CHATER 5: CONCLUSION AND POLICY RECOMMENDATION 5.1. Conclusion
5.2.3. Establishing condition for a successful depreciation
The estimated result shows that real depreciation currency can improves trade balance in the long run and vice versa. Therefore, real exchange rate of VND should be depreciated to enhance competitiveness of domestic producers.
However following a permanent depreciation, there are also potential spillover effects which could neutralize the effects of nominal depreciation with the aim to achieve real depreciation. In particular condition of Vietnam, we discuss two effects.
The first potential undesirable effect is the pass-through of the exchange rate on inflation. Following a permanent depreciation, imports prices will increase, causing average domestic price to increase. If domestic importers are slow to find substitution sources, increase in average domestic price will last long, pushing inflation to rise.
Exports prices, thus, increase then erode positive effects of depreciation. Although this effect is recommended to be important, previous studies on inflation in Vietnam suggest that monetary and credit growth, supply shocks and inflation inertia have been more important than the nominal exchange rate change in determining the
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inflation rate (Nguyen Tran Phuc and Nguyen Duc Tho, 2009). There is evidence that monetary growth has been a key driving force behind Vietnam’s inflation process. For example, Camen (2006) employed a VAR model to conduct an exploratory analysis of the role of external variables, such as the US money supply and commodity prices, as well as domestic factors in the determination of inflation in Vietnam during the period 1996–2005. The results suggested that the volume of domestic credit was the most important variable, accounting for about a quarter of the variations in the CPI — this exceeded the parts of the forecast error variance that were accounted for by commodity price and the nominal VND/USD rate. Similarly, the results founded in study by Vo Tri Thanh et al. (2000) indicate that only monetary aggregates had a significant and positive impact on inflation; by contrast, the impact of changes in the nominal exchange rate became much weaker and insignificant. Besides, The impacts of supply shocks and inflation inertia on inflation are also significant. For example, the liberalization of previously administered prices for key commodities such as rice, cement, urea fertilizer, and construction steel during 2002–2004 and petroleum products since 2006 has contributed to inflationary pressures (IMF, 2006). More recently, the international food and oil price shocks of 2007 have had a similar impact (Hoang Ngoc Hoa, 2008; Nguyen Quoc Hung, 2008). Research by the IMF (2006) indicates that there exists a high degree of inflation inertia in Vietnam. This finding suggests that inflationary expectations adapt quickly to actual inflation outcomes, so that temporary supply and price shocks would tend to result in permanent increases in core inflation. In short the results from all above research indicate that exchange rate pass-through is not a key determinant of inflation in Vietnam.
In the other hands, the ability to sterilize impact of depreciation manipulation is more important in Vietnam to cause pressure on inflation. In order to depreciate real exchange rate, nominal exchange rate must be devalued first. Normally, central bank uses large amount of home currency to buy foreign currencies, causing money supply in circulation to increase and threatening inflation to rise. To keep the money supply unchanged, thereby, inflation under control, central bank must use neutralized
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operation to absorb the increased money supply. However, to a certain extent, a sudden large amount of money supply increase in the economy although immediately sterilized can influence on inflation. This might lead to neutralization of nominal depreciation due to domestic price increase and consequently the tendency for the real exchange rate to appreciation. Vietnam once faces with this problem on 2007. On this year, foreign capital inflows strongly to the economy, putting VND under pressure of appreciate against USD. SBV, then, uses a very large amount of VND to buy USD.
The exact amount used is not announced but can be predicted through sudden rise of foreign exchange reserve. As a result, inflation rate rises up to 19 percent at the end of fiscal year although SBV does use neutralized operation, leading real exchange rate to appreciate though nominal exchange rate depreciate very little.
The second possible adverse effects stems from high dependence of domestic production and exports on imports, as large proportion of imports is input for production (as explained above). Hence, following real depreciation of currency, domestic producers’ competitiveness gains, they will produce more and, then, import more. However, their input costs now become higher due to more expensive imports.
Consequently, competitiveness gain involve from real depreciation might is eroded by increase in import prices. There is not only Vietnam but other countries, such as Turkey (kale (2001)), Singapore (Abeysingle, Yeok (1998)), Croatia (Tihomir Stucka (2004)) encountering this problem.
Thus, a real value depreciation of currency may turn out to be in vain or less effective. In order for a depreciation to improve trade balance significantly, there is some accompany solution needing to be done previously, including:
(i) Controlling inflation. In order words, depreciation should be done only when inflation under control. Vietnam’s economy has faced with high inflation since the second half of 2007 (table 3.1). Under high inflation, the sterilization intervention of SBV following a depreciation would be harder to take effect.
(ii) Developing subsidiaries industries. Negligible impact of real exchange rate on imports in the long run, indicates that domestic producers are slowly to substitute
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external production materials with domestic materials even when import prices increase following a depreciation. It is only because of slow developed of subsidiaries industries in the economy. Table 3.3 also proves that statement. Proportion of production materials reduces slowly from 2000 to 2010, in which most reduction is from fuels and raw materials. Therefore, only when subsidiaries industries are ready, a real depreciation can open the gate for domestic producers to substitute import materials for domestic ones.
(iii) Adjusting structure of export production towards high-valued-added products.
Although the long-run impacts of real exchange rate on exports is rather high (0.6), it is relative low to other countries. Also, table 3.2 show that export structure is slow to change from raw material products to processed and refined products. This implies that exports depend mainly on low value-added products. With such exports’
structure, exports encounter with low economic efficiency and narrow market because, as pointed out by Ha Van Su (2009), (i) elasticity of income to raw materials and foods is lower than that of processed products; (ii) population growth of industrial countries is very slow currently, increase in demand of these markets is not much; (iii) there is trend in creating synthetic materials and products to substitute for traditional materials and products; (iv) industrial countries are applied new barriers to protect domestic production. Therefore, depreciation exchange rate can lead to significantly improve in trade balance only when exports are elasticity to price changes.