Following a recent research visit, Niall Paul, Head of Emerging Markets, assesses the opportunities and challenges facing Vietnam.
Vietnam has delivered the world’s second-fastest growth rate per person since 1990, behind only China. If it can maintain a 7% pace over the next decade, it will follow the same trajectory as former Asian tigers such as South Korea and Taiwan, which underwent rapid industrialisation to become advanced, high-income countries. Despite this fact, Vietnam is one of the cheapest markets in Asia, trading at a valuation half that of most of its larger South East Asian competitors.
Comparison of regional equity markets (size of bubble represents dividend yield %)
Source: Bloomberg. Vietnam: VN All Share Index; main bourses of other markets used. As at 25/1/17.
With a strong economy and a clear reform programme, the country looks set to structurally re-rate closer to its peers. Following a recent research visit, Niall Paul, Head of Emerging Markets, assesses the opportunities and challenges facing Vietnam.
Good morning, Vietnam
Ho Chi Minh is booming. It feels like Bangkok 15 years ago, but without the unfinished construction sites that pockmarked the Thai capital following Asia’s Financial Crisis. With over 8 million residents, Ho Chi Minh is the largest city in a nation of 95 million people. These people are one of Vietnam’s greatest assets. Indeed, the country boasts some of the best demographics in Asia, with a quarter of the population less than 14 years old. Vietnam’s population is not just young but highly skilled. Public spending on education tops 6% of GDP, two percentage points more than the average for low- and middle-income countries. In global rankings, 15-year-olds in Vietnam beat those in America and Britain in maths and science. That pays dividends in a country that is looking to establish itself as a manufacturing powerhouse. Factories may be becoming more automated, but the machines still need operators. Workers must be literate, numerate and able to handle complex instructions.
In addition to a highly skilled workforce, Vietnam benefits from its close proximity to China. No other country is nearer to the manufacturing heartland of southern China, with connections by land and sea. Moreover, Vietnamese wages are just one-third of those in China, and it has a vast reservoir of rural workers to help dampen wage pressures. Nearly 70% of the population still live in the countryside, compared with only 44% in China. Thus, as Chinese wages rise, Vietnam is the obvious substitute for firms moving to lower-cost production hubs, particularly if they want to maintain links back to China’s extensive supply chains.
No wonder foreign direct investment in Vietnam surged 20% last year to a record $15.6bn. This is helping the country to capture market share in the global manufacturing industry. The IMF’s latest assessment of global market share showed that Vietnam enjoyed the largest gain in low end goods and the second largest gain in final electronic goods, behind only China. While Vietnam’s emergence as a major manufacturing hub would have been further catalysed by the Trans-Pacific Partnership, the failure of this trade agreement is expected to have a limited economic impact. In fact, even before Trump’s decision to withdraw from the TPP, Vietnam’s government had already been shifting its priorities towards developing closer ties with ASEAN+3 countries and North Asia.
Of course, Vietnam’s bright prospects extend far beyond FDI fuelled manufacturing. It also promises a powerful domestic growth story. Household consumption dominates the economy, accounting for two-thirds of GDP. Consumer sentiment is buoyant, with retail sales rising 10% year-on-year in December and 1.6m motorbikes sold in Ho Chi Minh alone over the last six months. They were everywhere, bolstered by an army of Uber scooters ferrying passengers around.
Source: TT International
Similarly, sales of larger passenger vehicles grew 30% last year, despite a special consumption tax of at least 40%. Such impressive trends look set to accelerate as the middle class expands from 10% of the population to 50% by 2035. Against this backdrop, many sectors are extremely under-penetrated. The most obvious example is food retail, with few formal supermarkets evident in Ho Chi Minh.
As consumption growth accelerates, so too does the pace of reform. One area of focus is state-owned enterprise (SOE) privatisation, which is vital to enhance productivity and inject cash into straining public coffers. Until now progress has been painfully slow. After 15 years of restructuring SOEs, only 8% of their capital has been privatised, according to official figures. However, in the past the government has mainly divested small slivers of unappealing companies. Now at last it is offering foreigners larger slices of its best assets. These include dairy company Vinamilk, as well as brewers Sabeco and Habeco. The government is also pushing for further increases in foreign shareholding limits, particularly in the banking sector, which will likely face a capital shortfall when Vietnam adopts Basel 2 regulatory rules later this year. Most corporates we met were underwhelmed on progress so far, though at a press conference the Prime Minister struck a defiant tone, stating “we want to raise the ceiling and expand access to the securities market. Right now if there are any foreign investors interested in buying any of our underperforming banks, we will sell them entirely”.
The primary motive underpinning these reforms is Vietnam’s desire to be included in the MSCI Emerging Market Index. It is hoped that MSCI will announce Vietnam’s inclusion later this year, and that the country will actually enter the index in 1-2 years’ time. Inclusion is such a high priority that a dedicated team has been tasked with facilitating reforms to achieve this goal. Encouragingly, Vietnam already meets many of MSCI’s requirements. For example, a country must have a minimum of three companies with a free float of greater than 50%. Vietnam has seven. However, more needs to be done in terms of FX convertibility and ease of foreign participation in the market.
Another reason for Vietnam’s focus on reform is that the government desperately needs the proceeds from its SOE equitisation drive if it is to rein in spiralling public debt. The country has a gaping fiscal deficit that exceeds 6% of GDP. Left unchecked, public debt will rise above the legal cap of 65% of GDP in 2017. The problem is compounded by SOEs, which have combined debts of $67bn. Much SOE debt is guaranteed by the state, while recent experience suggests that even when it is not, it will be assumed by the government in the event of an SOE failure. Indeed, after state-owned shipbuilder Vinashin defaulted on a $600m loan, the Ministry of Finance stepped in to guarantee a bond issuance to a group of more than 20 creditors, mostly commercial banks.
Rising debt levels will only add to concerns about asset quality in a banking system that is already undercapitalised. This is a legacy of rapid credit growth following Vietnam’s entry to the World Trade Organisation, which saddled many banks with a high proportion of problem assets. Consequently, when Vietnam introduces Basel 2 regulatory rules later this year, analysts expect a capital shortfall of $6bn in the banking system. Thankfully, many of the more prescient banks have prepared by raising capital through subordinated debt issuance. Moreover, non-performing loans at the big listed banks look manageable at between 2-3%. It must also be said that risk management in Vietnam’s banking sector has generally improved, with banks now setting aside additional reserves for loans to parts of the economy that could potentially overheat such as real estate.
If the real estate sector was to overheat, it wouldn’t be the first time. After it became clear that the SARS outbreak had been successfully contained, Vietnamese property prices rose rapidly from 2004 to 2007. By January 2008 inflation was running at 20%, forcing the central bank to hike interest rates from 6.5% to 15% in less than 6 months. This crushed developers’ balance sheets and sent the property market into a tailspin. During the down cycle, property related non-performing loans peaked at 50%. There were several false recoveries between 2010 and 2012, but most developers were still struggling at that stage. Then in August 2014, Capital Land re-launched a project in Ho Chi Minh called Vista Verde. It quickly sold 3,000 units and soon the market was up and running again. Today a steady stream of supply is met by robust demand, and prices are up 4.6% on last year. Though we are nearer the end of this cycle than the beginning, the long term outlook remains strong, with demand underpinned by powerful social pressure to marry and have children, as well as rising urbanisation. Vietnam currently has an urbanisation rate of 36% – the same as Thailand in 2000 – but this is expected to rise to 40% by 2020.
As can be seen, Vietnam faces a number of challenges, including spiralling public debts, inefficient SOEs, and an undercapitalised banking sector. But the government clearly understands this and is taking action. Meanwhile, Vietnam’s virtues of a young and highly skilled population and its proximity to China mean it offers many structural growth opportunities, both in terms of foreign investment and domestic consumption. Consequently, we expect Vietnam to be a rich source of ideas for our Emerging Market and Asian portfolios in the future.