The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .

The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .The role of vehicle currency in affecting trade balance: Empirical evidence from the trade of China and the association of South East Asian nations with the European Union .

-HO -HOANG GIA BAO

THE ROLE OF VEHICLE CURRENCY IN AFFECTING TRADE BALANCE: EMPIRICAL EVIDENCE FROM THE TRADE OF CHINA AND THE ASSOCIATION OF SOUTH EAST ASIAN NATIONS WITH

THE EUROPEAN UNION

DOCTORAL DISSERTATION

Ho Chi Minh City – 2023

-HO -HOANG GIA BAO

THE ROLE OF VEHICLE CURRENCY IN AFFECTING TRADE BALANCE: EMPIRICAL EVIDENCE FROM THE TRADE OF CHINA AND THE ASSOCIATION OF SOUTH EAST ASIAN NATIONS WITH THE

EUROPEAN UNION

MAJOR: FINANCEMAJOR ID: 9340201

DOCTORAL DISSERTATION

ACADEMIC SUPERVISORS:

1 ASSOC PROF DR TRAN THI HAI LY

2 DR DINH THI THU HONG

Ho Chi Minh City – 2023

(UEH), and no part of it has been submitted to any other university or organization toobtain any other degree All the references used in this dissertation are properly cited.

Ho Chi Minh City, 31 Jan 2023

Ho Hoang Gia Bao

I am much grateful to Prof Dr Tran Ngoc Tho, Assoc Prof Dr Phung DucNam, Dr Vu Viet Quang, Assoc Prof Dr Ha Thi Thieu Dao, Prof Dr Aaro Hazak,Assoc Prof Dr Le Thi Phuong Vy, Dr Nguyen Hoang Thuy Bich Tram, Dr Le ThiHong Minh, Dr Tran Thi Tuan Anh, and other professors for their valuable comments.

I am much grateful to the anonymous reviewers for their valuable comments

I am much grateful to my family and all the people who give me encouragementand support to conduct this PhD dissertation

Ho Chi Minh City, 31 Jan2023

Ho Hoang Gia Bao

CHAPTER 1: INTRODUTION 1

1.1 Research background and motivations 1

1.2 Research objectives 10

1.3 Research questions 11

1.4 Research scope 11

1.5 The contributions of the dissertation 11

1.6 The structure of the dissertation 15

1.7 The summary of Chapter 1 17

CHAPTER 2: LITERATURE REVIEW 18

2.1 The impacts of exchange rates on trade balances 18

2.1.1 The imperfect substitutes models 19

2.1.2 The Marshall-Lerner condition 23

2.1.3 The J-curve effect 26

2.1.4 The application of the method proposed by Rose and Yellen (1989) to identify the J-curve effect and the Marshall-Lerner condition 30

2.1.5 The review of empirical studies about the Marshall Lerner condition 33

2.1.6 The review of empirical studies about the J-curve effect 35

2.2 The dominance currency paradigm 45

2.5 Research hypotheses 51

2.6 The summary of Chapter 2 54

CHAPTER 3: METHODOLOGY 55

3.1 Explaining why the standard two-country model can be used for inspecting the role of a vehicle currency 55

3.2 Empirical models and the computation of the variables 64

3.2.1 The empirical models and the computation of the variables for the Research Objective 1 64

3.2.2 The empirical models and the computation of the variables for the Research Objective 2 68

3.3 Data description 73

3.4 Estimation method 75

3.4.1 Reasons to select the NARDL method 75

3.4.2 The estimation procedure 76

3.5 The summary of Chapter 3 80

CHAPTER 4: EMPIRICAL RESULTS FROM CHINA-EU TRADE 81

4.1 The trade between China and the whole EU 81

4.2 The trade between China and each EU member and the UK 90

4.3 The trade between China and the EU at industry level 107

5.1 The trade between the entire ASEAN and the whole EU 123

5.2 The trade between each ASEAN member and the whole EU 132

5.3 The trade between the entire ASEAN and the whole EU at industry level 143

5.4 The summary of Chapter 5 158

CHAPTER 6: CONCLUSION 160

6.1 The summary of the findings 160

6.2 The summary of contributions and policy implications 162

LIST OF PUBLICATION 166

REFERENCES 167

APPENDIX 183

B-P Breusch-Pagan test

CUSUM Cumulative Sum of Recursive Residuals

CUSUMSQ Cumulative Sum of Square of Recursive Residuals

EU-27 The European Union with 27 member countries

EU-28 The European Union with 28 member countries

NARDL Nonlinear Autoregressive Distributed Lags

UNCTAD United Nations Conference on Trade and Development

LIST OF TABLES

Table 1.2: Top 5 partners that the EU exported to in 2020 6Table 2.1: Examples of some studies at aggregate, bilateral, and industry levels forseveral selected countries 38Table 2.2: Examples of some published papers that accounted for the asymmetricimpacts of exchange rates on trade balances 41Table 3.1: The description of notations 56Table 3.2: Data sources for computing the variables 73Table 4.1: The descriptive statistics of the variables in China’s trade with the wholeEU-28 81Table 4.2: The results of unit-root tests for the variables in China’s trade with thewhole EU-28 82Table 4.3: The impacts of the real effective exchange rate on China’s trade balancewith the whole EU-28 83Table 4.4: The impacts of the vehicle currency USD’s exchange rate on China’s tradebalance with the whole EU-28 86Table 4.5: The impacts of the real effective exchange rate on China’s trade balancewith the whole EU-27 88Table 4.6: The impacts of the vehicle currency USD’s exchange rate on China’s tradebalance with the whole EU-27 89

104Table 4.9: The cases with long-run and/or short-run asymmetries in China’s trade witheach EU member and the UK 105Table 4.10: Comparing the performance of the BERi and VERi models in terms ofsignificant exchange rates’ coefficients 107Table 4.11: The descriptive statistics of the variables in China’s trade with the EU-28

at the industry level 108Table 4.12: The impacts of exchange rates on China’s trade balance with the EU-28 atthe industry level 111Table 4.13: The summary of exchange rates’ long-run impacts on China’s tradebalance with the EU-28 at the industry level 118Table 4.14: The list of industries traded between China and the EU-28 having long-runand/or short-run asymmetries 119Table 4.15: Comparing the performance of the REERj and VERj models in terms ofsignificant exchange rates’ coefficients 120Table 5.1: The descriptive statistics of the variables in the trade between the entireASEAN and the whole EU-28 123Table 5.2: The results of unit-root tests for the variables in the trade between the entireASEAN and the whole EU-28 124

trade balance with the whole EU-28 127Table 5.5: The impacts of the real effective exchange rate on ASEAN’s total tradebalance with the whole EU-27 130Table 5.6: The impacts of the vehicle currency USD’s exchange rate on ASEAN’s totaltrade balance with the whole EU-27 130Table 5.7: The impacts of exchange rates on the trade balance of each ASEAN memberwith the whole EU-28 133Table 5.8: The ranking of ASEAN members in terms of their trade shares with the EU-28 138Table 5.9: The summary of exchange rates’ impacts on the trade balances of 10ASEAN members with the EU-28 140Table 5.10: The cases with long-run and/or short-run asymmetric impacts of exchangerates on the trade balances of 10 ASEAN members with the EU-28 141Table 5.11: Comparing the performance of the AREERk and RUSDk models in terms

of significant exchange rates’ coefficients 142Table 5.12: The impacts of exchange rates on ASEAN’s trade balance with the EU-28

at the industry level 147Table 5.13: The summary of exchange rates’ impacts on ASEAN’s trade with the EU-

28 at the industry level 155

ASEAN’s trade balance with the EU-28 at the industry level 158Table A1: The review of some notable currency-choice studies 183Table A2: The results of unit-root tests for China’s trade with each EU members andthe UK 187Table A3: The results of unit-root tests for China’s trade with the EU-28 at the industrylevel 192Table A4: The results of unit-root tests for the trade between each ASEAN memberand the EU-28 193Table A5: The results of unit-root tests for the trade between ASEAN and the EU-28 atthe industry level 196Table A6: The impacts of the real effective exchange rate on China’s trade balancewith the whole EU-28 adding control variables 197Table A7: The impacts of the vehicle currency USD’s exchange rate on China’s tradebalance with the whole EU-28 adding control variables 198Table A8: The impacts of the real effective exchange rate on ASEAN’s trade balancewith the whole EU-28 adding control variables 199Table A9: The impacts of the vehicle currency USD’s exchange rate on ASEAN’strade balance with the whole EU-28 adding control variables 200

Figure 1.1: The shares of invoicing currencies versus the trade shares of the US,

Eurozone, and other countries from 1994 to 2014 2

Figure 1.2: The shares of USD and EUR in the exports of some country groups 3

Figure 1.3: The shares of USD and EUR in the trade of the EU with the partners outside the EU in 2020 5

Figure 2.1: The graphical presentation of the J-curve effect 26

Figure 4.1: The CUSUM and CUSUMSQ tests of the REER model 85

Figure 4.2: The CUSUM and CUSUMSQ tests of the VER model 87

Figure 4.3: The exports and imports of some merchandise groups traded between China and the EU in 2011 and 2021 110

Figure 5.1: The CUSUM and CUSUMSQ tests of the AREER model 126

Figure 5.2: The CUSUM and CUSUMSQ tests of the RUSD model 129

Figure 5.3: The percentages of some product groups in ASEAN’s exportation to the EU 145

Figure 5.4: The percentages of some product groups in ASEAN’s importation from the EU 146

CHAPTER 1: INTRODUTION 1.1 Research background and motivations

Exchange rates have always been spotlighted in the global trade as they canimpact the trade values and trade balances of many countries (Auboin & Ruta, 2013;Yazgan & Ozturk, 2019) Thus, exchange rates have important roles in trade policiesand are connected with trade disputes (Nicita, 2013; Betz & Kerner, 2016) Therefore,

it is not surprising when exchange rates have received so much attention from makers and researchers all around the world In the era of globalization, betterunderstanding of exchange rates, especially their connections with trade balances, hasbeen the increased need of policy-makers (Bahmani-Oskooee & Aftab, 2017) Sincethe introduction of the J-curve effect by Magee (1973) and the methods proposed byBahmani-Oskooee (1985) and Rose and Yellen (1989) to detect it, manifold studies inthe literature of international economics and international finance have scrutinized thelinks between exchange rates and trade balances in various countries However, theyhave the same limitation when most of them ignore the roles of vehicle currencies,which fails to reflect the common practice in global trade invoicing

policy-A vehicle currency is defined as the currency of a third country used in the tradebetween the other two countries (Goldberg & Tille, 2008) For instance, in the tradebetween a home country (e.g., Vietnam) and its partner (e.g., Germany), the currenciesused for invoicing the goods can be its currency (e.g., Vietnamese dong – VND), thepartner’s currency (e.g., Euro – EUR), or a vehicle currency belonging to a thirdcountry such as the US dollar (USD) It is a common practice in the global trade toinvoice the goods by vehicle currencies In fact, one of the most noticeable and stablepatterns in the global trade is that the USD has an overwhelming role and thus is usedfor invoicing the goods in the trade of many countries with their partners even whenthe US does not participate in such trade (Boz et al., 2022) Figure 1.1 shows the

dominance of USD as a vehicle currency in the global trade in the period 1999–2014 Itcan be observed that during this period, the share of the US in the global trade was lessthan 10%, but the USD was employed in nearly 40% of the total global trade value.This implies that roughly 30% of the world’s trade (i.e., the difference between 40%and 10%), without the participation of the US, was settled by the USD Therefore, theUSD is the most popular vehicle currency in the world The role of EUR as a vehiclecurrency in the global trade is not as important as the USD because most of its usageinvolves the Eurozone (also known as the euro area) where the EUR is the commoncurrency of 19 EU countries (Boz et al., 2022)

Figure 1.1: The shares of invoicing currencies versus the trade shares of the

US, Eurozone, and other countries from 1994 to 2014

Source: Boz et al (2022)

Notes: In the left column, the red, blue, and grey colors respectively indicate the shares

of USD, EUR, and other currencies employed in the global trade In the right column, the red, blue, and grey colors respectively indicate the proportions which the US, the Eurozone, and other countries occupied in the global trade.

It is also noticeable in the Figure 1.1 that although the remaining countries (i.e.,the countries that are not the US and do not belong to the Eurozone) held more than

50% of the global trade in the 1994–2014 period, the shares of their currencies wereless than 20% This once again reinforces the fact that the currencies of the countriesdifferent from the US and the Eurozone are lightly used in the global trade, and thus,those countries need to rely on vehicle currencies, especially the USD, in trading withthe partners different from the US.

Figure 1.2: The shares of USD and EUR in the exports of some country groups

Source: Boz et al (2022)

Notes: “EMs”, “LatAM”, and “Non–EA EU” respectively stand for emerging market economies, Latin America, and the EU countries that are not members of the Eurozone.

In each country group, the first bar indicates the period pre–2005, while the second,

third, and fourth bars respectively indicate the periods 2005–2010, 2010–2015, and post–2015.

The dominance of USD over the EUR as an essential invoicing currency is furtherillustrated in the Figure 1.2 which shows the shares of USD and EUR used in theexports of emerging market economies as well as the EU countries that are notmembers of the Eurozone Regarding the emerging market economies in Africa, theshares of USD employed in their exports were always higher than 60% in the periodspre–2005, 2005–2010, 2010–2015, and post–2015, but those of EUR were alwaysbelow 25% Regarding the emerging market economies in Asia, the average share ofUSD in their exports was more than 80%, but that of EUR was only below 3%.Regarding the emerging market economies in Latin America, while the average share

of USD was more than 93%, the average share of EUR was roughly 2% Thus, it can

be concluded that the role of USD as a vehicle currency in the exports of the African,Asian, and Latin American emerging market economies is much stronger than theEUR And this dominance of USD over the EUR remains in the imports of thosecountries (Boz et al., 2022) For the EU countries that are not the members of theEurozone, the share of the EUR increased from about 30% in the pre–2005 period tomore than 50% in the post–2015 period This implies that the EUR has gained moreimportance in those EU countries that do not use the EUR as their official currency.Also, the average share of USD in their exports was stable at approximately 25%,which indicates that the role of USD was not considerably reduced by the growth of theEUR In other words, although the EUR has gained much more share, the USD remainsbeing used as a crucial invoicing currency and/or a vehicle currency by the non-Eurozone members of the EU

To further depict the heavy utilization of USD by the whole EU, Figure 1.3clearly demonstrates that the USD still plays an important role in the trade, especially

in the importation, of the whole EU with the countries outside the EU Namely, in

2020, the USD was the most utilized currency in the EU’s imports from non-EUcountries with the share of 48.1% This fact is very noticeable because the EU is thehome of the world’s second most popular currency (i.e., the EUR) with the ambition topromote the usage of the EUR in the global trade

Figure 1.3: The shares of USD and EUR in the trade of the EU with the partners

outside the EU in 2020

Source: Eurostat (2021)

Nevertheless, the EU still strongly employs the USD as a vehicle currency,especially with non-EU partners To explain this point more clearly, Tables 1.1 and 1.2respectively provide the information about the top 5 partners that the EU importedfrom and exported to in 2020 Particularly, it can be seen in the Table 1.1 that the USonly held 11.8% of the total value of the EU’s imports, but the share of USD was

48.1% This is the persuasive evidence for the crucial role of USD as a vehiclecurrency in the EU’s imports although the EU is the home of the EUR – the world’ssecond most popular currency Namely, even if all the EU’s imports from the US wereinvoiced by the USD, the remaining 36.3% (i.e., the difference between 48.1% and11.8%) of the total value of the EU’s imports from other partners had to be settled bythe USD, which clearly indicates the role of USD as a vehicle currency And this isvery likely that the imports of the EU from China were also substantially invoiced bythe vehicle currency USD, given the fact that China has heavily relied on the USD as avehicle currency in its international trade instead of its own currency (Lai & Yu, 2015;Yang & Gu, 2016)

Table 1.1: Top 5 partners that the EU imported from in 2020

Source: European Commission (2021a)

Table 1.2: Top 5 partners that the EU exported to in 2020

Source: European Commission (2021a)

The role of USD as a vehicle currency in the exports of the EU is also revealed bythe Figure 1.3 and Table 1.2 Specifically, while the USD was employed in 29.4% ofthe EU’s total exports in 2020, the share of the US was only 18.3% Hence, even in theextreme case when all the EU’s exports to the US were invoiced by the USD, theremaining 11.1% of the USD utilization (i.e., the difference between 29.4% and18.3%) would undoubtedly serve as the vehicle currency in the exports of the EU to theother partners This is the convincing evidence for the role of USD as a vehiclecurrency in the exportation of the EU Consequently, the USD is a crucial vehiclecurrency in the trade of not only the emerging market economies but also the EU – thehuge, powerful economy and the home of the EUR Thus, the utilization of USD as avehicle currency is a global phenomenon, which is also a common and persistentpractice in the international trade (Boz et al., 2022)

Despite the aforesaid fact, most existing studies on the impacts of exchange rates

on trade balances ignored the role of vehicle currencies, especially the USD – thedominant one Namely, they normally relied on the two-country models, especially theversion of Rose and Yellen (1989), as the theoretical framework which does not coverthe roles of vehicle currencies Consequently, those studies used bilateral exchangerates between the home countries’ currencies and the foreign partners’ currencies,which is unable to reflect the patterns of global trade invoicing and fails to providedetailed results For instance, if no impact of the bilateral exchange rate on the tradebalance is found, the findings may suggest that the former does not boost or reduce thelatter However, if the role of USD as a vehicle currency is examined, the USD’sexchange rate can foster or discourage the trade balance, and thus more detailed andhelpful results can be recommended for the policy-makers Besides, the inadequate

investigation of vehicle currencies in the literature on exchange rate-trade balancerelationship reveals some notable research gaps that need to be filled.

Motivated by the patterns of global trade where the USD is the most influentialvehicle currency and the fact that it is ignored by the vast majority of the literature onexchange rate-trade balance relationship, the dissertation will identify the gaps andpropose the methods to fill them to make theoretical and empirical contributions to theexisting literature Specifically, the dissertation explains why the two-country modelversion of Rose and Yellen (1989), which is heavily applied to examine the impacts ofexchange rates on trade balances, can also be used for inspecting the role of a vehiclecurrency in determining a country’s trade balance with a foreign partner Thus, thisdissertation can provide the method for the incorporation of a vehicle currency,especially the USD, into the standard two-country model In addition, the dissertationreports the empirical evidences about the impacts of the vehicle currency USD’sexchanges rates on China’s and ASEAN’s trade with the EU The reasons to selectthose countries are based on their interesting features:

- Firstly, Asian emerging market economies have dominated the global trade ofall emerging market economies which have grown rapidly and increasingly contributed

to the world’s total output and consumption (Gruss et al., 2020; UNCTAD, 2018,2020) Among those Asian countries, China and nearly all of the ASEAN countries arethe most noticeable representatives Namely, in the period 2000–2018, based on thecalculation of the author from the Direction of Trade Statistics data from IMF, it isremarkable that 98.4% of the trade value of all Asian emerging market economiescame from the 10 following countries: China (58.9%), India (10.8%), Thailand (7.4%),Malaysia (7.3%), Indonesia (5.4%), Vietnam (4.2%), the Philippines (2.5%),Bangladesh (1.0%), Sri Lanka (0.5%), and Myanmar (0.4%) Obviously, China had anoverwhelming share in the total trade of Asian emerging market economies, which is

not abnormal because China is the second largest economy and has been the largestexporter in the world since 2009 (UNCTAD, 2021) In the top 10 traders from Asianemerging market economies, there are 6 members of ASEAN (i.e., Thailand, Malaysia,Indonesia, Vietnam, the Philippines, and Myanmar) which altogether occupied 27.2%

of the total trade share Thus, China and ASEAN are notable representatives of all theAsian emerging market economies in terms of the total international trade value

- Secondly, China and most of the ASEAN countries, similar to the other Asianemerging market economies, substantially employ the USD as a vehicle currency intheir trade (Goldberg & Tille, 2008; Lai & Yu, 2015; Yang & Gu, 2016; Huong, 2017,Boz et al., 2022) Although Singapore is not an emerging market economy, it stillconsiderably employs the USD as a vehicle currency (Yang & Gu, 2016)

- Thirdly, although the EU is the home of the EUR – the world’s second mostutilized currency, it strongly relies on the USD as a vehicle currency in trading withnon-EU partners, especially in its importation Moreover, the largest and the thirdlargest origins of the EU’s importation from non-EU countries are China and ASEAN(European Commission, 2021b) Therefore, it can be inferred that the USD is stronglyutilized as a vehicle currency in China-EU and ASEAN-EU trade

- Fourthly, the EU, China, and the US are the 3 biggest traders in the globe(European Commission, 2021c) Although the US used to be the largest trading partner

of both China and the EU, now, based on the calculation of the author and Amaro(2021), the EU is the biggest trading partner of China and vice versa Thus, the China-

EU trade is important enough to be researched And more interestingly, the China-EUtrade relies much on the USD as a vehicle currency

- Fifthly, ASEAN consists of 10 countries, and most of them have grown veryfast and gained more and more importance in the global trade The market of ASEAN

as a whole is very lucrative with more than 640 million customers, which is the eighth

biggest economy in the world (European Commission, 2021b) Thus, it is notsurprising when the priority of the EU is to promote their exports to ASEAN throughbilateral and region-to-region free trade agreements (European Commission, 2021b).Therefore, the ASEAN-EU trade can provide valuable empirical evidences for the roles

of USD as a vehicle currency in the trade between these two regions at different levels

of analyses

- Sixthly, by analyzing the China-EU and ASEAN-EU trade, the USD satisfiesthe definition of a vehicle currency Specifically, a vehicle currency is defined as athird-country’s currency used for invoicing the merchandise traded between the othertwo countries (Goldberg & Tille, 2008) Therefore, as the US is not involved in China-

EU and ASEAN-EU trade, the USD is considered a vehicle currency Thus, theresearch design of this dissertation is valid to examine the role of USD as a vehiclecurrency in China’s and ASEAN’s trade with the EU

- Seventhly, the choice of China-EU trade in this dissertation enables a new anddistinguishable analytical approach on the exchange rate USD/CNY Particularly,although USD/CNY has been in the spotlight of manifold research, it is investigated inconnection with the China-US relationship Nevertheless, virtually no paper examinesthe impacts of USD/CNY on China’s trade with the partners different from the US.Thus, this dissertation provides a new perspective on the role of USD/CNY in China-

EU trade, and the findings indicate that the exchange rate USD/CNY have significantimpacts on China’s trade balance with the EU at different levels of analysis

1.2 Research objectives

The objectives of this dissertation are depicted as follows:

- Research Objective 1: Scrutinize the effects of the use and nonuse of the

vehicle currency USD on China’s trade balance with the EU at different levels ofanalyses

- Research Objective 2: Scrutinize the effects of the use and nonuse of the

vehicle currency USD on ASEAN’s trade balance with the EU at different levels ofanalyses

1.3 Research questions

The research questions of this dissertation are listed as follows:

- Research Question 1: At each level of analysis, do the use and nonuse of the

vehicle currency USD have distinguishable effects on China’s trade balance with theEU?

- Research Question 2: At each level of analysis, do the use and nonuse of the

vehicle currency USD have distinguishable effects on ASEAN’s trade balance with theEU?

1.4 Research scope

The dissertation explains why the standard two-country model version of Roseand Yellen (1989) can be employed for analyzing the role of a vehicle currency,especially the USD Also, the dissertation explores the impacts of the use and nonuse

of the vehicle currency USD on China’s and ASEAN’s trade balances with the EU atdifferent levels of analyses The time span is from 2000Q1 to 2018Q1 For theindustry-level analyses, the time span is from 2002Q1 to 2018Q1 due to theunavailability of data The estimation method is Nonlinear Autoregressive DistributedLags (NARDL) The data are collected from various sources including Asian

Development Bank (ADB), Direction of Trade Statistics (DOTS), Eurostat, FederalReserve Bank of St Louis (FRED), General Statistics Office of Vietnam (GSO), andInternational Financial Statistics (IFS) The detailed description of the data and theestimation method are presented in Chapter 3.

1.5 The contributions of the dissertation

The dissertation has some theoretical and empirical contributions to the literature,which provides new information that can be helpful for policy-makers as well asresearchers

Regarding the theoretical contributions, this dissertation is the first study toexplain why the standard two-country model version of Rose and Yellen (1989), whichserves as the theoretical framework for the majority of the research about exchangerates’ impacts on trade balances, can be used for scrutinizing the role of a vehiclecurrency The explanation and the method suggested by this dissertation can overcomethe shortage of data about the percentage of a vehicle currency used in the trade of twocountries Furthermore, from the explanation and the method suggested by thisdissertation, researchers can apply the standard two-country model version of Rose andYellen (1989) to investigate the role of any vehicle currency in the trade of any twocountries in the world Thus, this dissertation makes a theoretical contribution to theliterature by strengthening the standard two-country model version of Rose and Yellen(1989) to make it applicable in the presence of a vehicle currency

The dissertation also has some empirical contributions to the literature.Specifically:

- First, the dissertation is the first research to provide the empirical evidencesabout the impacts of the vehicle currency USD’s exchange rate on China’s tradebalance with the EU at different levels of analyses

- Second, it is also the first research to provide the comparisons between theimpacts of the use and nonuse of the vehicle currency USD on China’s trade balancewith the EU at different levels of analyses.

- Third, the dissertation is the first research to provide the empirical evidencesabout the impacts of the vehicle currency USD’s exchange rate on ASEAN’s tradebalance with the EU at different levels of analyses

- Fourth, it is also the first one to compare the impacts of the use and nonuse ofthe vehicle currency USD on ASEAN’s trade balance with the EU at different levels ofanalyses

- Fifth, the construction of the proxy for the exchange rate between two regionshas been inadequately addressed by the existing studies This dissertation is the firstresearch to propose the construction of the proxy for the exchange rate between tworegions

- Sixth, the dissertation suggests a new factor leading to the deficiency ofsignificant findings Namely, besides the two factors causing the shortage of significantfindings already found by the existing literature (i.e., the aggregation bias andsymmetric assumption about exchange rate-trade balance linkage), the dissertationproposes that the neglection of the vehicle currency USD in the scrutiny of the tradebetween two non-US partners can be a new culprit

- Seventh, the research design of this dissertation can effectively assess the role ofUSD as a vehicle currency which has been neglected by prior studies It should benoted that in the existing studies that focus on the trade of a country with the rest of theworld, although the USD is included in the construction of real effective exchange rate,its role as a vehicle currency and its dominance have not been reflected According toGoldberg and Tille (2008), a vehicle currency is defined as the currency of a third

country utilized for invoicing the goods traded between the other two countries Thus,the USD is not considered a vehicle currency in the trade of a country and the rest ofthe world because the US is included in the rest of the world (which means the US isnot the third country) Moreover, the dominance of USD is also overlooked in thoseexisting studies To clarify this point, let consider an example about an imaginarycountry A that only trades with China, the US, and Japan with the respective tradeshares 50%, 30%, and 20% Thus, the three partners China, the US, and Japan fullyrepresent the rest of the world, and the common approach of the existing studies incalculating the real effective exchange rate between the currency XYZ of the country Aand the basket of the currencies of China, the US, and Japan is adjusting the exchangerates with the respective trade shares: (RCNY/XYZ)0.50 * (RUSD/XYZ)0.30 * (RJPY/XYZ)0.20, where

RCNY/XYZ, RUSD/XYZ, and RJPY/XYZ are respectively the real exchange rates of XYZ withCNY, USD, and JPY Nevertheless, the aforesaid approach has a critical limitationwhen it ignores the dominance of the USD in the global trade Specifically, if thecountry A invoices 90%1 of its exported and imported goods by the USD, but only 7%and 3% by the CNY and JPY, the real effective exchange rate should have beenconstructed in this way: (RCNY/XYZ)0.07 * (RUSD/XYZ)0.90 * (RJPY/XYZ)0.03 However, nearly allexisting studies failed to reflect the dominance of USD in analyzing the trade balance

of a country with the rest of the world as they just used the trade share that the USoccupied to reflect the role of the USD A noticeable fact in the global trade is that theUSD is used much more than the share that the US takes up in the global trade (asshown in Figure 1.1) Besides the studies on the trade of a country with the rest of theworld, many others centralized on the trade of a country with each of its partner atbilateral level or at industry level Again, the role of USD as a vehicle currency hasbeen ignored this this line of research For instance, Iyke and Ho (2018) inspectedSouth Africa’s trade with several partners such as China, Germany, India, Japan, the

trade in 2016, but the share that the US occupied in Vietnam’s total trade was only around 13.2%.

UK and the US at the bilateral level, but the role of USD as a vehicle currency isneglected Namely, although the USD is included in South Africa’s trade with the US,

it cannot be regarded as a vehicle currency because the US is not the third country inthat trade In South Africa’s trade with China, Germany, India, Japan, and the UK, theUSD is not included and thus its role as a vehicle currency is overlooked For anotherexample, Usman et al (2021) examined Pakistan’s trade with the UK at the industrylevel, but the role of the USD as a vehicle currency is missing Thus, almost all theexisting studies have ignored the role of USD as a vehicle currency Also, in order toevaluate the role of USD as a vehicle currency, the US need to be absent from the tradebetween the other two partners Hence, the research design of this dissertation, byselecting the trade of China and ASEAN with the EU, is valid to assess the role of thevehicle currency USD

1.6 The structure of the dissertation

The dissertation has 6 chapters Chapter 1 describes the research background andmotivations of the research Besides, the research gaps, objectives, questions, scope,and the contributions of the dissertation are also demonstrated Chapter 2 provides thedetailed review of the literature, both theoretically and empirically, on the impacts ofexchange rates on trade balances Moreover, the dominance currency paradigm and thechoice of invoicing currencies are reviewed Next, the research gaps are identified, andthe research hypotheses are developed Chapter 3 is about the methodology of thedissertation Namely, in the part 3.1, the author explains why the two-country modelcan be used for inspecting the role of a vehicle currency This explanation is crucial forensuring the persuasiveness of the methodology Next, in the part 3.2, the empiricalmodels for each research objective, including the computation of the variables, arethoroughly depicted As the analyses in each research objective are implemented atdifferent levels, the appropriate calculation of the variables is required Then, the part

3.3 describes the data sources in details And the part 3.4 presents the NARDLestimation procedure Chapter 4 and 5 report the empirical results from China-EU andASEAN-EU trade at different levels of analyses Finally, Chapter 6 is about theconclusion of the dissertation, which summarizes the findings as well as thecontributions and policy implications

The list of all the chapters and their contents is summarized as follows:

1.5.The contributions of the dissertation

1.6 The structure of the dissertation

1.7 The summary of Chapter 1

CHAPTER 2: LITERATURE REVIEW

2.1 The impacts of exchange rates on trade balances

2.2.The dominance currency paradigm

2.3.The choice of invoicing currencies

3.5 The summary of Chapter 3

CHAPTER 4: EMPIRICAL RESULTS FROM CHINA-EU TRADE

4.1 The trade between China and the whole EU

4.2 The trade between China and each EU member and the UK

4.3 The trade between China and the EU at industry level

4.4 The summary of Chapter 4

CHAPTER 5: EMPIRICAL RESULTS FROM ASEAN-EU TRADE

5.1 The trade between the entire ASEAN and the whole EU

5.2 The trade between each ASEAN member and the whole EU

5.3 The trade between the entire ASEAN and the whole EU at industry level5.4 The summary of Chapter 5

CHAPTER 6: CONCLUSION

6.1 The summary of the findings

6.2 The summary of contributions and policy implications

1.7 The summary of Chapter 1

The dominance of the USD in the global trade is indisputable Even without thepresence of the US, the USD is widely used as a vehicle currency between any twonon-US partners Thus, not only the emerging market economies but also the EUstrongly rely on the USD to invoice their exported and imported merchandise.Nevertheless, virtually all prior studies on the impacts of exchange rates on tradebalances have ignored the role of the vehicle currency USD, which fails to reflect thereality of the international trade invoicing practice as well as limits the detailedfindings that can be helpful for policy-makers

This dissertation explains the applicability of the standard two-country model toincorporate the role of a vehicle currency Moreover, this dissertation is the firstresearch to investigate the role of the vehicle currency USD in affecting China’s and

ASEAN’s trade balances with the EU at different levels of analyses, which has severaltheoretical and empirical contributions to the existing literature.

CHAPTER 2: LITERATURE REVIEW 2.1 The impacts of exchange rates on trade balances

From the last several hundred years up to now, a familiar, but not obsolete,question often asked by researchers and policy-makers is whether thedepreciation/devaluation2 of a country’s currency can increase its trade balance Toinvestigate that question, early studies tried to validate the Marshall-Lerner condition:the sum of import and export elasticities of demand in absolute value exceeding one(Bahmani-Oskooee & Zhang, 2014) This approach requires estimating two equations

of imports and exports separately, and the Marshall-Lerner condition only depicts thelong-run relationship between a country’s exchange rate and its trade balance(Bahmani-Oskooee & Mitra, 2010) Since the introduction of the J-curve effect byMagee (1973) which demonstrated that a country’s trade balance could be initially

lowered by the depreciation of its currency and then improved, researchers have paidmore attention to the short-run as well as long-run impacts of the exchange rate on thetrade balance (Bahmani-Oskooee & Mitra, 2010) The first paper introducing thetechnique to detect the J-curve effect was Bahmani-Oskooee (1985, 1989) whichfocused on the changes in the signs of exchange rates’ coefficients Rose and Yellen(1989) developed a version of standard two-country models to estimate the influences

of exchange rates on trade balances directly and conveniently Besides, they alsoproposed a new method to detect the J-curve phenomenon by observing the signs of anexchange rate’s coefficients in the short run and the long run Since Rose and Yellen(1989), innumerable empirical studies have been conducted for various countries in theworld And this model is probably the most utilized theoretical framework in theliterature on the impacts of exchange rates on trade balances

The remaining parts of this section will focus on the theoretical frameworksregarding the impacts of exchange rates on trade balances Namely, the imperfectsubstitutes models, especially the well-known two-country model version of Rose andYellen (1989), will be presented first Then, the author will review the Marshall-Lernercondition and the J-curve effect After that, the review of empirical studies willdemonstrate the development of the literature in order to identify what have beenresearched and what are still unexplored

2.1.1 The imperfect substitutes models

Various versions of imperfect substitutes models existed, but they rely on thesame crucial assumption: the imported merchandise cannot totally substitute domesticgoods (Khan & Knight, 1986; Rousslang & Suomela, 1988; Rose & Yellen, 1989).This assumption is very crucial as it is compatible with the empirical evidences ofcountries’ foreign trade and allows the constructions of export supply and importdemand functions as well as the estimation of finite elasticities (Goldstein & Khan,

1985) Since Armington (1969) proposed the imperfect substitutes assumption, theimperfect substitutes models have dominated the literature regarding trade policy andtrade balance (Khan & Knight, 1986; Boyd et al., 2001) The imperfect substitutesmodels vary from version to version, and they can be employed for different analyticalpurposes For instance, dissimilar imperfect substitutes models are used for estimatingthe welfare effects of tariffs and quotas (e.g., Baldwin, 1976; Broadway & Treddenick,1978; Rousslang & Suomela, 1988) For another example, diverse imperfect substitutesmodels are also used for examining the influence of loan subsidies on competing firms(e.g., Pollard & Berg, 1994), the role of exchange rate reform in promoting exportation(e.g., Zhang, 2001), the impacts of free trade agreement on a specific market (e.g.,Reinert & Scorza, 1996), the spill-over effect of a slowdown in a big country on itspartners (e.g., Thorbecke & Kato, 2021), etc Regarding the studies about the impacts

of exchange rates on trade balances, the imperfect substitutes models, especially theversion of Rose and Yellen (1989), have been substantially utilized Thus, as the two-country model version of Rose and Yellen (1989) is the most popular model toexamine the impacts of exchange rates on trade balances, the author will focus onreviewing this model and provide some comparisons between it and the other well-known versions such as those mentioned in Goldstein and Khan (1985) and Khan andKnight (1986)

In the two-country model version of Rose and Yellen (1989), there are twocountries trading with each other: the home country and the foreign country Thequantity of imports demanded by the home country (i.e., Q M ,h) is determined by its realincome (Y h), the price of the imported merchandise in its own currency (i.e., P M ,h), andits price level (P h), which is mathematically written as follows:

Q M ,h =f1

(

P h

)

(1)

Similarly, the quantity of imports demanded by the foreign country (i.e., Q M ,f) is afunction of its real income (Y f), the price of the imported merchandise in its owncurrency (i.e., P M ,f), and its price level (P f).

and Q X ,f It should be noted that P X ,h and P M ,h are measured in the currency of thehome country, while P X ,f and P M ,f are measured in the currency of the foreign country

Let E n and E r be the nominal and real exchange rate between the currencies of thehome and foreign countries, and 1 unit of the foreign currency equalizes E n units of thehome currency Thus, we have the following equations:

Q X ,h =Q M , f

(10)

Q M ,h =Q X , f

(11)

The trade balance of the home country with the foreign country in real terms (i.e.,

B h), defined as the difference in the values of its exports and imports, is calculated as:

Comparing the two-country model version of Rose and Yellen (1989) with those

of Goldstein and Khan (1985) and Khan and Knight (1986), there are manysimilarities Those models are nearly the same except for several differences in thevariables For instance, in the version of Goldstein and Khan (1985), the roles of tariffsand subsidies are included, but the rationale is identical to the model version of Roseand Yellen (1989) The model version of Khan and Knight (1986) is also analogous tothat of Rose and Yellen (1989), but it contains the roles of the foreign exchangereserves and capital inflows Accordingly, in the literature regarding the impacts ofexchange rates on trade balances, it can be witnessed that although different two-country imperfect substitutes models have different variables, they have the samerationale As stated by Khan and Knight (1986), there is a strong consensus in thosemodels Moreover, Rose and Yellen (1989) indicated that many models result in thefollowing function between the trade balance and its determinants:

B h =f5(E r ,Y h ,Y f)

(14)

The function in Equation 14 is the reduced form of the Equations 1 to 12 Roseand Yellen (1989) focused on this reduced form function to establish the directconnection between the exchange rate and trade balance with the inclusion of theincomes of the home and foreign countries And this approach of Rose and Yellen(1989) is very convenient and effective, which has become the standard practice andthus been most widely used in later studies on the J-curve effect of exchange rates ontrade balances In addition, the model version and the approach of Rose and Yellen(1989) can also be employed as an alternative for checking the Marshall-Lernercondition, which brings further flexibility and convenience for studying the impacts ofexchange rates on trade balances by estimate only one equation However, a noticeablelimitation of the two-country models including the version of Rose and Yellen (1989)

is that the role of a vehicle currency is neglected In other words, the invoicingcurrencies are assumed to be either the currency of the home country or that of theforeign country, and thus there is no third-country’s currency More detailedexplanation about how the two-country model version of Rose and Yellen (1989)relates to the Marshall-Lerner condition and the J-curve effect, together with theflexibility and convenience of the method of Rose and Yellen (1989) to test for theMarshall-Lerner condition and the J-curve effect, will be discussed in the followingparts

2.1.2 The Marshall-Lerner condition

The Marshall-Lerner condition (Marshall, 1923; Lerner, 1944) is a well-knowntheoretical framework that helps inspect if the depreciation of a country’s currency canstimulate its trade balance According to the Marshall-Lerner condition, the tradebalance is successfully encouraged by the depreciation of its currency if the sum ofimport and export elasticities of demand in absolute value surpasses one The Marshall-Lerner condition is in fact the simplification of the Bickerdike-Robinson-Metzler

condition (Bickerdike, 1920; Robinson, 1947; Metzler, 1948) Rose and Yellen (1989)emphasized that the partial derivative of the trade balance B h with respect to theexchange rate E r in Equation 13 is exactly the derivative connected with theBickerdike-Robinson-Metzler condition, which is depicted as:

The notations in the Equation 15 are explained as follows:

- B h: the value of trade balance of the home country with respect to the foreigncountry, measured by the difference between its exports and imports

- E r: the exchange rate between the two countries’ currencies Particularly, 1 unit

of the foreign currency is equivalent to E r units of the home currency Thus, theincrease of E r means the depreciation of the home currency

- Q M ,f: the quantity of merchandise imported by the foreign country

- P X ,h: the price of the merchandise exported by the home country nominated inthe home currency

- Q M ,h: the quantity of merchandise imported by the home country

- P X ,f: the price of merchandise exported by the foreign country nominated in theforeign currency

- ϵ h: the price elasticity (in absolute value) of the export supply of the homecountry

- ϵ f: the price elasticity (in absolute value) of the export supply of the foreigncountry

- η h: the price elasticity (in absolute value) of the import demand of the homecountry

- η f: the price elasticity (in absolute value) of the import demand of the foreigncountry.

The Bickerdike-Robinson-Metzler condition states that when the trade balance isinitially zero (i.e., Q M ,f P X , h =Q M ,h .E r .P X , f), it is fostered by the depreciation of thehome currency if the derivative in the Equation 15 is positive In other words, theBickerdike-Robinson-Metzler condition is satisfied if the following inequality happens:

From the above-mentioned theoretical framework of the Marshall-Lernercondition, it is clearly that the role of a vehicle currency is absent because the goodsare assumed to be invoiced by the currencies of the exporting countries Namely, thehome country uses its currency to invoice all the exported goods to the foreign countryand vice versa Thus, the role of vehicle currency is overlooked

2.1.3 The J-curve effect

While the Marshall-Lerner condition describes the requirement for the positiveimpact of a country’s currency devaluation on its trade balance in the long run, it doesnot address the short-run effect In fact, the trade balance can fall immediately after thedevaluation For example, Magee (1973) observed that, despite the devaluation of USD

in 1971, the trade balance of the US continued to decrease from -2.7 billion USD in

1971 to -6.8 billion USD in 1972 Hence, the problem is why the devaluation of USD

in 1971 not only was ineffective in stimulating the trade balance but also worsened it.And Magee (1973) proposed the J-curve effect framework to explain that issue.Particularly, before the improvement of the trade balance in the long run as expected

by the Marshall-Lerner condition, the currency devaluation can discourage the tradebalance in the short run Specifically, Magee (1973) introduced the currency-contractand the pass-through analyses during which the quantity of exported and importedgoods cannot be promptly adjusted in order to scrutinize the short-run impact ofdevaluation on the trade balance In the longer terms, when the quantity can change,the trade balance will grow if the Marshall-Lerner condition is satisfied Therefore, thereactions of the trade balance to the devaluation resembles the letter “J” which isregarded as the “J-curve effect” and illustrated by Figure 2.1

Figure 2.1: The graphical presentation of the J-curve effect