NATIONAL ECONOMICS UNIVERSITY
INSTITUTE OF PUBLIC POLICY AND
MANAGEMENT
ERASMUS UNIVERSITY
ROTTERDAM INSTITUTE OF
SOCIAL STUDIES
VIETNAM – NETHERLANDS PROJECT FOR MASTER’S PROGRAM IN DEVELOPMENT ECONOMICS
THESIS
THE IMPACT OF EXCHANGE RATE POLICY ON TRADE
BALANCE AND INFLATION IN VIETNAM

Student: Duong Thanh An
Class: MDE 12
Supervisor: Nguyen thi Thuy Vinh, PhD
Ha noi, 2014
TABLE OF CONTENTS
Ha noi, 2014 1
TABLE OF CONTENTS 2
LIST OF ABBREVIATION 4
LIST OF TABLES 5
LIST OF FIGURES 7
CHAPTER 1 1
INTRODUCTION 1
1.1The criticality of the study 1
1.2Research Purpose 2
1.3Scope of the Study 2
1.4Research Methodology 2
1.5Structure of the Thesis 3
CHAPTER 2 4
THEORETICAL FOUNDATION OF IMPACT OF EXCHANGE RATE ON 4
TRADE BALANCE AND INFLATION 4

1.2Research Purpose 2
1.3Scope of the Study 2
1.4Research Methodology 2
1.5Structure of the Thesis 3
CHAPTER 2 4
THEORETICAL FOUNDATION OF IMPACT OF EXCHANGE RATE ON 4
TRADE BALANCE AND INFLATION 4
2.1 Basic concepts of exchange rate 4
2.2Impacts of exchange rate on trade balance 8
CHAPTER 3 21
OVERVIEW OF THE IMPACT OF EXCHANGE RATE ON TRADE BALANCE AND INFLATION IN VIETNAM
21
CHAPTER 4 45
EMPIRICAL STUDY ON THE IMPACT OF EXCHANGE RATE ON TRADE BALANCE AND INFLATION IN
VIETNAM 45

LIST OF FIGURES
Ha noi, 2014 1
Ha noi, 2014 1
TABLE OF CONTENTS 2
LIST OF ABBREVIATION 4
LIST OF TABLES 5
LIST OF FIGURES 7
CHAPTER 1 1
INTRODUCTION 1
1.1The criticality of the study 1
1.2Research Purpose 2
1.3Scope of the Study 2
1.4Research Methodology 2
1.5Structure of the Thesis 3

export, keeping a consistent trade surplus with the US and becoming the country with
biggest foreign exchange reserve. Alan Greenspan, former Chairman of US Federal
Reserve, also tried to devalue US dollar to promote export and reduce trade deficit. On Dec
10, 2003, in order to explain his weak-dollar monetary policy, he said ambiguously on
CNN: “Now it is the time American should know the export potential…”. Since 2013, the
world has merely seen a sharp devaluation of the Japanese yen. This phenomenon has also
put a lot of controversy whether the Japanese currency devaluations to promote exports.
In Vietnam, trade deficit, which has been a persistent issue during the last 20 years, not
only shows weaknesses of the country’s economy but also implies potential instability in
the long run. The goal to have a balance in international trade in 2008, which was indicated
in International Trade Strategy during 2001-2010, was not met. In the past years, inflation
in Vietnam pretty high compared to other countries in the world while nominal exchange
rate of VND/USD was relatively stable. Therefore, there was many researchers suppose
that Vietnamese currency was overvalued and then give some suggestions on currency
devaluation to boost export as many countries in the world have ever done to improve the
trade balance. But other experts also noted that the devaluation can cause inflation, a
problem that Vieatnam has trying to solve.
There are many studies on impact of devaluation on trade balance or studies on exchange
rate pass-throught on domestic price in some countries in the world including Vietnam
(Nguyen Van Tien, 2009; Nguyen Thi Hien, 2011, Nhat Trung, 2011; Nguyen Duc Thanh,
2011; Nguyen Thi Kim Thanh, 2011). However, all of these researches have only focused
on either the inflation aspect or trade balance aspect rather than taken the trade-off between
them into consideration: a devaluation may improve trade balance but can cause inflation
in the economy. Therefore, it is very important to study the impact of change in exchange
1
rate on both trade balance and inflation in Vietnam to have a sound exchange rate policy
which can improve trade balacne without creating pressure on inflation.
1.2 Research Purpose
From the above analysis, the thesis has selected research topic as “The impact of
exchange rate policy on trade balance and inflation in Vietnam” which aims to answer

• Chapter 1 - Introduction
• Chapter 2 - Theoretical foundation of impact of exchange rate on trade
balance and inflation
• Chapter 3 - Overview of the impact of exchange rate on trade balance
and inflation in Vietnam
• Chapter 4 - Empirical study on impact of exchange rate on trade
balance and inflation in Vietnam
• Chapter 5 - Suggestions on improving the effectiveness of exchange
rate policy without creating pressure on inflation
3
CHAPTER 2
THEORETICAL FOUNDATION OF IMPACT OF EXCHANGE RATE ON
TRADE BALANCE AND INFLATION
2.1 Basic concepts of exchange rate
2.1.1 Definition of exchange rate
Although globalization and economic integration have been increasing and became a
global trend, most of countries still maintain its own currency. The growing international
trades and economic activities among countries brought about the needs for exchange
between currencies in certain conventions. Because of the need, exchanged rates came into
usage “Exchange rate is the comparative relationship between two currencies of two
countries”(Dinh Xuan Trinh, 2006).
When economic relations among countries became more sophisticated, especially given
the creation of letter of credits in foreign currencies, which are tradable in foreign
exchange market of a country, exchange rate was alternatively considered in a more
comprehensible manner as” the price of one currency in another country’s currency”.
For example, American businesses could import goods from United Kingdom and the
method of payment was determined as checks. These American importers had to pay
USD160 to buy a check value of GBP100 in an U.S. bank to pay for the Britain exporters.
These exporters, subsequently, deposited the checks at a Great Britain banks and received
GBP100. Consequently, the price of one GBP was 1.6 U.S. dollar and this is the exchange

F
and e as local price, foreign price, and exchange rate respectively at the
beginning of a certain year, ∆P
D
, ∆P
F
and ∆e are percentage changes of local good price,
foreign good price and exchange rate respectively calculated at the end of the year.
- PPP at the beginning of the year: P
D
= e * P
F
- PPP at the end of the year: P
D
(1+∆P
D
)=e(1+∆e).P
F
(1+∆P
F
)
- Therefore, (1+ ∆P
D
)=(1+∆e)(1+∆P
F
), or ∆e=
Under normal economic conditions: ∆P
F
≈0 so that ∆e≈∆P
D

S*
(1+I
D
T)*VND. Calling e
F
is the exchange rate at T. Based on IRP, one
USD and e
S
*VND must yield the same interest when converting in one currency:
1 + I
F.
.T = = = .T or .T
If T=1 then ≈I
D
-I
F
, in other words, If other factor unchange, the
change in exchange rate will be proportional to the difference between interest rates of
local currency and foreign currency.
Foreign currency interest rate difference between domestic and foreign market
If a country has higher interest rate on foreign currency deposits compared to that of
another country, that country with higher interest rate would attract capital flows from
outside into it and the inflow would push the supply of foreign currency up. Because of the
exogenous factor, the supply curve of USD moves rightward, the exchange rate goes down.
One of the most prominent efforts on quantifying the impact of foreign currency’s interest
rate differential between domestic and foreign markets was International Fisher Effect
(IFE) proposed by the economist Irvine Fisher. IFE said that the real interest rates of
different currencies of open economies would be equalized.
We define i
f

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 to Western
Germany and Japan.
Protectionism
Protectionism policies are tariffs, tax and non-tax trade barriers used by countries to protect
and enhance their industries’ competitiveness in international trade. The increased use of
protectionism like tariffs, quotas limits the volume of imports and subsequently reduces the
7
demand for foreign currency (the demand curve shits leftward) and in the long-run the
exchange rate will go down, local currency appreciates against foreign currency. For
example, if Vietnam increases the tariff on imported laptops from the U.S, this will make the
price of those imported laptops increased, demand going down (demand curve shifts
leftward) and exchange rate going down, VND appreciating against USD. The paradox of
protectionism is while tariffs and trade barriers are used to reduce import, supporting local
manufacturing and export industries, protectionism policies push the local currency to
appreciate. The appreciation of the local currency, in turn, negatively limits exports. In
summary, protectionism, in its relation with exchange rate, gives rise to an undesired result.
2.2 Impacts of exchange rate on trade balance
Exchange rate policy is a system of tools which are used to control the supply and demand
relationship on foreign exchange market and as a result adjust exchange rate to meet
desired goals. A highly-valued local currency compared to foreign currencies would
support export and limit import and vice versa. Thus, managing exchange rate policies can
have direct impact on trade balance. In addition, every time central banks announce
adjustments on foreign exchange rate policies, the debates on effect of such adjustment on
prices and inflation are emerged.
2.2.1 Exchange rate’s impacts on import and export performance
Volume effect
If the exchange rate, expressed in local currency, is high, with the same amount of foreign
currency the exporter receives from their export, these exporters will have more local

There have been multiple of evidences demonstrating the volume effect of exchange rate
on imports. For example, in Jan 1999, Argentine Peso appreciated 10% against Brazilian’s
Real and the appreciation resulted in 30% increase in the import of shoes from Brazil to
Argentina in the same year.
On the other hand, assuming a laptop imported from the U.S. to Vietnam has a price of
USD1000. The current exchange rate is 1USD = 15.000VND. These means a Vietnamese
has to pay VND15.000.000 for an imported laptop. Assuming the exchange rate is now
1USD=VND18.000. Given the new exchange rate, a Vietnamese now has to pay
18.000.000VND for the same imported laptop. So instead of paying 3.000.000VND more,
the Vietnamese can switch to locally-manufactured laptops and desktops. The demand for
imported laptops would decrease and subsequently laptops imported from the U.S. will
also go down.
As in the case of export, volume effect does not have immediate impact on import
9
activities but rather also has a lag. The lag of time allows importers to consider benefits of
imports given exchange rate change. When exchange rate, expressed in local currency,
goes down, importers need time to negotiate more import contracts, selecting and verifying
goods offered by new exporters who would not benefit without the exchange rate change.
When exchange rate goes up, the importers still have to honor previously-signed contracts
even if this means absorbing loss as a result of exchange rate volatility.
Price effect
As elaborated above, because of time-lagging feature of volume effect, exchange rate
fluctuation would not impact export volume immediately. However, there’s another effect
needed to be study during the transition period and it is named price effect. Assuming the
current exchange rate is 1USD = 15.000VND and the price of exported good is 2.000VND
in local currency. Before exchange rates increases, each unit of exported good is worth
0,1333USD (2000/15000). If the exchange rate is now 1 USD = 18.000VND, each unit of
exported good is only worth 0,1111USD now (2000/18000). On the other hand, if the
exchange rate falls to 1USD = 10.000VND, each unit of exported good will bring about
0,2USD (2000/10000). The Price Effect on export volume says that even though the

demand for coffee of Vietnam will decrease. When there is no demand, the good would be
removed from export list to the U.S. On the other hand, if exchange rate rises, list of goods
exported would be expanded to include more diversified goods because: firstly, businesses,
which could not have competed before, now can export and benefit from the exchange rate
rise; secondly, an increase in revenue of export allows these businesses to expand
production and diversify their own product categories.
For similar goods, the goods which consumes large amount of local materials are more
sensitive to exchange rate and those goods relying more on imported materials are less
sensitive. For example, the price of a shirt made of 50% imported materials is
100.000VND. The original exchange rate is 1USD = 15.000VND so the price of the shirt
in USD is 6,667USD.
If the exchange rate rises to 1USD = 18.000VND then the input cost will increase by
50%x100.000x3000/15.000 = 10.000VND. The price of the shirt now is 110.000/180.000
= 6,111USD. If the shirt is made of 100% local materials, the converted price of it would
be 100.000/18.000 = 5,556USD. In summary, goods which have high percentage of
imported contents are less impacted by exchange rate fluctuation.
When exchange rate moves down, list of imported goods tend to expand because: firstly,
local consumers, who could not have afforded for them because of high prices before, now
would buy them given their lower prices in local currency now; secondly, improved
revenues of imports help these businesses expand production and diversify their products.
11
If exchange rate rises, the conversion to local currency becomes more expensive and the
fact would curb the demand for imported goods. When the demand reaches zero, these
goods are excluded from import list.
Exchange rate’s impacts on each type of imported goods depend on how easy to substitute
the good. There are certain goods such as agricultural products and raw materials are more
prone to exchange rate fluctuation. While other goods such as gasoline, machinery and
complete built units, which are more difficult to be substituted, are normally not sensitive
to exchange rate volatility.
For example, Petrolimex imports diesel from Singapore at a price of 600USD/ton. When

activities as analyzed in Volume Effect and Price Effect part. In addition, currency
devaluation also creates what’s so called J-Curve Effect
Figure 2.1: J-Curve Effect in currency devaluation
Figure 2.1 examines the behavior of Vietnam’s trade balance in VND under currency
devaluation assuming that the trade account is balanced originally. After the currency
devaluation which happens at T = 0, exchange rate rises and as a result, prices of imported
goods in local currency also go up and the total value of imports rises either. The trade
account starts being in deficit. At the beginning, because of the timing lag of Volume
Effect, the value of export grows gradually. Even though the growth of export value
intensifies, once export value grows at slower rate than that of import growth, trade
account would still be in deficit.
However, after a period of time when the Volume Effect has more impact than the Price
Effect and the growth of total value of export exceeds that of import, the trade account would
be balanced, represented by the upward move of the graph starting from point T
1
. From T
2
,
trade account becomes surplus. The behavior of trade account is called the J-Curve Effect of
13
currency devaluation. There’re many evidences proving the existence of J-Curve when a
country devalues its currency. For example, in 1991, Krugman analyzed the impact of the
sharp currency devaluation of USD during the period of 1985-1987 (According to the Plaza
agreement on the exchange rate, which the U.S signed with several countries in September
1985. The dollar is adjusted depreciation) and found the existence of the J-Curve Effect in
U.S. economy. At the beginning, trade account was deficit, in both absolute value and as
percentage of GDP, but trade account was improved after 2 years. The trade deficit came
down from a record of USD158 billion in 1987 to USD107billion in 1989.
In compliance with the Plaza Accord signed between the U.S and some other countries in
September 1985, the USD was devalued up to 50% until 1987.

M
are
smaller in short-run than in the long-run. Meanwhile, in 1987 Gylfason announced a
summary based on 10 empirical studies from 1969 to 1981 in 15 developed countries and 9
developing countries and the generalization shows that these elasticity indexes were high
and Marshall-Lerner Condition was all met.
14
The fact that the elasticity indexes are normally smaller in short-run than in long-run,
together with Marshall-Lerner Condition, lead us to some key factors a country should
consider before devaluing its currency to improve its trade account:
Firstly, in short-run currency devaluation would worsen, not improve, trade account
because, in short-run, those indexes η
x
and η
M
are normally small and could not meet the
Marshall-Lerner Condition.
Secondly, if a country wants a high exchange rate elasticity of demand for export, it must
select to export those goods which have large supply sources and those sources could be
easily expanded to take advantage of favorable currency movement. Raw materials
normally depend on natural conditions and it is hard to quickly expand their supplies. In
general, only highly-processed goods meet the condition.
Thirdly, if a country wants a high exchange rate elasticity of demand for import, it must
import only those goods which are easy to be substituted. Those goods such as machinery,
complete-build units or components, oil and gas for production normally make import
inelastic to exchange rate movement.
Fourthly, using currency devaluation to improve trade account requires accurate estimation
of exchange rate elasticity of export and import. Not all currency devaluations improved
trade account in the long-run. Currency devaluation could improve trade account only if
elasticity indexes are big enough to meet Marshall-Lerner Condition.

Graph 2.1 shows 3 channels through which consumer prices can adjust to changes of
nominal exchange rate: direct, indirect and foreign direct investment.
Direct Effect – The direct effect includes the direct change in prices of both intermediary
and end-consuming imported goods because of higher exchange rate. Empirical research
normally uses imported good prices index to study the effect in an independent way.
Obstefeld and Rogoff (2000) and other researchers proved that imported goods are more
sensitive to exchange rate fluctuation compared to general consumer goods.
Graph 2.1: Mechanism of exchange rate pass-through on inflation
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Tỷ giá tăng (Phá giá nội tệ)
Direct Indirect FDI Decision
Increased
Prices of
component
made
overseas
Increased
prices of
imported
goods
Increased
demand for
locally-
produced goods
(to replace
imported ones
Increased
demand for
locally-
produced