This Background Papers study analyzes output performance of Vietnam in transition years. Output performed surprisingly well during the core transition years. During 1988–89, output growth reached an average of 6–7 percent per year, well above the average of 4–5 percent achieved since the unification of North and South Vietnam in 1975. Output growth in these two years was driven by strong performance in the agriculture and services sectors. During the second phase of the transition, 1990–91, output growth slowed somewhat to 5–6 percent.

Abstract

This Background Papers study analyzes output performance of Vietnam in transition years. Output performed surprisingly well during the core transition years. During 1988–89, output growth reached an average of 6–7 percent per year, well above the average of 4–5 percent achieved since the unification of North and South Vietnam in 1975. Output growth in these two years was driven by strong performance in the agriculture and services sectors. During the second phase of the transition, 1990–91, output growth slowed somewhat to 5–6 percent.

I. Output Performance in Transition 1/ 2/

One of the striking features of Viet Nam’s transition to a market economy has been the resilience of output. The level of general economic activity never declined; there was only a temporary deceleration in the pace of expansion under the impact of external shocks and fundamental changes in domestic policy. During the core transition period of 1988-91, the economy grew at an average annual rate of 6 percent in the face of comprehensive steps in the reorientation from a command system to a system based on market principles, including decentralization of decision making, creation of incentives, and the liberalization of trade, prices, and the exchange rate. At the same time, financial policies were tightened, although when the economy suffered the collapse of its commercial and financial relationship with the CMEA in 1990-91, the stance of monetary policies was temporarily relaxed. Since then, financial stabilization has been resumed, the reform process has continued, and the growth of the Vietnamese economy has accelerated to an annual rate of 8-9 percent.

This is a picture that contrasts sharply with the collapse of output in other transition economies in Eastern Europe, and the former U.S.S.R., raising questions about the factors accounting for Viet Nam’s success. The aim of this study is to explore those factors in the context of output developments by sector. In this, the emphasis is first on the strong supply response to reform policies, and the broadly favorable initial supply conditions. The paper then considers factors on the demand side, arguing that wage and price flexibility and buoyant exports helped sustain real demand.

1. Output and employment performance during the transition

Output performed surprisingly well during the core transition years. During the period of 1988-89, output growth reached an average of 6-7 percent per year, well above the average of 4-5 percent achieved since the unification of North and South Viet Nam in 1975. 3/ Output growth in these two years was driven by strong performance in the agriculture and services sectors. Industrial growth, however, stagnated. During the second phase of the transition, 1990-91, output growth slowed somewhat to 5-6 percent, as the impact of agricultural reform on food production tapered off.

Stages of the Transition

The start of Viet Nam’s transition (Doi Moi, which literally means renovation) is generally associated with the Sixth party congress of December 13-19, 1986. Although no specific actions were taken at the Congress, its tone, notably in the political report, was very critical and diagnosed many of the ills such as: (i) emphasis on large-scale projects; (ii) bureaucratic centralism; and (iii) excess money creation. Major reforms of the institutional framework of the economy followed in 1987-88, notably the passing of a liberal foreign investment law, the creation of a Treasury, and a two-tier banking sector; some partial price and wage liberalization policies were also instituted. As core transition period, however, the years 1988-89 should be singled out. In these years the centralized control of output and prices was dismantled and exclusive user rights were established in the agricultural sector. This was followed by a second phase, the period 1990-91, marked by the collapse of the CMEA- based trade system, the end to Soviet aid, and the disintegration of the cooperative system. In 1992, Viet Nam emerged from the transition period with an economy without pervasive subsidies, price or output control, but with a reasonably balanced fiscal situation, and moderate inflation.

Several special factors contributed to the measured output performance in those years. Those factors include: the coming on stream of oil production and a large—but statistically dubious—increase in state management production. The direct contribution of those factors to output growth is estimated at 9 percent of GDP during 1988-91 (Table 1), of which about half was on account of oil. 1/ However, excluding those factors, average annual growth is still estimated at about 4 percent, a more than solid performance compared to other transition countries.

Table 1.

Viet Nam: Real Growth Rate, Adjusted for Special Factors, 1987-94

(Percentage change)

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Sources: General Statistical Office; and staff estimates.

Output growth during the transition appears mainly to have been driven by structural changes rather than traditional factors of growth: investment and employment. Data on both are weak. However, investment is estimated to have declined somewhat after 1985 and did not start to increase again until 1990. Thus, investment itself did not drive output growth, but utilization of excess capacity did play a role (see Section 2b below). Overall employment is estimated to have increased relatively rapidly during the transition compared with historical trends, but the increase was small relative to the growth in output. The main contribution to output from the employment side may have come from the shedding and voluntary departure of over one million public sector workers, mainly from SOEs, a large proportion of whom were re-employed by the private sector. 1/

Sectoral Composition of the Economy

At the start of the transition, Viet Nam was still a largely agricultural economy: two-fifths of GDP was derived from agricultural production in 1987. Compared to other low income countries, Viet Nam nevertheless had a relatively large industrial sector. The share of industrial output in GDP (28 percent in 1987), ranked close to countries such as Kenya, Pakistan, and Sri Lanka which have double the per capita income of Viet Nam (Appendix Table 1).

The state sector was relatively small, with a share in 1988 of about 30 percent. However, with the inclusion of cooperatives—which dominated agriculture and had large shares in industrial and services output—the public sector share was 75 percent, which is comparable with other transition economies (see Table 2).

Table 2.

Importance of the State-Owned Sector in Various Countries

(In percent)

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Sources: Lipton and Sachs (1990), drawing upon Milanovic (1989); General Statistical Office; and staff estimates.

Gross social product. Share of services in social product in 1988 is just 12.6 percent, compared to a share of 36 percent in value added in 1989.

Share in rice production. Statistics on production of other agricultural products indicate that the share in total agricultural production of cooperative Is presumably smaller.

2. Sectoral output performance and supply side policies

a. Agricultural output

The positive response of the agriculture sector to the reforms of the transition period is well known. From importing about half a million tons of food annually in the period 1986-88, Viet Nam became the third largest exporter of rice with exports totalling about 1.4 million tons by 1989.

Following the reunification of Viet Nam in 1975, agriculture in the country as a whole was increasingly collectivized (see Box 3). In the process, and because of a forced switch of production from rice to other cereals, per capita food production slumped, falling over 10 percent between 1976 and 1980, despite a rapid increase in the area under cultivation (Appendix Table 2). Facing these difficulties, some reforms were initiated in the early 1980s that allowed farmers to sell production in excess of quotas at market prices, and boosted the use of fertilizer, mainly imported with Soviet aid. This policy met with substantial initial success, 1/ but soon thereafter production growth tapered off. The experiments with more liberal economic policies under Doi Moi, started in 1987, Initially had a perverse impact on paddy production. 2/ With rampant inflation eroding the nominal rice contract price to 10 percent of the market-price, production, particularly in the surplus producing areas, fell rapidly. Aggravated by adverse weather conditions, per capita rice output dropped by 8 percent, accompanied by a period of famine at end-1987 and early 1988 in parts of Viet Nam.

The Role of Cooperatives and the Regional Agricultural Output Response

At the outset of the reforms in 1988, cooperatives dominated production of paddy and some annual industrial crops; the private sector dominated the growing of vegetables, cereals other than paddy, most of the annual industrial crops, and a few of the perennial industrial crops (coffee and fruits). The state farms dominated only rubber production (see Appendix Table 4a).

Cooperatives never established firm roots in the South. In the main rice producing area, the Mekong delta, cooperatives did not cover more than 7 percent of the farmers, compared to nearly 100 percent in the North (Appendix Table 4b). Soon after the start of the reforms, the number of collective units declined (Appendix Table 4c) and many of the production brigades were disbanded.

The output response was strongest where the collective organization was weakest. Paddy production in the Mekong delta surged by 40 percent in 1988 and 1989. From 1986 to 1990, food grain output increased by 25 percent in the South and 11 percent in the North. From 1990 to 1993, output in the South grew by a further 13 percent, while output in the North surged by about 30 percent.

The famine, and the recognition that half way price liberalization and financially undisciplined reforms did not work, were among the key factors leading to the bold reforms that mark the first core phase of transition, 1988-89. In the agricultural sector, the core policies, undertaken throughout 1988, consisted of liberalizing agricultural prices, introducing competition among agricultural trading companies, granting individuals and families long-term user rights to the land they were cultivating, and removing internal barriers to trade. 1/ These reforms reduced the role of the cooperatives, particularly that of production brigades, and stimulated investment, while at the same time ensuring that competition led to increased availability of inputs and the sale of the large marketable surpluses that soon emerged. The reforms elicited a substantive output response: overall agricultural production increased in 1988 and 1989 by 4 and 8 percent, respectively, with per capita food production rising by nearly 10 percent in both years. It is estimated that the increase in paddy production, added 3 1/2 percent to GDP growth. 2/ The response of the nongrain agricultural sectors was more subdued and came later (Appendix Table 3). 3/

During the second phase of the transition, 1990-91, the growth of food output leveled off to a modest 1 percent per year. On the one hand, the CMEA trade collapse led to sharply higher prices for fertilizers, while on the other hand food prices were depressed by the sizable output response in the years before. In contrast, output of industrial crops surged a cumulative 24 percent, reflecting a delayed response of the perennial crops to the earlier liberalization measures.

b. Industrial output restructuring

Overall industrial output (on a value added basis) stagnated during the first phase of the transition period, after rapid growth in the years before, supported by large-scale Soviet aid. In the second phase of 1990-91, however, the industrial sector expanded by about 13 percent. Without the coming on stream of oil, industrial production would have declined by about 10 percent during the four transition years. Nevertheless, compared to other transition countries, where the industrial sector was particularly hard hit, this was a strong performance.

(1) Policies

Reform policies crucially affected the performance of the industrial sector and the restructuring that took place. First, most industrial prices were liberalized by end-1988. Although a few key prices such as those of cement, steel, and electricity remained controlled for official (state) customers, these were generally set close to the free market prices (Table 3). Second, the official exchange rate was devalued and aligned closely to the rate in the parallel market, export subsidies were eliminated, foreign currency earnings were allowed to be retained, and trade was liberalized, in particular by allowing production enterprises to trade directly abroad, thereby dismantling the tight and bureaucratic grip of the trading companies. These policies subjected the industrial sector to domestic and foreign competition. Thirdly, the state enterprise sector was reformed and the private sector encouraged. The state enterprise reforms focussed on ensuring autonomy in decision making, releasing the enterprises from the constraints of the central plan, and the credible institution of hard budget constraints. This resulted in impressive output gains, while the cash flow and net tax contributions generated by the state enterprises also improved quite dramatically (see Chapter II). Policies to encourage the private sector included providing access to credit, and introducing nondiscriminatory taxation and commercial legislation.

Table 3.

Viet Nam: Selected Prices end Interest Rates, 1988-94

(Dong per unit)

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Source: State Pricing Committee.

Official business prices were abolished in 1989.

Difference between interest rates on landing to industry (from December 1992 on short-term loans) and households’ three-month savings deposits.

Average monthly inflation during the quarter; not seasonally adjusted.

Measured with respect to nominal interest rates at the end of each quarter and average monthly inflation during that quarter.

These policies contributed to a substantial restructuring of the Vietnamese industrial sector. Activity moved away from cooperatives and poorly managed state enterprises towards the better managed and capitalized state enterprises, and private enterprises. The number of cooperatives declined to a sixth of the 1988 level, while the number of new private and household enterprises rose sharply (Appendix Table 5). In the event, several of the key heavy industries, and some of the consumer-oriented state enterprises, did relatively well—partly owing to demand factors—while scores of smaller (most locally managed) state enterprises were effectively bankrupted.

(2) Output

The main segment of the industrial sector that performed well during the transition, and for reasons not directly linked to the reforms, was the oil sector. Oil output from the sizable Bach Ho oil field, exploited by a Vietnamese Soviet joint venture, added 8 percentage points to growth of industrial value added during 1988-89, and a further 15 percentage points during 1990-91. Other heavy industries that performed well were the power and cement industries. In both there was excess capacity 1/ available. Cement production, In particular, benefitted from booming small-scale and foreign-invested construction that more than offset the decline in cement demand from large-scale Government investment projects. The collapse of the CMEA trade arrangement had the unexpected effect of boosting the domestic steel and fertilizer industries. Steel production was increased to partly replace imports, the costs of which soared after cheap imports from Russia ceased. Domestic fertilizer production likewise rebounded, in contrast to the sharp decline in the early reform period when farmers had preferred the cheap and higher quality supplies from the CMEA (Appendix Table 6).

In addition to these heavy industries, a number of domestic consumer industries, which were curtailed under central planning, expanded rapidly during the transition. In particular, the production of liquor, beer, and cigarettes responded to market demand and, toward the end of the transition, benefitted from the Implementation of foreign invested projects. Reflecting these developments, gross output in the energy, food, and building material sectors performed well.

In contrast, production in several other areas was cut. Gross production in the equipment, machinery, wood products, paper, and household materials (glass, porcelain, etc.) sectors performed poorly, with declines ranging from 10 to 25 percent. Products such as sewing machines, bicycles, and tires faced increasing competition from imports and production had to be drastically cut. 1/ Many of the local state enterprises did not survive the autonomy and increased competition. Yet, the loss of traditional exports through the collapse of traditional CMEA trade arrangements had a relatively limited direct impact on industrial output. The production of textiles (clothes) and some foodstuffs was most affected, but in general the impact was limited as most industrial products were produced for the domestic market. 2/

c. Services sector

The services sector boomed during the transition, with average annual growth of 14 percent during 1988-89 and 10 percent during 1990-91 (Appendix Table 7). Even excluding the hard to account for doubling of state management, value added rose by 10 percent on average during 1988-91. In most of the services subsectors the boom resulted from the liberalization measures undertaken during the transition period. Private transport, notably by road, benefitted from the elimination of the internal trade barriers; private retail outlets sprung up and increased their share in trade value added from 50 percent in 1988 to 60 percent in 1989 and 70 percent in 1991; tourism strengthened after the opening of the economy, and the arrival of businessmen rose sharply following the adoption of foreign investment legislation in 1987; and finance and other supporting services benefitted from the increased trade on a commercial basis. Large increases also took place in repairs and private housing services, the latter in part in response to the cutback in housing provided by the public sector and in part to fulfill the demand for many foreign representative offices. The categories tourism, repairs, and housing surged nearly 90 percent during 1988-91, contributing about two thirds to the services sector growth (excluding state management) over this period.

3. The role of demand

a. The level of demand

In Viet Nam, tight demand policies have been pursued to reduce inflation, which exceeded 300 percent in 1987-88, as part of a strategy aimed at achieving sustained economic growth in the context of structural reform and financial stability. In many transition economies, financial tightening and the containment of demand have, in the presence of wage and price rigidities, contributed to a fall in output. In Viet Nam, these adverse effects were cushioned for a number of reasons, as outlined below.

The main policy instruments to contain demand during late 1988 and early 1989 were high real interest rates, supported by stricter credit conditions for state owned enterprises (Table 3). Notably during early 1989, deposit interest rates on three-month savings of households were raised from 6 to 12 percent per month, rewarding depositors with positive real rates, compared to negative real rates prevailing before that time. Fiscal policies were initially expansionary, as the budget had to cope with a decline in Soviet aid and the costs of laying off many public sector employees. This was reflected in monetary financing of on average 6 percent of GDP in 1988-89. Despite such monetary financing, however, inflation was reduced to under 100 percent in 1989, as the velocity of broad money halved during the year. 1/ During 1990-91, fiscal policies became the main instrument for demand containment, while interest rates were effectively lowered and credit for state-owned enterprises was relaxed. This led to an upsurge in inflation in 1991, before renewed commitment to demand containment in 1992.

The impact of these tight nominal demand policies on real aggregate demand was limited for at least two reasons. The first reason was the absence of significant price and wage rigidity. Almost all prices had been liberalized, and notably prices of agricultural commodities showed a large extent of price flexibility. Moreover, compensation of employees of state enterprises was relatively flexible through the existence of bonus and welfare funds and a large share in compensation in the form of expenditure for new housing and housing maintenance. Expenditure on these items allowed enterprises a fair measure of wage flexibility. This flexibility was underpinned by limited increases in the nominal base wage.

The second important element in averting a fall in real aggregate demand was that the increase in oil production and agricultural export earnings helped sustain overall demand. The effect of the loss of foreign aid in 1990 fell in part on project-related imports of investment goods rather than on domestic demand, and was partly offset by a reduction in foreign debt payments. Also, the negative terms of trade effect associated with the CMEA collapse was smaller than in many other transition countries. In part, this was the case because prices which Viet Nam was paying for imports were relatively higher than those paid by other CMEA countries (see SM/90/186, especially Annex I), and Viet Nam was able to obtain improved prices for exports from the convertible currency area.

b. Demand composition

Attempts to explain the cause of output declines in other transition economies refer also to lags in adjustment. An intersectoral shift in demand takes time to be accommodated through a shift in production and production factors. During this time, output generally falls. Most transition economies have been characterized by excessive investment, an overemphasis on heavy industry, and the absence of an extensive services sector. The liberalization of prices, and the abandonment of the command structure determining production and investment, has led in those countries to massive shifts, in relative demand, which could not be readily accommodated as production factors, notably labor, needed to be reallocated.

By contrast, investment in Viet Nam was relatively small (about 10-15 percent of GDP) and new export markets, both for goods previously exported to CMEA partners and for new products, were readily found among Viet Nam’s fast growing neighbors and in Asia more generally.

Additionally, there is ample evidence of labor mobility in Viet Nam in terms of the observed shift from public to private sector employment. And although large shifts occurred between the state and the nonstate sectors and within the industrial sector, the demand shift between sectors was limited (see Appendix Table 9). All these points indicate that the adjustment cost of shifts in demand in terms of output was limited in Viet Nam.

Employment Trends

Employment in the industrial and service sectors grew rapidly during the first phase of the transition period, 1988/89, followed by stagnation at the time of the collapse of the CMEA trade arrangements. Within this overall trend, the public and private sectors show quite opposite developments. The public sector shed about one million people during 1988-92, or about one quarter of its work force. Private sector employment, on the other hand, increased by 1.8 million people, or about 45 percent (see Appendix Table 10) in these sectors.

4. Underrecording of output

One of the other major explanations for the measured output collapse in transition economies is the underrecording of emerging private sector output. In Viet Nam, as in other transition economies, the recording of private sector and joint-venture output is weak as data gathering for the industrial and services sectors has relied primarily on reporting by state-owned enterprises. However, in Viet Nam the underrecording of output growth, rather than explaining part of an output collapse, only strengthens the conclusion of successful performance.

There is strong evidence that industrial and services output by the private sector have been underrecorded. The fact that a large increase in private sector employment is barely reflected in private sector output is one indication. Another thread of evidence is that output in the construction sector increased much less than cement production. Despite a decline in the cement intensive large-scale investment projects, production of cement doubled during 1988-93, basically driven by private construction, which is poorly captured in official statistics. There are indications also of underrecording of the output contribution of the rapidly expanding wholly foreign-owned enterprises.

5. Acceleration of growth

The acceleration of growth to 8-9 percent during 1992-94 was unrelated to special factors, such as oil and state management output. Indeed, excluding those factors, output growth shows a much stronger upward trend—from 3-4 percent annual rate in the period 1988-91 to 7-8 percent annual rate during 1992-94 (Table 1).

Against a background of increasing macroeconomic stability, the acceleration in growth was supported by increased investment and additional structural reforms, creating a steady rise in employment. Investment is estimated to have increased from 15 percent of GDP in 1991 to 22 percent of GDP in 1994. A significant part of the increase is accounted for by foreign direct investment. As discussed in Chapter III, foreign direct investment increased from about $100 million in 1989 to $650 million (4 percent of GDP) in 1994, and is estimated to have had an impact on output of 2 percent of GDP or more in 1994. The Government increased its capital expenditure to about 7 percent of GDP in 1994, from a low of 3 percent in 1991, placing emphasis on the development of the energy sector. 1/ The rise in government investments was primarily financed through a growing surplus on current account operations, that reached 5 percent of GDP in 1994. The recorded nongovernment, nonforeign-financed investment—which in the official statistics consists mainly of housing—increased about 1 1/2 percentage points. However, there are abundant signs of increased private output related to nonhousing investment pointing to a possible underestimation of private sector investment. Employment grew steadily during 1992-94, at a rate slightly higher than the growth of the labor force. Employment growth in the nonagricultural sector accelerated from about 2 percent in 1992 to 3 percent in 1994, while growth in the agricultural sector increased at a steady 3 percent over the period.

The sectoral contribution to output changed from services (and agriculture in the very early transition years) to industry, and within industry from oil to other products. Industrial growth gradually accelerated to 14 percent in 1994, with strong performance across the board. Construction increased particularly quickly—nearly 50 percent during 1992-94—sparked by land reform (in particular, the establishment of urban residential land use rights following the issuance of the Land Law), and aided by foreign direct investment and increased government investment. The growth of oil production, by contrast, tapered off, but nevertheless increased by 10 percent in 1994. Also, slowing from earlier years, the services sector grew at a 9 percent annual rate in 1993-94, while agricultural output increased by 4 percent per year during 1993-94, after an exceptional 1992 performance. Agricultural performance was good in most subsectors, with relatively high growth in animal husbandry and perennial crops, such as coffee, rubber, and tea.

The prospects of sustaining recent high growth rates over the medium term appear good. Foreign investment commitments are increasing rapidly in response to favorable developments in international relations and administrative reforms. This investment will underpin growth particularly in light industry, tourism and supportive services. Agricultural prospects at current world market prices are quite favorable. In addition, further growth of the oil and gas industry is expected, following promising discoveries of gas reservoirs and several smaller oil depositories, and the application of techniques to sustain the life of the current main oil field.

6. Conclusion

The avoidance of a decline in output and the rapid move to high growth is one of the most remarkable features of Viet Nam’s transition to a market economy. Even after taking into account some special incidental factors, such as the coming on stream of oil, this observation remains valid. Decisive supply-side policies provided the basis for the successful transition. Those policies in essence brought about the textbook result that the underutilization of human and physical capacity due to controlled prices and lack of incentives could be rapidly redressed by liberalizing prices and getting the incentives right.

For the agricultural sector, the key requirements were land reform—the establishment of land-use rights—and the enhancement of competition for outputs and inputs through price and internal and external trade liberalization. For the state enterprise sector, the main policies consisted of increasing autonomy in decision making, establishing accountability, hard budget constraints, and increasing competition. The necessary Institutions were established to mobilize government revenues and improve the payments system. Foreign investment was sought to supplement domestic resources and widen the use of new technologies.

Government policies resulted in a large shift in labor from the public to the private sector; cooperatives were abandoned and the industrial structure was realigned. Nevertheless, no major sectors of the industry were abandoned as either export markets were found, or additional domestic demand–particularly following the collapse of the CMEA—took up the slack.

Decisive macroeconomic policies were effective in bringing down inflation. However, a demand collapse was avoided, primarily because price liberalization and remuneration policies allowed substantial price and wage flexibility. Stabilization policies were particularly effective in the presence of a large agricultural sector—generally characterized by homogenous products and small units—that facilitate competition. Political continuity and decisive implementation, prevented another potential problem, that of Government bail outs for inefficient firms.

The restructured economy formed a sound basis for accelerated growth in recent years. This growth is being sustained through increased investment, both from the Government and from foreign investors drawn by the ongoing reform commitment and increasing openness of the Vietnamese economy. Provided that sound and pragmatic policies are followed with the resolution which Viet Nam has shown throughout the transition period, there are good prospects for sustained high growth.

II. State-Owned Enterprise Performance

1. Introduction and background

An unwieldy and loss making state-owned enterprise (SOE) sector has often been cited as one main factor impairing the performance of transition economies. The case of Viet Nam appears to be different. Indeed, with economic activity generally buoyant, the performance of the SOE sector has surpassed the nonstate sector in several respects, and its share in the overall recorded economy has markedly increased. To a significant extent, SOEs have been transformed into commercially operated, increasingly foreign-invested, companies as part of the transition.

In terms of financial performance, the SOE sector has changed from being a large recipient of budget and bank support subsidies, under a soft budget constraint, to becoming a large net contributor to the state budget. The improvement in net budget contributions (tax payments after budget support) amounted to 12 percent of GDP between 1988 and 1994. While relatively modest arrears persist, both between enterprises and to the state-owned banks, the Government has generally refrained from bailing out insolvent enterprises or canceling their debt.1/ Moreover, credit to SOEs has been generally curtailed at the same time that fiscal revenue collection from SOEs improved.

The broadly favorable performance of the SOE sector can primarily be traced to sound policies. State-owned enterprises were given greater authority in managing their affairs, including decisions on pricing and production; overmanning was substantially reduced; enterprises were subjected to a hard budget constraint and increased competition. Specific factors, such as the coming on stream of oil during the transition period and the growing output of joint ventures with foreign enterprises, which are included in the SOE output statistics, contributed further.

2. State-owned enterprise performance

a. Output

The SOE sector performed generally well in the areas of industry, construction, and services with the total output share of these sectors, excluding cooperatives, rising from 25 percent of GDP in 1989 to 27 percent 1992 and 30 percent in 1994 (Table 4). 2/

Table 4.

Viet Nam: Importance of the State-Owned Enterprises, by Sector, 1989 and 1994

(In percent)

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Sources: General Statistical Office; and staff estimates.

State-Owned Enterprise Share in the Economy, and Size

At the start of the transition in 1988, about 75 percent of the economy was collectively organized. In contrast to other transition economies, the SOE sector in Viet Nam accounted for a relatively small part of production, 25 percent, and an even smaller part of employment, 12 percent. In industry and services, the state was responsible for over half the output. The predominant agricultural sector was mainly organized as a cooperative sector.

In 1988, about 12,000 SOEs were in existence, a quarter of which were in industry. Close to 80 percent of the 3,100 industrial SOEs were owned and managed by local government bodies (notably the provincial and district authorities). The centrally- run SOEs were much larger in size with over 500 employees on average (compared to 135 for the locally-managed firms) and produced on average 35 percent more per employee.

Of the 12,000 SOEs, about 6,500 remain after the shake out during the transition period and a policy of combining state enterprises. Only a handful of state enterprises have been privatized in an experimental program.

Initially, industrial SOEs performed well, only on account of oil production coming on stream. Excluding oil, industrial SOE value added fell by 7 percent during 1989-91 (Appendix Table 7). Particularly in 1989, SOEs faced problems as a shake out of the weaker enterprises took place, following price liberalization, interest, and exchange rate measures. Output rebounded, however, and has since registered rapid growth (10-17 percent per year). Indications are that in recent years SOEs have increasingly benefitted from foreign technology and capital, primarily through foreign direct investment, but also through domestically and foreign financed imports. Within the state-owned sector, the locally managed SOEs have fared considerably worse; their output fell by 22 percent, before recovering.

In the services sector, SOEs have been able to improve performance after severe difficulties in 1989-90, when trading companies lost about a third of their business to private retailers and traders. Since then their output has increased at a steady rate of 8-9 percent driven by companies in air transport and communications and, more recently, the financial sector.

b. Employment

One of the key features of transition in Viet Nam was the shedding of over one million public sector employees (Appendix Table 10). Public sector employment dropped from over four million in 1988 to less than three million in 1992, with about 85 percent of the decline accounted for by the state enterprise sector. 1/ Both absolute and relative declines in employment were particularly pronounced in the locally-managed SOEs. Employment in such enterprises halved, from nearly 1.5 million in 1988 to 3/4 million in 1994, As a result of increased output and declining employment, average productivity in the SOE sector climbed steeply, by nearly 70 percent from 1989 to 1992 and 30 percent from 1992 to 1994.

c. Financial performance

While data on profits are scant, data on overall cash flow of the state owned enterprise sector tell a story of an impressive improvement in financial performance. Net transfers to the budget improved by about 12 percent of GDP between 1988 and 1994, while at the same time net credit flows from the banking system to SOEs fell from 9 percent of GDP in 1988 to about 2 percent in 1993-94 (Table 5).

Table 5.

Viet Nam: Bank and Budget Support of Stata Enterprises, 1987-94

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Sources: Ministry of Finance; State Bank of Viet Nam; and staff estistates.

Capital transfers to most state-owned enterprises have been terminated since 1991.

At the start of the transition, subsidies received through the budget (over 8 percent of GDP in 1988) outweighed the tax payments of SOEs: tax contributions had dwindled while subsidies -for food, exports and capital investment had increased. During 1989-91, subsidies were drastically cut, reducing the amount of transfers to under 1 percent of GDP from 1991 onwards. Tax payments by SOEs suffered during this period as a result of diminished enterprise profitability, with the cost of laying off employees, reduced subsidies, and the CMEA collapse all weighing heavily. Tax losses were, however, offset by rapidly increasing revenues from oil during the 1989-91 period. Thereafter, revenue from SOEs increased, to about 12 percent of GDP in 1994 (from 8 percent in 1988); the bulk of the difference over 1992-94 was accounted for by increased payments from the non-oil sector.

At the start of the transition, SOEs were receiving nearly all nongovernment bank credit. The SOEs share in nongovernment credit, however, declined rapidly from. 90 percent at end-1990, to 80 percent at end-1992 and percent at end-1994, with corresponding increases in credit to the private sector and joint ventures. Net SOE credit fell from 9 percent of GDP in 1988 to 2-3 percent in 1992-94.

With data on investment indicating that investment by the state-owned sector (excluding foreign direct investment) increased modestly over the entire period as a percent of GDP, and with limited access to foreign funds, the trends in bank and budget support imply that the cash flow generated by the state-owned sector improved massively during 1988-94. Data on SOE profit taxes paid during 1991-94 indicate that profits (excluding oil-related profits) have about doubled over this period in relation to GDP, confirming the picture painted by cash flow trends.

3. Reforms in the state enterprise sector

a. Enterprise autonomy

Against a background of sound overall market policies (see Chapter I), the Vietnamese authorities pursued a number of specific policies to reform the state enterprises. A cornerstone of this reform was the recision of central planning powers in 1988-89 and the replacement of such powers with substantial state enterprise autonomy. Enterprises were given the authority to set most prices and to determine inputs and outputs. Significantly, Decree 176 spelled out the right of managers to lay off excess workers and provided guidelines for compensatory payments. In addition to explicit layoffs, further considerable downsizing resulted partly on account of de facto bankruptcies and partly because employees left of their own accord when effective pay declined (see Section c. below). State-owned enterprises also obtained greater powers to determine investments. Finally, while before the reforms enterprises were already free to generate production in excess of plan and sell it at market prices (known as “jumping the fence”), the reforms extended this discretion to all output.

b. Increased competition

A two-pronged strategy was followed in obliging the SOEs to use their new autonomy to pursue greater efficiency, profitability, and more market-oriented behavior in general. The first element in the strategy consisted of increasing competition; the second involved hardening the budget constraints on state enterprises and strengthening their accountability. Measures that contributed to increased competition Included: (i) allowing private sector enterprises equal access to credit and creating a legal framework more supportive of their operation; (ii) subjecting all enterprises to uniform rules of taxation; (iii) allowing all enterprises to establish direct trade links, or use trade companies of their own choice rather than a specific trade channel; and (iv) exposing all enterprises to foreign competition by liberalizing the import regime (see Chapter VI for details). In addition, competition was substantially enhanced by centrally-and locally-administered SOEs vying with each other in a new market environment and by competition from cooperatives—some quite large—which was enhanced by de facto privatization. In response to the new regulatory and entrepreneurial environment, an additional 130,000 private households started industrial businesses and the number of private industrial companies increased tenfold during 1988-93, albeit from a very low level.

c. Hard budget constraints

The second element of the strategy to induce profit maximizing behavior in the more autonomous state enterprises consisted of several core measures to harden the budget constraints on SOEs. First, most subsidies to enterprises were cut. 1/ The previously ample budgetary funding of working or other capital was eliminated for all but a small group of SOEs during the period of shocks from the CMEA collapse in 1990-91. Food and export subsidies were abolished with the price liberalization and unification of the exchange rate in early 1989, and implicit interest subsidies were removed by gradually raising lending rates vis-à-vis deposit rates, most particularly in 1990 and the second half of 1992. It remains, however, that SOEs have generally easier access to bank credit in foreign currency, and hence face lower effective borrowing rates than private enterprises. With the demise of the CMEA trading arrangement in 1990-91, large-scale extrabudgetary subsidies in the form of cheap imported inputs were no longer available. 1/ Second, bank credit was limited to profit making enterprises, and this measure was backed up by restrictions on bonus and welfare fund payments by enterprises in arrears. 2/ After the reform of the banking sector in 1988, state enterprises had to compete for access to bank loans, instead of relying on directed credit. Third, in 1990 several tax laws were passed which provided a more solid foundation for the taxes assessed on state enterprises and thereby limited the prevailing ex-post negotiation of tax liabilities, which was a main element in the earlier softening of budget constraints. Fourth, the monitoring of SOEs was simplified and strengthened. Performance came to be measured by the size of their profits and tax contribution, replacing a plethora of earlier criteria. Yet, progress in introducing coherent, transparent, and independently audited accounts has been slow and remains an important target. To spur progress in this area, the Vietnamese authorities have made several recent improvements to the institutional infrastructure, including the establishment of an interagency SOE reform committee, the institution of an SOE-asset management department in the Ministry of Finance, and the approval of a State-Owned Enterprise Law, obliging SOEs to make annual reports on their activities and finances.

Particular to Viet Nam’s experience is that the hardening of budget constraints was not undone through the build up of large arrears to other state enterprises and bail-outs by the budget (see Box 6). The relatively strong credibility of reform policies evidenced, for example, by the abstention from bail out when nearly all credit cooperatives went bankrupt in 1989-90, may be linked, in part, to political continuity under a national leadership committed to staying the course of reform; but it also reflects the lessons learned from the bad experience with relatively soft budget constraints, particularly in 1986-87, which contributed to severe inflation in those years.

In addition to the credibility of enforcement, another crucial factor in hardening budget constraints was that the Vietnamese authorities have also enforced their “ownership” rights. In some countries a “lack of ownership” or accountability emerged during a confused transition period, leading to widespread asset stripping and to nonsustainable bonus payments and other abuses. In Viet Nam, few such doubts about ownership have arisen: the exercise of ownership rights through monitoring and setting of targets was actually strengthened and substantial efforts have been made in fighting corruption.

Arrears

In the transition period, inter-enterprise arrears were mostly avoided, except for the early transition period. At April 1 1992, inter-enterprise arrears were frozen. The stock of uncleared arrears amounted to about D 8.2 trillion or 7 percent of 1992 GDP. In the meantime, this amount has declined to under D 7 trillion, or 3 percent of 1995 GDP, through the retrieval of some assets and absorption of the interest costs by creditors. The main outstanding problem is that the arrears are owed by firms that have collapsed. With land reverting back to the state after bankruptcy, few saleable assets remain. Most of the nonrecoverable assets are owed to Central Government-owned enterprises by (collapsed) municipally-owned enterprises. State-owned commercial banks are owed about D 2 trillion. Despite the drain on resources of noninterest earning arrears, most SOEs, including the state-owned banks, have been able to become profitable.

4. Further reform

Impressive progress notwithstanding, the Vietnamese authorities are aware that the performance of SOEs, still weak in some areas, needs to be further improved. Weaknesses include the continued lack of comprehensive, independently audited, accounts for the SOEs, which complicate plans for divestiture and the introduction of a stock exchange. In addition, recent plans for the formation of SOE conglomerates in different sectors may not be consistent with the aim of increasing efficiency and competitiveness. Implementing regulations of the recent SOE law also remain to be issued.

The authorities are working in collaboration with the World Bank on a comprehensive plan for restructuring state enterprise. The plan is likely to include gradual privatization, separation of regulatory and ownership functions, and a less discriminatory land regime, A crucial aspect that needs to be taken into account when determining the speed and extent of privatization is that government revenue continues to be heavily dependent on the well performing SOEs. At present, SOEs, excluding the oil sector and excises, contribute about four times as much in taxes, in terms of value added, as the private sector (Table 6), and care needs to be taken that tax collection is not harmed by reform efforts.

Table 6.

Viet Nam: Government Revenue Yield by Sector, 1992-94

(As a percentage of sectoral GDP)

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Sources: Ministry of Finance; General Statistical Office; and staff estimates.

III. Foreign Direct Investment

1. Introduction

From the start of the transition process, foreign direct investment (FDI) was expected to play a key role in upgrading the country’s infrastructure and productive capacity. It has indeed played that role, with disbursements, which have grown rapidly in the last few years, projected at just under $1 billion in 1995, and with a large stock of committed capital still to be disbursed. The Foreign Investment Law of December 9, 1987, while enacted somewhat later than comparable legislation in most other countries in the region, was one of the first major reform measures. It came at a time when virtually no supporting legal framework was in place and numerous elements of planning still pervaded the economy. The original law was liberal by international standards; after several amendments, the juridical regime for FDI compares favorably with corresponding regimes elsewhere in terms of tax incentives, import privileges, access to economic sectors, and admissible ownership forms. Indeed, the law offers generous tax concessions and duty exemptions, welcomes foreign investment in all economic sectors with the exception of defense industries, imposes no minimum capital requirement, permits 100 percent foreign ownership, and guarantees the unrestricted repatriation of capital and profits.

At an early stage, the Government designated the State Committee for Cooperation and Investment (SCCI) as the one agency to decide on investment applications to help simplify the approval process. In the event, however, the licensing process remained complicated and lengthy because most projects required additional approval from other agencies, including local authorities. According to a survey conducted in early 1994, 1/ the licensing of joint ventures took an average about one year and that of wholly foreign-owned enterprises twice as long. Coping with excessive bureaucracy has widely been regarded as the greatest challenge facing potential investors.

In response to complaints about burdensome procedures, the Government has taken measures from the beginning of this year to streamline the administrative process. Strict time limits have been set for the authorities to raise any objections to investment applications. And the responsibility for larger foreign investment projects has been transferred to the Prime Minister’s Office. There are signs that this has helped spur the disbursement of investment commitments.

2. Commitments

The distribution of FDI commitments by region, economic sector, and country of origin has undergone marked structural change.

As regards regional distribution, initially foreign investment was concentrated exclusively in the South (Table 7). The North caught up quickly, however, and now attracts over one third of new commitments. The bulk of all investment has gone to the industrial centers of Ho Chi Minh City and Hanoi/Haiphong. Barely 20 percent of commitments went to the countryside, where over 80 percent of the population lives. As a result, the immediate impact of foreign investment has been to intensify income and regional development disparities.

Table 7.

Viet Nam: Distribution of Licensed Foreign Direct Investment Commitments by Region, 1988-1995.

(shares in percent) 1/

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Source: State Committee for Cooperation and Investment; and General Statistical Office.

Commitment data exclude offshore investment in oil and gas.

January-June.

Total gross commitments for the period 1988 through end-June, 1995.

Sectoral distribution shifted from a brief initial emphasis on the development of offshore oil and gas deposits to the construction of hotels and tourism facilities and, since 1991, to manufacturing. More recently, large investments have been committed to establishing production facilities within export processing zones and industrial parks (Table 8). Overall, the industrial sector, including labor intensive manufacturing, has attracted almost 40 percent of total commitments, followed by housing, tourism and hotels with 24 percent. By contrast, very little foreign investment went to agriculture.

Table 8.

Viet Nam: Distribution of Licensed Foreign Direct Investment Commitments by Economic Sector, 1988-1995.

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Sources: State Committee for Cooperation and Investment; General Statistical Office; and staff estimates.

Including offshore investment in oil and gas.

January-June.

The breakdown for this period is not fully comparable to that in previous years due to a reclassification of projects.

Total gross commitments for the period 1988 through end-June, 1995.

Consists predominantly of investment into the infrastructure of export processing zones and industrial parks.

Balance of payments data.

In line with Viet Nam’s recent trade pattern, Asian neighbors dominate the distribution of foreign investment commitments by country of origin (Table 9 and Appendix Table 12). Taiwan Province of China leads the list, closely followed by Hong Kong. In 1994-95, two thirds of total commitments are accounted for by Asia including Japan, whose still small share has been rising rapidly since the lifting of the U.S. embargo in February 1994. The relative importance of Australia and France, who pioneered foreign investment with large projects when Viet Nam opened up in 1988, has since declined.

Table 9.

Viet Nam: Distributor, of Licensed Foreign Direct Investment Commitments by Country of Origin, 1988-1995

(Shares in percent) 1/

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Sources: State Committee for Cooperation and Investment; General Statistical Office; International Financial Statistics: and IMF, Direction of Trade Statistics.

Commitment data include offshore investment in oil and gas.

January-June.

Total gross commitments for the period 1988 through and-June, 1995.

Excluding Japan.

3. Disbursements

Although sizeable commitments were already being made in 1988 and new commitments rose rapidly in the following years (Chart 1), initial disbursement rates remained rather low, reflecting constraints on administrative capacity and related concerns of foreign investors. Since then, indications are that the pace of disbursement has quickened, most notably since the latter part of 1994. 1/

CHART 1.
CHART 1.

VIET NAM: LICENSED FOREIGN DIRECT INVESTMENT, 1988-95

(In millions of U.S. dollars) 1/

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Source: State Committee for Cooperation and Investment, Hanoi; and staff estimates.1/ Including offshore investment in oil and gas.2/ Balance of payments data.3/ January-June.

Balance of payments estimates suggest that actual FDI amounted to about 1 1/2 percent of GDP in 1988-1990, rose to about 2 1/2 percent of GDP per year in 1991-93, and climbed further to a rate of 4 percent of GDP in 1994. 1/ This places Viet Nam as having one of the highest inflows of direct investment relative to GDP. The impact of FDI on economic growth is difficult to gauge. However, on the basis of historical values of the incremental capital output ratios (ICOR) for total gross capital formation, FDI during the period 1988-94 may have accounted for a combined total of approximately 10 percentage points (one fifth) of aggregate economic growth. Rough as this estimate is, it should be regarded as a lower bound because the specific ICORs for foreign-invested projects can be expected to have been even smaller than the low aggregate ICORs measured since the late 1980s.

The indirect economic benefits of FDI, in the form of technology transfer and exposure to modern organization and management techniques, may have been as significant as the direct benefits. The state enterprise sector benefitted more from this process than the private sector. Owing to their relatively larger size, their established links with decision makers, and their access to land user rights and services, state enterprises were typically a more attractive domestic partner in joint ventures.

4. Outlook

Rising commitments, and recent improvements in public administration, promise quickening disbursement of FDI which should soon reach, or even exceed, the equivalent of 5 percent of GDP. New commitments during the first six months of 1995 have already attained levels exceeding the total recorded for 1994 as a whole. Some of this boom may be temporary, however; it may wear off after the licensing of a backlog of commitments in connection with the earlier mentioned streamlining of procedures. Also, new investment commitments may fall below trend, at least temporarily in the wake of measures recently taken by the Government to dampen speculation in the real estate market, and to ensure greater financial discipline. 2/

All told, the growth in FDI in Viet Nam has been impressive and the announcement in July 1995 that the United States would open diplomatic relations with Viet Nam triggered further announcements of upcoming projects. This, together with prospects of still further improving relations and Viet Nam’s impending entry into ASEAN, should help sustain a strong momentum of FDI over the medium term.

IV. Determinants of Inflation

1. Introduction

Viet Nam has had remarkable success in bringing inflation under control. In response to policies that the country has pursued, the increase in consumer prices declined from 394 percent in 1988 to 5 percent in 1993. Thereafter, however, despite continuing commitments to consolidate the gains that had been made, inflation re-accelerated. By end-1994, inflation stood at 14 1/2 percent and its pace increased further, to about 20 percent, in the first half of this year. The debate of the appropriate policy response has raised questions about the factors involved in inflation and whether the recent acceleration is likely to be temporary or protracted.

The objective of this chapter is twofold: (i) to examine the influence of money on inflation, with regard to both its earlier trend decline and its re-acceleration, and (ii) to address other determinants of inflation that, in addition to money, appear to have affected Its behavior. In this, the focus is on the inflationary repercussions from the recent sharp increases in rice prices in the wake of shocks to domestic supply and higher international prices.

Results of the analysis indicate a significant relationship between money and inflation. An increase in liquidity leads to higher inflation with a lag of one to four months, with the maximum impact involving a two-month lag. This confirms that the early introduction and consistent implementation of tight financial policies was a key element of Viet Nam’s success in bringing inflation under control.

In addition, however, there are indications that determinants other than money have also played a role in short-run movements in prices, most particularly in the re-acceleration of inflation. The argument is that the inflationary impact of the surge in rice prices has not been offset in the short run by a weakening of other prices. The consequence of this would be a rise in inflation above trend, associated with an increase in velocity. In the circumstances, it is assumed that changes in rice prices relative to other prices would be positively related to inflation in overall consumer prices. The results confirm this assumption. They suggest in particular that the impetus to inflation late last year initially came from rice prices and subsequently intensified under the impact of monetary expansion.

The chapter is organized as follows: Section 2 explores the relationship between money and inflation; Section 3 traces developments in rice prices, with respect to developments in domestic supply and international prices, and their role in inflation; Section 4 turns to the inflation impact of changes in relative prices testing a model that allows for a response of inflation to changes in relative prices, as well as money; Section 5 examines selected trends in the Vietnamese rice market for any evidence of potential pressures for monetary accommodation; Section 6 surmises the conclusions of the paper.

2. Money and Inflation

Money and Inflation have exhibited broadly similar trends, at least since the general liberalization of prices and the exchange rate (Chart 2), To examine more closely the link between money and inflation, we posit the following relationship:

Chart 2.
Chart 2.

Viet Nam: Money and Inflation, 1992 (January)-1995 (April)

(Year-on-Year, changes in percent)

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Source: General Statistical Office
[(M/p)t(M/P)t1]=λ[RMDt(M/P)t1](1)

Where the change in money stock in period t is a function of the difference between real money demand in period t (RMD) and money stock in period t-1. The above equation can be simplified and expressed in terms of rates of change:

Pt*=Mt*λRMDt*(1λ)Mt1*+(1λ)Pt1*

For lambda equal to unity we have P* - M* - RMD*, which relates changes in prices to differential growth in the money stock and real money demand.

We assume here, in the absence of monthly GDP data, that real money demand follows a rising trend, reflecting the general expansion of the economy and a general increase in the attractiveness of the dong as an asset since the beginning of the decade. Allowing for concurrent and lagged influences of changes in money on prices, we thus have.

P*=co+M*(L)(3)

Where -co is a constant term reflecting the trend growth in real money demand and L is a lag operator; the sum of lagged coefficients should approximate unity.

We estimate equation (3) for the period 1990 (December)-1995 (April), using an Almon polynomial lag model with a Prais-Winsten correction for autocorrelation. We incorporate six lags and assume that the lag coefficients can be approximated by a third order polynomial. Experiments with specifications that include lags of less than six months are also carried out for purposes of comparison. In order to examine the effect on inflation of a change in consumer spending and money holding patterns during the Tet festival season, we include dummy variables in the regression exercise. Hence, the precise form of the estimating equation reads,

Pt*=α+β0Mo*+….+β6Mt6*+δ1Tet1++δ3Tet3+Ut(4)

Where Pt* and Mt* represent month-to-month percentage changes in consumer prices and the money stock (contemperaneous and with lags), respectively. Tet1, Tet2, and Tet3 represent the Tet festival dummies, which take the value of one for the month of December, January, and February and zero for all other months. To carry out the empirical analysis, we use monthly data on consumer prices (CPI) and money stocks, including both dong liquidity and foreign currency deposits.

Results (Table 10) indicate that an increase in liquidity leads to higher inflation with a lag of one to four months, with contemporaneous money growth having no impact and money growth with a 1-2 month lag having the maximum impact. The constant term representing real money demand, has the expected negative sign. As indicated by the Tet dummy variables, an increase in consumer spending during the months of January and February significantly affects inflation. The results clearly suggest that the pursuit of tight monetary policy, in the process of transition to a market economy, has played a decisive role in Viet Nam’s success in curbing inflation.

Table 10.

Viet Nam: Inflation and Money-Regression Results 1990 (December)-1995 (April)

Dependent variable: Month-to-month percentage change in CPI

Independent variables: Month-to-month percentage change in total liquidity (contemporaneous and with lags)

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Durbin-Watson statistic close to 2.0 indicates the absence of serial correlation.

The sum of lag coefficients is an estimate of the long-run multiplier, and will approximate to unity as lag length increases.

Despite the reasonably high explanatory power of the model, however, the fitted path for inflation deviates from the actual path of inflation at certain times. In particular, we find that actual inflation is well above fitted values in the latter part of 1994 and the early months of 1995. To further analyze this issue, we estimated our model regressing the rate of growth of CPI on liquidity growth, using observations through the third quarter of 1994. The results from this estimation were used to make projections for the fourth quarter of 1994 and the first four months of 1995. It can be seen (Table 11) that our model projects a lower rate of inflation compared to the actual rate for the same period.

Table 11.

Viet Nam: Inflation and Money - Actual Versus Projected Inflation 1/

Dependent variable: Month-to-month percentage change in CPI (Dec. 1990 - Sept. 1994)

Independent variable: Month-to-month percentage change in total liquidity (contemporaneous and with lags) (Dec. 1990-Sept. 1994)

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Projections based on estimation of equation (4) for the period Dec. 1990-Sept. 1994.

It is evident from the above discussion that, despite a significant relationship between money and prices, there have been instances of spurts in prices that cannot be explained by changes in money. In the last quarter of 1994, inflation rose rapidly despite relatively tight liquidity growth in the second and third quarters of the year. This acceleration of inflation was associated with a sharp increase in rice prices and hence in the price of staples, relative to other CPI components, which we discuss in detail in Section 3.

3. Rice prices and inflation

The Vietnamese authorities have attributed the worsening of inflation from the latter part of 1994 to soaring rice prices, pushed up by natural calamities and rising international prices. In August 1994, the worst rains in seven years flooded eight northern provinces destroying large amounts of crops. Estimates by the Ministry of Agriculture put output losses in the Red River delta at up to one million tons of rice and other crops. According to the Ministry, the price effects of those output disruptions were exacerbated by hoarding and adverse expectations. In addition, there were said to be repercussions on domestic rice prices from increases in the (unrecorded) cross-border exports of rice to China, which was similarly weather stricken. At the Chinese border, prices for normal rice were approaching 4,000 dong/kg by end-1994, double their level in the North of Viet Nam, By contrast, in the South, despite heavy weather-related losses, output in the Mekong delta proved strong, helping national rice output to reach an estimated level of 23.5 million tons, 3 percent higher than in 1993. Nevertheless, market imperfections prevented the alleviation of the output shock in the North. Moreover, strong increases in international prices of fertilizer and rice coincided with the domestic output shocks (Table 12).

Table 12.

Viet Nam: International and Domestic Prices of Fertilizer and Rice, 1999-94 1/

(Annual average changes in percent)

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Source: General Statistics Office; Pricing Committee; State Bank of Viet Nam; International Financial Statistics.

The main rice producing areas of Viet Nam are Namha (NH) in the North, Quangnam-Danang (QNDN) in the Center, and Angiang (AG) in the South. The main urban areas are Hanoi (HN) and Ho Chi Minh City (HCMC).

The influence of the domestic and international shocks on the behavior of Vietnamese rice prices, most notably in the North (Nam Ha Province and Hanoi), that is apparent from Table 12 is also reflected in consumer staples prices and total consumer prices 1/ 2/ (Chart 3 -Chart 4 and Appendix Table 13-Table 14).

Chart 3.
Chart 3.

Vietnam - Consumer Staples Prices by Region

(January ’94 - May ’95; December ’93= 100)

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Source: General Statistics Office
Chart 4.
Chart 4.

Vietnam - Consumer Prices by Component January ‘94 - May ‘95

(cumulative changes in percent)

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Source: General Statistics Office

One prominent feature worth emphasizing is the steep increase in relative staples prices and the apparently associated acceleration of inflation. True, from a theoretical point of view, inflation and movements in relative prices are not necessarily related in any systematic manner. Indeed, no such sweeping claim Is made. The claim that is made is that, in Viet Nam, the increase in staples prices was not completely compensated by a weakening of other consumer prices, and thus involved an increase in overall prices. An attempt to corroborate the point that relative prices have influenced the pattern of inflation in Viet Nam, at least in the short run, is made in Section 4.

4. Relative prices and inflation

To examine the significance of the relationship between inflation and the price of staples relative to other goods, equation (4) is re-estimated, including the relative price of staples vis-à-vis other items included in the CPI (RPS) together with the other explanatory variables. It is clear from the results (Table 13) that, along with an increase in the explanatory power of the model, the relative price variable is highly significant in explaining movements in the price index. An increase in the price of staples translates into a shift away from savings towards higher expenditure, which even with a constant money stock leads to an increase in inflation through an increase in the velocity of money.

Table 13.

Viet Nam: Inflation, Money and Relative Prices Regression Results

Dependent variable: Month-to-month percentage change in CPI

Independent variables: Month-to-month percentage change In total liquidity (contemporaneous and with lags) and relative price of staples (RPS)

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Durbin-Watson statistic close to 2.0 indicates the absence of serial correlation.

The sum of lag coefficients is an estimate of the long-run multiplier, and will approximate to unity as lag length increases.

To further explore the issue, whether it is supply shocks transmitted through movements in staples prices that affect inflation, some additional experiments are carried out. Equation (4) is estimated regressing monthly rates of change in consumer prices excluding staples on total liquidity growth. The results indicate that money explains changes in CFI-excluding staples better than changes in aggregate CPI (Appendix Table 15). Similarly, money explains changes in CPI for “other food” and CPI for consumer goods better than changes in aggregate CPI; and it explains poorly, changes in staples prices (Appendix Table 16).

The results in this section are consistent with the assumption that supply factors influence inflation through changes in staples prices and, specifically, that changes in relative staples prices have been a significant factor in inflation, in addition to money.

The short run effect on inflation resulting from an increase in the relative price of staples should diminish, and inflation should again be more closely related to money, as shocks subside, as rice supply and distribution strengthens, as cost increases become more muted, and as demand pressures from neighboring countries decline. In turn, the prospects for monetary control and more lasting inflation control, depend importantly on any pressures seeking monetary accommodation. Some such pressure may be related to market imperfections. For, partial evidence on this score, Section 5 explores selective trends in the Vietnamese rice market.

5. Selective trends in rice market

Some evidence of imperfections in the Vietnamese rice market may be gleaned from the mark-up behavior of different rice prices across different regions. The presumption is that the persistence of any trend increase in the mark-up might give rise to pressures for monetary accommodation.

The main rice producing areas registered retail price margins over farmgate prices on the average order of 55 percent in the North, 62 percent in the Center, and 71 percent in the South. With trends generally declining, corresponding 1994 margins were close to 52 percent in the North and Center and 51 percent in the South.

The evidence from the here established tendencies in the Vietnamese rice market does not point to any systematic pressures for monetary accommodation. To the extent that there is a continuation of rising tendencies in relative paddy prices and of declining tendencies in relative rice retail prices, developments should be consistent with monetary control and a deceleration of inflation.

Furthermore, there are indications of a potential for large efficiency gains arising from a North-South dichotomy, which, if realized, would tend to reduce any pressure for monetary accommodation.

A North/South dichotomy, so apparent in the dispersion of the recent rice price increases, applies also to cost and price levels in the rice market as shown below. Over the years 1989-94 fertilizer prices, farmgate prices, and rice retail prices in the main rice producing areas in the North (Nam Ha) were, respectively, about 5 percent, 24 percent, and 15 percent higher than in the South (An Giang). In the urban centers, the level of rice retail prices in Hanoi was about 3 percent higher than in Ho Chi Minh City.

Table 14.

Viet Nam: Rice Cost and Price Levels, 1989-94

(Deviation from mean. 1/ in percent)

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Source: Pricing Committee, General Statistics Office.

Thirteen provinces.

These differences in cost and price levels are associated with important North/South differences in the manner in which rice markets are organized and operate. In the South, involvement of the private sector pervades trading and distribution at different levels ensuring relatively smoother functioning of markets and greater competition, both among private companies and state-owned companies. Activity of private companies ranges from importing fertilizer, and distributing it to farmers, to purchasing rice paddy from the farmers and selling the milled rice to domestic retailers and exporters. At the same time, state-owned and private companies also collaborate in that state companies regularly use private companies to carry out certain transactions, with corresponding gains in efficiency.

By contrast, the situation is different in the North where private sector activity in the market is not yet as firmly established and as well organized. And where the gains from efficiency and competition that are present in the South are largely lacking. In the circumstances, it would appear that making the system of trading and distribution in the North more akin to that in the South should pay off, reducing the gap in cost and price levels between the two regions, with gains in real incomes and on the inflation front.

This potential for narrowing the North-South dichotomy, when realized, would tend to dampen any pressure for monetary accommodation, including through a trend reduction in price mark up.

6. Conclusions

The findings of this chapter on the determinants of inflation in Viet Nam may be summarized as follows: (1) A monetary explanation broadly traces inflation in consumer prices over the past five years or so, since the shift from pervasive price and exchange rate controls to general price and exchange rate liberalization. (2) As for the re-acceleration of inflation from the latter part of 1994, following years of sharply declining inflation, in the wake of successful financial stabilization, changes in relative rice (and hence staples) prices are an important factor, in addition to a resurgence in monetary growth at the end of 1994. This confirms the view that the shocks related to natural calamities and foreign price increases in 1994 boosted relative staples prices from the second half of the year, fueling overall inflation. (3) There is no evidence of trends in rice (staples) prices that would seek monetary accommodation. Hence, with the inflationary effects of shocks subsiding, in the absence of new shocks, and provided expansion of liquidity is kept under control, it should be possible for inflation to resume its downward trend.

V. Stabilization and Adjustment in the Presence of Currency Substitution

The circulation of the dollar alongside the domestic currency, the dong, has been a major characteristic of the Vietnamese economy since at least the early 1970s, Indeed, “currency substitution” or “dollarization” 1/ extends to the store-of-value, unit - of- account, and medium-of-exchange functions typically reserved for the domestic currency.

The increasing use of foreign currency in the Vietnamese economy occurred against a background of large economic and financial imbalances, chronic shortages, high and variable inflation, and poor and sometimes arbitrary policy implementation. In this environment, economic agents preferred gold and dollars to holding domestic currency and hence attempted to protect the real value of their assets by reducing the use of the dong. While use of the dollar helped in a number of important ways, it also hindered. Increasingly, dollarization impaired the effectiveness of financial policies and heightened the sensitivity of the economy to external developments.

The constraints arising from dollarization were an important issue when the Government of Viet Nam decided to undertake comprehensive economic reform beginning in the late 1980s. It became apparent that large-scale, entrenched, dollarization required policy actions over and above what would have sufficed in a “normal” setting. Accordingly, the authorities took measures to enhance the attractiveness of the dong relative to the dollar with a view to reducing the role of foreign currency in the economy.

This chapter examines the policies undertaken by the Vietnamese authorities in addressing the problem of dollarization in the context of their overall stabilization and adjustment strategy. Section 1 provides a brief review of the growth in the use of the dollar before comprehensive economic reform. Section 2 draws on the dollarization literature to summarize the main channels through which currency substitution complicated the task of macroeconomic management in Viet Nam. Section 3 examines the efforts and effectiveness of the Government to deal with the dollarization problem. Section 4 concludes with general policy implications and lessons for Viet Nam.

1. Dollarization in Viet Nam: developments before comprehensive economic reform

The circulation and use of the U.S. dollar in Viet Nam has a long history. 1/ Since the Viet Nam war, the U.S. dollar has circulated widely and has effectively been a second legal currency. Other currencies as well as certain consumer items (including U.S. cigarettes) and gold coins also served as media of exchange and stores of value. Parallel foreign exchange rates fetched significant premia compared with official exchange rates–sometimes as much as 1,000 percent. The use of the dollar was officially tolerated, in part because the parallel markets provided necessary relief in an otherwise difficult economic environment. 2/

First, macroeconomic performance remained weak. Against a background of moderate growth, bank financing of large public sector deficits fueled high and variable inflation rates. At the same time, foreign exchange, which was increasingly drained off by military operations, became even more scarce. The official exchange rate was devalued on several occasions and multiple exchange rates proliferated. 1/ In an attempt to prevent exchange leakages to the parallel market, the Government created “Dollar-A certificates” which entitled holders to purchase foreign goods in special Government shops. 2/ The numerous exchange actions and multiple exchange rates suggest that the Government was seeking both to prevent leakages and attract dollars into official channels, without undertaking fundamental reform. In the circumstances, however, with the economic situation deteriorating and with expectations of further devaluations, the incentives to use dollars as a store of value and medium of exchange only increased.

In an attempt to suppress the parallel market and exact a levy on undeclared wealth, the Government undertook a currency reform in September 1985. Under the reform plan, legally-obtained old dong could be exchanged at a rate of 10-to-l for new dong; savings account dong were exchanged on a sliding scale (from 10-to-l old dong per new dong, for recent deposits, to 1-to-l for older deposits). Unfortunately, due to poor implementation, the “reform” further undermined confidence in the dong. The Government failed to print sufficient new currency; rumors of the impending reform drove up the parallel market rate to D 1,000/U.S. dollar in the month prior to the reform; and the loss of confidence in the value of the dong spurred inflation. A devaluation of the dong the day following the reform compounded the loss in confidence.

Efforts at systemic reform following the eighth plenum of the Vietnamese Communist Party Central Committee in 1985 were partial in nature and ultimately aggravated the economic situation. Under these efforts, an attempt was made to end the state subsidy program and pay wages and salaries of state employees entirely in cash, taking into account the prices of goods in the open market. Income limits were removed, so as to provide incentives for increased production. Overall, the reform effort was designed to eliminate large public sector deficits by bringing prices into line with costs and providing incentives for increased production. In the event, however, the reform effort ran into trouble almost immediately. Widespread shortages occurred and economic agents began hoarding goods. Inflation eroded almost immediately the value of public workers’ new all-cash wage package. In the end, the Government had to introduce rationing of a number of essential goods. The failures of the economic reform program and the earlier currency reform and the ensuing inflationary consequences all further weakened Government credibility and confidence in the dong.

2. Dollarization and problems of economic management

The use of dollars provided the economy with a “pressure release” for imbalances from inefficiencies in central planning, security for economic agents, a hedge against inflation, a means to purchase goods in the parallel market, and an efficient means of payment. But the increased use of dollars also had disadvantages. Increased dollarization complicated macroeconomic policy making and made the consequences of policy failure more serious. More generally, the increased sensitivity of the economy to external developments made the conduct of financial policy more difficult. To highlight some of those problems in the Vietnamese context, this section draws on the literature on the implications of dollarization for macroeconomic management.

On the fiscal front, dollarization weakened performance and policy effectiveness in a variety of ways. It lowered seignorage and inflation tax receipts and worsened the inflationary impact from the financing of a given budget deficit through the banking system. 1/ And it allowed a substantial portion of economic activity to escape taxation. Finally, dollarization also weakened public enterprise performance, in terms of both profitability and contribution to the budget, especially that of agricultural trading firms, as it aided in the diversion of production to the parallel market. 2/

On the monetary front, with the proportion of total liquidity under the coverage of the monetary authorities reduced, dollarization curtailed the effectiveness of monetary control. 3/ 4/ In the circumstances, the authorities’ attempts to contain (stimulate) aggregate demand through increases (decreases) in lending rates were rendered less effective. Dollarization made demand for dong more sensitive to external developments, as changes in foreign interest rates fed directly through to the asset allocation decisions of dollar holders. More generally, changes in foreign interest rates impact on aggregate domestic demand since higher (lower) foreign interest rates will tend to induce dollar holders to compress (expand) consumption and investment. Overall, as dollarization expanded in Viet Nam the influence of external monetary (interest rate) policies on domestic activities Increased. 1/

Finally, with lower seignorage and revenue from the inflation tax and the adverse impact of dollarization on tax and public enterprise performance, monetary policy to some extent accommodated higher-than-necessary public sector financing needs. This has in turn limited the authorities’ room to maneuver by reducing their ability to alter sectoral credit allocations within an overall credit envelope.

In the area of exchange rate policy, dollarization has affected the transmission mechanism by which exchange rate changes operate in Viet Nam. The disabsorption effect of devaluation has been weakened, since a given devaluation imposes a capital levy on a smaller proportion of liquid wealth, 2/ This weakening of exchange rate policy occurs irrespective of whether a parallel market premium exists. On the other hand, when the parallel market rate exceeds the official rate, as it did prior to the 1989 reforms, the potential expenditure- and production-switching effects of an exchange rate action are muted since such actions are nonbinding. That is, a devaluation would, if anything, only move the official rate closer to the parallel rate, thereby absorbing (reducing) part of the parallel market premium. In the context of extensive dollarization, however, this would do little to change incentives for producers and consumers—since they would continue to operate primarily on the basis of relative prices established in the parallel rather than the official market.

From a macroeconomic management perspective, exchange rate policy thus appeared less effective as a policy instrument. In fact, however, extensive dollarization and the parallel market premium only altered the nature of the transmission mechanism. High dollarization and accompanying parallel goods markets suggested that exchange devaluations would have an impact through at least two alternative channels. First, a devaluation could alter incentives at the margin between the use of the parallel and the official market. In essence, the closer the official rate moved to the parallel rate, the greater the incentive to shift activity from the “illegal” toward the “legal” (official) market. No change in absorption, production, or consumption need occur—only the channel through which flows of goods passed. In essence, the parallel market could be re-merged with the official market. Second, a large devaluation that substantially eliminated the parallel market premium could provide strong signalling and confidence effects, which, when coupled with other complementary policies, would support a substantial restructuring of incentives. For this latter effect to be significant, the Government would need to provide a corroborating signal that It intended to prevent any significant widening of the gap between the parallel and the official exchange rate. That is, it would have to maintain a flexible exchange rate policy as it focussed on stabilization and adjustment strategies.

3. Stabilization and adjustment in a dollarized setting

The year 1986 marked a turning point in economic management in Viet Nam, as a decision to dismantle the centrally planned system was announced. It was not, however, until 1988-89 that reforms began to be implemented in a comprehensive manner. Since then, Viet Nam has made remarkable progress in its transition to a market-based economy and toward attaining macroeconomic stability, even though dollarization has continued to be an important characteristic of the economy.

This section examines the main policy actions undertaken by the Vietnamese Government to deal with the problem of dollarization. Broadly, while the government has made substantial progress in addressing the incentives for dollarization and while these efforts have played an important role in the success of Viet Nam’s transition strategy, the impact on dollarization has so far been limited.

a. Policies to deal with dollarization

In grappling with the problem of stabilization and adjustment in a highly dollarized setting, the Government of Viet Nam has moved both to extend its control and influence over the use of dollars within the economy, while at the same time seeking to reduce the incentives for dollarization. These objectives have been pursued through five main policies:

(1) Legalization of foreign currency deposits

In an attempt to extend and increase its control and influence over the use of dollars within the economy, the Government ended in 1988 the proscription against the holding of foreign exchange by lifting foreign exchange surrender requirements and significantly liberalizing the use of foreign currency deposits within the domestic banking system for both companies (state-owned enterprises, joint ventures, and private firms) and individuals. A “no-questions-asked” policy was adopted, so that potential depositors would not be required to specify the source of their foreign exchange. 1/

By legalizing foreign-currency deposits, the Government was able to channel a large amount of dollars from the informal to the formal economy via the banking system. This liberalization has aided the transition process in a number of ways. First, given the severe shortages of foreign exchange in the earlier part of the 1980s, the legalization of foreign currency deposits gave the Government access to previously untappable foreign exchange resources. Second, the legalization of such deposits reduced incentives for (illegal) capital flight, while providing an easy-to-use medium to attract foreign exchange from overseas workers and expatriates. Although the balance of payments problems faced by the authorities at this stage were acute, both of these benefits helped contain the severity of the crisis.

While such a move could have resulted in additional substitution of foreign-denominated for domestic-denominated assets with little impact on intermediation, the impact in Viet Nam has been favorable. Overall, formal sector intermediation has risen as both foreign-currency deposits and domestic deposits have increased. While other factors have contributed to this increase, including lower inflation and higher real interest rates, it is clear that liberalization has aided the intermediation process, bringing dollars from the informal economy to the formal economy by removing part of the uncertainty surrounding the legal status of the dollar in the formal economy. Greater intermediation has helped mobilize savings for investment purposes, thereby promising the favorable growth outcomes of the past several years. Chart 5 shows the growth of foreign currency deposits and lending since the liberalization.

Chart 5.
Chart 5.

VIM NAM: FOREIGN CURRENCY DEPOSITS AND LENDING, 1986-94

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Sources: State Bank of Viet Nam and staff estimates.
(2) Interest rate policies

With the declining confidence in the dong and the growing use of dollars as a medium of exchange, store of value, and unit of account, the authorities moved to improve the attractiveness of the dong by raising and maintaining interest rates at positive levels in real terms. This policy has had three main effects: (i) it has increased the relative attractiveness of dong deposits compared to dollar holdings, (ii) it has increased dong deposits and thus intermediation, and (iii) it has aided in absorbing currency, thereby reducing incipient inflationary pressures. All three effects have been important in the stabilization and adjustment process.

To provide some indication of the role of interest rates in Viet Nam’s stabilization and adjustment as well as de-dollarization strategy, it is useful to examine developments at the beginning of the comprehensive reform. In March 1989, the Government moved to unify the multiple exchange rates at the level of the parallel market rate. At the same time, the Government also introduced a number of supporting policies, including a sharp increase in interest rates, especially on household deposits, to levels that were positive in real terms.

The moves had an immediate impact, as evidenced by a sharp decline in inflation in the months immediately following the announcements. For the three month period prior to the announcement and implementation of the policies, inflation averaged 7 1/4 percent per month. In the month subsequent to the announcement, inflation fell to 3 1/2 percent and, during the subsequent three months, inflation turned negative, averaging negative 1 1/2 percent per month. The re-alignment of incentives caused a shift out of dollars and into dong together with a sharp fall in the free market prices of gold and the dollar. Clearly, as a component of an overall scheme to reduce incentives for dollarization, the boost in dong interest rates played a major role. The same was true in 1992 when, after a loosening of financial conditions in the wake of the CMEA collapse, policies were again tightened, inducing a return of real positive interest rates, a shift into dong, and an appreciation of the exchange rate.

(3) Exchange rate policy

Following a period characterized by relatively rigid official exchange rates, multiple exchange rate practices, intensification of exchange restrictions, and the growth of a large parallel exchange market the authorities moved to unify the exchange rate in March 1989 at the level of the parallel rate, resulting in a fivefold increase in the price of foreign exchange. Subsequently, except for a few periods, the authorities maintained the official exchange rate within a margin of 10-20 percent of the parallel rate through late 1991. From the end of 1991, the official exchange rate has been maintained at virtually the same level as the parallel rate. 1/

while the design of the overall stabilization and adjustment strategy required movement on the exchange rate front, the choice of the authorities as regards the management of the exchange rate was, in part, forced by the aim to reduce widespread dollarization (in the form of the parallel market). The large devaluation was an attempt to shift foreign exchange back into official channels, or at least back into the banking system through foreign-currency deposits. At the same time, the choice of a flexible regime indicated that the authorities acknowledged that the same problems would re-emerge if the official exchange rate was not kept sufficiently flexible to prevent a parallel market premium from emerging.

The policy choice was reinforced by the nature of the Vietnamese economy—long borders that allow parallel trade, a concentration on primary production which has been subject to substantial world price shocks, uncertainties surrounding the breakdown of traditional international political relations, and the difficulty of ensuring a consistent array of structural, monetary, and fiscal policies in a rapidly evolving transition. Under such circumstances, an exchange rate anchor would not have been sufficiently credible—and hence would have been less effective at dealing with the dollarization problem. By announcing a flexible exchange rate policy, the authorities provided dollar holders with a strong signal that it meant to maintain the competitiveness of the official exchange rate vis-à-vis the parallel rate. 2/

(4) Disinflation policy

While disinflation is a standard objective of stabilization programs, it has a unique function in a case where dollarization is a problem. In such a case, disinflation is not only a policy objective, it is also a policy In and of itself—one that helps to redress the incentives for dollarization by reducing the opportunity cost of using the domestic currency. In the case of Viet Nam, the authorities have, since 1988, attempted to restore confidence in the dong also via a persistent policy of reducing the inflation rate. Thus, with the steady implementation of a disinflation strategy, including among other things higher interest rates and avoidance of monetary financing of the budget deficit as part of comprehensive credit restraint, the attractiveness of the dong has been enhanced and the incentive to use dollars reduced.

The steady application of a disinflation policy can lead to a virtuous cycle, in that declines in inflation will result in increased demand for dong and hence even lower inflation, 1/ In addition, a virtuous cycle may develop on the fiscal side, as activity which previously escaped taxation through the parallel market is now brought into official channels and seignorage receipts increase. Both of these factors tend to reduce the financing requirement and hence help in fighting inflation.

(5) Structural improvements to the banking system

Financial sector reform tends to be a typical element of structural adjustment programs, but its importance is enhanced in the context of a dollarized economy. Indeed, in Viet Nam in the period prior to reform, the problem of dollarization was likely aggravated by inadequate channels through which to save domestic currency, lack of appropriate financial instruments, uncertainty about the viability of banks or financial institutions in general, inappropriate policies concerning bank deposits (e.g., arbitrary holds on the withdrawal of funds), and inappropriate interest rate policies. Addressing these issues in the course of reform has since helped promote the use of the domestic currency and reduce incentives for dollarization.

b. Impact of policies to date

Notwithstanding the comprehensive efforts undertaken to address the problem, Viet Nam remains a highly dollarized economy. As shown in Chart 5, foreign currency deposits and lending (in millions of U.S. dollars and as a proportion of banking system assets) have grown rapidly following the liberalization of 1988. At the same time, anecdotal evidence suggests that the amount of dollars circulating in the economy remains high. Due (1995), for example, points out that: (i) the Viet Nam living standards survey of 1992/93 indicates that the ratio of dollar to dong holdings for the average household was more than 35 percent; and (ii) that in the larger cities of Viet Nam, prices of durable goods and real estate are openly quoted in dollars and that virtually all such transactions are effected in dollars. 1/ Moreover, cross - sectional evidence indicates that Viet Nam’s level of domestic financial intermediation is relatively low compared with other countries at similar levels of income—supporting the notion that a large proportion of transactions continue to be conducted outside the banking system. Partial support for this claim is found in the relatively high velocity of money in Viet Nam (between 4.5-5) over the last five years, relative to much lower values (in the range of 3-4) for Korea, Malaysia, and Thailand in the second half of the 1960s, at broadly comparable stages of development.

Evidence from other countries, especially Latin American countries, suggests that Viet Nam’s experience is not unique. Empirical studies of dollarization episodes (see, for example, Guidotti and Rodriguez (1992), Mueller (1994), and Savastano (1992)) suggest that, notwithstanding strong stabilization and adjustment efforts, dollarization can become so deeply entrenched that even strong economic programs fail to displace dollars with domestic currency—a phenomenon referred to as hysteresis. Confidence in the domestic currency, once lost, is difficult to fully re-establish once cash preservation and diversification techniques are learned and accepted. Moreover, the longer the prior period of high inflation, poor or inconsistent policymaking, and financial repression, the greater the time necessary for meaningful de-dollarization to occur. In this respect, while Viet Nam has adopted an array of policies that substantially reduce the incentives for dollarization, it may still take some time for the benefits of these efforts to be achieved. De-dollarization is a lengthy process that requires a persistent policy approach.

4. Conclusions and policy implications

After a lengthy period of poor economic performance and loss of confidence in the domestic currency, Viet Nam has since 1988/89 implemented policies aimed at restoring macroeconomic stability and the use of the dong as a medium of exchange. While the stabilization and adjustment efforts have met with a great deal of success, the process of de-dollarization has been slow. From a practical perspective, the slow process suggests several policy implications and lessons:

  • Only continued confidence-building efforts in the dong can ultimately help to displace dollars as a store of value, medium of exchange, and unit of account. In this regard, any attempts to regulate by fiat the use of the dong, and to ban the use of the dollar, are bound to fail. They would only tend to drive activity underground, and attack the symptom rather than the root cause of the problem.

  • Slippages in policy, such as the recent resurgence in inflation, will only slow the process further.

  • with dollarization remaining pervasive, macroeconomic policy instruments continue to be constrained.

  • De-dollarization is a slow process constrained by inertia. There is a possibility of a delayed reaction at this stage, but confidence building is important. Once confidence begins to return, a virtuous cycle may develop of de-dollarization, increased policy effectiveness, and improving macroeconomic performance.

VI. International Integration and Exchange Rate Policy

1. Introduction

Faced with the problems associated with years of central planning and the prospect of declining trade with (and aid from) the CMEA, Viet Nam turned to integrating its economy with the world economy, and adopted a market - oriented, export-led growth strategy at the end of the 1980s. The notable success Viet Nam has achieved thus far depended critically upon extensive trade reforms being accompanied by the adoption of a more open exchange system and a market - oriented exchange rate policy, which enabled Viet Nam to avoid the overvaluation of its currency and thus maintain its external competitiveness. This chapter provides a review of progress made in opening up the Vietnamese economy and analyzes how policy changes have promoted this process.

2. Growth and diversification of trade

Before the reforms, foreign trade in Viet Nam was subject to central decisions by the planning authorities and could only be carried out by a small number of state trading monopolies. Domestic prices were isolated from the influence of international prices through a complex system of multiple exchange rates and trade subsidies. Exports were discouraged by overvalued exchange rates and low procurement prices, while imports were impeded by an extensive system of quotas and licenses. Isolated from the world market, Viet Nam relied heavily on its former CMEA partners to obtain the basic commodities required, such as petroleum products and fertilizers, while exporters were obliged to fulfil CMEA quotas (agreed under a system of government - to - government protocols) before they were allowed to export to the convertible currency area.

With the liberalization of the trade and exchange regimes and the adoption of an appropriate exchange rate policy, exports and imports expanded rapidly from the late 1980s onward and there was a significant shift in trading partners from the former CMEA countries to those in the convertible currency area. Exports to the convertible currency area increased from about US$450 million a year in 1987-88 to US$2 billion in 1991. Imports from the convertible currency area also rose rapidly from about US$500 million a year during 1984-88 to US$1.8 billion in 1991. At the same time, exports to the nonconvertible area declined sharply from TR 645 million in 1988 to less than TR 80 million in 1991, and imports from the area fell from about TR 1.8 billion a year during 1987-88 to about TR 700 million in 1991.

While the demise of the CMEA necessitated the dramatic shift in trade partners, it cannot account for the overall expansion of trade since the late 1980s which has been extraordinary. Exports to both the convertible and nonconvertible areas had stagnated during 1986-87 (about US$350 million and TR 450 million a year, respectively), before doubling by 1989 to US$1 billion and TR 800 million, respectively. The expansion of exports to the CMEA in 1989 had reflected the last efforts to take advantage of the favorable trading arrangements before they disappeared, but overall exports continued to grow at a robust pace during 1990-94, at an average rate of more than 20 percent per annum. 1/ Total imports also have expanded rapidly at more than 20 percent per annum on average during 1990-94.

There has also been a notable diversification of exported goods over this period. Petroleum exports increased from US$80 million in 1988 to about US$850 million a year in 1993-94, reflecting the coming on stream of exploration and development projects in the mid-1980s, with their share in total exports rising from 11 percent in 1988 to 24 percent in 1994. With the liberalization of domestic prices and the reform of the agricultural sector, exports of rice also increased rapidly from zero in 1988 to US$430 million in 1994, the share in total exports rising from zero to 12 percent. 2/ There has also been a rapid expansion of exports of garments and other light manufactured goods, marine products, and coffee.

The progress Viet Nam has made in integrating with the world economy is clearly evident from the rise in the share of trade in GDP from 41 percent in 1989 to 52 percent in 1994. 3/ During the same period, exports as a share of GDP increased from 18 percent to 23 percent, while the share of imports in GDP rose from 23 percent to 29 percent.

3. Trade reform

For economic decisions relating to production and investment to be guided by appropriate market-based incentives that reflected Viet Nam’s comparative advantage, a transparent foreign trade regime needed to be established at the time domestic prices were liberalized. Only then would these prices indicate both scarcities in the domestic market and conditions in the world market. Viet Nam set about liberalizing its trade regime in 1988-89, which consisted at that time largely of controls, including a comprehensive system of export and import quotas, permits, and licenses as well as export duties and import tariffs.

a. Lowering nontariff barriers

Before 1989 all exports and imports were subject to quotas, but in January 1989, 81 quotas were removed leaving only 10 exported and 14 imported goods subject to them. At the same time, all budgetary export subsidies (and the resulting distortions) were eliminated. Later in May, the number of export and import quotas were further reduced to 7 and 12, respectively, and state enterprises were no longer obliged to fulfil their minimum export targets vis-à-vis the CMEA partners before being authorized to export to the convertible currency area. 1/ The remaining quotas have gradually been removed and there are currently no quotas on exports and imports. 2/ 3/

The number of imported goods requiring permits have also been reduced, albeit only recently (April 1995) from 15 to 7 (leaving petroleum products excluding lubricants, steel, cement, fertilizers, sugar, vehicles with less than 12 seats and components, and motorcycles and components). 4/ Also, the number of steps needed to obtain a permit has been reduced (from three to two) in late 1994; companies now need only to obtain a business license from the State Planning Committee and a trading license from the Ministry of Trade.

The requirement for Licenses for each shipment of exports and imports has also been recently reduced. For exports, shipment licenses for 22 commodity groups were issued since April 1993 for a 6 month period without limitation on the number of shipments and the requirement has been eliminated altogether since July 1994 except for rice, timber, and petroleum. The requirement for the first two items is maintained for reasons of food security and environmental protection. The requirement for petroleum is of little consequence at this stage, since there is only one state enterprise responsible for petroleum exports. For imports, the need for shipment licenses remains, although it is expected to be removed for about half of imports (In value terms) in August 1995.

b. Tariff rationalization

Along with the lowering of nontariff barriers, duties on exports and imports of goods were lowered and rationalized in the late 1980s. In April 1989, the number of export commodities subject to export duties fell from 30 (with the rates mostly in the 10 percent range) to 12, and most duty rates were also reduced (to around 3-5 percent by 1990). At the same time, the number of import commodities subject to tariffs dropped from 124 (with rates ranging between 5-50 percent) to 80. While there was some rationalization of the tariff structure, higher rates were also introduced (now up to 120 percent on a few luxury goods). In addition, in April 1991, the export duty on rice was reduced from 10 percent to 1 percent and exporters were exempted from import duties on inputs used for producing exports.

c. Decentralization of foreign trade

Nearly all foreign trade transactions in Viet Nam before 1988 were carried out by a few specialized foreign trade organizations (FTOs) that had a monopoly over trade in certain commodities. The FTOs were in most cases placed directly under the supervision of the branch ministry corresponding to their monopoly, the rest under the direct supervision of provincial authorities. In 1988, the restrictions on the establishment of FTOs were eliminated and many new FTOs were subsequently created by provincial authorities and state enterprises, ending the state’s monopoly over foreign trade. This enabled a large number of exporters and importers to establish direct contacts with foreign companies and thus bypass the administrative inefficiencies of the trading monopolies. The total number of firms and FTOs authorized to engage in foreign trade increased from 80 in 1987 to 600 in July 1990. Since January 1991, private as well as state enterprises have been allowed to engage directly in trade.

4. Exchange reform and exchange rate policy

A key to the success of Viet Nam’s export-led growth strategy has been the reform of the exchange system and the adoption of a flexible, market-oriented exchange rate policy. The distortions associated with multiple exchange rates were removed by the unification of exchange rates in early 1989. The adoption of a more flexible, pragmatic exchange rate policy, tracking closely the developments In the exchange rate prevailing in the large and well established parallel market, prevented the Vietnamese dong from becoming overvalued.

a. Exchange reform

(1) Exchange rate unification

Until March 1989, Viet Nam maintained a system of multiple exchange rates with different rates for trade transactions within the central plan, for invisible transactions, and for trade transactions outside the plan. This system caused large distortions in the structure of relative prices and hidden transfers among the various economic sectors, particularly because the various exchange rates were grossly overvalued. Although the State Bank made periodic adjustments in these rates, the adjustments were insufficient to compensate for the increases in domestic prices and production costs. As a result, importers were able to make large profits based on the difference between import and domestic prices, while exporters required budgetary support in the form of subsidies to compensate the losses realized on the artificially low (dong) export prices.

To eliminate these problems, the exchange rate for trade transactions within the central plan was devalued on September 15, 1988 from D 225 per U.S. dollar to D 900 per U.S. dollar. The exchange rate for most invisible transactions was devalued (and unified with the rate for trade transactions outside the central plan) on November 10, 1988 from D 368 per U.S. dollar to D 2,600 per U.S. dollar, and subsequently devalued four more times to D 3,500 per U.S. dollar on March 8, 1989. Finally, on March 13, 1989, the authorities unified the two existing official exchange rates of D 900 per U.S. dollar and D 3,500 per U.S. dollar, and raised the rate to D 4,500 per U.S. dollar, close to the parallel market rate.

(2) Liberalization of controls on foreign exchange

At the same time, many of the strict administrative controls on the holding and use of foreign exchange, that had driven substantial amounts of foreign exchange into the parallel market, were liberalized substantially to increase the supply of foreign exchange in the official market. A new foreign exchange control decree, issued on October 21, 1988, liberalized the retention of foreign exchange, and was designed to attract foreign exchange into the banking system as well as to adapt the exchange system to the new laws liberalizing foreign trade and investment. Under this new decree, companies that had fulfilled obligations to surrender foreign exchange were allowed to open foreign currency accounts, and individuals were permitted to open foreign currency accounts and hold foreign currency notes. 1/ Foreign currency could be sold to the Bank for Foreign Trade at the prevailing exchange rate, deposited into bank accounts bearing interest in foreign currency, or withdrawn for payment or transfer to other resident units or individuals. Also, foreign currency obtained by transfer from abroad could be used to pay for imported goods and services, to repay foreign loans, and for other transfers abroad. 1/

(3) Introduction of foreign exchange trading floors

In an effort to introduce a market for official foreign exchange transactions, the authorities set up a foreign exchange trading floor at the State Bank branch in Ho Chi Minh City in late August 1991, and in Hanoi later in November 1991. The trading floors were open three times a week in Ho Chi Minh City (Monday, Wednesday and Friday) and twice a week in Hanoi (Tuesday and Thursday). There were 40 market participants including 7 commercial banks and 33 foreign trade organizations, gold import companies and remittance companies. Foreign exchange demand and supply requests were submitted before each session, with the requests for import or debt payments made seven days in advance. With the creation of the trading centers, all authorized foreign exchange transactions had to take place at the rate established there, with a maximum margin for the selling rate of 0.5 percent on either side of the “fixing rate” (subsequently reduced to 0.1 percent). The fixing rates were set in relation to previous-day closing rates and, although the regulations allowed intervention by the authorities, they reflected for the most part developments in the trading floors.

(4) Introduction of an interbank foreign exchange market

On October 14, 1994, in an effort to move the exchange regime closer still to a market regime with broader coverage, the authorities introduced an interbank market for foreign exchange. This interbank market has de facto replaced the two foreign exchange trading floors, and the initial experience has been positive. Most of the big commercial banks have joined the market and the market has been functioning smoothly, with daily transactions initially averaging about US$3 million. 2/ The buying and selling rates are allowed to move within 0.5 percent on either side of the official reference rate, which is adjusted daily in line with market developments as reflected in the closing actual rate of the preceding day.

b. Exchange rate policy

Viet Nam’s exchange rate policy since the unification of the official exchange rates in March 1989 can be divided into two phases: the first, through August 1991, when the authorities adjusted the unified official exchange rate at irregular intervals with the explicit objective of maintaining the official rate within a range of 10 to 20 percent of the parallel market rate; and second, from September 1991 to the present, when the authorities introduced the market for foreign exchange directly into the exchange rate determination process, through the foreign exchange trading floors and subsequently the interbank foreign exchange market (see Chart 6). The phases of “following the market” and “unifying the market”—here “unifying” in the sense that the premium in the parallel market is lowered to zero to give rise to a unique exchange rate, rather than unifying the official exchange rates—are considered in turn.

Chart 6.
Chart 6.

V1ET NAM: EXCHANGE RATE DEVELOPMENTS, 1989-95 1/

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Sources: Data provided by the Vietnamese authorities; and staff estimates.1/ For the period before the unforation of the exchange rates in March 1989, the official rate is that applied to trade transactionsA decline indicates a depreciation.A decline indicates a appreriation.
(1) Following the market (March 1989-August 1991)
  • Background: the parallel market in Viet Nam

Owing to the illegal, albeit to some extent officially tolerated, nature of transactions in the parallel market, information on the size and functioning of the parallel market is neither readily available nor very reliable in Viet Nam, or in any other country. However, prior to the exchange reform, a substantial amount of foreign exchange had clearly been driven into the parallel market by, inter alia, the distortions created by the multiple official exchange rates, their significant overvaluation, and administrative controls on trade and foreign exchange. Parallel markets tend to develop in conditions of excess demand for a commodity subject to legal restrictions on sale, to official price ceilings, or both. Clearly foreign exchange transactions in Viet Nam were subject to both prior to the reform. The regulations on trade flows (quotas, permits, and license requirements as well as the administrative controls on foreign exchange) and the export duties and import tariffs created strong incentives to smuggle and fake invoices (to lower duties). The illegal trade created a demand for illegal foreign currency and, in turn, stimulated its supply. 1/

As in many other developing countries where balance of payments deficits are large and the central bank does not have sufficient reserves (or the borrowing capacity) to meet demand for foreign exchange at the official rate, the parallel market in Viet Nam became well developed and organized, with an exchange rate substantially more depreciated than the official rate. At end-1988, transactions on the parallel market were undertaken at D 4,000 per U.S. dollar, compared with D 900 per U.S. dollar for trade transactions within the plan and D 2,600 per U.S. dollar for invisible transactions and trade transactions outside the plan.

  • The parallel market rate: a good indicator?

The problem with estimating the extent of real exchange rate misalignment, and the appropriate nominal exchange rate, is that the equilibrium real exchange rate cannot be observed. One approach often adopted in practice to get around this problem is to look at the various components of the balance of payments, including the trade balance and net capital inflows, and to determine a base period in which actual and equilibrium real exchange rates were judged to be equal, and then attempt to determine the extent to which the equilibrium real rate had changed since then as a result of changes in its fundamental structural determinants, so that a comparison can be made with the path of the actual real exchange rate, 1/ This approach could not be adopted in the case of Viet Nam, as no previous year prior to doi moi, under pervasive central planning, could be considered an appropriate base year for a market-oriented economy.

The practical alternative for Viet Nam, in the face of so much change, was to use the parallel market rate as an indicator for exchange rate policy, to use information from the parallel market to gauge the extent of real exchange rate misalignment. 2/ The parallel market rate provided a simple and observable indicator, with the existence of a parallel market premium signalling excess demand for foreign exchange at the official exchange rate and, in turn, an overvaluation of the domestic currency at the prevailing official rate. The merits of this approach have been underscored in the literature; for example, models in the currency-substitution tradition (Calvo and Rodriguez (1977)) have been used by Edwards (1989) and Kamin (1993) to analyze the effects of unsustainable financial policies on the parallel market premium and the divergence of the real exchange rate from its long-run equilibrium value. The finding from these models is that, along the adjustment path, overvalued exchange rates are associated with high premia. 3/

This is not to imply that the premium in the parallel market is a perfect measure of overvaluation. In the short term, the premium is driven by expectations and can often be quite volatile reflecting the asset-price characteristics of the parallel exchange rate. The premium at a given point in time should therefore be viewed only as an indicator of the exchange rate that clears the market at that time (World Bank, 1993). Montiel and Ostry (1993) put forward an interesting argument that, because the parallel market premium is an asset price, it could be expected to exhibit much greater volatility than the official real exchange rate, in particular by responding to transitory shocks that leave the equilibrium real exchange rate unaffected. They caution against drawing inferences about deviations of the actual from the equilibrium real exchange rate based on observations of the premium at a given moment in time.

However, over a longer period of time, the premium provides a convenient and observable indicator of overvaluation. 1/ Many developing countries have therefore pursued exchange rate policies designed to narrow the gap between the official and parallel exchange rates by depreciating the official rate (see Aghevli et al, 1991). The aim, in effect, has been to contain the misalignment of the official rate by targeting the premium at reduced levels. Viet Nam has been highly successful in this regard (see Chart 7). 2/

Chart 7.
Chart 7.

VIET NAM: PREMIUM IN THE PARALLEL FOREIGN EXCHANGE MARKET, 1989-95

Citation: IMF Staff Country Reports 1995, 092; 10.5089/9781451840124.002.A001

Sources: Data provided by the Vietnamese authorities; and staff estimates.
(2) Unifying the market (September 1991-present)

During this second phase, the authorities strengthened significantly the relationship between the official rate and the parallel rate through the foreign exchange trading floors and the interbank market. The incentive to channel foreign exchange into the parallel market had been reduced to some extent by the relaxation of controls on the holding and use of foreign exchange in 1988 and trade liberalization during 1988-91 (noted above). However, the trading floors and the interbank market introduced a much greater market element into the determination of the official exchange rate and consequently brought a large share of foreign exchange transactions into the official market. The degree to which the official exchange rate became market determined is evident from the parallel market premium staying well below 1 percent from the beginning of 1992 to the present.

The key to a successful unification of the foreign exchange market in Viet Nam has been the consistency between the fiscal and monetary policies and the exchange rate policy. The devaluation of the official exchange rate was backed up by cuts in the budget deficit and tightening of domestic credit (see Box 7). 1/ Even though the rate of inflation did not fall immediately to a low level, it did decline substantially over time and the authorities accommodated inflation sufficiently through periodic devaluations to avoid severe overvaluation. 2/

In this sense, the exchange rate policy stance taken by the authorities since the late 1980s has been consistent and progressive: the pursuit of a flexible, market-oriented (and in many ways pragmatic) exchange rate policy, with movements in the parallel market rate, and subsequently in the trading floor and interbank market rates, providing a key indicator for the official exchange rate, as well as a narrowing of the gap between the official and parallel markets. While the authorities have intervened at times in the foreign exchange market, notably in 1993 when they resisted considerable pressure for depreciation by running down reserves, on the whole the exchange rate has not been used as a nominal anchor for stabilization. Instead, fiscal and monetary policies have carried this burden, allowing exchange rate policy to focus primarily on maintaining external competitiveness, and setting up the conditions for strong export growth and the achievement of a sound balance of payments position. The exchange rate has been relatively stable against the U.S. dollar during the last few years, but this reflects primarily the effectiveness of financial policies, rather than a conscious effort to anchor the exchange rate.

(3) Real effective exchange rate developments

The devaluation on March 13, 1989 of the official exchange rate for trade transactions within the plan from D 900 to D 4,500 per U.S. dollar resulted in a nominal and real effective depreciation of 500 percent-bringing about a massive realignment of exchange rates and a concomitant improvement of Viet Nam’s external competitiveness. 1/ The unification and devaluation of official exchange rates, combined with a tightening of financial policies (including a sharp rise in interest rates to positive real levels), had an immediate impact on the confidence in, and demand for, the Vietnamese dong. Subsequently, the official exchange rate was revalued by about 10 percent during the last nine months of 1989 (following the appreciation of the parallel rate) and the real effective exchange rate appreciated by 23 percent as a result, albeit to a level far below that which prevailed prior to the reforms (see Chart 6).

Elements of a Successful Unification

Theory and experience strongly suggest that fiscal reform and financial stabilization must accompany the unification of foreign exchange markets for it to be successful (see Agenor (1990) or Kiguel and O’Connell (1994) for a review of the arguments and experiences among many developing countries). The point made in the literature, and supported by the empirical evidence, is that, without these supporting policies, the devaluation of the official exchange rate only results in a temporary reduction of the parallel market premium. Under a floating exchange rate regime, an initial devaluation of the official rate results in a loss of fiscal revenue—this is often the case since the premium is an implicit tax on exports. Unless compensatory revenue measures are undertaken, the rate of inflation, and the rate of depreciation, will tend to rise, as the authorities attempt to compensate through an increase in monetary financing (assuming that a constant amount of real fiscal expenditure is to be financed; see Pinto (1989) for a formal exposition). Under a fixed exchange rate regime, the initial devaluation of the official rate will tend to reduce the premium temporarily, but the expansionary fiscal and credit policy will bring about inflation that results in a real appreciation of the exchange rate and therefore a rise of the premium reflecting the overvaluation of the official rate.

However, there was a relaxation of financial policies in 1990-91 in an attempt to mitigate the impact of the collapse of the CMEA and the parallel rate depreciated by 48 percent against the U.S. dollar in 1990 and further by 66 percent during the first 8 months of 1991. The official rate was devalued by 60 percent and 40 percent, respectively (see Chart 6). With domestic inflation accelerating to about 70 percent per annum in 1990-91, exchange rate developments tracked closely the inflation differential with Vietnamese trading partners, and the official rate was devalued often enough to keep the parallel market premium below 20 percent during most of 1990-July 1991 (within a narrow range of 2-7 percent during January-July 1991). As a result, the real effective exchange rate, while fluctuating from month to month, did not become increasingly overvalued and the real effective exchange rate index remained within a band between 100-125 (March 1989=100) during this period (see Box 8 and Chart 6).

Inflationary Impact of Devaluation When There is a Large Parallel Market

In economies like Viet Nam where the parallel market is large and well established, it is likely that much of the inflationary impact of a devaluation is absorbed early in the parallel market by the depreciation of the parallel exchange rate. In such cases, the prices of many tradable goods will have already increased as goods are smuggled in from neighboring countries (at parallel rates). So when the Government finally devalues, domestic prices will have already adjusted to the new “equilibrium” official exchange rate, and there would be no further inflationary pressures.

Both official and parallel exchange rates depreciated sharply when the trading floors were introduced in August 1991 (in anticipation, the parallel rate started to move sharply in July 1991). The exchange rates moved from about D 9,000 to about D 12,000 per U.S. dollar. By end-1991, the real effective exchange rate had returned to the level prevailing in March 1989.

By March 1992, the official and parallel exchange markets were effectively unified with the premium well below 1 percent (see Chart 7). Since then, both the official and parallel market rates have been broadly stable against the U.S. dollar, within a range of about D 10,500 to D 11,500 per U.S. dollar. Reflecting this stability against the U.S. dollar and generally lower inflation rates in Viet Nam, the real effective exchange rate has remained relatively constant at a level some 30 percent more appreciated than in March 1989.

Although the recent weakening of the U.S. dollar against the yen and the deutsche mark has resulted in a small depreciation of the real effective rate, taking the period after March 1989 as a whole, there has been a stabilization of the real effective rate from early 1992 onwards at a level somewhat more appreciated than those that prevailed during the preceding three years. While this might be seen as an indication of misalignment of the exchange rate of the dong, several developments in recent years suggest that it instead indicates an appreciation of the equilibrium real effective exchange rate (EREER) and should not be a cause for concern.

The EREER can be thought of as the relative price of tradable to nontradable goods yielding simultaneously internal and external equilibrium, where the former implies that the nontradable goods market is cleared continuously, 1/ and the latter implies that the current account deficit is financed by sustainable capital inflows. 2/ Higher capital Inflows would allow a larger current account deficit to be financed, and a more appreciated real effective exchange rate to be sustained. In Viet Nam, there has been: a recovery of official grants and loan disbursements from the low levels of 1990-91, as Japan and other official creditors have increasingly filled the gap left by the FSU; a marked rise In foreign direct investment, from US$100-200 million during 1989-91 to US$650 million in 1994, reflecting, inter alia, the liberalization of trade and exchange regimes; and, in December 1993, a Paris Club rescheduling covering Viet Nam’s arrears to Paris Club creditors involving a 50 percent reduction in the net present value. Since much of the debt was in arrears, the rescheduling covered a large portion of Viet Nam’s external debt, and effectively provided Viet Nam a stock of debt reduction—reducing if not eliminating its “debt overhang.” 3/

It would not seem, therefore, that there is a need for a significant realignment of the Vietnamese dong at this time. The parallel market has been stable, while the official rate has remained within 0.3 percent of the parallel rate during 1994 and the first months of 1995. And export growth continued to be robust in the early part of 1995, indicating that external competitiveness remains sound.