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Friday, June 14, 2024

Is it risky to cut interest rates?

By Vo Dinh Tri, Ph.D.

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Within only two weeks, the State Bank of Vietnam (SBV) has twice cut key interest rates. This move has stirred up concerns among certain observers that the SBV may have made a premature move compared to other central banks’ actions. However, there is a good reason behind the SBV’s move to support economic growth.

Inflation control vs growth

Since the U.S. Federal Reserve started to hike federal funds rates in March 2022 to fuel a war against inflation, many economies worldwide have found themselves mired in a dilemma of choosing between inflation control and economic growth. And inflation control has prevailed in several economies.

Though inflation control is also a target of macroeconomic stability for Vietnam, inflationary pressure in the country is not as acute as in other countries. Vietnam’s target inflation in 2022 was 4%, and Vietnam was one of the few countries able to keep the headline inflation close to the target.

One of the reasons behind this success was the structure of the basket of commodities and services used to measure inflation. Commodities and services that have greater weights on the CPI such as eating out, foods and foodstuffs, housing, electricity and running water have not been much affected by the global supply chain crisis or the energy crisis. Furthermore, the Government could intervene or control prices of certain essential commodities and services.

Inflationary pressure for Vietnam was also not strong in terms of imported inflation. It was because most of Vietnam’s imports came from China while its exports were largely shipped to the U.S., while inflation in China was even lower than its target rate.

As commodity prices have fallen lately and inflation cooled, inflationary pressure in Vietnam has also eased.

The World Bank in a recent report on East Asia-Pacific (EAP) economies revised down its predicted GDP growth for Vietnam to 6.3% in 2023 from the previous 6.7%.

As such, while inflationary pressure is not high, and as the economy needs support for growth, the SBV has decided to cut key interest rates. The situation in Vietnam is starkly different from that in other economies. Vietnam does not face a trade-off between inflation and growth.

Other favorable factors

According to the World Bank, EAP economies since the 1997 regional economic crisis have seen their fundamentals much improved. Data from three periods—1996-1997, 2010-2011, and 2021—showed that the situations of short-term sovereign debts, foreign reserves, money supply, inflation, and current account deficits of these economies have much improved, especially Vietnam’s. Only one issue of concern for Vietnam is the capital adequacy ratios at local banks, especially in the wake of Van Thinh Phat Group and Saigon Commercial Bank (SCB) scandals.

Currently, Vietnam and other EAP economies are greatly influenced by three external factors, namely the growth of advanced economies, the global prices of commodities, and monetary tightening.

The global economy in 2023 is predicted to have fared better lately given China’s reopening and better-than-expected Quarter 4, 2022 growth in the U.S. and the EU. The U.S. and China remain the most important drivers of Vietnam and EAP economies. Estimates indicate that if the U.S. or China grows by one percentage point, EAP economies would expand by an extra 0.5 or 0.3 point. But if the U.S. hikes interest rates by 0.25 point, EAP economic growth would contract by 0.5 percentage point. Higher hopes are therefore pinned on China’s growth as the Chinese government is determined to spur growth after stabilizing the real estate market and high-tech giants for now.

Regarding the global prices of commodities, especially energy, natural gas and crude oil, have fallen substantially since June 2022, with the crude price at one time hitting a low of US$65 a barrel. These days have seen the crude oil price go up again due to OPEC’s abrupt output cut, but analysts are of the view that the crude price should hover around US$80 per barrel. This level is a far cry from the peak of US$130 per barrel in March 2020. The natural gas futures for May 2023 delivery was US$2.14/Mmbtu on April 4, 2023, a sharp fall from US$9.32 last August. Vietnam is a net importer of oil products and crude oil, so falling energy prices will be an important factor to ease inflationary pressure.

Monetary tightening induced by runaway inflation in major economies like the U.S. and the EU has become more accommodative recently following concerns over the stability of the banking systems given the turbulence caused by Silicon Valley Bank (SVB), Signature Bank or Credit Suisse. Therefore, the pressure to hike interest rates will be relieved, with many predicting that the Fed will raise federal funds rates the final time this year, with a rise of 0.25 percentage point.

For Vietnam, problems with the corporate bond and real estate markets have been gradually tackled, with loosening seen in financial conditions. As the interest rate and financial conditions are correlated, if one factor is loosened, the policy space will be wider for the other factor.

Therefore, the SBV’s actions to cut rates twice in a short span of time may have resulted from prudent consideration of multiple factors, possibly those factors mentioned in the World Bank’s report. In the worst-case scenario, if the Fed makes an abrupt move (to hike its funds rate by 0.5 point) in its May 2023 policy meeting, Vietnam will still be able to stick to its target inflation and growth priority for the reasons analyzed above.

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