Vietnam - Recalibration of policy needed

October 3, 2011



Recalibration of policy needed


As the spectre of stagnation appears on the horizon, it may be time for Vietnam to consider a different policy direction.




Stagflation occurs when high inflation exists in parallel with stagnating production levels. This situation is completely different from the common concern of expanding production and increasing total demand putting pressure on price levels. In Vietnam, the risk of stagflation has begun to rear its ugly head.


Apart from consistency in tightening monetary policies, it is necessary to emphasise the use of fiscal policy in a more assertive way to cut public investment and government spending, thus curbing inflation. Open market operations (OMO) and the mobilisation of reserve requirements will continue to be useful measures to slow-down the money supply. Now is also a time for gradual cuts in interest rates in order to re-establish the normal yield curve and terminate existing distortions in “black” credit markets as well as the unreasonable interest rate structure.


Lacking the support of a tight fiscal policy, monetary policy cannot by itself reduce interest rates effectively under present conditions. Aggressive injections of liquidity into the banking system to force administered low interest rates might result in more inflation by the end of 2011 and early 2012, like last year.


Inflation in August has cooled down to 0.9 per cent on a month-to month basis (but still a 23 per cent increase over the same period of 2010) and may go even lower in the following two months. Generally, though, inflation can then accelerate quickly again during the last two months of the year due to high consumer demand during the coming holiday season, and many are concerned that the annual inflation rate could come in at 19-20 per cent for the year.


Moreover, the tightening monetary policies that will be applied over the last four months of this year and possibly into 2012 place a burden on businesses and most enterprises. The Association of Small and Medium Entrepreneurs said that, since the beginning of the year, 30 per cent of entrepreneurs had closed their doors due to high interest rates and an inability to access the capital required for production. Despite support from agriculture, as experienced in 2008, the gross domestic product (GDP) in the second half of this year might slow to 5 per cent in our view.


Although tight monetary policy reduces demand in the private sector, it is not enough to reduce total demand in the economy, which is the main contributor to high inflation. According to the latest figures, the budget expenditure disbursed in the first eight months was “bloated”. Vietnam’s economy faces a common predicament of trying to balance inflation and economic growth.


Coordination between monetary and fiscal policies to deal with stagflation becomes more imperative than ever in the process of “policy assignment” to deal with inflation for the rest of 2011 and perhaps well into 2012. We can use the simple IS-LM model in macroeconomic theory to illustrate the current policy applications in Vietnam as well as a proposed change in policy assignment. A simplistic concept, it can be quite powerful in its policy implications:


1. The IS-LM model can be recalled as the most basic tool to show the impact of both fiscal (IS) and monetary (LM) policies on output (Y, or growth) and interest rate (r).


2. An expansionary fiscal policy as being consistently used in Vietnam throughout the year can be interpreted as tending to move the IS curve to the right, raising interest rate r and output Y (pushing high growth).


3. At the same time, the tight monetary/credit policy pursued since February 2011 also tended to raise interest rate r and reduce Y (through reduced aggregate demand).


4. The current high interest rates in Vietnam can be easily explained by both ongoing fiscal and monetary policies. Thus to deal with stagflation, we propose to use tight fiscal policy (move of IS curve to the left) to deal with inflation and help reduce interest rate. Meanwhile we can release gradually monetary policy (move LM curve to the right) to reduce interest rate and raise Y out of output slowdown.


5. The art is the adequate doses between these two moves. A drastic injection of liquidity into the banking system through OMO like the State Bank move last week might not be appropriate at all, especially as there is little sign of cutting budget expenditure. Both actions are quite contrary to the above policy prescription and might push the end-year inflation rate substantially, perhaps well above 20 per cent projected above under present conditions.


As for the case of Vietnam, the following specific action can be proposed:


- Making more definite and firm decisions on fiscal policies to reduce aggregate demand via less government spending, especially public investment.


- Monetary policy should become more flexible to lessen the role of reducing aggregate demand and enhance the role of stimulating stagnant aggregate supply.


- In the last five months of this year and into 2012, the central bank will rely more on OMO and capital mobilisation through required reserve rates, especially with foreign currency loans, to limit money supply. The State Bank should lower interest rates to re-establish the normal yield curve and remove existing distortions in credit markets and interest rates.


- The ceiling interest rate of 14 per cent should be removed to raise the role of the market mechanism in the banking system, rather than the imposition of administrative tools that come with many side-effects.


- The above policy coordination will reduce the crowding-out effect. New budget execution information through July shows that expenditure and revenue have increased markedly since the beginning of the year. More determined fiscal restraint should be applied. Many analysts said that it was hard to find “room” to cut spending because it was distributed among provinces earlier this year, except for projects that were set up for state-owned enterprises but have not found financing. We consider specific items in the budget estimates for 2011 as approved by the 12th National Assembly Legistature and suggest some corrections to certain specific items to reduce the budget deficit compared with GDP, for submission to the 12th National Assembly.


- To win back market confidence, the Ministry of Finance should carefully review “State Budget Estimates in 2011”. It should also apply resolute measures to reduce “spending on investment and development” from VND152,000 billion to VND140,000 billion and to reduce “spending on economic development, society, defense, security and administration” from VND442,100 to VND413,142 billion. This year’s budget deficit will then be cut by 33 per cent from the estimated VND120,600 billion to 79,642 billion, or from 5.3 per cent of GDP to 3.5 per cent of GDP.


* Dr. Chi is a Senior Economic and Financial Advisor.
He was formerly Senior Investment Officer and Senior Economist at the International Monetary Fund (Washington, D.C.), and Visiting Associate Professor, MBA Program, at American University. He was recently Deputy Managing Director and Chief Economist at VinaCapital Group in Vietnam.


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