Information about Asia and the Pacific Asia y el Pacífico

VI Stabilization and Adjustment in the Presence of Currency Substitution

Krishna Srinivasan, Erich Spitäller, M. Braulke, Christian Mulder, Hisanobu Shishido, Kenneth M. Miranda, John Dodsworth, and Keon Lee
Published Date:
March 1996
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The circulation of the dollar alongside the domestic currency, the dong, has been a major characteristic of the Vietnamese economy since at least the early 1970s. Indeed, “currency substitution” or “dollarization”1 extends to the store-of-value, unit-of-account, and medium-of-exchange functions typically reserved for the domestic currency.

The increasing use of foreign currency in the Vietnamese economy occurred against a background of large economic and financial imbalances, chronic shortages of basic goods, high and variable inflation, and poor and sometimes arbitrary policy implementation. In this environment, economic agents preferred gold and dollars to holding domestic currency and hence attempted to protect the real value of their assets by reducing the use of the dong. While use of the dollar helped in a number of important ways, it also hindered. Increasingly, dollarization impaired the effectiveness of financial policies and heightened the sensitivity of the economy to external developments.

The constraints arising from dollarization were an important issue when the government of Vietnam decided to undertake comprehensive economic reform beginning in the late 1980s. It became apparent that large-scale, entrenched dollarization required policy actions over and above what would have sufficed in a “normal” setting. Accordingly, the authorities took measures to enhance the attractiveness of the dong relative to the dollar with a view to reducing the role of foreign currency in the economy. This section examines the policies the Vietnamese authorities implemented in addressing the problem of dollarization in the context of their overall stabilization and adjustment strategy.

Dollarization Before Comprehensive Economic Reform

The circulation and use of the U.S. dollar in Vietnam has a long history.2 Since the Vietnam War, the U.S. dollar has circulated widely and has effectively served as a second legal currency. Other currencies as well as certain consumer items (including American cigarettes) and gold coins also served as mediums of exchange and stores of value. Parallel foreign exchange rates fetched significant premiums compared with official exchange rates—sometimes as much as 1,000 percent.

The use of the dollar was officially tolerated, in part because the parallel markets provided necessary relief in an otherwise difficult economic environment. In 1981, the ownership of foreign currencies was officially banned, but several factors suggest that dollarization of the Vietnamese economy not only remained important, but also continued to increase. First, macroeconomic performance remained weak. Against a background of moderate growth, bank financing of large public sector deficits fueled high and variable inflation rates. At the same time, foreign exchange, which was increasingly absorbed by military operations, became even more scarce. The official exchange rate was devalued on several occasions and multiple exchange rates proliferated.3 In an attempt to prevent exchange leakages to the parallel market, the government created “Dollar-A certificates,” which entitled holders to purchase foreign goods in special government shops.4 The numerous exchange actions and multiple exchange rates suggest that the government was seeking to prevent leakages as well as to attract dollars into official channels without undertaking fundamental reform. In these circumstances, however, with the economic situation deteriorating and with expectations of further devaluations, incentives to use dollars as a store of value and a medium of exchange only increased.

Second, in an attempt to suppress the parallel market and exact a levy on undeclared wealth, the government undertook a currency reform in September 1985. Under the reform plan, legally obtained old dong could be exchanged at a rate of 10 to 1 for new dong; savings account dong were exchanged on a sliding scale (from 10 old dong to 1 new dong for recent deposits; 1 to 1 for older deposits). Owing to poor implementation, the “reform” further undermined confidence in the dong. The government failed to print enough new currency; rumors of the impending reform drove up the parallel market rate to D 1,000 per U.S. dollar in the month before the reform; and the loss of confidence in the value of the dong spurred inflation. A devaluation of the dong the day following the reform compounded the loss in confidence.

Finally, efforts at systemic reform following the Eighth Plenum of the Vietnamese Communist Party Central Committee in 1985 were piecemeal and ultimately aggravated the economic situation. Under these efforts, an attempt was made to end the state subsidy program and to pay the wages and salaries of state employees entirely in cash, taking into account the prices of goods in the open market. Income limits were removed, so as to provide incentives for increased production. Overall, the reform effort was designed to eliminate large public sector deficits by bringing prices into line with costs and providing incentives for increased production. In the event, however, the reform effort ran into trouble almost immediately. Widespread shortages occurred, and economic agents began hoarding goods. Almost immediately, inflation eroded the value of public workers’ new all-cash wage package. In the end, the government introduced rationing of a number of essential goods. The failures of the economic reform program and the earlier currency reform and ensuing inflationary consequences further weakened government credibility and confidence in the dong.

Dollarization and Problems of Economic Management

The use of dollars provided the economy with a “pressure release valve” for imbalances from the inefficiencies in central planning, and at the same time gave economic agents a hedge against inflation, a means to purchase goods in the parallel market, and an efficient means of payment. But the increased use of dollars also had disadvantages: complicating macroeconomic policymaking and exacerbating the consequences of policy failure. More generally, the increased sensitivity of the economy to external developments made the conduct of financial policy more difficult.

On the fiscal front, dollarization weakened performance and policy effectiveness in a variety of ways. It lowered seigniorage and inflation tax receipts and worsened the inflationary impact from the financing of a given budget deficit through the banking system.5 It also allowed a substantial portion of economic activity to escape taxation. Finally, dollarization weakened public enterprise performance, in terms of both profitability and contribution to the budget, especially that of agricultural trading firms, because it contributed to the diversion of production to the parallel market (see Tanzi and Blejer, 1982; El-Erian, 1988; and Fischer, 1982).

On the monetary front, with the proportion of total liquidity under the coverage of the monetary authorities reduced, dollarization curtailed the effectiveness of monetary control (see El-Erian, 1988; and Fasano-Filho, 1986).6 In these circumstances, the authorities’ attempts to contain (stimulate) aggregate demand through increases (decreases) in lending rates were rendered less effective. Dollarization made the demand for dong more sensitive to external developments, because changes in foreign interest rates fed directly through to the asset allocation decisions of dollar holders. More generally, changes in foreign interest rates affect aggregate domestic demand because higher (lower) foreign interest rates will tend to induce dollar holders to compress (expand) consumption and investment. Overall, as dollarization expanded in Vietnam, the influence of external monetary (interest rate) policies on domestic activities increased.7

Finally, with lower seigniorage and revenue from the inflation tax and the adverse impact of dollarization on tax and public enterprise performance, monetary policy to some extent accommodated higher-than-necessary public sector financing needs. This has in turn limited the authorities’ room to maneuver by reducing their ability to alter sectoral credit allocations within an overall credit envelope.

In the area of exchange rate policy, dollarization has affected the transmission mechanism through which exchange rate changes operate in Vietnam. The disabsorption effect of devaluation has been weakened because a given devaluation imposes a capital levy on a smaller proportion of liquid wealth.8 This weakening of exchange rate policy occurs irrespective of whether a parallel market premium exists. However, when the parallel market rate exceeds the official rate, as it did prior to the 1989 reforms, the potential expenditure- and production-switching effects of an exchange rate action are muted because such actions are nonbinding. That is, a devaluation would, if anything, only move the official rate closer to the parallel rate, thereby absorbing (reducing) part of the parallel market premium. In the context of extensive dollarization, however, this would do little to change incentives for producers and consumers—because they would continue to operate primarily on the basis of relative prices established in the parallel rather than in the official market.

Although from a macroeconomic management perspective, exchange rate policy appeared less effective as a policy instrument, in fact extensive dollarization and the parallel market premium only altered the nature of the transmission mechanism. High dollarization and accompanying parallel goods markets suggested that exchange devaluations would have an impact through at least two alternative channels. First, a devaluation could alter incentives at the margin between the use of the parallel and the official market. In essence, the closer the official rate moved to the parallel rate, the greater the incentive to shift activity from the “illegal” toward the “legal” (official) market. No change in absorption, production, or consumption need occur—only the channel through which goods flowed. In essence, the parallel market could be remerged with the official market. Second, a large devaluation that substantially eliminated the parallel market premium could provide strong signaling and confidence effects, which, when coupled with other complementary policies, would support a substantial restructuring of incentives. For this latter effect to be significant, the government would need to provide a corroborating signal that it intended to prevent any significant widening of the gap between the parallel and the official exchange rate. That is, it would have to maintain a flexible exchange rate policy as it focused on stabilization and adjustment strategies.

Stabilization and Adjustment in a Dollarized Setting

Economic management in Vietnam reached a turning point in 1986 when the decision to dismantle the centrally planned system was announced. It was not, however, until 1988-89 that reforms began to be implemented in a comprehensive manner. Since then, Vietnam has made remarkable progress in its transition to a market-based economy and toward attaining macroeconomic stability, even though dollarization has continued to be an important characteristic of the economy.

This subsection examines the main policy actions undertaken by the Vietnamese government to deal with dollarization. Broadly, while the government has made substantial progress in addressing the incentives for dollarization and while these efforts have played an important role in the success of Vietnam’s transition strategy, the impact on dollarization has so far been limited.

Policies to Deal with Dollarization

In grappling with the problem of stabilization and adjustment in a highly dollarized setting, the government of Vietnam has moved to extend its control and influence over the use of dollars within the economy while at the same time seeking to reduce the incentives for dollarization. These objectives have been pursued through five main policies:

Legalization of Foreign Currency Deposits. In an attempt to extend and increase its control and influence over the use of dollars within the economy, the government ended in 1988 the proscription against holding foreign exchange by lifting foreign exchange surrender requirements and significantly liberalizing the use of foreign currency deposits within the domestic banking system for both companies (state-owned enterprises, joint ventures, and private firms) and individuals. A “no-questions-asked” policy was adopted, so that potential depositors would not be required to specify the source of their foreign exchange.9

By legalizing foreign currency.deposits, the government was able to channel a large amount of dollars from the informal to the formal economy through the banking system. Liberalization has aided the transition process in a number of ways. First, given the severe shortages of foreign exchange in the earlier part of the 1980s, the legalization of foreign currency deposits gave the government access to previously untappable foreign exchange resources. Second, the legalization of such deposits reduced incentives for (illegal) capital flight, while providing an easy-to-use medium to attract foreign exchange from overseas workers and expatriates. Although the balance of payments problems faced by the authorities at this stage were acute, both of these benefits helped contain the severity of the crisis.

While such a move could have resulted in additional substitution of foreign-denominated for domestic-denominated assets with little impact on intermediation, the impact in Vietnam has been favorable. Overall, formal sector intermediation has risen as both foreign currency deposits and domestic deposits have increased. While other factors have contributed to this increase, including lower inflation and higher real interest rates, it is clear that liberalization has aided the intermediation process, bringing dollars from the informal economy to the formal economy by removing part of the uncertainty surrounding the legal status of the dollar in the formal economy. Greater intermediation has helped mobilize savings for investment purposes, thereby supporting the favorable growth outcomes of the past several years. Chart 6.1 shows the growth of foreign currency deposits and lending since the liberalization.

Chart 6.1.Foreign Currency Deposits and Lending

Sources: State Bank of Vietnam; and IMF staff estimates.

Interest Rate Policies. At same time that the government unified the multiple exchange rates at the level of the parallel market rate in March 1989 (see below), it also improved the attractiveness of the dong by raising and maintaining interest rates at positive levels in real terms. This policy has had three main effects: (1) it has increased the relative attractiveness of dong deposits compared with dollar holdings, (2) it has increased dong deposits and thus intermediation, and (3) it has helped absorb currency, thereby reducing incipient inflationary pressures. All three effects have been important in the stabilization and adjustment process.

These steps had an immediate impact, as evidenced by a sharp decline in inflation in the months immediately following the announcements. In the three months before the announcement and implementation of the policies, inflation averaged 7 1/4 percent a month. In the month after the announcement, inflation fell to 3 1/2 percent, and, during the subsequent three months, inflation turned negative, averaging—1 1/2 percent a month. The realignment of incentives caused a shift out of dollars and into dong together with a sharp fall in the free market prices of gold and the dollar. Clearly, as a component of an overall scheme to reduce incentives for dollarization, the boost in dong interest rates played a major role. The same was true in 1992 when, after a loosening of financial conditions in the wake of the CMEA collapse, policies were again tightened, inducing a return of real positive interest rates, a shift into dong, and an appreciation of the exchange rate.

Exchange Rate Policy. Following a period characterized by relatively rigid official exchange rates, multiple exchange rate practices, intensification of exchange restrictions, and the growth of a large parallel exchange market, the authorities unified the exchange rate in March 1989 at the level of the parallel rate, resulting in a fivefold increase in the price of foreign exchange. Subsequently, except for a few periods, the authorities maintained the official exchange rate within a margin of 10-20 percent of the parallel rate through late 1991. Since the end of 1991, the official exchange rate has been maintained at virtually the same level as the parallel rate.10

While the design of the overall stabilization and adjustment strategy required movement on the exchange rate front, the authorities’ choice of method for managing the exchange rate was, in part, forced by the aim to reduce widespread dollarization (in the form of the parallel market). The large devaluation was an attempt to shift foreign exchange back into official channels, or at least back into the banking system, through foreign currency deposits. At the same time, the choice of a flexible regime indicated that the authorities acknowledged that the same problems would reemerge if the official exchange rate were not kept flexible enough to prevent a parallel market premium from emerging.

The policy choice was reinforced by the nature of the Vietnamese economy—long borders that allow parallel trade; a concentration on primary production, which has been subject to substantial world price shocks; uncertainties surrounding the breakdown of traditional international political relations; and the difficulty of ensuring a consistent array of structural, monetary, and fiscal policies in the country’s rapidly evolving transformation. Under such circumstances, an exchange rate anchor would not have been sufficiently credible, and hence would have been less effective in dealing with the dollarization problem. By announcing a flexible exchange rate policy, the authorities provided dollar holders with a strong signal that it meant to maintain the competitiveness of the official exchange rate vis-à-vis the parallel rate.11

Disinflation Policy. While disinflation is a standard objective of stabilization programs, it has a unique function when dollarization is a problem: it is not only a policy objective, it is also a policy in and of itself—one that helps to redress the incentives for dollarization by reducing the opportunity cost of using the domestic currency. In Vietnam, the authorities have, since 1988, attempted to restore confidence in the dong also through a persistent policy of reducing the inflation rate. Thus, with the steady implementation of a disinflation strategy, including among other things higher interest rates and avoidance of monetary financing of the budget deficit as part of comprehensive credit restraint, the attractiveness of the dong has been enhanced and the incentive to use dollars reduced.

The steady application of a disinflation policy can lead to a virtuous cycle, in that declines in inflation will result in an increased demand for dong and hence even lower inflation.12 In addition, a virtuous cycle may develop on the fiscal side as activity that previously escaped taxation through the parallel market is now brought into official channels and seigniorage receipts increase. Both of these factors tend to reduce the financing requirement and hence help in fighting inflation.

Structural Improvements to the Banking System. Financial sector reform tends to be a typical element of structural adjustment programs, but its importance is enhanced in the context of a dollarized economy. Indeed, before Vietnam embarked on reform, the problem of dollarization was likely aggravated by inadequate channels through which to save domestic currency, lack of appropriate financial instruments, uncertainty about the viability of banks or financial institutions in general, inappropriate policies concerning bank deposits (for example, arbitrary freezes on the withdrawal of funds), and inappropriate interest rate policies. Addressing these issues in the course of reform has since helped promote the use of the domestic currency and reduce incentives for dollarization.

Impact of Policies to Date

Notwithstanding the comprehensive efforts undertaken to address the problem, Vietnam remains a highly dollarized economy. As shown in Chart 6.1, foreign currency deposits and lending (in millions of U.S. dollars and as a proportion of banking system assets) have grown rapidly since the liberalization of 1988. At the same time, anecdotal evidence suggests that the amount of dollars circulating in the economy remains high. Due (1995), for example, points out that (1) the Vietnam Living Standards Survey of 1992/93 indicates that the ratio of dollar to dong holdings for the average household was more than 35 percent, and (2) in the larger cities, prices of durable goods and real estate are openly quoted in dollars and virtually all such transactions are effected in dollars.13 Moreover, cross-sectional evidence indicates that Vietnam’s level of domestic financial intermediation is relatively low compared with other countries at similar levels of income, supporting the notion that a large proportion of transactions continue to be conducted outside the banking system. Partial support for this claim is found in the relatively high velocity of money in Vietnam (4.5-5) over the last five years, relative to much lower values (in the range of 3—4) for Korea, Malaysia, and Thailand in the second half of the 1960s, at broadly comparable stages of development.

Evidence from other countries, especially Latin American countries, suggests that Vietnam’s experience is not unique. Empirical studies of dollarization episodes (see, for example, Guidotti and Rodriguez, 1992;Mueller, 1994; and Savastano, 1992) suggest that, notwithstanding strong stabilization and adjustment efforts, dollarization can become so deeply entrenched that even strong economic programs fail to supplant dollars with domestic currency—a phenomenon referred to as hysteresis. Confidence in the domestic currency, once lost, is difficult to fully reestablish once cash preservation and diversification techniques are learned and accepted. Moreover, the longer the prior period of high inflation, poor or inconsistent policymaking, and financial repression, the longer it takes for meaningful de-dollarization to occur. In this respect, while Vietnam has adopted an array of policies that substantially reduce the incentives for dollarization, it may still take some time for the benefits of these efforts to be realized. De-dollarization is a lengthy process that requires a persistent policy approach.

Conclusions and Policy Implications

After a lengthy period of poor economic performance and loss of confidence in the domestic currency, Vietnam has since 1988/89 implemented policies aimed at restoring macroeconomic stability and the use of the dong as a medium of exchange. While the stabilization and adjustment efforts have met with a great deal of success, de-dollarization has been slow. From a practical perspective, the slow process suggests several policy implications and lessons:

  • Only continued efforts to build confidence in the dong can ultimately help to displace dollars as a store of value, medium of exchange, and unit of account. In this regard, any attempts to regulate by fiat the use of the dong, and ban the use of the dollar, are bound to fail. They would only tend to drive activity underground and attack the symptom rather than the root of the problem.
  • Slippages in policy, such as the recent resurgence in inflation, will only slow the process further.
  • With dollarization remaining pervasive, macro-economic policy instruments continue to be constrained.
  • De-dollarization is a slow process constrained by inertia. There is a possibility of a delayed reaction at this stage, but confidence building is important. Once confidence begins to return, a virtuous cycle may develop of de-dollarization, increased policy effectiveness, and further improvements to macroeconomic performance.
1Throughout this section, the terms “currency substitution” and “dollarization” are used interchangeably to refer to the use of dollars over and above what would occur for normal asset diversification needs in a stable macroeconomic environment. A number of authors, including Sahay and Vegh (1995a), Calvo and Vegh (1992), and Cuddington (1983), have proposed more refined definitions of the concepts, primarily on the basis of the function played by the foreign money in the domestic economy.
2This section draws primarily on International Currency Mialysis Inc., and Due (1995).
3In mid-1981, the base noncommercial exchange rate was de-valued to D 9.045 per U.S. dollar with three premium rates available: a foreign visitor rate (20 percent premium) and two inward remittance rates (a 30 percent premium for remittances of up to D 5,000 and a 40 percent premium for remittances of more than D 5,000). In October of the same year, an exchange rate of D 12 per U.S. dollar was created for export proceeds of local companies. About a year later, the premium rates for inward remittances were abandoned, although new rates were established based on the area from which the remittances were received: D 20 per ruble was applied to inward remittances from the nonconvertible areas and D 60 per U.S. dollar was applied to those from the convertible area. By May 1, 1985, the rate for dollar remittances rose to D 150 per U.S. dollar.
4Almost immediately, a large parallel market in Dollar-A certificates developed. These certificates commanded a premium over dollars (about 15 percent) because they could be used to buy imported items in dollar shops, which, in turn, could be resold in the curb market. By November 1982, the government had discontinued the system.
5See Fischer (1982) for a discussion of the role and importance of seigniorage in developing country finance.
6The existence of other substitutes for domestic liquidity, including gold, bonds, or even durable goods, also reduced the effectiveness of monetary policy (see Cuddington, 1983;Brillembourg and Schadler, 1979;Blejer, 1978; and Brittain, 1981).
7Miles (1978) provides a framework for analyzing the impact of changes in foreign interest rates on domestic economic activity; his framework focuses on the exchange rate, rather than on consumption or investment, as the transmitting variable.
9Under the system, firms and individuals have been allowed to make deposits in any currency, although banks determine the currencies in which they are willing to operate. It is estimated that well over 90 percent of all such deposits are denominated in dollars, with the balance divided among other major currencies, including Japanese yen, deutsche mark, Hong Kong dollars, pounds sterling, and French francs. By value, the majority of foreign currency deposits are owned by state-owned enterprises. The deposit-taking bank guarantees conversion back into the currency of deposit. In addition, individual banks set their own policies for interest remuneration (in terms of both the rate of interest paid and the currency of interest remuneration). In practice, however, the interest rate on deposits is limited by the ceilings set on foreign-currency-denominated lending rates. Typically, deposit interest rates in Vietnam have been lower than deposit interest rates available on similar instruments abroad, in part because banks themselves sometimes redeposit the foreign exchange in correspondent banks abroad but require a margin to cover administrative and other costs. While demand deposits account for the bulk of foreign currency deposits, the government allowed banks to offer foreign currency time deposits in May 1991.
10See Section VII for a more comprehensive discussion.
11The policy choice contrasts with theoretical results that argue for a fixed exchange rate regime (that is, a nominal exchange rate anchor) to promote stabilization and de-dollarization. See, for example, Due (1995) and Sahay and Vegh (1995b), who argue that exchange-rate-based anchors seem more successful than money anchors in stabilization efforts. The analysis in these papers, however, abstracts from uncertainty the required levels of reserves necessary before commitment to an exchange rate level, the appropriateness of the exchange rate level itself, and the ability to use instruments other than monetary policy in formulating a stabilization strategy.
12At this stage, it is not evident that a virtuous cycle has developed because hysteresis effects, discussed below, appear strong.
13Duc also cites unofficial estimates of $2—5 billion in circulation in Vietnam. TheFar Eastern Economic Review (1995) cites an official estimate of U.S. dollars in circulation of $600 million but also notes that anecdotal evidence suggests that the figure may be as high as $2 billion (with as much as $3 billion of gold circulating simultaneously).

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