- Krishna Srinivasan, Erich Spitäller, M. Braulke, Christian Mulder, Hisanobu Shishido, Kenneth M. Miranda, John Dodsworth, and Keon Lee
- Published Date:
- March 1996
Vietnam today stands on the threshold of a new era in its international relations and economic development. After almost a decade of concerted efforts, its economy and finances have been substantially reformed, and it is firmly integrated into the world economy. It has made substantial progress in regularizing its external debt arrears and is now beginning to benefit significantly from economic assistance and foreign direct investment (FDI). The momentum of change—guided by market principles and buoyed by strong growth—seems irreversible, with the old economic system and interventionist government policies viewed as having failed to raise the welfare of the general population. While many challenges remain, Vietnam’s accomplishments over the past few years bode well for its capacity to prevail.
The present Occasional Paper explores the pattern of transition of the Vietnamese economy, the policies that were applied, and the reasons for the country’s success. The paper’s two main messages are as follows. First, in comparison with other economies in transition, initial conditions in Vietnam were favorable: the structure of production (including the coming onstream of oil production) was amenable to a quick supply response; the legacy of a market economy was quickly revived in the south; integration with the former Council for Mutual Economic Assistance (CMEA) was relatively low; and neighboring Asian countries not only provided buoyant markets for Vietnamese exports, but also were seeking to invest their savings abroad. Second, the Vietnamese authorities implemented with some determination a coherent mix of mutually reinforcing structural reform and financial stabilization policies. The departure from the previously accepted paradigms and their replacement by market-based principles were made more radical owing to the sudden collapse of the CMEA and to the withdrawal of Soviet support. In particular, private enterprise was encouraged; key agricultural sector reforms were implemented; and prices, exchange rates, and foreign trade were liberalized. At the same time, bank financing of the fiscal deficit was eliminated, a hard budget constraint was imposed on public enterprises, liquidity expansion was reined in, and the attractiveness of the local currency as an asset was enhanced by the adoption of positive real interest rates. All these factors combined to elicit, in contrast to the decline in other transition economies, a positive output response, albeit from a low base, and to secure marked progress toward financial stability.
Of the six sections in this Occasional Paper, the first three focus on real sector developments in Vietnam’s transition, addressing in detail the response of output by sector, the performance of public enterprises, and the role of foreign direct investment.
An appropriate policy mix was a critical factor in maintaining buoyancy of output. Liberalization measures and the creation of incentives helped redress the underutilization of resources and induced large and relatively smooth shifts of labor from the public sector to the newly sanctioned private sector. A successful land reform, granting quasi property rights to the tiller without burdening him with debt, combined with the lifting of export restrictions spurred agricultural production. Aggregate demand held up relatively well, with exports increasing rapidly and with domestic demand substituting in part for the collapsing imports of the CMEA area. This was aided by reduced government intervention that allowed wage, price, and exchange rate flexibility.
The relatively small public enterprise sector (accounting for about one-fourth of total output and one-eighth of employment early in the transition) has been transformed under the impact of the same supply-side policies that have affected transition in the economy as a whole. Enterprises have become more autonomous in their decision making, while the budget constraint they face has become harder as subsidies and bank support were substantially curtailed. In the process, enterprises’ output performance strengthened as a result of restructuring, including the shedding of labor and the creation of joint ventures that attracted foreign investment and new technologies; the public enterprises became a net revenue contributor to the budget.
From the start, FDI was envisaged to play a central role in the transformation of the Vietnamese economy. Early approval of the Foreign Direct Investment Law, liberal by international standards, was a strategically important signal of the nature and direction of the reform process that was being set in motion. Although difficulties and delays arose as a result of cumbersome approval and licensing procedures, over the years, the Vietnamese authorities have gradually rationalized administrative procedures. As a result, disbursements of investment commitments have started to increase—with Vietnam having one of the highest ratios of foreign direct investment to GDP in the world and a corresponding positive impact on the economy. It is expected that, with improved procedures, with Vietnam’s integration with the Association of South East Asian Nations (ASEAN) and the ASEAN Free Trade Area (AFTA), and with full normalization of its international relations, foreign direct investment will play an increasingly important role in the modernization and growth of the Vietnamese economy.
The remaining three sections discuss inflation, dollarization, and exchange rate policy. The section on inflation shows that a close relationship exists between the money supply and price levels, with lags of one to two months. In slowing liquidity expansion and promoting demand for the domestic currency, financial stabilization policies—in particular, strong revenue efforts that allowed the cessation of monetary financing of the government deficit—have been instrumental in bringing inflation down from close to 400 percent early in the transition to rates in the single digits in 1993. This section also shows that variables other than money—in particular, increases in the price of rice—that were related to domestic output shocks and foreign price increases have affected inflation, at least in the short run.
In designing a transition strategy and pursuing financial reform and stabilization, the Vietnamese authorities have had to contend with pervasive dollarization (currency substitution) of the economy. Since the early 1970s, the U.S. dollar has been used, along with gold, as a medium of exchange, unit of account, and store of value, circulating alongside the Vietnamese dong. While constraining the conduct of domestic monetary policy and reducing gains from seigniorage, currency substitution has made it possible for the Vietnamese to protect their purchasing power and ensure greater efficiency in transactions. In response to the competition from an asset other than the dong, domestic policies have become more disciplined.
The section on currency substitution reviews the growing use of the dollar prior to reform, describes how dollarization complicates macroeconomic management, and assesses the efforts of the authorities to redress the problem. The main conclusions are that de-dollarization will be difficult to achieve and will result only from lasting improvements in the dong in all its functions as money. Accordingly, the emphasis must be on pursuing sound and credible financial policies, including an active interest rate policy, and on progress in financial sector reform. Once the attractiveness of the dong is ensured, the desire to substitute other assets, including the dollar, is expected to diminish considerably.
The section on international integration and exchange rate policy shows that, in opening up the economy, the authorities implemented trade and exchange reform to complement the strategy of encouraging foreign direct investment. In addition, the movement toward greater openness has been spurred by a market-based exchange rate policy. The early unification of the exchange rate, in which overvalued administered rates were aligned with the market rate, thereby securing an effective depreciation of the dong, and the subsequent broad stabilization of the exchange rate in the context of financial stabilization have served Vietnam well. Exchange rate developments have become a highly visible indicator of financial conditions and the stance of financial policies; the status of the dong has been enhanced, and export performance has been strong across the board. Indeed, the section argues that with the intensifying inflow of nondebt capital, the equilibrium value of the real effective exchange rate may have risen. This, in turn, suggests that a real appreciation of the dong at this stage would not necessarily imply an exchange rate misalignment in terms of a sustainable current account deficit.