II. Management of the External Current Account13
37. Vietnam is quickly transforming from an economy dominated by central planning and trapped at a low income level to a dynamic economy increasingly guided by market principles and integrated with the rest of the world. Since 1992, Vietnam has enjoyed five consecutive years of 8-10 percent real income growth fueled by strong exports and high foreign direct investment. During the same period, the external current account deficit (excluding official transfers) has widened significantly from about 2 percent of GDP in the early 1990s to a projected 12 percent in 1996. The bulk of this deficit has been financed by foreign direct investment that has grown from almost zero to 10 percent of GDP ($ 2.5 billion) in 1996 (Chart 1). Commercial external borrowing has been limited, as have disbursements of official development aid.
Chart 1:Investment and Savings
38. The strategy of high growth financed by high foreign savings involves risks for medium term viability. Foreign investors choose to invest in Vietnam expecting reasonable profits based on the assumption that the market reform process will continue and that there is underutilized capacity to be exploited. If these expectations are not met, the rate of return on investment will be lower than initially expected and new capital inflows will slow down, or worse, invested resources may be repatriated, imparting serious pressure on the balance of payments.
39. This paper reviews the current macroeconomic and external debt situation of Vietnam and discusses whether the current strategy of allowing high foreign savings to finance growth poses a threat to the country's external sustainability—i.e., will continuation of current policies lead to difficulties in servicing external debt-and to assess to what extent the economy is resilient to negative shocks. The next section discusses the underlying analytical framework. The paper then reviews recent developments in investment and savings trends as well as the pattern of financing of the current account deficit in Vietnam. Assessment of factors that enhance sustainability and resilience of the economy are then discussed in the context of Vietnam.
B. Analytical Framework
40. Investment and foreign borrowing (or capital inflows) represent a trade of resources across time. Borrowing increases current resources, but reduces available resources in the future when debt falls due. A necessary but not sufficient condition to justify borrowing from abroad is that borrowed resources should be invested in projects which produce a net stream of returns (discounted and evaluated at world prices) that is higher than the discounted value of debt service obligations. From a macroeconomic viewpoint, consideration also needs to be given to the effects of the overall level of foreign borrowing on the following: (i) current consumption; (ii) factor prices; (iii) future foreign exchange availability; and (iv) creditor behavior.
41. Within this framework, the authorities need to choose, and implement policies to achieve, the desired mix between different forms of foreign inflows. In the context of Vietnam, such flows consist of: concessional assistance, foreign direct investment, and foreign commercial borrowing.14 While foreign aid flows usually carry the lowest direct cost, their supply in the short term tends to be limited by donors' budget constraints. Over the medium term, however, economic performance and efficient utilization of aid can be important in expanding the availability of concessional assistance. In weighing the merits of foreign direct investment and commercial borrowing, there are several critical factors that need to be taken into account. Foreign direct investment has advantages insofar as dividends paid on equity largely depend on project profitability. In addition, projects financed by foreign direct investment facilitate the transfer of technology and management skills. On the other hand, commercial external borrowing or places a future burden on the economy irrespective of project efficiency and—at early stages in the development process—such borrowing may involve high interest costs or require guarantees by the Government.
42. This argument needs to be qualified to the extent that foreign direct investment will often involve a substantial loan component which may allow investors to repatriate earnings even in the context of low profitability or where projects are not ultimately viable. It is also necessary to recognize that fiscal incentives may be needed to attract foreign investment, and such incentives can have adverse effects on medium-term revenue mobilization. In general, however, the expectation is that foreign direct investment will have a lower cost than commercial external borrowing. Where outflows arising from foreign direct investment are found to be higher, then increased outflows will generally be associated with higher profitability and returns.
43. Chart 2 displays a static picture of the analytical framework. Line S is a supply curve of foreign inflows, representing, sequentially, foreign aid, foreign direct investment and foreign commercial borrowing. Commercial external borrowing is depicted to have the highest costs and these will tend to rise as the economy borrows more so as to compensate for lower risk adjusted returns. At some point (Qc), creditors will ration credit as any additional increase in the debt burden is perceived as increasing the probability of debtor repudiation. The curve D is the demand for capital inflows based on the marginal return on capital and the society's demand to smooth consumption over time.15
Chart 2:Current Account Deficit: An Analytical Framework
44. The chart highlights four policy-related aspects that are important in assessing the macroeconomic impact of a large current account deficit: (i) the composition and the costs of financing of deficit—the shape and the slope of the S curve; (ii) the return on investment—represented by the position of the demand curve, D; (iii) the conditions for achieving equilibrium, E; and (iv) the possibility of commercial credit rationing for some debtors which results in a backward bending supply curve.
45. Current account deficits of the same size can have very different marginal costs depending on the composition of deficit financing.16 For the same level of current account deficit, the marginal cost of foreign inflows will be lower for an economy that receives sizeable aid and foreign direct investment than for an economy with higher dependence on commercial borrowing.
46. The cost of external borrowing—the slope of the S curve—will also depend, inter alia, on the evolution of the real exchange rate (defined as a relative price of nontradeable and tradeable goods). From a macroeconomic viewpoint, foreign inflows including those for investment will partially finance consumption. By increasing demand for both tradeable goods (prices of which tend to be linked to international prices) and nontradeable goods (the supply of which tends to be relatively fixed in the short run), these foreign inflows are likely to increase the relative price of non-tradeable goods and thus appreciate the real exchange rate. When the debt falls due, the real exchange rate needs to depreciate to provide enough incentives to produce more tradeable goods to service the debt. This shift in the real exchange rate raises the cost of servicing debts as borrowing tends to occur when tradeable goods (or foreign exchange) are relatively inexpensive and repayment is made when tradeable goods are relatively expensive. In addition, the initial real appreciation tends to shift investment away from tradeables and toward nontradeable sectors such as in housing and retail establishments. The resulting small capital stock for tradeable production may make future adjustment more difficult—requiring significant real depreciation and suppression of consumption.
47. While at the firm level, the return on investment has stochastic elements depending on market conditions, managerial capacity and institutional and legal environments, the expected return on investment is primarily a function of the marginal product of capital. The marginal product will reflect both technical coefficients and the economy's capacity to absorb investment, which will decline as investment expands within any period. The absorptive capacity, in turn, will depend upon a wide range of factors, including availability of labor and infrastructure services.
48. At the equilibrium, E, there should be a three-way equality among the real return on capital, the real cost of marginal foreign borrowing, and the real social discount rate.17 The real social discount rate depends on pure rate of time preference, the expected rate of consumption growth, and the level of desire to smooth consumption over time. Expected consumption growth enters the definition of real social discount rate when the society prefers to smooth consumption over time—if, for example, high consumption growth is expected in the future, the real social discount rate will increase pushing up demand for consumption today. When the real social discount rate is below the return on capital, investment should be increased to lower the marginal capital returns and consumption should be decreased to raise the discount rate. When the real social discount rate is higher than the borrowing cost, the country should borrow more to increase current consumption which will lower the discount rate and raise the marginal cost of borrowing.
49. The optimal borrowing pattern can diverge from the three-way equality when creditors restrict lending/investing to reduce perceived country risk—at, for example, R in Chart 2. Credit rationing is one way that creditors seek to reduce the country risk for both sovereign and non-sovereign foreign debts. This may be the result of information asymmetry or the absence of legal recourse to gain control of defaulting overseas debtors' assets (Eaton and Stiglitz 1986). The point at which credit rationing ocours—Qe—is thus linked to both borrowers' ability and willingness to repay. The ability to repay is associated with the borrowers' policies to encourage tradeable production, and to mobilize sufficient resources to maintain a sound fiscal position. The willingness to repay is likely to be maintained when the benefit which debtors would receive from repudiating existing liabilities (present value of future debt service payments) are below the costs of repudiation (external trade disruptions). Thus, the more an economy is export-oriented, the higher will be the costs of repudiation, and the lower the probability that lending will be rationed.
50. Policies affect a number of these factors in a mutually reinforcing way. (i) Tight macroeconomic policies, especially fiscal polices,18 during the period of high foreign capital inflows are needed to prevent rapid appreciation of the real exchange rate and thereby reduce the cost of servicing debt flows, i.e., such policies would make the curve of S would be less steep; (ii) policies to utilize more aid resources and encourage foreign investment are needed to reduce the demand for commercial borrowing and thereby lower the cost of current account financing; and (iii) structural policies are needed to create a competitive business environment and ensure reasonable investor returns, i.e., the position of the D curve would be expected to be higher with a deepening of market reforms. Such structural reform policies would also, in turn, attract higher investment including foreign investment and may improve an economy's access to foreign aid.
C. Recent Developments in Investment, Savings and External Debt
51. Vietnam's transition to a market economy started in full force in 1988. Initial moves toward trade and price liberalization stimulated a strong supply response in agriculture and services, which offset initial negative growth of the manufacturing sector as state enterprises were restructured (1988-90). However, industrial growth started on a sustained basis by 1992, and GDP has grown at above 8 percent for five consecutive years since then. During the same period, exports have grown by 28 percent per year on average, and have become increasingly diversified into various light manufacturing goods, marine products, and cash crops.
52. Robust output and export growth has been supported by gross capital formation that increased significantly from 15 percent of GDP in 1990 to 24 percent in 1993 and is projected to be near 30 percent in 1996 (Chart 3).19 Foreign direct investment (FDI) has been a major cause of this increase. FDI grew from near zero in 1988-90 to 6 1/2 percent of GDP in 1993, and is projected at around 10 percent of GDP in 1996. Investment other than foreign direct investment, however, has been relatively stagnant at around 18 percent of GDP since 1993. The productivity of investment, as inferred from the incremental capital output ratio (ICOR), is comparatively high. Vietnam's ICOR hovers around 3 while ICORs in other ASEAN countries are within the range of 4 ½ - 5 1/4 (Table 1). The high productivity of investment in Vietnam reflects a low capital labor ratio, the existence of previously underutilized factors of production and the impact of new efficient technology being brought in by foreign investors.
Chart 3:Investment Pattern
53. The increase in investment has been financed by a widening of the current account deficit and high government savings. The widening of the current account deficit mainly reflects imports associated with the growing foreign direct investment. The current account deficit increased from about 2 percent of GDP in 1990-91 to 10 percent in 1995 and is projected at 12 percent of GDP in 1996 (Chart 4). Government savings also increased by 5 percentage points of GDP during 1993-96 as a result of the authorities' efforts to maintain tight fiscal management focusing on, first, revenue enhancement, and, more recently, streamlining of expenditures. The increase in foreign and government savings, however, has been accompanied by a decline in nongovernment savings of about 5 percentage points of GDP between 1993 and 1996.20 This decline in nongovernment savings is consistent with past findings that private savings may be adversely affected by increased government savings and that household savings may be negatively correlated with significant capital inflows (e.g., Giovannini, 1985, Schmidt-Hebbel, Webb, and Corsetti, 1992, and Masson, Bayoumi and Samiei, 1995). The fell in nongovernment savings may also reflect the population's general expectation that high economic growth will sustain strong consumption growth. Given the expectation of higher future consumption, the population may wish to smooth consumption over time by increasing current consumption. Statistics in this area have serious limitations, however, the trend in nongovernment savings is worrisome and ensuring external sustainability over the medium term will require steps to promote private savings, particularly in terms of financial sector development.
Chart 4:Savings Pattern
54. The widening of the current account deficit also needs to be viewed against the backdrop of an overhang of external debt that is in the process of being regularized. Prior to clearance of arrears with the IMF and debt rescheduling by the Paris Club in 1993, medium-and long-term (MLT) official debts in convertible currencies amounted to 38 percent of GDP. Debt restructuring agreements have since been concluded with all but one Paris Club creditor, and an agreement in principle has been reached with the London Club creditors. Most of the convertible currency public sector debt of $5 billion is thus already rescheduled or about to be regularized. It is estimated that at the end of 1996, convertible currency MLT public sector debt will amount to 20 percent of GDP. In addition to the convertible currency debt, however, Vietnam has still to settle the issue of outstanding transferrable ruble debts which amount to about TRIO billion, most of which is owed to the Russian Federation.21 The terms under which this latter debt is to be regularized will also have a crucial bearing on external sustainability over the medium term.
D. External Sustainability and Resilience
55. The size of the current account deficit in Vietnam relative to GDP is among the highest in Asia (Table 2) and in the world. As indicated earlier, external sustainability depends on a number of factors including (i) macroeconomic policy stance and associated movements in the real exchange rate; (ii) composition and terms of deficit financing; and (iii) depth of structural reforms.
Macroeconomic Policy Stance and the Real Exchange Rate
56. Tight macroeconomic policy, especially fiscal policy, is critical to reduce the initial pressure toward real appreciation that accompany significant foreign resource inflows. Over the last three or four years, Vietnam has demonstrated its willingness and ability to maintain tight monetary and fiscal policies with the result that inflation has come down significantly to single digit levels. These tight policies have helped ensure that the composition of expenditure between investment and consumption and of output between tradeable and nontradeable goods is consistent with the required future resource flows. An important result of these policies has been that the relative price of tradeable and nontradeable sectors (real exchange rate) after rising during 1992-93, has remained largely stable over the last two years when the current account deficit rose due to high foreign investment (Chart 5).22 At the same time, however, the real effective exchange rate (REER) shows a slightly different profile over the same period. The REER was stable during 1993 when relative prices indicated real appreciation and showed an appreciating trend more recently. The real effective rate and the relative price diverge from each other when the (unobservable) price of domestically produced tradeables diverges from the international price. It is possible, therefore, that rapid technical progress in the tradeable sector may explain higher real appreciation indicated by relative prices than by the real effective rate during 1993-94.
Chart 5:Relative Prices of Nontradeable and Tradeable Goods, and Real Effective Exchange Rate 1991-96 (1991 January-1.0)
Composition and terms of deficit financing
57. Foreign direct investment. Vietnam enjoys access to various types of foreign capital inflows. Most notable is that the foreign direct investment flows have financed 90 percent of the current account deficit during 1994-96 (Table 3). FDI covers a much higher proportion of the current account deficit than in other ASEAN countries—34 percent of current account deficit is expected to be covered by FDI in 1996 in Malaysia, 10 percent in Thailand, and 68 percent in Indonesia. It is estimated that about 30 percent of the FDI flows to Vietnam are equity transfers, and the rest are loans provided by or fully guaranteed by the foreign parent companies on favorable terms. It is claimed by both investors and the authorities that no implicit or explicit state guarantees have been provided on the loans associated with FDI.
|Foreign Direct Investment (net)||1710|
|Percent of current account deficit||90|
|Medium and Long Term Loans (net)||211|
|Percent of current account deficit||11|
|Short Term Loans (net)||274|
|Percent of current account deficit||14|
While most local partners of joint ventures are state enterprises, the local contribution is usually limited to land. The contracts are such that the invested firms, especially Vietnamese partners, undertake little individual loan risk. While loans are to be serviced by the joint ventures, should projects fail to produce a satisfactory stream of profits, foreign parent companies can opt to help them by extending additional loans, capitalizing interest payments or repaying creditors directly in the case of guarantees. To the extent foreign creditors share the cost of poor performance as well as the profit, these loans have some characteristics of equity.23 However, this is still an uncharted territory and the authorities need to be careful to avoid implicit debt guarantees and not to be involved in bailing out enterprises, especially in the event of failures of larger joint ventures.
58. Medium- and long-term loans. Gross aid disbursements (excluding grants) have been limited to less than $200 million per year on average during 1994-96. Despite high commitments, disbursements of project aid have been particularly slow mostly due to administrative delays in starting new projects. On the other hand, commercial medium- and long-term loans (largely public or publicly guaranteed) have been limited by government policy to about $200 million per year, and have been used mainly to supplement public sector financing of infrastructurel facilities. It is envisaged that future infrastructure development will utilize, to the extent possible, the existing aid pipeline rather than to place greater reliance on borrowing expensive commercial resources. Thus, provided aid begins to flow, significant borrowing of medium- and long-term commercial money should not be needed at this stage in Vietnam's development.
59. Short-term liabilities. So far, short-term borrowing in Vietnam has been limited to trade financing which should be self liquidating. In line with the rise in foreign trade flows, the annual increase in short-term liabilities during 1994-96 has been the equivalent of 14 percent of the current account deficit. Part of this increase, represents however, use of deferred letters of credit and the authorities have recently taken measures to limit this form of financing.
60. Debt service ratio. The debt service ratio arising from non-FDI capital flows is projected to be low—in the single digit range as a percent of exports-during the next 20 years (Table 4). The total debt service ratio including the FDI related inter-enterprise loans is also projected to remain at manageable levels.
Structural policies to maintain high investment
61. A key question is whether current policies in Vietnam will support continued high flows of FDI invested in quality projects over the medium term. Three issues are particularly relevant.
- First, structural reforms need to be deepened so that Vietnam's business environment becomes more conducive to competitive and productive investment—with commercial and institutional policies geared towards creating a level playing field between state and nonstate enterprises. State enterprise reform needs to be continued with accelerated privatization. Simple taxes should be applied equally to all enterprises and import tariffs should provide low effective rates of protection with low dispersion. Commercial and company laws should guarantee free entry into and exit from markets, and access to (and the terms of) bank credit should be firmly based on the financial health of enterprises and investment projects. In addition, enterprises should have equal access to foreign exchange.
- Second, while FDI project approvals should be largely automatic, emphasis should be placed on attracting high return projects in tradeable activities, particularly exports. Access to inexpensive foreign capital markets based on association with a foreign parent company and/or the size of the project should not form an excuse to implement low return projects. The authorities also need to be careful lest FDI flows be directly diverted into consumption purposes (for example, wage payments). These activities would have the effects of accelerating real appreciation without adding to the productive capacity in the tradeable sector, and increase the future cost of debt service. From the available data, it appears that FDI flows in Vietnam largely support either investment in the tradeable sectors or activities that are complementary to tradeable production—such as construction of export processing zones (Chart 6)
- Finally, for the economy to enjoy broad based growth based on continued foreign investment, improvement in infrastructure services is an urgent task. Delays in the removal of infrastructural bottlenecks for businesses could significantly lower the future return on capital. At the present time, while the Government is making efforts to improve its infrastructure base, many foreign investors are forced to build their own power plants or build access roads and water supply facilities both in and outside export processing zones.
|Total debt service||13.4||16.1||13.3|
|Excluding FDI loans||6.3||5.2||4.1|
|ASEAN Countries Indonesia||1996|
|Thailand||12.4|Chart 6:Foreign Investment Disbursements 1992-95 (Total=$5.1 billion)
Resilience to future shocks
62. A sustainable economy may not necessarily be resilient against future negative shocks. Resilience means that adjustments needed to cope with an unexpected external shock are relatively manageable. Four characteristics of the economy are important.
- The structure of the economy should facilitate a quick shift of resources into tradeable production or expansion of exports.
- The structure of the external debt should ensure that the economy will not suffer substantial capital outflows in a short time.
- The banking sector should be sound.
- The structure of external financing should prevent a severe cut in new capital inflows, especially through tight credit rationing.
Economic structure and resilience
63. Policies favoring tradeable production. Vietnam's recent maintenance of sound macroeconomic management has been as important for resilience as for sustainability. Tight financial policies, by reducing pressures toward real appreciation, improve incentives for investment in the tradeable sectors and, thereby, make future adjustments easier. In the event of an adverse shock, the economy would need increased production of tradeable goods from a larger tradeable capital basis and the required real depreciation and consumption reduction would be smaller.
64. Increasing export diversity. Vietnam's exports have significantly diversified over the past few years, increasing the resilience of the economy to external shocks. In 1990, rice and crude oil exports together were more than 50 percent of total commodity exports in Vietnam. Light manufacturing goods were less than 2 percent. By 1995, the sum of crude oil and rice exports has come down to less than 30 percent of much larger total exports, and light manufacturing exports have increased to 20 percent of the total. This casual observation can be corroborated when an index of concentration, the Herfindahl index, is used to measure export diversity (Table 5). This index is a sum of squared shares added in descending order—the larger the index, more concentrated the distribution is. A theoretical property of the index is that its inverse can be interpreted as a number of standardized export commodities. This index shows the level of diversity for Vietnam has been among the highest among the highly indebted poor countries and has now exceeded that of Malaysia.
Structure of external debt—maturity and ease of outflows
65. Adjustment costs are high when net capital flows turn around abruptly and debtors are forced to sharply increase tradeable production and squeeze consumption in a very short period. Short term liabilities, both debt and portfolio, carry high potential risks of a sudden shift in net flows. It is therefore important to limit the relative size of short term liabilities outstanding so that fluctuations in gross borrowing requirements are minimized. In Vietnam, the short-term debt outstanding comprised less than $1 billion in 1995 or about 11 percent of 1995 exports, and about 8 percent of the total debt outstanding. These are among the lowest when compared with other economies in the region (Table 6). Reserve coverage of short-term debt is 150 percent—lower than Malaysia but compatible with other ASEAN economies.
|As a share of MLT debt (1995)||8||10||16||143||100||23|
|As a share of exports (1995)||11||19||6||27||50||33|
|Reserves to short term debt (1996)||1.5||1.6||3.5||0.7||0.9||0.9|
66. It is important that banks are adequately supervised as financial weakness in the banking sector could precipitate or worsen external problems. The monetary authorities should be especially aware of commercial banks' foreign positions (including, to the extent possible, contingency liabilities) and the quality of their loan portfolios.
67. In Vietnam, reform efforts are continuing towards establishment of an efficient and competitive banking system through improvements in bank supervision and accounting standards, and through revisional banking laws. Progress so far, however, has been quite slow. The banking sector continues to be dominated by four state-owned commercial banks with deposits comprising more than 70 percent of total deposits. Prudential rules for loan classification, provisioning, and capital adequacy still to be established, it is difficult to assess the health of the banks. While international audits of these banks are underway, it will take another year to complete audits of all four banks.
Capital inflows and their rationing
68. Resilience of an economy to negative shocks could be substantially weakened if the shock were to be accompanied by credit rationing. Creditors and investors can cut off new credit lines, and especially when the stock of short term debt or portfolio investment is high, swings in net flows can be swift triggering severe balance of payments problems. Such behavior could exacerbate otherwise manageable negative shocks into major crises.
69. A review of past studies indicates that macroeconomic performance is the dominant factor determining each country's access to voluntary credits or investment.24 First, creditor behaviors are procyclical. Favorable terms of trade induces creditors to increase lending, while available credit tends to decline when countries need more resources to counter deteriorating terms of trade. Creditors also tend to extend more credits when economies grow faster than expected based on expansion of the tradeable sector. Above average growth in the nontradeable sector will tend to reduce foreign commercial resources that are made available to the economy. Second, the most important variables in determining creditors' willingness to lend are those that reflect the government's macroeconomic policies—in particular, the shares in GDP of exports, investment, and government revenues. These are all clearly linked to the capacity of the economy to generate foreign resources that can be made available for future debt servicing. In each of these areas, Vietnam has made substantial progress in recent years. Exports presently represent over 38 percent of GDP (up from 30 percent in 1991) while investment has risen from IS percent of GDP in 1991 to a projected 20 percent in 1996.
The share of government revenues in GDP has also risen. This is an indicator of government's capacity to mobilize resources to avoid fiscal crunches that may lead to financial crises, and more generally to maintain stable macroeconomic management with adequate resources allocated to those activities that are required for maintaining reasonable growth of the economy (public investment, operation and maintenance and social expenditures).
70. Vietnam's large current account deficit is not seen to pose an immediate threat to future external sustainability provided that sound macroeconomic management is maintained, debts are appropriately rescheduled and structural reform implementation deepened. Most of the indicators that are shown to be important tend to support the view that Vietnam's external position is sustainable and the economy resilient to future shocks. To summarize:
- Vietnam has demonstrated ability to maintain tight macro-financial policies that lessened pressure towards real appreciation.
Composition of financing
- The current account deficit at 12 percent of GDP in 1996 has been high, but 90 percent of the deficit has been financed by foreign direct investment.
- Short-term debt has been limited mainly to trade credit. Commercial medium and long term borrowing not associated to FDI has also been limited.
- Foreign project aid has been slow to disburse, but there are substantial commitments which are expected to lead to increased disbursements.
Return to investment
- The return to investment has been high as indicated by a relatively low ICOR.
- Infrastructure bottlenecks have not so far put pressure on factor prices, but these may become an absorptive capacity constraint in the future if foreign assistance continues to disburse slowly.
- Structural reform implementation has been strong in the past, though the pace has slowed recently.
- Nongovernment savings have tended to decline.
- The banking sector still needs to be reformed.
- International reserves at 9 weeks of imports are lower than desired, but are rising.
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