The exchange rate misalignment and its relationship with trade balance the case of vietnam

IFS : International Financial Statistics LIC : Low Income Country MoIT : Ministry of Industry and Trade PPP : Purchasing Power Parity REER : Real Effective Exchange Rate SBV : State Bank

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE EXCHANGE RATE MISALIGNMENT AND ITS RELATIONSHIP WITH TRADE BALANCE:

THE CASE OF VIETNAM

BY

CAO THANH BÌNH

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, AUGUST 2013

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE EXCHANGE RATE MISALIGNMENT AND ITS RELATIONSHIP WITH TRADE BALANCE:

THE CASE OF VIETNAM

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

Acknowledgement

I would like to express sincere gratitude to my supervisor – Dr Pham Thi Thu Tra for scientific guidance, patient encouragement and useful advices, which she has provided throughout the time of preparation and accomplishment of this paper I also would like to thank to Prof Howard Nicholas who gave helpful comments on the draft Special thanks to Prof Nguyen Trong Hoai, and Dr Pham Khanh Nam for guidance and support as our program administrators

I also would like to give my deepest thanks to my parents, and my beloved wife Khanh Linh for her spiritual supports, encouragements

Table of contents

Acknowledgement i

Table of contents ii

List of tables iv

List of figures iv

Abbreviations vi

Abstract vii

CHAPTER 1: INTRODUCTION 1

1.1 Introduction 1

1.2 Background, and problem statement 1

1.2.1 A brief history of Vietnamese exchange rate policy 1

1.2.2 Recent Vietnam economic concerns 2

1.3 Research objectives and research questions 5

1.3.1 Research objectives 5

1.3.2 Research questions 5

1.4 Justification of the study 5

1.5 Scope and limitation of the study 5

1.6 Organization of the study 6

CHAPTER 2: THEORETICAL FRAMEWORK 7

2.1 Introduction 7

2.2 Overview of exchange rate misalignment 7

2.3 Theoretical background of exchange rate misalignment 8

2.3.1 The Purchasing Power Parity approach 8

2.3.2 The Fundamental Equilibrium Exchange Rate 12

2.3.3 The Behavioral Equilibrium Exchange Rate 13

2.4 Empirical studies 18

2.5 Conceptual Framework 27

2.6 Summary 28

CHAPTER 3: DATA AND RESEARCH METHODOLOGY 30

3.1 Introduction 30

3.2 The PPP approach 30

3.3 The trade balance 31

3.4 The BEER approach 31

3.4.1 Real effective exchange rate (REER) 31

3.4.2 Other variables 31

3.4.3 The calculation of the Real Exchange Rate Misalignment 33

3.4.4 The econometric procedure of the BEER approach 33

CHAPTER 4: THE HISTORY OF ERMANAGEMENT IN VIETNAM 38

4.1 Introduction 38

4.2 Vietnam exchange rate history 38

4.3 Summary 46

CHAPTER 5: FINDINGS AND DISCUSSIONS 47

5.1 Introduction 47

5.2 Equilibrium real exchange rate and misalignment 47

5.2.1 BEER approach 47

5.2.2 PPP approach 56

5.3 The relationship between the PPP exchange rate misalignment and the Vietnam’s trade balance 57

5.3.1 The Vietnam’s trade structure 58

5.3.2 The conclusion 65

5.4 The movement of several Asian currencies 65

CHAPTER 6: CONCLUSIONS AND RECOMMENDATIONS 68

6.1 Conclusion 68

6.2 Policy recommendations 69

6.3 Limitations and directions for further studies 71

6.3.1 Limitations 71

6.3.2 Directions for further studies 71

References 72

Appendices 78

List of tables

Table 1: Several results of empirical researches for Chinese Renminbi 22

Table 2: Empirical studies of real ER misalignment in several countries 24

Table 3: The measurements and expected signs of variables 32

Table 4: Critical values for Dickey Fuller test 35

Table 5: Inflation and exchange rate trends in 1985 – 1992 41

Table 6: Descriptive statistics 47

Table 7: The correlation matrix of variables 48

Table 8: The values of stationary tests of all variables 49

Table 9: Regression result 50

Table 10: The values of stationary tests for residual (at level) 51

Table 11: Summary of estimating ER misalignment results in case of LICs 53

Table 12: The values of ER misalignment, according to BEER method 78

Table 13: The values of ER misalignment, according to PPP method 79

List of figures Figure 1: Inflation rate from period 1996Q1 to 2011Q3 3

Figure 2: Trade balance of all goods and services from 1995 to 2012 4

Figure 3: The conceptual framework 28

Figure 4: Inflation rate and nominal exchange rate (VND/USD) 39

Figure 5: Gaps between official exchange rate and unofficial market rate 39

Figure 6: Trading bands declared by the SBV 40

Figure 7: Inflation and exchange rate trends in 1985 – 1992 41

Figure 8: Official and black market exchange rate in 2008 to 2009 44

Figure 9: Official and black market exchange rate in 2010 to 2011 45

Figure 10: The residual of the regression result 51

Figure 11: The histogram of residual 53

Figure 12: The current exchange rate misalignment of the VND 55

Figure 13: The permanent exchange rate misalignment of the VND 55

Figure 14: The PPP ER misalignment (against a basket of currencies) 56

Figure 15: The average current misalignment and TB from 2000 to 2009 57

Figure 16: The average permanent misalignment and TB from 2000 to 2009 57

Figure 17: The PPP exchange rate misalignment and TB from 2000 to 2012 58

Figure 18: The structure of Vietnam’s export from 2006 to 2012 59

Figure 19: Several Vietnamese major exports’ products from 2000 to 2010 60

Figure 20: Several Vietnamese major exports’ products from 2000 to 2010 60

Figure 21: The structure of Vietnam’s import from 2006 to 2012 61

Figure 22: Several major imports’ commodities 61

Figure 23: The imports of necessary machineries for export sectors 62

Figure 24: The exports and imports of electronic products and parts 63

Figure 25: The exports and imports of mobile products and parts 64

Figure 26: The TB excluding the exports & imports of mobile products and parts 64

Figure 27: The percentage change of the nominal ER and the Vietnam’s inflation 66

Figure 28: The percentage change of the Vietnam’s nominal ER and PPP ER 66

Figure 29: The percentage change of PPP exchange rate of several currencies 67

IFS : International Financial Statistics

LIC : Low Income Country

MoIT : Ministry of Industry and Trade

PPP : Purchasing Power Parity

REER : Real Effective Exchange Rate

SBV : State Bank of Vietnam

TB : Trade Balance

USD : United States Dollar

VND : Vietnam Dong

Abstract

It is said that the exchange rate policy plays an important role in an economy

It links the domestic economy to other foreign ones And exchange rate misalignment is often the most interested topic of economists Hence, the aim of this research is to (i) estimate the exchange rate misalignment and (ii) investigate its relationship with trade balance, in case of Vietnam

The equilibrium exchange rates are obtained by two methods: the relative PPP approach and the Behavioral Equilibrium Exchange Rate (BEER) model The misalignment of exchange rate is defined as the difference between the actual and the equilibrium exchange rate In the BEER approach, the co-integration is used to test the long run relationship between the real effective exchange rate (REER) and several macroeconomics variables In the PPP approach, the misalignment of exchange rate is calculated simply based on the domestic and foreign CPIs

The result from the PPP approach suggests that: (i) the VND was undervalued and slightly overvalued from 2000 to the middle of 2007; (ii) the overvaluation of VND has sharply increased from the last half of 2007 up to now The exchange rate misalignment from PPP approach is chosen to examine the impacts on the Vietnam’s trade balance The conclusion is that the exchange rate misalignment does not have strong relationship with trade balance

Key words: exchange rate, misalignment of exchange rate, trade balance

CHAPTER 1: INTRODUCTION

1.1 Introduction

The purpose of this research is, first, to measure the Vietnam’s real exchange rate misalignment; second, to study its relationship on Vietnam trade balance The exchange rate misalignment is defined as the deviation between the equilibrium1and actual real exchange rate An exchange rate is named overvalued when it is higher than its equilibrium level; in the otherwise, an exchange rate is labeled undervalued when it is lower than its equilibrium level

This research presents two estimating exchange rate approaches: the relative PPP approach and the Behavioral Equilibrium Exchange Rate model First of all,

we need to quantify the real exchange rate equilibrium and calculate the misalignment of real exchange rate by using two methods above After that, by applying several visual graphs, we can investigate the relationship between the exchange rate misalignment and trade balance

1.2 Background, and problem statement

1.2.1 A brief history of Vietnamese exchange rate policy

In 1986, Vietnamese economy had been coped with persistent concerns such

as the shortage of food, skyrocketing inflation, and twin deficits Under pressure to reform, policymakers had to make a series of action to transform the Vietnamese economy from command to market oriented In accordance to that economic reforming process, Vietnam’s exchange rate regime also had several significant changes Vo, Dinh, Do, Hoang, & Pham (2000) found that multiple types of exchange rate were applied before 1989 The first official exchange rates were employed for foreign commercial transactions and non-commercial, respectively

1 There are several different definitions of equilibrium real exchange rate They will be reviewed specifically

in next chapter

The second rate included the compensation for export firms The third rate was applied separately for exchanging abroad remittances Obviously, that system seemed to be complicated and was implemented inefficiently Consequently, these exchange rates were merged into the unique official rate in March 1989 The official exchange rate was expressed publicly in the value of VND against USD by the State Bank of Vietnam (SBV) The cross exchange rate between VND and the third foreign currency is determined based on the information of SBV’s official exchange rate and the rate between USD against that foreign currency

From 1989 up to now, the Vietnamese exchange rate regime has been considered as a crawling band regime In theory, under crawling band system, the state bank declares the official exchange rate within a trading band; and it may change the value of official exchange rate and trading band according to the goals in certain periods In case of Vietnam, the exchange rate is declared officially by the SBV with a specific trading band Based on that information, Vietnamese commercial banks can decide their buying and selling exchange rate Besides two instruments above, the SBV still exercises various administrative tools to assurance its key role in the foreign exchange market In several periods, SBV has applied fixed interbank exchange rate with very low fluctuating band (i.e 1 percent) Therefore, numerous economists have considered that Vietnam exchange rate policy looks like fixed exchange rate regime

1.2.2 Recent Vietnam economic concerns

Recently, many economists have mentioned that the Vietnam’s exchange rate is misaligned, particularly, high overvaluation It leads to the urgent question, that VND should be devaluated or not However, finding the answer is a complex task since exchange rate policy is always a challenged issue Theoretically, the exchange rate policy can affect many macroeconomics variables such as the inflation rate, trade competitiveness, stability of financial system, and foreign exchange market’s performance (Ho and McCauley, 2003) On the one hand, it is

argued that government could react against inflationary threat by using a nominal exchange rate as an anchor (Giavazzi & Pagano, 1989) On the other hand, there are opinions that to ameliorate trade balance, the exchange rate must be devaluated enough to obtain competitiveness As a result, import decreases, export increases and trade balance improves (Dooley, Folkerts-Landau, & Garber, 2003)

The first and hottest major issue is the inflation when it has become a serious macroeconomic cyclical issue in recent years (Figure 1) Especially, Vietnam’s inflation rate hits around 23% in 2011, which is the highest rate of inflation comparing to other Asia countries Vietnam’s high inflation over years erodes the VND’s value and pushes pressures on living quality of Vietnamese people and exacerbates the Vietnam’s macroeconomic turbulences

Figure 1: Inflation rate from period 1996Q1 to 2011Q3

Source: Data from IFS

According to Svensson (1998), exchange rate policy can influence inflation

in several ways By keeping the nominal exchange rate stable, government can manage imported foreign goods’ prices, which come into the domestic consumer price index For this reason, inflation can be controlled partially by keeping exchange rate stable Moreover, in an economy which was highly affected by dollarization problem like Vietnam’s, the psychological expectation of holding foreign currencies plays a significant role Therefore, the stability of exchange rate value in VND against USD helps ensure the benefit of holding VND and leads to

maintain the confidence of keeping domestic currency Hence, this expectation also contributes to reduce inflation in certain ways

Trade deficit is the second major problem while it has dramatically climbed

up since 2000 (Figure 2), especially when Vietnam joined WTO at 2007 In theory, trade deficit is believed to dry up national foreign reserve, increase foreign debts, lead to a monetary crisis in several cases

Figure 2: Trade balance of all goods and services from 1995 to 2012

Source: Data from IFS

In the situation that trade deficit is one of major concerns, exchange rate policy is also considered as a supportive solution to improve it Traditionally, a depreciation of the domestic currency enhances competitiveness by increasing the price of import goods in domestic currency units and reducing the price of exports

in terms of foreign currencies Subsequently, the effect of currency depreciation can lead to an increase in exports’ volume and a decrease in imports’ volume and hence improve trade balance

Depending on the targets which are focused by policymakers, the exchange rate policy will be designed to deal with specific problem and bypass others From the end of 2010 up to now, Vietnamese government has prioritized the settlement of inflation by applying both market and non-market instruments to keep VND’s value almost unchanged However, if we pay attention on inflation too much, the misalignment of real exchange rate will happen dramatically due to the actual real

-25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00%

exchange rate is much different than its equilibrium level After all, this may erodes the competitiveness of domestic tradable goods and leads to deteriorate the trade balance

1.3 Research objectives and research questions

1.3.1 Research objectives

The goal of this research paper is to study the degree of real exchange rates misalignment and its relationship with trade balance

1.3.2 Research questions

a) Is the real exchange rate of the VND misaligned?

b) If it is right, is there a relationship between the Vietnam’s real exchange rate misalignment and its trade balance?

1.4 Justification of the study

There are few of studies that provide knowledge about the Vietnam exchange rate misalignment Hence, this is an interesting study that combines two separated estimating exchange rate misalignment methods First, the relative PPP based approach is the earliest and simplest one Second, the BEER model is the modern approach which is based on an econometrics model with a set of macroeconomics variables

Moreover, we offer a vision of exchange rate misalignment’s impacts on trade balance and propose appropriate policy recommendations So the evidence from this study is informative and useful for Vietnamese authorities when they consider a proper exchange rate policy

1.5 Scope and limitation of the study

This research examines the Vietnamese misalignment of exchange rate from 1995Q1 to 2011Q4 Since exchange rate issue is clearly a complex challenge, we

try to apply as many estimating methods as we can The BEER model covers from 2000Q1 to 2010Q2 while PPP computation covers from 1995Q1 to 2011Q4

Because of the lack of Vietnam macroeconomics data, several similar proxies have to be used to substitute major variables So the first limitation of this research is the unavailability of macroeconomics data Moreover, the PPP computation and the BEER model by themselves contain weaknesses because of their approach assumptions Hence, the second limitation comes from the model drawbacks

1.6 Organization of the study

This research is organized as follows: the first chapter is an introduction part The second chapter provides theoretical framework The third chapter presents the source of data and the research methodology The fourth chapter indicates the Vietnamese exchange rate management history The fifth chapter points out the findings and discussions The sixth chapter contains the conclusions and policy recommendations

CHAPTER 2: THEORETICAL FRAMEWORK

2.1 Introduction

In the literature, there are various equilibrium exchange rate concepts; and there are also corresponding approaches which are used to estimate these concepts However, it is said that the “proper” criteria, which can be used to conclude what is the most “correct” equilibrium exchange rate concept, do not exist That is the reason why there is no ideal model can be expected to deal with all policy questions Hence, depending on the particular questions that are being concerned, the appropriate concepts and models are picked up to solve corresponding problems Therefore, the main target of this chapter is to: (i) describe approaches that are utilized to calculate the misalignment of exchange rate and (ii) discuss briefly the exchange rate misalignment’s impacts on trade balance

2.2 Overview of exchange rate misalignment

The exchange rate misalignment is defined as the difference between the equilibrium and actual real exchange rate An exchange rate is named overvalued when it is higher than its equilibrium level; in the otherwise, an exchange rate is labeled undervalued when it is lower than its equilibrium level

In emerging and developing countries, the misalignment of exchange rate is one of the most essential issues in exchange rate regime Furthermore, exchange rate misalignments can originate in any regimes including fixed, floating, and crawling peg (Obsfeld and Rogoff, 1995) In a floating system, the existence of misalignment comes from speculative reasons which boost the real exchange rate too much than its equilibrium In fixed exchange rate regime or crawling peg system, the causes of misalignments are poor macroeconomic policies which prevent the appropriate movements of the exchange rate in the general economy’s tendencies

2.3 Theoretical background of exchange rate misalignment

In general, there are two major estimating approaches They are the relative Purchasing Power Parity based approach, and the model based approach First, the relative PPP based approach is the earliest one and is applied largely by many economists Second, the model based approach links the real exchange rate with a set of macroeconomic variables to a single equation, and obtains the equilibrium real exchange rate via this equation’s regression results This approach is divided into two classes: (1) the general equilibrium approach, and (2) the reduced form general equilibrium approach The most representative models of the first class are the Fundamental Equilibrium Exchange Rate (FEER) model, and the Desired Equilibrium Exchange Rate (DEER) model The most popular models of the second class are the Behavioral Equilibrium Exchange Rate (BEER) model, the Permanent Equilibrium Exchange Rate (PEER) model, and the Natural Real Exchange Rate Approach (NATREX) In this research, the relative PPP based approach, and the BEER model are chosen to measure the equilibrium exchange rate of VND because these methods are feasible to apply

2.3.1 The Purchasing Power Parity approach

Purchasing power parity (PPP) theory is the most common approach that deals with equilibrium exchange rate issue Due to its simplicity, it is applied broadly in various academic studies as well as in economic organizations’ yearly publications

2.3.1.1 The PPP concepts

PPP states that exchange rates will modify themselves to make sure that purchasing powers of different currencies are the same in the long run Theoretically, there are three versions of PPP concept: the law of one price, absolute PPP, and relative PPP

The first, “the law of one price”, is based on assumption that there are no transaction costs, trade barriers, and transportation costs in countries If it holds, then an individual tradable commodity that is sold in different countries has the same price when its price is expressed in a common currency This concept can be illustrated as in the mathematical equation:

In which, is the domestic price level of an individual tradable commodity ∗ is

the foreign price level of that commodity S is nominal exchange rate expressed as

the number of home currency units per foreign currency unit per (i.e 21000

VND/USD); so that an increase in S indicates a depreciation of the home-country

currency

The second, absolute PPP is the extension of the first concepts when the law

of one price holds for all of tradable commodities across countries This concept is expressed as:

In which, is the domestic price and ∗ is foreign price of a certain set of tradable

commodities S is the PPP (nominal) exchange rate that ensures the prices of a given

set of commodities in different countries are equal

The third, relative PPP points out that the difference in the inflation rates between domestic and foreign countries should be equal to the percentage change2

in the value of exchange rate The relative PPP is expressed in logarithm form as:

In reality, PPP theory scarcely holds even if its assumptions are not violated This is because all economies have various types of non-tradable goods and

2 The percentage change in the value of can be calculated via formula: ≈ − = ∆

services Furthermore, it takes time on transporting goods between countries and regions around the world; the information needed for comparing identical goods is not always available; the diverging income and preferences in different countries; the specialized in producing differential goods in spectacular countries These reasons above make the prices of similar goods vary in different countries That is the explanation why PPP is expected to hold over medium to long run

2.3.1.2 Applying the relative PPP approach to estimate equilibrium exchange rate

Traditionally, the relative PPP is the simplest approach which is applied mostly to estimate equilibrium real exchange rate in various macroeconomics models Using this approach to compute equilibrium exchange rate requires main important assumptions First, the equilibrium real exchange rate ( ) is defined as

the real exchange rate in the base year ( ) Second, this equilibrium exchange rate

is considered to be constant over years ( = ! = ⋯ = = = ) Third,

in several periods, could change slightly, however, the real exchange rates will converge in the long run

The misalignment real exchange rate (at year t) is defined as the percentage

deviation between the actual real exchange rate ( ) and the equilibrium real

exchange rate ( ) Hence, the value of this misalignment is:

The equation (4) means that the value of real exchange rate misalignment at

year t is equal the percentage change of the real exchange rate from year t to the

base year

In theory, the real exchange rate is defined as the nominal exchange rate adjusted by the domestic and foreign price levels (Rajan and Siregar, 2006) Hence, the real exchange rate is expressed mathematically as:

year t to the base year The different between the percentage change of the nominal

exchange rate ( − ) and the difference between the domestic and foreign

inflation )( − ) − ( ∗− ∗)* presents the domestic currency’s state

undervaluation In the otherwise, an overvaluation appears3

In this research, the misalignment of exchange rate will be calculated against

a basket of foreign currencies by applying the weighted of traded goods with Vietnam’s trading partners For this reason, the equation (7) will be modified to:

#$ = - /(34 − ) − )( − ) − ( ∗ − ∗ )*0 × 1 2 (8)

In which t is the year, n is the number of major trading partners of Vietnam,

and 1 is the shared volume of foreign country i’s traded goods and services compared to Vietnam’s total trade at time t

Although this approach saves a lot of estimating efforts due to its simplicity,

it contains three major weaknesses Firstly, the issue of choosing the base year is a complicated task and therefore it must be considered carefully Secondly, the assumption that mentioned about the unchanged equilibrium real exchange rate is

3 In this research, to obtain visual illustrations, the misalignment equation (7) is applied reversely Hence, a positive result presents an overvaluation, while a negative result presents an undervaluation

seriously criticized Thirdly, this approach contains few of variables that can explain the real exchange rates’ movements Hence, this approach does not capture changes from macroeconomic events These drawbacks lead to the needs of alternative estimating approaches which are presented later

2.3.2 The Fundamental Equilibrium Exchange Rate

The general equilibrium approach provides the equilibrium exchange rate by establishing the single equation between the real exchange rate and several fundamental macroeconomics factors Specifically, the equilibrium exchange rate obtained from this approach, is compatible with a certain set of fundamentals over the medium to long run

The FEER model, the best known one in this approach, was introduced by Williamson in 1994 According to Williamson (1994), FEER is the equilibrium exchange rate that satisfies both internal and external balance simultaneously in medium run By definition, the term “medium run” specify the period when output reaches its potential level Edwards (1989), Williamson (1994), and Elbadawi (1994) pointed out that internal balance refers to a situation when an economy runs

at full-employment level and its price level is stable; and external balance implies a condition when current account is at sustainable position over a medium run The term “sustainable” indicates the state in which all fundamental factors have impacts

on either internal or external balance, achieve their steady state level (Montiel, 1999) Because of the difficulty in identifying the value of potential output, it is assumed that internal will balance when external balance is obtained

Unlike relative PPP approach, the equilibrium exchange rate estimated by the general equilibrium approach is not necessarily constant The advantage of this approach (FEER and DEER) is that it contains more variables which can explain the movements of equilibrium exchange rate This approach clearly exceeds the relative PPP based approach in terms of the number of exchange rate determinants However, it has two main limitations First, this approach is based on normative

assumptions about internal and external balances Indeed, it is said that the term

“internal balance” is likely a controversial definition Moreover, the external balance condition is criticized because the assumption about the “sustainable value”

of current account is totally subjective sensation Hence the level of currency misalignment which is estimated by FEER method is possibly incorrect (Rajan and Siregar, 2006) Second, this approach requires enormous data However, in developing countries like Vietnam, macroeconomic data are scarce and limit in several sectors Therefore, this approach is clearly inappropriate in order to estimate the equilibrium exchange rate in this research

2.3.3 The Behavioral Equilibrium Exchange Rate

2.3.3.1 Overview

The BEER approach is defined by Clark & MacDonald (1999) This approach sets an equation that combines the real exchange rate with a set of macroeconomic fundamentals The equilibrium real exchange rate is estimated by investigating that equation The BEER approach’s foundation is based on the theory

of uncovered interest rate parity (UIP):

In which: In period (t), 5 ( 6 ) is the expected value of the nominal exchange rate

for period (t+1) $ , $∗ are the domestic and foreign nominal interest rates,

In which: In period (t), 5 ( 6 ) is the expected value of the real exchange rate for

period (t+1) 7 , 7∗ are the domestic and foreign real interest rates, respectively

The equation (10) can be written as below:

The BEER method assumes that term 5 ( 6 ) is settled mainly by a set of

macroeconomics fundamentals (? ) Therefore, by applying the BEER approach,

the relationship between the equilibrium exchange rate ( @ A) and fundamentals

can be expressed as below:

2.3.3.2 The construction of Behavioral Equilibrium Exchange Rate equation

The set of macroeconomic fundamentals (? ) is mentioned in various studies

Montiel (1999) classifies the fundamental variables into different categories: (i) monetary policy (e.g domestic credit), (ii) commercial policy (trade openness), and (iii) the international economic environment (e.g terms of trade, capital flows)

Following this approach, this set contains five explanatory variables, namely, net foreign assets (NFA), trade openness (OPEN), terms of trade (TOT), and foreign direct investment (FDI) However, the dependent variable is replaced by

multinational real exchange rate (REER) instead of bilateral real exchange rate (Q)

To examine Vietnam’s equilibrium exchange rate, this research will follow the BEER approach from Montiel (1999) and Jongwanich (2009) For that reason, the final equation is:

The next part will discuss more about the relationship between dependent variable (REER) and other explanatory variables

a Net foreign asset (NFA)

In various empirical studies, it is claimed that the impact of NFA on REER is ambiguous and the sign of this variable is different in spectacular research cases On the one hand, it is expected that there is a negative relationship between REER and NFA MacDonald & Ricci (2004) states that an increase in NFA will improve income and increase aggregate demand Consequently, it leads to an increase in the price level and the result is a decrease (appreciation) of REER In brief, NFA has negative impacts on REER

On the other hand, there are several cases that present the positive relationship between NFA and REER Empirically, Burgess, Fabrizio, & Xiao (2003) found that empirical evidence when examining the equilibrium exchange rate in Baltic’s countries within 8 years from 1994Q1 to 2002Q1 They argue that result happened because of two reasons Firstly, in several countries, the significantly growing external debt (decreasing NFA) could be financed by trade surpluses which are achieved by depreciating REER in the long run However, in the transitory position, an increase (decrease) in NFA may accompany by an increase (decrease) in REER Secondly, changes in risk premium may affect the relationship between REER and NFA A fall (rise) in risk premium would decrease (increase) the size of trade surplus which is needed to finance external debt As a result, in some special cases, it is expected to have positive relationship between REER and NFA

b Financial development (FD)

Domestic credit (DC) is a proxy for financial development DC increases when the central bank applies an expansionary policy This leads to a pressure on domestic prices, thus increasing imports, worsening current account, and causing the REER to increase (depreciate) Therefore, it is expected that there is a positive relationship between DC and REER

c Trade Openness (OPEN)

Trade openness is utilized as a measure for commercial policy The impact of trade openness on REER is also ambiguous According to Edwards (1994) & Elbadawi (1994), an increase in trade openness means that trade operation is more liberalized; tradable goods have cheaper prices and better quality This leads to a substitution from non-tradable to tradable goods, then it worsens trade balance and increases (depreciates) REER Therefore, trade openness is expected to have positive relationship with REER On the contrary, Maeso Fernández, Osbat, & Schnatz (2006) claims that in case of an economy enjoys growth and increases its trade activities but still applies protection instruments, REER will decrease (appreciate) when trade openness increases

d Terms of trade (TOT)

Terms of trade is considered to have ambiguous effects to the REER In theory, terms of trade has both income effects and substitution effects on REER (Edwards, 1989) The income effects lead to depreciation while the substitution effects cause appreciation Therefore, the final effect of the terms of trade on REER depends on the reality of each country

e Foreign Direct Investment (FDI)

In many studies, it is said that financial globalization is one of important factors which affects real exchange rate Xing & Zhang (2004) used FDI as a proxy

of financial globalization when they researched the income disparity in the China’s economy In terms of estimating equilibrium exchange rate, Frait & Komarek (2001) has also used FDI, which is a proxy of financial globalization, as an exchange rate determinant Hence, in this research, FDI is also used to represent the role of financial globalization to REER The relationship between FDI and REER is clearly negative Indeed, Elbadawi (1994), and Frait & Komarek (2001) claim that

an increase in capital inflows will appreciate real exchange rate

f Interest rate differential (RR)

An increase in interest rate differential leads to an increase in capital flows and therefore reduces (appreciates) REER Hence, the real interest rate differential

is expected to have negative relationship with REER However, most of empirical studies suggest that the interest rate differential does not have statistically significant impact on REER (Jongwanich, 2009)

2.3.3.3 The advantages and disadvantages of the BEER approach

The advantages of the BEER approach are, first, this method also includes many variables that can explain the movements of equilibrium exchange rate Second, unlike the FEER, the BEER approach is not based on normative measures

However, the BEER approach also contains several disadvantages Firstly, the most severe problem is that this approach is not based on any economics theories (such as macroeconomic balance theory – like FEER’s foundation) and it is just an empirical method Secondly, the choice of fundamental variables is not guided by any theories Thirdly, estimating the equilibrium exchange rate in time – series model faces difficult because long term macro data may be not available Hence, to bypass this weakness, economists usually use panel data to research the exchange rate in a group of countries or region

2.3.3.4 The relationship between exchange rate misalignment and trade balance

Dooley et al (2003) said that moderate undervaluation could increase competitiveness for export firms They argued that one of the most important factors which heavily affect production is the labor cost Currency undervaluation helps to reduce the costs of labor in a country compared to other competitor countries Lower cost means higher profit and therefore higher savings, investment The additional investment contributes to expand manufacturing Therefore, the sufficient currency undervaluation increases competitiveness for export firms In

terms of import side, the undervaluation of currency is that the imported prices of goods and services will be more expensive Hence, this has negative impacts on countries which need to import machineries and materials for production

The overvaluation is considered to have more severe effects on economy rather than the undervaluation In theory, a prolonged overvalued exchange rate results in misallocation of resources, inefficient loss Moreover, it also enlarges trade deficits, increases external debt, and lowering growth (Kaminsky, Lizondo, & Reinhart, 1997; Krugman, 1987) According to Clark et al (1998), overvaluation decreases competitiveness of tradable goods and services Schuh (1974) also emphasized that the overvaluation is similar to an implicit export tax The positive side of currency overvaluation is that it helps the imports of required commodities with cheaper prices This provides significant advantages for economies whose productions depend on foreign materials

The above argument was founded on the assumption that trade balance of a country is sensitive to fluctuations of the real exchange rate Nonetheless, if the relationship between real exchange rate and trade balances is not a strong one, then altering the value of the currency cannot affect trade gaps That is the case in which

a country is vertically specialized; the volume of its imports strongly affects the volume of its exports because exports’ products require imports as inputs in their manufacturing Therefore, in a more vertically specialized economy, its trade balance intends to be less sensitive to fluctuations of the real exchange rate (Kharroubi, 2011)

2.4 Empirical studies

a) Empirical studies in several Asian countries

Chinn (2000) uses PPP approach to measure eight East Asian countries’ currencies in the period before the crisis He wants to test whether the overvaluation exists or not He concludes that the Malaysian Ringgit, the Philippines Dollar, and

the Thai Baht were overvalued; the Korean Won and the Indonesian Rupiah were undervalued; other countries’ currencies don’t present obvious results

Zhang (2002) attempts to measure equilibrium real exchange rate in Hong Kong in the period from 1984 to 1998 by using BEER approach In this research, four fundamentals, which are applied in regression model, are the terms of trade, the resource gap (measured by (export – import) / GDP), the private investment, and the trade openness The Johansen approach is utilized to estimate the long run relationship between REER and fundamentals He states that in the long run the equilibrium real exchange rate is impacted by the terms of trade, the private investment and the trade openness The obtained results include an equilibrium rate, and a smooth one (by using a filter) The results present that Hong Kong Dollar was undervalued when it was firstly installed It continued to be undervalued until 1993 Then overvaluation happened from 1993 to 1995 After that the currency was adjusted to its equilibrium level

In the study of Sahminan (2005), he also uses the BEER method when examining the equilibrium real exchange rate of the Indonesia Rupiah In his research, data covers from 1993Q1 to 2005Q2 By using the Engle – Granger method, he states that three determinants including the productivity differential, the terms of trade, and the net foreign assets affect the long-run equilibrium real exchange rate of the rupiah However, in the short run, the error correction model proves that four determinants which can impact on the equilibrium real exchange rate are the terms of trade, the productivity differentials, the net foreign assets, and the interest rate differentials He concludes that the Rupiah was 40% overvalued in

1996 – 1997, undervalued during 1998 – 2003, and overvalued again in 2004

Macdonald (2004) tries to measure the equilibrium exchange rate for Singapore Dollar during 1983Q1 – 2003Q2 In his paper, the BEER approach is used to measure the Singapore’s equilibrium exchange rate The fundamentals include the terms of trade, the property prices, the net foreign asset, the output gap,

and the trade openness The output gap is a proxy which present for growth potential; and the property price is used to reflected household’s wealth The Johansen method is applied to show the long run relationship between the REER, and its determinants All of the variables are statistically significant with correct sign The result is that in most of time, the Singapore Dollar was close to its equilibrium This means that there is no evidence for misalignment of Singapore Dollar in 1983 – 2003

Kinkyo (2008) applies the BEER method in estimating the equilibrium real exchange rate for Korean Won in 1981Q1 – 2000Q3 The chosen fundamentals are: the relative price of non-traded to traded goods, the net foreign assets, the terms of trade, the interest rate differential, and the fiscal balance The Johansen co-integration test is applied to estimate the long run relationship In this research, the result shows that all chosen variables are statistically significant and have correct signs Additionally, the permanent equilibrium exchange rate is also obtained by using the Hodrick – Prescott filter The findings are (i) there were no considerable misalignments until mid - 1990s, (ii) the real exchange rate was overvalued by around 10% in the previous period before the Asian crisis, (iii) due to the massive depreciation in the nominal exchange rate, the Korean Won was undervalued 30%

in 1998

In case of Thailand, Jongwanich (2009) also use the BEER approach to measure the misalignment exchange rate for Thai Bath Besides the basic variables, she adds the capital inflows variables to the set of fundamentals Applying the simple Engle – Granger method, the result suggests that all variables are significant and have correct signs The outcome proves the overvaluation of the Thai Baht happened in two different periods First, it appeared in 1984 – 1985 Second, it occurred persistently from 1990 up to the Asian financial crisis in 1997 The causes

of the crisis are blamed for the huge short-term capital inflows and the expansion of

government expenditure However, the Thailand’s exchange rate went back to its long run equilibrium value due to the deep nominal depreciation during the crisis

Zakaria (2010) applies BEER approach to examine the Pakistan’s misalignment exchange rate during 1983Q1 to 2005Q4, and uses GMM method to investigate its impact on economic growth The set of determinants are the terms of trade, the trade restrictions, the capital accumulation, the government consumption, the capital inflows, the foreign exchange reserves, and the domestic credit Except the domestic credit, other variables are statistically significant His conclusions are (i) the Pakistan rupee was undervalued during the 1983 – 2005, (ii) the undervaluation has positive impact on growth rate in Pakistan

In the study of Cheng & Orden (2005), they calculate the exchange rate misalignment for Indian Rupee and examine its impact on agricultural policy measures during the period 1970s to 2002 The also use the BEER approach with Johansen co-integration procedures to find the long run relationship between variables The determinants are the government consumption, the terms of trade, the foreign exchange reserves, the openness, and the technological progress The result

is that the Rupee is overvalued in during the period 1980s and the early period 1990s They also indicate that the exchange rate overvaluation has potentially indirect negative effects to the agricultural sector in India during 1985 – 1992 and

1998 – 2002 Nevertheless, when the exchange rates went back to its equilibrium value, these effects are gradually eliminated

b) Empirical studies in China

There are various studies measuring the equilibrium exchange rate for Chinese Renminbi By applying a number of approaches including PPP, FEER, and BEER approach, economists obtain different outcomes

In most of cases, economists conclude that Chinese Renminbi was undervalued for several years Indeed, Coudert & Couharde (2005) apply both

FEER and BEER methods in order to get the appropriate level of the Renminbi misalignment Their results show that Chinese Renminbi was significantly undervalued in 2002 – 2003 Other surprising outcomes are (i) the misalignment of USD is influenced by the misalignment of Chinese Renminbi (ii) a revaluation of the Chinese Renminbi could affect the size of the US deficit Cheng & Orden (2005) also calculate the exchange rate misalignment for Chinese Renminbi by applying BEER method They claim that the substantial undervaluation in Renminbi comes from the stable economy with low inflation rates, accompanying by a rigid nominal exchange rate policy We clearly see that their results are quite similar with the research of Coudert & Couharde (2005) Other researches have the similar conclusions that the Chinese Renminbi was highly undervalued (Table 2)

Reversely, the research made by Wang (2004) shows the opposite results The author applies only a BEER model for the annual data from 1980 to 2003 The fundamental set contains the relative price of tradable to non-tradable goods, the net foreign assets, and the degree of openness His result suggests that there is no evidence about the misalignment during that period However, this strange result is obtained because the lack of the observations would make the fitted values very close to the actual values

Table 1: Several results of empirical researches for Chinese Renminbi

1 Jeong & Mazier

Source: Coudert & Couharde (2005)

c) Empirical research in other countries

In the other study of Melecky and Komarek (2007), the misalignment exchange rate for Czech Koruna is also derived from the BEER model Data covers from 1994Q1 to 2004Q1 They examine the potential determinants such as the productivity differential, the interest rate differential, the terms of trade, the foreign direct investment, the net foreign assets, the government consumption, and the degree of openness However, only four statistically significant determinants are the productivity differential, the real interest rate differential, the terms of trade, and the foreign direct investment Their finding is that the Czech Koruna was undervalued about 7 percent in the period 1994 to 2004

Frait, Komarek, & Melecky (2006) focus on the misalignment exchange rate for five European countries (Czech Republic, Hungary, Poland, Slovakia, and Slovenia) during 1995Q1 to 2004Q1 In this study, they present in detail several

techniques using in BEER approach The set of fundamentals includes the terms of trade, the productivity differential, the net foreign assets, the government spending, the trade openness and the foreign direct investment To obtain the current equilibrium exchange rate, they propose to use either Engle – Granger method or Auto Regressive Distributed Lag (ARDL) approach To get the persistent equilibrium exchange rate, they recommend using either Band-Pass filter or Hodrick-Prescott filter The result is that at the beginning of 2004, the five countries’ currencies were undervalued After that, each country also had alternating overvaluation and undervaluation periods together

Aliyu (2008) uses BEER method in order to calculate Nigeria Naira’s exchange rate misalignment during 1986Q1 to 2006Q4 The author treats the net foreign assets, the terms of trade shocks, the index of crude oil price volatility, the government spending, the index of openness, the index of monetary policy performance, and the index of productivity as the potential determinants The author applies Johansen’s co-integration analysis to find long run relationship between determinants and REER He also estimates the permanent exchange rate misalignment by utilizing Hodrick-Prescott filter The finding is that the Naira alternates between undervaluation and overvaluation

The following table will summarize the all empirical studies above:

Table 2: Empirical studies of real exchange rate misalignment in several countries

No Study Dataset Method & Variables Conclusion

1 Chinn

(2000)

Time series for 8 East Asian countries (1970Q1 – 1998Q3)

PPP - Nominal exchange rate, domestic price, foreign price

The Malaysian Ringgit, the Philippines Dollar, and the Thai Baht:

overvalued The Korean Won and the Indonesian Rupiah: undervalued

BEER - Terms of trade, resource gap, private investment, trade openness

The Hong Kong Dollar was undervalued (1984 – 1993), overvalued (1993 – 1995), undervalued (after 1995)

3 Sahminan

(2005)

Time series:

Indonesia (1993Q1 – 2005Q2)

BEER - Terms of trade, productivity differential, net foreign assets, and real interest rate differential

The Rupiah is overvalued (1996 – 1997), undervalued (1998 – 2003), overvalued (after 2004)

4 MacDonald

(2004)

Times series:

Singapore (1983Q1 – 2003Q2)

BEER - Terms of trade, property prices, net foreign asset, output gap, and trade openness

There is no evidence for misalignment of Singapore Dollar in

BEER - Terms of trade, net foreign assets, productivity differential, real interest rate differential, fiscal balance

The South Korean Won is overvalued in 1996Q1 – 1998Q1 After 1998: Won was undervalued

6 Jongwanich

(2008)

Time series:

Thailand (1970 – 2000)

BEER - Terms of trade, government expenditure, current account, net of reserve changes, foreign direct investment, portfolio, productivity, trade openness

The Thai Baht is overvalued 12% in

1996

BEER - Terms of trade, the trade restrictions, capital accumulation, government consumption, capital inflows, foreign exchange reserves, domestic credit

The Pakistan rupee was undervalued during the

1983 – 2005

Undervaluation has positive impact on economic growth

BEER - Terms of trade, government consumption, foreign exchange reserves, openness,

technological progress

The Indian Rupee is overvalued in 1980s – 1990s

BEER - Terms of trade, government consumption, foreign exchange reserves, openness,

BEER - Productivity differential, net foreign assets, trade policy openness

The Chinese Renminbi nearly equals

equilibrium level

BEER - Productivity differential, the interest rate differential, the terms of trade, the foreign direct investment, the net foreign assets, the government consumption, and the degree of openness

The Czech Koruna was undervalued about 7 percent in the period

Net foreign assets, terms of trade shocks, index of crude oil price volatility, government spending, index of openness, index of monetary policy performance, and index of productivity

The Nigerian Naira alternates between undervaluation and overvaluation

2.5 Conceptual Framework

The following conceptual framework will describe the theories about the measurement of misalignment of exchange rate approach and its relationship with trade balance Firstly, two approaches applied to measure the exchange rate misalignment are BEER and PPP PPP just uses nominal exchange rate, domestic and foreign price levels while BEER requires an econometrics process with several macroeconomics variables Secondly, the values of exchange rate misalignment are utilized to investigate its relationship with trade balance In the normal case, overvaluation (undervaluation) has negative (positive) effects on trade balance (Dooley et al 2003; Kaminsky et al., 1997; Krugman, 1987) However, if a country

is vertically specialized, then its trade balance is less sensitive to real exchange rate’s fluctuations (Kharroubi, 2011)

Figure 3: The conceptual framework

2.6 Summary

This chapter provides an overview of several approaches which is applied to measure the equilibrium exchange rate If the actual exchange rate is different from its equilibrium level, the misalignment happens Whether a currency is overvalued

or undervalued, it may have significant impact on various fields of an economy

Nominal ER

Domestic Price Level Foreign Price Level

Equilibrium Real Exchange rate

Actual Real Exchange rate

Therefore, the measurement of exchange rate misalignment becomes one of the most concerns in macroeconomics research However, there is no consensus which can determine the most “correct” value of exchange rate misalignment That is the reason why we must think carefully and choose the appropriate approaches In this research, the PPP and BEER approaches are focused in detail to measure the equilibrium exchange rate and furthermore, provide the exchange rate misalignment After examine the exchange rate misalignment, we also discuss about its relationship with trade balance

CHAPTER 3: DATA AND RESEARCH METHODOLOGY

3.1 Introduction

The aim of this chapter is to provide the source of data and the research methodology All of data are collected from GSO, Worldbank, IFS, and MoIT To estimate exchange rate misalignment, we have two estimating methods: BEER and PPP The PPP method is simple because it just needs the nominal exchange rate, domestic and foreign price levels The BEER approach is more complex; and we need a two-step Engle Granger procedure to analyze a regression function In addition, we also review several essential tests such as (i) Dickey-Fuller test for the stationary of series, (ii) the normality test, (iii) the heteroskedasticity test, and (iv) the serial correlation test

3.2 The PPP approach

The data for PPP approach cover for period from 2000M01 to 2011M12 The needed variable is the Consumer Price Index (CPI) for Vietnam and several countries Data for CPI is obtained from IFS, World Bank

In this research, the PPP misalignment of exchange rate will be calculated against a basket of foreign currencies by applying the weighted of traded goods with Vietnam’s trading partners:

In this research, the selected Vietnam’s major trading partners are: Japan, Singapore, China, Korea, United States, Thai Land, Australia, Hong Kong, Germany, Malaysia, France, Indonesia, United Kingdom, Netherlands, Russia, Philippines, Switzerland, Italy, Belgium, and India

3.3 The trade balance

The trade balance is calculated by the difference between exports and imports The specific data for exports, imports and trading commodities are from Vietnam agencies: GSO, Customs, and MoIT

3.4 The BEER approach

The BEER approach applies the data from 2000Q01 to 2010Q02 Variables for regression are the REER, the trade openness, the terms of trade, the net foreign assets, the domestic credit, the foreign direct investment, the real interest rate differential

3.4.1 Real effective exchange rate (REER)

The real effective exchange rate is defined as the weighted multilateral exchange rate which is adjusted for price indices REER can be presented in formula as:

3.4.2 Other variables

Data for variables are obtained from GSO, IFS, and DataStream NFA is calculated as the ratio of NFA (excluding FDI) to nominal GDP TOT is calculated

by the ratio of export price index to import price index FDI is measured as the ratio

of foreign direct investment to nominal GDP DC is measured as the ratio of the domestic credit to nominal GDP RR is measured as the difference between the real lending rate in Vietnam and the one in the U.S