MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS, HO CHI MINH CITY
FULBRIGHT ECONOMICS TEACHING PROGRAM

Nguyen Thi Thanh Huyen IS INFLATION TARGETING APPROPRIATE FOR
VIETNAM? MASTER IN PUBLIC POLICY DISSERTATION
Ho Chi Minh City, 2012 CERTIFICATION
I certify that I wrote this thesis myself.
I certify that the study has not been submitted for any other degrees.
I certify that any help received and 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

Nguyen Thi Thanh Huyen

ii
ACKNOWLEDGEMENTS
This master of public policy dissertation could not be completed if I have not
received the help and encouragement from many people. First, I am very grateful to
my supervisor, Dr. Jonathan R. Pincus, who kept an eye on the progress of my work
and was always helpful when I need his advice. His advices, supports, criticisms and
comments helped me to deeply understand the overall knowledge related my
dissertation. I also convey a special thank to Dr. Vu Thanh Tu Anh, the first teacher
who encourange me to begin this dissertation and many other teachers that were
always support me during the time I studied in Fulbright Economic Teaching
Programme.
I gratefully acknowledge the financial support of FETP, without which this
dissertation would not have been done.

2.2. Global evidence on I.T. adoptation 6
2.2.1 Evidence supporting I.T 6
2.2.2 Evidence against I.T 8
2.3. The prerequisites of I.T 10
2.4. Experiences of inflation targeters 12
2.4.1 Experiences of industrial country inflation targeters 12
2.4.2 Experiences of developing country inflation targeters 14
2.4.2.1 Chile 16
2.4.2.2 South Korea 18
2.4.2.3 Brazil 20
CHAPTER 3: THE MONETARY POLICY FRAMEWORK IN VIETNAM 23
iv
3.1 Independence of SBV 23
3.2 Monetary policy implementation in Vietnam 23
3.2.1 Monetary instruments 24
3.2.2 Monetary policy transmission mechanism 25
3.2.3 The strategy of monetary policy 26
3.2.4 Monetary policy effectiveness 30
CHAPTER 4: TESTING I.T PREREQUISITES FOR VIETNAM 33
4.1 Economic structure 33
4.1.1 A small, open economy with liberalized capital and trade 33
4.1.2 Dollarization and goldization 35
4.1.3 Exchange rate pass-through effect 36
4.2 Health of the financial system 37
4.3 Analytical capability of SBV 39
4.4 Central bank independence 39
CHAPTER 5: CONCLUSION AND RECOMMENDATIONS 43

U.K United Kingdom
USD United State Dollar
VAR Vector Autoregression
VND Vietnam Dong
WB World Bank

vi
LIST OF GRAPHS
Graph 3.1: Velocity of money in Vietnam 29
Graph 3.2: CPI, M2 and GDP growth rate of Vietnam 31
Graph 3.3: REER, NEER and Relative CPI of Vietnam 32
Graph 4.1: Trade deficit and openness of Vietnam economy 34
Graph 4.2: Capital inflow structure in Vietnam 34
Graph 4.3: USD/VND Exchange Rate 35
Graph 4.4 : Dollarization in Vietnam 36
Graph 4.5: Stock market capitalization in some countries 38
Graph 4.6 : Bond market development in Vietnam 38
Graph 4.7: Seigniorage to GDP in Vietnam 40
Graph 4.8: Real deposite rate in Vietnam 41
Graph 4.9: Fiscal balance to GDP in Vietnam 42


the country’s economic characteristics include a weak financial system and a lack of
central bank indepedence. Although the experience in some successful countries like Chile
and South Korea show that those conditions are not wholly met in these countries, at least
Chile and South Korea had good fiscal discipline and central bank independence. In
Vietnam, fiscal dominance exists with continuous fiscal deficits. Thus, to improve the
prevailing monetary policy framework, I.T may not be the best choice for Vietnam. REER
targeting is an alternative but it is also problematic. Vietnam is a highly open economy
with a high pass-through effect and dollarization. The dissertation recommends that at first
Vietnam should improve institutional conditions for monetary policy and strengthen
financial markets, and at the same time restructure the economy and impose fiscal
discipline on the government. Then choosing I.T or REER targeting or another monetary
framework will depend on political considerations and the desired balance between growth
and price stability.

1
CHAPTER 1: INTRODUCTION
Monetary policy is one of the most important macroeconomic policies in an
economy. The prevailing monetary policy framework in Vietnam now is a mix exchange
rate peg and monetary framework. But the effectiveness of monetary policy in Vietnam
is not easy to estimate as the central bank must target several objectives, including low
inflation, rapid growth and exchange rate stability. Besides, inflation has returned to
Vietnam in recent years and makes many economists think of I.T as the best choice but
it related many choices and conditions. These are the dynamics for me to carry out this
dissertation to answer the following questions
: First, is inflation targeting (I.T)
appropriate for Vietnam? Why and why not? And second, what are the implications
for Vietnam’s monetary policy framework? The dissertation uses institutional analysis


3
CHAPTER 2: THEORETICAL AND EMPIRICAL OVERVIEW ON I.T
I.T starts from the simple premise that the primary goal of monetary policy is to
achieve and maintain a low and stable rate of inflation (Masson et al., 1997, p. 5).
Although I.T became popular in 1990s it actually appeared much earlier. Haldane (1997,
p. 8) notes that price targets can be traced back to the last century – to Marshall (1887)
and Wicksell (1898), Fisher (1911) and Keynes (1923). In the 1990s, there was a wave of
countries trying to adopt I.T as a monetary policy framework. This section will discuss
the theoretical foundations of I.T, and then summarize the global evidence on the
implementation and evaluation of I.T.
2.1. Conceptual framework
2.1.1. Supporting ideas for I.T
So far, there is much research and debate on I.T as a monetary policy framework.
One supporting idea is that inflation is very costly and monetary policy is neutral in the
medium and long run, or monetary policy affects only the price level, and not output and
unemployment. (Friedman, 1967, quoted in Mishkin, 1997, p. 5) famously made the case
that there is no Phillips curve trade-off between unemployment and inflation in the long
run because inflation expectations counter-act the effects of monetary and fiscal policy.
Expectations can shift the Phillip curve upward, and hence there is no long run trade-off
between inflation and unemployment. An unemployment rate below the natural rate of
unemployment cannot be realized with permanently high inflation. In his Nobel prize
address (1967), Milton Friedman says that in the long run, higher inflation leads to
higher unemployment and the Phillip curve may be upward sloped.
Another supporting opinion (Mishkin, 1997, pp. 2-9) is that expansionary
monetary policy can not reduce unemployment whenever it increases above the “full-
employment level” because complicated macroeconomics models can not accurately

+ a
2
E
t
(Y
g
t+1
) – a
3
[R
t
– E
t
(p
t+1
)] + s
1

(2.2) p
t
= b
1
Y
g
t
+ b
2
p
t-1
+ b

t-1

where
Y
g
is the output gap
R is nominal rate of interest
p is rate of inflation
p
T
is inflation rate target
RR* is the “equilibrium” real rate of interest, that is the rate of interest consistent
with zero output gap which implies from equation (2.2), a constant rate of inflation, s
i

(with i = 1, 2) represents stochastic shocks, and E
t
refers to expectations held at time t.
Equation (2.1) is the aggregate demand equation with the current output gap
determined by the past and expected future output gap and the real expected rate of
interest.
Equation (2.2) is a Phillips curve with inflation based on current output gap and
past and future inflation.
5
Equation (2.3) is a monetary-policy rule. In this equation, the nominal interest
rate is based on expected inflation, the output gap, the deviation of inflation from target
(or “inflation gap”), and the “equilibrium” real rate of interest.


bank to have some flexibility in the short run, such as stabilization objectives including
the exchange rate and output as well as financial stability.
Considering all these problems, Bernanke and Mishkin (1997, p. 22) conclude
that I.T is not a rigid rule but rule-like with “constrained discretion” as the nature of I.T
is forward looking. But they conclude that it is too early to say if I.T is a fad or a trend.
The only thing they agree on are the advantages, such as transparency, coherent policy-
making and accountability of moving to an I.T. regime.
2.2. Global evidence on I.T. adoptation
Despite some problems and issues in I.T implementation, many countries around
the world have adopted I.T as a monetary policy regime and customized the approach in
various ways. I.T was first adopted in New Zealand, U.K (U.K), Canada and Sweden in
the 1990s (Allen et al., 2006, p. 4). As of 2010, there were 26 inflation targeters, of
which more than half were emerging market countries (Scott Roger, 2010, p. 4). The
evidence on the success of I.T is mixed. Some evidence says that I.T. improved the
performance of the economy and others say that it was not I.T. that enhanced the
macroeconomic performance but other factors.
2.2.1 Evidence supporting I.T
Neumann and von Hagen (2002) use VAR models with monthly and quarterly
data for six I.T. countries (Australia, Canada, Chile, New Zealand, Sweden, and the
U.K) and three non-IT countries (Germany, Switzerland, and the United States) for two
sample periods: a pre-IT period (1978-92) and a post-IT period (1993-2001) to examine
the volatility of inflation, output gaps, and central bank interest rates under I.T. The
evidence confirms that adopting I.T reduces the inflation rate and limits the volatility of
inflation and interest rates. Thus, I.T has helped the high-inflation countries to achieve a
degree of credibility similar to that of the Bundesbank and the Swiss National Bank. But
among inflation targeters, the U.K has performed best even though its target rate of
inflation was higher than others. However, this does not necessarily mean that I.T is
superior to monetary aggregate regimes, such as the Bundesbank’s approach to monetary
targeting between 1974 and 1998, or even to the strategy of Federal Reserve System

I.T to the observed outcomes as there were many other reforms that accompanied the
shift to I.T.
Moreover, Arestis and Sawyer (2003) says that the evidence on I.T practice as
mentioned in the above studies has some limits: (i) the evidence is not convincing as the
environment in the 1990s was very conducive to price stability, so that there is no proof
that I.T outcomes were better than non-I.T outcomes; (ii) the dangers of not adopting I.T

1
Measured by standard deviation of variables
8
never materialized, even though European Central Bank (ECB) and Fed did not move to
an I.T regime; (iii) in a number of countries like New Zealand, Canada and the U.K,
inflation had been “tamed” well before introducing I.T (Mishkin and Posen, 1997,
quoted in Arestis and Sawyer, 2003, p. 21).
2.2.2 Evidence against I.T
There are plenty of studies that give opposite evidence on the impact of I.T on
economic performance. Stephen G. Cecchetti and Michael Ehrmann (1999) study the
trade-off between inflation and output in the short run for 23 countries, including nine
inflation targeters (Australia, Canada, Chile, Finland, Israel, New Zealand, Spain,
Sweden, U.K) in the period 1984-1997, using a structural VAR model. The authors find
that aversion to inflation variability increased during the decade of the 1990s. The
inflation targeters increased their aversion to inflation volatility by more than the
nontargeters, although the difference is modest. For nine inflation targeters, inflation fell
by more than seven percentage points on average while the non-targeters’s average
reduction is only 3.6 percent. But all of these countries suffered higher increases in
output volatility as a result.
Ball and Sheridan (2004) examine the effects of I.T on macroeconomic

that economic conditions, structure, and institutional variables are systematically
associated with a country’s decision to adopt I.T. Low GDP growth and high real
interest rates are significantly associated with the choice of I.T. The negative impact of
high inflation on the choice of I.T reflects the fear of losing public credibility of the
central bank: they tend to adopt I.T when inflation rates are low as it is easier to fulfill
the goal. A sound fiscal position benefits the authority when adopting the I.T framework.
A de facto floating exchange rate regime seems a better indicator in describing the
choice of I.T than a de jure floating exchange rate regime.
The paper also carries out a descriptive analysis of 37 countries, of which eight
are industrialized inflation targeters except for Chile (Australia, Canada, Chile, Finland,
New Zealand, Spain, Sweden, and U.K) and 29 are nontargeters in pre- and post-I.T
adoptation for the period 1985-2000. The results show improvements to inflation and
output in both inflation targeter and nontargeter groups. It is not easy to evaluate the
impact of I.T on economic performance by descriptive analysis, but the inflation rate of
the I.T countries dropped more than that of the nontargeters for both the 37 country and
industrial-country-only cases. The results are similar with respect to the output. To
investigate further the impact of I.T on economic performance, the study fits a
10
regression model for 37 countries and finds that I.T at the same time lowers both
inflation and output variability but neither effect is statistically significant.
In sum, the global evidence tells us that the impact of I.T on macroeconomic
performance is controversial. The main reasons for these difference are the variations in
methodology (VAR models, difference in difference OLS models, partial adjustment
models, descriptive analysis and illustrative simulations), the countries selected, the
period used, as well data measurements (monthly, quarterly and yearly). It is therefore
difficult to specify the impact of I.T on economic performance. In fact, the observed
outcomes are different depending on factors specific to individual countries, their

Trade openness can force central banks to cope with the huge mobilization of goods,
which makes them more difficult in conducting monetary policy due to the danger of
huge trade deficit and imported inflation.
(iv) Institutional independence can be measured by six indicatiors, such as
absence of fiscal obligations (or fiscal discipline), operational independence, inflation-
focused mandate, favorable fiscal balance, low public debt and central bank
independence.
Most studies agree that independence is the first prerequisite of any central bank
that wants to adopt I.T. But this is not understood as full independence as the central
bank is only independent in terms of instruments to achieve the goal, especially
independent from fiscal policy (Amato and Gerlach, 2001; Masson et al., 1997;
Bernanke and Mishkin, 1997; Allen et al., 2006). Fiscal independence means that there
is no symptom of fiscal dominance, or monetary policy is not severely constrained by
fiscal developments. In other words, borrowing from the central bank and the banking
system for budget purposes must be very small, or the government does not rely on the
central bank to finance its budget shortfalls. Fiscal dominance can create inflationary
pressure when the government abuses this source of revenues from the central bank and
banking system, namely fiscal root inflation, and is left unchecked by the central bank.
Thus, monetary policy will meet difficulties in controlling fiscal-origin inflation and is
forced to follow the fiscal policy (accommodative monetary policy).
In developing countries, fiscal dominance is manifested in reliance on
seigniorage and financial repression (Masson et al., 1997, p. 23). The reliance on
seigniorage can come from a weak and unstable taxation system or abuse by the
authorities of this source of revenue. Financial repression – like interest rate ceilings,
extremely high reserve requirements, and directed credit - is both cause and effect of
12
shallow financial markets. Shallow financial markets limit the ability of the market to

First, inflation targets are announced by the government, the central bank or
combination of the two. The central bank pledges to keep inflation at or near the
announced target. The inflation rate to be targeted is often the Consumer Price Index
(CPI), excluding interest cost components, indirect taxes and subsidies, government
charges, and significant price effect changes in terms of trade, food and energy. This is
sometimes called core inflation. The target can be a specific number or range or goal
with an upper and lower band. Therefore, the central bank still has room for short term
stabilization measures for exchange rates and output.
For example, New Zealand and Canada announce target rates as a range (0-2
percent through the five year tenure of the Governor and 1-3 percent through 1998,
respectively), U.K and Sweden announce a specific target with a band, such as 2.5
percent ±1 percent (Masson et al., 1997, p. 19).
Second, together with the announcement of the authorities is the statement that
the central bank will be accountable for the inflation target. In New Zealand, the
responsibility for setting out inflation targets is stipulated in the Reserve Bank of New
Zealand Act of 1989, so there is a link between the tenure of the Governor of the
Reserve Bank and the achieving of the inflation target. In Switzerland, Canada and U.K,
the inflation goal is not stated by law but in statements by the central bank to the public.
Therefore, there are no sanctions on the central bank for missing the target but there will
be loss of prestige and reputation in personal or institutional terms. Bank governors are
less likely to be reappointed if they consistently miss inflation targets.
Third, another feature of these countries is that the inflation target is considered
the overriding goal, or, in other words, this is a committed goal by the authorities. Thus
the role of exchange rates and money growth is reduced, especially in cases of conflict.
Under I.T the money supply is endogenous to the model, and adjustments take place due
to changes in inflation expectations rather than mechanically through the money supply.
The relationship between money growth and inflation is unreliable due to unstable

adopted I.T when their macroeconomic and institutional conditions were relatively poor.
As seen in the IMF survey (Masson et al., 1997, p. 26), developing country inflation
targeters have very low CBI index compared to industrial inflation targeters. Similarly,
the seigniorage to GDP index is relatively high, and financial markets are shallower. A
high seigniorage index means that developing countries have high fiscal dominance.
Besides, shallow financial markets are a consequence of financial repression and also an
expression of fiscal dominance in these countries. Financial repression over a long
15
period leads to fragile banking systems in these countries and creates a dilemma for the
central bank between achieving financial stability and other objectives.
The second problem faced by emerging inflation targeters is a conflict of
objectives. Most of these economies are subject to tension between inflation and other
policy goals such as output growth, capital flows and the nominal exchange rates. In
most cases, the problem of conflict of objectives is left unsolved.
The third issue is the specification of the inflation target, such as the choice of
the level/horizon for the inflation target, the choice of an “escape clause” and the
problems of administered prices.
The fourth issue is a high level of dollarization, exchange rate fluctuations and
pass-through effects in emerging I.T countries (Mishkin, 2004, pp. 22-23). Exchange
rate depreciation can lead to inflation due to high import prices (supply side) and greater
demand for exports (demand side). In addition, liability dollarization means that a large
depreciation will lead to an increasing debt burden on domestic firms, deterioration of
balance sheets and financial instability, as the likelihood of bankrupcy becomes bigger
when the domestic debt burdens are so big that firms cannot pay. This phenomenon is
more severe when trade openness and capital mobility are high.
It is important to distinguish between the impact of exchange rates on inflation
and output to see if the shock stems from a sudden stop or a terms of trade shock (falling