HANOI - Vietnam 's economy is dangerously overheated, as one of the region's biggest market reform success stories threatens to become one its biggest busts.

Inflation jumped 25.2% month-on-month in May, the stock market is down about 63% over the same period last year, and many fear a looming property bubble could soon burst with disastrous consequences for local banks. Meanwhile, a growing trade deficit threatens to morph into a full-blown balance of payments crisis - there is already downward pressure on the dong.

Investment bank Morgan Stanley recently warned that loose bank lending has created a banking crisis. International ratings agency Fitch in May lowered its outlook for Vietnam's sovereign debt to "negative" from "stable", stating that the country's response to rising inflation "has been too slow and too small". It reiterated those warnings on Friday.

The State Bank has in recent weeks put a brake on money supply growth, making it difficult for firms to exchange foreign currency, including swapping US dollars for the local unit, the dong. It has also applied stricter rules for lending, increased compulsory bank reserves, expanded bond issues to absorb local currency and hiked interest rates.

The state of the real estate market is of particular concern, particularly for the possible knock on impact it could have on the banking sector. In the lead-up to its accession to the World Trade Organization, the government introduced a raft of legal reforms to stimulate the sector, including measures to encourage foreign interests to join with local companies. Those reforms included a new Land Law, Housing Law and Law on Real Estate Business, which together created a clearer legal framework for local and foreign companies.

During the ensuing local boom, many Vietnamese invested or borrowed speculatively to invest in the property market, which at the time offered considerably higher returns than interest earning bank deposits. Over the 12 months to March 31, Ho Chi Minh City's office market prices were up 94% year on year. Property investments have since declined, with prices for recent property transactions down as much as 20%-30% on last year's prices, according to VietNamNet Bridge, a leading Vietnamese news website.

Apartment prices in Ho Chi Minh City, the country's commercial hub, have fallen especially sharply this year and many recent buyers are now finding it difficult to maintain repayments to the banks. Nguyen Trung Vu, director of a local real estate firm, said that "land for construction projects has seen prices decrease by 20%-30% since the beginning of the year. The prices once hit 30 million to 32 million dong [US$1,852 - $1,975] per square meter, but now are selling at 20 million dong."

To escape rising wages and land costs in China, many global manufacturers were in the process of setting up shop in lower-cost neighboring Vietnam. Property developers from South Korea and Taiwan had begun work on huge developments in both Hanoi and Ho Chi Minh City, but have recently scaled back those plans. Office and apartment leasing fees in some low-range buildings have decreased compared with the end of 2007. The demand for high-grade offices has also been decreasing as foreign companies tighten their belts and lease in less-expensive buildings.

Foreign investor's confidence in the government's economic management waned earlier this year, when the sudden decision to postpone the third annual Vietnam Investment Forum scheduled for mid-March was announced. The organizer sent an e-mail to delegates stating that "owing to a combination of pressing macro- and micro-economic concerns, the Government of Vietnam has requested that Euromoney postpones this year's Vietnam Investment Forum". To many, that abrupt and unexpected move signaled that there were unforeseen economic problems on the horizon.

The postponement followed on last year's unsuccessful call by state-owned Vietcombank for strategic investors, which saw international financial players such as Goldman Sachs, GE Money, Mizuho and Nomura queue up for the chance to buy into one of the largest commercial banks in one of Asia's then fastest-growing economies. After looking at the bank and the rules governing Vietnam's privatization process, all the potential suitors walked away from the potential. Foreign investors likewise walked away from an invitation to take a strategic stake in the country's largest insurer after conducting independent due diligence.

The Vietnamese authorities apparently still hope that foreigners will come to the country's economic rescue, judging by new legislation passed by the National Assembly that allows six categories of foreign investors to buy apartments. Brett Ashton of Savills Vietnam said, "It is a move in the right direction and limiting foreign speculation is a good thing for Vietnam and Vietnamese buyers. The law should ensure that if foreigners sell their units, it is easy for Vietnamese buyers to pay the foreigner either in Vietnam or in the seller's country of residence."

Observers attribute the gathering meltdown to a lack of regulation and the government's overemphasis on maximizing short-term profits over ensuring medium-term macroeconomic stability. Tran Tien Cuong, director of enterprise reform at Vietnam's Central Institute for Economic Management, contends now that the government needs to rethink the reform process to re-attract global investors. "A better balance is needed between maximizing the value of the sale and finding sound partners who will generate long-term benefits through their investment."

In the interim, the government has imposed new restrictions to stave off potential collapse. With banks now under strict instructions to preserve their dong holdings, there are widespread reports of foreign-invested firms facing dong shortages at local banks. At a recent meeting of the Vietnam Business Forum, which meets twice a year and provides a formal channel of communication between the private sector and government, the problems of high inflation and a mounting trade deficit were openly discussed.

Michael Pease, chairman of the American Chamber of Commerce and General Director of Ford Vietnam echoed that assessment, saying "Vietnam's success in attracting foreign investment has largely been built on the expectation of economic and political stability". He appealed to the authorities to take "urgent and decisive action to curb a speculative real estate bubble that not only threatens the financial sector, but is also undermining Vietnam's long-term competitiveness".

At this juncture, all involved need to take responsibility to put in place the corrective actions required. Prime Minister Nguyen Tan Dung recently told the National Assembly that ineffective investment had led to poor competitiveness for products and in the overall economy. He said, "We cannot reduce inflation immediately in order to avoid other negative impacts on the national economy." While tightening monetary policy, he promised to practice more thrift in public expenditure and greater budgets for social welfare.

The Ministry of Finance is now also reconsidering the level of maximum foreign ownership, which is currently stuck at 49% in locally listed companies. As the stock market falls and domestic punters look to sell, the proposed reform would allow foreigners to buy more shares. That would mark a significant departure from the authorities' past emphasis on guarding against the potential destabilizing impact of foreign, rather than local, investor flight.

Some outside experts have asserted that the country has too many small commercial banks and that the government should support more mergers and acquisitions in the sector. State Bank deputy governor Nguyen Dong Tien has provisionally agreed that more M&A activity could help restore banking system stability and has launched new research on the ideal number of banks for the economy.

A wholesale restructuring at this delicate juncture could have mixed results, signaling both an official lack of confidence in the banking sector's stability while also demonstrating a medium-term commitment to needed structural reforms. Jonathan Pincus, senior economist of the United Nations Development Program in Hanoi, said "Vietnam has to recognize that there are global problems, but there are also problems that are very specific to Vietnam and need to be solved in Vietnam ."

In the meantime, as the stock market, property and investment climate decline, Vietnam's once-successful market reform experience is now at risk of coming completely undone. The moves made by Vietnam's until now untested technocrats will in the coming weeks and months ahead potentially make or break that effort.

Karl D John has a 15 year association with V V G, is chief executive officer of TCK Group (www.tckgroup.org), and a Vietnam-based investment consulting group. He lives in Hanoi.

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