Problem Statement
Since the onset of the 2008 global economic crisis, a robust recovery has remained elusive, with adverse shocks affecting nations across all continents The lingering threat of the European debt crisis has persisted from 2011 to the present, exacerbating economic instability worldwide.
In 2011, Vietnam's Government implemented Resolution 11/NQ-CP to combat inflation and ensure macroeconomic stability, emphasizing the careful application of monetary and fiscal policies The banking system and credit institutions play a vital role in mobilizing and distributing capital, making monetary policy essential for influencing investment flows and business strategies This policy not only supports working capital for businesses but also enables those with sound strategies to pursue long-term development through investment Additionally, monetary policy is crucial for maintaining price stability, managing foreign trade through exchange rate policies, and ensuring liquidity in international payments Consequently, understanding the impact of monetary policy on macroeconomic stability has become increasingly important for Vietnamese authorities.
Furthermore, it is often said that the more open and developed Vietnam is, the easier the economy to be affected by international circumstance as Vietnam was not h
The 1997 Asian crisis and the ongoing global financial crisis since 2008 have significantly impacted the economy, highlighting the need for a robust monetary policy framework As the economy becomes increasingly sensitive to global fluctuations, it is essential to develop effective monetary tools to manage economic adjustments, particularly during periods of recession.
Economic theories and empirical studies indicate that monetary policy shocks can significantly affect output and inflation through various channels However, the specific quantitative impact of these channels on Vietnam's economy, particularly regarding inflation in urban and rural areas, has not been thoroughly examined This gap hinders policymakers in formulating effective strategies tailored to the unique needs of each region Therefore, conducting an empirical study on the relationship between monetary policy channels and key macroeconomic variables, such as real output growth and inflation across urban, rural, and national levels in Vietnam, using updated data from May 2005 to June 2012, is both timely and essential.
Significant of the study
The interplay between monetary policy and economic outcomes, including real output growth and inflation, remains a significant topic of debate in both theoretical and empirical contexts Despite extensive research, opinions diverge regarding how macroeconomic variables are influenced by monetary policy across various countries.
Recent studies on monetary policy in Vietnam, such as Hoang (2010) and Camen (2006), have explored the effects of money supply changes on real output and inflation, revealing significant but minimal impacts While research has examined external factors influencing inflation fluctuations and the relationship between exchange rates and output, a clear understanding of how monetary policy shocks affect real output growth remains elusive Notably, Bui (2011) analyzed the effects of money growth on inflation, while Nguyen (2012) highlighted the role of credit in the monetary mechanism, yet both studies overlooked the differential impacts of monetary policy on urban versus rural inflation Additionally, many existing studies are based on outdated data, failing to account for recent inflation trends and the shifts in macroeconomic policy due to the global financial crisis, rendering their findings less relevant.
This study is crucial for Vietnam's current economic landscape, providing insights for policymakers to effectively manage monetary policy aimed at enhancing real output growth and controlling inflation Additionally, it serves as a foundation for future research on monetary and other policies across various regions, including rural and urban areas, thereby enriching the understanding of the evolution of Vietnam's money market Moreover, it contributes to the broader knowledge of the monetary transmission mechanisms within urban and rural contexts, as well as in comparison with other countries.
Research objectives
The main objectives of this thesis is:
• to clarify the relationship between monetary policy and real economy (real output growth and inflation) of Vietnam
• to clarify the difference of impact of monetary policy on inflation of the urban and the rural area ofVietnam separately
This article examines the effects of three primary monetary channels—interest rate, credit, and exchange rate—on Vietnam's real economy, focusing on real output growth and inflation By analyzing how these channels interact and influence economic performance, the study aims to provide insights into their roles in shaping Vietnam's economic landscape Understanding these dynamics is crucial for policymakers to implement effective monetary strategies that support sustainable growth and stability in inflation rates.
Research questions
This thesis aims at answering the following research questions:
• Do real output growth of Vietnam and inflation rate of the urban area, the rural area and all over of Vietnam affected by monetary policy?
The relationship between monetary policy changes by the State Bank of Vietnam and their impact on real output growth and inflation rates in both urban and rural areas of Vietnam is crucial Understanding how these policies influence economic performance can provide insights into the overall economic landscape of the country Significant shifts in monetary policy can lead to notable variations in inflation and real output, affecting both urban and rural populations differently Analyzing these dynamics is essential for assessing the effectiveness of monetary policy in promoting sustainable economic growth in Vietnam.
The impact of monetary policy changes on real output growth and inflation rates in Vietnam varies across urban and rural areas, as well as nationwide Understanding the time lag between these policy adjustments and their effects is crucial for assessing economic performance Analyzing the response of different regions helps identify the nuances in economic dynamics, providing valuable insights for policymakers.
• On the basis of research results, what is the most useful channel that is being used by the State Bank of Vietnam?
Thesis Structure
The thesis is structured into six chapters, beginning with the problem statement, significance of the study, research objectives, and research questions The second chapter reviews relevant literature, while the third chapter provides an overview of Vietnam's economic performance, financial system, and monetary policy tools Chapter four details the methodology employed in the regression model, presents estimated results, and discusses their policy implications for Vietnam The concluding chapter summarizes the study, outlines its policy implications and limitations, and suggests directions for future research.
LITERATURE REVIEW
Theoretical literature review
2.1.1 Mechanism of the impact of aggregate demand to output and price level
Both monetarists and Keynesians agree that the aggregate demand curve is downward-sloping and responds to changes in the money supply However, monetarists attribute shifts in this curve primarily to changes in the money supply, while Keynesians emphasize additional factors such as fiscal policy, net exports, and "animal spirits." Although Mishkin (1995, 1996, 2001) does not explicitly discuss changes in output and inflation, these changes can be inferred from the AD-AS model In this model, an increase in the money supply shifts the aggregate demand curve from AD1 to AD2, moving the economy from point E1 to E2, which results in an increase in output from Y1 to Y2 and a rise in the price level from P1 to P2 (Mishkin, 1995).
Figure 2.1: Keynesian AS-AD model h
2.1.2 Traditional Keynesian IS/LM model
The relationship between interest rates and output is illustrated in the traditional Keynesian IS-LM model When the Central Bank implements a tight monetary policy by reducing the money supply, the real money balance (M/P) decreases, causing the LM curve to shift leftward This shift indicates that the demand for money exceeds its supply, prompting individuals to sell bonds for cash, which subsequently raises interest rates Higher interest rates increase the cost of capital for production, leading to a decline in investment spending and net exports As a result, the new equilibrium in the IS-LM model reflects a decrease in output along the IS curve This process can be summarized by the connection: Ms ↓ → i ↑ → I ↓, NX ↓ → Y ↓.
1 The notation M 8 , i, I, NX, Y stands for Money supply, interest rate, Investment, Net export and Output, h
Further studies confirm that beside businesses' investment spending, a fall in investment could also be understood as a postponement in consumers' residential housing and consumer durable expenditure
The Mundell-Fleming Model enhances the traditional IS/LM framework by incorporating international trade and finance, illustrating how output responds to monetary policy shocks in an open economy with imperfect capital mobility When a central bank expands the money supply, real money balances increase, shifting the LM curve to the right and causing interest rates to fall below the world interest rate (r*) This leads to capital outflows, as investors seek higher returns abroad Consequently, the demand for foreign currency rises, resulting in the depreciation of the domestic currency This depreciation makes domestic goods cheaper compared to foreign goods, stimulating net exports and ultimately boosting output.
Tobin's theory of investment establishes a systematic relationship between stock prices, business investment, and output In his 1969 paper, Tobin defines "q" as the ratio of the market value of shares (V1) to the unit of capital (K1), expressed as q1 = V1/K1 When interest rates (r) rise, the opportunity cost of holding shares increases, making them less attractive compared to bonds This leads investors to sell shares for bonds, causing a drop in V1 As share prices decline, so does q1, which reduces the marginal benefit of investment—the gain in share value from additional capital At the optimal investment level, the lost dividends are balanced by capital gains, but a lower q1 diminishes the firm's ability to invest before the costs outweigh the benefits Consequently, firms may refrain from purchasing new investment goods when q1 is low, resulting in decreased investment and, ultimately, a reduction in output Mishkin (1996) highlights this relationship as part of the equity channel in the monetary transmission mechanism: "Ms t ~Pet~ qt ~It~ Y f."
Monetary transmission mechanism is defined as "the route by which monetary policy is translated into changes in output, employment, prices and inflation"
In Vietnam, monetary policy impacts the economy primarily through three channels: the interest rate channel, the credit channel, and the exchange rate channel Given the underdeveloped state of the Vietnamese stock market, characterized by low levels of VNINDEX stability and the absence of a housing index, this thesis will not address the equity price channel or the real estate channel.
In this part, three main channels mentioned above will be presented in greater detail as following:
In his 1995 research on the monetary transmission mechanism, Taylor highlights the crucial role of interest rates in shaping the economy's response to monetary policy He identifies a cyclical relationship between real GDP, inflation, and short-term interest rates A shift in short-term interest rates influences both long-term rates and exchange rates, although it is not the sole determinant of these variables over time Economic rigidities, such as price stickiness, mean that changes in nominal interest rates and exchange rates lead to fluctuations in real interest and exchange rates These real rate changes subsequently impact real investment, consumption, and net exports, all of which contribute to GDP fluctuations Ultimately, in the long run, real variables tend to revert to their normal levels when wages and prices are flexible.
In tum, the change in real GDP and inflation will also have effect on the short rate
A zero nominal interest rate can still stimulate the economy through a decrease in the real interest rate, driven by rising expected price levels and inflation An increase in broad money raises expected price levels, leading to higher expected inflation Consequently, the real interest rate declines, boosting investment, net exports, and overall output This relationship underscores the significant role of interest rates as a powerful monetary channel influencing economic output.
Expansionary monetary policy, as noted by Mishkin (2006), involves increasing the money supply (M5), which leads to a decrease in the real interest rate (Cir) This reduction in the cost of capital encourages businesses to boost investment spending and prompts consumers to enhance their expenditures on housing and durable goods, both of which are classified as investments Consequently, this surge in investment spending (I) results in a higher aggregate demand and an increase in output (Y).
Mishkin (1996) highlighted the significance of credit channels in the economy by presenting three key reasons He noted that credit market imperfections significantly influence firms' decisions regarding inputs and outputs, including their workforce and machinery Additionally, empirical evidence shows that small businesses facing credit constraints are more susceptible to monetary policy changes compared to larger firms Lastly, Mishkin emphasized that asymmetric information within imperfect credit markets can help explain various economic phenomena.
3 Notation are same as previous one, Pe, 1te are expectation of price level and expectation of inflation, respectively h
In their 1995 research, Bernanke and Gertler likened monetary policy transmission to a "black box," highlighting the need for empirical evidence regarding interest rate channel effects They proposed that the credit channel plays a crucial role in elucidating the effects of monetary policy on the economy, suggesting that analyzing the interaction between the external finance premium and interest rates could enhance understanding This credit channel addresses agency problems stemming from asymmetric information and costly contract enforcement in financial markets, and it is further divided into two specific channels: the bank lending channel and the balance sheet channel.
The bank lending channel illustrates how monetary policy impacts the economy by influencing the availability of bank loans and intermediated credit In the credit market, banks are crucial in addressing asymmetric information issues, as bank loans are not easily replaceable by alternative funding sources.
Large firms can access stock and bond markets for credit, but small and medium-sized enterprises primarily rely on bank loans for investment A contraction in monetary policy leads to decreased bank reserves and deposits, resulting in fewer bank loans and subsequently reduced investment When bank loans diminish, firms must seek new lenders and establish costly credit relationships, negatively impacting their performance and leading to further investment declines Consequently, output also decreases, as illustrated by Mishkin (1995) in the schematic summary: "Ms t - bank deposits - bank loans - I t - Y f."
The bank lending channel's significance remains debated, with researchers like Romer and Romer (1989) questioning the impact of monetary policy on bank loans, particularly following financial deregulation and innovation in the mid-1980s United States The introduction of certificates of deposit (CDs) has since eased banks' challenges in managing deposit reductions during monetary contractions Consequently, the decline in traditional bank lending globally has diminished the importance of banks and the availability of the bank lending channel (Edwards and Mishkin, 1995).
The balance-sheet channel, also known as the net worth channel, illustrates how monetary policy impacts the economy through changes in borrowers' balance sheets and income statements, which are influenced in various ways.
A monetary contraction that reduces the money supply can lead to lower equity prices, resulting in decreased net worth for firms This decline in net worth exacerbates issues of adverse selection and moral hazard, as reduced collateral value increases lenders' risks and potential losses Consequently, firms may be incentivized to pursue riskier investments, raising the likelihood of loan defaults As a result, diminished net worth can lead to decreased lending and investment, ultimately causing a reduction in output and aggregate demand This chain reaction illustrates the interconnectedness of money supply, equity prices, and economic activity.
Previous empirical studies related
Numerous studies have explored the relationship between monetary policy tools and macroeconomic indicators, supported by various theories Notable research includes the work of Bernanke and Blinder (1992) and Bernanke and Gertler (1995), which focused on the United States' monetary transmission mechanism Similar analyses have been conducted in other countries, such as Disyatat and Vongsinsirikul (2003), who developed a VAR model for Thailand, Morsink and Bayoumi (1999), who examined Japan, and Hsing (2004), who analyzed data from Venezuela.
In VAR-based research, short-term interest rates are often seen as key indicators of monetary policy, with Bemanke and Blinder (1992) highlighting the Federal Funds Rate as the Fed's primary tool for over three decades However, the interest rate transmission mechanism remains contentious, as evidence of its quantitative impact through the neoclassical cost of capital is limited For instance, Dimitriu et al (2009) found that in Romania, inflation significantly responded to interest rate shocks, while industrial production also reacted notably to interest rate variations In contrast, Boivin and Giannoni (2002) noted a declining responsiveness of real output to the interest channel in the U.S since the 1980s Additionally, research on "Tobin's q" has yielded limited success, prompting scholars like Bemanke and Gertler (1995) to propose that mechanisms beyond interest rates, such as the credit channel, play a critical role in monetary policy transmission.
Research on the impact of exchange rates on output yields varied findings Edwards (1986) analyzed twelve developing countries over 16 years, concluding that while devaluations negatively affect output in the short term, they can have a positive long-term impact when other factors remain constant, ultimately resulting in a neutral effect Similarly, Dumitriu et al (2009) found that in Romania, inflation and industrial production significantly respond to exchange rate shocks Additionally, Al-Mashat and Billmeier (2007) highlighted the crucial role of the exchange rate channel in Egypt's monetary transmission, noting that other channels are relatively weak.
Research on the effects of monetary policy tools on output growth and inflation in Vietnam reveals significant findings A study by Vo et al (2001) indicates that changes in exchange rates (ERs) have notably influenced the Granger-causality among output growth, inflation, and money growth While nominal ERs have occasionally acted as a leading indicator for output growth, this relationship has proven inconsistent Furthermore, current inflation and real industrial output growth are primarily driven by their historical trends Notably, real depreciation rates positively affect output growth, although the extent of this impact varies considerably.
Le and Wade (2008) developed a VAR model to explore the relationships between money, real output, price levels, real interest rates, real exchange rates, and credit, finding that monetary policy significantly influences real output and price levels, with the strongest effects on output occurring after four quarters In contrast, the impact on price levels took longer, from the third to the ninth quarter, although the significance of each channel was weak, with credit and exchange rate channels being the most notable Hoang (2010) analyzed the monetary transmission mechanism in Vietnam using a similar VAR approach, confirming that monetary policy affects real output and price levels, albeit at low levels, while credit significantly influences output, unlike interest and exchange rates, which do not significantly affect price levels Bui (2011) examined the effects of money growth on inflation in Vietnam from 2004 to 2010, revealing a significant positive impact of money growth on inflation in both the short and long run, emphasizing the crucial role of the credit channel in monetary transmission Nguyen (2012) further explored the relationship between credit and monetary transmission, finding that in a classical market, independent variables did not exhibit Granger causality with money supply, although money supply could predict most dependent variables, except for lending rates In an augmented market, domestic credit significantly predicted money supply, while price levels and lending rates did not in the classical market Additionally, in a tightening monetary policy scenario, output and refinancing rates responded to money policy shocks after one lag, with output being particularly sensitive to money shocks, while the lending channel's response was shorter and occasionally abnormal Overall, the credit channel emerged as a vital component of the monetary policy mechanism in Vietnam.
Endogenous Variables Real output, Nominal money, Fiscal deficit, Terms of trade, Real exchange rate, Government expenditure
Consumer Price Index, M1, M2, Federal Funds rate, three-month Treasury bill rate, ten-year Treasury bond rate,
Industrial production, Capacity utilization, Employment, Unemployment rate, Housing starts, Retail sales, Consumption, Durable-goods orders
Real GDP, GDP deflator, index of commodity prices, Federal funds rate, Final demand, Inventory investment
Real Private Demand and its 4 components, Consumer Price Index, Overnight call rate and Broad Money, Loan and Holdings of security
Research Method Time series data
Use VAR model in reduced form
Use Structural VAR model to analyze the Granger causality tests, variance decompositions, and impulse response functions
Use VAR model in reduced form to analyze impulse response functions
In the short run, a devaluation leads to a decrease in aggregate output However, after one year, it begins to exert an expansionary effect on output Ultimately, in the long run, devaluations do not impact output levels.
The federal funds rate serves as a key indicator of monetary policy, effectively forecasting real economic variables It is particularly noteworthy that tighter monetary policy leads to a short-term sell-off of banks' security holdings, while having minimal impact on loans The similar timing of responses in loans and unemployment to changes in monetary policy suggests that this transmission channel is active, despite the lack of a direct Granger-causal relationship between loans and unemployment.
Monetary policy significantly influences spending on durable goods, particularly with a notable and swift reaction of housing investment to changes in policy Additionally, both the balance sheet and bank lending channels are crucial factors in the dynamics of the housing market.
Monetary policy significantly influences banks' balance sheets, serving as a key source of economic shocks Banks are essential in transmitting these monetary shocks to overall economic activity, with business investment being particularly responsive to changes in monetary policy.
Exchange rate, Monetary aggregates (currency in circulation CU, M1, and M2), Real industrial output, Consumer Price Index
Output, inflation, and interest rates
Consumer Price Index (PRICE), and 14-day repurchase rate (RP14), private consumption, investment, exports, and imports, bank credit, real effective exchange rate (REER), asset prices, interest rate
Real GDP, real M2, real government deficit, real exchange rate, inflation rate
Official exchange rate (OER), Selling interbank exchange rate (SER), parallel selling exchange rate in Ho Chi Minh City (SSER), parallel selling exchange rate in Hanoi (HSER)
UseVAR models, Co- integration techniques, Error Correction Model (ECM) and simple Lucas-type production function
Use VAR model in reduced form and Structural VARs
Use VAR model to analyze variance decompositions, and impulse response functions
Use V AR model to analyze
World output, world crude price oil variance decompositions, and impulse response functions
The rate of changes in ERs has altered significantly the Granger-causality between output growth, inflation, and money growth
Nominal exchange rate changes, particularly in official and shadow exchange rates, have occasionally indicated output growth, though this relationship lacks consistency Current inflation and real industrial output growth are primarily influenced by their historical trends Additionally, real depreciation rates positively affect output growth, but the extent of this impact varies significantly.
The shift in the propagation mechanism has significantly reduced the variability of macroeconomic variables, leading to a decreased impact of monetary policy shocks on both output and inflation.
The stylized facts about the response of the economy to a tightening of monetary policy:
The aggregate price level shows minimal initial response but begins to decline persistently after about a year Meanwhile, output exhibits a U-shaped response, reaching its lowest point after approximately 4-5 quarters and gradually recovering over the next 11 quarters.
Investment is the most responsive element of GDP to monetary policy changes Real GDP shows a positive reaction to shocks in real M2, government deficit spending, and real exchange rate depreciation Conversely, lagged real output significantly declines in response to inflation rate shocks.
Real (distributed) GDP, Wholesale Price Index, Monetary Policy Stance Index and Nominal Effective Exchange Rate, Interest rate (three- month deposit rate), Domestic credit, Asset Price, Reserve Money
Real Industrial Output, Consumer Price Index, Broad Money, Real Lending Rate, Index of the Real Effective Exchange Rate and Domestic Credit
Consumer Price Index, Exchange Rate (ROL/EUR), Industrial
Production, Money supply (M2), Non- Government Credit, Three month offered interest rate from Romanian
World Oil Price, World Rice Price and Federal Funds Rate
Use VAR model in reduced form to analyze the Granger causality tests, variance decompositions, and impulse response functions
Use VAR model in reduced form to analyze the Granger causality tests, variance decompositions, and impulse response functions
The VAR model analysis reveals that during the initial year, government deficit spending and the inflation rate significantly influence variance decompositions, alongside lagged output However, beyond the first year, real M2 and the real exchange rate emerge as more impactful variables, demonstrating their importance for longer-term economic effects.
The exchange rate channel plays an important role in the transmission of the monetary stance Most other channels are quite weak
Monetary policy significantly influences real output, but the relationship between money supply and inflation in Vietnam remains ambiguous In this context, the credit and exchange rate channels play a more critical role compared to the interest rate channel.
Inflation and industrial production have significant responses to shocks from exchange rate, interest rates and money supply h
Real GDP and its 3 components, Consumer Price Index, Broad Money, Real Lending Rate, Index of the Real Effective Exchange Rate and Domestic Credit
Consumer Price Index, Broad Money, Real Industrial Output, Domestic Credit, Nominal Exchange Rate VND/USD, Nominal Lending Rate
Real Industrial Output, Consumer Price Index, Broad Money (M2), Domestic Credit, Refinancing Rate, Lending Rate
World Oil Price, World Rice Price and Federal Funds Rate
Use VAR model in reduced form to analyze the Granger causality tests, variance decompositions, and impulse response functions components, and inflation
Co integration Test, Error Correction mechanism (ECM) and Johansen
Chapter remarks
This thesis focuses on the impacts of monetary policy on macroeconomic variables in which two variables output and inflation are concentrated and clarified in details
The Keynesian AD-AS model illustrates the relationship between money supply and aggregate demand, indicating that an increase in money supply shifts the aggregate demand curve rightward in the short term, leading to a new equilibrium with higher output and price levels This thesis explores Aggregate Demand through the Traditional Keynesian IS-LM model, the Mundell-Fleming Model, and Tobin's q theory It employs the VAR model to analyze the impact of monetary policy on the economy, focusing on three primary channels: interest rate, credit, and exchange rate channels The study specifically examines the effects of monetary policy on the Vietnamese economy from May 2005 to June 2012.
ECONOMY PERFORMANCE, FINANCIAL SYSTEM
Economy performance
,._Economic Growth (Real GOP growth)
Since the economic reform in 1986, Vietnam has experienced remarkable economic growth, with an annual growth rate of 7.5% during the 1990s and peaking at nearly 10% in 1995 and 1996 From 2000 to 2007, the growth rate averaged 7.6%, positioning Vietnam among the highest growth rates in East Asia During this period, Vietnam's real GDP growth consistently ranked in the top 30 globally, according to the Central Intelligence Agency (CIA).
Between 2008 and 2010, Vietnam experienced a significant decline in growth, averaging 6.1%, with a particularly low GDP growth rate of 5.3% in 2009—the lowest in a decade This downturn was primarily driven by the global financial crisis and recession, which severely impacted Vietnam's economy, particularly in the sectors of exports, investment, and tourism.
Since 2011, Vietnam's economic growth has faced significant challenges, with a decline in growth rates, dropping from 5.9% in 2011 to just 5.03% in 2012 This downturn has been attributed not only to the global financial crisis and recession but also to weaknesses in macroeconomic management and monetary policy Recent uncertainties surrounding the banking system and state-owned enterprises have further exacerbated the situation According to a recent Moody's report, Vietnam's average real GDP growth rate is projected to remain around 5% per year over the next two years.
Vietnam experienced hyperinflation in the second half of the 1980s and early 1990s
In the years 1987 to 1991, the annual inflation rate was above 40% It was then followed by a reduction of the inflation rate to 32% in 1992 and closed to 10% in
1996 During this period, Vietnam made great effort to follow restrictive monetary policy and fiscal policy to control the inflation h
Year -Real GDP growth rate -Inflation
Figure 3.2: Inflation and real GDP growth rate
These policies were successful to keep inflation rate under 10% since 1996 It even went far above expectation as there was a slightly deflation in the year 1999 and
Since 2002, inflation rates remained below growth rates, aligning with the primary macroeconomic goals outlined in the Socio-Economic Development plan However, in 2008, inflation surged once more, largely influenced by the recent global financial crisis.
Finacial system and the role of Central Bank in Vietnam
Since 1988, Vietnam has undergone a significant transformation in its banking sector, shifting from a mono-bank system to a two-tier banking system This system comprises the State Bank of Vietnam (SBV), which operates under government oversight and is responsible for regulating the financial market and supervising commercial banks through monetary policy The SBV holds a monopoly on currency printing, serving as the legal tender for the government Additionally, the system includes Specialized Commercial Banks and other financial institutions that perform essential banking functions, such as facilitating loans and deposits for individuals and businesses.
The banking sector in Vietnam, particularly the State Bank of Vietnam (SBV), has made significant progress in its development However, amidst the unpredictable global and national economic landscape, challenges within the banking system and the central bank are inevitable Acknowledging the need for reform, the Vietnam Communist Party and Government have emphasized the reorganization of the SBV to function as a modern central bank that operates within a socialist-oriented market mechanism and aligns with international standards This transformation aims to enhance macroeconomic stability, control inflation, and boost the purchasing power of the Vietnamese currency to support the nation's economic growth Nonetheless, a critical question remains: what constitutes a modern central bank? Despite its apparent simplicity, this question lacks a definitive answer.
In developed countries like the USA, Canada, Europe, Switzerland, New Zealand, and Japan, organizational models operate independently from government influence In contrast, Vietnam's organizational model is directly governed by the state.
A study by the International Monetary Fund (IMF) published in December 2004 categorizes central banks worldwide into four levels of independence: independence in establishing operational objectives, independence in determining performance targets, independence in choosing operating instruments, and limited independence.
The highest level of independence for a central bank is seen in its ability to set operational objectives, where it has the authority to make decisions regarding monetary policy and exchange rates within the legal framework A prime example of this model is the U.S Federal Reserve System (FED).
The second level of central bank independence involves the authority to establish performance targets, allowing the bank to determine its monetary policy and exchange rate regime Unlike the first level, this stage includes a clearly defined operational objective mandated by law, such as the European Central Bank's (ECB) primary goal of maintaining price stability.
The third level of monetary policy independence involves the Government or National Assembly setting policy targets in collaboration with the Central Bank Once these targets are approved, the Central Bank is empowered to select the most suitable monetary tools to achieve them This model is exemplified by the Reserve Bank of New Zealand and the Bank of Canada, which effectively balance governmental oversight with central bank autonomy.
The fourth level of independence, known as limited independence, represents the lowest degree of autonomy for a central bank In this framework, the government acts as the primary decision-making authority regarding policy, including operational objectives and performance targets, while also intervening in the implementation of monetary policy This governmental involvement restricts the central bank's effectiveness, particularly in achieving its goal of maintaining monetary stability Currently, the State Bank of Vietnam exemplifies this scenario, where the limitations and shortcomings of this level of independence have become increasingly apparent.
Recent discussions on central bank reform in Vietnam suggest adopting an independent central bank model Proponents argue that greater independence from the government facilitates the achievement of low inflation targets, a theory supported by economic principles.
Moreover, some different researches have also come to the conclusion that countries whose central banks have a high level of independence often have low inflation rate (Eijffinger and DeHaan, 1996)
Research consistently supports the notion that monetary policy formulation, decision-making, and implementation should be entrusted to a professional and independent central bank This approach prioritizes price stability as the primary goal, ultimately enhancing the effectiveness of policy measures and bolstering the credibility of policymakers.
The State Bank of Vietnam needs greater autonomy in its policy decision-making to operate without interference from state agencies or political pressures It should also be empowered to manage all tools that influence monetary policy objectives, particularly in controlling inflation and limiting direct government financing of budget deficits.
Monetary policy
The Government is responsible for preparing an annual monetary policy plan, which includes projections for inflation and growth, and submits it to the National Assembly The National Assembly's role involves setting annual inflation and growth targets aligned with the state budget and economic growth objectives outlined in the Socio-Economic Development Plan Additionally, the Government organizes the implementation of monetary policy, determining the liquidity to be injected into the economy This activity must be reported to the National Assembly, which oversees the implementation of monetary policy.
The primary function of the State Bank of Vietnam (SBV) is to prepare and implement monetary policy using various tools while overseeing all banking activities This process involves not only the SBV but also the National Assembly, the Government, and the National Monetary Policy Advisory Board, which collectively set objectives and supervise the SBV's operations However, the Government's strong involvement can limit the independence of monetary policies Research by Radzyner and Riesinger (1997) indicates that central banks in transition economies, such as those in Central and Eastern Europe, have maintained independence in formulating and implementing monetary policy since the early 1990s, with Poland as an exception The Czech National Bank, the National Bank of Hungary, the Bank of Slovakia, and the Bank of Slovenia are mandated to design monetary policies independently, although significant issues are often discussed with the Government The study concludes that a central bank's independence significantly influences the effectiveness of its policies.
The State Bank of Vietnam (SBV) aims to stabilize the currency's value, which includes maintaining a stable exchange rate, controlling inflation, and promoting socio-economic development However, a closer look at Vietnamese economic policy reveals that economic growth is often prioritized as the government's primary objective (Camen, 2006).
The State Bank of Vietnam plays a crucial role in shaping macroeconomic policy by utilizing various monetary policy tools to achieve its annual objectives, which include managing the exchange rate and regulating total liquidity (M2) and credit within the economy Key instruments for controlling the money supply encompass essential monetary policy tools.
-ãã ãã-ã ãã-ãããã-ããã ãã-ã-ããã -ã-ããã-ããã ã ããã ã-ãã-ã-ããã-ããã ããã ããã-ããã -ã-ãããã ãã-ã -,
Figure 3.3: Interest rate in Vietnam
Source: SBVand World Bank website (2012, accessed on November 10, 2012)
Since the mid-1990s, interest rates in Vietnam have been progressively liberalized, with the implementation of a positive real interest rate policy beginning in late 1992 This policy has been adjusted flexibly in response to inflation rates The State Bank of Vietnam establishes three key interest rates: the base rate, discount rate, and refinancing rate.
The base rate, established as the reference rate for banks' interest rates on August 5, 2000, by Decision No 242/2000/QD-NHNN from the State Bank of Vietnam, has remained relatively stable over the years, maintaining a fixed rate of approximately 7.5% for over three years.
From 2002 to 2005, the base rate was maintained at 8.25% for nearly three years, despite significant fluctuations in other interest rates As illustrated in Figure 3.3, which covers the period from August 2000 to August 2012, the widening gap between the base rate and lending rates indicates that the base rate may no longer effectively signal lending rates for commercial banks.
The refinancing and discount rates serve as the upper and lower limits for lending from the State Bank, respectively Recently, these rates have been utilized as effective monetary policy instruments to enforce a tightening monetary policy.
Since July 2000, the State Bank has utilized a tool for trading securities with credit institutions, primarily through volume or interest rate auctions The typical securities involved include government bonds, State Bank bills, and other securities selected by the State Bank Initially, only short-term securities were traded, but by 2003, auctions began to include securities with maturities exceeding one year This tool has recently become crucial in managing the total liquidity injected into the economy.
Commercial banks in Vietnam are mandated to maintain a certain fraction of their deposits as vault cash to mitigate the risk of banking crises By adjusting the reserve requirement rate, the State Bank of Vietnam (SBV) can influence the amount of money that banks can circulate in the economy, thereby indirectly impacting the overall money supply This reserve requirement applies to all types of deposits, whether in domestic or foreign currency Although this tool has been in use since 1991 and was once a crucial instrument for monetary policy, its significance has diminished in the current economic landscape, as the SBV now primarily focuses on interest rate targets.
According to the International Monetary Fund (IMF), Vietnam's exchange rate regime is classified as a managed-floating or intermediate system Since the economic reforms initiated in 1986, Vietnam has transitioned from a multiple exchange rate system with two official rates to a single fixed exchange rate established by the State Bank of Vietnam (SBV) in 1989 This significant change followed the country's unification in the same year.
The determination of exchange rates has shifted towards a more market-oriented approach, particularly since 1991 when a narrow band system was established around an official exchange rate, transitioning from a pegged to a managed-floating exchange rate In this context, the Vietnamese Dong (VND) is the primary domestic currency, while the US Dollar (USD) is also widely utilized, with the bilateral VND/USD exchange rate serving as a crucial nominal anchor.
Chapter remarks
In recent years, Vietnam has relied heavily on a growth model focused on capital investment, particularly from public sources and state-owned enterprises (SOEs) This approach has created a trade-off between economic growth and inflation, resulting in a serious inflationary spiral due to expanded monetary policy To combat rising inflation, Vietnam implemented a tightening monetary policy starting in 2011, which successfully curbed inflation but also led to liquidity tensions in the banking system, increased interest rates, and a rise in bad debts Consequently, asset markets, including securities and real estate, faced significant challenges Therefore, in-depth studies on monetary policy are crucial for Vietnam's policymakers to effectively manage inflation and ensure macroeconomic stability.
RESEARCH METHODOLOGY
Model specification
This thesis employs vector autoregression (VAR) models to analyze the effects of monetary policy on output and inflation in Vietnam VAR models are advantageous as they can estimate the interrelationships among multiple endogenous variables simultaneously However, they lack a foundation in economic theory, which presents a drawback Given the uncertainty surrounding the monetary transmission mechanism in Vietnam, this methodology allows for minimal restrictions on the impact of monetary shocks on the economy, offering a significant benefit The decision to utilize a VAR approach is also supported by extensive empirical literature that has previously explored the monetary transmission mechanism, primarily focusing on reduced-form relationships between monetary policy and output with a limited set of variables.
A reduced-form V AR model can be written including three variables as follow:
• OUTPUT, CPI, M2 are endogenous variables
• a, ~'yare the vectors of constants
• u; is the vector of serially uncorrelated disturbances that have zero mean and a time invariant covariance matrix
The model estimation process consists of three steps: First, a basic reduced-form VAR model will be estimated using output growth, the consumer price index, and money supply to analyze the impact of monetary policy changes on the real economy Second, the consumer price index for urban and rural areas in Vietnam will be alternately incorporated into the basic model to assess the effects of monetary policy on inflation in these regions Finally, additional variables such as lending rates, domestic credit, and exchange rates will be added to the base model to evaluate their individual effects on output growth and inflation Additionally, the Dickey-Fuller test will be employed to check for stationarity of the variables.
Data availability and description
This thesis utilizes monthly data from May 2005 to June 2012 to analyze how real output growth and inflation respond to various monetary policy tools.
The data set contain the following variables:
+ GROWTH: Real industrial output growth of Vietnam is used as a proxy for output growth of the economy (GROWTH, 1994 based, measured in%) + CPI: Consumer price index (CPI, 20050, measured in%)
+ CPI_UB: Consumer price index of the urban area of Vietnam (CPI UB, 20050, measured in%)
+ CPI _ RR: Consumer price index of the rural area of Vietnam (CPI RR, 20050, measured in%)
+ M2: Broad money or high-powered money (measured in billions ofVND) + LR: Lending rate (measured in % )
+ CREDIT: Domestic credit (measured in billions ofVND)
+ E: Real Effective Exchange Rate (REER, 2005M50, measured in%) h
The data for this analysis is sourced primarily from the International Monetary Fund's International Financial Statistics (IFS), with the exception of the Real Industrial Output, Consumer Price Index (CPI), CPI Upper Bound (CPI UB), and CPI Relative Rate (CPI RR), which are obtained from the General Statistics Office (GSO) Additionally, the exchange rate (E) is calculated based on a basket of rates from the top 25 countries that have the largest trade shares with Vietnam, incorporating data from the IMF's Direction of Trade (DOT), OECD.Stat, and the U.S Federal Reserve.
The formula for growth, expressed as GROWTH = [(OUTPUTt - OUTPUTt_1) / OUTPUTt_1] x 100, measures the percentage change in Real Industrial Output, serving as a proxy for economic output growth based on constant prices from 1994 Vietnam's real industrial output growth is preferred over real GDP growth due to the unavailability of comprehensive output data throughout the study period Additionally, real output growth is favored over nominal output growth because nominal figures are not adjusted for price level fluctuations, which can distort true output growth trends By adjusting for the Consumer Price Index (CPI), real output growth provides a more accurate representation of changes in output performance.
The Consumer Price Index (CPI), adjusted to constant prices from 2005, serves as a key indicator of inflation across Vietnam, sourced from the General Statistics Office (GSO) While various inflation measures exist, including the GDP deflator, the State Bank of Vietnam (SBV) primarily relies on CPI as its main metric for assessing inflation trends.
CPI_UB (constant price in 2005) serves as an indicator of urban inflation in Vietnam, while CPI_RR (constant price in 2005) reflects rural inflation in the country These indices are accessible through the General Statistics Office (GSO) website.
• M2: Broad money or high-powered money, it is the sum of money and quasi- money, according to IMF definition h
The State Bank of Vietnam (SBV) regulates two key lending facilities: the discount rate and the refinancing rate, which together establish a band for the lending rate, effectively serving as a proxy for the interest rate channel in monetary policy While the SBV also sets a base interest rate, this rate rarely changes and does not accurately reflect the dynamics of supply and demand in the money market; instead, it primarily functions as a reference for commercial banks to determine their deposit and lending rates, making it less significant in modeling Vietnam's monetary policy.
Domestic credit serves as a crucial channel for monetary policy to affect output growth and is a key annual target set by the State Bank of Vietnam (SBV) in accordance with government objectives The significance of incorporating domestic credit into the analysis of monetary policy is supported by the research conducted by Vo et al (2000), which highlights the essential role of money supply in economic dynamics.
The Real Effective Exchange Rate (REER) serves as a crucial indicator of a country's monetary policy through the exchange rate channel It represents the weighted average of a nation's currency compared to a basket of major currencies, adjusted for inflation The weights are derived from the relative trade balances with each country in the index The REER is calculated by averaging the bilateral exchange rates with trading partners, factoring in their trade significance An increase in REER suggests that a country's exports are becoming more expensive and imports cheaper, which can diminish its trade competitiveness Understanding the REER is essential for assessing a nation's currency value and trade dynamics.
1 : tra e we1g te m ex o tra mg partner 1m timet: Wi = Ln i i) • i=l (IMt+EXt h i
The import revenue of the domestic country from trading partner i at time t is represented as IM 1, while the export revenue to trading partner i at the same time is denoted as EJf 1 The total trade between the domestic country and trading partner i during this period is calculated as the sum of IM 1 and EJf J.
Total exports from the domestic country to all trading partners at time t, total imports from all trading partners at the same time, and the overall trade volume between the domestic country and its trading partners during that period are represented by the variables :E'i=J(IM J, :E'i=J(EJf J, and :E'i=J(IM 1 + EJf J, respectively.
• CP 1 1 : consumer prices index of trading partner i in time t
• CP IVN 1 : consumer prices index of the domestic country in time t
• Ei 1 : is the exchange rate index for currency i in time t (constant rate in base time) expressed as domestic currency per foreign currency unit: E~ = ( iet ) x ebase
• ei 1 : exchange rate between domestic currency and currency of country i in timet (domestic currencies in 1 foreign currency)
• ei base : exchange rate between domestic currency and currency of country i in base time (domestic currencies in 1 foreign currency)
REER > 1: Domestic currency is assumed to be at low pnce and foreign currencies at high price, domestic goods and services are cheaper, net export increase, trade balance improves
REER < 1: Domestic currency is assumed to be at high pnce and foreign currencies at low price, foreign goods and services are cheaper, net export decrease, trade balance worsens
REER = 1: Domestic currency and foreign currencies are in the same purchasing power h
To calculate the Real Effective Exchange Rate (REER), it is essential to determine the foreign countries included as trading partners, assess their relative trade weights, and select the appropriate price indices for comparison This process is detailed in five subsequent steps.
Step 1: Base on the data of Vietnam's import and export revenue with countries in the world available from website IMP's DOT in the period 2005M5- 2012M6 (about 40 countries have trade share significantly with Vietnam), I pick out 25 trading partners have the largest trade share with Vietnam (Accounting for more than 86% of the total import and export revenue of Vietnam with the world, according to the statistical results in the Appendix 1) for REER calculation
Step 2: Calculate trade weighted index of each trading partners according to the formula (4.3) Base on the data of import and export revenue of Vietnam with trading partners available from website IMF's DOT in the period 2005M5 - 2012M6, I calculated total trade between Vietnam and trading partners respectively in timet (IM 1 +EX J, and total trade between Vietnam and all the trading partners respectively in timet (L:i=J(IM 1 +EX J) Then I calculated trade weighted index of the trading partners (total trade weight for each trading partner) according to the formula (4.3)
Step 3: Conversion of consumer prices index of trading partners and Vietnam to the same base time 2005M5 and then calculate the effective relative price indices (in this instance the weighted consumer price index of trading partners and the consumer price index of Vietnam)= CPI 1 1 CPIVN 1 •
Step 4: Conversion the exchange rate between currency of each trading partner and USD (trading partner currency in 1 USD) into the exchange rate between domestic currency and currency of each trading partner (VND in 1 trading partner currency), and then calculate exchange rate index for currency of each trading partner expressed as domestic currency per trading partner currency unit with constant rate in base time= (ei 1 1 eibase) x 100
Step 5: From the calculated results in the step 1 to step 4, I calculate RERR by the formula (4.1) h
The mean, median, maximum, minimum, standard deviation and number of observations of the variables used is summary in the following table:
VARIABLES GROWTH CPI CPI UB CPI RR M2 LR CREDIT E
(o/~ _(%) {_%} (Dfo}_ (Bil VND) (%) (Bil VND) (%) Mean 2.657542 142.9612 147.2411 143.8754 1597147 12.99796 1605926 91.00010 Median 1.304221 148.1000 149.1100 146.7600 1454082 11.29000 1342966 90.82044 Maximum 111.3960 201.1879 215.2192 207.5065 2987087 20.25000 3102963 100.0000 Minimum -48.71079 97.86047 97.59036 98.13607 533128.3 9.150000 493776.3 79.61151 Std Dev 20.41869 31.95395 37.09582 34.63825 752699.3 2.841240 879873.2 5.660319
Source: Author's calculation by using of data set introduced in this chapter
Test for stationary property"
In a conventional VAR model, it is essential for the variables to be stationary This thesis employs the Augmented Dickey-Fuller (ADF) test using Eviews6 software to assess the stationarity of macroeconomic variables within the VAR framework Determining the appropriate lag length for the ADF test can be challenging; insufficient lags may lead to regression residuals that do not resemble white-noise processes, while excessive lags can diminish the tests' ability to reject the null hypothesis of a unit root.
Table 4.2: Stationary tests for variables in level
VARIABLE EXOGENOUS AUGMENTED DICKEY-FULLER
CPI UB Constant, Linear trend -1.719326 0.7342
CPI RR Constant, Linear trend -1.660688 0.7600
Source: Author's calculation by using of data set introduced in this chapter
The ADF test results indicate that the GROWTH variable is stationary at level, while the CPI, CPI_UB, CPI_RR, M2, LR, CREDIT, and E variables are non-stationary Consequently, I opted to transform these non-stationary variables into a suitable format for analysis.
growth rate {percentage change) to eliminate non-stationary by taking 1st differences of the natural logarithm ofthe non-stationary variables and multiplying by 100
Table 4.3: Stationary tests for variables in percentage change
VARIABLE EXOGENOUS AUGMENTED DICKEY-FULLER
DL CPI Constant, Linear trend -4.319073 0.0048 (