STRATEGY
The Strengths and Weaknesses in Vietnam's Economy
August 28, 2007
James McCormack, Fitch Ratings - Vincent Ho, Fitch Ratings

Strengths Balance Weaknesses

Vietnam has been improving its external financial position and international foreign-exchange reserves (including gold). In 2006 it became a net external creditor for the first time. Fitch Ratings expects this to be sustained thanks to the forecasts that foreign-exchange reserves will grow faster than gross external debt (GXD). GXD also reached a decade low of 30% of GDP in 2006 and Fitch expects it to decline in 2007-2008. In addition, external debt service fell to 4.6% of current external receipts (CXR). Both ratios were below the 'BB' peer group medians. In 2007 Fitch forecasts Vietnam's external liquidity ratio to reach 690% (the third highest in the 'BB' peer group).

The debt of state-owned enterprises (SOEs) was about 29% of GDP in 2006, but it has declined along with the partial privatisation (equitisation) of SOEs. In addition, state-directed lending has been more contained after the transformation of the Development Assistance Fund (DAF) into Vietnam Development Bank (VDB) and the introduction of sounder regulations. Together with the faster equitisation of the state-owned commercial banks, Fitch expects the non-performing loan issue (mostly related to policy lending and held by state-owned financial institutions) to be resolved gradually.

However, ratings constraints exist in the public finances of Vietnam. Owing to higher oil prices, the general government fiscal deficit narrowed to 5.3% in 2006, worse than the BB median. Based on the forecasts of falling world oil prices and rising public infrastructure investments, Fitch expects the general government fiscal deficit to widen to over 7% in 2007-2008. In GDP terms, the general government debt has increased, as domestic debt has risen faster than external debt has declined.

Credit Outlook

Vietnam's weak public finances are a major constraint for positive rating actions. The government tends to rely more on domestic sources of financing, meaning the concerns are focused on the local currency rating. However, the level of general government domestic debt in GDP terms remains comparable to other BB peer sovereigns.

Strengths

• Improving external financial position.
• Strong and sustainable economic growth.
• SOEs' debt reducing.

Weaknesses

• Continuous fiscal deficits, expected to widen in 2007-2008.
• Rising general government debt.
• Further banking system reforms needed.

Political and Social Situation

Vietnam's ruling Communist Party concluded its 10th Congress in April 2006. New nominations to the politburo were accepted and Party General Secretary Nong Duc Manh was re-elected, signalling Vietnam's firm intention to remain on the path of reform. In addition, the appointments of President Nguyen Minh Triet and Prime Minister Nguyen Tan Dung to the politburo have been considered favourable to foreign investment and continuous development given their long-term involvement in Vietnam's reform process. However, fighting corruption and strengthening the leadership role of the Communist Party are likely to remain two of the major issues ahead.

In 2006, Vietnam marked the 21st anniversary of the 'doi moi' policy, which aims to restructure the country from the socialist-oriented model towards a market-based model. The main goals of the Social-Economic Development Plan (SEDP) 2006-2010 are sustaining the renovation policy; maintaining high economic growth at an annual average of 8.2% in support of country's graduation from low-income status by end-2010; and reducing poverty. In particular, the government expects investment to lead the economy. Hence, investment is intended to reach an average of 40% of GDP over 2006-2010, while public-sector investment (including government and SOEs) would also increase. Since 2004, the country has faced fewer immediate threats to social stability, but discontent arising from official corruption may provoke disturbances. In response, the government has stepped up its anticorruption efforts since the new Law on Prevention and Suppression of Corruption - focusing on corruption preventive measures in the public sector - was passed in November 2005. In January 2007, the Central Steering Committee for Anti-corruption and Prevention, chaired by Prime Minister Dung, announced it would regularly publish all proceedings of major corruption or economic criminal cases (including Project Management Unit 18, involving Ministry of Transport officials misappropriating state funds for infrastructure projects). Internationally, Vietnam and China have competing claims to the oil-rich Spratly and Paracel Island groups in the South China Sea. Nevertheless, it is unlikely that tensions over this issue will intensify into a major confrontation, and they are unlikely to affect the sovereign ratings.

Financial Sector

Vietnam's Banking System Indicator (BSI) is E, which implies a 'very low' banking system quality. The BSI measures a banking system's intrinsic quality or strength, derived from Fitch's long-standing individual bank ratings. In addition, the Macro-Prudential Indicator (MPI) of Vietnam is 2, which represents a 'moderate' vulnerability to potential systemic stress defined by Fitch. The E2 category for Vietnam is the same as Dominican Republic (B) and Iran (B+).

Figure 1: Banking System: Key Facts

	2006
BSIa	E
MPIa	2
M2 (% of GDP)	81.3
NPL Ratios (%)
IASb	15.0
VAS	3.2
Capital adequacy ratio (%)b	5.0
Public ownership (%)b	75.0
Foreign ownership (%)b	13.0

^aAs at September 2006
^bFitch estimates
Source: World Bank, SBV and Fitch estimates

Concerns for future growth of the banking system remain the dominance of the SOCBs (75% of system-wide assets) and the limited presence of foreign banks. The SOCBs have also been experiencing high NPLs from SOEs, arising from past state-directed lending. As supported by the government, loans to SOEs were frequently provided on an unsecured basis. As a result of government reforms initiated in the early 1990s, the share of credit extended by SOCBs to SOEs has been cut to 26.4% at end-September 2006 from 55.8% at end-1994.

Outstanding bank loans grew 15.9% between end-2005 and end-September 2006, which was substantially slower than the 31.6% rise in 2005. The credit slowdown was due to the banks' efforts to curb an increase in NPLs and conform to stricter prudential standards that were introduced by the SBV in April 2005. Lending growth by the SOCBs and other banks slowed to 9.4% and 30.4%, respectively at end-September 2006. Loans extended to SOEs grew 13.0% and those to non-SOEs 17.4%. Credit growth across all industrial sectors continued to slow.

Non-performing Loans

According to the SBV, end-2006 NPLs (mostly in SOCBs) were almost unchanged from end-2005 at 3.2% of loans, under the Vietnamese Accounting Standards (VAS). The four largest SOCBs - Bank for Agriculture and Rural Development (Agribank), Vietnam Bank of Foreign Trade (Vietcombank), Bank for Investment and Development of Vietnam (BIDV) and Vietnam Bank for Industry and Commerce (Incombank) - have NPL ratios ranging from 3% to 4%. However, these ratios could be higher if the loan classifications are based on the IAS. In order to narrow this gap, the SBV issued Decision 493 in April 2005, to be introduced in two stages. A first estimate of the NPL ratio, produced in early 2006 and based on Decision 493, was in the range of 8%-10%, which was somewhere between the NPL ratios under the IAS (World Bank's estimate was over 14%) and VAS. Despite the launch of restructuring efforts in 2001 to improve the financial health of the SOCBs, they have made slow progress. One of the major obstacles has been the ability to bring delinquent debtors to foreclosure and seize their assets, especially when those debtors are SOEs and 'their' assets actually belong to the government. The central Debt and Asset Trading Company (DATC), created under the finance ministry in 2003, could overcome this institutional constraint. However, it is still too early to assess the performance of the DATC, as it only began to operate in 2005.

In contrast, there was significant progress in reducing SOCBs' NPLs in 2004, when policy lending activities were transferred out of the SOCBs to two specialised institutions, the DAF and the Vietnam Bank for Social Policies. Policy lending continued to expand through the DAF, then shrank after it was transformed into the VDB amid the introduction of sounder regulations. Despite the changes, the VDB also reported NPLs of 2% at end-2004 under the VAS, which implies they would be higher if classified by the IAS.

Nevertheless, two SOCBs - Vietcombank and Mekong Delta Housing Development Bank - have lowered their NPL ratios and met the minimum capital adequacy ratio of 8%, making them ready to be equitised and this may be completed in 2007. The government would hold 50% of these SOCBs and use their equitisation proceeds to enhance the financial strength of the remaining SOCBs for equitisation purposes. The recapitalisation of the financially weak SOCBs by the government remains as an option, which could become a fiscal burden. Agribank, however, will remain wholly owned by the government in 2007. The delay of its equitisation could be partly explained by its traditional role in rural-related lending and its strategic nature.

Public Finance

With an oil trade surplus and a state-owned oil company, higher oil prices in 2005-2006 contributed to an increase in oil-related fiscal revenue. Oil revenue rose from 7.3% of GDP in 2005 to 8.2% in 2006, accounting for about 31% of total fiscal revenue. As the government changes the classification of administrative expenses of tax and customs, Fitch expects a rise in VAT revenue to 6.8% of GDP in 2007 from 6.1% in 2006. Nevertheless, Fitch expects the total fiscal revenue in GDP terms to shrink in 2007 and 2008, mainly due to falling oil prices.

General government expenditure (Fitch's definition) increased from 31.8% of GDP in 2005 to 32.2% in 2006, which was driven by both current expenditure (+0.2pp to 18.7%) and capital expenditure (+0.2pp to 8.8%). Current spending on salary reform of government workers amounted to 1% of GDP in 2006. Off-budget investments (OBIs) continued to rise from 2% of GDP in 2005 to 2.2% in 2006, mainly driven by increased infrastructure investments for transport and irrigation (financed by issuing infrastructure bonds) from 1.3% of GDP in 2005 to 1.6% in 2006. As a result, the general government fiscal balance remained in deficit of 5.3% of GDP (worse than the BB median deficit of 2.8%; and third only to Egypt at 8.2% and Sri Lanka at 7.3%) in 2006, which was narrower than the deficit of 5.9% in 2005. Fitch expects the overall fiscal deficit to widen to 8.4% in 2007 and 7.5% in 2008, mainly due to falling fiscal revenue, as mentioned previously, and rising expenditure. Both deficits would be higher than the medians (2.8% for 2007 and 2.5% for 2008) of the BB peer group in the respective years. Fitch expects the current expenditure to be the main forces driving up the overall fiscal expenditure. It also expects capital expenditure (including the infrastructure investments in the OBIs) to increase steadily in 2007 and 2008.

Equitisation of SOEs

The activities of SOEs account for 40% of the country's GDP and contribute almost 18% to the general government revenue. It will be necessary to speed up the restructuring and reform of SOEs to help them adapt to the market economy and meet the requirements of integration and international economic competition. Given this, the government has introduced various policies to create a uniform legal framework for the equitisation, reform and development of SOEs (including mergers, conversions to limited-liability companies, outright sales and liquidation). Equitisation would help to increase the autonomy of SOEs to make business decisions, but it would not remove all the distorted incentives faced by supervising ministries and provincial governments relating to lending policy at the provincial level and inefficient market regulation at the sectoral level. Despite that, the new investment and enterprise laws should provide a more level playing field to both the SOEs and private enterprises. Furthermore, World Trade Organization (WTO) membership is expected to make it more difficult to favour SOEs over other enterprises.

The government pledged in the early 1990s to strengthen its efforts to equitise SOEs. Their average size has grown, as has the share of their capital sold to outsiders. At end-2006, there were about 2,600 SOEs, down from about 12,000 SOEs in 1990. The government will equitise about 800 SOEs in 2007, including some corporations, SOCBs as well as public-service and insurance companies. Those to be equitised will also be listed on the stock exchanges.

Monetary and Exchange Rate Policy

Owing to its low degree of independence and its conflicting roles as owner and supervisor of the SOCBs, the State Bank of Vietnam (SBV) has limited capacity in conducting monetary policy and supervising the banking system. Reforms issued through Decision 112 in May 2006 aim to convert the SBV into a modern central bank that can run monetary policy and effectively supervise financial institutions. The policy targets of the SBV are to support economic growth; keep inflation below the real GDP growth rate; and maintain VND/USD exchange rate stability. However, monetary policy alone could not achieve these targets easily and simultaneously. In terms of the instruments, the SBV conducts monetary policy through either open market operations (OMOs), reserve requirements or both. In addition to these indirect monetary policy instruments, the SBV continues to announce the base rate as a reference to influence the deposit and lending rates, though it has been a less effective instrument. The government could also control prices administratively or take policy measures (such as fiscal measures) to directly influence prices. Inflation was 7.5% in 2006, down from 8.3% in 2005. Inflation of food and foodstuff (accounting for over 50% of the CPI basket) slowed from 11.2% in 2005 to 8.7% in 2006 and the inflation rate of transport and communications also fell from 8.3% to 7.1%. The higher oil and non-oil commodity prices did not have much impact as the government counteracted their changes by reducing their import tariffs. Despite tariff adjustments and a tight monetary policy stance, Fitch expects the country's inflation to be above 7% in 2007-2008. The VND is a highly regulated currency and is not fully convertible. Since January 2007, the SBV has widened the daily fluctuation limits of the VND against the USD from +/-0.25% to +/-0.5% to reflect the government's stance on more flexible exchange rate movements along with the accession to the WTO. The SBV is also mandated to safeguard this exchange rate policy through foreign-exchange interventions, if necessary.

The VND has long been depreciating slowly against the USD in the interest of maintaining the competitiveness of the export sector. However, the recent increase of portfolio investment capital inflows (see External Finance) into the financial market has caused the VND to reverse its course and appreciate. In addition, these capital inflows could drive up inflation. Despite a proposal by the SBV in mid-February 2007, Prime Minister Dung said there would be no urgent measures to control foreign capital on foreign 'indirect' investment to counteract the excessive speculative capital inflows. Fitch believes the government's stance on speculative capital inflows may slow down the net capital inflows of portfolio investment in 2007 and 2008.

This article is an extract from the report 'Socialist Republic of Vietnam' by Fitch Ratings.

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