Group 3 - Team IPO - Research Paper

8/8/2019 Group 3 - Team IPO - Research Paper

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RESEARCHPAPERG3TEAMIPO 1

ASSIGNMENT COVER PAGE

Subject Code: BAFI2089

Subject Name: Investment and Finance

Location where you study: RMIT Vietnam

Title of Assignment: Research Paper

File(s) Submitted Group 3 Team IPO Research Paper

Student name & ID: Bui Xuan Truong s3160821

Vu Thi Thuy Tien s3153733

Tran Ngoc Hoang Yen s3146085

La Nguyen My Tien s3146138

Learning Facilitator in charge: James Murphy

Assignment due date: 08-Sep-2008

Date of Submission: 08-Sep-2008

Number of pages including this one: (Pleasenumber your pages like this: page 1 of 7, page 2 of

7, etc)

19 pages

Words 3455 words


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2 INFLATIONINVIETNAM

Abstract: Discussing inflation in Vietnam from different aspects, thisreport aims at explaining the countrys development of inflation, thefactorsbehindthecurrenthighinflationlevel,theimpactsithasonthe

economy, and the remedies to deal with the issue. Focusing on theunderlying causes of inflation, concerning excessive growth of moneysupplyandaggregatedemandwithaleftwardshiftinaggregatesupply,themainsolutionsproposedareatighteningmonetaryandfiscalpolicyinthe shortterm and a flexible exchange rate combined with stronginvestmentintechnologyandeducationtopushaggregatesupplyinthelongterm.


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TableofContents

1. INTRODUCTION ....................................................................................................................4

2.VIETNAMSHISTORYOFINFLATION:........................................................................................4

2.1Period19751979:................................................. ............................................................. .................................................. 52.2Period19801984:... ......................................................... ............................................................. .......................................... 52.3Period19851989:... ......................................................... ............................................................. .......................................... 62.4Period19902000:................................................. ............................................................. .................................................. 62.5Period2001present: .................................................... ............................................................. ......................................... 7

3.CAUSESOFINFLATION:............................................................................................................83.1Demandpullinflation ...................................................... ............................................................. ......................................... 83.1.1Macroeconomicoverheating:...........................................................................................................................................8

3.1.2Inflexibleexchangeratepolicy ........................................................................................................................................8

3.2Costpushinflation .................................................. ............................................................. ................................................... 9

4.EFFECTSOFINFLATION: ......................................................................................................... 11

4.1Erodingpurchasingpower: ..................................................... ............................................................. ............................ 114.2Effectsonexchangerate,tradedeficitandforeignreserves: ............................................................................ 114.3Storageofotherassets: ................................................... ............................................................. ...................................... 124.4Discouragementofinvestment ........................................................ ............................................................. .................. 13

5.REMEDIES:.............................................................................................................................135.1Monetarypolicy:....................................................... ............................................................. ................................................ 135.2Fiscalpolicy: ..................................................... ............................................................. .......................................................... 14

5.3Supplysidepolicy: ................................................... ............................................................. ................................................ 14

6.RECOMMENDATION:.............................................................................................................15

7.CONCLUSION:........................................................................................................................17

REFERENCE:...............................................................................................................................17


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1. INTRODUCTIONThe purpose of this paper is to discuss inflation and history of inflation in Vietnam, the

causes and effects of the countrys current high inflation level, and the solutions available to resolvethe problem. We will first look at the development of inflation in major periods in the history of

Vietnams economy from 1975 until now. The report will then analyze different factors attributed to

the high inflation rates of Vietnam since 2007 in terms of both demand-pull and cost-push

inflations. After that, the current effects of inflation, mainly on the peoples purchasing power, the

trade balance, and investments, will be examined. Remedies to curb the inflation will be then given,

covering fiscal policies, monetary policies, and supply side policies. Finally, a recommendation will

be proposed combining different remedies and an action plan with clear time frames forimplementation.

2.VIETNAMSHISTORYOFINFLATION:

Inflation, as generally defined, is a sustained increase in the general level of prices for

goods and services (Investopedia 2008). Thus, the inflation rate measures the annual percentage

increase in price (Investopedia 2008). In Vietnam, the rate of inflation is calculated based on the

CPI, which is the consumer price index (US Department of State 2007)

Before analyzing different factors involved in the current high inflation level in Vietnam, it

is necessary to look at the historical facts of how the countrys inflation varied in the past 33 years

after the unification day. To gain an insight into different trends behind the statistics, the time is

divided into five main periods: 1975 1979, 1980 1984, 1985 1989, 1990 2000, and 2001

present. The graph below illustrates the fluctuated inflation level in the past 33 years, based on the

aggregated data from different sources:


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2.1Period19751979:

After the unification day, Vietnams economy was managed by the classical socialist model,

in which prices were rigidly set by the State. This administrative setting of prices imposed so-called

official prices on almost every kind of goods in the country. Only when the gap between the

prices of the parallel market and those of the official market was too much widened, the official

prices would be modified (Hung 1999). The prices, thus, did not reflect the real equilibrium of

supply and demand while the quantity of goods a person could buy was strictly limited by the

rationing mechanism. As a result, prices were kept quite stable and the inflation rate was relatively

low as shown in the graph.

2.2Period19801984:

The old system could not be sustained very long as there was no incentive for production

due to the mismatch between supply and demand. To stimulate more output, some small economic

reforms were made, two important ones of which were that farmers were allowed to sell theirsurplus products to the government at negotiated prices and the official prices were adjusted to


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better catch up with the free market ones. The reform, though resulted in a production recovery,

gave rise to a sharp increase in inflation to almost 100% (Klump & Bonschab 2004) due to the

States monetary expansion to assist with the rise in the official prices. Nonetheless, inflation in this

period was still partly restrained by the administrative pricing control and the rationing system

(Hung 1999).

2.3Period19851989:

The period experienced Doi Moi (which means renovation) that incorporated multiple

important reforms. The first reform in 1985 introduced a number of policies including pegging

official prices to market prices, monetization of workers income, removal of the rationing system,

and introduction of the new Dong(Hung 1999). Those led to a dramatic increase in the aggregate

demand as workers had higher incomes and the quantity of goods people could buy was no longer

restricted. The supply side, however, was inelastic as private sector development was blocked and

lands were still managed by the cooperatives, resulting in a surge in prices that had been largely

liberalized. In addition, the rise in the input prices and wages brought about a larger burden on the

budget deficit while the government already had to bear substantial subsidies (up to 5.3% of GPD in

1988 according to WB cited in Leung & Riedel 2001). The result was a rapid increase in money

creation to curb the deficits, leading to the volatile inflation level that peaked at 487% in 1986.

Fortunately, a comprehensive reform package in 1989 helped reverse the situation.

Agricultural lands were returned to farmers and trade was liberalized as private enterprises were

allowed to operate (Ninh 2003), providing a strong incentive to the supply side. Moreover,

government expenditure was cut back significantly with the removal of most subsidies, effectively

reducing the budget deficits from 8% in 1989 to 3.7% in 1990 (Hung 1999). In addition, deposit

rate was increased and access to credit of State-own enterprises (SOEs) was tightly controlled,

helping decrease the money growth. All of these components led to a drop of inflation rate to 35%

in 1989.

2.4Period19902000:

Vietnams economy in 1990s was stabilized with generally high economic growth and

slowing down inflation. Tax restructuring and non-inflationary financing resources were the two

important elements that further decreased the inflation level in this period (IMF 1998 cited in Ninh

2003; Hung 1999). The tax reform increased the government revenue, and thus reduced budget

deficit that might lead to monetary expansion. In addition, non-inflationary financing resources


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helped the government finance possible deficits without creating more money. Both of the two

approaches contributed to dampening the money supply growth. Moreover, due to the trade

liberalization and the lifting of the US embargo in 1994, capital inflow and exports increased

substantially, which eased the balance of payment. The result was impressive: inflation even

dropped to -1.7% in year 2000.

2.5Period2001present:


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Due to different reasons, the inflation level has gradually risen since 2003 and eventually

accelerating with a dangerous pace from year 2007 to present. Inflation from 2004 to 2006 (7.7%,

8.3%, 7.5% for the three years respectively) could be mainly explained by the increase in food

prices and fuel prices (Tumbarello 2007), which was strongly related to the global rising prices of

those commodities and the price liberalization policy (DBS 2008). However, double-digit inflation

from the end of 2007 (12.63% in December-2007) until now involves many other factors. In

August-2008, inflation peaked at 28.3%, the highest rate in 17 years (AP 2008). The situation is

attributed to a combination of different causes, including overheating of the economy, excessive

credit growth, increase in input prices, and inflexible exchange rate policy, which will be discussed

more deeply in later part. In fact, the government has implemented some measures to curb the high

inflation rate such as tight credit control and high interest rates. However, the effectiveness of those

measures still need to be examined in the future.

3.CAUSESOFINFLATION:

3.1Demandpullfactors

3.1.1Macroeconomicoverheating:

After being the 150th member of Word Trade Organization (WTO) in 2006 (Houng, Patrizia,

Noel and Pritha, 2007), Vietnam experienced soaring capital inflow and consumption. With a boom

in the real estate and stock markets last year, investment grew by 14% along with an excessive

growth in credit by 35% in the first half of 2007 (ADB 2007), leading to an increase in money

supply and aggregate demand. In the same period, due to higher incomes generated in those markets

and wage increases in other sectors, consumption was also pushed up with a rise of 23% in the retail

sector. On the other hand, infrastructure and skilled labor were in shortage (McCarty cited in ABC

2007), meaning aggregate supply was inflexible while aggregate demand was growing fast, which

overheated the economy and caused inflation.

3.1.2Inflexibleexchangeratepolicy

Since Vietnams accession to WTO, a large amount of foreign investment has been poured

into Vietnam and put an upward pressure on the Dong, threatening to weaken export

competitiveness (Theedgedaily 2008). Therefore, from 2004 to 2007, to encourage more foreigninvestment and maintain exports, the State Bank of Vietnam (SBV) applied the fixed exchange rate


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policy, setting theDongto depreciate by buying more than 10 billion USD (DBS 2008). As a result,

quantity ofDongflowing in the market went up (Chi and Bao, 2008), leading to a surplus in money

supply and higher liquidity. To solve the problem, SBV has applied sterilization: issuing bonds to

withdraw money from circulation in order to balance the demand and supply. However, because the

sterilization process was incomplete and the pegged exchange rate system was not flexible (DBS

2008), there was still surplus money flowing in the market, subsequently contributing to a higher

aggregate demand and inflation.

3.2Costpushfactors

Cost-push inflation is associated with a leftward shift in aggregate supply due to higher

costs of inputs. Like other countries, Vietnam has partly suffered high inflation because of the rise

in prices of crude oil, foodstuff and construction materials.

Energy crisisIn 2008, the world price of crude oil has skyrocketed: from $72 per barrel in 2007 to an

expected average $119 per barrel in 2008, increasing by 64.7% (EIA, 2008). This forced the

government to adjust the petroleum price to 19000 VND in July-2008, pushing up the prices of

other commodities. However, the effect of high petroleum price on inflation will be lower in the

future as the price has been reduced to 17000 this August-2008.

Source: EIA 2008


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Food price crisisDue to the increase in wealth and income in Asia especially China and India and ethanol

subsidies in America, the world prices of food like meat jumped dramatically over the late 2007 and

the early 2008 (The Economist 2007). Because of further price liberalization in the Vietnams food

market, domestic food prices have tracked the world prices, contributing to a 25% food inflation

rate YoY in February-2008 (DBS 2008). The spike in food price was also exacerbated by the rice

shortage rumor in April-2008, which caused people to hoard rice, leading to a self-fulfilling cycle

(Theedgedaily 2008).

Source: DBS Research Group 2008

Construction materialsOverall, construction materials' prices rose by 24.9% from 2007 to July 2008 (ROL 2008)

with main materials being steel, brick, and cement. This could be partly explained by the increases

in prices of imports of those materials, which was influenced by the international market (Phuong

2007).

Although Vietnam suffers both cost-push and demand-pull inflations, demand-pull inflation

should receive more concern as it is considered the main cause for higher inflation in Vietnam

compared other countries, which also suffer the same rising costs of inputs (Chi & Bao 2008)


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4.EFFECTSOFINFLATION:

4.1Erodingpurchasingpower:

Foreign capital firms State-owned enterprises

Supervisory staff 12 3

Office workers 2.2 1.4

Shop-floor workers 1.3 1.1

Table 1: Average wages in million Dong

Source: BNET, 2008

Though inflation is supposed not to affect peoples purchasing power in the long-term as

income will be automatically adjusted to match the rising prices in the future (Mankiw 2003), it

does in the short-term due to the wage stickiness. In fact, wage earners and firms did take intoaccount of inflation when setting the salaries. However, as the actual inflation is higher than the

expected one, the living standard of fixed income people, especially the working class, deteriorates.

The low average wages of workers in both state-owned and foreign firms, as shown in the table

above, have triggered thousands of them to go on strike this year (AFP 2008). High inflation may

also redistribute wealth of the society: from fixed income people to variable income ones, possibly

widening the gap between the rich and the poor.

4.2Effectsonexchangerate,tradedeficitandforeignreserves:

According to the purchasing power parity law (Viney 2007), a relatively high level of

inflation should produce a downward pressure on the value of VND, which is supposed to reduce

the VND/USD exchange rate. However, in pursuit of stabilizing the exchange rate to avoid market

volatility and import inflation, the SBV has been defending theDongby using foreign reserves to

buy VND, helping the currency appreciating against the inflationary pressure. Nonetheless, whilethe nominal effective exchange rate (NEER) is kept in control, the real effective exchange rate


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(REER), which reflects the relative prices of exchanged goods, is rising sharply corresponding to

the high inflation level (Theedgedaily 2008). As a result, exports become relatively more expensive

and imports become relatively cheaper. This not only undermines the competitiveness of exports

but also aggravates the trade deficit, which is better illustrated in the graph below:

Source: Theedgedaily 2008

Another indirect issue of current inflation is when the SBV uses foreign reserves to defend

the Dong, it is facing a risk of depleting the foreign reserves, which may lead currency crisis just

like Thailand in 1997 (Business News 2008). In short, the high rate of inflation puts the SBV in a

catch-22 situation: a Dongappreciation will help curb import inflation but widen the trade deficit

and possibly cause a currency crisis while a Dongdepreciation will improve the trade balance but

may worsen inflation due to higher prices of imports (Intellasia 2008)

4.3Storageofotherassets:

Inflation is forcing theDongto depreciate, encouraging people to store other assets such as

USD or gold to protect their wealth. Thus, hoarding of gold has actually risen, leading to a sharp

increase in gold imports with 1.2 billion USD imports of gold in the first four months of 2008,

compounding the high trade deficit (Theedgedaily 2008).


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4.4Discouragementofinvestment

As inflation is difficultly predictable, companies face confusion and inconvenience when

planning for investment (Mankiw 2003). The higher the inflation rate is, the more uncertain it is for

firms to predict the future costs and revenue, deterring them from easily accepting investment

projects. More over, cost-push inflation, one component of the current inflation, increases the firms

input costs, causing great difficulties to their operations, especially when the tightening policy takes

place.

5.REMEDIES:

5.1Monetarypolicy:

Tightening money supply:One of the first remedies the SBV should consider is a tightening monetary policy, including

bond issuance, raising compulsory reserve ratio, and tighter credit control. SBV can force

commercial banks to purchase bonds to reduce the money supply. A similar result can be achieved

by a higher reserve ratio imposed on the banks, effectively reducing their lending cash available.

Decrease in money supply resulting from the two measures may lower the aggregate demand due to

the consequent higher interest rates, leading to lower inflation. In addition, access to credit,

especially that of inefficient state-owned enterprises (Minh 2008), needs to be tightly controlled to

restrain the credit growth. This can only be done by closely supervising the compliance of the

commercial banks with the regulations on lending and credit quality. One disadvantage of the

remedy is if applied for too long, it may strongly discourage investment due to the higher costs of

taking loans enterprises have to bear, possibly leading to unemployment and even recession.

Moreover, it may also cause a deposit interest war among banks to improve their liquidity, which

actually has happened, bringing about their lower profitability, especially that of small banks (VNS

2008). As a result, higher lending interest rates will come, putting more burden on enterprises.

Regarding the credit control, if the policy is too rigid, it may cause harm to export activities and

production of key commodities (Huong cited in VietnamNet 2008)


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Exchange rate policy:- Fixed exchange rate: in current situation, a fixed exchange rate regime may prevent the

dongfrom weakening too fast, avoiding a surge in imports prices when demand for many kinds of

imports is inelastic, helping lower the inflationary pressure (VNS 2008). However, the policy can

lead to a higher trade deficit and a serious drain on foreign reserve. In the long-term, it will even

trigger inflation again as discussed earlier

- Floating exchange rate: as mentioned above, a floating exchange rate policy will prevent

an increase in money supply in the future, which is a cause of inflation, as it eases the need for

SBVs intervention and sterilization (Ishii 2007). However, if immediately floated at present, the

exchange rate will cause significant volatility and worsened inflation due to higher imports

prices as commented by Tai Hui - banks senior Southeast Asian researcher (VNS 2008).

5.2Fiscalpolicy:

Cutting of government spending: a reduction in government spending will decrease theaggregate demand, curbing the high inflation level. Public spending on infrastructure projects is the

most important one to be cut. However, only inefficient and unimportant projects should be

cancelled. Thus, an effective system for monitoring and evaluating public projects efficiency must

be established. In addition, administrative expenses in state-owned corporations must be closely

supervised and saving in this sector should be promoted

Import taxes: as one cause of inflation is the rising costs of foodstuff and materials, apossible solution is cutting import tariffs on those goods to ease the price pressure. However, lower

tariffs may lead to budget deficit as State revenue is reduced. It may also aggravate the trade deficit

due to the consequent higher demand for imports (Nghia cited in Laodong 2007).

5.3Supplysidepolicy:

Encourage production:As inflation relates to aggregate demand growing faster than aggregate supply, it is

suggested that the aggregate supply should be pushed up to bring down the increasing price

level. This can be achieved by higher development in agricultural, industrial, and service

sectors. As ordered by Prime Minister Nguyen Tan Dung (VietnamNet 2008), growth in

agriculture must be maintained with the support of the government in dealing with disasters and

epidemics, which happen frequently in Vietnam. Obstacles in administrative procedures must

also be removed to promote production development. More importantly, technology and quality


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of labor, which are two determinants of aggregate supply in the long term (Mankiw 2003), need

to be focused by investment in research and education. This, however, may face difficulty in the

short-term as the investment can be deterred by the tightening policy to fight inflation.

Stabilize and subsidization:According to the Prime Minister, price stabilization of basic commodities and services such

as electricity, fertilizer, cement, and transport fares, must be retained (VietnamNet 2008). The

solution is the government will keep prices of those things low to reduce the effect of inflation.

However, this comes at a cost that low prices will lead to no incentive for production (Du 2008),

resulting in lower quality and even lower quantity supplied. Regarding petroleum, there is an

idea that it should be subsidized by the government to curb inflation despite the high oil prices

of the world. Nonetheless, the costs of doing so are not low, including higher budget deficit,

distortion in resource allocation, and prevention of developing more efficient alternative modes

of transportation (Hameed 2008).

6.RECOMMENDATION:

The final recommendation we have come up with is a combination of different remedies rather

than a single solution:

- Monetary policy: issuing compulsory bonds, raising reserve requirements for commercial

banks, and tightening credit growth are the right remedies the government should implement to

reduce the money supply. Reserve ratio can be set at 12% for short-term deposits and 6% for

long-term deposits. To prevent the deposit interest war, SBV can impose an appropriate

basic interest rate on banks so that their rates cannot exceed more than 150% of the basic rate.

With the tight credit control, access to credit of producers of key commodities in agricultureand export activities will be given more flexibility to encourage production. Those remedies

can only last for one and a half years to prevent economy stagnation and high unemployment.

Regarding the exchange rate policy, a fixed exchange rate will be maintained in the very short

term to avoid rising prices in imports. However, the trading band will be widened gradually

combined with attempts to increase exports and decrease imports to reduce the trade deficit and

ease the running out of foreign reserves, aiming at a floating exchange rate in the next two

years.


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- Fiscal policy: cutting public spending on unimportant projects such as buildings and cultural

houses is a good remedy. However, important projects related to energy and traffic system

must be continued. A monitoring system to supervise project efficiency will be set up to clear

out inefficient plans. In the short-term, import taxes on important commodities such as

construction materials and foodstuff will be cut by 30% while tariffs on luxury goods such as

autos and alcohol will be raised by 60% to offset the rise in trade deficit and budget deficit.

- Supply side policy: prices of electricity, cement, fertilizer and transport fees will be kept

unchanged until the middle of 2009 to mitigate the inflationary pressure. After that, those

prices will be more flexible to provide incentives for production. Oil subsidy, however, will not

be granted due to many drawbacks as discussed earlier. In the long-term, what most important

is more investment must be poured in technology and education to bring aggregate supply to a

higher level.

ACTION PLAN:

DurationTask

Start End

Bond issuance (25 trillion VND) Jan 2008 N/A

Increasing reserve ratio (12% for short-term deposits and 6% for

long-term deposits

Jan 2008 Jun 2009

Tighter credit control Jan - 2008 Dec 2009

Fixed exchange rate with a gradually widened trading band Jan - 2008 Jun 2009

Floating exchange rate Jun - 2009 N/A

Cutting government spending Jan 2008 Jun - 2009

Cutting import taxes on commodities by 30% and raising tariffs on

luxury goods by 60%

Jan - 2008 Jun - 2009

Price stabilization for electricity, cement, fertilizer, and transport fees Jan - 2008 Jun - 2009

Higher investment in technology and education Jan - 2008 N/A


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7.CONCLUSION:

After 1975, Vietnams economy experienced skyrocketing inflation levels in the late 80s but

then enjoyed a stable growth and low inflation in the 90s. However, inflation again has become a

threat to the country in recent years, with the latest rate peaking at 28.3% this August-2008. The

three main causes identified for the situation are the overheating of the economy, the inflexible

exchange rate policy from 2004 until early-2007, and the rising prices of important commodities

mainly influenced by the international market. The high inflation consequently has eroded the

purchasing power of fixed-income people, increased inequality in the society, aggravated trade

deficit with a threat of currency crisis, and discouraged investment. Among remedies available,

tightening monetary policy and cutting in government spending are most important in the short-

term while a flexible exchange rate policy and larger investments in technology and education are

more important in the long-term.

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Group 3 - Team IPO - Research Paper