ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

ASEAN Economic Bulletin Vol. 29, No. 1 (2012), pp. 1–14 ISSN0217-4472print/ISSN1793-2831electronic

©2012ISEAS

DOI:10.1355/ae29-1a

The Determinants of Inflation in Vietnam, 2001–09

Huu Minh Nguyen, Tony Cavoli and John K. Wilson

This paper employs a simple macroeconomic model of inflation to empirically investigate the determinants of CPI inflation for Vietnam over the period 2001 to 2009. Vietnam is chosen as our focus for this study because of the country’s recent history of high inflation since the end of the Vietnam War in 1975 and the Adjustment of Price reforms in 1985. We are particularly interested in examining the role of the exchange rate in explaining inflation, and of the effect of supply side factors such as the prices of crude oil and rice. Using a range of time series estimation techniques, we find that inflation is persistent and that the money supply, oil prices and rice prices present the strongest influences on CPI inflation.

Keywords: Vietnam, inflation, vector autoregression.

I. Introduction

This study examines the determinants of inflation in the Socialist Republic of Vietnam, a developing transitional economy. The adverse effects of inflation are well known, and for Vietnam, price instability has been argued to be a strong factor in stifling economic development (Tran Van Tho et al. 2000). For example, throughout the 1980s and the early 1990s, there were significant inflationary pressures in Vietnam. This peaked at 587 per cent in 1986 (Dang Phong 2008). While such hyper-inflation has come under relative control, the July 2008 rate of 27 per cent was the highest in the whole of Asia (Mydans 2008). More generally, the Vietnam experience is not unique in terms of price instability. An understanding of the mechanisms by which inflation is transmitted through the economy

is thus of importance, particularly to developing nations.

This study builds upon earlier work by Goujon (2006) to investigate the determinants of inflation in Vietnam over the period 2001–09. To our knowledge, this is one of the few comprehensive analysis of inflation using these data and methods to be conducted for Vietnam, and thus contributes to our understanding of the inflation experience of this and other developing countries. We find that, unsurprisingly, inflation is quite persistent and that the growth in the stock of money and that external factors are prominent in influencing inflation.

The remainder of the paper is as follows: The following section presents some stylized facts relating to inflation in Vietnam, with emphasis on the period from 2001 to 2009 and discusses the existing literature relating to Vietnam. In sections

01 Tony.indd 1 4/3/12 9:31:34 AM

ASEAN Economic Bu l l e t in 2 Vo l . 29 , No . � , Apr i l 20 �2

III and IV, a model of inflation is presented and analysed using data from Vietnam. This analysis employs ordinary least squares (OLS), vector autoregression (VAR), and Granger causality tests. Section V concludes with a discussion and some policy implications.

II.  Vietnamese Inflation

II.1 A Brief History of Inflation in Vietnam

Following the end of the Vietnam War in 1975, and the establishment of the Socialist Republic of Vietnam a year later, Communist leader Le Duan stated his belief in “a glorious future for the country”, promising each Vietnamese family a TV set, a radio set and a refrigerator within the next ten years. His egalitarian, centrally planned socialism, unfortunately, only resulted in stagnation, food shortages and rampant inflation (Dang Phong 2008). Facing the prospect of economic collapse, Vietnam embarked on reforms toward a market economy. An ill-conceived 1985 reform package called Adjustment of Price, Wage and Money (Cai Cach Gia-Luong-Tien), however, created

skyrocketing inflation (Dang Phong 2008). Within a year of the Adjustment, inflation rate reached its peak of 587 per cent. It then remained high throughout the rest of the 1980s. The authorities were slow to react, but finally, starting in 1988–89, a number of measures, including raising interest rates, reducing subsidies to state-run enterprises, halting the increase in wages, and cutting public expenditures and budget deficits, helped in curbing the runaway rise in prices (Dang Phong 2008; Nguyen Tri Hung 1999). During most of the 1990s, Vietnam experienced only modest inflation (by developing countries’ standards). Between 1993 and 2002, inflation averaged 6 per cent per annum, ranging from –2 per cent to 17 per cent (IMF 2003b).

Consistent with the fluctuations of inflation in Figure 1, the period since the beginning of the twenty-first century might be divided into three sub-periods: 2001–03, 2004–07 and 2008–February 2009. The period 2001–03 marked the re-emergence of Vietnam from the Asian financial crisis, with its GDP growth rate returning to an impressive 6–7 per cent per annum. During these two years, the country’s macroeconomic

FIGuRe 1Vietnam-Consumer Price Index 2001–2009

Source: IMFa.

01 Tony.indd 2 4/3/12 9:31:34 AM

ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

performance was strong, fuelled by a growth in export and investment, while inflation, kept below 5 per cent, continued its modest course of the 1990s (Farber et al. 2008; IMF 2003a).

As economic expansion accelerated, the Vietnamese GDP growth rate reached 7.79 per cent in 2004, then 8.44 in 2005, the highest since 1996. Credit and broad money growth also rose sharply (General Statistics Office of Vietnam (GSO) 2009; IMF 2005). These developments all put pressure on the price level. In addition, droughts, outbreaks of avian flu and a number of external shocks, including rising rice and oil prices, acted together to push up food prices, which account for nearly 50 per cent of the Vietnamese CPI basket. As a consequence, two-digit inflation rate recurred: Year-on-year inflation reached 10 per cent in September 2004. The rate nevertheless fell back to 7.5 per cent in August 2006, a tolerable figure, though still among the highest in Asia (see Table 1) (IMF 2005, 2006a).

A continued emphasis on high growth saw the economy of Vietnam “overheated” in 2007. This, in concert with ascending commodity prices, in particular, the dramatic surge in the price of oil, led to a steep rise in CPI. The year 2008 witnessed an alarming increase in the rate of inflation, which peaked at nearly 30 per cent around July–August. As curbing inflation became the country’s priority rather than maintaining growth, the government tried to reduce import in order to cut the current account deficit, which in 2007 rose to over 9.5

per cent of GDP (IMF 2009). The State Bank of Vietnam (SBV) also tightened its money supply. The refinancing rate, kept unchanged at 6.5 per cent for the last fourteen months, rose to 7.5 per cent in February 2008, then dramatically from 7.5 to 15 per cent in June (Farber et al. 2008). As a result of proper measures, as well as of the ongoing global recession, inflation eased, even turning negative on a monthly basis in the last months of 2008 (IMF 2009).

II.2 Brief Literature Review of Inflation in Vietnam

As might be expected, the literature on inflation in Vietnam, a small developing economy, is not large. Nguyen Tri Hung’s 1999 working paper is perhaps the only comprehensive study in english on the history of Vietnamese inflation since the country’s transition to a market economy in the 1980s. In his study, Nguyen divides the Vietnamese transition into three sub-periods: 1980–84, 1985–89 and 1990–95, aptly narrating and analysing the inflation experience in each. A more updated, if briefer, history of inflation and the transitional period is provided by, inter alia, Vo Tri Thanhet al. (2002) and Le Anh Minh (2008) in their studies of Vietnam’s macroeconomic structures.

In the empirical literature of inflation determinants, different positions and/or methods of analyses have yielded different results. Shinichi and Pham Thai Binh (2005) and Le Viet Hung and

TABLe 1Headline Inflation Statistics 2002Q1–2006Q2

Mean Median Maximum Minimum Std DevASEAN4 5.8 5.1 10.8 3.1 2.2Newly Industrialised economies (NIes) 1.8 1.8 3.5 0.3 0.7Selected Asian economies 2.6 2.7 5.0 0.8 1.1Vietnam 6.0 5.6 10.4 1.6 2.6

Note: ASeAN-4: Indonesia, Malaysia, Philippines and Thailand; NIes: Hong Kong, South Korea, Singapore and Taiwan; Selected Asian economies: China, Indonesia, South Korea, Malaysia, Philippines, Singapore, Thailand and Vietnam.Source: IMF 2006a.

01 Tony.indd 3 4/3/12 9:31:35 AM

ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

Pfau (2008), while examining, respectively, the demand for money and the monetary transmission mechanism in Vietnam, all look at the relationship between money supply and inflation. The former, employing the vector error correction model (VeCM) over data from 1993 to 2004, find that growth rate of broad money of domestic currency always has a positive correlation with inflation, and monetary policy plays a very important role in determining the general price level. However, the latter, using a VAR over the period 1996–2005, show a significant link between money supply and real output but fail to confirm a significant connection between money and inflation.

In their study on the usefulness of monetary and exchange rate policies in Vietnam during the 1990s, Vo Tri Thanh et al. (2002) conclude that changes in money supply and exchange rate contain very little advance information on Vietnamese inflation. This result contrasts with Vo Van Minh (2009), who examines exchange rate pass-through in the period 2001–07. His findings support the impact of exchange rate fluctuations on consumer prices, though acknowledging this impact is modest and short-lived. Nguyen Cao Duc (2006), using a monetarist approach, shows the main determinants of inflation in Vietnam to be past inflation, money supply, exchange and interest rates.

More comprehensively, Camen (2006) and Goujon (2006) incorporate both structural/cost-push and monetarist/demand pull elements into their models to determine the agents of inflation. Camen (2006), using VAR, identifies total credit to the economy, commodity prices, the VND/u.S. dollar exchange rate and the u.S. money supply (as a measure of international liquidity conditions) as important agents during 1996–2004. Goujon (2006), utilizing a more sophisticated two-step estimation method, confirms the merit of exchange rate and commodity prices but stresses that inflation is explained by excess money, rather than total credit.

The International Monetary Fund has conducted two separate studies of inflation in Vietnam (IMF 2003b, 2006) for late 1990s to early 2000s. employing different methods (recursive VAR and VeC), these studies produce similar results,

suggesting past inflation, broad money growth, exchange rate, domestic demand conditions and commodity prices (especially the price of oil) are significant determinants of inflation. In addition, they conclude that inflation inertia plays a more important part in Vietnam than in many other countries in Asia.

Of all the aforementioned empirical studies, that of Goujon (2006), perhaps, deserves the most attention, as not only is it able to capture elements from major theories of inflation, but it also offers a clear, theoretically based inflation model for a standard price-taking small open economy. This model will be discussed in more detail below.

III.  An Inflation Model for Vietnam

This study follows the model developed by Goujon (2006). The model draws upon several different theories relating to the inflation process and is set in a small dollarized economy.1 Hence, it contains structural features, which are appropriate for analysing a developing country like Vietnam. The structure of the model is detailed below.

The (CPI) inflation rate is a weighted function of changes in the price of tradeable and non-tradeable goods, specified as:

∆ = ∆ + ∆p p pt tT

tNTθ θ( – )1 (1)

where p denotes the log of the consumer price index (CPI), r and pNT are the logs of the prices of tradeable and of non-tradeable goods, Y is the constant weight of the prices of tradeable goods in the CPI (0< θ <1) and ∆ is the first difference operator.

For a small, price-taking economy, the rate of change in the prices of tradeable goods is:

∆ = ∆ + ∆p e ptT

t tWλ µ (2)

where pt–1 is the log of the nominal exchange rate (VND/u.S. dollar) and stands for the international price of tradeable goods (in u.S. dollar).

As the economy of Vietnam is highly dollarized, fluctuations in the exchange rate effect not only the prices of tradeable goods but also those of non-

01 Tony.indd 4 4/3/12 9:31:36 AM

ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

tradeable goods. The change in the non-tradeable good prices is thus defined by Goujon (2006) as:

∆ = + ∆p EC etNT

t tα ζ–1 (3)

where EC represents excess money and ζ theimpact of the dollar-denominated price of particular non-tradeable goods. EC is in lagged form, as it is presumed that those holding excess money at the beginning of the current period will adjust their holdings and fuel inflation at the end.

The inflation equation is derived by substituting (2) and (3) into (1):

∆ = +[ ]∆ + ∆ +p e p ECt t tW

tλθ θ ζ θµ θ α( – ) ( – ) –1 1 1

(4)

and can be written in reduced form as:

∆ = ∆ + ∆ +p k e k p k ECt t tW

t1 2 3 1– (5)

Goujon (2006) does not employ money supply into this model, maintaining that the expansion of money supply may be, partly at least, absorbed by an increase in money demand. The real factor that induces inflation, it is argued, is excess money. Following this approach, equation (5) can only be estimated by first estimating money demand, and then excess money.

In lieu of performing such a two-stage estimation process, this study takes into account both the conventional money supply and aggregate demand, on which the demand for money depends: an approach used in many other studies on inflation. The interest rate is also included yielding our empirical specification:

∆ = ∆ + ∆ + ∆ + + ∆ +p k e k p k M k Y k rt t tW

t t t t1 2 3 4 52 ε (6)2

where εt denotes the error term. Monetary conditions are identified by interest rate (refinancing rate) rand money supply M2, defined as the total money stock, consisting of domestic currency (VND) in circulation along with VND-denominated and u.S. dollar-denominated bank deposits. Yt represents

domestic output and is measured by monthly industrial production. The international price of tradeable goods cannot be calculated directly. As a proxy, Goujon (2006) uses both the measure of foreign inflation (FI, computed as a weighted mean of the inflation rates of the ten main commercial partners of Vietnam) and the u.S. dollar-denominated export price of Vietnamese rice. The same approach is adopted here but, since oil is also a major tradeable good in Vietnam, rice price will be replaced by a composite index of both rice and oil prices (IOR).

Changes in the interest rate are expected to have a negative relationship with inflation; the other independent variables a positive one. The data on exchange rates, money supply, CPI and the price of oil used in this study are collected from the International Monetary Fund’s International Financial Statistics (IFS); that on industrial output value and interest rate from the General Statistics Office of Vietnam’s online database and the State Bank of Vietnam’s annual reports; while that on the price of rice from the Food and Agricultural Organization of the united Nations’ website. The ten major trading partners of Vietnam are identified using the IMF’s Direction of Trade Statistics (DOTS). Monthly data from January 2001 to February 2009 are used so that ninety-eight observations are available for estimation. For industrial output value, however, statistics are available only from January 2004 onward.

IV. Estimation and Results

IV.1 Data

We use IMF’s International Financial Statistics (IFS) yearbooks which contain time-series inflation data for over 200 countries. Our measures of trade volumes are taken from The IMF’s Direction of Trade Statistics (DOTS), which reports the value of exports and imports between each country and its trading partners. This enabled data to be extracted for the ten major trading partners of Vietnam over the period of estimation. The International Commodity Prices Database of the Food and Agriculture Organisation of the united

∆ = +[ ]∆ + ∆ +p e p ECt t tW

tλθ θ ζ θµ θ α( – ) ( – ) –1 1 1

∆ = ∆ + ∆ + ∆ + + ∆ +p k e k p k M k Y k rt t tW

t t t t1 2 3 4 52 ε

01 Tony.indd 5 4/3/12 9:31:38 AM

ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

Nations (FAO) provides statistics on international commodity prices. Sources of data specific to Vietnam are the General Statistics Office of Vietnam’s (GSO) online database and the State Bank of Vietnam’s (SBV) annual reports.3 Theformer provides documents and numbers related to socio-economic and cultural events in the country, whereas the latter contains useful national monetary and financial statistics.

The data on exchange rate, money supply, CPI and price of oil used in this study are collected from the IFS. Industrial output and interest rate data are taken from the GSO’s database and the SBV’s reports. Price data for rice were taken from the FAO’s database. Overall, our data set comprises monthly observations from the period January 2001 through February 2009, with the one exception of output value, which was only available from January 2004.

IV.2 OLS Estimates

Our first strategy is to use OLS estimation as our baseline specification. Results from the Augmented Dickey-Fuller (ADF) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests reveal that the time series data (in log differences) employed in this study are, for the most part, stationary. Table

2 reports the results of these tests. For the ADF Test, at the significant level of 1 per cent, the null hypothesis of a unit root is rejected for all variables, except ∆p. The KPSS Test shows that all variables are stationary.

To capture inflation inertia, one period lagged inflation (∆pt–1) is added as an independent variable. In addition, we included dummies to capture seasonal effects such as the Lunar New Year and Christmas period which would be likely to have an upward bias on prices.4

In Model 1, the one-period-lagged inflation is significant and seems to be the most important determinant of the variation in the price index, having a coefficient of 0.82. This means a 1 percentage point increase in past inflation rate, ceteris paribus, induces a rise of 0.82 in the current rate, confirming the inertia of inflation and suggesting that, because of the dominance of inertia, the effect of other independent variables is weak in the short term. This is also comparable with results produced by economists of the IMF (2006a), who, in their models for Vietnamese inflation, estimate the coefficient for past inflation as about 0.79. As the exchange rate regime in Vietnam is quite rigidly fixed to the u.S. dollar,5the finding is in accord with Loungani and Swagel (2001), who find that inertial factors often exert

TABLe 2ADF and KPSS Tests

ADF Statistics KPSS Statistics Without Trend With Trend Without Trend With Trend ∆p –0.50 (11) –1.45 (11) 0.39 [6] 0.03 [5] ∆e –10.03** (0) –9.98** (0) 0.14 [3] 0.14 [3] ∆M2 –7.99** (0) –8.17** (0) 0.30 [4] 0.05 [4] ∆r –8.53** (0) –8.50** (0) 0.05 [3] 0.03 [3] ∆FI –4.80** (4) –5.12** (4) 0.17 [5] 0.06 [5] ∆IOR –6.24** (0) –6.25** (0) 0.13 [4] 0.10 [4] ∆Y –10.44** (1) –10.38** (1) 0.23 [11] 0.20 [11]

NoteS: ADF’s Null Hypothesis: A unit root is present; KPSS’s Null Hypothesis: A time series is stationary. For ADF, the lag length, selected using the Schwarz information criterion, is given in parentheses; for KPSS, the bandwidth, determined by the Newey-West method with Bartlett kernel, is presented in square brackets. (**) shows the statistics are significant at the 1 per cent level.Source: Authors’ calculations.

01 Tony.indd 6 4/3/12 9:31:38 AM

ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

a strong influence on inflation in developing countries, especially those with fixed exchange rates.

As noted earlier, existing studies on inflation in Vietnam generally do not identify interest rate as a significant determinant of inflation. Here, the coefficients for ∆r display conflicting signs and, though significant, a very small in magnitude. Hence, there again seems to be little support for a pivotal role by interest rates in determining changes in the price level.6 In terms of money supply, only the coefficient for ∆M2t–2 is significant and has the expected sign, possibly suggesting that there is a certain delay in the effect of money growth on inflation. A one percentage point increase in two-period-lagged money growth is expected to fuel inflation by only 0.07 per cent. This weak short-run effect of ∆M2 can be explained by inflation inertia.

The impact of external price shocks is confirmed by the significance of the coefficient for the index

of oil and rice price changes. The magnitude of the effect, as indicated by the coefficients of 0.01 and 0.03, is quite small and can possibly be explained by inflation inertia. Surprisingly, however, the relationship between exchange rate and inflation cannot be established, as the coefficient for ∆e is statistically insignificant.

Model 2, with only sixty-one observations due to the shorter series for industrial output value, produces somewhat similar results. The inclusion of output growth slightly improves our model: ∆rt–2 becomes marginally significant at the 5 per cent level, and money supply now appears to play a greater role in the inflationary process. If ∆M2t–2increases by 1 percentage point, for instance, inflation is expected to rise by 0.13. Still, the effect of exchange rate is insignificant. The coefficient for output growth itself is also insignificant, and its size is negligible. This, however, does not necessarily mean that aggregate demand pressures have no influence on inflation. Rather, it may

TABLe 3Inflation equation estimates (OLS) (Dependent Variable: ∆p)

Variable Model 1 Model 2constant 0.00 (0.01) 0.02 (0.00)∆pt–1 0.82 (0.00) 0.76 (0.00)∆pNT 0.12 (0.22) 0.17 (0.14)∆rt –0.00 (0.00) –0.00 (0.01)∆θ 0.00 (0.05) 0.00 (0.05)∆M2t –0.01 (0.72) –0.12 (0.05)∆θ –0.05 (0.17) –0.10 (0.07)∆M2t–2 0.07 (0.04) 0.13 (0.03)∆∆ 0.01 (0.04) 0.02 (0.00)∆IORt–1 0.03 (0.00) 0.03 (0.00)∆∆pT

t = λ∆et+µ∆pwt — 0.00 (0.12)

R2 0.94 0.95Observations 95 61DW 1.88 1.78BG 3.60 (0.73) 10.64 (0.10)BPG 29.98 (0.07) 22.07 (0.39)

NoteS: DW is the Durbin-Watson statistic; BG is the Breusch-Godfrey serial correlation LM test; BPG is the Breusch-Pagan-Godfrey test for heteroskedasticity. P-values are presented in parentheses.Source: Authors’ calculations.

01 Tony.indd 7 4/3/12 9:31:38 AM

ASEAN Economic Bu l l e t in � Vo l . 29 , No . � , Apr i l 20 �2

be that industrial output growth is not a good substitute for demand conditions, or that it takes a while for its effect to be felt on the prices.

IV.3 Causality Test

In addition to OLS, pairwise Granger causality test is employed. For the purpose of this study, we are interested in the effect of lagged money supply, output, exchange rate, interest rate, foreign inflation and commodity prices on the current value of inflation. F-tests for the null hypothesis of the non-causality of these variables are computed for lag lengths of 2, 6 and 12. These are given in Table 4.

From Table 4, it can be seen that, with 2 lags, commodity prices do Granger cause inflation, lending support for the transmission of external disturbances to consumer prices. Also, there is strong evidence that causality runs from money growth to inflation, providing reinforcement for monetarist theories. However, while output growth

carries advance information on inflation, there is no evidence for exchange rate, interest rate or foreign inflation Granger causing changes in the price level.

Results using different lag lengths are similar in that they confirm money growth and external shocks as agents of Vietnamese inflation. Indeed, with both 6 and 12 lags, ∆M2 and ∆FI Granger cause inflation, whereas with 12 lags, causality again runs from ∆IOR to ∆p. Test statistics for exchange rate and output growth are mixed. Interest rates lack explanatory power on the future movements of inflation, regardless of lag lengths. This is consistent with the OLS finding that ∆rexerts little influence on price.

IV.4 Vector Autoregression (VAR) Results

As noted above, unit root and stationarity tests show that there is evidence suggesting that the variables are largely stationary. This is due to the fact that we have specified the variables in

TABLe 4Pairwise Granger Causality Tests for Inflation

Null Hypothesis Test Statistic

2 lags 6 lags 12 lags∆e does not 1.11 (0.33) 1.46 (0.20) 2.22 (0.02)Granger-Cause ∆p

∆r does not 0.52 (0.59) 1.22 (0.30) 1.56 (0.12)Granger-Cause ∆p

∆M2 does not 7.88 (0.00) 3.72 (0.00) 1.90 (0.05)Granger-Cause ∆p

∆FI does not 2.27 (0.10) 4.73 (0.00) 5.10 (0.00)Granger-Cause ∆p

∆IOR does not 4.63 (0.01) 1.68 (0.13) 1.88 (0.05)Granger-Cause ∆p

∆Y does not 3.09 (0.05) 6.33 (0.00) 1.36 (0.24)Granger-Cause ∆p

Note: Figures in parentheses are p-values.Source: Authors’ calculations.

01 Tony.indd 8 4/3/12 9:31:38 AM

ASEAN Economic Bu l l e t in 9 Vo l . 29 , No . � , Apr i l 20 �2

log differences in accordance with the analytical framework presented in section II. As such, in this study, we have a (7 × 1) vector which can be expressed in VAR form as:7

AXt = C + B(L)Xt–1+ζt (7)

where A is a matrix of contemporaneous coefficients, C is a (7 × 1) intercept vector, B is a matrix of coefficients for lagged terms, and ζt

is a (7 × 1) vector of disturbances to the system. L refers to the polynomial lag operator. We have employed the model incorporating the output variable, Yt, as we wish to include as much interaction as possible in this model. Since this model has fewer observations and being mindful of having sufficient degrees of freedom for statistical inference, we favour a parsimonious specification with 2 (monthly) lag model.

In using a VAR, the coefficients of the A matrix must be subject to identification restrictions through (cholesky) ordering the variables such that the model can produce impulse response function and variance decompositions. Here, our variables are ordered as follow: ∆IOR ∆FI ∆M2∆r∆p∆e∆Y.

Growth in commodity prices and foreign inflation are included together in this model and are ordered first as they are external factors and not likely to be affected by domestic economic conditions. Money supply growth and interest rates are ordered next, ahead of inflation, with the assumption that monetary policy responds to inflation expectations. exchange rate and output growth are ordered last, after inflation, as it is assumed that prices are, to a certain extent, rigid and only react to lagged ∆e and ∆Y.8

From the model given by equation (7), using the above ordering, two sets of results are generated: variance decompositions and impulse response functions. Variance decompositions (VDs) separate variance of forecast errors for a variable into contributions of its own shocks and shocks of other variables in the model, whereby revealing the relative weight of each shock plays in affecting that variable. Impulse response functions (IRFs) display the effect of a shock in a particular variable on all other variables.

It is clear from Table 5 that, throughout the twelve months in question, the innovation to inflation itself is the most important source of variation in inflation forecast errors, explaining 53.43 – 94.23

TABLe 5Variance Decompositions for Inflation

Period S.E. ∆IOR ∆FI ∆M2 ∆r ∆p ∆e ∆Y 1 0.08 1.34 0.6 3.42 0.39 94.23 0.0 0.0 2 0.09 12.67 2.9 2.08 3.17 71.55 0.0 7.6 3 0.1 12.89 2.05 11.64 2.26 63.69 0.16 7.28 4 0.1 13.14 4.9 12.9 1.88 58.29 1.83 7.01 5 0.1 12.83 4.79 13.8 2.11 57.43 1.74 7.28 6 0.1 13.6 5.0 15.62 2.24 54.41 1.82 7.23 7 0.1 13.67 5.11 16.32 2.2 53.88 1.95 7.15 8 0.1 13.46 5.25 16.41 2.19 53.57 1.96 7.13 9 0.1 13.43 5.24 16.55 2.19 53.47 1.96 7.12 10 0.2 13.42 5.26 16.55 2.21 53.45 1.97 7.11 11 0.2 13.43 5.26 16.54 2.21 53.43 1.98 7.12 12 0.2 13.42 5.26 16.53 2.21 53.46 1.97 7.11

Source: Authors’ calculations.

01 Tony.indd 9 4/3/12 9:31:39 AM

ASEAN Economic Bu l l e t in �0 Vo l . 29 , No . � , Apr i l 20 �2

FIG

uR

e 2

Res

pons

es o

f Infl

atio

n to

Cho

lesk

y O

ne S

tand

ard

Dev

iatio

n In

nova

tions

in o

ther

Var

iabl

es

No

teS:

DIF

FLN

CPI

= ∆

p, D

IFFL

NeR

ATe

= ∆e

, D

IFFI

R =

∆r,

DIF

FLN

M2

= ∆M

2, D

IFFF

OR

eIG

NC

PI =

∆FI

, D

IFFL

NIN

DeX

OI

= ∆I

OR,

D

IFFL

NIO

VALu

e =

∆Y.

Sou

rc

e: A

utho

rs’ c

alcu

latio

ns.

01 Tony.indd 10 4/3/12 9:31:39 AM

ASEAN Economic Bu l l e t in �� Vo l . 29 , No . � , Apr i l 20 �2

per cent of it. ∆M2 is the second most important source, reasserting the OLS and Granger Causality results that money growth plays a part in the inflation process. The contribution of ∆M2, quite small in the first two months, rises through 11.64 per cent in the third to 16.53 per cent in the twelfth month, implying that the effect of money supply on inflation is comparatively weak in short periods but increases in longer ones.

Apart from its own shock and ∆M2, ∆IOR is also an important source, contributing 1.34 – 13.67 per cent to variation in inflation, whereas ∆FIalso contributes 0.6 – 5.26 per cent, suggesting the predominant role of external factors in influencing Vietnamese CPI dynamics. This is hardly surprising, as foreign inflation is related to the price of imported goods, putting pressure on the general price level; and Vietnam is a highly open economy (see, for instance, IMF 2009). It is also understandable that oil and rice prices exert a strong impact. In the case of oil, although Vietnam is an exporter of crude oil, it has to import petrol products, and thus has to bear the effect of any oil price shock. With respect to rice, as Sofat (2008) points out, though Vietnam does not import the staple, it imports the high price, since Vietnamese sellers price their product using international prices.9

The OLS and Granger causality results fail to provide strong evidence on the impact of exchange rate on inflation. Here, that impact is also weak. In the first two months, the contribution of ∆e is practically zero. In the third month, it rises to 0.16 per cent, fluctuating in the 1.7–2 range afterwards. The influence of interest rate is only slightly stronger. Output growth, meanwhile, has a notable effect, contributing at most 7.6 per cent in inflation variance, confirming the part played by demand conditions.

In the IRF graphs, we examine a period of two years (24 months) to see the long run effect of other variables on inflation. It is shown that, again, Vietnamese inflation is highly inertial. In the event of a one standard deviation “own shock”, inflation will increase sharply in the first month before decreasing in the second month and reverting back to zero in the ninth. The graphs for ∆IOR, ∆M2

and ∆Y are somewhat similar, indicating that there is a positive and relatively persistent reaction by inflation to shocks in commodity prices, money and output growth. The effect of those three factors, however, reverts back to zero after nine to eleven months.

The graph for foreign inflation shows ∆p initially decreases following a shock in ∆FI, then, before stabilizing, fluctuates for around nine months below its pre-shock level. Similar observations can be seen in the graphs for ∆r and ∆e. The negative reaction of ∆p to shocks in ∆r and ∆e confirms our earlier results that exchange rate and interest rate exert little influence on Vietnamese inflation. It also supports Loungani and Swagel’s (2001) position that changes in the exchange rate has less influence on inflation in economies with fixed exchange rate regimes.

V.  Conclusions and Some Policy Messages

This study investigates the inflation process in Vietnam since the turn of the new century, from January 2001 to February 2009. OLS results identify inflation inertia, money supply and external cost shocks as significant determinants of inflation. Because of inflation inertia, the impacts of money supply and external shocks are found to be rather weak in the short-term. The effects of changes in output value, exchange rates and interest rates on inflation are much weaker. Findings from Granger causality test are somewhat inconclusive. There is evidence that causality runs from money growth and external shocks to inflation but results for output and exchange rate are mixed. Interest rates are found to lack information content on the future movements of inflation. The VAR, meanwhile, reveals that, apart from its own innovation, money supply, external factors and output all play a role in the Vietnamese inflation process.

From the results, a number of policy implications can be derived for Vietnam. First, it is true that external shocks, and thus imported inflation, are difficult to avoid, as Vietnam is a small and open economy. Second, the fact that inflation inertia is a main determinant of inflation is an unsurprising

01 Tony.indd 11 4/3/12 9:31:40 AM

ASEAN Economic Bu l l e t in �2 Vo l . 29 , No . � , Apr i l 20 �2

result. It is also potentially undesirable, implying that when the inflation rate reaches a new level, it is likely to stay there rather than reverting back. Inflation inertia may be explained by sticky inflation expectations. These expectations, in turn, are explained by the ruling regime’s policy of accepting a relatively high inflation rate to attain economic growth. They may also be entrenched

because the memory of a command economy marred with government failures and rampant inflation is still fresh in the mind of the Vietnamese people. The fact that Vietnam has a largely fixed exchange rate regime10 is a possible solution to this problem. This regime can impose a monetary discipline for Vietnamese authorities and also help to anchor inflationary expectations.

NOTES

1. See Hauskrecht and Nguyen Thanh Hai (2004) for a discussion of the high degree to which the Vietnamese economy is dollarized.

2. All variables included in the equation are in log differences except for ∆r, which is in first difference form only.

3. These publications are in Vietnamese and were translated for the purpose of this study. 4. The cross-correlation function (CCF) is used to determine whether any lagged values of other independent

variables should be employed in the regression. Its results suggest the utilization of ∆M2t–1,∆M2t2,∆M2t3,∆rt

1,∆rt–2,∆FIt–1,∆FIt2,∆IORt1 and ∆IORt2. However, after some preliminary regressions ∆M2t–3,∆rt–1,∆FIt–2 and ∆IORt–2 were removed due to their insignificance. From the table, the Durbin-Watson statistic and the Breusch-Godfrey test detect no sign of serial correlation. The Breusch-Pagan-Godfrey test, meanwhile, shows that heteroscedasticity is less of a concern. R2 is high, indicating that around 94–95 per cent of the variation in CPI is explained by the independent variables. Coefficients for seasonal dummies, though not reported, are mostly significant.

5. See, for instance, Nguyen Tran Phuc and Nguyen Duc Tho (2009). 6. There are two possible reasons for this. The first is that, in the general equilibrium set up of, say, a New

Keynesian model, interest rates — as a possible instrument of monetary policy — would influence aggregate demand (through an IS expression) before influencing inflation. In our partial equilibrium model, this effect is not observed. The second is that, in the case of Vietnam, where the monetary policy regime is exchange rate based, the domestic nominal interest rates do not assume the role of policy instrument and, as such, does not transmit monetary policy through aggregate demand and prices.

7. Despite the conclusions that we have formed over stationarity, we conducted Johansen tests for cointegration and we ran a Vector error Correction (VeCM) model for the purposes of robustness. We found that there are some cointegrating vectors, but not in sufficient numbers to justify using a VeCM in this instance. Furthermore, the available cointerating vectors were not sufficiently related to the equation of interest, inflation to justify the use of a VeCM. The cointegration results are not presented here but are available upon request.

8. The VAR is also estimated using some alternative orderings of variables. No considerable differences are observed.

9. Overall, the impacts of ∆IOR and ∆FI found here support Salih’s (1993) conclusion that inflation in oil-exporting developing countries is mainly imported from overseas.

10. See Cavoli and Rajan (2010).

ReFeReNCeS

Akbari, A.H. and W. Rankaduwa. “Determinants of Inflation and Feasibility of Inflation Targeting in a Small emerging Market economy: The Case of Pakistan”. Paper presented to the Conference on Monetary-cum-exchange Rate Regime: What Works Best for emerging Market economies?, Karachi, 15–16 November 2005.

Camen, u. “Monetary Policy in Vietnam: The Case of a Transition Country”. BIS Papers, Paper no. 31, Bank for International Settlements, Hong Kong, 2006.

Cavoli, T. and R.S. Rajan. “A Note on exchange Rate Regimes in Asia: Are They Really What They Claim to be?”. Economics Bulletin 30, no. 4 (November 2010): 2864–76.

Dang, Phong. Tu Duy Kinh Te Viet Nam [economic Thoughts in Vietnam]. Hanoi: Tri Thuc, 2008.

01 Tony.indd 12 4/3/12 9:31:40 AM

ASEAN Economic Bu l l e t in �� Vo l . 29 , No . � , Apr i l 20 �2

Dlamini, A., A. Dlamini, and T. Nxumalo. “A Cointegration Analysis of The Determinants of Inflation in Swaziland”.Central Bank of Swaziland’s Inflation Paper, 2001. <http://www.centralbank.org.sz/docs/Inflation_Paper.pdf>. Accessed 2 February 2009.

enders, W. Applied Econometric Time Series. Toronto: John Wiley & Sons, 1995.Farber, A., Nguyen Huu Tu, Tran Tri Dung and Vuong Quan Hoang. “The Financial Storms in Vietnam’s Transition

economy: A Reasoning on the 1991–2008 Period”. Centre Emile Bernheim Working Papers. Working Paper no. 08/023, université Libre de Bruxelles — Solvay Business School, 2008.

Food and Agriculture Organisation of the united Nations (FAO). International Commodity Prices, <http://www.fao.org/es/esc/prices>, various years.

Frisch, H. Theories of Inflation. Cambridge: Cambridge university Press, 1983.General Statistics Office of Vietnam (GSO). So Lieu Thong Ke Hang Thang (Monthly Statistical Information),

<http://www.gso.gov.vn/default_en.aspx?tabid=622>, various years.———.Key Indicators on National Accounts, <http://www.gso.gov.vn/default_en.aspx?tabid=468&idmid=3&ItemID

=8681>. Accessed 20 May 2009.Ghosh, A.R., A.M. Gulde, J.D. Ostry and H. Wolf. “Does the exchange Rate Regime Matter for Inflation and

Growth?”. Economic Issues, no. 2 (September 1996): 1–13.Ginting, e. and K. Bird. “explaining Inflation in Cambodia”. Paper presented to the 3rd Cambodian economic Forum,

Phnom Penh, 5 February 2009.Goujon, M. “Fighting Inflation in a Dollarized economy: The Case of Vietnam”. Journal of Comparative Economics

34, no. 3 (2006): 564–81.Hagger, A.J. Inflation: Theory and Policy. London: Macmillan Press Ltd, 1977.Hauskrecht, A. and Nguyen Thanh Hai. “Dollarization in Vietnam”. Paper presented to the 12th Annual Conference

on Pacific Basin Finance, economics, Accounting and Business, Bangkok, 10–11 August 2004.International Monetary Fund. International Financial Statistics (CD-Rom), various issues. (IMFa).———.Direction of Trade Statistics (quarterly updates), various issues (IMFb).———. Vietnam: 2003 Article IV Consultation- Staff Report; Staff Statement; Public Information Notice on the

Executive Board Discussion; and Statement by the Executive Director for Vietnam, IMF Country Report No. 03/380,2003a.

———.Vietnam: Selected Issues, IMF Country Report No. 03/381, 2003b.———. Vietnam: 2005 Article IV Consultation- Staff Report; Staff Statement; Public Information Notice on the

Executive Board Discussion; and Statement by the Executive Director for Vietnam, IMF Country Report No. 06/22,2005.

———.Vietnam: Selected Issues, IMF Country Report No. 06/422, 2006.———.Vietnam: Statistical Appendix, IMF Country Report No. 07/386, 2007.———. Vietnam: 2008 Article IV Consultation- Staff Report; Staff Statement; Public Information Notice on the

Executive Board Discussion; and Statement by the Executive Director for Vietnam, IMF Country Report No. 09/110,2009.

Laidler, D. and M. Parkin. “Inflation: A Survey”. Economic Journal 85, no. 340 (1975): 741–809.Le, Anh Minh. “Macroeconomic Policy Analysis of Vietnam: A Macro-econometric Model Approach”. Forum of

International Development Studies 36 (March 2008): 193–214.Le, Viet Hung and W.D. Pfau. “VAR Analysis of the Monetary Transmission Mechanism in Vietnam”. VDF Working

Paper Series. Working Paper 081, Vietnam Development Forum, Hanoi, 2008.Loungani, P. and P. Swagel. “Sources of Inflation in Developing Countries”. IMF Working Papers. Working Paper

01/198, International Monetary Fund, 2001.Mydans, S. “In Vietnam, even the Dead Feel the Pinch of Inflation”, <http://www.nytimes.com/2008/08/19/business/

worldbusiness/19iht-dong.4.15437621.html>. Accessed 23 May 2009.Nguyen Cao Duc. “Cac Nhan To Quyet Dinh Lam Phat cua Viet Nam Dua Tren Cach Tiep Can Tien Te” [Determinants

of Inflation in Vietnam Based on Monetary Approach], Nghien Cuu Kinh Te (Economic Studies), no. 4 (335) (2006): 3–16.

Nguyen Tran Phuc and Nguyen Duc Tho. “exchange Rate Policy in Vietnam, 1985–2008”. ASEAN Economic Bulletin26, no. 2 (2009): 137–63.

Nguyen Tri Hung. “The Inflation of Vietnam in Transition”. CAS Discussion Papers. Paper no. 22, Centre for ASeAN Studies, the Faculty of Applied economics and the Institute of Administrative Sciences of the university of Antwerp, 1999.

Pevcin, P. “The Determinants of Inflation in the Period of Transition: The Case of Slovenia”. Conference Proceedings: 2003 International Conference Enterprise in Transition, 2003, pp. 1422–34.

01 Tony.indd 13 4/3/12 9:31:40 AM

ASEAN Economic Bu l l e t in �� Vo l . 29 , No . � , Apr i l 20 �2

Salih, S.A. “Determinants of Inflation in Oil-exporting Developing Countries: An empirical Investigation 1970–1990”. Applied Economics 25, no. 4 (1993): 439–45.

Shinichi, W. and Pham Thai Binh. “Demand for Money in Dollarized, Transitional economy: The Case of Vietnam”. Paper presented to the 1st Vietnam Development Forum (VDF) Tokyo Conference on the Development of Vietnam, Tokyo, 18 June 2005.

Sofat, P. “Vietnam Inflation: Too Hot to Handle?”. Hong Kong and Shanghai Banking Corporation’s (HSBC) Report,<http://www.research.hsbc.com/midas/Res/RDV?p=pdf&ao=19&key=1kzrqx6blx&n=218571.PDF>. Accessed 5 February 2009.

State Bank of Vietnam (SBV). Bao Cao Thuong Nien (Annual Report). Ha Noi: State Bank of Vietnam, various issues.

Tran Van Tho, Nguyen Ngoc Duc, Nguyen Van Chinh and Nguyen Quan. Kinh Te Vietnam 1955–2000: Tinh Toan Moi, Phan Tich Moi [The Vietnamese economy 1955–2000: New Calculations, New Analyses]. Hanoi: Thong Ke, 2000.

Vo Tri Thanh, Dinh, Hien Minh, Do, Xuan Truong, Hoang, Van Thanh and Pham Chi Quang. “exchange Rate Arrangement in Vietnam: Information Content and Policy Options”. EADN Working Papers, Working Paper 18, east Asian Development Network, Hanoi, 2002.

Vo Van Minh. “exchange-Rate Pass-through and its Implications for Inflation in Vietnam”. VDF Working Papers Series. Working Paper 0902, Vietnam Development Forum, Hanoi, 2009.

Wooldridge, J.M. Introductory Econometrics: A Modern Approach, 3rd ed., Thomson South-Western, 2006.

Huu Minh Nguyen is currently undertaking a PhD in economics at the School of Commerce, university of South Australia.

Tony Cavoli is a Senior Lecturer in the School of Commerce, university of South Australia, and Visiting Senior Research Fellow in the Center for emerging Markets Policies at George Mason university, uSA.

John K. Wilson is a Senior Lecturer in economics and a member of the Centre for Regulation and Market Analysis, university of South Australia.

01 Tony.indd 14 4/3/12 9:31:40 AM