The relation between exchange rate and the balance of payments – Theory and reality in Vietnam

INTRODUCTION
1. The urgency of research
Since exchange rate is one of basic tools to help governments operate their macroeconomies and
especially to guarantee the balance of external economy, exchange rate and mechanism operating
exchange rate policies until now have been sensitive and decisive issues to every country.
Exports’competitiveness, trade balance and international payments, national reserves, changes of
manufacturing framework and trust in the national currency, the goverrnment and future, etc, are
inextricably linked and dependent on exchange rate.
In the high-speed inflationary economy, Vietnam has implemented raising the value of national
currency to curb inflation. As a result, the value of real exchange rate USD/VND (RER) and real
effective exchange rate (REER) in recent years have decreased, partly restricting exports and
promoting imports, which in turn leads to the deficit of trade balance. In addition, signs of
Vietnam’s unstable economy and impacts from the global financial crisis have lessened investment
flows towards Vietnam and reduced foreign exchange reserves which can be lower to the
international standard. This fact leads Vietnam’s economy to the new context in which the scarcity
of foreign exchange and the pressure from exchange rate became worrying problems while the gap
between rates in the free market has widened. Exchange rate is not only a result of the imbalance
between supply and demand of foreign currencies. Has the recent deficit of trade balance resulted
from many reasons one of which is exchange rate and pressure from changes of exchange rate
attributed to the deficit of current balance account and the decrease in capital balance account?
With hope of clarifying the foundation and reality to complete the orientation and solutions to
improve the positive relationship between exchange rate and the Vietnamese balance of payments,
especially when Vietnam has become an official member of the World Trade Organization (WTO) and
integrated into the global economy, the author chooses the thesis topic “The relation between exchange
rate and the balance of payments – Theory and reality in Vietnam” to analyse and research. In
addition, this thesis evaluates the influence of exchange rate USD/VND on the balance of payments and
vice versa, the impacts of partial balances on the pressure of exchange rate. From all analysis and
assessment, the project figures out achievements and limitations to propose a few solutions in order to
improve the positive relation in the future.

2. Domestic and international research situations

2.1 Domestic research overview
The relation between exchange rate and the balance of payments is content in the field of
international finance.
In Vietnam, the textbook International Finance (2010) published by Statistics Publishing
House written by Pr. Nguyen Van Tien researches on exchange rate considered as a influential
factor in the competitiveness of import-export prices through nominal and real exchange rate
measures. In addition, it provides useful information on theories to approach echange rates,
monetary, financial and exchange rate policies in the open economy in order to sustain the internal
and external balance of payments. Theoretical information from the textbook is obviously beneficial
and valuable for the author to use as theoretical factual foundations for further research on the
reality of the causal relation between exchange rate and the balance of payments in Vietnam.
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Research on “The real exchange rate and its impacts on trade balance” written by Pr. Nguyen
Van Tien has proved the relation between the real exchange rate and trade balance known as an
important part of current balance account and the balance of payments. According to research,
nations devaluating the national currency (i.e. the real bilateral or effective exchange rate larger
than 1) will stimulate exports and restrict imports, thus increasing the rate of export and import. In
the context of Vietnamese economy, the viewpoint still remains true. As a result, exchange rate
USD/VND in the period from 1999 to 2002 influenced the trade balance of Vietnam. Besides, the
theisis of PhD.Nguyen Thi Thu on “Exchange rate: Policies and Impacts on foreign trade” applied
methods of qualitative and general analysis to discover exchange rate’ impacts on export and
import, and on trade balance in 1991-2000. The conclusion is that direct influences from adjusting
exchange rate on the trade balance and current balance account are modest and slow. However,
exchange rate adjustment also has indirectly positive effects on export/import in Vietnam at that
time. Research on “Analysis of influences from the fluctuation in exchange rate (USD, EUR) on
Vietnam’s export in the global integration” (2008) written by Associate Professor Nguyen Thi Quy
approaches experiments, survey, investigation and quantification of the foreign currency
fluctuation’s impacts on export and also proves certain impacts of exchange rate USD and EUR to
VND on export. On the other hand, the thesis concludes that exchange rate played one of
contributors to changes in export. These results are in accordance with other domestic economists’

views that the improvement in the Vietnamese trade balance means more attention to operate
policies of exchange rate and foreign exchange (Nguyen Thi Mui 2009, Le Xuan Nghia 2009,
Nguyen Minh Phong 2009). Research on “Using ECM model in evaluation of the real exchange
rate’ imfluences on export in Vietnam” written by Nguyen Chien Thang 2003. By using Error
Correction Model (ECM), he investigates impacts of the real bilateral exchange rate USD/VND on
Vietnam’s export in the period 1986-2000 and results show that long-term elasticity coefficients for
Vietnam’s export is 1.13 while that of Lord’s research in Vietnam’s leather shoes export is 1.97 and
of Nguyen Van Cong (2002) is 1.33. Research on exchange rate’s impacts on the trade balance
written by Nguyen Van Cong is based on Marshall Lerner condition to examine the real exchange
rate’s impacts on the amount of exports and imports in the short and long term. The result is
Marshall Lerner is not satisfactory when the sum of export and import elasticity coefficients is
smaller than 1 (1.33 + (-1.28) = 0.05<1), recent research of Nguyen Van Tien and Dinh Thi Thanh
Long (Banking Academy-2009) on analyzing and calculating the elasticity of export and import
demand for exchange rate is based on examining 3 levels of exchange rate on the elasticity of
import and export. The result is with official exchange rate and its levels of ask/bid rates, the
Marshall Lerner condition is not satisfactory but with ask/bid rates of commercial banks and income
variable, it is.
2.2 International research overview
There are some particular research works on examination of the relation between exchange rate
and the balance of payments. Research on International Monetary and Financial Economics
written by Joseph P.Danields and David D. VanHoose (2005) clarifies the relation between
exchange rate and the balance of payments according to elasticity theory, expenditure theory,
monetary theory and investment portfolio theory. Research on Multinational Business Finance
of David K.Eiteman 2001 provides an overview of exchange rate’ influential factors, then
examining impacts of the balance and payments on exchange rate. Two research works are
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beneficially theoretical factual foundations for the author to continue doing research the reality of
this relation in Vietnam.
Research of Mohsen Bahmani-Oskooee and Gour Goswami 2003 “A Disaggregated
Approach to Test the J-Curve Phenomenon: Japan versus Her Major Trading Partners”

based on method of quantitative examination reveals the role of Japanese Yen exchange rate in
export growth and the improvement in trade balance in Japan in 1973-1998. Devaluation of
Japanese Yen in the long term improves trade balance of Canada, England and America. In China,
Alicia Garcia – Herrero and Tuuli Koivu 2009 with “China’s exchange rate policy and Asean
Trade” use statistics when China became one of members in WTO (2000) and quantitative results
are the increase in the real exchange rate of CNY increases 5% will lessen 7% export turnover and
4% import turnover of China because its demand of imports depends on exports. In addition, this
research proves that the increase in CNY exchange rate will put negative effects on exports of other
Asian countries. Research of Mohsen Bahmani-Oskooee and Artatrana Ratha 2008; Zehra Aftab,
Sajawal Khan 2008; Duasa Jarita 2010, etc, also illustrate the basic relation between exchange rate
and the balance of payments through investigating exchange rate’s impacts on the trade balance in
America, Pakistan, Malaysia, etc.
3. Research objectives
In order to clarify general theories and analyse the reality of the causal relation between
exchange rate and the balance of payments in Vietnam, the thesis proposes the orientation and
solutions to improve the positive relation between exchange rate and the balance of payments in
Vietnam in the future. By doing this, a suitable exchange rate policy which is offered will improve
the balance of payments, especially the balance of payments and trade balance so that exchange rate
in the foreign exchange market will stablize in the long term.
4. Research tasks
The thesis focuses on the following main contents:
- Clarify theoreticall issues on the balance of payments, exchange rate, exchange rate
policies and the relation between exchange rate and the balance of payments, especially the two-
way influence between exchange rate and trade balance. More importantly, the thesis examines
theories of devaluation conditions in order to improve trade balance through theories of elasticity,
J effect and modern approaching theories of the balance of payments such as monetary theory and
investment portfolio theory.
- Study experiences of conducting exchange rate policies in order to improve the
balance of payments in some particular countries.
- Research the reality of the balance of payments through analyzing partial balances

and simultaneously study developments and policies of foreign exchange rate in Vietnam from
1999 to 2009.
- Focus on the depth of bilateral impacts between the real bilateral and real effective
exchange rate and the balance of payments in Vietnam through analyzing specifically the causal
relation between exchange rate and partial balances of the balance of payments, and forming
quantitative models to measure these relations in Vietnam.
Based on international experiences and the reality of Vietnamese economy, exchange rate
policies and the balance of payments, the thesis also figures out lessons for Vietnam, then offering
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solutions to improve the positive relation between exchange rate and the balance of payments.
5. Subjects and scope of research
5.1 Research Subjects
The thesis’s subjects are exchange rate, balance of payments and their relationship.
5.2 Scope of research
The thesis focuses on the following issues:
- First, the thesis examines overall theories on the relationbetween exchange rate and the
balance of payments.
- Second, the thesis investigates the reality of the balance of payments, policies of exchange
rate and the relation between exchange rate USD/VND and the balance of payments in Vietnam
during the period from 1999 to 2009. Since trade balance is a significant part of the balance of
payments, the thesis centers deeply on the causal relation between real exchange rate and trade
balance.
- The thesis also analyses experiences of managing rate policies in some particular nations
such as China, Korea and the United States in order to improve the balance of payments.
5. Research methodology
Research methods used in the thesis include:
- Methods of Marxism dialectial and historical materialism based on applying the
Government and Party’s views and policies upon the economic development and integration stated at
the 9
th

and 10
th
Party Congress.
- Methods of material research and statistics to assess the reality, method of description-
generalization, inductive and deductive methods, methods of analysis, comparison and contrast,
combined with systematic theory and logical reasoning to propose solutions to relevant issues in the
thesis.
- Methods of Engle-Granger Causality Test model and error correction model (ECM) to
verify the causal relation between exchange rate and the balance of payments in Vietnam from 1999
to 2009.
- The thesis also makes use of results of other relevant scientific research projects according
to inheriting principles in order to prove and illustrate theoretical points in the thesis.
6. Research Structure
Besides introduction, conclusion and reference, the thesis is organized as follows:
Chapter 1: An overview of the relation between exchange rate and the balance of payments.
Chapter 2: The reality of the relation between exchange rate and the balance of payments in
Vietnam.
Chapter 3: Solutions to improve the relation between exchange rate and the balance of
payments in Vietnam in the future.
7. New contributions of the thesis
The thesis “The relation between exchange rate and the balance of payments – The theory and
reality in Vietnam” contributes the following new points:
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- Continue clarifying theoretical issues on exchange rate, policies of exchange rate and
providing criteria to analyse the balance of payments, especially study the relation between
exchange rate and the balance of payments;
- Study experiences of operating exchange rate policy in order to improve the balance of
payments of China, Korea and America and draw out 4 lessons related to the reality of Vietnam’s
economy;
- Provide an overview of exchange rate movements, policies of exchange rate in the period

1999-2009.
- Analyse the reality of the balance of payments in Vietnam can conclude that the pressure from
the deficit of overall balance stems from the deficit of trade balance in current account. This
situation will last in the long term as long as the manufacturing capacity and the competitiveness of
Vietnam’s goods and services are enhanced.
- Through studying the causal relation between exchange rate and the balance of payments, the
thesis shows that there is a bilateral relation between the real exchange rate and trade balance with a
certain lags. The sum of export and import elasticity coefficients larger than 1 permits Vietnam to
think about domestic currency devaluation in the future in order to improve trade balance with all
necessary conditions.
- In order to provide specific solutions to improve the relation between exchange rate and the
balance of payments, the author bases on evidence to predict the trend of the changes of exchange
rate of VND and other currencies to USD. The results are in the future the nominal exchange rate of
VND is likely to decrease compared to USD and Vietnam still has to encounter inflation issues.
Based on internal analysis of Vietnam’s economy, the Vietnamese balance of payments is foreseen
to be under the pressure of the deficit in trade balance.
- The thesis also forms a system of orientation and solutions to improve this relation. Proposed
solutions are based on two main groups: (i) The group of completing policies of exchange rate
based on benefits to international trade. In the short term, the thesis proposes scenarios for inflation,
the development of Vietnam and America to adjust exchange rate to support export and improve
trade balance. (ii) The group of improving the balance of payments in order to contribute to the
stabilization of exchange rate, increase the efficiency of operationg exchange rate based on two
main solutions, including a solution to improve current balance account and another to improve
capital balance account. The root to improve the balance of payments is to increase economic
competitiveness, good manufacturing capacity, replace imports, improve investment environment,
conduct tough fiscal policy in the current context and accept lower economic growth.
- In addition, the thesis provides conditional petitions to carry out solutions. Then, the long-
term stabilization of low inflation and improve environment for economic competitions will be key
answers to better the relation between exchange rate and the balance of payments in Vietnam.
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CONTENT
Chapter 1
An overview of the relation between exchange rate and the balance of payments
1.1 Exchange rate and exchange rate policies
1.1.1 Exchange rate and methods of determining exchange rate
The thesis examines exchange rate under the aspect of macroeconomic variables and their
effects the competitiveness of international trade. Exchange rate depends on many macroeconomic
variables including two main variables such as inflation (the Purchasing Power) and interest.
Basically, The law of Purchasing Power Parity explains the long-term changes of exchange rate
(The theory of the Interest Rate Parity) and explains the short-term fluctuations of exchange rate.
1.1.2 Policies of exchange rate
- Definition of exchange rate policies
- Aims of exchage rate policies
- System of exchange rate
- Tools of operating exchange rate
1.2 Basic issues on the balance of payments
1.2.1 Definition
The balance of payments is a generally statistical report, presenting systematically values of
all economic transactions between residents and non-residents during a specific period which is
often one year (Nguyen Van Tien 2010, Page 223).
1.2.2 The constitution of the balance of payments
The balance of payments includes 4 basic parts: Current balance account, Capital balance
account, Overall balance, Official Financing Balance.
1.2.3 The balance of payments and macroeconomic frame in the open market
The current balance account reflects the difference between savings and investment. It also
descibes the difference between national income and domestic expenditure; Current balance account
and Capital balance account; and Overall balance and the amount of supplying money in circulation.
1.2.4 Analysis of the balance of payments Phân tích cán cân thanh toán quốc tế
1.2.4.1 Current account
1.2.4.2 Capital and financial account

1.2.4.3 Overall balance (changes in official reserves)
1.3 The relation between exchange rate and the balance of payments
1.3.1 Exchange rate’ effects on the balance of payments
- Theory of elasticity: The main content of this theory is to analyse two factors which have
direct impacts on current balance account in the context of devaluation. Through analyzing export
and import elasticity coefficients in comparison with relative prices (exchange rate). The Marshall-
Lerner condition shows the successful devaluation of national currencies (the improvement in trade
balance) means the sum of export and import elasticity coefficients higher than 1.
- Theory of Absorption approach: This theory proves that the devaluation can improve trade
balance while savings from income increase more than the rise in expenditure.
- Theory of Monetary approach: In the system of fixed exchange rate, the increase in
domestic credit supply will lead to the deficit of the balance of payments and vice versa, the
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decrease in domestic creadit supply will lead to the surplus of the balance of payments. On the other
hand, in the system of flexible exchange rate, the increase in domestic credit supply will decrease
the value of national currency and vice versa, the fall in the domestic credit supply means the
increase in the value of national currency.
- Theory of porfolio approach: Exchange rate of a specific country is identified by the
demand-supply relation of financial assets (money, bonds).
1.3.2 Effects of the balance of payments on exchange rate
- In the system of fixed rate: The government takes responsibility for guarateeing the balance
of the balance of payments. If the sum of current balance account and capital balance account is not
approximatedly 0, the government can get invloved in the foreign exchange market by selling or
buying foreign exchange reserves.
- In the system of floating rate: The government does not get involved in operating exchange
rate. The fact shows that when the balance of payments is not in the state of balance, it will impacts
exchange rate to make the balance of payments return to the state of balance (David K.Eiteman
2001, Page.62).
- In the system of managed floating rate: The government can interfere to ensure to have an
expect exchange rate according to the context, the market’s conditions. The government often

applies methods to adjust exchange rate instead of directly getting involved in the foreign exchange
market. For instance, the government can employ interest policies.
1.4 Experiences of operating policies of exchange rate in some countries in order to improve
the balance of payments
The thesis studies experience of China, Korea and America.
Four valuable lessons suitable for Vietnam’s context are drawn from the thesis: (i) The
flexibility of exchange rate regime; (ii)Suitable exchange rate policies for each period of Vietnam’s
development; (iii) The coherence, synchronic schedule in the operation of exchange rate policies; và
(iv) Policies of exchange rate need a synchronic co-ordination with other macroeconomic policies.
Chapter 2
THE REALITY OF THE RELATION BETWEEN EXCHANGE RATE AND THE BALANCE OF
PAYMENTS IN VIETNAM
2.1 Exchange rate and policies of exchange rate in Vietnam in the period 1999-2009
2.1.1 Developments of exchange rate
2.1.1.1 Exchange rate movements before 1999
Impacted by the Asian financial crisis, USD/VND rates had been adjusted several times in
terms of official rates and margin to devalue VND against USD.
2.1.1.2 Exchange rate movements since 1999
- Since 1999, after adjusted (devalued) in 2 years 1997-1998, the nominal exchange rate
USD/VND has a tendency to increase over time, stablize in the long term and stay flexible in the
short term.
- According to the author’s calculation, the real exchange rate (RER) and the real effective
exchange rate (REER) since 2007 until now are likely to decrease significantly. The decrease in
RER and REER puts a negative influence on the competitiveness of Vietnam’s goods, leading to
the rise in imports and the fall in exports.
- From 2008 to now, the State Bank has had 5 times of adjusting the range of exchange rate
and 5 times of adjusting the average exchange rate of interbanks in order to keep up with the real
7
situation of the foreign exchange market. The average exchange rate of commercial banks have
always fluctuated at the ceiling price or near the ceiling price.

- Reasons for the fluctuation of exchange rate USD/VND in time include: the increasing far
difference between inflation and income in Vietnam compared to America and other nations;
continuous deficit of current balance account; the weakening of USD
2.1.2 Policies of exchange rate
- Since 2/1999, the mechanism of operating exchange rate has been changed (Dicision
64/1999 and 65/1999). Since then, the State Bank announced only the average exchange rate
USD/VND of in the market of interbanks. Exchange rate of commercial banks are calculated
according to the average exchange rate of interbanks in the range of fluctuation decided by the State
Bank (from ±0.1% to ±5%).
- Exchange rate of VND is linked inextricably to USD during research period
- Sometimes, the State Bank is late to adjust exchange rate to keep up with the current context
of market and has not fulfilled tasks and responsibilities of the management agency in predicting
and orienting the trend of market, which certainly causes many negative effects.
2.2 The reality of the balance of payments in Vietnam from 1999 to 2009
2.2.1 The context of Vietnam’s economy
- The economy has grown at high speed.
- Being a member of WTO offers the balance of payments, especially trade balance, many
chances and a few important challenges.
- The deficit of the balance of payments and budget balance is still large.
- The global financial crisis’s negative effects on the deficit of the balance of payments as
investment flows towards Vietnam are cushioned dramatically.
2.2.2 Current account
2.2.2.1 Developments of current account:
The balance state of current account of Vietnam is directly affected by the state of trade
balance because transactions of goods make up a large proportion of the total income and
expenditure in current account (approximately 70%-85%)
2.2.2.2 Reasons for the deficit of current account
Since the weak manufacturing capacity lessen the competitiveness of Vietnamese goods even
in the domestic market, the deficit of income balance and investment policies for growth and an
unsuitable policy of exchange rate encourage import.

2.2.2.3 Analyze the current account sustainability
Based on the ratio of current account to GDP and export revenues, the deficit of current
account in period 2007-2010 is alarming ( exceed 5% compared to GDP and nearly 20% compared
to export revenues). In the long term, this situation can causes risks to the economy when Vietnam
is unable to meet its foreign debts.
2.2.2.3 Financial sources for the deficit of current balance account
The official financial source for the deficit of current balance account is primarily from
capital balance (foreign investments and loans) and current transferring flows from remittances.
2.2.3 Capital Account
2.2.3.1 Foreign Direct Investment (FDI)
- Foreign direct investment towards Vietnam is the main source to finance the deficit of
current balance account through time.
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- Trade balance from the FDI sector in Vietnam is always in the state of deficit if FDI is
without oil sector.
- Besides oil, FDI in Vietnam is likely to be invested in industries which have high costs of
capital and need to import inputs such as projects of real estate and processing, etc, while light
industries, supporting industries and exporting oriented heavy industries constitute an insignificant
percentage of FDI towards Vietnam.
2.2.3.2 Foreign loans
- Official Development Assistance (ODA) plays a key role in the medium and long term
total loan capital.
- Investment capital flows in valuable papers in Vietnam which had witnessed a positive and
sensitive period since 2005 has fluctuated significantly in the period 2007-2010
2.2.4 Overall balance
- Vietnam has been and will undergo the deficit of trade balance and the main financing
source is from capital account through attracting direct investment flows, overseas loans and
remittances
- The balance of payments gains the endurance and sustainability only when Vietnam can
clear its overseas loans in the future through the surplus of trade balance.

2.3 The reality of the relation between exchange rate and the balance of payments of Vietnam
in the period 1999-2009
2.3.1 Exchange rate’s effects on the balance of payments
2.3.1.1 Exchange rate’s effects on trade balance
- From 1999 to 2002, the real bilateral and effective exchange rate are likely to increase,
contributing to the improvement in the competitiveness of international trade.
The real bilateral and effective exchange rate and rate of export compared to import (X/M) in
Vietnam from 1999 to 2009
Source: Collected and calculated from statistics of CEIC Database
- The real exchange rate (RER) and real effective exchange rate (REER) affect trade balance
with certain lags
- Under the pressure of high inflation, RER and REER which are going to be smaller than 1
encourage import and lower export’s competitiveness. As a result, growth speed of import is
higher than that of export in recent years, leading to the serious deficit of trade balance.
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USD/VND
RER USD/VND
2.3.1.2 Exchange rate’s effects on Vietnam capital account
- Policies of stablizing exchange rate in the long term and allowing the fluctuation of VND with
the trend of devaluation in the short term has attracted foreign investment flows towards Vietnam.
- Devaluing VND by 1% compared to foreign currency will increase the amount of FDI towards
Vietnam by 0.92% (Thi Hong Hanh Pham, Duc Thinh Nguyen 2010).
- The VND devaluation seems to put a positive effect on FDI flows, thus improving capital
balance to finance the deficit of Vietnam’s current balance account recently.
2.3.2 Effects of the balance of payments on exchange rate
2.3.2.1 Current account’s effects on exchange rate
- The deficit of current account is likely to increase and is one of reasons for VND devaluation
in recent years with increasing pressure.
- Pressure of increasing exchange rate because of current account is reflected through the
difference between exchange rate in the free market and official exchange rate.

2.3.2.2 Capital account’s effects on exchange rate
- Capital account’s flows is one of factors describing the relation of foreign currency demand-
supply of the economy.
- In 2 years 2006-2007, sources of foreign currency supply from export, remittances, FDI, FPI
increase dramatically, lessening the pressure from the scarcity of foreign currency in the foreign
exchange market.
2.3.3 Quantify the relation between exchange rate and the balance of payments
2.3.3.1 Research model
2.3.3.1.1 Cause-Effect relation between the real exchange rate and trade balance
Model in the long term:
1 2t t t
TB REER
β β ω
= + +

Model in the short term:
1
1 1
.
k h
t i t i i t i t t
i i
TB REER TB z
α β δ φ ϕ
− − −
= =
∆ = + ∆ + ∆ + +
∑ ∑

1

1 1
m n
t i t i i t i t t
i i
REER TB REER
α χ λ φν υ
− − −
= =
∆ = + ∆ + ∆ + +
∑ ∑

2.3.3.1.2 Examine Marshall Lerner condition
Model in the long term:
dNX X dy
M
dE E dE
α β χ γ
 
= + + +
 ÷
 
Model in the short term:
1
0 0 0
X
p p p
i
i i i i
i i i
dNX dy

M
dE E dE
α β χ γ
= = =
= + + +
∑ ∑ ∑
2.3.3.2 Statistics description
Quarterly statistics are from CEIC Database. Research period is from quarter1/1999 to quarter
4/2009 and quarter 1/1999 is the original quarter to establish the real effective exchange rate. Main
commercial partners chosen to calculate REER include: America, China, Japan, Taiwan, Korea,
France, German, Thailand, Singapore, Malaysia and Australia. The method to calculate the real
effective exchange rate (REER) or E is introduced at Chapter 1. Gross Domestic Products (GDP) is
collected to represent income variable.
2.3.3.3 Empirical Test Results
2.3.3.3.1 Causal relation between the real exhange rate anf trade balance
- The cause-effect relation between the real exchange rate and trade balance in the long term
really exists and its statistical value is reliant. This proves that exchange rate in the long term has a
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certain effect on trade balance and vice versa, the fluctuation of trade balance also affects the real
value of VND.
- In the short term, the situation of trade balance affected by its past situation when
coefficients of lag 1 and 2 have a signitificant value at 1%.
- Vietnam’s trade balance is also affected by the real effective echange rate of VND with the
signitificant value at 10%.
- Trade balance’s effects in the past (lag 1) has certain effects on the real exchange rate of
VND.
2.3.3. 3 .2 Results of Marshall Lerner condition examination
- Results show that in the long term, Marshall Lerner condition is satisfactory and has its
statistical value at 1% when
β

+
χ
>0 (0.989354+-0.772639 = 0.216715>0).
- Elasticity coefficient of export demand to the real exchange rate has its statistical value at
1% with lag 0, 1 and 4. Elasticity of coefficient of import demand, lag 0, 1 and 2 also has its
statistical value at 1% and 5%.
2.4 General conclusions on the reality of the relation between exchange rate and the balance
of payments
2.4.1 Positive impacts
- VND regularly adjusted to be devalued and flexible recently puts positive impacts on
Vietnam’s export.
- Developments of REER and trade balance is cointergrated and has a causal relation.
- Effects of the real bilateral and effective exchange rate USD/VND on trade balance with a
certain lags.
- Together with consequences, the fixed exchange rate (USD/VND) policy also brings
Vietnam’s export encouraging and positive signs contributing to improve trade balance.
- Both exchange rate and domestic income affect trade balance in the long term and short
term.
- Stable exchange rate policy in the long term with VND devaluation trend appears to
encourage foreign capital flows to Vietnam .
- The State Bank’s exchange rate policy with the gradual VND devaluation helps businesses
foresee the trend of exchange rate fluctuation and feel secure to carry out their business strategies
without concerning about the fluctuation of nominal exchange rate USD/VND.
- Capital account, the main part of the balance of payments, contributes to improve
exchange rate supply source in the foreign exchange, thus lowering the pressure on exchange rate
over years.
2.4.2 Negative effects and reasons
- Policy of exchange rate USD/VND has many consequences.
- Vietnam exchange rate policy is likely to overestimate the real value of VND to USD and
other currencies of main commercial partners.

- Dollarization and disadvantages of the ‘dual exchange rates” reality.
- Influence level of exchange rate on the balance of payments depends on the synchronism
with other economic policies.
- The State Bank’s adjustment in exchange rate often cannot keep up with the market’s
changes, late and likely to be different from the real value of VND due to the late response of the
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management policy, inaccurate predictability, conservativeness and bias in favour of some short-
term social-economic policies.
- The state of the balance of payments has obvious effects on exchange rate pressure,
especially the deficit of current balance account stemming from the deficit of trade balance.
Chapter 3
SOLUTIONS TO IMPROVE THE RELATION BETWEEN EXCHANGE RATE AND THE
BALANCE OF PAYMENTS IN VIETNAM IN THE FUTURE
3.1 Forecast the trend of changes in the Vietnam balance of payments and the fluctuation
exchange rate USD/VND in the period 2010-2015
3.1.1 The trend of changes in exchange rate USD/VND
3.1.1.1 Baselines
3.1.2.2 Forecast the trend of exchange rate fluctuation
- USD value is going to be stable again together with the gradual recovery of America’s
economy .
- The devaluation of the nominal value of VND compared to USD, JPY, CAD, EUR, GBP
will be at higher level in order to maintain Vietnam’s commercial and investment competitiveness.
3.1.2 Forecast the trend of changes in the Vietnam balance of payments
3.1.2.1Baselines
3.1.2.2 Forecasts
- Current account tends to be deficient but the deficit will be decrease over time because of the
deficit of trade balance.
- The balance of services continues to be deficient.
- Foreign investment towards Vietnam is going to rise gradually.
3.2 The orientation to improve the relation between exchange rate and the Vietnam balance of

payments
3.2.1 Adjust exchange rate for the improvement in the balance of payments
- Exchange rate adjustment in near future requires the factor of “stability” in the long term and
“flexibility” in the short term to encourage foreign investment flows for the improvement in the
capital balance.
- Besides exchange rate, Vietnam needs to adjust the macroeconomy to gain stable and
sustainable development.
- Exchange rate needs to be adjusted to heighten goods and services’’ competitiveness in
international trade. By doing this, the minimum of the target real exchange rate must be higher or
equivalent to 1.
- Policy of exchange rate adjustment needs to be flexible and acute before domestic and
foreign macroeconomic variables
- The State Bank can be independent on using tools of monetary policies.
3.2.2 The contribution of exchange rate to the balance between internal and external economy
- Exchange rate is adjusted to balance internal economy, stabilize inflation and gain
sustainable economic growth.
- Vietnam in hope of improving the economy to balance internally and externally is required
to cut out expenditure and adjust to devalue VND.
3.2.3 The balance of payments is adjusted to stabilize exchange rate
- Adjustment in the balance of payments contributes to decrease the budget deficit, restrain
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inflation and lessen the pressure on exchange rate.
- In the long term, the issue on macro stability considers restructuring economy as the
prerequisite to decrease excess of imports over exports, thus alleviate long term pressure on
exchange rate.
- Changes in the manufacturing framework increase additional value of domestic factors in
exports, raise investment effectiveness (decrease ICOR, excessive capital in the economy).
3.2.4. Co-ordinate synchronically macro-policies
- Find solutions to the target of internal balance which are stabilizing inflation, interest and
need to result from monetary and spending policies.

- It is worth the effort to lessen governmental expenditure and enhance the effectiveness of
investment.
3.3 Solutions to improve the relation between exchange rate and the balance of payments in
Vietnam in the near future
3.3.1 Solutions to complete exchange rate policy in order to improve the balance of payments
3.3.1.1 Select and form more flexible exchange rate system – BBC System
- BBC system has features considered as specific advantanges in comparison to other
exchange rate policies and suitable for the context of Vietnam.
- A purchase power parity rate should be allowed to change during time. BBC can be adjusted
to change during periods.
- A purchase power parity rate is calculated based on a currency basket, not only one foreign
currency. Therefore, it will help enhance advantages and price competitiveness over trade partners.
- Margins for purchase power parity rate are wide enough for exchange rate in the market to
fluctuate.
3.3.1.2 Select and build up the density of currency basket in order to identify the central exchange
rate
Here are steps to identify VND’s currency basket:
- Step 1: Choose the original time to identify the currency basket
- Step 2: Calculate densities of currencies of nations which have trade densities arranged in
descending order.
- Step 3, sum all densities until the total density of nations reaches approximately 80%
compared to the total trade revenue of Vietnam.
- Vietnam should select optimal currency basket based on currency baskets of its 10 biggest
trade partners.
3.3.1.3 Solution to identify the range of exchange rate fluctuation in BBC system
- Adjustment is based on the real bilateral and effective exchange rate which is beneficial, i.e
higher than1, to improve trade balance.
- Periodical range adjustment depends on each period and certain economic developments. If
the economy is stable and gains sustainable development, periodical range examination and
adjustment can be quarterly. However, in the context of unstable economy with high inflation, it is

essential to consider and adjust monthly.
3.3.1.4 Vietnam should adjust exchange rate to improve trade balance
Vietnam need carry out “exchange rate adjustment” and in far future, Vietnam can think
about “national currency devaluation” to improve trade balance.
3.3.1.4 .1 Conditions to devalue
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- Inflation needs to be maintained at relatively low level in the long time, for example 4-5%/
year and minimum time for stability must be 3 to 5 years.
- Export and import elasticity coefficients are big enough (to have the total sum higher than 1) or
at least J effect can perform with moderate lags (from 3 to 6 months).
- Foreign exchange reserve is large enough to maintain the fluctuation of national currency
value with the range established daily
- Exchange rate policy is necessary to combine with foreign trade policy and industrial
policy and other tools of monetary policies.
3.3.1.4 .2 Scenarios of exchange rate adjustment in the future
- Identify the target real exchange rate:
To improve trade balance, the real exchange rate is proposed to be 1; 1.02 and 1.045
equivalent to the real exchange rate from the original year Quarter 1/1999 (the current balance
account) for scenarios of exchange rate adjustment.
- Estimated inflation:
After analyzing scenarios of exchange rate, in the author’s personal view, the State Bank
needs to adjust the nominal exchange rate so that the real bilateral exchange rate RER is at least 1
and according to inflation conditions in 2011 and 2012, the State Bank can adjust the correlative
nominal exchange rate.
3.3.2 Solutions to improve the balance of payments to stabilize exchange rate
3.3.2.1 Solutions to improve current account
3.3.2.1.1 Foster the manufacturing capacity and competitiveness of Vietnam’s exports to improve
trade balance
- Invest in depth and innovate technology actively.
- Develop support industries, prioritize main export industries.

- Enhance the competitiveness of Vietnam’s exports through quality, design and variety.
3.3.2.2 Export supporting credit policy
- Prepare solutions to innovate and replace export credit solutions in order to be suitable for
WTO’s regulations: The formation and development of Industry Association is required to
implement immediately;
- Expand export credit insurance market.
3.3.2.1.3 Complete investment policy, enhance the effectiveness of using domestic and overseas
investment capital
- The Government needs to build up strategies and overall projects of investment.
- Enhance administrative reform, foster the effectiveness of governmental management towards
investment.
- Create policies to encourage national investment in order to force to manufacture domestic
goods to take place of imports.
- Develop centers which provide inputs, materials and play as import agents and material
providers for domestic export manafuring businesses.
3.3.2.2 Solutions to improve capital and financial balance
3.3.2.2.1 Form a stable and healthy fiscal policy
- Innovate budgets stably.
- Renovate budget expenditure in order to save in frequent expenditure and decrease
expenditure beyond budget.
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3.3.2.2.2 Control effectively capital transactions
3.3.2.2.3 Encourage foreign direct investment selectively
3.4 Propose conditions to implement solutions
3.4.1 Continue restraining inflation and stabilizing prices
3.4.2 Heighten validity of monetary policy
3.4.3 Raise the effectiveness of foreign exchange management policy
3.4.4 Strengthen the ability of prediction analysis
3.4.5 Co-ordinate synchronically monetary, exchange rate, fiscal, commercial and investment
policies

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CONCLUSION
Through the thesis “The relation between exchange rate and the balance of payments-
Theory and reality in Vietnam”, the author drawa out following conclusions:
First, improving current balance account in the balance of payments and putting this balance
to the state of balance are macroeconomic targets of any nations.
Second, there is a relation between exchange rate and the balance of payments. Exchange
rate is not only one of influential factors on the balance of payments but also the result of the
balance between foreign currency supply-demand stemming from the state of the balance of
payments, especially, exchange rate affects directly trade balance and indirectly others partial
balances. Although national curreny devaluation policy will encourage exports and restrain imports,
it doesn’t mean that every nation can devalue its currency without Marshall Lerner condition and J
effect satisfied. In fact, many research on elasticity theory examination based on Marshall Lerner
condition in countries in the world show that exchange rate has a certain effect on trade balance in
the balance of payments
Third, studying experiences from many countries proves that exchange rate policy is a great
contributor to current success on economy and society of China and Korea when these nations
implement domestic currency devaluation policy after preparing all necessary conditions for
boosting exports to the global market. Lessons for Vietnam from other countries’ experiences
include: exchange rate system should be flexible, suitable for each period of Vietnam’s
development, coherent and synchronic in operating exchange rate policy; and the implementation of
exchange rate policy needs synchronic co-ordination with other macroeconomic policies.
Fourth, studying the reality of the relation between exchange rate USD/VND and the Vietnam
balance of payments figures out some following points:
+ Even though the real nominal bilateral exchange rate USD/VND is likely to increase over
time, in recent years, under the pressure of inflation, the real value of VND tends to rise compared
to USD and other currencies of main commercial partners. This fact lowers the competitiveness of
price of Vietnam goods in the world market, worsens trade balance and heightens the pressure on
the balance of payments.
+ In the long term, developments of the real effective exchange rate REER and trade balance

are likely to be in same direction when the export elasticity coefficient is higher than import one.
+ It is obviously seen in research results that exchange rate and domestic income have both
impacts on trade balance in the long term and short term. However, trade balance is improved
partially only when the real exchange rate is adjusted to increase but can not limit import demand of
the economy because the marginal trend of import does not depend on subjective opinions of the
administration.
+ Research results in the long term show that Marshall-Lerner condition is satisfactory. These
results support views of some policy-makers and international financial organizations which
suggest that VND should be devalued and be a compass for solutions to operate exchange rate
policies in the future at Chapter 3.
Finally, based on research of the reality and quantifying effects of exchange rate USD/VND
at Chapter 2, the author suggests some proposals to orient and complete exchange rate policy in
order to improve trade balance, thus improving the balance of payments, and some specific
solutions needs implementing in the future. The thesis’s suggestions is that in the long term,
Vietnam needs to orient BBC exchange rate system and in the short term VND should be adjusted
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in order to make the real exchange rate higher than 1 so that Vietnam’s trade balance in the future
will be improved. In addition, the author creates scenarios to adjust exchange rate VND in the next
two years correlatively with prediction of Vietnam’s inflation, interest, economic growth and other
regional nations’, especially America’s.
Even though there are many efforts to fulfill the thesis and obtain research results above, the
thesis still maintains shortcomings because research on exchange rate, the balance of payments and
their relation are difficult, complicate and the author’s limited ability. Therefore, the author hopes
that the thesis will get support and contributory opinions from scientists to make the thesis more
complete.
Sincerely thank!
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