THE RELATIONSHIP BETWEEN CAPITAL INFLOWS
AND THE REAL EXCHANGE RATE IN VIETNAM
Nguyen Thi Vu Ha, PhD Student - VNU
Supervisors:
Prof. Nguyen Hong Son,
Dr. Nguyen Manh Hung
Outline
Introduction
Brief Review of Literature
Overview of Capital Inflows to Vietnam
Overview of Foreign Exchange Market in Viet Nam
Capital Inflows to Vietnam and the real exchange rate
Preliminary Results
Conclusion
Introduction
Definition
• Capital inflows are defined as the increase in net
international indebtedness of the private and the
public sectors during a given period of time
Two types of inflows
• Inflows that are driven by fundamental economic
factors  expected to be stable
• Inflows that are not driven by fundamental economic
factors  may be unstable
Introduction
• Additional resources available for productive investment
• Risk sharing with the rest of the world (equity)
• Greater external market discipline on macroeconomic policy
The
Role of
Capital
Inflows
• Enhanced access to technology and management skills (FDI)
• Broader access to export markets through foreign partners
(FDI)
• Training and broader exposure of national staff (FDI)
• Greater liquidity to meet domestic financing needs (FPI)
• Broadening and deepening of national capital markets (FPI)
• Improvement of financial sector skills (FPI)
Introduction
But, capital inflows
creates the
pressure to push
up the domestic
currency’s value
against the foreign
currencies such as
the United States
(US) dollar
The Central Bank
must intervene into
the foreign
exchange market
to buy in the dollar
from the
commercial banks
 inflation.
Important
explanations for
the occurrence of
two-digit inflation
rate in Viet Nam in
the period of 20072008.
Introduction
In Viet Nam, capital control
policies are applied to
change the scale and
structure of the capital
inflows to encourage longterm capital sources,
especially when much
capital has been poured
into the financial
investment and real estate
sector after Viet Nam
became the WTO member.
The government should
carefully analyze the
impacts of the capital
control policy frameworks.
The failure to alter
inappropriate control
policies may result in the
fall of GDP growth rate and
undermine price stability.
Introduction
Research questions:
• How has capital inflow impacted the real
effective exchange rate in Viet Nam? and
• What are the effective measures to cushion
the effects of capital inflow on exchange rate?
Brief Review of Literature
An increased foreign capital inflow helps the host countries to
achieve high economic growth but at the same time it creates
problems:
• inflation pressures, high real exchange rate (with adverse
effects on exports), loss of control over monetary policy, high
dollarization (Greenville, 2008; Kwan, 1998);
• lower domestic saving, and fall in the domestic interest rate or
the cost of capital (World Bank, 1996).
The impact depends on the volume of flows, the macroeconomic
policy framework, the microstructure of the flows and the
incentives in the financial sector (World Bank, 1996).
Brief Review of Literature
Capital inflows can create financial instability
(Kawai and Takagi, 2008).
• Capital inflows affect the financial system by pushing up equity
and other asset prices (the asset price inflation), reduce the
quality of assets and negatively affect the balance sheets of the
banks or finance companies because capital inflow often comes
through financial sector.
• Recent experience suggests that the impact of capital inflows
on asset prices has been particularly significant (Greenville,
2008; andSchadler, 2008).
Brief Review of Literature
Measures to manage capital inflows are often examined in
different ways and different dimensions.
• Some authors have looked at direct and indirect measures
(Kwan, 1998) while others concentrated in macroeconomic and
structural measures (Fernandez-Arias and Montiel, 1995;
Grenville, 2008; and Schadler, 2008).
Measures to cushion impacts of
capital inflows on ER
Capital Inflow
Create macroeconomic instability
(ER appreciation, Export and Import)
Capital
controls
Direct
measures
Currency
appreciation
Indirect
measures
Intervention
into FX
Without
sterilization
With
sterilization
Fiscal
Policy
Government
Expenditure
Capital Controls
Direct measures
Indirect measures
• Restrictions on the acquisition of
domestic securities or bank
deposits by non-residents and
overseas fund-raising activities
• Taxing short-term overseas
borrowings
• Restrictions on forward foreign
exchange transaction
• Withholding tax on bank deposit
by non-resident
• Restrictions on open foreign
exchange positions of banks
• Imposing higher reserve
requirements
Intervention into FX
Intervention into FX
Without sterilization
With sterilization
Direct measures
Indirect measures
Window guidance
Open market operations
Moral suasion
Issuance of central bank securities
Transfer of public deposits from private banks to
the central bank
Official discount rate operation
Manipulation of reserve requirements
Fiscal Policy
Dutch Disease Model (Corden, 1982):
• Appreciation of the real exchange rate following
capital inflows can be avoided by reducing demand
through the fiscal contraction.
Reduction in government expenditure can have a
favorable switching effect because government
expenditure tends to be spent more on non-tradable
goods (Athukorala, 2003)
Sterilizing foreign exchange
market interventions
Domestic
inflation
Increase domestic
money base
The Central buy
excessive flows
Domestic currency
appreciates
Capital
Inflows
Brief Review of Literature
Only a very limited number of studies on the relationship between
capital inflow management and the RER.
• Vo and Pham (2008) and Vo (2010) confirmed that capital
inflow could have both benefits and risks for Viet Nam, and
policy responses to a surge in capital inflows were always
constrained by the “impossible trinity.”
• To (2008) provided an analytical picture of the capital inflows
and outflows in Viet Nam. However, she did not discuss much
about the capital flow management. ER was examined in the
current researches in a very limited extent (i.e. by tracing its
movement).
• Some short articles have tried to analyze the link between
exchange rate and some specific components of capital inflows
(e.g. FDI, and FPI) but only for a short period of time and based
on qualitative analysis.
Overview of Capital Inflows to
Vietnam
5000
4000
3000
2000
1000
0
-1000
-2000
Implemented FDI ($mil.)
Other Investment ($mil.)
Portfolio Investment ($mil.)
Current Transfer ($mil.)
FDI
From 1991 to 2009, Viet Nam received 11,995 FDI projects with the
total registered capital of $191.2 billion, 35% of which were
implemented.
• After peaking in 1996, FDI inflows into Viet Nam had declined following
the Asian crisis.
• However, since 2004, it has increased rapidly, reaching more than
$12.0 billion in 2006 and $21.3 billion in 2007 in terms of committed
inflow.
• FDI inflow reached its peak again in 2008 with the total registered
capital of $71.7 billion. In 2010, the implemented FDI reached $11.0
billion, increasing by 10% compared to 2009
• The surge of FDI in the last three years reflects investors’ confidence in
Viet Nam’s economic reform and development prospect as well as the
shift of FDI in labor-intensive industries such as outsourcing logistics,
electronics, garments and manufacturing from China to Vietnam
FDI
The registered FDI has been allocated mainly in
manufacturing industry, real estate, hotels and restaurants,
construction and communications and telecom.
• In the 1990s, FDI was concentrated in import substitution
industries.
• Since 2000, it has been shifted to export manufacturing sector
and services sector.
• From 2008 until now, FDI was poured into real estate
businesses, creating a boom in real estate.
FDI
The foreign invested enterprises play an
increasingly significant role in Viet Nam’s economy.
• In 1995, these enterprises employed 220 thousand
workers and accounted for 6.3% of the GDP.
• In 2007, they employed almost 1,3 million workers and
accounted for 16.2% of the GDP. The growth rate of the
foreign invested sector is usually higher than other
sectors in Vietnam.
• The foreign invested sector is currently a dynamic force
for Viet Nam’s exports and the development of various
manufacturing industries
FPI
Since 2001, FPI began to flow into Viet Nam with
several funds having an average capital of $5.0-20.0
million each
FPI inflows in Viet Nam increased rapidly in 2006,
thanks to investments on the stock market by
international financial groups and funds.
Foreign investment funds brought in $2.0 billion of FPI
into Viet Nam at the end of 2006.
Foreign portfolio inflows accounted for 2.2% and
10.4% of the GDP in 2006 and 2007, respectively.
After a sharp fall in 2008 due to the impact of the
global financial crisis, the FPI inflow has recovered
since the beginning of 2009. As of August 2010, Viet
Nam’s stock market accounts for 40.0% of the GDP
Overview of Foreign Exchange
Market in Viet Nam
Before Doi Moi
• Vietnam had a mono-banking system in which central banking
and commercial banking activities were not separated. A three–
tier exchange rate (ER) system existed: official ER for foreign
trading, non-trading ER and internal ER used among banks and
other domestic business entities.
• Those ERs were fixed by the government based on economic
and granting agreements between the government of Viet Nam
and foreign governments.
• However, there was a paralleled informal/free foreign exchange
market with higher ERs than those set by the government.
Overview of Foreign Exchange
Market in Viet Nam
In March 1989
• the three-tier ER system was unified into a single official ER (OER) set by
the SBV.
• In principle, the OER was adjustable, based on inflation rate, interest
rates, balance of payment stance and the ER in the paralleled free foreign
exchange market.
• Based on the OER announced by the SBV, commercial banks were
allowed to set the ER for their own transactions within a band of (+/-) 5%
around the OER.
In May 1990
• The State Council passed two banking ordinances to transform the old
mono-banking system to a new two-tier banking system with SBV serving
as the Central Bank, and a system of commercial banks.
• Ordinance on State Bank of Vietnam, and Ordinance on Banks, Credit
Cooperative and Financial Enterprises
Overview of Foreign Exchange
Market in Viet Nam
In 1991
• OERs were set by auction, based on rates at two foreign exchange
floors (in Ho Chi Minh city and Hanoi) where the SBV played a
dominant role, by buying or selling large amounts of foreign currency.
Since September 1994
• the two foreign exchange floors were replaced with an inter-bank
foreign exchange market in which the SBV still remained influential as
the “last lender and last buyer” of foreign currency.
• Although the SBV has made big attempts to stabilize the exchange
rates, under the market pressure, since the mid-1990s, the ER band
has been widened continuously.
Overview of Foreign Exchange
Market in Viet Nam
Until the early 2000s, the most popular measure to
manage capital inflow was the interest rates.
• Since January 1991, domestic residents have been allowed to hold
foreign currency deposits.
• In 1993, the SBV began to apply ceiling on lending interest rates
• In 1998, the fixed spread between deposit and lending interest rates
was eliminated. However, three categories of ceilings on lending rates
were still in place: short-term, long and medium-term loans.
• In 1999, three types of ceilings were merged into one type of ceilings
on lending rate.
• In 2000, ceiling on interest rates was replaced by the basic monthly
rate and the SBV allowed credit institutions to determine the foreign
currency lending rates by the Singapore Inter-bank market rates.
• Since June 2002, the interest rate has been liberalized
Overview of Foreign Exchange
Market in Viet Nam
• Massive inflows of capital into Viet
Nam over the past years have loaded
mounting pressure on the ER of dong
against the dollar, and consequently
on the exchange rate policy to stabilize
the foreign exchange market.
Overview of Foreign Exchange
Market in Viet Nam
19000
•
Massive inflows of capital into Viet Nam over the past years
have loaded mounting pressure on the ER of dong against
18000
the dollar, and consequently on the exchange rate policy to
17000
stabilize the foreign exchange market.
16000
15000
14000
13000
12000
The NER has been consistently increasing
since the mid-2000s, experiencing a sharp
rise during the 2007-2009 periods.
Overview of Foreign Exchange
Market in Viet Nam
More market-oriented
instruments (e.g. sterilization,
gradual adjustment of ER
band) have been employed by
the SBV in combination with
administrative measures
However, the instability of the
exchange rates is rooted in
chronicle macro-economic
weaknesses (e.g. trade deficit,
fiscal deficit) which cannot be
addressed within a few days.
Capital Inflows to Vietnam and the
real exchange rate
This research is to explain the change in real effective
exchange rate (REER) with the following variables:
• FDI = Implemented FDI (% GDP)
• OCFW = Capital inflows excluding FDI (% GDP) = [Current transfer +
Portfolio investment + Other investment] (% GDP)
• EXMG = Excess money supply (%) = M2 growth (%) – GDP growth (%)
• GEXP = Government expenditure (%GDP)
• NER = Nominal exchange rate (dong/U.S dollar)
• OPEN = Openness of the economy = (Exports of goods and services +
Import of goods and services)/GDP
• GEXP, OPEN, EXMG and NER represent the current policy responses
to the impact of capital inflows on real effective exchange rate.
Capital Inflows to Vietnam and the
real exchange rate
The real effective exchange rate (REER) is calculated by Thanh
and Ha (2011) using the following formula:
REER = ∑Eiwi*Pi/P (VND/USD) of which:
• i = Viet Nam’s trading partner i
• E = exchange rate (VND/trade partner currency) = E(VND/USD) x
E(USD/Vietnam trade partner currency)
• w = trade weight between Vietnam and partners (%) = (export +
import)Vietnam-partner/total (export + import) of Viet Nam. There are 12
major trading partners.
• P = the price index.
Baseline model:
REER = f (FDI, OCFW, EXMG, GEXP, NER, OPEN)
• An increase (decrease) in REER indicates real depreciation
(appreciation).
Capital Inflows to Vietnam and the
real exchange rate
The common-sense hypotheses are:
• Increase of capital inflow, excess money supply
and government expenditure are associated with
real appreciation of VND
• Increase of nominal exchange rate and openness
are associated with real depreciation of VND
Capital Inflows to Vietnam and the
real exchange rate
The expectations can be explained as follows:
• First, the law of supply and demand in the foreign exchange market
indicates that increased foreign currency flows lead to an increase in
foreign currency supply.
• Second, appreciation of the RER following capital inflows can be
avoided by reducing demand through the fiscal contraction
• Third, to reduce the capital impact, the central bank needs to buy
excessive flows  increase domestic money base  a stimulation of
domestic inflation  The central bank offsets this effect by using the
open market operations or other monetary measures to reduce
domestic credit expansion
• Fourth, other things remaining unchanged, greater openness to trade
tends to avert the undue pressure for the appreciation of the real
exchange rate; and if the NER increases, centeris paribus, then the
RER will increase.
Capital Inflows to Vietnam and the
real exchange rate
All variables are
quarterly collected
from Q1 of 2000 to
Q4 of 2009.
Data for foreign
portfolio investment
is not available until
Q1 2005 but until
that time the amount
of FPI is negligible.
Variables
Data Sources
REER
Thanh and Ha (2011)
FDI
IFS
OCFW
IFS
EXMG
IFS
GEXP
GSO
NER
Joint Stock Commercial
Bank for Foreign Trade of
Viet Nam (Vietcombank)
OPEN
IFS and GSO
Preliminary Results
Regression Statistics
Multiple R
0.800591812
R Square
0.64094725
Adjusted R Square
0.573624859
Standard Error
0.043452776
Observations
39
ANOVA
df
SS
MS
6
0.107857182
0.017976
Residual
32
0.060420601
0.001888
Total
38
0.168277782
Regression
Coefficients
Standard Error
t Stat
F
9.520566
P-value
Upper 95.0%
Intercept
0.879934876
0.067488148
13.03836
2.39E-14
1.017403735
NEERVCB
1.52669E-05
0.085908132
0.000178
0.999859
0.175004405
OPEN
0.001269201
0.000487428
2.603872
0.013861
0.002262061
Preliminary Results
Regression Statistics
Multiple R
0.800591812
R Square
0.64094725
Adjusted R Square
0.573624859
Standard Error
0.043452776
Observations
39
ANOVA
df
Regression
Residual
Total
6
SS
0.107857182
MS
0.017976
32
38
0.060420601
0.168277782
0.001888
F
9.520566
Preliminary Results
Coefficients
Standard Error
t Stat
P-value
Upper 95.0%
Intercept
0.879934876
0.067488148 13.03836 2.39E-14
1.017403735
NEERVCB
1.52669E-05
0.085908132 0.000178 0.999859
0.175004405
OPEN
0.001269201
0.000487428 2.603872 0.013861
0.002262061
GEXP
-0.000303767
0.000655983 -0.46307 0.646447
0.001032426
EXMG
-0.00137825
0.000359892 -3.82962 0.000564
-0.000645174
FDI
-0.014777425
0.003425714 -4.31368 0.000144
-0.007799474
OCFW
0.007055656
0.001898426 3.716581 0.000771
0.010922624
Preliminary Results
1
2
3
• Increased FDI leads to real appreciation of VND against the USD
but the increased OCFW cause the REER to increase
(depreciation). The impact of FDI and OCFW on REER
(coefficient is different from 0) is statistically significant at 5%
level.
• Openness leads to produce real depreciation VND against the
USD. The impact of OPENESS on RER (coefficient is different
from 0) is statistically significant at 5% level.
• The increase in Excess money supply leads to real appreciation
of VND against the USD
Conclusion
In short, capital inflows have significant effects on real
effective exchange rate of Viet Nam but two types of capital
inflows have different effects on real effective exchange rate.
However, Viet Nam has possessed a limited number of
effective policy instruments to neutralize the effect of capital
inflows on the real effective exchange rate.
The econometric model shows that money supply currently
seems to be the only viable policy option to neutralize the
effects of capital inflows on real effective exchange rate.
Increase of capital inflows (FDI) lead to decrease in REER
(real appreciation of the dong), and this appreciation effect
can be neutralized by a cut in money supply.
Conclusion
Although targeting at NER remains a popular policy, this
is not an effective option to intervene into the foreign
exchange market.
This policy may not solve all problems in the long run
under the impact of capital inflows.
Since the 2008 crisis, Viet Nam’s policy adjustment to
cure the dong and stabilize the market has moved toward
freer exchange rate mechanism and depreciation of the
dong. Letting dong depreciate may be good when Viet
Nam is facing with high trade deficit.