-,; 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 CAIBAOHIEU MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, DECEMBER 2012 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 CAl BAO HIEU Academic Supervisor: Dr DINH CONG KHAI HO CHI MINH CITY, DECEMBER 2012 Contents Chapter 1: Introduction 1.1 Problem statement 1.2 Research questions 1.3 Research objectives Chapter 2: Overview of Vietnam's exchange rate, import activities and inflation 2.1 Exchange rate arrangement in Vietnam 2.2 Overview of Vietnam's import activities 2.3 Overview of Vietnam's inflation Chapter 3: Literature review 10 3.1 Linear approarch 10 3.2 Vector Error Correction Model approach 11 3.3 Vector Autoregression approach 11 Chapter 4: 4.1 Research methodology 14 4.2 Empirical framework 16 4.3 Data description 17 Chapter 5: • Research methodology, empirical framework and data description 14 Empirical results 20 5.1 ADF tests 20 5.2 Optimal lag length 20 5.3 VAR regression 20 5.4 Impulse response function: 24 5.4.1 Response to exchange rate of foreign price index 24 5.4.2 Response to exchange rate of import price index 25 ~ • 5.4.3 Response to exchange rate of consumer price index 26 5.4.4 Response to foreign price index of import price index 27 5.4.5 Response to foreign price index of consumer price index 28 5.4.6 Response to output gap of money supply 29 5.4.7 Response to output gap of consumer price index 30 5.4.8 Response to money supply of consumer price index 31 5.4.9 Response to import price index of money supply 32 5.4.10 Response to import price index of consumer price index 33 5.4.11 Response to consumer price index of money supply 34 5.5 Variance decomposition 35 5.6 Granger causality test 36 5.7 VARstable 37 5.8 Lagrange multiplier test 38 Chapter 6: Conclusion, Policy Recommendation and Future Work 39 6.1 Conclusion 39 6.2 Policy Recommendation 40 6.3 Future Work 41 References 42 Appendices 45 • ii List of figures Figure 1: REER, NEER and Exchange rate 1995-2012 Figure 2: Import by commodity group ofVietnam 1995-2010 Figure 3: Inflation ofVietnam 1996-2010 Figure 4: NEER, IMP and CPI of Vietnam 1999-2011 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 List of tables Table 1: VAR regression for import price index 21 Table 2: V AR regression for consumer price index 23 Table 3: Larange multiplier test 38 Table 4: ADF test of dlneerl 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 ofdlopi 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 "\ 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 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 LeVan 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 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 2.48% 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 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 ... inflation rate started to increase at faster rate than the rate of exchange rate depreciation, thus the nominal effective exchange rate and real effective exchange rate started to separate Vietnam... 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,... 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