Value in Vietnam (Jun 4, 2008)
Vietnam is in the midst of an economic crossroads. Not unlike China and India in the past, Vietnam is dealing with the dual-headed monster of high inflation/trade deficit. As value investors in Vietnam, how does this affect our view...
One year ago today, in reading about Vietnam we came across headlines that labelled it as ‘the Next China,’ ‘Asia’s Rising Star’ or “the Next Asian Tiger.” In some respects, Vietnam has become a victim of its own success. From centralised control and near famine 22 years ago, Vietnam’s success story is unparalleled, but now the government responsible for that turnaround faces its’ stiffest challenge yet; combating the dual problems of inflation and high trade deficit while factoring in potential global stagflation.
The impact of Vietnam’s current macroeconomic malaise can be most easily seen in the performance of VN-Index, which is down 56.5% this year, making it the worst performing in the world. Today, an investor can buy many listed stocks under 10x 2008 P/E. The question really becomes, what’s going to happen next?
If Vietnam’s problems have peaked, then an investment in the country today will look very smart in 2 to 3 years time, as low fundamental valuations look to be the kind that comes around once in a blue moon. But if policy response is badly mismanaged, and the global economy slows further, Vietnam’s recovery could be prolonged.
We believe the thesis which made Vietnam one of the most attractive investment destinations in the world two years ago has been unaffected by the current macroeconomic situation today. Extremely attractive population demographics, political stability and commitment, large amount of natural resources, and cultural resiliency have been the reasons Vietnam has been so successful in growing its’ economy to date, and these factors remain constant. As a worst case scenario, we see real GDP growth slowing to 5% this year, but more likely to remain a robust 7%, and for things to stabilise by year end. Furthermore, we intend to demonstrate why we think Vietnam is beginning to win the war against the inflation/trade deficit monster.
Inflation: up, up and away…?
Vietnam’s inflation stands at 25.2% YoY through May this year. This is the highest inflation in all of Asia . We understand inflation is a problem that spans the globe given a run-up in commodities prices, but Vietnam’s seems particularly high so we need to i) figure out why, ii) find out what’s being done about it, and iii) see what impact current policy measures are having.
Asian Inflation, Vietnam Outpaces its Neighbours
We need to dissect the 25.2% inflation number to understand Vietnam’s inflation. First, we need to break down the CPI basket into food and non-food inflation (which is something closer to core inflation). Food alone accounts for 42.9% of the CPI basket being the largest contributor to CPI (Korea’s food component of CPI is only 13.3%). We would then assume that as Vietnam’s food prices go, so too does Vietnam’s CPI go. Our assumption is correct, as food prices in Vietnam are up 42.4% YoY.
Around October of 2007 inflation in Vietnam began to spike. In fact, in the 2H07, Vietnam was a victim of several natural disasters which created supply shocks to Vietnam’s food supplies. Flooding in vital rice growing regions destroyed crops, about 5 million pigs had to be slaughtered due to blue ear disease, and an abnormally cold winter in the North of the country negatively impacted aquaculture.
Then, starting 1Q08 global commodities prices started to surge as a result of the sub-prime meltdown in the US. Hedge fund managers and other investors who had exposure to sub-prime investments look to alternative asset classes to move their funds into. With bond and equity markets in the US also looking unattractive, a lot of money shifted into commodities. Looking at rice futures as an example, a commodity that is very central to Vietnam culturally and economically (Vietnam is the second largest exporter of rice in the world and consume more rice per capita than most countries) we continue to see a trend that has particularly impacted this country. On the Chicago Board of Trade, Rough Rice futures reached a peak of US$25.07 in April, up 140% YoY. Vietnam’s farmers and distributors are guilty of hoarding supplies from the domestic market in an effort to cash in on high export value. Oil prices surging also affects the cost of fertilizer and increases base costs for fisherman, again feeding into food prices.
The last factor we must look at in regards to food inflation is the likelihood of consumer diets changing. Vietnam’s GDP reached US$820 per head in 2007, 3 years ahead of the government target. People in Vietnam today are able to eat more, and can afford higher priced diets which mean less rice and more high cost food products like wheat and dairy.
We begin to understand why food prices are up 42.4% YoY. However, we begin to see indications that food prices will level out shortly. The global commodities markets seem to have peaked, and especially in rice prices have fallen dramatically off their peak. Rough Rice futures are now trading at US$18.80, down 25% off their April high. Japan and Pakistan are releasing more rice for export, and in Vietnam Mekong Delta farmers have lobbied to export 4.5 ml tonnes instead of the official target of 4 ml tonnes given very successful harvests year to date, and expectated improved yield in the year’s remaining harvests. Thus far this year Vietnam has no one-off supply shocks to impact food price inflation anymore. Hoarders are watching the plummeting rice prices, and looking quickly to unload inventories. Food price inflation for Vietnam will likely decelerate and peak before the end of the year.
If Vietnam’s inflation is up 25.2% YoY, and food price inflation is up 42.4% and is also 42.9% of the CPI basket, then simple mathematical calculations indicate non-food inflation is only up about 12% YoY, and the growth slowed in a lot in May. While the number is high and does point to some overheating, the number is not devastating. We see the primary surge in non-food inflation is due to loose monetary policy in 2007, where a flood of liquidity from overseas and through broad money expansion has created price bubbles.
Credit growth surged by nearly 54% in 2007, a large portion of the money flooding into real estate and the stock market. At 10% of the CPI basket, we believe a surge in housing prices to be responsible for the bulk of non-food inflation. While no exact data is available, we see anecdotal evidence of a tremendous shift in the housing bubble. At the end of 2007, Ho Chi Minh City was more expensive than key Asian cities like Bangkok, Kuala Lumpur, Shanghai, and Seoul in key prices like prime office rent and total occupancy cost and in high end residential condominium prices. The rent this writer pays in Ho Chi Minh City today seems about the same of what he paid for a similar space in Chicago 3 years ago. A large amount of the 54% credit growth went to Vietnamese corporates who diversified into non-core real estate businesses. For example, we know of one shrimp exporter that set up a real estate business. It begs the question, what does a shrimp exporter know about real estate?
In any case, the said shrimp exporter is now out of the real estate business, and some anecdotal evidence suggests high end condominium prices are down as much as 50% this year in Ho Chi Minh City. We read this morning that one realtor Mr. Dung lost his job because of market conditions, and is now working as a debt collector for 1/75 the salary he earned as a realtor. We hope the irony is not lost on our reader. Mr. Dung is now probably collecting debt from a lot of the people he sold high end residential properties to! This report’s writer is now seeing identical units in his apartment building renting for 20% less than from a lease he signed 3 months ago!
The property bubble burst in Vietnam has come largely as a result of the State Bank of Vietnam’s efforts to drain liquidity from the monetary system. They achieved this in the first quarter of this year by increasing bank’s reserve ratio from 10% to 11%, raising key interest rates, and requiring banks to purchase VND 20.3 trillion worth of government bonds had a huge effect of draining liquidity from the system. Banks now are either lending at rates above 20%, or are simply not lending at all as they are very cash strapped. We hear rumours that several smaller banks will be forced to merge with larger banks in the next few months as they have reached the brink of insolvency. As credit growth has largely ceased, loose monetary policy will no longer be a cause for inflation.
Inflation is generally a lagging indicator, as macroeconomic conditions will take time to trickle through the supply chain into general prices. The 25.2% CPI number that was released in May most likely indicates what was happening in inflation two to three months ago. Thus, we think it is perhaps with little foresight that many people are over-emphasizing the inflation problem in Vietnam today. We believe our evidence suggests strongly that inflation will be under control in the short-term, and as such, it has not affected the fundamental reasoning behind investment in Vietnam. Inflation today will not impact Vietnam’s long-term growth.
Initial estimates for May are in, and the trade deficit for 2008 now stands at US$14.4 billion in the first 5 months of this year. We have roared through the government target of US$10.9 billion, a figure Vietnam surpassed in the first 4 months of the year. In May, the trade deficit was up US$3.3 billion, the largest MoM increase in Vietnam’s historical records.
The chart to the left demonstrates the rampaging trade deficit, which could become somewhere around 40% of GDP in 2008. A large trade deficit is actually quite normal in a country in Vietnam’s stage of development. Such a country imports large amounts of capital and intermediate goods to improve future competitiveness and export growth. In fact, imports for consumption have always averaged under 10% in this decade.
Again we have to look at global commodities markets as a prime cause behind the high figure. Steel, cement, fertilizer, and petroleum have all increased tremendously in price the first half of this year, and these account for a majority of Vietnam’s import value. May YoY import growth stands at a very high 70.4%, but export growth remains robust despite the global slowdown, showing 27.5% growth YoY in May.
For one example of how Vietnam’s current trade deficit might actually be “healthy” we have to look at the two major contributors of import growth so far this year, machinery and oil (no surprise). Machinery imports are up 47% YoY and oil imports are up 70.2% YoY through the first 4 months of 2008. A large amount of machinery imports are being deployed in the construction of oil refineries, and once completed, the refineries will substantially reduce Vietnam’s dependence on imported oil. Currently Vietnam is unable to produce petroleum and petroleum type products, instead only being able to drill and export crude oil. In February 2009, Vietnam’s first oil refinery will come online with a yearly capacity of 6.5 ml barrels of refined petroleum. Given that Vietnam imported 4.7 ml barrels of refine petroleum at a value of US$3.8 bn in the first 4 months of this year, we can already see a substantial turnaround in the trade deficit beginning early next year. Furthermore, Vietnam will complete a second refinery in 2013 with production capacity of 10 ml barrels. Finally, just this month a third refinery was announced with construction expected to commence this year.
Foreign Direct Investment (FDI), Official Development Aid (ODA), Portfolio Inflows, and Overseas Remittances have generally paid for Vietnam’s balance of trade, which has been negative every year this millennium. The balance of payments has always been positive, and as a result Vietnam has been able to accumulate foreign reserves of somewhere between US$22-25 bn. However, if we annualize capital account inflow estimates through May and compare with annualized trade deficit figures, Vietnam could be looking at a balance of payment deficit of around US$20 billion! Vietnam faces large pressure to its reserves and to its currency.
Some are drawing pre-Asian crisis similarities in Thailand, but we believe this is facetious. First, the VND is a non-convertible currency, meaning it should be safe from speculative attack. Second, 13 Asian nations in the region with Vietnam included have agreed to form a US$80 bn relief fund to prevent the exact sort of crisis to recur. Third, a substantial portion of Vietnam’s balance of payments deficit is in the form of long-term loans, which the country will not have to worry about funding this year.
A massive trade deficit left unchecked in the long-term can be highly detrimental, and we remain cognizant to such risk. However, we feel the burgeoning trade deficit is temporary given Vietnam’s current position in its’ natural economic development and bubble commodity prices. For example, we are hearing that steel importers have overestimated domestic demand, and have large inventories sitting at port that they cannot sell in Vietnam due to slowing demand and domestic price control. There is now talk they will export these inventories. Hence, we are confident that net steel imports will slow, if not turn into net steel exports.
Certain risks do pose a threat to our analysis however. First, our earlier example assumed capital account growth and trade deficit growth would remain constant. If, however, investors become fearful of current macroeconomic conditions, there is a real threat that the capital account growth will slow substantially. Portfolio inflows have largely been directed at Vietnam’s equity markets, which have plummeted this year. As for FDI, large institutions may think twice, or simply delay, their FDI disbursements until economic indicators cool down. In this instance, the balance of payment shortfall could become a lot worse.
We believe, however, that the risk of this worst case scenario is pretty small. We do not expect import growth to maintain its current pace in 2H08 for example, as commodity prices are expected to moderate, demand is falling, and interest rates are up. Furthermore, FDI commitments this year have surpassed US$14.7 bn, and in May alone commitments were US$7.5 bn. If this pace were to continue for the rest of the year, FDI commitments for 2008 will be around US$ 35.3 bn, US$15 bn or 74% higher than 2007! While this is not FDI disbursed, we feel it is highly unlikely that if FDI committed can grow so robustly disbursed FDI would actually contract. Also, we believe portfolio inflows will continue to be robust given the foreign sentiment we are seeing in the listed equities markets. Since April 7th of this year, foreigners have been net buyers of the VN-Index every single day. This is a result of emerging value, where 2008 estimated P/Es on the VN-Index are trading at somewhere around 10x, and falling. Consequently, in regards to capital account risk, we believe Vietnam is still a very attractive destination. Combine aforementioned factors with continued attractive population demographic, still low GDP/capita, and political instability in neighboring countries (rumours of renewed coup in Thailand, China vs. Tibet), Vietnam will remain a very attractive investment destination for many years to come.
However, the greatest trade deficit risk, in our opinion, is the risk of currency depreciation. The large trade deficit and high inflation are putting significant downward pressure on the VND, and as May’s inflation and trade deficit numbers come in, sentiment shows a high demand for the USD to sustain purchasing power. For a long time the VND was considered to be an undervalued currency, having pegged itself to the dollar and forced depreciation of 1% per year. In the last week of May, however, offshore NDF’s indicated a USD/VND spot rate of 22,500, which would suggest VND depreciation of around 38% in 12 months time!
Again we would like to mention that the VND is a non-convertible currency, so the NDF number is merely a suggestion of sentiment. We believe the government will sacrifice growth over currency depreciation, thus the likelihood of 38% depreciation is probably very overstated. We do expect some depreciation this year, maybe along the lines of 10%.
Overall, indications would suggest that increased interest rates, demand slowdown, and commodity price drops will moderate Vietnam’s trade deficit growth for the rest of the year. The biggest risk is the market sentiment both domestic and foreign. If locally Vietnamese hoard USD and exit out of VND, it will undermine the currency, and if foreigners feel the currency is overvalued, they will hold out in investing in Vietnam until equilibrium is reached. By the end of this year we expect trade deficit numbers will moderate, which should provide some relief to currency.
Trickle down effect…
Policy response to inflation has had some unintended consequences, which is trickling down through the economy as a whole. The liquidity crunch has left banks in a hard position. As we mentioned before, banks are not making new loans or are making loans at extremely high interest rates. Several banks are on the brink of insolvency as they have capital drained and increased exposure to non-performing loans (NPLs).
In fact, the whole process is a vicious cycle. The banks lent to speculators in the real estate and equities markets, credit growth which helped to create bubbles in these markets. When inflation began to soar, the State Bank of Vietnam was forced to tighten monetary policy which had a negative impact first in the stock markets. A large amount of retail investors had borrowed on margin, putting their portfolios up as collateral, to further invest in the market. At its’ peak in March 2007, the market was trading at 35x P/E and 3.5 P/B, clear indicators of an overvalued market. Margin calls forced investors to sell equities to fund losses, which led to further market retreat, which in turn led to further bank margin calls. Now, banks are stuck with portfolios of equities they accepted as collateral in a market that is down 56.5% this year. Banks have continued to unwind these portfolios, which has led to even further market correction. At this point, we feel the correction is overstated, and the large foreign buy sentiment in the market this year supports the hypothesis. But as banks have yet to completely unwind this bad debt, we expect already attractive values will become even more attractive!
The struggling stock market, usually a leading indicator, trickled into the property market. Combined with high input costs, we often read about how developers are simply leaving projects undone, or are even shaving a floor or two off contracted floor plans! Once again banks have large loan portfolios with exposure to the property market, and are finding their property NPLs on the rise. The same margin call cycle which affected the stock market is now affecting the property market, sending prices down.
As banks exposure to NPLs increases, and liquidity decreases, banks are left in a real pickle. They cease lending, which trickles down throughout the economy. In a country where bond markets and private equity are unsophisticated, corporates have generally raised capital for expansion through bank loans. We expect this to not be a viable source of funding for companies in the short-term, which leaves us in a very desirable position.
Essentially, we are now in the position that all value managers dream about. Markets are down tremendously, but the long-term Vietnam investment thesis is intact. Inflation and trade deficit will begin to moderate in the short-term and the market will continue to sell off as banks unwind their bad debt. This is the ideal situation for a value investor, as we are coming across some deals from companies with strong management, high profitability, and good cash flow that we can buy at below 5x P/E! These companies have nowhere to turn to for their funding needs, except for fund managers like ourselves. In Vietnam, it is a buyer’s market.