Effect of remittances on the real exchange rate the case of vietnam from 2000 to 2020

Remittances are a source of external financing for many developing economies and have been estimated to exceed other types of external funding such as foreign direct investments (FDIs) and foreign aid over the past two decades. According to the World Bank (2013) remittances generally reduce the level and severity of poverty, thus leading to positive effects such as higher human capital accumulation, improved health and educational spending, enhancing small business investment, etc. According to the report on Migration and Development conducted by the World Bank (WB) and the Global Knowledge Partnership on Migration and Development (KNOMAD), Vietnam continues to be one of the 10 largest remittance recipient countries in the world. Recognizing the important influence of remittances on Vietnams economy, my team has conducted the topic The effect of remittances on foreign exchange rate: The case of Vietnam.

FOREIGN TRADE UNIVERSITY FACULTY OF FINANCE AND BANKING ****** INTERNATIONAL FINANCE REPORT Effect of remittances on the real exchange rate the case of vietnam from 2000 to 2020 Instructor : Assoc Prof Dr Mai Thu Hien Class : TCHE414 Group : Ha Noi, 2023 FOREIGN TRADE UNIVERSITY FACULTY OF FINANCE AND BANKING ****** INTERNATIONAL FINANCE REPORT EFFECT OF REMITTANCES ON THE REAL EXCHANGE RATE: THE CASE OF VIETNAM FROM 2000 TO 2020 Instructor : Assoc Prof Dr Mai Thu Hien Class : TCHE414 Group : Ha Noi, 2023 TABLE OF CONTENTS LIST OF FIGURES .3 LIST OF TABLES ABSTRACT CHAPTER INTRODUCTION 1.1 Reason to choose this topic 1.2 Rationale of the study 1.3 Literature review 1.4 Structure of the research CHAPTER THEORETICAL BACKGROUND .9 2.1 Overview of remittance 2.1.1 Definition 2.1.2 Remittance in Vietnam (2010-2020) .10 2.1.3 Pros and cons evaluation .12 2.2 Overview of the real exchange rate .17 2.2.1 Definition 17 2.2.2 The real exchange rate in Vietnam from 2010 to 2020 18 CHAPTER EFFECT OF REMITTANCES ON THE REAL EXCHANGE RATE: THE CASE OF VIETNAM 21 3.1 Methodology .21 3.2 Results and evaluation 22 3.3 Effect on the real exchange rate in Vietnam .25 CHAPTER RECOMMENDATIONS FOR VIETNAM 26 CHAPTER CONCLUSION 28 REFERENCES 29 LIST OF FIGURES Figure 2.1 Amount of remittances remitted to Vietnam in the period 20102020 (Billion USD) .11 Figure 2.2 Real exchange rate of Vietnam from 2010 to 2020 20 LIST OF TABLES Table 3.1 Variables description 22 Table 3.2 Comparison of regression models’ results 23 Table 3.3 Variance Inflation Factor (VIF) result for multicollinearity test 24 ABSTRACT Remittances are a source of external financing for many developing economies and have been estimated to exceed other types of external funding such as foreign direct investments (FDIs) and foreign aid over the past two decades According to the World Bank (2013) remittances generally reduce the level and severity of poverty, thus leading to positive effects such as higher human capital accumulation, improved health and educational spending, enhancing small business investment, etc According to the report on Migration and Development conducted by the World Bank (WB) and the Global Knowledge Partnership on Migration and Development (KNOMAD), Vietnam continues to be one of the 10 largest remittance recipient countries in the world Recognizing the important influence of remittances on Vietnam's economy, my team has conducted the topic "The effect of remittances on foreign exchange rate: The case of Vietnam" The study will provide an overview of remittances and exchange rates as well as analyze the influence of remittances on the exchange rate in the specific case of Vietnam We would like to express our sincere thanks to the subject lecturer, Associate Professor PhD Mai Thu Hien for guiding and supporting us thoroughly and in detail so that we have enough knowledge and apply them to this essay Due to the lack of experience as well as the limitations of knowledge, the essay will certainly inevitably have shortcomings We look forward to receiving comments and suggestions from teachers to improve the essay Keywords: Remittance, Real Exchange Rate, Vietnam, Economic Growth CHAPTER INTRODUCTION 1.1 Reason to choose this topic Although remittance flows can contribute to economic development, they may come with costs Some recent studies show that it is also seen to be detrimental to the sustainability of the economy due to exertion of pressure on the real exchange rate These possible effects of remittance inflows on the domestic economy raise an important area for research and have in fact induced the exploration of the relationship between remittances and the real exchange rate more closely Hence, it raises the question of whether remittances have a positive or negative effect on the real exchange rate 1.2 Rationale of the study Based on previous research models and then practice collecting data from World Development Indicators, our team filtered out Vietnam's data on real exchange rates, remittances, and trade exchange rates (2010-2020) and analyzed them through STATA software The results obtained were quantified in terms of the impact of remittances on the real exchange rate of ASEAN countries Hence, providing an explanation mechanism and concluding to propose some recommendations to attract remittances to promote economic growth of Vietnam 1.3 Literature review The empirical research using time series data on the relationship between remittances and real exchange rates is quite limited There has been some amount of work, mainly panel studies that have been carried out over the last decade Research evidence shows that remittances have a favorable effect on a large range of recipient countries' development measures However, when flows are out of proportion to the size of the receiving economies, as was the case in several Latin American nations, they can also bring about a variety of undesirable issues Acosta, Lartey, and Mandelman (2008) used an imbalanced panel data set to investigate the effects of remittances on the real exchange rate for 109 developing and transitional countries from 1990 to 2003 An OLS nation fixed-effects model and the generalized method of moments (GMM) analysis found that GDP per capita, the terms of trade index, and GDP growth all resulted in real exchange rate appreciation, which is statistically significant at the 10% level Trade openness, on the other hand, was shown to be statistically negligible They discovered that an increase in remittances in developing nations leads to higher spending, which leads to an increase in the price of non-tradables As a result of this, the real exchange rate rises Furthermore, an increase in the price of non-tradables causes resource relocation, which reduces manufacturing productivity In a recent research of “Remittances, real exchange rate and the Dutch disease in Asian developing countries” (2010), Nguyen Phuc Hien, Cao Thi Hong Vinh, Vu Thi Phuong Mai, Le Thi Kim Xuyen analyze whether or not Asian developing countries have been affected by Dutch disease To investigate the relationship between remittances and the actual effective exchange rate, they use System Generalized Methods of Moment (S-GMM) for the linear dynamic panel data (DPD) model from 32 countries from 2006 to 2016 Their findings show that for every 1% increase in remittances per capita, the real effective exchange rate (REER) of these nations rises by 0.103%, undermining their competitiveness and sustaining the presence of Dutch disease Surprisingly, the Dutch sickness only manifests in countries with a modest ratio of remittances to GDP (less than or equal to 1%) Meanwhile, remittances cause REER depreciation in countries with a higher ratio Hassan and Holmes (2012) examined the long-run link between the real currency rate and remittances for less developed nations using a panel cointegration approach According to the findings, remittances cause real exchange rate appreciation Furthermore, a panel error correction model was built, which demonstrated that there is short-run causality from remittances to the real exchange rate This finding is also consistent with Combes, Kinda, and Plane (2011), who used the same technique to examine the effects of capital flows and exchange rate flexibility on the real exchange rate in developing economies The findings reveal both public and private flows are related with an increase in the real exchange rate Some other similar research also indicates that emittances can exert pressure on the real exchange rate, leading to appreciation of the local currency (Amuedo-Dorantes and Pozo 2004; Acosta, Lartey, and Mandelman 2007; Lopez, Molina, and Bussolo 2007; Lartey, Mandelman, and Acosta 2008) Simply, this pressure on the real exchange rate is analogous to “Dutch disease” dynamics: Developing countries receive aggregate inflows from migrants working abroad, and this increase in financial capital puts upward pressure on recipient countries’ local currency Evidently, most studies that are highlighted here point to the fact that an increase in remittances results in an appreciation of the real exchange rate Several studies, including those mentioned above, provide evidence on the short-run relationship between remittances and the real exchange rate However, very few investigations explore the long-run relationship and associated short-run dynamics associated with error correction In this respect, we contribute to the literature through an investigation of the long-run relationship between inflow of remittances and real exchange for a panel of high remittances recipient economies 1.4 Structure of the research Chapter Introduction Chapter Theoretical Background Chapter Effect of remittances on the real exchange rate: The case of Vietnam Chapter Recommendations for Vietnam CHAPTER THEORETICAL BACKGROUND 2.1 Overview of remittance 2.1.1 Definition Remittances are money that are moved from people residing or working abroad to their relatives in their home country In some developing countries, remittances can be the second-highest among income sources, outstripping international aid Remittances are contributing to creating significant additional resources for the country, reducing imbalances in the balance of payments, improving foreign exchange reserves and reducing pressure on exchange rate appreciation In the Balance of Payments and International Investment Position Manual (BPM6) remittances are perceived as a cumulative measure building upon three aggregation levels:  Personal remittances cover the transfer of household funds in cash or kind and household assets to a non-resident household, usually situated in the migrant’s home economy (including donations to family, etc.), but also the net income being generated through employment in other economies, either as seasonal or border worker, or as resident with nonresident entities (e.g international institutions domiciled in the resident’s home economy)  Total remittances additionally include social benefits, which were acquired by the above-mentioned economic activities of households in other economies, e.g pension rights  Total remittances and transfers to non-profit institutions serving households (NPISH) additionally include current and capital transfers of NPISH, such as donations in cash and kind, cross-border sponsorships, development aid programmes launched by public or private non-profit organizations (NGOs) in other countries addiction This type of remittance is not only meant to improve short-term material life, it is not meaningful promoter of rural economic growth Interest rates on USD deposits in Vietnam are high (about 5%/year) while deposits in the US have interest rates of about 0.5%/year, leading to the phenomenon of remittances flowing back home just to save money to enjoy interest rates Deposits are not used for investment and economic development purposes At the same time, this interest rate difference also makes it difficult for the management of foreign exchange and the management of monetary policy of the State Bank The figure of more than billion USD in 2010 is also the pressure to increase the total means of payment through the increase in net foreign assets (NFA), making it difficult for state banks to control the currency Thus, bringing out the downside of remittances is just for us to see the problem more accurately, not completely denying the great role of remittances in Vietnam's economy On the contrary, we have, are and will need to continue to increase remittances The issue here is that in parallel with the promotion measures, policies should be implemented to direct or motivate remittances to invest in the manufacturing sector and human areas such as education and public health to create positive long-term development effects for the country 16 2.2 Overview of the real exchange rate 2.2.1 Definition Exchange rate is simply understood as the price of one currency in terms of another There are two ways of expressing exchange rates: First, the exchange rate is expressed as: unit of local currency to unit of foreign currency: USD/VND = 23000 Second, the exchange rate is expressed as: unit of foreign currency to unit of local currency: VND/USD = 1/23000 In foreign exchange, credit and international trade payments, different types of exchange rates are formed and serve different purposes From the point of view of International Finance, exchange rates are divided into four categories: - Nominal exchange rate - Real exchange rate - Multilateral nominal exchange rate - Multilateral real exchange rate The nominal exchange rate is the rate at which the currency of one country can be exchanged for that of another The real exchange rate is the exchange rate between countries that takes into account the price level between these countries Formula of the real exchange rate is: 𝑒 × 𝑃∗ 𝑅𝐸𝑅 = If RER equal to 1, it means that goods between two countries have the same price If RER is smaller than 1, it means that foreign goods are relatively cheaper than domestic goods (in other words, the country's currency appreciates) In contrast, when the RER is bigger than 1, then the foreign 17 goods are relatively more expensive than domestic goods (the country’s currency depreciates) Multilateral nominal exchange rate is an exchange rate that measures the external value or external purchasing power of a currency relative to other currencies of partner countries It reflects the average relationship between the bilateral exchange rate of one currency against another Formula: 𝑛 𝑁𝐸𝐸𝑅 = ∑ 𝑤𝑗𝑒𝑗 𝑗=1 Based on this formula, it can be concluded that if the NEER increases, the domestic currency depreciates relative to all other comparable currencies Conversely, if the NEER falls, the domestic currency appreciates relative to all other comparable currencies Multilateral real exchange rate equals the multilateral nominal exchange rate adjusted for inflation, so it reflects the relative purchasing power of the domestic currency relative to other currencies Formula: 𝐶𝑃𝐼ư 𝑅𝐸𝐸𝑅 = 𝐶𝑃𝐼𝐷 𝑁𝐸𝐸𝑅 × If the REER rises, the domestic currency depreciates against all other comparable currencies Conversely, if the REER falls, the domestic currency appreciates relative to all other comparable currencies 2.2.2 The real exchange rate in Vietnam from 2010 to 2020 From 2010 to 2020, the Vietnamese foreign exchange market in general and the USD/VND exchange rate in particular has experienced an uneven road In the whole period above, the interbank USD/VND exchange rate had increased by about 24%, from 18,500 VND/USD to 23,070 VND/USD, with an average price increase of more than 2%/year However, this number is not enough to show the ups and downs that the domestic foreign exchange market has gone through 18 Exchange rate movements in the past 10 years can be divided into two completely opposite periods: (i) strong fluctuations in the period 2010-2015; (ii) become more stable from 2016 to 2020 In the period 2010-2015, the USD/VND exchange rate increased by an average of more than 3%/year, especially at times it increased by more than 5%/year (in 2010, 2015) In contrast, since 2016 until now, the USD/VND exchange rate has become somewhat more stable when the average price increase margin is only about 0.6%/year To achieve this radical change, the USD/VND exchange rate has been actively supported by fundamental factors, which are: First, the macroeconomic background has improved significantly Vietnam's economic growth has improved in both scale and depth with an average growth rate of over 6% per year over the past 10 years - one of the fastest growing countries in the world In addition, inflation tends to improve and is under the control of the Government Since peaking in 2011, the Government has introduced many measures and tools both in monetary and fiscal terms to reduce inflation and bring it to a level below the target level of 4% The internal stability of the economy is an important premise for the stability of the domestic exchange rate, especially from 2015 up to now Second, the State Bank's operating policy changes towards flexibility, closer to the market In the period before 2016, the State Bank usually managed the exchange rate by administrative measures, mainly through adjusting fixed price ceilings and floors The introduction of the central exchange rate mechanism since the beginning of 2016 marked an important turning point for the management agency in operating the foreign exchange market in a more flexible direction according to the balance of supply and demand in the market stabilize 19