The USD Strength and Economic Growth: An Empirical Study in Asia Pacific Countries

The USD Strength and Economic Growth: An Empirical Study in Asia Pacific Countries NGUYEN PHUC CANH University of Economics HCMC - canhnguyen@ueh.edu.vn Abstract The USD strength has

The USD Strength and Economic Growth:

An Empirical Study in Asia Pacific Countries

NGUYEN PHUC CANH

University of Economics HCMC - canhnguyen@ueh.edu.vn Abstract

The USD strength has strong impacts on trade activities, investment flows, and also consumption in opened countries through income effects and substitution effects, which are now stronger due to the higher integrations around the world Asia Pacific is one of the major economic areas in terms of population, economic scale, and their openness, which are also impacted by the USD strength This paper investigates the impacts of USD strength on real economic growth of 39 Asia Pacific countries (excluding China) using the panel data from

2000 to 2013 By recruiting the fixed effects and random effects models for panel data estimators, it is found that the income effects are strong and stronger in developing countries, but the 2008 global financial crisis has reduced them Furthermore, the Chinese economy is confirmed to have an important role in real economic growth of both developed and developing Asia Pacific countries

Keywords: USD strength; economic growth; Asia Pacific; income effects

1 Introduction

The USD is in the downward trend from 2000 until the slightly recovery in the 2008 global financial crisis, meanwhile the world economy, the US economy and also the Asia Pacific economy sharply fallen in 2008 and 2009 after a long increased trend beginning from 2001

Figure 5 USD strength and real economic growth

The Asia Pacific countries are majorly the small open developing economies except some large economies such as Australia, Japan, Korea, and China Excluding China, almost large developed economies in Asia Pacific such as Australia, Japan, and Korea have lower real economic growth rates

in the sample of 40 countries, while other small developing countries have higher growth rates than the world rate which prove a fact that Asia Pacific area is a dynamic area with high economic development

Table 8

Real economic growth at Asia Pacific

Economic growth Mean Rank Mean before

2008 Rank

Mean after

2008 Rank Min Max

Std Dev

0.0 20.0 40.0 60.0 80.0 100.0 120.0 140.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Economic growth and USD index

US Real GDP growth rate East Asia real GDP growth rate

Central Asia and Europe real GDP growth rate World real GDP growth rate

USD index

Economic growth Mean Rank Mean before

2008 Rank

Mean after

2008 Rank Min Max

Std Dev

Kyrgyz Republic 1.90 23 1.91 28 1.89 21 -0.21 4.35 1.48

Marshall Islands 0.99 34 1.19 33 0.71 35 -0.89 2.59 1.11

Papua New Guinea 1.87 25 0.94 36 3.12 7 -1.10 4.40 1.52

Therefore, the fluctuations in USD strength may have important roles in Asia Pacific economic activities such as trade and investment through the income effects and the substitution effects In the light of the 2008 global financial crisis, the studies of economic growth are focused again in more concentration on international integration, cross – country’s economic contagion and the fluctuations

in exchange rate which have strong impacts on trade activities and investment flows (Brooks et al., 2004; Ilzetzki et al., 2004; Magud & Vesperoni, 2015; Ng et al., 2008; Reinhart, 2012; Xiangqian & Guoqiang, 2005; Zhang et al., 2008) Still, these studies usually investigate the real exchange rate between one economy with one economy which of course has direct impact on the trade and investment activities between two of these countries, but they do not study the impact of an

increasing or a decreasing in the most important currency, USD, for overall economic activities While, almost of the trade and investment activities around the world are done under the USD for transacting, investing, paying, thus this study emphasizes on the effects of USD strength on economic growth at the most dynamic economic area, Asia Pacific

Moreover, the USD has fluctuated more and more in recent years, especial in the 2008 global financial crisis This fact puts to the question on the field of USD strength and the real economic growth at Asia Pacific area This paper investigates the impacts of USD strength on real economic growth at Asia Pacific economies from 2000 to 2013 in the relationship with the higher role of Chinese economy in this area and the world So, this study goes to contribute to the literature under three aspects Firstly, this study investigates the impact of USD strength which presents for the overall effects of change in exchange rate to the real economic growth at Asia Pacific which are going

to become the important area in the world Secondly, this study contributes new evidence of the influence of the 2008 global financial crisis on real economic growth through the exchange rate channel Thirdly, this study also considers the influence of Chinese economy on the neighbor countries which is now got more attention from both academic and practical eyes This study is divided into five sections The introduction presents the significant of this study, the literature review presents the literature on economic growth in the relationship with the effects of exchange rate, the third section is methodology and data which presents the estimation method and data, then the results and discussions present the findings of this study, and at last the conclusion section presents some main points which are draw from this study Next section presents the literature review

2 Literature review

From 19th century, the economic growth theories have been developed and they are one of the most active areas of empirical studies (Rebelo, 1992) In the studies of economic growth, the production function is the root that every economists go to build the growth model, it was firstly built in work of Cobb and Douglas (1928):

where Y is total production, L is labor input, K is capital input, A is total factor productivity, α and

β are the output elasticity of capital and labor, respectively

In the neoclassical growth model of Solow (1956) and Cass (1965), low economic growth rates are the results of low real rates of investment return by private agents The countries with low ratios of capital to labor will have high marginal products of capital and thereby they tend to grow at higher rates than rich countries (Barro, 1991a) In the 1950's and 1960's, capital fundamentalism theory argues that national stock of capital determines the national product (King & Levine, 1993) In the neoclassical growth model, population growth is not affected by GDP per capita thus population is endogenous, meanwhile the technological progress only effects on the GDP per capita through the increase in labor productivity Until 1980s, Paul Romer develops the Endogenous growth theory in

his studies such as Romer (1986), Romer (1989), Romer (1990), and Romer (1994), which explains technological progress as an exogenous variable He explains that the technological progress may have many explanations as technological development is seen as a public goods, the development in human capital, etc

In the light of these theories, many researches go to investigate the determinants of economic growth such as monetary policy, fiscal policy, capital flows, trade activities, law system, financial development, stock market, banking system, economic integrations, etc around the world (Afonso

& Furceri, 2010; Allen et al., 2005; Altunc & Aydın, 2013; Arestis & Demetriades, 1997; Demetriades,

& Luintel, 2001; Barro, 1990a, 1991b; Barro & Sala-i-Martin, 1992; Beck & Levine, 2001, 2004; Becker

et al., 1994; Bencivenga & Smith, 1991; Cavenaile et al., 2014; Chibba, 2007; Cooray, 2009; Galor & Tsiddon, 1997; Haq & Zia, 2009; Kaufmann & Kraay, 2002; Khan, 2007; Knack, 2002; Kneller et al., 1999; Kurtz & Schrank, 2007; Levine, 1996, 1997, 2001, 2005; Patrick, 1966; Prasad et al., 2007; Rajan

& Zingales, 1996, 2001; Rebelo, 1992; Stiglitz, 2000; Stulz, 2002)

In the line with analysis of Druck et al (2015), we assume that the economy produces two kinds

of goods which include non-tradable goods (N) and tradable goods (T) with prices as 𝑝𝑁, and 𝑝𝑇

which are determined in perfect competition market The Cobb – Douglas of N is the function of labor (L) and capital (K):

𝑌𝑡𝑁 = 𝑔(𝐿𝑁𝑡; 𝐾𝑡𝑁);g’L > 0 and g”LL <0; g’K > 0 và g”KK <0 (1) where 𝑌𝑡𝑁 is domestic output, 𝐿𝑁𝑡 is domestic labor and 𝐾𝑡𝑁 is domestic capital for N In the case

of open economy which allows import capital or other production materials and not allow for labor

flows, we assume they do not allow for foreign inputs for domestic production of N to protect domestic economy Meanwhile, with the production of T, the open economy will allow for foreign

production inputs for example foreign capital or foreign inputs if they are not available or they are

lacked in the domestic economy, thus the production function of T is

where 𝑌𝑡𝑇 is domestic output, 𝐿𝑇𝑡 is domestic labor and, 𝐾𝑡𝑇 is domestic capital, and 𝑀𝑡𝐼𝑇 is the

foreign inputs for domestic production of T The foreign inputs such as capital is impacted by the exchange rate, E (Brooks et al., 2004; Calvo et al., 1993; Magud & Vesperoni, 2015; Mundell, 1963; Reinhart, 2012; Reinhart & Calvo, 1999), thus the production function of N is:

Implying an increasing marginal product of each factor is a decreasing rate Owing to perfect competition and taking as given prices of goods, services, and factors of production, optimally:

𝑓 𝐿

𝑓𝑀 = 𝑤

for the T goods and g L =w in the N sector The marginal rate of transformation equals factors’ relative price Thus, the price of T goods, p T , is a function of input price which is the wage, w, and price of input imports, p MI:

Meanwhile, the price of foreign inputs certainly is the functions of international price (p WI) and

exchange rate (E) In the case of open countries, the domestic demand is assumed having no effects

on international price thus it is an exogenous factor In simplify, we assume it is fixed in real term,

thus the price of T goods is

Meanwhile, the price of N goods is:

On the domestic demand side, assume a standard well-behaved concave utility function, in which the representative agent derives utility from consuming non-tradable goods (𝑑𝑁), tradable goods (𝑑𝑇), import goods demand (𝑑𝑀) with price as 𝑝𝑀, and labour income is their only income source Thus, the agent’s optimization problem is given by

max

Subject to the budget constraint

In equilibrium, the marginal rate of substitution between each type of good needs to equal the relative price, namely

𝑢 𝑀

𝑢 𝑁 = 𝑝𝑀

𝑝 𝑁; 𝑢𝑀

𝑢 𝑇 = 𝑝𝑀

𝑝 𝑇 ; 𝑢𝑇

𝑢 𝑁 = 𝑝𝑇

Non-tradable goods without import and export, by definition, exhaust production:

Meanwhile, after satisfying domestic demand, if domestic output of tradable goods is higher

domestic demand, it can be exported (X), otherwise it can be imported (M), therefore

The trade balance is 𝑝𝑇𝑋 = 𝑝𝑀(𝑑𝑀+ 𝑀), in the case of open economy the demand of domestic export is assumed as the international demand of tradable goods Therefore, when we investigate the impacts of USD strength on economic growth in open economies, we have to investigate the impacts of USD strength on two dimensions:

Firstly, USD strength impacts on the price of foreign inputs for domestic production (𝑀𝑡𝐼𝑇) In the assumption that the production inputs can be exchange for each other The higher strength of

USD the higher price of foreign input thus domestic production is simulated to cut wage expenses of domestic labor to balance the equilibrium, the equation (4) will be:

In which 𝑎𝑖𝑗 is the contribution of factor j to produce goods i Given the change in relative price

∆𝑝𝑀𝐼 > 0, and ∆𝑝𝑇 = 0, then (12) can be expressed as

0 = 𝑎𝑇𝐿𝑤 + 𝑎𝑇𝑀𝐼𝑝𝑀𝐼, which results as ∆𝑤 = − 𝑎𝑇𝑀𝐼

𝑎 𝑇𝐿 ∆𝑝𝑀𝐼, so ∆𝑤 < 0

Thus, in this first dimension, we see that if USD strength increases, the labor income will be reduced and then people has lower income, while they face to the budget constraint thus they cut expenditures that leads to lower total aggregate demand and of course which is harmful for economic growth This is called as the income effect In the second dimension, USD strength also impacts on economic growth through the trade activities The production and the equilibrium of domestic

tradable goods is the function of domestic production, export and import (equation 11) The export

demand is function of international demand and exchange rate, meanwhile import demand is function of international price of import goods and exchange rate, in the case of increase in USD strength, the price of domestic export on international market will be relative cheaper, while domestic price of import goods will be relative expensive If domestic production can produce products to replace for import goods or domestic citizens can substitute other goods for import goods, import will be decreased Meanwhile, if international demand increases with the decrease in export price, the export will be increase As sum up, trade balance is increased and then simulate the aggregate demand and boost the economic growth That effect is called as substitution effects

So, as the theory stated, the USD strength may have either negative impact or positive impact on the real economic growth As the case of Asia Pacific countries which are almost the open developing countries with the high labor force and low labour productivity so the income effects may be strong since the producers can reduce the labor cost without fearing a lack of labor While, the exporting products from Asia Pacific almost are the agricultural products that are a suitable international demand for it thus the higher USD strength may not benefit for them, meanwhile the importing products at there are usually higher technologies products and the raw material such as iron or steel, therefore the higher USD strength will increase the input cost of production, so adding both of these reasons we see that the strengthen of USD may not have strong substitution effects In order to test these ideas, next section presents the methodology and data

3 Methodology and data

3.1 Methodology

To shed some light on the theoretical ambiguity presented above and base on the baseline specification following the study of Druck et al (2015) to test the impact of USD strength on the real economic growth at Asia Pacific through the model:

𝑦𝑡𝑖 = 𝑎 + 𝛽𝑋𝑡+ 𝜕𝑍𝑡−1𝑖 + ∅𝑉𝐼𝑋𝑡+ 𝑢𝑠𝑑𝑖𝑛𝑑𝑒𝑥𝑡∗ 𝑉𝐼𝑋𝑡+ 𝜀𝑡𝑖 (12)

in which 𝑦𝑡𝑖 is real GDP growth rate of country i in year t (realgdpg), 𝑋𝑡 is vector of main

explanatory variables including USD strength (proxy by USD index - usdindex), Chinese real GDP growth rate which proxy for influence of Chinese economy on neighbor economies (Chinarealgdpg),

but before testing the influence of Chinese economy, we test the base model with the real US

economic growth rate which proxy for the international economic growth (usrealgdpg); 𝑍𝑡−1𝑖 is vector of control variables including the ratio of net financial account on GDP of each country

(financialacc), the logarithm of GDP per capita of each country (loggdppc), in which they are lagged

to avoid the endogeneity problem in panel data; and the implied volatility of S&P 500 (VIX), 𝜀𝑡𝑖 is residual term Meanwhile, the interaction term between USD strength and the VIX is used to evaluate the difference in the impact of USD strength on Asia Pacific economic growth in the 2008 global financial crisis

In order to investigate the impacts of USD strength on real economic growth, the real GDP growth rate is seen as the best measurement which help us to exclude inflation The rates are calculated from the real GDP value of each country from the World Development Indicator of Worldbank While, the USD strength is proxied by the USD index which are calculated by the FED Meanwhile, the real GDP growth rate of US is used to proxy for the international economic growth The lagged real GDP per capita of each country is used to factor in income differences across countries The ratio of net financial account on GDP to control for the effects of international fund to the domestic economic growth Next section presents the source and the description of data

3.2 Data

This study collects data from 2000 to 2013 period of 39 Asia Pacific countries (excluding China) which are named in Table 1 The data sources are presented in Table 2

Table 9

Variables and sources

Realgdpg Real GDP growth rate Calculate from data of Worldbank

Usdindex Trade weighted USD index FED

Usrealgdpg Real GDP growth rate of US Calculate from data of Worldbank

Chinarealgdpg Real GDP growth rate of China Calculate from data of Worldbank

Loggdppc Logarithm of GDP per capita Calculate from data of Worldbank

financialacc Ratio of net financial account on GDP Calculate from data of ADB

Vix Implied volatility index of S&P 500 Yahoo finance

Data description in Table 3 shows that the Chinese real economic growth is over 4% in period from 2000 to 2013, while the overall economic growth rates of all Asia Pacific countries in our sample are just around 2.1%, moreover the US real economic growth rate is just around 0.8% Whereas, the USD is seemly in strength stage since 2000 to 2013 with the average point at 109.5

Table 10

Data description

The correlations between variables in Table 4 show that real economic growth rates in Asia Pacific countries have significant positive correlations with both US and Chinese real economic growth, which indicates the positive effects of both US and Chinese economic growth on the Asia Pacific area They also have positive correlation with financial account that indicates the significant role of external capital flows with the Asia Pacific countries

Table 11

Correlation matrix

Correlation realgdpg usdindex usrealgdpg loggdppc chinarealgdpg financialacc vix realgdpg 1.000

usdindex -0.029 1.000

0.503 usrealgdpg 0.232*** 0.237*** 1.000

0.000 0.000 loggdppc -0.245*** -0.099** -0.033 1.000

0.000 0.021 0.450 chinarealgdpg 0.195*** -0.122*** 0.121*** -0.009 1.000

0.000 0.004 0.005 0.831 financialacc 0.089** 0.047 0.069 -0.119*** 0.072 1.000

vix -0.207*** 0.091** -0.711*** -0.008 -0.352*** -0.034 1.000

Note: *, **, and *** denote significance levels of 10%, 5%, and 1% respectively

Meanwhile, The Asia Pacific real economic growth rates have negative correlation with Vix that means the 2008 global financial crisis may have negative effects on Asia Pacific economies The next section presents the estimation results and discussions

4 Results and discussions

The panel data estimations from pool least square (PLS) to fixed effects (FEM) and random effects (REM) are recruited respectively Due to the limitations of pool OLS in estimating the panel data (Kiviet, 1995), therefore FEM and REM are more preferred in panel data estimations (Ahn & Schmidt, 1995) In addition, we step by step put the control variables into model to test the consistence of our results, the results are presented in Table 5 from model (1) to model (5) show very strong consistence

of our results

Table 12

USD strength and economic growth at Asia Pacific countries

(REM)

2 (REM)

3 (FEM)

4 (FEM)

5 (FEM)

Note: *, **, and *** denote significance levels of 10%, 5%, and 1% respectively.

The significant negative coefficients of USD index indicate a stronger income effect at Asia Pacific countries which the higher USD strength harms to the real economic growth We can understand that the domestic production of almost Asia Pacific countries are developing that are on the way of innovating, and they import material for their products therefore the production will be impacted strongly by the strengthen of USD Besides, the Asia Pacific area is the area with the high dollarization situation (see Larraín & Tavares, 2003; Menon, 2007; Katada, 2008) which make the USD not only becomes a currency for transaction but also becomes a saving asset, thus people will keep saving more money into USD which are presented as the USD deposit at commercial banks or keep at their home when its strength goes up thus the consumption and private investment will be reduced and that distorts the economic growth The negative effects of USD strength on real economic growth at Asia Pacific countries also indicate that the substitution effects are weak at this area In fact, almost