The collapse of the Soviet Union in the late 1980s forced Vietnam to transform from central planning and autarky to market orientation and international re-integration. Overall, this has been very successful. GDP growth has averaged over 7% a year ― with foreign investment a key driver (Chart 1). Correspondingly, per capita income has risen sharply to nearly US$1200, although it is still well below the regional average.

Vietnam has numerous attractions for investors and exporters: a large, young and growing population; relatively well educated and cheap labour; sizeable natural resources; an advantageous location; and a high level of political and social stability.

There is also substantial risk. Macro-economic imbalances raise the probability of banking, currency and sovereign debt crises, and the business climate – while improving – is still very challenging (Chart 2).

The authorities’ pursuit of rapid economic growth over recent years has come at a cost of macroeconomic instability. Two imbalances that have emerged are large trade and fiscal deficits, rarities in Asia. In addition, inflation has accelerated ― to 20% in May 2011.

A December 2010 default by state-owned shipbuilder Vinashin has raised concerns about the credit quality of Vietnamese banks. Bank credit has risen strongly over the past decade, with the credit-to-GDP ratio more than tripling to 125% of GDP. A significant proportion of the loans have been funnelled into state-owned enterprises and real estate.

Vietnam’s economic troubles have been reflected in the currency. The dong has been repeatedly devalued, while FX reserves have slumped (Chart 4).

Of late, investors have gained some confidence from the government’s renewed focus on stability, through higher interest rates and lower credit and fiscal deficit targets. But with real interest rates still negative, and the trade deficit widening, further policy action may be necessary to ensure stability. Attempts to rein in growth may also worsen loan and liquidity problems at the banks and state-owned enterprises. FX reserves are low and do not provide a large buffer for any further shocks.

S&P view the country’s external foreign currency debt as speculative grade with a BB- rating and a negative outlook. Fitch rate Vietnam slightly lower, at B+ with a stable outlook. Public debt is equivalent to 53% of GDP. Contingent liabilities – in the banking sector and state-owned enterprises – are potentially large.

The Vietnamese Communist Party (CPV) has a firm grip on power, which ensures a high degree of political stability – according to the World Bank broadly in line with the regional average (Chart 5). Widespread support for the CPV reflects its success in raising living standards and creating and maintaining security.

While the party’s communist ideology has become less important over time, it still plays an active role in economic development. This is largely through a plethora of state-owned enterprises, which span most industries and account for nearly 40% of GDP. Since 1992, the government has undertaken an ‘equitisation’ program (part-privatisation), but progress has been fitful. Investors are concerned about the price of the assets, a lack of financial transparency, insufficient protection for minority owners, and poor corporate governance. The asset sales also face resistance from within the party.

Foreign investors are attracted to Vietnam by low labour costs, a large domestic market and rapid economic growth; not its investment climate. Foreign investors face numerous challenges including: inconsistent and evolving regulations, an unreliable legal system, a weak banking system, corruption, and industrial and credit policies that favour state-owned enterprises. The government is also relying on import controls and price restrictions to help rein in inflation and the trade deficit. Such controls might limit price rises and imports, but they also create shortages, encourage smuggling and damage investor confidence.

The World Bank ranks Vietnam in the second bottom quartile of countries for regulatory quality, rule of law and control of corruption – below the regional and OECD average (Chart 6). On another World Bank gauge – ease of doing business, which attempts to measure ‘regulation and red tape relevant to a domestic small to medium-size firm’ – Vietnam ranks around the 50th percentile. A key concern is investor protection.

The move towards a more market-based economic model has improved the quality of life for many Vietnamese. Per capita income has risen from US$100 in 1990 to over US$1000 (Chart 7). But, reflecting its low starting point and Vietnam’s rapid population growth, per capita income growth has not kept pace with the regional average. Moreover, the rural-urban income gap has widened, because the ‘new’ more prosperous economy of manufacturing and services is largely centred in urban areas.

Overall, security concerns are relatively low. On most benchmarks Vietnam is viewed as one of the more stable countries in the region (Chart 8).

One flashpoint is an ongoing dispute with China over the ownership of the resource-rich Spratly islands in the South China Sea. China has pressed foreign oil companies to abandon their offshore oil and gas exploration contracts with Vietnam.

*All 2010 figures unless specified

**The HDI is composite measure of human development: long & healthy life (life expectancy), education (literacy & education enrolment) and income (GDP per capita)

***Expressed as % of GDP unless specified