RISK MITIGATION IN PROJECT FINANCING IN VIETNAM: FROM LENDERS’ PERSPECTIVES IN THE PRIVATE SECTOR

The term project financing is used to refer to a wide range of financing structures which have one feature in common: the financing is not primarily dependent on credit support of the sponsors or the value of the physical assets involved (Clifford Chance 1991).

RISK MITIGATION IN PROJECT FINANCING IN VIETNAM:

FROM LENDERS’ PERSPECTIVES IN THE PRIVATE SECTOR

by

Duong Nhu Hung

A research study submitted in partial fulfillment of the requirements for the degree of

Master of Business Administration

Examination Committee : Prof J.P Gupta (Chairman)

Dr D.B Khang

Dr S Venkatesh

Previous Degree(s) : Master of Electrical Engineering

Technical University of Budapest Hungary

Scholarship Donor : The Government of Switzerland

Asian Institute of Technology School of Management Bangkok, Thailand April 1999

During the process of this research study, many persons and institutions whose involvementmade this research possible I would like to extend my appreciation and gratitude to all ofthem

I am very grateful to Prof J P Gupta for his guidance, help and encouragement in assistingthis research It was he who introduced me to the field of Project Financing and I am veryproud to have worked with him

I am also grateful to Dr Do Ba Khang and Dr S Venkatesh, for having served as thecommittee members They provided me with valuable suggestions to enhance the quality ofthis research

Outstanding acknowledgements are due to the government of Switzerland for providing thescholarship that enabled me to achieve the degree of MBA at the School of Management Ialso wish to acknowledge the Industrial School of Management for providing support during

The applications of project financing are increasingly wide spreading, particularly ininvestments that require risk sharing Risk mitigation is one of the most important elements inproject financing, but is not well addressed in literature in Vietnam This research attempts tohelp lenders to mitigate risks in project financing in Vietnam

By conducting interviews with bankers, project managers, government authorities and legalexperts, we analyze various aspects of risk mitigation at three levels: country, institution andproject levels The analysis is focused on the applications and limitations of risk mitigatingtechniques particularly at the project level An in-depth risk analysis is carried out in a real lifeproject

Our research suggests lenders to examine every risk separately and use overlappedprotections The predictability of the cash flow and the track records of the sponsors are themost important criteria in project financing Joining syndication with multilateral organizationssuch as IFC is a wise way to mitigate risk Joint Venture between an experienced foreigncompany and an influential state owned company is the most recommended form of business

in project financing in Vietnam

5.3 Private Businesses 225.4 Foreign Direct Invested (FDI) Companies 22

7.4 Major Difficulties for Lenders in the CSM Project 467.5 Comments on Project Financing in the case of CSM 49

List of Tables

No.

4-3 Summary of Opportunities and Threats of the Country Environment 20

5-2 Summary of Strength and Weakness of Key Partners in Vietnam 27

7-2 Summary of Risk mitigation arrangement in CSM project 50

List of Figures

No.

2-1 Traditional method of financing a project vs project financing 42-2 An IFC co-financing structure (Clifford Chance, 1991) 72-3 Project risk phases (IFC, 1996) 9

A6-1 Detailed Summary of Financing Structure of CSM Project 64

Since the opening policy, Vietnam has gradually integrated into the world economy With themarket of population of 70 millions, the incentives of government and the location in one ofthe most dynamic region, Vietnam has attracted both private and foreign investment.According to the estimation of government, the financing of the planned investments fordevelopment over the five years up to the year 2000 are to be in the order of US$41.4 billion.The Government hopes to mobilize slightly more than half of the total needed resources(US$20.9 billion) from domestic savings and the remainder (US$20.5 billion) from foreignsources, including US$13 billion of foreign direct investment (FDI) and US$7.5 billion ofofficial development assistance (ODA) (WB, 1999) Clearly, the demand for foreign capital inVietnam is enormous in coming years On the other hand, the Country environment ofVietnam is still considered as high risk (EIU, 1998) The lack of both capital and assets (usedfor mortgage) make the traditional method of financing based on the security or enforcingobligations might not appropriate in many circumstances, especially in large project with longrepayment time The promising opportunities plus the needs for risk sharing necessitateproject financing in Vietnam.

The government of Vietnam has opened door in many areas to all sectors including localprivate and foreign investment The limited capacity of government budget, the need forrunning economy efficiently and the open door policy of government have increased the role

of private investment in the economy of Vietnam

In project financing, sponsors usually contribute only a small portion of the capital Thelenders usually have to provide about 50%-70% of the total investment cost (Clifford Chance,1991) with limited recourse to the borrowers (sponsors) Meanwhile, they rarely involvedirectly in management of the project As a result, lenders are exposed to a lot of risks

The needs for project financing, the increasing private investment and the risk exposure ofthe lenders necessitate researches in risk mitigation in project financing in Vietnam,particularly in private sector On the other hand, not much literature is available in theseissues Thus, more researches in this field should be done

1.2 Statement of Problem

This research attempts to solve the problem “How to mitigate risks in project financing inVietnam, particularly in private sector?"

1.3 Objectives

 To analyze the country environment of Vietnam

 To analyze the key partners in project financing in the context of Vietnam with focus onprivate sector

 To analyze the financing structure, risk mitigating techniques and important issues for thelenders through an in-depth study of a typical case in project financing in Vietnam

 To make recommendations about risk mitigation for the lenders in project financing inVietnam

1.4 Scope

The research is written from the lenders’ perspectives with focus on risk mitigation in projectfinancing in private sector

1.5 Organization of the Research

The first chapter is the introduction including rationale, problems, objectives, scope and theorganization of the study

The second chapter is literature review, which provide back ground and terminology neededfor the analysis

The third chapter is methodology that creates the foundation for the analysis

The fourth chapter is the country environment analysis including the analysis of politicalenvironment, macroeconomic environment, and infrastructure and market opportunities.The fifth chapter is the analysis of key partners in project financing in Vietnam includinggovernment, state owned enterprises, local private companies, FDI companies, domesticbanks and IFC

The sixth chapter is the description of CSM project including the project profile, the financingstructure, and special agreements

The seventh chapter is the analysis of the CSM project including risk identification, riskmitigation to protect cash flow, the loan security package and some major difficulties in CSMproject

The eighth chapter is conclusions and recommendations including the limitation of theresearch, the summary of the main findings, the recommendations for the lenders andsuggestion for further study

Figure 1-1: Organization chart of the research

Description of CSM Case

Analysis of CSM Case

Conclusions and Recommendations Introduction

 and/or a mortgage on the assets of project entity.

The project financing differs from the traditional method of raising funds for projects In thetraditional method, the lenders look to the overall credit worthiness of the borrower and all ofthe borrower’s assets as security for their loan and not the assets and revenues from a singleproject In a project financing, lenders would not have direct recourse to the sponsors’ assets

or revenue but would rely on the economics of the project, project assets, and the revenuestream generated by the project (Figure 2-1)

The basic principle underlying project financing is to shift the burden of direct debt liabilitiesfrom the sponsors of a project to the project itself

Figure 2-2: Traditional method of financing a project vs project financing

(Source: Niehuss, 1999x)

Note: Loans are made directly to Note: Loans are made to the special

project sponsors but not to the project entity and not tto the

2.1.2 Reasons of project finance

Lenders and sponsors have different reasons to do project financing For the sponsor, projectfinancing is often more expensive than traditional financing, but it has certain advantages:

 Risk sharing Where debt is wholly or partially non-recourse to the borrowers andsponsors, all or some of the risks will be borne by the lenders if project fails to producesufficient cash flow This is important where the borrower is smaller to the size of theproject

 Political risks A business investing large sums overseas might wish to ensure that certainpolitical risks are borne by the lenders

 Ownership flexibility Large projects have very long lead times A properly structuredproject financing can give a sponsor the flexibility to increase or decrease its share of aproject during the planning and construction period

Lenders often find project financing more risky, but they have some reasons to do projectfinancing:

 High return for long periods

 Increase the visibility in the host country

 Support their key clients in overseas business ventures

2.2 Parties Involved in Project Financing

2.2.1 Project sponsors

The sponsors contribute equity in the project Frequently, the sponsors or third partyinterested in the success of the project are also required to provide back up credit support toensure that debt will be serviced by some credit worthy party if the cash flow from the projectrevenues is inadequate or interrupted

2.2.2 The project company

The Project Company is an entity that will operate the project Its identity, domicile and legalform will be determined by a range of factors For instance, legal framework of host countrymight prescribe the structures for foreign investment; there might be requirement for localparticipation

2.2.3 The borrower

The borrowing entity might or might not be the same as the Project Company There could beseveral borrowers, each raising funds separately to cover its individual participation in theventure

2.2.4 The banks

The sheer scale of many projects dictates that the financing will be syndicated A syndication

of banks might be chosen from as wide a range of countries as possible to discourage thehost government from taking action to expropriate or otherwise interfere with the project andthus jeopardize its economic relations with those countries Syndication might well includesome banks from host countries, particularly if there are restrictions on foreign banks takingsecurity over project assets The total finance package might involve different tiers of lending:some secured, some unsecured; some short term and trade related, some long term; part offinance might be subordinated to the right of other lenders

Commercial banks might also act as guarantors For example, where concessional ratefinancing is available from multilateral organizations or where export credit finance isinvolved, some or all of the commercial banks might agree to issue guaranteed or to openletter of credit in favor of the concessional rate lenders The benefits to the sponsors ofobtaining the concessional finance on a limited recourse basis could well outweigh the cost ofpaying guarantee fees and commissions

From the perspective of the commercial banks, this arrangement has the advantage that they

do not have to share the project security with the export credit lenders nor suffer theirinterference in accelerating the finance or enforcing security This might justify the additionalrisk taken on under the guarantees, particularly if the concessional lenders would haverequired a first priority interest in the security proceeds in any event

2.2.5 Other actors

The arranger The bank, which has arranged the financing, and syndication of lending willnormally take the lead role in negotiating the terms sheet and the credit and the securitydocumentation

The managers Managers and lead managers might be named in the documentation and inany publicity surrounding the launch of the project They will not normally assume anyparticular responsibilities to the borrower or to the other lenders

The agent The agent bank will be responsible for coordinating draw-downs and dealing withcommunication between the parties to the finance documentation, serving notices anddisseminating information, but they will not responsible for the credit decisions of the lenders

in entering into the transaction

Financial adviser The adviser will be familiar with the country where the project is locatedand can advise on structures and local conditions as well as having the expertise andcontacts to sell the project to the lending banks

Technical experts selected by the project sponsors or by the financial adviser, they might beretained to prepare the feasibility for the project

2.3 Project Financing Structures

Every project finance has its own special features Accordingly, there are many kinds offinancing structures Since most of the project financing in private sector in Vietnam involvesthe participation IFC, we will exam only the financing structures IFC

IFC often lends to the private sector and seeks no state support Its rate is notconcessionaire: indeed margins might be high The high margins and the political risk comfortassociated with IFC financing can attract commercial lenders into co-financing projects thatotherwise might not get off the ground.

A simplified example of an IFC co-financing is demonstrated as follows:

Off-take agreement

Off-take assigned to Investment agreement

security trustee for

A loan and B loan A loan $30m B loan $90m

IFCDeposit agreementBank1 Bank2 Bank3

Figure 2-2: An IFC co-financing structure

(Source: Clifford Chance, 1991)

 Multinational Company establishes a Joint Venture (PCo) with a local company toproduce cement in a developing country PCo obtains the government license, enter intoproject agreements and an off-take agreement with the multinational company

 IFC enters into “investment agreement” with PCo, for USD90 m and makes separate

“deposit agreement” with commercial banks for USD60m of the total loan

 The structure involves no direct contractual relationship between the banks and theborrower Under the documentation, IFC retains control of covenant performance,acceleration and payment; there is no formal agency structure as there would be in aconventional syndicated loan agreement

2.4 Risks Involved in Project Financing

2.4.1 Types of risks

Several major groups of risks include

1 Project construction and completion risk, if the project cannot be finished in time, cost

overruns, non-availability of land etc

2 Operational risk The main operational risk is that assets do not operate efficiently This

risk includes

 Project performance risk if there are shortfalls in expected capacity, output orefficiency For instance: poor management, high cost of service or change inownership.

 Technology risk if the project uses new but untested technology, or obsoletetechnology

 Fuel, materials risk if the supply of materials, fuel is disrupted, or there arechanges in their cost

 Human resource risk if there is unavailability or shortage of qualified people, workforce, reliable contractors

 Transportation risk if the transportation means are not available, changes intransportation cost

3 Commercial risk if there are falling demand, oversupply (market size risk), competition of

the import goods, changes in price (price risk) or buyers refuse or delay the payment(payments risk)

4 Non-commercials risk if lenders have concerns about the stability and consistency of

government's economic and political policies that would affect the prospective investment.Non-commercial risk include country risk (political and legal risk such as expropriation risk,regulatory interference, protectionism, tariffs, and changes in local law) environmental risk(related to all expense when damaging environment) and financial risk (fluctuation inexchange rate, interest rate, inflation)

 Project start-up During this phase equipment is tested, raw material inputs are ordered,project staffing is completed, and marketing starts Loan exposure may rise slightlyduring this phase due to working capital requirements and final payments to contractorsand equipment suppliers Initial sales from project start-up enable loan payoff tocommence This phase usually lasts around six months

 Operation Risk exposure declines as the loan is repaid The length of this phase and therate at which exposure declines depends on the repayment terms of the loan agreement.The average term of IFC loans to infrastructure projects has been just under elevenyears, made up of an average grace period of three years and a repayment term of eightyears

Figure 2-3: Project risk phases

(Source: IFC, 1996)

2.5 Managing Project Risks

IFC is an expert in project financing This part is summarized from the experience of IFC(1996)

Efficient risk allocation and mitigation are central to bringing projects to financial closure and

to providing appropriate incentives during construction and operation Efficient risk allocationoccurs where risks are assumed by the party best able to manage them Projects may still befinanceable if some risks are not allocated according to this principle, but costs-and ultimatelytariffs-will be higher Sponsors and lenders expect higher rewards for assuming higher risks.Mobilizing debt is particularly sensitive to having adequate risk management mechanisms inplace With at-risk debt supplying over half of project costs, achieving financial closure can

be stalled if the risk management needs of lenders are not met

According to IFC (1996), critical areas for lenders include market risk, non-commercial risks,insurance arrangements, force majeure provisions, and sponsor and government supportarrangements

2.5.1 Construction and Completion Risk

Private lenders will not generally accept construction or completion risk Instead they look tostrong, experienced sponsors for support arrangements and contractors to whom the riskscan be laid off In addition, the Project Company is providing completion support

Sponsors deal with completion risk by:

 Using fixed-price, date-certain turnkey construction contracts containing provisions liquidated damages if the contractor fails to perform (and bonuses for better thanexpected performance)

tot- Taking out business start up and other commercial insurance

 Building contingency amount into the financing plan

 Building excess capacity to create headroom to meet contracted output levels in the event

Early operation

 Maintaining standby credit facilities.

If a member of the sponsor group is also a supplier to the project there may be a potentialconflict of interest This will be reduced if the project’s regulatory framework defines tariffsdirectly, rather than in relation to a rate of return on investment (in which case there might be

an incentive to increase investment costs) Lenders can also mitigate the risk by:

 Undertaking independent reviews of contracts between the project company and thesupplier to ensure that they are "arms-length" and broadly competitive

 Requiring the Project Company to sign fixed-price, date-certain construction contracts,with penalties for non-performance

 Requiring sponsors to retain their ownership of the Project Company through theoperational stage

2.5.2 Operational Risk

Concession agreements often link payments to required performance levels, such asminimum power plant availability, new telephone or water connections, toll road/bridgecapacity or fault repair times Lenders generally require project companies to coveroperational risk through agreements with equipment and input suppliers, maintenanceagreements, and business interruption insurance (such as for fuel supply agreements to apower generator) Where the technical skills needed to ensure efficient operation reside withthe lead sponsor, lenders may require a minimum ownership agreement

Operational risk may arise through delays or failure caused by other parties Where the partyresponsible for the connection is a government agency, the obligations of that agency andremedial actions in the event of failure to perform may be set out in the concessionagreement

Because some operational risk is unavoidable, lenders seek to protect their position throughloan covenants designed to ensure that the borrower manages the project in a financiallyresponsible manner

2.5.3 Market Risk

Market risk is affected by market structure and buyer creditworthiness Lenders use severalstrategies to reduce their exposure to market risk:

 Independent appraisals

 Limiting debt exposure by controlling the maximum debt-equity ratios

 Sponsor guarantees Lenders may request partial sponsor support to service the debt

until the project is certified as physically and financially complete (limited recourse

financing) or full sponsor guarantees (corporate financing)

 Escrow accounts These enable debt servicing to continue in the face of a temporary fall

in revenues A nine-month debt reserve account was established for the CSM; thisproved useful after the Dong devaluation reduced the foreign exchange equivalent of theplant's revenues A debt reserve accounts are usually offshore and denominated inforeign exchange

 Standby letters of credit Issued by the purchaser in favor of the project, these serve thesame purpose as a debt reserve account.

 Government guarantees of contractual performance Where payment risks is due to anon-creditworthy state-owned entity, sponsors and lenders may request (Governmentguarantee of the entity's payment obligations under contracts sinned with the project

 Government sometimes bundle an existing asset into concession to give lenders moreconfidence

2.5.4 Non-commercial risks

Many projects are heavily exposed to non-commercial and political risk at both the countryand project level While some risks such as expropriation or convertibility risk apply to manyprojects financed by foreign investors others such as payment risk or regulatory risk, aremore infrastructure-specific

Project sponsors or lenders cannot remove these risks entirely But several mechanismshave been used to mitigate them:

 Contractual provision Specifying "automatic" formulas in contracts or regulatory regimesfor adjusting tariffs in the face of inflation or devaluation (or defining tariffs in foreignexchange terms) may help to depoliticize tariff adjustments

 Focusing on lower risk projects Projects that generate foreign exchange revenues (forinstance, ports, airports, and international telecom) mitigate convertibility risk Projectsthat supply services for which there are demonstrable excess demand (for example,power plants where there are blackouts, early cellular projects) are likely to be lower risk.Projects that sell their services into "wholesale" markets (for example, power plants sell todistributors, ports to shippers) are less likely to be subject to political interference thanthose which supply retail customers

 Innovative structuring Several power projects are located on barges that can be towedaway if necessary

 Partnering with local investors (or the government) Developing a project in partnershipwith a local investor may reduce political risks for a foreign investor Some projectsponsors have taken this further, and deliberately sought to spread local ownership morewidely through partial public offerings

 Involving official financing institutions Different types of official financing Institutions offervarious types of security to project sponsors, as well as some costs, such as bureaucraticprocessing procedures Some institutions (including IFC) offer assurance by theirpresence as investors and lenders, their track record of good project performance, andnot having been included by host governments in debt rescheduling Agencies such asthe Overseas Private Investment Corporation (OPIC) or the Multilateral InvestmentGuarantee Agency (MIGA) provide political risk insurance for financiers The WorldBank's guarantee scheme, which involves a counter-guarantee from the host government,provides assurance to lenders on specific risks such as the contractual performance ofstate-owned enterprises

 Careful identification of majeure events (and procedures to be followed in their event) andcomprehensive insurance arrangements

2.5.5 Force Majeure

Force majeure provisions define the events that are beyond the control of either party, or theiroccurrence gives either party the right to suspend obligations under the contract Forcemajeure events usually fall under two groups:

 Domestic political events, such as war, riot, sabotage, radioactive contamination, generalstrikes, lapses of consent, and changes in laws that affect the project

 Non-political events or "acts of God," such as natural disasters, fire epidemics, or strikes.Sometimes a third category of political events occurring outside the country is alsoconsidered (for instance, strikes in a supplier country preventing delivery of equipment ontime)

 Market capacity constraints For some risks the cost of available capacity is escalating asthe size of projects increases Insurance capacity for risks such as earthquake, volcaniceruption, and typhoon depend on project location, it’s existing risk profile, andunderwriters' exposure in the country or region

 Change in insurance market For example, take-or-pay obligations are not being insured,and insurers have argued that principal repayments should be excluded from debt servicecover because they can be rescheduled

 Technology risks Where underwriters consider technology to be untested, no insurance

is provided during the crucial testing period The solution is for the manufacturer to becontractually bound to cover what would otherwise be uninsurable

 Local legal requirements Although most countries expressly prohibit the placing ofinsurance directly outside the country, arrangements whereby local insurers effectively

"front" internationally reinsured pro-rams are usually permitted, with the local insurerretaining a small percentage

 Costs Weighting lenders' requirements against sponsors' desire to contain costs is anongoing issue Delay in start-up insurance in particular attracts high premiums, andsponsors try to contain costs by keeping indemnity periods low and deductibles high

 Experience has shown that if insurance issues are discussed early with sponsors,coverage is usually more comprehensive Sponsors are encouraged to retain theservices of professional brokers or consultants, and lenders usually require certification ofthe adequacy of insurance arrangements by an independent insurance adviser

Figure 3-3: Model for Analyzing Project Financing

The Analytical Model is based on the following assumptions:

Financial capacity Experience Motivation Special advantage

Project Level

Project Analysis

Risk Analysis Cash flow protection Loan security package

Extent Analysis Sensitivity Analysis Effectiveness &

 Country (or industry) opportunities and threats can affect the project directly (arrow3) or indirectly through the key partners (arrow 1- 2)

 The strength and weakness of the key partners can directly affect the project(arrow2)

 Lenders follow the theory described in literature reviews They would primarilyfocus on the project risk analysis, cash flow protection, and loan security package.Based on the above assumptions, the lenders should focus on analyzing (i) the opportunitiesand threats of the country (or industry) (ii) the strength and weakness of the key partners, and(iii) the risk analysis, cash flow protection and loan security package of the project

In this research, we will stand in the position of foreign lenders who are considering lending toprivate sector in Vietnam The key partners include:

 Government, State owned enterprises (SOEs), the private companies and the ForeignDirect Invested (FDI) companies, because they can be the borrowers of the loan (thesponsor of the project)

 Domestic banks (include foreign banks’ branches), because they can play important role

in supporting local sponsors

 International Finance Corporation (IFC), if the lenders consider lending to non-state sectorbecause IFC is a major lender in project financing in non-state sector in Vietnam

In order to make consistent analysis, we need the measures for evaluating country, keypartners and project According to the pilot interviews, we create three groups of measures

1 Measures for country environment opportunities and threats include:

 some economic indicators such as GDP, foreign exchange rate, debt status of thecountry etc

 qualitative evaluations For instance, the event that the country has jointed aninternational organization can improves the outlook about the country

 analysis of government policy, and

 Country forecasts, because the lenders would be more concerned with the futurerather than with the past

2 Measures for the strength and the weakness of the partners include

 financial capacity For instance, how strong and credit worthy are the sponsors?

 Experience For instance, how experienced are the sponsors?

 motivation for the investment For instance, Is the sponsors profit-motivated, orgovernment target motivated?

 special advantages For instance, Do the sponsors receive favored treatment fromthe government such as concessional land-use right?

3 Measures for evaluating project include

 the extent analysis For instance, How large is the commercial risk? etc

 the sensitivity analysis For instance, How does the commercial risk affect thecash flow?

 the effectiveness and the limitations analysis For instance, how effective is theoff-take agreement in hedging against the market risk?

We can increase the measures in each group to make the analysis more accurate, but itwould also complicate the model We have to make the tradeoff between the accuracy andthe complication

We also have to analyze the linkage between the three levels For instance, how countryopportunities and threats affect the strength and weakness of the sponsors, and thereforeindirectly affect the project? How do country opportunities and threats directly affect project?How do the strength and weakness of the sponsors affect the project?

Since it is difficult to conduct a large-scale survey to collect detailed financial data ofcompanies, we will analyze only a typical case to understand the financing structures and riskmitigating techniques Therefore, the financing structure and risk mitigation of the chosencase must cover as much as possible the common features of project financing Afterscanning some large projects in Vietnam, we chose the CSM as the typical case for ouranalysis

3.2 Data

Data was obtained through the in-depth interviews with selected people such as investmentofficers of banks, Government authorities such as Ministry of Planning and Investment (MPI),experts in economics research Institute (ERI) and managers at some large projects,particularly the CSM project Data was also collected from the secondary sources:Government annual reports, Journal, book, and Internet

Both the Party and Government commit to continue the reform, especially in the field ofprivatization, improving data transparency and government administration However, theimplementation of reforms faced several problems First, it is the weakness of thebureaucracy The bureaucracy lacks a public service ethic, and is hampered by vestedinterests, which result in a lack of consistency in policy implementation within and betweendepartments There is also high level of corruption The collective decision making processoften acts as constraint on the speed with which decisions are made Taken together, suchproblems make it difficult for the government to steer the country rapidly in any singledirection.

In relationship with foreign countries, Vietnam has improved substantially its position.Vietnam’s relations with the US have gradually improved since the establishment ofdiplomatic relations in 1995 Although full economic normalization – represented by thesigning of a bilateral trade accord and the award of normal trade relations (NTR-formerlyknown as most favored nation trading status) has not established, the two US organizations,the Overseas Private Investment Corporation (OPIC) and export-import Bank (EXIM) areallowed to offer insurance and trade finance to US firms wishing to do business in Vietnam.Vietnam also has become a member of ASIAN, which strengthens its political position in theregion

Table 4-1: Important Economic indicators of Vietnam

1993 1994 1995 1996 1997 1998* 1999* 2000* 2001* 2002*GDP US Bn 12.8 15.5 20.3 23.3 24.7 24.6 25.7 28.5 30.5 32.1GDP growth % GDP 8.1 8.8 9.5 9.3 8.8 5.2 5 6.1 7.1 6.9Gross fix investment

%GDP

52.6 11.3 16.7 12.3 16.5 6.5 8.6 10.5 12 10

Gov revenue %GDP 22.3 24.7 23.9 23.6 21.8 19.8 18.8 18.9 19 19.1Gov expenditure

%GDP

27.1 26.5 25.2 24.2 23.6 22 21.3 21.4 21.8 22Budget balance %GDP -4.8 -1.8 -1.3 -0.6 -1.8 -2.2 -2.5 -2.5 -2.8 -2.9Current account %GDP -10.9 -7.7 -9.2 -10.4 -6.8 -7.5 -7.3 -7.6 -8.4 -8.9Foreign debt %GDP 42.8 39.7 37.4 42.2 40.1 42.4 43.2 44.6 48.2 51.7Exchange rate 10,64

The gross fix investment, which come from government budget, state owned companies,private sector and foreign direct investment, was above 10 percent of GDP during theeconomic boom 1993-97 The gross fix investment fall sharply in 1998 but is expected toincrease again when the foreign investors return to the region

The inflation rate was high during the economic boom but it decreased in 1997 The inflationincreases a little in 1998 again because the Government devaluates DONG In the next fewyears, inflation is expected to be under ten percent

4.2.2 Government Budget

Although the government revenue has increased in absolute term but it has decreased as thepercentage of GDP because tax receipt, which account for 80 percents of governmentrevenue has increased slowly Historically, tax collection has been heavily based on revenuefrom SOEs But as their growth slows, eroding profits, SOEs will contribute a shrinking share

to government revenue On the other hand, tax on trade will grow more slowly in next fewyears as Vietnam lowers its import tariffs to meet the requirement under the ASEAN FreeTrade Area (AFTA) Common Effective Preferential Tariff (CEPT) program

Slower growth in revenue will force the government to compress spending, in order to keepthe budget deficit under control With the memory of the hyperinflation of mid-1980s still fresh,the government is unlikely to monetise the deficit; indeed, it will be cautious about borrowingexcept on concessional terms from aid donors (ODA) (See Appendix A4-1)

4.2.3 Current Account and Exchange rate

Current account balance was around 10 percent during the economic boom It is expected todecrease a little to about 6-7% in the next few years The foreign debt is currently at amanageable level, at around 42% of GDP This ratio is expected to increase rapidly, to 52%

by the year 2002, mainly as a result of government borrowing from Japan, the World Bankand ADB to fund SOEs restructuring, the widening budget deficit, and capital investmentprojects Japan is the largest donor to Vietnam Although most of Japan ‘s aid to Vietnam is inthe form of concessional loan, the expected rising yen can increase debt-servicing costs indollar term

The Dong value has been reduced by 20% during the period 1993-98 The furtherdevaluation of Dong is expected because of the devaluation pressure from the neighboringcountries

The prime rate of about 28% was quite high during 93-95 The rate was decreased in 1996,partly because of the stricter control of government on lending rate

4.3 Infrastructure

Infrastructure in Vietnam is still very poor Poor road and rail infrastructure poses difficultiesfor retail and wholesale distribution, which is generally time consuming and costly Theupgrading of roads is under ways, but is progressing slowly Major problems include financingand implementation problems The power generation and distribution system is only justcoping Particularly in the dry season, power cuts and brownouts are common Only thetelecommunications in main urban has been much improved compared with a few years ago

In the main cities, users are unlikely encounter problems, except the high cost However, outside the main urban centers, the standard of service is still poor

The government has offered many incentives to attract foreign investment in infrastructure.However, private sector participation in developing infrastructure is still very limited Most ofthe infrastructure is funded by ODA through government guarantee Recently, thegovernment has approved a new law on BOT, which can attract private sector in investing ininfrastructure

4.4 Market Opportunities

Despite a GDP of 25 billions in 1998, Vietnam is still a potential market with population of 78millions There is strong demand for capital goods, raw materials and for some consumergoods The demand for consumer goods has been increased rapidly, but still far behindcompared with the average of Asia (Table 4-2)

Table 4-2: Some indications about the living standards

Although there is no shortage of unskilled labor, there are some shortage of skilled labor,especially in main cities and fastest growing southern provinces such as Dong Nai and Binhduong

Table 4-3: Summary of Opportunities and Threats of the Country Environment

Political Stable political system

Commitment to reformMember of many world, regionalorganization

Lack of consistency in policyimplementation

High level of CorruptionCollective decision making process:slow

Macro

economic

Strong GDP growthInflation is controlledODA disbursement increase

Both GDP growth and investment slowdown

Dong expect to devalueInflation expect to increaseGovernment deficit

Foreign debt expect increaseStrict control over foreign currencyPrime rate is high

Infrastructure Current improvement in

telecommunication

Poor infrastructureMarket

opportunities

Population of 78 MLabor force of 38 M, well educatedand cheap

Incidence of strike is infrequentHigh demand for capital goods, rawmaterials, and consumer goods

GDP per capita : lowLack of skilled laborHigh cost of living in main cities, urbanareas

As the conclusion, there are a lot of opportunities in investment in Vietnam, but the countryrisk is high (table 4-3)

Since the government budget always run deficit, the most important funding for government’sprojects come from Official Development Aid (ODA) (Appendix A4-1) Lending to government

is the least risky, but the government projects often require highly concessional loan (lowinterest with high grace period)

5.2 State Owned Enterprises (SOEs)

Vietnam has made decisive thrust of the market-oriented reforms of the state enterprisesduring 1988-1992 The SOEs received more autonomy The managers were given theauthority to set most prices, select appropriate mixes of inputs and outputs, lay off excessworkers as long as they follow the compensatory payments, and broadly determine theirinvestment programs The legal framework has also become more supportive for theoperation of SOEs As a result, these measures greatly improved enterprises financialperformance through 1994 The number of SOEs was reduced in a series of merger andliquidations from 12,000 to 6,000 between 1988-92, and their labor force was cut from2.7millions to 1.7 millions Nevertheless, the SOEs’ contribution to GDP increased from 25%

to 30% of GDP in 1994 Net transfers to the budget from SOEs, which had been about zero

in 1988, increased steadily to 12% of GDP in 1994 because of elimination of most subsidiesand much higher tax collections (IMF, April 1998)

The largest advantages of the SOEs over other forms of business is that the SOEs still enjoyprivileged legal status, receive explicit and implicit preferences in access to credit, land useright, fiscal and regulatory treatment, and enjoy targeted trade protection The governmentpolicy is to encourage foreign investors to form joint ventures with SOEs by limiting the ability

of foreign firms to establish foreign wholly-owned companies in certain areas; making itrelatively difficult to obtain access to land and credit and overcome administrative hurdleswithout the preferences afforded to the SOEs partners

However, the SOEs still face a lot of difficulties when investing in large projects First of all,most of SOEs lack liquid capital They have to rely heavily on the debt financing Since most

of their assets are state owned, they cannot be mortgaged for loan The banks should acceptlending to SOEs without collateral It can be very risky for non-state commercial banks Thelack of liquid capital is also a reason that most of SOEs can contribute capital to joint venturesonly in the form of property Second, many SOEs operate with high debt/ equity ratio becausethey can get the guarantee from a higher level government agencies However, in case oftroubles, it is difficult to get the money from the guarantors Another big problem is the lack ofcompetency in project management that reduces the efficiency in investment

5.3 Private Businesses

Since the Doi Moi reforms, the government has gradually created a better businessenvironment for private enterprises Private property rights are gradually better recognized.Government has created initiatives to promote competition and curb unfair business practice

By strengthening the legal frame work, the revised Domestic Investment Law passed in May

1998 is designed to create a more level playing field between the state and the private sector(for example, by improving tax incentives for domestic investors)

At the same time, the number of SOEs will shrink as the process of equitization, merger andliquidation moves forward more quickly in the next few years In early August 1998, theMinistry of Finance announced that local governments had been instructed to restructurearound 3,380 SOEs- of which around 1,000 are to be equitized

However, in practice the private sector remains disadvantaged in many areas, such as use rights and access to credit Regulations on setting up private business also represent asignificant hindrance to the development of the private sector As a result manyentrepreneurs carry out their activities informally There is still a strong mentality amongprivate businesses that it is important to keep a low profile if they are to avoid unwelcomeinterference by government officials, especially the tax office The lack of capital is also one

land-of the most head-aching problems land-of local private companies

The local private companies are often business oriented, dynamic and flexible, but they arestill facing many difficulties Therefore, they can best be a potential partner in projectfinancing in the future

5.4 Foreign Direct Invested (FDI) Companies1

In order to attract foreign investment into Vietnam, the government has introduced the law onforeign investment, offered a lot of incentives including tax After the financial turmoil in theSoutheast Asia Region in the latter half of the 1997, the government has made some furtherprogress in improving the environment for FDI by revising the legislation on FDI in 1996 andseveral subsequent implementation measures In addition to the government incentives, theforeign companies often have strong financial capacity and experience in business Theyoften receive the support from their parent companies

However, the foreign companies are often restricted from some areas of the economy Forinstance, foreign wholly owned companies are not encouraged in some industries such asbeverage industry, telecommunication Foreign companies often face difficulties in access toland use right The rules and regulations for accessing foreign exchange can also causedifficulties for foreign companies Although the government has offered a lot of investmentincentives for foreign investors, some irrational and unstable legal frameworks can disturb theoperation of foreign companies

Generally, the government prefers foreign companies to form joint venture with a state ownedcompanies This form of business seem to be most attractive in project financing because itcan combine the strength of the foreign companies with strength of being a state ownedcompany

1 Include Joint Venture

Table 5-2: Investment of the economy during 1996-1997

(Unit: Trillion Dong at price 1995)

(Source: Vietnam Investment Review, 30November 1998)

We see that the both FDI and private companies account for more than half of the totalinvestment in the economy during 1996-97

5.5 Banks in Vietnam

5.5.1 Overview of local banking system structure and regulation

Vietnam initiated banking reforms in 1988-1989, when the mono-bank system that served theneeds of the centrally planned economy was split into a two-tier banking system, consisting ofthe State Bank of Vietnam as the central bank and four state commercial banks In 1990,rules on the sectoral specialization of these banks were removed, and entry into the bankingsystem was liberalized In subsequent years, interbank markets were initiated for both foreignexchange and short-term domestics’ funds, and guarantees and other procedures wereintroduced to help secure lending The structure of interest rate was rationalized, the reserverequirements and the refinancing rate were each unified, and the Government introducedTreasury bill auctions (IMF, April 1998)

As a result of these reforms, the banking sector expanded considerably and banks beganoffering a broader range of services Currently, besides the four state owned commercialbanks, there are joint stock, joint venture banks and foreign bank branches (See appendixA5-1) However, the state commercial banks still account for 80% of deposits (See appendixA5-2) The major of credit is still given to the SOEs, but the state owned commercial banks(SOBs) have increased their credit to the other sectors In 1994 SOBs gave only one-third oftheir credit to non-state sectors, but in 1997 almost half of the total credit of SOBs wasextended to the non-state sector (see appendix A5-2) This means the change in policytoward lending of the SOBs

5.5.2 Local Banks

The largest advantage of local banks (including state owned commercial bank and joint stockbanks) over the foreign banks (including joint venture banks and foreign banks branches) isthat they can take the mortgage of land use right, property Their operation is less restricted

in credit operation, particularly in local currency They also have the larger network and arefamiliar with local business

However, the local banks have a number of weaknesses One of the most serious problems

is that most banks do not have strong equity Low equity limits the lending capacity of localbanks, because according to the regulation bank can not lend one customer an amount that

is larger than 15% of the bank equity This regulation restricted small bank from funding largeprojects However, the State Bank has recently solved this problem by allowing syndicatedloans.

Another problem is the overdue loan According to IMF (1998), at the end of September

1997, banks classified about 13% of total loans as overdue, compared with less than 8% atthe end of 1995 While the increase in the proportion of overdue loans partly reflects a one-time adjustment due to the stricter implementation of loan classification criteria since thebeginning of 1997, overdue have continued to rise subsequently Given the banks’ weakcapital base, these developments raise concerns in the event of a slowdown in economicgrowth or additional adverse economic shocks

Lending of state owned banks is sometimes subject to political direction Banks can provideloans to state enterprises on an unsecured basis This problem makes the overdue loan moreserious In addition, roughly one-third of total credit is extended in foreign currency, of whichover 70% are to state enterprises (IMF, 1998) The banks’ indirect exposure to foreignexchange risk is very high, as the state enterprises have in most cases used foreign currencyloans for domestic operations, and do not have access to instruments that would allowhedging of exchange risk

Bankers have little experience with the functioning of market based financial systems Anumber of Joint-stock banks are experiencing difficulties as a result of fast credit expansionbased on inadequate risk appraisal This is one of the reasons that the local banks arereluctant to do project financing because they are not familiar with the practices

Several other recent developments raise additional concerns about the soundness of bankingsector Two of the four state commercial banks were caught up in highly publicized fraud-related scandals and there have been several cases of defaults on letters of credit andpayment delays by joint-stock banks and the state owned Vietcombank While the authoritieseventually directed banks to regularize the situation and further tightened regulation toprevent a recurrence, these incidents have had an adverse impact on creditor sentiment.The lack of a transparent policy on collateral is a big obstacle for long term lending Bankscan lend without collateral, but if the business fail to repay, bankers can be taken to criminalcourses As a result, banks rely heavily on the collateral For the same reason, many bankswould rather lend to SOEs than to private sector because in case of problem they would faceless serious punishments This phenomenon leads to poor lending

The mechanism of dealing with mortgage is also a big problem When the borrowers fail torepay debt service, it is quite complicated and lengthy to enforce and sell the security,particularly the assets related to the government property

In Vietnam the risk free rate is too high (current treasury bonds is about 14%) It makes thelong-term loan impractical In practice, banks rarely offer loan period more than 3 years.Weak discipline is a serious problem among attitude of local managers Many do notseriously think about their responsibility before entering into a business When the problemsoccur, they are reluctant to solve according to the international practices For instance, oneGovernment owned bank guaranteed a loan for a local company, but it refused to do itsobligation when the local company could not repay the loan The credit rating of the countrywas down graded seriously and then the bank had to repay the loan The discipline of thelocal companies is even more questionable That is why many banks refuse to accept thecorporate guarantee

5.5.3 Foreign banks

Foreign banks often have strong lending capacity and more experience on international loanmarket They might have long time relationship with foreign companies, and better know theirclients

The largest disadvantage of foreign banks is that they cannot take land use right, property asthe mortgage whereas the most valuable of many local companies is their property

Another problem is that their operations are often restricted, particularly in mobilizing andlending local currency The government does not encourage the foreign banks to open theirbranches in Vietnam It limits their operating network Compared with the local banks, foreignbanks are often less familiar with local business

5.6 International Finance Corporation (IFC) in Vietnam

5.6.1 Operation of IFC in Vietnam

Since the opening policy in 1985, the participation of the private sector in the economy hasbeen increased The opportunity of market development has attracted different sources offunding However, project financing in non-state sector was quite a new concept in Vietnam

In 1994, the International Finance Corporation (IFC) (See appendix A-5-3) was the firstorganization to provide medium term, limited recourse loan without the governmentguarantees Up to now, IFC has approved investments in 21 projects with a total cost ofUS$1.5 billion IFC will support these projects with debt and equity investments totalingUS$581 millions, including US$320.4 million of syndication with other financial institutions(See appendix A5-4) The projects approved to date by IFC are in industries ranging fromcement, steel and infrastructure to agribusiness, tourism and financial services Most of theseprojects have the equity per total investment ranking between 30%-50% (IFC, January 1999).IFC is also providing technical assistance in the areas of capital markets development andattracting foreign investment

According to many investment experts, IFC is the strongest player in providing projectfinancing in Vietnam; other banks and financial organizations usually follow IFC

5.6.2 Role of IFC in project financing in Vietnam

According to the analysis in previous chapter, Vietnam’s business environment is considered

as high risk for investors Because of such a high-risk business environment, without theguarantee of a creditworthy party, foreign banks would be reluctant to lend to private sectors

in Vietnam This situation can be improved when some institutions (including IFC) areinvolved Their presence in private sector of Vietnam can be an assurance for the foreigncommercial banks

Most commercial lenders can have some risk covers when participating in IFC’s syndicatedloan (the B loan program) Under a B-loan structure IFC becomes the sole lender of record tothe project, acting on behalf of both itself and participating banks IFC is responsible forprocessing disbursements by participants, and for subsequent collection and distribution ofloan payments received from the borrower This structure offers several advantages toparticipating banks (IFC, 1996):

 Likely access to foreign exchange: while there are no guarantees of access to foreignexchange for debt service, no IFC loan, including the portion funded by participants, hasever been included in the general rescheduling of a borrowing country’s foreign debt.

 A strong historical performance record: despite investing in difficult country environment,IFC’s projects have demonstrated a strong repayment record, with very few write-offs

 Regulatory benefits: partly on the basis of this record, bank regulators in most OECDcountries exempt B-loan participants from country-risk provisioning requirements

However, the requirement of IFC is sometimes too rigid The subordinated lenders oftencomplain the conditions imposed by IFC Another problem is that lending of IFC does notalways have profit motivation, but often have political motivation

The policy of IFC is to support non-state sector The targets of IFC’s loan would be theprivate and foreign companies However, in Vietnam the government policy encourages theforeign investors to form joint venture with state owned companies Meanwhile, most privatecompany is too small to do a large project To avoid legal complications and minimize therisks in its early operation in Vietnam, IFC currently is focusing on lending to the jointventures between a large international company and a state owned local company

Table 5-2: Summary of Strength and Weakness of Key Partners in Vietnam

Governmen

t

Low risk Require highly concessional loan

Limited in a few critical orinfrastructure projects

Major source: ODASOEs Privileged legal status

Favor treatment: access to credit,land use right, fiscal andregulatory treatment, target tradeprotection

Government encourage toestablish JV with foreigncompanies

Efficiency : lowCompetency in project management:low

Lack of liquid capitalAssets cannot be mortgagedHigh debt/equity ratio

Limited land use right and access tocredit

Regulatory interference bygovernment officials, especially taxoffice

Lack of capitalFDI

companies Strong financial capacityExperience in business

Support from parent companiesGovernment incentives

Limited access to some areas of theeconomy

Difficult access to landRelationship with local authoritiesLocal

InexperiencedMotivation toward lending: too muchfocus on mortgage

Burdened with mortgagesHigh interest rate

Weak disciplineForeign

Restricted operationLess familiar with local businessCannot take the mortgage of land useright, property

IFC Strong influence on local

governmentExperience in project financingAssurance of reducing country risk

Rigid proceduresPolitical motivation

As the conclusion, the joint venture seem to be the most recommended form of business inproject financing, because it combine both the financial strength, experience of a foreignsponsors with the advantages of being an influential state own company Joining syndicationwith IFC is a wise way to mitigate risk in project financing in Vietnam (Table 5-2)

By the end of 1990, some top managers of GFH traveled to Vietnam for the first time Theirfirst contacts were the Ministry of Construction, the National Cement Corporation and thecement producer VNC Company After a stay of one week, they all came to the conclusionthat this promising country could be of great interest to GFH The world’s leading cementproducer, GFH and the largest state owned local cement producer, VNC signed thememorandum of understanding (1991) and then the Joint Venture Agreement (1993) Thejoint Venture Company called CSM was established to build, own and operate the cementplant project The project was given investment license in February 1994

After signing memorandum of understanding in 1991, both GFH and VNC carried out theactual project studies which lasted about one and half year These studies included rawmaterials studies, evaluation of various locations, technical concepts and alternative layoutstudies Finally, they chose the site of building cement plant at the deposit of the mainmaterial in Honchong (Kien giang province, about 300 km by road from Hochiminh city) andthe site of building cement terminal in Catlai, near Hochiminh city, the main market for CSM According to the business plan, the Catlai terminal was built first in 1994 because thisrequired a smaller investment After finishing the construction of Catlai terminal in 1997, CSMstarted to import clinker as the input for operation of Catlai The CSM strategy was to createthe initial foothold in the market before the whole project could operate full capacity Theconstruction of the main cement plant in Honchong started in August 1995 The plant enteredinto operation in March 1998 Currently the cement plant has not passed the testing periodyet

The cement plant in Honchong has the annual capacity of producing 1.4 million tons highquality Ordinary Portland Cement (OPC) The plant includes the cement plant, threelimestone quarries, the clay pit and the sea port Other materials required to produce cementsuch as gypsum, coal, fuel oil are received by ship and are also stored in covered storagehalls

The Ordinary Portland cement (OPC) is transported to Catlai terminal by two leased marinevessels In Catlai, OP cement will be blended with pozzolana, and then bagged for sale