Foreign investors are pouring money into Vietnam stocks amid an improving growth outlook for the communist-ruled Southeast Asian nation. However, analysts have warned Hanoi not to overinflate the economy amid high debt levels and external risks.

Despite threats including the North Korean crisis, rising U.S. interest rates, and the prospect of a U.S.-China trade war, overseas investors have not lost their enthusiasm for Asia’s emerging markets.

However, according to Bloomberg data only one such market has attracted inflows every month this year: Vietnam. The benchmark Vietnam Ho Chi Minh Stock Index was up by over 20 percent as of September 8, with its one-year return of 24 percent placing it among the region’s leading performers.

The nation’s equities are in a “sweet spot” due to rising foreign direct investment (FDI), falling interest rates, credit growth and “reasonable” valuations, Asia Frontier Capital’s Thomas Hugger told Bloomberg News.

In its Asian Development Outlook 2017 report, the Asian Development Bank (ADB) projected gross domestic product (GDP) growth of 6.5 percent this year and 6.7 percent in 2018 for the nation of 96 million people, marking an improvement from last year’s 6.2 percent expansion.

The report said FDI continued to rise, with disbursements by the end of the first quarter 2017 estimated at $2.7 billion, up 4 percent on the prior quarter last year, accounting for 6.5 percent of GDP.

Total FDI is expected to reach a new record of more than $16 billion in 2017, helping the manufacturing sector surge and keeping the jobless rate low, which has dropped to 2.3 percent. Inflation dipped to 2.7 percent in 2016, although the ADB sees it rising to 4 percent this year and 5 percent in 2018.

Meanwhile, Vietnam’s export growth has averaged 20 percent in the first eight months of 2017, making it the strongest performer in emerging Asia, according to Capital Economics.

“Vietnam’s growth has been steady, aided by a diversified growth base and rising domestic demand. Accompanying structural reforms have also helped in steering the economy to a growth path that is compatible with manageable inflation and credit growth,” ANZ economist, Asia, Eugenia F. Victorino, said in an August 25 report.

Victorino also pointed to inflation being “contained,” reduced fiscal subsidies and an improving external position amid a rising current account surplus, which has been rewarded by sovereign credit rating upgrades. GDP for the second quarter rose by an estimated 6.2 percent, up from 5.1 percent in the first quarter, making growth above 6 percent “in the bag” for 2017.

Unsustainable Growth

However, the Australian bank’s economist warned that Vietnam’s goal of achieving GDP growth of 6.7 percent in 2017 risked a return to the “unsustainable growth model of the past.”

“Already, the improvement in domestic demand has been accompanied by an acceleration of credit,” he said. Credit growth has averaged 17.8 percent since 2015, overshooting official targets, and in April this year already exceeded the State Bank of Vietnam’s official full-year target of 18 percent.

Despite the credit growth, the central bank surprised markets with a 0.25 percentage point cut in its discount and refinancing rates in July. Last month, Vietnamese Prime Minister Nguyen Xuan Phuc called for the credit growth target to be raised even higher, to 22 percent, in support of Hanoi’s GDP growth target.

The nation’s banking sector is already handicapped by a high level of nonperforming loans, with Vietnam having lagged only Hong Kong in its surge in private credit growth over the past decade. Local banks’ capital adequacy has weakened as a result, with Moody’s estimating a total capital gap of $9.5 billion (4.6 percent of GDP) as at the end of 2016.

“The emerging environment of rising credit amidst weak capitalization levels has once again raised the possibility of misallocation of credit,” Victorino said.

“We take some comfort that a large share of new credit is directed to households instead of being dominated by state-owned enterprises like in the past. Nevertheless, the sharp rise in credit to the construction and real estate sectors over the last couple of years warrants caution.”

Victorino said an upward revision to the credit growth target would “make the warning lights shine brighter.”

Capital Economics has also pointed to Vietnam having the second-highest ratio of government debt to GDP in emerging Asia. Vietnam’s 60 percent debt ratio trails only Sri Lanka’s near 80 percent and exposes it to potential headwinds. The London-based consultancy sees Vietnam’s central bank cutting interest rates again before year-end to support the nation’s growth prospects, with fiscal policy constrained from further stimulus.

In its latest review, the International Monetary Fund (IMF) said Vietnam’s underlying growth momentum “remains robust, underpinned by strong manufacturing activity and FDI, robust domestic demand, and a rebound in agricultural production.”

However, while the Washington-based institution noted measures toward fiscal consolidation, such as a pledge to curb the fiscal deficit to 3.5 percent of GDP by 2020, “concrete measures have not yet been fully identified.”

“Bank reforms have progressed, but nonperforming loan NPL resolution, bank recapitalization, and legal reforms to strengthen market discipline have been sluggish. Good progress has been made on the legal framework for state-owned enterprise reforms, but implementation has been slow,” it warned.

The IMF pointed to downside risks including high public debt, slow NPL resolution, tighter global financial conditions and shocks to external demand, including rising protectionism.

“On the upside, successful implementation of the authorities’ ambitious reform agenda could raise growth potential and increase resilience to shocks. Fast implementation of the Vietnam-European Union (EU) and other bilateral trade agreements would fuel exports and FDI,” it said.

Trade Deals

Critics have also warned that a crackdown on political dissidents could jeopardize the long-sought after trade deal with the EU, currently Vietnam’s second-largest trading partner behind China. Trade between the two has expanded to more than $48 billion from $10 billion over the past decade, and an agreement could boost Vietnam’s GDP by an additional 2.7 percent a year.

However, the abduction of a former executive of the state-owned PetroVietnam Construction company, who was reportedly kidnapped in Germany while seeking asylum, sparked a row with Berlin and could threaten the EU trade deal.

“Even before the kidnapping, some EU states had been arguing that the deal ought to be ratified only on the condition that Vietnam improve its human-rights record. Angering the strongest economy in the EU bloc by conducting an extra-judicial detention on its territory will hardly improve things,” warned Bloomberg contributor Ilaria Maria Sala.

However, Vietnam has also pushed for other free trade agreements. Despite tensions with China in the South China Sea, it has urged the completion of negotiations this year over the ASEAN-led Regional Comprehensive Economic Partnership (RCEP), along with continuing its involvement in the Trans-Pacific Partnership (TPP) pact despite U.S. withdrawal.

Vietnam is also scheduled to eliminate all remaining import tariffs with its neighbors by 2018, under the ASEAN Free Trade Area (AFTA) pact, likely delivering another export boost.

Recent economic gains have not been reflected in improved economic or political freedoms, however. The Heritage Foundation’s 2017 “Index of Economic Freedom” ranked Vietnam 147th, well below China’s 111th although not far behind India’s 143rd ranking. Similarly, Reporters Without Borders’ 2017 “World Press Freedom Index” rated Vietnam a lowly 175th, just one rank ahead of China and comparable to North Korea’s 180th place.

Vietnam’s nominal GDP of approximately $201 billion puts it below other smaller Southeast Asian nations such as Malaysia and Singapore (around $296 billion each), ranking it as the world’s 48th largest economy. This compares to China’s estimated $11.2 trillion GDP, according to 2016 IMF data.

Yet providing Hanoi can implement promised reforms while containing external risks, the prospect of a sustained rise up the global economic rankings is in sight, mirroring the economic success of its biggest communist rival.

By Anthony Fensom - The Diplomat - September 11, 2017