MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HO CHI MINH CITY - - LÊ THỤY PHƯƠNG TÂM THE EFFECT OF TRADE AND FINANCIAL LIBERALIZATION ON INFLATION VOLATILITY Master thesis in Economic HO CHI MINH - 2017 MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HO CHI MINH CITY - - LÊ THỤY PHƯƠNG TÂM THE EFFECT OF TRADE AND FINANCIAL LIBERALIZATION ON INFLATION VOLATILITY Major: Finance - Banking Major code: 60340201 MASTER THESIS IN ECONOMIC Supervisor: Đinh Thị Thu Hồng, Ph.D HO CHI MINH - 2017 Declaration of Originality I certify that this thesis is entirely my own work, based on my personal study and research and that I have acknowledged all material and sources used in its preparation, whether they be books, articles, reports, and any other kind of document I also certify that this thesis has not previously been submitted for assessment in any form to the University of Economics Ho Chi Minh City or to any other institution for any other purposes Ho Chi Minh, 12 October 2017 Table of Contents SUB COVER PAGE DECLARATION OF ORIGINALITY LIST OF ABBREVIATIONS LIST OF TABLES LIST OF FIGURES ABSTRACT CHAPTER INTRODUCTION AND RESEARCH QUESTION 1.1 INTRODUCTION .1 1.2 RESEARCH QUESTIONS CHAPTER LITERATURE REVIEW .8 2.1 THEORETICAL LITERATURE 2.1.1 Trade Liberalization .8 2.1.2 Financial Liberalization .10 2.1.3 Inflation .12 2.1.4 Inflation and Inflation Volatility 14 2.1.5 Trade Liberalization and Inflation Volatility 16 2.1.6 Financial Liberalization and Inflation Volatility 18 2.2 EMPIRICAL EVIDENCE 20 2.2.1 Inflation and Inflation Volatility 20 2.2.2 Trade Liberalization and Inflation .21 2.2.3 Trade Liberalization and Inflation Volatility 23 2.2.4 Financial Liberalization and Inflation .25 2.2.5 Trade and Financial Liberalization simultaneously and Inflation .26 CHAPTER DATA AND METHODOLOGY 28 3.1 DATA 28 3.2 METHODOLOGY 36 3.2.1 Econometric Models 36 3.2.2 Statistical Approaches 37 CHAPTER EMPIRICAL RESULTS 39 4.1 LIBERALIZATION AND INFLATION VOLATILITY 39 4.2 ROBUSTNESS ANALYSIS .43 4.2.1 Effect of trade and Financial Liberalization joinly 43 4.2.2 Adding further controls .44 4.2.3 Varying the data frequency 47 4.2.4 Varying the Inflation Volatility using annual data .50 4.2.5 Varying the measurement for Financial Liberalization .51 CHAPTER IN REFERENCE TO VIETNAM 52 CHAPTER CONCLUSIONS 55 REFERENCES APPENDIX List of Abbreviations CPI: Consumer Price Index FEM: Fixed effect model FO: Financial openness GDP: Gross Domestic Product GMM: Generalized method of moments GNP: Gross National Product GEXP: Government expenditure growth GROWTH: GDP per capita growth IFS: International Financial Statistic IMF: International Monetary Fund INF: Inflation OLS: ordinary least squares POP: Population REM: Random effect model RGDP: GDP per capita TO: Trade openness VINF: Inflation volatility VOL: GDP per capita volatility WDI: World Development Indicator WEO: World Economic Outlook WTO: World Trade Organization List of Tables TABLE 3.1 EXPECTED SIGNS 32 TABLE 3.2 DESCRIPTIVE STATISTICS FOR MAIN VARIABLES 33 TABLE 3.3 DESCRIPTIVE STATISTICS FOR CONTROL VARIABLES USED IN ROBUSTNESS SECTION 33 TABLE 3.4 CORRELATION MATRIX FOR MAIN AND CONTROL VARIABLES 34 TABLE 4.1 REGRESSION RESULTS: TRADE OPENNESS AND INFLATION VOLATILITY .39 TABLE 4.2 REGRESSION RESULTS: FINANCIAL OPENNESS AND INFLATION VOLATILITY 41 TABLE 4.3 REGRESSION RESULTS: THE EFFECT OF TRADE OPENNESS AND FINANCIAL OPENNESS SIMULTANEOUSLY 42 TABLE 4.4 ROBUSTNESS ANALYSIS: EFFECT OF TRADE AND FINANCIAL OPENNESS JOINTLY 43 TABLE 4.5 ADDITIONAL CONTROLS: TRADE OPENNESS AND INFLATION VOLATILITY .45 TABLE 4.6 ADDITIONAL CONTROLS: FINANCIAL OPENNESS AND INFLATION VOLATILITY 46 TABLE 4.7 DIFFERENT DATA FREQUENCY: SIX-YEAR WINDOWS 48 TABLE 4.8 DIFFERENT DATA FREQUENCY: SIX-YEAR ROLLING WINDOWS 49 TABLE 4.9 INFLATION VOLATILITY USING ANNUAL CPI DATA 50 TABLE 4.10 DE JURE MEASUREMENTS FOR FINANCIAL OPENNESS 51 TABLE 5.1 REGRESSION RESULTS FOR VIETNAM .54 TABLE 0.1 HAUSMAN TEST FOR THE FIRST MODEL WITH TRADE OPENNESS TABLE 0.2 HAUSMAN TEST FOR THE SECOND MODEL WITH FINANCIAL OPENNESS TABLE 0.3 CORRELATION MATRIX OF VARIABLES IN THE FIRST MODEL TABLE 0.4 CORRELATION MATRIX OF VARIABLES IN THE SECOND MODEL TABLE 0.5 MODIFIED WALD TEST FOR TRADE OPENNESS TABLE 0.6 MODIFIED WALD TEST FOR FINANCIAL OPENNESS TABLE 0.7 REGRESSION WITH DRISCOLL-KRAAY STANDARD ERRORS FOR TRADE OPENNESS TABLE 0.8 REGRESSION WITH DRISCOLL-KRAAY STANDARD ERRORS FOR FINANCIAL OPENNESS TABLE 0.9 UNIT-ROOT TEST FOR VINF TABLE 0.10 UNIT-ROOT TEST FOR TO TABLE 0.11 UNIT-ROOT TEST FOR FO TABLE 0.12 UNIT-ROOT TEST FOR RGDP TABLE 0.13 UNIT-ROOT TEST FOR GEXP TABLE 0.14 UNIT-ROOT TEST FOR VINFT1 List of Figures FIGURE 1.1 INFLATION FROM 1991 TO 2014 FIGURE 1.2 EXPORTS, IMPORTS AND FINANCIAL TRANSACTIONS FROM 1991 TO 2014 FIGURE 3.1 SCATTER PLOTS BETWEEN TRADE OPENNESS AND INFLATION VOLATILITY 35 FIGURE 3.2 SCATTER PLOTS BETWEEN FINANCIAL OPENNESS AND INFLATION VOLATILITY 35 FIGURE 5.1 INFLATION, TRADE AND FINANCIAL OPENNESS IN VIETNAM 53 Abstract This thesis provides evidence for the relationships between trade liberalization and inflation volatility, and between financial liberalization and inflation volatility Using a set of dynamic panel data for 142 emerging market and developing countries over the period of 1991-2014, this research finds statistically significant associations between each openness variables and inflation volatility The robustness analyses also consider other control variables, different time windows and different measurements for inflation volatility as well as financial liberalization The same result is consistently observed for both trade and financial openness, suggesting that trade and financial liberalization are associated with lower inflation volatility 53 Vietnam is also included in the set of emerging markets researched in this thesis aiming to find the impact of openness on inflation volatility The economic trends experiencing by Vietnam is somewhat consistent with the global trends Moreover, the relationships among inflation volatility, inflation, trade openness and financial openness are presented in figure 5.1 showing periods from 1991 to 2014 Economic Openness and Inflation Volatility for Vietnam Percentage 60 40 20 -20 -40 1991-1993 1994-1996 1997-1999 2000-2002 2003-2005 2006-2008 2009-2011 2012-2014 -60 Inflation volatility Inflation Trade openness Financial openness Figure 5.1 Inflation, Trade and Financial Openness in Vietnam Figure 5.1 Line graph showing inflation, inflation volatility, trade and financial openness in Vietnam for eight three-year windows for 1991-2014 Data used is same as one in this study Data source: IFS, WDI, and Lane and Milesi-Ferretti (2006) dataset As can be seen from the line graph, the trends for trade and financial openness increased while that of inflation and inflation volatility decreased Specially, these trends are more noticeable in the 2006-2008 period, which is compatible with the results of this research In addition, GMM estimate is also performed specifically for Vietnam to investigate the relationship between the two economic openness and inflation volatility The result, which is consistent with the overall results in this thesis, is presented below 54 Table 5.1 Regression results for Vietnam Variable TO FO VINFt1 1.3091106 1.508 -.09167916** -2.077 -.57569562 -0.581 TO FO RGDP GEXP -.06889963* -1.663 -.00012008 -0.038 -.22969846* -1.770 2.3565587* 1.792 02113637* 1.664 Table 5.1 Regression results for six-year rolling windows using GMM method Dependent variable is VINF (inflation volatility) *, ** and *** denote significance at the 10 percent, percent and percent level, respectively Terms below the coefficients are t-stats (VINFT1–first lag of inflation volatility, TO–trade openness, FO–financial openness, RGDP–GDP per capita and GEXP–government expenditure growth) Since three-year window data only gives periods, a GMM regression based on a time series data of six-year rolling windows and a similar set of instrument variables examine the situation in Vietnam The regression statistics present a coefficient of -0.916 and -0.230 at and 10 percent significant level for trade openness and financial openness, respectively The negative relationships between economic openness and inflation volatility still hold for Vietnam, considering the limited number of observations available Therefore, the policy makers in Vietnam may control the volatility of inflation through two channels which are trade and financial openness Together with expanding openness, government also needs to take in to account other enhancing policies to limit drawbacks of trade and financial liberalization which are mentioned in previous session If government is able to control all factors sensibly, economic openness could contribute significantly to economic development 55 CHAPTER Conclusions In this thesis, I estimate the associations of trade and financial liberalization on inflation volatility with different mechanisms through which trade and financial affect inflation volatility considered First of all, trade openness creates more freetrade markets with other international partners; thus, it encourages competition, diversifies consumption, restricts high prices when demand increases in domestic market as well as prevents monopolist suppliers pushing high prices intentionally Besides, a more opened market bears higher costs when high inflation volatility impact on decision of investors through their real profits, influencing policy makers’ incentives for more disciplined monetary policy Second of all, financial openness attracts more funds as well as diversified currencies from oversea in the form of FDI and FPI Financial globalization increase elasticity of demand for money, reducing governments’ temptation to print excessive money, hence lower inflation volatility In addition, the fear of penalties in the form of capital outflows also contributes to a more disciplined economic policy engaged by the authorities The main contribution of this thesis is its finding in the negative effect of financial liberalization on inflation volatility and the negative relationship between trade liberalization and inflation volatility in emerging market and developing countries Furthermore, the models in this thesis use GMM method to estimate the effects, thus the results of regression account for endogeneity issues among variables Moreover, the associations of negative influence of both trade and financial openness is ensured through a series of robustness tests, which include the use of other frequency windows, measurement for financial openness and inflation, and the simultaneously model for trade and financial liberalization The robustness tests consistently illustrate the same negative effects of trade and financial openness on inflation volatility Hence, the conclusions of these effects are reliable statistically References Aisen, A and Veiga, F.J., 2008 Political instability and inflation volatility Public Choice, 135(3), pp.207-223 Alfaro, L., 2005 Inflation, openness, and exchange-rate regimes: the quest for short-term commitment Journal of Development Economics, 77(1), pp.229-249 Badinger, H., 2009 Globalization, the output–inflation tradeoff and inflation European Economic Review, 53(8), pp.888-907 Ball, L.M., 2006 Has globalization changed inflation? (No w12687) National Bureau of Economic Research Barro, R.J and Gordon, D.B., 1983 A positive theory of monetary policy in a natural rate model Journal of political economy, 91(4), pp.589-610 Bartolini, L and Drazen, A., 1996 Capital account liberalization as a signal (No w5725) National bureau of economic research Bleaney, M and Fielding, D., 2002 Exchange rate regimes, inflation and output volatility in developing countries Journal of development economics, 68(1), pp.233-245 Borio, C.E and Filardo, A.J., 2007 Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation Bowdler, C and Malik, A., 2017 Openness and inflation volatility: Panel data evidence The North American Journal of Economics and Finance, 41, pp.57-69 Bruno, M and Easterly, W., 1998 Inflation crises and long-run growth Journal of Monetary Economics, 41(1), pp.3-26 Cavelaars, P., 2009 Does globalisation discipline monetary policymakers? Journal of International Money and Finance, 28(3), pp.392-405 Cukierman, A and Meltzer, A.H., 1986 A theory of ambiguity, credibility, and inflation under discretion and asymmetric information Econometrica: journal of the econometric society, pp.1099-1128 Cukierman, A., Web, S.B and Neyapti, B., 1992 Measuring the independence of central banks and its effect on policy outcomes The world bank economic review, 6(3), pp.353-398 Chinn, M.D and Ito, H., 2006 What matters for financial development? Capital controls, institutions, and interactions Journal of development economics, 81(1), pp.163-192 Chinn, M.D and Ito, H., 2008 A new measure of financial openness Journal of comparative policy analysis, 10(3), pp.309-322 Davis, G and Kanago, B., 1998 High and uncertain inflation: results from a new data set Journal of Money, Credit and Banking, pp.218-230 Dornbusch, R., Krugman, P and Cooper, R.N., 1976 Flexible exchange rates in the short run Brookings Papers on Economic Activity, 1976(3), pp.537-584 Elder, J., 2004 Another perspective on the effects of inflation uncertainty Journal of Money, Credit, and Banking, 36(5), pp.911-928 Fatás, A., & Mihov, I., 2005 Policy volatility, institutions and economic growth CEPR Discussion Paper, No 5388 Fischer, S., Sahay, R., & Végh, C., 2002 Modern hyper- and high inflations Journal of Economic Literature, XL(3), 837–880 Fisher, R.W., 2005 Globalization and monetary policy (No 118) Warren and Anita Manshel Lecture in American Foreign Policy, Harvard University, Nov 3, 2005 Friedman, M., 1977 Nobel lecture: inflation and unemployment Journal of political economy, 85(3), pp.451-472 Ghosh, A., 2014 How openness and exchange-rate regimes affect inflation? International Review of Economics & Finance, 34, pp.190-202 Golob, J.E., 1994 Does inflation uncertainty increase with inflation? Economic Review-Federal Reserve Bank of Kansas City, 79(3), p.27 Granato, J., Lo, M and Wong, M.S., 2006 Testing monetary policy intentions in open economies Southern Economic Journal, pp.730-746 Gruben, W.C and McLeod, D., 2002 Capital account liberalization and inflation Economics letters, 77(2), pp.221-225 Gruben, W.C and McLeod, D., 2004 The openness–inflation puzzle revisited Applied Economics Letters, 11(8), pp.465-468 Gupta, A.S., 2008 Does capital account openness lower inflation? International Economic Journal, 22(4), pp.471-487 Hartmann, M and Herwartz, H., 2012 Causal relations between inflation and inflation uncertainty—Cross sectional evidence in favour of the Friedman–Ball hypothesis Economics Letters, 115(2), pp.144-147 International Monetary Fund, 2006, ―How Has Globalization Affection Inflation?‖ chapter in World Economic Outlook: Globalization and Inflation, April Kim, D.H and Lin, S.C., 2012 Inflation and inflation volatility revisited International finance, 15(3), pp.327-345 Lane, P.R., 1997 Inflation in open economies Journal of International Economics, 42(3), pp.327-347 Lane, P.R., 2006 and Milesi-Ferretti, G.M The external wealth of nations mark ii: revised and extended estimates of foreign assets and liabilities, 1970–2004 IMF WP, 69 Mathieson, D.J and McKinnon, R., 1981 How to Manage a Repressed Economy Princeton Essays in International Finance, 145 Mishkin, F.S., 2003 Economic and Financial Crises in Emerging Market Economies An Overview of Prevention and Management In Economic and Financial Crises in Emerging Market Economies (pp 1-30) University of Chicago Press Narayan, P.K., Narayan, S and Mishra, S., 2011 Do remittances induce inflation? Fresh evidence from developing countries Southern Economic Journal, 77(4), pp.914-933 Pourgerami, A and Maskus, K.E., 1987 The effects of inflation on the predictability of price changes in Latin America: some estimates and policy implications World Development, 15(2), pp.287-290 Razin, A and Yuen, C.W., 1995 Can capital controls alter the inflationunemployment tradeoff? (No w5239) National Bureau of Economic Research Rodrik, D., 1998 Who needs capital-account convertibility? Essays in international finance, pp.55-65 Rogoff, K., 2003 Globalization and global disinflation Economic Review-Federal Reserve Bank of Kansas City, 88(4), p.45 Romer, D., 1993 Openness and inflation: theory and evidence The Quarterly Journal of Economics, 108(4), pp.869-903 Rother, P., 2004 Fiscal policy and inflation volatility ECB Working Paper, No 317 M.W and Shambaugh, J.C., 2012 Exchange rate regimes in the modern era MIT Press Temple, J., 2002 Openness, inflation, and the Phillips curve: a puzzle Journal of Money, Credit, and Banking, 34(2), pp.450-468 Wei, S.J and Tytell, I., 2004 Does financial globalization induce better macroeconomic policies? (No 4-84) International Monetary Fund CongThuong electronic newspaper(2017) Vietnam, 10 years after joining WTO: good achievements Available at Appendix Appendix Statistical results for different statistical approaches and unitroot tests Table 0.1 Hausman test for the first model with Trade Openness Table 0.2 Hausman test for the second model with Financial Openness Table 0.3 Correlation matrix of variables in the first model Table 0.4 Correlation matrix of variables in the second model Table 0.5 Modified Wald test for trade openness Table 0.6 Modified Wald test for financial openness Table 0.7 Regression with Driscoll-Kraay standard errors for trade openness Table 0.8 Regression with Driscoll-Kraay standard errors for financial openness Table 0.9 Unit-root test for VINF Table 0.10 Unit-root test for TO Table 0.11 Unit-root test for FO Table 0.12 Unit-root test for RGDP Table 0.13 Unit-root test for GEXP Table 0.14 Unit-root test for VINFt1 Appendix List of countries Afghanistan, Albania, Algeria, Angola, Antigua and Barbuda, Argentina, Armenia, Aruba, Azerbaijan, The Bahamas, Bahrain, Bangladesh, Barbados, Belarus, Belize, Benin, Bhutan, Bolivia, Botswana, Brazil, Brunei Darussalam, Bulgaria, Burkina Faso, Burundi, Cabo Verde, Cambodia, Cameroon, Central African Republic, Chad, Chile, China, Colombia, Comoros, Congo, Dem Rep., Congo, Rep., Costa Rica, Cote d'Ivoire, Croatia, Djibouti, Dominica, Dominican Republic, Ecuador, Egypt, Arab Rep., El Salvador, Equatorial Guinea, Ethiopia, Fiji, Gabon, Gambia, The, Georgia, Ghana, Grenada, Guatemala, Guinea, Guinea-Bissau, Guyana, Haiti, Honduras, Hungary, India, Indonesia, Iran, Islamic Rep., Iraq, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Kyrgyz Republic, Lao PDR, Lebanon, Lesotho, Liberia, Libya, Macedonia, FYR, Madagascar, Malawi, Malaysia, Maldives, Mali, Mauritania, Mauritius, Mexico, Moldova, Mongolia, Montenegro, Morocco, Mozambique, Myanmar, Namibia, Nepal, Netherlands, Nicaragua, Niger, Nigeria, Oman, Pakistan, Panama, Papua New Guinea, Paraguay, Peru, Philippines, Poland, Qatar, Romania, Russian Federation, Rwanda, Samoa, Sao Tome and Principe, Saudi Arabia, Senegal, Serbia, Seychelles, Sierra Leone, Solomon Islands, South Africa, Sri Lanka, St Kitts and Nevis, St Lucia, St Vincent and the Grenadines, Sudan, Suriname, Swaziland, Syrian Arab Republic, Tajikistan, Tanzania, Thailand, Timor-Leste, Togo, Tonga, Trinidad and Tobago, Tunisia, Turkey, Uganda, Ukraine, Uruguay, Vanuatu, Venezuela, RB, Vietnam, Yemen, Rep., Zambia, Zimbabwe ... impact of financial liberalization on inflation volatility Having considered the individual effect of trade and financial liberalization of volatility of inflation, the question arises as to whether... 2.2.2 Trade Liberalization and Inflation .21 2.2.3 Trade Liberalization and Inflation Volatility 23 2.2.4 Financial Liberalization and Inflation .25 2.2.5 Trade and Financial Liberalization. .. to as trade and financial liberalization This thesis aims to close the literature gap by conducting a research about the effect of both trade and financial liberalization on inflation volatility