Finding value in Vietnam

From an investment perspective, it always helps to get out in front of events, particularly if they can have a material effect on stock prices. The CFA Institute notes that roughly $10 trillion is benchmarked to MSCI’s developed, emerging and frontier market indices, while the Investment Company Institute estimates that total net assets of worldwide regulated funds have more than doubled in the past 10 years, surpassing $49 trillion at the end of 2017. So any reclassification on a national level can have a major bearing on capital inflows and prices on domestic stock markets.

The reclassification issue has become more relevant as institutional investors make greater use of passive strategies that rely on tracking benchmark indices more closely. However, reclassifications can produce effects in international capital flows which may appear counterintuitive.

Upgrades aren’t always positive where valuations are concerned due to changes in index weighting. There have been instances where countries have experienced significant investment outflows after they have been upgraded from emerging to developed market status. This is because their relative weighting in developed market indices has been substantially reduced from their emerging market rate.

There are other effects to take on board. Funds usually allocate inflows proportionally to the weighting each country has within an index. Therefore larger weightings imply both larger inflows during periods of expansion and larger outflows during redemptions.

Essentially, where Vietnam is concerned, it’s something of a balancing act. The country’s weighting in the frontier market funds we’ve reviewed comes in at 14.4 per cent. Although its relative weighting in percentage terms would be reduced considerably within an emerging market index, the passive funds covering this end of the market draw in massive capital flows because of the potential growth rates on offer. So, even a marked reduction in weighting could still give way to increased capital inflows – and increased valuations.

Thus Vietnam’s looming upgrade could – we believe – result in improved capital inflows, but it should also provide new avenues for investors looking to gain exposure to one of Asia’s fastest growing economies. This is to be welcomed given that there are limited options available at present, with exchange traded funds (ETFs) providing the easiest route to market, although there are a handful of managed funds available (see box below).

'Doi Moi' and the abandonment of collectivism

Vietnam’s journey from a centrally planned economy through to more liberalised trade policies has its genesis in 1986 with the introduction of a government reform programme known as 'Doi Moi' (renewal). Over time, economic reforms were allied to tightening legislative and regulatory strictures, designed to improve transparency and guarantee an equitable framework for investors.

The reforms gave rise to a surge in entrepreneurial activity and foreign direct investment, although the economy wasn’t immune to the impact of the Asian financial crisis of 1997. As bank credit inflows clicked into reverse, licensed investment in the country fell from $8.6bn to $1.6bn between 1996 and 1999 – a decline of over 80 per cent. An imbalance in favour of regional capital flows, together with limited hard currency availability (the government had restricted the convertibility of local currency into US dollars), meant that it was disproportionately exposed to regional slowdowns.

Admittedly, some of the policy issues that had undermined Vietnam’s economy could be traced back to its membership of the Council for Mutual Economic Assistance (Comecon), a socialist trading bloc disbanded in 1991 following the collapse of the Soviet Union. Vietnam had already started throwing off the vestiges of its membership long before the Asian financial crisis, although the subsequent capital drain laid bare vulnerabilities at the heart of the economy, thus convincing government policymakers that further reforms were necessary.

Expanding commercial ties beyond the region

Vietnam had to look beyond the ASEAN regional markets, a process eventually aided by currency devaluation – and improved access to global capital markets. Policymakers had come to the view that sustained economic growth had to be achieved within the constraints of a robust regulatory backdrop, meaning that further trade liberalisation measures couldn’t be pursued at the expense of macroeconomic stability – in short, a more co-ordinated approach to economic development.

Now, two decades on, it has trade pacts in place with Australia, New Zealand, China, India, Japan, and South Korea. And it is re-examining the Trans-Pacific Partnership agreement (TPP) as another means of opening up Vietnam’s market to investors. Critically, commercial ties are strengthening with the US, particularly in the area of manufactured goods. And Vietnam has just signed a trade deal with the European Union which will eliminate 99 per cent of customs duties on bilateral goods trade, currently worth €47bn a year.

After enduring years of political tumult, the Vietnamese people are now concentrating on building prosperity. It’s worth noting that while the growth of neighbouring China’s manufacturing sector initially crowded out other sectors of the economy, the expansion of Vietnam’s service sector has been in evidence since the early years of the reforms, underpinned, as the World Bank puts it, by "strong underlying retail sector growth, supported by buoyant private consumption and record tourist arrivals”.

Growing pains – the predictable credit bubble

The country now boasts a stable credit rating, with gross government debt equivalent to 61.5 per cent of gross domestic product (GDP) in 2017 (the UK rate was 85.3 per cent; Japan’s was 253 per cent). However, there’s a flipside: although debt levels remain serviceable, Vietnam’s debt-to-GDP ratio has grown too rapidly over the past 15 years or so. And because of an immature domestic bond market – and a dearth of foreign buyers – the government has had to rely on domestic borrowing, meaning that the proportion of local debt to total public debt has also risen sharply, although measures have been taken to improve the quality and duration of bonds.

Rapid economic growth gave way to unsustainable credit expansion at the start of the millennium – hardly a novel experience in the region – but it resulted in an inflationary surge, a subsequent hike in interest rates, the inevitable collapse in property values and a spike in the number of non-performing loans. This chain of events has obviously been repeated in other fast-growing economies, although it’s generally accepted that the government is now prioritising macroeconomic stability above untrammelled growth.

Still, the brakes haven't been put on completely. The World Bank estimates that the country’s GDP grew by 6.81 per cent in 2017, slightly in advance of the long-term average, while foreign direct investment increased to $13.3bn in the nine months through to September, a 6 per cent increase over the same period in 2017, bringing total registered foreign direct investment to around $330bn.

Demographics and the resource base

As the easternmost country on the Indochina Peninsula, Vietnam is well placed geographically to exploit large regional markets such as South Korea and Japan, and through maritime links to Singapore and the west coast of the US. Demographics also work in its favour, with 60 per cent of its population of 92m under the age of 35, together with a rapidly expanding middle class. Educational attainment is high for the region, along with mobile commerce penetration. The service sector accounts for about half of domestic output, while manufacturing generates a third of GDP through fast-growing segments such as telecommunications, clothing and apparel. And it’s not difficult to appreciate why the country continues to poach manufacturing jobs from emerging market economies. Figures from Statista reveal that manufacturing wages in Vietnam (at $2.55 an hour) are half those on offer in China and 39 per cent adrift of the hourly rate in Mexico.

Over the past decade, the Vietnamese government has introduced policy measures designed to rebalance the economy away from the natural resource sector to other higher value-added activities, as well as toughening environmental protection policies. That obviously makes sense, especially given the comparative advantage it still holds in labour costs. But unlike some other Asian economies, Vietnam has an abundance of natural resources, including sizeable oil & gas deposits, and significant hydropower potential, although its rapid growth rates have seen the country flip from a net energy exporter to an importer. Nevertheless, the country still runs a hefty current account surplus; 3.7 per cent of GDP for 2018, as per estimates from Standard Chartered.

Realpolitik and the Westward tilt

So a fast-growing services sector, allied to broadening export markets (particularly flows to the US) and supportive demographics. All this bodes well for a country still governed under a nominally Marxist–Leninist communist system (a peculiar scenario for investors one would imagine). However, it’s worth remembering that the 'Doi Moi' reforms were essentially introduced to engender political stability, ergo the continuation of the one-party state. This entailed ongoing economic reform, the success of which is best exemplified in the decline of the poverty rate, which fell from 75 per cent in 1984 to 5.8 per cent within the space of 30 years. It is also illustrated by figures from the World Bank which show that 99 per cent of the populace now use electricity as their main source of lighting, against 14 per cent in 1993.  

Economic progress is a critical factor that helps maintain social order and political stability. But it’s telling that the Communist Party sought to reduce external pressure by increasing linkages to the West to reinforce the regime’s legitimacy. The Journal of Current Southeast Asian Affairs states that the Communist Party has sought to “amplify the regime’s linkage to the West [and] is essentially intended to boost the economy and protect it from exogenous pressures on political democratisation”. Although it’s true that political opposition in the country is still repressed, The Journal notes that “Vietnamese society is becoming increasingly pluralistic” – a prerequisite for an outward-looking mercantile economy. And the reality is that most businesses in Vietnam operate in a free market, albeit with some state controls. MR

Funds not available via private investor platforms: Fiera Capital Europe Magna New Frontiers; T. Rowe Price Frontier Markets Equity