CHAPTER 2: LITERATURE REVIEW 2.1. General arguments about exchange rate
2.4. The role of exchange rate policy to trade balance
2.4.4. The importance of exchange rate policy to trade balance
In classic trade theory, exchange rate plays no role in determining competitiveness. The standard trade model suggests that determinants of international competitiveness comprise entrepreneurial activities, accumulation of resources, and product-process innovation. Thus, the conventional trade theories do not stress any role of exchange rate policies in improving international competitiveness (Le Dang Trung, 2009).
However, since exchange rate policy focuses on controlling movements of exchange rate to obtain policy target in short and long run, an undeniable role of exchange rate policy, as Mussa (1984) pointed out, is to set relative prices between tradables in terms of non-tradables, then, intervene into competitiveness. Although, using the exchange rate policy as an instrument for the government to affect trade competitiveness and thus, the trade balance, is still controversial as there is considerable disagreement concerning the effectiveness of devaluation as a tool for
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improving trade balance, some governments have written practical stories. Among them, Chinese Government is deserved to be the most typical one. The trade balance of China has attracted attention of global governments for decades due to its rapidly increasing surplus. Since 2000, China runs large trade surplus with the world’s three major economic centers – the United States, the European Unions, and Japan. In 2008, trade surplus of China to the world reached record at USD295.5 billion (Republic of China General Administration of Customs, Global Trade Atlas).
Although what causes the China’s trade balance phenomenon is now still on debate, some key reasons are pointed out, among which the role of exchange rate policy costs much attention. As an evidence, Staiger and Sykes (2008) studying the foreign exchange policies of China over the past 15 years show that China has intervened in the foreign exchange markets through selling the Renminbi and buying foreign currencies so that the Renminbi has been marketed at prices lower than its values. In order words, Bank of China undervalues its currency for long time to increase competitiveness of China’s goods relative to trading partners’ goods, as a result, China achieves tremendous surplus trade balance to the rest of the world. The foreign exchange policy to undervalue Renminbi is certainly just one of main reasons leading to success of China’s foreign trade, it is valuable lesson for developing countries due to China’s persistency not to appreciate Renminbi value regardless pressure from trading partners.
Another typical case is Korean miracle in period of 1962-1980 which stands out as the mode model of export-driven industrialization which sets target to change comparative advantage of the country that attained by ―correct‖ pricing and ―realistic‖
exchange rate policies (Kwan S. Kim, 1991). Along with other policies to stipulate export, the Korean government implemented exchange rate reform in 1962, following which the won was devalued from 130 to 255 won per dollar and gradually decreased in later years when exchange rate controls were liberalized. The devaluation was based on a study comparing world and domestic prices, with the new rate reflecting the median purchasing power parity in international markets. The effective exchange
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rate for exports accordingly increased rapidly from 264 in 1962 to 320.9 in 1975 causing competitiveness increase of Korea in foreign trade. What noticeable in this case is that the government, in addition to periodic devaluations, continued to adjust export incentive rates between devaluations in order to maintain the incentive rate at a relatively stable level in the face of more rapid inflation domestically than abroad.
The successfulness of these governments is persuasive evidence for the role of exchange rate policy to trade balance. Nonetheless, each economy reacts differently to exchange rate changes than insular ones. It is recommended that exchange rate policy manipulation should not be overused and it cannot do the work alone, out of the macroeconomic context and without supporting macroeconomic policies because the exchange rate as a policy instrument can have more effects in addition to the impact on trade competitiveness (Dornbusch, 1996). Also, McKinnon and Ohno (1997) have shown already that in open economies, exchange rate changes may have unpredictable effects on trade balances. In other words, with the correct setup of models for an open economy, depreciation may not improve the trade balance and appreciation may not make it deteriorate. Therefore, when the decision on using the tool is made, there are two important factors that the government should take into consideration: the magnitude of a necessary change (depreciation/appreciation) and the duration of the policy.
Chapter summary
Each open economy nowadays trades with many foreign counterparties, thus, government no longer concern the competitiveness between its country with any single trading partner but with all trading partners. REER index taking into account trade shares of each trading partner is best reflects the competitiveness of a country relative to its trading partners therefore it is used in most studies to explore the impact of exchange rate on trade balance. Although the conclusions do not unify for all cases, many studies show strong influence of exchange rate on trade balance in short and long run. Also, the successfulness of some government when using exchange rate as key measurement to improve trade balance proves undeniable role of exchange rate
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policy to trade balance. Controlling trade balance now becomes important responsibility of all government due to its key determinant to current account.
However, there is no common formula for all countries to successfully improve trade balance with exchange rate measurement. Exchange rate may be effective in one country but not in others, therefore, depending on macro-economic condition, government of each country has to use exchange rate with its own and unique formula.
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Chapter 3:
PERFORMANACE OF TRADE BALANCE AND EXCHANGE RATE IN VIETNAM IN 2000-2010
3.1. The background of Vietnam’s economy in 2000-2010 period
As a transitory and developing country, Vietnam is classified into group of countries with highest economic growths. From the Renovation (Doi Moi) Policy, Vietnam has successfully maintained annual average economic growth rate of 7 percent which allows the economy to double its scale over a decade. For this performance, IMF and World Bank assume Vietnam’s economy’s growth to be miraculous and typical among transitory countries.
Table 3.1 - GDP, Inflation, FDI, FII, ODA, Current transfer in 2000-2010
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 GDP
growth* 6.8 6.9 7.1 7.3 7.8 8.4 8.2 8.5 6.2 6.3 6.78
Inflation
rate* -0.6 0.8 4 3 9.5 8.5 6.6 12.6 19.9 6.88 11.75
FDI ** 1298 1300 1400 1450 1610 1889 2315 6550 7800 4000 11000
FII** 865 1313 6243 -400 1290 1800
Current
transfer** 1921 1250 1921 2239 3093 3380 4049 6430 7000 4100 3879
* in percentage (%); ** in million USD;
Source: GDP growth and inflation rate are from General Statistic Office (GSO); FDI, FII, Current transfer are from International Financial Statistics (IFS)
The period of 2000-2010 witnesses important and significant milestones in development process of Vietnam. In the first two years, the economy has not entirely recovered since the East Asia crisis, its growth rate, as a result, was below the average of 10 years before. However, the US-Vietnam Bilateral Agreement coming into force from the end of 2001 opened new opportunities for the economy to cooperate with the largest economy of the world. In addition, since 2002, thanks to policies to ameliorate investment environment, develop market-driven financial institutions, stipulate privatization and equitization process, and increase percentage of shares held by foreign investors in equitised state-own enterprises, foreign direct investment (FDI) has found way to return. Moreover, the boom of the stock market from 2005
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highlighted Vietnam with the hottest one among other investment destinations, thus, helping the economy to raise funds from not only local but also foreign investors.
That the government of Vietnam successfully issued 750 million USD bonds in New York Stock Exchange in the last quarter of 2005 also rose the position of Vietnam to a higher level in eyes of international investors. Besides, on recognizing the importance of current transfer of overseas compatriots, the government promulgated policies to simplify administrative formalities as a result of which current transfer increased year-by-year. Associating with internal resources, all above external resources contributed indispensable capital to the economy on growing momentum, thereby, it took back growth rate above 7.5 percent in the background of inflation under control from 2004 to 2006 (Table 3.1).
At the beginning of 2007, Vietnam marked another milestone on her development process with the event of officially becoming a member of The World Trade Organization (WTO), thanks to which the economy continues to integrate more deeply and broadly into the world economy. Spectacularly, along with more improving and opening policies to attract external resources, remittances, foreign direct and indirect investments (FII) strongly increased more than expected, creating impulse for the economy to reach the highest growth rate at nearly 8.5% in the same year. The economy kept growing well within the first half of 2008, however, high inflation which occurred at the end of 2007 turned out to be out of control in the second half of the year and unluckily accompanied with the global financial crisis breaking out at the same time. As an unevitable result, GDP growth rate decreased at 6.2 percent and the macro-economy fell into instability with hyperinflation at 19.9 percent. Unlike previous crisis, the financial crisis in 2008, in some ways, shows the integration of Vietnam’s economy is deep enough to be affected by fluctuation in the global economy, warning the government about coming threats.
From 2009, in the common context of global economy, external resources for development such as FDI, FII, remittance declined greatly, putting internal resources in charge of helping the economy to overcome crisis. It was the effectiveness of
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stimulating economic policies that played an important role to bring the economy through the bottom of crisis with growth rate at 5.32 percent and inflation under control of 6.52 percent. Although there is optimistic sign of recovery such as the return of external resources, the economy once again spent difficult year in 2010 with hyperinflation due to vulnerable macro-economy under impact of the world economy.
In general, this is the period Vietnam integrating more deeply and widely into global economy. While the agreements with US and WTO are the milestones opening new opportunities for Vietnam to cooperate with the rest of the world, the global crisis is another one expressing its integration is deep and wide enough to be affected by the performance of the world economy. In this circumstance, foreign trade of Vietnam experiences significant change.
3.2. The performance of trade balance in 2000-2010 period
On the integration process of Vietnam into global market, foreign trade is specified to be not only the pioneer but also the driving force. In the first decade of 21st century, the value of foreign trade significantly rises from 30,120 million USD in 2000 to the peak of 144,134 million USD in 2008. Although reducing in 2009, the annual average growth of foreign trade remains high at 20 percent which is much higher than growth of GDP in the same period, accordingly, increasing the openness of the economy from 0.96 in 2000 to 1.60 in 2008.
Figure 3.1 – The trade balance*, current account of Vietnam in 2000-2010
-25000 -20000 -15000 -10000 -5000 0 5000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Trade balance Current account
*Export FOB price, Import CIF price.
Source: Trade balance is from GSO, Current account is from IFS
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However, the growth of foreign trade rises along with the growth of trade deficit (Figure 3.1). Before 2006, trade deficit is rather small, around 5,000 million USD.
Current account deficit to GDP, correspondingly, is below 5 percent. Trade deficit turns to be serious from 2007 at 14,120 million USD, the year Vietnam joins WTO, and reaches peak in 2008 at 21,774 million USD, causing current account deficit-to- GDP ratio rises up to 10 percent.
According to Nguyen Ngoc Bao (2010), on the economy growth and development processes of a nation, trade deficit plays certain roles. In terms of the overall balance of the economy, trade deficit is a manifestation of the mobilization of external resources into that process. In terms of importing subjects, trade deficit is an expression of production facilities formation of FDI projects. In terms of development level of imports, trade deficit may be a supporting channel to create new capacity and modernize the economy. Vietnam is also a developing country, thus, its deficit on trade balance is normal and understandable. The problem is trade deficit of Vietnam is not a phenomenon, having arisen recently but lasting for long time. Moreover, Vietnam’s trade balance becomes dangerous with large deficit since 2007. In this circumstances, trade deficit can cause many negative impacts on the economy, among which, the immediate pressure on balance of payment and its following problems is the first can be seen.
In order to have an adequate picture about trade balance of Vietnam, it is necessary to explore it more deeply through value, and structure.
3.2.1. In terms of value:
In period of 2000-2010, both exports and imports are increasingly year-by-year, except in 2009 due to the global crisis. In detail, the values of exports and imports increase from 14,483 million USD and 15,636.8 million USD respectively in 2000 to the peak of 61180.2 million USD and 82,953.8 million USD respectively in 2008 (Figure 3.2). After a backward step in 2009, exports and imports take back normal speed to increase in 2010 at 67,430 million USD and 80,791 million USD respectively. If excluding the year of 2009, the average growth rates of exports and
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imports are 20.6 percent and 24.6 percent respectively, explaining for larger and larger trade deficit.
However, while the growth rate of exports is rather stable and steady, around the average growth rate, that of imports is unstable and sharply fluctuant, especially when there is a shock. For example in 2007, the year Vietnam became member of WTO, the growth rates of exports and imports are 21.93 percent and 39.5 percent respectively, causing trade deficit to become serious at 14,120.8 million USD. Also in year of 2009, year of global crisis, while year-on-year exports reduces at 6.68 percent, year- on-year imports reduce at 15.68 percent, accounting for large decrease in trade deficit compared to previous year. The range of import growth, as shown in figure 3.3, is wider than that of export growth, indicating imports are more sensitive than exports under a shock.
Figure 3.2 – Values of exports and imports (Million USD) in 2000-2010
0.0 10000.0 20000.0 30000.0 40000.0 50000.0 60000.0 70000.0 80000.0 90000.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Exports Imports
Source: GSO
Figure 3.3 - Growth of export and import (percent) in 2000-2010
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
0.000 0.100 0.200 0.300 0.400 0.500 0.600 0.700 0.800 0.900 1.000
Export growth (Left axis) Import growth (Left axis) X/M (Right axis)
Source: Author’s calculation on GSO’s data
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Besides, although average imports growth rate is higher than average exports growth rate, there are sometimes the former is lower than the latter and in these times, trade balance is improved. From 2000 to 2003, import growth rate is always larger export growth rate, the trade balance represented by export-to-import ratio (X/M) to see the trend of trade balance from year-to-year, deteriorates, X/M decreases. The reversal situation happens in next three years (2003 to 2006), X/M increases, the trade balance improves. Also, from 2006 to 2008, X/M decrease as import growth rate is larger than export growth rate. In the last two year, X/M increases (Figure 3.3).
In the other hands, because Vietnam exports in FOB price and imports in CIF price, its trade balance should be examined in the same price to explore Vietnam’s merchandises’ terms-of-trade more accurately. The FOB trade balance2 shows that: (i) trade balance turned into deficit from 2002 (while CIF trade balance3 is deficit from 2000); (ii) the values of trade deficit in FOB price are much lower than the values of trade deficit in CIF price, just about 60 percent of the latter (Figure 3.4). These indicate that service for foreign trade (mainly freight, insurance) is not developed adequately to support local exporters and importers, thereby contribute largely to deteriorate trade balance.
Figure 3.4 – Trade balances in FOB prices and CIF prices in 2000-2010
-25000.0 -20000.0 -15000.0 -10000.0 -5000.0 0.0 5000.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
CIF Trade balance FOB Trade balance
Source: CIF trade balance: GSO; FOB trade balance: IMF
2 That means trade balance calculated by imports and exports in FOB prices
3 Trade balance calculated by imports in CIF prices and exports in FOB prices
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3.2.2. In terms of structure by products
According to classification of foreign trade standard, structure of exports reveals two weak points. Firstly, although ratio of processed and refined goods to raw and preliminary processed goods is rising, it is still low in comparison with other countries. The proportion of processed and refines goods in total exports is lower than 50 percent before 2002 and passes 50 percent in 2002 then reaches to 55 percent in the last three years (Table 3.2). This change indicates that merchandise exports have advanced in recent years towards gradually increasing the proportion of processed goods. Nonetheless, comparing with neighbor countries, this proportion of Vietnam is much smaller. For examples, the proportion of processed and refines goods in total exports of Thailand, Malaysia, Singapore, China and Philippines are 76 percent, 74 percent, 80 percent, 92 percent, 87 percent respectively (World Bank, 2010).
Table 3.2 – Structure of exports by foreign trade standard in 2000-2010
2000 2001 2002 2003 2004 2005 2006 2007 2008 Total exports 100 100 100 100 100 100 100 100 100 Raw or
preliminary
processed goods 55.8 53.3 49.6 46.6 47.4 49.6 48.3 44.6 44.2 Processed and
refined goods 44.2 46.7 50.4 53.3 52.6 50.4 51.7 55.4 55.2 Other 0.04 0.00 0.01 0.02 0.01 0.02 0.02 0.04 0.58
Source: GSO
Secondly, category of exporting goods is monotonous and undiversified. For more than 10 years, main exporting products of Vietnam remain unchanged with minerals (crude oil, coal), agricultural products, seafood, electronic products, textiles and garments. This structure makes the value of exports depending on world prices of a few products, especially these prices are usually fluctuant.
As can be seen over structure of exports, it takes 10 years for the economy to adjust the proportion of processed and refined goods in total exports from 45 percent to 55 percent. This structure also explains the steadiness and stability of exports growth since the main determinants of growing are due to old market expansion, new
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market development, price change4. In other words, the contribution of value added contained in products is very small. This slow change also implies that it will cost more time for the economy to increase the value added contained in exporting products because of the time need to research, experiment, use techniques and technologies and applies them into production. As a result, improving the trade balance by adjusting the structure of export cannot achieve in a few days or months, even years.
While exports’ structure exposes to depend on undiversified and low-value-added products, imports’ structure indicates the dependence of export production. Table 3.3 shows that large proportion of importing products (about 90 percent) is accounted by production materials including machinery, equipment, tools, fuels and raw material which are necessary for production, including export production. Thus, it is obvious that exports production highly depends on imports. This indicates the lack of subsidiaries industries for exports in the economy. This is the reason that some studies suggest not to use exchange rate tool to improve trade balance because depreciation can increase the input costs of exporting production, then increase the cost of goods sold and remove the effect of depreciation to reduce export prices (For example, Le Van Tu (2010)).
Table 3.3 – Structure of imports in 2000-2010
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Production
materials 93.8 92.1 92.1 92.2 93.3 89.6 88.0 90.5 88.8 90.2 - Machinery,
equipment, tools,
accessories 30.6 30.5 29.8 31.6 28.8 25.3 24.6 28.6 28.0 29.3 - Fuels and raw
materials 63.2 61.6 62.3 60.6 64.5 64.4 63.4 61.9 60.9 60.9 Consumption
products 6.2 7.9 7.9 7.8 6.7 10.4 12.0 9.5. 11.2 9.8
4 UNCTAD handbook of Statistics 2009 shows that, the rises of prices of minerals, raw agricultural materials which are main exporting products of Vietnam are 20.2 and 8.8 respectively from 1999 to 2008.