Luận văn thạc sĩ UEH exchange rate and trade balance, a new approach using big mac index for the

UNIVERSITY OF ECONOMICS

HO CHI MINH CITY

VIETNAM

INSTITUTE OF SOCIAL STUDIES

THE HAGUE

THE NETHERLANDS

VIETNAM - NETHERLANDS

PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

EXCHANGE RATE & TRADE BALANCE:

A NEW APPROACH USING BIG MAC INDEX

FOR THE CASE OF THAILAND

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

VO THE ANH

Academic Supervisor:

Dr. VO HONG DUC

HO CHI MINH CITY, DECEMBER 2014

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ACKNOWLEDGEMENTS

It is assistance, guidance, and encouragement that contribute to the success of this

thesis. Therefore, I would like to express my gratitude to those who always stand by

me during periods of writing thesis.

My profound appreciation and sincere thanks must first be expressed to my

academic supervisor, Dr. Vo Hong Duc, Director of Economic Regulation Authority in

Perth, Australia, for his interest, encouragement, and guidance throughout thesis￾writing process from initial themes to entire finish, especially during boring time of

reading the final draft.

I would like to express my grateful thanks to Assc. Prof. Dr. Nguyen Trong Hoai,

Dr. Truong Dang Thuy, Dr. Phung Thanh Binh, and Dr. Pham Khanh Nam, Lectures at

Department of Economics Development at University of Economics (HCMC), for their

helpful commands and valuable pieces of advice during the time I write the thesis.

Special thanks are extended to Dr. Le Van Chon for his invaluable econometric

guidance. Thanks to such academic commands, advice, and guidance, I could finish the

thesis on the best way.

I am be grateful to not only staff members at Department of Economics

Development at University of Economics (HCMC) but also my classmates at VNP￾MDE 19 for their help and support and for offering such a warm and friendly studying

atmosphere.

Most importantly, I am indebted to my parents for financing my study as well as

for their constant love and moral support. This thesis could not be finished without

their comprehension.

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ABSTRACT

This thesis focuses on achieving two main objectives: (i) an evaluation of the

Thailand’s currency to confirm whether a currency is over- or undervalued during the

period from 1980 to 2013 for the case of Thailand; and (ii) a consideration of the

effects of a currency’s devaluation on trade balance for the case of Thailand. In this

study, these effects are considered in different aspects such as the determinants of a

trade balance of Thailand; and the long run relationship between bilateral exchange

rate and Thailand’s trade balance.

In relation to the first objective, the prominent feature of the study is to use the

Big Mac Index (BMI), the first ever study of this kind conducted in Vietnam, for

evaluating Thailand’s currency and to apply this evaluation in the context of the link

between exchange rate and trade balance. Nevertheless, the common-used index, the

Consumer Price Index (CPI), is also utilized to compare the effectiveness of BMI with

that of the CPI.

Theoretical grounds for evaluating a currency in term of purchasing power parity

(PPP) theory are first presented, together with the theory of the link between currency’s

devaluation and trade balance. Next, the empirical studies associated with such theory

are discussed. Empirical models and results are reported accordingly.

To obtain the first objective, the PPP hypothesis is required to be satisfied in

terms of panel cointegration tests. The fully modified OLS (FMOLS) technique is

adopted to determine the equilibrium exchange rate for evaluation process. On the

grounds of the tests of PPP, the panel-based unit root tests as developed by Breitung

(2001) and the panel cointegration tests by Pedroni (1999, 2001, 2004) and Kao (1999)

are adopted. The empirical results confirm a solid validity of PPP for the case of CPI￾based exchange rate and a weak evidence of the PPP for BMI-based exchange rate. In

the relation to evaluate Thailand’s currency, the results illustrate that (i) the valuation

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of Thailand currency using CPI-based exchange rate is fairly consistent to that of BMI￾based exchange rate with an exception of the outcomes during the 1997 Asian

financial crisis; and (ii) the Big Mac exchange rate is better when bilaterally evaluating

the Thailand Baht to US dollar.

The second main objective - a consideration of the effects of a currency’s

devaluation on trade balance - could be achieved by the two procedures. The first

procedure is to analyze how changes on exchange rate policy, fiscal policy, and

monetary policy affect Thailand’s trade balance. In this task, effects of devaluation on

trade balance are examined on various scenarios: (i) the entire sample of 62 countries

who are trading partners with Thailand; (ii) different geography (between regions and

regions of countries); (iii) different income levels; and (iv) during different periods in

which Thailand’s currency is over- or under-valued. Both OLS method and IV

technique are employed because of an endogeneity problems as mentioned in previous

studies. The empirical findings indicate that the exchange rate policy plays a central

role in explaining Thailand’s trade balance and the fiscal and monetary policies are

beneficial in some cases.

The second procedure is to examine the long run relationship between a

devaluation of Thailand’s currency and trade balance with the applications of the

panel-based co-integration tests by Pedroni (1999, 2001, 2004) and Kao (1999) and the

FMOLS model. The panel FMOLS estimations illustrate that a devaluation of Thailand

Baht could provide positive effects on trade balance in the long run, especially for the

groups of country with high income, upper middle income, in America, and Europe.

The individual FMOLS regressions between Thailand and each of her 62 trading

partners indicate that the devaluation of Thailand’s currency would stimulate

Thailand’s trade performance with over 20 trading partners, but hurt its performance

with the other 10 countries and inconclusive conclusion for the others.

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ABBREVIATIONS

PPP Purchasing Power Parity

BMI Big Mac Index

CPI Consumer Price Index

M-L Marshall-Lerner

OLS Ordinary Least Squares

FMOLS Fully Modified Ordinary Least Squares

IMF International Monetary Fund

VND Vietnam Dong

IV Instrumental Variable

OECD Organization for Economic Cooperation and Development

VAR Vector Autoregressive

ARDL Autoregressive Distributed Lag

ECM Error Correction Model

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Contents

LISTS OF FIGURES........................................................................................... viii

CHAPTER 1............................................................................................................1

INTRODUCTION...................................................................................................1

1.1 Problem Statement ...................................................................................1

1.2 Research Objectives .................................................................................3

1.3 The Structure of the Thesis ......................................................................3

CHAPTER 2............................................................................................................5

LITERATURE REVIEW........................................................................................5

2.1 Theoretical Grounds.................................................................................5

2.1.1 PPP Theory...........................................................................................5

2.1.2 Alternative approaches to devaluation theory ......................................6

2.2 Conceptual framework ...........................................................................12

2.3 Empirical reviews...................................................................................13

2.3.1 Test of PPP Theory.............................................................................13

2.3.2 Evaluation of a currency.....................................................................15

2.3.3 Determinants of a Trade Balance .......................................................16

2.3.4 Devaluation and Trade Balance..........................................................17

CHAPTER 3..........................................................................................................25

THAILAND’S TRADE BALANCE AND...........................................................25

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ITS BIG MAC INDEX..........................................................................................25

3.1 Thailand’s Trade Balance.......................................................................25

3.2 Big Mac Index ........................................................................................27

CHAPTER 4..........................................................................................................31

RESEARCH METHODOLOGY..........................................................................31

4.1 Panel unit root test..................................................................................31

4.2 Panel cointegration test ..........................................................................32

4.2.1 Kao’s cointegration test......................................................................32

4.2.2 Pedroni cointegration test ...................................................................33

4.3 Fully modified OLS approach................................................................36

4.4 Empirical models....................................................................................37

4.4.1 Test of PPP theory ..............................................................................37

4.4.2 Evaluation of Thailand’s currency .....................................................39

4.4.3 Determinants of Thailand’s Trade Balance........................................39

4.4.4 Devaluation and Thailand’s Trade Balance .......................................45

CHAPTER 5..........................................................................................................47

DATA AND RESEARCH FINDINGS.................................................................47

5.1 Data description......................................................................................47

5.2 Empirical results.....................................................................................49

5.2.1 Test of PPP theory ..............................................................................49

5.2.2 Evaluation of Thailand’s currency .....................................................52

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5.2.3 Determinants of Thailand’s trade balance ..........................................56

5.2.4 Devaluation and Thailand’s Trade Balance .......................................63

CHAPTER 6..........................................................................................................73

CONCLUSION .....................................................................................................73

6.1 Conclusions ............................................................................................73

6.2 Implications for research and policies....................................................76

6.3 Limitations..............................................................................................77

REFERENCE ........................................................................................................79

APPENDIX ...........................................................................................................86

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LISTS OF FIGURES

Figure 2.1: Conceptual framework for exchange rate effects on trade balance.............12

Figure 3.1: Thailand’s trade balance during 1995-2013 periods...................................26

Figure 5.1: Misalignments of nominal exchange rate based on CPI and BMI ..............53

LISTS OF TABLES

Table 3.1: The structure of Thailand’ trade classified by currency ...............................27

Table 5.1: Data Description ...........................................................................................48

Table 5.2: Unit root test for PPP testing ........................................................................50

Table 5.3: Panel cointegration test for PPP....................................................................51

Table 5.4: Results of OLS and IV estimation for determinants of Thai trade balance..57

Table 5.5: Estimation results for undervaluation and overvaluation periods ................59

Table 5.6: Estimation results for countries within each of the seven sub-samples........61

Table 5.7: Results of Breitung (2001) unit root test - level and first difference............64

Table 5.8: Cointegration test..........................................................................................65

Table 5.9: Panel results of FMOLS estimation..............................................................67

Table 5.10: Individual results of FMOLS estimation ....................................................70

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CHAPTER 1

INTRODUCTION

1.1 Problem Statement

Exchange rate is possibly one of the most concerned subjects among academics,

exporters, importers, investors as well as policy-makers because its vitally important

roles played in the international economics. While academics have concerned and

developed theories of disequilibrium and equilibrium real exchange rate, the policy￾makers concentrate more on exchange rate adjustment in order to examine its effects

on the economy. Additionally, exchange rate risk is a key element related directly to

the costs and profits for importers, exporters as well as foreign investors. Furthermore,

it is argued that developing countries have tendency to devaluate their currency in

order to gain the relative competition. Given the importance of exchange rate in the

economy, issues in relation to exchange rate attract my interest and that this a key

reason for my choice to make a topic for the thesis.

In February 2014, with the opening of the first ever branch of McDonald’s, a

giant US fast-food company in Ho Chi Minh City, Viet Nam, the Economists

Magazine have added the Vietnam Dong (VND) to its collection of Big Mac Index

(BMI). This index provides McDonald’s burger prices in all different parts of the world

in terms of local and foreign currencies. The index is considered as a lighthearted guide

in order to evaluate whether a currency of a particular country of interest is at its

correct level. The index has been increasingly well-recognized as a global standard

with its existence in several international economics books and many academic studies.

The thesis aims to evaluate the real value of Thailand Baht and to consider the

link between Thailand Baht depreciation and Thailand’s trade balance. Thailand is

opted to study due to several reasons. First, according to Bahmani-Oskooee and

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