TESTING THE PURCHASING POWER PARITY BETWEEN THE HASHEMITE KINGDOM OF JORDAN AND ITS MAJOR TRADING PARTNERS

Transcription

1 From the SelectedWorks of Anwar Salameh Gasaymeh October 27, 2009 TESTING THE PURCHASING POWER PARITY BETWEEN THE HASHEMITE KINGDOM OF JORDAN AND ITS MAJOR TRADING PARTNERS Anwar Salameh Gasaymeh, university putra malaysia Available at:

2 TESTING THE PURCHASING POWER PARITY BETWEEN THE HASHEMITE KINGDOM OF JORDAN AND ITS MAJOR TRADING PARTNERS Anwar Salameh Gasaymeh*, Lee Chin and M. Azali Department of Economics, University Putra Malaysia, UPM, Serdang, Selangor Darul Ehsan, Malaysia Abstract This study examines the validity of Purchasing Power Parity (PPP) and investigates the market integration between The Hashemite Kingdom of Jordan and its major trading partners namely, Japan, United Kingdom, Tunisia, Morocco, Switzerland, Israel, Pakistan, Turkey, Sudan and Iran. Unit root tests, Johansen cointegration test and vector error correction model (VECM) were employed to test the data covering the period of 1990Q1-2006Q4. The unit root tests demonstrated that all variables are integrated of order one. The results of cointegration tests showed that there exists a cointegrating relationship between exchange rate, domestic and foreign price levels for seven countries namely, Japan, UK, Switzerland, Israel, Pakistan, Tunisia and Morocco and other three countries does not have cointegration relationship. For the VECM, it is found that the error correction terms (ECTs) for Jordan-Japan, Jordan-UK, Jordan- Switzerland, Jordan-Israel, Jordan-Pakistan Jordan-Tunisia, and Jordan-Morocco carried the expected sign. This suggests that whenever there is a deviation from the equilibrium cointegrating relationship, exchange rate interacts in a dynamic fashion in adjusting to restore long-run equilibrium. Last but not least, all the models passed all the diagnostic checking. As a conclusion, these results provide evidence on PPP model hold in the long run and the Jordanian economy is integrated with these seven countries. * corresponding author: gasaymeh@yahoo.com

3 Introduction The Hashemite Kingdom of Jordan (in Arabic, al-mamlakeh al- Urduniyyeh al-hashmiyyeh, or al-urdun) is playing a very important role politically and economically through the region and located in the heart of the Middle East. Jordan has access to the Red Sea via the port city of Aqaba, located at the northern end of the Gulf of Aqaba. The Kingdom of Jordan occupies a strategic location in the Middle East. Jordan participates in the World Trade Organization, has free trade with the European Union and with many Arab countries. Jordan has Qualifying Industrial Zones (QIZ) that allows free trade into the United States. Jordan managed to reach a number of Arab and International agreements with friendly countries namely, Japan, United Kingdom, Tunisia, Morocco, Switzerland, Israel, Pakistan, Turkey, Sudan and Iran. The agreement aims to deepening the trade integration and promoting mutual investments between the member countries, to increase investment opportunities between the two countries and to facilitate trade movement between the countries and double taxation avoidance. A special topic to be taken into consideration by investors and monetary authorities is the integration of the international market. This topic is not discussed very widely ranging between the Middle East and North Africa (MENA) Countries, and not much research has been done on the topic of market integration of MENA. But this topic has been investigated for the market of United States of America (U.S.A.). The main purpose of this study is to examine the validity of Purchasing Power Parity (PPP) and to investigate the market integration between The Hashemite Kingdom of Jordan and its major trading partners namely, Japan, United Kingdom, Tunisia, Morocco, Switzerland, Israel, Pakistan, Turkey, Sudan and Iran. Although Purchasing Power Parity is regarded as one of the central doctrines in international economy, no studies are done on the Jordan with its trading partners. The rest of the paper is organized as follows. Section 2 discusses the PPP theory and literature review. The third section is a review on the methodology and data employed in this study. Section four reports the empirical results of this study and the last section provides the conclusion and overview of this study. 2.1 Theory of PPP PPP stated that, the exchange rate between two currencies are in equilibrium when their purchasing power is the same in each of the two countries that is the law of one price, that identical goods should sell for identical prices in

4 different countries markets. That means the exchange rate between countries should be equal to the ratio of the countries price levels of a fixed basket of goods and services. When the country s domestic price level is getting increased more rapidly than its major trading partner that tell us a country experiencing inflation, that country s exchange rate must depreciate in order to return to purchasing power parity. There are two types of purchasing power parity theory, absolute and relative purchasing power parity. Absolute purchasing power parity theory states that the exchange rate between the currencies of two countries should equal the ratio of the price levels of the two countries and the basket of goods should be the same domestically and abroad if the goods prices are converted into a common currency, in other words, absolute purchasing power parity theory postulates that the purchasing power of money should be equal between countries. S= P/P* (1) Where S is the nominal exchange rate measured in units of domestic currency per unit of foreign currency, P is the domestic price level and P* is the foreign price level. The relative PPP hypothesis, on the other hand, states that the exchange rate should be proportionate to the ratio of the price level and does not compare domestic and foreign levels of purchasing power, but rather focuses on changes in this purchasing power. The relative PPP is said to hold when the rate of depreciation of one currency relative to another matches the differences in aggregate price inflation between the two countries concerned. If the nominal exchange rate is defined simply as the price of one currency in terms of another, then the real exchange rate is the nominal exchange rate adjusted for relative national price level differences. When PPP holds, the real exchange rate is a constant, so that movement in the real exchange rate represents deviations from PPP. Hence, a discussion of the real exchange rate is tantamount to a discussion on PPP (Sarno and Taylor). S=k (P/P*) (2) Where k is a constant parameter, since information on national price levels normally is available in the form of price indices rather than absolute price levels, absolute PPP may be difficult to test empirically. 2.2 Literature Review

5 The PPP theory has been tested for several countries using various statistical methods, sample periods and frequency of data. Despite the extensive research on PPP, to our knowledge, there are only a few analyses for the Middle East countries. In particular, Abumustafa (2006) for Jordan, and Drine and Rault (2008) for different panels of countries including Jordan. Abumustafa (2006) examined PPP between Jordan and Japan, and between Jordan and Germany using unit root method and found no evidence of PPP. Drine and Rault (2008) apply panel cointegration techniques to test the PPP for different panels of countries, such as the OECD, the countries in Africa, Asia, Middle East and North Africa (MENA), Latin America and Central and Eastern European. They reported favorable evidence of PPP in the OECD panel while weak PPP in MENA panel. For the remaining panels, their study shows that PPP does not seem to characterize the long-run behavior of the real exchange rates. Previous empirical studies on Asian countries have found mixed results. Phylaktis and Kassimatis (1994), Salehizadeh and Taylor (1999), Wang (2000) and Azali et al. (2001) found evidence to support long-run PPP for Asian economies. However, Lee (1999) found mixed evidence of PPP from thirteen Asian Pacific economies. On the other hand, the results of Cooper (1994), Doganlar (1999), Baharumshah and Ariff (1997), Holmes (2001), Alba and Papell (2007) and Jiranyakul and Batavia (2009) failed to show evidence in supporting PPP for Asian Pacific countries. There are numerous studies on PPP conducted on developed countries. Some recent studies that supported exchange rate stationarity for developed countries are Oh (1996) for the G-6 and OECD countries, Papell (1997) for the industrial countries, Lothian (1997, 1998) for the OECD countries, Husted and MacDonald (1998) for the OECD, Coakley and Fuertes (1997) for the G-10 countries and, Koedijk et al (1998) for 17 developed countries. On the other hand, some studies have also shown that the real exchange rate of non-stationary. These are done by Canzoneri et al. (1999) for the OECD countries, Alba and Park (2003) for 65 developing countries, and Wu and Chen (1999) for eight Pacific countries and 15 developed countries. Recently, there are some studies re-investigate this PPP issues by using non-linearity approach. Obstfeld and Taylor (1997), and O'Connell and Wei (1997) reported additional evidences of non-linear reversion of prices. However, O'Connell (1998), using a balance threshold autoregression (TAR) model for the post-bretton Woods real exchange rates in a panel framework find little support for PPP deviations. Wu and Chen (2008) investigated purchasing power parity

6 convergence using a threshold vector error-correction model. They found that PPP convergence and the half-life of real exchange rates is less than two and a half years. 3. Methodology and Data In this study we first examine the time series properties. The unit root test of ADF and KPSS tests were used to examine the stationarity of the data. The unit root tests were first implement on level, and then on first difference of the data. If the series are of first order, then we may proceed to test the existence of the longrun relationship among these variables using Johansen cointegration test. If the maximum eigen statistic and trace statistic greater than 5% critical value, then we rejected the null hypothesis. Lastly, using vector error correction model (VECM) to investigate the dynamic short run relationship between the exchange rate and the price level as well as its adjustment towards long run equilibrium. Various diagnostic tests such as normality test (Jarque-Bera), an autocorrelation test (Langranger multiplier), a heteroskcedasticity test (ARCH Test) and a stability test (Ramsey RESET) had been performed to ensure the robustness of the model. We employ quarterly data from 1990Q1-2006Q4 including three major trading partners with Jordan, the countries are, Japan, United Kingdom, Switzerland, Pakistan, Israel, Tunisia, Morocco, Sudan, Turkey and Iran. The data are obtained from IMF's International Financial Statistics and data are the nominal exchange rate (ER) and consumer price (CPI) for all the countries. The Hashemite Kingdom of Jordan is treated as base country. 4. Results The ADF and KPSS unit root tests were conducted and the results can be seen in Table 1 and Table 2. The result of ADF test clearly shown that for all the countries the null hypothesis of unit root cannot be rejected at 1% significant level when all the variables are in the level but can be rejected when they are tested at first difference; this means all the variables are stationary at first difference. The results of KPSS test shows that the null hypothesis of stationary or no unit root can be rejected at 1% significant level when all variables are tested in their level. However, the null hypothesis of stationary cannot be rejected when all variables are tested in their first differences. Thus, we concluded that all the series are I (1) process. Table 1: The ADF unit root test At Level First Difference Variable Constant Trend Constant Trend

7 ER J-Japan (3) (3) (2)*** (2)*** CPI Jordan (0) (0) (0)*** (0)*** CPI Japan (4) (2) (3)*** (0)*** ER J-UK (0) (0) (0)*** (0)*** CPI UK (5) (5) (4)*** (2)*** ER J-Pakistan (0) (0) (0)*** (0)*** CPI Pakistan (1) (1) (0)*** (0)*** ER J-Switzerland (0) (0) (0)*** (0)*** CPI Switzerland (4) (0) (0)*** (0)*** ER J-Morocco (0) (0) (0)*** -7.33(0)*** CPI Morocco -2.69(5) (0) (0)*** (0)*** ER J-Israel (0) (0) (0)*** (0)*** CPI Israel (10) (0) (0)*** (0)*** ER J-Tunisia (0) (0) (0)*** (0)*** CPI Tunisia (7) (5) (0)*** (4)*** ER J-Iran (1) (1) (0)*** (1)*** CPI Iran (1) (1) (0)*** (0)*** ER J-Sudan (3) (4) (3)*** (3)*** CPI Sudan (3) 0.484(0) (1)*** (0)*** ER J-Turkey (0) 0.372(0) (1)*** (1)*** CPI Turkey (4) 2.264(1) (0)*** (0)*** Notes: Figures are the t-statistics for testing the null hypothesis that the series is nonstationary. *** and ** denotes significance at 1% and 5% levels. Figures in parenthesis are lag length. Table 2: The KPSS unit root test At Level First Difference Variable Constant Trend Constant Trend ER J-Japan (0)*** (0)*** 0.126(0) 0.064(0) CPI Jordan (6)*** (3)*** (6) (0) CPI Japan (1)*** (6)*** 0.436(4) 0.143(7) ER J-UK 1.176(0)*** (0)*** (3) (4) CPI UK (6)*** (3)*** (4) (9) ER J-Pakistan 1.023(6)*** (6)*** 0.405(9) (2) CPI Pakistan 1.048(6)*** (6)*** (14) (9) ER J- Switzerland 0.796(0)*** 0.736(0)*** (2) (2) CPI Switzerland 0.796(0)*** 0.736(0)*** (2) (2) ER J- Morocco (1)*** (1)*** (2) (1)

8 CPI Morocco (6)*** (6)*** (11) (0) ER J- Israel 1.003(6)*** 0.247(6)*** 0.461(8) 0.057(7) CPI Israel 0.985(6)*** 0.278(6)*** 0.462(9) 0.096(1) ER J- Tunisia 0.944(6)*** 0.695(0)*** 0.086(2) (2) CPI Tunisia 1.065(6)*** 0.258(6)*** 0.455(13) (2) ER J-Iran 1.397(1)*** 0.410(4)*** 0.102(2) 0.049(2) CPI Iran 1.746(1)*** 0.413(4)*** 0.447(8) 0.114(4) ER J-Sudan 1.348(1)*** 0.406(1)*** 0.440(4) 0.043(9) CPI Sudan 1.338(4)*** 0.347(5)*** 0.447(4) 0.095(6) ER J-Turkey 1.638(1)*** 0.390(1)*** 0.421(3) 0.140(3) CPI Turkey 1.764(1)*** 0.415(1)*** 0.433(4) 0.144(5) Notes: Figures are the LM-statistics for testing the null hypothesis that the series is stationary. *** and ** denote significance at 1% and 5% levels. Figures in parenthesis are lag length. All the series are I (1) process; the cointegration test can be implement to examine the long-run relationship among these variables. Table 3 displays the results for the Johansen cointegration test. The results showed that there exists a cointegrating relationship between exchange rate, domestic and foreign price levels for Jordan and seven countries namely, Japan, UK, Switzerland, Pakistan, Israel, Tunisia and Morocco. And there is no cointegrating relationship among Jordan-Iran, Jordan-Sudan and Jordan Turkey. The existence of a long run relationship between the exchange rates of Jordan and its trading partner, CPI Jordan and CPI trading partner support the theory of PPP, indicating that it will hold over the estimated periods. Table 3: The Johansen-Juselius cointegration tests Null Hypotheses Eigenvalue Trace Critical Value (1%) Max-Eigen Critical Value (5%) Jordan-Japan (r = 0) *** *** (r 1) (r 2) Jordan-United Kingdom (r = 0) *** *** (r 1) (r 2) Jordan-Pakistan (r = 0) *** *** (r 1) (r 2) Jordan- Switzerland

9 (r = 0) *** *** (r 1) (r 2) Jordan-Morocco (r = 0) *** *** (r 1) (r 2) Jordan-Israel (r = 0) *** *** (r 1) (r 2) Jordan-Tunisia (r = 0) *** *** (r 1) (r 2) Jordan-Iran (r = 0) (r 1) (r 2) Jordan-Sudan (r = 0) (r 1) (r 2) Jordan-Turkey (r = 0) (r 1) (r 2) Notes: r indicates the number of cointegrating vectors. *** and ** denote significance at 1% and 5% levels. For the country pairs which cointegration relationship are detected, we precede to the VECM, which is a test for short-run relationships between the exchange rate, domestic price level and foreign price level. Table: 4 reported the VECM obtained for Jordan-Japan, Jordan-United Kingdom, Jordan -Pakistan, Jordan- Switzerland, Jordan-Israel, Jordan-Tunisia and Jordan-Morocco respectively. The diagnostic tests such as normality test (Jarque-Bera), an autocorrelation test (Langranger multiplier), a heteroskcedasticity test (ARCH Test) and stability test (Ramsey RESET) are also reported. The estimated coefficients of cointegrating vector shown in Table 4 indicate that there are correctly signed for Jordan-Japan, Jordan-Tunisia. Hence, it seems represent a PPP relationship for Jordan-Japan, Jordan-Tunisia. It is found that the errorcorrection terms (ECTs) for Jordan-Japan, Jordan-United Kingdom, Jordan Switzerland, Jordan-Pakistan, Jordan-Israel, Jordan-Tunisia, and Jordan-Morocco carried the expected sign. This suggests that whenever there is a deviation from the equilibrium cointegrating relationship, exchange rate interacts in a dynamic fashion in adjusting to restore long-run equilibrium. Lastly, all the models passed

10 all the diagnostic checking. The diagnostic tests results showing that the residuals were normally distributed, there was no serial correlation, no heteroskedasticity or misspecification problems, and the models are stable. Variables Expected Sign Jordan- Japan Table 4: Vector Error-Correction Results Country-pairs Jordan- Jordan- Jordan- Jordan- UK Switzerland Israel Pakistan Standardize β Cointegrating Vector Jordan- Tunisia Jordan- Morocco ER t CPI t ** 1.56*** 6.27*** 0.38*** -3.45*** -4.88*** 2.64*** CPI* t *** -1.02*** *** 0.20** 2.17*** 5.02*** -5.93*** Standardize α Coefficients ECT *** *** ** *** 0.22 *** ** -0.02*** ER t ER t CPI t CPI t CPI* t CPI * t C D D D D Diagnostic Tests R Adjusted R S.E. of Regression F-Statistics JB BG (LM Test) ARCH Test Ramsey RESET Note: = First difference operator; ***, ** and * denote significant at 1%, 5% and 10% level respectively. D1, D2, D3 and D4 are dummies introduced to correct the normality. D1 = 1 in 1999Q1, 2000Q3, 2002Q1, 2003Q2, 2006Q3 and 2006Q3; D1= -1 in 1991Q2, 1993Q1, 1993Q4, 1993Q3, 1999Q2, 2002Q4, 2002Q2; and zero in all other quarters. D2 = 1 in 1990Q3, 1992Q2, 1994Q1, 1994Q4, 1996Q3, 2001Q2, 2006Q3; D2 = -1 in 1992Q3, 1994Q3, 1996Q4, 1998Q3, 1999Q1, 1999Q3, 2000Q1, 2004Q1, 2005Q1; and zero in all other quarters). D3 = 1 in 1999Q1, 2000Q3, 2002Q1, 2003Q2, 2006Q3 and 2006Q3; D3= -1 in 1991Q2, 1993Q1, 1993Q4, 1993Q3, 1999Q2, 2002Q4, 2002Q2; and zero in all other quarters. D4 = 1 in 1990Q3, 1992Q2, 1994Q1, 1994Q4, 1996Q3, 2001Q2, 2006Q3; D4 = -1 in 1992Q3, 1994Q3, 1996Q4, 1998Q3, 1999Q1, 1999Q3, 2000Q1, 2004Q1, 2005Q1; and zero in all other quarters. 5. Conclusion

11 The main purpose of this study is to examine the validity of Purchasing Power Parity (PPP) and to investigate the market integration between The Hashemite Kingdom of Jordan and its major trading partners namely, Japan, United Kingdom, Switzerland, Pakistan, Israel, Tunisia, Morocco, Sudan, Turkey and Iran based on data covering the period of 1990Q1-2006Q4. The results of cointegration tests showed that there exists a cointegrating relationship between exchange rate, domestic and foreign price levels for Jordan and seven countries namely, Japan, UK, Switzerland, Pakistan, Israel, Tunisia and Morocco Hence, lending support to the validity of PPP. And there is no cointegrating relationship among Jordan-Iran, Jordan-Sudan and Jordan Turkey due to recent agreement made with Jordan and some trade barriers such as double taxation and political situation was not stable, The Iranian, Sudanese economy are suffering under the continuing threat of international economic sanctions. The findings of PPP hold between Jordan and its major trading partners implied that the Jordanian economy is integrated with these countries. Hence, these had important policy implication on cross-border agreement for international trade and investment with these countries. It is promising the efforts to promote trade with these economies and further removal of barriers with these countries. Given the goods and services markets appeared quite integrated, future liberalization will be likely pronounced in financial markets. If we envision this process of integration continuing, in particular in the Middle East region, and to the extent that this process requires even more political engagement, we believe the prospects for cooperation along a variety of dimensions are good. References Abumustafa N. I New Evidence of the Validity of Purchasing Power Parity from Jordan. Applied Economic Letters, 13, Alba J. D. and Papell D.H Purchasing Power Parity and Country Characterstics: Evidence from Panel Data Tests. Journal of Development Economics, 83, Alba, J.D. and Park, D Purchasing Power Parity in Developing Countries: Multi-period Evidence under the Current Float. World Development, 31, Azali, M.; Habibullah, M. S. and Baharumshah, A. Z Does PPP Hold between Asian and Japanese Economies? Evidence using Panel Unit Root and Panel Cointegration. Japan and the World Economy, 13, Baharaumshah, A.Z., and Ariff, M., Purchasing Power Parity in Southeast Asian Countries Economies: A Cointegration Approach. Asian Economic Journal, 11,

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