VIETNAM’s challenges: cooling down the overheating economy & transforming growth into development

   Vietnam currently faces a four-pronged challenge: growing trade and current account deficits; rising inflation, fragile banking system, and a tighter external payment position (declining reserve/import ratio and larger short-term debt). These challenges must be tackled simultaneously to beef up domestic and foreign confidence in Vietnam‘s development prospects. A key assumption, today, is that a trade deficit of $11 billion and a current account deficit of roughly $9 billion/year in next 5 years (8% of GDP) can be financed by FDI, i.e., non-debt creating flows. However, Vietnam is competing in the capital markets with a number of emerging market countries to mobilize financing (and by a growing number of developed countries with large external financing requirements!). Vietnam must thus remain attractive and competitive to keep attracting tourism flows, FDI and portfolio inflows, while stemming capital flight. Private deposits in international banks are rising and currently reach more than $800 million.  The risk therefore is that double-digit inflation (currently 14% year on year) will shake the confidence of domestic and foreign economic agents, leading to a vicious circle of downgrading, tighter borrowing conditions, and expectations of further dong depreciation, capital flight, and imported inflation. Curbing credit growth and cutting the budget deficit are thus prerequisites to stabilize the economy. The clock is ticking. 

   On April 13, the Vietnam's State Bank issued circular 11 capping the ceiling rate for foreign currency at 3% per year. This move aims at reducing the role of the dollar as hedge against inflation while stimulating deposits in Dongs in the domestic banking system. Will this work? The risk of a confidence crisis into the dong would lead to a gradual process of dollarization, a large spread in the black market, and larger gold holdings. Then the situation can get quickly out of control. The SBV has taken the right policy measures to stem this risk. The 3% interest rate cap on dollar deposits is a good start to stem foreign currency deposits but it will work only if people do not expect capital appreciation in dollar deposits versus dong deposits. All this depends on the Dong’s real exchange rate, i.e. its purchasing power. 

   Strengthening the Dong, however, is not a technical matter but rather a matter of long-term confidence in Vietnam’s socio-economic development prospects. This requires stemming capital flight, reducing the trade deficit, increasing reserves, while developing domestic capital market, i.e., restoring confidence (the domestic capital market remains small by regional standards). To keep the Dong competitive (to stimulate exports and attract capital inflows), depreciating the exchange rate has little meaning if the real effective exchange rate does not get more competitive. What makes things challenging in Vietnam is that exports are import-based (e.g., machinery and equipment, steel as well as intermediary goods for processing trade). Hence exports tend to rise hand in hand with imports!

   Since the end of 2009, the SVB devalued the dong by roughly 20% against the US dollar. The first problem is that this depreciation does not fully offset the price differential between Vietnam and its main trading partners. The second problem is that the overwhelming $ reference is at odds with the modest share of the US market in Vietnam’s overall trade, i.e., only 20%. The € zone represents at least 25% of non-oil exports. Thus, exchange rate management should be made more flexible, with a currency basket that reflects the currencies of trading partners, a so-called real effective exchange rate.

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