Inflation reached a ten-year high of 12.6 percent last year.

Commonly known as a “monetary phenomenon,” inflation occurs when there is too much money in circulation relative to the volume of goods and services.

In Vietnam, in order to support the steadily growing production of goods and services in recent years, the government has constantly increased the money supply.

This is suspected of causing inflation.

Yet, it isn’t just expanding supply and shrinking demand that is pushing down the purchasing power of money - or pushing up price levels.

For the past few years, factors such as bird flu and bad harvests caused by floods have also reduced the supply of food and consequently pushed up prices.

China’s increasing demand for input materials to fuel its phenomenally growing industry has also added upward pressure on input prices worldwide, especially oil and gasoline prices.

But at the end of 2007, when all the offenders lined up for investigation, the Vietnamese government’s monetary policies, or lack thereof, had to take most of the blame.

Neighboring countries have also had to cope with increasing food and fuel prices but none of these countries suffered an inflation rate as high as Vietnam’s.

Last year, the record level of foreign investment, direct and otherwise, pouring into the country increased both demand for the dong and the amount circulating in the market, thus fueling inflation.

The State Bank of Vietnam (SBV) had two options.

It could have either relaxed its control on the exchange rates so that the dong would gain in value relative to foreign currencies.

A revalued dong would make Vietnamese exports more expensive to international consumers and thus reduce exports.

Or it could have bought a large amount of foreign currencies to increase its foreign exchange reserves and keep the value of the dong down to benefit exports and growth.

SBV chose the second option - without using other methods, such as issuing high-interest bonds, to help absorb the excess money in circulation in the market.

The end result was an upward-spiraling demand for money to conduct transactions the rate of production couldn’t keep pace with.

Solutions?

In the face of high inflation, Vietnam still has many options.

One of them is to lower its GDP growth target until inflation reaches a healthier level of five percent to six percent.

This is often seen as the most effective and direct way to curb inflation since high targeted growth pushes up demand for goods and services while supply lags.

However, at present the Vietnamese government is following policies that are only fueling demand.

For instance, it is encouraging high levels of investment to boost economic growth.

Yet, the current Incremental Capital Output Ratio (ICOR) index for Vietnam, measured by annual investment divided by annual increase in GDP, is quite high.

It suggests the Vietnamese economy isn’t using investment efficiently.

Though the quantity of investment is unquestionably important, it is the type and quality of investment that ultimately matters.

For instance, investment in highly-productive sectors that aren’t labor intensive is considered much more conducive to sustainable economic growth.

The government is thus strongly encouraged to screen all investment inflows for possible upward pressure on inflation.

As for the State Bank, it can also pitch in the efforts to curb demand by tightening up its credit and monetary policies.

For instance, it can reduce or discourage loans for activities that don’t directly fuel production by increasing interest rates and requiring a higher level of bank reserves.

In addition, the State Bank should give exchange rates more latitude to operate according to market forces.

It has been making a start in this direction with the recent 50 percent increase in the interbank exchange rate margin.

This move allows banks to offer exchange rates at a wider margin from the rate announced daily by the State Bank.

And last but not least, the central bank can issue high-interest bonds to attract money currently in circulation.

By Pham Do Chi - Nguyen Hoai Bao *
 
Source: TBKTSG

(*) Pham Do Chi is a former senior expert at IMF with a Ph.D. in economics from the University of Pennsylvania in the US and Nguyen Hoai Bao is a macroeconomics lecturer at Ho Chi Minh City Economics University