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The Asian Financial Crisis and Banking Reform in China and Vietnam

Thomas R. Gottschang

August 2001

COLLEGE OF THE HOLY CROSS, DEPARTMENT OF ECONOMICSFACULTY RESEARCH SERIES, WORKING PAPER NO. 02-02*

Department of EconomicsCollege of the Holy Cross

Box 45AWorcester, Massachusetts 01610

(508) 793-3362 (phone)(508) 793-3710 (fax)

http://www.holycross.edu/departments/economics/website

*All papers in the Holy Cross Working Paper Series should be considered draft versions subjectto future revision. Comments and suggestions are welcome.

†Thomas R. Gottschang, Department of Economics, Box 152A, College of the HolyCross, Worcester, MA 01610-2395, 508-793-2678 (phone), 508-793-3710 (fax),[email protected]

The Asian Financial Crisis and Banking Reform in China and Vietnam

Thomas R. Gottschang†

College of the Holy Cross

August 2001

Abstract

The collapse of financial markets and exchange rates across Southeast and East Asia in1997 and 1998 affected the economies of China and Vietnam much less than those of most otherAsian countries. Ironically, the two transitional economies were protected to a great extent bythe incomplete nature of their banking reforms and financial market development. The yuan andthe dong were not yet traded internationally, securities markets were in very early stages ofdevelopment, and tax codes, trade regulations, and accounting standards in the two countries didnot yet fully conform to international norms. Yet the non-convertibility of their currencies servedto shield the Chinese and Vietnamese economies from the sharp declines in exchange rates andsecurities prices that devastated the incomes of millions of people in Thailand, South Korea,Indonesia, and Malaysia.

This paper examines the implications for future policy reforms in China and Vietnam ofthe impact of the Asian financial crisis. The relative immunity of the two economies calls intoquestion some central assumptions of conventional economic development theory. It is no longerclear that full currency convertibility should be sought at the earliest opportunity. Theexperiences of the Asian economies in the late 1990s suggest that emphasis on development ofstable, efficient domestic banking systems and mature financial markets should take priority overfull integration with international financial markets. This argument has been developed by PanYotopoulos in his book, Exchange Rate Parity for Trade and Development (Cambridge, 1996),and merits further consideration with respect to the financial policies of Vietnam and China.

JEL Classification Codes:

Keywords: China, currencies, free banking, Manchuria

THE ASIAN FINANCIAL CRISIS AND BANKING REFORM IN CHINA AND VIETNAM

Thomas R. Gottschang College of the Holy Cross

Worcester, Massachusetts, USA 2nd International Convention of Asian Scholars

Berlin, 9-12 August 2001

“Please tell us exactly what the United States Government does to make the US dollar a hard

currency.” – Vietnamese economist attending a course on neoclassical market economics, National Economics University, Hanoi, Vietnam, February, 1993

I. The Asian Financial Crisis of 1997-98

In 1997 and 1998, the bursting of investment bubbles in commercial real estate and other

assets of several major rising Asian economies led to plummeting exchange rates and sharp

contractions of investment, trade, and GDP. While Thailand, Indonesia, Malaysia, the

Philippines, and South Korea entered periods of economic crisis, however, other countries in the

region weathered the storm with relatively little damage. These included, at one extreme, the

nations with the most highly developed financial markets, Singapore, Hong Kong, and Taiwan,

and at the other, those with the least developed financial systems, China and Vietnam. Although

many observers predicted that the “Asian contagion” would inevitably lead to devaluation of the

Chinese yuan, it remained firm at 8.3 to the U.S. dollar. (E.g., Ito Kiyoshi, “China and Hong

Kong are Headed for Collapse,” Japan Echo, Vol. 25, No. 3, June 1998, p. 38; “China Causes

Jitters in Asia,” Business Asia, August 16, 1998.) Indeed, Chinese and foreign analysts pointed

out that a stronger case could be made for appreciation of the yuan: China’s trade balance was

overwhelmingly positive, China held massive reserves of hard currency, and foreign investors

held few yuan assets that could be sold into the international market. (The argument was made

by Lin Yifu in Lu 1998.)

Gottschang: Asian Crisis, China and Vietnam 4

Officials of the IMF and other international analysts pointed out that the crashes had been

worst in countries where unwise lending practices coincided with attempts to sustain pegged

exchange rates. Banks in Thailand, Indonesia, and Malaysia had financed overvalued real estate

development projects with short-term foreign loans denominated primarily in US dollars.

Foreign lenders, meanwhile, were encouraged by the promise of stability implied by the

exchange rate pegs. When the real estate projects failed, foreign funds were withdrawn, the

domestic currencies depreciated, despite efforts to prop them up, and the banks faced dollar debt

service while holding non-performing domestic assets of sharply reduced value. (Moreno 1998;

Glick 1998.) In the view of the IMF the lessons of the crisis were: First, that the afflicted

countries should tighten the regulations on their banking systems to prevent the wide-spread

instances of moral hazard and adverse selection that had fueled the real estate boom. Second,

countries that are deeply involved in the international financial markets must choose between

either freely floating exchange rates (e.g., Singapore) or immutably fixed rates (as in currency

boards, e.g., Hong Kong) if they wish to avoid similar crises in the future. (Fischer 2001; Glick

1998; Moreno 2001.)

For the transitional economies of China and Vietnam, whose banking and finance

markets remain seriously stunted by the effects of their former central planning systems, the

message of the crisis must appear more ominous and confusing. While the potential rewards of

engaging in the international financial markets are great, the dangers clearly are daunting.

Perhaps most troubling, neither foreign analysts nor financial professionals in the crisis countries

were able to foresee the timing or the severity of this crisis. (Glick 1998, p. 1.) The central

implication of this experience for China and Vietnam has been clearly stated by David

O’Connor: “it is a matter of urgency to strengthen the domestic financial system before moving


ahead with greater financial opening.” (O’Connor, p. 63) The question is, how can these

fledgling financial systems be developed so as to enable their countries to engage with a degree

of security in the international financial markets, while at the same time supporting and

strengthening economic growth, development, and stability at home?

The purpose of this paper is to explore some of the issues that China and Vietnam face in

the process of developing and strengthening their financial systems in preparation for integration

with the international financial markets. First, it will discuss the residual effects of the centrally

planned system on today’s banking and finance structures in China and Vietnam. Second, it will

briefly outline the history of banking reform in the two countries. The third section will introduce

the concept, developed by Pan A. Yotopoulos, that market forces under freely floating exchange

rate regimes tend to systematically undervalue the currencies of developing countries and to

cause distortions in their economic structures that retard overall growth in incomes. In light of

the Yotopoulos analysis the paper will then explore three major issues of banking reform facing

China and Vietnam: the development of grass-roots banking, the challenges of WTO and

international competition, and the choice of exchange rate regime. The concluding section will

suggest that we should expect the development of “complete” financial markets in China and

Vietnam to be a lengthy process that may be speeded to only a limited degree by foreign

partners and competitors.

II. Why Are China and Vietnam Different?

China and Vietnam are fundamentally different from the other “emerging” economies in

Asia because the deficiencies in their financial institutions are direct results of the Soviet-style

centrally planned economic model that both employed for nearly 30 years. Under the central


planning model, investment decisions were made by plan. Financial markets did not exist, and

banks served only to hold deposits of individuals and enterprises, and to disburse funds to meet

the needs of enterprises for planned activities. Banks made no consumer loans. Loans to

enterprises were allocated on the basis of planned activity, or under government direction, with

no consideration of risk. Enterprises – firms – were owned either collectively, or by the different

levels of government. There were no significant privately owned firms, no stocks, and none of

the panoply of financial instruments that support the operations of firms in market-based

industrial nations. The only form of financial asset was the savings account. (Yi 1994, pp. 19-

24.)

The legacy of this system for the banking and finance sectors of China and Vietnam in

the post-planning period has been profound. First, when the decision was made to shift to a

market-based economy, including market-based financial systems, the institutions and

instruments of a modern financial system not exist. More importantly there were no trained and

experienced professionals qualified to operate modern financial intermediaries, nor were the

universities prepared to educate people in these fields. Finally, the legal and regulatory structures

that guide financial markets in other countries did not exist in either China or Vietnam.

Financial services is one of several “strategic” service sectors that are essential to the

operation of a modern economy, but had no role in the centrally planned model and therefore

atrophied to the point of extinction in the Soviet-style economies. A characteristic of the

“strategic” service sectors (others include law and accounting) is that they require highly trained,

experienced professional workers, as well as an understanding of their importance on the part of

government officials and enterprise managers. The need for lengthy training and necessarily


gradual evolution of the strategic service sectors is one important reason for the surprisingly long

period of transition in most of the formerly centrally planned economies. (Rask et al. 1998)

The second major problem inherited from the centrally planned system is the seemingly

endless question of how to deal with inefficient state owned enterprises (SOEs). In both

countries SOEs have continued to employ a large share of the urban labor force, and in China,

continue to provide housing, health care, education and other social benefits to the families of

their workers. Because of their political importance, and because they belong to powerful

government agencies, the banks have found it difficult, and often impossible to refuse requests

from SOEs for new loans for investment and also for “working capital” – current operating

funds. The governments are caught between the equally unpalatable options of ignoring the pleas

of the SOEs and letting them go out of business, with large increases in unemployment, or

forcing the banks to make loans that will almost certainly fail to perform, thereby reducing their

ability to extend credit to worthy projects and threatening the very foundation of a market-based

financial system. (Lo 2001, pp. 18-23; O’Connor 2000, pp. 55-56; Lardy 1998, pp. 21-59.)

III. Banking Reform in China and Vietnam by the Late 1990s: A Brief Outline

The history of banking reform has been treated in detail for China by numerous authors,

including Lardy (1998), Yi (1994), Lo (2001), Holz (2000), and O’Connor (2000), and for

Vietnam in works including Fforde ( 1996, pp. 263-267), the International Monetary Fund (IMF)

(1999), O’Connor (2000). This section will only sketch out the central points of those histories

and focus on the overall state of the two countries’ banking and finance sectors today.

When the central planning system was abandoned in the 1980s, the leaderships of both

countries recognized the need to institute market-based mechanisms for mobilizing savings and


allocating them to investment projects. Each country fairly quickly took measures to convert the

old banking structure into a commercial banking system, controlled by a central bank, as in the

industrialized economies. The People’s Bank of China became China’s central bank, while the

Agricultural Bank of China, the People’s Construction Bank of China, and the Bank of China –

the foreign exchange arm of the system – were converted into commercial banks, along with the

Industrial and Commercial Bank of China, which was created to handle the household enterprise

accounts of the People’s Bank. The State Council also established the China International Trust

and Investment Corporation for the purpose of seeking foreign investment. The theoretically

market-oriented banks, however, were required to make “policy loans” at the direction of the

central and local governments, primarily to state-owned enterprises (SOEs). Such policy loans

often were not repaid, resulting in steadily declining asset values for the banks.

In the 1990s the Chinese government took two major policy steps with the goal of

creating a true commercial banking sector. In 1992 three policy-lending banks were created to

separate the burden of government mandated-loans from the operations of the commercial state

banks. At the same time, the establishment of national and regional share-holding banks was

begun. All of the share-holding banks, however, were owned by central and local governments,

except for the China Minsheng Bank, which was owned by private enterprises. By the late 1990s

the bad debt problem had not abated and the government established four “asset-management

companies,” modeled on the resolution trust companies instituted in the United States to

liquidate the assets of failed thrift institutions in the 1980s. (Lo, 2001, p. 23-26; Holz, 2000, p.

90) The process of debt restructuring by the asset management companies is expected to be

lengthy and difficult.


Like China, the core of the banking system in Vietnam now consists of a central bank –

the State Bank of Vietnam – plus four large state-owned specialized commercial banks:

Vietcombank (foreign trade), the Bank for Agriculture and Rural Development, the Industrial

and Commercial Bank, and the Bank for Investment and Development. As of 1998, the state

banks held 82 percent of total bank assets and accounted for 80 percent of all loans and deposits.

The system is also similar to China’s in that the state banks are obligated to respond to

government loan requests, and consequently hold large volumes of non-performing loans,

primarily made to SOEs. In addition to the state banks there is a group of joint stock banks, 51 as

of 1998, owned by SOEs and private entities, 23 branches of foreign banks, and four joint-

venture banks. Many of the joint stock banks, however, have also faced solvency problems, some

because they have made excessive loans to SOEs, others because of other forms of poor risk

assessment. By early 1999 the State Bank of Vietnam had prepared a plan to reorganize some of

the joint stock banks and to close others. (International Monetary Fund 1999, pp. 23-41;

O’Connor, 2000, pp. 56-57)

Perhaps the most important difference between China and Vietnam in the recent histories

of their banking systems is that since 1949, the Chinese banks have served as reliable savings

institutions and have received a very large share of personal income as savings deposits in the

reform era. During the 1980s and 1990s the savings rate averaged over 35 percent of GDP.

(Yabuki, 1999, p. 201) The banking system in Vietnam has had a much more troubled history

and enjoys little confidence from Vietnamese households. In the late 1980s, the Vietnamese

government allowed private credit cooperatives to operate as a supplement to the banking

system. Unfortunately, many of the cooperatives engaged in unwise, and in some cases

fraudulent activities, including pyramid schemes. In the spring and summer of 1990, nearly all of


the credit cooperatives were swept away by a wave of bankruptcies. Thousands of small private

businesses were ruined by the crash, cooperative managers and responsible officials were

prosecuted, and depositors demonstrated in the streets. The long-term effect of the credit

cooperative scandal was to destroy public confidence in the banking system, which became

popularly associated with crime and corruption. (Fforde, 1996, pp. 265-266) To compound the

problem in the succeeding years, Vietnamese banks have shown little interest in providing loans

to individuals and small business, and bank officers are widely believed to still engage in corrupt

activities.

By the year 2001, both China and Vietnam had established many of the institutions of a

modern banking and finance system, including two very active stock exchanges in China and an

embryonic one in Vietnam. At their cores, however, the banking systems remained dominated by

the state and many of their decisions were consequently subject to both moral hazard and adverse

selection, resulting in heavy burdens of non-performing debt. In addition, the financial systems

of the two countries remained very thin. There was little consumer lending and few financial

instruments were available. The secondary credit markets and reinsurance markets that serve to

offset uncertainty and risk in advanced economies were almost entirely absent.

IV. Exchange Rates and Development: The Yotopoulos View

Clearly the banking and financial systems of China and Vietnam are still in the early

stages of development. What are the implications of the Asian Financial Crisis for their future

development strategies? In 1996, Pan Yotopoulos presented an unorthodox analysis arguing that

a country’s development path can be adversely affected by a purely free market floating


exchange rate regime. Several elements of his analysis may be relevant to the situations of China

and Vietnam today.

The central point of Yotopoulos’ theory is that conditions of incomplete markets that are

common to developing countries tend to cause market forces to systematically undervalue those

countries’ currencies in the international exchange market. Markets in developing countries are

often incomplete because of information deficiencies. Credit markets particularly suffer from

information asymmetries, which prevent lenders from accurately assessing risk, pushing interest

rates above their optimum level and attracting higher risk investment projects. The problem of

inadequate risk assessment is often compounded by incomplete insurance markets, and problems

with credit and insurance retard and distort capital goods markets because investors are unable to

adequately hedge against uncertainties about the future. (Yotopoulos, pp. 40-44) These

descriptions accurately describe conditions in China and Vietnam today.

Yotopoulos goes on to point out that in free market exchange rate regimes, the currencies

of developing countries are less desirable as stores of value than international hard currencies,

resulting in consistent under-valuation of the domestic currencies. (Yotopoulos, p. 52) When the

domestic currency is undervalued, foreign demand for goods that can be internationally traded

increases, drawing resources away from the sectors that are not subject to trade. (Yotopoulos, pp.

56-57)

Yotopoulos’ second major point is that the key to balanced, sustainable development is

broad-based growth in domestic demand. (Yotopoulos, p. 289.) He argues that the challenge for

development is to “leapfrog” out of the early stage of surplus labor and low incomes, to the

advanced stage, in which production is characterized by high levels of capital and technology,

products have high value-added, and labor receives high wages. For this purpose, the


governments of developing countries should intervene in markets to increase the exchange rate

for domestic currency, promote non-tradable sectors, and stimulate income growth throughout

the economy, not just in the exporting sectors. Export growth will then result from industries that

have matured in the domestic market. (Yotopoulos, pp. 191-192, 289) After presenting country

case studies, Yotopoulos contends that this was the approach employed successfully by Japan

and Taiwan. (Yotopoulos, pp. 289-290)

This analysis is relevant to China and Vietnam because both are clearly still in the surplus

labor stage of development, with very incomplete markets, particularly in their financial systems.

Of the two, Vietnam is in greater danger of following a development path skewed toward low

value-added products, with 42 percent of its export value in 1999 accounted for by oil, coal,

rubber, rice, coffee, and marine products. (International Monetary Fund, 2000, p. 28) Both

countries, however, have in fact enjoyed strong growth in domestic demand and non-tradable

industries. Probably the best example is the residential housing market, which boomed in rural

China from the beginning of the reform period and has taken off in the cities with the shift to

privatization of housing in the last few years. Vietnam has also experienced a boom in

construction of private residential housing since the late 1980s. (Fforde, 1996, p. 284) Other

sectors that have grown rapidly on the basis of domestic demand in both countries are

agriculture, processed food, house wares, electronics, clothing, and education.

The question raised by the Yotopoulos analysis for the future development of the banking

and financial systems is how they can help to direct the two economies toward the broad-based

income growth and stable, sustainable development that Yotopoulos advocates.


V. Key Challenges in Banking Reform and Development of Financial Markets

A. Deepening and Diversification at the Grass Roots

While most of the attention of foreign analysts and domestic bank officials has been

devoted to large-scale financial issues, such as the development of stock markets and investment

intermediaries, the most important deficiency in both countries’ systems is arguably the lack of

an active local banking sector focused on consumers and small business. In Vietnam, small-scale

bank loans to either consumers or small businesses are almost unknown, and the saving rate in

formal banks is only 16 percent. (Gates, 2000, pp. 21-24; Han and Baumgarte 2000, p. 9) In

China, a survey of over 600 private enterprises conducted in 1999 found over 90% of initial

capital came from owners, start-up teams and families. (Gregory 2001) And while the household

saving rate in China is among the highest in the world, mortgages have only become common in

the last few years and consumer loans of all kinds still constitute less than 3 percent of

commercial bank business. (China Daily, 13 August 2000)

The banking systems of advanced industrial economies are grounded on dense networks

of local bank branches, which carry out the daily financial needs of consumer households and

small businesses. They hold deposits, make payments, issue a variety of small-scale financial

instruments, such as certificates of deposit, and make small-scale loans for small business

operations and all manner of consumer purchases, most importantly housing mortgages. Other

loans are made for the purchase of automobiles, home improvements, education, medical

expenses, or vacations.

For China and Vietnam, expansion of the local banking sector could supply several

important benefits. First, for Vietnam, increased saving in formal banks would increase the


amount of funds available for investment nationwide. Vietnam actually has a very active small-

scale loan market, but it takes place through informal intermediaries, outside the bank system.

The informal system is often efficient for individual borrowers and lenders, but it cannot provide

either the volume or range of options that would exist in a locally-oriented banking system

linked to the formal financial markets.

The second benefit of an active local banking network would be to stimulate consumer

demand by providing ready access to consumer loans. In 1999 and 2000, China faced the

unprecedented problem of deflation, caused by lagging consumer demand. The government tried

to encourage households to spend some of their savings by reducing interest rates on savings

accounts and eventually by levying a tax on interest income. A campaign by local bank branches

to market consumer loans could have achieved a similar result. Consumer loans would also be

spent largely on local small business.

A third benefit of an active local banking network would be to accelerate the growth of

small business, first by improving access to credit, and second by improving the financial

services available for business operations. A large part of the small business sector produces

non-tradable goods, such as food service, small-scale construction, construction materials, repair

services, plumbing, machine shops, barber shops, and so on. These are occupations that are

relatively labor-intensive, but also relatively high in value-added. They create large numbers of

jobs with fairly good pay. This is the kind of industry that is not susceptible to foreign

competition and that is not directly vulnerable to international market fluctuations, unlike the

exports of primary products (rice, oil, coal, tea, rubber) that low exchange rates promote.

For both countries, increased consumer and small business bank activity would serve to

deepen and diversify their presently very thin bases of financial instruments. Mortgage loans are


the most obvious example of a type of asset that plays a major role in the financial markets of

advanced countries, and has great potential in China and Vietnam, but is presently untapped.

Mortgages are also a good example of relatively stable, long-term assets that can play a buffering

role because they are not directly vulnerable to international market or exchange rate

fluctuations.

The final benefit of an active local banking network is to serve as a training ground for

financial professionals. Talented bank workers who begin as tellers or clerks will work their way

up to become loan officers, branch managers, and may eventually be chosen for positions in the

national system. In this way, a large pool of trained, experienced professionals would become

available for financial systems that currently face a severe shortage of qualified personnel.

Problems and Bright Spots

For both Vietnam and China the greatest challenge to developing a vibrant grass-roots

banking network is the lack of a culture of formal sector consumer borrowing. In Vietnam the

problem exists on both the consumer and the bank sides. Consumers have a well-founded distrust

of banks and are very reluctant to entrust their savings to them. Banks have been regrettably

prone to fraudulent behavior and crony lending and have shown little inclination to bother with

the small sums involved in consumer business. In China, there is no hesitation on the part of

households in putting their money in banks, but neither the banks, nor consumers have become

comfortable with the notion of consumer loans.

Fortunately, in each country there is some basis for optimism. In the case of Vietnam,

there is active consumer borrowing in the informal sector, much of it on a fairly large scale,

including most financing of new residential housing. A major source of informal lending is the

tightly-knit extended Vietnamese family, but there is also a substantial amount of lending by


informal financial intermediaries – called the “curb market” in some countries. Data obtained

from Vietnam’s countrywide Living Standards Measurement Surveys of 1992-93 and 1997-98

show that at the time they were surveyed, about half of the households were borrowers and 14

percent were lenders. In addition, nearly half of the lenders had borrowed funds at an average

rate of 1.3% per month, and were lending at an average 2.6% per month. In other words, they

were acting as financial intermediaries. (Haughton, 2000, p. 87) Clearly one approach for the

Vietnamese banking system would be to analyze the services provided by informal lenders and

create local bank branches that offered comparable services, as well as the other amenities of a

formal bank. Another approach would be to find a way to legalize the informal lenders and link

them to the formal system.

China also has a powerful tradition of family financial assistance and a long history of

informal credit arrangements. A major new incentive for consumer lending by banks has begun

to operate in China with the long awaited privatization of housing and a commensurate need for

an active mortgage market. One reason for the endurance of SOEs in China is that they provided

their workers and their families with most social services, including their housing, for which only

nominal rent was paid. By the end of 1999, housing reform plans were in place throughout

China, favorable tax policies were implemented, and the People’s Bank of China had required

commercial banks to extend the terms available for mortgage loans and to reduce the interest

rate. (China Daily, 9 January 2000) In 1999, the four major state commercial banks made a total

of 74.6 billion yuan (US$9 billion) in mortgage loans to individuals. (China Daily, 23 August

2000)


The crucial need for regulation

A difficult prerequisite for the development of local banking in both countries is the need

for effective regulation. Particularly in Vietnam, households will not be willing to entrust their

savings to bank accounts unless they have substantial assurances that they will be protected

against the kind of fraudulent behavior that caused the credit cooperative debacle of 1989-90,

and that many suspect has continued to occur in the banking system since then. (Fforde, 1996, p.

277) China also has an unhappy history of urban credit unions, which became popular in the

1980s, but suffered from poor management and bad lending practices and were converted into

urban commercial banks, which continue to experience shortages of qualified personnel and high

rates of bad loans. (China Daily, 27 July 2001) Regulation is problematic because it requires not

only appropriate laws, but also qualified and experienced officials, and a culture of integrity and

professionalism.

B. The WTO and International Competition: Challenges and Opportunities

China is poised to enter the World Trade Organization (WTO) and has agreed to open its

banking and financial markets to foreign competition when it does so. Chinese bankers fear that

they will have trouble competing with foreign banks that offer a wider range of services and are

more experienced in competitive markets. (China Daily, 19 April 2001) Vietnam is not close to

joining the WTO, but in July 2000 finally signed a major trade agreement with the United States

that will require significant opening of Vietnamese financial markets to foreign banks.

(O’Connor, 2000, p. 63)

It is undoubtedly true that some foreign banks will bring expertise, financial products and

access to credit that their Chinese and Vietnamese counterparts will initially find difficult to

match. However, given the current deficiencies in the financial systems of China and Vietnam,


foreign participation in their financial markets would more constructively be regarded as an

opportunity for improvement rather than as a threat. When foreign banks enter the Chinese and

Vietnamese markets, they will require local personnel to conduct day-to-day business and to

provide accurate assessments of local conditions. They will provide training to their local staff,

and afford opportunities to work with financial professionals who are experienced in

international financial markets. They will also set standards and provide previously unavailable

products that local banks will have to adopt in order to be competitive. Such changes can give a

major impetus to the fundamental reform efforts that have been stalled for so long.

C. Exchange Rate Regime

The conclusion of the Yotopoulos analysis regarding exchange rates is that the

governments of countries in the surplus labor, low-income phase of development should not

allow the exchange rates for their currencies to be determined purely by market forces. In fact,

the Chinese and Vietnamese governments have both intervened extensively and regularly in the

foreign exchange market to achieve exchange rate goals.

China: The Hong Kong connection and the dollar peg

Prior to the reform era the exchange rate for the Chinese yuan was seriously overvalued.

In the 1980s, efforts were made to bring the exchange rate into line with market value by a series

of devaluations, accompanied by the institution of a foreign exchange “swap market,” in which

Chinese exporting enterprises could trade foreign exchange at rates set primarily by supply and

demand. In the 1990s, the official exchange rate was gradually aligned with the swap rate.

(Zhang, 2001) Since the last major devaluation of the Chinese yuan in 1994, it has been closely

linked to the U.S. dollar at about 8.3 yuan per dollar. (China Statistical Yearbook 2000, p. 588)

Over the same period China has maintained a similarly stable relationship between the yuan and


the Hong Kong dollar, which has been fixed to the US dollar by a currency board since 1983.

(Mussa 2000, p. 26.) Thus, while China describes itself as operating a “managed floating rate

regime” (Zhang 2001, p. 81), which the IMF designates as a “soft peg” regime (Fischer 2001, p.

9), in fact it has tied itself to the HK currency board, a position it defended vigorously during the

Crisis.

Vietnam’s dual currency system

Vietnam has endured considerably more monetary and exchange rate instability than

China. Like the Chinese yuan, the Vietnamese dong was greatly overvalued before the reform

era. In the late 1980s, Vietnam went through a period of near-hyperinflation and the official

exchange rate lagged far behind the market rate. (Fforde 1996, p. 214) By the early 1990s,

however, inflation was curtailed and the official exchange rate was virtually unified with the

market rate. (Gates 2000, p. 14) Since that time the government has intervened in the foreign

exchange market as needed to follow what the IMF considers a “pegged rate in a horizontal

band.” (Fischer 2001, p. 21) For most of the early and mid-1990s the rate was around 11,000

dong to the US dollar, followed by a phased devaluation to about 14,000 per dollar between 1997

and 1999. (International Monetary Fund 2000, p. 26) The relative stability that Vietnam has

achieved in its exchange rate is further supported by the large role that the US dollar plays in the

Vietnamese money supply. Dollar deposits have fairly consistently accounted for around a third

of total bank deposits in Vietnam and the dollar is widely held as currency and used particularly

in payment for high value purchases. (International Monetary Fund 2000, p. 21; O’Connor 2000,

p. 53)

Effects of the peg regimes


Both China and Vietnam have achieved substantial stability in their exchange rates in the

past decade, raising their citizens’ confidence in the domestic currency. During the height of the

Asian Crisis, China was an object of international praise for its ability and willingness to hold the

line against devaluation. To the extent that the exchange rates have been higher than the free

market would have generated, Yotopoulos’ recommendation has already been met, and if his

analysis is correct, the non-tradable sectors of the two economies should be correspondingly

strengthened.

VI. Conclusions

1. China and Vietnam are still in the early phase of developing modern banking and finance

systems. Neither country yet has the variety of financial institutions and financial instruments

that smooth transactions and buffer against uncertainty in advanced industrial economies.

2. Both countries are in need of effective legal and regulatory frameworks and qualified

personnel to implement them.

3. Deficiencies in the financial systems cannot be corrected quickly. Well-designed laws and

policies can create an appropriate framework, but effective operations can only be carried out

by trained, experienced financial professionals, working with experienced lawyers,

accountants, regulatory officials, and customers. Adam Fforde comments on the Vietnamese

credit cooperative crash: “The financial events of 1989-90 illustrate that the development of a

capital market takes time and, more important, that it should take time.” (p. 266)

4. Foreign financial institutions can and should be used to assist with training, management and

marketing ideas, standards, and access to international sources of credit, but they cannot

substitute for domestic professionals.


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