Far Eastern Economic Review

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Far Eastern Economic Review
May 2008
By Jonathan Pincus and Vu Thanh Tu Anh

What a difference a year makes. Early last year, a spate of stories appeared in the international press proclaiming Vietnam as "the New Asian Miracle" and "the Next Asian Tiger." The country joined the World Trade Organization in January 2007, prompting a surge in annual foreign direct investment approvals to more than $20 billion. The Ho Chi Minh City Stock market caught fire, with the index reaching a peak of 1,170 in March, up 140% year on year. Rising global commodity prices drove export revenue to nearly $50 billion, an increase of more than 20% over 2006. For the year as a whole, the economy grew by an impressive 8.5%, the fastest pace since 1996.

Cut to March 2008. A major investors' conference -- marketed under the title "Sustaining Growth and Reform in Asia's Next Tiger" -- was suddenly cancelled at the request of the government owing to "pressing macro- and microeconomic concerns." The government later claimed that the organizer's permits were not in order. On March 25, the stock market bottomed out at 496, a fall of 57% off the peak of a year earlier. In the same month, the official year-on-year inflation rate rose to 19.4% led by a worrying 31% increase in food prices. The first quarter 2008 trade deficit came in at $7.4 billion, four times higher than the first quarter of 2007.

The abruptness of Vietnam's economic fall from grace has raised concerns about the stability of the financial system, particularly if conditions continue to worsen. The good news is that Vietnam's macroeconomic fundamentals are still sound. The country is not heavily indebted, export growth is strong and the State Bank of Vietnam has added substantially to foreign-exchange reserves over the past year. Vietnam is less integrated into global capital markets than Thailand and Indonesia, and therefore unlikely to suffer as much from the fallout of subprime mortgage defaults in the United States. The government could restore stability relatively quickly by achieving control over public spending and borrowing by state-owned enterprises. The bad news is that political constraints may place even this relatively simple task beyond the reach of Vietnam's policy makers.

Vietnam's economy is overheating. Global factors such as high energy and food prices have contributed to inflation, but the fact that prices have risen much faster in Vietnam than in neighboring countries suggests that domestic factors are more important. These factors include credit growth in excess of 50% and a fiscal deficit equivalent to 7% of GDP. The resulting money growth sent prices of nontradables spiraling and fueled a property bubble that drove prices of prime real-estate assets to double or triple in the space of one year.

The origins of overheating can be found in a sudden surge in capital inflows in 2007. Disbursed FDI, remittances, development aid and portfolio flows exceeded $20 billion or 30% of GDP. Like many developing countries, Vietnam put considerable effort into attracting foreign capital, but was unprepared for it when it finally arrived in large amounts. The SBV has traditionally targeted the exchange rate and allowed the money supply to adjust, a strategy that makes sense in an economy in which many people prefer to conduct business in foreign currencies and hold foreign-currency assets. Moreover, the instruments of monetary policy do not yet function well in Vietnam. Interest rates are a blunt instrument when directed credit to SOES make up a quarter of the stock of loans and when the banks are organized into an explicit cartel to avoid outbreak of competition. The market for government bonds is thin and the secondary market is in its infancy. Because yields on government bonds are lower than the inflation rate, bond purchasers are betting that the pegged exchange-rate regime will hold. As the odds on this bet increase, dong-denominated bonds become less attractive to foreigner and domestic investors alike.

The failure to sterilize the sudden flood of foreign capital (by selling dong-denominated securities) fueled lending growth among the small joint-stock banks. These banks lent aggressively to property developers and buyers of real estate and equities. Rising property, and share prices also put more collateral in the hands of people that owned these assets, prompting them to borrow more. Large state-owned conglomerates joined the property craze, financed by state-owned banks at favorable rates.

In addition to sparking credit growth, the surge of capital inflows also financed a widening of the trade- and current-account deficits. An important difference that separates Vietnam from most of East and Southeast Asia is that Vietnam is a net capital importer. In other words, Vietnam routinely runs trade- and current-account deficits financed by inflows of foreign capital. This is not a bad or even a risky thing for a country at the early stages of industrialization. Vietnam needs to buy equipment and inputs for its growing industries and must finance these imports through a combination of exports and foreign-capital inflows. The trouble is that dependence on short-term portfolio flows can be destabilizing if there is a sudden change of investor sentiment.

On top of the monetary shock Vietnam also piled on an expansionary fiscal policy led by public investment. In 2007, investment as a share of GDP exceeded 40%, half of which was undertaken in the public sector and partially financed by state banks. Herein lies the second major difference between Vietnam and the neighbors. The more successful among the East and Southeast Asian countries have adopted a conservative fiscal-policy stance. These governments know from experience that price inflation sets off workers' demands for higher wages and makes exports less competitive. They also see the legitimacy of the state linked to the welfare of people who are defenseless against inflation such as school teachers, agricultural workers, pensioners and the urban poor.

The government's response to the resulting inflationary pressure was to increase the reserve requirements of the banks by 100 basis points in February 2008, adding to a 500 basis point hike (in May 2007.) SBV also required the larger banks to buy 20.3 trillion dong in state treasury bills carrying a yield of 7.8% by mid-March. For a time, SBV limited purchases of dollars to control money growth. All of these encouraged the banks to hoard Vietnam dong liquidity, forcing up interbank lending rates as high as 43% in late February. Fearing the effect of a wave of margin calls on the balance sheets of the smaller banks, the government also narrowed the intraday trading band on the stock market to 1% from 5%.

These minor adjustments have had the intended effect on lending rates and the property market. Anecdotal evidence suggests land prices in Ho Chi Minh City have fallen about 20% from their peak in December 2007. But government policy has been inconsistent. SBV capped savings rates at a below-inflation 12%, and then stood by passively as the Vietnam Bankers' Association enforced a cap of 11% on its members. More importantly, aside from vague appeals for efficiency in the use of public funds, nothing has been done to reign in the state banks and the public-investment program. As long as fiscal policy is expansionary, monetary tightening will simply drain funds out of the nascent private sector. In the meantime, inflation will continue unabated.

There is no shortage of people in Vietnam who understand the causes of the current economic instability and the steps needed to quell price inflation and restore stability to the markets. Vietnam's problems are neither complicated nor unmanageable.

Unfortunately, these people are not in a position to do much about it. Vietnam's policy-making institutions are fragmented to the point of paralysis. Monetary policy is the preserve of SBV, but the Ministry of Finance has been assigned the task of controlling inflation. Monetary policy is also overseen by a National Financial and Monetary Policy Committee that includes technical advisors and representatives of other government agencies. The Ministry of Finance sets tax policy and recurrent spending, but investment spending is under the Ministry of Planning and Investment. Appointments are under the command of the Communist Party, which issues policy guidelines. Meanwhile, the state-owned conglomerates report directly to the prime minister, bypassing the ministries, and are not averse to appealing to him or other senior politicians to get what they want.

Fundamental reforms are needed to simplify the policy-making apparatus. Most East and Southeast Asian countries created advisory boards staffed by highly trained, well-paid experts to steer macroeconomic policy. In some cases these institutions wielded the levers of power; in others they gave political leaders advice insulated from the party politics. For example, Korea's Economic Planning Board assumed direct control over planning, fiscal policy and statistics, while Taiwan's Council for Economic Planning and Development functioned more in an advisory role.

Vietnamese institutions are characterized by ambiguous lines of authority and consensus decision making. On the plus side, Vietnamese politics has been marked by stability. But consensus-based decision making has also reinforced a tendency to distribute rents widely across the system. This problem is evident in the allocation of public investment. Vietnamese politicians approve 10 projects when one will do, and spread them across the landscape. For example Vietnam is building a string of deep sea ports in central Vietnam despite the fact that port infrastructure in the southern provinces of Ho Chi Minh City, Dong Nai, Binh Duong and Ba Ria Vung Tau -- which together comprise more than 50% of Vietnam's job growth and nonoil budget revenues -- is stretched to the breaking point. The highway authorities have plans for $40 billion worth of new roads. Vietnamese infrastructure projects are expensive by international standards despite a widely acknowledged problem of poor quality. Although the government recognizes the need to close the fiscal deficit to control inflation, it is difficult to see who will make the hard choices necessary to make public investment more efficient.

Corruption thrives when it is considered a normal cost of doing business. On April 18 the Supreme People's Procuracy dropped bribery charges against Bui Tien Dung, the former head of the Ministry of Transport's scandal-tainted Project Management Unit 18. Charges against his boss, former Deputy Transport Minister Nguyen Viet Tien, were dropped in March despite the national embarrassment caused by the apparent misuse of Japanese and World Bank development aid. Vietnam receives low marks in comparison to other East Asian countries on the various corruption perceptions surveys. For example, the World Bank's composite rankings based place Vietnam below even China and far below Thailand and Malaysia. The prevalence of corruption makes it more difficult to close the fiscal deficit, since officials on all levels are benefiting from the proliferation of high cost projects.

In the early 1990s, concern over the poor performance of state-owned industrial enterprises led the government to try a new approach. General corporations and conglomerates were created out of existing firms, supposedly following the model of the Japanese keiretsu and Korean chaebol. The idea was that larger firms would realize economies of scale and scope, which would enable them to compete internationally. The gap in the logic was that most of the conglomerates -- firms like the mining corporation Vinacomin, the shipper Vinalines, the electricity producer evn and the state-oil company Petro-Vietnam -- earned their money from mineral rents or preferential access to the domestic market. Rather than wade into the treacherous waters of international competition, most preferred to build on their market power in Vietnam to move into lucrative domestic ventures in the property market, financial services, telecommunications and tourism.

The conglomerates did not turn into world beaters, but they did learn how to trade on their political influence at home. SBV has recently granted banking licenses to three conglomerates (FPT, the insurer Bao Viet and PetroVietnam), and more are in the queue. These companies are replicating the familiar Southeast Asian pattern of creating diversified corporate empires around a cash-generating monopoly and a bank to provide easy access to capital.

The few companies that produce products for export have used political connections to secure government-guaranteed loans to expand into unrelated sectors. The shipbuilder Vinashin received the proceeds of Vietnam's first sovereign bond issue in 2006 and then took a billion dollar loan from Credit Suisse. More recently, Vinashin and Vinatex -- a textile and garment producer -- secured loans from Deustche Bank of $2 billion and $500 million, respectively, on the occasion of Prime Minister Nguyen Tan Dung's official visit to Germany.

Even so, government is showing signs of losing patience with the conglomerates. At a recent meeting with general corporation bosses to discuss measures to control inflation, the prime minister revealed that although the conglomerates and other state corporations account for 60% of outstanding loans of the state-owned commercial banks and 70% of Vietnam's foreign borrowing, they produce only 40% of GDP. In early April he ordered all state general corporations and conglomerates to invest at least 70% of their capital in their core businesses. But the conglomerate reaction suggests disciplining them will not be so easy. Chairman of PetroVietnam Dinh La Thang, referred to this mild sanction as "shock therapy" and remarked that "even when state conglomerates and enterprises investment in noncore businesses accounts for up to 40% or 50% of total investment and if these investments are profitable then the government should not ask them to disinvest from these businesses as this would cause the enterprises to collapse."

Vietnam has won plaudits from the international community for its poverty-reduction record, near universal primary education and improvements in basic indicators such as the infant mortality rate and access to safe drinking water. Yet for an avowedly socialist government Vietnam relies heavily on out-of-pocket spending to finance basic health and education. Public spending on health is the second lowest in the region, after Indonesia. Public funds targeted to help the poor don't always reach them. According a recent United Nations Development Programme study, 45% of transfer payments in health go to the richest fifth of the population, as compared to 7% to the poorest quintile. The corresponding figures for education assistance are 35% and 15%.

Beyond the numbers, there are also concerns about the quality of health and education services. Intel delivered a blow to Vietnam's self-image as a rising star in knowledge-based industries when the company announced that after testing 2,000 students from the five top technology universities only 40 students met their minimum standards. According to Intel, this was the lowest success of any country in which they have a presence. No wonder Vietnamese household spend an estimated $1 billion per year on education overseas. The domestic system fails to deliver quality, even to those who can afford to pay.

Gore Vidal once described the American economy as "socialism for the rich and free enterprise for everyone else." Vietnam is rapidly heading in the same direction. The formation of an elite class that enjoys access to state power and resources has potentially serious political consequences for a ruling party that claims to represent the interests of working people. Rising food prices are hurting the poor, but they are not an immediate threat to political stability. Yet the growing perception that the state looks after the interests of powerful people while leaving the poor to their own devices can only have a corrosive effect on the government's authority over the long term.

Economic reform succeeded in Vietnam beyond most observers' expectations. Integration into global markets has stimulated economic growth and improved the living standards of millions of Vietnamese people. Export growth has averaged over 20% per annum since 1990, with the top earners in labor intensive products such as garments and seafood. These industries have provided steady jobs to millions of rural Vietnamese who had previously only known lives of economic insecurity and extreme poverty. Export growth is driven by farmers, a nascent private sector consisting mostly of very small firms and foreign enterprises. The private and foreign invested sectors account for nearly all of the job growth recorded over the past seven years.

Welded to this competitive but low margin economy is a separate system consisting of capital-hungry state firms concentrated in natural-resource exploitation and producing goods and services for the domestic market. These firms account for the bulk of borrowing from state-owned banks and have begun to borrow overseas. They have leveraged their political influence to diversity into the lucrative domestic property and financial markets. Although data on their performance is sorely lacking, the rate of return on state capital is far lower than in the private and foreign invested sectors.

More worrying still, the conglomerates have been allowed to open banks and nonbank finance companies. The developing world is full of examples of the hazards of interlocking corporate and banking interests. From Chile's grupos to South Korea's chaebol and Indonesia's konglomerat, the melding of banks and powerful corporations has led to imprudent intragroup lending, loss of control over monetary policy and ultimately financial instability. Vietnam should think carefully about the implications of this strategy before proceeding any further down this road.

Vietnam's current inflation and macroeconomic instability are direct consequences of the country's long-term growth problems. These challenges are one and the same. Monetary tightening alone won't solve Vietnam's inflation problem. Driving up interest rates in the absence of action to reduce the fiscal deficit may succeed in cooling off the small private sector, but would have little effect on the conglomerates, which borrow from state banks at preferential rates or overseas. Higher borrowing costs will also make it harder to reduce the fiscal deficit in the short term. The government will not bring down inflation until it regains control over public investment and learns how to discipline its state-owned conglomerates.

Vietnam's government has begun to realize that it cannot build a robust securities market without first ensuring that the banking system is sound. SBV is carefully monitoring the balance sheets of the small banks for signs of trouble. This is vital, since these banks are over-exposed to the inflated property market. Should one of them come to SBV for relief, the authorities should be ready to take action to make sure that the problem is quickly contained.

Long time Vietnam watchers are quick to note that Vietnamese policy makers have a way of piecing together pragmatic solutions when times get tough. What begins as "fence breaking," or spontaneous defiance of the rules, often ends up as official policy. Vietnamese policy makers will not let ideology get in the way of something that works. The conventional wisdom holds that this attitude will enable Vietnam to muddle through this current bout of instability.

Yet this time the government has to do more than just get out of the way. Fence breaking now takes the form of state conglomerates establishing banks and building residential estates. Instead of sanctioning this kind of behavior, the authorities need to regulate it. Financial liberalization in particular is a risky business in the absence of a transparent regulatory framework and credible enforcement. The problem is that Vietnam's new economy has produced a new kind of politics, one based less on ideology than on the formation of powerful interest groups. Imposing discipline on these groups, most of which emanate from within the state, is the central challenge facing the Vietnamese leadership not only this year but in all likelihood for many years to come.


Mr. Pincus is chief economist of the United Nations Development Programme in Vietnam. Mr. Vu is an economist with Harvard University's Vietnam Program.