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 IMPACT OF OIL PRICE ON INFLATION THE CASE OF VIET NAM A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By TRUONG NGO TRONG NGHIA Academic Supervisor: DR NGUYEN VAN NGAI HO CHI MINH CITY, NOVEMBER 2012 Acknowledgement Over two years not so long but it is one of the most interesting periods of my life with many impressive memories I would like to take this opportunity to express my deep gratitude to the Vietnam-Netherlands Master Program for Economics of Development for organizing many helpful and exciting curriculums For the completion of this thesis, I have indebted to many people who have given me their continued support, advice and guidance First of all, I would like to express my sincere gratitude to my supervisor Dr Nguyen Van Ngai who gave me valuable guidelines, comments, suggestions, and inspiration for the successful completion of this study Besides, his friendly and thoughtful instructions have given me a great deal of encouragements to overcome difficulties in the whole research process I am also thankful to Dr Nguyen Trong Hoai, Dr Nguyen Hoang Nam, Dr Tu Van Binh, MBA Ly Thi Minh Chau, Tutor-Mr Phung Thanh Binh and all lecturers and program administrators in the Vietnam – The Netherlands Program for M.A in Development Economics They gave me advanced knowledge and help me kindly during the course I would like to express my heartfelt thank to all my classmates in MDE15, MDE16, especially Tran Tuyet Hanh, Tran Van Long, Le Trong Binh, Vo Thi Ngoc Trinh, Le Anh Khang, Nguyen Van Dung, Nguyen Xuan Phap, Nguyen Le Thao Nguyen and other classmates for their continuous support and encouragement Last but not least, I would like to express my deepest thanks to my parents, my brother, my close friends who have always given the most favorable environment and kept encouraging me that made me feel more confident during my study ii Certification “I certify that the content in this thesis has not already been submitted for any degree and has not submitted for any other degree until now I certify that this thesis is done from the best of my knowledge All the aids that I received during the time in preparing the thesis as same as all sources used have been acknowledged in my thesis.” Signature Truong Ngo Trong Nghia Date: iii / / 2012 Abstract A steep upward trend in the price of crude oil in recent years, reaching a spike record in middle of 2008, has led to increasing concern about its impacts on macroeconomic, both abroad and in Vietnam In this study, using the vector auto regression approach (VAR) with monthly dataset from 2001M1 to 2010M10, I attempt to empirically investigate the dynamic effects of oil price and Vietnam macroeconomics Focusing on the reduced-form of causal relationships between world oil price (expressed in Vietnamese price) and macroeconomic variables, I have used both linear and non linear form of oil prices to get the results of their impact on price level and output In empirical analysis, I find consistent evidence that oil price shocks have a significant effect on output and price level in short term In detail, my research finds a weak and positive statistically significant association between oil price shocks and price level The output is more highly sensitive and I find an empirical evidence about the negative impact of oil price shocks on economic growth although it’s not straight forward I also assert the existence of asymmetric impact of oil price proxies’ changes on economic growth rate Key words: inflation, GDP, oil price shock, VAR models, Cointegration, Granger causality, Phillips curve iv TABLE OF CONTENTS Acknowledgement ii List of Tables List of Figures List of Acronyms Chapter 1: Introduction 1.1 Problem statement 1.2 Research Objectives 1.3 Research Questions 1.4 Scope and methodology of the Study 1.5 Thesis structure 10 Chapter 2: Literature Review 11 2.1 Review oil shocks in history 11 2.1.1 Suez Crisis in period 1956-1957 14 2.1.2 OPEC Embargo in 1973-1974: 14 2.1.3 Iranian revolution and oil price fluctuation in 1979 15 2.1.4 Iran-Iraq War in 1980-1981 15 2.1.5 The great price collapse in 1981-1986 15 2.1.6 First Persian Gulf War in 1990-1991 16 2.1.7 The downtrend of oil price in 2001 16 2.1.8 Growing demand and stagnant supply 17 2.2 How higher oil prices affect the economy 18 2.2.1 Why oil shock seems to be the big economic headache 18 2.2.2 The scenario of oil price and inflation in Vietnam 21 2.3 Review price level and inflation theories 22 2.4 The transmission mechanism of oil price shocks 25 2.5 Approaches to estimate oil impact on macro economy variables 30 2.6 Empirical studies about the oil price-macroeconomic relationship 32 2.7 Conceptual Framework 44 Chapter 3: Model Specification and Data 45 3.1 Analytical Framework 45 3.2 Model Specifications 46 3.3 Steps of Estimation 50 3.3.1 Descriptive statistics 50 3.3.2 Unit root testing 50 3.3.3 Granger Causality Test 51 3.3.4 Impulse response functions 53 3.3.5 Variance decomposition 53 3.4 Data Sources 53 Chapter 4: The impact of oil price on inflation-the case of Vietnam 56 4.1 Descriptive Statistics 56 4.2 Unit Root Test 57 4.3 Var Granger Causality Test 58 4.4 Impulse Responses and Variance Decompositions 61 4.5 Asymmetric Impacts 65 4.6 Result comparisons 70 Chapter 5: Conclusion and Policy Implication 73 5.1 Conclusions 73 5.2 Policy Implication 75 5.3 Limitation and Further Studies 78 5.3.1 Limitation 78 5.3.2 Further Studies 79 References 81 Appendix 88 List of Tables Table 2.1: Summary results of empirical studies 40 Table 3.1 The definition of variables in the model 55 Table 4.1: Description statistic of key variables 56 Table 4.2: Augment Dickey-Fuller test 57 Table 4.3: Philips-Perron test 58 Table 4.4: Optimal lag length 59 Table 4.5: VAR Granger- CausalityTest 60 Table 4.6: Variance Decompositions for Var Model 62 Table 4.7: Granger causality test of proxies of oil price shocks 65 Table 4.8: Accumulated Response of PC_IP_SA to non-linear oil price shocks 68 List of Figures Figure 2.1: Price of oil in 2009 dollars, 1973:M1-2010:M10 Price of West Texas Intermediate deflated by CPI (Hamilton, 2011) 12 Figure 2.2: The natural logarithm of the real price of oil, 1861-2009, in 2009 U.S dollars 12 Figure 2.3: When oil prices head up, the US turns grey: the oil market and US recessions 18 Figure 2.4: Illustration of oil price and macroeconomic variables in level 21 Figure 2.5: Factor contributions of price level 23 Figure 2.6: Cost-push inflation in the AS-AD model 24 Figure 2.7: Demand-pull inflation in the AS-AD model 25 Figure 2.8: Two round effects of oil price increases 26 Figure 2.9: Mix transmission channels of oil price shocks 27 Figure 2.10: Conceptual framework 44 Figure 4.1: The relationships of variables 60 Figure 4.2: The impulse response functions for basic model 62 Figure 4.3: The variance decompositions of variables 64 Figure 4.4: The impulse response functions of output to negative oil price changes 66 Figure 4.5: The impulse response functions of price level to net oil price increase 69 List of Acronyms AIC: Akaike Information Criterion AR: Autoregressive ARCH: Autoregressive Conditional Heteroskedasticity CPI: Consumer Price Index GARCH: Generalized Autoregressive Conditional Heteroskedasticity INF: Inflation OLS: Ordinary least squares OPEC: Organization of Petroleum Exporting Countries PPI: Producer Price Index SBV: State Bank of Vietnam SC: Schwartz criterion UK: the United Kingdom US: the United States of America VAR: Vector Auto Regressive WTI: West Texas Intermediate than normal oil price Remarkable points, cumulatively in 10 month, 1% point shock in net oil price increasing within months (PC_NOPI4) could cause to cumulatively decrease the growth rate of output by about 0.56% , and 1% point decrease in negative oil price change (PC_VOP_DECREASES) could encourage to cumulatively increase the growth rate of output by about 1.1% Finally, there was discrimination at variance with decomposition of economic growth and inflation On average, oil price fluctuations explained 20% and 6% of the fluctuations in economic growth and inflation after the shock months during research time At the same time, the consumer index-price level just contributed the fluctuation of economic growth rate around 7% I strongly argue that the consumer price index represented for inflation now is distorted and need to be treated carefully in Vietnam 5.2 Policy Implication The study would like to give some relevant implications for policy maker related to oil price and macroeconomic Although Vietnamese governance has implemented some policy for subsidy and stable the petroleum price but we could not mitigate the impact of world oil changes on output efficiently The estimation results of thesis emerged the important role of oil channel in the relationship with inflation and output in Vietnam Through reasonable policy at each period, some recommendations and approaches proposed to be implemented in order to mitigate the impact of oil price shocks on macroeconomic in Vietnam are bellows: First, understanding the linkage between oil prices and price level is important to most monetary authorities for attempt to controlling inflation Based on the knowledge of the oil price increase’ inflationary effects, Vietnamese monetary authorities can progress appropriate policy to mitigate these shocks in short run and long run Other side, in short term, output also responses to oil shock immediately and strongly in both oil increasing case and decreasing case In scenario of oil increasing, Vietnamese policy makers need to allocate stabilizing funds efficiently, reduce import tax, and apply price ceiling for selling petroleum The Government should encourage export activities by subsidies or taxes to take advantage to increase the economic 75 activity and growth rate, as oil price decrease after a few months Furthermore, once investment determines the long term effect of oil price shock, we need to control lower interest rate to stimulate investment and cope with the negative impact of oil price shock Second, in long term, the government have encourage the policy to increase more domestic value added to oil and petroleum in Vietnam by expanding the production of downstream activities in Dung Quat Plant (Quang Ngai) to meet more local demand and reach fast to the level for export in near future In that way, we can reduce importing the volume of petroleum Third, one of the priority sector, biofuels is coming to be key factor by which could mitigate or prevent future oil shocks Vietnam is surpluses of rice and sugar currently, the biofuels industry would seem to be great potential to decline remarkably oil consumption In reality, Vietnamese government issued Decision No 177 to use bio fuel to reduce the dependence on petroleum In fact, many subsidized programs have been carried out as ethanol biofuel production in Quang Nam province (with a capacity of 100,000 tons / year), biofuels ethanol 99.7% of Vietnam's Oil and Gas Group (Petro Vietnam) in the province of Phu Tho (made from cassava and sugarcane with the capacity of 100 million tons / year)7 However, there remain many challenges for Vietnam’s biofuels development in the 1) coming years, including : Production costs remain high and the industry still needs government’s support to compete with fossil fuels; 2) Infrastructure for production and distribution has not been totally built; 3) Access to export markets of the importing country requires strict adherence to Decision No 177/2007/QD-TTg Prime Minister on 20 November 11, 2007, approving the “Development projects bio fuel 2015, vision 2025”, source: http://www.gov.vn Source: Database of 2010 of AITVN (Asian Institution Technology in Viet Nam) http://www.windenergy.org.vn/index.php?page=nhien-lieu-sinh-hoc 76 various quality standards and other environmental requirements while Vietnam does not have compliance capacity; Hence, the government should continue to prove support policy for this field Fourth, I agreed with the viewpoint of Wakeford (2006) that economic activities should be much more localized than it is now Therefore, Vietnam’s transport infrastructure investment patterns should be informed Government should plan to develop rail transports that they are powered by electricity instead of liquid fuels It makes sense in the case of oil depletion In particular, public transportation (electric rail systems, bus systems) in major urban areas need to be considered to replace automobile and motorbike for petroleum consumption reduction and green environment Moreover, total energy consumption can be distinguished mainly over sectors: industry, transportation and residential Each sector is determined by its structure, scale and energy efficiency We need to analyze all the factors including total economic output, population, per capita disposable income, energy structure, industrial structure, industrial energy efficiency, vehicle utilization, vehicle number, and residential sector energy efficiency Authorizes should consider carefully energy efficiency improvement annually of each sectors to give the appropriate price controls Then we can prevent the phenomenon that there are exists of group benefits by different subsidies related to low energy prices due to lack of incentives to enhance energy efficiency and inhibit energy use Government needs to control and supervise to ensure the relative policies or supports effectively The other remarkable point is that Vietnam needs to have more supports for huge construction depots The total inventory will ensure not only the necessary level of reserves for energy security but also lower costs and to stabilize life market For example, Petrolimex and KTC established national petroleum depot in Kien Giang by the end of 2011 With 100,000 m3 capacity, this depot will ensure a stable supply of fuel costs Kien Giang province and neighboring areas Next, in terms of long run, global warming can be affected by the key factors of fossil fuel depletion and climate change Therefore, the strategy of investment is very important to expand the generation and distribution of energy In addition, the 77 economic growth could not be harmful and oil imports could be reduced by applying an energy conservation policy Therefore, it is essential to have the support programs for the enterprises to invest in renewable energy sources as solar and wind Moreover, on the trend of global integration, electronic communications will be more important to decline oil demands in near future Physical transports and much more economic activities could be substitute by new form of communications gradually So we are of advantage to have support policy to improve net shopping, online purchases, Internet banking… Last but not least, strongly agreed with Tang et al (2010), reducing costs is considered to response to high energy prices To that, we should enhance technology to strengthen energy-saving efforts, adjust economic structure towards a less energy-intensity and scale up the use of renewable energies to get the sustainable development while the environment will be preserved That would be a mission of Vietnam and international community Once, we understand the importance of oil shock’s role in macroeconomic and its mechanism clearly We can eliminate the bad effects on it due to new policy implemented efficiently and successfully So far, my explanation and argument are quite preliminary and lot of works remains to be done For the future work, it is interesting to explain this phenomenon theoretically and empirically in more details 5.3 Limitation and Further Studies 5.3.1 Limitation Whether this study has answered most of the key questions about the role of oil price in macroeconomic in Vietnam case, it still has some limitations In fact, the availability of data resources is very limited for Vietnam country Due to this reason, the study cannot access longer period of time Additionally, Vietnam’s GDP value only has existed since the year of 2000, so that the thesis must use industrial output value as a proxy for GDP In the near future, we hope GSO can collect data and inform GDP by monthly, and also improve other indicators excluding CPI to stand for inflation 78 It is difficult to reach significant results from this unique result and further research is needed to obtain a more reliable conclusion Even VARs model are a powerful tools for indentify the role of oil price in macroeconomic But according to Asteriou (2007), the VAR models have been criticized by the following aspects First, they are a-theoretic since they are not based on any economic theory Second, they are criticized due to the loss of degrees of freedom Thus, if the sample size is not sufficiently large, estimating that large a number of parameters, say, a three-variable VAR model with 12 lags for each, will consume many degrees of freedom, creating problems in estimation Third, the obtained coefficients of the VAR models are difficult to interpret since they totally lack any theoretical background 5.3.2 Further Studies This study has employed impulse response and variance decomposition of VAR model to examine the role of oil for monthly data 2001:M1 to 2010:M10 A further study could use monthly data for longer period to see the correlation, also reaction between them more exactly An addition, the further study should employ different model to consider whether above conclusion is still effective and find out whether long run impacts exist in the case of Vietnam According Wakeford (2006) said “Peak oil is thus likely to entail the worst combination of oil shock types: sharp, sustained, repeated and cumulative The probable effect of this on the global economy will be a severe bout of stagflation, particularly as central banks are primed to raise interest rates in an attempt to curb inflation and inflationary expectations However, it must be reiterated that this shock will be unlike any of the previous shocks, which all occurred in the context of a longrun rising trend in oil production Peal oil represents a structural break of the highest order” In this study, we just use dummies for two month in middle of 2008 that is temporary treatment So in future, the research need more data and should apply technique of structural break point here: may separate to sub data sets and start the new trend after break point 79 Besides that, the study could add several variables such as unemployment, real wage rigidities (referring Blanchard and Garli, 2007), crude oil export or volume of petroleum import to exploit how the changes of estimated result with joined new variables Hence, potential study may expand by consider the new determinants 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Sub-questions: - Which are the directions of the causality relationships among oil price, price level and output? - How are the impacts of oil. .. of high oil prices on world economics, the scenario of oil price and inflation in Vietnam It also includes the review inflation theories, the transmission mechanism of oil price shocks, the approaches... impacts of oil price on the macroeconomics? - Are there any different impacts of proxies of oil price on inflation rate and economic growth rate of Vietnam when oil price is in trend of increasing