Effect of exchange rate on trade balance of Vietnam: The role of vehicle currency and bilateral trade agreements

Abstract

This paper studies how exchange rate movements impact Vietnam’s bilateral trade balance with the European Union and the United States. We adopt a two-stage Bayesian strategy by working with 35 quarterly observations and a dataset marked by severe multicollinearity: single-equation models under shrinkage priors establish baseline results for each trading partner, and a Bayesian Seemingly Unrelated Regression (SUR) then estimates both equations jointly, exploiting the cross-equation error correlation that arises when global shocks hit both relationships at once. Four key findings stand out: the USD/VND rate results in being the dominant exchange rate channel for Vietnam’s competitiveness - it shapes the EU trade balance almost as strongly as the US balance, which leads directly to the vehicle currency role of the dollar. The European-Vietnam Free Trade Agreement (EVFTA) policy variables state an asymmetric narrative: positive for the EU surplus, negative for the US, consistent with trade diversion rather than pure creation. Covid-19 pulled the two relationships in opposite directions, contracting EU-bound shipments while US households ramped up purchases of Vietnamese electronics and furniture. Finally, the sizeable cross-equation covariance
(Σ₂₁ = 0.737) confirms that treating the two bilateral relationships as independent would discard meaningful information. These results carry important implication that the State Bank of Vietnam’s exchange rate mandate, as well as for the design of future FTA negotiations, which should account for potential displacement effects on existing trading partners.