## _cr06422

## Source details

**Canonical URL:** [_cr06422](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06422.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06422.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06422.pdf.json)

---

### Overview and context
- Vietnam reduced inflation from a peak of 453 percent in 1986 to the single digit range during the second half of the 1990s following price liberalization and the “Doi moi” reforms.
- Headline inflation (year-on-year) declined from 9.7 percent in 2004 and 8.8 percent at end-2005 to 7.5 percent in August 2006, but remained well above rates in Vietnam’s major trading partners.
- After remaining in the single digit range, inflation began an upward trend that accelerated in late 2003 and became more persistent thereafter, remaining higher than in other emerging markets in the region except Indonesia.

### Main findings and interpretation
- Monetary developments have exerted an increasing influence on inflation in Vietnam in recent years.
- Inflationary inertia plays a larger role in Vietnam than in other countries in the region, implying more difficulty reducing inflationary expectations.
- Output gap helps explain short-term inflation fluctuations, but movements in core inflation have become increasingly important, possibly reflecting second-round effects of oil price increases.
- Evidence on Balassa-Samuelson-type effects is mixed; overall there is no strong support that inflation is primarily a benign Balassa-Samuelson effect.
- The desirable rate of inflation depends importantly on how a country’s inflation compares with inflation in neighboring countries and trading partners.
- There is little reason to believe current inflation will correct itself in the absence of appropriately restrained macroeconomic policies.

### Recent determinants of inflation (2003–06)
- Headline inflation characteristics (2002Q1-2006Q2 sample statistics):
  - ASEAN-4: Mean 5.8, Median 5.1, Maximum 10.8, Minimum 3.1, Std. Dev. 2.2
  - Newly-industrialized economies (NIEs): Mean 1.8, Median 1.8, Maximum 3.5, Minimum 0.3, Std. Dev. 0.7
  - Selected Emerging Asian Countries: Mean 2.6, Median 2.7, Maximum 5.0, Minimum 0.8, Std. Dev. 1.1
  - Vietnam: Mean 6.0, Median 5.6, Maximum 10.4, Minimum 1.6, Std. Dev. 2.6
- Core inflation:
  - Proxy for core inflation (nonfood CPI net of fuel and fuel-related items) trended up in Vietnam faster than in most neighboring countries.

### Food supply and oil price shocks; demand amplification
- Food price dynamics:
  - Food price inflation in Vietnam was both higher and more volatile than in other regional countries and was the most important contributor to the inflation pick-up beginning in 2004.
  - Standard deviation of food price inflation during January 2003-June 2006:
    - Vietnam: 5.1 percent
    - ASEAN-4: 3.1 percent
    - NIEs: 1.3 percent
  - Contributing factors: international food price increases (especially rice), government regulation of rice exports, avian flu pressures on beef/fish/seafood, and widespread droughts causing supply shortfalls.
  - Food staples inflation moderated somewhat in 2005, but foodstuffs inflation remained in the double-digit range in 2005.
- Demand-side amplification via wages and public-sector pay:
  - Common minimum wage increases: 38 percent in January 2003; 20.7 percent in October 2005; 28.6 percent in October 2006.
  - Average civil service wages increased by an additional 30 percent in October 2004.
  - Minimum wages in foreign-invested firms raised by 39-45.8 percent (42% on average) as of February 2006.
  - Rising economic activity and generalized aggregate demand increases likely fueled inflation expectations and prolonged supply shock effects.
- Petroleum price impacts (direct contribution to CPI inflation, period averages, annual percentage change):
  - 2001: Petroleum Prices 0.02
  - 2002: 0.14
  - 2003: 0.22
  - 2004: 0.83
  - 2005: 1.02
  - Direct effect accounted for 3.27 percent of the CPI basket until April 2006; indirect effects accounted for 2.6 percent until April 2006.
- Petroleum price contributions by component (2001–2005 period averages):
  - Fuel for cooking: 2001 0.03; 2002 0.11; 2003 0.08; 2004 0.27; 2005 0.44
  - Fuel and lubricants: 2001 -0.02; 2002 0.01; 2003 0.10; 2004 0.52; 2005 0.49
  - Public transport (indirect): 2001 0.01; 2002 0.03; 2003 0.04; 2004 0.04; 2005 0.09
  - Electricity (indirect): 2001 0.03; 2002 0.31; 2003 0.02; 2004 0.00; 2005 0.01
- Domestic policy responses:
  - Domestic oil prices were increased nine times between end-2003 and August 2006 but generally remained below world prices.
  - Average petroleum prices raised in two stages in April and August 2006 by a cumulative 18.5 percent.
  - After international oil prices began to retreat in September 2006, authorities reinstated the import duty on most petroleum products other than kerosene and diesel, initially at 5 percent and subsequently increased to 15 percent, and reduced gasoline prices by 8.5 percent.
- Second-round effects:
  - Core inflation trended up with significant contributions from housing and construction materials, transportation and telecommunications, garments, and household goods and equipment—likely reflecting second-round effects of oil price increases.
  - Correlation coefficient between core and oil price inflation was 0.86 over January 2003-April 2006.

### Relative prices, Balassa-Samuelson evidence, and administered prices
- Price and productivity indicators (2003–Aug 2006 period averages, annual percentage change):
  - CPI inflation: 2003 3.2; 2004 7.7; 2005 8.3; Jan-Aug 2006 7.8
  - Price of nontradables: 2003 4.1; 2004 6.6; 2005 5.9; Jan-Aug 2006 7.5
  - Price of tradables: 2003 2.8; 2004 8.1; 2005 9.0; Jan-Aug 2006 8.1
  - Relative price of nontradables/tradables: 2003 1.2; 2004 -1.4; 2005 -2.8; Jan-Aug 2006 -0.6
  - GDP deflator: 2003 6.7; 2004 8.2; 2005 8.0
  - Import prices: 2003 3.2; 2004 5.4; 2005 -0.9
  - Export prices: 2003 1.1; 2004 6.6; 2005 11.8
- Real exchange rate and productivity:
  - Significant REER appreciation occurred in 2005, reflecting a de facto peg of the dong to the U.S. dollar and consequential nominal effective appreciation during 2005; trends attenuated in 2006 as earlier nominal effective appreciation was reversed.
  - Evidence on Balassa-Samuelson effects is mixed:
    - Productivity in the tradable sector trended up relative to nontradable sector (consistent with Balassa-Samuelson).
    - Labor productivity increased more rapidly in Vietnam than in the United States proxy and the real exchange rate appreciated (also consistent).
    - However, other evidence (including regressions and relative-price trends) is mixed or contrary, leaving unclear whether recent inflation is a temporary relative-price adjustment or a persistent phenomenon.
- Administered prices:
  - Administered prices officially estimated to account for less than 10 percent of Vietnam’s CPI basket.
  - A large number of prices were controlled between 1992 and 2002 (Decision 137 of April 27, 1992).
  - Prices liberalized to a great extent during 2002–04 included rice, cement, urea fertilizer, and steel for construction.
  - Key prices and tariffs—electricity, water, petroleum products, air tickets, bus fares, postal services and telecom charges—continue to be set by the government; some remain subject to legal ceilings or administratively set price ranges.
  - The largest increases in inflation occurred after the bulk of price liberalization took place, and during a period in which administrative controls on some prices were tightened; this timing complicates attribution of inflation increases to liberalization alone.

### Empirical approach and econometric results
- Methods used:
  - Disaggregated analysis of headline inflation components and proxies for core and fuel inflation.
  - Vector Error Correction Model (VECM) to estimate proximate determinants of inflation (2001Q1–2006Q2).
  - Cross-country dynamic panel model (differenced GMM) for Q1 2000–Q2 2006 to explain Vietnam’s inflation differential.
  - Panel regressions with country-fixed effects to identify inflation threshold harmful to growth (1980–2005).
- VECM (2001Q1–2006Q2) main results (accumulated impulse responses over two years; shocks standardized to one standard deviation):
  - Monetary factors influenced CPI dynamics with a lag of about 12 months.
  - CPI responds positively to a narrowing output gap.
  - Depreciation of the nominal exchange rate exerts upward pressure on CPI, but pass-through is relatively modest and incomplete.
  - A positive shock to broad money temporarily increases output with a one-year lag but does not have a positive long-term effect on output; the positive impact on output disappears after two years.
  - A nominal depreciation has a temporary positive effect on output that peaks after about one year and then tapers off.
- Cross-country dynamic panel model (sample: China, Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand, Vietnam; Q1 2000–Q2 2006):
  - For full sample, current inflation depends positively on past inflation, the output gap, and broad money, and negatively on NEER.
  - Vietnam-specific findings:
    - Inflation persistence: one percentage point of past inflation is associated with an inflation increase of about 0.79 percent in the current period in Vietnam — 0.18 percentage points higher than the sample average; persistence implies effects last about 20 quarters in Vietnam versus about 10 quarters in selected Asian countries.
    - Money effect: Over 2000Q1–2006Q2, money had a negative effect on inflation in Vietnam (regression 2). Over 2002–06, money effect becomes positive and statistically significant: a one percentage point increase in broad money is associated with an increase in inflation of about 0.1 percent (0.016+0.08).
    - Exchange rate pass-through: A depreciation of the NEER by one percentage point is associated with an increase in inflation of 0.12 percent in Vietnam, approximately 0.1 percentage points higher than in the rest of the sample.
    - Output gap: Effects similar to other countries; a one percentage point increase in the output gap increases inflation by the same amount as in other emerging countries in the sample.
  - Selected reported coefficients (Table 7 highlights):
    - Past inflation (cpi t-1): 0.61***, 0.64***, 0.62***, 0.66***, 0.67*** across regressions.
    - M2 growth (t-1): 0.044**, 0.079***, 0.016**, 0.039**, 0.022.
    - NEER growth (t-2): -0.034***, -0.025**, -0.422***, -0.027**, -0.036***.
    - Output gap (t-1): 0.094**, 0.089**, 0.045, 0.086**, 0.080*.
    - Vietnam dummy on past inflation: 0.18***.
    - Vietnam dummy on M2 growth (selected specifications): -1.268**; in another specification 0.080*.
    - Observations: 184 (regressions 1,2,4,5) and 152 (regression 3).
    - Sargan test p-values: 0.991, 0.992, 0.992, 0.993, 0.996.
    - Tests of autocorrelation: order 1 p-values reported as 0.000 (several regressions) and order 2 p-values around 0.10–0.20.
- Inflation and growth (panel 1980–2005, country-fixed effects):
  - Quadratic specification of log inflation and square of log inflation yields an estimated growth-maximizing (optimal) inflation rate implied by the quadratic specification of 3.6 percent.

### Inflation versus regional peers
- Since 2004, headline inflation in Vietnam has been higher than in other emerging Asian countries, with the sole exception of Indonesia.
- Stylized cross-country facts:
  - Inflation is largely a monetary phenomenon for the period beginning in 2003 and is closely correlated with credit growth.
  - Inflation is negatively correlated with openness (imports over GDP) and with NEER.

### Reserve adequacy — key facts and forward-looking assessment
- Gross international reserves (GIR) held by the State Bank of Vietnam (SBV) more than tripled from US$3 billion at end-2000 to US$10.9 billion as of mid-2006.
- Reserve coverage was about 11 weeks of imports as of mid-2006, below the 3-month benchmark commonly used for low-income countries.
- GIR increased from about 11 percent of GDP in 2000 to nearly 17 percent of GDP in 2005.
- Vietnam’s first dollar-denominated sovereign bond was issued in October 2005 in the amount of US$750 million.
- Forex deposits rose from US$1.8 billion in 2000 to US$11.4 billion as of June 2006.
- Banks’ net foreign assets (NFA) declined from US$4.6 billion in 2001 to US$3.2 billion in 2005.
- Import coverage of reserves increased from about 2.1 months of imports in 2000 to 2.6 months of imports as of mid-2006.
- Foreign-currency deposits declined from more than 40 percent of total deposits in 2000 to less than 30 percent in 2006, but degree of dollarization remains high relative to the regional average.
- Coverage of short-term external debt on a remaining maturity basis appears adequate; bulk of external debt is public or publicly-guaranteed and highly concessional; private debt mostly FDI-related and trade credits.

### Reserve adequacy stress-test scenarios and outcomes (medium-term projections)
- Baseline Scenario (SEDP 2006–2010 assumptions):
  - Continued strong investment-led growth of around 7½ percent per year.
  - Foreign currency deposits assumed to stabilize at 20 percent of GDP.
  - Broad money rises to 100 percent of GDP by 2011.
  - Outcomes: reserve coverage of imports leveling off at 3–4 months; coverage of short-term debt based on remaining maturity averaging over 600 percent; GIR fully cover foreign-currency deposits; reserves above upper bound required to service short-term debt in event of capital flight or withdrawal of dollar deposits.
- Alternative Scenario 1 — Increase in short-term debt to regional average:
  - Short-term debt nearly triples from about 4 percent of GDP in 2005 to about 11½ percent of GDP from 2006 onward.
  - Outcomes: reserve coverage of short-term debt declines but averages more than 200 percent over the projection period; inadequate to service short-term debt while covering capital flight equivalent to 20 percent of broad money and inadequate in case of a run on dollar deposits.
- Alternative Scenario 2 — Decline in the oil price:
  - Uses published Spring WEO baseline (3/9/2006) which assumes oil prices lower by 13, 20, 18, 17 and 15 percent over the years 2006–2010 relative to the August 1, 2006 WEO baseline.
  - Impact peaks at about -1 percent of GDP on the current account in 2007 and about -0.1 percent of GDP by 2009.
  - Outcomes: current account indicators and short-term debt coverage remain in safe ranges; composite minimum benchmarks remain basically covered.
- Alternative Scenario 3 — Worsening of the trade balance:
  - Trade deficit increases to about 6.4 percent of GDP (from 4.8 percent under the baseline).
  - Outcomes: stock of reserves 25 percent lower than under the baseline; coverage of short-term debt remains adequate but other indicators fall below respective benchmarks; GIR/Imports decline to < 3 months; GIR/ST Debt falls to < 100% over time.
- Alternative Scenario 4 — Combined effects of scenario 1 and 3:
  - Outcomes: reserves decline to < 3 months of imports; GIR/ST Debt falls to about 1½ times and then to < 100%; other indicators fall below benchmarks, including composite measures falling to < 10% in some cases.
- Alternative Scenario 5 — Increase in monetization:
  - Broad money rises to 145 percent of GDP.
  - Outcomes: reserves remain reasonably adequate to cover capital flight if short-term debt remains low; reserve coverage would be inadequate if short-term debt had risen to regional levels.
- Alternative Scenario 6 — Increasing dollarization:
  - Foreign-currency deposits increase to 30 percent of GDP by 2011 (from 20 percent under the baseline).
  - Outcomes: reserve accumulation would be insufficient to cover short-term debt by remaining maturity in the event of a run on forex deposits; GIR/Forex Deposits falling to < 80%.
- Composite minimum benchmarks:
  - Using short-term external debt plus potential capital flight proxied by 10 percent to 20 percent of broad money: Vietnam held sufficient reserves since 2002 to cover the lower-range estimate (10 percent of broad money) but was insufficient to cover the upper-range estimate (20 percent of broad money) in earlier years.
  - Composite benchmark based on short-term external debt plus foreign-currency deposits: GIR fell clearly below this minimum threshold throughout the period studied.

### Real exchange rate (REER) developments and trade openness
- Stylized REER movements:
  - CPI-based REER appreciated significantly during the 1990s, rising by more than 30 percent between 1992 and 2000.
  - REER depreciated by 15 percent during 2002-04.
  - REER appreciated by 13 percent in 2005, largely reversing the 2002-04 depreciation.
- REER and fundamentals (FMOLS regressions, sample 2000Q4-2005Q4):
  - NFAGDP (Net Foreign Asset percent of GDP): coefficient ≈ 0.019–0.022 with p-values indicating significance; interpretation: an increase in NFA of 1 percentage point of GDP is associated with an appreciation of the REER of about 2 percent.
  - TOT (terms of trade): coefficient ≈ 0.005–0.007 with p-values indicating significance in some specifications; interpretation: a 1 percent increase in terms of trade is associated with a 0.6-0.7 percent increase in the REER.
  - LRGDPPC (relative per capita GDP, log): coefficients negative in several specifications (e.g., -0.547 [0.003]; -0.634 [0.000]), contrary to Balassa-Samuelson prediction.
  - OPENNESS: negative association with REER (e.g., -0.008) but not statistically significant.
- Empirical interpretation:
  - Movements in the ratio of the banking system’s NFA to GDP and terms of trade help explain REER variation.
  - Trade openness appears broadly associated with REER depreciation but not statistically significant.
  - Evidence does not support a strong Balassa-Samuelson effect during the sample period; relative productivity/proxy results are mixed or opposite to theory—possible explanation: large underemployed agricultural labor force limiting wage pass-through.
- Unit-root/PPP testing for 1992Q1-2005Q4:
  - ADF statistic: -2.843, p-value [0.059]
  - Phillips-Perron statistic: -2.841, p-value [0.052]
  - Observations 56; R-squared 0.132; Adj R-squared 0.116; SE of regression 0.031; Durbin-Watson 0.99
  - Null that the real exchange rate has a unit root is rejected in this testing framework.

### Policy implications and recommendations (selected)
- For inflation:
  - Contain monetary and credit growth to reduce inflationary pressures given increased responsiveness of domestic prices to monetary conditions.
  - Recognize strong inflation inertia; policies to reduce inflation expectations may require concerted actions beyond short-term supply-side measures.
  - Monitor administered price liberalization and manage timing and communication to avoid one-off level shocks being mistaken for persistent inflation.
- For reserve adequacy and external vulnerability:
  - Move toward greater exchange rate flexibility at an appropriate time to encourage hedging and risk management and reduce costly adjustments in future adverse scenarios.
  - Strengthen monitoring and regulation of capital account transactions and improve data reporting and disclosure requirements.
  - Expand monitoring of private sector foreign liabilities, manage debts of an enlarged public sector, strengthen corporate governance and insolvency regimes, and upgrade supervision and regulation of the banking system.
  - Weigh costs of reserve holdings (including sterilization costs and SBV balance-sheet risks) against benefits of lower vulnerability as capital account liberalization proceeds.

*Prepared by Patrizia Tumbarello (APD). Source: IMF staff report content provided in the supplied PDF.*

### 1.      Vietnam was remarkably successful in bringing down inflation in the 1990s to a

### _cr06422 - 1.      Vietnam was remarkably successful in bringing down inflation in the 1990s to a

### Overview and context
- Vietnam reduced inflation from a peak of 453 percent in 1986 to the single digit range during the second half of the 1990s following price liberalization and the “Doi moi” reforms.
- After remaining in the single digit range, inflation began an upward trend that accelerated in late 2003 and became more persistent thereafter, remaining higher than in other emerging markets in the region except Indonesia.
- Headline inflation (year-on-year) declined from 9.7 percent in 2004 and 8.8 percent at end-2005 to 7.5 percent in August 2006, but remained well above rates in Vietnam’s major trading partners.

### Empirical approach and chapter structure
- The chapter addresses: whether recent inflation is temporary or persistent; roles of supply shocks, higher oil prices, and administered price liberalization; evidence of excess demand; and reasons for Vietnam’s inflation differential with regional peers.
- Methods used:
  - Disaggregated analysis of headline inflation components and proxies for core and fuel inflation (Section B).
  - Vector Error Correction Model to estimate proximate determinants of inflation (Section C).
  - Cross-country dynamic panel model to explain Vietnam’s inflation differential (Section D).
  - Simple panel model with country-fixed effects to identify the inflation threshold harmful to growth (Section E).
- Main summary (Section F) and econometric specifications and data issues in Annex 1.

### Main findings
- Monetary developments have exerted an increasing influence on inflation in Vietnam in recent years.
- Inflationary inertia plays a larger role in Vietnam than in other countries in the region, implying more difficulty reducing inflationary expectations.
- Output gap helps explain short-term inflation fluctuations, but movements in core inflation have become increasingly important, possibly reflecting second-round effects of oil price increases.
- Evidence on Balassa-Samuelson-type effects is mixed.
- The desirable rate of inflation depends importantly on how a country’s inflation compares with inflation in neighboring countries and trading partners.

### Recent determinants of inflation (2003–06)
- Headline inflation characteristics:
  - Vietnam’s volatility and persistence in inflation were high compared to other emerging Asian economies during 2002Q1-2006Q2 (Table 1).
  - Table 1 statistics (2002Q1-2006Q2):
    - ASEAN-4: Mean 5.8, Median 5.1, Maximum 10.8, Minimum 3.1, Std. Dev. 2.2
    - Newly-industrialized economies (NIEs): Mean 1.8, Median 1.8, Maximum 3.5, Minimum 0.3, Std. Dev. 0.7
    - Selected Emerging Asian Countries: Mean 2.6, Median 2.7, Maximum 5.0, Minimum 0.8, Std. Dev. 1.1
    - Vietnam: Mean 6.0, Median 5.6, Maximum 10.4, Minimum 1.6, Std. Dev. 2.6
- Core inflation:
  - Proxy for core inflation (nonfood CPI net of fuel and fuel-related items) trended up in Vietnam faster than in most neighboring countries (Figure 3).

### The food supply and oil price shocks
- Food price dynamics:
  - Food price inflation in Vietnam was both higher and more volatile than in other regional countries and was the most important contributor to the inflation pick-up beginning in 2004.
  - Standard deviation of food price inflation during January 2003-June 2006:
    - Vietnam: 5.1 percent
    - ASEAN-4: 3.1 percent
    - NIEs: 1.3 percent
  - Contributing factors: international food price increases (especially rice), government regulation of rice exports, avian flu pressures on beef/fish/seafood, and widespread droughts causing supply shortfalls.
  - Food staples inflation moderated somewhat in 2005, but foodstuffs inflation remained in the double-digit range in 2005.
- Demand-side amplification:
  - Progressive increases in the common minimum wage and large civil service wage scale adjustments increased purchasing power:
    - Common minimum wage increases: 38 percent in January 2003; 20.7 percent in October 2005; 28.6 percent in October 2006.
    - Average civil service wages increased by an additional 30 percent in October 2004.
    - Minimum wages in foreign-invested firms raised by 39-45.8 percent (42% on average) as of February 2006.
  - Rising economic activity and generalized aggregate demand increases likely fueled inflation expectations and prolonged supply shock effects.
- Petroleum price impacts:
  - Direct contribution of petroleum prices to CPI inflation (period averages, annual percentage change):
    - 2001: Petroleum Prices 0.02
    - 2002: 0.14
    - 2003: 0.22
    - 2004: 0.83
    - 2005: 1.02
  - Direct effect accounted for 3.27 percent of the CPI basket until April 2006; indirect effects accounted for 2.6 percent until April 2006.
  - Petroleum price contributions by component (2001–2005 period averages):
    - Fuel for cooking: 2001 0.03; 2002 0.11; 2003 0.08; 2004 0.27; 2005 0.44
    - Fuel and lubricants: 2001 -0.02; 2002 0.01; 2003 0.10; 2004 0.52; 2005 0.49
    - Public transport (indirect): 2001 0.01; 2002 0.03; 2003 0.04; 2004 0.04; 2005 0.09
    - Electricity (indirect): 2001 0.03; 2002 0.31; 2003 0.02; 2004 0.00; 2005 0.01
  - Domestic policy responses:
    - Domestic oil prices were increased nine times between end-2003 and August 2006 but generally remained below world prices.
    - Average petroleum prices raised in two stages in April and August 2006 by a cumulative 18.5 percent.
    - After international oil prices began to retreat in September 2006, the authorities reinstated the import duty on most petroleum products other than kerosene and diesel, initially at 5 percent and subsequently increased to 15 percent, and reduced gasoline prices by 8.5 percent.
  - Second-round effects:
    - Core inflation trended up in recent years with significant contributions from housing and construction materials, transportation and telecommunications, garments, and household goods and equipment—likely reflecting second-round effects of oil price increases.
    - Correlation coefficient between core and oil price inflation was 0.86 over January 2003-April 2006.

### Relative prices and the Balassa-Samuelson question
- Price and productivity indicators (period averages):
  - Table 4 (Period average, Annual percentage change) for 2003–Aug 2006 Prel.:
    - CPI inflation: 2003 3.2; 2004 7.7; 2005 8.3; Jan-Aug 2006 7.8
    - Price of nontradables: 2003 4.1; 2004 6.6; 2005 5.9; Jan-Aug 2006 7.5
    - Price of tradables: 2003 2.8; 2004 8.1; 2005 9.0; Jan-Aug 2006 8.1
    - Relative price of nontradables/tradables: 2003 1.2; 2004 -1.4; 2005 -2.8; Jan-Aug 2006 -0.6
    - GDP deflator: 2003 6.7; 2004 8.2; 2005 8.0
    - Import prices: 2003 3.2; 2004 5.4; 2005 -0.9
    - Export prices: 2003 1.1; 2004 6.6; 2005 11.8
- Real exchange rate and productivity:
  - Significant real effective exchange rate appreciation occurred in 2005, reflecting a de facto peg of the dong to the U.S. dollar and consequential nominal effective appreciation during 2005; these trends attenuated in 2006 as earlier nominal effective appreciation was reversed.
  - Evidence on Balassa-Samuelson effects is mixed:
    - Figure 7 shows a trend increase in productivity in the tradable sector relative to the nontradable sector, consistent with Balassa-Samuelson.
    - Figure 8 shows labor productivity increased more rapidly in Vietnam than in the United States proxy and that the real exchange rate appreciated—also consistent with Balassa-Samuelson.
    - However, the mixed nature of evidence means it is unclear whether recent inflation is a temporary relative-price adjustment or a more persistent phenomenon.

### Implications and interpretation
- Some idiosyncratic Vietnam-specific factors may have magnified and perpetuated external shocks’ impact on inflation.
- Demand pressures—wage rises, civil service wage reforms, and robust economic activity—likely amplified food price inflation and helped sustain inflationary expectations.
- Core inflation’s rising importance and inflationary inertia suggest that reducing inflationary expectations may be more difficult in Vietnam than in neighboring countries.
- Whether inflation is primarily a temporary relative-price adjustment (Balassa-Samuelson) or a persistent, policy-driven phenomenon remains a key question for appropriate policy response.

*Prepared by Patrizia Tumbarello (APD). Source: IMF staff report content provided in the supplied PDF.*

### 15. On the other hand, there is no evidence of a medium-term trend increase in the

### _cr06422 - 15. On the other hand, there is no evidence of a medium-term trend increase in the

### Evidence on relative prices and the Balassa-Samuelson effect
- No evidence of a medium-term trend increase in the relative price of nontraded goods compared to traded goods.
- According to the Balassa-Samuelson effect, the relative price of nontraded goods compared to traded goods "should show a strong upward trend."
- Given this absence, it is difficult to attribute recent years’ inflation to equilibrating changes in relative prices between the tradable and nontradable sectors.

### Dual-economy explanation for limited pass-through to wages
- In a dual economy with a large underemployed agricultural labor force, pass-through of tradable-sector productivity gains to wages in other sectors may be limited.
- Any upward pressure on wages in the lower-productivity nontradables sector is likely to be constrained while a large pool of underemployed labor in agriculture remains willing and able to secure employment in the nonagricultural sector at currently prevailing wages.
- The discussion cites Harris-Todaro, 1970, as an example of this mechanism.

### The role of administered prices in inflation dynamics
- Administered prices can play an important role in influencing inflation dynamics.
- Administered prices are currently officially estimated to account for less than 10 percent of Vietnam’s CPI basket.
- Administered prices were much more prevalent at earlier stages of the transition to a market-based system.
- Price liberalization typically should not cause permanent increases in the rate of inflation, but would lead to one-off adjustments in the price level during the liberalization period.

### Historical price controls and liberalization in Vietnam
- A large number of prices were controlled between 1992 and 2002, in accordance with Decision 137 of April 27, 1992.
- The prices of several important commodities, including rice, cement, urea fertilizer, and steel for construction, were liberalized to a great extent during 2002–04.
- Key prices and tariffs—including for electricity, water, petroleum products, air tickets, bus fares, postal services and telecom charges—continue to be set by the government.
- Some prices for other key inputs remain subject to legal ceilings or administratively set price ranges.
- The government tightened controls over these prices over the last two years as part of efforts to limit inflation.

### Timing of inflation relative to liberalization and controls
- The largest increases in inflation occurred after the bulk of price liberalization took place, and during a period in which administrative controls on some prices were tightened.
- Consequently, the actual rate of inflation may have understated the extent of inflationary pressures over the last two years.

*Source: _cr06422 - 15. On the other hand, there is no evidence of a medium-term trend increase in the*

### Chapter III below.

### Chapter III

### Background and price liberalization
- Ordinance No.40 on Prices, 2002; Decree No. 170 of December 12, 2003; and Circular 15 of March 9, 2004 are noted as part of administered-price liberalization.
- While it is difficult to argue that price liberalization has made a significant contribution to the recent up-tick in inflation, it probably played a role in increasing the impact of monetary conditions on inflation.

### Demand pressures and the output gap
- Conceptual point:
  - The output gap is defined as the difference between actual output and potential output, with potential output defined as the level of output consistent with stable inflation.
  - When output grows above its long-term potential rate, inflationary pressures emerge via bottlenecks, capacity limits, and tightening labor markets.
- Empirical evidence for Vietnam (2000Q1–2006Q2):
  - A preliminary assessment does not point to any consistent pattern of causality between the output gap and inflation because the output gap exhibited limited variability through most of this period.
  - Recent data suggest the increase in inflation during 2005 could be partly attributed to the output gap being estimated to have been above potential during 2005 (Figure 9).
  - Short-term fluctuations of inflation appear particularly influenced by the behavior of the output gap (Figure 10).
  - Econometric analysis (section D, and the VECM in section C) corroborates these findings.

### Monetary and credit aggregates as indicators of demand pressures
- Prior empirical studies found little evidence of a robust link between monetary growth and inflation in Vietnam in earlier periods, despite rapid monetary and credit expansion.
- Evidence since 2002:
  - Correlation between money and inflation became positive and strong beginning in 2002, with trends in monetary aggregates appearing to affect inflation with a lag of about 12 months (see correlation matrix, Tables 5 and 6, and Figure 11).
  - Growth of credit to the economy appears more highly correlated with CPI inflation during this recent period, suggesting credit may have become a useful leading indicator of inflation.
  - Caution: Correlation with lagged monetary and credit aggregates is not proof of causation, especially given possible shifts in money demand.

- Factors complicating money–inflation relationships:
  - De facto peg of the dong to the U.S. dollar through most of the period under review (except late 1990s Asian crisis) made the exchange rate an important anchor and helped contain import-price increases.
  - Monetary growth was largely fueled by market-driven increases in net foreign assets rather than by policy-induced financing of fiscal deficits.
  - State-owned banking system accumulated substantial excess liquidity, moderating money–credit multiplier effects.
  - These balancing effects may have weakened in recent years as import penetration leveled off and state-owned banks intensified lending to meet government investment and growth targets.
  - Liberalization of administered prices likely increased responsiveness of domestic prices to monetary actions.

### Vector Error Correction Model (VECM) results (2001Q1–2006Q2)
- Model specification:
  - Quarterly VECM for 2001Q1–2006Q2 including: headline CPI, broad money (M2), nominal effective exchange rate (NEER), and the output gap.
  - Output gap defined as actual output less potential output (percent of potential), potential estimated using an HP filter with end-point bias correction via projected output data.
- Main results (accumulated impulse responses over two years; shocks standardized to one standard deviation):
  - Monetary factors influenced CPI dynamics with a lag of about 12 months.
  - CPI responds positively to a narrowing output gap (actual GDP increasing relative to potential).
  - Depreciation of the nominal exchange rate exerts upward pressure on CPI, but pass-through is relatively modest and incomplete.
  - A positive shock to broad money temporarily increases output with a one-year lag but does not have a positive long-term effect on output; positive impact on output disappears after two years.
  - A nominal depreciation has a temporary positive effect on output that peaks after about one year and then tapers off.

- Units and presentation:
  - Inflation is expressed in percentage points divided by 100. The output gap is expressed in percentage points. Quarters reported on horizontal axis.

### Cross-country dynamic panel model: Sources of inflation (2000Q1–2006Q2)
- Sample: China, Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand, and Vietnam; quarterly data Q1 2000–Q2 2006.
- Estimation method: Differenced generalized method-of-moments (GMM) estimator; dependent variable = current CPI inflation.
- Explanatory variables:
  - Lagged inflation (inflation inertia)
  - Lagged broad money (M2)
  - Lagged NEER (pass-through)
  - Lagged output gap (excess demand)
  - Country-specific dummy for Vietnam to assess differential effects.

- Key econometric findings (summary of reported results):
  - For the full sample, current inflation depends positively on past inflation, the output gap, and broad money, and negatively on NEER.
  - Degree of openness played no role in explaining inflation across the sample (result not shown).
  - Vietnam-specific results:
    - Higher persistence in inflation: one percentage point of past inflation is associated with an inflation increase of about 0.79 percent in the current period in Vietnam — 0.18 percentage points higher than the sample average.
      - Persistence interpretation: effects of a shock last about 10 quarters in the selected Asian countries and about 20 quarters in Vietnam.
    - Money effect:
      - Over 2000Q1–2006Q2, money had a negative effect on inflation in Vietnam (regression 2).
      - Over 2002–06 (regression 3), money effect becomes positive, statistically significant, and stronger than in other countries. Based on 2002Q1–2006Q2 results, a one percentage point increase in broad money is associated with an increase in inflation of about 0.1 percent (0.016+0.08), equivalent to 0.08 percentage points higher than in other countries.
    - Exchange rate pass-through:
      - A depreciation of the NEER by one percentage point is associated with an increase in inflation of 0.12 percent in Vietnam, approximately 0.1 percentage points higher than in the rest of the sample (regression 4).
    - Output gap:
      - Effects of the output gap on inflation are similar in Vietnam and the other countries (Vietnam dummy not significant for output gap in regression 5): a one percentage point increase in the output gap increases inflation by the same amount as in the other emerging countries in the sample.

- Selected reported coefficients (from Table 7 regressions):
  - Past inflation (cpi t-1): 0.61***, 0.64***, 0.62***, 0.66***, 0.67*** across regressions.
  - M2 growth (t-1): 0.044**, 0.079***, 0.016**, 0.039**, 0.022.
  - NEER growth (t-2): -0.034***, -0.025**, -0.422***, -0.027**, -0.036***.
  - Output gap (t-1): 0.094**, 0.089**, 0.045, 0.086**, 0.080*.
  - Vietnam dummy on past inflation: 0.18*** (significant).
  - Vietnam dummy on M2 growth (selected regressions): -1.268**; in another specification 0.080*.
  - Observations: 184 (regressions 1,2,4,5) and 152 (regression 3).
  - Sargan test p-values: 0.991, 0.992, 0.992, 0.993, 0.996.
  - Tests of autocorrelation: order 1 p-values reported as 0.000 (several regressions) and order 2 p-values around 0.10–0.20.

### Inflation versus regional peers and panel evidence (2000–06 and 2003–06 comparisons)
- Since 2004, headline inflation in Vietnam has been higher than in other emerging Asian countries, with the sole exception of Indonesia.
- Stylized cross-country facts:
  - Inflation is largely a monetary phenomenon for the period beginning in 2003 and is closely correlated with credit growth.
  - Inflation is negatively correlated with openness (imports over GDP) and with NEER.

### Inflation and growth: non-linearity and optimal inflation
- Empirical background:
  - Literature suggests inflation may negatively affect growth after a threshold; prior literature produces threshold estimates ranging widely from 3 percent to 40 percent.
- Panel analysis for selected Asian countries (Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand, and Vietnam) over 1980–2005:
  - Regressions of real GDP growth on log of inflation and square of log inflation (country-fixed effects).
  - Results:
    - Linear specification: coefficient on log inflation reported as -0.47 (model 1).
    - Quadratic specification: coefficient on log inflation positive (0.31 reported in table heading) and coefficient on square of log inflation negative (-0.3198***), implying non-linear concave relationship.
    - Estimated growth-maximizing (optimal) inflation rate implied by the quadratic specification is 3.6 percent.
- Interpretation:
  - At very low inflation, relationship with growth can be positive; beyond a threshold, relationship becomes negative. The estimated optimal rate of 3.6 percent is at the low end of prior literature but coherent with lower global inflation in recent decades.

### Conclusions
- Multiple empirical approaches were used to analyze Vietnam’s inflation process; structural changes over two decades complicate stable behavioral estimation.
- Main conclusions:
  - Monetary factors appear to have become an important determinant of inflation in recent years, possibly because liberalization of administered prices increased the responsiveness of domestic prices to monetary actions.
  - Inflation inertia in Vietnam is stronger than in other Asian countries; recent food supply and oil price shocks have resulted in a more permanent increase in core inflation.
  - No strong evidence supports the notion that inflation is primarily a benign Balassa–Samuelson effect (productivity-driven increases in nontradable prices relative to tradables).
  - There is little reason to believe current inflation will correct itself in the absence of appropriately restrained macroeconomic policies.

*Source: Fund staff estimates and analysis in Chapter III, _cr06422 - Chapter III below.*

### References

### References

### Bibliographic references
- Al-Mashat, R., 2004, “Vietnam’s Experience with Rapid Credit Growth and Low Inflation,” (unpublished; Washington: International Monetary Fund).
- Blinder, A., 1997, “Commentary,” Federal Reserve Bank of St Louis Review, May/June, pp. 157-162.
- Blinder, A., E. Canetti, D. Lebow, and J. Rudd, 1998, Asking about Prices: A New Approach to Understanding Price Stickiness (New York, NY: Russell Sage Foundation Publications).
- Blinder, Christiano, L., J. M. Eichenbaum, and C. Evans, 1996, “The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds,” The Review of Economics and Statistics, Vol. 78, No. 1, pp. 16-34.
- Bruno, M., and W. Easterly, 1995, “Inflation Crises and Long-Run Growth,” NBER Working Paper, No. 5698 (Cambridge, MA: National Bureau of Economic Research).
- Burdekinm, R., A. Enzau, M. Keil, T. Sitthiyot, and T. Willett, 2000, “When Does Inflation Hurt Economic Growth? Different Nonlinearities for Different Economies,” Claremont Colleges Working Paper in Economics 2000-22 (Claremont, California, Claremont McKenna College).
- Central Institute for Economic Management, 2006, Vietnam’s Economy in 2005 (The Publishing House of Political Theory, Hanoi).
- Coe, D., and C. J. McDermott, 1996, “Does the Gap Model Work in Asia?,” IMF Working Paper No. 96/69 (Washington: International Monetary Fund).
- Easterly W., and S. Fischer, 2001, “Inflation and the Poor,” Journal of Money, Credit, and Banking, Part 1, Vol. 33, Issue 2 (May), pp. 160-178.
- Fischer, S., 1993, “The Role of Macroeconomic Factors in Growth,” Journal of Monetary Economics, Vol. 32, No. 3 (December), pp.485-512.
- Gosh, A., and S. Phillips, 1998, “Warning: Inflation May be Harmful to Your Growth,” IMF Staff Papers, Vol. 45, No. 4, pp. 672-710.
- Harris, J., and M. Todaro, 1970, “Migration, Unemployment and Development: A Two-Sector Analysis,” American Economic Review, Vol. 60, pp.126-142.
- International Monetary Fund, 2006, World Economic Outlook, April 2006, Inflation and Globalization, (Washington: International Monetary Fund).
- Ito, T., and K. Sato, 2006, “Pass-Through of Exchange Rate Changes and Macroeconomic Shocks to Domestic Inflation in East Asian Countries,” NBER Working Paper No. 12395 (Cambridge, MA: National Bureau of Economic Research).
- Khan, M., 2005, “Inflation and Growth in MCD Countries,” Mimeo, International Monetary Fund.
- Khan M., and A. Schimmelpfenning, 2006, “Money or Wheat?,” IMF Working Paper No. 06/60 (Washington: International Monetary Fund).
- Khan, M., and A. S. Senhadji, 2001, “Threshold Effects in the Relationship Between Inflation and Growth,” IMF Staff Papers, Vol. 48, No. 1, pp 1-21.
- Laxton, D., and P. Pesenti, 2003, “Monetary Rules for Small, Open, Emerging Economies,” Journal of Monetary economics, Vol. 50, No. 5:1109-52.
- Lee, Il Houng, 2005, “Impact of Oil Price Increase in Vietnam and Policy Response,” presentation made at the Institute for Price and Market Research, October 21, Hanoi.
- Nguyen Tri Hung, 1999, “The Inflation in Vietnam,” CAS Discussion Paper, No. 22, Center for ASEAN Studies, Belgium.
- Palomba, G., 2006, “Explaining Higher Inflation in Indonesia,” Indonesia Selected Issues, IMF Country Report No. 06/318 (Washington: International Monetary Fund).
- Peiris, S.J., 2003, “Inflationary Dynamics in Vietnam,” in Vietnam: Selected Issues, IMF Country Report No. 03/381 (Washington: International Monetary Fund).
- Rudebusch, G., and L. Svensson, 1998, “Policy Rules for Inflation Targeting,” NBER Working Paper No. 6512 (Cambridge, MA: National Bureau of Economic Research).
- Sarel, M., 1996, “Nonlinear Effects of Inflation on Economic Growth,” IMF Staff Papers, March 1996, pp.199-215.
- Tobin, J., 1971, “Money and Income: Post Hoc Ergo Propter Hoc?” in Essays in Economics, ed. by J. Tobin, Vol. 1, Chapter 24 (Amsterdam, North-Holland Publishing Company).
- Troung Van Phuoc and Chu Hoan Long, 2005, “The Determinants of the Consumer Price in Vietnam: A Quantitative Approach,” (unpublished, Hanoi).

### ANNEX 1 — Specification of the Econometric Models and Data Issues

- Vector Error Correction Model (Section C)
  - Description:
    - A Vector Error Correction Model (VECM) is a restricted Vector Autoregression (VAR) model designed for use with nonstationary series that are known to be cointegrated.
    - Cointegration relations are built into the specification so that the long-run behavior of the endogenous variables converges with their cointegrating relationships while allowing for short-run adjustment dynamics.
  - The following system was estimated (system replicated exactly as in source):
    - CPI
      CPI_t = β_15 * CPI_{t-1} + β_14 * CPI_{t-1} + β_13 * CPI_{t-1} + β_12 * CPI_{t-1} + β_11 * CPI_{t-1} + α_1 ln(CPI_{t-1}) + β_11 ∆ln(M2) + β_12 ∆ln(NEER) + β_13 ∆ln(Outputgap) + β_14 ∆ln(CPIC) + C + ε_1t
      (Note: system in source contains multiline lag notation and log-difference forms; preserved variable names as in original.)
    - 2M
      2M_t = β_25 * 2M_{t-1} + β_24 * 2M_{t-1} + β_23 * 2M_{t-1} + β_22 * 2M_{t-1} + β_21 * 2M_{t-1} + α_2 ln(2M_{t-1}) + β_21 ∆ln(M2) + β_22 ∆ln(NEER) + β_23 ∆ln(Outputgap) + β_24 ∆ln(CPIC) + C + ε_2t
    - NEER
      NEER_t = β_35 * NEER_{t-1} + β_34 * NEER_{t-1} + β_33 * NEER_{t-1} + β_32 * NEER_{t-1} + β_31 * NEER_{t-1} + α_3 ln(NEER_{t-1}) + β_31 ∆ln(M2) + β_32 ∆ln(NEER) + β_33 ∆ln(Outputgap) + β_34 ∆ln(CPIC) + C + ε_3t
    - Outputgap
      Outputgap_t = β_45 * Outputgap_{t-1} + β_44 * Outputgap_{t-1} + β_43 * Outputgap_{t-1} + β_42 * Outputgap_{t-1} + β_41 * Outputgap_{t-1} + α_4 ln(Outputgap_{t-1}) + β_41 ∆ln(M2) + β_42 ∆ln(NEER) + β_43 ∆ln(Outputgap) + β_44 ∆ln(CPIC) + C + ε_4t
    - (The source presents the VECM in system form with ln and ∆ln terms and lag indexing; variable names preserved.)

- Dynamic Panel Model (Section D)
  - Model estimated to explain Vietnam’s relatively high inflation rate compared to other countries in the region:
    - VNMdummy GDPimp NEER ygap M
      π_it = α + β_1 π_{it-1} + β_2 (M2_{it-1}) + β_3 (ygap_{it-1}) + β_4 (NEER_{it}) + β_5 (GDPimp_{it}/2) + γ VNMdummy_{i} + ε_it
      (Source notation: VNMdummyGDPimpNEERygapM itititititiit11524131211 /2 γ β β β β π α π + + + + + = −−−−− , where π_it is current inflation; preserved component names and lag structure as in source.)
  - Definitions:
    - π_it is current inflation, i indicates the country, and t the time period.
    - π_{it-1} is lagged inflation (inflation-inertia).
    - M2_{it-1} is lagged broad money.
    - ygap_{it-1} is the output gap (one period lag).
    - NEER is the nominal effective exchange rate.
    - Country-specific dummies for Vietnam are introduced to capture differential effects for Vietnam relative to regional peers.

- Data Issues
  - Data availability constraints:
    - The need for real GDP series to calculate the output gap dictated that 2000 was the earliest starting date.
    - Most monetary series in many Asian countries suffered structural breaks after the 1997 Asian crisis.
    - In Vietnam a structural break in the monetary aggregates occurred in 1999, reflecting the switch to a large survey for the collection of monetary data.
  - Quarterly data:
    - Actual quarterly output data are preferable to estimated monthly data constructed by interpolation.
    - Real GDP data in Vietnam are available on a quarterly basis from 1999 onwards.

### II. ASSESSING RESERVE ADEQUACY IN VIETNAM—A FORWARD LOOKING APPROACH

- A. Introduction — Key points and context
  - Vietnam’s international reserves increased sharply in recent years, reducing several external vulnerability indicators.
  - Gross international reserves (GIR) held by the State Bank of Vietnam (SBV) more than tripled from US$3 billion at end-2000 to US$10.9 billion as of mid-2006.
  - As imports also grew, reserve coverage was about 11 weeks of imports as of mid-2006, below the 3-month benchmark commonly used for low-income countries.
  - Rapid growth of bank deposits and a high degree of dollarization kept official reserves lower than foreign-currency deposits throughout the period.
  - Transition to an emerging market and planned move towards full convertibility of the dong by 2010 will require close monitoring of external vulnerability and reserve adequacy indicators, and enhanced capacity building in risk management.
  - During early transition years risks may be mitigated by low short-term debt and limited private capital mobility; over time external vulnerability could increase as capital account restrictions are liberalized and administrative controls on state-owned enterprises and banks are removed.
  - The chapter outlines a framework for assessing and monitoring external vulnerability, and describes sections:
    - Section B: preliminary assessment using historical and cross-country comparisons against common thresholds.
    - Section C: qualitative modification of vulnerability assessment as reforms proceed.
    - Section D: balance of payments stress testing for medium-term prospects of vulnerability indicators.
    - Section E: main findings and policy recommendations.

- B. Vietnam’s Reserve Adequacy during 2000–2005 in an International Perspective — Key findings and statistics
  - Global and regional context:
    - World holdings of reserves topped US$4.3 trillion as of end-2005.
    - As of February 2006 China overtook Japan as the country with the largest reserve holdings in the world.
  - Reserve motives and benchmarks:
    - The literature commonly cites three months of prospective imports as a general rule for low-income countries with no access to international capital markets.
    - For emerging markets a widely accepted minimum standard is the Guidotti-Greenspan rule of one hundred percent coverage of short-term debt on a remaining maturity basis.
  - Vietnam-specific indicators:
    - GIR increased from about 11 percent of GDP in 2000 to nearly 17 percent of GDP in 2005.
    - The increase is in line with Asia region trends but much lower than increases in China, India, Korea or Malaysia.
  - Additional contextual facts:
    - Vietnam’s first dollar-denominated sovereign bond was issued in October 2005 in the amount of US$750 million.
    - The government was considering the possibility of a new bond issue in the latter part of 2006.
  - Relevance of both current account and capital account vulnerability indicators despite Vietnam’s de jure capital account restrictions, given:
    - Rapid monetization.
    - Relatively high dollarization.
    - De facto fixed exchange rate.
    - Incipient access to international capital markets and gradual capital account opening.

*Italic: Content adapted from _cr06422 - References and accompanying annex and chapter text.*

### Box 1: Selected Reserve Adequacy Benchmarks

### Box 1: Selected Reserve Adequacy Benchmarks

### Benchmarks and Vulnerabilities
- Gross international reserves (GIR) to prospective imports of goods and non-factor services:
  - Benchmark: Three months
  - Vulnerability: Current account
  - Description: Standard benchmark for low-income countries and countries without access to international capital markets. Benchmark could be made country specific, depending on past and expected future volatility of current account flows.
- GIR to broad money:
  - Benchmark: No recognized benchmark
  - Vulnerability: Capital flight
  - Description: Particularly relevant for countries whose financial systems are subject to rapid shifts in market sentiment, often associated with an overvalued currency, a weak banking system or unpredictable shifts in asset preferences.
- GIR to short-term (ST) external debt (based on remaining maturity):
  - Benchmark: 100%
  - Vulnerability: Liquidity
  - Description: Particularly relevant for countries with market access, substantial private external borrowing and/or large public debt service payments.
- GIR to ST external debt plus ST foreign-currency linked public domestic debt (based on remaining maturity):
  - Benchmark: No recognized benchmark
  - Vulnerability: Liquidity
  - Description: Particularly relevant for the countries above and those which have a large fraction of domestic debt denominated in foreign currency.
- GIR to ST external debt plus current account deficit:
  - Benchmark: No recognized benchmark
  - Vulnerability: Current account and liquidity
  - Description: Particularly relevant for countries with a large current account deficit and market access.
- Consolidated banking sector reserves (CBSR) to ST debt by remaining maturity plus resident’s foreign exchange deposits:
  - Benchmark: No recognized benchmark
  - Vulnerability: Liquidity
  - Description: Particularly relevant for dollarized economies.

### Vietnam: Key Reserve Adequacy Findings (2000–2005 / mid-2006)
- Import coverage of reserves:
  - Increased from about 2.1 months of imports in 2000 to 2.6 months of imports as of mid-2006.
  - Remains below the low-income country benchmark of three months of prospective imports of goods and non-factor services.
- GIR to broad money:
  - Ratio remained broadly steady over the past five years (relative to the period covered).
  - Used as indicator of vulnerability to capital flight triggered by loss of confidence in the domestic currency or banking system.
  - Vietnam has a lower reserve coverage of broad money than most countries in the region (notable exception: China).
- Dollar deposits and banking sector reserves:
  - Forex deposits rose from US$1.8 billion in 2000 to US$11.4 billion as of June 2006.
  - Banks’ net foreign assets (NFA) declined from US$4.6 billion in 2001 to US$3.2 billion in 2005.
  - GIR coverage of dollar deposits remained less than one hundred percent; consolidated banking sector reserves (CBSR) coverage exceeded one hundred percent in recent years.
  - Foreign-currency deposits declined from more than 40 percent of total deposits in 2000 to less than 30 percent in 2006, but degree of dollarization remains high relative to the regional average.
- Short-term external debt:
  - Coverage of short-term debt on a remaining maturity basis appears adequate.
  - Bulk of external debt is public or publicly-guaranteed and carries highly concessional terms; private debt mostly FDI-related and trade credits.
  - Expected trends: graduation from low-income status will progressively decrease concessionality of new public external borrowing and increase recourse to international capital markets; equitization and relaxation of borrowing regulations likely to raise private external debt exposure.

### Composite Minimum Benchmarks and Vietnam’s Position
- Composite benchmark based on short-term external debt falling due within one year plus potential capital flight proxied by 10 percent to 20 percent of broad money:
  - Using c = a + (0.1*b) and d = a + (0.2*b).
  - Vietnam held sufficient reserves since 2002 to cover the lower-range estimate (10 percent of broad money) but was insufficient to cover the upper-range estimate (20 percent of broad money) in earlier years.
- Composite benchmark based on short-term external debt plus foreign-currency deposits:
  - GIR fell clearly below this minimum threshold throughout the period studied.
  - CBSR hovered around or exceeded the benchmark in several years, indicating banking system reserves provided a more comprehensive buffer against runs on forex deposits.

### Transition Risks and Policy Implications
- Transition to a more open capital account will increase the relevance of balance-sheet vulnerability indicators and the need for improved monitoring of capital flows.
- Required institutional and regulatory improvements include:
  - Expanded monitoring of private sector foreign liabilities (short-term foreign liabilities of banking sector, unhedged foreign-currency debt of non-financial sector, SOEs’ foreign-currency liabilities, derivative exposures).
  - Effective management of debts of the enlarged public sector.
  - Sound supervision and regulation of financial institutions.
  - Improved corporate governance and insolvency regimes.
- Exchange rate regime considerations:
  - Pegged exchange rates usually require higher reserve coverage to stabilize the exchange rate and maintain credibility.
  - Move toward a more flexible exchange rate regime is the authorities’ medium-term objective and needs appropriate timing to minimize transition risks.

### Stress Test Scenarios and Results (Medium-Term Projections)
- Baseline Scenario (SEDP 2006–2010 assumptions):
  - Continued strong investment-led growth of around 7½ percent per year.
  - Foreign currency deposits assumed to stabilize at 20 percent of GDP.
  - Broad money rises to 100 percent of GDP by 2011.
  - Outcomes: reserve coverage of imports leveling off at 3–4 months; coverage of short-term debt based on remaining maturity averaging over 600 percent; GIR fully cover foreign-currency deposits; reserves above upper bound required to service short-term debt in event of capital flight or withdrawal of dollar deposits.
- Alternative Scenario 1 — Increase in short-term debt to regional average:
  - Short-term debt nearly triples from about 4 percent of GDP in 2005 to about 11½ percent of GDP from 2006 onward.
  - Outcomes: reserve coverage of short-term debt declines but averages more than 200 percent over the projection period (above the 100% Guidotti-Greenspan benchmark); inadequate to service short-term debt while covering capital flight equivalent to 20 percent of broad money and inadequate in case of a run on dollar deposits.
- Alternative Scenario 2 — Decline in the oil price:
  - Uses published Spring WEO baseline (3/9/2006) which assumes oil prices lower by 13, 20, 18, 17 and 15 percent over the years 2006–2010 relative to the August 1, 2006 WEO baseline.
  - Impact peaks at about -1 percent of GDP on the current account in 2007 and about -0.1 percent of GDP by 2009.
  - Outcomes: current account indicators and short-term debt coverage remain in safe ranges; composite minimum benchmarks remain basically covered.
- Alternative Scenario 3 — Worsening of the trade balance:
  - Trade deficit increases to about 6.4 percent of GDP (from 4.8 percent under the baseline).
  - Outcomes: stock of reserves 25 percent lower than under the baseline; coverage of short-term debt remains adequate but other indicators fall below respective benchmarks; GIR/Imports decline to < 3 months; GIR/ST Debt falls to < 100% over time.
- Alternative Scenario 4 — Combined effects of scenario 1 and 3:
  - Outcomes: reserves decline to < 3 months of imports; GIR/ST Debt falls to about 1½ times and then to < 100%; other indicators fall below benchmarks, including composite measures falling to < 10% in some cases.
- Alternative Scenario 5 — Increase in monetization:
  - Broad money rises to 145 percent of GDP (comparable to recent China levels).
  - Outcomes: reserves remain reasonably adequate to cover capital flight if short-term debt remains low; however, reserve coverage would be inadequate if short-term debt had risen to regional levels.
- Alternative Scenario 6 — Increasing dollarization:
  - Foreign-currency deposits increase to 30 percent of GDP by 2011 (from 20 percent under the baseline).
  - Outcomes: reserve accumulation would be insufficient to cover short-term debt by remaining maturity in the event of a run on forex deposits; GIR/Forex Deposits falling to < 80%.

- Summary table highlights (textual):
  - Baseline: GIR/Import > 3 months; GIR/M2 22–26%; GIR/ST Debt > 6 times rising to > 130%; GIR/Forex Deposits > 20% bound; Composite I above lower bound during 2008–11.
  - Alt. 1: GIR/ST Debt > 2 times; Composite II < lower bound.
  - Alt. 2: GIR/Import > 3 months; GIR/ST Debt > 5 times rising to 120%; Composite II < lower bound.
  - Alt. 3: GIR/Import declining to < 3 months; GIR/ST Debt > 5 times falling to < 100%; Composite II < lower bound.
  - Alt. 4: GIR/Import declining to < 3 months; GIR/ST Debt > 1½ times falling to < 100%; Composite I falling to < 10%; Composite II < lower bound.
  - Alt. 5: GIR/M2 falling to 18%; Composite I > 10% but < 20%.
  - Alt. 6: GIR/Forex Deposits falling to < 80%; Composite II < lower bound.

### Conclusions and Policy Recommendations
- Overall assessment:
  - Vietnam’s terms of trade and strong balance of payments imply current reserve levels are broadly adequate, though below the three-month import benchmark.
  - Most liquidity-based indicators point to low vulnerability; low openness to capital flows and concessional external debt have kept short-term debt low.
  - Under the staff baseline, vulnerability to external debt distress remains low over the medium term, though dollarization poses continuing risks.
- Policy recommendations:
  - Move toward greater exchange rate flexibility at an appropriate time to encourage hedging and risk management and reduce costly adjustments in future adverse scenarios.
  - Strengthen monitoring and regulation of capital account transactions and improve data reporting and disclosure requirements.
  - Put in place institutional arrangements to monitor private sector foreign liabilities, manage debts of an enlarged public sector, strengthen corporate governance and insolvency regimes, and upgrade supervision and regulation of the banking system.
  - Weigh the costs of reserve holdings (including sterilization costs and risks to the SBV balance sheet) against the benefits of lower vulnerability as capital account liberalization proceeds.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06422.pdf*

### References

### References and Excerpt: Assessing Real Exchange Rate Developments in Vietnam

### References (selected from source)
- De Beaufort Wijnholds, J. and A. Kapteyn, 2001, “Reserve Adequacy in Emerging Market Economies,” IMF Working Paper, WP/01/143, International Monetary Fund, Washington D.C.
- Greenspan, Alan, 1999, “Currency Reserves and Debt,” Remarks before the World Bank Conference on Recent Trends in Reserve Management, Washington D.C., April 29.
- Guidotti, Pablo, 1999, Remarks to the G-33 Seminar, Bonn, Germany (March 11).
- Hviding, K., M. Nowak, and L. Ricci, 2004, “Can Higher Reserves Help Reduce Exchange Rate Volatility?”, IMF Working Paper, WP/04/189, International Monetary Fund, Washington D.C.
- International Monetary Fund, 2001, “Guidelines for Public Debt Management,” International Monetary Fund, Washington D.C. http://www.imf/org/external/np/mae/pdebt/2000/eng/guide.pdf
- International Monetary Fund, 2001, “Issues in Reserve Adequacy and Management,” International Monetary Fund, Washington D.C. http://www.imf.org/external/np/pdr/resad/2001/101501.pdf
- International Monetary Fund, 2002, “Assessing Sustainability”, International Monetary Fund, Washington D.C. http://www.imf.org/external/np/pdr/sus/2002/eng/052802.pdf
- International Monetary Fund, 2004, “Liquidity Management”, (unpublished; International Monetary Fund, Washington D.C.).

### Key findings on Vietnam’s real exchange rate (from chapter excerpt)
- Long-run evolution of the dong’s CPI-based real effective exchange rate (REER) since 1992 appears broadly consistent with the Purchasing Power Parity (PPP) Hypothesis.
- Movements in the REER appear to have been in line with movements in key fundamentals such as the net foreign assets (NFA) of the banking system and the terms of trade.
- Opening up of the economy to international trade may have contributed to the depreciation of the REER during 2002-04, although the evidence on this effect is not statistically significant.
- The effect of differential productivity growth between tradable and nontradable sectors is estimated to have been statistically significant during 2000–05 but with the opposite sign from that predicted by the Balassa-Samuelson hypothesis, raising questions about the hypothesis’ relevance for Vietnam over that recent five-year period.

### Stylized facts on REER movements and associated macro variables
- CPI-based REER movements:
  - Appreciated significantly during the 1990s, rising by more than 30 percent between 1992 and 2000.
  - Depreciated by 15 percent during 2002-04.
  - Appreciated by 13 percent in 2005, largely reversing the 2002-04 depreciation.
- Inflation and nominal exchange rate dynamics:
  - Early/mid-1990s REER appreciation largely driven by Vietnam’s still high rate of inflation while the NEER showed no noticeable trend.
  - As inflation fell to the single-digit range in the late 1990s, REER movements began to reflect NEER trends.
  - Dong’s de-facto peg to the U.S. dollar helped keep NEER fluctuations narrow in the most recent two years covered, while persistently higher domestic inflation relative to trading partners produced significant REER appreciation.
- Balance of payments and external flows:
  - Strong FDI inflows exceeded 10 percent of GDP during 2002-04.
  - Export growth and FDI supported the balance of payments and foreign exchange market through the mid-1990s.
  - After the Asian crisis, FDI fell sharply and export growth slowed, contributing to downward pressure on the dong and partial reversal of earlier real appreciation.
  - Recovery in export growth in 1999–2000 produced large surpluses in the overall balance of payments (as measured by the change in the banking system’s NFA), helping stabilize the REER at a level about 30 percent above its 1992 level.
  - The depreciation of the REER in 2002-04 coincided with a significant narrowing of the balance of payments surplus; the depreciation was largely reversed in 2005–06 as the balance of payments surplus expanded again.

### Main fundamentals discussed and their theoretical effects on the REER
- Net foreign assets (NFA) of the banking system:
  - Higher NFA support a stronger real exchange rate via higher income from assets and increased domestic consumption, pushing up non-tradable prices and the REER.
- Terms of trade:
  - An improvement raises domestic income and strengthens the balance of payments, putting upward pressure on the REER; a positive terms of trade shock is akin to a positive productivity shock raising wages and non-tradable prices.
- Trade openness:
  - Multiple channels:
    - Removal of trade restrictions can reduce domestic tradable prices and discourage import substitution, tending to depreciate the REER.
    - If trade restrictions previously kept primary product prices artificially low (e.g., rice), liberalization can raise the overall price level and appreciate the REER.
  - Net effect can vary across phases of liberalization; empirical evidence for Vietnam on this channel during 2002-04 is not statistically significant.

### Empirical and graphical evidence (as summarized)
- Movements in the ratio of the banking system’s NFA to GDP track a substantial portion of the REER variation since the early 1990s.
- Terms of trade show greater short-term volatility but help explain longer-period REER variation.
- Figures in the source illustrate:
  - GIR coverage indicators (GIR as a percentage of GDP; GIR in months of total imports; GIR as a percentage of short-term debt; Ratio of GIR to M2; Ratio of GIR to Forex Deposits) with projections and alternative scenarios.
  - Coverage of a composite minimum benchmark based on Broad Money (M2) and on Forex Deposits under baseline and several alternative scenarios (e.g., Alternative 1: Short-Term Debt at Regional Average; Alternative 2: Lower Oil Price; Alternative 3: Worsening of Trade Balance; Alternative 4: Higher Short-Term Debt and Worse Trade Balance; Alternative 5: Higher M2 as percent of GDP; Alternative 6: Higher Dollarization).
- Note on scenario construction (from figure notes):
  - For M2-based benchmark: minimum benchmark = short-term debt (remaining maturity) + 10-20 percent of broad money; 10 percent benchmark (20 percent benchmark) interpreted as minimum reserves to service short-term debt in event of capital flight equivalent to 10 percent (20 percent) of M2.
  - For forex-deposits-based benchmark: minimum benchmark = short-term debt (remaining maturity) + foreign currency denominated deposits in the banking system; represents minimum reserves necessary to service short-term debt in event of a run on foreign currency deposits.
- Figure indices and series explicitly cited:
  - Nominal and Real Effective Exchange Rate Indices (2000=100) and Inflation (In percent).
  - The dong’s bilateral exchange rates vis-à-vis U.S. Dollar, Euro and Japanese Yen (Indices 2000M1=100).
  - Foreign Direct Investment (FDI) as percent of GDP; Import Growth; Export Growth; Change in NFA of the Banking System.

*Excerpted from: _cr06422 - References (and attached chapter pages on real exchange rate developments in Vietnam).*

### 10.      The role of openness to trade appears to have been more complex, possibly

### 10.      The role of openness to trade appears to have been more complex, possibly

### Trade liberalization, FDI, imports, and REER
- Vietnam’s signing of the ASEAN Free Trade Agreement (AFTA) in 1995 led to sharp reductions in tariffs on imports from the ASEAN countries.
- Under the US Bilateral Trade Agreement (BTA) signed in 2001:
  - average tariffs on Vietnam’s exports to the US were reduced to 3-4 percent from some 40 percent.
  - Vietnam undertook significant commitments to reduce its own tariff and nontariff trade barriers.
- These measures coincided with:
  - a rebound in FDI inflows,
  - a surge in imports for capacity expansion in foreign-invested companies,
  - a revival of strong export growth.
- Trade openness (total trade in goods and services) rose from about 50 percent of GDP in 1991 to over 150 percent of GDP in 2005.
- Although IMF Trade Policy Database shows Vietnam’s average tariff rate rose in the late-1990s and has since remained broadly unchanged, revenue-based measures (average customs revenue on imported goods as a share of imports) have been on a declining trend—suggesting tariff data may understate trade liberalization due to tariffication of quantitative restrictions.

### Export structure and commodity shares (1992 vs 2005)
- Manufacturing goods share of total exports:
  - 1992: 6 percent
  - 2005: 35 percent
- Crude oil share:
  - 1992: 31 percent
  - 2005: 23 percent
- Rice:
  - 1992: 12 percent
  - 2005: 4 percent
- Other primary commodities:
  - 1992: 37 percent
  - 2005: 18 percent
- Other: 1992: 14 percent; 2005: 20 percent
- Net oil exports amounted to 4.5 percent of GDP as of 2005.

### Real exchange rate (REER) and Purchasing Power Parity (PPP)
- Simple unit-root testing indicates Vietnam’s REER evolution is consistent with the PPP hypothesis for the sample 1992Q1-2005Q4:
  - Augmented Dickey-Fuller (ADF) statistic: -2.843
  - p-value [0.059]
  - Phillips-Perron statistic: -2.841
  - p-value [0.052]
  - Observations 56
  - R-squared 0.132
  - Adj R-squared 0.116
  - SE of regression 0.031
  - Durbin-Watson 0.99
- The null that the real exchange rate has a unit root is rejected in this testing framework.

### Methodology and data
- The analysis adopts Edwards (1989) extended-PPP framework to relate REER to fundamentals.
- Sample period and frequency:
  - quarterly dataset 2000Q1-2005Q4 (regressions reported for sample 2000Q4-2005Q4).
- Where quarterly data were unavailable (fiscal deficit, relative real GDP per capita, trade openness), cubic spline interpolation was used to generate quarterly data.
- Estimation method:
  - Phillips-Hansen fully-modified OLS (FMOLS) to address serial correlation and endogeneity concerns.
- Key variables (as used in regressions):
  - LREER: log(Real Effective Exchange Rate)
  - NFAGDP: Net Foreign Asset (percent of GDP) of banking system
  - TOT, LTOT: Terms of trade (and log)
  - FISCGDP: Fiscal deficit (percent of GDP)
  - OPENNESS: ratio of exports and imports to GDP
  - CUSTREV1: customs revenue from VAT on imports and taxes on exports (percent of imports)
  - CUSTREV2: customs revenue from VAT on imports (percent of imports)
  - LRGDPPC: log(Real GDP per capita relative to trading partners)

### Sample correlations (2000Q1-2005Q4) — pairwise coefficients (Table 2)
- Correlations with Real Exchange Rate:
  - Net Foreign Asset: 0.26
  - Terms of trade: -0.09
  - Fiscal Deficit: 0.01
  - Openness: -0.59
  - Custom Rev 1: 0.19
  - Custom Rev 2: 0.38
  - Rel. per capita GDP: -0.50
- Indicative interpretations from correlations:
  - REER positively correlated with net foreign assets of the banking system.
  - REER negatively correlated with measures of trade openness (higher total trade-to-GDP or lower customs revenue → more open).
  - Terms of trade are negatively correlated with REER over the sample (magnitude small).
  - Relative productivity (per capita GDP) is negatively correlated with REER—contrary to Balassa-Samuelson prediction.

### Regression results (FMOLS, dependent variable: log(REER); sample 2000Q4-2005Q4; p-values in brackets)
- Summary of main coefficient estimates (Table 3):
  - Constant:
    - column (i): 3.993 [0.000]
    - column (ii): 4.165 [0.000]
    - column (iii): 3.8746 [0.000]
    - column (iv): 1.7473 [0.231]
    - column (v): 2.141 [0.141]
    - column (vi): 1.3167 [0.352]
  - NFAGDP:
    - column (i): 0.022 [0.003]
    - column (ii): 0.022 [0.001]
    - column (iii): 0.019 [0.014]
    - column (iv): 0.021 [0.003]
    - column (v): 0.022 [0.002]
    - column (vi): 0.019 [0.015]
    - Interpretation: An increase in NFA of 1 percentage point of GDP is associated with an appreciation of the REER of about 2 percent.
  - TOT:
    - column (i): 0.006 [0.036]
    - column (ii): 0.005 [0.053]
    - column (iii): 0.007 [0.019]
    - Interpretation: A 1 percent increase in terms of trade is associated with a 0.6-0.7 percent increase in the REER.
  - LTOT:
    - column (i): 0.618 [0.043]
    - column (ii): 0.557 [0.061]
    - column (iii): 0.702 [0.022]
  - FISCGDP:
    - coefficients range from -0.006 to -0.004 with p-values [0.327]–[0.513] (not statistically significant)
    - Interpretation: an increase in the fiscal deficit is associated with an appreciation in the REER, but results are not statistically significant.
  - CUSTREV1:
    - column (v): 0.007 [0.954] (not significant; unexpected sign)
  - CUSTREV2:
    - column (vi): -0.006 [0.549] (not significant)
  - OPENNESS:
    - columns reporting OPENNESS: -0.008 [0.249] and -0.008 [0.435] (negative association but not statistically significant)
    - Interpretation: increasing trade openness as measured by total exports and imports as a share of GDP is associated with a depreciated REER, but not statistically significant.
  - LRGDPPC (relative per capita GDP, log):
    - coefficient examples: -0.547 [0.003]; -0.634 [0.000]; -0.351 [0.203]
    - Interpretation: sign is negative and in some specifications statistically significant—contrary to Balassa-Samuelson prediction.
- Note: shaded numbers in source denote coefficients significant at 10 percent or higher. Econometric software Microfit does not report R-square for Phillips-Hansen estimates.

### Interpretation of econometric findings
- Robust findings:
  - Net foreign assets of the banking system are positively and economically significantly associated with REER movements (≈ 2 percent REER appreciation per 1 percentage point of GDP increase in NFA).
  - Terms of trade shocks positively affect REER (≈ 0.6-0.7 percent REER appreciation per 1 percent TOT increase).
- Trade openness:
  - Broadly associated with a depreciation of the REER in some specifications, but effects are not statistically significant.
  - Customs revenue measures as proxies for openness are unreliable during parts of the sample due to tariffication of customs duties; some revenue variables show unexpected signs and lack statistical significance.
- Balassa-Samuelson effects:
  - Evidence does not support a significant Balassa-Samuelson effect during the sample period; relative per capita GDP (productivity proxy) coefficients are negative (some statistically significant), i.e., opposite to theoretical prediction.
  - Possible explanation: economy may not have been at full employment; excess labor in agriculture could dampen wage pressure in nontradable sector.

### Conclusions and caveats
- Main conclusions:
  - Movements in net foreign assets of the banking system and the terms of trade likely played a significant role in recent REER movements in Vietnam.
  - Trade liberalization appears broadly associated with REER depreciation in the period under review, but this effect is not statistically significant.
  - Balassa-Samuelson-type effects are unlikely to have been a major influence on the exchange rate during this period.
- Data and structural-change caveats:
  - Results are illustrative given data limitations, short sample period, and rapid structural changes in the economy.
  - A more rigorous estimation of determinants of the equilibrium REER will likely require longer data series and a period when the pace of structural change eases.

*Source: IMF staff estimates and analysis as presented in the chapter text.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06422.pdf_