Testing for explosive bubbles in the South African-US exchange rate using the sequential adf procedures

This paper seeks to explore the existence of speculative bubbles in the South African - US exchange rate using the sequential augmented Dickey-Fuller (ADF) unit root procedures. In particular, the paper uses the sup ADF (SADF) and the generalized SADF (GSADF) right-tailed unit root tests proposed by Phillips, et. al. (2011, 2012) to investigate the existence of explosive bubbles in the South African rand -US dollar exchange rate for the time period running from January 1980 through July 2012. According to Kindelberger and Aliber (2005) bubble is a sharp increase in asset prices whereby the initial increase generates expectations of further increases and hence attracting new buyers. In the spirit of Engel (1999), this study constructs the relative prices of traded and nontraded goods as fundamentals for nominal exchange rates. Obstfeld and Rogoff (1996) suggest that the nominal exchange rate should be considered as an asset price. This assertion implies that the nominal exchange rate is influenced by the current and expected values of fundamentals. This study adopts the sequential ADF unit root procedures because they have the ability to detect periodically collapsing bubbles. They are also robust in the presence of multiple breaks resulting from possible bubble bursts. The results from the standard right-sided ADF test statistic suggest that there is no explosive bubble in the nominal South African – US exchange rate, the real exchange rate of traded and nontraded goods. However, as pointed out by Evans (1991), the results from the standard right-sided ADF test may be misleading especially if periodically collapsing bubbles occur during the period under study. In contrast, the results from the SADF and the GSADF tests provide evidence in support of the existence of explosive bubbles in the nominal Rand-dollar exchange rate, the real exchange rate of traded and nontraded goods. The explosive behavior exhibited by the South-African - US exchange rate can be interpreted as evidence of speculative bubble given that this behavior is driven by the relative prices of traded and nontraded goods.