The effect of exchange rate movements on vietnam’s trade balance

MASTER IN FINANCIAL MANAGEMENT THE EFFECT OF EXCHANGE RATE MOVEMENTS ON VIETNAM’S TRADE BALANCE Graduate Student Nguyen Thuy Trang Supervisor Dr Nguyen Cam Nhung HANOI, 2021 ABSTRACT Thesis title The[.]

MASTER IN FINANCIAL MANAGEMENT

THE EFFECT OF EXCHANGE RATE MOVEMENTS ON VIETNAM’S TRADE

BALANCE

Graduate Student: Nguyen Thuy Trang Supervisor: Dr Nguyen Cam Nhung

HANOI, 2021

ABSTRACT

Thesis title: The effect of exchange rate movements on Vietnam’s trade

balance

Pages: 48

University: Vietnam National University, Hanoi

Graduate School: International School

Graduate Student: Nguyen Thuy Trang

Supervisor: Dr Nguyen Cam Nhung

Key words: Exchange rate, trade balance, Vietnam, SPSS, effect

This study clarifies the impact of the fluctuation of the VND/ USD exchange rate on trade balance in Vietnam by using SPSS tool Variables used in this research included exchange rate and trade balance Trade balance was drawn from import and export value from the statistics of Vietnam Customs The time range for conducting data research was from 2000 to 2018, specifically data used are monthly statistics The nominal effective exchange rate data is taken from Vietnam customs from the first day of June 2000 to the first day of June 2018 for each The result of findings showed that the exchange rate appreciation had negative effect on the trade balance In details, revaluation in exchange rate had trend to make trade deficit; and devaluation in exchange rate had trend to make trade surplus

ACKNOWLEDGEMENT

I wish to express my sincere appreciation to my supervisor, Doctor Nguyen Cam Nhung, who has the substance of a genius: she convincingly guided and encouraged me to be professional and do the right thing even when the road got tough Without her persistent help, the goal of this project would not have been realized The physical and technical contribution of ‘International School’ is truly appreciated Without their support, this project could not have reached its goal

Thank you!

Author

Nguyen Thuy Trang

TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION 1

1.1 Rationale and background 1

1.2 Research objectives 4

1.3 Scope of research 4

1.4 Research methods 5

CHAPTER 2: LITERATURE REVIEW 6

2.1 Concepts of exchange rate 6

2.1.1 Exchange rate 6

2.1.2 Effect of exchange rate movements on import and export 8

2.1.3 VND/USD (Jan, 2000 – Jan, 2018) 11

2.2 Exchange rate policy in Vietnam 13

2.2.1 Exchange rate regime 13

2.2.2 Exchange rate policy administration 15

2.3 Trade balance 17

2.3.1 Definition of trade balance 17

2.3.2 Trade deficit and trade surplus 18

2.3.3 Importance of trade balance in economy 20

2.3.4 Effect of trade surplus and trade deficit on economic indicators 22 2.4 Factors impacting trade balance 25

2.5 Theorical framework of relationship between exchange rate and trade balance 27

2.5.1 J-curve theory 27

2.5.2 Import and export elasticity and Marshall-Lerner 29

2.6 Trade balance in Vietnam from 2000 to 2018 31

2.7 Previous studies 37

2.8 Research gaps and aims 40

2.9 Conceptual framework 41

CHAPTER 3: RESEARCH METHODOLOGY 42

3.1 Methodology 42

3.2 Data collection procedures 44

3.3 Data analysis procedures 44

3.4 Analytical process 45

3.5 Reliability and validity 46

CHAPTER 4: FINDINGS AND DISCUSSION 46

4.1 Data analysis of VND/USD 46

4.1.1 Correlation analysis of variables 46

4.1.2 Regression analysis 47

4.1.3 Result of regression model 49

4.1.4 Suitability test 50

4.1.5 Multicollinearity test 50

4.1.6 Self-correclation test 51

4.1.7 Calibration distribution test of residual 51

4.2 Data analysis of NEER 53

4.3 Discussion 57

CHAPTER 5: CONCLUSION AND RECOMMENDATIONS 60

5.1 Summary of the findings 60

5.2 The implication of the research 60

5.3 Limitations of the research 61

5.4 Recommendations 62

LIST OF ABBREVIATIONS

VND: Viet Nam Dong CPI: Customer Price Index

USD: United States Dollar SVAR: Structural Vector

Autoregressive SPSS: Statistical Package for the

and Rights Organization

IRF: Impulse Response Function

GDP: Great British Pound ARDL: Autoregressive Distributed

Lag JPY: Japanese Yen FDI: Foreign Direct Investment E: Exchange Rate EX: Export

GDP: Gross Domestic Product EI: Import

SBV: State Bank of Vietnam R2: R square

TB: Trade Balance F-Test: Fisher Test

VECM: Vector Error Correction

Model

VIF: Variance Inflation Factor P-P: Probability

LIST OF TABLES

Table 3.1: Variables used in SPSS 43

Table 4.1 : Correlation analysis results 46

Table 4.2: Descriptive statistics 47

Table 4.3: the result of regression model 49

Table 4.4: Suitability of the model 40

Table 4.5: Analysis of variance 40

LIST OF FIGURES/ GRAPHS

Graph 2.1: the effect of devaluation on price and volume of imports and

exports 10

Graph 2.2: the effect of revaluation on price and volume of imports and exports 11

Figure 2.1: Exchange rate of VND/USD (1/1/2000- 1/1/2018)(Vietnam customs, 2019) 12

Figure 2.3: J curve effect 28

Figure 2.4: Trade balance of Vietnam from 2000 to 2018(Vietnam customs, 2019) 32

Figure 2.5: the conceptual framework of effect of exchange rate volatility on trade balance 42

Figure 4.1: Frequency histogram of normalized quadrant 52

Figure 4.2: P-P plot of standardized regression residuals 53

Figure 4.3 The result of research model 53

CHAPTER 1: INTRODUCTION

1.1 Rationale and background

Since the early 20th century (supplanting an earlier French term mundialisation), the term ‘globalisation’ has been appeared, developed its current meaning some time in the second half of the 20th century, and came into popular use in the 1990s The development of ‘globalisation’ has continuously affected almost every countries in modern economy Thereby in the context of globalisation and international economic integration, mechanisms and policies to regulate exchange rates are very important to directly affect the trade balance and macroeconomic stability in each country

As a result, imbalance in the trade balance has become a favoured research topic within community of economists

Manyara (2017) concentrates on effects of exchange rates volatility on imports and exports in Kenya Volatility of exchange rates has both positive and negative impacts on trade balance; while exchange rate and trade balance have a positive correlation with each other in a long-run Osoro (2013) share a common opion with Manyara (2017) about the positive relationship between these two variables in Kenya in long term Positive relationship between exchange rate volatility and trade balance usually happens to developed countries because these countries have high volume and value in exports In terms of negative relationship, Clark (1973) explains that the volatility of exchange rates reduces international trade transactions and makes profit change Hooper and Kohlhagen (1978) states a greater risk for personal decision making posing by exchange rate Economic agents experience greater uncertainty with international trade when they cannot predict the value

of foreign transaction; thus, it is difficult for firms to project their trade

activities Chowdhurry (1993) also shows that the exchange rate volatility has

a significant negative impact on exports for the G-7 countries The other study about the impact of exchange rates movements on trade of the G-7 countries done by Kroney; and Lastrapes (1993) states that the effect of exchange rate uncertainty on trade may vary across countries because of the differences in the level of competition, the use of hedging instruments, the economic scale

of production and openness to international trade In addition, they found that export prices are much more impacted than export volumes One more time, Caporale and Dorodian (1994) affirm a significant negative relation between exchange rate uncertainty and trade flows through their study on the effect of exchange rate variability on US imports from Canada

The result of a Vietnamese study of Vinh Nguyen and Duong Trinh (2019) about “the impact of exchange rate volatility on exports in Vietnam: bounds testing approach” shows that export performance is influenced by the volatility of exchange rate in long run This is a negative relationship as a one percent increase in exchange rate volatility reduces export volume significantly about 0.11 percent Thuan Dong (2016) states that real depreciation in exchange rate significantly plays a positive role on improving the trade balance in both aggregate model and disaggregate models Income

of domestic enterprises and its trading partners have negative and positive significant impacts on the trade balance respectively

Passing many years of economic construction, Vietnam has had to face with the situation of trade deficit for a long time due to many different reasons (CEIC, 2019); and exchange rate is one of the important reasons influencing the change of trade balance In the case that the trade deficit is prolonged; it will lead to a shortage of foreign currency as a consequence, which leads to the insolvency of transactions outside the country and leaves serious

consequences for the economy Therefore, how to create the trade surplus is

an extremely difficult issue for Vietnamese policy makers Since 2000, Vietnam has experienced much devaluation of VND compared to USD The exchange rate has been changed, and the nominal exchange rate has risen very high Although having to face with trade deficit in many periods, Vietnam economy still enjoy trade surplus in other periods That is the excess of export over import over a period of time

From 2000 to 2008, Vietnamese economy had to face prolonged trade deficit In 2008, 2009 and 2010, the balance of payments was fairly balanced because the balance deficit and the capital and financial balance surplus were approximately the same During the period from 2008 to 2010, as a result of the global economic crisis, trade declined and capital mobility also declined Thereby, the balance deficit and the surplus of capital and finance balance both decreased Foreign currency reserves decreased from 2008 to 2010 because the State Bank sold foreign currencies to peg the VND during this period In 2011 the foreign currency reserve increased slightly because the State Bank temporarily did not sell foreign currency

It is notable that Vietnam’s trade deficit was already at its peak, especially the trade deficit with neighbouring China Of the total deficit of 17 billion USD in goods of Vietnam to the world, the deficit with China alone reached 12 billion USD, followed by the trade deficit with competitors ASEAN countries and South Korea, only in surplus with the US and EU Thus, in order to maintain growth, Vietnam needs to control macroeconomic policies to promote the effectiveness of these policies to economic indicators and cope with the crisis

The management of exchange rate and balance trade is extremely important to in Vietnam which directly impacts trade balance Therefore, it is

necessary to examine the impacts of exchange rate on the trade balance in order to give recommendations for better managing exchange rate and trade

balance in Vietnam Thus, the author chooses "The effect of exchange rate

movements on Vietnam’s trade balance" as master thesis research topic

or lowly priced and its impact on the competitiveness of goods The results of the analysis show how the exchange rate policy affects the balance of trade

1.3 Scope of research

The thesis studied fluctuations of exchange rate and trade balance in Vietnam in the period from the second quarter of year 2000 to the second quarter of 2018 The reason for choosing this time period was to have accurate evaluation about the impact of exchange rate volatility on trade balance; whether that there was negative or positive relationship between exchange rate and trade balance and whether that exchange rate made trade balance deficit or surplus It would be difficult to assess the impact of exchange rate on trade balance if the given time period was too short

Moreover, there is a prolongation on trade deficit in the period from

2000 to 2008 In the period 2008-2018, Vietnamese economy achieved important and particularly impressive results, especially when looking back at the developments and difficulties caused by the global financial and economic crisis in the year 2008 Macro-economic difficulties, difficulties from markets and especially business and production activities not only require attention on

economic management, governance, issuance and management and adjusting policies, especially monetary policy of the State Bank (SBV), but also be a measure, be a quantitative evaluation of the effectiveness of monetary policy

in the past period

period from the first quarter of year 2000 to the fourth quarter of 2018

CHAPTER 2: LITERATURE REVIEW

Literature is going to review many aspects relating to exchange rate such

as its theory, classification, and policy The exchange rate between VND and USD in the period of the first quarter of year 2000 to the fourth quarter of

2018 is important to be given in this literature review at aim to see how its movements are In addition, concepts and factors impacting trade balance are analysed in order to understand more about trade balance Based on J-curve theory and Marshall-Lerner, literature review presents the relationship between exchange rate and trade balance At the end of this chapter, previous overseas and domestics researches will be described so that we can perceive how exchange rate affects trade balance in different countries and on various time periods

2.1 Concepts of exchange rate

2.1.1 Exchange rate

Gary (2014) concreates exchange rate as ratio of which one of these currencies can be exchanged for any other at any given point in time In the macroeconomic context, the exchange rate is influenced by many factors, such as production capacity or technological developments All of these factors are subject to change based on the actual situation of each country Therefore, the exchange rate also suffers the same effects Thus, the ratio of the exchange rate is only temporary, could changes daily The ratio of today is different that of yesterday It can increase or decrease day by day Sometimes, the ratio is remained without movement Lu (2011) also states the similar definition that exchange rate is the price of some foreign currencies in terms

of home currency In particular, one foreign currency can buy how much of home currency Generally speaking, exchange rate is the price of one

currency in terms of another currency The volatility of exchange rate is the increase or decrease of the price of the currency The price can be either fixed

or floating Central bank has the role in deciding fixed exchange rates and floating exchange rates which are made decision based on the demand and supply of the market Every country has the exchange rate of changing its domestic currency into other currencies There are some major currencies which are mostly used for changing the price such as USD, EUR currency (EURO), GBP currency (English currency), and JPY (Japanese currency) USD is the most popular and called the global currency There is one reason for why USD is the global currency that it accounts for 64% of the central banks’ foreign exchange reserves (Blue Bull Capital, 2018)

Exchange rate is divided into nominal exchange rate and real exchange rate Nominal exchange rate is the rate at which one foreign currency can be exchanged for how much of domestic currency In other sentence, nominal exchange rate is the price of a foreign currency in terms of domestic currency

For example:

E$/VND=23.155 US exchange rate (in US terms, Dollars per VND)

EVND/$= 0.04318 VND exchange rate (in VND terms, VND per Dollars)

So, E$/VND=1/EVND/$

The increase in E$/VND means VND depreciated and USD appreciated If one currency can buy more or less another currency, it means that the currency is appreciated or depreciated respectively

It is more complicated to understand real exchange rate Real exchange rate means how much price of goods and services in domestic country can be exchanged for the price of goods and services in foreign country Or, based on the calculation of Arkolakis (2014), real exchange rate equals nominal

exchange rate multiplied by the inverse of the relative price levels The formula for real exchange rate as follows:

Real exchange rate = (nominal exchange rate*domestic price)/foreign price

Basing on the formula above, it is true that real exchange rate is high when domestic price is higher than foreign price Economic trend is to increase import and decrease export as goods in overseas are cheaper than goods in domestics In contrast, when real exchange rate is low, export will increase and import will decrease

Exchange rate pass-through: is a measure of how responsive international prices are to changes in exchange rates Formally, exchange-rate pass-through is the elasticity of local-currency import prices with respect to the local-currency price of foreign currency, often measured as the percentage change, in the local currency, of import prices resulting from a one percent change in the exchange rate between the exporting and importing countries A change in import prices affects retail and consumer prices When exchange-rate pass-through is greater, there is more transmission of inflation between countries Exchange-rate pass-through is also related to the law of one price and purchasing power parity

2.1.2 Effect of exchange rate movements on import and export

2.1.2.1 Effect of devaluation of currency on imports and exports

The movements of exchange rate occur when there is appearance of devaluation and revaluation of the currencies In other words, the value of a country’s currency can increase or decrease compared to other currencies in fixed exchange rate In particular, devaluation means there is a fall in value of

a currency The devaluation of a currency has some effect on import and export of a country It will make imports more expensive and exports cheaper

A country with its depreciated currency will have exports more competitive and appear cheaper to foreign customers Consequently, the demand for exports will increase As in the case of Vietnam, when VND is depreciated compared to USD, Vietnam goods appear cheaper and become more attractive to overseas customers Therefore, demand for exports will go up As

a result, there is an increase in Vietnamese exports Generally, devaluation makes commodity price of a country cheaper to foreign customers; accordingly, export volume increases to match with the increasing demand of foreign customers

Devaluation makes exports price cheaper and exports volume higher; but makes imports price more expensive and imports volume lower In details, imports commodity such as petrol, food, and raw materials will be more expensive Simply understanding, when the currency of a country is depreciated, people of the country have to spend more money to buy products

in overseas markets As a result, the demand for imports accordingly reduces There is a fact that devaluation of a country’s currency will create trade surplus for the country The reason is that trade surplus equals exports minus imports When exports increase and imports decrease, trade surplus occurs as the consequence of this phenomenon In other words, devaluation is necessary

to reduce the size of trade deficit

Devaluation could cause higher economic growth Part of AD is (X-M) therefore higher exports and lower imports should increase AD (assuming demand is relatively elastic) In normal circumstances, higher AD is likely to cause higher real GDP and inflation So, devaluation causes higher inflation The reason is that expensive imports lead to high costs; and high costs cause the result of the increase in the prices of domestic goods and services

Graph 2.1: the effect of devaluation on price and volume of imports

and exports

Source: Pettinger (2019)

In conclusion, devaluation is interested by exporters because they can increase the quantity of exports The profit is high although the price of commodity is low Trade deficit has opportunity to improve because exports are high imports in terms of the quantity High quantity will create high revenue In other sentences, devaluation makes trade surplus As a result, economic growth might increase On the other hand, devaluation makes the price of imports increase Thus, costs are high which promote the increase in inflation Expensive imports will lead to high price in domestic products which is the result of high inflation

2.1.2.2 Effect of revaluation of currency on imports and exports

Being different from devaluation, revaluation means the increase in the value of a country’s currency in relation to a foreign currency Revaluation will make exports more expensive and imports cheaper In other sentences, the price of exports commodity will be more expensive to foreigners This leads to the reduction in exports demand Consequently, there is reduction in the quantity of exports Imports become more attractive to domestic

B of P improves Aggregate demand

rises

Economic growth improves

customers because the price of imports is cheaper So, demand for imports rises In the consequence, the quantity of imports also increases In the consideration of trade balance, account surplus can reduce due to the increase

of imports and decrease of exports A country wants to appreciate the value of currency at aim to delete trade surplus and reduce the situation of accumulating too many foreign reserves Revaluation stimulates import demand and curbs export demand (Quynh Anh, 2018) The success of revaluation depends much on the response of import and export goods

Apart from the effect on trade balance, revaluation impacts inflation either high or low If the exporting country’s currency revaluates, demand for its goods will decrease, thereby leading to high inflation Conversely, if the importing country’s currency revaluates against the exporting country’s currency, low inflation may occur because of availability of cheap imports

Graph 2.2: the effect of revaluation on price and volume of imports

and exports

Source: Pettinger (2019)

2.1.3 VND/USD (Jan, 2000 – Jan, 2018)

The following line chart presents the history data of VND/USD from year Jan, 2000 to Jan, 2018 The data is chosen on 1st January of each year

Current account

B of P decreases

Aggregate demand reduces

Economic growth

is slow

Figure 2.1: Exchange rate of VND/USD (1/1/2000- 1/1/2018)

Source: Vietnam customs (2019)

Based on the table above, it can be seen that VND/USD has changed so much In months of year 2000, investors can use one dollar to buy average 14 thousand VND Passing nearly 20 years, one dollar can buy average over 23 thousand VND As a result, USD is appreciated and VND is depreciated in general There are some reasons making USD increase (Phan Minh Ngoc, 2018) Firstly, Vietnam has high foreign currency reserves It is to reserve USD in Vietnam Dollar currency reserves has reflected the difference between demand and supply of USD which is the factor deciding the change

of VND/ USD In fact, high demand of USD in Vietnam is the cause of abundant USD resource In the case that if USD supply is higher than USD demand, the exchange rate has trend to decrease (VND is appreciated compared to USD) This is not good for export; so State bank has to buy USD

in order to reduce the press on the increase of VND This contributes to the increase in foreign currency reserves Secondly, USD is appreciated when the

reduction in USD resource from foreign investors happens It means foreign investors decrease the investment of USD in financial operations such as stock, or financial market This is the result of weakening VND and strengthening USD

2.2 Exchange rate policy in Vietnam

In the process of international economic integration associated with trade liberalization, exchange rate policy plays an important role as a tool to regulate international economic relations and has an impact on economic growth through increasing the competitive ability of enterprises Moreover, exchange rate policy improves the balance of payments as well as major balances in the economy Therefore, the exchange rate policy should be completed, combined with financial and monetary instruments to contribute to macroeconomic stability, curb inflation, and support businesses' development

2.2.1 Exchange rate regime

Many countries have chosen several exchange rate regimes to diminish the flexibility of exchange rate Christmann (2018) states different types of exchange rate regimes in managing exchange rate movement, including flexible exchange rates, managed floating rates, target bands, crawling pegs, conventional pegs, currency boards, and monetary unions or dollarization which are presented as below:

i.Flexible Exchange Rates – Flexible exchange rates fluctuate constantly

in response to market forces

ii.Managed Floating Rates – These are the rates under which authorities

intervene to limit short-term currency fluctuations without the goal to keep the exchange rate at a certain level

iii.Target Bands – Under target bands, the authorities intervene to keep the

exchange rate within a pre-arranged range

iv.Crawling Pegs – The crawling peg system is when the exchange rate is

regularly adjusted in the same direction by a pre-arranged amount

v.Conventional Pegs – Conventional pegs are those in which the

authorities intervene to keep the exchange rate at a pre-arranged level

vi.Currency Boards – The regime under which the only role of monetary

policy is to keep the domestic currency’s value constant relative to a particular foreign currency

vii.Monetary Unions or Dollarization – Under a monetary union, such as

the European Monetary Union, several countries adopt a common currency Dollarization involves one country unilaterally adopting the currency of another

Stone, Anderson and Veyrune (2008) describes three type of exchange rate regimes Those are hard exchange rate pegs, soft exchange rate pegs, and floating exchange rate regimes In terms of hard exchange rate pegs, these entails either the legally mandated use of another country’s currency (also known as full dollarization) or a legal mandate that requires the central bank

to keep foreign assets at least equal to local currency in circulation and bank reserves (also known as a currency board) Panama, which has long used the U.S dollar, is an example of full dollarization, and Hong Kong SAR operates

a currency board currencies that maintain a stable value against an anchor currency or a composite of currencies The exchange rate can be pegged to the anchor within a narrow (+1 or –1 percent) or a wide (up to +30 or –30 percent) range, and, in some cases, the peg moves up or down over time—usually depending on differences in inflation rates across countries Costa Rica, Hungary, and China are examples of this type of peg As the name implies, the floating exchange rate is mainly market determined In countries that allow their exchange rates to float, the central banks intervene (through

purchases or sales of foreign currency in exchange for local currency) mostly

to limit short-term exchange rate fluctuations However, in a few countries (for example, New Zealand, Sweden, Iceland, the United States, and those in the euro area), the central banks almost never intervene to manage the exchange rates

In Vietnam, with the regime of floating exchange rate with the State regulation, the exchange rate is flexibly adjusted according to the supply and demand of foreign currencies in the market under the State's control and regulation This exchange rate system is selected by most countries including Vietnam Under this mechanism, daily the State Bank of Vietnam (SBV) announced the average exchange rate of the previous day on the interbank market The purpose is that commercial banks can base on the average exchange rate of previous day to determine the exchange rate of today However, this exchange rate must revolve around the amplitude announced

by the State Bank in each period

Thus, this exchange rate regime will have the intervention of the State Bank to limit the sharp fluctuations of exchange rates such as the regulation

of trading amplitude between VND and USD, maintain the USD exchange rate at the target level to avoid possible risks to international business activities This exchange rate regime has both ensured the stability of the exchange rate, created favourable conditions for import and export activities, and ensured flexibility and anticipation

2.2.2 Exchange rate policy administration

Exchange rate policy is one of the economic policies that promote economic growth through increasing the competitiveness of domestically produced goods and supporting exports - an important component of economic growth The transmission mechanism of exchange rate policy has

the opposite effect between exporters and importers In case of an increase in the exchange rate, it will be positive for the competitiveness of exporting enterprises due to the competitive advantage of prices and protection of home-made consumer goods; otherwise, the increase in exchange rate increases costs for enterprises which must import inputs for production and business activities Even, it is detrimental for even exporting enterprises if they have to import production materials for their exports

Thanh Huyen (2018) states that exchange rate policy as an indirect tool

of monetary policy is directed toward the internal balance and external balance of the economy, including price stability, economic growth and trade balance stabilisation Before having impacts on the internal balance and external balance, the exchange rate policy - a purposeful intervention of the monetary regulator along with supply – demand relationship in the foreign exchange market causes exchange rate fluctuation, which will have certain effects on prices, output and trade balance Thus, when the exchange rate policy is adjusted, its impact on macroeconomic variables will also change According to data from the State Bank, from 2008 until now, the State Bank of Vietnam has operated the exchange rate policy towards a moderate depreciation of the VND, which has affected the export price of Vietnam in the world market more competitively In addition, the SBV also allowed commercial banks to liberalize foreign exchange points, allowed free conversion of strong foreign currencies and floated fees on options contracts between USD and VND; especially allowed the implementation of an agreed upon exchange rate mechanism, directed credit institutions to concentrate foreign currencies on lending loans to import essential commodities, regulated foreign currency supply and demand, and increased market liquidity However, the impact from efforts in managing the exchange rate policy on

export targets is not significant due to the structure of export products in raw form and low-price elasticity in the world market or depends too much on imported materials

There is a matter that continuous devaluation in long time will cause higher and higher inflation If VND is depreciated at 1 percent compared to USD, it will make export price reduce 0.21 percent and import price rise 0.49 percent The fluctuation of exchange rate affects the dollarization of Vietnam, leading to the erosion of the means of payment and preservation of the value

of VND Therefore, managing exchange rate policy with the aim of economic growth in the current context should pay attention to the following solutions:

i Regarding long-term goals: It is necessary to persevere solutions to implement macroeconomic stability, first of all maintaining low inflation Control of consumer price index will contribute to lower inflation rate, improve competitiveness of exports, and support businesses to cut input costs Besides, it is necessary to complete the inter-bank foreign currency market in order to help the State take measures to intervene when necessary

ii Regarding the exchange rate management mechanism: The State Bank

of Vietnam should continue to manage the exchange rate in a flexible manner, in which the VND exchange rate should be determined based on

a basket of key currencies Mechanism of exchange rate tightly tied to USD can be effective during the period affected by the world financial crisis

2.3 Trade balance

2.3.1 Definition of trade balance

Trade balance is sometimes called balance of trade According to Romero (2012), trade balance means the difference between import and

export of a particular country More clearly, it is the calculation of exports minus imports In the other aspects, David and Roy (1996) describe trade balance as “a reflection of how long a country has been a borrower or lender

in international capital markets” Will (2019) provides a similar definition of trade balance that the value of imports and exports of a country in a period of time is different from each other Trade balance has the role in helping economists to evaluate the strength of the economy of a country If a country imports more goods and services than exports in term of value, the country has trade deficit Vice converse, if the country exports more goods and services than imports in term of value, the country has trade surplus The formula for calculating trade balance is very simple as follows:

TB = total value of exports – total value of imports

2.3.2 Trade deficit and trade surplus

Trade deficit

There are two kinds of balance of trade: trade deficit and trade surplus Countries would like to enjoy trade surplus because trade surplus proves the development of the country’s economy Actually, although being developed countries with strongly economic development, they have still put up with trade deficit in some periods Thanh Hang (2018) describes some causes leading to trade deficit Firstly, it is the difference between savings and investment Based on the survey of Carol, Finn, Katleen, Tien Quang and Duc Khai (2006), the yearly financial savings rate of Vietnamese people is low; they save only 3 percent of their income Their forms of savings include postal savings, savings in state-owned commercial banks, private banks and credit organizations and informal savings and savings by lending In recent years, the hot growth of stock market and real estate market makes people feel

richer, which also increases consumption and reduces savings On the other hand, investment has trend to highly increase Monetary policy loses which leads to the reduction in domestic interest rate As a result, domestic investment increases Secondly, Vietnam’s trade deficit is related to the structure of import and export goods In Vietnam, it is commercial issue The increase in export also means the increase in import 2/3 of export value is imported material High costs of inputs surely lead to trade deficit Organizations have to take much amount of money to import inputs for production and manufacture Consequently, the value of exports is lower compared to high costs of inputs Besides, the competitive ability of domestic goods is still low In other words, Vietnam has no key items on international markets So, total value collected from international markets is not high Supposing that Vietnam had some kinds of key goods and services on overseas markets, export values would be high It is estimated that Vietnam will have to face trade deficit in 2019 The amount could be up to 3 billion USD (Nguyen Hoai, 2019) The expectation for export turnover in 2019 is

265 billion USD, down 17.4 percent from 2018

Trade surplus

Trade surplus occurs when the growth of exports is stronger than imports (John, 2016) In other sentences, trade surplus happens when a country exports more goods and services than it imports For example, if Vietnam exported 2 trillion USD worth of goods and products and imported only 5 billion USD worth of goods and products; so, it had a trade surplus of 1.5 trillion USD Higher the price of goods and products is, higher the value

of exports is As a result, trade plus is better Trade surplus is considered as a measure to watch the economic development of a country as it bases on

2.3.3 Importance of trade balance in economy

As known that trade balance is the difference between imports and exports Thus, the increase or decrease in imports or exports shows the health

of the economy of a country; it also means the ability to compete in global markets is strong or weak Trade balance not only directly impacts the change

of financial market, but also has a fundamental effect on the value of a country's currency on the foreign exchange market

Import value indicates the demand for goods and services from the foreign market of the local people, while the export value indicates the demand for goods supplied by one country to other countries On the other hand, the currency of a country is very sensitive to the volatility of the economy mainly derived from the trade deficit; and this currency is only stable when the balance of trade shows that demand for goods and services from other countries is higher, leading to a trade surplus The bond market is quite sensitive to risks from imported inflation Through a trade balance report of a country, investors can comprehensively and generally identify the country's trade situation compared to other countries in the world

If there is a trade surplus, it means that a country's export turnover is much larger than imports, which indicating that the country's economy is growing strongly and opening up lots of attractive investment opportunities in that country In contrast, trade balance deficit shows that the country's competitiveness is poor The trade balance has an impact on interest rates and securities prices The stock price falls if the trade balance is in deficit; this also indicates the competitiveness of domestic companies is poor On the other hand, the trade balance deficit shows that imports increase At that time, interest rates have tendency to rise; and exchange rates can increase based on trade deficit

A positive trade balance figure showed a trade surplus while the negative data showed a trade deficit This is an economic event that stimulates the volatility of the dollar If the demand for export exchange is stable, it will lead

to positive trade balance growth, which will support the dollar and vice versa

In the details, trade balance has the important role to the economy of each country As analysed above, trade balance is related to imports and exports Therefore, both imports and exports play the role to the development

of the economy Export is a factor that create growth stimulus In addition, export positively resolve unemployment and improve people lives It also increases GDP and national income thereby increasing domestic consumption Export is a growth factor, positively resolving unemployment and improving people's lives, increasing GDP and national income thereby increasing domestic consumption A company finds potential opportunities to sell its products in foreign markets; so, it will produce more products to meet the demand Certainly, domestic people have jobs to earn their livings; their life is also improved The improvement in human’s life is the result of the increase in consumption As a result, GDP and national income is a certainty

to increase

Export creates capital sources for import In fact, a company can remain commercial activities, business activities or production activities when its goods and products are consumed, especially sold in foreign markets Profit generated from export activities will partially be invested in importing materials and equipment at aim to create more goods and products Ultimate purpose is to remain commercial activities As a result, export makes the world developed

Export in trade balance contributes to economic restructuring, promotes the development of related industries, or support and expand consumer markets to facilitate domestic production capacity

In terms of import, it has the role in promoting the process of economic restructuring, supplementing sources of production materials and consumer goods funds Import makes the world more complete Without imports, there will not be exports Both imports and exports together promote the development of society and the global economy

Imports erase monopoly status, thoroughly disrupting closed economy This is easy to understand that a company can find suppliers from many foreign countries over the world instead of only one supplier from one country The economy has chance to access to new markets and new opportunities Generally speaking, the increase in imports or exports all bring about the development or the expansion of business operations Relationships among countries are improved and widen in terms of trade, culture, politics, and society It cannot deny the role of imports as well as exports in the process of developing, integrating into the world economy

2.3.4 Effect of trade surplus and trade deficit on economic indicators

Trade deficit

Both trade deficit and trade surplus have impact on some important economic indicators such as GDP and inflation In particular, trade deficit makes GDP decrease; vice converse, trade surplus makes GDP increase (Amanda, Chen, and Papanyan, 2017) However, these figures must be considered within the context of a country’s overall size For instance, the U.S may have a large trade deficit, but since most of its goods and services are produced and consumed domestically, this trade deficit does not have a major impact on its overall GDP (Justin, 2019) It is clear that trade deficit seriously

impacts GDP of a country Certainly, when a country has imports higher than

exports, the value contributing to GDP is low According to Sean (2019), GDP increases when there is a trade surplus In contrast, if domestic customers spend more on foreign products than domestic producers selling to foreign customers GDP will decrease as the result of trade deficit In fact, GDP includes private consumption spending, investments, government spending and the result of exports minus imports When exports minus imports equal a negative number, GDP has trend to reduce

Jobs are one of effects that trade deficit impacts on When a country

continuously experiences a trade deficit, negative consequences can affect economic growth and stability If there is a need for more imports than exports, domestic employment may be lost Theoretically, this is reasonable, but unemployment can actually exist at a very low level even if the trade deficit and high unemployment can occur in countries with surpluses

Similarly, continuous trade deficit usually has negative impact on

interest rate of the country The downward pressure on a country's currency

will weaken its value, which makes the price of goods in that currency more expensive; in other words, it can lead to inflation To combat inflation, the central bank may be motivated to enact restrictive monetary policy instruments including raising interest rates and reducing money supply Both inflation and high interest rates can hinder economic growth

Trade deficit also effects inflation of a country In the case that a country

has trade deficit in a long time, it will have to face the risk of economic recession Trade deficit causes the shortage of foreign reserves In other words, if a country does not have enough foreign reserves to maintain import and export activities, it will have to borrow foreign currency from foreign

countries However, borrowing foreign currency in a long time is the consequence of the increase in inflation

In terms of foreign direct investment, theoretically the balance of

payments must always be zero As a result, the trade deficit must be offset by

a surplus in the nation's capital and financial accounts This means that deficit countries experience a greater level of foreign direct investment For a small country, this can be detrimental, since a large part of the country's assets and resources are owned by foreigners who can control and influence the use of assets and resources According to Friedman, the trade deficit is never harmful in the long run because money will always return to the country in one form or another, such as through foreign investment

Referring to monetary value, a country's export demand affects the value

of its currency American companies selling goods abroad must convert those currencies into dollars to pay workers and their suppliers, which drives up the price of the local currency When export demand decreases against imports, the value of the currency decreases In fact, in a floating exchange rate system, the trade deficit should theoretically be adjusted automatically through exchange rate adjustments in the foreign exchange market In other words, the trade deficit is a sign that the currency of a country is desired on the world market (Thanh Hang, 2018)

reduction in unemployment rate It is better for farmers to export agricultural products to overseas markets Exports are good for a country to increase foreign reserves, stabilize exchange rate and stabilize macro economy The value that exports brings to can be in foreign currencies Thus, there is an increase in the accumulation of foreign reserves and import and export activities are ensured

2.4 Factors impacting trade balance

There are very many factors impacting on trade balance However, this research only states some of main factors which clearly impact trade balance

Trade policies

It is clear that barriers and restrictions on trade impact import and export activities of a country Policies that restrict imports or exports will make change to the relative prices of those goods and services; consequently, import or export can be more or less attractive (Mary, 2018) According to economic rules, imports and exports will increase when tariff is low, even no tariff Business persons will not have to pay a tax payment for importing or exporting goods; and they would like to make more imports and exports Vice converse, if a country applies high tariff to prevent risks or to limit import or export volumes, imports and exports are sure to decrease High fee for paying tax does not usually attract business persons to import and export goods and commodity Countries with high import tariff application may have larger trade deficits than countries with open trade policies (Kim, 1996) The reason

is that high import tariff is the cause of shutting out of export markets

Inflation

In the case that inflation of a country is high, it means the price to produce a unit of a product may be higher than the price in a lower-inflation country (Mary, 2018) A manufacturing company must spend more money on

buy materials for producing products Naturally, the price of products must be high At that time, volumes as well as value of exports may be reduced As a result, trade balance is impacted, possible deficit In contrast, low inflation leads to low costs Low costs create opportunities for manufacturing goods Low costs for materials are a certainty Consequently, consumption and export are better The noise in export activities lead to the increase in volume

as well as value of exports Trade balance will be positive in surplus (Frugman, 2009)

Foreign currency reserves

In order to compete effectively in extremely competitive international markets, a country has to invest in modern equipment and machines to improve productivity Certainly, the country has to buy these equipment and machines from foreign countries Accordingly, it is necessary for the country

to have enough foreign currency reserves so that it can buy inputs In other words, the country must have availability of sufficient foreign exchange to be used for payment of inputs The country cannot buy these inputs without enough foreign currency reserves As a result, there is reduction in imports When imports decreased, exports also decreased due to the lack of inputs for production This impacts imports and exports Trade deficit may occur as the consequence of insufficiency of foreign currency reserves (Minh Uyen, 2012)

Demand for commodity

Demand for commodity in international market is very wide The demand for a particular products or services is an essential component of international trade A company can increase exports when satisfying the demand of international market The increase in exports is a good sign of trade surplus (Hall, 2018) For example, when demand for oil is high, the

price of oil will increase The trade balance of oil-exporting and oil-importing countries alike If a small oil importer faces a falling oil price, its overall imports might fall The oil exporter, on the other hand, might see its exports fall Depending on the relative importance of a particular good for a country,

such demand shifts can have an impact on the overall balance of trade

Exchange rate

Exchange rate affects the relative price of domestically produced goods and goods on the international market When a country’s domestic currency is appreciated, the price of imported goods will become cheaper while the price

of exported goods becomes more expensive for foreigners Therefore, the appreciation of domestic currency will be detrimental to exports, which is favourable for imports (Khim, Lim and Hussian, 2003) The result is the decline in exports On the contrary, when the domestic currency is depreciated, exports will have an advantage while imports are at a disadvantage and exports increase The change of imports and exports is the cause leading trade deficit or trade surplus

2.5 Theorical framework of relationship between exchange rate and trade balance

2.5.1 J-curve theory

Curve J is a line that describes the phenomenon of current account balance being bad in short term and only being improved in the long term The line being illustrated for this phenomenon is shaped like the letter J According to the study of Krugman (1991), who found the J curve effect when analysing the devaluation of USD currency during the time period from year 1985 to year 1987, it was originally current account balance deteriorated; then, current account balance has improved about two years The model is as following:

Figure 2.3: J curve effect

Source: Ogbonna (2018)

The reason for the appearance of the J curve is that the price effect is superior to the quantity effect in the short term; thus, worsening the trade balance, whereas the quantity effect is more dominant than the price effect in the long run; so, trade balance is improved Several factors affect the time of the influence on the trade balance in the theory of J- curve effect as follows:

i Production capacity of imported substitutes: For developing economies

(Vietnam belongs to this group of countries), they cannot produce some kinds of products and goods; or be able to produce, but the quality is not as good and price may be higher Therefore, although import prices are more expensive, consumers cannot choose domestic products This extends the duration of the price effect;

Surplus

Time

Deficit

ii Proportion of qualified goods for export: For developed countries, the

proportion of qualified goods entering in international market is high; the effect of the price affecting the trade balance is often low In contrast, developing countries have a small proportion of these goods;

so, a devaluation of the currency makes export volumes increase more slowly This makes the mass effect less impact on the trade balance than that in developing countries Therefore, the impact of improving the trade balance of dumping in developed countries is often stronger in developing countries;

iii Proportion of imports in the price of domestically produced goods: If

this proportion is high, the production cost of domestic goods will increase when imports increase This eliminates the cheap price advantage of exports when devaluation Therefore, currency devaluation has not necessarily increased the volume of exports;

iv Flexibility of wages: Currency devaluation often increases consumer

price index If wages are flexible, it will increase according to the price index This increases the cost of production, thereby making domestic prices reduce the advantages from currency devaluation;

v Consumer psychology and national brand of domestic goods: if

domestic consumers have a psychological attitude towards foreign goods, an expensive cost of imported goods and cheap goods in the country have an impact on their consumer behaviour They will continue using imported goods even though prices are more expensive Next, the extent of the increase in the number of exports depends on the trust and preference of foreign consumers’ exported goods

2.5.2 Import and export elasticity and Marshall-Lerner

The elasticity coefficient method was first applied by two authors Alfred Marshall and Abba Lerner and developed by Joan Robinson (1973) and Fritz Machlup (1955) This method is based on some assumptions: supply and demand of goods have perfect elasticity, meaning that for each given price, the demand for imported and exported goods is always satisfied The content

of this method mainly analyses the effects of the dumping on current account balance

Export elasticity coefficient: represents the percentage change in exports when the exchange rate changes 1%

ηx=dX/X/dE/E Import elasticity coefficient: represents the percentage change of export when the exchange rate changes 1%

ηm=dM/M/dE/E Under Marshall-Lerner Condition, currency devaluation has a positive impact on the trade balance, the absolute value of the total elasticity of export price and import price must be greater than 1 (Sevcan and Birgul, 2016) The dumping leads to the decrease in the price of exported goods identified in foreign currency; so, the demand for exports increases At the same time, the price of imported goods identified in the domestic currency becomes higher, reducing the demand for imported goods

The net effect of the dumping on the trade balance depends on price elasticity If exports are elastic by price, the rate of increase in demand for goods will be greater than the discount rate; thus, export turnover will increase Similarly, if imports are elastic by price, spending on imports will decrease Both of these factors contribute to the improvement of the trade balance

Some experimental studies of elasticity like Yue and Hua (2002), Bénassy - Quéré and Lahrèche - Révil (2003), Lau et al (2004), Marquez and Schindler (2006), Shu and Yip (2006) found out that in the long term (from two to three years) the total export and import elasticity are greater than 1; meaning that devaluation has an impact on imports and exports According to experimental survey by Goldstein and Kahn (1985), the total long-run elasticity coefficient (longer than two years) is always greater than 1, while it tends to approach 1 in the short term (less than 6 months) In general, most researchers believe that the coefficient of export elasticity and the coefficient

of import elasticity in short term are smaller in the long term Therefore, Marshall-Lerner conditions can only be maintained in the long term There is

a view that developing countries often rely heavily on imports, so the price elasticity of import demand is small (meaning that the import value will not decrease much when devaluing the domestic currency) (Julian, 2017) Developed countries have relatively competitive export markets, so the elasticity of export demand may be larger (meaning that export value increases sharply when devaluing the domestic currency) This implies that devaluation in developed countries will have a stronger impact on trade balance than in developing countries; in other words, dumping is a solution that can improve trade deficits in this country, but may not have an impact in other countries It also recommends that developing countries be cautious when using strong devaluation of their domestic currency to stimulate exports

2.6 Trade balance in Vietnam from 2000 to 2018

As seen in the following table, Vietnam had more trade deficit than trade surplus and going on for many years and many continuous years From year

2002 to year 2011, Vietnam’s trade deficit was highest at 12,78 billion USD

in 2008 This was also the year of global economic crisis So, it can be said that the trade deficit in 2008 was the common situation of the world The second highest trade deficit was 10,36 billion USD in 2007; this was the beginning year of global economic crisis period Based on the formula of trade balance, imports were higher than exports in these years From 2012 to

2018, trade surplus was highest at 6, 8 billion USD in 2018 Vietnam’s import and export were considered as the most strength over nearly 20 years Trade balance in 2013 was zero The year 2019 was estimated to be deficit when trade deficit in first five months was 0,43 billion USD (Vietnamese customs, 2019) Although exports always increased in comparison with the previous year, the increase of imports was much larger That was the reason for trade deficit in Vietnam

Figure 2.4: Trade balance of Vietnam from 2000 to 2018

Source: Vietnam customs (2019)

In order to explain the reason for a prolonged trade deficit in Vietnam,

Do Hanh Nguyen (2014) states that Vietnam's account deficit stems partly