Major Financial Issues and Recent Policy Responses

Despite the possibility of sustaining high growth over the medium-term, vulnerabilities in economic growth and the financial systems still remain in Viet Nam. There are a number of reasons for such a concern. To a certain extent, Viet Nam's economy still relies significantly on external resources to finance its investment-savings gap. Meanwhile, domestic capability to efficiently serve and absorb those resources is quite limited and the economy has been financially nurtured by rather ailing banking systems. Moreover, the economy can be hit by international trade and capital flow shocks or a global recession.

The Banking System

The first issue concerns the non-performing loans (NPLs) of the banking industry. It has gone down significantly in recent years but the sustainability of loan quality is seriously questionable in the future. Some major factors may increase future NPLs. The large SOEs' and public investments inefficiency, and the conflict of interest issues related to the lending of funds raised through bond issuances of SOEs could result in the loss of repayment capability of those borrowers. Moreover, the risks associated with real estate and securities-related loans, which were substantial in several JSCBs, are quite high in the context of high inflation and an asset bubble.

Obviously, one of the key measures in conjunction with restructuring the banking system is to reform the SOE sector. Since 2005, SOE reform has changed significantly in nature, with its focus shifted to large SOEs with the goal of their equitization and listing on the stock market. Several state business groups were established, hoping to gain stronger competitiveness in the new environment and international markets thanks to improvements in their efficiency and management capability. At first, the transformation of large SOEs was allowed as an experiment; but later on this somehow became a movement and nearly all of them have engaged in various kinds of business activities, including financial ones. There are concerns about the transparency of the SOE reform process and risk management of these business groups.

The banking industry has also faced a prolonged double mismatch problem (maturity mismatch and currency mismatch). Normally, short-term deposits account for 75% of total deposits, but the share of medium-and long-term loans in total credit rose from 22% in 1995 to about 40% in recent years (this figure is much higher for some JSCBs in 2007). At the same time, commercial banks have only been allowed to use about 25–30% of short-term deposits to make medium and long-term loans. The risks seem to be magnified in the presence of direct lending and conflict of interest issues, especially when related to loans of questionable real estate deals and other big projects.

The currency mismatch was most severe during 1999–2002 due to sharp increases in foreign currency deposits and a decrease in foreign currency loans, measured as shares in total deposits and total loans, respectively (Figure 18 [ PDF 101.4KB | 1 page ]). It has recently been narrowed, but remains problematic due to its sensitivity to the exchange rate and interest rate fluctuations, especially in the context of a rather high degree of dollarization.¹⁷ The SBV has attempted to gradually eliminate dollarization. However, this is no easy task as some contradicting policies continue to be in place (such as policies for encouraging remittances) and in the context of having capital flows.

The problem of macroeconomic policy consistency should be looked into for greater clarity. Consistency between monetary and exchange rate policies is approached as, according to Johnston and Otker-Robe (1999), the relationship between exchange rates (ERs) and interest rates at a point in time and the sustainability of these policy mixes over time. The consistency at a point in time can be best demonstrated by the conditions of covered and uncovered interest rate parities (CIP and UIP).¹⁸ These two parities indicate the interdependent relationship between the domestic interest rate and ER at a point in time, when investors consider different returns on various financial assets to maximize return on their portfolios. The policy consistency over time determines the sustainability of the chosen policy mix. The risks and costs of this kind of policy inconsistency are ineffectiveness of monetary policy and encouragement of speculative activities. This point can be illustrated by two case studies: the intensification of dollarization during 1998– 2001, and the “mini-crisis” in 1996–1997 (Box 3).

The present situation seems to be reversed due to the weakening USD and increasing VND-denominated interest rates (Table 16 [ PDF 357.5KB | 1 page ]). The VND became more attractive than the USD (a reason for the declining degree of dollarization). This has contributed to the encouragement of VND-based foreign exchange investments in such as local bonds, real estate, equity markets, and foreign currency borrowings for imports (given high inflation and expectation of stability/appreciation of nominal ER). Some of these kinds of investments can also be speculative.

Box 3: Dollarization, Double Mismatches and Speculative Activities

Following the UIP condition, it can be observed that during 1997–2001, given the expectation of further exchange rate (ER) depreciation and lower VND-denominated interest rates, the public had shifted from the preferred portfolio in favor of USD (Table 16). This was particularly the case in 2000 when the FED raised the prime rate to remarkable levels. Due to capital controls, commercial banks attempted to attract foreigncurrency deposits for deposits abroad to earn the differential spread. The deposits abroad rose remarkably, from USD 537 million in 1998 to USD 2.088 billion in 2000 and 1.197 billion in 2001 (Appendix B). In other words, the macroeconomic policy inconsistency in favor of holding USD was a major underlying determinant of the dollarization intensification during 1999–2001, and in certain circumstances this encouraged commercial banks to speculate on currency gains rather than focus on productive investments.

The mini-crisis in 1996–1997 is another illustration of the danger of macroeconomic policy inconsistency and problem of double mismatch (Vo et al 2003). In 1996 the very high VNDdenominated interest rates attracted a substantial increase in banking deposits, while credits were hardly expanded due to the high lending rates and tight regulations on credit ceilings. Reserves in commercial banks rose substantially and many banks had excessive reserves (some banks even refused to accept more deposits). This situation created incentives for banks to evade government controls. A letter of credit (LC) was one important channel for evasion since up to that time LCs were excluded from credit ceilings. LCs were seen as an off-balance activity of banks, generating opacity on the balance sheets of banks.

Firms also attempted to evade regulations on limits of foreign-currency borrowings (only importers and other import-related activities can obtain loans in foreign currencies). Although at that time Viet Nam had imposed certain restrictions on CA and KA, the flows of funds from abroad through deferred payments on LCs had been outside those restrictions. Domestic enterprises were allowed to have their trade credit guaranteed by commercial banks through deferred LCs. In fact, this was equivalent to enterprises borrowing short-term foreign currency loans from abroad through domestic commercial banks. Moreover, in an environment of a very high VND interest rate and limited foreign currency loans, but with stability and rigidity of exchange rates as an implicit government guarantee against foreign exchange risk, there was, of course, a strong incentive for domestic firms to borrow from abroad. Thus both commercial banks and firms had incentives to lend and borrow through LCs.

As a result, domestic firms (both SOE and private enterprises) borrowed a large amount of short-term USD loans. The amount of LCs was estimated to have accumulated to USD 1.5 billion by early 1997. Net flows on short-term debt increased significantly, from about USD 120 million in 1993 and 1994 to USD 311 million in 1995 and USD 224 million in 1996. It had become thereafter largely negative in 1997.

The consequences were severe. First, it widened the CA deficit at an alarming level (Appendix B). Second, a large part of this short-term borrowing was channelled into a speculative real estate market, resulting in a market boom. But the market turned into bust later, in early 1997, when those firms could not pay back the debt. Third, it weakened the banking system and the financial sector as a whole. Around 40% of the LCs (equivalent to 3 percent of the GDP) guaranteed by commercial banks became bad debts.

As a result, the SOCBs and some other JSCBs defaulted on these guaranteed short-term debts, leading to the concern about the level of foreign exchange reserves and about Viet Nam's commitment to international financial arrangements. The SBV had to use foreign reserves to bail out these commercial banks. It was estimated that the stock of foreign reserves fell by the equivalent of 5 weeks of imports. Viet Nam's sovereign credit rating was lowered from Ba3 to C.

Moreover, the evasion of banks weakened the effectiveness of the monetary policy because the direct control mechanism was eroded, distorting monetary aggregates. In addition, it generated upward pressure on the exchange rate. Due to a sharp increase in demand for foreign exchange by the end of 1996 and early 1997, the SBV broadened the band between selling and buying rates of foreign exchange from 1% to 5% in February 1997. In addition, in mid-1997, the SBV set strict limits on the amount of deferred LCs and tightened controls over commercial banks' LC guaranteeing. To import goods on the restricted goods list a deposit equivalent of 80% of each LC was required instead of the previous 0-30% level. As a result, during the second half of 1998, the value of late LC payments fell from around USD 350 million to some USD 200 million at the end of 1998.

Another issue is that the management capability at both the macro- and micro-levels cannot keep pace with the new development dimensions of the banking sector. In fact, there are still shortcomings in the banking industry as much as there is still a weak financial capacity of commercial banks (low CAR, low reserves and low loan quality) and weak risk management. According to a survey by Ernst & Young, the banks' application of 19/25 principles (3/25) does not fully comply with the BASEL Core Principles (Nguyen 2007). Furthermore, the underdevelopment of a regulatory framework with limited supervision and monitoring capacity of the key bodies, the SBV, the MOF and the SSC, makes banking activities less transparent and more fragile. As mentioned by Vo et al (2007),

Viet Nam's banking system is still vulnerable due to limited supervision, monitoring and governance capacity. On-site monitoring and supervision is constrained due to inadequate quantity and quality of human resources. Off-site supervision, meanwhile, fails to meet contemporary requirements in compiling and processing information. Lending supervision has yet to cover all credit-related financial institutions due to lack of effective collaboration amongst authorized agencies and de-facto institution-based financial system governance. Certain international practices and standards have been recently adopted; yet banking governance standards generally have yet to meet the CAMEL and BASEL provisions.

The SBV is now undergoing more radical reforms to be a modern, relatively independent central bank. The Government also began reforming the entire supervision system towards the establishment of a new single supervision system like the FSA (Financial Service Authorities) in the UK.

The Stock and Bond Markets

During a stock market boom, the greatest concerns of the Vietnamese authorities have been how to control speculative activities that make the stock market too volatile and at the same time, how to facilitate long-term investment for the development of the economy as a whole. Facing such challenges, the SSC has repeatedly warned investors of risks associated with overheating in the market's development, followed by the SBV's measure to restrain loans to bank-backed securities companies in December 2006. Within a few days, the SSC promulgated six measures to improve regulation and monitoring of the securities market's operations, including: (i) postponing the lifting of maximum shares of listed companies permitted to foreign investors; (ii) cooperating with the SBV to monitor lending for security investment, repo transactions and other transactions related to security collateralization of commercial banks; (iii) investigating securities companies which reportedly discriminate between customers, and/or misuse information; (iv) requiring listed companies to disclose and disseminate their operational and financial results as of 2006 to better inform investors in the market; (v) re-registering representative offices of foreign investment funds in Viet Nam; and (vi) promoting further information disclosure so that investors can make better informed, rational investment decisions.

However, the reaction of the stock market proved that such policy measures were not significantly effective. There has not yet been a clear sign of market fever relief (Figure 9). In order to protect the stability of the banking system in particular, and the financial system as a whole, with the fear that stock-collateralized loans could become NPL, in April 2007, the SBV decided to impose a ceiling of 3% of total lending for stock collateralized loans (Direction 03/QD-NHNN). The VN-Index afterward has fluctuated with a declining trend.

Development of the stock market in Viet Nam is obviously very much dependent on the SOE reform process. To be aware of the problem, the government has focused on reforming large SOEs with a determined action plan. According to a public announcement plan, there are about 2,100 SOEs at present, of which about 1,500 have been or will be equitized over 2006-2010. This suggests also that close to 80 corporations and large firms will have to go public. Moreover, 550 SOEs were to be equitized in 2007. However, in 2007, only 65% of these SOEs were successfully equitized. As stock market indexes have been declining, the government was observedly puzzled over the trade-off between the financial surplus it could gain from initial public offerings (IPOs) and implementation of the committed SOE reform schedule. In turn, this has created a serious disequilibrium in the stock market. With the IPOs of some large state-owned corporations (e.g. Dam Phu My, Bao Viet Insurance Company, and Vietcombank), the market sentiment is that the Government is desirous of getting a greater financial surplus from such IPOs.

Furthermore, there are also some concerns about the role of the State Capital Investment Corporation (SCIC), which was set up in 2005 closely following the model of Singaporean Temasek. Motivations are to remove a conflict of interest concerning line ministries or provinces and to achieve a more rational and efficient use of state capital through divesting state shares, including outright sale, and seeking strategic partners and mergers. The SCIC is also determined to increase transparency when utilizing state capital, including in operations of entities in which it is vested. Although the SCIC has a profit oriented mandate, whether it could be a market stabilizer remains questionable. Risks due to the agent-principal relationship can arise if there is not effective supervision over the SCIC and the SCIC does have sufficient expertise in dealing with complex financial activities (more about the SCIC in Box 4).

Box 4: Role of the SCIC

The SCIC began operations in August 2006 to concentrate state shareholding in the equitized SOEs under one single entity. Important companies in its portfolio include VinaMilk, Pacific Airlines, FPT, and Bao Minh. By the end of March 2007, the SCIC had received ownership rights from 433 equitized SOEs with a total book value of about 3.4 trillion dong. By the end of 2007, the SCIC expected to receive ownership rights in 1,033 enterprises, excluding banks, with state holdings of 7.2 trillion in book value and an estimated market value of 36 trillion dong.

The SCIC has classified equitized SOEs into three groups, A, B, and C. It will concentrate on strengthening or restructuring enterprises in Group A, which operates in sectors considered strategic. Group B enterprises with good potential will be supported for listing on the stock market. Group C comprises enterprises where the state does not need to invest in them over the long term. SCIC will gradually sell state shares in companies of this group. In 2007, it planned to sell stakes in 50 companies with a total book value of about 227 billion dong (USD 14.2 million).

One area that needs to be clarified is the role of the SCIC in relation to the General Corporations or Economic Groups which operate under the holding company structure. At present, it appears that SCIC will receive ownership rights on a case-by-case basis. Reportedly, for the two banks to be equitized later this year, Vietcombank and MHB, it has been instructed by the Prime Minister to receive the rights.

Until now, policy responses for developing an effective bond market, which is quite a long-term process, have been insufficient and inappropriate. Equity markets may exist where bond markets fail to thrive. The bond market in Viet Nam is still very modest and lacks necessary components including the following¹⁹:

• An appropriate legal framework with the effectiveness of a judiciary system;
• High quality of information and adoption of strict accounting and disclosure standards;
• The presence of independent risk-rating and other information generating agencies;
• An efficient and reliable clearing and settlement arrangement; and
• Some forms of tax incentives during the initial stage of development.

Moreover, the bond market in Viet Nam is heavily dominated by Government bonds. It is necessary, however, to strengthen the role of the Government as the primary issuer.

With the opening of the economy, full participation in the regional and international bond markets is unavoidable. Viet Nam has been involved in all dimensions of regional financial cooperation, including the regional surveillance system, the Chiang Mai Initiative (CMI), the regional bond market development and monetary policy and ER coordination. However, the effectiveness of such involvement is very limited and obviously depends very much on how the country can effectively develop its domestic bond market. The practical issues of engagement in the ASEAN stock market link and in the regional bond market are basically theoretical now and have yet to be put into practice.

Foreign Capital Inflows²⁰

Viet Nam continues to be on the right track for attracting FDI with a more liberal and neutral investment environment. Recently, the Government has moved towards unifying domestic and foreign investment regulations, aiming to establish a level playing field for both domestic and foreign investors. Commitments to the WTO, especially those of the services sector, are quite broad and deep and are in favor of FDI. Major obstacles, however, still exist such as red tape and corruption, an inconsistent and barely transparent system of legal documents and unpredictable policy changes. The recent slow pace of FDI realization²¹ has also revealed major bottlenecks in attracting FDI in an efficient manner due to weaknesses in the infrastructure and a shortage of skilled laborers.

ODA inflow has been the result of the gradual strengthening of a set of common commitments between the Vietnamese government and the donor community in line with the Hanoi Core Statement (HCS) on aid effectiveness (Table 17 [ PDF 139.8KB | 1 page ]). In particular, in 2006, the government issued Decree 131/2006/ND-CP (in replacement of Decree 17/2001/NDCP in 2001) to accelerate decentralization of ODA management and utilization, giving full responsibility to project executing agencies for appraisal, approval and implementation of ODA-financed programs/projects. However, some shortcomings in this field such as the modest effectiveness of anti-corruption programs and the lack of capacity for monitoring and evaluation, especially at local level, necessitate more radical solutions. Last but not least, having transparent and effective public-private partnership (PPP) schemes are still questionable.

Regarding portfolio flows with trade in services, financial liberalization and WTO commitments implementation, FIEs were allowed to be transformed into share-holding companies (since 2004). The government also provided guidance for purchasing and selling securities by foreigners at the STC. Moreover, the Ordinance on Foreign Exchange Management issued in December 2005 gave permission for individuals to obtain overseas borrowings and domestic economic entities to make overseas lending if they met necessary conditions. Soon after, it led to some uncontrollable problems related to external debt monitoring. As a result, the SBV had to delay issuing a Circular for guiding the implementation of the Ordinance. As a reflection, although the KA is now relatively open for capital inflows, Viet Nam needs to think seriously about the sequencing of full KA liberalization in conjunction with improvements in the financial supervision system.

Macroeconomic Policies

In an economy open to capital inflows, policy consistency over time requires the authorities to have either a very strong commitment to a pegged ER or pursue a flexible ER. However, efforts to maintain macroeconomic policy consistency are constrained by the well-known “impossible trinity” or “impossible tri-lemma,” which states the impossible coexistence of exchange rate stability, free movement of international capital, and monetary autonomy.²² Policymakers can have several macroeconomic policies to respond to capital inflows such as sterilization, revaluation of the nominal exchange rate/greater exchange rate flexibility, and fiscal austerity. Other policy measures such as liberalization of capital outflows, controls on capital inflows, and trade liberalization can also be implemented. The effectiveness of such policies is presented in Appendix C [ PDF 93.1KB | 1 page ].

Appendix C shows that not one single possible policy response to a surge in capital inflow is perfect in terms of achieving both goals of macroeconomic stability and economic growth. ER flexibility and appreciation seem to be the best effective response to large capital inflows because it avoids side effects attendant to other policy responses. But it could also create a policy inconsistency that is very much dependent on external conditions, such as the position of the foreign currency the local currency is pegged to. That in turn would encourage short term speculative capital inflows. Sterilization is often costly and ineffective, but remains most the commonly used since policymakers are generally reluctant to allow the exchange rate to appreciate because of fears of undermining export competitiveness and the resulting lower economic growth. Fiscal tightening could be a good option, yet it faces several limitations, especially in terms of approval and action. Moreover, it could lead to lower investment and hence, a lower economic growth rate if public investment still accounts for a large share of total investment.

Recently, SBV's conduct of monetary policy turned out to be more complicated as it faced two problems, namely, increasing macroeconomic policy inconsistencies (Table 16) and the “impossible trinity” as capital inflows surged, especially in 2007. The SBV has had to consider a trade-off between exchange rate stability and inflation targeting policy. Basically there have been two main arguments to the dilemma facing the SBV. The first is that appreciation can hurt exports and economic growth; yet historically the SBV has pursued a rather weak VND policy in order to promote exports. The second is to let VND appreciate which seems to be in line with macroeconomic fundamentals and foreign exchange behavior of many other East Asian economies and moreover, it could be a sign for the economy that the VND is no longer only in a position of depreciation (JP Morgan 2007). So what is the choice by the SBV in practice?

In general, the SBV and the government are more concerned about the possible negative impact of appreciation on exports and the slowdown of economic growth. In January 2007, the SBV widened the trading band of the VND/USD from ± 0.25% to ±0.5% around its daily reference rate. The VND/USD appreciated in nominal terms of only 0.2% for the whole year of 2007. At the same time, the SBV kept all official interest rates such as refinancing, discount and basic rates unchanged since early 2006 in order to provide a stable signal to the market (Figure 19 [ PDF 146.7KB | 1 page ]), although the rates set by commercial banks increased slightly (Table 16). While stabilizing the nominal ER, the SBV quickly built up its foreign exchange reserves, which increased from USD 11.5 billion in 2006 to USD 23 billion by the end of 2007.

As inflation accelerated in the first half of 2007,²³ the SBV only attempted to sterilize the excess liquidity through the OMO and the increased reserve requirements. It is reported that the SBV regularly withdrew up to VND 11,000–14,000 billion (USD 688-875 million) per week from circulation since May 2007. At the end of the year, this figure rose to as much as VND 15,000–16,500 billion (USD 938–1.031 million) (World Bank 2007). Since June 2007, the SBV has raised its reserve requirements. For VND deposits under 12 months, the compulsory reserve rate increased from 5% to 10%; for VND deposits between 12 and under 24 months, from 2% to 4%. Correspondingly, rates for foreign currency deposits are from 8% to 10% and from 2% to 4%.

But the sterilization was ineffective and costly (CIEM 2008). The money supply (both M2 and domestic credit) expanded sharply in 2007 in comparison with that of previous years since 2003, which was already high (Table 6). The inflation rate jumped from 9.4% in 2004, 8.4% in 2005 and 6.7% in 2006, to 12.6% in 2007. The SBV was recognized by the Government to be “perplexed” in conducting monetary policy, which was considered a major cause, together with cost-push and demand-pull reasons, of higher inflation. Moreover, in the context of the weakening USD and increasing international commodity prices, keeping the stability of the nominal VND/USD also meant a significant import of international inflation.

To be more proactive in controlling the money supply, the SBV in the last few months introduced several policy measures:

• By the end of December 2007, the trading band of the VND/USD was cautiously widened to ± 0.75% and as a result, the nominal VND/USD appreciated by 0.3% over the first two months of 2008;
• In January, lending restrictions for stock investment changed from 3% of total loans outstanding to 20% of charter capital, which limits potential growth in such investment credit;
• Since 1 February 2008, the rates of compulsory reserve requirements have been raised to 11% (from 10%) for VND and foreign currency deposits under 12 months, and to 5% (from 4%) for those deposits between 12 months and under 24 months;
• Also since 1 February 2008, all official interest rates have been increased, from 6.5% to 7.5% for the refinancing rate, from 4.5% to 6.0% for the discount rate, and from 8.25% to 8.75% for the basic rate; and
• In particular, in the second week of February 2008, the SBV decided to issue by 17 March 2008 365-day-bills worth VND 20,300 billion with a coupon of 7.8% and requested a compulsory purchase by 41 commercial banks.

What can be observed in the following days ahead is that some JSCBs, which have a maturity mismatch problem because a significant proportion of their lending consists of medium and long-term loans (e.g. those going to the real estate market and consumption of durable goods), will not have sufficient liquidity to meet the new policy measures. The inter-bank market became too heated with overnight rates of 25–30%. As a result of the “liquidity chaos,” the SBV was forced to pump out VND 33,000 billion. Those banks were, however, in a difficult position in terms of liquidity because they held T-bills/bills issued by the SBV. They increased their annual VND deposit interest rates to 14.6% to mobilize as many as deposits they could. The race for higher deposit interest rates among commercial banks began. It calmed down only by the end of February 2008 as the SBVissued directive requested that all commercial banks not raise annual deposit interest rates more than 12% and promise to meet the liquidity of the banking system through the inter-bank market with reasonable rates.

The liquidity chaos once again shows how high the cost could be if the policy of keeping the nominal stability of ER persists in conjunction with the maturity mismatch problem in the banking system or even only in some commercial banks (due to weak supervision) and the inappropriate policy actions leading to more serious macroeconomic policy inconsistencies. The fact that the SBV had to use some administrative measures to control the situation will have higher costs due to distortions in resource allocation. This action, though temporary and necessary, can be seen as a step backward in the process of improving monetary instruments.²⁴ The movements of the some key macroeconomic variables in the first two months of 2008 will make the policy option more complicated. Inflation rose by more than 6%.²⁵ The rise in deposit interest rates by banks could soften the liquidity problem but it imposes a higher risk for several banks.

Fiscal tightening can be a good response to capital inflows. It contains inflationary pressure and reduces pressure on real appreciation and increases interest rates. However, up to now, Viet Nam has had no serious intention of using fiscal policy as a policy complement to monetary and ER policies in response to capital inflows. For a long time, fiscal policy has followed the “golden rule,” meaning the budget should have savings, i.e. total revenues are higher than current expenditures (Table 18 [ PDF 100.3KB | 1 page ]) and the budget deficit cannot be financed by seigniorage.

Room for reducing the budget deficit seems to be small. However, the budget deficit is rather huge. Budget revenue still relies heavily on crude oil exports and import tariffs. The former item has fluctuated much and moreover, because of some technical problems, the volume of crude oil exports will not increase unless new oil resources are found. The latter item has significantly decreased over time due to trade liberalization (Table 18). There is also uncertainty about the impact of tax reforms (e.g. personal income tax, asset tax, etc.) on the budget revenue. On the expenditure side, the government is facing increasing pressure on infrastructure development and upward adjustment of salaries for public servants (because of higher inflation rates, the government was forced to raise public salaries several times, by 10%–20% each, during 2004–2008). Nevertheless, investment expenditure is recognized as inefficient in terms of selecting projects and disbursements (at least 20–30% of investment expenditure can be saved).

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