Problem Statement
Since the onset of the 2008 global economic crisis, a robust recovery has remained elusive, with adverse shocks impacting nations across all continents The threat of the European debt crisis has persisted from 2011 to the present, contributing to ongoing economic instability.
In 2011, Vietnam's Resolution 11/NQ-CP aimed to curb inflation and ensure macroeconomic stability through careful monetary and fiscal policies The banking system and intermediate credit institutions play a crucial role in mobilizing and distributing capital, making monetary policy essential for investment flows and business strategies It not only supports working capital for businesses but also enables enterprises with sound strategies to pursue long-term development through investment Furthermore, monetary policy is vital for maintaining price stability, managing foreign trade through exchange rate policies, and ensuring liquidity in international payments Consequently, understanding monetary policy and its impact 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
The Asian financial crisis of 1997 and the ongoing global financial crisis since 2008 have significantly impacted the economy, highlighting the importance of developing effective monetary policy tools As the economy becomes increasingly sensitive to global fluctuations, establishing a robust system to adjust monetary policies is essential, particularly during periods of recession.
Recent economic theories and studies indicate that monetary policy shocks can significantly affect output and inflation through various channels However, there has been a lack of quantitative analysis on how these channels specifically impact different regions of Vietnam, including urban and rural areas, as well as the country as a whole This gap in research poses challenges for policymakers aiming to implement effective strategies tailored to each region's needs 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, 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, is a topic of significant theoretical and empirical debate Despite extensive research, opinions remain divided on how macroeconomic variables are influenced by monetary policy across different countries.
Recent studies on Vietnam's monetary policy have explored various aspects, such as Hoang's (2010) investigation into the effects of money supply changes on real output and inflation, which indicated a significant, albeit low, impact on these economic indicators Camen (2006) examined external and policy factors influencing inflation fluctuations, while other research has focused on the effects of exchange rate changes on output However, these studies often fail to clearly define how monetary policy shocks affect real output growth in Vietnam or address the differential impacts on inflation in urban versus rural areas Bui (2011) analyzed the relationship between money growth and inflation, and Nguyen (2012) highlighted the role of credit within Vietnam's monetary mechanism, yet both studies overlooked the urban-rural inflation dynamics Additionally, most research relies on outdated data, failing to account for recent inflation trends and the implications of the current global financial crisis, rendering their findings less relevant to today's economic landscape.
This study is crucial for Vietnam as it provides insights for policymakers to effectively manage monetary policy, aiming for growth in real output and control of inflation It also serves as a foundation for further research on monetary policy across various regions, including rural and urban areas, enhancing understanding of the evolution of Vietnam's money market Additionally, the study contributes to the broader knowledge of the monetary transmission mechanism both within Vietnam and in 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 influence of three primary monetary channels—interest rate, credit, and exchange rate—on Vietnam's real economy, focusing on real output growth and inflation It highlights how fluctuations in interest rates affect investment and consumption, while the credit channel impacts the availability of loans, ultimately shaping economic activity Additionally, the exchange rate channel's role in affecting import and export dynamics is analyzed, providing insights into its broader implications for economic stability and growth in Vietnam.
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?
This study aims to investigate the impact of monetary policy changes by the State Bank of Vietnam on real output growth and inflation rates across different regions, including urban, rural, and the country as a whole, to determine the direction and significance of these changes.
The impact of monetary policy changes on real output growth and inflation rates in Vietnam varies across urban and rural areas Understanding the time lag between these policy adjustments and their effects is crucial for assessing economic performance This analysis focuses on how quickly shifts in monetary policy influence growth and inflation in different regions of Vietnam, providing insights into the overall economic landscape.
• 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 comprises six chapters, beginning with a statement of the problem, the study's significance, research objectives, and 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 the estimated results, and discusses their policy implications for Vietnam The final chapter summarizes the study, highlights 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 recognize that the aggregate demand curve slopes downward and shifts with changes in the money supply However, monetarists attribute movements in this curve primarily to money supply changes, 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 price levels, the AD-AS model allows us to infer these changes 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
2.1.2 Traditional Keynesian IS/LM model
The relationship between interest rates and output is illustrated in the Keynesian IS-LM model, where a tight monetary policy by the Central Bank reduces the money supply, leading to a decrease in real money balances This causes the LM curve to shift left, indicating higher demand for money than supply, prompting individuals to sell bonds for cash and resulting in increased interest rates Consequently, the higher capital costs for production lead to reduced investment spending and net exports The new equilibrium in the IS-LM model reflects a decline in output, encapsulated by the connection: Ms! + i j + 1!, NX! + Y !.
1 The notation M 8 , i, I, NX, Y stands for Money supply, interest rate, Investment, Net export and Output,
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, particularly 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*), resulting in capital outflows This capital movement raises the demand for foreign currency, leading to a depreciation of the domestic currency Consequently, domestic goods become relatively cheaper than foreign goods, which boosts net exports and ultimately increases output.
Tobin's theory of investment establishes a systematic connection 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 rise, the opportunity cost of holding shares increases, making them less appealing compared to bonds This leads financial investors to sell their shares, resulting in a decline in the market value of shares (V1) Consequently, a drop in share prices reduces the value of q, which in turn decreases the marginal benefit of investment At the optimal investment level, the marginal dividend forgone is offset by the additional capital gains on shares A lower valuation of q implies that firms are less likely to invest, as the cost of new capital may outweigh the benefits Thus, when q is low, firms may refrain from purchasing new investment goods, leading to decreased investment and a subsequent decline 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 through three primary channels: the interest rate channel, the credit channel, and the exchange rate channel Given the underdeveloped state of the Vietnamese stock market, which is susceptible to speculation, and the absence of a housing index, this thesis does 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 significance of interest rates in shaping the economy through monetary policy He identifies a cyclical relationship between real GDP, inflation, and short-term interest rates Changes in short-term interest rates influence both long-term interest rates and exchange rates, although other factors also play a role over time Due to economic rigidities, such as price stickiness, fluctuations in nominal interest and exchange rates lead to variations in real interest and exchange rates These real rate changes subsequently impact real investment, consumption, and net exports—key components of GDP—ultimately resulting in shifts in real GDP In the long run, real variables tend to revert to their normal values when wages and prices of goods are flexible.
In tum, the change in real GDP and inflation will also have effect on the short rate
At a zero nominal interest rate, a decline in the real interest rate can still boost the economy through anticipated price levels and inflation An increase in broad money raises expected price levels, leading to higher expected inflation Consequently, this results in lower real interest rates, which in turn stimulates investment, net exports, and overall output This relationship can be summarized as: Msj ~ Pej ~ nej ~ ir-1 ~ Ij, NXj ~ Yj The findings indicate a robust connection between interest rates and their impact on economic output, highlighting interest rates as a significant monetary channel.
Expansionary monetary policy, as outlined by Mishkin (2006), increases the money supply (M5) and results in a decrease in the real interest rate (Cir), effectively lowering the cost of capital This reduction encourages businesses to boost their investment spending and prompts consumers to increase expenditures on housing and durable goods, which are also categorized as investments Consequently, this surge in investment spending (I) contributes to a rise in aggregate demand and an increase in overall output (Y).
Mishkin (1996) highlighted the significance of credit channels in the economy by presenting three key points Firstly, credit market imperfections influence firms' decisions regarding inputs and outputs, including workforce and machinery Secondly, empirical evidence shows that small firms facing credit constraints are more susceptible to monetary policy changes compared to larger firms Lastly, he emphasized that asymmetric information within imperfect credit markets aids in understanding various economic phenomena.
3 Notation are same as previous one, Pe, 1te are expectation of price level and expectation of inflation, respectively
In their 1995 study, Bernanke and Gertler likened monetary policy transmission to a "black box," expressing concerns over the lack of empirical evidence supporting the interest rate channel's effects They proposed that the credit channel plays a crucial role in elucidating how monetary policy influences the economy, suggesting that the interplay between the external finance premium and interest rates could provide a clearer understanding This credit channel addresses agency problems stemming from asymmetric information and the costly enforcement of contracts in financial markets, and it is categorized into two distinct channels: the bank lending channel and the balance sheet channel.
The bank lending channel illustrates how monetary policy impacts the economy by altering 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 a reduction of bank loans, which subsequently causes a decline in investment As firms struggle to find new lenders and establish costly credit relationships, their performance suffers, leading to a further drop in investment and output This relationship is summarized by Mishkin (1995) as "Ms t - bank deposits - bank loans - I t - Y f."
The bank lending channel's significance remains a topic of debate among researchers Romer and Romer (1989) question the extent to which bank loans are influenced by monetary policy, citing financial deregulation and innovation in the U.S during the mid-1980s The introduction of certificates of deposit (CDs) has enabled banks to better manage deposit declines during monetary contractions Consequently, this development, coupled with a global decline in traditional bank lending, has diminished the importance of banks and 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 leading to a decline in money supply can result in lower equity prices, which subsequently decreases net worth and exacerbates issues of adverse selection and moral hazard Adverse selection arises as reduced net worth diminishes the value of collateral, causing lenders to face greater losses Concurrently, moral hazard increases as firms, witnessing a drop in equity value, may be incentivized to pursue riskier investments, heightening the likelihood of loan defaults Consequently, this decline in a firm's net worth can lead to reduced lending and investment, ultimately decreasing output and aggregate demand This relationship can be summarized as: "Ms! -+ P e! -+ adverse selectionj, moral hazardj -+ lending! -+ I! -+ Y !" (Mishkin, 1995).
Previous empirical studies related
Numerous studies have explored the relationship between monetary policy tools and macroeconomic indicators, focusing on the monetary transmission mechanism across different periods Notable research includes the works of Bernanke and Blinder (1992) and Bernanke and Gertler (1995) in the United States This analysis has also been applied internationally, with Disyatat and Vongsinsirikul (2003) developing a VAR model for Thailand, Morsink and Bayoumi (1999) examining Japan, and Hsing (2004) analyzing data from Venezuela.
Short-term interest rates are commonly used as indicators of monetary policy stance in VAR-based research, with Bemanke and Blinder (1992) highlighting the Federal Funds Rate as the primary tool of the Fed for over three decades However, the interest rate transmission mechanism remains contentious, as evidence of its quantitative effects through the neoclassical cost of capital is limited 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) observed a declining response of real output to the interest channel in the U.S since the 1980s Additionally, empirical research on Tobin's q has been inconclusive, leading researchers like Bemanke and Gertler (1995) to propose that mechanisms beyond interest rates, such as the credit channel, play a crucial role in monetary policy transmission.
Research on the impact of exchange rates on output yields varied results 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 effect in the long run, with overall effects becoming neutral 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 importance of the exchange rate channel in Egypt, demonstrating its crucial role in the transmission of monetary policy, while noting that other channels remain relatively weak.
Research in Vietnam has explored the effects of monetary policy tools on output growth and inflation A study by Vo et al (2001) indicates that changes in exchange rates significantly influence the Granger-causality among money supply, inflation, and output growth While nominal exchange rates have occasionally acted as a leading indicator for output growth, this relationship has proven inconsistent Furthermore, current inflation and real industrial output growth are largely determined by their previous trends, with real depreciation rates positively impacting output growth, albeit with fluctuating significance.
Le and Wade (2008) developed a VAR model to analyze the relationships between money, real output, price level, real interest rate, real exchange rate, and credit, finding that monetary policy significantly influences real output and price levels, particularly with the strongest effects on output observed after four quarters However, the impact on price levels took longer, from the third to the ninth quarter, with weak significance across channels, though credit and exchange rate channels were more prominent Hoang (2010) further examined the monetary transmission mechanism in Vietnam, confirming that while monetary policy affects real output and price levels, the effects are minimal He noted that credit has a significant impact on output, while interest and exchange rates do not significantly influence price levels Bui (2011) studied the effects of money growth on inflation, revealing a positive long-run and short-run impact, emphasizing the credit channel's importance in Vietnam's monetary transmission, alongside the bi-directional causality between interest rates and inflation Nguyen (2012) found that in a classical market, money supply can predict most dependent variables except for lending rates, while in an augmented market, domestic credit significantly predicts money supply Additionally, price levels and lending rates can forecast money supply but not in a classical market, and during tightening monetary policy, output and refinancing rates respond to shocks after a lag, with the lending channel exhibiting short and sometimes abnormal responses Overall, the credit channel is crucial in Vietnam's monetary policy framework.
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 important to recognize that while nominal interest rates provide insights, the federal funds rate is particularly informative Monetary policy influences the composition of bank assets, and tighter policies lead to a short-term reduction in banks' security holdings, with minimal impact on loan activities The similar timing of loan responses and unemployment changes to monetary policy adjustments suggests that this 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 in the housing sector, which shows a swift response to changes in policy Key factors in this dynamic include the balance sheet and bank lending channels, both of which are crucial to the functioning of the housing market.
Monetary policy and the balance sheets of banks serve as significant sources of economic shocks, with banks playing a vital role in transmitting these monetary shocks to overall economic activity In particular, business investment demonstrates a heightened sensitivity to changes in monetary policy, underscoring the interconnectedness between banking operations and economic performance.
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 the cases of official and shadow exchange rates, have served as inconsistent indicators for output growth, though this relationship lacks stability Current inflation and real industrial output growth are primarily influenced by their historical trends Additionally, real depreciation rates positively impact output growth, but the extent of this effect varies significantly.
The alteration in the propagation mechanism has significantly reduced the variability of macroeconomic variables, leading to a weaker 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 consistently after about a year Meanwhile, output exhibits a U-shaped reaction, 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, while 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 are the most significant factors influencing variance decompositions, alongside lagged output However, beyond the first year, real M2 and the real exchange rate emerge as more impactful variables, demonstrating their extended influence over the long term.
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 than the interest rate channel.
Inflation and industrial production have significant responses to shocks from exchange rate, interest rates and money supply
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 examines Aggregate Demand through various theories, including the Traditional Keynesian ISILM 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 rates, credit, and exchange rates The study specifically investigates the effects of monetary policy on Vietnam's economy from May 2005 to June 2012.
ECONOMY PERFORMANCE, FINANCIAL SYSTEM
Economy performance
,._Economic Growth (Real GOP growth)
Since the 1986 economic reform, Vietnam has experienced remarkable economic growth, with an annual growth rate of 7.5% during the 1990s, 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, the country's economy demonstrated consistent high growth, with the Central Intelligence Agency (CIA) reporting that Vietnam's real GDP growth often ranked in the top 30 globally.
Between 2008 and 2010, Vietnam experienced a significant decline in growth, averaging 6.1% Notably, in 2009, the GDP growth rate plummeted to 5.3%, marking the lowest level in a decade This downturn was primarily driven by the global financial crisis and recession, which severely affected key sectors of the Vietnamese economy, including exports, investment, and tourism.
Since 2011, Vietnam's economic situation has deteriorated, with the growth rate declining from 5.9% in 2011 to just 5.03% in 2012 This downturn is attributed not only to the global financial crisis and recession but also to significant weaknesses in organizational and macroeconomic management, particularly in monetary policy and banking administration These issues have led to increased uncertainty regarding risks associated with the banking system and state-owned enterprises A recent report by Moody's projects that Vietnam's average real GDP growth rate will only reach approximately 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
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 the growth rate, aligning with the key macroeconomic goals outlined in the Socio-Economic Development plan However, in 2008, inflation surged again as a consequence of 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 structure 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 issuance, providing legal tender to the government Complementing the SBV is a network of Specialized Commercial Banks and other financial institutions that perform essential banking functions, including borrowing and lending to individuals and businesses.
The banking sector, particularly the State Bank of Vietnam, has made significant progress in its development However, amidst the unpredictable global and national economic landscape, certain shortcomings within the banking sector and the central bank remain evident Acknowledging the necessity for reform, the Vietnam Communist Party and Government have emphasized the need to reorganize the State Bank of Vietnam to function as a modern central bank This transformation aims to align with international standards and support macroeconomic stability, inflation control, and the enhancement of Vietnam's currency purchasing power, ultimately contributing to the country's economic growth Despite this clarity of purpose, a fundamental question persists: what exactly constitutes a modern central bank? This seemingly simple inquiry has yet to be satisfactorily addressed.
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) in December 2004 categorizes central banks worldwide into four levels of independence: independence in setting operational objectives, independence in establishing 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, including monetary policy and exchange rate decisions, as mandated by law A prime example of this model is the U.S Federal Reserve System (FED), which exemplifies the autonomy that a central bank can attain in its operations.
The second level of central bank independence involves the authority to establish performance targets, granting the bank the responsibility for determining monetary policy and the exchange rate regime Unlike the first level, this stage specifies a key operational objective in legal terms, such as the European Central Bank's primary goal of "maintaining price stability."
The third level of monetary policy involves granting independence to the Central Bank in selecting operating instruments In this model, the Government or National Assembly sets the monetary policy targets after discussions with the Central Bank Once approved, the Central Bank is empowered to use its discretion in choosing the most effective monetary tools to achieve these targets Notable examples of this approach include the Reserve Bank of New Zealand and the Bank of Canada.
The fourth level of independence, classified as limited independence, signifies the lowest degree of autonomy for a central bank In this scenario, the government acts as the primary decision-making authority, influencing both operational objectives and performance targets, which restricts the central bank's ability to effectively execute monetary policy This limitation hampers the central bank's capacity to maintain monetary stability, a challenge currently faced by the State Bank of Vietnam, highlighting the shortcomings of this level of independence.
Recent discussions on central bank reform in Vietnam have highlighted the argument for adopting an independent central bank model Proponents assert that greater independence from the government facilitates the effective implementation of strategies aimed at maintaining low inflation rates, a concept supported by economic theory.
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 generally supports the notion that monetary policy should be managed by a professional and independent central bank focused on maintaining price stability This approach enhances the effectiveness of policy measures and bolsters the credibility of policymakers.
The State Bank of Vietnam requires increased autonomy in policy decision-making to operate free from state agency interference and political pressure Additionally, it should possess the authority to manage all instruments 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 that includes projections for inflation and economic growth, which is then submitted to the National Assembly The National Assembly sets the annual targets for inflation and growth in alignment with the state budget and the 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 execution of monetary policy.
The primary function of the State Bank of Vietnam (SBV), as outlined by the Government and National Assembly, is to prepare and implement monetary policy through various tools while managing 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 play crucial roles in setting objectives and supervising the SBV's operations However, the Government's strong involvement can limit the independence of monetary policies In contrast, research by Radzyner and Riesinger (1997) indicates that central banks in transition economies, such as those in Central and Eastern Europe (CEEC-5), have maintained independence in formulating and implementing monetary policy since the early 1990s, with the exception of Poland While central banks like the Czech National Bank and others are formally obligated to design monetary policy independently, they still engage in discussions with the Government regarding significant changes or issues This independence is believed to positively influence the effectiveness of central bank policies.
The State Bank of Vietnam (SBV) aims to stabilize the currency's value, which encompasses maintaining the exchange rate regime, controlling inflation, and promoting socio-economic development However, a closer examination of Vietnam's economic policies 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 two primary annual objectives: managing the exchange rate and regulating total liquidity (M2) and credit within the economy The effective control of money supply is achieved through key monetary policy instruments.
-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 gradually liberalized, with a policy of positive real interest rates initiated in late 1992 and adjusted according to inflation The State Bank of Vietnam establishes three key interest rates: the base rate, discount rate, and refinancing rate.
Since August 5, 2000, the base rate has served as the reference rate for banks' interest rates, following Decision No 242/2000/QD-NHNN issued by the State Bank of Vietnam This rate has remained relatively stable, notably fixed at approximately 7.5% for over three years.
From 2002 to 2005, the base interest rate was maintained at 8.25% for nearly three years, despite significant fluctuations in other interest rates As illustrated in Figure 3.3, which depicts the base and lending rates from August 2000 to August 2012, the gap between these rates has been widening This trend suggests 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 by the State Bank Recently, these rates have been utilized as key 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 common securities involved include government bonds, State Bank bills, and other selected securities Initially, only short-term securities were traded; however, since 2003, securities with maturities exceeding one year have also been auctioned This tool has recently become crucial in regulating the total liquidity injected into the economy.
The required reserve ratio is a fraction of deposits that commercial banks must hold as vault cash, aimed at minimizing the risk of bank crises By adjusting this requirement, the State Bank of Vietnam can influence the amount of money commercial banks can circulate in the economy, thereby impacting the overall money supply This regulation applies to all types of deposits, whether in domestic or foreign currency, and has been in effect since 1991 While it was once a crucial monetary policy tool, its significance has diminished in the current economic landscape, as the State Bank now primarily focuses on interest rate adjustments.
According to the IMF, Vietnam's exchange rate regime is classified as a managed-floating or intermediate system (Vo et al., 2001) Following the economic reforms initiated in 1986, Vietnam transitioned from a multiple exchange rate system with two official rates to a single fixed exchange rate, which was established in 1989 and administered by the State Bank of Vietnam (SBV) Since this unification in 1989, the exchange rate framework has evolved significantly.
The determination of exchange rates has shifted towards a more market-oriented approach, particularly since the establishment of a managed-floating system in 1991, which replaced the previously pegged exchange rate with a narrow band around an official rate In this context, the Vietnamese Dong (VND) is the primary domestic currency, while the US Dollar (USD) is also commonly used, making the bilateral VND/USD exchange rate a crucial nominal anchor in the economy.
Chapter remarks
In recent years, Vietnam's growth model has heavily relied on capital investment, particularly from public sources and state-owned enterprises (SOEs), leading to a trade-off between growth and inflation This approach has resulted in an inflationary spiral, prompting the government to implement a tightening monetary policy since 2011, which has successfully curbed inflation However, this has also led to liquidity tensions in the banking system, rising interest rates, and an increase in bad debts and overdue loans, severely impacting asset markets, including securities and real estate Therefore, in the current context, in-depth studies on monetary policy are essential for policymakers to effectively manage inflation and ensure macroeconomic stability in Vietnam.
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 offer the benefit of simultaneously estimating the interrelationships among multiple endogenous variables, while their limitation lies in not being grounded in economic theory 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 The decision to use a VAR approach is further supported by a substantial body of empirical literature, discussed in Chapter II, that explores the monetary transmission mechanism, primarily focusing on reduced-form relationships between monetary policy and output with a limited number 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 involves three key steps First, a basic reduced-form VAR model will be estimated using three variables: output growth, consumer price index, and money supply, to assess the impact of monetary policy changes on the real economy In the second step, the consumer price index for urban and rural areas in Vietnam will be alternately substituted into the model to evaluate how monetary policy affects inflation in these regions Finally, the model will incorporate different variables, such as lending rates, domestic credit, and exchange rates, to analyze their individual effects on output growth and inflation Additionally, the Dickey-Fuller test will be employed to ensure the 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%)
The variables utilized in this analysis are 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 Real Rate (CPI RR), which are obtained from the General Statistics Office (GSO) Additionally, the exchange rate variable (E) is calculated based on a basket of exchange rates from the top 25 countries that have the largest trade share with Vietnam, incorporating data from the IMF's Direction of Trade (DOT), OECD.Stat, and the U.S Federal Reserve.
The formula for growth is calculated as GROWTH = [(OUTPUTt - OUTPUTt_1) / OUTPUTt_1] x 100, representing the percentage change in Real Industrial Output, which serves as a proxy for economic output growth based on 1994 constant prices This measure is preferred over real GDP growth due to the unavailability of comprehensive output data for the entire study period Additionally, real output growth is utilized instead of nominal output growth because nominal figures are not adjusted for price fluctuations, which have been significant over time By adjusting for the Consumer Price Index (CPI), real output growth provides a more accurate reflection of changes in output growth.
The Consumer Price Index (CPI) at constant 2005 prices 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.
The CPI_UB (constant price in 2005) serves as an indicator of inflation in urban areas of Vietnam, while CPI_RR (constant price in 2005) reflects inflation in rural areas Both indices can be accessed 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
The State Bank of Vietnam (SBV) regulates two key lending rates: the refinancing rate, which acts as the ceiling, and the discount rate, serving as the floor, together forming a band for lending rates This lending rate is utilized in regression analysis as a proxy for the interest rate channel in monetary policy Although the SBV sets a base interest rate, it remains largely unchanged and does not accurately reflect money market supply and demand Instead, it serves as a reference for commercial banks to determine their deposit and lending rates, making it less significant for modeling Vietnam's monetary policy.
Domestic credit serves as a crucial channel for monetary policy to impact output growth, making it a key annual target for the State Bank of Vietnam (SBV) as defined by the Government The significance of incorporating domestic credit into monetary policy studies is supported by research on the role of money supply conducted by Vo et al (2000).
The Real Effective Exchange Rate (REER) serves as a crucial indicator of monetary policy through the exchange rate channel, representing the weighted average of a country's currency against a basket of major currencies, adjusted for inflation The weights in this calculation are derived from the relative trade balances of the country in question compared to other countries included in the index For a comprehensive understanding, the specific formula for calculating REER is outlined in detail.
1 : tra e we1g te m ex o tra mg partner 1m timet: Wi = Ln i i) • i=l (IMt+EXt i
In time t, IM 1 represents the import revenue of the domestic country from trading partner i, while EJf 1 denotes the export revenue to trading partner i The total trade between the domestic country and trading partner i during the same period is indicated by the sum of IM 1 and EJf 1.
Total exports from the domestic country to all trading partners at time t, total imports from those partners at the same time, and the overall trade between the domestic country and its trading partners are represented by the equations :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
To calculate the Real Effective Exchange Rate (REER), it is essential to determine the selection of foreign countries that will serve as trading partners, assess their relative trade weights, and identify the relevant price indices for comparison This process can be outlined in five detailed 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)
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 the macroeconomic variables within the VAR framework Selecting the correct lag length for the ADF test can be challenging; insufficient lags may cause the regression residuals to deviate from white-noise behavior, while excessive lags can diminish the test's 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 variables CPI, CPI_UB, CPI_RR, M2, LR, CREDIT, and E are non-stationary Consequently, I opted to transform these non-stationary variables to achieve stationarity.
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 (