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Tuesday, November 29, 2022

A forex policy that can work

By Associate Prof. Pham The Anh, PhD (*)

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It is probably high time for Vietnam to embrace a more flexible forex policy, possibly a measured floating scheme similar to the approach taken by regional countries in the aftermath of the 1997-1998 financial crisis.

Current forex policy

In the past, reality in Vietnam showed that the currency peg did not entail success in inflation control. Like in many other developing and emerging economies, Vietnam’s currency peg only helped contain inflation in that it cushioned the impact of price changes on import prices and thus consumer prices if the local currency was not artificially devalued and if money supply was put under tight control.

Since 2016, the State Bank of Vietnam (SBV) has applied a new forex management policy which relies on a basket of foreign currencies of major trading partners, but in reality, the local currency has still been tied to the U.S. dollar. Having enjoyed success for several years in terms of a low rate of money supply, inflation control and merchandise trade surplus, Vietnam has seen new uncertainties emerging on the forex market. At commercial banks, the U.S. dollar has strengthened 5%-6% against the Vietnamese dong currency compared to early this year. The gap between the formal exchange rate at banks and that on the informal forex market has widened, leading businesses and the public to buy dollars as a safe haven despite the SBV’s intervention by selling large amounts of dollars.

These uncertainties are external ones caused by major central banks worldwide tightening their monetary policies via interest rate hikes. As Vietnam’s economy is highly exposed to the world due to the signing of numerous free trade agreements (the ratio of trade value to GDP being over 200%) coupled with the low compliance by banks to safety criteria, Vietnam’s currency peg has seen shortcomings like before.

The currency peg has prompted a rapid change in forex holdings, from long to short position. With depleted foreign reserves, the SBV does have enough ammunition to keep the local currency stable. Even though it is not formally recognized, the informal forex market has always existed alongside the formal one, which allows the public to step up their forex holdings. This is a waste of resource. The wild swing of the forex rate has also widened the spot sell/buy rates, affecting the interests of enterprises when dealing with banks which in turn stimulates the forex holding mentality among enterprises. The faster pace of the forex rate change than committed by the SBV has also eroded confidence in the agency, although the factors behind such changes are external ones. The inflow of foreign investment has also dwindled pending further examination.

Stabilizing the forex market and curbing dollarization and imported inflation can only work on the basis of a good foreign trade balance and low domestic inflation (tight control over money supply), not on the currency peg. Anytime trade deficit and inflation climb, and when external uncertainties emerge, expectations on local currency devaluation would surface. By then, minor steps of a measured devaluation by the SBV are not enough to douse such expectations, and the forex rate will often breach the permissible margin, more so on the informal market.

As the economy is increasingly exposed to the world and the capital account becoming freer, the local economy will be more vulnerable to external shocks. By employing the currency peg, the SBV will frequently face these shocks and can hardly manipulate its monetary policy in a proactive way to achieve domestic goals. Clearly, the interest rate hike and U.S. dollar sales to prop up the local currency under the current circumstances will hinder economic recovery, and fail to ensure liquidity for the banking system, possibly upending the financial market. Such hardships are all the more challenging as many credit organizations have not closely adhered to capital adequacy ratio criteria.

A measured floating mechanism

It is probably high time for Vietnam to embrace a more flexible forex policy, possibly a measured forex floating scheme similar to the approach taken by regional countries in the aftermath of the financial crisis in 1997-1998. Unlike the existing currency peg, under the measured floating mechanism, the central bank will refrain from announcing the central forex rate; the daily commercial forex rate will primarily be driven by market forces.

However, the SBV can still resort to intervention measures like forex dealing on the interbank market and/or controlling the inbound/outbound capital flow to soften the forex rate movement. Specifically, via open market operations, discount and recapitalization tools as well as trading on the forex market, the SBV will be able to control money supply, thus adjusting the forex rate and the target interest rate.

A measured forex floating mechanism will bring about more benefits than the currency peg. First, prices of most commodities as well as salaries at local enterprises are market driven. The measured forex floating scheme will align domestic and global price changes, helping improve the allocation of resources in the economy. Second, the exposure of the Vietnamese economy is high, but it is not bound to any singular major economy, and therefore, a measured forex floating scheme will not only help Vietnam cushion impacts of external shocks, but also enable the country to better absorb such shocks from global commodity markets.

Further, our calculations show that impacts from a weaker local currency on consumer prices (transfer effect) in Vietnam in previous years were stronger than in other developed and developing economies. However, such impacts would soften if Vietnam maintains a low and stable inflation rate. In addition, the pegging policy with the one-direction adjustment (devaluing the local currency only) will heighten the transfer effect much more than that caused by the measured forex floating scheme. In such a mechanism, measures and vehicles to hedge against forex risks can be developed, and as such, impacts by forex changes on the economy would be bearable compared to a pegging policy that is not fully executed.

Inflation control and forex market modernization

However, in order for a measured forex floating mechanism to pay off, Vietnam must commit to the pre-targeted inflation control which serves as an expected inflation anchor. This is conditional on an independent monetary policy. That is to say the policy must be based on transparency, without being affected by fiscal policy nor influenced by economic or financial entities on the market. And in order to achieve the inflation target in an open economy, the SBV shall regulate the monetary market towards this inflation goal. The measured forex floating mechanism will allow the SBV to employ regulatory measures in a flexible and proactive manner via open market operations and trading on the forex market.

Another condition required for the measured forex floating mechanism to operate seamlessly to facilitate better allocation of resources in the economy is to modernize the forex market. Currently, Vietnam’s forex market is mainly characterized by direct transactions; other forex derivative products have not been introduced or too costly; the total forex trading volume is still trivial compared to regional forex markets; the SBV still accounts for the lion’s share on the interbank market. Foreign currencies must be deemed an asset. Once in place, the measured forex floating mechanism will allow participants to engage in forex transactions like for other securitized products. The emergence of derivative tools as well as other intermediary financial institutions will help reduce risks for participants. These will be issues to be addressed by competent authorities if Vietnam is to have a bustling and truly efficient forex market.

(*) National Economics University

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