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Saturday, February 4, 2023

Real interest rate too high

By Hoang Xuan Huy

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Lately, knock-on effects from the monetary tightening policy designed to fight inflation and maintain the forex rate, coupled with negative impacts from the corporate bond crisis (and the response to that crisis as well) have led to liquidity constraints, prompting banks to hike interest rates sharply

The deposit rate for 12-month savings has climbed to 11% at many banks, pulling the average market rate to over 10%. As the average inflation in recent years hovered around 4%, and is poised to stay this low next year, the real interest rate has exceeded 6%, which is probably the highest real interest rate in many years.

What are the reasons behind the high real interest rate?

First, it is the monetary tightening policy formulated to fight inflation and to cope with the real estate bubble that has got highly inflated. The outcome is that banks have faced liquidity problems while the real estate market has cooled.

Second, it is the monetary tightening policy meant to safeguard the forex rate as the U.S. dollar has much strengthened against other currencies worldwide due to the hawkish stance by the U.S. Federal Reserve to curb inflation. Having maintained the strength of the local currency for a long time despite the sharp appreciation of the greenback that has stimulated dollar holding, the State Bank of Vietnam (SBV) could no longer safeguard the forex rate when short-term funds flowed back stateside for a higher interest rate, and consequently, Vietnam dong weakened by 9% against the U.S. dollar. This sharp weakening has adversely impacted the financial market, prompting the SBV to double down on monetary tightening to stabilize the forex rate. The domestic interest rate was hiked again due to this policy.

Third, the crisis on the corporate bond market fueled by “black-swan” events such as irregularities at Tan Hoang Minh and An Dong companies, and heavy-handed countermeasures by policymakers like toughening conditions for bond issues and the coercive redemption of problematic bonds have sent liquidity at banks into a tailspin.

Therefore, the sharp hike of interest rates has stemmed from multiple factors, but the core was the tighter control in monetary, foreign exchange and corporate bond management. The multi-purpose tightening policy has prompted the monetary market to overheat, stimulating banks to join an interest rate competition despite the Government’s effective inflation control, and thus, the real interest rate has been pushed to a new high.

Remedies for policy miscalculations

The risks of runaway inflation, forex rate and corporate bonds did exist, but the response was excessively strong, resulting in a liquidity crunch and steep interest rates.

Such developments can be seen as follows:

Regarding inflation, it is apparent that inflation control is now facilitated by demand pull, cost push and inflation expectation.

Regarding demand pull: data shows that Government expenditure, public investment, and private investment are staying low, and the overall number is expected to fall as a result of shrinking expenditure in the private sector due to concerns over the economic prospect and rising unemployment. In addition, higher expenditure stemming from higher prices of assets is unlikely now that investors have become poorer given the sharp fall of assets like stocks, real estate and cryptocurrencies. Similarly, expenditure for investment also tends to fall due to bleak economic prospects and higher capital costs that discourage investors from expanding business or start new projects.

Regarding cost push: As prices of important materials like iron, copper, building materials, and petrol have fallen, and as prices of essential products like food and foodstuff are put under good control, inflation in Vietnam has been harnessed well. Therefore, worries over the impact of cost-push expenditures on inflation will be low in the coming time.

Regarding inflation expectation: Signs of inflation having topped out in other countries due to their monetary tightening, especially in the U.S., coupled with the possibility of a recession in the foreseeable future have doused inflation worries. At the same time, key factors driving inflation have been well controlled in the country, so the expected inflation is very low.

Regarding forex rate: There is no question about Vietnam dong weakening against the U.S. dollar due to policies by Fed. However, as the SBV managed to maintain the strength of Vietnam dong over a long period of time in the context of regional currencies falling steeply and the flight of cheap capital back to the U.S., the expectations of a sharp devaluation have run high, and the devaluation has then really occurred.

However, given the current developments, including a huge trade surplus as well as a surplus in the international settlement account, and a low inflation rate compared to that stateside, it is of little value to keep the forex rate stable at all cost, and in fact, the forex market has become stable again quickly.

Regarding the corporate bond market: Tightening the management of the corporate bond market is imperative. However, excessive measures by competent agencies have adversely affected the financial market, including the side effect of pushing up interest rates.

Therefore, in order to bring interest rates back to an appropriate level (with the real interest rate at some 2-3%), policymakers need to consider the following solutions:

First, fine-tuning the monetary policy that ensures liquidity for banks suitable to the credit growth for the economy. The sudden move by the SBV to tighten money supply while credit growth remained high has prompted a liquidity crunch, forcing banks to push up interest rates. This can be seen through the comparison of money supply and credit growth over the years. While money supply and credit growth were almost on a par in previous years, the gap has widened this year, with credit growth posting 11% in the year to end-October while money supply inched up by less than 4% only. Therefore, adjusting monetary and credit policies to appropriate levels are vital for maintaining an agreeable interest rate level.

Second, ensuring liquidity for banks, especially those banks directly related to the corporate bond market, by discounting corporate bonds for banks when these (healthy) banks purchase and hold this debt instrument. Such a move will on one hand help tackle the corporate bond crisis, and on the other hand improve liquidity for banks to lower interest rates. With the corporate bond yield of some 15% now, a policy to offer a discount rate for this valuable paper at under 10% will be sufficient for banks to join forces in tackling this bond crisis and thus boosting liquidity for the entire economy.

Third, the SBV needs to apply credit ratings for commercial banks (and using credit ratings by international organizations) when considering to grant credit growth limits for different banks, instead of resorting to its own measures like the lending to deposit ratio or the capital adequacy ratio, as the current method stimulates banks – instead of improving their performance quality – to step up mobilization to meet the central bank’s LDR condition which contributes to the interest rate hike like now. Further, the SBV needs to clarify, at a well-chosen time, its standpoint to allow banks to declare bankruptcy, which will encourage the people to choose better-performing banks to deposit their money, instead of rushing to those banks offering high interest rates without weighing risks associated with such high rates.

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