## analysis Currency Crisis Effect on the stock Market

*March 26, 2009 at 5:22 am* *
3 comments *

Currency Crisis Effect on the stock Market :

A Case Study In Indonesia

The financial crisis that started in Thailand in July 1997 has sent shock waves throughout South Korea, the Philippines, Malaysia, Indonesia and other countries. The Thai authorities could not maintain stable its currency, the Bath, linked to basket of other currencies. And finally affect the Ringgit currency, Peso and Rupiah. The crisis was under way. The crisis soon spread to the stock markets. Turmoil in both currency and stock market is of major interest : Does currency depreciation lead to stock market declines or vice versa ? this essay analysis the dynamic between stock prices and the exchange rate. From the viewpoint of microeconomic, a change in the exchange rate is expected to affect firms’ portfolios. A depreciation of the local currency most likely will increase local company’s profit, hence its stock price, especially for tradeable goods producers. The central point of this portfolio approach lies in the following argument : A decrease in stock prices reflects lower expected return which result in decline depreciation.

In this paper we employ Indonesia as a case study to investigate the causality of the relationship between the composite share price index and the exchange rate. We also analyse whether changes in the exchange rate lead to change in stock price indices for various sectors, and/ or vice versa.

2. THEORICAL ECONOMIC BACKGROUND

The Static Model

Marshall ( 1998 ) argues that the of a firm or a national economy depends on the state of investor confidence. There N identical firm, which behave competitively, and there are N identical investors (where N is a large number). Suppose that output of a firm has only a single variable input, working capital (“ liquidity”), denoted *L*. the assumption is that the firm has a fixed quantity of physical capital, *K*, and needs working capital *L*, in order to produce. Thus the return to lenders, denoted *r*, equal the marginal value product of working capital. The return to lender, *r* , or gross rate of return on working capital equal to (1+R, where R is net rate of return.

Suppose the model is :

*Q = F(K,L) *(1)

If the initial amount is not available, the firm produces zero output. So, the form of * F * is :

Where *f * is a decreasing return-to-scale production function. This function should have property of convexity. The equation (2) as the production function satisfies the following condition :

*F (K,y-L*)-FL (K,y-L*)L>0 *(3)

Where *y * is a unit of wealth of each investors. Condition is necessary in order to have a unique solution when the producer side tries to maximize the profit. Given these simplifying assumption, the total cost for firm during a period is given by :

* Total Cost = rL *(4)

Recall that *L is * working capital value, *r * is a gross are of return on working capital to the lender and assume *r =(1+R),where * R is rate of net return. Then, economic profit (π) is the difference between total revenue and total costs :

π =* F(K,L) *(5)

the firm seeks to maximize profit by choosing the optimal amount of working capital. By applying the first-order condition of the firm’s profit maximization problem . And the addition of 5 of this method are 15 other methods listed in this journal.

The Dynamic Model

After discussing the static model above, we now shift a dynamic model. The static model in the previous discussion did not account for the asset market where share in the firm can be traded. In this model, the stock market is included into a dynamic economic equilibrium.

And the addition of 5 of this method are 39 other methods listed in this journal.

Nagayasu (2000) tried to put “the Marshall’s Rational Expectations Approach” into a present value model to establish the relationship between stock prices and the exchange rate.

Sanjoyo Currency Crisis Variables :

· Stock Price,

· Dividend of the stock,

· Mathematical Expectations Conditioned on the Information.

Those variables relates the price of the stock to its expected future cash flow (dividend) discounted to the present using a constant discount rate or time-varying discount rate.

Since dividend in the future period enter the present value formula, the dividend in any one period is likely to be only a small component of the price. Similarly, the discount rate between any one period and the next is only a small component of the long-horizon discount rate applied to a distant future cash flow. Therefore persistent movement in the discount rate have much larger effect on price than temporary movements do. For this reason, we are going to expand the stock price model in the long-horizon context.

Assume that the expected discount rate is constant, R :

E_{t}(R_{t}+1)=*R* for all *t*

That expectation can be solved forward by repeatedly substituting out future price and using The Law of Iterated Expectations to eliminate future-dated expectations.

On the other hand, as the global capital market becomes more and more integrated, capital moves rapidly to find higher expected returns of to investment. The lower rate of return on domestic assets encourages capital outflow that leads to the currency depreciation. So, could be interpreted that the changes in the stock price may lead to changes in the exchange rate.

**ECONOMETRIC APPROACH **

** **

This is about the validity of the present value model for bonds, stocks, and other economic variables, to stimulate by two problems that arise in testing a linear functions of the present value of expected future economic variables. This approach means not only that the current stock price is determined by the expected value of the exchange rate but also causal relationship exist from the stock price to the exchange price.

**THE UNIT ROOT TEST**

Standard regression model is used. The assumption of classical regression model is that both the *x _{t}* and

*y*

_{t}variables is stationary and the error has a zero mean and finite variance.

Many economic and financial (stock price) series have been found to the display the characteristics of non stationary process.

**THE COINTEGRATION TEST**

Most economic and financial time series are subject to some type of trend or non-stationarity. However, this is not seem to be the ideal solution.

**VECTOR AUTO REGRESSION TEST**

In the regression model, there’s a pair of economic variables *x*_{t} and *y*_{t that and observed over time.}

**4. Empirical Result**

This study choose the rupiah exchange rate based on Banker’s Trust Company Quotation to represent the market price, The Jakarta Composite Index to represent all stock price from all listed firms. The daily data is are between 31 January 1996 until 31 July 2000.

To analyse the relationship between the exchang rate and stock prices, the data are deivided into three sub-periods in order to see how sensitive the model is to choice of period.

- Period before crisis (31 January 1996 – 1 July 1997)
- Period of peak crisis (2 July 1997 – 17 June 1998)
- Period post crisis (18 June 1998 – 31 July 2000)

In the third period the central bank began to bring base money growth under control which was effective in stabilising inflation.

**The Composite Index and Sectoral Indices**

The composite index consist of 287 firm’s stock prices and designed to capture the performance of stock exchange. The capitalization was equivalent to 45 %of GDP.

Manufacturing index is the largest capitalization of all. It’s about 42% and it’s contains of 139 firms. The second largest is infrastructure, transportation and utilities it’s about 25% of the total. The communication firms are predominant in this index. The third largest market capitalization reflects the financial index, at around 11% of the total. Trade and service in the forth place with 10% of the total. The construction, property and real estate index are in the fifth place with 6% of the total and for the result, agriculture index accounts for only a small portion of market capitalization.

**Stability Of The Exchange Rate And The Stock Indices**

The exchange rate has a unit root, or random-walk, or non-stationary is accepted for all periods. It means that the exchange rate follows a random-walk. Exchang rate changes at a particular point in time are independent of previos changes.

The test for the composite share price index shows a stationary process without trend. There was a tendency to go to a long-run mean in the post-crisis period.

Other indices that exhibit stationary are the mining and infrastructure, transportation and utilities indices. The remain sectoral indices like agriculture, manufacturing, construction, property and real estate, trade, services and investment and finance are non-stationary at level.

None of the indices was stationary in the pre-crisis periode and only the finance index was stationary during the peak crisis period.

**Long-run Equilibrium Exchange Rate and Stock Indices**

We can say that in the long run the relationship between the exchange rate and the composite share price index has a steady state or long run equilibrium.

Other relationship which have a long equilibrium are:

1. Between the exchange rate and real estate index

2. Between the exchange rate and finance index.

The finding indicate that the exchange rate has close relationship with the composite share price index and the property and real estate and finance indices.

**General Stronger Causality From Exchange Rate to Stock Price in The Post Crisis Period**

In the post-crisis period, the exchange rate had a significant affect on the composite share price index and all the stock indices.

The mining and manufacturing indices were positively affected by the exchange rate. It means, the decrease of enchange rate caused the mining and manufacturing decrease too.

The Exchange rate changes have negative effect to the changes other indices. The exchange rate changes in the composite share price index with negative sign.

**Tendency For Stonger Causality From Stock Prices to Exchange Rate During Pre-crisis Period**

There was tendency for stonger causality from stock prices to the exchange rate than in the reverse direction. Changes in the composite index and the property and real estate and trade and services make a negative sign to the changes in the exchange rate.

On the other hand, there was lack of causality from the exchange to the stock price indices during this period. It because the exchange rate was under control of the central bank n managed exchange rate regime.

**Broad Lack of Causality in The Peak Crisis**

The rupiah was became weak because of the effect from the exchange rate turmoil in Thailand. To response that pressure, Bank Indonesia decided to alter the exchange rate regime from managed float to free float.

The exchange rate changes during the peak crisis period did not affect the stock price indices except the mining and infrastructure indices.

The movement of the exchange rate cannot explain the movement of stock price indices and vice versa because there are lack of any relationship between them.

One possibilities was the economic agents faced the uncertain condition of the economy and the crisis confidence in Indonesia’s future.

**Contrast Between Tradeable and Non-tradeable Sectors**

In the post-crisis period, Exchange rate changes caused changes in the mining and manufacturing indices with positive sign. It means that any depreciation in exchange rate caused increases in the value of firms in mining and manufacturing. Depreciation of the rupiah would increase competitiveness of these sectors and raise firms’ profit thus increasing the value of their stock.

The price of listed firms in agriculture index would increase when the exchange rate appreciates. Depreciation of the rupiah lead to increase domestic inflation which effect on lower domestic demand.

The price of non-tradeable firm’s product were affected by exchange rate changes with negative sign. It means, depreciation of the rupiah caused declines in the infrastructure, property and real estate indices.

**Conclucion**

Changes in composite price index and property and real estate, financial indices provided early indication of the currency crisis when the central bank applied a managed float regime. The VAR test shows that these stock indices caused exchange rate changes before crisis period. The causality relationship between the exchange rate and the stock market indices disappeared during the peak crisis period.

Entry filed under: EKONOMI.

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