The relationship between inflation and inflation uncertainty in viet nam over the period 1995 2010

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY IN VIETNAM OVER THE PERIOD 1995-2010 BY NGUYEN VAN DUNG MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, NOVEMBER, 2011 UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE RELATIONSHIP BETWEEN INFLATION AND INFLATION UNCERTAINTY IN VIETNAM OVER THE PERIOD 1995-2010 A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By NGUYEN VAN DUNG Academic Supervisor: DR TU vAN BiNH HO CHI MINH CITY, NOVEMBER, 2011 TABLE OF CONTENTS List of Tables List of Figures List of Acronyms Acknowledgement Abstract Chapter 1: Introduction 1.1 Background of the Study 1.2 Problem Statement 1.3 Research Objectives 1.4 Research Questions 1.5 Research Hypotheses 1.6 Justification of the Study Scope of the Study 1.8 Organization of the Study Chapter 2: Literature Review 2.1 Inflation Uncertainty 2.2 Theories about the inflation-inflation uncertainty relations 2.3 Approaches to estimate inflation uncertainty 2.4 Methods to test the causal relationship between inflation and inflation uncertainty 2.5 Empirical studies about the inflation-inflation uncertainty relationship 2.6 Conceptual Framework Chapter Summary Chapter 3: Research Methodology and Data 3.1 Research Methodology 3.1.1 Descriptive statistics 3.1.2 Unit root testing 1.3 Diagnostic tests for serial correlation, heteroskedasticity and ARCH effects 29 11 3.1.4 Measuring inflation 3.1.5 Granger causality t 3.1.6 Analytical Framew 3.2 Data 3.3 Chapter Summary Chapter 4: Findings and Discussion 4.1 Descriptive statistics 4.2 Unit root testing 4.3 OLS estimation of AR(p) model of inflation 4.4 Measuring inflation uncertainty 4.5 Granger causality tests Comparison with previous studies 4.7 Chapter Summary Chapter 5: Conclusion and Policy Implications 5.1 Conclusion 5.2 Policy Implications 5.3 Limitation and Further Studies 5.3.1 Limitation 5.3.2 Further Studies References 111 List of Tables Table 2.1: Early empirical studies about the inflation-inflation uncertainty relationship 19 Table 2.2: Empirical studies about the inflation-inflation uncertainty relationship using the simultaneous estimation approach Table 2.3: Empirical studies about the inflation-inflation uncertainty relationship using the two-step approach with symmetric GARCH models to estimate inflation uncertainty Table 2.4: Empirical studies about the inflation-inflation uncertainty relationship using the two-step asymme t ric In Table 4.1: Unit root tests Table 4.2: Lag selection of AR(p) process Table 4.3: OLS estimation of AR(13) model Table 4.4: AR(13)-(GARCH(1,1), TARCH(1,1), PARCH(l,l), EGARCH(1,1)) models Table 4.5: Granger Causality Tests List of Figures Figure 4.1: Descriptive statistics of inflation in Vietnam 1995-2010 34 Figure 4.2: Average rates of inflation by month in the period 1995-2010 (%) .34 Figure 4.3: Inflation uncertainty of the AR(13)-EGARCH(1,1) model 45 Figure 4.4: Inflation and inflation uncertainty over the period 1995-2010 46 IV List of Acronyms AIC: Akaike Information Criterion AR: Autoregressive ARCH: Autoregressive Conditional Heteroskedasticity EGARCH: Exponential Generalized Autoregressive Conditional Heteroskedasticity GARCH: Generalized Autoregressive Conditional Heteroskedasticity HQ: Hannan-Quinn criterion OLS: Ordinary least squares PARCH: Power Autoregressive Conditional Heteroskedasticity SBV: State Bank of Vietnam SC: Schwartz criterion TARCH: Threshold Autoregressive Conditional Heteroskedasticity UK: the United Kingdom US: the United States of America v Acknowledgement I would like to express my sincere gratitude to my supervisor Dr Tu Van Binh who gave me valuable guidelines, comments, suggestions, and inspiration for the successful completion of this study Besides, his friendly and inspiring approach has given me a great deal of encouragements to overcome difficulties in the whole research process I am also thankful to all lecturers and program administrators in the VietnamThe Netherlands Program for M.A in Development Economics They gave me wonderful knowledge and help me kindly during the course Last but not least, I would like to express my appreciation to my family, my friends who have given me a lot of support when I pursue my studies at the program Vl Abstract The study investigates the causal relationship between inflation and inflation uncertainty in Vietnam over the period 1995-2010 using the two-step procedure Inflation uncertainty is modeled by both symmetric model (GARCH(1,1)) and asymmetric models (TARCH(l,l), PARCH(l,l), EGARCH(l,l)) The results indicate that there exists an asymmetric impact of inflation shocks on inflation uncertainty, implying that a positive inflation shock induces higher inflation uncertainty, while a negative inflation shock induces lower inflation uncertainty Based on information criteria including AIC, SC, and HQ as well as diagnostic tests, AR(13)-EGARCH(l,l) is considered the best model to model inflation uncertainty Then Granger causality tests are employed to test the causality between inflation and inflation uncertainty (estimated by the AR(13)-EGARCH( 1,1) model) The results support that a rise in inflation significantly leads to more inflation uncertainty, which confirms the Friedman-Ball hypothesis; and increasing inflation uncertainty leads to more inflation, confirming the Cukierman-Meltzer hypothesis, which indicates an "opportunistic" State Bank of Vietnam The policy implication is that the monetary authorities have to keep inflation low, stable and predictable to eliminate the negative impact of inflation uncertainty Key words: inflation, inflation uncertainty, relationship, GARCH models, Granger causality tests Vll Chapter 1: Introduction 1.1 Background of the Study Vietnam experienced hyperinflation m the late 1980s (approximately 300%/year) and early 1990s (approximately 50%/year) due to bad weather, weak financial system, and especially poor governance of the authority The year 1995 marked an important turning point when hyperinflation was completely controlled and Vietnam began its deep international integration (i.e formally normalized diplomatic relations with the US and became the full member of ASEAN) The years after 1995 witnessed the 1997-1998 Asian Financial Crisis and its consequences to the world prices and aggregate demand Because of the negative consequences of the crisis, both demand for Vietnamese goods and domestic demand declined This period was marked by low inflation with mild deflation in 2000 (-0.5%) despite rapid monetary and credit growth (approximately 3040%/year) and VND's sharp devaluation (approximately 36%) in the period 19972003 (Nguyen & Nguyen, 2010) After the period of stably low inflation, inflation began increasing sharply with 9.5% in 2004 When the negative impact of the Asian crisis declined, demand began to rise Demand increase and the rise of salary in both the public and FDI sector in 2003 pushed the prices to rise Additionally, supply shocks (due to bird flu and bad weather) contributed to the price increase The government considered supply shocks mainly responsible for inflation Food prices increased by 15.5% compared with the general inflation rate of 9.5% and inflation of non-food products was 5.2% in 2004 (Nguyen & Nguyen, 2010) For the fear of increasing inflation, State Bank of Vietnam (SBV) implemented tightening monetary policy, making interest rates increase slightly, and fixed the exchange rate since 2004 The rigid management of exchange rate untillate-2008 did not stabilize inflation as in the period 2000-2003 Inflation, after declining slightly in 2006, increased sharply to 12.6% in 2007 and up to 20% in 2008 (Nguyen & Nguyen, 2010) • There are many causes of high inflation in the period 2007-2008, which include the sharp increase of minimum wage rate, sharp rise of international commodity prices, lax and inflexible monetary policy, rigid exchange rate management, and the opening of Vietnam to the world economy since Vietnam's join the WTO in late-2006, leading to indirect investment flows of foreign countries into Vietnam, pushed stock prices and asset prices increase dramatically To stabilize the exchange rate, SBV had to pump a large amount of money into the economy (approximately VND 145 thousand billion), contributing to more severe inflation In fact, the increase of money supply and credit growth in the economy in the last decade was very strong, especially in 2007 when M2 increased by 47% and credit growth increased by 54% (Nguyen & Nguyen, 2010) Impacts of the 2007-2008 Global Financial Crisis made inflation slow down in Vietnam since late-2009 The decrease of international prices and total demand made Vietnam reverse alarming trend of increased inflation since 2008 However, for fear of recessionary impacts, the government introduced the stimulus package since the second quarter of 2009, which made money supply and credit soar The early months of 2010 saw relatively stable inflation rates However, inflation increased sharply since September 2010 and reached 11.75% for the whole year In general, the period 1995-2010 is the relatively stable inflation time compared with the hyperinflation period in the late 1980s-early 1990s Inflation is rather low in a decade from 1996 to 2006 However, high inflation has returned to the Vietnamese economy since 2007 with two-digit inflation rate, which poses many threats to the economy 1.2 Problem Statement Inflation is a worldwide problem that causes a negative impact on every economy in the world In the Vietnamese case, the country incurred relatively high ability in such bad situations, which in tum raises inflation uncertainty All these ' factors contribute to the sharp increase of inflation un -1 1996 Figure 4.4: Inflation and inflation uncertainty over the period 1995-2010 As we can see from figure 4.4, inflation and inflation uncertainty seem to have a positive relationship Inflation and inflation uncertainty move in the same direction with increasing inflation going with more inflation uncertainty, and vice versa However, this graphical observation just gives a suggestion about the possible relationship between the two variables In order to investigate this relationship evidently, we have to carry out the next Granger causality tests 4.5 Granger causality tests Table 4.5: Granger Causality Tests H0 : Inflation does not Granger-cause inflation uncertainty Two lags Four lags Six lags Eight lags 46 Ten lags Twelve lags H0 Inflation uncertainty does not Granger: cause inflation Two lags Four lags Six lags Eight lags Ten lags Twelve lags Notes: (+)and(-) are the signs of the sum of coefficients oflagged variables (inflation in the first hypothesis and inflation uncertainty in the second hypothesis) Table 4.5 reports the results of Granger causality tests for the inflationinflation uncertainty nexus at two, four, six, eight, ten, and twelve lags The first null hypothesis of causality not going from inflation to inflation uncertainty is rejected at all lags at 1% level of statistical significance Similarly, the second null hypothesis of inflation uncertainty not Granger-causing inflation is also rejected at all lags at 10% level of statistical significance or smaller, except for the test at lag four In addition, the positive signs of the sum of lagged inflation in the first hypothesis and lagged inflation uncertainty in the second hypothesis at all lags suggest the positive bi-directional relationship between inflation and inflation uncertainty It means that rising inflation will lead to a rise in inflation uncertainty, which confirms the Friedman-Ball hypothesis In the meantime, more inflation uncertainty will lead to more inflation, which confirms the Cukierman-Meltzer hypothesis Evidence of the Cukierman-Meltzer hypothesis indicates that the government and SBV might not have been determined to fight inflation It has been widely discussed in the literature about the relationship between the independence of the 47 - ' central bank and the effects of uncertainty on inflation (i Neyapti (1992); Alesina & Summers (1993); Grier and Pe Grier and Perry (1998), rising uncertainty causes inflation where the central banks are highly independent Converse have low independence (measured by Cukierman et al (1 (1993)) exhibit 'opportunistic' behavior Specifically, th uncertainty to increase inflation with an effort to stimulat Empirical evidence is found in Grier and Perry hypothesis is approved in the US, the UK and Germany w bank independence On the other hand, the Cukierma approved in Japan and France which have relatively low c Another study by Fountas et al (2004) concludes that the in Germany and the Netherlands which have strongly ind However, the Cukierman-Meltzer hypothesis is confirm France which have relatively low central bank independen comes up with the similar conclusion, Colombia, Israel, M countries which have moderate to high independent centr hypothesis holds for these economies Meanwhile, ev Meltzer hypothesis in Hungary, Indonesia, and Korea is p independent central banks The State Bank of Vietnam is considered not an ind the governor is a member of the cabinet Moreover, SBV the Party's policies As a result, SBV normally has less au monetary policy, which helps to explain why evidence of hypothesis is found in Vietnam over the period 1995-2010 4.6 Comparison with previous studies As for the confirmation of the Friedman-Ball hypo study is consistent with all previous studies using both the 48 - ' as Grier and Perry (1998), Thornton (2007), Fountas et al (2004), Daal et al (2005), Erkam and Cavusoglu (2008), Nazar and Mojtaba (2010), Asghar et al (20 11) and the simultaneous estimation approach such as Caporale and McKiernan (1997), Fountas (2001), Kontonikas (2004), Thornton (2006), Keskek and Orhan (2010) This finding once again confirms that the Friedman-Ball hypothesis holds in all countries regardless of the econometric techniques to find out the relationship In terms of the confirmation of the Cukierman-Meltzer hypothesis, this study is in line with the majority of previous studies using the two-step approach such as Grier and Perry (1998), Thornton (2007), Fountas et al (2004), Daal et al (2005), Erkam and Cavusoglu (2008), Nazar and Mojtaba (2010), Asghar et al (2011) However, it is worth noticing that the finding for Vietnamese case is not similar to all countries in these listed studies, implying that the relationship running from inflation uncertainty to inflation is different across countries due to the dissimilarity in the independence of the central bank and economic development Regarding transitional countries which share much similarity with Vietnam like Russia (Erkam & Cavusoglu, 2008), the results are similar, with the support for both the Friednam-Ball hypothesis and Cukierman-Meltzer hypothesis With respect to other countries in the Southeast Asian region, the findings agree with the study of Jiranyakul and Opiela (20 10), which confirms both the Friedman-Ball hypothesis and Cukierman-Meltzer hypothesis in Malaysia, Indonesia, the Philippines, Singapore, and Thailand 4.7 Chapter Summary This chapter has presented the research findings Descriptive statistics indicate the high and volatile nature of inflation during this period The evidence from variance equations shows an asymmetric impact of inflation shocks on inflation uncertainty, indicating that a positive inflation shock induces higher inflation uncertainty, while a negative inflation shock induces lower inflation 49 - • uncertainty Moreover, the Friedman-Ball hypothesis hypothesis are also strongly supported 50 Chapter 5: Conclusion and Policy Implications 5.1 Conclusion The study has analyzed the inflation-inflation uncertainty relationship in Vietnam over the period 1995-2010 using the two-step procedure First, different types of GARCH models (GARCH(l,l), EGARCH(l,l), TARCH(l,l), PARCH(l,l)) are employed to estimate inflation uncertainty Based on information criteria including AIC, SC, and HQ as well as diagnostic tests, AR(13)-EGARCH(l,l) is considered the best model to model inflation uncertainty Then Granger causality tests are employed to test the causality between inflation and inflation uncertainty (estimated by the AR(13)-EGARCH(l,l) model) The results support the following conclusions First, there exists an asymmetric impact of inflation shocks on inflation uncertainty, indicating that a positive inflation shock induces higher inflation uncertainty, while a negative inflation shock induces lower inflation uncertainty Second, a rise in inflation significantly leads to more inflation uncertainty, which confirms the Friedman-Ball hypothesis Third, more inflation uncertainty will lead to more inflation, confirming the Cukierman-Meltzer hypothesis, which indicates an "opportunistic" State Bank of Vietnam (SBV) 5.2 Policy Implications The study suggests many implications for policymakers concerning inflation and inflation uncertainty As for the causal direction from inflation to inflation uncertainty, the following suggestions are proposed Firstly, the asymmetric impacts of inflation shocks on inflation uncertainty are identified through the TARCH, PARCH, and EGARCH framework, which indicates the necessity of inflation stabilization policies If these policie!) are successfully implemented, inflation level will be reduced, and eventually lower the 51 ~ , succeeding price volatility Moreover, Granger causality confirm the Friedman-Ball hypothesis in Vietnam ov implying that increasing inflation leads to more uncertai the negative consequences of uncertainty on the real eco literature review section) As a result, it is once aga inflation stabilization programs successfully to lower uncertainty However, what should the policy makers in d inflation in Vietnam is due to a combination of man inflation (fuel, raw material, salary, etc have increased s years, pushing the price of goods increase); second, dem of consumers, enterprises and the government increase e countries like Vietnam, ineffective investments of SO case)); third, monetary inflation (excessive supply ofM2 for example, in the period 2007-2010 M2 increased by by only 26.8%) All these factors happened at the same t rates dramatically over the past few years Hence, there m of monetary policy, fiscal policy, and administrative mea not only in the short-run but also in the long-run With respect to monetary policy, SBV must reduc circulation by: rising interest rates, reserve requirement, growth (for example, the government has tried to limit M 15-16% and credit growth of 15%-18% in 2011 ) Furthe more bonds and assign them to commercial banks to circulation In terms of exchange rate management, VND increase slightly against USD This is in line with the cur losing its value against other major currencies Slightly i may affect exports; however, the negative impacts are no VND's increase in value will reduce import prices, inc 52 prices in the domestic market (as import accounting for the majority of the country's GDP), and make the income of the residents more valuable With respect to fiscal policy, the government must control government spending, public investment and investment of SOEs tightly Specifically, unnecessary administrative expenses in state agencies must be reduced to lower pressure on the demand side Most importantly, the government must improve the effectiveness of public investment and SOEs investment; inefficient projects must be strongly eliminated With respect to administrative measures, the government must improve the network of supplying goods so that goods going from producers to consumers through less middle men, which reduces transaction costs and price level especially in high-demand period such as Lunar New Year, new school year Additionally, the authority has to limit the speculation of necessities (such as food which accounts for nearly 50% of CPI basket), support the low-income people through various social programs Finally, there must be good coordination among different departments and local authorities in the implementing stage to create collective power to ensure the success of inflation stabilization programs In summary, strong coordination among fiscal policy, monetary policy, and administrative measures would help to respond effectively to all causes of inflation In particular, fiscal policy would help reduce the "pain" caused by tightening monetary policy (for example, people having monthly income lower than VND million are exempted from personal income tax from August to December 2011; enterprises are reduced by 30% corporate income tax in 2011 ), making the fight against inflation does not affect sustainable growth and employment As for the relationship running from inflation uncertainty to inflation, the strong evidence of the Cukierman-Meltzer hypothesis explicitly shows an "opportunistic" SBV which has not followed the price stabilization policy consistently In other words, it supports the government's development and industrialization targets, and often finances the fiscal deficits that results In order to 53 reduce inflation uncertainty, the monetary authorities should adopt the following recommendations Firstly, the government and SBV must show strong determination of controlling inflation, consider it as the top priority Policy responses must be announced and implemented quickly whenever there are threats of inflation Moreover, the authorities must monitor the implementation process, making sure that the policies have quick, strong, stable and predictable effects These quick responses and proper monitoring will create belief in the investors and public; thereby inflation uncertainty can be reduced both in the short-run and long-run Secondly, the government and SBV have to eliminate asymmetric information problem to ensure that the general public are well-informed of causes, current state, solutions, and forecasts of inflation In particular, information about food prices, fuels, as well as exchange rate, interest rate policy, credit growth target, forecast of essential import and export product prices, etc should be better explained and broadcast to the general public through various forms of the media (television, radio, newspapers, internet, etc.) These actions help to communicate the policy stance, rationalize and anchor inflation expectation Thirdly, SBV, the main agency responsible for fighting inflation, must be strengthened to set and implement monetary policy more effectively Currently, SBV exhibits many weaknesses such as weak autonomy and overreliance on administrative instruments These drawbacks are due to not only political but also technical factors In terms of political side, the governor does not have full autonomy to make and implement monetary measures to achieve the inflationary target Technically, SBV tends to use administrative measures, which indicates "central planning" way of managing monetary policy, which is old-fashioned in the modem market economy Hence, SBV must be restructured in terms of organization, operations and human resources to perform its function better This would eventually increase SBV's transparency and accountability, which helps reduce uncertainty 54 eliminated, reducing much economic loss 5.3 5.3.1 Limitation inflation-inflation uncertainty relationship properly, the problem of generated regressors Inflation uncer is employed as the regressor in the second step multicollinearity because inflation and inflation relationship Consequently, the standard errors in which may cause the biasness of Granger tests' resu ' explicitly in the model • 1995 when inflation and macro economy in Vietnam The difficulties in obtaining inflation data in from investigating the relationship for this very interesting period with a lot of volatility and changes in macro economy 5.3.2 Further Studies The credibility of monetary policy plays an important role in determining the level of inflation uncertainty Hence, further study should employ different models which can consider effects of monetary and exchange rate regimes on inflation uncertainty explicitly Additionally, future study may investigate this relationship after the year 2010 to identify whether the above-mentioned results continue hold for Vietnam, especially whether we can find a "stabilizing" SBV after 2010 55 Potential studies may also examine the effect of inflation as well as inflation uncertainty on real output growth employing the method of estimating inflation uncertainty presented in this research Moreover, it is interesting to use Markovswitching 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Sub-questions: (i) Is there an asymmetric impact of inflation shocks on inflation uncertainty? (ii) Does inflation