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 PASS-THROUGH TO VIETNAM’S IMPORT AND DOMESTIC PRICES BY CAI BAO HIEU MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, DECEMBER 2012 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 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 PASS-THROUGH TO VIETNAM’S IMPORT AND DOMESTIC PRICES A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By CAI BAO HIEU Academic Supervisor: Dr. DINH CONG KHAI HO CHI MINH CITY, DECEMBER 2012 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Contents Chapter 1: Introduction. 3 Chapter 2: Overview of Vietnam’s exchange rate, import activities and inflation .1 Exchange rate arrangement in Vietnam .2 Overview of Vietnam’s import activities .3 Overview of Vietnam’s inflation. 8 Chapter 3: Literature review .2 Vector Error Correction Model approach .3 Vector Autoregression approach.
11 Chapter 4: Research methodology, empirical framework and data description. 17 Chapter 5: Empirical results .2 Optimal lag length .4 Impulse response function: .1 Response to exchange rate of foreign price index .2 Response to exchange rate of import price index. 25 i LUAN VAN CHAT LUONG download : add luanvanchat@agmail.3 Response to exchange rate of consumer price index .4 Response to foreign price index of import price index .5 Response to foreign price index of consumer price index .6 Response to output gap of money supply .7 Response to output gap of consumer price index .8 Response to money supply of consumer price index .9 Response to import price index of money supply .10 Response to import price index of consumer price index .11 Response to consumer price index of money supply .6 Granger causality test .8 Lagrange multiplier test. 38 Chapter 6: Conclusion, Policy Recommendation and Future Work.
45 ii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com List of figures Figure 1: REER, NEER and Exchange rate 1995-2012. 6 Figure 2: Import by commodity group of Vietnam 1995-2010. 7 Figure 3: Inflation of Vietnam 1996-2010. 8 Figure 4: NEER, IMP and CPI of Vietnam 1999-2011.
9 Figure 5: Response to exchange rate of foreign price index. 25 Figure 6: Response to exchange rate of import price index. 26 Figure 7: Response to exchange rate of consumer price index. 27 Figure 8: Response to foreign price index of import price index.
28 Figure 9: Response to foreign price index of consumer price index. 29 Figure 10: Response to output gap of money supply. 30 Figure 11: Response to output gap of consumer price index. 31 Figure 12: Response to money supply of consumer price index.
32 Figure 13: Response to import price index of money supply. 33 Figure 14: Response to import price index of consumer price index. 34 Figure 15: Response to consumer price index of money supply. 35 Figure 16: VAR stable.
37 iii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com List of tables Table 1: VAR regression for import price index. 21 Table 2: VAR regression for consumer price index. 23 Table 3: Larange multiplier test. 38 Table 4: ADF test of dlneer1.
46 Table 5: ADF test of dlimp. 46 Table 6: ADF test of dlcpi. 47 Table 7: ADF test of dlm2. 47 Table 8: ADF test of dlopi.
47 Table 9: ADF test of dlpi. 47 Table 10: Optimal lag length. 48 Table 11: Granger causality test. 48 Table 12: Vector Autoregression results.
50 Table 13: Impulse - Response Function. 57 Table 14: Variance decomposition. 69 iv LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Abbreviations ADB Asian Development Bank ADF Augmented Dickey-Fuller ARIC Asia Regional Integration Center CPI Consumer Price Index ERPT Exchange Rate Pass-Through FPI Foreign Price Index GAP Output Gap GSO General Statistics Office Of Vietnam HP Hodrick-Prescott Filter IFS International Financial Statistics IMF International Monetary Fund IMP Import Price Index M2 Broad Money Supply NEER Nominal Effective Exchange Rate OPI Oil Price Index REER Real Effective Exchange Rate USD United States dollar VAR Vector Autoregression VECM Vector Error Correction Model VND Vietnam Dong v LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Acknowledgement I would like to give my sincerest thanks to my supervisor, Dr. Dinh Cong Khai, who has provided me valuable support throughout the process of this thesis.
My study would not have been possible without his patience, encouragement, insightful comments and correction in all time of doing the research and writing the paper. I am also deeply grateful to Dr. Le Van Chon for his dedicated, generous, enthusiasm and thoughtful helps about Stata technique and Econometrics model. Thank to those important guidance and useful advice, I have overcome many obstacles to complete the research work.
Last but not least, I would like to give a big gratitude to my dear family and friends who always encourage and stand beside me during my difficult moments. Their love have inspired me a lot and lifted me up; hence my mere expression of thanks does not suffice. vi LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Abstract This paper estimates the exchange rate pass through to Vietnam’s import prices and domestic inflation with monthly data from January 1999 to October 2011. By applying Vector Auto Regression methods, Impulse Response function, Variance Decomposition as well as combining with Granger causality, VAR stable, Lagrange multiplier tests, the results show that exchange rate passed through almost fully to import price index immediately and strongly at the first month, after that it fluctuates to go up and down next months.
The transmission from exchange rate to consumer price index is smaller than to import price index but it penetrates with longer periods around 10 months. Expanding money supply just explains for variance of inflation 2. But it is not the surprising result, because the State Bank of Vietnam conducts monetary policy timely and appropriately. The results of variance decomposition, however, reveal that the most important factor affecting on both import and consumer prices is domestic demand pressure (output gap) with 32% and 14% respectively.
Therefore the policy recommendation should focus on controlling domestic demand pressure as a priority to cut down high inflation. Government also can be confident with easing monetary policy due to its small effect on inflation. Nonetheless, the economy still needs the stable exchange rate policy in order to keep the trust on domestic currency. vii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Chapter 1: Introduction 1.1 Problem statement Exchange rate is one of the most important factors in macro-economic management.
It affects supply and demand of foreign currencies, exports and imports, national debts and reverses. When a domestic currency appreciates; the country’s exports become more expensive and its imports become cheaper in foreign markets and vice versa for the depreciation of domestic currency. Appreciation will make balance of trade lower, while depreciation will increase it. Vietnam is following the export-led growth strategy; therefore export activities need to receive a priority.
In recent years, import activities, however, have increased significantly; reducing net import is also a main concern now. Exchange rate adjustment to depreciate domestic currency will be the useful tool to achieve those two goals. However, when the State Bank depreciates domestic currency; this will cause pressure on inflation through three channels: the import prices increase will directly affect on domestic prices, export activities are pushed up thus the supplies for domestic market decrease and export prices at domestic market increase, and aggregate demand for non-tradable goods increases also put a burden on inflation. Furthermore, depreciation has a common aspect like easing monetary policy; it means the economy will encounter with inflation risk.
In order to balance this effect, the State Bank needs to manipulate tightening monetary policy such as increasing reserve ratio or capital adequacy ratio. Definitely, there is a close relationship between money supply and exchange rate; and government should consider this connection to control inflation effectively. 1 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.2 Research questions Overall, these raise questions about the degree of exchange rate pass-through (ERPT) to import prices and then transfer to domestic inflation. Whether it is fully or partially transferred to prices? When the State Bank of Vietnam depreciates Dong, how does monetary policy response? Therefore, ERPT to import and domestic consumer prices needs to be measured quantitatively to answer above questions and then recommend implication for inflation control as well as monetary policy.
We have a definition of ERPT as the percentage change in local currency import prices of importing country reacting to one percent change in exchange rate between trade partner countries (Goldberg and Knetter 1996). It is important to understand ERPT for several reasons: first, in order to assess monetary policy transmission on prices and forecast inflation, we need to know the degree and timing of pass-through. Second, knowledge of the size and speed of exchange rate pass-through into inflations is useful for the inflation targeting adoption (Lian, 2006). ERPT has been studied since 1980s by Dornbursh (1987), Krugman (1986), Knetter (1989), Taylor (2000), Toh and Ho (2001), Campa and Goldberg (2002), Otani, Shiratsuka and Shirota (2005), Ghosh and Rajan (2009).
In the early stage, most of researchers focused on examining the ERPT in United States, Euro Area and developed countries. They also had a debate on limited pass-through of exchange rate across countries due to deviation from the law of one price. Recently, there have been papers studying this subject in emerging markets, new small open economies and developing countries. The transmission of exchange rate into disaggregate industries has been focused as well.
2 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.3 Research objectives There have been, however, a few studies regarding ERPT in Vietnam. It is necessary to measure ERPT to know how it affects on the economy, how it responses to government’s policies. This study aims to estimate the degree and speed of ERPT to distribution chain from import prices to domestic inflation (consumer prices) in Vietnam. The study also examines the relationship between inflation and monetary policy as well as other factors.
This research approaches the issue under Vector Auto Regression (VAR) method combining with the analysis of Impulse Response Functions (IRF) and Cholesky Variance Decomposition. After that I will check Granger causaliy, VAR stable and do Larange multiplier test. The null hypothesis will follow the hypothesis of many previous researches that the exchange rate has no effect on import and domestic prices (in other words, the ERPT is zero). My research also has limitations.
Due to data availability, I cannot obtain Producer Price Index to establish the systematic distribution chain from Import Prices Index to Producer Prices Index and finally to Consumer Price Index. I also ignore the structural change when Vietnam joined WTO in 2007. This paper does not cover ERPT in disaggregated industries, and this will leave for researches in future. This paper includes 6 parts.
After the introduction is part 2 with the overview of Vietnam’s exchange rate, import activities and inflation. Part 3 is literature review; part 4 is research methodology, empirical framework and data description. The empirical results are presented in part 5. Part 6 will conclude what I found in estimation process and then will suggest policy recommendation.
3 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Chapter 2: Overview of Vietnam’s exchange rate, import activities and inflation 2.1 Exchange rate arrangement in Vietnam All we know that Vietnamese economy achieved many successes thanks to the Renovation or “Doimoi” program in 1986. The economy step by step changed from the centrally planned to the market-oriented system.