Is Vietnam facing a currency crisis?

 
By Moody’s Economy.com
13-06-2008 


Investors have soured on Vietnam in recent months, sending the country’s benchmark stock index down nearly 60% and putting its economy increasingly at risk of foreign capital flight. Meanwhile, Vietnam’s year-to-date trade deficit in May — a whopping US$14.4 billion (RM47.52 billion) — exceeds the US$12.4 billion shortfall for all of 2007.

Is Vietnam headed for a currency and balance of payments crisis? A number of emerging market analysts have sounded the alarm, but currency speculators may get burned if they are betting on the kind of rout that brought down the Thai baht in 1997.

Though Vietnam’s black-market currency exchange rate has reportedly jumped to a record high of more than 18,000 dong (RM3.55) per US dollar — the official rate last week was 16,268 dong — Vietnam can still avoid a currency crisis if the government restores macroeconomic credibility by acting quickly and decisively.

It has done so before, from 1989 to 1992, when it launched bold and comprehensive reforms that squelched hyperinflation, drastically changing inflation expectations and increasing confidence in the domestic currency.

Granted, there is much to worry about: May CPI inflation soared to more than 25% year-on-year (y-o-y), driven largely by the sharp spike in food prices. A sense of déja vu and fears of skyrocketing inflation are causing individuals and merchants to hoard rice, cement and steel—a return to old habits formed back when annual inflation exceeded 60%.

This behaviour not only exacerbates inflationary pressure, creating intermittent shortages of key commodities, but it also has prompted a stampede into gold, the inflation hedge of choice. For this reason, the price of gold has tended to be a reliable proxy for the public’s assessment of the government’s ability to stabilise the economy.

Gold’s price in recent months underscores their stunning lack of confidence. Moreover, gold imports have risen sharply, aggravating the trade deficit. According to the World Bank, during the first four months of this year, Vietnam spent about US$1.2 billion to import 43 tons of gold.

The public’s mistrust is not surprising, given recent policy missteps. Even before putting in place the regulatory infrastructure needed for sound, stable development of the domestic financial market, the government accelerated the process of external liberalisation and failed to act quickly to prevent the economy from overheating. Instead, credit growth has shot up, and favoured state enterprises have been allowed to go on an investment spending spree. Consequently, the twin deficits in the balance of trade and fiscal budget have spun almost out of control. This year, the current account deficit as a share of GDP may rise to 7.8%, while the IMF projects Vietnam’s budget deficit to decline slightly to 6.6% of GDP from an estimated 6.9% in 2007.

The origins of Vietnam’s woes can be blamed in part on extreme swings in investor sentiment and the inexperience of Vietnamese policymakers who seem to not appreciate the dangers of a premature opening of the capital account. In 2006 and 2007, Vietnam was among Asia’s fastest-growing economies, and its stock market boom quickly acquired bubble dimensions. At its peak in March 2007, the combined capitalisation of the Ho Chi Minh City and Hanoi stock exchanges rose to nearly US$29 billion — more than 40% of GDP — from less than US$1 billion in 2005.

Investors were extraordinarily bullish in anticipation of Vietnam’s World Trade Organisation accession. The country was thought to be a prime investment destination and attracted huge flows of foreign capital. According to the World Bank, foreign direct investment inflows rose to an estimated US$6.7 billion, a little more than private remittances. To prevent this large inflow of foreign capital from driving up the value of the domestic currency, which would have undermined the country’s export competitiveness, the State Bank of Vietnam bought more than US$10 billion in 2007.

Unfortunately, the SBV’s effort to sterilise its interventions in the foreign exchange market were not successful, and the accumulation of reserves expanded the monetary base. The outcome was runaway credit growth, an overheating economy, surging inflation, and rapid deterioration in Vietnam’s external accounts.

An important indicator of the overheating has been the astonishingly sharp acceleration in import growth, especially relative to export growth. The latter has been curbed by the US downturn and subsequent slowdown in other developed economies. Import growth soared soon after Vietnam formally joined the World Trade Organisation in January 2007 and sought to contain inflationary pressures by accelerating the pace of WTO-mandated tariff reductions. Although this move was praised by the IMF, it not only failed to produce the desired results, it also contributed to a ballooning trade deficit.

The primary driver of import demand has been domestic enterprises, many of them state-owned. To analyse the sources of growth, Vietnam’s statistics office disaggregates import data by type of ownership. A distinction is made between imports by the FDI sector — enterprises that receive foreign direct investment and account for nearly 44% of industrial output and more than 50% of total exports — and imports by the domestic sector. The latest data show a sharp reversal in import share, with the domestic sector accounting for more than 70% of total imports in recent months.

Import costs have soared because of purchases of commercial aircraft and oil refinery equipment, as well as because of the sharp growth in imports of steel, machinery and equipment, petroleum, electronics, computers, and vehicles. During the first four months of this year, imports of iron and steel jumped by 153%, fertilizer by 165%, and automobiles by a whopping 333%.

To cool down the overheating economy, the government recently ruled that state-owned enterprises must obtain approval before investing in the financial and property markets. This is a step in the right direction to control overinvestment, and hence, the fast-growing trade deficit. Additional administrative measures may be needed to impose fiscal discipline. The central bank also should address the problem of negative real interest rates, which creates a strong incentive for domestic firms to borrow.

During the early 1990s, the Vietnamese authorities were able to bring down inflation and strengthen confidence in the currency by raising nominal interest rates sufficiently to ensure positive real rates of interest. It should do so again, quickly and decisively. In this regard, the SBV’s recent decision to raise the base rate to 14% from 12% is a positive step, although it is probably still not enough to restore faith in the currency.

A bitter lesson
Concerns are mounting about a currency crisis in Vietnam in the next 12 months. Yet the government should not have responded to these concerns by declaring that it has sufficient foreign reserves to defend the dong.

The bitter lessons of the Thais and Indonesians in 1997 are very clear: Even US$22 billion can be used up very quickly when the currency is under heavy pressure from determined and well-financed speculators. The only way to regain credibility is by employing serious tools to attack the roots of the problem, which are an overheating economy and excessive inflation.

Because the dong has been unofficially roughly pegged to the declining US dollar, Vietnam’s nominal effective exchange rate (NEER) has been declining, and the export growth rate has thus far risen appropriately. However, Vietnam’s inflation rate far exceeds that of its main trading partners, causing the real effective exchange rate (REER) to climb sharply, and, related to this, import growth has gone through the roof. The sharp divergence between the NEER and REER shows that it is the inflation rate that is hurting competitiveness, not the nominal exchange rate. The government should focus on attacking inflation by raising interest rates, a strategic move that would also blunt speculative pressure against the currency.

The central bank recently announced that the trading band of the dong will be widened and lowered the official exchange rate by 1.96% against the US dollar. Although greater exchange rate flexibility over the medium term may benefit the development of Vietnamese financial markets, it must be administered carefully during this difficult period.

The dong is set to weaken further in the near term, and a wider trading band would allow the currency to depreciate at a faster pace. This is a risky move, for it is likely to worsen inflationary pressures and lower confidence in the currency, setting off a self-reinforcing vicious cycle. The exchange rate depreciation could overshoot and cause greater harm to the economy.

To prevent a currency and balance of payments crisis, it is necessary that the government take a tough tightening stance. This could dampen growth in the near term, but the benefits outweigh the downside, as it would take an extended period for an economy to recover from a major crisis.

(quoted from theedgedaily.com)