Effect of budget deficit on inflation rate in Vietnam

 Hue University Journal of Science 
 ISSN 1859-1388 
 Vol. 126, No. 5B, 2017, pp. 117–127 
 EFFECT OF BUDGET DEFICIT ON INFLATION RATE 
 IN VIETNAM 
 Nguyen Thi Thuy Minh1, *, Nguyen Thi Thuy Duong2 
 1 HU – University of Economics, 100 Phung Hung Street, Hue city, Vietnam 
 2 Phu Xuan University, 28 Nguyen Tri Phuong Street, Hue city, Vietnam 
Abstract: In recent years, Vietnam has achieved a high economic growth rate, so inflation has 
become a noticeable problem. The relationship between the state budget deficit and inflation is 
a two-way dialectical relationship. However, within the limit of this article, the authors only 
study the one-way relationship: the effect of budget deficit on inflation rate in Vietnam. The 
prolonged budget deficit and the remediation of the state budget deficit by different methods 
have affected the inflation rate differently. This effect is analyzed both quantitatively and 
qualitatively and includes five approaches: the impact of fiscal policy inflation, the impact of the 
state budget deficit level on inflation, the impact of budget deficit funding on inflation, the 
independence of the monetary policy and its effect on inflation, and the effect of public 
expenditure on inflation. 
Keywords: budget deficit, inflation, monetary policy, fiscal policy, public expenditure 
1 Introduction 
To quickly narrow the gap with other countries and avoid lagging too far behind economically, 
the Vietnamese government has prioritized high economic growth. However, this high 
economic growth has led to high inflation over time in Vietnam. There were many reasons 
causing the inflation, especially when Vietnam has integrated into the world economy, and the 
reasons stem from both the inside and the outside. Therefore, finding the causes behind 
inflation in order to solve it has become a major concern. Together with high inflation, the 
prolonged and persistent budget deficit would also be mentioned. The question here is: “How 
has the budget deficit affected the inflation situation in Vietnam?” Studying the effect of the 
budget deficit on inflation has an importantly realistic significance. This article analyzes this 
relationship quite comprehensively in terms of both qualitative and quantitative aspects. It also 
points out the importance of management and use of the state budget and the balance between 
budget revenues and expenditures in order to control inflation in Vietnam. 
* Corresponding: thuyminh93@gmail.com 
Submitted: April 11, 2017; Revised: September 9, 2017; Accepted: November 16, 2017. 
Nguyen Thi Thuy Minh, Nguyen Thi Thuy Duong Vol. 126, No. 5B, 2017 
2 Theoretical background and methodology 
2.1 Theoretical background 
From the monetarist view, the budget deficit causes inflation. According to Hamburger and 
Zwick (1981), budget deficits can lead to inflation, but only to the extent that they are 
monetized. Generally, the budget deficit per se does not cause inflationary pressures but 
rather affects the price level through the impact on money aggregates and public 
expectations, which in turn trigger movements in prices (Solomon and de Wet, 2004). Many 
previous empirical studies employed econometric techniques methods to examine the effect 
of budget deficit on inflation. The most common one uses the single-equation econometric 
model, treating inflation as a dependent variable and the budget deficit as an independent 
variable among others (Abizadeh and Yousefi, 1998; Ahking & Miller, 1985; Hamburger & 
Zwick, 1981; McMillin & Beard, 1982). However, they have shown conflicting results about 
this relationship. While some results support the hypothesis that the budget deficit causes 
inflation by a positive statistically significant coefficient of the budget deficit, some yield 
the inconclusive result by an insignificant coefficient (Solomon and de Wet, 2004). 
2.2 Methodology 
The research analyzes the qualitative and quantitative effect of the budget deficit on the 
inflation rate. Five aspects are involved, namely the impact of the fiscal policy, the impact 
of the state budget deficit level, the impact of budget deficit funding, the independence of 
the monetary policy and its effect on inflation, and the effect of public expenditure. 
Previous studies and the reality in Vietnam were used as the basis for this study. 
 The data were collected from the General Statistics Office (GSO), the Asian 
Development Bank (ADB) and the Ministry of Finance. These organizations reported the 
annual information about the deficit and inflation in Vietnam over a long period from 1994 
to 2015. 
 As mentioned above, a common way to examine this relationship is using the 
econometric model. Solomon and de Wet (2004) employ a model in which the budget 
deficit, GDP and the exchange rate are treated as exogenous variables and the inflation or 
Consumer Price Index (CPI) as an endogenous variable. 
 This study aims to identify the effect of the budget deficit on the inflation rate in 
Vietnam using the multiple-regression method. The model includes one dependent variable 
which is the inflation rate and four independent variables 
 lnY = βo + β1 · BD+ β2 · lnE + β3 · GDPg + β4 · lnM2 + ε 
where Y is the inflation rate (%); BD is the budget deficit rate (%); E is the exchange rate 
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(VND/USD); GDPg is the Gross Domestic Product growth rate (%); M2 is the money supply 
(billion VND); βo is a constant; and ε is an error term; β1, β2, β3, β4 are the coefficients. 
Budget deficit rate 
As explained previously, the budget deficit affects the price level through the impact on 
money aggregates and public expectations, which in turn triggers movements in prices 
(Solomon and de Wet, 2004). However, this relationship depends on the lag effect of the 
budget deficit and many other factors; so it is expected to have a positive or negative or 
insig ... d rapidly. For 
example, in the budget structure of 2009, spending on development grew up to 30.78 %, and 
this did not significantly increased inflation but affected the inflation in the following years. It is 
clear that the structure of budget expenditures also had a certain effect on the inflation rate. The 
year with big expenditures on, for example, the salary would experience the increase in 
inflation rate. Meanwhile, more spending on development investment would cause the lagging 
effect for inflation in the following years. 
 Figure 1. Inflation rate and budget deficit over period 1994–2015 
 Source: General Statistics Office and the Ministry of Finance, 2016 
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 In terms of budget deficit amount, this value has increased in absolute terms. Figure 2 
shows that inflation tended to move together with the budget deficit value. However, there 
were also periods when they did not move in the same direction. 
 Figure 2. Value of the budget deficit and inflation rate over period 2000–2015 
 Source: General Statistics Office, the Ministry of Finance and ADB, 2016 
 A quantitative analysis is conducted using the least square method with 4 
independent variables: the budget deficit rate (BD), the exchange rate (E), the Gross 
Domestic Product (GDP), and the money supply (M2); the dependent variable is the 
inflation rate (Y) with 22 observations (data obtained from 1994 to 2015). The result is 
shown in Table 1. 
 Table 1. Quantitative results of research model 
 Independent variables Estimated coefficients p > | | 
 Intercept 489.3406** 0.017 
 Budget deficit (BD) –5.2900*** 0.001 
 GDP (GDP) 0.0127 0.989 
 ln exchange rate (lnE) –63.7187** 0.011 
 ln money supply (lnM2) 11.9553*** 0.001 
 R2 0.5739 
 Adjusted R2 0.4736 
 N 22 
Note: p-values are in asterisk ( ***) denote significance at the 1 % level 
 Source: calculation data obtained from General Statistics Office and ADB, 2016 
 According to the data, 57.39 % of the variation in inflation is explained by the model. The 
coefficient of the budget deficit is negative statistically significant at 1 %, which conflicts with 
the theory mentioned above. The reason could be the lag effect of the budget deficit on inflation 
and the budget expenditure structure, i.e. how much and when the government spends the 
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budget in each sector. It is very complicated to determine this lag effect because it depends on 
each period, and this effect is also affected by other factors through multiple mechanisms. 
Therefore, this study suggests that there should be a more comprehensive research about this 
lag effect and its mechanism, and how the budget affects the inflation. 
 Among 3 other variables, only M2 has a positive statistically significant coefficient at 1 %, 
and this is consistent with the monetarist (and neo-classical) models “changes in the inflation 
rate closely depend on changes in the money supply” (Solomon and de Wet, 2004). 
3.3 Effect of sources of finance budget deficit on inflation 
In addition to increasing the use of revenue and cutting unnecessary spending, there are two 
methods to offset the budget deficit: issuing money and borrowing money. 
Money issuing 
The impact of this method was clearest in period 1986–1990. This was a period of economic 
difficulty with lack of funding sources and high level of budget deficit. The state mainly used 
the money-issuing tool to compensate for the deficit, which caused an increase in the money 
supply and resulted in an imbalance between money and goods, leading to a very high inflation 
rate (Nguyen & Nguyen, 2011). Inflation reached an average of 232.5 % during this period. 
Because of these consequences, the money issues method is rarely used to offset the budget 
deficit. 
 Table 2. Source of the budget deficit’s finance for period 1986–1990 
 Year 
 1986 1987 1988 1989 1990 
 Content 
 Budget deficit (billion VND) 37.20 135.70 1,093 2,203 2,250 
 Amount of money issued to 
 22.90 89.10 450 1,655 1,200 
 offset budget (billion VND) 
 Percentage of money issues (%) 61.56 65.66 41.17 75.12 53.33 
 Percentage of borrowings and aids (%) 38.44 32.10 32.60 24.88 46.67 
 Others (%) – 2.24 26.23 – – 
 Source: general Statistics Office 
Borrowing money 
 Domestic borrowing 
 Borrowing money is the main method to finance the budget deficit, especially domestic 
borrowing in the form of issuance of Government securities. The government authorizes the 
State Treasury to issue securities that may take in the form of treasury bills, treasury bonds or 
project bonds. 
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 According to Vu (2013), domestic borrowing allows the government to control the budget 
deficit without increasing its currency base or reducing its foreign reserves. Therefore, it is a 
quite effective measure that would mobilize temporary idle money, avoid the risk of a foreign 
debt crisis and easy to conduct. However, this measure may restrain the development of 
business activities in the non-state sector. 
 Moreover, in Vietnam, bonds are mainly sold to credit institutions and are often 
discounted by commercial banks at the State Bank. Along with that, the large domestic debt of 
State Bank has pushed up interest rates. If the State Bank wants to achieve the goal of monetary 
policy, it has to pump money into the economy to stabilize the interest rates and promote 
business. The issuance of credit or buy-in transactions on open market of the State Bank would 
have the effect of increasing money supply and putting pressure on inflation. 
 Foreign borrowing 
 In addition to domestic borrowing, the government may borrow money from foreign 
governments and financial institutions such as the World Bank, the International Monetary 
Fund (IMF), the Asian Development Bank (ADB), intergovernmental organizations and 
international organizations, etc. Foreign borrowing can be in the form of issuing hard foreign 
currency bonds abroad and credit borrowing. 
 Foreign borrowing would increase debt repayment obligations, potential exacerbation of 
the debt crisis, dependence on foreigners both economically and politically, reducing excessive 
foreign exchange reserve, and the national storage would lead to an exchange rate crisis. At the 
same time, foreign borrowing would increase the supply of foreign currency in the market, 
causing pressure on the domestic currency. To maintain the stability of the exchange rate, the 
State Bank intervenes by increasing the domestic money supply in the market, and if the market 
does not absorb promptly, this increase would raise the inflation rate. 
 In conclusion, the funding source for the budget deficit could affect the inflation directly 
or indirectly. It could affect immediately if the government uses the money issues measure or 
impact with a certain lag through multiple channels and mechanisms of action such as the 
borrowing method. 
3.4 Effect of public expenditure on inflation 
Vietnam's economic growth has been still largely based on the capital factor, of which the 
government has a high proportion of the investment capital. As shown in figure 4, in period 
1995-2012, the investment capital for state sector fluctuated from 35% to 60%. Despite the large 
proportion of investment, the contribution of state sector to GDP was not adequate and was 
always lower than 40% (figure 5). In period 2000–2011, the average state capital investment ratio 
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was 46.55 %, but this sector contributed an average of 36.89 % in GDP over this period (To, 
2012). This partly shows that the public investment was not efficient with higher losses than 
that of other economic sectors. 
 Figure 3. Structure of investment capital Figure 4. Structure of GDP 
 by economic sectors by economic sectors 
 Source: General Statistics Office 
 The state sector had a large proportion of investment but high losses that led to the state 
budget deficit. The budget was always in a state of deficit mainly due to large public 
investment, but the public investment did not create the corresponding value of goods. There 
was an imbalance of payment, causing high inflation. Therefore, improving the efficiency of 
public spending would be a measure to control inflation. 
3.5 Independence of monetary policy and its impact on inflation 
There have been numerous studies demonstrating that the independent central bank model has 
a good impact on controlling inflation and budget deficits. There are four independence levels 
of the central bank: the highest level is "Independence in goal setting”; the second level of 
independence is "Independence in setting performance criteria"; the third level is 
"Independence in the choice of operating instrument"; and the lowest level of independence is 
"Limited independence or even no independence" (Solomon & De Wet, 2004). The State bank of 
Vietnam is currently at the lowest level of independence. This has had a certain impact on the 
State bank's capacity building. Vietnam's monetary policy is still serving economic growth and 
the government's purpose, not as independent as in other countries. 
 The central bank has low independence and accordingly is in the context of a persistent 
budget deficit; it must be responsible for advancing the state budget and handle the budget 
deficit. This amount has not usually been paid in time and is non-guaranteed, and the money 
supply, therefore, also has been influenced and then partly affected the inflation. 
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4 Conclusions and solutions 
Both quantitative and qualitative analysis of many aspects of the impact has proved that the 
persistent budget deficit, the low independence of central bank, and the ineffective public 
expenditure are the main reasons for high inflation in Vietnam. Therefore, in order to control 
inflation, the government should: 
 First, control the state budget deficit actively rather than passively deal with the 
consequence of the high budget deficit, manage the budget revenue well to create sustainable 
and stable revenue sources during the period of economic growth, control revenue sources and 
reduce tax loss, etc., and manage public spending and prevent losses and waste. 
 Second, deal with the relationship between investment expenditures and regular 
expenditures, central budget and local budgets, closely manage and supervise borrowing loans, 
limit the use of budgetary advance, exploit other sources of revenues and control borrowing in 
such a limited amount that its effects are predictable. 
 Third, enhance the independence of the State Bank, secure foreign exchange reserves, 
further administrative reforms, combine harmoniously the fiscal policy and the monetary 
policy, pay attention to the wage reform and raise the quality of forecasting, boosting domestic 
production and labor productivity. 
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