The impact of exchange rate on bilateral trade between Vietnam and China

The impact of exchange rate on bilateral trade between Vietnam and China VO THANH THU University of Economics HCMC – vothanhthu@ueh.edu.vn TRAN QUOC KHANH CUONG Van Hien University – c

The impact of exchange rate on bilateral trade

between Vietnam and China

VO THANH THU

University of Economics HCMC – vothanhthu@ueh.edu.vn

TRAN QUOC KHANH CUONG

Van Hien University – cuong.tqk@vnp.edu.vn

Abstract

The goal of this paper is to investigate the short term and long term relationship between exchange rate and trade balance on the trade balance between Vietnam and China Differing multivariate methods such as Johansen Cointegraion test, Vector Error Correction Model and monthly time series data spans from 2011:1 to 2015:12 have been employed The results prove the relationship among trade balance, real exchange rate, domestic and foreign output or ML condition hold The positive coefficient implies that the devaluation of Vietnamese currency will improve the bilateral trade between Vietnam and China Last but not least, the prominent aim of this paper is to prove the existence of Purchasing Power Parity between Vietnam and China hold before examining the effect of real exchange rate to trade balance

Keywords: PPP; VECM; exchange rate; trade balance; ML condition

1 Introduction

Özkan (2013) states that real exchange rate plays an important role in the

macroeconomic such as economic development, sustainable growth, especially in the

trade balance The trade balance is a component of Gross Domestic Product (GDP) GDP which will increase if trade of balance is surplus, and decrease if trade of balance is deficit

In recent years, Vietnam almost has a trade deficit with China The exchange rate between Vietnam and China has been considering as a reason for trade deficit Vietnam is in need

to depreciate its currency because exchange rate plays a crucial role in the economy This problem is very important because exchange rate plays an important role in the economy,

especially in emerging market such as Vietnam (Stone et al., 2009) It will effect on

inflation targeting which is one of the urgent issues in Vietnam in recent years

According to Marshall-Learner (ML) condition or J Curve, the exchange rate is vital in the trade balance Both of them state that if the currency is depreciation, with the condition that adding the absolute value of the elasticity of export and import more than one, the trade balance will increase in the long run The authors often use the formula to check the relationship of exchange rate and trade balance as follow:

TB = f(RER, Y, Y*) where RER is real exchange rate and is calculated with the assumption Purchasing Power Parity between two countries is hold However, in the reality, many studies have proven PPP between two countries does not hold such as: Assaf (2006), Doğanlar (2006) This is the limitation of papers when the authors do not prove PPP hold Therefore, in this paper, PPP is proved hold in the long term before calculating the RER

The next part of this study include: section 2 briefly discusses the literature review; section 3 presents the model specification, section 4 presents the results and discussion

2 Literature review

2.1 The purchasing power parity approach (PPP)

The PPP was first studied by the Salamanca School in Span in the 16th century At that time, PPP was basically means that when we changed to the common currency, the price level of every country should be the same (Rogoff, 1996)

Cassel introduced the term purchasing power parity (PPP) in 1918 After that, PPP became the benchmark for a center bank to build up the exchange rate and for scholars

to study exchange rate determinant The model of PPP of Cassel became the inspiration for Balassa and Samuelson to set up their models in 1964 They independently worked

and gave the final explanation why absolute PPP became the good theory of exchange rate

(Asea and Corden, 1994) The reason is that the relative price of each good in different countries should be equal to the same price when changing into the same currency The PPP has two versions, including absolute and relative PPP (Balassa, 1964)

According to the first version, Krugman et al (2012), define that absolute PPP implies that

the exchange rate of pair countries equal tothe ratio of the price level of these countries This mean:

Shapiro (1983) states that the relative PPP implies the ratio of domestic to foreign

prices would equal the ratio change in the equilibrium exchange rate This states that

there is a constant k which has the relationship between price level and the equilibrium exchange rate,

In the empirical studies, checking the validity of PPP by unit root test was popular in 1980s based on Dickey and Fuller approach, nevertheless, this approach has low power (Ender and Granger, 1998)

After Johansen (1988) develops a method of conducting VECM, which becomes the benchmark model for many authors test PPP approach There are some papers have proved PPP hold such as Yazgan (2003), Doğanlar et al.(2009), Kim (2011), Kim & Jei (2013), Jovita Gudan (2016), and some papers do not such as Basher et al (2004), Doğanlar (2006)

2.2 Marshall – Lerner condition

According to Bahmani-Oskooee (1991), Marshall – Lerner was that if the currency depreciated, the trade balance would improve in the long run with the condition that the sum of the absolute value of the elasticity of export and import is more than one Assuming that the condition is satisfied, the appreciation of home country makes imported goods from abroad cheaper, thus, the consumers of Home country buy more Foreign consumer finds imported goods are more expensive and they buy less than before appreciation As Consequence, Home country has trade deficit Nevertheless, if Home country is depreciated, an opposite effect would be taken place and Home country would enjoy trade surplus with the rest of the world

Furthermore, the condition states that devaluation of currency has positive effects on the trade balance if the total of the absolute value of the elasticity of export and import is larger than one For that reason, the effects on trade balance rely upon the elasticity of price

However, the disadvantage of the Marshall – Lerner condition is that it can not explain why the trade deficit occurs in the short run after currency depreciation The reason why trade is deficit, which happens in the short run, was explained by Akbostanci in 2004 Most exporters and importers have signed the contract before depreciation In the short

run, the quantity of export and import does not change much; nevertheless, the depreciation makes the imported goods cost more in domestic currency Therefore, the value of imported goods rises while exported products do not change a lot As a result, trade balance becomes deficit

Seeking for the relationship between trade balance and exchange rate is one of the most interested topics in international trade There have been many authors such as Rose, Yellen, Bahmani-Oskooee, Arize, Shahbaz have conducted researches in many countries from developing to developed one The common techniques, which are applied, are Johnsen cointegration (1988) technique such as Bahmani-Oskooee (1991), Onafowora (2003) etc., and Autoregressive Distributed Lags (ARDL) such as Narayan (2006),

Shahbaz et al., (2012) etc

Matesanz and Fugarolas (2009) examined the relationship between trade balance and exchange rate in Argentina from 1962 to 2005 The results indicated that the most important thing is that the trade balance of Argentina was supported by Argentina currency undervaluation As a result, M-L condition took place in Argentina Last but not least, in their paper, they argued that the coefficient of real exchange rate can be positive

or negative If the coefficient is positive, the M-L condition will hold, this means that when

a currency is devaluated, trade balance will increase, or vice versa

The conclusions for J curve or M-L Condition are very different While any researchers such as Bahmani-Oskooee (1991), Shirvani and Wilbratte (1997), Narayan (2006) claim that that there is only the long run relationship between trade balance and exchange rate, Rose and Yellen (1988) and Rose (1990), Rahman et al.,(1997) insist that there is no relationship between the two factors Some papers indicate that if real exchange rate is depreciation, it will lead to trade balance deterioration such as Arora et al., (2003) and

Shahbaz et al., (2012)

3 Model specification

Model for purchasing power parity approach

Take log from the equation (1) we have:

Log(s t ) = log(p t) – log(p%∗) (3)

where: s is natural log exchange rate of VN, pt and p%∗ is the natural log CPI of VN and CPI

of China respectively

If all variables mean reverting, the real exchange rate is calculated by the PPP approach following the equation:

where all variables are log form, s is log exchange rate of VN, pt and p%∗ is the log CPI of

VN and CPI of China respectively

Model for trade balance

Determining the relationship of exchange rate, GDP Vietnam and GDP China with trade balance follow the equation:

Ln(TB) = α0 + α1ln(Q)+ α2ln(Yt) + α3ln(Y%∗) + εt (5) where TB is trade balance and is defined as the ratio of export to import, Q is the real exchange rate defined as the relative price of domestic to foreign goods or RER = P/ (SP*) whe5re: S is nominal exchange rate, P is domestic price index and P* is foreign price index

Yt and Y%∗are Vietnam real income and China real income respectively εt is white noise process

The expected signs of the coefficient of real exchange rate can be positive or negative

α1 is positive if the real exchange rate of VND depreciation encourages exporting goods and reduces imported goods, then increase trade balance, or Marshall Lerner condition holds If α1 is negative, the M-L does not hold or depreciate of VND which makes trade balance worsen

The expected sign of the coefficient of Vietnam real income will be negative When Vietnam income increases, Vietnamese imports more goods and services from China, therefore, trade balance will decrease or α2 < 0 Similarly, the expected sign of the coefficient of China real income will be positive When China income increases, Chinese imports more goods and services from Vietnam, therefore, trade balance of Vietnam will increase or α3 > 0

Becauseofthe limitation of data, the index of industrial production (IIP) will be used

to replace for real income as a proxy

Doing VEC Model follows the steps:

Step 1: Testing unit root test based on ADF test

VECM requires variables are stationary and therefore all-time series express no spurious regression Augmented Dickey-Fuller test whether each variable stationary or not

Step 2: Using Johansen (1988) test to test the cointegration of these variables

Using Johansen (1988) technique with maximum likelihood to test cointegration The precondition before doing this test is determine lag order p

Optimal lag must be chosen before conducting Johansen (1988) procedure In view package, there are five lags length criteria which have the same power Therefore, if there are more than 1 lag criteria, every lag is used for every case in VECM

Step 3: Running VECM

VECM can be written as:

∆𝑙𝑛𝑇𝐵, = 𝛿/+ 768,𝜃2∆ ln 𝑇𝐵"56 + 768,𝛾2∆ ln 𝑌"56+ 7 𝜑2∆ ln 𝑌"56∗

µ6∆ ln 𝑄"56

7

68, + 𝜆 ln 𝑇𝐵"5,− 𝛼/ − 𝛼,ln 𝑄"5,− 𝛼Aln 𝑌"5,− 𝛽Cln 𝑌"5,∗ +

where ∆ is the first difference operator, 𝜆 is the speed of adjustment coefficient of long run, TB is trade balance, Q is the real exchange rate, Y is IIP of Vietnam, Y* is IIP of China and 𝜀, is white noise

The estimating coingtegration relationship of the function 5 reflects the long run relationship of parameters And the equation 6 yields a short run and long run relationship among variables (Matesanz and Fugarolas, 2009)

𝜆 is the speed of adjustment coefficient of long run If 𝜆 is negative in sign and signification, there is long run causality running from dependent variables to the independent variable In other words, the real exchange rate, Vietnam income and China income impact on bilateral trade between Vietnam and China

Wald test is used to test whether short run causality between exchange rate and trade balance takes place

3.1 Data for PPP approach

Nominal exchange rate (is defined as the number of units of domestic currency per unit of foreign currency), consumer price index of Vietnam and consumer price index of China are in terms of logarithm form and data spans from 2011:1 to 2015:12 Nominal exchange rate was collected from Thomson Reuter, Consumer Price Index of Vietnam, base year = 2010, was collected from IFS and Consumer price index of China, base year

= 201, was collected from OECD

3.2 Data for trade balance

This procedure needs real exchange rate, trade balance between Vietnam and China, industrial production index (as a proxy of GDP) of Vietnam and China All variables are natural logarithm Data was collected from IFS (export, import) and ERIC (IIPVN, IIPCN, base year: 2010 and are calculated by the authors) indicator system spans from 2011:1 to 2015:12

4 Results and discussion

4.1 PPP approach

Unit root test

The Augmented Dickey Fuller test is used to check the stationary of consumer price index of Vietnam (CPIVN), consumer price index of China (CPICN) and nominal exchange rate (S) between Vietnam and China All variables have log form Mackinon (1996) which

is available in Eview 8 package software is used as the critical value

Table 1

Unit root test for PPP approach

Variables

ADF

At level At first different

t – statistic p-value t – statistic p-value

Note: *, ** indicate significant at 5% and 1% levels respectively

Table 1 reports the results of unit root test for time series of consumer price index of Vietnam (CPIVN), consumer price index of China (CPICN) and nominal exchange rate (S) between Vietnam and China As the table suggests, all variables have t-statistic greater than the critical value at level As the consequence, all variables have unit root or nonstationary at level

On the contrary, at the first difference of S and CPICN have the t-statistic smaller than critical value at 1% Therefore, they do not have unit root or stationary at the first difference Similarly, CPIVN has t-statistic smaller than the critical value at 5% so that it

is stationary at the first difference

As being analyzed above, all variables are nonstationary at level and stationary at first difference, therefore they cointegrated at I(1) or same order As a result, Johansen (1988) procedure is examined to investigate the cointegration among these time series

Optimal lags for VECM

Table 2

Lag criteria for PPP approach

LR: sequential modified LR test statistic

FPE: Final prediction error

AIC: Akaike information criterion

SC: Schwarz information criterion

HQ: Hannan-Quinn information criterion

Table 2 illustrates criterion for choosing lag 1 In other words, 1-lag was chosen for conducting Johansen (1988) procedure or testing cointegration of three variables

Johansen (1988) procedure for cointegration test

For the reason all variables are cointegrated at the first order I(1), Johansen (1988) cointegration with 1 lag is conducted to test the long run relationship among variables

Table 3

Johansen cointegration test with 1 lags

Number

of Ces

Cointegration equation

Statistic Critical

value (5%) Statistic

Critical value (5%)

Table 3 presents the Johansen (1988) cointegration test The results indicate Trace test statistically significant at 5% because the statistic is greater than the critical value of 5%

As consequence, the null hypothesis of r = 0 is rejected R = 0 implies one cointegration equation in the long run That is the reason why VECM can be used to find out the long run relationship of three variables

Table 4

The speed of adjustment coefficient of long run

Coefficient Std Error t-Statistic Prob

Table 4 𝜆 equals -0.479592and probability equals 0.001 Error Correction Term is negative and significant in sign For this reason, variables take place relationship in the long run or all variables come back to mean As a result, real exchange rate is calculated followed this formula: q = s + p* - p with all variables have logarithm

4.2 The impact of the exchange rate on trade balance

Unit root test

Similarity of PPP approach, the Augmented Dickey Fuller test is used to check the stationary of real exchange rate (Q), industrial production index of China (IIP CN), industrial production index of Vietnam (IIP VN) and trade balance (TB) All variables have the natural log form Mackinon (1996) which is available in Eview 8 package software, is used as the critical value as well

Table 5

Unit root test on time series

Variables

ADF

At level At first different

t – statistic p-value t - statistic p-value

Note: ** indicate significant at 1% levels TB and Q test unit root with “Exogenous: Constant, Linear Trend”

The table 5 reports the results of unit root test for time series of trade balance (TB), real exchange rate between Vietnam and China, industrial production index of Vietnam (IIP VN) and industrial production index of China (IIPCN) The table 5 illustrates that all variables have a t-statistic greater than the critical value at level As the consequence, all variables have unit root or nonstationary at level On the contrary, at the first difference, all variables have the t-statistic smaller than the critical value of 1% Therefore, all variables have not unit root or stationary at the first difference

To sum up, all variables nonstationary at level and stationary at the first difference; therefore, they cointegrated at I(1) This is the reason why Johansen (1988) procedure can

be used to examine the cointegration among these time series

4.3 Optimal lags for VECM

Table 8 Lag selection of VECM

Table 6 suggests that five criteria choose two lags differently, 1 and 8 Therefore, in this paper, all of lags wereused for conducting VECM Choosing the best model is based

on the diagnostic check after running VECM