EXCHANGE RATE POLICY AND TRADE BALANCE a CASE STUDY OF VIETNAM

MINISTRY OF EDUCATION AND TRAINING FOREIGN TRADE UNIVERSITY DISSERTATION EXCHANGE RATE POLICY AND TRADE BALANCE: A CASE STUDY OF VIETNAM Major: International Trade Policy and Law NG

MINISTRY OF EDUCATION AND TRAINING

FOREIGN TRADE UNIVERSITY

DISSERTATION

EXCHANGE RATE POLICY AND TRADE BALANCE:

A CASE STUDY OF VIETNAM

Major: International Trade Policy and Law

NGUYEN PHUONG DUNG

Ha Noi - 2017

MINISTRY OF EDUCATION AND TRAINING

FOREIGN TRADE UNIVERSITY

DISSERTATION

EXCHANGE RATE POLICY AND TRADE BALANCE:

A CASE STUDY OF VIETNAM

Major: International Trade Policy and Law

Full Name: Nguyen Phuong Dung SUPERVISOR: DR NGUYEN PHUC HIEN

Ha Noi - 2017

I will be entirely responsible for the dissertation‘s contents

Hanoi, December 5th 2016

Author

Nguyen Phuong Dung

ACKNOWLEDGEMENT

The dissertation has been completed under the guidance of Dr Nguyen Phuc Hien I would like to express my sincerely thanks for his great knowledge and enthusiasm supports for my research

Besides, I would like to thank my family, my colleagues who have given me lots of facilitation, cares, and encouragement during my research period

By this occasion, I am much grateful to the Department of Graduate Studies and Foreign Trade University - who have always create the most favorable conditions for MITPL3 to complete our research program

TABLE OF CONTENTS

INTRODUCTION 1

1 The importance of research 1

2 Research purpose 2

3 Scope of the research 2

4 Research Methodology 3

5 Structure 3

LITERATURE REVIEW 4

CHAPTER 1: 9

THEORY OF EXCHANGE RATE POLICY AND TRADE BALANCE 9

1.1 Exchange rate 9

1.1.1 Definition of exchange rate 9

1.1.2 Exchange rate policy and regime 14

1.2 Trade balance 21

1.2.1 Definition of trade balance 21

1.2.2 Factors affecting trade balance 21

1.3 Impacts of exchange rate policy on trade balance 24

1.3.1 Concept of currency devaluation 24

1.3.2 J-Curve Effect 25

1.3.3 Marshall-Lerner Condition 26

CHAPTER 2: 28

EXCHANGE RATE POLICY AND TRADE BALANCE IN VIETNAM 28

2.1 Overview of exchange rate policy and trade balance in Vietnam 28

2.1.1 Exchange rate policy of Vietnam 28

2.1.2 Trade balance of Vietnam 46

2.2 Empirical study on the impacts of Vietnam exchange rate policy and the

trade balance 58

2.2.1 Methodology 58

2.2.2 Empirical Result 63

CHAPTER 3: 69

RECOMMENDATIONS ON EXCHANGE RATE POLICY TO IMPROVE TRADE BALANCE 69

3.1 Orientation of Vietnam in the context of deeper economic integration 69

3.2 Recommendation on exchange rate policy of Vietnam to improve trade balance 71

3.2.1 Moving to a flexible exchange rate 71

3.2.2 Coordination between exchange rate policy and other macro policies 74

CONCLUSION 79

REFERENCES 81

APPENDIX

DATA DESCRIPTION 86

LIST OF ABBREVIATION

ASEAN Association of Southeast Asian Nation

CPI Comsumer Price Index

EU European Union

FDI Foreign Direct Investment

IFS International Financial Statistics

IMF International Monetary Fund

OER Offical exchange rate

USA United States of America

USD United States dollar

VND Vietnamese dong

WTO World Trade Oranization

LIST OF TABLES

Table 1: Exchange rate arrangements 18

Table 2: Advantages and disadvantages of each exchange rate regime 19

Table 3: Exchange rate amplitudes adjustment, 1996 - 2000 32

Table 4: Exchange rate amplitudes adjustment, 2001 - 2007 33

Table 5: Exchange rate amplitudes adjustment, 2008 - 2015 39

Table 6: Exchange rate adjustment, 2008 - 2015 39

Table 7: Vietnam's exchange rate regimes, 1989 - 2016 42

Table 8: Vietnam‘s macro-economic data, 1996 - 2000 48

Table 9: Export - Import market structure, 2000 - 2005 50

Table 10: Vietnam‘s macro-economic data, 2001 - 2007 51

Table 11: Export - Import market structure, 2005 - 2015 54

Table 12: Vietnam‘s macro-economic data, 2008 - 2015 56

Table 13: Export - Import between Vietnam and US 57

Table 14: Correlation 63

Table 15: Lag order selection criteria 64

Table 16: Short run variance decompositions 65

Table 17: Johansen 66

Table 18: Long run variance decompositions 67

LIST OF FIGURES

Figure 1: NEER calculation 11

Figure 2: REER caculation 12

Figure 1: J-Curve Effect in currency devaluation 26

Figure 2: Vietnam inflation rate, 1980 - 1996 29

Figure 3: VND/USD exchange rate, 1996 - 2000 31

Figure 4: VND/USD exchange rate, 2001 - 2007 33

Figure 5: VND/USD exchange rate, 2008 - 2015 34

Figure 6: VND/USD exchange rate in 2016 41

Figure 7: VND/USD NBER and RBER, period of 1996 - 2000 47

Figure 8: Exchange rate and trade balance, 1996 - 2000 47

Figure 9: VND/USD NBER and RBER, 2001 - 2006 49

Figure 10: Exchange rate and trade balance, 2001 – 2007 50

Figure 11: VND/USD NBER and RBER, 2008 - 2015 52

Figure 12: Exchange rate and trade balance, 2008 - 2015 53

Figure 13: Trade balance in 2016 55

Figure 14: Short run Impulse response function 64

Figure 15: Short run variance decompositions 65

Figure 16: Long run Impulse response function 66

Figure 17: Long run variance decompositions 67

SUMMARY

The dissertation with the topic of ―Exchange Rate Policy and Trade Balance:

A case study of Vietnam‖ has reiterated several theories about the exchange rate, exchange rate policy and trade balance, the factors affecting the exchange rate and the trade balance, the J-curve Effects and Marshall-Lerner conditions Besides, the authors also summarize the exchange rate policy, the trade balance of Vietnam over the periods since the Renovation (Doi Moi)

Besides, in empirical study, by using the VAR model, the study has analyzed the impact of the real bilateral exchange rate of VND versus USD and the trade balance of Vietnam focusing on the quarterly data of the period of 2007 Q1 – 2016 Q2 (after Vietnam‘s accession to the WTO)

The empirical study shows that in the case of Vietnam: (1) the movement of exchange rate only slightly affects trade balance (2) not only the exchange rate but also other factors have a significant impact on trade performance in Vietnam (3) GDP has the largest effect to trade balance

Based on the result, the author gives some recommendation on improving the trade balance, including: (1) Increasing the management floating (2) Coordination between exchange rate policy and other macro policies

INTRODUCTION

1 The importance of research

The trade deficit is a matter of great concern to the countries around the world, due to its impact on the macro-economic balance As a WTO member involved in the process of international economic integration, Vietnam has faced many challenges, including the problem of trade deficit According to data from the General Statistics Office, the trade balance of Vietnam often falls into serious deficits Therefore, when performing a macroeconomic research, we could not disregard this unsettled problem

On December 28th, 2011, Prime Minister Nguyen Tan Dung has issued the Decision 2471/QĐ-TTg1 that approved The Strategy on export and imports for the period of 2011-2020, with visions to 2030 The overall targets were set with the total export turnover in 2020 should triple in 2010, with a per capita average of over USD 2,000; the trade balance is secured Specific targets were given as following:

- The average growth rate of exports should be 11-12% per year in 2011-2020,

or 12% in 2011- 2015 and 11% in 2016-2020 The figure should be kept at 10% in 2021-2030

- The growth rate of imports should be lower than that of exports, standing at 10-11% on average per year in 2011-2020, or below 11% in 2011-2015 and below 10% in 2016-2020

- It is necessary to gradually reduce the trade deficit and keep the excess of import over export below 10% of the export turnover by 2015 so as to guarantee the trade balance by 2020 and reach trade surplus in 2021-2030

The prerequisite for Vietnam to achieve the above objectives is to ensure the coordination between macroeconomic policies, including exchange rate policy The exchange rate is an important variable in the open economy and implementing the exchange rate policy is very important for each country Exchange rate interacts closely with macroeconomic indicators such as interest rates, inflation, economic

1 http://www.chinhphu.vn/portal/page/portal/English/strategies/strategiesdetails?categoryId=30&art cleId=10051303

growth and the international balance of payments In particular, the mutual interaction between these variables is deeper in the countries applying the fixed exchange rate or managed floating, or anchored to a currency regime

Currently, there are many controversial issues surrounding the exchange rates

of Vietnam There are two conflicting views The first point that the real exchange rate of Vietnam is overvalued, so the devaluation is necessary to promote exports and restrict imports The second opinion is from the State Bank; the devaluation has

no impact on Vietnam trade balance due to the exports of VN is inelastic by price (Governor Le Minh Hung – SBV)

Is Vietnamese currency overvalued or low? And how can it affect the balance

of trade of Vietnam? Can Vietnam's exchange rate policy meet the goal of improving the trade balance? Therefore, this dissertation will research the relationship between exchange rates and trade balances in the case of Vietnam

2 Research purpose

To answer the questions:

- Whether the changes in exchange rate influence the trade balance in Vietnam?

- What is the most effective exchange rate policy for Vietnam to improve trade balance?

3 Scope of the research

- Focusing on the impact of real exchange rate of US dollar against VND on

trade balance over period 2007 – 2016

- The data: The data is mainly collected from the data sources of the International Monetary Fund (IMF) and Vietnam General Statistical Office (GSO), the State Bank of Vietnam (SBV) Other data is from the Ministry of Finance, World Bank (WB), Asian Development Bank (ADB) In case there are some difference between the data of GSO, SBV and IMF and the author decide to choose

the data from IMF

4 Research Methodology

In the study, the author use some research methods such literature study, comparative study, quantitative analysis Besides, the dissertation used vector auto regression (VAR) model for research goal Exchange rate, trade balance and gross domestic product (GDP) are interdependence relationships, therefore VAR model is one of the most successful, flexible, and easy to use models for the analysis of multivariate time series It is a natural extension of the univariate autoregressive model to dynamic multivariate time series The VAR model has proven to be especially useful for describing the dynamic behavior of economic and financial time series and for forecasting

The study applies VAR model to confirm if the causal relationships among variables exist and what impact directions of the relationships are The study also computes impulse response functions to know the impact of a shock in depreciation

on trade balance and computes variance decomposition to understand the role of exchange rate in the variance of trade balance

5 Structure

The dissertation includes 3 chapters as follow:

Chapter 1: Theory of exchange rate policy and trade balance

Chapter 2: Exchange rate policy and the trade balance of Vietnam

- Overview of exchange rate policy and the trade balance of Vietnam

- Empirical study on the impacts of Vietnam‘s exchange rate policy and the trade balance

Chapter 3: Recommendations on exchange rate policy to improve the trade balance

LITERATURE REVIEW Kirstian Nilsson and Lars Nilson (2000) in their paper ―Exchange rate

regimes and Export Performance of Developing Countries‖ have analyzed the exports of 100 developing countries to the EU‘s member countries, Japan, USSA and covers some 70-80% of these developing countries and the net effects of developing countries‘ choice of exchange rate regime on their exports The issue should be highly relevant for policy makers since export-led growth is often put forward as a main development strategy for developing countries The authors introduced a gravity model for estimating the exporting effects of different

exchange rate regimes for the period 1983 to 1992 using OLS The results indicated

that the more flexible the exchange rate regime, the greater the exports of developing countries, holding other things constant The result is stable over time

The fact that the number of developing countries under the various exchange rate regimes has fluctuated substantially over the study period implies that the results are quite robust The findings may be interpreted such that the net effects on exports of real exchange rate misalignments (over and undervaluation) are negative, and that these effects dominate the potentially negative export effects of exchange rate volatility in relation to the invoicing currency of exports

Tihomir Stucka (2004), in his paper ―The Effects of Exchange rate change

on the Trade Balance in Croatia‖, aimed at a formal quantitative estimate of the long-run and short-run impacts of exchange rate changes on the merchandise trade balance The author utilized three different econometric techniques - the ARDL

approach The results seem to suggest that improvement of the trade balance after a

permanent devaluation/depreciation is very limited A 1% permanent devaluation

results in a new equilibrium level, which is 1.34% above the old equilibrium, at best Also, the initial adverse effect in the shape of a J-curve phenomenon might be significant Hence, before drawing conclusions from the estimated reduced form model one has to weigh trade balance benefits with potential unfavorable effects of

a permanent depreciation

Dinh Thi Thuy Vinh (2007) in her paper ―The Impact of Real Exchange

Rate on Output and Inflation in Vietnam: A VAR approach‖ Vietnam using VAR approach‖ showed that although the main sources of variance in output and price level are ―own shocks‖, innovations in the real exchange rate account for a higher proportion of the variation of output than that of price level A real devaluation has positive impact on both output and inflation The devaluation shock may affect inflation and output growth via raising money supply and improving trade balance However, the real exchange rate changes do not have a significant effect on output

in the long run The results derived in this study support the argument that Vietnam should move to a more flexible exchange rate regime, or Vietnam should not insist

on controlling the exchange rate while being under pressure of economic integration that forces the exchange rate regime to a more floating one The study showed that greater flexibility of the exchange rate will help the economy improve its trade balance and increase the output growth, while the inflation situation is not seriously affected Furthermore, when Vietnam fully integrates into the world economy in the near future, it will face more foreign competition and external shocks while the functions of other macroeconomic instruments such as tariffs or export subsidies are restricted Then, greater flexibility would facilitate adjustments to external shocks and rapid structural changes, and allow for a further strengthening of Vietnam‘s exchange reserve situation The change of US interest rate should be taken into consideration in planning and carrying out monetary policies In addition, in the long-run, the impact of real exchange rate on the output level, though positive, but not so statistically significant Therefore, not the exchange rate instrument, but enterprise efforts, structural or institutional reforms are the main sources for improving the competitiveness of the economy

Ng Yuen-Ling, Har Wai-Mun, Tan Geoi-Mei (2008), in their paper ―Real

Exchange Rate and Trade Balance Relationship: An Empirical Study on Malaysia‖,

attempted to identify the relationship between the real exchange rate and trade balance in Malaysia from the year 1955 to 2006 The study used Unit Root Tests, Cointegration techniques, Engle-Granger test, Vector Error Correction Model

(VECM), and impulse response analyses In the research, the results support the

empirical validity of the Marshall-Lerner condition through VECM, indicating that depreciation has improved the trade balance This result has further confirmed

through the empirical work reported by Baharumshah (2001) The empirical work for a different set of countries that reported by Shirvani and Wilbratte (1997), Sugema (2005), Akbostanci (2002) and Thorbecke (2006) are also suggested Marshall-Lerner condition exists However, VECM analysis does not find the evidence of the short term worsening of trade balance suggested by the J-curve

effects Thus, by using impulse response functions, the result show that Malaysian

trade balance has not followed the J-curve pattern of adjustment or in another word, the result shows no evidence for the J-curve hypothesis This result is

consistent with Baharumshah (2001) The empirical work for different set of countries that reported by Rose and Yellen (1989), Akbostanci (2002), Ahmad and Yang (2004), Gomez and Alvarez-Ude (2006), also suggested that no evidence of J-curve effects The author implicated that, in order to achieve the desired effects on trade balance, the countries should depend on policy that focusing on the variable of real exchange rate, which is the nominal exchange rate to aggregate price level At the same time, the devaluation-based policies (affected through changes in nominal exchange rate) must cooperate with stabilization policies (to ensure domestic price level stability) to achieve the desired level of trade balance However, devaluation-based policies had caused some problem Devaluation-based policies would cause increases in the cost of import This might lead to import inflation that would damage the domestic firms that use imported inputs Besides that, the devaluation-based policies may not effective in improving trade balance if other countries also apply the devaluation-based policies at the same time On the other hand, the countries should implement the policy that focuses on the production of imported-substituted goods Import-substitution policy may work well in improving domestic income and trade balance

Elif Guneren Genc and Oksana Kibritci Artar (2014) in their paper ―The

Effect of Exchange Rate on Exports and Imports of Emerging Countries‖ have determined the impact of exchange rates on imports and to investigate the impact of exchange rates on exports of economically developing countries This paper

focused on establishing whether there is a co-integrated relationship between effective exchange rates of selected emerging economies The study applied the

methodology of the co-integration Panel Mode for the period of 1985-2012 The

result of this study shows that there is co-integration between real effective exchange rate and export-import of emerging economies in the long run In total 5

of 22 emerging countries (Bolivia, Cameroon, Dominica, Gabon and Mexico) have both long-term relationship and short-term parameters and are statistically

significant It is concluded that overall findings indicate that exchange rate effects

support the expected results for the selected emerging countries

Nicola Kim Rowbotham, Adrian Saville & Douglas Mbululu (2014) in

their paper ―Exchange Rate Policy and Export Performance in Efficiency-Driven Economies‖ have examined the impact of exchange rate on export performance in a sample of nine efficiency-driven economies over the period 1990 to 2009 (Brazil, the Dominican Republic, Malaysia, Mauritius, Mexico, Peru, South Africa, Thailand and Turkey, which all have floating exchange rate arrangements during the survey period) They used Panel data models with fixed-effects method The purpose of the research was to assess whether efficiency-driven economies, developing could achieve export growth through the price competitiveness effect that is brought about by currency depreciation In this regard, Prebisch (1964) developed the early arguments that currency weakness was a means to boost export performance through price competitiveness Subsequent research has produced mixed results and has tended to be limited in terms of sample size and survey

period Hence, further research in this field is justified Their principal finding in

this regard, which extends to a sample of 9 economies over a period of twenty years, is that a weakened currency does not improve export performance Contrary

to popular thinking, their findings show that export growth is associated with currency strength in the case of efficiency-driven economies with flexible exchange rate regimes Moreover, when they allow for lag effects of exchange rate movement, the impact on export performance is slightly more pronounced – although the explanatory power of currency moved is statistically insignificant in

the lagged specifications of our model Moreover, they found that any explanatory

power afforded by currency is superseded by the explanatory power of GDP growth It suggests that export growth may be impacted to a greater extent by income than price

Ramesh C Paudel and Paul J Burke (2015) in their paper ―Exchange rate

policy and export performance in a landlocked developing country: The case of Nepal‖ have examined the implications of Nepal‘s exchange rate policy for its export performance over the period 1980–2010 The authors first documented Nepal‘s long-standing currency peg against the Indian rupee and that Nepal‘s real

exchange rate appreciated substantially from the late 1990s They used a gravity

modeling approach to confirm that this real exchange rate appreciation has adversely affected Nepal‘s exports, especially to third-country markets Nepal‘s

exchange rate-related export competitiveness trap provides a motivation to reconsider the current peg

In conclusion, theoretical and empirical research proved that there is a relation between trade balance and exchange rate policy and policy makers can use the exchange rate to manage export and import performance to reach the trade balance target However, both exchange rate and trade balance are affected by many different factors that make their relationship difficult to understand and difference

to each country It requires countries to scrutinize and adopt the flexible measure to

achieving trade balance target

1.1.1.2 Classification of exchange rate based on the relations between these currencies:

Exchange rate is classified based on many criteria: Business transactions (Bid rate – Ask/Offer rate), Maturity (spot, forward), Market (official rate – market rate) and the relationship between currencies Classification according to the relationship between currencies is an important criterion, applied in objectives research on competitiveness in trade between countries In the process of understanding the competitiveness of prices of goods and services between

countries, instead of using the exchange rate, the researchers often use the index rate (evaluated at a base year) for comparison The exchange rate index includes:

- Nominal Bilateral Exchange Rate (NBER): NBER is the actual quote for a currency versus another currency without mentioning the inflation differences between the two countries

- Real exchange rate (RBER): Real exchange rate consists of the rate of exchange rate adjusted for purchasing power

RBER: real exchange rate

NBER: The nominal bilateral exchange rate

Pf: Foreign price level Ph: Domestic price level

If RBER = 1, domestic currency and foreign currency has the same purchasing power parity (PPP)

If RBER > 1, domestic currency is undervalued This will help to encourage export and restrict import

If RBER < 1, domestic currency is overvalued, the price of product in domestic will be higher than in the foreign country It will help to restrict export and increase import

- Nominal Effective Exchange Rate (NEER): NEER is not an exchange rate NEER is an index that is an unadjusted weighted average rate at which one country's currency exchanges for a basket of multiple foreign currencies This basket of foreign currencies is chosen on the basis of the domestic country's most important trading partners, as well other major currencies

Unlike the relationships in a nominal exchange rate, NEER is not determined for each currency separately Instead, one individual number, typically an index, expresses how a domestic currency‘s value compares against multiple foreign currencies at once

If domestic currency increases against a basket of other currencies inside a floating exchange rate regime, NEER is said to appreciate If the domestic currency falls against the basket, the NEER depreciates

Figure 1: NEER calculation

Source: Author’s description based on NEER definition.

In economics, the NEER is an indicator of a country's international competitiveness in terms of the foreign exchange market

The NEER just only describes the relative value; it cannot definitively show whether a currency is strong or gaining strength in real terms It only describes whether a currency is weak or strong, or weakening or strengthening, compared to foreign currencies With all exchange rates, the NEER can help identify which currencies store value more or less effectively Exchange rates influence where international actors buy or sell goods NEER is used in economic studies and for policy analysis about international trade

- Real effective exchange rate (REER): Is the weighted average of a country's currency relative to an index or basket of other major currencies, adjusted for the effects of inflation The weights are determined by comparing the relative trade balance of a country's currency against each country within the index In other ways, the NEER may be adjusted to compensate for the inflation rate of the home country relative to the inflation rate of its trading partners and the resulting figure is the REER

The REER is used to measure the value of a specific currency in relation to an average group of major currencies The REER takes into account any changes in

𝑒𝑛𝑖= Ei/𝐸𝑛𝑖 𝒆𝒋𝒊 𝒘𝒋

𝒏

𝑱=𝟏

NEER

relative prices and shows what can actually be purchased with a currency This means that the REER is normally trade-weighted

By calculation, the REER is derived by taking a country's NEER and adjusting it to include price indices and other trends The REER, then, is essentially

a country's NEER after removing price inflation or labor cost inflation The REER represents the value that an individual consumer pays for an imported good at the consumer level This rate includes any tariffs and transaction cost associated with importing the good Besides, the REER can also be derived by taking the average of the bilateral real exchange rates (RER) between country and its trading partners and then weight it using the trade allocation of each partner Regardless of the way in which REER is calculated, it is an average and considered in equilibrium when it is overvalued in relation to one trading partner and undervalued in relation to a second partner

A country's REER is an important measure when assessing its trade capabilities and current import/export situation The REER can be used to measure the equilibrium value of a country's currency, identify the underlying factors of a country's trade flow, look at any changes in international price or cost competition, and allocate incentives between tradable and non-tradable sectors

A country can positively affect its REER through rapid productivity growth When this happens, the country realizes lower costs and can reduce prices, thus making the REER more advantageous for the country

Figure 2: REER caculation

Source: Author’s description based on REER definition.

Exchange

rates (E it )

Weight (w it )

Averaging Formula

1.1.1.4 Factors that influence exchange rate:

- Interest rates

+ Interest rate differential between local currency and foreign currency

According to the study of John Maynard Keynes about the Interest Rate Parity theory (IRP), the equilibrium of foreign exchange market requires the equilibrium

of interest rates; interest rates of deposits in two different currencies must be the same when converting into one currency Keynes has explained that under normal conditions, arbitrage opportunities will prevail until forward prices are in line with interest rate differential As a result, interest differential is offset by profit or loss on the forward market Thus, the lower interest rate on one country‘s currency will be compensated by higher forward price compared to that of the currency of the country with higher interest rates

+ Foreign currency interest rate difference between domestic and foreign market

When a country has higher interest rate on foreign currency deposits in comparison with that of another country, capital will flow into the country with higher interest rate This inflow would push the supply of foreign currency up Because of the exogenous factor, the supply curve of USD moves rightward; the exchange rate will go down

However, sometimes the interest rate differential did not make the change in exchange rate These situations normally happen when an economy is in unstable, potentially crisis-like, condition Under that situation, even though how high the interest rate would be, investors will not risk their capital to earn profit from interest rate differential A typical example of the situation is the economic crisis during the period of 1971-1973; the interest rate in New York market was 1.5 times that of London market, triple that of Frankfurt market but the short-term capital flow were not directed to New York but Western Germany and Japan

- Inflation rate differential

If a country‘s inflation rate increases relative to the foreign country while other things being equal, the domestic currency will be depreciated Therefore, the domestic have more demand for foreign currency The export of country is relatively more expensive and the foreigners will have less demand for country‘s export Therefore, due to the increase of exchange rate (the domestic currency is devalued), the demand of foreign currency increase while the supply of foreign currency decrease

- Management policy: If the government want to protect their industries‘ competitiveness, they can use protectionism method like tariffs, tax, and other non-tax barriers…The Government can use quota to limits the import‘s volume, or increase the income tax on aboard investment or tax on imported goods to reduce the demand for foreign currency The demand for the foreign decrease and the exchange rate goes down

1.1.2 Exchange rate policy and regime

IMF suggests the discrimination of exchange rate policy regime with 4 main groups, including Hard pegs, Soft pegs, Floating regime and Residual This classification became effective on February 2nd, 2009

1.1.2.1 Hard pegs

- Exchange arrangements with no separate legal tender

The currency of another country circulates as the sole legal tender (formal dollarization), or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union

Adopting such regimes implies the complete surrender of the monetary authorities' independent control over domestic monetary policy

- Currency board arrangements

A monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation

This implies that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets, eliminating traditional central bank functions, such as monetary control and lender-of-last-resort, and leaving little scope for discretionary monetary policy Some flexibility may still be afforded, depending on how strict the banking rules of the currency board arrangement are

1.1.2.2 Soft pegs

- Conventional fixed peg arrangements

The country formally pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed from the currencies of major trading or financial partners and weights reflect the geographical distribution of trade, services, or capital flows The anchor currency or basket weights are public or notified to the IMF

The country authorities stand ready to maintain the fixed parity through direct intervention (i.e., via sale or purchase of foreign exchange in the market) or indirect intervention (e.g., via exchange-rate-related use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or intervention by other public institutions)

There is no commitment to irrevocably keep the parity, but the formal arrangement must be confirmed empirically: the exchange rate may fluctuate within narrow margins of less than 1% around a central rate—or the maximum and minimum values of the spot market exchange rate must remain within a narrow margin of 2% for at least six months

- Pegged exchange rate within horizontal bands

Classification as a pegged exchange rate within horizontal bands involves confirmation of the country authorities‘ de jure exchange rate arrangement The value of the currency is maintained within certain margins of fluctuation of at least 1% around a fixed central rate, or a margin between the maximum and minimum value of the exchange rate that exceeds 2%

It includes arrangements of countries in the ERM of the European Monetary System, which was replaced with the ERM II on January 1, 1999, for countries with margins of fluctuation wider than 1% The central rate and width of the band are public or notified to the IMF

- Stabilized arrangement

Classification as a stabilized arrangement entails a spot market exchange rate that remains within a margin of 2% for six months or more (with the exception of a specified number of outliers or step adjustments) and is not floating The required margin of stability can be met either with respect to a single currency or a basket of currencies, where the anchor currency or the basket is ascertained or confirmed using statistical techniques

Classification as a stabilized arrangement requires that the statistical criteria are met and that the exchange rate remains stable as a result of official action (including structural market rigidities)

- Crawling peg

The currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-a-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners The rate of crawl can be set to generate inflation-adjusted changes in the exchange rate (backward looking) or set at a predetermined fixed rate and/or below the projected inflation differentials (forward looking) The rules and parameters of the arrangement are public or notified to the IMF

Maintaining a crawling peg imposes constraints on monetary policy in a manner similar to a fixed peg system

- Craw-like arrangement

For classification as a crawl-like arrangement, the exchange rate must remain within a narrow margin of 2% relative to a statistically identified trend for six months or more (with the exception of a specified number of outliers), and the exchange rate arrangement cannot be considered as floating

Usually, a minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is required; however, an arrangement is considered crawl-like with an annualized rate of change of at least 1%, provided the exchange rate appreciates or depreciates in a sufficiently monotonic and continuous manner

1.1.2.3 Floating

- Floating

Floating exchange rate is largely market determined, without an ascertainable or predictable path for the rate In particular, an exchange rate that satisfies the statistical criteria for a stabilized or a crawl-like arrangement is classified as such unless it is clear that the stability of the exchange rate is not the result of official actions Foreign exchange market intervention may be either direct

or indirect and serves to moderate the rate of change and prevent undue fluctuations

in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible with floating

Indicators for managing the rate are broadly judgmental (e.g., balance of payments position, international reserves, parallel market developments) Floating arrangements may exhibit more or less exchange rate volatility, depending on the size of the shocks affecting the economy

- Free Floating

A floating exchange rate can be classified as free floating if intervention

occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or data confirming that intervention has been limited to at most three instances in the previous six months, each lasting no more than three business days

1.1.2.4 Residual

Other managed arrangement

This category is a residual and is used when the exchange rate arrangement does not meet the criteria for any of the other categories Arrangements characterized by frequent shifts in policies may fall into this category

Table 1: Exchange rate arrangements

14 Ecuador, El Salvador, Marshall

Islands, Micronesia, Kosovo, San Marino…

Arabia, Venezuela, Denmark, Cameroon, Gabon, Reb Of Congo, Kuwait, Nepal…

- Pegged exchange rate

within horizontal bands

Bangladesh, Lao P.D.R, Sudan…

Botswana

- Crawl-like arrangement 10 Croatia, Iran, Jamaica, …

3 Floating Regimes (market-determined rate)

Albania, Brazil, Colombia, Thailand, Philippines, India…

Poland, Russia, Sweden, United Kingdom, United States, EMU, Austria, Belgium, France, Germany, Italy

4 Residual

- Other managed

arrangement

20 Cambodia, Liberia, Syria,

China, Myanmar, Angola…

Source: IMF – Annual Report on Exchange Arrangement and Exchange Restrictions (AREAER) 2016

Table 2: Advantages and disadvantages of each exchange rate regime

1 Hard pegs

- Exchange arrangement with no separate legal

tender

Not subject to the risk of domestic currency depreciation ⟹ Don‘t have to raise interest rates to increase the value of the domestic currency

The central bank has no role of lender of last resort Monetary policy depends on the country of the foreign currency

- Currency board

arrangement

Ensure the stability The international balance of payments is always adjusted (When the reserve deficit

⟹ Tightening monetary ⟹ rising interest rates ⟹ stable)

Require large enough of foreign exchange reserves, tight public spending, the financial system must be strong and be closely monitored Monetary policy loses stability The economy loses the ability to adjust if there are shocks on prices

2 Soft pegs

- Conventional peg Reduce transaction costs and exchange rate

risks; in line with the smaller countries with deep integration and high inflation and of

- Vulnerable when there is speculation

- The central bank no longer holds the role

of lender of last resort

- Pegged exchange rate

within horizontal bands

- Stabilized arrangement which international trade depends on an

important partner, monetary policy is steady and reliable

- Crawling peg

- Crawl-like arrangement

3 Floating Regimes (market-determined rate)

- Floating Combining the advantages of fixed exchange

rate and floating regime

- When the economy is stable, the central bank has less intervention; exchange rate policy is relatively independent

- When economic uncertainty, there must be intervention by the central bank to reduce the volatility in the foreign exchange market

- Complex, unlisted central rate and fluctuation band

- Difficult to determine the time with it is unstable and need the central bank to intervene The too early intervention could affect foreign investment flows and narrow international trade.The late intervention could break the country's balance of trade and investment

- Free floating Not be affected by speculation, withstand the

crisis and shocks Allowing central banks implement monetary policy independently

- Short-term cash flow can fluctuate sharply

- It will be dangerous with foreign debt in foreign currency if the foreign currency‘s appreciated

1.2 Trade balance

1.2.1 Definition of trade balance

The trade balance (or balance of trade) is the difference between a country's exports and imports for a given time period (month, quarter or year ) which is caculated by the net exports (exports minus imports)

The trade balance is the largest component of the country's balance of payments Trade balance is used as a statistical tool to help to understand the relative strength of a country's economy compared to other countries' economies and the flow of trade between countries

A country that imports more goods and services than it exports has a trade deficit Conversely, a country exports more goods and services than it imports has a trade surplus The formula for calculating the trade balance can be simplified to exports minus imports; however, the actual calculation is included of some factors

A trade surplus or deficit, taken on its own, is not necessarily a viable indicator of an economy's health The numbers must be taken in context relative to the business cycle and other economic indicators such as the gross domestic product (GDP) of the country For example, in a recession, countries like to export more, creating jobs and demand in the economy In a strong expansion, countries prefer to import more, providing price competition, which limits inflation

In 2015, the European Union, Germany, China and Japan all had very large trade surpluses, while the United States, the United Kingdom, Brazil, Australia and Canada had the largest trade deficits

1.2.2 Factors affecting trade balance

Trade balance is caculated by the net exports Therefore, it is influenced by all

of the factors that influence on international trade

- Impact of National Income:

If a country‘s income level (national income) increases by a higher percentage than those of other countries, its current account is expected to decrease, other things being equal As the real income level (adjusted for inflation) rises, so does

consumption of goods A percentage of that increase in consumption will most likely reflect an increased demand for foreign goods

- Impact of Exchange Rates:

Each country‘s currency is valued in terms of other currencies through the use

of exchange rates, so that currencies can be exchanged to facilitate international transactions

Real exchange rate changes reflect national competitiveness When the real exchange rate is high, the local goods become more expensive for foreigner but foreign goods become cheaper for domestic Country's exports will be higher while imports will be lower Therefore, with a high real exchange rate, net exports will be lower and the current account deficit will be higher

According Albe (2008), because the real exchange rate is the relative price of goods and services of a country, with a rise in the real exchange rate, the domestic and foreign people will consume less domestic products and more foreign products, which leads to lower net exports

The economists often use the J curve to explain the relationship between the trade balance and the currency devaluation They said that after the devaluation

of the local currency, the initial trade balance will be declined, but in the end it is improved (with conditions other assumptions remain unchanged)

However, if the nominal exchange rate decrease but were offset by higher domestic inflation, so the real exchange rate will not change, therefore, it will not impact on net exports (Miles and Scott 2005)

- Impact of Inflation:

If a country‘s inflation rate increases relative to the countries with which it trades, its current account will be expected to decrease, other things being equal Consumers and corporations in that country will most likely purchases more goods overseas (due to high local inflations), while the country‘s exports to other countries will decline

- Impact of Government Policies:

A country‘s government can have a major effect on its balance of trade due to its policies on subsidizing exporters, restrictions on imports, or lack of enforcement

on piracy

+ Subsidies for Exporters:

Some governments offer subsidies to their domestic firms, so that those firms can produce products at a lower cost than their global competitors Thus, the demand for the exports produced by those firms is higher as a result of subsidies

Many firms in China commonly receive free loans or free land from the government These firms incur a lower cost of operations and are able to price their products lower as a result, which enables them to capture a larger share of the global market

+ Restrictions on Imports:

If a country‘s government imposes a tax on imported goods (often referred to

as a tariff), the prices of foreign goods to consumers are effectively increased Some industries, however, are more highly protected by tariffs than others American apparel products and farm products have historically received more protection against foreign competition through high tariffs on related imports

In addition to tariffs, a government can reduce its country‘s imports by enforcing a quota, or a maximum limit that can be imported Quotas have been commonly applied to a variety of goods imported by the US and other countries

+ Lack of Restrictions on Piracy:

In some cases, a government can affect international trade flows by its lack of restrictions on piracy For example, in China, piracy is very common; individuals (called pirates) manufacture CDs and DVDs that look almost exactly like the original product produced in the US and other countries They sell the CDs and DVDs on the street at a price that is lower than the original product They even sell the CDs and DVDs to retail stores It has been estimated that US producers of film, music, and software lose $2 billion in sales per year due to piracy in China

As a result of piracy, China‘s demand for imports is lower Piracy is one reason why the US has a large balance-of-trade deficit with China However, even

if piracy were eliminated, the US trade deficit with China would still be large

1.3 Impacts of exchange rate policy on trade balance

1.3.1 Concept of currency devaluation

"Devaluation" means official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets

a new fixed rate with respect to a foreign reference currency

For example, China has devaluated their currency twice within two days by 1.9% and 1% in July 2015

In contrast, depreciation is used to describe a decrease in a currency's value (relative to other major currency benchmarks) due to market forces, not government

or central bank policy actions Under the second system central banks maintain the rates up or down by buying or selling foreign currency, usually but not

always USD The opposite of devaluation is called revaluation

Depreciation and devaluation are sometimes incorrectly used interchangeably,

but they always refer to the reduction in the value of a currency in terms of other currencies Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power) Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation Generally, a steady process of inflation is not considered devaluation, although if a currency has a high level of inflation, its value will naturally fall against gold or foreign currencies

In some cases, a country may revalue its currency higher (the opposite of devaluation) in response to positive economic conditions, to lower inflation, or to please investors and trading partners This would imply that existing currency increased in value, as opposed to the case with redenomination where a country issues a new currency to replace an old currency that had declined excessively in

value (such as Turkey and Romania in 2005, Argentina in 1992, Russia in 1998, Germany in 1923, or Bizone/Trizone in 1948)

Present day currencies are usually fiat currencies with variable market value Some countries hold floating exchange rates while others maintain fixed exchange rate policies against the United States dollar or other major currencies These fixed rates are usually managed by a combination of legally enforced capital controls or through government trading of foreign currency reserves to manipulate the money supply Under fixed exchange rates, persistent capital outflows or trade deficits may lead countries to lower or abandon their fixed rate policy, resulting in a devaluation (as persistent surpluses and capital inflows may lead them towards revaluation)

In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation When speculators buy out all of the foreign reserves, a balance of payments crisis occurs

Economists Paul Krugman and Maurice Obstfeld have presented a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate is equal to the nominal exchange rate In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen In these circumstances, the currency value will fall very far very rapidly It occurred during the 1994 economic crisis in Mexico

1.3.2 J-Curve Effect

Impact of currency devaluation depends on how quickly import and export react to the changes in relative prices: the impact of real exchange rate changes on net exports may be weak in the short term and even incorrect

The J-curve effect refers to a "J" shaped section of a time-series graph in

which a period of negative or unfavorable returns is followed by a gradual recovery that stabilizes at a higher level than before the decline The J-curve effect is often seen in a country's balance of trade and equity fund returns In country‘s trade

balance, J-curve model is the impact of the curency devaluation to net exports over time In short, total value of imports exceeds its total value of exports and net exports will decrease (become more negative) resulting in a trade deficit, because reducing real exchange rate will increase the cost of imports and reduces the price

of exports However, after some time, exports increase and imports decrease and net exports will be improved

Economic analysts and policymakers may factor the J-curve effect into their analyses and decisions as a way to gauge both short- and long-term effects of a variable change (for example, a decline in exchange rates) or new policy

Figure 3: J-Curve Effect in currency devaluation

demanded will increase proportionately more than the decrease in price, and total export revenue will increase Similarly, if goods imported are elastic, total import expenditure will decrease Both will improve the trade balance

Empirically, it has been found that trade in goods tends to be inelastic in the short term, as it takes time to change consuming patterns and trade contracts Thus, the Marshall–Lerner condition is not met, and a devaluation is likely to worsen the trade balance initially If the domestic currency devalues, imports become more expensive and exports become cheaper due to the change in relative prices Initially, there will be a deterioration of the trade balance which can be attributed to lags in recognition of the changed situation, lags in the decision to change real variables, lags in delivery time, lags in replacement of inventories and materials and lags in production These lags ensure that the demand for exports remains inelastic in the short term

In the long term, consumers will adjust their behavior to the new prices, and trade balance will improve When the prices become flexible, there will be a positive quantity effect on the trade balance because domestic consumers will buy fewer imports and foreign consumers will buy more of country‘s exports But this offsetting is a negative cost effect on the trade balance since the relative cost of imports will be higher The net effect on the trade balance is positive or negative depends on whether the quantity effect outweighs the cost effect or not If the quantity effect is greater, then it is said that the Marshall–Lerner condition is met and the effect is called the J-curve effect

For example, assume a country is a net importer of oil and a net producer of ships Initially, the devaluation immediately increases the price of oil, and as consumption patterns remain the same in the short term, an increased sum is spent

on imported oil, worsening the deficit on the import side Meanwhile, it takes some time for the shipbuilder's sales department to exploit the lower price and secure new contracts Only the funds acquired from previously agreed contracts, now devalued

by the currency devaluation, are immediately available, again worsening the deficit

on the export side

CHAPTER 2:

EXCHANGE RATE POLICY AND TRADE BALANCE IN VIETNAM

2.1 Overview of exchange rate policy and trade balance in Vietnam

2.1.1 Exchange rate policy of Vietnam

2.1.1.1 Period of 1989 – 1996 (After the establishment of interbank foreign exchange market)

Context:

Before 1989, Vietnam is centrally planned, subsidized economy It means Government managed all sources of goods and raw materials and coordinated all the steps of the economy from planning, collecting, circulating to distributing to end user

The banking of Vietnam was the fully state-owned one level system The State Bank is the only agency providing local banking services, with the task of ensuring the financial resources allocated to economic units under the state plan Therefore, the SBV action is not associated with banking standards with no analysis or credit risk management

The pressures for change and reform had been building up for a number of years came to a head in 1986, when the country was faced with an economic crisis characterized by persistent food shortages, worsening inflation, and significant deficits in both the state budget and external trade In this period, traditional trade relations between Vietnam and the Soviet Union and the socialist countries in Eastern Europe has fallen into crisis due to the disintegration of the socialist in these countries Vietnam has faced a series of economic and political challenges; innovation is an inevitable requirement

Hyperinflation in period 1986 - 1989 has become a driving force for the renovation of Vietnam since 1989

Figure 4: Vietnam inflation rate, 1980 - 1996

Data source: IFS

The authorities undertook a series of decisive and fundamental measures to shift the economy from a bureaucratic, central planning model to a more market-oriented, decentralized system, starting with the re-organization of the banking system from one level into two levels State Bank no longer simultaneously undertakes two roles: the manager and the provider of banking services The main responsibility of the central bank is managing the system of commercial banks (including the Bank for Foreign Trade, Investment Development Bank, Industrial

and Commercial Bank, Agricultural Bank)

Exchange rate policy:

Before 1989, Vietnam used multi-exchange-rate regime There was a

complicated system of multiple fixed exchange rates: an official trade rate for foreign trade transactions, another non-trade rates for non-trade transactions, a so-called internal settlement rate for the purpose of compensating export enterprises for their losses, and a separate rate for remittances received from overseas (Vo Tri Thanh et al 2000; Nguyen Van Tien 2006)

Reform of the banking system in 1989 was implemented in parallel with the merger of two exchange rates and strongly currency devaluation, interest rates

0 50 100

increasing and credit growth control This comprehensive reform helped subdue inflation of Vietnam In this period, multi-exchange rate system was replaced by single exchange rate regime In line with the broader economic reform process, Vietnam‘s exchange rate regime has gone through major changes In March 1989, the multiple exchange rates were unified into a single official rate, set and announced by the SBV (IMF 1996) Commercial banks were allowed to determine their buying and selling rates within a band of ±5% around the announced official rate, with a maximum bid-ask spread of 0.5% The official rate was subject to

regular adjustments by the SBV It is the crawling bands exchange rate regime in

the period of 1989 – 1990

Since then, Vietnam has made adjustments in the exchange rate mechanism The central bank conducted stable monetary policy via commitments to keep the exchange rate steady for certain periods In late 1991, with the opening of two foreign exchange (FX) trading floors (in Ho Chi Minh City and Hanoi), the official rate became determined on a daily basis (IMF 1996) In setting this rate, the SBV would be guided to some extent by the previous day‘s closing rates on the two trading floors Commercial banks were allowed to quote within a (narrowed)

trading band of less than 0.5% around the announced official rate It is the pegged

exchange rate within narrow band regime in the period of 1991 – 1993

In October 1994, the trading floors were replaced by a more comprehensive and sophisticated - interbank foreign exchange market, but there were no significant changes in the underlying exchange rate mechanism Exchange rates at commercial banks fluctuated within the amplitude of ±0.5% of the announced OER By the November of 1996, the amplitude was broadened from ±0.5% to ±1%

Conventional fixed pegged arrangement was applied in the period of 1994 – 1996

2.1.1.2 Period of 1997 – 2000 (the Asian Financial crisis)

Context:

It was the period of the Asian financial crisis Vietnam is not in the center of

the storm, but also is slightly affected