MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS, HO CHI MINH CITY FULBRIGHT ECONOMICS TEACHING PROGRAM --------------------------------------- VO CHAU THUY TRIEU DEVELOPING THE DOMESTIC GOVERNMENT BOND MARKET: COUNTRY EXPERIENCES AND SUGGESTIONS FOR VIETNAM Major: Public Policy Code: 60340402 MASTER OF PUBLIC POLICY THESIS SUPERVISOR Dr. Pincus Ho Chi Minh City – 2013 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 1 CERTIFICATION I hereby certify that - I wrote the thesis by myself. - the study has not been submitted for any other degrees. - any help I received as well as all sources used have been acknowledged in this thesis with the best of my knowledge.
- the study does not necessarily reflect the views of the Ho Chi Minh City Economics University or Fulbright Economics Teaching Program. Author Vo Chau Thuy Trieu LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 2 Table of Contents CERTIFICATION .4 LIST OF GRAPHS .10 Chapter 2 LITERATURE REVIEW .1 Financial repression is ineffective for the economy.2 Benefits of a developed domestic government bond market .13 Chapter 3 COUNTRY EXPERIENCES .1 How did Malaysia develop their domestic bond markets? .1 Situation and motivation for reform .2 How did Thailand develop its bond market? .1 Situation and motivation for reform .1 Developing the bond market is important for Vietnam.2Vietnam government debt market overview .3 Types of government debt securities.2 Government-guaranteed bonds .5 Factors hinder Vietnam’s domestic government bond market .1 Interest rate cap .2 Statutory liquidity ratios of banks .6 Suggestions for Vietnam’s bond market .44 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 3 Chapter 5 CONCLUSION .48 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 4 ABBREVIATIONS BTH: Thailand Bath HNX: Hanoi Stock Exchange HSX: Ho Chi Minh City Stock Exchange MOF: Ministry of Finance OMO: open market operations SBV: State Bank of Vietnam USD: U. dollar VND: Vietnam dong LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 5 LIST OF GRAPHS Graph 3.1: Bond outstanding value of Malaysia .2: Domestic financing profile of Malaysia .3: Size of Thailand financial market .4: Financing profile of Thailand (% GDP) .5: Regional Government bond turnover ratio .1: Bank credit to GDP of regional countries.2: Vietnam bond outstanding value .3: Vietnam domestic bond issuances .4: Vietnam GDP growth and inflation rate .5: Regional bond market size in % GDP .6: Regional countries’ government bond bid-ask spreads .7: Vietnam government bond auctions over years.42 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 6 ABSTRACT While other countries use open market operations (OMO) as an indirect instrument to manage the liquidity in the economy to steer market interest rates, Vietnam has to use direct instruments of interest rate control which have been proved inefficient for the economy. After reviewing papers on using OMO to implement monetary policies of countries in the world, the thesis finds that Vietnam is lacking a vibrant domestic government bond market to facilitate the conduct of OMO.
Vietnam’s conventional secondary government bond market is just seven years old and the country’s government debt market is just beginning to develop. By looking at the experiences of countries in the region which have similar features to Vietnam’s domestic bond market, this thesis aims to derive lessons to help improve and boost the development of the domestic government bond market. This paper goes through the development of government bond markets in Malaysia and Thailand when they were at the first stage of developing their bond markets twenty years ago in order to discover key policies to promote the bond market. From that result, the dissertation considers whether these measures can apply to Vietnam.
The main recommendation is for the government of Vietnam to set up a primary dealer system facilitating bond auctions and trading as well as supporting the conduct of open market operations, to build a market-based benchmark yield curve and provide tax exemption to government bond investors. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 7 Chapter 1 INTRODUCTION 1.1 Background Transition to indirect instruments: global trends Inflation control is among the top priorities of every government. Controlling inflation requires careful management of the money supply by the central bank. Central banks possess three main indirect instruments of reserve requirements, discounting eligible bank assets, and open market operations (OMO).
However, Mishkin (1995, 540) argues that OMO has more advantages than the other two in implementing monetary policy. Thus, using this instrument has become a common trend in the developed countries. Country experiences show that indirect instruments especially market-based operations have brought greater benefits for economies than direct tools whether in developing or developed countries. The benefits are mentioned by William et al (1996), in which the authors state that “They [indirect instruments] permit the authorities to have greater flexibility in policy implementations.
Small, frequent changes in instrument settings become feasible, enabling the authorities to respond rapidly to shocks and to correct policy errors quickly.” Meanwhile, direct instruments including interest rate controls, credit ceilings, and directed lending often lose effectiveness because economic agents find means to go around them, according to the paper. Research on implementing monetary policies has shown that there has been a clear trend of switching to using indirect instruments and then a greater reliance on market-based operations since the 1970s given the advantages of market-based instruments. Buzeneca and Maino (2007) find that direct instruments of monetary policy are no longer used in the majority of countries and there is a trend towards reliance on indirect instruments especially on open market operations. In the 2004 survey of IMF of 45 central banks around the world, there is no developed country using direct instruments while a few developing countries still use them.
Meanwhile, the ratio of emerging market economies and developing economies using market-based instruments has increased compared to results in the 1998 survey. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 8 Vietnam: delaying the trend Thus the transition to greater reliance on market-based operations, particularly open market operations, in implementing monetary policy is a global trend which is relevant to Vietnam. The country liberalized interest rates in 2002 and since 2000 has introduced open market operations in conducting monetary policies. However, Vietnam’s transition has been delayed.
Since 2008 the State Bank of Vietnam (SBV) has reintroduced direct or administrative instruments to implement monetary policy. The year 2007 saw a boom on the stock market that was mainly caused by a massive inflow of foreign capital, equal to about 18 percent of GDP. SBV was unable to sterilize these inflows, with the result that money supply increased sharply. According to World Bank data, net foreign portfolio investment strongly increased from USD1.31 billion in 2006 to USD6.
Stock market capitalization increased from three percent of GDP in December 2005 to 43 percent of GDP by March 2007, according to World Bank (2009, 90). In addition to the price bubble on stock and property markets, the rapid increase in money supply contributed to price inflation which peaked at 28 percent per annum in 2008. High inflation led to rising nominal lending rates which hindered enterprises’ access to bank loans. In 2008, SBV tried to use indirect instruments of raising policy rates and reserve requirements, aiming to rein in the inflation.
However, it did not have much effectiveness since banks had considerable excess stocks of reserves (Riedel and Pham 2012).The central bank therefore had to use the direct instrument of the ceiling rates again and also forced banks to buy central bank bills totaling VND20.3 trillion in March 2008. The central bank wanted to restrain inflation at that time but also wanted to decrease nominal interest rates as instructed by the government, so they officially came back to direct monetary instruments by asking banks to set lending rates within the band of 150 percent of the prime rate set by SBV. By May 16, 2008 the central bank issued directive 16/2008/QD-NHNN on the prime rate managing mechanism, ending the period of six LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 9 years of interest rate liberalization. However, as large amounts of money were withdrawn via central bank bills, many banks experienced a liquidity shortage and had to raise deposit rates which in turn pushed nominal lending rates higher.
Banks competed with each other to attract deposits, which also put upward pressure on lending rates for enterprises. Stricter administrative instruments from the central bank to punish banks breaking the rule were applied. The central bank even set up a hot line to receive information about banks giving loans at rates higher than the ceiling level. Inflation has become the biggest threat to the Vietnamese economy since 2008, except in 2009 during the global recession.
Given the lower inflation rate in 2009, SBV let banks negotiate lending rates in 2010. However, when high inflation rose again in 2010 and 2011 prompting a rise in interest rates, the central bank came back to administrative controls again in 2011 aimed at decreasing market lending rates. These measures have continued until the end of 2012 as banks have to give loans at rates no higher than the ceiling given by the central bank. SBV in fact used two indirect instruments of required reserve ratios and lending facilities to rein in inflation - but they didn’t help much.
The reason is that Vietnam has maintained a pegged foreign exchange rate regime and does not have an independent monetary policy, according to Riedel and Pham (2012). Theoretically, there are three things that cannot happen at the same time, namely free capital inflows, pegged exchange rate, and independent monetary policy. Vietnam received massive foreign capital inflows in 2007 and still wanted to peg its foreign exchange rate to support exports, so its monetary policies cannot have effectiveness as the central bank’s purposes. For example, large foreign capital entering Vietnam has made local currency stronger.
To keep the foreign exchange rate stable, the central bank had to buy foreign capital and supply money to the economy which put pressure on prices. Meanwhile, Vietnam could not rely much on open market operations to manage the money supply, or in this case sterilize the unexpected increase in money supply, like other countries with developed financial markets. Because Vietnam’s domestic bond market was too small relative to the capital inflow and liquidity in the secondary market was low, the government could not sterilize its foreign exchange operations. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 10 But even if it could, this probably would not have solved the problem.
Rising domestic interest rates would attract even more capital given the pegged exchange rate, making the problem even worse. For small economies with large capital inflows there may be no “equilibrium” set of exchange rates and interest rates (Ocampo, Rada and Taylor 2009). Research on implementing monetary policies has pointed out many reasons for limited effectiveness of open market operations. However, one prerequisite mentioned by most papers is an active secondary government bond market.
Vietnam also has a secondary government bond market but it cannot support the conduct of money market operations for monetary policy implementation. Finding out suggestions to improve Vietnam domestic government bond market is the target of this thesis.2 Policy questions Therefore, the thesis will find answers to two questions: - What are problems of Vietnam domestic bond market? - How can Vietnam develop a government bond market? LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 11 Chapter 2 LITERATURE REVIEW 2.1 Financial repression is ineffective for the economy Financial repression will hinder financial system’s development while interest rate control is considered the main measure of financial repression (Kitchen 1995). Interest rate controls are a policy tool that results in financial repression, but which nonetheless is preferred by some developing countries which do not have or cannot use indirect instruments given shallow financial markets. Most of governments control interest rates due to uncertainties on the market but this action also leads to distorted interest rates and dampens the development of the financial markets, thus exerting a negative effect on economic growth (Kitchen 1995).