Produced by: ABN AMRO Bank NV

Friday 6 June 2008

Local Markets Strategy - Asia Vietnam: not the 1997 crisis redux
In 2007 when Vietnam was already overheating, a surge in capital inflows led to a sharp acceleration in import growth and, together with surging food prices, to a sharp acceleration in inflation. But VND and USD liquidity has been tightened sharply , import growth is already slowing and inflation is bound to follow suit over the next few months. Onshore rates appear set to rise further which suggest going long the forward points. At the same time, a sovereign default appears unlikely in the next year or so, and the economic stabilization we expect will see sovereign risk fall, which suggests selling the 5 yr CDS.

Economics/Strategy

Asia

Investors concerns
Chart 1 : Headline inflation has accelerated on the back of food prices (CPI, %, Y/Y)
45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Ju n03 Headline
Source: ABN AMRO
`

Chart 2 : A strong acceleration in import growth suggests overheating (%, Y/Y)
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% -10% Feb-06 Feb-07 Feb-08 Oct-05 Oct-06 Jun-05 Jun-06 Jun-07 Oct-07

Ju n04

Ju n05 Food

Ju n06

Ju n07 Non food CPI

Imports
Source: ABN AMRO

Exports

Recent inflation and external trade data has generated market concerns over the possible consequences of overheating and led Moody’s, S&P and Fitch to place Vietnam on negative outlook. Inflation has accelerated to 25.2% y/y in May 08, from 7.3% in May 07. However, this reflects largely an increase in food prices: food price inflation accelerated to 42.4% in May 08, against 9.2% in May 07 and the weight of food and foodstuff in the CPI is .43 (.47 up to May 06). The non food CPI accelerated by 7.4% in May 08, from 4.8% in May 07.
Overheating and loss of monetary control

But the acceleration in food price inflation explains only about 80% of the acceleration in headline inflation over the past year, which suggests some spillovers from food to the broader price index. Vietnam’s economy is experiencing resource pressures after years of fast growth: during 2003-07, Vietnam grew by 8% a year on average, the fastest growing economy in Asia after China and India. And Vietnam’s current account deficit widened from nearly 0 to 10% of GDP in 2007.
Analyst
Dominique Dwor-Frecaut
Singapore +65 6518 7382 domi.df@sg.abnamro.com

Important disclosures can be found in the Disclosures Appendix.

www.abnamroresearch.com Level 21, One Raffles Quay, South Tower, Singapore 048583, Singapore

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But the fast pick up in inflation suggests monetary accommodation. M2 growth is unlikely to have slowed from the 40% showed by the last available monetary survey in June 07. A fairly stable ratio of M2 to reserve money up to mid-07 suggests M2 growth may have been driven by reserve money growth. Reserve money growth in turn has been accelerating largely due to an acceleration in the growth of net foreign assets: during 2007 Vietnam’s FX reserves increased by USD9.4 bn or 13% of GDP.
Chart 3 : A rising ratio of NFA to reserve money suggests active sterilization
1.3 1.2 1.1 1 0.9 0.8 0.7 0.6 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Mar-07 0.5 0.4 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Mar-07 -20 60 40 20 0

Chart 4 : Nevertheless, reserve money growth has been accelerating (% Y/Y)
100 80

NFA growth
Source: ABN AMRO

reserve money growth

Source: ABN AMRO

At the same time, the ratio of net foreign assets to reserve money has increased from about 0.6 in March 2003 to 1.2 in June 07 which suggests active sterilization by the SBV (for a given level of FX reserves, sterilization substitutes MSBs to reserve money). But with Vietnam’s highly open capital account, policy can either control interest rate or the exchange rate but not both. The spot USD/VND rate rose during Q1-Q3 07 and subsequently fell up to end-Q1 08. The acceleration of inflation suggests VND flexibility has not been sufficient to limit the impact of the capital inflows on money growth. With an open capital account and an overheating economy, sterilization is likely to have pushed up onshore rates and brought in more foreign inflows. Overheating has also pushed up import growth, that accelerated to a peak at 85% in April 08. By contrast, export growth has hovered around a trend of 25% y/y for the past few years and even accelerated since Q3 07. With the sharp acceleration in import growth, the trade deficit reached USD14.4 bn during January-May 2008, against USD10.4 for the whole of 2007. The combination of strong export growth and ballooning import growth suggests that, until recently, the sharp increase in the trade deficit has reflected an intensification of overheating, rather than a loss of competitiveness. Policy tightening Faced with what is likely to have been spiralling money growth (unfortunately no data is available after June 07), policy makers have implemented a number of measures to tighten liquidity and credit growth:
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From December 06, restrictions on bank lending for equity investments From June 07 onwards, increases in banks reserve requirements in February and May 08, hikes in official interest rates: the refinancing rate now stands at 13%, from 6.5% in January 2008

in March 08 compulsory purchases of SBV bonds by the banks

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Chart 5 : A spike in interbank rates
20 18 16 14 12 10 8 6 4 2 0 Dec-07 Feb-08 Oct-07 Jun-07 Jan-08 May-07 Mar-08 May-08 Sep-07 Aug-07 Nov-07 Apr-08 Jul-07

Chart 6 : Government bonds have sold off sharply (1 yr bond yield)
20 18 16 14 12 10 8 6 4 2 0 Feb-07 Dec-06 Dec-07 Feb-08 Oct-06 Oct-07 Jun-07 Apr-07 Aug-07 Apr-08 Jun-08

1m interbank rate
Source: ABN AMRO

overnight interbank rate

Source: ABN AMRO

These liquidity measures have seen bank liquidity tighten sharply and a spike in the inter-bank rate. Banks have scrambled to raise deposits, which saw the SBV initially impose a cap on the deposits rates banks could offer. On May 19, SBV removed the cap and announced banks were free to set their own lending and deposit rates within 1.5 times of the base rate, to be announced monthly and raised to 12% from 8.75% in April. Banks however have continued to struggle with the high cost and availability of funding. Many banks are charging their clients an administrative fee above the controlled interest rate in order to maintain positive margins of intermediation (see Reuters, Vietnam keeps 12 % base rate unchanged, 2 June 2008). The tightening of bank liquidity has also led to a sharp fall in the equity index as banks had lent large amounts to securities companies or had been directly funding equity purchases. In addition, foreign portfolio inflows seem to have stopped (see below). Equity market weakness has been further compounded by the uncertainty on the economic outlook caused by the ongoing liquidity squeeze. The main equity index is down to 400, from a peak at 1100 in October 2007. In addition, the government is implementing a fiscal consolidation program. The general government deficit was 7.5% of GDP in 2007, up from 3.9% of GDP on average over the previous 5 years. According to the World Bank, the government has postponed or cancelled public investment worth VND13 tn (1.1% of GDP). Moody’s estimates that the government deficit is likely to shrink to 5.2% of GDP in 2008, which would help relieve demand pressures. While policy tightening seems to have led to a VND liquidity crunch, USD liquidity has also become very tight, as shown by a sharp increase in the forward premium. This reflects the widening of the trade deficit mentioned above as well as:

Unmet demand for spot USD at the official exchange rate. The IMF classifies Vietnam’s exchange rate regime as a de facto peg. Under the peg, the State Bank of Vietnam (SBV) announces a daily reference rate, with a +/-2% band. But there are signs that securing USD at the official exchange rate for current and capital account transactions has become difficult.

A loss of confidence: caused by rising inflation and import growth, a steep fall in the equity market, a liquidity crunch and the compounding of economic uncertainty caused by a lack of availability of timely economic data, including FX reserves.

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A fall in private transfers that represented USD6.2 bn in 2007 and have fuelled consumption but also equity ad real estate investment. Because private transfers are partly driven by an investment objective, they are likely to have declined in line with financial markets.

A likely stop in short term capital inflows:

in 2007, Vietnam’s capital account

was in surplus of USD18.8 bn or 26% of GDP, including FDI of USD6.6 bn, LT loans of USD2 bn and portfolio flows of USD7.4 bn (10% of GDP). Most of that investment seems to be in Vietnam still: Vietnam held USD23 bn in FX reserves at end-07 and there is no information to suggest FX reserves have significantly declined. Because of the shortage of USD, it seems foreign investors have not repatriated their investments. Rather, it is very likely that inflows of short term investments such as equities, bonds or bank deposits have ground to a halt. By contrast, FDI inflows seem to be continuing briskly.

Hedging: with many investors unable to buy back USD and repatriate their investments, many have sought to hedge their long VND position by shorting the currency on the NDF market.

Chart 7 : The equity market has weakened sharply (Vnindex)
1400 1200 1000 800 600 400 200 0 Feb-06 Feb-07 Dec-05 Dec-06 Dec-07 Feb-08 Oct-05 Oct-06 Oct-07 Jun-06 Jun-07 Apr-06 Apr-07 Aug-05 Aug-06 Aug-07 Apr-08 Jun-05 Jun-08

The 1 m outright has spiked
19500 19000 18500 18000 17500 17000 16500 16000 15500 15000 Dec-07 Feb-08 Oct-07 Jun-07 Jan-08 May-07 Mar-08 May-08 Sep-07 Aug-07 Nov-07 Apr-08 Jul-07 100 -400 1600 1100 600 2600 2100

1 m outright
Source: ABN AMRO

spot

discount/premium (RHS)

Source: ABN AMRO

Inflation and external deficit to stabilize The very sharp tightening of VND and USD liquidity suggest inflation and the trade deficit are likely to stabilize. First, as mentioned above, the balance of payments surplus is likely to have declined if not turned into a deficit, thereby reducing the growth of net foreign assets that likely was the main source of money growth. Second, while the base rate and the reported inter-bank rate are negative in real terms, actual VND liquidity is much tighter than suggested by these rates as credit generally does not seem available at the official lending rate ceiling. The SBV cap on lending rates at 1.5 times the base rate or 18% has made it more profitable for banks to invest in Treasury bonds with a 22 to 25% yield than to extend credit. The larger banks that have been able to maintain their liquidity are generally not lending to new customers and focusing on maintaining the quality of their loan book instead. This suggests inflation is likely to slow within the next few months. So far this has not happened likely due to the very fast food price inflation and the lags involved in the transmission of tighter liquidity to the economy. But import growth has slowed sharply in May: imports were down m/m and import growth fell to 48% y/y, from 85% y/y in April which is indicative of a slowdown in demand and money growth. And while there have been reports of workers strikes and demand for higher wages these are unlikely to be accommodated as long as bank liquidity remains tight. Some banks have found it difficult to adjust to the tighter monetary conditions and
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have received liquidity injections from the SBV but these are the smaller private banks. At this stage SBV liquidity injections appear unlikely to be on a scale with macroeconomic consequences. (see Vietnam moves to help ease inflation, World Bank says, 4 June 2008) With the VND and USD liquidity crunch, the import growth slowdown is likely to continue. A possible scenario for the 2008 balance of payments involves containing the trade deficit to about USD19 bn and the current account deficit to about USD17 bn through import compression. The current account deficit could be funded by capital account surplus of USD14 bn including FDI of USD8 bn and long term borrowings of USD4 bn, as well as by a FX reserve draw down of USD5 bn (see appendix: balance of payments projections). Greater capital inflows than assumed in our scenario would allow Vietnam to fund a larger current account deficit, higher imports and support a higher GDP growth rate. Overall, the government growth forecast of 7% in 2008 (cut from initially 9%) may be difficult to reach but past experience with import and credit growth slowdown suggests GDP growth could remain close to 5%. The slowest GDP growth rate of the past decade, 4.8% in 1999 was associated with import growth of 1% for the year. By contrast, our balance of payments scenario assumes import growth for the whole of 2008 would be capped at 35%. Similarly, over the past 10 years, the slowest growth in domestic credit has been 17% in 1998, which was associated with GDP growth of 6%. This compares with domestic credit growth of 50% in 2007, and a government target of 30% for 2008. An IMF program appears unlikely until Vietnam agrees to an independent audit of the SBV balance sheet, a standard safeguard required by the IMF from all countries that borrow from it (see Vietnam: 2003 Article IV consultation-Staff Report, IMF, December 2003). In any event, it may not make much difference to the macroeconomic and financial outlook. With or without an IMF program, Vietnam will have to stabilize its economy i.e. reduce its overall growth rate. In addition, Vietnam can borrow only a limited amount from the IMF, due to the small size of its quota: the most Vietnam has been able to mobilize from the IMF was about USD0.5 bn in 1994, an amount dwarfed by private capital inflows. The main impact of an IMF program would be on investors confidence, which could facilitate a resumption of capital inflows, though a resumption of very large scale capital inflows may not facilitate economic stabilization. Risks The main risks to our scenario are hard landing and banking crisis. Hard landing could be caused by excessive liquidity tightening and misallocation of credit and FX. Because tightening is taking place through a restriction of the quantity of VND and USD liquidity available rather than through an increase in the price of USD and VND credit, it may be difficult to calibrate. Gradualist policies would be easier to implement if prices were allowed to adjust to their market clearing levels. In addition, Vietnam’s ratio of investment to GDP is high at 39% and jumped by 5% from 34% in 2006, which is indicative of inefficiencies and low productivity. Hence, the negative impact on GDP growth of an investment growth slowdown could be mitigated by greater investment efficiency. Greater investment efficiency in turn would require that interest rates and USD/VND be allowed to adjust to their market clearing level. For instance, credit rationing and preferential access of the state sector to credit could impair overall economy wide rates of returns on investment. Raising investment efficiency will eventually require the liberalization of banks deposit and lending rates.

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Furthermore, a continued shortage of USD could lead to significant input and capital goods shortages and eventually lower industrial output. FDI in Vietnam tends to export labour intensive goods with a high import contents and could be severely affected. In 2006, FDI were estimated to employ 1.1 mn workers and account for 17% of GDP (see Managing capital flows in Vietnam, ADB, May 08). This suggests the USD shortage is likely to become politically unsustainable once shortages of critical inputs and capital goods develop. Because the SBV appears unwilling to sell its FX reserves to the market, the USD shortage is likely to be resolved through VND depreciation. The spot VND has been depreciating since end-March 08. Reaching a market clearing level for the VND could take place either through a float, a step adjustment (one took place on March26-27) or a pick up in the pace of depreciation. Either way, faster VND depreciation would best take place after investor confidence has been stabilized, for instance after several data releases showing inflation and import growth slowing or as part of a comprehensive program of reforms. In addition, an orderly depreciation of the VND would require higher onshore interest rates. Hence we expect that by end-08, the spot USD/VND rate will rise to about 17,900 and the base rate will be hiked to 20% from currently 12%. A sovereign default appears unlikely within the next few years. Vietnam’s general government debt represented 36% of GDP in 2007 and while two third is in FX, about 90% of government FX debt is on concessional terms. The IMF expects only a increase in the ratio of government debt to GDP to a peak at 43% of GDP in 2009 in a base case scenario involving continued fiscal consolidation and fast growth. The risk to Vietnam’s public finances comes perhaps more from the banking system than from direct public sector spending. Vietnam is over banked with 5 state banks sharing 55% of banking credit, 34 domestic private banks sharing 29% of banking credits and 36 foreign private and joint venture banks sharing 9% of total banking credits. The government is aware that consolidation is unavoidable and the plan is for the larger banks to eventually take over smaller, non performing institutions. In addition, banks capital adequacy has improved in recent years and NPLs at state owned banks fell to 3.2% of assets in 2006. Furthermore at mid-07, foreign currency deposits net of banks foreign assets represented 19% of total deposits, down from 23% in March 05 and from a peak at 30% in December 1997. Based on global accounting standards Vietnamese banks may not be as strong as suggested by this data. For instance, Moodys estimates actual NPLs could be as much as 10 to 15% of assets. However, the example of Japan shows that banks with a low capital base can continue to operate for quite some time as long as they remain liquid. At this stage, Vietnamese policy makers seem able to prevent the VND liquidity crunch from destabilizing the banking system. In addition, the hike we expect in VND interest rates does not suggest increased dollarization. While there are weaknesses in Vietnam’s financial sector that reflect the country low level of income per capita and the transition from central planning to a market based economy, there is no compelling evidence that a systemic crisis is likely over the next 18 months. Not the 1997 crisis redux Vietnam does not appear to be on the brink of a 1997 type crisis. While Vietnam’s monetary policy faces a dilemma similar to that of for instance Thailand in 1997, risk management appears stronger in Vietnam now than in Thailand in 1997. Sterilized intervention in Vietnam does not seem to have worked due to overheating and an open capital account. With a large excess of savings over investment (the current account deficit represented 10% of GDP in 1997), it is likely that sterilization
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operations put pressure on onshore rates and attracted even more inflows. In 2007, inflows of currency and deposits represented USD2.6 bn, against a net outflow of USD1.5 bn in 2006 and the capital account surplus represented 26% of GDP. Similarly, in Thailand the 1996 current account deficit was 8.1% of GDP in 1996 but the capital account was in surplus of 10.7% of GDP. The BoT sterilization operations proved self-defeating because they actually raised onshore interest rates and foreign inflows. In both 2007 Vietnam and 1997 Thailand, an attempt to control both interest rates and the exchange rate led to a loss of monetary control. By contrast, sterilized large scale intervention has proven much more sustainable than expected in Asia in the aftermath of the 1997 crisis as private investment collapsed. Large current account surpluses i.e. excesses of savings over investment allowed Asian central bank to sterilize their FX purchases without putting pressure on onshore rates. During 2000-07 Asian countries, including China, were able to accumulate USD2.5 tn worth of FX reserves while maintaining monetary conditions consistent with price stability (see The effectiveness of foreign exchange intervention in emerging market countries, BIS papers 24, May 2005). In Thailand, the loss of monetary control led to a float of the currency and a balance of payments crisis as a loss o confidence stopped the rolling over of Thailand’s large ST FX debt. And because Thai banks had funded illiquid loans with unhedged ST FX debt, the balance of payments crisis was accompanied by a banking crisis. In Vietnam by contrast:
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Hot money inflows have stopped as explained above Vietnam’s ST FX debt is much smaller than Thailand’s was. Vietnam ST FX debt was USD3.8 bn at end-07, against FX reserves of USD23 bn. By contrast Thailand’s ST FX debts in 1997 were USD38 bn while there were virtually no available FX reserves since these had been on-lent to commercial banks and the reserve position of the BoT had been inflated by forward FX contracts.

Vietnamese banks do not have ST FX debts: rather they have FX deposits representing about 20% of total deposits. Thai banks had short term debts of USD24.4 bn in 1997,about 20% of deposits but these are less stable and less subject to government controls than foreign currency deposits.

The Vietnamese government is tackling the overheating head on with policy tightening. By contrast Asian countries did not tighten until they got hit by the 1997 crisis.

Thailand’s public finances in 1997 were stronger than Vietnam currently.

In order

to accommodate large capital inflows, Thailand run budgetary surpluses up to the 1997 crisis. However these surpluses entailed under-spending in investments with long gestation period such as infrastructure, health and education that are still affecting the country’s growth prospects. Trading strategies There is still room for Vietnam to stabilize its economy and maintain growth close to 5% and that is the basis of our guarded optimism on the fundamentals. Foreign investors’ focus on inflation and the trade balance, against our expectations that both will improve and that a systemic banking crisis is unlikely in the short run suggest a tightening of the CDS spread going forward. This suggests selling the 5 yr CDS at 325 bp. Onshore interest rates are likely to rise as: the tightening of liquidity is still ongoing; an eventual liberalization (if partial) of lending rates is likely to maintain banking system profitability and efficiency; an eventual depreciation of the spot USD/VND is likely to be accompanied by higher policy rates in order to limit exchange rate

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volatility. Hence we suggest going long the forward points i.e. selling the 1m NDF at 17,650 and buying the 12 m at 21,175.
Chart 8 : CDS spread to tighten (5 yr CDS spread bp)
400 350 300 250 200 150 100 50 0 Mar-07 May-07 Mar-08 Jan-07 Jan-08 May-08 Sep-06 Nov-06 Sep-07 Jul-07 Nov-07

Chart 9 : Forward points are likely to rise further
6000 5000 4000 3000 2000 1000 0 -1000 Feb-08 Feb-08 Jan-08 Jan-08 Jan-08 Mar-08 Mar-08 May-08 May-08 Apr-08 Apr-08 Jun-08 18500 18000 17500 17000 16500 16000 15500 15000 14500 14000

12 m points
Source: ABN AMRO

1 m points

Fixing (RHS)

Source: ABN AMRO

But even with a higher USD/VND spot rate, without more VND flexibility, Vietnam could go through renewed episodes of loss of monetary control. Greater flexibility would allow the exchange rate to absorb capital flows volatility and foster the development of hedging instruments. At the same time, since Vietnam’s main exports consist of commodities, a flexible exchange rate could reduce the output volatility associated with terms of trade shocks. Without greater VND flexibility investors should therefore be on the lookout for renewed spikes in inflation and VND weakness.

Appendix: balance of payments projections
Table 1 : Balance of payments USD bn
2000 Trade balance Exports % change Imports % change Invisibles services investment inc. transfers Current account Capital account FDI Portfolio loans MLT loans ST loans Currency and deposits Overall BoP Errors and omissions Change in FX reserves FX reserves
Source: ABN AMRO

2001 0.6 15.0 4.0% 14.4 2.3% 0.0 -0.6 -0.6 1.3 0.7 0.2 1.3 0.1 0.1 0.0 -1.2 0.8 -0.9 0.3 3.8

2002 -1.1 16.7 11.2% 17.8 23.3% 0.4 -0.8 -0.8 1.9 -0.7 1.9 1.4 -0.1 -0.1 0.0 0.6 0.8 -1.0 0.4 4.2

2003 -2.6 20.2 20.6% 22.7 28.0% 0.7 -0.8 -0.8 2.2 -1.9 3.3 1.4 0.5 0.5 0.0 1.4 0.7 0.8 2.2 6.4

2004 -2.3 26.5 31.4% 28.8 26.6% 0.7 -0.9 -0.9 2.5 -1.6 2.8 1.6 1.2 1.2 0.0 0.0 0.5 -0.3 0.8 7.2

2005 -2.4 32.5 22.5% 34.9 21.3% 1.9 -0.2 -1.2 3.4 -0.5 3.1 1.9 0.9 0.9 0.9 0.0 -0.6 0.7 -0.5 2.0 9.2

2006 -2.8 39.8 22.7% 42.6 22.1% 2.6 0.0 -1.4 4.1 -0.2 3.1 2.3 1.3 1.0 1.0 0.0 -1.5 0.3 1.4 4.4 13.6

2007 -10.3 48.6 22.0% 58.9 38.3% 3.3 -0.9 -2.2 6.4 -7.0 18.7 6.6 7.4 2.1 2.0 0.1 2.6 8.4 -1.6 9.4 23.0

2008 f -18.8 60.8 25% 79.5 35% 1.5 -0.5 -2.0 4.0 -17.3 14.0 8 2 4 4 0 0 -4.8 0 -4.8 18.2

0.4 14.5 26% 14.1 33% 0.3 -0.6 -0.6 1.5 0.6 -0.7 1.3 0.1 0.1 0.0 -2.1 -0.3 -0.7 0.1 3.5

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LO C A L M AR K E T S ST R AT E G Y AS I A 6 JU N E 20 08

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