MBA MBA TROY 4G VIETNAMESE FOREIGN EXCHANGE TROY RM M INTERNATIONAL FINANCE

VIETNAMESE FOREIGN EXCHANGE

INSTRUCTOR: DR. ANAND KRISHNAMOORTHY

GROUP MEMBERS: NGUYEN THI HONG DIEP TRAN MINH HAI TRUONG MINH HOANG

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GROUP No.4 MBA TROYa4G | 0 P ge HANOI - AUGUST 24, 2011

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CONTENT
1. Vietnams exchange rate regime: apparent official preference and supporting mechanisms .................................................................................................................... 1 1.1. Preference for stability in the VND/USD exchange rate .......................................... 1 1.2. Mechanisms to support stability in the VND/USD rate ............................................ 3 2. Implications for development of the forex market .............................................. 7 2.1. Low volatility of the official exchange rate .............................................................. 8 2.2. Lack of interest in derivatives ................................................................................... 8 2.3. Minor role for interbank transactions and low market turnover ............................... 8 2.4. Dominant role of the SBV......................................................................................... 9 2.5. Illiquidity risk ............................................................................................................ 9 2.6. Incentives for transactions in the parallel market and dollarization ....................... 10 2.7. Non-transparency and inaccurate price signals ....................................................... 10

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The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. The foreign exchange market defines the relative values of different currencies. The primary purpose of the foreign exchange is to support international trade and investment, by allowing businesses to convert one currency to another currency. The foreign exchange market has become more and more important in the globalized economy. In the foreign exchange market, exchange rate is one of the most important factors affecting international transactions. Different countries have different exchange rate regime depending on their economy, currency, politics and other factors. This paper attempts to give some striking characteristics of the exchange rate regime in Vietnam with apparent official preference and supporting mechanisms from the last years of 1900s to 2011 and the implications for developments of the forex market. 1. Vietnams exchange rate regime: apparent official preference and supporting mechanisms 1.1. Preference for stability in the VND/USD exchange rate In the literature, the preference by some monetary authorities for a fixed exchange rate regime is often provided a theoretical underpinning in terms of a stabilizing nominal anchor, especially in the context of high inflation, rapid growth in monetary and credit aggregates, and large government budget deficits. Under such conditions, an exchange rate (ER) peg relative to a major foreign currency could serve as a suitable anchor, especially in countries where the domestic government lacks a track record in policy making that would establish its credibility with market participants. It is not surprising that Vietnam has considered the U.S dollars (USD) a key nominal anchor. Some of its most important trading partners, such as China, Hong Kong, Singapore, Thailand and Malaysia, have generally preferred a stable ER relative to the USD. Vietnams own experience in reducing inflation during the first half of the 1990s Group No. 4 Page |1

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also served to underscore the benefits that an effective peg to the USD could bring. There may also be a variety of non-economic (e.g, political or strategic) reasons for the authorities to prefer a stable VND/USD exchange rate. Trends in exchange rates For the purpose of reviewing major trends in exchange rates, the author compiled a set of data for nominal and real effective rates. Figure 1 illustrates annual movements of the nominal VND/USD rate (of which a rise corresponds to a weakening of the VND) from 1985 to 2008 whereas Figure 2 shows major trends displayed by the nominal USD/VND exchange rate (expressed as an index), as well as the NEER and REER, over the period 1992-2007 - annual data for NEER and REER are available only for 1992 onwards.

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As can be seen from these figures, during the years 1992-1996, and again during 2004-2007, the USD/VND rate was very stable while the NEER and REER experienced substantial changes. By contrast, during the initial Doi Moi years (1985-1991, shown in Figure 1) as well as the Asian Financial Crisis and its aftermath (1997-2003) the USD/VND rate indicated major weakening of the VND against the USD. A closer examination of the four sub-periods indicates that, in an ex post sense, the authorities apparently preferred a stable nominal USD/VND exchange rate whenever that was feasible during the past two decades. There were two sub-periods (1992-1996, 20042007) when the VND was effectively pegged to the U.S dollar, so that the path of nominal effective exchange rate (NEER) was dictated by the strength of the U.S dollar relative to the currencies of other trading partners. Similarly, real effective exchange rate (REER) was determined residually given the values of NEER and the inflation rate differential between Vietnam and its trading partners. As it happened, in both of the above sub-periods, REER tended to increase, indicating a loss of competitiveness. The other two periods (1985-1991, 1997-2003) were periods when, arguably, the authorities had little choice but to allow large movements in the nominal bilateral VND/USD rate. The former period covered the launch of the Doi Moi process while the latter involved the Asian financial crisis and the implementation of trade liberalization measures. It would appear that whenever such contingencies had passed, the authorities would return to a relatively stable VND/USD rate. 1.2. Mechanisms to support stability in the VND/USD rate The current exchange rate regime operates within the framework of an announced official exchange rate and an allowable exchange rate band. These two devices have been used to slow down, if not eliminate, short-term changes in the exchange rate, even when there was strong market pressure for either a depreciation or appreciation of the domestic currency. When the resultant commercial exchange rates failed to clear the market, as they very frequently did, the authorities tended to rely on official intervention to meet part of the imbalance between demand and supply, supplemented by moral suasion and Group No. 4 Page |3

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administrative measures. Official exchange rate

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Since 1999 the State Bank of Vietnam (SBV) has determined the average VND/USD exchange rate on the interbank market on each banking day and announced it as the official exchange rate on the following banking day. However, this determination process has not been transparent and has contained to a large extent elements of the subjective will of the SBV. In general, it can be expected that the bid-ask spreads in the interbank market would be smaller than in the bank-client market. Thus, the average interbank rate should be somewhere between the ask rate and the bid rate quoted in the bank-client market. Yet in practice, the official exchange rate has frequently been set below the bid rate quoted in the client market on the previous day. Additionally, the announced average interbank rate has often appeared rather sticky or even rigid, despite evidence of rapid developments in the market. For example, when there was upward pressure on the exchange rate (i.e., the VND was depreciating) and commercial banks consistently quoted their trading rates at the upper bound of the allowed band, in principle the band should have moved up each trading day. Thus, the average interbank rate should have increased daily by an amount equal to one-half of the width of the band. Historical data show, however, that it tended to increase slowly and sometimes did not increase at all. Allowable trading band The trading band, within which commercial quotations are allowed to fluctuate, has been quite narrow except for the periods around the 1997-1998 Asian Financial Crisis and the 2007-2008 Global Financial Crisis (see Figure 3). It would appear that increases in the width of the allowable trading band have been used mainly to respond to episodes of strong pressure for the VND to depreciate. In particular, the repeated broadenings of the band in 1997 and 2008-2009 allowed the VND/USD exchange rate to be adjusted upward in response to major external shocks. When the immediate urgency had passed, however, the band tended to be narrowed again. Group No. 4 Page |4

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The allowable trading band has been adjusted in terms of the official exchange rate. In the period of 2008 and 2009, the allowable trading band was 3%, however, it was widened from 3% to 5% in March, 2009 due to the sharp decrease of the exchange rate in the Interbank market. To implement Resolution No.02/NQ-CP of the Government on key solutions in guiding the implementation of the 2010 socio-economic development and to improve the liquidity of the foreign exchange market, the State Bank of Vietnam (SBV) has released an announcement on a new foreign exchange management regime. Accordingly, on February 11th, 2011, under pressure of appreciating of USD, the SBV reset the official exchange rate at 20,693 VND/USD and the allowable trading band was depreciated from 3% to 1%. It was also announced that the SBV will manage the inter-bank average exchange rate in a relatively flexible manner in the coming time. These measures will create favorable conditions for decisively managing the exchange rates in line with the foreign currency supply-demand condition and increase the liquidity of the market, thereby contributing to controlling the trade deficit and facilitating the implementation of a more active and flexible monetary policy. Group No. 4 Page |5

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Official intervention, administrative rationing

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Given the operation of administered pricing, through the setting of both the official exchange rate and the allowable trading band, frequent instances of non-clearance of the market were unavoidable. By default, the SBV often found it necessary to intervene in order to manage such market imbalances, aiming at keeping the exchange rate VND/USD at the required level and within the allowable band. During much of the period under study, the VND was under pressure to depreciate, and there was a persistent excess demand for USD at the commercially quoted exchange rates, which were already pushed to their upper limit. Accordingly the SBV had to sell quantities of USD. Due to the need of conserving official foreign exchange (forex) reserve, however, the SBV tended to meet only part of the prevailing excess demand, and to use administrative arrangements to ration some of the available forex among potential buyers. In particular, only those commercial banks with short positions exceeding a certain size could approach the SBV to buy foreign currency at the quoted exchange rates. Moreover, the system allowed priority to be given to the importation of essential goods (such as petroleum, fertilizer and medicine), and to commercial banks that serve customers engaging in these priority activities (Tran Nga 2008). This means that other customers must turn to the parallel black market or other ad hoc channels to address their unmet demand for USD - or just wait. There were, of course, some periods when Vietnam also experienced pressure for the domestic currency to appreciate. For example, due to a surge in capital inflows in late-2007 and early-2008, the SBV faced the dilemma of whether or not to intervene in the forex market to prevent the VND/USD exchange rate from falling. The Banks handling of this episode suggests that, in comparison with China, Vietnams monetary authorities may have been less inclined to intervene fully in the forex market even when the domestic currency was subject to appreciating pressure. Discussions in the domestic Vietnamese literature acknowledge that the SBV was Group No. 4 Page |6

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confronted at the time with a number of conflicting macroeconomic objectives. On the one hand, if the exchange rate were allowed to be more flexible, an appreciation of the VND would ensue and this was considered harmful to the countrys external competitiveness. On the other hand, if the SBV were to maintain the prevailing exchange rate by buying foreign currency, this could add to the growth in money and credit, with potentially inflationary consequences. In the event, the SBV chose to adopt a compromise, halfway approach. The VND/USD exchange rate was allowed to fall, but not too sharply. At the same time, with commercial exchange rate quotes straining at the lower bound, the excess supply of foreign currency was considerable and many participants were unable to convert USD proceeds into VND. 2. Implications for development of the forex market The current exchange rate regime has been described by the authorities as a managed float. In principle, under a managed float, the exchange rate is determined by market forces, and the governments influence on this rate is effected only through its own purchases and sales in the forex market (Moosa, 2004). In the case of Vietnam, the justification for the term float being in the above description is that the SBV no longer sets the official ER, but simply notifies the average interbank rate determined on the preceding business day through the interaction between supply and demand in the market. The regime is managed in that the exchange rate can move only within a stipulated band, the SBV remains a major participant in the market and various forms of administrative exchange controls and rationing are maintained. As mention in previous section, in practice the system has tended to rely so heavily on the managed part that perhaps the term adjustable peg might be a more appropriate description at least, in a de facto sense. In any case, it is clear that the nominal VND/USD rate has frequently been sticky if not completely stable. In turn, such stickiness has brought about a series of linked structural and operational deficiencies of Vietnams forex market as presented below.

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2.1. Low volatility of the official exchange rate

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The official VND/USD exchange rate has followed a gradual upward trend with very little volatility except for the periods of the Asian Financial Crisis and the recent World Financial Crisis. This gives rise to a high degree of predictability and an expectation among market participants that the SBV will frequently intervene to limit volatility in the official rate. 2.2. Lack of interest in derivatives The low volatility of the exchange rate, coupled with the one-way nature of most daily movements, means that businesses generally perceive little foreign exchange risk. As a result, there is little incentive for market participants to develop greater sophistication in terms of ability to form views regarding the future paths of the exchange rate, or to manage exchange rate risks. 2.3. Minor role for interbank transactions and low market turnover The gradually rising and sticky trend of the exchange rate VND/USD provided little incentive for dealers from commercial banks to form views on the path of the exchange rate, take position or manage risk in the interbank market. Instead, they would concentrate on providing intermediary services to businesses, endeavoring to make their forex positions squared within their own customer base. This explains why the bulk of forex transactions have been spot transactions between banks and their clients, rather than interbank swaps and forwards which tend to dominate forex markets internationally. The small size of the interbank market in Vietnam suggests that it has not served well as a place for market forces to interact, thus poorly performing its price discovery function. Further, the limited role of the interbank market also implies a low turnover for the entire forex market. Daily total turnover on Vietnams forex market increased seven-fold from around $20 million in 1995 to around $150 million in 2006. In spite of such seemingly remarkable growth, the market has remained very small compared with forex Group No. 4 Page |8

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markets in other countries. This can be appreciated by comparing the size of a forex market to the relevant countrys international trade volume. 2.4. Dominant role of the SBV Given the fact that the targeted official exchange rate has been kept stable for long time and the trading band has been quite narrow, the SBV has been required to stand ready to respond to instances of non-clearance of the market. Naturally, the SBV has become the dominant player in the interbank market. The inference about the SBVs role is well supported by available data. In the four years 1999 to 2002, the transaction volume involving the SBV was estimated to be 29%, 65%, 68% and 60% of the total interbank market turnover respectively (SBV 1999, 2000, 2001, 2002). The corresponding figure for 2004 was perhaps as high as 85 percent.6 These data also suggest that, if putting those transactions conducted by the SBV aside, the actual inter-bank market has been very limited indeed. The limited trading in the interbank market with the dominant role of the central bank would obviously point to the fact that commercial banks will turn to the interbank market only when necessary in order to square or re-establish their desired position. 2.5. Illiquidity risk Market participants in Vietnam have experienced frequent bouts of extreme illiquidity. The operation of the forex market has depended on the intervening activities of the SBV. Because of the VNDs long-term depreciating trend relative to the USD, it is not possible for the SBV to fully meet the excess demand for USDs on a sustainable basis. Partial or zero intervention, however, implies prolonged excess demand and market illiquidity: when the commercially quoted exchange rate is already at its highest allowable level, supply simply dries up, as banks and other market participants have little incentive to sell. Periods of market illiquidity represented times of difficulty for corporate customers in conducting forex transactions. It is interesting to note in this connection that, at times, Group No. 4 Page |9

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the risk of exchange rate changes has been transformed into a risk of illiquidity, in that it may become impossible for a bank customer to buy or sell foreign currency at the quoted rates. 2.6. Incentives for transactions in the parallel market and dollarization The parallel (black) forex market has always been a part of contemporary business life in Vietnam: its existence predated the 1980s economic reform process. While, in a strict sense, transactions in this market have always been illegal, the long-running excess demand for USDs ensures its continued existence. As mentioned earlier, there have been cases where corporate customers had to resort to transactions with much higher prices in the informal parallel market when doors in the official market were all closed. Anecdotal evidence provided to the author suggests that some bank customers have begun to search for and deal with each other directly, often with the assistance of commercial banks. Thus the current framework of regulations has actually created opportunities for the parallel market to exist and have its continual substantial impact though it is illegal and the SBV aims to narrow its influence. 2.7. Non-transparency and inaccurate price signals With circumventing activities, forex transactions have often been conducted at rates that were substantially different from the quoted commercial rates. However, these actually applied rates would not be officially reported with the related transactions due to their illegality. Such a market could hardly provide accurate price signals for market participants and policy makers. An implication of this is that exchange rate data that are available from official sources (including the SBV and IMF) do not fully reflect market realities. Any use of these data for economic analysis might lead to biased results. - The End -

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