Having Tamed Inflation, Vietnam Tackles Overleveraged Banks…

Despite hosting a few interesting consumer stories such as Vinamilk, Vietnam has been from my top down perspective a highly risky investment destination, plagued by sustained macro instability. Having been touted by Asian brokers as a ‘mini China’,  perhaps it’s finally living up to that name as it undergoes a painful deleveraging process and local tycoons get hauled away in handcuffs amid political uncertainty. It’s positive that the authorities have followed through on stabilising the macro environment as reflected in falling inflation and a becalmed VND. However, the country’s overextended banks and their fast deteriorating loan quality (with NPLs already probably well over 10%) have been the trigger for recent headline grabbing events, which have seen the local market slump over 20%.

The chief executive of Vietnam’s Asia Commercial Bank (ACB), Ly Xuan Hai, was arrested last week and he could face up to 20 years in prison if found guilty of the rather quaint sounding charges of “deliberately acting against state regulations on economic management and causing serious consequences”. Moody’s lowered Asia Commercial Bank’s credit rating to B2 from B1 last week in the wake of these developments and put the company on review for future downgrades.

Annual GDP growth averaged more than 7% in the decade leading up to the inflation crisis of 2008, but has slowed to just 4.7% in Q2 2012 as the government tightened credit in an attempt to restore confidence in the currency, and dissuade its citizens from hoarding gold and USD. Slower inflation has created room for the State Bank of Vietnam to try to boost economic growth by cutting policy interest rates, but having cut rates by five percentage points already this year, the bank may have reached the point where further easing has limited impact, until bank nonperforming loans are dealt with, so they can boost lending. In any case, slashing rates much further risks reversing retail flows back out of the VND and into gold and the USD.

The State Bank of Vietnam’s Governor told the national assembly recently that the non- performing loan ratio is now at 10%, although the bank’s official figure as at the end of June was only 4%. The bank expects 5.1% growth in 2012, which looks ambitious as the slowdown reflects weak domestic demand. With consumer credit tight, most Vietnamese are taking a conservative approach to consumption, as wage growth slows and unemployment rises, while some of the highest gold holdings as a share of total household wealth in the world are no longer generating a spending windfall. Reflecting this, import growth on a YTD y/y % growth basis has slowed from 24-26% a month throughout 2011 to under 7% in August.

Business in Vietnam has long been characterised by a lack of transparency, weak corporate governance, and rampant fraud/corruption far exceeding anything seen even in less than exemplary Indonesia or China.  The corruption clampdown amid widening economic inequality and popular discontent at the politically connected business elite (sound familiar?) is long overdue, and has gone far beyond celebrity tycoons. For instance, eight executives at Vinashin received prison sentences of up to 20 years in April after the shipbuilder nearly collapsed in 2010, having run up around $4.4 billion in debt. With the boom unravelling, the rise of hardliners such as Communist President Truong Tan Sang, may pull the country from a reform path (and the shift in oversight of the anti-corruption governing body from the Prime Minister to the Secretary General of the Communist party is telling) but privatisation revenues remain crucial and regaining the confidence of foreign portfolio investors will be a priority. I concluded in that note last February that: ‘By the beginning of Q4, we should know if they have the stomach for this fight; if so, Vietnam will finally become a sensible long-term investment destination for portfolio investors rather than that ‘mini China’ investment sound bite.’

After a series of missteps, Vietnamese authorities have showed impressive resolve to restore policy credibility, and if they can now reform the banking sector and manage its NPL issues, the country can belatedly aspire to graduate from frontier market status later this decade. Although the local market remains largely a retail driven casino (with price trends correlating inversely with VND gold prices, a factor driving this year’s Feb-May rally), resumption of the delayed privatisation program would be a positive sign of intent and local consumer, pharmaceutical and infrastructure plays look thematically attractive longer term, while property and construction materials remain exposed to a prolonged downturn.

Banks may deliver a ‘dead cat’ rebound, but with acknowledged NPLs having gone from 2% at end 2010 to 10% now, and with a series of corruption scandals from the credit boom coalescing, they will be a volatile ride. The benchmark equity index has fallen 21% from its high this year on May 8th, and is now trading at a 9.4x PER, or about a 33% discount to the MSCI South East Asia Index. If for no other reason, events in Vietnam are worth watching as a precursor to policy changes facing China’s Communist party, where many of the same economic and social stress points as well as a loss of political authority are evident, albeit on a vastly greater scale. Furthermore, it’s not at all inconceivable that the two countries, with a historically uneasy and sometimes violent relationship, will come to blows in the not too distant future as domestic pressures drive geopolitical posturing.

Macau’s VIP Gamblers Go AWOL, Like China’s Capital Inflows…

I was bearish on Macau casinos throughout 2011, viewing them as a conduit for money laundering as well as a temporary beneficiary of the credit and liquidity explosion in 2009/10, noting in February last year that: ‘A lot of official statistics on the Chinese economy are at best of dubious quality, but casino revenues for Macau are reliable and the trend is worth watching closely. On a back of the envelope calculation of average casino margins the total cash wagered by Chinese gamblers must be in the order of $750-800bn, from an economy which officially had nominal GDP in 2010 of $5.7trn…the activity of Chinese high rollers in Macau is also a useful leading indicator of domestic liquidity conditions and I would keep a close eye on trading in those casinos as much as money market rates.’ That insight remains valid, and those liquidity conditions are de facto being tightened by rising capital outflows, as much as weak bank deposit growth.

With restricted corruption opportunities for mainland officials from land sales as real estate investment slides,  a squeeze on the shadow banking system since early 2011 as well as growing political pressure to ‘tone down’ conspicuous consumption, fewer have been making high-roller trips to Macau and the tough junket market can’t be replaced by a still healthy mainstream tourist market.  After surging 58% in 2010 and 42% in 2011, gross gaming revenue growth looks to be slowing to 12% this year and at best half that next. Gross gaming revenue growth was 12% y/y in June but softened to just 1.5% in July, and gaming activity is correlating with high-end retail activity in both China and HK. As in retailing, it looks wise to concentrate any exposure on the mass market players, because the VIP squeeze will worsen in coming months as the political mood shifts further, and overall growth in VIP revenues for 2013 may well struggle to be positive.

In expectation of RMB weakness, Chinese companies have been accumulating dollars at a record pace this year and total foreign currency deposits have increased $137bn, or 50%, since January. However, reduced flow of funds into China’s financial system mean inherently tighter conditions in money markets, making it more difficult for banks to make loans, and frustrating Beijing’s attempts to boost economic momentum.

This week, the PBoC injected a net RMB 278bn into the interbank money market, the largest net injection since early January. The overall monetary/credit backdrop remains subdued; M2 money supply increased by 13.9% y/y in July while M1 narrow money was up just 4.6% y/y while currency in circulation increased by 10%. RMB deposits are also falling again; total bank deposits fell by RMB500bn compared to the end of June, and both deposit growth and the reversal in capital flows are both acting as constraints on the default bank credit driven response to a cyclical slowdown in China. This is apparent in the lending figures; new lending to non-financial corporations was RMB358.8bn in July, down from RMB644bn in June of which only RMB92bn was in medium/long-term loans likely to result in real economic activity, while RMB152.6bn came from bill financing.

I covered the complex mechanics of Chinese monetary policy in a monthly note last November, and noted that a key element of money creation arose from weak FX sterilisation of sustained current account inflows via the RRR, which leaked into the real economy via the shadow banking sector; recent outflows imply that this money creation process has gone into reverse, tightening liquidity. What I underestimated then was just how fast reserve accumulation would slow in H1, as capital flight became a significant factor. RRR reductions and repo operations do not necessarily represent net easing when the capital account is seeing accelerating outflows and the RMB is declining in nominal (if not real effective) terms. From a stance of buying dollars and selling RMB sterilised via the bill market back to exporters over the past decade, the PBoC now has to sell USD to the market amid a domestic shortage, and surging demand for foreign currency deposits. That changes the liquidity dynamics within the economy fundamentally.

China’s trade surplus and FDI inflows mean pretty constant inflows of foreign funds into the economy, but the pace of growth has slowed dramatically. In the past, expectations that the RMB would rise meant those funds were rapidly exchanged. Purchases of foreign exchange that fall below monthly inflows from trade and investment suggest either hot-money outflows, or a decision by firms to hold their foreign earnings in dollars. The country’s banks were net sellers of 3.8bn RMB in July, from net buyers of RMB 200-400bn a month for most of 2011 i.e. local bank foreign exchange purchases are lower than the monthly trade/investment inflows, and it confirms anecdotal evidence that exporters are reluctant to settle in RMB. China’s banks have been sellers of dollars in five of the past 10 months, purchasing just RMB 145bn in FX over that combined period, compared to the RMB 905bn that flowed into the country via its cumulative trade surplus. To put that in context, in Jan-Oct 2008, China’s banks were net purchasers of RMB 3.6trn in FX and massive inflows of capital were a key factor behind China’s soaring bank lending, property prices and consistent RMB appreciation. The balance of payments deficit in Q2, the first since 1998, reflected these new and potentially structural trends.

The capital outflows so far represent only a minor reversal viewed against the over $3trn in FX reserves, and SAFE won’t be a forced seller of its vast stock of US Treasuries just yet. The flow trend has been negative since September 2011, but the overall FX position hasn’t changed much in the past year, standing at RMB25trn, ex FDI flows (which are down almost 9% y/y). Inflows of foreign money into China have slowed this year, despite the QFII scheme being more than doubled to $80bn but the key issue is that Chinese investors seem to be increasingly evading the country’s strict capital controls to send money offshore. The interesting question is whether those controls are tightened in response, or alternatively this ‘leakage’ accelerates capital account liberalisation.

Although the RMB’s real effective exchange rate index dropped only slightly in July on BIS calculations, from a record high of 106.49 in June, a significant nominal (say 2-3%) depreciation of the RMB in H2 would imply a degree of desperation, as well as complicating the US relationship and RMB internationalisation efforts. The PBoC will be attempting to manage a very gentle downward glide path for the currency, having struggled to stem its natural rise until recent months. As much as momentum in real estate prices and food inflation, the radical and on-going shift in China’s capital flows and consequently monetary environment will be a critical constraint on policy options. And it’s not great for the Baccarat tables either.

China Rebalancing Trends Depend on H2 Stimulus Focus…

While the consensus obsesses over GDP growth, the key issue for China remains the quality and sustainability of incremental activity. We introduced the China Rebalancing Index back in the February monthly note; it’s an equally weighted diffusion index taking a standardized composite measure of seven key economic trends to act as a statistical summary of evolving structural trends, rather than looking for contemporaneous or lagging correlations or cyclical turning points as with a composite leading/coincident index approach. The components offer an insight into whether the Chinese economy is evolving in a sustainable direction toward greater household consumption/private sector service growth or further structural imbalance by experiencing incremental growth driven by SOE/heavy industry/fixed investment activity. China now faces a choice between a consumer oriented fiscal stimulus or another surge in fixed asset investment funded by bank lending; the latter seems to be already in motion, as covered in recent notes.

In fact, the overall officially calculated profits of Chinese industrial enterprises fell for the third straight month in June, slipping by 2.2% in H1 y/y, compared to 29% y/y growth in H1 2011. With construction related heavy industry comprising 22% or so of A-share trailing earnings, added to the 45% in banks, it’s no surprise that Chinese equities have been battered by endless downgrades/profit warnings, and despite some very constructive regulatory changes. However, profits fell by a more moderate 1.7% y/y in June, an improvement over May’s 5.3% y/y drop, perhaps an early signal that recent policy easing/fast-forwarding of infrastructure spending by the NDRC may be stabilising the sector. Across Asia, the latest total new orders less inventories data looks soft, particularly for Japan, Korea and Taiwan while new export orders also remain weak.

However, the euro zone uncertainty has been a key factor in dampening activity, and further tangible progress should be reflected not just in equity risk premia but real forward looking economic activity by late Q3. China’s PMI sits at 50.1 on the official measure and at 49.3 on the unofficial HSBC measure and the consensus is looking for real GDP growth to accelerate from 7.6% y/y in Q2 to 8.5% by Q4. That pace looks very unlikely given the structural nature of the recent slowdown, and certainly couldn’t be sustained for long, but a free-fall scenario has also looked unlikely at this stage, particularly if the export outlook stabilises. Recent M2 and lending growth data, as well as the PMI numbers, support the view that the Chinese industrial sector will at least suffer a diminishing policy headwind in H2, albeit at the cost of prolonging structural imbalances.