Vietnam changes course

Those who wrote off Vietnam's economic management as hopelessly sclerotic during January's 11th Communist Party Congress would be wise to take a second look. Though inflation in is on the rise, Vietnam's economy is suddenly looking up.

Held every five years, the party conclave sorts out the pecking order of the Vietnamese political elite. Finding the congress a yawner, many reporters turned their attention to criticizing the Hanoi government's economic management, echoing notes sounded the previous month by the Wall Street Journal.

Unable to shake their fixation on "growth at any price", feckless policymakers had triggered runaway inflation, the Journal had opined. Vietnam's economy was in the bucket and prospects were dim that the congress had changed anything, according to many reporters' assessment.

But in fact, much has changed. Buoyed by a fresh mandate for a second five-year term, Prime Minister Nguyen Tan Dung has sharply tightened credit, reined in state spending and begun to wring out inflationary expectations. Additionally, Dung has served notice that the government is going to impose discipline and economic sense on the nation's investment decision-making.

If Dung gets his way, the year-long run-up to the congress could be seen as a watershed, the moment when the enormous economic costs of allowing state enterprises and provincial governments to allocate most of the nation's investment capital at last became too evident to ignore.

Before the party congress, Dung's hands were tied by the political imperative of wooing delegates, including large blocs representing state enterprises and local party chapters. Foreign advisors and some of the nation's best economists were dismayed when Dung told audiences late last year that state enterprises would continue to play a leading role in the economy and were a strategic instrument of state policy.

That statement came after the debt-ridden state-owned Vietnam Shipbuilding Group (Vinashin) defaulted on a US$600 million syndicated loan to international lenders. At the time, The Economist wrote "if the government does not take the state-owned enterprises by the scruff of the neck, it will be able to do little else."

Dung was personally embarrassed by the Vinashin debacle, which made global headlines and sparked criticism of his government's economic management. He had been instrumental in the group's formation and in facilitating huge loans intended to establish Vietnam as a global shipbuilding power. When Vinashin was caught overextended in a global recession downdraft, the prime minister acknowledged failures of oversight.

Many state enterprises have flouted Hanoi's central guidance by "diversifying" into financial services, real estate and other sectors outside of their core businesses. Less reported but equally galling was their refusal to trade in dollar holdings for Vietnam's local currency when foreign exchange shortages began to drive down the dong a year ago.

Where foreign critics generally err is in the assumption that, inasmuch as Vietnam is a single party state, all the central government needs to do is issue orders. However, Hanoi's failures to bring nominally subordinate bodies into line doesn't imply a deficiency of desire so much as a lack of capability.

With state enterprises in mind, Martin Rama, the former chief economist at the World Bank's Hanoi office, often warned of the danger of "state capture" by political-economic bodies deemed "too big to fail". By one count, there are still some 1,473 companies, large and small, that are solely owned by the state. Additionally, the state still holds a majority share in many more so-called "equitized" companies.

These firms are the legacy of Hanoi's 30-year effort to build a "socialist" economy on the Soviet model. Though Vietnam swerved gradually onto the capitalist road between 1986 and 1991, many enterprises retained and cultivated close ties to government organs at both central and local levels. The Soviet-trained managers in both the enterprises and the ministries have regarded these relationships as unexceptional and, indeed, highly useful.

Until now, state enterprises have enjoyed extremely easy access to credit. Vietnam's banks have perceived loans to even loss-making state enterprises as risk-free because of the implicit government guarantee. Loans to state enterprises are said to account for around 40% of Vietnamese bank assets.

The banks' eagerness to channel funds to the state sector has not only starved the private sector but also undermined government efforts to direct capital chiefly to projects that promise a high rate of return. And it has made a mockery of the level playing field supposedly established by the enterprise and investment laws of 2005.

Last month, the government announced that it would cut subsidies to the state-owned sector this year by nearly 19%, or about 2.5% of gross domestic product (GDP). Subsequently it said that these funds would be redirected to public employees - one salaried worker in three, if public enterprises are included - in the form of a 14% wage increase to offset higher living costs.

Profligate provinces
Dung and his colleagues must also impose greater discipline over spendthrift local governments. Like the state enterprise sector, provincial administrations have in recent years achieved the ability to ignore inconvenient directives from Hanoi.

Strong economic growth in a dozen or so of Vietnam's 61 provinces and self-governing cities has established a robust tax base and freed them of dependence on handouts from the central government. Moreover, leaders in all localities are able to invoke the support of patrons higher up in the party structure when important interests are at stake.

What seemed to be an enlightened policy to decentralize decision-making back in 2005 has in the implementation turned out badly for Hanoi. In that year, authority to approve most investment proposals was ceded by the ministry of planning and investment (MPI) to provincial governments.

In short order, province after province built a surfeit of industrial parks and granted rights to build steel mills, cement plants, seaports, luxury hotels, resort developments and whatever else foreign promoters were peddling, no matter how redundant or uneconomic these ventures were on a national scale.

Abetted by lax credit, Hanoi's failure to discipline investment decisions has driven down significantly the efficiency of capital. Vietnam's incremental capital output ratio (ICOR, a measure of how much new productivity is created by an increment of capital) has steadily deteriorated over the 20 years since the nation committed to "market socialism".

Though a phenomenal 45% of GDP was invested according to the regime's statistics, 2010 economic growth was a mere 6.9% - a result far inferior to the statistics posted by China or comparable Southeast Asian neighbors.

A widely noted study by researchers at Vietnam's respected Central Institute for Economic Management calculated ICOR for the economy as a whole at 8.78 for the period 2001-2009. Effectively the measure showed that it took nearly $9 of new investment to generate annually $1 of new wealth. The state sector proved most inefficient with an its ICOR for the period of 17.55.

Nor were the results posted by foreign investors particularly impressive with an ICOR of 11.14 over the same nine year period. The leader in terms of ICOR was Vietnam's indigenous private sector, which required only $4.62 of new investment to generate another one dollar of annual output.

To be sure, Vietnam's government does not lack for advice on macroeconomic strategy. It gets plenty of it from the Asian Development Bank (ADB), the International Monetary Fund (IMF), Japanese growth guru Kenichi Ohno and a platoon of Harvard University professors as well as from its own economists. Prescriptions vary in detail but all agree that unless Hanoi makes radical changes to its development model, growth is doomed to slow and perhaps stall as Vietnam falls into a so-called "middle income trap".

Grossly simplified, the argument is as follows: Vietnam has put paid to widespread poverty by putting more workers and more resources into productive use. Today the average citizen of this nation of 88 million can consume $3,000 worth of goods annually - a level of wealth the previous generation could only dream of. However, to advance to the next economic level, Vietnam must march up the value chain.

The Dung government's commitment to achieve "rapid and sustainable development" is set out in a strategic document that was circulated well in advance of the party congress. It's a coherent and clear narrative of what ought to be but was lacking in specifics. Except for the bit about retaining the state enterprise sector, it's the sort of plan that gladdens the hearts of World Bank, ADB and IMF staffers.

The government seems persuaded that what's been achieved so far - a quadrupling of national income over the past 20 years - is indeed fragile, vulnerable to the whims of foreign companies looking for the cheapest place to stitch together a product. Enterprises of this sort are assigned some of the blame for Vietnam's balance of payments troubles - a consequence of the necessity to import a high percentage of the inputs for the manufactured goods they export. It's a situation that has necessitated successive devaluations of the dong to maintain competitiveness.

However, an economic paradox has emerged. Vietnam has become highly attractive to foreign businesses that originally went to China to set up low-skilled, labor-intensive production but now find themselves squeezed by rising rents and labor costs. Vietnam's local jurisdictions are happy to welcome such enterprises but the central government is lukewarm to further growth in the low-wage sweatshop sector of the economy.

Instead, Hanoi increasingly says it wants to lure investments that provide "sustainable growth". This, policymakers believe, will flow from the partial privatization of state enterprises (presumably making them more sensitive to market disciplines) and the recruitment of multinationals committed to upgrade local technology and managerial skills as well as promote backward integration in industrial production.

Hanoi has recently scored some notable successes in attracting knowledge-intensive manufacturing investments, including big multinational commitments from Intel, Canon, Nokia, Samsung and First Solar, the US leader in solar panel fabrication. That's raising concerns in regional countries such as Thailand and Malaysia, which compete for the same foreign investments and have a considerable head-start in industrializing their economies.

Inferior infrastructure
More high tech firms may be induced to produce for export in Vietnam if Hanoi is able to address pressing infrastructure needs.

Vietnam's transportation infrastructure is notoriously ill-coordinated and overtaxed. Too often new roads lead to nowhere, bridges are unused because proper approaches haven't been built and moving goods from the plant onto a container ship generally takes too long for today's just-in-time production requirements. Vietnam reportedly needs $16 billion annually for roads, ports, highways and other infrastructure; at best, it can supply only half of that amount from public funds.

Meanwhile, the nation's electric power system is unable to satisfy demand that's recently been growing at 15% per annum. Pricing is a big part of the problem. For years, Hanoi required the national power company, the state-owned Electricity of Vietnam (EVN), to sell power dirt-cheap to help spur economic activity and alleviate poverty.

With prices kept artificially low, EVN wasn't able to mobilize funds to invest in new power plants. Absent price guarantees, foreign investors were unwilling to help meet the capacity shortfall. In early 2010, the government, EVN, Vinacomin (the state-run coal and minerals conglomerate) and a number of foreign investors reached agreement in principle on raising the price of electricity to more economic levels. As a result, there's been a recent surge in power plant construction, with new facilities expected to come on line as early as 2013.

Now the onus is on Hanoi to pass sharply higher power costs to the consumer. As another dry season of widespread outages and brownouts drew near last month, Dung announced a 15% increase in the household electricity tariff. That's a heavy hit for consumers already reeling from price increases in basic food stables and transportation. (Inflation in March hit 14% year on year). But even if the power price hike is adjusted for inflation, the boost in revenue will be nowhere near enough to fund the increases in generating supply that are needed.

One approach that may help close infrastructure gaps is public-private partnerships (PPP). Japan, South Korea and the European Chamber of Commerce have all urged Hanoi to supply enough public financing to make it economic for foreign firms to invest their own funds and mobilize loans for transport infrastructure projects, an approach common in neighboring nations. In November 2010, Vietnam established a PPP framework that has been hailed as a solid first step towards the establishment of a system that meets the requirements of international lenders.

Reining in state enterprises has been on the agenda of Vietnamese reformers for years. So far their successes have been minimal as the cozy and profitable alliance between state enterprise managers and party apparatchiks has been relatively impervious to the economic and financial arguments advanced by inner-party technocrats.

However, last year's Vinashin debacle seems to have catalyzed a new resolve at the top to tackle the state sector. Dung seems at least rhetorically to have embraced thorough reform of state enterprises, including accelerated privatization of its stronger members - firms like Vietnam Airlines and Petrolimex, the motor fuels retailer - and closer scrutiny of how its weaker members use public funds.

With the object lesson of Vinashin's meltdown still vivid and the forward momentum of Dung's re-appointment to a second five-year term at this year's congress, now is clearly the time to act. To be sure, it is common in Vietnam for the state to issue edicts it can't enforce, including the government's latest drive against a distortion-creating currency black market.

A March 16 Politburo resolution endorsed the government's efforts to deal with macroeconomic imbalances but on the subject of state enterprises said only that there should be reforms with a view toward equitization and that state companies should stick to their main lines of business. The new Central Committee elected in January has yet to convene and thus hasn't weighed in on the need for sweeping state sector reforms.

Yet Dung has clearly set a new tone by putting a brake on credit and spending and announcing his intention to rationalize the country's investment decision making. It's a message that the regime hopes global money managers put on their radar and visiting foreign reporters take note.

David Brown is a retired American diplomat who writes on contemporary Vietnam. He may be reached at nworbd@gmail.com.