The impact of exchange rate fluctuation on trade balance in short and long run

ix ABBREVIATION ADB: Asian Development Bank ADF: Augmented Dickey-Fuller ADRL: Autoregressive Distributed Lag AIC: Akaike Information Criterion CPI: Consumer Price Index ECM: Error Corr

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HOCHIMINH CITY

PHAM THI TUYET TRINH

THE IMPACT OF EXCHANGE RATE FLUCTUATION

ON TRADE BALANCE IN SHORT AND LONG RUN

THESIS OF MASTER IN ECONOMICS

HO CHI MINH CITY – 2011

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HOCHIMINH CITY

PHAM THI TUYET TRINH

THE IMPACT OF EXCHANGE RATE FLUCTUATION

ON TRADE BALANCE IN SHORT AND LONG RUN

Major: Finance and Banking

Major code: 60.31.12

THESIS OF MASTER IN ECONOMICS

ACADEMIC SUPERVISOR: Ph.D NGUYEN VAN PHUC

HO CHI MINH CITY – 2011

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ACKNOWLEDGEMENTS

I would like to send special thanks to all the teachers who gave interesting lecture

to me for their devoted instruction during my studying in this master course

I am specially thankful to Ms Ha Thi Thieu Dao for her precious data without which I could not finish this study and for her carefully reading, editing and detailed comments on my study

I express my profound sense of gratitude and sincere thanks to Mr Nguyen Van Phuc, academic supervisor, for suggesting research problems, giving valuable guidance and providing constant encouragement

I am particularly indebted to my family, especially my mother and my daughter, who have given me great emotion and encouragement

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ABSTRACT

This study shows the short and long-run impact of exchange rate on trade balance in Vietnam Following a depreciation of real exchange rate, trade balance initially deteriorates Trade balance will improve after two quarters and new equilibrium will be set after twelve quarters Johansen’s cointegration analysis and autoregressive distributed lag (ADRL) are respectively used to explore long-run impact, giving similar estimation results, showing trade balance improvement following a depreciation Corresponding error correction modes (ECM) based on long-run cointegration equations also come to consistent results, indicating immediate deterioration of trade balance after a depreciation Impulse response functions based on ECM and unrestricted Vector AutoRegression (VAR) exhibit J-curve pattern of trade balance when there is a permanent depreciation

Key word: exchange rate and trade balance, cointegration, autoregressive distributed lag, J-curve

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CONTENTS

Acknowledgement i

Abstract ii

Content iii

List of tables vii

List of figures viii

Abbreviations ix

CHAPTER 1: INTRODUCTION 1.1 Background to the study and statement of problem 1

1.2 Research question 2

1.3 Research objectives 2

1.4 Methodology 3

1.5 Limitation 3

1.6 Organization of the study 3

CHAPTER 2: LITERATURE REVIEW 2.1 General arguments about exchange rate 5

2.1.1 Exchange rate concepts 5

2.1.2 Nominal exchange rate and real exchange rate 6

2.1.2.1 Bilateral nominal and real exchange rate 6

2.1.2.2 Real effective exchange rate 7

2.1.3 Main determinants of exchange rate movement 9

2.1.3.1 Differential in inflation 9

2.1.3.2 Terms of trade 10

2.1.3.3 Differential in interest rates 10

2.1.3.4 Political stability and economic performance 10

2.1.3.5 Condition of balance of payment 11

2.2 Trade balance concepts 11

2.2.1 Trade balance as an account on the balance of payment 11

2.2.2 Determinants of trade balance 12

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2.3 Relationship between exchange rate and trade balance 13

2.3.1 The elasticities approach 13

2.3.1.1 Marshall-Lerner condition 13

2.3.1.2 The J-curve effect 14

2.3.2 Keynesians multiplier approach 15

2.3.3 Theoretical model 16

2.3.4 Empirical evidences 17

2.3.4.1 Brief of empirical studies on developed countries 17

2.3.4.2 Brief of empirical studies on developing countries 18

2.3.4.3 Summary of empirical studies on Vietnam 19

2.4 The role of exchange rate policy to trade balance 20

2.4.1 Exchange rate policy concepts 20

2.4.2 Exchange rate regimes 21

2.4.3 Instruments of exchange rate policy 23

2.4.3.1 Direct instruments 23

2.4.3.2 Indirect instruments 23

2.4.4 The importance of exchange rate policy to trade balance 24

Chapter summary 26

CHAPTER 3: PERFORMANACE OF TRADE BALANCE AND EXCHANGE RATE IN VIETNAM IN 2000-2010 3.1 The background of Vietnam’s economy in 2000-2010 period 28

3.2 The performance of trade balance in 2000-2010 period 30

3.2.1 In terms of value 31

3.2.2 In terms of structure by products 34

3.2.3 In terms of structure by trading partners 36

3.3 The fluctuation of exchange rate in 2000-2010 period 38

3.3.1 Nominal exchange rate under management of The State bank of Vietnam and the role of US Dollar 38

3.3.2 Movement of real exchange rates 41

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3.3.2.1 Real exchange rates computation 41

3.3.2.2 Analysis bilateral real exchange rate and real effective exchange rate 44

Chapter summary 48

CHAPTER 4: ESTIMATING THE IMPACT OF REAL EXCHANGE RATE ON TRADE BALANCE IN VIETNAM IN 2000-2010 4.1 Model specification 49

4.2 Data description 50

4.2.1 Technical data description 50

4.2.2 Econometric characteristics of the data 51

4.2.2.1 Seasonality 51

4.2.2.2 Stationarity 52

4.3 Model for estimation 53

4.4 Estimation of long-run effect 54

4.4.1 Johansen’s cointegration analysis 55

4.4.2 Autoregressive distributed lag (ARDL) approach 57

4.5 Estimation of short-run effect 63

4.5.1 Error-correction model (ECM) 64

4.5.2 Impulse response 66

Chapter summary 67

CHATER 5: CONCLUSION AND POLICY RECOMMENDATION 5.1 Conclusion 69

5.2 Policy recommendation 70

5.2.1 Exchange rate policy should take into account trade competitiveness 70

5.2.2 Determining value of VND based on currency basket 73

5.2.3 Establishing condition for a successful depreciation 74

5.2.4 Depreciating currency to improve trade balance 77

5.3 Limitation 78

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REFERENCES 80 APPENDIX A: REER computation 86 APPENDIX B: Estimation output and relevant test for long-run impact of real exchange rate on trade balance 99 APPENDIX C: Estimation output of Johansen’s cointegration test for long- run impact of real exchange rate on exports and imports 102 APPENDIX D: Output of ECM model estimation based on cointegrating equation obtained by Johansen’s procedure and ARDL approach 103 APPENDIX E: Narayan’s new set of critical values for the bound F-test 106

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LIST OF TABLES

Table

2.1 Exchange rate regime classification by IMF 22

3.1 GDP, Inflation, FDI, FII, ODA, Current transfer in 2000-2010 28

3.2 Structure of exports by foreign trade standard in 2000-2010 34

3.3 Structure of imports in 2000-2010 35

3.4 Trade balances (million USD) with 17 largest trading partners 37

3.5 Real exchange rates of some currencies 38

3.6 Fluctuation bands applied from 1999-2010 39

3.7 Nominal exchange rate between VND and USD in 2000-2010 39

3.8 VND/USD RER and REER 44

4.1 ADF and PP tests results for non-stationarity of variables 53

4.2 Correlation matrix of variables 54

4.3 Cointegration Rank Test: Trace and Maximum Eigenvalue Statistics 55

4.4 Granger Causality Test in Vector AutoRegression (VAR) 56

4.5 Statistic of selecting lag order (SBC and AIC) and F-Statisctics for testing the existence of a levels trade balance equation 59

4.6 Estimated ARDL(2,3,0) model 60

4.7 Ramsay RESET test for estimated ARDL(2,3,0) model 60

4.8 Breusch-Godfrey Serial Correlation LM Test for estimated ARDL(2,3,0) model 61

4.9 ECM for trade balance based Johansen’s procedure 64

4.10 ECM for trade balance based on ARDL (2,3,0) 64

4.11 Breusch-Godfrey Serial Correlation LM Test for ECM 65

4.12 Ramsey RESET Test for ECM 65

4.13 Impulse response of trade balance following real exchange rate shock 66

5.1 Shares of main trading partners (percent) of neighboring countries, 2004 72

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LIST OF FIGURES

Figure

2.1 The J-curve effect 15

3.1 The trade balance, current account of Vietnam in 2000-2010 30

3.2 Values of exports and imports (million USD) in 2000-2010 32

3.3 Growth of export and import (percent) in 2000-2010 32

3.4 Trade balance in FOB prices and CIF prices in 2000-2010 33

3.5 VND/USD exchange rate and trade balance in 2000-2010 41

3.6 RER and trade balance 45

3.7 VND/USD RER, VND’s REER and USD’s REER 46

3.8 REER and trade balance with major trading partners 47

4.1 Series used in empirical analysis: TB, REER, GDP,GDP* 51

4.2 Seasonally adjusted series: TB, REER, GDP,GDP* 52

4.3 CUSUM test for estimated ARDL(2,3,0) model 61

4.4 CUSUM Test for ECM 65

4.5 Evolution of trade balance following real depreciation 67

5.1 VND/USD exchange rate and RER, NEER, REER of VND 2000-2010 71

5.2 NEER, REER of some countries 79

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ABBREVIATION

ADB: Asian Development Bank

ADF: Augmented Dickey-Fuller

ADRL: Autoregressive Distributed Lag

AIC: Akaike Information Criterion

CPI: Consumer Price Index

ECM: Error Correction Model

GDP: Gross Domestic Product

GSO: General Statistical Office

IFS: International Financial Statistics

IMF: International Monetary Fund

NEER: Nominal Effective Exchange Rate

NER: Bilateral Nominal Exchange Rate

OECD: Organization for Economic Cooperation and Development

PP: Phillips-Perron

PPI: Producer Price Index

REER: Real Effective Exchange Rate

RER: Bilateral Real Exchange Rate

SBC: Schwarz Bayesian Criterion

SBV: State Bank of Vietnam

TB: Trade Balance

USD: United States Dollar

VAR: Vector AutoRegression

VND: Vietnam Dong

WPI: Wholesale Price Index

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CHAPTER 1

INTRODUCTION

1.1 Background to the study and statement of problem

Vietnam is a young open economy on the process of industrialization in which exports are considered to be motivation for developing The export-driven industrialization of Vietnam has achieved success with impressive increase in export volume at 20 percent on annual average during the past ten years However, that figure is still lower than annual average increase of import volume for the same period, about 22 percent, which leads to lasting trade-balance deficit The performance of Vietnam’s trade balance is the consequence of low competitiveness which could be changed by two approaches: internal and external While internal approach relies on supply-side policies such as influencing labor productivity or wages, the latter deals with exchange rate policy to devaluating/ appreciating local currency against foreign currencies In this study, we take the latter approach to explore the trade balance

In literature, there are many empirical studies focusing on the relationship between exchange rate and trade balance which have come to various conclusions Some studies show undeniable evidences on long-run and short-run relationships between exchange rate and trade balance Some come to contrary conclusion that there is no relation between them The others conclude existing relation in the long run but not in the short run Reasons standing behind these different results mainly rest on countries, observation periods and econometrics methodologies employed However, all researches concluding that exchange rate fluctuation has significant influence on trade balance also prove that depreciation would increase export, restrain import, and improve trade balance

In Vietnam, since trade-balance deficit became serious, some researchers have turned their attention to examine the role of exchange rate Although most studies conclude the fluctuation of exchange rate in Vietnam has impacts on trade balance in the long run, the short-run impact is still an open question Besides, the most popular

1.2 Research question

The study tries to explore complete impact of exchange rate on trade balance in both short and long run Correspondingly, the study aims to answer the following questions:

1 Whether there is a stable long-run relationship between the exchange rate and the trade balance of Vietnam? If that stable long-run relationship does exist, whether a permanent depreciation of exchange rate would lead to improvement of the trade balance?

2 Whether depreciation of exchange rate causes negative short-run impact on trade balance? How long does it take for positive impact of that depreciation to occur? (Does J-curve effect exist in Vietnam’s exchange rate-trade balance relationship?)

3 What are the solutions to improve the trade balance of Vietnam by using exchange rate tool?

1.3 Research objectives

To answer research questions, the study proceeds

- To calculate real effective exchange rate (REER) of Vietnam Dong against main trading partners’ currency as a proxy for measuring the competitiveness of merchandise trade

- To find out the reasons behinds the response of trade balance to exchange rate’s impact for the purpose of suggesting practical and feasible solutions for policy makers to manage exchange rate to improve trade balance

1.4 Methodology

Due to the fact that results related to the long-run and short-run relationships between exchange rate and trade balance often depend upon the observation period and the economic technique employed, three (3) econometric modeling are employed

in this study to obtain sound results

 Firstly, Johansen’s cointegration analysis and Autoregressive Distributed Lag (ARDL) approach developed by Hashem M.Pesaran, Yongcheol Shin, and Richard J.Smith (2001) are employed to explore the long-run impact of exchange rate on trade balance

 Secondly, error-correction models (ECM) based on the long-run estimating of the cointegration trade balance equations in the long run are used to explore short-run impact related J-curve pattern

1.5 Limitation

This study tries to figure out the impact of exchange rate fluctuation on trade balance in Vietnam Based on estimated results, exchange rate measurement is proposed to use at appropriate time and level to improve trade balance However, exchange rate fluctuation brings to not only trade balance change but also other unfavorable impacts on the economy In this study, we do show how exchange rate change can make benefit trade balance but cannot show adverse impacts of that change on the economy (if any) In order words, we cannot weight between benefit of trade balance and other potential loss of the economy following a depreciation Thus,

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the solution to depreciation currency to improve trade balance seems to be less

persuasive in the context of a whole economy

1.6 Organization of the study

The study is organized into 5 chapters

Chapter 1: Introduction

Chapter 2: Literature review

Chapter 3: Performance of exchange rate and trade balance in Vietnam in 2000-2010 Chapter 4: Estimating the effect of exchange rate on trade balance in Vietnam

Chapter 5: Conclusion and policy recommendation

2.1 General arguments about exchange rate

2.1.1 Exchange rate concepts

In general and popular acknowledgement, exchange rate (also known as foreign exchange rate) between two currencies specifies the price of one currency in term of another currency (Maurice D.Levi,1996)

Components of an exchange rate between two currencies comprise quote currency and base currency The former is currency measuring the value of the other (base currency) The latter is expressed value through term currency and usually equals a unit in quoting

When quoting exchange rate, there are indirect quotation or direct quotation and

US style quotation or Europe style quotation Indirect and direct quotation is based on country chosen to be home currency Thereby, indirect quotation expresses value of home currency in term of foreign currency and direct quotation expresses value of foreign currency in term of home currency US – Europe style quotation is based on the role of US dollar in quotation In US style quotation, US dollar is term currency

In Europe style quotation, US dollar is base currency

According to Foreign Exchange Ordinance (2005), in Vietnam, exchange rate of Vietnam Dong (VND) against foreign currency is the amount of VND per one foreign

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currency unit This implies direct quotation is used in Vietnam Also, all mentioned exchange rate in this study is quoted directly

2.1.2 Nominal exchange rate and real exchange rate

2.1.2.1 Bilateral nominal and real exchange rate

The bilateral nominal exchange rate (NER) between two currencies is defined as the price of one unit foreign currency in domestic currency terms (Hinkle et al 1999) NERs are popular because they are daily quoted by commercial banks for the purpose of serving customers who have demands for buying and selling currencies Therefore, depending upon supplies of and demands for currencies, NERs of currency pairs are determined One main problem with these NERs is they could not show what people can buy when they hold a unit of foreign currency The bilateral real exchange rate (RER) between two currencies can solve that problem

RER is defined as the ratio of the domestic price of tradables to non-tradables goods within a single country (Hinkle et al., 1999)1 It measures the units of non-tradable goods that can be converted into one unit of tradable goods in a country An increase in RER in domestic currency terms implies an improvement in the country’s competitiveness since there is an increase in relative price Under the assumption that the prices of the tradables will be equal all around the world, the real exchange rate defined on the basis of tradable and non-tradable goods distinction can be mathematically represented as:

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RER computed in equation (2.1) tells how it changes value over the time relative

to a base year If RER is higher than 1 (RER>1), home currency is undervalued, average prices in home country are lower than those in foreign country, domestic goods have gained competitiveness In reverse, if RER is lower than 1 (RER<1), home currency is overvalued, average prices in home country are higher than those in foreign country, domestic goods have lost competitiveness

When computing RERs, researchers face with many problems among which the choice of empirical price and cost indices makes most confused This problem is common to both developed and developing countries but tend to be more severe in developing countries Edwards (1989) noted that issues such as the existence of parallel foreign exchange markets, substantial smuggling and unrecorded trade and wide fluctuations in the terms-of-trade, trade policies and patterns, introduce complexities in the measurement of real exchange rate in developing countries, which are not commonly encountered in industrial countries Theoretically, RER on the basis of tradables and non-tradables is computed with wholesale price index (WPI) (or sometimes, producer price index (PPI)) and consumer price index (CPI) as proxy (for example Edwards (1988), Edwards (1989), Baffes et al (1999), Elbadawi (1994) There are two relevant arguments for this statement Firstly, the CPI is compiled from the change in price of consumption goods to domestic consumers Therefore, it is heavily affected by most of non-traded goods and thus able to stand for a measure of non-traded price In contrast, based on the assumption of the law of one price, the prices of exports and imports are determined by the law of one price in the international market The WPI itself possesses greater proportion of traded goods, it is then chosen from main trading partners Such WPIs multiplied by the bilateral nominal exchange rates generate an appropriate measure of traded goods price in the home country (Edwards, 1989, Baffes, 1999) Thereby, in this study we use WPI and CPI as proxy for tradables and non-tradebles, respectively

2.1.2.2 Real effective exchange rate

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Although RERs can tell the competitiveness of home country relative to one foreign country, a country, in practice, does not trade with only one foreign country but many foreign countries To compare the competitiveness of domestic goods relative to all trading partners, the concept of real effective exchange rate (REER) is used

REER (in order words multilateral real exchange rate) is an average of the RERs between home country and each of its trading partners, weighted by the respective trade shares of each partner Being an average, a country’s REER may be in

―equilibrium‖ (display no overall misalignment) when its currency is overvalued relative to that of one or more trading partners so long as it is undervalued relative to others (Luis A.V Catão, 2007)

Theoretically, there are Arithmetic Mean (AM) method and Geometric Mean (GM) method of averaging to calculate REER (Maxwell, 2004) defined respectively

as follow:

Where RERi denotes real exchange rate of home currency against foreign currency

i computed according to equation (2.1), wi denotes weights attached to currency i, t

denotes time periods

According to these methods, when REER is lower than 1 (REER<1), home currency is overvalued relative to chosen based period, domestic goods have lost competitiveness In reverse, REER is higher than 1 (REER>1), home currency is undervalued relative to chosen based period, competitiveness of domestic goods increases

Obviously, these two alternative ways of defining the REER index are different in methods of averaging which causes strength and weak in computing As Maxwell

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(2004) pointed out that the major strength of the AM is its ease of computation, which makes it more appealing to researchers and practitioners, including those in Vietnam The GM even though not as easy to compute as the AM, also has certain useful properties such as its symmetry and consistency The AM is influenced greatly by the base year chosen in the computation of the index and researcher has to rebase when trend analysis needs to be done The analysis of misalignment is relative to the base year and therefore limited when the AM index is used However, the GM indices are not influenced by the base period chosen While the AM gives larger weights to currencies which have appreciated or depreciated to a significant extent alongside the home country currency, the GM treats depreciation and appreciation symmetrically This makes the GM more efficient in capturing trends in REER For all reasons above, this study uses the GM method of averaging to calculate REER of Vietnam Dong

2.1.3 Main determinants of exchange rate movement

There are numerous factors effecting exchange rate movement between two currencies This part discusses five (5) factors which are theoretically and practically evidenced to cause fluctuation of exchange rate Although the ways these factors effect exchange rate are various, in general, all that give rise to supply of a currency will reduce it value and vice versa and all that give rise to demand for a currency will increase it value and vice versa

2.1.3.1 Differential in inflation

In the 1920s, Gustav Cassell popularized the PPP theory which generally states that a country with a consistently lower inflation rate exhibits a rising currency value,

as its purchasing power increases relative to other currencies

For example, if inflation rate in country A is lower than that in country B, prices

of goods in country B is relatively higher than prices of goods in country A The effect, then, exhibits in trade between two countries Exports of country A to country

B will increase and imports of country A from country B will decrease As a result demand for currency A increases and demand for currency B decreases The value of

relation to its trading partners

2.1.3.3 Differential in interest rates

The relationship between interest rate and exchange rate is complex, but at the core, currency with higher real interest rate will appreciate against currency with lower real interest rate (Maurice D.Levi, 1996) Because, the higher real interest rate offers investors in an economy a higher return relative to the other Therefore, higher interest rate attracts foreign capital and cause the exchange rate to rise

For example, real interest rate of currency A is higher than that of currency B Assume that capital movement is allowed between two country then investors interest

to invest in currency A As a result, demand for currency A ups (investors exchange currency B for currency A) which rises the value of currency A or exchange rate in country A decrease)

2.1.3.4 Political stability and economic performance

Political condition and economic performance directly effect allocation funds of investors Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital A country with positive attributes will draw investment funds away from other countries perceived to have more political and economic risk The more investors invest in a country, the more they demand for its currency and cause rise in value to that currency against the others Political

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turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries

2.1.3.5 Condition of balance of payment

The balance of payment account of a country is a record of the flows of payment between the residents and the rest of the world in a given period Entries in the account that give rise to a demand for the country’s currency are identified by a plus sign Entries giving rise to supply of the country’s currency are identified by a minus sign Therefore, the balance of payment reflects all the supply of and demand for a country’s currency

The balance of payment includes two main divisions: current account and capital account While the current account records international performance in trade of the country with other nations, the capital account records the volume of capital flowing

in and out the country Because the balance of payment itemizes all the factors behind the demand for and supply of a currency, the condition of balance of payment would cause pressure on appreciation or depreciation of that currency In details, a deficit on balance of payment implies that demand for foreign currency is higher than supply of foreign currency in that country which causes exchange rate to rise In reverse, a surplus on balance of payment implies that demand for foreign currency is lower than

supply of foreign currency in that country and cause exchange rate to fall

2.2 Trade balance concepts

2.2.1 Trade balance as an account on the balance of payment

The trade balance is a component of the current account, which also includes other transactions such as income from the international investment position as well as international aid (or unilateral transfer) The trade balance is the difference between the value of exports and imports in an economy over a certain period (hence, also named net export) A positive or favorable trade balance is known as a trade surplus if

it consists of exporting more than is imported; a negative or unfavorable trade balance

is referred to as a trade deficit or, informally, a trade gap The trade balance is

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sometimes divided into a goods and a services balance In this study, the trade balance

is referred to merchandise trade

2.2.2 Determinants of trade balance

The trade balance of a country includes the value of exports and imports which are, according to Maurice D.Levi (1996), determined by 6 factors In general, all factors that increase/ decrease exports improve/ deteriorate the trade balance, all factors that increase/ decrease imports deteriorate/ improve the trade balance

- The prices in home country and those in foreign country If inflation in home

country exceeds inflation elsewhere, cost of production in home country is higher than that in others, then, ceteris paribus, goods of home country become

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less competitive and thus the quantity of home country’s exports declines while imports rises As a result trade balance becomes deficit

- The exchange rate movements For a particular level of domestic and foreign

prices of internationally traded goods, the lower the exchange rate is the more deficit trade balance is In details, ceteris paribus, when home currency’s value increase, exchange rate decrease, prices of goods in home country become more expensive while prices of goods in foreign countries become cheaper The result is exports decrease, imports increase, net export decrease

- Change in world prices Changes in the worldwide prices have two-way

impacts on trade balance If prices of what home country exports rise, then the value of exports increases Ceteris paribus, the trade balance improves If prices of what home country imports rise, then the value of imports increase Ceteris paribus, the trade balance deteriorates

- Foreign incomes In case foreign buyers experience an increase in their real

incomes, the result is an improvement in the export market for raw materials and manufactured goods of home country Ceteris paribus, this increase home country’s exports and therefore improve the trade balance

- Import duties and quotas A higher import tariffs (taxed on imported goods) or

a lower import quotas (the quantity of imports permitted into a country) and higher non-tariff trade barriers (such as quality requirements and red tape) will reduce import into that country In case foreign countries apply these methods, exports of home country will decrease In case home country applies these methods, imports into home country will decrease

2.3 Relationship between exchange rate and trade balance

2.3.1 The elasticities approach

2.3.1.1 Marshall-Lerner condition

The elasticities approach is rooted in a static and partial equilibrium approach to the balance of payments which can be typical by Alfred Marshall (1842-1924), Abba Lerner (1903-1982) and Joan Robinson (1903-1983) The Marshall-Lerner condition

With definition of elasticity of demand for exports (in other words, percentage change of exports when exchange rate changes 1 percent), ηx, and the elasticity of demand for imports (in other words, percentage change of imports when exchange rate changes 1 percent), ηm as follow:

(2.5) The Marshall-Lerner condition states that a real devaluation (or a real depreciation) of the currency will improve the trade balance if the sum of the elastictities (in absolute values) with respect to the real exchange rate is greater than one (ηx+ ηm>1)

So far, the Marshall-Lerner condition has been tested in many studies which come

to different results Most studies, however, conclude that Marshall-Lerner condition is met in the long-run elasticity but not met in the short-run elasticity (for example see Hooper et al 2000) That means real devaluation seems to improve the trade balance

in the long run but not in the short run Explanation for the statement is that elasticity

is large in the long run but small in the short run Scientists now prove this theory contains defectiveness, among which the distinction between short-run and long-run elasticitities is crucial and leads to what is known as the below J-curve effect

2.3.1.2 The J-curve effect

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The J-curve, first advanced by Stephen P.Magee (1970), completes one defective point of Marshall-Lerner condition, analyses that it takes times for people to adjust their preference toward substitutes That explains why demand is more inelastic in the short run than in the long run Therefore, after a depreciation and consequent increase

in import prices, a country’s residents might continue to buy imports both because they have not adjusted their preferences towards domestically produced substitutes and because the domestic substitutes have not yet been produced Only after producers begin to supply what was previously imported and after consumers decide

to buy import substitutes can import demand fully decline after a depreciation Similarly, exports expand from depreciation only after suppliers are able to produce more for export and after foreign consumers switch to these products As a result, depreciation worsens the trade balance in the short run but subsequently improve it The time path of changes in the trade balance which has the pattern of letter J might look like that shown in Figure 2.1 (Maurice D.Levi, 1996)

Figure 2.1 – The J-curve effect

Source: Maurice D.Levi, 1996

2.3.2 Keynesians multiplier approach

Keynesian multiplier approach is a modified and extended version of the elasticities analysis in the sense that it take care of the limitation of the latter Keynesians agree with elasticities approach that a devaluation of a country’s currency will improve the trade balance However, Keynesians argues that elasticities approach

Trade balance

Time Surplus (+)

Deficit (-)

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does not take into account the effect of any change in exchange rate on real output and money variables of the economy because it assumes terms-of-trade changes are the only initial effect of devaluation Thus, Keynesians focus on the automatic adjustment that would take place if a shift in a country’s payment position occurred In other words, multiplier analysis pays more attention to cross-correlations among relative goods prices and demand and supply Suppose that a country, initially in equilibrium, experiences a downward shift in demand for its exports, with a consequent initial deficit The reduction in exports would lead to a decline in home-country income, which in turn would reduce expenditure via the multiplier With a positive marginal propensity to import and to save, import would decline by some fraction of the initial adverse shift in trade balance This could partly offset the initial shirt in equilibrium position

2.3.3 Theoretical model

Exploring the impact of exchange rate on trade balance is interesting of many researchers Since there are different views on this relation, researchers have developed various models based on particular condition of cases of countries Among them, the two-country imperfect substitutes model specified in Goldstein and Kahn (1985) and Rose and Yellen (1989) is most widely used Based on this model, Tihomir Stucka (2004), taking into account main issues of elasticities approach and Keynesians approach, develops a model in which the trade balance is expected to depend on the real exchange rate and a measure of domestic and foreign income respectively Thus trade balance is endogenous variables while real exchange rate, domestic and foreign incomes are exogenous variables

TB = f(Y, Y*, E), , , (2.5) Where TB represents trade balance, Y represents domestic income, Y* represents foreign income, E denotes real exchange rate in term of direct quotation

In this model, imports, exports and trade balance refer to the merchandise component, domestic income represents for demand of imports and supply of exports,

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foreign income represents for demand of exports Key assumptions of the models are that neither imports nor exports are perfect substitutes for domestic goods, so that finite elasticities for demand and supply can be estimated for most traded goods Besides, real foreign income and real exchange rate are expected to be positively related to the trade balance, while domestic income negatively related to the trade balance

2.3.4 Empirical evidences

This part shows the results of previous studies when exploring exchange rate-trade balance relation in developed countries, developing countries and Vietnam Though some studies extended the above model to more exogenous variables, most studies use exact model (2.5) to estimate trade balance equation

2.3.4.1 Brief of empirical studies on developed countries

Among developed countries, United States (US) and Japan have received most of attention in this field of study Andrew K Rose and Janet L Yellen (1989) used quarterly data for the period between 1960 and 1985 at the bilateral level between US and its six largest trade partners but did not find J-curve pattern or long-run relationship between bilateral exchange rates and trade flows Kanta Marwah and Lawrence R Klein (1996) investigated influence of the real bilateral exchange rate on bilateral trade balance in both the US and Canada with their respective five largest trading partners by using quarterly data between 1977 and 1992 They maintained that after depreciation, trade balance, both in the US and Canada, follows an S-curve pattern, i.e after the initial J-curve shape trade balance has a tendency to worsen again by the end Bahmani-Oskooee and Brooks (1999) use Autoregressive Distributed Lag (ARDL) approach, analyze bilateral disaggregated US data with respect to 6 major trading partners They do not find any evidence of J-curve effect but find a significant long-run relationship between the trade balance and exchange rate, indicating a real depreciation of the US dollar has a favorable effect on the US trade balance Bahmani-Oskoee and Zohre Ardalani (2006) refocused research in the

US on the industrial level and estimated its corresponding import and export

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functions They employed ARDL approach to cointegration analysis developed by Pesaran, Shin, and Smith (2001) Their results show that in half of the 66 estimated export functions for US industries, coefficient on exchange rate is as expected significantly negative However, in the case of import functions only in 13 out of 66 cases estimated coefficients on exchange rate have the correct, positive sign Thus this study shows that if aggregated data are used, significant exchange rate coefficients in some sectors could be offset by insignificant ones in other sectors and could lead to the wrong conclusion that exchange rate has no impact on trade flows

Unlike US, results obtained for Japan support both long-run and short-run impact

of exchange rate on trade balance Gupta-Kapoor and Uma Ramakrishnan (1999) when using quarterly data in 1975-1996 period and employing the Johansen’s cointegration analysis, find a long run relation between trade balance, exchange rate, and foreign and domestic income Moreover, by estimating the corresponding error correction model (ECM) as well as impulse response they demonstrate the existence

of a J-curve effect These estimates suggest that in the first five quarters trade balance deteriorates, and subsequently improves reaching a new equilibrium value in approximately 13 quarters Jung and Doroodian (1998) also obtain J-curve existence

by applying the Shiller lag model Marcus Noland (1989) also supports the result above when investigates the period 1970 through 1985 The results show currency depreciation does improve trade balance in the long run and after seven quarters from depreciation, the trade balance start improving and achieves a new equilibrium after

16 quarters

2.3.4.2 Brief of empirical studies on developing countries

Upadhyaya and Dhakal (1997) test the effectiveness of devaluation on the trade balance for 8 developing countries applying the methodology proposed by Wickens and Breusch (1988) The two researchers find that only in Mexican case, the devaluation improves the trade balance in the long-run Bahmani-Oskoose and Kanitpong (2001) when testing on disaggregated quarterly data by ARDL cointegration between Thailand and her main five trading partners for period 1973-

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1990, find evidence of the J-curve in bilateral trade with US and Japan only Bahmani-Oskoose (2001) investigate the long-run response of Middle Eastern countries’ trade balance to devaluation by applying the Engle-Ganger and Johansen-Juselius cointegration methodology and find a favorable long-run effect of a real depreciation on the trade balance for seven countries Wilson (2001) examines the relationship between the real trade balance and the exchange rate for bilateral merchandise trade between Singapore, Korea and Malaysia with respect to US and Japan but finds no evidence of a J-curve effect except Korean trade with the United States Tihomir Stučka (2004), using The ARDL cointegration approach for Croatian case finds long-run and short-run relationship between real exchange rate and trade balance and J-curve effect His obtained long run cointegrating relations show that one percent depreciation improves trade balance on average by 0.9% to 1.3% Estimated impulse responses indicate that it takes two and half years to achieve the improvement above, while the adverse effect of depreciation seems to be a short lived, just above one quarter Pavle Petrovíc and Mirjana Gligoríc (2010) by using Johansen’s procedure, ARDL and corresponding ECM show that exchange rate depreciation in Serbia improves trade balance in the long-run while giving the rise to the J-curve effect in the short-run

2.3.4.3 Summary of empirical studies on Vietnam

There is few empirical research to examine the impact of exchange rate and trade balance in Vietnam although there are some qualitative researches on this relation Lord (2002) uses cointegration equation and ECM model to explore the impact of real exchange rate on trade balance of Vietnam from 1990 – 2001 Obtained results indicate that the effect of Vietnam’s real effective exchange rate on its international competitiveness and export demand are statistically significant in the global market and a number of regional markets The long-run real exchange rate elasticity of demand for exports in the global market is equal to –1.8 in the short run and –2.0 in the long run In the short run, the competitive price elasticity ranges from -0.1 in the ASEAN-5 market to –0.3 in the US market, while in the long run it ranges from –0.4

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in the US market to –1.9 in the EU market Another study by Phan Thanh Hoan and Nguyen Dang Hao (2007), also use cointegration theory for quarterly data from 1995(1) to 2005(4), finding that real exchange rate have impact on trade balance in the long run One percent depreciation of real exchange rate causes trade balance to increase by 0.7 percent Most recent study by Pham Hong Phuc (2009) uses ordinary least square (OLS) method to test the impact of exchange rate on trade balance Although this study support the impact of exchange rate on trade balance, the OLS method seems to not appropriate Exchange rate, trade balance and also GDP are usually non-stationary at their level When using these non-stationary data in OLS model, as Chish Brooks (2008) specifies, can lead to spurious regression, invalid standard assumption for asymptotic analysis (in other words, the usual ―t-ratios‖ will not follow a t-distribution, and the F-statistic will not follow a F-distribution)

Thus, though results related to the long-run and short-run relationships between exchange rate and trade balance are not consistent among studies, they do indicate the positive impact of exchange rate on trade balance in long-run and negative impact of the former on the latter in the short run The reasons behind different results among studies mainly rely upon the observation period and the economic technique employed However, the two most popular modeling techniques to explore long-run relation are Johansen cointergration analysis and ARDL Based on the obtained long-run equation, ECM is used to explore short-run relation

2.4 The role of exchange rate policy to trade balance

2.4.1 Exchange rate policy concepts

As one of key components of monetary policy, exchange rate policy, in broad meaning, is all activities of government (usually represented by central bank) to intervene into supply of and demand for foreign exchange in the economy through a chosen exchange rate regime (in other words, exchange rate mechanism) and an intervening instruments system to obtain specific target of this policy in particular and general target of monetary policy

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As an unseparated component of monetary policy, targets of exchange policy must unify or be accordant with those of monetary policy According to Ohno (2003), there are many possible goals of exchange rate policy for macroeconomic authorities of developing countries, including: competitiveness, price stability, current account adjustment, domestic financial stability, public debt management, prevention of currency crisis, minimizing the impacts of various external shocks, promoting growth, FDI and industrialization

Exchange rate policy in each country usually comprises two components: (i) the choice of exchange rate regime; (ii) a system of instruments so that central bank can use to intervene into fluctuation of exchange rate

2.4.2 Exchange rate regimes

Every country that has its own currency must decide what type of exchange rate arrangement to maintain (Aleksandra Sozovska, 2004) Exchange rate regime may be explained as the method that is employed by the governments in order to administer their respective currencies in the context of the other major currencies of the world

In academic discussion, there are three basic methods that governments can choose to follow - the floating exchange rate, the fixed or pegged exchange rate and the managed floating exchange rate

If a government decides to follow floating exchange rate regime, it must allow national currency to fluctuate under market forces without intervention In this regime, central bank has no responsibility for the fluctuation of exchange rate The movement of exchange rate determined by supply of and demand for currencies in the market, therefore, is unexpected which acts as a tax on trade and, more importantly, a tax on investment in traded-goods industries The extremely floating exchange rate like this does not exist nowadays since central banks frequently intervene to avoid excessive appreciation or depreciation

In reverse, if a government decides to follow fixed exchange rate regime, it will match national currency’s value to the value of another single currency or to a basket

of other currencies, or to another measure of value, such as gold This exchange rate

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regime is appropriate for small open countries to stabilize the value of their currency against the currency they are pegged to Because currency following this regime is always under pressure of fluctuation, central bank must do a lot to maintain the official exchange rate to response movements of market forces

Finally, if a government decides to follow managed floating exchange rate regime,

it neither pegs nor leaves its currency to be set by the market but try to manage it to a certain degree According to Hu Xiaolian (2010), the content of the managed floating exchange rate regime includes three aspects First, the floating of exchange rate is based on market supply and demand so that the exchange rate plays a role as a price signal Second, the range of floating adjustment is based on trade and current account balances to reflect the "managed floating" nature Third, the exchange rate is determined with reference to a basket of currencies

Extremely floating and pegged exchange rate regime were prevalent in history such as the regime between two World Wars and the regime in Bretton Woods System respectively Nevertheless, history shows that these two regimes contain many vital problems to open economies While pegged exchange rate regime under Bretton Woods System is vulnerable to speculative attacks, floating exchange rate regime ignores the role of central bank against one of important variables in open economy and causes cost to international transactions That is the reason why there is now consensus that central banks should closely observe performance of exchange rate and have appropriate intervention into its

Besides, as an international organization exercising surveillance over the effective operation of the international monetary system, the International Monetary Funds (IMF) arranges nine exchange rate regimes into three basic academic categories according to their degree of flexibility (Table 2.1)

Table 2.1 – Exchange rate regimes classification by IMF

Fixed-rate regimes Intermediate regimes Flexible regimes Currency unions Horizontal bands Managed floats

Independent/ Pure floats

Source: IMF

Because there is no single exchange rate regime best for all countries in all circumstances, IMF suggests that countries should choose the regime tailored for their

national policies and circumstances

2.4.3 Instruments of exchange rate policy

Depending on the sensitivity of instruments on supplies of or demands for foreign exchange, instruments of exchange rate policy can be divided into two groups:

to their short-term liabilities and international settlements which measure demands for foreign currencies in the short run In the other hands, direct intervene through foreign exchange market may also changes currency base, then affects total money supply in the economy which can cause pressure on inflation or deflation if central banks do not use neutralized instruments

Besides, other administrative tools can directly affect on supply of and demand for foreign currencies such as force to resell foreign currencies, regulations to restrict subjects buying and trading foreign exchange… Although these tools are directly and strongly effective, central banks in market economy are not encouraged to use due to their administrative force

2.4.4.2 Indirect instruments

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Indirect instruments are used when central banks do not want to cause immediate effect on exchange rate however central banks can finally obtain purpose through adjusting other macroeconomic variables such as

- Rediscount rate Ceteris paribus, a rise in rediscount rate can increase market interest rate which attracts inflow foreign capitals as a result cause exchange rate to decrease

- Required reserve in foreign currency By adjusting required reserve ratio, central bank can cause impact on cost of foreign capital that make change

to deposit rate in foreign currency finally make change to supply of or demand for foreign currency

- Ceiling deposit rate By applying a unattractive-ceiling deposit rate to commercial banks, central bank can directly affect on supply of foreign currency on foreign exchange market because depositors will exchange foreign currencies for home currency and deposit home currency with much higher interest rate

2.4.4 The importance of exchange rate policy to trade balance

In classic trade theory, exchange rate plays no role in determining competitiveness The standard trade model suggests that determinants of international competitiveness comprise entrepreneurial activities, accumulation of resources, and product-process innovation Thus, the conventional trade theories do not stress any role of exchange rate policies in improving international competitiveness (Le Dang Trung, 2009)

However, since exchange rate policy focuses on controlling movements of exchange rate to obtain policy target in short and long run, an undeniable role of exchange rate policy, as Mussa (1984) pointed out, is to set relative prices between tradables in terms of non-tradables, then, intervene into competitiveness Although, using the exchange rate policy as an instrument for the government to affect trade competitiveness and thus, the trade balance, is still controversial as there is considerable disagreement concerning the effectiveness of devaluation as a tool for

2008, trade surplus of China to the world reached record at USD295.5 billion (Republic of China General Administration of Customs, Global Trade Atlas) Although what causes the China’s trade balance phenomenon is now still on debate, some key reasons are pointed out, among which the role of exchange rate policy costs much attention As an evidence, Staiger and Sykes (2008) studying the foreign exchange policies of China over the past 15 years show that China has intervened in the foreign exchange markets through selling the Renminbi and buying foreign currencies so that the Renminbi has been marketed at prices lower than its values In order words, Bank of China undervalues its currency for long time to increase competitiveness of China’s goods relative to trading partners’ goods, as a result, China achieves tremendous surplus trade balance to the rest of the world The foreign exchange policy to undervalue Renminbi is certainly just one of main reasons leading

to success of China’s foreign trade, it is valuable lesson for developing countries due

to China’s persistency not to appreciate Renminbi value regardless pressure from trading partners

Another typical case is Korean miracle in period of 1962-1980 which stands out as the mode model of export-driven industrialization which sets target to change comparative advantage of the country that attained by ―correct‖ pricing and ―realistic‖ exchange rate policies (Kwan S Kim, 1991) Along with other policies to stipulate export, the Korean government implemented exchange rate reform in 1962, following which the won was devalued from 130 to 255 won per dollar and gradually decreased

in later years when exchange rate controls were liberalized The devaluation was based on a study comparing world and domestic prices, with the new rate reflecting the median purchasing power parity in international markets The effective exchange

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rate for exports accordingly increased rapidly from 264 in 1962 to 320.9 in 1975 causing competitiveness increase of Korea in foreign trade What noticeable in this case is that the government, in addition to periodic devaluations, continued to adjust export incentive rates between devaluations in order to maintain the incentive rate at a relatively stable level in the face of more rapid inflation domestically than abroad The successfulness of these governments is persuasive evidence for the role of exchange rate policy to trade balance Nonetheless, each economy reacts differently to exchange rate changes than insular ones It is recommended that exchange rate policy manipulation should not be overused and it cannot do the work alone, out of the macroeconomic context and without supporting macroeconomic policies because the exchange rate as a policy instrument can have more effects in addition to the impact

on trade competitiveness (Dornbusch, 1996) Also, McKinnon and Ohno (1997) have shown already that in open economies, exchange rate changes may have unpredictable effects on trade balances In other words, with the correct setup of models for an open economy, depreciation may not improve the trade balance and appreciation may not make it deteriorate Therefore, when the decision on using the tool is made, there are two important factors that the government should take into consideration: the magnitude of a necessary change (depreciation/appreciation) and the duration of the policy

Chapter summary

Each open economy nowadays trades with many foreign counterparties, thus, government no longer concern the competitiveness between its country with any single trading partner but with all trading partners REER index taking into account trade shares of each trading partner is best reflects the competitiveness of a country relative to its trading partners therefore it is used in most studies to explore the impact

of exchange rate on trade balance Although the conclusions do not unify for all cases, many studies show strong influence of exchange rate on trade balance in short and long run Also, the successfulness of some government when using exchange rate as key measurement to improve trade balance proves undeniable role of exchange rate

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policy to trade balance Controlling trade balance now becomes important responsibility of all government due to its key determinant to current account However, there is no common formula for all countries to successfully improve trade balance with exchange rate measurement Exchange rate may be effective in one country but not in others, therefore, depending on macro-economic condition, government of each country has to use exchange rate with its own and unique formula

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Chapter 3:

PERFORMANACE OF TRADE BALANCE AND EXCHANGE RATE

IN VIETNAM IN 2000-2010

3.1 The background of Vietnam’s economy in 2000-2010 period

As a transitory and developing country, Vietnam is classified into group of countries with highest economic growths From the Renovation (Doi Moi) Policy, Vietnam has successfully maintained annual average economic growth rate of 7 percent which allows the economy to double its scale over a decade For this performance, IMF and World Bank assume Vietnam’s economy’s growth to be miraculous and typical among transitory countries

Table 3.1 - GDP, Inflation, FDI, FII, ODA, Current transfer in 2000-2010

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 GDP

growth* 6.8 6.9 7.1 7.3 7.8 8.4 8.2 8.5 6.2 6.3 6.78 Inflation

rate* -0.6 0.8 4 3 9.5 8.5 6.6 12.6 19.9 6.88 11.75 FDI ** 1298 1300 1400 1450 1610 1889 2315 6550 7800 4000 11000

Current

transfer** 1921 1250 1921 2239 3093 3380 4049 6430 7000 4100 3879

* in percentage (%); ** in million USD;

Source: GDP growth and inflation rate are from General Statistic Office (GSO); FDI, FII, Current transfer are from International Financial Statistics (IFS)

The period of 2000-2010 witnesses important and significant milestones in development process of Vietnam In the first two years, the economy has not entirely recovered since the East Asia crisis, its growth rate, as a result, was below the average

of 10 years before However, the US-Vietnam Bilateral Agreement coming into force from the end of 2001 opened new opportunities for the economy to cooperate with the largest economy of the world In addition, since 2002, thanks to policies to ameliorate investment environment, develop market-driven financial institutions, stipulate privatization and equitization process, and increase percentage of shares held by foreign investors in equitised state-own enterprises, foreign direct investment (FDI) has found way to return Moreover, the boom of the stock market from 2005

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highlighted Vietnam with the hottest one among other investment destinations, thus, helping the economy to raise funds from not only local but also foreign investors That the government of Vietnam successfully issued 750 million USD bonds in New York Stock Exchange in the last quarter of 2005 also rose the position of Vietnam to a higher level in eyes of international investors Besides, on recognizing the importance

of current transfer of overseas compatriots, the government promulgated policies to simplify administrative formalities as a result of which current transfer increased year-by-year Associating with internal resources, all above external resources contributed indispensable capital to the economy on growing momentum, thereby, it took back growth rate above 7.5 percent in the background of inflation under control from 2004 to 2006 (Table 3.1)

At the beginning of 2007, Vietnam marked another milestone on her development process with the event of officially becoming a member of The World Trade Organization (WTO), thanks to which the economy continues to integrate more deeply and broadly into the world economy Spectacularly, along with more improving and opening policies to attract external resources, remittances, foreign direct and indirect investments (FII) strongly increased more than expected, creating impulse for the economy to reach the highest growth rate at nearly 8.5% in the same year The economy kept growing well within the first half of 2008, however, high inflation which occurred at the end of 2007 turned out to be out of control in the second half of the year and unluckily accompanied with the global financial crisis breaking out at the same time As an unevitable result, GDP growth rate decreased at 6.2 percent and the macro-economy fell into instability with hyperinflation at 19.9 percent Unlike previous crisis, the financial crisis in 2008, in some ways, shows the integration of Vietnam’s economy is deep enough to be affected by fluctuation in the global economy, warning the government about coming threats

From 2009, in the common context of global economy, external resources for development such as FDI, FII, remittance declined greatly, putting internal resources

in charge of helping the economy to overcome crisis It was the effectiveness of