Vietnam's hard economic lesson for China
By Chan Akya

Over the past few weeks, the decline of Vietnam from its erstwhile status of an Asian "tiger" economy to being one of the first victims of a new regional crisis has been swift and perhaps, outside of the country, unlamented. At the heart of the escalating problems in the country are government actions aimed at preventing a loss of competitiveness on its exports, and therein hangs the tale for the rest of Asia.

The following brief mention in a recent article (Cheap talk, pricey banks, Asia Times Online, June 4, 2008) now appears to be rapidly becoming the main story in the region:
Vietnam represents a cautionary example for all Asian governments. The country attempted to fight market attempts to push the value of its currency, the dong, higher. This was "achieved" by strong-arm
tactics including the arrest of some bankers and pushing through drastic limitations on foreign investors. Stuck with a number of their investments, foreign investors have pushed up Vietnam's credit costs in external markets, by more than 100 basis points in the past two weeks alone, essentially rendering any recourse to such financing untenable for the country. Meanwhile, the loss of investor confidence has pushed stock markets into a downward spiral, with the benchmark index falling every day in May (absolutely unprecedented anywhere in the world).

This is the problem with traditional Asian responses to market forces, dictated as they are by communist ideology rather than rational understanding. The fallout from Vietnam though is quite negative for smaller Asian economies, such as the Philippines, as it shows the limits to market patience with such government shenanigans. A rising US dollar would make matters worse for Asia in the short run, by creating greater inflation and sharper declines in household wealth, even as the concurrent benefits on exports fail to materialize thanks to a US recession.
Since then, the problems with Vietnam have only become worse, with the currency in free fall against the US dollar as foreigners are trying to get their investments out as quickly as possible. Averting this would require the authorities to increase interest rates sharply in order to maintain the attraction of the dong, but doing so will only increase bad debts at the local banks and in turn spark a surge in non-performing loans at state-controlled banks.

Even with its stock of foreign exchange reserves, the government cannot abide by the situation as the country desperately needs continued foreign investments to complete the various factory investments and infrastructure projects that lie at the heart of its rejuvenation. It is perhaps not too dramatic a statement to point out that the Vietnamese government has inadvertently launched itself into an economic death spiral.

In the inter-connected world economy of today though, the problems of Vietnam are hardly ever going to stop in the country itself. There are countries that will benefit from the situation, and others that will be hurt by it. Unfortunately for readers of this publication, most Asian countries fall in the second category namely the ones that will be hurt by the Vietnam situation.

Already, the cracks are visible in the case of the Philippines and Indonesia, two other countries in Southeast Asia that share many of the characteristics of Vietnam. Between rising imports of commodities and oil, as well as burgeoning investment needs that demand to be addressed, these countries have been running current account deficits. The funding for the deficit has come from foreign investments and remittances from nationals working abroad. Given the obvious parallels to the Vietnam story, it is highly possible that both countries will face rising outflows from foreigners as well as slowing remittances from their own nationals working abroad in the near future.

These problems though pale with those that are increasingly visible in the case of Asia's growth engine, namely China. While the broad metrics of GDP size, foreign exchange reserves and population all put China in a different league to the Southeast Asian minnows above, there are also important similarities. In any event, the experience of Japan in the early 1990s should put an end to any notion that large Asian economies with trade surpluses cannot suffer from financial crises.

Cracks in the Great Wall
To be sure, making any quick comparison between Vietnam and China would prove perilous given that the latter runs a strong current account surplus besides boasting large foreign direct investment inflows, both of which provide adequate financing for its expanding economy.

Still, the similarities with Vietnam on another level are also astounding. Much like its southern communist neighbor, China has been anxious to control any rapid appreciation of its currency. Its attempts to sterilize the large inflows of short-term foreign capital have only been partly successful even if one goes by statistics released by the People's Bank of China (PBoC). Indeed, M2 growth has been accelerating in recent times as the central bank finds it impossible to sterilize the combination of trade and investment inflows and banks find new ways of lending. (Note - the temptation to use graphs in this section was quite high for me, but I forswore the use of graphics in my articles a long time ago. Readers with more numerical minds can consult official statistics of China to bear out everything written in this article).

Additionally for the authorities, their main tool for preventing monetary expansion has been the use of suasion, that is telling banks not to lend to certain sectors, such as property, that could in turn create inflationary impacts elsewhere. Official statistics and anecdotal evidence both now show that money is being made available to a number of sectors that central authorities had forbidden a little while ago.

This is happening because banks are increasingly hamstrung in their efforts to make money as they bear the brunt of reserve increases that are designed to force them to buy more government originated bonds as against private investments. However, the authorities clean forgot that state-owned enterprises have almost unlimited authority to borrow from banks, and now appear to be using their borrowings to lend to Chinese companies in need, including in some of the forbidden sectors. As the state-owned companies are not controlled or overseen by the PBoC, they are free to do whatever they please even if the essential risk of their activities, that is bad loans, are still ultimately borne by the big commercial banks.

Secondly, various other kinds of semi-legal loans seem to be increasing. Temporary loans that are repaid before the end of every quarter are in particular proving quite popular for companies with large investment needs. As the PBoC only monitors loans "on" the balance sheet on quarter-end reporting dates, this has created a free market for short-term loans.

True, it is difficult for any large construction project to be funded by such loans, but the experience of Vietnam and previously the Asian financial crisis in the late '90s shows that such methods can and do come about when policies make profitable lending difficult. In the case of various companies engaged in such projects, the changes are visible in their increased working capital needs, with one component, namely inventories, feeding into the GDP statistics.

Lastly, interest rates in China are still too low relative to the amount of inflation in the economy. This means that anyone who can borrow does so at rates that are far too low - what are referred to as negative real rates; when people pay costs lower than inflation. That is prime fodder for asset bubbles and this is exactly what is happening in many parts of China, often visible as joint projects between state-owned companies or local government bodies with "local" property companies.

At the top level, the following are becoming more apparent:
  • More inflation in both producer and consumer products even if authorities attempt to exercise price controls in the latter category.
  • Rising balance sheets of both banks and large state-owned companies as they circumvent current lending restrictions.
  • An attendant rise in financial risks across the official banking system and more severely in the unofficial banking system.
  • Falling construction standards as companies attempt to finish projects quickly in order to repay banks before quarter-ends (Note - this was certainly one factor seen in the latest earthquake casualties).
  • Poor corporate governance at many banks and state-owned companies, where officials with access to loan facilitation may be misusing their privileges.
  • Continued financial speculation by Chinese investors in markets as diverse as stocks, property and commodities.
  • No let-up in the accumulation of short money aimed at benefiting from a quick change in the value of the Chinese currency.

    For China, the dangers of avoiding a Vietnam situation would simply push it to a Japan imbroglio. As such, there are only a few market-based measures that work here: firstly to float the currency, secondly to boost interest rates in order to combat inflation and thirdly to improve supervision of the financial system.

    Combined, all these suggest that existing policy efforts (which famously avoid all of the above three suggestions) at taming the financial markets have been a colossal failure in China. The situation described above is starkly similar to the one witnessed by Japan in the 1980s that eventually culminated in the Plaza accord, which in turn pushed the Bank of Japan to raise interest rates sharply even as the economy started slowing down. The result was calamitous, as the Japanese economy entered a permanent downward spiral.

    While there are many, including me, who hope that such an eventuality doesn't come to pass, China now risks being suspended in a policy vacuum that puts it right between the experience of Japan and Vietnam. The nomenclature of the Middle Kingdom could thus get an altogether new and ironic meaning if China fails to undertake urgent policy responses.

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