How does ppp hold between australia and its trading partners

__________________________________________________________ THE AUSTRALIAN NATIONAL UNIVERSITY School of Finance and Applied Statistics Research Project in International Finance _____________________________________________________________________ DANG H. PHAM U4278723 Research Project in International Finance: 2007 Dang H. Pham HOW DOES PPP HOLD BETWEEN AUSTRALIA AND ITS TRADING October the 26th, 2007 2 Research Project in International Finance: 2007 Dang H. Pham Table of Contents I. INTRODUCTION ......................................................................................... 4 II. LITERATURE REVIEW .............................................................................. 6 1. Theoretical background ......................................................................................... 6 2. Empirical evidences about PPP ............................................................................. 7 3. Australian evidence................................................................................................. 9 III. METHODOLOGY .................................................................................... 11 1. Test of PPP............................................................................................................. 11 2. Effects of trade and investment on PPP.............................................................. 12 IV. DATA ...................................................................................................... 13 V. RESULTS DISCUSSION.......................................................................... 15 1. PPP with 12 countries.......................................................................................... 15 2. Effect of trading and FDI on PPP ....................................................................... 20 VI. CONCLUSION ........................................................................................ 22 VII. FUTURE RESEARCH DIRECTIONS..................................................... 23 3 Research Project in International Finance: 2007 Dang H. Pham I. INTRODUCTION The interrelations between three major components of the international market (international trade, foreign exchange and capital market) are explained by the economic theories called the international parity conditions. It is considered to be unique to the field of International Finance (Eiteman, Stonehill and Moffett 2006:102). Deriving from the Law of one price, the absolute form of purchasing power parity (PPP) states that if the market is frictionless the price of identical products and services should be the same in different markets. For instance, if the price of the product in Australian dollar is PAUD, then the price of the identical product in U.S. dollar (PUSD) should be equal to PAUD adjusted for exchange rate (SUSD/AUD), or PAUD x SUSD/AUD = PUSD . Thus, the nominal exchange rate can be simply expressed as the ratio of the two prices (SUSD/AUD = PUSD / PAUD). If this is not the case, the arbitrageurs in an efficient market could make riskless profit by shipping the goods from locations where the price is low to locations where the price is high (Taylor and Taylor, 2004). They will trade the opportunity away and bring the conditions back to “parity”. If the PPP holds perfectly the nominal exchange rate adjusts to maintain a constant real exchange rate equal to 1. The relative form of PPP involves only that the change in nominal exchange rate offsets the differential between home and foreign price level. While international trade plays a vital role in a PPP , obviously the market frictions such as transportation cost, taxes, tariffs and duties, and non-tariff barriers such as quotas and import licenses are the main causes of some deviations from PPP. In recent years we have seen the emergence of multinational and bilateral free trade arrangements where governments set the objectives to bust up trades by removing trade barriers. Australia has joined WTO and signed free trade agreements with the United States and Thailand in 2005, with Singapore in 2003 and with New Zealand from 1993. It is now in negotiating Free Trade Agreements with other countries and areas such as Japan, ASEAN, Malaysia, China, Chile and Gulf countries. This research project tests the PPP between Australia and its trading partners over the period from 1984 to 2006 and provides some insights on particular effects that the level of bilateral trade and investment have on their PPP . Using quarterly of foreign exchange rates and proxy for country price level (both consumer price index and producer/whole sales price index) evidence from my sample shows that PPP holds for 4 Research Project in International Finance: 2007 Dang H. Pham some countries while it does not hold for others. Further, the higher level of bilateral trade significantly and positively associates with the higher level of PPP . Foreign investment level is found to have positive impacts on PPP but not significantly. This research is outlined as follows: Part II reviews PPP literature, in which the subsection 1 on PPP theoretical background highlights the law of one price and the role of international trade as crucial conditions for the existence of the parity condition. An overall picture about extant empirical literatures on PPP including Australian evidences is provided in subsection 2 and 3. From these reviews we develop our arguments about the impacts of trade and investment on the PPP s between Australia and its trading partners. Part III presents the hypothesis our research and the methodologies, models we use to test the hypothesis in details. Part IV describes and discuss about the data used in our research. The results of this research are reported and discussed in Part V. Conclusion is provided in Part VI; and Part VII proposes some direction for future research. 5 Research Project in International Finance: 2007 Dang H. Pham II. LITERATURE REVIEW 1. Theoretical background Economists widely believe that the PPP theory hold at least approximately because of the possibility of the international goods market arbitrage. In the formal way, the PPP theory states that the percentage change in the exchange rates over a given period simply offset the difference in inflation rates in the countries concerned over the same period. Therefore, in the relative form of PPP, according to Eiteman et al. (2006:105), “if a country experiences a higher rate of inflation, and its exchange rate does not change, then its goods prices will be relatively more expensive”. Eiteman et al. (2006:105) also states that “if the spot exchange rate between two countries starts in equilibrium, any change in differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the exchange rate”. Hence, the relative PPP is useful for forecasting the spot exchange (long run) rates from the expected inflation rates in the two countries. The model is described as follows: t f t h fh fh t S SE )1( )1()( / 0 / π π + += (1.1) or (1.2) fhfhS ππ −=Δ / Where: is the expected spot exchange rate at time t, is the current spot exchange rate, )( / fhtSE fhS /0 hπ is the inflation rate in home country and fπ is the inflation rate in foreign country. is the change in spot exchange rate in a period of time t. fhS /Δ However, international goods markets are far less liquid than financial markets and the frictions seem to be considerable and it is the fact that there is in existence goods that fall outside the various range of homogeneous goods. Therefore, short-run international arbitrage has only limited effect of leveling international goods market prices (Rogoff, 1996). While the traditional PPP theory holds that the real exchange rate should be constant and equal to 1, there is another assumption of long-run deviations from PPP. Harrod (1933), Balassa (1964) and Samuelson (1964) build their model of the equilibrium exchange rate on the observation that rich countries tend to have higher price levels than poor countries. This is because rich countries are relatively more productive in the traded high-tech goods and they grow richer as a result. Income rises as a result of 6 Research Project in International Finance: 2007 Dang H. Pham the higher productivity in tradable goods will cause price level to rise also. This effect modeled by Harrod, Balassa and Samuelson seem to be stronger over time where data show a strong positive relationship between income and price level. If this is true, then the real exchange rate is not constant over time. In general, as PPP theory is derived from the law of one price, its basic condition is the perfect international trade of goods and services. If there is no trade, obviously no PPP exists. The perfect trading market (without friction and transaction costs) is the key assumption in PPP theory. In this research, an examination on PPP relation between Australia and its different trading partners to find out the consistency and inconsistency with the above-mentioned assumption is therefore necessary. 2. Empirical evidences about PPP There has been a heightened level of extant literature on the validity of PPP. The results of the PPP tests varies according to according to whether (i) price and exchange rate levels (absolute PPP) or changes in prices and exchange rates (relative PPP) are studied; (ii) individual commodity prices or nominal price levels are employed; (iii) purely traded goods’ prices or non-traded as well as traded goods prices are considered; (iv) bilateral or multilateral approach is adopted; and (v) the short run or the long run is investigated (Rush and Husted, 1985). In the respect of long-run or short-run validity of PPP, for example, evidence from Edler and Lehmann (1983), Enders (1988) and Ardeni and Lubian (1991) reject long-run PPP. However, Diebold, Husted and Rush (1991), Cheung and Lai (1993), Edison (1987), Frenkel (1981), Branson (1981), Desai (1981), and Miller (1986) strongly support that the PPP holds in the long run and poorly in the short-run. Cooper (1994) claims that the main reasons for the inconclusive results are due to the difference in particular currencies under consideration, the price indices used to measure price levels of inflation, and the method of analysis employed. Early empirical tests (mainly in the 1970s) find support for the long-run and continuous PPP (Frankel, 1976 and1981). This might be partly due to the data of a period of stable exchange rates (few years post-float after 1971- collapse of the Bretton Woods Agreement). On the other hand, PPP deviates significantly from equilibrium in the short-run PPP due to the sticky nominal prices (Dornbusch, 1976). However, there is no evidence of how far do exchange rates deviate from the mean and how fast they revert to the mean, knowing that mean reversion of exchange rates 7 Research Project in International Finance: 2007 Dang H. Pham toward its mean is the key characteristic and necessary condition for long-run PPP to hold (Taylor and Taylor, 2004). Studies employing unit root test of real exchange rate (the null hypothesis is that real exchange rate follow a random walk) could not reject the random walk (see, for example, Roll 1979); Contemporary empirical studies of PPP are dominated by unit root tests with more advanced techniques. Frankel ( 1986) tests the first order autocorrelation model for the real exchange rates: tt eeee εδ +−=− − )~()~( 11 where e~ is the assumed constant equilibrium real exchange rate and δ is the autocorrelation coefficient. If δ >1 it is an explosive process; if δ =1, then exchange rates follow a random walk; if δ <1, then there is mean reversion. The evidence from this test rejects the hypothesis of random walk at 5% significant level. Abuaf and Jorion (1990) estimate a system of univariate autoregressions and find in general that PPP hold in the long-run. Others studies using longer data sets and more sophisticated models also reject the null hypothesis of random walk (see, for example, Glenn, 1992; Dielbold, Husted &Rush,1991; and Cheung and Lai, 1994). As evidence from many studies have shown that exchange rates have mean reversion characteristics, it is desirable to know how fast the exchange rates revert to the mean or in other words to what extent of time horizon PPP holds? Reviews of Rogoff (1996) reveal that studies seem to agree that the deviation from PPP real exchange rate has half-life of 3 to 5 years. While some recent studies use non-linear dynamic models that allow for the autoregressive coefficients to vary find supportive evidence of non-linear long-run PPP. For example, Taylor, Peel and Sarno (2001) find support for non-linear mean- reverting real exchange rates. They also find that ‘modest’ deviation of less than 5% have half-life of less than 3 years while deviations greater than 5% have even shorter half-life. Sarno and Valente (2006) test long-run PPP using complex non-linear model. Their results indicate that long-run PPP does appear to hold. Further, PPP deviations revert more quickly under floating exchange regimes. In contrast, other latest studies on the validity of PPP even using advanced techniques still have different results. For example, Alba and Papell (2007) examines the long-run PPP using panel data methods to test for unit roots in the USD real exchange rates of 84 countries finds that PPP holds for European and Latin American countries but not for Asian and African countries. Arghyrou and Gregoriou (2007) tests for long-run PPP 8 Research Project in International Finance: 2007 Dang H. Pham using more sophisticated unit root test on G7 countries over the last 30 years. They find that PPP does not hold in the long-run. In general, PPP test appear to be a puzzle. The extremely high short-term volatility of exchange rates hardly reconcile with the long-run PPP and the half-life of PPP reversion of 3 to 5 years is too long to be caused by short-run sticky nominal prices (Rogoff, 1996) states,. Perhaps the international goods market is not as integrated as we think, with large trading frictions creating a ‘band of inaction’ that permits wild fluctuation in nominal exchange rate with no effect on price levels (Rogoff, 1996; Taylor and Taylor, 2004). Alba and Papell (2007) share the same view when they find evidence that PPP is stronger in countries that have higher levels of trade, closer to the US (physical distance), and countries characteristics affect PPP adherence. Based on these finding, when testing PPP between Australia and its trading partners, this paper hypothesizes that PPP hold better between Australia and its major trading partners. 3. Australian evidence In the Australia context, empirical evidence of PPP is also inclusive. For example, Corbae and Oularis (1991) claims that PPP does not hold in long run for the Australian dollar, as the data follow a random walk. Conversely, Olekalns and Wilkins (1998), when re-examining the data used by Corbae and Oularis (1991), find different results that the long-run PPP holds for Australian dollar. The research conducted by Bhati and McCrae (2004) supports the long-run PPP when the Australian dollar is used as the based currency in relation with the Asia-Pacific trading partners of Australia. The exceptions include Singapore, Indonesia and New Zealand with poor evidence of PPP. Koedijk, Schotman and Vandijk (1998: p.60) point out that “there is substantive evidence that PPP holds for many currencies, although not for every currency to the same extent”. The only one thing that is clear from the evidences for Australia is that PPP varies across its trading partners. It is our conjecture that the level of PPP depends on the degree of trade relation between the host country and the foreign country. Hence, it is deserved a comprehensive investigation in this research. This research project tests PPP using the Australian dollar as a base currency with other 10 currencies selected from countries classification by the Reserve Bank of Australia (RBA) based on trade weights (described in Appendix 1). The test aims to find evidence which shows PPP 9 Research Project in International Finance: 2007 Dang H. Pham holding better with higher trade weighted countries. Some abnormal cases rejected by the test will be further discussed for appropriate reasons. 10 Research Project in International Finance: 2007 Dang H. Pham III. METHODOLOGY 1. Test of PPP The main objective of this study is to provide an overall understanding of how PPP holds between Australia and its trading partners. We select the representing countries categorize them into groups which have different trading levels with Australia. Test of PPP is conducted for each country/currency and compare to each others and between different groups. We test the PPP using relative form. Based on the equation (1.2) we construct the regression model as follows: εππβα +−+=Δ )(/ fhfhtS (2.1) hπ and fπ are home and foreign quarterly inflation rates respectively (based on CPI change); and is the quarterly change in the nominal exchange rate. fhtS /Δ Under the relative form (equation 1.2) the condition for PPP to hold is that the estimated values of α = 0 and β = 1 (estimated from 2.1). We hypothesize as follows: H0: PPP holds or α = 0 and β = 1 HA: PPP does not hold or α is different from 0 and β is different from 1 We use F-statistics to test the null that α = 0 and β = 1 jointly (Wooldridge 2006:150-160). F-statistics are calculated using the error terms of restricted model and error terms of unrestricted model as follows: )1/( /) −− −= knSSE qSSESSEF ur urr The unrestricted model is the model (2.1) Under the null hypothesis model of (2.1) becomes: this is called the restricted model. εππ +−=Δ )(/ fhfhtS k is the number of variables in model (2.1); n is the number of observation, 11 Research Project in International Finance: 2007 Dang H. Pham q is the number of variables restricted. If F-statistic > critical value then we reject the null hypothesis to accept the alternative. Otherwise, we cannot reject the null hypothesis and conclude PPP holds. For the purpose of ranking the level of PPP between different trading partners, we also look at p value and R-squared as supplementing measures. 2. Effects of trade and investment on PPP Since the actual relationship between exchange rates and price levels often deviate from the parity and tend to revert from time to tine. Reasonably, the more exchange rates deviate from the theoretical PPP the less PPP holds for that currency. We measure the deviation from the equation of relative form of PPP as follows: t f t h fh t fh t S SonPPPdeviati )1( )1( / 1 / π π + +−= − (2.2) hπ and fπ are home and foreign quarterly inflation rates respectively (based on CPI change); and and are exchange rates at time the quarterly change in the nominal exchange rate at time t and t-1. fh tS / 1− fh tS / Effects of trade and investments on PPP is estimated from the regression of PPP deviations against annual trade weights and foreign direct investment level in the following model: tInvestmentTradePPPdev εβββ +++= 210. (2.3) The sign and the significance of 1β and 2β estimated from (2.3) indicate the effect of trade and foreign investment on PPP . 12 Research Project in International Finance: 2007 Dang H. Pham IV. DATA Among Australia trading partners, we select 12 countries/currencies that their trading weights range from the high to low across the sample period from 1984 – 2005 (See Table 1) for our sample. Table 1. List of currencies of Australia’s trading partner countries selected for PPP test. The trade weights represent the level of trading between that country and Australia. No. Currency Average Trade Weights (%) 1 Japanese yen 16.95 2 Chinese renminbi 8.92 3 European euro 12.81 4 United States dollar 14.62 5 South Korean won 6.16 6 Singapore dollar 4.25 7 New Zealand dollar 5.71 8 United Kingdom pound sterling 5.23 9 Malaysian ringgit 3.01 10 Indonesian rupiah 2.99 11 Canadian dollar 1.57 12 Swiss franc 0.78 (According to trade weights table announced annually by RBA) The quarterly nominal exchange rates of Australian dollar to the 12 currencies for the period from 1984 to 2006 are collected from the Website of the Reserve Bank of Australia. We obtain quarterly Consumer Price Index (CPI) and Producer Price Index (PPI)/Wholesale Price Index (WPI)1 (from hereon PPI and CPI are referred to as PPI for convenience) of the 12 countries for the same period from Datastream-economics database. fh tS /Δ is calculated from the quarterly nominal exchange rates between the Australian dollar and the foreign currency. The selection of quarterly data deriving from the needs that time interval should be long enough for the differences in countries’ inflation rates to take effect on the corresponding exchange rates. Changes in nominal exchange rates are estimated from the following formula: 1 1 − −− t tt S SS . Inflation rates 1 WPI is used instead of PPI for countries that PPI is not available (for example Australia) 13 Research Project in International Finance: 2007 Dang H. Pham are measured using CPI and PPI by the following formula: 1 1 − −− t tt CPI CPICPI and 1 1 − −− t tt PPI PPIPPI . We use both CPI and PPI for our PPP test because some countries’ trading relationship with Australia may rely on industrial go than consumer goods. Then, theoretically, the parity conditions are guaranteed by the arbitrage activities in industrial goods markets rather than consumer markets. Hence, PPI is better than CPI to reflect the PPP with those countries. This is also consistent with the extant literature that several studies use both CPI and whole sale price index (WPI) (See, for example, Chinn 1999). Further, In and Sugema (1995) and Bhati and McCrae (2004) indicate that there is no evidence determining whether CPI or WPI is better. The exports and imports between Australia and the 12 countries are collected from the database of UNCTAD. Foreign Direct Investment (FDI) into Australia and from Australia to the 12 countries are collected from database of UNDP. However, the FDI data are only available from 1992 to 2003. Therefore, we do the test of the effect of trade on PPP separately first. And then we do the second test to see the effects of both trade and FDI on PPP in a multivariate regression using data from 1992-2003. The time-period of data in this case is quite short for an examination of long-run PPP we do not expect to obtain significant results from this test. However, the signs of the effects are also helpful for the future research direction. 14 Research Project in International Finance: 2007 Dang H. Pham V. RESULTS DISCUSSION 1. PPP with 12 countries Table 2 reports results of our regression model (2.1) using OLS method. CPI changes are used as proxy for the inflation rates in home (Australia) and foreign countries. If we set 5% significance level to reject the null hypothesis, the results indicate that we reject PPP for 9 countries. PPP holds only for Malaysia, United States and United Kingdom. Table 2 also ranks the countries from high level of PPP to low level (even insignificant). PPP with New Zealand is not rejected if we set the significance level at 10%, showing that New Zealand is quite close to United Kingdom in the level of PPP . It should be noted that Japan, which is always the biggest trading partner of Australia, shows an insignificant PPP and relatively weaker than many smaller trading partner. Although, China is the second largest trading partner of Australia now, PPP with China is at lowest level. This may be due to the Chinese exchange rate regime. Table 2. α and β are estimated from equation using OLS method. CPI is used to measure the inflation rates. F-statistics are calculated by the formula εππβα +−+=Δ )(/ fhfhtS )1/( /) −− −= knSSE qSSESSEF ur urr which used for testing α =0 and β =1 jointly. P- value of F-statistics shows the probability of having the F-statistics above the F critical value. Country α β F-statistics P-value Malaysia 0.0026 0.37 2.14 0.123372 United States -0.0048 1.51 2.26 0.110163 UK -0.0041 0.35 2.27 0.109906 New Zealand 0.0012 1.64 2.72* 0.071340 Canada -0.0063 1.10 4.92** 0.009464 Korea 0.001 -0.30 6.19** 0.003092 EU 0.0096 -3.05 6.33** 0.005749 Switzerland -0.0046 -0.49 13.17** 0.000010 Japan -0.0151 0.974 13.44** 0.000008 Singapore -0.0085 0.57 14.30** 0.000004 Indonesia 0.0397 0.48 18.84** 0.000000 China 0.011 -0.35 27.70** 0.000000 * Significant at 10% level * * Significance at 1% level 15 Research Project in International Finance: 2007 Dang H. Pham PPP is rejected with many countries as reported in Table 2 when CPI is used to estimate the inflation rates in both countries. The CPI index reflects the price level of a basket of consumer goods. The extent to which CPI represents a country general price level depends on the market structure that country. Also, the degree to which any differences in CPI level between two countries depends on the size of the trading on consumer goods relative with other foreign trade markets (e.g. industrial goods markets). It is reasonably for us to do another test that use PPI index as proxy for country price level. We expect that the industrial goods market may be more influential on foreign exchange rates fluctuation than the consumer goods market. The results of the second test using PPI changes as proxy for the inflation rates are reported in Table 3. Table 3. α and β are estimated from equation using OLS method. PPI/WPI is used to measure the inflation rates. F-statistics are calculated by the formula εππβα +−+=Δ )(/ fhfhtS )1/( /) −− −= knSSE qSSESSEF ur urr which used for testing α =0 and β =1 jointly. P-value of F-statistics shows the probability of having the F-statistics above the F critical value. Country α β F-statistics P-value Korea 0.004 1.085 0.36 0.698979 Singapore 0.0041 1.126 0.82 0.444955 United States 0.001 0.816 0.94 0.393484 Malaysia 0.006 1.054 0.98 0.379556 Japan -0.0016 0.673 1.41 0.249991 China 0.0162 0.914 1.73 0.184897 Switzerland -0.0025 0.61 2.03 0.137938 United Kingdom -0.0026 0.63 2.58* 0.081697 Canada -0.0008 0.638 5.56** 0.005381 New Zealand -0.0021 0.373 11.04** 0.000055 EU 0.0033 -0.013 12.26** 0.000195 Indonesia -0.0107 2.047 35.30** 0.000000 * Significance at 10% level * * significance at 1% level 16 Research Project in International Finance: 2007 Dang H. Pham The results in Table 3 indicate that only PPP is rejected for only 5 countries (at 5% significance level) or only for 4 countries if 10% significance level is set. Overall, the PPP holds better when our test use PPI as proxy for price level. In particular, the PPP holds better with CPI for some countries (New Zealand and Canada), while for almost others, PPP holds better with PPI (e.g. Korea, Singapore, Japan and China). We argue that industrial goods market with Australia may have much more influential on foreign exchange rate than the consumer goods market. Figure 1 and Figure 2 present the structure of Australia’ foreign trade. Figure 1 Australia Imports in two different markets – Industrial and Consumer Australia Imports 0 5000 10000 15000 20000 25000 30000 35000 Ma r-8 4 Ma r-8 6 Ma r-8 8 Ma r-9 0 Ma r-9 2 Ma r-9 4 Ma r-9 6 Ma r-9 8 Ma r-0 0 Ma r-0 2 Ma r-0 4 Ma r-0 6 cu rr en t p ric e Consumer Industrial Source: RBA Figure 2 Australia Exports in two different markets – Industrial and Consumer 17 Research Project in International Finance: 2007 Dang H. Pham Australia Exports 0 5000 10000 15000 20000 25000 30000 35000 Ma r-8 4 Ma r-8 6 Ma r-8 8 Ma r-9 0 Ma r-9 2 Ma r-9 4 Ma r-9 6 Ma r-9 8 Ma r-0 0 Ma r-0 2 Ma r-0 4 Ma r-0 6 cu rr en t p ri ce Consumer Industrial Source: RBA It is clearly indicated in Figure 1 and 2 that the industrial goods market dominates both Australia’s import and export trading activities. This fact explains, to some extent, why in general PPP holds better when PPI is used as proxy for the price levels. For country specific cases, countries such as New Zealand and Canada may have the same comparative advantages as Australia (natural resources and agriculture products). Therefore, their industrial markets with Australia are less important than consumer market, which explains the worse PPP found when using PPI as proxy. Our results confirm the findings in previous studies (see, for example, Bhati and McCrae, 2004; and Cooper, 1994). One important reason for the rejections of PPP in both tests using CPI and PPI is the impact of transaction costs. Sercu, Uppal and Hulle (1995:1317) state that “In reality, though, commodity trade is costly. As a result of these costs, international imbalances between marginal utilities will be left uncorrected as long as they are sufficiently small relative to the cost of shipping”. Hence, the long distance between Australia and America, Europe could partly imply relatively higher transactions costs so as to negatively impact the PPP . Furthermore, capital mobility (excluding FDI) is recently considered a major force that may distort the PPP since a huge amount of capital assets transactions creates a 18 Research Project in International Finance: 2007 Dang H. Pham great impact on exchange rates. The CPI indices never reflect international capital transactions. Cooper (1994: p.170) claims that the reason that PPP poorly explains exchange rates is that: “...it ignores capital flows. In recent years, capital has been free to move from country to country. Cross border trade in financial assets swamps foreign exchange transactions in goods and services. It is estimated that almost US$ 100 trillion equivalent is traded annually on foreign exchange markets and it is twenty times the value of the World trade in goods.” United States and United Kingdom are the largest sources and destination of capital mobility (excluding FDI) in and out of Australia. This could partly explain why they are larger trading partners than other countries but PPP levels are lower. Figure 1 and Figure 2 show the level of capital (excluding FDI) mobility between Australia and some foreign countries. Figure 1: Foreign Investment in Australia, 31 December 2005 (Source: Australian Bureau of Statistics Website) Figure 2: Australian Investment Abroad, 31 December 2005. (Source: Australian Bureau of Statistics Website) 19 Research Project in International Finance: 2007 Dang H. Pham 2. Effect of trading and FDI on PPP The PPP theory assumes the law of one price in an efficient international trade market as the fundamental conditions for a parity relationship (The law of one price works). Reasonably, the higher trade levels imply a more efficient market then the better PPP we can expect. This research paper also examines the effect of trading between Australia and its trading partners from 1984 to 2005 on their PPP . FDI also represents the capital mobility effect; however, FDI is very different from the portfolio capital investment in that it normally goes with the increase of trade and less liquidity. Therefore, we expect that FDI may have positive effect on PPP . This research will also make an effort to test the effect of FDI on PPP . Results are reported in Table 4 below. Table 4. Present results of regression PPP deviation against trade and FDI. Since we can collect more data on trade than FDI, effect of trade on PPP is separately tested using data from 1984-2005. The result shows that relative trading level significantly (at 5%) increase the PPP . Then we examine effects of trade and FDI on PPP using data from 1992-2003. We find no significant results. However, the sign of coefficients show that all trade and FDI seem to increase the PPP . Data Period Trade FDI 1984-2005 -0.09 ( 2.2 )* NA 1992-2003 -0.09 ( 1.22 ) -0.006 ( 0.45 ) * Significant at 5% Results in Table 4 are obtained when PPP deviations are regressed against the trade weights level from 1984 to 2005 using Pooled cross-sectional data for all 12 countries together. The negative significant at 5% of trade factor indicates that relative trade level does decrease the PPP deviation. In other words, relative trade levels significantly increase the level of PPP . We can not collect enough FDI data for the full range of our study period. In fact, the data are only available from 1992-2003 (UNCTAD database). Hence, we test the 20 Research Project in International Finance: 2007 Dang H. Pham effect of trade and investment in a multivariate regression using data only from 1992- 2003. Results from this test are not significant for all trade level and FDI. This could be due to the lack of data for our long-run PPP study. However, the sign of the coefficients of trade and FDI indicate that FDI seems to have positive impact on the PPP . 21 Research Project in International Finance: 2007 Dang H. Pham VI. CONCLUSION Empirical studies so far still hold inconclusive view on the existence of PPP in the real world even for the long-run. Some issue relating to testing PPP remains a puzzle. We test the PPP between Australia and its 12 trading partners for the period from 1984 to 2006. The results reject PPP for 9 countries when we use CPI changes as proxy for inflation rates. However, when PPI is used instead, PPP is rejected for only 5 countries with 5% significance level. The domination of trading in industrial goods market, to some extent, explains why PPP holds better with PPI. In country specific level, we find that PPP hold better with CPI for some countries (New Zealand, Canada). Other countries show better PPP with PPI. The same competitive advantages of New Zealand and Canada explain that abnormal results. Investigation on the effect of level of trade on PPP deviation reports that trading decrease the level of PPP deviation or, in the other words, increases PPP. This effect is found significant at 5%. FDI seem to have positive effect on the level of PPP where our evidence shows a negative sign against PPP deviations but far to be significant. We suggest that the insignificant result for FDI may have its reason in the shortage of Data which allows us to conduct the test only from 1992-2003, too short for a long-run PPP test. 22 Research Project in International Finance: 2007 Dang H. Pham VII. FUTURE RESEARCH DIRECTIONS Since PPP is known theoretically to be affected by many other factors such as the transaction costs, the difference in levels of income, portfolio capital investment activities, and further studies could improve the results by doing more comprehensive test on the effect of those factors on the level of PPP . Consumer goods markets often imply the country specific cultural characteristic, thus income cases consumer goods in one market can not be used in other market. In that case the law of one price hardly works well in practice. Take Japan consumer goods market for example, there are a lot of consumer products that are produced uniquely for the Japanese market and can not be use outside Japan. Therefore, future studies on PPP can be interesting to model the cultural factors. 23 Research Project in International Finance: 2007 Dang H. Pham References Adler, M. and Lehman, B. (1983) Deviations from Purchasing Power Parity in the Long Run. Journal of Finance 38 (December 1983), 1471-1487. Alba, J. & Papell, D. (2007) PPP and Country Characteristics: Evidence From Panel Data Tests, Journal of Development Economics, vol. 83, pp. 240-51. Ardeni, P. G. and Lubian, D. (1991) Is there trend reversion in purchasing power parity?. European Economic Review, 35, p. 1035-1055. Arghrou, M. & Gregoriou, G. (2007) Testing for PPP Correcting for Non-linearity Using the Wide Bootstrap, Economic Letter, vol. 95, pp. 285 -90. Australian Bureau of Statistics (2006) International Investment Position, Australia: Supplementary Country Statistics, 2005. [Accessed 28 September 2006] Balassa, B. (1964) The PPP Doctrine: A Reappraisal, Journal of Political Economy, vol. 72, no. 6, pp. 584-96. Bhagwati, J. (1984) Are Services Cheaper in Poor Countries, Economic Journal, vol. 94(347), pp. 279-86. Branson, W. H. (1981) Comment: The Collapse of Purchasing Power Parity during the 1970’s. European Economic Review, 16(May 1981), p. 167-171. Bhati, S. and McCrae, M. (2004) Purchasing Power parity: Evidence from Asia Pacific Countries. Journal of American Academy of Business, Sept. 2004, 5,1/2, p.210. Chinn, M. D. (1999) Measuring Misalignment: Purchasing Power Parity and East Asian Currencies. IMF Working Paper. WP/99/120. Cooper, J. B. (1994) Purchasing Power Parity: a cointegration analysis of the Australian, News Zealand and Singapore currencies. Applied Economics Letter,1994,1,167-171. Cheung, Y. W. and Kon, S., L. (1993) A fractional cointegration analysis of purchasing power parity. Journal of Business and Econmic Statistics, Vol.11(1993) 103-112. Cheung, Y. & Lai, K. (1994) Mean Reversion in Real Exchange Rate, Economic Letters, vol. 46, no. 3, pp. 251-56. Corbae, D. and Oularis, S. (1991) A test of long run purchasing power parity allowing for structural breaks. Economics Record, Vol.67(1991) 26-33. Cumby, R & and Obstfeld, M. (1984) International Interest Rate and Price level Linkages under Flexible Exchange Rates: A Review of Recent Evidence, in Exchange Rate Theory and Practice, J & Marston, C eds, University of Chicago Press, Chicago. Desai, M. (1981) Testing Monetarism, London: Frances Printer. Diebold, F. X., Husted, S. and M., Rush (1991) Real exchange rate under gold standard. Journal of Political Economy, 99(1991) 1252-1271. 24 Research Project in International Finance: 2007 Dang H. Pham Dornbusch, R (1976) Expectation and Exchange Rate Dynamics, Journal of Political Economy, vol. 84, no. 6 , pp. 1167-76. Edison, H. J. (1987) Purchasing Power Parity in the Long Run: A Test of the Dollar/Pound Exchange Rate (1890-1978). Journal of Money, Credit and Banking, Vol.19, No.3(August 1987), p. 376-387. Enders, W. (1988) ARIMA and Cointegration Tests of PPP under Fixed and Flexible Exchange Rate Regimes. Review of Economics and Statistics 70(August 1998), p. 504-508. Eiteman, Stonehill and Moffett (2006) International Business Finance (6thEddition). Sydney: Longman Frankel, J. A. (1981) The Collapse of Purchasing Power Parities during the 1970s, European Economic Review, 16 (November 1981), p. 145-165. In, F. and Sugema, I. (1995) Testing Purchasing Power Parity in a multivariate frameworks. Applied Economics, Vol. 27 (1995), p 891-899. Koedijk, K. G., Schotman P. C. and Vandijk, M. A. (1998) The re-emergence of PPP in the 1990s, Journal of International Money and Finance, 17(1998) 51-56. Miller, S. (1984) Purchasing Power Parity and Relative Price Variability Evidence from the 1970s. European Economic Review, 26 (December 1984), p. 353-367. Olekalns, N. and Wilkins, N. (1998) Re-examining the evidence for long-run purchasing power parity. The Economic Record, 74, p. 54-61. Rogoff, K (1996) The Purchasing Power Parity Puzzle, Journal of Economic Literature, vol. 34, pp. 647-68. Roll, R. (1979) Violation of PPP and Their Implication For Efficient International Commodity Markets, in International Finance and Trad, Samat, M. and Szego, K eds, Ballinger Press, Cambridge, pp. 133-76. OECD Stat. (2006) CPIs all items [Extracted on 21 September 2007] Rush, M. and Husted, S.(1985) Purchasing power parity in the long run. Canadian Journal of Economics, 18, 137-145. Sarno, L. & Valente, G. (2006) Deviation From PPP Under Different Exchange Rate Regimes: Do They Revert and If So, How?, Journal of Banking and Finance, vol. 30, pp. 3147-69. Sercu, P., Uppal, R. and C. Van Hulle (1995) The exchange rate in the presence of transaction costs: Implication for test of Purchasing Power Parity. The Journal of Finance, Vol. 50, No. 4. (Sep., 1995), 1309-1319. Taylor, M. P. and McMahon, P. C. (1998) Long Run Purchasing Power Parity in the 1920s. European Economic Review, 32 (1998), 179-197. Taylor, A. & Taylor, M. (2004) The Purchasing Power Parity Debates, Journal of Economic Perspectives, vol. 18, no. 4, pp. 135-58. Taylor, M., Peel, D & Sarno, L (2001) Non-linear Mean-reversion in Real Exchange Rates: Toward a Solution to the Purchasing Power Parity Puzzle, International Economic Review, vol. 42(4), pp. 1015-42. 25 Research Project in International Finance: 2007 Dang H. Pham The Reserve Bank of Australia (2006) Exchange Rates Since 1983 [Accessed 25 September 2007] 26