(Reprinted from HKCER Letters, Vol.35, November 1995)

 

The Transition to Market Economy in Vietnam

James Riedel

 

Editor's note: The opening of Vietnam in recent years has attracted a lot of interest from both business and academics. While economic reforms in Eastern Europe and Russia have encountered various difficulties, Vietnam's experiences have been more promising. In a talk held by the Centre, Professor James Riedel shared with us his views and comments on Vietnam's recent economic performance. The following is an edited version of his talk.

Introduction

Before I go into the topic, I would like to make some personal notes related to Vietnam. I guess everyone in my generation in the United States has intense personal feelings about Vietnam, whether they served in the army or not. In my case, I did serve Vietnam in the army from late 1964 to early 1966. I learnt Vietnamese and worked as an interpreter in Vietnam. In my spare time, I taught English. In these fourteen to fifteen months of service, I decided my future career in teaching and discovered that I had lifelong interests in Asia. So for me, my time in Vietnam thirty years ago was really noteworthy. In 1991 or 1992, I had the opportunity to go to Vietnam and lectured at the state planning committee on the role of the government in the market economy. Since then, I have lectured on related topics and conducted research a few times.

Vietnam is in the transition to a market economy, but that is only a means to a greater end, which is to make the economy prosperous and dynamic. The leadership in Vietnam did not decide to "go market" because of an ideological conversion from Marxism-Leninism to capitalism, but because they discovered the hard way that the alternative to a market economy did not work. They also had a lot of evidence from other countries in the region, in particular from their ideological soul mate, China, that the market economy can work. So in 1986 Vietnam launched its reform program under the banner doi moi, which means "renovation" in Vietnamese. This was a very bold political move, but an obviously economic one.

The advantages of a market economy were not oversold in Vietnam. On the contrary, the success the doi moi program achieved has exceeded anything imagined by those who coined the slogan. In 1986, when Vietnam launched the doi moi, the economy was in chaos. Inflation was soaring at about 400 percent. People were fleeing the country by whatever means possible. Today, the leadership in Vietnam can look back on five to six years of GDP growth at an average rate of about 8 percent. Inflation has been brought down from triple to single digits, and even the boat people are now coming back. Vietnam is now attracting finance from all over the world, including the United States.

So the question is: How did they do it? Why was Vietnam's transition to a market economy apparently so much more successful than many other countries? especially Russia and those in Eastern Europe? Is Vietnam's success in the past years sustainable over the long run? If not, what are the missing ingredients of a successful strategy for long-term growth? Vietnam has created a market economy, but is it efficient and dynamic? I will give a history of economic reform in Vietnam, and try to interpret it with respect to the above special questions, and especially from the perspective of long-term growth in Vietnam.

The Vietnam Economy: 1975-1986

Basically, we can divide the history of economic reform in Vietnam into two parts: socialist transformation from 1975 to 1986, and the reform embracing the market since 1987. The first part of socialist transformation is from 1975-1980. From 1976 to 1977, the government's effort to collectivize agriculture met with the boycott of farmers who destroyed fruit trees and sold off agricultural equipment. As a result, there was little agricultural growth in the Second Five-Year Plan from 1976 to 1980. Annual agricultural output growth (1.9 percent) was significantly lower than population growth (2.3 percent). Nationalization of industries and commerce was no more successful. At the latest as of 1977, there were still 15,000 private businesses operating in the Saigon area. Subsequently, in 1978, the government made a very severe crackdown on the so-called "bourgeois elements" in the south and within a very short period of time, more than thirty thousand private businesses closed their doors. The outcome of this was disastrous in terms of economic progress. There was very little industrial output growth over the Plan (0.6 percent per year).

Not only was output growth much lower than the target levels under the Plan, the problem was compounded by the failure of promised foreign assistance from Western countries and China to materialize after Vietnam's invasion of Cambodia in 1978. So by 1980, the economy was in a very bad condition. The positive side of this was to give strong support to the reformers in the private sector. In 1979, in the Sixth Plenum of the Fourth Party Congress, the decision was made to continue the socialist transformation, but to slow it down.

As a result, Vietnam introduced some market reforms to repair the economy. In agriculture, the government introduced the contract system similar to the one implemented in China, whereby households were given quotas in a cooperative. They were allowed to retain and trade the surplus agriculture output beyond their quota. The result was very strong economic expansion in agriculture. In the industrial sector, there was also market-oriented reform. They adopted the so- called "three-plan system."

Under Plan One, the enterprises were provided with the inputs at subsidized prices but were required to supply set quantities of goods to the state. Under Plan Two, the enterprises could produce beyond the amount specified in Plan One and buy additional inputs, and Plan Three allowed enterprises to engage in sideline activities. These reforms, even though partial, met with quite a bit of success. Industrial output expanded tremendously in the early 1980s. However, there were also problems. The strong response to these market-oriented reforms during this period made the macroeconomic imbalances in the economy unmanageable. Large deficits in the public sector and the state-owned enterprise led to rapid expansion in the money supply, and inflation surged. The inflation basically undermined the whole reform process because wages of the public were fixed and their real income was declining, which severely slashed the support for further reform progress. So by 1986, the system began to collapse and another crisis surfaced.

Thus, in 1986, when the Sixth Party Congress was preparing to meet, the Vietnamese authorities were facing two realities. The first one was that the all-out approach to socialist transformation of the economy did not work. In the early period there was no output growth at all but the population grew very rapidly. Real capita income fell from an already intolerably low level. The second one was that partial or gradual market-like reform was also seriously flawed. There was output response but the macroeconomic imbalance which led to inflation undermined the support of the reforms. So in December 1986, the leadership in Vietnam decided to change the course of the economy and transform it from a socialist to a market economy. The slogan for the economic reform program adopted was doi moi. It suggests not a full-scale conversion from socialism to capitalism, but rather a cautious acceptance of the market as a means for achieving economic growth and thereby preserving and strengthening the party's political and economic control. The goal was to transform the economy gradually into a socialist market economy through step-by-step procedures.

Economic Reform Since 1986

The reform in agriculture went beyond the contract system established earlier. They eliminated the quota system on household production. In 1988 they basically gave household land tenure and the right to transfer the tenure. They effectively privatized agriculture, which was the dominant sector of the economy at that time. In industry, there were only few reforms initially. Because of the "socialist orientation" of the market economy, there was no attempt to reform and privatize the state enterprises. However, private economic activity did blossom in the informal commercial sector. Stores and restaurants opened up almost as fast as they had been cracked down in 1978. Another important step was the elimination of the state monopoly of foreign trade in 1988, allowing the establishment of Foreign Trade Organizations (FTOs) and permitting some firms to engage directly in international trade outside the FTOs. They also opened up their economy to foreign direct investment.

There were strong economic responses to these market-oriented reforms, but again, as in the early 1980s, macroeconomic imbalance undermined the economy. From 1986 to 1989, inflation was extremely high; the inflation rate was 487 percent, 301 percent, and 394 percent in 1986, 1987 and 1988 respectively. The source of macroeconomic imbalance was deficits of the public sector which were financed by borrowing from the central bank and, until 1990, from the Soviet Union. The rapid expansion of credit resulted in sharp increases in prices. The higher the rate of inflation was, the more people shifted from dong, the local currency, into dollars and gold, which were circulating freely at the time. This triggered further instability of the economy. The inflation also undermined international competitiveness, with the dong significantly overvalued in real terms. The trade balance was increasingly in deficit (up to about 10 percent of GDP in 1989) and largely financed by credit from the Soviet Union. Vietnamese authorities were well aware of the fact that theis credit would no longer be forthcoming because the Soviet Union was collapsing. Thus, by 1989, three years after the beginning of the reform under the doi moi, the economy was facing severe crisis.

Under the pressure of an imminent crisis, the authorities boldly decided to accelerate the process of transition to a market economy with a combination of structural reforms and stabilization measures. The main structural reform, adopted in early 1989, included the elimination of price control and the system of state procurement. One cannot overstate the importance of these measures. The dual pricing system that had been in place destroyed both efficiency and stability. Firms were to sell at low prices and they then had to be financed by credit from the central bank. This led to the creation of money and, in turn, inflation.

The stabilization program Vietnam adopted in 1989 was pure IMF orthodoxy albeit without the IMF behind it. The two key components of the program were raising and liberalizing interest rates, and devaluing and unifying the exchange rate. As a result, inflation was almost brought to a halt by mid-1989. Credit continued to grow but there was a substantial portfolio shift to dong assets from dollars and from gold. These helped stabilize the economy significantly.

How did Vietnam manage to reduce the growth of credit? Credit was growing because of public sector deficits. To reduce these deficits, Vietnam had no option of raising taxes. The tax base in Vietnam was extremely weak; most of the government revenues came from taxing the state enterprises, and the price reform undermined the profitability of these enterprises. The only way that the Vietnam government could bring the budget deficit down was to cut government spending, and it did that in 1989 to 1991. In these two years, they reduced the deficits by a six full percentage points of GDP. They did it by cutting subsidies to state enterprises, reducing investment programs, constraining wage increases below inflation, and demobilizing one-half million soldiers. As a result, money growth was controlled, and inflation was cut down to the single-digit level.

Another important element in Vietnam's successful stabilization program was the growth of exports. Vietnam was critically dependent on some key imported inputs like steel and fertilizer, which came mainly from the Soviet Union. Without foreign exchange, it was difficult to import inputs. The success of Vietnam to continue to import inputs was achieved through a combination of good policies and good luck. The good policies were the liberalization of trade and devaluation of the currency to stimulate export growth. The liberalization in agriculture met with tremendous responses, and within one year, transformed Vietnam from a rice importer to one of the largest rice exporters in the world. Rice output increased by about 25 percent in just one year, which had a strong impact on exports to convertible currency areas. Good luck came as oil became the most rapidly growing export in 1992, which contributed substantially to Vietnam's export growth. Nevertheless, manufactures still played a very small role in exports, accounting for just 13 percent of total export in 1992.

Gradualism or Big Bang?

It is often suggested that the success of Vietnam, like that of China, is evidence of the superiority of the gradual approach in the transition to a market economy over the big bang approach adopted by Eastern Europe and Russia. However, the reforms in Vietnam can be described as anything but gradual. They privatized the dominant sector of the economy--agriculture--in only a year or two. They brought inflation down from triple- to single-digit in just a few years. Vietnam's reforms were even more dramatic than many of those undertaken in Eastern Europe, and the stabilization policy was much more like shock therapy than any other reforms that had been adopted in the world. The difference was that Vietnam did not suffer from an implosion like that in Eastern Europe. The reason Vietnam's reforms were seen as gradual rather than big bang is that people have mistaken the outcome of the reforms with the reforms themselves. Vietnam implemented its reforms more rapidly and dramatically than Eastern Europe or Russia, but the outcomes were quite different.

Why were the outcomes so different? The main reason may lie in the fundamental structural differences of the economies of Vietnam and the Eastern European countries. In Vietnam, like China, the dominant sector was agriculture. The agricultural sector was in a much stronger position to respond to market-oriented reforms than the industrial sector. In fact, the industrial sector in Vietnam suffered very much the same outcomes as in Eastern Europe. In Vietnam, the state enterprises sacked about one-third of their work force. A total of 800,000 people were released from the state enterprises in one to two years after the 1989 reform. Besides, the number of state-owned enterprises fell from 12,000 to 7,000. If the industrial sector in Vietnam had occupied a position comparable to that in Eastern Europe, the bang could have been just as big. So the evidence is that Vietnam does not demonstrate the superiority of the gradual approach to economic reform. On the contrary, it demonstrates exactly the opposite because the attempts to go step-by-step and move gradually, first towards socialist transformation and then towards a market economy, failed. It was only when Vietnam decided to go all-out and full-scale towards a market economy with a sound stabilization program that they succeeded.

In the past, economic reform in Vietnam was motivated not by any desire to go towards market, but was mainly a reaction to imminent crisis. Since 1992, the economy grew rapidly and inflation was low. Consequently, the pressure for reform has much disappeared and the pace of reform has also been much slower. Still, reform is going on in a number of sectors. There has been some reform in the financial sector. The number of banks has been increased to 60. Nevertheless, 90 percent of the credit is issued by the four large state-owned banks, and there are still many regulations and controls on banks. State-owned enterprises have also been reformed. The authorities tried to correct some regulations and remove some bureaucratic control, but sometimes they still move in the wrong direction, as the government is too eager to help large corporate groups to achieve efficiency and international competitiveness. There are also reforms in the legal system. However, in Vietnam, there are too many laws applying to separate things. It is difficult to honor the principle of equal treatment under the law and to take care of all kinds of imbalances in the legal system. It is also difficult to avoid discrimination against private enterprises. In the trade sector, despite the various reforms, there is still a lot of bureaucratic discretion and many restrictions on trade such as license and permit requirements. There have also been changes in foreign investment policy, generally towards trade liberalization. But still, one has to seek approval for foreign direct investment according to government criteria. Vietnam is still moving towards a market economy, but the government demonstrates that it also wants control. It is not ready to accept the free-wheeling of the market economy.

Interpreting the Transition Experience

What unfolded under doi moi certainly exceeded what the reformers imagined when they launched this program. Success in Vietnam has been really tremendous. Nevertheless, we have to bear in mind that Vietnam is a poor country and it will remain poor for a very long time. The per capita income of Vietnam that the World Bank estimates is about US$250; in purchasing power parity terms, it might be US$750 to US$800, which still makes Vietnam one of the world's poorest countries. A recent World Bank household survey finds that more than half of the 14 million households in Vietnam are below the poverty line. Moreover, even if Vietnam continues to grow at the current rate of 8 or 9 percent annually, it will still take 25 years to achieve the level of per capita income like that of Thailand today, and 50 years to match the present level of Taiwan. What Vietnam needs is to grow rapidly for a long time, just to catch up and make up for decades of economic loss during the wars. For Vietnam to be really a success, they need a long-term strategy for steady growth, and the appropriate strategy is right there in Asia.

Conditions in Vietnam today--a highly dense population and the lack of natural resources--are not much different from those in Taiwan 35 years ago, and not different from that in China. If Vietnam is looking for a long-term strategy for growth, it has to look at its neighbours. Given a highly dense population, to raise its per capita income, Vietnam has to industrialize. And in order to industrialize efficiently, it has to follow its comparative advantage, which means labor-intensive manufacturing. This in turn implies a strong export orientation.

The export-oriented industrialization strategy has brought success to Taiwan and South Korea, not to mention Hong Kong, and subsequently China, Thailand, and other South East Asian economies. It may also help Vietnam. Then has Vietnam taken the steps necessary to implement this growth strategy? One thing that is required is macroeconomic stability. All these successful economies in East Asia demonstrate macroeconomic stability. Vietnam has achieved great success in macroeconomic stability. In fact, macroeconomic stability is only as secure as the latest government budget. Keeping the budget deficit at a low level is important but not easy, and yet the government of Vietnam is dedicated to make it. This in turn helps maintain a relatively low inflation. The other thing that is required is relatively high saving and investment rates. All the countries that are successful in South East Asia have high saving and investment rates. Vietnam has also seen its investment rate rise substantially, doubling from 1990 to 1995, but they still have a long way to go as public dissaving is always a problem. Another thing that is necessary is an open trade regime, but not a free trade regime. Taiwan did not have a free trade regime until recent years. This can help give exporters free access to inputs and outputs. Vietnam has made great strides in opening up the economy, although bureaucratic control is still a problem. In short, Vietnam is moving in the right direction and is poised for industrialization.

Missing Ingredients

A key factor for successful long-term growth is that there are people taking advantage of favorable economic conditions. In Hong Kong, Taiwan, Korea, there are private enterprises, and in China, town and village enterprises, accounting for the dynamics of industrialization. Does Vietnam have sufficient numbers of entrepreneurs to make the export-oriented industrialization work? One would be impressed by the entrepreneurial spirit in Vietnam. On the streets of Ho Chi Minh City, one can "smell economics," and if it is different in Ha Noi, it is only in a matter of degree. So it seems that strong entrepreneurship does exist in Vietnam. Unfortunately, there are not many official statistics to confirm this impression.

Along with the reforms, the private sector in Vietnam became more important. From 1990 to 1992, there was a decline in the state enterprise sector and a rise in the private sector, mainly household firms. Basically, state cooperatives became household firms with an average size of two employees. The number of household firms increased significantly, and the growth of private sector activity was, until 1992, almost entirely among private household firms. The role of private corporations with firm size above 40 employees has been small. In 1992, there were only 1,114 private corporate firms compared with 959 in 1990, and they accounted for only 2 percent of industrial employment and 4 percent of industrial output. This sector is growing rapidly but is still insignificant in the economy.

Is the private corporate sector a missing ingredient of the export-oriented industrialization strategy? For this, we can look to the experience of the countries that have succeeded with the strategy, for an answer. Taiwan would be an ideal comparator because it shares many similar characteristics with Vietnam, in terms of population density and the lack of natural resources. Even though Taiwan was not a normal socialist economy, its manufacturing sector was highly socialist. In fact, in the 1960s, state-owned enterprises in manufacturing in Taiwan accounted for over 50 percent of manufacture output, and were much more important than state-owned enterprises in Vietnam. From the 1960s onward, those state-owned enterprises in Taiwan did not diminish but instead continued to grow. Taiwan never succeeded in privatizing its manufacturing enterprises, but the share of manufacturing output produced by state-owned enterprises fell from 56 percent in 1952 to only 10 percent in 1993. The private sector became more dominant, accounting for over 90 percent of the incremental increase in real value-added in manufacturing between 1960 and 1993. This driving force of manufacturing growth is the fuel of economic growth in Taiwan. Like Vietnam, the private sector in Taiwan has two parts: the family enterprises and corporate enterprises. The family enterprises are the most numerous, but they accounted for only 5 percent of the manufacturing output in 1986. The private corporate enterprises accounted for 85 percent, with the state-owned enterprises accounting for the remaining 10 percent. On the other hand, the output-capital ratio, which is a rough indicator of the rate of return, is about three times higher in the private corporate sector than in the state-owned enterprises, and is two times higher than in family firms. These cues indicate that for an export-oriented industrialization strategy to work, you have to have a kind of dynamic private corporate sector with small to medium-sized enterprises which are large enough to be efficient and small enough to be flexible to be able to compete in the world economy. Taiwan did not favor the private corporate sector. If any favor has been given, that would be to the state-owned enterprises. But Taiwan is wise enough to allow the development of private corporations.

Thus, the missing ingredient in Vietnam is the lack of a private corporate sector. The problem is not that the government is not promoting the private sector but that it prevents small private enterprises from evolving. The government prefers to deal with large corporations and large investors so that they can keep better control. It would be very difficult to control with many small to medium-sized private enterprises forming a complicated network of industries like that in Hong Kong and Taiwan. This is the most serious problem in Vietnam on its road to success.

Conclusion

To conclude, from the experience in Vietnam, two points can be made. Firstly, contrary to popular opinion, Vietnam is not demonstrating the superiority of the gradual approach. It was only when Vietnam undertook full-scale market reform that they could really achieve success. Secondly, we cast doubt on the degree of Vietnam's success. It is not to diminish the tremendous gains that have been achieved. Vietnam is one of the great turnarounds in economic history. Nevertheless, for Vietnam to be a real success, it has to grow rapidly for decades to make up for lost time and to complete the journey to a high-income and dynamic economy. Therefore, they need a strategy for longterm growth. The strategy is very obvious. It may not be as successful in Vietnam as in other countries because the infrastructure is relatively poor and the internal environment is less favorable. Nonetheless, there is no alternative. Whether the strategy, if adopted in Vietnam, will be less successful than in Taiwan in the 1960s and 1970s or not, it is still the only way for Vietnam to go. For that strategy to work, it seems that the government has to accept the free-wheeling of a private economy. At the moment, the government is focusing far too much on the reform and privatization of the state-owned corporations, which is a highly political issue. These are all important but much less important than to create an environment for firms to grow in the private sector, because these small to medium-sized enterprises are going to determine what kind of market economy Vietnam has. Vietnam is a market economy but having a market economy is not enough. Most of the worst-performing economies in the world are market economies. What Vietnam needs is not only a market economy but a well-functioning one. It needs a dynamic and prosperous market economy like those surrounding Vietnam in Southeast Asia.

Professor James Riedel has been a professor of international economics at the Johns Hopkins University since 1976 and serves as a consultant to the World Bank and the Asian Development Bank. He has been a keen observer of Asian-Pacific trade and development issues in general and of Hong Kong in particular. His earliest publication was The Industrialization of Hong Kong, 1974. He is also an academic advisor of the Hong Kong Centre for Economic Research.

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