Were the East Asian currencies overvalued according to purchasing power parity? : a cointegration approach

Abstract

As a result of the recent East Asian crisis, all regional currencies have lost their value. An interesting issue to address would be whether the East Asian currencies were overvalued precipitating the crisis and whether they would rebound to their original equilibrium levels, and if so, the speed of adjustment towards equilibrium. This thesis proposes to examine these issues by referring to the theory of Purchasing Power Parity (PPP) and Uncovered Interest Rate Parity (UIP) by using the Johansen multivariate cointegrating technique. In order to use these theories, they have to be empirically valid and relevant. The first part of this thesis examines the validity of the long-run bilateral and multilateral PPP relationships. Tests for PPP were conducted using quarterly data for seven East Asian countries - Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand - all relative to the US dollar, Japanese yen or a trade-weighted index over the 1973Q3 - 1998Q2 period. The deflators used in this paper are the consumer price indices (CPIs) and wholesale price indices (WPIs). Evidence was found only for the weak form and semi-strong form PPP. Therefore, the PPP relation was augmented with interest rate differentials. Although there is more evidence of cointegration, there is still limited support for the strong form PPP, even with the presence of interest rates. The second part of the thesis examines the misalignment measures. The evidence leans towards an overvaluation of at least six currencies, the exception being the Taiwanese dollar.