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Though providing a theoretical fillip to local assets, which most fund managers still deem undervalued across a host of metrics, a recent string of both fiscal and monetary accommodation in Vietnam may be indicative of a more fundamental and structural storm developing.  As alluded to recently the number of non-performing loans (NPL) reported across Vietnamese banks still falls woefully short of more widely accepted, objective measures (another upwards revision this week by State Bank of Vietnam (SBV) central governor Nguyen Van Binh puts the number at around 6 percent of total loans), a fact not lost on officials so much as it remains an irritant and moreover a roadblock impeding the industry’s consolidation.  The latest alarm bell comes not from Fitch (which earlier this year gave an NPL estimation of 13 percent) but from the Hanoi National University’s Vietnam Centre for Economics and Policy Research (VEPR), whose latest annual report will show that the entire banking sector’s bad debts amount to roughly 14 percent of total outstanding loans, “six-fold more than the central bank’s regulated 2.3 percent.”

To this end while much has been made historically in Vietnam about taming often rampant inflation, supporting the dong and moderating credit growth, the SBV now most fervently frets over a lack of lubrication in the system as deposit rate cuts (now 9 percent) so far have only padded net interest margins (rather than grow balance sheets) and GDP forecasts look ever-shaky.  Though interbank lending rates hover at historical lows, loan extension remains muted such that the SBV’s supposed plan of replacing ‘bad’ money with ‘good’ looks premature at best and grossly naïve at worst; small banks cannot post adequate collateral in the eyes of their larger peers, according to some observers, while more draconian requirements keep SME borrowing costs sticky (around 18 percent) and the economy, by extension, stagnant (since M2 annual growth lags that of nominal GDP).  Analysts with Hanoi-based HSC point to a defacto two-tiered banking system (state-owned commercial banks and larger private sector banks on one hand, whose NPL levels are considered worse, versus the rest) whose liquidity “resembles an African river in drought season with a couple of large stagnant pools surrounded by dry river beds.”  The opaque nature of bad loans, how they’re provisioned for, and ultimately how many can be siphoned off to entities such as the Ministry of Finance’s Debts and Assets Trading Company (DATC) only hinders the process.  “Forbearance with the current problems in the banking system will only lead to an accumulation of problems,” warns Sanjay Kalra, the International Monetary Fund’s country representative.

Finally, the desire to ease funding mechanisms contrasts with the natural maturation of the country’s credit cycle (deleveraging balance sheets is desirable to reverse the credit-money supply gap that has so far subsidized growth but also fueled inflation).  Price-cooling measures introduced last year such as Resolution 11/NQ-CP hypothetically help accelerate this dynamic—Vietcombank Securities notes credit outpaced deposit growth by ~300bp/annum over the past decade—while tiered growth and rate caps, it is hoped, will strangle the sector’s more risk-loving players and encourage mergers.  In practice, however, the whole system may be grinding to a halt, and an opaque accounting of bad loans isn’t exactly conducive to deal-making as many banks struggle with still inadequate capital adequacy ratios (CAR).  This ratio computes capital over risk weighted assets and measures the financial strength of a bank to protect depositors. Deteriorating asset quality leads to higher impairment charge that erodes profit, reduces equity and by extension the financial strength.  Vietnam banking industry income, noted one sector analyst, has been heavily depend[ant] on lending activities with the interest income/total income ratio of some banks reaching above 90 percent.”  That crutch is now a liability.

Despite myriad reassuring market signals, namely improved dong sentiment (evidenced by the absence of premium on unofficial USD/VND and an expected continued surplus of over USD2bn in the country’s balance of payments despite a likely [petrol fueled] customs trade deficit widening given an improving structural flow [i.e. FDI/remittance] to leakage dynamic), declining 5yCDS premiums (~530bp in October 2011 to ~270 last month) and annualized inflation projections now well below August’s 23 percent peak and last year’s 18.6 percent average (triggering a reverse repo cut in March, followed by refinance and discount rate cuts this month), the central bank’s (SBV) monetary tightrope act remains treacherous given ongoing commercial bank consolidation and moderating credit extension (11 percent last year [versus a 22 percent government target] and average annual growth >35 percent from 2006-10) that comes against the backdrop of slowing growth.  A mooted about plan to remove deposit rate ceilings by July, for instance, and thus adopt a more efficient market-oriented paradigm contrasts with the IMF’s opinion that lower deposit rates make it more difficult for weak lenders to attract funds (though in theory at least capped deposit rates may also pressure further dong depreciation) and is indicative of the slippery slope the SBV current navigates in trying to weed out weak lenders and bolster the dong’s credibility while concurrently lowering lending rates.

Yet while looser monetary policy feeds M2 growth (total money supply up ~1.06 percent in 1Q2012) and presumably fuels liquidity (local papers cited an unnamed SBV Deputy Governor in March, for instance, as saying that it was both “unfeasible and unnecessary to impose a cap on lending interest rates as [they] will automatically go down on surplus liquidity and easing inflation expectations”) interbank market health–which on its face appears healthier YTD–looks to also be correlated with the efficiency and speed of consolidation as falling rates, rather than a function of confidence, could be symptomatic of risk aversion as growing NPLs make stronger balance sheets within the sector less rather than more likely to lend to weaker ones.  As has been pointed out the vast discrepancy between how loans are classified may be a roadblock to reform as it tends to vastly understate the country’s climbing (since 2006) non-performing loan (NPL) trend (2012 sector NPL forecasts from Fitch, for instance, are more than 2x those provided by the state) given differences in loan classification between two accounting systems.

At present, per the Vietnam Accounting Standard (VAS) banks classify amounts of NPLs that cannot be paid in lieu of  the gross outstanding loan, while per the International Accounting Standard (IAS) method the entire loan amount is the basis (as an aside, a further reason underlying the country’s NPL gap may also relate to the inability of most Vietnamese banks to build out or adapt their internal risk management/credit rating strategies to the herein linked 2005 directive).  Larger than acknowledged NPLs would theoretically magnify risk and also threaten to accelerate a negative feedback loop which I’d argue strikes at the foundation of the very sector consolidation efforts deemed so integral to the country’s macro stability in the first place.  One proxy for this thesis, and the extent to which a liquidity crunch is already or may soon be underway is the velocity of interbank loans as bad debts and subsequent recollections between banks rise.

While back-to-back easing announcements from Ghana left us surprised, nothing compares of late to the State Bank of Vietnam’s (SBV) 100 bp reverse repurchase rate cut (to 14% as of Monday) which came on the heels of June’s inflation reading of 21%–a 31-month high–and the ensuing consensus among analysts for a 100 point hike.  At first blush the dovish cuts seem counter to the state’s alleged, newfound resolve away from its hitherto growth fetish and towards a more prudent, macroprudential mantra.  Indeed, Barclays reiterated its “underweight” call this week citing heightened risk, though admittedly this comes just one month after it expressed a “constructive view on [the] sovereign” in the belief that “the government is taking appropriate steps to tackle growth, inflation, currency and banking system vulnerabilities.”  Yet a more nuanced take tells a different story and suggests that the SBV still may have its eye on the ball despite this latest Jekyll and Hyde routine.  Consumer prices actually slowed on a monthly basis in June, for instance, and broad money supply growth remains relatively subdued, up just 2.45 percent YTD versus 7.5 percent during the first five months of 2010, which bodes well for H211 figures and the thesis that this summer marks inflation’s peak.  To that end February’s announced policy paradigm shift has effectively reversed the once runaway spread between the unofficial USD/VND rate and spot (a proxy measure for domestic confidence in the currency), meaning that measures to curtail dollar lending and black market trading, as well as to increase the attractiveness of holding dong deposits are becoming entrenched.  What has failed to take hold, however, is a healthy borrowing and lending dynamic among domestic banks which explains why growth, at 5.6 percent annualized, still lags the state’s now twice-cut GDP target (6 percent currently for 2011 from 7-7.5 percent initially).  While “reasonable lending rates” per one CEO should be 15-18 percent and deposit rates at 13-15 percent, for instance, one report this week stated that banks were offering to pay dong deposits at 20 percent while charging companies roughly 25 percent, well above the central bank’s deposit rate ceiling of 14 percent and the catalyst for a further liquidity squeeze as companies become reluctant to borrow and banks reluctant to lend.  The vicious cycle has triggered a liquidity scare of sorts–at least in the country’s ‘productive’ sectors, i.e. agricultural companies, export businesses and SMEs–against the backdrop of further FX reserve development (USD13.5bn at the end of May from USD12bn at the end of 2010, per the IMF), part of the country’s strategy of managing an omnipresent trade deficit made feasible given historical sticky structural flows (FDI, remittances).  Macroprudential policy isn’t just about price stability, but also the way in which capital is deployed.  There’s no reason the SBV can’t pursue both agendas at once.

Prime Minister Nguyen Tan Dung and the State Bank of Vietnam’s (SBV) vigilance in combating inflation will only intensify following recent word that consumer prices climbed 17.51 percent y/y in April–the fastest pace in 28 months.  Moreover the rise was somewhat expected, per analysts with VinaCapital, given a 18-24% fuel price hike in late February; a 15.3% hike in power prices effective in March; pass-through from a weaker VND; and lagged impact of strong credit growth.  Likewise, however, the SBV’s aggressive response since mid-February–a macro stabilization effort it labels “cautious and tight”–could see a delayed yet forceful impact that should allow nimble investors to strategically enter 5y CDS as well as sovereign credit beginning mid-year.  Aside from finally explicitly eschewing growth in favor of price stability (a virtuous policy if there ever was one for emerging market leaders), PM Dung’s mandate has seen the SBV raise interest rates across the board–refinancing, discount and reverse-repo rates (the most vital to interbank rates and also the defacto rate at which the central bank lends money via the open market) sit at 13, 12 and 13 percent–though at least until inflation’s delta softens look for further tightening to 2008 levels when rates peaked at 13, 15 and 15 percent, respectively.

Curtailing credit growth (especially dollar related) is also a priority; the SBV announced earlier this month it would hike reserve ratios by 2 percentage points in May (to a range of 3-6 percent) to discourage the use of foreign currency in the banking system. Thus while ongoing inflation and liquidity concerns should keep bond prices pressured in the near-term, and cause CDS  spreads to widen on further balance of payment and dong depreciation concerns, structural flows (FDI and remittances) remain robust and it appears that the government has finally committed itself to sending a clear and consistent signal about prioritizing economic stability over growth and stabilizing expectations (including a black market and gold trading clamp down).  Inflation may yet spike up however, as fuel prices will likely need to rise even more given rampant smuggling into Cambodia.  Ho Chi Minh Securities, for instance, gives a FY2011 CPI forecast now of 17.9% with an August y/y peak of 19.2%.

Vietnam’s effective dong depreciation of 7.2% last week (combining a new reference rate of VND20,693 per dollar versus the prior-VND18,932 and a narrowing of the trading band to +/-1% from +/-3%) will help balance FX demand and supply onshore per analysts since spot will drift closer to the open market rate.  That said, FT noted today that “the dong hit a new low of 22,000 against the dollar in the black market, more than 6 percent below the official exchange rate” while Bloomberg reported a rash of dollar buying by companies looking to finance their imports, suggesting omni-present concerns with the government’s “growth mania” that one analyst likened to “dancing on a razor blade.”  The battle is a psychological one that hitherto has failed to be adequately addressed as four consecutive devaluations in 15 months have damaged credibility; remember the observation awhile back that Vietnam must import in order to export.  Against that backdrop a devalued dong helps exporters but not before it slams the value of imports: the country’s customs trade deficit of USD12.4bn in 2010 was higher than forecasted and will widen this year to roughly USD14-15bn per Barclays, some 20 percent higher than the bank’s analysts initially projected just two months ago.  And while FDI (Vietnam remains an attractive venue for developed country-based corporations to spread their wings) and remittances into Vietnam (projected to be just shy of USD18bn in 2011) remain “supportive”, the level of FX reserves underpinning the overall balance of payments is deteriorating: according to Reuters, quoting a state-run newspaper, reserves were “more than USD10bn” at the end of 2010 compared with USD16bn in 2009 and USD26bn in 2008.

Likewise the central bank’s rate tightening (interbank lending rates up 2 percentage points with base and discount rates at 9 and 7 percent respectively unchanged but likely to move up in the near term; VinaCapital writes for instance that “an increase in the State Bank base rate” will help counteract the aforementioned import price pressures) to date will not meaningfully impact inflation (now 12.2%) which has trended upwards since October.  Analysts with Credit Suisse, for one, argue that devaluation is just making the problem worse:  “according to the regression-based analysis we conducted, official devaluations can worsen the inflation problem, even though in practice a significant number of people already transact in USD and exchange the VND at an unofficial rate. This partly reflects the fact that food contributes to over 40% of the CPI basket and that people are likely to still continue conducting transactions for food in VND.  Amid rising commodity prices, this devaluation can deliver an additional blow to CPI inflation, which can further reduce the trust in the currency if not properly complemented by a credible stance to bring up interest rates to fight inflation. To be sure, we think devaluation is needed in the longer run to help the trade balance, but this should come after the policy authorities have brought down inflation to a manageable level.”  To help do so the government will need to curtail both excessive credit (30% last year, above the target of 25%) and money supply growth (25.3% versus a target of 23%) which in turn will depend on the degree that the country’s top rulers are willing to make a break from high-growth policies that are taking it, per some observers, down the very path that devestated so many Asian Tigers in the late 90s when countries “ramped up growth rates and flooded their economies with easy credit only to trigger a financial crisis that swept the region  and forced the restructuring of scores of state-backed conglomerates.”  With pundits pointing to a second, five-year term for Prime Minister Nguyen Tan Dung when the National Assembly meets in May, Vietnam’s economic fate may depend on whether the Politiburo truly becomes more prudent and less starry-eyed.  Yet plenty are pessimistic.  “The best intellectual talent in this country is pulling out its hair at the moment,” lamented one observer to the WSJ.

The International Monetary Fund stated earlier this fall that Vietnam’s foreign reserves, including gold, would grow to $15.4bn by the end of 2010–and $19.2bn next year–from $14.1bn year-end 2009, after a sustained drop since 2008 as foreign currency inflows lagged during the economic crisis and Vietnamese individuals and firms began hoarding dollars and gold (said sentiment persists, evidenced by the state’s rate of 19.500 Vnd/USD and the black market’s 21.000 Vnd/USD offer) against the backdrop of a burgeoning trade deficit (which more than doubled to $12.4bn in 2007, rose by roughly 40 percent in ’08 and has since retreated slightly to $10.66bn YTD 2010) and rampant inflation (spiking to 24.4% last year)  from government-fuelled money supply growth and the absence of inflow sterilization through either debt issuance or reserve requirement hikes.  In fact, it’s these two indicators (trade deficit, inflation) and where one thinks they’re headed in the next six months which likely underlies any investment thesis on whether or not Vietnam’s VN index is inherently underpriced at the moment.  FT notes, for instance, that the market has fallen 14% YTD, trades on a 2010 forecasted P/E of 10.6 (see FT graphs) and is 63% below its 2007 historical peak despite the fact it remains one of Asia’s fastest growing countries in terms of output (over 7% forecasted next year).  HSBC, in fact, has practically called the bottom

The question about trade is something of a conundrum because ironically it speaks to Vietnam’s strength as an exporter (dominated by crude oil, textiles and garments, rice and coffee).  But as Ayumi Konishi, Vietnam country director for the Asian Development Bank notes, “for Vietnam to export, first they have to import, because the foreign-invested manufacturers can’t source the equipment they need from inside the country.”  Yet this paradigm may be shifting–and if it does, watch out.  Dragon Capital noted to investors last month that the monthly trade gap deficit had dropped 20-30%yoy since July and that “on a 3m/3m basis (excluding oil and gold) exports are running well above imports, at a respective +35% versus +18%. If this trend continues into 2011, the market will begin to note a clearly declining trade deficit.”  Per inflation, though, the matter may be more muddled.  A recent WSJ piece spoke to the inefficiencies of “Hanoi’s aggressively pro-growth economic policies, such as low interest rates and state-subsidized lending” that laid the groundwork for current inflationary pressures and the dong devaluations that have hitherto played into a psychologically damaging, negative feedback loop in consumers’ minds (it also underscores just how politically ambiguous Vietnam remains from an ideological standpoint–a tension that does nothing for economic stability).  Per Dragon, however, the country’s inflation rate was 9.66 percent in October, holding above 8 percent–the government’s target for the year–for the ninth consecutive month.  But “the biggest contributors continue to be food and education,” Dragon wrote, and despite constituting roughly three-quarters of the rise, “they are one-offs that will not recur in coming months. Apart from them, the CPI basket was only up about 0.6%…[and] as inflation usually climbs a total 1.2-1.6% in Nov-Dec, we can expect it at 8.8-9.3% by year-end.”  Nevertheless the dong could fall more than expected this time around given that the central bank, somewhat lacking tact, hinted earlier this month that it wouldn’t devlaue again “until at least the Lunar New Year festival” next February, creating no doubt an awkward limbo period.  So in sum, Vietnam is either cheap, or markets in this case at least may be more efficient than we give them credit for.

A fairly recent WSJ piece highlights the reemergence of interest among many investors in frontier currencies, driven primarily by the persisting, low interest rate environment among more developed countries.  Geoffrey Pazzanese, co-manager of the Federated InterContinental Fund (RIMAX), points to currencies in Vietnam, Kuwait and Indonesia in particular as currencies that diversifying investors seem especially keen on.  That said, the piece notes, frontier currencies tend to be thinly traded, relatively speaking, and also may represent “complex currency systems that are strictly controlled by central banks, [such] as in Vietnam, [which] can also make it difficult to execute trades swiftly.”  Per Vietnam, for instance, the central bank devalued the dong in mid-August for the third time in the past year to help curb a widening trade deficit, meaning that banks in turn will need to keep lending rates level or perhaps even raise them in order to keep their real rates positive.  And because many analysts expect further devaluation in the future, the government’s benchmark rate of 8 percent is likely to rise as well.  “All in all, the 2 percent devaluation came sooner than we had expected, but it was also smaller than we had expected,” Singapore-based Tamara Henderson, head of Asian foreign exchange research at Australia & New Zealand Banking Group Ltd., wrote several weeks ago.  “We continue to expect a move to the 20,000 level in the dollar-dong in the first part of 2011.”

We’ve documented previously the thesis that low-wage countries like Vietnam will continue to displace China as the latter’s unit labor costs continue to rise and its manufacturing becomes less and less competitive.

The Economist, however, takes exception in last week’s report on China’s labor market, arguing that “the next China” is indeed still in China, but rather its inland provinces rather than the coastal cities where surplus labor is rapidly vanishing.

“Vietnam, for example, is often touted as the next China. Its stock of foreign direct investment has tripled since 2000 and its exports have quadrupled. In July Hoya, a Japanese maker of optical glass, announced a $146m factory near Hanoi to make the glass substrates from which hard disks are fashioned. Intel is due to open a $1 billion plant, assembling and testing silicon chips.

Vietnam is cheap: its income per person is less than a third of China’s. But its pool of workers is not that deep. Strains are already showing in its labour market. Workers downed tools 95 times in the first three months of this year. The Communist Party has decreed double-digit pay rises and firms are grumbling about a new labour law. Vietnam is not perhaps the sanctuary from strife that firms fleeing China’s coasts might wish for.”

Further confirmation of the gradual manufacturing shift away from China and towards regional frontier markets in an Economist piece this week (“Culture Shock”) about how the rising number of labor disputes in China (largely revolving around wage increases) is beginning to intensify the country’s “shift from being the world’s workshop to its shopping mall: as employees demand and get higher incomes, the country’s attractiveness as a manufacturing base ebbs but its appeal as a consumer market grows.”  While companies’ collective response has to some degree been in part to mollify the wage demands, “firms with labor-intensive work have been shifting it to cheaper Asian countries like Vietnam, Thailand and Cambodia. Uniqlo, a clothier, plans to reduce its proportion of Chinese-made garments from 90% to 65% in the next three to five years.” Of course, foward-looking investors are already contemplating the next logical step. Per Paul Collier, a professor of economics at Oxford, “over the past three decades, offshoring shifted labor-intensive manufacturing from the OECD countries to Asia. In the next decade, expect the same process to begin shifting these activities from Asia to Africa.”

In a recent interview with Reuters (video linked herein), Timothy Drinkall, a portfolio manager for Morgan Stanley’s Frontier Emerging Markets Fund (NYSE:FFD) touts investing in Bangladesh, a country Drinkall’s fund has had exposure to for over two years, while the MSCI just added it to their Frontier Markets Index (at 1.8%) this past May.  Drinkall opines that Bangaldesh is at “the very early stages of an investment boom” and is thus the anti-Vietnam, an economy he feels will struggle to grow in the near-term like it has for the past decade.  While Bangladesh’s economy is roughly the same size as Vietnam’s, its FDI/capita is strongly lagging at $95 versus 6.5.  Moreover, Drinkall argues, its banking system in particular is vastly “underpenetrated,” with total loans/GDP in the 40-45% range, versus Vietnam’s 2009 reading of 142%, and most firms are correspondingly underleveraged.  A quick look at FFD’s makeup finds  Bangladesh’s Brac Bank, in its Top 25 holdings.  Aside from being overweight Bangaldesh, Drinkall is also bullish on Saudi Arabia, Nigeria, Kenya, Lebanon and Argentina from an overall, top-down standpoint.

JGW

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