ASIA

Market Commentary
EM Trading Strategy
June 5, 2008

Market Commentary
Vietnam is at More Risk of a Banking Crisis, Not Yet a BOP Crisis
For specific trade ideas associated with this sector review, please contact Johanna Chua (Hong Kong: + 852 2501-2357)
johanna.chua@citi.com

Key Points
The historically sharp depreciation of the VND spot has highlighted growing fears of a Thai-style
BOP crisis, but we think fears of a BOP crisis are overstated – foreign capital flows are not that
mobile in Vietnam and channels for domestic capital flight are constrained (two avenues could
be gold purchases and import over-invoicing/export under-invoicing).
What we are more worried about is a banking crisis and its fiscal and output loss implications.
While banking crisis is often associated with “sudden stops” of capital flows that can trigger a
BOP crisis, the channel through which this can happen in Vietnam may be slower than others
given that the trade deficit wasn’t funded by a large degree of short-term external leverage,
portfolio assets are very illiquid, and there are regulatory restrictions for dollar repatriation. We
think it is likely that even up to now, Vietnam’s FX reserves buffer is still relatively high.
However, protracted policy paralysis will worsen the problems – deepen the bank sector
problems, make the macro adjustment more painful and could eventually allow a banking crisis
to feed into a BOP/currency crisis though we are not close to this yet, and there’s sufficient
policy flexibility that authorities could exercise to prevent this from happening.
VND bonds. Positioning of VND bonds is too lopsided toward foreign holders trying to exit
while growth hasn’t slowed down significantly enough to make a notable dent on inflation/trade
balance. Thus, it’s too early to call the bottom. The further risk to bonds is tightening liquidity
conditions, FX weakness pass-thru on inflation and when eventually, the government needs to
fiscalize losses from the banking sector, the VND bond supply overhang to meet financing
needs should grow.
Vietnam CDS. While Vietnam’s credit fundamentals are deteriorating, the biggest unknown is
the extent of deterioration given lack of information on the banks, and uncertainty of the timing
of a proactive policy response. While technicals may mean that CDS will be choppy as foreign
holders of Vietnam bonds/equities have no other way to hedge, we think the current CDS
spread levels at 335bps (mid) for 5yr looks roughly “fair”, pricing in one-notch downgrade to
high single-B. Barring further developments, we would look to sell protection at around 380-
390bps, and buy protection at around 290-300bps in the near-term.

Citigroup Global Markets Asia Limited 1 Emerging Market Trading Strategy

 Market Commentary — Vietnam is at More Risk of a Banking Crisis, Not Yet a BOP
June 5, 2008 Crisis

Sharp VND depreciation is a symptom and aggravator of the problem

Amid lack of policy action and bleaker outlook on addressing overheating concerns, VND has depreciated
11.6% in the last month versus only 0.9% depreciation of the official rate in the same period. The interbank
rate now trading 10.2% above the “official VND” ceiling (using +2%) is not only driven by persistently high
inflation but growing loss of confidence that is prompting fears (almost hysteria) of the country’s
deteriorating balance of payment picture, magnified by the sizeable trade deficit. While exports grew 27% in
Jan-May, imports rose 70% during the same period, with largest contribution to import growth led by steel,
gold, autos, refined petroleum and machinery. Lack of stability in the VND will only worsens inflation,
exacerbates the run on VND, deepens a banking crisis, exacerbates the asset price correction and creates
a vicious spiral. Thus, while some FX adjustment is certainly warranted, we think SBV should find a credible
range for the VND and stabilize the exchange rate to prevent a damaging overshoot.

Figure 1. USD/VND Interbank rate vs. the Official Corridor

10 M ar 2008 : F X B a n d w as
1 8 ,5 0 0
w id en ed to + /- 1%
24 D ec 20 07: F X B an d w id en ed to + /-
2 Jan 2007: F X B an d w as w id en ed to + /- 0.5% 0.75% fr
fro m + /- 0.25% o f o fficial rate

1 8 ,0 0 0

C e ilin g V N D R a te
1 7 ,5 0 0
F lo o r V N D R a te
V N D In te rb a n k O ffe r
O fficia l V N D ra te
1 7 ,0 0 0

1 6 ,5 0 0

1 6 ,0 0 0

1 5 ,5 0 0
F e b -0 6 Ap r-0 6 J u n -0 6 Au g -0 6 O c t-0 6 D e c -0 6 F e b -0 7 Ap r-0 7 J u n -0 7 Au g -0 7 O c t-0 7 D e c -0 7 F e b -0 8 Ap r-0 8 J u n -0 8

Source: Citi

Banking crisis is the main worry...

We think government contingent liabilities and output loss from a possible banking crisis is the
MAJOR source of vulnerability. In our earlier note (Vietnam Trip Note – Not Very Comforting – 26 May
2008), we were more worried about the scale of government contingent liabilities from the banking system
given the rapid rise of credit growth in the last year, with credit to GDP hitting 95% of GDP in 2007 (we think
SOE investment played a big role here), the very low level of provisioning, weak credit risk management
capabilities and likely sizeable exposure to the vulnerable property sector. Banks are also chronically
exposed to both term maturity and currency mismatches as they fund themselves largely on deposits and
short-term credits and lend long-term, sometimes in USD. Demand for USD loans was likely high in recent
past given the “illusion” of FX stability as well as the lower USD lending rates vs. VND. In general, we think
Vietnam’s evolving risk of a banking crisis is a result of both weak supervision and prudential standards and
premature financial liberalization
Degree of fiscal burden is hard to quantify, but some private capital injection may be needed. Given
lack of data and time lag to default, the distribution of evolving non-performing assets among state-owned
commercial banks (SOCBs) and Joint Stock Banks (JSBs) and the ultimate onus on the government

Citigroup Global Markets Asia Limited 2 Emerging Market Trading Strategy

 Market Commentary — Vietnam is at More Risk of a Banking Crisis, Not Yet a BOP
June 5, 2008 Crisis

remains unclear. A delay in addressing the problems only increases its severity and duration. We think
major sources of bank non-performing assets will come from property developers and SOEs that have
expanded aggressively outside of their core businesses. According to a report by the Finance Ministry,
SOEs have invested a total of VND117 trillion (US$7.3 billion, 10% of GDP)) in financial investment and real
estate, most of which is funded through bank loans, with some companies having ridiculous debt to equity
ratios of around 20-22.1 To limit the fiscal cost to the government of any systemic problems in the banking
system, we think government should not only allow some banks to fail, merge/consolidate other banks but
also facilitate the injection of private (including foreign) capital into the banking system, including raising the
foreign ownership ceiling (currently at 30%) and selling assets at realistic prices (an issue that has caused
the continued to delay of the equitization process of SOCBs).

Reviewing balance of payment pressure points

Dissecting the 1Q08 balance of payments. While we already discussed the 2007 BOP figures in our
earlier report, we look at the 1Q08 BOP figures, where data seems to show that Vietnam still incurred a
surprising BOP surplus of $2.8bn in 1Q08. However, we note that five things:
1) Unlike in 2007, the significant widening of the trade deficit this year, driven by 70% import growth is
not largely funded by FDI. While net FDI inflows was able to cover about 63.7% of the trade deficit
in 2007, it only covered about 20.7% of the trade deficit in 1Q08 given the low rate of FDI
disbursal. This only improved slightly in April when FDI disbursal picked up, but still only covered
about 28% of trade deficit in Jan-April 2008. Nonetheless, this is still far better than in Thailand
where in the two years prior to the Asian crisis, FDI only covered 9% of the trade gap.
2) Net portfolio flows was still positive at $1.4bn in 1Q08 – may not be surprising as it wasn’t until the
latter part of March that sentiment significantly turned—and we expect portfolio flows could have
turned net negative on the back of withdrawal of funds from bond investments (we estimate
probably about $400m of the outstanding foreign holding of bonds out of $2-$3bn, may have been
unwound in the last few months) and possible non-resident deposits looking to be deployed in
equities/bonds and investments that may be reversing.
3) Overseas worker remittances, as captured by “private transfers” picked up strongly to $2bn, but as
we highlighted in our earlier note, remittance figures in Vietnam are overstated given that a
significant portion of this is actually invested (in property, for example) and should thus be counted
in the capital rather than current account.
4) The surge in “currency and deposits” in the capital account, hitting $3.3bn in 1Q08 alone versus
$2.6bn in all of 2006, is equivalent to “net short-term capital” of commercial banks largely
comprised of the: a) change in net foreign assets (NFA) (i.e. a positive figure means decline in
NFA, i.e. commercial banks selling foreign assets and/or incurring foreign liabilities); and, b) trade
credits (the latter has been typically very small in Vietnam).
5) The positive errors and omissions of $1.2bn could be another form of undisclosed portfolio inflows.

1
See Saigon Times Weekly – “Off the Track, in the Storm” (3 May 2008)

Citigroup Global Markets Asia Limited 3 Emerging Market Trading Strategy

 Market Commentary — Vietnam is at More Risk of a Banking Crisis, Not Yet a BOP
June 5, 2008 Crisis

Figure 2. Vietnam – Balance of Payments (in US$ billions)

2002 2003 2004 2005 2006 2007F 1Q08
Trade Balance -1.054 -2.581 -3.854 -2.439 -2.776 -10.360 -7.050
Export 16.706 20.149 26.485 32.447 39.826 48.561 13.160
Import 17.760 22.730 30.339 34.886 42.602 58.921 20.210
Services Balance -0.749 -0.778 0.061 -0.219 -0.008 -0.894 -0.277
Investment Income -0.721 -0.811 -0.891 -1.219 -1.429 -2.168 -0.510
Net Transfers 1.921 2.239 3.093 3.380 4.049 6.430 2.550
o.w. private transfers 1.767 2.100 2.919 3.150 3.800 6.180 2.000
Current Account -0.603 -1.931 -1.591 -0.497 -0.164 -6.992 -5.287
Net FDI 1.400 1.450 1.610 1.889 2.315 6.600 1.462
Net Medium-to-long term loans* -0.051 0.457 1.162 0.921 1.025 2.043 0.635
Net Short-term Loans 0.007 0.026 -0.054 0.046 -0.030 0.091 0.056
Portfolio Investments - - - 0.865 1.313 7.414 1.366
Currencies & deposits 0.624 1.372 0.035 -0.634 -1.535 2.623 3.322
Capital Account 1.980 3.305 2.753 3.152 3.173 18.771 6.841
Errors & Omissions -1.020 0.777 -0.279 -0.459 1.398 -1.611 1.214
Overall balance 0.357 2.151 0.883 2.196 4.407 10.168 2.768
Source: Vietnam –Managing Capital Flows – ADBI Institute, government source

Need to assess the speed of adjustment in the trade balance and capital flows in order to assess
Vietnam’s vulnerability to a balance of payments crisis:
1) Trend in the monthly trade deficit – while this should narrow eventually, adjustment may be
slow. There are some promising signs -- steel imports are already being re-exports as
construction demand drops, car imports reportedly dropped in May following an increase in
import duties from 60% to 83%), import duties on gold was doubled to 1% (but unlikely to be a
major deterrent in our view), SOE investments is being curbed and access to working capital,
especially dollar funding to pay for imports should now be relatively tighter. Moreover, the recent
depreciation of the VND should also help narrow the gap. However, we think adjustment to the
trade gap normally takes time.
2) Meanwhile, the speed of short-term capital outflows need to be monitored – watch out for
both portfolio unwinds and non-resident deposits. While there is a sizeable cumulative
portfolio inflow of $8.8bn since January 2007, we think a significant amount of this is difficult to
unwind given lack of liquidity/difficulty in unloading assets (e.g. government only allows +/2%
intraday fluctuation on the VN stock index) though will continue to leak out gradually. However,
without a functioning market (i.e. no liquidity), it is already as if there are capital controls already
in place. What worries us a bit are potential capital flows that are channeled through the banking
system, for example, non-resident deposits, which may be showing up in either the “currencies
and deposits” of commercial banks (as an increase in foreign liabilities). However, while non-
residents cannot technically open VND deposit accounts without an underlying investment/
transaction (i.e. one technically cannot just open a deposit account to speculate on the VND), we
think there could be mechanisms that regulations are circumvented and it is difficult to ascertain
the magnitude of capital outflows that can go out through the banking system. Moreover, there
may be some foreign deposits that are not yet deployed (maybe explained by the huge gap
between FDI commitments and disbursals) that could be repatriated (subject to documentation

Citigroup Global Markets Asia Limited 4 Emerging Market Trading Strategy

 Market Commentary — Vietnam is at More Risk of a Banking Crisis, Not Yet a BOP
June 5, 2008 Crisis

requirements) if the foreigner loses confidence in Vietnam and could result in an unraveling of
the NFA position of the banks.
3) Trend in FDI flows – a sudden stop of FDI flows would be a big negative. A major plus in
Vietnam has been the strong trends in FDI in recent years. The SBV expects FDI disbursals to
hit $8.3bn (9.3% of GDP) in 2008 from $6.7bn in 2007, which could potentially fund a little over
half of the expected current account deficit this year. However, if growing macro stability risks
cause FDI projects to be delayed and disbursals to be frozen, then the deterioration of the BOP
would worsen. Nonetheless, we argue that a number of persistent features of Vietnam will
continue to attract foreign interest – favorable demographics for labor-intensive manufacturing,
political stability (so far), liberalization reforms on the back of WTO and some promising sectors
with structural shortages (tourism) (we note that a recent AT Kearney Global Retail Development
Index has identified Vietnam as the most attractive retail market for investors, outpacing India) –
but a sharp macro adjustment brought about by systemic banking risks alongside already
lingering rigidities to FDI disbursal (e.g. bureaucracy, infrastructure bottlenecks, protracted
delays in SOE equitization with unrealistic price expectations) could put some FDI flows at risk.

It seems only a modest amount of external debt, particularly short-term external debt has been built
up during the boom year. In stark contrast to Thailand prior to the crisis, the BOP does not reveal a
significant amount of short-term borrowing – in fact, net short-term loan inflow was small at only $91m in
2007 and $56m in 1Q08, or cumulatively 0.2% of GDP, though this doesn’t take into account short-term
liabilities incurred by the commercial banks (hard to tell how much that is from the figures on the change in
NFA because we don’t know the breakdown of the flow of foreign assets and liabilities of the banks). In
Thailand, FX reserves was not even sufficient to cover short-term external debt by remaining maturity in the
run-up to the Asian crisis, making them very vulnerable to sudden stops of capital flows. Vietnam has both
a bigger FX reserve buffer and we think stickier capital flows.

Domestic capital flight is restricted. The dong is not a convertible currency and residents face tight limits
in the amount of dong they can convert to USD and take overseas without underlying transactions/required
documentation. Of course, there are ways domestic capital can find avenues to flee, e.g. by over-invoicing
imports and under-invoicing exports; and, purchasing gold, which in itself is a form of domestic capital flight.
Nonetheless, we think the overall ease of triggering massive capital flight appears much more restrictive in
Vietnam than in other countries in EM countries associated with twin crises (banking +BOP crisis), which
means Vietnam may have more time and puts a cap on the degree of adjustment in the VND.

Overall, we think that official foreign reserves probably have not been depleted too much yet. With
FX reserves reportedly around $23bn at the end of 2007, a BOP surplus up until 1Q08 and stickiness of
capital flows, with some long-term flows still coming in (FDI commitments reportedly hit $15.3bn in Jan-May,
up 23% yoy, though it’s unclear how much was disbursed in May ($3.1bn disbursed ytd as of April), we think
FX reserves could still be hovering close to $20bn range or covering about 3.5 times short-term debt by
remaining maturity and 3 months of imports. However, the longer the government delays the macro
adjustment needed, the greater risk that capital flows continues to wane while the trade balance adjustment
is delayed, in which case the risk of a twin crisis – banking crisis contaminating the balance of payments –
grows.

Citigroup Global Markets Asia Limited 5 Emerging Market Trading Strategy

 Market Commentary — Vietnam is at More Risk of a Banking Crisis, Not Yet a BOP
June 5, 2008 Crisis

Vietnam 5yr CDS is pricing a one-notch downgrade

Vietnam 5yr CDS has significantly underperformed comparable EM spreads in the last three months,
lagging Indonesia and Philippines 5yr CDS spreads by 100bps and 125bps, respectively, since end of
March. While the re-pricing on a historical basis looks severe, the stark lack of policy action by the
government for so long (which surprised us a bit) means embedded credit deterioration is worse than we
initially thought when Vietnam CDS first blew up. Thus, we think the CDS sell-off, which is initially driven by
strong hedging demand from Vietnam local bonds and equities can also be rationalized by a re-pricing of
the overall credit risk of Vietnam. Based on the current exponential relationship between ratings and
spreads, we think Vietnam 5yr at current spread levels (5yr at mid-spread of 335bps) is equivalent to an
implied ratings of a high single-B, a notch below its current ratings, and a 1.5 notches higher than Pakistan.
We think this looks relatively “fair”, given that we think the window for a policy response to avert a credit
event (i.e. default) remains wide (i.e. default risk on the small amount of external commercial debt in
Vietnam remains low) and the risk of a double-downgrade, at this point, remains low. Barring any further
developments, we would look to sell protection at around 380-390bps, and buy protection at around 290-
300bps.

Figure 3. Sovereign CDS Spreads vs. Ratings Curve

700

3-Jun-08 ARG PAK

600
VENZ
31-Mar-08 LEB

500

400 VIET
5yr CDS

UKR
300 INDO
TUR

200 ELSAL PHIL

SOAF
COLOM
HUN THAI PAN
KOR POL ROM
100 BUL CROA
RUS MEX
MAL BRAZ PERU
CHIL
CHNA
0
5 A3/A-
7 9
Baa2/BBB Ba1/BB+
11 Ba3/BB-
13 B2/B
15 Caa1/ 17
A1/A+
CCC+
Average of M oody's & S&P's ratings

Source: Citi.

Citigroup Global Markets Asia Limited 6 Emerging Market Trading Strategy

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