MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS, HO CHI MINH CITY FULBRIGHT ECONOMICS TEACHING PROGRAM Nguyen Thi Thanh Huyen IS INFLATION TARGETING APPROPRIATE FOR VIETNAM? MASTER IN PUBLIC POLICY DISSERTATION Ho Chi Minh City, 2012 MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS, HO CHI MINH CITY FULBRIGHT ECONOMICS TEACHING PROGRAM Nguyen Thi Thanh Huyen IS INFLATION TARGETING APPROPRIATE FOR VIETNAM? Public Policy Major Code: 603114 MASTER IN PUBLIC POLICY DISSERTATION SUPERVISOR Dr. JONATHAN R. PINCUS Ho Chi Minh - 2012 i CERTIFICATION I certify that I wrote this thesis myself. I certify that the study has not been submitted for any other degrees. I certify that any help received and all sources used have been acknowledged in this thesis with the best of my knowledge. The study does not necessarily reflect the views of the Ho Chi Minh City Economics University or Fulbright Economics Teaching Program. Author Nguyen Thi Thanh Huyen ii ACKNOWLEDGEMENTS This master of public policy dissertation could not be completed if I have not received the help and encouragement from many people. First, I am very grateful to my supervisor, Dr. Jonathan R. Pincus, who kept an eye on the progress of my work and was always helpful when I need his advice. His advices, supports, criticisms and comments helped me to deeply understand the overall knowledge related my dissertation. I also convey a special thank to Dr. Vu Thanh Tu Anh, the first teacher who encourange me to begin this dissertation and many other teachers that were always support me during the time I studied in Fulbright Economic Teaching Programme. I gratefully acknowledge the financial support of FETP, without which this dissertation would not have been done. I also express my thankfulness to my colleagues in the Monetary Policy Department, State Bank of Vietnam who are very helpful and enthusiastic colleagues, for their sharing experiences and data to complete the dissertation. I also would like to convey special thanks to Mr. Nguyen Xuan Thanh, Mrs. Nguyen Thi Kim Chau, Mr. Tran Thanh Phong, Mr. Tran Thanh Thai, Mr. Truong Minh Hoa and Ms. Hoang Ngoc Lan, who assisted me a lot of things in terms of adminstration to stabilize the study here. At the same time, I owe a large debt of gratitude to my parents and mother-in- law, who helped to arrange family works for me to study. Last, I thank my husband and daughters for their patience and support for me. iii CONTENTS CERTIFICATION i ACKNOWLEDGEMENTS ii CONTENTS iii ABBREVIATIONS v LIST OF GRAPHS vi LIST OF TABLES vii ABSTRACT viii CHAPTER 1: INTRODUCTION 1 CHAPTER 2: THEORETICAL AND EMPIRICAL OVERVIEW ON I.T 3 2.1. Conceptual framework 3 2.1.1. Supporting ideas for I.T 3 2.1.2. The model of I.T 4 2.1.3. Issues in the implementation of I.T 5 2.2. Global evidence on I.T. adoptation 6 2.2.1 Evidence supporting I.T 6 2.2.2 Evidence against I.T 8 2.3. The prerequisites of I.T 10 2.4. Experiences of inflation targeters 12 2.4.1 Experiences of industrial country inflation targeters 12 2.4.2 Experiences of developing country inflation targeters 14 2.4.2.1 Chile 16 2.4.2.2 South Korea 18 2.4.2.3 Brazil 20 CHAPTER 3: THE MONETARY POLICY FRAMEWORK IN VIETNAM 23 iv 3.1 Independence of SBV 23 3.2 Monetary policy implementation in Vietnam 23 3.2.1 Monetary instruments 24 3.2.2 Monetary policy transmission mechanism 25 3.2.3 The strategy of monetary policy 26 3.2.4 Monetary policy effectiveness 30 CHAPTER 4: TESTING I.T PREREQUISITES FOR VIETNAM 33 4.1 Economic structure 33 4.1.1 A small, open economy with liberalized capital and trade 33 4.1.2 Dollarization and goldization 35 4.1.3 Exchange rate pass-through effect 36 4.2 Health of the financial system 37 4.3 Analytical capability of SBV 39 4.4 Central bank independence 39 CHAPTER 5: CONCLUSION AND RECOMMENDATIONS 43 5.1 Conclusion 43 5.2 REER monetary policy framework is also problematic 44 5.3 Recommendations 45 REFERENCES 47 v ABBREVIATIONS ADB Asian Development Bank CBI Central Bank Indepedence CPI Consumer Price Index FCD Foreign Currency Deposits FDI Foreign Direct Investment Fed Federel Reserve System FII Foreign Indirect Investment GDP Gross Domestic Products GSO General Statistics Office I.T Inflation Targeting IFS International Funds Statistics IMF International Monetary Fund MoF Ministry of Finance NCM New Concensus Macroeconomics NEER Nominal Effective Exchange Rate OECD Organization for Economic Coorperation and Development OLS Ordinary Least Square RER Real Exchange Rate REER Real Effective Exchange Rate SBV State Bank of Vietnam U.K United Kingdom USD United State Dollar VAR Vector Autoregression VND Vietnam Dong WB World Bank vi LIST OF GRAPHS Graph 3.1: Velocity of money in Vietnam 29 Graph 3.2: CPI, M2 and GDP growth rate of Vietnam 31 Graph 3.3: REER, NEER and Relative CPI of Vietnam 32 Graph 4.1: Trade deficit and openness of Vietnam economy 34 Graph 4.2: Capital inflow structure in Vietnam 34 Graph 4.3: USD/VND Exchange Rate 35 Graph 4.4 : Dollarization in Vietnam 36 Graph 4.5: Stock market capitalization in some countries 38 Graph 4.6 : Bond market development in Vietnam 38 Graph 4.7: Seigniorage to GDP in Vietnam 40 Graph 4.8: Real deposite rate in Vietnam 41 Graph 4.9: Fiscal balance to GDP in Vietnam 42 vii LIST OF TABLES Table 3.1: Exchange rate adjustment milestones of SBV 28 Table 3.2: Total reserves in months of imports in Vietnam 28 viii ABSTRACT Monetary policy is one of the most crucial macroeconomic policies in an economy in general and in Vietnam in particular. Considering the low effectiveness of monetary policy in Vietnam, many economists think that inflation targeting (I.T) is a best choice for the future. The dissertation takes a comprehensive look at the I.T framework in theoretical and empirical terms, the conditions as well as the global experiences in industrial and developing countries. In theory, the I.T model does not mention other determinants of inflation such as real shocks, exchange rate movements and fiscal roots. It is surprising that although I.T is applied nearly everywhere but not all countries are successful and I.T is often not the key determinant of success. Other factors are also important, such as fiscal descipline, the economic structure, financial system strength, central bank indepedence and political support for the inflation target. The disseration also tests the conditions of Vietnam using some prerequisites for I.T suggested by the IMF and finds that Vietnam is not suitable for this framework because the country’s economic characteristics include a weak financial system and a lack of central bank indepedence. Although the experience in some successful countries like Chile and South Korea show that those conditions are not wholly met in these countries, at least Chile and South Korea had good fiscal discipline and central bank independence. In Vietnam, fiscal dominance exists with continuous fiscal deficits. Thus, to improve the prevailing monetary policy framework, I.T may not be the best choice for Vietnam. REER targeting is an alternative but it is also problematic. Vietnam is a highly open economy with a high pass-through effect and dollarization. The dissertation recommends that at first Vietnam should improve institutional conditions for monetary policy and strengthen financial markets, and at the same time restructure the economy and impose fiscal discipline on the government. Then choosing I.T or REER targeting or another monetary framework will depend on political considerations and the desired balance between growth and price stability. [...]... economy The prevailing monetary policy framework in Vietnam now is a mix exchange rate peg and monetary framework But the effectiveness of monetary policy in Vietnam is not easy to estimate as the central bank must target several objectives, including low inflation, rapid growth and exchange rate stability Besides, inflation has returned to Vietnam in recent years and makes many economists think of... economists think of I.T as the best choice but it related many choices and conditions These are the dynamics for me to carry out this dissertation to answer the following questions: First, is inflation targeting (I.T) appropriate for Vietnam? Why and why not? And second, what are the implications for Vietnam’s monetary policy framework? The dissertation uses institutional analysis of monetary policy, case... inflation targeters like Chile and Korea is the strict fiscal rule and central bank independence However, the institutional conditions in Vietnam shows that Vietnam does not yet meet the requirements for adopting I.T Therefore, the dissertation finds that Vietnam’s monetary policy need transparency, accountability, coherence and communication first Then, the dissertation recommends institutional reforms... dissertation also emphasizes the experiences of Chile, Korea and Brazil to test the application of I.T in Vietnam such as the fiscal obligations and independence of Central Banks 23 CHAPTER 3: THE MONETARY POLICY FRAMEWORK IN VIETNAM 3.1 Independence of SBV Article 3, Law of State Bank of Vietnam (2010) stipulates that national monetary policy involves stabilization of the value of the local currency... Vietnam as this is the most updated study Le and Pfau (2008, p 13) specified a VAR model of the monetary transmission mechanisms in Vietnam for the period 1996-2006 and found a strong link between money supply and real output, though no strong connection between money supply and inflation Also, they found that the interest rate channel played little role in transmitting monetary policy for Vietnam... on I.T to see if I.T is a really superior monetary policy regime for central banks, then examine the prerequisites, experiences of inflation targeters and the conditions in Vietnam in order to give policy implications for Vietnam The dissertation finds that I.T is not a perfect regime in both theory and practice, the success of I.T depends on the institutional and economic conditions in individual country... an instrument to support economic growth or control inflation These objective conflicts are really problems in conducting monetary policy in Vietnam 3.2.2 Monetary policy transmission mechanism There have been a number of studies of monetary policy in Vietnam but few of them focus on the monetary policy transmission mechanism Since 2000, a few econometric models have examined the short-run relations... fundamentals and finance data in Vietnam in the period 2000-2010 I.T is applied in many industrial as well as developing countries and the adoption of I.T based on specific theoretical framework and some key assumptions regarding institutional prerequisites to using the inflation rate as a nominal anchor There are very few research mentioning adoption I.T in Vietnam (Le Anh Tu Packard, 2007; Mai Thu... then the impact will be 26 limited due to the fact that the money aggregate in Vietnam (M2) is distorted by the high level of dollarization Similarly, the interest rate is a useless tool as it is capped and the credit tool has limited impact due to the problem of directed credit All of this will make adopting I.T in Vietnam more difficult as the theoretical model shows that interest rate must be a strong... policy The monetary policy strategy in Vietnam is not clearly defined as a money growth target, exchange rate peg, I.T or “just-do-it” framework It is a mixed framework with multi-objectives This, to some extent, allows the Government and SBV more flexibility in conducting monetary policy but there are some of problems in terms of effectiveness Exchange rate peg: Vietnam adopted an exchange rate peg since . rate of Vietnam 31 Graph 3.3: REER, NEER and Relative CPI of Vietnam 32 Graph 4.1: Trade deficit and openness of Vietnam economy 34 Graph 4.2: Capital inflow structure in Vietnam 34 Graph. of Vietnam U.K United Kingdom USD United State Dollar VAR Vector Autoregression VND Vietnam Dong WB World Bank vi LIST OF GRAPHS Graph 3.1: Velocity of money in Vietnam 29. Dollarization in Vietnam 36 Graph 4.5: Stock market capitalization in some countries 38 Graph 4.6 : Bond market development in Vietnam 38 Graph 4.7: Seigniorage to GDP in Vietnam 40 Graph 4.8: