the management of foreign exchange rate regime in a market-oriented economy

Shortcomings of SBV’s management on current exchange rate regime...43 CHAPTER 3: SELECTING AN APPROPRIATE FOREIGN EXCHANGE RATE REGIME IN THE PERIOD OF RECOVERY IN VIETNAM...45 3.1.. BOP

TABLE OF CONTENTS

LIST OF TABLES 3

LIST OF FIGURES 3

ABBREVIATION 4

INTRODUCTION 5

1 The essential of the research 5

2 Research Methodology 7

3 Research scope: 8

4 Research structure: 8

CHAPTER 1: THE MANAGEMENT OF FOREIGN EXCHANGE RATE REGIME IN A MARKET-ORIENTED ECONOMY 9

1.1 The history and development of exchange rate regime 9

1.2 Categories of exchange rate 10

1.2.1 Definition of exchange rate and exchange rate regime 10

1.2.2 Categories of exchange rates 11

1.2.2.1 Official and unofficial exchange rate 11

1.2.2.2 Nominal and real exchange rate 11

1.2.2.3 Real Exchange Rate and Real Effective exchange rate 12

1.2.3 Categories and trends of foreign exchange rate regimes in the world 12

1.2.3.1 Categories of foreign exchange rate regimes 12

1.2.3.2 Trends of foreign exchange rate regimes in the world 14

1.3 Effects of foreign exchange rate regime on the macroeconomics variables 16

1.3.1 Balance of Payment 17

1.3.1.1 Current Account 18

1.3.1.2 Capital Account 19

1.3.1.3 Effects of exchange rate and exchange rate regime on BOP 20

1.3.2 Inflation 22

1.3.3 The Effectiveness of Fiscal policy 23

1.4 The management of foreign exchange rate and exchange rate regime 25

1.4.1 Rate of Exchange Under the Gold Standard: 25

1.4.2 Rate of Exchange Under Managed Paper Standard 26

1.4.3 Rate of Exchange Under Exchange Control 27

1.5 Theoretical Determinants of Exchange Rate Regimes 27

1.5.1 OCA Theory 27

1.5.2 Impossible Trinity 28

1.5.3 Currency crisis 29

1.5.4 Political economy 30

CHAPTER 2: THE EVALUATION ON EXCHANGE RATE REGIME OF VIETNAM OVER TIME 32

2.1 The management of foreign exchange rate regimes and the fluctuation of foreign exchange rate in Vietnam through periods 32

2.2 Evaluation of the foreign exchange regime management on Vietnam’s economy 34

2.2.1 Effects of foreign exchange rate regime on BOP 34

2.2.2 Effects of foreign exchange rate regimes on inflation 37

2.3 Factor effecting the selection of foreign exchange rate regime 40

2.3.1 Interest rate 40

2.3.2 The expectation level of changing foreign exchange rate regime 41

2.3.3 Inflation 41

2.3.4 The decrease in the intervention level of Central Bank 42

2.4 Shortcomings of SBV’s management on current exchange rate regime 43

CHAPTER 3: SELECTING AN APPROPRIATE FOREIGN EXCHANGE RATE REGIME IN THE PERIOD OF RECOVERY IN VIETNAM 45

3.1 The economy of Vietnam in the recovery period 45

3.1.1 The opportunities 45

3.1.2 The difficulties and challenges 46

3.1.3 Implication to the foreign exchange rate regime 47

3.2 Recommendations on selecting an appropriate foreign exchange rate regime in the recovery period 48

3.2.1 Recommendations on foreign exchange rate regime selection and management 49

3.2.1.1 Narrow the gap between official and unofficial exchange rate market 49

3.2.1.2 Implement the crawling floating exchange rate regime 50

3.2.2 Suggestions about supporting policies for regulating exchange rate regime 52

3.2.3 Others recommendations 55

3.2.3.1 Building and following up the early warning model of foreign exchange rate and market crisis 55

3.2.3.2 Controlling foreign exchange rate regime through other factors 59

CONCLUSION 63

REFERENCES 65

LIST OF TABLES

Table 1.Categories of foreign exchange rate regimes……… ……… 12

Table 2.Exchange rate regimes in Vietnam , 1989-2009……….… … 31

LIST OF FIGURES Figure 1 Exchange rate around the official rate, 03/1989 to 12/2009……….….32

Figure 2.Nominal exchange rate and trade balance of Vietnam……….….… 35

Figure 3.Vietnam's inflation over the period 1991-1999……….……….….38

Figure 4.Vietnam’s Balance of Payments……….………….….41

BOP : Balance of Payment

CPFF : Commercial Paper Funding Facility

FDI : Foreign Direct Investment

FII : Foreign Indirect Investment

GSO : General Statistics Office (Vietnam)

IMF : International Monetary Fund

GDP : Gross Domestic Products

LIBOR : London Interbank Offered Rate

NEER : Nominal Effective Exchange Rate)

OER : Official Exchange Rate

PPIP : Public Private Investment Program

PPP : Purchasing Power Parity

REER : Real Effective Exchange Rate

SBV : State Bank of Vietnam

TALF : Asset-Backed Securities Loan Facility

TARP : Troubled Asset Relief Program

WB : World Bank

WTO : World Trade Organization

First of all, I would like to give a warm thanking to all the lecturers of AdvanceProgram of National Economics University in accordance with all the staff of NationalResearch Department of the National Financial Supervisory Commission – NFSC forgiving me such a good basic knowledge of economics in general and exchange rateregime in particular during the time of my internship

Especially, I would also want to give a sincere gratitude to my supervisor Dr LePhong Chau who directly guides me in the process of making my report Moreover, Dr

Le Xuan Nghia – the Vice chairman of National Financial Supervisory Commission isalso the person that gives me lots of constructive comments to improve my report

In two months working at Research Department of the National FinancialSupervisory Commission – NFSC, I have tried my best to get information andproposed some recommendations to selecting an appropriate foreign exchange rateregime in the recovery period in Vietnam However, there are certain limitations andmistakes due to the lack of time and information Therefore, I am willing to receive anycomments and suggestions This two months of training at NFSC is such a valuableexperience that I will never forget It does help me a lot in preparing for my futurecareer

Dang Vuong Anh

1 The essential of the research

Vietnam’s economy is now in the process of transformation and development withdeep integration with the world economy especially after its participation to WTO in

2006 In order to develop a strategy for the sustainable development, the Party andGovernment have determined to create a platform for macroeconomic stability, a stableposition before the integration era However, the process of expanding economy hascreated more pressure on the financial system This requires timely reformations inmechanisms and operating policies to achieve the objectives of sustainabledevelopment, reduces trade deficits, inflation, and efficiently absorbs foreigninvestment flow

Exchange rate regime has long been considered one of the most important tools formonetary policy For a developing country like Vietnam, it is the key variable tostabilize the economic situation by its influences not only on the framework of tradeand investment, but also on both monetary system, the entire macro economy andfinancial system Moreover, the exchange rate also contributed to the cause of globaleconomic and financial crises Fundamental objectives of exchange rate regime are tolimit the negative externalities and to support the commercial activities to minimizeand prevent risks to the economy

In the context of integration and multi-dimensional impacts, the monetary,exchange rate policy in Vietnam is expressing increasingly shortage of conformity inthe future when the economy is highly opened In addition, increasingly strongfluctuations of the turnover of capital flows along with the development of diversifiedfinancial institutions and financial instruments caused the exchange rate managementpolicies become more complex and difficult to control A reasonable and flexiblemechanism for exchange rate adjustment is very important factor in order to support

the control of inflation, dollarization, as well as to maintain competitiveness andpromote export’s growth.

After the great impact of the 2008 financial crisis on the Vietnam’s economy, thegovernment has clearly defined the target in 2009 is to be against the economicdownturn and to ensure the social welfare Strategic objectives with specific criteria ofeconomic development vision 2011 – 2015 were proposed by the Ministry of Planningand Investment such as 5-year GDP average (2011-2015) increased by 7.5-8% peryear, budget deficit in 2015 is 4.5%, current account deficit in 2011-2015 at about USD30.7 billion, balance of capital surplus is 69 billion dollars, the overall balance ofpayments surplus is about USD 25.6 billion Among various instruments to achievethese goals, the VND/USD exchange rate management is important Thecompetitiveness capacity of exports, the trade balance and balance of payments status,the national reserves, changes in production structure and confidence in the currencyand the government, which are all factors measuring the health and motivationdominated developing country's economy, depend deeply on the official exchange rate.The flexibility of exchange rate policy is also reflected in the flexibility in theselection of the target rate of the policy It is really difficult to satisfy multipleobjectives with an exchange rate policy in the same time, but keep applying anexchange rate policy just to serve a certain goal though a long period of time andignore the changes in the environment is also not an appropriate strategy For example,

in order to reach the goal of reducing debt obligations, maintaining a low-rate policy,which valued its currency, may be essential in the time of maturity, but if this policy ismaintained for too long, it could harm the long-term goal rather than maintain the tradebalance’s stability or boosting exports Therefore, every single period of the economyneeds clearly defined objectives consistent to the specific context in order to promotethe effectiveness of the exchange rate regime

Observing the current trend of the economy, I have decided to do my research onthe topic “Selecting an appropriate foreign exchange rate regime in the recovery period

in Vietnam” with the aim of evaluating the effectiveness of the exchange rate regimeapplied at present time, particularly in the recovery period after the crisis, focusing onopportunities and challenges along with of the medium and long term economicdevelopment’s orientations of the Communist Party and Government, proposing somerecommendations for improving the exchange rate regime in the near future.

Quantitative Analysis: Given limited time and knowledge, the research just limitedwithin evaluating data, converting raw data into informative charts and computingforecasting indicators rather than constructing of new model

Simulation method: is a method of creating an assumed economic environment toinvestigate the extent of the economy reactions to the vagaries of macroeconomicvariables or shocks from crises, economic downturns

Synthesis comparison method: information and data of different countries in thesame period of time were collected and compared to Vietnam’s

Because of the fact that exchange rate is a macro-economic variable, the data used

in this research are secondary information (available from different sources), with theiraccuracy and reliability were verified

3 Research scope:

The scope of my research limited to the role, impact and effectiveness of theexchange rate’s regime and mechanism currently applied in Vietnam tomacroeconomic variables during the period of economic recovery On that basis, otherpreferential policies were studied and proposed

4 Research structure:

The research consists of three parts

Chapter 1: The management of foreign exchange rate regime in a market-orientedeconomy

The aim of this chapter is introducing the scientific rationale of selecting anappropriate foreign exchange rate regime in the recovery period, going deep on thehistory of the formation and development of the exchange rate regimes, categorizingand analyzing various types of mechanisms being applied now, the impact of thosemechanisms to macroeconomic variables and relating factors

Chapter 2: The evaluation on the current foreign exchange regime of Vietnam.This chapter evaluates the Vietnam’s exchange rate regime through each periodwith the focus from 2009 until now, proposes comments on the implications, factors ofthe mechanisms and the exchange rate regimes in the last period

Chapter 3: Selecting an appropriate foreign exchange rate regime in the period ofrecovery in Vietnam

Propose some solutions to improve the exchange rate regime in Vietnam during theperiod of economic recovery

CHAPTER 1: THE MANAGEMENT OF FOREIGN EXCHANGE RATE

REGIME IN A MARKET-ORIENTED ECONOMY The history and development of exchange rate regime

At the dawn of human kind, barter is the first and most common payment methodamong countries About 4000 years ago in the Middle East, the turning point occurredwhen coins were used and the first professional money dealer appeared and exchanged

a certain amount of coins of this country for a corresponding amount of coins ofanother country, marked the birth of the exchange rate and foreign exchange market.After the collapse Roman Empire and at the early stage of Medieval Ages witnessedthe decreasing in the currency exchange activity among countries due to unstablepolitical situation, religious and international trade restrictions Not until the 19thcentury, the foreign exchange trading activities officially boomed again

World War I and the Great Depression 1929 - 1933 made the foreign exchangemarket brake up into small pieces; the exchange rate regime based on the gold standardwas also collapsed in 1931 After the World War II (1939 - 1945), with the supportfrom the huge gold reserves - 70% of the world's gold reserves at that time (obtainedfrom selling weapon to parties participating in the war and reparation fee paid bydefeated countries which was forced to pay in gold by the US ) – the U.S dollar(USD) has become one of the main currency of international economy Besides, therole of government was reflected dramatically in the foreign exchange market’sstability, tight controlling value for money, and exchange rate regime adjustment.Bretton Woods agreement (1944) had brought a new order, determined the US Dollar

as the reserves and the mean of international payment Other currencies were fixed to

US Dollar US Dollar’s value is anchored to gold at the exchange of $ 35 per ounce ofgold Most central banks chose US Dollar as the world reserve currency because of theunlimited gold exchange of the U.S central bank However, that fixed exchange ratesystem was under great pressure during the period 1967 - 1971 due to a serious

imbalance in the trade balance between countries which had too much of U.S dollarreserves In addition, the official price of gold based on Bretton Woods Agreement wascheaper than that of gold on the black market, followed by the speculation and massiveexchange from dollars into gold August 15th 1971, U.S officially stopped goldexchange activity and Bretton Woods exchange rate system collapsed The floatingexchange rate regime began to diversify and extend to the present time A noteworthypoint in the development history of the exchange rate and foreign exchange market wasthe introduction of the European common currency, marked a turning point when theexchange rate between the members’ currencies could be anchored at the same equalrate, shared a common mechanism.

Categories of exchange rate

1.1.1 Definition of exchange rate and exchange rate regime

The exchange rate is a comparison of price between the two currencies of differentcountries or could be considered as the price of one currency expressed in a differentcurrency

Example: (04/11/2010 - Vietcombank) 1USD = 19,495 VND

An exchange system quotation is given by stating the number of units of "quotecurrency" (price currency, payment currency) that can be exchanged for one unit of

"base currency" (unit currency, transaction currency)

For example, in a quotation that says the EUR/USD exchange rate is 1.2290(1.2290 USD per EUR, also known as EUR/USD; the quote currency is USD and thebase currency is EUR

When currency X appreciated against the currencies Y (or Y devaluated against X),the exchange rate between X and Y on the foreign exchange markets base on Y will bereduce, but that based by X will increase

The exchange rate regime is the way a country manages its currency in respect toforeign currencies and the foreign exchange market It is closely related to monetarypolicy and the two are generally dependent on many of the same factors.

1.1.2 Categories of exchange rates

4.1.1 Official and unofficial exchange rate

With the floating exchange rate, exchange rate is determined by the market Withthe fixed exchange rate, exchange rate is determined by the Government Somecountries, in which both market’s and government’s regulations participate instipulating the exchange rate, have an official exchange rate (listed by the Government)and an unofficial rate, also known as the parallel exchange rate or black marketexchange rate The official exchange rate also has several types: the interbankexchange rate, exchange rate of commercial banks, accounting exchange rates

4.1.2 Nominal and real exchange rate

Nominal exchange rate is the exchange rate which does not consider relative prices

or inflation between the two countries In contrast, Real exchange rate is the actual ratebased on the relationship of prices or inflation between the two countries, thus reflectsthe purchasing power and competitiveness of a country One of the most importantelements of the real exchange rate is the international competitive position of acountry Real exchange rate volatility along with the depreciation of currency to reflectproduction costs for domestic goods of that country increase If the production costs ofother countries do not change, this country will take advantage of internationalcompetitiveness

The relationship between these two types of exchange rates

Real exchange rate = Nominal exchange rate *

= Nominal exchange rate *

4.1.3 Real Exchange Rate and Real Effective exchange rate

Real exchange rate is the actual rate based on the relationship of prices or inflationbetween the two countries, thus reflects the purchasing power and competitiveness of acountry

Real effective exchange rate is the exchange rate between currency A with a variety

of other currencies at the same time This rate is calculated based on the valueweighted average of real exchange rates between currency A currency with each othercurrency

1.1.3 Categories and trends of foreign exchange rate regimes in the world

4.1.4 Categories of foreign exchange rate regimes

Since the end of the fixed exchange rate regime Bretton Woods in 1971, mostcountries around the world had applied floating exchange rates However, the fixedexchange rate continues to exist and be transformed into many different intermediateformats Here are the classifications provided by the International Monetary Fund IMF(2008)

Table 1 Categories of foreign exchange rate regimes

Exchange rate

No of countries 1997

No of countries 2008

Representative

1 Floating - The exchange rate is

determined by the market’s demand and

44(24.31%)

40(21.28%)

UK, US, EU,Japan

- The State bank hardly intervenes and there is notargeted exchange rate

2.Managed

Floating

- The exchange rate is determined by the market’s demand and supply

- The State bank may intervene and there is targeted exchange rate

23(12.71%)

44(23.4%)

Thailand,Singapore,Malaysia, India

2(1.06%)

Costa Rica,Azerbaijan

8(4.26%)

3(1.6%)

68(36.17%)

Russia, Jordan

intervenes regularly to maintain the exchange rate

12(6.63%)

13(6.91%)

Hongkong,Brunei, Bungary

10(5.32%)

Bolivia, Panama

Source: IMF (statistics) (2008)

4.1.5 Trends of foreign exchange rate regimes in the world

The first trend - Unifying the exchange rate regime: According to the IMF, thetransition from the regime of two or more exchange rates to unified exchange rateregime is a global trend and widespread From 1973, shortly after the collapse ofBretton Woods, approximately 50% of the countries applied bilateral exchange rates,but by 2001 this figure is only around 7% A study by Rogoff (2004) showed that theeconomy which has two exchange rate regimes often has 2 – 3 times poorer growth andhigher inflation rates than countries with unified exchange rate regime

The second trend - Moving towards the two extremes: In the past two decades, mostcountries tended to whether completely fixed or floating exchange rate regime, inwhich the floating regime increasingly dominated the fixed one

Fixed exchange rate regime restricts the fluctuation of exchange rates, so there is noneed to reserve for exchange rate risk When applying this mechanism, governmentsand central banks easily achieve the targeted goals However, this mechanism makesthe FOREX market underdeveloped and creates potential risks of demand and supplyimbalance Foreign currency shortage becomes frequent, limiting the growth ofinternational trade In addition, intervention costs and foreign exchange reservesmanagement cost is huge.

Floating exchange rate regime provides the clear reflection about the current supplyand demand situation as well as the volatility of the foreign exchange market Thismechanism ensures regulations of the foreign exchange market, prevents the domesticmarket from the outside market's volatility, and protects economic stability and growth.However, applying this regime, the government will face more difficulties andchallenges in selecting the appropriate economic policy because of frequently andunpredictable changes And because of no interference of the government's role, centralbank has very limited power

Kurt Schuler's research has shown that the historical evidence proved that these twobasic mechanisms are less influenced by the financial and monetary crisis then theintermediary regimes For example, the crisis in 1997 caused heavy damage to thecountries of Southeast Asia, Russia and Brazil, which officially or unofficially havelinked their currencies, but do not drop floating or anchored entirely with the U.S.dollar Meanwhile, countries like Panama (no central bank, with no local currency andforeign exchange transaction), Jordan (Central Bank formally adopted a fixed exchangerate 0.709 Dina / US dollar and no foreign exchange transaction), Cuba, China areless affected or easily overcome the crisis

The regime of fixed exchange rates appears to be suitable with the developing,under-developed economies or dependent on another economy The advantages of thisexchange rate regime are economic stability, low inflation, crises prevention and themaintenance of the prestige and role of government It is relatively suitable for

countries with large foreign exchange reserves, with clear and consistent competitiveadvantage and strategic orientation such as China.

However, countries with emerging economies and are in the transition period such

as Thailand, Philippines, Singapore when apply a fixed exchange rate regime willoften face with the financial crises, resulting in speculation and finally a floatingexchange rate has to be applied As the highly-opened and sensitive economy with highgrowth of international trade, fixed exchange rate regime does not show itseffectiveness and even stifles the economic growth However, these countries stillconsider floating exchange rate mechanism as a potential threat that could reduce thecredibility of the Government's role, affect export when domestic currencyappreciate… As a result, these central banks typically apply strong interventions such

as stabilizing foreign exchange reserves funds, open market operations, controlling ofcapital to keep the exchange rate objectives

For countries with highly developed economies like Japan, EU the financial andmonetary systems are at high level, a floating exchange rate regime has proved to playquite a large role in promoting their economic growth, curbing inflation andminimizing the impact of economic shocks and recession

Effects of foreign exchange rate regime on the macroeconomics variables

Today, in the context of liberalization and globalization which was characterized byrapid capital flows between the economic sectors, the exchange rate has become a veryeffective tool in regulating the external economic relations among countries Alongwith the transformation of the world economy, countries tend to shift gradually to theapplication of a floating exchange rate regime But there are still some countries whichgovernments peg their currencies to a currency of another or a basket of currencies at afixed exchange rate

Exchange rate regime is one of the most important macroeconomic policies of thedeveloping countries or countries which have their economies in the transition period

Impacts of these policies are extremely robust to many other macroeconomic variablessuch as inflation, balance of payments, money supply, as well as the effectiveness offiscal and monetary policies in general.

1.1.4 Balance of Payment

A balance of payments (BOP) sheet is an accounting record of all monetarytransactions between a country and the rest of the world These transactions includepayments for the country's exports and imports of goods, services, and financial capital,

as well as financial transfers The BOP summarizes international transactions for aspecific period, usually a year, and is prepared in a single currency, typically thedomestic currency for the country concerned Sources of funds for a nation, such asexports or the receipts of loans and investments, are recorded as positive or surplusitems Uses of funds, such as for imports or to invest in foreign countries, are recorded

as a negative or deficit item

When all components of the BOP sheet are included it must balance – that is, itmust sum to zero – there can be no overall surplus or deficit For example, if a country

is importing more than it exports, its trade balance will be in deficit, but the shortfallwill have to be counter balanced in other ways – such as by funds earned from itsforeign investments, by running down reserves or by receiving loans from othercountries

While the overall BOP sheet will always balance when all types of payments areincluded, imbalances are possible on individual elements of the BOP, such as thecurrent account This can result in surplus countries accumulating hoards of wealth,while deficit nations become increasingly indebted Historically there have beendifferent approaches to the question of how to correct imbalances and debate onwhether they are something governments should be concerned about

4.1.1 Current Account

In economics, the current account is one of the two primary components of thebalance of payments, the other being the capital account The current account is thesum of the balance of trade (exports minus imports of goods and services), net factorincome (such as interest and dividends) and net transfer payments (such as foreign aid).You may refer to the list of countries by current account balance

The current account balance is one of two major measures of the nature of acountry's foreign trade (the other being the net capital outflow) A current accountsurplus increases a country's net foreign assets by the corresponding amount, and acurrent account deficit does the reverse Both government and private payments areincluded in the calculation It is called the current account because goods and servicesare generally consumed in the current period

The balance of trade is the difference between a nation's exports of goods andservices and its imports of goods and services, if all financial transfers, investments andother components are ignored A nation is said to have a trade deficit if it is importingmore than it exports

Positive net sales abroad generally contribute to a current account surplus; negativenet sales abroad generally contribute to a current account deficit Because exportsgenerate positive net sales, and because the trade balance is typically the largestcomponent of the current account, a current account surplus is usually associated withpositive net exports This however is not always the case with open economies such asthat of Australia featuring an income deficit larger than its trade deficit

The net factor income or income account, a sub-account of the current account, isusually presented under the headings income payments as outflows, and incomereceipts as inflows Income refers not only to the money received from investmentsmade abroad (note: investments are recorded in the capital account but income from

investments is recorded in the current account) but also to the money sent byindividuals working abroad, known as remittances, to their families back home If theincome account is negative, the country is paying more than it is taking in interest,dividends, etc.

4.1.2 Capital Account

At high level:

Breaking this down:

Foreign direct investment (FDI), refers to long term capital investment such as thepurchase or construction of machinery, buildings or even whole manufacturing plants

If foreigners are investing in a country, that is an inbound flow and counts as a surplusitem on the capital account If a nations citizens are investing in foreign countries thatare an outbound flow that will count as a deficit After the initial investment, anyyearly profits not re-invested will flow in the opposite direction, but will be recorded inthe current account rather than as capital

Portfolio investment refers to the purchase of shares and bonds It’s sometimesgrouped together with "other" as short term investment As with FDI, the incomederived from these assets is recorded in the current account - the capital account entrywill just be for any international buying and selling of the portfolio assets

Other investment includes capital flows into bank accounts or provided as loans.Large short term flows between accounts in different nations are commonly seen whenthe market is able to take advantage of fluctuations in interest rates and / or theexchange rate between currencies Sometimes this category can include the reserveaccount

Reserve account: The reserve account is operated by a nation's central bank, andcan be a source of large capital flows to counteract those originating from the market.Inbound capital flows, especially when combined with a current account surplus, cancause a rise in value (appreciation) of a nation’s currency - while outbound flows cancause a fall in value (depreciation) If a government (or if it’s authorized to operateindependently in this area, the bank itself) doesn't consider the market driven change toits currency value to be in the nations best interests', the bank can intervene

4.1.3 Effects of exchange rate and exchange rate regime on BOP

Balance of payments consists of two main parts: current accounts and capitalaccounts For capital account, the major factors which affect the balance of capitalaccount are investment and interest rates; when the domestic interest rate changes, itwill stimulate the flow of capital in or out of that country While the exchange ratefactor hardly affects the balance of capital and just only take the form of exchangebetween one currency to other currency to invest in a country with attractive interestrates

For current account, income and one-way current transfers are not affected byexchange rate factors; the change in exchange rate does not alter the balance of incomeand one-way transfer Because the balance of income depends on the amount ofprecious investment, when the exchange rate changes, it does not affect theprofitability of this investment Besides the balance of one-way current transfer isincome distribution between economic entities and abroad.

Exchange rate directly affects the trade balance and service balance; the fluctuation

of exchange rate causes these two factors change Normally, exchange rate changeswill impact strongly on the trade balance through export-import activities of a country

in open economy

The exchange rate regime in which the domestic currency is undervalued may havegood impact on export and restrict import, balance the current account from deficit tosurplus Conversely, when the domestic currency appreciates, making domestic goodsmore expensive to export, resulting in loss of competitiveness, while the demand forimports increases makes the state’s deficit will become more apparent Therefore,

selecting appropriate exchange rate will make the trade balance or current accountautomatically balanced.

When considering the impact of exchange rate regime on trade balance, in fact justfocus on the impact on trade balance through export-import activities, positive impact

on international trade activities International

1.1.5 Inflation

One important goal of monetary policy is to control the inflation in the economy.The exchange rate is part of monetary policy that central banks want to use to achievethis goal, so exchange rate is the derived element in the process of inflation in acountry

With other factors remain constant, when the exchange rate rises and the currencyloose its value against foreign currencies, this will create pressure on inflation Growthrate makes the price of imported goods in domestic currency increased, includinggoods for personal consumption and intermediate goods for production, makes theprice of the whole economy increases eventually Conversely, when exchange ratefalls, price of imported goods goes down, contributing to the domestic price level goesdown and reduces inflation pressure This relationship is expressed through thefollowing formula:

 With: α – Proportion of domestic manufactured goods

(1- α ) – Proportion of imported goods

P - Price of domestic manufactured goods (in domestic currency)

P*- Price of imported goods (in foreign currency)

E – Exchange rate (No units of Domestic currency/1 unit of foreign currency)

P1 – General price of goods of the whole economy

Stabilizing the exchange rate can help boost the confidence in the currency, forcethe government to control budget deficits and credit growth, thereby enhance the level

of trust in the government's policy and the inflation will gradually be reduced andbecome stable

1.1.6 The Effectiveness of Fiscal policy

Exchange rate regime has close relationship with monetary and fiscal policy Theanalysis is based on the Mundell-Flemming model, developed in 1960 with the basicassumptions: (i) the economy is considered to be opened, so that any small change in

interest rate caused by the policy does not affect the world interest rate, (ii) the flow ofcapital is circulated freely and completely flexible, (iii) the economy is at its fullcapacity stage, so the demand will increase lead to increasing in supply without raisingprices, (iv) no expected changes in exchange rate, (v) the economy satisfies theMarshall-Lerner’s condition Results of the analysis indicate that there is a tradeoffbetween the effectiveness of monetary and fiscal policy under different exchange rateregimes in an economy In an economy with fixed exchange rate regime, the centralbanks can not perform effectively independent monetary policy.

In an open economy, money markets and the principle of "Trinity ofImpossibilities" – Mundell - Flemming model always exist together This theory statesthat a country can not simultaneously achieves three objectives of macro policy:

- Exchange rates stability

- Liberalization of capital flows

- Monetary policy independence

A country can not simultaneously achieve all 3 goals in macroeconomic policy; itonly can select a maximum of 2 for 3 as targets In case of a tight monetary policy isimplemented which makes higher interest rates in the country, free capital inflowincreases, boosts the supply of foreign currency, make the domestic currencyappreciates When the cash inflow is too much, if government wants to keep exchangerates stable, the central bank is required to increase supply of domestic currency andbuy foreign currencies, making interest rate fall back

In conclusion, the exchange rate regime is an important part in the economy whichhas a direct impact to the macro-economic variables such as inflation, trade balance,import, export, unemployment rate as well as the monetary policy Depending on thecharacteristics of each country in each geographic area, specific economic, politicalinstitutions, the government will choose an appropriate exchange rate regime (floating

or fixed) But the ultimate goal is to ensure the stability of the macro economy’s

variables, to achieve the most important goals (economic growth sustainability,inflation management and economic shocks avoidance.

The management of foreign exchange rate and exchange rate regime

The term ‘rate of exchange’ expresses the price of one currency in terms of another.Thus, it indicates the exchange ratio between the currencies of two countries Supposefor example, one Indian Rupee is equal to 13 USA Cents This implies that in theexchange market, one Indian Rupee will fetch 13 Cents Just as the price of acommodity is determined by its demand and supply conditions, the price of a foreigncurrency (i.e., the rate of an exchange) is also determined on the basis of demand andsupply of the currency In fact, the rate of exchange of a currency will keep onchanging in the foreign exchange market, due to changes in demand and supplyconditions of the currency In this section we shall study about exchange rate variesunder different monetary standards

1.1.7 Rate of Exchange Under the Gold Standard:

Under the Gold Standard the monetary authorities are committed to a policy ofconverting gold into currency and currency into gold This means, the buying andselling of gold at a specified fixed price in unlimited quantities will be allowed

If two countries are on the Gold Standard, the rate of exchange between the twocurrencies concerned will be fixed on the basis of par value This means that themonetary authorities would first establish gold value of the country‘s monetary unit.This is called par value of the currency, Buying and selling of gold will be allowedbetween the two countries This will establish pars of exchange The rate at which thecurrency units of one country will exchange for the currency units of the other, woulddepend upon the quantity and purity of gold represented by each The ratio between thequantity of gold represented by the gold represented by the two units is termed as themint par of exchange of mint parity Mint par of exchange or mint parity is defined as

the exact equivalent of the currency unit of one country expressed in terms of thecurrency unit of another based upon the weight and fineness of the metal contained intwo coins according to the respective mint regulations The mint par of exchange,hence expresses ―the number of units of one currency which should legally containthe same amount of pure metal as does (legally) a given number of units of anothercurrency.

1.1.8 Rate of Exchange Under Managed Paper Standard

When the two countries are on inconvertible paper standard, there is no link withany metal, gold or silver As such the rate of exchange is determined on the basis ofdemand and supply of foreign currencies The exact rate of exchange is mainlyinfluenced by their purchasing power parity The Purchasing Power Parity Theory isassociated with Swedish economist Gustav Cassel The theory states that where theexchange rate between two countries is free to move without limit, if tends toapproximate to the point, where each currency will buy as many goods in the othercountry‘s market as in its own home market

This can be briefly illustrated by means of an example Suppose, a bale of cotton issold for Rs.500 in India (price in the home-market) and the same bale of cotton is soldfor 10 dollars in USA‘s market, then the rate of exchange between Rupee and Dollarwill be 50 Rupees for a Dollar, ignoring transport costs This Purchasing Power Paritytheory is defective in several respects:

(a) Price in the home-market depends upon price level internally, which will beaffected by the inflationary conditions in the economy

(b) Different types of goods enter into the international trade to find the rate ofexchange will be impossible

(c) The theory wrongly assumed that changes in price level induce changes in theexchange rate In fact, it is the exchange rate that influence the price level; and

(d) The theory does not consider the demand for foreign exchange, reciprocal demandfor commodities, capital movement, etc., which will affect the exchange rate.

1.1.9 Rate of Exchange Under Exchange Control

The term ‘exchange control’ refers to the regulation of transactions involvingforeign exchange to relieve pressure on the exchange value of a particular currency.The exchange control may take any form In the most extreme form, it involvesmaintaining, for an indefinite period, an artificial value of the currency This will beentrusted with the Central Banking authority, which will administer the exchangecontrol legislations In such a situation, the rate of exchange is not determined on thebasis of demand and supply forces, but is fixed arbitrarily by the central authorities Tomaintain that rate, all the citizens of the country are compelled to surrender foreignexchange to the Central Authorities at specified rates, and then the proceeds will berationed among those who are in need of foreign exchange on the basis of priorities

Theoretical Determinants of Exchange Rate Regimes

The determinants of exchange rate regimes in this research would center aroundfour main approaches The traditional approach is embodied in the theory of OptimumCurrency Areas (OCA) The modern discussions on the choice of exchange rate regimeinclude the impossible trinity view, the political economy view and the currency crisesapproach These traditional and modern models imply a set of potential determinants ofexchange rate regimes

The early literature, based on the theory of Optimum Currency Area (OCA) byMundell (1961), stressed the geographical and trade characteristics This approachweighs the trade and welfare gains from a stable exchange rate against the benefits ofexchange rate flexibility as a shock absorber in the presence of nominal rigidities.Since stable exchange rates increase trade gains, pegs are more suitable for countries

characterized by high trade openness A rigid regime is also preferred in smalleconomies, as small countries tend to trade more internationally Finally, thegeographical concentration of a country’s trade favors pegging the currency to its maintrading partner.

1.1.11 Impossible Trinity

A key ingredient of the Mundell-Fleming framework is the assumption of perfectcapital mobility This implies international arbitrage across countries in the form ofuncovered interest parity From this model it follows that it is impossible tosimultaneously achieve the three goals: exchange rate stabilization, capital marketintegration and independent monetary policy This is usually referred to as ”impossibletrinity” The currency crises in Mexico, Asia, Brazil and Russia, and increasing capitalmobility brought the ”impossible trinity” hypothesis to the forefront and resulted in the

”bipolar view” of exchange rate regimes According to this approach, high capitalmobility made intermediate regimes less viable in financially open economies Sincemonetary policy in financially open economies cannot be aimed simultaneously atmaintaining a stable exchange rate and at smoothing cyclical output fluctuations, thesecountries should move to the corner solutions, i.e pure float or hard peg

In addition, the rapid process of financial deepening and innovation reduced theeffectiveness of capital controls Consequently, the traditional trinity dilemma has beenreduced to the monetary policy-exchange rate stability trade-off Moreover, countrieswith relatively undeveloped financial sectors lack market instruments to conductdomestic open market operations Thus, low financial development should increase theprobability of adopting pegs

1.1.12 Currency crisis

The early literature of balance-of-payments crises (Krugman 1979) stressed thatcrises were caused by weak ”economic fundamentals”, such as excessive expansionary

fiscal and monetary policies It shows that, under a fixed exchange rate, domestic creditexpansion in excess of money demand growth leads to a gradual but persistent loss ofinternational reserves and, ultimately, to a speculative attack on the currency Theprocess ends with an attack because economic agents understand that the fixedexchange rate regime will collapse, as it is inconsistent with current economicconditions The empirical implication of this model is that expansionary monetarypolicy combined with a fixed exchange rate leads to external imbalances As aconsequence, a country experiencing a high rate of inflation might be reluctant to fix itsexchange rate

According to Krugman’s currency crisis model, the collapse of pegged exchangerate is accompanied by a steady erosion of international reserves In fact, the attack on

a currency immediately depletes reserves and forces the authorities to abandon theparity Thus, the level of international reserves has often been used as a leadingcurrency crisis indicator A country willing to peg has to hold a high amount ofinternational reserves to improve the credibility of its exchange rate arrangement While this traditional approach stresses the role played by declining internationalreserves in triggering the collapse of a fixed exchange rate regime, some recent modelssuggest that the decision to abandon the parity or to choose a flexible regime may stemfrom the authorities concern about the evolution of other key economic variables Forinstance, Ozkanand Sutherland (1995) presented a model in which the authorities’objective function depends positively on certain benefits derived from keeping a fixednominal exchange rate and negatively on the deviations of output from a certain level.Under a fixed exchange rate, increases in foreign interest rates lead to higher domesticinterest rates and lower levels of output, making it more costly for the authorities tomaintain the parity More generally, this approach suggests that a variety of factors,which may affect the authorities’ objective function, could be used as indicators of acurrency crisis For instance, an increase in the domestic interest rate, needed tomaintain a fixed exchange rate, may result in higher financing costs for the

government To the extent that the authorities are concerned about the fiscalconsequences of their exchange rate policy, the decision to adopt a peg may depend onthe public deficit.

However, the link between the exchange rate regime and the public deficit is notclear A flexible exchange rate may reduce the risk of speculative attacks and ofinterest rates increases, necessary to defend the peg Nevertheless, as a flexible regimeincreases the uncertainty, the risk premium raises the interest rates and thus the level ofthe public deficit

1.1.13 Political economy

Numerous authors emphasized the credibility gains of adopting a peg arrangement

It has been argued that governments with a low institutional credibility, willing toconvince the public of their commitment to price stability, may adopt a peg as a

”policy crutch” to tame inflationary expectations Accordingly, weak governments thatare more vulnerable to expansionary pressures may choose to use a peg as aninstrument to eliminate (or considerably reduce) these pressures In addition, someauthors argued that a fixed exchange rate disciplines the government because any fiscalexcess might result in a currency crisis

Collins (1996) and Edwards (1996) built their empirical models around aframework in which the political cost associated with a devaluation under fixedexchange rates plays a major role While Collins did not directly use political economyvariables in her analysis, Edwards introduces variables that measure the degree ofpolitical stability and the strength of the government He found out that weakergovernments and unstable political environments reduce the likelihood that a peg will

be adopted His results reflected the”sustainability hypothesis”, contradicting” policycrutch” approach

CHAPTER 2: THE EVALUATION ON EXCHANGE RATE REGIME

OF VIETNAM OVER TIME The management of foreign exchange rate regimes and the fluctuation of foreign exchange rate in Vietnam through periods

Vietnam has made many adjustments in the exchange rate regime since the countryended the focused mechanism bureaucracy in 1989 However, the entire changes justconcentrated around the pegged exchange rate regime In Vietnam, the U.S dollar wasalmost considered the default currency for pegged exchange rate The State Bank ofVietnam (SBV) announced exchange rate USD / USD Based on internationalexchange rate between the dollar and other currencies in foreign currency, thecommercial banks will set the exchange rate between that currency and USD

Table 2 Exchange rate regimes in Vietnam , 1989-2009

Before 1989 Many regimes

1989-1990 Crawling bands

1991-1993 Pegged exchange rate within horizontal bands

1994-1996 Conventional fixed peg arrangement