Tài liệu Demand for money in lao pdr and policy implications

MINISTRY OF EDUCATION AND TRAINING VIET NAM NATIONAL ECONOMICS UNIVERSITY SOMPHAO PHAYSITH DEMAND FOR MONEY IN LAO PDR AND POLICY IMPLICATIONS (Finance and Banking) Code : 62.34.02.01 A dissertation submitted to the National Economics University in fulfillment of requirements for the degree of Doctor of Philosophy in Economics Supervisors : Prof. Dr. TRAN THO DAT Hanoi, December 2012 i DECLARATION I hereby declare that this doctoral dissertation “Demand for money in Lao PDR and policy implications” is written by me and has not been published yet. I am responsible for my declaration. Somphao Phaysith ii ACKNOWLEDGEMENT First of all, as the Governor of the Bank of the Lao PDR, I am very pleased and greatly honored for taking the opportunity to take part in the doctoral program organized jointly between the National University of Laos and National Economics University of Vietnam. After a number of years following this program, my study is devoted to the title: “Demand for Money in Lao PDR and Policy Implications”. I would like to express my heartfelt appreciation to the Lao People’s Revolutionary Party and Ministry of Education and Sport of Lao PDR for granting me this opportunity to undertake this rewarding doctoral program and achieve the result successfully as my wish comes true. As one of the candidates for this program, I would like to extend my gratitude and appreciation to the leaders and management staff of these two universities for making this program possible to enhance capacity building for Lao leaders, who are well qualified from the program. During the five-year program, I have got the close guidance and knowledge from the lecturers of the two universities as well as relevant authorities for their support that enable me to ease difficulties and hurdles and to complete the program successfully. My achivement is also due to valuable academic support from Prof. Dr. Tran Tho Dat, my academic advisor and close supervisor for my research, who enable me to fulfill all requirements of the doctoral program on a timely manner. My special thank also goes to Assoc. Prof. Lai Phi Hung, the program coordinator. I would also like to extend my profound appreciation of wholehearted assistance and cooperation between our two nations, Lao PDR and Vietnam. iii My research is carried out with the staff development grant from the Bank of the Lao PDR. Furthermore, I shall not forget and pay tribute to kind support and sincere assistance rendered by the BOL staff, namely Mr. Phetsathaphone Keovongvichit, Ms. Fongchinda Sengsourivong, Mr. Soulysak Thamnuvong, and Mr. Khamkeo Visisombath. Lastly, my profound thanks go to my beloved family, including my wife and my two daugthers for their encouragements, care and motivation during my research. They always provide me very important supports, and love during the period of hardship. All of their supports provided are the power injecting to me to strive the various difficulties and to complete the program successfully as the task assigned by the Party and Lao people. iv TABLE OF CONTENTS DECLARATION ........................................................................................................ i ACKNOWLEDGEMENT ........................................................................................ ii TABLE OF CONTENTS ......................................................................................... iv ABBREVIATION .................................................................................................... vi LIST OF TABLES .................................................................................................. vii LIST OF FIGURES ............................................................................................... viii INTRODUCTION ..................................................................................................... 1 CHAPTER I: OVERVIEW OF THEORETICAL AND EMPIRICAL STUDIES ON MONEY DEMAND ............................................................ 7 1.1. A brief theoretical overview ........................................................................ 7 1.1.1. Quantity theory of demand for money ........................................................... 7 1.1.2. Keynesian approach (John Maynard Keynes) .............................................. 10 1.1.3. Friedman‟s model of the demand for money ............................................... 14 1.2. Some empirical problems in estimating money demand functions............... 15 1.2.1. Functional forms ........................................................................................... 16 1.2.2. Choice of variables ....................................................................................... 17 1.2.3. Empirical estimation problems ..................................................................... 20 1.3. Some Asia-specific studies on the money demand function ................... 23 Conclusion of chapter 1 .......................................................................................... 28 CHAPTER II: LAO FINANCIAL SYSTEM AND MONETARY POLICY .... 31 2.1. Economic development .............................................................................. 31 2.2. Overview of monetary developments in Lao PDR .................................. 34 2.3. Banking system ........................................................................................... 35 2.3.1. Mono-bank system. ...................................................................................... 37 2.3.2. Banking system reform ................................................................................ 40 2.4. Monetary Policy .......................................................................................... 47 2.4.1. Monetary instruments. .................................................................................. 47 2.4.2. Target of monetary policy ............................................................................ 51 2.5. Dollarization ................................................................................................ 54 2.6 Bond market................................................................................................ 56 v 2.7 Stock market ............................................................................................... 58 2.8 Interbank market ....................................................................................... 59 2.9 Exchange rate policy .................................................................................. 60 Conclusion of chapter 2 .......................................................................................... 66 CHAPTER III: DEMAND FOR MONEY IN LAO PDR ................................... 67 3.1. The theory-based money demand function for Lao PDR ....................... 67 3.2. Data description and issues ....................................................................... 69 3.2.1. Definition of money ..................................................................................... 69 3.2.2. Scale variable................................................................................................ 71 3.2.3. Opportunity costs.......................................................................................... 71 3.3. Unit root and co-integrated test ................................................................ 73 3.3.1. Unit roots test ............................................................................................... 73 3.3.2. Johansen co-integration test ......................................................................... 74 3.4. Estimating money demand function for Lao PDR by using ECM ............ 76 3.4.1. Engle and Granger: Error Correction Models .............................................. 76 3.4.2. Estimated results and hypothesis testing ...................................................... 77 Conclusion of chapter 3 .......................................................................................... 93 CHAPTER IV: POLICY IMPLICATIONS......................................................... 94 4.1. Laos economic development strategy ....................................................... 94 4.1.1. Macro-economic targets ............................................................................... 94 4.1.2. Targets of Economic Sectors ........................................................................ 95 4.2. Monetary policy recommendations .......................................................... 99 4.2.1. Monetary instruments ................................................................................. 100 4.2.2. Choosing intermediate target...................................................................... 100 4.2.3. Increasing banking supervisor .................................................................... 102 4.3. Some recommendations to Lao government .......................................... 103 4.3.1. Dedollarization ........................................................................................... 103 4.3.2. Stimulate financial market development .................................................... 105 CONCLUSION ...................................................................................................... 107 REFERENCE ........................................................................................................ 109 APPENDIX ............................................................................................................ 115 vi ABBREVIATION Lao PDR Lao People‟s Democratic Republic Laos Used under monarchy regime BOL Bank of the Lao PDR MOF Ministry of Finance BCEL Banque Pour le Commerce Exterieur or Bank for Foreign Trade Lao LDB Lao Development Bank APB Agricultural Promotion Bank SOCBs State-Owned Commercial Banks GDP Gross Domestic Product Banknote Banknotes issuing by tri-parties of the coalition government in 1962 Kip Potpoi Liberated currency under Lao Patriotic Front NPL Non-Performing Loans RR Reserve Requirement C.I.B Credit Information Bureau vii LIST OF TABLES Table 1.1. Estimated income elasticity and interest rate semi-elasticity for selected Asian countries ...................................................................... 26 Table 3.1: Unit Root Test Results ........................................................................ 78 Table 3.2: Likelihood ratio test: lag lengths test .................................................. 79 Table 3.3: Johansen test: the max and trace tests results at 5% ........................... 80 Table 3.4: Diagnostic tests for the short run dynamic money demand model, equation (9) ......................................................................................... 82 Table 3.5: Short-run dynamic estimation, dependent variable is  ln rmt ............ 90 Table 3.6: Long-run relation, dependent variable is ln rmt .................................. 91 Table 4.1: Nonperforming loans ratio and number of banks in Lao PDR ......... 103 viii LIST OF FIGURES Figure 1.1: Determinants of money demand function ........................................... 30 Figure 2.1: GDP growth (1991-2011) ................................................................... 33 Figure 2.2: GDP by Components (Bil. Kip), Source: BOL .................................. 33 Figure 2.3: GDP growth, Inflation rate, M2 growth, M2 to GDP and FX to total deposit. ........................................................................................ 35 Figure 2.4: Interest rates of deposits and loans in Kip .......................................... 50 Figure 2.5: Monthly loans interest rates by currency (%) ..................................... 50 Figure 2.6: Money supply- M2 (billion Kip)......................................................... 52 Figure 2.7: Deposits by currency (%).................................................................... 55 Figure 2.8: Relationship between M2, inflation and exchange rate (%) ............... 63 Figure 2.9: Exchange rate (Kip/USD) movement (%) .......................................... 65 Figure 2.10: Average exchange rate (Kip/USD) ..................................................... 65 Figure 3.1: Cumulative Sum of Squares of Recursive Residuals.......................... 82 Figure 4.1: Money and interest rate targets ......................................................... 101 Figure 4.2: Lao PDR: money multiplier and velocity, January, 1999 – September, 2012 ............................................................................... 102 1 INTRODUCTION The international experiences confirm that countries with well-developed financial systems grow faster and more consistently and are better able to adjust to economic shocks. A good financial market and system of institutions can channel funds from savers to the most productive investors. A typical financial system in a transitional economy, especially banking system had limited capacity to assess credit risk and fund allocation according to the government plans. Furthermore, government had a strong control over the financial system, such as setting interest rate ceilings, entry barriers, and interference in credit allocation. According to McKinnon (1973) and Shaw (1973), such financial repression leads to reduction in private savings, thereby decreasing the resources available to finance capital accumulation, with a negative impact on growth. The Lao PDR is in the process of transition toward a market economy, the requirement of government‟s operation to change its intervention methods and scope is a fundamental way. One of these fundamental changes is the way the government conducts its monetary policy as well as the development of financial system, especially the banking system to achieve desirable economic growth. The relationship between monetary growth and economic growth is still on debate. Hossain and Chowdhuey (1996 p.126) argued that there is a clear correlation between money supply growth and economic growth in the long-run. Other studies in the field also point out the importance of monetary policy, especially, in managing the demand side of the economy. In order to make the monetary policy more efficient and effective, the prerequisite for the monetary authority must be able to predict the demand for money of the economy with acceptable accuracy. Theoretical views of 2 demand for money have usually been based on the consideration of money as a medium of exchange. The Keynesian models represent money with the role of transactions and the role of store of value. Analytically, demand for money is the sum of three components: transactions, precautionary, and speculative demand. Milton Friedman argued that physical goods should be regarded as a substitute for money and that higher expected rate of inflation should induce a portfolio shift from money to physical assets as well as financial assets (hard currencies) in the context of transition and underdeveloped countries. The fact that money does not bring interests like other alternative assets means that money holders should receive compensation in some other forms. Following the idea of Keynes, many economists attempted to model the demand for money based on the above consideration. Although they are different technically, the main idea is still based on the so-called „liquidity services‟, which money gives in compensation for the interest earning foregone. The relationship between the demand for money and its key determinants is an important building block in macroeconomic theories and is a crucial component in the conduct of monetary policy (Goldfeld, 1974). Even in the era of inflation targeting, a well-specified money demand function is of utmost importance for the effective implementation of monetary policy – especially to track both, the interest rates and the stock of money – in order to access the impact of monetary policy upon the economy. As a result, the issue of long-run relationship between broad money, its determinants and also the stability of the demand for money has always been in the center of research. Stable money demand is particularly important for policy makers to choose a credible monetary policy instrument. For instance, the unstable money demand caused by the financial reforms of the late 1970s, the financial innovations and the financial integration induced many central banks in 3 developed countries to switch from monetary targeting to the interest rate targeting as a monetary policy instrument. The same view was proposed by Poole (1970) who showed that the interest rate should be targeted if the money demand function is unstable. However, monetary targeting can play an important role in the formulation of an efficient monetary policy strategy, even though the monetary policy of developed countries typically uses an interest rate targeting as a policy instrument. Monetary aggregates can be appropriate indicators for future inflation in the medium term and long-term. As mentioned by Valadkhani (2006) an emerging consensus among economists is that it is not advisable to concentrate exclusively on a single policy instrument while neglecting another important information variable. Both interest rate and monetary aggregates are important in selecting appropriate monetary policy actions. Monetary aggregates, however, will only be related to the real economy if the money demand function is stable. Thus, the stability of money demand entails whether monetary targeting is an appropriate guide to policy. Due to its particular importance, the money demand function was studied extensively in many countries as can be seen from a large body of literature on theoretical as well as empirical studies of the demand for money, which discussed in Chapter I. However, these studies had been largely carried out for developed countries. One explanation for that is the lack of good quality data on developing countries. Lao PDR is not an exception in that respect. Indeed, the low quality and short time horizon of Lao economic data is well known among researchers. One main reason is that Lao PDR just adopted the system of national account (SNA) in 1992 and the statistical system is still underdeveloped. The dissertation titled “Demand for money in Lao PDR and policy implications” can be viewed as earliest research in the case of Lao PDR. This 4 fact, while telling us about many difficulties, also can be viewed as an encouraging attempt for us since „learning by doing‟ in many cases may be the best strategy to learn. Objectives of research The main purpose of this dissertation is to estimate the money demand function for Lao PDR during the period of the first quarter of 1993 to the second quarter of 2010 (1993Q1-2010Q2), using available data. Taking into account some limitations mentioned above, conclusion of the dissertation should be viewed as a suggestion. However, by doing so it is hopefully to establish an appropriate framework for future studies in this field once the comprehensive data are available. In addition, the results of this study can hopefully reveal some important issues and areas required to improve, especially data problems which will raise awareness among policy makers to improve the quality of economic database of the country. Research Questions The main research question: What is the money for demand in the Lao PDR? The specific research questions: 1. What are the behavior of money demand patterns? 2. How has the money demand contributed to the monetary stability for the conduct of monetary policy? 3. What are direct and indirect factors influencing the demand for money in the Lao PDR? 4. What are the problems and obstacles confronting the Lao PDR in conducting monetary policy? Research Methodology In light of analyzing money demand function for Laos, this study uses a 5 basic and popular theoretical framework surrounding the money demand analyzed from various empirical works. After formulating the theoretical model, this dissertation adopts a framework of the Error Correction Model, which is widely used, to analyse the money demand in both developed and developing economies, to examine factors driving money demand balances in Lao PDR over a period of 1993-2011. This econometric model, an Error Correction Model is believed to be well- suited for the empirical investigation through rigorous empirical testing. Contribution of the study To the best knowledge of the author, the current study represents the first attempt to examine the factors influencing the money demand for Lao PDR. This study will provide a quantifiable estimation of the money demand in Lao PDR for the first time by using a quarterly data. The outcomes of the study can be useful for the purpose of conducting monetary policy for policy makers of the country‟s central bank. The economic variables which are used to conduct monetary policy identified in this study will be helpful to systematically consider for monetary policy and facilitate policy discussions in the country. The outcomes will provide the information needed in key decisions and in formulating the future design of monetary and exchange rate policies, which will significantly impact on the overall macroeconomic stability. The findings will be useful for central bankers to understand the factors influencing money demand in the Lao PDR, especially taking into account of dollarization problem prevailing in the economy. The study also updates the database of the Lao PDR financial statistics. One important contribution of this study is constructing economic variables especially annual GDP data to quarterly GDP data. This provides a good starting point to study the relationships between the money balance and other economic variables in the economic framework. Further, this study can be adopted to estimate money demand in other similar developing countries as the Lao PDR. 6 Database The data used in this analysis is taken from the Bank of Lao PDR. The estimated sample uses quarterly data in the period from Q1/1993 to Q2/2010. Structure of dissertation Besides the introduction, conclusion, appendices, references, this dissertation includes 4 chapters as follows: Chapter I: Overview of theoretical and empirical studies on money demand This chapter reviews the main theories of money demand in order to explore what factors can affect the demand for money. It also present some empirical studies of money demand. The lessons learned from literature survey will help select the appropriate modeling framework and choosing suitable variables in the following chapters. Chapter II: Lao PDR financial system and monetary policy. The overview of financial system development of Lao PDR will be presented in this chapter. In particular, major developments of the banking sector in the last 20 years will be reviewed. The monetary policy will be sketched with emphasis on the new role of the Bank of the Lao PDR. The current pros and corns of BOL monetary policy raises the need to estimate money demand function. Chapter III: Demand for money in Lao P.D.R. In this chapter, the empirical framework of money demand function for Lao PDR. will be formulated and estimated; the specific problems in the case of Lao PDR. will also be discussed. Chapter IV: Policy implications. Based on empirical estimation of chapter III, some policy implications for not only the Lao government but also for the BOL will be suggested in this chapter. 7 CHAPTER I OVERVIEW OF THEORETICAL AND EMPIRICAL STUDIES ON MONEY DEMAND 1.1. A brief theoretical overview 1.1.1. Quantity theory of demand for money The quantity theory of demand for money proposes a direct and proportional relationship between the quantity of money and the prevailing price level. This relationship emerges within the classical equilibrium framework using two separate, but equivalent expressions. The first expression is associated with American economist Irving Fisher and is called the “equation of exchange”. The second expression is associated with Cambridge University‟s Arthur C.Pigou is called the “Cambridge approach” or the “cash balance approach”.  Fisher’s “equation of exchange” The Fisher‟s equation of exchange provides an important relation between four macroeconomic variables to determine the nominal value of aggregate income1. The four variables in the equation of exchange are the total amount money in circulation, M, an index of the total value of aggregate transactions, T, the price level of articles traded, P, and a proportionality factor V denoting the “transaction velocity of money”. The equation is given below: MV  PT (1.1) The classical economists (including Fisher himself) built this relationship in the nineteenth and early twentieth centuries. Since the classical 1 One should note that while Fisher developed the algebraic formulation of the equation of exchange in 1911, it was John Stuart Mill who originally stated the relation, expanding on the ideas of David Hume. 8 economists believed that wages and prices were completely flexible, they posited that the level of aggregate output produced in normal economic period, Y, would remain at the full employment level, so Y is by definition is nation‟s total potential level of output. Fisher assumed that the ratio between the level of transactions, T, and output, Y, is reasonably stable ( Y  t  T ) and hence T can be treated as constant in the short-run. Fisher believed that the velocity of money, V, is determined by the institutions in an economy, because these directly affect the way in which individuals conduct transactions. For example, if consumers use charge accounts and credit cards to conduct their transactions, and consequently use money less often when making purchases, less money is required to conduct the transactions generated by nominal income (M decreases relative to PT). Hence, velocity, defined as  PT  / M , will increase. On the other hand, if consumers find it more convenient to purchase items with cash or checks (both of them are counted as money), more money is used to conduct the transactions generated by the same levels of nominal income, hence velocity will fall. Fisher theorized that institutional and technological features of the economy that affect velocity change only slowly over time, so velocity can safely be considered constant in the short-run. By dividing both sides of the equation of exchange by V, we obtain the money demand function: M d  1 / V  / PT (1.2a) M d  kPY (1.2b) Or equivalently, Equation (1.2b) states that because k is a constant in the short-run (because V and t are constant in the short-run), PY, pins down the quantity of money that people demand, Md. Fisher believed that people hold money only 9 to conduct transactions and have no freedom of action in terms of the amount they want to hold. The demand for money is determined by the level of transactions generated by the level of nominal income, PY, and by the institutions in the economy that affect the way people conduct transactions that determine velocity, V, and hence k. Therefore, Fisher‟s quantity theory of money suggests that the demand for money is purely a function of income. Interest rates have no effect on the demand for money.  Cambridge approach to money demand A group of classical economists, including Alfred Marshall and Arthur C. Pigou in Cambridge, England, studied the demand for money by considering how much individual want to hold, given a set of circumstances. This approach is different from Fisher‟s approach to money demand. Fisher held the central assumption that individual demand for money is driven by the institutional environment, as this is the main factor that affects whether individuals use money (i.e., cash and check) to conduct transactions. In Cambridge model, the individual demand for money is note completely bound by institutional constraints such as whether one can use credit cards to make purchases. Instead, individual desire money because money is a medium of exchange and a store of wealth. Cambridge economists concluded that money demand would be proportional to nominal income and expressed the demand for money function as: MD  kPY (1.3) In the short–run, k is the constant of proportionality and money demand does not depend on the interest rate. However, money demand can depend on the interest rate when velocity is not constant over time. From our discussion so far, the quantity theory of money emerges as the theory with a simpler approach to estimating money demand. The estimating equation is 10 MV  PY (1.4) Where M denoted nominal money stock, V denotes the income velocity of circulation, P denoted the prevailing price level and Y denoted the real income. Note that the elegant expression for money demand given by the quantity theory of money relies on the assumption of constant velocity. In reality, however, the velocity is especially during periods of financial liberalization. In these cases, equation (1.4) cannot capture the complex relationship between the money demand and other macroeconomic variables. Hence, we will turn to two other approaches to the theory of money demand: the Keynesian approach and Friedman‟s modern quantity theory approach. Both approaches consider the demand for money as part of the general problem of wealth allocation, but place emphasis on different aspects of the problems. 1.1.2. Keynesian approach (John Maynard Keynes) In 1936, Keynes famous book, “The General theory of Employment, Interest and Money”, abandoned the classical view of economics. In its place, he offered a theory of demand for money that emphasized the importance of interest rates. Keynes‟ theory of money demand (referred to as liquidity preference theory), focus on the factors that influence individual decisionmaking. He postulated that there are three motives driving the demand for money: transaction motive, precautionary motive, and speculative motive. With this view, money demand is a function of real income (Y) and the interest rate (r). M / P  f  r ,Y  (1.5) Equation (1.5) has the key implication that velocity is not constant and is positively correlated with the interest rate, which fluctuates substantially. 11 Initially, Keynes suggested a liquidity-preference schedule like the following equation, MD  M 1  M 2  M 1Y   M 2  r  (1.6) where: MD is the total demand for money, M1 is the sum of transaction and precautionary demands and M2 is speculative demand. In this schedule, transaction and precautionary demand depend only on the level of income, Y, where dM 1/ dY  0 . The speculative demand depends only on the level of interest rate, r, where dM 2 / dr  0 . The following sections review the work of other economists who have further developed the Keynesian theory of money demand. 1.1.2.1. Transaction demand- Baumol-Tobin model The transaction motive is the demand for money arising from the use of money as regular payment for goods and services. The trade-off is between the amount of interest an individual forgoes by holding money, the costs and conveniences of holding money. Baumol and Tobin set up their model by analyzing a per-period model of an individual managing his wage in every time period, assuming that the person is paid in bonds an amount Y at the beginning of a period. An additional assumption is that the amount Y is spent uniformly over the time period. Each time the individual requires money for consumption, he has to convert bonds to money and incur two costs in the process:  Transaction costs, (tc), which represent the direct cost of converting bonds into money  Interest opportunity cost, which is forgone interest earned by converting bonds into money. Solving to find the optimal number of transactions yields the minimum sum of transaction costs and interest opportunity costs. This solution can be