Relationship Between Balance Of Payments And Exchange Rate Finance Essay

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The accedence of developing countries such as China, Thailand, Vietnam…to the international trade give them the prosperous and economic growth; however the countries have faced many issues in managing their macro-economy to sustain the economic growth and development. Especially, in Vietnam, the government usually has serious difficulties in managing and operating the economic with the deficit in the Balance of Payments, the depreciation domestic currency and retraining the local inflation.

The balance of payment is one of the most considerations of the governments when they formulate the national trade, fiscal and monetary policies, so it has the significant important role in government's policy decision-making. It also has an indispensable part to organizations (i.e. banks, companies, nongovernment organizations) and individuals that are directly or indirectly involved in international trade and finance (Dominick Salvatore, 2011). And the Balance of Payments is a significant indicator of the pressure on the exchange rate of a country (David K. Eitman, Arthur I. Stonehill & Michael H. Moeffett, 2010). In the context of Vietnam, the surplus in the Balance of Payments encourages the governments allow the value of the domestic currency to increase. On the other hand, the significant deficit in Balance of Payments force the government to devalue the price of VND (David K. Eitman, Arthur I. Stonehill & Michael H. Moeffett, 2010).

Next, the theories of exchange rate determination that related to the inflation and the balance of payments are Purchasing Power Parity Approaches and Balance of Payments Approaches respectively. According to Purchasing Power Parity approaches, the determination of the equilibrium of exchange rate in long term is the ratio of domestic prices relative to foreign prices (David K. Eitman, Arthur I. Stonehill & Michael H. Moeffett, 2010). And along with Balance of payments approaches, the exchange rate reflects the transactions in the current and financial accounts of the balance of payments (David K. Eitman, Arthur I. Stonehill & Michael H. Moeffett, 2010). The exchange rate movements also produce the risk for firms, because they result in foreign exchange exposure, i.e. transaction risk, translation exposure and operating or economic exposure. The transaction risk refers to the exposure of the firm's contractual transactions in foreign currencies (Jeff Madura, 2008). The translation exposure refers to the exposure when the firms translate or consolidate their subsidiaries' financial statements to the currency of the parent company (Jeff Madura, 2008). The economic exposure refers to the exposure of a firm's present values, which are affected from the changes in operating cash flows, which are effected movements of exchange rate (David K. Eitman, Arthur I. Stonehill & Michael H. Moeffett, 2010). Thus, the transaction exposure is the subfield of the economic exposure (Jeff Madura, 2008). In the context of Vietnam, USD is considered as a tool to invest; thus when the value of USD increase with respect to the value of VND, people and investor will exchange from VND to USD. There are two reasons behind that fact; first, they want to invest in USD; second, they afraid of the inflation and the devaluation in VND.

Therefore, the movements of exchange rate will impact the inflation in Vietnam. And the inflation impacts everyone directly or indirectly. It impacts on savers and investors, people with fixed incomes (i.e. pension payment); for example, if the inflation rate goes up higher than the return on savings or investment, the received money will be worth less than it was when they deposited. However, the increase in the inflation may impact positively the people who owe money; they may generally get benefit from inflation if the value of the money they repay is less than that of the amount of their loans. On the other hand, the inflation may affects negatively the people who lend money, if the value of the money they lend to other people is worth than the value of money the borrowers repay them. To be noted, the inflation will influences business; the inflation will increase the costs, so the companies have to try to increase their incomes higher than the increase in inflation in order to compensate the increase in the costs (Gerson Antell and Walter Harris, 2005). The inflation also impacts the international trade of a country. In the circumstances of other things equal, if the inflation rate increases relative to that of the trade-partner countries, its current account will decrease. Because the people in that country will purchase more imports from foreign countries due to the higher local inflation, while the exports of that country will decline (Jeff Madura, 2008). That will impact the demand for and supply of the currencies of that currencies (Jeff Madura, 2008)

Next, I would like to mention briefly about the three things the research is going to study.

First, tn principle, the balance of payments is a summary statement which embraces all the transactions of the residents of a nation with the residents of all other nations, and they are recorded during a period of time. (Dominick Salvatore, 2011:434).Thus, it summarizes all transaction into some categories and only the net balance of each one is included and has time dimension. The transactions in the balance of payments are international, and are classified as credits or debits. The credit transactions refer to the receipts of payments from foreigners and they are noted with a positive sign. On the other hand, the debit transactions refer to the payments to foreigners and they are noted with a negative sign. (Dominick Salvatore, 2011).

Next, "an exchange rate is the price of one currency expressed in terms of another" (Glen Arnold, 2008:965). There are two ways of quotation for exchange rate (i.e. direct quotation and indirect quotation). Within the direct quotation, the exchange rate between a domestic currency and foreign one is equal to the number of the domestic currency to purchase one unit of a foreign currency (Dominick Salvatore, 2011). The indirect quotation is vice versa. Next, the movements of the exchange rate refer to the terms depreciation and appreciation. The depreciation is increases in the price of the foreign currency with respect to the domestic currency; and the appreciation refers to decreases in the price of the foreign currency with respect to the domestic currency page (Dominick Salvatore, 2011). Thus, the depreciation in this study refers to the increases of the price of USD with respect to VND, and the appreciation refers to decreases in the price of USD with respect to VND. In Vietnam, USD is the most popular foreign currency and it has an significant important role in the economy in Vietnam. Moreover, the people in Vietnam invest so much in USD in order to earn interest or avoid the risk of inflation of VND. Therefore, the exchange rate that the study will collect and analyze is the exchange rate between USD and VND - USD\VND. The rate is quoted directly, that means the rate reflect how much domestic currency (i.e. VND) for one unit of foreign currency (i.e. USD)

Next, I would like to mention about the inflation, the method to measure the inflation in this study and the inflation in Vietnam. According to Romer "Inflation is an increase in the average price of goods and services in terms of money" (2006: 497). The inflation is measured by many methods such as: consumer price index, producer price index, GDP inflation indices, etc. The CPI and PPI are fixed-weight measures; that means the same basket of goods and services is analyzed each month. Meanwhile, the GDP inflation indices are a variable-weight measure; within this method, the basket of goods and services being assessed depended on what was produced during a particular quarter (Evelina M. Tainer, 2006). Among those methods, CPI is the most popular method to measure inflation in the world because it has many advantages with respect to other methods. For example, the GDP inflation indices cover more items than CPI, but the GDP inflation indices are released only quarterly; meanwhile the monthly release of the CPI help people observe the inflation closely and constantly. Moreover, the PPI just embraces the price changes in wholesales business; it does not involve services which is the fastest-growing section in the world (Bernard Baumohl, 2005). Therefore, CPI is more relevant to the cost of living and the cost of doing business. Consumer price index refers how much consumers pay for goods and services, that influences individual and corporate investment, the cost of business and the quality of life (Bernard Baumohl, 2005). And CPI is an index number which expresses percentage changes from base year.

Structure of literature review

The literature review of this study will follow the format:

The Balance of Payment

The definition

The constituents of the Balance of Payments.

When the Balance of Payments is surplus and deficit. Their impact on inflation and exchange rate

An overview about the Balance of Payments in Vietnam and its challenges

The Inflation

The definition

How to measure the inflation - The method applied in the context of Vietnam

The influence of the inflation on the exchange rate and the Balance of Payments

The overview about the inflation in Vietnam and its problems

The exchange rate

The definition

Why the author choose the exchange rate between VND and USD to study.

The impact of the movements of exchange rate on the Balance of Payments and the deficit

The overview about the Vietnamese currency regime and the exchange rate between VND and USD in Vietnam

The relationship or reciprocal among The exchange rate, the Balance of Payments and the Inflation in the context of developing countries that has the conditions and situations like Vietnam

The issue and challenges that Vietnam is facing in the relationships among the exchange rate (USD/VND), the Balance of Payments and the Inflation

Significance of the study

This study will produce the reader an overview and help them understand more about the relationship or reciprocal among the Balance of Payments, the movements of exchange rate and the Inflation in Vietnam. So, the study will produce significant benefits:

The government in Vietnam will have one more useful research paper in the governance of the macro-economy, especially about the control and manage the Inflation, the state of Balance of Payments when the exchange rate moves.

The benefit of the study is helping the firms in Vietnam can understand and forecast the inflation and the exchange rate (USD/VND) in Vietnam better. That will help them hedge their incomes and payments in order to reduce the risks. As we know, Inflation causes instabilities and distorts economic decisions; however only unexpected inflation rates causes problems, not anticipated inflation rates. (Evelina M. Tainer, 2006)

3. Research questions and objectives

3.1 Research questions

The study will try to answer the following questions in the context of Vietnam:

1. How the exchange rate moves when the state of Balance of Payment is deficit or surplus?

2. How the inflation responds to the movements of exchange rate between USD-VND?

The research will not only analyze the movements of the three factors in the past form 1995 to 2010 but also try to produce the main reasons and causes behind the movements. Those will help the readers can have a deep and big view about the relationships between the Balance of Payments & the exchange rate (USD-VND); and between the exchange rate (USD-VND) & The inflation.

3.2 Research objectives

There are two main objectives:

1. Finding common movements of the exchange rate when the Balance of Payments deficit and surplus; and the common respond of the inflation to the movements of the exchange rate.

2. Clarifying the main reasons and causes in those facts.

In order to achieve the objective one, the author will collect date from 1995 to 2010; then the data will be examined by employing SPSS or Microsoft Office Excel

Next, the second objectives will require more comprehensive academic reading and secondary researches or from some specialists and officers in the government to clarify the deep reasons behind the facts.

4. Research methodology & Research design

4.1 research methodology

This part will involve in the methodology or procedure to find out the relationship between the three factors in the context of Vietnam. The study will the method involved in secondary data collection, and there may be interviews with some specialists; then the analysis will be used to find the conclusions.

4.2 Research design

The author proposes the questions and hypothesis; then the author collected quantitative data and information from secondary resources to analyze and find the answers. The questions and hypothesis come first and guide the process of gathering data.

According to what I mention above, I can declare that the epistemology of this research is positivism. The data of this research is analyzed to test the hypotheses. The author is independent from what are being researched.

4.3 Data collection

The research method of collecting data in this study is collecting data and information from secondary data sources.

The author will collect data for exchange rates between VND and USD, the state of Balance of Payments and the Inflation in Vietnam, the balance of payments in Vietnam and the inflation in Vietnam from 1995 to 2010.

The research will collect the date from 1995, because that is the time U.S abolished completely the trade embargo to Vietnam. That influenced international trade in Vietnam and created the relation between the balance of Payments and the exchange rate between USD-VND as well as the impact of the exchange rate on the inflation in Vietnam

5. Time scale

This study is divided into four stages and the duration of each stage in particular and that of the study in general are predicted as follows:





Literature review

4 weeks


Collecting Data

6 weeks


Data analysis and presentation

4 weeks


Conclusion and recommendation

3 weeks

It is flexible to change the duration of study subject due to unexpected problems occurring during the research process

6. Resources

The research process will be involved in the following resources:

A laptop computer to do the study

Internet access to collect data and information

Online library access to approach academic papers related to the study.

The assistance from government's staff to access the date of exchange rates, the inflation index and the state of Balance of payments.

Particular, the researcher needs the instructor's guidance of how to use software to analyze data such as Microsoft Office Excel or SPSS, or others.