VII International Integration and Exchange Rate Policy
- Krishna Srinivasan, Erich Spitäller, M. Braulke, Christian Mulder, Hisanobu Shishido, Kenneth M. Miranda, John Dodsworth, and Keon Lee
- Published Date:
- March 1996
Faced with the problems associated with years of central planning and the prospect of declining trade with, and aid from, the CMEA, Vietnam turned to integrating its economy with the world economy and adopted a market-oriented, export-led growth strategy at the end of the 1980s. The notable success Vietnam has achieved thus far depended critically upon extensive trade reforms accompanied by the adoption of a more open exchange system and a market-oriented exchange rate policy, which enabled Vietnam to avoid the overvaluation of its currency and thus maintain its external competitiveness. This section reviews Vietnam’s progress in opening up its economy and analyzes how policy changes have promoted this process.
Growth and Diversification of Trade
Before the reforms, foreign trade in Vietnam was subject to central decisions by the planning authorities and could be carried out only by a small number of state trading monopolies. Domestic prices were isolated from the influence of international prices through a complex system of multiple exchange rates and trade subsidies. Exports were discouraged through overvalued exchange rates and low procurement prices, while imports were impeded by an extensive system of quotas and licenses. Isolated from the world market, Vietnam relied heavily on its former CMEA partners to obtain basic commodities, such as petroleum products and fertilizers, while exporters were obliged to fulfill CMEA quotas (arranged through a system of government-to-government protocols) before they were allowed to export to the convertible currency area.
With the liberalization of the trade and exchange regimes and the adoption of an appropriate exchange rate policy, exports and imports began to expand rapidly in the late 1980s, and there was a significant shift in trading partners from the former CMEA countries to those in the convertible currency area. Exports to the convertible currency area increased from about $450 million a year in 1987-88 to $2 billion in 1991. Imports from the convertible currency area also rose rapidly from about $500 million a year during 1984-88 to $1.8 billion in 1991. At the same time, exports to the nonconvertible area declined sharply from 645 million transferable rubles in 1988 to less than 80 million transferable rubles in 1991, and imports from the area fell from about 1.8 billion transferable rubles a year during 1987-88 to about 700 million transferable rubles in 1991.
While the dissolution of the CMEA necessitated the dramatic shift in trade partners, it cannot account for the overall expansion of trade since the late 1980s, which has been extraordinary. Exports to both the convertible and nonconvertible areas stagnated during 1986-87 (about $350 million and 450 million transferable rubles a year, respectively), before doubling by 1989 to $1 billion and 800 million transferable rubles, respectively. The expansion of exports to the CMEA in 1989 reflected the last efforts to take advantage of the favorable trading arrangements before they disappeared, but overall exports continued to grow at a robust pace during 1990-94, at an average rate of more than 20 percent a year.1 Total imports have also expanded rapidly, at more than 20 percent a year on average during 1990-94.
Over the same period, exported goods also became more diversified. Petroleum exports increased from $80 million in 1988 to about $850 million a year in 1993-94, reflecting the coming onstream of exploration and development projects in the mid-1980s, with their share in total exports rising from 11 percent in 1988 to 24 percent in 1994. With the liberalization of domestic prices and the reform of the agricultural sector, exports of rice also increased rapidly, from zero in 1988 to $430 million in 1994, the share in total exports rising from zero to 12 percent.2 Exports of garments and other light manufactured goods, marine products, and coffee also expanded rapidly.
The progress Vietnam has made in integrating with the world economy is evident from the rise in the share of trade in GDP from 41 percent in 1989 to 52 percent in 1994.3 During the same period, exports as a share of GDP increased to 23 percent from 18 percent, while the share of imports in GDP rose to 29 percent from 23 percent.
To ensure that economic decisions relating to production and investment would be guided by appropriate market-based incentives that reflected Vietnam’s comparative advantage, a transparent foreign trade regime needed to be established when domestic prices were liberalized. Only then would these prices indicate both scarcities in the domestic market and conditions in the world market. In 1988-89, Vietnam set about liberalizing its trade regime, which consisted at that time largely of controls, including a comprehensive system of export and import quotas, permits, and licenses as well as export duties and import tariffs.
Lowering Nontariff Barriers
Before 1989, all exports and imports were subject to quotas, but in January 1989, quotas were removed on all but 10 exported goods and 14 imported goods. At the same time, all budgetary export subsidies were eliminated. Later in May, the numbers of export and import quotas were further reduced to 7 and 12, respectively, and state enterprises were no longer obliged to fulfill their minimum export targets vis-à-vis CMEA partners before being authorized to export to the convertible currency area.4 The remaining quotas have gradually been removed, and there are currently no quotas on exports and imports.5
The number of imported goods requiring permits has also been reduced, albeit only recently (April 1995), from 15 to 7 (leaving petroleum products excluding lubricants, steel, cement, fertilizers, sugar, vehicles with fewer than 12 seats and components, and motorcycles and components).6 Also, the process for obtaining a permit was reduced to two steps from three in late 1994; companies are now required only to obtain a business license from the State Planning Committee and a trading license from the Ministry of Trade.
The requirement for licenses for each shipment of exports and imports has also been recently reduced. For exports, shipment licenses for 22 commodity groups have been issued since April 1993 for a six-month period without limitation on the number of shipments; the requirement was eliminated altogether in July 1994 except for rice, timber, and petroleum. The requirement for the first two items is maintained for reasons of food security and environmental protection. The requirement for petroleum is of little consequence at this stage because only one state enterprise is responsible for petroleum exports. For imports, shipment licenses are still required, although the requirement is expected to be removed in early 1996.
Along with lowering nontariff barriers, the authorities lowered and rationalized duties on exports and imports of goods in the late 1980s. In April 1989, the number of export commodities subject to export duties fell from 30 (with the rates mostly in the 10 percent range) to 12, and most duty rates were also reduced (to 3-5 percent by 1990). At the same time, the number of import commodities subject to tariffs dropped from 124 (with rates ranging between 5 percent and 50 percent) to 80. Although the tariff structure was rationalized to some extent, higher rates were also introduced (now up to 120 percent on a few luxury goods). In addition, in April 1991, the export duty on rice was reduced to 1 percent from 10 percent, and inputs used for producing exports were exempted from import duties.
Decentralization of Foreign Trade
Nearly all foreign trade transactions in Vietnam before 1988 were carried out by a few specialized foreign trade organizations that had a monopoly over trade in certain commodities. These organizations were in most cases placed directly under the supervision of the branch ministry corresponding to their monopoly, the rest under the direct supervision of provincial authorities. In 1988, restrictions on the establishment of foreign trade organizations were eliminated, and many new ones were subsequently created by provincial authorities and state enterprises, ending the state’s monopoly over foreign trade. These developments enabled a large number of exporters and importers to establish direct contacts with foreign companies and thus bypass the administrative inefficiencies of the trading monopolies. The total number of firms and foreign trade organizations authorized to engage in foreign trade increased from 80 in 1987 to 600 in July 1990. Since January 1991, private as well as state enterprises have been allowed to engage directly in trade.
Exchange Reform and Exchange Rate Policy
A key to the success of Vietnam’s export-led growth strategy has been the reform of the exchange system and the adoption of a flexible, market-oriented exchange rate policy. The distortions associated with multiple exchange rates were eliminated by the unification of exchange rates in early 1989. The adoption of a more flexible, pragmatic exchange rate policy that closely tracked developments in the exchange rate prevailing in the large and well-established parallel market prevented the Vietnamese dong from becoming overvalued.
Exchange Rate Unification
Until March 1989, Vietnam maintained a system of multiple exchange rates with different rates for trade transactions within the central plan, for invisible transactions, and for trade transactions outside the plan. This system caused large distortions in the structure of relative prices and hidden transfers among the various economic sectors, particularly because the various exchange rates were grossly overvalued. Although the State Bank of Vietnam adjusted these rates periodically, the adjustments were insufficient to compensate for the increases in domestic prices and production costs. As a result, importers were able to make large profits based on the difference between import and domestic prices, while exporters required budgetary support in the form of subsidies to offset the losses realized on the artificially low (dong) export prices.
To eliminate these problems, the authorities devalued the exchange rate for trade transactions within the central plan on September 15, 1988, from D 225 per U.S. dollar to D 900 per U.S. dollar. The exchange rate for most invisible transactions was devalued (and unified with the rate for trade transactions outside the central plan) on November 10, 1988, from D 368 per U.S. dollar to D 2,600 per U.S. dollar. The rate was subsequently devalued four more times, to D 3,500 per U.S. dollar on March 8, 1989. Finally, on March 13, 1989, the authorities unified the two existing official exchange rates of D 900 per U.S. dollar and D 3,500 per U.S. dollar and raised the rate to D 4,500 per U.S. dollar, close to the parallel market rate.
Liberalization of Controls on Foreign Exchange
At the same time, many of the strict administrative controls on the holding and use of foreign exchange that had driven large amounts of foreign exchange into the parallel market were liberalized substantially to increase the supply of foreign exchange in the official market. A new foreign exchange control decree, issued on October 21, 1988, liberalized the retention of foreign exchange and was designed to attract foreign exchange into the banking system as well as to adapt the exchange system to the new laws liberalizing foreign trade and investment. Under this new decree, companies that had fulfilled obligations to surrender foreign exchange were allowed to open foreign currency accounts, and individuals were permitted to open foreign currency accounts and hold foreign currency notes.7 Foreign currency could be sold to the Bank for Foreign Trade at the prevailing exchange rate, deposited into bank accounts bearing interest in foreign currency, or withdrawn for payment or transfer to other resident units or individuals. Also, foreign currency obtained through transfers from abroad could be used to pay for imported goods and services, to repay foreign loans, and for other transfers abroad.8
Introduction of Foreign Exchange Trading Floors
In an effort to introduce a market for official foreign exchange transactions, the authorities set up a foreign exchange trading floor at the State Bank branch in Ho Chi Minh City in late August 1991, and in Hanoi in November 1991. The trading floors were open three days a week in Ho Chi Minh City (Monday, Wednesday, and Friday) and twice a week in Hanoi (Tuesday and Thursday). There were 40 market participants, including 7 commercial banks and 33 foreign trade organizations, gold import companies, and remittance companies. Foreign exchange demand and supply requests were submitted before each session, with requests for import or debt payments made seven days in advance. With the creation of the trading centers, all authorized foreign exchange transactions had to take place at the rate established there, with a maximum margin for the selling rate of 0.5 percent on either side of the “fixing rate” (subsequently reduced to 0.1 percent). The fixing rates were set in relation to previous-day closing rates and, although the regulations allowed intervention by the authorities, they reflected for the most part developments in the trading floors.
Introduction of an Interbank Foreign Exchange Market
On October 14, 1994, in an effort to move the exchange regime closer still to a market regime with broader coverage, the authorities introduced an interbank market for foreign exchange. This interbank market has de facto replaced the two foreign exchange trading floors, and the initial experience has been positive. Most of the big commercial banks have joined the market, which has been functioning smoothly, with daily transactions initially averaging about $3 million.9 The buying and selling rates are allowed to move within a band of 0.5 percent on either side of the official reference rate, which is adjusted daily in line with market developments as reflected in the actual closing rate of the preceding day.
Exchange Rate Policy
Vietnam’s exchange rate policy since the unification of the official exchange rates in March 1989 can be divided into two phases “following” the market and “unifying” the market: the first, through August 1991, when the authorities adjusted the unified official exchange rate at irregular intervals with the explicit objective of maintaining the official rate within a range of 10-20 percent of the parallel market rate; and second, from September 1991 to the present, when the authorities introduced the market for foreign exchange directly into the exchange rate determination process, through the foreign exchange trading floors and subsequently through the interbank foreign exchange market (see Chart 7.1).
Chart 7.1.Exchange Rate Developments
Sources: Vietnamese authorities; and IMF staff estimates.
Note: Before the unification of the exchange rates in March 1989, the official rate is that applied to trade transactions.
1A decline indicates an appreciation.
2A decline indicates a depreciation.
Following the Market
Background: The Parallel Market in Vietnam. Owing to the illegal, albeit to some extent officially tolerated, nature of transactions in the parallel market, information on the size and functioning of the parallel market is neither readily available nor very reliable. However, prior to the exchange reform, a substantial amount of foreign exchange had clearly been driven into the parallel market by, among other forces, the distortions created by the multiple official exchange rates, their significant overvaluation, and administrative controls on trade and foreign exchange. Parallel markets tend to develop in conditions of excess demand for a commodity subject to legal restrictions on sale, to official price ceilings, or both. Foreign exchange transactions in Vietnam were subject to both prior to the reform. The regulations on trade flows (quotas, permits, and license requirements as well as the administrative controls on foreign exchange) and the export duties and import tariffs created strong incentives to smuggle and fake invoices (to lower duties). The illegal trade created a demand for illegal foreign currency and, in turn, stimulated its supply.10
As in many other developing countries where balance of payments deficits are large and the central bank does not have sufficient reserves (or the borrowing capacity) to meet demand for foreign exchange at the official rate, the parallel market in Vietnam became well developed and organized, with an exchange rate substantially more depreciated than the official rate. At the end of 1988, transactions on the parallel market were undertaken at D 4,000 per U.S. dollar, compared with D 900 per U.S. dollar for trade transactions within the plan and D 2,600 per U.S. dollar for invisible transactions and trade transactions outside the plan.
The Parallel Market Rate: A Good Indicator? The problem with estimating the extent of real exchange rate misalignment, and the appropriate nominal exchange rate, is that the equilibrium real exchange rate cannot be observed. One approach often adopted in practice to get around this problem is to look at the various components of the balance of payments, including the trade balance and net capital inflows, and to determine a base period in which actual and equilibrium real exchange rates were judged to be equal. The next step is to determine the extent to which the equilibrium real rate has changed since the base period as a result of changes in its fundamental structural determinants, so that a comparison can be made with the path of the actual real exchange rate.11 This approach could not be adopted in the case of Vietnam because no year prior to doi moi, under pervasive central planning, could be considered an appropriate base year for a market-oriented economy.
The practical alternative for Vietnam, in the face of so much change, was to use the parallel market rate as an indicator for exchange rate policy, to use information from the parallel market to gauge the extent of real exchange rate misalignment.12 The parallel market rate provided a simple and observable indicator, with the existence of a parallel market premium signaling excess demand for foreign exchange at the official exchange rate and, in turn, an overvaluation of the domestic currency at the prevailing official rate. The merits of this approach have been underscored in the literature; for example, models in the currency-substitution tradition (Calvo and Rodriguez, 1977) have been used by Edwards (1989) and Kamin (1993) to analyze the effects of unsustainable financial policies on the parallel market premium and the divergence of the real exchange rate from its long-run equilibrium value. The finding from these models is that, along the adjustment path, overvalued exchange rates are associated with high premiums.13
This is not to imply that the premium in the parallel market is a perfect measure of overvaluation. In the short term, the premium is driven by expectations and can often be quite volatile, reflecting the asset-price characteristics of the parallel exchange rate. The premium at a given time should therefore be viewed only as an indicator of the exchange rate that clears the market at that time (World Bank, 1993b). Montiel and Ostry (1994) put forward an interesting argument that, because the parallel market premium is an asset price, it can be expected to exhibit much greater volatility than the official real exchange rate, in particular by responding to transitory shocks that leave the equilibrium real exchange rate unaffected. They caution against drawing inferences about deviations of the actual from the equilibrium real exchange rate based on observations of the premium at a given moment in time.
However, over a longer time, the premium provides a convenient and observable indicator of over-valuation.14 Many developing countries have therefore pursued exchange rate policies designed to narrow the gap between the official and parallel exchange rates by depreciating the official rate (see Aghevli, Khan, and Montiel, 1991). The aim, in effect, has been to contain the misalignment of the official rate by targeting the premium at reduced levels. Vietnam has been highly successful in this regard (see Chart 7.2).15
Chart 7.2.Premium in the Parallel Foreign Exchange Market
Sources: Vietnamese authorities; and IMF staff estimates.
Unifying the Market
During this second phase, the authorities strengthened significantly the relationship between the official rate and the parallel rate through the foreign exchange trading floors and the interbank market. The incentive to channel foreign exchange into the parallel market had been reduced to some extent by the relaxation of controls on the holding and use of foreign exchange in 1988 and trade liberalization during 1988-91 (noted above). However, the trading floors and the interbank market introduced a much greater market element into the determination of the official exchange rate and consequently brought a large share of foreign exchange transactions into the official market. The degree to which the official exchange rate began to be determined by market forces is evident from the parallel market premium staying well below 1 percent from the beginning of 1992 to the present.
The key to a successful unification of the foreign exchange market in Vietnam has been the consistency between fiscal and monetary policies and the exchange rate policy. The devaluation of the official exchange rate was backed up by cuts in the budget deficit and a tightening of domestic credit (see Box 7.1).16 Even though the rate of inflation did not fall immediately to a low level, it did decline substantially over time, and the authorities accommodated inflation sufficiently through periodic devaluations to avoid severe overvaluation.17
Box 7.1.Elements of a Successful Unification
Theory and experience strongly suggest that fiscal reform and financial stabilization must accompany the unification of foreign exchange markets for it to be successful (see Agenor, 1990; or Kiguel and O’Connell, 1994, for a review of the arguments and experiences of many developing countries). The point made in the literature, and supported by the empirical evidence, is that without these supporting policies, the devaluation of the official exchange rate results in only a temporary reduction of the parallel market premium. Under a floating exchange rate regime, an initial devaluation of the official rate results in a loss of fiscal revenue—this is often the case because the premium is an implicit tax on exports. Unless compensatory revenue measures are undertaken, the rate of inflation and the rate of depreciation will tend to rise as the authorities attempt to compensate by increasing monetary financing (assuming that a constant amount of real fiscal expenditure is to be financed; see Pinto, 1991, for a formal exposition). Under a fixed exchange rate regime, the initial devaluation of the official rate will tend to reduce the premium temporarily, but the expansionary fiscal and credit policy will bring about inflation that results in a real appreciation of the exchange rate and therefore a rise of the premium reflecting the overvaluation of the official rate.
In this sense, the authorities’ exchange rate policy stance since the late 1980s has been consistent and progressive: they have pursued a flexible, market-oriented (and in many ways pragmatic) exchange rate policy. Movements in the parallel market rate, and subsequently in the trading floor and interbank market rates, have been used as a key indicator for the official exchange rate, and the gap between the official and parallel markets has been narrowed progressively over time. While the authorities have intervened at times in the foreign exchange market, notably in 1993 when they resisted considerable pressure for depreciation by running down reserves, on the whole they have not used the exchange rate as a nominal anchor for stabilization. Instead, fiscal and monetary policies have carried this burden, allowing exchange rate policy to focus primarily on maintaining external competitiveness and setting up the conditions for strong export growth and the achievement of a sound balance of payments position. The exchange rate has been relatively stable against the U.S. dollar during the last few years, but this reflects primarily the effectiveness of financial policies, rather than a conscious effort to anchor the exchange rate.
Real Effective Exchange Rate Developments
The devaluation on March 13, 1989 of the official exchange rate for trade transactions within the plan from D 900 to D 4,500 per U.S. dollar resulted in a nominal and real effective depreciation of 500 percent—bringing about a massive realignment of exchange rates and a concomitant improvement of Vietnam’s external competitiveness.18 The unification and devaluation of official exchange rates, combined with a tightening of financial policies (including a sharp rise in interest rates to positive real levels), had an immediate impact on the population’s confidence in, and demand for, the Vietnamese dong. Subsequently, the official exchange rate was revalued by about 10 percent during the last nine months of 1989 (following the appreciation of the parallel rate), and the real effective exchange rate appreciated by 23 percent as a result, albeit to a level far lower than the rate that prevailed prior to the re-forms (see Chart 7.1).
However, there was a relaxation of financial policies in 1990-91 in an attempt to mitigate the impact of the collapse of the CMEA, and the parallel rate depreciated by 48 percent against the U.S. dollar in 1990 and by an additional 66 percent during the first eight months of 1991. The official rate was devalued by 60 percent in 1990 and 40 percent in the first eight months of 1991 (see Chart 7.1). With domestic inflation accelerating to about 70 percent a year in 1990-91, exchange rate developments tracked closely the inflation differential with Vietnam’s trading partners, and the official rate was devalued often enough to keep the parallel market premium below 20 percent during most of 1990-July 1991 (within a narrow range of 2-7 percent during January-July 1991). As a result, the real effective exchange rate, while fluctuating from month to month, did not become increasingly overvalued, and the real effective exchange rate index remained within a band of 100-125 (March 1989 = 100) during this period (see Box 7.2 and Chart 7.1).
Box 7.2.Inflationary Impact of Devaluation When There Is a Large Parallel Market
In economies like Vietnam where the parallel market is large and well established, much of the inflationary impact of a devaluation is likely to be absorbed early in the parallel market by the depreciation of the parallel exchange rate. In such cases, the prices of many tradable goods will have increased already as goods are smuggled in from neighboring countries (at parallel rates). When the government finally devalues, domestic prices will have already adjusted to the new “equilibrium” official exchange rate, and there will be no further inflationary pressures.
Both official and parallel exchange rates depreciated sharply when the trading floors were introduced in August 1991 (in anticipation, the parallel rate started to move sharply in July 1991). The exchange rates moved from about D 9,000 to about D 12,000 per U.S. dollar. By the end of 1991, the real effective exchange rate had returned to the level that had prevailed in March 1989.
By March 1992, the official and parallel exchange markets were effectively unified, with the premium well below 1 percent (see Chart 7.2). Since then, both the official and parallel market rates have been broadly stable against the U.S. dollar, within a range of about D 10,500 to D 11,500 per U.S. dollar. Reflecting this stability against the U.S. dollar and generally lower inflation rates in Vietnam, the real effective exchange rate has remained relatively constant at a level some 30 percent more appreciated than in March 1989.
Although the recent weakening of the U.S. dollar against the yen and the deutsche mark has resulted in a small depreciation of the real effective rate, taking the period after March 1989 as a whole, the real effective rate has stabilized since early 1992 at a level somewhat more appreciated than those that prevailed during the preceding three years. While this might be seen as an indication of misalignment of the exchange rate of the dong, several developments in recent years suggest that it instead indicates an appreciation of the equilibrium real effective exchange rate and should not be a cause for concern.
The equilibrium real effective exchange rate can be thought of as the relative price of tradable to nontradable goods, yielding simultaneously internal and external equilibrium, where the former implies that the nontradable goods market is cleared continuously,19 and the latter implies that the current account deficit is financed by sustainable capital in-flows.20 Higher capital inflows would allow a larger current account deficit to be financed and a more appreciated real effective exchange rate to be sustained. In Vietnam, there has been a recovery of official grants and loan disbursements from the low levels of 1990-91, as Japan and other official creditors have increasingly filled the gap left by the former Soviet Union; a marked rise in foreign direct investment, from $100-200 million during 1989-91 to $650 million in 1994, reflecting, in part, the liberalization of trade and exchange regimes; and, in December 1993, a Paris Club rescheduling covering Vietnam’s arrears to Paris Club creditors involving a 50 percent reduction in the net present value. Because much of the debt was in arrears, the rescheduling covered a large portion of Vietnam’s external debt and effectively provided Vietnam with a stock of debt reduction—reducing if not eliminating its “debt overhang.”21
It would not seem, therefore, that there is a need for a significant realignment of the Vietnamese dong at this time. The parallel market has been stable, while the official rate remained within 0.3 percent of the parallel rate during 1994 and the first months of 1995. And export growth continued to be robust in the early part of 1995, indicating that external competitiveness remains sound.
Exports in transferable rubles in 1990-91 are converted into U.S. dollars at 2.4 transferable rubles per U.S. dollar, the average cross rate vis-à-vis the dong during 1988-91.
An earlier base year is problematic in that it is not clear which of the then-existing exchange rates should be used.
The 7 remaining exported commodities were rice, coffee, peanuts, rubber, coconut meat and oil, logs and lumber, and metals and metal waste. The 12 remaining imported commodities were transportation vehicles, cement, electronic goods and components, textiles, bicycles, electric fans, beer and soft drinks, cigarettes, cosmetics, and ready-made clothes.
Limits are set on exports of garments to the European Union (under the Multifiber Arrangement) and on exports of cassava, but these are stipulated by the market countries.
At the end of June 1995, exports of the following goods were banned: weapons and explosives, antiques, drugs, poisonous chemicals, and wild animals and plants. Imports of the following were also banned: weapons, drugs, poisonous chemicals, undesirable cultural material, firecrackers and toys harmful to children, cigarettes, used goods excluding motorcycles and vehicles with fewer than 12 seats, and vehicles with right-hand drive.
The eight commodities no longer requiring permits are explosives, fabric, cloth, jute bags, paper, materials used to produce cigarettes, milk, and electronic appliances and accessories.
In October 1994, the authorities introduced new foreign exchange regulations to promote the use of the dong and to increase the supply of foreign exchange in the interbank foreign exchange market, which was set up at the same time. Concerned that there would be a shortage of foreign exchange in the new market, the government introduced—on a temporary basis—a partial surrender requirement. However, a shortage never materialized, and the regulations have only been enforced loosely.
However, the trading organizations that participated in the foreign exchange trading floors must now conduct their foreign exchange transactions through commercial banks.
In some countries, capital controls (often motivated by recur-rent balance of payments problems) were the primary factor leading to the emergence of a parallel market for foreign exchange. See Kamin (1991) for an account of Argentina’s experience in the 1980s.
In the use of the premium as an indicator of real exchange rate misalignment in developing countries, see Quirk and others (1987).
This view of the relationship between the premium and real exchange rate misalignment has some empirical support. For ex-ample, studies of a number of devaluation episodes (see Edwards, 1989; and Kamin, 1993) find that the parallel market premium often rises very rapidly immediately before a major devaluation and then falls off just after the devaluation. A positive correlation between the premium and the extent of the real exchange rate overvaluation would seem to be suggested in such cases.
Even in the longer run, it is important to recognize that the premium reflects not only the overvaluation, but also the risks of transactions in the parallel market.
Reducing high premiums in the parallel market reduces the implicit taxation of exports, curbs rent-seeking activities, and lessens administrative discretion in the allocation of foreign exchange.
In brief, on the revenue side, while receipts from state enterprises declined sharply, the adverse effects were mitigated by increased revenue from the nonstate and trade sectors as well as by growth in oil revenue. In 1989, the tax system was extensively revised, with a view to broadening the base and establishing uniform tax treatment of public and private entities. On the expenditure side, budgetary subsidies, which had amounted to some 7 percent of GDP, were largely eliminated in conjunction with the 1989 price and exchange rate reforms, and state enterprises were required to meet their investment needs from their own resources.
The intensity with which financial stabilization policies were pursued during 1989-94 was not even, but substantial progress was nevertheless made. In early 1989, interest rates were raised sharply to positive levels in real terms, while the public sector’s financial position improved. As a result, inflation fell from about 400 percent in 1988 to 35 percent in 1989. While external shocks associated with the loss of aid from the former Soviet Union and the collapse of trade with the CMEA, combined with monetary financing of fiscal deficits, resulted in a rise in the inflation rate (to about 70 percent a year in 1990-91), the authorities tightened monetary policy considerably in late 1991 and reestablished positive real interest rates. By 1993, inflation had dropped to 5 percent, although it has since picked up to more than 10 percent.
The devaluation of the official rate for invisible transactions and trade outside the plan from D 3,500 to D 4,500 per U.S. dollar resulted in a 29 percent depreciation of the effective rates for these transactions.
In a dynamic context, this might be thought of as the natural or the nonaccelerating inflationary rate of unemployment.
For the poorest heavily indebted countries, such as Vietnam, that have lost access or do not have easy access to international capital markets, the meaning of “sustainable capital inflows” could be extended to include “sustainable aid inflows.”
High-debt stocks can discourage investment, both domestic and foreign. If the debt is on the books, there is always the expectation that it will have to be serviced and that investors will be taxed to service it.