Academic journal article Journal of Southeast Asian Economies

The Impact of Exchange Rate Fluctuation on Trade Balance in the Short and Long Run: The Case of Vietnam

Academic journal article Journal of Southeast Asian Economies

The Impact of Exchange Rate Fluctuation on Trade Balance in the Short and Long Run: The Case of Vietnam

Article excerpt

I. Introduction

In Vietnam's current phase of economic development, exports are deemed crucial for growth. Although the county's export-driven industrialization has succeeded with an impressive growth rate of exports (an annual average of 20 per cent over the past ten years), the growth rate of imports over the same period was higher (22 per cent), resulting in a trade deficit. Before 2006, this deficit was not critical and was valued at around US$5,000 million. The deficit hit serious levels from 2007 onwards, when the figure stood at US$14,120 million and peaked at US$21,774 million in 2008. In that year, the current account deficit-to-GDP ratio had doubled from 5 per cent in 2006 to 10 per cent.

Researchers have not paid much attention to the impact of the exchange rate on trade balance in Vietnam until recently, when the country's real exchange rate (RER) began appreciating in 2003 and climbed to 20 per cent in 2008--an indication of its losing competitiveness. However, empirical studies examining the relationship between the RER and trade balance are limited. Most studies focus on the long-run relationship; the short-run impact and the time path response of trade balance to the depreciation of the RER have not been properly explored. (1) This paper aims to fill this gap by measuring the impact of the RER on trade balance in the short and long run. The methodology used for estimating the long-run impact is a cointegration analysis based on the autoregressive distributed lag (ARDL) approach developed by Pesaran, Shin and Smith (2001). The short-run impact is explored using the corresponding error correction model (ECM) that is obtained from the long-run cointegration equation. The responsiveness of trade balance to exchange rate shocks is examined using the impulse response function (IRF).

II. Literature Review

The Marshall-Lerner condition states that a real devaluation (or a real depreciation) of the currency will improve the trade balance if the sum of the elasticities (in absolute values) with respect to the RER is greater than 1. However, most studies conclude that the Marshall-Lerner condition is met in the long run, and not in the short run because demand is more inelastic in the short run than in the long run (see Hooper, Johnson and Marquez 2000, pp. 8-9). This means that real devaluation might improve trade balance in the long run, but not in the short run. For example, Magee (1973, pp. 308-309) shows that it takes time for people to adjust their preferences towards substitutes. Therefore, exports expand post-depreciation only after suppliers are able to produce more products for export, and after foreign consumers have made the switch to these products. Magee's analysis suggests that depreciation worsens trade balance in the short run but subsequently improves it, resulting in a time path of change that takes the form of a J-curve.

Numerous empirical studies, including studies focusing on developed countries, have explored the relationship between currency depreciation and trade balance. Some show undeniable evidence of a long- and short-run relationship between these two variables. Others conclude that there is either no relation between them, or that only a long-run relation exists. The reasons for these varying results lie in the selection of different countries, observation periods and econometric methodologies. However, all of the studies which conclude that exchange rate fluctuation has a significant influence on trade balance indicate that depreciation would increase exports, restrain imports and improve overall trade balance.

Rose and Yellen (1989) employed quarterly data for the period 1960-85 to examine bilateral trade between the United States and six of its largest trading partners, but they could not find statistical evidence of a long-run relationship (or a J-curve pattern) between bilateral exchange rates and trade flows. Marwah and Klein (1996) studied the impact of the real bilateral exchange rate on two-way trade balance in the United States and Canada, and five of their largest trading partners for the period 1977-92. …

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