Déjà vu / 謝國忠
Vietnam has descended from heaven to hell in a matter of weeks. The chorus of praises still echoes in the fund raising circles: Asia's hidden dragon, the one in the China-plus-one strategy among multinationals, and the next China. Then, its stock market collapsed like a house of cards. While its officially controlled exchange rate, the dong, remains stable, its 12month forward price in the offshore market is already 30% lower. Vietnam's crisis bears eerie resemblance to the Thai bath crisis that heralded the Asian Financial Crisis in 1998. Are we headed for another emerging market crisis?
Yes, we are entering another wave of emerging market crisis that seems to occur every ten years. Several prominent economies may experience collapsing asset prices and weakening exchange rates. But, this wave wouldn't spread like wildfire like the one ten years ago. Emerging economies have been running over half a trillion dollars of trade surpluses per annum (mainly attributable to China and oil exporters) in contrast to the aggregate deficits ten years ago. Dollar shortage would inflict only a few economies like Vietnam, India, or some East European economies. Further, the economies with massive foreign exchange reserves could help those with dollar shortage. Hence, this wave of crises would be more limited in scope.
Vietnam's crisis is self-inflicted. It didn't handle the hot money well and allowed it to supercharge its money supply. The resulting credit surge went into stock and property speculation. Inflating asset prices exaggerated the economic growth rate, which supported the hype behind the hot money inflow. The resulting overheating triggered accelerating inflation. As the government took action in early 2008 to rein in inflation, hot money began to flee. The resulting currency weakness worsened inflation and forced further tightening. The virtuous cycle turns into a vicious one.
Most bubbles start with a good story. Vietnam has averaged 7.5% GDP growth rate in the past decade. Its poverty rate has been halved since 1993 to 24%. Since China began to appreciate its currency in 2005, Vietnam gained extra attention as an alternative production base to China. To attract export manufacturing businesses, Vietnam promised them to keep its exchange rate low and pegged it to the US dollar. The policy did work wonders and attracted many businesses (mainly in garments, shoes, and furniture) from Pearl River Delta. Even though Vietnam runs a large trade deficit, it is largely financed by foreign direct investment ('FDI'), i.e., its trade deficit or investment surge is FDI-led and self financing.
Its currency policy then laid the seed for today's trouble. Vietnam's economic successes began to attract the attention of international capital. While Chinese retail investors view big international fund management houses with awe, thinking they have secret recipes for making money, they are actually run by their marketing managers who sell funds rather than fund managers who invest money. The marketing managers want to sell funds that are hot and, hence, easy to sell. When a country gains prominence in international media, it is easy to sell funds in its name. But, it is exactly the wrong time to invest, as the media attention usually means overvaluation. Hence, international capital, pushed by big fund management houses, adds fuel to fire and amplify the economic overheating. Vietnam is just the latest example in the long history of 'from rags to riches and to rags again' for emerging markets.
Vietnam registered 10% of GDP in current account deficit in 2007. There is no doubt that it partly resulted from overheating. Excessive optimism drove some of the investment growth. But, Vietnam does need investment to build up its industry. Despite the hype over its export success, it remains a backward economy. Primary commodities like oil, rice, fish, and wood account for half of its exports. On value added basis, these commodities probably account for three quarters of its exports, as manufacturing exports have value added of about 50% or less. Vietnam is still a primary producer in global trade. As China's production cost rises, it is a golden opportunity for Vietnam to repeat East Asia's export-led development success. Indeed, the total FDI last year was quite close to its current account deficit, i.e., its imports were probably driven by foreign businesses.
The current account deficit didn't stop Vietnam's foreign exchange reserves from rising by $10 billion (or 12% of its GDP), mainly due to portfolio investment inflow, i.e., hot money. The money came from retail fund investors in Asia, Europe, and the United States. They heard about Vietnam and, egged on by their brokers, bought into various Vietnam funds. The inflow was going to push up Vietnam's currency value. To maintain its export competitiveness, Vietnam's central bought up the inflow to keep the currency from appreciating. It led to massive money growth. The government didn't stop the money growth from turning into credit growth. Bank lending rose by 50% in 2007 and above 60% in early 2008.
Anytime you see massive credit growth, the chances are that the money is flowing into stock and property market, regardless of what government data say. Other economic activities are not structured to absorb such rapid credit growth. Vietnam has set up 19 small joint stock banks. Of course, they would grab any opportunity to expand at the expense of large state banks. The easiest areas to lend money into are for stock trading and property development. The lending results in rising stock and property market. The rising asset prices increase the value of collaterals-land and stocks, which boosts lending.
The overheating led to high inflation. By the end of 2007, Vietnam couldn't ignore inflation on the ground that it was due to food and energy only and mostly imported. Inflation spread into all areas. In February 2008, the government acted with a package to cool demand, mainly by downsizing government investments and issuing bonds to decrease liquidity. The tightening, of course, led to diminished economic growth expectation. The strong funds inflow on growth optimism began to leave as growth outlook declined. The withdrawal of liquidity amplified the stock market decline that was already under way.
After rising by seven times in the previous three years, the stock market index began to dive in the fall of 2007, as the government restricted lending for market speculation. The fleeing hot money turned the decline into a total collapse. It has lost two thirds over the past seven months. While tightening is the immediate trigger for asset deflation, it was a bubble to begin with and would burst sooner or later. The mistake is not tightening but tolerating the bubble for so long.
When a bubble bursts, it is difficult to maintain order regardless of how good policies are. By definition, bubble bursting is a disruptive even. It is too late to stop a painful adjustment after a bubble has formed. It is just not possible to avoid pain after tolerating an asset bubble. Good policies, however, could keep the disruption short, say, less than one year. For example, China's tightening in 1994 restored stability relatively quickly. Korea's adjustment policy in 1998 brought the economy back in the following year. Bad policies could throw a country into a prolonged turmoil. For example, Indonesia's turmoil after 1998 lasted for five years.
Good policies must be internally consistent. There are two common mistakes that governments make in trying to restore macro stability: (1) fighting inflation without cooling demand and (2) depreciating currency to maintain competitiveness. Globalization has complicated inflation fighting, as more and more factors that affect inflation are determined by world markets rather than at home. Whatever excuses one may have, limiting money growth is a must for fighting inflation. Without some sort of quantitative control of money supply during high inflation, stabilization policy is likely to fail.
In Vietnam's situation, it must stabilize the deposit base and control credit growth. The former requires interest rate to be set above inflation rate. The surging demand for physical gold in Vietnam is a dangerous sign that inflation expectation is high. As paper money is exchanged into gold, it boosts money velocity and, hence, inflation. To stop this vicious dynamic of high inflation from taking hold, the government must ensure that the value of bank deposits is protected.
Controlling credit growth is the other side of the coin in stabilizing money supply. The government may have to set quotas for credit growth for the banks. The targets should decline relatively quickly to low double digit growth rate from the peak of over sixty percent. As the government restricts credit expansion, it has to eliminate many investment projects. Probably, many buildings have to remain unfinished, similar to what China experienced after 1994.
The bout of high inflation has eroded Vietnam's competitiveness. The market is betting that it has to devalue to protect its export-led development strategy and has priced in 30% devaluation in the forward market. Currency devaluation is not always bad. But, it doesn't work for Vietnam. Devaluation works best when an economy has excess capacity. For example, Korea had massive overcapacity in heavy industries in 1998 and devaluation played an important role in its economic recovery. Vietnam, however, hasn't built up its industrial capacity. Devaluation leads to more inflation, which then requires more devaluation to maintain competitiveness. The vicious dynamic can plunge the country into prolonged instability. Vietnam's per capita income is below $1,000. There is plenty of scope to improve competitiveness via improving efficiency.
Vietnam should defend its currency as a core strategy for fighting inflation. It should obtain dollar liquidity lines from its neighbors and the international financial institutions like the IMF, World Bank, and Asian Development Bank. If it can demonstrate a credible policy for currency stability, it would decrease demand for dollars and gold at home, which would cool inflation by slowing down money velocity. Of course, supporting the currency is not effective without controlling money supply and curtailing investments.
Vietnam is quite similar to China in 1992-93. The country already possesses the necessary elements for an economic takeoff. International investors see the potential and pile in. The government has trouble controlling itself and tries to satisfy all the interest groups by tolerating investment projects and credit expansion. In 1992, China's monetary excess was due to rampant and voluntary money printing out of ignorance about its inflationary consequence. Hot money inflow was the most important driver in Vietnam's monetary excess. The similarities between the two are an optimistic and inexperienced government that wanted to look from bright side whenever possible and tolerated excessive credit expansion for too long.
Once its economy stabilizes, Vietnam has a great future like China fifteen years ago. It has a good labor force and a pro-growth government. It needs to build up its infrastructure and industrial base. It needs to be patient in building up the economy, not trying to do everything at once. What is occurring is a lesson to its government and its economic management would improve in the future due to the lesson learnt. While international capital is pulling out of the stock market en masse, its market is probably worth investing now on low valuation. Of course, as foreign money continues to pull out, the market may sink further. The recovery would take time like China's market in 1994.
The contagion effect of Vietnam's crisis has been limited so far. Dollar abundance among developing economies is the reason. In 1998, most developing economies had short-term dollar debts. Debt investors tend to run as soon as they feel uncertainty, as their upside is interest income but the downside is losing principal. The contagion effect today could come from hot money in stock and property market pulling out. When one pulls money out of stock or property market, their prices fall. Hence, the quicker the outflow, the less the outflow. This self-balancing dynamic makes the contagion less serious than ten years ago.
Limited contagion effect doesn't mean that the international community shouldn't help Vietnam. As a neighbor, China may have to assume a special responsibility. Any crisis has unpredictable consequences. Cambodia and Laos, for example, are vulnerable to what's going on in Vietnam. The stability of Indochina is important to China's Southwest. It is in China's interest to lend a hand. If Vietnam asks China for help, China should say yes.
Limited contagion doesn't mean that other emerging economies can carry on like before. What's affecting Vietnam is affecting others. The bottom line is that, after years of fast monetary expansion, inflation is affecting everyone. Almost all the developing economies need to limit demand growth to contain inflation. As many, if not most, emerging economies have overvalued asset markets, containing inflation means asset deflation, which is painful.
India has been a superstar in the current growth cycle. Unlike the other three in the BRIC group, it has trade and fiscal deficits. Hence, it is vulnerable to a turbulent adjustment like Vietnam. Its inflation may climb to double digit rate soon. Its social consequences could lead to political instability. The fiscal constraint may force the government to stop fuel subsidy. The resulting inflation surge may lead to instability and frighten away hot money. As the massive amount of hot money flees its stock market, it could further destabilize the country. If India enters turbulent adjustment, it would have serious consequences through eroding confidence for emerging economies as a whole. So much of the faith in emerging economies comes from optimism over China and India. If one star dims, the optimism would come under the severest test since 1998.
While we are not witnessing a repeat of 1998, many emerging economies may encounter turbulence in 2008. Some may experience full blown crisis.
