Chapter1: Nature and background of the study

1.1

Introduction

Globalisation has resulted in a new configuration of world trade, production and

finance, and has had a direct impact on international competitiveness, trade and
financial flows and relative prices. In addition, it has brought about changes in the
dynamic interactions of economic variables, including possibly the way changes in
the exchange rate affect the economy. This applies to Vietnam as well. An exchange
rate is essentially what its name implies: it is the rate at which one would need to
exchange ones currency for the currency of another country. These rates of exchange
can change at a moments notice (or less) in currency markets where the currencies
are freely floating. Thus, the exchange rate is a conversion factor, a multiplier or a
ratio, depending on the direction of conversion. Exchange rate is undoubtedly
important because it allows for the conversion of one country's currency into that of
another, thereby facilitating international trade for purchases of goods and services
and/or transfer of funds between countries, and it allows price comparison of similar
goods in different countries. In general, the price difference between similar goods
determines which goods are traded and where they are shipped or sourced. It is safe to
say that the exchange rate is a significant factor influencing the competitiveness of
agricultural commodities and the profitability of farming enterprises. Therefore, the
purpose of this research is to point out which factors play a significant role on the
result of the the exchange rate. Throughout this research, we look at some main
factors which affect the exchange rate with data gathered mainly from secondary
research.
1.2

Overview of exchange rate in Vietnam from 1993 to 2013

In order to put the overall discussion into perspective, this part provides a general
overview of the major points in the exchange rate in Vietnam in recent years. As
observed and recorded, the exchange rate in Vietnam was lowest in 1994 at
9946.07 and hit the highest rate in 2013.

1.3

Rational for the study

The foregoing discussion implies the fact that there has been a fluctuation in the
exchange rate in Vietnam throughout the period from 1993 to 2013. Vietnam economy
experiences important turning points in 2007 when became the official members of
WTO. Taking this under consideration, conducting the research on this period enables
us to capture the effects of economic elements on the amount of FDI more precisely.

1.4

Assumptions

In order to apply ordinary least squares method which is the one utilized in this paper,
10 classical assumptions and 1 optional assumption must be satisfied; however in this
research, we focus on detecting and solving the violation of following assumptions
namely: multicollinearity, heteroscedasticity, autocorrelation and normal distribution
of residual to make sure that our model is applicable.

Chapter2: Literature review

2.1

Theories of exchange rate

2.1.1 The Purchasing Power Parity or PPP happens to be one of the most significant
approaches to determine exchange rate. PPP is primarily based on the Law of One
Price. However, this law is based on the assumption that identical goods are sold at
equal prices. It is a flow model of the balance of payment. This law lays down that
exchange rate of currencies have to compensate for the differences in prices of goods.
The Relative PPP approach continues to be applied till date. This approach lays down
the fact the exchange rate has to compensate for the difference in inflation rate. PPP is
not a very reliable determinant since changes in technology, commercial policies,
labor force and tastes change the national productivity, which in turn changes the real
exchange rate.
2.1.2 The Balance of Payment Approach depends on the assumption that there exists
an exchange rate and there exists internal and external equilibrium. The internal
equilibrium is based on the assumption that there is full employment. The external
equilibrium is the equilibrium in the balance of payments. This theory is more
dependable as it can explain permanent deviations in PPP. This approach offers
guidance on short term ups and downs. There are certain disadvantages of this
approach. The model does not inform about the exact rate of unemployment. Next, the
exchange rate does not maintain its consistency in accordance with the external
accounts.
2.1.3 Monetary and Portfolio Approach is an approach in which the prices of various
domestic and foreign assets are decided. The agent is given a portfolio choice of
various assets. The instruments, which are either money or bonds, have an expected
return that could be invested. This investment opportunity determines the exchange
rate. The opportunity of investment arises when the expected depreciation does not
compensate the difference in exchange rates.

2.2

Prior research
Tran Phuc Nguyen and Duc-Tho Nguyen Griffith Business School (AFE)
Griffith University: Vietnams exchange rate policy and implications for its
foreign exchange market, 1986-2009
Jean-Pascal Bassino and Hironobu Nakagawa, Paul Valry University:
Exchange rates and exchange rate policies in Vietnam under French rule,
1878-1945
Tran-Phuc Nguyen, D.T. Nguyen, Jen Je Su and Tarlok Singh: Shifts in
exchange rate regime and inflation persistence in Vietnam, 1992-2010

2.3

Model specification

With the knowledge getting from the prior researches and by applying the
econometrics theory to examine the effect of each factor, we choose our model as
below:

In which the variables are:

EXRATE: Exchange rate
VNI: Vietnam Interest rate
USI: US Interest rate
M: Money supply
TR_GDP: Trade per GDP
D: Dummy variable. D=1 if 2007-2013
D=0 if 1993-2006
2.3.1 Dependent variable
For this research, we choose the exchange rate as the dependent variable. With the
fundamental knowledge getting from some prior researches, we analyze effects of the
following factors on the exchange rate: Vietnam interest rate, US interest rate, money
supply and trade per GDP.
2.3.2

Independent variables

2.3.2.1 Vietnam interest rate

Interest rates and exchange rates are highly correlated. By manipulating interest
rates, central banks exert influence exchange rates, and changing interest rates
impact currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if additional factors serve to drive the currency
down. The opposite relationship exists for decreasing interest rates - that is,
lower interest rates tend to decrease exchange rate.

2.3.2.4 US interest rate

Like Vietnamese interest rate, US interest rate also plays a significant role in affecting
the exchange rate. Hence, we choose US interest rate, along with Vietnam interest rate
as independent variables to study if these two factors can greatly affect the dependent
variable or not.
2.3.2.3

Money supply

From what we have learned in Microeconomics, in many circumstances an increase in

the money supply could lead to a depreciation in the exchange rate. Thats why money
supply is the 3rd independent variable we would like to use in order to research more
about the relationship of it with the exchange rate and how it can affect the exchange
rate in the process.
2.3.2.2

Trade per GDP

A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports rises
by a greater rate than that of its imports, its terms of trade have favorably improved.
Increasing terms of trade shows greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relations to its trading partners. Therefore, trade per GDP is chose as another
independentvariable.
2.3.3 Dummy variable
Apart from four independent variables mentioned above, we choose one dummy
variable (D) which is the time frame. D=1 if 2007-2013 and D=0 if 1993-2006. The
reason we decided to use it as dummy variable is because Vietnam economy
experiences important turning points in 2007 when became the official members of
WTO.

https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp94.pdf
https://edis.ifas.ufl.edu/fe546
http://www.tradingeconomics.com/vietnam/currency
http://www.investopedia.com/articles/basics/04/050704.asp
http://www.economicshelp.org/blog/11550/currency/money-supply-and-theexchange-rate/