This study has found an empirical support of Purchasing Power Parity (PPP) theory for an East Asia transition economy – Cambodia. It is based on the results of cointegration among KHR/USD, Cambodia CPI, and world CPI over the monthly period May 2001-February 2009. This finding is useful for policy implications i.e. de-dollarization (and exchange rates) policy designs in Cambodia.Cambodia; Dollarization; Exchange Rates; Purchasing Power Parity

Tuck Cheong Tang

Venus Khim-Sen Liew

English

Research Papers in Economics

     
 
 
  
  
Volume 30, Issue 2 
  
An empirical investigation of purchasing power parity for a transition economy 
- Cambodia 
  
 
 
Venus Khim-Sen Liew  
Faculty of Economics and Business, Universiti Malaysia 
Sarawak 
Tuck Cheong Tang  
Department of Economics, School of Business, Monash 
University Sunway campus
Abstract 
This study has found an empirical support of Purchasing Power Parity (PPP) theory for an East Asia transition 
economy – Cambodia. It is based on the results of cointegration among KHR/USD, Cambodia CPI, and world CPI 
over the monthly period May 2001-February 2009. This finding is useful for policy implications i.e. de-dollarization 
(and exchange rates) policy designs in Cambodia.
 
Citation: Venus Khim-Sen Liew and Tuck Cheong Tang, (2010) ''An empirical investigation of purchasing power parity for a transition 
economy - Cambodia'', Economics Bulletin, Vol. 30 no.2 pp. 1025-1031. 
Submitted: Sep 17 2009.   Published: April 21, 2010. 
 
      
 
1 
 
1. Introduction 
 
Purchasing Power Parity (PPP) hypothesis postulates that in an efficient market, identical basket 
of goods and services faces the same price in different countries when converted to a common 
currency.  In other words, nominal exchange rate is adjusted to reflect differences in price levels 
across countries.  The validity of PPP does reflect relative prices in determination of  foreign 
exchange rate.  In addition, PPP can be used to judge whether the nominal exchange rate is 
under-valued or over-valued, while PPP also implies integration of the goods markets of the 
countries.  PPP depicts the international competitiveness of a country’s goods and services. In 
general, empirical studies support that PPP holds in the long-run.
1 
 
The current study aims to contribute to the  existing literature of PPP by exploring the case of a 
transition economy in East Asia. Other transition economies are China, Lao People's Democratic 
Republic and Vietnam.
2 Cambodia provides an interesting sample country in the PPP framework 
mainly due to the natural of exchange system in the country.   From the Sihanouk period (1953-
1970)  to  Democratic  Kampuchea period  (1975 -1978),  post-Democratic  Kampuchea  period, 
Cambodia’s exchange rate systems have undergone several revolutions.
3  In 1990, Cambodian 
Riel was introduced with two exchange rate systems namely (1) official rate - which is classified 
as managed floating by International Monetary Fund   (IMF)  and is  mostly  used for  external 
transactions; and (2) the parallel rate , which  is  tolerated by the g overnment and it actually 
dominates interbank and most other transactions (IMF, 1997, p.154).   
 
In the era of dollarization ( suddenly introduced in the early 1990s), the share of the USD has 
reached more than 70% of the total currencies (Kang, 2005), and the USD circulates freely and is 
used for payment in Cambodia (IMF, 1998, p. 166).   Interestingly, under the highly dollarized 
economy, economic policies such as monetary, fiscal, international trade policies are not fully 
available  in  Cambodia  (Kang,  2005,  p.  201).   The  market  economy  since  1980s  and  the 
liberalization policies in the last decade in Cambodia might promote exchange rate volatility (or 
uncertainty) (Wong and Tang, 2008).  A better understanding of the fundamental of exchange 
rate – PPP is promising from the policy makers’ point of view i.e. de-dollarization. 
 
Next section describes the empirical testing method for PPP, and their findings are discussed.  
Section 3 concludes the study. 
 
 
2. Empirical Findings 
 
The PPP hypothesis has been widely examined by researchers with application of cointegration 
approach i.e. PPP is supported if the nominal exchange rate, domestic and foreign price levels 
are found to be cointegrated.   In this study, the candidate variables employed are the bilateral 
KHR/USD exchange rate (ER), the consumer price indices (CPIs) of Cambodia (P) and U.S.A. 
(P
*). The data covers monthly observations between May 2001 and February 2009 from the 
                                                             
1 See, for instance, Taylor and Taylor (2004) and Taylor (2006) for surveys on PPP study. 
2 Cambodia was one of the first least developed countries to join the World Trade Organization (WTO) in 2004. 
3 http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=13 accessed 17/9/09.  
 
2 
 
CEIC Asian Database.  For the analysis purpose, all data are then converted into logarithmic 
form, ln.  
 
The  augmented  Dickey-Fuller  (ADF)  (Dickey  and  Fuller,  1979,  Said  and  Dickey,  1984), 
Phillips-Perron (PP) (Phillips and Perron, 1988) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) 
(Kwiatkowski et al., 1992) (see Tables 1 and 2) show non-stationary for the exchange rate and 
the CPIs of both of the Cambodia and U.S.A. or they are integrated of order one, I(1).  
 
 
Table 1: Unit root test results of variables in their levels 
Variable  Unit Root Test         
  ADF    PP    KPSS 
lnER  -1.538(0)    -2.431(3)    0.212(7)
** 
lnP  -2.243(1)    -1.870(5)    0.245(7)
*** 
lnP
*  -2.827(8)    -2.732(1)    0.136(6)
* 
Critical Value           
1%  -4.06    -4.06    0.216 
5%  -3.46    -3.46    0.146 
10%  -3.18    -3.18    0.119 
Notes:  ADF, PP and KPSS denote augmented Dickey-Fuller, Phillips-Perron and Kwiatkowski-Phillips-Schmidt-
Shin (1992) unit root tests. All tests include a constant and trend terms in the estimation. Optimal lag determined by 
AIC (for ADF) and Newey-West bandwidth (for PP and KPSS) is given in parentheses. lnER, lnP and lnP
* represent 
the  natural  logarithmic  form  of  nominal  exchange  rate  (Riel  per  USD),  Cambodia’s  CPI  and  U.S.A.’s  CPI 
respectively. 
*, 
** and 
*** denote significant at 10, 5 and 1% level respectively. 
 
Table 2: Unit root test results of variables in their fist differences 
Variable  Unit Root Test         
  ADF    PP    KPSS 
∆lnER  -9.221(0)
***    -9.221(1)
***    0.050(1) 
∆lnP  -5.061(0)
***    -4.710(2)
***    0.123(5) 
∆lnP
*  -5.220(7)
***    -4.495(1)
***    0.083(1) 
Critical Value           
1%  -2.59    -2.59    0.739 
5%  -1.94    -1.94    0.463 
10%  -1.61    -1.61    0.347 
Notes: All tests include a constant term in the estimation. See also notes to Table 1. 
 
Subsequently, Johansen’s multivariate cointegration test is applied to test the validity of PPP, 
and the results (see Table 3) show a cointegrating relation – it implies that nominal exchange 
rate, and Cambodia and U.S.A. price levels are cointegrated. Thus, long-run PPP is valid for 
Cambodia.   
 
 
 
 
  
 
3 
 
Table 3. Johansen cointegration tests 
Trace Test         
Null Hypothesis  Alternative Hypothesis  Test Statistic  5% Critical Value 
0 = r   0  r   46.761
**  42.915 
1 ≤ r   1  r   18.333  25.872 
2 ≤ r   3  r   4.222  12.518 
Maximum Eigen Test         
Null Hypothesis  Alternative Hypothesis  Test Statistic  5% Critical Value 
0 = r   1 = r   28.428
**  25.823 
1 ≤ r   2 = r   14.111  19.387 
2 ≤ r   3 = r   4.222  12.518 
Notes: ** indicates rejection of the null hypothesis at 5% significance level. A VAR(13) is shown to be optimal 
based on the Likelihood Ratio (LR) statistics and Akaike Information Criterion (AIC). Intercept and linear trend 
terms are included in cointegrating equation for optimality, based on the Pantula Principle for the specification of 
the deterministic components in the cointegration test (see, for instance, Hatemi, 2002). 
 
 
Nevertheless, a fundamental question of whether the Riel (per USD) is under-valued or over-
valued  can  initially  be  answered  by  the  PPP.
4    The estimated PPP equation,  ERt  =  2.82 
+3732.26(P/P
*)t +et is used to generate the residuals series in order to depict the Cambodian 
exchange rates valuation.  As Figure 1 showed, the Riel was over-valued for the periods 2001-
2004, and 2007-2008, but under-valued the Riel in between 2004 and 2007 (including the latest 
observed periods).  In February 2009, the actual exchange rate is 4,122 Riel for one USD.  In 
fact, less Riel is actually needed to buy a Dollar (i.e. under value), since the fitted (estimated 
equilibrium value) is 4,080 riel in exchange for one USD.  
 
   
 
 
   
                                                             
4 Hoarau (2008) points out that evidence of long-run PPP implies that misalignment indicators of exchange rate can 
be obtained from simple PPP calculations. Similar determination of under-valuation or over-valuation of exchange 
rate after establishing the long-run validity of PPP was conducted in Furman and Stigliz (1998), Chinn and Dooley 
(1999),  Sazanami and Yoshimura (1999), Chinn (2000). This way of misalignment evaluation has been extended to 
the monetary model of exchange rate (see, for instance, Lee and Azali, 2005).  
  
 
4 
 
 
Figure 1. Plot of Nominal Exchange Rate (Riel per USD), Fitted and Residual, May 2001-
Februari 2009. 
 
 
3. Concluding remarks 
 
This study attempts to validate a well-examined international economics theory i.e. purchasing 
power  parity  (PPP)  hypothesis  for  a  transition  economy  –  Cambodia.  The  finding  of 
cointegration reveals that PPP is valid for Cambodia. The valuation of Riel per USD is changing 
over the sample period May 2001- February 2009, and there is a signal of under-valuation of 
Riel in the recent period i.e. January and February of 2009 (see Figure 1).  It does help to provide 
a fundamental understanding to policy makers in order to formulate exchange rates policy and 
other relevant policies in a relation to de-dollarization as focused by the Cambodian government 
(see Kang, 2005).    
 
 
 
-200
-100
0
100
200
3,800
3,900
4,000
4,100
4,200
2001 2002 2003 2004 2005 2006 2007 2008
Residual Actual Fitted
over-value 
under-value 
Fitted  
over-value 
Actual 
Residual  
 
5 
 
 
References 
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Chinn, M.D. (2000) “Three Measures of East Asian Currency Overvaluation” Contemporary 
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Dickey, D.A. and W.A. Fuller (1979) “Distribution of the Estimators for Autoregressive Time 
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Furman,  J.  and  J.  Stigliz  (1998)  “Economic  Crises:  Evidence  and  Insights  from  East  Asia” 
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6 
 
 
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08/p6808exchangewongtang.pdf (accessed 17/09/09). 
 
 
 
 
 
 
 
 
 
 

Distribution of the Estimators for Autoregressive Time Series with a Unit Root”

Economic Crises: Evidence and Insights from

Exchange Rate Volatility and International Visitor Arrivals to the Home of World Heritage

Fiscal Policy in Sweden:

Is Dollarization Good for Cambodia?”

Real Exchange Rates and Purchasing Power Parity: Mean Reversion in

Restructuring East Asian Exchange Rate Regimes”

Statistical Analysis of Cointegration Vectors”

Testing for a Unit Root in

Testing for Unit Roots in Autoregressive Moving Average Models of Unknown Order.

Testing PPP for Central American Real Exchange Rates. Evidence from

Testing the Null Hypothesis of Stationarity against the Alternative of a Unit Root”

The Purchasing Power Parity Debate”

An empirical investigation of purchasing power parity for a transition economy - Cambodia

http://www.accessecon.com/Pubs/EB/2010/Volume30/EB-10-V30-I2-P96.pdf

An empirical investigation of purchasing power parity for a transition economy - Cambodia

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