Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Seasonal Price Movements and Unit Roots in Indonesian Rice Market

Integration

Carol Alexander and John Wyeth1.

Abstract

The use of cointegration techniques to measure market integration and Granger Causality to establish the
direction and strength by which markets influence each other is taken a stage further. The importance of first
testing whether trends and cycles in the price series are deterministic or stochastic processes is pointed out. This
in turn establishes the appropriate form of equations to be used for measuring market integration, both over the
long run trend of prices and within cycles. Testing the nature of the process is particularly important for the
treatment of seasonality since dummy variables, commonly used in regression equations to allow for seasonal
and other cycles, is only valid for deterministic processes. The treatment of seasonality explained here also
provides new opportunities for investigating the nature of integration over cycles. The techniques are applied to
data for the Indonesian rice market where both trend and seasonal processes are shown to be stochastic.
Integration is shown to occur through the CPI which is "caused" by the main supplier and "causes" the prices in
other markets.

(N.B. Abstract contains 174 words)

1 Carol Alexander is professor of finance and chair of the risk management group at the ISMA centre, Reading
University (www.ismacentre.reading.ac.uk). John Wyeth is a consultant in agricultural economics who works mainly in
developing countries. Many thanks to the Indonesian Food Logistics Agency (Bulog) for their support in addressing the question
dealt with in this paper while he was policy advisor there funded by the British Overseas Development Administration and to the
Institute of Development Studies at the University of Sussex where he was a Visiting Fellow whilst working on an earlier version of
this paper. The opinions expressed in the paper are those of the authors and should not be attributed to any of the institutions
mentioned.

© Carol Alexander and John Wyeth, 1995

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

CONTENTS

Abstract 3
1. Introduction .....................................................................................................................................................5
2. The regression approach to market integration .........................................................................................6
3. Market integration with stochastic and deterministic trends and cycles. ..............................................7
3.1. Definitions.......................................................................................................................................7
3.2. The Indonesian rice market ..........................................................................................................9
3.3. Univariate analysis. .....................................................................................................................13
3.3.1. Long - run data generation processes...........................................................................14
3.3.2. Seasonal patterns ............................................................................................................18
3.4. Multivariate analysis...................................................................................................................24
3.4.1. Seasonal cointegration and market integration in cycles ..........................................26
3.4.2. Granger causality and seasonal error correction models. .........................................30
4. Summary and conclusions...........................................................................................................................33
References ............................................................................................................................................................37

LIST OF TABLES

1. Indonesian Provincial rice production .......................................................................................................11

2. Mathematical definition and notation of deterministic and stochastic processes................................16
3. Dickey Fuller tests..........................................................................................................................................17
4. Tests for seasonal unit roots (nominal data)..............................................................................................23
5. Tests for long run cointegration (nominal & real series) .........................................................................25
6a). F Tests for annual cointegration (nominal data)....................................................................................28
6b). F tests for annual cointegration (real data).............................................................................................29
7. F Tests for causality to and from CPI..........................................................................................................31
8. LM causality tests within real annual cycles .............................................................................................32
9. LM causality tests based on VAR(2) of real annual cycles ......................................................................33

LIST OF FIGURES

1. Map of Indonesia showing major market centres.....................................................................................12

2. Provincial surpluses and deficits in the Indonesian rice market ............................................................12
3. The Jakarta 'Medium' rice price series ........................................................................................................14
4. Jakarta Medium rice prices after first differencing ...................................................................................15
5. Argand diagram of seasonal unit roots ......................................................................................................20

© Carol Alexander and John Wyeth, 1995 2

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

1. Introduction

Market integration indicates the extent to which events in one section of a market are reflected by events
occurring elsewhere in the same market. It continues to be a preoccupation for development economists
concerned with a variety of policy issues which include investigation into ways in which famines develop, the
establishment of famine early warning systems, measuring levels of market efficiency that will help decisions to
be made on government intervention (or non intervention) policies and so on2.

The simplest approach to measuring market integration is to correlate variables, usually prices, collected
from different parts of the market. Although much used and even recommended3 this technique has been
criticised for a number of reasons. One is that there are many influences on prices and it is not always easy to pin
down exactly what is being correlated, still less do the results indicate the presence of the causality that the
existence of integration requires.

The main alternative procedures depend on regression analysis and the most widely used set of equations
developed in this respect was pioneered by Ravallion (1985, 1986 and 1987)4. The results he and others who
followed achieved provided much more information than is available from correlation analysis but were valid
only under certain conditions of exogeneity. Subsequently therefore, Alexander and Wyeth (1994) described a
technique based on cointegration that made it possible to test for this exogeneity as well as indicate the direction
and strength of causality in price formation between different sections of a market5.

The next section of this paper reviews the essential elements of the regression approach as it stands and
how it is modified by principles of cointegration. The following section stresses the need to determine whether
trends and cycles in data generation processes are stochastic or deterministic and the way in which this affects
how the data should be analysed. It also describes statistical tests for the type of data generation process, both
for the long run (trend) and for cycles, and applies them to data from the Indonesian rice market. The final
section summarises the points made in the paper as well as the implications of the findings for market integration
in the Indonesian rice market.

1. The regression approach to market integration

The Ravallion procedure has been described in a variety of places and need not be repeated in detail. In
summary however, the equations start from an assumption that the market is divided into a single central or
reference area and any number of outlying regions. The central area dominates price formation and:

(1) Pi = fi(R, Xi) for i = 1, . . . N

where "P" refers to the price in the local (or outlying) markets "i". "R" is the price in the central reference market
and X is a vector which incorporates other exogenous factors including seasonal variations.

2 These and other applications have been discussed in, for example, Harriss (1979), Ravallion (1987), Faminow and
Benson (1990), Wyeth (1992).
3 For example by Goetz and Weber (1986) p.107-112
4 Earlier on Monk & Petzel (1984) had also used regression but with a simpler and less useful equation.
5 This problem was also noted and dealt in a similar way by Palaskas and Harriss-White (no date)

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 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Similarly the price in the reference market is expressed as a function of the prices in all the local markets as
follows:

(2) R = f (P1, . . . ., PN, X)

The model is complete since it has n + 1 equations and n + 1 endogenous variables. In practice, however,
only equations (1) are usually estimated. Expressed in a linear form, allowing for the inclusion of lags and re-
writing in the form of an error correction mechanism6, they become:

(3) ∆Pit = (ai - 1)(Pit-1 - Rt-1) + bi0∆Rt + (ai+bi0+bi1-1)Rt-1 + ciXit + εit

Ravallion's system of measuring market integration has dominated the literature on the subject since it
was introduced in the mid 1980's and has continued to be refined and used ever since7. It is most useful where
there is a central dominant market and the full structural form can only be estimated by OLS under conditions of
exogeneity. If prices in the dominant market are not exogenous to those in the peripheral markets it is either
necessary to use a simultaneous estimation method such as 2SLS to estimate the equations in their structural
form, or reformulate the equations in a reduced form to allow the use of OLS8.

A further problem pointed out by Alexander and Wyeth (1994) is that a price series can in any case only
be included in the equations if it is first found to be econometrically integrated. If this condition is fulfilled then
combinations of the series may then be tested for cointegration. If cointegration exists the Engle Granger
Representation theorem validates the use of the Ravallion system, though still only in its reduced form.

Alexander and Wyeth (1994) described the cointegration approach and showed how it could be used for
testing not only for the exogeneity of the central market but also the direction of Granger causality that must exist
between cointegrated series. They also pointed out that this approach is valid between any two markets, whether
one of them is considered a dominant central one or not, thus making it unnecessary to look for a single reference
market in the first place. Palaskas and Harriss-White (1993 and undated) dealt with these problems in a similar
way. They continued to assume local rural markets dependent on a single central market but they use Granger
causality only to establish which of the markets under study should be considered as the reference one.

2. Market integration with stochastic and deterministic trends and cycles.

2.1. Definitions

Movements in times series are normally classified into three major components: a secular trend over time,
cyclical changes within that trend and residual movements of individual elements in the series away from the
trends and cycles. Cyclical variations, which are often caused by seasonal influences, may include just one peak
and trough a year, in which case it is an annual cycle. Alternatively it may be a biannual cycle with two peaks
and troughs a year, or a cycle that is triannual or greater. On the other hand cycles may occur over periods of
greater than a year, as business cycles or cycles connected with non seasonal weather patterns often do. When
cycles vary so much in length confusion is sometimes caused when the expression "long run" is used to refer
both to secular trends and to longer cycles. In the present paper references will therefore generally be either to

6 An "error correction mechanism" (ECM) is simply an equation that corrects for previous disequilibria between the
dependent and independent variables by including a disequilibrium term on the right hand side: (Pit-1 - Rt-1 ) in this case. For
details see, for example, Ravallion (1987) pp 104-109 or Alexander and Wyeth (1994) pp. 305 - 307.
7 Most notably by Timmer (1987)
8 The use of the terms "structural" and "reduced" describe whether the system includes endogenous variables as
explanatory variables in some of the equations (the "structural" form) or whether all explanatory variables are pre-determined (the
"reduced" form).

© Carol Alexander and John Wyeth, 1995 4

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

"trends" or to "cycles". Since the paper deals with prices in a rice market the main cycles are seasonally
influenced and the term "seasonal" is also sometimes used to refer to that type of cycle in particular. If the
phrase "long run" is used however, it will be made clear whether the reference is to trends or to cycles.
Similarly, since cycles can occur over a short or a long period, use of the term "short run" on its own to refer to
seasonal or cyclical variations will also be avoided.

Another fundamental distinction to make is whether the trends and whether the seasonal or other cycles
within the series are "deterministically" or "stochastically" generated. These terms are most easily defined
mathematically with reference to the stationarity of the residuals, and this is done below. It is usually not
possible to tell from casual visual inspection of a time series whether any trend or cycle it contains is
deterministic or stochastic. It is important to find out before investigating the existence, level and direction of
causal influences between any two or more time series however, because the result has implications both for the
type of tests of economic integration that should be used and for the appropriate stationarity transformation of
the data.

The importance of establishing the nature of the generating process in this respect can be illustrated by the
normal procedure for dealing with seasonality when using regression analysis, which is to insert dummy
variables into the equations. The justification is that, if significant, the coefficients on the dummies will indicate
the extent to which seasonal changes shift the overall result of the equations. In fact, as will be shown below,
this procedure is not valid when the cyclical fluctuations are stochastically generated. This implies that there can
be no certainty that one of the most frequent methods of dealing with seasonals, that of using dummy variables,
is valid without first checking for the nature of the process.

The importance of distinguishing between deterministic and stochastic movements in price series was
pointed out in Alexander and Wyeth (1994)9 but no tests were offered that would distinguish between them.
Indeed the techniques used for dealing with stochastically generated seasonals have only very recently become
available. After a description in Section 3.2 of the data to be used therefore, Section 3.3 looks in greater detail
into the implications of whether the processes are stochastically or deterministically generated both for the long
run trends (Section 3.3.1) and for seasonality (Section 3.3.2). It shows how to test which is present in the data and
indicates the consequences for establishing stationarity.

The discussion in Section 3.3 concentrates on the univariate case, dealing with the preliminary tests that
need to be done on the individual data series in order to establish whether they can be used in cointegration
analysis, first of the trends and then of the cycles. Section 3.4 then deals with the multivariate case, showing how
the nature of the series established in 3.3 affects the investigation of cointegration again first for the long run
trend (Section 3.4.1) and then for the seasonals (Section 3.4.2). The calculations are carried out for the bivariate
case, dealing with the prices series in pairs, though dealing with more than two series at once is similar though
more complex and is mentioned again in the conclusion. In each of the sections mentioned attention is first
given to the methodology of the calculation and then the implications of the results are discussed.

2.2. The Indonesian rice market

The data used to illustrate the points made in this paper come from the rice market in Indonesia10. Rice is
the principal staple in that country and the post 1966 New Order government established the objective of
promoting rice production enough to move the economy from being the biggest importer of rice in the world to
self sufficiency in the crop. This goal, achieved by 1984, made rice the focus of close government attention
exercised mainly through the Ministry of Agriculture and through "Bulog" the government sponsored food
logistics agency.

9 Footnote 9 in Alexander and Wyeth (1994).

10 These are essentially the same data that were used in Alexander and Wyeth (1994)

© Carol Alexander and John Wyeth, 1995 5

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

The price of rice in Indonesia is determined on the open market, but Bulog intervenes through floor and
ceiling prices to help promote some seasonal price stabilisation. In order to allow it to do so Bulog, along with
the Central Statistical Office, has been monitoring prices over many years. The task has been complicated by the
large size of the country, the number of rice varieties available, the price differentials among them, their differing
importance in different parts of the country and the effect on all of these of constant changes in the interaction of
rice production technologies, conditions and tastes. To provide a single relatively comparable and consistent
series, therefore, periodic consumer surveys on buying patterns are used to identify a single variety in each area
which is suitable for designation as a "Medium", or average, rice applicable to that centre. The Medium rice in
any one place may vary as buying patterns alter and this leads to descrete jumps in the series from time to time.
Nevertheless, changes are designed in such a way as to minimise their effect on each series and so, although far
from perfect, the result is an unusually long series of rice prices which is broadly consistent and without any
gaps. Since the Medium rice is chosen in each geographical area to represent a similar quality and popularity,
the Medium rice price series in each centre is also broadly comparable with the Medium rice price in the other
centres11.

Medium rice prices are established for each of the 27 Provincial capitals and testing for integration among
all of these market centres would be a cumbersome task. For the purposes of this paper only seven have been
chosen to cover the most important Provinces and to reflect the variety of different types of market in the
country, and the analysis is carried out for the period from January 1979 to December 1990. To help place these
areas in the context of the overall Indonesian rice market Table 1 indicates the major characteristics of each centre
and marks those chosen for analysis whilst the map in Figure 1 shows their geographical location.

It is clear from the last column of Table 1 that there are only a few Provinces which provide a surplus of
rice and can act as suppliers to the deficit areas. Jakarta, the capital city, is included in the analysis as the largest
of these deficit areas as well as the biggest market. Surabaya, on the other hand, is the capital of the Province
with the largest surplus available for distribution to other areas. Bandung is the capital of the largest rice
producing Province but it does not have as great a surplus as Surabaya because it is also a large consumer. These
three cities are all on the island of Java.

11 A more detailed discussion may be found in Wyeth (1992) pp 21-27, Alexander and Wyeth (1994) p.312 and 314 and
in the appendix by Wyeth in Ellis et al (1991)

© Carol Alexander and John Wyeth, 1995 6

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Table 1.
Indonesian Provincial rice production

Provincial population Production 1988 Bulog surplus

(milled rice)*2 (deficit)*3
Region City (abbrev'n)*1 Province 000 tonnes regional % 000 tonnes regional % tonnes-av 83/88

Sumatra Banda Aceh Aceh 3,291 20.3% 712 21.0% (23,861)

Medan (MED) North Sumatra 10,321 1,688 (94,248)
Pekanbaru Riau 2,765 267 (43,656)
Padang W. Sumatra 4,268 1,031 (38,922)
Jambi Jambi 1,958 350 (24,544)
Palembang S. Sulawesi 5,984 872 (31,754)
Bengkulu Bengkulu 1,060 183 (15,669)
Lampung Lampung 6,957 850 (5,688)

Java Jakarta (JAK) DKI Jaya 8,770 60.5% 26 60.2% (223,783)

Bandung (BAN) W. Java 34,037 6,486 62,681
Semarang C. Java 29,475 4,900 41,848
Yogyakarta DI Yogya 3,086 407 (17,419)
Surabaya (SUR) E. Java 33,589 5,240 380,902

Kalimantan Pontianak W. Kalimantan 3,012 4.8% 441 4.8% (31,602)

Balikpapan E. Kalimantan 1,831 139 (22,387)
Banjarmasin (BJN) S. Kalimantan 1,241 627 (25,423)
Palangkaraya C. Kalimantan 2,478 165 (14,260)

Sulawesi Menado N. Sulawesi 2,564 7.0% 206 8.7% (29,595)

Palu C. Sulawesi 1,723 247 (9,546)
Kendari S.E. Sulawesi 1,199 91 (8,521)
Ujung Pandang (UJU) S. Sulawesi 7,088 1,931 137,740
East Islands Denpasar Bali 2,878 7.4% 540 5.2% 14,803
Mataram N.T.B. 3,312 687 49,705
Kupang N.T.T. 3,242 196 (26,233)
Ambon Maluku 1,773 17 (28,602)
Jayapura (JAY) Irian Jaya 1,455 15 (37,134)
Dilly E. Timor 638 25 5.2% (15,376)
179,995 100% 28,340 100% (80,545)

Notes:
*1. Regions marked in italics are included in the study and the abbreviation used in foregoing tables is shown.
*2. Assumed milling ratio of 68%.
*3. Bulog Provincial procurement less distribution is used as a proxy for provincial rice surplus.

© Carol Alexander and John Wyeth, 1995 7

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Figure 1.
Map of Indonesia showing major market centres.

Banda
Aceh

Med
an

Pekan Mana
baru do

SUMA Pontia KALIMA

TRA
Pada nak NTAN
Balikpa Pal
ng pan u
Jam Palanka
bi raya SULA
Palemb
ang Banjarm WESI Kend Jayap
asin ari ura
Bengk
ulu Amb NT IRIAN
on JAYA
T
Lamp JAKA
ung RTA Semar Ujung
Pandang
ang
Band
ungYog Surab
Matar
ya aya am
JA Denpa Dil
VA sar BA Kupa i
LI NT ng
B

Provincial
Capitals
Provincial Capitals selected for calculation
of rice price integration

© Carol Alexander and John Wyeth, 1995 8

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Figure 2
Provincial surpluses and deficits in the Indonesian rice market
400,000

300,000

200,000

100,000

(100,000)

(200,000)

(300,000)
Bandah Aceh Padang Bengkulu Bandung Surabaya Banjarmasin Palu Denpasar Ambon

Medan Jambi Lampung Semarang Pontianak Palangkaraya Kendari Mataram Jayapura

Pekanbaru Palembang Jakarta Yogyakarta Balikpapan Menado Ujung Pandang Kupang Dilly

Surplus (deficits) in tonnes

Provincial Centres

Selected for analysis Other Centres

Of the others Medan is on the island of Sumatra while Banjarmasin is on Kalimantan, the Indonesian side
of the island of Borneo. Jayapura, on Irian Jaya, the Indonesian side of the island of New Guinea, represents a
remote deficit region and one of the few places in the country where the market is complicated by important
staples other than rice. Finally Ujung Pandang, on the island of Sulawesi, is capital of a generally surplus
Province but one where the main production season differs from the other main growing region centred on Java.
Of these seven centres only Surabaya, Bandung and Ujung Pandang represent surplus areas. Jakarta, Medan,
Banjarmasin and Jayapura have overall deficits. The distribution of the surplus and deficit Provinces from the
data in Table 1 is illustrated more clearly in Figure 2.

Much of our analysis focusses on the role of the CPI in rice price formation. We shall be asking whether
rice price movements, both seasonal and in the trend, are influenced by inflation. In order to answer this we have
removed the rice component from the CPI (more details of how this was done are available from the authors).

2.3. Univariate analysis.

Figure 3 provides an example of what one of the rice price series, that of Jakarta, looks like and shows the
obvious increasing trend that is present in this and all the other series, clearly making them non-stationary
processes. Section 3.3.1 discusses the importance of investigating whether they are stochastically generated or
deterministic and show how this can be done.

Although less obvious from simple observation the data sets may also contain cyclical fluctuations,
whether from seasonal or from other sources. Section 3.3.2 first investigates whether such cycles exist in the
series presented and, having found that they do, goes on to investigate whether they in turn are stochastic or
deterministic in nature, and how to test for integration depending on the result.

© Carol Alexander and John Wyeth, 1995 9

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Figure 3
The Jakarta Medium rice price series

600

550

500

450

400
Current Rupiah / kg

350

300

250

200

150

100
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Years

2.3.1. Long - run data generation processes

Nelson and Plosser (1982) demonstrate that many economic variables are integrated of order 1 (denoted
I(1)): that is their stochastic part is non-stationary but becomes stationary after first differencing12. The obvious
trend in the price series exemplified in Figure 3 and, more to the point, their logarithms, as well as their
appearance after first differencing, shown for Jakarta in Figure 4 suggests that these could be examples of data
generated by I(1) processes. On the other hand it is also possible that each trend is deterministic rather than
stochastic, in which case it would be I(0) + trend and modelled by a trend stationary rather than a difference
stationary process. The standard mathematical definitions of these terms and the notation used are summarised
in Table 2.

12 In symbols, yt ~ I(1) ⇒ ∆yt ~ I(0).

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 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Figure 4
Jakarta Medium rice prices after first differencing

100

80

60
Monthly price difference: Rph/kg

40

20

-20

-40

-60

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Years

As already pointed out, it is important to establish which of these two types of data generating processes is
applicable from the outset because of the implications for the subsequent data analysis. Trend stationary
processes are not I(1) because their stochastic part is already stationary, and even though they are non-stationary
and their first differences are stationary, it is not appropriate to take first differences because this induces
negative autocorrelation into the error term13. Also, deterministic trended variables cannot be "cointegrated" in
the usual sense and there is no 'disequilibrium term' in the error correction representation. Hence multivariate
modelling of market integration should be based on vector autoregressions of detrended variables14 rather than
the error correction type of Ravallion model.

13 To see this, take first differences of the DGP for a TSP, which yields
∆yt = β + ∆zt = β + ηt.
Suppose zt = ρ zt-1 + et with ρ<1. Then the stationary error term ht is:
ηt = ∆εt + ρ∆εt-1 + ρ ² ∆εt-2 + ...
= εt - (1-ρ)εt-1 - ρ(1−ρ)εt-2 - ...
Thus differencing introduces a negatively autocorrelated moving average error term and it is better to detrend the data by
regression on a constant and trend to induce stationarity.
14 Such variables should be detrended by taking the residuals from a regression on a constant and a time trend.

© Carol Alexander and John Wyeth, 1995 11

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Table 2.
Mathematical definition and notation of deterministic and stochastic processes

Deterministic trend Stochastic trend

or trend stationary process (TSP) or difference stationary process (DSP)
Terminology: or stationary plus trend. or integrated process of order 1
or random walk.

Notation: yt ~ I(0) + trend yt ~ I(1)

Data generation yt = α + βt + zt yt = β + yt-1 + zt

process (DGP): where zt ~ I(0). where zt ~ I(0).

A number of techniques are available to test whether the DGP has a deterministic or a stochastic trend,
including those from Durbin and Hausman as well as from Dickey and Fuller. The simplest is the augmented
Dickey Fuller (ADF) test and Table 3 reports the results of these as carried out for the logarithm of our seven
series of rice prices. The first two columns are used to confirm that data are indeed stationary only after first
differencing, and a full description of this test is given in Alexander and Wyeth (1994). The 'aug' (augmentation)
lag is the minimum number of lagged dependent variables which are needed in the Dickey-Fuller regressions in
order to remove serial correlation from the residuals15.

The corresponding augmented Dickey-Fuller statistic is reported next, and beneath this in parentheses is a
χ2(4) Portmanteau serial correlation test for the residuals (5% critical value = 9.49). Thus the augmentation lag
has been chosen so that it is just large enough to ensure this Portmanteau statistic is beneath the 5% critical value.
It is also possible to test for the distinction between difference and trend stationarity by adding a trend to the
maintained model for the ADF tests16. It is well known that the ADF test has lower power than alternative tests
such as the Durbin-Hausman or Schmidt-Phillips (see Choi, 1992 and Schmidt and Phillips, 1992), but it should
be pointed out that all such tests may have arbitrarily low power (see Cochrane, 1991). Thus the results in the last
two columns of Table 3 need to be treated with caution.

15 The Dickey-Fuller regression is ∆yt = a + byt-1 + et, et ~ i.i.d. (0,s²) , and the null hypothesis of β = 0 and the
alternative β < 0 tests for I(1) versus I(0) respectively. Note however that the error term may be misspecified and, more specifically,
negatively autocorrelated and to guard against this the regression is "augmented" by lagged first differences to ensure white noise
residuals. There is a problem here because, although adding lagged dependent variables should remove any serial correlation in the
residuals, it can also significantly reduce the power of these tests. However this danger has to be set against the one of error
misspecification undermining the results of standard (i.e. non augmented) Dickey-Fuller tests.
16 So the Dickey-Fuller regression becomes ∆yt = a0 + a1t+ byt-1 + et where et ~ i.i.d. (0,s²).

© Carol Alexander and John Wyeth, 1995 12

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Table 3
Unit Root Tests (using logs of rice prices)

Provincial I(1) VS I(0) I(2) vs I(1) DSP vs TSP Durbin-

Centre aug. lags ADF stat. aug. lags ADF stat. aug lags ADF stat. Hausmann
JAK 1 -1.13 0 -9.42 1 -4.14 42.06
(4.38) (4.67) (4.29)
BAN 1 -1.34 0 -7.52 1 -4.73 46.69
(1.49) (2.34) (0.83)
SUR 1 -0.63 0 -9.57 1 -3.27 31.23
(1.06) (1.14) (1.53)
MED 1 -1.14 0 -9.38 1 -3.82 34.97
(3.21) (3.56) (1.43)
BJN 1 -1.06 0 -10.44 1 -2.37 18.45
(2.53) (2.48) (1.99)
UJU 1 -1.04 0 -8.84 1 -3.21 20.57
(5.00) (5.06) (3.82)
JAY 0 -2.30 0 -11.59 0 -2.94 18.82
(1.92) (18.4) (1.14)
CPI 3 -2.86 2 5.38 2 -4.85 5.68
(2.57) (3.69) (6.14)
5% cv -2.88 -2.88 -3.44 55.35

Although the results for the CPI are marginal the first column leads us to conclude that each series is non-
stationary, and the second column shows that each series is stationary after first differencing. The third column
contains mixed results: according to Dickey-Fuller tests Surabaya (SUR), Banjarmasin (BJN), Ujung Pandang
(UJU) and Jayapura (JAY) are I(1) (stochastic), whereas all the other series are I(0) + trend, or in other words are
deterministic, or TSP. However the fourth column, which reports results of Durbin-Hausmann tests, indicates
that we may attribute the finding of TSPs to the low power of Dickey-Fuller tests. Hence the general conclusion
from Table 3 is that the data series are all stochastic (DSP) rather than deterministic (TSP)17. This means that a
suitable long-run DGP for each series takes the form:

yt = a + yt-1 + et , et ~ i.i.d. (0,s²)

and, denoting the lag operator by B so that (1 - B) denotes the first difference operator ∆, (1-B)yt is stationary. In
the terminology used in the next section, each series has a unit root at the long-run frequency since the
polynomial (1 - B) = 0 has a root at B = 1.

2.3.2. Seasonal patterns

The existence of cyclical patterns in the data is shown with the help of spectral density analysis which is
illustrated in the diagrams of power spectra in Appendix 1. These show spectral densities of the first difference
of the logarithm of the rice price data in which peaks occur at specific frequencies between 0 and π18. In all
seven of these spectra we have a strong peak at frequency π/6, period 12, which is the annual cycle in the data.
Some spectra exhibit "echo" effects at frequencies which are multiples of π/6, and these are particularly
pronounced in Medan and Jayapura. Banjarmasin has rather a peculiar spectrum with seasonal frequencies that
are a little confused but still show at least one clear cycle.

17 This was also the assumption concerning the trend that was made in Alexander and Wyeth (1994). In that paper the
assumption was implicit, however: implied by the use of the Engle - Granger two step cointegration test which is only valid for
stochastic processes. Here an explicit test for stochasticity has been applied.
18 A peak at frequency λ corresponds to a cycle of period 2π/λ , i.e. 6λ/π cycles per year in monthly data.

© Carol Alexander and John Wyeth, 1995 13

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

The general conclusion of these diagrams is that at least one seasonal cycle does exist in all the series, so
here once again we need to investigate whether they are more appropriately modelled by deterministic or
stochastic equations. In the case of the trend this was investigated using unit root tests. In the case of the
seasonal cycles it is investigated by looking for seasonal unit roots. The deterministic model of seasonal cycles
represents data which can be perfectly forecast with a constant seasonal pattern :

yt = α1 + α2M2t + ...... + α12M12,t

where M2, ... M12 are monthly dummies. As already pointed out, this is normal procedure when using systems
of regression equations, and an assumption is therefore usually implicit that the seasonals are deterministic in
nature.

The alternative model introduced by Hylleberg, Engle, Granger and Yoo (1990) (abbreviated as 'HEGY') is
that the series have a stochastic, rather than a deterministic, seasonal such as:

yt = ρ yt-12 + εt et ~ i.i.d. (0,s²)

This is stationary if ρ < 1, but has unit roots at all seasonal frequencies if ρ = 1. For in this case ∆12 yt
= (1-B12)yt is stationary, but:

(1-B12) = (1 - B)(1 + B)(1 + B2)(1 + B + B2)(1 - B + B2)(1+√3B + B2)(1 - √3B + B2)

so if ρ = 1 there are 12 roots of 1 - B12 = 0 on the unit circle in the complex plane, which are ±1, ±i, ±½(1 ± √
3i), and ±½(√3 ± i).
Figure 5 reproduces an Argand diagram in which we have drawn all 12 unit roots to illustrate the
corresponding seasonal frequency by the second polar co-ordinate (i.e. the angle made between the ray and the
real axis). From the frequency we calculate the number of cycles per year in the usual way. Thus the 12 seasonal
unit roots have frequency 0, π, ±π/2, ±2π/3, ±π/3, ±5π/6 and ±π/6 corresponding to 0, 6, 3, 4, 2, 5 and 1
cycles per year respectively, as shown by the numbers inside the circle on the diagram. The roots at each of these
frequencies are denoted by Π (i.e. upper case π's). ThusΠ1 denotes the root at +1; Π2 is the root at -1; Π3 and
Π4 are the roots at ±i, Π5 is the root at -1/2 + √3i/2, Π6 is its complex conjugate at -1/2-√3i/2; Π7 is 1/2 +
√3i/2 and Π8 is at its complex conjugate 1/2-√3i/2; Π9 is -√3/2+i/2 and Π10 is √3/2-i/2; and finally Π11
denotes the root at √3/2 + i/2 and Π12 is at the complex conjugate √3/2-i/2.

© Carol Alexander and John Wyeth, 1995 14

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Figure 5
Argand diagram of seasonal unit roots
Imaginary part

+i Π3

Π5 3
Π7
4 2

Π
9
5
Π11
1

Π2 6
Π1 Real part
-1 ' +1

7 11
Π Π
10 12

8 10

Π6 9 Π8 frequency ( e.g. Π / 6 )

-i Π
4

Argand diagram of possible unit roots in monthly data. Figures inside the unit circle denotes number of
cycles per year, frequency of the root is the polar angle.

Only the unit root at +1 , which corresponds to the long-run frequency has been detected so far, and our
present purpose is to ask whether roots at any other frequencies exist19. The HEGY methodology, generalised
to monthly data by Beaulieu and Miron (1993), can be used to test for the existence of unit roots at the seasonal
frequencies. To do this the data are first filtered in 12 different ways, to remove each of the seasonal roots in turn.
For example the filter:
L(B) = (1 + B + B2 + ... + B10 + B11)

removes all roots except those at frequency zero, and

M(B) = - (1 - B + B2 - B3 + ... - B11)
filters for all roots except those at frequency π (i.e. 6 cycles per year)20, and so on. We call the filtered series y1
(which is the long-run trend), y2 (6 cycles per year), y3, y4 ( 3 cycles per year), y5, y6 (4 cycles per year), y7, y8 (2

19 But if unit roots exist at all frequencies then prices in different months can move arbitrarily far apart because no two
monthly series will be cointegrated with unit coefficients. This is a strong critique of seasonal integration given by Osborn (1993) (in
the discussion following Engle et. al. 1993).
20 A minus sign is added in the equation so that the standard ADF critical values (which are negative) apply.

© Carol Alexander and John Wyeth, 1995 15

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

cycles per year), y9, y10 (5 cycles per year) and y11 , y12 (1 cycle per year). A complete list of seasonal filters for
monthly data is given in Beaulieu and Miron (1993) and we shall be paying particular attention to the annual
filter, that is the filter showing the existence of a single annual cycle as follows:

A(B) = - 1/2 (1 + √3B + 2B2 + √3B3 + B4 - B6 -√3B7 - 2B8 - √3B9 - B10)

Graphs of the data after filtering with A(B), so that all but the annual unit roots are removed, that is the
unit roots relating to a single annual cycle, are shown in Appendix 2. We shall return to these later when
discussing the relationships between different regions.

Next we run Dickey-Fuller regressions of the form:

12
∆12 yt = DET + AUG + ∑ π k yk ,t −1 + εt
k =1

where the deterministic component DET has an intercept and seasonal dummies but no trend21, and the
augmentation by lagged dependent variables AUG usually needs careful tailoring to each series (see Hylleberg,
1993). In the event it was found that lags of 1, 2 or 3 were sufficient for each regression to have serially
uncorrelated residuals. Now existence of each unit root Πi in the Argand diagram may be tested by the null
hypothesis πi = 0.

Table 4 reports ADF statistics on the coefficients π1 to π12 for each nominal rice price series and the CPI
(all in logarithms). From the critical values below the table, it is clear that the null hypothesis of a long-run unit
root (i.e. the ADF statistic on π1) cannot be rejected, but that of a unit root at frequency π is clearly rejected. For
the other seasonal unit roots, rejection of the null can be made if πk-1∩πk = 0 (see HEGY)22. Evidence of an
annual unit root is very strong indeed, for all the series, the possibility of a biannual root is also indicated (but
results are marginal) and finally, there is strong evidence against the existence of unit roots at other frequencies.

These results are interesting because they clearly demonstrate the existence of seasonal unit roots and little
other empirical work has shown such significant evidence of them23. Since unit roots do not exist at all
frequencies, however, the standard "spring becomes summer" critique of the seasonal unit root model24 does not
apply. It also opens up the possibility of using seasonal cointegration techniques to investigate market
integration occurring within seasonal cycles, which has not been done before. The study of market integration
over a long run trend is an idea which goes back to Ravallion (1986), but now we have the techniques to
investigate the impact of seasonal fluctuations on short-run integration, and this will be dealt with in Section 3.4.

21 Various combinations of intercept, trend, and seasonal dummies are possible, each with different critical values.
Given the absence of deterministic trend in our data, only intercept and seasonals seems most appropriate.
22 The critical region for πk=0 (k even and >2) is two sided because these coefficients can be positive or negative under
the alternative, and if πk=0 is not rejected then πk-1=0 is tested against πk-1<0 (see Beaulieu and Miron, 1993).
23 Note that the existence of the annual unit root, implying that the single annual seasonal cycles is stochastic,
invalidates the use of dummies. The use of dummies in Alexander and Wyeth (1994) therefore erroneously implied that the
seasonals were deterministic.
24 See Osborn (1993)

© Carol Alexander and John Wyeth, 1995 16

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Table 4.
Tests for seasonal unit roots (nominal data)

Cycles per year Unit

Root JAK BAN SUR MED BJN UJU JAY CPI (frequency) root?

Π1 0.33 0.98 0.58 0.25 -0.24 0.35 -1.05 0.40 0 YES

(long run)
Π2 -3.74 -6.04 -4.76 -5.74 -5.31 -5.80 -4.41 -4.10 6 (π) NO

Π3 0.59 1.29 0.75 -0.25 -1.69 -0.18 0.50 -0.61

3 (±π/2) NO
Π4 -4.74 -5.28 -3.76 -3.45 -3.88 -4.29 -3.64 -4.21

Π5 -4.26 -2.05 -2.36 -2.21 -0.96 -1.27 -2.47 -2.71

4 (±2π/3) NO
Π6 4.41 5.49 5.16 4.36 4.93 6.11 4.48 4.71

Π7 2.88 3.39 1.49 1.98 1.26 2.96 1.09 2.26

2 (biannual ?
Π8 -1.63 -1.22 -2.40 -2.14 -3.07 -1.74 -2.76 -2.14 i.e. ±π/3)

Π9 -6.74 -6.81 -6.32 -6.51 -5.00 -6.02 -5.46 -4.39

5 (±5π/6) NO
Π10 1.34 3.97 2.16 4.41 4.06 3.70 1.98 3.62

Π11 1.35 1.92 1.65 1.90 1.54 1.44 1.77 0.83

1 YES
Π12 0.23 0.96 -0.29 0.15 -0.30 0.25 -1.14 -0.07 (annual,
i.e. ±π/6)
Approximate critical values are:
Significance Π1 Π2 Πodd Πeven
5% -2.76 -2.76 -3.25 1.86
1% -3.32 -3.28 -3.83 2.60

2.4. Multivariate analysis

Having established that both trends and existing seasonals are stochastic I(1) processes, we are able to
choose the appropriate techniques for measuring cointegration between two or more series in each case. This is
done first by examining in the trend processes and then employing tests developed in Engle, Granger, Hylleberg
and Lee (1993) - 'EGHL' - for cointegration at the frequencies for which seasonal unit roots exist.

© Carol Alexander and John Wyeth, 1995 17

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

2.4.1. Cointegration and market integration in trends.

Bivariate tests for the trend stochastic processes are based on the Engle and Granger two-step procedure25.
First OLS is used to estimate cointegrating regressions of the form:

y1,i,t = const + αij y1,j,t + zij,t

where yi denotes the ith (log) price series and yi1 is yi filtered for all unit roots but the long run stochastic trend,
i.e. y1,i,t = (1 + B + B2 + B3 + .... + B11) yi. Secondly the residuals zij are tested for stationarity using the standard
cointegration ADF critical values given in Engle and Granger (1987). The results are reported in Table 5.

Table 5.
Tests for long run cointegration (nominal & real series)

JAK BAN SUR MED BJN UJU JAY CPI

JAK -2.70 -1.70 -4.45 -1.71 -2.78 -2.51 -4.86

BAN -2.69 -2.93 -2.98 -3.50 -4.92 -3.09 -5.46

SUR -1.56 -1.96 -2.97 -1.28 -1.36 -1.69 -3.77

MED -4.52 -3.25 -2.94 -3.61 -4.97 -3.14 -5.12

BJN -1.97 -2.27 -1.68 -3.76 -3.37 -4.44 -5.15

UJU -2.79 -2.97 -1.49 -4.93 -3.15 -2.73 -4.15

JAY -2.75 -2.45 -2.10 -3.26 -4.36 -2.88 -5.51

CPI -4.37 -4.05 -3.64 -4.70 -4.45 -3.68 -4.56

Notes to Table 5:
1. Row variables are dependent variables in cointegrating regression
2. Critical values are -3.37 (5%) and -4.07 (1%).

Small sample bias can seriously affect results in the Engle-Granger procedure, particularly when there are
more than two variables in the cointegrating regression. In order to check for this problem we have calculated
ADF statistics twice for each pair of price series, using each series as the dependent variable in turn. The
objective is to see if the same level of significance is obtained in either direction. The results from both sets of
equations are shown in Table 5 and only the Ujung Pandang/Bandung (UJU/BAN) relationship appears
distorted by the small sample bias. That is to say: only in the case of those two series do the results show serious
differences depending on which series is made the dependent variable. In all other cases the cointegration results
are fairly robust to swapping dependent and independent variables.

The most striking feature of the results is that each rice is highly cointegrated in the long-run with the CPI,
even though the CPI has been adjusted to remove its rice price component.26 The question arises as to whether
inflation is driving the rice price series in the long-run, and this will be addressed below (in Section 3.4.3). The

25 This procedure is as described in Alexander and Wyeth (1994).

26Unitroot tests on the real rice price series indicate a degree of stationarity commensurate to the strength of cointegration
with the CPI: ADF(1) statistics range from -2.11 for SUR to -3.67 for BAN.

© Carol Alexander and John Wyeth, 1995 18

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

strongest long-run cointegration links are between Medan (MED) and the following centres: Jakarta (JAK),
Banjarmasin (BJN) and Ujung Pandang (UJU). It is worth noting that there is no evidence here of any links with
Surabaya, and indeed Surabaya exhibits the correct cointegration with the CPI. Since Surabaya is the Province
with the largest surplus of rice and therefore the biggest source of supply, this is an interesting result and its
implications will be discussed further below.

2.4.1. Seasonal cointegration and market integration in cycles

The EGHL procedure for testing bivariate cointegration at the single annual cyclical frequency requires the
use of both y11 and y12 in the cointegrating regressions (similarly, for cointegration over the biannual cycle we
would need to use both y7 and y8 ). On the other hand, since y11,t may be written simply in terms of y12,t and
y12,t-1, the cointegrating regression should take the form:
y12,i,t = const + θ1,ij y12,i-1,t + θ2,ij y12,j,t + θ3,ij y12,j-1,t + zij.

However the model parameters will not be identified unless we restrict one of them to be zero so,
following EGHL, we set θ1,ij to be zero for all i and j. Since zij is a linear combination of variables which have
already been filtered for all but annual unit roots, we need to use a Dickey-Fuller type regression to test zij for
annual unit roots. Recall that y12 = A(B) y where:
A(B) = - ½ (1 + √3B + 2B2 + √3B3 + B4 - B6 -√3B7 - 2B8 - √3B9 - B10)

and that 2(-1+√3B-B2) A(B) = (1-B12). Thus:

F(B) = ( -1 + √3B - B2)

will filter out any remaining annual unit root in zij and
zij* = ( -1 + √3B - B2) zij is the appropriate dependent variable in these regressions. Also, instead of a single
lagged level we need two lags of zij (to capture roots at frequencies +π/6 and -π/6). Thus an ADF(1) regression
takes the form:
zij,t* = const + α zij,*t-1 + ρ1 zij, t-1 + ρ2 zij, t-2 + error

where the null hypothesis of no cointegration at the annual frequency implies that both ρ1 and ρ2 are zero.
EGHL provide both 't' and 'F 'critical values of this joint hypothesis, but for quarterly data only27. Since the
results of both 't' and 'F' tests turned out to be qualitatively similar, in Table 6 we report the results of only the 'F'
tests, and only for real data.

27 Since we know of no Monte Carlo simulations for the critical values of these tests for monthly data, we can comment
only on relative strength of cointegration between the different regions. For information, the 5% and 1% critical values for quarterly
data are given in EGHL p.296 as 6.98 and 9.81 respectively.

© Carol Alexander and John Wyeth, 1995 19

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Table 6.
F tests for seasonal cointegration (real data)

JAK BAN SUR MED BJN UJU JAY

JAK 3.68 3.03 3.18 2.00 6.09 4.82

BAN 3.75 9.61 5.14 1.23 11.91 1.28

SUR 4.48 8.96 4.39 3.23 11.86 2.14

MED 6.22 8.36 6.02 2.45 7.39 3.45

BJN 6.22 5.05 8.78 4.19 8.56 7.26

UJU 6.18 10.80 9.70 3.25 8.56 2.04

JAY 9.18 4.11 3.41 4.37 4.37 3.77

Notes to Tables 6(a) and 6(b):

1. Row variables are dependent variables, and column variables are independent variables in cointegrating regression:
Y*t = const + a11 X*t + a12X*t-1 + a13Y*t-1 + error
* *
where Y and X are log price series having been filtered for all but annual unit roots.
2. Critical values are 6.98 for 5% and 9.81 for 1%.

The qualitative nature of our results is unchanged when tests are performed on the nominal series, and
when the identifying restrictions are not employed in our tests (for more details see Alexander and Wyeth
(1995)). This demonstrates the robustness of our conclusion that cointegration is only affected by inflation in the
long-run trend data generation process. We have also checked for small sample bias by using each rice prices
series as the dependent variable in turn to see how much bias the identification problem mentioned above
introduces. Again the problem does not generally seem to be a serious one and the few results that we have
found in favour of cointegrated annual cycles are robust to each of these differences in methodology.

The strongest cointegration of annual cycles occurs among Surabaya (SUR), Ujung Pandang (UJU) and
Bandung (BAN) , and this is evident in both the nominal and the real series. The graph in Appendix 2(h) plots the
real price series of these three regions together, after filtering for all but the annual unit root. The graph in
Appendix 2(i) shows the annual cycles in Jakarta and Banjarmasin, to demonstrate how dissimilar annual cycles
can be.

It should be mentioned that tests for common biannual cycles, which are similar to those above28, were
also carried out However results were fairly inconclusive, which is not surprising given the marginal nature of
the evidence in Table 4 for unit roots at the biannual frequency.

28 In this case the cointegrating regression contain level and lagged y8, where y8 = -√3/2 (1 + B - B3 - B4 + B6 + B7 - B 9- B10
) y and so (1 - B + B2) is the appropriate filter for the residuals of the cointegrating regression when used in ADF-type tests for
stationarity.

© Carol Alexander and John Wyeth, 1995 20

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

2.4.2. Granger causality and seasonal error correction models.

The connection between cointegration and Granger causality has been documented in earlier work
(Alexander and Wyeth, 1994) and we use these ideas to explore two questions that have arisen in the course of
the present paper. They are: (i) whether inflation is the common stochastic trend which is driving the rice
prices over the long-run trend; and (ii) what the Granger causal flows are in those places with significant
common annual cycles, i.e. Surabaya, Ujung Pandang and Bandung.

In fact seasonal error correction models (ECMs) may be used to answer both of these questions. To
question the long-run trend we take nominal series which have been filtered for all but the unit root at frequency
zero. That is, we apply the filter L(B) = (1 + B + B2+...+B10+B11) to each (log) price series (y) and then obtain
cointegrating vectors (z) with the CPI as in Table 5. The corresponding seasonal error correction model takes the
form:
p q
∆12 yt = α ∑ δ j ∆ 12 yt − j + ∑ β j ∆12 ln CPIt − j + µ zt −1 + ε t
j =1 j =1
with a similar equation for the CPI. Note that since (1-B)L(B) = 1-B12 this model may also be written:
p q
∆ y *
t = α∑ δ j ∆ y *
t− j + ∑ β j ∆ ln CPIt*− j + µ z t −1 + ε t
j =1 j =1

where x* = L(B) x 29.

Estimating these models by OLS we find that lags of 1 and 2 are generally sufficient for both dependent
and independent variables, and we may then test for Granger causality to and from the CPI with F (or LM)
exclusion tests in the usual way (see Alexander and Wyeth, 1994). The results in Table 7 are both 'dynamic' and
'long-run trend' causality tests 30. Both are given because in some cases feedback from equilibrium can obscure
the results (see Alexander, 1993).

The most striking feature of Table 7 is that Surabaya (SUR) alone Granger causes the CPI at a very high
significance level, and Surabaya alone is not Granger caused by the CPI even at 10%. In all the other rice price
series the causality in the trends operates in the other direction and they are therefore driven by the CPI. This is a
very significant result and it leads us to conclude that the common unit root for the long run trend can be
attributed to an inflationary stochastic trend.

29 In Jakarta, Bandung, Medan and Pontianak, where the is some evidence of cointegration with the CPI also at the
annual frequency, two lags of the annual cointegrating vector should be included as additional explanatory variables. Hence the F
tests for these rices have different critical values in Table 7.
30 Dynamic tests look at the significance of the two lagged rice terms in the CPI equation, (or the two lagged CPI terms
in the rice equation) and long-run (trend) tests are for the joint significance of all but the lagged dependent variables in these
seasonal error correction models.

© Carol Alexander and John Wyeth, 1995 21

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Table 7.
F tests for causality to and from CPI

Rice price TO CPI FROM CPI

series Dynamic Trend Dynamic Trend
JAK 1.32 0.89 1.73 2.92
BAN 0.23 0.23 1.51 2.45
SUR 7.09 4.97 0.46 1.16
MED 0.37 0.28 0.85 2.24
BJN 2.72 1.93 1.96 5.13
UJU 0.57 0.57 0.68 3.17
JAY 1.31 1.26 1.48 4.45
5% cv 3.07 2.68 3.07 2.68

As a consequence of these findings we concentrate on the real rice price series when looking for properties
in the annual cycles in order to investigate cyclical integration between Surabaya, Ujung Pandang and Bandung.
In other words we examine the causal flows between their annual cycles, again using a seasonal error correction
model. Denoting the three real rice price series (in logarithms) by y1, y2 and y3, we formulate the basic model as:

p q r
∆12 y1t = α ∑ δ j ∆ 12 y1t − j + ∑ β j ∆12 y 2t − j + ∑ γ j ∆12 y 3t − j
j =1 j =1 j =1

+ µ11 z1t −1 + µ12 z1t −2 + µ 21 z 2 t −1 + µ 22 z 2 t −2 + εt

with similar equations for y2 and y3. Here z1 and z2 are the cointegrating vectors from tests of annual
cointegration (such as those in Tables 6(a) & (b)) and no cointegrating vectors for the long run trends are included
since we are modelling the real series.

In the previous section we filtered the real data to remove all possible unit roots but those at frequency π
/6 (the annual frequency, showing a single annual cycle), and these series are shown in the graphs of Appendices
2 & 3. It is natural to investigate properties of annual cycles using these data, and if we put
yi* = A(B)yi for i = 1,2,3 we may reformulate the above seasonal error correction model in a form that we shall
estimate, viz:

p q r
F ( B) y1 *
f
= ∑δ j
F ( B ) y1 *
t− j
+ ∑β j
F ( B) y2 *
t− j
+ ∑ γ j F ( B ) y 3*t − j
j =1 j =1 j =1

+ µ11 z1t −1 + µ12 z1t −2 + µ 21 z 2 t −1 + µ 22 z 2 t −2 + εt

where F(B) = (-1 + √3B - B2).

To avoid any small sample bias we have used for z1 and z2 in each equation the cointegrating vectors
which are obtained from a tri-variate Johansen procedure based on a VAR(3) of y1*, y2* and y3*31. This seasonal
error correction model is then estimated by OLS, and it is found that p = q = r = 2 provides an adequate fit to the

31 Hence the 3rd and 4th lags of each cointegrating vector are used in the ECM in place of the 1st and 2nd lags as
written (see Johansen, 1988).

© Carol Alexander and John Wyeth, 1995 22

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

data. Standard LM exclusion tests of the Granger causality hypothesis are then χ2 distributed with either 2 or 6
degrees of freedom, depending on whether feedback from the equilibrium is admitted.

Table 8.
LM causality tests within real annual cycles

From To Dynamic Long-run

SUR UJU 4.93 11.64
UJU SUR 7.31 9.70
SUR BAN 10.97 17.99
BAN SUR 0.33 8.45
UJU BAN 0.38 13.93
BAN UJU 0.33 8.45
5% cv 5.99 12.60

Results are reported in Table 8 and we see from there that there is a moderate amount of bi-directional
causality between Surabaya and Ujung Pandang, but it is only Surabaya which significantly influences
Bandung32.

The results of this paper show that, in both the long-run trend and in the single annual cycle Surabaya
plays a very special role as an exogenous determinate of prices in the Indonesian rice market. We therefore take
a final look at Surabaya, and compare it with Ujung Pandang and Jakarta, within the framework of an 8
dimensional VAR(2) of the annual filtered series. In Table 9 we quote χ2(2) exclusion tests for the lagged
Surabaya terms in the first column, lagged Ujung Pandang terms in the second column and lagged Jakarta terms
in the last column.

Table 9.
LM causality tests based on VAR(2) of real annual cycles

From
SUR UJU JAK
JAK 8.04 1.57
BAN 6.55 4.38 5.85
SUR 2.48 0.40
To: MED 12.87 0.96 5.04
BJN 16.43 22.44 21.62
UJU 9.37 2.08
JAY 25.82 10.97 7.66

The results here suggest that Surabaya influences the annual cycle of every rice at 5% - and Granger causes
Medan, Banjarmasin, Ujung Pandang and Jayapura at 1%. However, Ujung Pandang and Jakarta only Granger
cause Banjarmasin and Jayapura, both of which are small, peripheral markets. The obvious conclusion is that
any price control by the government should target Surabaya as the primary cause of seasonal price movements in
the Indonesian rice market.

32 The χ2(6) statistic of 13.93 for long-run causality from Ujung Pandang to Bandung is clearly attributable only to
equilibrium feedback, because the dynamic causality figure of 0.38 is very low.

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 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

3. Summary and conclusions.

An Overview

This paper suggests ways of improving the accuracy of measures of market integration that depend on
cointegration techniques. The procedure used by these techniques is first to check the individual data series for
unit roots at all seasonal frequencies and in the long run trend , then test for cointegration between pairs of
series, and finally establish the direction and extent of Granger causality from one market to another.

It is pointed out that this procedure, and in particular the type of tests to be used for integration and the
appropriate stationarity of the data, depends on whether the data generating processes within the series are
stochastic or deterministic. The test for determining which of these two characteristics describes the trend in the
data involves calculating Dickey Fuller statistics to see whether the series are integrated I(1), then adding a trend
to the maintained model for the augmented Dickey Fuller test and seeing whether the result is still significant.
Only if it is and the series are shown to be difference stationary (stochastic) processes then the use of the Engle
Two step procedure for establishing cointegration and Granger causality in the trend is validated.

The presence of seasonal and other cycles is established using spectral density analysis and whether those
cycles are deterministic or stochastic is studied by searching for unit roots at the frequencies for which stochastic
cycles are found, using ADF statistics once again. The test for seasonals is particularly important because the
usual method of allowing for seasonal fluctuations in time series is to include dummy variables, and this
procedure is only valid when the process is deterministic. Otherwise the cycles are better modelled using the
"HEGY" equations. In this case, if the cycles are stochastic processes, then the recently introduced "EGHL"
procedure for testing bivariate cointegration can be used.

These methods are explained and applied to data from seven different areas within the Indonesian rice
market. In the analysis of the trend processes there are mixed results but these are attributed to the weak power
of the tests used and the general conclusion is that the trends are all difference stationary (stochastic) processes.
This makes it valid to apply the Engle Granger two step procedure for testing cointegration between pairs of
series. Although cointegration is found to exist between several series the main general pattern is the strong
cointegration between every single series and the consumer price index used as a measure of inflation.

The Results

When the next stage in the procedure, that of looking at the direction of Granger causality implied by the
cointegration, is applied the causality is clearly shown to be from the CPI toward the individual series in all cases
except that of Surabaya, whereas in the case of Surabaya the causality is reversed.33 Two general conclusions
are drawn from these observations. The first is that the CPI is the mechanism through which prices are affecting
each other and the second is that of these series Surabaya is the most important determinant of prices. In other
words: Surabaya is driving the CPI and the CPI is driving the other prices, so Surabaya is driving the other prices
through the CPI.

It is not hard to think of an explanation for this phenomenon. A glance at Figure 2 makes it clear that
Surabaya represents by far the largest surplus area in the country. Since rice is the only important staple in most
(but not all) of Indonesia it can be assumed that demand is relatively constant throughout the year, at least when
compared with supply. It is not difficult to conclude that if supply is less constant than demand it will be
changes in supply that most affect changes in the demand supply relationship and hence price. Surabaya, as the
largest single supplier, is the main origin of these changes. There are other surplus areas too, of course,
including Bandung and Ujung Pandang but, even though the harvest in Sulawesi, where Ujung Pandang is the
capital, is at a different time from the harvest in East Java, represented by Surabaya, the predominance of the

33 Recall that the CPI has been stripped of its rice component before the analysis.

© Carol Alexander and John Wyeth, 1995 24

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

Surabaya surplus seems to swamp any effects from the other surplus areas when it comes to price determination.
Jakarta, on the other hand, although the most important market and the largest deficit area, represents relatively
stable demand and so is not a prime mover in price changes.

In the seasonal analysis strong evidence is found for an annual unit root, implying the existence of a single
stochastically generated annual cycle. The EGHL procedures allow us to look for cointegration between the
annual cycles in pairs of series but only 3 of the 21 pairs of series showed any evidence of this. Nevertheless,
those three pairs (which included Surabaya, Ujung Pandang and Bandung) were sufficient to lead us to the
conclusion that prices are being driven by the surplus Provinces, both over the trend and within the seasonal
cycles. The important influence of the CPI over the long run, however, is not repeated in the seasonal analysis.

The Methods

However in both the trend, where Surabaya Granger Causes the CPI and then the CPI Granger causes the
other rice prices, and in the annual cycle where Surabaya influences the other surplus centres of Ujung Pandang
and Bandang, it is clear the the most efficient form of price control would be to target the medium rice of
Surabaya. The information available from the methods applied in this paper can be compared with that from
Alexander and Wyeth (1994). Previously the assumption implied by the nature of analysis used was that the
trends were stochastic while the seasonals were deterministic whereas it now transpires that both processes are
stochastic. The finding that the seasonals are not deterministic after all means that it was inappropriate to use
seasonal dummies as was done in the earlier paper. On the other hand the discovery has opened up new
possibilities for study of the seasonals using the HEGY procedures.

The multivariate analysis of this paper has been confined to investigation of the relationships between
pairs of series. It is also possible to extend the methodology to deal with more than two series. This involves
looking for the number r of cointegrating vectors among k different rice price series and using the procedure
developed by Johansen (1988) to test for r=j versus r>j for j= 0,1,2,....k-1. In the present case Johansen trace tests
indicate between 2 and 4 cointegrating vectors among the seven series under study, depending on the lag length
chosen for the maintained vector autoregression. This implies the existence of between 3 and 5 common
stochastic trends, but in the present case there was no natural interpretation of either the trend or the
cointegrating vectors and no extra information added to the analysis34.

A Final Word

The effect of the points made in this paper is to enrich the accuracy and amount of information that can be
obtained about market integration using cointegration procedures. On the other hand it has not made the
analysis any more accessible to non specialists. Both regression and cointegration approaches do have a cost in
terms of complexity and, in an effort to find out whether correlation coefficients could be used as a quick and
dirty first approach to measuring market integration Wyeth (1992) compared the results from correlation, both on
unadjusted data and some simple transformations to correct for the more obvious shortcomings of correlation
analysis. It was found that the simpler measures did not give a very satisfactory indication of what would be
shown by the more complicated measures. This suggests that in spite of the growing complexity of the analysis
there is still a need to rely on it and that it continues to be worthwhile putting some effort into understanding it.

34 For example the first cointegrating vector is:

VAR(2) = ljak + 0.344lban + 0.513lsur - 0.601lmed - 0.852lbjn + 0.542luju + 0.008ljay
where ljak, lban etc are the logarithms of the resepective price sereies.

© Carol Alexander and John Wyeth, 1995 25

 Seasonal Price Movements and Unit Roots in Indonesian Rice Market Integration

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