The impact of exchange rate policy on trade balance and inflation in Vietnam = Tác động của chính sách tỷ giá hối đoái đối với cán cân thương mại và lạm phát ở Việt Nam

NATIONAL ECONOMICS UNIVERSITYINSTITUTE OF PUBLIC POLICY AND MANAGEMENT ERASMUS UNIVERSITY ROTTERDAM INSTITUTE OF SOCIAL STUDIES VIETNAM – NETHERLANDS PROJECT FOR MASTER’S PROGRAM IN DEVE

NATIONAL ECONOMICS UNIVERSITY

INSTITUTE OF PUBLIC POLICY AND

MANAGEMENT

ERASMUS UNIVERSITY ROTTERDAM INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS PROJECT FOR MASTER’S PROGRAM IN DEVELOPMENT ECONOMICS

THESIS THE IMPACT OF EXCHANGE RATE POLICY ON TRADE

BALANCE AND INFLATION IN VIETNAM

Student: Duong Thanh An Class: MDE 12

Supervisor: Nguyen thi Thuy Vinh, PhD

Ha noi, 2014

TABLE OF CONTENTS TABLE OF CONTENTS

LIST OF ABBREVIATION

LIST OF TABLES

LIST OF FIGURES

ACKNOWLEDGEMENT

CHAPTER 1: INTRODUCTION 1

1.1 The criticality of the study 1

1.2 Research Purpose 2

1.3 Scope of the Study 2

1.4 Research Methodology 2

1.5 Structure of the Thesis 3

CHAPTER 2: THEORETICAL FOUNDATION OF IMPACT OF EXCHANGE RATE ON TRADE BALANCE AND INFLATION 4

2.1 Basic concepts of exchange rate 4

2.1.1 Definition of exchange rate 4

2.1.2 The determinants of exchange rate 5

2.2 Impacts of exchange rate on trade balance 8

2.2.1 Exchange rate’s impacts on import and export performance 8

2.2.2 Currency devaluation and trade balance: J-Curve Effect 12

2.3 Impact of exchange rate on inflation 15

2.3.1 The mechanism of exchange rate’s impacts on price level 16

2.3.2 Purchasing Power Parity (PPP) and deviation from PPP 18

CHAPTER 3: OVERVIEW OF THE IMPACT OF EXCHANGE RATE ON TRADE BALANCE AND INFLATION IN VIETNAM 21

3.1 Foreign exchange rate management in Vietnam 21

3.2 Impacts of exchange rates on Vietnam’s trade balance and inflation 25

3.2.1 The period 1992 - 1997 (before the Asian financial crisis) 25

3.2.2 The period from July 1997 to 1999 (the Asian financial crisis period) 30

3.2.3 The period 2000 - 2006 (after the period of the Asian financial crisis,

preparation to join in WTO) 33

3.2.4 The period from the year 2007 - 2012 37

CHAPTER 4: EMPIRICAL STUDY ON THE IMPACT OF EXCHANGE RATE ON TRADE BALANCE AND INFLATION IN VIETNAM 45

4.1 Methodology 45

4.2 Data and Data Sources 46

4.3 Results and Discussions 47

4.3.1 Unit root test 48

4.3.2 Granger causality test 48

4.3.3 Impulse response functions 49

4.3.4 Variance decompositions 50

CHAPTER 5: SUGGESTION ON IMPROVING THE EFFECTIVENESS OF EXCHANGE RATE POLICY WITHOUT CREATING PRESSURE ON INFLATION 54

5.1 Orientation of exchange rate policies 54

5.2 Suggestions for using exchange rate policies to restrict trade deficit without causing any further pressures on inflation 56

5.2.1 Expansion of exchange rate trading bands instead of domestic currency’s devaluation 57

5.2.2 Enforcement of multi-foreign currency policy 58

5.2.3 Actively transferring structure of exported and import goods in the positive direction 59

5.2.4 Synchronous collaboration of exchange rate policies with other macroeconomic policies 60

5.3 Conclusions 61

BIBLIOGRAPHY 1

LIST OF ABBREVIATION

LIST OF TABLES

Table 3.1: Vietnam’s exchange rate regimes, 1989 - 2012 22

Table 3.2: Growth and inflation rates in the years over the period 1986 - 1992 26 Table 3.3: Correlation between nominal and real exchange rates by PPP in 1992 - 1997 period 27

Table 3.4: Situation of trade balance during 1993 - 1997 period 28

Table 3.5: Devaluation levels of some regional currencies 30

Table 3.6: Some targets of 1997 - 1999 period 32

Table 3.7: Real price index of currencies compared to United States dollars 41

Table 4.1: Unit root tests 47

Table 4.2: Granger Causality Test: P-values of Chi-square 48

Table 4.3: Variance Decompositions for 2000-2012 period 51

Table 4.4: Variance Decompositions for 2007-2012 period 52

LIST OF FIGURES

Figure 2.1: J-Curve Effect in currency devaluation 13

Graph 2.1: Mechanism of exchange rate pass-through on inflation 16

Figure 3.1: Inflation and VND/USD nominal exchange rate, 1992- 1997 26

Figure 3.2: Export, import and the trade balance of 1991 - 2007 period 34

Figure 3.3: Inflation in Vietnam and VND/USD nominal exchange rate, 1992-2006 period 36

Figure 3.4: Inflation in Vietnam and VND/USD nominal exchange rate, 2007-2011 period 38

Figure 3.5: Changes in the payment balance and inflation rate for 2001-2010 .39

Figure 3.6: Real and nominal exchange rates of VND/USD 40

Figure 3.7: Vietnam’s export market’s structure for the year 2010 41

Figure 3.8: Vietnam’s import market’s structure for the year 2010 42

Figure 4.1: Response functions of trade balance ratio and inflation to exchange rate shocks for 2000 – 2012 period 49

Figure 4.2: Response functions of trade balance ratio and inflation to exchange rate shocks for 2007 – 2012 period 50

On this occasion, I am much grateful to the Institute of Public Policies and Management National Economics University and particularly to Doctor Giang Thanh Long who havecreated favorable conditions for me to complete this research program

-CHAPTER 1 INTRODUCTION 1.1 The criticality of the study

As early as the second half of the last century, many countries like Japan and South Koreaconsider exchange rate policy as an effective tool of their international trade policy toimprove trade deficit, increase international reserve, and boost international trade for theultimate goal of becoming an Asian economic dragons At its early stage of economicreform, China also embraced the “magical stick” of exchange rate to benefit from theirexport, keeping a consistent trade surplus with the US and becoming the country withbiggest foreign exchange reserve Alan Greenspan, former Chairman of US FederalReserve, also tried to devalue US dollar to promote export and reduce trade deficit On Dec

10, 2003, in order to explain his weak-dollar monetary policy, he said ambiguously onCNN: “Now it is the time American should know the export potential…” Since 2013, theworld has merely seen a sharp devaluation of the Japanese yen This phenomenon has alsoput a lot of controversy whether the Japanese currency devaluations to promote exports

In Vietnam, trade deficit, which has been a persistent issue during the last 20 years, notonly shows weaknesses of the country’s economy but also implies potential instability inthe long run The goal to have a balance in international trade in 2008, which was indicated

in International Trade Strategy during 2001-2010, was not met In the past years, inflation

in Vietnam pretty high compared to other countries in the world while nominal exchangerate of VND/USD was relatively stable Therefore, there was many researchers supposethat Vietnamese currency was overvalued and then give some suggestions on currencydevaluation to boost export as many countries in the world have ever done to improve thetrade balance But other experts also noted that the devaluation can cause inflation, aproblem that Vieatnam has trying to solve

There are many studies on impact of devaluation on trade balance or studies on exchangerate pass-throught on domestic price in some countries in the world including Vietnam(Nguyen Van Tien, 2009; Nguyen Thi Hien, 2011, Nhat Trung, 2011; Nguyen Duc Thanh,2011; Nguyen Thi Kim Thanh, 2011) However, all of these researches have only focused

on either the inflation aspect or trade balance aspect rather than taken the trade-off betweenthem into consideration: a devaluation may improve trade balance but can cause inflation

in the economy Therefore, it is very important to study the impact of change in exchange

rate on both trade balance and inflation in Vietnam to have a sound exchange rate policywhich can improve trade balacne without creating pressure on inflation

1.2 Research Purpose

From the above analysis, the thesis has selected research topic as “The impact of

exchange rate policy on trade balance and inflation in Vietnam” which aims to answer

the following questions:

Vietnam?

trade balance without accelerating inflation in Vietnam?

1.3 Scope of the Study

The study mainly focuses the impact of nominal exchange rate of U.S dollar againstVietnamese dong (USD/VND) on trade balance and inflation in Vietnam over the period

2000 - 2012 Beside, the study also consider the role of other exchange rates of maintrading partners’ currencies against VND in improving trade balance and controllinginflation such as CNY/VND, EUR/VND, JPY/VND and SGD/VND

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For empirical study, the thesis uses monthly data from 2000 to 2012

1.5 Structure of the Thesis

The thesis includes 5 chapters as follow:

balance and inflation

and inflation in Vietnam

balance and inflation in Vietnam

rate policy without creating pressure on inflation

CHAPTER 2 THEORETICAL FOUNDATION OF IMPACT OF EXCHANGE RATE ON

TRADE BALANCE AND INFLATION 2.1 Basic concepts of exchange rate

2.1.1 Definition of exchange rate

Although globalization and economic integration have been increasing and became aglobal trend, most of countries still maintain its own currency The growing internationaltrades and economic activities among countries brought about the needs for exchangebetween currencies in certain conventions Because of the need, exchanged rates came into

usage “Exchange rate is the comparative relationship between two currencies of two

countries”(Dinh Xuan Trinh, 2006).

When economic relations among countries became more sophisticated, especially giventhe creation of letter of credits in foreign currencies, which are tradable in foreignexchange market of a country, exchange rate was alternatively considered in a more

comprehensible manner as” the price of one currency in another country’s currency”.

For example, American businesses could import goods from United Kingdom and themethod of payment was determined as checks These American importers had to payUSD160 to buy a check value of GBP100 in an U.S bank to pay for the Britain exporters.These exporters, subsequently, deposited the checks at a Great Britain banks and receivedGBP100 Consequently, the price of one GBP was 1.6 U.S dollar and this is the exchangerate between GBP and USD

From a country’s perspective, there are two ways to interpret exchange rate:

definition is used in some countries which list the exchange rate in indirect manner(Local currency/Foreign currency) such as U.K., U.S…In such way, the price offoreign currency is not externally expressed

definition is used in countries which implement indirect quotation (Foreigncurrency/Local currency) Currently, most of countries, including Vietnam, use thequotation convention In Vietnam, according to the Foreign Exchange Ordinance

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No 28/2005/PL-UBTVQH11, Article 4, Clause 9 exchange rate is defined as theprice of a foreign currency in the local currency of Vietnam, Vietnamese Dong(National Assembly Standing committee, 2006).

Within the scope of the research, if there’s no specific note on terms used, those terms

“exchange rate”, “foreign exchange rates” are used interchangeably to specify the price

of the foreign currency (USD) in the local currency of Vietnamese Dong With that being said, the increases in exchange rate mean the local currency depreciates and vice versa.

2.1.2 The determinants of exchange rate

Inflation differential

There were many economic events in history proving the impact of inflation differential onexchange rate, particularly the hyper-inflation in Germany In 1920s, Germany printed somuch money to pay for government’s spending and the consequence is the price index in

1924 jumped 6.666.666,7% compared to that of 1923 Germany’s Mark depreciated to ahistorical record (Johnathan Mc.Cathy, 1998) The impact of inflation differential onexchange rate can be presented relatively in the form of Purchasing Power Parity (PPP)model as below:

foreign good price and exchange rate respectively calculated at the end of the year

Hence, assuming there is no change in other factors, the change in exchange rate isapproximate to the difference between inflation levels of the two countries

Interest rate differential between local currency and foreign currency

The first model on the impact of interest rate differential between local currency andforeign currency on exchange rate was first proposed by the Interest Rate Parity theory

(IRP) of John Maynard Keynes The foundation of IRP is: the equilibrium of foreignexchange market requires the equilibrium of interest rates; interest rates of deposits in twodifferent currencies must be the same when converting into one currency Keynesexplained that under normal conditions, arbitrage opportunities will prevail until forwardprices are in line with interest rate differential As a result, interest differential is off set byprofit or loss on the forward market Thus, the lower interest rate on one country’scurrency will be compensated by higher forward price compared to that of the currency ofthe country with higher interest rates.

change in exchange rate will be proportional to the difference between interest rates oflocal currency and foreign currency

Foreign currency interest rate difference between domestic and foreign market

If a country has higher interest rate on foreign currency deposits compared to that ofanother country, that country with higher interest rate would attract capital flows fromoutside into it and the inflow would push the supply of foreign currency up Because of theexogenous factor, the supply curve of USD moves rightward, the exchange rate goes down.One of the most prominent efforts on quantifying the impact of foreign currency’s interestrate differential between domestic and foreign markets was International Fisher Effect(IFE) proposed by the economist Irvine Fisher IFE said that the real interest rates ofdifferent currencies of open economies would be equalized

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Vietnam and the U.S respectively After a period of time T, 1$ deposit in the U.S would

Based on IFE, the two real interest rates must be equal:

Combining this with relative PPP,

exchange rate would be equal to the different between interest rates of the foreign currency

in domestic market and foreign market

However, sometimes the interest rate differential did not make the change in exchangerate These situations normally happen when an economy is in unstable, potentially crisis-like, condition Under that situation, even though how high the interest rate would be,investors will not risk their capital to earn profit from interest rate differential A typicalexample of the situation is the economic crisis during the period of 1971-1973; the interestrate in New York market was 1.5 times that of London market, triple that of Frankfurtmarket but the short-term capital flow were not directed to New York but to WesternGermany and Japan

Protectionism

Protectionism policies are tariffs, tax and non-tax trade barriers used by countries to protectand enhance their industries’ competitiveness in international trade The increased use ofprotectionism like tariffs, quotas limits the volume of imports and subsequently reduces the

demand for foreign currency (the demand curve shits leftward) and in the long-run theexchange rate will go down, local currency appreciates against foreign currency Forexample, if Vietnam increases the tariff on imported laptops from the U.S, this will make theprice of those imported laptops increased, demand going down (demand curve shiftsleftward) and exchange rate going down, VND appreciating against USD The paradox ofprotectionism is while tariffs and trade barriers are used to reduce import, supporting localmanufacturing and export industries, protectionism policies push the local currency toappreciate The appreciation of the local currency, in turn, negatively limits exports Insummary, protectionism, in its relation with exchange rate, gives rise to an undesired result.

2.2 Impacts of exchange rate on trade balance

Exchange rate policy is a system of tools which are used to control the supply and demandrelationship on foreign exchange market and as a result adjust exchange rate to meetdesired goals A highly-valued local currency compared to foreign currencies wouldsupport export and limit import and vice versa Thus, managing exchange rate policies canhave direct impact on trade balance In addition, every time central banks announceadjustments on foreign exchange rate policies, the debates on effect of such adjustment onprices and inflation are emerged

2.2.1 Exchange rate’s impacts on import and export performance

Volume effect

If the exchange rate, expressed in local currency, is high, with the same amount of foreigncurrency the exporter receives from their export, these exporters will have more localcurrency when exchanging their foreign currency to local one For example, a Vietnameseexporter sold an amount of goods worth USD100.000 to an overseas importer with paymentterm of 3 months At the moment, the exchange rate is 1 USD = 15.000 VND After 3months, the exchange rate becomes 1 USD = 16.000 VND and the importer makes thepayment of USD 100.000 to the exporter When converting the receipt proceed into VND atthe time of payment, the exporter earns (16.000-15.000)*100.000 = 100.000.000 VND ofprofit from exchange rate volatility On the other hand, the low exchange rate, i.e the localcurrency is highly valued, will make revenues collected from export activities reduced inlocal currency term; export is not encouraged and there would be decreasing trend in export.The topic was debated frequently on the U.S.’s public media at the end of 2002, right before

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FED’s implementation of weak-dollar policy The New York Times, on Dec 21, 2002,reported that the 10% appreciation of USD against other major currencies including JPYwould make the country’s export revenue decrease from 10% of GDP to 7% of GDP.

In conclusion, exchange rate, in local currency term, has impacts on the volume of goodsexported in the way that: if exchange rate increases, export volume would increase and viceversa, if exchange rate decrease, volume of goods exported could decrease The change involume of exported goods is called “volume effect” of exchange rate’s impact on export.However, volume effect does not have immediate effect on export activities but it rather has acertain lag of, normally, several months These three months are the window of time duringwhich the exporters consider the pros and cons of more export given the exchange ratevolatility When the exchange rate increases, exporters need time to adjust their productionschedule, negotiating new export contracts and expanding supply chain When the exchangerate decreases, exporters still have to honor signed contracts, willing to push sales for thoseproduced goods at the cost of loosing margins because of exchange rate volatility

Foreign exchange rate changes impact the volume of imports in the opposite way as it doeswith exports: If the exchange rate increases, the volume of imports will decrease and viceversa, if exchange rate decrease, the volume of import tends to increase The fluctuation involume of imports as a result of exchange rate change is called exchange rate’s volumeeffect on imports

There have been multiple of evidences demonstrating the volume effect of exchange rate

on imports For example, in Jan 1999, Argentine Peso appreciated 10% against Brazilian’sReal and the appreciation resulted in 30% increase in the import of shoes from Brazil toArgentina in the same year

On the other hand, assuming a laptop imported from the U.S to Vietnam has a price ofUSD1000 The current exchange rate is 1USD = 15.000VND These means a Vietnamesehas to pay VND15.000.000 for an imported laptop Assuming the exchange rate is now1USD=VND18.000 Given the new exchange rate, a Vietnamese now has to pay18.000.000VND for the same imported laptop So instead of paying 3.000.000VND more,the Vietnamese can switch to locally-manufactured laptops and desktops The demand forimported laptops would decrease and subsequently laptops imported from the U.S willalso go down

As in the case of export, volume effect does not have immediate impact on import

activities but rather also has a lag The lag of time allows importers to consider benefits ofimports given exchange rate change When exchange rate, expressed in local currency,goes down, importers need time to negotiate more import contracts, selecting and verifyinggoods offered by new exporters who would not benefit without the exchange rate change.When exchange rate goes up, the importers still have to honor previously-signed contractseven if this means absorbing loss as a result of exchange rate volatility.

Price effect

As elaborated above, because of time-lagging feature of volume effect, exchange ratefluctuation would not impact export volume immediately However, there’s another effectneeded to be study during the transition period and it is named price effect Assuming thecurrent exchange rate is 1USD = 15.000VND and the price of exported good is 2.000VND

in local currency Before exchange rates increases, each unit of exported good is worth0,1333USD (2000/15000) If the exchange rate is now 1 USD = 18.000VND, each unit ofexported good is only worth 0,1111USD now (2000/18000) On the other hand, if theexchange rate falls to 1USD = 10.000VND, each unit of exported good will bring about0,2USD (2000/10000) The Price Effect on export volume says that even though theVolume Effect may not have immediate effect, exchange rate fluctuation will haveimmediate impact on the value of export: if the exchange rate, as expressed in localcurrency, rises, value of export will decrease in term of foreign currency and vice versa, ifexchange rate falls, value of export will increase in term of foreign currency

The Price Effect on import volume says that even though the Volume Effect may not haveimmediate effect, exchange rate fluctuation will have immediate impact on the value ofimport in term of local currency: if the exchange rate, as expressed in local currency, rises,value of import will be higher in term of local currency and vice versa, if exchange rate falls,value of import will be lower in term of local currency For example, a computer mouseimported from the U.S has the price of 2USD/unit If the exchange rate is1USD=15.000VND, the local-currency price of the mouse would be 30.000VND If theexchange rate rises to 1USD=18.000VND, the new price is now 2*18.000VND =36.000VND/unit A Vietnamese buyer has to pay 6.000VND more for each imported mouse

Impact of exchange rate on structure of imported and exported goods

Among exported goods, agricultural products and raw materials are more sensitive toexchange rate volatility compared to other products including machinery, complete built

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units (CBU), gasoline, etc The reason for the difference is those raw materials andprimitive goods are easier to find substitutes while machinery, manufacturing componentsand gasoline tend to be more difficult to find substitutes If exchange rate falls, exportedgoods become relatively more expensive and those easy-to-be-substituted goods are first to

be removed from foreigners’ consumption list and the percentage of the goods out of allexported goods would fall Assuming that American consumers buy Vietnamese coffee atthe price of 8.000VND/kg, when the exchange rate is at 1USD = 16.000VND, anAmerican has to pay 0,5 USD for 1 kilogram of Vietnamese coffee When the exchangerate falls down to 1USD = 10.000VND, the American has to pay 0,8USD for the samekilogram of coffee Because coffee is a good which is easy to be substituted, the Americancould simply switch to coffee from Brazil or other types of beverage such as black teainstead of bearing 0.3USD more for each kilogram of coffee If Vietnam keeps theexchange rate unchanged and cost of producing coffee locally does not go down, the U.S.’sdemand for coffee of Vietnam will decrease When there is no demand, the good would beremoved from export list to the U.S On the other hand, if exchange rate rises, list of goodsexported would be expanded to include more diversified goods because: firstly, businesses,which could not have competed before, now can export and benefit from the exchange raterise; secondly, an increase in revenue of export allows these businesses to expandproduction and diversify their own product categories

For similar goods, the goods which consumes large amount of local materials are moresensitive to exchange rate and those goods relying more on imported materials are lesssensitive For example, the price of a shirt made of 50% imported materials is100.000VND The original exchange rate is 1USD = 15.000VND so the price of the shirt

in USD is 6,667USD

If the exchange rate rises to 1USD = 18.000VND then the input cost will increase by50%x100.000x3000/15.000 = 10.000VND The price of the shirt now is 110.000/180.000

= 6,111USD If the shirt is made of 100% local materials, the converted price of it would

be 100.000/18.000 = 5,556USD In summary, goods which have high percentage ofimported contents are less impacted by exchange rate fluctuation

When exchange rate moves down, list of imported goods tend to expand because: firstly,local consumers, who could not have afforded for them because of high prices before, nowwould buy them given their lower prices in local currency now; secondly, improvedrevenues of imports help these businesses expand production and diversify their products

If exchange rate rises, the conversion to local currency becomes more expensive and thefact would curb the demand for imported goods When the demand reaches zero, thesegoods are excluded from import list.

Exchange rate’s impacts on each type of imported goods depend on how easy to substitutethe good There are certain goods such as agricultural products and raw materials are moreprone to exchange rate fluctuation While other goods such as gasoline, machinery andcomplete built units, which are more difficult to be substituted, are normally not sensitive

to exchange rate volatility

For example, Petrolimex imports diesel from Singapore at a price of 600USD/ton Whenexchange rate is 1USD = 15.000VND, Petrolimex has to pay 9.000.000VND for a ton inlocal currency If the exchange rate moves to 1USD = 18.000VND, the cost in localcurrency is 10.800.000VND/ton Even though the local cost has increased by1.800.000VND but because Vietnam could not produce the product on its own and othercountries also quote diesel price in USD, Vietnam has no choice but continue to importdiesel from Singapore

2.2.2 Currency devaluation and trade balance: J-Curve Effect

Currency devaluation is an actively-debated topic within academic community and thereare two prevailing of opinion: supporting group and objecting one The supporting group,which is comprised of foreign economist, praises a substantial devaluation to improve thecompetitiveness of goods, promoting export growth and restructuring the economy,removing challenges faced by businesses and reducing fiscal deficit Meanwhile, localeconomists are suspicious of positive impacts of currency devaluation, arguing thatdevaluation could push inflation higher, damage consumers’ confidence on public policiesand increase public debt

The concept of currency devaluation

Currency devaluation is a deliberate downward adjustment to a country's official exchangerate relative to other currencies In a fixed exchange rate regime, only a decision by acountry's government (i.e central bank) can alter the official value of the currency Itcontrasts to "revaluation" The representation of currency devaluation is the increase ofexchange rate The core idea of currency devaluation is that a country reduces purchasingpower of its currency from its real purchasing power against that of foreign currencies.Example: In September 1992, GBP was devalued by more than 20%, making the exchange

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change from 1GBP = 2,95 DEM to 1GBP = 2,35 DEM (Tran Ngoc Tho and Nguyen NgocDinh, 2005) In the past, the term “devaluation” was only used in fixed exchange rateregimes while the term “depreciation” was used in floating exchange rate regimes.

J-Curve Effect

Currency devaluation is represented by the sharp increase in exchange rate, which isexpressed in local currency The increase of exchange rate impacts export and importactivities as analyzed in Volume Effect and Price Effect part In addition, currencydevaluation also creates what’s so called J-Curve Effect

Figure 2.1: J-Curve Effect in currency devaluation

However, after a period of time when the Volume Effect has more impact than the Price Effect and the growth of total value of export exceeds that of import, the trade account would

trade account becomes surplus The behavior of trade account is called the J-Curve Effect of

currency devaluation There’re many evidences proving the existence of J-Curve when acountry devalues its currency For example, in 1991, Krugman analyzed the impact of thesharp currency devaluation of USD during the period of 1985-1987 (According to the Plazaagreement on the exchange rate, which the U.S signed with several countries in September

1985 The dollar is adjusted depreciation) and found the existence of the J-Curve Effect inU.S economy At the beginning, trade account was deficit, in both absolute value and aspercentage of GDP, but trade account was improved after 2 years The trade deficit camedown from a record of USD158 billion in 1987 to USD107billion in 1989

In compliance with the Plaza Accord signed between the U.S and some other countries inSeptember 1985, the USD was devalued up to 50% until 1987

The effectiveness of improving trade account using currency devaluation

Based on the long-term effect of currency devaluation, WB and IMF normally suggestcurrency devaluation when some country faces difficulty in trade account Theseinstitutions consider currency devaluation as an effective method which can help thosecountries, including Vietnam, with developing export industries to fight against the threat

of trade deficit However, there are examples showing that currency devaluation does notalways help improve the trade deficit situation A quantitative research done by ZhaoyongZhang (1996) on monthly data series from January 1991 to February 1996 could not findany correlation between exchange rate movements and trade account of China, eventhough during the period China had devalued its currency of CNY by 50% through a series

of exchange rate interventions

Based on pragmatic approach, there is an objective need to understand under whatconditions that currency devaluation would improve trade account The condition which iscalled Marshall-Lerner Condition was developed based on elasticity concept

Calling η X the exchange rate elasticity of demand for export, i.e.by how much, in percentage, export would change if the exchange rate rises by 1%, η M is exchange rate elasticity of demand for import or by how much, in percentage, import would change if exchange rate rise by 1% The Marshall-Lerner Condition asserted that currency devaluation will only improve trade account if η x + η M >1.

smaller in short-run than in the long-run Meanwhile, in 1987 Gylfason announced asummary based on 10 empirical studies from 1969 to 1981 in 15 developed countries and 9developing countries and the generalization shows that these elasticity indexes were highand Marshall-Lerner Condition was all met

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The fact that the elasticity indexes are normally smaller in short-run than in long-run,together with Marshall-Lerner Condition, lead us to some key factors a country shouldconsider before devaluing its currency to improve its trade account:

Firstly, in short-run currency devaluation would worsen, not improve, trade account

Marshall-Lerner Condition

Secondly, if a country wants a high exchange rate elasticity of demand for export, it must

select to export those goods which have large supply sources and those sources could beeasily expanded to take advantage of favorable currency movement Raw materialsnormally depend on natural conditions and it is hard to quickly expand their supplies Ingeneral, only highly-processed goods meet the condition

Thirdly, if a country wants a high exchange rate elasticity of demand for import, it must

import only those goods which are easy to be substituted Those goods such as machinery,complete-build units or components, oil and gas for production normally make importinelastic to exchange rate movement

Fourthly, using currency devaluation to improve trade account requires accurate estimation

of exchange rate elasticity of export and import Not all currency devaluations improvedtrade account in the long-run Currency devaluation could improve trade account only ifelasticity indexes are big enough to meet Marshall-Lerner Condition

Fifthly, even if those elasticity indexes meet Marshall-Lerner condition, a country, which

wants to devalue its currency, must know that international trade depends not only onexchange rate but also on other synchronized actions in fiscal policy, income, etc

Devaluations must be considered in combination with other policies Lessons learnt fromthe Black Tuesday in Russia in 1989 would remind us about this At that time, the centralbank of Russia did wrongly devalue the Ruble against USD, having Russian people feelunconfident on the economy The devaluation led to severe consequences including sharpincrease of goods’ price and export were severely hurt

In conclusion, exchange rate and trade balance have a very tight relation to each other.Both theoretical research and empirical studies in different countries proved that exchangerate could be used to influence both import and export to achieve target trade balance.However, both exchange rate and trade balance are sensitive macroeconomic indicatorsand they are both impacted by multiple factors which make their relationship sometimesdifficult to understand In theory, exchange rate’s impact on trade balance is represented bythe J-Curve Effect A more quantitative estimation of exchange rate’s impacts on trade

balance is Marshall-Lerner Condition These are important foundation for export-focusedcountries like Vietnam to consider when managing trade balance using exchange rate.

2.3 Impact of exchange rate on inflation

The impacts of exchange rate on prices in local currency are estimated by exchange ratepass-through effect Exchange rate pass-through is understood as the percentage change ofdomestic prices in currency of the importing country if exchange rate between the twocurrencies of the two trade partners changes by 1 percent In other words, exchange ratepass-through is really the exchange rate elasticity of price level

2.3.1 The mechanism of exchange rate’s impacts on price level

The impacts of exchange rate on prices in local currency are estimated by exchange ratepass-through effect Exchange rate pass-through is understood as the percentage change ofdomestic prices in currency of the importing country if exchange rate between the twocurrencies of the two trade partners changes by 1 percent In other words, exchange ratepass-through is really the exchange rate elasticity of price level

Graph 2.1 shows 3 channels through which consumer prices can adjust to changes ofnominal exchange rate: direct, indirect and foreign direct investment

Direct Effect – The direct effect includes the direct change in prices of both intermediary

and end-consuming imported goods because of higher exchange rate Empirical researchnormally uses imported good prices index to study the effect in an independent way.Obstefeld and Rogoff (2000) and other researchers proved that imported goods are moresensitive to exchange rate fluctuation compared to general consumer goods

Graph 2.1: Mechanism of exchange rate pass-through on inflation

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Tỷ giá tăng (Phá giá nội tệ)

Direct Indirect FDI Decision

Increased demand for locally- produced goods (to replace imported ones

Increased demand for locally- produced goods

Increased demand for labor;

higher wages

Increased production of local goods as substitutes for imported goods through FDI

Production of local goods

grows

Higher consumer prices Exchange rate rises (local currency

devaluation)

Indirect Effect- The indirect effect is based on the theory of substitute nature of

locally-made goods and imported ones The indirect effect includes the substitution betweenlocally-made goods and imported goods in domestic market (internal substitution) and inforeign market (external substitution) In Russia, after the currency crisis in 1998, internalsubstitution reduced the consumption of high-quality but expensive imported goods andincrease the consumption of cheap, locally-made goods The result is that prices of locally-produced goods rise External substitution also happens because locally-produced goodsnow become cheaper for foreigners and demand for those local goods also rises Becausenominal wage is fixed in the short-run, the effect would push real wage down and, as aresult, increase output and promote national export External substitution requires the study

of shifting strategic capital expenditure behavior of local producers (Obstfeld &Maurice,2001) Local producers substitute intermediary imported goods by locally-produced ones However, when real wage comes back to the initial level, cost rises and thismakes output decline In the long-run, the effect is illustrated by Marshall-LernerCondition Historical data on current account balance of Russia after the crisis in 1998confirmed that the rise of domestic output is the result of the devaluation of Ruble in 1998

FDI Effect – The sharp devaluation of the Ruble in 1998 sharply reduced the demand of many

imported goods and real wage in foreign currency Previously, multinational companiessupplied many goods to the country During the crisis, these companies had to face a toughchoice: either losing market share for their export or building their own manufacturing plants

in the country to take advantages of wage and technology Many of them did open branches orshift production plants into Russia (FDI inflow) Production growth increased labor demandand pushed wage up In turn, these pushed the exchange rate higher

Besides, the exchange rate change can affect domestic prices in dollarization economy

through another way called dollarization effect – Dollarization is commonly understood as

the situation in which foreign currency is widely used as a substitute for local currency inall or some monetary functions; the economy is considered to be wholly or partiallydollarized Based on IMF’s criteria, an economy is considered to have high-level ofdollarization when total deposits in foreign currency exceeds 30% of M2 which includescashes in circulation, current account deposits, term deposits, and foreign currencydeposits In unofficially-dollarized countries, the demand for local currency is unstable.Whenever there are unstable conditions, people suddenly convert local currency to foreignone and this forces local currency depreciated and a period of inflation would commence.When people keep large amount of deposits in foreign currency, changes in interest rates indomestic or foreign country would create big shift from one currency to another one(currency arbitrage) These changes would make it difficult for central banks in settingtheir target of money supply and create instability in banking system Additionally, in adollarized economy, prices of goods are listed in foreign currency, when exchange raterises or falls, prices of goods would also rise and fall at the same pace

In summary, there are several parallel processes through which prices of goods react to themovement of exchange rate

2.3.2 Purchasing Power Parity (PPP) and deviation from PPP

The exchange rate pass-through on domestic prices is a critical factor in transmittingeconomic shocks in open economies However, traditional macroeconomic models paidless attention to the factor For instance, most of floating exchange rate models supportsthe Purchasing Power Parity theory and as a result the exchange rate pass-through hascomplete effect

Purchasing Power Parity theory (one-price rule) – the theoretical foundation of

exchange pass-through argued that exchange rate pass-through must has full effect (i.e.,exchange rate elasticity must be 100% and there is no chance to profit from currencyarbitrage in the long-run) Therefore, studying exchange rate pass-through effect alsomeans studying PPP One-price rule among countries can be expressed as below:

P = P* x E

expressed as the number of local currency unit per one foreign currency unit (directexpression)

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Based on the assumptions, a macroeconomic model, which was developed by Obstfeld &Rogoff (1995, 1998, 2000) and assumed local prices are fixed in the currency of thecountry of the producer, suggested that prices would move in a one -one relationship withexchange rate.

But even under simple demand-supply model in which one-price rule is complied with,there are still difference in exchange rate pass-through impact on prices in local market and

in among countries In a big economy, the inflation effect, as a result of local currencydevaluation, is normally combined with global price reduction (possibly because ofslowing demand) In these situations the effect of exchange rate pass-through will bereduced In a small economy, local currency devaluation normally does not impact globalprices Thus, the exchange rate pass-through effect would be perfect (100%) in thesesituations In summary, even under simple models which support one-price rule, theexchange rate pass-through effect is not the same in all countries and is normally higher insmaller economies compared to bigger ones

PPP model is based on assumptions which may be unrealistic Perfect competition and zerotransaction cost are some example of underlying unrealistic assumptions Empirical studiesproved that the exchange rate pass-through in many cases does not reach perfect level Isards(1977) is one of the first people expressed his doubt on the possibility that global pricearbitrage would reduce price difference among countries to the level of transportation cost.There are many theories explaining why the exchange rate pass-through could not reachperfect level The model developed by Obstfeld & Rogoff (2000) suggested some reasonsincluding the existence of transportation cost which make import goods’ prices higher andthe market segmentation Even when imported goods can perfect substitute local goods, it

is still impossible to consume those imported goods in large quantity because of theirexpensive prices Under these circumstances, exchange movement has little impact on thefluctuation of CPI Another similar approach by McCallum& Nelson (1999) argued thatgoods themselves play not a big part in individual consumption Consumers are willing topay for marketing services, distribution and retailing services through which the goodsreach those consumers Possibly, these costs play a bigger part out of the value of thegoods If that is the case, exchange rate movement may not impact end-consuming goodssubstantially Burstein, Neves & Rebelo (2003) said that the role of intermediary goodsand services in domestic distribution is quite important in term of quantity, but they stillcannot explain completely the different impacts of the exchange rate pass-through

A low exchange rate pass-through level may not be as a result of fixed goods price, butmay be due to optimal price discrimination policy Bergin & Feenstra (2001) and Bergin(2001) developed a general balanced model in which the exchange rate pass-through is notperfect (100%) even if the price is floated completely Coestti & Dedola (2001) developedanother model in which the exchange rate pass-through is partially created by thedistribution cost difference in domestic market and overseas market In their model, theexchange rate pass-through effect could not reach perfect level, because exporters in amonopoly industry would assume that demand of importers must depend on localdistribution cost.

Alternative approach to the above ones is the model developed by Bachetta & Wincoop(2002) In the model, the author ignored distribution cost but focused on optimal pricingscheme of companies The foundation of the model is that the currency of valuation woulddepend on the level of competitiveness of imported goods compared to locally-producedones If the competitive level is high, importing companies will value in local currency andthus, the exchange rate pass-through effect will be zero Even when companies faceexchange rate risk, they would not want to change the goods’ prices in order to protect itsmarket share Therefore, the more competitive level between local producers and importers

is, the smaller the exchange rate pass-through is

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CHAPTER 3 OVERVIEW OF THE IMPACT OF EXCHANGE RATE ON TRADE BALANCE

AND INFLATION IN VIETNAM

3.1 Foreign exchange rate management in Vietnam

Prior to the year 1986, basically a multi-exchange rate regime existed in Vietnam, of whichforeign currencies to determine exchange rates were mainly Yuan (before 1959) andUSSR’s Ruble (since the year 1959) During the entire 1970s and 1980s, trade foreignexchange rate between Vietnamese dong and Ruble was fixed and used to record paymentbalance between Vietnam and countries in council of mutual economic assistance.Together with the trade rates, non-trade rates were used for diplomacy, pupils and studentsstudying abroad, etc The principle of the state’s foreign trade monopoly also createdfavorable conditions for another rate type to exist, which is the internal rate for balancesheets It was used for internal transactions between banks and foreign trade organizations.Inflow of USD appeared in Vietnam since the policy of foreign direct investment attractionwas promulgated in 1985 At that time, the official rate between VND and USD wassubjectively determined based on 1:1 relation of USD and SUR to form the rate of 1 USD

= 18 VND

In general, during this period, foreign trade activity itself was distorted by the close economy, thus the rate was determined in a subjective and voluntarist way This did not reflect any signals of the market’s demand-supply Therefore, the rate did not affect the trade balance and inflation

Vietnam has made a great deal of adjustments in the exchange rate mechanism since the

subsidized, centralized, and bureaucratic regime was ended in 1989 Nevertheless,

naturally, these changes focused on the pegged exchange rate regime In Vietnam, USD

was almost made default as the rate pegging currency The State Bank of Vietnam (SBV)was the body that announced VND/USD rate Based on international rates between USDand other foreign currencies, commercial banks set up rates between those foreigncurrencies and VND

Table 3.1 summarizes the exchange rate regimes that Vietnam has applied since 1989 Thisclassification is based on IMF’s classification system

Table 3.1 Vietnam’s exchange rate regimes, 1989 - 2012 Time Applied regime Exchange rate regime’s features

Before 1989 Multi-exchange

rate regime

- Three official exchange rates

- Free market’s exchange rates co-existed withthe state’s exchange rates (until present time)

1989 - 1990 Crawling bands

with adjusted amplitude

- Official exchange rate (OER) was unified

- OER was adjusted by SBV based on signals ofinflation, interest rates, payment balance andthe rates in the free market

- Banks were allowed to set up exchange ratesfor transactions within the amplitude of +/-5%

- Use of foreign currencies was strictlycontrolled

1991 - 1993 Pegged exchange

rate within horizontal bands

- The control of foreign currency use got stricterwith limitation of taking money out of borders

- An official foreign currency reserves wasestablished to stabilize exchange rates

- Two foreign currency transactional stocks wereset up in Ho Chi Minh City and Hanoi

- OER was formed based on bidding exchangerates at the two stocks

- Exchange rates at commercial banks were 0.5%lower than the announced OER

1994 - 1996 Conventional fixed

peg arrangement

- Inter-bank foreign currency market was formed

to replace the two exchange rate transactionalstocks; the State Bank of Vietnam continued itsstrong intervention into transactions in thismarket

- OER was formed and announced based on theinter-bank exchange rate

- Exchange rates at commercial banks fluctuatedwithin the amplitude of +/-0.5% of theannounced OER By the year 1996, the

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Time Applied regime Exchange rate regime’s features

amplitude was broadened from less +/- 0.5% to+/-1% (November 1996)

- OER was kept stable at VND11,100/USD

1997 - 1998 Crawling bands

within adjusted amplitudes

- Exchange rate amplitudes at commercial bankscompared to OER were broadened from +/- 1%

August 1998)

August 1998)

1999 - 2000 Crawling peg - OER was the average inter-bank exchange rate

of the exchange rate

2007:conventional pegged

2004-arrangement

- OER had been gradually adjusted from VND14,000/USD in the year 2001 to 16,100/USD inthe year 2007

- Exchange rate amplitudes at commercial banks

year 2007

2008 - 2012 2008: other

managed arrangement

2009: Stabilized arrangement (soft

VND16,100/USD in early 2008 toVND16,500/USD (June 2008 to December2008), VND17,000/USD (from January 2009

to November 2009), VND17,940/USD(December 2009 to January 2010),

Time Applied regime Exchange rate regime’s features

equivalent to a devaluation of 3.3%,VND18,932/USD (August 2010), equivalent adevaluation of 2.1%, VND20,693/USD(February 2011)

banks were gradually adjusted to +/-0.75%

November 2009), +/-3% (February 2010).Commercial banks kept the exchange rate atthe ceiling rate of OER, +/-1% (the year

VND20,828/USD in 2012.

(Source: Vo Tri Thanh et al 2000, Nguyen Tran Phuc (2009) and Decisions on exchange

rates by the SBV and IMF)

Based on the pegged exchange rate policy, during the economic periods with remarkablechanges due to internal reform or external factors, the State Bank have made certainadjustments in exchange rate amplitude and central exchange rates to adapt to thosechanges After impacts disappeared, the exchange rate regime resumed to the fixed orpegged regime with adjustments Specifically, Vietnam had made adjustments to regimeswith broader amplitudes during 1989 - 1991 periods when Vietnam lifted its subsidizedmechanism, 1997 - 1999 period when the Asian financial crisis occurred and 2008 - 2009period with the global financial - economic crisis

Besides, the State Bank also changed intervention measures: from direct intervention(before 1991) to indirect intervention via transaction stocks (1991 - 1993) and inter-bankexchange rates (since 1994) The official central exchange rate announced by the StateBank was the average inter-bank rate of the previous working day This was themechanism maintained from the year 1999 until today

Another feature of Vietnam’s exchange rate mechanism was shown through the

two-24

exchange rate mechanism In reality, although the State Bank applied only one officialexchange rate for all commercial transactions nationwide, the free market’s exchange rateco-existed During the 1990s, due to export-related discriminations between state-ownedand private corporations, it was hard for private corporations to access foreign currencysources from the bank system At present, such discrimination type is still applied bycommercial banks to corporations and individuals under “Non-incentive” like those whouse foreign currencies for traveling, importing luxurious goods or goods that have not beenable to be produced locally The very discrimination makes the black foreign exchangemarket continue its existence

3.2 Impacts of exchange rates on Vietnam’s trade balance and inflation

Policies since 1992 have seen several changes, like switches from management model byaverage internal exchange rate for balance sheet for all goods ranges Such exchange rateshave been maintained quite stably or if with changes, the changes are little to stabilizematerial price system for imports and exports In such situation, the Government selected

to change foreign currency management method and renovate VND/USD managementmechanism in 1992

3.2.1 The period 1992 - 1997 (before the Asian financial crisis)

The exchange rate mechanism for 1989-1991 period was found insufficient due to the lack

of strict supervision, even the State’s relaxation related to foreign currency incomes, thismade the national foreign reserves slowly increase and the foreign currency marketencounters periodical fevers (often quarter or year ends when demands for imports and duedebts highly increase), the government’s financial deficit and foreign debts quickly

increase, inflation is severe and the national foreign reserve is small Therefore, the period

from 1992 to the financial crisis in South East Asia (July 1997), Vietnam’s policy makers switched to exchange rate management for anti-inflation by stability of nominal exchange rates During the whole period from 1992 to 1997, the exchange rates had been always

kept low ranging from 10,500 to 11,200 This selection made remarkable influences on the

national economic development

Figure 3.1: Inflation and VND/USD nominal exchange rate, 1992- 1997

(Source: General Statistics Office and the State Bank, 2010)

Through the above figure 3.1, it can be found in the year 1992, the inflation and exchangerates did not come up to expectations due to some following reasons:

Firstly, impacts caused by the inflation were severe during 1986 - 1991 period Imported

goods’ prices swiftly increased, which stimulated inflation and the threat of inherently highinflation The year 1992 was the year with rather high economic growth, which was alsoone reason of higher inflation rate compared to that of the previous years (Table 3.2)

Table 3.2: Growth and inflation rates in the years over the period 1986 - 1992 Year 1986 1987 1988 1989 1990 1991 1992

(Source: General Statistics Office) Secondly, in the last months at the end of 1991, the exchange rate suddenly increased to

VND13,000/USD while inputs for production were mainly imported

Thirdly, FDI flow into Vietnam quickly increased By 1991, total FDI into Vietnam only

reached USD213 million However, registered FDI had strongly increased since 1992 andreached the peak in 1996 with a total registered capital up to USD8.6 billion

From 1993 to 1995, social investment had strongly increased, including investment ininfrastructure construction to serve for the new economy’s development All these pushedtotal demand and prices to increase The inflation in this period was also due to pushingcost: During this period, prices of some goods like cement, power, and gasoline wereincreased, making strong increase in inputs costs, decrease in supplies and higher prices.Together with other monetary policies (credit, interest rate, etc), the State Bank intensifiedforeign currency management, well managed the supply of money to serve for foreign

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currency selling and buying to make exchange rate stable, make virtual demands for foreigncurrencies, gold and some goods down, the inflation controlled Fixed exchange ratestemporarily made positive contributions to constrain inflation in this period, attract foreigndirect investment, and boost up economic growth at a high speed of over 8% per year

However, the maintenance of nominal exchange rate was almost fixed in the conditionsthat inflation was controlled, but still higher than that of America and nations with keycommercial relations with Vietnam, at the same time, USD had tended to increase since theyear 1995, making VND to be appraised higher and higher than real values This formedand accumulated factors that caused instability and held back economic development.Reality on changes in nominal exchange rate from the year 1992 to the time prior to theregional financial and currency crisis proved this (Table 3.3)

Table 3.3: Correlation between nominal and real exchange rates by PPP

in 1992 - 1997 period

1992 1993 1994 1995 1996 1997 Nominal exchange rate

Source: Asia’s week

Table 3.3 showed that from the year 1992 to the time before the regional financial crisis(1997), the nominal exchange rates generally stood stable However, if comparing to theexchange rate calculated in line with the method of Purchasing power parity, real exchangerates increased and deficit in trade balance counted totally in currency continuouslyincreased (Table 3.4) In the period of 1994, Vietnam’s economy was affected by thedevaluation of Yuan Yuan devaluated, therefore China’s goods became attractive forVietnam, which led to increases in imports to Vietnam, including smuggled imports crossborders

Table 3.4: Situation of trade balance during 1993 - 1997 period

1993 1994 1995 1996 1997 Export (U.S $ billion) 2.98 4.05 5.2 7.33 9.19

Import (U.S $ billion) 3.92 5.83 8.16 11.1 11.59

The trade balance -0.94 -1.78 -2.96 -3.77 -2.4

Source: General Statistics, World Bank, IMF

Stabilization of fixed nominal exchange rate in case of lending interest rates in foreigncurrency much lower than that in VND was a reason to encourage borrowings in foreigncurrencies to make spreading investment in ineffective projects due to low appraisals offoreign currencies It also encourage investors to invest in industries that utilized muchcapital and imported raw materials - one resource considered as rare in Vietnam, this wasagainst the economic strategies based on effective exploitation of available resources andcompetitive advantages of human resource This caused and accumulated factors that madethe trade balance imbalanced In addition, it held back exports, encouraged imports,causing great pressure on local production, particularly industries, agricultures for exports There have been several studies that show Vietnam’s trade balance deficit in the year 1996was extremely severe For instance, CIEM (2002) utilized the qualitative model tocalculate permitted annual import level for Vietnam during 1990 - 1999 period andconcluded that in the year 1996, actual import level exceeded the permitted import level,from USD 325 million to 627 million At the time, the trade balance rightly realized its role

as a marco economic index that presented Vietnam’s economic stability reached the redline and needed prompt intervention by the Government

At the end of the year 1996 and early 1997, Vietnam did have to make some decisions onpolicies to strengthen the trade balance Currency devaluation was among the choicesdepending on Mashall-Lerner conditions as mentioned in the previous part Anothermeasure was to make direct intervention to imported-exported goods in the direction ofincreasing customs taxes and non-tax measures for imported goods together with exportsubsidies This measure’s shortcomings were shown to cause unhealthy competition andlosses for social welfare Vietnam implemented the second way effectively instead ofcurrency devaluation Researches showed that since the year 1997, most of Vietnam’snon-customs measures such as quota, taxes, technical barriers like goods standards,

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transportation, and preservations, etc had got more powerful and until 2000(McCathy,A 1999)

There have been many qualitative models to prove for the ineffectiveness if Vietnam

conducted currency devaluation during this period General features of these models is

that they could not find out relationship or little relationship between devaluation and imports in this period For example, Nguyen Van Cong (1997) run regression for data from

between changes of exchange rates and imports for the long-term Nguyen Ngoc Thanh

1998 with another model and found a relationship as their expectations of decline in importwhen exchange rates increased However, these authors emphasized that this increase wasvery little and tests showed that it was statistically insignificant Whereas these researchesshowed exchange rates made remarkable impacts on exports Nguyen Van Cong stated thatwhen Vietnam carried out 1% devaluation of VND if other conditions were unchanged,Vietnam’s exports would increase by 1.57% A more reserved way, estimation made byNguyen Ngoc Thanh and Kaliappa Kalirajan show that a devaluation of 1%, Vietnamexport volume would increase from 0.95% to 1.10% in the long-term and a modestincrease from 0.12% to 0.27% in the short term Nevertheless, these figures did not help usconfirm positive influences of the devaluation on the trade balance These figures had notprovided evidence for the existence of J curver effects in this period if Vietnam carried outthe devaluation

from 0.9 to 1.57, there were several hopes in the devaluation’s long-term effectiveness(ηX+ηM>1) if estimates were reliable Also right to the expectations, in the short time, the

utilized the exchange rate policy to address the issue of alarming trade balance deficit,within over the first year, the trade deficit would occur in the direction of seriousnessbefore having an improvement

Passive devaluation of domestic currency in the situation of an alarming trade balance was

a risky decision for a young nation in financial - monetary policy management and also forthe period of pursuing its policies of marcoeconomy stabilization, inflation restriction and

with high growth rate like Vietnam.

3.2.2 The period from July 1997 to 1999 (the Asian financial crisis period)

In the year 1997, the exchange rate was managed to resist impacts caused by the regional financial crisis and solve overvaluation of VND in the previous time The currency crisis made remarkable influence on Vietnam’s economy

The financial and currency crisis in South East Asia arising in July 1997 made Vietnameseauthorities change the viewpoints on exchange rate management Although someeconomists optimistically stated that Vietnam’s economy was "immune” from the crisis,there were at least 4 arguments to reject this

Firstly, the crisis was spreading all over South Asia and South East Asia where export

turnover made up about 30% and around 70% - 80% of FDI into Vietnam An intensivecrisis in a market with such a high density could not make no impact on Vietnam

Secondly, the crisis made several currencies in the region strongly devaluate compared to

USD while VND was pegged on USD This meant VND was overvalued , which causedfurther impacts on the competitive Vietnamese goods (Table 3.5)

Table 3.5: Devaluation levels of some regional currencies

Finally, the clearest signals of the financial and currency crisis’s impacts on Vietnam in 1997

- 1998 were shown through a series of adjustments of exchange rate management which was

30