V is for Vietnam

It might be difficult to remember given the chaos of the past two years, but in late 2007 Vietnam was one of Asia's emerging stars, with GDP growth largely in line with that of China. But within months, like most export-orientated developing countries, it was hit particularly hard as the GFC unfolded.

Yet as credit markets thaw, Vietnam is now on the verge of what appears to be an impressive V-shaped recovery. Indeed, on Wednesday this week the nation's central bank was forced to raise official interest rates and devalue its long-suffering currency, the dong, in an attempt to dampen rising inflation. But in the midst of this recovery lurk hidden dangers that could threaten Vietnam's remarkable turnaround.

Up until a couple of months ago, economists and analysts were extremely concerned about Vietnam's economy – in the first half of 2009 GDP grew by only 3.9 per cent, contrasting with growth rates of 6.2 per cent in 2008 and over 8 per cent between 2005 and 2007. Exports were down around 14 per cent year-on-year, the value of direct foreign investment had plunged 82 per cent, and domestic consumption stalled.

Then, just as suddenly as this emerging economy went off track, it turned the corner, revved its little engine, and started back on the road to growth. The Asian Development Bank is now predicting the economy will grow by 5.4 per cent in 2009, and Credit Suisse believes that Vietnam could see GDP growth of 8.5 per cent in 2010.

Unfortunately for investors, the Ho Chi Minh Stock Exchange has struggled to find the same traction. The VN Index fell from its all-time high of 1167.36 points in early 2007 to 235.5 points on February 24 this year (a 79 per cent fall). Since then the market has recovered but has been struggling to hold above 500 points. Following the government's decision to raise interest rates and devalue the currency on Wednesday, the VN Index dropped 4.5 per cent, its largest fall in more than seven months, to a three-month low of 503.41.

Just as in other markets around the world, the sharp fall in equities and private consumption, plus rumours the government was planning to devalue the nation's currency, led many investors to seek the safety of gold as an investment, sending local gold prices soaring well above international levels. The government responded in early November by lifting restrictions on gold imports for six of the country's commercial banks. This has helped to bring the price back down towards international levels.

Forecasts of strong growth and the flow of fast and easy credit have not managed to instil confidence in the banking system of a nation that has only embraced the free-market system since 1984 and is a largely cash-based society.

As a result, Vietnamese lenders are struggling to meet rising demand for loans as households plough money into the safe havens of gold and US dollars. To tackle this problem, commercial banks have deposit interest rates as high as 9.99 per cent and are offering gifts and bonuses to attract savings, according to Vietnamese media reports. Meanwhile, the government is trying to push state-owned companies to offload their foreign currency reserves to assist the banking system, saying that the SOEs hold between $US5 billion and $US6 billion in US dollars.

Vietnam, like many other governments, worked to address the downturn through large stimulus packages which included interest-rate subsidies, a temporary 30 per cent cut in the corporate tax rate for small and medium-sized businesses and financial assistance to poor households. And up until this week, the State Bank of Vietnam was adamant it would not raise rates. However these massive subsidies, combined with falling government income, has led the Asian Development Bank to forecast that Vietnam's budget deficit will widen to 10.3 per cent of GDP this year from 4.1 per cent of GDP in 2008.

At the present, keeping a lid on inflation just one of the challenges the Vietnamese government is facing. After hitting 23 per cent in August 2008, inflation eased to 8.3 per cent in the period between January and August 2009. The Asian Development bank, however, has warned "inflation pressures re-emerged in the second quarter as commodity prices edged up and growth accelerated”.

Following the trouble the central bank has had in controlling the value of the currency, some analysts are now wondering whether the bank has the mettle to keep the economy on an even keel.

According to AMP Capital's Shane Oliver, the combination of easy money conditions in the US and other developed countries, positive fundamentals in emerging markets and a greater focus on China by global investors there is a good chance that assets prices could soon become over-valued.

"The next big asset bubble may be in emerging markets or related themes,” he warns.

The Vietnamese government faces many obstacles as it moves from an emerging economy to a developed economy, but its present concern should be (and is) how to keep a lid on growth and inflation, while convincing its citizens and global investors of the relative stability of the banking system and currency.

It's a big ask, but without that stability, the V-shaped recovery will be short-lived.