Economic growth and balance of payments constraint in Vietnam

This paper focuses on the question of whether economic growth was constrained by Vietnam’s balance of payments during the 1990-2004 period, by using the model developed by Thirlwall. Based on quarterly and annual data from the period, we found that economic growth was indeed constrained by the country’s balance of payments, although deficits in the trade and current account were partly relieved by external inflows of capital such as foreign direct investment, official development assistance, and debt. This is evidence that the Vietnamese Government must adopt policies that can relieve the balance of payments and foster economic growth.

Economic Growth and Balance of Payments Constraint in Vietnam

Pham Sy An*

Introduction

ABSTRACT This paper focuses on the question of whether economic growth was constrained by Vietnam’s balance of payments

during the 1990-2004 period, by using the model developed by Thirlwall Based on quarterly and annual data from the

period, we found that economic growth was indeed constrained by the country’s balance of payments, although deficits

in the trade and current account were partly relieved by external inflows of capital such as foreign direct investment,

official development assistance, and debt This is evidence that the Vietnamese Government must adopt policies that can

relieve the balance of payments and foster economic growth

Economic growth is usually the primary goal of an economy To accelerate economic growth, it is worth billions to identify where the source of economic growth comes from and this has been the subject of much controversy among economists On one side, economists such as Solow (1957), Romer (1986), Lucas (1988), and Krugman (1989) suggest that economic growth originates from the supply side, such as labor, capital, total factor productivity (TFP), and research and development (R&D) In their eyes, factors like supply and productivity play a major role in economic growth and the differences in economic growth among countries are due to differences in factors like supply and productivity On the other side, economists such as Keynes (1936) and Thirlwall (1979) believe that demand will induce or constrain economic growth Thirlwall (1979), a post-Keynesian economist, considered demand, especially international trade,

as the principal factor accelerating or constraining growth He suggests that the dominant constraint on demand is balance of payments in an open economy and his model, the so-called Balance of Payments Constrained Economic Growth model, stresses primarily on balance of payments as a constraint of economic growth

In the 1998-2001 period, for instance, after the Asian financial crisis, Vietnam experienced the phenomenon of supply exceeding demand, and the economy fell into stagnation Growth was low and deflation and disinflation appeared In confronting the situation, the government

*

Pham Sy An is a research fellow at the Vietnam Institute of Economics, Vietnam Academy of Social Sciences The author would like to thank Dr Vo Tri Thanh (CIEM), Nguyen Cao Duc (CAF), and James Donald (ANU) for their

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determined to stimulate domestic demand Expansionary monetary policy and relaxed fiscal policy were implemented through credit expansion, low interest rates, and increases in government spending This is clear evidence indicating that supply does not guarantee growth Moreover, unemployment and capital waste prove that available production factors are underutilized in reaching potential output (Vietnam Institute of Economics 2002) In the case of supply exceeding demand, sources will be underused, while when demand exceeds supply, sources from other places will flow into the economy to satisfy demand

Until now, the relationship between the balance of payments and economic growth has not been recognized in Vietnam Researchers have focused on looking for sources of economic growth in Vietnam under the form of production function (supply side), such as Tran Vo Hung

Son and Chau Van Thanh (1998), Le Dang Doanh et al (2002), and Chu Quang Khoi (2003)

Therefore, this paper is the first attempt at investigating economic growth in Vietnam from the demand side The purpose of the paper is to answer the question of whether or not economic growth was constrained by the balance of payments in Vietnam during the 1990-2004 period The paper applies Thirlwall’s balance of payments constraint model

The paper is structured into five sections and will be presented in two issues of the Review Following the Introduction, Section 1 briefly reviews the picture of Vietnam’s economy and considers economic growth in relation to balance of payments during the 1990-2004 period Section 2 develops the Balance of Payments Constrained Economic Growth Model Section 3 estimates the growth constrained by balance of payments in the Vietnamese economy using quarterly data from the 1990-2004 period Finally, Section 4 provides conclusions and policy implications

1 Economic growth in Vietnam’s economy during the 1990-2004 period

1.1 Economic overview

In the early 1980s, Vietnam’s economy was essentially a centrally-planned economy The State controlled and intervened in the means of production as regards physical inputs, output, and prices It established trade barriers, especially in foreign trade, and set dual foreign exchange rates as well as interest rates The result was hyperinflation and slow economic growth

At the end of the 1980s, the Vietnamese Government launched the “doi moi” (economic

renovation) process at the Sixth Congress of the Communist Party, with the nature of the process being a movement away from a centrally-planned economy towards a market-oriented economy

In the first three years of doi moi, changes took place in foreign investment policy, land policy,

foreign trade policy, and banking policy However, the failure of these efforts to stabilize the economy until 1989, as well as the expectation of aid from the former Soviet Union drying up, created the strongest pressure on reform In March of 1989, Vietnam adopted a radical and comprehensive reform package aimed at stabilizing and opening up the economy, and enhancing freedom of choice for economic units in order to fundamentally change the economic management system in the country The reform measures consisted of complete price liberalization, large devaluation and unification of the exchange rate, increases in interest rates to

positive levels in real terms, substantial reductions in subsidies to the SOE sector, encouragement of the private sector and a return to family farming on the basis of long-term leases The 1989 reform package was considered the most successful since the basic conditions were created for the transformation into a market-oriented and open economy

After the 1989 reform package was implemented, hyperinflation fell rapidly from three digit levels to two digit levels, economic growth gradually improved, growth rates in exports and imports increased, and Vietnam became a rice exporting country after a long period of importing rice These initial achievements encouraged the economic renovation program and were an initial stepping stone on the path to success during 1992-1997 The successful years began with the

Seventh Party Congress in June 1991, which decided to continue doi moi by establishing and

developing basic markets such as the labor market, capital and money markets, and an official foreign exchange market, and allowed prices and interest rates to be determined by market forces In this period, economic growth was impressive, recording 8.77% on average Inflation also fell quickly to single-digit levels, except in 1992 (17.5%) Inflation was thus under control, contributing significantly to macroeconomic stabilization and creating good conditions for high economic growth Growth rates in exports and imports in these successful years were quite high and played an important part in promoting high economic growth Moreover, high foreign investment flows and high savings to investment ratios were achievements in the period and this time marked a new phase of international integration, with Vietnam becoming a full-member of ASEAN in 1995

The Asian financial crisis suddenly broke out in Thailand and quickly spread its negative effects to other Asian countries such as Indonesia, Malaysia, and South Korea in 1997 Although the financial crisis did not impact directly on Vietnam’s economy, it had considerable indirect influence and curtailed the high economic growth of previous years Growth fell unexpectedly to 5.76% in 1998 and continued to be low from 1998 to 2001 Inflation in the period after the Asian financial crisis was strangely low (a disinflation rate), and a minus figure in 2000 (a deflation rate

of -0.6%) This phenomenon is a symbol of stagnation (low rates of inflation and growth) In this period, Vietnam became a member of APEC in 1998 and signed the Bilateral Trade Agreement with the US in 2000 Vietnam was also actively preparing the groundwork for its WTO accession After the repercussions from the Asian financial crisis eased, economic growth was partly restored and inflation inched upwards (4% in 2002, 3% in 2003, and 9.5% in 2004) As existing difficulties pass, though, new ones arise Although the Asian financial crisis was a good lesson for Vietnam, it is now being forced to reform its institutions and economy under pressure of international competitiveness if it wants its economy to integrate into the global economy with general laws and recording high growth as well as stability

1.2 Economic Growth in the 1990-2004 Period

In the 1990-2004 period, economic growth varied according to policy responses and changes

in internal as well as external environments As regards macroeconomic policies, the 1990-2004 period can be divided into two sub-periods: 1990-1995 and 1996-2004 The former was for

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stabilizing macroeconomic policies and the latter for macroeconomic stabilization to record higher growth However, for the purpose of this paper the 1990-2004 period will be divided into three sub-periods: 1990-1997, 1998-2001, and 2002-2004, to reflect the status of economic growth and the relationship between economic growth and balance of payment constraints

Business cycle of economic growth in the 1990-2004 period

Traditional theories of the business cycle that considers cycles to be self-sustaining have been substituted by modern theories that attribute cyclical fluctuations to the cumulative effect of shocks and disturbances that continually affect the economy (Chatterjee 2000) Based on this shock-based view of the business cycle, we can examine the cumulative effect of shocks and disturbances that brought about fluctuations in economic growth during the 1990-2004 period After implementing structural and orthodox reforms in 1989, natural and financial resources were allocated more efficiently, creating new incentives to produce goods and services In the first two years of this period, economic growth averaged 5.45% Then the cumulative effect of institutional reforms spurred economic growth to high levels during the 1992-1997 period, until the second shock came in the form of the Asian financial crisis in July 1997 While the first shock buffeted economic growth through the reallocation of natural and financial resources, the second shock impacted on economic growth through trade and investment

Prior to the Asian financial crisis, Vietnam’s economy was considered a small, open one in terms of the ratio of trade to GDP, and it connected with the outside through trade and investment The shocks from the crisis influenced Vietnam’s economy through these channels, especially as its trade was concentrated primarily on Asian countries and substantial foreign direct investment came from Asian countries There is a third channel that can affect Vietnam’s economic growth: the financial channel Vietnam’s capital account in the balance of payments was controlled and restricted, so the shocks from the Asian financial crisis could not buffet Vietnam’s economy through portfolio investment and, consequently, the impact of the shocks on economic growth were not so severe

The effect of the shocks on economic growth then died out, Vietnam’s economy recovered and trade and FDI were also restored Since 2002, economic growth has been high and other macroeconomic indicators such as the budget deficit and inflation have been stable

Period of economic stabilization and high growth: 1990-1997

The 1990-1997 period was characterized by high growth rates and stability in the socio-economic climate High socio-economic growth was only seen during 1992-1997, because in the first two years Vietnam had yet to break out of the “bad” period in the 1980s During 1990-1991, Vietnam’s economy recovered its balance to motivate the following years of 1992-1997 Thus, the 1990-1997 period can be divided into two sub-periods: 1990-1991 and 1992-1997 For these reasons, the period can be called the period of economic stabilization and high growth

The need to confront potential macroeconomic crises was increasing, and in the beginning of

1989 the government decided to audaciously combine structural reform and orthodox stabilization measures Structural reform brought about the liberalizing of most domestic prices,

while orthodox stabilization measures included raising interest rates, restraining credit expansion, and devaluating the exchange rate (Liunggren 1994) The result was an astonishing fall in inflation (from 393.8% in 1988 to 34.7% in 1989) However, by the end of 1989 high inflation had returned and continued upwards in 1990 and 1991 (67.1% and 67.5%, respectively) The balance of payments became serious and the collapse of the Soviet Union, one

of Vietnam’s major donors and trading partners, resulted in grave shortages of necessary imported inputs for production, particularly petroleum and fertilizer Growth was just 5.09% and 5.81% in 1990 and 1991, respectively (Liunggren 1994) All of these were synonymous with a latent return of macroeconomic instability

Reduction in aid from the Soviet Union, devaluation to reach the prevailing market exchange rate, and trade liberalization motivated exports and earned foreign exchange This in turn increased imported inputs for production

Economic growth and the inflation rate surprisingly averaged 8.77% and 9.65%, respectively Indeed, the stabilization period (1990-1991) was a springboard for the high growth seen in 1992-1997

In this period, the renovation process continued with several proposed macroeconomic reforms, such as (1) establishing and developing basic markets like labor, official exchange rate, capital and money markets; (2) allowing prices, interest rates, and exchange rates to be market determined; and (3) innovating administrative procedures

Growth rates for industry and construction as well as services were high during this period, especially industry and construction, at 13.25% per annum Industry was considered the engine

of growth Moreover, the proportion of agriculture, forestry, and fishery fell compared to the proportion of industry, construction and services Structural changes in the economy by increasing industrial and manufactured goods and decreasing agricultural products in the GDP showed a positive tendency in the process of development

Table 1: Growth rates of agriculture, industry, and services (%)

(1994 prices)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

GDP 5.09 5.81 8.7 8.08 8.83 9.54 9.34 8.15 5.76 4.77 6.79 6.84 7.04 7.3 7.6 Agriculture, forestry and fishery 1 2.18 6.88 3.28 3.37 4.8 4.4 4.33 3.53 5.23 4.63 2.79 3.62 3.9 3.3 Industry and Construction 2.27 7.71 12.79 12.62 13.39 13.6 14.46 12.62 8.33 7.68 10.07 10.32 9.95 10.32 10.3 Services 10.19 7.38 7.58 8.64 9.56 9.83 8.8 7.14 5.08 2.25 5.32 6.13 6.31 6.32 7.3

Source: The General Statistics Office (GSO) (1996, 2000, 2005)

The current account deficit as a percentage of GDP was relatively high compared with other periods and the trade deficit increased during the high growth period (see Figure 1) To speed up economic growth, a large trade deficit is inevitable as developing countries often import capital goods and intermediary inputs for production while exporting primary products and low value-added goods, and this was the case with Vietnam

Figure 1: GDP growth rate and Trade balance/GDP ratio

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

Source: GSO (1996, 2000, 2005)

The coefficient of the correlation between economic growth and the ratio of the trade balance

to GDP in the 1990-1997 period was -0.7 This was negative and quite high It raises the question: what happens if there is a shortage of foreign exchange for imports? If this was to occur, imports would be reduced and domestic resources such as labor and machinery would be underemployed, and economic growth would be not be as high as usual Fortunately, this did not happen in Vietnam, where the shortage of foreign exchange was supplemented mainly by inflows of FDI and partly by debt and net transfers

The coefficient of the correlation between GDP (%) and FDI was 0.53 This is moderate and positive In the high growth period, FDI was high on average as well and the reduction in economic growth in 1997 compared with 1996 was accompanied by a simultaneous decline in FDI levels Thus, FDI partly impacted intuitively on economic growth

In summary, in order to impulse economic growth, developing countries need to import the necessary inputs for production, but the level of exports required to earn foreign exchange aimed

at financing imports are rarely met, so inflows of capital such as debt and foreign investment are very important In the case of Vietnam, the scarcity of foreign exchange was fortunately supported by FDI, and partly by net transfers from remittances and debt

Period of economic slowdown after the Asian financial crisis: 1998-2001

The Asian financial crisis in 1997 put an end to Vietnam’s high economic growth Growth fell suddenly from 8.15% in 1997 to 5.76% in 1998 Although Vietnam’s economy was not seriously affected directly like other Asian countries, it was hit indirectly In the same period, Vietnam’s economy also suffered from recession, with symptoms of disinflation and low economic growth

In this period, growth and inflation averaged approximately 6% and 2.38%, respectively The growth rate of industry, considered “the engine of growth”, unexpectedly declined The Asian financial crisis resulted in a slowdown in the economies of influential countries and the unavoidable consequences were reductions in exports to and imports from these countries as well

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as their investment to Vietnam Furthermore, Vietnam’s currency devaluation was sufficient to enhance competitiveness compared with other countries in Asia

In this period, the trade balance and current account were slightly in deficit and even surplus

in 1999-2001, but economic growth was low compared with the previous period It is worth noting that narrowing the gap in the trade deficit can be a bad sign for developing countries, as they must import capital goods and intermediate inputs for domestic production and for export Vietnam’s imports, as well as exports, fell significantly in the period, and unemployment concurrently increased It is also important to understand that in order to reduce the trade deficit and still accelerate economic growth, it is not necessary to restrain imports because this will affect domestic production and exports So the import of necessary inputs for production can continue to be encouraged, and exports will simultaneously expand However, less developed countries usually export primary goods that have low prices and income elasticities in demand, while importing manufactured goods that have high prices and income elasticities in demand, so the trade deficit will widen unless reductions in economic growth drive decreases in imports In the case of Vietnam, the period of high economic growth was also the period of a large trade deficit, as well as the current account deficit The foreign exchange gap was filled by foreign financial resources However, if the trade deficit continuously widened and the gap was not bridged by financial resource due to unsustainable warnings about Vietnam’s balance of payments in the international community, then there would not be the minimum amount of foreign exchange required to achieve targeted growth rates and economic growth would be constrained by the balance of payments Of course, this has not happened in Vietnam’s case at present It is a reminder of the important theory that shows that reductions in the trade deficit due

to limiting or decreasing imports will constrain economic growth, as in 1998-2001 period

In the period, inflows of foreign investment into Vietnam decreased because foreign investors feared that instability in the regional socio-economic environment could affect Vietnam’s economy In the 1990-1997 period, FDI increased strongly, at an average of 66.2%, but then fell by 12% in the 1998-2001 period despite the new Law on FDI in 1996 and its amendment on 9 June

2000 to improve the investment climate and attract inflows of foreign investment

Another economic event to occur in 1999-2001 was recession This stemmed from supply exceeding demand in the domestic economy The industrial structure leaned towards the import-substitution industry, which had a high effective rate of protection, and the growth of heavily protected industrial output has far outdistanced manufactured export growth (Dapice 2002) Confronting this situation, the government executed a demand-stimulus policy1 aimed at stimulating domestic demand Although the government implemented several measures such as reducing tax rates and interest rates and expanding credit, domestic demand was not stimulated

as expected and supply still exceeded demand because of poor management and lack of coordination in policies (See Le Xuan Sang (2003), Nguyen Van Tau (2001))

In summary, the low growth rate during the period was due to weaknesses in the domestic production structure and adverse external shocks Although the trade balance, the current account

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and the overall balance were in slight deficit and even surplus, economic growth was low This period was a lively example of economic growth being constrained by demand in an open economy Reduction in external demand (exports) resulted in a decrease in demand for imports

of capital goods and an increase in unemployment in export activities This in turn brought about reductions in income and, subsequently, domestic demand To stimulate demand, the government must increase its expenditure but, of course, budget revenue was reduced due to the recession This created a large budget deficit Moreover, the gap between savings and investment also increased This period quite clearly indicated that in an open economy, economic growth will be constrained by balance of payments and one gap in foreign exchange can bring about two other gaps, in savings and budget

Period of economic recovery and integration into the global economy: 2002-2004

The repercussions from the Asian financial crisis subsided but new difficulties arose Economic growth began to recover and the inflation rate also increased slightly in 2002 and

2003, suddenly jumping to nearly 10% in 2004 Vietnam was also preparing to commit to WTO membership requirements, so it was urgent to quickly liberalize trade and finance as well as reform state-owned enterprises and administrative procedures

In this period, economic growth recovered and the trade balance was in deficit because the value of imports exceeded that of exports, although growth in exports was restored, at 25.3% and 28.9% in 2003 and 2004, respectively Again, the opposite relationship between the trade balance and economic growth is clearly visible A large trade deficit brings about high economic growth And the foreign exchange gap is mainly financed through FDI inflows, and partly by net remittances and debt In terms of export destinations, Vietnam still exports primarily to Asia, followed by the US and Europe Vietnam imports chiefly from Asia Lack of diversity in the origin of imports and the destination of exports can result in a high level of risk when adverse domestic shocks occur that negatively affect the balance of payments and then economic growth

In summary, economic growth recovered during this period and the trade deficit was high Exports were mainly primary goods and land-based products The import of machinery, equipment, materials, and fuel dominated total imports The Vietnamese Government continued

to reform the economy on the threshold of international economic integration, but many weaknesses were revealed and challenged the process of reform, especially the dubious nexus and kinship among government, state-owned enterprises, and commercial banks

In conclusion, the following remarks on Section 2 of this paper can be made Firstly,

economic growth went through three sub-periods: the periods of stabilization and acceleration (1990-1997), recovery (1998-2001), and integration (2002-2004) Each sub-period had specific characteristics and policy responses to adapt to changes in the internal and external environment

Secondly, the economic structure changed slowly This was unexpected in the process of industrialization and improvements in competitive capacity Thirdly, economic growth and the

trade balance, as well as the current account, have an opposite relationship And these deficits were filled by FDI, debt, and net transfer Thus, economic growth would have been severely

constrained by balance of payments if no capital inflows bridged the gap in the trade balance and

current account

2 The balance of payments constrained growth model

Thirlwall, a post-Keynesian economist, uses his model, the so-called Balance of Payments

Constrained Economic Growth Model, similar to a dynamic version of Harrod’s (1933) Foreign

Trade Multiplier, to explain the position of trade and the balance of payments in economic

growth Thirlwall (1979) reckoned that economic growth is ultimately constrained by the balance

of payments In his original model, international trade, particularly elasticities in demand for

exports and imports in respect to price and income, plays a considerable role in explaining the

differences in growth rates across countries It is necessary, therefore, to revisit Thirlwall’s

growth law and its other modified models

The initial equilibrium condition is given by:

ME P

X

ME P F

X

ME P R

X

m f

x

d X IDP P ME IDP

D ME P F

X

In which X is the quantity of exports, is the price of exports in domestic currency, M is the

quantity of imports, is the price of imports in foreign currency, E is the exchange rate

measured as the domestic price of foreign currency, is the value of nominal net capital inflows

measured in domestic currency, R is value of remittance, is the value of nominal revenues,

in domestic currency, of invisible services related to production factors, the so-called “

d

P

f

P

F

x

IDP

IDP

revenues”, is the value of nominal expenditures, in domestic currency, of the invisible

services related to production factors, the so-called “

m

IDP

IDP expenditures”, and D is debt service

Recognizing that a country can obstinately face a trade deficit, Thirlwall and Hussain (1982)

developed the “Extended Model”, with the initial equilibrium condition [2] Elliot and Rhodd

(1999) highlighted the importance of debt servicing in the equilibrium condition, so the initial

condition can be included in [5] And other economists can modify the initial equilibrium

condition in putting forward the importance of certain factors in the balance of payments such as

capital flows, interest payments (Brid 2001), interest, dividends, and profits of the current

account of balance of payments (Ferreira and Canuto 2003) in accordance with studied countries

In [3], due to the importance of remittance in filling the deficit in the trade balance in many

developing countries, it is necessary to add remittance to the initial condition

Taking logarithm and rates of growth infers:

e m p x

e m p f x

e m p r x

m f

x

d x idp p m e idp

d e

m p f

x

In which, lower case letters represent rates of growth of the respective variables; θ and

(1−θ) represent the shares of exports and capital flows as a proportion of these receipts, γ and

)

1

( −γ are the shares of exports and remittance as a proportion of these receipts, ω and (1−ω)

are the share of exports of goods and IDP revenues as a proportion of total receipts in the

current account, α and (1−α) show the share of imports and IDPexpenditures as a proportion

of total payments in current account, and ρ and (1−ρ) are the shares of imports and debt

service on total expenditure

The normal multiplicative import and export demand functions have the forms:

Y P E

P

a

Z E P P

b

In which a and b are constants, ψ is the price elasticity of demand for imports (ψ < 0), η is

the price elasticity of demand for exports (η < 0), Y is domestic income, Z is the level of world

income, π is the income elasticity of demand for imports, and ε is the income elasticity of

demand for exports Taking logarithm and rates of growth give:

) ( )

) ( )

Substituting [13] and [14] into equations [6] to [10] and implementing some algebraic

manipulations, we obtain:

π ε ψ

1

π ψ

θη θ

θ

π ψ

γη γ

γ

απ αψ

ωη α

α α

ω ω

ρπ ρψ

θη ρ ρ ρ θ

θ

The real exchange rate, by assumption, does not change very much in the long run2

(p d − p f −e=0) or the Marshall-Lerner condition is just satisfied (ψ +η =1) and x≡εz, equations

[15] to [19] become:

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