Economic Research

Macro Commentary February 15, 2012

VinaCapital
Sunwah Tower, 17F 115 Nguyen Hue, District 1, Ho Chi Minh City, Viet Nam

Alan Pham, PhD Chief Economist

T: +848 3821 9930, ext: 233, alan.pham@vinacapital.com

AN ASSESSMENT OF SBVS INTERVENTION IN THE FX MARKET

I.

Background
In this memo we (i) seek to clarify those various factors that contribute to the relative value of the VND/USD, and (ii) thereby, attempt to assess the VND stability in 2012. Our exercise is motivated by this fact: the inflation rate in the US has been very low for several years, hovering about 2-3%. Meanwhile, inflation in Vietnam has been running in double digit range (for ex: 18% for 2011). Theoretically speaking, this discrepancy would be reflected in a 16% per annum depreciation of the VND. However, this has not been the case. In recent years, the VND has depreciated about 5% against the USD.

II.

Discussion
In an environment where market forces are allowed to operate freely, such loss in VND value (equal to the 16% mentioned above) would indeed occur. However, real economic conditions are quite different: o The VND is not a convertible currency. It is not freely bought and sold on international financial markets. Actually, the VND is not much in demand outside Vietnam. FX traders do not consider it profitable to make a market in the VND. o The VND is not allowed to be freely floating such that its values can be determined by market forces. In reality, the above 2 conditions are satisfied because of the SBVs active role in the market. As the countrys central bank, it is explicitly charged with a responsibility to manage the VND value. In fact, a completely free float exists only in theory. All nations manage their currency to various degrees because its value plays a central role in macroeconomic policy. Under its current policy, the SBV adopts a managed floating policy called a crawling peg. o It pegs the VND to the dollar at a certain rate (fixed at 20,828 for the time being). o The peg is then allowed to crawl along either up or down as reflection of SBVs judgment of market developments. o The crawl is further limited by a +/- 1% band on either side of the pegged rate, forming a monetary snake within which the VND can fluctuate. As can be observed, this is an elaborate framework involving: the peg, the daily crawl, the bandwidth. The inflation differential between the US and Vietnam is not allowed to freely impact on relative values of the two currencies.

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Economic Research

A. Other factors influencing the VND value.

That is not all. The govt also uses a host of other policy steps and administrative instruments. Their purpose is to influence directly or indirectly the supply and demand for the USD. o Imports of foreign goods and services are subject to limits and restrictions. Legitimate needs for foreign currency like purchasing capital equipment or overseas medical treatment are mostly approved. Luxury goods are usually declined or restricted. o Exports are encouraged. Industries with export potential are given easy bank credit and other lenient conditions. They contribute to FX earnings that would support VND value. The SBV maintains a large differential between deposit rates on the VND and USD (currently fixed at 14% and 2%, respectively). This returns gap would make it more profitable and desirable to hold the VND , thereby boosting its value in a powerful way. Many analysts consider this a decisive policy step in supporting the VND. A reduction in this gap would quickly translate into a weaker national currency. A carry trade has developed : o Overseas Vietnamese have incentives to send USD home for conversion and deposit at banks. In the USA or EU markets, their capital would earn only very low returns (less than 1%). o Many individuals and companies in Vietnam are tempted to take out USD loans (at 6%), convert them into VND, and enjoy a deposit rate of 14%.

B. Intervention by the central bank.

Last but not least, the SBV often directly intervenes in the FX market. Such interventions are usually necessitated by strong and immediate market pressures, which must be countered at once. Other measures (as described above) may take too long to be effective. For example: in August September 2011, world gold prices rose precipitously due to the EU debt crisis and a weak US economic recovery. Domestic gold prices in Vietnam followed the world trend, but were then pushed upwards even further by speculative factors. A scramble for dollars began to develop as speculating groups and common people sell VND on a large scale to obtain USD for importing or smuggling gold. In order to support the VND, the SBV intervened by entering the market and sell dollars. In the event, during the summer months of 2011, it had accumulated a dollar war chest of nearly USD6 bn and added that to its reserve holdings. Thus when the gold fever got going, SBV had the wherewithal to mount a large-size intervention, and was able to blunt the gold-induced attack on the VND. After some gyrations, the USD/VND rate returned to stability. Governor Binh felt sufficient confidence in his policy to publicly pledge that any VND loss in value would be limited to 1% in Q4 of 2011. And his confidence later turned out to be justified. In this case, SBVs intervention proved successful in restoring stability to the FX market and supporting the VND value. The main reason lies in the resources at its disposal: a war chest of USD6 bn was on hand. However, the successful intervention came with a price tag: it cost the SBV USD1.5 bn. In subsequent weeks , a smaller operation along the same line drained away USD150 mn. This series of interventions provided empirical evidence in support of a hypothesis among policy experts: it would take about USD2 bn of reserves to stabilize the FX

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Economic Research market once it has gone unstable. This is very useful intelligence for policy making. It helped determine the amount of resources needed for any effective intervention. A smaller amount would be unlikely to have the hoped-for impact. An issue is whether such an intervention involves a subsidization to support the VND value. To put the matter in context, we can look at a subsidy on electricity price. It is provided to consumers at below market price (or even below production cost), and would generate a cost to the budget.

C. The costs of intervention.

Loss of foreign reserves. o As mentioned, each intervening operation carries an average price tag of USD2 bn . o Vietnams low FX reserves (covering about 2 months imports, versus a 3 months safe margin) represent a limited national resource that must be accumulated from export earnings, FDI disbursements, remittances. o Once used up in intervening operations, such reserves are gone, and no longer available to pay for necessary imports, or for supporting the BOP position. Impact on monetary policy. o When such reserves must be purchased on the open market, as happened in mid 2011, an equivalent amount of VND must be injected into the system, contributing to a rise in M2, and possible inflation pressures. Loss due to buy high and sell low. o When the SBV intervenes to bring down the free market rate (in support of the dong) it would sell dollars at a lower price than going market rate. When these dollars were previously bought at open market prices, the differential is a loss to the government. This is a price paid by the state to have resources for intervention purposes.

D. Conclusions.

From our assessment of SBVs recent FX policy actions, we can conclude that: o The current economic environment in early 2012 is favorable for a stable VND, especially in the next 6 months. o Some of the reasons are: Declining inflation, reducing the VND loss in value. Improving trade deficit (in fact it turned into a 170 mln surplus in Jan 2012). A BOP surplus in 2011. Another surplus projected for 2012. FX reserves rising. FX management by SBV has been skilful and effective.

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Economic Research Intervention in FX market, though costly, has proven effective as can be seen in the gold fever episode of Sep 2011. The SBV has been both willing (as a policy option) and able (with enough reserves) to intervene when necessary. o We believe that the SBV now considers market intervention as a major policy tool to support VND stability. Recent press reports indicate that it has entered the market and purchased USD to beef up reserves. This would provide the resources for any future market intervention. _____________________________________________________________________________________

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