Vietnam: Fast and steady Asia Pacific Economic Outlook, Q4 2017

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Vietnam stands strong as far as short-term growth prospects are concerned. However, to sustain long-term growth and reach its goal of becoming an upper-middle-income nation by 2035, the country needs to tackle fiscal consolidation, access to funds for development projects, protectionist trade policies from abroad, and aging demographics.

Introduction

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Vietnam is one of the fastest-growing nations in the fastest-growing region of the global economy. After a slight loss of momentum in 2016 due to severe drought and weak oil prices, economic growth in Vietnam is likely to edge up in 2017 due to multiple supporting factors. Domestic demand and capital formation remain healthy, and foreign investment continues to flow into the economy to support export growth as external demand strengthens. While these factors are likely to spur fast and steady short-term growth, there are challenges to medium- and long-term growth that Vietnam needs to address.

Strong growth in the first half of 2017

Real GDP growth accelerated in Vietnam in Q2 2017. Output produced during the quarter increased by 6.2 percent relative to a year ago, accelerating from 5.1 percent in the previous quarter. All three major sectors of the economy experienced quicker growth in Q2 compared to the previous quarter. The services sector grew 7.1 percent relative to a year ago. Within the services sector, the boarding and lodging subsector experienced particularly quick growth due to an increased number of international visitors, primarily from China. The industry and construction sector also grew 7.1 percent from a year ago. Robust growth in manufacturing more than compensated for the slowdown in the mining sector due to weak oil prices and suspended offshore drilling in the South China Sea.

The manufacturing sector continues to gain from an inflow of foreign investment. Growth in construction was also robust during the quarter reflecting strong residential investment that has been boosted by the liberalization of the housing market since 2015, and the country’s continued drive to develop physical infrastructure. Agriculture, forestry, and fishery grew 2.9 percent albeit from a low base in the previous year when Vietnam experienced the worst drought in a century. Over the last five years, industry and construction and services have recorded quick growth, while the agriculture, forestry, and fishery sector, which accounts for roughly 40.0 percent of Vietnam’s employed workforce, has grown relatively slowly (see figure 1).1

Average annual growth rate over the last five years by sector

What is fueling Vietnam’s continued growth?

At present, Vietnam finds itself in a sweet spot for economic growth. About 70.0 percent of the population is of working age, unemployment is low, domestic demand is robust, and fixed capital formation is growing rapidly. Most importantly, an ever-increasing inflow of foreign direct investment (FDI) continues to support healthy export growth. In the first half of 2017, export of goods and services increased 18.0 percent relative to a year ago. Imports, however, outgrew exports in the first half of the year, increasing 22.3 percent, resulting in an overall trade deficit.2 The domestic-owned sector recorded a trade deficit, while the foreign-owned sector posted a trade surplus—a pattern that underlines the importance of export-oriented FDI inflows in funding imports for domestic consumption.

However, strong inflows of FDI and an overall trade surplus in four of the last six years (driven by the trade surplus of the foreign-owned sector of the economy) contributed to an upward trend in the exchange rate of the Vietnamese dong from 2011 until the end of 2016. During this period, the trade-weighted nominal exchange rate remained comparatively flat, while the trade-weighted real exchange rate trended upward. Vietnam’s higher inflation rate compared to its primary trading partners (the United States, the European Union, China, and South Korea) during these years meant that at the relatively flat trade-weighted nominal exchange rate, domestic output in Vietnam was more expensive than the same basket of output in its trading partners. This explains the upward trend in the trade-weighted real exchange rate. While an upward trend makes imports for domestic consumption cheaper, it also hurts the competitiveness of Vietnam’s exporters. However, a spurt in the growth of imports in the first half of 2017 contributed to a lower trade-weighted nominal exchange rate for the dong despite the continued inflow of export-oriented FDI. A lower nominal exchange rate, in turn, contributes to a lower real exchange rate. Additionally, a steady drop in the inflation rate in Vietnam since the start of 2017 has contributed to the drop in the trade-weighted real exchange rate (see figure 2).

This reversal in the trade-weighted real exchange rate is likely to support further export growth in the short term especially as external demand recovers. Export growth in the second half of 2017 will continue to be dominated by the foreign-owned sector of the economy. In 2016, FDI inflows reached a record high and accounted for 72 percent of the country’s total goods exports.3 In the first six months of 2017, FDI was up 6.5 percent from the same period a year ago.4 An increase in the number of new licensed projects and registered capital during the first half of the year is likely to contribute to further expansion of the foreign-owned sector, which in turn, is likely to boost overall exports in the near term.

Lower inflation and strong import growth in 2017 has led to a weakening of the trade-weighted real exchange rate

One key determinant of Vietnam’s overall export performance is Samsung’s Vietnam-based manufacturing plants. The South Korean conglomerate accounts for 20.0 percent of all Vietnam’s exports.5 Furthermore, 40.0 percent of all Samsung’s smartphone devices are made in Vietnam.6 The success of the newly launched Samsung Galaxy S8 smartphone is likely to be beneficial to Vietnam’s export numbers.

Challenges to future growth

While critical FDI inflow is likely to continue in the short term, other factors might serve as a drag on growth. The need for fiscal consolidation is one such factor. Fiscal debt has grown roughly three times faster than real GDP over the last five years. In fact, Vietnam hit its self-imposed ceiling on public debt, set at 65.0 percent of GDP, at the end of 2016.

In response, the administration has committed to a comprehensive fiscal consolidation plan. While this may be a prudent measure to sustain medium- to long-term growth, it is also likely to slow growth in the short term. Lower government spending is likely to affect large infrastructure projects. For example, delayed payments for Ho Chi Minh City’s metro railway project, due to a shortfall in funding, have led to delays in construction.7 The Vietnamese administration is now looking toward private financiers to close the gap in funding. However, such funding gaps, particularly for large infrastructure projects, could potentially draw FDI flows that might have otherwise headed to other sectors such as manufacturing. Furthermore, factors such as lack of transparency in large state-owned enterprises—which account for a majority of bad loans in Vietnam—might serve as obstacles to private funding. Additionally, by virtue of its status as a middle-income nation, Vietnam no longer has access to cheap credit from institutions such as the World Bank and the Asian Development Bank.

And while the private sector continues to be buoyed by strong domestic demand, there are potential risks. Credit has expanded aggressively, growing at the rate of 19.8 percent in Q1.8 Though rapid credit growth is likely to support GDP growth in the short term, it could put Vietnam’s banking sector at risk in the medium to long term.

For now, the financial system appears stable. At the end of Q1, the ratio of nonperforming loans to total outstanding loans in the banking sector was relatively low at 2.6 percent.9 However, this does not account for bad loans sold by credit institutions to the Vietnam Asset Management Company (VAMC) since it was set up in 2013. If the VAMC’s share of bad loans is taken into account, the ratio rises to 5.8 percent.10 Furthermore, if rescheduled bad debts are taken into account, the ratio of bad loans rises to 10.1 percent.11 Recent banking sector reforms allow the VAMC and credit institutions to sell assets pledged as collateral to bad loans at market price, even at a discounted rate, in order to avoid litigation and speed up the process of cleaning the banking sector of toxic loans. However, a renewed surge in bad debt due to aggressive credit lending could slow growth.

On the trade front, the failure of the Trans-Pacific Partnership (TPP) and the threat of protectionism might have dented hopes of quicker economic growth in the medium to long term. However, in the short term, exports to major destinations such as the United States and the European Union are likely to continue. Vietnam’s dependence on China as a source of vital imports is also likely to continue.

Finally, while Vietnam does enjoy a demographic advantage in the short term, its population is also aging fast. At present, the median age in Vietnam is 26 years, but birth rates are falling and life expectancy is rising. According to the World Bank, the number of people in Vietnam above the age of 65 years will triple by 2040.12 Moreover, Vietnam’s rapid aging is likely to happen at lower per capita income levels compared to countries that currently have old populations.13 Boosting productivity will therefore be essential to sustain quick growth in the medium to long term.

The short-term outlook remains bright

The short-term outlook for Vietnam’s economy remains bright. Inflation has slowed through the first half of 2017 and monetary policy rates were revised down in July. This is likely to keep domestic demand robust. A gradual strengthening of the global economy, particularly Vietnam’s export markets, is likely to keep external demand healthy. Vietnam’s quick growth and future prospects will likely keep foreign investment flowing in over the short term. The International Monetary Fund forecasts GDP growth of 6.3 percent in 2017, slightly higher than in the previous year.14 Reform, policy, and global developments will determine whether Vietnam grows fast enough to reach its target of being an upper-middle-income nation by 2035.