the management of foreign exchange rate regime in a market-oriented economy

P a g e | 1 TABLE OF CONTENTS ACKNOWLEDGEMENT 5 INTRODUCTION 6 1.The essential of the research 6 2.Research Methodology 8 3.Research scope: 9 4.Research structure: 9 CHAPTER 1: THE MANAGEMENT OF FOREIGN EXCHANGE RATE REGIME IN A MARKET-ORIENTED ECONOMY 10 1.1.The history and development of exchange rate regime 10 1.2.Categories of exchange rate 11 1.2.1. Definition of exchange rate and exchange rate regime 11 1.2.2. Categories of exchange rates 12 1.2.2.1. Official and unofficial exchange rate 12 1.2.2.2. Nominal and real exchange rate 12 1.2.2.3. Real Exchange Rate and Real Effective exchange rate 13 1.2.3. Categories and trends of foreign exchange rate regimes in the world 13 1.2.3.1. Categories of foreign exchange rate regimes 13 1.2.3.2. Trends of foreign exchange rate regimes in the world 15 1.3.Effects of foreign exchange rate regime on the macroeconomics variables 17 1.3.1. Balance of Payment 18 1.3.1.1. Current Account 19 1.3.1.2. Capital Account 20 1.3.1.3. Effects of exchange rate and exchange rate regime on BOP 21 1.3.2. Inflation 23 1.3.3. The Effectiveness of Fiscal policy 24 1.4.The management of foreign exchange rate and exchange rate regime 26 1.4.1. Rate of Exchange Under the Gold Standard: 26 1.4.2. Rate of Exchange Under Managed Paper Standard 27 1.4.3. Rate of Exchange Under Exchange Control 28 1.5.Theoretical Determinants of Exchange Rate Regimes 28 1.5.1. OCA Theory 28 1.5.2. Impossible Trinity 29 1.5.3. Currency crisis 29 1.5.4. Political economy 31 Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 2 2.1.The management of foreign exchange rate regimes and the fluctuation of foreign exchange rate in Vietnam through periods 33 2.2.Evaluation of the foreign exchange regime management on Vietnam’s economy 35 2.2.1. Effects of foreign exchange rate regime on BOP 35 2.2.2. Effects of foreign exchange rate regimes on inflation 38 2.3.Factor effecting the selection of foreign exchange rate regime 41 2.3.1. Interest rate 41 2.3.2. The expectation level of changing foreign exchange rate regime 42 2.3.3. Inflation 42 2.3.4. The decrease in the intervention level of Central Bank 43 2.4.Shortcomings of SBV’s management on current exchange rate regime 44 3.1.The economy of Vietnam in the recovery period 46 3.1.1. The opportunities 46 3.1.2. The difficulties and challenges 46 3.1.3. Implication to the foreign exchange rate regime 48 3.2.Recommendations on selecting an appropriate foreign exchange rate regime in the recovery period 49 3.2.1. Recommendations on foreign exchange rate regime selection and management 50 3.2.1.1. Narrow the gap between official and unofficial exchange rate market 50 3.2.1.2. Implement the crawling floating exchange rate regime 51 3.2.2. Suggestions about supporting policies for regulating exchange rate regime 53 3.2.3. Others recommendations 56 3.2.3.1. Building and following up the early warning model of foreign exchange rate and market crisis 56 3.2.3.2. Controlling foreign exchange rate regime through other factors 60 CONCLUSION 64 LIST OF TABLES Table 1.Categories of foreign exchange rate regimes………………… …………… 12 Table 2.Exchange rate regimes in Vietnam , 1989-2009…………………….… … 31 LIST OF FIGURES Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 3 Figure 1. Exchange rate around the official rate, 03/1989 to 12/2009…………….….32 Figure 2.Nominal exchange rate and trade balance of Vietnam……………….….… 35 Figure 3.Vietnam's inflation over the period 1991-1999………………….……….….38 Figure 4.Vietnam’s Balance of Payments……………………………….………….….41 Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 4 ABBREVIATION BOP : Balance of Payment CPFF : Commercial Paper Funding Facility FDI : Foreign Direct Investment FII : Foreign Indirect Investment GSO : General Statistics Office (Vietnam) IMF : International Monetary Fund GDP : Gross Domestic Products LIBOR : London Interbank Offered Rate NEER : Nominal Effective Exchange Rate) OER : Official Exchange Rate PPIP : Public Private Investment Program PPP : Purchasing Power Parity REER : Real Effective Exchange Rate SBV : State Bank of Vietnam TALF : Asset-Backed Securities Loan Facility TARP : Troubled Asset Relief Program WB : World Bank WTO : World Trade Organization Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 5 ACKNOWLEDGEMENT First of all, I would like to give a warm thanking to all the lecturers of Advance Program of National Economics University in accordance with all the staff of National Research Department of the National Financial Supervisory Commission – NFSC for giving me such a good basic knowledge of economics in general and exchange rate regime in particular during the time of my internship. Especially, I would also want to give a sincere gratitude to my supervisor Dr. Le Phong Chau who directly guides me in the process of making my report. Moreover, Dr. Le Xuan Nghia – the Vice chairman of National Financial Supervisory Commission is also the person that gives me lots of constructive comments to improve my report. In two months working at Research Department of the National Financial Supervisory Commission – NFSC, I have tried my best to get information and proposed some recommendations to selecting an appropriate foreign exchange rate regime in the recovery period in Vietnam. However, there are certain limitations and mistakes due to the lack of time and information. Therefore, I am willing to receive any comments and suggestions. This two months of training at NFSC is such a valuable experience that I will never forget. It does help me a lot in preparing for my future career. Dang Vuong Anh Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 6 INTRODUCTION 1. The essential of the research Vietnam’s economy is now in the process of transformation and development with deep integration with the world economy especially after its participation to WTO in 2006. In order to develop a strategy for the sustainable development, the Party and Government have determined to create a platform for macroeconomic stability, a stable position before the integration era. However, the process of expanding economy has created more pressure on the financial system. This requires timely reformations in mechanisms and operating policies to achieve the objectives of sustainable development, reduces trade deficits, inflation, and efficiently absorbs foreign investment flow. Exchange rate regime has long been considered one of the most important tools for monetary policy. For a developing country like Vietnam, it is the key variable to stabilize the economic situation by its influences not only on the framework of trade and investment, but also on both monetary system, the entire macro economy and financial system. Moreover, the exchange rate also contributed to the cause of global economic and financial crises. Fundamental objectives of exchange rate regime are to limit the negative externalities and to support the commercial activities to minimize and prevent risks to the economy. In the context of integration and multi-dimensional impacts, the monetary, exchange rate policy in Vietnam is expressing increasingly shortage of conformity in the future when the economy is highly opened. In addition, increasingly strong fluctuations of the turnover of capital flows along with the development of diversified financial institutions and financial instruments caused the exchange rate management policies become more complex and difficult to control. A reasonable and flexible mechanism for exchange rate adjustment is very important factor in order to support Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 7 the control of inflation, dollarization, as well as to maintain competitiveness and promote export’s growth. After the great impact of the 2008 financial crisis on the Vietnam’s economy, the government has clearly defined the target in 2009 is to be against the economic downturn and to ensure the social welfare. Strategic objectives with specific criteria of economic development vision 2011 – 2015 were proposed by the Ministry of Planning and Investment such as 5-year GDP average (2011-2015) increased by 7.5-8% per year, budget deficit in 2015 is 4.5%, current account deficit in 2011-2015 at about USD 30.7 billion, balance of capital surplus is 69 billion dollars, the overall balance of payments surplus is about USD 25.6 billion. Among various instruments to achieve these goals, the VND/USD exchange rate management is important. The competitiveness capacity of exports, the trade balance and balance of payments status, the national reserves, changes in production structure and confidence in the currency and the government, which are all factors measuring the health and motivation dominated developing country's economy, depend deeply on the official exchange rate. The flexibility of exchange rate policy is also reflected in the flexibility in the selection of the target rate of the policy. It is really difficult to satisfy multiple objectives with an exchange rate policy in the same time, but keep applying an exchange rate policy just to serve a certain goal though a long period of time and ignore the changes in the environment is also not an appropriate strategy. For example, in order to reach the goal of reducing debt obligations, maintaining a low-rate policy, which valued its currency, may be essential in the time of maturity, but if this policy is maintained for too long, it could harm the long-term goal rather than maintain the trade balance’s stability or boosting exports. Therefore, every single period of the economy needs clearly defined objectives consistent to the specific context in order to promote the effectiveness of the exchange rate regime. Observing the current trend of the economy, I have decided to do my research on the topic “Selecting an appropriate foreign exchange rate regime in the recovery period Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 8 in Vietnam” with the aim of evaluating the effectiveness of the exchange rate regime applied at present time, particularly in the recovery period after the crisis, focusing on opportunities and challenges along with of the medium and long term economic development’s orientations of the Communist Party and Government, proposing some recommendations for improving the exchange rate regime in the near future. 2. Research Methodology In the process of researching, the method of qualitative and quantitative analysis, simulation and synthesis comparison. Qualitative analysis: based on proven economics theorems, practical experience applied in other countries and the actual conditions of Vietnam’s economy, combined with logical thinking, reasoning and dialectical analyzing, I have made identifications, descriptions and commentaries on the issue. Quantitative Analysis: Given limited time and knowledge, the research just limited within evaluating data, converting raw data into informative charts and computing forecasting indicators rather than constructing of new model. Simulation method: is a method of creating an assumed economic environment to investigate the extent of the economy reactions to the vagaries of macroeconomic variables or shocks from crises, economic downturns. Synthesis comparison method: information and data of different countries in the same period of time were collected and compared to Vietnam’s. Because of the fact that exchange rate is a macro-economic variable, the data used in this research are secondary information (available from different sources), with their accuracy and reliability were verified. Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 9 3. Research scope: The scope of my research limited to the role, impact and effectiveness of the exchange rate’s regime and mechanism currently applied in Vietnam to macroeconomic variables during the period of economic recovery. On that basis, other preferential policies were studied and proposed. 4. Research structure: The research consists of three parts. Chapter 1: The management of foreign exchange rate regime in a market-oriented economy. The aim of this chapter is introducing the scientific rationale of selecting an appropriate foreign exchange rate regime in the recovery period, going deep on the history of the formation and development of the exchange rate regimes, categorizing and analyzing various types of mechanisms being applied now, the impact of those mechanisms to macroeconomic variables and relating factors. Chapter 2: The evaluation on the current foreign exchange regime of Vietnam. This chapter evaluates the Vietnam’s exchange rate regime through each period with the focus from 2009 until now, proposes comments on the implications, factors of the mechanisms and the exchange rate regimes in the last period. Chapter 3: Selecting an appropriate foreign exchange rate regime in the period of recovery in Vietnam. Propose some solutions to improve the exchange rate regime in Vietnam during the period of economic recovery. Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh P a g e | 10 CHAPTER 1: THE MANAGEMENT OF FOREIGN EXCHANGE RATE REGIME IN A MARKET-ORIENTED ECONOMY 1.1. The history and development of exchange rate regime At the dawn of human kind, barter is the first and most common payment method among countries. About 4000 years ago in the Middle East, the turning point occurred when coins were used and the first professional money dealer appeared and exchanged a certain amount of coins of this country for a corresponding amount of coins of another country, marked the birth of the exchange rate and foreign exchange market. After the collapse Roman Empire and at the early stage of Medieval Ages witnessed the decreasing in the currency exchange activity among countries due to unstable political situation, religious and international trade restrictions. Not until the 19th century, the foreign exchange trading activities officially boomed again. World War I and the Great Depression 1929 - 1933 made the foreign exchange market brake up into small pieces; the exchange rate regime based on the gold standard was also collapsed in 1931. After the World War II (1939 - 1945), with the support from the huge gold reserves - 70% of the world's gold reserves at that time (obtained from selling weapon to parties participating in the war and reparation fee paid by defeated countries which was forced to pay in gold by the US. ) – the U.S. dollar (USD) has become one of the main currency of international economy. Besides, the role of government was reflected dramatically in the foreign exchange market’s stability, tight controlling value for money, and exchange rate regime adjustment. Bretton Woods agreement (1944) had brought a new order, determined the US. Dollar as the reserves and the mean of international payment. Other currencies were fixed to US. Dollar. US. Dollar’s value is anchored to gold at the exchange of $ 35 per ounce of gold. Most central banks chose US. Dollar as the world reserve currency because of the unlimited gold exchange of the U.S. central bank. However, that fixed exchange rate system was under great pressure during the period 1967 - 1971 due to a serious Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh [...]... unofficial rate, also known as the parallel exchange rate or black market exchange rate The official exchange rate also has several types: the interbank exchange rate, exchange rate of commercial banks, accounting exchange rates 1.2.2.2 Nominal and real exchange rate Nominal exchange rate is the exchange rate which does not consider relative prices or inflation between the two countries In contrast, Real... Note: There was no floor margin in the period 08/1991 to 09/1994 and 01/1998 to 06/2002 Another feature of the exchange rate regime in Vietnam is the dual exchange rate regime Even though State Bank actually apply a single official rate for all commercial transactions on a national scale, but the unofficial market exchange rate still presents in parallel with the official exchange rate Individuals have... Categories of exchange rates 1.2.2.1 Official and unofficial exchange rate With the floating exchange rate, exchange rate is determined by the market With the fixed exchange rate, exchange rate is determined by the Government Some countries, in which both market’s and government’s regulations participate in stipulating the exchange rate, have an official exchange rate (listed by the Government) and an unofficial... TIME 2.1 The management of foreign exchange rate regimes and the fluctuation of foreign exchange rate in Vietnam through periods Vietnam has made many adjustments in the exchange rate regime since the country ended the focused mechanism bureaucracy in 1989 However, the entire changes just concentrated around the pegged exchange rate regime In Vietnam, the U.S dollar was almost considered the default currency... 36 exchange rate regime was not adjusted consistently with the economic situation of such a developing country like Vietnam, contributing to the worse trade balance Floating exchange rate regime stated that by floating, the exchange rates could always be adjusted according to market supply and demand, ensuring the balance in the market regularly thus ensuring that the balance of payments A national... will be rationed among those who are in need of foreign exchange on the basis of priorities 1.5 Theoretical Determinants of Exchange Rate Regimes The determinants of exchange rate regimes in this research would center around four main approaches The traditional approach is embodied in the theory of Optimum Currency Areas (OCA) The modern discussions on the choice of exchange rate regime include the impossible... exchange rate Real exchange rate is the actual rate based on the relationship of prices or inflation between the two countries, thus reflects the purchasing power and competitiveness of a country Real effective exchange rate is the exchange rate between currency A with a variety of other currencies at the same time This rate is calculated based on the value weighted average of real exchange rates between... Dang Vuong Anh P a g e | 14 supply - The State bank hardly intervenes and there is no targeted exchange rate - The exchange rate is determined by the market’s demand and 2.Managed supply Floating - The State bank may 23 44 Thailand, Singapore, (12.71%) (23.4%) Malaysia, India 11 2 Costa Rica, (6.08%) (1.06%) Azerbaijan 7 8 intervene and there is targeted exchange rate - Free fluctuation in the 3 Pegged... Dang Vuong Anh P a g e | 22 For current account, income and one-way current transfers are not affected by exchange rate factors; the change in exchange rate does not alter the balance of income and one-way transfer Because the balance of income depends on the amount of precious investment, when the exchange rate changes, it does not affect the profitability of this investment Besides the balance of. .. demand will increase lead to increasing in supply without raising prices, (iv) no expected changes in exchange rate, (v) the economy satisfies the Marshall-Lerner’s condition Results of the analysis indicate that there is a tradeoff between the effectiveness of monetary and fiscal policy under different exchange rate regimes in an economy In an economy with fixed exchange rate regime, the central banks . exchange rate (listed by the Government) and an unofficial rate, also known as the parallel exchange rate or black market exchange rate. The official exchange rate also has several types: the interbank exchange. types: the interbank exchange rate, exchange rate of commercial banks, accounting exchange rates 1.2.2.2. Nominal and real exchange rate Nominal exchange rate is the exchange rate which does not. rate and exchange rate regime 11 1.2.2. Categories of exchange rates 12 1.2.2.1. Official and unofficial exchange rate 12 1.2.2.2. Nominal and real exchange rate 12 1.2.2.3. Real Exchange Rate and