1 EXCHANGE RATE PASS-THROUGH INTO INFLATION IN VIETNAM: AN ASSESSMENT USING VECTOR AUTOREGRESSION APPROACH NGUYEN Dinh Minh Anh * , TRAN Mai Anh ** and VO Tri Thanh *** Published on Vietnam Economic Management Review, 2010 Updated by NGUYEN Dinh Minh Anh 1/2011 Abstract This paper has estimated the pass-through of exchange rate into inflation in Vietnam during M1:2005 - M3:2009 using the Vector Auto-regression (VAR) model. The result shows that the pass-through coefficient is 0.07 after a period of 2 months since the initial shock to exchange rate. This impact is completely removed in the third month. In comparison with such coefficients of some other developing countries, the exchange rate pass-through into inflation in Vietnam is at moderate-sized level. The paper also finds that high inflation in Vietnam in recent years is mainly due to the expansion of money supply. To control inflation, therefore, the State Bank of Vietnam (SBV), first and foremost, needs to manage money supply. Moreover, as the money supply is effectively controlled, an exchange rate arrangement following market determinants will not cause inflation. Also, VND interest rate is one powerful tool to control the inflation. Key words: Exchange rate, Pass-through, Inflation, VAR. JEL Classification Numbers: F31, C32, E52 1. INTRODUCTION Exchange rate is a crucial economic variable to the open economies. The exchange rate can affect the economy through different channels such as trade, prices, and budget. One of its most important impacts is on inflation, which is broadly termed as the exchange rate pass-through (ERPT) into inflation. The higher the pass-through coefficient is the more effective is the exchange rate as a tool for controlling inflation. The exchange rate pass-through effects in various economies can be different. For instance, during Asian 1997-crisis, a devaluation of Won had only marginal impact on the inflation rate in Korea, whereas a devaluation of Rupiah led to a considerably high inflation rate in Indonesia. Since Doimoi (Renovation) the success of Vietnam in attaining rather high economic growth has largely been attributed to macroeconomic stability. In recent years, however, the economy has been facing with pressures of rising inflation, increasing trade imbalance, dollarization and capital inflow fluctuation. In this context, it is very essential to understand the degree and timing of exchange rate pass-through, especially as an inflation targeting policy is adopted. There have been, in fact, some studies of the relationship between exchange rate movement and inflation in Vietnam. Hang (2010) finds that the exchange rate policy could not be against * NGUYEN Dinh Minh Anh, University of Economics and Business (UEB), Vietnam National University (VNU) ** TRAN Mai Anh, University of Economics and Business (UEB), Vietnam National University (VNU) *** VO Tri Thanh, Vice President of Central Institute for Economic Management (CIEM).
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EXCHANGE RATE PASS-THROUGH INTO INFLATION IN VIETNAM:
AN ASSESSMENT USING VECTOR AUTOREGRESSION APPROACH
NGUYEN Dinh Minh Anh*, TRAN Mai Anh
** and VO Tri Thanh
***
Published on Vietnam Economic Management Review, 2010
Updated by NGUYEN Dinh Minh Anh 1/2011
Abstract
This paper has estimated the pass-through of exchange rate into inflation in Vietnam during
M1:2005 - M3:2009 using the Vector Auto-regression (VAR) model. The result shows that the
pass-through coefficient is 0.07 after a period of 2 months since the initial shock to exchange
rate. This impact is completely removed in the third month. In comparison with such coefficients
of some other developing countries, the exchange rate pass-through into inflation in Vietnam is
at moderate-sized level. The paper also finds that high inflation in Vietnam in recent years is
mainly due to the expansion of money supply. To control inflation, therefore, the State Bank of
Vietnam (SBV), first and foremost, needs to manage money supply. Moreover, as the money
supply is effectively controlled, an exchange rate arrangement following market determinants
will not cause inflation. Also, VND interest rate is one powerful tool to control the inflation.
Key words: Exchange rate, Pass-through, Inflation, VAR.
JEL Classification Numbers: F31, C32, E52
1. INTRODUCTION
Exchange rate is a crucial economic variable to the open economies. The exchange rate can
affect the economy through different channels such as trade, prices, and budget. One of its most
important impacts is on inflation, which is broadly termed as the exchange rate pass-through
(ERPT) into inflation. The higher the pass-through coefficient is the more effective is the
exchange rate as a tool for controlling inflation.
The exchange rate pass-through effects in various economies can be different. For instance,
during Asian 1997-crisis, a devaluation of Won had only marginal impact on the inflation rate in
Korea, whereas a devaluation of Rupiah led to a considerably high inflation rate in Indonesia.
Since Doimoi (Renovation) the success of Vietnam in attaining rather high economic growth has
largely been attributed to macroeconomic stability. In recent years, however, the economy has
been facing with pressures of rising inflation, increasing trade imbalance, dollarization and
capital inflow fluctuation. In this context, it is very essential to understand the degree and timing
of exchange rate pass-through, especially as an inflation targeting policy is adopted.
There have been, in fact, some studies of the relationship between exchange rate movement and
inflation in Vietnam. Hang (2010) finds that the exchange rate policy could not be against
* NGUYEN Dinh Minh Anh, University of Economics and Business (UEB), Vietnam National University (VNU)
** TRAN Mai Anh, University of Economics and Business (UEB), Vietnam National University (VNU)
*** VO Tri Thanh, Vice President of Central Institute for Economic Management (CIEM).
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inflation unless the money supply and credit growth rate were managed. However, this study
does yet estimate the magnitude and timing of the changes in exchange rate into inflation. Using
Vector Auto-regression (VAR) approach for evaluating the impact of one-time exchange rate
shock to inflation, Minh (2009) shows that, the exchange rate pass-through in Vietnam is at the
medium level as compared to other economies. It does not, however, provide with logical
explanations about the order of variables in Cholesky decomposition. Moreover, there is a doubt
about the study’s conclusion that the changes in aggregate demand do not affect inflation. The
objective of this paper is also to study the exchange rate pass-through issue in Vietnam,
attempting to overcome some drawbacks in previous studies.
The remainder of the paper is organized as follows. Section 2 reviews theoretical background
and econometric techniques for estimating the ERPT. Section 3 describes the model,
methodology and relevant data used for quantitative assessment in the case of Vietnam. It then
presents the estimation of the exchange rate shocks to the domestic prices along the distribution
chain. Finally, Section 4 concludes with a summary of findings, policy recommendations and
suggestions for further research.
2. THEORETICAL BACKGROUND
The definition of the exchange rate pass-through into prices can be somehow understood
differently. Olivei (2002) regards the ERPT as the response of import price in percentage when
the nominal exchange rate changes by 1%. Some other the studies such as Lian (2006) and
Nkunde Mwase (2006) use a broad definition of ERPT, which reflects the changes of the
domestic prices1 in response to 1% - exchange rate shock. This paper follows the later definition.
It is mostly about the exchange rate pass-through into inflation (ERPTIF) meaning the change in
percentage of the consumer price in response to 1% - change of the exchange rate2. Similarly, it
can also be the exchange rate pass-through into the import price (ERPTIP) or the exchange rate
pass-through into the production price (ERPTPP).
According to Nicoleta (2007), the changes in exchange rate can influence the inflation rate
through two channels: direct and indirect ones. The direct channel can be seen through the
exchange rate shock as a devaluation of local currency. This makes the imported consumer
goods and raw materials become more expensive. The later leads to higher production costs and
as a result, higher consumer prices (Figure 2.1).
Figure 2.1: The direct channel of exchange rate
1 The domestic price means the import price, the production price and the consumer price.
2 Sometime in short it also refers just as the exchange rate pass-through (ERPT)
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Source: Nicoleta (2007).
The indirect channel supposes that a depreciation of domestic currency makes domestic goods
cheaper and hence, demand for this country’s exports increases. This will trigger an increase in
labor demand, wages and aggregate demand, and as a result, could lead to inflation. This effect,
however, can only happen in the long-run due to rigidity of price in the short term. But the
dollarization phenomenon may magnify the indirect effect. As domestic currency devalues, the
prices of assets (like real estate or luxury items) counted in foreign currencies increase, and this
causes the increases in consumer prices (through income-generating asset effect).
There are many different important factors – both macro and micro – determining the pass-
through of exchange rate (Box 2.1). Following the classification by An (2006), the micro factors
are: 1) pricing-to-market and mark-up adjustments; 2) market segmentation features such as
transportation and distribution costs, non-tariff barriers and the role of multinational
corporations; 3) the degree of returns to scale; and 4) the elasticity of demand for imported
goods. Macro factors include: 1) the level of inflation and the perceived persistence of exchange
rate swings; 2) the monetary policy environment; and 3) the size and openness of the economy.
Box 2.1: Factors affects the pass-through of exchange rate into inflation
Micro factors
1) Krugman (1987) analyses the pricing-to-market phenomenon, according to which foreign suppliers,
wishing to keep constant market shares, accept smaller profit margins when the importing country's
currency depreciates. Pricing-to-market thus implies a lower pass-through.
2) Burstein et al (2001) find that the local distribution costs (such as wholesaling and retailing) represent
up to 40% of the final retail price of any commodity. As these costs are less dependent on exchange rate
developments, they may consequently lower the pass-through even for internationally tradable goods.
3) Yang (1997) and Olivei (2002) study the degree of returns to scale, concluding that the rate of
exchange rate pass-through is inversely related to the elasticity of the marginal cost with respect to output.
If the marginal costs decrease with output, higher demand stimulated by price decreases resulting from
exchange rate appreciation should lead to further cost and thus price reductions, implying a higher rate of
pass-through.
4) Foreign suppliers are likely to adjust their prices according to the perceived demand elasticity in the
import country. The higher the elasticity of demand to price changes, the less likely are firms to pass
through the whole exchange rate shock (Yang 1997).
Macro factors
1) Taylor (2000) argues that the inflationary environment and the perceived persistence of shocks are
decisive determinants of pass-through rates. More precisely, firms are less likely to adjust their prices if
the exchange rate changes or inflation are expected to be volatile and temporary (a point also stressed by
Mann (1986) and empirically supported by McCarthy (2000)).
2) The connection between inflation and pass-through levels implies that monetary policies should also
affect the transmission of exchange rate movements to domestic prices. Gagnon and Ihrig (2004) find that
countries with credible and anti-inflationary monetary policies generally exhibit lower pass-through
levels.
3) Country openness, proxied by the import share in total production, also affects pass-through rates.
Intuitively, the more open the country is to international trade, the greater the exchange rate pass-through
to consumer prices should be. Moreover, according to McCarthy (2000), a small country should
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experience higher pass-through levels than a large country. This is because the fall in demand in a large
country in reaction to domestic price increases resulting from exchange rate depreciation reduces world
demand and hence depresses world prices.
Source: Heidi Cigan et al (2008).
In measuring ERPTIF, two techniques have been commonly used in a number of studies. The
first technique known as the standard single-equation regression technique is used in the studies
by Olivei (2002), Campa and Goldberg (2005), Campa, Goldberg and González-Mínguez
(2005), and Otani, Shiratsuka and Shirota (2005). They apply the OLS to evaluate the pass-
through, with polynomial distributed lags to capture the dynamic response of traded goods prices
to exchange rate changes. But this method has a disadvantage paying no attention to the time
series properties of the data, as most macroeconomic series and asset prices such as exchange
rates, economics growth or inflation are non-stationary. Therefore, the assumptions of the OLS
estimation are violated, leading to the problems of spurious regression. Moreover, the estimation
could suffer from inconsistency problems due to the endogenous determination of exchange rates
and prices.
The second technique is named as VAR. McCarthy (2000) is among the first researches
employed the VAR framework to estimate the ERPT. The VAR models have several advantages
compared to the single-equation-based methods. First, they could solve endogeneity problem
inherent in the single-equation-based methods. Moreover, the estimated impulse response
functions trace the effects of a shock to one endogenous variable on other variables through the
structure of VAR, which allows us to assess not only pass-through within a specific period, but
also its dynamics through time. VAR approach, therefore, is an effective measure of the degree
and timing of pass-through parameters. Some typical studies using VAR models are of Hahn
(2003) and Faruqee (2006) for the cases of developed countries, especially in European, Ito and
Sato (2006) for East Asian countries, Belaisch (2003) for Brazil, and Leigh and Rossi (2002) for
Turkey. In this paper, we also use a VAR model to estimate the ERPTIF in Vietnam. The
empirical evidence is shown in Section 3 after a brief examination of the relationship between
exchange rate movement and inflation in Vietnam since 1990s.
3. EMPIRICAL EVIDENCE
Figure 3.1 shows the changes in exchange rate and inflation in Vietnam during 1992-2009.
Figure 3.1: Nominal exchange rate and inflation in Vietnam (1992-2009)
Source: Authors’ own calculation from IFS and GSO.
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Exchange rate (VND/USD) Inflation rate (%)
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In the early 1990s when the inflation rate was considerably high (up to 35% in 1992), Vietnam
had efforts to control inflation using different policies, including adopting a relatively rigid
exchange rate regime. This option has theoretical foundation that keeping exchange rate stable
can improve trust in domestic currency, forcing the government to control budget deficit and
credit growth and thus, reduce inflation and stabilize the macroeconomic situation. In fact,
inflation during 1992 - 1996 was managed quite effectively. However, it is not the case in the
later periods. During 1997-2003 when Vietnam experienced the Asian crisis and the recovery
after, Vietnamese Dong (VND) was devalued continuously against USD. Yet, high inflation did
not occur, even the economy fell into the period of deflation in 2000-2001. Also, the application
of a relatively rigid exchange rate policy from 2004-2008 did not help the economy control
inflation. Inflation rate increased over the years and then skyrocketed to about 23% in 2008.
A look at the exchange rate and inflation in Vietnam indicates that their relationship is
complicated and the impact of the changes in exchange rate on inflation should be determined by
many other macro-factors. It is worth, therefore, having an empirical evidence of the magnitude
as well as timing of the ERPT in recent years.
3.1. Empirical framework
Based on arguments in Section 2, we set up a VAR model including 7 endogenous variables