On the Conduct of Monetary Policy in Vietnam

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On the conduct of monetary policy in Vietnamapel_1335 1..13

Tra Pham and James Riedel*

Vietnam has the highest inflation rate in Southeast Asia (over 20 per centyear-on-year). This paper examines the extent to which inflation inVietnam is due to its conduct of monetary policy. It is argued that, hadthe central bank implemented policy on a more timely basis, inflationwould not have been as high as it was, but the more fundamentalproblem is that the central bank does not have the tools it needs toconduct monetary policy effectively. Monetary policy is further compli-cated by Vietnam’s exchange rate policy. By choosing to peg the currencyand maintain fairly free capital mobility, the country has all but given upthe ability to pursue an independent monetary policy. As a consequence,the central bank is forced to attempt to sterilise its foreign exchangeinterventions, which it is ill-equipped to do. The paper argues that finan-cial sector liberalisation is needed not only to promote growth but also tomaintain macroeconomic stability.

Macroeconomic stabilisation is at the top of thepolicy agenda in Vietnam.1 The inflation raterose to 22 per cent in May 2011 (year-on-year).The value of the dong in May 2011 was down19 per cent from a year ago, as indeed it wouldhave to be for Vietnam to maintain its interna-tional price competitiveness. Bank lendingrates in May 2011 were reportedly above20 per cent, again as they would have to be forlenders to be willing to make a loan if theexpected inflation rate were anywhere near thecurrent rate. The problem is inflation. Since it iswidely understood that ‘inflation is always andeverywhere a monetary phenomenon’, ques-tions have been raised about the State Bank ofVietnam’s (SBV) conduct of monetary policy.

Does the SBV deserve criticism? The answeroffered here is an unequivocal ‘yes’ and ‘no’.

‘Yes’, had the SBV implemented policy on amore timely basis, the inflation rate wouldprobably not be as high as it is. But, ‘no’, thefundamental problems plaguing the conduct ofmonetary policy in Vietnam are not of theSBV’s making. The SBV does not have the toolsit needs to conduct monetary policy effectively,in large part because the government has notgiven priority to financial sector liberalisation,and in particular to the development of a liquidsecondary bond market.

In addition, the SBV faces another challengein conducting monetary policy that is notalways given due consideration, which is Viet-nam’s exchange rate policy. By choosing to pegthe dong to the dollar—albeit with adjust-ments that have increased in magnitude andfrequency in the recent years—and maintain

* Tra Pham, ••, International University and Vietnam National University, and James Riedel, ••, Johns Hopkins UniversitySchool 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, JonathanPincus, 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

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© 2012 The AuthorsJournal compilation © 2012 Crawford School of Economics and Government,The Australian National University and Blackwell Publishing Asia Pty Ltd.

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fairly free capital mobility—de facto, if not dejure—Vietnam has all but given up the abilityto pursue an independent monetary policy.The only opening for an independent monetarypolicy that is available to the SBV is through thesterilisation of foreign exchange market inter-ventions. Indeed, attempts to sterilise massiveintervention in the foreign exchange markethave been the main driver of monetary policyin recent years.

The scope of this paper is confined to theSBV’s conduct of monetary policy, by whichwe mean how and to what effect it has used theinstruments of monetary policy at its disposal.We do not address the issue of how credit wasallocated, which, given its rapid growth underconditions of high and volatile interest rates,has justifiably raised concerns about a deterio-ration in the quality of bank loans and agrowing vulnerability of the banking system toa crisis.

Analytical framework

A stylised version of the balance sheets of thefinancial and non-financial sectors of theeconomy (presented below) serves as a frame-work for analysing the conduct of monetarypolicy in Vietnam. The money supply (M),broadly defined, consists of currency in circu-lation (CC) and bank deposits (DEP) held by

households and businesses. Currency in circu-lation is a liability of the central bank, and bankdeposits are liabilities of the commercial banks.Commercial banks, in turn, deposit with thecentral bank a fraction of the deposits they takefrom households and businesses as bankreserves (BR). The liabilities of the central bankconstitute base (or reserve) money (B = CC +BR). Since the liabilities of the central bank arematched by its assets, base money can also bedefined as the sum of central bank assets (B = R+ D + NC) (Table 1).

The central bank conducts monetary policyby adjusting the size of its balance sheet (B)and by adjusting the money multiplier (mm),defined as the ratio of the money supply tobase money:

mmMB

CC DEPCC RR ER

cc r e

= = ++ +

= ++ +1

.

As shown in the above equation, the size ofthe money multiplier depends on the ratios ofcurrency to deposits (c), required reserves todeposits (r), and excess reserves to deposits(e). In the reserve requirement ratio (r), thecentral bank has an instrument for managingthe money supply by changing the moneymultiplier.

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

Table 1A stylised version of the financial system

Central bank Commercial banks Households/businesses

Assets Liabilities Assets Liabilities Assets Liabilities

Foreignreserves (R)

Currency incirculation(CC)

Loans Deposits(DEP)

Currency incirculation(CC)

Loans

Domesticsecurities (D)

Bank reserves(BR)

Bank reserves(BR)

Net claims oncommercialbanks (NC)

Deposits(DEP)

Otherliabilities

Net claims oncommercialbanks (NC)

Other assets

ASIAN-PACIFIC ECONOMIC LITERATURE

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The Australian National University and Blackwell Publishing Asia Pty Ltd.

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government bonds—and by borrowing fromand lending to commercial banks through itslending facilities (for example, the discountand repo windows). When the central bankbuys (sells) government debt or lends to(borrows from) banks, its assets (D or NC) andliabilities (BR) go up (down), and with it themoney supply.

In countries with developed financialmarkets, central banks typically rely mainly onopen market operations—that is, buying andselling government bonds in the secondarybond market. Little use is made of the reserverequirement ratio or lending to commercialbanks. The reserve requirement ratio is aclumsy and often ineffective tool of monetarypolicy, especially when commercial banks holdexcess reserves, and hence are not constrainedby the reserve requirement ratio. Lending tocommercial banks via the discount or repowindows is also not an effective way to managebase money. Generally, central banks set thediscount interest rate 100–200 basis pointsabove the inter-bank interest rate to discouragecommercial banks from borrowing reservesexcept in exceptional circumstances.

The opposite is the case in Vietnam. Theabsence of a liquid secondary governmentbond market limits the use of conventionalopen-market operations in Vietnam. Instead,the SBV relies mainly on its lending facilities(refinance and repo windows) to manage basemoney, and uses the reserve requirement ratioto adjust the money multiplier. As a result, it isdifficult for the SBV to ‘fine-tune’ monetarypolicy or take timely actions. In addition, theSBV 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 sectorsof the economy—all of which create well-known distortions and inefficiencies in thecredit market.

Exchange rate policy asmonetary policy

The conduct of monetary policy depends onexchange rate policy. If a country chooses to fix

(or closely manage) its exchange rate, it has ipsofacto chosen a monetary policy. Under a fixedexchange rate regime, the central bank isobliged to intervene in the foreign exchangemarket, buying foreign reserves (R↑) when-ever there is an excess supply, and sellingforeign reserves (R↓) whenever there is anexcess demand in the foreign exchange market.When the central bank intervenes, buying andselling foreign exchange reserves, base moneygoes up and down, and with it (via the moneymultiplier) the money supply. That is why, as ageneral rule, a country that fixes its exchangerate cannot have an independent monetarypolicy. The money supply is, in effect, deter-mined by conditions in the foreign exchangemarket, in other words by international tradeand foreign capital flows.

There are, however, exceptions to thegeneral rule. One exception is if a country thatfixes its exchange rate tightly controls supplyand demand in the foreign exchange market,for example by strictly controlling foreigncapital inflows and outflows. The other excep-tion is if a country sterilises the monetary effectof its intervention in the foreign exchangemarket by matching the purchase (sale) offoreign reserves with the sale (purchase) ofdomestic securities. Through sterilisation, thecentral bank can, in principle, increase orreduce its foreign reserves without any effecton the size of its balance sheet (that is, withoutany effect on base money, and hence on themoney supply).

Foreign exchange market intervention

Vietnam pegs its currency to the dollar, butwith sporadic adjustments. In spite of theseadjustments, which, as noted, have increasedin magnitude and frequency in recent years,the SBV has been obliged to intervene heavilyin the foreign exchange market to keep thenominal exchange rate within the band that itsets around the official rate. The annual level ofcentral bank intervention is indicated by thechange in foreign reserves in the balance ofpayments, illustrated in Figure 1.

PHAM AND RIEDEL — ON THE CONDUCT OF MONETARY POLICY

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As Figure 1 indicates, 2007, the yearVietnam acceded to the WTO, was a watershed.Foreign direct and indirect investment inVietnam soared to a level equivalent to25 per cent of GDP. After financing a currentaccount deficit of about 10 per cent of GDP, theSBV was obliged to buy foreign reservesequivalent to 15 per cent of GDP.

The excess supply of foreign exchangeended in the second quarter of 2008, whenforeign (indirect) investors, spooked by risinginflation and growing trade deficits, made arun on the currency, forcing the SBV (in Q22008) to sell back to the market about one thirdof the US$13 billion in foreign reserves it hadpurchased from the Q1 2007 through Q1 2008.

An excess demand for foreign exchangere-emerged in Q1 2009 and continued throughQ3 2010 (the most recent quarter for which IFSbalance of payments data are available), asdomestic residents attempted to convert dongassets into dollars and gold in anticipation ofdevaluation. Since much of the domestic capitalflight in 2009 and 2010 was via the black

market, it showed up in the balance of pay-ments as negative net errors and omissions,that is, unrecorded capital outflow. As a resultof the foreign capital flight in 2008 and domes-tic capital flight in 2009 and 2010, all of theforeign exchange reserves accumulated in 2007and Q1 2008 were sold back to the market(together with an additional US$1 billion) bythe end of 2010, leaving the level of reserves ata precariously low level at the beginning of2011 (Figure 2).

Sterilisation of market intervention

As Figures 3 and 4 indicate, foreign reserveswere the principal component of base moneyuntil the SBV was obliged to sell off a largeportion of its foreign reserves in 2009 and 2010.In 2007 and Q1 2008, when foreign capitalflooded the foreign exchange market, requiringlarge interventions to prevent nominal appre-ciation, the SBV undertook to sterilise itsreserves purchases, mainly by selling dong-

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

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Capital Account Balance

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Current Account Balance

Change in Foreign Reserves

Source: IMF, International Financial Statistics, online.


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denominated ‘sterilisation bonds’ (claims onthe SBV) to commercial banks. However, thelevel of sterilisation did not match the level ofintervention; hence, base money and M2 grewrapidly, leading to an acceleration of inflation(discussed below).

With the reversal of capital flows from mid-2008 onwards, the SBV was again obliged tointervene heavily in the foreign exchangemarket, selling foreign exchange from itsreserves to meet the commercial banks’ excessdemand. To offset the massive reduction inbase money that would otherwise haveoccurred from its sale of foreign exchange tobanks, the SBV sterilised its intervention bybuying domestic securities and, more signifi-cantly, by lending bank reserves to commercialbanks through the SBV’s refinance and repolending facilities. As Figures 3 and 4 indicate,the volume of SBV lending to commercialbanks exceeded the amount required to steri-lise the monetary effect of selling foreign

exchange to the commercial banks, therebyallowing for an expansion of base money.

Instruments of monetary policyin Vietnam

Figures 5 and 6 provide an overview of howthe SBV has used the reserve requirement ratioand its lending facilities to manage base moneyand the money multiplier.

From 2006 to early 2009, the growth rate ofM2 closely paralleled the growth rate of basemoney, albeit with more volatility in thegrowth rate of base money because of seasonalvariation in the demand for cash (which, asshown below, is associated with the lunar newyear). The close relationship between theaverage growth rates of base money and M2until early 2009 implies that, over that period,the money multiplier was fairly constant, asindeed Figure 6 shows it was. However, in

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

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Net FDI Portfolio Flows Other Net Flows E&O

Source: IMF, International Financial Statistics, online.E&O =, FDI = ••.


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early 2009, the money multiplier began to risedramatically, creating an almost 20 percentagepoint disparity between the growth rates ofbase money and M2.

Reserve requirement ratio

The money multiplier rises when the ratio ofcurrency in circulation to deposits declines(c↓), the reserve requirement ratio declines(r↓), or excess reserves decline (e↓). AsFigure 7 indicates, the currency–deposit ratiohas been declining, steadily over the entireperiod, not abruptly in 2009 when the moneymultiplier began to rise. Figure 7 also indicatesthat seasonal factors, in particular the lunarNew Year holiday, explain the volatility in basemoney. The main explanation for the rise in themoney multiplier in 2009 and 2010 was areduction in the reserve requirement ratio andexcess reserves, as illustrated in Figure 8.

The ineffectiveness of the reserve require-ment ratio as an instrument of monetary policy

when commercial banks hold excess reserves isclearly revealed in the statistics for the year2007. In 2007, the SBV was obliged to buy upcommercial banks’ excess supply of foreignexchange, consequent on massive inflows offoreign capital. In an attempt to sterilise themonetary impact of its foreign exchange pur-chases, the SBV, in mid-2007, more thandoubled the reserve requirement ratio, but, asindicated in Figure 4, this move did not havethe expected effect of lowering the money mul-tiplier. The reason it did not, as Figure 6 indi-cates, is because commercial banks, at thattime, were holding a large stock of excessreserves at the SBV, and hence were not con-strained by the reserve requirement ratio. As aresult, the rise in the reserve requirement ratiodid 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 thesame time, capital flight required the govern-ment to sell off a substantial amount of foreign

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

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

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Change in NFA Change in Net Claims on Govt Change in Net Claims on Banks

Source: IMF, International Financial Statistics, online.NFA = ••.

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

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reserves to prevent an even larger devaluationof the dong than occurred. To sterilise the mon-etary effect of selling off foreign reserves and tostimulate the economy by easing credit condi-

tions, the SBV lowered the reserve requirementratio from about 12 per cent to only 2 per cent.The reserve requirement ratio was not revisedupward until early 2011, even though by early

Figure 6The money multiplier: January 2005 through October 2010

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

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


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2010, it was acknowledged that the economywas overheating and monetary tightening wascalled for. Lowering the reserve requirementratio in 2009 worked to raise the money multi-plier as the SBV intended it to do, but whenmacroeconomic 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 reverserepo lending facilities to sterilise foreignexchange market intervention and managebase money. In 2007 and early 2008, the SBVissued compulsory sterilisation bonds to com-mercial banks to absorb, at least partially,excess banks reserves created by SBV foreignexchange purchases from commercial banks.When the foreign capital flow reversed direc-tion, in particular in 2009 and 2010, the SBVused its lending facilities to replace decliningbank reserves consequent on its foreignexchange sales to commercial banks.

The magnitude of SBV borrowing fromcommercial banks (through the issuance of

compulsory sterilisation bonds) and lending tocommercial banks (through the refinance andreverse repo facilities) is shown in Figure 9.The commercial banks were compelled to holdsterilisation bonds in 2007 and 2008, but theywere not compelled to borrow from the SBV tosterilise the sale of foreign exchange to thecommercial banks in 2009 and 2010. Instead,the commercial banks were offered the oppor-tunity to borrow reserves at interest rates wellbelow market rates (even below the inter-bankrate), creating profitable interest arbitrageopportunities. Consequently, commercialbanks borrowed heavily from the SBV, at leastuntil April 2011, when spiralling inflationeventually led the SBV to raise its lending ratesfrom 7 per cent to 15 per cent, significantlyreducing (if not eliminating) the profitability ofborrowing reserves. As a result of the banks’massive borrowing from the SBV, net reserves(commercial banks’ deposits at the SBV minusnet borrowing from the state bank) fell precipi-tously to negative levels by the end of 2010,eliminating entirely the liquidity cushion thatbank reserves provide (Figure 10).

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

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


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The growth of base money, M2,and inflation

As Figure 11 indicates, Vietnam experiencedtwo surges in money and credit growth overthe past five years. The first, in 2007 and 2008,was driven by the monetisation of massivecapital inflows that were only partially steri-lised. The second, in 2009 and 2010, resultedfrom the rise in the money multiplier conse-quent on reductions in the reserve requirementratio, and by growth in central bank credit tocommercial banks that more than offset thedecline in base money consequent on decliningforeign reserves. As Figure 12 suggests, thesurge in money and credit growth in 2007–08and again in 2009 and 2010 was accompaniedby a rise in the inflation rate, validating thewell-known proposition that inflation is alwaysand everywhere a monetary phenomenon.

Conclusion

The SBV’s attempts to sterilise its heavy inter-vention in the foreign exchange market arewhat have largely formed its conduct of mon-etary policy in recent years. Since sterilisationis a means of finessing rather than correctingthe market disequilibria that required inter-vention in the first place, the SBV has beenforced to adjust the rate at which it pegs thedong to the dollar repeatedly and in ever largeramounts. Moreover, the sterilisation tools at itsdisposal have not been up to the task, as twowaves of double-digit inflation in the past fiveyears attest.

One solution might be to float the currency,but that would simply shift the problem, notsolve it. Surges in capital inflows and outflowsthat are of magnitude of those of recent yearswould have caused major swings in the

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

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SBV Loans to Commercial Banks

via Discount & Repo Windows

SBV Sterilization Bonds

Issue to Banks

Source: IMF, International Financial Statistics, online.SBV = State Bank of Vietnam.


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Figure 10Net bank reserves as a % of deposits

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to Deposits

Ratio of Net Reserves

to Deposits


Figure 11Monthly (YOY) money and credit growth rates (percentages)

10

15

20

25

30

35

40

45

50

55

60

M1

2006

M7

2006

M1

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M7

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M1

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M7

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M1

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M7

2009

M1

2010

M7

2010

M1

2011

M2 Growth Rate

Credit Growth Rate



11


12

3

4

5

67

8

9

1

JOBNAME: No Job Name PAGE: 12 SESS: 9 OUTPUT: Wed Mar 28 21:00:37 2012 SUM: 4AE1C5AB/v2501/blackwell/A_journals/apel_v26_i1/apel_1335

nominal and real exchange rate, with deleteri-ous consequences for resource allocation andgrowth every bit as severe as those associatedwith monetary instability. Given the impor-tance of export-oriented industrialisation andthe under-development of Vietnam’s financialsector, Vietnam is currently in no position tofloat its currency.

One step that could be taken to strengthenthe conduct of monetary policy would be totighten controls on capital flows. Recent mea-sures aimed at restricting gold trading and dis-couraging the holding of dollar deposits in thebanking system are, in essence, forms of capitalcontrol. Although these measures have beencredited with easing pressure on the currency,it remains to be seen how effective they willturn out to be, since such controls have beenfound to be notoriously ineffective when dif-ferentials on expected returns in domestic andforeign currencies are high. Nonetheless, itwould seem to be an auspicious time for theSBV to review its policy on capital controls.

Financial liberalisation and development ofa liquid bond market are overdue. These mea-sures would strengthen the conduct of mon-

etary policy, and they would facilitate thefinancing of the government deficits andprovide an important instrument for financinglong-term investment. Financial liberalisationwould also help the SBV to wean itself from itsoverreliance on administrative measures, suchas caps on interest rates, targets on creditgrowth, and quotas on lending by sector,which distort credit markets and lead to mis-allocation of Vietnam’s scarcest resource—capital.

Macroeconomic policy is difficult as it canonly be understood in a general equilibriumframework. The goods market, money market,and foreign exchange market are inextricablylinked by a unique configuration of relativeprices—the interest rate, exchange rate, andinflation rate. That being the case, the authori-ties can attempt to anchor the macroeconomyby fixing (or targeting) one of those relativeprices, but it cannot simultaneously target all ofthem. Attempting to do so by administrativedirectives, as the SBV won’t do, all but guaran-tees that macro disequilibrium in one manifes-tation or another will be a permanent feature ofthe economy.

Figure 12Monthly (YOY) money and credit growth rates (lagged) and the CPI inflation rate

0

10

20

30

40

50

60

70

M9

2006

M1

2007

M5

2007

M9

2007

M1

2008

M5

2008

M9

2008

M1

2009

M5

2009

M9

2009

M1

2010

M5

2010

M9

2010

M1

2011

M5

2011

Rate of Growth of Credit

(lagged 6 months)

Rate of Growth

of M2 (lagged 9 months)

CPI Inflation Rate



12



12

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7

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On the Conduct of Monetary Policy in Vietnam