Towards A Greater Role for the Domestic Private Sector in Vietnam's Economic Development

Javed Hamid
Regional Director, East Asia and Pacific, The International Finance Corporation

Distinguished guests and participants, ladies and gentlemen,

I am delighted to be here this afternoon. It is an honor and real pleasure for me to have been invited to participate in this conference on Opening Markets and Continuing Growth in Vietnam. This conference presents an important opportunity for government policy-makers, business leaders and international donors to discuss and identify strategies for making further progress on Vietnam’s economic development and transition to a market economy.

IFC has been active in Vietnam for over a decade now. Not only have we supported more than 20 projects costing over $1.2 billion with around $400 million in financing but have also had an active technical assistance and advisory program. Based on our experience in Vietnam as well as in other transition economies, I would like to share our views on what can be done to realize the full potential of the private sector in promoting Vietnam’s development.

• First, I would like to talk about the main development challenges that Vietnam is facing today and the role that the private sector can play in addressing those challenges;
• Second, I will discuss the current status of the domestic private sector and how some of the impediments to its growth can be addressed.
• Third, I will discuss the role that IFC is prepared to play in supporting private sector development in Vietnam.

Vietnam has made remarkable progress in the 1990s. The economy doubled and the incidence of poverty was halved. Despite these achievements, there are still around 30 million people living in poverty. This is over a third of the total population. It is estimated that around 25 million people are either underemployed or unemployed. This is about 60 percent of the labor force. To create jobs for the unemployed, the underemployed and the new additions to the workforce, Vietnam will have to again double the economy in this decade. For this to happen, both the level and the quality of investment have to increase substantially. According to World Bank estimates, to double the economy total investment has to increase from an average of 25% of GDP in the 1990s to an average of 30% of GDP in the course of this decade. At this higher level of investment, Vietnam’s productivity will have to be about 40% higher than the average in the 1990s. The domestic private sector will have to play a key role in reaching these objectives.

The government is reducing the rate of investment in the state sector as part of its reform program. Foreign investment has stabilized at around $1bn per year, and can improve further depending on how favorably Vietnam’s investment environment compares to ASEAN countries and to China. However, attaining FDI levels achieved prior to the Asian crisis in a sustainable manner will be challenging. Thus to meet the government’s development objectives, the domestic private sector will have to contribute not only the additional 5% of GDP in investment, but will have to compensate for the expected decline in SOE investment. The reallocation of investment resources from the state to the private sector will also bring about the improvement in productivity that is needed to achieve Vietnam’s development objectives.

In this decade, most of the new jobs will have to be created by the domestic private sector, mainly SMEs. In the SOE sector, currently employing about 2 million people, estimates suggest that as much as a third of the workforce could be redundant. The Foreign Invested Sector is an important source of high paying jobs, however close to 90 percent of the stock of foreign investment is in capital-intensive industries. Therefore there are the domestic private SMEs which are generally more labor intensive and export-oriented, that will need to undertake the investment. The World Bank estimates that private SMEs’ manufacturing output will have to grow by 18-25 percent a year to generate the number and the type of jobs that are needed in Vietnam.

How attainable are these objectives? Recent trends in private sector growth and investment are encouraging.

The domestic formal private sector has been growing rapidly and has emerged as the most dynamic component of the Vietnamese economy in the last 2-3 years. Between January 2000 and December 2002, about 60,000 new private enterprises have been registered. This is more than the total number of enterprises registered in Vietnam in the previous decade. The growth in private enterprise creation has contributed to a significant increase in gross capital formation from 26% of GDP in 1999 to about 30% in GDP in 2001.

We have seen an accelerating growth in private industrial output. Private domestic industrial output grew at 20.3% in 2000 and 19.3% in 2001, significantly higher than SOEs and foreign invested enterprises, which grew 11.9 and 14.7% respectively. This is within, although at the lower end of the 18-25% range growth that needs to be maintained to achieve Vietnam’s development objectives.

Impressive growth can also be seen in private sector employment. It appears that new and existing private companies have added nearly 250,000 new wage jobs in 2001—a one-year increase of almost 45 percent.

This impressive growth in the domestic private sector over the last 2-3 years reflects a significant shift in official attitudes to private sector development. The shift is perhaps best exemplified by the enactment of the Enterprise Law and the formal endorsement of the private sector following the Fifth Plenum of the Ninth Party Congress in March 2002.

But despite all this progress, the formal domestic private sector in Vietnam remains small and its achievements are fragile. As of 2002, the formal domestic private sector still accounts for less than 8 percent of total GDP, 6 percent of manufacturing output and about 3 percent of total employment. The private sector’s small base means that its impressive rates of job creation still fall far short of matching the growth of the overall work force. For government development objectives to be realized, private sector growth has to accelerate. How to achieve this in Vietnam?

Development and growth come from two main sources: creation of new firms and growth of small and medium firms into larger ones. Vietnam has made good progress in facilitating market entry and business creation. However, significant unrealized potential remains in creating a business environment that supports the growth of small and medium size private firms into large ones. I would like to focus on some of the main impediments to growth as identified in a recent survey of private and state owned enterprises conducted by IFC and the World Bank.

To grow and develop private enterprises need access to resources such as financing and land. In our recent survey, about two thirds of the surveyed private firms identified access to financing and about a third identified access to land as a severe or major constraint to their development.

The difficulties of private enterprises in accessing finance reflect the rudimentary stage of development of Vietnam’s financial system. According to results from the IFC survey, private enterprises relied on personal savings, friends and family and retained earnings for 85 percent of their total financing, with intermediated financing, mainly through banks, accounting for only 15% of the total. Although there are insurance companies , a leasing industry and a fledgling stock market in Vietnam, there is paucity of alternative forms of outside financing. Many of the newly emerging small and medium sized enterprises are in the services and IT sectors where intangible assets represent most of their balance sheet. This type of companies have special financing needs--mainly in the form of private equity and venture capital. In our recent survey, lack of access to outside equity is viewed by one third of private firms as a major constraint. Therefore, to sustain the growth of private companies, especially in the services and hi-tech sectors, the development of alternative sources of financing has to accelerate.

Bank loans will remain the main source of outside financing for private firms. However, private companies face significant problems in accessing bank loans. These problems reflect both supply and demand side constraints. On the supply side, banks are reluctant to make loans to private enterprises because private enterprises do not enjoy the explicit or implicit guarantees associated with state ownership. In our survey for example, we find that for similar types of companies, SOEs enjoy a two to one advantage over private firms in accessing bank loans. This comparison includes relatively larger and more established private companies. Broadly for the SMEs sector, access will be much less. In the absence of implicit or explicit government guarantees, banks may be reluctant to lend to private companies because it is often hard for banks to conduct a good risk appraisal –due to lack of training and experience. With the recent removal of restrictions on interest rates , banks are now able to price the risk into their loans if they can assess this risk accurately.

On the demand side, private enterprises are often reluctant to access bank credit because the procedures require a higher level of transparency with respect to their business activities. Private enterprises operate with high level of informality in Vietnam. Their behavior reflects the belief that the costs of higher visibility in the form of larger size or more transparency outweigh the benefits, because larger size and higher transparency invite inspections and bureaucratic harassment. Such behavior is “encouraged” by certain aspects of taxation policies that are inconsistent with the objective to promote the growth of SMEs into larger companies. For instance, while the official corporate tax rate is broadly in line with regional levels, the effective tax rate in Vietnam is much higher because all gains and incomes are taxable, while not all legitimate expenses are tax deductible. Vietnam is probably unique in the region with its cap on marketing expenses. This discourages companies from aggressively pursuing market opportunities and could be particularly damaging for companies in the services sector, where significant part of the expenses are of the nature of marketing expenses. Furthermore, local companies are subject to a surcharge of 25% on return on equity above 20%. This is a major disincentive for companies to grow and become more transparent.

However, the main problem in accessing bank loans as revealed by our survey is insufficient collateral. Collateral requirement is overwhelmingly viewed as the most problematic issue by 66 percent of private firms interviewed in our survey. Problems with collateral reflect to a large extent problems in accessing land. This brings me to the other major constraint identified by private firms in our survey—the difficult access to land.

Land is under public ownership and state management in Vietnam. Users have land use rights that can be transferred, inherited, mortgaged, contributed as capital, or leased. The legal framework for land administration has been evolving with the 1998 and 2001 amendments of the Land Law of 1993. Reform in this area needs to continue at an accelerated pace as there are a number of anomalies in the land administration process that are constraining the growth of private enterprises.

There are two main ways to obtain land use rights for commercial use: lease from the government and through transfer. Obtaining land use rights through lease from the government is a very lengthy and costly process. Private businesses need to go through three levels of government agencies, present a project proposal and obtain numerous approvals. In our recent survey, private enterprises report an average processing time of about 200 days. Furthermore, land in Vietnam is scarce and the increase in the so-called specialized land, which is the land category for most business uses, has to come from other categories such as agricultural land. This involves compensation and resettlement of current users. Private enterprises have to pay the compensation costs which include compensation not only for the recovered land, but also for the assets erected on it, damages to the occupants, costs relating to any job re-location caused by the clearance process, etc. Paying these costs is in addition to the land rental. This makes the cost of the land use rights very expensive. In addition, the compensation and clearance process is often subject to disputes, negotiations and can be very time consuming. Thus 4 to 5 years can elapse between the application for land use rights and the time when the land can be put to use by the business. Private businesses, however, start paying rents usually from the date the decision for land leasing is made. In summary, the process is lengthy and drains significant portion of entrepreneurs’ resources thus making growth more difficult.

An alternative way to obtain land use rights is through transfer. Land use rights can not be transferred without state permission. Approval is based on “state planning objectives” allowing for significant administrative discretion. Land users can not transfer land use rights without title, the so–called certificate of land use rights. However, significant portion of land users do not have certificates of land use right due to a variety of reasons including complex procedures, high allotment fees, incomplete cadastral mapping, and more importantly, few substantive benefits conveyed by land titles. Furthermore, there is a transfer tax of 2-4 percent. Given these difficulties, it is not surprising that an estimated 70 percent of all transactions in land use rights take place in the vibrant unofficial market whereby private businesses lease land areas from SOEs, non-state enterprises, or directly from households. These unofficial transactions carry substantial risks for business as they are punished by administrative sanctions and therefore can not serve as a basis for sustained growth.

The social cost of these anomalies is very high as access to land appears to be a major factor in business expansion. When asked how would your business change if land was easier or cheaper to obtain, majority of the CEOs in the recent IFC/World Bank survey (82 per cent) said that they would expand plant size and about one-third said that they would diversify into new activities.

The government is aware of these issues and initiatives in the areas of tax and land administration are on the reform agenda for this year. However policy changes alone will not be enough and it is incumbent on all players—the policy makers, the financial institutions, and the private companies—to take the additional steps needed to realize the full potential of the private sector.

The policy makers have to focus on developing an even more transparent and consistent framework for private sector development based on the rule of law. They need to foster a more even playing field and reduce the costs of compliance with rules and regulations. Informal activities should gradually be absorbed into the formal market system by simplifying rules and regulations and by better enforcement and protection of property rights. The shift from concessionary (known as asking-giving in Vietnam) to normative regulations as demonstrated by the passage and implementation of the Enterprise Law should be extended to other areas, land use rights in particular. Policy makers also need to introduce greater fairness, transparency, and consistency in the taxation of private firms. Tax provisions which are inconsistent with normal business practices and penalize growth should be abolished. Taxation policies should be such that people are not forced to hide what they have earned in a honest way. The creation of a vibrant private sector depends to a large extent on the level of confidence that private investors have in the system and how much they believe that the rules do not discriminate against them and that enforcement is fair.

Second, the financial sector clearly plays an important role in private sector development. Without a diversified financial system, it is difficult for firms to grow. Private firms still have limited access to intermediated financing. To correct this situation, policies have to be introduced to create a level playing field for bank loans, and to increase alternatives to bank lending by developing new sources of financing such as private equity funds. Banks need to strengthen their risk assessment skills and develop the capacities to lend not only against collateral but also based on the intrinsic merits of projects. A vibrant private sector needs strong private financial institutions. Private financial institutions tend naturally to focus on under-served market segments, especially younger and smaller firms, which constitute the bulk of the private sector today.

But policy changes and a diversified financial system will not be enough. Domestic private companies can and should take steps themselves to improve their access to credit and enhance their ability to grow. Domestic private firms need to formalize their structures and operations, become more transparent, and upgrade their management skills. These steps will give Vietnams’ private companies greater access to outside sources of finance and will increase their global competitiveness. But let’s face it, they will do this only if they have confidence in the system and if they know that such steps will be rewarded with even greater political acceptance, less bureaucratic interference, and more access to finance.

We in IFC are actively working with policy makers, financial institutions, and businesses to support private sector development in Vietnam.

As some of you are aware, IFC in conjunction with the World Bank and the Ministry of Planning and Investment, hosts the Vietnam Business Forum bi-annually during the Consultative Group meetings. We believe that Vietnam is fortunate in having this on-going dialogue between the authorities and the private sector on practical steps that can be taken to foster private sector activity. We would encourage the government to engage more pro-actively in this dialogue.

We also believe that efforts to develop a robust and diversified financial system need to be accelerated. In the past, we have advised on the establishment of the stock exchange. More recently we made our first investment in a private bank in Vietnam. This is being supplemented with management advice and training to help the bank upgrade its credit and risk assessment skills, improve corporate governance and move to international standards of accounting and disclosure. We expect to make further investments in this sector in the future.

Support for small and medium enterprises, which constitutes the majority of the domestic private sector at present, will remain a high priority for IFC. We have already established a special institution--The Mekong Project Development Facility--to provide advice and assistance to SMEs and build capacity of local service providers. More recently, a Bank Training Center has been established to upgrade skills in the private banking sector. IFC is also actively providing financing, both debt and equity, to the smaller companies in Vietnam through various financial intermediaries including banks, leasing companies and equity funds.

These are just a few highlights of our program in Vietnam, which covers a broad range of sectors and instruments. In cooperation with the policy makers, the financial sector and the business community, we will continue to support investments and policy initiatives that help realize the full potential of the Vietnamese private sector.

Thank you.