FORECASTING OF NATURAL RUBBER PRODUCTION IN MALAYSIAN AND WORLD MARKETS: AN ECONOMETRIC ANALYSIS

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1 FORECASTING OF NATURAL RUBBER PRODUCTION IN MALAYSIAN AND WORLD MARKETS: AN ECONOMETRIC ANALYSIS By AYE AYE KHIN, EDDIE CHIEW F. C, ZAINALABIDIN MOHAMED AND MAD NASIR SHAMSUDIN Department of Agribusiness & Information Systems Faculty of Agriculture University Putra Malaysia Kuala Lumpur, Malaysia

2 FORECASTING OF NATURAL RUBBER PRODUCTION IN MALAYSIA AND WORLD MARKETS: AN ECONOMETRIC ANALYSIS Aye Aye Khin 1, Eddie Chiew Fook Chong 2, Zainalabidin Mohamed 2 and Mad Nasir Shamsudin 2 ABSTRACT Malaysia is the world s third largest producer of natural rubber (NR). The agriculture sector s share to Gross Domestic Product (GDP) is estimated to remain stable at 7.5 percent in 2008 from 7.6 percent in Value added from rubber in 2007 contributed 6.3 percent to the Agriculture Sector compared to oil palm which was 29.7 percent. Price fluctuation and production uncertainty characterized the sector and can jeopardize the industry as well as have a negative impact on the rubber small holder income. Forecasting of NR price and production is therefore vital in future planning. The objectives of this paper are to determine inter-relationships between NR production and price and to derive and forecast the natural rubber production of Malaysia and the world production by using the econometric model with Vector Error Correction Method (VECM). The model was developed to forecast short-term annual prices and production in Malaysia and the world market. Annual price and production data from 1975 to 2007 were collected to estimate NR production for Malaysia and the world from 2007 to Based on these forecasts, world NR production is predicted to decrease to around 8 million metric tones (MT) in 2010, a decrease of percent from Likewise, Malaysia s NR production is also predicted to decrease to around 800 thousand metric tones (MT) in 2010, a decrease of percent from Keyword: Forecasting, Natural Rubber Production, Vector Error Correction Method, Malaysia and World Rubber Market. Introduction Malaysia is the world s third largest producer of natural rubber (NR). The agriculture sector s share to Gross Domestic Product (GDP) is estimated to remain stable at 7.5 percent in 2008 from 7.6 percent in Value added from rubber in 2007 contributed 6.3 percent to the Agriculture Sector compared to oil palm which was 29.7 percent ( as can be seen in Table Ph.D Candidate ayeaye5@yahoo.com, Department of Agribusiness & Information Systems, Faculty of Agriculture, Universiti Putra Malaysia (UPM), Serdang, Selangor, Malaysia. Tel: , Fax: Lecturers, Department of Agribusiness & Information Systems, Faculty of Agriculture, UPM.

3 Table 1: Value Added in the Agriculture Sector (at constant 2000 prices) Growth (%) Share to Agriculture (%) Agriculture Oil plam Rubber Cocoa Forestry and logging Other agriculture Fishing Livestock Estimate 2 Including paddy, fruits vegetables, copra, tobacco, tea, flowers, pepper and pineapples. Source: Department of Statistics and Ministry of Finance, Malaysia (2008). An important aspect of the rubber industry s structure is the size of the holding, represented by the size of the area planted i.e. new planting, replanting (with removing the root-stock) and uprooting (without removing the root-stock), the age of trees and the yield profiles and technical progress and other factors influencing the production and prices. When the tree is between 25 and 35 years old, a decision about replanting or uprooting must be made. Otherwise, the yield will decline to very low levels in the years thereafter. If this hectare is not replanted, NR production will be reduced. If it is replanted, this implies no NR production during the immaturity period. However, when production starts, the yield profile will be considerably higher than the previous years because of technical progress, which encouraged higher tapping intensities. Finally, the higher tapping intensities carried out will depend on prices and labour availability (Burger & Smit, 2000). Natural rubber is a vital commodity used in the manufacture of a wide range of rubberbased products. Rubber (Hevea brasillensis) plays a major role in the socio-economic fabric of many developing countries. Over 20 million families are dependent on rubber cultivation for their livelihood in the world natural rubber market ( com/irrdb/naturalrubber) in Many of these small growers have holdings of only less than two hectares. The years 1997 to 1999 as shown in Figure 1 as well as in the year 2000 were turbulent years for the economies in South-East and East Asia. The extremely low prices experienced during these years contributed to increased rural poverty in many countries, especially rubber smallholders in South East Asia. Rubber prices fluctuation is mainly respond to supply and demand factors. Lower prices could trigger higher demand resulting in a supply deficit situation, affecting a price and a new equilibrium can be expected. Consequently, low prices due to overproduction generally have a negative impact on harvesting, encouraging farmers to switch to other crops, a factor which again permits world prices to rise.

4 2500 Natural Rubber Price of SMR20 (US$/ton) Periods PSMR20 (US$/ton) Figure 1: World Natural Rubber Price of SMR20 (US$/tonne) from 1975 to 2007 Currently, the three Southeast Asian countries produce some 80 percent of the world s natural rubber output. About 85 percent of NR production goes into making tyres. The Malaysian economy maintained a steady growth path in the second quarter of 2008 by registering a 6.3 percent growth in GDP (Table 1). NR production in 2008 was recorded at 1,207 thousand MT, an increase of 0.6 percent (1,200 thousand MT) when compared with The smallholding sector contributed 0.6 percent of total production while the estate sector, the remaining 0.4 percent in 2008 (Table 2). Table 2: Rubber Area, Yield and Production in Malaysia. Change (%) Total Area( 000 hectares) 1,230 1, Smallholdings 1,177 1, Estate Yield (kg per hectare) Smallholdings 1,414 1, Estate 1,620 1, Total Production ( 000 MT) 1,200 1, Smallholdings 1,133 1, Estate % of World Production Estimate Source: Ministry of Plantation Industries and Commodities, Department of Statistics and Ministry of Finance, Malaysia (2008).

5 Exports of Malaysian NR in 2007 decreased about percent to 1,018 thousand MT when compared with 2006 (1,134 thousand MT). During the year 2008, exports of NR were mainly to the People s Republic of China 100,826 MT, Federal Republic of Germany 31,922 MT, U.S.A. 17,065 MT, REP. of Korea 13,717 MT, France 10,461 MT, Islamic Republic of Iran 10,084 MT and Brazil 9,395 MT. Total exports of these seven countries accounted for 73.5 percent of the overall NR exports ( Since NR is an important commodity, forecasting future production is important, decision-making process in production, replanting and uprooting. There are many ways of making forecasts. Forecasting process involves the five steps: they are to decide what to forecast, to evaluate and analyze appropriate data, to select and test model, to generate forecast, and to make monitor accuracy. However, forecasts are rarely perfect, are more accurate for groups than individual items, and are more accurate in the short term than long time horizons (Clements and Hendry, 2004). This paper explores the situations of short term future production of natural rubber in Malaysia and the world. The objectives of this paper are to determine inter-relationships between NR production and price and to derive and forecast the natural rubber production of Malaysia and the world production by using the econometric model with Vector Error Correction Method (VECM). The model was developed to forecast short-term annual prices and production in Malaysia and the world market. Annual price and production data from 1975 to 2007 were collected to estimate NR production for Malaysia and the world from 2007 to Background Natural Rubber is a native of the Amazon basin and spread to other countries of South- East and South Asia such as Malaysia, Indonesia, Thailand, Sri Lanka and India and introduced from there to countries in the tropical belts of Asia and Africa during late 19th century. Thailand was the largest producer with an annual production of 3.06 million tons (31.2 percent of World s NR production), followed by Indonesia at 2.79 million tons (28.6 percent) and Malaysia at 1.19 million tons (12.3 percent) in However, in 2008, Indonesia has become the largest producer about 2.73 million tons, followed by Thailand at 2.63 million tons and Malaysia at 1.29 million tons (IRSG Rubber Bulletin Vol.61 No.8/ No.9, May/June 2007 ( com/en.html). Table 3 and Figure 2 shows that world natural rubber supply-demand relationships and natural rubber supply was 8.6 million MT in 2004 and estimated to 9.3 million MT in Conversely, world natural rubber demand was 8.3 million MT in 2004 and estimated to reach 9.9 million MT in The years 2008 shows a deficit situation in the world natural rubber supply at million MT in 2008.

6 Table 3: World Natural Rubber Production/Consumption and Supply Surplus/Deficit ( 000 MT unless otherwise indicated) Countries Thailand 2,984 2,833 2,690 2,580 2,633 Indonesia 2,066 2,271 2,450 2,600 2,733 Malaysia 1,169 1,126 1,200 1,240 1,288 India Others 1,672 1,702 1,720 1,760 1,823 World Supply a 8,634 8,703 8,890 9,040 9,340 % change China 1,630 1,826 1,990 2,150 2,325 North & Latin America 1,810 1,848 1,850 1,850 1,890 Japan ,025 India Africa Europe Countries 1,491 1,560 1,610 1,530 1,710 World Demand a 8,343 8,777 9,150 9,510 9,880 % change World Supply a 8,634 8,703 8,890 9,040 9,340 World Demand a 8,343 8,777 9,150 9,510 9,880 Surplus/Deficit a Rounded to nearest 10,000 metric tones (MT) Source: IRSG; Economist Intelligence Unit (October 2 nd, 2006) 10,000 tonnes Year Supply Deman ,000 tonnes Surplus/ Deficit -600 Figure 2: World Natural Rubber Supply and Demand from 2004 to 2008 (IRSG, 2006)

7 % -6.4% -17.6% -31.0% 10,000 tonnes % Qr 1 Qr 2 Qr 3 Qr Year Figure 3: World Natural Rubber Stocks from 2004 to 2008 (IRSG, 2006) China was the largest consumer 2.33 million MT, at (26.2 percent of world s NR consumption), followed by U.S.A at 1.89 million MT (10.5 percent) and Japan at 1.03 million MT (9.1%) in 2008 (Table 3). Changes to the world stock situation will also affect the price, supply and demand of world natural rubber. Figure 3 shows the stock of natural rubber was 2.4 million MT in 2004 and it reached 0.93 million MT in The deficit of world natural rubber stock was percent in Moreover, the stock of NR, related to the changes in price, supply and demand of NR, showed an increasing trend from 1999 onwards (Burger and Smit, 2000). Tightness in the rubber market provides upward pressure on prices and vice versa. Literature Review Burger and Smit (2000) studied the long-term and short-term analysis of the natural rubber market. The essential elements of NR long-term supply model are: planted area, new planting, replanting and uprooting, the age of the area and the yield profiles, technical progress, other factors influencing normal production and prices. The variables used for demand model are the NR share in total world rubber consumption, the ratio of the Singapore RSS1 price of NR (in US$) and the US export unit value of SBR (Styrene- Butadiene Rubber) (in US$) and also the short-term price model included world natural rubber average production, world total rubber consumption, exchange rate, private world stocks, RSS1 price in Singapore (US$/tonne) and a dummy (taking in time trend). It included the economies of key players in the natural rubber market both on the demand side, on the supply side and price fluctuations. Burger and Smit (2001) found that the economies of key players in the natural rubber market both on the demand side and on the supply side were severely affected: substantially lower or even negative growth and dramatic declines in exchange rates. This has resulted in turbulent developments in the natural rubber market in that period as well as in the year 2000.

8 They also indicated that there is a clear relationship between rubber consumption and GDP. The natural rubber supply was not available in sufficient quantities at competitive prices. It was found that synthetic rubber prices tended to follow, rather than lead, natural rubber prices, as NR was the dominant price. Insufficient supply and high prices reduced the growth in consumption of natural rubber. Ismail (2007) indicated that rubber industry of Malaysia has undergone important structural changes, from an important raw product producer in its early years to a major processed product manufacturer. He also stated that through research and development and conductive government policies, have managed to become a major manufacturer of processed rubber products. The rubber industry has always produced positive net trade flows, provided steady employment and consistent earnings for the government. In addition, current higher prices due to supply and demand factors as well as the rise in petroleum prices augur well for the further development of the rubber industry in Malaysia. Zainal Abidin (2007) studied about the dilemma for the Malaysian Rubber Industry in facing globalization. He explained that both world production and consumption were characterized by increasing trends and it was quite an irony that Malaysian rubber production was contrary to world production trend. This was due to an alternative crop (palm oil) that was less labor intensive, experiences a less volatile world market price and higher return to investment in Malaysia. However, world natural rubber production has increased due to the government assistance programs for smallholders in major producing countries, which encouraged higher tapping intensities which increased both tree and land productivity. Econometric Model Methodology The papers reviewed regarding the supply, demand and price relationship in the earlier studies were based on the models developed by Meganathan (1983), Tan (1984), Mad Nasir et al. (1993), Fatimah & Zainalabdin (1994), Barlow et al. (1994), Ferris (1998), Burger and Smit (1997 & 2000) and Lim (2002). The Vector Error Correction (VECM) method was developed to forecast short term yearly prices and production in the Malaysia and the world market. Yearly data from 1975 to 2007 on price of NR and production were collected and estimated in order to predict NR production for Malaysia and the world from 2007 to Supply It had identified the supply of natural rubber (TPNR) as a function of the related factors as follow: TPNR t = ƒ(psmr20 t-i, TPNR t-i, D1, T, e ti ) (1) where:

9 TPNR = Total production of natural rubber (Total Supply) (000 MT) PSMR20 = Average FOB annually price of SMR20 (US$ /tonne) deflated by the CPI. D1 = A dummy, taking the value of 1 in production increased annually and 0 otherwise. T = Time trend, 1975 to 2007 e i = error terms Vector Error Correction (VECM) Method A vector error correction (VEC) method is a restricted vector autoregression (VAR) designed for use with non-stationary series that are known to be cointegrated (Gilbert, 1986 and Hendry and Ericsson, 2001). The VEC has cointegration relations built into the specification so that it restricts the long-run behavior of the endogenous variables to converge to their cointegrating relationships while allowing for short-run adjustment dynamics. The cointegration term is known as the error correction term since the deviation from long-run equilibrium is corrected gradually through a series of partial short-run adjustments (Engle and Granger, 1987). Results Table 4: Estimated Structural Equation of Supply Model (Malaysia) Summary Statistics of the Regression Coefficients Dependent Variable Independent Variable Coefficient Std. Error t-statistic Econometric Model Vector Error Correction Method Supply (TPNR t ) PSMR20 t *** TPNR t *** D1 (TPNR) C R-squared Adjusted R-squared Cointegration Method Supply (TPNR t ) PSMR20 t TPNR t *** D1 (TPNR) C Source: Own Data Calculations Note: *** Statistically significant at the 0.01 level, ** at the 0.05 level, and * at the 0.10 level. Table 4 shows that the estimated structural equation of supply model of Malaysia. The equation as a whole explained about 79 percent of the variation in supply. The coefficient

10 of price (PSMR20) results is consistent with the prior expectation, an increased production of 0.16 percent if the price of PSMR20 increase by 1 percent and it is significant at the 0.01 level. The coefficient of production in the pervious period shows a positive sign, an increased production of 0.04 percent of the total production significant at the 0.01 level. Burger and Smit (2000) found that at the each short-term supply log-linear model, a 1 percent increase in price of RSS1 in Singapore, average and other things unchanged, increases the total production of natural rubber (TPNR) by 0.1 percent, 0.06 percent, 0.18 percent and 0.07 percent in Malaysia, Indonesia, Thailand and Philippines, respectively. Table 5: Estimated Structural Equation of Supply Model (World) Summary Statistics of the Regression Coefficients Dependent Variable Independent Variable Coefficient Std. Error t-statistic Econometric Model Vector Error Correction Method Supply (TPNR t ) PSMR20 t *** TPNR t *** D1 (TPNR) C R-squared Adjusted R-squared Cointegration Method Supply (TPNR t ) PSMR20 t TPNR t *** D1 (TPNR) C Source: Own Data Calculations Note: *** Statistically significant at the 0.01 level, ** at the 0.05 level, and * at the 0.10 level. Table 5 shows that the estimated structural equation of supply model of world natural rubber market. The slope coefficient of price of PSMR20 measures the proportional change in total production of natural rubber (TPNR) for a given proportional change in price of PSMR20. Therefore, a 1 percent increases in price of PSMR20, average and other things unchanged, increases in total production of natural rubber (TPNR) by 0.15 percent for world natural rubber market. The coefficient of production in the pervious period also is an increased production of 0.49 percent of the total production significant at the 0.01 level. The equation as a whole explained about 88 percent of the variation in supply.

11 Total Production of Natural Rubber (000, MT) Periods Malaysia TPNR Actual (000 MT) Malaysia TPNR Forecast (000 MT) Figure 4: Total Production of Natural Rubber in Malaysia Forecasting from 1975 to World Total Production of Natural Rubber (000, MT) Periods World TPNR Actual (000 MT) World TPNR Forecast (000 MT) Figure 5: World Total Production of Natural Rubber Forecasting from 1975 to Figure 4 and 5 showed the projections for Malaysia and the world natural rubber production year from 1975 to Based on these forecasts, Malaysia natural rubber production will also decrease to around 800 thousand MT in 2010 a decreased of percent from 2007 (Figure 4). Besides, world natural rubber production will decrease to around 8 million MT in 2010 a decreased of percent from 2007 (Figure 5). The results show that both of natural rubber productions would be on a decrease trend and it is due to the fall in oil prices to 80 US$ per barrel makes synthetic rubber prices more competitive, putting further pressure on natural rubber prices. However, natural rubber production would be increased to some extent if the government assistance programs for smallholders, which would be encouraged tapping and increased both tree and land productivity in natural rubber producing countries.

12 Conclusion For many years now, MRB (Malaysia Rubber Board) and IRSG (International Rubber Study Group) have forecasted the price of natural rubber which will be beneficial for the industry in their future economic planning. The forecasting is related to the current and expected fundamentals of the natural rubber producers and consumers as well as traders and planners for new investment decisions in the natural rubber markets. Malaysia is one of the major producer and exporter of natural rubber in the past few decades. The rubber industry has always produced positive net trade flows; provides steady employment and consistent earnings for the government. For some historical and economic reasons, the plantation sector shifted from rubber to oil palm and rubber crops that were due for replanting were replaced with oil palm. Malaysia s natural rubber production would decline in the near future and this was because there would be clearly explained by the areas to be planted in future which would become a constraint to Malaysia. The government would impose a limitation to land expansion for natural rubber and hence, area planted would be stagnant due to zero increase in new planting during 2004 to 2006 (MRB, Quarterly Natural Rubber Statistical Bulletin, 2006). Recently, declines at the world stock-exchanges and commodity markets of 20 percent and more, were caused by the global financial crisis. What is happening right now will change the world sustainably. The global finance system needs to be renovated and the architecture of the new system of the world economy also cannot be predicted at this stage ( The demand for natural rubber has also weakened dramatically, following the financial crisis. Many car manufacturers are forced to reduce the production heavily, stop production or have to announce short-time work ( natural rubber trading department, 10/13/2008). Low demand, increasing production and weaker oil prices lead to falling prices of NR. If the price of natural rubber would be higher, it would be resulted in a shift in the comparative advantage of rubber production against other crops, in particular palm oil, which attracted smallholders to revive rubber tapping. Otherwise, higher prices would be the major factor to induce more intensive tapping. If global economic growth, especially in developed countries and large developing countries continued at the current pace, further price strengthening would be expected. It would be recovered the falling prices of NR in the short term by supply management to decrease intensive tapping ( content/view/30/30, 7/6/2008, 10:14 pm). The forecasting of NR production would be beneficial for the industries in their future economic planning. The results presented have assumed that normal global economic scenario. However, with the global financial crisis which have resulted in perhaps a widespread global recession, with its concomitant shrinking demand including that of virtually all commodities. It would be interesting to factor in the new parameters of reduced demand of rubber, due in part to the global vehicle sales contraction due to lower purchasing power and delayed buying decisions, and the appropriate supply response by rubber producing countries, in particular the tripartite countries, to determine what the new production forecast of natural rubber would be in the interim world market.

13 References Burger, K., and H. P. Smit. (2000). Long-Term and Short-Term Analysis of the Natural Rubber Market. Department of Econometrics, Economic and Social Institute, Faculty of Economics and Business Administration, Vrije University, De Boelelaan 1105, 1081 HV Amsterdam, The Netherlands. Burger, K., and H. P. Smit. (2000). Natural Rubber in the Coming Decade Policies and Projections. International Rubber Forum, International Rubber Study Group, 9-10 November, Antwerp, Belgium. Clements, Michael P., and Hendry, David F. (2002). A Companion to Economic Forecasting. Blackwell Publishing, 350 Main Street, Malsen, MA , USA. Ferris, John N.(1998). Agricultural Prices and Commodity Market Analysis. Latif, I. A. (2007). Rubber Industry of Malaysia. 50 yeas of Malaysian Agriculture Transformational Issues Challenges & Direction edited by Fatimah Mohamed Arshad, Nik Mustapha R. Abdullah, Bisant Kaur and Amin Mahir Abdullah; Penerbit Universiti Putra Malaysia, UPM Serdang, Selangor Darul Ehsan, Malaysia Rubber Board Quarterly Natural Rubber Statistical Bulletin, my.com. Mohamed, Z. A. (2007). Which Strategy? To Exit or to Defend? A Dilemma for the Malaysian Rubber Industry in Facing Globalization. 50 yeas of Malaysian Agriculture Transformational Issues Challenges & Direction edited by Fatimah Mohamed Arshad, Nik Mustapha R. Abdullah, Bisant Kaur and Amin Mahir Abdullah; Penerbit Universiti Putra Malaysia, UPM Serdang, Selangor Darul Ehsan, Makridakis, S., Wheelwright, S. C. & Hyndman, R. J. (1998). Forecasting Methods and Applications. Third Edition, John Wiley & Sons, Inc. Pindyck, Robert S. and Rubinfeld, Daniel L. (1998). Econometric Models and Economic Forecasts. (4 th Edition). Copyright by the McGraw-Hill Companies, Inc.