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Procedia Economics and Finance 5 (2013) 502 511

International Conference on Applied Economics (ICOAE) 2013

Gold as a Hedge against Inflation: The Vietnamese Case

Hau Le Longa,b,*, Marc J.K. De Ceustera,c, Jan Annaerta,c, Dalina Amonhaemanona,d
Universiteit Antwerpen, Prinsstraat 13, 2000 Antwerpen, Belgium b Cantho University, 3/2 street, Cantho city, Vietnam c University of Antwerp Management School, Sint-Jacobsmarkt 9, 2000 Antwerpen, Belgium d Prince of Songkla University, Kaunpring, 92000 Trang, Thailand
a

Abstract We investigate the inflation-hedging properties of gold in Vietnam, reaching formidable records in 1980s-1990s. Consistent with conventional belief, we find that gold provides a complete hedge against both the ex post and ex ante inflation. In addition, its return is positively related to unexpected inflation, although the statistical evidence does not strongly support this. However, in general, we cannot reject that gold does provide a complete hedge against inflation. Furthermore, our findings support the Fisher hypothesis that nominal gold returns move in a one-for-one correspondence with expected inflation. The study has implications for both investors and government. 2013 2013 The Authors. Published by Elsevier The Authors. Published by Elsevier B.V. B.V. Selection and/or peer-review under responsibility of the Organising Committee of ICOAE 2013. Selection and/or peer-review under responsibility of the Organising Committee of ICOAE 2013
Key words: Vietnam; inflation; gold returns; hedging

1. Introduction Maintaining the purchasing power of investment assets over time has always been of great interest for longterm investors (Roache and Attie, 2009). This concern was already addressed by Fisher (1896) who postulates that expected nominal interest rates should move one-for-one with expected inflation. This so-called Fisher hypothesis, generalized to other investment assets, implies that the expected nominal return on any investment asset should be equal to its real return plus the expected inflation rate (Fama and Schwert, 1977). Apart from the protection against the expected inflation, long-term investors also show the desire to preserve their wealth

* Corresponding author. Tel.:+32-03-265 4154; fax: +32-03-265 40 64. E-mail address: llhau@ctu.edu.vn.

2212-5671 2013 The Authors. Published by Elsevier B.V. Selection and/or peer-review under responsibility of the Organising Committee of ICOAE 2013 doi:10.1016/S2212-5671(13)00059-2

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against unexpected inflation, especially in turbulent times. These ambitions naturally lead to an active debate about the type of asset protecting most effectively investors wealth against inflation, both expected and unexpected. Given its role as either an investment asset (Chua and Woodward, 1982) or a store of value (Harmston, 1998), gold is often advanced by both academics and practitioners as an excellent candidate. By the latter it is often viewed as a good instrument for protecting investment portfolios against inflation and currency depreciation. Gold possesses several characteristics that might attract people in general and investors in particular. Gold sets itself apart from other commodities by its being durable, relatively transportable, universally acceptable and easily authenticated (Worthington and Pahlavani, 2007). In addition, golds positively skewed returns might provide it safe-haven properties (Lucey, 2011). Although some view gold as a barbarous relic with no modern role to play or just another commodity which hardly adds value in an investment strategy (Ranson and Wainright, 2005), the public opinion (Blose, 2010), policy makers and academics such as Wang, Lee and Thi (2011), believe that the gold price tends to increase along with the general level of prices providing a hedge against total inflation. Dempster and Artigas (2010) show that while gold achieves high returns in high inflation years, its returns are still mildly positive in the low and moderate inflation years. Also the demand for gold was shown to grow as expected inflation rises (Moore, 1990). On its role as financial asset, it is believed that The beauty of gold is, it loves bad news. In line with popular beliefs, the literature suggests that gold potentially provides not only a good hedge against the ex ante inflation but also against the ex post inflation, although its effectiveness may depend on the economic conditions or characteristics of each country (Wang, Lee and Thi, 2011). Chua and Woodward (1982) show that the extent to which gold can act as an inflation-hedging asset is determined by the magnitude and volatility of the domestic inflation rate relative to the changes in gold prices. In this paper, we investigate the potential role of gold as an inflation-hedging asset for Vietnam, one of the highest goldconsumers of the world (World Gold Council, 2011; 2012). This study contributes to the existing literature in a number of ways. First, most previous studies take a U.S. perspective. By studying the inflation hedging capacity of gold investment for a developing country, where financial markets are much less developed and other inflation hedges are less available, we provide valuable international evidence. Second, although Levin, Montagnoli and Wright (2006) claim that holding gold is more than adequate as an inflation hedge for investors in developing and major gold-consuming countries. Vietnam presents a unique case study since gold is used publicly and to the same extent as the national currency (VND) for the purpose of saving, payment and transactions with commercial banks. Hence, our results provide insight about the inflation-hedging ability of gold in a unique environment. Thirdly, the gold return-inflation relationship reflects the extent to which gold is popular in the economy relative to the fiat money and other investment assets. The study hence may partially help Vietnams authorities in formulating and implementing effective monetary policy, and also other macro policies to utilize the capital resource accumulated in gold for economic development. Finally, as research on gold is relatively limited compared to that on stocks, bonds and foreign exchange (Lucey, 2011), the study may enrich the literature on the gold market. The remainder of the paper is structured as follows. Section 2 reviews the existing literature. In section 3, we discuss the research questions. We present the methodology used in section 4. Section 5 describes the data and their descriptive statistics. Empirical results are discussed in section 6. Finally, we conclude.

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2. Literature survey Chua and Woodward (1982) classify demand into use demand and asset demand. The former involves its use in the production of jewelry, medals, coins, electrical components, etc., while the latter implies the role of gold as an investment asset by governments, fund managers and individuals. Although the Bretton Woods system collapsed in 1971, the traditional role of gold as a store of value lives on in many, especially Asian, countries (Wang, Wang and Huang, 2010). That is, central banks around the world continue to hold gold in their reserves, and investors continue to use gold as a tactical inflation hedge and as a long-term strategic asset (Dempster and Artigas, 2010). The historical link to money might reinforce the culturally and traditionally embedded image of gold as an immutable store of value (Baur and Lucey, 2010). The underlying idea of inflation-hedging value of gold is that if gold is successful in its store-of-value function, it must be able to preserve the relative rate of exchange with other goods and services (Harmston, 1998). Empirical studies attempt to justify the value of gold as an inflation-hedging asset from both aspects, ex post and ex ante, as well as in both the short and the long-run. Among others, Chua and Woodward (1982) is one of the early studies testing golds effectiveness as inflation hedge. Regressing nominal gold returns on both the expected and unexpected inflation in six major industrial countries over period 1975-1980, they find that while nominal gold returns are positively related to both inflation rates for the U.S., the relationship is not consistent for the other countries, namely, Canada, Germany, Japan, Switzerland and the U.K. These findings indicate that gold can effectively hedge against inflation for the U.S., but not for the others, which is possibly explained by the differences in structural characteristics of these economies. Examining the U.S. data over 1968-1999, Adrangi, Chatrath and Raffiee (2003) document that gold returns only have a positive relationship with expected inflation, but that they do not covary with unexpected inflation. On the contrary, covering the U.S. data over the period 1988-2008, Blose (2010) finds no relationship between nominal gold returns and expected inflation. 3. Research Question Given the roles of gold in the context of Vietnam as discussed above, a strong and positive relationship between gold and inflation would be expected due to two links. The first possible link is the culturally embedded value of gold, given its significant role in the country. A second connection may be due to the positive relation between inflation and economic growth, which in turn increases the demand for gold due to the increase in wealth. Since the paper is to investigate whether gold can protect the wealth of Vietnamese people against inflation, we first investigate the ex post relationship between gold returns and inflation rates as a starting point. In the second step, we use an ex ante model to examine the relation between gold returns and both the expected and unexpected inflation. The ex ante model can provide a more straightforward way to test the Fisher hypothesis (among others, see Boudoukh and Richardson (1993); Nelson (1976)). Moreover, by doing this we can separate the hedging ability of the asset against each component of inflation in order to justify the bad news-loving characteristics of gold. 4. Methodology 4.1. The Fisher hypothesis

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Fisher (1930) states that the expected nominal interest rate is equivalent to the sum of the expected real interest rate and the expected inflation rate, and also that the real and monetary sectors of the economy are largely independent. Therefore, the expected inflation should be fully reflected into the expected nominal interest rate. The theory is generalized to nominal returns on any asset, which should move one-for-one with expected inflation (Fama and Schwert, 1977). Formally, the proposition can be represented by , (1)

where is the conditional expectation operator at time ; denotes the nominal return on an asset from time to ; is the appropriate equilibrium real return on the asset from time to and represents the inflation rate from time to . Equation (1) can be equivalently reformulated as . In (2), the cross-product term routinely as (2)

is usually negligible. Hence, the representation of (2) is

(3)

4.2. Empirical model We investigate the ex post relationship between the nominal asset return and inflation using the following regression: , (4) where and are coefficients and is the error term. Following Fama and Schwert (1977), we also estimate the following ex ante model in the second step: , where is the error term. (5)

Since both explanatory variables are orthogonal, consistent estimates of and can be obtained as long as expected inflation is observable. In equation (5), (Fama and Schwert, 1977) indicate three cases for the hedging potential of an asset: (a) (b) (c) If If If , the asset is said to be a complete hedge against expected inflation: , the asset is a complete hedge against unexpected inflation. , the asset is considered as a complete hedge against inflation.

It should be noted that the approach by (Fama and Schwert, 1977) requires a suitable measurement for the expected and unexpected inflation rates. We use the ARIMA model (Box and Jenkins, 1970) to estimate the expected and unexpected inflation for this study. We estimate all regressions by OLS (Ordinary Least

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Squares), since our focus is to examine the short-run influence of inflation on the asset returns, and not the feedback from returns to inflation. We use the Newey-West corrected covariance matrix when computing the test statistics in order to account for heteroskedasticity and residual autocorrelation (Newey and West, 1987). 5. Data and summary statistics 5.1. Data We follow a number of previous studies, e.g., Bodie (1976); Cohn and Lessard (1981); Fama and Schwert (1977) and use quarterly data aggregated from monthly data to avoid the inherent technical issues of monthly CPI data. Monthly time series data are obtained from various sources. The gold price index of Vietnam over January 2001-December 2011 period is collected from the Vietnam General Statistics Office (GSO), while CPI is obtained from Datastream. Since economic and financial time series are usually found to be nonstationary (see, e.g., Fuller (1995); Nelson and Plosser (1982); Phillips (1987)), we transform the gold price index and CPI into returns and inflation rates, respectively using log changes. Both gold returns and inflation rates are stationary according to the ADF and the KPSS tests. 5.2. Summary statistics Table 1. Summary statistics

This table reports the summary statistics for the whole sample and autocorrelation up to the 4th lag for all variables. In the table, R are the gold returns; is the actual inflation rate; E() is the expected inflation rate and UE() is the unexpected inflation rate. The summary statistics are expressed in percentage. Returns and inflation rates are calculated as the log changes of the gold prices index and CPI, respectively, from time (t-1) to t. Expected and unexpected inflation rates are decomposed from the actual inflation rates by Autoregressive (AR) model, where expected inflation rates are the linear prediction of the AR model and unexpected inflation rates are the residuals of the AR(3) model . (**) indicates significance at the 5% level.

Mean Median Min Max Std Skewness Kurtosis N

Summary statistics (%) R -0.06 0.02 0.34 0.10 -14.34 -1.94 11.99 2.36 5.01 0.79 -0.42 -0.12 3.76 3.91 44 46

E() 0.03 -0.03 -1.07 0.99 0.38 0.21 3.99 43

UE() 0.00 -0.01 -1.52 1.96 0.71 0.40 3.25 43

Autocorrelation Lags R -0.37 -0.09 1 -0.20 -0.07 2 -0.05 -0.45** 3 0.21 0.13 4

Table 1 reports the summary statistics for all variables and the serial correlations up to the 4th lag for gold returns and inflation rates. Gold has a negative average return with a relatively high standard deviation over the sample period, while inflation rates are relatively stable over time. Besides, although the distribution of gold returns and inflation rates can be characterized as negatively skewed and leptokurtic, we cannot reject its normality using the normality test by D'Agostino, Belanger and D'Agostino Jr (1990). Regarding the autocorrelations, both time series generally show a quick decay over time after the first lag, although the inflation rate shows a significantly high autocorrelation at the third lag. Given these results, we use an AR(3) model to decompose the actual inflation rates into expected and unexpected inflation rates.

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5.3. Regression results

Table 2. Regression results of gold returns on actual, expected and unexpected inflation rates. The table reports the regression results of gold returns on actual, as well as expected and unexpected inflation rates at the contemporaneous term [equation (4) and (5)] as presented below for convenience. Expected and unexpected inflation rates are decomposed from the actual inflation rates by using Autoregressive (AR) models, where expected inflation rates [ ] are the linear prediction of the AR model and unexpected inflation rates [ ] are the residuals of the AR model . In the table, is the number of observations, is the adjusted R-squared; is the F-test. The t-values for testing the hypothesis or or are shown in the brackets next to the coefficients, and the robust t-values for testing the hypothesis or or or or are reported in the parentheses below the coefficients. (***), (**) and (*) indicate significance at the 1%, 5% and 10% level, respectively.

0.00 (-0.22)

1.43

[0.59] (1.97)**

44

0.05

3.86 *

0.00 (-0.31) F value for testing the null hypothesis that F-

2.98 [1.39] (2.09)** : 0.99

0.96 [-0.05] (1.08)

43

0.07

3.39 **

Regression results for gold returns on actual, as well as expected and unexpected inflation rates are shown in Table 2. Gold returns are positively correlated with the actual inflation at the 5% level. Although the regression coefficient is greater than one (1.43), it is not statistically different from one. Therefore, it can be concluded that gold provides a good hedge against ex post inflation in Vietnam, i.e., a complete hedge against ex post inflation. As for the ex ante model, our results point to a significantly positive relationship with expected inflation at the 5% level. Despite its large value (2.98), the coefficient is again statistically indistinguishable from one. In other words, the results support the Fisher hypothesis of a one-to-one relationship between gold returns and the expected inflation rates. The regression coefficient on the unexpected inflation is also positive and close to one (0.96). However, because of its relatively large standard error it is neither significantly different from zero nor one. This implies that we do not find strong evidence that gold provides a hedge against the unexpected inflation, but we cannot reject its one-to-one relationship with the unexpected inflation. On the other hand, both coefficients on expected and unexpected inflation are found to be statistically jointly indistinguishable from one using an F-test (H_0:==1). In short, we find the clear evidence that gold provides a good hedge against both the ex post and ex ante inflation in Vietnam, while the results are largely also consistent with gold being able to protect against inflation according to Fama and Schwert (1977). 5.4. Stability analyses Structural changes may occur in our time series due to economic shocks, market crises and various institutional reforms. Such episodes, if not taken into account, may induce structural shifts and bias the estimated results (Alagidede and Panagiotidis, 2010; Worthington and Pahlavani, 2007). In this study, we indeed identify a number of exogenous changes that may have impacted the gold return-inflation relationship. The study period has experienced some significant institutional changes on the stock market of Vietnam,

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which might have affected the domestic gold market and should be taken into consideration. Specifically, in March 2002, the stock market switched from three trading days a week to daily trading, thereby significantly increasing market liquidity. Another possible switching point is around the beginning of 2006 when several important institutional reforms took place. For instance, foreign investors were allowed to hold up to 49% ownership of Vietnamese listed non-financial firms. Moreover, this year was also marked with the introduction of new security regulation remedying the shortcomings of the existing legal framework and facilitating market development. In addition, in the same year, the Hanoi stock exchange was officially opened for trading. The joint effects of these facts significantly affect the stock market in terms of its liquidity and market capitalization. Taking these structural changes into account, we incorporate two dummies for three sub-periods defined by two break points to check the stability of the gold return-inflation relationship in Vietnam. Dividing sub-periods in this way can therefore provide a robustness check of the traditional belief, but only supported by few formal statistical studies (Wang, Lee and Thi, 2011), that gold can provide an absolute protection against general inflation, e.g., the 17th Century British Mercantilist Sir William Petty described gold as wealth at all times and all places. Table 3 presents the summary of regression results of equation (6) and (7). Considering the results for equation (6), the ex post gold return-inflation relationship is consistently positive for all subsamples, where the coefficient is greater than one for the two latter sub-periods (2nd sub-period: 2.27 and 3rd sub-period: 1.62), but is almost zero for the first one (0.05). While the coefficients for the second and third sub-period are significantly different from zero at the 1% and 10% level respectively, this is not the case for the first one. Especially, the coefficient for the second sub-period is significantly different from one at the 5% level, showing that gold provides a more than complete hedge against ex post inflation over this sub-period. Yet, since the coefficient for the third sub-period is not statistically different from one, we can conclude that gold provides a complete hedge against ex post inflation over the period.
Table 3. Stability analysis for both regressions on actual inflation, and both expected and unexpected inflation. The table reports the regression results of gold returns on actual, expected and unexpected inflation rates at the contemporaneous term, [equation (4) and (5)] incorporated with dummies for sub-periods and then denoted as equation (6) and (7), presented below for convenience. In the table, R is the gold returns; t is the actual inflation rate at time t. There are three sub-periods, so two dummies are employed: is a d dummy variable for the 1st sub-period [2000Q2-2002Q1] ( if the 1st sub-period and , otherwise); is a dummy variable for the 2nd sub-period [2002Q2-2005Q4] ( if the 2nd sub-period and , otherwise); The subscript of the coefficients refers to the respective sub-period. Expected and unexpected inflation rates are decomposed from the actual inflation rates by using Autoregressive (AR) model, where expected inflation rates [ ] are the linear prediction of the AR model and unexpected inflation rates [ ] are the residuals of the AR model . is the number of observations, is the adjusted R-squared; is F-test. The t-values for testing the hypothesis or or are shown in the brackets next to the coefficients, and the robust t-values for testing the hypothesis or or or or are reported in the parentheses below the coefficients. (***), (**) and (*) indicate the significant level at 1%, 5% and 10%, respectively.

Equation (6) 0.05 [-1.40] (0.10) 2.27 [1.99]** (3.55)*** 1.62 [0.66] (1.67)* 0.01 (1.33)

Equation (7) -4.11 [-17.70]*** (-14.34) *** 3.01 [1.38] (2.06)** 3.71 [1.48] (1.92) * 0.30 [-5.49]*** (2.36)**

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0.00 (0.56) 0.00 (0.55)

-test for dummy

44 0.07 3.32** 2.86*

2.05 [1.62] (3.15)*** 0.96 [-0.03] (0.71) 0.01 (6.89)*** 0.01 (0.17) 0.00 (0.62) 43 0.10 527.68*** 10.99*** 2.74*

Regarding regression (7), the coefficient on expected inflation is significantly positive at the 5% and 10% for the second and third sub-period respectively, but significantly negative at the 1% level for the first one. The coefficients on unexpected inflation are all consistently positive, with those for the first and second subperiods statistically significantly different from zero at the 5% and 1% level, respectively. Given the large standard errors on expected and unexpected inflation for the 2nd and 3rd sub-period, we cannot reject that these coefficients are equal to unity. In contrast, the unity of coefficients on both expected and unexpected inflation is strongly rejected at 1% of significance for the first sub-period. However, the findings for the first sub-period here should not be exaggerated because of the effects of the deflationary years mentioned above as well as the very limited number of observations in the period. Interestingly, the consistently positive relationship between gold returns and unexpected inflation over all sub-periods, experiencing fluctuations in economic conditions such as aggregate supply and demand shocks (see, e.g., Nguyen, Cavoli and Wilson (2012); Vu (2012)), does reinforce the hedging potential of gold against bad news. 6. Conclusion In this paper, we find that gold provides a good hedge against both the ex post and ex ante inflation in Vietnam. Although gold returns show oversensitivity to the inflation, i.e. an increase of one percent in inflation (both the ex post and ex ante rates) results in a more-than-one increase of gold returns, we cannot reject the one-to-one relationship between the nominal gold returns and inflation. Our results hence indicate the evidence to support the Fisher hypothesis. In addition, we also find that gold possibly provides a complete hedge against a surprise in inflation, although the statistical evidence does not support this finding. Nevertheless, we also cannot reject that gold can provide a complete against inflation. Overall, the empirical evidence tends to confirm the conventional beliefs about the inflation-hedging properties of gold. Furthermore, these findings are highly robust over sub-periods in which institutional changes in the capital market were taken place and economic conditions were fluctuated, i.e., supply and demand shocks on inflation. This study has several implications for both investors and the Vietnamese government. In general, investors in Vietnam can protect their wealth by investing in gold. On the other hand, the fact that the public tends to rely on gold as an investment channel to protect their wealth shows a weak confidence in the fiat money, which may result in difficulties for the authorities in conducting monetary policies. Moreover, the gold hoarding, instead of investing in other channels such as stocks and bond market, may reduce a large amount of financial resources for the economic development of the country. Therefore, the authorities should devote more efforts in recovering the confidence in the fiat money, as well as changing the routine of being large gold hoarding of

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the population. In addition, the authorities should also introduce more investment channels to mobilize the capital resources accumulated in gold. 7. References
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