This study examines the existence of long-run equilibrium relationship between the Cambodia’s real exchange rates and real interest differentials. The results of cointegration tests (i.e. Engle-Granger tests, and Johansen’s multivariate tests without and with structural breaks) show that these variables are cointegrated over the sample period of November 1994 - August 2009. This empirical finding illustrates the fundamental understanding of the role of real interest differential in determining real exchange rates in Cambodia, and it is useful for policy considerations.Cambodia; Real exchange rates; Real interest differentials

Tuck Cheong Tang

English

Research Papers in Economics

 
Department of Economics 
Issn 1441-5429 
Discussion paper 08/10 
 
Real Exchange Rates and Real Interest Differentials: The Case of a 
Transitional Economy - Cambodia 
 
Tuck Cheong Tang
1 
 
 
 
Abstract: 
This study examines the existence of long-run equilibrium relationship between the 
Cambodia’s real exchange rates and real interest differentials.  The results of cointegration 
tests (i.e. Engle-Granger tests, and Johansen’s multivariate tests without and with structural 
breaks) show that these variables are cointegrated over the sample period of November 1994 - 
August 2009.  This empirical finding illustrates the fundamental understanding of the role of 
real interest differential in determining real exchange rates in Cambodia, and it is useful for 
policy considerations.    
 
Key words: Cambodia; Real exchange rates; Real interest differentials 
 
JEL classifications: F30; F41 
 
 
 
 
 
 
 
 
 
 
                                                           
1 School of Business, Monash University Sunway campus 
 
© 2010 Tuck Cheong Tang 
All rights reserved. No part of this paper may be reproduced in any form, or stored in a retrieval system, without the prior 
written permission of the author. 
 1.  Introduction 
 
Cambodia is one of the transitional economies in South East Asia, which has 
undergone several episodes of transition over the past decades.  Starting from a planned 
economy to a market economy in the late 1980s, and continuing to make a substantial 
transition from an agricultural based economy to an industry and services based economy in 
the recent decades.  Nevertheless, an important research concern has to be made on Cambodia 
since the country has been dollarized suddenly in the early 1990s.
2   It is mainly due to the 
lack of public confidence on the domestic currency (Riel) and also of politically instability.  
Interestingly, as the empirical evidence reported by Zamaroczy and Sa (2002), Cambodia has 
been virtually fully dollarized since 1995.
3  Under the era of dollarization, the essential 
economic policies such as monetary, fiscal, international trade policies and so on are not fully 
available to Cambodia (Kang, 2005, p. 201).  Theoretically speaking, dollarization does help 
in stabilizing the domestic price level.  However, it does not work well as the Cambodian 
inflation rates are rather unstable.
4 
  
As illustrated by the time series plots in Figure 1, the Cambodian foreign exchange has 
experienced depreciation in Riels over the period October 1994 - August 2009.  A substantive 
depreciation occurred between 1995 and 1998, and it was followed by a significant 
depreciation for the remaining periods as shown by a gradually upward trend since 1998. The 
averaged exchange rates have depreciated from 2,486 Riels/$US in 2005 to 4,054 Riels/$US 
in 2008.  In fact, the Cambodian government cannot protect its economy from outside shocks 
through the control of exchange rates and the foreign exchange market (Kang, 2005, p. 205) 
due to the loss of flexibility and independence in monetary and exchange rate policies as a 
result of dollarization.  Meanwhile, the banks and the financial institutions have been 
authorized to determine the level of interest rates on deposits and loans in both of the local 
currency and foreign currencies according to each institution’s ability and interest rate policy.
5  
Recently, the other interest rates on financial assets such as T-bill rates, bond rates and so on 
do not exist in Cambodia – no such financial market recently exists in Cambodia.  The deposit 
rates are decreasing from an average of 8.39 % p.a (2008) to 1.91% p.a (2008), while the 
lending rates (cost of borrowings) are slightly declined from 18.59 % p.a in 2005 to 16.01% 
p.a in 2008. Both the deposit rates and the lending rates are co-moving since 1995 to 2001, 
but divesting then with a wider differential between these interest rates, for example as in 
August 2009, the deposit rate is 1.5% p.a., while the lending rate is 15.97% p.a.  These 
volatilities can be explained by the structural reforms in the interest and external policy that 
have been proposed and partly implemented such as the Financial Sector Development 
Strategy for 2006-2015, and Financial Sector Blueprint for 2001-2010.   
  
                                                           
2 The history of dollarization in Cambodia has been briefly documented and it is available to access at 
ftp://202.47.111.146/ftp/other_publications/NoteMD117-14%20article%20dollarization.pdf Accessed: 31 
December 2009. 
3 Consistently, (Ra, 2008)’s study has found that the dollarization is the strongest for Cambodia than of Vietnam 
and Laos. 
4 The inflation rate is about 1.1% p.a  (per annual) in 1995, and it was increased extremely to 10.1% p.a. in 1996.  
However, deflation of -0.8 and -0.6 have been occurred in 2000 and 2001, respectively.  Recently, the 
Cambodian inflation rates are rising from 1.2 % p.a. (2003) to 7.7% p.a (2007), while there is as high as 25% p.a 
in the year of 2008.  These statistics are obtained from the World Tables, World Bank.   
 
5 Prakas on The Liberalization of Interest Rate Setting The Governor of the National Bank of Cambodia, Article 
1. http://www.nbc.org.kh/read-prakas.asp?id=67#top (Accessed: January, 6 2010). 2,000
2,500
3,000
3,500
4,000
4,500
0
5
10
15
20
1996 1998 2000 2002 2004 2006 2008
Riels/$US
Deposit Rate % pa
Lending Rate % pa
 
(Source: International Financial Statistics, IMF) 
Figure 1 Plot of nominal exchange rate, deposit rate, lending rate for October 1994 – 
August 2009. 
 
More recently, Cambodia has been considered as a case study for empirical investigations of 
the fundamental topics of international macroeconomics.  For example, in 1998 Joyeux and 
Worner (1998) studied the PPP (purchasing power parity) hypothesis in Cambodia. By using 
monthly observations of January 1991 to April 1997, they found that the market rate (bilateral 
buy end-of-period market rate Riels/$US) is determined by PPP in the long-run. Consistently, 
Bahmani-Oskooee, et al. (2009)’s study finds that the Cambodian real exchange rates are 
stationary - which is validating the PPP hypothesis.   Recently, Ra (2008) has modeled the 
dollarization phenomenon for three transitional economies in south-east Asia, namely 
Cambodia, Laos, and Vietnam.  The empirical tests suggest positive effects of the expected 
rate of depreciation in market exchange rates on dollarization, and the coefficients are 
statistically significant only for Cambodia and Laos (not for Vietnam). By using quarterly 
data of 1996-2006, Lau and Tang (2009)’s study finds an empirical support of twin deficit 
hypothesis in Cambodia, in which the budget deficits do cause external deficits in the short-
run, and a long-run relationship does exist between these fiscal and external variables. 
 
The main objective of this study is to investigate the existence of a long-run equilibrium 
relationship between real exchange rates and real interest rate differentials in Cambodia by 
using cointegration approach.  This study extends the existing knowledge on the literature of 
international macroeconomics with a special reference to Cambodia. This theoretically 
identified equilibrium relationship is an essential input to understand the predictability of real 
exchange rates, which is relevant for the exchange policy discussions, and evaluate the 
monetary authority interdependent.
6    
 
Next section briefly describes the conceptual framework of this study, and the variables and 
data are then discussed.  Section 3 reports the empirical results of cointegration tests between 
                                                           
6 For example, Beng and Ying (2000) find a fairly robust long-run relationship between the level of the Ringgit-
US Dollar real exchange rate and the real interest rate differential over the monthly data from May 1985 to May 
1996. They suggest that impossible holy trinity holds, in which the monetary authority is not able to the 
exchange rate from the effect of domestic monetary policy. real exchange rates and real interest differentials for Cambodia, and conclusion is made in 
Section 4. 
 
 
2.  Theoretical framework and Data  
 
Long-run equilibrium relationship between real exchange rates and real interest 
differentials is theoretically derived from both the PPP (purchasing power parity) and the UIP 
(uncovered interest parity) (see Meese and Rogoff, 1988). The final derivation yields an 
equation which captures long-run equilibrium relationship between real exchange rate and 
real interest differentials (Nakagawa, 2002, pp. 632-633) as in equation (1).   It is more 
commonly named as sticky-price model of exchange rate determination which ex ante 
purchasing power parity is held in the long-run (see, Bahmani-Oskooee, et al. 2009) that the 
PPP is hold for Cambodia). 
 
k t k t k t t c r r q        ) (
*
, ,             (1) 
where q is real exchange rate; r is real domestic interest rate; 
*denotes foreign (world) 
country; c is a constant term; and ε is residuals.  This reduced form equation depicts the real 
exchange rate of the home currency is reversely related to the difference between domestic 
and foreign real interest rates (Nakagawa, 2002, p. 633). Equation (1) is similar to Model Ia 
by Beng and Ying (2000, p. 96).   
 
 
The monthly data of real exchange rates (q) and real interest rate differentials (i.e. 
deposit rate - inflation rate, r
D and lending rate - inflation rate, r
L) spans between November 
1994 and August 2009.   The raw data are obtained from the International Financial 
Statistics, International Monetary Fund. The real interest rates are constructed by multiplying 
nominal exchange rates, Riels/$US with a ratio of foreign price level to domestic price level 
(i.e. U.S.’s CPI and domestic CPI, respectively). The real rate of interest is the difference 
between nominal interest rate (i) and inflation rate. The domestic interest rates (i) are deposit 
rates (i
D) and lending rates (i
L) since the relevant rates of returns such as T-bill rates and bond 
rates do not exist in Cambodia.  
   
 
A standard procedure to cointegration is to ensure the underlying macroeconomics 
variables are non-stationary or I(1) process (Engle & Granger, 1987). Table 1 illustrates the 
results of augmented Dickey-Fuller (ADF) tests that the three variables are non-stationary in 
levels, but stationary after the first-differenced ~ I(1).  It allows cointegration testing.  
 
Table 1 Augmented Dickey-Fuller (ADF) tests (Dickey & Fuller, 1979) 
Varaibles  Test statistics 
q  -0.609 (0.978) [1] 
∆q  -4.240 (0.001)*** [7] 
r
D  -0.934 (0.949) [11] 
∆r
D  -22.057 (0.000)*** [0] 
r
L  -1.864 (0.669) [8] 
∆r
L  -22.067 (0.000)*** [0] 
Notes: Level constant and trend, first-differenced constant only.   Maximum of 13 lags modified AIC [.] 
p-value in (.)  *** denotes significant at 1% level.  
 
 3.  Empirical Results  
 
Initially, Engle and Granger (1987)’s two-step procedure is applied on equation (1).  
The Ordinary Least Squares (OLS) estimations and ADF tests on the estimated residuals, ε 
(ε
’) are reported in Table 2.  The real interest rate differential for Cambodia’s deposit rates 
(r
D) has significant negative impact on the Cambodian real exchange rates, while the real 
interest rate differential for Cambodia’s lending rate (r
L) exhibits positive relationship.  
However, the ADF tests on the residual series (u and u
’) suggest cointegrating relation q -r
D, 
but it is not the case for q -r
L.    Hence, a long-run estimation of relation q- r
L, can be 
considered as ‘spurious’ regression, or no long-run relationship between q and r
L. 
 
 
Table 2 Engle-Granger cointegration tests 
            q = -0.016r
D +8.219 + u 
       p-value (0.000)   (0.000) 
 
ADF (ε) test statistic, -1.682 (0.088)
**  
            q = 0.009r
L +8.092 + u
’ 
      p-value (0.028)    (0.000) 
 
ADF (ε
’) test statistic, -1.267 (0.189) 
Note: 
** denotes significant at 5% level.  
 
  The long-run relationship between real exchange rates and real interest rate 
differentials is further reaffirmed by the Johansen’s multivariate tests Johansen and Juselius 
(1990) with imposing various lag length as suggested by a set of information criterions (see 
Table 3). Both the trace statistics and maximum eigen-value statistics show a cointegrating 
vector of q - r
d rather than of q – r
L, which is in line with the former finding of Engle-Granger 
tests.    
 
 
 
 
 
 
Table 3 Johansen’s multivariate cointegration tests 
  q - r
d  q - r
L 
  SC  HQ  LR, FPE & AIC  SC & HQ  FPE & AIC  LR 
Lag length  2  3  12  2  5  9 
Trace statistics  20.509
*** 
(0.008) 
18.731
** 
(0.016) 
23.605
*** 
(0.002) 
11.006 
(0.211) 
10.252 
(0.262) 
7.441 
(0.527) 
 
Max-Eigen 
statistics 
 
18.648
** 
(0.010) 
 
17.281
** 
(0.016) 
 
19.048
*** 
(0.008) 
 
9.659 
(0.235) 
 
7.101 
(0.477) 
 
4.535 
(0.799) 
Notes: The trend assumption allows for liner deterministic trend in data, while the intercept (no trend) is imposed 
into cointegrating equation and test VAR.   LR: sequential modified LR test statistic; FPE: final prediction error; 
AIC: Akaike information criterion; SC: Schwarz information criterion; and HQ: Hannan-Quinn information 
criterion.  The null hypothesis of none cointegration vector is being tested by the trace statistics and maximum 
eigen-value statistics.  
*** and 
**  denote significant at 1% and 5% level, respectively, and  (.) is p-value.  
 
 
To note that both cointegration testing procedures of the Engle-Granger tests and the 
Johansen’s multivariate tests do not take the possible structural breaks into account since it is 
relevant for Cambodia which is experiencing a series of structural reforms and shocks in the 
country over the past decades. Applying the approach proposed by (Lanne, et al. (2002), two 
break dates have been detected and identified i.e. 1995M4 for the q, and 1997M7 for both r
D and r
L.
7   The Johansen’s multivariate tests with two break dates show the existence of a 
cointegrating vector between q and r
d, while no cointegration has been suggested for between 
q and r
L.   
 
 
Table 3 Johansen’s multivariate tests with unknown structural breaks 
Long-run relation  Trace statistics for the null hypothesis of none 
cointegrating vector, r0 = 0 
q -r
D  38.38 (p-value, 0.0018)
*** 
q -r
L  21.54 (p-value, 0.2554) 
Notes:  Two break dates have been identified i.e. 1995M4 for real exchange rates (q) and 1997M7 for deposit 
rates and lending rates (R
D and R
L). Three lags as suggested by AIC from a maximum of 12 lags.  An intercept is 
included.  *** denotes significant at 1% level.  The computation of trace statistics with two break dates were 
carried out by JMulti statistical software (http://www.jmulti.de/). 
  
 
4.  Conclusions 
 
This study explores the long-run equilibrium relationship between real exchange rates of 
Riels/$US and real interest differentials in a transition economy, Cambodia.  A battery of 
cointegration tests i.e. Engle-Granger tests, Johansen’s multivariate tests without and with 
unknown structural break(s), have been used for analysis. The monthly data between 
November 1994 and August 2009 supports this theoretical relationship between real exchange 
rates and real interest rate differentials (Cambodia’s deposit rates).   This finding initially 
enhances fundamental knowledge of the so-called sticky-price model of exchange rate 
determination in Cambodia, in which the country’s real exchange rates can be predicted by 
the variation between domestic real interest rates (real deposit rates, r
D) and world real 
interest rates (r
*).  By the same token, as following Beng and Ying (2000), the impossible 
holy trinity is held for Cambodia, in which theoretically, the monetary authority (National 
Bank of Cambodia) is not able to insulate the exchange rate from the effect of domestic 
monetary policy. Perhaps, the finding from this study is elementary in order to gather an 
empirical output on the basic real exchange rate model, rather than offering an advanced 
framework which taking into consideration of a dollarized country.    
 
 
References 
Bahmani-Oskooee, M., Kutan, A. M., & Zhou, S. (2009). Towords solving the PPP puzzle: 
evidence from 113 countries. Applied Economics , 41 (24), 3057-3066. 
Beng, G. W., & Ying, S. L. (2000). Exchange rate and interest rate differential: the case of the 
Malaysian Ringgit/US dollar. Applied Economics Letters , 7 (2), 95-97. 
                                                           
7 The procedure involves choosing a reasonably large AR order as a first step, then picking the break date which 
minimizes the GLS objective function used to estimate the parameters of the deterministic part.  The two break 
dates suggested above may be linked to the following events that the Cambodian economy has been expanded 
and financial intermediation has been deepened since 1995, which later causes the fluctuations in the 
composition of agents’ dollar assets (Zamaroczy & Sa, 2002, p. 20). According to (Zamaroczy & Sa, 2002, p. 3), 
although, the country has achieved good economic progress during 1994-1995 under the International Monetary 
Fund (IMF) supported program, factional fighting broke out briefly in July 1997, resulting in a temporary 
setback in development and foreign investment.  
 Dickey, D. F., & Fuller, W. A. (1979). Distribution of the estimators for autoregressive time 
series with a unit root. Journal of American Statistical Association , 74 (366), 427-431. 
Engle, R. F., & Granger, C. W. (1987). Cointegration and error correction: Representation, 
estimation, and testing. Econometrica , 55 (2), 251-276. 
Johansen, S., & Juselius, K. (1990). Maximum likelihood estimation and inference on 
cointegration - with applications to the demand for money. Oxford Bulletin of Economics and 
Statistics , 52 (2), 169-210. 
Joyeux, R., & Worner, W. E. (1998). Price and exchange rate determination between the 
Mekong river economies of Cambodia and Thailand. Journal of the Asia Pacific Economy , 3 
(3), 424-445. 
Kang, K. (2005). Is dollarization good for Cambodia? Global Economic Review , 34 (2), 201-
211. 
Lanne, M., Lutkepohl, H., & Saikkonen, P. (2002). Comparison of unit root tests for time 
series with level shifts . Journal of Time Series Analysis , 23 (6), 667-685. 
Lau, E., & Tang, T. C. (2009). Twin deficits in Cambodia: an empirical study. Economics 
Bulletin , 29 (4), 2789-2800. 
Meese, R., & Rogoff, K. (1988). Was it real? the exchange rate-interest differential relation 
over the modern floating-rate period. Journal of Finance , 43 (4), 933-948. 
Nakagawa, H. (2002). Real exchange rates and real interest differentials: implications of 
nonlinear adjustment in real exchange rates. Journal of Monetary Economics , 49 (3), 629-
649. 
Ra, H.-R. (2008). Modeling the dollarization: a case study for Cambodia, Laos, and Vietnam. 
Global Economic Review , 37 (2), 157-169. 
Zamaroczy, M. d., & Sa, S. (2002). Macroeconomic adjustment in a highly dollarized 
economy: the case of Cambodia. International Monetary Fund. 
 
 

Cointegration and error correction: Representation, estimation, and testing.

Comparison of unit root tests for time series with level shifts .

Distribution of the estimators for autoregressive time series with a unit root.

Exchange rate and interest rate differential: the case of the Malaysian Ringgit/US dollar.

Is dollarization good for Cambodia?

Macroeconomic adjustment in a highly dollarized economy: the case of Cambodia. International Monetary Fund.

Maximum likelihood estimation and inference on cointegration - with applications to the demand for money.

Modeling the dollarization: a case study for Cambodia, Laos, and Vietnam.

Price and exchange rate determination between the Mekong river economies of Cambodia and Thailand.

Real exchange rates and real interest differentials: implications of nonlinear adjustment in real exchange rates.

Towords solving the PPP puzzle: evidence from 113 countries.

Twin deficits in Cambodia: an empirical study.

Was it real? the exchange rate-interest differential relation over the modern floating-rate period.

Real Exchange Rates and Real Interest Differentials: The Case of a Transitional Economy - Cambodia

http://www.buseco.monash.edu.au/eco/research/papers/2010/0810cambodiatang.pdf

Real Exchange Rates and Real Interest Differentials: The Case of a Transitional Economy - Cambodia

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics