VIETNAM'S INFLATIONARY CONUNDRUM

UNCLAS SECTION 01 OF 03 HANOI 001729 SIPDIS SENSITIVE BUT UNCLASSIFIED SIPDIS DEPT FOR EAP/MLS, EB/IFD, USAID/ANE, USAID EGAT/EG BANGKOK PASS TO RDM/A DEPT PASS USTR FOR D BISBEE SINGAPORE FOR TREASURY S BAKER DEPT PLEASE PASS FED RESERVE SAN FRANCISCO FOR A MAYEDA E.O. 12958: N/A TAGS: EFIN EAID ECON PREL VM SUBJECT: VIETNAM'S INFLATIONARY CONUNDRUM Ref: Hanoi 1475 HANOI 00001729 001.2 OF 003 ¶1. (SBU) Summary: Vietnam is not sure how to tackle growing inflation, which reached a 20-month high of 8.8% in September. Government efforts to maintain simultaneously a stable exchange rate, low interest rates and open capital markets run smack into the "impossible trinity" of economic theory. Most central bank officials and economists acknowledge the limitations with the more modest measures used to date to deal with rising prices. As inflation continues to mount, pressure will increase on the government to make a policy choice for a stronger dong, higher interest rates or capital controls. Exercising these options could make exports less competitive, raise the cost of doing business or exacerbate uncertainty in capital markets, respectively, affecting various constituencies, such as farmers, business people and investors, differently. Notwithstanding public pronouncements for a targeted depreciation, it appears that the government is keeping all options are on the table, including a more flexible currency, as a means to tame inflation. End Summary. VIETNAM'S IMPOSSIBLE TRINITY -------------- ¶2. (SBU) Vietnamese newspapers have been filled with reports about rocketing inflation, and the average Vietnamese person will confirm that the cost of daily existence has gone up. The most recent release from the General Statistics Office shows that inflation is at 8.8% for September, up from 8.6% in August and 8.4% in July. The Government of Vietnam has reacted to the public concern by cutting tariffs on food and other consumer goods (see reftel). The results of these cuts, however, have not been swift or significant, even with official efforts to follow through on whether sellers have passed on the benefits of lower input prices to consumers. The ineffectiveness of these supply-side measures has led to larger questions about Vietnam's macroeconomic management policy. It appears that Vietnam is facing the classic "impossible trinity" of open economies - the economic incompatibility of maintaining a fixed exchange rate, free capital movement and an independent monetary policy which fixes interest rates at non-market levels. A country can generally have two out of the three, but Vietnam is trying to have them all. The combination of a dong essentially fixed against the dollar and a low, fixed interest rate will be impossible to maintain over the long term as strong capital inflows into the Vietnamese markets will increase the upward pressure on inflation. What's Driving Inflation? -------------- 3.(SBU) There are various factors causing the general price level to rise in Vietnam, including increased domestic demand for goods and services, including imports, as the economy continues to expand combined with issues on the supply side. Vietnamese economists, however, have also pointed to the impact of another contributing factor as the country becomes more integrated with the global economy, namely, the inflow of foreign capital. Vietnam's young stock market and improved investment climate have attracted a flood of new money that has affected domestic prices. The Treasurer for HSBC reported that the SBV was "shocked" by the amount of foreign capital inflows coming into Vietnam starting in late 2006. Although there is no official number, various estimates by both the private sector and the Government of Vietnam put the amount of foreign portfolio investment into dedicated Vietnam-only investment funds at around five billion dollars. ¶4. (SBU) In the last quarter of 2006, foreign capital inflows began to increase substantially and create pressure on the dong to appreciate. In the first quarter of 2007, the government considered but refrained from the option of imposing capital controls. The State Bank of Vietnam (SBV) did, however, intervene to hold down the value of the dong with by its purchases of dollars. The government reinforced its policy further in this direction of a weak dong on June 25 when Deputy Prime Minister Nguyen Sinh Hung announced the target of a one percent depreciation in the exchange rate for 2007 to support exports. At the same time, the government has been targeting low interest rates to support growth. ¶5. (SBU) Letting the dong appreciate and raising interest rates on bank loans would have dampened inflationary pressures, but the GVN policy to hold the exchange and interest rates constant has left the government with few effective tools at its disposal. Thus, the SBV resorted to other instruments to try to attempt to control HANOI 00001729 002.2 OF 003 inflation. In May, the SBV raised the reserve ratio to 10 percent up from 5 percent for dong deposits up to one year and to 4 percent up from 2 percent for 12-24 month dong deposits. In July, the government reduced a range of import tariffs and retail fuel prices (reftel). On August 14, as inflation continued to rise, the SBV announced further measures: an increase in the 84-day T-bill yield of 25 basis points to 5 percent, and a new one-year T-bill and set yields at 7 percent. These bills, which earn what is essentially a negative real interest rate, were not big sellers and allegations abound that the SBV engaged in pressuring the commercial banks into purchasing them. As most economic analysts expect inflationary pressures to continue, the SBV's dilemma will become more difficult unless it changes the course followed so far with respect to a stable (and indeed weaker) exchange rate, a low interest rate, and relatively free flows of capital. Why is the GVN fixing currency and interest rates? -------------- -------------- ¶6. (SBU) GVN authorities have targeted a one percent depreciation of the dong in order to support exports, which account for 69 percent of GDP. The HSBC Treasurer emphasized that GVN officials are especially sensitive to a weak dong's positive impact on the competitiveness of Vietnam's agricultural exports. Market tools for hedging, such as foreign currency futures or commodity futures, are not well-developed or widely understood by local agriculture producers. Agriculture comprises 20 percent of GDP and employs approximately 55 percent of the labor force. Another economist from the Fulbright school added that income (unadjusted for inflation) in the rural areas has not been increasing over the past few years. As a result, the share of the labor force in agriculture has been dropping by about 2 percent a year since 2002 as labor has moved from rural to urban areas. Moreover, the GVN has made poverty reduction a central theme of its economic reform agenda, and as migration to urban centers increases, fostering the economy of rural areas has become increasingly important. Thus, the government is concerned that a stronger dong would make agricultural exports less attractive and hurt farmers. That said, the economist opined that Vietnamese authorities are not as wedded to a long term targeted exchange rate as Chinese authorities. ¶7. (SBU) Vietnamese authorities have also targeted a low interest rate to support growth. Interbank lending rates currently are approximately 6 to 7 percent, and lending rates are in the low to mid double digits. According to the Fulbright School economist, some influential voices in the business sector oppose an increase in interest rates as it would increase the cost of funding new and existing enterprises during a time of rapid economic expansion. What can the SBV do? -------------- ¶8. (SBU) The difficulty of balancing these competing interests becomes more apparent when speaking with the State Bank of Vietnam. Various SBV officials give conflicting assessments of the issue and of the State Bank's ability to control monetary policy in their meetings with Econoff and visiting Treasury Deskoff. Deputy Division Chief of Market and Exchange Rate of the Foreign Exchange Department Dao Xuan Tuan insisted that the exchange rate and interest rates stay on target and that the free flow of capital was the central problem. Without acknowledging Deputy Prime Minister Nguyen Sinh Hung's announcement of late June to the contrary, Dao further stated that the SBV is not targeting the dong to depreciate by 1 percent for 2007. Rather, he said, the SBV is seeking an exchange rate that would support exports but also take into account inflationary pressures. ¶9. (SBU) SBV'S Director of Monetary Policy Department Nguyen Ngoc Bao insisted that the SBV is fully addressing the problems of the "impossible trinity" and has the complete range of central bank tools at its disposal. Bao noted that the government is rethinking the official inflation policy which currently states that the inflation rate should be numerically below the real GDP growth rate. (Comment: this rule has no sound basis in economic theory. End comment.) ¶10. (SBU) In the most frank assessment, SBV Director of Banking Development Strategy Department Le Xuan Nghia (who is also an Advisory Expert of Prime Minister and Member of the Financial - Monetary Policy Advisory Council of Government) noted that to resolve the problem the GVN is likely to be more flexible with the exchange rate in the future. He implied that currently the Ministry HANOI 00001729 003.2 OF 003 of Finance (MOF) is trying to maintain both interest rate and exchange rate stability, failing to understand the "impossible trinity" that is binding Vietnam. As a likely sign of the institutional clashes going on behind closed doors between the MOF and SBV, he joked that the MOF thinks Vietnam can operate under "its own economic theory," eliciting outright laughter amongst his staff. ¶11. (SBU) Finally, in his first meeting with Ambassador Michalak on September 10, the new SBV Governor, Nguyen Van Giau, said that he was not concerned by the inflation issue in general because this year's inflation is not out of line with 2006 (6.6%),2005 (8.4%), or 2004 (9.4%). Local economists agree that there is no reason to panic, but believe that the situation is exacerbated by the SBV's lack of monetary tools. ADB Country Director in Viet Nam Ayumi Konishi recently observed that while strong economic growth will continue, the relatively high level of inflation calls for the Vietnamese Government's "close attention." So Who Really Makes Monetary Policy? -------------- ¶12. Despite various SBV statements to the contrary, local economists say that the State Bank suffers from capacity constraints and a lack of policy making ability. A high level official at the IMF in a meeting with Econoff and Treasury's Southeast Asia Financial Attache said that exchange rate policy is made by the Economic Council of the Communist Party, not the SBV. A Dragon Capital private equity managing director reiterated the same sentiment, noting that resolving the "impossible trinity" will be foremost "a political decision." The HSBC Treasurer elaborated, stating that the difficult decision on either letting interest rates rise (and hurting businesses) or allowing the dong to appreciate (and harming the agricultural sector) falls to the Politburo. He stated that GVN officials are seeking guidance from the Communist Party on which policy tool to put in place, and joked that "they're trying to avoid blame" and will not make a decision until they know they have political cover from higher ups. ¶13. (SBU) In addition, an economist at the Fulbright Economic School in HCMC stressed the capacity issues at SBV, stating that the SBV "is not used to these kinds of problems" and it is only now starting to think like a modern central bank on how to address these issues. Nevertheless, he expressed confidence that the SBV would have the ability to move quickly up the learning curve. Many private sector contacts agree that Prime Minister Dzung recognizes the capacity constraints of the SBV and wants to strengthen its analytical capacity and ability to formulate appropriate monetary and exchange rate policies. Most market participants expect new SBV Governor Giau, a Dzung loyalist, to support these plans. COMMENT -------------- ¶14. (SBU) Although the GVN appreciates that high inflation poses risks to Vietnam's economic performance, its response to date shows a reluctance to take any measures that would alter its current approach on the exchange rate, interest rate and capital flows. This may be changing. The continued growth in inflation, combined with economic and political concerns about it impact, shows that inflation is an economic issue that is not going away. Notwithstanding public pronouncements for a targeted depreciation, it appears that the government is keeping all options are on the table, including a more flexible currency, as a means to tame inflation. We will continue to advocate supply-side measures as well, such as increased listings of SOEs, as a preferred way to deal with the challenges of increased capital inflows. End Comment. ¶15. (U) Treasury Vietnam Desk Officer Susan Chun visited Hanoi and Ho Chi Min City August 7 to 21. This cable was coordinated with Chun, Congen Ho Chi Minh City and Southeast Asia Financial Attache Susan Baker. MICHALAK