EXCHANGE RATE POLICY AND TRADE BALANCE a CASE STUDY OF VIETNAM

MINISTRY OF EDUCATION AND TRAINING
FOREIGN TRADE UNIVERSITY

DISSERTATION

EXCHANGE RATE POLICY AND TRADE BALANCE:
A CASE STUDY OF VIETNAM

Major: International Trade Policy and Law

NGUYEN PHUONG DUNG

Ha Noi - 2017


MINISTRY OF EDUCATION AND TRAINING
FOREIGN TRADE UNIVERSITY

DISSERTATION

EXCHANGE RATE POLICY AND TRADE BALANCE:
A CASE STUDY OF VIETNAM

Major: International Trade Policy and Law

Full Name: Nguyen Phuong Dung
SUPERVISOR: DR. NGUYEN PHUC HIEN

Ha Noi - 2017

i
DECLARATION
I hereby declare that the dissertation is my own research and was completed by the
guidance by Dr. Nguyen Phuc Hien.
The research results are independence, faithful and have never been disclosed. The
data in the in tables and figures serving for analysis and evaluation were collected,
inherited and developed by the writer from different sources (published research of
other authors, magazine, website) with clear and transparent quotes.
I will be entirely responsible for the dissertation‘s contents.

Hanoi, December 5th 2016
Author

Nguyen Phuong Dung.


ii
ACKNOWLEDGEMENT
The dissertation has been completed under the guidance of Dr. Nguyen Phuc Hien. I
would like to express my sincerely thanks for his great knowledge and enthusiasm
supports for my research.
Besides, I would like to thank my family, my colleagues who have given me lots of
facilitation, cares, and encouragement during my research period.
By this occasion, I am much grateful to the Department of Graduate Studies and
Foreign Trade University - who have always create the most favorable conditions
for MITPL3 to complete our research program.


iii
TABLE OF CONTENTS

INTRODUCTION .......................................................................................................1
1. The importance of research ............................................................................1
2. Research purpose ............................................................................................2
3. Scope of the research ......................................................................................2
4. Research Methodology ...................................................................................3
5. Structure .........................................................................................................3
LITERATURE REVIEW............................................................................................4
CHAPTER 1: ..............................................................................................................9
THEORY OF EXCHANGE RATE POLICY AND TRADE BALANCE ................9
1.1 Exchange rate ...............................................................................................9
1.1.1 Definition of exchange rate.................................................................9
1.1.2 Exchange rate policy and regime ......................................................14
1.2 Trade balance..............................................................................................21
1.2.1 Definition of trade balance ...............................................................21
1.2.2 Factors affecting trade balance .........................................................21
1.3 Impacts of exchange rate policy on trade balance ......................................24
1.3.1 Concept of currency devaluation ......................................................24
1.3.2 J-Curve Effect ..................................................................................25
1.3.3 Marshall-Lerner Condition ...............................................................26
CHAPTER 2: ............................................................................................................28
EXCHANGE RATE POLICY AND TRADE BALANCE IN VIETNAM .............28
2.1 Overview of exchange rate policy and trade balance in Vietnam ..............28
2.1.1 Exchange rate policy of Vietnam .....................................................28
2.1.2 Trade balance of Vietnam .................................................................46


iv
2.2 Empirical study on the impacts of Vietnam exchange rate policy and the
trade balance ..............................................................................................58
2.2.1 Methodology .....................................................................................58

2.2.2 Empirical Result ...............................................................................63
CHAPTER 3: ............................................................................................................69
RECOMMENDATIONS ON EXCHANGE RATE POLICY TO IMPROVE
TRADE BALANCE..................................................................................................69
3.1 Orientation of Vietnam in the context of deeper economic integration .....69
3.2 Recommendation on exchange rate policy of Vietnam to improve trade
balance .......................................................................................................71
3.2.1 Moving to a flexible exchange rate ..................................................71
3.2.2 Coordination between exchange rate policy and other macro policies
...........................................................................................................................74
CONCLUSION .........................................................................................................79
REFERENCES ..........................................................................................................81
APPENDIX
DATA DESCRIPTION .............................................................................................86


v
LIST OF ABBREVIATION
ASEAN

Association of Southeast Asian Nation

CPI

Comsumer Price Index

EU

European Union

FDI

Foreign Direct Investment

IFS

International Financial Statistics

IMF

International Monetary Fund

OER

Offical exchange rate

USA

United States of America

USD

United States dollar

VND

Vietnamese dong

WB

World Bank

WTO

World Trade Oranization


vi
LIST OF TABLES
Table 1: Exchange rate arrangements .......................................................................18
Table 2: Advantages and disadvantages of each exchange rate regime ...................19
Table 3: Exchange rate amplitudes adjustment, 1996 - 2000 ...................................32
Table 4: Exchange rate amplitudes adjustment, 2001 - 2007 ...................................33
Table 5: Exchange rate amplitudes adjustment, 2008 - 2015 ...................................39
Table 6: Exchange rate adjustment, 2008 - 2015 ......................................................39
Table 7: Vietnam's exchange rate regimes, 1989 - 2016 ..........................................42
Table 8: Vietnam‘s macro-economic data, 1996 - 2000 ...........................................48
Table 9: Export - Import market structure, 2000 - 2005 ...........................................50
Table 10: Vietnam‘s macro-economic data, 2001 - 2007 .........................................51
Table 11: Export - Import market structure, 2005 - 2015 .........................................54
Table 12: Vietnam‘s macro-economic data, 2008 - 2015 .........................................56
Table 13: Export - Import between Vietnam and US ...............................................57
Table 14: Correlation ................................................................................................63
Table 15: Lag order selection criteria .......................................................................64
Table 16: Short run variance decompositions ...........................................................65
Table 17: Johansen ....................................................................................................66
Table 18: Long run variance decompositions ...........................................................67


vii

LIST OF FIGURES
Figure 1: NEER calculation ......................................................................................11
Figure 2: REER caculation........................................................................................12
Figure 1: J-Curve Effect in currency devaluation .....................................................26
Figure 2: Vietnam inflation rate, 1980 - 1996 ..........................................................29
Figure 3: VND/USD exchange rate, 1996 - 2000 .....................................................31
Figure 4: VND/USD exchange rate, 2001 - 2007 .....................................................33
Figure 5: VND/USD exchange rate, 2008 - 2015 .....................................................34
Figure 6: VND/USD exchange rate in 2016 .............................................................41
Figure 7: VND/USD NBER and RBER, period of 1996 - 2000 ..............................47
Figure 8: Exchange rate and trade balance, 1996 - 2000 ..........................................47
Figure 9: VND/USD NBER and RBER, 2001 - 2006 ..............................................49
Figure 10: Exchange rate and trade balance, 2001 – 2007 .......................................50
Figure 11: VND/USD NBER and RBER, 2008 - 2015 ............................................52
Figure 12: Exchange rate and trade balance, 2008 - 2015 ........................................53
Figure 13: Trade balance in 2016..............................................................................55
Figure 14: Short run Impulse response function .......................................................64
Figure 15: Short run variance decompositions .........................................................65
Figure 16: Long run Impulse response function .......................................................66
Figure 17: Long run variance decompositions ..........................................................67


viii
SUMMARY
The dissertation with the topic of ―Exchange Rate Policy and Trade Balance:
A case study of Vietnam‖ has reiterated several theories about the exchange rate,
exchange rate policy and trade balance, the factors affecting the exchange rate and
the trade balance, the J-curve Effects and Marshall-Lerner conditions. Besides, the
authors also summarize the exchange rate policy, the trade balance of Vietnam over
the periods since the Renovation (Doi Moi).

Besides, in empirical study, by using the VAR model, the study has analyzed
the impact of the real bilateral exchange rate of VND versus USD and the trade
balance of Vietnam focusing on the quarterly data of the period of 2007 Q1 – 2016
Q2 (after Vietnam‘s accession to the WTO).
The empirical study shows that in the case of Vietnam: (1) the movement of
exchange rate only slightly affects trade balance (2) not only the exchange rate but
also other factors have a significant impact on trade performance in Vietnam. (3)
GDP has the largest effect to trade balance.
Based on the result, the author gives some recommendation on improving the
trade balance, including: (1) Increasing the management floating (2) Coordination
between exchange rate policy and other macro policies.


1

INTRODUCTION
1. The importance of research
The trade deficit is a matter of great concern to the countries around the world,
due to its impact on the macro-economic balance. As a WTO member involved in
the process of international economic integration, Vietnam has faced many
challenges, including the problem of trade deficit. According to data from the
General Statistics Office, the trade balance of Vietnam often falls into serious
deficits. Therefore, when performing a macroeconomic research, we could not
disregard this unsettled problem.
On December 28th, 2011, Prime Minister Nguyen Tan Dung has issued the
Decision 2471/QĐ-TTg1 that approved The Strategy on export and imports for the
period of 2011-2020, with visions to 2030. The overall targets were set with the
total export turnover in 2020 should triple in 2010, with a per capita average of over
USD 2,000; the trade balance is secured. Specific targets were given as following:
- The average growth rate of exports should be 11-12% per year in 2011-2020,

or 12% in 2011- 2015 and 11% in 2016-2020. The figure should be kept at 10% in
2021-2030.
- The growth rate of imports should be lower than that of exports, standing at
10-11% on average per year in 2011-2020, or below 11% in 2011-2015 and below
10% in 2016-2020.
- It is necessary to gradually reduce the trade deficit and keep the excess of
import over export below 10% of the export turnover by 2015 so as to guarantee the
trade balance by 2020 and reach trade surplus in 2021-2030.
The prerequisite for Vietnam to achieve the above objectives is to ensure the
coordination between macroeconomic policies, including exchange rate policy. The
exchange rate is an important variable in the open economy and implementing the
exchange rate policy is very important for each country. Exchange rate interacts
closely with macroeconomic indicators such as interest rates, inflation, economic
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2

growth and the international balance of payments. In particular, the mutual
interaction between these variables is deeper in the countries applying the fixed
exchange rate or managed floating, or anchored to a currency regime.
Currently, there are many controversial issues surrounding the exchange rates
of Vietnam. There are two conflicting views. The first point that the real exchange
rate of Vietnam is overvalued, so the devaluation is necessary to promote exports
and restrict imports. The second opinion is from the State Bank; the devaluation has
no impact on Vietnam trade balance due to the exports of VN is inelastic by price
(Governor Le Minh Hung – SBV).
Is Vietnamese currency overvalued or low? And how can it affect the balance

of trade of Vietnam? Can Vietnam's exchange rate policy meet the goal of
improving the trade balance? Therefore, this dissertation will research the
relationship between exchange rates and trade balances in the case of Vietnam.
2. Research purpose
To answer the questions:
- Whether the changes in exchange rate influence the trade balance in
Vietnam?
- What is the most effective exchange rate policy for Vietnam to improve trade
balance?
3. Scope of the research
- Focusing on the impact of real exchange rate of US dollar against VND on
trade balance over period 2007 – 2016.
- The data: The data is mainly collected from the data sources of the
International Monetary Fund (IMF) and Vietnam General Statistical Office (GSO),
the State Bank of Vietnam (SBV). Other data is from the Ministry of Finance,
World Bank (WB), Asian Development Bank (ADB)... In case there are some
difference between the data of GSO, SBV and IMF and the author decide to choose
the data from IMF.


3

4. Research Methodology
In the study, the author use some research methods such literature study,
comparative study, quantitative analysis. Besides, the dissertation used vector auto
regression (VAR) model for research goal. Exchange rate, trade balance and gross
domestic product (GDP) are interdependence relationships, therefore VAR model is
one of the most successful, flexible, and easy to use models for the analysis of
multivariate time series. It is a natural extension of the univariate autoregressive
model to dynamic multivariate time series. The VAR model has proven to be

especially useful for describing the dynamic behavior of economic and financial
time series and for forecasting.
The study applies VAR model to confirm if the causal relationships among
variables exist and what impact directions of the relationships are. The study also
computes impulse response functions to know the impact of a shock in depreciation
on trade balance and computes variance decomposition to understand the role of
exchange rate in the variance of trade balance.
5. Structure
The dissertation includes 3 chapters as follow:
Chapter 1: Theory of exchange rate policy and trade balance
Chapter 2: Exchange rate policy and the trade balance of Vietnam
- Overview of exchange rate policy and the trade balance of Vietnam
- Empirical study on the impacts of Vietnam‘s exchange rate policy and the
trade balance
Chapter 3: Recommendations on exchange rate policy to improve the trade
balance


4

LITERATURE REVIEW
Kirstian Nilsson and Lars Nilson (2000) in their paper ―Exchange rate
regimes and Export Performance of Developing Countries‖ have analyzed the
exports of 100 developing countries to the EU‘s member countries, Japan, USSA
and covers some 70-80% of these developing countries and the net effects of
developing countries‘ choice of exchange rate regime on their exports. The issue
should be highly relevant for policy makers since export-led growth is often put
forward as a main development strategy for developing countries. The authors
introduced a gravity model for estimating the exporting effects of different
exchange rate regimes for the period 1983 to 1992 using OLS. The results indicated

that the more flexible the exchange rate regime, the greater the exports of
developing countries, holding other things constant. The result is stable over time.
The fact that the number of developing countries under the various exchange rate
regimes has fluctuated substantially over the study period implies that the results are
quite robust. The findings may be interpreted such that the net effects on exports of
real exchange rate misalignments (over and undervaluation) are negative, and that
these effects dominate the potentially negative export effects of exchange rate
volatility in relation to the invoicing currency of exports.
Tihomir Stucka (2004), in his paper ―The Effects of Exchange rate change
on the Trade Balance in Croatia‖, aimed at a formal quantitative estimate of the
long-run and short-run impacts of exchange rate changes on the merchandise trade
balance. The author utilized three different econometric techniques - the ARDL
approach. The results seem to suggest that improvement of the trade balance after a
permanent devaluation/depreciation is very limited. A 1% permanent devaluation
results in a new equilibrium level, which is 1.34% above the old equilibrium, at
best. Also, the initial adverse effect in the shape of a J-curve phenomenon might be
significant. Hence, before drawing conclusions from the estimated reduced form
model one has to weigh trade balance benefits with potential unfavorable effects of
a permanent depreciation.


5

Dinh Thi Thuy Vinh (2007) in her paper ―The Impact of Real Exchange
Rate on Output and Inflation in Vietnam: A VAR approach‖ Vietnam using VAR
approach‖ showed that although the main sources of variance in output and price
level are ―own shocks‖, innovations in the real exchange rate account for a higher
proportion of the variation of output than that of price level. A real devaluation has
positive impact on both output and inflation. The devaluation shock may affect
inflation and output growth via raising money supply and improving trade balance.

However, the real exchange rate changes do not have a significant effect on output
in the long run. The results derived in this study support the argument that Vietnam
should move to a more flexible exchange rate regime, or Vietnam should not insist
on controlling the exchange rate while being under pressure of economic integration
that forces the exchange rate regime to a more floating one. The study showed that
greater flexibility of the exchange rate will help the economy improve its trade
balance and increase the output growth, while the inflation situation is not seriously
affected. Furthermore, when Vietnam fully integrates into the world economy in the
near future, it will face more foreign competition and external shocks while the
functions of other macroeconomic instruments such as tariffs or export subsidies are
restricted. Then, greater flexibility would facilitate adjustments to external shocks
and rapid structural changes, and allow for a further strengthening of Vietnam‘s
exchange reserve situation. The change of US interest rate should be taken into
consideration in planning and carrying out monetary policies. In addition, in the
long-run, the impact of real exchange rate on the output level, though positive, but
not so statistically significant. Therefore, not the exchange rate instrument, but
enterprise efforts, structural or institutional reforms are the main sources for
improving the competitiveness of the economy.
Ng Yuen-Ling, Har Wai-Mun, Tan Geoi-Mei (2008), in their paper ―Real
Exchange Rate and Trade Balance Relationship: An Empirical Study on Malaysia‖,
attempted to identify the relationship between the real exchange rate and trade
balance in Malaysia from the year 1955 to 2006. The study used Unit Root Tests,
Cointegration techniques, Engle-Granger test, Vector Error Correction Model
(VECM), and impulse response analyses. In the research, the results support the


6

empirical validity of the Marshall-Lerner condition through VECM, indicating that
depreciation has improved the trade balance. This result has further confirmed

through the empirical work reported by Baharumshah (2001). The empirical work
for a different set of countries that reported by Shirvani and Wilbratte (1997),
Sugema (2005), Akbostanci (2002) and Thorbecke (2006) are also suggested
Marshall-Lerner condition exists. However, VECM analysis does not find the
evidence of the short term worsening of trade balance suggested by the J-curve
effects. Thus, by using impulse response functions, the result show that Malaysian
trade balance has not followed the J-curve pattern of adjustment or in another
word, the result shows no evidence for the J-curve hypothesis. This result is
consistent with Baharumshah (2001). The empirical work for different set of
countries that reported by Rose and Yellen (1989), Akbostanci (2002), Ahmad and
Yang (2004), Gomez and Alvarez-Ude (2006), also suggested that no evidence of Jcurve effects. The author implicated that, in order to achieve the desired effects on
trade balance, the countries should depend on policy that focusing on the variable of
real exchange rate, which is the nominal exchange rate to aggregate price level. At
the same time, the devaluation-based policies (affected through changes in nominal
exchange rate) must cooperate with stabilization policies (to ensure domestic price
level stability) to achieve the desired level of trade balance. However, devaluationbased policies had caused some problem. Devaluation-based policies would cause
increases in the cost of import. This might lead to import inflation that would
damage the domestic firms that use imported inputs. Besides that, the devaluationbased policies may not effective in improving trade balance if other countries also
apply the devaluation-based policies at the same time. On the other hand, the
countries should implement the policy that focuses on the production of importedsubstituted goods. Import-substitution policy may work well in improving domestic
income and trade balance.
Elif Guneren Genc and Oksana Kibritci Artar (2014) in their paper ―The
Effect of Exchange Rate on Exports and Imports of Emerging Countries‖ have
determined the impact of exchange rates on imports and to investigate the impact of
exchange rates on exports of economically developing countries. This paper


7

focused on establishing whether there is a co-integrated relationship between

effective exchange rates of selected emerging economies. The study applied the
methodology of the co-integration Panel Mode for the period of 1985-2012. The
result of this study shows that there is co-integration between real effective
exchange rate and export-import of emerging economies in the long run. In total 5
of 22 emerging countries (Bolivia, Cameroon, Dominica, Gabon and Mexico) have
both long-term relationship and short-term parameters and are statistically
significant. It is concluded that overall findings indicate that exchange rate effects
support the expected results for the selected emerging countries.
Nicola Kim Rowbotham, Adrian Saville & Douglas Mbululu (2014) in
their paper ―Exchange Rate Policy and Export Performance in Efficiency-Driven
Economies‖ have examined the impact of exchange rate on export performance in a
sample of nine efficiency-driven economies over the period 1990 to 2009 (Brazil,
the Dominican Republic, Malaysia, Mauritius, Mexico, Peru, South Africa,
Thailand and Turkey, which all have floating exchange rate arrangements during
the survey period). They used Panel data models with fixed-effects method. The
purpose of the research was to assess whether efficiency-driven economies,
developing could achieve export growth through the price competitiveness effect
that is brought about by currency depreciation. In this regard, Prebisch (1964)
developed the early arguments that currency weakness was a means to boost export
performance through price competitiveness. Subsequent research has produced
mixed results and has tended to be limited in terms of sample size and survey
period. Hence, further research in this field is justified. Their principal finding in
this regard, which extends to a sample of 9 economies over a period of twenty
years, is that a weakened currency does not improve export performance. Contrary
to popular thinking, their findings show that export growth is associated with
currency strength in the case of efficiency-driven economies with flexible exchange
rate regimes. Moreover, when they allow for lag effects of exchange rate
movement, the impact on export performance is slightly more pronounced –
although the explanatory power of currency moved is statistically insignificant in
the lagged specifications of our model. Moreover, they found that any explanatory

8

power afforded by currency is superseded by the explanatory power of GDP
growth. It suggests that export growth may be impacted to a greater extent by
income than price.
Ramesh C. Paudel and Paul J. Burke (2015) in their paper ―Exchange rate
policy and export performance in a landlocked developing country: The case of
Nepal‖ have examined the implications of Nepal‘s exchange rate policy for its
export performance over the period 1980–2010. The authors first documented
Nepal‘s long-standing currency peg against the Indian rupee and that Nepal‘s real
exchange rate appreciated substantially from the late 1990s. They used a gravity
modeling approach to confirm that this real exchange rate appreciation has
adversely affected Nepal‘s exports, especially to third-country markets. Nepal‘s
exchange rate-related export competitiveness trap provides a motivation to
reconsider the current peg.
In conclusion, theoretical and empirical research proved that there is a
relation between trade balance and exchange rate policy and policy makers can use
the exchange rate to manage export and import performance to reach the trade
balance target. However, both exchange rate and trade balance are affected by many
different factors that make their relationship difficult to understand and difference
to each country. It requires countries to scrutinize and adopt the flexible measure to
achieving trade balance target.


9

CHAPTER 1:
THEORY OF EXCHANGE RATE POLICY AND TRADE BALANCE

1.1 Exchange rate
1.1.1 Definition of exchange rate
1.1.1.1 Definition
According to Business Dictionary2, exchange rate is the price for which the
currency of a country can be exchanged for another country currency.
According to Oxford Dictionaries3, exchange rate is the value of one currency
for the purpose of conversion to another.
According to the Investopedia

4

, exchange rate is the price of a

nation‘s currency in terms of another currency.
In conclusion, exchange rate is “the price for which the currency of a
country can be exchanged for another country currency”.
Within the scope of this thesis, the concepts of ―exchange rate‖ and ―foreign
exchange rates‖ are used interchangeably to specify the price of a unit of foreign
currency (USD) in terms of the domestic currency of VND (direct quotation). This
means, the increases in exchange rate mean the local currency depreciates and vice
versa.
1.1.1.2 Classification of exchange rate based on the relations between
these currencies:
Exchange rate is classified based on many criteria: Business transactions
(Bid rate – Ask/Offer rate), Maturity (spot, forward), Market (official rate – market
rate) and the relationship between currencies. Classification according to the
relationship between currencies is an important criterion, applied in objectives
research on competitiveness in trade between countries. In the process of
understanding the competitiveness of prices of goods and services between
2

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10

countries, instead of using the exchange rate, the researchers often use the index
rate (evaluated at a base year) for comparison. The exchange rate index includes:
- Nominal Bilateral Exchange Rate (NBER): NBER is the actual quote for a
currency versus another currency without mentioning the inflation differences
between the two countries.
- Real exchange rate (RBER): Real exchange rate consists of the rate of
exchange rate adjusted for purchasing power.

RBER: real exchange rate
NBER: The nominal bilateral exchange rate
Pf: Foreign price level

Ph: Domestic price level.

If RBER = 1, domestic currency and foreign currency has the same purchasing
power parity (PPP).
If RBER > 1, domestic currency is undervalued. This will help to encourage
export and restrict import.
If RBER < 1, domestic currency is overvalued, the price of product in
domestic will be higher than in the foreign country. It will help to restrict export and
increase import.
- Nominal Effective Exchange Rate (NEER): NEER is not an exchange rate.
NEER is an index that is an unadjusted weighted average rate at which one

country's currency exchanges for a basket of multiple foreign currencies. This
basket of foreign currencies is chosen on the basis of the domestic country's most
important trading partners, as well other major currencies.
Unlike the relationships in a nominal exchange rate, NEER is not determined
for each currency separately. Instead, one individual number, typically an index,
expresses how a domestic currency‘s value compares against multiple foreign
currencies at once.


11

If domestic currency increases against a basket of other currencies inside a
floating exchange rate regime, NEER is said to appreciate. If the domestic currency
falls against the basket, the NEER depreciates.
Exchange
rates
(Eit)
Weight
(wit)

Averaging
Formula

NEER
𝒏

𝒆𝒊𝒋

𝑒𝑛𝑖 = Ei/𝐸𝑛𝑖

𝒘𝒋

𝑱=𝟏

Figure 1: NEER calculation
Source: Author’s description based on NEER definition.
In economics, the NEER is an indicator of a country's international
competitiveness in terms of the foreign exchange market.
The NEER just only describes the relative value; it cannot definitively show
whether a currency is strong or gaining strength in real terms. It only describes
whether a currency is weak or strong, or weakening or strengthening, compared to
foreign currencies. With all exchange rates, the NEER can help identify which
currencies store value more or less effectively. Exchange rates influence where
international actors buy or sell goods. NEER is used in economic studies and for
policy analysis about international trade.
- Real effective exchange rate (REER): Is the weighted average of a country's
currency relative to an index or basket of other major currencies, adjusted for the
effects of inflation. The weights are determined by comparing the relative trade
balance of a country's currency against each country within the index. In other
ways, the NEER may be adjusted to compensate for the inflation rate of the home
country relative to the inflation rate of its trading partners and the resulting figure is
the REER.
The REER is used to measure the value of a specific currency in relation to an
average group of major currencies. The REER takes into account any changes in


12

relative prices and shows what can actually be purchased with a currency. This
means that the REER is normally trade-weighted.

By calculation, the REER is derived by taking a country's NEER and
adjusting it to include price indices and other trends. The REER, then, is essentially
a country's NEER after removing price inflation or labor cost inflation. The REER
represents the value that an individual consumer pays for an imported good at the
consumer level. This rate includes any tariffs and transaction cost associated with
importing the good. Besides, the REER can also be derived by taking the average of
the bilateral real exchange rates (RER) between country and its trading partners and
then weight it using the trade allocation of each partner. Regardless of the way in
which REER is calculated, it is an average and considered in equilibrium when it is
overvalued in relation to one trading partner and undervalued in relation to a second
partner.
A country's REER is an important measure when assessing its trade
capabilities and current import/export situation. The REER can be used to measure
the equilibrium value of a country's currency, identify the underlying factors of a
country's trade flow, look at any changes in international price or cost competition,
and allocate incentives between tradable and non-tradable sectors.
A country can positively affect its REER through rapid productivity growth.
When this happens, the country realizes lower costs and can reduce prices, thus
making the REER more advantageous for the country.
Exchange
rates (Eit)
Weight
(wit)
Relative
price or cost
indices (P,
𝑷∗𝒊𝒕 )

Averaging
Formula

𝑒𝑛𝑖 = Ei/𝐸𝑛𝑖

Figure 2: REER caculation
Source: Author’s description based on REER definition.

𝒏

REER
𝒆𝒊𝒋

𝑱=𝟏

𝒘𝒋

𝑷𝒋
𝑷∗𝒋


13

1.1.1.4 Factors that influence exchange rate:
- Interest rates
+ Interest rate differential between local currency and foreign currency
According to the study of John Maynard Keynes about the Interest Rate Parity
theory (IRP), the equilibrium of foreign exchange market requires the equilibrium
of interest rates; interest rates of deposits in two different currencies must be the
same when converting into one currency. Keynes has explained that under normal
conditions, arbitrage opportunities will prevail until forward prices are in line with
interest rate differential. As a result, interest differential is offset by profit or loss on
the forward market. Thus, the lower interest rate on one country‘s currency will be

compensated by higher forward price compared to that of the currency of the
country with higher interest rates.
+ Foreign currency interest rate difference between domestic and foreign
market
When a country has higher interest rate on foreign currency deposits in
comparison with that of another country, capital will flow into the country with
higher interest rate. This inflow would push the supply of foreign currency up.
Because of the exogenous factor, the supply curve of USD moves rightward; the
exchange rate will go down.
However, sometimes the interest rate differential did not make the change in
exchange rate. These situations normally happen when an economy is in unstable,
potentially crisis-like, condition. Under that situation, even though how high the
interest rate would be, investors will not risk their capital to earn profit from interest
rate differential. A typical example of the situation is the economic crisis during the
period of 1971-1973; the interest rate in New York market was 1.5 times that of
London market, triple that of Frankfurt market but the short-term capital flow were
not directed to New York but Western Germany and Japan.
- Inflation rate differential


14

If a country‘s inflation rate increases relative to the foreign country while
other things being equal, the domestic currency will be depreciated. Therefore, the
domestic have more demand for foreign currency. The export of country is
relatively more expensive and the foreigners will have less demand for country‘s
export. Therefore, due to the increase of exchange rate (the domestic currency is
devalued), the demand of foreign currency increase while the supply of foreign
currency decrease.
- Management policy: If the government want to protect their industries‘

competitiveness, they can use protectionism method like tariffs, tax, and other nontax barriers…The Government can use quota to limits the import‘s volume, or
increase the income tax on aboard investment or tax on imported goods... to reduce
the demand for foreign currency. The demand for the foreign decrease and the
exchange rate goes down.
1.1.2 Exchange rate policy and regime
IMF suggests the discrimination of exchange rate policy regime with 4 main
groups, including Hard pegs, Soft pegs, Floating regime and Residual. This
classification became effective on February 2nd, 2009.
1.1.2.1 Hard pegs
- Exchange arrangements with no separate legal tender
The currency of another country circulates as the sole legal tender (formal
dollarization), or the member belongs to a monetary or currency union in which the
same legal tender is shared by the members of the union.
Adopting such regimes implies the complete surrender of the monetary
authorities' independent control over domestic monetary policy.
- Currency board arrangements
A monetary regime based on an explicit legislative commitment to exchange
domestic currency for a specified foreign currency at a fixed exchange rate,
combined with restrictions on the issuing authority to ensure the fulfillment of its
legal obligation.


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This implies that domestic currency will be issued only against foreign
exchange and that it remains fully backed by foreign assets, eliminating traditional
central bank functions, such as monetary control and lender-of-last-resort, and
leaving little scope for discretionary monetary policy. Some flexibility may still be
afforded, depending on how strict the banking rules of the currency board
arrangement are.

1.1.2.2 Soft pegs
- Conventional fixed peg arrangements
The country formally pegs its currency at a fixed rate to another currency or a
basket of currencies, where the basket is formed from the currencies of major
trading or financial partners and weights reflect the geographical distribution of
trade, services, or capital flows. The anchor currency or basket weights are public or
notified to the IMF.
The country authorities stand ready to maintain the fixed parity through direct
intervention (i.e., via sale or purchase of foreign exchange in the market) or indirect
intervention (e.g., via exchange-rate-related use of interest rate policy, imposition of
foreign exchange regulations, exercise of moral suasion that constrains foreign
exchange activity, or intervention by other public institutions).
There is no commitment to irrevocably keep the parity, but the formal
arrangement must be confirmed empirically: the exchange rate may fluctuate within
narrow margins of less than 1% around a central rate—or the maximum and
minimum values of the spot market exchange rate must remain within a narrow
margin of 2% for at least six months.
- Pegged exchange rate within horizontal bands
Classification as a pegged exchange rate within horizontal bands involves
confirmation of the country authorities‘ de jure exchange rate arrangement. The
value of the currency is maintained within certain margins of fluctuation of at least
1% around a fixed central rate, or a margin between the maximum and minimum
value of the exchange rate that exceeds 2%.