Facing cyclical and structural challenges that are arguably as significant as any moment since the 1997 Asian financial crisis, Vietnam’s real GDP growth has markedly decelerated in recent times. From an annualised performance of 6.8% in 2010, it fell to 5.9% in 2011 falling further to 4.4% in the beginning of 2012. Whilst GDP growth rebounded to 5.4% in the third quarter of 2012, it remains below trend.
Sluggish growth has been persistent over the last five years, trending slowly downward during this period. This was partly the result of a cyclical downturn, caused partly by the stabilisation measures implemented in 2010-11 and the slow pace in structural reforms which have been held back by poor policy coordination and a slow, consensus-seeking decision-making approach. State-owned enterprises in Vietnam remain inefficient and corrupt, and systemic risks emanating from debt-ridden banks remain high while public investments are non-productive and pose a drag on growth. The real estate sector has also stagnated and the overall macro picture is one of consistent gloom, despite efforts to stabilise the economy last year moderately succeeding in containing inflation and narrowing the trade deficit.
The problems Vietnam faces are not unique, being characteristic of an economy undergoing the transition from a command to market economy; however, in recent years Vietnam has experienced significant growing pains compared to most Asian countries. Whilst longer-run growth has been robust (averaging 7% year-on-year over the past decade), Vietnam has been relatively prone to severe bouts of macroeconomic instability.
The cyclical and structural factors causing macroeconomic instability in Vietnam are as follows:
- First, there appears to be an underlying growth bias in the policies of the government.
Excessive credit growth (Figure 1), to satisfy growing investment needs, has periodically exacerbated overheating pressures. In the past five years, there were two waves of double digit inflation, and Vietnam’s inflation is markedly higher than its regional peers (Figure 2). The delay in the withdrawal of stimulus measures and the inability to raise interest rates in a timely manner in late 2010, coupled with high commodity prices, contributed to inflationary pressures. Vietnam also experienced high inflation during 2008 that rose as rapidly as it fell. The proximate cause was an unprecedented surge in capital inflows (reflecting investors’ optimism about Vietnam following its WTO accession) which were not adequately sterilised by the relatively inexperienced central bank.
Figure 1. Credit, money supply and inflation
Figure 2. CPI Inflation
Lately, the State Bank of Vietnam again prioritised growth, cutting rates five times since early 2012 given the less favourable external outlook and receding overheating risks. This has triggered concerns that the government is prematurely relaxing monetary policy to protect growth (and thus social stability) that might cause inflationary pressures. The IMF has warned that while the recent rate cuts in quick succession were justified in light of rapidly falling inflation and a weak economy, there is a risk of eroding market confidence and triggering renewed pressure on both prices and the exchange rate if further rate cuts are implemented too rapidly (IMF 2012). Premature easing of policy also risks inflationary expectations becoming unanchored and could significantly damage the credibility of the central bank1.
Similarly, the World Bank (2012) warned that whilst the authorities stabilised the economy last year with Resolution 11 (a package of monetary and tightening fiscal measures and reforms), the current relative price stability cannot be taken for granted given the historical precedent. The gradual relaxation of monetary policy could cause inflationary pressures to re-emerge, alongside the planned move to liberalise energy market and raise minimum wages for civil servants. As such, there is “only a small probability that inflation will continue to fall till the end of 2012 and end the year below 5%” (World Bank 2012).
- Second, rapid structural change, accompanying challenges in formulating policy and inadequately experienced policymakers have contributed to stresses.
The government’s lack of experience in macroeconomic management has aggravated price instability, as could be seen in the aftermath of the country’s WTO accession in 2007-08 when capital inflows were not properly sterilised. Its goal of inflation at a level below GDP growth – a dubious notion – was abandoned in 2007.
Importantly, monetary policy in Vietnam is made more difficult by the rapid structural changes occurring in the economy (which could for instance destabilise the link between monetary growth and the real economy) and the partial dollarisation in the system. The existing balance sheet problems of banks and enterprises also likely restricted the effectiveness of bank lending as a channel for monetary transmission (Camen 2006).
Further, the relatively undeveloped money and bond markets limit the scope of conventional open-market operations in Vietnam. The State Bank of Vietnam instead relies on its lending facilities (refinancing and discount rates) to manage base money and often utilises the reserve requirement ratio to adjust liquidity. It is therefore difficult for it to 'fine tune' monetary policy or take timely actions. Given that it routinely resorts to non-market administrative measures to manage its economy, such as caps on interest rates, quotas on bank credit and restrictions on lending to different sectors, create credit market distortions and inefficiencies are prevalent.
- Third, the central bank lacks the capacity to maintain monetary discipline, negating the role of the fixed exchange rate as a monetary anchor.
Vietnam’s fairly liberalised capital account and openness to capital flows has complicated the implementation of monetary policy, making it difficult for the State Bank of Vietnam to maintain a stable exchange rate and an independent monetary policy. With Vietnam pegging its currency to the dollar, the system has not delivered on price stability as the State Bank of Vietnam has been reluctant to surrender its monetary independence, as required by a fixed exchange rate. This lack of autonomy has undermined the credibility of its inflation-targeting commitments and prevents inflation expectations from being anchored, thereby undermining macroeconomic stability.
Suffice to say, the loose credit conditions in recent years, together with the dominance of an inefficient state sector, have resulted in inefficient investments. Easy credit conditions have also led to concerns about the quality of bank assets. Vietnam’s non-performing loans stood at 3.6% of assets at the end of March 2012, although this ratio is likely to be higher if measured by internationally accepted standards. Questions regarding the soundness of the banking sector2 are not new, but concerns have intensified following a scandal involving a Vietnamese bank ACB two months ago. Nonetheless, the financial market has yet to show signs of any stress, as the unofficial exchange rate is trading tight to the official one (Figure 3).
Figure 3. Vietnam’s exchange rates
Unless there is significant risk aversion caused by a loss in domestic confidence, the risk of a balance-of-payments crisis is low. However, Vietnam’s fragile banking sector and its poor inflation track record could precipitate a loss of confidence in the Vietnamese dong, leading residents to convert their dong assets into either dollars or gold to hedge against inflation or domestic currency depreciation. The flight of domestic capital, which is typically reflected in the errors and omissions item of the balance-of-payments accounts, has contributed to the widening of the deficit since late 2008 (Figure 4). Although the hoarding of gold and dollars by residents outside the financial system has begun to decline, it is still considerable and hindered the accumulation of foreign-exchange reserves. At end-2011, foreign-exchange reserves amounted to $13.1 billion, equivalent to only 1.4 months of imports. This is low by international standards, even though the significant narrowing of the current-account deficit to 0.4% of GDP in 2011, from 12% in 2008, provides some reassurance.
Figure 4. Vietnam’s balance of payments
Vietnam’s economic performance has been marred by large swings in economic and financial conditions. The inability to respond quickly to changing conditions, the pro-growth bias of the State Bank of Vietnam, as well as a 'stop and go' policy style highlighted by the tightening and loosening of countercyclical policies in quick succession partly explain this. Further, the problems facing Vietnam are symptomatic of deeper underlying issues. Inefficient state-owned enterprises and weaknesses in the banking system need to be addressed expeditiously with measures such as strengthening corporate governance, enforcing stricter standards for recognising bad loans, and equitising state banks. Fortunately, total external debt levels are low and most external debt is concessional. However, some risks remain – contingent liabilities from state-owned enterprises and the financial sector are not captured under public and publicly-guaranteed debt statistics and pose some risks to fiscal sustainability.
Despite these challenges, Vietnam remains attractive to investors given its burgeoning middle class and favourable demographics. In the medium-to-long term however, productivity gains must begin to make up for the weaker growth that will come from a dwindling demographic dividend (McKinsey 2012)3. But first, the country must get the basics right, chief among which is maintaining macroeconomic stability. For Vietnam to encourage a stable, sustainable macroeconomic environment, it should implement structural reforms and not prematurely relax fiscal and monetary policy to protect growth at all costs.
IMF (2012), Article IV Staff Consultation Report
World Bank (2012), “Taking Stock: An Update on Vietnam’s Recent Economic Development”, June 4-5.
Camen, Ulrich (2006), “Monetary Policy in Vietnam: the case of a transition economy”, Bank of International Settlement (BIS) Paper 31, December.
McKinsey Global Institute (2012), “Sustaining Vietnam’s Growth: The Productivity Challenge”, 2012.
1 According to the IMF, the State Bank of Vietnam should instead seize the opportunity to bolster their credibility by aiming for inflation well below their original target of below 10%, rebuild international reserves and accept somewhat slower economic growth. It should err on the side of caution and be prepared to delay rate cuts depending on developments in the course of the year.
2 According to the World Bank, Vietnam is an 'underbanked' country, with total assets in the country equivalent to just over 20% of GDP, a level well below that of Asian countries. Vietnam is also 'overbanked' in that there are too many financial institutions chasing after too few assets in the system.
3 According to a McKinsey report, to continue expanding at around 7% per year, Vietnam needs to boost productivity growth by 50%, from 4.1% annually to 6.4%. Without this boost, the glide path for Vietnam’s growth would decline to between 4.5 and 5% annually, significantly below the 7% more typical in recent years and the government’s own target, set at the 11th National Party Congress in January 2011, of 7 to 8% annual GDP growth by 2020.