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                      ON THE ECONOMY OF VIETNAM


                                     Luu Quoc Cuong

A research submitted in partial fulfillment of the requirements for the degree of Master of
Business Administration

Examination committee       Professor John C.S. Tang (Chairman)
                            Dr. Truong Quang
                            Dr. Fredric W. Swierczek

Nationality                 Vietnam
Previous Degree             Bachelor of Economics
                            University of Economics, Ho Chi Minh City
                            Ho Chi Minh, Vietnam

Scholarship Donor           Government of Switzerland

                               Asian Institute of Technology
                                  School of Management
                                    Bangkok, Thailand
                                        April 1999


First of all, I would like to express my profound gratitude and appreciation to my advisor,
Professor John C.S. Tang, for his invaluable support and guidance throughout my research
work. I also wish to extend my deepest thanks to Dr. Truong Quang and Dr. Fredric W.
Swierczek for their valuable comments and suggestions. It is my privileged to have them as
members of my research committee.

I am very grateful to Professor Dao Cong Tien, the Ex-President of the University of
Economics HCMC, for his help in nominating me to this program. Without his nomination, it
was impossible for me attend the program. He taught me to look at the problem with an
optimistic view even in the worst situation.

This research would not have succeeded without the cooperation and assistance of all the
laboratory supervisors and staff of the School of Management. My special thanks are also due
to all the staff of SAV program for their help during my first year in this program.

My sincere thanks are given to my donor, the Government of Switzerland for their financial

This research is dedicated to my family. Their unchanging and unconditional love
accompanies me all the time, and is the source of my spirit strength helping me to overcome
all the difficulties and challenges during my study in AIT.


During the past decade Vietnam has made remarkable achievement in economic growth as
well as poverty reduction. The average growth rate has reached 7-8 percent annually and per
capita income has increased to US$ 300 in 1996 from barely US$ 100 in 1987. However. like
other Asian countries, Vietnam has been seriously hit by the Asian financial crisis, happened
in July 1997, and it seems that Vietnam is now facing a real coming tough period.

This research examines the current economic situation of Vietnam in light of the Asian
financial crisis, how much damage the crisis causes and what are the troubles Vietnam is
coping with. Many internal weaknesses of the economy of Vietnam regarding to its state-
owned enterprise sector, rural investment, banking system and trade regime are found. These
weaknesses have become worsen by the crisis which has affected almost all the aspects of the
economy. It is undoubted that without immediate actions, significant progress that was
achieved over the past decade might be reversed and Vietnam will be put on the edge of a real

This research comes to conclusions that although the crisis does not cause a sudden shock to
Vietnam, its negative spillover effects make the economic situation, which has been
deteriorating sharply in recent years, become worsen. Radical measures are now badly needed
to arrest further economic slowdown. Enhancing the efficiency of state-owned enterprise
sector, improving banking service, reforming and expanding trade, and reinvigorating rural
development, those measures should be put on the first agenda of the reform program.

                               TABLE OF CONTENTS

Chapter   Title                                                                     Page

          Title page                                                                    i
          Acknowledgement                                                              ii
          Abstract                                                                    iii
          Table of contents                                                           iv
          List of figures                                                            vii
          List of tables                                                            viii

1         Introduction                                                                 1
          1.1    Rationale                                                             1
          1.2    Problem statement                                                     2
          1.3    Objectives of the research                                            2
          1.4    Research methodology                                                  2
          1.5    Limitation of the research                                            3
          1.6    Organization of the research                                          3

2         The Asian financial crisis: evolution, causes and economic impacts           4
          2.1   Onset of the crisis and its evolution.                                 4
                2.1.1 Phase I (January-April 1997): Lead up to the crisis in Thailand 4
                2.1.2 Phase II (May - beginning of July 1997): The Thai crisis and its
                        initial spillover effects                                      5
                2.1.3 Phase III (beginning of July – mid-October 1997): Crisis engulfs
                        the ASEAN-4                                                    5
                2.1.4 Phase IV (mid-October – mid-December 1997): Spillovers across
                        global financial markets                                       6
          2.2   Causes of the crisis                                                   7
                2.2.1 Bubble investment                                                7
                2.2.2 Export slowdown                                                  7
                2.2.3 Weak financial system                                            8
                2.2.4 The perception of low foreign exchange risk.                     8
          2.3   Economic impacts of the crisis                                         8
                2.3.1 ASEAN-5 affected countries                                       8
                2.3.2 Advanced economies                                               9
                2.3.3 Developing countries                                            10

3         Recent economic performance and internal weaknesses of the economy of
          Vietnam                                                              11
          3.1    The "doimoi" program of reform and stabilization              11
                 3.1.1 Unprecedented levels of growth                          11
                 3.1.2 Opening the economy to foreign trade                    12
                 3.1.3 Foreign investment - the primary stimulus to growth     13

           3.1.4 Rapid growth in domestic savings and foreign savings           14
    3.2    Recent economic development                                          14
           3.2.1 Economic growth                                                15
           3.2.2 Foreign investment and domestic savings.                       16
           3.2.3 Low inflation                                                  17
           3.2.4 Current account deficit                                        17
           3.2.5 Trade balance.                                                 18
           3.2.6 Structure of financing and foreign reverse                     19
           3.2.7 Debt burden reduced                                            20
    3.3    Assessing Vietnam’s recent economic performance                      20
           3.3.1 Pattern of growth: more capital intensive, more inward looking 20
           3.3.2 Role of the private sector                                     22
           3.3.3 Distribution of the gains from growth                          22
           3.3.4 Sustainability of stabilization gains at risk                  23
    3.4    Internal weaknesses                                                  25
           3.4.1 Inefficient state enterprise sector.                           25
           3.4.2 Bias trade regime                                              27
           3.4.3 Financial system                                               29
           3.4.4 Rural sector                                                   32

4   Effects of the crisis on the economy of Vietnam                            34
    4.1    Spillover effects                                                   34
    4.2    Vietnam’s vulnerabilities                                           35
           4.2.1 Slowdown in GDP growth.                                       35
           4.2.2 Exchange rate and competitiveness                             36
           4.2.3 Stagnating exports.                                           37
           4.2.4 Falling foreign investment                                    38
           4.2.5 Increasing unemployment                                       40
           4.2.6 Pressure on external and fiscal balance                       41
           4.2.7 Increasing inflation                                          41
    4.3    Positive effects                                                    42

5   Recent reform actions of Vietnam (Septem ber 1997 - November 1998)         43
    5.1   Reforming state enterprises                                          43
          5.1.1 Wholly state-owned enterprises                                 44
          5.1.2 Equitization                                                   44
    5.2   Promoting private small and medium enterprises                       46
    5.3   Reforming the banking system                                         46
          5.3.1 Recapitalization of state-owned commercial banks (SOCBs).      46
          5.3.2 Improving the regulatory framework.                            47
    5.4   Trade policy                                                         48
          5.4.1 Protection and non-transparency                                49
          5.4.2 Tariff structure                                               49
    5.5   Improving business environment                                       50

6   Prospect of the crisis and long-term performance of Asian countries         51
    6.1   Prospect of the crisis                                                51
          6.1.1 Outlook for Japan                                               51
          6.1.2 China: growing economic problem                                 52
    6.2   Long-term growth performance of the Asian countries                   52
          6.2.1 Potential strengths                                             52
          6.2.2 Weaknesses                                                      54
          6.2.3 Long-term perspective                                           55

7   Conclusions and recomme ndations                                             57
    7.1   Conclusions                                                            57
          7.1.1 Lessons for Vietnam                                              57
          7.1.2 Challenges to the economy of Vietnam                             59
    7.2   Recommendation                                                         61
          7.2.1 Promoting a strong private sector and building an efficient state
                 enterprise sector.                                              61
          7.2.2 Reforming and expanding trade                                    62
          7.2.3 Improving banking service                                        64
          7.2.4 Reinvigorating rural development.                                65
          7.2.5 Ensuring transparency and reliable information                   67
          7.2.6 Adjusting exchange rate                                          67
          7.2.7 Increasing domestic saving                                       67

    References                                                                  68

                              LIST OF FIGURES

Figure       Title                                                           Page

Figure 3.1   FDI approvals dominated by construction and by heavy industry    13
Figure 3.2   Widening investment – Saving gap                                 14
Figure 3.3   Distribution of rural credit                                     33

Figure 4.1   Export partners, 1996                                            38
Figure 4.2   Undisbursed FDI Investment partners – end 1997                   39
Figure 4.3   FDI Commitments and actual disbursement 1993 – 1998 (US $        39

                                 LIST OF TABLES

Table        Title                                                             Page

Table 3.1    Vietnam's recent growth compares favorably with other              11
             rapidly growing East Asian countries.
Table 3.2    GDP growth rates (percent)                                         15
Table 3.3    Balance of payment                                                 18
Table 3.4    Exports--selected commodities                                      19
Table 3.5    Vietnamese industry shifts towards protected capital- intensive    21
Table 3.6    Low share of manufacturing exports in total exports (percent)      21
Table 3.7    Limited role of private sector in industry: evidence from          22
             ownership of industrial firms as of July 1, 1995
Table 3.8    Widening rural- urban income gap                                   23
Table 3.9    SOE sector: selected indicators                                    25
Table 3.10   Weakening performance of Vietnam's financial system (end of        31
             period, percentage)

Table 4.1    Projected import volume growth of trading partners (%)             34
Table 4.2    GDP growth rates (percent)                                         36
Table 4.3    Changes in currency prices                                         36
Table 4.4    Pre-crisis wage levels (1996)                                      37

Table 5.1    Equitization outcome (average for equitized 17 SOEs)               45

Table 7.1    Selected Vietnamese exports to Europe, U.S. and Japan, 1996        63

                                          Chapter 1

1.1    Rationale

For the past three decades, no other group of countries in the world has produced more rapid
economic growth or such a dramatic reduction in poverty as the East and Southeast Asian
countries. Korea, Malaysia, and Thailand have virtually eliminated absolute poverty, and
Indonesia is within reach of that goal. Per capita income levels have increased tenfold in
Korea, fivefold in Thailand, and fourfold in Malaysia. In fact, per capita income levels in
Hong Kong and Singapore now exceed those in some Western industrial countries.

After so many years of outstanding economic performance, Asia began to suffer the economic
turmoil and was dragged into the financial crisis which leads to economic deficit for almost
every countries in the region. Started from Thailand, which used to be a mecca of foreign
investors, the crisis widely spread to Malaysia, Indonesia, the Philippines and Singapore. Even
many recently financial scandals in Japan and the Republic of Korea were also partly
influenced by the crisis. Although the government in these countries has paid full attention in
order to find a prescription for the disease, and many international financial institutions such
as World Bank, IMF have given much help, the prospect of a restabilization in the region
seems to be still far in the future.

In Vietnam, the situation is similar, though it happens a little later. Opening up to the regional
and global community since 1987, Vietnam has conducted the transformation from the
centralized economy to the market-oriented economy in the hope of catching up with its

For many years continuously, Vietnam has achieved a high and rapidly economic
development. From a rice-imported country, Vietnam becomes the third largest rice exporter
in the world. Inflation rate decreased considerably and the average growth rate in the recent
years has come up to around 8 - 9%.

However, since the end of 1997 the situation in Vietnam has not been as bright as it was. At
the end of 1998, following its neighbouring countries, Vietnam began to experience an
economic downturn. The growth rate, estimated at 9% at the beginning of the year, had to be
revised down to 6% at the year end. There are many signs showing that the financial crisis has
begun to make its presence in Vietnam and nobody knows how much damage it will cause to
the country. It definitely requires Vietnam to make every efforts to be survived in the coming
tough period.

1.2       Proble m statement

In the past decade, three main sectors that made the largest contribution to the growth rate of
Vietnam economy were rural sector, foreign investment and export activities. However, the
performance of these sectors in recent year, given the current turmoil of Asia, has not been
very well. The slowdown in export activities due to the devaluation in most of Asian
currencies and the decrease in foreign investment has seriously affected the capital inflows
which is badly needed for Vietnam now. These problems together with the internal
weaknesses of Vietnam economy such as inefficient state enterprise sector, bias trade regime
and fragile banking system has put Vietnam in a difficult situation and threaten to destroy the
remarkable economic success which has been achieved in the past.

In addition, Vietnam’s neighbouring countries are applying many measures to enhance their
competitive advantage, and this will certainly result in a less favourable external environment
for Vietnam’s economic growth. It is clear that if Vietnam does not take an active and
immediate policy to improve its competitiveness, the country can not maintain its highly
growing rate and the stabilization of the economy will be put on the edge of a real crisis.

1.3       Objectives of the research

Despite recent remarkable growth, there are many signs showing that the economy of Vietnam
is now facing with potential threats to stabilization gains. The internal weaknesses in banking
system, trade regime and SOEs sector which is taking the main role in the economy, have
proved to be the big constraints for continuing progress. In such a difficult situation, the
regional crisis, therefore, happened in a most unexpected time for Vietnam and has worsen the
situation. Objectives of this research are:
         assess the current situation of the economy of Vietnam, how much damage the crisis
          causes to Vietnam in light of the financial crisis in Asia and;
         suggest necessary measures to be taken by the Government to cope with the challenge.

1.4       Research methodology

Data and information about the financial crisis, either regional o r local, comes from a variety
of practical and academic sources.

Several articles from finance and economic journals and magazines such as The Economist,
Asiamoney, Far Eastern Economic Review are collected and analyzed to get the general
picture of the crisis. Reports and related materials from international financial institutions such
as World Bank, IMF are used as references for examining the current situation as well as the
long-term performance of Asian countries. Local economic magazines such as Viet nam
Investment Review, Vietnam Economic News, Vietnam Business Journal, Saigon Times

Weekly help to study the current situation of Vietnam economy. The view of point of the
insiders is seen by analyzing reports and documentary from many ministry of Vietnam like
Ministry of Finance, Ministry of Planning and Investment, the Central Board of Economics.
Opinions of outside consultant organizations such as Harvard Institute for International
Development, United Nations Development Program are also used as an important source of
information for the research.

1.5    Limitation of the research

Since 1996, before the crisis happened, Vietnam has experienced a decrease in foreign capital
inflows. The reason for this is recent deteriorated business environment to which the
complicated administration system has contributed the most. Corruption is another problem,
not only in Vietnam but in most of the crisis countries, which seems to be the underlying
reason, even direct trigger in some cases such as in Indonesia and South Korea, for the crisis.
These important issues, due to time and data constraint, are not examined in the research.

1.6    Organization of the research

Chapter 1:     Introduction
Chapter 2:     The Asian crisis: evolution, causes and economic impacts
Chapter 3:     Recent economic performance and internal weaknesses of the economy of
Chapter 4:     Effects of the crisis on the economy of Vietnam
Chapter 5:     Recent reform actions of Vietnam
Chapter 6:     Prospect of the crisis and long-term performance of Asian countries
Chapter 7:     Conclusion and Recommendation

                                          Chapter 2

The most significant event in the world economy in 1997 was the financial crisis that besieged
much of Asia. The event that this region might beco me embroiled in one of the worst financial
crisis in the post war period was hardly ever considered a realistic possibility. The economies
of east Asia have been some of the most successful emerging market countries in terms of
growth and gains in living standards. With generally prudent fiscal policies and high private
saving rates, these countries had become a model for many others. This success had led
domestic and foreign investors to underestimate the countries’ economic weaknesses: export
growth had slow markedly; the current account deficit was persistently large ; and the real
exchange rate had appreciated to a level that appeared unsustainable. The fundamental policy
shortcomings and their ramifications were fully revealed as the crisis deepened.

2.1     Onset of the crisis and its evolution.

According to the “World Economic Outlook” Interim Assessment, December 1997, a survey
by the staff of the International Monetary Fund, the evolution of the crisis in east Asia in 1997
and its broader spillover effects can be divided into four broad phases in which the
ramifications for the world economy became increasingly significant: (1) the lead up to the
exchange market crisis in Thailand; (2) the Thai crisis and its initial spillover effects on
emerging market economies; (3) the widening and deepening of the crisis among the ASEAN–
4 countries; and (4) the spread of the pressure to other Asian economies and the emergence of
broader effects on world financial markets.

2.1.1   Phase I (January-April 1997): Lead up to the crisis in Thailand

After periodic episodes of speculative attacks in 1996, the Thai baht came under renewed
downward pressure in late January and early February. There were concerns regarding the
sustainability of the U.S dollar peg in the face of a large c urrent account deficit, high short-
term foreign debt, the collapse of a property price bubble, and an erosion of external
competitiveness resulting in part from the dollar'’ continued rise against the Japanese yen.

There were at this time few signs of market nervousness about situations in the neighbouring
ASEAN-4 countries, and all of which had significantly smaller current account deficit.
However, as the situation in Thailand deteriorated, concerns that the financial sectors in these
countries also might be exposed to gluts in the property sector contributed to a downturn in
equity prices, particularly in Malaysia and the Philippines. Elsewhere, equity prices continued
to fall in Korea, where the current account position had weakened sharply in 1996, do mestic
demand remained sluggish, and corporate balance sheets were severely strained by debts
incurred to finance past expansion.

2.1.2 Phase II (May - beginning of July 1997): The Thai crisis and its initial spillover

Severe pressure on the Thai baht reemerged in early May, prompting the central bank initially
to intervene heavily in the spot and forward markets, before moving on May 15 to introduce
capital and exchange controls, aimed at segmenting the onshore and offshore markets, and to
allow interest rates to rise. These measures, however, failed to restore confidence in the
currency, and strong pressures continued in the second half of May and June. On this
occasion, the neighboring Asean-4 countries also suffered limited spillover effects, but these
pressures abated fairly quickly as the authorities intervened in exchange markets, and raised
interest rate.

Elsewhere, there were no indications of a more broadly based loss of confidence in global
financial markets. In Korea, concerns about corporate bankruptcies persisted, but confidence
was buoyed somewhat by a pickup in export receipts and a narrowing of the current account

In the face of continued large capital outflows, Thailand on July 2 abandoned its exchange rate
peg against the dollar and allowed the baht to float. After dropping initially by about 10
percent, the baht continued to weaken in the succeeding weeks as concerns intensified about
the uncertain political situation and the delay in the adoption of a comprehensive economic
package to support the new exchange regime and address the weaknesses in the financial
system. The falls in the baht immediately raised doubts about the viability of exchange rate
arrangements in neighboring countries.

2.1.3   Phase III (beginning of July – mid-October 1997): Crisis engulfs the ASEAN-4

Outside Thailand, the strongest pressures emerged initially in the Philippines, where the
authority had also been maintaining a de facto exchange rate peg to the U.S. dollar. After
seeking briefly to defend the peg through interest rate hikes and intervention, the authorities
allowed the peso to float on July 11, and subsequently imposed restrictions on the sale of non-
deliverable forward contracts to nonresidents in an attempt to limit speculation against the
peso. Spillover effects spread quickly to Malaysia, where the authority opted to allow the
ringgit to depreciate rather than raise interest rates, and also to Indonesia, where on July 21
the rupiah fell sharply within the official intervention band. Subsequent measures to tighten
liquidity conditions in Indonesia failed to stem the growing exchange market pressures, and
the authority allowed the rupiah to float on August 14. At the time of the rupiah’s float, the
Thai baht had weakened by a cumulative 18 percent against the dollar, compared with more
moderate falls of around 10 percent for the other ASEAN-4 countries. The situation worsened
markedly over the next two months, reflecting concerns about the effects of currency
depreciation and about the commitment of the authorities to implement policies needed to
restore exchange rate stability. The actual or threatened imposition of controls on capital
outflows during the crisis may also have served to further undermine investor confidence.

By mid-October, the cumulative declines of the ASEAN-4 currencies against the dollar
exceeded 30 percent for Indonesia and Thailand and 20 percent for Malaysia and the

Philippines. Equity markets also recorded further heavy losses in August before stabilizing
somewhat in September.

As the southeast Asian crisis deepened, spillover effects began to spread to other countries in
Asia, mainly reflecting concerns about the adverse effects on growth and export
competitiveness of developments in the ASEAN-4 countries and also concerns about the
soundness of financial systems. The Singapore dollar and the Taiwan dollar weakened
moderately in July, and the Hong Kong dollar came under temporary attack in early August.
Equity prices in Hong Kong and Taiwan peaked in August before turning do wn as interest
rates were raised to counter exchange rate pressures.

Spillover effects beyond the Asean region remained fairly limited. On the whole, global
financial market remained buoyant, and the effects of the worsening crisis in Southeast Asia
were still contained within the region.

2.1.4 Phase IV (mid-October – mid-December 1997): Spillovers across global financial

Financial markets in Asia came under further downward pressure in mid-October, but on this
occasion the spillover effects were much more far-reaching. Several factors contributed to the
renewed weakness within the ASEAN-4 countries, including political uncertainty and concern
about the adequacy of financial sector restructuring in Thailand, and concerns about the
absence of stronger measures to cut government-sponsored infrastructure spending in
Malaysia. These concerns were compounded by an intensification of exchange market
pressures elsewhere in the region. In Taiwan, the authority stopped intervening to support the
exchange rate on October 17, allowing the Taiwan dollar to depreciate by about 6 percent. In
Hong Kong, interest rates rose and forward premiums on the Hong Kong dollar widened amid
strong pressures on the fixed parity against the U.S. dollar under the currency board
arrangement. These pressure triggered a three-day equity price decline of more than 23 percent
in Hong Kong, culminating in a 10 percent drop on October 23.

Following this initial sell-off, global financial markets remained highly volatile through
November, and risk spreads widened across the board, particularly affecting the flow of funds
to emerging markets. In Asia, downward pressure on the Korean won intensified in the last
week of October, and equity prices fell sharply. After intervening heavily to defend the won,
the authorities widened the daily fluctuation band from 4.5 to 20 percent on November 20 and
subsequently requested financial support from the IMF. Among the ASEAN-4 countries,
exchange rates have suffered further large declines since late October, and equity prices have
also generally continued to lose ground.

In emerging markets more generally, there were sharp equity market declines in many
countries in late October and early November, the largest being in market that had recorded
substantial gains earlier in the year. In Latin America, the Brazilian real came under intense
downward pressure as developments in Asia contributed to increased market concerns about
competitiveness and the external accounts. Interest rates also rose in Argentina and, to a lesser
extent, in Mexico, where the peso weakened by about 7 percent against the dollar. Reflecting

the broad nature of the spillover effects, exchange market pressures emerged also in a number
of other countries, including Greece, Russia, and Ukraine, in all cases prompting sharp interest
rate hikes to defend the domestic currency. In Russia, official interest rates were raised by 7
percentage points in early November as the ruble came under downward pressure in the wake
of a 20 percent fall in the stock market on October 28. The authorities also announced that the
intervention band for the ruble would be widened from 10 to 30 percentage points in 1998 and
would no longer move in line with targeted inflation differentials. Interest rates rose sharply
again at the beginning of December as pressures on the ruble intensified.

2.2     Causes of the crisis

2.2.1   Bubble investment

The years preceding the crisis were characterized by an unprecedented boom in asset markets,
most importantly the stock and property markets (especially, but not exclusively in Bangkok).
Real estate investment continued to boom despite the fact that offices, hotels, and apartments
were experiencing declining occupancy rates. Much of this investment was being financed
abroad in US dollar denominated debt because interest rate for these loans were lower than
those in Thailand as long as the Thai baht/US dollar exchange rate did not change.

However, by 1996, it was apparent that the rapid expansion of office and residential property
supply in Bangkok and other regions was leading to some alarming surpluses and growing
vacancy rates. This led to financial difficulties for a number of major property developers, and
some of them began to have problems meeting foreign and domestic debt obligations.

2.2.2   Export slowdown

In early 1996 Thailand’s export performance which had been seen as a major engine for its
double-digit growth over the previous decade, began to deteriorate. From the second quarter of
1996 to the end of the first quarter in 1997, growth of total exports was negative. For the
remainder of 1997 it was positive but low by historical standards. In the first quarter of 1998
growth once again became negative.

Manufactures, which account for over 80 percent of total exports, have had a greater variance
in growth rates than total exports recently. Manufactured exports decline through the final
three quarters of 1996, and resumed positive growth in 1997, but at very low rates. In the first
quarter of 1998 they became negative (-3.9%) once again. Even in the most successful quarter
over this period, manufactured growth rates pale in comparison with 22 to 25 percent growth
that had been the norm previously.

The decline in the rate of growth of manufactured exports and in the absolute level of a
number of Thailand’s traditional labor- intensive exports significantly preceded the onslaught
of the crisis in early to mid-1997.

The cyclical downturn in the demand for electronics had an adverse effect on export growth,
which led to skepticism about the robustness of economic growth in the countries concerned.
This threatened the large inflow of foreign capital, which was now badly needed to sustain the
increasing current account deficits.

2.2.3   Weak financial system

In financial systems, weak management and poor control of risks, together with lax
enforcement of prudential rules and inadequate supervision had led to a sharp deterioration in
the quality of banks’ loan portfolios.

By the end of 1996, the short-term foreign liabilities of Thailand’s and Indonesia’s banking
sectors exceeded the total foreign exchange reserves held by governments. This created a
situation which was especially prone to financial panic. Lenders began to fear for the
creditworthiness of the their loans, and this quickly arose a “race to the exit”. Since there were
not enough reserves for everyone to be able to convert their assets, a rush to try to be near the
front of the queue became greater, and also the panic.

The banking problems that were becoming apparent in late 1996 and in 1997 were due
primarily to exposure to real property and stocks. The next stage followed from increases in
interest rates in 1997, as government engaged in increasingly desperate measures to try to
maintain the baht exchange rate.

Liquidity problems arising from falling confidence in the local currency, and from policy-
induced higher interest rates aggravated banking problems. In Thailand, the government
opened a large window of support through its Financial Institutions Development Fund
(FIDF). Through this window, enormous amounts of liquidity support were provided to the
banking sector. Meanwhile the incidence of non-performing loans in banks and finance
companies continued to increase.

2.2.4   The perception of low foreign exchange risk.

The maintenance for too long of pegged exchange rate regimes, which came to be viewed as
implicit guarantees of exchange value, encouraged external borrowing – often at short
maturity. This led to excessive exposure to foreign exchange risk in both the financial and
corporate sectors.

2.3     Economic impacts of the crisis

2.3.1   ASEAN-5 affected countries

The most discernible impact of the financial crisis has been a sharp decline in private capital
inflows to the five affected countries. According to recent estimates by the Institute of
International Finance, the five affected Asian countries suffered net private capital outflows of
$12 billion in 1997, compared to net inflows of $93 billion in 1996. Private capital flows from

commercial banks exhibited the sharpest decline. At the end of 1997, as investors’ confidence
was shattered, maturing short-term debts in several economies were not rolled over. This
resulted in an outflow through commercial banks of about $21 billion, as compared with
inflows of about $56 billion in 1996.

Foreign direct investment in these economies remained more or less constant at about $7
billion, approximately the same as in 1996. The relatively small role foreign direct investment
played in these economies in recent years made them increasingly vulnerable. Port folio
investment suffered a large outflow of as much as $12 billion in 1997, in contrast with an
inflow of about $12 billion in 1996. The affected countries’ reserves fell sharply, despite
official assistance and a narrowing of their combined current account deficit.

2.3.2   Advanced economies

The impacts of the crisis depends on three sets of factors. The first is the importance of trade
and the financial links with the crisis economies; these links are generally closest in the Asia-
Pacific region. The second factor is the economy’s starting position. The contractionary effects
of adjustment in the crisis economies will be most damaging in economies where activity and
confidence were already weak. And third, the impact on any country will depend on how it is
affected by the developments in foreign exchange and financial market that have accompanied
the crisis.

Initially, the current crisis in Southeast Asia was not expected to have much of an impact on
the world economy. However, the scene changed quickly as Korea, the world’s 11th largest
economy and 12th largest in terms of its share of world trade, became embroiled in the crisis.
The five affected countries (including Korea) account for about 20 percent of Australia’s and
Japan’s exports, 8 percent of the United States’ exports, and 3 percent of Europe’s exports.
Measured by a more relevant yardstick, exports to the affected countries account for 2.8
percent of Australia’s GDP, 1.7 percent of Japan’s GDP, 0.7 percent of the United States’
GDP, and 0.6 percent of Europe’s GDP. Economic forecasts indicate that the total direct
impact of the crisis will be to reduce real GDP in OECD countries by around 0.6 percent (0.4
percent for the European Union, 0.6 percent for the United States, and 1.4 percent for Japan).

In Japan, the crisis hit an economy whose nascent recovery had already stalled. After four
years of stagnation, output in Japan had grown by 4 percent in1996, and early part of 1997 it
seemed that self- sustaining growth was taking hold. But activity declined sharply in the
second quarter and remained below its first quarter level in the remainder of the year. In the
latter part of the year and early 1998, the Asean crisis and (especially its spread to Korea),
concerns about the domestic financial sector, and the renewed weakening of equity prices fed
on each other, contributing to continued weakness in domestic spending. The crisis also
weakened exports, both through the compression of demand in a number of neighboring
partners and through losses of competitiveness in relation to them.

The advanced economies of North America and Europe will generally be less adversely
affected by the crisis. U.S. economic performance in 1997 was exceptionally favorable, with
the fastest growth in 9 years, the lowest inflatio n in 32 years, unemployment falling to its

lowest level in 24 years, and virtual balance in the federal budget for the first time since the
early 1970s.

2.3.3   Developing countries

Developing countries in all regions are being adversely affected to varying degrees by the
Asian crisis. High risk premia, looses of competitiveness, lower commodity prices, and
stepped-up efforts to address domestic and external imbalances are likely to cause most
developing countries to experience at least moderate slowdown in growth in 1998.

China has been relatively immune to contagion from the crisis, partly because its capital
inflows consist primarily of direct investment while vehicles for financial speculation are
limited. The real effective exchange rate has risen somewhat (by about 6 percent) as a result of
a large depreciation in the region, but the trade position remains strong, and international
reserves are large. Growth is expected to slow moderately this year, owing to weakening
domestic demand as well as the more difficult international environment.

In India, the rupee has fallen by about 10 percent against the U.S. dollar since late 1997, partly
as a result of spillovers from the regional crisis, but its exchange value is little changed on a
real multilateral basis. Capital inflows are expected to be sustained, and there remains
considerable potential for higher foreign direct investment. The recent slowing of growth,
while partly attributable to cyclical factors, suggests that the boost given by the reforms
initiated on 1991 has been wearing off.

In Mexico, the Asean crisis led to a marked increase in exchange market and interest rate
volatility. A substantial, temporary increase in interest rate helped to stabilise the exchange
rate, although the peso fell to new low against the dollar in February while the equity market
recovered some of its earlier losses.

                                           Chapter 3

3.1     The "doimoi" program of reform and stabilization

In 1986, the Government of Vietnam launched a comprehensive reform program to respond to
severe macroeconomic instability, economic stagnation and growing rural hunger. Structural
reforms were aimed at building a multi-sector economy by recognizing and formalizing the
role of the private sector, opening the economy to foreign trade and investment, and returning
to a system of small- holder agriculture. The underlying strategy was to introduce market
principles to enhance the efficiency of the economy, while at the same time preserving a
central role for the state in economic management. Implementation gathered momentum in
1989 when price controls were largely phased out and agriculture reverted to family farming
as opposed to farming based on collectives. Since then, reforms have been extended to cover a
broad range of areas. Success of the program has provided the macroeconomic stability that
has underpinned economic growth and generated significant inflows of foreign investment.

3.1.1   Unprecedented levels of growth

Under the reform program, Vietnam has achieved rapid growth. From a low of 4 percent in
1987, the annual rate of growth has increased to over 9 percent in both 1995 and 1996,
averaging 7.3 percent annually for the past decade. This has translated into annual per capita
real income growth of about 5 percent. In US dollar terms, per capita income grew from barely
$100 in 1987, to over $300 in 1996 (World Bank, October 1997). This growth performance
compares well with the performance of a wide range of countries (s ee Table 3.1.)

                      Table 3.1: Vietnam's recent growth compares favorably
                         with other rapidly growing East Asian countries.

 Country or Country Grouping              Average GDP Growth         Average GDP per Capita
                                            Rate ( percent )         Growth Rate ( percent )
 Vietnam ( 1987 – 96 )                            7.3                         5.2
 Low income countries (ex. China and              2.3                          -
 China ( 1987 – 95 )                                9.8                        8.6
 Other East Asia Countries:
 Hongkong ( 1970 - 85 )                             8.0                        5.8
 Indonesia ( 1970 - 85 )                            7.1                        4.9
 South Korea ( 1960 - 75 )                          9.1                        7.2
 Malaysia ( 1970 - 85 )                             6.9                        4.4
 Thailand ( 1970 - 85 )                             6.4                        4.0
 Selected Transition Economies a/                  -1.3                        -1.3
Note: a/ Includes Bulgaria, Czech Republic, Hungary, Poland and Slovak Republic.
Source: World Bank

All key sectors have participated in growth. Overall, the service sector has grown the fastest,
at an annual rate of nearly 10 percent over the period, with industry and agriculture growing at
nearly 9 percent and just over 4 percent respectively over the period. This sectoral pattern of
growth implies that both the service and industrial sectors have assumed greater importance in
total output, while agriculture, though still the dominant sector of the economy, has contracted
substantially as a share of total production.

Growth in agriculture has been propelled by intensification of rice production in the wake of
de-collectivization and the return to family farming. Productivity improvements were due
mainly to technological progress in the form of improved seeds and increased use of tractors
and pumps. Paddy output increased some 57 percent between 1988 and 1996, from 17 million
to 27 million tons. Much of this growth came from a 37 percent aggregate yield increased and
the expansion of irrigated area, which increased cropping intensities. This increased
productivity has allowed bumper crops in 1996 and 1997, despite natural disasters such as
flooding and droughts. Vietnam has also become a leading exporter of rice, a dramatic
turnaround from the late 1980s when it could not feed itself and when rural hunger was
widespread. Production response has been slower for other crops but is still dynamic-about 20
percent for industrial crops. Their growth has however come essentially from area expansion.

In services, growth was fastest in banking sector while fuel extraction and a construction
boom have been driving factors in industrial growth. The growth in fuel production reflects
the coming on stream of crude oil extraction activities in the offshore oil fields in the early
1990s. Capital intensive industry accounted for over 58 percent of industrial growth over the
period. More labor-intensive areas of industry, notably textiles, leather, food and foodstuffs
have also expanded but at a slower pace.

Both state and the non-state sectors experienced growth but the state sector has growth much
faster, reflecting the increasing number of joint venture operations between SOEs and foreign
investors. The difference is most glaring in agriculture, where the non-state sector grew by
barely 4 percent annually compared with over ten percent for the state sector. This difference
is also partly explained by state sector dominance of the rapidly growing industrial crops.

3.1.2   Opening the economy to foreign trade

Trade expansion has been an important component of growth. Trade reforms have increased
Vietnam's volume of external trade in parallel with a substantial diversification of trade. Trade
has risen to about 97 percent of GDP in 1996 from 46 percent in 1989. Export growth has
averaged 28 percent annually, doubling as a share of GDP from about 20.5 percent in 1989 to
over 41 percent in 1996, while import growth has averaged 31 percent annually. At the same
time, the share of rice and crude oil exports has declined to about 30 percent in 1996 from 40
percent in 1990, while the share of manufactured exports has risen to nearly 30 percent from
barely 2 percent in 1990.

In 1996, Vietnam recorded trade with a total of over 100 trading partners. Trade reforms have
occurred in parallel with a move towards market-oriented exchange rate management. In 1989,
the Government re-aligned the exchange rate and adopted a market-oriented exchange rate
policy. The official exchange rate was devalued by about 73 percent (in real terms), to close to

the level in the parallel market. An interbank foreign exchange market was introd uced in 1994,
with buying and selling rates allowed to move within a band around the official reference rate
stipulated daily by the central bank. Since March 1992 the difference between the official
exchange rate and the exchange rate in the parallel market has been usually less than one
percent. Since 1993, there has been little volatility in both the nominal and real exchange rates.

3.1.3   Foreign investment - the primary stimulus to growth

Investment has tripled in real terms expanding as a share of GDP from 11.6 percent in 1989 to
nearly 28 percent in 1996. The stimulus for this growth has come mainly from the non-
government sector and in particular from foreign investment in the form of FDI. Investment
expenditure by the non-government sector rose from barely 6 percent of GDP to 21 percent in
1996, with foreign investment increasing to 8 percent of GDP and 28 percent of total
investment expenditure in 1996.

FDI commitments have gradually diversified into manufacturing, but remain dominated by
construction activities (about 44 percent of total commitments). Manufacturing still represents
only about one quarter of commitments. Within manufacturing, heavy industry is dominant.
Overall, about 43 percent of commitments has gone into production of tradable goods,
including manufacturing, while production of purely non-tradables absorbed about 26 percent
of commitments. The remaining 31 percent has gone into other non-tradable activities which
are export-oriented or contribute towards improving the investment climate (notably, hotel and
communications). SOE investment has also been concentrated in heavy industry, including
cement, steel, fertilizer and in agricultural cash crops, such as rubber, coffee, and tea.
Government investment has been largely in infrastructure, transport and communications,
water management, and also industry and construction.

         Figure 3.1: FDI approvals dominated by construction and by heavy industry

                                 Others                   Heavy Industry
                                  17%                             Oil
                                                              17% and Gas
                  Construction                                      Industry
                      8%                                               5%
              Transportation-                                       Light Industry
             Post and Telecom                                            10%
                    7%                                        Hotel-Tourism
                          Office-Apartment                        12%

        Note: Cumulative through 1996
        Source: Ministry of Planning and Investment

3.1.4    Rapid growth in domestic savings and foreign savings

Vietnam's recent growth has been propelled by growth in both savings and investment but
investment growth has outstripped savings, as reflected in the widening current account
deficit. Saving increased at an impressive rate, rising from 3 percent of GDP to a peak of 17.3
percent in 1993 but has tapered off to about 16 percent in 1996. Government savings increased
as revenue performance improved but savings patterns have been driven by non-Government
savings which rose to a peak of 14.6 percent of GDP in 1993 before declining to about 10.6
percent in 1996. This increase is likely due in part to increased incomes and lower inflation,
which has helped protect real returns to savings. Nevertheless this link does not explain the
recent declining trend. One possible explanation of this recent trend is lower savings of the
SOE sector, given indications of weakening financial performance of the sector. It could also
indicate that individual savers perceive the recent rapid growth in incomes as a permanent
rather than a temporary change and have thus reduced their share of savings even as income
growth remained high.

                         Figure 3.2: Widening investment – saving gap

        20                                                           Total Investment
        15                                                           National Saving













         Source: General Statistic Office

3.2      Recent economic development

Vietnam's sound economic performance continued in 1996 and 1997. Growth was maintained
in the 8-9 percent range, both monetary and fiscal policy remained sound, and exchange rate
management became more flexible. Reforms continued, albeit at a much slower pace than
earlier in the reform program. However, there were worrying developments in the economy:
growth appeared to be slowing; foreign direct investment slowed noticeably and domestic
savings stagnated. There have been increasing problems in the banking system; and growing

evidence of deteriorating performance of SOEs. The external balance was improved but
mainly as a result of the introduction of import controls, and changes in the structure of the
financing of the current account deficit raised concerns about its medium term sustainability.
Moreover, with the recent currency and financial crises in Southeast Asia, the external
environment facing Vietnam is far less favorable. One immediate consequence of these
regional developments is that the economy has lost competitiveness as the dong has
appreciated substantially relative to several regional currencies.

3.2.1   Economic growth

Economic growth overall continued at a high level. The 1996 GDP growth was 9.3 percent,
only slightly below the rate of 1995. In 1997, GDP growth continued at a high level, but
slowing to the range of 8.8 percent.

                            Table 3.2. GDP growth rates (percent)

                          Item                         1995         1996        1997

        Total GDP                                       9.5          9.3         8.8
               Agriculture, Forestry, and Fishery       5.1          4.4         4.5
               Industry                                13.9         14.4        13.2
               Services                                10.6         10.0         8.6
        Source: General Statistic Office

In agriculture, Vietnam continued to reap large production benefits from the liberalization of
rice production and marketing, continuing investment in irrigation, improvements in the
availability of critical inputs and high- yielding varieties, better extension services and
favorable weather. Sector growth averaged close to 4.5 percent in 1996 and at the same level
in 1997. Rice continued to lead agricultural growth, reaching a record level of production
(over 26 million tons) in 1996. The 1997 winter-spring harvest was at 13.3 million tons,
another record, which resulted in the first ever rice surplus in the North. The Government also
took several important steps to liberalize the rice trade in early 1997.

Agricultural growth was also spurred by high growth of other food crops and industrial crops:
other food crops, such as maize and peanuts, grew by over eight percent in 1996 ; coffee
production registered double-digit increase in both 1996 and 1997 (16 percent in 1996 and 21
percent in 1995) while rubber production recovered from weak performance in previous years,
growing by about 19 percent in 1996. Marine products also continued to represent an
increasing share of agriculture, as fisheries, particularly agriculture, recovered from two years
of debilitating disease incidence. The strong performance of non-traditional agriculture
reflects the Government's increasing emphasis on agricultural diversification.

Industry continued to lead growth. Nevertheless during the first nine months of 1997,
industrial output growth slowed to about 13 percent year-on- year from 13.5 percent in the
same period of 1996. Growth in the sector (outside of construction) was driven mainly by
foreign- invested enterprises, which grew at about 20 percent while growth of both the state

and domestic non-state sectors slowed from about 13 percent in 1996 to about 10 percent in
1997. The slowdown in the growth of state sector output illustrated the difficulties that many
SOEs face due to over - employment, inefficient production technologies and in many cases,
unskilled labor and management. The private sector continued to be dominated by small
household enterprises, reflecting to a large extent Government restrictions on entry and
expansion. Activities in construction slowed sharply in 1996 and further in 1997, reflecting the
downturn in hotel, office and apartment construction and the slump in real estate prices that
surface first in Ho Chi Minh City during 1996.

Services continued to grow in line with aggregate GDP. The most important trend within the
sector was the slow down in the banking and insurance sub-sector which grew only 6 percent
in 1996, after very rapid growth in the previous two years (23 percent in 1994 and about 28
percent in 1995). This reflected both the small number of new financial institutions after very
rapid growth and the slowing of economic growth, especially in real estate. There were also
worrying developments in the banking sector: several joint stock banks experienced liquidity
and asset quality problems and were unable to meet their letters of credit obligations timely.
The implementation of stricter loan loss classification standards in 1997 also revealed a large
and growing level of non-performing loans.

3.2.2   Foreign investment and domestic savings.

Investment, especially foreign direct investment (FDI), has provided a major impetus to
economic growth over the past several years. But, beginning in 1996, there were some
indications that the interest of foreign investors in Vietnam might be waning. FDI approvals in
1996 were US$ 8.6 billion - the highest level ever - but this was achieved only by the approval
of two mega- land development projects at the end of December, totaling over US$ 3 billion.
One of these two projects has already been suspended. Without these two projects, FDI
approvals in 1996 would have been lower than in 1995. In addition, FDI approval in the first
eight months of 1997 were only US$ 3.5 billion, 18 percent lower than in the same period in
1996. In 1996, FDI disbursements fell to US$ 1.8 billion from US$ 2.3 billion in 1995. While
in 1997 disbursements were rising again, lower-than-anticipated FDI disbursements could be
linked to the cumbersome procedures for the approval, registration and implementation of
foreign- invested projects. It could also be linked to stricter enforcement of existing foreign
exchange balancing requirements, which has restricted access to foreign exchange for imports
for several FDI ventures. The slowdown in foreign investment is a worrying trend, as foreign
investment is a key component of the Government's industrialization and modernization plans
and its financing plan.

Maintaining a high level of investment is critical to the realization of the Government's growth
targets. Attaining these growth targets while maintaining external stability requires a
significant increase in domestic savings. Savings performance compared favorably with other
countries at similar income levels and in 1996 national savings was again the largest source of
funding for investment. But savings have leveled off since 1994 due to declining non-
government savings. This decline is of concern as further improvements in Government
savings will be difficult in the near term.

3.2.3   Low inflation

Vietnam's success in maintaining low inflation continued in 1996 and 1997. Inflation was 4.5
percent at the end of 1996 and declined slightly to about 4 percent by September 1997. This
was achieved through a combination of sound fiscal and monetary policies. Exchange rate
appreciation and the strong supply response in agriculture were also important factors.

An analysis of the components of inflation over 1996 and 1997 indicates differing trends
between the food and non-food components. Food prices declined in some months, due to a
combination of production increase and the exiting impediments to the rice trade. Non-food
prices also remained low, about 5 percent on an annual basis in July 1997, but were on an
upward trend since the end of 1996. Price increases were strongest in the manufacturing and
service sub-sectors.

3.2.4   Curre nt account deficit

The trade and current account deficits widened considerably in 1996, reaching a level that
raised concerns about medium- term macroeconomic stability. In parallel, the decline in
disbursements of FDI, was only partially offset by an increase in Official Development
Assistance (ODA). With a higher inflow of short-term capital, including deferred payment
letters of credit, gross official reserves rose in nominal terms, but declined as a proportion of
imports. In early 1997, both the trade and current account deficits were lower mainly in
response to the imposition of tight controls on imports and on external borrowing as well as a
slowdown in economic activity.

                                   Table 3.3: Balance of payment
                                           (US$ million)

                                1990     1991     1992        1993     1994     1995      1996     1997

Expo rts total                  1,731    2,042     2,475       2,985    4,054    5,198    7,330     8,955

Imports total                   -1,775   -2,107   - 2,535     -3,532   -5,250   -7,543   -10,483   -10,313

Trade Balance                     -44      -65          -60     -547   -1,196   -2,345    -3,153    -1,358

Services and Transfers           -218      -69           49     -220       11      417      710      -338
Interest Payments                -238     -248         -284     -335     -221     -360     -494      -462
Official Transfers                 88       55           64      194      135      150      150       175
Others                           -118       88          269      -80       97      474    1,046       713

Current Account Balance          -262     -134          -10     -767   -1,185   -1,928    -2,443    -1,696

Capital Account Balance           122      188          656      -78      897    1,762    2,105     1,980
Disbursements                     233      109          540       54      272      443      772       695
Scheduled Amortizat ions         -279     -104         -175     -652     -547     -733     -674      -796
Amort izat ion of Debt Relief       0        0            0        0        0        0
Short Term Loans ( Net )           48       19          -41     -313      124     -184      169      -520
Direct Foreign Investment         120      165          333      832    1,048    2,236    1,838     2,601
Errors and Omissions               -2       -4         -378     -210     -121      -32       40       -57

Overall Balance                  -142       50         268    -1,056     -409     -199     -298       228

Financing                         142       50         -268    1,056      409      199      298      -228
Change in NFA (exel IM F)        -159     -276         -463      477     -292     -439     -471      -368
IMF Cred it ( Net )                 0       -6            0      -39      175       92      178       -41
Go ld Revaluation                   0        0            0        0        0        0        0
Debt Rescheduling                   0        0            0      883        0        0        0         0
Change in Arrears                 301      332          195     -266      526      546      591       181

Memorandu m Item:
Dong per US$                    5,133    9,274    11,150      10,640   10,978   11,100   11,500    12,938

Source: State Bank of Vietnam

3.2.5     Trade balance.

The trade deficit expanded to US$ 3.2 billion in 1996 (about 14 percent of GDP), considerably
larger than in 1995. Both exports and imports expanded sharply, each growing by 40 percent
in US$ terms. All key components of merchandise exports experienced growth. Light
manufactured exports doubled, increasing from US$ 1 billion in 1995 to US$ 2 billion in 1996
driven by growth in textiles and garments, and footwear. Agricultural exports (including rice)
and crude oil exports also increased sharply during 1996. Rice exports rose to 3.2 million tons,
securing Vietnam's position as one of the world's leading rice exporters. Crude oil exports
grew by 30 percent, split about equally between a rise in the price of crude oil and higher

Merchandise imports rose to over US$ 10 billion, about 45 percent of GDP. Capital and
intermediate goods imports were the fastest growing import items. Official, reported consumer
good imports grew slowly and constituted only a small proportion (about 12 percent) of total
imports. However, imports of consumer goods were probably significantly higher, due to the
smuggling of these goods through China, Cambodia and along Vietnam's long coast.

                           Table 3.4: Exports--selected commodities
                                          (US$ million)

                                              1995           1996            1997
                                                                           Jan - Jun

        Rice                                   547            855             458
        Crude Oil                             1,033          1,346            684
        Coffee                                 596            337             291

        Marine Products                        621            651             351
        Coal                                    89            115              53
        Rubber                                 193            163              90

        Tea                                     27             33             13
        Agriculture & Forestry Products       1,749          1,481             -
        Light Industrial Goods                1,143          2,099           1450

        Others                                 145            251              -

        Total Exports                         5,198          7,330           4,100

        Source: Ministry of Trade and General Customs Department.

During the first nine months of 1997, merchandise exports continued to grow rob ustly,
increasing by about 23 percent compared with the same period in 1996. Imports, in contrast,
declined by 2 percent over the same period. This might reflect a combination of the slowdown
in economic activity, excess imports of basic commodities financed through letters of credit in
1996, and most importantly, temporary bans on a number of imports (including some
consumer goods and basic commodities). But, with the lifting of some import bans in mid-
1997, imports began to rise again. Moreover, in September and October 1997, there was some
evidence that Vietnam's loss of competitiveness was beginning to effect export growth.

3.2.6   Structure of financing and foreign reverse

In 1996, the burgeoning trade deficit was only partially offset by a surplus on the service
account, leading to a current account deficit of about 11 percent of GDP – a substantial
increase from the level of 1995. The bulk of the financing of the current account deficit was
provided by FDI and ODA. But commercial and short term debt also increased. This is a
concern as Vietnam capacity to service its external debt remains weak. In aggregate, there was

a surplus on the balance of payments and gross official reserves rose by over US$ 400 million
in 1996. However, reserve growth was outstripped by import growth, leading to a slight
decline in Vietnam's reverse cover to just under nine weeks of imports by the end of 1996.

3.2.7   Debt burden reduced

During 1996 and 1997, the Government resolved its outstanding commercial debt in arrears
with its commercial bank creditors. Vietnam has made considerable progress in resolving the
large overhang of external debt inherited from the pre-reform period.

Another external debt issue which received considerable attention during 1996 and early 1997
was deferred payments letters of credit. In the first half of 1996, a large number of letters of
credit were guaranteed by commercial banks in Vietnam. The payment on some of these
letters of credit were deferred until one year after the delivery of goods. Estimates of the stock
of these letters of credit reached as high as US$ 1.5 billion in early 1997. In mid-1997, when a
large proportion of these letters of credit became due, there were reports of defaults as some of
the proceeds of the LCs had been used for non-trade purposes, such as real estate investments,
or had financed an excess of imports which could not be sold during a slowdown in economic
activity. In some cases, the commercial banks could not meet the external obligations that they
had guaranteed. While most payments have been made, this incident and the overall
weakening performance of the banking sector may have already had adverse effects on
external perceptions of Vietnam's creditworthiness. It illustrates the need to further improve
external debt monitoring, as well as the regulatory and supervisory capability of the State
Bank in order not to damage Vietnam's progress towards improving its external

3.3     Assessing Vietnam’s recent economic performance

3.3.1   Patte rn of growth: more capital intensive, more inward looking

Vietnam's recent growth, has been characterized by increasingly capital- intensive
industrialization and by growing investment in inefficient, low-return investments. Industry
has become a larger share of GDP in line with the Government's industrialization objectives.
However, it has also shifted towards import-substituting, capital- intensive production. In 1989,
Vietnam had virtually no heavy industry. Nearly half of manufacturing employment was
concentrated in two labor-intensive sectors: textiles and food processing (Ljunggren B., 1993).
The picture has changed substantially since capital- intensive industry has expanded more
rapidly than labor- intensive industry: real output of capital intensive industry (outside of oil)
grew by over 15 percent annually, outpacing labor-intensive industry which grew about 10
percent annually. Consequently the share of the former increased to about 25 percent of total
industrial output, while light industry declined to 53 percent.

 Table 3.5: Vietnamese industry shifts towards protected capital- intensive activities (percent)

            Item                   1990 1991       1992 1993 1994 1995            1990-95
  A. STRUCTURE (in percent)

  Capital intensive Industry a/      42     45      47      48     50      49        47
  Labor intensive Industry           58     55      53      52     50      51        53
  B. GROWTH (in percent)

  Total Industry                    -3.3 10.4 17.1 12.7 13.5 14.7                  13.7
  Capital intensive Industry                15.7 19.0 16.9 17.4 11.0               16.0
  o/w industry excluding oil                13.5 16.9 18.1 18.2 9.7                15.3
  Labor intensive Industry                   3.3   13.9 10.5 13.7 11.0             10.5
 Note: a. including oil, energy, metallurgy, construction material, and machinery.
 Source: General Statistic Office

This trend is a concern given that production in most of these capital- intensive import
substituting industries receives high rates of effective protection. It suggests that they are
inefficient, yield low returns to the economy, and are uncompetitive at world market prices.
The automobile industry is a case in point. These activities are carried out mainly by SOEs but
have in recent years been given an important boost with significant inflows of FDI either as
joint ventures with SOEs or as wholly owned foreign ventures. Under a less distorted
incentive regime, the profitability of production in these areas is likely to be substantially
lower and fewer resources would be drawn into them, but current high levels of protection
make them very attractive for both domestic and foreign investors. However, the returns to the
economy are low. Quite apart from the costs to the economy in terms of inefficiency of resource
use, the opportunity costs in terms of extra jobs that could have been created in labor-intensive
activities are probably considerable.

In a few labor intensive manufacturing areas notably garments, textiles and footwear, Vietnam
has achieved remarkable export success. However, the increasing focus on protected import-
substituting production is reflected in the fact that while Vietnam has made progress in
opening up its economy and in diversifying exports, manufactured exports remain a relatively
low share of total exports especially compared to other East Asian countries.

           Table 3.6: Low share of manufacturing exports in total exports (percent)

                         Country                          1996
                Vietnam                                   28.6
                China                                     85.4
                Indonesia                                 60.6
                Malaysia                                  80.5
                Philippines                               83.3
                Thailand                                  81.5
               Source: General Statistic Office and State Bank of Vietnam

3.3.2   Role of the private sector

Since its formal recognition at the beginning of the reform program, Vietnam's private sector
has grown considerably but still consists almost entirely of small family farms and household
businesses. In both agriculture and industry, growth of non-state sector output has lagged
behind growth of the state sector. In industry, domestic private sector share of output declined
to under 58 percent in 1995, from over 67 percent in 1990. Manufacturing production is
currently concentrated in SOEs while a multitude of very small firms provide the bulk of
employment. Currently in Vietnam, the domestic corporate private sector still accounts for
under one percent of GDP (Riedel,J., Chuong S. Tran, April, 1997). In 1995, there were fewer
than two thousand such firms in manufacturing, accounting for only about 8 percent of the
total registered capital in the sector. These trends are worrisome because de spite evidence of
its potential dynamism, Vietnam's private sector is still not playing the important role that the
Government recognizes it could play in Vietnam's economic development. In the other
successful East Asian economies, the corporate private sector consisting largely of small and
medium scale firms- and not the Government sector - has provided the backbone for
successful labor absorbing growth. In addition, the weakness of the private sector implies
there is very little avenue for the kind of competition which is needed to promote efficiency
and thus support sustained rapid growth. SOEs in particular have little incentive to improve
their performance since competition from the private sector is weak.

                     Table 3.7: Limited role of private sector in industry:
                evidence from ownership of industrial firms as of July 1, 1995

                                 Sole      Limited Joint-Stock Household     State-
                              Proprietor   Liability Companies Enterprises   Owned
                              Enterprises Companies                        Enterprises

In all branches of industry
Number                           18,243        7,346          165        800,000        6,310
Capital (Dong millions)           3,071        5,693         1,704          -          77,656

In manufacturing
Number                           5,030         1,735           41        400,000        2,777
Capital (Dong millions)           758          1,628          183           -          21,099

 Source: General Statistic Office

3.3.3   Distribution of the gains from growth

The benefits of growth are likely to be captured more by urban and relatively well off
segments of the population, with poorer groups benefiting less from growth. In other words,
they limit the "quality of growth". While reforms have provided initial improvements in living
standards, there is still an estimated 51 percent of the population living below the poverty line.
About 20 percent of the population is classified as food poor. Furthermore, rural- urban income
gaps have widened since 1990. Per capita income growth in urban areas has averaged about

8.8 percent annually between 1991 and 1995 compared to only 2.7 percent for rural areas
(World Bank, 1996). The gap between rural and urban per capita incomes has thus widened
steadily. In 1994, average rural incomes were barely one fifth of urban incomes. This growing
income inequality is in contrast to the Government's objectives of achieving greater equity and
social justice.

                         Table 3.8: Widening rural- urban income gap
               (rural GDP per capita as % of urban GDP per capita, 1990 - 1994)

                               1990         1991        1992        1993         1994
         Whole country         25           28          21          19           18
         North                 20           22          17          15           14
         South                 31           35          26          23           23
        Source: General Statistic Office

Recent events in the rice sector could further worsen rural- urban income inequalities. In spite
of the dramatic growth of rice production, there have been concerns about declining rice prices
and possible declines in rural incomes linked to the regulation of the rice market. In 1996 the
domestic and international trade in rice was subject to a myriad of formal and informal
regulations, including both severe restrictions on the domestic trade and movement of rice as
well as export quotas (International Policy Research Institute, October 1996). The costs of
this system became apparent in 1996, when rice production grew significantly. The export
quota was not expanded rapidly enough, leading to a sharp drop in domestic rice prices.
Towards the end of 1996, domestic rice prices rose closer to international levels when the
quota was finally raised.

Despite the Government's attempts to liberalize the domestic and international trade in rice in
early 1997, there are concerns that the domestic price of rice has fallen below international
prices. The adverse effect of this decline on rural incomes, may have been exacerbated by the
continuing real appreciation of the Dong. It is not clear the extent to which this adverse effect
on rural incomes has been offset by increasing incomes from other crops. Nevertheless, with
more than 80 percent of the population living in rural areas and large proportion of these
households dependent on rice (either directly or indirectly) for their livelihood, the decline in
rice prices is a worrying trend and could indicate the erosion of initial progress in rural poverty
reduction, and a further widening of the rural- urban income gap.

3.3.4   Sustainability of stabilization gains at risk

Vietnam's successful stabilization effort has been an important factor in achieving and
sustaining rapid economic growth, but recent developments point to potential threats to
stabilization gains. As indicated above, the Government's fiscal position has strengthened
considerably since the beginning of the reform program. Steps taken early in the program to
harden budget constraints and rationalize the SOE sector indicate that the consolidated fiscal
balance also improved in the initial years of the reform program.

However, there was increasing evidence that the financial performance of the state enterprise
sector was deteriorating. Budget revenues from state enterprises had declined as a percentage
of GDP, from over 12 percent in 1994 to about 8.5 percent in 1997. Moreover, in 1996 more
than 80 percent of budget revenues from state enterprises were derived from only a small
minority of enterprises, indicating that the vast majority of them might be loss making. Further
evidence was provided by recent Government announcements of increased financial support to
state enterprises, including eliminating collateral requirements for SOE borrowing from the
banking system. Data from the banking system also indicated an increase in overdues from
SOE clients and defaults by a number of SOEs on their letter of credit obligations. A sharps
deterioration in the economic performance of state enterprises would pose considerable
difficulties for macroeconomic stability, as revenues from SOEs still constituted 40 percent of
budget revenues and SOEs accounted for about 50 percent of domestic credit.

There were also concerns about the sustainability of Vietnam's external bala nce, as the current
account deficit reached over 11 percent of GDP in 1996 (excluding smuggled imports which
could be significant). There were important reasons for concern. First, the incentive regime
under which resources, including foreign savings, were being allocated was distorted. While
the widening deficit had resulted largely from an expansion in imports of intermediate goods
and capital equipment and had been financed by foreign investment inflows, existing
distortions in the trade regime had drawn a substantial part of FDI resources into industrial
sub-sectors enjoying very high effective rates of protection. There was a danger, therefore, that
these investments could be inefficient and uncompetitive at world market prices. In addition, a
substantial part of FDI flows had also gone into non-tradable activities. Both of these trends
could jeopardize Vietnam's ability to achieve the productivity gains necessary to sustain a high
rate of growth.

Second, trends in the structure of financing posed risks for sustainability. For much of the
period, as noted above, the large current account deficit had been financed almost exclusively
by foreign direct investment and official development assistance. Hence, the deficit has been
financed without an excessive buildup of explicit government or government-guaranteed
foreign debt. Much of the debt on FDI ventures has come from parent companies or other
foreign entities at generally favorable terms, with maturity exceeding seven years add interest
rates less than one percentage point over LIBOR. However, more recent trends were cause for
concern. FDI disbursements in 1996 were significantly lower than in 1995. Concurrent with
the slowdown in FDI disbursements and the widening current account deficit, there was
evidence that short-term debt, including deferred letters of credit, might have played a
relatively larger role in financing Vietnam's current account deficit. Given that Vietnam still
has a large overhang of external debt and its repayment capacity is still weak, financing a large
current account deficit through short term or non-concessional debt could harm Vietnam's
hard-won gains in re-establishing creditworthiness.

Finally, even though Vietnam has not had to finance its deficit by international reserves,
changes in official reserves during 1996 did not keep pace with the rapid growth of imports.
As a result, Vietnam's reserve cover dropped to just under 9 weeks of merchandise imports by
the end of 1996 which is low by international standards and leaves Viet nam extremely
vulnerable to external shocks.

The Government had recognized the unsustainability of such a large current account deficit. It
had tried to tackle the widening imbalance through a combination of measures involving
tighter controls on external borrowing by state enterprises and state banks, more aggressive
enforcement of foreign exchange balancing requirements in the foreign investment law and
import bans. These measures would at best have only temporary beneficial effects, and over
the longer term, would increase existing distortions in the incentive regime.

3.4     Inte rnal weaknesses

3.4.1   Inefficient state enterprise sector.

Although the contribution of the State enterprise sector to GDP is still significant and has been
growing faster than the private sector, a closer analysis of the evidence however reveals that
the picture may not be as rosy. The recent rapid growth in SOE output in the national accounts
data is driven by increased output of FDI joint ventures with SOES, which is counted as part
of state sector output. If production under FDI joint ventures with SOEs were netted out, the
output performance of the SOE sector would not look as strong. In 1996 for example, gross
output in the foreign- invested manufacturing sector grew by close to 30 percent while output
of the SOE sector alone (i.e. excluding joint ventures) grew by much less - barely 12 percent.
In addition, data available on enterprise contributions to the budget shows that about 80
percent of contributions is provided by only 360 enterprises (out of a total of about 6,000).

                        Table 3.9: SOE sector: selected indicators

        ITEM            1987 1988     1989 1990 1991 1992            1993 1994 1995 1996

  SOE growth rate       5.9    7.3    4.6      3.0    11.5   11.7    11.9   13.5   12.7     -
  SOE share in :
  GDP (%)               35.8   32.5   33.2     32.9   34.1   36.2    40.8   41.3   42.3   42.9
  Domestic Credit       70.7   64.9   53.7     53.3   64.7   72.6    57.3   53.9   51.2   48.5
  Total Investment        -     -      -        -      -      -       -      -      -     20.0
  Budget Revenues         -     -     57.6     58.8   89.8   56.7    49.9   48.8   41.1   41.4

  Total Employment      9.7    9.5    8.7      6.9    5.9    5.4     5.2    5.0    5.2     5.2
  (workers, million )

 Source: General Statistic Office and Ministry of Finance.

There are even more disturbing trends regarding recent SOE performance. First the
indebtedness of the sector is high and grew by over 13 percent in 1996. SOE overdues to the
banking sector has risen and their exposure to foreign currency risk is high. SOEs are also
suffering from production inefficiencies stemming from overemployment, inefficient
production technologies and unskilled labor and management. Inefficiencies in rice marketing
are particularly striking. Increasing Government efforts to replace direct subsidies, which have

been largely eliminated with other forms of indirect support, in particular soft credit, would
also suggest that the financial performance of the sector is not strong. In 1995, the
Government created a National Investment Fund to provide preferential credits for selected
sectors and disadvantaged regions. While in theory both private sector firms and SOEs can
qualify for loans from this fund, in practice, loans have gone almost exclusively (close to 90
percent of the total volume of loans) to SOES. The fund currently has close to 600 billion
dong in capital. Credits are extended at an interest rate of 0.81 percent a month for priority
industries and 0.7 percent for disadvantaged areas (compared to "market" rates of about one
percent per month). While the size of the fund is relatively small and is intended to be phased
out by 2000, it still represents an unfair advantage state enterprises have over the private
sector. It is also not clear that loans will be adequately assessed before being granted. The
Government has justified the creation of this Fund on the basis of a scarcity of medium to
longer-term credit. Empirical evidence shows however that while increased availability of
long term finance enhances productivity among manufacturing firms, this result is reversed in
case such credit is subsidized.

An indication of the weakening in SOE financial performance in 1997 was the approval by the
Minister of Finance in July that working capital to SOEs was supplemented in the last half of
the year. Moreover, the State Bank of Vietnam has issued several other directives to the State
Owned Commercial Banks aimed at improving the availability of credit to SOEs. In particular,
SOEs are not required to have collateral when borrowing from State Owned Commercial
Banks. In addition, even loss- making SOEs can access funds upon submission of a sound
operational plan (it is not clear how or by whom assessment of soundness will be carried out).
Although direct subsidies have been largely eliminated, these recent measures constitute a
reversal of earlier efforts to subject SOEs to hard budget co nstraints, further tilts access to
credit in favor of the SOE sector and distorts the allocation of financial resources.

The financial performance of SOEs is deteriorating, despite the fact that Vietnam's SOE sector
still enjoys considerable advantages over the private sector. As discussed above, there are
increasing efforts by Government to provide easier access to credit for SOES. SOEs also have
significant greater advantages over the private sector in their access to land. An important
stated objective of the new land law issued in 1993 was to reduce the advantage enjoyed by
state enterprises by requiring the transformation of their long-term land use rights into rental
land use rights. However, the new regulations do not alter the existing land distribution: the
SOE sector has a substantial advantage over private firms in the form of more favorable initial
land allocation. SOEs are estimated to control over 2 million hectares of land. No effective
legal system now exists for the private sector to gain access to this land unless it is approved
by the Government. SOEs with large amounts of land use rights are also able to use their land
as capital contribution to joint ventures with FDI and thus earn "rents."

Complicated business registration procedures and tough entry requirements also imply
significant barriers to entry for new private sector firms. Prospective businesses must obtain
three separate licenses before they begin operation. Application for these licenses requires the
preparation of detailed business plans which are reviewed by provincial and in many cases by
central government officials. Granting of the licenses is usually made subject to the absence of
a state enterprise in that proposed sector and location of activity. Furthermore, lice nses are

issued to cover very narrowly areas of activity. These advantages enjoyed by SOEs imply that
they face very little competition and therefore have little incentive to become efficient.

Aside from the direct implications for private sector growth, there are other important risks
associated with not pushing ahead on SOE reform. The financial performance of enterprises is
likely to worsen unless they are made more competitive. This will weaken the consolidated
public sector fiscal position, which is in turn likely to spill over to the Government fiscal
deficit as Government support to financially strapped enterprises increases or as SOE revenues
to the budget are eroded. State Owned Commercial Banks financial performance may also be
compromised as they are forced to finance SOE losses. This could lead to inflationary
pressure, to appreciation of the real exchange rate and reduced competitiveness. Banking
sector development could be hampered and financial crises could emerge.

3.4.2   Bias trade regime

Trade reforms have increased the openness and outward orientation of the economy and have
succeeded in securing new markets for trade while drawing in unprecedented levels of
external capital inflows. However, certain features of the pre-reform trade regime remain and
in many areas, trade liberalization has been achieved through selective relaxation rather than
through removal or dismantling of trade regulations. Recently, the Government has resorted to
increasing use of instruments of managed trade notably import bans. This recent trend, and the
fact that there is considerable scope for discretion in the interpretation and application of
existing rules, suggest that reforms so far are fragile. To succeed in sustaining recent rapid
export growth, remaining trade distortions stemming from the current tariff structure, from
controls on entry into international trading and from controls on the volume of trade need to be
dealt with. Above all, implementation of reform measures need to be consistent and
transparent in order to provide a credible policy environment. Trade taxation.

Despite important improvements, Vietnam's tariff policy discourages the import of consumer
goods and encourages the import of intermediate and investment goods. At the same time, it
provides significant effective rates of protection for specific intermediate and investment
goods industries.

There are several adverse effects of Vietnam's current tariff policy. First, high protection of
import substitution is drawing resources into inefficient capital- intensive activities. This could
constrain export growth and development in the longer run as import substitution activities
bring more profits than export activities. Moreover, input costs for exporters rise either
because they are forced to use higher priced domestically produced inputs, or because they
have to pay significantly more than world prices for imported inputs. This makes Vietnamese
exporters less competitive even in areas of activity where Vietnam should normally be able to
compete strongly on world markets. This impact is likely to be exacerbated by the heavy
dependence of Vietnamese exports on imported inputs, such as petroleum products, cotton and
fabrics, steel, etc.

                                              27 Controls on entry.

Currently, enterprises cannot engage in export or import activity unless they have been granted
a license from the Ministry of Trade certifying them as competent to undertake international
trading activity. Trade licenses also specify the commodities that the enterprise can trade. For
enterprises that are producers, as of late-1996, import-export licenses are granted that allows
them to export directly and import equipment specific to the production of their export
commodities. Enterprises that are only engaged in trading, are granted business and trade
licenses that indicate the categories of goods they may trade. Guidelines have been provided
for interpreting what commodities are covered under these categories but detailed
interpretation could vary from one official to another.

The requirement that enterprises not owned by central government agencies must have the
license of the Ministry of Trade in their area of establishment imply a formidable barrier to
entry, particularly by the private sector. This is evidenced by the fact that such trading is
dominated by state enterprises. Several enterprises engaged in domestic wholesale and retail
trade or service activity, have to import goods through these licensed enterprises for a fee of
about 1-2 percent of the consignment. This suggests monopoly rents are being made by
enterprises with trade licenses and represents another distortion that may be helping keep state
enterprises afloat. Controls on trade volumes.

Trade in specific commodities is still regulated through bans, quantitative limits and
authorization or approval by specialized agencies. A small number of goods are banned from
export reflecting security and cultural objectives. The list of banned imports appears to change
from year to year. In May 1997, imports of a few items were temporarily banned. In addition,
tourism automobiles and motor bikes were banned for the whole of 1997, apparently to
encourage local production of these goods. Imports of some key producer goods are also
subject to controls for the purpose of balancing the economy. For these products, the Ministry
of Trade, in consultation with the Ministry of Planning and relevant line ministries develop a
plan based on assessments of likely demand and local production. A global quota target for
imports is announced, the rights for which is then allocated to selected enterprises (again
mostly state enterprises). Until 1997, the number of commodities managed this way
progressively declined. In 1996, only imports of petroleum products, fertilizer, cement, sugar
and steel were managed this way. In 1997 however, two additional goods, construction paper
and glass, were added again to this list. Imports of sugar have also been banned as imports of
certain types of steel on the grounds that local production is sufficient to satisfy demand.
Quotas have also been set on imports of some other steel products.

This system of growing quantitative restrictions on imports is problematic for several reasons:
(i) it sends the signal to producers and potential producers of these goods that they have a
guaranteed market regardless of price or quality thus supporting continued operation of
inefficient activity; (ii) local producers will be forced to use higher cost domestic production
thus eroding their competitiveness; (iii) there is significant scope for individual discretion in
applying the rules since the restrictions do not identify the commodities in terms of tariff
nomenclature; and (iv) quotas tend to be allocated largely to the local producers of the same

goods, rather than to independent traders, thus reinforcing their oligopolistic positions. For
example in 1997, 40 percent of the total quota of steel was allocated to the Steel Corporation
alone. In the case of cement in particular, imports of clinker (main material input) are also
subject to quota thus constraining the scope of competition among domestic producers. The
import restrictions and the allocation of quota to producers serve to reinforce their local
monopolies while increase the expense of users.

Quotas are also used to manage imports of passenger motor vehicles, motorcycles and of kits
for assembly. The inefficiencies created by import controls is evident in the high costs of
local production of goods. Glaring examples are sugar and motor vehicle assembly. In both
cases, consumers bear the costs through higher prices while inefficient production is rewarded.
There is also the more fundamental loss to the economy in terms of misused resources.
Certain specialized agencies are responsible for identifying classes of goods which require
certification before they can be traded internationally, and for approving applications to trade
in these categories. It is not clear the degree to which this process acts as a barrier to trade but
they may serve to preserve the privileged positio n of state-owned traders.

Export quotas are applied for rice as well as for the export of textiles and garments to the EU,
Canada and Norway. Rice export quotas reflect Government concerns about food security.
The quota is allocated to selected traders twice during the year. The regulation of rice exports
means some export revenues are forgone. Moreover, the allocating of quota entitlements to a
restricted number of trading companies probably shifts revenue away from producers to
exporters, thus contributing to rural/urban income disparities. Moreover, in the wake of
bumper crops of rice, export quotas have contributed to depressed rice prices and falling rural
incomes. Exports of textiles and garments are determined tinder bilateral agreements with the
relevant partners. The allocation of these quotas is also not market determined.

3.4.3   Financial system

The financial sector in Vietnam consists essentially of the banking sector. Earlier reforms in
1988 set up a two-tier system by separating commercial banking from central banking and
creating four State Owned Commercial Banks and the State Bank of Vietnam as the central
bank. In 1990, the forced sectoral specialization of State Owned Commercial Banks was
removed and entry into the banking system was liberalized. At the end of 1996, aside form the
State Owned Commercial Banks, Vietnam's financial sector had expanded to include 52 joint-
stock banks (shareholders are private entitles, state-owned enterprises and state-owned
commercial banks), 23 branches of foreign banks, four joint- venture banks, 62 representative
offices of foreign banks, 68 credit cooperatives, two finance companies and one government-
owned insurance company. There were also close to 900 people's credit funds operating in the
system. Recent reforms include (i) the rationalization of the structure of interest rates in 1995-
96, (ii) the unification of reserve requirements across institutions and across deposit types, (iii)
the cessation of concessionary refinancing for state-owned commercial banks and (iv) the
establishment of a unified refinancing rate. In addition, the Government took initial steps in
1995 to develop money markets by introducing T-bill auctions and an interbank deposit and
foreign exchange market. In 1995, the turnover tax on banks' intermediation activity was

Despite this progress, Vietnam's financial sector remains relatively shallow compared to
countries with similar levels of per capita income. The ratio of broad money to GDP amounts
to only 25 percent and bank credit to the economy to only 19 percent of GDP. While the
interest rate policies pursued by the State Bank of Vietnam have largely been in line with
achieving financial deepening, it appears that other factors have blocked intermediation.
Among them are low public confidence, restrictions on withdrawals from foreign currency
deposits, restrictions on foreign and joint venture bank deposit mobilization and deficient
infrastructure. In addition to the low financial depth, the sector suffers from a low level o f
competition which is hampering efficient resource allocation. Despite the recent entry of a
large number of banks, the system continues to be dominated by state-owned commercial
banks which account for almost 75 percent of total banking system assets with the remaining
system assets being held by branches of foreign banks, joint-stock banks (their share of
banking system assets amount to ten percent each) and joint venture banks.

Finally, the system appears to be financially fragile. First, bank overd ues appear to have risen
quite substantially since the end of 1995, after having declined steadily from 1992. At the end
of June 1997, banks classified about 15.4 percent of total loans as overdue. The increase in
loan overdue ratio partly reflects the implementation of stricter loan classification standards at
the beginning of 1997 and is therefore partly a one time stock adjustment. But, overdues rose
between March 1997 and June 1997 indicating that there is an ongoing deterioration in the
quality of bank portfolios. The current level of overdues is worrisome as they indicate a large
amount of non-performing loans in the economy. Loan losses could wipe out over 50 percent
of the system's total capital, even under the extremely optimistic assumption that banks
recover 50 percent on their non-performing loans. The picture is even worse for the State
Owned Commercial Banks. With an overdue ratio of 16.4 percent of total loans which is
equivalent to over 180 percent of their capital, up to 90 percent of their capital could be wiped
out even under similar optimistic loan recovery assumption. The high level of overdues
coupled with a weak capital base leave the State Owned Commercial Banks highly vulnerable
to a slowdown in economic growth or to adverse economic shocks.

Furthermore, the means by which the Government has sought to address the problem of rising
overdues may have the effect of hiding and aggravating the worsening situation. Banks are
now permitted to extend the maturity of past due loans virtually indefinitely. The majority of
loans in Vietnam are short term. This recent move mitigates any positive impact on increased
transparency that the new loan classification rules could provide. In addition, banks are likely
to be further adversely impacted as they are now permitted to lend to SOEs unsecured and are
facing significant foreign exchange exposure.

              Table 3.10: Weakening performance of Vietnam's financial system
                                (end of period, percentage)

                                    1990    1991   1992    1993    1994    1995    1996    1997

  Total Banking System
  Total Overdues/Capital                            88.1    95.5   85.0    61.9    75.7    112.3
  Total Overdues/ Total Loans                       13.7    11.1    6.0     7.8     9.3     15.4
  Total Overdues/Total Assets                        6.0     6.6    5.5     4.4     5.5      8.9
  Total Capital/Total Assets         6.8     7.4     6.8     6.9    6.9     7.1     7.2      7.9

  State Owned Commercial Banks
  Total Overdues/Capital            48.8   106.7   109.0   125.6   121.0   105.5   128.4   181.4
  Total Overdues/ Total Loans        8.6    19.7    13.7    11.6    10.2    8.9     11.0    16.4
  Total Overdues/Total Assets        3.3     7.0     7.0     6.9     6.3    5.2      6.4    13.0
  Total Capital/Total Assets         6.8     6.6     6.6     5.5     5.0    4.9      5.0     7.2

 Source: State Bank of Vietnam.

Defaults on letters of credit and payment delays by several smaller joint stock banks and by
the government-owned VietcomBank raise further concerns-about the soundness of the sector
and has adversely affected the confidence of the international banking community. The
financial fragility of the banking system can be attributed to a variety of factors: an inadequate
regulatory and supervisory system, including inadequate loan classification rules, and the
absence of loan loss provisioning rules; weak disclosure rules; inadequate resources to assess
and monitor credit risk coupled with inadequate risk management systems; and weak bank
management. In addition, rapid credit growth during the last six years has put further strain on
the weak credit risk assessment and monitoring skills.

Recent events in neighboring countries (Thailand and the Philippines) also indicate another
cause for concern. Against the background of a stable exchange rate and a large differential
between loans denominated in domestic and foreign currency, borrowers tend to engage in
interest rate arbitrage and take out loans denominated in foreign currency. If borrowers do not
have a natural hedge against such risk (as exporters) and they do not hedge their open
positions they become exposed to foreign currency risk. For example, the recent depreciation
of the baht severely hurt the repayment capacity of banks' borrowers and in turn adversely
affected the loan portfolio of financial institutions. In Vietnam, the stable Dong has made
foreign currency loans that carry much lower interest rates very attractive to domestic
borrowers. As a result, 34 percent of total credit is extended in foreign currency. State
enterprise exposure to foreign currency risk is even higher as about 50 percent of their loans
are denominated in foreign currency. The resulting high indirect exposure of 'the banking
system to foreign currency risk is disturbing since hedging instruments are not available for
borrowers and foreign currency loans are limited to import activities.

3.4.4   Rural sector Public investment - biased against agriculture.

Government investment in agriculture does not match the sector's contribution to the national
economy nor its ability to generate employment. While agriculture employs three-quarters of
Vietnam's workers and contributes over one-quarter of GDP, it receives only 7.5 percent of
total public investment.

Moreover, most public investment in agriculture is inefficient, as it is overwhelmingly
concentrated in SOEs. Three-quarters of Vietnam's SOEs are in agriculture, forestry, and agro-
processing. The rural SOE sector makes a small contribution to employment but has a big
claim over public sector resources. Nearly half the total investment made in agriculture goes to
4.500 SOEs. Government plans for investment in agricultural SOEs, that employ about 1.5
million workers, call for more than $3 billion between 1996 and 2000, more than twice the
amount planned for Vietnam's 10 million farm household.

Government support to non-SOE agriculture has been meager, less than 10 percent of its
support to SOEs in the sector. Furthermore, two-thirds of rural, non-SOE public expenditure is
spent on irrigation rehabilitation and flood control infrastructure rather than for infrastructure
modernization. FDI in agriculture has also been minimal. Only 7 percent of FDI is expected to
go into agriculture. This is largely due to the regulatory barriers to forming new enterprises
and the inability of foreign investors to access land and local credit without being involved in
a joint venture with an SOE, which is often not an attractive proposition. Inadequate financing for private farm and non-farm enterprises in rural areas.

A central impediment to growing rural employment is lack of market-priced credit for farmer
and small-and medium-sized private enterprises (SMEs). Small entrepreneurs are starved of
capital. While only 12-15 percent of rural private enterprises have bank loans, three-quarters
say they would like to borrow capital. These enterprises either remain without capital or are
forced to borrow short term at high interest rates from private money lenders or from relatives.
At least 50 percent of rural households are not served by the formal rural credit system. In the
country as a whole, less than 10 percent of available credit goes to the rural private sector.

                              Figure 3.3: Distribution of rural credit

                     Construction     10%
              Rural Industry


       Sources: Rising to the challenge – Economic report of the World Bank
       Consultative Group for Vietnam, December, 1998.

The credit system serves rural industry badly as Figure 3.3 demonstrates. Part of the problem
is the inability to apply use-rights to non- farm land as collateral, which prevents rural
entrepreneurs from securing bank loans, plus the fact that foreign investors are prohibited from
holding equity in private firms.

Subsidized credit to SOEs creates a vicious cycle in the banking system: when credit is
subsidized, there is a strong tendency to try to hold down interest rates on deposits, too. This
depresses the amount of savings in the banking system as a whole, reducing the total amount
of credit available for rural lending. Controls prevent banks from applying interest rates that
cover the costs of funds, operating costs and risk. Ultimately, bank losses are underwritten by
the Government, which then has fewer funds to devote to productive rural enterprise. With
available credit constrained by the economic downturn, it is likely that even less will be
available for the rural private sector given the continued preference for financing the state

                                         Chapter 4

4.1    Spillover effects

The regional economic crisis, and its repercussions in marke ts throughout the world, is having
a profound impact on Vietnam’s economy. The country also faces increased competitiveness
from its neighbors, an erosion of foreign investment as the environment is seen by investors as
increasingly hostile. These factors exacerbate other external and internal weaknesses,
compounding the problems Vietnam faces today.

In the short run, Vietnam will be adversely affected by shrinking world demand for its goods
and reduced availability of investment funds. The Institute for I nternational Finance has
calculated that net private international investment available to Asia-Pacific countries in 1998
was only $19.4 billion, down from $59.7 in 1997, and $161.0 billion in 1996. They forecast
that only $23.4 billion will be available in 1999. Even if Vietnam manages to maintain its pre-
crisis share of these funds, which will be very difficult without major structural reforms, this
will leave a large hole in its external financing needs.

Since Vietnam’s trade and other economic links are overwhelmingly with its East Asian
neighbors, lower growth of regional GDP and import volume makes Vietnam highly
vulnerable. Japan faces a two-year contraction in GDP and imports (Table 4.1). East Asia
(excluding China) will take three years to reach two-thirds of its import growth rate of earlier
years. China’s imports will probably grow at a fraction of their growth in previous years. Only
U.S and European GDP and imports are projected to grow robustly, near earlier rates. Lack of
MFN access to the American market, which at least until now has been the most resilient and
dynamic part of the world economy, is especially costly for Vietnam at this time. In more
general terms, Vietnam's non- membership in the WTO will continue to restrict its trade
options to a much greater extent than most of its ASEAN neighbors, and hence make it a less
attractive investment location.

              Table 4.1: Projected import volume growth of trading partners (%)

              Partners              1991-1997      1998      1999      2000       2001
  USA                                   7.7        11.0       8.7       5.2        5.5
  Europe                                3.7         7.1       6.4       5.2        5.6
  Japan                                 6.3         -7.5     -0.8       4.0        6.0
  Southeast and East Asia              12.7        -11.3      4.3       8.2        9.0
  (exc. China and Japan)
  China                                15.1        3.0       6.0        6.0       6.0
  Weighted import volume growth        10.5        -7.1      4.2        7.1       7.0
  of Vietnam’s trading partners
 Source: Development Prospect Group, World Bank, October 1998.

At the same time as Vietnam’s markets and sources of investment funds are shrinking, there is
increasing competition from Asean neighbors who have already begun to make significant
adjustments in response to the economic crisis. In the short run, the main effect is through the
competitive advantage arising from these countries' recent devaluation.

A longer run, and much more important, competitive effect will arise from the far-reaching
structural adjustments being undertaken in neighboring countries. Vietnam's neighbors had
already undertaken major liberalization and deregulation programs over the past decade and a
half. These programs have had a major beneficial impact on their industrial competitiveness.
The crisis, together with associated political changes, have provided an opportunity to
overcome the influence of many of these vested interests and to make new progress in
structural and deregulatory reform. Countries that are successful in these reforms will have a
major competitive advantage in the future over those that do not. This will pose a new and
very important policy challenge to Vietnam, which had already been lagging significantly
behind its neighbors in regulatory reform.

As a result of this legacy of past controls, Vietnam has one of the least transparent and highest
cost economies in the region. This has steadily reduced its attractiveness to investors, and has
seriously distorted investments which have been made by guiding them into capital intensive
and uncompetitive upstream sectors, and "strategic" sectors already burdened by large excess
capacity. As a result of the crisis, investors have become much more risk averse and less
tolerant of high cost and non-transparent policy regimes. Without a serious renewal of
economic reforms, Vietnam will fall much further behind its ASEAN neighbors.

In addition, the economic crisis in the region and in the world has manifested itself in a
collapse in confidence. Once confidence is lost, it is difficult to restore. Not only have
investors lost a great deal of confidence in Asia, but also their expectations and demands have
suddenly increased. Problems that used to be tolerated in times of rapid growth are no longer
felt to be tolerable. This applies especially to complex, uncertain and non-transparent policy
environments. As a result, policy reforms are necessary now, not simply to reduce costs and
improve efficiency, but also as a signal to restore confidence in a country's markets and among
potential investors.

4.2     Vietnam’s vulnerabilities

4.2.1   Slowdown in GDP growth.

In 1998, for the first time, Vietnam government had to revise annual growth targets to more
realistic figures, as concern mounts over the current economic slump. All three drivers of the
economy have suffered: export, representing two- fifth of GDP and growing in the past at 25
percent on average, are now not growing at all; investment, representing more than a quarter
of GDP, is actually falling and agricultural growth is down to 2.5 percent, due mainly to
drought, compared to growth of 4.5 percent last year.

                               Table 4.2. GDP growth rates (percent)

        Item                                         1991-1996         1997   1998

        Total GDP                                        8.4            8.8     6
               Agriculture, Forestry, and Fishery        4.4            4.5    2.5
               Industry                                 12.8           13.2    8.0
               Services                                  9.0            8.6    3.0

        Source: General Statistic Office

Overall domestic demand growth is down, as evident from falling retails sales and rising
vacancies in office and residential space, and service sector growth has been reduced as trade
related services, tourism and real estate have slumped. Demand for construction work and
construction materials have fallen because of the large decline in foreign investment.
Smuggled imports from neighbors, made cheap by devaluation and excess capacity in those
countries, are displacing sales of domestically-produced goods. The large fall in growth of
domestic and export demand was reflected in lower growth in industrial and service sector

4.2.2   Exchange rate and competitiveness

The effects of the regional crisis have also made Vietnam less competitive, for two reasons.
First, there have been substantial currency devaluation in the crisis countries. Indonesia’s
exchange rate depreciated by nearly 80 percent (see Table 4.3), while of the Philippines,
Thailand, Malaysia and South Korea depreciated by around 35-40 percent. The Vietnam dong,
on the other hand, has been devalued by much less and not enough to restore competitiveness
to pre-crisis levels. Three exchange rate adjustments in July 1997, February 1998 and August
1998 devalued the dong by around 17 percent, but this was insufficient to offset the gains in
competitors’ position. In real terms, the dong’s exchange rate appreciated relative to June
1997. On a bilateral basis, vis-a-vis any individual affected country, Vietnam’s export is less

                               Table 4.3. Changes in currency prices

                 Currency              % change on Sept 1998 from June 1997

                 Indonesia                               -78
                 Korea                                   -36
                 Malaysia                                -33
                 Philippines                             -40
                 Thailand                                -39
                 Vietnam                                 -17

                Source: Rising to the Challenge - Economic report of the
                World Bank Consultative Group for Vietnam, 1998

Vietnam’s labor cost advantage has been reduced as a result of the real appreciation of the
dong. Before the crisis Vietnam’s labor cost was less than a fifth of others, except Indonesia
(see Table 4.4). Since then, the cost of unskilled and minimally-skilled labor in Indonesia has
fallen in dollar terms and may now be on par with or lower than that of Vietnam, given the
relatively large devaluation of the rupiah and ongoing deflation in Indonesia. Nevertheless,
Vietnam’s labor cost advantage vis-a-vis most other countries remains, even if it has been
somewhat diminished.

                           Table 4.4: Pre-crisis wage levels (1996)

        Country     Unskilled     Skilled     Technician      Engineer         Middle
                     labor         labor        (US$/       (US$/month)      Management
                   (US$/ day)   (US$/day)       month)                       (US$/month)

  Indonesia         2.00-3.00       6.10         250            380              560
  Malaysia             7.97        13.28         578           1,395            1,992
  Philippines       4.00-6.70    7.00-9.17     350-550        650-962        1,076-1,307
  Taiwan               37.5         51.5        1,378          1,568            2,225
  Thailand          5.12-6.13    6.61-7.28     282-560        584-749         700-1,221
  Vietnam           1.29-1.37    2.15-2.38     100-185          195              220

 Source: World Bank, Philippines: Managing Global Integration, November 1997

Second, reforms currently being implemented in crisis countries will make them more
attractive to investors and exporters than they were before. These countries are liberalizing
their legal framework for property ownership and foreign investment, eliminating tax
disincentives to restructuring and new domestic investment, as well as lowering trade barriers.
The financial sectors of such countries are being made leaner and more efficient through rapid
restructuring of banks and firms. China, though not in crisis, is also implementing a second-
round of reforms; state-owned enterprises are being liquidated and restructured in large
numbers while banks are being restructured and strengthened.

Before the crisis, businesses viewed Vietnam’s regulatory and external trade impediments as
among the worst in the region. Vietnam was placed close to the bottom in competitiveness
among 58 countries surveyed in 1997 (The Global Competitiveness Survey, 1997). The most
daunting constraints cited by firms in Vietnam related to legal regulatory trade and tax
regimes. Government regulation of firms’ activities and their discretionary application
featured most prominently. The firms did say, however, that Vietnam had certain clear
advantages in the following areas: high demand for firms’ products, low wage costs, easy
availability of labor, less instructive labor regulations, and excellent securities.

4.2.3    Stagnating exports.

Vietnam’s dependence on Asia for exports is huge and that makes the impact of the regional
recession unavoidable. East Asia (including Japan) accounted for about 70 percent of
Vietnam’s exports.

                              Figure 4.1: Export partners, 1996

                      U.S, Canada     Others
                           3%          6%                  ASEAN
                  Europe                                    27%

                               Non-ASEAN Asia

Source: General Statistic Office and Ministry of Planning and Investment

Vietnam’s export growth has fallen to around 3 percent in 1998. Low growth of both export
volume and price explain the decline. Export price experienced a sharp decline in almost all
major export commodities: 37,2% in rubber, 17% in marines, 15% in garment and footwear,
12,9% in peanut. Because supply exceeds demand in the world market, the price of crude oil
has sharply declined. Therefore, despite the increase in the quantity of crude oil exports, up
34% compared with 1997, foreign currency revenue in 1998 has actually fallen by 18% - a
loss in real terms of US$ 588 millions.

Apart from the outstanding success of rice and crude oil, output of many manufactured and
processed items have registered a steep decline. Major trading partners such as Japan and
South Korea have cut their imports of Vietnamese non-traditional exports like garments,
textiles, leather goods and marine products. East Asia and Japan’s import contraction affects
these items disproportionately since these countries constitute more than half of Vietnam’s
market for these goods.

Only exports to China, Philippines and Indonesia grew in 1998, with export growth to
Indonesia driven mainly by rice. Vietnamese exporters are striving to diversify to non-Asian
markets. Exports to Europe grew in 1997 by more than ninety percent, albeit from a low base;
and in 1998 exports are growing in excess of twenty-five percent. Exports to the U.S. are
growing at a rapid rate, too, twenty- five percent per year in both years. This geographic
diversification has helped to maintain some grow in export earnings.

4.2.4   Falling foreign investment

Foreign investment inflows have fallen by around 60 percent in 1998 and are likely to fall
further in 1999. New commitments are falling even more sharply – new licenses for foreign
investment fell from $8.5 billion in 1996, to $4.0 billion in 1997 and $1.8 billion in 1998.At
the end of 1998, the number of foreign investment projects had decreased by 29 percent while

the registered capital decreased by 49 percent. Statistics released by the Ministry of Planning
and Investment confirmed that during the first 11 months of the fiscal year 1998, Vietnam
licensed 211 new foreign invested projects with the total registered capital of 1,821 million,
compared to 479 projects with $ 4.0 billion in 1997.

                 Figure 4.2: Undisbursed FDI investment partners – end 1997

                                 U.S Others              ASEAN
                                 17%  3%

       Source: General statistic Office and Ministry of Planning and Investment

Besides the serious decline of licenses for new projects, the implementation of already
licensed projects has also slowed down. Undisbursed licensed investment stand at about $26
billion, of which about half is for real estate and tourism sectors, where demand and prices
have collapsed. About two-thirds is from East Asia and Japan, where many firms are strapped
for cash. None of this augurs well for higher foreign investment flows in the near term. Even
worse, in 1998 about $7-8 billion from licensed projects was withdrawn for a variety of
reasons including shortage of capital from foreign investors (Nguyen Tri Dung, 1998).

     Figure 4.3: FDI commitments and actual disbursement 1993 – 1998 (US $ million)

         6000                                                     Commitments
         4000                                                     Actual FDI
         3000                                                     disbursements











       Source: Ministry of Planning and Investment

The impact of the crisis is changing the nature of foreign investment flows. More than half of
the foreign investment in 1998 came from outside Asia. This reflected a sharp decline in Asian
investment. Large investors like Thailand, Malaysia and Hong Kong invested little in 1998.
Only Japan, Taiwan, Singapore and Korea continue to invest, but at lower levels than before.
Also, the sectoral composition of investment was different: much less in real estate sector.

It is noted that foreign investment in Vietnam had begun its steep decline since the end of
1996, before the Asian crisis happened. Therefore the crisis should not be blamed as the only
and main cause to the gloomy picture of Vietnam foreign investment. The local and foreign
communities agree that the country’s low competitiveness, undeveloped legal system, and
undisciplined state administrators are some of the underlying reason for the drop in foreign
investment in Vietnam.

4.2.5   Increasing unemployment

In 1998, unemployment rates in both urban centres and rural communities are at dangerous
levels, reaching almost 10 percent in some cities and 30 percent in the countryside. Especially,
in the urban areas, unemployment rate was rising for the second consecutive year. According
to a survey of the Ministry of Labor released at mid-December 1998, unemployment in major
cities has increased by 0.84 percent, reaching on average 6.85 percent, while Hanoi and
Haiphong have been particularly hard hit, registering unemployment rates of 9.09 and 8.43
percent respectively. Increased rural- to-urban migration is exacerbating the situation.
According to the Hanoi Department of Labor, while these figures were high in themselves,
they did not include the number of rural villagers who had come to Hanoi in search for job.

Contrary to Government target rates of five percent urban unemployment and 25 percent rural
underemployment by the year 2000, joblessness has become a major problem since 1996 when
unemployment rates hovered around 5.87 percent. According to Nguyen Hung, the reporter of
Vietnam Investment Review, until 1996, employment growth still kept pace with labor force
growth. In 1997, employment growth was negative for the first time since “doi moi” reforms
were initiated. Agriculture and industry shed labor with employment falling by 6.2 percent and
5.6 percent, respectively. Vietnam’s labor force is in excess of 40 million and growing by 1.2
million annually, with 30 million living in rural area.

Falling employment in industry probably reflects the high capital- intensive of production that
has been encouraged by import protection. The question in terms of generating employment is
whether policies to encourage production of labor- intensive products will be adopted.

Though service sector productivity remains low, more than half the labor shed by agriculture
and industry was absorbed by the rural service sector and another third, by the urban service
sector. Large declines in service sector growth rate will jeopardize the capacity of that sector
to absorb labor, creating more unemployment. The slowdown in services reflects, amo ng other
things, lower activity in banking given increasing difficulties in that sector, and a slowdown in
trade and real estate activities. The slowdown in hotel and tourism activity is related to
Vietnam’s decreasing attractiveness as a tourist destination relative to other countries in the

The Asian financial crisis is blamed for the heavy joblessness in many state and foreign
invested enterprises. 92,274 people in the state sector, representing eight percent of wage
earners, have lost their jobs in 1998, rising to 11 percent in foreign invested joint ventures.
Currency devaluation in neighboring countries have made them more attractive manufacturing
destinations while foreign investment, traditionally dominated by Singapore, South Korea,
Thailand and Malaysia has evaporated. Companies who shifted operations to Vietnam in
recent years, most notably textile and footwear manufactures, have announced mass layoffs
due to weakening Asian market.

4.2.6   Pressure on external and fiscal balance

The slowdown in export and foreign investment have led to pressures on Vietnam’s external
balance position. So far, however, the government has managed to avoid balance of payments
crisis by taking actions to reduce imports, and to preserve or mobilize additional foreign
exchange, albeit sometimes through very short-term measures. Hence, in 1997, the slowdown
of export growth and reduced private transfers were balanced by import contraction and high
inflows of FDI and ODA. In 1998, trade and current account balances came under pressure
due to lower export growth and FDI inflows. As a result, current account deficit has declined
from 7.6 percent of GDP in 1997 to 4.6 percent in 1998.

A closer look at Vietnam external balance performance since the onset of the crisis reveals
important reasons for concern. The approach used by the government to contain the external
balance position and avoid a balance of payments crisis has so far relied heavily on import
restrictions. While this provided a short-term solution, it is neither sustainable nor consistent
with a return to a longer-term growth, given the import content of production and the
dependence on capital and intermediate goods imports. Unless Vietnam is able to restore rapid
export growth or significantly increase domestic savings performance as an alternative for
foreign savings, it will have to continue to settle for a much lower growth path consistent with
its current much lower import capability, or resort to other sources of external financing -
largely short-term, non-concessional debt – that will certainly compromise the economy’s
ability to service its debt, eventually create a balance of payment crisis. While Vietnam
external reserves have increased to an estimated 7-9 weeks of imports, it is still insufficient to
provide a comfortable degree of cushioning against a prolonged external shock and ward off a
balance of payment crisis.

The fiscal balance is also under pressure. Revenue as a share of GDP fell in1997 and 1998
continuously. Weaker State-owned enterprises performance and lower import-tax receipts
explain most of the stagnation in revenue. The government has responded to this situation by
cutting planned current expenditures. Capital expenditures were also being cut by postponing
27 projects. Total expenditure grew only marginally in 1998 as a percentage of GDP.

4.2.7   Increasing inflation

At the end of 1998, inflation was likely to rise above ten percent in the wake of increasing
market prices and the recent seventeen percent devaluation of the dong against the dollar. The
exchange rate adjustment has had increased production costs for domestic enterprises, lifting
product prices at a time when market demand remains unchanged. According to the General

Statistical Office, in 1998, state-owned companies had suffered around US $ 111.5 million as
a result of the exchange rate adjustment.

The country’s production relies very much on imported materials and as these costs increase,
the market price of product will increase accordingly. Consumer price index has been another
economic headache over 1998. The price of consumer commodities increased by 6.86 percent
compared with December, 1997, of which food and foodstuff prices increased by 9.6 percent,
soft drink prices by 3.6 percent, education prices by 6.1 percent, healthcare prices by 6.1
percent, garment and footwear prices by 0.5 percent and household utility prices by 1.3
percent. Overall, at the end of 1998 the consumer price index increased 9.1 percent from the
same period of 1997 (Nguyen Tri Dung, September 1998).

In January 1999, statistical figures have showed a sudden increase in commodities price and
inflation has reached to double-digit number. One of the reasons for this is the implementation
of Value-Added-Tax, which came into effect since January 1. A closer look at other economic
factors, which have remained unchanged, reveals that the application of this new kind of tax
has created a psychological worry to consumers, and therefore put a pressure on commodities

4.3    Positive effects

As mentioned above, the economy of Vietnam itself contains serious weaknesses which could
lead to the unstability and threaten to put the country to the edge of a real crisis. The Asian
financial crisis, with its harder and harder pressures, has forced Vietnam to restructure its
economy. Accelerating the reform process in almost all areas of the economy is the only way
for Vietnam to be survived. This will help enhance the motives for the renovation process and
encourage efficient use of resources. By this way, Vietnam will be ab le to overcome this
difficult situation and establish a solid ground for a long-term stable and substantial

The Asian crisis has somewhat broken out the over-dependence of Vietnam foreign trade on
Asia. Although it is a big market for a majority Vietnam export commodity, Asia has proved
to be a volatile and risky market. The crisis creates opportunities for Vietnam to seek to new
markets outside the region, especially Europe and the U.S. this will help Vietnam to
compensate for the shrinking Asian import as well as to establish a multi-relation in foreign
trade, avoiding over dependence on one region. Moreover, in order to be successful in
penetrating into new markets, Vietnam has to improve the quality of its goods. This will help
to enhance the competitiveness of Vietnam’s commodity, preparing for further development in
the period after the crisis.

                                           Chapter 5
                     (SEPTEM BER 1997 - NOVEMBER 1998)

In 1998, Vietnam's reform has picked up momentum, but it is not adequate to arrest the
economic slowdown. Notable progress has occurred in some areas such as trade, banking,
state enterprise and the climate for investment. What is lacking is a sufficient degree of
consistency and synergy among these reforms. For example, registered private firms can
export or import more easily, but registration of private businesses, a prerequisite for trading,
is still as difficult as before. Equitizations are being accelerated but their efficiency- impact
will be limited if the trade regime remains protectionist.

5.1      Reforming state enterprises

An open trade regime, a "hard budget" constraint, lending decisions made on a commercial
basis, and good corporate governance are the best instruments for ensuring efficient and
competitive SOEs. Without them, scarce resources like investment, credit, and foreign
exchange are wasted. At present, however, none of these are applicable to Vietnamese state
enterprises. The import regime is geared to protecting SOEs and the banks are geared to
bailing them out.

The Government's announced strategy is limited and not sufficient to achieve the intended
results. Its recent decisions and decrees describe three responses to the situation:

     liquidate the unprofitable and non-viable SOEs;
     equitize profitable SOEs that are not classified as wholly state-owned;
     change the relationship between board of directors and management for enterprises to
      remain under majority state control.

                                  Box 5.1. State enterprise policy

-     Government issued Decree on equitization to simplify the process of equitization and allow
      limited foreign shareholding, (July 1998);
-     Issued Prime Minister's Directive No.20 to adopt alternative ways of reforming SOEs, e.g.
      divestiture outright sale, competitive bidding, etc. (April 1998):
-     Prime Minister's Decision approved a list of SOEs to be equitized (Sept. 1 998);
-     Government initiated classification of all SOEs (Sept 1998):
-     Approved Decision to create a National Enterprise Reform Committee (June 1998);
-     Announced targets for equitization of 400 and 1,000 SOEs by 1999 and 2000, respectively (Feb.

While these are moves in the right direction, they are not sufficiently comprehensive. For
example, many SOEs that are currently unprofitable may become "potentially viable" with
some restructuring. Conversely, when import protection is reduced, some currently profitable
SOEs may become non-viable; pre-emptive restructuring could help them to shed their
unprofitable parts, reschedule their debt, or alter their product-mix so as to become viable.

5.1.1   Wholly state-owned enterprises

In Vietnam, the lack of clear ownership identification of SOEs undermines corporate
governance as it leaves open the issue of who exactly should be monitoring the managers. To
a certain extent, the identification of a board of direc tors to oversee the corporation partially
addresses this issue but the difficulty in identifying owners, and specifying who will be
responsible for SOE liabilities, is typically the constraint on governance. The mixing of SOE's,
commercial and social functions, and the fact that the state is the ultimate owner and regulator
of SOEs gives rise to unclear governance objectives and conflicts of interest. At the same
time, effective corporate governance is difficult to exercise when the institutions responsible
for the management of state assets rarely receive timely, accurate, and useful information
about the financial performance of the firms they control.

Relatively few outside monitors, especially banks, exercise strong discipline on Vietnam's
wholly state-owned enterprises. This contributes to weak corporate governance. The state-
owned commercial banks are mainly agents of the state, making the owner and creditor, one
and the same. SOE mergers (or threat of takeovers) can be effective disciplining devices
against poor management. But in Vietnam up to now, most mergers and takeovers of SOEs
are engineered by the government and often do not represent commercially-driven actions.

The bottom line is that without a fundamental reorientation in governance ince ntives toward
modern commercial principles, those wholly state-owned SOEs, will either continue to be
ruled (explicitly or implicitly) by the old procedures with the resulting inefficiency, and a
corporate governance vacuum. The consequence, again, is that managers end up with de- facto
control over the enterprises. This may lead to inefficient performance of the firms, given
conditions that the firms receive financial subsidies and do not face any fierce competition.

5.1.2   Equitization

Notable progress has been achieved in equitization. In the first eleven months of 1998, over
twenty-seven SOEs were equitized, which was more than the seventeen equitizations that were
carried out over the previous three years. But that was much less than the target of 150
announced earlier of the year. Ambitious targets for the next two years have also been
announced: 400 equitizations by 1999 and 1,000 by 2000. To accelerate equitization, new
decrees and decisions were approved simplifying the process of equitization and expanding
the modalities of equitization (Prime Minister’s Directive 20/CT-TTG, April,1998 and Decree
44/CP of July, 1998). Box 5.2 highlights some of these positive changes. The classification
process has been completed in Hanoi and Ho Chi Minh City. Similar classifications are now
underway in the rest of the country.

                       Box 5.2: Key improvements in equitization process

       For all SOEs:

   Line ministries, people's committees, and general corporations have been given authority
    to select and implement equalization;
   The valuation process through centralized, now requires fewer steps;
   Proceeds from sale of locally-owned SOEs can be retained by local authorities' budgets;
   Foreign entities are permitted to buy limited shares in equitized SOEs.

       For small SOEs (assets < VND 1 billion), more options are now permitted:

   sale without conversion to joint-stock company possible;
   outright sale, divestiture, or dissolution of the entire SOE;
   use of competitive tendering to sell an SOE or shares of SOE; and
   line ministries and local authorities will have the authority to decide on which options to
    use to sell.

Source: Board of Equitization

This acceleration of equitization is prompted in part by the initial results of equitizations.
Immediate post-privatization performance of seventeen equitized SOEs has been good. On
average, sales revenue doubled and employment rose forty percent. None laid off workers.
This positive record is partly because only profitable, small SOEs, with few redundant
workers and little debt, were equitized.

               Table 5.1: Equitization outcome (average for equitized 17 SOEs)

           Equity Capital ( VND bil)                                  90.0
           Employee Shares (%)                                        46.0
           Private Shares (%)                                         20.0

           Pre-Equitization Revenue (VND bil)                         32.3
           Post-Equitization Revenue (VND bil)                        66.5

           Pre-Equitization Labor                                      232
           Post-Equitization Labor                                     322
          Source: General Statistic Office

However, the pace of equitization may be slowed by four problems. First, the preparation
process for equitization, though much simplified, still remains centralized. Too many parties
are responsible for finalizing the valuation and the potential for unrealistically high valuations
is likely. There is still a need for the development of a "business-plan", which many firms lack
the expertise to prepare. Second, the level of debt for most SOEs is high and no systematic
method of dealing with this has been formalized in decrees. Third, funds for compensation and
training of retrenched labor are not adequate. Designs of safety-net programs are being

discussed with the World Bank and other donors. Fourth, the Government has limited the
scope for private sector participation in equitizations, by restricting an individual company's
shareholding to only 20 percent of total ownership for minority Government-owned
enterprises. While the intention is to ensure more broad-based ownership, it discourages
companies which could have brought additional capital into the enterprise if they got majority
control. Strategic foreign partners in the case of some enterprises can bring in capital,
technical and managerial expertise, and access to foreign markets. They can raise profitability
and employment and thus make their shares attractive for others to buy.

5.2     Promoting private small and medium ente rprises

Though overall industrial growth has outstripped service sector growth, growth in the number
of private SMEs has been far higher in services than industry. This reflects the bias in
industrial growth in favor of capital- intensity and large size. From 1994 to 1997, trading SMEs
have tripled in number while those in construction and other services have doubled. The faster
growth of service SMEs is largely because this sector is less dominated by state enterprises
and thus experiences fewer restrictions on private participation.

Recent Government polices have gone some distance in reducing restrictions on private SMEs
though much more still remains to be done. Two such policies are worth mentioning. First,
small firms are now allowed to export directly. This will help small firms most of all as they
were least able to bear the additional transactions costs of previous restrictions. Second,
requirements to import through state enterprises, or to satisfy stipulated conditions of capital
and qualified personnel needed for being registered as an importer, have been removed.

However, private SMEs still suffer from many external and internal constraints. They are only
allowed to export or import goods that are associated with the activity for which they got their
business license. This opens the way for considerable discretion on the part of officials, and
thus delay and perhaps corruption. The transactions cost of SMEs' operations is still too high
for several reasons. The documentation requirements and the number of approvals for
"registering a private business" are many times more cumbersome and complex than
registering a cooperative. Access to land rights and use of land is more restricted for private
firms than for state enterprises. Land leases require many approvals and land-use rights
cannot be used as collateral in banks nor provided as equity in a joint venture. Of course, there
are internal constraints, too. SMEs generally have limited business experience limited capital,
limited access to market information, and weak management skills.

5.3     Reforming the banking system

5.3.1   Recapitalization of state-owned comme rcial banks (SOCBs).

Recent Government announcements which require raising the legal minimum capital for
SOCBs, but include no measures for the restructuring of SOCBs or SOEs , are worrying . New

regulations require a doubling of capital for the Agricultural Bank and tripling for the other
SOCBs. It is imperative that these higher minimum capital requirements are not implemented
until a comprehensive rehabilitation plan for relevant SOCBs is developed and implemented.
That plan would include structural measures (i.e., transferring non-commercial concessional
lending to "policy banks", writing off some "policy" loans and frozen loans from the previous
bank regime, and announcing equitization or joint venture arrangements with foreign banks) ;
and operational measures (i.e. reorganizing management, improving internal controls, and
training). Recapitalizing SOCBs without restructuring banks' objectives and operations, or
their SOE borrowers, is unlikely to work.

Recapitalizing banks without restructuring SOEs will risk another round of recapitalization in
the near future. Trade liberalization may weaken currently profitable SOEs and recapitalized
banks may be asked to keep them afloat. Any approach to restructuring SOEs must begin with
assembling information on the large problem borrowers of each SOCB. This information
should be classified into borrowers that are potentially viable and thus candidates for workout,
and those that are not. The workout on the potentially viable SOEs must be conducted on
strictly commercial lines, to ensure least-cost solution for the budget.

5.3.2   Improving the regulatory frame work.

The regulatory framework governing bank operations is weak. Proper regulation and
supervision is hampered by the lack of clearly defined standards of safe and sound banking
practices, inadequate accounting systems, and inadequately-trained inspectors. Unless better
regulations are issued, accounting systems are improved, and on-site inspection of banks is
strengthened, there will be insufficient incentives for banks to behave prudently. Restructured
and recapitalized banks will not remain healthy for long.

The State Bank is drafting new regulations to implement the Law on Credit Institutions passed
in 1997. Vietnam's current prudential regulations for loan classification, loan- loss provisioning
and capital adequacy rules are more lax than those of most countries in the region. There is an
urgent need to revise these regulations. Loan classification and loan-loss provisions must
reflect stricter time-based classification as well as promote better subjective assessment of the
loans themselves. The current capital adequacy requirement of 5 percent is too low and this
level is not even assessed on a risk-weighted basis. New rules on loan classification, loan- loss
provisioning, capital-adequacy and so on, are still being drafted.

                                       Box 5.3: Banking reform

-  Approved the Law on the State Bank of Vietnam (Nov., 1997) confirming its dominant role in
   implementing monetary policy, and in regulating credit institutions, as well as establishing
   a high- level Financial & Monetary Committee to supplement State Bank of Vietnam's advise to
   the Government on monetary policy.
- Approved Law on Credit Institutions (Nov., 1997) to be supplemented by decrees on
   prudential regulations which establishes the legal regime for all credit institutions, both banks
   and non-banks;
- Established a Bank Restructuring Committee and initiated restructuring of Joint-Stock Banks in
   HCM City.
- Issued Directive on "Special Control Regime for Banks in Trouble" to guide SBV intervention
   in troubled banks ( July 1998 ) ;
- Initiated intervention in several Joint stock Banks (Sept. 1998)
Source: The State Bank of Vietnam

5.4       Trade policy

While in 1998 the Government has taken several steps to liberalize trade thereby reducing the
cost of exporting and importing, it has not gone far enough. Box 4.4 cites the specific actions
taken. The challenge now is to implement them in a way that makes these actions meaningful.
Three problems stand in the way of such implementation. First, some of the measures still
permit a lot of discretion in their implementation. For e xample, firms are free to import and
export only those goods that are associated with the business activities for which they are
registered. Second, implementing regulations have not been issued though laws and decrees
were approved several months ago. Third, cumbersome and complex customs' processes are
making implementation of liberal rules difficult.

                                         Box 5.4: Trade policy

-     Approved legislation (May, 1998) to lower the maximum import tariff to 50% (with the
      exception of six groups) and number of tariff-rates to 15, but implementing regulations have
      yet to be issued;
-     Allowed domestic firms (Decision 55, Mar 1998) to export goods directly, requiring no export
      license, (with the following exceptions: rice, explosives, books, precious stones, antiques etc.)
      as long as export goods are within the scope of firms' line of business (Mar 1 998);
-     Removed licensing of imports of consumer goods but implementing regulations have yet to be
      issued (May, 1998);
-     Removed conditions of minimum capital ($200,000) and qualified personnel for registered
      firms to become importers, as long as imports are within scope of firms' line of business (July
-     Liberalized allocation of rice export quotas to privates sector, by allocating a part of the quotas
      to non-state firms for the first time (Jan 1998);
-     Allowed private firms to import fertilizer (Jan 1998).
Source: The Ministry of Trade

5.4.1   Protection and non-trans parency

The non-transparency of Vietnam's import regime implies higher transactions cost of
importing- and thus exporting - than in other countries. Import restrictions are applied on a
discretionary and ad hoc basis increasing business uncertainties. For instance in 1998,
temporary import bans were levied on selected goods as their inventories increased. More
recently, the authorities are increasingly using foreign exchange controls as an instrument of
import restriction. High and uncertain import protection keeps state enterprises afloat but
discourages exports of processed agriculture and light manufactures, both of which are critical
for sustaining rural growth in particular, and higher export growth in general.

High protection of capital- intensive industries makes larger profits possible for producers of
those goods. Foreign invested enterprises and state enterprises invest more in these sub-
sectors. More scarce foreign exchange is allocated to them as priority sectors but they generate
little employment for each dollar invested, and divert funds from potential export-sectors. As
long as investment rates, including foreign investment rates, were high, and as long as export
growth rates were high, the cost of such inefficiency could be tolerated. Now, with sharp
declines in available savings for investment, the cost is much greater.

Non-tariff measures provide most of the high protection. Import quotas, import licensing, and
import bans cover a significant share of imports and are the binding import restrictions. They
apply to sensitive goods such as petroleum, fertilizer, cement, sugar, glass and steel. Based on
balancing projected demand and supply of these goods, the Government attempts to ensure
that demand for output of large state enterprises is adequate. Imports of passenger cars,
motorbikes, and used machinery and equipment are restricted, and imports of cigarettes, used
consumer goods and auto parts are banned.

5.4.2   Tariff structure

The current import tariff structure in Vietnam is characterized by high and dispersed effective
rates of protection and uneven incentives. The average weight tariff is low at sixteen percent
but dispersion is high. There are currently twenty-four bands between zero and sixty percent.
Recent legislation has lowered the maximum tariff rate to fifty percent and reduced the
number of bands to fifteen, but this measure has not yet to be implemented. The already high
dispersion of tariffs is exacerbated by special surcharges of five to ten percent (depending on
import price fluctuations) on selected imports such as petroleum, iron, steel, and fertilizer.
Customs valuation for some commodities is also based on administratively determined
minimum prices, generally higher than invoice prices, which increases protection further.
Certain excises are levied only on imports, complicating the economy's protection structure. If
non-tariff restrictions were factored into estimates of protection for cement, steel, and glass,
the rates would be much higher.

5.5      Improving business environme nt

Vietnam does not yet offer an easy climate for entrepreneurs. Both domestic and foreign
businesses find that the complex and detailed nature of permit requirements, the opaque nature
of decision- making, and the prevalence of corruption are barriers to doing business. The recent
Global Competitiveness Survey found that unclear procedures, lack of public information,
bureaucratic discretion on the part of middle level officials, and long delay were the factors
which caused Vietnam to be viewed by the private sector as near last in competitiveness out of
fifty-eight countries. Similarly, Transparency International ranks Vietnam forty-third in its list
of fifty-two countries. The Government recognizes these issues and has announced that
improving the efficiency of public administration, establishing accountability among public
officials, and addressing corruption are important steps in developing a vibrant economy in
                               Box 5.5: The climate for investment

-     Amended Law on Promotion of Domestic Investment (May 1998) allowing domestic and
      international organizations, and individuals, to buy shares or to contribute capita l to domestic
      enterprises, including equitized SOEs; it also provides additional incentives for domestic
      investment (similar to those provided to foreign investors);

-     Approved new Decree on foreign investment (Feb. 98) providing additional incentives to
      foreign investors and issued implementing regulations for each sectors;

-     Government has begun private - public dialogue, to better understand constraints faced by
      private foreign investors (Feb. 1998 onwards). A "hotline" has been established to take

Source: The Ministry of Planning and Investment

                                          Chapter 6
                      OF ASIAN COUNTRIES
6.1     Prospect of the crisis

How bad the coming market meltdown gets depends on three things: Japan, China and the
regionwide debt deflation. Japan’s government holds the most important key. If Japan can
kick-start its huge economy, that could help lift the rest of the region out of recession.

6.1.1   Outlook for Japan

Economic conditions in Japan deteriorated sharply in 1997. F iscal policy was more
contractionary than initially expected. In addition, confidence was undermined by continuing
strains in the financial sector and concerns about spillover effects from the financial crisis
elsewhere in Asia. Lower confidence, in turn, put downward pressure on equity prices toward
the end of the year, weakening the capital base of the banks and reinforcing doubts about their
ability to deal with non-performing loans.

As regards the Asian crisis, Japan has been affected more than the other major industrial
countries, given Japan strong trade linkages with and large volume of lending to the region.
About 20 percent of Japan’s merchandise exports in 1996 were to the five Asian countries
most affected by financial turmoil, While about 17 percent of imports originated from these

Movements in the exchange value of the yen in recent months have been mixed. The yen
depreciated sharply against other major currencies in the latter half of 1997, reaching in early
1998 its lowest level against the dollar since early 1992. The declines against major currencies
were balanced by the rise in yen versus other Asian currencies, so that the nominal and real
effective value of the yen fell by much less.

In the financial sector, strains intensified toward the end of 1997, revealing unexpectedly large
losses. The Japan government said that $ 555 billion of loans are doubtful. The true figure
could be much more than that. Japan’s bad debt problem could amount to upwards of 25
percent of GDP. All this bad debt puts immense deflationary pressure on Japan’s economy.
The exposure of Japanese banks to Asia, in conjunction with the stagnation of the domestic
economy, also heightened concerns about future loan losses.

To address the deteriorating situation, the government has introduced a number of measures to
restore confidence in the financial system and reduce the risk of a credit crunch. They included
the provision of up to 17 trillion yen (31/2 percent of GDP) in public funds to the Deposit
Insurance Corporation to protect depositors of failed banks, and the provision of an additional
13 trillion yen in funds to the Deposit Insurance Corporation to purchase preferred shares and
subordinated debt of solvent banks. These measures boost significantly the funds available to

resolve failed institutions and protect depositors, and they have had some effect in boosting
market confidence since mid-January.

According to IMF, although sound macroeconomic policies are critical to supporting recovery
in Japan, more rapid implementation of structural reforms and further deregulation measures
are also necessary to help reinvigorate the Japanese economy.

6.1.2   China: growing economic problem

China can be destabilizing for the region. Deflationary forces are still more power ful in China
than anywhere else in Asia. There is concern that with little foreign capital coming in, the
government’s fiscal spending machine will not be powerful enough to generate the growth that
the country badly needs to keep people at work.

China has growing economic problems of its own that will sooner or later make a reminbi
devaluation tempting. The slowing of China’s economy is considered as the biggest problem
in 1999, not only for China but for the whole world.

China government is fighting back more vigorously than Japan. Credit lines are being
loosened and interest rates quickly being driven down. A boost through infrastructure
spending equal to 2 – 3 percent of GDP is also planned. But China faces serious obstacles to
any attempt to grow its way out of trouble. Exports and direct investment flows weakened
substantially in the second half of 1998. In addition, it has a bad debt problem of its own. At
least 25 to 30 percent of its bank loans are un-collectible, and China could need as much as
$270 billion – a quarter of annual GDP – to recapitalize them (Jim Rohwer, July 1998).

6.2     Long-term growth performance of the Asian countries

6.2.1   Potential strengths Macroeconomic stability

The fast-growing East Asian economies generally maintained a relatively high degree of
macroeconomic stability until recently. Fiscal and current account deficits were less than one-
half the average for other developing countries, and inflation for the most part was kept in the
single digits. In some economies (for instance, Indonesia, Taiwan and Thailand), legislation
limited the size of public sector deficits, while in other economies (for instance, Korea,
Malaysia, and Singapore) strong political support for anti- inflationary policies acted as a
constraint on fiscal policies. Also, in Hong Kong, the currency board arrangement in place
since 1983 has disciplined fiscal policy as well as constraining monetary action. Disciplined
macroeconomic policies provided a stable environment for private sector decision making and
contributed to the high rates of saving, domestic and foreign investment, and export growth
that were ingredients in the region’s growth performance.

                                             52 Human resource

Human capital formation advanced at a rapid pace, both quantitatively and qualitatively, in
almost all the rapidly growing east Asian economies. As early as 1965, primary school
enrollment rates were already higher in this region than in many other developing countries.
Hong Kong, Korea, the Philippines, and Singapore had achieved universal primary education,
and even Indonesia - a populous nation and, at the time, one of the poorest developing
countries - had a primary school enrollment rate of over 70 per-cent. In the past three decades
further significant progress was achieved. In Korea, secondary school enrollment increased
from around 35 percent in 1965 to virtually 100 percent in 1995, while Indonesia’s secondary
school enrollment rate of close to 50 percent in 1995 was higher than in other countries with
comparable levels of income. In Thailand, the secondary school enrollment rate is nearly 50
percent in 1995. Not only enrollment rates, but also the quality of education improved
significantly during the past three decades in most of the east Asian economies, as average
education expenditure per pupil rose and pupil- teacher ratios were reduced.

By raising the skill level of the workforce, education and training contribute directly to the
expansion of an economy’s productive capacity and growth potential. It is estimated that
education accounts directly for about 10–15 percent of the growth in output per worker in the
east Asian economies in the period 1960–94. Moreover, empirical evidence indicates that,
although foreign direct investment is an important vehicle for the transfer of technology to
developing countries, the productivity of foreign direct investment is higher than that of
domestic investment only when the host economy has a minimum of human capital (Jose De
Gregorio, and Jong -Wha Lee, June 1998). Domestic saving

Several factors contributed to the rapid rise in domestic saving. Perhaps most important was
the rapid pace of economic growth, which, by raising income levels above subsistence, led to
higher aggregate saving rates. Rapid growth may have helped to raise overall saving also by
increasing the incomes of the working young at fast rate. The fruits of favorable economic
policies - including a stable macroeconomic environment, especially low rates of inflation,
positive real interest rates, and a fast pace of financial deepening - are also likely to have had a
strong positive influence on saving rates. In some countries, particularly Malaysia and
Singapore, well-developed mandatory saving schemes have been in existence since the 1960s
and 1970s. Export orientations and trade openness

A key ingredient of the East Asian economies’ successful development strategy was their
export orientation. Although each of these economies, other than Hong Kong, went through an
initial import- substitution phase, they subsequently promoted exports while, in most cases,
continuing to protect domestic industries from import competition (Anne O. Krueger, March
1997). In large part, manufactured exports - initially labor- intensive manufactures and more
recently high-technology exports such as machinery and equipment - have led the export

Exports have been regarded as vital to the east Asian growth strategy, for several reasons.
First, exports provided demand needed to sustain the growth process. For the most part, these
countries had relatively small internal markets - small populations or low per capita incomes at
the initial stages of development. Therefore, rapid growth required external markets. Second,
producing for export markets encouraged efficiency because domestic firms had to compete
internationally. Third, export promotion reinforced both the need for, and the ability to
maintain macroeconomic stability. In addition, as exports rose and generated income they
contributed to government revenues and the government’s ability to maintain fiscal balance, in
a virtuous circle.

Many government policies assisted the export drive. Thus, despite high effective rates of
protection, ex-porters had access to imports at close to world prices through a variety of
channels, including free trade zones, export-processing zones, and tariff exemptions.

Expanding intraregional trade also played a critical role. A large part of this trade consisted of
trade in intermediate goods, allowing the East Asian economies to generate economies of
scale. This expansion was aided, in part, by the more advanced economies in the region,
starting with Japan and subsequently Korea, Singapore, and Taiwan. These countries invested
directly and relocated firms to other East Asian economies. By the mid-1990s, about one-half
of the exports of each of the East Asian economies went to other countries in the region,
including Japan. The Philippines is the least regionally integrated economy, with more than
one-third of exports destined to the United States. China and Indonesia are the most regionally
integrated, with almost 60 percent of their exports directed to other countries in the region.

6.2.2   Weaknesses Inefficient investment

There is a variety of evidence suggesting that in the east Asian economies the efficiency of
investment has declined, partly because of their rapid rates of convergence to-ward the levels
of per capita income of the advanced economies, but in some economies also partly owing to

In recent years, in several of the east Asian economies increased portions of investment have
been in nontraded or protected sectors - such as real estate or petrochemicals in Indonesia,
Malaysia, and Thailand - that generated low returns, or in sectors with high or excess capacity
such as semiconductors, steel, ships, and automobiles in Korea - that also yielded low or even
negative returns. In Thailand, for example, value added in the construction and real estate
sector grew by over 11 percent annually in real terms between 1992 and 1996, rising from
121/2 to 14 percent of GDP. During this period office vacancy rates increased, reaching 15
percent by the end of 1996. Similarly, in Indonesia the construction and real estate sector grew
at over 13 percent annually between 1991 and 1996, rising from 91/2 to 101/2 percent o f GDP,
while in Malaysia, the construction sector grew by over 14 per-cent annually between 1993
and 1997.

In Korea, government policies, such as access to easy credit through directed lending, played
an important role in allowing the chaebols to pursue growth and market share, with inadequate

attention to profitability. Particularly by the 1990s, when Korean production accounted for
significant shares of world production in industries such as semiconductors, steel, ships, and
automobiles, profits fell as these industries increasingly suffered from excess capacity and
intense competition worldwide. Despite the drop in profits, easy access to credit induced the
chaebols to continue to invest and diversify away from core businesses into other industries,
often also characterized by excess capacity. As a result, by 1996, the net profits of the 30
largest chaebols were close to zero, with six chaebols filing for bankruptcy in early 1997
before the beginning of the crisis. Financial system

In all of the East Asian economics financial intermediation expanded rapidly over the past
three decades. However, the rapid expansion of financial intermediation in the East Asian
economies was not always matched by a commensurate strengthening of regulatory and
supervisory systems. Indeed, all of these economies in varying degrees suffered from financial
sector distress at times during the past two decades. In several instances, such as in Hong
Kong during 1982–86, Indonesia during the early 1990s, Malaysia during 1985–88, the
Philippines during the mid-1980s, Taiwan Province of China during 1983–84, and Thailand
during 1983–87, some financial institutions failed or were closed. In Malaysia, the closure of
banks led to runs on other banks, while in Hong Kong the period of fina ncial sector problems
coincided with a period of exchange market pressure. In other cases - for example, Korea
during the mid-1980s and Singapore in 1982, although banks did not fail, non-performing
loans grew, and financial institutions came under significant stress.

In large part, investment in the crisis economies was financed by bank lending. As the returns
from investment fell in these countries, the quality of bank asset portfolios declined as well. In
Thailand, non-performing loans of commercial banks reached almost 8 percent of total credit
outstanding by mid-1996, and non-performing loans of other financial institutions were even
larger. Property lending had increased to about 20 percent of total lending. Exposure to the
property sector was high also in Thailand and Malaysia, where it had reached about 18 percent
and 25 percent of total lending, respectively. In Korea, commercial bank profitability,
measured by re-turns on assets or equity, had declined substantially during the 1990s (See
Sung Kwack, 1998).

Banking sector distress in these economies was caused by both external and domestic factors.
External causes included increases in international interest rates, falling export demand (in
Korea), or terms of trade shocks (in Malaysia and the Philippines). Domestic causes included
weak prudential regulations, speculative borrowing, and lending on noncommercial criteria,
often to clients connected to bank management or the government.

6.2.3   Long-term perspective

The crisis has revealed the fundamental weaknesses in the economies concerned. Distorted
incentives in project selection, combined with insufficient expertise in the monitoring and
evaluation of projects, weak prudential supervision and regulation, and low capital adequacy
ratios, resulted in the buildup of structural weaknesses in undercapitalized financial systems
(Morris Goldstein, June 1998).

These problems, however, should not lead one to overlook the many positive features of the
east Asian economies - in particular, their outward orientation, their emphasis on human
capital formation and technology transfer, and their high saving rates. Indeed, their prospects
for rapid economic growth are still favorable but will require significant changes from the
model based on very high rates of capital accumulation and, especially in recent years, high
reliance on capital inflows.

From a long-term perspective, a fundamental question facing the east Asian economies is
whether they can gradually shift from mainly input-driven growth to growth that is based more
on stronger gains in efficiency. That will depend on continuing improvements in the
institutional infrastructure to provide a supportive climate for investment and the supply of
finance, risk taking and innovation, and the efficient allocation of investment.

                                           Chapter 7

7.1     Conclusions

7.1.1   Lessons for Vietnam

The importance of relying mainly on domestic savings for development, and minimizing
reliance on foreign debt The most successful NIEs have maintained domestic savings rates of
well over 30% of GNP. Notably, the economies least affected by the crisis are the ones that
have relied mainly on domestic savings for development and avoided excessive reliance on
foreign debt, especially Taiwan, Hong Kong and Singapore. On the other hand, Indonesia has
been carrying a relatively heavy foreign debt for some years (67% of GNP at the end of 1997),
which involved a continued financial balancing act, and left the country vulnerable to financial
crisis. Similarly, Thailand’s foreign debt is also significant as a share of GNP (62%). The
Philippines, despite restructuring and progress in recent years, is still carrying significant debts
from the Marcos years (63% of GNP). In this regard, the state has an important role in
developing and maintaining an environment where savers have strong confidence that the state
will ensure the long-term integrity of property rights and wealth ownership; a sound and
healthy banking sector in which depositors can have long-term confidence; and a rationally-
valued exchange rate that does not encourage excessive foreign borrowing of undervalued
foreign currencies.

High economic growth rates, even in the presence of relatively healthy macroeconomic policy
indicators, do not necessarily imply sustainable development, especially in the case of
Vietnam where the economy has a small GDP base. In the years before the current crisis
emerged, most of the East Asian countries concerned were enjoying relatively high rates of
economic growth and seemingly reasonable macroeco nomic indicators (low budget deficits or
even surpluses in some cases, low inflation rates, and reasonable growth in the money supply).
However, the role played by the state for many years in directing or heavily influencing the
allocation of financing, as well as in depriving markets of essential information on which to
base rational decisions, resulted in a large number of unsustainable investments financed by
domestic and foreign debt. The related build-up over time of weak and non-performing loans,
combined with inadequate bank capital and loan- loss provisioning, left these countries
vulnerable to financial crisis.

State-directed lending eventually has heavy inefficiency costs contributing to the financial and
structural imbalances, financial instability and crisis. State-directed lending has proven
particularly damaging when the state has attempted to directly lend to specific industries or
interest groups. This was the case in South Korea during the latter half of the 1970s and early
1980s through state-directed bank loans to Chaebol, which brought the country to the brink of
financial crisis in the mid-1980s. In more recent years, the state continues to exercise
“guidance” on domestic banks to lend to Chaebol, even when the solvency of some of these
Chaebol appeared quite shaky. Similarly in Indonesia, state-directed lending to the ruling
family’s interests underlies much of that country’s current difficulties.

Government failure in either withholding essential information from the market or enforcing
legal requirements related to transparency, accountability and financial reporting of corporate
finance helped set up the market failure and ongoing financial crisis. One of the most
important ingredients to well- functioning and efficient markets is easy access to reliable
information on which rational decisions can be based. Lack of reliable information increases
the risk of over- investment in some areas and under- investment in others. In the years leading
up to the current regional crisis, little was known about the real financial health of the
corporate and banking sectors in Indonesia, South Korea, and Thailand due to the lack of
reliable published audits. Hence, redressing the information void as well as greater
transparency will be essential to restoring investor confidence and recovery in the crisis

Careful management of the liquidity and maturity structure of a country’s foreign financial
obligations is critical to reducing vulnerability to sudden capital outflows which can in turn
impact on solvency. While a great deal of the current regional crisis is a result of a build-up
over time of poorly performing investments, vulnerability to crisis was heightened by
government failure to monitor the overall maturity and liquidity structure of fore ign financial
obligations. Vulnerability resulted from a sizeable build-up of short-term foreign debts, as well
as a build-up of portfolio equity flows which could be quickly liquidated (as occurred in all of
the crisis countries).

Lack of the state prudential supervision of the financial sector contributed to market failure in
the banking sectors in a number of crisis countries. This is one area where more effective
government regulation and supervision is clearly needed in all of the current crisis countries to
minimize the risk of additional market failure, since unregulated banking by nature can be
prone to excessive risk taking and moral hazard. This kind of market failure was particularly
highlighted in the case of Indonesia, where family-controlled banking and finance companies,
often lending on the basis of personal relationships with limited accountability to financial
regulators, built- up large portfolios of speculative investments in real estate.

Protection trade policies aimed at developing import substitution industries tended to lead to
balance of payments problems, especially where the domestic markets were small. Almost all
countries in East Asia have attempted protected import substitution, including Taiwan and
South Korea during the 1950s, Singapore in the early 1960s, and Malaysia, Thailand and
others during the 1970s and early 1980s. However, experience indicates that the smaller the
domestic market’s purchasing power, the more quickly balance of payments financial
difficulties, were experienced.

Postponement of needed reforms eventually leads to the build-up of dangerous structural and
financial imbalances. In many cases, the governments in the crisis countries were aware for
some years of the need to redress legal and regulatory impedime nts which resulted in
problems related to transparency, accountability, corporate sector profligacy and others. Even
in the few months prior to the outbreak of the ongoing crisis in July 1997, most of the
governments concerned appeared to believe that there was still plenty of time to implement the
needed reform decisions and actions on a very gradual step-by-step basis.

7.1.2   Challenges to the economy of Vietnam Similar causes to a crisis

The continuously rapid growth of the economy of Vietnam over the past several years has
relied mainly on foreign capital inflows (ODA, FDI) and growing export. However, the
contribution of more than 1,000 foreign investment enterprises to export is still low compared
to total GDP. If production under foreign investment sector were netted out, the growth in
domestic enterprises output is only about 5 – 6 percent of GDP. This leads to the threat of a
quickly negative effect to the economy once there is a decrease in export and foreign

Current account deficit has been experienced for many years (10,1 percent of GDP in 1995,
11,3 percent in 1996 – Source: State Bank of Vietnam). Considerable trade and current
account deficits usually put pressure on exchange rate and further foreign debt.

The relative pegged exchange rate regime which has been maintained for many years, has
resulted to the appreciation of Vietnam dong against other Asian currencies. Given the
unstable macroeconomic environment and the increasing demand for invested capital, this will
have a negative impact on the trade balance.

Foreign debt, after normalizing relations with international organizations and reestablishing
relation with international financial communities, has been increasing substantially. Up to the
end of 1998, the foreign debt of Vietnam has come up to 46 percent of GDP. This burden is
worrisome, given the inefficient use and bad management funding sources, even overdue in
many state-owned enterprises.

The efficiency of investment is rather low due to inappropriate investment structure. While
capital for rural infrastructure remains inadequate, a significant foreign and domestic capital
has flowed to property business though supply has been over demand. In Hanoi so far, there
has been more than 300 hotels and the vacant room rate has no w been up to 50 percent. In
many cities, property price has decreased 40 percent.

In spite of reforms in early 1990s, the banking system in Vietnam remains shallow, especially
in loan loss protection and supervision. Low qualified credit and bank overdue which have
risen substantially during the recent years wiped out over 50 percent of the system’s total
capital. Consequently, when the property market has slowed down (especially since 1996) and
many enterprises have been loss- making, some of the banks have become unable to meet their
liabilities on time. Features which help to avoid the crisis

The financial market of Vietnam is too fledgling to integrate into the regional financial
market. The lack of a securities market makes the freely buying and selling of government
bonds or equity stocks impossible. The restriction on foreign participation in ownership has
prevented an immediate withdraw of capital in a short time which could cause currency shock.

The Vietnam dong is still an unconvertible currency and therefore it can avoid a direct effect
from the regional financial crisis.

Capital inflows to Vietnam has been mainly in form of FDI which has usually been invested in
long-term production, construction projects. A quickly outflow of short-term foreign capital is

The majority of government foreign debt has come from ODA sources which are mainly
medium and long-term debts. Short-term debt is only about 10 percent of total foreign debt.
Hence, the pressure on demand of foreign currency for debt payment is not as hard as in other
regional countries.

The exchange rate regime in general is flexible and has been adjusted gradually on the basic of
economic stability. The adjustments, on one side, reflected rather well the relation between
supply and demand in currency market, on the other side, encouraged exports and controlled
imports. Specifically, there had been six adjustments during the period of 1986-1997. In
February 1997, right before the crisis, commercial banks were allowed to widen the band from
1 percent to 5 percent around the official rate. After the crisis happened, in mid October 1997,
this band was widened to plus/minus10 percent. This prudent exchange rate policy has
released the pressure of devaluation on Vietnam dong, preserved foreign reserve and help to
escape a sudden shock for the economy.

This research comes to conclusion that:

   By analyzing the similar and different features of the Vietnam economy to other Asian
    countries, it is apparent that the Asian financial crisis will not happen in Vietnam as the
    same way as it did in the region. However, given the closely economic relation with Asia,
    especially East and Southeast Asia, the Asian financial crisis has indirectly affected almost
    all the areas of Vietnam economy, especially in export and foreign investment.

   While Vietnam is facing with a lot of internal troubles, the Asian financial crisis with its
    negative spillover effects could be a trigger for a real crisis in Vietnam. The economic
    situation now is quite serious for Vietnam – threatening to undermine and reverse the
    remarkable progress in poverty reduction that was achieved over the past decade.

   Without strong measures to address the current economic slowdown, poverty will begin
    rising in the coming two years. It is essential that actions should be taken now rather than
    be delayed. Success in mobilizing resources, using resources more efficiently and
    addressing the difficult situation will require a series of measures implemented promptly.
    The government of Vietnam is making good progress in a number of important areas but
    now need to significantly step up the pace of reforms.

7.2      Recommendation

In such a difficult situation, I suggest that the Government of Vietnam should put measures for
its internal weaknesses; including measures for SOEs sector, banking system, trade regime and
rural development; on the first agenda of its reform program. Among of those, enhancing the
efficiency of SOEs sector must be the first priority because investment resources will be less
plentiful and therefore each dong, dollar should be made to work harder. In addition,
improving the business environment to attract foreign investment, moving to a more
competitive dong exchange rate to promote export and mobilizing domestic saving to avoid
excessive reliance on foreign capital are also critical for Vietnam to be survived in this tough

7.2.1    Promoting a strong private sector and building an efficient state enterprise sector.

A vigorous reform effort is needed in Vietnam to help make SOEs more efficient and
internationally competitive, and to unleash the productivity of the private sector. This effort
would need to be centered around two broad thrusts: (i) fostering competition by leveling the
playing field between the private sector and SOEs; and (ii) restructuring the SOE sector to
improve its productivity and ensure adequate oversight over its financial performance. Leveling the playing field

Measures are needed to remove unfair and distortionary advantages that SOEs enjoy over the
private sector in access to credit and to land, promote ease of entry into various areas of
economic activities, and reform trade to reduce protection provided to SOEs activities.

     Recent State Bank of Vietnam directives to SOBCs with regard to lending to SOEs could
      be review to ensure that SOEs access to crerdit (as for the private sector) is base on sound
      credit risk assessment. Any other forms of financial support to SOEs would also need to be
      clearly justified and made subject to good financial performance.

     Existing land regulations could be revised to permit: (a) the transfer of land use rights
      upon the direct agreement of the parties concerned and without need for Government
      approval; (b) determination of rental rates for land on the basis of their market value; and
      (c) allow more neutral and transparent taxation of land use rights.

     Entry by the private sector could be eased by relaxing licensing and registration
      requirements for entry into both domestic and international business activities. Business
      licenses need to be issued for broader areas of activity and the requirement that there be no
      SOEs already engaged in the proposed sector and scope of activity could be removed.
      Business establishment, registration and investment licenses could also be simp lified and
      centralized in one single agency and into one single license.

     Reforms to reduce tariffs, and phase out controls on trade volumes will also contribute
      towards leveling the playing field between SOEs and the private sector.

                                                61 Restructuring the SOE sector.

Earlier reforms have increased the autonomy of SOE managers but much less has been done to
increase their accountability. In addition, it is costly for the state to manage and supersive
effectively the still large number of SOEs - currently about 6,000. Improved supervision and
accountability would prevent abuse of increased SOE autonomy and strengthen management
and efficiency. This calls for a two-pronged approach - a downsizing of the SOE sector and
improvements to the supervision and accountability of those enterprises that will remain in
state hands.

Equitization. The Government has so far proceeded cautiously on enterprise equitization,
completing only 34 so far. The Government could move ahead more rapidly on equitization by
first completing the ongoing classification of enterprises in the whole country, identifying
which are public service enterprises that could remain in the public portfolio and which are
business enterprises which would be eligible for equitization or eventual divestiture and which
enterprises could be closed down; and by establishing clearer guidelines for equitization to
ensure transparency in bidding procedures and to guard against under compensation.

Given the successes of the recent equitization process, the Government could proceed with a
larger round of equitization. This could include a pilot program to experiment with more rapid
methods of divesting, such as auctions and management employee buy-outs for enterprises
that are too small to equitize (i.e. enterprises with equity under US$100,000, or fewer than 50
employees), releasing restriction on private sector participation in equitization, allowing them
to hold up to 50 percent of total ownership of SOEs. This would both rid the Government of a
tremendous administration burden and help create a dynamic entrepreneurial class.

Improving supervision and accountability. Relationships between entreprises and Government
need to be redefined to give entreprises the flexibility and the incentives to respond
appropriately to these new pressures to improve their performance. Earlier reforms have
increased autonomy for managers and thus some degree of flexibility. To complement this
increased autonomy, enterprises supervision and accountability needs to be strenghthened.
Government could establish systematic evaluation and monitoring of enterprise performance,
based on a simple set of measurable financial indicators. Government could also provide
incentives for improved performance through a system of appropriate rewards for good
performance and penalties- including changing management - for poor performance. This will
require that enterprises have appropriate accounting standards in place to measure and track
their financial performance.

7.2.2   Reforming and expanding trade Reform priorities in trade.

There is an urgent need to announce a program of trade reform, with emphasis on removing
non-tariff barriers and replacing them with tariffs. Current trade policies provide high
protection to capital- intensive products like cars, steel, cement as well as other consumer
goods and encourage over- investment in these areas. Announcement that such protection will
be reduced over the next two-to-three years will discourage further flows of investment to

those sectors and encourage existing producers in those sectors to begin adjusting to the
announced change. More importantly, the announced liberalization will lead to increasing
flows of investment - both foreign and domestic- into labor- intensive exports, processed
agricultural exports and rural industry, areas where Vietnam is most competitive.

There should be three priorities for the announced trade reform. First, non-tariff measures
should be phased out over the next two years and replaced with tariffs which do not exceed the
current maximum rate. Second, tariff levels and the number of tariff rates should be reduced.
Third, all export taxes and restrictions, except those imposed for environmental reasons,
should be phased out at a quicker pace in order to boost export.

The restrictiveness of current foreign exchange rule should be relaxed. The recent requirement
that all enterprises surrender eighty percent of their foreign currency balances to domestic
banks accounts is undermining perceptions of and incentives for investment in Vietnam. The
transparency of tax rules should also be enhanced in several ways. Customs procedures should
be clarified to streamline trade and expedite clearance of goods. Export expansion outside Asia.

The potential for expanding exports to Europe and the United States is large. The U.S and
Europe take only five percent and twenty-two percent respectively of Vietnam's exports
though they are large markets of world exports. Europe's market is not fully tapped by
Vietnamese exporters; their actual share of European imports is significantly lower than
neighboring countries. European quotas have been raised several times but they are not fully
used. Vietnam's administration of garment export quotas to Europe is neither transparent nor
efficient. It favors state enterprises at the national and provincial level. Small and medium-
sized private firms, often more efficient, are unable to access these quotas. And the quotas are
not legally tradable. The Government is considering auctioning a small share of these quotas
to the highest bidders. To have a large impact on exports to Europe, a much greater share must
be auctioned to generate revenue and to make fuller use of quotas.

           Table 7.1: Selected Vietnamese exports to Europe, U.S. and Japan, 1996

                               EUPOPE        JAPAN        USA        MFN       Non-MFN
                                                                     Tariff     Tariff
Total Exports                  ( US$000)    (US$000)    (US$000)      (%)        (%)
                                 1,547,2     1,913,7     335,637      4,9        35.3
Of Which :
Food products                  40,870    393,598           39,574        5,5         21,6
Textiles                       14.150     71,631              164       10,2         55,5
Wearing apparel / Garments    456,089    488,580           25,567       13,4         69,3
Leather Products              309,865     72,367           11,746        5,6           33
Wood products                  23,382     42,532              760        2,1         31,4
Chemical, rubber, plastic     336,241     43,126           31,863        4,3         28,4
Source: United Nations Comtrade System 1996

Vietnam exports little manufactures to the United States. Table 7.1 shows that export of
textiles, garments, leather, wood and plastic products to the US are far below levels of those to
Europe and Japan. Exports to the US are low because non-MFN tariffs on those exports are
five to fifteen times higher than the MFN tariffs applicable to their competitors' exports.

MFN-access to the US is dependent on trade agreement between the two countries. This will
require further liberalization of trade and investment in Vietnam. In fact, the US Government
expects Vietnam to meet WTO standards to get MFN status. Many of the measures sought by
the US are consistent with those under ASEAN and AFTA trade agreements.

Estimates of the impact of most- favored- nation access suggest that Vietnam could raise its
exports to United States by nearly eight hundred million dollars. This is not surprising given
that such access will make Vietnamese exports significantly more competitive vis-a-vis those
from other countries selling in the US market. Half of the estimated increase in exports will
consist of clothing and the rest will be light manufactures and processed agricultural goods.
These products are all within the ambit of Vietnam's comparative advantage.

7.2.3   Improving banking service

To remedy the weaknesses in the Vietnamese banking system, reforms should include three
types of actions:

   intervention in weak and troubled banks to maintain confidence in the banking system
    while containing fiscal costs ;
   development of a prudential regulatory framework and good standards of bank supervision
    to ensure prudent banking in the future, and;
   creating a level playing field for all banks to provide better banking services. Rehabilitating state-owned commercial banks (SOBCs)

As a first step, a clear strategy for the future role of the largest SOCBs needs to be elaborated.
Key decisions on the number, size, and ownership structure of these banks have to be made.
Next, operational reforms should be initiated to improve management and control. It will not
be easy to change the lending practices of state-owned commercial banks. In spite of
legislation insulating SOCBs form directed credit, lending is influenced indirectly, by non-
economic criteria, especially for state enterprises. This is because of confusion about the roles
of these banks. A new set of goals for SOCBs, where efficient mobilization of deposits and
allcation of credit is encouraged, needs to be explicitly articulated. Clarifying the role of
SOCBs, distinguishing them form policy banks, and implementing these changes in pratice,
will be a major challenge. Policy environment of banks.

Competition among banks is necessary to improve banking services and to mobilize more
deposits. Change in policies with respect to bank entry-exit, interest-rate ceilings and leveling
the playing field for all banks, including foreign banks, are relevant for enhance competition

and better service. There should be stringent fit and proper test for qualifications and expertise
of new bank management in licensing procedures for entry of new bank. Inadequate
adjustment of ceilings on interest rates and restrictions on dong deposit mobilization for
foreign banks weaken banks' incentives to mobilize deposits and allocate credit to the most
efficient users. Upward adjustment of those rates a nd greater flexibility are clearly warranted.
Similarly, restrictions on foreign banks' mobilization of dong deposits should be abolished in
order to expand both deposits and banking services.

7.2.4   Reinvigorating rural development.

To preserve the gains made in poverty reduction and sustain economic growth, Vietnam must
reinvigorate farm household production and encourage development of the private, off- farm
industries that have spurred rural industrialization in other Asian countries. The Government
must also ensure a safety net for those hardest hit by the crisis. Several policy steps can be
taken which require no resources, other steps require the reorientation of public expenditures
and an end to the investment bias against the rural sector. Vietnam must reform land and credit
markets; deregulate the business environment; end preferential treatment of SOEs; improve
rural infrastructure; and encourage fiscal decentralization. Equitize / Reform rural SOEs.

Vietnam has about 4,500 SOEs in the rural sector. Half of these are loss- making, generating
little employment, draining the budget, and undermining the banking system.

The bulk of rural infrastructure and social services are provided by Government monopolies.
Equitization should be extended to management companies in charge of irrigation, rural
drinking water supply, and transport. Restructuring inefficient State Forestry Enterprises will
save millions of dollars and create the incentives to spur natural conservation. Reform land-use right

Creating a clear system of land-use rights is critical to enabling households and private
enterprises to secure bank loans. Without adequate credit, neither farmers nor private, off- farm
industry can develop.

Issuing a decree and clarifying current    laws, are urgent priorities. It is critical that land users
understand their rights, that rights are   enforced, and land users are able to employ them in
practice. Specifically, maximum area       of land holdings, uncertain and short-term land-use
rights, constraints on the transfer of     land, and high land taxes are issues needed to be
addressed. Remove all regulatory barriers and market obstructions.

Removing market restrictions is an immediate and costless way to bolster rural growth.
Restrictions on agricultural land use include those imposed at the local level that mandate the
planting of particular crops, and prevent farmers from diversifying their cropping or moving

into more profitable off- farm businesses. The Government should also move away from
numerical targets for commodities' production, allowing farmers to diversify their cropping.

Vietnam' s legitimate concern about food security is best addressed by raising farm
productivity and rural incomes, improving access to markets and long-term credit, enabling
food to be stored and transported efficiently, rather than by focusing resources on guaranteed
rice cultivation. Promote rural industrialization by linking rural to urban infrastructure.

Vietnam must improve access both within rural areas, and between rural areas and its cities
and towns. Linking cities and towns to their hinterlands will provide a market for agricultural
products and a conduit for industry to escape high urban costs. It will also encourage dynamic
synergies as urban business capital is combined with low cost rural labor.

Weak rural infrastructure constrains rural industrialization. While 62 percent of national
highways are paved, only a quarter and 13 percent, respectively, of provincial and district
roads are asphalted. Moreover, while 88% percent of Vietnam 's communes are connected to
the nearest district center by roads, most of these roads are not paved and cannot be used on
the whole year. Though economic returns to improved access are high, current expenditure on
rural transportation infrastructure in the period of 1996 and 2000 is only 5 percent of the total
planned allocation for all transportation infrastructure. Such low levels of investment lead to
high production costs, spoiled goods, lost opportunities, and inequality.

Access to electricity has improved throughout the country, but is still only available to about
half of those in the countryside, and only 35 percent of the rural population is connected to the
national grid. This compares poorly with the cities and is a serious obstacle to attracting
industry to rural regions. Rural electrification is also important for expanding irrigation (which
is increasingly dependent in pumping) and food processing. Expanding rural electrification
should be a key objective in rural infrastructure investment. By 2000, 80 percent of communes
and all communes in rural regions should be electrified. In agriculture, rehabilitation and
modernization of irrigation works should be a priority as degraded and out-of-date systems
cannot deliver cost-effectively water or support needed crop diversification. End the funding bias against the rural sector.

The rural economy is underfunded in relation to its contribution to employment and to
economic output. This should be redressed by reducing funding and credit provision to SOEs.
The World Bank's new rural development strategy for Vietnam recommends reallocating 20
percent of total public investment ($3.4 of $17.1 billion) for the period 1996-2000 , from
support of SOEs to provision of rural public goods. Such a reallocation would enable
substantial increases in spending in rural infrastructure and social services.

Though the Government estimates that over 40 percent of public investment will be provided
by overseas development aid, investment goals cannot be met without greater private sector
participation. Widening the role the private sector already plays in health, and inviting more

private participation in education and infrastructure provision, may alleviate some of the
Government 's burden for providing services.

Spending on rural infrastructure should be increased by de-emphasizing the growth center
strategy that favors the big cities, and reducing spending on agricultural SOEs. Of total
infrastructure spending, the allocation for agricultural should be doubled.

7.2.5   Ensuring transparency and reliable information

There is an urgent need in Vietnam for much greater transparency and reliable information,
particularly in the country's banking and corporate sectors. Vietnam's economy remains one of
the most information-starved in the world. While there has been a proliferation of new
statistics on SOEs in recent years, many of these have been inconsistent and incomplete, and
do not enable an assessment of the real profitability and financial health of the SOE sec tor. A
major reason for the lack of reliable data has been inconsistent and incomplete accounting
practices in the past years. Therefore, broad-based urgent action is needed in undertaking
reliable and independent audits of SOEs and banks. To be useful for both the state and the
market, such independent audits should be based on international accounting criteria and
standards. Similarly, greater transparency is needed in the state budgetary process, and
publishing of the state budget, to guide and encourage efficient public expenditures. Greater
transparency and access to reliable information would also greatly limit the scope for
corruption, which has been of growing concern to both the Party and the Government in recent

Regarding to Vietnam’s current investment climate, most economists agreed that despite the
government’s commitment to reform and integration, Vietnam still has a lot to do. First and
foremost is to reform the administrative apparatus. Key to this is the vital issue of the
strengthening the State’s administrative system. The biggest difficulty that foreign investors
have encountered is that numerous policies and regulations promulgated by the Central
Government have been either neglected or wrongly interpreted by the local authorities.

7.2.6   Adjusting exchange rate

Moving towards a more competitive dong exchange rate will be unavoidable and inevitable in
order to promote exports as well as discourage a flood of cheap imports. The exchange rate
should be depreciated gradually in order to avo id financial instability for the economy.

7.2.7   Increasing domestic saving

Clearly Vietnam's low domestic savings rate of around 16% of GNP (albeit more than double
the rate of 1990) will need to increase substantially to over 30% to avoid excessive reliance on
foreign savings, particularly foreign debt. Achieving this higher savings rate will require an
improvement in the overall enabling environment and incentive framework. Therefore, the
state should play an active role in maintaining an environment with positive real interest rates,
legally guaranteeing the long-term integrity of property rights and wealth ownership,
managing rational inflation and exchange rate so that savers can have confidence in the long-
term value of the currency.


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