Depreciation pressures on the dong have eased but linger
We believe pressures on the dong have eased in the short run as 1) the country has a healthy balance of payments, thanks to a trade surplus and positive FDI inflow; 2) PBOC has undertaken measures to mitigate Rmb depreciation pressure; and 3) market sentiment has improved in the official and black markets. In the long run, we think policy makers will tolerate modest depreciation in the dong amid broad US$ strength.

We do not project a policy rate hike in end-2018
The recent developments in Vietnam’s money market offer a slew of signals on where we are in the interest rate cycle. Interbank rates rose to a record high, bond yields rebounded and there was a small hike in deposit rates. We view this tightening of liquidity in the banking system as a normalisation of monetary conditions. As such, we believe that the SBV will not be rushed into a policy rate hike this year.

Fundamentals remain sound compared to other emerging markets
In many emerging markets, financial conditions have tightened more appreciably, particularly for countries with large current account deficits and high inflation rates. For Vietnam, we believe that the risk is relatively limited since Vietnam has much stronger fundamentals than Argentina and Turkey or even Indonesia and seems less vulnerable to current account pressures compared to other Asian countries.

Be selective to ride an escalating US-China trade war
We think pressure is building for Vietnamese technology exporters, especially computer parts and components. However, we also see a silver lining for domestic exporters of handbags, furniture and fishery products as US tariffs on Chinese imports in these categories are unlikely to be absorbed by the producers, rendering them uncompetitive vis-à-vis Vietnam.
 

 

Growth remains robust and broad-based

Vietnam’s GDP growth remains resilient
The Vietnamese economy expanded by 6.8% yoy in 2Q18 after GDP growth of 7.5% yoy in the first quarter (revised up from an initial estimate of 7.4% yoy). Vietnam’s real GDP therefore recorded robust growth of 7.1% yoy in 1H18, led by strong manufacturing activity and domestic consumption. In our previous note, we forecast GDP growth to ease in the second half of 2018. However, the latest reading on industrial activities points to sustained strength in manufacturing. According to the General Statistics Office (GSO), the IIP rose 14.3% in July and 13.4% in August, supported by stronger manufacturing and a rebound in mining activities. As expected, the debut of the Nghi Son Refinery and Petrochemical complex boosted petroleum products output by 60.5% yoy in the first eight months of 2018, bolstering manufacturing growth. Despite an escalating trade war, export growth was sustained in the Jul-Aug period with the launch of Samsung’s Galaxy Note 9 smartphone.
 

In addition, domestic demand remains resilient, supported by sustained high consumer confidence levels. Retail sales (ex-inflation) grew 8.5% yoy in the first eight months of 2018 vs. 8.4% in the same period the previous year. Despite a high base in 3Q17, we expect GDP growth in 3Q18 to remain strong at 6.8% yoy. Our 2018 economic growth forecast remains unchanged at 6.8% as we maintain our 4Q18 GDP forecast at 6.5%. However, we see the likelihood of a positive growth surprise in 4Q18, which could raise full-year GDP growth to 6.9%.

1. Positive current account: Vietnam posted a surprise US$2.2bn trade surplus in August 2018, thanks to the recovery of telephone exports; although there were net outflows in both equity and bond markets in July-August 2018, FDI inflow has continued to support the supply side of US$.
2. The People’s Bank of China (PBOC) raised its reserve requirement on some trading of foreign-exchange forward contracts from 0% to 20%, making it more expensive to short the Rmb. This is meant to be part of its counter-cyclical measures to control the Rmb depreciation.
3. Sentiment on the dong has improved in the black market. In addition, the spread between the dong and US$ interbank rates has turned positive, reducing the banks’ incentive to hoard US$.

In the medium term, depreciation pressure could reappear if the US-China tariff dispute escalates into a full-blown and sustained trade war. Another risk is currency turmoil in emerging markets, especially evident in Argentina and Turkey. However, Vietnam is well equipped to weather the volatility due to a healthy balance of payments, in our view.

For now, investors are waiting for two more Fed rate hikes in the remaining months of 2018 and several more in 2019. We think policy makers could tolerate some modest depreciation in the dong amid broad US$ strength. Meanwhile, a sharp depreciation is unlikely given the lessons learnt by policy makers in August 2015 where a sharp competitive devaluation of the VND could hurt market confidence and endanger Vietnam’s economic stability. Furthermore, stiff tariffs on Chinese imports into the US imply that Vietnam does not need to match the devaluation of the Rmb to maintain competitiveness versus Chinese exports as was the case in previous rounds of competitive devaluation.

Compared to other Asian currencies, such as the Indian rupee, Indonesian rupiah and Philippine peso, which have been among the worst-performing regional currencies, Vietnam has experienced a relatively small depreciation (just 2.5% YTD). We maintain our forecast of a 3.0-3.6% full-year depreciation vs. the US$ for 2018.
 

Higher rate environment still on the cards

Interbank liquidity is tightening, driven by pressure on the dong
In our view, pressure on the dong has tightened banking liquidity since July 2018 because of a direct FX intervention by the central bank in selling US$. In mid-July 2018, the State Bank of Vietnam (SBV) sold nearly US$2bn worth of forex to commercial banks, which led to a fall in dong liquidity. In order to counteract this action, the SBV injected liquidity into the banking system via open market operations (OMO). However, we see that the intended neutralisation was not sufficient to bring down interbank rates. The overnight rate is currently at the highest level seen in 2018, hovering at around 4.0-4.5%.
 

Government bond (G-bond) yields on the rise
The Vietnam government bond market experienced a sharp decline in yields during the first half of the year due to excess liquidity in the banking system which led to easy absorption of government bond auctions. However, as liquidity has tightened and foreign investors have continued their net selling in the bond market, Vietnam bond yields have significantly recovered since the last two months. Yields on 5-year and 10-year government bonds are currently at 4.5% and 5.1%, respectively. Both yields have recovered to the same levels as at the end of last year. The yield spread between Vietnam and US government bonds widened to 212 basis points from its record low of 123 basis points in early 2018. In the primary market, demand for G-bonds has declined with the average winning ratio at around 54.3% in three recent months. Winning yields have also increased; the yield on 10-year government bond posted an increase of 34bp in 3Q18. We think a sharp drop in bond yields in the first half was largely driven by excess liquidity in the banking system. Therefore, tightening interbank liquidity led to a rebound of G-bond yields to their normal levels rather than foreign selling of bonds as was the case in many Asian emerging markets; this is largely because foreign participation in Vietnam’s G-bond market is rather limited. Nonetheless, this and yields’ rise in itself is not a clear signal for any potential policy rate hikes in the near term as yields still remain low relative to historical levels even as the policy rate has remain unchanged.

 

We are not too concerned about a recent rise in deposit rates
In recent months, many local banks have adjusted up their deposit rates across tenors by 10-30 basis points. There might be concerns about higher funding costs for banks, but we still believe these adjustments will not have a significant impact on local banks’ profitability as well as the outlook for lending rates. We see two main reasons for the recent hike in deposit rates: 1) the SBV only allows banks to use 40% of their short-term capital for long and medium-term loans from 2019 instead of 45% as in this year. Therefore, banks have to raise deposit rates for tenors of more than 12 months in order to attract more long term funding to meet SBV’s requirement for next year; and 2) in first half of 2018, some major banks cut deposit rates to unusually low levels because of excess liquidity. Now, with liquidity tightening, a hike in deposit rates is a necessity. In early August 2018, the SBV issued Directive No.04, which strictly controls credit growth pace and credit quality of the banking system. As the SBV communicated a more conservative monetary policy, we think the SBV has recognised the need for measures to contain rising external risks. In other words, we see SBV’s communication of their monetary policy direction as a strong signal indicating their intention to implement a tighter monetary policy in the future, even if this is accomplished without a hike in policy rates.

What do we expect?
Our observations are that the SBV has tightened by 1) reducing interventions in the OMO market; 2) requiring banks to control their lending according to credit growth limits set by the SBV; and 3) targeting credit growth at a maximum of 17% for 2018, lower than the 18.2% recorded last year. While we stress that the recovery of interbank rates and bond yields alone is not a clear signal for a hike in policy rates, it is a helpful starting point to assess the outlook for interest rates, especially from 2019 onwards. For now, domestic inflation is stable and the dong has only depreciated slightly against the US dollar. If the dong faces greater pressure and inflationary expectation rises beyond the 5.0% threshold, the SBV might be forced to hike rates. Against the backdrop of rising global uncertainty led by lingering concerns about emerging market financial turmoil, increasing global trade tensions and monetary policy tightening by the central banks in developed countries in 2019 and beyond, we believe SBV’s policy rate hike is likely to happen next year. We now project a 50bp hike in policy rates in 2019, bringing the discount rate and refinancing rate to 4.75% and 6.75%, respectively.

Emerging market financial turbulence is unlikely to have a huge impact on Vietnam
Turkey and Argentina are experiencing a bout of financial instability against the backdrop of rising US rates and the effects of a resurgent US$. The instability is evident in the sharp depreciation of the Turkish lira and Argentine peso, which have fallen by 65.0% and 105.2% YTD, respectively. Weak fundamentals, as evidenced by high inflation and sizeable current account and budget deficits have contributed to the erosion of confidence in these economies and are spurring anxiety in financial markets that tightening credit cycle conditions globally may spread to a broader set of frontier and emerging economies, including Vietnam. As we see in Figure 11, Turkey and Argentina seem vulnerable according to all indicators. For Asia frontier and emerging countries, we think a high current account deficit and high inflation rate might trigger a large currency depreciation. For Vietnam, we believe that the risk is relatively limited since Vietnam has much stronger fundamentals than Argentina and Turkey, and seems less vulnerable in its current account balance compared to other Asian countries such as Indonesia, the Philippines and India.

In particular, Vietnam’s August headline inflation eased to just under 4.0% from 4.5% in Jun 2018, due to a decline in government-administered healthcare costs. Although we see broad inflationary pressures in food and transportation prices, we expect administrative controls and monetary tightening from the SBV to keep inflation under control this year (the SBV’s target of below 4%). If successful, this will be well below levels seen in Argentina and Turkey. Other vulnerability indicators show a mixed picture. Vietnam is more vulnerable than peers in terms of external debt and import cover. However, it is important to note that external debt risk is contained as concessional loans account for around 40% of government guaranteed external debt. Regarding import cover, traditional “rules of thumb” that have been used to guide reserve adequacy suggest that countries should hold reserves covering 100% of short-term debt or the equivalent of three months’ worth of imports. But for FDI-dependent economies like Vietnam that operate in downstream stages of the export manufacturing value chain, we think these traditional measures of reserve adequacy have limited relevance as a sizeable portion of Vietnam’s imports are inputs for manufactured exports. If exports slow down due to a full-blown of trade war, import deceleration will follow, thereby mitigating the risk of a balance of payments crisis.

Neither Turkey nor Argentina are important export markets for Vietnam, therefore, the impact of a sharp depreciation of the Turkish lira and Argentine peso on Vietnam’s trade is not significant. However, Argentina is Vietnam’s largest source market for corn and animal feed products, accounting for 50.8% and 46.2% of total imports of these two products into Vietnam in 2017, respectively. Therefore, domestic animal feed companies (DBC VN Equity, Not Rated) could benefit from the plummeting peso, and thereby lower their production costs. Since Turkey and Argentina do not compete directly with Vietnam in terms of exports to a significant degree, we do not believe that Vietnam will lose export market share to these countries as a result of the devaluation.

The escalating US-China trade war remains the biggest unknown
In our view, the big risk that markets may not yet have fully factored in is the growing threat of a trade war between the US and China, whose effects would ripple through regional supply chains. With the US$50bn of tariffs becoming a done deal for both countries, the focus is now on the next US$200bn of Chinese goods and US$60bn of US goods that are targeted for additional tariffs. In the latest development, President Trump announced 10% tariff hikes on an additional US$200bn of Chinese goods, starting from 24 September 2018 with the tariff expected to kick up to 25% from 01 January 2019. If implemented, the latest round of tariffs would cover half of the total Chinese goods imported into the US and nearly all of US goods exports to China in 2017.
 

Vietnam was in the top 15 list of the US’s import partners with around US$46bn worth of imports in 2017. The US was ranked 3 rd in Vietnam’s list of top trading partners with total trade of US$51bn in 2017. China, on the other hand was Vietnam’s top trading partner with a total trade value of US$94bn in 2017. The US was Vietnam’s largest export destination in 2017 (19.4% of total exports) while China was Vietnam’s largest import partner (27.5% of total imports). In this report, we access the list of the whole package of tariffs for Chinese goods including: 1) the US$50bn that was already implemented; and 2) the proposed US$200bn awaiting official implementation by the US. In our view, the direct impact on Vietnam from the US tariff on Chinese goods is relatively insignificant for the US$50bn list as most of the products on this list are comprised of intermediate inputs and capital equipment; consumer goods made up only 1% of the list; the total value of Vietnam’s export products that are exposed to this list was around US$4.4bn, only accounting for 2.1% of Vietnam’s total exports in 2017.

However, we are concerned about the next set of tariffs worth US$200bn on Chinese goods. We estimate the total value of Vietnam’s export products that are exposed to the US$200bn list to be around US$13.5bn, which is equivalent to 29.3% of Vietnam’s total exports to the US and 6.3% of Vietnam’s total exports in 2017. In our view, the impact of the ongoing US-China trade war on Vietnam could be four-pronged:

• Direct decline in demand for intermediate goods used in the production of China’s exports to the US (negative). Indirect decline in demand for final consumer goods due to rising costs for US consumers (negative).
• Potential rise in demand for alternative sources if the US needs substitutes for Chinese goods (positive).
• Indirect impact on Vietnam’s exports to China as a result of slower Chinese economic growth denting Chinese consumption (negative).

Figures 13 &14 illustrate the types of goods subject to the US tariffs. The list has been expanded to target consumer products. Figure 15 shows the potential products from Vietnam that are exposed to the US$200bn list. Vietnam is one of the top suppliers of furniture (PTB VN Equity, Not Rated) and handbags (GIL VN Equity, Not Rated), after China. Therefore, Vietnam could become an alternative sourcing destination for the US, thereby benefiting exports. The US tariffs on Chinese agricultural products could also indirectly benefit Vietnam. In fact, Vietnam’s exports of agricultural products, fishery products (VHC VN Equity, Not Rated), vegetables & fruits will benefit the most if the US needs substitutes for Chinese imports. Moreover, these measures would directly raise the price of the Chinese goods that are subject to the tariffs and therefore encourage Vietnamese exporters to raise prices as well.

In contrast, companies that produce intermediate goods used in the production of China’s exports to the US may see softer demand. The imposition of direct tariffs on telecommunication equipment and computer exports is likely to hurt Vietnam’s exports of these products. Since some of these products are reprocessed and re-exported to China in the form of semi-finished products, tariffs on Chinese goods may harm Vietnamese exports as they might cascade up the value chain. However, in the case of telephone exports, most Vietnamese exports are final products. Therefore, the impact will not be significant, in our view. Computer parts & components might be affected the most. For other types of products (auto parts, electrical transformers, plastics, lamps, steel, aluminium), we assume that they are not sold as raw or intermediate products to be re-exported to the US. In other words, they are more subject to Chinese end consumption which could suffer indirectly due to a sharper slowdown in China’s economy due to the trade war.

Originally published by CIMB Research and Economics on 27 September 2018.