Not a Doi Moi Contagion

One of the sweetest investment ideas of recent years has suddenly turned sour. Vietnam's Ho Chi Minh stock market has plunged nearly 60% this year, falling every single day in May (you read that right; its market declined 25 consecutive days). Selling pressure got so intense, officials were forced to close the market for several days. This is a far cry from the recent past, when it seemed we couldn't go a week without talk of Vietnam as the wave of the future—"the new China." Now, we're hearing proclamations of a new contagion, à la 1998's Asian Contagion. Which one is it?

To be sure, Vietnam's economic ascendancy has been impressive. One of the last bastions of communism embraced free-market principles in its "doi moi" (renovation) program, first introduced in the mid-1980s. Though the government maintains a significant economic role, it's sold many state-owned assets to the private sector, opened the economy to foreign investment, and even inked a free trade agreement with the US in 2000.

The country's newfound belief in free markets had predictable results. Next to China, Vietnam was the world's fastest growing economy in the last half-decade. This success culminated with its admission into the World Trade Organization in 2007. Market performance was equally impressive—stocks jumped an annualized average of 54% from 2004 to 2007.

Yet the same policies that sowed the seeds of success bred its decline. Due to the government's ultra-loose monetary policy, the economy began to overheat. Loose money also fueled rapid inflation, which hit a 16-year high in May at 25% year-over-year. Markets freaked out accordingly.

The bad news kept coming. Moody's cut the country's economic outlook to negative, citing "policy shortcomings in addressing inflationary and balance-of-payments pressures." The government revised down its 2008 growth target, from 9% to 7%. The central bank began tightening the screws—nearly doubling interest rates to 15%. Then there was a run on the country's currency, the dong, which plummeted as much as 40% in the derivatives market. (the dong is managed and only tradable onshore; a large offshore derivatives market has developed where investors bet on the currency's direction.)

Some of this might sound familiar to you—an Asian Contagion redux: a booming economy, rising asset prices and inflation, rapidly increasing interest rates, a run on a currency. The larger worry, of course, is Vietnam's "implosion" will seep throughout the region much like Thailand did a decade ago. True to form, the media's latched on to stories of "runaway" inflation and rising interest rates as proof of the second coming. However, despite the furor, this is not a repeat of a decade ago.

To be sure, price levels are elevated—most countries are posting their largest increases since the Asian Financial Crisis. But that's largely attributable to strong growth and rising food and energy prices. In China, for example, food prices account for over three quarters of the rise in headline inflation in the past year. This stands in stark contrast to the 1980s and 1990s—periods dominated by several emerging markets crises—when inflation was truly broad-based.

There is also evidence that pressures from rising food prices may be easing. Many agriculture commodities have turned down from recent highs, and emerging market governments have begun reversing the protectionist measures put in place to offset feared inflation. Vietnam, for example, repealed export tariffs meant to keep local food prices within its peoples' reach. Cambodia recently followed suit, and India announced it would remove similar measures later this year.

Governments are taking a similar approach to higher energy prices. In the past month, Thailand, Indonesia, Malaysia, India, and China have all reduced their subsidies on fuel. While possibly exacerbating headline inflation figures near-term, the reductions will benefit economic health in the long run. Not only do subsidies keep demand artificially high, they also wreck government finances.

And that's one positive consequence of higher food and energy prices. Unlike ten years ago, today's policymakers are swallowing tough medicine and suffering the (lesser) consequences now. They do not, under any circumstances, want the IMF knocking on their door again—the psychological scars are still too fresh.

In addition, almost every major episode of "runaway" inflation in emerging markets has been precipitated by financial vulnerabilities or fiscal crisis. Neither can be found across emerging markets today. Fiscal positions have significantly improved in the past decade. Where unmanageable deficits were the norm throughout the mid-1990s, most countries have moved solidly into surplus. (Note: Though history has shown deficits don't matter for the developed world, they can lead to a loss of faith in emerging market currencies and potentially a harmful capital exodus). This puts governments in a much stronger position to fend off crises. And their financial system, while still a work in progress, has also strengthened considerably. The level of non-performing loans has plummeted and continued strong economic growth suggests the situation will only improve.

Of course, high inflation isn't a good thing, and emerging market economies aren't immune to crisis. By their nature, they're more volatile and unpredictable than their developed market peers. But before we write off an entire region at the first sign of trouble, consider today's strong fundamentals and the lessons of history. This is not the next Asian Contagion.