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 EXCHANGE RATE & TRADE BALANCE: A NEW APPROACH USING BIG MAC INDEX FOR THE CASE OF THAILAND A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS BY VO THE ANH Academic Supervisor: Dr. VO HONG DUC HO CHI MINH CITY, DECEMBER 2014 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ACKNOWLEDGEMENTS It is assistance, guidance, and encouragement that contribute to the success of this thesis. Therefore, I would like to express my gratitude to those who always stand by me during periods of writing thesis. My profound appreciation and sincere thanks must first be expressed to my academic supervisor, Dr.
Vo Hong Duc, Director of Economic Regulation Authority in Perth, Australia, for his interest, encouragement, and guidance throughout thesis- writing process from initial themes to entire finish, especially during boring time of reading the final draft. I would like to express my grateful thanks to Assc. Nguyen Trong Hoai, Dr. Truong Dang Thuy, Dr.
Phung Thanh Binh, and Dr. Pham Khanh Nam, Lectures at Department of Economics Development at University of Economics (HCMC), for their helpful commands and valuable pieces of advice during the time I write the thesis. Special thanks are extended to Dr. Le Van Chon for his invaluable econometric guidance.
Thanks to such academic commands, advice, and guidance, I could finish the thesis on the best way. I am be grateful to not only staff members at Department of Economics Development at University of Economics (HCMC) but also my classmates at VNP- MDE 19 for their help and support and for offering such a warm and friendly studying atmosphere. Most importantly, I am indebted to my parents for financing my study as well as for their constant love and moral support. This thesis could not be finished without their comprehension.
i LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ABSTRACT This thesis focuses on achieving two main objectives: (i) an evaluation of the Thailand’s currency to confirm whether a currency is over- or undervalued during the period from 1980 to 2013 for the case of Thailand; and (ii) a consideration of the effects of a currency’s devaluation on trade balance for the case of Thailand. In this study, these effects are considered in different aspects such as the determinants of a trade balance of Thailand; and the long run relationship between bilateral exchange rate and Thailand’s trade balance. In relation to the first objective, the prominent feature of the study is to use the Big Mac Index (BMI), the first ever study of this kind conducted in Vietnam, for evaluating Thailand’s currency and to apply this evaluation in the context of the link between exchange rate and trade balance. Nevertheless, the common-used index, the Consumer Price Index (CPI), is also utilized to compare the effectiveness of BMI with that of the CPI.
Theoretical grounds for evaluating a currency in term of purchasing power parity (PPP) theory are first presented, together with the theory of the link between currency’s devaluation and trade balance. Next, the empirical studies associated with such theory are discussed. Empirical models and results are reported accordingly. To obtain the first objective, the PPP hypothesis is required to be satisfied in terms of panel cointegration tests.
The fully modified OLS (FMOLS) technique is adopted to determine the equilibrium exchange rate for evaluation process. On the grounds of the tests of PPP, the panel-based unit root tests as developed by Breitung (2001) and the panel cointegration tests by Pedroni (1999, 2001, 2004) and Kao (1999) are adopted. The empirical results confirm a solid validity of PPP for the case of CPI- based exchange rate and a weak evidence of the PPP for BMI-based exchange rate. In the relation to evaluate Thailand’s currency, the results illustrate that (i) the valuation ii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com of Thailand currency using CPI-based exchange rate is fairly consistent to that of BMI- based exchange rate with an exception of the outcomes during the 1997 Asian financial crisis; and (ii) the Big Mac exchange rate is better when bilaterally evaluating the Thailand Baht to US dollar.
The second main objective - a consideration of the effects of a currency’s devaluation on trade balance - could be achieved by the two procedures. The first procedure is to analyze how changes on exchange rate policy, fiscal policy, and monetary policy affect Thailand’s trade balance. In this task, effects of devaluation on trade balance are examined on various scenarios: (i) the entire sample of 62 countries who are trading partners with Thailand; (ii) different geography (between regions and regions of countries); (iii) different income levels; and (iv) during different periods in which Thailand’s currency is over- or under-valued. Both OLS method and IV technique are employed because of an endogeneity problems as mentioned in previous studies.
The empirical findings indicate that the exchange rate policy plays a central role in explaining Thailand’s trade balance and the fiscal and monetary policies are beneficial in some cases. The second procedure is to examine the long run relationship between a devaluation of Thailand’s currency and trade balance with the applications of the panel-based co-integration tests by Pedroni (1999, 2001, 2004) and Kao (1999) and the FMOLS model. The panel FMOLS estimations illustrate that a devaluation of Thailand Baht could provide positive effects on trade balance in the long run, especially for the groups of country with high income, upper middle income, in America, and Europe. The individual FMOLS regressions between Thailand and each of her 62 trading partners indicate that the devaluation of Thailand’s currency would stimulate Thailand’s trade performance with over 20 trading partners, but hurt its performance with the other 10 countries and inconclusive conclusion for the others.
iii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ABBREVIATIONS PPP Purchasing Power Parity BMI Big Mac Index CPI Consumer Price Index M-L Marshall-Lerner OLS Ordinary Least Squares FMOLS Fully Modified Ordinary Least Squares IMF International Monetary Fund VND Vietnam Dong IV Instrumental Variable OECD Organization for Economic Cooperation and Development VAR Vector Autoregressive ARDL Autoregressive Distributed Lag ECM Error Correction Model iv LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Contents LISTS OF FIGURES .3 The Structure of the Thesis .2 Alternative approaches to devaluation theory .1 Test of PPP Theory .2 Evaluation of a currency .3 Determinants of a Trade Balance .4 Devaluation and Trade Balance. 25 THAILAND’S TRADE BALANCE AND. 25 v LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ITS BIG MAC INDEX .1 Thailand’s Trade Balance .2 Big Mac Index .1 Panel unit root test .2 Panel cointegration test .1 Kao’s cointegration test .2 Pedroni cointegration test .3 Fully modified OLS approach .1 Test of PPP theory .2 Evaluation of Thailand’s currency .3 Determinants of Thailand’s Trade Balance .4 Devaluation and Thailand’s Trade Balance. 47 DATA AND RESEARCH FINDINGS .1 Test of PPP theory .2 Evaluation of Thailand’s currency.
52 vi LUAN VAN CHAT LUONG download : add luanvanchat@agmail.3 Determinants of Thailand’s trade balance .4 Devaluation and Thailand’s Trade Balance .2 Implications for research and policies. 86 vii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com LISTS OF FIGURES Figure 2.1: Conceptual framework for exchange rate effects on trade balance.1: Thailand’s trade balance during 1995-2013 periods .1: Misalignments of nominal exchange rate based on CPI and BMI. 53 LISTS OF TABLES Table 3.1: The structure of Thailand’ trade classified by currency .2: Unit root test for PPP testing .3: Panel cointegration test for PPP.4: Results of OLS and IV estimation for determinants of Thai trade balance .5: Estimation results for undervaluation and overvaluation periods .6: Estimation results for countries within each of the seven sub-samples.7: Results of Breitung (2001) unit root test - level and first difference .9: Panel results of FMOLS estimation .10: Individual results of FMOLS estimation. 70 viii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CHAPTER 1 INTRODUCTION 1.1 Problem Statement Exchange rate is possibly one of the most concerned subjects among academics, exporters, importers, investors as well as policy-makers because its vitally important roles played in the international economics.
While academics have concerned and developed theories of disequilibrium and equilibrium real exchange rate, the policy- makers concentrate more on exchange rate adjustment in order to examine its effects on the economy. Additionally, exchange rate risk is a key element related directly to the costs and profits for importers, exporters as well as foreign investors. Furthermore, it is argued that developing countries have tendency to devaluate their currency in order to gain the relative competition. Given the importance of exchange rate in the economy, issues in relation to exchange rate attract my interest and that this a key reason for my choice to make a topic for the thesis.
In February 2014, with the opening of the first ever branch of McDonald’s, a giant US fast-food company in Ho Chi Minh City, Viet Nam, the Economists Magazine have added the Vietnam Dong (VND) to its collection of Big Mac Index (BMI). This index provides McDonald’s burger prices in all different parts of the world in terms of local and foreign currencies. The index is considered as a lighthearted guide in order to evaluate whether a currency of a particular country of interest is at its correct level. The index has been increasingly well-recognized as a global standard with its existence in several international economics books and many academic studies.
The thesis aims to evaluate the real value of Thailand Baht and to consider the link between Thailand Baht depreciation and Thailand’s trade balance. Thailand is opted to study due to several reasons. First, according to Bahmani-Oskooee and 1 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Kantipong (2001), Thailand has an intense motivation to devaluate her currency owing to the fact that after Asian currency crisis, Thailand was one of the most suffered countries in comparison with other nations in the Asian region. Consequently, it lost market shares of many export products and services to China and other ASEAN countries.
As a consequence, the country suffered a severe deficit in its trade of balance. Therefore, the strategy of devaluation would allow Thailand increasing her regional competitiveness, recovering her lost market shares, and improving the trade balance (Bahmani-Oskooee and Kantipong, 2001). Second, earlier researchers cast doubt on whether the Consumer Price Index (CPI) reflects the real exchange rate in the economy. In this study, the Big Mac Index (BMI) is used as an appropriate substitute in lieu of the CPI to re-examine the roles of the exchange rate to the Thailand economy.
The use of the BMI, the first attempt of this kind in emerging country, is argued to be an advance. From that, a comparison between BMI-based exchange rate and CPI- based exchange rate in regardless of Thailand’s trade balance is made. This thesis provides key advantages compared to previous studies. First, earlier works investigated the link between real devaluation and trade balance without testing whether the currency used in the study is over- or under-value, so their results are ambiguous.
In this paper, the valuation of a currency is conducted before it is used to consider the influences of devaluation on trade balances for a particular nation. Second, the Big Mac index is initially applied in the contexts of real exchange rates and trade balances although a majority of authors have exploited this index for testing purchasing power parity (PPP), forecasting the trend of exchange rate (Ong, 1997; Yang, 2004; Cumby,1996; Clements & Lan, 2010). Clements and Lan (2010) and Ong (1997) argued that Big Mac index offers a sense of simplicity and creates a surprisingly accurate result.