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Thoughts on Vietnam
Vietnam is a viable option to China but many underestimate the challenges.
A grumble about the jungle
In the scramble to find a supply chain to supplant China, Vietnam is often shortlisted for good reasons. The country has a sizable working population, labor rates one third China, and a fairly stable government has been following, at least partially, the playbook of a liberalizing reformer for coming on twenty years. Indeed, over the past decade, there has been progress in manufacturing capabilities particularly the growth of electronics-related operations. Beyond the electronics sector, however, results are uneven with spotty performance in apparel and automotive.
In efforts to characterize changes in the manufacturing landscape in Asia, many reporters herald a “Rising Vietnam” narrative, regularly giving short shrift to major issues such as shallow supply chains, institutional immaturity, fiscal shortfalls, and a demographic deficit. Added to these macroeconomic challenges Vietnam presents a host of microeconomic and company-level issues that bedevil and derail direct investors. Vietnam will certainly offer an alternative supply chain for some, but for most and especially over the short term, it will disappoint by delivering costs much higher than anticipated.
Go big or go home
The most visible success stories in Vietnam are the Japanese and South Korean operations who began investing in Vietnam about 20 years ago but really got moving in the wake of anti-Japanese demonstrations in China in 2005 when they concluded that “China plus one” was the secure strategy for low-cost country manufacturing. Since 2000, Japan and South Korea have accounted for 33% of the cumulative FDI; last year these two countries were the largest investors, contributing 50% of FDI.
Over the course of the past decade, investments from around Southeast Asia have trickled in as many searched for lower cost labor and a dual source to backstop issues that might arise in China. In 2009, US tariffs on tires coming out of China led Chinese, Japanese and Korean companies to build tire plants in Vietnam to skirt US tariffs. Today Vietnam is a major tire producer due in no small part to the readily available raw materials (rubber) and significant investments in modern equipment, training and management oversight from leading low-cost producers.
Overall, since 2009, exports have been growing by 18% per annum. Electrical equipment occupies the largest category, accounting for just under half of all exports and growing at 36% per annum. In 2016, Vietnam imported and exported nearly $200 billion. 20% of this—$40 billion—is one category, mobile devices, and one company, Samsung. Yes, that’s $40 billion in mobile devices (and $50 bn in 2017!) per year coming from two of Samsung’s largest global operations which are responsible for 40% of all Samsung’s mobile devices.
These exports figures are a dramatic change from 2003 when about half of Vietnam’s $20 billion in exports were primary materials; manufactured exports only began a rapid acceleration in 2005, doubling in just the last six years. Given these facts it is no wonder that Vietnam has very shallow supply chains making it primarily the final assembly point for inputs sourced from mostly around Asia. In 2016, Vietnam imported $60 billion in materials and parts from China, $32 billion from South Korea and $13 billion from Japan. These imports included all manner of materials from packaging, to fabric, to electronic components to name but a few.
A second challenge is the dearth of labor, particularly skilled labor. Of the 50 some odd million workers in Vietnam, only a mere 12% have graduated college. Today about 600,000 college graduates are added to Vietnam’s labor pool each year. However, the vast majority of workers will have only completed the statutory 9 years of education, leaving the country woefully short of middle-level management talent. Vietnam has made significant progress by doubling the number of college graduates in just 10 years, but decades of war and general social unrest have done lasting damage to educational institutions. Finally, like other autocratic nations, the current leadership has an uneasy relationship with an educated public leading to insufficient investment in this critical area.
Given this heightened global demand for low-cost manufacturing and the limited supply of operations of any scale, the overall unemployment rate is less than 3% and wages have been rising at about 10-20% per annum (depending upon the region and qualifications required). Those who search for middle-level management with multilingual skills will find few options in Vietnam and will quickly reach for their regional leaders in Hong Kong or China for support.
Unfortunately, that support—even if pulled from the Vietnamese diaspora—is often unwelcomed by the locals as it comes with all manner of historical baggage. Cultural clashes, some of which have been violent, are commonplace particularly when traditional foes are brought in to lead. The last hot war between China and Vietnam ended in 1979, but skirmishes continued along the contested border throughout the 80s. Relations were normalized in 1991. Chinese expansion in the South China Seas coupled with perennial weaponization of trade, such as banana embargoes, does nothing but stoke a tradition of suspicion if not outright hatred. Those that try to replicate the success of Japanese and Korean companies in Vietnam must confront these human capital constraints and will also need to remember that the buildup took more than a decade to yield results.
A State half pregnant with capitalism
Vietnam is a one-party state that vacillates between conflicting political philosophies. When expedient they will sing from the World Bank hymnbook, expounding the virtues of free speech and liberal policies, proudly describing moves up the Competitive Indices of the World Economic Forum. Said differently, they will sound like followers of capitalism. But in point of fact, their guiding principle is one of cognitive dissonance: Socialism with Vietnamese Characteristics. Hashtag: The Party runs the show. Such operating principles—business norms in Vietnam—have concrete ramifications that inhibit growth.
Take infrastructure as an example. According to the Global Infrastructure Hub, Vietnam needs $605 billion over the next two decades in order to sustain economic growth. Of that, $260 billion needs to be allocated for electricity and $133 billion for roads. Unfortunately, fiscal revenues at $54 bn are running 14% behind expenses and the government is unwilling to increase leverage rates as debt levels have gone from 36% of GDP in 2009 to close to 65% this year, a level that exceeds the States professed limits.
Moreover, as Vietnam is now ranked a middle-income country it can no longer apply for favorable credit from the World Bank or Asian Development Bank. And while there has been talk and some movement with China’s Belt and Road Initiative (BRI), Vietnam seems justifiably hesitant to take money from China. The Mekong River project is stalled ostensibly due to environmental concerns, but negative reports in the press about aggressive vendor-financing and subsequent defaults of BRI deals in Sri Lanka and Pakistan have tempered enthusiasm for BRI.
Vietnam has tried to leverage public private partnerships (PPP) in an effort to fund infrastructure demand, but the legal framework to support these investments are incomplete and not aligned with policy initiatives. For example, in Vietnam, the standard practice is to only allow tolls on roads where there is an alternative free route, but this constrains investment.
Private investment in roads, which never exceeded $400 mn in one year anyway, has vanished. As such, local lenders are the principal source of funding, accounting for 80% of the total. For now, it seems that the private sector is the only means to plug the investment gap, but opaque regulations and bureaucratic dithering will continue to make such investment unlikely.
The trade war is a temporary boon
Vietnam is operating at capacity with full employment and a straining infrastructure. The recent trade tiff between the US and China has exacerbated demands on an already overburdened system. In order to stay competitive, many manufacturers are scouting around and finding that there is a lot to grumble about.
In the meantime, odds are that the US and China will settle their dispute in short order. Once this happens, most sourcing teams will be back in China trying to take waste out of operations rather than mucking around in the manufacturing jungle that is Vietnam. Others, hopefully with the requisite determination and long-term commitment, will roll up their sleeves and put in the very meticulous work that is required to recreate a reliable manufacturing operation in a developing market.