EXCHANGE RATE PASS-THROUGH TO VIETNAM’S IMPORT AND DOMESTIC PRICES
CAI BAO HIEU (VNP16)
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.
(This is the thesis summary, The full is now at Library of Vietnam-Netherland Progamme: 1A Hoang Dieu, Phu Nhuan Dist, Ho Chi Minh city, Vietnam)
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. 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.
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).2. Literature review
With linear approach we can name the researches of Ihrig et al. (2006) about ERPT in G7 countries for both import and consumer prices and another research of Campa and Goldberg (2005) analyzed ERPT to import prices across countries and product categories in the Euro Area.
There are many researchers applied VECM to measure EPRT such as Kim (1998), Beiner & Bijsterbosch (2009), Dahl & Lo (2005), etc.
Final, the VAR approach is the most popular method which has been used by many researchers all over the world. There are a wide range of papers concerning about ERPT in Euro Area, emerging countries, Latin countries, comparing those together or just ERPT of a specific country such as United States, United Kingdom, Switzerland, China, etc.
Faruquee (2006) estimated ERPT in Euro Area with monthly data from 1990 to 2002. Zori et al. (2007) measured ERPT in emerging markets based on 12 countries in Latin America, Asia and Central and Eastern Europe. One study of Marazzi et al. (2005) focused on ERPT in US. Jin (2010) explored ERPT in China.
3. Research methodology, empirical framework and data description
3.1 Research methodology
The theoretical framework which we base to conduct empirical framework is from purchasing power parity (PPP) theory.
Where h denotes the home country, f is foreign country. Phm is the import price measured in home country currency. Pfx is the export price measured in foreign currency, E is the nominal exchange rate between home currency vis-à-vis foreign currency (home currency/foreign currency).
According to Hooper and Man (1989), Goldberg and Knetter (1997) and Campa and Goldberg (2002), the exporting firms set the prices depended on the markup (Markup x) on marginal cost of production of foreign exporting firms ( Cfx ).
Hooper and Man (1989) argue that an exporting firms set up their markup basing on the market demand pressure in both foreign and home markets (Y ), and competitive pressure in the home country market. On the other hand, the competitive pressure in the importing market is measured by the profit margin, i.e. price over production costs. Therefore, the markup is presented as follows (Vo, 2009):
Where represents competitive pressure in the home market and Yβ represents demand pressure in both home and foreign market and 0< α <1, β > 0.
Simplify equation (4) we get:
We take logarithm equation (5):
We can rewrite equation (6) as simple linear equation by generating variables as follows:
From equation (7) we can know the elasticity of import price with respect to the change of exchange rate (ERPT) of home country is (1-α ). If α = 0, we have complete pass-through effects. If α = 1, we have zero pass-through and 0< α <1, we have limited or incomplete pass-through.
We will arrange equation (7) to obtain α , and then we can analyze the movement of ERPT. Because ERPT is measured by coefficient (1 - α), ERPT has an inverse relationship with α.
From equation (8) we have the movement of ERPT as follows:
If demand in both home and foreign markets (y) increase, α decreases and hence ERPT increases and vice versa for case of α decreases.
If ph increases, raising inflation in the home market, α decreases and ERPT increases and vice versa;
If Phm increases, α increases and ERPT decreases and vice versa;
If home currency depreciates (or e increases),α will decrease and ERPT increases and vice versa.
If Cfx increases, α will increase leading to the decrease of ERPT and vice versa.
3.2 Empirical framework
This study will apply the Vector Auto Regression (VAR) approach to measure the level of ERPT. According to Faruquee (2006), using the VAR approach to examine exchange rate pass-through has several advantages compared with single-equation methods. First, the single equation method estimates pass-through into a single price import or consumer prices separately. It does not further distinguish between the types of underlying exchange rate shocks that may be arriving. By investigating exchange rate pass-through into a set of prices along the pricing chain, the VAR analysis characterizes not only absolute but relative pass-through in upstream and downstream prices (p.64, 65). Second, after running VAR model, we can apply Cholesky variance decomposition to identify specific structural shocks affecting the system. Using this identification scheme, one can map the empirical results into a well-defined shock in an economic model of incomplete pass-through.
We have matrix of VAR approach McCarthy (2002) as follows:
Where Yt is the 7 vectors of variables [OPI, NEER, FPI, IMP, GAP, CPI, M2], ω0 is intercept, βi is coefficient of matrices 7x7 and ut is error term.
OPI: oil price index (Crude Oil price index, Brent UK), NEER: nominal effective exchange rate, FPI: foreign exporters’ price index, IMP: import price index, GAP: output gap, CPI: consumer price index, M2: broad money.
3.3 Data description
Data to estimate ERPT to import price index and domestic price index is monthly time series from January 1999 to October 2011 with 154 observations; January 1999 is the base. All data are extracted from International Financial Statistics (IFS) of IMF organization, Asia Regional Integration Center (ARIC) of Asia Development Bank (ADB), Datastream and General Statistics Office (GSO) of Vietnam.
All variables will be generated under natural logarithm form. Since they have characteristic of time series, we need to do Augmented Dickey-Fuller test (ADF) to find the existence of unit root except output gap variable. Then taking first differences and ADF test one more time will be applied respectively. The results show that all variables are integrated at I(1)
Oil price index (OPI) is used to represent for foreign demand pressure. OPI will be exogenous variable because it affects all the rest of variables and it is not affected by any variable in the econometric model.
Nominal effective exchange rate (NEER) stands for exchange rate e; NEER is calculated basing on trade weight of 20 mainly countries trade partners with Vietnam. After that I will generate a new variable NEER1 = 1/NEER to quote to VND/foreign currency. With this change we can see that when VND depreciates, nominal exchange rate increases, and this change also is consistent with the definition of the exchange rate used in the pass through literature.Domestic demand pressure is presented by GAP (Output Gap = Real GDP Potential GDP). Due to data availability, I cannot obtain monthly GDP. Therefore, like many previous empirical studies, I will use Industrial Production Index (IPI) to proxy for real GDP. Then I apply Hodrick-Prescott filter to compute output gap.
Based on Campa and Goldberg (2002), the exporters’ price index is calculated as follows:
Where REER is real effective exchange rate, NEER is nominal effective exchange rate, CPI is domestic price index.
The broad money (M2) is added to reflect the effect of government’s monetary policy response.
Import price index is calculated by weight of 20 mainly countries being trade partners with Vietnam. The formula is below:
Where wi is import trade weight of Vietnam with 20 main partners. They are Japan, Singapore, China, Korea, Thailand, Australia, Hongkong, German, Malaysia, French, Indonesia, UK, Netherlands, Russia, Philippines, Switzerland, Italy, Belgium and India. Consumer price index (CPI) is used to represent for domestic inflation.
4. Empirical results
4.1 ADF tests
The results of ADF test show that all variables (except GAP) have unit root. Therefore we need to take first difference of them and then apply ADF test again for those new variables. The results tell us that we will reject Ho (variable has a unit root) at I(1).
I do not apply ADF test for GAP; because HP filter removed cyclical component during its processing.
4.2 Optimal lag length
There are many lag length selection criteria such as: Aikaike’s information criterion (AIC), Schwarz information criterion (HQIC), Hannan-Quinn criterion (HQC),etc... We have the optimal lag length is 2.
4.3 VAR regression
Table 1: VAR regression for import price index*, ** and *** denote statistical significance at 1%, 5% and 10% level, respectively.
The pass-through effect is immediately and completely at lag order 1. With 1% change of exchange rate leading to a little bit more than 1% change of import price. 1% increase of foreign price index at lag order 1 will increase 3.122% of import prices. 1% change of oil prices causes 0.406% change of import prices.
Table 2: VAR regression for consumer price index*, ** and *** denote statistical significance at 1%, 5% and 10% level, respectively.
The transmission of exchange rate to consumer price is moderately with 0.104% and 0.068% at the first and the second lag order. The response of Output gap, money supply and import price are rather small.
4.4 Impulse response function:
With impulse response outcome we can trace out how typical shocks will affect a variable through time. In this paper, I apply impulse response function for 24 months.
Response to exchange rate of foreign price index
Response to exchange rate of import price index
The response of import price is very high in the first month (0.97%), slightly decreases in the second month (-0.008%), continues decreasing in the third month (-0.395) and goes back to increase in the fifth and sixth months, the process ends from the tenth month.
Response to exchange rate of consumer price index
Consumer price always has positive response with the change of exchange rate (0.109%, 0.118%, 0.061%...), the response moves to zero from the twelfth month. We can see that the transmission from exchange rate to inflation is smaller but longer than that of to import.
Response to foreign price index of import price index
Import price reacts extremely to the change of foreign price (3.06%) then it reduces in the second and the third months (-1.95%, -1.02%) after that it reserves to increasing trending and dies out at the eleventh month.
Response to foreign price index of consumer price index
The shock of foreign price index leads to positive response of consumer price index during the whole 24 periods and it becomes extinct from the eleventh month.
We can conclude that the shock of foreign price index transfers to inflation is more stable and gradual than to import.
Response to output gap of money supply
When output gap is up, money supply is down. It means that money supply of later period is smaller than that of previous period. This reflects the tightening monetary policy of the State Bank. The State Bank of Vietnam perceives that inflation increases due to output gap increases; therefore it shrinks money supply timely.
Response to output gap of consumer price index
Increasing in output gap makes increasing in consumer price index (0.039%, 0.013%...), it turns to negative at the third month and backs to positive in all months later.
Response to money supply of consumer price index
The response is small with 0.039% and 0.067% in the first and second months, and then it is negative in the third and fourth months, and once again the response is positive in the rest of months. We can see that monetary policy is conducted following the change of output gap to minimize the effect of money supply on inflation.
Response to import price index of money supply
One percent shock of import price index will cause negative response of money supply most of 24 period months. Clearly, monetary policy reacts well with the change of output gap as well as import prices to control inflation. Specifically, the tightening money supply is conducted.
Response to import price index of consumer price index
The positive change in import price causes positive response of consumer price through time but with weak degree.
4.5 Variance decomposition
Variance decomposition will help us know which shocks are most important in explaining the variance or the movement of a variable through time. The same as impulse response function, period time to explore variance decomposition is 24 months.The most important factors explaining import price are: Output gap (32%), foreign price index (7.5%), money supply (7%), while exchange rate can explain for variance of import price index just 3.6%. Through these numbers, we know that domestic demand pressure plays the main role in import prices moving; exchange rate is not actually a key factor as expected.
The movement of consumer price index is explained by foreign price index (18.7%), output gap (14.5%), exchange rate (5.4%), money supply (2.48%).
Output gap can explain average 9.1% for the movement of money supply, while the explanation of exchange rate to money supply is lower with 4.9%. These show that monetary policy is conducted based on output gap rather than exchange rate.
Beside that money supply also can explain around 8.5% for the movement of output gap. Technically, there is a close relationship between output gap and money supply.
4.6 Granger causality test
Null hypothesis of Granger causality test is “X does not Granger cause Y”; the test results will tell us whether variable X be useful predicting variable Y.
Granger causality implies a correlation between the current value of one variable and the past values of others, meaning that information containing in variables up to lag p is statistically significant. It does not mean changes in one variable cause changes in another and thus it depends on the statistical property of data.
Exchange rate: no variable Granger causes.
Consumer price index: all variables Granger cause domestic inflation.
Foreign price index: only Output gap has Granger-cause foreign price index.
Output gap: money supply and consumer price index Granger cause Output gap.
Money supply: Output gap and consumer price index Granger cause money supply.
Import price index: foreign price index and Output gap Granger cause import price.
4.7 VAR stable
After applying VAR regression, Impulse-Response Function, Variance Decomposition as well as Granger causality test. I will apply the VAR stable to check the eigenvalue stability condition. The result shows that all the eigenvalues lie inside the unit circle. Therefore VAR satisfies stability condition.
4.8 Lagrange multiplier test
Based on result of Lagrange multiplier test, we cannot reject Ho (no auto correlation at lag order) at 5% level. It means there is no residual autocorrelation at lag order 2. However there is residual autocorrelation at lag order 1.
5. Conclusion, Policy Recommendation and Future Work
My findings reveal that the import prices react to the change of exchange rate instantly and strongly. Then the response reduces gradually and ends after around ten months. Going further with consumer prices, the response is slower and weaker than that of import prices. It is reasonable because ERPT works through the transmission mechanism from import prices to consumer prices. However the effect on consumer prices lasts longer than that of import prices.
The results of relationship among money supply with output gap, import prices as well as consumer prices also tell that the State Bank of Vietnam is controlling monetary policy reasonably. The response of money supply is timely and accordingly with the shocks of output gap, import prices and consumer prices.
The result of variance decomposition shows that output gap has the biggest effect on the movement of import price index. Definitely, domestic demand pressure caused the serious disease of Vietnam’s import. We lack of material resources for manufacturing; that is why the production of economy still depends so much on importing goods from foreign countries.
The output gap also plays an important role in the movement of inflation; this notifies that Vietnam’s economy is suffering demand-pull inflation. The economy is growing so hot while the capacity cannot absorb appropriately with the development. Inflation occurs as a consequence of this problem.
The impact of exchange rate on consumer price index is rather small while the impacts of foreign prices index and output gap on consumer price index are considerably. So the inflations of other countries are imported into Vietnam. Additionally, domestic demand puts pressure on inflation with the same degree as foreign price index. These two factors, together, make inflation of Vietnam is hit by both inside and outside factors.Government should concentrate on output gap, as output gap takes important roles not only for import price index but also consumer price index. The root of inflation comes from demand-pull factor due to over rising of real GDP. We have the formula of aggregate demand AD = C + I + G + NX. Cutting down government spending of inefficient investments is one way to reduce inflation.
Widening the capacity of the economy is another way to cut down inflation as well as to increase the potential output. The excess of demand tell us that the factors of production are being used inefficiently. Hence, government should encourage all resources of economy especially private sector. Because companies in of private sector have the strongest economic incentive and they have to do their best to survive in the market. And they will use resources with the most efficiently.
In addition, government should restructure the economy to develop industries of intermediate goods of production. This will help to establish Vietnam’s industrial production chain and thus it can reduce cost of importing from foreign countries and build a stable and independent production. Developing industries of intermediate goods can solve for problem of domestic demand, for that reason, the problem of inflation is partially solved as well.
It is more clearly if I can examine the ERPT to disaggregated level. We are able to answer which industry, which kind of goods are most and least affected when currency depreciation. When we know the structure inside we will have a clear picture of ERPT to import prices as well as inflation of Vietnam.
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