Where has all the dong gone?

In fact, the currency doesn’t go anywhere outside the economy.

The feeling of a currency shortage is simply caused when the supply of money does not satisfy demand, which has been exaggerated by expectations formed during the past era of easy monetary policy.

Money creation

In every country, the central bank (in Vietnam, that’s the State Bank of Vietnam) is the sole agency authorized to produce and issue money.

The central banks pump money into the economy through commercial banks and the Treasury.

Suppose the central bank loans out VND100.

The recipient keeps VND70 for spending and saving and deposits the remaining 30 dong into a bank.

The bank keeps 10 percent of this amount, or VND3, in its reserves and loans out the remaining 90 percent, or VND27.

The recipient of the VND27 then spends that money.

The receiver of that VND27 deposits it in a bank.

The bank then sets aside 10 percent of that VND27, or VND2.7, as reserves and lends out the remaining VND24.3.

As the process continues, banks always have 30 dong in reserves but ultimately, VND300 is created as checking deposits (D).

As a result, the initial 100-dong money base (MB) creates VND370, which is termed money supply (M).

The money supply comprises VND70 dong in currency (C), VND30 in bank reserves (R) and VND270 in loan credits (CR). (see Table 1.)

The ratio of the money supply to the monetary base (M/MB) is called the money multiplier (m).

m can be calculated by this formula: m = (1+c)/(r+c) with r = R/D and c = C/D. (In reality, the calculation and measurement of money supply is more complicated. Money is categorized into M1, M2, M3 and L.)

Vietnam’s monetary situation

Between 2000-2007, the average growth of monetary base was 2.37 percent, the growth of the money supply was 29.3 percent and credit increased by 31.5 percent.

That was rather high compared with the economic growth, especially in recent years.

By the end of last year, the total credit in the economy was roughly the same as the total gross domestic product (GDP) and the money supply, 1.2 times GDP.

This level is quite high for the Vietnamese economy and is gradually approaching the level of some regional countries.

The money multiplier has increased from about 3 to more than 4.

This progress is thanks to: (1) an improved banking system that has attracted more clients; (2) the stable macro-economic climate over a long period which has improved the public confidence and reduced the need for people to keep cash, which in turn has reduced the proportion of cash in total payments; and (3) the ratio of reserves to deposits in the banking system has also decreased, possibly because banks have improved their capital use effectiveness, especially after they adopted a concentrated capital management modality (see graphs 1 and 2). (This calculation of money supply in fact lacks two important factors, namely the volume of foreign currencies and gold, which functions like cash in the economy.)

Negative inflationary and monetary changes started in 2007, fueled by exceeding open of the monetary market.

After the macroeconomy became unstable in 2008, the monetary policy was tightened, giving rise to the feeling of shortage of money.

If the instabilities are not handled appropriately, they can reduce the money multiplier and, as a result, the money supply, assuming that the monetary base is unchanged.

Graph 1: Monetary data of Vietnam

Graph 2 Money and credit supplies

Why that feeling of shortage?

Some say hedge funds are holding lots of dong, waiting for an opportunity to manipulate the currency for huge profits.

That scenario, which unfolded once before during the Asian financial crisis in the last decade, could really hurt the domestic economy.

This argument, however, is unconvincing since the dong is not yet a convertible currency.

Even if the funds could hold a lot of dong, they would have had to either deposit it in Vietnamese banks or transfer it abroad.

In the first case, the money would still be circulating in the domestic economy.

Otherwise, since it is inconceivable that some funds would keep trillions of dong in their safes, there would have to be a burgeoning market for the dong somewhere else in the world.

This is very unlikely too.

Trade in dong may exist in some economies but the volume is not significant enough to cause a real shortage in Vietnam.

Such a “virtual” shortage is, in fact, caused by the central bank’s tightened monetary supply.

Demand has increased due to several factors.

First, many grant projects were developed with a rosy expectation of easy access to capital, based on the high credit growth of the past few years.

However, what is happening now is the exact opposite.

As a result, many investors have no money to carry out their projects.

So those who complain about the money shortage are those who cannot make new investments, a few businesses that have already locked up their loan-based capital in property or the stock market and some industries – catfish farming, for example – that are having trouble obtaining the large amounts of capital they need for the harvest season.

Most investors use bank loans to ensure an adequate cashflow.

In other words, money did not disappear from the system.

There is even more money now after banks injected credit worth more than VND200 trillion (US$11.9 billion) into the economy in the first six months.

That amount is half of last year’s total bank loans.

Secondly, as prices soared at a double-digit rate, people’s need to keep cash also rose at the same pace.

Also, the economic instability has hurt people’s confidence and made them keep more cash at home.

Because of these factors, more cash has been kept in the economy instead of in banks.

Based on past data and assuming that other factors are unchanged, in order that the volume of money in the economy is equivalent with total bank loans (which was VND1,250 trillion ($74.6 billion) by the end of April 2008 and is planned to increase by 30 percent to VND1,380 trillion ($82.4 billion) by the end of this year, the central bank is to supply VND60 trillion ($3.6 billion) in the first six months and nearly VND100 trillion ($5.9 billion) in the whole year.

The supply must be even higher if the amount of cash kept at home increases, not to mention the impact of the central bank’s order to commercial banks to increase compulsory reserves and buy treasury bonds.

In reality, to enforce its tightened monetary policy, the central bank has pumped less money into the economy.

It may even have absorbed some money from the economy.

This has caused the monetary base to shrink or, at least, not to increase as fast as some might have expected.

(It might also be possible that the central bank has injected a larger amount of money into the economy, but if more cash were put in piggy banks as mentioned above, supply would still fall short of demand.)

For those reasons, it is understandable that many feel the pinch of a money shortage, which is, in fact, a sign that the monetary policy is working.

Inflation is caused by a surplus of money in the economy so some money must be drained to curb inflation.

The question is, why do prices keep increasing despite the reduced volume of money?

The pressure to increase prices turns out to be heavily influenced by people’s expectation.

Over the last few months as prices were soaring, people assumed they would keep rising, which turned out to be the case.

After the amount of money reduced or, at least did not increase, the economy now has, for example, VND100, which is equivalent to 100 units of goods.

A reasonable price is therefore VND1 per unit of goods.

However, the expectation factor hikes the price to VND1.2 per unit of goods.

This has caused the shortage of money and lack of liquidity.

However, as time goes by, without more money pumped into the economy and with the volume of goods remaining unchanged, prices will reduce.

This is the desired effect of the tightened monetary policy on inflation.

It should be noted, however, that if the existing volume of money is put into effective use, inflation will get worse.

In other words, when the economy has VND100 but less than 100 units of goods, rising inflation is possible.

That is why monetary tightening must go hand in hand with lower public spending.

Moreover, since monetary tightening would affect liquidity, the government needs to adopt appropriate solutions to ensure stability for the banking system.

In conclusion, the feeling of money shortage is obvious in the time of tightened monetary policy.

It makes us think twice about every dong we plan to spend.

As a result, more goods will be produced and less money misspent, which will alleviate the price increase pressure.

Provided that macroeconomic policies are carried out appropriately, the monetary state will go back to normal.

Source: TBKTSG