How to Peg Exchange Rate?

 

Following the devaluation decision, the officially quoted exchange rate is getting closer to the free market rate. Fears of dollar hoarding happened as companies anticipated. Empirically, when the official exchange rate is revised up, the rate on the black market will experience a wide volatility before easing down but a new rate will be created and the gap with the quoted rate is widened again. A dual rate mechanism has existed in Vietnam for long but the SBV is unable to eradicate it as it lacks stronger and more comprehensive solutions.

The primary weight on exchange rates is mounting trade deficit that Vietnam is unable to settle for many years. The trade deficit was some US$12 billion in 2010 and was forecast to reach US$13-14 billion in 2011. Although it was kept below 20 percent of exports, it was enough to heighten pressures on exchange rate.

 

Another fundamental reason is the rising dollarization of economy. The public tends to increase hoarding of US dollars other than local currency on fears of devaluation. Thus, people and companies hold a very large amount of greenback but they do not sell while the country’s reserve is not large enough to interview into the volatile market. Growing pressure on exchange rate results in dollar fevers and the SBV is forced to adjust its officially quoted exchange rate. After many times of increases, the quoted rate is still lower than the rate on the actual market rate.

 

In the latest devaluation of 9.3 percent, many experts predicted that the SBV would gradually float foreign exchange market because it was a matter of time. In the past 15 months, Vietnam devalued its currency four times in an attempt to reduce trade gap and narrow the gap between officially quoted rate and free market rate. This policy may lead to higher inflation growth which is already at a two-year high, according to the International Monetary Fund (IMF). However, an adjustment to exchange rate may cause volatility in the short term but will bring in trust of the people and foreign investors in the medium and long terms - a good condition to lure direct and indirect foreign investment capital.

 

It may take a very long time to reach the “market” rate as the SBV’s adjustments only resulted in exchange rate fluctuations, caused dollar fevers on the black market, and undermined the confidence of the public and business community. The forex exchange market needs more radical solutions.

 

With respect to trade deficit, although Vietnam has a relatively high export growth, averaging over 20 percent a year, this achievement has been overshadowed by much faster import expansion. Trade gap is increasingly widening. It accounted for 12 percent of the country’s GDP in the 2007 - 2010 stage. Reducing trade deficit is a most-discussed policy for years but the result is weak, leading to growing strains on forex market, local currency devaluation, dollarization and loss of public confidence in local currency.

 

With escalating prices in recent months, volatile exchange rate has eroded public confidence. Late last year, the IMF urged the Vietnamese government to tighten monetary policy to restore the order of foreign exchange market and curb inflation. Mr Benedict Bingham, IMF Senior Resident Representative in Vietnam, said: Vietnam needs many policies to restore macroeconomic stability. Monetary policies should primarily direct to inflation control and fiscal policies should aim at curbing public debt.

 

Exchange rate is not only a problem for the SBV but also the entire economy. If the central bank devalues the local currency many times, the purpose of stabilising the exchange rate is still distant. Even, some experts recommended that the SBV should not run after the black market and suffer pressure from it when it regulates exchange rate policies. The root of the problem - trade deficit - is still in existence, the rise in exchange rate is possibly not enough to solve it.

Reducing trade deficit is a difficult job. On the market, from toothpicks to luxury cars are imports. Meanwhile, exports have very low value. However, the Government has recently adopted measures to tighten public spending and investment and instructed the central bank to cap credit growth at 20 percent this year. Anti-inflationary policies also help ease pressures on exchange rate and local currency depreciation.

 

According to Dr Cao Si Kiem, former SBV Governor, Vietnam cannot apply free interest and free exchange mechanism at present but it requires State interventions because the supply and demand is not stable and inflation is high. If there is no State management, speculation will be unavoidable.

 

Mr Kiem added that people do not know supply and demand exactly and they usually react to the market movement. Even, they purchase more when the USD price rises up and they sell off when the price drops.

Nonetheless, with repeated dollar fevers, the market needs a quick-effective medicine to put a stop to fevers before radical solutions are taken. Although the official exchange rate has been raised, people tended to hoard more dollars because they think the real value will be higher. The SBV needs supporting policies to increase USD sources for the banking system and weaken the public interest in the greenback. One expert recommended SBV to allow buying/selling US dollars through third currencies like euro or yen, buying/selling future US dollars, and monetary options. The ceiling rate still needs but the real traded value should be higher. The high or low margin reflects future expectations in exchange rates. If people can buy/sell foreign currencies at high prices on the official market, they will sell to banks. The hoarding will be decreased as they can purchase foreign currencies more easily. Bringing supply and demand to match is the first step to unite the black and official markets.

 

Unfortunately, these forex operations are disallowed by the SBV although they are very popular in other nations.

 

Another expert recommended that instead of depositing foreign currencies at foreign banks at low interest rates, the SBV should take them back and lend commercial banks to fund companies. In return, companies must sell foreign currencies to the SBV.

 

Currently, the central bank has not had any effective medicine to heal the dollar fever. It is a catastrophic choice to intervene into the market with very limited forex reserve but the SBV still has to do it given bad impacts of black market movements.