Sri Lanka’s Mercantilists have for several years stared in envy at Vietnam, claiming that it was an ‘export oriented’ country and if only exports grew and island’s monetary troubles involving forex shortages and balance of payments troubles would end. It did not end there. It was further claimed that growth of non-traded sectors was bad and that was the reason for repeated external troubles.
Until recently the very same Mercantilists directed the same admiration at Bangladesh. Now with Taka falling they are foxed. The reason currencies fall has nothing to do with trade as Mercantilists imagine. The reason currencies fall, and reserves are lost is because central banks print money to suppress rates either for flexible inflation targeting now or for growth in the old days. In a nutshell pegged exchange rate collapses due to the policy rate. To be exact, the policy rate being mis-targeted.
Typically, even fairly well-managed pegs collapse after about 8 to 10 years, in the second or third Fed cycle (See Graph 1).
The Vietnam dong last collapsed around 2011 when the country tried a stimulus gambit soon after the US Fed’s 2001-2009 bubble collapsed. To stop the stimulus credit bubble – which had also been running for many years in line with the Fed, policy rates had to be raised to 13% (see Graph 2).
In 2018 when the US hiked rates, policy rates were around 4%, enough to slow credit and keep the economy stable. Vietnam has a two way liquidity auction system which allows interbank rates to go up around 150 basis points without a policy rate hike.
Vietnam did not print money unlike other countries during the pandemic. However, rates fell as automatically domestic credit slowed for a while, and the central bank collected reserves. The central bank followed by cutting rates.
As the economy recovered in 2021 the State Bank of Vietnam did not raise rates. When the US started hiking rates, the 2.5% rate was not good enough to slow credit. The currency started to come under pressure from around June. Unlike currency boards, soft pegs have to inject new money into the banking system to sterilize interventions, allowing banks to continue lending without deposits (see Graph 3). The low rates in the second or third cycle, is the key reason pegs collapse in the second or third Fed cycle after the original collapse.
IMF AND US PRESSURE
Vietnam had another problem. It came under pressure from the US and IMF to run inconsistent and non-credible discretionary policy instead of simply raising rates to maintain the exchange rate (external anchor) and maintain stability, the bulwark of its economic success.
East Asian central banks generally keep rates slightly higher than the US and collect reserves instead of printing money, running a gently deflationary policy. However, Washington and the IMF put pressure on Vietnam to abandon this policy claiming that it kept the currency undervalued using cherry picked statistics.
Washington falsely labelled Vietnam as a currency manipulator as the fixed exchange rate stability boosted foreign investment and exports, claiming it was creating a trade surplus unfairly. IMF piled on the pressure falsely claiming that the Dong was under-valued using the so-called EBA-lite model asking for domestic investment to be pushed up.
“CA strength should be addressed through structural, institutional, and financial sector reforms to raise private investment and protect public investment while raising its efficiency,” the 2019 IMF staff report said.
“The modernization of the monetary framework, with greater two-way exchange rate flexibility, would also help external adjustment by facilitating nominal appreciation and reducing the need to accumulate reserves.”
The IMF claimed that the Dong was undervalued despite having a real effective exchange rate of 130 points, another statistical method used to ‘value’ an exchange rate. The pressure to ‘modernize’ the monetary policy framework is nothing other than a call to print money using discretionary policy without having a floating exchange rate. Though Vietnam got through the 2018 tightening cycle with overnight rates rising, IMF has had some success in destabilizing its policy.
“The modernization effort has been gradually implemented in line with the Decision No. 986/QĐ-TTg dated on August 08, 2018, by the Prime Minister which requires, as conditions allow, the monetary policy to be conducted mainly through the SBV’s operations in the financial markets, and for the administrative measures to be removed,” an IMF report said in 2020.
“The SBV appreciates the support offered by the IMF through the FPAS program, which aimed at enhancing the liquidity forecasting and policy analysis capacity of the SBV. The initiative is part of the overall efforts to modernize the monetary policy framework, taking into consideration the international best practices and the country specifics.”
MONETARY POLICY MODERNIZATION
Monetary policy modernization is nothing other than new tools to inject liquidity into the banking system, allowing banks to lend without deposits and generally target rates in a pegged regime. Sri Lanka came to grief with similar policies.
Whether rates are cut and enforced with liquidity injections for stimulus (basically John Law), for flexible inflation targeting (contradictory anchor conflicting policy), or to accommodate a real shock – like Covid-19 the results are the same. SBV however is trying to resist the IMF pointing out that the external anchor has helped bring stability to the country.
“The SBV operates the exchange rate policy within the monetary policy frame work to achieve long-term objective of prices and macroeconomic stability,” the IMF’s staff report said two years later.
“The authorities emphasize the importance of implementing exchange rate management mechanism that suites the current level of financial market development as well as the monetary policy framework.
“For Vietnam, stability of the exchange rate has played a crucial role in anchoring inflation and market expectation. The monetary policy framework with current exchange rate management mechanism has effectively helped the SBV achieve the ultimate goals of macro economic stability and anchoring inflation expectation during the volatile and highly uncertain period.”
However, a non-credible peg is a non-credible peg. It is not a hard peg. Whether the changes made to the SBV framework under pressure from IMF will bring down the country in 2022 remains to be seen. But by 2022 the IMF got its extra domestic investment wish in Vietnam. Property investment picked up substantially.
When the US started to suddenly hike rates, after printing money in 2020 and 2021, Vietnam was late in raising rates. The dong started to come under sustained pressure from around June as the economy continued to recover and large volumes of reserves vanished, the State Bank of Vietnam is rapidly raising rates, which is having knock on effects. In October there were rapid rate rises. Now policy rates are at 6%.
The property sector is under substantial pressure. There are a large number of uncompleted projects with rates rising. Low interest rates have also pushed savers into risky bonds. At least one such scheme has already got into trouble. There are long queues for fuel, the reason for which is unclear.
When reserve collecting economies start to unravel media and pundits will blame everyone else, other than flexible policy. The companies were over-extended.
They got into property. They got into nontraded sectors. The heedless push not to run deflationary policy and the push to boost domestic investment to stop collecting reserves by Washington would be forgotten.
Currency boards (and currency boards like central banks) which raised rates earlier and matched the domestic credit cycle more to the US would fare better. Cambodia is also doing well under dollarization. Though pressure to operate ‘monetary policy’, in other words to give power to half a dozen persons in a rate setting committee to decide interest rates for an entire nation and being mis-targeted under stimulus, is being brought by the IMF.
Like Sri Lanka, discretionary monetary policy has succeeded spectacularly in Laos with the currency collapsing from 9.500 to 17,500 to the US dollar over the past year. Most developing countries operate such ‘flexible exchange rates’ where monetary policy errors and forex shortages from sterilized forex sales are compensated by currency depreciation.
There is little hope for such countries where the entire economic community and the IMF is behind non-rule based flexible policy for two reasons: a) the softpegged central bank refuses to give up collecting reserves through a peg and clean float, and b) refuses to run policy compatible with a reserve collecting peg. Flexible policy will dominate, with its inevitable consequences.