What are the options for exchange rate policy in 2016?

(Baonghean) - The history of Vietnam's exchange rate fluctuations shows that the market often experiences a surge in psychological reactions after each exchange rate adjustment by the State Bank of Vietnam (SBV).

In reality, the fluctuations in the international foreign exchange and financial markets in 2015 necessitated changes in the exchange rate management mechanism to meet the requirements of Vietnam's increasingly deep integration into the global economy. Accordingly, the central bank could implement monetary policy independently, aiming to pursue long-term growth and inflation targets.

The historical value of the Vietnamese Dong is closely linked to macroeconomic fluctuations both domestically and internationally. The choice of exchange rate regime in each period has also had a certain impact on exchange rate volatility. Essentially, Vietnam maintains a pegged exchange rate to the US dollar, adjusting the official exchange rate and its fluctuation range to reflect major macroeconomic developments in each period. Exchange rate fluctuations are fundamentally tied to the State Bank of Vietnam's (SBV) exchange rate adjustments.

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However, the rapid daily fluctuations in exchange rates clearly demonstrate the market's psychological reaction after each adjustment. The dramatic developments in the international foreign exchange and financial markets at the end of 2015, in the context of the US Federal Reserve raising interest rates, the depreciation of the Chinese yuan, and its official designation as a reserve currency of the International Monetary Fund (IMF), led to exchange rates reaching near-zero levels at several points. However, the challenge of managing exchange rates in 2016 is significant, as the Fed officially raised interest rates on December 19, 2015, ending a seven-year period of near-zero interest rates, making it very difficult to maintain a rigid commitment to exchange rates.

In a preliminary assessment of the effectiveness of Vietnam's exchange rate management mechanism over the past 20 years, Dr. Bach Ngoc Thang stated that the many positive theoretical impacts of the fixed (adjustable) exchange rate pegged to the USD regime implemented by the State Bank of Vietnam (SBV) over the past 20 years cannot be denied. Notably, it has helped stabilize the foreign exchange market, control inflation, and facilitate international transactions. However, the fixed exchange rate regime can lead to dollarization in the economy, erode public confidence in the value of the domestic currency, and reduce the effectiveness of monetary policy. Furthermore, the SBV's exchange rate adjustments are often unpredictable, disrupting economic activities and making it very difficult for businesses and individuals to develop stable medium-term business plans, according to Dr. Bach Ngoc Thang.

Given the current situation, how should exchange rate policy be changed? Based on analyses of the real effective exchange rate, a recent group of economic researchers argues that the State Bank of Vietnam's exchange rate management mechanism over the past 20 years (especially the recent period of 2007-2015) has not significantly helped to increase the competitiveness of Vietnamese goods in the international market. Furthermore, the trend of the real effective exchange rate has closely followed that of China over the past 20 years.

The changes to Vietnam's exchange rate management mechanism in 2016 need to be considered within two new contexts: the Chinese yuan officially becoming a reserve currency of the IMF, and the Fed officially outlining its normalization (increasing) interest rate roadmap for the 2016-2018 period. The first context needs to be taken seriously, as Vietnam is heavily dependent on trade with China. Changes in the yuan exchange rate could have significant impacts on the Vietnamese economy. In the second context, the Fed's interest rate hike roadmap will put significant pressure on Vietnam's current account in the short term as short-term speculative capital tends to flow back to the US, where interest rates are higher – as analyzed by Associate Professor Dr. Nguyen Van Thang, a representative of the research group.

According to experts, given the two new contexts mentioned above, the new exchange rate management mechanism needs a certain degree of flexibility to avoid disrupting market expectations. In 2016, the exchange rate management policy needs fundamental adjustments to lay the groundwork for interest rate liberalization in the following years. This is necessary because Vietnam has been and is integrating deeply into the global economy. Furthermore, the rigid and passive exchange rate management mechanism of the past will not be very helpful to the Vietnamese economy in the context of a volatile global financial system. A new exchange rate management mechanism should aim for exchange rate flexibility, so that the exchange rate plays a greater role in establishing balance in the foreign exchange market and the balance of payments. A flexible exchange rate mechanism would also help eliminate dollarization in the economy, allowing the central bank to independently implement monetary policy to achieve key objectives related to growth and inflation control in the medium and long term - Associate Professor Dr. Le Quanh Canh commented.

Overall, regarding exchange rate policy in 2016, experts believe that the central bank may gradually reduce its peg to the USD in exchange rate management. Instead of relying solely on a single currency to guide the exchange rate, the State Bank of Vietnam (SBV) could introduce a reference, such as the nominal effective exchange rate against a basket of major currencies. This rate would serve as the basis for exchange rate pairs in the interbank market. Initially, the SBV will still need to maintain the daily exchange rate fluctuation band, but allow for a gradual widening of the band. The fundamental change in this new exchange rate management mechanism is that the closing rate of the previous day can serve as a reference for the opening rate of the following day in the interbank market. The essence of this new mechanism is that the exchange rate can change daily but will still be "tied" by the daily trading band.

To further clarify the above viewpoint, experts believe that flexible exchange rate adjustment is essential, and it is highly likely that the State Bank of Vietnam (SBV) will make changes to its exchange rate management mechanism in 2016 to achieve this goal. The SBV's recent move to lower the interest rate on individual USD deposits to 0% will put significant pressure on foreign exchange trading, rather than credit transactions as before. If the SBV fails to introduce a more flexible exchange rate management mechanism, the goal of combating dollarization will not be achieved. The exchange rate management mechanism mentioned above will allow for flexible exchange rate adjustments, preventing dollarization in the economy.

However, implementing this new exchange rate mechanism requires certain conditions. Firstly, the State Bank of Vietnam needs to maintain a sufficiently large amount of foreign exchange reserves to intervene when there are significant fluctuations in the market. Secondly, it needs to strengthen forecasting and remain steadfast in pursuing long-term goals regarding inflation and growth. This second condition will create important foundations for building a new, modern exchange rate policy in the future, because changes in macroeconomic policy need to be based on good forecasts to adjust market expectations and incentives, aiming to achieve long-term goals, rather than short-term goals and chasing past developments – Associate Professor Dr. Nguyen Van Thang warned.

Red River