Introduction

1.      Background and relevance of the  study

One of the main objectives of Vietnam’s financial reforms is maximizing the opportunities of international financial integration. International financial integration, if not appropriately monitored, can be very risky. The risks involved include: (i) a potential crisis triggered from poor management of capital flows, especially short- term flows, and (ii) the possibility that the monetary policy is undermined in the sense that the policy fails to reach its intended targets or in other words, the independence of the monetary is undermined.

First, short-term capital flows can be volatile and easily reversed, and can generate an adverse impact on the balance sheets of financial institutions and firms. Second, experiences from developing countries, especially some East Asian and Latin American countries in the early 1990s show that in order to maintain monetary autonomy, the authorities of these countries attempted to influence the domestic interest rate trend. But they were facing increasing difficulty in the trade- off between maintaining pegged exchange rates and monetary independence whilst effectively managing the risks of cross-border capital movements (Leung, 1996, p.16). Thus, to manage the risks of cross- border capital movements, macroeconomic policies, especially consistency between monetary and exchange rate policies, is of significance.

During the 1990s Vietnam has imposed comprehensive capital controls. Therefore it has not exposed to massive capital inflows. However, inflows still exist in the forms of foreign direct investment and external bank borrowing. In addition, a high degree of dollarization in the economy seems to create the problem of so-called “capital flows within-the-economy”, undermining efforts to maintain monetary autonomy. Moreover, similar to some regional crisis- hit countries, Vietnam also has attempted to maintain a fixed exchange rate regime while maintaining the effectiveness of the monetary policy.

Thus, it is important to examine whether during the 1990s Vietnam had the difficulty in maintainin such a policy mix and whether maintainance of that policy mix has caused any potential risks and costs for the economy. Furthermore, Vietnam can learn valuable lessons from other developing countries on how to better manage macroeconomic policies in the gradual process of financial liberalization. Although the problem of consistency between monetary and exchange rate policies in Vietnam has been addressed by some authors such as ADB (1999) and Vo Tri Thanh et al (2001), this problem has not been sufficiently studied. Thus, a study about this problem especially ones focusing on dealing with capital flows is both interesting and necessary.

2.      Scope  and research questions of the study

The objective of the thesis is to study the importance of consistent macroeconomic policy, focusing on monetary and exchange rate policies in managing capital flows by analyzing the experiences of some developing countries: Thailand, Indonesia and Chile.

The thesis will explore the following research questions:

Main research question:

How important is the consistency between exchange rate and monetary policy, including interest rate policy for Vietnam in managing capital flows?

Sub- research questions:

1)      What are the macroeconomic policies adopted in response to capital flows and their consequences? Why is consistency between exchange rate and monetary policies including interest rate policy important in dealing with capital flows? What are the costs and risks involved if this policy mix is inconsistent?

2)      What are experiences of other developing countries (Thailand, Indonesia and Chile) in dealing with capital flows with regard to coordination between monetary and exchange rate policies?

3)      Have monetary and exchange rate policies in Vietnam been consistent during 1990s? If not, what are the potential costs and risks involved?

4)      What lessons can be drawn for Vietnam in terms of managing macroeconomic policies in the process towards financial liberalization?

3.      Methodology of the study

This thesis employs descriptive, analytical and quantitative methods. Econometric models are used to evaluate the offset coefficient of sterilized intervention of Vietnam in 1990s in order to assess the difficulty in pursuing an independent monetary policy in the context of pegged exchange rate and capital inflows. Another econometric model of the uncovered interest rate parity is run to test whether the uncovered interest rate parity holds in Vietnam during 1990s.

4.      Structure of the thesis

The thesis contains three chapters. Chapter 1 introduces an approach to the ‘consistency between monetary and exchange rate policies’ and some conducting in conducting an independence monetary policy under a fixed exchange regime. Chapter 2 reviews the experiences of Thailand, Indonesia and Chile and offers several lessons for other developing countries in regard to their monetary and exchange rate policies and other policy response to capital flows. Chapter 3 assesses the consistency/inconsistency between these two policies in their relation to capital flows in Vietnam, and their associated problems and it also puts forward a number of relevant lessons and policy recommendations in terms of management of capital inflows. Finally, concluding remark and areas for further research are presented.

CHAPTER 1: ANALYTICAL FRAMEWORK

This chapter presents the analytical framework for subsequent analyisis in the following chapters.

1.     An Introduction to the Consistency between Monetary and Exchange rate Policy Mix

As the process of increasing financial integration is taking place, emerging market economies should follow an approach that helps to obtain the benefits of the capital flows and minimize the risks involved. This thesis will focus on the one of the four elements of this approach, a consistency between monetary and exchange rate policy, which is approached as, according to Johnston and Otker-Robe (1999), the relationship between exchange rate and interest rates at a point in time and the sustainability of these polices over time.

First is the consistency or compatibility of monetary and exchange rate at a point in time. It can be best demonstrated by the covered and uncovered interest rate parities. These two parities indicate the interdependent relationship between domestic interest rate and exchange rate at a point in time. If these two variables are set inconsistently, there will be potential risks and costs involved. Both uncovered and covered interest parity conditions imply that with greater freedom of capital movements, if both interest rate and exchange rates are set inconsistent with this condition it will lead to short-term capital flows because market participants will switch investments between currencies. Second, the other element of policy consistency is consistency over time. It determines the sustainability of the chosen policy mix. It requires the authorities to have either a very strong commitment to a pegged exchange rate or pursue a flexible exchange rate.

2.     The conduct of monetary policy in an open economy

In an open economy, the efforts of maintaining the independence of the monetary policy face many difficulties. First, it is very difficult or even impossible in keeping the autonomy of the monetary policy while pursuing the fixed exchange rate. Second, sterilization-the intervention used by the central bank aimed at maintaining the autonomy of the monetary policy in a broad context of various policy responses to capital inflows and the measure of the independence of the monetary policy under fixed exchange rate: the offset coefficient are introduced. Finally, the independence of the monetary policy is also largely affected by the intensity of dollarization.

1.1.            The endogenity of monetary policy under fixed exchange rate: The mundell-fleming model.

The well-known Mundell-Flaming model indicates that under a fixed exchange rate regime, the money supply is endogenous either in the context of free capital movements or capital controls. Any attempt to expand money supply just leads to a fall in foreign reserves both with and without capital controls. The model and this implication is examined by using IS-LM-CM analysis. According to these discussion, it can be concluded that a consistent monetary and exchange rate policy mix is likely to be either: (i) a flexible interest rate (or monetary) policy to support the exchange rate set (the exchange rate is pegged or tightly managed); or (ii) interest rates are determined to achieve domestic monetary objectives and exchange rate is assigned greater flexibility.

1.2.            policy responses to capital flows: Sterilization - attempt to maintain the Independence of Monetary Policy.

The experience of the 1990s have shown that cross-border capital movements, both in and out, can have significant macroeconomic consequences. Policy responses include sterilization, exchange rate policy including revaluation of the nominal exchange rate, and greater exchange rate flexibility, capital account measures including liberalization of capital outflows, and controls on capital inflows, and other measures such as fiscal austerity measures, trade liberalization, and prudential measures.

Among these policy responses, sterilized interventions have been the most widely used measure. Although sterilization is always possible in a technical sense, the effectiveness of sterilization is very limited. It could induce further unintended capital inflows and skew the capital inflows’ composition toward short-term maturities that may have adverse effects on the economy. The offset coefficient can be used to assess the degree to which a monetary policy change becomes offset by international flows. The absolute value of the offset coefficient can be used to assess the ability of maintaining an independent monetary policy under a fixed exchange rate regime in the context of high capital mobility.

1.3.            Dollarization and the conduct of monetary policy

Implementation of monetary policy is not only constrained by the exchange rate regime but it is also constrained if  dollarization exists in the domestic economy. First, it is impossible to supply the intended amount of money and monetary authorities may favor exchange rate anchor to make money supply endogenous. Second, dollarization reduces the basis of inflation tax, thus reducing seigniorage. More importantly, there is a possibility of the vicious circle of dollarization if there is high degree of correlation between the inflation rate and expected depreciation/appreciation of the domestic currency. This process makes the domestic money holdings decrease gradually. In this sense, dollarization is similar to a very mobile short-run capital flows within-the-economy (Leung and Ngo Huy Duc, 1998). Third, effects of devaluation under a fixed exchange rate are restricted by dollarization.

Chapter 2. Case studies: Thailand, Indonesia & Chile.

Thailand, Indonesia and Chile were chsosen for case studies. These contries, which all adopted pegged exchange rate regimes like most other developing economies, had faced surges of capital inflows in the early 1990s. Particularly, Thailand is a typical example of having maintained the rigid pegged regime for a long period while attempted to keep monetary autonomy in face of free substantial capital inflows. In fact, this practice had accumulated costs and risks for the economy. Like Thailand, Indonesia is also Vietnam’s neighboring country that before the crisis had been often seen as a model for Vietnam’s economic development. In addition, its banking sector during 1970s and 1980s had many features in common with Vietnam’s sector during 1990s. Thus, Indonesian experience of policy response, in particular monetary and exchange rate policies to various external shocks over the past three decades should be very interesting. Chile’s experience of reintroduction of capital controls in early 1990s seems to achieve intended objectives of managing the sizable capital inflows. However, it is not clear that whether such capital controls can be sustained to help Chile to maintain an independent monetary under the pegged exchange rate to avoid potential risks and costs in the longer run.

1.      The Case of Thailand

Thai experience showed that much vulnerability leading to the 1997 crisis were mainly created by inconsistent policy mix between monetary and exchange rate policies and weaknesses in the financial and corporate sectors.

First, inconsistency of the monetary and exchange rate policies during the period are reflected in:

§         A fixed exchange rate policy was maintained and BoT announced that it would not devalue the baht.

§         Nominal interest rates on US-dollar borrowing were lower than nominal rates on domestic borrowing

§         In addition, BoT tightened its credit controls on domestic borrowing in 1995 while BIBF borrowing remained easy.

In order to maintain the autonomy of the monetary policy under the pegged exchange rate, sterilization was the most significant policy response to the initial sizeable capital inflows. However, the intended effect of this policy was very limited. In fact, it associated with higher domestic interest rates (see Figure 1), attracted capital inflows and shifted the composition of the inflows toward more short-term component as well as caused the quasi-fiscal costs. Furthermore, the policy mix combined such a tight monetary policy with a rigid exchange rate created strong incentives for residents to expose themselves to excessive foreign exchange and liquidity risks, led to the volatility of the short-term capital inflows and the increasingly shortened external debts of the domestic corporate sector. Second, weaknesses in the financial and corporate sectors exacerbated the vulnerabilities.

From the experiences of Thailand, as to monetary and exchange rate policy, greater exchange rate flexibility may stem the cycle of foreign exchange intervention and sterilization. This vicious cycle seems to attract more capital flows and accumulates costs and risks on the economy.

Figure 1. Thailand, Interest rates, and the sterilization index, 1988-97.

Note:    Left scale: Nominal interest rate (deposit rate): % per annum.

Right scale: Sterilization index: Absolute values.  

- Sterilization indices range from 0 to 2. A value of 0 implies limited contraction in domestic credit (typically associated with limited sales of either public sector or central bank securities) during the year; a value of 1 was assigned to more strenuous sterilization though open market sales of government paper; a value of 2 implies the situation when open market operation is substantial in scale or were accompanied by raise in banks’ reserve requirement and/or transfer of government deposits from commercial banks to the central bank.

Source: Data from IMF (1999b) International Financial Statistics Yearbook, Washington D.C.: International Monetary Fund and Table 2 in Motiel, P. and C. Reinhart (1999) ‘Do capital controls and macroeconomic policies influence the volume and composition of capital flows? Evidence from the 1990s’, unpublished working paper, http://www.puaf.umd.education/papers/reinhart.htm, accessed on 28 January 2001.

2.     The case of INDONESIA

Although Indonesia has opened its capital account very early, in contrast with conventional wisdom in terms of the sequencing of the financial liberalization, the consistency of macroeconomic policies had been absent. In Indonesia, the governments has attempted to control not only two of the nominal macroeconomic variables but sometimes three or even four of these variables (the price level, the monetary aggregates, the nominal exchange rate and the nominal interest rate) at the same time.  To deal with the sizeable capital inflows in order to curb the resulting monetary expansion, sterilization was conducted. However, like Thailand, it incurred substantial quasi-fiscal costs, asssociated with higher interest rates and further surge of capital inflows. But differently from Thailand, Bank of Indonesia allowed a more flexible exchange rate regime by widening the intervention band of the crawling peg regime, especially during 1995-97. Such flexibility of the exchange rate regime left more room for conducting control over monetary aggregates and discouraged partly the purely speculative capital flows. This flexibility helped to improve the consistency of the monetary and exchange rate policies. However, because of the contagion effects, Indonesia could not avoid being hit by the spread of the crisis.

3.     THE CASE OF CHILE

Chile had an open capital account already in late 1980s when there were sizable capital inflows. The causes of the massive capital inflows were both pull and push factors. To deal with this initial surge in capital inflows, several measures had been taken including sterilization, exchange rate policy (revaluation and widening the exchange rate band), and the reintroduction of the capital controls. Sterilization, like the case of Thailand and Indonesia, at last is ineffective in limiting the magnitude and short-maturity composition of the capital inflows. In addition, the costs the central bank had to burden were also significant. The reintroduction of the capital controls were unlikely to reduce the volume of the subsequent capital inflows and but it could reduce the share of the short-term component. In addition, in terms of exchange rate policy adjustments, Chile had allowed several revaluation and greater exchange rate flexibility. These measures help to curb part of purely speculative capital flows and allows more room for exercising controls over monetary aggregates. As pointed out by above-mentioned empirical studies, Chilean capital control measures enable the monetary authorities to control the domestic interest rate in short-run only, but not in the long run. Thus, it indicates the impossible implementation of an independent monetary policy, in particular interest rate policy in the long run.

4.     Lessons from the country experiences

It can be said that the impact of capital inflows on economic performance[1] differed between the countries. However, these differences lead to some useful lessons for other developing countries in terms of managing the risks of cross-border capital movements.

First, in terms of exchange rate, Chile pursued crawling exchange rate regime with the intervention band being gradually widened. The Chilean exchange rate regime was much more flexible than those of Thailand and Indonesia were. Although Indonesia had a crawling peg regime before the crisis, its intervention band was narrow and was widened lately. This experience suggests the significance of greater exchange rate flexibility among various types of policy response to minimize the risks involved in capital flows.

Table 1. Thailand, Indonesia, and Chile: Policy Mix in Response to the Inflows

1/ Despite announcements of broader intervention band, exchange rate variability does not change appreciably.

2/ As discussed in the previous section, although Thailand imposed capital controls but up to the embark of the crisis the measure lasted in a very short time and its effectiveness was very weak.

Source: Adapted from Reinhart and Reinhart (1998).

Second, these countries' experiences provided evidences that the reintroduction of the capital controls seemed to alter the composition of the capital flows but not the volume of the capital inflows. Chilean experience suggests a sustainable solution to stabilize the short-term capital inflows is the design of a consistent monetary and exchange rate policy which ultimately permit the domestic interest rate to converge with the international interest rate level. Thus, developing countries should not rely only on capital controls as the major policy response in minimizing the risks of cross-border capital movements while still maintaining an inconsistent policy mix between monetary and exchange rate policy. These countries’ experience points out the ineffectiveness and harmful impacts of sterilization used to maintain the monetary independence in the long run.

Third, the soundness of the banking system and the sequence of capital liberalization are also important in managing capital flows. Developing countries must define a suitable sequence for financial liberalization, especially capital account liberalization given the specific development of the financial sector.

CHAPTER 3: MONETARY POLICY, EXCHANGE RATE POLICY AND CAPITAL INFLOWS IN VIETNAM DURING 1990s.

Vietnam has had many similar macroeconomic vulnerabilities  such as a fragile banking sector with high ratio of nonperfoming loans, a crawling peg exchange rate regime, and lack of coordination between macroeconomic policies, in particular monetary and exchange policies. Although the size is smaller, the “Letter of credit” crisis in 1996-97 has a similar pattern to the regional crisis hit Thailand, Indonesia etc,. The significantly negative spread between local dollar-denominated interest rate and foreign interest rate during 1999-2000 resulted from rigid implementation of the monetary policy created incentives for domestic banks to deposit dollar funds abroad. This practice, in addition to further dollarize the economy, leads to short-term and volatile capital flows, further causing the difficulty and revealing the weaknesses of Vietnam’s monetary authorities in managing capital flows. In both cases, Vietnam can learn valuable lessons from experiences of a consistent coordination between monetary and exchange policies in managing short-term volatile capital flows.

This chapter will focus on (i) what are the developmental issues of monetary and exchange rate policy framework, and capital movement regulations in practice so as to provide a background for subsequent analysis, (ii) assessing the consistency/inconsistency between these two policies in their relation to capital flows, and their associated problems. This chapter also undertakes empirical studies by testing two models. Overall, these studies aim at empirically assessing the degree of difficulty that Vietnam has to face in maintaining an inconsistent policy mix consisting of a pegged exchange rate and an independent monetary policy. In particular, first, the uncovered interest rate parity is tested so as to assess whether and to what extent the current capital account regulations in Vietnam can divorce the domestic interest rate from the international rate, and so as whether an independent monetary policy (in the sense of an independent domestic interest rate trend) has been attempted. These findings will suggest some policy recommendations to improve the consistency between monetary and exchange rate policy in Vietnam during the process of increasing financial integration. Second, another test is run to estimate the offset coefficient in order to interpret the degree of actual autonomy of the monetary policy in Vietnam in 1990s. The larger the offset coefficient, the greater difficulty the central bank has to face in continuously maintaining an independent monetary policy under fixed exchange rate, or it indicates greater inconsistency of this policy mix overtime. Some changes to improve the consistency of the policy mix will be drawn from these findings during the process towards increasingly financial integration.

1.     Macroeconomic environment during 1990s

1.1.            An Overview of ECONOMIC and financial ReformS

In 1986, Vietnam started doimoi to transform itself from a closed economy into a market-oriented one. Growth rate of the economy recorded at a remarkable level in the first half of 1990s, around 8-9 percent annually, especially in the industry and services sectors. Vietnam has carried out substantial reforms in the financial sector in the 1990s. The current financial system is characterized as an oligopolistic market structure, the unclear separation between commercial and noncommercial (or policy) financial activities, and the direct controls by the governments (Leung and Le Dang Doanh 1999, Vo Tri Thanh et al 2001). During the past few years, Vietnam’s banking system has revealed its structural fragility. Vietnam’s monetary authority still relies heavily on direct instruments.

1.2.            Developmental Issues of the Monetary Policy, exchange rate policy and capital mobility in vietnam

In order to reach the  predetermined money supply, with the underdeveloped financial and monetary markets, Vietnam’s monetary authorities still relies heavily on direct instruments (interest rate control, credit ceiling) rather than on indirect ones (reserve requirement, refinancing and open market operations). The description indicates the pegged exchange rate regime maintained in Vietnam in 1990s.

During 1990s, the net capital inflows into Vietnam rose remarkably but fell after reaching their peak in 1996. First, with regards to foreign direct investment (FDI), FDI has been the major source of flow but it has declined after the Asian crisis. But FDI inflows in Vietnam has involved a significant foreign loan component. Second, concerning external borrowing, since 1997, external borrowing has played a more important role but it creates external debt for Vietnam. In addtion, Official Development Assistance (ODA) accounts for a large proportion of external borrowing. But ODA could be a long-term burden of debt rather than a source of assistance.

With regards to capital controls, Vietnam has imposed comprehensive controls on capital flows. First, capital controls in Vietnam are used for a wide variety of purposes that are unrelated to and not necessary for dealing with risks of short-term capital movements. Second, due to the lack of transparency and pervasivation, Vietnam’s quantity-based capital controls which are much more distortionary and costly than price- based capital control instruments are increasingly difficult to enforce in a highly integrated world. Third, regulations of Vietnam’s international capital flows suffer from a serious lack of transparency, consistency and predictability).

Vietnam is a highly dollarized economy. Dollarization, which can be seen as “highly mobile capital flow within-the-economy” to some extent, complicates the management of macroeconomic policies, especially exchange rate and monetary policies.  It limits the effectiveness of monetary policy. Dollarization can create the vicious circle of raising expected depreciation once inflation emerges, then dollarization is intensified that in turn raises inflation rate and expected depreciation. Hence high dollarization makes the Vietnam dong vulnerable to currency and financial crisis.

2.     MONETARY, EXCHANGE RATE POLICIES and Capital Flows

1.1.            The ‘Letter of Credit’ Crisis, 1996-97

Credit ceiling and other direct regulation measures created incentives for banks and other financial institutions to evade these controls. Letter of credit (LC) was one important channel through which banks can evade credit ceilings since up to that time LC was excluded from credit ceiling. During this period, the exchange rate was very rigid and hedging tools were not available. Therefore, under the circumstances that the exchange rate was rigid and seemed to be stable, and large gap between domestic and international interest rates existed, strong incentives for enterprises to borrow in US dollars was set up, especially though LC.

In fact, large amount of such short-term US dollar loans was borrowed by enterprises. The increase in short-term inflows and the raise in the error and omissions account, which is believed to reflect the disguised capital flows were both significant in 1996. The stock of letters of credit was estimated to accumulate at US$ 1.5 billions by early 1997 (World Bank, 1997).

The consequences of this type of external borrowing were severe. First, it widened the current account deficit. Second, a large part of this short-term borrowing was channeled into speculative real estate market, resulting in a boom in this market which was similar to Thailand and Indonesia. Third, it weakened the banking system and the financial sector as a whole.

Lessons could be drawn from this crisis. The imposing of lending rates in 1996 without proper consideration of domestic inflation and international interest rates in the context of rigid pegged exchange rates could generate severe impacts on both macroeconomic management and microeconomic. This situation well illustrates the implication of both uncovered and covered interest parity conditions that with greater freedom of capital movements, short-term interest rates in domestic market will increasingly be determined by these theorems. In this case, the interest rate and exchange rates were set inconsistent with this condition, leading to short-term and volatile capital flows.

1.2.           dollarization intensified, Period 1999-2000

The consistency between monetary and exchange policies still continued to be absent in the period 1999-2000. This inconsistency can be seen in the relationship between three main variables: domestic interest rates, dollar-denominated interest rates (both foreign dollar-denominated and local dollar-denominated interest rates), and expected depreciation (see Figure 2). It is necessary to take the local dollar-denominated rate also into consideration given Vietnam’s highly dollarized economy with comprehensive capital controls. During this period, Vietnam’s monetary authorities have attempted to maintain an independent monetary policy, in particular maintaining a domestic interest rate trend, which is independent and contrary to international level. This policy was not consistent with the rigid pegged exchange rates. In the context of increasing financial integration, this policy mix generates negative consequences, such as higher dollarization, higher expected depreciation of the domestic currency, which can have adverse impacts on the economy in the long-run

3.     EMPIRICAL STUDy

Ø      Objective of the study: to undertake an empirical study on the uncovered interest rate parity and estimating the offset coefficient for Vietnam.

First, concerning the former, as mentioned in chapter 1, the consistency of the monetary and exchange rate policies is partly demonstrated by the uncovered interest rate parity. This parity requires the strong assumption of free capital mobility and perfect substitutes between domestic and foreign financial assets. In the case of Vietnam, as described in the previous section, eventhough Vietnam now is far from financially integrated with the rest of the world, and employs a comprehensive capital controls, there are existing short-term and volatile capital flows in the forms of capital flows “within-the-economy” and other types of capital flows (such as trade financing through LC during 1996-97, dollar fund deposited at offshore banks during 1999-2000, and other disguised capital flows). In this context, running a test so as to see whether the uncovered interest rate parity holds in Vietnam will help to find whether and to what extent the current practice of capital controls can divorce the domestic interest rate from the international one, and can prevent Vietnam from financially integrating with the rest of the world during 1990s.

Second, estimating the offset coefficient is also necessary. On the one side, as indicated in the theoretical framework that under fixed exchange rate, it is difficult to maintain an independent monetary policy (including the maintenance of an independent domestic interest rate trend) either with or without capital controls. The attempt to have such a policy mix leads to potential costs and risks. It generates a high offset coefficient that reflects the increasing difficulty that the country concerned has to face over the long run. On the other side, the previous description about Vietnam macroeconomic environment has shown that Vietnam has simultaneously pursued both a fixed exchange rate regime and an independent interest rate trend especially during the two periods 1996-97 and 1999-2000. Thus, it is interesting to estimate this offset coefficient for Vietnam in order to find that whether Vietnam has to face the same difficulty and if it has, how severe this difficulty is.

Ø      Relationship between the two tests

Although these are two separate tests, their findings are well connected. First, the UIP test examines whether Vietnam has succeeded in reaching the target of keeping an independent interest rate trend. This finding will strengthen the implication of the second test about the efforts made by Vietnam’s monetary authorities to maintain an independent monetary policy. Second, the UIP test’s finding about the extent of the current practice of capital controls in Vietnam will complement the interpretation of the offset coefficient estimated by the second test. Overall, the two tests will strengthen the previous section’s description about and analysis of the inconsistency of the policy mix: a fixed exchange rate and attempt to pursue an independent monetary policy and its related potential costs and risks.

1.1.            An empirical study on Uncovered interest rate parity

3.1.1.      The model

The uncovered interest parity condition:

i_t,k = i*_t,k + Ds^e_t,t+k  (1)

with i_t,k denoting domestic interest rate, i*_t,k – international interest rate, and Ds^e_t,t+k = [(e_e+1 – e_s) / e_s] – expected depreciation over period t, t+k.

To test this condition, the usual test is the paramenterisation of the above condition as:

Ds^e_t,t+k = a + b(i_t,k  - i*_t,k )  +  e_t (2)

The null hypothesis of uncovered interest parity (UIP) is b=1.

The uncovered interest differential (UID) is:

UID_t,k =  i*_t,k  -  i_t,k  +  Ds_t,t+k  (3)

If the uncovered interest parity condition holds, the uncovered interest differential is expected to be equal to zero.

Interpretation of the magnitudes of the coefficient b of the equation (2) and the uncovered interest differential of the equation (5) indicate the degree of the financial integration of the concerned economy with the world market.

For simplicity, during the test the term ED stands for Ds_t,t+k  using the black market exchange rate, while EDIB also stands for Ds_t,t+k  using the interbank market exchange rate. IVN denotes domestic three-month deposit interest rates which is a proxy for i_t,k while IW denotes the three-month interbank offer US dollar interest rate in the Singapore market on the last Friday of the month, which is a proxy for i*_t,k .  ID stands for (i_t,k  - i*_t,k ) (ID = IVN – IW).

3.1.2.      Estimation results

The estimation of (2) will be: (use the black market exchange rate to calculate ED)

 ED  =  0.2172   –   0.1796 ID

p-value:   (0.1464)

If instead, we use the inter-bank market exchange rate for ED calculation, we obtain similar results:

EDIB  =  0.2057  –  0.1506 ID

   (0.08)

p-value of  a = 0.0001 and b = 0.0856, respectively.

3.1.3.      Summary of findings

During the sample period, the uncovered interest rate parity does not hold in Vietnam’s market. This is consistent with the current financial market in Vietnam since the assumptions under the uncovered interest rate parity are perfect capital mobility and perfect substitutions between domestic and foreign financial assets while in Vietnam capital controls are still extensive and very poor substitutions between domestic and foreign assets.[2] In addition, the parity also does not hold in Vietnam when the domestic interest rate is substituted by the local dollar interest rate. This implies the concurrent isolation of the local dollar interest rate from the world rate.

1.2.            Monetary independence and the offset coefficient in vietnam

Experiences of emerging countries indicate that under pegged exchange rate regime, the most popular response to sizable capital inflows in order to maintain independent monetary policy, in particular monetary aggregates is sterilization. It is interesting to examine that in order to reach the target of maintaining an independent monetary policy, whether an effective sterilization has been exercised in Vietnam under the pegged exchange rate regime by estimating the offset coefficient for Vietnam.

Offset coefficient: theoretical framework

Generally, there are two approaches to estimating the offset coefficient in the study of monetary independence: the monetary approach to the balance of payments and the portfolio balance model of exchange rate determination in the literature. In this thesis, we will try the Monetary approach to the balance of payments to run the estimation as the other approach ‘the Portfolio balance of model of exchange rate determination’ has been used to run the model for Vietnam by other authors, such as  in Vo Tri Thanh et al (2001).

Following the theoretical derivation, the following equation will be run:

r = b₀ + b₁D log  P + b₂D log Y - b₃D i + b₄d  + u_t    (6)

Where Y, i and P are denoted for real income, the interest rate, and prices, respectively. And r and d stand for the ratios [F / (F + D)] D log F and [D / (F + D)] D log D, respectivey with F and D are denoted for Net foreign assets and Net domestic assets.

If the Monetary Approach to the Balance of Payment is correct, b₁ is expected to equal unity, b₂ and  b₃ to take values similar to those estimated in conventional money demand equations (that are 1 and –0.01 respectively) and b₄ to equal to –1.

Estimation results

Using EViews package and employing OLS technique to run the regression, we obtain the equation:

          r  = 0.0145 +  0.6762 D log P  +  0.1130 D log Y -  0.0497 D log i -   0.5531 d

p value:   (0.004)     (0.003)                   (0.056)                (0.397)                  (0.003)  

The Wald test indicates that the coefficient of the variable d differs significantly from –1.

Coefficients of the variables D log P, d and the intercept are statistically significant at 5 percent level. Coefficient of D log Y is significant at 10 percent level. That the coefficient of the variable D log i is insignificant might be justified by the fact that the interest rate does play a little role in explaining the growth rate of Net Foreign Asset (dependent variable-r).

It can be said that all coefficients are correctly signed in terms of the approach of monetary to the balance of payments. However, all the coefficients are less than the predicted value. This is likely to reflect the fact that Vietnam is far from a financially deepened economy.