namely, fixed exchange rates, independent monetary policyand free capital movements, mainly due to the weak interest rate mechanism

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Sign Restrictions Identification Specification

Specification

Six lags for all three countries examined (AIC)

A VAR we estimate includes a constant

A horizon constrained for the sign restrictions to be imposedover (k) is five (a half year horizon) (convention)

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

Results

We analyze the impulse responses of the real stock pricesindex to contractionary MP shocks and to depreciation shocks

To examine if there is difference in the influence of the MP actions and of ERdevelopments on the stock market (the systematic feature in terms ofpersistence of the impact)

We analyze variance decomposition

To assess the importance of MP and of ER in explaining movements of thereal stock prices index

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

MP Shocks (Left) and ER Shocks (Right), Malaysia

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

MP Shocks (Left) and ER Shocks (Right), South Korea

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

MP Shocks (Left) and ER Shocks (Right), Thailand

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

Summary Results from Real Stock Prices Imp Responses

MP Shocks ER Shocks

MalaysiaRelationship: Negative Relationship: NegativeSignificant: No Significant: 3rd-15th mth (13 mths)

Persistent: NoMagnitude: f bigger than s

South KoreaRelationship: Negative Relationship: NegativeSignificant: 4th-43rd mth (40 mths) Significant: 7th-10th mth (4 mths)Persistent: Yes Persistent: NoMagnitude: f bigger than s Magnitude: f bigger than s

ThailandRelationship: Negative Relationship: PositiveSignificant 1st-35th mth (35 mths) Significant: 1st-4th mth (4 mths)Persistent: Yes Persistent: NoMagnitude: f bigger than s Magnitude: f bigger than s

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

Variance Decomposition for Real Stock Prices, Reported atPeak During 12 Months Following the Shocks

Variable Contract MP Depreciation Both

MalaysiaFin sector 16.19 (11 months) 17.53 (9 months) 33.69 (11 months)

Market 15.56 (12 months) 17.02 (12 months) 32.58 (12 months)

South KoreaFin sector 16.92 (12 months) 16.20 (12 months) 33.12 (12 months)

Market 15.23 (12 months) 15.68 (12 months) 30.91 (12 months)

ThailandFin sector 10.71 (11 months) 12.70 (1 month) 23.29 (11 months)

Market 8.84 (12 months) 10.87 (12 months) 19.71 (12 months)

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Impulse Responses Var Decomp Findings

Main Findings

MP shocks result in a strongly persistent effect on realstock prices (the average of 37.5 months)

The impact of ER shocks is short-lived over the short-run(the average of 7 months)

ER is as important as MP for explaining the dynamics ofreal stock prices

ER developments have been more important in theshort-run

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Asian Crisis/Open Economy/Fixed ER

Robustness

Include the Asian crisis dummy, the Federal Funds rate orthe dummy isolating the fixed ER period or use realeffective ER

To take into account the 97-98 Asian financial crisis, the open economy natureof countries examined and the fixed ER period

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion Asian Crisis/Open Economy/Fixed ER

Inclusion of Dummy Variable or Federal Funds Rate or theUse of Real Effective ER

Final products of the VAR models including impulseresponses and variance decomposition are robust

Granville and Mallick (2009) emphasize that Uhligmethodology is robust to non-stationarity of seriesincluding breaks and, consequently, do not include anydummy variable in the system

Countries examined do not adjust their interest ratessystematically in response to economic conditions in theUS

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion What We Do What We Find Conclusion 1 Conclusion 2

What We Do

Employ a Bayesian structural vector autoregression model toexamine the effect of MP and of ER on stock pricemovements in Asia

Use sign restrictions to simultaneously and uniquelyidentify contractionary MP and depreciation shocks in anintegrated framework

Consider standard VAR analyses including impulseresponses and variance decomposition

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion What We Do What We Find Conclusion 1 Conclusion 2

What We Find

From impulse responses

I MP shocks result in a strongly persistent effect on realstock prices whereas the impact of ER shocks is short-livedover the short-run

From the variance decomposition

I ER is as important as MP for explaining the dynamics ofreal stock prices (more important in the short-run)

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion What We Do What We Find Conclusion 1 Conclusion 2

Conclusion 1: MP and Stock Prices

Because of the mistimed and/or persistent effect of MP on bothreal economy and financial markets, we argue that one needs to becautious in using MP to constrain asset price misalignment

Monetary authorities could significantly affect equity marketvaluations by adjusting interest rates

Monetary policy would only make situations worse if stockprice misalignment does not result in significant damage whenit ends or if interest rates are high at the moment that abubble bursts

The impact of such high interest rates on the real economywould last for another couple of years and make thelanding harder

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion What We Do What We Find Conclusion 1 Conclusion 2

Conclusion 1: Other Instruments

Strong consensus that well structured prudential policy andregulatory system could make financial markets and financialsystems less prone to troublesome situation is achieved

The need for contractionary MP to burst a bubble is likelyto be reduced

Nevertheless, deciding what form such regulation andsupervision should take is the more difficult issue

Banking regulation should change cyclically to rule outlending booms on the back of rises in asset prices

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion What We Do What We Find Conclusion 1 Conclusion 2

Conclusion 2: ER and Stock Prices

Due to the evidence that ER principally has a contemporaneousimpact on equity prices, we suggest that, in the short-run, suchincorrectly aligned asset price might be potentially corrected byfocusing on ER movements

ER fluctuations are major concern to monetary authorities,even if they are targeting inflation

As suggested by Mishkin and Savastano (2001),(inflation-targeting) central banks should not pursue a policyof benign neglect to ER

Nevertheless, it is challenging for central banks, especiallyones targeting inflation, to focus on ER movements sincethis might obstruct reaching the target rate of inflation

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets

Introduction Methodology Results Robustness Conclusion What We Do What We Find Conclusion 1 Conclusion 2

With information provided, the appropriate policy response topotential misalignments of stock prices would be calibrated by thecentral bank

Questions and Comments

Tim Leelahaphan The University of Warwick, UK Monetary Policy, Exchange Rate and Asian Stock Markets