Monetary policy transmission and bank lending channel in Vietnam

Abstract The transmission of monetary policy is the center of economic studies, this field was renewed in light of the 2008 global financial crisis with arguments about the effectiveness and the determinants of transmission channels especially in emerging markets such as Vietnam which may have strong bank lending channel while asset price channel and exchange rate channel may be weak. This study tries to investigate the existing of interest rate channel, exchange rate channel, asset price channel, and bank lending channel in Vietnam which are seen as the main channels in monetary policy transmission. In addition, this study tries to investigate the determinants of bank lending channel and the effects of the 2008 global financial crisis on bank lending channel in Vietnam that are important for Vietnamese policy makers in conducting monetary policy, stabilizing banking systems, financial markets and the economy. Firstly, this study utilizes the VAR model to examine the existing of interest rate channel, asset price channel and exchange rate channel, one by one, by using monthly macroeconomics data from 2003 to 2012 including market interest rates, the stock market index and exchange rate to proxy for interest rate channel, asset price channel and exchange rate channel respectively. Then this study uses SVAR models to test the existing of these channels in a system with the same data sample. Secondly, this study collects yearly data from 30 Vietnamese commercial banks such as loans, assets, loan loss provision, capital from 2003 to 2012 to investigate the existing and the determinants of bank lending channel through the system GMM models. Then, this study uses the S&P 500 implied volatility index to investigate the effects of the 2008 global financial crisis on bank lending channel through the same system GMM models. With the first main objective, this study has found the evidence of cost channel in Vietnam that reflects the ineffective of monetary policy in controlling inflation thus it is a big challenge for Vietnamese policy makers in conducting monetary policy. But, this study did not find statistical evidences of exchange rate channel and asset price channel which may be suggest that they are weak or do not exist in Vietnam. In the second main objective, this study found the evidences of bank lending channel in Vietnam, it was also affected by the commercial bank characteristics such as bank capital, bank size. This study also found that the 2008 global financial crisis had significant effects on bank lending channels which is stronger in crisis. First of all, this study has contribution to the empirical literature about the existence of cost channel in a small open economy. Secondly, this study contributes empirical evidences of bank lending channel, the determinants and the effects of the crisis on bank lending channel in an emerging market. Thirdly, this study has major contributions to Vietnamese policy makers in conducting monetary policy and stabilizing the banking system and financial markets, especially in the case of facing further external shocks in the future such as the global crisis. With the academic contributions, this study defined that economists should test all transmission channels in one model for better controlling the interactions between channels and better measuring the effectiveness of each channel. With the empirical results, this study has significant practical implications for Vietnamese policy makers in developing debt and equity markets, controlling the risky activities of banking systems and applying unconventional monetary policies such as inflation targeting.

MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HO CHI MINH CITY

*****

NGUYEN PHUC CANH

MONETARY POLICY TRANSMISSION AND BANK LENDING CHANNEL IN VIETNAM

PHD THESIS

HO CHI MINH CITY, 2016 MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HO CHI MINH CITY

*****

NGUYEN PHUC CANH

MONETARY POLICY TRANSMISSION AND BANK LENDING CHANNEL IN VIETNAM

Major: Finance and Banking Code: 62.34.02.01

PHD THESIS

ACADEMIC ADVISORS

1 Prof Dr SU DINH THANH

2 Assoc Prof Dr VO XUAN VINH

HO CHI MINH CITY, 2016

ACKNOWLEDGEMENTS

I am deeply indebted to my academic advisers Pro.Dr Sử Đình Thành and Assoc.Pro.Dr Võ Xuân Vinh for their fundamental roles Pro.Thành and Pro.Vinh have provided me with guidance, assistances, and supports during my study They have given

me autonomy on decision making and researching the topic, while continuing to provide valuable feedbacks, advices, and encouragement In addition to our academic collaboration, I greatly appreciate the bonding relationships between Thành, Vinh and

I Additionally, I am deeply thankful to Dr Trầm Thị Xuân Hương, my lecturer and my researching partner at School of Banking, who has assisted me in researching the topic

in this thesis She has also advised, encouraged and generously allowed me to apply our shared works in presenting this thesis I gratefully acknowledge lecturers from the research methodology course at University of Economics Ho Chi Minh City who have provided me with basis methodologies for this study Such methodologies have helped

me understand, find and utilize correct methods

I would like to thank my dear colleagues at School of Banking and University of Economics Ho Chi Minh City for their substantial influence The School of Banking and University of Economics Ho Chi Minh City provide the best environment for studying and researching I also give my thanks to colleagues in International department at School of Banking, they always supported and encouraged me in this study and helped me a lot throughout my career I also would like to thank the board of professors and the independent external reviewers who gave me a lot of useful comments and advices on my first presentation, their comments are one of the major contributing factors that allowed me to complete this version of my thesis

I am deeply thankful to my family for their love, support, and sacrifice Without them, this thesis would never have been written

Ho Chi Minh City, Apr/2016

Nguyen Phuc Canh

ABBREVIATIONS

ARDL Autoregressive Distributed Lag Model

BRICS BRICS Group (including Brazil, Russia, India, China and

South Africa)

DSGE Dynamic Stochastic General Equilibrium Model

FAVAR Factor Augmented Vector Autoregression

FDICIA Federal Deposit Insurance Corporation Improvement Act

G7 Canada, France, Germany, Italy, Japan, UK, US

HLE Household Liquidity Effects

IS-LM Investment, Saving–Liquidity Preference, Money Supply

IPVN Vietnam Industrial Production

LIBOR London Interbank Offer Rate

MPTM Monetary Policy Transmission Mechanism

M2 Money Supply definition (expanded money supply)

NEER Nominal Effective Exchange Rate

OECD Organization for Economic Co-operation and Development

KMV EDF KMV’s Expected Default Frequency

S&P 500 S&P 500 Index

SVAR Structured Vector Autoregression

VECM Vector Error Correction Models

VIX The implied volatility of S&P 500 index options

VND Vietnam Dong (Currency of Vietnam)

VNIBOR Vietnam Interbank Offer Rate

VNindex Vietnam composite stock index

UPLC Unexpected Price Level Channel

WACC Weighted Average Capital Cost

TABLE OF CONTENTS

ACKNOWLEDGEMENTS i

ABBREVIATIONS ii

LIST OF TABLES x

LIST OF FIGURES xii

CHAPTER 1 1

INTRODUCTION 1

1.1 The overview of Vietnamese economy and monetary policy 1

1.1.1 The Vietnamese economy 1

1.1.2 The State Bank of Vietnam 2

1.1.3 The Vietnamese monetary policy 3

1.1.4.1 Market interest rates 4

1.1.4.2 Inflation 4

1.1.4.3 Exchange rate 6

1.1.4.4 Credit 6

1.1.4.5 Stock markets 7

1.2 Research gap identification 8

1.3 Research objectives and questions 10

1.4 The scope of this study 11

1.5 Research methodologies and data 12

1.5.1 Methodologies 12

1.5.2 Research data 13

1.6 Some key concepts 13

1.7 The structure of study 15

CHAPTER 2 18

THEORETIAL FRAMEWORK AND LITERATURE REVIEW 18

2.1 Monetary policy 18

2.1.1 Introduction 18

2.1.2 Central bank 19

2.1.3 Monetary policy targets 19

2.1.4 Monetary policy tools 20

2.1.5 The ineffectiveness of monetary policy 21

2.1.6 Monetary policy and fiscal policy 21

2.1.7 Unconventional monetary policies 22

2.1.7.1 Quantitative easing program 22

2.1.7.2 Inflation targeting policy 23

2.1.8 Summary 24

2.2 Monetary policy transmission 25

2.2.1 Conceptual framework 25

2.2.2 Monetary policy transmission channels 26

2.2.2.1 Interest rate channel 27

2.2.2.2 Exchange rate channel 29

2.2.2.3 Asset price channel 30

2.2.2.4 Credit channel 32

2.2.2.5 Expectation channel 35

2.2.3 The lag and effectiveness of monetary policy transmission 36

2.2.3.1 The transmission lags of monetary policy 36

2.2.3.2 The effectiveness of monetary policy transmission 38

2.3 Bank lending channel 38

2.3.1 Introduction 38

2.3.2 Transmission mechanism 39

2.3.3 Existing conditions 39

2.3.4 Empirical evidences 40

2.3.5 Determinants of bank lending channel 41

2.3.5.1 Macroeconomic conditions 41

2.3.5.2 The development of financial markets 44

2.3.5.3 Regulations in banking sector 45

2.3.5.4 The competition in banking sector 46

2.3.5.5 Microeconomic determinants 47

2.4 Studies of monetary policy transmission and bank lending channel in developing countries 53

2.5 Studies of monetary policy transmission and bank lending channel in Vietnam 58

2.6 Summary and research motivations 60

CHAPTER 3 62

METHODOLOGY 62

3.1 Monetary policy transmission testing models 62

3.1.1 The relationships between monetary policy, output and inflation 62

3.1.2 Estimating effects of monetary policy 63

3.1.3 Database in study of monetary policy transmission 65

3.1.4 Proxy variables for monetary policy 66

3.1.4.1 Policy rates 66

3.1.4.2 Money supply 67

3.1.5 Variables of commercial bank characteristics in bank lending channel 68 3.2 Econometric models for monetary policy transmission testing 69

3.2.1 VAR and related models 69

3.2.1.1 VAR model 69

3.2.1.2 SVAR model 74

3.2.2 Cointegration models 76

3.2.2.1 ECM 76

3.2.2.2 VECM 77

3.2.2.3 ARDL 77

3.2.3 DSGE model 78

3.2.4 GMM model for panel data 78

3.3 Research methodologies for this study 81

3.3.1 Research procedures and testing hypothesizes 81

3.3.2 Vietnam monetary policy transmission testing models 85

3.3.2.1 VAR model 85

3.3.2.2 SVAR model 86

3.3.3 Bank lending channel testing model 90

3.3.4 Research data 94

3.4 Summary 96

CHAPTER 4 97

EMPIRICAL EVIDENCES FROM VIETNAM 97

4.1 Monetary policy transmission 97

4.1.1 Data 97

4.1.2 VAR model results 99

4.1.3 SVAR model results 106

4.1.4 Robustness check 108

4.2 Bank lending channel in Vietnam 116

4.2.1 Data 116

4.2.2 GMM results and discussions 116

4.2.3 Robustness test 123

4.2.4 The effects of the crisis on the bank lending channel in Vietnam 126

CHAPTER 5 130

CONCLUSIONS AND POLICY IMPLICATIONS 130

5.1 Introduction 130

5.2 Review of research questions, methodology and findings 130

5.3 Academic contributions 137

5.4 Policy implications 139

5.4.1 Choosing monetary policy tools 139

5.4.2 Appling unconventional monetary policies 142

5.4.3 Developing debt and equity markets 144

5.4.4 Capability of commercial banks 145

5.4.5 Risk of commercial banks 147

5.5 Limitations and suggestions for further research 149

6 LIST OF AUTHOR’S PUBLICATION i

7 LIST OF REFERENCES v

8 APPENDIXES xxxvii

LIST OF TABLES

Table 3.1 Restriction matrix in SVAR model of Neri & d'Italia 87

Table 3.2 SVAR restriction matrix 89

Table 3.3 Expected correlations 92

Table 3.4 Formulas and sources of variables in VAR and SVAR models 94

Table 3.5 Formulas and sources of variables in GMM model 95

Table 4.1 Data statistical description 97

Table 4.2 New statistical description 97

Table 4.3 Granger causality test results 98

Table 4.4 The development of Vietnam stock market 104

Table 4.5 Granger causality test for DLVNI 105

Table 4.6 Variance decomposition for CPI from SVAR 108

Table 4.7 Variance decomposition for CPI from SVAR with DRDR 113

Table 4.8 Variance decomposition for CPI from SVAR with DRFR 115

Table 4.9 GMM data description 116

Table 4.10 Bank lending channel with each effect of bank characteristics 117

Table 4.11 Bank lending channel with whole effects of bank characteristics 120

Table 4.12 Bank lending channel with new measure of bank characteristics 121

Table 4.13 Bank lending channel with whole effects by new measure of bank characteristics 122

Table 4.14 Bank lending channel with RFR for each effects 123

Table 4.15 Bank lending channel with RFR for whole determinants 124

Table 4.16 Bank lending channel with RDR for each effects 125 Table 4.17 Bank lending channel with RDR for whole determinants 125 Table 4.18 The impacts of the 2008 global financial crisis on bank lending channel in Vietnam 128 Table 5.1 Financial market development in Vietnam 144

LIST OF FIGURES

Figure 1.1 Vietnamese macroeconomic factors 1

Figure 4.1 Impulse response function of CPI in IRC 100

Figure 4.2 Impulse response function for ERC 102

Figure 4.3 Impulse response function of VAR(5) for APC 104

Figure 4.4 Impulse response function of SVAR 107

Figure 4.5 Impulse response function of VAR for IRC with DLM2 109

Figure 4.6 Impulse response function of VAR for ERC with DLM2 110

Figure 4.7 Impulse response function of VAR for APC with DLM2 111

Figure 4.8 Impulse response function of SVAR with DRDR 112

Figure 4.9 Impulse response function of SVAR with DRFR 114

Figure 4.10 VIX index 127

Figure 5.1 Moody’s KMV EDF index 147

Abstract

The transmission of monetary policy is the center of economic studies, this field was renewed in light of the 2008 global financial crisis with arguments about the effectiveness and the determinants of transmission channels especially in emerging markets such as Vietnam which may have strong bank lending channel while asset price channel and exchange rate channel may be weak

This study tries to investigate the existing of interest rate channel, exchange rate channel, asset price channel, and bank lending channel in Vietnam which are seen as the main channels in monetary policy transmission In addition, this study tries to investigate the determinants of bank lending channel and the effects of the 2008 global financial crisis on bank lending channel in Vietnam that are important for Vietnamese policy makers in conducting monetary policy, stabilizing banking systems, financial markets and the economy

Firstly, this study utilizes the VAR model to examine the existing of interest rate channel, asset price channel and exchange rate channel, one by one, by using monthly macroeconomics data from 2003 to 2012 including market interest rates, the stock market index and exchange rate to proxy for interest rate channel, asset price channel and exchange rate channel respectively Then this study uses SVAR models to test the existing of these channels in a system with the same data sample Secondly, this study collects yearly data from 30 Vietnamese commercial banks such as loans, assets, loan loss provision, capital from 2003 to 2012 to investigate the existing and the determinants of bank lending channel through the system GMM models Then, this study uses the S&P 500 implied volatility index to investigate the effects of the 2008 global financial crisis on bank lending channel through the same system GMM models With the first main objective, this study has found the evidence of cost channel in Vietnam that reflects the ineffective of monetary policy in controlling inflation thus it

is a big challenge for Vietnamese policy makers in conducting monetary policy But, this study did not find statistical evidences of exchange rate channel and asset price channel which may be suggest that they are weak or do not exist in Vietnam

In the second main objective, this study found the evidences of bank lending channel

in Vietnam, it was also affected by the commercial bank characteristics such as bank capital, bank size This study also found that the 2008 global financial crisis had significant effects on bank lending channels which is stronger in crisis

First of all, this study has contribution to the empirical literature about the existence

of cost channel in a small open economy Secondly, this study contributes empirical evidences of bank lending channel, the determinants and the effects of the crisis on bank lending channel in an emerging market Thirdly, this study has major contributions to Vietnamese policy makers in conducting monetary policy and stabilizing the banking system and financial markets, especially in the case of facing further external shocks in the future such as the global crisis With the academic contributions, this study defined that economists should test all transmission channels in one model for better controlling the interactions between channels and better measuring the effectiveness of each channel

With the empirical results, this study has significant practical implications for Vietnamese policy makers in developing debt and equity markets, controlling the risky activities of banking systems and applying unconventional monetary policies such as inflation targeting

CHAPTER 1

INTRODUCTION

1.1 The overview of Vietnamese economy and monetary policy

1.1.1 The Vietnamese economy

The ‘Doi Moi” policy since 1980s has been transmitted to the Vietnamese economy from plan to market-oriented economy, but it is still limited to phrase "market economy under the management of the state" The changes in economy led to many changes in the economic structure and even in the law system with the birth of the 1992 constitution

that had acknowledged private sectors (see table 1.1 in Appendix 1 for more information about law system innovations) The Vietnamese economy has gone through high growth

periods from 1994, in which it has had two slow periods due to the 1997 Asian economic

crisis and the 2008 global financial crisis (see figure 1.1 and 1.2 in appendix 1) To cope

with crisis and slowdown in the economy, Vietnamese government implemented a stimulus packages worth 143,000 billion VND (equivalent to USD 8 billion at 2009 exchange rate) in 2009, then increased to 160,000 billion VND later (equivalent to USD

9 billion), it has recovered GDP growth to 6.8% in 2010, but their effects did not last long, Vietnam fell into instability again in in 2011 and 2012

Figure 1.1 Vietnamese macroeconomic factors

Vietnamese macroeconomic factors

In the trend of international integration, Vietnam has integrated stronger and deeper into the world economy by signing the Vietnam – U.S trade agreement in 2001 and officially joined WTO on 11/Jan/2007, thus trade activities have increased from 10 billion USD in 1994 to over 80 billion USD in 2006, and over 200 billion USD in 2012

(see figure 1.3 in Appendix 1), which makes the Vietnamese economy more vulnerable

to the international shocks which became clearer in the 2008 global financial crisis when the Vietnamese economy fell into a difficult situation: bad debt in the banking system, inventory rising, recession in the real estate market and securities market, especially the real estate market which severely degraded in 2011 and 2012

1.1.2 The State Bank of Vietnam

Roles, duties, and functions of the State bank of Vietnam (SBV) was separated by the 1990 banking ordinance, it was defined as an agency of the council of ministers

(now is government) with the functions of managing monetary policy, credit, and

banking system in order to stabilize currency values, and the role of the exclusive money printing department of Socialist Republic of Vietnam However, the 1990 banking ordinance didn’t clearly indicate the independence of SBV in monetary policy

conducting under the government management (see table 2.1 in Appendix 2) According

to the 1990 banking ordinance, SBV could use rediscount rate (article 43), reserve requirement (article 44), minimum deposit interest rates and maximum lending interest rates (article 43), clearing organization (article 45), but it didn’t directly mention how SBV could manage the money supply and policy rates Then, the 1997 state bank act specified that SBV was a government agency with functions of monetary management, banking system management, and money issuing SBV aimed to stabilize currency value, ensure safety of banking system and credit institutions, and promote economic development (clause 1, 2, 3 of article 1) Article 2 of the 1997 state bank act also stated that SBV was the monetary policy conductor, SBV could use: refinance rates, reserve requirements, interbank payments, and credit supply management to conduct monetary policy Until 2003, the 2003 state bank act amendment was launched to amend some articles of the 1997 version that provided more specific details on rediscount rates,

refinance rates, open market operations, base rates, and banking operations, but the roles and functions of SBV did not change

The operations of SBV were more apparent in the 2007 – 2012 period when the Vietnamese economy fell into crisis In 2010, the Vietnamese parliament approved the

2010 state bank act with changes in comparison to the 2003 version, in which the most important change was the SBV’s function of monetary policy conducting in article 2 However, the 2010 state bank act still defined that SBV was a government agency; it remains under government control in monetary policy conducting The annual target of inflation is still defined by Vietnamese parliament thus there is no progression in the independence of SBV However, there is an important step in determining the main target of monetary policy, the 2010 state bank act defines that price stability is sole target of monetary policy that doesn’t include the target of economic growth Article 10

of the 2010 state bank act defines monetary policy tools as refinance rates, rediscount rates, foreign exchange rates, reserve requirements, open market operations, and other tools that are permitted by government

1.1.3 The Vietnamese monetary policy

SBV had expanded the monetary policy in the 2000 – 2007 period to cope with the

1997 Asian crisis and to stimulate economic growth, then they expanded and tightened monetary policy on numerous occasions in the 2008 – 2012 period After the 1997 Asia crisis, Vietnam expanded monetary policy to stimulate investment and consumption to cope with crisis, thus M2 grew up to 39.2% in 1999 and 56.2% in 2000

(see figure 2.2 in Appendix 2) After joining the WTO in 2007, high economic growth

combined with large capital inflows made M2 raise up to 46.1% in 2007, and it was still

high in the 2008 – 2012 period (see figure 2.2 in Appendix 2) Money supply from under

50,000 billion VND in 1994 had increased to over 200,000 billion VND in 2000, nearly

1 million billion VND in 2006, and over 3.6 million billion VND in 2012 (see figure 2.1 in Appendix 2) Besides that, SBV constantly couldn’t keep targets of monetary

policy From 2004 to 2006, targets of M2 growth rate were 22%, 22%, and 23-25% per year respectively, but SBV always broke them in implementation, M2 growth rates were

actually higher than targets from 7% to 10% per year, this situation continued in 2007,

2009, 2010 and 2012 and then after (see table 2.2 in Appendix 2)

Vietnam interbank offer rate (VNIBOR) decreased in 1999, 2000 and then stabilized

at 6% to 7% per year in 2001 – 2007 period alongside money supply growth (see figure 2.3 in Appendix 2) SBV kept a low interest rate to cope with the 1997 Asian crisis and

kept it for a long time to simulate economic growth in the latter period In the next period, VNIBOR fluctuated: increasing sharply in 2008, decreasing in 2009, increasing again in 2010 and 2011, and then decreasing in 2012 The changes in VNIBOR reflected unstability in monetary policy, SBV tightened monetary policy to control inflation in

2008, expanded to stimulus economic growth in 2009, tightened again to control inflation in 2010 and 2011, and then expanded to stimulate the economy in 2012 and

continuing (see figure 2.3 in Appendix 2) It is easy to realize that SBV has lost their proactive approach in monetary policy conducting (see figure 2.4 in Appendix 2) The

changes in money supply and policy rates all confirmed that SBV had expanded monetary policy in 2000 – 2007 period, tightened in 2008, expanded in 2009, 2010,

tightened in 2011, and expanded again in 2012 and the following years (see figure 2.4

in Appendix 2) These changes led to several changes in Vietnam’s macroeconomic

factors

1.1.4 The Vietnamese monetary policy and macroeconomics factors

1.1.4.1 Market interest rates

Market deposit rates and lending rates had changed in the same patterns with VNIBOR Average deposit rates fell sharply from 9.23% in 1998 to 3.65% in 2000, meanwhile lending rates fell less and slower then they were stable at a low level in the

2000 – 2007 period (see figure 2.5 in Appendix 2), but they fluctuated with the changes

in monetary policy by increasing in 2008, decreasing in 2009, increasing in 2010, 2011, and dropping in 2012

1.1.4.2 Inflation

Prior to 2000, inflation was low and it even fell sharply to -1.6% in 2000, low inflation along with low economic growth motivated SBV to expand monetary policy

in the period after 2000, but the expansionary monetary policy in the long term created inflation risk The overheating economic growth, large and inefficient public investment, a sharp increase of aggregate demand after joining WTO, long lasting budget deficit, high credit growth, and high money supply growth in combination with the increase in the world commodity price, and other things had pushed Vietnamese inflation to a high rate in 2008 – 2012 period Inflation rose sharply from 8.33% in 2007

up to 23.08% in 2008, which created a major shock to the Vietnamese economy SBV tightened monetary policy immediately in 2008 by raising policy rates, reducing money supply, while Vietnamese government tightened fiscal policy, cut spending to cope with

inflation which fell sharply from 23.08% in 2008 to 5.93% in 2009 in just one year (see figure 2.6 in Appendix 2) Both contractionary monetary policy and contractionary fiscal

policy helped control inflation, but this sudden change in inflation was not completely good for the economy because GDP growth fell to 5.3% in 2009, the lowest rate in

comparison with the previous period (see figure 1.2 in Appendix 1)

The spreading of the 2008 global financial crisis put Vietnam in danger of recession

so the government implemented a stimulus package, while SBV implemented expansionary monetary policy in 2009 to stimulate economy GDP growth recovered to 6.8% in 2010, but expansionary monetary policy and expansionary fiscal policy once

again caused inflation in 2010 and 2011 (see figure 2.6 in Appendix 2) With the

experience of 2008, Vietnamese government immediately issued Resolution no.11 that tightened fiscal and monetary policy to cope with inflation This policy helped inflation decrease, but it couldn’t completely control inflation, Vietnam’s inflation rose to over

18% in 2011 (see figure 2.6 in Appendix 2) As stated, one of the problems of SBV in

conducting monetary policy was policy disciplines, which was reflected more clearly through inflation targets SBV usually didn’t achieve inflation targets, for example it was set less than 5% but the actual figure was 7.7% in 2004, the same situation

happened in 2005, 2008, 2010 and 2011 (see table 2.3 in Appendix 2)

1.1.4.3 Exchange rate

The USD/VND rate increased from 10,966 in 1994 to 15,994 in 2006 and 20,293 in

2012 (see figure 2.8 in Appendix 2) Vietnamese currency remained stable in 1994 and

1995, but the outflow of foreign capital plus the decrease in export put pressures on exchange rates throughout the 1997 Asia crisis USD/VND increased with a low stable step after 2000, until 2007 it was at 16,105 In fact, the increase in money supply, low interest rates, more open economy as well as trade deficit led to depreciation of VND After 2007, the USD/VND continued to rise in 2008, 2009, 2010, and 2011, and stilled

in 2012 (see figure 2.8 in Appendix 2) due to the dual deficits in trade balance and

balance of payments in 2009 and 2010 in combination with the 2008’s global financial crisis, the trend of capital withdrawal out of Vietnam, the low remittances in 2009, thus SBV declared currency devaluation on numerous occasions throughout the 2008 – 2012 period1 In addition, high inflation in 2008 has lost people’s faith in VND so people turned to hold USD rather than VND despite the high interest rate of VND’s deposits

In addition, the high economic growth rate required large capital input, but Vietnamese stock market had just launched in 2000, and it was too small to meet the capital needs

of the economy Credit had fluctuated strong in the 2008 – 2012 period but it grew higher and rose from over 1 trillion VND in 2007 to over 3 trillion VND in 2012, but

1One of the most depth devaluation was on 11/2/2011, SBV devalued VND up to 9.3%

credit growth rates usually exceeded the targets of SBV such as in 2004, 2005, 2006,

2007, 2009, and 2010 (see table 2.4 in Appendix 2), these over-controlled growth caused

overheating growth and bad debt risks for the Vietnamese banking system and economy However, credit growth rate was much lower than the target of SBV in 2012 which shows that Vietnam economy had fallen into low-growth stage with low needs

of capital Looking at the credit growth pattern, we find that it is quite contrary to policy rates and market rates patterns, when policy and market rates raised, credit growth decreased and vice versa

in all remaining years in 2000 – 2007 period, these fluctuations were primarily caused

by the investor’s psychology and the foreign portfolio investment Vietnamese economy grew higher and was more stable in the 2000 – 2007 period, but VNindex increased stronger in 2005 – 2007 period when foreign investment went in and the herd

behavior of domestic investors (see figure 2.12 in Appendix 2) Meanwhile, VNindex

changed very little even when economy, credit, investment, money supply grew and interest rates were low in the 2002 – 2004 period This shows that money supply during

2002 – 2004 period didn’t go into stock markets, it mainly went into manufacturing or other channels, possibly real estate But at the end of 2005 and 2006, a large amount of money went into stock markets that made the VNindex and the HNXindex increase

sharply (see figure 2.12 and 2.13 in Appendix 2) Thus, stock markets may not have

responded strictly to monetary policy in the 2000 – 2006 period After booming in 2007, Vietnam’s stock market declined rapidly in 2008 and hit rock bottom in early 2009 when inflation was high and the 2008 global financial crisis impacted around the world

A large amount of money was injected into the economy through economic stimulus policies in 2009, while lower interest rates helped the Vietnamese stock markets to make a slight recovery in 2009, then it continued to lower until 2012 after the stimulus policies ended

1.2 Research gap identification

The analysis of macroeconomic, monetary policy and macroeconomic factors has shown that Vietnamese economy grew rapidly in the 2000 – 2007 periods The rapid economic growth was seemly contributed from expansionary monetary policy, bank credit operations with low inflation and low interest rates, and other elements Monetary policy was expanded with low policy rates, high money supply growth in the 2000 –

2007 period, but it reversed and change many times in the 2008 – 2012 period However, the overheating economic growth, credit growth, and money supply growth had caused the Vietnamese economy to many more problems in 2008 – 2012 period The patterns of macroeconomic data suggest that the effects of the Vietnamese monetary policy on economy may have been transmitted through market interest rates and bank credit during the 2000 – 2012 periods, meanwhile it may not have been

transmitted through stock markets and exchange rates

Meanwhile, the theory states that the monetary policy impacts on the economy through various transmission channels including interest rate channel, exchange rate channel, asset price channel, credit channel and expectation channel, and bank lending channel is an important sub-channel of credit channel in developing countries such as Vietnam (Angeloni, Kashyap, Mojon, & Terlizzese, 2002; Apergis & Christou, 2015; Bassett, Chosak, Driscoll, & Zakrajšek, 2014) Theoretical and experimental studies confirm that monetary policy transmits through some main channels: interest rate channel, exchange rate channel, asset price channel, credit channels2 and expectation

channel (Mengesha & Holmes, 2013) However, in developed countries, interest rate

2 Credit channel includes bank lending channel and other sub-channels

channel is the most important transmission channel, while bank lending channel is the enhanced channel for interest rate channel through commercial bank credit supply (Altunbas, Fazylov, & Molyneux, 2002; Altunbas, Gambacorta, & Marques-Ibanez,

2009, 2012) In emerging countries, bank lending channel is an important channel

(Mishra & Montiel, 2012), which are affected by macroeconomic factors, industry factors, and bank characteristics (Altunbas et al., 2002; Altunbas et al., 2009, 2012) If the central bank tightens monetary policy, credit supply of commercial banks plummet and more in small commercial banks, particularly the ones whose funds mainly come from deposits (Kashyap & Stein, 2000; Stein, 1998) Monetary policy also impacts more strongly on commercial banks that have small enterprises (Peek & Rosengren, 1995a,1995c; Van den Heuvel, 2002b)

In fact, Vietnam is a small open emerging economy which has transmitted to the market economy since the 1980’s Vietnam now may share common characteristics of small open emerging countries that have an incomplete institutional framework with a young equity market, and an emerging financial market so that interest rate channel might not be the most important channel While, exchange rate channel might be weak due to the intervention of government in foreign exchange markets and financial markets Furthermore, asset price channel might also be weak due to the low-development stock markets In contrast, Vietnam has the right potential conditions for the existence of bank lending channel, which may become an important channel such

as Vietnamese economy depends strongly on commercial banks in capital supply; private sectors (including enterprises, households, and individuals) rely heavily on bank loans for investment, consumption and other economic activities; while Vietnamese commercial banks rely heavily on deposits to supply loans, and they almost can’t replace this source easily

There are many potential determinants of bank lending channels including macroeconomics and microeconomics elements, in which bank capital, bank scale, bank liquidity and bank risk are important characteristics which must be noticed and studied (Altunbas et al., 2002; Altunbas et al., 2012) Meanwhile, the 2008 global

financial crisis has strongly affected on Vietnamese economy so that monetary policy transmission and bank lending channel may be affected and changed

From both academic aspects and empirical aspects, we need a comprehensive study about monetary policy transmission in an emerging market such as Vietnam that are motivations for this study in Vietnam The next section presents objectives of this study

1.3 Research objectives and questions

So, the research topic on monetary policy transmission and especial bank lending channel are mentioned as the essential topic in studying monetary policy, especially in emerging markets such as Vietnam

Firstly, this study attempts to test the existence of interest rate channel, exchange

rate channel, and asset price channel in Vietnam, these results are significant considerations for Vietnamese policy makers in conducting the monetary policy This first objective aims at finding the existences of monetary policy channels and also defines which important channel in Vietnam This first study also is done as the background for next objective of this study in finding the bank lending channel in Vietnam Since the bank lending channel is a sub-channel in credit channel, meanwhile the other channels such as interest rate channel, exchange rate channel, and asset price channel are seen as the main channels in monetary policy transmission, but credit channel is also found strong in developing countries with low – development of financial markets and high intervention of government into foreign exchange market such as Vietnam So, this study firstly tests the existence of interest rate channel, exchange rate channel and asset price channel to make sure the sense of credit channel existence in Vietnam and then go to the second part of this study

Secondly, this study attempts to investigate the existence of bank lending channels

and then analyze the determinants of bank lending channel including the effects of the

2008 global financial crisis which are also good for Vietnamese policy makers in conducting monetary policy but also in stabilizing banking system and financial

markets Finally, this study attempts to discover some policy implications for Vietnamese policy markets in conducting monetary policy, especially in facing shocks such as the global crisis in the future In order to achieve these research objectives, this study goes to answer these questions

1 Which do channels of interest rate channel, exchange rate channel and asset price channel exist in Vietnam?

2 Does bank lending channel exist in Vietnam? And do bank size, bank capital, bank liquidity, bank risk, and the 2008 global financial crisis effect on bank lending channels in Vietnam?

The scope of study is very important which may affect to the reliable of the study,

so next section presents this scope

1.4 The scope of this study

This study is going to examine the monetary policy transmission and bank lending channel in Vietnam in period from 2003 to 2012

Firstly, Vietnam as a developing and emerging economy that is also an open

small economy which is suitable for studying monetary policy transmission and bank

lending channel as stated in the purpose of this study Secondly, in order to satisfy the

requirements of statistical models we need an appropriate period of time that why this study is going to study in the period from 2003 to 2012 which is enough time to study monetary policy transmission This period is also suitable to test the impacts of the 2008 global financial crisis on the monetary policy transmission with the point on 2008

Thirdly, this study is going to examine the existences of interest rate channel, exchange

rate channel and asset price channel which are seen as the main channels of monetary policy transmission in both developed and developing countries Meanwhile, due to lack of data about expectations thus this study is not going to examine the expectation channel In addition, the credit channel will be tested through the bank lending channel

Fourthly, this study is going to test the existence of bank lending channel through the

micro-data of bank characteristics in Vietnam which will present for supply – side of credit channel Meanwhile, the other determinants such as macroeconomic conditions are not examined because these factors present for the demand – side of credit channel which are the factors in balance sheet channel In order to find the right answers for study’s questions, we need appropriate methodologies which will be clarified in next section

1.5 Research methodologies and data

1.5.1 Methodologies

Many previous studies have used the VAR model (vector autoregression model) to study the monetary policy transmission (Bernanke & Blinder, 1992; Walsh, 2010), however the VAR model still has some drawbacks such as VAR depends on volume of data, or economic theory which sometimes can not work even when the conditions of VAR model are derived from this theory Therefore, researchers suggest using SVAR (structural vector autoregression model) which is developed from VAR for better measurement of monetary policy transmission SVAR requires fewer conditions than the standard VAR model, but it still provides two tools to analyze monetary policy transmission including impulse response functions and variance decomposition, while the SVAR model is proposed to be used for small open economies because SVAR helps detect and measure shocks better (S Kim & Roubini, 2000) Meanwhile, the system GMM model is considered as most appropriate to measure panel data due to the advantages of this model in solving endogeneity, heteroskedasticity, autoregression problems of dynamic panel data in comparison with other models such as pooled least square, fixed effects model or random effects model (Arellano & Bond, 1991a; Arellano

& Bover, 1995b; Blundell & Bond, 1998, 2000; S Bond & Meghir, 1994; S R Bond, Hoeffler, & Temple, 2001)

Thus in the first main body, this study is going to use the VAR models to investigate

the existence of interest rate channel, exchange rate channel, and asset price channel in Vietnam through a monthly time series from 2003 to 2012 one by one Then this study

is going to use the SVAR model as the main model to check the test the evidences of above channels These results will answer for the 1st question In the second main body,

this study uses the system GMM model to investigate bank lending channel in Vietnam,

in which this study also measures the impacts of bank characteristics and the 2008 global financial crisis on bank lending channel by yearly panel data in 2003 – 2012 period The data of commercial bank characteristics such as size, capital, liquidity and risk are incorporated into GMM model to investigate the determinants of bank lending channels Then, this study use S&P 500 implied volatility index to investigate the effect

of the 2008 global financial crisis on bank lending channel These results will be answered the 2nd question

1.5.2 Research data

This study will use two kinds of data: Vietnamese macroeconomic data and microeconomic data from commercial banks in the 2003-2012 period Monthly macroeconomic data including exchange rate, VNIndex, policy interest rates, market interest rates (lending and deposit interest rates), money supply, and GDP growth from

2003 to 2012 that were collected from SBV, General Statistics Office of Vietnam and IMF; while other international variables such as U.S interest rates, U.S GDP, oil prices and other international data are collected from IMF Yearly microeconomic data including total asset, liquidity asset, capital, liquidity and loan loss provision are collected from audited financial statements and annual reports of Vietnamese commercial banks in 2003 – 2012 period In order to be easier in understanding this study, the next section presents some key concepts which are related to monetary policy, monetary policy transmission and bank lending channel

1.6 Some key concepts

Monetary policy In general, monetary policy is the macroeconomic policy that is

executed by a central bank in order to influence money supply and/or interest rate with

the ultimate target is inflation stability (Begg, Fischer, & Dornbusch, 2008)

Central bank Central bank is the monopoly agency in money issuance; it is also the

government's bank, the bank of the banks, the lender of last resort, the payment system manager, and the banking system supervisor (Castiglionesi, 2007; Smart, 1999; Summers, 1991) Yet, the most important role in a central bank is the monetary policy

manager (Goodhart, 1988)

Monetary policy targets Monetary policy targets are often expressed in several

aspects such as maintaining economic stability, ensuring optimal unemployment, or stabilizing the financial system, etc (Richard Clarida, Gali, & Gertler, 1998; Rogoff, 1985) Yet in reality, a central bank cannot achieve all targets at one time so they have

to choose the most important targets in monetary policy conducting, this is price stability (Cecchetti & Krause, 2002)

Monetary policy tools To achieve monetary policy targets, central bank uses different

tools including three important tools: open market operations, policy interest rates, and reserve requirements (Bean, Paustian, Penalver, & Taylor, 2010; Hamilton & Wu, 2012; Kashyap & Stein, 2012)

Monetary policy transmission Central bank can use open market operations, policy

interest rates, or reserve requirements to influence short-term interest rates on the interbank market in order to conduct monetary policy They aim at price stability so that there must be a process to transmit monetary policy changes into real economic variables, this process may result in multiple transmission channels with different levels (Afandi, 2005a; Agha, Ahmed, Mubarik, & Shah, 2005; Aleem, 2010; Andrieş & Stoica, 2014; Angeloni & Ehrmann, 2003; Baglioni, 2007; Barran, Coudert, & Mojon, 1996; Beck, Colciago, & Pfajfar, 2014) Studies on monetary policy transmission have been implemented in many countries and areas (Mishra & Montiel, 2012), almost all previous studies confirm that monetary policy transmits through interest rate channels, exchange rate channels, asset price channels, credit channels, and expectation channels (Dabla-Norris & Floerkemeier, 2006; Honda, 2004; Mukherjee & Bhattacharya, 2011)

Bank lending channel In contrast to traditional channel of monetary policy

transmission (such as interest rate channels, exchange rate channels, and asset price

channels), bank lending channels focus on the impact of monetary policy on bank credit supply (Altunbas et al., 2002; Altunbas et al., 2012)

Monetary policy → fund of commercial banks → credit supply → investment,

consumption → aggregate demand → output Thus, this study is going to investigate the monetary policy transmission and bank lending channels in Vietnam that is presented in 5 chapters The next section presents the detail of each chapter in this study

1.7 The structure of study

This study is structured as

Chapter 1: Introduction This chapter firstly collects and then analyses monetary

policy and the effects of monetary policy on macroeconomic variables in Vietnam from

2000 to 2012 It finds that Vietnamese monetary policy was expansionary in the 2000 – 2007 period, yet it has changed and fluctuated in the 2008 – 2012 period The fluctuations in Vietnamese monetary policy impacted on other economic variables strongly, especially in and after the 2008’s global financial crisis Market interest rates are changed in line with policy rates, while money supply had increased highly over a long period from 2000 to 2007 lead to high inflation in 2008 – 2012 Through analysis, this chapter suggests that Vietnam may have interest rate channel, while exchange rate channel and asset price channel may be weak, and bank lending channel may be strong Then it shows the necessary objectives and questions of this study In which, this part presents more detail on some main concepts in monetary policy, monetary policy tools,

monetary policy targets, monetary policy transmission, and bank lending channels Chapter 2: Theoretical framework and Literature review This chapter presents a

fully detailed literature review on monetary policy transmission and bank lending channel It summarizes that monetary policy transmits through interest rate channel, exchange rate channel, asset price channel, credit channels, and expectation channel In which, a bank lending channel is an important sub-channel of a credit channel with some existence conditions: enterprises depend on bank loans, commercial banks can’t

replace all funds from deposits, central banks can impact on bank credit supply and some other conditions

Chapter 3: Methodologies This chapter presents methodologies that are used for

monetary policy transmission and bank lending channel testing It finds that we can use policy rates or money supply to proxy for monetary policy, yet policy rate is a better indicator In studying monetary policy transmission, time series data is the main kind

of data that is used with certain conditions in relationship between economic variables Econometric models which are suitable with time series data in studies of monetary policy transmission are VAR, SVAR, FAVAR, ECM, VECM, ARDL, DSGE, GMM, and some other models In which, VAR and SVAR have the advantage of measuring time series data and GMM has the advantage of measuring panel data From this basis, this chapter goes to build models for empirical studies: VAR and SVAR are used to test interest rate channel, asset price channel, and exchange rate channel by monthly time series data, while the system GMM model is used to test bank lending channel by annual panel data

Chapter 4: Empirical evidences from Vietnam This chapter presents results of

monetary policy transmission testing and bank lending channel by using statistical models from chapter 3 Through VAR and then SVAR, this study finds the evidence of cost channel in Vietnam, and that this study does not find the evidences of exchange rate channel and asset price channel Meanwhile, bank lending channel is strong and affected by characteristics of commercial banks including size, capital, and it is also affected by the 2008 global financial crisis This study goes further to test the robustness

of results by recruiting money supply (M2) to replace for VNIBOR in VAR and SVAR models, and rediscount rate and refinance rate for VNIBOR in GMM model This study finds that M2 is not a good proxy for Vietnam monetary policy, meanwhile results are not change in models with rediscount rate and refinance rate

Chapter 5: Conclusions and policy implications This chapter goes to conclusions

and gives some recommendations that are based on experiences in the world, situation

in Vietnam, and results of this study This chapter also goes to clarify its limitations and suggests some new direction studies

M x V = P x Y (2.1)

where: M - monetary supply, V - money velocity in circulation, P - average price

level, Y - real output

If real output doesn’t react to changes in money supply, policy makers shouldn’t try

to change money supply because it will change the price instead of real output (Begg et al., 2008) Money supply is defined as M1, M2, M3, and M4 in England; M1, M2 in US; M1, M2, and M3 in Europe and Japan3, and it depends on monetary base which is supplied by central bank and the monetary multiplier which is created by the banking system activities, therefore money supply depends on monetary policy and banking

3 See more detail about money supply definition in Appendix 1

system operations Money demand depends on the demand of private sectors including incentives to keep money for transactions, hedging, speculation and public sectors including demand for expenditure and investment (B M Friedman, 1956) A change in money supply or money demand will alter nominal market interest rates so that the central bank changes money supply or policy rates to influence on nominal market

interest rates to conduct monetary policy (B M Friedman, 1981)

2.1.2 Central bank 4

Central bank is monopolized for printing and issuing money, it is also the government bank, the bank of commercial banks, the lender of last resort, the manager

of payment system, the agency for monetary policy implementation, and the supervisor

of the banking system Central bank acts as the bank of government and the bank of commercial banks in deficit funding, credit activities, and other financial activities Central bank is also the lender of last resort which helps avoid crashes in the financial system (Diamond & Dybvig, 1983) Central bank also manages foreign exchange reserves to ensure the stability of exchange rates and the economic stability with external shocks (Chowdhury, Hoffmann, & Schabert, 2006) Finally, central bank plans, implement and supervise monetary policy which is called monetary policy conducting (Blinder, Ehrmann, Fratzscher, De Haan, & Jansen, 2008; B M Friedman, 1999)

2.1.3 Monetary policy targets

Central bank conducts monetary policy to aim at economic stability, optimal unemployment, financial system stabilizing, but price stability is always the most important target5 (Cecchetti & Krause, 2002; Geraats, 2002; O Issing, 2004; Jean Louis

& Balli, 2013; Spyromitros & Tuysuz, 2012; Van der Cruijsen & Demertzis, 2007) In order to achieve price stability, full employment, economic growth, central bank has to focus on intermediate targets such as money supply (M1, M2 or M3), short-term and long-term interest rates (Flood & Isard, 1988; B M Friedman, 1976; Rogoff, 1985)

4 See more detail about central bank in Appendix 4

5 See more detail about monetary policy target of some central banks in Appendix 5

However, they have to accept some trade-offs in monetary policy conducting such as the trade-off between inflation and unemployment (Gali & Monacelli, 2005; Herring & Marston, 1977; Otmar Issing, 2003; A W Phillips, 1958) Central bank conducts monetary policy to achieve price stability through three main tools: open market

operations, policy interest rates (in short: policy rates) and reserve requirements

2.1.4 Monetary policy tools

Policy interest rates Central bank uses different policy rates to conduct monetary

policy such as rediscount rate, and interbank offer rate Central bank cuts policy rates

to expand monetary policy and vice versa

Policy rates → market interest rates → economic activities

Currently, there are different types of policy rates around the world6 In monetary policy conducting, the limitation of this tool is that central bank has to wait for a response from the market Instead, central bank can use open market operations which

has a direct impact on money supply and market interest rates

Open market operations Central bank buys or sells short-term securities on the open

market to directly impact on money supply and money demand thereby it has an effect

on market interest rates and other economic elements (Thành & Hằng, 2008)

Open market operations → money base → money supply → market interest rates

Central bank uses open market operations quite often nowadays7 Besides open market operations, central bank also uses reserve requirements to impact on money creation mechanism in the banking system in order to conduct monetary policy

Reserve requirements Central bank uses mandatory reserve requirements to impact

on money supply since reserve requirements have a direct influence on the monetary creating multiplier that is created by banking system8

6 See more detail about policy interest rates in Appendix 6

7 See more detail about open market operations in Appendix 7

8 See more detail about reserve requirements in Appendix 8

Reserve requirements → cash leakage → money creating multiplier → money supply

→ market interest rates

Central bank usually uses more than one tool to conduct monetary policy such as raise policy rates combined with selling securities on the open market and increasing reserve requirements to tighten monetary policy However, monetary policy is not always effective in promoting price stability, economic growth, and job optimization as expected (Mengesha & Holmes, 2013)

2.1.5 The ineffectiveness of monetary policy

Central bank may ease monetary policy to prevent the economic downturn by reducing policy rates to stimulate investment and consumption then increase aggregate demand and output (Moss, 2007) Nevertheless, expansionary monetary policy sometimes can’t stimulate economic growth due to the liquidity trap (Dieppe & McAdam, 2006), due to individuals and households may decide to hold cash rather than other assets when the interest rate closes to zero, money demand will simultaneously increases with money supply therefore expansionary monetary policy can’t stimulate investment and consumption anymore Deflation is also another problem in monetary policy conducting In a deflated environment, real interest rates are higher than nominal interest rates thus real borrowing costs will be higher than nominal costs so that investments will be limited even when interest rates drop to near nil (Bernanke & James, 1990) Besides monetary policy, fiscal policy is also an important macroeconomic tool The interactions between monetary policy and fiscal policy are important in influencing aggregate demand and the economic activities (Lucas Jr & Stokey, 1983; Mankiw & Taylor, 2011)

2.1.6 Monetary policy and fiscal policy

Through expansionary fiscal policy, government increases spending, decreases taxes or does both simultaneously to stimulate investment and consumption (Moss, 2007) However, the expansion of government spending increases budget deficit and interest rate then reduce investment and consumption in the private sector, which is known as “crowding out effects” (Abrams & Schitz, 1978; Cebula, 1978) In fact,

monetary policy and fiscal policy can’t substitute each other because monetary policy impacts on money supply and interest rates to influence aggregate demand, while fiscal policy impacts on aggregate demand through government spending and taxation

The expansionary fiscal policy in combining with the contractionary monetary policy: interest rates will increase, while output may increase or decrease which is

dependent on the total effect of both policies by aggregate demand

The contractionary fiscal policy in combining with the expansionary monetary policy: output can increase, decrease, or not change, while interest rates will decrease

The expansionary fiscal policy in combining with the expansionary monetary policy:

both policies will increase output, while interest rates can increase, decrease, or not change

The contractionary fiscal policy in combining with the contractionary monetary policy: output will decrease, while interest rates can increase, decrease, or not change

The interactions between monetary policy and fiscal policy affect the effectiveness

of overall macroeconomic policies in many countries (Buti, Roeger, & In't Veld, 2001; Buti, Roeger, & Veld, 2001; Leith, Moldovan, & Rossi, 2015; Melitz, 2000) In fact, price stability, economic growth, job creation, and financial system stability are easily achieved by neither monetary policy nor fiscal policy, thus policy makers have to smooth the coordination between them in macroeconomic policy conducting Nowadays, with more innovations in financial markets and the economy, central banks also try to innovate monetary policy to adapt with new situations (Chortareas & Noikokyris, 2014; Girardin & Moussa, 2011; Lyonnet & Werner, 2012)

2.1.7 Unconventional monetary policies

2.1.7.1 Quantitative easing program

Quantitative easing program (QE) is an unconventional monetary policy to cope with the deflation and near nil interest rate situation by the central banks in Japan, U.K., and U.S Central banks enact quantitative easing by purchasing without reference to the interest rate a set quantity of bonds or other financial assets on financial markets from

private financial institutions The goal of this policy is to increase money supply rather than to decrease the interest rate, which can’t be decreased further in a near nil interest rate or deflated economy QE was firstly conducted in Japan from 2001 to 2005 when they were faced with stagflation (Girardin & Moussa, 2011) After the 2008’s global financial crisis, some central banks conducted QE such as the Bank of England in 20099, Fed in many times (QE1 in 200810 with the value up to 1,700 billion US dollars, QE2

in 2010 with the value up to 600 billion US dollars, the QE3 in 2012 with the value up

to 40 billion US dollars per month) to deal with crisis and stimulate economic growth The real effects of QE remain controversial, yet it helped curb and prevent the crisis and promote economic growth in Japan (Girardin & Moussa, 2011), but it couldn’t do the same in the case of the U.K (Lyonnet & Werner, 2012), while the effectiveness of

QE in the U.S is still being argued now QE is evidence of innovations in monetary policy conducting, and inflation targeting (Svensson, 1999)

2.1.7.2 Inflation targeting policy

Inflation targeting policy originated in New Zealand in 1989, then many countries have applied this policy, such as Chile, Canada, Israel, England, Sweden, Finland, Australia and Spain (Svensson, 2000) Until 2011, over 29 central banks have applied the inflation targeting policy around the world11 (Hammond, 2012) In inflation targeting, central banks set an inflation target for monetary policy, and then will do anything to achieve this target Inflation targeting policy has three important characteristics (Svensson, 1999):

- Central bank defines inflation target

- Central bank has a clear policy framework for economic decision-making and inflation target decision-making

- Central bank has transparency and responsibility

9 http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx, logged on 13/May/2015

10 http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm logged on 13/May/2015

11 See more detail about inflation targeting policy in table 9.1 of Appendix 9

After defining the inflation target, central bank has to conduct monetary policy in order to achieve this target12 People will look at the central bank activities to follow, which then creates inflation expectation in the economy Inflation targeting policy requires independence, transparency, and responsibility of the central bank It needs the people's confidence in the central bank since people will change their inflationary expectations differently from the central bank’s target if they don’t trust in the central bank, thus inflation targeting policy will fail (Roger, 2010) Information transparency

is required in inflation targeting policy due to its various benefits (De Haan, Eijffinger,

& Waller, 2005) such as the confidence of people in the central bank policy (Svensson, 2003), the stability of economic expectations (Eusepi, 2005), the low cost of the crisis (Chortareas, Stasavage, & Sterne, 2003; M Dai & Sidiropoulos, 2008), low and stable inflation (Demertzis & Hughes Hallett, 2007; Van der Cruijsen & Demertzis, 2007), and the stability of macroeconomic (Spyromitros & Tuysuz, 2012)

2.1.8 Summary

Central banks conduct monetary policy to aim at price stability, economic growth, full employment, and financial system stability However, central banks can’t achieve all targets once, there are some tradeoffs between targets such as inflation and unemployment Central banks conduct monetary policy through policy rates, open market operations, and reserve requirements to impact on aggregate demand through intermediate variables such as market interest rates, exchange rates, asset prices, and expectations Monetary policy may not take effect in the case of deflation, liquidity trap,

or near nil interest rates These situations bring some difficulty for central bank in monetary policy conducting so that the quantitative easing program and inflation targeting policies are launched to cope with these situations Although the QE program has been implemented in Japan, England, and U.S., it is still argued about their effectiveness Meanwhile, inflation targeting policy is a new trend in the monetary

12 See more detail about the target of inflation in inflation targeting policy in table 9.2 of Appendix 9