AN EMPIRICAL ANALYSIS ON THE PARALLEL FOREIGN EXCHANGE MARKET: THE
CASE OF VIETNAM
Duy Hung Bui
PhD candidate
Griffith Business School
Department of Accounting, Finance and Economics
Gold Coast campus, Griffith University, Queensland 4222, Australia
d.bui@griffith.edu.au
Abstract
The existence of the parallel foreign exchange market has created several complications to the
State Bank of Vietnam in their attempts to manage the foreign exchange market and the
exchange rate. So far, the literature on the exchange rate in Vietnam has been focused on the
official exchange rate, ignoring the parallel foreign exchange market. This market has only
mentioned in the research as a factor creating many difficulties for monetary authorities,
therefore, it should have measures to eliminate this market. Results from monetary analysis to
the parallel exchange market show that money supply and the official exchange rate are the most
important factor affect to the exchange rate in the parallel market. An increase of money supply
by 1% causes the exchange rate in the parallel market depreciated by 0.015%. A 1 per cent
devaluation of the official exchange rate would bring about 1.33 per cent devaluation of the
parallel market rate. These results bespeak the State Bank of Vietnam’s efforts to reduce the
market premium seem to be not success and stimulating economic growth by money supply
would lead to deprecation in both markets.
Keyword: The official exchange rate, the parallel foreign exchange market, the exchange rate
premium
1. Introduction.
The parallel foreign exchange market is often illegal, existing together with the legal official
exchange market, and emerging because of the restrictions on foreign exchange transactions in
countries with a fixed exchange rate regime (Lizondo, 1991). In some countries, in response to a
balance of payment crisis, the government allows the existence of the parallel foreign exchange
market for financial transactions (Kiguel & O'Connell, 1995). Although it is common in
developing countries, the size of this market varies from country to country and depends upon
the range of restrictions imposed on exchange transactions and the degree to which these
restrictions are enforced by authorities (Agénor, 1992; Edwards, 1989; Kiguel & O'Connell,
1995; Phylaktis, 1996).
In the literature, the parallel exchange market has been studied and modelled in a number of
approaches. The supply and demand approach, proposed by Culbertson (1975) and Sheikh
(1976) analysis the equilibrium conditions in a foreign exchange market where foreign exchange
transactions are limited. The monetary approach, initiated by Blejer (1978), emphasises the role
of equilibrium in the monetary market. This approach was then further developed by Agénor
(1991) and Olgun (1984). The portfolio approach, developed by Dornbusch, Dantas, Pechman,
de Rezende Rocha, and Simōes (1983) emphases on the interaction of stock and flow conditions
in the black market in determining both the premium on foreign exchange and the rate of change
of the stock of black dollars.
Vietnam is a developing country with a fixed exchange rate regime and the use of foreign
currency is under control of the monetary authorities. Hence, like other developing countries,
Vietnam also has the parallel exchange market that exists together with the official exchange
market though, it is illegal. The existence of the parallel exchange market creates several
1
complications to the State Bank of Vietnam in their attempts to manage the foreign exchange
market and the exchange rate. Fluctuations in the parallel market rates affect both the level of
international reserves, the position of the economy and portfolio decisions of the public.
Therefore, a strong understanding of the parallel foreign exchange market will help the SBV
have sound policies in the foreign exchange market.
The rest of the paper is organized as follows. Section 2 is an overview of the Vietnam’s parallel
foreign exchange market. Section 3 is methodology and data. Section 4 is the empirical results.
Some concluding remarks are presented in section 5 which concludes the paper.
2. Vietnam’s parallel foreign exchange market
2.1 The emergence of the parallel foreign exchange market in Vietnam
The parallel exchange market in Vietnam has emerged due to the fixed exchange rate system,
restrictions on using foreign exchange and limited foreign exchange supply in the official
exchange market. In addition, a long period of high inflation and annual devaluation of the
Vietnamese Dong (VND) have created opportunities for people to make a profit through
speculative activities in the parallel market. It has also forced people to view foreign currency as
a good place to protect their wealth. Of course, this demand cannot be satisfied in the official
market because of SBV’s regulations, hence, the parallel market is popular.
2.2 The foreign currency supply in the parallel foreign exchange market.
The largest distributor is remittance from overseas. According to the Sate Committee for
Overseas Vietnamese Affairs, there are around 4.5 million Vietnamese, including more than
400,000 guest workers, living in more than 100 countries and territories worldwide. The
remittance from these overseas forces increases annually and made Vietnam among the top 20
countries which have the highest volume of remittance in the world. In 2011 it accounted for
about 7% of GDP (The World Bank, 2011) and is higher than Official Development Assistance
and foreign direct investment (Figure 1).
Figure 1 the share of remittance, FDI, and ODA in GDP
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
2000
2001
2002
2003
FDI
2004
2005
ODA
2006
2007
2008
2009
2010
2011
Remittances
Source: The World Bank
A large volume of remittances sent to Vietnam came through the parallel exchange market due to
the high disparity in exchange rate between the official and the parallel market. More
importantly, as can be seen in Figure 2, up to 73% of total remittance is used for direct
consumption (Pfau & Long, 2008) that directly flows into the parallel foreign exchange market.
In recent years, due to the development of the Vietnamese stock market and real estate sector, a
large volume of remittances have been used in these two sector. However, in recent years, due to
2
strict regulation as well as the various stimulative polices, the remittance sold to banks has
increased (30% in 2012 compared to 14% in 2011).
Figure 2 Remittance distribution
6.60%
6%
14.40%
73%
Consumption
Education
House repairing
Other
Source: Pfau and Long (2008)
In additions, foreign currency also come from tourism, smuggling, domestic residents who work
in foreign companies or joint ventures, and export enterprises. However, these categories do not
have much of a share of the market.
2.3 The effects of the parallel market exchange rate
In the literature, the parallel exchange rate has been shown to have impact on the official
exchange rate (Apergis, 2000; Bahmani-Oskooee & Tanku, 2006; Jianping, 1998; Noorbakhsh &
Shahrokhi, 1993), inflation (Onour & Cameron, 1997), and export and import (BahmaniOskooee, 2002; Degefa, 2001; Yiheyis, 1997). In the case of Vietnam, from actual observation,
the imbalance in the foreign exchange firstly appears in the parallel market expressed by the
sharp increase of the parallel market exchange rate. This market is also the place where traders
often implement the speculative activities. For example, in the period 1997-1998, when the
Asian Financial Crisis happened, traders in the parallel market took advantage of this crisis,
raised the exchange rate to 14,600VND=1USD, creating a significant gap (the exchange rate
premium) with the official rates. Afraid of VND devaluation, people withdrew VND deposits to
buy USD to protect their wealth, leading to imbalance in the foreign exchange market.
Figure 3 Exchange rate and premium
25000
25.00%
20000
20.00%
15.00%
15000
10.00%
10000
5.00%
5000
0.00%
-5.00%
Official rate
Parallel rate
Source: The SBV
3
Premium
31/12/2012
31/12/2011
31/12/2010
17/08/2010
2009
11/02/2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
3. Methodology and data
3.1 Methodology
The monetary approach to the parallel foreign exchange market initially developed by Blejer
(1978) and then further developed by Agénor (1991) is used. This approach focuses on the
disequilibrium in the money market in explaining movements in output, price, the parallel
market exchange rate, and change in net foreign assets.
Money market
Starting with the basic relationships of the monetary sector as follow:
Ms = R + D
(1)
Md = P*md
(2)
md = f(y,Пe)
(3)
where Ms is the nominal money supply, R is the foreign exchange reserve of the central bank, D
is the domestic net asset, Md is the demand for nominal money, P is the price level, md is the real
demand for money, which is a function of real income and expected domestic inflation.
The condition for stock equilibrium in the money market is that the changes in the nominal
money supply equal changes in the nominal demand for money, that is:
∆𝑀𝑠 = ∆𝑀𝑑
(4)
Differentiating logarithmically equation (1) and (2) and substituting into equation (4), yields
(1 − 𝛼)∆𝑅 + 𝛼∆𝐷 = 𝑝 + 𝑚𝑑∗
(5)
Where p is the domestic inflation
Domestic price determination
Domestic price level, P, is determined by a weighted average of the prices of tradable, PT, and
non-tradable, PNT
pt = βpT + (1-β)pNT
(6)
Since the Vietnamese economy is small open economy, the prices of tradable goods is
determined by world prices, p*.. Different from the assumption in Blejer (1978) that the demand
for current account transactions are satisfied in the official market. In Vietnam, the official
exchange market is rationed for priority purpose, other demand for the current account
transactions have to find foreign exchange in the parallel exchange market. Hence, the domestic
price depend on the world price and the rate of change of the exchange rate in the official rate, e,
and the parallel market, b
pT = θe + (1-θ)b + p*
(7)
An excess supply of money implies an excess demand for both trade and non-tradable goods –
that is, an excess demand for foreign currency in the parallel market, since demand for foreign in
the official market is rationed. In equation (1) the component of money supply are domestic
credit and international reserves. As a fixed exchange rate country, the SBV only can control the
ex ante money supply by changing the domestic credit component of the base. Hence, the ex ante
excess supply of money equal to the ex ante domestic credit and the money demand D - md..
Assuming that the excess demand for non-tradable goods varies with the excess demand
throughout the economy, the following equation can be postulated for the determination of the
price of non-tradable goods.
pNT = pT + (D – md),
>0
4
(8)
Substituting equation (7) into equation (8) and then equation (8) into equation (6), the domestic
inflation equation will be express as a function of world inflation, of the official exchange rate,
and of the ex-ante disequilibrium in the money market as follow:
pt = φ[e + (1-θ)b + p*] + (1-φ)[(D – md)]
(9)
where φ = 1/(1+(1-θ)) if all goods are traded θ=1 then φ = 1 and the domestic rate of inflation
in a fixed country is fixed to the world rate.
The parallel market exchange rate
The demand for foreign exchange is derived from the demand for current account transaction,
Dc, and the demand for foreign exchange as an asset, Da
D = Dc + Da
(10)
Because of foreign exchange policy in Vietnam, the demand for foreign exchange assets have to
be found in the parallel market. The demand for this purpose depends on the expectation of
depreciation in the parallel market, b*. Hence,
Da = δ + δ1b*
(11)
The expectation of depreciation in the parallel market, in turn, depends on the differential
between domestic and foreign prices and the expected domestic inflation, П*. Thus,
b* = P/P*b + П*
(12)
The demand for current account transactions can be partly satisfied in the official market and the
rest in the parallel market. The demand depends on income and the deviation of domestic prices
from foreign prices.
Dc =  + 1Y + 2(P/P*b)
(13)
As mentioned above, the supply of foreign exchange in the parallel market mainly comes from
remittance. This supply, S, simply assumes dependence on the differential between the parallel
market rate and the official rate.
S =  + 1(b/e)
(14)
The parallel exchange rate is determined by market forces; hence, supply for foreign exchange
should be equal to demand of foreign exchange.
S=D
(15)
To find the equilibrium exchange rate in the parallel foreign exchange, equation (12) is
substituted into equation (11), and then equation (13) and equation (11) are substituted into
equation (10). Using supply for foreign exchange in equation (14) and the market equilibrium
condition in equation (15), the parallel market rate is expressed in the form of equation as
follows.
b =  + 1Y + 2(P/P*) + 3i* + 4e
(16)
Substitute the domestic inflation equation in (9) into equation (16) to eliminate p would yield the
final monetary equation for the black market exchange rate as follow:
b = ξ + ξ1p* + ξ2y + ξ3i* + ξ4e + ξ5(D – md)
(17)
In equation (17), the parallel market rate has positive relationship with the official rate, domestic
expectation and money supply, negatively relationship with foreign price, level of income.
Real income and demand for money
5
The model assumes that output (real income) responds positively to the excess supply of real
money balances and the deviation of the actual output from its trend level. It will be simply
specify that
y = (M/P)t-1 + y* + yt-1
(18)
Where y* denotes the capacity output.
Real money demand depends on real income, y, and expected inflation, i*
𝑚𝑑 = 𝜏 + 𝜏1 𝑦𝑡 − 𝜏2 𝑖𝑡∗
(19)
The summary of equations in the model are shown as follows
The parallel market exchange rate:
b = ξ + ξ1p* + ξ2y + ξ3i* + ξ4e + ξ5(D – md)
The real income
y = (M/P)t-1 + y* + yt-1
The real money demand
𝑚𝑑 = 𝜏 + 𝜏1 𝑦𝑡 − 𝜏2 𝑖𝑡∗
3.2 Data
Quarterly data on the official market rate, e, and the parallel market rate, b, are collected from
the State Bank of Vietnam (SBV) from 1995 to 2007. However, since 2007, SBV has stopped
collecting data on the parallel market rate because of the illegality of this market. Hence, this
data is now collected from various available sources. The data on real income (output), domestic
inflation rate and world inflation rate, are collected from the General Statistical Office and from
the Bureau of Labour Statistics. Because the VND is pegged with the USD and the transactions
in the parallel exchange market are mainly conducted by the USD, the level of inflation in the
United States is used for measuring the foreign inflation.
As the fact that output gap is not statistical data, there is no available source for this data. Hence,
this data is calculated from nominal output data by the Hodrick-Prescott method. Regarding to
expected inflation rate, the SBV have just started to conduct survey to collect inflation
expectation from entrepreneurs and people, thus this data is also not available from the General
Statistic Office or the SBV. For this reason, expected inflation will be calculated from past
inflation rates using Almon’s polynomial distributed lag technique.
Vietnam also does not have available data for expected inflation, therefore expected inflation is
estimated by using a traditional adaptive expectation hypothesis as follows:
∗
𝑖𝑡∗ = 𝜖𝑖𝑡 + (1 − 𝜖)𝑖𝑡−1
4. Estimation results.
The structural parameters of the model have been estimated by Two-Stage Least Squares
technique with the official exchange rate, output gap, expected inflation, and the United States
consumer price level as instrumental variables. Estimation results are presented in Table 1
indicating R2 is very high from 0.97 to 0.99 expressing the good explanation of dependent
variable on independent variables. The results for the real income equation indicate that real
money demand in the previous and capacity output have positive impact on real income. If real
money demand in the previous period and capacity output increase by 1%, real income would
increase by 0.33% and 1.035%.
Table 1 Parameter Estimates of the Model
(Two-Stage Least Squares, instrumental variable procedure)
6
Logy = 8.67 + 0.33*log(M/P)-1 + 1.035*logy*
(44.77)
(21.69)
R2 = 0.976
SER = 0.05
DW=0.11
Logb=1.12+0.12logp_us+0.064logy +0.15i*+1.33loge+0.0155log(D-md)
(0.19)
(1.47) (0.3)
(5.69)
(2.66)
2
R = 0.971
SER = 0.027
DW= 1.93
Log(M/P)= -0.74-1.68i*+0.49logy
(-5.95)
(1.27)
R2= 0.99
SER = 0.04
DW=1.49
Estimates for money demand indicate that the coefficient of real income is not statistical
significance. It means that real income has no impact on real money demand. This result is
different from the theory and the literature. However, expected inflation has negative effect on
real money demand as the expectation. When the expected inflation increases by 1%, money
demand would reduce by 1.68%.
Among other variables the ex-ante excess of money supply and the official exchange rate play an
important role in determining the parallel market exchange rate. The coefficient of ex-ante
excess of money supply is positive as predicted. An increase of ex-ante excess of money supply
by 1% causes the exchange rate in the parallel market depreciate by 0.015%. This result has been
consisted with the development of the parallel market exchange rate and money supply in
Vietnam since 2007 (Figure 4).
Figure 4 Money supply development and the parallel exchange rate
40.00%
30.00%
20.00%
10.00%
-10.00%
1997Q3
1998Q1
1998Q3
1999Q1
1999Q3
2000Q1
2000Q3
2001Q1
2001Q3
2002Q1
2002Q3
2003Q1
2003Q3
2004Q1
2004Q3
2005Q1
2005Q3
2006Q1
2006Q3
2007Q1
2007Q3
2008Q1
2008Q3
2009Q1
2009Q3
2010Q1
2010Q3
2011Q1
2011Q3
2012Q1
0.00%
-20.00%
Changes in the parallel market rate
Changes in money supply
Source: The SBV
The official exchange rate also positively affects the parallel market exchange rate. The elasticity
of the parallel market rate with respect to the official is about 1.33 suggesting that a 1 per cent
devaluation of the official exchange rate would bring about 1.33 per cent devaluation of the
parallel market rate, all other things being equal. Against expectation, all the exogenous
variables in the model including foreign price, real income, and expected inflation are not
statistical significance. The parallel market rate is only affected by the SBV’s activities on the
official exchange rate and money supply. The result indicates that the SBV’s efforts to reduce
the market premium seem to be not success because devaluation in the official market would
lead to devaluation in the parallel market.
5. Conclusion
The main purpose of this paper is to analyse the determinant of the parallel market exchange rate
by using the monetary approach the the parallel foreign exchange market. Because Vietnam
follows a fixed exchange rate regime, to some extent, the parallel market rate can be considered
7
as a proxy for free exchange rate. However, the estimation results indicate that money supply
(Net domestic asset) and the official exchange rate are the most important factor affect to the
exchange rate in the parallel market. It was the case in the period from 2000 to 2007 when the
SBV sharply increase money supply to stimulate economic growth, as a results the exchange
rates in both market were deprecated significantly.
References
[1] Agénor, P.-R. (1991). A monetary model of the parallel market for foreign exchange. Journal
of Economic studies, 18(4).
[2] Agénor, P.-R. (1992). Parallel currency markets in developing countries: theory, evidence,
and policy implications: International Finance Section, Department of Economics,
Princeton University.
[3] Apergis, N. (2000). Black market rates and official rates in Armenia: evidence from causality
tests in alternative regimes. Eastern Economic Journal, 26(3), 335-344.
[4] Bahmani-Oskooee, M. (2002). Does black market exchange rate volatility deter the trade
flows? Iranian experience. Applied Economics, 34(18), 2249-2255.
[5] Bahmani-Oskooee, M., & Tanku, A. (2006). Do the black market and the official exchange
rates converge in the long run? Journal of Economics and Finance, 30(1), 57-69.
[6] Blejer, M. I. (1978). Exchange restrictions and the monetary approach to the exchange rate.
The Economics of Exchange Rates, 117-128.
[7] Culbertson, W. P. (1975). Purchasing Power Parity and Black‐Market Exchange Rates.
Economic Inquiry, 13(2), 287-296.
[8] Degefa, D. (2001). The parallel foreign exchange market and macroeconomic performance
in Ethiopia (Vol. 107): African Economic Research Consortium.
[8] Dornbusch, R., Dantas, D. V., Pechman, C., de Rezende Rocha, R., & Simōes, D. (1983).
The black market for dollars in Brazil. The Quarterly Journal of Economics, 98(1), 2540.
[9] Edwards, S. (1989). Exchange controls, devaluations and real exchange rates: The Latin
American Experience: National Bureau of Economic Research Cambridge, Mass., USA.
[10] Jianping, D. (1998). China's foreign exchange black market and exchange flight: analysis of
exchange rate policy. The developing economies, 36(1), 42-44.
[11] Kiguel, M., & O'Connell, S. A. (1995). Parallel Exchange Rates in Developing Countries.
The World Bank Research Observer, 10(1), 21-52. doi: 10.2307/3986565
[12] Lizondo, J. S. (1991). Alternative Dual Exchange Market Regimes: Some Steady-State
Comparisons. Staff Papers - International Monetary Fund, 38(3), 560-581.
[13] Noorbakhsh, A., & Shahrokhi, M. (1993). The official and black (parallel) foreign exchange
markets: Causal relationships: Empirical evidence. Global Finance Journal, 4(1), 65-76.
doi: 10.1016/1044-0283(93)90014-p
[14] Olgun, H. (1984). An analysis of the black market exchange rate in a developing
economy—The case of Turkey. Weltwirtschaftliches Archiv, 120(2), 329-347.
[15] Onour, I., & Cameron, N. (1997). Parallel Market Premia and Misalignment of Official
Exchange Rates. Journal of Economic Development, 22(1).
[16] Pfau, W., & Long, G. T. (2008). Gender and remittance flows in Vietnam during economic
transformation. Asia-Pacific Population Journal, 23(2).
[17] Phylaktis, K. (1996). Black market for foreign currency: a survey of theoretical and
empirical issues. FINANCIAL MARKETS INSTITUTIONS AND INSTRUMENTS, 5, 102124.
[18] Sheikh, M. A. (1976). Black market for foreign exchange, capital flows and smuggling.
Journal of Development Economics, 3(1), 9-26.
[19] Yiheyis, Z. (1997). Export adjustment to currency depreciation in the presence of parallel
markets for foreign exchange: The experience of selected sub‐Saharan African countries
in the 1980s. The Journal of Development Studies, 34(1), 111-130.
8