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Cablegate: Part I: Latest Economic Data Sends Hcmc Analysts Into A

VZCZCXRO6960
PP RUEHCHI RUEHDT RUEHFK RUEHHM RUEHKSO RUEHNAG RUEHNH RUEHPB
DE RUEHHI #0634/01 1511131
ZNR UUUUU ZZH
P 301131Z MAY 08
FM AMEMBASSY HANOI
TO RUEHC/SECSTATE WASHDC PRIORITY 7912
INFO RUEHHM/AMCONSUL HO CHI MINH 4784
RUCNASE/ASEAN MEMBER COLLECTIVE
RUEHZU/ASIAN PACIFIC ECONOMIC COOPERATION
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC

UNCLAS SECTION 01 OF 04 HANOI 000634

SENSITIVE
SIPDIS

SINGAPORE FOR TREASURY
TREASURY FOR SCHUN
USTR FOR DBISBEE
STATE FOR EEB/IFD

E.O. 12958: N/A
TAGS: EFIN EAID ECPS ECON EAGR ETRD VM
SUBJECT: Part I: Latest Economic Data Sends HCMC Analysts Into A
Panic

Refs: A) Hanoi 610, B) Hanoi 606, C) HCMC 359, D) Hanoi 572

HANOI 00000634 001.2 OF 004

1. (SBU) Summary: After a record of good performance through the
first half of 2007, missteps in fiscal and monetary policy have set
the stage in 2008 for concerns that the GVN needs stronger
macro-economic management. High inflation, exchange rate
fluctuations and lack of SOE control have eroded confidence in the
GVN's ability to manage its economic growth in a sustainable manner.
Many analysts are becoming increasingly shrill in their warnings.
There is cause for concern, but right now the situation is one of
speculation, mostly focused on the ability of the GVN to manage its
way out of the situation. Clearly, some analysts are looking to
make headlines, but the multilateral developments banks have some
confidence that the GVN has the ability to deal with the current
period of instability. The next three to six months will be a test
of the GVN's ability to make the correct monetary and fiscal
decisions. End summary.

Optimists, Pessimists, and Those In Between
-------------------------------------------
2. (SBU) Experts in HCMC looking at Vietnam's economy tend to be
easily divided into two camps: the optimists and the pessimists. To
a great extent, the optimist camp is composed of long-term investors
such as factory owners who see considerable additional growth
potential in Vietnam while the pessimist camp is composed of
investors with a shorter term perspective, such as stock market,
financial and real estate investors capitalizing on the real estate
boom that has been sweeping Vietnam for the past few years. Even
among the pessimists, most turn immediately optimistic when the
discussion turns to Vietnam's long-term prospects. The multilateral
development banks take a less polarized approach. The IMF Resident
Representative acknowledges that headline economic numbers are not
good and probably won't be for some time, but calls the current
situation more of a "confidence game" about the GVN's ability to
manage its fiscal and monetary policy. He adds that lack of timely
and reliable economic data only fans the flames of speculation, as
analysts and investors tend to fill in the blanks with worst-case
scenario information. In his estimation, the new budget and higher
interest rates will have some effect, but it is too early to say
what that effect will be.

FDI Must Stay Strong
--------------------
3. (SBU) Many analysts (e.g., HSBC, Standard and Poor's, UBS,
Standard Chartered, etc., as well as domestic Vietnamese analysts at
private investment funds) have begun to focus on how Vietnam's
current account deficit and GVN inflation policy could hurt investor
confidence as well as on how a fall in investor confidence would
then diminish Vietnam's ability to service its current account
deficit. If foreign direct investors (FDI) and/or portfolio
investors -- foreign indirect investment (FII) -- do not continue to
pour money into Vietnam at a rate at least equal to that of 2007,
the country will not be able to finance its growing trade deficit.
Fortunately, as of April 22, total registered FDI for the year was
at 7.6 billion USD, up by 41.4 percent over the same period in 2007,
meaning that FDI flows are continuing and are on pace to increase
over last year. Some businessmen do expect the global slowdown will
have some effect on inflows later in the year.

Inflation Gets the Ball Rolling
-------------------------------
4. (SBU) While the May 2008 year-on-year inflation of more than
twenty-five percent is quite high, even that figure understates the
price increases currently being felt by Vietnamese consumers since
the present inflationary spike began only five or six months ago
(reftels). By May, prices were already nearly 16 percent above
their level in January 2008, which is equal to an annualized
inflation rate of nearly 40 percent. Financial analysts point to
the GVN's failure to properly sterilize surging capital inflows in
2007 as causing the money supply to rise by 46 percent in 2007 and
credit to expand by 54 percent. Predictably, this money supply
growth sparked inflation in 2008. Unsterilized capital inflows were
not the only culprit behind the expanding money supply. As part of
the GVN's fixation on maintaining a stable dollar-dong exchange
rate, the SBV consistently purchased dollars for dong in 2007 to
keep the exchange rate from appreciating against the USD (reftel),
pumping more dong into the economy. These monetary policy errors
were compounded by lack of budgetary discipline: massive amounts of
state investment into highly inefficient State Owned Enterprises
(SOEs) were channeled rapidly into "bubble" areas of the economy,
such as real estate speculation and stock market investments. One

HANOI 00000634 002.2 OF 004


senior foreign banker recently told us that many of the affiliated
banks opened by Vietnamese SOEs in 2007 were little more than cash
machines to transform modest capital investments into huge lending
portfolios directed almost exclusively to the SOEs' directors, their
families and political backers. Recent statements by the PM that
the GVN plans to get control of SOE spending are a step in the right
direction, but economists are watching to see if these statements
are backed up by decisive action.

Compounding Policies
--------------------
5. (SBU) As the inevitable inflationary surge resulting from the
exploding money supply became evident in early 2008, analysts argue,
the GVN and State Bank of Vietnam (SBV) attempted to react using
well intentioned but ineffective administrative measures. Rather
than tightening monetary policy via interest rates, the SBV
maintained a cheap money policy with deposit and lending rates
capped well below the rate of inflation (at 12 percent and 14
percent, respectively). The resulting negative real interest rates
for depositors and borrowers alike squeezed liquidly out of the
banking system at the same time it increased the demand for credit.
The SBV reduced liquidity in the banking system further by requiring
most financial institutions to purchase government bonds paying just
7.8 percent interest. The recent removal of interest rate controls
has helped reduce tensions, although rates are still effectively
capped at 18 percent for both depositors and borrowers, meaning that
real (inflation-adjusted) interest rates remain below zero
(reftels). The SBV also moved recently to raise the base and
discount rates, and while the IMF thinks they are still too low, the
SBV has indicated a willingness to reevaluate the current rates
depending on how the situation develops (reftel).

6. (SBU) By spring of 2008, the Vietnam's booming private sector was
feeling the effects of this combination of policies, with many
manufacturers and exporters unable to obtain the operating credit
they needed. Much of the lending that did occur was directed
lending by state-owned commercial banks (SOCBs) to inefficient SOEs.
Those banks -- primarily SOCBs or banks owned by the largest SOEs
-- whose large branch networks and/or large employment base enable
them to maintain a large (captured) deposit base despite low deposit
interest rates continue to make a profit, particularly because a
number of banks have been able to lend at 20 - 22 percent despite
formal controls to the contrary. Smaller or less well-connected
banks, however, are losing deposits and may face bankruptcy.
Analysts are watching to see if the PM's statements on SOE control
will apply to these banks, as well.

The Financial Crisis Theory
---------------------------
7. (SBU) Proponents of the financial crisis theory in HCMC point to
a number of factors and policies that are leading Vietnam toward
financial instability. Very high inflation combined with a
relatively inflexible exchange rate policy means that in real terms
the dong is rapidly appreciating versus the dollar. Negative real
interest rates on dong-denominated deposits (even after the recent
liberalization) place additional downward pressure on the dong.
While some press has speculated that the GVN will announce a much
needed widening of the trading band on the dong (from 1 to 2
percent), market pressure is mounting for a steeper depreciation.
Published reports indicate that open market and black market rates
on the dollar had climbed to 17,750 dong by May 28, which represents
a depreciation of nearly ten percent from the official rate and is
well below the critical psychological level of 17,000 that many cite
as the rate beyond which the GVN does not want the dong to fall.
The exchange rate market will continue to be the real barometer of
the level of speculation and where the "herd mentality" is headed.
In recognition of this, the SBV made a public announcement earlier
this week that it had sufficient liquidity to defend the dong, which
seems to have calmed the market considerably.

8. (SBU) Downward pressure on the dong is being increased by the
interest rates available on dollar-denominated accounts held in
Vietnamese banks. In contrast with the negative real rate on dong
deposits, the current six percent rate paid on dollar deposits is
well above the U.S. inflation rate and above the rates available to
most U.S. depositors, thus encouraging investors to sell dong in
order to buy dollars. Another clear indicator that GVN policies are
serving to drive money out of the banking system and onto the street
is the skyrocketing demand for gold. The World Gold Council
reported that Vietnam was the world's largest buyer of gold in the
first quarter 2008, up 140 percent over the same quarter in 2007 to
32 tons.

HANOI 00000634 003.2 OF 004

9. (SBU) The Central Bank has reportedly already spent in excess of
$2 billion defending the dong. The "doomsday" thinking goes that
with losses like those over the past few months, the GVN's current
policy of using open market purchases to support for the dong may
soon prove impossible -- or too expensive -- to maintain. If the
GVN then decides to implement non-market mechanisms such as currency
controls to prevent the dong from falling further, the unintended
consequence would be to adversely impact capital inflows. Anxious
"hot money" investors in the stock and financial markets could well
head to the doors if they fear that the GVN would block them from
repatriating capital, and even if existing investors do not (or
cannot) leave, once currency controls were in place Vietnam would be
unlikely to attract the types of additional inflows required to
finance a current account deficit. Our contacts at the SBV,
however, indicate that Vietnam has sufficient reserves to defend the
dong for the better part of a year while the necessary policy
adjustments are made.

10. (SBU) Proponents of the crisis theory in HCMC also cite other
factors as contributing to what they see as an upcoming "perfect
storm" of financial variables and mis-directed policies. Vietnam's
current account deficit continues to mushroom, surpassing the target
for all of 2008 in just the first five months of the year. One
analyst predicts the deficit may reach 19 percent by the end of
2008, nearly double the 10 percent of GDP level that many believe
precipitated the financial crisis in Bangkok in 1997. Until
recently, however, Vietnam's current account deficit was made up
largely of capital investment goods (machinery, etc.) and was
financed by inflows of equally long-term FDI. Beginning in 2007,
the crisis theorists state, the situation began to change as the
value of imports soared well above the value of export earnings and
FDI combined. This left Vietnam financing imports with Foreign
Indirect Investment, which includes quite a bit of short-term "hot
money" that can flow out as quickly as it flowed in. Analysts argue
that a slow-down in the rate at which additional FII flows could
push Vietnam towards financial instability, but this argument is
weakened by the fact that most of the estimated $10 billion held by
investment funds in Vietnam resides in long-term, closed-end funds.
Furthermore, regular data on "hot money" flows is lacking, making
analysis of this type difficult to verify.

11. (SBU) Despite central government policy that remains firmly in
favor of attracting more FDI, many provincial officials across the
south are evidently drawing a simplistic direct line between FDI
inflows and inflation. By focusing on the FDI flows themselves
rather than Vietnam's inappropriate fiscal policy as the root cause
of inflation, some officials appear to have decided that they should
contribute to the fight against inflation by slowing the inflow of
FDI. At their monthly breakfast at the CGR, AmCham's leaders
uniformly expressed their belief that provincial authorities may be
slowing the processing of permits and are erecting other red tape
barriers in a well-intentioned but clumsy attempt to slow FDI. A
recent lunch of Consuls General in HCMC revealed that other major
investors share this perception. If central authorities are unable
to reverse these provincial policies, the composition of Vietnam's
balance of payments could further deteriorate.


Getting Vietnam's Economy Back on Track
---------------------------------------
12. (SBU) Most in HCMC's financial sector argue that abandoning
distorting administrative measures and liberalizing exchange rate
and interest rate mechanisms remain Vietnam's best bet to tackle
inflation and restore financial equilibrium. The more holistic
thinkers add that meaningful administrative reform projects will
help turn pledged FDI in implemented FDI, helping to keep the
all-important capital inflows coming to finance the investment goods
imports needed for Vietnam's continued growth. Better judgment in
government spending, SOE investment and state-owned commercial bank
lending, firmly based on sound economic decision-making, would boost
investor confidence, increase the efficiency of investment and build
Vietnam's capacity to grow.

13. (SBU) Long-time Vietnam watchers in HCMC, though equally pained
by short-term loses, remain more sanguine and call for a steady
continuation of systemic reforms: cutting red tape, reducing the
still bloated SOE sector, strengthening the judicial system and
internalizing the trade investment rules that Vietnam agreed to on
joining the WTO. They point to the steep drop in Vietnam FDI in
1998 just after the Asian Financial Crisis -- including a credit
crunch and the bottom dropping out of the property market -- as an

HANOI 00000634 004.2 OF 004


indication that Vietnam has not escaped past economic cycles.
"Making the tough economic choices requires a level of pain," a
leading fund manager said earlier this year, "and the Vietnamese
pain threshold is remarkably high."

Comment
-------
14. (SBU) A serious financial situation in Vietnam is not
inevitable, but it is possible, including bankruptcy for some of the
smaller, newer banks. Just how likely it is depends to a great
extent on what the GVN does next. Vietnam must recognize the serious
macroeconomic challenges facing its economy and gather the political
will to act. A number of our contacts -- particularly Vietnamese
analysts -- lament that many in the GVN are simply more comfortable
trusting direct controls than market mechanisms. Unfortunately,
while administrative controls are seductively simple, they rarely
work as intended and more often backfire in practice. At this
stage, what Vietnam needs most is good advice and the will to follow
it. Luckily, advice is not in short supply from monetary
authorities such as the IMF and regional development banks, from its
ASEAN neighbors and from donor countries. Department of Treasury
technical assistance -- strengthening bank supervision, tax reform
and debt management -- will prove valuable. Indeed, these bodies
have been giving the same good advice for months already. In the
long term the United States can best help Vietnam to avoid future
financial crises by increasing Vietnam's long-term capacity for
economic governance, especially through the USAID-funded Support for
Trade Acceleration (STAR) program which helps build the GVN's
capacity for everything from cutting red tape via Project 30 to
mobilizing capital for infrastructure through municipal and
provincial bond issuances. Post will continue to follow the
situation closely and will report septel. End comment.

15. (U) This cable was drafted by Con Gen HCMC in coordination with
Embassy Hanoi and the Regional Financial Attache at Embassy
Singapore.

MICHALAK

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