Exchange rates and inflation - the case of Vietnam
/Vietnam has an open economy. In fact, it has become more and more open over time, part of the doi moi economic reforms that started in the late 80s. Now, as I have written about, it has an extremely large export economy. At the same time the government maintains a managed “floating” exchange rate regime. Basically, it doesn’t want too much volatility in the exchange rate, plus it wants to favor exports over imports.
Having that exchange rate regime is interesting, because it means the government has to make decisions that can have real economic impacts, and they have to do it every day. Because of that, they need to really understand how the economy is affected by the fixed-ish exchange rate. One important element is inflation.
Does the exchange rate have an impact on inflation? Put another way, would devaluing the VND cause inflation, because if so, they might not want to do that. It turns out, people much smarter than me, have studied this! I found a great paper (Chapter 12, page 323) that looks at the inflationary impacts of exchange rate shocks on the Vietnamese economy.
Notes: Left axis (index, 2010=100): consumer (CPI), import (IMP) and producer (PPI) prices. Right axis: USD/VND exchange rate.
Source: SEACEN, page 327
This paper runs a lot of regressions on changes in the exchange rate on three price indices: consumer, import and producer prices. First, let’s just look at the chart on the right. It sure seems like devaluation of the VND/USD rate is correlated with increased prices, the CPI and PPI more than the IMP.
That makes intuitive sense - if it gets more expensive to import things, then those products will get more expensive in the store. But we need to remember a few things:
Sellers set ultimate prices. They don’t just take their cost and add a set dollar amount or percentage. Let’s say their cost rises 10%, they might not want to raise their prices by 10% immediately, because it could hurt sales. So they might decide to charge less and take a lower profit margin.
Plus, not everything in the country is imported - locally produced goods shouldn’t see much change in prices directly because of changes in the exchange rate.
Not everything is priced on the USD/VND exchange rate - things imported from Australia will see different shocks. We talk about the USD because it is the most important currency, but it’s not the only one. Something that Americans need to realize.
Oh, one more thing. It takes a while for prices to flow through. That’s because inventories are likely a mix of goods bought over time - some at old, lower prices and some at new, higher prices. Sellers have a bit of time before their margins are hurt.
Those are mostly direct impacts. But there are also indirect effects. If imports are more expensive, that has to mean that exports are less expensive for other countries. So there will be more exports, and then exporters will compete for labor and raw materials, bidding up those prices.
It turns out dollarization is a important contributor here. If prices are in dollars (like they are for luxury goods and cars in some countries), then you will see bigger effects. Vietnam actually was somewhat dollarized until fairly recently, but is much less so today.
Well, it turns out that the effect is significant, is positive, but isn’t that big. Looking at the table to the right, both PPI and CPI increase but both less than 0.1% (0.074 and 0.054, respectively) after a 1% shock to the exchange rate. Imports (IMP) increase the most, at 0.135, but that still seems lower than I would be expected. The author’s agree:
[T]he exchange rate could explain about 4% of the import price movements, nearly 9% of producer price movements and approximately 3% of consumer price movements after 6 months. This implies that the impact of the exchange rate shock on prices in Vietnam is rather modest
The paper also looks at commodity price shocks and demand shocks, both of which have a smaller impact on prices than changes in the exchange rate.
What does this tell us?
The central bank probably shouldn’t worry too much about changes in the exchange rate leading to rampant inflation. In fact, it probably has room to devalue, in order to boost exports (although given already rising exports and fears of a US backlash, it would probably be best if it didn’t).
Oh, and keep dollarization down. This is a good point overall, because it is hard to control an economy, when you don’t control the currency.