The effect of oil price to inflation in vietnam

ABSTRACT This study analyses the oil price – inflation relationship by means of analysing the impact of oil prices on consumer price index - CPI in Vietnam using monthly data for the pe

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

Lâm Minh Minh

THE EFFECT OF OIL PRICE TO INFLATION IN VIETNAM

MASTER’S THESIS

In Financial and Banking Ology code: 60.31.12

Supervisor

Dr Nguyễn Thu Hiền

Ho Chi Minh City 2010

ACKNOWLEDGEMENT

This research would not have been possible without the support of many people Firstly, I wish to express my deep sincere gratitude to my supervisor who is also my instructor, Dr Nguyen Thu Hien (Vice Dean, School of Industrial Management, University of Technology) for her invaluable advice and helps Without her, this thesis could not have been completed

Special thanks to my professors who are in university of economics HoChiMinh city and Dr Cao Hao Thi in university of Technology HoChiMinh city without whose knowledge and assistance this study would have been successful

My thanks would also go to all of my classmates, my colleagues for all

of their friendship and encouragement

Finally, I would like to express my deepest gratitude and honour to my dear parents for not only the love they devote to me but also for the time I took from them which should have been my devotion to them in their aged time My greatest thanks would go to my family, their encouragement give a power to finish this research

ABSTRACT

This study analyses the oil price – inflation relationship by means of analysing the impact of oil prices on consumer price index - CPI in Vietnam using monthly data for the period of Jan 1995 – Nov 2010

This study reports on the research results by testing the model of relationship between three main factors as global oil price, domestic oil price and Vietnam’s CPI through using three main testings as stationarity test, cointegration test and causality test That testings is collected based on the testing of many previous researches that post on website of science direct The study may also provide some equation to quantify their relationship such

as the impact of global oil price to domestic oil price, the effect of domestic oil price to CPI and the effect of global oil price to CPI with the purpose of forecasting work

Key word: oil price, inflation, CPI, the impact of oil price

TABLE OF CONTENT

ACKNOWLEDGEMENT I ABSTRACT II TABLE OF CONTENT III LIST OF FIGURE VI

CHAPTER 1: INTRODUCTION 1

1.1-INTRODUCTION 1

1.2-RESEARCH BACKGROUND 1

1.3 - RATIONALE OF THE RESEARCH 2

1.4-RESEARCH OBJECTIVE 3

1.5-SCOPE AND METHODOLOGY OF THE RESEARCH 3

1.5.1 - Scope of Research 3

1.5.2 - Research Method 4

1.6-STRUCTURE OF RESEARCH 4

CHAPTER 2: LITERATURE REVIEW 5

2.1-INTRODUCTION 5

2.2-TRANSMISSION CHANNELS OF OIL PRICES 5

2.2.1 - First-round effect 6

2.2.2 - Second-round effect 7

2.3 – PREVIOUS RESEARCHES: 8

2.4-CONCLUSION 10

CHAPTER 3: METHODOLOGY 11

3.1-INTRODUCTION 11

3.2-BUSINESS RESEARCH 11

3.3-RESEARCH DESIGN 12

3.3.1 - Research Hypotheses: 13

3.3.2 - Draft of Research Model: 15

3.4-RESEARCH MODEL 15

3.5 – O VERVIEW D ATA 21

3.5.1–HISTORY OF WORLD OIL PRICE 21

3.5.2–INFLATION OF VIETNAM: 25

3.5.3 – Oil price of Vietnam: 29

3.6 – C ONCLUSION 31

4.1 - I NTRODUCTION 32

4.2 - D ATA D ESCRIPTION 32

4.2.1 Global oil price 33

4.2.2 Domestic oil price in Vietnam 33

4.2.3 Consumer price index 34

4.2.4 Exchange rate in Vietnam 35

4.3 - T ESTING C ORRELATION B ETWEEN V ARIABLES : 36

4.4 - T ESTING S TATIONARITY 39

4.5 - T ESTING C OINTEGRATION : 42

4.5.1 - Relationship between global oil price and domestic oil price 42

4.5.2 - Relationship between domestic oil price and CPI 44

4.5.3 - Relationship between global oil price and CPI of Vietnam 45

4.6 - T ESTING C AUSALITY : 46

4.6.1 - Causality test for WO – DO 47

4.6.2 - Causality test for DO – CPI 48

4.6.3 - Causality test for WO - CPI 49

4.6.4 - Causality test for WOEX - CPI 50

4.7 - F INDINGS AND C ONCLUSIONS : 51

CHAPTER 5: CONCLUSIONS AND IMPLICATIONS 53

5.1 - I NTRODUCTION 53

5.2 - C ONCLUSIONS OF THE RESEARCH 53

5.2.1 - Summary of hypotheses and results 53

5.2.2 - Conclusion 54

5.3 - I MPLICATIONS OF THE RESEARCH 55

5.4 – L IMITATIONS : 56

LIST OF REFERENCE 58 

List of Figure

Figure 1.1 – Outline of chapter 1 1

Figure 1.2 – Structure of the Research 4

Figure 2.1 – Outline of chapter 2 5

Figure 3.1 – Outline of chapter 3 11

Figure 3.2 – Research Design 13

Figure 3.3.1 – Transmission Channels of Oil Price 14

Figure 3.3.2 – Original Research Model 15

Figure 3.4 – Research Model 17

Figure 3.5 – Crude Oil Prices 1869-2009 22

Figure 3.6 – Crude Oil Prices 1947 – 2009 23

Figure 3.7 – CPI of term end and average 1992 – 2010 27

Figure 3.8 – Gasoline R92 Retail’s Price in Vietnam 29

Figure 4.1 – Outline of chapter 4 32

Figure 5.1 – Outline of chapter 5 53

Figure 5.2.1 - Summary of hypotheses and results 54

List of Table

Table 4 – Descriptive Statistics 32

Table 4 1 – Correlations Matrix 38 

Table 4 2 – Testing the stationarity of variables 39 

Table 4 3 – Testing variable of first difference 39 

Table 4 4 – Testing variable of second difference 40 

Table 4 5 – Model Description (CPI) 40

Table 4 6a – Model Summary 42

Table 4 6b – Coefficients 42

Table 4.7a – Model Summary 43

Table 4.7b – Coefficients 43

Table 4.8a – Model Summary 44

Table 4.8b – Coefficients 44

Table 4.9a – Model Summary 45

Table 4.9b – Coefficients 45

Table 4.9c – Model Summary 45

Table 4.9d – Coefficients 46

Table 4.10 – Causality test for DO and WO 47

Table 4.11 – Causality test for DO and CPI 48

Table 4.12 – Causality test for WO and CPI 49

Table 4.13 – Causality test for CPI and WOEX 50

Table 5.1 – Summary of hypotheses and results 53

List of ABBREVIATION

- WOEX : Global oil price transferred in VND

Figure 1.1 – Outline of chapter 1

1.2 - Research Background

At the beginning of the year 2007, domestic oil price had increasing continuously following the sharp hiking of the world oil price Incessant fluctuations of global crude oil price also lead to change of overall domestic prices During the same time, in dealing with the effects of finance crisis derived from American mortgage crisis in

2008, Vietnamese government’s monetary policy and its macro targets have been adjusted from time to time

Articles repeated in many newspapers and magazines conclude that increases in oil prices such as those seen in recent years passed through the country’s inflation Whenever oil price increases, other prices also rise later It raised living expense higher than before, while salary and wages have been kept stable still As a result, the

Introduction 1.1

Research background 1.2

Problem statement 1.3

Research Objective 1.4

Scope and Methodology 1.5

Structure of the Research 1.6

residential life gets tougher, although Vietnamese oil price is somehow still subsidized

by the government From 1995 up to now, domestic oil price is floating under government’s acceptance

1.3 - Rationale of the Research

It is easy to recognize that rising oil prices tend to affect the overall consumer price index (CPI) directly and indirectly

- Directly, through raising its energy cost component, which includes the prices of energy-related items, such as motor fuels, gas, and electricity Gasoline and fuel oil are derived directly from crude oil, so their prices follow oil prices very closely An increase in the price of oil may also affect energy costs through the prices of other items that are close substitutes, thus leading to an increase from the prices of oil-related energy to natural gas price The extent to which rising oil prices translate into higher overall inflation through higher energy costs depends on their persistence If oil price continue to rise, it may lead to sustained increases in the overall price level, that

is, to an increase in the overall inflation rate

- Indirectly, through effective the core portion of the CPI, because energy prices represent a considerable portion of the production cost for many of the items in it, such

as transportation services In addition, if workers have to pay higher energy prices themselves, they may bargain for compensating wage increases, which also increases the production costs of items in the core CPI The extent to which rising oil prices translate into higher core inflation through higher production costs depends, among other things, on how much they break into the overall inflation expectations of those who set prices and wages In fact, if rising oil prices lead to higher inflation expectations over the longer term, rising energy and wage costs are more likely to be passed through in terms of rising consumer prices In this case, rising oil prices may lead to sustained increases in the core portion of the CPI, that is, to an increase in core inflation

However, the matter is how strong the relationship between changes in crude oil prices and in inflation is In theory, the causal relationship is clear A sharp jump in the price of crude oil causes an inflationary shock and the impact will be greatest when

a country is a large-scale importer of oil and has many industries that use oil as an essential input in the production process

From articles on newspaper or magazine such as VN express, Saigon time and Tuoi Tre newspaper etc… it is generally concluded that oil price affects to inflation – CPI

1.4 - Research Objective

This research, therefore, puts an effort onto checking the relationship between oil prices and inflation to answer the following question

Q1 Do oil prices affect to inflation rate?

Q2 How do oil prices affect to inflation rate?

This research measures the relationship of oil price fluctuation and inflation rate, specifically consumer price index (CPI)

As noted above, the objective of this research is to test the hypothesis that

- Oil prices affect to CPI or not

- Oil prices affect to CPI by measuring the relationship between global oil price, local oil price and CPI in long term

It provide specific picture about the issue to macroeconomist and policymaker in dealing with managing inflation during the current finance crisis

1.5 - Scope and Methodology of the Research

1.5.1 - Scope of Research

This research is only using official data that announced on public information channels With the inflation, a chief measure of price inflation is the inflation rate, the annually percentage change in a general price index The research is concentrated on fluctuation of the inflation rate through the core inflation – consumer price index (CPI)

of every month in Vietnam While the oil price base on the crude oil price of

international trade The reason of this using is that Vietnam is an oil importer Although Vietnam is an exporter of crude oil, the fuel and gasoline in consuming domestic trading is imported from Singapore and others Therefore, oil price is controlled by the crude oil price of international trade

Beside main factors were measured that oil price affect to inflation, the research consider effect of relating components of CPI or other factors on oil prices such as interest rate policy and government’s monetary policy for controlling inflation

1.5.2 - Research Method

Firstly, relevant papers were reviewed to study their model of research and find out the model for my research After that, I collect demanding data and select the modelling for processing data With quantitative analysis, I choose monthly data from 1995 to

2010, total n = 191 months By using Multiple Linear Regression analysis (MLR) of SPSS software version 15 and Eview software version 6.0, the result will indicate specific relationship between oil price and CPI Chapter 3 will discuss the methodology for this study in more details

1.6 - Structure of Research

The structure of this research is shown in figure 1.2

Figure 1.2 – Structure of the Research

Introduction Chapter 1

Literature Review Chapter 2

Methodology and Overview Data Chapter 3

Data analysis and Findings Chapter 4

Conclusion and Implication Chapter 5

Chapter 2: LITERATURE REVIEW

2.1 - Introduction

The previous chapter introduces an overview of the research background, the rationale

of the study, the research objective, and the research question This chapter is searched and reviewed relevant theories in the literature The aim of this review is to determine the relationship between oil price and inflation in Vietnam

Figure 2.1 – Outline of chapter 2

2.2 - Transmission channels of oil prices

As documented in many studies, the dramatic rise in oil prices during the 1970s has been associated with subsequent economic downturns (Hamilton and Herrera 2004) Although there is some debate as to whether oil shocks are the main cause of recession (Bohi 1989), it is widely accepted that oil price shocks at least partially pass through into inflation Understanding the empirical linkage between oil prices and inflation rates is then important as most monetary authorities to conduct policy to accommodate these shocks (Bernanke 2007)

International oil prices are highly relevant to understand firm price setting behaviour, given that the share of household spending devoted to refined oil products is substantial and that oil and refined oil products are an input in the production of goods and services Oil price shocks affect the economy through different channels: the supply side, the demand side and the terms of trade (Martin Schneider, 2007) The transmission mechanism linking global oil prices to consumer price inflation is quite complex and the strength and timing of the different channels depend on numerous

Introduction 2.1

Transmission Channels of Oil Prices 2.2

Previous Researches 2.3

Conclusion 2.4

- On the demand side, oil price shocks drive up the general level of prices, which translate into lower real disposable incomes and thus reduces demand Indirect effects refer to the impact of changes on consumer prices that occur as oil prices impact on producer cost and prices The indirect effect on consumer prices is considerably harder to estimate, so it is useful to consider different approaches Among the different non-energy goods and services included in the CPI basket, oil and oil refined products are particularly relevant in the production process of

some services, such as transport services The indirect effect reflects the change

in the cost of producing goods and services which use petroleum products as an input and its pass through to final prices Industries which employ oil intensive technologies are particularly affected by changes in the price of oil, since their marginal cost vary to a larger extent This transmission channel has a considerably lower speed of pass through than the direct impact and a strength that varies according to factors such as market competition, cyclical developments or the expected transitory or permanent nature of the shock

2.2.2 - Second-round effect

Consumer prices may also be affected by so-called second-round effects These refer to the fact that first-round price changes may trigger a revision of inflation expectations that lead to a resetting of final prices, either directly or indirectly, through the wage-bargaining process Revisions in inflation expectations may entail price changes, to the extent that firms try to maintain profits in real terms

If nominal wage are reset as a result of an oil price shock, unit labour costs of firms vary and may be pass through final price At any rate, inflation expectations of households and firms depend on how expectations of medium-term inflation are anchored by the monetary policy framework, so that inflation expectations can remain stable following an oil price shock if the central bank is credible enough (Luis J, Allvarez, Samuel Hurtado, Isabel Sánchez and Carlos Thomas, 2009)

In the others word, apart from their direct effects on the general price level, oil price also have second round effects, as rigid nominal wages and price and wage indexation add to inflation Higher wage pressures and weaker demand dampen employment In addition to that, a deterioration of confidence and stock market reactions can amplify the impact of a shock Furthermore, economics are hit by changes in the international environment brought about by oil price shocks Climbing import prices trigger a deterioration of the term of trade and thus precipitate welfare losses In brief, second round effects arise should oil price

changes impact on wages specifically and inflation expectations and price setting more generally Oil prices may also impact on real side of economy via purchasing power and terms of trade effects, etc

2.3 – Previous Researches:

There have been many published researches on the relationship between oil prices and inflation in the world They studied this relationship in many different countries, from developed countries to developing countries

The paper by Martin Schneider (2004) looks into the impact of oil prices changes on growth and inflation Oil price shocks affect the economy through the supply side (higher production costs, reallocation of resources), the demand side (income effects, uncertainties) and the terms of trade The effects of oil price shocks have become less intense over time (thanks to technological innovation, the development of cost-effect-asymmetric An increase in the price of oil feeds through to GDP growth to a much larger extent than a decline, a phenomenon that can be attributed to adjustment costs associated with sectoral reallocations, the implications of uncertainties for spending on consumer durables and investment, and nominal wage rigidities Furthermore, the element of surprise in oil price hikes seems to play a considerable role Thus, when a rise in the price of oil occurs after a prolonged period of oil price stability, it has a larger impact than a price hike which immediately follows previous cuts

Imad A.Moosa (1993) addresses an issue that has been the subject of debate in the media and in academic circles The paper concerns the effect of oil prices initiated by OPEC on economic activity in OECD countries Results of cointegration test indicated that there is no long-run relationship between oil prices and macroeconomic variables

in OECD countries However, causality testing indicates the existence of unidirectional causality from oil prices to domestic prices and output

While Apinya Wanaset of School of Economics of Sukhothai Thammatirat Open University (Thailand) aimed to examine the pass-through effects of key macroeconomic variables on the exchange rate in Thailand by using a Vector

Autoregressive (VAR) analysis The macroeconomic variables used in that study are exchange rate, GDP, CPI, money supply, and oil price from the period of 1993Q1 through 2008Q4 The result from the VAR analysis suggest that first, all key macroeconomic variable, including GDP, CPI, money supply, and oil price have affected exchange rate volatility from impulse response analysis Second, for the variance decomposition analysis, CPI shock has the most influential effect on exchange rate volatility Finally, the causality tests suggest that GDP absorbs all of the effects from exchange rate, money supply, CPI, and oil price At the same time, GDP affects money supply as well In sum, the result imply that changes in key macroeconomic variable are likely accompanied by exchange rate volatility

With “The pass through of oil prices into euro area consumer liquid fuel prices in an environment of high and volatile oil price” by Aidan Meyler considers the pass through of oil prices into consumer liquid (i.e petrol, diesel and heating) fuel prices in such an environment The main contribution of this paper is a comprehensive combination of many features that have been considered before but rarely jointly These features include: (1) the analysis of the euro area as an aggregate and a large number of countries (the initial 12 member states); (2) the consideration of different time periods; (3) the modelling of the data in raw levels rather than in log levels This turns out to have important implications for findings; (4) the use of high frequency (weekly) data, which, as results will suggest, are the lowest frequency one should consider; (5) the investigation of the different stages of the production chain from crude oil prices to retail distribution - refining costs and margins, distribution and retailing costs and margins; (6) the examination of prices including and excluding taxes – excise and value added; (7) the modelling of prices for three fuel types – passenger car petrol and diesel separately and home heating fuel oil; (8) lastly paper also address the issue of possible asymmetries, allowing for the pass through to vary according to (a) whether price are increasing or decreasing and (b) whether price levels are above or below their equilibrium level The main findings are as follows: First, as distribution and retailing costs and margins have been broadly stable on

average, the modelling of the relationship between consumer prices excluding taxes and upstream prices in raw levels rather than in logarithms has important implications for the stability of estimates of pass through when oil price levels rise significantly Second, considering spot prices for refined prices improves significantly the fit of the estimated models relative to using crude oil prices It also results in more economically meaningful results concerning the extent of pass through Third, oil price pass through occurs quickly, with 90% occurring within three to five weeks Fourth, using a relatively broad specification allowing for asymmetry in the pass through from upstream to downstream prices, there is little evidence of statistically significant asymmetries Furthermore, even where asymmetry is found to be statistically significant, it is generally not economically significant Lastly, these results generally hold across most euro area countries with few exceptions

And “Recent oil price shock and Tunisian economy” by Sonia Zouari-Ghorbel is to study the oil prices – macroeconomy relationship by the analysis of the role of subsidy policy The vector autoregression (VAR) method was employed to analyse the data over the period 1993Q1 - 2007Q3 The results of the model using both linear and non-linear specifications indicate that there is no direct impact of oil price shock on the economic activity The shock of oil prices affects economic activity indirectly The most significant channel by which the effects of the shock are transmitted is the government’s spending

2.4 - Conclusion

This chapter provides theoretical framework for the research However, with the reason regarding the relationship of oil price and inflation aspect as discussed above such as first round effect and second round effect or direct and indirect, a research model will be studied more details in chapter 3

Figure 3.1 – Outline of chapter 3

3.2 - Business Research

Business research is defined “as a systematic inquiry whose objective is to provide information to solve managerial problem” (Donald R.C & Pamela S.S., 2003) There are some ways to classify business research It can be classified based on characteristic

of data, source of data and the purpose of research or the frequency of the study Base

on the purpose of research, one of the following three types of methods was often applied:

- Exploratory study: This is the basic level of research This type is used when there

is a need to clarify the understanding of problem, or when it is uncertain about which theory is relevant or can be applied to explain the nature of phenomena

- Descriptive study: The objective of descriptive study is “to portray an accurate

profile of persons, events or situations” (Robson, 1993) This may be an extension of

an exploratory research It is necessary to have a clear picture of the characteristics of which the data will be collected prior to the collection of data

Introduction 3.1

Business Research 3.2

Research Design 3.3

Research Model 3.4

Overview Data 3.5

Conclusion 3.6

- Causal study: In this type of research, the emphasis is on studying a specific

situation or a problem in order to explain the relationship between variables

Based on the characteristics of data needed and research purpose, researchers can choose either qualitative or quantitative approach or a combination of these two types

In addition, data can be acquired via a variety of strategies such as experiment, survey, case study, grounded theory or action research

Quantitative research is aimed to determine the relationship between one thing (an independent variable) and another (a dependent or outcome variable) in a population Quantitative research designs are either descriptive (subjects usually measured once)

or experimental (subjects measured before and after a treatment) A descriptive study establishes only associations between variables An experiment establishes causality For an accurate estimate of the relationship between variables, a descriptive study usually needs a sample of hundreds or even thousands of subjects; an experiment, especially a crossover, may need only tens of subjects The estimate of the relationship

is less likely to be biased if you have a high participation rate in a sample selected randomly from a population In experiments, bias is also less likely if subjects are randomly assigned to treatments, and if subjects and researchers are blind to the identity of the treatments

In all studies, subject characteristics can affect the relationship you are investigating Limit their effect either by using a less heterogeneous sample of subjects or preferably

by measuring the characteristics and including them in the analysis In an experiment, try to measure variables that might explain the mechanism of the treatment In an unblended experiment, such variables can help define the magnitude of any placebo effect (Will G Hopkins, 2000)

3.3 - Research Design

The first step in business research is to determine what objective the researcher wants

to achieve Research design then enables the researcher to select appropriate methods

in order to meet the research objectives in the most efficient way

To measure the effect of oil price to inflation, this study employs a descriptive method because of describing the relationships among variable Data for this research was collected from official resource And then quantitative analysis through regression with the sample size n=191 and significant or not significant at the 5% level is applied

in order to testing and measuring the relationship of oil price and inflation

The research process of this study is shown in figure 3.2

Figure 3.2 – Research Design

3.3.1 - Research Hypotheses:

Base on the above literature review of chapter two, some previous study indicated that the shock of global oil price affect to inflation specifically consumer price index (CPI) through several channel It summarize in the Diagram as below

Findings and Conclusion Result Data Analysis

Data Analysis Data collection

Clean Data

Data Collection Data sources Data Selection

Fundamental Theory Objective

MethodLiterature review

Figure 3.3.1 – Transmission Channels of Oil Price

However, when analysed the impact of oil price changes to inflation, consumer price is also affected by several factors such as monetary policy, interest rate, exchange rate, etc Vietnam is an oil importer country So, exchange rate is an important role in conversion of global oil price to retail prices

Some hypotheses are produced as below:

H1: Domestic oil price are positively related to global oil price changes

H2: Inflation of Vietnam (CPI) is positively related to domestic oil price changes H3: Inflation of Vietnam (CPI) is positively related to global oil price changes H4: Effect of exchange rate to inflation is negative or positive

H5: Effect of interest rate policy to inflation is negative or positive

H6: Effect of monetary policy to inflation is negative or positive

H7: Effect of other factors such as economic growth rate, out-put, the stimulus, the budget deficit, unemployment, etc… to inflation is negative or positive

First round effect

Second round effect

Oil price

Direct cost: Input cost (energy

cost)

Indirect cost (Transportation service)

Salary / wage

Inflation (CPI)

Basing on the rationality status of collecting data and some factors such as interest rate policy, monetary policy, economic growth rate, out-put, the stimulus, the budget deficit, unemployment, etc could not collecting and these factors were strictly controlling by government, this research is only testing the hypotheses H1, H2, H3 and H4

3.3.2 - Draft of Research Model:

The following research model is synthesized all of the above literature review and hypotheses

Figure 3.3.2 – Original Research Model

3.4 - Research Model

Reviewing literature and draft collecting data for this research are performed to test the possibility of research model reality The literature included such diverse and refined positions as “oil prices by themselves do not have significant macroeconomic effects” (Bohi, 1991), “oil price increases matter but decreases do not” (Mork, 1989), “oil price increases matter if they are large enough relative to past experience” (Hamilton, 1996), and “the effects oil price increases are a function of their size relative to their current degree of variability” (Lee, Ni, and Ratti, 1995) Moreover, there are several reasons why the macroeconomic effects of oil price changes might be difficult to identify (Hooker, 2002)

(1)

(2) (1)

(4)

(5)(3)

Interest rate policy

Others (growth rate, …)

Domestic oil

price

Exchange rate

One is the time series behaviour of oil prices themselves Oil prices rarely fell in nominal terms, and movements in oil prices tended to be concentrated into abrupt level increases, due in large part to the regulatory price and quantity fixing schemes (Hamilton, 1985) Prices then fell gradually, collapsed, and have swung widely in both directions through the present It is only in the past ten years, therefore, that data has existed to differentiate many hypotheses about specification An extreme example is asymmetry: until we observe price decreases, nothing empirical can be said about the effects that they might have (Hooker, 2002)

A second difficulty in identifying the effects of oil price shocks on macroeconomic variables is lack of a dominant theoretical mechanism Researchers have argued variously that oil primarily affects the macroeconomy as an import price through the terms of trade; as an input price through the production function either by increasing costs or by increasing uncertainty and thus deferring irreversible investment; as a shock to the aggregate price level that reduces real money balances; and as a relative price shock which leads to costly reallocation of resources across sector (Mork, 1994) Finally, the possibility that monetary policy systematically responds to oil price movements makes it difficult to identify which is the cause of any resulting macroeconomic effect

In summary, the factor related to macroeconomy in the draft research model will be not concerned such as interest rate policy, monetary policy, output, unemployment, stimulus, budget deficit, etc …

Hence, the research model is produced as below

Figure 3.4 – Research Model

With the above of research model, we employ different tools of mathematic for testing and measurement each of relationship between variables

H1: The relationship between global oil price and domestic oil price will test by correlation coefficient

H2: Effect of domestic oil price to consumer price (CPI) will test by correlation coefficient and regression

H3: Effect of global oil price to inflation (CPI) of Vietnam will test by correlation coefficient and regression

H4: Effect of exchange rate to inflation (CPI) of Vietnam will test by correlation coefficient and regression and combine with global oil price

In summary, the previous literature employed several methodologies to investigate the relationship between oil price and inflation, such as least square analysis, panel data studies, macro model simulation, and Vector Auto Regressive (VAR) models, Imad A Moosa (1993), Apinya Wanaset (2008) and Hamilton J (2000) In this research, the VAR model is applied with two or three variables, as below:

CPI = Consumer Price Index OIL = Oil price changes

EX = Exchange rate The basic VAR process can be expressed in this form:

oil price

H2

H1H3

Global oil

price

INFLATION (Consumer price index - CPI) in Vietnam Exchange rate

ut = Rt t=1,2,……T p≥1 and 1≤ i ≤ p where, Yt = vectors are observable

µ = vector of intercept term

I = vector of coefficient

t = vector of error term

R = unknown fixed non-singular matrix The tools employed by a VAR analysis in this research that three tests will be employed:

(1) The first test: The Dickey-Fuller unit root test (stationarity test) is applied to

univariate time series to see whether each of the variables under consideration is stationary or not (follow a random walk) If y is any of variables then the Dickey-Fuller regression is written in its general form as

where  is the first difference operator (xt = xt – xt-1) and t is time

The lagged dependent variables (xt-i), which are called the augmentation terms, are added to ensure residual whiteness If the regression is estimated without the augmentation terms (k=0) the test statistic is known as the Dickey-Fuller (DF) statistic; this is the appropriate test statistic if the residuals are white noise On the other hand, if the regression is estimated with k augmentation terms, the statistic is known as the augmented Dickey-Fuller statistic, AFD(k), where k is the order of the test In both cases, the test statistic is the t ratio of the coefficient

on xt-1 However, the test statistic does not have the standard t distribution but

rather a skewed distribution In implementing this test, the null hypothesis that xthas a unit root (non-stationarity) is given by H0 : β2 = 0, which is rejected if the test statistic is negative and greater in absolute terms than the critical value as tabulated by MacKinnon (1990)

The Dickey-Fuller test will be applied to the levels of variables and their first differences, as this is required to determine the order of integration If a variable

xt is non-stationarity while its first difference xt is stationarity this variable is said to be integrated of order 1

Furthermore, if Dickey-Fuller unit root test give the non-stationary result that means not a random walk Season algorithm is employed to test stationary through ACF/PACF algorithms The seasonal decomposition procedure removes periodic fluctuations from time series, such as annual or seasonal highs or lows

It is used primarily as a preliminary tool when attempting to analyze trend in such series So based on the ACF/PACF graph give us the stationarity or not

(2) The second test: The residual based Engle-Granger cointegration test will be

applied to bivariate model

yt = α + βxt + t the test is conducted to find out if there is a long-run relationship between the price of oil, x, and any of the other variables

The purpose of test is to find out if there is a long-run relationship between the CPI and global oil price If cointergration is found it implied that while the variables may wander around in the course of time, they cannot drift too far apart from each other The power of this technique lies in its ability to discriminate between genuine long-run relationships and spurious relationships

If two variables turn out to be integrated of order 1, then if they are cointegrated they must produce a stationary linear combination

where and are the OLS (ordinary least squares) estimates of the cointegrating regression Therefore, to test for cointegration, the Dickey-Fuller test is applied to the empirical residuals by estimating the following OLS regression:

To reject the null hypothesis of no cointegration (H0:  = 0) the DF or the ADF statistic must be significantly negative

(3) The third test: Granger’s causality test is simple that if x causes y then y is

better explained by x than by its lagged values alone The following regression is run:

And then the hypothesis H0: 1i=0 is tested, and if rejected it implied that x causes y Similarly, the hypothesis of causality in the opposite direction can be test by running the regression:

And testing the null hypothesis H0: 2i=0 In neither case is allowance made for contemporaneous causality

Furthermore, Granger’s representation theorem stipulates that if y and x are cointegrated then there is valid error correction representation of the form

where  is the residual of the cointegrating regression This specification implies causality in at least one direction (ie either 1 or 2 or both are statistically significant) (Imad A Moosa, 1993)

3.5 – Overview Data

3.5.1 – History of World Oil Price

The year 1859 was a double milestone in world history Charles Darwin published

his Origin of Species, and across the Atlantic, in a 33 state America, Edwin Drake

sank the first US oil well in Titusville, Pennsylvania Darwin offered the concept of the extinction of entire species as the backdrop for a potentially finite “Human Era”, while Drake’s discovery ushered in the “Oil Era” (Yergin, D 1991and Darwin, C 1859) Since that year, oil has become the foundation of individual empires and a source of wealth for nations endowed with abundant reserves Measured in antiquated units of 42 gallon barrels, oil is both a practical commodity and tradable international currency Oil is used to produce a wide diversity of products, such as fuel, plastics, paint, nylon, cosmetics, toothbrushes and toothpaste, etc It becomes a

main role of input in many industries

Figure 3.5 - Crude Oil Prices 1869-2009

Source: World Bank

Our freedom of movement depends on oil for gasoline, a liquid that propels, pollutes, and has typically cost less than most bottled water Oil’s global abundance

is ultimately unknown, yet the competition for control of this resource in the Middle East and fear about its future has been an impetus for war (Greene, D L 2009) The very long term data in figure 2.2 indicate that crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply Since 1869 US crude oil prices adjusted for inflation have averaged $21.05 per barrel in 2006 dollars compared to

$21.66 for world oil prices Fifty percent of the time prices U.S and world prices were below the median oil price of $16.71 per barrel

Figure 3.6 - Crude Oil Prices 1947 - 2009

Source: World Bank

The results are dramatically different if only post-1970 data are used In that case, U.S crude oil prices average $32.36 per barrel and the more relevant world oil price averages $35.50 per barrel The median oil price for that period is $30.04 per barrel The decline in the price of crude when adjusted for inflation for the international producer suffered the additional effect in 1971 and 1972 of a weaker US dollar Established in 1960 OPEC, with five founding members Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, took over a decade to establish its influence in the world market By the end of 1971, six other nations had joined the group: Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria From the foundation

of the Organization of Petroleum Exporting Countries through 1972 member countries experienced steady decline in the purchasing power of a barrel of oil

As oil prices have climbed over the last several years, the memory of the 1970s and early 1980s has not been far from the minds of the public or of monetary policymakers In those earlier episodes, rising oil prices were accompanied by double-digit overall inflation in the U.S and in several other developed economies Indeed, central bankers say they are determined not to let this experience recur, emphasizing that they intend to maintain their credibility with the public in securing

The period since 2003 witnessed a dramatic increase in crude oil prices, culminating

in 2008's meteoric rise of crude oil prices to near $150/bbl as of mid year in the price of West Texas Intermediate crude The bulk of this rise was quite quickly reversed, as prices fell to roughly $45 by the end of December The run-up both impinged on business operating margins and squeezed the real disposable incomes

of households This no doubt restrained the growth of aggregate demand in a U.S economy already reeling from the transition from housing boom to housing bust and the rapid unravelling of key components of our financial infrastructure As such, the surge in oil prices may well have been instrumental in tipping the U.S and global economy into recession and brought into sharp focus the importance of the question

of what effect do oil price movements have on output?

This analysis explores the effects that oil price shocks have on U.S economic growth We begin with a well-known model developed by James Hamilton, consider refinements to his definition of an oil price "shock," and then explore alternatives to the basic reduced-form model employed by Hamilton It is found that

a structurally inspired error-correction model (ECM) for non-farm business output, which allows for oil price changes to have both long-run and short-run effects, performs better than the reduced-form model and also shows significantly smaller

adverse effects of rising oil prices Our preferred model suggests that oil prices reduced GDP growth by about 0.4 percentage points on average through the first three quarters of 2008, before contributing 1.7 percentage points in the fourth quarter as prices plummeted

However, one justification for looking at a measure that excludes energy prices is that they are typically quite volatile; for example, after rising steadily and hitting a record of about $145.31 per barrel in July 2008, oil prices then fell to under $100 per barrel in September 2008 Temporary oil price increases do not tend to pass through to the prices of non-energy goods and services when the central bank is credible that is, when inflation expectations are well-anchored and, therefore, will

not result in persistently higher overall inflation

3.5.2 – Inflation of Vietnam:

It was a great success that Vietnam’s government was good control in reducing inflation 775% of 1986 to 5.2% of 1993 by properly using finance and monetary policies But inflation grew up again at 14.4% in 1994 Once again, inflation has declined whereby State banks of Vietnam (SBV) had implemented the tools of monetary policy to reduce monetary supply; especially inflation rate fell from 12.7% in 1996 to 4.6% in 1997 and 3.6% in 1998 Associated with the post East Asian financial crisis of 1997-1998, the economy was fallen into deflation in 1999-

2001 (0.1%, -0.6% and 0.8%) Many policies that stimulate and increase the supply

of goods and services on the market were applied Achievement of applying these measures was reduction of deflation, increasing significantly of total demand, quickly recovery of investment such as increased the total social investment capital

to 14.6% in 2000 compared to 1999, markedly increased government expenditure from the state budget, and rapidly increase consumer demand Specially, the total retail sales and services rose 1.5% in 1999 up 9.1% in 2000, figure of exports was from 2% in 1998 to 23.3% in 1999 and 25% in 2000, and in 2001 the total national export turnover reached 15.1 billion up 45% compared to 2000 Producing of industry, agriculture and services had been improved to positive steps Foreign

investment had shown signs of recovery, in 2000 with registered capital 1.973 billion up from 1.568 billion in 1999; in 2001 total registered capital has grown to

$3 billion So, the stagnant capitals of banks were partially resolved

So far in 2002 was considered a successful year in all areas of the country Growth rate of all economic sectors had high growth, which should include service industries, especially tourism industry Inflation was controlled at 4% However, average of growth rate was below the median growth rate in the last 10 year Income levels and consumption of the population was too low so that encourage market development and investment Interest rate decreased but deposit still increased It means that people had not still increased consumption and investment Economy was quite changes with 7.04% of growth rate only after China (8%) Inflation was still 4%, however, increasing of the commodities’ price was 2.9% In the year 2003, the effect of Iraq war aimed to nearly global energy crisis, especially rising price of almost commodities 3% Moreover, speculation of fuel, gasoline and oil were appeared Gold price also fluctuated two or three times per day So, implementation of import gold to stabilize the domestic gold market had restricted partially inflation After efforts of government to control the economy, growth rate was 8.4% whereas consumer price index (CPI) of 2004-2006 was 9.5%, 8.4% and 6.6% Vietnam's continued commitment to inclusive development provides the vision responsive to running an efficient government Inflation in Vietnam began to increase from 2004, CPI increased to 12.6% and particularly increased in the last months of year end

From 2007 to 2008 global economic crisis occurred with the beginning of subprime mortgage crisis in US It was a memorable year for the macroeconomic and inflation of Vietnam in the 2008 Continuously rising of CPI on early months was the highest level which had reached 30% Ending in 2008, CPI rose 19.89%, calculated the average annual increase of 22.97% In 2009, by effect of recessionary global economy, price of many commodities was also declined relatively low and domestic inflation under controlling CPI in 2009 rose 6.52%, however,

significantly lower than in recent years However, compared to other countries in the region and around the world was much higher

Figure 3.7 – CPI of term end and average 1992 – 2010

Source: General statistic organization (CPI in 2010 is objective)

The Vietnam Annual Economic Report 2010 was completed with the assumption that the Vietnamese economy is in the process of recovery However, the economic crisis has left behind numerous economic challenges: accumulated macroeconomic imbalances from recent years, weaknesses in the control and combination of polices, and demand for the acceleration of economic structural reform All of the above dictate that Vietnam must adopt new strategies to adapt to the current situation

Analysis of factors affected inflation in Vietnam under the three main groups:

3.5.2.1 Costs of input – supply side (increased fuel prices, electricity, water,

adjusting the exchange rate)

The events of increased electricity prices 6.8% from 01/3/2010, petrol prices 6.5% (total 2 times), and coal sold to electricity from 28 to 47% will affect directly rising inflation up 0.16% which fuel, electricity and water occupied 30%-40% production prices Most comments were concerned the increased price

of electricity and other basic goods will be strongly influenced commodity prices throughout the economy and GDP growth

CPI of term end CPI average

Especially, on 10th Feb 10/02 adjustment of rising interbank rate 3.3% and official ceiling exchange rate 19100 VND/USD by State Bank (SBV) will affect the price of domestic goods, as import-export turnover is now about 1.5 times GDP

Moreover, increasing basic salary and minimum wage by 10-15% will affect the production costs of the business and commodity prices In addition, increase of the minimum wage entails raising price of other products in market

3.5.2.2 - Demand side (the stimulus, the budget deficit )

The effect of demand pull comes from the demand-supply gap to cause fluctuant commodity prices The prices of goods are increased whenever abrupt increase in demand with unchanging in supply or sudden decrease of supply with unchanging of demand In 2009, the economic stimulus packages and strengthens government’s expenditure also caused to rise in demand Effects from this increased demand continued into 2010, and putting pressure on many commodity prices

3.5.2.3 - Monetary policy (increased money supply, increased credit, etc )

Inflation rates in the industrialized economies have been increasing in recent years, even though some of the countries’ government have had control by monetary policy In 2009, monetary policy was extended; the interest rate and reserve requirement ratio is set low Credit growth in 2009 up to 37.74% is relatively high compared to the average of recent years M2 money supply growth to level 28.7% is lower than in 2006 and 2007, but it still relatively high compared with 2008 and the remaining earlier years Moreover, there are many new issued regulations to use monetary policy control banking system such as circular 13/2010/TT-NHNN date 20 May 2010 issued by SBV regulating prudential ratios in operations of credit institutions, etc

3.5.3 – Oil price of Vietnam:

Retail gasoline prices in Vietnam are state regulated In the period 1995 – 2003 domestic oil price was quite stable as 4,400VND/litre in 1998 and 4,800VND/litre

in 1999 In 2000, oil price increase two times: 5,100VND/litre on 12 Jul 2000 and 5,400VND/litre on 21 Sep 2000 It began fluctuant from 2004 to 2007 Adjustment

of oil price had four times in 2004 as 5,600 – 6,000 – 6,900 – 7,000 – 7,500VND/litre Peak of this adjustment commonly used 92 octane petrol was 19,000VND/litre ($1.15) on 21 Jul 2008, up from 14,500 dong per liter, according

to importing firm Petrolimex Vietnam has raised petrol prices by 31% and domestic fuel prices by as much as 36% as it seeks to reduce state subsidies for the commodity The rise will put prices in Vietnam, which depends heavily on oil imports, more in line with the rest of Asia Energy prices have been rising worldwide, adding to inflation worries According to a recent report from the Asian Development Bank, the threat of high inflation could undo the economic progress made by Vietnam in the past 20 years (Hồ Bá Tình, 2010)

Figure 3.8 – Gasoline R92 Retail’s Price in Vietnam

Source: General statistic organization

Figure 3.8 – Gasoline R92 Retail’s Price in Vietnam

16 Jul 1998 4,400 27 Apr 2006 11,000 02 Apr 2009 11,500

10 Jul 1999 4,800 09 Aug 2006 12,000 11 Apr 2009 12,000

12 Jul 2000 5,100 12 Sep 2006 11,000 08 May 2009 12,500

21 Sep 2000 5,400 06 Oct 2006 10,500 10 Jun 2009 13,500

20 Jun 2001 5,400 13 Jan 2007 10,100 01 Jul 2009 14,200

20 May 2002 5,400 03 Jun 2007 11,000 09 Aug 2009 14,700

01 Nov 2002 5,400 05 Jul 2007 11,800 30 Aug 2009 15,700

18 Feb 2003 5,600 16 Aug 2007 11,300 01 Oct 2009 15,200

02 Jan 2004 5,600 22 Nov 2007 13,000 24 Oct 2009 15,500

22 Feb 2004 6,000 25 Feb 2008 14,500 20 Nov 2009 16,300

19 Jun 2004 6,900 21 Jul 2008 19,000 15 Dec 2009 15,950

01 Jul 2004 7,000 14 Aug 2008 18,000 14 Jan 2010 16,400

01 Nov 2004 7,500 27 Aug 2008 17,000 21 Feb 2010 16,990

29 Mar 2005 8,000 17 Oct 2008 16,000 27 May 2010 16,490

03 Jul 2005 8,800 18 Oct 2008 15,500 06 Aug 2010 15,990

17 Aug 2005 10,000 31 Oct 2008 15,000 08 Sep 2010 16,400

22 Nov 2005 9,500 08 Nov 2008 14,000 30 Nov 2010 16,400

manipulation The State is expected to reduce price subsidies for diesel, kerosene and fuel oil and apply market selling prices to fuel oil from 2007 and diesel oil and kerosene from 2008

Since 2009 Petroleum enterprises is freedom to adjustment oil price in the market through compliance government’s regulation by decree 84/2009/NĐ-CP date 15 Oct

2009 issued by government about petroleum business Therefore, gasoline price is

more fluctuant depending on global oil price

3.6 – Conclusion

This chapter provides details of the research methodology and research design used in this study The focus on this chapter was on the development and analytical methods employed for assessment of the measurement and data analysis as well The next chapter will provide the data analysis result and the findings