Cablegate: Vietnam's Inflationary Conundrum

Published: Mon 1 Oct 2007 05:30 PM
DE RUEHHI #1729/01 2741730
P 011730Z OCT 07
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Ref: Hanoi 1475
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1. (SBU) Summary: Vietnam is not sure how to tackle growing
inflation, which reached a 20-month high of 8.8% in September.
Government efforts to maintain simultaneously a stable exchange
rate, low interest rates and open capital markets run smack into the
"impossible trinity" of economic theory. Most central bank
officials and economists acknowledge the limitations with the more
modest measures used to date to deal with rising prices. As
inflation continues to mount, pressure will increase on the
government to make a policy choice for a stronger dong, higher
interest rates or capital controls. Exercising these options could
make exports less competitive, raise the cost of doing business or
exacerbate uncertainty in capital markets, respectively, affecting
various constituencies, such as farmers, business people and
investors, differently. Notwithstanding public pronouncements for a
targeted depreciation, it appears that the government is keeping all
options are on the table, including a more flexible currency, as a
means to tame inflation. End Summary.
2. (SBU) Vietnamese newspapers have been filled with reports about
rocketing inflation, and the average Vietnamese person will confirm
that the cost of daily existence has gone up. The most recent
release from the General Statistics Office shows that inflation is
at 8.8% for September, up from 8.6% in August and 8.4% in July. The
Government of Vietnam has reacted to the public concern by cutting
tariffs on food and other consumer goods (see reftel). The results
of these cuts, however, have not been swift or significant, even
with official efforts to follow through on whether sellers have
passed on the benefits of lower input prices to consumers. The
ineffectiveness of these supply-side measures has led to larger
questions about Vietnam's macroeconomic management policy. It
appears that Vietnam is facing the classic "impossible trinity" of
open economies - the economic incompatibility of maintaining a fixed
exchange rate, free capital movement and an independent monetary
policy which fixes interest rates at non-market levels. A country
can generally have two out of the three, but Vietnam is trying to
have them all. The combination of a dong essentially fixed against
the dollar and a low, fixed interest rate will be impossible to
maintain over the long term as strong capital inflows into the
Vietnamese markets will increase the upward pressure on inflation.
What's Driving Inflation?
3.(SBU) There are various factors causing the general price level to
rise in Vietnam, including increased domestic demand for goods and
services, including imports, as the economy continues to expand
combined with issues on the supply side. Vietnamese economists,
however, have also pointed to the impact of another contributing
factor as the country becomes more integrated with the global
economy, namely, the inflow of foreign capital. Vietnam's young
stock market and improved investment climate have attracted a flood
of new money that has affected domestic prices. The Treasurer for
HSBC reported that the SBV was "shocked" by the amount of foreign
capital inflows coming into Vietnam starting in late 2006. Although
there is no official number, various estimates by both the private
sector and the Government of Vietnam put the amount of foreign
portfolio investment into dedicated Vietnam-only investment funds at
around five billion dollars.
4. (SBU) In the last quarter of 2006, foreign capital inflows began
to increase substantially and create pressure on the dong to
appreciate. In the first quarter of 2007, the government considered
but refrained from the option of imposing capital controls. The
State Bank of Vietnam (SBV) did, however, intervene to hold down the
value of the dong with by its purchases of dollars. The government
reinforced its policy further in this direction of a weak dong on
June 25 when Deputy Prime Minister Nguyen Sinh Hung announced the
target of a one percent depreciation in the exchange rate for 2007
to support exports. At the same time, the government has been
targeting low interest rates to support growth.
5. (SBU) Letting the dong appreciate and raising interest rates on
bank loans would have dampened inflationary pressures, but the GVN
policy to hold the exchange and interest rates constant has left the
government with few effective tools at its disposal. Thus, the SBV
resorted to other instruments to try to attempt to control
HANOI 00001729 002.2 OF 003
inflation. In May, the SBV raised the reserve ratio to 10 percent
up from 5 percent for dong deposits up to one year and to 4 percent
up from 2 percent for 12-24 month dong deposits. In July, the
government reduced a range of import tariffs and retail fuel prices
(reftel). On August 14, as inflation continued to rise, the SBV
announced further measures: an increase in the 84-day T-bill yield
of 25 basis points to 5 percent, and a new one-year T-bill and set
yields at 7 percent. These bills, which earn what is essentially a
negative real interest rate, were not big sellers and allegations
abound that the SBV engaged in pressuring the commercial banks into
purchasing them. As most economic analysts expect inflationary
pressures to continue, the SBV's dilemma will become more difficult
unless it changes the course followed so far with respect to a
stable (and indeed weaker) exchange rate, a low interest rate, and
relatively free flows of capital.
Why is the GVN fixing currency and interest rates?
--------------------------------------------- -----
6. (SBU) GVN authorities have targeted a one percent depreciation
of the dong in order to support exports, which account for 69
percent of GDP. The HSBC Treasurer emphasized that GVN officials
are especially sensitive to a weak dong's positive impact on the
competitiveness of Vietnam's agricultural exports. Market tools for
hedging, such as foreign currency futures or commodity futures, are
not well-developed or widely understood by local agriculture
producers. Agriculture comprises 20 percent of GDP and employs
approximately 55 percent of the labor force. Another economist from
the Fulbright school added that income (unadjusted for inflation) in
the rural areas has not been increasing over the past few years. As
a result, the share of the labor force in agriculture has been
dropping by about 2 percent a year since 2002 as labor has moved
from rural to urban areas. Moreover, the GVN has made poverty
reduction a central theme of its economic reform agenda, and as
migration to urban centers increases, fostering the economy of rural
areas has become increasingly important. Thus, the government is
concerned that a stronger dong would make agricultural exports less
attractive and hurt farmers. That said, the economist opined that
Vietnamese authorities are not as wedded to a long term targeted
exchange rate as Chinese authorities.
7. (SBU) Vietnamese authorities have also targeted a low interest
rate to support growth. Interbank lending rates currently are
approximately 6 to 7 percent, and lending rates are in the low to
mid double digits. According to the Fulbright School economist,
some influential voices in the business sector oppose an increase in
interest rates as it would increase the cost of funding new and
existing enterprises during a time of rapid economic expansion.
What can the SBV do?
8. (SBU) The difficulty of balancing these competing interests
becomes more apparent when speaking with the State Bank of Vietnam.
Various SBV officials give conflicting assessments of the issue and
of the State Bank's ability to control monetary policy in their
meetings with Econoff and visiting Treasury Deskoff. Deputy
Division Chief of Market and Exchange Rate of the Foreign Exchange
Department Dao Xuan Tuan insisted that the exchange rate and
interest rates stay on target and that the free flow of capital was
the central problem. Without acknowledging Deputy Prime Minister
Nguyen Sinh Hung's announcement of late June to the contrary, Dao
further stated that the SBV is not targeting the dong to depreciate
by 1 percent for 2007. Rather, he said, the SBV is seeking an
exchange rate that would support exports but also take into account
inflationary pressures.
9. (SBU) SBV'S Director of Monetary Policy Department Nguyen Ngoc
Bao insisted that the SBV is fully addressing the problems of the
"impossible trinity" and has the complete range of central bank
tools at its disposal. Bao noted that the government is rethinking
the official inflation policy which currently states that the
inflation rate should be numerically below the real GDP growth rate.
(Comment: this rule has no sound basis in economic theory. End
10. (SBU) In the most frank assessment, SBV Director of Banking
Development Strategy Department Le Xuan Nghia (who is also an
Advisory Expert of Prime Minister and Member of the Financial -
Monetary Policy Advisory Council of Government) noted that to
resolve the problem the GVN is likely to be more flexible with the
exchange rate in the future. He implied that currently the Ministry
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of Finance (MOF) is trying to maintain both interest rate and
exchange rate stability, failing to understand the "impossible
trinity" that is binding Vietnam. As a likely sign of the
institutional clashes going on behind closed doors between the MOF
and SBV, he joked that the MOF thinks Vietnam can operate under "its
own economic theory," eliciting outright laughter amongst his staff.
11. (SBU) Finally, in his first meeting with Ambassador Michalak on
September 10, the new SBV Governor, Nguyen Van Giau, said that he
was not concerned by the inflation issue in general because this
year's inflation is not out of line with 2006 (6.6%), 2005 (8.4%),
or 2004 (9.4%). Local economists agree that there is no reason to
panic, but believe that the situation is exacerbated by the SBV's
lack of monetary tools. ADB Country Director in Viet Nam Ayumi
Konishi recently observed that while strong economic growth will
continue, the relatively high level of inflation calls for the
Vietnamese Government's "close attention."
So Who Really Makes Monetary Policy?
12. Despite various SBV statements to the contrary, local
economists say that the State Bank suffers from capacity constraints
and a lack of policy making ability. A high level official at the
IMF in a meeting with Econoff and Treasury's Southeast Asia
Financial Attache said that exchange rate policy is made by the
Economic Council of the Communist Party, not the SBV. A Dragon
Capital private equity managing director reiterated the same
sentiment, noting that resolving the "impossible trinity" will be
foremost "a political decision." The HSBC Treasurer elaborated,
stating that the difficult decision on either letting interest rates
rise (and hurting businesses) or allowing the dong to appreciate
(and harming the agricultural sector) falls to the Politburo. He
stated that GVN officials are seeking guidance from the Communist
Party on which policy tool to put in place, and joked that "they're
trying to avoid blame" and will not make a decision until they know
they have political cover from higher ups.
13. (SBU) In addition, an economist at the Fulbright Economic
School in HCMC stressed the capacity issues at SBV, stating that the
SBV "is not used to these kinds of problems" and it is only now
starting to think like a modern central bank on how to address these
issues. Nevertheless, he expressed confidence that the SBV would
have the ability to move quickly up the learning curve. Many
private sector contacts agree that Prime Minister Dzung recognizes
the capacity constraints of the SBV and wants to strengthen its
analytical capacity and ability to formulate appropriate monetary
and exchange rate policies. Most market participants expect new SBV
Governor Giau, a Dzung loyalist, to support these plans.
14. (SBU) Although the GVN appreciates that high inflation poses
risks to Vietnam's economic performance, its response to date shows
a reluctance to take any measures that would alter its current
approach on the exchange rate, interest rate and capital flows.
This may be changing. The continued growth in inflation, combined
with economic and political concerns about it impact, shows that
inflation is an economic issue that is not going away.
Notwithstanding public pronouncements for a targeted depreciation,
it appears that the government is keeping all options are on the
table, including a more flexible currency, as a means to tame
inflation. We will continue to advocate supply-side measures as
well, such as increased listings of SOEs, as a preferred way to deal
with the challenges of increased capital inflows. End Comment.
15. (U) Treasury Vietnam Desk Officer Susan Chun visited Hanoi and
Ho Chi Min City August 7 to 21. This cable was coordinated with
Chun, Congen Ho Chi Minh City and Southeast Asia Financial Attache
Susan Baker.
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