Friday, January 9, 2015

Commodities and Currencies Part II (Very Wonkish)

I’ve maintained that the decline in the Ringgit is largely a function of the decline in global oil prices. Here’s some proof (or to be more precise, corroborating evidence):


The above charts show daily price movements of a barrel of Brent crude (in USD terms) and the USD/MYR exchange rate (in MYR terms) since 2012. The graphs are fairly similar, with a positive correlation of 60.5% between the two series.

Correlation is of course not the same as causation. You can’t say from the above that one causes the other. So I ran through a couple of different models to prove causality exists in the statistical sense. If you don’t want to go through all the technical stuff, you can jump to the conclusion.

First up is a couple of straightforward linear regression (in log form), which yields the following (standard errors in {}):

LOG(USDMYR) = 0.075{0.01}*LOG(USDXCB) - 1.51{0.05} + [AR(1)=0.99[0.00]] R2=0.987

LOG(USDXCB) = 0.70{0.11}*LOG(USDMYR) + 5.54{0.13} + [AR(1)=1.01{0.00}] R2=0.991

The AR terms were required handle serial correlation in the error terms. Unit root tests of the residuals (using ADF and KPSS tests) confirm stationarity, which means that there is a long run relationship between Brent prices and the USDMYR exchange rate. The direction of causality can’t be determined however, as both regressions are equally valid.

[Students might recognise this as the original Engle-Granger approach to testing for cointegration]

So on to the next –a VAR:


The lag length of one was chosen by examining lag length criterion methods like AIC and SIC, the majority of which suggested a lag of one (I tested up to lag 30). Log transformation of the variables yielded largely similar results, so I’m not bothering to report those. Even without fiddling with AR terms, the R2 is very high at 0.988.

Just examining the standard errors will tell you all you need to know – USDMYR doesn’t help determine Brent prices, but the opposite is not true. The standard error for the coefficient of the USDMYR(-1) term for the USDXCB vector is larger than the coefficient itself, i.e. the null hypothesis that the coefficient is not statistically different from zero cannot be rejected. The other coefficient estimates are all statistically significant.

More formally:


USDXCB Granger causes USDMYR, but USDMYR does not Granger cause USDXCB.

To put all this into laymen’s terms, I’ve proven statistically that Brent prices move first followed by the MYR exchange rate, and that there is a close relationship between the two.

Unfortunately, because of the lag length of one, you can’t test for cointegration via the Johansen procedure, otherwise it might be possible to determine the underlying structural form of the relationship via a vector error correction model. That could possibly be done with an ARDL Pesaran-Shin bounds testing procedure, but I don’t have the software for that.

One other thing gleaned from this whole exercise: the forecast estimates suggest the sell down in the Ringgit has been excessive – it’s now substantially lower than the long term relationship suggests. With Brent at USD50 per barrel, the implied USDMYR exchange rate should be about 0.295, or RM3.38 per USD, compared to yesterday’s exchange rate of RM3.57. That’s approximately a 5.4% difference.

As usual, the FX markets have overshot the fundamental value.

Technical Notes:

  1. Exchange rate and Brent crude oil data from the Pacific Exchange Rate Service


  1. Great article. Its so nice to see how you apply theory into practice.

  2. These findings, though interesting and factually verifiable, are not unexpected. Given the role of oil in the national revenue base, any decline in crude prices is bound to have the stated impact. In fact, the 3.57 range is not far off from the 3.50 speculated by Maybank. And I reckon the current value is consistent with this simple observation:

    "Declines in Ringgit vs USD and crude oil prices so far suggests every USD10/bbl drop in crude oil price can result in 6 sen depreciation in Ringgit vs US Dollar based on end of day closing prices"

    So there is no oversell as the data implies.
    Even more pertinent is this observation:

    "At the same time, our FX Research Team noted the elevated short-term correlation between Ringgit
    and crude oil price in recent months i.e. 0.93 in Aug
    -Dec 2014 compared with the longer term correlation of 0.71 for the July 2005 - Dec 2014 period"

    which more or less also explains the MYR decline in tandem with Brent crude.

    Be that all the above may entail, one wonders if the 1997 Ringgit decline could be mapped similarly. I doubt that is the case as I wager reliance on crude revenue now far outstrips reliance back then and moreover crude was not sliding back then. That by itself, reflects how reliant on oil revenue the local economy has become over the last decade, starting 2004

    And you would find a similar pattern if you, say map the Venezuelan, Libyan,Iranian etc currencies with falling crude and therein would lie the g-spot to everything why....hahahahaha

    The Indomitable Skull and Bones

    1. @anon

      Read the first sentence of paragraph three of my blog post. If correlation and similar price patterns were all that mattered, I wouldn't have bothered writing this blog post. I'm getting fed up with analysts showing me correlations, as if that matters at all. Lots of market prices are correlated but are otherwise not linked in any way. Correlations are meaningless unless you can demonstrate causality.

      Second, absolute export revenue from crude oil and condensates has doubled since 2000, but as a ratio to total exports, the share has fallen steadily and is now a third lower than it was a decade ago.

      Crude oil production in Malaysia also peaked in 2004, and is now 25% lower.

  3. Relax, you shouldn't be so snarky. I am not the analyst, you are. I just quote from authoritative sources that probably tell me otherwise though admittedly I am not from your field:

    The reality, is we are highly dependent on petroleum and its ancillary companion, LNG revenue, now more than ever.

    The Indomitable Skull and Bones

  4. @anon

    LNG yes, petroleum yes; crude no. That may seem like nit-picking, but it really isn't. Pricing structures for LNG and petroleum products are not necessarily tied to crude oil prices. Even actual LNG sales are not dependent on spot LNG prices.

    More to the point, taking all the above together is still only around 10% of Malaysian exports. The numbers look large, but not in relation to total trade.

    1. Sorry, that last number was a typo, it's actual about 20%

  5. wheres the like button?


  6. nice article bro, i just have one question, how to determine the correlation between Malaysia's commodity and its currency. since you have mention that "there are positive correlation of 60.5% between the two series of graph." i realized that there must have specific formula to calculate it. Hopefully you can answer my question since currently i am doing research study related to this topic.

    1. @anon

      I use EViews:

      ...but it isn't cheap.

      Actually, it can be done in Excel as well, using the CORREL function.