Dollarization of financial assets and liabilities of the household sector, the enterprises sector and the banking sector in Vietnam

Dollarization of financial assets and liabilities of the household sector, the enterprises sector and the banking sector in Vietnam By MA Nguyen Thi Hong 1 Hanoi, July, 2002 Introduction Dollarization is a common phenomenon in countries that have experienced severe inflation. In these countries, high inflation implies the weaknesses of money authorities in controlling and stabilizing money movements; due to erosion of its confidence in the local currency, the public tends to hold foreign currencies in stead of the local currencies for the store-of-value and medium-of-exchange purposes. In the last decade, although inflation had been controlled at low rate, dollarization was still frequent in developing and transitional economies, including Vietnam. In the 1970s and 1980s, Vietnam s economy fell into serious economic and financial imbalances marked by hyperinflation. In this context, the US dollar was circulated widely and performed medium-ofexchange and store-of- value functions but was not deposited with the banking system. Since the start of economic reforms, the banking system has developed strongly in both quantitative and qualitative terms. In conducting the monetary policy, the State Bank has achieved great successes in curbing inflation, stabilizing the value of local currency, and building up the public confidence in the banking system that has been undergoing a fundamental restructuring process. Previously, the dollarization was mainly took the form of foreign currency cash in circulation that was out of the banking system s control. It was seen as a cause of instabilities and uncertainties in the monetary and foreign exchange markets. To date however, the dollarization has been gradually moved to the form of foreign currency deposits with the banking system. Despite such a new pattern of dollarization, the current situation of dollarization still poses significant challenges to the State Bank of Vietnam in conducting monetary policy and acting as lender of last resort because of narrowed domestic currency market. Therefore, cost and consequences of dollarization, policy implications to dedollarization have become under hot debates, particularly in recent years when the degree of dollarization rose again. So far, a number of researches on dollarization in Vietnam have been undertaken such as John R.Dodsworth, e tal, 1996, Vietnam: Transition to a Market Economy published by IMF and recent research on Foreign currency deposits in Vietnam in Selected Issues in 2002; research on Dollarization for the case of Vietnam based on econometric analysis by Ngo Huy Duc published by the Australian 1 This paper was presented at the JICA-State Bank of Vietnam Joint Research Project Workshop on Dollarization and its effect on monetary and foreign exchange rate policies and the development of financial system: Vietnam, Lao PDR and Cambodia, July 5,2002, Hanoi 1

National University in 1995; a research on Increasing dollarization in Vietnam by Andreas Hauskrecht, Germany expert in 2000. Having analysed and evaluated the degree of dollarization from the whole country s point of view and in terms of different aspects, these researches also pointed out causes and effects as well as policy implications to reduce dollarization in Vietnam. However, no research exits that provides a comprehensive assessment of the degree of dollarization of different sectors of the economy (namely households, enterprises and banks) from both sides of balance sheets. By using the banking statistics, it is also possible to gain an insight onto the relationship among them because the banks serve as financial intermediaries. Such study should be a pre-requisite for suggesting any measures to reduce the degree of dollarization. In this spirit, the paper examines the degree of dollarization by each economic sector in Vietnam during 1990-2001. Based on an overview of current situation of dollarization by each economic sector, the paper also discusses foreign the exchange risks facing to banks and business firms in the context of increasing dollarization. In recent years, Vietnam Government has introduced the foreign currency surrender requirements aimed at concentrating all foreign currency revenues from the current account transactions to the banking system. How this policy has affected the foreign exchange risks exposed to banks and business firms will also mentioned in this paper. Finally, based on analyses provided, the author has made some policy implications to dedollarization with a view to enhancing the State Bank of Vietnam s ability in controlling monetary movements in the coming years. 2. Evaluating the degree of dollarization by sectors in Vietnam, 1990-2001 Macroeconomic system consists of different economic units such as households, enterprises, banking system and government. Among them, the banking system plays a very important role as financial intermediaries, channelling funds from savers to investors and providing various banking services to the economy. In an economy with high ratio of financial deepening, all sectors of the economy tend to deposit their money with the banking system, evaluating the degree of dollarization by each sector is an easy work because the data of assets and liabilities of the banking system can help. However, in an economy with low ratio of financial deepening like Vietnam, evaluating the degree of dollarization is so difficult, particularly the degree of dollarization of household sector 2. 2.1. Dollarization of household sector Since the economic reform program has been initiated, a series of economic reforms have been took place. Of which, the banking system reform is one of key reforms that brought many encouraged 2

economic achievements in managing macroeconomic developments, stabilising and developing the economy. Particularly, thanks to the reforms in exchange rate policy, foreign exchange regulations and thanks to the economic achievements such as curbing inflation, contributing to high economic growth rate, the banking system has built up the confidence from the public. As a result, a large amount of foreign currencies have been attracted to the banking system in the form of foreign currency savings. 2.1.1. Deposit dollarization of household sector During the period of hyperinflation, individuals and households preferred to keep their savings in the form of valuable assets such as foreign currencies of gold rather than in bank account. An outstanding features of the foreign exchange market existence of informal foreign exchange market [i.e. a paralleled market for the illegal foreign exchange transactions]. The use of USD was common in the South of Vietnam under the war. After the war, the U.S. dollar continued to be held by public as a creditable instrument to serve as store of value, unit of account and medium of exchange under the hyperinflation circumstance and the weakness in economic performance. Despite the prevailing foreign exchange regulations did not allowed using the USD for every day commerce transactions, a large amount of foreign currencies were still held by individuals and households and were used for many payment transactions in paralleled market outside the government s controlling. A new decree on foreign exchange regulation issued on October 21, 1988 was designed to attract foreign currencies that had been traded in paralleled market into the banking system as well as to enhance the liberalisation of foreign trade and investment. In March 1989, by unifying all different exchange rates and announcing the official exchange rate closely with the exchange rate in paralleled market, the State Bank of Vietnam officially devalued VND five times. Other reforms in foreign exchange regulations were also taken place. In the past, the overseas Vietnamese s remittances were only paid in VND to recipients but since February 1995, the Decision of the State Bank s Governor No 48-Q /NH7 has allowed people to keep their money in the form of foreign currency savings and can withdraw in foreign currencies or exchange into Vietnamese Dong. This reform has encouraged overseas Vietnamese to remit their money to their relatives in Vietnam (more than 1 billion of USD per year). In 1999, the Prime Minister s Decision No.170/1999/QD-TTg dated 19 th August 1999 was promulgated to encourage, and create favourable conditions for overseas Vietnamese to remit their money to their relatives in Vietnam. According to this Decision, the beneficiary does not have to pay income tax on the received amount. They have the right to draw their funds in Vietnamese Dong or in foreign currencies as required, to sell to commercial banks or exchange bureau or to open the personal foreign currency account with an authorised credit institution. 2 The financial deepening ratio (M2/GDP) was less than 20 percent until 1998 and increased to 27 percent in 1999. This ratio has been improved to 50 percent in 2000 and 57.7 percent in 2001. 3

With above reforms, households can freely hold USD or VND deposits with the banking system. Their behaviour changes overtime depending on the rate of returns on Dollar and Dong. Comparing the rate of return between VND and USD, the Table 1 shows that VND was more attractive than USD during 1992-1997 and less attractive than USD since 1998. Table 1. Vietnam: Savings interest rate of USD and VND, 1992-2001 Year VND depreciation USD savings interest Total yields of USD VND savings interest Unit: percent per year Differences in yields on VND and USD (1) (2) (3) (4) (4 3) 1992-8.13 4.05-4.08 34.1 38.18 1993 2.62 3.2 5.82 20.4 14.58 1994 1.92 3.5 5.42 16.8 11.38 1995-0.33 4.5 4.17 16.8 12.63 1996 0.33 4.8 5.13 9.6 4.47 1997 11.57 5 16.57 9.6-6.97 1998 12.70 5 17.70 9.6-8.10 1999 0.89 4.7 5.59 5.25-0.34 2000 3.54 4.43 7.97 4.45-3.52 2001 3.90 3 6.90 5.95-0.95 Source: The State Bank of Vietnam. The end of period exchange rate is used to calculate the VND depreciation If households deposit all their money with the banking system, when the VND is more attractive than USD, they shift to hold USD and its FCD/M2 ratio will increase, and when USD is more attractive than VND, they shift to hold VND and its FCD/M2 ratio will decline. The Figure 1 shows that the deposit dollarization as measured by the FCD/M2 ratio of households increased from less than 5 percent during 1992-1996 to nearly 20 percent in recent years. The question is why during 1992-2997 when the rate of return on VND was higher than the rate of return on USD, the deposit dollarization of household sector (as measured by its FCD/M2 ratio) still increased. The possible answer may be that the households kept their money not only in the form of deposits with the banking system but also in the form of cash. Especially under hyperinflation pressures, they tend to hold foreign currency or gold as a store-value instrument. Thanks to stronger banking reforms, the public became more confident in banking system, and their bank deposit tends to grow accordingly. As a result, a large amount of foreign currency cash was driven to the banking system, especially since 1996, when overseas Vietnamese s remittance has increased rapidly (more than USD 1 million per year). It is clearly that the increased amount of foreign currency deposits may be partly caused by the net dollar inflows that households received from foreign countries every year and partly caused by the dollar 4

existed in circulation previously have been attracted to the banking system. Because the data of M2 as illustrated in the monetary survey does not include dollar cash held by households, so when the dollar cash flowed to the banks, the FCD/M2 of household sector increased 3. In addition, during this period, VND depreciated against USD resulting in the increased Dong value of dollar savings of households, hence the value of M2 as well as the degree of deposit dollarization of households increased. Since 1997, when the Asian crisis occurred and spread its effects, the confidence on VND deteriorated sharply and people tended to speculate and hold foreign currencies. The degree of dollarization in this period increased rapidly to nearly 20 percent of M2. This level is higher than the degree of dollarization of business firms in recent years as illustrated in the Figure 2 of this paper. Trillions of VND 70 65 60 55 50 45 40 35 30 25 20 15 10 5 0 Figure 1: Deposit Dollarization of individuals and households, 1991-2001 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year The total FCD of households The FCD/ total deposits ratio of households The FCD/M2 ratio of households Percent 60 50 40 30 20 10 0 The Figure 1 also shows that the FCD/total deposits 4 ratio of households increased from stable ratio of 10 percent during 1992-1994 to more than 30 percent in 1998 and to 50 percent during 2000-2001. This implied that households tend to hold their deposits dominated in USD rather than in VND. 3 If people deposit all their money with the banking system (means that M2 as illustrated in the monetary survey is an adequate measure of money), when the rate of return on VND is higher than that of USD, people shift to hold VND, the FCD/M2 ratio will decline. In the fact, households did not deposit all their money in the banking system, so the data of M2 as illustrated in the monetary survey did not include forewing currency cash held by households. 4 Including VND and foreign currency deposits of households 5

Although the degree of deposit dollarization of households increased, this phenomenon did not reflect the bad situation because the foreign currency cash flowing to the banking system has supplied more funds for credit expansion. The important thing here is that how to encourage the individuals and households to sell these foreign currencies to the banking system. From that, commercial banks can supply more in the foreign exchange market to meet the demand of foreign currencies for expenditure of enterprises such as imported goods and services, external debt payments... as well as sell to the State Bank of Vietnam to increase the international reserves. Although large amounts of foreign currencies hold by households have been channelled into the banking system in the form of foreign currency savings, the foreign currency cash is still circulated widely in paralleled market. Therefore, evaluating the degree of cash dollarization of household sector is needed in addition to its deposit dollarization. 2.1.2. Cash dollarization of household sector (analysing from statistical discrepancies) It is impossible to evaluate the degree of dollarization accurately because the amount of foreign currencies hold by households is not directly observable. In Vietnam, foreign currency cash in circulation may come from different channels such as overseas Vietnamese s remittance, labour compensation paid by non-residents to local staff in Vietnam, transport of foreign currency across borders by tourist, aeroplane and ship crews and business travellers, cash received from smuggling...the multiplicity of channels and the poor statistics put difficulties in measuring degree of foreign currency cash hold by individuals and households. With the assumption that the data of private transfer item(net) as illustrated in the balance of payments of Vietnam can be a good proxy for net dollar inflow of households 5, the paper compares the data of private transfer item in the balance of payments with the change in foreign currency savings with the banking system of households. The household s transactions are only recorded in the private transfer item in the balance of payments. When households have net dollar inflow 6, if they put all their money in the banking system, the foreign currency savings of households will increase, and then the net foreign assets of the banking system will increase 7. If they keep some money in their pocket, foreign currency cash will be accumulated in circulation. 5 Individuals such as local staff of nonresident entities in Vietnam also get paid in foreign currency. However, this amount may be insignificant compared to a large amount per year (more than 1 billion of USD) remitted to Vietnam in recent years. Foreign currencies accompanied by foreigners when they entry in Vietnam may be mostly used to pay to service companies like tourism, airline...companies who have foreign currency deposit with commercial banks, partly be sold to commercial banks at bureau of exchange, the remaining amount is floating in parallel market but this amount may be insignificant. The data of net private transfer item in the balance of payments include all overseas Vietnamese s remittance through the banks, and the post and include foreign currency cash accompanied by people who declared at the Custom Office when they entry minus Vietnamese s remittance to nonresidents and minus foreign currencies accompanied the people who declared at the Custom Office when they departure. 6 Means that private transfer item in the balance of payments has positive sign. 6

Table 2: Private transfers and foreign currency deposits of household sector, 1995-2001 1995 1996 1997 1998 1999 2000 2001 Total FC deposits (trillion of VND) 1.37 2.94 6.9 16.2 21.7 43.19 54.0 The end of exchange rate (VND/USD) 11,015 11,150 12,292 13,890 14,028 14,514 15,004 Total FCD (million of USD) 124 263 561 1,166 1,546 2,975 3,600 Change in total FCD (million of USD) 8 139 298 605 380 1,429 625 Net private transfers (million of USD) 140 1,050 710 950 1,050 1,585 1,100 Change in total FCD/net private transfer (percent) 13 42 63 36 90 57 FC cash accumulation in circulation (million of USD) 911 412 345 670 156 475 Source: Data of net private transfers in the balance of payments of Vietnam and the data of foreign currency deposits in the monetary survey The Table 2 shows how does the private transfer explain the increase in deposit dollarization and cash dollarization of households. As illustrated in the Table 2, the net private transfers increased rapidly from 140 USD million in 1995 to more than USD 1 billion in 1996. The net private transfer was over USD 1 billion per year on average during 1995-2001. However, the change in foreign currency savings was not as high as net private transfers implying that households did not put all their money in the banking system and as a result, the foreign currency cash accumulated in circulation every year. For the whole period of 1996-2001, the net private transfer was more than USD 6 billion. In the mean while, the foreign currency deposits of households increased nearly USD 3.5 billion. As a result, about USD 2.5 billion in cash accumulated in circulation in the past six years. The change in the FCD/net private transfer ratio may be a good indicator that implies the behaviour of households in holding the USD in the form of cash or deposit. In 2000 when the world interest rate increased, households tend to put their money in the banking system to earn high interest. As a result, the ratio of FCD/net private transfer was 90 percent. In 2001, when the world and domestic interest rates declined, this ratio was only 57 percent. The above result reflects that in 1996-2000, the net private transfer supplied a large amount of foreign currency cash to unofficial market in Vietnam (USD 2.6 billion) 9. The amount of foreign currency cash in unofficial market may be much more than that because in 1995, the IMF calculation showed that there was about USD 2.5 billion hold in foreign currencies and about USD 3 billion hold in gold by the public. This fact was also confirmed by the data of VLSS in 1997. According to the data of VLSS in 1997, households held 47.7 percent in gold and dollar, 22.3 percent in Dong cash and Dong denominated financial 7 Increase in net foreign asset is recorded in the balance of payments with negative sign. 8 Is calculated by difference between the amount of foreign currency savings at the end of one year and the amount of foreign currency at the end of previous year. 9 Individuals and households can sell their foreign currencies to commercial banks through the Exchange Bureau. But in the fact, almost people come to the gold shops for their transactions implying that foreign currency cash in circulation is still significant. 7

assets, and 25.3 percent in non-monetary assets. Dong cash is 10.0 and savings at depository institution are only 7.9 percent 10. In short, it can be concluded that the degree of both deposit and cash dollarization of households has increased, especially in the second haft of 1990s. The degree of dollarization of households in recent year was higher than the degree of dollarization of business firms. Both the deposit and cash dollarization of households were caused by increase in net inflows of private transfers thanks to the reforms in foreign exchange regulations and policies that encourage the overseas Vietnamese s remittances. Over time, Vietnamese households have tended to put their money in to the banking system that leads to the increased financial deepening ratio. 2.2. Dollarization of business firms All change in the behaviour of business firms in choosing between local currency and foreign currency will effect on the structure of assets and liabilities of the banking system. Therefore, analysing the structure of assets and liabilities of the banking system can evaluate the degree of deposit dollarization of business firms. This approach is suitable with the case of Vietnam because the prevailing foreign exchange regulations do not allow business firms to open their account with foreign banks abroad except for some economic entities like post, insurance, airline... companies and foreign direct enterprises 11. The amount of foreign currencies that such enterprises deposited with foreign banks is not significant because these enterprises have to transfer to their account with the domestic banks when their account balances exceed the certain amount as stipulated in their licence. The data released by The International Settlement Banks (BIS) also suggested that Vietnamese cross-border deposits played a minor role and were relatively stable during 1999-2000, increasing by USD 24 million in 1999 to some US 130 million at the end of 2000, which was equivalent to less than 3 percent of foreign currencies in the Vietnamese banking system (IMF, 2001, Vietnam: Selected Issues and Statistics Appendix). Through analysing the structure of assets and liabilities of the banking system, the following section will evaluate the degree of deposit and loan dollarization of business firms and compares to the degree of dollarization of households. 2.2.1. Deposit dollarization of business firms Since 1998, the foreign exchange regulations have allowed business firms and individuals freely to deposit their foreign currencies with the banking system. As a result, business firms hold both foreign currency and VND deposits with the commercial banks. In addition, thanks to open door policy, business firms have taken part strongly in external economic transactions such as international trade, foreign direct 10 VLSS,1997 11 These entities have been approved by the State Bank of Vietnam for open their account with foreign banks abroad. 8

investment, and external borrowing... As a result, holding foreign currencies to meet their external payment requirements was demanded by this sector. It can be said that the increasing trend of foreign currency deposits in terms of absolute value reflects the international and global integration of the economy. The degree of dollarization as measured by the FCD/M2 ratio had decreased sharply from 39.7 percent in 1991 to 8.4 percent in 1998. The possible explanation is that during 1991-1998, the VND was more attractive than USD as illustrated in the Table 1 that led to change in the behaviour of business firms (they shifted from USD to VND during this period). In terms of percentage in total deposits of economic enterprise, the ratio of foreign currencies to total deposit of this sector decreased in 1991-1998 period Trillions of VND 40 35 30 25 20 15 10 5 0 Figure 2. Vietnam: Deposit Dollarization of Economic enterprises, 1991-2001 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Total FCD of business firms Total FCD/total deposits of business firms Total FCD/M2 Percent 80 70 60 50 40 30 20 10 0 (Reduced sharply form 75.5 percent in 1991 to 27.7 percent in 1998). But the Figure 2 shows that foreign currencies deposit of business firms increased very sharply during 1992-2001. How to explain the increasing trend of deposit dollarization of business firms during 1998-2001? - Firstly, since 1998, the Asian crisis spread its effects to many countries in the region. Many regional currencies were devaluated strongly while VND was adjusted not as much as other currencies. During this period, people expected VND depreciation and the confidence of the public in VND was deteriorated sharply. In this period, the co-ordination between interest rate policy and exchange rate policy was inconsistent. When the world interest rate increased, domestic rates in many countries have been adjusted upward to avoid pressure on exchange rates while in Vietnam only the interest rates of deposits denominated in USD was raised by banks but Dong interest rate continued to decline. As a result, USD became attractive than VND (see the Table 1) and business firms tended to speculate and hold foreign 9

currencies. In fact, business firms usually overbalanced foreign exchange expenditure needed weekly and monthly compared to the actual demand in order to keep foreign currencies in their account and some enterprises did not subject to the foreign currency surrender requirement stipulated by the State Bank. -Secondly, since 1999 when Asian countries have recovered after the crisis, the trade balance of Vietnam has been improved thanks to strong recovered export performance; - Thirdly, the surrender requirement that was introduced in 1998 reduced from 80 percent in 1998 to 50 percent in 1999 and continued to reduce to 40 percent in 2001. In short, although the value of foreign currency deposits of business firms had increasing trend in the period of 1991-2001, the degree of its deposit dollarization as measured by the FCD/M2 ratio decreased during 1991-1997 and stared to increase slightly since 1998. Although increase again since 1998, the degree of deposit dollarization of business firm was lower than that of households (During 2000-2001, the FCD/M2 of business firm was 12 percent while the FCD/M2 of households was nearly 20 percent). 2.2.2. Loan dollarization of economic enterprises In the context of Vietnam became more integration with foreign trade and intentional finance, the economic enterprises demanded more foreign currencies to meet their expenditure for external transactions as discussed previously. In the case of capital shortage, enterprises have to borrow from banks. The Figure 3 shows the stable trend of foreign currency loans to economic enterprises during 1991-1999 but increasing rapidly in 2000-2001. The possible explanation was that: - The prevailing foreign exchange regulations before the end of 2001 stipulated that the foreign currency loans are only expanded to meet the demand of foreign currencies for imports, so loans denominated in foreign currencies fluctuated depending on the imports of economic enterprises. In the 1990s, the value of imports has risen rapidly, resulted in the increased demand of foreign currency loans. However, the value of foreign currency loans was rather stable during 1991-1996 despite the fact that imports increased rapidly. The reason is that the enterprises can borrow foreign currencies from foreign countries and from domestic market as well as they can buy foreign currencies from banks to meet their foreign currency demand. In fact, a large proportion of import value was financed by capital flows such as foreign direct investment and external borrowing, so the foreign currency loans provided by the domestic banking system was not as high as the increased value of imports. 10

Figure 3. Loan Dollarization of economic enterpries, 1994-2001 Trillion VND Percent 40 45 35 40 30 35 25 30 25 20 20 15 15 10 10 5 5 0 0 1994 1995 1996 1997 1998 1999 2000 2001 Year Total FCL of economic enterprises Total FCL/M2 - Whether the economic enterprises borrow foreign currencies or VND not only depended on the increased demand of foreign currencies but also depended on the relation between exchange rate and interest rate. The change in interest rate in credit market may lead to a change in the flows of funds affecting the relationships between demand and supply in the credit market and thereafter in the foreign exchange market, in turn causing a change in foreign exchange rate. In 1996, the lending interest rate ceiling was maintained at high level, even higher than the average of interest rate in the world and regional market. Under the circumstance that inflation was low; the real lending interest rate is high. The difference in interest rate between international and domestic markets led to the strong incentives among domestic enterprises to import by opening the deferred letter of credit with commercial banks. The gap between international and domestic interest rates and the appreciation in VND actually created a great benefit from importing goods and borrowing from abroad. Therefore, the demand of foreign currency loans from the Table 2 shows how does the private transfer explain the increase in deposit of dollarization and cash dollarization of households. As illustrated in the Table 2, the net transfer increased rapidly form 140 USD million in 1995 to more than USD 1 billion in 1996. The net private transfer was over USD 1 billion per year on average during 1995-2001. However, change in foreign currencies savings was not high as net transfer implying that households did not put all their money in the banking system and as result, the foreign currency cash accumulated in circulation every year. The Figure 3 shows that the amount of foreign currency loans expanded to enterprises was stable at VND 19 trillion during 1996-1997. In 1998-1999, although domestic interest rate was adjusted to reduce but the foreign currency loans declined because the decreased imports due to import restrictions that was introduced in 1997 and the Asian crisis effects. In 2000, the growth rate of import has recovered and grew 11

at high rate (nearly 35 percent), the demand of foreign currency loan increased. In addition, since the end of 2000, the commercial banks were allowed to grant foreign currency loans for other requirements other than for imports as stipulated previously. During 1991-1999, the foreign currency loans from the banking system of economic enterprises were rather stable as mentioned above, the M2 increased every year to meet the desired amount of money for the economy, the FCL/M2 of economic enterprises ratio as proxy for the degree of its loan dollarization has declined, from 38 percent in 1994 to 16.1 percent in 1999 and stable around at 20 percent in 2000-2001. The question here is that who get more foreign currency loans from the banking system? In total foreign currency loans granted to economic enterprises, about 70 percent are loans to the state-owned enterprises. The Table 3 shows foreign currency loans to SOEs accounted for nearly a haft of total loans to SOEs while the foreign currency loans to non-sate enterprises accounted for less than 25 percent of total loans to non-soes. Table 3. Loan Dollarization of State Owned Enterprises and Non-State Owned Enterprises, 1994-1998 Unit: Trillions of VND and percent 1994 1995 1996 1997 1998 Foreign currency loans to SOEs 10.5 12.5 14.1 13.3 13.2 %/Total credit to SOEs 49.8 51.8 52.5 43.1 35.1 %/Total credit to Enterprises 31.4 29.5 27.7 21.5 18.2 Foreign currency loans to non-soes 2.4 3.0 4.5 6.1 5.7 %/Total credit to non- SOEs 19.6 16.6 18.7 19.4 16.4 %/Total credit to Enterprises 7.2 7.2 8.8 9.7 7.9 Source: IMF, 1999, Selected Issues on Vietnam Economy In short, in the 1990s, both loan and deposit dollarization of economic enterprises decreased during 1991-1999 and started to increase slightly in the past two years. The degree of loan dollarization was higher than the degree of deposit dollarization. Of which, the degree of loan dollarization of SOEs was higher than the loan dollarization of non-state enterprises. 2.3. Dollarization of commercial banks Acting as a financial intermediary and offering banking services to other sectors of the economy, banks also take part in foreign exchange dealing and portfolio investment management to maximise their profits. The banks can use the foreign currencies that they mobilised from the rest of economy in (i) expanding foreign currency loans to the economy; (ii) selling foreign currency to gain the domestic 12

currency; (iii) depositing with foreign banks abroad. If the banks do not change their structure of portfolio investment, when the amount of foreign currencies in liabilities side increases, it will be matched by increase in foreign currencies in asset side. The degree of dollarization of commercial banks not only depend on the degree of deposit and loan dollarization of other sectors in the economy but also depend on their decisions in changing structure of portfolio investments. Therefore, this paper will evaluate the dollarization of commercial banks in terms of deposit and loan dollariaztion as well as deposits with foreign banks abroad. This analysis will provide information for discussing the foreign exchange risk faced by commercial banks and economic enterprises in this paper. 2.3.1. Liability dollarization of commercial banks There is a closed relation between the degree of liability dollarization of other sectors in the economy and of the commercial banks because they are financial intermediaries that receive deposits, grant loans and offer settlement services. As mentioned above, the degree of deposit dollarization of economic enterprises has declined during 1991-1997. Adversely, the degree of deposit dollarizarion of households has increased despite the VND was more attractive than USD during that period. Totally, the degree of liability dollarization of commercial banks as measured by the FCD/M2 ratio declined sharply during 1991-1993 and rather stable during 1994-1996. The reason why there was a sharp decline in the degree of dollarization of banks during 1991-1993 is that in this period, the rate of return on VND was much higher than the rate of return on USD. The demand of foreign currencies for external transactions was still at low level because Vietnam started to open its economy, so the international transactions were not expanded strongly. In addition, the amount of foreign currency deposits of households was insignificantly in this period. 13

Figure 4: Deposit Dollarization of commercial banks, 1991-2001 Trillions of VND 100 90 80 70 60 50 40 30 20 10 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1-Nov Year Total FCD The FCD/total deposist ratio The FCD/M2 ratio Percent 70 60 50 40 30 20 10 0 Source: The State Bank of Vietnam During Asian crisis and its aftermath, the confidence of the public in VND was eroded and the rate of return on VND was higher than that on USD. Both households and economic enterprises shifted to hold USD. As a result, the FCD/M2 ratio increased to about one-third during 2000-2001. Vietnam is grouped in countries that have the moderate degree of dollarization (JEC, 1999, Basics of Dollarization). Above analysis highlighted the degree of the liability dollarization of the whole commercial banks. The banking system has been dominated by five state owned commercial banks (SOCBs) that accounted for about 80 percent of total bank assets and take 70-80 percent of total deposits and total credit of the whole banking system. Particularly, the public have more confidence in SOCBs when they put foreign currencies in their savings account. The joint venture banks and foreign branches have not allowed to receive money savings from the public. As a result, the degree of liability dollarization of SOCBs was higher than that of non-socbs (sees the Table 5). 2.3.2. Asset dollarization of commercial banks The degree of asset dollarization of commercial banks has closed relation with the degree of liability dollarization that depends on their decisions in mobilising funds and decisions made by economic enterprises and individuals. As illustrated in previous section, in the 1990s, they attracted an increasing amount of foreign currencies. 14

There are three cases to use the dollar mobilised funds (i) lending in USD the rest of the economy; (ii) depositing with foreign banks abroad; (iii) selling dollar for the Dong. - The option of selling dollar to the State Bank is limited because of a large amount of foreign currency deposits was savings. Moreover, with high expectation of VND depreciation, all economic entities try to get the long position in foreign exchange. - The options between expanding credit and depositing with foreign banks abroad depend on a series of important elements such as interest rate, exchange rate, credit risk, capital flows and the central bank s policy... - The option of using dollar for lending is very constrained with high expectation of depreciation of VND existed during Asian crisis and aftermath. The Table 3 shows that the degree of loan dollarization of commercial banks as measured by the FDL/M2 ratio has decreased from stable ratio of 29 percent to 12-14 percent during 1999-2001. How to explain for that? Foreign currency loans were mainly provided to economic enterprises because until 2000, the foreign exchange regulations did not allow commercial banks to lend foreign currencies to individuals. So all most foreign currency loans of commercial banks were expanded to the economic enterprises had been discussed in the Section 2.2.2. One of the reasons is that economic enterprises borrowed from abroad in terms of commercial loans. Table 4: Asset and liability dollarization of commercial banks Trillions of VND and percent 1994 1995 1996 1997 1998 1999 2000 2001 FC deposits 9.50 11.12 13.20 18.69 24.06 37.22 70.44 87.19 %/Total deposits 42.05 33.15 31.40 33.10 32.45 36.81 41.27 40.84 %/M2 22.1 21.1 20.4 22.9 23.5 26.1 31.6 31.7 FC loans 12.87 15.50 18.56 19.40 18.96 18.12 32.05 36.29 %/Total credit to economy 38.61 36.67 36.58 31.19 26.11 16.07 20.58 19.19 %/M2 29.94 29.42 28.69 23.77 18.51 12.70 14.38 13.19 Foreign assets na 9.57 11.20 18.71 29.73 61.28 61.74 79.36 Deposits abroad na 7.51 9.96 15.92 24.01 58.66 58.66 73.28 %/M2 na 17.46 18.90 19.51 23.45 41.13 26.32 26.65 Sources: State Bank of Vietnam - In recent years, the major motive for these banks to compete to attract dollar deposits is to earn the spread between domestic dollar rate and foreign dollar rate on the funds deposit with foreign banks abroad. In 1998, many commercial banks faced the accumulation of excess liquidity, since the rate of capital mobilisation is substantially higher than the rate of credit extending. Many commercial banks have no choice but continually declining the lending interest rate in attempt to extend the credit operations and drain their excess liquidity. This tendency led to a large gap between VND and USD deposit interest rate in the 15

credit market. Though the current foreign exchange regulations restricted a certain transactions that are allowed to trade in USD. In fact there were a large amount of VND drew from bank deposits, transfer into USD and then deposit again into bank accounts in USD in order to gain the benefit from higher interest rate. The foreign currency deposits of some commercial banks soared. In 1999-2000, The Fed raised the interest rate six times. According to that, European Central bank (ECB) also raised their interest rate, and then the interest rate in another international inter-bank markets increased. Under this trend of international interest rate, commercial banks in Vietnam gradually increased their interest rate to attract foreign currencies into bank accounts. However, lending rate could not be raised accordingly, because of the interest rate ceiling regulated by the SBV. Moreover, the domestic credit market seemed to be frozen and the investment absorption of the economy was very weak, credit expanding was limited. In the other side, despite of the increase in USD interest rate, domestic interest rate in USD was still lower than that in international markets (about 1.4-1.8 percent at the beginning of 2000). Using mobilised foreign currency funds in domestic market to deposit abroad became profitable activities for commercial banks. As a result, and the commercial banks have deposited with foreign banks abroad while the foreign currencies channeled to the State Bank of Vietnam to enhance the international reserves were not significant. Table 5. Dollarization of SOCBs and non-socbs (From assets and liabilities sides) Unit: Trillion of VND 1994 1995 1996 1997 1998 1999 2000 2001 FCD of commercial banks na na na na na 43.8 70.4 89.7* 12 - SOCBs na na na na na 31.7 52.4 67.5* - Non-SOCBs na na na na na 12.1 18.0 22.2* FCL of commercial banks 12.9 16.4 18.6 19.4 18.9 28.9 32.1 36.3 - SOCBs 9.3 10.9 11.3 11.2 17.7 13.1 16.2 19.0 (%/ Total credit to the economy) 28.0 25.8 22.2 18.0 24.4 11.6 10.4 10.0 - Non-SOCBs 3.5 5.4 7.3 8.2 4.4 15.8 15.8 17.3 (%/Total credit to the economy) 10.6 12.9 14.4 13.2 6.0 14.0 10.2 9.1 FCD abroad na na na na na na 58.7 73.3 - SOCBs na na na na na na 45.8 55.0 (% /total foreign currency deposits of na na na na na na 78.2 75.0 commercial banks) - Non-SOCBs na na na na na na 12.8 18.2 % /total foreign currency deposits of commercial banks na na na na na na 21.8 25.0 Source: Data of 94-98: IMF, 1999, Selected Issues on Vietnam Economy; Data of 2000-2001: SBV. Data before 1999 includes 4 SOCBs and 24 non-socbs. Since 1999, Data includes 6 SOCBs and 83 non- SOCBs. The foreign currency deposits abroad of commercial banks increased rapidly in 1998-2000, 12 Data at the end of 8/2001 16

especially reached a peak of VND 73.28 trillions in 2000 (approximately USD 5 billion). The degree of foreing assets dollarization as measured by the deposits abroad/m2 ratio has increased and reach at peak of 41 percent in 1999. Increase in foreign currency deposits abroad leads to increase in the foreign asset of the banking system. In 1999, the foreign assets in the banking system soared by 58 percent. The growth rate of broad money was 42 percent. This was the highest rate from 1992 in which net foreign assets weighted 30 percent in 42 percent of total growth rate. Although the reserve requirement applied for foreign currencies has been adjusted to be higher and at 15 percent in 2001, the foreign currency deposits has rise with slower growth rate compared with that in 1999-2000. The paradox in Vietnam now is that while commercial banks hold a large amount of foreign currency deposits with foreign banks abroad in 2000-2001, The State Bank of Vietnam had to intervene in foreign exchange market to meet the demand of foreign currencies for imports. - The share of foreign currency loans granted by SOCBs in total credit to the economy declined from 28 percent in 1994 to around 10 percent in 2001. In the mean while, the foreign currency deposits abroad of SOCBs accounted for about 70 percent of total foreign currency deposits abroad. The foreign currency fund mobilized by Non-SOCBs was limited because as mentioned above, dollarization in terms of foreign currency savings by individuals increase rapidly due to the fact that the public still believe in SOCBs and they deposit their foreign currency with SOCBs. In addition, all foreign bank branches and joint venture bank are not allowed to receive savings subject to stipulation by the Central bank. 3. Foreign exchange exposure Foreign exchange exposure is one of the dangerous features for both the banking system and enterprises when the degree of dollarization increased, particularly when the foreign currency loans were expanded. When commercial banks expand foreign currency loans, both commercial banks and economic enterprises may face to foreign exchange risk. Following paragraph looks at the foreign exchange risk faced by both lender and borrower: + For enterprises: - The share of dollar lending in total loans was around 10 percent in 1991, and reached slightly less than 40 percent in 1996, 30 percent in 1998 (over 50 percent in the case of non-state banks), of which over 70 percent was loans expanded to SOEs. Under circumstance that the dollarization intensified and the VND expected to depreciate, the imported inputs for domestic production of enterprises became costly. Institute of Financial Studies (Ministry of Finance) estimated that at least 70 percent of Vietnam s imports (say USD 13 billion) were manufactured materials (USD 9 billion). It means that if VND value is reduced by VND 1,000 (e.g. from 13,000 VND/USD to 14,000 VND/USD), manufacturing expenditure will 17

increase by VND 9,000 billion. As a result, profit goes down. And the number of unprofitable enterprises increased. - In addition, the depreciation of the VND has increased the debt burden of Vietnamese enterprises whose commercial loans increased during previous years. We can realize this situation by the prevalence of deferred Letters of Credit, which caused tensions in foreign currency supply in 1998. With the dollar outstanding debt of VND 19 trillions and VND depreciation of 24.5 percent from the beginning of 1997 to the end of 1998, increased enterprise s debt to the banks by USD 321 million. This trend can result in widespread bankruptcies that lead to the more difficulties in the banking sector. + For commercial banks: - Under circumstance that VND was expected to depreciate, banks seem not to be risky when they lend in USD to economic enterprises. In the context of VND depreciation, the number of loss-making enterprises may increase as discussed above. In this case, the commercial banks may face the credit risk. Because foreign currency loans granted to SOEs accounted for a large part in total foreign currency loan granted to the economy and some enterprises did not doing well resulting in arrears (see Table 6). The increased arrears will make the banking system s financial situation unsoundly. Table 6: Arrears of Foreign currency loans of economic enterprises Unit: Percent 1994 1995 1996 1997 1998 The arrears/fcl ratio (%) 7.2 4.8 5.6 15.9 16.3 - SOEs (% compared to the pervious period) 9.5 6.6 7.2 16.3 15.4 - Non-SOEs (% compared to the pervious period) 1.2 1.2 3.1 15.4 17.9 Sources: IMF, Selected Issues on Vietnam economy - The banking system had attracted an increased amount of foreign currencies. The gap between domestic and international interest rate created favorable opportunities for SOCBs (they always to maintain long foreign exchange position) in stabilizing revenue form foreign currency deposits with foreign banks. For Non-SOCBs, foreign currency loans were exceeded the mobilized foreign currency fund. They always maintained the short foreign exchange position. The fact that there was an increase in arrears in last two years has exposed foreign exchange risk to them in some extent. The banks indirect exposure also was very high, as the SOEs have often used foreign currency loans for domestic operation. The increasing overdue foreign currency loans are another concern. 18

Moreover, particularly non-state banks were highly leveraged in foreign currency lending, with ratio of foreign currency loans to foreign currency deposits as high as 130 percent in 1999. 13 Table 7: Vietnam: Foreign Exchange Position of Commercial Banks, 1994-1998 Unit: Million of USD and percent 1994 1995 1996 1997 1998 Foreign exchange position, long (>0) or short (<0) 14 In million of USD 134 144 115 217 753 - SOCBs 157 182 211 270 717 - Non-SOCBs -22-39 -96-53 37 15 % Foreign assets and liabilities 11.3 9.7 6.1 12.2 38.8 - SOCBs 13.2 12.3 11.2 15.2 36.9 - Non-SOCBs -1.9-2.6-5.1-3.0 1.9 Foreign exchange position, long (>0) or short (<0) 16 In million of USD 148 280 332 385 785 - SOCBs 252 390 451 452 751 - Non-SOCBs -104-110 -119-67 35 % Foreign assets and liabilities 12.5 18.9 17.5 21.6 40.5 - SOCBs 21.3 26.3 23.8 25.4 38.7 - Non-SOCBs -8.8-7.4-6.3-3.8 1.8 Sources: IMF, 1999, Selected Issues on Vietnam Economy, p 32. 4. The surrender requirement and foreign exchange exposure In 1998, the Government introduced the Decision No 37/1998/QDD-TTg dated Feb, 14, 1998 under which all economic enterprises, including foreign direct investment enterprises, companies, cooperatives and other economic enterprises established and operated subject to the Law of Vietnam have to transferred their foreign currency revenues from merchandise and services transactions into their foreign currency accounts opened with the foreign exchange eligible commercial banks. The economic enterprises that are allowed to open foreign currency account with foreign banks were allowed to maintain the certain balance of foreign currency as stipulated in the license. In fact, this Decision seems to be not effective 13 This ratio is calculated by the author by using the data of foreign currency loans and foreign currency deposits in the Table 4 14 Foreign assets minus foreign exchange liabilities 15 In Mar, 1998, short foreign exchange position of Non-SOCBs is 82 million of USD 16 Foreign currency deposits with foreign banks abroad minus foreign deposits of nonresidents and short-term loans in foreign currencies. 19

because economic enterprises usually overbalanced foreign exchange expenditure needed weekly and monthly compared to the actual demand. In the September of 1998, The Government issued the Decision No.173/1998/QD-TTg dated 12 th September 1998 on the obligation to sell and right to buy foreign currencies of institutional residents. This Decision specifies that enterprises have to sell 80% of their foreign currencies received from current account transactions to banks within a 15-day period from receipt. Besides that, the Decision also affirms the right to buy foreign currencies of institutional residents when they need foreign currencies to facilitate their current account transactions and other eligible transactions. In the context of VND depreciation, the surrender requirement policy will create loss for enterprises that are involved in both export and import activities. When they have foreign currency revenue, they sell to commercial banks at low exchange rate and when they need foreign currencies for international payments, they have to buy at higher exchange rate. In 1999, the foreign currency pressure was not strongly like previous period. In order to increase the actives in using the foreign currency for economic enterprises, the surrender requirement has been reduced to 50 percent as the decision No 180/1999/QDD-TTg dated 30, August 1999. In 2000, this ratio reduced to 40 percent. Reducing the surrender requirement ratio allowed economic enterprises more active in holding foreign currency, create more favorable financial conditions for domestic economic enterprises as well as foreign direct enterprises. Many exporters that are also importers can hold foreign exchange currency in their account to finance for import and therefore, the foreign exchange risk decreased. 5. Conclusion and policy implications From evaluating the degree of the dollarization by sectors, the paper highlighted the overall picture of dollarization in Vietnam in the past decade. Some main features of dollarization by sectors can be summarized as follows: - From the whole country s point of view, in 1990s, thanks to strongly reforms in banking fields, the degree of dollarization in Vietnam has slowdown in the 1990-1996 and started to increase slightly since 1997 when the Asian crisis occurred. - The degree of deposit dollarization of household sector had increasing trend while the degree of deposit dollarization of economic enterprises had decreasing trend. In recent years, the degree of deposit dollarization of households is higher than that of economic enterprises. 20