Therefore, it isvery important to study the impact of change in exchange rate on both tradebalance and inflation in Vietnam to have a sound exchange rate policy which canimprove trade bal
INTRODUCTION
The criticality of the study
In the latter half of the 20th century, countries such as Japan and South Korea utilized exchange rate policy as a strategic instrument in their international trade efforts, aiming to reduce trade deficits, enhance international reserves, and stimulate trade, ultimately striving to emerge as leading Asian economic powers.
In its early economic reform stages, China utilized exchange rate manipulation to enhance exports, resulting in a consistent trade surplus with the US and the largest foreign exchange reserves globally Alan Greenspan, the former Chairman of the US Federal Reserve, also sought to devalue the US dollar to boost exports and decrease the trade deficit, hinting at this strategy during a 2003 CNN interview by emphasizing the importance of export potential Since 2013, the significant devaluation of the Japanese yen has sparked debate over its effectiveness in promoting exports.
Vietnam has faced a persistent trade deficit over the past 20 years, highlighting weaknesses in its economy and potential long-term instability The goal of achieving a balanced international trade, outlined in the International Trade Strategy for 2001-2010, was not realized by 2008 Additionally, Vietnam has experienced relatively high inflation compared to other countries, while the nominal exchange rate of the VND against the USD remained stable As a result, many researchers believe that the Vietnamese currency is overvalued and suggest currency devaluation as a strategy to stimulate economic growth.
Many countries have historically pursued export strategies to enhance their trade balance However, experts caution that devaluation can lead to inflation, a challenge that Vietnam is currently working to address.
A brief literature review on the impact of exchange rate policy on trade
1.2 A brief literature review on the impact of exchange rate policy on trade balance and inflation in Vietnam
The chosen research topic for this thesis is "The Impact of Exchange Rate Policy on Trade Balance and Inflation in Vietnam," focusing on key questions regarding the relationship between exchange rate policies and their effects on trade balance and inflation rates in the country.
Whether the changes in exchange rate affect trade balance and inflation in Vietnam?
Devaluation impacts trade balance and inflation by altering the cost of exports and imports, often leading to a more favorable trade balance but potentially increasing inflationary pressures Vietnamese policymakers should consider adjusting the exchange rate policy to enhance trade balance while implementing measures to control inflation, such as monitoring price levels and ensuring that devaluation does not excessively raise import costs Balancing these factors is crucial for sustainable economic growth in Vietnam.
This study examines the influence of the nominal exchange rate of the U.S dollar against the Vietnamese dong (USD/VND) on Vietnam's trade balance and inflation from 2000 to 2012 Additionally, it explores how the exchange rates of other major trading partners' currencies, including CNY/VND, EUR/VND, JPY/VND, and SGD/VND, contribute to enhancing trade balance and managing inflation in Vietnam.
The author uses a combination of research methodologies including literature study, qualitative analysis, comparative study, etc.
The thesis explores the interdependent relationships among exchange rates, trade balance, and inflation using the Vector Auto Regression (VAR) model This model is recognized for its flexibility and ease of use in analyzing multivariate time series data As an extension of the univariate autoregressive model, the VAR model effectively captures the dynamic behavior of economic and financial time series, making it a valuable tool for both analysis and forecasting.
The study employs a VAR model to examine the existence and direction of causal relationships among variables It calculates impulse response functions to assess the effects of exchange rate depreciation on trade balance and inflation Additionally, variance decomposition is utilized to analyze the exchange rate's contribution to the fluctuations in trade balance and inflation.
THEORETICAL FOUNDATION OF IMPACT OF EXCHANGE RATE
Basic concepts of exchange rate
Despite the rise of globalization and economic integration, most countries continue to use their own currencies The increase in international trade and economic activities has created a demand for currency exchange, leading to the establishment of exchange rates, defined as the comparative relationship between the currencies of two nations (Dinh Xuan Trinh, 2006) As economic interactions became more complex, particularly with the introduction of letters of credit in foreign currencies tradable in the foreign exchange market, exchange rates began to be viewed as the price of one currency in terms of another.
American businesses can import goods from the United Kingdom using checks as their payment method For instance, to pay British exporters, American importers needed to purchase a check worth GBP 100 for USD 160 at a U.S bank The British exporters then deposited these checks at their local banks, receiving GBP 100 in return This transaction establishes the exchange rate between GBP and USD at 1 GBP equaling 1.6 USD.
From a country’s perspective, there are two ways to interpret exchange rate:
The exchange rate represents the value of a local currency in terms of a foreign currency, a definition commonly used in countries like the U.K and the U.S In these regions, the exchange rate is presented indirectly, indicating the price of foreign currency without explicitly stating it.
The exchange rate is defined as the price of a foreign currency expressed in the local currency, a convention widely adopted by many countries, including Vietnam According to the Foreign Exchange Ordinance No 28/2005/PL-UBTVQH11, Article 4, Clause 9, the exchange rate specifically refers to the value of foreign currency in relation to the Vietnamese Dong.
In this research, the terms "exchange rate" and "foreign exchange rates" are used interchangeably to refer to the value of the US dollar (USD) in Vietnamese Dong (VND) An increase in the exchange rate indicates a depreciation of the local currency, while a decrease suggests an appreciation.
2.1.2 The determinants of exchange rate
Historical economic events, particularly Germany's hyperinflation in the 1920s, illustrate the significant impact of inflation differentials on exchange rates During this period, Germany excessively printed money to finance government expenditures, leading to an astronomical increase in the price index, which soared by 6,666,666.7% in 1924 compared to previous levels.
1923 Germany’s Mark depreciated to a historical record (Johnathan Mc.Cathy,
1998) The impact of inflation differential on exchange rate can be presented relatively in the form of Purchasing Power Parity (PPP) model as below:
We define PD, PF and e as local price, foreign price, and exchange rate respectively
11 at the beginning of a certain year, ∆P , ∆P and ∆e are percentage changes of localD F good price, foreign good price and exchange rate respectively calculated at the end of the year.
- PPP at the beginning of the year: P = e * PD F
- PPP at the end of the year: PD(1+∆P )=e(1+∆e).P (1+∆P )D F F
- Therefore, (1+ ∆PD)=(1+∆e)(1+∆PF), or ∆eUnder normal economic conditions: ∆P ≈0 so that ∆e≈∆P - ∆PF D F
The change in exchange rates closely reflects the inflation rate differences between two countries, provided that other factors remain constant Additionally, the interest rate differential between local and foreign currencies plays a significant role in influencing exchange rate movements.
The Interest Rate Parity (IRP) theory, proposed by John Maynard Keynes, illustrates the relationship between interest rate differentials in local and foreign currencies and their impact on exchange rates According to IRP, equilibrium in the foreign exchange market necessitates equivalent interest rates across different currencies when converted Keynes emphasized that arbitrage opportunities will arise under normal conditions, aligning forward prices with interest rate differentials Consequently, a lower interest rate in one country’s currency is balanced by a higher forward price relative to a currency with a higher interest rate, ensuring market equilibrium.
Foreign currency interest rate difference between domestic and foreign market
Countries offering higher interest rates on foreign currency deposits attract capital inflows, increasing the supply of foreign currency This influx causes the supply curve of USD to shift rightward, resulting in a decrease in the exchange rate.
Protectionism policies, including tariffs and trade barriers, are implemented by countries to bolster the competitiveness of their industries in international trade These measures, such as increased tariffs on imported goods, reduce the volume of imports and lower the demand for foreign currency, leading to a depreciation of the exchange rate and an appreciation of the local currency For instance, if Vietnam raises tariffs on U.S laptops, the price of these imports will rise, causing demand to decrease and subsequently appreciating the VND against the USD However, this appreciation negatively impacts exports, creating a paradox where protectionism, intended to support local manufacturing, ultimately hinders export competitiveness Thus, the relationship between protectionism and exchange rates results in unintended consequences that can undermine economic goals.
Impacts of exchange rate on trade balance
Exchange rate policy encompasses a set of tools designed to regulate the supply and demand dynamics in the foreign exchange market, ultimately influencing the exchange rate to achieve specific objectives A stronger local currency can enhance exports while restricting imports, and conversely, a weaker currency can have the opposite effect Consequently, effective management of exchange rate policies directly impacts the trade balance Furthermore, any announcements by central banks regarding adjustments to foreign exchange rate policies often spark discussions about their potential effects on prices and inflation.
2.2.1 Exchange rate’s impacts on import and export performance
A high exchange rate in local currency means exporters receive more local currency when converting their foreign earnings, which can lead to reduced revenue in local currency terms Consequently, this discourages exports and may result in a downward trend in export volume In summary, the exchange rate significantly affects export volumes: an increase in the exchange rate correlates with higher export volumes, while a decrease can lead to a reduction in goods exported.
The "volume effect" of exchange rates significantly influences both exports and imports When exchange rates rise, exporters face delays in adjusting their production schedules and negotiating new contracts, while importers must honor existing agreements, often at a loss Conversely, a decrease in exchange rates allows exporters to push sales despite margin losses and enables importers to negotiate new contracts with foreign suppliers This dynamic results in decreased import volumes when exchange rates increase and increased volumes when they decrease The fluctuations in import volumes due to exchange rate changes highlight the need for importers to adapt to new market conditions, selecting and verifying goods from new exporters who benefit from favorable exchange rates.
The time-lagging feature of the volume effect means that exchange rate fluctuations do not immediately impact export volume; however, the price effect plays a crucial role during this transition For instance, with an exchange rate of 1 USD = 15,000 VND, an exported good priced at 2,000 VND is valued at 0.1333 USD If the exchange rate rises to 1 USD = 18,000 VND, the value drops to 0.1111 USD, while a decrease to 1 USD = 10,000 VND increases the value to 0.2 USD This highlights that although the volume effect may be delayed, exchange rate fluctuations have an immediate impact on export value: an increase in the local currency exchange rate results in a decrease in export value in foreign currency, and a decrease in the exchange rate leads to an increase in export value.
Agricultural products and raw materials are more vulnerable to exchange rate fluctuations than other exports like machinery and gasoline, primarily because substitutes for these goods are readily available When the exchange rate declines, exported goods become pricier, leading consumers to prioritize alternatives, particularly for easily substituted items For instance, if the exchange rate shifts from 1USD = 16,000VND to 1USD = 10,000VND, the price of Vietnamese coffee rises from 0.5 USD to 0.8 USD per kilogram for American consumers Given the availability of substitutes such as Brazilian coffee or other beverages, American buyers may opt for these alternatives rather than pay the increased price Consequently, if Vietnam maintains its exchange rate and production costs remain constant, demand for Vietnamese coffee in the U.S is likely to diminish.
When there is no demand, the good would be removed from export list to the U.S.
An increase in the exchange rate can lead to a broader range of exported goods, as businesses that previously struggled to compete can now benefit from this rise Consequently, the boost in export revenues enables these companies to expand their production capabilities and diversify their product offerings.
2.2.2 Currency devaluation and trade balance: J-Curve Effect
The concept of currency devaluation
Currency devaluation refers to a intentional reduction of a nation's official exchange rate compared to other currencies, primarily executed by the government or central bank in a fixed exchange rate system This process stands in contrast to currency revaluation and is represented by an increase in the exchange rate Essentially, currency devaluation diminishes the purchasing power of a country's currency in relation to foreign currencies, impacting its economic dynamics.
Currency devaluation is characterized by a significant rise in the exchange rate, measured in local currency, which influences both export and import activities as discussed in the Volume Effect and Price Effect sections Furthermore, this devaluation leads to the phenomenon known as the J-Curve Effect.
Figure 2.1: J-Curve Effect in currency devaluation
Figure 2.1 illustrates Vietnam's trade balance in VND following a currency devaluation, assuming an initially balanced trade account After the devaluation occurs at T = 0, the exchange rate increases, leading to higher prices for imported goods in local currency and an overall rise in import value, resulting in a trade deficit Initially, due to the timing lag of the Volume Effect, export value increases gradually However, if the growth rate of exports lags behind that of imports, the trade account will remain in deficit, highlighting the limited effectiveness of currency devaluation in improving the trade balance.
The World Bank (WB) and the International Monetary Fund (IMF) often recommend currency devaluation as a solution for countries experiencing trade account difficulties They view this strategy as an effective means to bolster export industries, helping nations like Vietnam combat the challenges posed by trade deficits.
In conclusion, exchange rate and trade balance have a very tight relation to each other Both theoretical research and empirical studies in different countries proved
The exchange rate plays a crucial role in influencing both imports and exports to achieve a desired trade balance However, the relationship between exchange rates and trade balances is complex, as both are sensitive macroeconomic indicators affected by various factors Theoretical frameworks such as the J-Curve Effect illustrate the exchange rate's impact on trade balance, while the Marshall-Lerner Condition provides a quantitative estimation These concepts are essential for export-focused countries like Vietnam when managing their trade balance through exchange rate adjustments.
Impact of exchanges rate on inflation
The exchange rate pass-through effect measures how changes in exchange rates influence local currency prices, specifically reflecting the percentage change in domestic prices when the exchange rate between trading partners shifts by 1 percent Essentially, it represents the exchange rate elasticity of the price level, highlighting the relationship between currency fluctuations and their impact on import prices in the domestic market.
2.3.1 The mechanism of exchange rate’s impacts on price level
The exchange rate pass-through effect measures how changes in exchange rates influence local currency prices Specifically, it refers to the percentage change in domestic prices within the importing country resulting from a 1 percent change in the exchange rate between two trading partners' currencies Essentially, exchange rate pass-through reflects the exchange rate elasticity of the price level.
Graph 2.1 shows 3 channels through which consumer prices can adjust to changes of nominal exchange rate: direct, indirect and foreign direct investment
Direct Effect – The direct effect includes the direct change in prices of both intermediary and end-consuming imported goods because of higher exchange rate.
Empirical research typically utilizes the imported goods price index to independently analyze its effects Studies by Obstfeld and Rogoff (2000) and others have demonstrated that imported goods exhibit greater sensitivity to fluctuations in exchange rates than general consumer goods.
Graph 2.1: Mechanism of exchange rate pass-through on inflation
Prices of component made overseas
Increased prices of imported goods
Increased demand for locally- produced goods (to replace imported ones
Increased demand for locally- produced goods
Increased demand for labor; higher wages
Increased production of local goods as substitutes for imported goods through FDI
Production of local goods grows
Exchange rate rises (local currency devaluation)
Tỷ giá tăng (Phá giá nội tệ)
The indirect effect refers to the substitution between locally-made and imported goods, both in domestic and foreign markets Following Russia's 1998 currency crisis, internal substitution led to decreased consumption of expensive imported goods and increased demand for affordable locally-produced items, resulting in higher prices for these local goods Additionally, external substitution occurred as locally-made products became more affordable for foreign consumers, boosting demand and promoting national exports This shift required local producers to replace imported intermediary goods with domestic alternatives However, once real wages returned to previous levels, production costs increased, leading to a decline in output The long-term effects align with the Marshall-Lerner Condition, as historical data post-crisis supports the notion that the devaluation of the Ruble in 1998 spurred domestic output growth.
The sharp devaluation of the Ruble in 1998 significantly decreased the demand for imported goods and real wages in foreign currency, prompting multinational companies to reassess their strategies Faced with the dilemma of either losing market share or establishing local manufacturing plants, many opted to invest in Russia, leading to increased foreign direct investment (FDI) inflow This influx of production not only boosted labor demand but also resulted in rising wages, further contributing to an appreciation of the exchange rate.
In a dollarized economy, the exchange rate fluctuations significantly impact domestic prices through the dollarization effect, where foreign currency is used extensively as a substitute for local currency An economy is deemed highly dollarized when foreign currency deposits exceed 30% of M2, which includes cash, current account deposits, and term deposits In such economies, the demand for local currency becomes unstable, leading individuals to convert local currency to foreign currency during uncertain times, resulting in currency depreciation and inflation Additionally, significant deposits in foreign currency can trigger currency arbitrage due to shifts in interest rates, complicating central banks' ability to manage money supply and fostering banking instability Consequently, in a dollarized environment, the prices of goods, often listed in foreign currency, fluctuate in tandem with changes in the exchange rate.
In summary, there are several parallel processes through which prices of goods react to the movement of exchange rate.
2.3.2 Purchasing Power Parity (PPP) and deviation from PPP
The exchange rate pass-through significantly influences domestic prices and the transmission of economic shocks in open economies Despite its importance, traditional macroeconomic models often overlook this factor For example, many floating exchange rate models align with the Purchasing Power Parity theory, leading to a complete effect of exchange rate pass-through on prices.
The Purchasing Power Parity (PPP) theory, also known as the one-price rule, posits that exchange rate pass-through should have a complete effect, implying that exchange rate elasticity is 100% and long-term currency arbitrage opportunities do not exist Consequently, analyzing the exchange rate pass-through effect inherently involves examining PPP, which maintains that prices for identical goods should be consistent across different countries.
The domestic price (P) is determined by multiplying the overseas price (P) by the exchange rate (E), which is expressed as the number of local currency units per one unit of foreign currency This formula illustrates the relationship between domestic and overseas pricing, highlighting the impact of exchange rates on local prices.
A macroeconomic model developed by Obstfeld and Rogoff (1995, 1998, 2000) posits that when local prices are fixed in the producer's currency, there will be a direct one-to-one relationship between prices and exchange rates.
The PPP model relies on several assumptions that may not hold true in reality, such as perfect competition and the absence of transaction costs Empirical research has demonstrated that exchange rate pass-through often fails to achieve perfection Notably, Isard (1977) was among the first to question whether global price arbitrage could effectively narrow price disparities between countries to merely the cost of transportation.
Various theories explain the incomplete exchange rate pass-through, with Obstfeld and Rogoff (2000) highlighting factors such as transportation costs and market segmentation that elevate import prices, limiting consumer access despite the availability of substitutes McCallum and Nelson (1999) further argue that marketing, distribution, and retailing costs significantly influence consumer spending, suggesting that exchange rate fluctuations may have a minimal effect on final goods prices Additionally, Burstein, Neves, and Rebelo (2003) emphasize the importance of intermediary goods and services in domestic distribution, although they do not fully account for the varying impacts of exchange rate pass-through.
A low exchange rate pass-through may not solely stem from fixed goods prices; instead, it can result from an optimal price discrimination strategy Research by Bergin & Feenstra (2001) and Bergin (2001) introduced a comprehensive balanced model demonstrating that exchange rate pass-through can be less than perfect, even when prices are fully floated.
Dedola (2001) proposed a model highlighting that the exchange rate pass-through is influenced by the differing distribution costs between domestic and international markets Their findings indicate that the pass-through effect does not achieve perfection, as exporters in a monopolistic industry perceive that importer demand is contingent upon local distribution expenses.
An alternative approach to pricing models is presented by Bachetta and Wincoop (2002), who emphasize optimal pricing strategies while disregarding distribution costs Their model suggests that the currency of valuation is influenced by the competitiveness of imported goods relative to local products When competition is high, importing companies prefer to value goods in local currency, resulting in a zero exchange rate pass-through effect Even in the face of exchange rate risks, companies are likely to maintain their prices to safeguard their market share.
Therefore, the more competitive level between local producers and importers is,the smaller the exchange rate pass-through is.
OVERVIEW OF THE IMPACT OF EXCHANGE RATE ON TRADE
Foreign exchange rate management in Vietnam
Prior to the year 1986, basically a multi-exchange rate regime existed in Vietnam, of which foreign currencies to determine exchange rates were mainly Yuan (before
From 1959, the Vietnamese dong was fixed against the USSR's Ruble, facilitating trade and recording payment balances between Vietnam and other nations in the Council for Mutual Economic Assistance throughout the 1970s and 1980s In addition to trade rates, non-trade rates were established for diplomatic purposes and for students studying abroad The state's foreign trade monopoly also allowed for the existence of an internal rate, which was utilized for internal transactions among banks and foreign trade organizations.
Since the introduction of foreign direct investment policies in 1985, Vietnam has seen a significant inflow of USD Initially, the official exchange rate was arbitrarily set, establishing a conversion of 1 USD to 18 VND, reflecting a 1:1 relationship between the USD and the SUR.
During this period, foreign trade activities were skewed by a closed economy, leading to a subjective determination of rates that did not align with market demand and supply signals Consequently, these rates had no impact on the trade balance or inflation.
Since the end of the subsidized and centralized regime in 1989, Vietnam has significantly reformed its exchange rate mechanism, primarily focusing on a pegged exchange rate system The US dollar (USD) has become the default currency for this peg, with the State Bank of Vietnam (SBV) responsible for announcing the VND/USD exchange rate Commercial banks then establish rates between the Vietnamese dong (VND) and other foreign currencies based on international USD rates A summary of the exchange rate regimes applied in Vietnam is presented in Table 3.1.
1989 This classification is based on IMF’s classification system
Table 3.1 Vietnam’s exchange rate regimes, 1989 - 2012
Time Applied regime Exchange rate regime’s features Before 1989 Multi-exchange rate regime
- Free market’s exchange rates co-existed with the state’s exchange rates (until present time).
1989 - 1990 Crawling bands with adjusted amplitude
- Official exchange rate (OER) was unified.
- OER was adjusted by SBV based on signals of inflation, interest rates, payment balance and the rates in the free market.
- Banks were allowed to set up exchange rates for transactions within the amplitude of +/-5%.
- Use of foreign currencies was strictly controlled
1991 - 1993 Pegged exchange rate within horizontal bands
- The control of foreign currency use got stricter with limitation of taking money out of borders
- An official foreign currency reserves was established to stabilize exchange rates.
- Two foreign currency transactional stocks were set up in Ho Chi Minh City and Hanoi
- OER was formed based on bidding
Time Applied regime Exchange rate regime’s features exchange rates at the two stocks.
- Exchange rates at commercial banks were 0.5% lower than the announced OER
- Inter-bank foreign currency market was formed to replace the two exchange rate transactional stocks; the State Bank of Vietnam continued its strong intervention into transactions in this market
- OER was formed and announced based on the inter-bank exchange rate.
- Exchange rates at commercial banks fluctuated within the amplitude of +/- 0.5% of the announced OER By the year 1996, the amplitude was broadened from less +/- 0.5% to +/-1% (November 1996).
- OER was kept stable at VND11,100/USD.
1997 - 1998 Crawling bands within adjusted amplitudes
- Exchange rate amplitudes at commercial banks compared to OER were broadened from +/- 1% to +/-5% (February 1997); to +/-10% (13 th October 1997) and later down to +/- 7%
Time Applied regime Exchange rate regime’s features
- OER was adjusted to VND 11,800/USD
(16 th February 1998) and VND12,998 /USD (07 August 1998) th
1999 - 2000 Crawling peg - OER was the average inter-bank exchange rate of the previous working day (from 28 February 1999) th
- Exchange rate amplitudes at commercial banks decreased less than 1%.
- OER was stabilized at VND 14,000/USD
floating with no preannounced path of the exchange rate
- OER had been gradually adjusted from VND 14,000/USD in the year 2001 to 16,100/USD in the year 2007.
- Exchange rate amplitudes at commercial banks were adjusted to +/-0.25% (from
01 st July 2002 to 31 December 2006) st and +/- 0.5% in the year 2007.
- OER had been gradually adjusted from about VND16,100/USD in early 2008 to VND16,500/USD (June 2008 to December 2008), VND17,000/USD (from January 2009 to November
Time Applied regime Exchange rate regime’s features
(soft peg) VND18,544/USD (from February
2010), equivalent to a devaluation of 3.3%, VND18,932/USD (August 2010), equivalent a devaluation of 2.1%, VND20,693/USD (February 2011).
- Exchange rate amplitudes at commercial banks were gradually adjusted to +/-0.75% (from 23 rd December 2007 to 09 March 2008), th +/-3% (from 06 November 2008 to th
23 rd March 2009), +/-5% (from 24 th March 2009 to 25 November 2009) th and +/-3% (26 November 2009), +/- th 3% (February 2010) Commercial banks kept the exchange rate at the ceiling rate of OER, +/-1% (the year
2011) Exchange rate has been stable around the VND20,828/USD in 2012. (Source: Vo Tri Thanh et al 2000, Nguyen Tran Phuc (2009) and Decisions on exchange rates by the SBV and IMF)
Under the pegged exchange rate policy, the State Bank of Vietnam has made necessary adjustments to the exchange rate amplitude and central exchange rates during significant economic changes caused by internal reforms or external factors Once the impacts of these changes subsided, the exchange rate regime reverted to a fixed or pegged system with appropriate adjustments.
Between 1989 and 1991, Vietnam made significant adjustments to its economic regimes, particularly during the transition away from a subsidized mechanism This trend continued during the Asian financial crisis from 1997 to 1999 and was further exacerbated by the global financial and economic crisis of 2008 to 2009.
Impacts of exchange rates on Vietnam’s trade balance and inflation
Since 1992, policies have undergone significant changes, including a shift from managing average internal exchange rates for balance sheets across all goods These exchange rates have remained relatively stable, with only minor adjustments, in order to stabilize the material pricing system for imports and exports In response to this situation, the Government opted to revise the foreign currency management approach and update the VND/USD management mechanism in 1992.
3.2.1 The period 1992 - 1997 (before the Asian financial crisis)
The exchange rate mechanism from 1989 to 1991 proved inadequate due to insufficient supervision and the government's relaxed stance on foreign currency earnings, leading to a slow increase in national foreign reserves and periodic fluctuations in the foreign currency market, particularly during high demand periods This situation contributed to a rising financial deficit, escalating foreign debts, and severe inflation, all amidst limited foreign reserves Consequently, from 1992 until the Southeast Asian financial crisis in July 1997, Vietnamese policymakers shifted to a strategy of exchange rate management aimed at combating inflation by stabilizing nominal exchange rates, which consistently remained low between 10,500 and 11,200 This approach significantly impacted the country's economic development during that period.
3.2.2 The period from July 1997 to 1999 (the Asian financial crisis period)
In 1997, Vietnam's exchange rate effectively withstood the pressures of the regional financial crisis, addressing the prior overvaluation of the Vietnamese Dong (VND) This currency crisis had a significant impact on Vietnam's economy.
The financial and currency crisis that swept through Southeast Asia in July 1997 prompted Vietnamese authorities to reassess their approach to exchange rate management In response to the crisis, there emerged a shift in economic perspectives, with some economists expressing optimism about Vietnam's economic resilience and potential for recovery.
"immune” from the crisis, there were at least 4 arguments to reject this
Firstly, the crisis was spreading all over South Asia and South East Asia where export turnover made up about 30% and around 70% - 80% of FDI into Vietnam.
An intensive crisis in a market with such a high density could not make no impact on Vietnam
The crisis led to significant devaluation of various regional currencies against the USD, while the Vietnamese Dong (VND) remained pegged to the USD As a result, the VND became overvalued, adversely affecting the competitiveness of Vietnamese goods in the market.
Table 3.5: Devaluation levels of some regional currencies
Time Rupiad Ringgit SGD Baht Perso
The crisis led to a surge in foreign currency speculation, driven by expectations of domestic currency devaluation by the Vietnamese government This resulted in a slow increase in domestic currency savings, while savings in foreign currencies, particularly among households, rose rapidly Additionally, businesses sought various methods to retain foreign currency assets.
The situation involved 31 currencies that were withheld from banks in anticipation of a devaluation As pressure mounted on the overvalued domestic currency, the financial landscape became increasingly precarious Compounding the issue, a disordered savings structure left commercial banks facing significant uncertainty and risk.
The 1997-1998 financial and currency crisis significantly impacted Vietnam, evident in the country's adjustments to its exchange rate management This included the gradual widening of the trading band and an incremental increase in the official exchange rate.
3.2.3 The period 2000 - 2006 (after the period of the Asian financial crisis, preparation to join in WTO)
Following a significant deficit in 1999 due to currency overvaluation, the trade balance deficit continued to rise, echoing trends from the 1992-1997 period This pattern suggests that a crisis in the trade balance could be anticipated approximately 4 to 5 years after 1999, around 2003-2004 Indeed, this prediction materialized, as these years witnessed unprecedented deficit levels.
In 2003, Vietnam's trade balance deficit reached a concerning 12.75% of GDP, escalating to an absolute deficit of USD 5.5 billion in 2004 This alarming trend prompted significant media and institutional scrutiny By 2005, the Ministry of Trade projected the trade deficit would exceed USD 6 billion, but the actual figure was reported at USD 4.5 billion Researchers indicated that Vietnam faced a severe crisis in its current account and trade balance during this period, with estimates suggesting actual imports surpassed permissible levels, highlighting ongoing economic challenges.
713 million in the year 2004 (Nguyen Van Lich, 2006) Although the deficit level in the year 2005 declined a bit, uncertainties caused by the deficit of trade balance remained potential (General Statistics Office, 2010).
The devaluation of the Vietnamese dong has positively impacted exports, but the effects vary significantly across different markets and product categories Notably, Japan and South Korea showed limited responsiveness to exchange rate fluctuations, with export turnover improving by only 50% due to the dong's devaluation In contrast, markets in the United States and the Eurozone experienced a 75% increase in export turnover Additionally, when factoring in China's influence, the exchange rate impacts were consistent across other markets, indicating that China's factors are more pronounced in Japan and South Korea than in Vietnam This disparity can be attributed to the unique characteristics of Vietnam's market and export structures.
Using statistics intuitively to examine the relationship between nominal exchange rates and trade balance or inflation often obscures the clear impact of exchange rates on these factors This qualitative analysis tends to reveal only a static relationship, while the effects of exchange rates on trade balance and inflation are subject to time lags Consequently, an empirical study is necessary to provide a more definitive and reliable understanding of how exchange rates influence both trade balance and inflation.
DATA AND METHODOLOGY
Methodology
In recent years, VAR analysis has become a popular method for assessing the impact of monetary policy on output and prices in developing and transition economies, as noted by various studies (Ganev et al., 2002; Starr, 2005; Hericourt, 2005; Mohanty and Turner, 2008; Aleem, 2010) This approach is favored for its lower data requirements and the flexibility of its underlying assumptions Specifically, in transition economies, VAR estimation demonstrates strong predictive capabilities (Asle, 2008) and effectively illustrates the macroeconomic interrelations among variables The impulse responses generated by the VAR model allow for an understanding of how shocks to one variable affect others in the system However, since the model's innovations are typically contemporaneously correlated, it is essential to transform the data to obtain a diagonal contemporaneous covariance matrix.
The paper employs an estimated VAR model to test Granger causality and analyze impulse response functions and forecast error variance decompositions for each dependent variable Impulse response functions illustrate how a shock to one variable influences changes in other variables over time, considering the effects of all model variables Meanwhile, the forecast error variance decomposition reveals the extent to which fluctuations in each variable are attributable to its own shocks compared to those from other variables Consequently, impulse response functions indicate the directional dynamic responses of variables to various innovations, while variance decompositions quantify the magnitude of these responses to shocks.
This study employs a VAR model analyzing three key variables: exchange rate, price level (CPI), and trade balance (TB), which includes exports (EX) and imports (IM) The nominal exchange rate typically influences the price level, while the trade balance is more closely tied to the real exchange rate (RER) Consequently, both nominal (USD) and real exchange rates are examined The Granger Causality test incorporates not only the VND/USD exchange rate but also evaluates the effects of the VND against other currencies, including the Euro (EUR), Chinese yuan (CNY), Japanese yen (JPY), and Singapore dollar (SGD), to assess their impact on inflation and trade balance.
The conventional VAR model can be expressed as follow:
(4.1) Where: - is an Yt (nx1) vector of endogenous variables in VAR
- A0 is an (nx1) vector intercept terms
- Ai is an (nxn) matrices of coefficients
- is anεt (nx1) vector of error terms with zero mean and constant variance
Macroeconomic time series often exhibit significant persistence, typically described by a unit root process, indicating that some shocks have a lasting impact and the series is non-stationary (Ender, 1995) To analyze the integration order or stationarity of each series, we utilize the Augmented Dickey-Fuller (ADF) unit root tests If the series display different orders of integration, transformations are necessary Conversely, if they share the same order, we apply Johansen’s cointegration test to determine their cointegration status (Johansen, 1991) In such instances, the VAR model can be reformulated into a vector error correction (VEC) model, with the lag length determined by the adjusted Likelihood ratio (LR) test for small samples as outlined by Lutkepohl (1991).
Data and Data Sources
This study analyzes monthly data from January 2000 to September 2012 to assess the effects of exchange rates on inflation and trade balance in Vietnam The focus on this period is due to the introduction of a new official exchange rate policy by Vietnam in 2000, where the State Bank of Vietnam (SBV) began using an average inter-bank exchange rate between the VND and USD as the official rate This policy shift is seen as a significant move towards a more flexible exchange rate regime Additionally, the study examines the impacts during the sub-period from January 2007 to September 2012 to account for structural changes in the economy following Vietnam's accession to the WTO.
The real exchange rate is bilateral rate of VND against USD, measured as the nominal exchange rate adjusted to the U.S and domestic consumer price indices.
An increase in the exchange rate indicates a depreciation of the domestic currency The nominal exchange rates of the Vietnamese dong (VND) against the Euro, Chinese yuan, Japanese yen, and Singapore dollar are calculated using cross exchange rates with the US dollar (USD).
The trade balance, defined as the ratio of exports to imports (EX/IM), is a key metric in analyzing the relationship between trade balance and exchange rates This ratio is advantageous because it remains unaffected by the units of measurement and can be interpreted as either nominal or real trade balance (Bahmani-Oskooee, 1991) Furthermore, it effectively addresses the challenges associated with employing the logarithmic form of a trade deficit.
All of data are obtained from IFS and DOT of IMF and expressed in natural logs.
RESULTS AND DISCUSSIONS
Unit root test
The Augmented Dickey-Fuller unit root tests reveal that, at a 5 percent significance level, all time series are non-stationary, except for the trade balance, when considering constant and constant & trend conditions However, these series become stationary after applying first differences Consequently, the VAR models need to be adjusted to first differences to effectively test Granger causality and to conduct impulse response function analysis and variance decomposition.
Granger causality test
Table 4.2 presents the Granger causality test results from VAR models analyzing three key variables: exchange rate, price level, and trade balance, covering the period from 2000 to 2012 The findings indicate that certain exchange rates Granger-cause both price levels and trade balances Notably, the EUR, JPY, and SGD do not significantly influence the trade balance across the entire sample; hence, VAR models were adjusted to include export and import variables separately to better assess the exchange rate's impact on trade balance The tests further reveal that fluctuations in the EUR, JPY, and SGD can influence price levels, which subsequently affect both exports and imports.
Table 5.2 Granger Causality Test: P-values of Chi-square
RER USD CNY EUR JPY SGD
Note: The parentheses show that there is Granger causality from CPI to the considering variables
Since Vietnam joined the WTO, the effects on inflation have intensified, primarily due to increased exchange rate pass-through linked to the country's import structure The influx of foreign direct investment (FDI) has led to a greater reliance on imported machinery and materials for production As a result, fluctuations in the exchange rate significantly impact domestic prices, highlighting the interconnectedness of global trade and local economies.
Granger causality tests indicate that fluctuations in exchange rates have a more significant impact on exports than imports within the sub-sample, suggesting that effective exchange rate policies can enhance export performance and improve trade balance deficits Additionally, these tests reveal that, alongside the USD/VND exchange rate, other currencies such as the CNY and SGD also significantly influence inflation and trade balance Furthermore, in recent years, the EUR has played a notable role in affecting trade balance and export dynamics.
Impulse response functions
Figure 5.1 Response functions of trade balance ratio and inflation to exchange rate shocks for 2000 – 2012 period Response of TB to USD Response of CPI to USD
Accumulated Response of TB to
Accumulated Response of CPI to
Figure 4.1 illustrates the response functions of the trade balance ratio and inflation to shocks in the nominal exchange rate of the VND against the USD The findings indicate that a depreciation of the VND can gradually enhance the trade balance ratio, while it has an immediate effect on inflation, with the impact on inflation dissipating after four months.
41 while the impact on trade balance ratio is longer However the impact on trade balance ratio is not stable and significant as the impact on inflation.
Figure 5.2 Response functions of trade balance ratio and inflation to exchange rate shocks for 2007 – 2012 periods
Response of TB to USD Response of CPI to USD
Accumulated Response of TB to USD Accumulated Response of CPI to USD
Figure 4.2 illustrates the effects of exchange rate shocks on the trade balance ratio and inflation from 2007 to 2012 Analysis of the 2000-2012 period reveals that a depreciation in the exchange rate leads to a notable increase in inflation lasting approximately four months However, during this timeframe, the enhancement of the trade balance ratio is not as significant compared to the improvements observed in the earlier 2000-2012 period.
Variance decompositions
Table 4.3 presents the share of fluctuation in the trade balance ratio and inflation that are caused by difference shocks by calculating variance decompositions at forecast horizons of 24 months.
Table 5.3 Variance Decompositions for 2000-2012 periods
The nominal exchange rate fluctuations of the VND against the USD play a minimal role in influencing the variances of the trade balance ratio and inflation Instead, the primary drivers of variance in both the trade balance index and inflation are attributed to "own shocks," which account for over 80% of the forecast error variance in the medium term.
The exchange rate plays a more significant role in influencing the trade balance ratio than in affecting inflation, accounting for over 5% of the variance in trade balance and around 4% in inflation variance.
Between 2007 and 2012, the analysis reveals that the exchange rate plays a minimal role in influencing the variance of the trade balance ratio and inflation Specifically, at an 18-month horizon, the exchange rate contributes over 6% to the variance in inflation, while accounting for only 4% of the variance in the trade balance ratio Notably, at a 24-month horizon, the exchange rate's impact remains consistent for both inflation and the trade balance ratio.
Table 5.4 Variance Decompositions for 2007-2012 period
In conclusion, empirical studies indicate that the exchange rate significantly influences inflation in the short term, particularly following Vietnam's accession to the WTO Additionally, devaluation can enhance the trade balance deficit over the long term, particularly boosting export performance Furthermore, the exchange rate of the Vietnamese Dong (VND) against the US Dollar (USD) and other currencies plays a crucial role in affecting both inflation and trade performance in Vietnam.
CONCLUSION AND RECOMMENDATION
Conclusions
The thesis titled "The Impact of Exchange Rate Policy on Trade Balance and Inflation in Vietnam" examines the theoretical and practical aspects of how exchange rate fluctuations affect Vietnam's trade balance and inflation rates Through comprehensive data analysis, the research highlights the relationship between exchange rates and key economic indicators, providing valuable insights into the factors influencing trade balance and inflation in Vietnam.
1 Systematic presentation of theories on exchange rates to provide theoretical foundations of exchange rates and their impacts on trade balance and inflation
2 Collection of some field researches of exchange rates’ impacts on trade balance and inflation, leading to illustrated conclusions for the research
3 Overview of actual state of Vietnam’s exchange rate management during the period from 1992 to 2011, which analyzed exchange rate policies’ impacts on trade balance and inflation in Vietnam.
4 Applying VAR model to analyses empirically the impact of the change in exchange rate on inflation and trade balance using monthly data from 2000 to 2012.
5 Based on qualitative and quantitative analyses, the author has given some suggestion for the use of exchange rate mechanisms in the next coming time and synchronous measures to make exchange rates become as a tool to improve the trade balance but limit pressures on the inflation in Vietnam.
The effective management of foreign exchange rates in Vietnam should align with their roles and characteristics, particularly within the context of a managed flexible exchange rate mechanism This approach, when implemented alongside complementary policies, supports economic development strategies and enhances the trade balance while minimizing inflationary pressures Given Vietnam's robust economic potential and adequate foreign currency reserves, this mechanism can be sustained, allowing for market interventions to stabilize the national currency's purchasing power and maintain stable prices for goods and services Ultimately, a suitable foreign exchange rate mechanism must reflect the intricate relationships between exchange rates, interest rates, economic growth, and inflation over various periods.
The thesis highlights the necessity for a more flexible exchange rate mechanism to align the Vietnamese currency with its equilibrium based on key economic fundamentals Implementing immediate measures such as expanding margin trading and pegging the VND to a basket of currencies, rather than solely to the USD, is essential for achieving this goal.
In addition, there need the synchronized solutions in structural adjustment of export and import products as well as coordination with other macroeconomic policies.
While the thesis presents valuable contributions, it remains limited in scope Incorporating additional variables that reflect fiscal and monetary policy instruments could enhance the analysis of how exchange rate policy coordinates with other policies to achieve economic objectives Furthermore, the research overlooks changes in the economic structure, which may restrict the validity of the results and conclusions drawn.
Suggestions for using exchange rate policies to restrict trade deficit
without causing any further pressures on inflation
Vietnam now satisfies many conditions, which makes the application of managed floating exchange rate mechanism bring more benefits compared to fixed exchange
The 49 rate mechanism in Vietnam operates under a market-driven approach, where the prices of goods and salaries in various enterprise sectors are determined by market forces Floating exchange rates facilitate the alignment of local goods prices with global market trends, promoting more effective economic allocation (Friedman, 1953) Additionally, Vietnam's economy is characterized by significant openness without heavy reliance on specific partners, enabling floating exchange rates to mitigate the impact of external currency market shocks while also providing protection against fluctuations in the international goods market (Fleming, 1962; Mundell, 1963).
Exchange rate policies alone do not significantly impact trade balance or inflation To enhance the effectiveness of a floating exchange rate policy in improving Vietnam's trade balance and mitigating inflationary pressures, several strategic approaches are recommended.
6.2.1 Expansion of exchange rate trading bands instead of domestic currency’s devaluation
The expansion of the exchange rate trading band enhances the flexibility of exchange rates and broadens the factors influencing them, leading to improved market characteristics and increased effectiveness in controlling inflation Flexible exchange rates can help limit the growth of the money supply, a key driver of inflation in recent years While maintaining a weak VND supports exports, it has also contributed to a staggering 135% increase in Vietnam's money supply since 2005, exacerbating inflation By adopting flexible exchange rates, the government can strategically purchase USD when market rates are favorable, reducing costs in VND and bolstering national foreign currency reserves.
6.2.2 Enforcement of multi-foreign currency policy
The value of the Vietnamese Dong (VND) is primarily determined in relation to the US Dollar (USD), with banks calculating VND exchange rates against other foreign currencies based on the VND/USD rate This creates a situation where the VND appears to be fixed to the dollar, while its relative prices against other currencies fluctuate freely Empirical analysis indicates that changes in the USD and other currencies significantly impact Vietnam's inflation and exports Consequently, the free fluctuation of these currencies can introduce risks and affect the economy in ways that are challenging to manage.
In the near future, the Vietnamese Dong (VND) should be pegged to a basket of currencies, including the USD, EUR, JPY, Chinese Yuan, and Singapore Dollar The exchange rate bands will be determined based on the average of this currency basket; for instance, if the VND/USD exchange rate exceeds the allowed limits while the VND/EUR or other rates remain within bounds, the State Bank may refrain from intervening in the USD exchange rate The inclusion of EUR, SGD, and JPY is strategic, given Europe's significance as a major trade partner and Japan and Singapore's high import-export turnover with Vietnam, along with their status as top investors in the country Additionally, considering the Chinese Yuan is essential due to China's competitive presence in import-export markets, which can help enhance Vietnam's competitiveness through future exchange rate adjustments.
Vietnam currently faces a significant trade deficit with China, which is unlikely to improve in the short term, particularly with the impending establishment of the ASEAN-China free trade area One potential strategy to address this imbalance is to incorporate the Yuan into the currency basket for exchange rate calculations, enabling Vietnam to leverage exchange rates as a tool to enhance its trade balance with China in the near future.
Pegging the Vietnamese Dong (VND) to a basket of currencies helps mitigate dollarization in Vietnam, thereby enhancing the independence of the country's monetary policies In addition to reducing dollarization and increasing monetary policy autonomy, implementing exchange rate bands based on the average of strong currencies promotes transactions in alternative currencies, allowing exchange rates to adjust more favorably according to supply and demand dynamics in the foreign currency market.
6.2.3 Actively transferring structure of exported and import goods in the positive direction
To modernize domestic production, imports remain crucial, while exports are vital for addressing trade balance deficits Implementing exchange rate policies to enhance exports should be complemented by diverse strategies, including goods range and income policies, to foster intensive export development Currently, exports primarily consist of crude and minimally processed goods with low added value Although these goods are sensitive to exchange rate fluctuations, increasing their supply is challenging in the short term, leading to delays in improving the trade balance through such policies Relying heavily on exporting these goods only leverages static advantages from natural resources, which could negatively impact long-term trade balance improvements and hinder the transition from crude product exports to a more industrialized export strategy that gradually reduces dependency on imports.
Vietnam's export structure is heavily reliant on agricultural and fishery products, as well as resources like crude oil and rubber, with raw materials accounting for 70% of export value This dependence on imports, coupled with excessive consumer spending on luxury goods, creates significant pressure on the trade balance and inflation To address these issues, it is essential to implement policies that limit raw material imports, promote domestic resources, enhance the efficiency of imported machinery and equipment, and develop supporting industries Additionally, the government should launch campaigns to discourage the use of imported luxury goods.
To enhance the quality of products for both domestic and export markets, it is essential to implement policies such as increasing import taxes on petroleum and gasoline Additionally, fostering the development of supporting downstream industries and providing capital and technical support to industries can significantly improve product quality This can be achieved through various means, including worker training and collaboration with industry associations to ensure local manufacturers adhere to high-quality standards.
6.2.4 Synchronous collaboration of exchange rate policies with other macroeconomic policies
To enhance effectiveness and efficiency of foreign exchange rate policies toward the economy, there must have collaboration with other macroeconomic policies like fiscal and monetary policies.
Cautious fiscal policies should be preserved and adjustments of tax policies should
In the context of Vietnam's integration into the international economy and its membership in the WTO, the country has removed many non-customs barriers to enhance commercial activities Moving forward, to improve its trade balance and address import surpluses, Vietnam should effectively implement technical barriers, including quality standards, safety measures for production processes, labeling, transportation, and preservation of goods The strategic use of these barriers not only helps to limit import surpluses and supports macroeconomic policies for socio-economic development but also safeguards consumers' legitimate interests These rational and legal barriers are recognized and permitted by the WTO, as outlined in the Agreement on Technical Barriers to Trade (TBT).
Spending policies must prioritize essential investments, particularly in civil construction, while eliminating unnecessary expenditures and implementing measures to reduce losses and waste It is crucial to maintain the budget deficit at a manageable level to avoid macroeconomic instability, but fiscal policies should not be overly restrictive, as this could hinder long-term economic growth Additionally, a shift from direct to indirect monetary policy tools will allow for more flexible and effective management, minimizing negative economic impacts As the monetary market evolves, prices such as interest and exchange rates will be determined by supply and demand, leading to better capital allocation and reducing macroeconomic imbalances, thereby enhancing the effectiveness of monetary policy management.
The enhancement of foreign exchange rate policy requires coordinated efforts across multiple measures, extending beyond the Central Bank's actions By assessing current conditions, suitable tools and strategies will be chosen to implement a unified exchange rate policy, aiming to achieve optimal outcomes.
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