Increased investment in Vietnam encourages economic development, although challenges remain

Among the world’s most impressive emerging market success stories of the past three decades, Vietnam has been achieving high growth rates, encouraging a huge reduction in poverty and attracting billions of dollars of foreign investment. What was, until relatively recently, considered a comparatively poor country by regional standards – with an economy previously weakened by decades of war – is now solidly middle-income. If Vietnam is able to maintain its current momentum, it might potentially achieve high-income status within the coming few decades.

According to The Economist, Vietnam has achieved the world’s second-highest growth rate per person since 1990, behind only China. Central to this success has been the country’s ability to leverage its advantages; it benefits from a strategic location in South-east Asia with access to a range of developed and emerging markets, a substantial domestic market, political stability, and a strong culture of entrepreneurship and work.

The government and the central bank – the State Bank of Vietnam (SBV) – are widely regarded as pursuing prudent and coherent policies that maintain growth while simultaneously enhancing systemic stability. However, the authorities are aware of some weaknesses, including a growing fiscal gap, credit risk and high levels of bad debt, inefficient state-owned enterprises (SOEs) and weaker productivity, and they are moving to address them. Vietnam’s political system places a strong emphasis on raising incomes and promoting macroeconomic stability, with once-high inflation kept in check and job creation a priority.

Doi Moi

Vietnam has been better able to capitalise on its key competitive advantages since the Doi Moi reforms launched in 1986. Doi Moi means “renovation”, and the reform programme was designed to create a socialist-oriented market economy, combining the dynamism and efficiency of capitalism with the low inequality, social justice and active state participation of a socialist system. The Doi Moi reforms were an extension of earlier efforts aimed at decentralising the government’s system of economic management and introduce market elements in a compartmentalised form.

While Vietnam remains a communist country and the government retains an active role in the economy, the philosophy of Doi Moi has led to the country embracing private enterprise and large-scale international investment. Early reforms led to SOEs moving towards a focus in profit – rather than production targets – and in the early 1990s, changes promoting the private sector were formalised. The number of joint stock and limited liability companies soared, catalysing the rapid development of the economy. Partly as a result, Vietnam has achieved remarkable success in poverty reduction, with the poverty rate falling from around 50% in the 1990s to just 3% in 2016. Poverty is largely concentrated among ethnic minority groups in remote areas, and overseas development assistance and government funds are increasingly targeting these areas, as the majority of the country has moved on to middle-income status.

Recent Performance

The Vietnamese economy grew by an estimated 6.21% in 2016, according to the government’s General Statistics Office (GSO). This was the third consecutive year that the country achieved growth of 6% or more, following a 6% expansion in 2014 and 6.7% in 2015. Furthermore, this high rate of growth constitutes a slowdown on previous years. On the whole, Vietnam bucked the regional trend of the early 2010s, with its economy cooling less than many of its neighbours following the global downturn of 2008. The economy is internally stable an in 2016 and the main risks were external; global headwinds came from Britain’s referendum decision to leave the EU, slowing growth in some major emerging markets, and continued uncertainty around the eurozone.

Growth was slightly below the 6.3-6.5% target set by the government, as the agriculture and mining sectors lagged due to domestic and international factors. However, manufacturing (including construction) grew strongly, growing by 7.6% in 2016 and expanding 13.6% in the final quarter of the year, driving the country’s overall fourth-quarter GDP growth to 6.7%, up from 6.6% in the third quarter. Throughout the year, the manufacturing purchasing managers’ index produced for the Japanese business publishing company Nikkei registered in positive territory, above the 50.0 “no change” level, and peaking at 54.0 in November 2016. New business registered by manufacturers grew for 13 straight months to 2016, and the outlook for 2017 is regarded as positive.

Favourable Investment Climate

Vietnam’s competitive advantages have continued to draw export-oriented manufacturing investment. The country attracted a record $15.8bn in 2016, up 9% on 2015, with landmark investments including $1.5bn from LG Display’s for an organic light emitting diodes screen plant, and LG Innotek’s $550m camera factory. Despite a trend towards muted international demand, Vietnam’s exports continued to grow strongly, by 8.6%, while imports rose by 4.6%, pushing the country’s trade surplus $2.68bn, according to the GSO.

Foreign direct investment (FDI), and the jobs it creates, feeds through into higher domestic demand for goods and services. In what is already a market of 90m people, investment has spurred economic activity. Domestic consumption has helped Vietnam weather some of the international economic challenges of the past decade, and continued to do so in 2016. Retail sales, a good barometer of economic health, grew by 9.1%.

Other strengths included tourism, with a record 10m visitors coming to Vietnam in 2016 and domestic tourism growth soaring by 48% in 2015 to end the year at a record 57m (see Tourism chapter). The sector directly contributes about 5% to GDP, according to the World Tourism and Travel Council, with its total impact estimated at more than 9%.

Agricultural growth fell to just 1.36%, from around 2.2% in 2015 – already one of the worst years in the past half-decade – due largely to a series of supply shocks: namely, drought in the coffee-growing Central Highlands, excessive salination in the Mekong Delta’s paddy fields, cold weather in the north, and floods in the centre of the country. The fishing industry also suffered a major setback, attributed to an April leak at a steel mill at Ha Tinh in the north of the country. However, the rice harvest in the last quarter pushed the sector into positive territory, despite yields being lower than usual. Meanwhile, mining – in which the GSO includes the oil industry – shrank by 4%, partly on the back of low coal and oil prices, though it had managed 6.5% growth in 2015.

Breakdown

In 2015 industry and construction accounted for 38.5% of GDP, and the service sector 44.1%, according to the Foreign Investment Agency (FIA). Services have become an increasingly important part of the economy in recent years, rising from 42% in 2011, when industry and construction contributed 37.9% to GDP. Under the country’s Five-Year National Socio-economic Development Plan 2016-20 and the associated Restructuring the Economy Plan 2016-20, the government intends to raise the economic contribution of industry and services to 85% of GDP, further reducing dependence on agriculture, the volatility of which has had a considerable impact on overall growth figures. However, agriculture still accounts for 47% of total workforce employment, according to the World Bank. As a result, it is expected that the agricultural sector will remain hugely important for the foreseeable future.

Looking Ahead

The nation’s GDP growth is expected to continue at similarly high levels in 2017, despite concerns about a global slowdown. The Asian Development Bank (ADB) forecast 6.3% growth and the IMF expects 6.2%, while the government itself has set a higher target of 6.7%.

In an August 2016 assessment of Vietnam, Moody’s Investors Service affirmed Vietnam’s B1 (speculative) credit rating, with a stable outlook, noting the country’s “robust economic growth and diversified economy”. The company forecast sustained 6% growth over the coming two years, citing resilience to the slowdown in China, low inflation and buoyant consumer sentiment.

While growing domestic demand has trimmed the current account – the agency forecast a small surplus of 0.6% of GDP – it expects the reformed exchange rate regime to help adjustments and ensure that the country continues to run a balance of payments surplus.

Moody’s has also graded Vietnam increasingly well for its institutional strength, thanks to accelerated reform, though the country still scores comparatively low. Like most analyses, the report highlighted risks from fiscal imbalances and high credit growth, coupled with questionable asset quality in the banking sector.

“A moderation in credit growth and a reduction in the fiscal deficit would reduce macroeconomic vulnerabilities,” Sebastian Eckardt, senior economist for the World Bank in Vietnam, told OBG. “Nonetheless, we expect 6% GDP growth on average over the next five years, based in Vietnam’s fundamental strengths, robust domestic demand growth and sustained performance of the FDIdriven, export-oriented manufacturing sector.”

Global Downsides

A number of global risks weigh on the outlook. The results of the 2016 US presidential election have added new uncertainty to the international outlook, and there may be a direct impact on Vietnam from the new president’s opposition to the Trans-Pacific Partnership (TPP), a major trade pact of which the country was expected to become one of the biggest beneficiaries. Thus far, Vietnam has outperformed many of its Asian peers in GDP growth, but the region’s slowing may still have a drag effect on the Vietnamese economy. However, this risk should not be overstated. The ADB forecasts that the 45 countries it groups as “developing Asia” will grow by 5.6% in 2017, well above the global average.

However, the economy is not immune from the possibility of external shocks in 2017, particularly considering the rising risk of political instability in Europe and the increasingly complex relationship between the US and China. There are downside risks from Europe, where the UK is likely to start the process of exiting the EU and where the eurozone continues to struggle with low growth and changing political forces, as well as banking difficulties in Italy and growing debt burdens in a number of countries. The geopolitical risks that could also arise from China involve growing tensions over the South China Sea, where Beijing has been increasingly assertive about its territorial disputes with a number of countries in the region, including Japan, Taiwan and Vietnam. The early-2017 escalation of the dialogue between China and the US has resulted in forecasts that trade relations may be disrupted and logistics complicated.

On the other hand, there are potential upsides to the base case scenario. These include faster rebalancing in China, which is looking to shift from an investment and industry-based growth model to one with a bigger role for consumer spending and services. This would benefit Vietnam’s role as a finished-goods exporter, with investors increasingly looking to shift industrial production into other countries in Asia outside China. A promised infrastructure investment and tax-cut programme from the US may help lift global growth.

Small Businesses

In late 2016, Vu Viet Ngoan, chairman of Vietnam’s National Financial Supervisory Commission, a body that advises the prime minister, said that the government intended to respond to global headwinds by boosting the domestic sector and encouraging the private sector to take the leading role in economic growth. To this end, the government is looking to put in place new support for small and medium enterprises (SMEs). Current figures suggest that SMEs account for 98% of businesses, 40-50% of GDP and around 50% of employment.

Despite the important economic contribution that these smaller businesses are making, they tend to find it difficult to access capital. Additionally, many entrepreneurs struggle to link their firms into the supply chains of the country’s FDIdriven industries, or into the SOEs that dominate some sectors. The majority of SMEs are micro-enterprises, with minimal or no collateral, and limited management and accountancy capacity. “To an extent, the Vietnamese economy is made up of four areas that exist side by side,” Virginia Foote, president and CEO of Bay Global Strategies, an investment consultancy, told OBG. “There are SOEs, there are blue chip domestic companies that do well with access to land and financing, there are 100% foreign-owned companies in manufacturing and services. Then there are SMEs in all sectors, which are often the weakest players.”

In an effort to provide stimulus to this sector, the government has deployed several incentives. In late 2016, the National Assembly discussed a long-debated draft law that would cut corporation tax on SMEs from the normal business rate of 20% to 17%, and 15% for “super-small” enterprises, for the 2017-20 period. The plan also pledges support for the development of business plans, management capacity, and corporate transparency, to help small businesses obtain access to credit, and includes incentives for the developers of economic and industrial zones to include more SMEs in their complexes, boosting economies of scale and helping integration into the supply chain.

“Boosting the domestic private sector is really key to escaping the middle-income trap, looking at the countries that have successfully done so,” Eckardt told OBG. “So the government is trying to put in polices to promote SME growth. They need a better business climate, as well as macroeconomic stability, and lower interest rates.”

Productivity

Both SMEs and SOEs struggle with low levels of productivity. According to the IMF, domestic manufacturers’ average output per worker is just over one-fifth of that of enterprises with significant foreign investment. Agriculture, which employs nearly half the workforce, has similarly low levels of productivity. Given the sector’s share of GDP, this has a significant effect on the economy as a whole and is one reason that Vietnam’s growth rate lagged behind those of the most successful East Asian countries during periods when they were at a similar stage of development. The aging population proportionate to the workforce may become a further drag on growth. Vietnam’s total factor productivity has in fact fallen by around 1.5 percentage points since the 2000s, despite rapid development in most areas. Better integration with the successful domestic blue-chip and FDI companies would help technology and knowledge transfer to raise output.

Soe Reform

Almost as important as development of SMEs is reform of Vietnam’s hundreds of SOEs. The government’s programme of equitisation – the process of turning an SOE into a joint-stock company, often as a prelude to privatisation or part-privatisation – has made significant progress in recent years, with hundreds of enterprises equitised, but many sectors have dominant state-owned players, often with preferential access to land and capital, and conflicts of interest with the government agencies that control and regulate them. As well as crowding out resources for private players, the inefficiency of SOEs serves to dampens overall productivity. These productivity gains are expected to become increasingly important over the coming few years as Vietnam’s cost advantages over other markets are likely to begin being eroded by rising wages, although investment to address bottlenecks in infrastructure are expected to help ease this pressure.

While Vietnam’s primary and secondary education system is widely lauded for achieving results above the average for the country’s income level, tertiary education is considerably weaker. Vietnam’s long-term goals of moving up the manufacturing value chain and boosting in-country innovation that will be necessary for achieving high-income status are likely to require considerable reforms to the education system.

Fiscal Policy

In January 2017 Huynh Quang Hai, the deputy finance minister, announced that the government achieved revenues of VND1100trn ($49.2bn) in 2016, 7.8% above the government’s target for the year. Hai said that public debt to GDP reached 64.73%, just below the 65% ceiling set by the National Assembly. Some analysts had predicted that Vietnam would struggle to stay within the limits, and indeed some say that, by different calculations, it has already been exceeded.

A sizeable trade deficit and the associated debt burden remains a downside risk to the economy, though opinion differs on how serious the issue actually is. According to Bloomberg, the nation’s trade deficit stood at $6.73bn in the first half of 2016, up from $2.26bn in the same period of 2015. The country has also been running deficits averaging about 6.5% since 2012, thanks to corporate income tax cuts, tariff reductions, tax exemptions and incentives, and falling oil revenues. At the end of 2016, the government submitted a draft resolution intended to remove obstacles to enterprise development. According to the draft, enterprises with revenue under VND20bn ($897,000) and innovative start-ups are subject to a 17% tax rate. On the outlay side, expenditure has been rising, including higher interest payments on debt, though capital expenditure has been constrained. In mid-2016 the IMF forecast that the budget deficit would reach 6.5% of GDP for the full year, narrowing slightly to 6% in 2017. The government is actively seeking to address the potential risks from the growing debt burden, and Prime Minister Nguyen Xuan Phuc has said that the current rate of expenditure is unsustainable over the medium term. The official deficit target for 2017 is 3.5% and the government is currently focusing on increasing income through better tax collection and management of public assets and land, tackling corruption issues, making procurement less costly and divesting away from government stakes in non-core sectors.

Credit Growth

Domestic credit grew by 18.7% in 2016, around the average level for recent years. State-owned banks retain a large market share, and the government has used credit growth to oil the wheels of economic growth at a time of moderate fiscal consolidation and global economic uncertainty. The pace of Vietnam’s GDP growth has risen in recent years, meaning that credit is playing an increasingly important role.

The SBV has set a target of 18% credit growth for 2017, in line with recent trends, although the central bank’s own survey of credit institutions forecasts it could be slightly higher at 19%. Rising credit risk is a concern for the banking sector. Much of the acceleration in lending in early 2016 was due to rising credit to the property and financial sectors, and retail lending including mortgages, leading the IMF, among others, to question the productivity of new credit in the system.

Loan Performance

Concerns are particularly acute after a banking crunch in 2012 saw the non-performing loan (NPL) ratio rise to 17%. Some SOEs had used cheap credit to expand into non-core sectors in which they then struggled, running up large debts. For example, state-owned shipbuilder Vinashin diversified into businesses including insurance and distilling, while energy firm PetroVietnam moved into leisure and real estate. Meanwhile, other banks were accused of lending recklessly to companies linked to their owners. The government committed itself to addressing the problem, creating the Vietnam Asset Management Company (VAMC), which took on many of the banks’ bad debts in exchange for bonds. Largely as a result, the official NPL ratio stood at a reasonable 2.58% at the end of the second quarter of 2016, down from 2.62% in the first quarter, and 3.72% at the end of the second quarter of 2015.

The VAMC bonds are collateralised with the NPLs’ underlying assets, while the commercial banks continue to manage their NPLs and are obliged to repurchase unresolved bad debt from the asset manager at the end of a five- to 10-year provisioning period. Thus, the VAMC acts as a warehouse for bad debt, rather than a bad bank, per se, while it is obliged to sell bad assets at book rather than market value. This has led many in the sector to question the organisation’s effectiveness as a means of addressing the root of the problem. The IMF estimated in mid-2016 that impaired loans including NPLs sold to VAMC and previously restructured loans were around 12.5% of the total, adding that this was a conservative estimate of the overall NPL ratio. Nonetheless, some banks have successfully reduced their underlying NPL burden, with Vietcombank, the country’s fourth-largest lender by assets, expected to be the first to pay back its VAMC bonds, by early 2017. “Since the beginning of the year [2016], credit has grown steadily, meaning the economy is on a positive recovery, at the same time it reflects the relatively good capital absorption capacity of enterprises, as well as ensuring the credit system liquidity,” the FIA said in a statement to OBG. “Bad debts are continuously being resolved, and [this is] associated with improving credit quality, and ensured system liquidity and safety.”

In March 2016 the state issued Decision No. 35/ NQ-CP, which supports and develops enterprises through 2020, urging ministries, branches and localities to focus on five key methods to help enterprises. The plan implements reforms that create a supportive environment that encourages start-ups and innovative enterprises; ensures trading rights, as well as the right to equal access to resources and equal opportunities for business enterprises; reduces business costs for enterprises; and protects the interests of businesses.

Consumption

Although the government has focused heavily on increasing trade, investment and manufacturing, domestic consumption is also helping to fuel growth. This expansion is in large part driven by Vietnam’s fast-moving consumer goods (FMCG) segment, which is continuing to accelerate. Beverages, including beer, dominated FMCG sales in the first quarter of 2016, accounting for 39% of turnover, with milk products contributing 16% and food 15%. This was followed by tobacco products (13%), personal care items (8%), household products (6%) and baby products (4%).

Consumers are becoming more sophisticated, according to Nguyen Anh Dung, director of retail measurement services at Nielsen Vietnam.  “Urban consumers are increasingly demanding and expecting better choices. They’re looking for more innovations and new consumption experiments,” he said in 2016. “With a lack of innovation, FMCG is becoming more basic items, which consumers would still buy, but only at a sufficient level.”

New Products

The public’s appetite for new products is both a challenge and an opportunity. According to a recent study, Vietnamese consumers try more new products than other South-east Asian shoppers, with 88% of consumers saying they bought a new item during their last shopping trip, compared to a regional average of 69%. This trend has both potential upsides and downsides. While maintaining customer loyalty to existing brands is a challenge for manufacturers, this willingness to try new things is also a key advantage for firms breaking into the Vietnamese market or existing players launching new product lines.

However, as trade barriers are lowered as a result of the ASEAN Economic Community and the TPP, Vietnamese FMCG producers are likely to face greater regional and international competition. Though there has been some slowing, medium-term potential in the market is strong, according to a report issued by the Ministry of Industry and Trade. Fuelled by growing incomes and a young and active consumer base, FMCG spending is expected to reach $173bn by 2020, up 23.6% from the $140bn forecast for 2016.

Indeed, consumer confidence remained strong throughout 2016. Sentiment in the second quarter was only marginally down on the opening three months of the year, according to an August Nielsen survey, with the index at 107 points, two below the first quarter’s peak. The vast majority of Vietnam’s manufacturing and processing firms also have a positive outlook for the second half, a GSO survey reported, with more than 90% of respondents expecting production to either increase (55%) or remain stable (35.4%) in the second half of the year. Another area of potential growth is Vietnam’s rural regions, home to roughly two-thirds of the population. According to a report by market survey firm Kantar Worldpanel, household income in rural areas is rising faster than in urban centres, albeit from a lower base. Sales of domestic FMCGs are already increasing at more than twice the rate of foreign brands in the segment, and Vietnamese brands’ market share in non-urban areas is expected to grow from 54% of total FMCG sales in 2015 to an estimated 64% by 2020.

Inflation

Annual consumer price inflation (CPI) came in below the government target of 5%, at 4.74%, in 2016, according to the GSO, despite pressures from rising prices for some core goods. The rate represented a significant rise from a record low of 0.63% in 2015. A difficult year for parts of the agriculture sector – with drought, cold weather, and flooding affecting different parts of the country, and the El Niño phenomenon lowering crop yields – contributed to higher food prices, while increases in the price of some government health care services also had an impact.

The government has set a CPI target of 4% for 2017. Core inflation remains low, and the more flexible exchange rate regime should help to cushion shocks. Ensuring that inflation is kept relatively low is a key priority for policy-makers, particularly given Vietnam’s past struggles with hyperinflation and a strong desire to maintain the real income growth that has brought increasing prosperity, which has kept domestic demand steady and underpinned social and political stability.

The most significant risk to the overall inflation outlook comes from rising global energy prices. The local press reports policymakers saying that interest rates may go up by 1-2% in 2017 due to inflation and policy moves by other central banks. “There is a realisation that growth at all costs is not good,” Anirban Lahiri, senior research manager at Viet Capital Securities, an investment firm, told OBG. “So the authorities have taken a more hawkish stance on inflation. They’ve been helped by low commodity prices, but there are bottlenecks in the economy and not much spare capacity. If inflation does come back, interest rates will rise, which will crimp growth somewhat.”

Outlook

Vietnam’s remarkable success over the past three decades has been based on bold reforms and sound macroeconomic management, which have helped the country to capitalise on its geographical and demographic competitive advantages. Given this rate of progress, some see Vietnam pulling ahead of some of its Southeast Asian neighbours to achieve the levels of economic development of Korea or Taiwan in the coming decades. The country seems well on track to become an affluent middle-income economy.