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Vietnam Should Introduce More FX Flexibility, IMF Says

Given the "trilemma" in international economics, introducing more FX flexibility is a key step for modernizing their monetary policy framework toward the IT regime.

Vietnam Should Introduce More FX Flexibility, IMF Says
Nhat Trung15:49 04/09/2019
The foreign exchange (FX) rate is one of nominal anchors for monetary policy in Vietnam. The State Bank of Vietnam (SBV) sets 4 percent of inflation as a domestic nominal anchor, but in addition to the target inflation rate, the SBV daily announces the target FX rate vis-à-vis US dollar as an external nominal anchor. 
To keep the FX rates within the predetermined band around the target, the SVB actively intervenes to the FX market through their reserve accumulation/decumulation, in addition to adjusting interest rates in the interbank market.
Introducing more FX flexibility is a key to modernizing a monetary policy framework. While a political decision requires broader consensus building to overcome pervasive fear of floating in the government, there is consensus in the SBV for a shift to inflation targeting (IT). 
Given the "trilemma" in international economics, introducing more FX flexibility is a key step for modernizing their monetary policy framework toward the IT regime. Hence, investigating what drives FX rates and how FX flexibility affects the macroeconomy should help them move ahead toward IT.
To examine the effects of introducing FX flexibility, the following two-step approach is adopted, based on DSGE modeling.
First, a small open economy DSGE model is constructed and its parameters estimated on Vietnamese data. Then, the time series data for output growth, inflation and real exchange rates are decomposed into several structural shocks.
Second, keeping the estimated structural parameters and shocks unchanged, counterfactual policy exercises for the economy are conducted: (i) without FX interventions, and (ii) with strict commitment to IT. 
It is important to use a micro-founded model for the counterfactual policy exercises because any changes in a policy framework will change the private sector's behavior (Lucas critique). For instance, investors' behavior in a floating FX system is expected to be different from that in a fixed FX system, where the SBV systematically reacts to FX fluctuations. Hence, the estimated relationship between aggregate variables under a fixed exchange rate regime by, for instance, VAR cannot be directly used to analyze the effects of introducing a new policy framework.