The transmission of fiscal policy from countries with trade relations to Vietnam: Gvar model application

nto inflation in Vietnam . Scientific conference 1. (2018 ) Spill-Over Effect of Fiscal Policy between Vietnam and Its Trading Partners. ISBN 978-604-922-660-1 1 CHAPTER 1: INTRODUCTION 1.1 Background When economies are open and integrated with the rest of the world through international trade, shocks from one country can spread to other countries through different channels. Therefore, the cross- border effect of fiscal policy has become a common academic concept. Many theories help explain the transmission mechanism of international fiscal policy and draw different conclusions (Frenkel & Razin, 1985, 1987; Fleming, 1962; Mundell, 1963; Svensson, 1987; Reinhart, 1988). They found three main transmission channels, including interest rates, terms of trade, commodity prices, which could affect household consumption and output. This transmission can create a "prosper-thy-neighbor" effect, if the fiscal stimulus abroad leads to an increase in domestic output or the "beggar-thy-neighbor" effect, if these effects are opposite. Not only academically, the transmission of international fiscal policy is also a matter of concern to policymakers around the world. In an interview with the Financial Times on March 15, 2010, the head of the International Monetary Fund (IMF) and French finance minister, Christine Lagarde, said: “Berlin should consider boosting domestic demand to help deficit countries to compete and reorganize their public finance sector”. This implies that the change in German government spending, considered the leading country of the European, could transform the economies of other countries in the region. However, expanding the economy in large countries sometimes will not enhance the wealth of less-developed countries as mentioned in the research of Knight & Masson (1987) and Lewis (1980). The effect of international fiscal transmission may be altered by the various 2 factors in the macro economy, for example, price adjustment, scale and openness, and the condition of interest rate near the limit of zero (Devereux & Yu, 2019). The financing mechanism for fiscal expansion is also a significant factor (Giorgio & Traficante, 2018). 1.2 Research gaps Since the global financial crisis in 2008, many researchers have found that expansionary fiscal policy has become an effective stabilizing tool in boosting recessionary demand around the world, when monetary policy also seems to reveal certain limits in dealing with the global economic downturn (Auerbach & Gorodnichenko, 2013, Corsetti & Müller, 2013). The transmission of foreign fiscal policy is also amplified when domestic monetary policy is having effective low interest rates (Blagrave et al., 2018). Therefore, in response to the global crisis, policy makers try to increase government spending to stimulate the declining world demand. This raises concerns that fiscal expansion measures in one country may spread to other countries. Sometimes, it can worsen policy goals pursued by other countries (Gambetti & Gallio, 2016). Beckman (2018) also demonstrates that the spread of foreign fiscal policy can reduce the host country's economic growth. Therefore, incumbent policy executives are more likely to approve fiscal expansion as their trading partners loosen fiscal policy. We can see that some countries will benefit from the difficult and political decisions of others. Are policymakers' beliefs consistent with theoretical predictions and empirical evidence? So far, however, evidence of the extent of international spread of fiscal policy from countries that are considered "giants" of the world to small, emerging 19 5.2 Contribution of the thesis 5.3 Limitations The GVAR model can handle common break points by using strong standard errors when considering the effects of foreign variables and based on the analysis of the impulse response function rather than points estimate. These break points creates a structural breaks in the model and once these events take place it creates a spillover effect to the rest of the countries. For example, events in the global economy that have occurred in history such as the 2008 financial crisis in the US, or the Asian financial crisis in 1997. However, it did not handle specific break points for each model, such as country-specific shocks. Handling of these individual breakpoints increases the number of parameters in the regression model and reduces the stability of the model in terms of data limits. 18 CHAPTER 5. CONCLUSIONS AN RECOMMENDATIONS 5.1 Implication of research findings and policy recommendations According to empirical results, an expansion of Chinese government spending in the long run can increase Vietnam's terms of trade, causing the price of goods in Vietnam to decrease because of the substitute tradable goods between the two countries, giving Vietnam an export advantage. The price of domestic goods has also decreased, resulting in an increase in the purchasing power of the currency and thus driving Vietnamese household spending. This will increase the output of Vietnam's economy. Also according to Corsetti and Pesenti (2001), subtitute tradable goods will increase Vietnam's economic usefulness (increase in output), giving the "prosper-thy- neighbor" effect. Empirical results also find similar effects with the case of China. The effects found in other countries are negligible or insignificant. Besides China being Vietnam's major trading partner, South Korea, Japan, the United States, and Euro Area also had close trade relations. However, Vietnam has not yet exploited the trade potential in these countries. The author recognizes that these countries are countries with the potential of the world's famous industry for high technology, and science. Vietnam mainly competes with these countries only in terms of its agricultural potential with lower value products. As a result, Vietnam does not seem to have benefited from the fiscal expansion in these countries. Thereby, the author also found that building and participating in the global supply chain is a method that not only helps Vietnam increase its internal growth capacity and at the same time can benefit from the external fiscal shock. 3 countries like Vietnam is still limited. Moreover, these quantitative studies based on the typical baseline models predicting this cross- border spillover effect also provide insights in policymaking for dealing with external forces from international fiscal policy. Therefore, the thesis will contribute to the empirical evidence on the estimates related to spillovers from fiscal shock of trading partners to Vietnam. 1.3 Objectives and research questions The thesis examines the fiscal policy transmission from the trading partners to Vietnam - a small economy, still heavily dependent on agricultural advantages and less resistant to external shocks. The thesis will in turn explore whether or not the spread of fiscal policy from countries with trade relations to Vietnam and the change in the spread characteristics from different countries to the Vietnamese economy. 1.4 Subject and the scope of study The thesis studied the fiscal policy transmission from countries with trade relations to Vietnam in the period 1995-2017. The thesis performed on the largest trade partners of Vietnam as China, South Korea, Taiwan, Australia, Singapore, United States, Euro Area, Japan, Thailand, Indonesia, Malaysia, Philippines to clarify the interdependence between the economies that have trade relations with each other. This commercial partners expect to represent the entire trade relations of Vietnam with total exports and imports to these countries accounted for over 70% turnover of Vietnamese trade. 4 1.5. Research Methodology: The thesis uses the global vector autoregression model (GVAR) of Pesaran et al. (2004), developed by Dees et al. (2007) to assess international spillover effects from the countries having trade relations with the Vietnamese economy. 1.6. Summary of results and contributions of the thesis According to empirical results, an expansion of Chinese government spending in the long run can increase Vietnamese term of trade, causing the prices of Vietnamese goods to decrease because of the substitute tradable goods between these two countries, giving Viet Nam an export advantage. The price of domestic goods has also decreased, resulting in an increase in the purchasing power of the currency and thus driving Vietnamese household spending. This will increase the output of Vietnam's economy. CHAPTER 2: THEORY BACKGROUND AND LITERATURE REVIEW 2.1 Theory background 2.1.1 Transmission of fiscal policy through interest rates 2.1.2 Transmission of fiscal policy through consumer behaviour 2.1.3 Transmission of fiscal policy through terms of trade 2.1.4 Transmission of fiscal policy through other macro factors Table 1: Summary of transmission mechanisms for international fiscal policy Interest rate * Expanding government spending with bonds: - Increasing domestic income causes a rise in domestic interest rates, leading to a rise in the domestic currency. Therefore, the increase in 17 reg prg rhog roug rmg Figure 11: Vietnam's response to the increase in Chinese government spending -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0 4 8 12 16 20 24 28 32 36 40 -0.025 -0.02 -0.015 -0.01 -0.005 0 0.005 0.01 0.015 0 4 8 12 16 20 24 28 32 36 40 -0.015 -0.01 -0.005 0 0.005 0.01 0.015 0.02 0.025 0 4 8 12 16 20 24 28 32 36 40 -0.015 -0.01 -0.005 0 0.005 0.01 0.015 0.02 0.025 0 4 8 12 16 20 24 28 32 36 40 -0.1 -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 0.1 0 4 8 12 16 20 24 28 32 36 40 16 the economy in the first quarter increased the real money supply. Increasing money supply will create pressure to reduce interest rates, thus increasing the current purchasing power of households and thereby boosting output in the economy. This is similar to the theory of Obstfeld and Rogoff (1995), Corsetti, Meier and Muller (2010), arguing that an increase in government spending in major countries reduces world interest rates, thereby stimulating consumption and increase production. In the long term, the author also sees a decrease in real exchange rates, domestic prices of Vietnam and an increase in household spending and Vietnam's output. Thereby, we can confirm the effect of "prosper-thy-neighbour" that the Vietnamese economy has received from the increase in Chinese government spending (Figure 21). 5 Fiscal expansion spreads along channels foreign demand leads to an increase in foreign production. The above effect can be offset when: -The increase in world interest rates reduces the demand for foreign goods, making the output of foreign countries decrease. * Expanding government spending by tax: - Sometimes, it does not affect world interest rates so foreign output may be constant. * Expanding government spending with temporary debt: - Expectation of a future tax increase reduces short-term interest rates in the future so the current long- term interest rate decreases with increasing spending on foreign goods, so world output increases. * Position of net capital inflows and spending mainly on foreign goods in both public and private sectors: -The decrease in domestic interest rate makes consumption of foreign goods increase, so the output of foreign countries may increase. 6 Consumer behavior * Expanding government spending by tax: -The increase in domestic income and the increase in tax financing for government spending make foreign currency balances likely unchanged so foreign output is not affected. * Expanding government spending with money: - Increasing inflation leads to an increase in current consumption, so foreign output increases (if traded goods are substituted) * Expanding government spending in developed countries: -Increasing currency prices increases commodity prices in developed countries, so the trade balance in developing countries may decrease (if consumption preferences of developing countries are high-value goods in another country). * A part of government spending for foreign goods: -In flexible prices: foreign production increases but domestic output may decrease due to an increase 15 increase. Thereby, the increased real effective exchange rate of Vietnam in the first quarter reduced Vietnam's demand for goods for foreigners. A decline in total demand for goods in the economy has led to a fall in Vietnam's domestic prices. This is shown by the 1.1% decline in the growth rate of Vietnamese domestic prices in Q1 (Table 1). However, in this case, the Vietnamese people also increased their demand for foreign goods, causing the price of foreign goods to rise. Therefore, this impact has reduced Vietnam's real exchange rate in the second quarter. Along with that, it also increased the demand of foreigners for Vietnamese goods. As a result, Vietnam's domestic prices increased in Q2, reaching 0.3% (Table 1). Through the above analysis, Vietnam's domestic prices are sensitive to the terms of trade between Vietnam and China. This is because the trade in goods between Vietnam and China is primarily a substitute product. Therefore, the behavior of the importer may change rapidly with changes in the selling price and towards cheaper places. This result is similar to the theory of Corsetti and Pesenti (2001), Obstfeld and Rogoff (1995). Consumer behaviour also changed in response to changes in the domestic prices of Vietnam by Chinese government spending shocks. From there, it can have an impact on the output growth rate of the economy. The growth rate of household spending increased by nearly 1% in Q1 when domestic prices decreased, and decreased by 0.12% in Q2 when domestic prices increased. The growth rate of output also changes, increasing by nearly 1% in the first quarter and decreasing by 0.13% in the second quarter. The increase in household spending and Vietnam's output is supported by an increase in the money supply growth in Q1 (up 3.7%). The slowdown in domestic price growth in 14 now, China, Korea, Japan, the United States, Euro Area are important trade partners of Vietnam. CHAPTER 4: RESULTS AND DISCUSSION 4.1 Results of GVAR model estimation 4.1.1 Testing unit root 4.1.2 Identify and estimate the models for each country 4.2 Check for long-term relationships and persistent profile 4.3 Simultaneous effects and cross correlation between countries 4.4 Fiscal analysis and variance decomposition from trading partner countries with Vietnam 4.4.1 The impact of fiscal policies of trade partner countries on Vietnamese household consumption 4.4.2 The impact of fiscal policies of trade partner countries on Vietnam's output 4.4.3 The impact of fiscal policies of trade partner countries on Vietnam's real balance 4.4.4 The impact of fiscal policy of the country's trading partners on the terms of trade of Vietnam 4.4.5 The impact of fiscal policies of countries that are trading partners on Vietnam's domestic prices 4.5 Discuss the research results In the short run, the increase in Chinese government spending has pushed Vietnam's real effective exchange rate to appreciate 0.6% in the first quarter and downward adjustment to -1.2% in the second quarter. Vietnam's real effective exchange rates decline shows that the selling prices of Vietnamese goods are more competitive than foreign goods. This will give an advantage to Vietnam's trade balance. The opposite will happen if Vietnam's real effective exchange rate 7 Terms of trade in domestic goods prices, leading to a decrease in household consumption. -In rigid prices: Domestic and foreign production increase because of the decrease in world trade value, leading to a smaller money supply than the demand. The decrease of domestic currency makes the trade balance increase so domestic output also increases. * Government spending only for domestic goods: -Increasing income increases domestic trade, leading to an increase in domestic prices and an increase in the competitiveness of foreign goods, leading to an increase in the foreign trade balance. -In the long term, increasing demand for foreign goods increases the price of foreign goods and reduces foreign household consumption. It could be appeared if the tradable goods between these two countries are subtituted. 8 Macro factors -The national scale is inversely proportional to the effect of foreign spillover. - Trade openness is positively correlated with the effect of foreign spillover. - Tight monetary policy increases the spillover effects of fiscal shock abroad. + If the interest rate is near the zero limit, it will create a negative spillover effect on foreign output. Source: Author synthesized 2.2 Empirical studies 2.2.1 Transmission of fiscal shock in developed countries Beckman (2018) focuses on the international effect of fiscal policy in OECD countries. The author presented evidence that the expected changes in fiscal policies of partner countries have explained most of the movement of domestic fiscal dynamics in a short time from 1998 to 2015. The author argued that policymakers always consider fiscal policy strategies of trade partners before establishing domestic fiscal policy. If incumbents expect their major trading partners to issue expanded fiscal policies, they are more likely to adopt their own expansion policies. Yet, when incumbents expect their partners to enact restrictive policies, they are less likely to finance expansionary policies. If not, they would boost foreign economies 13 3.2.2 Vietnamese data processing by Denton-Cholette method Particularly for Vietnam, the dataset on government spending, household consumption and gross domestic product is only reported annually. Therefore, the thesis used Denton-Cholette adjustment technique. Some studies, such as Chen (2007), Isaac et al (2015) conducted a study comparing the results of decomposition to quarterly data from annual data available. They have shown that the Denton- Cholette method produces accurate separation results and overcomes the disadvantages of the original Denton (1971) method. 3.2.3 Trade density matrices of countries in the sample The thesis uses matrices that change year by year, collected from IMF trade statistics. This will help the trade matrices better reflect the macroeconomic events taking place in that year, thereby bringing about more appropriate impacts. Through the results of the calculation of the trade density matrix of Vietnam and its trading partners, we can see that, in the period from from 1995 to 1999, Japan, Korea, Taiwan, Singapore and Euro Area were the main trading partners of Vietnam. These countries always account for a large proportion of the total import and export value of Vietnam. Until 2000, China began increasing its trade with Vietnam. The reason is that during this period, China began to launch a program to expand global trade activities, preparing to join the WTO. The proportion of China's trade gradually surpasses that of Korea. By 2003, trade activities of Vietnam and the US were gradually improved and reached a high proportion of trade after the Vietnam-US bilateral trade agreement officially came into effect in December 2001. The two main trading partners, China and the United States, have gradually replaced the leading positions of Singapore and Taiwan since 2009. From 2010 to 12 - Recursion process, and the dynamics of model can be analyzed using generalized impulse response function (GIRFs). - The persistent profile function (PP) is used to find the impact characteristics of the system or the individual shocks of each variable on the cointegration relationship in the GVAR model over time. 3.2 Research data The dissertation collects a dataset from 1995Q2 to 2017Q4 for 13 countries including Australia, China, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand, USA, Euro Area and Vietnam from IMF for all variables in the model. Chinese quarterly dataset on government spending, household spending, and output are extracted from Datastream. In addition, because of the completeness and uniformity in the real effective exchange rate calculation, this variable was chosen to be collected from the European economic organization Bruegel. In particular, the growth rate of government spending, the growth rate of household spending, the growth rate of output (GDP) is adjusted to eliminate inflation factor to find real quantities for variables. In addition, the real money balances is calculated by dividing the nominal money supply M1 by the consumer index (CPI) representing inflation. These CPIs are all converted to the same base year as 2010. Besides, the world oil price index is taken from the average spot price of Brent crude oil, West Texas Intermediate, and Dubai Fateh crude oil price, sourced from IMF. 3.2.1 Seasonal adjustment with the X-13A-S program All data of the variables included in the model are removed seasonality through the adjustment program X-13A-S of IMF implemented in a two-step approach. 9 with repressive effects on their country. Thus, foreign fiscal policy has a spillover effect on the domestic economy. 2.2.2 Fiscal transmission from developed countries to developing countries Dias and McDermott (2004) used the vector error correction (VEC) method to perform regression according to the theoretical models of Corsetti and Pesenti (2001) for the case of Brazil and the USA. The results are confirmed to be consistent with the theoretical model of Corsetti and Pesenti (2001) when considering production, household consumption and real money balances. The long-term relationship between world fiscal position and the real effective exchange rate (REER) has shown that the currency appreciation is the result of an expansionary fiscal policy shock. CHAPTER 3: METHODS AND RESEARCH DATA 3.1 Modelling the transmission of international fiscal policy under the approach of GVAR The thesis uses the global vector autoregression model (GVAR) of Pesaran et al. (2004), developed by Dees et al. (2007) to assess spillover effects from trading partner countries on Vietnam's economy. These trading partners include China, South Korea, Taiwan, Australia, Singapore, United States, Euro Area, Japan, Thailand, Indonesia, Malaysia and the Philippines. These countries account for over 70% of turnover of Vietnam’s foreign trade in 2017 (IMF Trade Statistics). With the GVAR approach, this model allows for interdependence between countries by combining the error correction models of individual countries. Thanks to this feature, we can consider an individual country in a global context (Chudik & Pesaran, 2014). Individual model is linked to the rest of the world through foreign and 10 global characteristic variables. Therefore, the spillover effects from external shocks to domestic economic activities are found. Thereby, we can easily distinguish the different transmission characteristics between different countries 3.1.1 Models of individual countries To test whether the transboundary impacts of fiscal policy in trading partner countries can bring prosperity to Vietnam, the thesis studied this issue through five aspects: household consumption, output, money balance, domestic prices and terms of trade. These factors may highlight positive or negative effects on the economy. In this way, we can clearly see the nature of the international fiscal transmission in different countries to Vietnam. First, the thesis examines the impact of foreign governments spending on the Vietnamese output. We can find the effect of "prosper-thy-neighbour" when Vietnam's production receives positive effects from external shocks (Obstfeld & Rogoff, 1995). Conversely, if the impact is detrimental, it may be the "beggar-thy-neighbour" effect mentioned in the theoretical model of Corsetti & Pesenti (2001). Second, the thesis will look at how foreign government spending affects household consumption in Vietnam. Household consumption is one of the main components of GDP, helping us to explain the change in output. Moreover,