assignment fin6633 group no 4.v2

8/4/2019 Assignment FIN6633 Group No 4.v2

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Group No. 4 P a g e | 0

VIETNAMESE FOREIGN EXCHANGEMBA TROY 4

INTERNATIONAL FINANCE

VIETNAMESE

FOREIGN EXCHANGE

INSTRUCTOR:

DR. ANAND KRISHNAMOORTHY

GROUP MEMBERS: NGUYEN THI HONG DIEP

TRAN MINH HAI

TRUONG MINH HOANG

MBA

TROY

GROUP No.4

MBA TROY 4GHANOI - AUGUST 24, 2011




VIETNAMESE FOREIGN EXCHANGEMBA TROY 4

CONTENT

1.Vietnam’s exchange rate regime: apparent official preference and supporting

mechanisms .................................................................................................................... 1

1.1. Preference for stability in the VND/USD exchange rate .......................................... 1

1.2. Mechanisms to support stability in the VND/USD rate ............................................ 3

2. Implications for development of the forex market .............................................. 7

2.1. Low volatility of the official exchange rate .............................................................. 8

2.2. Lack of interest in derivatives ................................................................................... 8

2.3. Minor role for interbank transactions and low market turnover ............................... 8

2.4. Dominant role of the SBV......................................................................................... 9

2.5. Illiquidity risk ............................................................................................................ 9

2.6. Incentives for transactions in the parallel market and dollarization ....................... 10

2.7. Non-transparency and inaccurate price signals ....................................................... 10




VIETNAMESE FOREIGN EXCHANGEMBA TROY 4G

VIETNAMESE FOREIGN EXCHANGE MARKET

The foreign exchange market (forex, FX, or currency market) is a global, worldwide

decentralized financial market for trading currencies. The foreign exchange market

defines the relative values of different currencies. The primary purpose of the foreign

exchange is to support international trade and investment, by allowing businesses to

convert one currency to another currency. The foreign exchange market has become more

and more important in the globalized economy. In the foreign exchange market, exchange

rate is one of the most important factors affecting international transactions. Different

countries have different exchange rate regime depending on their economy, currency,

politics and other factors.

This paper attempts to give some striking characteristics of the exchange rate regime

in Vietnam with apparent official preference and supporting mechanisms from the last

years of 1900s to 2011 and the implications for developments of the forex market.

1. Vietnam’s exchange rate regime: apparent official preference and supporting

mechanisms

1.1. Preference for stability in the VND/USD exchange rate

In the literature, the preference by some monetary authorities for a fixed exchange

rate regime is often provided a theoretical underpinning in terms of a stabilizing “nominal

anchor”, especially in the context of high inflation, rapid growth in monetary and credit

aggregates, and large government budget deficits. Under such conditions, an exchange

rate (ER) peg relative to a major foreign currency could serve as a suitable anchor,

especially in countries where the domestic government lacks a track record in policy

making that would establish its credibility with market participants.

It is not surprising that Vietnam has considered the U.S dollars (USD) a key

nominal anchor. Some of its most important trading partners, such as China, Hong Kong,

Singapore, Thailand and Malaysia, have generally preferred a stable ER relative to the

USD. Vietnam‟s own experience in reducing inflation during the first half of the 1990s





also served to underscore the benefits that an effective peg to the USD could bring. There

may also be a variety of non-economic (e.g, political or strategic) reasons for the

authorities to prefer a stable VND/USD exchange rate.

Trends in exchange rates

For the purpose of reviewing major trends in exchange rates, the author compiled a

set of data for nominal and real effective rates. Figure 1 illustrates annual movements of

the nominal VND/USD rate (of which a rise corresponds to a weakening of the VND)

from 1985 to 2008 whereas Figure 2 shows major trends displayed by the nominal

USD/VND exchange rate (expressed as an index), as well as the NEER and REER, over

the period 1992-2007 - annual data for NEER and REER are available only for 1992

onwards.





As can be seen from these figures, during the years 1992-1996, and again during

2004-2007, the USD/VND rate was very stable while the NEER and REER experienced

substantial changes. By contrast, during the initial Doi Moi years (1985-1991, shown in

Figure 1) as well as the Asian Financial Crisis and its aftermath (1997-2003) theUSD/VND rate indicated major weakening of the VND against the USD.

A closer examination of the four sub-periods indicates that, in an ex post sense, the

authorities apparently preferred a stable nominal USD/VND exchange rate whenever that

was feasible during the past two decades. There were two sub-periods (1992-1996, 2004-

2007) when the VND was effectively pegged to the U.S dollar, so that the path of

nominal effective exchange rate (NEER) was dictated by the strength of the U.S dollar

relative to the currencies of other trading partners. Similarly, real effective exchange rate

(REER) was determined residually given the values of NEER and the inflation rate

differential between Vietnam and its trading partners. As it happened, in both of the

above sub-periods, REER tended to increase, indicating a loss of competitiveness.

The other two periods (1985-1991, 1997-2003) were periods when, arguably, the

authorities had little choice but to allow large movements in the nominal bilateral

VND/USD rate. The former period covered the launch of the Doi Moi process while the

latter involved the Asian financial crisis and the implementation of trade liberalization

measures. It would appear that whenever such contingencies had passed, the authorities

would return to a relatively stable VND/USD rate.

1.2. Mechanisms to support stability in the VND/USD rate

The current exchange rate regime operates within the framework of an announced

official exchange rate and an allowable exchange rate band. These two devices have been

used to slow down, if not eliminate, short-term changes in the exchange rate, even when

there was strong market pressure for either a depreciation or appreciation of the domestic

currency. When the resultant commercial exchange rates failed to clear the market, as

they very frequently did, the authorities tended to rely on official intervention to meet

part of the imbalance between demand and supply, supplemented by moral suasion and





administrative measures.

Official exchange rate

Since 1999 the State Bank of Vietnam (SBV) has determined the average

VND/USD exchange rate on the interbank market on each banking day and announced it

as the official exchange rate on the following banking day. However, this determination

process has not been transparent and has contained to a large extent elements of the

subjective will of the SBV. In general, it can be expected that the bid-ask spreads in the

interbank market would be smaller than in the bank-client market. Thus, the average

interbank rate should be somewhere between the ask rate and the bid rate quoted in the

bank-client market. Yet in practice, the official exchange rate has frequently been set

below the bid rate quoted in the client market on the previous day.

Additionally, the announced average interbank rate has often appeared rather sticky

or even rigid, despite evidence of rapid developments in the market. For example, when

there was upward pressure on the exchange rate (i.e., the VND was depreciating) and

commercial banks consistently quoted their trading rates at the upper bound of the

allowed band, in principle the band should have moved up each trading day. Thus, the

average interbank rate should have increased daily by an amount equal to one-half of thewidth of the band. Historical data show, however, that it tended to increase slowly and

sometimes did not increase at all.

Allowable trading band

The trading band, within which commercial quotations are allowed to fluctuate, has

been quite narrow except for the periods around the 1997-1998 Asian Financial Crisis

and the 2007-2008 Global Financial Crisis (see Figure 3). It would appear that increases

in the width of the allowable trading band have been used mainly to respond to episodes

of strong pressure for the VND to depreciate. In particular, the repeated broadenings of

the band in 1997 and 2008-2009 allowed the VND/USD exchange rate to be adjusted

upward in response to major external shocks. When the immediate urgency had passed,

however, the band tended to be narrowed again.





The allowable trading band has been adjusted in terms of the official exchange rate.

In the period of 2008 and 2009, the allowable trading band was ± 3%, however, it was

widened from ± 3% to ± 5% in March, 2009 due to the sharp decrease of the exchange

rate in the Interbank market.

To implement Resolution No.02/NQ-CP of the Government on key solutions inguiding the implementation of the 2010 socio-economic development and to improve the

liquidity of the foreign exchange market, the State Bank of Vietnam (SBV) has released

an announcement on a new foreign exchange management regime. Accordingly, on

February 11th, 2011, under pressure of appreciating of USD, the SBV reset the official

exchange rate at 20,693 VND/USD and the allowable trading band was depreciated from

± 3% to ±1%. It was also announced that the SBV will manage the inter-bank average

exchange rate in a relatively flexible manner in the coming time. These measures will

create favorable conditions for decisively managing the exchange rates in line with the

foreign currency supply-demand condition and increase the liquidity of the market,

thereby contributing to controlling the trade deficit and facilitating the implementation of

a more active and flexible monetary policy.





Official intervention, administrative rationing

Given the operation of administered pricing, through the setting of both the official

exchange rate and the allowable trading band, frequent instances of non-clearance of the

market were unavoidable. By default, the SBV often found it necessary to intervene in

order to manage such market imbalances, aiming at keeping the exchange rate VND/USD

at the required level and within the allowable band.

During much of the period under study, the VND was under pressure to depreciate,

and there was a persistent excess demand for USD at the commercially quoted exchange

rates, which were already pushed to their upper limit. Accordingly the SBV had to sell

quantities of USD. Due to the need of conserving official foreign exchange (forex)

reserve, however, the SBV tended to meet only part of the prevailing excess demand, and

to use administrative arrangements to ration some of the available forex among potential

buyers.

In particular, only those commercial banks with short positions exceeding a certain

size could approach the SBV to buy foreign currency at the quoted exchange rates.

Moreover, the system allowed priority to be given to the importation of essential goods

(such as petroleum, fertilizer and medicine), and to commercial banks that servecustomers engaging in these priority activities (Tran Nga 2008). This means that other

customers must turn to the parallel black market or other ad hoc channels to address their

unmet demand for USD - or just wait.

There were, of course, some periods when Vietnam also experienced pressure for

the domestic currency to appreciate. For example, due to a surge in capital inflows in

late-2007 and early-2008, the SBV faced the dilemma of whether or not to intervene in

the forex market to prevent the VND/USD exchange rate from falling. The Bank‟s

handling of this episode suggests that, in comparison with China, Vietnam‟s monetary

authorities may have been less inclined to intervene fully in the forex market even when

the domestic currency was subject to appreciating pressure.

Discussions in the domestic Vietnamese literature acknowledge that the SBV was





confronted at the time with a number of conflicting macroeconomic objectives. On the

one hand, if the exchange rate were allowed to be more flexible, an appreciation of the

VND would ensue and this was considered harmful to the country‟s external

competitiveness. On the other hand, if the SBV were to maintain the prevailing exchangerate by buying foreign currency, this could add to the growth in money and credit, with

potentially inflationary consequences. In the event, the SBV chose to adopt a

compromise, halfway approach. The VND/USD exchange rate was allowed to fall, but

not too sharply. At the same time, with commercial exchange rate quotes straining at the

lower bound, the excess supply of foreign currency was considerable and many

participants were unable to convert USD proceeds into VND.

2. Implications for development of the forex market

The current exchange rate regime has been described by the authorities as a

managed float. In principle, under a managed float, the exchange rate is determined by

market forces, and the government‟s influence on this rate is effected only through its

own purchases and sales in the forex market (Moosa, 2004). In the case of Vietnam, the

justification for the term „float‟ being in the above description is that the SBV no longer

sets the official ER, but simply „notifies‟ the average interbank rate determined on the

preceding business day through the interaction between supply and demand in the

market. The regime is „managed‟ in that the exchange rate can move only within a

stipulated band, the SBV remains a major participant in the market and various forms of

administrative exchange controls and rationing are maintained. As mention in previous

section, in practice the system has tended to rely so heavily on the „managed‟ part that

perhaps the term „adjustable peg‟ might be a more appropriate description – at least, in a

de facto sense. In any case, it is clear that the nominal VND/USD rate has frequentlybeen sticky if not completely stable. In turn, such stickiness has brought about a series of

linked structural and operational deficiencies of Vietnam‟s forex market as presented

below.





2.1. Low volatility of the official exchange rate

The official VND/USD exchange rate has followed a gradual upward trend with

very little volatility except for the periods of the Asian Financial Crisis and the recent

World Financial Crisis. This gives rise to a high degree of predictability and an

expectation among market participants that the SBV will frequently intervene to limit

volatility in the official rate.

2.2. Lack of interest in derivatives

The low volatility of the exchange rate, coupled with the one-way nature of most

daily movements, means that businesses generally perceive little foreign exchange risk.

As a result, there is little incentive for market participants to develop greater

sophistication in terms of ability to form views regarding the future paths of the exchange

rate, or to manage exchange rate risks.

2.3. Minor role for interbank transactions and low market turnover

The gradually rising and “sticky” trend of the exchange rate VND/USD provided

little incentive for dealers from commercial banks to form views on the path of the

exchange rate, take position or manage risk in the interbank market. Instead, they would

concentrate on providing intermediary services to businesses, endeavoring to make their

forex positions squared within their own customer base. This explains why the bulk of

forex transactions have been spot transactions between banks and their clients, rather than

interbank swaps and forwards which tend to dominate forex markets internationally.

The small size of the interbank market in Vietnam suggests that it has not served

well as a place for market forces to interact, thus poorly performing its price discovery

function.

Further, the limited role of the interbank market also implies a low turnover for the

entire forex market. Daily total turnover on Vietnam‟s forex market increased seven-fold

from around $20 million in 1995 to around $150 million in 2006. In spite of such

seemingly remarkable growth, the market has remained very small compared with forex





markets in other countries. This can be appreciated by comparing the size of a forex

market to the relevant country‟s international trade volume.

2.4. Dominant role of the SBV

Given the fact that the targeted official exchange rate has been kept stable for long

time and the trading band has been quite narrow, the SBV has been required to stand

ready to respond to instances of non-clearance of the market. Naturally, the SBV has

become the dominant player in the interbank market.

The inference about the SBV‟s role is well supported by available data. In the four

years 1999 to 2002, the transaction volume involving the SBV was estimated to be 29%,

65%, 68% and 60% of the total interbank market turnover respectively (SBV 1999, 2000,

2001, 2002). The corresponding figure for 2004 was perhaps as high as 85 percent.6

These data also suggest that, if putting those transactions conducted by the SBV aside,

the actual inter-bank market has been very limited indeed.

The limited trading in the interbank market with the dominant role of the central

bank would obviously point to the fact that commercial banks will turn to the interbank

market only when necessary in order to square or re-establish their desired position.

2.5. Illiquidity risk

Market participants in Vietnam have experienced frequent bouts of extreme

illiquidity. The operation of the forex market has depended on the intervening activities

of the SBV. Because of the VND‟s long-term depreciating trend relative to the USD, it is

not possible for the SBV to fully meet the excess demand for USDs on a sustainable

basis. Partial or zero intervention, however, implies prolonged excess demand and market

illiquidity: when the commercially quoted exchange rate is already at its highestallowable level, supply simply dries up, as banks and other market participants have little

incentive to sell.

Periods of market illiquidity represented times of difficulty for corporate customers

in conducting forex transactions. It is interesting to note in this connection that, at times,





the risk of exchange rate changes has been transformed into a risk of illiquidity, in that it

may become impossible for a bank customer to buy or sell foreign currency at the quoted

rates.

2.6. Incentives for transactions in the parallel market and dollarization

The parallel (black) forex market has always been a part of contemporary business

life in Vietnam: its existence predated the 1980s economic reform process. While, in a

strict sense, transactions in this market have always been illegal, the long-running excess

demand for USDs ensures its continued existence. As mentioned earlier, there have been

cases where corporate customers had to resort to transactions with much higher prices in

the informal parallel market when doors in the official market were all closed. Anecdotal

evidence provided to the author suggests that some bank customers have begun to search

for and deal with each other directly, often with the assistance of commercial banks. Thus

the current framework of regulations has actually created opportunities for the parallel

market to exist and have its continual substantial impact though it is illegal and the SBV

aims to narrow its influence.

2.7. Non-transparency and inaccurate price signals

With circumventing activities, forex transactions have often been conducted at rates

that were substantially different from the quoted commercial rates. However, these

actually applied rates would not be officially reported with the related transactions due to

their illegality. Such a market could hardly provide accurate price signals for market

participants and policy makers. An implication of this is that exchange rate data that are

available from official sources (including the SBV and IMF) do not fully reflect market

realities. Any use of these data for economic analysis might lead to biased results.

- The End -

assignment fin6633 group no 4.v2

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