Banking Paper Final

THE BANKING SYSTEM OF VIETNAM: PAST, PRESENT AND FUTURE Fulbright Research Project / Assigned Country: Vietnam September 2000 – June 2001 Nam Tran Thi Nguyen

Nam Tran Thi Nguyen Fulbright Research Paper

INTRODUCTION

3

CHAPTER I: TRANSITION FROM MONO-BANKING SYSTEM TO COMMERCIAL BANKING SYSTEM

6

BANKING STRUCTURE BEFORE RENOVATION

6

STRUCTURAL REFORMS POST-RENOVATION CAPITAL MOBILIZATION CREDIT ALLOCATION

10 12 15

CHAPTER II: THE ASIAN CRISIS AND THE BANKING SECTOR

23

THE AILING SOE SECTOR

24

DIRECT EFFECTS OF ASIAN FINANCIAL CRISIS ON BANKING SECTOR FOREIGN EXCHANGE EXPOSURE POOR ASSET QUALITY WEAK CAPITAL BASE REGULATORY AND OPERATIONAL ISSUES

26 26 28 29 30

CURRENT BANKING REFORMS

31

CHAPTER III: LONG-TERM ISSUES CRUCIAL TO BANKING REFORMS

33

DEVELOPMENT OF OPERATIONAL INFRASTRUCTURE AND REGULATORY FRAMEWORK

34

REFORMS OF THE STATE-OWNED ENTERPRISE SECTOR

36

GROWTH OF PRIVATE SECTOR

39

INCENTIVE FACTOR

41

CHAPTER IV: DEVELOPING A MODERNIZED FINANCIAL SYSTEM

43

STOCK MARKET

43

BOND MARKET

44

CHAPTER V: CONCLUSION

46

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INTRODUCTION The economic development of Vietnam during the 1990’s has been well documented. Initiated in 1986, the “Doi Moi” or Renovation reforms began the transformation of Vietnam from a centrally planned economy into a market economy and have resulted in tremendous economic growth for Vietnam.1 Throughout the 1990’s, Vietnam relied primarily on Foreign Direct Investment (FDI) and private consumption as the engine of economic growth; and, as long as growth continued impressively, the government’s commitment and push for structural reforms faded into the background. In 1996, the Asian Financial Crisis hit most Asian economies. Vietnam began to feel the effects of the Crisis in 1997 when FDI dried up and state-owned enterprises posted heavy losses. As economic growth slowed, the structural weaknesses of the economy surfaced and became the forefront of debates, particularly the fragile state of the banking sector. The government realizes the importance of an effective banking sector to the health of the economy and has voiced firm commitments to reform the antiquated sector. In an effort to shed some light into the nebulous conditions of the banking sector, this paper seeks to explain the transformation of the banking system from a centrally planned system into a marketoriented system, delve into the issues that continue to plague the banking sector, and examine the issues crucial to the development of a modern banking system and essentially, a more comprehensive financial system. In order to establish the platform necessary for achieving sustainable growth, Vietnam must restructure its financial system. An effective and competitive financial system functions as a mechanism that efficiently mobilizes and allocates capital and contributes to the macroeconomic stability of an economy. In the case of Vietnam, the current financial system 1

Vietnam experienced growth of 9% per annum during the first half of the 1990’s.

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can be characterized as rudimentary, consisting of primarily the banking system. Prior to the reforms of the late 1980’s, the banking system functioned as a credit rationing mechanism, a mechanism used by the government to distribute capital within the centrally planned economy. Thus, to understand the state of the financial system of Vietnam and its direction, one must examine the transition of the banking system from a mono-banking system to a market oriented two-tier banking system; comprehend the issues arising from the relationship between the banking system and state sector; and grasp the growing importance of the private sector and the developing capital markets. This paper consists of four primary sections. Section I examines the transformation of the banking system from a mono-banking system into a commercial, two-tier banking system. This transformation began in 1986 with structural reforms that resulted in the creation of a twotier banking system, with banking functions divided between the central bank and commercial banks. During this restructuring period, the government, acting through the central bank, utilized interest rate as the primary mechanism for policy implementation. The structural transformation and policies implemented will be assessed to understand their contributions to the economic growth of the 1990s, as well as the shortcomings of the banking reforms. A clear understanding this transformation is crucial to understanding the inherent weaknesses and current fragile state of the banking sector. Section II dives straight into the current state of the banking system and the reforms implemented following the Asian Financial Crisis of 1997. In this section, the ideological and political tie between the banking sector and state-owned enterprise (SOE) sector will be explored to better understand the reform process and fundamental complications. Section III examines long-term issues of the banking system and the complexities of banking reforms in

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relations to other reforms, particularly SOE restructuring, private sector growth, regulatory and framework reforms, and incentive factor. Lastly, section IV looks at the critical issues in developing a more comprehensive financial system, specifically the development of the stock and bond markets. Incomplete reforms of the past decade have left the banking system in a precarious state. By elucidating the past and present conditions of the banking sector, this paper hopes to provide the basis for a comprehensive understanding of the banking sector and its direction.

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Nam Tran Thi Nguyen Fulbright Research Paper

CHAPTER I: TRANSITION FROM MONO-BANKING SYSTEM TO COMMERCIAL BANKING SYSTEM Prior to the Renovation reforms initiated in 1986, Vietnam functioned under a centrally planned economy in which the government, not the market, dictated the objectives and modes of production. In its transition to a market-oriented economy, Vietnam had to fundamentally change the infrastructure of its economy. In the case of its financial infrastructure, the period from 1988 to 1992 marked drastic changes, initiated by the structural shift from a mono-banking system to a two-tier banking system in 1988. Under the mono-banking system, one entity accounts for both central and commercial banking responsibilities; whereas, under the two-tier system, the central bank controls monetary policies, leaving the commercial banks to handle commercial banking activities. Since the initial spurt of reforms, the government has dragged its feet, partly due to an indirect effect of the glacial pace of SOE reforms. The failure to cleanse the banking system of the values, objectives and operations of a centrally planned economy leaves the banking system in a weak and fragile condition. Under such vulnerable conditions, the banking system cannot perform its role as the financial intermediary and facilitate the process of capital mobilization and allocation, thus becoming a hindrance to the development and modernization of the economy. Banking Structure Before Renovation Under a centrally planned economy, the mono-banking system functioned as an entity responsible for implementing financial and monetary policies with the objective of providing the necessary means for the state sector to meet the targets of production. Formed in 1951, the State Bank of Vietnam (SBV), formerly known as the National Bank of Vietnam, was entrusted with both the functions of a central bank and a commercial bank. As a central bank, the SBV

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regulated monetary policy, managed the national reserves and issued banknotes. As a commercial bank, SBV mobilized savings from the public and allocated credit to enterprises. From 1976 –1985, the objectives and operations of the banking system can be summarized as follows: The major task of the Bank is, through its credit supply and monetary management, to participate in establishing and promoting a planning economy. The Bank has to increase rapidly credit to ensure capital sufficient for businesses and production operations of the state sector, helping them develop production in accordance with the plans.2 Under the mono-banking system, funds were mobilized from households and the state sector and channeled back to the state sector.

Government

Households

SBV

Saving deposits

SOEs Mandatory deposits

During this ten-year period, the imprudent use of interest rate mechanism and credit rationing by the SBV created financial chaos and contributed to the abysmal economic conditions of Vietnam. By using the banking system to support the state sector and state-owned enterprises, the government created an environment of dissavings, inefficient capital allocation and inflationary pressures. As a central bank, SBV’s failure to manage interest rate policy contributed to an environment of dissavings and inflationary pressures. From 1980 – 1987, while inflation rate escalated, interest rate was virtually at a standstill. As a result, interest rate in real terms reached 2

Decision of the Fourth Vietnamese Communist Party Congress, Su That Press, 1997, p.45.

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negative levels. Deposits in banks lost value as inflation outpaced interest earned on deposits, resulting in an environment of dissavings. Households ceased to deposit their savings into state banks. Instead, they channeled their savings into real assets, such as real estate, gold and foreign currencies. State-owned enterprises, which were required to establish deposit accounts with the banks, took advantage of the loose supervision from banks to retain their cash. These SOEs then used the cash to purchase and hoard commodities in their inventories, which were then sold in the black market for profits.3 In an environment of negative real interest rates, dissavings from households and state sector occurred, which in turn drastically reduced the capital available for investments. In a market economy, interest rate is the price of credit. Depositors supply capital to banks in return for an interest on the deposited capital. The banks in turn lend the deposited capital to borrowers at an interest greater than the value of the deposit rate plus the transaction cost. Under a market economy, a bank will not lend unless interest rate on credit exceeds the value of interest rate on deposit accounts plus transaction cost, and enterprise will not borrow unless the benefits of borrowing outweighs the cost of credit. Under the mono-banking system, interest rates were not determined by the interaction between the demand and supply of credit, but rather by the needs of the state sector. To encourage investments in the state sector, the authorities set lending rates at low levels to reduce the cost of borrowing capital. By artificially suppressing the lending rates, the authorities created excess demand for credit and a gap in official rates and market rates.4 In other words, enterprises, even those with excess capital, would borrow to take advantage of the difference between official and market rates. As a result, 3

Phan, Minh Tue, Literature Review of the Development of the Vietnamese Banking System…, 1998. Patrick, Hugh and Park, Yung Chu, The Financial Development of Japan, Korea, and Taiwan, Growth Regression and Liberalization, 1994, p.337-338. 4

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artificial credit demand increased, while supply of credit fell sharply. By 1985, total credit outstanding stood at 36 billion VND and total savings stood at 9.4 billion VND.5 Without external investments and credit, the government had to print money to fill this gap, resulting in the hyperinflation of the 1980s. At one point, inflation was in excess of 400%. The misuse of interest rates during this period resulted directly from the practice of credit rationing. A fundamental tenet of a centrally planned economy is the allocation of scarce resources, such as capital, to priority sectors. Under such a policy, heavy industries received the bulk of available credit, while light industries, trade and service sectors remained credit hungry. Without market instruments, lending was not based on risk assessment but based on government directives. “Credit has not been allocated according to the principle of highest returns, financial resources have not been supplied to investment, while they could have been earning real returns. Thus, credit has been in surplus in areas (for some uses) and in deficit in others.”6 This undisciplined approach to lending has resulted in high levels of non-performing loans (NPL), then and today, highlights the issue at the core of the failure of the Vietnamese banking system. By the mid-1980, the banking system was in disarray. Credit rationing policies distorted the allocation of resources. Imprudent monetary policies discouraged the mobilization of savings and contributed to the hyperinflation of 1980s. When Vietnam decided to implement the Renovation reforms, it also began the reform process for its banking system. In 1988, the authorities relinquished its mono-banking ideology and created a two-tier banking system to complement its push towards a market-oriented economy.

5 6

Phan, Minh Tue, Literature Review of the Development of the Vietnamese Banking System…, 1998. Ibid.

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Structural Reforms post-Renovation The implementation of the Renovation reforms brought two major changes to the banking system of Vietnam. First, the structure of the banking system took on a new form. In 1988, the banking system shifted from a mono-banking system to a two-tier system, whereby responsibilities of a central bank were separated from those of commercial banks. Under the two-tier system, the State Bank of Vietnam retained the responsibilities of the central bank, specifically responsibilities for monetary policies. Commercial banking responsibilities were transferred to the two newly created state-owned commercial banks. By creating a two-tier banking system, the government had hoped to create a competitive banking system that would respond more efficiently to the demand and supply of credit, thus creating a system of financial intermediaries capable of responding to the needs of individuals and businesses in a marketoriented economy. By structurally unbuckling the commercial banking activities from the devices of the central bank, the authorities reshaped the system into what it is today. Second, from 1988 to the Asian Financial Crisis in 1997, the SBV proved adept at implementing interest rate policies to mobilize funds and control inflation. During this period, interest rate control was the key ingredient in the monetary policies implemented by the SBV. In theory, under a two-tier banking system, the central bank aims to stabilize the financial sector and the economy with its monetary policies. The commercial banks assess those monetary policies and economic conditions to determine the cost of borrowing and lending, thus dictating the mobilization of funds and allocation of credit. The reforms of the late 1980s and early 1990s have had a positive effect on Vietnam's banking system, as evidence in the steady increase in deposits and a diversification in lending. However, reforms have not gone far enough. As unveiled by the

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Asian Financial Crisis, the two-tier banking system of Vietnam has proved inadequate in its role of the financial intermediary. In 1990, the government implemented the Decree Law on the State Bank and the Decree Law on the Banks, Credit Cooperatives, and Finance Companies, creating the financial institutions that are present in Vietnam today. Currently, the banking sector is dominated by the four state-owned commercial banks (SOCBs): Bank for Foreign Trade of Vietnam (Vietcombank), Vietnam Industrial and Commercial Bank (ICBV), Bank for Investment and Development of Vietnam (BIDV), and Vietnam Bank for Agriculture and Rural Development (VBARD). These four banks account for approximately 80% of total lending (see Table I.1). In addition to the four SOCBs, the banking system includes: 51 joint-stock banks, whose shareholders include state-owned enterprises and private entities; 23 foreign bank branches; and 4 joint-venture banks. Table I.1: Features of State-owned Banks Institution As of December 31, 1998 SOCBs Vietcombank ICBV BIDV VBARD Total SOCBs Joint Stock banks Foreign Bank Branches Joint Venture Banks

Description

Primary import-export bank Specializes in industrial finance Specializes in finance for development investment and infrastructure projects An agriculture finance specialist Non-state banks; Ownership consists of private investors and SOEs Multi-national banks, such as Citibank and ANZ Joint venture between foreign banks and state banks

Total Banking Sector Source: State Bank of Vietnam, IMF and Standard & Poor's * Numbers are inclusive of foreign bank branches and joint venture banks.

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Assets (in billion VND)

Assets (% of Total)

33,683 33,548 30,714

20.6 20.5 18.8

36,119 134,063 16,349

22.1 82.0 10.0

13,079*

8.0*

163,491

100.0

Nam Tran Thi Nguyen Fulbright Research Paper

In this paper, discussions on the banking sector will be limited mostly to domestic banks. Foreign related banks account for merely 8.0% of total bank assets and currently face rigorous restrictions that prevent them from becoming more active in the banking sector.7 Regulations restrict foreign banks to receiving only 25% of deposits from non-borrowing customers, thus limiting the banks’ ability to raise local funds and participate in dong lending. Consequently, these banks cater to mainly foreign and joint venture companies and large national enterprises and their involvement are often in the form of trade finance in cross border transactions. Under this reformed structure, the commercial banks are allowed to set their interest rates, subject to the restrictions set by the SBV. There are no direct restrictions on deposit rates, but the restrictions on the maximum interest rate on loans and on the spread on the profit margin between loan interest rate and deposit interest rate substantially affect the strategies of each bank. Even with these restrictions on interest rate implementation, the commercial banks have managed to more efficiently mobilize funds relative to the mobilization efforts in the 1980s. With the rapid growth in deposits, lending consequently has become more diversified. Overall, reforms did have positive results…the increase in deposits and diversification of lending marked the positive trends of the first half of the 1990s. Capital Mobilization Throughout the 1980s, savings were in the form of commodities: household savings went into commodities such as gold and US dollar and corporate savings went into unnecessary inventories and equipment. By the late 1980s, the liberalization of the economy and the reforms of the banking sector evoked a shift in private saving behavior. The 1989 reform in interest rate

7

Foreign related banks include joint venture banks since joint venture banks face the similar regulations and restrictions that foreign banks face.

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policy in which interest rates on deposits were adjusted from strongly negative to positive real terms established a fundamental working tool for the banking system to initiate a serious capital mobilization campaign. As real interest rate became positive, saving deposits became a more attractive item in saving portfolios. By implementing sensible interest rate policies, the government and banking sector managed to provide people with an alternative to commodity savings and was able to harness part of the growing individual wealth that resulted from the economic boom. Consequently, during the 1990s, bank deposits on average increased more than 40% per annum (Table I.2). Table I.2: Growth of Deposits

Dong Deposits Demand Deposits (1) Time Deposits (2)

1992

1993

8.1 4.0 4.1

10.6 4.8 5.8

1994

1995

1996

(in trillion VND) 14.8 22.0 28.3 5.0 6.9 10.2 9.8 15.1 18.1 (Annual Percentage Changes) 39.7 48.6 28.7 4.4 37.3 48.6 69.0 54.3 19.6

1997

1998

37.6 14.7 22.9

49.2 18.2 31.0

Dong Deposits -30.9 32.8 31.0 Demand Deposits -10.0 43.8 24.2 Time Deposits -41.5 26.6 35.3 Source: State Bank of Vietnam and IMF estimates (1) Deposits without time restrictions on withdrawals. Nominal rates for demand deposits are minimal, and often equates to slightly negative real rates. (2) Deposits with time restrictions (3-month, 6-month, 9-month, 1-year). Nominal rates for time deposits are higher than those for demand deposits, equating to positive real rates.

In looking at the type of deposits, one should focus on the time deposits. Time deposits serve as a better indicator of public confidence in the banking system than demand deposits, since time deposits have the time dimension that demand deposits lack. Demand deposits can be seen as stashing one's money into the bank to safeguard it from a home robbery, whereas time deposits can be viewed as investments. The deposit trends from 1989 to 1998 contain two visible kinks. The first kink occurred during the period of 1990-91 with the collapse of the credit cooperatives. With a capital base of 862 billion VND, of which only 83 billion VND was their

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own capital, these credit cooperatives lent 791 billion VND. At the end of 1990, overdue loans stood at 510 billion VND, equivalent to 64.5% of total loans.8 Unable to recollect these loans, the credit cooperatives collapsed, which quickly eroded the public confidence in the banking system. Time deposits in banks fell drastically in 1991, as people opted to put their savings in real assets and commodities. Even those who continue to put their money in banks substituted time deposits with demand deposits. In 1992, deposit growth turned upwards as the government pushed interest rates to positive levels in real term. From 1993 to 1995, deposits grew at a rapid rate, and by 1994, confidence in the banking system was virtually restored. The government and SBV had achieved credibility in its adjustments of interest rates to incorporate inflation and ensure a positive real rate of interest. Besides increased credibility in interest rate policy, public confidence bloomed as economic growth maintained its impressive rate of 9% per annum, FDI reached record levels ($ 9.5 billion in 1995), and inflation stabilized. Furthermore, financial assets, namely savings deposits, became more attractive as non-financial assets stabilized and even depreciated in value, i.e. the Vietnamese dong (VND) stabilized against the U.S. dollar and the price of gold dropped. Accordingly, time deposits grew at 69% in 1994 and 54% in 1995. The second kink in deposit growth occurred at the end of 1996 with the outbreak of the Asian Financial Crisis. In the wake of the Asian Financial Crisis and the mounting burden of overdue loans in the Vietnamese banking system, particularly in the joint-stock banks, individuals became more cautionary with their savings. Growth in dong deposits declined from 48.6% in 1995 to 28.7% in 1996. More drastic is the decline in the growth of time deposits,

8

World Bank, Vietnam – Financial Sector Review: An Agenda for Financial Sector Development, Report No.13135, March 1995.

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which fell from 54.3% in 1995 to 19.6% in 1996. However, despite the two visible kinks in deposit growth, saving deposits overall grew at a rapid pace during the 1990s. Prudent interest rate policy, coupled with a growing economy and improving macroeconomic stability, played a pivotal role in the growth of bank deposits. At the micro level, confidence in the banking system stem from the simplification of banking procedures, particularly at the SOCBs. SOCBs have improved their computer networks and remittance systems, which significantly simplifies the transfer of funds between bank branches. Though, remittances between different banks have seen little progress and remain a major hindrance to the modernization process of the banking system. Other improvements include the elimination of the disclosure requirement,9 shortening of the time required to make a withdrawal, and increase in the number of transaction offices across the country. Despite the rapid growth in deposits over the past decade, the banking system has made little progress with the mobilization of long-term funds. Most banks tend to keep saving deposits for less than six months, due to the uncertainty of the minimum deposit rate set by the SBV. Banks do not want to incur the risk of a fluctuating interest rate. At this point in time, the SBV as a central bank has not established itself as a credible and politically independent institution. Furthermore, after two decades of central planning and various banking collapses, public confidence in the banking system is still tenuous. And, without a deposit insurance system, individuals are still weary of depositing their money in the bank for a longer period of time. Credit Allocation In modernizing its banking system, the Vietnamese government and banking officials had to change its concept of credit allocation from credit rationing to the state sector to prudent credit 9

Prior to 1997, individuals were required to disclose the source of deposit money.

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distribution to state and private sectors base on risk analysis. To a certain extent, the authorities have achieved success in shifting from credit rationing policies and moving towards a more diversified credit allocation, as evidence from the increase in credit to the private sector. The private sector, which accounted for less than 10% of total credit in 1991, has seen its share of total credit rise to 48% by the end of 1998. Private sector share of credit within SOCB credit portfolio has also risen. At the end of 1998, SOCB had lent 43% of total credit to the private sector (Graph I.1). Graph I.1: Credit Distribution to SOEs and Private Sector Credit to Private Sector

Credit to SOEs 40.0

Trillion VND

Trillion VND

40.0 30.0 20.0 10.0 0.0

30.0 20.0 10.0 0.0

1994

1995

SOCB

1996

1997

1998

1994

NonState Banks

1995

SOCB

1996

1997

1998

NonState Banks

Source: IMF and State Bank of Vietnam

Interestingly, the banking system achieved greater credit diversification despite the continuing dominance of state banks in lending activities. Throughout the 1990s, SOCBs’ share of total credit to the economy has remained relatively steady, floating from the high 70 percentiles to the low 80 percentiles. According to the International Monetary Fund, SOCBs’ share of total credit stood at 81.4% in 1999. Overall, credit growth of SOCBs has kept pace with overall credit growth (Graph I.2).

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Graph I.2: Distribution of Credit 130.0

Annual % Change

115.0 100.0 85.0 70.0 55.0 40.0 25.0 10.0 -5.0 1994

1995

1996

1997

1998

T otal Credit SOCB Credit NonState Bank Credit

Source: IMF and State Bank of Vietnam

The diversification of credit to both state and non-state sector signifies a positive result from the reforms of the early 1990s; however, these reforms fall short in dealing with crucial steps needed to modernize the banking system. Behind the improvement in credit allocation looms three immediate and important questions: 1) even though the private sector account for almost half of total credit, does private sector receive equal access to credit as SOE 2) does private sector have access to different types of credit and 3) is credit allocation really based on risk analysis? Up until 1996, non-state banks, consisting of joint-state banks and foreign banks, were steadily gaining shares from SOCBs in the lending market. The flexibility and aggressiveness of the non-state banks compared to those of the SOCBs enabled them to push credit lending to high levels during the period of rapid economic expansion. However, it is also the non-state banks' aggressive and at times undisciplined lending, particularly those of the joint-state banks, that resulted in high levels of non-performing loans (NPLs). NPLs grabbed worldwide attention when the Asian economies began spiraling downward in 1996. Both state and non-state banks

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incurred high levels of NPLs, but the collapse of some high profile joint-stock banks in Ho Chi Minh City channeled the initial wave of criticism and reprimands to the non-state sector. Clearly, the dominance of the SOCBs within the banking sector has major implications. First, SOCBs’ umbilical tie to SOEs and political influence translates to unequal access to capital for the private sector. Legally, there is no discrimination between state own enterprises and private enterprises. However, SOCBs discriminate against private enterprises in the following ways: 1) private enterprises often cannot get the bank to issue a letter of credit (L/C) unless they have deposits with the bank equal to 100% of the amount they wish to borrow 2) private enterprises cannot use under-construction projects as collateral, whereas state enterprises can 3) SOEs have state assets to use as collateral and 4) private enterprises cannot utilize their real property when forming a joint-venture as collateral, whereas SOEs may.10 The relationship between SOCBs and SOEs will be explored in further detail in a later section of the paper. The four issues outlined above highlight the obstacle that collateral requirements pose to private enterprises in attaining access to credit, particularly medium and long-term credit. Enterprises have strong needs for long-term capital to invest in their infrastructure and equipment, however, they have little collateral for securing the credit. Banks exacerbate the situation by evaluating collateral strictly and often setting values of collateral assets at 50% of their market value. Thus, private enterprises are forced to look for loans from the informal financial sector, friends/relatives and informal credit market, which consists of groups of money lender and rotating saving and credit association call hui societies. However, capital mobilized from friends and relatives is limited and capital from informal credit market is of short maturity and requires

10

Saito, Hideto, The Current Status of the Financial Sector in Vietnam, May 1997.

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high interest payments. Consequently, these enterprises borrow strictly for working, short-term capital needs. The inadequate supply of medium/ long-term capital affects both the state and private sectors. Banks contend that longer-term loans are difficult to grant because companies generally are either low profit businesses or even if businesses are highly profitable, they lack the collateral. Other reasons pointed out by banks include: concern for the rising level of bad debt, lack of information about the companies and industries, high interests rates, and borrowing restrictions placed on banks (i.e. limiting lending to l0% of owned capital). All these issues are valid explanations for the banks' strict stance on lending medium/ long-term capital. However, the underlying macro issue that obstruct the medium/ long-term credit market, a fundamental issue that officials must find solutions to before other reforms can be implemented, lies with banks’ limitations on maturity transformation and restrictive interest rate structure. As pointed out in the Credit Mobilization section, individuals hold their savings in short-term deposits. Enterprises, on the other hand, require credit to invest in long-term fixed investments, such as technology, equipment and infrastructure. As intermediaries, banks must utilize bank deposits to allocate appropriate credit, which in Vietnam's case require the transformation of short-term deposits into longer-term credit. Currently, banks are using a method of pulling short-term deposits with different maturities to change the term and provide longer-term loans.11 The increased in saving deposits and the utilization of maturity transformations have allowed banks to steadily increase the proportion of medium/long-term credit as a percentage of total credit. However, the mismatch in maturities between deposits and longer-term credit substantially limits banks’ ability to grant longer-term credit. Thus, by the end of 1998, medium/long-term lending 11

Horiuchi, Akiyoshi, Reformation of Fiscal and Financial System in Vietnam, May 1997.

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in dong denominations accounted for 21% of total lending, whereas working capital loans in dong denominations still accounted for 47% (Graph I.3).12 Graph I.3: Breakdown of Dong Lending 80.0 Total Dong Lending (% of Total Credit)

70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 1994

1995

Working Capital

1996

1997

M edium/ Long-term

1998 Other

Source: State Bank of Vietnam * Other includes mostly construction and investment loans under state plans, and loans by foreign grant and investment agent funds.

The second underlying issue hindering a more rapid expansion of medium/ long-term credit resides with the imprudent lending rate structure. In a market-based banking system, interest rates on long-term lending should be higher than rates on working capital lending to reflect the maturity and credit risks of the loans. However, in the Vietnamese banking system, the interest rates on working capital loans has been consistently higher than interest rates on medium/long-term loans. Again, interest rates in Vietnam are dictated by the SBV. In this case, SBV places a ceiling on lending rates and throughout the early 1990s, purposefully set lending rates at attractive levels to induce enterprises to seek out loans to build infrastructure and buy equipment and machinery. Commercial banks, without incentives to incur riskier loans, are

12

International Monetary Fund, IMF Staff Country Report No. 99/55, July 1999.

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discouraged from extending longer-term lending. Only since 1996 have interest rates on medium/ long-term loans outpaced the rates on working capital loans (Graph I.4). Graph I.4: Real Lending Rates, 1994-1999

Real Lending Rates (%)

14.0 12.0 10.0 8.0 6.0 4.0 2.0

Working Capital

Fe b99

19 98

19 97

19 96

19 95

19 94

0.0

Fixed Capital

Source: IMF and State Bank of Vietnam

A prudent interest rate structure would provide the proper incentive for banks to issue longer-term credit. First, in order to effectively meet the demands for longer-term credit, banks need to find sources of longer-term funding. But, to encourage individuals to invest in long-term investments, banks must establish their credibility and offer instruments of long-term investments, such as longer-term certificate of deposits, bonds, etc. At present, the bond market is weak and ineffective and will be discussed in a later section. Establishing credibility and gaining the tools to offer more complex investment instruments require that banks improve and modernize their operational structure and governance. These issues are part of a larger fundamental problem of the banking sector. As the banking system shifts from a collateral-based system to a risk-assessed based system, banks must be given the tools to perform their risk assessments. Internally, the banking system needs strict and consistent standards to classify its assets and liabilities and improvements in governance and management. Externally, to assess the

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risk of a company, banks need to be able to understand the company’s business and financial statements and the industry. Politically, the authorities need to sever the political tie between the banking sector and state-owned enterprises to level the playing field and improve efficiency. Prior to the Asian Financial Crisis, banking reforms occurred at the macro level, i.e. the restructuring of banks and banking functions and the liberalization of interest rate structure. However, following the initial spurt, the pace of reforms has waned. Weaknesses in accounting practices, banking supervision and regulatory infrastructure leave the banking system fragile and vulnerable. The Asian Financial Crisis demonstrated to Vietnam that an unstable financial/banking system could lead to macroeconomic instability and economic fallout. In the next two sections, the affects of the Asian Financial Crisis on the banking system and current reforms and long-term outlook of the banking system will be examined.

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CHAPTER II: THE ASIAN CRISIS AND THE BANKING SECTOR From 1992 to 1997, the Vietnamese economy grew at a rate of 9% per annum. During this period of tremendous growth, large inflows of Foreign Direct Investment (FDI), with investments coming mostly from Asian countries, and huge imports led to a boom in consumption and domestic investment. From 1992 to 1996, Vietnam experienced negative net exports, as imports outpaced exports. However, by 1998, the Asian Financial Crisis cut deep into the Vietnamese economy as Asian economies froze investments and domestic consumption slowed, resulting in a sharp decline in FDI and import. Without the surge in FDI and private consumption, Vietnam’s export growth and productivity growth could not retain the high economic growth experienced during the first half of 1990’s (Table II.1). Accordingly, the International Monetary Fund estimates that real GDP growth of Vietnam declined to 3.5% by the end of 1998.13 Table II.1: Contribution to real GDP Growth (in Percentage) Domestic Demand Private Consumption Foreign Direct Investment Net exports of goods and services Real GDP Source: IMF

1992-1997 13.4 9.1 3.4 -4.6 8.8

1997 1.7 5.8 3.9 6.5 8.2

1998 2.3 5.1 -8.3 1.2 3.5

The Asian Financial Crisis contributed to the economic slowdown in Vietnam by substantially reducing FDI and domestic demand, but more drastically, the crisis exposed the underlying structural weaknesses of the economy, particularly that of the state-owned enterprise (SOE) and banking sector. Years of strong economic growth masked the frail infrastructure and enabled

13

International Monetary Fund, IMF Staff Country Report No. 99/55, July 1999.

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Vietnam to act sluggishly with structural reforms. Not surprisingly, numerous SOEs suffered financially during the crisis and the banking sector proved ineffective as a financial intermediary. The Ailing SOE Sector As of 1998, there were 5,800 state-owned enterprises in Vietnam. From 1996 to 1998, the state sector accounted for approximately 42% of GDP, yet its contribution to economic growth fell from 51% in 1996 to slightly negative in 1998 (Table II.2). Table II.2: Contribution to real GDP Growth 1996 GDP

9.3

State Nonstate Foreign invested

4.7 3.2 1.4

State Nonstate Foreign invested

50.5 34.4 15.1

1997 (Percentage points) 8.2

1998 3.5

3.9 -0.5 2.7 2.9 1.6 1.1 (Percent of Total GDP Growth) 47.6 -14.3 32.9 82.9 19.5 31.4 (Percent Share in GDP) 43.1 41.3 48.3 49.5 8.5 9.2

State 42.8 Nonstate 49.5 Foreign invested 7.7 Source: International Monetary Fund Note: GDP calculations at constant prices 1992-1998.

Clearly, the economic downturn in Asia substantially affected the SOE sector. The economic downturn resulted in the stagnation of domestic demand and the rise in competition from Asian countries. Stagnating domestic demand has led to stagnating sales from SOEs and an accumulation of inventories. The devaluation of the Asian currencies resulted in cheaper exports from these countries. The relatively cheaper exports from other Asian countries compete directly with Vietnamese SOEs for market share, and without the cost advantage, Vietnamese SOEs have difficulty competing against its more efficient Asian counterparts. The Asian economic slowdown exposed the inefficient and uncompetitive nature of the SOEs. In an effort to assess

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the SOE sector, the Ministry of Finance (MoF) developed a reporting system that categorized SOEs into three groups. At the end of 1997, MoF reported that 40% of SOEs were considered “profit-maker”, 44% were “temporary loss-maker”, and 16% were “permanent loss-maker”. According to the World Bank, even before Vietnam felt the effect of the Asian economic slowdown, it was estimated that less than two-fifths of SOEs were profitable. The economic slowdown merely exacerbated a sector already in distress. As stated earlier, the SOE sector maintains an “umbilical” tie to the banking sector. The worsening of the SOE sector directly affects the banking sector in two ways. First, bank credit pumped into unreformed SOEs is a misallocation of scarce capital. According to the IMF, the increase in SOE credit in 1998 was mostly in the form of directed lending and medium and longterm loans, suggesting that SOCBs were influenced into making the loans to help SOEs sustain production and stay afloat. Directed lending includes construction and investment loans under state plan and onlending of foreign grants. Second, loans to non-profitable SOEs hampers banks’ portfolios and credit liquidity by significantly augmenting the probability of incurring non-performing loans (NPLs). Officially, the permanent loss-makers classify 30% of their shortterm loans as overdue and a bank debt to fixed asset ration of around 90%, compare to a ratio of less than 50% for profit makers. According to World Bank estimates, at the end of 1997 the temporary loss-maker and permanent loss-maker had debts of approximately 20 trillion and 43 trillion VND, equivalent to $1.4 billion and $3 billion, respectively. In a market where total credit at commercial banks stand at approximately $7.2 billion,14 the debts incurred by lossmakers are significant. The economic slowdown simply reduced the number of enterprises capable of servicing their debts and raised the level of NPLs. If the SOEs do not improve their 14

Capital Intelligence, National Banking Environment: Vietnam, November 1998.

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Nam Tran Thi Nguyen Fulbright Research Paper

operations and become more efficient, banks will have to shoulder higher NPLs, leading to a decline in capitalization and liquidity and possibly a financial crisis that will require substantial budgetary support. Clearly, reforms of the SOE sector must be a key component to a thorough strategy for reforming the banking sector. Direct Effects of Asian Financial Crisis on Banking Sector The Asian Financial Crisis and the resulting economic downturn evoked the much needed awareness to the stagnation of banking reforms in Vietnam, stagnation that has left the banking system in a state of disarray and vulnerability. The Crisis compelled the government to deal with the immediate issues threatening the stability of the banking system, specifically the foreign exchange exposure, the mounting level of non-performing loans, the weak capital base and the profitability and operational issues of banks. Furthermore, the Crisis revealed the precarious conditions of the joint-stock banks (JSB), the most vulnerable segment of the banking sector. It was the default and failure of some major JSBs in Ho Chi Minh City that set off the alarm on the fragile state of the entire sector. Even though JSBs account for a small portion of commercial banking activities, but in Ho Chi Minh City, which accounts for one quarter of Vietnam's GDP, 40% of FDI and over half of total exports, JSBs account for more than 25% of banking assets and together with foreign bank branches account for 60% of total lending in the city.15 The instabilities of JSBs pose macroeconomic threats to the economy of Ho Chi Minh City, and thus a threat to the overall economy. Foreign Exchange Exposure The banking system’s direct exposure to exchange rate risk is mitigated by prudential controls. However, banks face indirect exchange risk through their clients. According to the 15

International Monetary Fund, IMF Staff Country report No. 99/55, July 1999.

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Nam Tran Thi Nguyen Fulbright Research Paper

World Bank, approximately one-third of total credit is foreign currency denominated, of which 70% is extended to SOEs. Since enterprises do not have instruments to hedge currency risks and do not have adequate currency reserves, they face extreme difficulty in servicing their obligations when the economy experiences a downturn, especially the weakening of the export sector. In the case of Vietnam, the above situation has translated into a continuing rise in the overdue of foreign currency loans. Within SOCBs, shares of overdue foreign currency loans rose from 6.6% in 1995 to 15.4% in 1998. For non-state banks, overdue in foreign currency loans rose from 1.2% in 1995 to 17.9% in 1998.16 The exchange rate risk is especially high for JSBs, since JSBs make foreign currency loans far in excess of their foreign currency deposits. The problems with JSBs surfaced in traumatic fashion in 1997 and 1998 when some large JSBs in Ho Chi Minh City defaulted on a number of deferred letters of credit (L/C)17, thus triggering negative reactions from the international banking community. In Vietnam, letters of credit are issued through collaborative efforts from Vietnamese banks and foreign banks. Vietnamese banks issue the L/Cs on behalf of local importers; however, foreign suppliers require guarantees from foreign banks before they accept the L/Cs and deliver the goods. The L/Cs calamity arose when local importers defaulted on payment for goods and the Vietnamese banks declined to repay the overseas banks. These defaults were in part due to the economic downturn that created hardships for local importers; however, a number of the defaults came as the result of local importers pursuing a quick profit. Local importers imported the supplies and subsequently sold them in the domestic market. They then used the funds generated from the transaction to speculate in real estate, with the hope of 16

State Bank Vietnam and IMF estimate. Letter of Credit (L/C): a bank’s promise that goods will be paid for upon presentation of shipping documents. L/C is a tool used to facilitate foreign trade. 17

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making a quick profit before the L/Cs came due. When economic growth halted and real estate speculations faltered, companies could not generate the funds to make payments on the L/Cs. As payments became overdue, JSBs had to assume the obligations of the L/Cs. By the end of 1998, Vietnamese banks owed approximately $200 million to foreigners, with more than 100 million owed to Korean companies.18 Poor Asset Quality The L/Cs problem points to a more alarming issue that besieges the entire banking sector, the issue with non-performing loans. The problems with the letters of credit reflect the deteriorating balance sheets of joint-stock banks. At the end of 1998, NPLs at JSBs stood at 17.5%. Recently, with the market volatility and economic slowdown, authorities estimated that NPLs at JSBs to be at 30 – 40%, an astounding figure but a figure that is still far below estimates by the IMF using internationally accepted standards. The precarious situation with JSBs can potentially have adverse affects on the overall economy. However, a more pressing concern for the authorities is the increasing level of NPLs within the state-owned banks, which if left unchecked has the potential to evoke a financial crisis and thus, an economic meltdown in Vietnam. According to the SBV, non-performing loans at SOCBs account for approximately 12 – 14% of total assets in mid-1999 compare to 5% of total assets in 1995. However, based on audits using international standards, NPLs at state-owned banks were estimated to be 30 – 35% of total loans at the end of 1997.19 Any further increases in the levels of NPLs could lead to liquidity problems and declining capitalization. In the short-run, these problems require budgetary support and translate to an increase in fiscal cost for Vietnam. The World Bank and

18 19

Schiffrin, Anya, “Cleaning House”, The Vietnam Business Journal, August 1999. IMF, IMF Staff Country Report No.99/55, July 1999.

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IMF estimates that the cost of bank restructuring, i.e. writing-off unrecoverable loans and recapitalizing banks, would increase 1 or 2% of GDP annually from the existing capital cost estimate of 8 – 10% of GDP per annum.20 In the long-run, an incapacitated banking system cannot efficiently mobilize and allocate capital within an economy, and thus hinders economic development and growth. Weak Capital Base Another threatening problem facing the banking sector is the weak capital base. Recently, the government issued a requirement that state-owned banks meet the minimum capital base requirement of $100 million; however, by international standards, these nominal terms are still relatively small. A small capital base substantially restricts the flexibility of banks in allocating capital and confines the diversity of banks’ portfolios, which essentially exposes the banks to greater internal and external shocks. On paper, the capital to asset ratio of 5.0% and capital to total loans of 8.6% for SOCBs indicate that SOCBs are adequately capitalized.21 However, the absence of reliable disclosures, particularly with loan loss provisions and nonperforming loans, cloud the validity of the ratio. By convention loan loss provisions are counted as capital reserve. The actual level of loan loss provisions within the SOCBs should be much lower than official numbers since a large portion of those provisions should have been written off to reflect the true level of non-performing loans. Thus, capital must be adjusted to reflect the appropriate level of loan loss provisions. Total assets also must be adjusted to exclude the over due loans that should be classified as non-performing assets. Under more stringent guidelines

20

IMF and World Bank, “A Framework for Cutting Losses of SOEs,” August 25, 1999. Joint-stock banks had an average capital to asset ratio of 18.5% and capital to total loans ratio of 30%. However, an SBV assessment in 1998 revealed that many of the JSBs were severely undercapitalized and much of the capital came from borrowed fund. IMF Staff Country Report No. 99/55, July 1999. 21

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for reporting and classifying non-performing loans and loan loss provision, the capital to asset ratio should reveal that the capital base of SOCBs is actually very weak. It is not surprising that a weak capital base plagues the SOCBs. These banks experience very low profitability and have difficulty generating capital. Of the four state-owned banks only two have reported profits during the past four years. Also, they are state-owned and thus do not have access to private capital investment. Lastly, budgetary support from the government is minimal; however, bailouts are often advised against since they create expectations that the government is prepared and willing to support and assist in bailouts when difficult circumstances arise. Regulatory and Operational Issues It is well understood that the underdeveloped nature of the financial system and the inadequate state of the legal, accounting and regulatory framework hinder banks from pursuing its basic market-oriented banking tasks. Furthermore, the inadequacies of banking supervision and regulations prevent the banking system from shifting to risk-based assessments. For example, loan classification is still based on time past due rather than on the loan’s credit risk, issues with collateral valuation have not been defined and settled and loan loss provision until recently was restricted to a maximum of 2% of total loans.22 In addition to the regulatory and operational issues, the incentive issue presents a formidable obstacle. The Vietnamese banking system simply does not provide incentives for bankers to operate in a market-oriented manner. This incentive issue will be explored in a later section of the paper.

22

The 2% restriction on loan loss provisions was implemented for tax purposes, i.e. to prevent banks from eluding taxes by writing profits as loan loss provisions.

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Current Banking Reforms As summarized by the World Bank in a report published in December 1999, Vietnam: Preparing for Take-off, the Vietnamese government has developed a five-track reform program that includes: restructure JSBs, restructure SOCBs, improve regulatory, supervisory and legal framework, leveling the playing field for all banks, and developing the human resources in the banking sector. As of 1999, the following measures have been implemented: • • • •

•

Completed financial assessment by SBV of all 52 JSBs and independent diagnostic audits of the four SOCBs by international consultants; Issued regulations on “Special control” regime including revoking licenses of troubled banks and “special supervision” regime which strengthens supervisory oversight; Closed four JSBs in Ho Chi Minh City, placed another six JSBs under SBV’s “special control” regime and merged two JSBs; Initiated development of legal framework for removing non-commercial lending activities from SOCBs: submitted to the government a plan to shift the Bank for the Poor into a Policy Bank to lend to socially targeted groups and issued a decree to establish a Development Support Fund to be funded by the budget to provide loan guarantees and interest subsidies for strategic purposes; Issued several prudent regulations for banking operations.

Clearly, most of the measures mentioned above were undertaken to deal with the most threatening issue of the banking sector, the precarious conditions of the joint-stock banks. The other measures address the core problem of the SOCBs, the banks’ non-commercial lending activities. However, those measures are at this point merely proposals. SOCBs are still trying to develop a restructuring plan, and implementation is still far off. As for improving regulations, the SBV has issued new regulations regarding prudential ratios, limits on lending to a single borrower, and clearer standards for classifying loans and loan loss provisions. The liberal classification of loans under the old regulation was a major impediment to an accurate assessment of the health of the banks. However, the new regulation fails to rectify the core issue,

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which is the need to disclose and classify the whole value of the loan overdue when any part of the principal or interest is overdue.23 If the SOCBs were to switch to international standards for classifying loans, about 35 – 40% of total loans would be classified as non-performing loans, which would greatly reduce the asset levels of all banks. This explains why the government and SBV have not acted aggressively in reforming the classification of loans. Clearly, still much more work needs to be done to incorporate international accounting standards into the banking system and move towards a risk-based system.

23

Currently, loan classification remains primarily based on the time past due, rather than on the risk of the loan. This current scheme does not reflect the probability of loss.

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CHAPTER III: LONG-TERM ISSUES CRUCIAL TO BANKING REFORMS The Asian Financial Crisis in 1997 devastated the economies of Asia. The Crisis signified the importance of a stable financial system to economic stability and growth. Over the next three to four years, the Vietnamese authorities will focus on implementing a Three-Year Agenda aimed at developing a healthy banking system. The table below is a World Bank summary of the government’s three-year agenda (Table III.1).24 Table III.1: A Three-Year Agenda to Develop the Banking System Restructuring JSBs and SOCBs • • •

• • •

Create a sound and transparent mechanism for resolution of failed/ troubled financial institution. Implement regulatory framework for all 51 JSBs and action plans for all JSBs in phases. Establish an Asset Management Company (AMC) to facilitate corporate debt restructuring. AMC would buy and sell bank loans secured by collateral that the banks could not liquate because of the nature of the asset, lack of documents, or origin of the loans. Agree on key elements of the restructuring plans between the government and SOCB involving strengthening management, resolving NPLs and developing phased capitalization. Complete detailed restructuring plan for each SOCB and develop an implementation table. Equitize one of the four large SOCBs by the end of 2002. Remove non-commercial lending activities except when there is a specific government guarantee.

• • • • •

Strengthening Legal, Regulatory and Supervisory Framework Adopt the international standard for classifying NPLs. Adopt regulations that prohibit lending to shareholders and directors. Move towards risk-based approach to bank supervision. Develop plan to upgrade accounting standards and systems to international standards. Initiate training programs for banking staff in credit risk management.

• •

Leveling the Playing Field for All Banks Relax restrictions on dong deposit mobilization by foreign banks. Ensure that SOCBs have no preferential treatment relative to JSBs.

•

At this point, reforms are focused on the near-term health of the banking sector, i.e. the containment of the problems with JSBs and the shifting to market-based instruments and internationally accepted standards. The government’s medium-term reform objectives, as outlined in the three-year agenda, are appropriate. However, to implement these reform 24

World Bank, Vietnam: Preparing for Take-off?, December 1999, p.35.

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objectives requires strenuous commitment, the commitment to establish a modern and competitive financial system. Vietnam must concentrate on the short and medium-term reforms but maintain focus on the long-term objective. In order to achieve its of goal developing a modern, sound and competitive banking sector, Vietnam must deal with the fundamental issues of 1) creating the infrastructure and environment necessary for the implementation of banking functions and 2) providing incentives for people and institutions to pursue banking activities according to the law and in competitive manners. These two fundamental issues will be examined in context to the development of a regulatory framework and operational infrastructure, the reforms of the state-owned enterprise sector, the growth of the private sector, and the incentive factor to clarify and offer insights into long-term reforms and objectives. Development of Operational Infrastructure and Regulatory Framework As mentioned above, the development of a regulatory framework and operational infrastructure is crucial to banking reforms, not to mention to overall economic reforms. In the past three years, the government has passed new laws and decrees to strengthen the banking sector. New bank regulations have resulted in improvements in a number of areas, such as clearer loan classification, more robust loan loss provision, and stronger capital to asset ratio.25 To enforce these new regulations, banks need to restructure its operations. Key elements to operational restructuring include: •

25

Investments in Human Capital. Replace the old management team with a capable team and equip bank officers with skills to carry out basic banking duties. At this time in Vietnam, firing workers represent a major headache for firms, not to mention firing management. Also, with the scarcity of banking professionals, replacements would be hard to find. Under these circumstances, the near-term solution is to train a number of Vietnamese bankers at the management level and perhaps import bankers from abroad.

Refer to IMF Staff Country Report No. 99/55 by International Monetary Fund, July 1999, for detail.

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•

• •

The long-term approach is to create incentives for people to enter the banking profession and establish well-developed training programs. Improve Internal Procedures. Banks on a constant and procedural basis must examine its credit conditions, collateral valuation, borrowers’ performances, and capital intake from loan repayments and interest payments. These procedures increase the probability that banking regulations are being followed. Strengthen Governance Structure. Banks must create incentives for management and employees to enforce internal controls and audit. Engage in Twinning Arrangements. Vietnamese bankers do not have much experience managing market-oriented, risk-based banks. By engaging in twinning arrangements, a Vietnamese bank can hire a reputable international bank to help with its operational restructuring in return for equity participation by the international bank 2 to 3 years down the road. This arrangement enables domestic banks to utilize financial professionals and their expertise for the restructuring process, a valuable option especially since Vietnam lacks experienced banking professionals.

These banking regulations and operational reforms are specific to the banking sector. In conjunction to these sector-specific reforms, the government must also focus on the legal and regulatory reforms that affect all aspect of the economy; for without these legal and regulatory reforms, banking reforms would be virtually non-applicable. It is said that Vietnamese enterprises have three sets of financial books: one for the authorities, one for the World Bank/IMF, and one for internal purposes. The government recognizes the importance of tightening accounting standards and the need to shift to international accounting standards to ensure accurate information and financial reporting at both enterprises and banks. Currently, laws on accounting and auditing are weak and not enforced. Clarity and transparency are still a long way from becoming the norm in Vietnam due to its secrecy laws. The state still has vast power over institutions and enterprises as legitimized by the State Secrecy Act. In other areas, authorities have focused and undertaken steps to strengthen regulations on bank licensing, bankruptcy, collateral valuation, and foreclosure. However, in the

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long-run, these reform measures are futile if the government continues to adhere to such ideologically incompatible laws as the State Secrecy Act. Reforms of the State-owned Enterprise Sector As documented in this paper, the state-owned enterprise sector maintains an umbilical tie to the banking sector and is the primary culprit for the heavy NPLs experienced by banks. When the government initiated SOE reform in 1989, it began with the consolidation of the SOE sector and a drastic cut in direct budget subsidization to SOEs.26 From 1989 – 1992, the consolidation process drastically reduced the number of SOEs from 12,000 to 6,000, mostly through mergers and closures. In theory, the cut in direct subsidies from the government brings about more financial and operational discipline within the SOEs. In the case of Vietnam, the lack of state funding was offset by privileged access to scarce capital from other sources, particularly credit from state-owned banks. Banking regulations heavily favor SOEs, as exemplified in a recently introduced law that abolished the need for SOEs to provide collateral in obtaining state funding. A banking law that requires the SBV to act to “facilitate social economic development in a manner consistent with socialist orientations” best summarizes SOEs’ privileged access to the banking sector.27 “State-owned credit institutions may extend unsecured loans pursuant to the direction of the government. Any loss on such loans occurring as a result of objective reasons shall be dealt with by the government.”28 In other transitional economies, authorities have pursued SOE reforms through aggressive privatization schemes. In the case of Vietnam, SOE reforms began with a strong spurt with the consolidation of the sector from 1989 – 1992, but thereafter have progressed 26

Prior to reforms, state funds had to be provided to the SOEs to cover their ongoing failure to meet their budgets. Article 1.3 LSBV. 28 Article 52 LCI. 27

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painstakingly slow. The government established equitization schemes in 1992.29 However, from 1992 – 1997, only 17 SOEs were equitized. The slow progress has been the result of a number of factors…most importantly, owning government bodies have been unwilling to give up control and managers and workers have been unwilling to trade in the social safety net and security of state ownership for the risk and rewards of a market economy. Furthermore, the authorities still emphasize the importance of SOEs to the growth of the economy. In a speech in March 2001, Le Kha Phieu, the general secretariat of the Communist Party from 1996 to 2001, declared “state-owned enterprises must play the primary role in the growth of Vietnam.” Under such mindset and approach, it is no wonder that enterprise reforms progressed extremely slowly during the 1990s. Not surprisingly, it took the Financial Asian Crisis and economic downturn to bring the issue of SOE reform back to the forefront of policy debate. The glacial pace of SOE reforms has two direct repercussions on the banking system: 1) the unprofitability and inability of SOEs to service their loans has resulted in unstably high levels of NPLs and 2) the large presence of the SOE sector in the economy and its preferential treatment by the authorities squeezes the private sector from the tight credit market. In the long-term, the government must push more aggressively with SOE reforms, particularly hastening the pace of equitization. Equitization changes the structure of ownership and provides management and staff with incentives to improve performance and achieve profitability. A smaller and more efficient SOE sector eases the burden on the government (and fiscal budgets) and the banking sector and strengthens the private sector. In 1998, the government picked up the momentum of SOE reforms by equitizing 39 SOEs. In 1999, 149

29

Equitization is the conversion of state-owned enterprises into joint stock companies. The Vietnamese government uses equitization as the official term in place of privatization.

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enterprises were equitized, followed by another 350 enterprises in 2000. Despite the recent pickup in the pace of equitization, the ratio of SOEs equitized against the number scheduled under the restructuring program is still low (Graph III.1). Authorities plan to consolidate another 3,800 SOEs, either by equitization, merger or bankruptcies, by 2005. Graph III.1: Slow Pace of Equitization 400

100%

350

90% 80%

No. of companies equitized

70%

Units

Accumulated equitization ratio* 250

60%

200

50%

150

40%

% Ratio

300

30%

100

20%

50

10%

0

0% 1993 - 1997

1998

1999

2000E

2001E

*Note: The equitization ratio refers to SOEs equitized against the total number scheduled for equitization Source: World Bank, CSFB

Given the Vietnam’s track record in recent years, the achievability of the plan seems out of reach. To increase the pace of equitization, authorities must cope with the entrenched interests of SOE managers, workers, local officials and even ministry officials. At the ministry level, authorities must establish a firm commitment to develop and implement a comprehensive reform program. At the worker level, strengthening the social safety net to support laid-off individuals is a must. These safety nets must aim to compensate workers for their loss incomes during the period of unemployment as they transition to new jobs and provide the training support to improve worker mobility.

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The SOE sector is clearly a drag to the economic health of Vietnam. SOEs consume bank credit and other sources of scarce capital. Their protected monopoly hinders competition and private sector involvement, which essentially hinders increased efficiency and higher economic growth. Reforming the SOE sector is vital to the reform process of the banking sector, as well as the long-term health of the economy. Growth of the Private Sector In the past, Vietnam has placed the primary emphasis on the state-sector as the organic engine of growth. However, the SOE sector has proven highly inefficient and represents a major impediment to the health of the banking sector. The private sector, consisting of farmers, household enterprises, private small-medium enterprises (SME) and foreign invested enterprises and accounting for 51% of economic output, has the potential to become the engine of economic growth and macroeconomic stability. In order to harness the potential of the private sector, a range of reforms must be implemented, such as trade, private investment, SOE, and banking. In this paper, private sector growth will be examined in context with SOE and banking reforms. A vigorous private sector can unleash the human capital potential of Vietnam. For years, Vietnam has been known for its capable and hard working labor force. The population currently stands at 85 million with over 50% under the age of 25 and over 90% is literate. By leveling the playing field for all enterprises, both state and private, particularly equalizing access to bank credit, Vietnam can harness the potential of the private sector and its human capital. One of the major impediments to the growth of the private sector is the inadequate access to capital. During the past decade, credit to the private sector has grown to approximately 49% of total credit. This growth was promising, particularly to the agriculture sector, which received

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the bulk of the credit. However, for SMEs, faster credit growth did not translate to equal access, especially in terms of medium and long-term credit. Access to medium and long-term credit is a problem for all enterprises, but private enterprises face a tougher hurdle than SOEs because of collateral requirements. SOEs do not need collaterals to obtain loans, whereas private enterprises must meet high collateral requirements, a narrow field of acceptable collateral assets, and low collateral valuations by banks. Clearly, the bulk of medium and long-term credit goes straight to SOEs. Without access to longer-term credit, private enterprises cannot investment in technology and infrastructure developments necessary for expansion. Private enterprises, specifically SMEs, are forced to work with sub-optimal equipments and factories. SMEs are highly export oriented and operate in labor-intensive sectors like garments, seafood, footwear, and plastic products. Vietnam’s competitive advantage lies with these labor-intensive, export oriented sectors; hence, it is imperative that authorities allow private enterprises more flexibility and better access to capital to take advantage of such opportunities. Conversely, the growing importance and modernization of the private sector undoubtedly will provide additional pressure for the authorities to reform the banking sector. From the perspective of the private sector, banking reform will improve the situation with NPLs, increase liquidity, lower policy oriented lending to SOEs, and give private sector greater access to banking credit. Furthermore, a comprehensive reform of the banking sector necessitates a similar push with reforms of the SOE sector. SOE reforms, specifically equitization and divestitures, could enlarge the SME sector by adding more enterprises and thus, jump-start the private sector. As pointed out by Oleh Havrylyshyn and Donal McGettigan in a recent report, the implementation of comprehensive equitization schemes, in conjunction with reforms to improve the private sector, is key to SOE

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reforms.30 In other words, private sector, SOE, and banking reforms are each indispensable aspects of each sector’s reform agenda. Incentive Factor At the heart of Vietnam’s economic struggles lies the entrenched system of a centrally planned economy, a system that lacks the incentive factor. Under the centrally planned system, the State set specific physical targets for each state enterprise in each sector and even specifies where to obtain inputs for production, what technology is appropriate, and where to sell the products. Neither employees nor citizens had incentives to maximize efficiency or exceed expectations. The same mentality applies to the banking sector, and in a market-oriented economy, the lack of incentive hinders bankers’ judgment and impedes bankers’ from taking the necessary risks in a risk-oriented market. The authorities can reform banking regulations and framework, but without a thorough change in ideology to provide the proper incentives for bankers, a risk-based commercial banking system will be hard to achieve. In Vietnam, bankers avoid taking risks in lending credit, especially to private enterprises, since a bad loan can send the bankers to jail. The monetary incentive for bankers to take such risks is minimal, and the chances of the loan becoming a bad loan are too high. Bankers are at the mercy of a statue that gives the authorities the power to press charges against them using the accusation of harboring “the intention to contravene and cause serious consequences making loss of Socialist properties.” Consequently, banks tend to play safe by lending to SOEs and setting high collateral requirements and low collateral valuation to discriminate against the more risky private enterprises. At present, offences committed in businesses and trading activities are

30

Oleh Havrylyshyn and Donal McGettigan, Privatization in Transition Countries: A Sampling of the Literature, 1999, WP/99/6.

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considered criminal offences. The current civil law in Vietnam does not issue sentences severe enough to punish business and trading offences; therefore, the authorities send these cases to the criminal court with the objective of deterring others from committing such offences. Specifically, when an enterprise is charged with offences, the banker/s involved in lending to the accused enterprise also take full responsibility. The authorities accuse the banker of irresponsibly granting huge loans to the accused enterprise, which contributed to the enterprise’s offences, and due to the banker’s lack of diligence, the loans will turn into NPLs and result in losses to the State. To further highlight the problem arising from an inappropriate incentive scheme, take for an example a banker who faces a situation whereby a loan to an enterprise temporarily becomes a bad loan. The banker must decide either to refinance the loan to aid the enterprise through its temporary hardship or begin the process of foreclosure. By foreclosing the enterprise, the banker takes away the opportunity for the enterprise to withstand the hardship and perhaps surface later as a fully functional business. If the banker decides to extend the loan and refinance and the enterprise eventually collapses, then there is some probability that the banker will be charged with “the intention of causing losses to State properties.” Under such circumstances, the banker will likely not extend the loan, since the repercussion outweighs the minimal financial compensation. During the past few years, SOCBs have been criticized for not aggressively utilizing idle deposits, i.e. for not fully utilizing deposits as lending credits. Without a proper incentive scheme, bankers’ hesitation is not surprising. Clearly, in order to establish a modern, risk-based banking system, the authorities must provide the proper incentives for bankers to take the necessary risks…the authorities must create a system of risk and reward to incentivize both bankers and employees.

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CHAPTER IV: DEVELOPING A MODERNIZED FINANCIAL SYSTEM The crux of this paper has focused on the past, present and future of the banking sector. Banking in Vietnam is still fairly basic, consisting of mostly short-term deposits and short-term lending. The economy needs a stable system and more importantly, a modern system to support a modern economy. At present, Vietnam must concentrate on reforming the banking sector, but it must also focus on developing the capital markets, particularly the bond and stock markets. The presence of capital markets would provide an alternative venue for the allocation and distribution of capital and ease the credit burden of the banking sector. Stock Market The stock market plays an integral part in the mobilization of capital, especially in a modern economy. In the case of Vietnam, a stock market would not only facilitate capital mobilization but would also provide more impetus for SOE reforms, specifically impetus for equitization. After a decade of delays and frustrations, the stock market in Ho Chi Minh City (HCMC) finally opened in July 2000. The opening of the stock exchange marks an important step in building a modern financial sector, but much more needs to be done to broaden the role of the stock market. Currently, the stock market is highly restricted, both by regulations and uncertainty. The market is limited to nine hours of trading per week and stock prices are restricted to movements of no more than 2% of their opening prices. Furthermore, the authorities have set stringent eligibility requirements for listing on the stock exchange. Stringent eligibility, coupled with enterprises’ uncertainty about the stock market, has resulted in only four listed companies. At present, companies are skeptical about listing on the exchange, mostly

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because listing would require financial disclosure. Consequently, the exchange today consists of four listed companies and a series of government bonds. Investors have greeted the stock exchange enthusiastically. Stock prices have soared. Investors line up at security companies two hours before they open to buy shares, signifying the unbalance state of enormous demand and insufficient supply. After a decade of waiting, investors are hungry for shares and have the capital to buy them. The State Security Commission (SSC), the entity responsible for the regulations and operations of the stock market, needs to act aggressively to increase company listings. More importantly, the SSC must cooperate tightly with security companies to develop an underwriting program. With the current listing process, companies merely register to make shares available for trading; meaning no capital is raised for the company. An underwriting program would create the venue for enterprises to raise capital for investments and entice enterprises to view the stock exchange more positively, since the capital generated from the underwriting goes directly to the enterprises. Furthermore, a stronger stock market would provide more impetus to improve regulatory framework and pursue reforms, including banking, SOE and private sector reforms. Bond Market In addition to the stock market, the bond market represents another venue for raising capital, especially medium to long-term capital. Currently, the Vietnamese bond market consists solely of government and bank issued bonds. The bond market is weak and lacks liquidity, i.e. there is no secondary market for bonds. In August 2000, the SSC permitted round lot bond trading to occur on the stock exchange in an attempt to stimulate the bond market. However, the first bond transaction on the stock exchange occurred nine months later in April of 2001.

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Investors have kept their distance from bond buying and selling because bonds yield low-profit, despite the low-risk investment. With the lukewarm bond market in Vietnam, banks have requested permission to issue bonds overseas. Currently, there are no corporate bonds listing in Vietnam; however, PetroVietnam, presently in collaboration with BP Amaco to develop the Nam Cong Son Oil reserve, is working with Morgan Stanley to issue $300 million of bonds overseas. Clearly, Vietnam must look overseas to find bond investors and jumpstart its bond issuance. As the stock exchange expands and domestic investors become more sophisticated, bonds will become more attractive as investors seek to diversify their portfolios.

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V: CONCLUSION In August 2000, Vietnam took a major step onto the global trade arena when it signed a trade agreement with the U.S. The agreement will open the U.S. market to Vietnamese enterprises; a market that experts say is worth $1 billion to the Vietnamese economy per annum. Furthermore, in another three years, Vietnam’s concessionary status under the AFTA (Asia Free Trade Agreement) agreement will terminate. At which time, Vietnam will undoubtedly face heavier competition as it lowers its tariffs on most products and eliminates certain quotas to meet ASEAN standards. Vietnam at present stands at a juncture: should it aggressively pursue reforms to take advantage of new found opportunities or play the more politically stable “wait and see” game and risk falling further behind. Vietnamese people seem all too eager to take advantage of these new opportunities. They greeted President Bill Clinton with open arms. The streets of Ho Chi Minh City are littered with Internet cafes and cell phones. Lines form outside of security companies for the opportunity to invest in the stock market and perhaps the future “Microsofts” of Vietnam. Parents and students spend hard earned money to take English and computer lessons to gain the upper-hand in the competitive market for well-paying, office positions. The people seem to enthusiastically embrace technology and opportunities. Is the government committed to creating the necessary infrastructure to unleash this enthusiasm and potential? As pointed out in this paper, reform of the banking sector is crucial to the development and growth of the overall economy. The banking system acts as the financial intermediary between the savers and investors and the borrowers (borrowers being both individuals and enterprises). Individuals need capital to turn ideas into businesses. Enterprises need capital to

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expand and grow. The authorities understand that a competitive banking system that mobilizes and allocates capital according to the principle of risk and reward is important to the health of the economy. But, to establish such a system requires a firm commitment to reforms and a break from the past. A firm commitment to reforms means pushing through with short-term reforms, i.e. restructuring the joint-state banks, reorganizing the state-owned banks, and setting up a policy bank; while maintaining focus on long-term reforms, i.e. establishing a credible accounting and regulatory framework, accelerating SOE and private sector reforms, and creating the proper incentive scheme. During the past decade, the large inflows of FDI have fuelled investments and economic growth. Now, as foreign investments dwindle, Vietnam must rely more on itself for capital. Furthermore, Vietnam wants to modernize its economy; and, a stable and effective banking system is crucial to the modernization process of an economy.

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REFERENCES Borish, Michael, Long, Milland, and Noel, Michel, Restructuring Banks and Enterprises – Recent Lessons from Transition Countries, World Bank, 1995. Capital Intelligence, Vietnam: National Banking Environment, November 1998. Ibid., Bank Industry Risk Analysis – Vietnam, November 1998. Citibank Cash Management Asia Pacific, Vietnam, October 2000. Havrylyshyn, Oleh and McGrettigan, Donal, Privatization in Transition Countries: A Sampling of Literature, 1999. Horiuchi, Akiyoshi, The Vietnamese-Japanese Joint Studies Hanoi Workshop Background Paper – Fiscal and Monetary Policy – Executive Summary: Reformation of Fiscal and Financial System in Vietnam, May 1997. International Monetary Fund, IMF Staff Country Report No. 99/55 – Vietnam: Selected Issues, July 1999. Ibid., IMF Staff Country Report No. 99/56 – Vietnam: Statistical Annex, July 1999. Ibid., IMF Staff Country Report No. 98/30 – Vietnam: Selected Issues and Statistical Annex, April 1998. Ibid., IMF Concludes Article IV Consultation with Vietnam, August 2000. Lau, Joseph and Chem, Chia Tse, Vietnam: Cautious Optimism, Credit Suisse First Boston: Emerging Markets Economics Research, August 2000. Phan, Minh Tue, Literature Review of the Development of the Vietnamese Banking System and of the Related Theoretical Debates Since the Late 1980s, 1998. Sakurai, Kojiro, The Vietnamese-Japanese Joint Studies Hanoi Workshop Background Paper – Fiscal and Monetary Policy – Macroeconomic Developments Focusing on Monetary Economy, May 1997. Saito, Hideto, The Vietnamese-Japanese Joint Studies Hanoi Workshop Background Paper – Fiscal and Monetary Policy – The Current Status of the Financial Sector in Vietnam, May 1997. Schiffrin, Anya, Cleaning House, The Vietnam Business Journal, August 1999.

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Vietnam Banking & Finance Media Monitoring Service, SOE Equitization on NA Agenda Again, December 2000. Vietnam Investment Review, Five-point Reform Plan Wins IMF Loan Approval, April 2001. Ibid., Banking and Finance, April 2001. World Bank, Vietnam: Preparing for Take-off? – How Vietnam Can Participate Fully in the East Asian Recovery, December 1999. Ibid., Vietnam – Financial Sector Review: An Agenda for Financial Sector Development, Report No. 13135, March 1995. Ibid., Vietnam – Public Sector Management and Private Sector Incentives, An Economic Report, Report No. 13143, September 1994. Ibid., Vietnam – Transforming a State-owned Financial System – A Financial Sector Study of Vietnam, Report No. 9223, April 1991.

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