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1.1. Background the thesis In Vietnam exchange rates were unified in March 1989. Since then, the Vietnamese Government has applied a managed float exchange rate regime aimed at matching the official rate with the parallel one. A non-official market for foreign exchange has existed for long time in parallel with the official one, and has been recognized by not only the public, but also the authorities. Although there have been a lot of studies considering the subject of exchange rate in Vietnam, it does not appear to have a work which considers the parallel exchange rate as a dependent subject for investigating. Therefore, it is time to undertake a quantitative analysis on determinants of the parallel market exchange rate in Vietnam. This thesis is an attempt at investigating the subject. 1.2. Focus and scope of the thesis The scope of this thesis is to examine Vietnam's fundamental short-run determinants of the parallel market US exchange rate in recent four years, from the beginning of 1997 to the end of 2000. 1.3. Research questions The major objective of this thesis is to make an effort to answer the following questions: 1. What were the fundamental determinants of the short-run foreign exchange rate in Vietnam's parallel market during 1997-2000? 2. Has the magnitude of these determinants stabilized during 1997-2000? 3. What are macroeconomic policy implications concerning Vietnam's determinants of the parallel rate in the context of the goal of achieving market stability to contribute to proper exchange rate arrangements? 1.4. Methodology of the thesis The method of analysis used in the thesis is mainly quantitative. The data used is weekly secondary data. Data for exchange rates (official and parallel) and other micro-data are directly calculated from the primary daily database by the author. Macro data is withdrawn from monthly or yearly secondary data through linear interpolation. Sources for the data are the State Bank of Vietnam, the General Statistic Office, Central Institute for Economic Management, the Information Center for Development, the World Bank, and related published works. 1.5. Structure of the thesis The thesis consists of five chapters. Chapter 1 is the introduction. Chapter 2 provides an analytical framework. Chapter 3 presents an overview of Vietnam parallel foreign exchange market. Chapter 4 is devoted to testing hypothesis. Chapter 5 summarizes the main findings and offers policy recommendations as well as discusses the research limitations for further study. The Economics of Parallel Foreign Exchange Markets 2.1. Definitions Kiguel et al. (1997) define parallel foreign exchange systems as those in which a market - determined exchange rate, typically applying to financial transactions but often to a portion of trade transactions as well, coexists with one or more pegged exchange rates (p. 17). Ghei and Kamin (1999) define a parallel foreign exchange market system as one in which transactions take place at more than one exchange rate (ER) and at least one of the prevailing rate is a freely floating, market-determined rate (the parallel exchange rate - PER). Parallel market systems represent a subset of the broader category of multiple ER regimes, which refer to any regimes in which two or more ERs are applied to the same currency (p. 499). Grosse (1994) focuses on the concept of black market and distinguishes it from that of parallel market. He defines a foreign exchange (FE) black market as a market for purchase/sale of foreign currency that operates outside the legal financial system of a country (p. 1). Thus, FE black market is distinguished from a FE parallel market in that the former is a subset of the later. In general, parallel markets are simply FE markets that operate parallel to the official market that is carried out through a country's commercial banking system. Parallel markets may be legal or illegal, but they involve nonbank intermediaries. Black markets are parallel markets that explicitly operate outside of the legal rules in the country. 2.2. Analytical framework 2.2.1. Market Analysis 2.2.1.1. The Demand Side The principal demand for parallel FE market comes from the two sources whose restricted access to the official market led to creation of the parallel market. Firstly, those importers whose ability to buy foreign goods is prohibited for any reason may resort to extra-legal sources of funds to buy those goods and often also to smuggling to bring the goods into the country from which they are restricted. Secondly, those investors/savers who wish to hold overseas funds or just foreign-currency instruments, but who are prohibited from doing so, may resort to the parallel market to obtain those funds. 2.2.1.2. The Supply Side On the supply side of the FE parallel market, a variety of participants are also arrayed. Firstly, The phenomenon of underinvoicing exports that are passed through the official market is one source of dollars into the parallel market. Additional exports may produce FE that is brought into the country through the parallel market when they are exported as contraband. Secondly, FE also may be brought into the parallel market by local residents living abroad, when they choose to remit funds to their relatives or friends or to invest funds locally. These expatriates may decide to use the parallel market for their remittances because of its favorable ER going from foreign to local currencies, or to evade taxes on wealth or income from abroad. Thirdly, a category of participant on the supply side in the parallel market are arbitrageurs, who profit from buying FE in the official market and selling it in the parallel market. These participants are especially sensitive to fluctuations in the ER. 2.2.2. Models of Parallel Exchange Rate Determination 2.2.2.1. Grosse's Linear Model Based on an analysis of the interaction between demand and supply Grosse (1994) develops a simple linear model of black/paralle ER determination in Latin American countries. · The demand side: - + - - - + Dbm = d(PER; Idom-Ifor; risk; idom-ifor; PER-OER; domestic wealth) where: Dbm : demand for FE in the black market PER : ER in the black market, local currency/USD OER : ER in the official market, local currency/USD I : inflation, domestic (dom) and foreign (for) i : interest rate, domestic (dom) and foreign (for) wealth : value of domestic wealth people hold, can be measured by GDP, or total time deposits held by the people. risk : cost of getting caught in the black market, measured by the penalties imposed by the studied country's Government on violators of the ER laws. · The supply side: + - + + + Sbm = s(PER; risk; idom-ifor; PER-OER; overseas wealth) where the variables are defined previously, and where overseas wealth refers to foreign currency wealth of domestic savers and overseas wealth of expatriates who remain overseas. · The reduced equation: To estimate the price of black/parallel market dollars, the two structural relationships are transformed into implicit price (ER) functions and then presented in a reduced form equation, as shown:
Pbm = a - b1(idom-ifor) + b2(Idom-Ifor)
- b3(PER-OER) - b4(overseas wealth) + Limitation of the model: Some of the proxy variables obtained for use in the estimations may be highly correlated among themselves (they had correlation coefficients higher than 0.5). For example, the value of the country's dollar deposits in US banks may be highly correlated with both the country's GDP and with domestic wealth. Similarly, the foreign assets may be highly correlated with GDP and with the main inflation measure used in the equations. The domestic wealth measures tend to be highly positively correlated, as do the foreign asset measures, and the domestic wealth measures may be highly negatively correlated with the foreign asset measures. For this reason, the estimations need using varying specifications to try to overcome the intercorrelations.
The thesis aslo instroduces two more models of PER determination, namely:
AN OVERVIEW OF VIETNAM PARALLEL FOREIGN EXCHANGE MARKET 3.1. The Exchange rate policy changes in 1989-2000 During the period of 1989-2000, Vietnam ER policies experienced a lot of changes towards a more and more flexible ER regime. The starting step was unification of the multiple rate and large devaluation of the nominal official rate during the period 1988-1991. This period characterized by such changes as: the government decision assigned the SBV to be in charge of managing the FE in Vietnam, an introduction of the government's exchange rate determination method based on the market changes; allowing the economic units and individuals to open foreign account in banks; allowing them to use their FE for payments, constrained through banking system only. The next years (1991 - 1996) characterized by an introduction and running of the FE Trading Centers and the Interbank Markets later. Partly loosened FE control and capital control were introduced in this period via regulations on foreign borrowing, allowing open of foreign account abroad, regulations on remittances and invisible transfers. Further, the exchange rate determination method has been applied based on the rates prevailing in the Centers and the Markets. The operation of the foreign reserve fund shows noticeable achievement. Since the second haft of 1996, the economy faced with the significant internal and external economic changes. The government applied a tight FE control and capital control to restrain demand and at the same time to increase supply of FE for loosening devaluation pressures. In early 1999, the introduction of new principle for setting ER, using the average inter-bank ERs of the previous working day for the announced official rate, is marked as the most important change in the FR system since 1996. This policy does obviously contribute to increasing the flexibility of Vietnam ER regime. 3.2. The parallel market for foreign Exchange in Vietnam 3.2.1. Market Analysis 3.2.1.1. The Demand The principal classes of buyers of FE who have participated in Vietnam parallel market in recent years fall into three main categories: importers, savers/investors, and arbitrageur/ speculators. Each of these categories operates quite distinctly from the others. Illegal imports have aslo been accelerating in recent years, leading to a great demand for FE. The amount of smmugling imports in the first six month of 1997 alone is estimated more than USD 400 million. It is estimated that there are 40 tons of gold worth USD 420 million smuggled into Vietnam annually. Investors/savers. Not only individuals but enterprises in Vietnam often choose to hold USD as a secured financial asset. The parallel market, therefore, provides foreign currency instruments, and often it provides funds transfer as well. Also included here may be foreign firms and individuals who have a local presence but who wish to hold funds overseas to obtain a higher or safer return. As Vietnam is an economy with high degree of dolarization, the parallel market has been an important market for foreign asset in the country. Bear speculators. In Vietnam, financial intermediaries play an important role in this category. They do the business as in any financial market, holding financial instruments in US dollar converting back to VND when the devaluation has occurred, or when they choose to realize their losses, in the event that the expected devaluation does not occur or is less extreme than anticipated. 3.2.1.2. The Supply Suppliers of parallel Vietnam FE include overseas residents, contraband exporters, exporters who underinvoice their sales, importers who overinvoice their purchases, smugglers who have FE from their illegal exports, and arbitrageurs who contribute to make the market clear. Overseas residents. It is estimated that there exist many billions of USD held in cash in the public, and that about one third of the total amount of dollars was transferred from overseas Vietnamese into Vietnam outside the official channels in 1999. Contraband exporters, those who fail to declare their exports to the authorities. Besides, exporters who underinvoice their sales and importers who overinvoice their purchases aslo play a very important role in the supply side of the parallel market in Vietnam. Smugglers. In Vietnam, smuggling has become more and more severe recently, taking account for significant quantity of underground economic transactions. The FE earned from this business naturally turns back to Vietnam through the parallel market. Arbitrageurs. These participants in Vietnam mainly include financial intermediaries in all kinds and sizes. 3.2.2. Behavior of the Parallel Exchange Rate It is found that while the parallel rate strongly depends on economic and trade conditions, the premium almost totally depends on ER policies. This finding is logical since the parallel rate is in nature based on demand and supply conditions of FE markets, and the premium by definition is primarily determined by the relative difference between the parallel and official rates which is in turn regulated by policies. This finding in the case of Vietnam, however, is not only a reconfirmation of the logic, but a good suggestion for further quantitative studies. Alternatively, it should be weighted the role of policy change as the most important determinant of premium, meanwhile economic and trade conditions must be highlight in any model of PER determination. MODEL SPECIFICATIONS AND EMPIRICAL RESULTS 4.1. Hypothesis Development
PERt
=
a +
i=1
S7
(b1ip*t+1.Di
+
b2iINTEDI3*t+1.
Di +
b3iINFADI*t+1.Di
+
4.3. the Empirical model 4.3.1. The Model Selected and Method of Estimation 4.3.1.1. The Model After undertaking the process of model selection, it is found among 15 models an appropriate one of PER determination in Vietnam during the period of 1997 - 2000. That is one in adaptive expectation form:
PERt
=
a +
i=1
S7
(b1ip*t+1.Di
+
b2iINTEDI3*t+1.
Di +
b3iINFADI*t+1.Di
+ However, since expected values Xi*t+1 are not observed, we consider another regression that can bring the same results with observed variables Xit: PERt = a' + i=1 S7 (li.PERt-1.Di + b'1ipt.Di + b'2iINTEDI3t.Di + b'3iINFADIt.Di + b'4iGPt.Di + b'5iGDPt.Di + b'6iTRENDt) + vt (4.2) where a = a(1-l i), b'ji = bji(1-l i) (j =1,2,…6, i =1,2,…7), and vt = ut - lut-1. 4.3.1.2. The Use of Instrumental Variable Method Since equation (4.2) involves a regression of PERt on PERt-1, the model faces the problem of autocorrelation (explanatory PERt-1 is correlated with the error term vt = ut - lut-1). Thus estimation of equation (4.2) by OLS gives us inconsistent estimates of the paramaters. To solve the problem, we use the instrumental variable (IV) method. In this case, pt-1 is used as an instrument for PERt-1. Therefore, the model can be rewritten as: PERt = a' + i=1 S7 Di.(li.pt-1 + b'1ipt + b'2iINTEDI3t + b'3iINFADIt + b'4iGPt + b'5iGDPt) + b'6iTRENDt + vt (4.3) 4.3.1.3. The Use of Differentiation Method Because most of variables are in time series type, the problem of 'spurious' regression may arise when carrying out regression if they are nonstationary series. Therefore, it is necessary to test the stationarity of variables before running the above regression. If the variables' series are nonstationary, we will adopt the differentiation method to avoid this problem, or run the regression in the ith differenced form where ith differenced series of variables are nonstationary.
PER1t
=
i=1S7
(li.p1t-1.Di
+b'1ip1t.Di
+
b'2iINTEDI1t.Di
+
b'3iINFADI1t.Dit
+ where X1t denotes for the first differenced Xt series. 4.3.2. Model Adjustment, Estimation Results, and Hypothesis Testing 4.3.2.2. Model Adjustment After taking necessary tests, we refer to two conclusions: i) the PER1 time series is stationary, or it is an I(0) stochastic process, which means PER itself is an I(1) time series. Therefore, we can say that the movements of parallel exchange rate follow the random walk. ii) equation (4.1) should be regressed in its first-difference form to avoid 'spurious' and other related problems which may arise in estimation due to nonstationary data. Exclude GDP variable (a long-run one) from the equation, and rewrite the equation in traditional form: PER1t = a + i=1S7 (li.p1t-1.Di +b'1ip1t.Di + b'2iINTEDI1t.Di + b'3iINFADI1t.Dit + b'4iGP1t.Di)] (4.5) where proxies have been identified as before. The intercept a is employed because we still assume there may be a trend in PER series (a = b'6i). 4.3.2.3. Estimation Results and Hypothesis Testing
Regarding other residuals and stability tests (Serial correlation LM test, ARCH LM test, Ramsay RESET test, etc.), it is found that other classical assumptions in OLS are satisfied. Table 2 Result of the Adjusted Model Adopting AR(1) Process
4.3.3. Interpretation of the Result Box 1 presents regression result after eliminating all the dummy variables from equation (4.5).
Result of the estimation are periodically summarized in Table 3. It is clear that estimates of the parameters change corresponding to the presence of new FE policies.
Since b'i = (1-l)bi, we can withdraw from Table 3 values of coefficients in (4.1). The results are presented in Table 4.
Figure 1, based on Table 4, illustrates how FE policy changes effect the ways the above four factors influence the PER both in terms of degree and direction. Each factor's influence is presented by a line as shown in the figure. Values of coefficients are demonstrated by the lines' slope which were shown to be changed when a new policy was introduced. From the results above it can be drawn one more important conclusion that the presence of administrative policies in ER arrangement has strongly affected the degrees and directions of the relationships between the determinants and the PER. In other words, the policies have created distortions in the FE market. In summary, the empirical results show that there are four major determinants of US exchange rate in Vietnam parallel market, namely, the expected spread between the official and parallel rates (p*), the expected difference between domestic short run deposit interest rates of VND and USD (INTEDI3*), the expected difference between the growth rates of price level in Vietnam and US (INFADI*), and the expected market gold price in Vietnam (GP*). Another factor which may be seen as the fifth determinant is changes in ER arrangement policies. This qualitative factor influences the PER by regulating the degrees and directions in which the four quantitative determinants affect the parallel rate. This observation on one hand points out the importance of ER policy options, and on the other reminds us the short-run nature of the investigation. CONCLUSION AND RECOMMENDATIONS 5.1. Summary of main findings The econometric analysis in this thesis shows that there are four major quantitative determinants of US exchange rate in Vietnam parallel market, namely, i) the expected spread between the official and parallel rate (p*), ii) the expected difference between short run deposit interest rates on VND and USD in Vietnam (INTEDI3*), iii) the expected difference between the growth rates of price level in Vietnam and US (INFADI*), and iv) the expected market gold price in Vietnam (GP*). Another, and a qualitative, factor which may be seen as the fifth determinant is the changes in ER arrangement policies. This factor influences the PER in terms of regulating the degrees and directions in which the four quantitative determinants affect the parallel rate. Among the four quantitative explanatory variables examined, during the period of 1997-2000, the variable which continuously has effects on the parallel rate behavior is the expected spread between the parallel official rates. It has been shown that the expected spread is the most important determinant of the PER in Vietnam. These four quatitative explanatory variables indicates that four factors: i) opportunity for arbitrage between the official and parallel markets, which motivates USD to flow from former to the latter; ii) the divergence of the domestic interest rate on USD from that on VND, which affects the supply of USD; iii) the changes in domestic rate of return of VND compared to the USD, and iv) prices of substituable assets for USD, which influences the demand for USD, are the most important ones determining the exchange rate of USD in the parallel market. It is also proven that the presence of ER policies has strongly affected the degrees and directions of the relationships between the four main determinants and the PER. The magnitude of these determinants of the parallel rate is shown not stabilized during 1997-2000, especially in the periods frequently witnessing the monetary authorities' interventions into the foreign exchange market. The results aslo remark that when a sudden devaluation of VND occurs, there are significant changes in the degree of influence of the price differential and interest rate differential factors, as well as in foreign exchange's substitutability with other assets, of which gold is a good instance. From late of 1990 to the end of 2000, along with the absence of administrative interference into the market, the magnitude of these determinants become stable. Among other major determinants, the expected opportunity for arbitrage, or the expected spread between the parallel and official rates raises as the dominant factor influencing the parallel rate behavior. Two factors of price differential and interest rate differential both play modest but consistent roles in the parallel rate determination, whereas changes in gold price is observed to have inconsistent effect on the parallel rate and depends much on the expectation of the VND's devaluation. Based on the understanding about Vietnam's determinants of the parallel rate in the context of the goal of achieving the market stability, this thesis brings out some macroeconomic policy implications. Firstly, it is proven that administrative intervention to the foreign exchange market can not dominate the irresistible increase in the parallel exchange rate, but make the rate behave unstably. Although a market average rate system (MARS) was adopted in February 1999, only when the policy of high surrender requirements was removed in August of this year, did the parallel rate vary in a predictable manner. Secondly, that the VND is widely expected to be one day more devaluated results a higher expected return on USD than on any other domestic asset. This makes the substitutability of other liquidity asset, such as gold, has become inconsiderable. 5.2. Policy recommendations The findings of this study lead to three policy recommendations for the parallel market and FE arrangement in Vietnam. First, firmly shifting from administrative to economic intervention into the market is a valuable lesson not only from the past, but in the present. The Vietnamese Government and the SBV should consider administrative means of controlling the FE markets and the exchange rate only as the last resort. Second, the findings suggest that Vietnamese monetary authorities need a higher degree of creditability in carrying out macro-policies in general and FE policy in particular. It has been shown that the persistent belief in further devaluation of VND has helped the PER be immune from market gold price fluctuation. The results strongly suggest that the monetary authorities avoid a sudden devaluation policy, and adopt a gradual approach to the devaluation of the VND. A sudden devaluation may quickly narrow the gap between the parallel and official rates, but it has after-effects that erode the monetary authorities' creditability. The third recommendation is that the authorities should use the parallel market in the one hand as a source of market information for ER alightment, and in the other hand as a means of semidevaluation to carry out the gradual devaluation policy mentioned above. 5.3. limitations and points for further studies A number of potential areas for further research on the parallel market for FE in Vietnam can be identified. Firstly, and maybe most importantly, there is an opportunity for further studies that specify, based on other approaches, models of PER determination in such ways other than the one has been specified in this research. The model specification in this thesis is very simple, and developed on the basis of traditional demand-supply analysis. By adopting other model specifications, one is able to provide a more precise answer to the question about the determinants of the parallel foreign exchange rate. Secondly, this research has a short-run nature in terms of both method and data employed. The method of first-difference equation fails to reflect long-run relationships between the explanatory variables and the dependent variable. For further investigation, the test for cointegration in the level equation could be carried out to ensure whether it is sensible to run a cointegrating regression to find long-run trends in relationships between the variables. Moreover, the set of data employed in this research is short-run, and there is a need for further study involving a longer time period with long-run data, such as quarterly or annual data. However, this limitation of this thesis can only be overcome in "long run" because time series data for Vietnam's economy are now still limited within around 10 years. One more limitation that can be an opportunity for further studies is that this study has focused merely on exchange rate policies without considering the influence of other macro policies on the PER. Future studies comparing the interaction of ER policy and other macroeconomic policies can provide a more complete explanation to the PER's behavior. Finally, the assessment and interpretation of the obtained estimation results are implicitly based on the assumption that causation in the model specification is one-way, from the right-hand-side determinants to the PER without any significant feedback. In the future, it is likely to be more rational to test this possible feedback by employing the Granger's test for causality in the model specification. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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