REGULATION OF INTEREST RATE BY THE STATE BANK OF VIETNAM (SBV) potx

Interest rate and investment: In respect of investment, it concerns more about businesses, who increase their investment if they can borrow money at low REAL LENDING interest rate.. This

GROUP ASSIGNMENT

International Finance

REGULATION OF INTEREST RATE

BY THE STATE BANK OF VIETNAM (SBV)

Group Members:

Pham Duc Trung

Vu Hieu Trung Phan Tung Nguyen Nguyen Thu Phuong Tran Quoc Loc

English Speaking Group 2 Intake 13

CFVG Hanoi

HANOI, JUNE 2006

Table of Contents

F OREWORD 3

1 T HE R OLES OF I NTEREST R ATE 4

1.1 Interest Rate and Consumption/Investment 4

1.2 Interest Rate and Inflation 5

1.3 Interest Rate and Exchange Rate/Trade Balance 5

1.4 Interest Rate and the Financial Market 5

1.5 Balance Among Factors 6

2 T HE I NTEREST R ATES R EGULATING M ECHANISM BY SBV 8

2.1 The shock of interest rates during 1990s 8

2.2 Basic Rate – Period from June 2000 – May 2002 9

2.3 Freely Negotiable Interest Rate – Period from June 2002 up to now 9

2.4 Interest Rate and the Stability/Development of Financial Market 13

2.5 Balance among three Objectives of Inflation Control, GDP Growth and the Stability of Financial Market 14

3 R ECOMMENDATION FOR SBV TO R EGULATE I NTEREST RATE 17

3.1 Improve the current regulating mechanism 17

3.2 Set up and perfect indirect monetary tools 18

3.3 Determine clear objectives of monetary policy 19

R EFERENCE 20

We would like to present to you our study on the Regulation of Interest Rate by the State Bank of Vietnam (SBV) as our team’s assignment for the course of International Finance,

CFVG, Hanoi, Vietnam We hope that this study can give you some information and analysis

on the monetary policies of Vietnam We would like to express our sincere thank to Dr Michel Henry Bouchet, for his lessons and guidance during the course

Pham Duc Trung

Vu Hieu Trung

Phan Tung Nguyen

Nguyen Thu Phuong

Tran Quoc Loc

MBA Intake 13

CFVG, Hanoi, June 2006

1 THE ROLES OF INTEREST RATE

Interest Rate is a key economic factors, which have close relations with other factors

In this section, we will study such relation and the level of interaction between interest rate and other factors in Vietnam

1.1 Interest Rate and Consumption/Investment

Interest rate and consumption:

Because the consumption is by individual and households and the borrowing for consumption is very low in Vietnam, it relates more closely with the deposit interest rate, than the lending rate If the REAL DEPOSIT interest rate is high, people tend to save more money

in deposit, rather than spending

On the other side, if the consumption is high, the income available for saving is low, and the banks have to increase deposit interest rate to get more deposit

Interest rate and investment:

In respect of investment, it concerns more about businesses, who increase their investment if they can borrow money at low REAL LENDING interest rate In Vietnam, where bank loans are major local sources of financing investment, interest rate is very important for investment On the other side, if the investment is high (e.g in booming economy), banks demand more money by increasing DEPOSIT rates, while increase LENDING rates to compensate and get profits from the investors (who are hungry for money)

Collectively, a low real interest rate will boost consumption and investment, which results in the growth of [HOT] economy; while a high real interest rate tends to COOL the economy Empirical evidence in Vietnam shows that, when the effect of inflation is removed, the Real GDP goes in opposite direction against Real Interest Rate

-4 -2 0 2 4 6 8 10 12

2000 2001 2002 2003 2004 2005

6.2 6.4 6.6 6.8 7 7.2 7.4 7.6 7.8

Real Interest Rate - Three-month deposits (households) Real Interest Rate - Short-term lending

Real GDP (annual percentage change)

1.2 Interest Rate and Inflation

Following the quantity theory of money, as the interest rate increases, the money supply decreases, and the price tends to decreases to balance the equation of quantity theory

of money (MV ≡ PV) In addition, an increase in interest rate will cause both the consumption

and investment demand to decrease as discussed above, which results in the decrease of aggregate demand of economy, and a lower equilibrium price can be expected due to the move of demand curve to the left

However, this effect seems to be SHORT-TERM because the decrease of investment will finally result in the decrease of supply (decrease of T), which in turn moves the supply curve to the left and bring the price back to the first equilibrium position

M x V = P x T

Quantity

P1

P2

D1 D2

S1 S2

1.3 Interest Rate and Exchange Rate/Trade Balance

In an open-door market, the interest rate also greatly affects the exchange rate and trade balance of country If the interest rate of one country is high, it attracts the capital inflow, which results in the increase of foreign currency supply; this in turn increase the local currency value and import, while discourages the export

Generally, the above-mentioned relationships work well in a developed economy But

in developing world, the inefficiencies of financial market and the irresponsiveness of economy usually limit the relationships Especially for Vietnam, where there are still many restrictions on the capital flow and foreign exchange transaction, the interaction between interest rate and exchange rate is limited

1.4 Interest Rate and the Financial Market

In this study, the financial market is defined as the middle-man between the saving (S) and the investment (I), which brings the unused capital to the investors In this market, the interest rate can be considered as the price of money, which plays a critical role in competition among the banks

Deposit side vs Lending side:

The utility package offered by the banks to the depositors mainly includes the interest rate, the quality of service, and the credibility If the banks can not compete with higher

service quality and creditability, the only weapon for competition is the interest rate In addition, a bank with low service quality and creditability usually offers high deposit interest rate This is really the case for Vietnam, where all the state-owned banks offer lower deposit rate than private banks, but they can get much more deposits than the private banks, because the creditability of state-owned bank is very high (no failure due to the Government’s

support), while private banks are fiercely competing with each other for deposits Please refer

to the following table for the current deposit interest rate (May, 2006) of three biggest state-owned banks and private banks

Deposit Interest

It is also noted that the interest rates of all state-owned banks are nearly same

On the other hand, the utility package offered by the banks to the investors mainly includes the low cost of capital, service quality, the quality of loans (in term of availability, flexibility, and amount) In addition to the quality of investment/loans and service quality, lending interest rate is also a key competition factor However, because there is more differentiation, and the banks’ bargaining power is stronger on the lending side, the

competition force is always fiercer on the deposit side

Interest Rate and Financial Crisis:

There is always a force to push the banks to race for the higher deposit and loan amount, and to capture the bigger market share To obtain high deposit amount, the bank may increase the interest rate of deposit With the big amount of deposit obtained, the bank can also offer good quality of loans, and gain more and more power on the lending side (in term

of availability, flexibility and amount)

On the other side, to release the captured deposit, the banks can not increase the lending interest rate too high The “price war” of interest rate is always a danger for the

banking system, because it deduces the margin (lending rate – deposit rate – operation

expenses) and it can lead the banking system to crisis In Vietnam, the failure of some small banks (or small credit institutions) in 1990s is one bloody experience of this type

1.5 Balance Among Factors

As discuss above, the interest rate interacts with other economic factors: (i) consumption/ investment (or collectively GDP); (ii) inflation; (iii) exchange rate; (iv) stability

of financial market

As the Central Bank of Vietnam, SBV always try to find out a balance to monitor the interest rate Based on the degree of interaction between interest rate and other factors, SBV can generally pursuit following policy:

a) Liberalizing Interest Rate: This is an irreversible trend for many countries in the world, because it can help allocate resources (money) effectively and efficiently This is one

of the reforms suggested by John Williamson, 1989, in his so-called “Washington

Consensus”;

b) Prevent harsh “price war” of interest rate in Banking System, to prevent failure of

banking system (crisis of the Financial Market);

c) Keep an eye on the inflation; in the case of Vietnam, this may be to control the inflation rate of one-digit;

d) Given the above constraints, the real interest rate should be low enough to keep high GDP growth, because the real interest rate has a strong relation with consumption and investment as discussed above

We will discuss more deeply into these policies in next part

Inflation

Stability

of Financial Market

Exchang

e Rate

Consump tion/Inve stment

Real Interest Rate

2 THE INTEREST RATES REGULATING MECHANISM BY SBV

In transition from the command economy to the market economy, Vietnam has gone through many changes in the regulating mechanism to liberalize the interest rate from 1992 up

to now Even, in this study, we will concentrate on the period from 2000 up to now but we will take a look for the interest rates situation in Vietnam from during the period from 1994 to

1997 when the Vietnam economy has been shocked because of the wrong interest rates policy

2.1 The shock of interest rates during 1990s

In 1994, instead of lowering the interest rate according to the policy adopted by the Conference of Bankers at the beginning of the year, the State Bank preserved the status quo

on the grounds that the inflation rate in the first half of 1994 had shown a tendency to become higher by the second half than what had been planned by the National Assembly

In 1994, the inflation rate reached 14.4%, and the real interest rate was: 25.2%-14.4%

= 10.8% Many commercial banks had even offered much higher deposit rates (from 32% to 36% a year) and caused the real interest rate to increase to 18-22%, therefore it's obvious that the state Bank should have reduced the interest rate in 1994 In 1996, the State Bank reduced the interest rate four times and caused a lot of losses to commercial banks The first joint stock bank in Vietnam, by publicizing its balance sheet, had to admit that its interest in black was lower than its interest in red

Up to now, there is no answers to such questions as how many joint stock banks had to suffer losses because of the reductions of the interest rate and how many banks had to violate regulations on interest rates with a view to saving themselves from losses Bits of information gathered in 1996 showed that rural joint stock banks had to increase the deposit rate to 1.6-1.7% a month, thus they had certainly been allowed to violate the interest rate-ceiling of 1.5% A branch of foreign banks has violated the regulation on interest rate-ceiling by requiring local banks to deposit 50% of loans supplied by this branch, thus it has doubled the lending rate on loans in foreign currencies This branch, therefore has avoided the danger of bad loan because it held 50% of the loan supplied

Calculations publicized by the press showed that in 1996 banks had to suffer losses because even if they could lend 80% of their deposits, they couldn't collect enough interest on loans to cover their interest in red, that is, their overheads became losses In July 1997 when the interest rate-ceiling was reduced, no attention was paid to losses suffered by joint stock banks If they observe the bank margin of 0.35%, the deposit rate will be only 0.65% and become unattractive, therefore joint stock banks have to offer a deposit rate of 0.8-0.85% to 3-month deposits, and raise bank charges in order to reduce potential losses

Let's study an example: With deposits of 100 billion, a bank has to pay 0.8-0.85% interest, or 80-85 million If it can lend 80 billion (this is rarely seen in reality) and receives interest at 1%, or 80 billion, it will certainly suffer losses because it has to pay the overheads The loss will be bigger if it pays 0.85% interest on deposit Only State-owned commercial banks (except for banks for agriculture) can avoid losses because its call deposits represent over 50% of its total deposits Strange to say, the State Bank has paid no attention to this situation although many bankers at the conference have given voice to the regulation on

interest rate-ceiling The State Bank has thought that joint stock banks as well as state owned bank had to suffer losses in order to carry out the regulation on interest rate In order to avoid losses and bankruptcy, joint stock banks have to find ways to increase the lending rate One of alternatives is to follow in footsteps of the branch of foreign bank as stated above When the interest rate-ceiling is reduced, it's necessary to help joint stock companies to avoid losses

When the central bank wants to encourage the economic development, it will lower the interest rate, whereas the interest rate-ceiling in Vietnam was fixed by the Government in this period, so the central bank has to use administrative measures to enforce it, however, the regulation didn't provide for subsidies given to banks suffering losses, therefore all officials from the central bank tended to pay no attention to the fact that joint stock banks had raised the lending rate That was why many rural banks have officially offered the deposit rate of 1.6-1.7%

2.2 Basic Rate – Period from June 2000 – May 2002

During this period, the SBV sets a promulgated interest rate, called “Basic Rate” and a

bandwidth The basic interest rate affects all other interest rates arising in the market economy It is a kind of interest rates playing an important role in the market mechanism in general and our market economy in particular The basic interest rate is determined by the central bank and announced on the basis of real situation and targets of the national monetary policy The point 12, Article 9 of the Law on the State Bank of Vietnam stipulates: " The basic interest rate is the interest rate announced by the State Bank of Vietnam making a ground for credit institutions to fix their business interest rates" However, it is argued that the basic interest rate is a broad concept including different rates of capital re-allocation, rediscount, interbank market; maximum rate for loans and minimum rate for deposits

Other banks can set their own interest rate for local currency loans, but it is not allowed to be higher than the sum of basic rate and bandwidth The bandwidth for local currency is 0.3% for short-term loans, and 0.5% for mid-term and long-term loans

For foreign currency, the interest rate for short-term loans shall not be higher than 3-month SIBOR+1%; and the interest rate for mid-term and long-term loans shall not be higher than 6-month SIBOR+1%

This regulating mechanism is rather free for other banks to set their own interest rate The credit expansion capability of banks is released to finance the economy, particularly by the long-term loan This mechanism allows the banks to manage their own strategies and operation better than the previous However, the basic rate and the bandwidth are set by the SBV subjectively, and not in line with the actual conditions of money supply – demand The

regulating tool is completely administrative, and the market forces have limited effects on the interest rate

Therefore, the mechanism has been replaced by negotiable mechanism on June 2002

2.3 Freely Negotiable Interest Rate – Period from June 2002 up to now

From June 2002, the interest rate was freely negotiable by the new policy of SBV that

“the banks can fix their own interest rate on loans on the basis of market capital supply –

demand and the creditability of borrowers”

This new policy has completely freed the market interest rate The SBV no longer control the interest rate directly, but they start to use many indirect tools, including required reserve ratio, basic rate, refinancing and discount rate, open market operation

Required Reserve Ratio:

The required reserve ratio can be set between 0 – 20% as required by the Law on State

Bank However, the actual ratio set by SBV is too low to have considerable effects on the money supply:

Required reserve ratio Types of financial institutions

Dec 2002 Aug 2003 Jul 2004 State-owned banks, Urban banks, Foreign bank branch 3% 2.0% 5%

In July 2004, SBV increase the required reserve ratio by 1 – 3% This is an action to

control the inflation Theoretically, other banks have to increase the loan interest rate to offset the loss of revenue due to additional “dead money” retained in their reserve account at SBV,

otherwise their profit ratio will be reduced However, in July 2004, the interest rate in the market is as high as 11% - 14% per year, and the SBV pays interest rate on the required reserve amount (SBV does not pay interest on the reserve in excess of requirement) Therefore, the market interest rate has not increased as expected

Though the theory suggests that an increase in the required reserve ratio will result in a decrease of money supply, there seem to be no clear correlation between the two in Vietnam This may be explained by the fact that banks usually retain more money than the required reserve ratio (this is a usual phenomenon of developing countries) Another reason is that the required reserve ratios is rather low, and even the increase by 3%, the ratio is only 5% in comparison with a common 7 – 10% for developing countries Therefore, the required reserve

ratio should not be highly appreciated as a tool for regulation of interest rate if it is not increased to a more meaningful level

Basic rate:

From June 2002, the basic rate is no longer compulsory for other banks, but it serves

as a “guiding indicator” for the market interest rate It is calculated based on the interest rate

of 15 biggest banks for the best investors Following figure is the moving trend of basic rate

in comparison with the market rate