MINISTRY OF EDUCATION AND TRAINING STATE BANK OF VIETNAM BANKING ACADEMY OF VIETNAM VU MAI CHI INTEREST RATE TARGETING OF MONETARY POLICY OPERATION IN VIETNAM MAJOR : BANKING AND FINANCE CODE : 9340201 SUMMARY OF DOCTORAL THESIS IN ECONOMICS HANOI - 2019 THIS THESIS IS COMPLETED AT BANKING ACADEMY OF VIETNAM Supervisors: Dr Bui Tin Nghi Banking Academy of Vietnam Dr Vo Tri Thanh Central Institute for Economic Management Referee 1: Referee 2: Referee 3: This thesis will be examined byExamnination of Banking Academy of Vietnam at The thesis can be found at: - National Library of Vietnam - Banking Academy Library on the of in the year 2019 LIST OF WORKS RELATED TO THE THESIS HAS BEEN PUBLISHED A Scientific articles, scientific proceedings Vu Mai Chi (2016), "State Bank of Vietnam’s operation of reserve requirement instruments in the recent time and some recommendations", Financial & Monetary Market Review Vol 15, 2016 Ha Thi Sau, Vu Mai Chi (2016), "Using open market operations for development of Vietnam’s monetary market", Vietnam Banking Review Ha Thi Sau, Vu Mai Chi (2018), "Banking inspection and supervision for the restructuring of credit institutions and assurance of the safety of operation of Vietnam's banking system", Proceedings of the Scientific Conference May, 2018 Vu Mai Chi, “Non- traditional monetary policy to enhance the effectiveness of interest rate transmission channel, implication for Vietnam to improve monetary policy” International Conference: "Evolution of Monetary Policy Framework after the Global Financial Crisis", December, 2017 Vu Mai Chi, “The effectiveness of interest rate transmission channel in Vietnam” Vietnam Socio-Economic Development, Vol 92, 2018 Vu Mai Chi (2018), "Evaluating the transmission mechanism of the State Bank of Vietnam’s monetary policy over the recent time", Vietnam Banking Review, Vol 16 August 2018 Ha Thi Sau, Vu Mai Chi (2018), "Banking inspection and supervision operations of the State Bank Vietnam and some recommendations", Banking Science & Training Review, Vol 195, August 2018 Vu Mai Chi, Tran Anh Quy (2018) "Bad debt handling in Vietnam over periods: Concerns and recommendations", Vietnam Banking Review, Vol 21, November 2018 Vu Mai Chi (2018), "Macro safety policy framework: World’s experiences and recommendations for Vietnam", National Conference Article, 2018 10 Vu Mai Chi (2019), "The framework for operation of the State Bank’s monetary policy from 2012 to present: Some judgments and recommendations", Financial & Monetary Market Review, No 20, 2019 B Research Projects Nguyen Thi Hong (2015), "Improving the operation efficiency of open market operations", Code: DTNH.02 / 2014 of State Bank, Sectorial Research Project (member) Pham Chi Quang (2018), "Monetary policy transmission mechanism for period 2006 -2016: Basis for formulation of a framework for monetary policy operation in Vietnam", Sectorial Research Project (member) Nguyen Tuong Van (2019), Financial education – World’s experiences and policy recommendations for Vietnam, Sectorial Research Project (member) Ngo Kim Thanh (2019), Flexible Inflation Targeting (FIT) and implications to Vietnam's policy framework, Grassroots Research Project (member) INTRODUCTION The necessity of the research Monetary policy has been always a magnet for scholar interest in a global scale, as the recent years have seen a variety of research works delving into the selection of operational targets that intensify the effects and efficacy of monetary policy, thereby enforcing the roles and intervention of State Bank in the economy - finance and monetary markets Theoretically, subject to the movements of the monetary market and specific national economic environment, state banks may choose different operational targets including monetary aggregates (credit, money supply) or price (interest rates, exchange rates) and adopt monetary policy instruments to achieve these goals, In previous decades, monetary controls and regulation of the ability to supply credit to the economy proved a contributory efficacy against inflation However, parallel to the faster evolution of the market economy, the link between monetary indicators and inflation and economic growth as the ultimate goals has turned weaker This explains why the Central Bank of developed countries (namely America, England, Germany, Japan) and developing countries (Thailand, Malaysia, etc.) have put down the monetary aggregate targeting and shifted to the price targeting (interest rate targeting) In deed, they admirably succeeded in constraining the inflation and stabilizing the economic growth In those countries pursuing an inflation targeting framework (such as Australia, Canada, Finland, New Zealand, Spain, Sweden, England), monetary policy makers also use interest rates as the key variable to achieve the target inflation rate In the Vietnam’s context, on the other hand, State Bank of Vietnam mainly have pursued the money supply targeting of the State Bank's monetary policy, particularly: (i) Before Vietnam’s admission to WTO (2001-2006), the State Bank of Vietnam (State Bank) basically aligned its monetary policy along money supply targeting and prioritized economic growth as the ultimate goal upon annual approval of the National Assembly (about 7-8% / year in average), rather than persevering in attempt to constrain inflation; (ii) From 2007 to 2011, State Bank's monetary policy persisted in the monetary aggregates with an inclination to economic growth without long-term orientation and perseverance in inflation control Nonetheless, under the pressure of Vietnam's deeper integration regionwide and world-wide, the domestic economy was generally exposed to the fluctuations of capital flows and prices in the international market, which weakened the curb of State Bank on monetary indicators Although the monetary policy in this period somewhat succeeded in accelerating the economic growth, such thriving was not stably maintained over the years, Typically, in the 1970s large industrial countries such as the US, UK, Germany, selected money supply targeting (M1, M2, or credit growth) to deal with the highest inflation after World War II and the collapse of Bretton Wood System due to swelling demand for loans in many countries and deficit of current account in the US as inflation hiked and interest rates climbed, which lead to monetary market unrest Production and business faced hardship, especially during the global financial crisis (2008) (iii) From late 2011, in compliance with Resolution No 11 / NQ-CP on major solutions for controlling inflation, stabilizing the macroeconomy and ensuring social security, the State Bank step by step tried combining the monetary and price channels (interest rate, exchange rate) of monetary policy by issuing at the year beginning State Bank’s Directive 01 on orientation for M2 growth, credit, reduction of deposit and lending interest rates and commitment of exchange rate adjustment As a result, the monetary policy solutions proved their proactive and flexible effects and appropriateness to the actual situation Inflation dropped from double digit (8.13%) at the end of 2011 to 2.66% in 2016, marking the longest period of inflation calmness in the last decade This greatly helped maintaining the macroeconomic stability and supporting economic growth (from 5.25% in 2012 to 6.21% in 2016) (iv) Since 2017, the world and domestic economy has recovered under favorable conditions such as low inflation, high international payment balance; but monetary policy has encountered new challenges coming from the fluctuation of exchange rates under the devaluation and fierce vacillation of currencies in Vietnam’s reference basket This, on one hand, impacts the competitiveness, and on the other hand requires to maintain the macroeconomic and financial stability against a vulnerability worsened by a high economic openness As such, the monetary policy would further head for a synchronous and flexible combination of M2 controls and curbs on credit at an appropriate level, constraint of inflation, more attention to a proper meditation of VND liquidity, in order for a stabilized foreign currency market and exchange rates This sometimes lead to some upsurge or sharp fall of market short-term interest (2016 – months / 2018 ) against a steady low inflation level This revealed how the State Bank's current monetary policy is confusing and inconsistent with the interest rate-targeting approach Driven by the successes achieved in period 2011-2016 and pressure of the deeper economic integration and exposure to external shocks, many international think tanks and experts2 recommended Vietnam to make a complete transition from monetary to interest rate channel of monetary policy, so as to control and maintain a low inflation level in the long term Moreover, the increasingly growing and changing financial and monetary markets require a more flexible monetary policy of the State Bank 3, and reduction of administrative interventions, so that the market can develop in its natural way and become an effective capital supply channel that transmits the effects of monetary policy and regulate market interest rates Besides, recent movements of interest rates revealed that the economic IMF (2014) recommended SBV to keep improving the operation of monetary policy towards increased role of price signals (mainly interest rates) in the economy Focusing controls on the money supply limited the proactivity of the State Bank in regulating the market, which may cause fluctuations of market interest rates, especially interbank rates reactions to changes in interest rates have appeared abundantly parallel to the acceleration of financial market, while credit institutions have become more responsive and caught up on State Bank's interest rate signals On the other hand, the 4th Industrial Revolution 4.0 outbreak over all aspects of life along with the birth and growth of new Fintech-based financial and banking services that can substitute the functions of money has shaken the linkage between monetary indicators and economic growth and inflation In replacement, price (interest rates) signals will be the key factor for Central Banks to achieve their monetary policy goals Based on the above judgments and pursuant to the two key tasks of the State Bank's monetary policy as outlined in the Development Strategy of Vietnam Banking Sector to 2025, with Orientations to 2030, which was issued under Decision No 986 / QD-TTg dated August 08, 2018 of the Prime Minister: (i) "To complete a monetary policy framework that aims to control inflation, stabilize the currency value, contributing to maintaining the macroeconomic stability, creating conditions for raising the efficiency of mobilizing and allocating the capital sources in the economy, promoting sustainable growth; Increasing the independence of the SBV in the management of the monetary policy”; (ii) “To redirect the regulatory channel of monetary policy from money supply to interest targeting; using indirect instruments toward gradual elimination of interest rate administrative interventions as practicable; continuing open market operations as the primary tool that mediates the available capital of credit institutions, in order to achieve the monetary policy goals from time to time", it can be said that an in-depth exploration of the transition into interest rate targeting of monetary policy should be conducted, in order to enhance the effectiveness and efficacy of the monetary policy That is why the PhD student take "Interest rate targeting of monetary policy operation in Vietnam” as her doctoral thesis title The thesis will focus on analyzing and evaluating data, verify the transmission mechanism of the interest rate targeting, thereby assessing the feasibility of operation of the target rate in Vietnam, comparing empirical findings in Vietnam’s context with international evidences, and eventually recommending solutions Literature review 2.1 Foreign researches - Many foreign studies have pointed out the shortcomings of money supply targeting (i) The correlation between monetary supply and the ultimate targets (inflation, growth) and interest rates became increasingly weaker and brittle (Goldfeld and Sichel, 1990; Benati and Frederic S Mishkin-2000, Enzo Croce and Mohsin S Khan -2000, Don Nakornthab-2009, argued that the more the financial market grows, the less sustainable the relations among monetary targets (such as M2 growth, credit) and ultimate targets of inflation and economic growth become Therefore, it is necessary to think twice about using monetary indicators as the target of monetary policy Goodhart, 2010; Lucas Jr and Nicolini, 2015) Hagen and Hofmann (2009) identified the increasingly feeble link between inflation and economic growth, implying that signs of inflation pressure from money supply growth or economic growth viewpoint has been nullified Frederic S Mishkin (2000) analyzed the money supply channel of monetary policy in countries (USA, England, Canada, Germany, Switzerland) from 1970 to 1980 and found that the pursuit of monetary supply control was rather ineffective due to the loose tie between monetary indicators and inflation and growth Mishkin and Savastono (2000) pointed out drawbacks of money supply targeting, especially in the context of low inflation and an escalating financial integration; (ii) Money demand function becomes less and less reliable: Bahmani - Oskooee and Rehman (2005) studied seven Asian emerging countries and found that many of them had an unstable money demand, namely Malaysia, Pakistan, Philippines and Thailand Hassan, Ali and Dawood (2016) examined the money demand function in Pakistan between 1972 and 2013 and concluded that the money demand function became unstable and susceptible to various macroeconomic factors Jiranyakul, K and Opiela, T.P (2014) argued M1 fluctuations were provisional, so it was difficult for Thailand to use M1 as an intermediate target Avouyi-Dovi, Drumetz and Sahuc (2012) proved the instability of money demand function in the Euro zone Wei Liao and Sampawende J.-A Tapsoba (IMF, 2014) argued that the rapid development of a market-oriented financial system lead to the instability of money demand function and a faster interest rate liberalization in China - Researches share a conclusion on recommendation for Central Banks to redirect their monetary policy toward price (interest rate) targets against the context of well controlled inflation, higher advancement of financial & monetary market and deeper international integration: William Poole (1994) concluded constraint of money supply was important to deal with high inflation of 20%, 50% or 200%, but for low inflation, the relation between money supply and inflation became unreliable Cagan (1956) found that in a hyperinflation period, the latency of money supply’s effects on inflation could be just a few weeks Kerstin Mitlid and Magnus Vesterlund (2001) stated that under a developed ground of financial market, technology and payment systems, monetary policy tended to influence the monetary market interest rates through overnight interest rates rather than via the supply of money Ho (2008) emphasized the constant effort of both developed and developing countries to research and complete their interest rate targeting Maehle (2014) said that monetary indicators would be gradually replaced by price (interest rate) targets through a cross-check mechanism of price targets (interest rates) Bindseil (2016) reaffirmed the importance of an interest rate corridor and short-term interest rate targeting for an effective organization of money market - Investigations into regulatory experiences of developed and emerging countries revealed that most countries choose interest rates as the pillar for their new monetary policy framework: the US Federal Reserve (Fed) focused primarily on interest rate targets The Bank of England (BOE) removed the monetary supply targets and used interest rates as the base for implementation of an inflation-targeting monetary policy framework (1990) At the same time, European Central Bank (ECB) and Central Banks of industrialized countries with thriving financial markets (New Zealand, Sweden, etc.) also inclined to interest rate targets when realizing their monetary policy The Central Banks of Malaysia, Thailand, Philippines and South Korea also used monetary policy instrument to influence the economy through market principles (prices) - Most of countries that adopt the inflation-targeting monetary policy framework often considers interest rates as the main and critical transmission channel that mirrors regulatory signals: Don Nakornthab (2009) concluded that since the 1997 -1998 crisis, Thailand has shifted to the inflation targeting monetary policy framework and used policy rates to influence the short-term market interest rates Works of Hannan and Berger (1991) and Neumark and Sharpe (1992) concerning interest rate adjustments in the United States banking were developed by Cottarelli and Kourelis (1994) and Borio and Fritz (1995), pointing out a delayed efficacy of interest rates in short-term, but flawless transmission of effects in long term Mojon (2000), Toolsema et al (2001), De Bondt (2002), Sander and Kleimeier (2004) and De Bondt (2005) concerning the Euro zone argued that the transmission of effects from monetary market interest rates to banking rates is not optimal Kwapil and Scharler (2010) used the Engle-Granger cointegration method and autoregressive distributed lag (ARDL) model to point out a faster transmission of the interest rate targeting in the US than that in the Euro zone - All studies on the influence mechanism and efficacy of monetary policy via channels, especially interest rates, used VAR models as methodology: normal VAR, structural VAR (SVAR), FAVAR A variation of VAR model, which is Vector Error Correlation – VEC, was particularly preferred Disyatat and Vongsinsirikul (2003) estimated the original VAR model using classic variables such as output, inflation, base rates, exchange rates per quarter during period 1993-2001 of Thailand Poddar, Sab and Khachatryan (2006) researched on the effects of monetary policy on a small economy like Jordan by running the VAR model for period 1996-2005, using fixed variables such as output, foreign exchange reserves, interest rate difference between local currency and USD Fed San Francisco Fed also used FAVAR model to evaluate the efficacy of China’s monetary policy in period 2000-2011 It was common that studies based in small open economies used SVAR, for examples: Cushman and Zha (1997), Brischetto and Voss (1999), Dungey and Pagan (2000), Parrado (2001), and Buckle et al (2007) 2.2 Domestic researches - Domestic researches indicated a loose relation between monetary targets and inflation and recommended for reliance on interest rate targets: Hung and Pfau (2008) said that M2 causally impacted on output but did not on inflation during period 1996-2005 IMF (2003, 2006) concluded on the that instable influence of M2 with about 12 -month latency on inflation Minh (2009) and Nguyen and Nguyen (2010) argued M2 had negligible impacts on CPI with a latency of about months or longer Camen (2006) supposed that M2 growth explained less than 5% of inflation fluctuations during period 1996 -2005 This is due to the instability of money demand function Christopher Adam, Michael Goujon and Sylviane Guillaumont Jeanneney (2003) concluded on an inclination of industrialized countries to put down monetary targets and take up interest rates Ha Huynh Hoa (2010), Le Thanh Tung (2015) demonstrated an one-way causal relation from interest rates and exchange rates to money demand and the one-way causal impact of money demand on growth which was represented by high inflation risk Bui Van Hai and Tran Thi Minh Trang (2015) noted interest rates and money demand as two important factors affecting output - Previous studies focused on analyzing the relationship between monetary policy and macroeconomic policies, post-crisis experiences and solutions for improvement of monetary policies: Nguyen Thi Kim Thanh 2004, Duong Thu Huong 2005, Nguyen Ngoc Bao 2008 examined the relationship between macro accounts and monetary policy establishment and operation against the context of capital transaction liberalization Some researchers dissected the use and improvement of monetary policy instruments and transmission of monetary policy effects (Nguyen Thi Kim Thanh 2005; Tran Thi Loc 2002) Ha Thi Sau (2016) delved into the credit risk channel of credit institutions to explain the transmission of monetary policy’s impacts on the ultimate goals in the wake of the financial crisis Chu Khanh Lan (2017) investigated the unconventional monetary policy applied by Central Banks of some developed countries - Unlike this thesis, recent studies were inclined to application of inflation targeting monetary policy framework: previous studies such as Tran Thi Loc; Nguyen Van Ha (2007); Nguyen Huu Nghia (2005), Do Thi Duc Minh (2006) Typically, To Anh Duong et al (2012) measured the feasibility to apply the inflation targeting framework, conditions and roadmap for application in Vietnam Recently, Vo Tri Thanh (2016) and Nguyen Thi Hien (2016, thesis) have evaluated the monetary policy framework of Vietnam and the benefits as well as conditions needed for the transition to the inflation targeting framework - Related studies often focused on assessing and analyzing interest rate policies or impacts of State Bank’s regulatory interest rates without insights into the practice of regulatory target selection: To Kim Ngoc (2003, thesis) examined the efficacy of Vietnam’s monetary policy via the use of State Bank's interest rate instruments in period 1995-2002 Nguyen Ngoc Bao (2005, thesis) revealed the impacts of interest rate policies on macroeconomic variables Nguyen Thi Kim Thanh (2010) probed the impacts of real interest rates on economic growth using OLS model To Anh Duong (2015) implied the bigger role of interest rates in transmission of monetary policy’s effects and a greater sensitivity of investors to interest rates Work of Duma and Ha Nga (2013) argued that the efficacy of interest rate channel was still weak while the lending interest rates were more and more responsive to State Bank's interest rate policies, against the declining impacts of the credit channel Nguyen Thanh Nhan (2016, thesis) has recently analyzed the efficacy of interest rate channel in monetary policy of Vietnam in period 2006-2015 Bui Quoc Dung (2017) provided quantitative and qualitative evaluation of the transmission mechanism of monetary policy in Vietnam in general and efficacy of interest rate channel in particular - Quantitative studies often used VAR models to assess the efficacy of monetary policy through channels: Le and Pfau (2008) developed a VAR model and found no significant impacts of interest rate channel, yet a strong influence of money supply on production Camen (2006) used an original Baysian VAR model to verify the efficacy of monetary policy Bhattacharya and Duma (2012) studied Vietnam's monetary policy between 2004 and 2012 using SVAR model and pointed out that interest rates only affected inflation for a short time; Nguyen Thi Lien Hoa and Dang Tran Dung (2013) also used SVAR method and came up with a weak impact of exchange rate and interest rate and strong impact of M2 with a 6-month latency on inflation VAR-based study of Tran Thi Xuan Huong et al (2014) concluded that post-crisis increase of interbank interest rates lead to the upsurge of lending interest rates Nguyen Thi Thuy Vinh (2015) investigated the transmission channels of monetary policy based on VAR model and data from 1995 to 2009 Bui Van Hai and Tran Thi Minh Trang (2015) used VAR model to record interest rates and money demand as two essential factors affecting output Pham Tuan Anh (2016) conducted his research based on VAR / SVAR model and monthly data obtained from 1995 to 2013 Nguyen Phi Lan (2016) used SVAR model to assess the efficacy of monetary policy transmission channels Bui Quoc Dung (2017) has recently used VAR model to demonstrate how well inflation targeting may help control inflation for the period from 2011 to present Pham Chi Quang (2019) studied the transmission mechanism of monetary policy for period 2006 -2016 using VARs and VEC variations, Engel-Granger regression model Uncharted researches: filling the gap Literature review shows that previous studies left certain uncharted domains, specifically: (i) Studies primarily approached interest rate as a money policy instrument or merely listed and qualitatively assessed the effectiveness and efficacy of interest rates; not so many works considered interest rate as a regulatory target for evaluation and elaboration of under monetary policy in order to influence the economy and eventually achieve the ultimate goals of inflation or economic growth - Advantages: Convenient for observation, control and implementation; shorter temporal latency; direct effects on the spending and investment; effective support to an economy in recession period: - Disadvantages: Temporal latency; requiring determination of the degree of interest rate changes; cumulative effects; risk of liquidity trap 1.2.2 Interest rate targeting of monetary policy operation by the Central Bank  Setting up the target interest rate: This is the base interest rates of the Central Bank, which is announced officially or informally The manner to operate this interest rate depends on national specific conditions Basically, there are two approaches to base interest rate (or target interest rate) as follows: (i) Base interest rate is the interest rate of an instrument/operation of Central Bank that supplies (for cases of England, Europe, Thailand, Philippines) or absorbs liquidity (for Czech Republic, Japan, etc.) Thus, the transmission of monetary policy to the monetary market and other markets is often mediated by price difference (ii) base interest rate is the market interest rate (usually concurring overnight or 1week interbank interest rate): Central Bank shall clearly announce the target interest rate and regulate the system liquidity so that the market interest rate stays close around the target This is the case of the US, Australia and New Zealand  Developing an interest rate corridor system According to IMF (2014; 2015) works on interest rate targeting of monetary policy operation in advanced and emerging countries implied that most countries enforced their monetary policy in accordance with the two following models: (i) Floor interest rate corridor system including: (1) Floor System (with base interest rate as the floor); and (2) Tiered-Floor System (with two tiers of floor interest rate) (ii) Mid-rate corridor system including: (1) Mid-corridor system targeting a market rate, applied in the US, Brazil, Canada, Chile, Czech Republic, Mexico, Sweden, etc.; (2) Mid-Corridor system with the Policy rate attached to a central bank instrument) Nonetheless, in fact there may be many variations of the above two systems or even other interest rate corridor frameworks that fit the financial structure and monetary policy framework of specific countries  Determining the target interest rate The most well-known principle for determination of base interest rate is the Taylor Rule, developed on the actual prices and output - which are general economic goals of most Central Banks in the world This makes Talor Rule outperform those rules based on money 10 supply or exchange rates Talor Rule is used in cases: (i) interest rates are considered as inputs for elaboration of policies; (ii) interest rates are used to describe important relation between inflation and employment, prices and actual output 1.2.3 Transition from money supply-targeting to interest rate targeting operation of monetary policy  Overview of monetary aggregate-targeting operation of monetary policy Monetary based/targeting operation of monetary policy refers to the procedure where the Central Bank sets up monetary aggregate (MB) as the operational targets and intermediate targets of monetary policy, including MB / M1, M2 or M3, so as to realize the monetary policy and achieve the ultimate goals of inflation or economic growth This operation framework is based on the following factors: (i) Central Bank operates the monetary policy based on the monetary supply indicator; (ii) Discloses targets for the selected monetary supply indicator; (iii) Explain when the actual indicator fluctuates beyond the target range - Advantages: Observability of monetary supply; Fast and strong impacts; increased accountability for constraint of inflation - Disadvantages: requiring assurance of a close relationship between intermediate targets and ultimate targets; less effective for increasingly developed economy and finance; complexity of money supply - demand fluctuations, which are not understandable to the public  To differentiate interest rate targeting and money supply targetiong operation  As regard to the transmission mechanism: in short term, Central Bank may by its monopoly create a monetary base (MB) and determine the interest rate i or the amount of money supply by fixing the money base or interest rates In the long term, Central Bank can only choose either monetary supply or interest rate approach to the operation of monetary policy  Regarding the characteristics and application conditions: (i) If the Central Bank chooses monetary supply targeting; (ii) If the Central Bank selects price (interest rate) targeting  Reasons for the transition from monetary supply targeting to interest rate targeting First, the instable relationship between monetary supply and inflation or economic growth Second, assumptions of the monetary theory are in deed no longer fit the current conditions Third, the interbank monetary market operates more efficiently and has better liquidity, which empowers interest rates to better transmit the signals of monetary policy 11 Fourth, stable macroeconomic environment, well-controlled inflation, wide-ranging liberalization and constant development of the financial market 1.2.4 Bases and principles for the transition to interest rate targeting - Bases for Central Banks: (i) Interest rates are more and more directly and effectively linked to the economy; (ii) Central Banks function to manage commercial banks and influence the interbank lending interest rates; (iii) Notices related to operation of monetary policy often emphasize interest rates rather than monetary supply; (iv) It is common for Central Banks to immediately raise the target short-term interest rate when predicting a higher inflation rate than the target inflation rate, and vice versa - Principles for transition: required principles, including two key requirements as follow: (i) Central Banks should persevere with the goal of price stability; and (ii) To enhance the Central Banks’ independence 1.2.5 Conditions for transitions into interest rate targeting operation of monetary policy  Macroeconomic, financial and monetary conditions  Evolutional sophistication of the financial market  Financial openness and liberalization  Viewpoint on monetary policy operation  Commercial scale  Independence and transparency of Central Banks 12 CHAPTER WORLD’S EXPERIENCES IN TRANSITION INTO INTEREST RATE TARGETING OF MONETARY POLICY OPERATION AND LESSONS FOR VIETNAM 2.1 World’s experiences in transition into interest rate targeting of monetary policy This thesis delved into the transition process; interest rate operation mechanism; determination of target interest rates; formulation of interest rate corridor model; selection of monetary policy instruments and transmission mechanisms of target interest rates in so me countries 2.1.1 Federal Reserve-Fed 2.1.2 European Central Bank (ECB) 2.1.3 Bank Negara Malaysia (BNM) 2.1.4 Bank of Thailand (BOT) 2.1.5 Bangko Sentral ng Pilipinas (BSP) In bottom line, interest rate targeting operation, as a replacement of monetary supplytargeting policy, in order to constrain inflation around the target level, has facilitated to maintain low interest rates and restrict fluctuations within the interest rate corridor, thereby promoting the economic growth, creating more jobs and stabilizing the financial system 2.2 Lessons for Vietnam 2.2.1 Inflation targeting framework is appropriate to the reality and development requirements There are two methods to announce on inflation targeting: (i) Setting up specific and strict inflation targeting (applied by ECB, US, Japan, etc.); (ii) Setting up flexible inflation targeting (Philippines, Thailand, etc.) In the long term, the State Bank should consider developing a flexible inflation targeting framework that ensures a broad monetary policy framework and realization of other targets, especially against the context of Vietnam’s wide-ranging and in-depth economic structuring 2.2.2 Establish a transparent and effective transmission mechanism for monetary policy 2.2.3 Lessons to be drawn for transition from money supply-targeting to interest ratetargeting operation - Target system and selection of monetary policy instruments - Setting up target interest rates and interest rate corridors 2.2.4 Use of unconventional monetary policy in the context of financial crisis 2.3 Notes to take during transition to interest rate targeting First, the width of interest rate corridor Second, how to announce the Central Bank's base interest rate to reinforce the monetary policy signals, orientate interbank interest rate and format interest rates Third, the dependence of interbank market on liquidity reserve instruments that facilitate the Central Bank's execution of monetary policy Central Bank’s cost factors should be taken into account 13 CHAPTER RECENT PRACTICE OF MONETARY POLICY OPERATION AND FEASIBILITY TO APPLY INTEREST RATE TARGETING IN VIETNAM 3.1 Monetary policy implementation by the State Bank from 2007 to present 3.1.1 Macroeconomic background Since late 2007, Vietnam, under the influence of international commodity prices and interest rates, has suffered hiking inflation The global financial and economic recession coupled with prolonged loose fiscal and monetary policies destabilized the macro economy, which was proved by a high budget overspending, braked economic growth, double-digit inflation, and piled up bad debts of credit institutions The years from 2012 have seen some efforts to regulate policies and ease off economic puzzles Besides, signals of the world’s economic recovery came into sight The domestic economy then has robustly revived with inflation constrained under the target level Vietnam was elevated from rank "BB-" to "BB" by rating agencies and bears a stable outlook; CDS index reflecting the risk level of Vietnamese Government bond has plummeted The domestic economy, however, remains worthy of concern for some aspects such as: (i) Instable economic structure and institution; (ii) Stagnation of capital, securities and real estate markets; Vulnerability of the banking system; (iii) Risk of re-emerging inflation due to impacts of other than monetary factors 3.1.2 Current status of the State Bank’s monetary policy operation  Targets of the State Bank’s monetary policy  Use of monetary policy instruments 3.1.3 Evaluation of the State Bank’s monetary policy operation over the recent time  Achievements  Shortcomings and causes 3.2 Assessment of the feasibility of interest rate targeting in monetary governance of Vietnam 3.2.1 Legal basis of interest rate targeting - Law on the State Bank of Vietnam issued in 2010 - Development Strategy of Vietnam Banking Sector to 2025, with Orientations to 2030 as issued in attachment to the Prime Minister's Decision No 112/2006 / QD-TTg dated May 24, 2006 - Government’s Resolutions, the annual Directive 01 of State Bank on orientation for M2 growth, credit, reduction of deposit and lending interest rates and commitment of exchange rate adjustment 14 3.2.2 Current status of interest rate operation  State Bank’s regulatory interest rates  Interbank market interest rates  Interest rates applied by credit institutions to customers  Evaluating the State Bank’s operation of the interest rate operation 3.2.3 Establishing an interest rate targeting transmission mechanism for monetary policy in Vietnam  Bases of the transmission mechanism  Description of the interest rate-targeting transmission mechanism Diagram 3.1 : Interest rate-targeting transmission mechanism for monetary policy applied by the State Bank PHASE Monetary market shortterm interest rate Policy interest rate Refinancing rate, Rediscount rate PHASE Intermediate GIAI ĐO ẠN 2targets - M2; Credit growth; - Financial market medium & long-term interest rates; - Exchange rate PHASE Inflation; Growth Ultimate targets Operational targets Standing Facilities OMOs rate Interest rate of reserve requirement/Excess reserves Target interbank interest rate Source: Author The transmission mechanism of monetary policy through the interest rate channel can be dissected into three phases: (i) Phase is the transmission within the financial (monetary) domain from the base interest rate to money market rates (ii) The second phase of the transmission is the reaction of banks' deposit and lending rates (long-term interest rates) against the fluctuations of money market interest rates; (iii) Phase represents the transmission from the financial domain to the entire economy (i.e output and prices), which will depend on the impacts of interest rates on consumption and investment 15 3.2.4 Qualitative and quantitative analysis of interest rate-targeting transmission mechanism for monetary policy in Vietnam  Qualitative analysis  Interest rate interoperation in Vietnam (i) Period 2007-2010: Interbank interest rates experienced sharp fluctuations in the same trend with OMO interest rates of the same maturity, while other State Bank's regulatory interest rates (base rates and refinancing rate) had negligible impacts on interbank market interest rates For many times, interbank interest rates were higher than OMO bid interest rate and credit institutions’ deposit and lending rates However, interbank interest rates and primary market interest rates shared quite consistent moves, while primary market interest rates fluctuated in the same direction with a latency of over months and are higher than the interbank interest rates, and slower pace of increase / decrease (ii) Period 2011-2017: Interbank interest rates tended to decrease and stay low; the linkage from the State Bank's regulatory interest rates, then the interbank interest rates to primary market interest rates (OMO policy interest rate) Interbank interest rate Market Interest rate remains obscure and instable over time Nonetheless, market interest rate movements in the recent years implied that interest rates would take bigger and bigger role to dominate activities of the economy  Interest rate-targeting transmission mechanism for achievement of ultimate targets + In the wake of its admission to WTO, especially since late 2008, Vietnam saw a weaker correlation between monetary supply and interest rates in particular and market liquidity, which limited the State Bank's ability to regulate the market + Since the second half of 2011, in response to the unrest macroeconomy, soaring inflation (in 2011: 18.13%), high interest rates, poor liquidity of credit institutions, the State Bank had taken actions towards combination of both money supply and interest rate channels + From 2016 to 2018, against the context of low inflation, an economy on way to revive, surplus payment balance yet high rate of public debt, volatile financial market and a bulk of outstanding bad debt, State Bank continued its flexible operation of the monetary policy by synchronously blending multiple monetary policy instruments, so as to properly control intermediate targets of M2 and credit  Quantitative analysis - Interest rate interoperation in Vietnam To measure how well the interest rate channel of monetary policy worked in Vietnam, this thesis used ordinary least squares (OLS) that allowed a measure of the inter-operation 16 from State Bank's base interest rate (OMO bid interest bid rates) to overnight and 3-months interest rate - money market rate (MMR) (1); and eventually to the average 1-year VND deposit and lending rates (2) The relations between interest rates is expressed by the following equation: (2) generally implies that the “pass-through” effect is incomplete; perfect “pass-through” effect (Coricelli et al, 2006) = signals a Results: there existed an instant inter-operation from OMO interest rates to short-term interest rates The impacts on long-term business interest rates are positive and statistically significant This result is consistent with the theory basis and reality - Interest rate-targeting transmission mechanism for achievement of ultimate targets Vector Autoregresive (VAR) or VECM model was used as an analysis technique to process data in this study Stationerity test and Cointegration test were conducted, then came Optimal lag determination, Impulse response function (IRF) and Variance decomposition (VD)  Data description and verification steps + Description and Augmented Dickey Fuller Test (ADF): Data source for the study were taken from Quarter I/2001 to Quarter IV/2017, totaling 64 observations + Results of tests: - Granger - Causality test: M2 and DLendingrate were the causes for Granger to change macroeconomic variables of a real economic sector; at the same time, CPI affected both DLGDP and DLendingrate Thus, operation of monetary that combines M2 money supply and market interest rate for period 2012 - 2016 targets seemed useful for achievement of ultimate targets - Testing for cointegration using the Johansen method: found a cointegration relationship among variables in the model Therefore, the research would use an vector error correction model (VECM) to estimate the long-term relationship between data series, thereby working out an equation (ECM) that represents the impacts of factors on the real GDP value  Model formulation and experimental results  Short-term relation among variables under the VAR model In order to analyze the transmission via interest rate channel, the endogenous IR interest rate (t) will be added to the model Y(t) = [y(t) CPI(t) IR (t) M2(t)] (6) Then the overall VAR model will be as follow: Yt= c + ∑ 17 Where, c is vector of the constant, θi is the matrix of lag coefficients and εt is vector of the noise; is vector of endogenous variables, CPI is the overall inflation rate; M2 is the change percentage of the total means of payment; Lendingrate is the average lending interest rate - Determination of the optimal lag: it worked out that the optimal lag of the model is - Verification of residuals: There was a correlation among residuals, so, in order for measurement of the impacts of shocks, Cholesky's method was used VAR Residuals M2 Residuals DLENDINGRATE Residuals 1.0 0.5 0.0 -0.5 -2 -1.0 -4 -6 03 04 05 06 07 08 09 10 11 12 13 14 -1.5 15 03 04 05 06 07 CPI Residuals 08 09 10 11 12 13 14 15 12 13 14 15 DLGDP Residuals 008 004 000 -1 -.004 -2 -3 03 04 05 06 07 08 09 10 11 12 13 14 15 -.008 03 04 05 06 07 08 09 10 11 Figure 3.2: Residuals of money supply, interest rate, inflation and growth Source: Author's calculations based on Eview 10 - Results of push function: Results of the cumulative reaction function (Figure 3.3) revealed that the increase in M2 triggered a rise of interest rate in -2 quarters, then drop by 0.5-0.6% in the next 4-5 quarters; and bouncing back from late th quarter onwards with a decreasing pace for nearly years thereafter Response to Cholesky One S.D Innovations ± S.E Response of DLENDINGRATE to M2 Response of CPI to M2 1.6 1.2 0.8 0.4 0.0 -0.4 -1 10 10 10 Response of DLGDP to M2 003 002 001 000 -.001 -.002 -.003 Figure 3.3: Reaction function of growth, inflation and interest rate against 1% change in money supply - It can be seen from Figure 3.4 that a positive shock of interest rates reduced the growth rate with a fairly long lag of 2-3 quarters and reached the peak of impact at -0.01% 18 after 5-6 quarters Still, it is shown that increased interest rates triggered inflation climbing and peaking after quarters at 1%; such high inflation lasted for a medium term VAR model did not imply a decrease of prices after increase of interest rate Response to Cholesky One S.D Innovations ± S.E Response of CPI to DLENDINGRATE Response of DLGDP to DLENDINGRATE 1.2 001 0.8 000 0.4 -.001 0.0 -.002 -0.4 10 10 Figure 3.4: Reaction function of growth and inflation against 1% change of interest rate: Source: Author's calculations based on Eview 10 - Results of variance decomposition: The results of variance decomposition, contrary to economic theories, implied no major role of interest rate shocks in the fluctuation of growth (only 6.87% after 10 quarters), yet a clearer decisive determinant of prices (15.38% after 10 quarters) Variance Decomposition using Cholesky Factors Variance Decomposition of M2 Variance Decomposition of DLENDINGRATE 100 100 80 80 60 60 40 40 20 20 M2 CPI 10 Variance Decomposition of CPI 80 80 60 60 40 40 20 20 M2 CPI 8 10 10 DLENDINGRATE DLGDP Variance Decomposition of DLGDP 100 M2 CPI 100 DLENDINGRATE DLGDP 10 DLENDINGRATE DLGDP M2 CPI DLENDINGRATE DLGDP Figure 3.5: Results of variable variance decomposition Source: Author's calculations based on Eview 10  Long-term relation among variables under VECM model The specific regression equation will be as follows: DLGDP = α - β1*CPI - β2* DLendingrate - β3 *M2 - β4*εt-1 + ut VECM model results showed that in the long run there would be no causal relationship between the money supply and economic growth, but there would be a positive correlation between interest rates and inflation and an opposite correlation between interest rates and growth Any imbalance in such correlations of variables would be balanced off within quarters 19 When putting credit growth and nominal effective exchange rate (NEER) into the regression vector model to analyze the transmission mechanism of the monetary policy, it was shown that credit as an intermediate target, which had been already under the State Bank’s administrative controls, had a relatively faster and stronger impact on economic growth and inflation Meanwhile, interest rates and exchange rates, which are two marketdriven channels of monetary policy transmission, brought about narrower effects It is implied by quantitative analysis that in the short term, Vietnam's practical context is not really favorable for the transmission of monetary policy through the interest rate channel However, an analysis of long-term relations and assessment of interest rate data current status pointed out a perfect effect of policy rates (OMO) on short-term interbank market interest rates (overnight and -month) and the influence of these shortterm interest rates on the deposit and lending rates of credit institutions A negative correlation between interest rates and economic growth and positive correlation between inflation and economic growth in the short or long term were also seen 3.3 Conclusions upon analysis of qualitative and quantitative models 3.3.1 Results of interest rate transmission mechanism in Vietnam  For State Bank's regulatory rate  For business interest rates of credit institutions 3.3.2 The limitations of interest rate transmission and reasons - Vietnam's financial market size is narrower than that of regional countries The financial market structure remains inharmonious as the banking system is still the mainstay - Financial instruments are not diversified, which limits the participation of investors, the scope for growth of market, hence a limited effectiveness of the interest rate channel in the long term - The economic dollarization also limits the efficacy of the interest rate channel in Vietnam - Despite its improvements, the monetary market remains under-developed and fails to well allocate liquidity among credit institutions, while financial instruments are not diversified - The health and efficiency of banks play an important role in transmitting the regulatory interest rates to the deposit and lending rates, thereby influencing the consumers and investors’ behavior - Banks' deposit and lending rates are not promptly responsive to the changes of State Bank's monetary policy instruments or regulatory interest rates - The economy is pursuing a wide-ranging growth and heavy dependence on investment capital The loose fiscal policy has cooled off the efficacy of monetary policy in inflation control, thus constraining the influence of the interest rate channel - Although State Bank's legal status has been elevated under the Law on the State Bank of Vietnam in 2010, the State Bank's operation of monetary policy, interest rates and exchange rates is not really independent 20 CHAPTER RECOMMENDATIONS AND SOLUTIONS FOR TRANSITION INTO INTEREST RATE TARGETING OF MONETARY POLICY IN VIETNAM 4.1 Development Strategy of Vietnam Banking Sector to 2025, with Orientations to 2030 4.1.1 Domestic and foreign macroeconomic prospects affecting Vietnam's banking and financial system  Prospects of international economy  Prospect of domestic economy  Banking sector’s viewpoints on innovation, development and targets In consideration of the domestic and foreign macroeconomic situation, socio economic development objectives for the 2016-2020 period under Resolution of the XIIth Party Congress and the National Assembly, Decision 986 / QD-TTg dated August 08, 2018 approving the Development Strategy of Vietnam Banking Sector to 2025, with Orientations to 2030 of the Prime Minister, the banking sector focuses on the main objectives as follows: (i) to make the State Bank a true modern central bank with a higher independent position, a rational organizational model and synchronous, effective and efficient operation mechanism; (ii) to bring the system of credit institutions to higher development level equal to four ASEAN leading countries, ensuring the comprehensive financial universalization 4.1.2 State Bank's operation of monetary policy until 2025 with a vision to 2030 In the coming time, State Bank's operation of monetary policy will focus on key tasks mentioned in the Development Strategy of Vietnam Banking Sector to 2025, with Orientations to 2030 issued in attachment to Decision 986 / QD –TTg dated August 08, 2018, particularly: (i) To complete a monetary policy framework that aims to control inflation; (ii) To redirect the regulatory channel of mon etary policy from monetary aggregates to interest rate targeting 4.2 Recommendation for a transition to the interest rate targeting operation of monetary policy in Vietnam 4.2.1 Formulation of mechanism for interest rate-targeting operation of monetary policy  Setting up and select target rates (policy rates) Pursuant to the Law on the State Bank of Vietnam in 2010, the State Bank shall announce "refinancing rates, base rates and other interest rates to operate the monetary policy and prevent usury" Accordingly, the State Bank has issued regulatory interest rates including: base rates, refinancing rates, rediscount rates, OMO bid interest rates of valuable papers, overnight lending interest rates for interbank electronic payment 21 In fact, the State Bank’s operation implies that the short-term interest rate target is the overnight interbank market interest rates, which is appropriate to the market movements and exchange rate expectations  Establishing a mechanism for interest rate-targeting operation of monetary policy a Building an interest rate corridor with “2 ceilings” and “1 floor’’ - For ceiling rate (lower ceiling rate), take the OMO 7-day maturity bid interest rates of valuable papers - For ceiling rate (higher ceiling rate), take the interbank overnight lending rate - For the floor rate, set up and make use of deposit instruments of credit institutions with an overnight term - Width of the interest rate corridor: at first, the interest rate corridor may be quite broad at around 300-400 per cent (as recommended by IMF) and gradually narrows down to 200-250 per cent, even lower than 150-200 per cent - The target overnight interest rate is placed at the middle of the corridor, between the ceiling rate and the floor rate - Mechanism of operation: interbank market overnight interest rates are mediated and constrained within the corridor and kept close to the target interbank overnight interest rate - The target interest rates and interest rate corridor will be announced by State Bank as for the current central exchange rate and exchange rate amplitude, on periodic basis after every Monetary Policy Council meeting b For other interest rates of the State Bank, such as refinancing rates; VND deposit interest rate of reserve requirement c Interest rates applied by credit institutions to customers 4.2.2 Recommendations for operation mechanism in response to economic unrest or crisis 4.3 Solutions for transition to interest rate-targeting operation of monetary policy 4.3.1 Formulate and apply a flexible inflation targeting framework for monetary policy 4.3.2 Consolidate and complete the monetary policy target system 4.3.3 Reform and improve the efficiency of monetary policy instruments 4.3.4 Enhance the independence and accountability of the State Bank 4.3.5 Develop the monetary market as an effective transmission channel of monetary policy 4.3.6 Solutions to improve the State Bank's statistics, analysis, reporting and forecast systems 4.3.7 Restrict “black credit” to minimize the negative impact on the interest rate transmission mechanism 4.3.8 Complementary solutions 22  Solutions to effectively implement the Project on credit institution system restructuring and complete the project by 2020  To reinforce the inspection and supervision in order to stabilize the banking system operation, thereby improving the transmission capacity of the interest rate channel  Solutions to improve and develop the monetary market  To combine macroeconomic policies, especially fiscal policy  Solution to promote communication 4.4 Recommendations to stakeholders 4.4.1 Recommendations to the Government 4.4.2 Recommendations to relevant ministries and agencies 4.5 Proposal on a roadmap for transition to interest rate-targeting operation of monetary policy The State Bank's transition from money supply-targeting to interest rate-targeting operation of monetary policy will be elaborated and implemented from now till 2030 The process will be divided into 03 phases, each of which will attach to specific plans Diagram 4.1: Roadmap for transition to interest rate-targeting operation of monetary policy in Vietnam Formulate & complete necessary conditions - Complete documents guiding monetary policy instruments, applying interest payment for excess of reserve requirements; - Formulate and complete the target system of monetary policy towards interest rate targeting, regulating exchange rates in line with the market mechanism - Completie and supplement regulations on assurance of banking operation safety; - Complete the legal framework for disposition of bad debts and collaterals Till 2020 Set up interest ratetargeting operation mechanism for monetary policy Officially shifted into interest rate-targeting operation of monetary policy - Fo rmulate a substitute for the 2010 Law on the State Bank of Vietnam towards strengthened independence, transparency and accountability of the State Bank; establishing a Monetary Policy Council - Pro mote the use of indirect monetary policy instruments; remove administrative measures - Set up a mechanis m to control interest rates by forming a floorceiling corridor, announcing target interest rates, interbank interest rate curve - Co mplete the project on money market development; pro moting disclosure of information Interest rate – targeting operation 2020-2025 23 - Operate the monetary policy proactively and flexibly in strict combination with the fiscal policy to achieve the ultimate target of inflation control through the interest rate channel - Formulate a formal and transparent inflation forecasting model; a system that evaluates the market stability and safety and warns of market risks - Study and apply Basel III standard in monitoring the operational safety of credit institutions and improving the effectiveness of monetary policy transmission - Build and consolidate the databases for analysis and forecast, further applying modern science and technology Interest rate – targeting ooperation 2025 -2030 CONCLUSIONS Current practice of monetary policy in Vietnam is seen to be inclined to money supply channel due to subjective and objective causes This resulted in a poor effectiveness and efficacy of the monetary policy, thus hindering the optimal support for banking operation development In a responsive insight into the global fateful trend and guidelines of the banking sector, this thesis represents an intensive effort to explore and systematize the general theoretical foundation of interest rate targeting of monetary policy operation, and frame a reasoning for the transition from money supply targeting to interest rates targeting operation The work also took into account experiences of some developed and developing countries that have succeeded in this transition Then, the thesis focused on assessing the feasibility to apply interest rate targeting for the State Bank’s operation of the monetary policy for period 2007 – 2017 This laid the ground for recommendations, solutions and a roadmap to be given, so that Vietnamese policy makers and implementers can formulate and complete the mechanism for interest rate targeting operation in the coming time Using traditional research methods such as statistics, description and comparison in combination with econometric models, specifically VAR models, the thesis delved into the inter-operation of interest rates and the relation between interest rates and ultimate targets of Vietnam’s economy, then concluded on the reasons for contemporary shortcomings of the State Bank's interest rate operation It is found that although the transmission of monetary policy through the interest rate channel was poor in a short term, there would be a flawless influence of OMO interest rates on OMO interbank market short-term interest rates (overnight and 3-month) and the impacts of interbank short-term interest rates on the credit institutions’ deposit and lending rates A negative correlation between interest rates and economic growth and positive correlation between inflation and economic growth in the short or long term were also seen Such findings ground the author to propose a framework for interest rate targeting of monetary policy operation, which focuses on setting up target the interbank overnight interest rates as policy rate, at the same time, formulating an interest rate corridor with ceilings and floor This is a critical foundation for Vietnam to manipulate its monetary policy in pursuit of flexible inflation targeting as the ultimate goal in the future As well, in consideration of set targets, necessary conditions and principles that ensure a successful transition, the thesis proposed important solutions to achieve such targets 24 ... Vietnam” Vietnam Socio-Economic Development, Vol 92, 2018 Vu Mai Chi (2018), "Evaluating the transmission mechanism of the State Bank of Vietnam’s monetary policy over the recent time", Vietnam...THIS THESIS IS COMPLETED AT BANKING ACADEMY OF VIETNAM Supervisors: Dr Bui Tin Nghi Banking Academy of Vietnam Dr Vo Tri Thanh Central Institute for Economic Management Referee 1: ... operations of the State Bank Vietnam and some recommendations", Banking Science & Training Review, Vol 195, August 2018 Vu Mai Chi, Tran Anh Quy (2018) "Bad debt handling in Vietnam over periods: Concerns