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Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 121 Real Effective Exchange Rate: A Transmission Channel for the Impact of Economic Growth on Exports in Vietnam NGUYEN QUANG HIEP Hung Yen Industrial College – nqhsta@gmail.com NGUYEN THI NHA Hung Yen Industrial College – nthsta@gmail.com ARTICLE INFO ABSTRACT Article history: This article analyzes the role of real effective exchange rate as a transmission channel for the impact of economic growth on Vietnam’s exports. Using quarterly data for the period of 1994–2013, the analysis results show that economic growth, real effective exchange rate (REER), and exports tend to fluctuate in the same direction. Furthermore, according to the results of the VAR model, economic growth impacts on and promotes export growth through increased productivity that improves the competitive advantage of products. The exchange rate, as an important channel, allows for a positive impact of economic growth on exports in Vietnam. Received: Jan. 21. 2015 Received in revised form: May. 07. 2015 Accepted: Dec. 30 2015 Keywords: Verdoorn’s Law. economic growth, real effective exchange rate, exports. 122 Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 1. Introduction Exchange rate, in its close relation to macroeconomic outcomes, is considered an important factor to affect the competitiveness of goods in foreign trade as well as other economic variables. The fluctuation in exchange rate may alter the relative prices of goods/services through domestic and foreign currencies and thus significantly affect import-export activities. In reality, an increase in effective exchange rate index leads to VND’s real-value depreciation and higher international trade competitiveness, which contributes to export improvement. Conversely, the effective exchange rate index, in its decreasing trend, causes VND’s appreciation, weakened competitiveness, and thereby reducing export growth rates. Many studies, in fact, have verified that growth in the economy, boosting the productivity due to higher economies of scale, offers a greater product competitive advantage, thus resulting in a rise in export turnover. Accordingly, real effective exchange rate can be regarded as a transmission channel for the impact of growth on exporting activities. This paper conducts an in-depth analysis of the management mechanism and exchange rate process in Vietnam over the past years. Qualitative and quantitative methods, in addition, are adopted to demonstrate the role of the real effective exchange rate in transmitting the effects of economic growth on Vietnam’s exports. 2. Theoretical bases and research framework 2.1. Review on theoretical and empirical research Verdoorn’s (1949) research on the growth of labor productivity indicated a statistical relation between the growth rates of output and labor productivity, afterward referred to as Verdoorn’s law, which postulates that a positive relation exists between these two factors, especially for the manufacturing sector, and can be performed as: P = α + βQ + ε β>0 (1) where P and Q are labor productivity and output of the manufacturing sector respectively; β is Verdoorn coefficient, and its positive value indicates a positive relation between the two factors; and ε is an error term. The Verdoorn’s law is set as a basis for most hypotheses on the impact of economic growth on exports. As such, the more rapid growth in output causes an increase in productivity due to higher economies of scale. When an economy flourishes, it also Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 123 increases productivity. If the growth rate of wages cannot reach that of the productivity, then there should be a drop in prices and thereby an improvement in both competitiveness of exports and exporting activities. Also, according to Helpman and Krugman (1985), exports can be expanded by higher economies of scale. Due to improved exporting activities, the scale is extended, whereas the costs are lowered, and it is likely to achieve higher productivity. Bhagwati (1988) demonstrated that countries’ competitive advantage in the international market and their trade expansion are attributed to economic growth, which could enhance the process of skill formation as well as technology advances and thereby production efficiency. Blecker (2009) adopted the virtuous circle model to represent a positive relationship as a widening circle between exports and economic growth, in which a higher rate of output growth would lead to an increase in productivity, resulting from large economies of scale; thus, greater product competitive advantages can be gained, bringing about export turnover increase. 2.2. Research framework As shown by prior theoretical and empirical research, economic growth may enhance productivity due to higher economies of scale, thereby giving bigger competitive advantage of products and involving improved export turnover. One of important factors reflecting and also influencing product competitiveness is REER, whose volatility, in reality, is closely associated with macroeconomic outcomes. An increase (decrease) in the exchange rate also positively (negatively) affects exporting activities as were earlier discussed in this paper. Thus, in light of the impact of economic growth on Vietnam’s exports, the following framework can be provided. Growth in Higher product Growth in economy (GDP) competitiveness (REER) exports (X) Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 124 3. Research data and methodology 3.1. Method First, we perform qualitative analysis to evaluate the fluctuations in economic growth, REER, and exports, and then examine certain relations and fluctuation trends revealed by these factors. Next, to justify the qualitative approach, we employ VAR model considering three quarterly variables, namely logarithm of exports (LNX), logarithm of REER (LNREER), and logarithm of GDP (LNGDP), all of which are tested for stationarity via ADF unit root test. Selection of the optimal lag length of these variables is in accordance with LR, FPE, and AIC standards. We then continue with Granger causality test to determine the relationships among these variables. We also estimate their response to endogenous shocks in addition to variance decomposition intended to measure the impact of economic growth on exports through such a transmission channel as REER. 3.2. Data 3.2.1. Variables and scales Gross domestic product (GDP): measured by real GDP of Vietnam (VND billion) and shown in 1994 constant prices. Exports (X): Vietnam’s real export value (VND billion), estimated by dividing nominal export value by deflated value. Real effective exchange rate (REER)1: exchange rate of VND relative to the currencies of main trade partners. Based on Vietnam’s total import-export turnover compared to that of foreign partners, ten top selected exporters consist of Taiwan, Germany, South Korea, America, Japan, France, Singapore, Thailand, China, and Australia. REER at period i (REERi) can be computed as: n REER =  e . i j=1 i j CPI ij CPI i .w j (2) where eij = Eij/E0j is nominal exchange rate of jth foreign currency at period i compared to that at the original period; Eij and E0j are nominal exchange rates of jth foreign currency in foreign currency basket at period i and the original period respectively; wj Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 125 is trade proportion of countries whose currency is involved in the foreign currency basket, measured by import-export turnover in trading with partner j as a ratio to total import-export turnover in trading with all countries in the foreign currency basket; CPIji and CPIi are adjusted price indices of partner j and of Vietnam at period i respectively, standardized at 1994 constant prices. Thus, in order to estimate REER with Eq. 2, the CPI of Vietnam and ten trade partners has to be considered as average price index compared to that of the original year. Nominal rate (E) is the exchange rate between VND and other currencies in the currency basket, and its average for each term should be taken. For France and Germany in particular, the selected rate is that between VND and Euro. Import-export turnover is measured as value of Vietnnam’s import and export compared to that of its trade partners, and uniformly in million US dollars. Nominal effective exchange rate (NEER): exchange rate between VND and currencies of main trading partners; its measurement is basically the same as that of REER, realized as follows: NEERi = n e w j 1 i j j (3) 3.2.2. Data sources Data on GDP and exports are collected from General Statistics Office of Vietnam (GSO), whereas those used to measure REER and NEER are gathered from the International Financial Statistics (IFS) database of International Monetary Fund (IMF) and also from the GSO. Particularly, data on Taiwan are retrieved from the website of National Statistics, Republic of China (Taiwan) (see more at http://eng.stat.gov.tw). 4. REER as a transmission channel for the impact of growth on Vietnam’s exports 4.1. The current state of REER and its role in transmitting the impact of economic growth on exports In Vietnam many adjustments have been made to exchange rate mechanism by eliminating the centralized, bureaucratic, and State-subsidized mechanism. However, these changes basically involved a pegged exchange rate regime to the USD, whereby the official rate and fluctuation margins were altered periodically to response to different shocks. Additionally, during the stages of sharp fluctuations in the national economy Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 126 caused by internal and external impacts the State Bank of Vietnam (SBV) decided to adjust the central rate and margins in order to counteract those effects. Once these factors were controlled, the exchange rate regime returned to fixed or crawling peg (Table 1). Table 1 Vietnam’s exchange rate regimes over time Period Before 1989 1989–1990 Exchange rate regime De facto exchange rate features Multiple exchange rate arrangements - Three types of official rates Exchange rates within crawling bands - Official exchange rate (OER) established - Floating rates coexisting with state rates (until reporting periods) - OER adjustments based on signals of inflation, interest rates, balance of payments, and floating rates - Exchange rate fluctuations within margins of +/-5% - Strict control over foreign currency use 1991–1993 Pegged exchange rates - Stricter control over foreign currency use and restrictions on cross-border money transfer within horizontal - Forex reserve fund established for exchange rate stabilization bands - OER determined on the basis of bid rates from the two floors (encountering forceful intervention by SBV) - Two forex trading floors in HCMC and Hanoi set up - Exchange rate fluctuation margin of less than 0.5% of announced OER 1994–1996 Conventional fixed peg arrangements - Vietnam’s interbank forex market established as a replacement for two forex trading floors, also recorded with forceful intervention by SBV - OER announced based on interbank rate - Exchange rate fluctuations within margins of +/-5% of announced OER (by end-1996 extended from less than +/0.5% to +/-1%) - OER maintained at 11,100 VND/USD Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 Period 1997–1998 Exchange rate regime Exchange rates within crawling bands 127 De facto exchange rate features - Exchange rate fluctuation margins broadened to +/-5% and +/-10% proposed in Feb 1997 and Oct 1997 respectively, and then narrowed to a 7% band in Aug 1998 - OER revalued to 11,800 VND/USD and 12,998 VND/USD in Feb 1998 and Aug 1998 respectively 1999–2000 Conventional fixed peg - Announced OER set to be the average interbank rate of previous trading day (28 Feb, 1999) arrangements - Exchange rate fluctuation margin narrowed to a 0.1% band - OER maintained at 14,000 VND/USD 2001–2007 Crawling Pegs - OER gradually adjusted from 14,000 VND/USD in 2001 to 16,100 VND/USD in 2007 - Exchange rate margins increasing to +/-0.25% (between Jul 1, 2002 and Dec 31, 2006) and to +/-0.5% (2007) 2008–2014 Exchange rates within crawling bands - OER set differently, in an increasing trend, at 16,100 VND/USD (early 2008); 16,500 VND/USD (Jun 2008–Dec 2008); 17,000 VND/USD (Jan 2009–Nov 2009); 17,940 VND/USD (Dec 2009–Jan 2010); 18,544 VND/USD (Feb 2010–Aug 2010); 18,932 VND/USD (Aug 2010–Feb 2011); and 20,693 VND/USD (from Feb 2011 onward) - OER maintained at 20,828 VND/USD from late 2011 to Jun 28, 2013 and adjusted to 21,036 VND/USD - Exchange rate margins revalued periodically, increasing to +/-0.75% (Dec 23, 2007–Mar 9, 2008), +/-1% (Mar 10, 2008– Jun 25, 2008), +/-2% (May 26, 2008–Nov 5, 2008), +/-3% (Nov 6, 2008–Mar 23, 2009), +/-5% (Mar 24, 2009–Nov 25, 2009) and afterward narrowed to +/-3% (Nov 26, 2009–Feb 11, 2011) and +/-1% (Feb 11, 2011 to end-2014). - OER reaching 21,246 VND/USD (Jun 19, 2014) and 21,458 VND/USD (Jan 7, 2015) Source: Nguyen et al. (2010) and authors’ compilation from SBV statistics Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 128 Exchange rate policy was adjusted to curb inflation and attract foreign investments during 1992–1997. Concerning inflation control, it aimed to maintain the stability of nominal VND/USD rate, and maintaining a nearly fixed rate, while Vietnam’s inflation rate, despite having been reduced, was still higher than those of the US and its main trade partners, caused the VND to be over-evaluated between 1996 and 1998 (Figure 1). This led to a negative impact on Vietnam’s exports, reflected through a decrease in export growth from 36% in 1994 to 1.9% in 1998. The periods of 2001–2007 and 2012–2013 also saw quite stable VND/USD rates. Yet, the de facto rate, in these stages, did not drastically reduce under the impact of pegged exchange rate mechanism; therefore, we could still observe rather significant growth in exports. During the period of 2008–2011, thanks to the country’s continuous moves to devalue the VND in order to deal with the global economic crisis and soaring inflation occurring in 2007–2008, an increase in de facto exchange rate in 2010–2011 contributes to a strong rise in exports possibly observed after shocks of its negative growth in 2009 (Figure 1). 300,0 250,0 200,0 150,0 100,0 50,0 0,0 NEER REER VND/USD Figure 1. VND/USD rate, NEER, and REER of Vietnam In general, therefore, the nominal VND/USD rate tends to follow a cycle with two stages. The first stage corresponds to the periods of strong fluctuations, namely: (i) Asian financial crisis during 1997–2000; and (ii) global financial crisis in 2008–2011, with efforts made for macroeconomic stability. In these periods market pressures forced SBV Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 129 to broaden exchange rate margins or decide on official devaluation, causing a large increase in NEER compared to the rate of the previous period. The second one coincides the periods of 1993–1996 and 2001–2007 when the economy was in stable development, and the stage, in addition, features the exchange rate regime in which the rate rigidly pegged to the US dollar. Figure 1 indicates that a correlation exists between NEER and REER in the period of 1994–2004. Both indices show decreasing and increasing trends in 1994–1998 and 1999–2004 respectively, but from 2005 a clear divergence between them is reflected. REER tends to relatively fall, whereas NEER continues to rise, and its rise is caused by a large devaluation of the VND against the USD through SBV’s adjustments to exchange rates from 2008 to the first half of 2011. Additionally, the constantly devalued USD compared to other currencies of such Vietnam’s major trade partners as Australia, China, Japan, Thailand, etc. also causes Vietnam’s NEER to devalue sharply. Meanwhile, the inflation rate of Vietnam is far higher than that of its trade partners, so the REER shows a significant decrease from 2005, especially in the period of 2008–2009, but tends to rise during 2010–2011 and then falls again in 2012–2013. This also partly explains why Vietnam’s export growth is negative in 2009 but recovers strongly in the next two years before falling into the decline between 2012 and 2013. 30% 130 20% 120 REER 140 GGDP, GX 40% 0% 100 -20% 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 -10% 110 1994 10% 90 80 GGDP GX REER Figure 2. REER, GDP growth (GGDP), and export growth (GX) Source: GSO and authors’ calculations Nguyen Quang Hiep & Nguyen Thi Nha / Journal of Economic Development 23(1) 121-136 130 In addition, Figure 2 suggests that REER, export, and economic growth in Vietnam tend to fluctuate positively during the periods of 1995–1999 and 2002–2012 despite some deviations. This demonstrates the existence of ralations among these three factors over the past few years. In the years of 1996–1998, 2005–2009, and 2012–2013, REER tends to fall, being compatible with a drop in exports during the same periods, while the three factors particularly show significant decreases in the crisis periods of 1997–1998 and 2008–2009. However, the REER reveals an increasing tendency, corresponding to economic growth rate rises in the 2002–2004 and 2010–2011 periods, which, theoretically, results in enhanced Vietnam’s international competitiveness. Indeed, another strong increase in export in those years confirms these relations. 4.2. Quantitative analyses of the relations among growth, REER, and exports in Vietnam This section contributes to empirical analyses of and findings for the relations among growth, REER, and Vietnam’s exports. Specifically, REER, a proxy for competitiveness of exports, is used as a mediator and/or transmission channel for the impact of growth on exports. We also take logarithm of the data series including 60 observations with a quarterly frequency over the period of 1999–2013. Table 2 Stationarity test for the data series Variable LNGDP ADF test statistic Critical value (at 1% level) ADF(1) = -1.033887 -3.548208 ADF(1) = -7.504916*** -3.550396 ADF(0) = -1.832654 -3.546099 D(LNX) ADF(0) = -8.940892*** -3.548208 LNREER ADF(1) = -2.193841 -3.548208 ADF(1) = -8.406355*** -3.550396 D(LNGDP) LNX D(LNREER) Note: D and (***) denote first difference and 1% significance level respectively. Source: compiled from estimated results