Interrelationships among stock prices of Taiwan and Japan and NTD/Yen exchange rate

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Abstract

Since the Asian Financial Crisis in 1997, the relationship between stock prices and exchange rates has received considerable amount of attention from the economists, international investors and policy makers. The work reported here employs various linear and non-linear, time-series methodologies to investigate the short-term and long-term interrelationships among the stock prices of Taiwan and Japan and the NTD/Yen exchange rate during the period of January 1991–July 2005. The findings from this study include: firstly, the stock prices of Taiwan and Japan impact each other for short durations; secondly, with regard to relationship between stock prices and exchange rates, the portfolio approach is supported for the short-term and the traditional approach is more plausible for the long-term in the Taiwanese financial market, whereas the portfolio approach is not suitable for the Japanese stock market; and thirdly, there appears to be no long-term relation between NTD/Yen exchange rate and the stock prices of Taiwan and Japan.

Introduction

The Asian Financial Crisis (AFC) in 1997 struck the economy of many Asian countries. They have experienced the continuous devaluation of their domestic currencies and severe hit against the stock markets. However, the financial and economic conditions in these countries have since gradually recovered. Nevertheless, the issue of whether stock prices and exchange rates are related has brought out considerable attention from the economists, international investors and policy makers. Empirically or theoretically, many economists suggested a significant relationship between exchange rates and stock prices.2 However, the results are quite mixed with the sign and causal direction between exchange rates and stock prices.3,4 Mok (1993) found weak bi-directional causality between stock prices and the exchange rates, while Bahmani-Oskooee and Sohrabian (1992) and Nieh and Lee (2001) argued for a bi-directional causality between stock prices and exchange rates in the short run but not in the long run.

Because the total value of Japanese international trade is placed third globally, second only to America and Germany, Japan plays a very important role in the global economic and financial system. On the other hand, Taiwan's economy is highly open to international trade and investment. Thus the volatility of exchange rate of the New Taiwan Dollar (NTD) against the currencies of Taiwan's major trading partners (e.g. the US Dollar and the Japanese Yen) may affect both the exporters and importers significantly in Taiwan. For instance, if the exchange rate appreciates, exporters will lose their competitiveness in international markets. Their profits will shrink, and the stock prices will drop. On the contrary, if the exchange rate depreciates, importers will lose their competitiveness in domestic markets (consumers may not afford to purchase “higher-price” imported products), their sales and profits will be reduced, and the stock prices will drop as a result.

Due to the mutual effects of exchange rates on stock prices as mentioned above, it is difficult to predict the overall impact of the varying exchange rate on the Taiwanese and Japanese stock markets. Whether it is favorable or unfavorable depends on the entire industrial structure within a country. Studies emphasizing on the impact of the exchange rate on stock price for Taiwan can be found in Wu (1997), Guo and Wu (1998) and Chiao, Hung, and Nwanna (2001); whereas Choi, Hiraki, and Takezawa (1998), He and Ng (1998), Doukas, Hall, and Lang (1999), Caporale, Pittis, and Spagnolo (2002), Elyasiani and Mansur (2005) and Homma, Tsutsui, and Benzion (2005) among others, studied the relationship between the exchange rate and stock price of Japan.

For an extended period of time Taiwan has experienced a widening trade gap (deficit) with Japan. The main explanation could be that the majority of Taiwan imports from Japan are more capital-intensive and comparable expensive goods; while the majority of Taiwan exports to Japan are more labor-intensive and cheaper goods. This degenerating condition of trade imbalance with Japan has remained unchanged so far. In fact, for any country faced with a high trade deficit, the obvious way to solve this problem is either with quantitative restrictions, or high duties on imports, or a devaluation of domestic currency. However, there is no perfect solution among these three options. In particular, the way of devaluation may involve some inflationary consequences to the extent it raise prices of imports. This problem still requires attention because the more open the economy of a country is, the more vulnerable it is to macroeconomic shocks from abroad through shifts in the trade balance. Additionally, as an export-oriented country, Taiwan heavily depends on electronics products exported to its major trading partners. Japan, like most of the other Asia-Pacific countries, is a main competitor to Taiwan. In the case when the exchange rate of NTD against Japanese Yen (NTD/Yen) appreciates, Taiwan exporters may lose their competitiveness in the world markets and their stock prices would shrink. Studies investigating the causal relations and the international transmission between these two financial assets of Japan and Taiwan can also be found in Sewell, Stansell, Lee, and Below (1996), Chen and Wu (1997), Granger, Huang, and Yang (2000) and Pilbeam (2001).

In prior empirical studies concerning the exchange rate, the US dollar was mostly utilized as the base-currency, while a few studies used the Japanese Yen instead.5,6 Because Japan is one of the major trading partners of Taiwan, the exchange rate of the NTD/Yen plays a crucial role and may possibly influence Taiwan's economy as well as stock market. Therefore, while investigating the relationship or financial transmission between these two countries, it may be more appropriate to consider Yen as the base-currency (i.e. NTD/Yen in this paper).

The main purpose of our study is to fully investigate the dynamic short-term causal relations and the long-term equilibrium relations between these two major financial assets, the stock prices of Japan and Taiwan and the exchange rate, by employing various conventional and advanced time-series techniques. The findings of the lead–lag relations and the long-term co-movements among the three variables considered may provide the multinational enterprises and the international investors an excellent reference for their asset allocations.

More recently, it has been suggested that linear conventional time series methodologies fail to consider information across regions, and lead to inefficient estimations and lower testing power. One proposed approach to increase power in testing is to consider the use of non-linear techniques. In this study, we attempt to employ the advanced time-series methodologies, incorporating the endogenous structural break, namely Zivot and Andrews (1992) (hereafter ZA) for the unit root test and Gregory and Hansen (1996) (hereafter GH) for co-integration, to investigate and analyze the dynamic short-term causal relations and long-term co-movements among the three variables considered.

The remainder of this paper is organized as follows: Section 2 describes the data used in this study, Section 3 introduces the methodologies used, Section 4 presents the empirical results, and Section 5 concludes this paper.

Section snippets

Data

This research is conducted using the basis of the NTD/Yen exchange rate,7 closing Taiwan Stock Exchange Index (TW stock) and the Nikkei 225 Index (JP stock). Data are collected from the AREMOS Statistical Data Bank of Ministry of Education, Taiwan. The sample period runs from January 1991 to July 2005, for a total of 175 monthly observations are obtained for each variable. This specific

Methodologies

This paper utilizes various time-series models, conventional linear and advanced non-linear algorithms, to analyze the long-term and short-term interrelationships among stock prices of Taiwan, Japan, and the NTD/Yen exchange rate.

Empirical results

Firstly, the results of the three unit root tests, ADF, PP and NP, are summarized in Table 1, which show that the null of non-stationarity cannot be rejected for any levels of the series. After first differencing, however, the null is rejected at least at the 5% significance level for all series. We thus conclude that all the variables considered in this paper are the I(1) type series.

We further adopt the advanced ZA non-linear unit root test considering a structural break. The results of the

Conclusion

This study attempts to employ both the conventional and advanced time series methodologies, incorporating endogenous structural break to explore the dynamic short-term and long-term interrelationships among the NTD/Yen exchange rate and stock prices of Taiwan and Japan. Firstly, it is found that from both conventional ADF, PP, and NP tests and advanced ZA test with structural break, all variables are insured I(1) non-stationary time series. For the long-term equilibrium relationship, the

Acknowledgement

The authors acknowledge Professor Dutta for his valuable comments and suggestions in the 2005 International Conference on Business and Finance held in Tamkang University, Taiwan. Those comments have greatly enhanced the quality of this paper.

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