April 17, 2008
In the recent months, inflation has become the largest socio-economic problem in Vietnam. The main cause of this inflation is large capital inflow relative to the absorptive capacity of the Vietnamese economy. It is causing the consumption boom, the construction boom, asset market instability, inflation, and the ballooning trade deficit. Additionally, overheating has been fueled by strong public spending and supply shocks such as global commodity inflation, natural disasters and animal diseases.
Once the situation has come to this level, some damage to the macroeconomy is inevitable. The policy goal should now be to shorten and minimize the damage. Specifically, the government should aim at the soft landing of the macroeconomy rather than the crash. Soft landing means temporary disturbances in growth, living standards, market order and the financial sector with positive (but lower-than-expected) growth this year. By 2009, the worst time should be largely over. By contrast, the crash means falling into near-zero or even negative growth, credit crunch, accumulation of bad debt, and significant decline in people’s welfare for at least a few years. At present, there is a good chance of soft landing if the following policy package is implemented. Although not perfectly, the Vietnamese government is already moving toward this policy package.
First of all, the growth target for 2008 must be lowered from upper 8%. This has already been done. 6.5-7.5% is still a very respectable growth target in a bad year like this.
Second, credit and money must be tightened. The State Bank has already adopted bold measures such as raising bank reserve ratios and forced TB purchases. Some criticize these as non-market tools, but in a near-crisis situation all measures must be tried including administrative ones. The only condition is that they must be applied in proportion with the problem size and not excessively.
Third, public spending must be curbed, at least for this year. Investment has two effects, on supply and demand, and they tend to conflict with each other. While construction of infrastructure is absolutely necessary to sustain long-term growth, it increases domestic demand and accelerates inflation. In 2008, the second effect must be the main concern and temporary slowdown of public spending must be accepted. High public investment can be resumed when the macroeconomic balance is restored. Public investment must also be efficient, but that is a long-term goal not achievable immediately.
Fourth, the land bubble must be popped. In an overheated economy, commodity inflation and asset bubbles usually go hand in hand, enhancing each other. Vietnam’s stock market bubble burst last year, and excess liquidity shifted from the stock market to the land market. At present, real estate prices are still very high though there is some sign of slowing down. Falling land prices will cause some difficulties in the balance sheet of commercial banks (through souring of real state loans and collaterals) but the government should not be too worried about this. The size of potential bad debt in Vietnam will be proportionately less than the US subprime shock or the Japanese banking crisis in the 1990s. Under the current circumstances, the cost of delaying the adjustment is likely to be higher than the cost of bursting the real estate bubble now.
Fifth, the State Bank should monitor and curb commercial bank loans administratively, especially loans going to the real estate market, until all asset markets return to normal. This should be more effective than forced TB sales in cooling the overheated economy.
Sixth, capital inflow should be monitored closely in terms of volume and sectors. Administrative regulation may be introduced temporarily, if necessary, until macroeconomic stability is restored.
The important thing is that all these measures should be used simultaneously and moderately, rather than relying on one measure excessively. For example, tight credit is easy to adopt but if this tool is used too strongly, it will create severe distortions in the financial market. How much is “moderate” for each measure is difficult to say in advance. The government must be pragmatic and attentive in adjusting the intensity of the policy measures above.
How about price controls and busting monopoly? Around the world, these measures are often used to punish “bad guys” and show the government’s determination to do something. But economically, they are rarely effective. When all costs are rising, it is unfair to criticize some sellers for raising their prices. The problem must be solved macroeconomically.
Finally, adopting a flexible exchange rate is recommended by many economists and international organizations. However, it is not a fundamental solution. When overheating is caused by capital inflow, exchange rate adjustment can do little to improve the macroeconomic trade-off. Depreciation will worsen the inflation and appreciation will accelerate the loss of competitiveness. In the current situation of Vietnam, the exchange rate is at best a secondary policy tool whose effects should not be overestimated. Even if the Vietnamese dong is unchanged against the US dollar, macroeconomic soft landing can be attained by the policy package suggested above. Top priority should be to remove liquidity from the domestic goods and asset markets.
(Published in Saigon Times, May 3, 2008)