Amid the myriad booms

and bubbles the asset world has witnessed in recent months, one stands out, at

least for originality: Vietnam.

It is awash in more money than it can handle.

In mid-March, a

thousand portfolio investors, investment bankers and fund managers crowded into

Hanoi’s Melia Hotel for an investment conference that coincided with a flurry

of announcements about new funds being formed to invest in Asia’s latest

miracle economy. Here was the successor to China

of the past decade, Thailand-Malaysia of the 1985-1995 era, Taiwan and Korea

of 1975-1985 and Japan

during the post-1965 boom. Vietnam

is the latest to fly in the Asian geese formation.

Although a handful

of pioneers have dabbled there since 1994 after its doi moi reform (which began in 1986) gradually moved in the

direction of capitalism, the past few months have seen a foreign feeding frenzy

that has caught the imagination of local punters, who have rushed to the stock

market in unprecedented numbers. Although the market has come off 15 percent or

so since an index peak of 1170 in early March, it is still double its level

when the latest bull run began in November 2006 and four times the level of

early 2006 when the markets began to wake up. (There are separate markets in Ho

Chi Minh and Hanoi

but the Ho Chi Minh one is the most active and the preferred listing location).

More remarkable,

perhaps, than the rise in the index has been the increase in market

capitalization from around a year ago to today’s US$15 billion plus ‑ around 24

percent of GDP. That has been the result of a flood of new listings thanks to

tax changes that have forced many companies whose shares were once traded only

on an over-the-counter basis to list. Hitherto many had preferred to avoid the

reporting and regulatory requirements of a listing, but now they are finding

that listing can bring share prices as well as tax benefits. (Altogether there

are about 2,800 OTC companies but most seldom trade.)

New markets are

particularly prone to speculative excesses and Vietnam is no exception. This has

been a money-and-momentum driven market with scant regard for such niceties as

price-to-earnings or price-to-book ratios. They are there for quick profits and

an improvement on the modest yields of bank deposits. As for the foreigners,

they say they are there for the long term, which is mostly true.

But what can they do

other than buy stocks when they have fast-growing funds dedicated to doing just

that, sometimes almost regardless of price? There are now some 20 foreign funds

with money to invest in Vietnam,

compared with only four a year ago. This is in addition to investment by

foreign individuals or through participating certificates sold by investment

banks, including HSBC and Merrill Lynch, which hold baskets of major stocks.

The fact is that Vietnam

is being swamped with foreign money, adding to a credit-driven surge in local

speculation. Combined, this could have destabilizing macro-economic effects as

well as an equities bubble in danger of bursting. Some of the money earmarked

for investment will remain on the sidelines for the time being. Some will find

its way into OTC shares or new equitizations ‑ the process of state companies

becoming tradable, which in most cases also means issuing shares to private investors,

managers and employees.

In one case, Dragon Capital,

the oldest of the foreign funds, has used cash to buy control of a

Canadian-listed company, Tiberon Minerals, whose main asset was a Vietnamese

wolfram deposit.

But the estimated $2

to 3 billion of new foreign portfolio money waiting in the wings is a huge

amount for this market to absorb. It may not seem so big relative to a $16bn

market capitalization but it is huge relative both to the free float of those

listed and bearing in mind that foreign holdings for some counters, mainly

banks, are close to their limits (30 percent in the case of banks).

This is money

earmarked for Vietnam.

There is more discretionary foreign money that may still want to come in, for a

long term punt on Asia’s latest star.

Meanwhile foreign direct investment into businesses is running at around $10

billion in promised projects and around $2 billion in actual disbursements.

Even if the

foreigners decline to buy with an index trading at some 50 times earnings,

there is no guarantee that locals will not continue to pile in as the market is

fuelled by rapidly growing money supply, itself partly driven by the foreign

cash inflow. There are plenty of examples. Big institutions had mostly exited

Nasdaq well before its small investor-driven 2000 peak. Closer to home, the Bangladesh

market continued to boom long after foreigners exited.

There has been talk

that the government might try to dampen the market and money supply excesses by

imposing new controls on foreign portfolio capital. The mess that Thailand

made of this has probably been a deterrent. So, too, is the knowledge that the

government should be able to take this opportunity to speed up the equitization

and new listing processes.

The issue for Vietnam

now is whether enough new large state companies can come to the market, or at

least be made available during the equitization process, to absorb the excess

of foreign and local money. There are several major companies planning to do so

this year but whether that can happen quickly enough is debatable given that

bureaucracy moves slowly. It also faces genuine problems in determining asset

values of state companies, particularly those with large but unutilized land

banks and the lack of any meaningful market in land.

The foreigners would

like to use the current weight of money waiting to invest to persuade the

authorities to increase foreign ownership limits – 30 percent for banks and 49

percent for most other companies. But the government fears that this would

simply drive prices further and use up funds which it would prefer to see

deployed in the new listings.

The market could

anyway lose momentum of its own accord before the new listings arrive, in which

case the authorities may face the choice of slowing them down or even halting

them – as happened in the past in China – or seeing the weight of new

paper collapsing the market, a result that could have political consequences.

Among foreign fund

managers, the optimists do not expect a correction of more than 30 percent.

They argue that accelerating earnings will soon show up in results and make the

PE ratios look less inflated. They note, too, that the Vietnam stock

index is capitalization-weighted and that though several of the heavyweight and

liquid stocks are expensive by most measures, the smaller companies usually trade

on much lower ratios. It is also argued that as new large stocks come to the

market at IPO prices kept to moderate levels by the regulatory authority, the

overall index valuation will come down without the necessity of a crash.

Others are less sanguine

and suggest that once the domestic momentum goes out of the market, small

punters will head for the exit in droves and the foreign money will only be a

palliative. If that is the case, the market could easily go back to the 600

level or worse and, like its Chinese precursors, go through a long period of

inaction with both PE and earnings falling. A worst case scenario could see the

index back to 300 which would itself slow reform and bring new listings to a

halt.

The theory is that

the current average PE ratio is around 45 and could come down to 30 assuming

(perhaps optimistically) earnings growth of 30 percent in 2007. But that would

still leave it at about double what might be expected for a market with great

growth potential but erratic corporate governance, a heavy presence of banking

stocks and huge demands on capital if current 7-8 percent GDP growth is to be

sustained.

Some of the biggest

demands for capital will come from the power sector and Vietnam plans to use the market to

raise capital for separately listed power producers under the Electricity

Vietnam umbrella. Such capital intensive ventures are seldom the stuff of

market booms.

For now the financial

markets look promising only in parts. Participants mostly praise the structure

and management of the stock exchanges which have had few trading problem –

though abuses by brokers are believed widespread, as in other markets where

profits come more from proprietary trading books than from commissions.

A bond market, too,

is emerging to which foreigners have access. Thus far it trades mainly

government bonds. But public debt issues will continue to grow – outstanding

government bonds are only equal to about 10 percent of GDP compared with as

much as 40 percent in Thailand

and Malaysia.

Corporate bond issues will also likely expand as investors become more

confident of their accounts.

Generally speaking, Vietnam’s institutional financial development is

more advanced than China’s

was at a similar stage. However, there

is one major problem which is being exacerbated by the current credit boom: the

banking system. Its health is not only critical for macro-economic stability,

it is also a key to stock prices: eight of the top 20 stocks by market

capitalization are banks, and new ones are coming to the market soon

As the banking system

is largely state-owned it may not be in danger of the kind of meltdown suffered

in many countries during the Asian financial crisis of 1997-1998. However,

credit has almost certainly been growing too fast even for an economy with 13

percent nominal growth and still in the process of monetization. Large state-owned

enterprises still get the lion’s share of credit and although the official figures

for nonperforming loans have been falling and are now around 5 percent, many foreign

observers are skeptical. They suggest that a realistic 15 percent NPL for state

banks is realistic.

Many banks could be

technically insolvent and in need of new capital. To make matters worse, there

are far too many banks and lately some are said to have been using their excess

liquidity to play in the stock market. There are four large SOE banks and 36

joint-stock banks. Of the latter, four have 60 percent of Vietnam’s loans

so the rest are very small. The whole banking sector is changing for the better,

including the central bank. But it looks to have lagged behind credit growth

and thus exposes the economy to potential dangers.

For an increasingly

open economy ‑ foreign trade is now equal to 80 percent of GDP –foreign

exchange reserves are a modest US$13 billion. Although up from $9 billion at

end-2005, it is barely satisfactory relative to foreign trade – it is not quite

equal to three months of imports and it is only a quarter of the fast-growing

monetary base.

Complicating matters

is that some 25 percent of bank deposits are in foreign currencies. While banks

hold significant liquid assets offshore, local borrowers of foreign currency

could present the banks with major problems if the dong were to fall sharply or

the local economy experience a major downturn. Despite the success of farm,

footwear and textile exporters, oil still accounts for 25 percent of exports.

In short, Vietnam

has probably not done enough during this period of easy money to reduce risk by

increasing its forex reserves. So it will need to be on guard so that today’s

inflow excesses do not become tomorrow’s outflow flood and drain those

reserves. The sooner the government can get new listings to market while the

foreign cash is available the quicker it can build its reserves and bring

market prices to levels which make a future bust less likely.

For now the dong

looks stable enough. Inflation has come down and with it the controlled

depreciation. The current account deficit is only 2 percent of GDP and capital

controls remain in place. However, looking ahead, the banking system will have

to manage a transition to a more open economy. Foreign banks’ access to dong

deposits will increase and foreign ownership of local banks will be permitted

from April 1.

By 2011 Vietnam

aims to abolish most capital controls. These are ambitious targets and are

requirements built into bilateral agreements linked to World Trade Organization

accession. They carry opportunities for the modernization of a socialist-era

banking system and for amalgamations to reduce the number of players. But all

financial sector liberalizations carry risks either of credit excess or the

privatization of entities which lack sufficient capital and expertise to

survive tougher times.

The best argument

for Vietnam

is a macro one. But even the best macro performance – as in the case of China – can be

ignored by the market for years. There are several reasons why this could

happen in Vietnam.

The price of capital, now at an all time low, could rise, putting a strain on

financial markets in an economy with huge growth potential but also huge

capital requirements. Another possibility is that, as happened in Vietnam in the mid-1990s and in China

more recently, easy access to capital results in over investment, excess

capacity and a sharp fall in profits.

Vietnam’s economy has been growing at a fast yet

quite steady pace for more than a decade. However, three events over the past

years have served to underwrite confidence that this will continue and that

Vietnam will take its place among the more successful and prosperous east Asian

nations, perhaps catching Thailand in a generation and Taiwan by mid-century.

First, entry into

the World Trade Organization. This was no surprise after years of negotiations

during which Vietnam

acquired trade access to the EU, US and other major markets. However,

membership and related bilateral agreements, especially with the US, are

set to force continued reform and opening up of the economy, including much of

the service sector, to foreign entry and competition.

The Party Congress

in 2006 which saw not only another smooth transition of leadership but the

promotion of younger figures who came to prominence in the postwar years and are

associated with economic reform and the continued shift to a market economy.

The party remains highly authoritarian and will come under pressure for

political change as the economy develops. But Vietnam

has achieved more internal democracy and decentralization than its communist

peers and never subjected the people to the violent ideological swings

experienced in China.

Reform has been slow but steady and seemingly well thought through.

However, as in any

transition economy where the borders between the state and private sector are

blurred, corruption is rife. It is closely associated both with the normal

obstructionism of the bureaucracy and now with the spoils that can come from

equitization. More equitization is needed – 40 percent of the economy is still

in SOE hands – but ill-gotten gains are a seemingly inevitable part of the

process.

Meanwhile foreign

investors, though often admiring the Vietnamese work ethnic, find the

bureaucracy a source of interminable delays and sometimes chauvinist attitudes,

a sense that it is wrong for foreigners to be able to profit from the labor or

resources of the Vietnamese. However, nationalism seems to have waned somewhat

as opening up has come to be seen as a success. In any event, economic

nationalism was never as entrenched in freewheeling Ho Chi

Minh City and the south generally, as in Hanoi.

The third, already

mentioned, was the tax decision which resulted in the dramatic development of

the stock market and hence of foreign interest, which also spilled over into

the bond and real estate markets.

The macro bull story

is easy enough to understand. Firstly, Vietnam

is playing catch-up with China

and most of Southeast Asia. Its shift of

manpower from agriculture to manufacturing is relatively recent. It could

certainly be slowed by adverse global conditions or a shortage of capital but

it is probably no more vulnerable than other Asian economies.

Second, it has among

the best demographics in Asia if not the

world. Population growth is slowing. The workforce is still expanding by 2

percent a year but that will gradually slow to less than 1 percent by 2020. The

percentage in the working age 15-59 group will soon reach 66 percent and remain

close to that very high level for the next fifteen years.

The macro story is

enhanced by a high savings rate – currently 35 percent of GDP and still rising,

which may be behind China

but is up to the levels enjoyed by earlier fast developers like Taiwan and Thailand. And the fiscal position

is stable enough with a deficit of less than 2 percent of GDP and government at

45 percent of GDP. The foreign debt proportion is high (27 percent of GDP) but

most of it is long term, low interest loans. Short term debt is modest.

Vietnam lacks China’s

economies of scale and there is no equivalent to Taiwan

or Hong Kong to provide instant access to

capital and markets. But Vietnam

does enjoy some compensating advantages. Most of its population is concentrated

in two delta regions which keeps down infrastructure costs. And those regions

are close to the sea and hence the markets of Asia

and the world.

A combination of geography

and domestic politics has also served to limit income imbalances, at least

compared with China.

The social, health and educational safety nets of socialism have not all been

sacrificed on the altar of GDP growth. Vietnam is probably right to look

for 8 percent growth, not 10 percent. It has a good record in tackling issues

such as avian influenza and education is making progress albeit from a low

base. Although the rural/urban income gap is, as everywhere, large at a ratio

of two to one it is far less severe than in China. Pollution is not yet a very

serious problem and reliance on gas and hydro for the majority of its power

needs is an advantage.

But make no mistake,

Vietnam

has literally little room for maneuver. Population density per hectare of cultivable

land is higher even than Bangladesh.

But is a tribute to its productivity that despite this it remains among the top

world exporters of rice, coffee, rubber and (mostly farmed) seafood and farm

output continues to grow by 3-4 percent a year.

It may be that Vietnam

is arriving at the maximum growth stage too late – as the export-driven model

of development looks likely to be under severe pressure from global trade

imbalances. But Vietnam can

probably gain market share at the expense both of higher cost China and low cost but low efficiency Indonesia and south Asia.

But whatever happens

to global conditions it needs to beware of getting carried away by easy money,

which inevitably ends not in a great leap forward but a crash of markets and

hopes.