Can devaluation be effective in improving the balance of payments in Vietnam?

eciation (LR tests are significant at the 10% level in all models). LR tests also reject the hypothesis of deletion of constant or error correction terms (ECT) in these models. In sum, the growth rates of money supply affect future inflation and exchange rate depreci- ation, while exchange rate depreciation does not influence the future money supply growth and inflation. In addition, inflation also influences the exchange rate depreciation and then reveals the possibility of adjusting money growth rates by the SBV to stabilise the economy. The interre- lationship between these variables can be seen more accurately through forecast error variance decomposition, which is explained in the following section. 474 N.N. Thanh, K. Kalirajan / Journal of Policy Modeling 28 (2006) 467–476 Table 4 The variance decomposition of inflation rate (D ln CPI) Time horizon (quarter) 20 Observations from 1993Q4 to 1998Q3; proportion of forecast variance explained by changes in D ln CPI D ln E D ln MS Model (1) (CPI, VCBE, M1) 1 72.18 0.37 27.45 3 70.99 0.41 28.60 6 70.71 0.41 28.88 9 70.71 0.41 28.88 12 70.71 0.41 28.88 Model (2) (CPI, VCBE, M2) 1 81.40 3.83 14.77 3 81.02 3.86 15.12 6 80.98 3.87 15.15 9 80.98 3.87 15.15 12 80.98 3.87 15.15 Model (3) (CPI, HNE, M1) 1 73.59 2.59 23.82 3 71.52 3.68 24.80 6 71.35 3.72 24.93 9 71.35 3.72 24.93 12 71.35 3.72 24.93 Model (4) (CPI, HNE, M2) 1 83.66 5.28 11.06 3 81.99 6.07 11.94 6 81.96 6.08 11.96 9 81.96 6.08 11.96 12 81.96 6.08 11.96 Source: authors’ estimates by using Microfit 4.0. 4.3. Forecast error variance decomposition Before analysing variance decompositions, it is necessary to confirm whether the combination of variables in the VECM is linear or non-linear, in order to choose the orthogonal or general case of variance decompositions. The covariance matrices of errors from all VECM models in the short run are considered diagonal matrices since their covariances are very small and approaching zero. This suggests that combinations of variables in these models are linear. Therefore, the orthogonal case for variance decompositions is applied in this study. In this section, the forecast error variances of each variable are decomposed into the proportion attributable to each of the random shocks. The results of forecast error variances of inflation are reported in Table 4. Money supply growth is the most important source of variability for inflation. The shocks of M1 growth contribute a substantial change from around 23% to 28% of inflation variations (models (1) and (3)), the contributions of M1 growth to inflation variation are larger than for the case of M2 (from around 12% to 15%) in models (2) and (4). In contrast, depreciation of exchange rate accounts for only around 0.4–3.9% of the forecast error variance of inflation in the case of Vietcombank exchange rates and from around 2.6% to 6.0% for the case of Hanoi parallel market rates (models (3) and (4)). This means that the shocks of exchange rate depreciation affect the variation of inflation only a little. These results are consistent with the Granger causality tests in Table 3. N.N. Thanh, K. Kalirajan / Journal of Policy Modeling 28 (2006) 467–476 475 So through variance decompositions, money growth is determined as a major source of variation for inflation, while exchange rate depreciation has contributed only a little for variation in inflation. Thus, the empirical results of this paper show that there has been two-way causality between money supply growth and inflation, exchange rate and inflation, and money supply growth and exchange rate in Vietnam in the 1990s. 5. Conclusions and policy implications Both the long run and short run results of this paper suggest that devaluation can be implemented to encourage exports and to improve current account balance and BOP, and also to reduce the real exchange rate appreciation in the short run. Because, this study has shown that the depreciations have a small effect on stimulating inflation in the short run (assuming money supply growth is constant) and that they also have positive effects on encouraging exports (although exchange rate’s effects on exports in the long run are larger than that in the short run) and limiting imports. In addition, regional and multiple trade agreements between Vietnam and other countries require the reductions in tariffs and other barriers to foreign trade. Therefore, Vietnam has to rely on the flexible exchange rate policy to encourage exports and BOP rather than using tariffs and exports price policy. However, this study also shows that while money growth rates are the most important source to generate inflation in both short and long runs, exchange rates depreciations do have a strong effect to stimulate inflation in the long run. The potential of high inflation is possible if the SBV implements an easy monetary policy. Therefore, it is necessary to coordinate closely between monetary and exchange rate policies to perform successfully the devaluation of the domestic currency. The effective controls of money supply are the most important measure to control inflation and this must be put as the first priority of the SBV. The policy suggestions to control the money supply effectively are as follows. Controlling money supply in the face of large capital inflows is not an easy job for the SBV. The large cap- ital inflows will cause an increase in domestic inflation (more currencies to buy few goods) and real exchange rate appreciation (excess supply for foreign currencies). To sterilise these conse- quences of large capital flows, indirect monetary instruments such as the open market operations (OMO), refinancing, reserve requirements (RRs), foreign exchange swaps, and variable deposit requirements need to be implemented effectively. The foreign exchange swaps, and variable deposit requirements are effective tools in terms of sterilising capital flows that have been successfully implemented in Indonesia and Spain. Especially, through foreign exchange swaps, the central bank can make an agreement to sell foreign exchange against the domestic currency and simultaneously to buy it at a specific date in the future. The foreign exchange is bought by banks and may be invested abroad or is lent to domestic residents, but its effects are to reduce the domestic currency base (at a given money multiplier, money supply will be reduced). With foreign exchange swaps, the central banks are highly flexible at times to buy and sell foreign exchange (Lee, 1997). Foreign exchange swaps have been implemented in Vietnam since 1998, but they are still little used. Although this instrument still has disadvantages,1 with the development of the financial sector and experience gained by the 1 This instrument may cause losses for the central bank if the difference between the spot rate and forward rate is smaller than the interest rate differential between the foreign and domestic markets; this also contains the foreign exchange risk when the central bank converts foreign currency into local currency (Lee, 1997). 476 N.N. Thanh, K. Kalirajan / Journal of Policy Modeling 28 (2006) 467–476 SBV during the banking and financial reform, this instrument could be increasingly introduced in the near future. Other macroeconomic policies such as fiscal policy, reform of State-Owned Enterprises (SOEs), and external economic relation policies need to be considered when implementing the devaluation policy in order to stimulate exports and to improve BOP, but inflation still must be controlled and macroeconomic stability maintained. 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