Viet Nam Errs in Bid to End Grey Market in Dong: Andy Mukherjee

Stability or flexibility?

It isn't quite clear which of those two goals Vietnam's central bank is pursuing with respect to its currency, which some analysts say is ripe for a crisis.

The concern is that an overvalued exchange rate, coupled with a trade deficit and an intolerable surge in inflation may spook foreign investors to pull their money out of Viet Nam, and in this they may be joined by locals.

On June 26, the central bank announced it would double -- to 2% -- the limit it imposes on the daily change in the tightly controlled official rate for trading Vietnamese dongs into U.S. dollars and vice versa.

That does sound like a small move toward greater flexibility in what's essentially a currency pegged to the U.S. dollar.

Besides allowing for a controlled release of devaluation pressures, an orderly decline in the currency may also help narrow the trade deficit, which almost tripled from a year earlier to about $15 billion in the first half of 2008.

Seeking export competitiveness through a cheaper currency isn't much of a policy option for Viet Nam at present. Exports aren't even a big concern. The trade gap is wide because Viet Nam is importing too much.

Too sharp a depreciation in the dong could, by pushing up the local price of imported goods, stoke inflation, which is already very high. Consumer prices rose about 27% from a year earlier in June. (The General Statistics Office in Hanoi usually announces data before the month has ended.)

And that might help explain why the central bank decided to ban trading in dong using currencies other than the dollar. The move seems to signal a preference for exchange-rate stability.

Two Markets

The central bank is seeking to establish the supremacy of the artificially high official exchange rate -- which is meaningless to most people who need dollars, except importers authorized by the government -- over the more realistic rate prevalent in the parallel market.

The official rate this week, before the change in policy caused the dong to fall 1.4% on June 27, was about 16,615 dongs to the dollar. At that price, few, if any, traders are willing to sell dollars. Why would they when one unit of the U.S. currency has, of late, fetched from 17,500 to 18,500 dongs in the unofficial market?

In other words, the currency market is fractured down the middle. Want dongs? You'll get them easily at the official rate. Want dollars? Go to another market, which falls ``somewhere between grey and black,'' says Kevin Snowball, a portfolio manager at PXP Viet Nam Asset Management in Ho Chi Minh City.

Layer of Legitimacy

Third-currency trades bestowed a layer of legitimacy on the parallel market. Traders could buy euros or yen by paying in dongs -- without any restrictions -- and then convert them into dollars.

Now the escape hatch has been shut.

``The ban on third-currency trading goes in the wrong direction since it takes away the arbitrage channels that normally serve to make the market deeper and more efficient,'' Paul Gruenwald, an economist at Australia & New Zealand Banking Group Ltd., wrote in a recent note to clients. ``This is equivalent to banning the parallel market.''

A more efficient way to seek the much-needed convergence between the official and the unofficial exchange rates would be for the State Bank of Viet Nam to show strong commitment to sell dollars from its foreign-exchange reserves in the market.

This would ease a perceived shortage of dollars and give greater confidence to the Vietnamese people to hold local currency assets. The ``trick,'' Gruenwald says, is to ensure that domestic confidence is not lost.

`Hot Money'

Most of the foreign money in Viet Nam is for long-term direct investment. The share of ``hot money'' is small, and that makes large-scale capital flows out of Viet Nam unlikely, Nomura Securities Co. said in a report this month.

Short-term foreign liabilities are a fraction of Vietnam's estimated international reserves of $20.7 billion, making the dong more defensible than was, say, the Thai baht in 1997.

Viet Nam also has strict controls on capital flows, though any country that's open to trade can see a large amount of capital moving in -- or out -- through wrongly invoiced exports and imports.

Morgan Stanley has warned investors that Viet Nam may be headed for a ``currency crisis.'' The dong is ``excessively overvalued,'' Goldman Sachs Group Inc. said earlier this month.

Deutsche Bank AG and Daiwa Institute of Research Ltd. have suggested that Viet Nam will need a rescue package to put its house in order. The government has said it doesn't need any such help from the International Monetary Fund or another lender.

Rather than seeking to influence private expectations, the government is trying to push them underground. At least that's what the restriction on using a third currency to trade dongs against dollars seeks to accomplish.

Turning away from a market doesn't make it disappear. An exchange rate that's determined by state diktat and judged by the market to be inappropriate can't prevail forever. (Bloomberg)