Reconsidering Vietnam’s Exchange Rate Mechanism:

A Preliminary Discussion

Kenichi Ohno (VDF & GRIPS) Jan. 2004

USDVND

Brief History Late 1980s: multiple rates and high

inflation under international isolation Early 1990s: global integration starts,

inflation stabilization succeeds 1991-96: $1=11,000d (nominal

anchor) 1996-98: stepwise devaluations,

coping with the Asian crisis Feb.1999-now: slow depreciation

VND/ USD Exchange Rate

4000

6000

8000

10000

12000

14000

16000De

c-89

Dec-

90

Dec-

91

Dec-

92

Dec-

93

Dec-

94

Dec-

95

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

High inflatio

n

Inflation stabilization with

$1=11,000d

Stepwise devaluatio

n

Asian crisis

Slow depreciation under daily averaging

Vietnam: Real Effective Exchange Rate(Dec. 1989 = 100)

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

19

89

M1

2

19

90

M1

2

19

91

M1

2

19

92

M1

2

19

93

M1

2

19

94

M1

2

19

95

M1

2

19

96

M1

2

19

97

M1

2

19

98

M1

2

19

99

M1

2

20

00

M1

2

20

01

M1

2

20

02

M1

2

20

03

M1

2

Depreciate

Appreciate

Current System

The central rate is set daily at the average of interbank exchange rates on the previous transaction day, with a band of ±0.1%

Problems:--It is merely a technical procedure without links to p

olicy goals or economic fundamentals.--Policy intention of SBV is not transmitted to the mar

ket.--No criteria to judge the appropriateness of VND’s le

vel or system.

Vietnam (SBV) Should

Define exchange policy goals Adopt a system which can attain

these goals Within that system, have

operational rules for daily management

Discuss exchange rate policy more openly and consistently (accountability, dialogue with market and investors)

Issues to be considered Which policy goals? Use and limits of REER Ambiguity of “competitiveness” Menu of exchange rate mechanisms Exchange rate smoothing Exit policy problem China factor

1. Which Policy Goals?

Competitiveness Price stability Current-account adj

ustment Financial stability (b

al.sheet problem) Public debt manage -ment (ODA loans)

Prevention of currency crisis

Coping with external shocks

Growth, FDI, industrialization

Possible goals of exchange rate policy

Balancing Flexibility & Stability

Competitiveness requires ex.rate flexibility Price stability requires ex.rate stabilityBut this is not a dilemma in dynamic context

A developing country receives various shocks. Proper policy response sometimes requires flexibility, other times stability.

Goals: General Advice

--In normal times, the goal should be balancing exchange rate flexibility and stability: maintain competitiveness under price stability

--Policy judgment should always be exercised. VND cannot be put on an autopilot. Do not expect a simple formula.

--Adopt a system in which the degree of flexibility and stability can be adjusted at any time without causing crisis or political problem (both free float and rigid fix are undesirable since they do not satisfy this condition.)

2. Real Effective Exchange Rate REER should be regularly calculated

by SBV as a basic indicator of overall competitiveness.

However, limits of REER should also be recognized:

--Base year problem --Choice of price index

--Choice of partner countries --Data availability --International comparability of commodity baskets

3. Ambiguity of “Competitiveness”

Vertical trade structure--Major trading partners (Japan/EU/US) are not true competitors (China/ASEAN/Mexico...)

Low domestic content of major exports--primary commodities, garment, footwear, electronics

High exchange rate pass-through--As prices adjust, any VND/USD rate can be the “correct” rate

Structural changes under doi moi & global integration

Apart from REER limits, the concept of competitiveness faces fundamental problems in developing countries.

SBV Should:--Calculate REER regularly for policy input.

--Also systematically monitor a large number of economic variables including: growth, prices, money, budget, trade & BOP, forex market, FDI & investment, banks, business conditions, asset markets, etc.

--Use judgment and information above to make a policy decision.

--Conduct research on measuring competitiveness, pass-through, global & regional trends, etc.

4. Exchange Policy Menu

Free float Managed float Bipolar view (free

float or rigid fix)

Currency board Dollarization Currency basket

(Dollar/Euro/Yen)

Crawl Adjustable peg Target zone

--Soft vs. hard--Real vs. nominal--Announced or not--Narrow or wide, etc.

Soft dollar peg Eclectic view

--Names do not matter much. Actual operation is the key.

--Pick a system which allows a mix of exchange rate stability and flexibility.

As a general rule, I recommend:

Short-term stability against USDLong-term flexibility against USDNamely, exchange-rate smoothing (filtering out high-frequency movement)

5.Exchange Rate Smoothing

Short-term fluctuation contains more noise and less fundamentals.

Prevention of one-way swings such as bubble, herding, etc.

Demand & supply do not meet or the rate would be too volatile without intervention.

Official provision of “hedging” when forward markets, options, etc. do not exist.

WHY SMOOTH?

0(-) (+)

Before smoothing

After smoothing

Smoothing with a trend

Distribution of Exchange Rate Changes

Movement driven by market forces without intervention

Exchange Rate Smoothing: An Illustration

Crawling peg with variable speed

Managed float

Adjustable peg with frequent revisions

6. Exit Policy Problem How to transit from a fixed to a

more flexible exchange rate system without crisis.

Again, the key is to adopt a system where the mix of flexibility and stability can be adjusted.

Normal operation and crisis response must be clearly distinguished.

Sometimes, the exchange rate comes

under severe pressure

--The critical decision is whether to resist the pressure or to float. If float, the timing of floating is important.

--If it is decided to float, prepare measures that minimize the shock and the period of floating:Temporary trade & capital controls, social protection, protection of banks & firms, etc (Kazakhstan in 1999). Don’t accelerate reforms or tighten macro policies during attack.

--In a typical currency crisis, a 30% depreciation is normal. But shocks may be heavy or light depending on policies.

7. China Factor Lessons for Vietnam China as a risk factor for Vietnam

--Bursting of the Chinese bubble (consumption and housing)

--Mishandling of RMB policy and regional currency repercussions (China now faces a sort of the exit policy problem)

My Recommendation:Variable Crawl with Monthly

Evaluation

Monthly monitoring

VND/USDCrawl speed adjustments

Time

Variable Crawl for Vietnam SBV mainly sets the rate, while market f

orce is used as a supplementary input. (VN’s financial markets are still primitive.)

SBV monitors the situation monthly and adjusts the crawling speed if necessary.

The actual movement may not be very different from today, but SBV assumes more accountability based on proper analysis.

The EndIf enough interest exists, VDF will start research on exchange rate management