The exchange rate misalignment and its relationship with trade balance the case of vietnam

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE EXCHANGE RATE MISALIGNMENT AND ITS RELATIONSHIP WITH TRADE BALANCE: THE CASE OF VIETNAM BY CAO THANH BÌNH MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, AUGUST 2013 UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE EXCHANGE RATE MISALIGNMENT AND ITS RELATIONSHIP WITH TRADE BALANCE: THE CASE OF VIETNAM A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS BY CAO THANH BÌNH Academic Supervisor: PHẠM THỊ THU TRÀ HO CHI MINH CITY, AUGUST 2013 Acknowledgement I would like to express sincere gratitude to my supervisor – Dr Pham Thi Thu Tra for scientific guidance, patient encouragement and useful advices, which she has provided throughout the time of preparation and accomplishment of this paper I also would like to thank to Prof Howard Nicholas who gave helpful comments on the draft Special thanks to Prof Nguyen Trong Hoai, and Dr Pham Khanh Nam for guidance and support as our program administrators I also would like to give my deepest thanks to my parents, and my beloved wife Khanh Linh for her spiritual supports, encouragements i Table of contents Acknowledgement i Table of contents ii List of tables iv List of figures iv Abbreviations vi Abstract vii CHAPTER 1: INTRODUCTION 1.1 Introduction .1 1.2 Background, and problem statement 1.2.1 A brief history of Vietnamese exchange rate policy 1.2.2 Recent Vietnam economic concerns 1.3 Research objectives and research questions 1.3.1 Research objectives 1.3.2 Research questions 1.4 Justification of the study 1.5 Scope and limitation of the study 1.6 Organization of the study CHAPTER 2: THEORETICAL FRAMEWORK 2.1 Introduction .7 2.2 Overview of exchange rate misalignment 2.3 Theoretical background of exchange rate misalignment 2.3.1 The Purchasing Power Parity approach 2.3.2 The Fundamental Equilibrium Exchange Rate 12 2.3.3 The Behavioral Equilibrium Exchange Rate 13 2.4 Empirical studies .18 2.5 Conceptual Framework 27 2.6 Summary 28 CHAPTER 3: DATA AND RESEARCH METHODOLOGY .30 ii 3.1 Introduction .30 3.2 The PPP approach 30 3.3 The trade balance .31 3.4 The BEER approach 31 3.4.1 Real effective exchange rate (REER) .31 3.4.2 Other variables 31 3.4.3 The calculation of the Real Exchange Rate Misalignment .33 3.4.4 The econometric procedure of the BEER approach 33 CHAPTER 4: THE HISTORY OF ER MANAGEMENT IN VIETNAM 38 4.1 Introduction .38 4.2 Vietnam exchange rate history 38 4.3 Summary 46 CHAPTER 5: FINDINGS AND DISCUSSIONS 47 5.1 Introduction .47 5.2 Equilibrium real exchange rate and misalignment 47 5.2.1 BEER approach 47 5.2.2 PPP approach 56 5.3 The relationship between the PPP exchange rate misalignment and the Vietnam’s trade balance 57 5.3.1 The Vietnam’s trade structure 58 5.3.2 The conclusion 65 5.4 The movement of several Asian currencies 65 CHAPTER 6: CONCLUSIONS AND RECOMMENDATIONS 68 6.1 Conclusion .68 6.2 Policy recommendations 69 6.3 Limitations and directions for further studies 71 6.3.1 Limitations 71 6.3.2 Directions for further studies 71 References 72 Appendices 78 iii List of tables Table 1: Several results of empirical researches for Chinese Renminbi 22 Table 2: Empirical studies of real ER misalignment in several countries 24 Table 3: The measurements and expected signs of variables 32 Table 4: Critical values for Dickey Fuller test 35 Table 5: Inflation and exchange rate trends in 1985 – 1992 .41 Table 6: Descriptive statistics 47 Table 7: The correlation matrix of variables .48 Table 8: The values of stationary tests of all variables .49 Table 9: Regression result 50 Table 10: The values of stationary tests for residual (at level) 51 Table 11: Summary of estimating ER misalignment results in case of LICs 53 Table 12: The values of ER misalignment, according to BEER method 78 Table 13: The values of ER misalignment, according to PPP method .79 List of figures Figure 1: Inflation rate from period 1996Q1 to 2011Q3 Figure 2: Trade balance of all goods and services from 1995 to 2012 Figure 3: The conceptual framework 28 Figure 4: Inflation rate and nominal exchange rate (VND/USD) 39 Figure 5: Gaps between official exchange rate and unofficial market rate 39 Figure 6: Trading bands declared by the SBV 40 Figure 7: Inflation and exchange rate trends in 1985 – 1992 41 Figure 8: Official and black market exchange rate in 2008 to 2009 44 Figure 9: Official and black market exchange rate in 2010 to 2011 45 iv Figure 10: The residual of the regression result 51 Figure 11: The histogram of residual 53 Figure 12: The current exchange rate misalignment of the VND 55 Figure 13: The permanent exchange rate misalignment of the VND 55 Figure 14: The PPP ER misalignment (against a basket of currencies) 56 Figure 15: The average current misalignment and TB from 2000 to 2009 57 Figure 16: The average permanent misalignment and TB from 2000 to 2009 57 Figure 17: The PPP exchange rate misalignment and TB from 2000 to 2012 58 Figure 18: The structure of Vietnam’s export from 2006 to 2012 59 Figure 19: Several Vietnamese major exports’ products from 2000 to 2010 60 Figure 20: Several Vietnamese major exports’ products from 2000 to 2010 60 Figure 21: The structure of Vietnam’s import from 2006 to 2012 61 Figure 22: Several major imports’ commodities 61 Figure 23: The imports of necessary machineries for export sectors 62 Figure 24: The exports and imports of electronic products and parts 63 Figure 25: The exports and imports of mobile products and parts 64 Figure 26: The TB excluding the exports & imports of mobile products and parts 64 Figure 27: The percentage change of the nominal ER and the Vietnam’s inflation 66 Figure 28: The percentage change of the Vietnam’s nominal ER and PPP ER 66 Figure 29: The percentage change of PPP exchange rate of several currencies 67 v Abbreviations BEER : Behavioral Equilibrium Exchange Rate ER : Exchange Rate FEER : Fundamental Equilibrium Exchange Rate GSO : General Statistics Office IFS : International Financial Statistics LIC : Low Income Country MoIT : Ministry of Industry and Trade PPP : Purchasing Power Parity REER : Real Effective Exchange Rate SBV : State Bank of Vietnam TB : Trade Balance USD : United States Dollar VND : Vietnam Dong vi Abstract It is said that the exchange rate policy plays an important role in an economy It links the domestic economy to other foreign ones And exchange rate misalignment is often the most interested topic of economists Hence, the aim of this research is to (i) estimate the exchange rate misalignment and (ii) investigate its relationship with trade balance, in case of Vietnam The equilibrium exchange rates are obtained by two methods: the relative PPP approach and the Behavioral Equilibrium Exchange Rate (BEER) model The misalignment of exchange rate is defined as the difference between the actual and the equilibrium exchange rate In the BEER approach, the co-integration is used to test the long run relationship between the real effective exchange rate (REER) and several macroeconomics variables In the PPP approach, the misalignment of exchange rate is calculated simply based on the domestic and foreign CPIs The result from the PPP approach suggests that: (i) the VND was undervalued and slightly overvalued from 2000 to the middle of 2007; (ii) the overvaluation of VND has sharply increased from the last half of 2007 up to now The exchange rate misalignment from PPP approach is chosen to examine the impacts on the Vietnam’s trade balance The conclusion is that the exchange rate misalignment does not have strong relationship with trade balance Key words: exchange rate, misalignment of exchange rate, trade balance vii CHAPTER 1: INTRODUCTION 1.1 Introduction The purpose of this research is, first, to measure the Vietnam’s real exchange rate misalignment; second, to study its relationship on Vietnam trade balance The exchange rate misalignment is defined as the deviation between the equilibrium1 and actual real exchange rate An exchange rate is named overvalued when it is higher than its equilibrium level; in the otherwise, an exchange rate is labeled undervalued when it is lower than its equilibrium level This research presents two estimating exchange rate approaches: the relative PPP approach and the Behavioral Equilibrium Exchange Rate model First of all, we need to quantify the real exchange rate equilibrium and calculate the misalignment of real exchange rate by using two methods above After that, by applying several visual graphs, we can investigate the relationship between the exchange rate misalignment and trade balance 1.2 Background, and problem statement 1.2.1 A brief history of Vietnamese exchange rate policy In 1986, Vietnamese economy had been coped with persistent concerns such as the shortage of food, skyrocketing inflation, and twin deficits Under pressure to reform, policymakers had to make a series of action to transform the Vietnamese economy from command to market oriented In accordance to that economic reforming process, Vietnam’s exchange rate regime also had several significant changes Vo, Dinh, Do, Hoang, & Pham (2000) found that multiple types of exchange rate were applied before 1989 The first official exchange rates were employed for foreign commercial transactions and non-commercial, respectively There are several different definitions of equilibrium real exchange rate They will be reviewed specifically in next chapter After excluding the contribution of mobile manufacturing sector, we see that the “new” trade balance also shares the same trend with the real exchange rate misalignment This is quite consistent with the original result (Figure 17) 5.3.2 The conclusion After examining the Vietnam’s structure of export and import, we can deal with the issue about the relationship between the exchange rate misalignment and trade balance in Vietnam (in Figure 17 & Figure 26) From the trading data in the previous parts, we see that Vietnam’s exports rely closely on imports In the export side, Vietnam usually exports either products in raw types such as crude oil, coal, and agriculture products, or labor - intensive products from light industry, and handicraft sectors In the import’s side, the accumulated overvaluation helps Vietnamese firms buy input materials and machineries for production with relatively cheap prices This gives significant advantages for production goods for domestic consumptions as well as exports It is clear that Vietnam vertically specializes for most of its export products Therefore, its trade balance is less sensitive to the exchange rate misalignment In other words, exchange rate misalignment has a little effect on trade balance 5.4 The movement of several Asian currencies From the middle of 2005 up to now, the Vietnam’s inflation has been increasing more rapidly than the percentage change in the nominal exchange rate of the VND to the USD (Figure 27) Moreover, difference between domestic and the US’s inflation also dominates the percentage change in the nominal exchange rate According to PPP approach, it is claimed that the VND has been overvalued cumulatively Although the SBV has the devaluated the VND at several times, however, it is not enough for dominating the inflation That is the reason why the nominal exchange rate and the PPP exchange rate have opposite tendencies (Figure 28) 65 In the previous part, according PPP approach, we have indicated that the VND has been overvalued in recent years The next step is to apply PPP approach to examine the currency’s movement of the VND and other Asian foreign currencies The chosen currencies are the Chinese Renminbi (RMB), the Malaysian Ringgit (MYR), the Singaporean Dollar (SGD), the Thai Baht (THB), the Japanese Yen (JPY), the Taiwan Dollar, and the Korean Won The reason of choosing those countries’ currencies is that those countries are either major trading partners or competitors of Vietnam The base time for this calculation is June, 2005 because it is the time China started to adjust its RMB after a long time kept it unchanged Figure 27: The percentage change of the nominal exchange rate (in absolute values) and the Vietnam’s inflation 2005M07 2005M09 2005M11 2006M01 2006M03 2006M05 2006M07 2006M09 2006M11 2007M01 2007M03 2007M05 2007M07 2007M09 2007M11 2008M01 2008M03 2008M05 2008M07 2008M09 2008M11 2009M01 2009M03 2009M05 2009M07 2009M09 2009M11 2010M01 2010M03 2010M05 2010M07 2010M09 2010M11 2011M01 2011M03 2011M05 2011M07 2011M09 2011M11 120.000 % 100.000 % 80.000 % 60.000 % 40.000 % 20.000 % 0.000 % -20.000 % Exchange rate (%) Inflation rate (%) Source: Author’s calculations Figure 28: The percentage change of the Vietnam’s nominal exchange rate and the Vietnam’s PPP exchange rate 2005M07 2005M09 2005M11 2006M01 2006M03 2006M05 2006M07 2006M09 2006M11 2007M01 2007M03 2007M05 2007M07 2007M09 2007M11 2008M01 2008M03 2008M05 2008M07 2008M09 2008M11 2009M01 2009M03 2009M05 2009M07 2009M09 2009M11 2010M01 2010M03 2010M05 2010M07 2010M09 2010M11 2011M01 2011M03 2011M05 2011M07 2011M09 2011M11 80.000% 60.000% 40.000% 20.000% 0.000% -20.000% -40.000% -60.000% Exchange rate (%) PPP exchange rate (%) Source: Author’s calculations 66 The Figure 29 suggests that we can divide countries’ currencies into two main groups Countries in the first group are: Malaysia, Singapore, and Thailand have integrated their currencies to RMB These currencies’ movement shares the same trend with RMB The second group includes Japan, Korea, and Taiwan Those countries keep their currencies more undervalued against China RMB to maintain currency advantages The Figure 29 also concludes that the VND is highly overvalued compared to selected foreign currencies Due to this reason, the competitiveness of domestic tradable goods has been eroded dramatically In terms of currency competitiveness, devaluation is significantly necessary for restoring the advantages of domestic goods Figure 29: The percentage change of PPP exchange rate of several currencies 70.0% 50.0% 30.0% 10.0% -10.0% -30.0% 2005M06 2005M09 2005M12 2006M03 2006M06 2006M09 2006M12 2007M03 2007M06 2007M09 2007M12 2008M03 2008M06 2008M09 2008M12 2009M03 2009M06 2009M09 2009M12 2010M03 2010M06 2010M09 2010M12 2011M03 2011M06 2011M09 2011M12 -50.0% VN (VND/USD) Malaysia (MYR/USD) Thailand (THB/USD) Taiwan (TWD/USD) China (RMB/USD) Singapore (SGD/USD) Japan (JPY/USD) Korea (KRW/USD) Source: Author’s calculations 67 CHAPTER 6: CONCLUSIONS AND RECOMMENDATIONS 6.1 Conclusion The exchange rate is one of the most important variables for economy Indeed, the exchange rate can influence the inflation rate, trade competitiveness, stability of financial system, and foreign exchange market’s performance On the one hand, government can curb inflation by using a nominal exchange rate as an anchor On the other hand, it is expected that an economy can take advantage of its weak currency to obtain competitiveness The positive consequences are the improved trade balance, and the additional growth for the economy Hence, launching an exchange rate policy is always a challenged mission because governments often apply exchange rate to deal with opposed targets A common issue occurs when running exchange rate policies is the appearance of the misalignment of exchange rate Theoretically, the exchange rate misalignment represents the situation in which the actual real exchange rate is not in its equilibrium level There are two types of exchange rate misalignment: overvaluation and undervaluation Many economists developed various approaches to measure the equilibrium exchange rate However, the “best” method which can conclude the “correct” value of equilibrium exchange rate does not exist Depending on the concerns, the appropriate method will be applied to deal with specific problems In this research, two chosen approaches are the PPP and the BEER The PPP approach indicates that from 2000 to the middle of 2007, the VND was undervalued and slightly overvalued; and from the last half of 2007 up to now, the overvaluation of VND has sharply increased The BEER approach shows that Vietnam has experience overvaluation and undervaluation for several periods After obtaining the value of exchange rate misalignment, the next step is to investigate the PPP exchange rate misalignment relationship with trade balance The 68 result claims that the misalignment of exchange rate and trade balance share the same trend This is somewhat strange compare to theory The reason comes from the Vietnamese trade structure In the export’s side, the common commodities are either products in raw types such as crude oil, coal, and agriculture products, or labor - intensive products from light industry, and handicraft sectors while in the import’s side, Vietnamese firms buy input materials and machineries for production Because most of Vietnam’s export products rely heavily on imports, it is claimed that Vietnam is a vertically specialized country Hence, Vietnam’s trade balance is less affected by exchange rate misalignment Because overvaluation has increased fast from 2008 up to now, the problem of devaluation is considered for many times Although this problem is far from this research, there are several studies that mention about the impacts of devaluation to inflation in Vietnam Goujon (2006) examines the determinants of inflation in Vietnam during 1990s, claims that inflation is partially explained by changes of exchange rate Moreover, he also suggests that in such country experienced with dollarization like Vietnam, the control of exchange rate is compulsory even though during low inflation periods Nguyen & Nguyen (2011) also suggest that there is a positive relationship between exchange rate devaluation and inflation in Vietnam in the period 2001 – 2010 In detail, they argue that the volatilities generated from the significant devaluation in 2009 – 2010 created the psychological expectation from the public Therefore, devaluation may cause inflation expectation and this may lead to the real inflation in Vietnam 6.2 Policy recommendations In the short – run, two of the most Vietnamese government’s concerns are inflation and trade deficit In theory, high inflation has negative impacts on the living standards of people while trade deficit is believed to dries up national foreign reserve, increase foreign debts, lead to a monetary crisis Exchange rate policy is one of methods which may deal with these issues A recent raising question is that 69 Vietnamese government should devaluate its currencies or not A devaluation of VND is expected to increase the competitiveness of Vietnam’s goods and hence, promote the exports and give additional growth to domestic economy However, at the same times, it also pushes pressures on inflation which is awfully severe in recent years The answer obtaining from this research suggests that the government should not devaluate the VND although its value is relatively overvalued compared to other currencies This is because: (i) the Vietnamese exports are still increasing although the overvaluation VND is high in recent years, (ii) due to the Vietnam’s trade structure, the overvaluation of VND has little effects to the trade balance in 2000 – 2012, (iii) a devaluation of VND will not help the trade balance, but it absolutely increases inflation rates because it raises the price of imported commodities as well as creates psychological expectation which causes inflation expectation and leads to real inflation However, in the long – run, the economic prosperity issue is more important than improvement of the trade balance Devaluation may help recover the economy from the current downturn due to two reasons Firstly, it may reduce the level of dependence on imports of several sectors Indeed, devaluation will raise the prices for imported inputs and thus, provides incentives for domestic production for substituting needed foreign materials In other words, it provides opportunities for Vietnam to reconstruct the domestic economy Secondly, the VND is highly overvalued compared to other currencies (Figure 29) Hence, devaluation will improve the competitiveness of Vietnamese goods In a nutshell, sufficient devaluation is good for Vietnam’s economy in the long – run 70 6.3 Limitations and directions for further studies 6.3.1 Limitations Theoretically, the impact of exchange rate misalignment on trade balance differs across sector, depending on the sectorial degree of vertical specialization However, due to data availability, we cannot to analyze this impact on different sectors This research does not provide a rigorous empirical study to examine the relationship between the exchange rate 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??s impacts on trade balance 2.2 Overview of exchange rate misalignment The exchange rate misalignment. .. between the Vietnam? ??s real exchange rate misalignment and its trade balance? 1.4 Justification of the study There are few of studies that provide knowledge about the Vietnam exchange rate misalignment. .. band; and it may change the value of official exchange rate and trading band according to the goals in certain periods In case of Vietnam, the exchange rate is declared officially by the SBV with