VINACHEM

Cutting the dollar-denominated interest rate may reduce foreign currency speculation in theory, but in reality it requires more than just this monetary tool to stabilise the dong and the overall macro-economy, writes Do Thien Anh Tuan, a lecturer with the Fulbright Economics Teaching Programme.

After the Federal Reserve raised its rate, central banks around the world responded accordingly, by either increasing their interest rates or devaluing their currency against the dollar. Meanwhile, the State Bank of Vietnam responded in a different manner by slashing the interest rate on the dollar-denominated savings for individuals, from 0.25% to zero per year.

In its statement following this move, rather than speaking about the forex rate, the monetary authority emphasised instead the purpose of its anti-dollarisation policy. Nevertheless, the State Bank of Vietnam’s (SBV) action should reduce speculation on the greenback, which will ease the pressure on the forex rate, at least for the remainder of the year.

Some people are of the opinion that cutting the rate will also help to promote dong-denominated savings. And while many will no doubt sell their dollars and switch to VND, there will also be others who will insist on holding on to their USD in the hope of making a profit off the greenback.

Let’s take this out of the abstract and look at the numbers. Say we had US$100,000 in savings when the interest rate was still 0.25%. After a year, we would have received US$250 in interest, equivalent to VND5.6 million. Is it worth it? Not really. However, since September, when the dollar-denominated interest rate dropped from 0.75% to 0.25%, many depositors held on to their savings in USD. What was their purpose? Was it because the 0.25% interest rate was highly lucrative? For these depositors, I believe not.

The 0.25% rate, however, was still better than nothing. However, the difference between these two rates is negligible in terms of the monetary value it offers depositors. The outgoing interest rate of 0.25% was equal to the interest rate for the VND-denominated current accounts at banks.

That being said, the dollar is a more convenient currency for making import payments, making debt settlements, studying abroad, paying medical bills, as well as for inclusion in an investment portfolio.

This is especially true for organisations that often have a dollar-denominated deposit balance much larger than that of individuals. Such organisations will retain their foreign currency accounts, despite the interest rate on the dollar-denominated accounts for organisations being reduced to zero in September.

For Vietnam, a country that has opened up and integrated deeply into the world economy, completely eliminating dollarisation is extremely difficult and costly. Vietnam’s dollarisation rate has, in fact, been trimmed down significantly, standing at about 10-12% at present. The rate is considered relatively low in accordance with the International Monetary Fund’s (IMF) classification.

The dollar-denominated rate, which was referred to as “zero bound”, cannot be cut any further. As such, the SBV’s interest rate tool is no longer available to them. This creates a so-called liquidity trap, whereby depositors still hold on to the greenback due to its liquidity, rather than its profitability. And so, even though the dong-denominated rate is higher than the dollar-denominated rate, it cannot persuade depositors to ditch the dollar and deposit in dong, as the central bank had expected.

Apart from its purpose in terms of liquidity, holding on to the dollar allows depositors to diversify their investments, or – to put it plainly – not to put all their eggs in one basket. The correlation coefficient between the dollar yields to other financial assets is negative; therefore, the greenback is one of the assets that can diversify risks very well, and help investors to minimise unsystematic risks. Thus, cutting the interest rate to nil is not an issue here.

What’s more important is the expectation that the USD will continue to strengthen in the future. We should understand that, even if the USD/VND remains unchanged in the domestic market, the dollar has, in fact, gained strength in the international market, and this will benefit dollar-holders. An importer, for instance, could choose to hold USD rather than VND to settle their payment in a future point in time, rather than spending VND to buy the USD, especially in light of expectations that the SBV will adjust the FOREX rate in the near future.

If, in the next three months, the SBV decides to devalue the dong by another minimum increment of 0.25%, the profit made on dollars as a result of this three-month devaluation over the course of a year will be four-fold higher than the 0.25% interest rate on the USD-denominated deposits. However, this does not take into account forex or transaction costs.

At this point, it is worth reminding ourselves that there are other investment channels apart from savings, such as real estate, stocks, or gold. If there was a trend of dollar selling, would the macro-economic instabilities disappear?

For foreign investors who are indirectly investing or who hold an investment portfolio in Vietnam, once they expect that the SBV will devalue the dong, even when the SBV has not actually adjusted the FOREX rate, they will quickly sell their portfolio and temporarily divest from the local market.

The slower they act, the more losses they will incur. And this explains why foreign investors have been net selling in the stock market in past weeks. Selling their investment portfolio, including government bonds, will increase the local interest rate, and boost the financial burden on the public debt and state budget deficit.

It remains to be seen whether cutting the dollar-denominated interest rate (in a bid to reduce greenback hoarding and consequently increase the supply – or decrease the demand – for the foreign currency) will harm the economy as a whole. Previously, when the interest rate in the US was low while the dollar-denominated rate was higher in Vietnam, overseas remittances flew into the country to enjoy the higher interest rate.

Now it is the other way around, so will this affect overseas remittances flowing into Vietnam? We will have to wait for some time before we can gauge the impact. However, if it is the case here, can trimming the USD demand make up for the decrease in the USD supply due to the decline in remittances and other foreign indirect investments (FII)?

All in all, to reduce the pressure on the forex rate and USD speculation, it is of the utmost importance to stabilise the value of the dong and the macro-economy for the sake of the production sector. Low inflation in the past two years was a good sign, and it is helping to reduce the pressure on the forex rate, compared to the fierce period of 2009-2010.

If we expect high inflation in the times ahead, the dong will keep facing pressure to devalue. In order to keep the forex rate stable, it comes down to maintaining a stable production base and keeping a low inflation rate. Forex fluctuation is an indicator of an unstable macro-economy, it is the consequence not the cause.

The administrative tools and policies, such as the interest rate ceiling, tend to hold back the development of the financial system, distorting economic relations, and misallocating resources (mainly focused on the low-productivity public sectors).

Experiences from other countries have shown that maintaining a low FOREX rate to facilitate access to foreign currency among the public sector will likely be traded off with the cost of increasing the interest rate in an economy. Ultimately, a higher interest rate will make economic recovery more difficult and prevent the economic restructuring that Vietnam is pursuing.