SBV official: Vietnam not ready yet for free floating exchange rate

However, Vietnam is not ready yet to let the central rate for the dong/ dollar float freely in accordance with the market forces, added Dung, explaining that Vietnam's financial market is not yet fully developed and domestic businesses do not have enough insurance mechanisms in place to reduce the risk of dealing in foreign currencies.

Free floating regime? Not yet!

Although Vietnam is following a more flexible exchange rate regime, it is not ready to let the dong/dollar exchange rate float freely as demand and supply vary, Dung highlighted.

“The current exchange rate mechanism is the right choice for an emerging economy like Vietnam,” Dung said, indicating that the more flexible exchange rate fixing would strengthen the country’s foreign trade and investment, especially after Vietnam has entered a variety of free trade agreements (FTAs).

He referred to Viet Nam's conclusion of negotiations for FTAs with the Eurasian Economic Union, the European Union, South Korea and the Trans-Pacific Partnership (TPP) last year.

Vietnam anticipates a sharp increase in foreign investment this year as manufacturing firms capitalize on its cheap labor and the prospect of the TPP slashing tariffs.

The current flexible mechanism calculates the daily reference rate based on a weighted average of Vietnamese dong prices in the interbank market in the previous day's trading against prices of eight major foreign currencies at seven in the morning Hanoi local time. This takes into account currency movements in the U.S, China, the European Union, Japan, Taiwan, South Korea, Thailand and Singapore.

Dung said the current mechanism “allows Vietnam to adjust the exchange rate according to changes in major partners' currencies to ensure the competitiveness of Vietnamese products in the international market. At the same time, the current mechanism will prevent extreme movements in the exchange rate, creating favorable conditions for companies in their production and business activities.”

Dung pointed out that Vietnam has not let the dong/dollar exchange rate float freely because it could cause sharp fluctuations in a short period of time under pressure from psychological elements, market expectations and the impacts of domestic and international economic and financial changes.

He added that only highly developed economies with fully grown financial markets can provide businesses with effective financial instruments to minimize risks related to foreign currencies.

Bui Quoc Dung, head of the State Bank of Vietnam's Monetary Policy Department. Photo by VnExpress

Market-based rate mechanism

Earlier this year, the SBV or the central bank decided to ease exchange rate rules, setting the official mid-point rate of the Vietnamese dong against the U.S. dollar on a daily basis.

Vietnam previously adopted a system in which the dong was allowed to trade around a fixed rate that the central bank only adjusted occasionally.

The new policy has been in place for three months, and the foreign exchange market has shown positive signs.

“The dollar/dong exchange rate has quickly improved compared to the rate in 2015 with good market liquidity. Dollar hoarding has considerably eased. The SBV has bought a large amount of foreign currencies to supplement the State's foreign exchange reserves,” said Dung.

“The foreign exchange market has maintained stability amid sharp fluctuations in the international market. This shows that the new mechanism has successfully helped absorb external shocks, minimizing negative impacts on the exchange rate. On the other hand, the new mechanism has also curbed foreign currency hoarding,” Dung added.

Introduction of forward contracts

The new market-based rate is part of several measures the central bank has taken recently to manage the dollar/dong exchange rate in a more flexible way. Dung listed the additional measures as follows:

First, the central bank issued Circular 15 on October 2, 2015 to regulate financial institutions trading in foreign currency. The rule has discouraged individuals and institutions from hoarding dollars as well as encouraged financial institutions to boost their derivatives and forward exchanges in the interbank market in order to reduce risks in dealing with foreign currencies.

The central bank, in the second move, decided to abolish the interest rate ceiling on dollar deposits offered by banks to organizations, companies and individuals. The move is aimed to encourage businesses and individuals to shift to holding the Vietnamese dong to earn higher returns instead of hoarding dollars.

Together with the above measures, the central bank has also introduced forward sales of U.S. dollars to commercials banks who are allowed to cancel their forward contracts during a three-month period.

Forward contracts have made the exchange rate correlate with market expectations and move flexibly in line with domestic and international market developments.

With the introduction of forward contracts, the central bank is more proactive in “guiding the market [and] stabilizing market psychology”.

"[The central bank] uses forward sales as an instrument to support and guide the market. [It helps] control the maximum range in which the exchange rate is allowed to fluctuate in a certain period of time. [The central bank will be able] to shift the supply sources of foreign currencies from the future to the present time [so that it can] boost market liquidity, stabilize the rate and give financial institutions the freedom to balance seasonal supply and demand to meet customers’ demands," Dung explained, "credit institutions which were up for forward contracts dated December 31, 2015, have all cancelled their deals after managing to balance the supply and demand in the [interbank] market."

Last year, the Vietnamese dong weakened around 3 percent in both the interbank and unofficial markets against the central bank's pledge to let the currency slip by only 2 percent.

In mid-August 2015, the central bank widened the trading band in which dong/dollar transactions are allowed to move from 1 percent to 2 percent either side of the fixed mid-point. A week later, the central bank further weakened the currency by extending the trading band to 3 percent.