Undervalued currency may undermine sentiment to reform

Following are the key excerpts:

Reporter: Some experts suggest a wider trading band between the U.S. dollar and Vietnam dong following China’s strong yuan devaluation last week. Do you agree with them?

Mr. Dan Svensson: It is hard to pinpoint an optimal exchange rate but generally it may be a good idea to ease the peg to the U.S. dollar and widen the trading band. That would initially probably result in further depreciation of the local currency. At the same time Vietnam should not only rely on exchange rate policy to stay competitive in export markets.

Vietnam should not become dependent on a weak dong but instead increased competiveness must be achieved through improved infrastructure and structural reforms both in public and private sectors. An undervalued currency may undermine the sentiment to do reforms.

Reporter: Local media has painted a gloomy picture about China’s role in Vietnam’s balance of trade and the negative impact of the yuan devaluation on the Vietnam dong. What is your view?

Mr. Dan Svensson: Vietnam’s large trade deficit with China is a problem and a weaker yuan will not mitigate it. Vietnam needs to take a broader view on the problem and find other means than the currency to enhance the competiveness to China.

Reporter: If the yuan is depreciated further, what would happen to the value of the dong?

Mr. Dan Svensson: As the market sentiment looks right now it will most likely put more pressure on the dong. Still deposit rates are likely to compensate for any depreciation.

Reporter: Vietnam’s foreign exchange reserves of US$40 billion or 12 weeks of import cover at the end of July allow the State Bank of Vietnam (SBV) to intervene to stabilize the forex market for a while. But is this a costly gamble for the central bank or not in the medium term?

Mr. Dan Svensson:  I agree that intervention in the foreign exchange market must be done with extreme caution as it otherwise can be both inefficient and very expensive. The force of a market going in one direction is very tough or even impossible to stop through intervention.

Reporter: The central bank is expected to lower interest rates to support economic activity. Will it be a big challenge for the SBV to make the local currency stable and keep interest rates low at the same time under the current circumstances?

Mr. Dan Svensson: I agree that there is a critical level for interest rates to maintain the dong stability. At the same time real interest rates, nominal interest rates adjusted for inflation, are very high compared to peers and which is not healthy for the economy. This shows that pursuing monetary policy in a fixed exchange rate environment is not easy.

Reporter: How would Vietnam’s foreign exchange market be like in the remaining months of the year?

Mr. Dan Svensson:  Unlike 2013 and 2014, the Vietnam dong will this year not have support from strong positive external balances. Also there is a high likelihood that the U.S. dollar will remain strong. This will probably exert further mild pressure on the local currency. But the SBV’s widening of the trading band this morning was decisive and timely and most importantly provided flexibility for the future.

Reporter: What are the impacts of a weaker Vietnam dong on the country’s public debt?

Mr. Dan Svensson: All-in-all the foreign debt will be more expensive to service but it will be manageable. Although Vietnam’s commercial foreign debt is quite small, official development assistance (ODA) loans must in reality also be serviced. Equally important, an uncertain currency environment also has negative impact on investor’s willingness to buy dong denominated bonds.

Reporter: Demand for bonds remains lackluster and investor sentiment is dismal due to the recent volatility of the currency market. What is the outlook for the government bond market towards the year-end?

Mr. Dan Svensson: It is a tricky situation with very low inflation and very high real interest rates. The G-bonds now have competition from many other asset classes at the same time as the investor basis is both narrow and thin. The banks which principally are the only investors face pressure to increase lending. Also the uncertain currency will cause upward pressure on the banks’ deposit rates. The market first wants to push up rates and then towards the end of the year try to pull them down again. But generally rates may be stuck in a fairly narrow band.

Reporter: How about foreign investors’ moves if demand for G-bonds does not improve much and the FX market is unpredictable?

Mr. Dan Svensson: Vietnam may have to wait for long-term strategic investors as the market is too small, illiquid and sensitive. As regards to FX volatility we must remember that many of Vietnam’s Asian peers through the year also have undergone huge swings. Vietnam’s bond market has in U.S.-dollar terms through the years given a very high return but most investors have missed it. For instance, since 2007 Dragon Capital’s Vietnam Debt Funds annual U.S.-dollar-gross return is 12.7%.

Reporter: Do you see a firmer U.S. dollar against Vietnam dong in the next two years?

Mr. Dan Svensson: It is not my base scenario. In my view there is no need for such strong depreciation of the local currency. I think 1-4 % per year is sufficient. Tools like the REER index, which suggest greater need to devalue, may not be applicable to frontier market economies.