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Vietnam was barely emerging from theoverheating caused by its own success atattracting capital in massive amounts. Whilethe government reacted swiftly,macroeconomic instability could underminethe efforts to increase the efficiency ofcapital accumulation. For now, the mostlikely scenario is one in which capitalinflows decline substantially, bringingVietnam back to a pre-WTO environment.But this is not the only possible scenario.Given the uncertainty, the immediatepriority is to be ready to cushion the shocksstemming from the balance of payments.The standard prescription in this respect is tolet the exchange rate fluctuate freely, andVietnam is moving in that direction.However, getting there may take some timeand meanwhile, the effectiveness of otherpolicy tools, from monetary policy to fiscalpolicy, is limited. This suggests that thegovernment should prepare to face moreturbulence in the near future. Containingrisk requires decisive action in the financialsector. Creating a modern central bankempowered to adopt appropriate monetarypolicy, building the institutional capacity toimplement such policy, upgrading the abilityof the banking system to assess credit risk,and improving the quality of financial sectorsupervision, will be critical to make Vietnamless vulnerable. There is also a need toimprove communication with market

participants and the public at large. Progresshas been made in relation to financial sectorindicators. But better and more current datais also needed in relation to governmentrevenue and expenditures, including publicinvestments. Last but not least, ensuringstability has a social dimension. Rapidinflation and the deceleration of growthaffect jobs and purchasing power. In a timeof possible hardship it is crucial to ensurethat resources can be channeled to those whoneed them most.

An uncertain world

At a time when Vietnam is consolidating itsglobal integration, the world economy hasturned much more unpredictable. Theprotracted negotiations that led to WTOaccession had been conducted during aperiod of remarkable stability and sustainedgrowth. International trade volumes wereincreasing steadily and country riskpremiums had fallen. At the culmination ofthis process, in 2007, Vietnam was mainlysuffering from its own success. Accession tothe WTO was seen as a clear indication thatthe government was serious about economicreform and the reliance on marketmechanisms. In a world of abundant capitaland growing trade, capital flowed in, underthe form of FDI, portfolio investments andremittances by the overseas Vietnamesecommunity. Volumes were so large that

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they would have been difficult to manageeven for a seasoned central bank. Vietnamdid not have one at the time.

In the fall of 2008, difficulties gotcompounded by turbulence in the worldeconomy. A financial crisis of unprecedentedproportions led to a collapse in credit, in spiteof abundant liquidity. Starting with arelatively narrow segment of the mortgagemarket in the United States, the financialcrisis spread from one class of assets toanother, forcing the adoption of massivebailout packages all over the world.Economic activity was hit to a larger extentthan anticipated, with major industrialcountries going into recession, andinternational trade slowing down. Aftertrending upwards for several years, andexperiencing a surge in late 2007, commodityprices fell sharply in 2008 (Figure 11.1).

This unprecedented global turbulence takesplace at a time when Vietnam has become amuch more open economy. The ratio of

international trade to GDP increased from 46percent in 2001, when reforms accelerated,to an estimated 72 percent in 2008.International commitments made to accedeto the WTO resulted in higher internationalcapital mobility. While the dong is notconvertible, foreigners face almost norestriction to purchase bonds and stocks inthe domestic market, nor to sell them andrepatriate the proceeds if they wish to do so.It is very difficult to achieve economic andfinancial integration without beingsusceptible to contagious effects. Suddenglobal turbulence is thus combined withincreased Vietnamese exposure.

With the balance of payments as the mainsource of instability in the near future,cushioning the impact of its fluctuations onthe domestic economy is a priority. Slowerexport growth and a slowdown in inflowswould constraint the pace of capitalaccumulation, and some depreciation of thedong would take place. But Vietnam couldalso hold well in its export markets, FDI

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Figure 11.1: Dramatic Fluctuations in Commodity Prices

Source: World Bank (2008e).

disbursements could continue in spite of alower implementation rate (simply due to thesheer volume of approvals) and remittancesmay not fall by a large margin. While thefirst scenario is the most plausible, thesecond one is not totally unrealistic.Forecasting the balance of payments istherefore difficult. Rather than preparing forjust one scenario, the government needs tobe ready to respond.

Macroeconomics first

The economic reforms needed to improvethe efficiency of capital mobilization inVietnam are microeconomic in nature.However, microeconomic reforms alone willfail to deliver if the economy is subject tomacroeconomic instability.

The experience of Vietnam in late 2007 andearly 2008 is telling in this respect. Havinglost control of credit growth, asset pricessurged and investments followed the pricesignals. The rapid diversification ofEconomic Groups and large StateCorporations diversified in the direction ofreal estate and financial investmentsactually showed that they had a strong profitdrive. The problem was not so much theirresponse, but rather the wrong economicsignals they were responding to. Wrongmarket signals, especially when they last forlong, create systemic risk (Box 11.1). Andpolicy makers are not well equipped to dealwith it. A stable macroeconomic context isthus a pre-condition for efficient capitalmobilization.

In light of the uncertainties associated withinternational trade and capital movements,the government should try to steer theeconomy along a steady growth path in themedium term, while building in strong

stabilizing mechanisms to cope with short-term fluctuations.

A steady growth path, one that is notassociated with major changes in theexternal debt position, requires a tradedeficit that is commensurate with both theinvestment needs of Vietnam andavailability of long-term capital. In recentdebates, capital inflows have been blamedfor the large trade deficit. But as long asthose inflows are being invested, andespecially invested well, the trade deficitshould not be a matter of concern. Efficientinvestment should sooner or later translateinto a higher supply of goods and services,hence into more exports and less imports.Trying to suppress the trade deficit, as someclaim Vietnam should do, is the same astrying to reduce domestic consumption andinvestment. This would not be the rightchoice for a country that is not yet rich andneeds to grow.

As for short-term stabilization mechanisms,the standard recommendation is to let thenominal exchange rate fluctuate. Vietnam ismoving in the direction of increasedflexibility, by gradually widening thefluctuation band around the rate set by SBV.However, whether the ultimate objective ofthe government is a fully flexible exchangerate is unclear at this point. And even if itwere, there are understandable reasons whythe transition may take some time.

In an economy not yet used to exchange raterisk, and with limited hedging instrumentsavailable, there could still be sizeablecurrency mismatches in enterprises andbanks. Large fluctuations in the nominalexchange rate could then result in importantbalance-sheet effects, possibly leading to

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bankruptcies. For instance, an enterprisewhich sells to the domestic market but isindebted in dollars would suffer from thedepreciation of the dong. Large exchangerate fluctuations may also affect

competitiveness in the short term, and createuncertainty among investors who seeVietnam as an export platform. Andexchange rate movements also create awedge between interest rates in domestic

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Box 11.1: Systemic Risk in East Asian Economic Crises

The crises that shook East Asia over the last two decades had all a systemic elementembedded. This is why they were so difficult to stop and eventually so costly. The way theyunfolded provides useful insights for Vietnam.

The common cause of the crises in Thailand, Indonesia and South Korea, in 1997, was themismatch between the composition of assets and liabilities in terms of their tenure andcurrency. In varying degree, banks and enterprises in the three countries were borrowingshort-term credits in foreign currencies (mainly dollars) from abroad and financing long-term investments in domestic currencies. This mismatch resulted in large un-hedgedforeign currency liabilities. When foreign investors and lenders stopped refinancing theircredits, out of their concern about the borrowers’ financial health, enterprises had toliquidate assets to repay their short-term credits. This pushed asset prices down,complicating further the already vulnerable situation of enterprises. Meanwhile, thesecountries’ international reserves were not sufficient to counter the reversal of short-termcapital flows. The result was a massive depreciation of local currencies. Lower assetprices and more expensive debt burdens brought many of those enterprises intobankruptcy, creating major recessions.

The root causes of Japan’s decade-long economic stagnation were the protracted stock andproperty market bubbles of the late 1980s. It is often difficult to distinguish a bubble from aboom sustained on strong fundamentals. And it is tempting to misconstrue bubbles as asignal of the skills of policy makers, the vibrancy of the investment climate or the greatnessof the nation. In the case of the stock market, the P/E ratio can be used as a starting pointto assess those claims. A market-wide P/E ratio is measured as the ratio between totalmarket capitalization and the total earnings of all companies traded in the market. Themeasure varies depending on whether past earnings or forecasted earnings are used in thecalculation. Before the specifics, a very general rule of thumb is that a market-wide PERhigher than 20 is a sign of overheating. A higher P/E ratio can be justified for rapidly growingeconomies such as China, India or Vietnam. Just before Japan’s stock market collapsed in1990, Tokyo’s market-wide P/E ratio was registering over 60, while the total marketcapitalization surpassed 160 percent of GDP. Prolonged loose monetary policy is generallyrecognized as the primary cause of this bubble. Given how large the departure fromeconomic fundamentals was, when the bubble burst debtors became insolvent and banksportfolios deteriorated sharply. A general reluctance to lend followed, and economic activitysuffered.

Source: Noritaka Akamatsu (2008).

and foreign currency, which may amplifyshort-term capital movements and lead toinstability. For example, with a flexibleexchange rate, a sudden capital inflowwould lead to the appreciation of the dong,making interest rates in dong more attractivethan interest rates in foreign currency. Thiscould in turn attract more short-term capital(under the form of carry trade), pushing thedong even higher up.

If not all the burden of adjustment can fall onthe nominal exchange rate, at least in theshort term, then other stabilizing mechanismsare needed. Monetary policy is an obviouscandidate, but its effectiveness is reduced ina context of international capital mobility ifthe exchange rate is rigid. And there areother shortcomings resulting from the factthat Vietnam has not completed the reform ofits financial sector yet. That leaves fiscalpolicy as one of the main macroeconomictools available to government. Butinstitutional shortcomings in public financialmanagement, especially in relation to publicinvestment, reduce the effectiveness of thistool as well. Additional stabilizers can beconsidered in relation to trade and to short-term capital flows, but their merits are morequestionable. All of this suggests that even ifpriority is given to macroeconomic stability,Vietnam could face considerable turbulencein the near future.

Containing risk

The overheating of the Vietnameseeconomy was fortunately brief. While thefirst signs were apparent in September 2007,a strong stabilization package was adopted inMarch 2008, barely six months later. Byinternational standards, this is a remarkablyswift response. But the ensuing decline in

asset prices, combined with the surge ininterest rates and the tightening of bankingcredit, has resulted in increased levels ofstress for borrowers. The extent to whichreal estate investors and urban developerswill be able to service their debts is unclear.Growing difficulties to sell abroad could alsocreate stress for manufacturing enterprises.The resulting increase in the share of badloans is bound to affect commercial banks,especially those who lent more recklessly insupport of formerly booming sectors.

Accelerating financial sector reform mayhold the key to preventing this combinationof stress and uncertainty to drift intosystemic risk. At the risk of simplifying, fourelements need to be combined. First,authorities have to be empowered to adoptthe appropriate monetary policy, reactingquickly to market signals and avoiding thedevelopment of asset price bubbles like theone that affected Vietnam in late 2007.Second, the authorities also need to build thecapacity to implement the chosen monetarypolicy without creating unnecessary hiccupsalong the way. Third, commercial banksneed to upgrade their ability to assessborrower risk and allocate creditaccordingly. And fourth, the authorities needto be able to quickly identify sources ofborrower stress and weak bank portfolios, soas to intervene effectively.

Implementing the banking reform agendaapproved in 2005 would help on several ofthese fronts. One of the building blocks ofthe agenda is the creation of a moderncentral bank, taking out of SBV the exerciseof ownership rights on SOCBs, focusing itsmandate on price and financial sectorstability, and giving it the technical andoperational autonomy to conduct its own

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analyses, make recommendations to thegovernment and implement monetarypolicies. This should help overcome thefragmentation in responsibilities formonetary policy, currently scattered acrossfour SBV departments. Passing a new Lawon the SBV is critical to accomplish thesegoals.

The smooth implementation of monetarypolicies requires the development of themoney market, eventually leading to theemergence of a Vietnam Inter-Bank OfferRate (VNIBOR). To do so, it is crucial tominimize volatility in the level of excessreserves in the banking system. But thestabilization of reserves is made difficult bythe lack of reliable of information ongovernment cash flows. Indeed, thegovernment itself creates large demand forbank notes, but estimating how this demandwill evolve is challenging. The budgetexecution process makes it difficult toforecast future expenditures, whereas largeinflows such as petroleum income createuncertainty on the revenue side. As spendingauthorities, line ministries have depositaccounts with SOCBs, but they movedeposits from SBV to those accounts ratherunexpectedly. State Treasury deposits at thecentral and provincial levels stay within theSBV system, but those at the district leveland below are made to commercial banks,often without prior notice to SBV. On thefunding side, better coordination is neededon the issuance of government securities.While a significant volume of governmentbonds is sold by SBV on behalf of MOF, anequally significant volume is issued in theform of retail bonds through MOF’s ownoutlets. Other government bonds areauctioned at the stock trading centers. It is

not clear that SBV is well informed inadvance of those other funding activities.

Strengthening the credit culture ofcommercial banks to assess credit risksrequires bringing in strategic investors, withrecognized management capacity andtechnical skills. This is already happening inthe case of JSBs; it is one of the buildingblocks of the banking reform agenda in thecase of SOCBs. Unfortunately, the stockmarket slump prompted by the stabilizationpackage adopted in March 2008 has resultedin understandable delays in the equitizationof SOCBs. There is agreement thatmaximizing efficiency should be the mainobjective, rather than maximizinggovernment revenue. But there is a concernthat selling state assets at this point wouldamount to handing them over at bargainprices to investors who would subsequentlymake handsome capital gains. And this couldresult in criticism and suspicion, potentiallyundermining the state reform process.However, as the economy stabilizes, thegovernment should try to put SOCBequitization back on track.

Last but not least, authorities need to be ableto quickly identify borrower stress and weakbank portfolios so as to intervene and avoidaffecting market sentiment. In this respect,Vietnam is seriously lagging behind in theimplementation of its credit rating system.As part of the banking reform roadmap, in2005 it was decided that banks had toclassify all their loans based on a series ofquantitative performance indicators,including the number of days a loan wasoverdue and whether it had been rolled over.This was in line with the Basel I agreement.Banks were also instructed, within threeyears, to adopt a credit rating system well

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suited to their customer base. The threeyears elapsed in May 2008, but only a coupleof commercial banks have abided. Settingup these qualitative credit rating systems,having them certified, and linking them toSBV, so as to have a real time picture of thestress faced by the banking system, is anurgent priority.

Improvements in accounting standards areneeded as well. Two kinds of systemic riskremain hidden under Vietnamese standards.Currently, assets and liabilities in foreigncurrency need to be converted into dong, butthey do not need to be identified separately.Based on financial reports, it is thereforeimpossible to tell whether an enterprise or abank is exposed to exchange rate risk. Or,put differently, whether it would suffer froman appreciation or a depreciation of thedong. Second, Vietnamese standards do notrequire “marking to market”. This meansthat the value of assets is recorder at facevalue, or at purchase price, not at marketprice. For example, if a commercial bankholds government bonds and these aretrading substantially below par, marking tomarket would reveal a loss. But underVietnamese standards the bank could stilllook very profitable. Marking to market isdifficult in the case of property, but feasiblein the case of financial assets.

Better credit rating systems and improvedaccounting standards should help identifywhich individual banks are facingdifficulties, but they are less well-suited toassess systemic risk. Consider, for instance,the quality of lending for real estate andurban development in the midst of a realestate bubble. As long as property priceskeep going up, the level of credit risk will

look tolerable. If anything, marking tomarket will increase the fraction of loansbeing classified as safe. However, creditrisk could increase dramatically if the bubblewas to burst. Assessing this kind of riskrequires a different approach, known asstress test. In this case, an apparentlyhealthy bank portfolio is subject tohypothetical shocks (a collapse in propertyprices, an increase in interest rates) to assesswhich fraction of outstanding credit would beat risk. In a context of increased turbulence,SBV should conduct stress tests as part of itssupervision tasks.

Communicating well

In times of financial turbulence, when marketsentiment is an important determinant offinancial decisions, adopting the rightpolicies may not be enough. It is alsonecessary to make sure that market playersunderstand both the situation and the policiesadopted, so as to avoid panic reactions anddangerous herd behavior. Market sentimentis particularly important in the case ofVietnam, a country which not yet perceivedby everybody as a market economy. Historicreasons, influencing the way in whichgovernment decisions are made andcommunicated, may easily result inmisunderstandings. And unwarrantedperceptions may easily become true, simplybecause financial markets are vulnerable toself-fulfilling prophecies.

Vietnam was perhaps close to one of thoseself-fulfilling prophecies around end-May2008. Despite the fact that a contractionarypolicy had been put in place by end-February, and a comprehensive stabilizationpackage had been announced by end-March,there was considerable uncertainty

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regarding their effectiveness at containingthe surge in inflation and reducing aballooning trade deficit. The country riskpremium, measured through the price offive-year Credit Default Swaps (CDS) wasincreasing steadily. A large devaluation ofthe dong was also expected, according to theone-year Non-Deliverable Forward (NDF)exchange rate. And none of the importantpolicy measures announced by thegovernment seemed to be able to make adent in these trends (Figure 11.2). Thevolume of transactions on these twoinstruments may not have been large, andmany of those involved were probablyforeign holders of Vietnamese bonds. Butthe message was unambiguous.

On the other hand, these trends ended upbeing sensitive to more “sensational” news.On May 29, 2008, a note by the research unitof an investment bank claimed that Vietnamwas heading towards a currency crisis. Thissent the NDF skyrocketing, to 22,500 dongper dollar, against the official 16,069 dongexchange rate. In early June, consensus by

participants at the highly visible mid-yearCG meeting that the stabilization packagewas working marked a turning point forCDS. A few days later, on June 28, at avideo-conference with investors fromaround the world, the government explainedits policy stance and for the first time everpublicly announced the level of itsinternational reserves. This was formally inviolation of the Law on State Secrets, but theimpact justified such a bold step, as the NDFplummeted.

Since then, the global financial crisis hasexacerbated perceptions about risk, pushingthe CDS up considerably. But it is encouragingthat the government has taken other importantsteps to increase policy transparency andimprove communication with markets andwith the public at large. In particular, Vietnamis by now current in its data reporting for theIMF’s International Financial Statistics. Andthe level of international reserves is nottreated as a secret anymore.

However, communication is an area wherethere is still room for improvement. Much of

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Video-conferencewith investors

Mid-term CGmeeting

Figure 11.2: Good policies are not enough

Source: World Bank.

the communication effort still relies on theannouncement of a growth target for GDP.This is certainly a succinct way for outsidersto assess whether the priority of thegovernment is to stabilize the economy or tosupport economic growth. But a target is notthe same as a forecast. More importantly, atarget is not particularly informative aboutthe concrete policies the government plansto adopt to reach it.

There is of course the expectation that lowgrowth targets will be associated with lessambitious investment plans, and thereforewith a more cautious fiscal policy stance.But in this respect, a much more effective ofcommunicating would be to produce timelyand reliable budget data. At present, as wasdiscussed earlier in this report, it is difficultto tell what the actual level of the budgetdeficit is. This is partly due to discrepanciesfrom international practice especially in theway amortization of debt is treated (it iscounted as expenditure in Vietnam and as afinancing item in the rest of the world). Butthe most important shortcomings are relatedto the carryover of both revenue andexpenditure from one year to the next.

Consider, for instance, the situation in 2007.Even after computing the amortization ofdebt according to international practice, thelevel of the budget deficit appeared to bequite high, at 5.6 percent of GDP. However,if the deficit is measured through thefinancial resources that had to be mobilizedto bridge it (domestic and foreign debt, plusbanking credit) it appears to be much moremodest, probably in the order of 2.2 percentof GDP. The difference between these twofigures is mainly due to revenue carryover.In other words, in 2006 the governmentended up spending less than it had planned

(for instance, due to poor projectimplementation) and resources stood idle ina Treasury account. The carryover could beparticularly important in 2008, a year whenmany contractors for public investmentprojects walked away due to the high cost ofcement and other construction materials.

If the government of Vietnam wants toimprove the communication of its policies andavoid potentially costly misunderstandingswith market participants, it should do forbudget statistics what it recently did forfinancial sector statistics. Namely, it shouldproduce them and release them in a timelyfashion, according to accepted internationalstandards. Doing so will be more difficultthan in the case of financial statistics, due tothe poor monitoring of the implementation ofpublic investment projects. This is an areawhere short term macroeconomic policymeets medium-term economic reform.

Social impacts

Stability has a social dimension as well. Thesurge in food and oil prices since late 2007,and the acceleration of inflation morebroadly, had an impact on the wellbeing ofmany Vietnamese households. Vietnam is anet exporter of food, and its foreign sales ofcrude oil roughly match its foreign purchasesof gasoline, implying that at an aggregatelevel the country gained from high foodprices and was not adversely affected byhigh fuel prices. Households producing foodfor the market were clearly better off. But amajority of households do not produce foodand all of them are buyers when it comes togasoline. Microeconomic simulations usingindividual records from the 2006 VHLSSsuggest that 51 percent of all households and86 percent of urban households are worse off

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when the price of rice increases. On theother hand, the deceleration of growthassociated with the stabilization policy first,and with the global financial turbulencelater, could result in jobs being lost or notbeing created rapidly enough to absorb thelarge number of entrants into the labormarket.

Ensuring stability involves addressing thesehardships. Failure to do so would not only bequestionable on ethical grounds: it could alsoundermine popular support for criticallyimportant policy choices. But effectivelymitigating the losses experienced byaffected households is difficult in practice.

The standard economic response is to providecash transfers which are commensurate withthe losses, at least in the case of poorerhouseholds. More recently, it has becomecommon to condition those transfers on thebeneficiary households taking actions whichare considered socially desirable, such askeeping their children in school. However,poverty reduction in Vietnam has not relied toany large extent on cash transfers, conditionalor not. Cash transfers at the individual or thehousehold are seen as potentiallyundermining the sense of self-reliance, if notdirectly the work ethic. Large redistributionmechanisms are in place, but thebeneficiaries are lower levels of government,from poorer provinces to disadvantagedcommunes. Budget allocation norms andProgram 135 Phase II are clear examples ofthis approach. Support to poor householdstakes a different form, namely ensuring theircapacity to be part of the mainstream

economy. Poor households get free insurancecards, are exempted from paying school feesfor their children, and can borrow withoutusing collateral, among others.

A Vietnamese response to the hardshipscreated by macroeconomic turbulence wouldthus require that two conditions be met.First, the targeting of households facinghardship should be reliable (Box 11.2). Andsecond, a sufficient amount of resourcesshould be available to ensure that thosehouseholds effectively have access to thebenefits they are entitled to.

Other possible measures to address hardshipconcern wage setting mechanisms. In 2008,high inflation has eroded the purchasingpower of wages in urban areas, especiallyaffecting the many migrants who work inindustrial zones and live barely above thepoverty line. The current collective bargainingand dispute resolution mechanisms are toorigid to process requests for wageadjustments. This has resulted in either longdelays between price increases and wageincreases or socially costly wildcat strikes.More flexible mechanisms for workers toappoint their representatives, and swifterconciliation in the event of disagreements,would contribute to more stable realearnings and more peaceful industrialrelations at the enterprise level. A betterfunctioning collective bargaining systemshould also help cushion adverse demandshocks, when wage moderation may beneeded to preserve jobs.

With the world being more uncertain and the

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Box 11.2: Identifying Poor and Vulnerable Households

Local authorities are requested to classify all households in their jurisdiction into a few broadcategories, typically including: hungry, poor, near poor and well-off. Households in the “poorlist” (the first two groups) are then entitled to a series of benefits. The classification isconducted at the lowest levels of government and updated once a year. Supposedly, it isguided by objective measures including the level of monthly income per person. In practice,subjective considerations by local officials and the views of the community also play a role.This subjective or social element results in a lack of consistency regarding what it is to be“poor” in different parts of the country. For this reason, the poverty rates produced byaggregating “poor household lists” tend to be unreliable. But the actual ranking ofhouseholds within a community, and even within a similar area, is much more reliable.

At present, the quality of targeting by local authorities is hampered on three fronts:

● Unknown households. This is a serious issue in rapidly urbanizing areas, which are hometo many migrants not even know to the police. These households do not show up in povertycounts, are not included in surveys, and can not be reached to channel benefits to them. InVietnam, these unregistered households do not cluster in specific locations, but instead arespread out over urban areas that are often densely populated. In urban areas, local officialshave limited knowledge of households residing in their localities, as opposed to rural areas,where mostly everybody knows each other. The number of unknown households isprobably increasing in urban areas.

● Households moving in and out of poverty. These often define an entire “grey area” inbetween the poor and near-poor categories. Households in this “grey area” may be non-poor in one period but then see their income fall below the poverty line in the next.Macroeconomic instability most probably exacerbates those movements. But the annualhousehold classification exercise may fail to capture them.

● “Undeserving” households. Local officials in Vietnam are found to exclude people from the“poor household list” because of what they consider socially reprehensible behaviour, suchas drinking, gambling or commercial sex, even when these households would be poor byobjective criteria, such as their monthly income per person.

By excluding people from the “poor household list”, authorities not only curtail their accessto benefits, they also distort poverty counts. This may not be the only source of bias though.Local authorities may be tempted to overestimate the number of poor, in the hope to attractmore resources. There is also anecdotal evidence of local officials underestimating thenumber of poor to demonstrate good performance.

These biases may be resolved by anchoring district-level aggregates of the “poor householdlist” to small-area estimates (SAE) of poverty. SAEs, also known as poverty maps, could beused to determine the budget allocation across provinces and districts, while “poorhousehold lists” would determine how district budgets are distributed further down, tocommunes, villages and households.

The use of poverty maps, however, would not resolve the three forms of exclusion listedabove. Perhaps a way to address them is to give households the opportunity to request are-assessment of their poverty status, in between scheduled assessments, if they considerthemselves poor but for any reason they have not been classified as such.

Vietnamese economy being more exposedto it, the risk of facing macroeconomicinstability is higher. This may result in aquestioning of the merits of globalintegration, which would be a mistake.Global integration has been one of the mainforces behind poverty reduction and a driverof economic reforms across a range ofsectors. Importantly, given the level of thedomestic savings rate, capital from abroadwill be needed for Vietnam to sustain rapideconomic and become an industrial countrywithin one generation. Finding acceptableways to mitigate the impact of fluctuations inworld prices, and monitoring capital inflowsin terms of their objective and time horizon,are defensible moves. But going beyondthat point could hamper Vietnam’s ability toattract the long-term capital it so much needs.To ensure macroeconomic stability, aninvestment program reconciling Vietnam’sneeds with the availability of long-termresources is needed. In the short term, thereconciliation will have to rely onmacroeconomic policy tools. Fiscal policy isone of them. In this respect, the successfulexperience with adjustment in 2008, when anumber of poorly performing projects wheredelayed or stopped, opens the door for abetter management of state-fundedinvestments. However, investment efficiencydepends on microeconomic policies muchmore than on macroeconomic rules. A

review of the investment cycle, from fundingto implementation, suggests several areas forimprovement. The shortage of long-termfinance and the lack of a proper institutionalframework for private participation ininfrastructure are the main shortcomings onthe funding side. Weakness in the preparation,appraisal and monitoring of budget-fundedprojects, and the possibility for EconomicGroups and large State Corporations to controlfinancial institutions, are the mainshortcomings on the implementation side.

Preserving integration

With the balance of payments as the mainsource of instability for the Vietnameseeconomy, the temptation to reconsiderglobal integration may arise. Massive capitalinflows were at the root of overheating inlate 2007. The surge in the internationalprice for rice fanned the flames of an alreadyhigh inflation in early 2008. Since then,market sentiment has been volatile and theglobal financial crisis is putting new strainson the Vietnamese economy. In light ofthese developments, and aware of thecontinued global turbulence ahead, somemay wonder whether the benefits fromglobal integration outweigh its costs.

Backtracking on international integrationwould be a mistake, however. Becoming afull member of the global economy has

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enormously contributed to economic growthand job creation in Vietnam. From theincreasing commercialization of agriculturalproduction to the development of labor-intensive manufacturing, participating inworld markets has helped reduce povertyrapidly. Commitments made to accede to theWTO have exposed sectors previouslydominated by large State Corporations tohealthy competition. International agreementsalso served to “lock in” economic reformsand induce policy improvements across theeconomy. FDI would not have grown as fastas it did since 2006 had it not been for thesignal that accession to the WTO sent to theworld, regarding the commitment of thegovernment to economic reform. Even thesurge in the international price of rice,certainly detrimental to urban populationgroups, was beneficial to rural households inthe deltas, many of whom are still poor.

The way in which the surge in theinternational price of rice was handled byseveral Asian countries is telling in thisrespect. Out of an understandable concernfor food security, India, Vietnam and thePhilippines took measures to increase thesupply of rice available for the domesticmarket. But these restrictive measurescompounded the problem. With only afraction of the global supply of rice tradedinternationally, attempts to redirect thesupply towards the domestic marketsharply curtailed the volume of riceavailable in the already thin internationalmarket. In this context, food security forone country becomes food insecurity foranother.

In Vietnam, an export quota of 4 million tonswas set up in March 2008 out of concern forfood security. Later in the month the

Vietnam's Food Association issued a seriesof regulations on compulsory registration ofrice export contracts. Each exporter wasallowed to register first-6-month exportstotaling no more than half of its average totalrice exports in 2006 and 2007. In April, aban on new rice export contracts wasimposed until June, in the anticipation ofpossible losses of spring crop in the North.By May, the domestic price of rice topped588 dollars per ton, an increase of 73 percentover March prices. The fever was mostnotable in the South - the major riceproduction and export region. Internalpreparation and consultation on a NationalFood Security Strategy was launched. InJune, the international price started todecline, and so did the domestic prices. InJuly, the rice export quota was raised to 4.5million tons, and the ban on the new riceexport contract was removed. The decisionwas made to apply an absolute value taxinstead of a tax on export values. Later, itwas announced that the tax would besuspended if the international price of ricewent below 600 dollars per ton.

Price-based mechanisms of this sort usuallycreate fewer distortions than quantity-basedinterventions, like the original export quota.If designed well, an export tax can smoothfluctuations in international prices withoutpreventing the operation of markets. Othercountries have designed relativelysophisticated mechanisms to stabilize theirexport earnings. It does not necessarilyfollow that Vietnam should go in the samedirection as those countries. But it would beimportant that any effort to mitigate thepotentially adverse impacts of globalintegration be conducted in accordance withinternational agreements, so that it is not

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perceived as an attempt to backtrack onglobal integration.

Perceptions matter even more in the case ofcapital flows than they do in the case of tradein goods and services. The capital account isthe potentially most volatile part of thebalance of payments, with surges in inflowsleading to overheating and sudden outflowsthreatening financial stability. Yet, attemptsto control inflows and outflows wouldseriously affect market sentiment and couldthus undermine Vietnam’s efforts to attractmore capital to speed up its economicgrowth.

Monitoring inflows

While attempts to manage capital flows couldbackfire, there is certainly scope to monitorthem better. A mechanism is in place toscreen FDI applications, and it might haveinfluenced the volume of approvals, or atleast its distribution over time. Indeed, MPIwas slower at processing applications in late2007, when the Vietnamese economy wasfacing overheating, and faster during 2008,when there were concerns about the balanceof payments. This might have been adeliberate attempt to smooth inflows, or itmight have occurred just by chance.However, there are more efficient ways tohandle the FDI flow of applications than tojust speed up or slow down the administrativeprocess.

While some FDI projects are clearlybeneficial to Vietnam, others have beenmore controversial. One recent example isthe hotly debated Van Phong Port, whichinvolved disagreements between the Koreanfirm Posco and Vinalines. Other projectshave raised environmental concerns,especially in relation to their management of

dangerous waste in the vicinity of residentialareas. Concerns have also been flagged onthe large number of FDI projects approvedfor golf courses, as they compete withagriculture for land and water, at a timewhen food security has been at stake.

In the drive towards decentralization, theauthority to approve a majority of FDIprojects now rests with provincialgovernments. But given the size of a typicalprovince, some of the adverse impacts fromthose projects may be felt elsewhere. Forinstance, a deep sea port in one provincemay reduce shipment volumes in the deepsea ports of neighboring provinces. Andwater discharges from industrial parks mayaffect downstream locations in otherprovinces as well. Keeping the FDI approvalprocess decentralized encourages healthycompetition among provinces, with each ofthem trying to improve its investmentclimate in order to attract more capital. Butit is also important to avoid drifting into whatsome commentators see as a race to thebottom. This calls for a stronger oversight ofFDI approvals by MPI, with a focus oncompliance with regional development plansand environmental impact assessments.

There is also room for improvement in themonitoring of short-term inflows. Theexperience of neighboring countries in thelate 1990s shows that currency mismatchescan result in systemic risk. As exchange rateflexibility increases, un-hedged currencymismatches in enterprises can result insubstantial losses, raising doubts about theirability to service their obligations. Suchdoubts can make banks more cautious intheir lending, potentially triggeringdangerous cycles of credit contraction,bankruptcies and capital outflows. To

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minimize the risk of this happening in Vietnam,authorities should more systematically checkwhich banks and businesses are carrying un-hedged foreign exchange liabilities,particularly short-term ones, while havinglong-term assets.

Portfolio inflows should be monitored notonly in relation to their volume, but also totheir tenure, invested assets and type of end-borrowers. For example, to the extent thatthe foreign portfolio investment is channeledinto short-term assets such as bank depositsor money market instruments, the country’sinternational reserves should be built up tofully and readily counter their possiblereversals. On the other hand, short-termforeign currency borrowing by FDI firmsguaranteed by their parent companiesoverseas should cause less worry. Foreigncapital invested in illiquid, non-standardizedassets including stocks in the informal stockmarket should also be less dangerousbecause a panicked exit from such aninvestment, even if possible, would causesubstantial losses to the investor. The lossesor the difficulty to exit would be greater, thelarger the investor. Foreigners investing insuch assets knowingly of the risk tend to belong-term oriented.

To monitor portfolio inflows as they arechanneled through the financial sector, SBV,SSC and the Insurance Department of MOFwould need to regularly exchangeinformation and coordinate their actionsclosely. In this regard, the establishment ofa high level committee to monitor financialflows and ensure the stability of the financialsystem and the economy is a welcome actionby the Government.

Identifying the characteristics of the end

investors behind an investment manager,broker or nominee would also helpunderstand the nature of the inflows. So far,a significant part of the foreign portfolioinvestments in Vietnam’s stock market hasbeen long-term oriented. Yet, some hedgefunds have participated in the market, andthis needs to be watched closely. It is noteasy to identify end investors when thesource of money is overseas (and, therefore,outside the jurisdiction of Vietnam).However, the SSC’s tightening ofregistration and reporting requirements forrepresentative offices of foreign investmentmanagers was a good start. A strong anti-money laundering (AML) regime shouldalso help.

Investment volume

The domestic savings rate has been in theorder of 30 percent of GDP over the last fewyears. Even if those savings were investedin a very efficient way, they would probablynot be sufficient for Vietnam to become anindustrial country within one generation, asit aspires to. An alternative would be toincreasing the domestic savings rate. Butthis would be equivalent to decreasingdomestic consumption, which may not be thepreferred choice for a country that is barelyentering the middle-income group. And inany event, there is relatively little that policymakers can do to influence the savings rate;the age composition of the population andsubjective preferences play a much moreimportant role in this respect.

The only viable alternative to sustain rapidgrowth is therefore to mobilize capital fromabroad. However, in seeking externalfinance Vietnam should also take a cautiousstance, so as to avoid increasing is external

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debt beyond prudent levels, or becomingvulnerable to sudden reversals in capitalflows. This requires a well-consideredinvestment program that matches Vietnam’sneeds with the availability of long-termfinance.

Forecasting long-term capital inflows isdifficult, especially at a time of globalturbulence. But some components aredriven by relatively steady, structural trends.For instance, a significant portion ofremittances goes into long-term investments,mainly in real estate but also in smallbusinesses. The community of overseasVietnamese who left in the aftermath ofreunification is ageing, is prosperous, isincreasingly confident in the policiesadopted by the government, and is graduallyrenewing ties with relatives and with thecountry more broadly. Many members ofthis community are investing in Vietnam fortheir retirement. These long-term inflows,which may account for a third of totalremittances or more, can be expected tocontinue on a slightly upward trend despitethe global turbulence.

A better monitoring of capital inflows shouldalso help refine forecasts in relation to FDIand portfolio investments. In the case ofFDI, actual inflows are dominated by theimplementation of previously approvedprojects, not by the flow of new approvals.And some large projects account for a largeshare of the total. Adequate oversight intheir case should be informative of what canbe expected overall. In the case of portfolioinvestments, it is important to identify thosewhich are more prone to sudden reversal.

In practice, the reconciliation of totalinvestment and savings (both domestic and

external) is achieved, in one way or another,through macroeconomic policies. The moststraightforward way is through a flexibleexchange rate. By not intervening in theforeign exchange market, the authoritiesforce the current account deficit to be equalto the net capital inflow. However, thereconciliation is done in this case with theentire net inflow, including both long-termand short-term capital. Therefore, with aflexible exchange rate investment is higherin periods with large short-term inflows andlower in periods with capital outflows. Indeveloping countries, where short-terminflows and outflows may represent a largeshare of GDP, this results in a highervolatility of investment.

Regardless of the merits and demerits of fullexchange rate flexibility, Vietnam may notget there in the short term, or perhaps noteven in the medium term. This means thatother policy instruments will have to be usedto reconcile the level of investment with theavailability of long-term capital fromabroad. Monetary policy is an obviouscandidate, but its effectiveness is still limitedin Vietnam’s case. This is partly because amodern central bank is yet to be established,and the mechanisms for it to intervene in themoney market still need to be strengthened.But in addition, with a relatively rigidexchange rate it is difficult to control moneysupply, because sharp fluctuations in capitalmovements have an impact on liquidity.

That leaves fiscal policy as an important toolfor macroeconomic policy in the near future.And to some extent fiscal policy means publicinvestment policy. This is because trying toadjust to a change in capital inflows mainlythrough recurrent expenditures could be bothdifficult and inefficient. There are obvious

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institutional rigidities on governmentemployment and salaries. And even if theycould be overcome, just freezing salaries ordownsizing personnel based on the availabilityof short-term resources would be baddevelopment policy, as it would underminelong-term efforts to improve human resourcemanagement in the civil service. Also, there isonly so much that can be accomplished bycanceling seminars or reducing the use ofofficial cars. Cuts across the board would leadto inefficiency and waste; reallocation ofresources across units takes time.

A promising way to increase flexibility inpublic investment policy is to build on theexperience of 2008, when the need tostabilize the economy required large cuts inpublic investment projects. In April, thegovernment instructed all state units toreview, reduce or postpone slow andinefficient projects. The relevance of theinvestment objectives, the availability offunding and the track record on performancewere identified as the basic criteria to guidethe review. Less than two months later, 28line ministries and central agencies, 43provincial governments and eight EconomicGroups and large State Corporations hadreported back on the projects to bepostponed or cancelled. There were 995 ofthem, accounting for roughly 4 trillion dong,or the equivalent of 7.8 percent of totalinvestments from the state budget. Inaddition, the issuance of off-budget funds forinvestment purposes was cut by 9 trilliondong, equivalent to one quarter of the annualplan. On the other hand, disbursements wereallowed for projects completed ahead oftime, and additional funding was madeavailable for highly effective projects in keysocio-economic areas.

This effective response could be easilyembedded into the routine management ofpublic investment projects. For instance, athree-tier system to monitor projectperformance could be established. Barringexceptional circumstances, publicinvestment projects that address urgentsocio-economic needs and are implementedaccording to schedule would not be subjectsto cuts in funding or delays. At the otherextreme, projects whose relevance isquestionable or whose track record onimplementation is weak would be subject toin-depth review, restructuring orcancellation, regardless of the availability ofresources. In between these two, therewould be a range of projects that would beallowed to continue in good times, but couldbe delayed in times of fiscal adjustment.

Investment efficiency

The volume of investment is determined atthe macroeconomic level, but its efficiencydepends on a number of decisions which aremicroeconomic in nature. The value chainanalogy is useful to link those decisions andunderstand where the largest efficiencygains can be made. Value chain analysestrace the price of a product through variousstages in its production process (say, fromthe farm gate to the consumer table)identifying the segments where a jump inprices occurs, and assessing whether thejump reflects genuine value added or ratherlimited competition. In the same spirit, themore detailed analyses presented earlier inthis report allow to decompose theinvestment process into a series of stages,including the raising of resources, theselection of investment projects and themanagement of their implementation. Atone end of this chain lie the cost of

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investment and at the other its returns. Theissue is then to identify what prevents highreturns from materializing.

In raising resources for investment, the maininefficiencies seem related to the shortageof long-term finance and the institutionalconstraints to develop PPPs in infrastructure.This means that investment projects withpotentially high returns may never see thelight simply due to the lack of funding.

The bond market is still thin, and willprobably remain that way in the absence of areliable yield curve. For the latter toemerge, more progress is needed inconsolidating the large number ofoutstanding series of government bonds andbills, each with limited trading. The mainobstacle in relation to private partnerships isthe absence of a specialized agency with thecapacity to foster competition aroundinvestment projects, and to identify thefinancial support needed for those projects tobe attractive when there is a perceivedviability gap.

Other sources of funding for investment arein relatively better shape, but efficiencygains are possible in their case too.

The tax system, which remains the mainsource of funding for public sectorinvestments, has seen considerableimprovements but could still do better in termsof efficiency and equity. Its workhorses, VATand EIT already have a good design, althoughboth would benefit from further simplification.But modern natural resource taxation and agenuine property tax are still missing, and thetax burden remains unevenly distributedbetween large taxpayers and the emergingdomestic private sector.

Banking credit has expanded remarkably

and its composition has changedsubstantially in recent years, with both thelending share of SOCBs and the borrowingshare of SOEs declining over time. Thenecessary improvement in this case has to dowith the monitoring of credit risk, so as torapidly identify borrowers under stress andweak lending portfolios.

The stock market has also shown enormousdynamism in recent years, and theaccomplishments should not be overshadowedby the slump associated with the stabilizationpackage first and the global financial crisislater. But several improvements can bemade at the level of the trading platforms.Perhaps the biggest contribution to arenewed vibrancy of the stock market in themedium term would come from a faster (butstill transparent) equitization of large SOEsand SOCBs.

While much can be done to increaseefficiency in the raising of resources forinvestment, the biggest weaknesses in theVietnamese value chain seem to lie in its lasttwo stages, namely the selection ofinvestment projects and the management oftheir implementation. The concern is notrelated to private investment projects,including those of SOEs operating in acompetitive environment, because in theircase the market punishes bad choices andpoor execution. The main concern is withpublic investment, because relying onmarkets as a correcting device is not alwayspossible in their case. In this respect, it isimportant to distinguish between budget-funded projects and projects by EconomicGroups and large State Corporations.

In relation to budget-funded projects,decentralization has brought the key

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decisions closer to the beneficiaries, whichin principle should result in more relevantprojects being selected. But decentralizationhas also led to weaker project appraisal andimplementation processes. Cost-benefitanalyses are not always undertaken, and themonitoring of project execution is not strongenough to avoid substantial delays and costoverruns.

Two important measures can be adopted toremedy these shortcomings. First, a PublicInvestment Law could spell out morespecifically the steps through which lineministries and local governments need to goas they prepare, appraise and implementprojects. And second, MPI should developthe capacity to review feasibility studies andmonitor implementation. This second stepis particularly important at a time when theability to adjust investment volumes rapidlymay hold the key to macroeconomic

stability in an increasingly uncertain world.

Investments by Economic Groups and largeState Corporations may not be as inefficientas they are often portrayed. But this may owemuch to the economies of scale characterizingthe sectors they operate in. Also, theventuring of these groups into finance andreal estate during the overheating period oflate 2007 and early 2008 is to some extent areflection of wrong market signals comingfrom an inappropriate monetary policy.However, their initiatives to establish theirown banks and deposit-taking institutions area source of concern. Control over financialinstitutions would reduce the need for them todevelop genuinely bankable projects, andwould allow poor investment decisions to bepursued way beyond what is reasonable.Preventing this development is thus a priorityfrom the point of view of investmentefficiency.

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