News Room - Business/Economics

Posted on 28 Jul 2008

Vietnam faces tough inflation fight

After almost two decades of successful development, Vietnam's economy is being ravaged by inflation and macroeconomic instability as never before. How did this happen and what remedies are available to deal with it?

The country's successes are well documented. Vietnam's sizzling growth over the past 15 years has brought its poverty rate down from 58% in 1993 to around 15% last year. Thanks to political stability and prudent macroeconomic management, it has also managed to lure foreign investors. Foreign direct investment (FDI) approvals have increased impressively, reaching US$20.3 billion last year.

However, the recent surge in inflation to double-digit levels could unsettle foreign investors and threaten the development gains made to date if not contained. Thus for Vietnam, the choice is clear: it should restore macroeconomic stability rather than try to pursue high growth.

While many countries in the region are also experiencing high inflation rates, the increase has been abnormally high in the case of Vietnam. The year-on-year consumer price index (CPI) reached a record 26% in June. This was mainly due to the rapid rise in food prices, but even core inflation (which excludes food and fuel) is estimated to have increased 15%.

Some of the causes of Vietnam's high inflation are externally induced, but others are home-made. For an open economy such as Vietnam, dramatic increases in the international prices of food, fuel and construction materials have a large impact on domestic prices.

For instance, the export price of Vietnamese rice more than doubled within just three months, to around $700 per tonne in March. This helped to push domestic rice prices upwards as well. Food prices were also adversely affected by a severe winter, avian flu and livestock diseases. Food inflation quickly permeated into non-food areas as well. The prices of housing and construction materials increased as demand for houses, industrial and commercial complexes remained strong as a result of high investment.

Vietnam's exchange rate system, which is a de facto peg to the US dollar within a narrow band, compounded the inflationary problem. Preserving export competitiveness required that the booming foreign investment inflows last year be "sterilised" to prevent dong appreciation. Accordingly, the State Bank of Vietnam (SBV) purchased large amounts of foreign currency from the banking system. The move, however, was not enough to fully sterilise the liquidity inflows to the economy, leading to large monetary expansion.

The excess liquidity in the system combined with the rapid expansion of the joint stock banks, resulting in a sharp acceleration in domestic credit (by 54% last year compared to 29% in 2006) mostly to the real estate and securities sectors. Such a pace compromised banks' loan appraisal procedures as well as their credit quality.

Thus, the unsterilised liquidity inflows, unusually high domestic credit growth, expansionary fiscal policy, and aggressive public investment were the principal home-made causes of Vietnam's high inflation.

Signs of overheating The signs of overheating of the economy are evident in infrastructure bottlenecks (such as severe electricity shortage and congested roads and ports), a tight labour market - with skilled and semi-skilled labour supply falling far behind demand - and a sharp widening of the trade and current account deficit. The trade deficit in the first half (around $15 billion) was already higher than for the whole of last year ($12 billion), while the current account deficit is running at an alarming level of around 10% of GDP.

It is little surprise, therefore, that the non-deliverable forward rate of the dong in offshore markets is considerably more depreciated than the official spot rate, indicating that the dong is under heavy downward pressure. As people hedge against high inflation, there are indications of liquidity being converted into gold.

Under such circumstances, curbing inflation, restoring macroeconomic stability and engineering a soft landing of the economy have become the most important tasks facing Vietnam's government.

Government response Appropriately, the government in February and March switched its priority from pursuing high growth to macroeconomic stability with a downward adjustment of growth target from 8.5-9% to 7% for this year. The government also announced its plan to pursue tight monetary and fiscal policies, cutting back state expenditures and public investment projects with a view to reducing trade deficits.

The prime interest rate has been raised three times to reach 14% on June 11. The credit growth ceiling for the commercial banks has been set at below 30% for the year and their credit for real estate and stocks has been restricted to 3% of their total loans outstanding.

The reserve requirement ratio (the proportion of deposits banks hold in the form of cash reserves) has been increased significantly from 5% to 12% effective from June 27. Banks have been required to purchase central bank bills worth about $1.3 billion in a move to mop up cash from the banking system.

By way of maintaining exchange rate flexibility, the daily US dollar/dong trading band has been doubled to plus or minus two percent from the prevailing official rate.

Administratively, the price freeze on several essential goods and services has been extended to the end of the year.

Thanks to all of these measures, there are some signs of inflation easing. The credit controls and cuts in investment projects have also brought imports down, helping to reduce the trade deficit from nearly $3 billion in May to $1.3 billion last month.

But concerns remain about whether these measures will be enough to bring inflation to a manageable level. For instance, sales of SBV bills have been insufficient to slow credit growth. There may therefore be a need for further interest rate hikes.

Considering that the pegged exchange rate has limited the central bank's degree of monetary management, a greater degree of exchange-rate flexibility (with due consideration for export competitiveness) could be an option to improve the effectiveness of monetary policy and neutralise the inflationary impact of capital inflows. On the fiscal side, more cuts in public investment projects (on top of those already announced) may be needed. Off-budget investment projects also need to be reined in. And portfolio capital flows and interbank transactions may need to be closely monitored.

Good mid-term outlook Exposure to global markets has inevitably complicated Vietnam's macroeconomic management. Notwithstanding tighter monetary and fiscal policies, inflation this year is expected to remain high. While it may slow next year, it will still be at double-digit levels. Thus the immediate economic outlook is volatile.

However, healthy FDI inflows during the first quarter of this year and unabated inflows of remittances (expected to reach around $8 billion this year) are among the signs that investors are giving the government's anti-inflationary policies the thumbs up.

If these policies are strongly enforced, and demand pressures and inflation brought under control, Vietnam's prospects for sustained growth in the medium term will remain good.