Exploring the Role of Institutional Quality, Trade Openness, and Financial Development in Driving the Real Exchange Rate: Evidence in Southeast Asia Countries

Abstract

This research is focused on investigating the potential factors driving real exchange rates (RER), including institutional quality, trade openness, and financial development. Advanced analysis methods such as Dynamic Ordinary Least Square (DOLS), Fully Modified Ordinary Least Square (FMOLS), Generalized and Simultaneous Quantile Panel Regression (GSQPR), and Granger Causality have been applied to a balanced panel of nine Southeast Asian economies from 2002 to 2020. The empirical results suggest that an improvement in institutional quality leads to the appreciation of the domestic currency compared to foreign currency. Additionally, a high degree of trade openness is associated with the depreciation of the domestic currency, which may be due to fluctuations in capital influx from international trade. These findings are consistent across most RER quantile levels through GSQPR. However, the effect of financial development, as measured by the bank's credit to the private sector, on the domestic currency value is observed only at lower quantile levels of RER. Furthermore, the study finds unidirectional causality relationships running from the identified drivers to RER, using the Granger causality approach. Based on the findings, the research discusses theoretical and policy implications for Southeast Asian economies.