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UNCLAS SECTION 01 OF 03 HANOI 001729 
 
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E.O. 12958: N/A 
TAGS: EFIN EAID ECON PREL VM
SUBJECT: VIETNAM'S INFLATIONARY CONUNDRUM 
 
Ref: Hanoi 1475 
 
HANOI 00001729  001.2 OF 003 
 
 
¶1. (SBU) Summary:  Vietnam is not sure how to tackle growing 
inflation, which reached a 20-month high of 8.8% in September. 
Government efforts to maintain simultaneously a stable exchange 
rate, low interest rates and open capital markets run smack into the 
"impossible trinity" of economic theory.  Most central bank 
officials and economists acknowledge the limitations with the more 
modest measures used to date to deal with rising prices.  As 
inflation continues to mount, pressure will increase on the 
government to make a policy choice for a stronger dong, higher 
interest rates or capital controls.  Exercising these options could 
make exports less competitive, raise the cost of doing business or 
exacerbate uncertainty in capital markets, respectively, affecting 
various constituencies, such as farmers, business people and 
investors, differently.  Notwithstanding public pronouncements for a 
targeted depreciation, it appears that the government is keeping all 
options are on the table, including a more flexible currency, as a 
means to tame inflation.  End Summary. 
 
VIETNAM'S IMPOSSIBLE TRINITY 
---------------------------- 
 
¶2. (SBU) Vietnamese newspapers have been filled with reports about 
rocketing inflation, and the average Vietnamese person will confirm 
that the cost of daily existence has gone up.  The most recent 
release from the General Statistics Office shows that inflation is 
at 8.8% for September, up from 8.6% in August and 8.4% in July.  The 
Government of Vietnam has reacted to the public concern by cutting 
tariffs on food and other consumer goods (see reftel).  The results 
of these cuts, however, have not been swift or significant, even 
with official efforts to follow through on whether sellers have 
passed on the benefits of lower input prices to consumers.  The 
ineffectiveness of these supply-side measures has led to larger 
questions about Vietnam's macroeconomic management policy.  It 
appears that Vietnam is facing the classic "impossible trinity" of 
open economies - the economic incompatibility of maintaining a fixed 
exchange rate, free capital movement and an independent monetary 
policy which fixes interest rates at non-market levels.  A country 
can generally have two out of the three, but Vietnam is trying to 
have them all.  The combination of a dong essentially fixed against 
the dollar and a low, fixed interest rate will be impossible to 
maintain over the long term as strong capital inflows into the 
Vietnamese markets will increase the upward pressure on inflation. 
 
 
What's Driving Inflation? 
------------------------- 
 
3.(SBU) There are various factors causing the general price level to 
rise in Vietnam, including increased domestic demand for goods and 
services, including imports, as the economy continues to expand 
combined with issues on the supply side.  Vietnamese economists, 
however, have also pointed to the impact of another contributing 
factor as the country becomes more integrated with the global 
economy, namely, the inflow of foreign capital.  Vietnam's young 
stock market and improved investment climate have attracted a flood 
of new money that has affected domestic prices.  The Treasurer for 
HSBC reported that the SBV was "shocked" by the amount of foreign 
capital inflows coming into Vietnam starting in late 2006.  Although 
there is no official number, various estimates by both the private 
sector and the Government of Vietnam put the amount of foreign 
portfolio investment into dedicated Vietnam-only investment funds at 
around five billion dollars. 
 
¶4.  (SBU) In the last quarter of 2006, foreign capital inflows began 
to increase substantially and create pressure on the dong to 
appreciate.  In the first quarter of 2007, the government considered 
but refrained from the option of imposing capital controls.  The 
State Bank of Vietnam (SBV) did, however, intervene to hold down the 
value of the dong with by its purchases of dollars.  The government 
reinforced its policy further in this direction of a weak dong on 
June 25 when Deputy Prime Minister Nguyen Sinh Hung announced the 
target of a one percent depreciation in the exchange rate for 2007 
to support exports.  At the same time, the government has been 
targeting low interest rates to support growth. 
 
¶5. (SBU) Letting the dong appreciate and raising interest rates on 
bank loans would have dampened inflationary pressures, but the GVN 
policy to hold the exchange and interest rates constant has left the 
government with few effective tools at its disposal.  Thus, the SBV 
resorted to other instruments to try to attempt to control 
 
HANOI 00001729  002.2 OF 003 
 
 
inflation.  In May, the SBV raised the reserve ratio to 10 percent 
up from 5 percent for dong deposits up to one year and to 4 percent 
up from 2 percent for 12-24 month dong deposits.  In July, the 
government reduced a range of import tariffs and retail fuel prices 
(reftel).  On August 14, as inflation continued to rise, the SBV 
announced further measures: an increase in the 84-day T-bill yield 
of 25 basis points to 5 percent, and a new one-year T-bill and set 
yields at 7 percent.  These bills, which earn what is essentially a 
negative real interest rate, were not big sellers and allegations 
abound that the SBV engaged in pressuring the commercial banks into 
purchasing them.  As most economic analysts expect inflationary 
pressures to continue, the SBV's dilemma will become more difficult 
unless it changes the course followed so far with respect to a 
stable (and indeed weaker) exchange rate, a low interest rate, and 
relatively free flows of capital. 
 
Why is the GVN fixing currency and interest rates? 
--------------------------------------------- ----- 
 
¶6.  (SBU) GVN authorities have targeted a one percent depreciation 
of the dong in order to support exports, which account for 69 
percent of GDP.  The HSBC Treasurer emphasized that GVN officials 
are especially sensitive to a weak dong's positive impact on the 
competitiveness of Vietnam's agricultural exports.  Market tools for 
hedging, such as foreign currency futures or commodity futures, are 
not well-developed or widely understood by local agriculture 
producers.  Agriculture comprises 20 percent of GDP and employs 
approximately 55 percent of the labor force.  Another economist from 
the Fulbright school added that income (unadjusted for inflation) in 
the rural areas has not been increasing over the past few years.  As 
a result, the share of the labor force in agriculture has been 
dropping by about 2 percent a year since 2002 as labor has moved 
from rural to urban areas.  Moreover, the GVN has made poverty 
reduction a central theme of its economic reform agenda, and as 
migration to urban centers increases, fostering the economy of rural 
areas has become increasingly important.  Thus, the government is 
concerned that a stronger dong would make agricultural exports less 
attractive and hurt farmers.  That said, the economist opined that 
Vietnamese authorities are not as wedded to a long term targeted 
exchange rate as Chinese authorities. 
 
¶7.  (SBU) Vietnamese authorities have also targeted a low interest 
rate to support growth.  Interbank lending rates currently are 
approximately 6 to 7 percent, and lending rates are in the low to 
mid double digits.  According to the Fulbright School economist, 
some influential voices in the business sector oppose an increase in 
interest rates as it would increase the cost of funding new and 
existing enterprises during a time of rapid economic expansion. 
 
What can the SBV do? 
-------------------- 
 
¶8. (SBU) The difficulty of balancing these competing interests 
becomes more apparent when speaking with the State Bank of Vietnam. 
Various SBV officials give conflicting assessments of the issue and 
of the State Bank's ability to control monetary policy in their 
meetings with Econoff and visiting Treasury Deskoff.  Deputy 
Division Chief of Market and Exchange Rate of the Foreign Exchange 
Department Dao Xuan Tuan insisted that the exchange rate and 
interest rates stay on target and that the free flow of capital was 
the central problem.  Without acknowledging Deputy Prime Minister 
Nguyen Sinh Hung's announcement of late June to the contrary, Dao 
further stated that the SBV is not targeting the dong to depreciate 
by 1 percent for 2007.  Rather, he said, the SBV is seeking an 
exchange rate that would support exports but also take into account 
inflationary pressures. 
 
¶9. (SBU) SBV'S Director of Monetary Policy Department Nguyen Ngoc 
Bao insisted that the SBV is fully addressing the problems of the 
"impossible trinity" and has the complete range of central bank 
tools at its disposal.  Bao noted that the government is rethinking 
the official inflation policy which currently states that the 
inflation rate should be numerically below the real GDP growth rate. 
 (Comment: this rule has no sound basis in economic theory. End 
comment.) 
 
¶10. (SBU) In the most frank assessment, SBV Director of Banking 
Development Strategy Department Le Xuan Nghia (who is also an 
Advisory Expert of Prime Minister and Member of the Financial - 
Monetary Policy Advisory Council of Government) noted that to 
resolve the problem the GVN is likely to be more flexible with the 
exchange rate in the future.  He implied that currently the Ministry 
 
HANOI 00001729  003.2 OF 003 
 
 
of Finance (MOF) is trying to maintain both interest rate and 
exchange rate stability, failing to understand the "impossible 
trinity" that is binding Vietnam.  As a likely sign of the 
institutional clashes going on behind closed doors between the MOF 
and SBV, he joked that the MOF thinks Vietnam can operate under "its 
own economic theory," eliciting outright laughter amongst his staff. 
 
 
¶11.  (SBU) Finally, in his first meeting with Ambassador Michalak on 
September 10, the new SBV Governor, Nguyen Van Giau, said that he 
was not concerned by the inflation issue in general because this 
year's inflation is not out of line with 2006 (6.6%), 2005 (8.4%), 
or 2004 (9.4%).  Local economists agree that there is no reason to 
panic, but believe that the situation is exacerbated by the SBV's 
lack of monetary tools.  ADB Country Director in Viet Nam Ayumi 
Konishi recently observed that while strong economic growth will 
continue, the relatively high level of inflation calls for the 
Vietnamese Government's "close attention." 
 
So Who Really Makes Monetary Policy? 
----------------------------------- 
 
¶12.  Despite various SBV statements to the contrary, local 
economists say that the State Bank suffers from capacity constraints 
and a lack of policy making ability.  A high level official at the 
IMF in a meeting with Econoff and Treasury's Southeast Asia 
Financial Attache said that exchange rate policy is made by the 
Economic Council of the Communist Party, not the SBV.  A Dragon 
Capital private equity managing director reiterated the same 
sentiment, noting that resolving the "impossible trinity" will be 
foremost "a political decision."  The HSBC Treasurer elaborated, 
stating that the difficult decision on either letting interest rates 
rise (and hurting businesses) or allowing the dong to appreciate 
(and harming the agricultural sector) falls to the Politburo.  He 
stated that GVN officials are seeking guidance from the Communist 
Party on which policy tool to put in place, and joked that "they're 
trying to avoid blame" and will not make a decision until they know 
they have political cover from higher ups. 
 
¶13.  (SBU) In addition, an economist at the Fulbright Economic 
School in HCMC stressed the capacity issues at SBV, stating that the 
SBV "is not used to these kinds of problems" and it is only now 
starting to think like a modern central bank on how to address these 
issues.  Nevertheless, he expressed confidence that the SBV would 
have the ability to move quickly up the learning curve.  Many 
private sector contacts agree that Prime Minister Dzung recognizes 
the capacity constraints of the SBV and wants to strengthen its 
analytical capacity and ability to formulate appropriate monetary 
and exchange rate policies.  Most market participants expect new SBV 
Governor Giau, a Dzung loyalist, to support these plans. 
 
COMMENT 
------- 
 
¶14. (SBU) Although the GVN appreciates that high inflation poses 
risks to Vietnam's economic performance, its response to date shows 
a reluctance to take any measures that would alter its current 
approach on the exchange rate, interest rate and capital flows. 
This may be changing.  The continued growth in inflation, combined 
with economic and political concerns about it impact, shows that 
inflation is an economic issue that is not going away. 
Notwithstanding public pronouncements for a targeted depreciation, 
it appears that the government is keeping all options are on the 
table, including a more flexible currency, as a means to tame 
inflation.  We will continue to advocate supply-side measures as 
well, such as increased listings of SOEs, as a preferred way to deal 
with the challenges of increased capital inflows.  End Comment. 
 
¶15. (U) Treasury Vietnam Desk Officer Susan Chun visited Hanoi and 
Ho Chi Min City August 7 to 21.  This cable was coordinated with 
Chun, Congen Ho Chi Minh City and Southeast Asia Financial Attache 
Susan Baker. 
 
MICHALAK