July 27th, 2008

What is happening in Vietnam rings an alarm bell for China

I have seen a couple of articles around about the temptation of “the Greener Grass” of Vietnam, since China is currently raising concerns about inflation, shortage of workers and energy, strengthening currency, changing policies andsocial unrest.

Looks like China no longer appears as a bargain and some corporations might be tempted by mitigating the risk of their overdependence over operating in one country only.

The International Herald Tribune make a very interesting point here, not by ranking the two countries systems but by pointing out their similarities and why top Chinese policy makers have been watching the Vietnamese economic unfold : What is happening in Vietnam rings an alarm bell for China.

There is little contagion risk, as the Vietnamese economy is less than a third of the size of nearby Thailand, which triggered the 1997 Asian financial crisis.

But China and Vietnam have similar fundamental economic problems. Both face mounting inflation pressures, they have large foreign money inflows and both have been reluctant to let their currencies appreciate in recent years.

Vietnam, often referred to as little China, has followed its larger neighbor in beginning market-oriented reforms.

Like many of its Asian neighbors who want to use exports to pull out of poverty, Vietnam chose to resist currency appreciation so it could keep its costs low.

Importantly, Vietnam, unlike China, failed to soak up the funds it injected into the domestic banking system when it bought up the foreign investment inflows. The result was 54 percent credit expansion in 2007 and a current inflation level above 25 percent.

“The issues are the same, but their policies are completely different,” said James McCormack, a managing director at Fitch Ratings. “China’s response to inflation has been more aggressive and effective.”

China’s pockets are deeper. It boasts large reservoirs of domestic and foreign cash, which help it lock in excess liquidity and release it when necessary. It has $1.7 trillion in foreign reserves, the largest amount ever held by any country.

Still, the Vietnam experience is a rude awakening for China. Before the Vietnam crisis, several influential domestic experts in China had proposed that policy makers allow domestic inflation to rise to correct the undervaluation of the currency, instead of allowing the nominal exchange rate to go up.

Vietnam shows that that would have been a big mistake because inflation can do a lot of damage. Exports would be hurt because high inflation drives up the cost of doing business.

Vietnam has been so focused on rapid economic expansion that it forgot how economic overheating could sacrifice short-term growth.

By comparison, Beijing has been far more assertive in controlling liquidity.

Last week, Beijing unexpectedly lifted the bank reserve ratio, the money banks must hold in cash or on deposit, by a full percentage point to a record 17.5 percent. Many experts see this as a signal that Beijing is taking inflation more seriously.

What makes Vietnam’s currency policy even more vulnerable, the country has a fairly open capital account.

Vietnam, on the other hand, has operated a policy that pushes the dong slightly lower against the dollar each year.

Vietnam has taught Chinese leaders that negative real interest rates, an open economy and fixed currency are a “recipe for disaster,” said, Hong Liang, an economist at Goldman Sachs. No country can fix interest rates and exchange rates unless the economy is closed. Both Vietnam and China have moved to become more open and market oriented.

The lesson for China is that it needs to allow more flexibility in the yuan and to take seriously the risks posed by inflation. Otherwise, what seems like a minor headache could well turn into a policy nightmare.

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