Nov. 4 (Bloomberg) -- Vietnam is caught in a “vicious circle” between boosting exports by weakening the dong and the impact that a devaluation may have on confidence in the currency, Morgan Stanley said.

Vietnam will probably devalue its currency about 4 percent to 18,500 against the dollar by year-end, according to Australia & New Zealand Banking Group Ltd. Citigroup Inc. expects the dong’s official rate to weaken to 18,100 by the end of December, and HSBC Holdings Plc predicts the currency will fall to 18,200.

“A one-off devaluation could create expectations of further devaluation, leading to more local holdings of U.S. dollars and resulting in the central bank needing to hold more reserves to support the currency,” Morgan Stanley economists Deyi Tan, Chetan Ahya and Shweta Singh wrote in research published today.

A weaker dong may help boost exports, which declined 14 percent in the 10 months through October, as well as slowing demand for imports, helping to hold down the country’s widening trade deficit, Moody’s Economy.com said this week.

The dong’s official exchange rate weakened to 17,860 against the dollar as of 3 p.m. in Hanoi, from 17,486 at the end of 2008. In the black market, the currency fell to 18,620 per dollar today, according to an information service run by Vietnam Posts & Telecommunications.

Depreciation Pressure

The gap between the two rates shows the dong is under pressure, Morgan Stanley said. “Not weakening the currency means external balance pressures will persist and depreciation tendencies will continue,” Tan, Ahya and Singh wrote.

One-year non-deliverable forwards for the dong fell 3.2 percent today to 20,505 per dollar, the most since Sept. 1, according to data compiled by Bloomberg. Forwards are agreements in which assets are bought and sold at current prices for delivery at a future specified time and date.

The forwards prices “should be interpreted with care” due to low liquidity in the futures market, Moody’s Economy.com said in research this week.

Vietnam’s policy of managing the dong has resulted in a drop in foreign reserves to about $16 billion, from around $24 billion in the fourth quarter last year, Morgan Stanley said.

Inflation, Deficit Rise

The State Bank of Vietnam said last month that it is seeking loans from organizations such as the Asian Development Bank and the World Bank to prevent instability in the dong.

Vietnam’s central bank has held its key interest rate at 7 percent since February, after cutting the rate from 14 percent in October 2008. The State Bank said last week that it plans to keep the rate unchanged until early 2010.

Citigroup said in September that maintaining the current monetary policy was unsustainable given signs inflation may accelerate. Consumer prices gained 2.99 percent in October from the same month a year ago, from a 2.42 percent gain the previous month. Inflation peaked at 28.3 percent in August 2008, the highest rate in Asia.

The trade balance has moved from a surplus in the first quarter to an $8.8 billion deficit through October, according to preliminary estimates from the government statistics office. A $1.9 billion shortfall was recorded for October alone.

“The current loose monetary policy may not be translating into the most optimal productive capacity expansion for exports as it tends to be biased towards real estate, hotels and construction rather than factories and infrastructure,” wrote Tan, Ahya and Singh.

To contact the reporter on this story: Jason Folkmanis in Ho Chi Minh City at folkmanis@bloomberg.net

Last Updated: November 4, 2009 03:09 EST