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Vietnam: Down, but not out

Emerging Markets Research 5 June 2008

Nicholas Bibby Over the last two months, sentiment on Vietnam has deteriorated rapidly, driven by a sharp
Senior Regional Economist widening of the trade deficit in Q1 and a marked acceleration in inflation, which hit a 10-
nicholas.bibby@barcap.com year high in May. VND NDFs are now pricing in a significant devaluation of the dong.
+65 6308 3511
Given the country’s inflation problem, we do not believe the central bank currently
www.barcap.com
intends to devalue the VND. A weaker currency would add to inflation pressures and
require a much more aggressive tightening of monetary policy, which would increase the
likelihood of stress in the banking sector. In addition, we expect the trade deficit to
contract in the coming months as the impact of the authorities’ tighter monetary and
fiscal policies starts to bite. This improving trend, in conjunction with a low level of
external debt and an estimated USD23bn worth of FX reserves, should buy Vietnam
enough time to bring inflation under control.
However, underlying demand-led inflation pressures require further tightening of policy,
which we believe will force the central bank to raise interest rates at least 400bp over the
next two to three months. Absent a significant tightening of monetary policy, Vietnam
runs the risk of a balance of payments crisis and devaluation of the VND. However, we
believe that the State Bank of Vietnam is not under immediate pressure and the likely
timing of any move would be late Q3 or early Q4. After accounting for bid/ask in the
1mth tenor, and assuming yesterday’s Association of Banks in Singapore (ABS) fix
(17,742), NDFs are pricing a depreciation of 5.3%. In our opinion, the magnitude of the
devaluation priced into VND NDFs is at least partially a function of investors attempting
to hedge/cover exposures in a very thin market.

Figure 1: VND NDFs are now pricing in a devaluation of Figure 2: … but the dynamics for a correction in the
more than 25% in one year… current account are in place (% of GDP)

25,000 NDF 10% Current account Trade balance

23,000
5%

21,000
0%
19,000
-5%
17,000

-10%
15,000

13,000 -15%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1999 2001 2003 2005 2007 2009

Source: Reuters, Barclays Capital Source: CEIC, Barclays Capital

Please read carefully the important disclosures at the end of this publication.
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Concern over a devaluation may be overdone

VND NDFs signalling a Sentiment on Vietnam has reversed sharply over the past two months. At the start of
devaluation the year, the market expected Vietnam’s central bank to allow the VND to appreciate in
order to help dampen inflation and correct imbalances caused by a large balance of
payments surplus. However, sentiment has soured over the last few weeks, with VND
NDFs now pricing in a significant devaluation of the currency. The deterioration in
sentiment was sparked by a sharp widening in the trade deficit, which rose to USD8.4bn
in Q1 08 from USD1.7bn in Q1 07, and the marked acceleration in inflation over the
first five months of the year. Even though Vietnam faces problems, we believe the risk
of a devaluation of the magnitude that is currently being priced in by the market is
slight. Indeed, given the country’s inflation problem, we believe a devaluation of the
VND is the last thing the State Bank of Vietnam wishes. A weaker currency would
exacerbate inflationary pressures – currently the central bank’s principal concern – and
necessitate much more aggressive monetary policy tightening, which in turn, could
increase stress in the banking sector.

Problems a result of lax monetary and fiscal policies

Policy settings have In our view, Vietnam’s current problems stem from the central bank keeping
been kept too loose monetary policy too loose through 2006 and 2007. This reflects the government’s
desire to maintain a rapid pace of growth in order to move up from the ranks of low-
income countries by the end of 2010. The dash for growth was reflected in the State
Bank of Vietnam’s three-pronged mandate: 1) support growth, 2) keep inflation
below the rate of real GDP growth, and 3) maintain VND/USD stability. The bias for
fast growth and loose monetary policy settings also came against a backdrop of
structural change in the banking sector (with the establishment of a number of
private-sector banks) and large balance of payments surpluses, as foreign capital
poured into Vietnam and drove a sharp rise in credit growth.

Increase in capital Vietnam has not released its 2007 balance of payments data and has not disclosed the
inflows in 2007 led to a level of its FX reserves since June 2007. However, we estimate the country’s overall
marked rise in BoP balance of payments surplus swelled to around USD9.5bn (13.9% of GDP) last year from
surplus… USD4.3bn (or 7.1% of GDP) in 2006 due to a marked increase of inflows on the capital
account. Although we believe the current account deficit widened to USD4bn (5.6% of
GDP) last year from USD0.2bn (0.3% of GDP) in 2006, the shortfall was more than offset
by an estimated USD13.9bn (19.5% of GDP) net inflow on the capital account. This
… which the State Bank compares with a capital account surplus of USD4.9bn (7.4% of GDP) in 2006. Net inflows
of Vietnam left of FDI (on the back of Vietnam’s admittance into WTO) and medium-term loans
unsterilised… increased last year, but the principal source of inflows came from portfolio investment in
Vietnam’s equity and fixed income markets. We estimate that net portfolio inflows stood
at USD7.0bn last year against USD1.3bn in 2006. Owing to the nascent state of Vietnam’s
capital markets, the central bank failed to sterilise these inflows. This led to a marked
acceleration in the growth of both narrow and broad money aggregates, which in turn,
… leading to rapid
drove a surge in credit growth last year – we estimate it expanded 53% in 2007 after
money and credit
increasing 27.6% in 2006 and 36.5% and 2005. By our calculation, at the end of 2007, the
growth
amount of credit outstanding stood at 98.6% of GDP, up from 68.9% of GDP in 2005.

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Figure 3: Overheating pressures evidenced by current account deficit and high credit growth
Current account surplus offset current account deficit Domestic credit boosted by BoP surplus
in 2007 (USD mn)

20,000 Current account Capital account 60 Domestic credit (% y/y, LHS) 16%
Balance of payments surplus (% GDP, RHS)
14%
15,000 50
12%
10,000 40
10%

5,000 30 8%

6%
0 20
4%
-5,000 10
2%

-10,000 0 0%
99 00 01 02 03 04 05 06 07E 08F 99 00 01 02 03 04 05 06 07

Source: CEIC, Barclays Capital

On a customs basis,
trade deficit widened to
52.6% of GDP in Q1 08
Not surprisingly the loose monetary policy settings, in conjunction with the
government’s lax fiscal stance, led to an increase in inflation pressures through the later
part of 2007 and early 2008. CPI inflation rose to a 10-year high of 25.2% y/y in May,
accompanied by a deterioration in the trade balance, with import growth accelerating
to 75.2% y/y in Q1 08. On a customs basis, we estimate the trade deficit widened to
52.6% of GDP in Q1 08 from 20.6% in Q4 07 and 17.5% in full-year 2007. The speed
and extent of this deterioration (especially when coupled with high inflation), is clearly
unsustainable and would likely lead to significant balance of payments pressures and
probably a devaluation of the VND.

Near-term risks for devaluation seem to be low

Vietnam does not look
to be on the brink – yet
However, we are sceptical that Vietnam will be forced to devalue its currency over the
next couple of months. Firstly, we estimate that FX reserves stood at USD23.5bn at the
end of last year, or 4.4 months of import cover 1 . Additionally, the capital account is
likely to have been in surplus until the start of April, as evidenced by foreign investor
net buying of Vietnamese equities and the premium on VND forwards. Despite
heightened market volatility in May, foreign investors were still net buyers of
Vietnamese equities. With respect to the sell-off in the NDFs, while the risk premium
started to rise in April, the real spike in rates did not take place until May. One further
barrier to capital flight has been the drying up of liquidity in the onshore bond market.
This likely means that a significant amount of investment in domestic bonds is unable
to exit, which may have led to accelerated demand to hedge risk via the illiquid NDF
market. The inflows on the capital account though Q1 08 likely helped offset the
worsening in the trade balance seen in the first three months of the year. As a result, we
believe the drawdown on FX reserves has not been too severe, so far.

1 We include imports of goods and services in the import coverage ratio.

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Figure 4: Foreign investor sentiment and only just turned down in last few weeks
Foreign investors still net buyers of Vietnamese stocks VND NDF (premium)

1,200 Foreign net buying (USD mn, LHS) 400 25,000 NDF
HCMC index (RHS) 350
1,000 23,000
300
800 250 21,000
200
600 19,000
150
400 100 17,000
50
200 15,000
0
0 -50 13,000
2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: CEIC, Bloomberg

External debt remains
very low
Debt servicing ratios are
at levels not normally
associated with stress
Low short-term debt
implies limited roll-over
risk
We take additional comfort from Vietnam’s low level of external debt. It is worth noting
that the country’s net external debt stood at USD0.3bn or 0.4% of GDP at the end of
2007. By comparison, just prior to the 1997 balance of payments crisis, Thailand’s net
external debt position stood at USD57.2bn (30.2% of GDP), while Korea’s amounted to
USD124.2bn (22.7% of GDP). At the end of 2007, Vietnam’s total external debt is
estimated to have been USD23.8bn (33.4% of GDP). Of this, USD17.5bn (or 73.5% of
total liabilities) is owed by the government, with private-sector foreign debt standing at
USD6.3bn. It is also important to note that most of the government’s USD13.7bn in
outstanding debt is in owed to multilateral and bilateral agencies. By our calculations,
the country’s debt service ratios are currently levels that are not normally associated
with significant stress. We estimate that Vietnam faces USD2.5bn in debt service costs
this year, which is around 4% of exports and 15% of FX reserves. Crucially, there is only
a small amount of short-term debt outstanding – we estimate USD3.8bn. Although
some analysts have compared Vietnam’s current situation to the 1997 Asian financial
crisis, the country’s relatively small amount of short-term foreign debt that needs to be
rolled over is an important difference, one that in our view buys the authorities some
time to narrow the trade deficit and rein in inflation.

Figure 5: Level of external debt looks manageable

USD bn 2003 2004 2005 2006 2007E
External debt 14.1 16.1 18.7 21.1 23.8
% GDP 35.6 35.4 35.3 34.6 33.4
% reserves 221.7 2.24 224.1 155.3 101.2
Public sector 11.0 12.3 13.7 14.8 16.0
Multi & bi-lateral 9.7 10.6 11.4 12.6 13.7
Private Sector 3.1 3.8 5.0 6.3 8.8
Medium-term 13.2 14.5 16.5 18.3 20.0
Short-term 0.9 1.6 2.2 2.8 3.8
% of FX reserves 12.6 15.3 23.9 21.3 16.2
Debt service 1.1 1.2 1.7 2.0 2.3
% FX reserves 17.3 17.0 18.4 14.7 9.8
% exports 4.7 4.0 4.6 4.5 4.2
Interest payments 0.3 0.3 0.6 0.8 0.9
Amortisation 1.1 0.9 1.1 1.2 1.4
Source: CEIC, IMF, Moody’s, Barclays Capital

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Trade balance has started to react to tighter policy

Authorities have started
to tighten monetary
policy
Although the central bank was relatively sanguine about inflation pressures in 2007, it has
become more hawkish since the start of the year. For one thing, inflation has become a
political issue: real incomes have started to fall, sparking a rise in strikes and protests
against high prices. In our view, the social consequences of high inflation, as well as the
rapid deterioration in the trade balance, have led the authorities to become more focused
on inflation. This shift can be seen in the statements of various government officials over
the past few months. Apart from more hawkish comments, on 19 May, the State Bank of
Vietnam raised its benchmark rate to 12% from 8.75%. This also follows the introduction
of quantitative controls on lending, especially to the overheated property sector, and the
central bank’s withdrawal of liquidity from commercial banks. The government has also
announced cuts in government spending to complement the tighter monetary policy,
with a large number of government-led projects being halted. Whilst this has had little
impact on inflation so far, the tightening of credit has led to a moderation in growth and
a tentative improvement in the trade balance. GDP rose by 7.5% y/y in Q1 08 following a
rise of 8.5% in 2007. The slowing in growth was led by the construction sector, where
output rose 3.3% y/y in Q1, following a gain of 12% in 2007.

Figure 6: Growth is slowing

Slowdown in growth led by construction sector (% y/y) Public sector investment has been cut back (% y/y)

20 GDP Construction 200 State investment

National government
15 150 Local government

10 100

5 50

0 0

-5 -50

-10 -100
2000 2001 2002 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008

Source: CEIC

Trade balance also looks
to be turning around
Although they are not as clear as the slowdown in economic activity, there are signs
that the worst is over with respect to the widening trade deficit. After increasing by
75.2% y/y in Q1 08 and by 84.9% in April, import growth slowed to 47.8% in May. On a
seasonally adjusted m/m basis, imports fell by 14.6% in May, which left the 3mma
showing a decline of 2.7% versus a rise of 2.7% in April and 7.7% increase in March.
The moderation was led by domestic enterprises (which accounted for most of the
excess), where imports rose 57.2% y/y in May following gains in excess of 100% in both
April and March. By product, the slowdown was broad based, with all the major
categories recording slower growth in May. Growth in imports of machinery slowed to
42.3% y/y in May from 74.5% in April, while the rise in steel imports decelerated to
50% from138.3%.

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Figure 7: Trade deficit looks set to narrow on weaker import growth

Trade deficit is staring to stabilise (USD mn) Import growth is slowing (% y/y)

1,000 Trade balance (LHS) Exports 90 160 Capital goods Intermediate

500 Imports 80 140 Chemicals Consumer
70 120 Petroleum
0
60 100
-500 80
50
-1,000 60
40
-1,500 40
30
-2,000 20
20 0
-2,500 10 -20
-3,000 0 -40
-3,500 -10 -60
2003 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

Source: CEIC

Export growth holding Export growth has held up through the first two months of Q2 and has led the trade
up deficit to narrow to USD2.6bn in May from USD2.8bn in April and USD3.3bn in March.
As the full impact of the government’s tightening measures start to bite in Q3, we
expect the softer import growth to become more pronounced and slip to 18.5% y/y in
Q3 08 against an estimated rise of 54.7%y/y in Q2. Furthermore, we expect imports to
decline 5% y/y in Q4 on the back of a high base. With exports expected to average an
increase of 20% y/y in H2 08, this would translate into the trade deficit moderating to
USD3.5bn in Q3 and USD0.9bn in Q4, following deficits of USD7.6bn in Q2 and
USD8.4bn in Q1. For the full year, we look for a trade deficit of USD20.4bn (20.4% of
GDP), against 2007’s USD12.4bn shortfall (17.4% of GDP).

Figure 8: Export growth is benefiting from high commodity prices

Capital and intermediate goods main source of imports Export growth is being supported by high commodity
(% of total imports) prices (% y/y)

Capital goods Intermediate Chemicals 130 Energy

Consumer Petroleum Clothing & footwear
100% 110
Electronics
90% 90 Agricultural products
80% Other
70% 70
60% 50
50%
40% 30
30% 10
20%
-10
10%
0% -30
2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

Source: CEIC

On BoP basis, the trade
deficit is likely to reach
17.4% of GDP
This is projected to translate into a trade deficit of USD12.4bn (17.4% of GDP) on a
balance of payments basis. On a balance of payments accounting basis, the trade deficit
is generally around half the size of the trade gap measured on a customs basis, because
service costs (eg, shipping and insurance) are stripped out of the BoP figures but are
included on a customs basis. In the case of Vietnam, this has meant that the import bill
on a BoP basis is 9.3% smaller than on a customs basis. Due to the strength of import
growth through the early part of 2008, we expect to see a concomitant increase in

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imports of factor services. However, this will be offset to some extent by a sharp rise in
visitors, which should boost the tourism account. In the first five months of the year,
tourist arrivals were up 15.8% y/y following a rise of 16.2% in 2007. Overall, we look for
a services deficit of USD2bn. As with the service sector balance, the income balance is
expected to be in deficit this year, as foreign investors repatriate profits.

Figure 9: A sharp contraction in trade deficit in H2 08 should limit the size of current account deficit
Trade deficit set for sharp correction in H2 08 Current account deficit set to widen to 10.1% of GDP in
2008 (% GDP) and then correct sharply

500 Trade balance (USD mn, 3mma) 10% Current account Trade balance
0
5%
-500

-1,000 0%
-1,500

-2,000 -5%

-2,500
-10%
-3,000

-3,500 -15%
Jan 05 Jan 06 Jan 07 Jan 08 1999 2001 2003 2005 2007 2009

Source: CEIC, Barclays Capital

Current account deficit
to widen to USD9.1bn in
2008
Offsetting this deficit is expected to be an USD5.8bn surplus on transfers, up USD0.3bn
from last year’s level. Official transfers (ie, grants from multilateral and bilateral
agencies) are likely to be USD0.3bn, and remittances from overseas Vietnamese
workers are expected to amount to USD5.5bn. This will translate into a current account
deficit of USD9.1bn, or 10.1% of GDP. By comparison the central bank is expecting a
current account deficit of 7.5% of GDP in 2008. The current account gap we project is
clearly unsustainable given the country’s level of FX reserves. However, it is important
to note that the deficit is really a tale of two halves, with the bulk of the deterioration
taking place in H1 08 before improving sharply in H2. By 2009, we look for Vietnam to
run a current account surplus of USD4.3bn.

Figure 10: Current account balance to improve in 2009

USD bn 2004 2005 2006 2007E 2008F 2008F
Current account -1.6 -0.5 -0.2 -3.9 -9.1 4.3
% GDP -3.4 -0.9 -0.3 -5.6 -10.1 0.4
Trade balance -2.3 -2.4 -2.8 -7.3 -12.4 0.4
% GDP -5.0 -4.6 -4.6 -10.2 -13.8 0.4
Services -0.9 -0.2 0.0 -0.1 -0.6 -0.2
% GDP -1.9 -0.4 0.0 -0.2 -0.5 -0.2
Investment -.09 -1.2 -1.4 -1.9 -2.0 -2..0
% GDP -2.0 -2.3 -2.3 -2.6 -2.3 -2.0
Transfers 2.5 3.4 4.1 5.3 5.8 6.0
% GDP 0.4 0.4 0.4 0.4 0.3 0.3
Source: CEIC, IMF, Barclays Capital

Capital account surplus This widening of the current account deficit should be partly offset by a surplus on the
to narrow this year capital account. We look for net FDI inflows to total USD2.5bn, down USD0.5bn from
2007 as tighter monetary conditions and high inflation cause some delays in planned

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investments. This is despite the continued rise in FDI approvals this year, which rose by
298% y/y in the year to end May to USD14.7bn. Vietnam is likely to attract USD2.5bn in
net inflows of medium-term loans this year, and we expect the country to receive
USD2bn in official assistance loans, roughly the same as in 2007. However, due to credit
concerns, we expect commercial loans to fall to UD1.2bn from USD2.1bn in 2007. We
estimate that Vietnam has USD700mn in amortisation payments this year. Lastly, we
look for portfolio flows to record a deficit of USD3bn following last year’s inflow of
USD7bn as foreign investors cut their holdings of stocks and equities.

Figure 11: Capital account surplus to narrow in 2008

2004 2005 2006 2007E 2008F 2009F
Capital account 2.5 2.6 4.4 13.9 1.1 7.3
% GDP 5.4 5.0 7.4 19.5 1.1 8.0
Net FDI 1.3 1.4 1.8 2.2 1.5 2.0
Medium term loans 1.4 1.4 1.1 3.2 2.5 2.8
Net portfolio — 0.9 1.3 7.0 -3.0 3.0
Short-term capital -0.3 -1.0 0.3 1.6 0 0
Overall balance 0.9 2.1 4.3 9.9 -8.1 12.1
% GDP 1.9 4.0 7.1 13.9 -9.0 12.4
FX reserves 7.1 9.2 13.6 23.5 15.4 27.5
% GDP 15.8 17.4 22.3 33 17.1 28.1
Source: CEIC, IMF, Barclays Capital

Vietnam projected to Taken all together this should lead to a capital account surplus of USD1.1bn in 2008
post a USD9.0bn following a surplus of USD13.9bn in 2008. This, in combination with the current
balance of payments account deficit, is projected to lead to a balance of payments deficit of USD9.0bn, which
deficit this year would equate to FX reserves falling to USD15.4bn by the end of the year. This would
lead to an import coverage ratio of 2.3 months, low by Asian standards. But it should be
noted that a large amount of Vietnam’s imports are inputs for the country’s exporters,
which imparts a downward bias to the coverage ratio. Other debt sustainability ratios –
short-term debt to FX reserves, FX reserves as a percentage of GDP, and debt service as
a percentage of exports – provide a greater degree of comfort (see Figure 5). This leads
us to believe that from a purely balance of payments perspective, there is little reason
for Vietnam to devalue its currency at this time.

Vietnam could receive In addition, Vietnam is a signatory of the Chang Mai Initiative, which should allow the
some balance of country to receive some BoP support from other Asian central banks. Under the aegis of a
payments support from number swap agreements between Asian central banks and a general fund, the scheme
other Asian central (which was set up after the 1997 balance of payments crisis) has USD83bn that can be
banks lent to signatories of the agreement. The amount available to Vietnam under the scheme
would be limited, as Vietnam currently does not have any outstanding bilateral swap
agreements with other Asian central banks; it is a signatory of the general scheme.
However, this probably would not stop other Asian central banks from agreeing to
provide funds for balance of payments support on an individual basis. Given the region’s
fears of “contagion” risk, such support is likely, in our view.

Inflation remains the key near-term risk

CPI inflation hit a Our two biggest concerns are: 1) inflation, and 2) a hard landing for the economy, and
10-year high in May the impact it would have on asset quality in the banking sector. As we have already
mentioned, the CPI has risen sharply over the last 12 months with inflation hitting a 10-
year high of 25.2% in May following a rise of 16.4% y/y in Q1 08 and 8.4% in 2007. As
with the rest of Emerging Asia, Vietnam is contending with the twin supply shocks of

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higher prices for food and energy. Of the two, the more problematic at the moment is
food, which accounts for 42.9% of Vietnam’s CPI basket. Like the rest of Asia, Vietnam’s
food prices have surged this year, climbing 35.4% y/y in May following a 28.4% rise in
Q1 and a 10.5% increase last year. On an annualised seasonally adjusted m/m basis,
food prices rose 34.8% last month, accelerating from 26.5% in March and an average
monthly increase of 10.2% in 2007.

Figure 12: Inflationary pressures rising on the back of higher food prices…
CPI being pushed higher by food component (% y/y) Seasonally adjusted CPI and food component (% m/m)

40 CPI Food prices 60 CPI Food prices

35
50
30
40
25

20 30

15
20
10
10
5

0 0
2003 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

Source: CEIC

As with the rest of the
region, rice prices are
pushing up food costs
Although there has been a general increase in food prices over the last 12 months (due
in part to higher costs for inputs like fertilizer), the main culprit is rice. Rice prices have
risen sharply this year around Asia, along with a broad-based rise in soft commodity
prices. However, this upswing in prices has been exacerbated by a drop in global rice
stocks to their lowest level since 1983-94 according to the USDA. This has led a number
of key exporting countries to ban exports of rice as governments try to secure domestic
supplies. Although Vietnam, a major rice exporter, does not suffer from a shortage of
rice, high prices around the world, an inadequate distribution system and hording have
led to a significant increase in the domestic price of rice. Indeed the rise in rice prices is
the main factor behind May’s 67.8% y/y increase in the food category of the CPI basket.
Government attempts to stabilise rice prices have so far had little impact.

Summer rice harvest In the immediate term, the government hopes for some relief in mid-June or early July,
should provide some when the summer rice harvest takes place. Due to high prices at the start of the year, a
relief number of farmers in the country’s south planted a third harvest. The hope is that the
increase in supply will help to dampen rice prices in Vietnam. Traded rice prices in
Thailand and the US have already fallen from their early May highs, so there is some
reason to believe that rice prices, and by implication food prices, may be peaking.
However, gains are likely to remain elevated on a y/y basis, as a significant moderation
in prices is unlikely to take place until Q4 08, when the main harvests in key growing
countries, such as Thailand (the world’s largest rice exporter) and the Philippines (the
world’s largest importer) take place. This is likely to keep the increase food prices in the
high double digits until the end of the year 2 .

2 That said, rough rice futures prices on the CBOT exchange have fallen from a peak of USD 24.46/cwt on 23

April 2008 to US 18.80/cwt on 4 June 2008, a drop of 23%.

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However, demand-led The other issue for the authorities is demand-led inflationary pressures resulting from
inflationary pressures the rapid increase in the money supply and the overheating of the economy over the
need to be addressed last 18 months. Non-food prices rose by 11.9% y/y in May following an increase of 9%
y/y in Q1 and 5.9% in 2007. We suspect that underlying inflationary pressures are
actually higher than reported because of the use of price controls, as well as the fact
that the government has failed to pass on the full increase in oil prices over the last 12
months, despite formally abolishing subsidies in 2007. One bright spot on the non-food
side is that on a seasonally adjusted m/m basis, inflation showed signs of levelling off in
May, when it rose by 1% following a gain of 1.8% in April.

Figure 13: … as well as demand-led pressures

Non-food CPI being driven higher by demand led On Seasonally adjusted m/m basis non-food prices
pressures (% y/y) show signs of stabilising (% m/m)

40 CPI Non-food prices 40 Non-food CPI

35
35
30
30 25
25 20
15
20
10
15 5
10 0
-5
5
-10
0 -15
Mar 03 Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 98 Mar 00 Mar 02 Mar 04 Mar 06 Mar 08

Source: CEIC

Authorities need to Demand-led pressures are likely to persist until the later part of the year, and we believe
tighten policy further the central bank will be forced to maintain its tightening bias through Q3. While the
market’s focus seems to be squarely on the need to raise interest rates, Vietnam’s
economy and its monetary system are very much like China’s, where quantitative
measures designed to cool credit growth tend to have a more immediate impact. These
are likely to involve such measures as restrictions on extending credit to overheated
sectors, the State Bank of Vietnam withdrawing deposits from commercial banks, and
an increase in banks’ required reserves. However, we believe the central bank will also
be forced to raise interest rates, with at least 400bp of hikes likely over the next two to
three months.

Interest rates need to be The main reason for the higher rates is the risk of the “dollarisation” of the economy. Due
hiked to avoid the to previous bouts of high inflation, Vietnam has traditionally been a highly dollarised
dollarisation of the economy – in 2001, just under 45% of the deposits held in banks were USD-denominated.
economy Due to improved growth prospects, a stable VND and quiescent inflation, this proportion
had fallen to just less than 25% of deposits by the middle of last year. Although no data
have been released since mid-2007, the central bank governor has said that he believes
locals are increasing holdings of USD because of fears that high inflation could erode the
value of their savings. We also suspect that holdings of gold have risen. Even in a best-
case scenario, headline inflation is likely to be sticky over the coming months. Although
we do not believe that the authorities have to raise interest rates above the rate of
inflation to arrest the flows into USD, deposit rates will have to be markedly higher than
they are now. Given the concerns of the government and the central bank over inflation,
and the draconian rate hike in May, we think it is likely that the central bank will hike

10 Emerging Markets Research Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

rates further. If they do not, Vietnam runs the risk of a balance of payments crisis and
devaluation of the VND by the end of Q3 or early Q4, in our view.

Banking sector remains a risk

Highly leveraged One cost of this expected tightening of monetary policy will be lower growth. While the
balance sheets government has cut its forecast of 2007 GDP growth to 7.5%, we believe that outlook is
vulnerable to a optimistic given the nature of the inflation shock and the aggressive tightening of
deterioration in asset monetary policy. We expect GDP growth to be around 6% y/y by year-end, with
quality downside risk. Due to the highly leveraged nature of banks’ balance sheets (domestic
credit is estimated to have stood at 100% of GDP at the end of 2007) and the rapid
expansion of credit over the last few years, we expect asset quality to deteriorate over
the next 12 months. Further risks would arise if banks (especially private-sector banks)
suffer liquidity problems due to the aggressive tightening of monetary policy and
potential dollarisation of deposits. So far, reports suggest that only a couple of small
private-sector banks have suffered liquidity problems (see Fitch: Particularly
Challenging Environment for Vietnamese banks, 29 May 2008), with the larger private-
sector banks and state-owned banks benefiting from their stronger deposit bases.

Fundamental credit view on issuers covered in this report

Issuer Current credit view Previous credit view
Government of Vietnam Stable Stable
Note: Positive = We expect issuer fundamentals to improve over the next 6-12 months; Stable = We expect
issuer fundamentals to remain stable over the next 6-12 months; Negative = We expect issuer fundamentals to
deteriorate over the next 6-12 months.
NA = We do not currently have a fundamental credit view on this issuer.
Source: Barclays Capital.
http://ecommerce.barcap.com/research/cgi-bin/public/disclosuresSearch.pl
BCMADSDSID|40050460,Stable

Barclays Capital Emerging Markets Research 11

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Emerging Markets Research Analysts

Piero Ghezzi
Head of Emerging Markets Research
+44 (0)20 3134 2190
piero.ghezzi@barcap.com
Asia
Jon Scoffin Peter Redward Nicholas Bibby Sailesh Jha
Head of Research, Asia-Pacific Head of Emerging Asia Research Senior Regional Economist – Korea, Senior Regional Economist – India, Indonesia,
+65 6308 3217 +65 6308 3528 Philippines, Thailand, Vietnam Pakistan
jon.scoffin@barcap.com peter.redward@barcap.com +65 6308 3511 +65 6308 3201
nicholas.bibby@barcap.com sailesh.jha@barcap.com
Wai Ho Leong Yan Zheng Puay Yeong Goh
Regional Economist – Malaysia, Singapore, Economist – China, Hong Kong Strategist
Taiwan +65 6308 3093 +65 6308 3014
+65 6308 3292 yan.zheng@barcap.com puayyeong.goh@barcap.com
waiho.leong@barcap.com
Emerging EMEA
Matthew Vogel Jeff Gable Koon Chow Aleksandra Evtifyeva
Head of Emerging EMEA Research Head of ABSA Capital Research Senior FX Strategist Economist – Russia, Kazakhstan
+44 (0)20 7773 2833 +27 113502321 +44 (0)20 777 37572 +44 (0)20 3134 1120
matthew.vogel@barcap.com jeff.gable@absa.co.za koon.chow@barcap.com aleksandra.evtifyeva@barcap.com
Christian Keller Divya Kumar Svitlana Maslova Advin Pagtakhan
Senior Economist – Turkey, Romania, FX Analyst Economist – Central Europe, Ukraine Credit and Portfolio Strategist
Central Europe +44 (0)20 777 39710 +44 (0)20 777 34255 +44 (0)20 777 34346
+44 (0)20 777 32031 divya.kumar@barcap.com svitlana.maslova @barcap.com advin.pagtakhan@barcap.com
christian.keller@barcap.com
Latin America
Eduardo Levy-Yeyati Rodrigo Valdes Paulo Hermanny Alejandro Grisanti
Head of Latin America Research Chief Latin America Economist – Brazil, Chief Latin America Strategist Senior Economist – Colombia, Peru,
+1 212 412 5963 Chile, Mexico +1 212 412 1370 Venezuela
eduardo.levyyeyati@barcap.com +1 212 412 5981 paulo.hermanny@barcap.com +1 212 412 5982
rodrigo.valdes@barcap.com alejandro.grisanti@barcap.com
Roberto Melzi Andrea Kiguel Paulo Mateus Sebastian Vargas
Senior Strategist Analyst Strategist Economist – Argentina
+52 55 5241 3260 +1 212 412 5965 +55 (0)11 5509 3295 +54 (0)11 4850 1230
roberto.melzi@barcap.com andrea.kiguel@barcap.com paulo.mateus@barcap.com sebastian.vargas@barcap.com
Jimena Zuniga
Economist – Brazil, Chile, Mexico
+1 212 412 5361
jimena.zuniga@barcap.com
Quantitative Research
Rogerio Oliveira Donato Guarino Adam Heiderich Juha Seppala
Head of EM Quantitative Research Quantitative Research Quantitative Research Quantitative Research
+44 (0)20 313 41482 +1 212 412 5564 +55 (0)11 5509 3290 +212 412 5606
rogerio.oliveira@barcap.com donato.guarino@barcap.com adam.heiderich@barcap.com juha.seppala@barcap.com

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