DSpace at VNU: On the conduct of monetary policy in Vietnam

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On the conduct of monetary policy in Vietnamapel_1335 34 45

Thi Thu Tra Pham and James Riedel*

Vietnam has the highest inflation rate in Southeast Asia (over 20 per cent

year-on-year in 2011) This paper examines the extent to which inflation in

Vietnam is due to its conduct of monetary policy It is argued that, had the

central bank implemented policy on a more timely basis, inflation would not

have been as high as it was, but the more fundamental problem is that the

central bank does not have the tools it needs to conduct monetary policy

effectively Monetary policy is further complicated by Vietnam’s exchange

rate policy By choosing to peg the currency and maintain fairly free capital

mobility, the country has all but given up the ability to pursue an

indepen-dent monetary policy As a consequence, the central bank is forced to attempt

to sterilise its foreign exchange interventions, which it is ill-equipped to do

The paper argues that financial sector liberalisation is needed not only to

promote growth but also to maintain macroeconomic stability

Macroeconomic stabilisation is at the top of the

policy agenda in Vietnam.1 The inflation rate

rose to 22 per cent in May 2011 (year-on-year)

The value of the dong in May 2011 was down

19 per cent from a year ago, as indeed it would

have to be for Vietnam to maintain its

interna-tional price competitiveness Bank lending

rates in May 2011 were reportedly above

20 per cent, again as they would have to be for

lenders to be willing to make a loan if the

expected inflation rate were anywhere near the

current rate The problem is inflation Since it is

widely understood that ‘inflation is always and

everywhere a monetary phenomenon’,

ques-tions have been raised about the State Bank of

Vietnam’s (SBV) conduct of monetary policy

Does the SBV deserve criticism? The answer

offered here is an unequivocal ‘yes’ and ‘no’

‘Yes’, had the SBV implemented policy on a more timely basis, the inflation rate would probably not be as high as it is But, ‘no’, the fundamental problems plaguing the conduct of monetary policy in Vietnam are not of the SBV’s making The SBV does not have the tools

it needs to conduct monetary policy effectively,

in large part because the government has not given priority to financial sector liberalisation, and in particular to the development of a liquid secondary bond market

In addition, the SBV faces another challenge

in conducting monetary policy that is not always given due consideration, which is Viet-nam’s exchange rate policy By choosing to peg the dong to the dollar—albeit with adjust-ments that have increased in magnitude and frequency in recent years—and maintain fairly

* Thi Thu Tra Pham, Lecturer in Economics, International University and Vietnam National University, and James Riedel, Professor of International Economics, Johns Hopkins University School of Advanced International Studies, Washington

DC The paper was written under the auspices of the USAID/STAR-Vietnam project The paper reflects the views and opinions of the authors and not necessarily those of USAID/STAR or any government agency The authors are grateful

to Ben Bingham, Vuong Quan Hoang, Phan Quang, Jonathan Pincus, and Scott Robertson for comments and suggestions, but alone are responsible for any errors or omissions.

1 Resolution 11, February 24, 2011, made it official.

doi: 10.1111/j.1467-8411.2012.01335.x

free capital mobility—de facto, if not de jure—

Vietnam has all but given up the ability to

pursue an independent monetary policy The

only opening for an independent monetary

policy that is available to the SBV is through the

sterilisation of foreign exchange market

inter-ventions Indeed, attempts to sterilise massive

intervention in the foreign exchange market

have been the main driver of monetary policy

in recent years

The scope of this paper is confined to the

SBV’s conduct of monetary policy, by which

we mean how and to what effect it has used the

instruments of monetary policy at its disposal

We do not address the issue of how credit was

allocated, which, given its rapid growth under

conditions of high and volatile interest rates,

has justifiably raised concerns about a

deterio-ration in the quality of bank loans and a

growing vulnerability of the banking system to

a crisis

Analytical framework

A stylised version of the balance sheets of the

financial and non-financial sectors of the

economy (presented in Table 1) serves as a

framework for analysing the conduct of

mon-etary policy in Vietnam The money supply

(M), broadly defined, consists of currency in

circulation (CC) and bank deposits (DEP) held

by households and businesses Currency in cir-culation is a liability of the central bank, and bank deposits are liabilities of the commercial banks Commercial banks, in turn, deposit with the central bank a fraction of the deposits they take from households and businesses as bank reserves (BR) The liabilities of the central bank constitute base (or reserve) money (B =

CC + BR) Since the liabilities of the central bank are matched by its assets, base money can also be defined as the sum of central bank assets (B = R + D + NC) (Table 1)

The central bank conducts monetary policy

by adjusting the size of its balance sheet (B) and by adjusting the money multiplier (mm), defined as the ratio of the money supply to base money:

B

CC DEP

CC RR ER

c

c r e

= = +

+ + =

+ + +

1

As shown in the above equation, the size of the money multiplier depends on the ratios of currency to deposits (c), required reserves to deposits (r), and excess reserves to deposits (e) In the reserve requirement ratio (r), the central bank has an instrument for managing the money supply by changing the money multiplier

In addition, the central bank manages the size of its balance sheet (that is, base money) through open-market operations—buying and selling domestic-currency securities, mainly

Table 1

A stylised version of the financial system

Central bank Commercial banks Households/businesses Assets Liabilities Assets Liabilities Assets Liabilities Foreign

reserves (R) Currency incirculation

(CC)

Loans Deposits

(DEP) Currency incirculation

(CC)

Loans

Domestic

securities (D)

Bank reserves (BR)

Bank reserves (BR)

Net claims on commercial banks (NC)

Deposits (DEP)

Other liabilities Net claims on

commercial

banks (NC)

Other assets

government bonds—and by borrowing from

and lending to commercial banks through its

lending facilities (for example, the discount

and repo windows) When the central bank

buys (sells) government debt or lends to

(borrows from) banks, its assets (D or NC) and

liabilities (BR) go up (down), and with it the

money supply

In countries with developed financial

markets, central banks typically rely mainly on

open market operations—that is, buying and

selling government bonds in the secondary

bond market Little use is made of the reserve

requirement ratio or lending to commercial

banks The reserve requirement ratio is a

clumsy and often ineffective tool of monetary

policy, especially when commercial banks hold

excess reserves, and hence are not constrained

by the reserve requirement ratio Lending to

commercial banks via the discount or repo

windows is also not an effective way to manage

base money Generally, central banks set the

discount interest rate 100–200 basis points

above the inter-bank interest rate to discourage

commercial banks from borrowing reserves

except in exceptional circumstances

The opposite is the case in Vietnam The

absence of a liquid secondary government

bond market limits the use of conventional

open-market operations in Vietnam Instead,

the SBV relies mainly on its lending facilities

(refinance and repo windows) to manage base

money, and uses the reserve requirement ratio

to adjust the money multiplier As a result, it is

difficult for the SBV to ‘fine-tune’ monetary

policy or take timely actions In addition, the

SBV routinely resorts to non-market

adminis-trative measures, such as caps on interest rates,

limitations on the growth rate of bank credit,

and restrictions on lending to different sectors

of the economy—all of which create

well-known distortions and inefficiencies in the

credit market

Exchange rate policy as

monetary policy

The conduct of monetary policy depends on

exchange rate policy If a country chooses to fix

(or closely manage) its exchange rate, it has ipso

facto chosen a monetary policy Under a fixed

exchange rate regime, the central bank is obliged to intervene in the foreign exchange market, buying foreign reserves (R↑) when-ever there is an excess supply, and selling foreign reserves (R↓) whenever there is an excess demand in the foreign exchange market When the central bank intervenes, buying and selling foreign exchange reserves, base money goes up and down, and with it (via the money multiplier) the money supply That is why, as a general rule, a country that fixes its exchange rate cannot have an independent monetary policy The money supply is, in effect, deter-mined by conditions in the foreign exchange market, in other words by international trade and foreign capital flows

There are, however, exceptions to the general rule One exception is if a country that fixes its exchange rate tightly controls supply and demand in the foreign exchange market, for example by strictly controlling foreign capital inflows and outflows The other excep-tion is if a country sterilises the monetary effect

of its intervention in the foreign exchange market by matching the purchase (sale) of foreign reserves with the sale (purchase) of domestic securities Through sterilisation, the central bank can, in principle, increase or reduce its foreign reserves without any effect

on the size of its balance sheet (that is, without any effect on base money, and hence on the money supply)

Foreign exchange market intervention

Vietnam pegs its currency to the dollar, but with sporadic adjustments In spite of these adjustments, which, as noted, have increased

in magnitude and frequency in recent years, the SBV has been obliged to intervene heavily

in the foreign exchange market to keep the nominal exchange rate within the band that it sets around the official rate The annual level of central bank intervention is indicated by the change in foreign reserves in the balance of payments, illustrated in Figure 1

As Figure 1 indicates, 2007, the year

Vietnam acceded to the WTO, was a watershed

Foreign direct and indirect investment in

Vietnam soared to a level equivalent to

25 per cent of GDP After financing a current

account deficit of about 10 per cent of GDP, the

SBV was obliged to buy foreign reserves

equivalent to 15 per cent of GDP

The excess supply of foreign exchange

ended in the second quarter of 2008, when

foreign (indirect) investors, spooked by rising

inflation and growing trade deficits, made a

run on the currency, forcing the SBV (in Q2

2008) to sell back to the market about one third

of the US$13 billion in foreign reserves it had

purchased from Q1 2007 through Q1 2008

An excess demand for foreign exchange

re-emerged in Q1 2009 and continued through

Q3 2010 (the most recent quarter for which

International Financial Statistics balance of

pay-ments data are available), as domestic residents

attempted to convert dong assets into dollars

and gold in anticipation of devaluation Since

much of the domestic capital flight in 2009 and

2010 was via the black market, it showed up in the balance of payments as negative net errors and omissions, that is, unrecorded capital outflow As a result of the foreign capital flight

in 2008 and domestic capital flight in 2009 and

2010, all of the foreign exchange reserves accu-mulated in 2007 and Q1 2008 were sold back to the market (together with an additional US$1 billion) by the end of 2010, leaving the level of reserves at a precariously low level at the beginning of 2011 (Figure 2)

Sterilisation of market intervention

As Figures 3 and 4 indicate, foreign reserves were the principal component of base money until the SBV was obliged to sell off a large portion of its foreign reserves in 2009 and 2010

In 2007 and Q1 2008, when foreign capital flooded the foreign exchange market, requiring large interventions to prevent nominal appre-ciation, the SBV undertook to sterilise its reserves purchases, mainly by selling

dong-Figure 1 Major balances of the balance of payments: quarterly (US$ millions)

-8000 -6000 -4000 -2000 0 2000 4000 6000 8000 10000

Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010

Capital Account Balance plus Errors and Ommisions

Current Account Balance Change in Foreign Reserves

Source: IMF, International Financial Statistics, online.

denominated ‘sterilisation bonds’ (claims on

the SBV) to commercial banks However, the

level of sterilisation did not match the level of

intervention; hence, base money and M2 grew

rapidly, leading to an acceleration of inflation

(discussed below)

With the reversal of capital flows from

mid-2008 onwards, the SBV was again obliged to

intervene heavily in the foreign exchange

market, selling foreign exchange from its

reserves to meet the commercial banks’ excess

demand To offset the massive reduction in

base money that would otherwise have

occurred from its sale of foreign exchange to

banks, the SBV sterilised its intervention by

buying domestic securities and, more

signifi-cantly, by lending bank reserves to commercial

banks through the SBV’s refinance and repo

lending facilities As Figures 3 and 4 indicate,

the volume of SBV lending to commercial

banks exceeded the amount required to

steri-lise the monetary effect of selling foreign

exchange to the commercial banks, thereby allowing for an expansion of base money

Instruments of monetary policy

in Vietnam

Figures 5 and 6 provide an overview of how the SBV has used the reserve requirement ratio and its lending facilities to manage base money and the money multiplier

From 2006 to early 2009, the growth rate of M2 closely paralleled the growth rate of base money, albeit with more volatility in the growth rate of base money because of seasonal variation in the demand for cash (which, as shown below, is associated with the lunar new year) The close relationship between the average growth rates of base money and M2 until early 2009 implies that, over that period, the money multiplier was fairly constant, as indeed Figure 6 shows it was However, in

Figure 2 The capital account plus errors and omissions: quarterly (US$ millions)

-6000 -4000 -2000 0 2000 4000 6000 8000 10000

Q1 2006

Q3 2006

Q1 2007

Q3 2007

Q1 2008

Q3 2008

Q1 2009

Q3 2009

Q1 2010

Q3 2010

Net FDI Portfolio Flows Other Net Flows E&O E&O = error and omissions, FDI = foreign direct investment.

Source: IMF, International Financial Statistics, online.

early 2009, the money multiplier began to rise

dramatically, creating an almost 20 percentage

point disparity between the growth rates of

base money and M2

Reserve requirement ratio

The money multiplier rises when the ratio of

currency in circulation to deposits declines

(c↓), the reserve requirement ratio declines

(r↓), or excess reserves decline (e↓) As

Figure 7 indicates, the currency–deposit ratio

has been declining, steadily over the entire

period, not abruptly in 2009 when the money

multiplier began to rise Figure 7 also indicates

that seasonal factors, in particular the lunar

New Year holiday, explain the volatility in base

money The main explanation for the rise in the

money multiplier in 2009 and 2010 was a

reduction in the reserve requirement ratio and

excess reserves, as illustrated in Figure 8

The ineffectiveness of the reserve

require-ment ratio as an instrurequire-ment of monetary policy

when commercial banks hold excess reserves is clearly revealed in the statistics for the year

2007 In 2007, the SBV was obliged to buy up commercial banks’ excess supply of foreign exchange, consequent on massive inflows of foreign capital In an attempt to sterilise the monetary impact of its foreign exchange pur-chases, the SBV, in mid-2007, more than doubled the reserve requirement ratio, but, as indicated in Figure 4, this move did not have the expected effect of lowering the money mul-tiplier The reason it did not, as Figure 6 indi-cates, is because commercial banks, at that time, were holding a large stock of excess reserves at the SBV, and hence were not con-strained by the reserve requirement ratio As a result, the rise in the reserve requirement ratio did not force banks to rein in credit growth Recall that in 2009, the government imple-mented a stimulus policy to counter the defla-tionary effects of the global recession At the same time, capital flight required the govern-ment to sell off a substantial amount of foreign

Figure 3 Level of base money and its components (VND billions)

-200000 -100000 0 100000 200000 300000 400000 500000 600000

M1 2005

M7 2005

M1 2006

M7 2006

M1 2007

M7 2007

M1 2008

M7 2008

M1 2009

M7 2009

M1 2010

M7 2010 M1

Net Domestic Assets Net Foreign Assets Base Money

Source: IMF, International Financial Statistics, online.

Figure 4 Change (YOY) in base money and its components (VND billions)

-150000 -100000 -50000 0 50000 100000 150000 200000

Change in NFA Change in Net Claims on Govt Change in Net Claims on Banks NFA = net foreign assets.

Source: IMF, International Financial Statistics, online.

Figure 5 Rate of growth of base money and M2: January 2006 through October 2010 (%)

-20 -10 0 10 20 30 40 50 60 70

M1 2006 M7 2006 M1 2007 M7 2007 M1 2008 M7 2008 M1 2009 M7 2009 M1 2010 M7 2010 M1 2011

M2 Growth Rate Base Money Growth Rate

Source: IMF, International Financial Statistics, online.

reserves to prevent an even larger devaluation

of the dong than occurred To sterilise the

mon-etary effect of selling off foreign reserves and to

stimulate the economy by easing credit

condi-tions, the SBV lowered the reserve requirement ratio from about 12 per cent to only 2 per cent The reserve requirement ratio was not revised upward until early 2011, even though by early

Figure 6 The money multiplier: January 2005 through October 2010

3.0 3.5 4.0 4.5 5.0 5.5 6.0

M1 2005 M7 2005 M1 2006 M7 2006 M1 2007 M7 2007 M1 2008 M7 2008 M1 2009 M7 2009 M1 2010 M7 2010 M1 2011

Source: IMF, International Financial Statistics, online.

Figure 7 Currency/deposit ratio: January 2005 to October 2010

0.10 0.15 0.20 0.25 0.30 0.35

M1 2005 M7 2005 M1 2006 M7 2006 M1 2007 M7 2007 M1 2008 M7 2008 M1 2009 M7 2009 M1 2010 M7 2010 M1 2011 Ratio of Currency in Circulation to Total Deposits

Sources: IMF, International Financial Statistics, online; State Bank of Vietnam, online.

2010, it was acknowledged that the economy

was overheating and monetary tightening was

called for Lowering the reserve requirement

ratio in 2009 worked to raise the money

multi-plier as the SBV intended it to do, but when

macroeconomic conditions changed in 2010,

the SBV failed to respond by raising r

Net claims on commercial banks

The SBV has also used its refinance and reverse

repo lending facilities to sterilise foreign

exchange market intervention and manage

base money In 2007 and early 2008, the SBV

issued compulsory sterilisation bonds to

com-mercial banks to absorb, at least partially,

excess banks reserves created by SBV foreign

exchange purchases from commercial banks

When the foreign capital flow reversed

direc-tion, in particular in 2009 and 2010, the SBV

used its lending facilities to replace declining

bank reserves consequent on its foreign

exchange sales to commercial banks

The magnitude of SBV borrowing from

commercial banks (through the issuance of

compulsory sterilisation bonds) and lending to commercial banks (through the refinance and reverse repo facilities) is shown in Figure 9 The commercial banks were compelled to hold sterilisation bonds in 2007 and 2008, but they were not compelled to borrow from the SBV to sterilise the sale of foreign exchange to the commercial banks in 2009 and 2010 Instead, the commercial banks were offered the oppor-tunity to borrow reserves at interest rates well below market rates (even below the inter-bank rate), creating profitable interest arbitrage opportunities Consequently, commercial banks borrowed heavily from the SBV, at least until April 2011, when spiralling inflation eventually led the SBV to raise its lending rates from 7 per cent to 15 per cent, significantly reducing (if not eliminating) the profitability of borrowing reserves As a result of the banks’ massive borrowing from the SBV, net reserves (commercial banks’ deposits at the SBV minus net borrowing from the state bank) fell precipi-tously to negative levels by the end of 2010, eliminating entirely the liquidity cushion that bank reserves provide (Figure 10)

Figure 8 Ratio of reserves to dong and total deposits and the reserve requirement ratio

0.00 0.05 0.10 0.15 0.20 0.25

M1 2006 M7 2006 M1 2007 M7 2007 M1 2008 M7 2008 M1 2009 M7 2009 M1 2010 M7 2010 M1 2011 Reserve Requirement Ratio

Ratio of Reserves

to Dong Deposits

Ratio of Reserves

to Total Deposits

Sources: IMF, International Financial Statistics, online; State Bank of Vietnam, online.

The growth of base money, M2,

and inflation

As Figure 11 indicates, Vietnam experienced

two surges in money and credit growth over

the past five years The first, in 2007 and 2008,

was driven by the monetisation of massive

capital inflows that were only partially

steri-lised The second, in 2009 and 2010, resulted

from the rise in the money multiplier

conse-quent on reductions in the reserve requirement

ratio, and by growth in central bank credit to

commercial banks that more than offset the

decline in base money consequent on declining

foreign reserves As Figure 12 suggests, the

surge in money and credit growth in 2007–08

and again in 2009 and 2010 was accompanied

by a rise in the inflation rate, validating the

well-known proposition that inflation is always

and everywhere a monetary phenomenon

Conclusion

The SBV’s attempts to sterilise its heavy inter-vention in the foreign exchange market are what have largely formed its conduct of mon-etary policy in recent years Since sterilisation

is a means of finessing rather than correcting the market disequilibria that required inter-vention in the first place, the SBV has been forced to adjust the rate at which it pegs the dong to the dollar repeatedly and in ever larger amounts Moreover, the sterilisation tools at its disposal have not been up to the task, as two waves of double-digit inflation in the past five years attest

One solution might be to float the currency, but that would simply shift the problem, not solve it Surges in capital inflows and outflows that are of a magnitude of those of recent years would have caused major swings in the

Figure 9 SBV borrowing from and lending to commercial banks (VND bill)

-100000 -50000 0 50000 100000 150000 200000 250000

M1 2005 M1 2006 M1 2007 M1 2008 M1 2009 M1 2010 M1 2011

SBV Loans to Commercial Banks via Discount & Repo Windows

SBV Sterilization Bonds Issued to Banks

SBV = State Bank of Vietnam.

Source: IMF, International Financial Statistics, online.