The role of credit and monetary transmission in vietnam, a VAR approach

The bank lending channel: concentrates the variability of loan supply through deposit institutions caused by the effect of monetary policy actions.. Andthey introduced CC commodities and

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE ROLE OF CREDIT AND MONETARY TRANSMISSION IN VIETNAM: A VAR APPROACH

BY

NGUYỄN LÊ THẢO NGUYÊN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, May 2012

HO CHI MINH CITY

VIETNAM

INSTITUTE OF SOCIAL STUDIES

THE HAGUE THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE ROLE OF CREDIT AND MONETARY TRANSMISSION IN VIETNAM: A VAR

APPROACH

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYỄN LÊ THẢO NGUYÊN

Academic Supervisor:

Dr NGUYỄN VĂN NGÃI

HO CHI MINH CITY, May 2012

2

I sincerely thank Tutor- Mr Phung Thanh Binh who provided me materials, alsoeconomic techniques relevant to my thesis I am grateful to all lecturers and tutors ofVietnam-Netherlands Master Program in Development Economic, who have madeinvaluable contributions.

I wish my express my special thanks to my friends Nguyen Van Dung, Le Anh Khang,

Vo Thi Ngoc Trinh They have spent a lot of time and effort in helping me during mywriting

Last but not least, I thankful to my lover, parents and brother who were always beside

me and gave me spiritual support

Among different channels (namely: interest rate, asset price, credit, exchange ratechannel) are affected by monetary policy, which one plays as a key channel in thismechanism In this study, I investigate the role of credit channel in monetarytransmission mechanism in the case of Vietnam Two different specifications of loanmarkets are conducted: classical market (without domestic credit) and augmentedmarket (with domestic credit) to look for the evidences of the role of credit Vectorautoregression model which focuses on the reduced form will be employed as maineconometric techniques in this thesis The empirical results support that credit channelplays important role in monetary transmission in Vietnam case The correlationbetween lending channel and monetary policy is somewhat weak The policyimplication that credit sector should be carefully controlled when implements newmonetary policy

Key words: domestic credit, credit channel, monetary policy transmission, VAR

model

LIST OF TABLES

Table 2.1: One decade and Vietnam’s credit

Table 3.1: The data sources

Table 4.1: Description of variables

Table 4.2: Augment Dickey-Fuller test

Table 4.3: Philips- Perron test

Table 4.4: Optimal lap-Classical market

Table 4.5: Optimal lap- Augmented market

Table 4.6: VAR Regression Statistic- Classical market

Table 4.7: VAR Regression Statistic- Augmented market

Table 4.8: Variance Decompositions for vector autoregression for Classical and Augmented Market

LIST OF FIGURES

Figure 3.1: Analytical Framework

Figure 4.1: The impulse response functions for classical market

Figure 4.2: The impulse response functions for augmented market

LIST OF ABBREVIATIONS

IFS-IMF: International Financial Statistic- International Monetary FundsSBV: State Bank of Vietnam

OMOs: Open Market Operation

SOCBs: State Owned Commercial Bank

JSBs: Join Stock Bank

ADF: Augmented Dickey Fuller

PP: Philips-Perron

LR: sequential modified LR test statistic

FPE: Final prediction error

AIC: Akaike information criterion

SC: Schawarz information criterion

HQ: Hannan-Quinn information criterion

U.S: United States

TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION 9

1.1 RELEVANCE AND BACKGROUND OF STUDY 9

1.2 PROBLEM STATEMENT 10

1.4.RESEARCH QUESTION 11

1.6 STRUCTURE OF THESIS 12

CHAPTER 2: LITERATURE REVIEW 14

2.1 CREDIT CHANNEL THEORY 14

2.2 MONETARY POLICY FRAMEWORK OF VIETNAM 16

2.2.1 LEGAL FRAMEWORK 16

2.2.2 MONETARY POLICY STRATEGY AND INSTRUMENTS 17

2.2.3 VIETNAM’S FINANCIAL MARKET OVERVIEW 19

2.3 EMPIRICAL LITERATURE 21

3.1 ANALYTICAL FRAMEWORK 27

3.2 MODEL SPECIFICATION 28

3.3 DATA SOURCES 30

3.4 STEPS OF ESTIMATION 32

CHAPTER 4: FINDING AND DISCUSSION 34

4.1 DESCRIPTIVE STATISTIC 34

4.2 UNIT ROOT TESTS 35

4.3 VAR REGRESSION STATISTICS FOR CLASSICAL AND AUGMENTED MARKET 37

4.4 IMPULSE RESPONES AND VARIANCE DECOMPOSITIONS 40

4.5 RESULTS COMPARISON 47

CHAPTER 5: CONCLUSION AND POLICY IMPLICATION 49

5.1 CONCLUSIONS 49

5.2 POLICY IMPLICATION 50

5.3 LIMITATION AND FURTHER STUDIES 53

5.3.1 LIMITATION 53

5.3.2 FURTHER STUDIES 53

REFERENCES 55

APPENDIX 58

CHAPTER 1: INTRODUCTION

This chapter will present how important of this study is, its objectives and researchquestions In addition, a brief of methodology is also mentioned in this chapter Finally,the scope and structure of thesis are deal with in this part

1.1 RELEVANCE AND BACKGROUND OF STUDY

The restructuring of state owned commercial banks (SOCBs) and the establishment ofjoin stock banks (JSBs), had appeared since Vietnam financial reform in the first haft

of 1990s Consequently, the finance system of Vietnam has deepened whenmonetization increased continuously (in 2004, the ratio M2 to GDP was aboveestimated 70% compare to 25% in mid-1990) Seventy-three percentage of total credit

is provided by SOCBs in 2004 The credit market and other parts of financial system to

be segmented proceeding JSBs and others small banks supplied credit primarily toprivate sector, whereas SOCBs almost loaned both sectors equivalently (Camen, 2006)

When Vietnam took part in the World Trade Organization (WTO), lead to the surge ofnew foreign direct investment and portfolio inflows Globalization, it’s synonymouswith Vietnam has posed significant challenges to their economy Unfavorable balance

of payments is also the major concern Vietnam’s financial sector has been explosionsince 2000 year only, noticeable in 2007-2008 periods Consequently, Vietnam’s creditmarket grew too hot, the number was estimated about 50 percentage in January 2008,that contributed a positive element to inflation rising, got 14 percentage at this time(Ishii, 2008) And at early months of year 2011, Vietnam’s inflation rate accelerated to13.89 percent in March, peak out at highest in 25 months Moreover, the trade gapincreased to $1.15 billion that month after look over $1.11 billion in February (S&PReporting, 2011)

1.2 PROBLEM STATEMENT

For facileness, most of economic models usually assume that the changes of economywhich affect by financial conditions have just relatively bounded by set of severalfinancial variables They could be risk-free interest rates in short term or governmentbond rates in long term (Hall, 2001)

However, once the system of financial develops with high degree, especially in recentyears, its impact on the economy becomes wider and deeper Hence, it’s quite hard tofind the root of problem when the economy is developed, because of some variablesmay not be indicated For example, the world financial crisis in 2008 had a root fromcredit sector, typically, mortgage assets crisis in the U.S or the refugee capital ofVietnam security market in 2008 due to the easing monetary policy in previous years

In the past, many economists such as Pintinkin, Gurley, Shaw, etc., emphasized theimportant role of financial intermediaries and credit markets Modigliani andPapademos (1977) also admitted that the traditional theory of monetary mechanismignored the functions of financial intermediaries and bank credits Financialintermediaries were strong influence on credit supply than money supply (Gurley andShaw, 1956) Evidently, credit channel contributes a significant factor and affectsdirectly to decisions of policy makers

Hence, understanding the position of credit channel in financial market is crucial topolicy makers In detail, understanding the transmitted mechanism of monetary policythrough credit channel is very important As a result, indentify the role of creditchannel in monetary transmission is essential for enhancement current policies By thatway, it contributes to the achievement of national economic objective

1.3 RESEARCH OBJECTIVE

This study aims to identify the role of credit channel in Vietnam’s monetarytransmission mechanism, specify 1996-2010 period Following the main objective, thethesis:

- To analyze whether past value of credit helps predict the money supply;

- To examine the impact of credit shocks on money supply, also other macro

- Does the past value of credit help predict money supply?

- How does money supply reaction to credit shock?

- Whether credit shocks plays important role in forecasting money supply’s error?

1.5 METHODOLOGY

To carry out above objectives, this study uses quarterly data from 1996:Q1 to 2010:Q3 Econometric techniques and descriptive statistic will be employed as primaryquantitative in this research

Descriptive statistic analysis gives an overview of all variables that are used in thisthesis Those are including: the distribution, variation, central tendency of all originalalso changed data Since then, we can a cursory evaluate the quality of employed data.Concerning to the econometric techniques of time series data, vector autoregression(VAR) will be employed to answer key questions Due to the data is time series, unitroot test is used to examine for stationary of all variables to ensure the validation of t-test and F-test in firstly Next, optimal lag lengths for VAR model is chosen bydifferent criteria to have the best model Granger causality test will help us answer firstsub question whether past value of credit is useful to forecast money supply Then,impulse responses and variance decompositions are two popular techniques of VARmodel to answer two last sub questions respectively Collecting from those empiricalresults, we can conclude the role of credit channel in monetary transmission inVietnam case.

1.6 STRUCTURE OF THESIS

The study is organized as following:

Chapter 1 introduces the importance of thesis, relevance and back ground of study, theobjectives and research questions And the methodology is presented as briefly in thispart

Chapter 2 demonstrates the literature review Firstly, credit channel theory ismentioned as a core of study Secondly, empirical studies about the role of creditchannel in monetary policy transmission are presented In addition, the chapter givesoverview the Vietnam’s monetary policy framework, in which focuses on the creditmarket

Chapter 3 presents analytical framework, then develop the model which helps usanswer key question Finally, data description as well as steps of economic techniqueswill be mentioned in this chapter.

Chapter 4 shows the empirical results and discussion Finally, results comparison isalso presented in this part

Chapter 5 give conclusion, suggests some practical policy implications, and discussesthe limitations and direction for further studies

CHAPTER 2: LITERATURE REVIEW

In this part will be described theories applied in thesis as briefly Next, the framework

of monetary policy in Vietnam is presented in this part Besides that, some remarkableempirical studies regarding to the role of credit in monetary transmission in othercountries, also in Vietnam will be introduced

2.1 CREDIT CHANNEL THEORY

Credit channel theory is based on the existing of external finance premium, reflectedtypically by principal agent problem between lender and borrower Bernanke andGertler (1995) had discussed in some details through two possible linkages, these arethe bank lending channel and the balance-sheet channel This thesis will mention twolinkages which are relevant to credit channel theory

The bank lending channel: concentrates the variability of loan supply through deposit

institutions caused by the effect of monetary policy actions

Banks, that remain dominant information sources in the economy, so that, canovercoming asymmetric information problems and other fictions in credit markets.That is a reason why many borrowers depend on bank credit, specially small andmedium size enterprises Once this function still remains, the influence of bank lendingchannel in monetary policy transmission continues its role

In case, the government does expansionary monetary policy, bring to increases thebank deposits from customers or bank reserves; the quantity of bank loans availablewould be increased, then investment increases, lead to output increases

Conversely, tightening monetary policy is synonymous with reducing bank reserves orcustomer deposits, which leads to a decreased of quantity of bank loans available.Next, reduce investment spending and output decrease as consequently

Another side of credit view, when we mention to the impact of monetary policy toenterprises, small firms suffer bad effects on expenditure than large firms (Mishkin,1996) The reason is because of more dependent on bank loan with small companies,whereas big companies can access huge capital through stock and bond markets, notnecessary via bank channel.

Balance sheet channels: focuses influence of monetary policy changing on borrower’s

balance sheets and income statement

In balance sheet aspect, the changing in company’s worth due to the variability ofmonetary policy tends to raise the adverse selection and moral hazard problems whengrant loans to those companies The borrowers have less collateral in case, theprobability moral hazard problem happen will high if those firms want to access theloan More details, the company with lower equity prices has tendency to accept riskyprojects Then, the more risky the firms take, the more probability the firms could notpaid back their loans, which leads to bank collapsed and decreased in lending, and alsoinvestment spending Meanwhile, the banks request the lenders provide more collateralfor their crediting due to net worth declining, hence have an increase the adverseselection problems, and reduce fund for investment as consequences

Here is several ways which monetary policy acts upon on firm’s balance sheet:

Expansionary monetary policy, as already dealt with earlier, is the reason of rising in equity stake In this circumstance, adverse selection and moral hazard problems were decreased as well Next, firm’s valuation will increase and the sources of capital, whichprovide for investment, are also higher and lead to increasing in aggregate demand

In other way, lower interest rates by the reason of expansionary monetary policy alsocause the firm’s balance sheet reformation because of the effect of cash flow.Therefore, adverse selection and moral hazard problems can be lessened As a result,

capital available for loan will increase, investment spending growth, aggregate outputincrement finally.

Monetary expansion is the reason which brings to the unforeseen increase in the pricelevel, hence raises the net worth of companies and lower adverse selection and moralhazard problems It implicates a rise in investment spending and aggregate output

On the other hand, contractionary monetary policy causes a decline in equity price orreducing in cash flow Therefore, a lower net worth of business firms because of theincrease of adverse selection and moral hazard problems, in turn decrease leading tofinancing investment and consumption

2.2 MONETARY POLICY FRAMEWORK OF VIETNAM

2.2.1 LEGAL FRAMEWORK

According to “Law on the State Bank of Vietnam”, the SBV is a body of governmentand the central bank of the Socialist Republic of Vietnam The Law also stated thatNational Assembly and the government are responsible to give decisions, also itssupervisor relevance to monetary policy The government has function to prepare aplan, including projection annual inflation rate for monetary policy It determines theamount of liquidity which to be injected in the economy The government has to reportthe progress on implementation of monetary policy to National Assembly The role ofSBV includes exercise monetary policy, as designed by government In addition, theSBV will conduct the state’s management through monetary and bank activities and act

as currency issuing bank, bank of credit institutions, and bank of government Thoseactivities have goal to stabilizing the currency value, preserve banking activities andbanking system, and adapting with state budget and economy growth within thecontext of the country’s socialist orientation (State Bank of Vietnam, 2003)

Base on SBV Law, SBV operates as a part of Vietnamese government, while theNational Assembly plays an important role in monetary decision A strong intervened

of government; also National Assembly in the implementation money policy exhibitsthat the limited of SBV’s independence instruments (Camen, 2006)

2.2.2 MONETARY POLICY STRATEGY AND INSTRUMENTS

The Vietnam’s monetary policy strategy is extracted from five years plan of Social andEconomic Develop Strategy And the government has duty to formulate the action planfor implementation Not only the targets for injection of liquidity into the economy areset, but also M2, credits, deposit and other target related will be determinate asimportant part of government’s action plan (Camen, 2006)

The SBV, as a part of government, bases on macroeconomic and monetary objectives,announces annual targets for total liquidity and credit to the economy Each year, theSBV arranges a report the implementation monetary policy of that year and monetaryoutlook for next year Then, the SBV submits it for the government consideration andapproval Finally, government will submit this report to National Assembly forapproval, after consulting with National Monetary Policy Advisory Board1 (Hung andPfau, 2008)

Regarding to monetary instruments, a number of indirect tools have been introducedinclude reserve requirement, refinancing, discount financing facilities, open marketoperation and foreign exchange interventions

reserves are distributed into classes depend on deposit maturity, the sectoral focus ofbank, and the kind of currency deposits (domestic or foreign currency) Deposits of lessthan a year are higher than those for more than a year and interest subsidized for bankswhen credit for agriculture sectors or People Credit’s Fund (Camen, 2006).

In 2008 year, reserve requirement was used as an effective tool in order to constraininflation due to strong economic and monetary movements both domestically andinternationally On February 2008, the SBV raised the reserve requirement ratio by 1percentage point applicable to both local and foreign currency deposits in most ofcredit institutions (SBV, 2008) In recent years, with goal to prevent economic downturn, the SBV decreased required reserve applicable to VND deposit for below 12months twice in 2009 from 6% to 5% and to 3%, exception for Vietnam Bank forAgriculture and Development reduced this rate from 3% to 2% and 1% (SBV, 2009)

In 2010 year, SBV continued to keep reserve requirement ratio at low level; in specific;3%, 1% for VND deposit below and more than 12 months respectively For foreigncurrency, SBV also adjusted down to help credit institution increase foreign currencyfunding (SBV, 2010)

Open Market Operations (OMOs)

OMOs have been used by State bank since July 2000 Over those years, this instrumentproves its importance and becomes a single most significant monetary instrument forcontrolling liquidity OMOs were flexibly managed in line with other monetary policyinstruments, thus helping to stabilize the money market SBV conducted by issuingSBV’s compulsory bills, higher base interest rate, in particular, increasing 182-day and364-day bills with the annual rates of 7.5% and 7.75% respectively for sake of inflationcontrol at first 7 months of 2008 (SBV, 2008) The first half of 2009, SBV had offered

to purchase valuable papers for maturity 14-days, that supplied short-term capital andfacilitated credit institutions to meet capital need for economic stimulus programs

(SBV, 2009) However, this action of SBV was unsuccessful because of low demand

of fund and surplus financial resources at that timing Continuity, OMOs wereconducted to support credit institutions in first 9-months of 2010 by purchasingvaluable papers, but increased interest rate for those papers due to high inflationpressure at 3-months end of 2010 (SBV, 2010)

Discount Policy

Besides changing reserved requirement, a refinancing and a discount facility areanother tool of SBV’s discount policy The form of refinancing rate and rediscount rateare fairly similarly However, rediscount rate is set by SBV that base on collateralvaluable papers such as draft, promissory note, bond etc Commercial banks use thosevaluable papers as collateral to access funds form SBV While refinancing rate is givenrely on commercial bank’s loan by SBV Commercial banks use those loans ascollateral for their loan from SBV Because of this difference, refinancing rate isusually higher than rediscount rate in practical Recently, the SBV has used refinancingrate as a mean of supplementing ensure short term lending and liquidity to creditinstitution in 2010 SBV provided mainly 1 to 2 months refinancing to guaranteeliquidity of economy And at late 2010 year, the SBV conducted refinancing in order topromptly adapting the high demand for deposit withdrawals of economic organizationsand individuals during Lunar New Year (SBV, 2010)

2.2.3 VIETNAM’S FINANCIAL MARKET OVERVIEW

Historically, only the SBV and two SOCBs provided almost all financial services forVietnam’s financial system In 1988, two years after Doi moi, the SBV was separatedand operated as the central bank in which specializes in the monetary policy andfinancial supervision Next step of financial reform is appearance of join stock of

commercial banks and foreign banks in 1991, 1992 respectively To fulfill policy

finance, Development Assistance Fund was established in 2000 year Vietnam’s

financial market connects closely in non-commercial lending in past, in which

agriculture sector dominance (World Bank report, 2006)

In the World Bank’s report related to the state of Vietnam’s capital market in 2006

commented that Vietnam’s banking sector had expanded rapidly, mostly by supplying

loans to private sector SOCBs still remain dominant for credit to economy Despite of

sector reform, the banking sector remains financially weak and requires reinforcement

to enhance its stability and lending capacity (World Bank report, 2006)

Table 2.1: One decade and Vietnam’s credit

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Credit to

Source: Calculated from IMF-IFS and GSO data

In the banking sector credit, credit to the economy rose from VND 155 trillion in 2000

(35 percent GDP) to VND 2,690 trillion (136 percent GDP) in 2010 (as shown table

2.1) Only one decade, the supplied credit increased seventeen times Noticeable,

Vietnam’s credit growth was too fast since late 2007 (50 percent credit’s growth) This

phenomenon could be explained by a massive capital inflows and real estate price

bubbles as collateral loan (Vietnam Plus News, 2009)

Vietnam’s credit growth 2011 and orientation in 2012

According to Reuters Article, total outstanding loans in Vietnam’s banking systemgrew 10.9 percent last year from 2010 That is a lowest rate of credit growth in onedecade recently This number was well smaller than a target 15-17 percent, which hadbeen cut under 20 percent initially in 2011 year Meanwhile, deposit growths 8.89percent from 2010 and money supply expanded an estimated 9.27 percent in monthlyreport of SBV

Vietnam is targeting credit growth at 15-17 percent this year and a 14-16 percentincrease in money supply (Reuters News, 2012) Monetary policy will be used byCentral Bank to meet a credit growth Nguyen Van Binh, the Governor of SBV, quoted

in December lending growth could stay below 15 percent SBV continues to focus ondevelopment of agriculture and rural sectors, production of goods for export, auxiliaryindustries and to support small and medium-sized enterprises (Baomoi News, 2011).Agribank, Vietnam’s top lender by assets, is still chosen in fund disbursement, accountfor 75-89 percent of its loans for agriculture and rural development Further, centralbank has allocated various annual credit growth targets for domestic banks For rankingbetween zero and 17 percent, SBV divided banks into four groups, which havemaximum loan growth rate of 17 percent, 15 percent, 8 percent and zero percentrespectively (Reuters New, 2012)

2.3 EMPIRICAL LITERATURE

In recent years, many empirical studies related to the role of credit in monetary policytransmission have been done At beginning, Bernanke and Blinder (1988) were raisedthis problem in famous paper “Credit, Money and Aggregate Demand” IS/LM model

as simple tool which they employed to measure variance of money demand shock Andthey introduced CC (commodities and credit) curve that had shape like IS/LM curve totest the role of credit channel through bank lending channel when shock happening.They divided two sub-samples (1974:1-1979:3 and 1979:4-1985:4) and concluded thatthe variance of money-demand shocks was much smaller than that of credit-demandshocks during the first sub-period but more important relative in 1980’s.

A question about the role of credit channel and monetary transmission was raised afterthat And Ramey (1993), had been conducted this topic in his study since BenBernanke wrote his paper He used monthly sample size of American from 1954:1 to1991:12 to answer the question whether had the relative importance of money andcredit channel in monetary transmission mechanism With purpose analyze thismechanism in detail the author employed dynamic stochastic general equilibriummodel and eight variables (including: industrial product, M1, M2, bank loans, Federalrate, 6-month commercial rate, 3-month Treasury rate, inflation rate) As the result, hedenied the role of credit channel when concluded money channel is much moreimportant than credit channel in direct transmission policy shock during that time.After that, Bernarke and Gertler (1995) postulated credit channel was importantcomponent in “black box”2 Two linkages of credit channel are bank lending andbalance sheet channel were presented very details Most of studies afterwards take thisidea as main orient when want to examine credit role In order to view the responses topolicy shocks, vector autoregression method operated as efficiently tool in study Theyrecognized credit channel could indentify significant cost due to the capital effects ofthe pure neoclassical type

In his investigation following Korea’s financial crisis, Kim (1999) explored the role ofcredit channel in monetary policy transmission He based on monthly data from 1993:1

to 1998:5 and combined three methodologies: a narrative approach, disaggregated bank

2 Bernanke and Blinder had treated monetary transmission mechanism was “black box” in journal

data, disequilibrium model to test for bank lending channel For econometricspecification, standard vector autoregression was employed to identify whether loansupply are really important The result provided persuadable proofs of the importantrole of credit channel afterward consequence of the financial crisis.

Following years, many researchers, did the study nearly the same that topic However,many countries which had various characteristics, so those results also were diverse.Unlike empirical working previous, Warner and Georges (2001) offered novel test ofcredit view of monetary transmission by using stock market return They estimated theabnormal return for daily stock market return of common shares of U.S manufacturingfirms Research’s finding showed that there was no consistent relationship betweenabnormal stock returns and credit constraint both two periods (recessionary: 1990-1991and expansionary: 1993-1994) Similarly effect with Warner and Georges, in hisempirical study, Suzuki (2004) had study whether lending view3 was correct in thecase of Australia during 1985:Q1-2000:Q2 The author found that lending channel isless dominant in Australia, because of some features of Australia bank’s behavior Inanother view, Lown and Morgan (2002), Disyatat and Vongsinsirikul (2003) shed light

on credit effects in U.S and Thailand economy respectively For Lown and Morganpaper, the authors looked for evidence of both type of credit effects by usinginformation on bank’s commercial credit standards as proxy for bank creditavailability The applied vector autoregression (VAR) model extended to resolve

“mystery”4 One remarkable of this study, loan market was classified by two forms;those are classical market and augmented market By market discrimination, the authorcould find out the role of credit standard in U.S economy The empirical concluded thatthe dynamic of commercial credit standards matter a lot both loans and output Take ontypical econometric methodology, VAR model, Disyatat and Vongsinsirikul engaged3

The economists who supported the view: bank loans play important role in monetary policy

transmission mechanism.

4 Lown and Morgan (2002) treated credit effect as mystery.

three main variables of Thailand economy (real output, the CPI, and 14-day repurchaserate) through 1993-Q1 to 2001-Q4 to measure the intensity of money markettransmission to private areas The study realized that investment was significance tomonetary shocks and bank played as essential adhesive for monetary policyimplementation in reality.

While explored the variation financial environment after inflation targeting inThailand, Charoenseang and Manakit (2006) realized that transmission of monetarypolicy through the credit channel was dominant than interest rate channel during June-

2000 to July-2006 Typically, that is dependent capital sources of economic activities

on bank lending in Thai financial market Once again, the authors confirmed theimportant role of commercial bank lending in Thai economy

In the same year, Podpiera (2007) had employed commercial banks data to study theimpact of monetary policy shocks on loan market in Czech case; meanwhile Kubo.A.(2007) concentrated credit channel when investigate the monetary transmissionmechanism in Thailand, highlighting credit channel Both empirical studies supportedthe important role of credit channel at research timing More specifically, Podpieraadopted Kashyap and Stein model, with balance sheet data of Czech banks covers1996:Q1 to 2001:Q4 The empirical finding showed that the changes of monetarypolicy alter the growth rate of loans, special period 1999-2001 And Kubo used astructure vector autoregression (SVAR) to learning the effect of exogenous monetarypolicy shock influence to price and other domestic macroeconomic Monthlyobservations between May-2000 to December-2006 were conducted and contained fivevariables: customer price index, industrial production, producer price index, inter-bankovernight lending rate and private credit aggregates From the paper’s result, theauthors realized that behind the success the BOT (Bank of Thailand’s), credit channelcontributed as important factor during that time Moreover, the empirical found that

negative movement effects on import demand when examined the impact of monetarypolicy shock on international variables in SVAR system.

Balazs Egert (2009) had been investigated the achievement of research in the context

of monetary transmission mechanism, in which Central and Eastern Europeconcentration The paper showed that a reducing in inflation rate is basic factor madethe degree of exchange rate transmission downward over time And credit channeldemonstrated as a key channel in monetary policy transmission, whereas asset pricechannel could not prove its powerful in flat of stock and bond market The same thatwork of Balazs Egert , Fiorentini.R and Tamborini.R (2001) had raised a ring to Italy’spolicy makers when realized the importance role of credit supply during past decade’sresearch

Once again, with objective to examine the monetary policy transmission for India case.Abdul (2009) also employed VAR model combined with macroeconomic variableslike: bank rate, repo rate, reserve repo rate; etc The same previous study, researcheradmitted that bank lending channel was crucial important in monetary policytransmission to Indian’s economic activities Furthermore, Fed’s rate wasrecommended inclusion when analysed in monetary shocks, because of its strongaffected to emerging country like Indian Nearest study, Catão and Pagan (2010)employed an expectation-augmented SVAR to study monetary transmission in Braziland Chile Most of data which they accounted from IMF’s International FinancialStatistics (IFS) and the Brazilian Planning Ministry Research Institute (IPEA) andCentral Bank of Chile They realized the important role of a bank-credit channel whenincorporated key structural features of Emerging Market economies by structuremodel They also exhibited when the typical size of credit shocks happens wouldrobust effects on output and inflation, especially in Chile where the penetration in banksystem was higher

In the context of credit role in monetary policy transmission in Vietnam, there are hasbeen not much study related to this topic Only in 2008, in line with this subject, inspite of not directly touch on the role of credit problem, Hung and Pfau (2008) havebeen analyzed the monetary transmission mechanism of Vietnam The authorsemployed the vector autoregression approach (VAR) which focused on the reduced-form relationship between money, real output, price level, real interest rate, realexchange rate and credit A remarkable conclusion was the weakness connectionbetween monetary policy and each channel in Vietnam case and the credit andexchange rate channel played an important role than interest rate channel.

In short, this chapter has toughed core of thesis through credit channel presentation.Credit theory is explained by external finance premium Monetary policy shock caninfluence loan market through bank lending channel and balance-sheet channel.Regarding to Vietnam monetary policy framework; National Assembly acts sovereignmonetary policy activities whereas SBV exercises the policies as orientation Reserverequirement, OMOs, discount policy are main monetary instruments of Vietnam Inempirical literature part, a majority empirical study recognizes the important role ofcredit channel despite of different country or econometric technique However, there is

CHAPTER 3: MODEL SPECIFICATION AND DATA

This part will include the analytical framework aim to give an overview about

methodology which be conducted in my thesis Next, VAR model will be introduced as

the key methodology to test the role of credit channel in monetary policy transmission

in Vietnam And finally, the steps of estimation which are employed in this thesis, are

briefly explained

3.1 ANALYTICAL FRAMEWORK

Rely on theory and empirical studies, an analytical framework is conducted below

Figure 3.1: Analytical Framework

When Vietnam’s government implements new monetary policy through money supplyadjustment, this will be transmitted four channels; namely; interest rate channel,exchange rate channel, asset rate channel and credit channel All channels will affectmacro economy variables such as output, inflation through different ways as theory.Asset channel does not work as expected because of inexperience stock market inVietnam; hence, I do not analyze that channel in the study Otherwise, Vietnam’scapital mobility had controlled strictly in past Capital inflow or outflow is mainlydriven by interest rate in Vietnam Other words, Vietnam’s capital mobility isimperfect, exchange rate channel does not including in my paper Lastly, interest ratechannel and credit channel are consider in my thesis, in which concentrate the role ofcredit channel in the transmission of monetary policy in the case of Vietnam Twomarkets are classical market (without credit) and augmented market (with credit), thatare introduced to explore the credit role VAR model will be employed both marketsthrough three tests, they are Granger causality, impulse response, and variancedecomposition From the collected results, we can realize the differences between twomarkets At last, the role of credit channel in monetary policy transmission mechanismwill be indentified.

3.2 MODEL SPECIFICATION

In order to meet the objective thesis, Vector autoregression (VAR) model will bedeveloped to answer a question: whether credit channel is key factor in monetarypolicy transmission in the case of Vietnam

Following the result of Stock and Watson (2001), VARs comes in with three varieties:reduced form, recursive and structural The thesis uses VAR approach and focusing onreduced form as convenient method to reap its targets

A reduced form describes each variable as linear function of its own past value and the past value of all other variables A reduced form of VAR model can be derived as:

Where: t = 1, ,T denotes time;

Yt is an m-dimensional vector of endogenous variables

C denotes a vector of constants;

 (L) denotes vector polynomial of lag operator with optimal lagorder;

t is assumed to be vector white noise residual

The error term (t) in the regression is the unpredicted movements in the variables aftertaking its past value into account Each equation is estimated by ordinary least squaresseparately and the number of optimal lagged value will be resolved by differentmethods

The variables used for this thesis are quarterly from 1996:Q1 to 2010:Q3 Because of aspecific characteristic of Vietnam, hence, we are hardly to access data for longerperiod Those variables are M2, customer price index, domestic credit, real industrialoutput, refinancing rate, lending rate Table 3.1 will describe in details the definition,also the sources of data in briefly Those macroeconomic variables represent aparsimonious but potential complete for macroeconomy in the case of Vietnam Therehave several motivations for choosing this particular set of variables As the work ofRomer and Romer (1990), a decreased in the quantity of reserves leads to a reductionthe quantity of loan availability Furthermore, that reduction in stock of reserves hascaused by contrationary monetary policy M2 is chosen because of it is the most widelyused measures of money and policy shock in Vietnam case And refinancing rate is