Mobilizing Finance for INTERNATIONAL DE VELOPMENT IN FOCUS Local Infrastructure Development in Vietnam A City Infrastructure Financing Facility Alessandra Campanaro and Cuong Duc Dang INTERNATIONAL DEVELOPMENT IN FOCUS Mobilizing Finance for Local Infrastructure Development in Vietnam A City Infrastructure Financing Facility Alessandra Campanaro and Cuong Duc Dang © 2018 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 21 20 19 18 Books in this series are published to communicate the results of Bank research, analysis, and operational experience with the least possible delay. The extent of language editing varies from book to book. This work is a product of the staff of The World Bank with external contributions. 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Contents Foreword  vii Acknowledgments  ix Abbreviations  xi Overview of a City Infrastructure Financing Facility   1 CHAPTER 1:  Introduction  1 Demand-Side Analysis  2 Supply-Side Analysis  6 Legal Framework  7 Local and International Experiences with Infrastructure Funds   10 Financing Facility Options   16 Conclusion and Recommendations for Reform   23 Notes  25 References  25 A Demand-Side Analysis of the Provincial CHAPTER 2:  Governments  27 Macroeconomic and Development Considerations   28 Institutional Framework  30 Budget Process and Fiscal Relationship between the Central and Provincial Governments  31 Provincial Financial Perspective   32 Methodology  34 Effective Demand: National Perspective on the Need for Infrastructure  37 International Creditworthiness Approaches at the Subsovereign Level  71 Suggested Criteria for Provinces in Vietnam   77 Conclusions  79 Notes  80 References  80 A Supply-Side Analysis of the Vietnamese Banking CHAPTER 3:  Sector  83 Banking Industry Issues   87 Macroeconomic Instability Affects Government Creditworthiness   90 Exploring New Market Segments   92 Assessment of Commercial Banks that Lend to Provincial Governments  92  iii iv | Mobilizing Finance for Local Infrastructure Development in Vietnam Commercial Bank Constraints in Lending to Provincial Governments  95 Incentives for Commercial Banks to Lend to Provincial Governments  98 Summary of Key Findings   100 Rapid Assessment of Performance of Selected Commercial Banks  100 Conclusion and Recommendations   120 Notes  123 References  124 An Assessment of the Legal Framework for a City CHAPTER 4:  Infrastructure Financing Facility in Vietnam   125 Vietnamese Juridical Framework for Capital Mobilization by Provincial Governments   125 Overview of Past and Current Credit and Financial Institutions   137 Legal Assessment and Recommendations for Setting Up a City Infrastructure Financing Facility   145 Recommendations on the Legal Structure and Setup of a City Infrastructure Financing Facility   148 Notes  150 List of Key Legal Documents   153 APPENDIX A:  Boxes 3.1 Vietnam Banking Reform Timeline 84 3.2 Qualifications for Banks to Participate in a City Infrastructure Financing Facility Program for Provincial Lending 122 4.1 City Infrastructure Financing Facility Recourse Mechanism 147 Figures 1.1 Structuring Options for a City Infrastructure Financing Facility   17 1.2 Credit Enhancement Facility Reserve Fund   18 2.1 Sources of Provincial Debt, Year-End, 2012   33 2.2 Projected Gross Regional Domestic Product Growth, Quang Ninh Province  39 2.3 Ratio of Actual and Projected Revenue to Gross Regional Domestic Product, Quang Ninh  40 2.4 Actual and Projected Revenue, Quang Ninh   40 2.5 Ratio Recurrent Expenditure to Revenue, Quang Ninh   41 2.6 Actual and Budgeted Capital Expenditures, Quang Ninh   41 2.7 Composition of Capital Program, Quang Ninh   42 2.8 Debt Profile, Quang Ninh   43 2.9 Debt Sustainability Analysis Indicators: Liquidity Ratio, Quang Ninh   45 2.10 Debt Sustainability Analysis Indicators: Solvency Ratio, Quang Ninh   45 2.11 Debt Sustainability Analysis Indicators: Debt Service to Revenue, Quang Ninh  45 2.12 Capital Program with and without Borrowing, Quang Ninh   46 2.13 Gross Regional Domestic Product Growth, Dong Nai   47 2.14 Actual and Projected Revenue to Gross Regional Domestic Product, Dong Nai  48 2.15 Actual and Projected Revenue, Dong Nai   48 2.16 Recurrent Expenditure to Revenue, Dong Nai   49 2.17 Actual and Budgeted Capital Expenditure, Dong Nai   49 2.18 Composition of Capital Program, Dong Nai   50 2.19 Debt Profile, Dong Nai   50 2.20 Debt Sustainability Analysis Indicators: Liquidity Ratio, Dong Nai   51 2.21 Debt Sustainability Analysis Indicators: Solvency Ratio, Dong Nai   51 2.22 Debt Sustainability Analysis Indicators: Debt Service to Revenue, Dong Nai  52 Contents | v 2.23 Budgeted versus Potential Capital Program with Borrowing, Dong Nai   53 2.24 Gross Regional Domestic Product Growth, Bac Ninh   54 2.25 Actual and Projected Revenue to Gross Regional Domestic Product, Bac Ninh  54 2.26 Actual and Projected Revenue, Bac Ninh   55 2.27 Ratio of Recurrent Expenditure to Revenue, Bac Ninh   56 2.28 Actual and Budgeted Capital Expenditure, Bac Ninh   56 2.29 Composition of Planned Capital Program, Bac Ninh   57 2.30 Debt Profile, Bac Ninh   57 2.31 Debt Sustainability Analysis Indicators: Liquidity Ratio, Bac Ninh   57 2.32 Debt Sustainability Analysis Indicators: Solvency Ratio, Bac Ninh   58 2.33 Debt Sustainability Analysis Indicators: Debt Service to Revenue, Bac Ninh  58 2.34 Capital Program with and without Borrowing, Bac Ninh   59 2.35 Comparison of 11 Provinces Participating in Revenue Sharing, 2013   60 2.36 Provincial Recurrent Costs, 2013   61 2.37 Projects Identified by Provinces, 2015–20   62 2.38 Projected Effect of Loan Period on Annual Installments   64 2.39 Effect of Loan Period on Amount Borrowed with Fixed Installments   64 2.40 Budget Deviations in Dong Nai and Quang Ninh Provinces   67 2.41 Types of Controls over Local Government Borrowing   73 2.42 The Cascading Approach of Risk Evaluation   76 B3.1.1 Vietnam Banking Reform Snapshot   84 3.1 Total Assets of Vietnamese Commercial Banks   84 3.2 Chartered Capital and Number of Banks per Category   85 3.3 Liquidity Risks Facing Selected Commercial Banks   87 3.4 Growth of Loans and Deposits in the Banking Sector   88 3.5 Estimates of Nonperforming Loans   89 3.6 Changes in Nonperforming Loan Rate of Commercial Banks   89 3.7 Allocation of Credit and Nonperforming Loans   90 3.8 Proportion of Banking Industry’s Short-, Medium-, and Long-Term Loans   91 3.9 Vietcombank Asset Portfolio   103 3.10 Customer Shares of Vietcombank’s Loan Portfolio   103 3.11 Vietcombank’s Loan Portfolio, by Industry   103 3.12 Length of Terms in Loan Shares of Vietcombank’s Loan Portfolio   103 3.13 Vietcombank Liquidity Ratios   104 3.14 Length of Total Liability of Vietcombank   105 3.15 LienVietPostBank Asset Portfolio   107 3.16 Customer Shares of LienVietPostBank Loan Portfolio   107 3.17 LienVietPostBank Loan Portfolio, by Industry   107 3.18 Length of Terms in Loan Shares of LienVietPostBank Loan Portfolio   107 3.19 LienVietPostBank Liquidity Ratios   109 3.20 Length of Total Liability of LienVietPostBank   109 3.21 Maritime Bank Asset Portfolio   111 3.22 Customer Shares of Maritime Bank   111 3.23 Maritime Bank’s Loan Portfolio, by Industry   111 3.24 Length of Terms in Loan Shares of Maritime Bank’s Loan Portfolio   111 3.25 Maritime Bank Liquidity Ratios   112 3.26 Length of Total Liability of Maritime Bank   112 3.27 VietinBank Asset Portfolio   114 3.28 Customer Shares of VietinBank’s Loan Portfolio   114 3.29 VietinBank’s Loan Portfolio, by Industry   114 3.30 Length of Terms in Loan Shares of VietinBank’s Loan Portfolio   114 3.31 VietinBank Liquidity Ratios   116 3.32 Length of Total Liability of VietinBank   116 3.33 HSBC Vietnam Asset Portfolio   118 3.34 HSBC Vietnam Liquidity Ratios   119 3.35 Average Loan Tenor of Four Vietnam Commercial Banks   121 B4.1.1 City Infrastructure Financing Facility Recourse Mechanism   148 vi | Mobilizing Finance for Local Infrastructure Development in Vietnam Map 2.1 Vietnamese Provinces  38 Tables 1.1 Comparison of Three Types of Financing Facilities   22 1.2 Financing Options versus Government Objectives   23 2.1 Summary of Budget and Expenditures at Central and Local Levels   31 2.2 Capital Expenditures for 204 Infrastructure Projects, Quang Ninh   42 2.3 Planned Borrowing by Quang Ninh, D, billions   43 2.4 Debt Capacity Approaches   63 2.5 International Types of Control over Subsovereign Borrowing   73 2.6 Sample of Numeric Control Measures Used Globally   74 2.7 Criteria for Creditworthiness of Provinces   78 3.1 Key Groups of Banks by Market Focus and Strengths   85 3.2 Products of Key Groups of Banks in Vietnam   86 3.3 Characteristics of Selected Commercial Banks   87 3.4 Commercial Banks’ Direct Lending to Provincial Governments   93 3.5 State-Owned Commercial Bank Lending Rates, by Recipient   93 3.6 Key Findings on Lending to Provincial Governments by Commercial Banks  101 3.7 Key Financial Information for Vietcombank   102 3.8 Vietcombank’s Direct Loan Transactions with Vietnam’s Two Biggest Cities: Hanoi and Ho Chi Minh City   104 3.9 Vietcombank’s Net Liquidity Gap (as of June 2016), D, millions   105 3.10 Key Financial Information for LienVietPostBank   106 3.11 LienVietPostBank’s Lending to Cities and Provinces   108 3.12 LienVietPostBank’s Net Liquidity Gap (as of June 2016), D, millions   109 3.13 Key Financial Information for Maritime Bank   110 3.14 Maritime Bank’s Net Liquidity Gap (as of June 2016), D, millions   112 3.15 Key Financial Information for VietinBank   113 3.16 VietinBank’s Portfolio of Lending to Provincial Governments   115 3.17 VietinBank’s Net Liquidity Gap (as of June 2016), D, millions   117 3.18 Key Financial Information of HSBC Vietnam   118 4.1 ­ Legal Structure and Considerations for a City Infrastructure Financing Facility  149 Foreword Since the decentralization and liberalization reforms in the 1990s, Vietnam has experienced rapid urbanization and remarkable economic growth. By 2025, more than half of the population will live in cities. The country is at a critical juncture now. Decentralization has delegated significant responsibilities to pro- vincial governments while the affordability of local infrastructure investments has become a fundamental challenge for the provinces. The provinces need to leverage their balance sheets and use debt financing to fund their infrastructure needs. This transition will require enhanced capacity by the provinces to lever- age private finance, as well as an enabling regulatory and legal environment for subnational borrowing. Apart from the primary cities of Hanoi and Ho Chi Minh City, which already have demonstrated capacity and experience in tapping capital markets on their own, a group of secondary provinces (net contributors to the central government budget) have shown strong demand for local infrastructure financing and poten- tial creditworthiness for leveraging private capital. These provinces will need to enhance their capacity to obtain private capital in the market; standardize pro- vincial budgeting, accounting, and financial reporting procedures; and ensure better quality of financial disclosure. Prepared with the cooperation and support from the Ministry of Finance, the State Bank of Vietnam, as well as selected subnational governments and com- mercial banks, this book explores the potential development of a city infrastruc- ture financing facility (CIFF) in Vietnam, which aims to catalyze subnational borrowing for local infrastructure development in the context of the above-­ mentioned opportunities and challenges. Global experience has shown that because public funding resources are increasingly scarce, moving toward a more market-driven local infrastructure financing model is a critical step for subna- tional governments. This book’s findings can offer some implications for policy makers in other developing countries, especially those transitioning from a cen- income to tralized to a decentralized system, and those transitioning from a low-­ middle-income group. The book confirms that there is broad interest among commercial banks in Vietnam to lend to provincial governments. The banking sector has been grad- ually recovering from the global financial crisis and has substantial untapped capital available for new funding opportunities. Yet, unfamiliarity with the  vii viii | Mobilizing Finance for Local Infrastructure Development in Vietnam subnational budget process, and the overall perception of high risk, still limits the willingness of commercial banks to provide financing to local governments. Overcoming the existing technical and operational challenges will require capacity building, including standardization and disclosure of provincial finan- cial reporting, and improvement to the banks’ expertise in analyzing and pricing provincial credit risks. Maturity mismatches that exist between the short-term deposits and the long-term tenors needed for infrastructure loans indicate that it is still important to explore other longer-term financing for infrastructure investments in the long run. There remain significant challenges in the reform of the legal and regulatory framework that constrain the development of the provincial debt market in Vietnam, such as (a) lack of legal clarity in provincial authority to borrow from commercial banks, (b) restrictions on maturities, (c) unspecified debt security, (d) moral hazard resulting from the implicit guarantee of the central govern- ment, (e) inadequate standards of disclosure, and (f ) inappropriate standards of default and insolvency. To effectively stimulate provincial borrowing from the capital markets, further policy reforms must address these issues. Many countries have set up financing facilities to catalyze the market, enhance the capacity of both the demand side (subnational governments) and the supply side (capital markets or commercial banks), and help identify future necessary reforms for furthering subnational borrowing based on implementa- tion experience. Informed by both local and international experience, the pro- posed City Infrastructure Finance Facility (CIFF) could provide incentives for medium- to long-term lending in the provinces, while fostering a credit culture among provincial governments. In turn, this will enhance the governments’ capacity to finance themselves in the markets in the longer term. Such experi- ence will also enable provinces to productively use the untapped liquidity of commercial banks in the short to medium term, while familiarizing commercial banks with provincial government practices. In the long term, the CIFF could be expected to pool risks and tap the capital market. Ultimately, a well-functioning subnational borrowing market would help provinces to finance their infrastructure needs in a decentralized system and would pave the way for inclusive and sustainable urbanization and growth of Vietnam.  Ousmane Dione Ede Ijjasz-Vasquez Country Director for Vietnam Senior Director for Social, Urban, The World Bank Rural & Resilience Global Practice The World Bank Acknowledgments This book is the final product of Vietnam City Infrastructure Financing Facility Advisory Services and Analytics activity. The lead authors and co–task managers of this book are Alessandra Campanaro (Senior Urban Specialist; Social, Urban, Rural, and Resilience Global Practice) and Cuong Duc Dang (Senior Urban Specialist; Social, Urban, Rural, and Resilience Global Practice), with support from Roland White (Lead Urban Specialist; Social, Urban, Rural, and Resilience Global Practice), Richard Torkelson (Consultant), Johan Kruger (Consultant), Hung Tran (Consultant), Pham Nghiem Xuan Bac (Consultant), and Vision & Associates Co., Ltd. The book was produced under the overall guidance of Abhas K. Jha (Practice Manager; Social, Urban, Rural, and Resilience Global Practice), Victoria Kwakwa (Regional Vice President, East Asia and Pacific Region), and Ousmane Dione (Country Director, Vietnam). Peer review comments from Bjorn Philip (Program Leader, West Bank and Gaza), Kalpana Seethepalli (Senior Economist; Finance, Competitiveness, and Innovation) and Alwaleed Fareed Alatabani (Lead Financial Sector Specialist; Finance, Competitiveness, and Innovation) are gratefully acknowledged. Administrative assistance has been provided by Inneke Herawati Ross (Senior Program Assistant) and Giang Thi Huong Nguyen (Senior Program Assistant). The book benefitted from editorial support provided by Publications Professionals, LLC. Additional research and editorial support has been provided by Lawrence Tang (Public Finance Analyst, Consultant) and Taotao Luo (Urban Analyst, Consultant). The team would also like to thank Public-Private Infrastructure Advisory Facility (PPIAF) for co-financing this publication. Established in 1999, PPIAF is a multi-donor technical assistance facility housed inside the World Bank Group. PPIAF is a global facility dedicated to strengthening the policy, regulatory, and institutional underpinnings of private-sector investment in infrastructure in emerging markets and developing countries. PPIAF catalyzes private participa- tion through public-private partnerships (PPPs); market-based financing of subnational entities; and by supporting the generation, capture, and dissemina- tion of best practices relating to private-sector involvement in infrastructure. For more information, visit www.ppiaf.org.  ix Abbreviations ADB Asian Development Bank AfD Agence Française de Développement ASEAN+3 Association of Southeast Asian Nations + China, Japan, and Korea BIDV Bank for Investment and Development of Vietnam BOT build-operate-transfer CEF credit enhancement facility CGIF Credit Guarantee and Investment Facility Ltd. CIFF city infrastructure financing facility CJSB commercial joint-stock bank DAF development assistance fund DBP Development Bank of the Philippines DDMEF Department of Debt Management and External Finance DSA debt sustainability analysis EVN Vietnam Electricity Company FCF free cash flow FDI foreign direct investment GDP gross domestic product GMB group management board GRDP gross regional domestic product IFC International Finance Corporation IMF International Monetary Fund JICA Japan International Cooperation Agency JSCB joint-stock commercial bank LLC limited liability company LDIF local development investment fund LGU local government unit LGUGC LGU Guarantee Corporation LVPB Lien Viet Post Bank MDF municipal development fund MOF Ministry of Finance MPI Ministry of Planning and Investment MSB Maritime Bank MUFIS Czech Republic’s Municipal Infrastructure Financing Company  xi xii | Mobilizing Finance for Local Infrastructure Development in Vietnam NPL nonperforming loans ODA official development assistance PFI private financing institution PFM public finance management PMU project management unit PPC provincial People’s Committee PPCo provincial People’s Council PPP private-public partnership PWRF Philippine Water Revolving Fund RFF retail financing facility SBL State Budget Law SBV State Bank of Vietnam SEDP Socio-Economic Development Plan SME small and medium enterprises SOE state-owned enterprise SOCB state-owned commercial bank SPE special purpose entity SRF state revolving fund ULB urban local body UNDP United Nations Development Programme USAID U.S. Agency for International Development VAT value-added tax VDB Vietnam Development Bank WFF wholesale financing facility WSPF water and sanitation pooled financing entity 21,500 Vietnamese dong = 1 US$ 1 Overview of a City Infrastructure Financing Facility INTRODUCTION Over the period of 1994 to 2016, Vietnam has witnessed significant economic development, with gross domestic product (GDP) growth rate ­ averaging at around 7 percent per year and yielding more than a threefold increase in income per capita overall. The economic expansion has been accompanied by rapid urbanization and steady decentralization of respon- sibilities to provincial governments. Currently, 35 percent of the population lives in urban areas and this rate is expected to increase to 50 percent by 2025, reinforcing the positive effects of agglomeration on the growth, pros- perity, and liability of its cities. Such transformation also sees significant financial challenges for governments at different levels. As seen in many countries, most of the urban infrastructure can hardly be funded on a pay- as-you-go basis from scarce public budgets. Governments need to leverage their balance sheets and use debt financing to fund their infrastructure investment needs. This juncture also presents an opportunity for Vietnam because a signifi- cant part of the investment needs could likely be met by a more efficient use of available resources. The increased efficiency is particularly important because the flow of concessional Official Development Assistance (ODA) funds, which have served as a major source of subnational infrastructure financing, is expected to slow down as Vietnam emerges into a middle-­ income country. The debt limit of the government of Vietnam has also started to constrain the capacity of the central government to expand its ODA port- folio and channel funds to subnational governments. Moving toward a more market-driven basis is becoming an urgent issue for subnational infrastruc- ture financing in the country. The Vietnamese government has been making gradual progress improv- ing provincial government access to credit financing. In the early 2000s, the government established a Local Development Investment Fund (LDIF) financ- ­ ing framework for provinces to borrow for cost-recovery infrastructure projects. LDIFs have achieved modest successes in some provinces. Meanwhile, g overnment has passed several laws and issued many regulations the  ­  1 2 | Mobilizing Finance for Local Infrastructure Development in Vietnam authorizing provincial government borrowing since the 2000s. The recent State Budget Law (SBL) of 2015 reflects the shift toward a more enabling framework for subnational borrowing, including a substantial increase in the statutory debt limit compared with the previous regulation. However, regulatory policy reforms need to be further pursued on several aspects to effectively stimulate provincial borrowing from the capital markets and commercial banks. Recognizing the potential and challenges for mobilizing private capital avail- able to finance the emerging demand for municipal infrastructure investments among provinces, the government of Vietnam has engaged the World Bank since 2013 to identify a financing instrument that can be piloted to catalyze the subna- tional debt market. In particular, the government has been exploring the cre- ation of a municipal development fund (MDF) to catalyze the development of a subnational debt market. The Ministry of Finance (MOF) engaged the World Bank to undertake analytical work to develop the concept and explore the possi- bility of developing such a pilot mechanism—a city infrastructure financing facility (CIFF). This book presents the findings of three assessments that focused on (a) the borrowing capacity and creditworthiness of selected provincial governments, (b) the capacity of the commercial banking sector to invest in provincial govern- ments, and (c) the current status of Vietnam’s regulatory framework. The pilot CIFF in Vietnam would help develop a steadily expanding provin- cial government debt market in which financial risk is appropriately allocated and properly priced. In Vietnam, provincial government financial risk is not clearly and legally distinguished from central government financial risk. Commercial banks and the capital market cannot properly price provincial debt on the basis of each province’s credit strength. Thus, a key development goal of this book is to inform the design of a CIFF to ensure its objectives of stimulating private sector debt financing for provincial infrastructure. If a financing facility were structured to require private investors to lend their own capital to finance provincial government infrastructure—hence placing their money at risk—the facility would create a significant leveraging effect and would expand private sector financing on a more sustainable basis. DEMAND-SIDE ANALYSIS Like many other developing countries, Vietnam faces a demand for infrastructure funding that exceeds the abilities of the public and the donor ­ community to provide. Vietnam needs an annual investment of approximately US$25 ­ billion (D 537.5 trillion) for infrastructure development. To meet that demand, existing public and private sources are able to contribute only an esti- mated US$16 billion (D 344 trillion) per year. Thus, a shortfall of US$9 billion (D 193.5 trillion) is unfunded each year (World Bank 2013). To finance this shortfall, policy makers must create an enabling environment for the enhanced participation and leveraging of private resources for infrastructure funding at the provincial level. This environment can be achieved by removing impedi- ments that prevent the private sector from participating fully in lending to the provinces at appropriate terms. The level of overall government debt is approaching 64 percent of the GDP— almost at the maximum level of 65 percent set by Vietnam’s National Assembly. Because Vietnam has a unitary financial system, provincial government debt is Overview of a City Infrastructure Financing Facility | 3 counted as part of the national debt figures. Provincial debt at the end of 2012 amounted to 1.3 percent of GDP, mostly incurred by the five largest cities: Hanoi (the capital), Ho Chi Minh City, Da Nang, Can Tho, and Hai Phong. The situation has not been changed considerably since 2012, and provincial borrowing remains at a relatively insignificant level. Provincial government borrowing Provincial governments can supplement their ability to undertake capital proj- ects by borrowing and they have the authority to borrow for projects contained in the state budget. Provinces can tap the following sources to borrow: (a) the State Treasury for short-term loans not exceeding one year, (b) on-lending from the central government of ODA funding, (c) the Vietnam Development Bank (VDB), (d) state-owned and commercial banks, and (e) bond issues to tap the capital markets. The bulk of provincial borrowing is sourced from the VDB, from the State Treasury, and from on-lending by the central government, with a small percent- age (27 percent) supplied through the issue of municipal bonds and other sources (World Bank 2014). Commercial bank lending is practically nonexistent in the current environment. Provincial governments will have to finance a major portion of the infra- structure gap because more than 75 percent of government spending for infrastructure is now the responsibility of the provinces (World Bank 2013). This large gap cannot be managed on a pay-as-you-go basis from each prov- ince’s budget. Therefore, the provinces will need to leverage their balance sheets to borrow more from private sector investors to fund their infrastruc- ture needs. Although provinces are not prevented from borrowing from the commercial banking sector legally, commercial bank lending to provincial governments in Vietnam has been very limited. As detailed in the section “Supply-Side Analysis,” commercial banks are reluctant to finance local authorities, and they view lend- ing for local development as very risky, particularly in the absence of a clear recourse collateral mechanism and multiyear budgeting. Most banks’ lending experiences with provincial governments have been as a servicing agent for the central government’s program of on-lending funds from ODA sources for infra- structure. In such cases, the banks conduct little or no technical risk assessment and therefore do not develop the capacity to evaluate, price, and monitor provin- cial government projects according to commercial principles. The repayment capacity of projects and borrowers is rarely considered because of the banks’ assumption that the provincial government had the implicit guarantee of the central government. On the demand side, many provincial governments are not motivated to seek commercial financing for their own investment projects because commercial rates are relatively high compared with the favorable rates of the VDB or the state treasury. Provinces may also legally borrow from the local currency bond market. However, only a few provincial governments have gained access to financing in the capital markets through bond issues—namely, the provincial governments of Hanoi, Ho Chi Minh City, Da Nang, Dong Nai, Quang Ninh, and Bac Ninh— totaling approximately US$853 million (D 18.35 trillion). Although the Vietnam MOF and the World Bank have been working toward a market-based borrowing system, at present this effort is constrained because the amount of local 4 | Mobilizing Finance for Local Infrastructure Development in Vietnam borrowing and the interest rates for such borrowing are controlled by the MOF. Furthermore, issuing municipal bonds is time consuming and cumbersome and entails relatively high fixed costs (that is, the costs of documentation, advertise- ment, payment to securities companies, and so on). As a result, issuing munici- pal bonds has been very limited and is considered worthwhile only for relatively large projects. The effective demand for each province is collectively determined (a) by the legal caps set by the SBL on the amount of debt each province can incur, (b) by the overall governmental debt ceiling of 65 percent of GDP set by the National Assembly for the country, and (c) by the fiscal condition of each province. The previous SBL (passed in 2002) established a cap on the amount of capital that provinces can mobilize, which must not exceed 30 percent (with an exception of 100 percent for Hanoi and 150 percent for Ho Chi Minh City) of the annual capital expenditures for construction in the provincial budget. The effect of this cap is that total borrowing, assuming recurrent costs average 70 percent of the budget, is limited to approximately 9 percent of a province’s total own revenues in a given year, irrespective of what could be afforded on a sustainable basis. As elaborated in the section “Legal Framework,” the new SBL of 2015, which became effective in the state budget year of 2017, increases the legal caps for the provinces, thus creating more fiscal space for borrowing. The new law will also require more financial dis- cipline and better budgeting at the provincial level to ensure that debt incurred remains sustainable. For potential borrowing volumes, an assessment—detailed in chapter 2— identified the potential provincial effective demand by focusing on the debt capacity of a sample of 3 out of the 11 second-tier provinces that are net contrib- utors of revenue to the central government budget.1 These provinces are Quang Ninh, near the China border and the port city of Hai Phong; Dong Nai, in the south near Ho Chi Minh City; and Bac Ninh, in the north near Hanoi. The assess- ment was based on the new SBL’s statutory debt ceiling limit for net contributing provinces, namely 30 percent of provincial revenues. The assessment gives a good indication of debt levels that are affordable and sustainable, and it complies with the new statutory debt ceiling. The financial data provided by those three provinces were analyzed through a free cash flow method and a debt sustainability analysis. According to available data, the three provinces are preliminarily assessed to be financially healthy and able to absorb substantial amounts of additional debt (chapter 2) within the new SBL debt cap. That cap limits their total debt stock at 30 percent of the previous year’s revenue, assuming loan tenors are extended. The analysis of the three provinces indicated considerable fiscal space for borrowing before the debt ceil- ing is reached or the ability to service debt becomes an issue. The initial realistic aggregated borrowing demand of 11 provinces is estimated to be D 6.6 trillion (US$307 million) and remain around D 6.45 trillion (US$300 million) per year over the next five years. Weaknesses that may inhibit provincial borrowing If the private sector is expected to take the full risk when lending to provincial governments, it will do so only after conducting a credit assessment on the province’s financial data to ensure that it meets the need of the individual bank. Although the new SBL of 2015 substantially increased the limit for the Overview of a City Infrastructure Financing Facility | 5 provinces to borrow, several weaknesses can affect a provincial government’s borrowing ability: • Lack of timely availability and integrity of information. Financial data must be collected from multiple sources and are often inconsistent, raising funda- mental integrity concerns. The budget cycle is long, and final audited figures do not have to be available until 18–20 months after the end of the financial year. That system renders the actual figures virtually useless as a manage- ment tool or as a base to assess financial creditworthiness. • Incomplete financial statements. Provincial budget information often lacks details needed for banks to make a decision because, for example, (a) ODA loans are regarded as off budget, (b) debt is not accounted for, (c) the activities of state-owned enterprises with varying degrees of autonomy are not shown, (d) carryovers are not formally reflected, and (e) contingent liabilities are not transparent. • Substantial year-to-year swings in projected provincial data. These swings inhibit predictability and make credit assessments with any degree of integ- rity impossible. • Significant underestimation of revenue and consistent overspending on cap- ital. The tendencies are to underspend or overspend against budget, which indicates a weakness in financial management and a lack of management information systems. • Low revenue collection in provinces. Collection in provinces averages about 60 percent of potential revenue (World Bank 2015). • An unclear regulatory framework. Banks prefer clarity in regard to the rela- tionship between a provincial borrower and a lender, especially as far as default and recourse measures are concerned, and they need to see provincial credit risk legally differentiate from central government debt repayment responsibility. Benefits to provinces from a city infrastructure financing facility Because of the issues described, there is potentially a substantial level of demand from the provinces for access to and support from a new facility to promote more provincial borrowing. However, regulatory constraints and the financial attractiveness of the terms offered by the financing facility—­ particularly in comparison with the two current primary sources of provincial government credit (VDB and the state treasury)—will have a significant influ- ence on the ultimate effective demand. In particular, effective demand for pro- vincial borrowing will be dependent on the degree to which reforms are implemented to extend debt tenors, promote more autonomy, enhance reve- nues, and improve financial management capacity. The efforts to facilitate the creation of a long-term debt market for provincial infrastructure financing will also have to be accompanied by substantial interventions to make a clear legal distinction between central government and provincial debt and to build financial-management capacity at the provincial level. Finally, efforts to stim- ulate stronger demand for provincial borrowing will have to be managed in the context of a macro-environment in which national government debt (which includes provincial debt) is already approaching the statutory limit set by the National Assembly. 6 | Mobilizing Finance for Local Infrastructure Development in Vietnam SUPPLY-SIDE ANALYSIS Vietnam’s banking sector has shown impressive growth in both loans and depos- its since 2000. The fastest growth rate took place from 2002 to 2007, when total loans and deposits grew at a compounded annual growth rate of 35.8 percent and 37.5 percent, respectively. This growth rate peaked in 2007, when loans grew by 53.9 percent and deposits grew by 51.5 percent. The slowdown in loan growth has largely been the result of a high level of bad debts or nonperforming loans (NPL) on the balance sheets of Vietnam’s banking sector. Overall, the banking sector is gradually recovering from the global financial crisis and only recently addressed the substantial NPL overhang. In a period of low investment demand and low individual consumption, com- mercial banks are looking for new funding opportunities. It is estimated that the whole commercial banking system had about D 200 trillion, equivalent to US$9.3 billion, of untapped capital. Having commercial banks lend to provincial governments on a market basis would represent a new frontier for the Vietnamese banking industry. Historically, commercial banks had loans for government infrastructure projects at both the central and provincial levels secured with central government guarantees. Hence such loans were essentially riskless. However, in the rare instances in which short-term direct loans were made to provincial governments by commercial banks, they were not provided with proper collateral or a guarantee. In the absence of a recourse mechanism, the lender banks have been exposed to greater credit risks. Commercial banks in Vietnam have shown some experience in providing loans at longer tenors. On average, the banks used approximately 31 percent of their assets to make loans at tenors greater than five years. This suggests that the banks have the ability to lend at longer tenors and could possibly do so for pro- vincial governments, if the appropriate regulations were put in place to autho- rize it. However, commercial banks would need to balance any expansion of long-term lending to provincial governments with the potential increase in liquidity risk, given that extensive mismatches already exist between long-term assets and long-term liabilities. Hence, the availability of a refinancing window through which the banks could obtain longer-term capital to fund long-term loans to provincial governments would potentially serve as a key market stimu- lant for commercial banks. Although commercial banks are interested in diversifying their portfolios, they would approach lending to provincial governments with caution, because of the following operational as well as legal and regulatory constraints: • Commercial banks have limited expertise in analyzing provincial govern- ment books, records, and management and thus have no internal credit assessment process for identifying and evaluating the risks of lending to pro- vincial governments. • Commercial banks would prefer to depend on their own internal credit review of each province to help them assess the risks of lending to provincial governments. • Commercial banks generally assume that all provincial government debt is merely an extension of the national debt and ultimately guaranteed. However, because there is uncertainty about this assumption, banks prefer to buy cen- tral government bonds. Central government bonds are viewed as more valu- able and trusted assets that insulate banks from having to deal with myriad Overview of a City Infrastructure Financing Facility | 7 provincial government issuers and interpretations of an ambiguous provin- cial government regulatory system. • Commercial banks perceive that direct loans to provincial governments pose a high risk of nonpayment and are concerned that they have no clear, legal right to protect themselves and their investors in the event of a default. • Commercial banks want their investments to have security, which could be achieved with credit enhancements, a recourse mechanism, or government guarantees. • Commercial banks need liquidity because there is no market for trading bank loans to provincial governments or rediscounting them to the state treasury. • Commercial banks are concerned with deal size, frequency, and credit quality. • Commercial banks need clear, timely, regular, frequent, and comprehensive disclosure about the financial condition of their borrowers. • Commercial banks want regular communication with their borrowers, not just when they are about to request a loan or a debt issuance. LEGAL FRAMEWORK The three main laws that control borrowing by provincial governments in Vietnam are the SBL of 2002, revised in 2015; the Law on Public Debt Management; and the Law on Credit Institutions. At present, there is no legal prohibition for commercial banks or the capital markets to provide loans to pro- vincial governments. However, provinces are forbidden to borrow from offshore financing entities. The authority for provincial borrowing is not unfettered, and there are certain legal limits on how much provinces may borrow. State Budget Law Under SBL 2015, effective since January 2017, provinces may borrow to offset their local budget deficit (which should be used only for investment in proj- ects that are included in medium-term public investment plans already decided by the provincial People’s Council) and to repay the principal of debts. The law specifies the limits of local budget borrowing on the basis of the revenue that provinces are entitled to retain, instead of on the investment spending for capital construction as stipulated under the SBL 2002 previously. Such limits are differ- ent for groups of provinces, broken down by the difference between the prov- inces’ retained revenues and its current expenditures, as follows: • Hanoi and Ho Chi Minh City can borrow up to 60 percent of the provincial revenue they are entitled to. • Provinces entitled to revenue that exceeds their recurrent expenditure amount can borrow up to 30 percent of that revenue. • Provinces entitled to revenue equal to or lower than their recurrent expendi- ture amount can borrow up to 20 percent of that revenue. The financial capacity of the provincial budgets in the estimation year must be below financing needs generated by the investment plan for the year. In addi- tion, provinces are required to meet the ceiling of the local budget deficit annu- ally allocated for each province by the central government because the local budget deficit is included in the state budget deficit and decided by the 8 | Mobilizing Finance for Local Infrastructure Development in Vietnam National Assembly. The government of Vietnam prescribes in detail when a local budget deficit is permitted to ensure the debt repayment capacity of localities and to fit the total deficit of the state budget. Under SBL 2015, provincial governments can borrow in the form of bond issuance, on-lending from the government’s foreign loan, or other legitimate sources allowed by law. Generally, in the annual budgeting process of local gov- ernments, each provincial People’s Congress prepares a budget estimate on local deficit, borrowing, and repayment of debt based on the balancing capacity of local budget, borrowing balance limit, and demand for development investment capital; submits it to the provincial People’s Council for approval; and then sub- mits it to the central government for approval. The 2015 SBL, including all its guiding legislation, is silent on recourse to ensure that, in the case of provincial government default on borrowings from other sources (such as commercial banks or capital markets), the lenders or financiers could recover the funds from the provincial budget. Nonetheless, MOF budget officials reported that the MOF has an informal recourse mecha- nism when a provincial government fails to repay advances from the state ­treasury,2 which is to deduct the amount of arrearages from the provincial gov- ernment’s future budget allocations. It should be noted that advances from the state treasury are not legally regarded as borrowing or loans provided by the central government (that is, the MOF) to the provincial government. Law on public debt management The Law on Public Debt Management (29/2009/QH12; June 17, 2009) autho- rizes provinces to issue bonds or borrow from “legitimate domestic financial sources.”3 The law authorizes provinces to enter into loan agreements and stip- ulates that the source for payment shall be “guaranteed” by the provincial budget and revenue from investment projects by the provinces. This language could be interpreted to provide lenders with some comfort, although if a default were to happen, there is no clear, explicit recourse for a lender under this law. The Law on Public Debt Management does not specify that provincial gov- ernments can actually borrow from commercial banks because the definition of “other legitimate financial sources” does not explicitly include commercial banks. Guidance included in Decree 79/2010/ND-CP (issued July 14, 2010) also does not clarify the definition to include commercial banks. However, this has not inhibited provincial government borrowing, because commercial banks are commonly understood to be a “legitimate financial source.” Nevertheless, the Prime Minister’s Instruction 25 in 2014, which prevented provinces from bor- rowing from commercial banks to cover the expenditures of the local budgets (including investment in infrastructure development) for the purpose of state budget management for the last months of 2014, is still perceived as in effect because no document yet says that Instruction 25 is no longer applicable. This continues commercial banks’ perception that lending to provinces is not fully legally supported, and it needs to be clarified clearly in a legal document to change this perception. The Law on Public Debt Management also authorizes the MOF to directly provide or authorize a financial or credit institution to make available on-lending of the government’s foreign loans to provincial governments. On-lending bene- ficiaries include (a) financial and credit institutions taking loans for further lend- ing to users under credit programs or credit components of programs and Overview of a City Infrastructure Financing Facility | 9 projects using foreign loans, (b) enterprises taking loans for investment in pro- grams and projects capable of recovering part or all of the loans, and (c) provin- cial governments taking loans for investment in socioeconomic development within the provincial budget spending task. Decree 78/2010/ND-CP (issued July 14, 2010) provides further guidance and clarifies that the MOF shall authorize financial and credit institutions to act as on-lending agencies in the following cases: (a) on-lending to enterprises for execution of specific investment programs or projects and (b) implementa- tion of credit limits or programs subject to conditions on borrowers, areas, sec- tors, on-lending interest rates, and other relevant conditions. In cases of on-lending of a government foreign loan to a provincial government, the MOF is responsible for evaluating the debt repayment capacity of the provincial ­ government and ensuring that the on-lending interest rate is the same as the foreign loan interest. Law on credit institutions The Law on Credit Institutions (47/2010/QH12; June 16, 2010) is the underlying legal framework for credit activities in Vietnam. The law contains general regu- lations about permitted activities for commercial banks, which are regulated by the SBV. The law is silent about lending to provincial governments. To clarify the Law on Credit Institutions, SBV issued Document 1354/NHNN- CSTT, dated April 12, 2002, and, at the request of the MOF, Document 576/ NHNN-CSTT, dated June 10, 2005, to commercial banks providing guidelines related to making loans to provincial budgets for infrastructure projects. The provisions of Document 576 state that commercial banks are responsible for their loans to provincial budgets for infrastructure development and for comply- ing with the laws on bank credit and the state budget, as well as the guidance of the State Bank of Vietnam. One of the most limiting provisions of the issu- ance is that commercial banks may only issue loans with a maximum duration of 24 months. From a legal perspective, such documents have only guiding power—not binding power. However, commercial banks that have made loans to provin- cial governments seem to be strictly following the SBV’s guidance in Official Letter 576/NHNN-CSTT dated June 10, 2005 so as to avoid any subsequent legal consequences. To resolve uncertainties, SBV should issue future guidance related to commercial bank lending to provincial governments ­ in the form of a circular that has binding power in order to open up more commercial bank loan activity with provincial governments and to provide more protection for the banks. In 2015, a new SBL was enacted by the National Assembly that became effective in budget year 2017. Among other things and as mentioned in the sec- tion on the SBL, this law changes the provincial debt caps (a) for Hanoi and Ho Chi Minh City to 60 percent of the provincial revenue; (b) for provinces that have revenue that exceeds the recurrent expenditure amount to 30 percent of the provincial revenue; and (c) for provinces that have revenue equal to or lower than the recurrent expenditure amount to 20 percent of the provincial revenue. This is a positive change, because it will allow the 11 provinces that are  net contributors of revenue to the central government to increase their debt caps by 21 percent over the old law, assuming recurrent costs average 70 percent of the budget. 10 | Mobilizing Finance for Local Infrastructure Development in Vietnam The MOF has also drafted a new circular that will replace Circular 86/2004/ TT-BTT (issued August 25, 2004), which would guide the management of capital from provincial government budgets for infrastructure development. The new circular would provide more detailed guidelines related to provincial govern- ments’ borrowing from credit institutions. This draft circular contains important reforms, including requirements that (a) provincial governments have to comply with the SBL, the Public Debt Management Law, and the new circular; (b) loans are to be a part of the annual capital mobilization plan approved by the provincial People’s Council; (c) the dong is to serve as the currency for loans to provincial governments; (d) interest rates will be determined by the market; (e) the loan terms must be suitable to the implementation time of the project; and (f ) loans are disbursed to the provincial government’s account at the state treasury. These changes in laws and regulations demonstrate that the government is moving to improve provincial government access to credit institution funding, and at a greater amount than previously allowed. However, to implement a CIFF with a capability to stimulate more provincial government borrowing, additional regulatory reforms will be necessary from the MOF and SBV to address funda- mental issues that have been identified. These issues include the following: • The absence of clear stipulations on a recourse mechanism, including its detailed procedures, that could ensure that in the case of provincial govern- ment’s default, lenders and financiers could recover funds from the provin- cial budget • The absence of specific guidance or regulations regarding the assessment of credit risks relating to the loans to be provided by commercial banks to the provincial governments, which is critical given the dearth of experience among commercial banks for assessing loans to provincial governments • The current maximum allowable loan term of 24 months for loans provided by the commercial banks to provincial governments, which is grossly inap- propriate given the financing needs of infrastructure investments Finally, if the government is successful at stimulating more provincial ­ overnment borrowing, it will add to the stock of national debt and thereby g be required to either raise the debt ceiling or adjust overall levels of national ­government debt. LOCAL AND INTERNATIONAL EXPERIENCES WITH INFRASTRUCTURE FUNDS Vietnam has authorized several financing programs supported by major donor investments that are focused on either a specific source of repayment, for exam- ple project revenues, or a specific sector, such as water. Two of these programs— Local Development Infrastructure Funds (LDIF) and the Asian Development Bank’s (ADB) Water Sector Investment Program—are still evolving and are briefly described here. Local development infrastructure funds LDIFs are special subnational finance institutions created at the provincial level to mobilize capital and invest it in the municipal infrastructure projects of each province. LDIFs were first piloted in Ho Chi Minh City in 1997, and the legal Overview of a City Infrastructure Financing Facility | 11 framework supporting this municipal financing vehicle has continuously been updated, most recently in 2013 (via Decree 37/2013/ND-CP) to clarify the sec- tors that LDIFs can invest in, to delegate business decision making to provincial People’s Committees, and to allow cofinancing between LDIFs. LDIFs are expected to operate as commercial-oriented entities, raising medium- and long-term capital from domestic and foreign sources and investing in municipal infrastructure projects that will generate a sufficient financial return on investment. LDIFs are statutorily restricted to financing revenue-­ generating municipal infrastructure in their respective provinces. The LDIF model has expanded to 36 of the 63 provinces, mobilizing capital for infrastructure investment. Funding commitments have grown from US$40 million to approximately US$144 million as of February 2015. According to World Bank Implementation Support Reports (IEG Review Team 2017; World Bank 2014), each dollar invested from LDIF had leveraged US$1.73 in investment from the private sector as of March 2015. LDIFs have proven to be an important financing channel in Vietnam, but there are limits to their effectiveness as a broad-based municipal-infrastructure financing vehicle. LDIFs are statutorily restricted to financing revenue-generat- ing municipal infrastructure, which leaves a major gap for infrastructure invest- ments that do not have explicit revenue streams. LDIF professionals have developed new and better technical and financial-management skills, which could be used to help provinces obtain loans from commercial banks to finance provinces’ non–revenue-generating infrastructure projects. Asian Development Bank's water sector investment program The ADB financing facility was established in 2010 with a fund commitment up to US$1 billion for the water-supply needs of Vietnam identified in its Socio- Economic Development Plan 2011–2015. The program expects to leverage more than US$1.7 billion from private investors in the water sector. The program terms are flexible and can be tailored to individual project needs. The program terminates in 2020, unless extended. Progress is very slow because loans get bogged down in the provincial govern- ment approval process. The local standing committees, which need to approve everything, meet only two times a year, so getting variances is time consuming. Some variances may need central government approval, in some cases from the prime minister. Provincial governments are also reluctant to establish and approve water tariffs at proper levels to pay for operations, maintenance, and debt service. The result is that applicants for funding from the ADB facility that cannot demonstrate they have the ability to pay a loan back from system tariffs are forced to try to get other financial support from the provincial budgets to finance the project. ADB staff members agreed that investors, including the ADB, would welcome the legal establishment of a recourse mechanism. The ADB was encouraged to learn about the CIFF feasibility study but had no reaction to the wholesale or retail options. Internationally, countries have successfully met their subnational infrastruc- ture development challenge by using other financing mechanisms. Some coun- tries have activated borrowing by setting up second-tier financing using their commercial banks. Others have used intermediaries to provide access to local currency capital markets, and many regularly use credit enhancement 12 | Mobilizing Finance for Local Infrastructure Development in Vietnam techniques to strengthen their credit profile to initiate access to capital markets. Examples of each of these models are provided here to help inform the Vietnamese government as it considers establishing a broader intervention to provide provincial governments access to private sector investments. International experience of infrastructure funds Infrastructure wholesale financing funds Colombia and the Czech Republic formed local development finance companies as second-tier (wholesale) lenders to their countries’ commercial banks. These banks then handled the review, credit assessment, and loan approval process for local government borrowing. Colombia’s Findeter (Financial Territorial Development SA), a public financial institution, was capitalized frequently by international donors until it had issued enough loans to enable the company to recycle repayment streams and gain access to the local capital market for funds to make new loans. The Czech Republic’s Municipal Infrastructure Financing Company (MUFIS) provided the capitalization for its commercial bank lenders to make loans to local governments. A key difference is that Findeter discounted the loans to the commercial banks and the Czech Republic did not. As the munic- ipal credit market grew in the Czech Republic, the commercial banks stopped borrowing from MUFIS and started using their own resources. However, Findeter still provides discounted loans to its commercial bank system for on-lending to local governments (World Bank 2013). Retail financing facility In 1987 the United States government decided to appropriate capitalization grant funds (nonrepayable) to all 50 states and required that such funds be main- tained in perpetuity and be used to provide state revolving fund (SRF) loans for public water and wastewater infrastructure needs. The federal authorizing stat- utes allowed for leveraging, but many states opted to merely use the first on a direct loan basis. Hence, each state created its own retail-like entities to manage these funds. Several states used their treasury, others used simple bond banks, others formed new types of bond banks (called revolving funds) to leverage their capitalization. From a retail perspective, the capitalization could be used to makes loans from each dollar of SRF federal money received either at zero inter- est or at some predetermined interest rate. This retail structure is known as the direct loan model, which has been employed by over 20 states. This type of direct loan model works well if the need for financing water or wastewater projects equals or is less than the capital that the bond bank has on hand for providing financial assistance to its municipalities. A second retail structure is known as the cash flow model and is used by at least 27 states. In this case, a revolving fund makes direct loans first and then leverages the repayment stream of those direct loans by pledging them to pay the debt service of a capital market bond issue. The proceeds of the bond issue are then loaned out in new direct loans to municipalities. This model has the advan- tage of making money available sooner than it otherwise would be from the loan repayment stream of the original direct loans. In the second structure, by aggregating or pooling municipal loans to issue debt, municipal bond banks provide market access, particularly for numerous small local municipalities and school districts. These local units often borrow infrequently, and their debt issues are small. By using their respective Overview of a City Infrastructure Financing Facility | 13 higher-rated bond banks, each will pay lower debt service and issuance costs (shared pro rata) than would be typical of a local governmental unit trying to obtain debt financing with its own credit profile. The credit strength of municipal bond banks is based on three criteria: (a) a general obligation loan pledge from each local government that supports its indi- vidual debt service repayment obligation or revenue bond pledges from water and sewer utilities backed by the statutory pledge of property taxes by the under- lying local government, if enterprise revenues are insufficient; (b) substantial debt service reserves (equal to maximum annual debt service or to 1.25 times average annual debt service) that offer significant default tolerance; and (c) strong oversight and legal protections combined with a history of timely receipt of payments from borrowers. Bond banks internally screen all loan applications, regularly monitor partici- pants’ credit quality once loans are made, and review annual budgets and audits. Most important, payments from borrowers are scheduled to provide sufficient notification of nonpayment and to allow time to cover any shortfalls from the bond bank’s substantial debt service reserves. Finally, bond banks also have state deficiency make-up provisions, which have rarely been tested. Credit-rating agencies recognize that a deficiency make-up provides additional credit enhancement if the mechanics are soundly structured to provide timeliness of payment or when a state treasurer serves as a member of the bond bank’s gov- erning body, providing incentive for central government cooperation. The strength of the bond banks is also based on their ability to get timely and audited local financial data, to attract private investors in the capital markets, and to enforce payment of provincial government debt obligations using a legally approved recourse regime, if needed. In India, the state government of Tamil Nadu established a water and sanita- tion bond bank (Water and Sanitation Pooled Fund [WSPF]) and issued its first pooled financing transaction in December 2002 to enable its small- and medium-size local governments (urban local bodies, ULBs) to obtain financing at market rates for their water and sanitation infrastructure needs. This entity’s credit structure followed the general norms articulated earlier for bond banks. By aggregating or pooling municipal loans to issue debt (as a pooled financing entity), municipal bond banks provide market access. Moreover, the program added some strong credit features such as requiring the routing of all ULBs rev- enues (including transfer payments from the state government of Tamil Nadu) to a special no-lien escrow account in a local commercial bank. In that same bank, the ULB was required to establish a different and separate fixed deposit account that would be filled monthly from the aforementioned escrow account to ensure that by the end of the 10th month that fixed deposit account would have enough funds to make the yearly required debt service payment to the trustee bank servicing the WSPF bond debt service for the pooled issue. This fixed deposit provision would enable the staff of WSPF to monitor the ULB account and have time to act if the account was insufficient to make the required debt service payment. Additional credit enhancement mechanisms were put in place for recourse (intercepting direct devolution payments to the defaulting ULB) and for liquidity, each pool financing had a bond service fund (a reserve fund) capitalized in cash by the Tamil Nadu government and a partial guarantee from the US Agency for International Development (USAID) to replenish 50 percent of any principal withdrawn from the bond service fund to meet timely WSPF debt service payments (Fitch Ratings 2003). 14 | Mobilizing Finance for Local Infrastructure Development in Vietnam The state of Quintana Roo in Mexico created a bond bank to finance local government water and sanitation projects. In an arena in which municipal credit ratings are low compared with domestic investment grade standards, credit enhancement is a necessity for gaining access to debt capital markets. The bond bank was formed as a pooled financing vehicle with a credit structure based solely on intercepting different local government revenue streams and pledging them to pay for local debt obligations to the bank, thereby increasing the credit rating of the borrowing entity. This is a gross revenue pledge credit structure—in which debt is paid first, operations and maintenance second—that results in very high ratings (AA). This approach was used to overcome a number of constraints that prevented the state of Quintana Roo from building a strong, effective, and consistent financ- ing framework for the water and sanitation ­sector. For example, water utilities, not being federal entities, received no national tax transfers. Water bill collection rates were very low, because Mexico guaranteed water supply to its citizens even if they did not pay for it. Pledging revenue streams from water utilities was not perceived as secure by potential investors. Credit enhancement facilities The Philippine Water Revolving Fund (PWRF) is a pooled loan financing facility focused on local water utility infrastructure that was funded by a Japan International Cooperation Agency (JICA) loan to the Development Bank of the Philippines (DBP) and by private financing institutions (PFIs), mainly commer- cial banks. The financing ratio ranged from a 50 to 75 percent DBP/JICA loan to a 25 to 50 percent PFI loan share. The JICA loan was backed by a sovereign guarantee from the Philippine government and had favorable concessional terms, namely an effective interest rate 100–200 basis points lower than the then prevailing market rate and a 30-year tenor with a 10-year grace period. The PFI loan was lent at market terms for a term of 20 years with a right for the PFIs to exit after the 7th year. Lending decision criteria and due diligence were all based on the PFIs’ requirements, so the PWRF catered to only creditworthy water ser- vice providers. The PWRF loan security package included an intercept of the internal revenue allotment coming from the national government to local gov- ernment units (LGUs) in case of default, as well as a debt-service reserve fund. Despite the structure, the PFIs were still concerned about the water-utility default risk and demanded more protection. So, the PWRF obtained a credit risk guarantee that covered up to 85 percent of the PFI loan from a private domestic guarantee corporation, the provincial government, and the LGU Guarantee Corporation (LGUGC), backed up by a coguarantee of the USAID Development Credit Agency for up to 50 percent of the LGUGC’s exposure, enabling the pro- gram to be implemented (PWRF 2011). The Philippine financing facility was able to support the policy of the govern- ment by shifting the financing of water utilities to market-based sources and mobilizing additional resources by leveraging public funding (ODA and central government funds) with private funds. The PWRF successfully channeled more than P4.0 billion (US$91.2 million), of which P2.45 billion (US$55.8 million) came from private banks, in financing for 21 water and sanitation projects over a six-year period. The design of the PWRF created a mechanism whereby local private banks could invest in the sector with low risk. This transformed the way banks assessed and financed projects—moving from collateral-based to project-based lending with guarantees and liquidity coverage credit enhancements that significantly Overview of a City Infrastructure Financing Facility | 15 lowered bank financing risks. Training provided by the staff of the financing facility, along with an appraisal guidebook on how to assess water utilities and water projects, enabled several private banks to learn how water utilities operate and how a well-managed utility can make an excellent borrower (PWRF 2011). What the examples demonstrate In several of the examples examined, an external credit enhancement or guar- antee was required to make a transaction marketable because private sector investors have limited or no experience with subnational governments, their budget practices, or history of borrowing and repayment. Vietnam will undoubt- edly need to use credit enhancement techniques to attract private sector inves- tors who will lend their money to provincial governments. Two external financial guarantee entities are briefly profiled here as examples of how such mechanisms work and in what sectors they provide guarantees. The examples validate the need for Vietnam to develop some type of credit enhancement mechanism to stimulate its provincial national debt financing using private ­sector investments. LGUGC is a private Philippine financial guarantee corporation, owned 38 percent by the Bankers Association of the Philippines, 37 percent by the DBP, and 25 percent by the ADB. LGUGC was incorporated on March 2, 1998, and guarantees the indebtedness of LGUs, water districts, electric cooperatives, renewable energy technology providers, state universities and colleges, and medium to large enterprises. It facilitates local government access to private sources of financing through credit enhancement, is leveraged 10:1, and does not allow acceleration of debt when a project goes into default. A new ADB-capitalized guarantee program was approved by the SBV for use in Vietnam for a corporate bond transaction. The guarantee program is offered by Credit Guarantee and Investment Facility Ltd. (CGIF), which was established in 2010 as a trust fund of ADB. It is rated AA by S&P and AAA by three other regional rating agencies. CGIF provides 100 percent guarantees primarily on local currency bonds issued by creditworthy corporations that are domiciled in 13 member countries of ASEAN+3 (Association of Southeast Asian Nations + China, Japan, and the Republic of Korea). The guarantees issued by CGIF are irrevocable and unconditional commit- ments to pay bondholders upon nonpayment by issuers throughout the tenor of the bonds. CGIF retains the right to accelerate the principal claim payments prior to the maturity of the debt issuance upon default of the issuer or to main- tain the payment schedule of the guaranteed obligations. CGIF’s leverage ratio— as measured by the ratio of aggregate outstanding guarantees to total paid-in capital plus retained earnings after deducting loss reserves and illiquid investments—will not exceed 2.5:1. CGIF has a single risk country threshold of ­ US$350 million. On December 5, 2014, CGIF closed its first guarantee for a D 2.1 trillion (US$98.2 million) bond for Masan Consumer Holdings, a subsidiary of Masan Group Corporation, marking the first time a nonbank corporate Vietnamese bond had been issued with a fixed rate, 10-year tenor. Vietnam should not copy these examples exactly but rather design a financ- ing facility with the best techniques to ensure that Vietnam meets the long-term objective of access to private sector financing for its provincial governments and to make clear who bears the credit risk obligations when provincial govern- ments borrow. The goal is to create a sustainable private sector financing 16 | Mobilizing Finance for Local Infrastructure Development in Vietnam capacity in the country, not a permanent public funding capacity. When infra- structure needs cannot be satisfied solely from central or local budgets, interna- tional experience has shown that central governments have stepped in to try to alleviate this problem. Each government created its own type of mechanism through which local entities could gain access to private sector financing. The critical differences between the mechanisms reflect individual country policy preferences. For example, Colombia chose to subsidize its local governments by discount- ing loans to commercial banks so that borrowing became more affordable. This option created a lengthy demand for more resources to maintain the subsidies and, therefore, effectively crowded out private sector capital market financing. The Czech Republic’s MUFIS, on the other hand, did not subsidize local gov- ernments; it merely provided capital to their commercial banks for financing local governments at market rates, preparing local governments to gain access to the capital market once it matured in that country. Other countries created highly rated structures that provide access to the market for a basket of local government loans to achieve savings through that process. Although this  crowds out private sector financing for individual localities on their own credit, the mechanism still acquires its funding from the private sector at capital market rates. To mitigate risk, virtually all these mechanisms used some form of financial structuring (overcollateralization, reserve funds, and so forth), and many acquired public or private financial guarantees as a credit enhancement. Such examples were found in Tamil Nadu and the Philippine Water Fund to provide comfort about debt repayment for private lenders, especially in the initial phases of obtaining private sector debt financing. FINANCING FACILITY OPTIONS The 2013 World Bank report, Assessment of Financing Framework for Municipal Infrastructure (World Bank 2013), described successful international models that could be applied to Vietnam. These models include MDFs (wholesale option), public funding intermediaries (retail option), market-oriented financial intermediaries, credit enhancement, and land-based infrastructure financing programs. This chapter describes the fundamental workings and risks and miti- gations associated with retail finance, credit enhancement finance, and whole- sale finance but not land-based financing programs (figure 1.1). Retail financing A “retail” financing facility (RFF) provides direct loan financing to provincial governments; the government is required to create a special purpose entity to act as a financial intermediary between the provinces and the facility. The entity invests the monies of the facility (usually capitalization grants from the govern- ment or donors); establishes the loan application, review, and approval processes for provincial governments; determines the terms and conditions for loan approval; makes loans and disburses funds to the borrowers; and provides over- sight and surveillance of the performance of the provincial governments to ensure that they use the money for allowable capital purposes and repay their loan obligations on time and in full. Overview of a City Infrastructure Financing Facility | 17 FIGURE 1.1 Structuring Options for a City Infrastructure Financing Facility Retail finance Credit enhancement Wholesale finance source finance source source Grant-escrowed Release of escrowed Discounted to provide credit Loan funds once loan taking support for repayment loans are credit risk approved PC loans fully paid off Discounted loan Loan Approved Approved taking repayment commercial commercial credit risk banks banks Bank loan Bank loan Loan Loan taking taking repayment repayment credit risk credit risk Selected provincial Selected provincial Selected provincial governments (PCs) governments (PCs) governments (PCs) Note: Selected provincial governments are net contributors of revenue to the central government. PCs = People’s Committees. This type of financing facility does not leverage its equity, nor does it induce private sector financing for provincial governments; properly managed, it should not have any recourse to the central government budget should loan obligations not be repaid. A retail facility takes on the full credit risk of the provincial gov- ernments, which means that, if a provincial government fails to repay its direct loans, the facility will have less money in the future to make new loans. There would be no capital market impact. An RFF would not achieve the government’s goal of stimulating private sec- tor lending to provincial governments because it is unlikely to leverage private capital. It also would be under great pressure to provide cheap capital, which would crowd out private sector competition to provide provincial government financing. The creation of a new bureaucracy would take time. If the retail facil- ity provided subsidized financing, it would put pressure on the government to commit to funding it incrementally over time. Consequently, there is little inter- est in going in this direction from the Vietnam government or the World Bank. On the positive side, an RFF might be considered in the future as a potential tool to help finance poorer provinces by providing technical help to structure their projects so they could be financed from a variety of governmental, donor, or ODA sources. The RFF then might blend funding from the province’s own budget, from grants provided by the central budget, or from ODA loans on-lent through the budget, and possibly from private sector proceeds generated by exe- cuting pooled loans financed by commercial banks or the capital markets. There are many managerial benefits that can accrue to even the poorest provinces from the experience of preparing and going through the lending process. This is what motivated the creation of bond banks and ultimately revolving funds in some developed and developing countries. 18 | Mobilizing Finance for Local Infrastructure Development in Vietnam In the future when the market is more developed, a retail entity could itself become a conduit financing entity (similar to bond banks), obtain its own rating, and obtain additional nondiscounted financing (pooled financing) from the local currency capital markets on behalf of the provincial governments, particularly those that are poorer with smaller issuance needs. Acting as a conduit financing entity, the retail facility would still be exposed to provincial credit risk, but in this case the impact of nonpayment would severely damage the facility’s credit rating and its future ability to function at all. That is why the government would need to authorize a recourse mechanism and allow the facility to use various credit enhancement techniques to strengthen the creditworthiness of the facility. Credit enhancement financing A credit enhancement facility (CEF) is used to boost the credit of borrowers and mitigate risk to enable them to gain access to external private sector funding. The most common technique used is a reserve fund, which is funded with extra resources generated internally or externally and is pledged to repay specific loan obligations in the event of a default (figure 1.2). The reserve fund type of credit enhancement leverages its equity (which can be as high as 10–1),4 induces private sector investment, exposes the facility to only a portion of the local government risk, and has no recourse to the central government. The reserve fund needs to be able to be legally pledged to provide security for a specific local government loan and make it available to pay a por- tion of the debt service on that loan if the local government defaults on its pay- ment obligation. Credit enhancement makes provincial government debt more attractive for investment. An issuer’s financial value is solely in its cash flows. Therefore, mit- igating default risk is one of the best ways for a lender to get comfortable about recovering its invested capital. Credit enhancement stabilizes cash flows, thus broadening the investment opportunities for domestic markets. A CEF is estab- lished to provide a provincial government a standby source of liquidity over and above the cash flow pledged by the provincial government to repay its debt should it ever be needed. FIGURE 1.2 Credit Enhancement Facility Reserve Fund Reserve Commercial Bank fund • Used if loan repayment is late • Limit is 1 year of debt service • Set up for each local government loan Loan • Cash deposit from CIFF (US$100 Repayment • Special escrow account total debt (US$10/year) • 10% total debt or 1-year debt service with 10-year • Local government replenishes for fixed rate tenor) Local Government Note: CIFF = city infrastructure financing facility; LG = local government. Overview of a City Infrastructure Financing Facility | 19 Credit enhancement involves using external financial techniques to provide investors with additional security that they will be repaid. The role of external credit enhancement is to bolster (over collateralize) cash flows in support of debt service. When used to finance a government, credit enhancement should be in a form that mitigates default risk rather than enhances recovery value. A provincial government’s agreement to repay its debt is generally considered a type of general obligation commitment that does not normally need credit enhancement. This means that the revenues of the provincial government are standing behind its debt obligation and that they are sufficient to repay debt. However, if investors judge provincial governments to be marginally or less than creditworthy or they are first-time issuers of debt or there is no recourse mech- anism established in law and regulation to potentially recover their investment upon a default, investors will demand some sort of external credit enhancement be obtained before they will lend. The main characteristics of external credit enhancement are as follows: • The issuer (province) remains the sole obligor for the debt. • The external credit enhancement is legally authorized, if provided by a gov- ernment or governmental entity, or is contractually valid if provided by a pri- vate entity or a bank. • The external credit enhancement is managed by a trustee-initiated trigger that can be either proactive (when the trigger is activated by the insufficiency of funds within a debt service account some days in advance of a scheduled payment date) or reactive (when the trigger is activated post-default). A pro- active trigger, which mitigates default risk, has a higher value to investors than a reactive trigger, which enhances recovery value on a post-default basis. Credit enhancement techniques will be necessary to provide comfort to pri- vate sector lenders, particularly in the early stages of financing provincial gov- ernment infrastructure needs. The SBV reported that it has regulations covering risk mitigation (credit enhancement) techniques that the commercial banks can use when making loans for corporate clients.5 These included earmarking and pledging revenues, hard asset pledges, parent company guarantees, among ­others. As mentioned, the SBV recently gave approval to use a private company’s CGIF, credit guarantee, for the first time on a corporate debt issue, which was favorably viewed and priced in the local currency in Vietnam’s debt capital market. Therefore, it is reasonable to expect that the SBV could develop risk ­ mitigation regulations specifically tailored to provincial governments, allowing commercial banks and the capital markets to use various risk mitigation tech- niques to encourage more provincial government financing. Many credit enhancing techniques can be used by governments to reduce investor concerns about repayment of their investment. Some of the more com- mon ones are briefly presented to give the government a sense of what investors internationally have accepted as risk mitigants to encourage them to finance subnational public infrastructure debt. The techniques are as follows: • Guarantee: a legally binding commitment by a central government, either 100 percent or partial, to pay debt service of a defaulting subnational govern- ment. Guarantees of this type increase a central government’s debt burden and count as contingent liabilities on their balance sheet. • Unlimited full faith and credit pledge: a contractual agreement by the subnational government (backed by clear legal authority) to repay its ­ 20 | Mobilizing Finance for Local Infrastructure Development in Vietnam debt  obligations from the first revenues generated by that subnational government and a commitment that they will raise fees and taxes to ensure ­ such debt is repaid. • Limited obligation pledge: a contractual agreement by a subnational govern- ment in which it requests additional budgetary resources to ensure that its debt obligations are repaid or pledged that it will make best efforts from any resources available to the subnational government to repay its debt obliga- tions (a nonbinding, moral obligation pledge). • Double barrel pledge: a contractual commitment to use two or more sources of revenue, such as the taxes collected by the subnational government and revenues from a specific user fee, to repay a subnational government debt obligation. • Recourse: a legally binding authority to intercept central government payments to the subnational government if it doesn’t repay its debt. This ­ cash stream is a valuable asset for subnational governments because these revenue streams can be used for credit enhancement, especially if the ­ payment streams are definable, regular, statutorily and formulaically established in law or policy, and are authorized for any subnational govern- mental purpose. Credit enhancement mechanisms have not been used for provincial govern- ment debt obligations in Vietnam, and there is no current regulation or guid- ance on using these risk mitigation tools. However, the value of credit enhancement has recently been accepted by the SBV and the debt capital mar- kets for a corporate bond issued by Masan Consumer Holdings. This develop- ment and the risk mitigation guidelines used by SBV for corporate debt issuances should enable the MOF and the SBV to move quickly to prepare risk mitigation and credit enhancement guidelines for provincial government debt obligations. The application of a reserve fund is not complex, but it is new to Vietnam officials. The complexity will come from the process of establishing the best coverage levels for the reserve fund and determining the amount of financing it can support. A reserve fund should be sized to help provincial government debt obligations get approval from private investors; it is not a full ­ guarantee, which would only distort any serious effort to perform a true credit analysis of provincial governments. Wholesale financing A wholesale financing facility (WFF) provides direct funding to commercial banks, which then on-lend to subnational governments to finance their infra- structure. A wholesale facility’s loans, especially if discounted, will crowd out private lending because the proceeds from the loans will become the only source of money that the commercial banks use to provide longer tenor loans to local governments. This would lead to a long-term need to capitalize the wholesale facility, as happened in Colombia, where the Findeter program took over 15 years to evolve and required multiple infusions of capital from the government and donors. The risk of this problem would be lowered if the wholesale facility’s loan to the bank is at market rate or if the facility requires the bank to commit a sig- nificant portion of its own assets to blend into a single loan to a subnational gov- ernment and allows the bank to charge normal commercial interest rates for its funds. In the Czech Republic, the WFF (MUFIS) downsized after 10 years once Overview of a City Infrastructure Financing Facility | 21 its debt capital market was able to provide financing for provincial government and corporate debt issuances. A wholesale facility is an attractive, short-term way to stimulate or jump-start private sector financing of a subnational government’s infrastructure needs, because the financing from the central government will be used by commercial banks as a long-term deposit, which can then be used to extend subnational gov- ernment loan tenors. It is also a way to develop risk mitigation or credit enhance- ment techniques for subnational government borrowing while using commercial bank loan preparation, review, risk mitigation, and approval processes to facili- tate financial discipline at the subnational government level. Ultimately this will enable subnational government access to capital market financing on a more sustainable basis with longer terms. Once started, however, a wholesale facility may become very difficult to ter- minate. Commercial banks are fundamentally short-term lenders with short- term depositors, whereas financing for infrastructure should be financed on a longer tenor basis to make costs more affordable to the borrower. This asset mis- match makes it unrealistic to expect the commercial banking sector to be the final financing solution for subnational government infrastructure financing in the long run. Ultimately, subnational government financing should be done in the Vietnam capital market. However, its incipient status dictates that interim solutions be sought. In this sense, commercial banks could fill a vacuum in the short term and contribute to building a subnational lending market. Their pres- ence in the market may contribute to developing more discipline about subna- tional government infrastructure financing with a goal to getting subnational governments ready to gain access to the capital market in the future. This would be a sustainable financing strategy for the country. A WFF may limit the achievement of the government’s goal of properly pric- ing and stimulating private sector investment in provincial government infra- structure if not designed carefully to safeguard moral hazards and long-term risks. Provincial governments around the world always look for the cheapest sources of funds to carry out their infrastructure programs. Provincial govern- ments will bring intense pressure on the government to use the funds in the wholesale facility like a grant or with deeply subsidized interest rates. If allowed, doing so would prevent the evolution of a credit culture in the provincial govern- ments and crowd out any hope of private sector lending. Also, if the wholesale facility is intended to stimulate private-bank lending, then WFF loans to com- mercial banks should be conditioned on the bank’s cofinancing each loan. The facility should be open to all qualified commercial banks that want to provide provincial government loans. If not, it will crowd out banks that are not on the WFF’s preferred list. A model of a CIFF with a wholesale function, which uses the government’s foreign loan ability, may not work without clarification or an appropriate amend- ment to Decree 78/2010. As mentioned earlier, the on-lending agency for the government’s foreign loans to provincial governments is always only the MOF itself. Thus, for a CIFF to be legally established, it is necessary to have (a) a clar- ification or an appropriate amendment of Decree 78/2010, allowing the estab- lishment of a CIFF with wholesale function or (b) an international loan treaty signed by the government or Finance Ministry and an international donor, such as the World Bank, allowing the establishment of a CIFF with credit enhance- ment function; or (c) a combination of (a) and (b) that allows the establishment of a CIFF with wholesale function and credit enhancement function. 22 | Mobilizing Finance for Local Infrastructure Development in Vietnam Potential structure of city infrastructure financing facility Each option has advantages and disadvantages associated with the government’s overall objective of expanding provincial governments’ access to private sector resources for their infrastructure programs (table 1.1). Among all the options explored for Vietnam to accomplish its private sector financing objective, a sound option would be for the national government to establish a WFF to make infrastructure loans to eligible provincial governments and, in addition, to set up a separate facility that would provide credit enhance- ment for the loans that are financed by the wholesale facility. The former would be structured to provide capital to make loans to qualified commercial banks and require the banks that want to develop a provincial government line of business to cofinance (that is, put their own capital at risk) each provincial government approvable loan. Simultaneously, the government could create a CEF, ex ante capitalized with a smaller amount of funding, to mitigate provincial government risks to the participating banks, thereby providing a subsidy for the provincial government borrower. The credit enhancement mechanism leverages private sector borrowing and revolves back to the facility at the end of the loan term to be used in other loan transactions. Because the government believes that new techniques should be subject to pilot testing before making permanent changes to its system, it would make sense to combine both the wholesale option and the credit enhancement option into a single initiative. TABLE 1.1  Comparison of Three Types of Financing Facilities ATTRIBUTES RFF CEF WFF Dedicated entity to manage Yes Yes Yes Managed by SPE Entity established in/outside Agency/department/PMU in/ of MOF outside of MOF Program focus Poorer/not fully creditworthy Creditworthy provinces Creditworthy provinces provinces Minimum expected timeline 3 years 2 years 2 years for setup New start-up capital injection Yes Yes Yes Leverage of private capital No Yes Yes, if commercial banks required to put in capital MOF oversight Yes Yes, limited Yes Credit risk SPE and provinces Creditworthy provinces Commercial banks Size of exposure 100% to MOF Creditworthy provinces 100% to banks Interest rate Established by SPE Market rate established Market rate established (with MOF oversight) by bank by bank Recycle repayments Possible, if allowed Yes Possible, if allowed Crowd out private investment Yes No Partial Encourage capital market No Yes Yes, if bank is required to lending cofinance loans New legal/regulatory changes Yes Yes Yes New skills required Yes Yes Yes Improvement of provincial No Yes Yes management Note: RFF = retail financing facility; CEF = credit enhancement facility; WFF = wholesale financing authority; MOF = Ministry of Finance; PMU = project management unit; SPE = special purpose entity. Overview of a City Infrastructure Financing Facility | 23 TABLE 1.2  Financing Options versus Government Objectives OBJECTIVE RFF CEF WFF Attract private-sector debt financing No Yes Maybea Increase infrastructure financing Yes Yes Yes Provide sustainable private-sector financing No Yes Maybea Separate central-government risk from provincial credit risk No Yes Yes a. "Maybe" becomes "yes" if the central government requires cofinancing from commercial bank funds. From an institutional perspective, this study’s findings indicate that the best solution is for the MOF to set up a CIFF with a wholesale and credit enhance- ment capability on a five-year pilot basis and to structure it into two separate units or divisions separately providing wholesale financing and credit enhancement. This entity should be established within the MOF (that is, as a ­ department or a project management unit) and would require the CIFF to be authorized under a decision of the MOF or a decision of the prime minister (or a decree of the government). Simultaneously, the MOF could form another sepa- rate unit dedicated to legal and regulatory reforms, as well as organize training and education programs to build the financial capacity of the provincial govern- ments and the banks. In summary, table 1.2 shows how the three financing options measure up against the government’s objectives outlined at the beginning of this book. The conclusions assume that all the legal, regulatory, and capacity-building efforts are implemented as recommended. The judgment of “maybe” in the table’s wholesale option is based on an uncertainty about whether the government will require cof- inancing by the commercial banks. If cofinancing is not required, then it is doubt- ful that the wholesale option will attract any additional private financing. CONCLUSION AND RECOMMENDATIONS FOR REFORM The enabling environment in Vietnam for provincial governments to obtain pri- vate sector funding for their infrastructure is weak. The government is perpetu- ally barraged by provincial government officials asking for more funding for their infrastructure needs from the central budget or ODA sources. The govern- ment responds to this annual demand by allocating resources from the central budget to help poorer provinces, but there is not enough to meet all the critical provincial demands. No one solution solves all problems. However, the glue that keeps things together is a strong, clear legal and regulatory framework for lenders and bor- rowers. The second part of that equation is to employ the expertise of all the people involved in financing so they can use the law and regulations properly, ensuring that they speak the same financial language and know how to prepare and evaluate bankable projects. A CIFF with a wholesale function and a credit enhancement function would meet the twin objectives of the Vietnamese government to mobilize more funds for provincial governments for infrastructure development and to develop the capacity of the commercial bank and debt markets for financing provincial gov- ernment infrastructure. For the implementation of the potential CIFF program, weaknesses in the legal and regulatory framework need to be addressed in future 24 | Mobilizing Finance for Local Infrastructure Development in Vietnam reforms, and capacity-building programs are needed for both the governments and the commercial banking industry. Ultimately, those would help lay the foun- dation for further development of provincial debt market for public infrastruc- ture investments in Vietnam. Legal and regulatory upgrades The current legal and regulatory framework must be upgraded to meet the gov- ernment’s financial objective. In general, this will involve a thorough review of the existing legal framework to identify all the rules that are now in place (an ex ante review), determine which inhibit borrowing, and revise them to unlock pri- vate sector financing whether or not the government establishes a financing facility. Chapter 4 in this book provides a legal and regulatory summary that is a good starting point for examining the current rules and identifying changes needed in several critical borrowing-related regulations, such as the following: • Change the debt cap on provincial borrowing, measured now as a percentage of capital spending. This changed in 2017 under the new 2015 SBL to a per- centage of provincial revenues. • Lengthen or remove the two-year limit on tenor for commercial bank loans to local governments. • Clarify that provincial financial liabilities are not central government liabilities. • Allow provincial governments to pledge revenues to pay debt service, estab- lish escrow accounts, and enter into overcollateralization agreements, among other capabilities. A new legal and regulatory framework needs to be developed to govern what happens after provincial-government debt is issued. Vietnam needs to establish a recourse mechanism to deal with the full range of rights and obligations of lenders and borrowers in the event of a default. This sensitive issue requires a great deal of collaboration and coordination within various levels of government, as well as with the private investor community. Commercial banks have made it clear that they need a legal recourse mechanism to get comfortable with provincial-­ government credit risk. The MOF staff at meetings conducted during the report period acknowledged that an ex post legal system is required. Mature countries like South Africa and the United States have established recourse mechanisms specifically for local governments, because they cannot go out of business. These legal recourse mechanisms have been used in the United States for the last few years because of the 2007–08 financial crisis and have provided an orderly method to handle some very dramatic and large defaults by US municipalities. The central government has moved directly to make some changes to laws and regulations to facilitate provincial government use of commercial bank financing. However, the typical approach of the government is to use pilot projects to demon- strate new ways of doing things before committing to scale up reforms, as was done with the LDIF and public-private partnerships programs. The government could develop a pilot financing facility to stimulate commercial bank financing of provincial governments and use it to request approval from appropriate govern- mental authorities for exemptions that would apply only to the approved pilots. For example, this would be the way to get clearance to initiate work on creating a recourse mechanism. Subsequently, the experiences of the pilot programs could be used to guide future changes in law and regulation. Overview of a City Infrastructure Financing Facility | 25 Increased financial management capacity For the provincial government, needs to commit money and time to extensively develop the financial knowledge and skills of the personnel in various central government and provincial government agencies. If they are to accept long-term credit risk, commercial banks will require high-quality and timely data and other information from provincial officials to enable banks to make informed and pru- dent credit decisions. Data at the moment are dated, unreliable, and even con- flicting. Among the provinces, this study found that annual deviations of up to 50 percent of actual expenditure against budget seem to be the norm rather than the exception. Financial management skills—specifically planning, budgeting, accounting, reporting, and auditing skills—will have to be upgraded to improve provincial governments’ financial management capacity. A capacity-building assistance program would be also needed at commercial banks and at central ministry agencies involved in finance and banking regula- tion. Bankers and their regulators need more formal education about provincial government finances, as well as different credit enhancement mechanisms and how they can be applied to mitigate risk in provincial government transactions. The banks need to develop a provincial government credit-assessment tool, and regulators and finance agencies need to develop standardized financial report- ing requirements to appraise the credit condition of provincial governments. NOTES 1. The 11 net contributing provinces are Ba Ria Vung Tau, Bac Ninh, Binh Duong, Can Tho, Da Nang, Dong Nai, Hai Phong, Khanh Hoa, Quang Ninh, Quang Ngai, and Vinh Phuc. Overall, there are three tiers of provinces and cities in Vietnam. The top tier comprises special cities with relatively good fiscal conditions and sufficient capacity to borrow from the bond market on their own, such as Hanoi and Ho Chi Minh City. The second tier in- cludes provinces that are net contributors of revenue to the government of Vietnam; how- ever, the provinces have limited access to funding for urban infrastructure. The third-tier provinces depend heavily on the central government’s transfers and have very limited creditworthiness. 2. MOF Budget Office meeting with World Bank staff and consultants, March 31, 2015. 3. This book was prepared before the new Law on Public Debt Management (LPDM) 2017, was approved (which goes into effect July 2018); therefore, the main discussion is focused on LPDM 2009. Draft LPDM was reviewed in the preparation of this book and does not substantially affect the discussion on the regulatory framework.  4. In the United States, most revenue bond issuers are required by investors to have a funded cash reserve equal to 10 percent of the par amount raised. To achieve higher credit ratings and to lower the interest rate on debt, some issuers fund reserves at a higher percentage of the par amount of bonds they issue. Reserve funds that exceed 30 percent of par generally are rated in the AA to AAA categories. 5. Briefly discussed in authors’ meeting with SBV and MOF on June 10, 2015, although regu- lations were not provided. REFERENCES Fitch Ratings. 2003. “Water and Sanitation Pooled Fund (WSPF).” India Public Finance Credit Analysis. Fitch Rating Services, New York. IEG Review Team. 2017. Vietnam-VN-Local Development Investment (LDIFP). Washington, DC: World Bank. Monitor Consulting. 2015. Assessment of Vietnam Banking Sector. Report. 26 | Mobilizing Finance for Local Infrastructure Development in Vietnam Moody’s Investor Services. 2014. Banking System Outlook, Vietnam. PWRF (Philippine Water Revolving Fund). 2011. Philippine Water Revolving Fund (PWRF) Support Program Final Report. Washington, DC: United States Agency for International Development. SBV (State Bank of Vietnam). 2014. “Vietnam’s New Regulation on Capital Adequacy and Liquidity of Credit Institutions.” Circular 36/2014/TT-NHNN. Hanoi: State Bank of Vietnam. World Bank. 2013. Assessment of the Financing Framework for Municipal Infrastructure in Vietnam. Washington, DC: World Bank. ———. 2014. “Ho Chi Minh City Investment Fund for Urban Development Project, 2007–12.” Implementation Completion Report Review, World Bank, Washington, DC. ———. 2015. Making the Whole Greater than the Sum of the Parts: A Review of Fiscal Decentralization  in Vietnam. Summary Report, World Bank, Washington, DC. http:​ //­d ocuments.worldbank​ .org/curated/en/389051468187138185/text/103669-v1-WP​ -P128790-v1-PUBLIC-FDR​-summary-FINAL-Oct6–15.txt. 2 A Demand-Side Analysis of the Provincial Governments Vietnam has experienced profound changes that have transformed the country in the past two decades. The nation’s transition to a market economy has been accompanied by economic growth that averaged around 7 percent annually between 1994 and 2016. Poverty has been drastically reduced as well, from 58.0 percent of the population under the poverty index in 1993 to 14.5 percent in 2008, and further down to 3.0 percent in 2017.1 Vietnam’s transformation also has been marked by rapid urbanization that offers unique opportunities for the country’s development. Since 1990s, the government of Vietnam has pursued a path of fiscal decentralization, which has given provincial govern- ments greater responsibilities in public finances and infrastructure development. A fundamental challenge for maintaining Vietnam’s high level of growth is the need to improve the affordability and efficiency of infrastructure investment. A major cause of investment inefficiency is the fragmentation of public infra- structure investment, which results in duplication and waste. In addition, Vietnam’s decentralized investment system faces the challenges of uneven administrative capacity at the local levels (provincial governments and smaller), insufficient accountability and transparency, poor coordination, and unpredictable availability of financial resources. Policy makers have an ­ ­ opportunity to correct these inefficiencies in infrastructure investment; that is, they can do more with the same amount of resources. The government’s current framework for municipal infrastructure invest- ment lacks a proper mechanism for providing clear, transparent, and effi- cient funding allocations from all available sources. Improving that framework would link the investment planning process at national and sub- national levels to reduce unnecessary fragmentation and competition among provinces. The World Bank report, “Assessment of the Financing Framework for Municipal Infrastructure in Vietnam” (World Bank 2013) recommends setting up a municipal development fund that could act as a specialized financing facility at the national level to enhance credit, guarantee service, and fund municipal infrastructure. Taking into account relevant interna- tional experience, the Vietnamese government and the World Bank also are  27 28 | Mobilizing Finance for Local Infrastructure Development in Vietnam exploring the establishment of a city infrastructure financing facility (CIFF) as a wholesale market instrument that would evolve into a full-scale entity that can facilitate local government borrowing from the private sector at market-related spreads. A growing number of provinces in Vietnam have attained the requisite ­ capacity to assume greater fiscal responsibility for financing their municipal infrastructure needs if the enabling environment is put in place to allow them to leverage private sector capital. Eleven so-called second-tier provinces, which are net contributors (excluding the two major cities of Hanoi and Ho Chi Min City) to the central government budget, consistently generate local revenues that exceed their recurrent expenditures. The resulting budget surpluses can be ­ leveraged to fund local infrastructure needs. This chapter has two objectives. First, it aims to analyze whether the ­provinces have sufficient effective demand to finance infrastructure by borrowing from a facility such as the CIFF. Three of 11 secondary provinces were selected for a closer assessment: Bac Ninh, Dong Nai, and Quang Ninh Province. The second objective is to (a) review some international practices, approaches, and ­ experiences of municipal governments that have attained subsovereign creditworthiness and (b) draw preliminary conclusions about creditworthiness ­ criteria and debt management. An assessment of the demand for financing must consider that provinces and cities that report directly to the central government have limited experience in long-term borrowing and are more accustomed to meeting their capital require- ments from their own resources: grants and short-term loans. Although some provincial governments have borrowed from commercial banks or the capital markets, for many, such transactions would represent a substantial change in how they operate. This chapter provides a preliminary review of the available pipelines for bankable projects in the three provinces visited, using the project information provided to the study team by the provinces. The projects are some that potentially could be implemented if funding, land, and approvals were in place. The research assessed sustainable debt levels and constraints at both the central and provincial levels, using the three provinces as pilots for the assess- ment of possible overall demand. MACROECONOMIC AND DEVELOPMENT CONSIDERATIONS The International Monetary Fund (IMF) issued a press release in late 2014 with the following description of Vietnam’s economic status: Economic performance has improved over the last year and the economic recovery is taking hold, although domestic activity remains weak, in part constrained by weak banks and inefficient state-owned enterprises (SOEs). Inflation has declined, the current account remains in large surplus, and international reserves have increased. The authorities place a priority on preserving macroeconomic stability, tackling banking sector vulnerabilities, and reforming SOEs, though implementa- tion has been gradual in some key areas. Outlook and risks: Growth is projected to recover gradually over the coming years, with the current account returning to a deficit and inflation contained. On current policies, public debt is projected to reach 60 percent of gross domestic product (GDP). Risks include weaker trading partner growth, geopolitical A Demand-Side Analysis of the Provincial Governments | 29 tensions, slow structural reforms, and delayed fiscal consolidation. Early conclu- sion to key trade negotiations would be growth-positive. Fiscal policy: Deficits have been sizable and rising public debt requires attention. A medium-term growth-friendly consolidation is recommended, ­ based on enhancing revenue and rationalizing unproductive expenditures while preserving crucial social and capital spending. This would ensure public debt sustainability with space to address contingent liabilities from banking sector and SOE restructuring. Banking sector reform: Several policy measures have been taken recently, but the overall gradual approach will likely continue constraining credit growth and keep the system susceptible to shocks and significant asset deterioration. A more expeditious recognition of nonperforming loans, bank restructuring and orderly resolution would support robust credit creation and macro-financial stability (IMF 2014, 1). Vietnam’s real GDP growth for 2014 was 5.5 percent with an estimated 5.6 percent for 2015, and the consumer price index was 5.2 percent in 2014 with a projection of 5.0 percent for 2015. Per capita GDP, according to Fitch bond ratings, was D 4,0162,000 (US$1,868), and GDP was D 3,676 trillion (US$171 ­billion). In 2014, Vietnamese bonds were given ratings of BB- by Standard & Poor’s, BB- by Fitch, and B2 by Moody’s. Mirroring the IMF statement, the Fitch rating reports of November 2014 rec- ommended the following measures for improving the state of Vietnam’s econ- omy: (a) manage fiscal deficits, (b) make contingent liabilities more transparent, (c) further reform the thinly capitalized banking sector, (d) show estimated SOE debt as aggregated instead of fragmented, (e) pursue SOE reform more vigor- ously, and (f ) focus policy on increasing stability and maintaining stable inflation. According to the United Nations Development Programme (UNDP) (2013) only 4.2 percent of the population lived in multidimensional poverty, while an additional 7.9 percent were vulnerable to multiple deprivations. The Human Development Index value for 2012 was 0.617—in the medium human develop- ment category—positioning Vietnam at 127 out of 187 countries and territories (UNDP 2013). These statistics point to two factors that could affect the creation of a CIFF. First, if Vietnam continues its economic growth, its status will change from a lower-middle-income country to an upper-middle-income country, probably in the next decade. That change would have a significant effect on official development assistance (ODA), giving the government a limited time to carry out externally supported reforms and to improve institutional arrangements and reforms. Vietnam depends to an extent on ODA, but both the quantity and structure of the assistance are likely to change as the balance between loans and grants changes and becomes predominantly loan based. Second, the level of government debt is estimated by the World Bank to be approaching the maximum level—65 percent of GDP—set by the National Assembly. To manage this debt increase, the government could again curtail capital programs as it did in 2011, which could place a ceiling on borrowing by provincial authorities. In 2010 the government of Vietnam prepared a Socio-Economic Development Plan (SEDP) for the period 2011–20, which articulated the following growth strategy goals (World Bank 2015): (a) keep average GDP growth at 6.5–7.0 percent, (b) target social investment at 33.5–35.0 percent of GDP, (c) keep the budget 30 | Mobilizing Finance for Local Infrastructure Development in Vietnam deficit below 4.5 percent after 2015, (d) do not allow government and national debt to exceed 50 percent of GDP, (e) keep the consumer price index at percent, and (f ) keep urban unemployment below 4 percent by 2015. 5–7 ­ The following are some of the SEDP strategies the government aimed to apply for the 5 years starting in 2011: • Restructure public investment, first targeting investments sourced from the state budget and government bonds, by modifying the regulation on manage- ment decentralization. The restructuring will maintain the principle that investment should go only to projects that go through the required proce- dures and only when capital sources, capital level, and capital balancing capacity are clear. • Without delay, determine the criteria and priority order that will be the basis for approving or rejecting investment projects. • Restructure the financial market, focusing on the commercial banking system and financial institutions. • Continuously strengthen the public investment apparatus of the central gov- ernment and local governments at all levels, and pilot an urban government model without delay. Unfortunately, the SEDP goals for the 5 years 2016–20 are not yet quantified to the same level of detail and do not provide additional guidance. The statistics cited earlier indicate that economic growth will continue and that the Human Development Index will show continuous improvement; how- ever, the central debt, which is approaching the maximum target, may slow eco- nomic growth. Policy makers should therefore explore other means to address the substantial need for investment and to stimulate the flow of private sector resources for funding infrastructure. INSTITUTIONAL FRAMEWORK Assessing the needs, constraints, and challenges of local government infrastructure financing requires an overview of the state administrative structure. Vietnam is a unitary state divided into provinces and cities under the direct control of the central government. It has five tiers of government: the cen- tral government; 58 provinces; five cities that fall under the direct control of the central government; about 680 districts; and about 11,000 communes. Each of these entities has both legislative and executive authority. At the central govern- ment level, legislative authority rests with the National Assembly, and executive authority rests with line ministries and agencies. At the local level—­ provincial and below—each tier of government has People’s Councils to exercise legislative authority and people’s committees and line departments to exercise executive authority. In some instances, the People’s Councils are being abol- ished, and the positions of party secretary (of the council) and chairman of the People’s Committee have been merged. Hanoi and Ho Chi Minh City are regarded as ­special cases, with higher authorities. That is, the cities have a higher degree of independence and decision-making capacity, and because they have some market access already, they are not included in this assessment. In a strictly legal sense, the provinces and cities are branches of the central government that have budget implementation responsibilities. Provinces are responsible for all municipal trade services, such as water, sanitation, and solid A Demand-Side Analysis of the Provincial Governments | 31 waste removal, as well as public transport, roads, education, health, and eco- nomic development. Most provinces have their own water and sanitation ­utilities (although sanitation is a hugely neglected sector). They have some input into setting tariffs, but they mostly maintain the tariffs well below the centrally authorized national limits. Electricity is provided and distributed by a state- owned company, Vietnam Electricity Company (EVN), and other state-owned entities, but provinces buy some of their electricity from independent suppliers. BUDGET PROCESS AND FISCAL RELATIONSHIP BETWEEN THE CENTRAL AND PROVINCIAL GOVERNMENTS Budgets of local authorities are prepared and submitted through a bottom-up process in which local legislatures review and appropriate funds for the local budgets before submitting them to the central government. The national legis- lature ultimately adopts a state budget for the entire country by consolidating the central and local budgets. Provincial budgets are an integral part of this unitary budget, but they have more decentralized spending (Albrecht, Hocquard, and Papin 2010). The process has been regulated by the State Budget Law (SBL), which regulates the relationships between the different government levels. The 2002 SBL was revised in 2015; the new SBL took effect January 1, 2017. This nested budget approach is unique to centralized economies, and it cre- ates ambiguity in terms of responsibilities for execution. However, the responsi- bility for managing budget expenditures is largely decentralized to the provinces, with the provision that the budget as implemented should comply with the approved state budget (although substantial discretion to adapt the budget is generally accepted). The provinces’ capacity and ability to develop their own source revenue is very unequal. The SBL incorporates a redistribution system to equalize revenues, with richer provinces contributing more to the central gov- ernment, which in turn makes grants to the poorer provinces. Local authorities in Vietnam are responsible for over half of total government spending (table 2.1). Those expenditure shares are executed directly by TABLE 2.1  Summary of Budget and Expenditures at Central and Local Levels D, TRILLIONS US$, BILLIONS Total state budget 816 38 Total state expenditure 978 46 Total deficit 162 8 Local budget 490 23 Official development assistance 105 5 Recurrent expenditure (central level) 337 16 Recurrent expenditure (local level) 322 15 Capital and development investments 82 4 (central) Capital and development investments (local) 93 4 Source: Ministry of Finance. Vietnam Budget 2012-13. Numbers are rounded. 32 | Mobilizing Finance for Local Infrastructure Development in Vietnam provincial, district, and communal authorities out of revenues raised and retained within their jurisdictions and out of transfers from the upper levels of government. Therefore, local authorities have played a significant role in provid- ing services that reduce poverty in the country. The central government is still responsible for large national-level projects, and some of the recent increases reflect stimulus spending to address the effects of the 2008 global economic crisis. The economic stimulus measures adopted after the crisis resulted in overheating of the economy and high inflation and led to the curbing of capital spending in October 2011 (Prime Minister’s Instruction 1792/CT-TTg, dated October 5, 2011). Nonetheless, local authorities now have more direct responsibility for capital spending, and the only borrowing that is allowed is for capital spending. The budget cycle and consolidation process is slow, with final figures not required until 14 months after year-end and financial data not available often 18–20 months after year-end. This deficiency in the budget system renders inef- fective the use of actual expenditure as a management tool. Budgeting and per- formance tracking against the budget do not occur regularly, and the existence of a  large number of SOEs and extrabudget funds makes a full assessment difficult. PROVINCIAL FINANCIAL PERSPECTIVE Local revenue is divided into two categories: income retained by the prov- inces and income shared with the central government. Income that is 100 percent retained by the provinces includes land and housing taxes and regis- tration fees on the natural resources tax, licensing, transfer of land use rights, and sale of state property. Income shared with the central government includes value added tax (except value-added tax—VAT—on imports), corpo- rate income tax (except uniform accounting), personal income tax, special consumption tax on domestic goods and services, and environmental protec- tion tax. The sharing ratio established for each 5-year stabilization period defines the proportion of shared revenue that is retained by the province. The central government retains 100 percent of some revenue, including VAT on imports, import and export taxes, revenue from petroleum, consumption tax on imports, and corporate income tax (with uniform accounting). Other sources of provincial funding include intergovernmental transfers from the central government, as a distribution component (not applicable to all prov- inces); tariff and tax income (own revenue); income from land transactions; borrowing; ODA income; and private-public partnerships (PPPs). Provinces that have a higher level of income contribute to the state budget using a shar- ing formula. The central government in turn makes unconditional transfers to less affluent provinces and earmarks funds to targeted national programs in provinces. Provincial authorities can supplement their ability to undertake capital projects by borrowing, and they have borrowing power for projects con- tained in the state budget. However, the province must maintain a balanced budget. Provinces and their SOEs can currently tap the following sources to borrow: (a) Treasury for short-term loans not exceeding 1 year, A Demand-Side Analysis of the Provincial Governments | 33 (b)  on-lending from central government or ODA FIGURE 2.1 f unding,  (c) the Vietnam Development Bank (VDB), ­ Sources of Provincial Debt, Year-End, 2012 state-owned and commercial banks, and (e) bond (d)  ­ Borrowing from other sources, issues to tap the capital markets. On-lent from 3% Based on the most recent data available, 51 provinces central government incurred some debt in the period of 2006–12 (World Bank external loans, 2014a). The provincial debt financing remains driven by 8% central government financing, with local bond issuance accounting for less than 30 percent of total provincial debt Local Borrowing from (figure 2.1). Provincial debt amounted to 1.3 percent of GDP, Vietnam Bank government and the share of the five biggest cities was 50 percent. bond issue, for Development, 38% Commercial bank debt has been limited up to now, at least 22% until 2015. All provincial borrowing requires approval from the cen- tral government, which monitors compliance with the Borrowing from thresholds. Such debts are closely monitored by the Ministry State Treasury, of Finance (MOF) under the SBL ceilings and are usually 29% considered as on-budget borrowing, although that designa- Source: World Bank 2014a. tion is not reflected in the budget. The 2002 SBL placed a ceiling on borrowing by provinces under Clause 26(g), as follows: The mobilized capital debit balance at the time of submitting the plans and the debit balance if the plans are approved must not exceed 30 percent of the annual domestic capital construction funding of the provincial-level budget, excluding investment capital supplemented according to objectives of a non-regular stability nature from the central budget to the provincial-level budget. That rule set the ceiling of total outstanding debt at 30 percent of the capital expenditure in a given year, and a letter from the State Bank of Vietnam (SBV letter 576, May 8, 2015) restricts the borrowing tenor from commercial banks to 2 years. Taken together, these two rules severely limit borrowing by the prov- inces. In most creditworthy provinces, the debt service ceiling would probably be far below the sustainable level. Short-term debt makes sense for provinces because it allows them to make maximum use of their limited spending flexibility. However, short-term borrowing and bond issues are unsuited for funding infrastructure with an economic life of 15–20 years. The implication of the current debt ceiling is that total borrowing would be restricted to approximately 9 percent of a province’s own total revenue, given that the capital expenditure would account for an average of 30 percent of provincial budgets, regardless of what the province could afford over the long term. The 2015 SBL recognized this limitation, and the MOF recommended that the National Assembly amend the restrictions in the following ways: (a)  total debt must not exceed 60 percent of previous years’ revenue in the case of Ho Chi Minh City and Hanoi; (b) total debt must not exceed 30 percent of previous years’ revenue for provinces in category 22; and (c) total debt must not exceed 20 percent of previous years’ revenue for provinces in category 3. The amendment will create more spending flexibility but will also require more financial discipline and better budgeting to ensure that 34 | Mobilizing Finance for Local Infrastructure Development in Vietnam incurred debt remains sustainable. Allowable debt stock for category 2 provinces would increase from approximately 9 percent to 30 percent of revenue, depending on the percentage of recurrent expenditure in total revenue. The 2015 SBL provides for the creation of small reserves at both the central and provincial levels. Those reserves are sometimes used as bridging loans. Given a single central budget, the credit risk of all debt incurred by provincial governments can actually be viewed as central government debt, at least at the credit exposure level. That view was confirmed by this study’s consultation with Agence Française de Développement (AfD): according to the Vietnamese consti- tution, there is only one state and one budget (Albrecht, Hocquard, and Papin 2010). The only exception would be debt from limited recourse projects with ring-fenced income streams. The study found limited evidence that recourse instruments were being used at scale, but this instrument could be used more widely in the future. METHODOLOGY Ideal approach To determine possible effective demand for infrastructure funding and to  identify the funding gap, the study team should create a development plan  and the associated funding plan. That approach would entail the following: • Analyze the historical trends in income, expenditure on capital backlogs, expenditure on economic backlogs, and so forth in the province. • Design a long-term development plan that identifies (a) backlogs in infrastructure, (b) the balance between social and technical infrastruc- ture to promote and support growth, (c) expected urbanization rate, (d) predicted economic growth rate, (e) predicted inflation rate in the con- struction industry, and (f ) poverty-reduction goals and subsequent improvement in the quality of life that enhances the requirement for services. • Design the long-term capital investment plan in alignment with the financial plan, including identifying multiyear projects. • Develop a financial plan that is consolidated with the capital investment plan and that articulates (a) predicted economic growth and increases in revenue, (b) revenue increases due to increased rates and taxes, (c) predicted inflation rate, (d) composition of and increases in recurrent costs, (e) prudent liquidity reserves, (f ) existing debt, (g) likely market conditions, (h) statutory con- straints, and (i) market constraints on borrowing (that is, solvency ratios, debt service cover, and so on). The financial plan in the last step would then translate into a funding plan that matches projects with the most appropriate instrument and funding source. Those sources might be ODAs, provinces’ own resources, or borrowing, and they are used when determining a fund’s mobilization plan. This study did not allocate sufficient resources to undertake primary research to determine the size of provinces’ effective demand for infrastructure funding. It therefore accepted the projections provided by the provinces, despite the A Demand-Side Analysis of the Provincial Governments | 35 possibility that the data may be deficient. Because final accounts in provincial governments are available only after 18–20 months, actual data for the period 2012–14 were collected for this study. Basic research approach as adopted The methodology used in this study aims to establish a potential range of effec- tive demand for infrastructure funding to assess the need for infrastructure on a national basis. The study first investigates what financial constraints might be imposed by the government of Vietnam’s macroeconomic policy, the govern- ment’s planned actions, or the current public debt levels that would inhibit pro- vincial borrowing more than the statutory restrictions contained in the SBL. Those findings are based on whether public debt is at a level at which the central government could restrict provincial borrowing. Once the study team makes those assessments, the projected sustainable debt levels for the three sample provinces can be analyzed. The method’s analytic approach first assesses the debt capacity and then superimposes other constraints to assess effective demand. Three of eleven provinces for analysis—Quang Ninh, Bac Ninh, and Dong Nai—which would serve as indicators of what the effective demand could be. That demand is determined by using affordability and sustainable debt levels based on the provinces’ own projections of their financial position, and not by considering the credit see-through that might result from the unitary budget. Further, the analysis used statutory constraints imposed by the 2015 SBL, which uses a total debt stock ceiling of 30 percent of the previous year’s revenue for s econd-tier provinces. The debt capacity for the second-tier provinces ­ under  the 2002 SBL was set at 30 percent of capital expenditure in a given year, which limited the conditions to less than what is allowable under the new SBL. Analytic methods The study used two analytic methods: free cash flow (FCF) and debt sustainabil- ity analysis (DSA). Free cash flow analysis FCF analysis is often used by commercial lenders to supplement the ratio tests.3 The methodology is based on at least a 10-year view. The main numeric assump- tions used in this study are as follows: • The analysis period was set at 10 years because it is the minimum that is nor- mally used for infrastructure projects. • Loan terms were set at 2 years in 2016, with tenor increasing to 7 years by 2020. • All loans were regarded as amortizing, on the assumption that bonds would be matched with sinking funds. • An additional 3 percent of the capital program was added annually to the recurrent costs. • To avoid duplication, debt calculations were based on the capacity of the previous year being used in the following year. ­ 36 | Mobilizing Finance for Local Infrastructure Development in Vietnam The projected annual operational surplus (revenue minus recurrent expen- diture) is viewed as available for discretionary allocation. Discretionary reve- nue can be used to service debt or can be invested in the capital program. Any unforeseen reduction in revenue or an unexpected increase in operational and maintenance costs can normally be accommodated by a corresponding reduc- tion in the annual direct capital investment (the discretionary component), providing a substantial risk buffer. This protection would pose a challenge only if all capital expenditure covered multiple years, eliminating the flexibility of the discretionary component, or when fixed recurrent expenditure grows to a level at which the risk of having insufficient discretionary funds available becomes real. The analysis assumed that all discretionary income (after adjusting for the cumulative impact of existing and previous-year borrowing) will be used to borrow annually. Any statutory or regulatory constraints will be superimposed, and the maximum borrowing capacity in any year will be adjusted accordingly. In practice, of course, actual borrowing will be less concentrated and the cash flow managed more circumspectly and smoothly. FCF is a good quick method of determining the maximum debt that can be borrowed sustainably while complying with statutory requirements. The results in practice are tested against the normal ratios applied by lenders to ensure that no breaches of the particular lender’s credit conditions occur (normally mostly by a ratio analy- sis). The tests would include debt coverage ratios, liquidity tests, and other measurement tools. The FCF analysis provides reliable maximum debt absorp- tion capacity if the projections of both the revenue and the recurrent income are reasonable. Debt sustainability analysis The second analytic method used in the study, DSA, is based on macroeconomic criteria and ratios. The DSA tests the current and potential financial position against certain criteria to assess the fiscal capacity of the province to take up debt on a sustainable basis. The analysis uses a set of ratios based on gross regional domestic product (GRDP) to assess how the province’s current debt and poten- tial future debt will affect its future ability to service its debt. The first step in such an analysis is to set a baseline scenario on how selected macroeconomic and debt variables might evolve. The indicators and variables normally used are (a) real GRDP growth as a basis, (b) solvency ratio expressed as debt exposure to GRDP (norm of 25 percent), (c) liquidity ratio expressed as debt service to local revenue (norm of 25 percent), (d) fiscal sustainability ratio expressed as interest to recurrent spending (an acceptable norm often is 10–15 percent), (e) primary fiscal deficit, and (f ) ratio of local revenue to recurrent expenditure (in excess of 1). The DSA assesses compliance with these nonabsolute norms, not to calculate quantitative sustainable debt but to form a view of the sustainability of the debt under certain projected scenarios and the degree of fiscal space remaining. As used in this study, the DSA was intended to confirm or adjust the sustainabil- ity of the quantified levels as calculated in the FCF approach. Application of analyses to provincial data This study applied the FCF and DSA analyses described to the data supplied by the provinces to determine the sustainable levels of debt and trends in the finan- ­ omponents cial data that may affect financial creditworthiness. The most critical c A Demand-Side Analysis of the Provincial Governments | 37 of any province’s debt sustainability are its economic base and its projected growth, as well as the projected increase in revenue and the rate at which recur- rent expenditures are increasing. Using the information supplied by the three provinces, the analyses assessed the potential pipeline of infrastructure projects to form a view of the size, sector, and state of readiness of each project. This book discusses the potential that the other provinces would be contributing to the central government using the financing facility, and the potential that they are not contributing to the central government but are receiving transfers from the central government and using the facility. The study also identifies other entities that potentially could use the financing facility. The final step analyzes the aggregate information of the 11 provinces. The assessment identifies the nonfinancial provincial constraints that could inhibit the provinces’ use of the financing facility and estimates the potential range of effective demand from all the factors discussed in this section. EFFECTIVE DEMAND: NATIONAL PERSPECTIVE ON THE NEED FOR INFRASTRUCTURE The amount available for infrastructure development from both public and private sources totals only D 344 trillion (US$16 billion) annually, resulting in a shortfall of D 193.5 trillion (US$9 billion) each year (World Bank 2013). Whether inflation, rapid urbanization, economic growth, and provision for rehabilitation and refur- bishment are included in these figures is not clear, but at a macro level they repre- sent a huge demand for infrastructure funding. Such findings are not unexpected for a developing economy, and it is clear that the resources of the public sector will be incapable of satisfying this demand, even with substantial ODA. If the provinces had the capacity to implement infrastructure projects, the annual D 193.5 trillion (US$9 billion) gap in funding might be closed by addi- tional borrowing, for example, at a weighted average of 5 percent annually over a 10-year term. There is concern that public debt is already approaching the maximum level set by the National Assembly. However, the curtailment of pro- vincial borrowing as a result of uncontrolled public debt expansion may not likely occur given the general short tenor of subnational debt (generally within 24 months) and an approximately 6–7 percent GDP annual growth projection through 2019. Furthermore, not all infrastructure projects are paid for by central or local gov- ernment, so some of the required funds could come from the private sector through companies created by the provinces. Because provinces are responsible for 75 per- cent of government spending on infrastructure (World Bank 2014a), funding through the private sector would help in situations in which provincial capital expenditures were severely curtailed, as they were in 2011, when the central gov- ernment reined in inflation and cooled down the economy by slowing down investment in infrastructure (Prime Minister’s Instruction 1792). Repeating such action could negatively affect the effective demand of provinces for infrastructure expenditure. Quang Ninh province analysis Quang Ninh is a coastal province bordering on China and the Gulf of Tonkin (map 2.1). The economy is still largely based on agriculture but has a high 38 | Mobilizing Finance for Local Infrastructure Development in Vietnam MAP 2.1 Vietnamese Provinces 102°E 104°E 106°E 108°E 110°E VIETNAM CHINA CITY INFRASTRUCTURE FINANACING FACILITY ASA Ha Cao Bang Giang 4 5 MAJOR ROADS Ho Lao Cai Lai Chau Town ng 9 PROVINCE CAPITALS 1 3 (Re 8 Bac Can 22°N d) 10 22°N Tuyen 7 Lang Son NATIONAL CAPITAL Quang 2 Yen Bai Thai Nguyen Da 13 PROVINCE BOUNDARIES Son La Viet Tri 12 Bac Giang B la Vinh Bac Giang Dien VinhYen ( ck) 11 Yen 14 15 INTERNATIONAL BOUNDARIES Bien Phu Bac Ninh 6 HANOI 17 Hai HaiDuong Duong Ha Long Hoa Binh Hung 18 16 Yen 19 Hai Phong Hung Yen 21 20 Ha Nam 22 23Thai Binh PROVINCES M Ninh Ninh Binh Nam Dinh a Binh 24 25 20°N 1 Lai Chau 32 Da Nang 20°N 26 2 Dien Bien 33 Quang Nam LAO Thanh Hoa PEOPLE’S Gulf 3 Lao Cai 34 Quang Ngai 4 Ha Giang 35 Kon Tum DEM. REP. of Ca 27 5 Cao Bang 36 Gia Lai Tonkin Hainan I. 6 Son La 37 Binh Dinh (China) 7 Yen Bai 38 Phu Yen Vinh 8 Tu Yen Quang 39 Dak Lak 9 Bac Kan 40 Dak Nong 28 Ha Tinh 10 Lang Son 41 Khanh Hoa Me 18°N 18°N ko 11 Phu Tho 42 Binh Phuoc g n 12 Vinh Phuc 43 Lam Dong 13 Thai Nguyen 44 Ninh Thuan Dong Hoi 29 14 Bac Giang 45 Tay Ninh 15 Quang Ninh 46 Binh Duong 16 Ha Noi 47 Dong Nai Dong Ha 17 Bac Ninh 48 Binh Thuan 30 18 Hung Yen 49 T.P. Ho Chi Minh THAILAND Hue 19 Hai Duong 50 Ba Ria-Vung Tau 31 20 Hai Phong 51 Long An 32 Da Nang 16°N 16°N 21 Hoa Binh 52 Tien Giang 22 Ha Nam 53 Dong Thap 33 Tam Ky 23 Thai Binh 54 Ben Tre 24 Ninh Binh 55 An Giang 25 Nam Dinh 56 Vinh Long Quang Ngai 34 26 Thanh Hoa 57 Tra Vinh 27 Nghe An 58 Kien Giang 35 28 Ha Tinh 59 Can Tho Kon Tum 29 Quang Binh 60 Hau Giang 37 30 Quang Tri 61 Soc Trang 14°N 14°N Pleiku 31 Thua Thien Hue 62 Bac Lieu 36 Quy Nhon 63 Ca Mau 38 Ba Tuy Hoa 39 CAMBODIA Buon Ma Thuot 40 41 Nha Trang Gia NghiaDa Lat 12°N 12°N 42 Dong 44 Xoai 43 M Phan Rang- 45 Thap Cham ekong VIETNAM Tay Ninh Thu Dau 46 47 48 Mot Bien Hoa Phan Thiet Ho Chi Minh City 49 53 51 55 Cao Lanh Tan An 50 Long Xuyen 52 My Tho Vinh Long Ben Tre Vung Tau Phu 59 56 54 10°N 10°N Quoc Rach Gia Can Tho 58 Tra Vinh lta 60 57 Vi Thanh De 61 Soc Trang ng Gulf ko 62 Me of Ca Mau Bac Lieu 0 50 100 150 200 Kilometers Thailand 63 0 50 100 150 Miles IBRD 43227 I FEBRUARY 2018 104°E 106°E 108°E A Demand-Side Analysis of the Provincial Governments | 39 potential growth in the mining, tourism, and industrial sectors. In 2013 the population was estimated at 1,200,000, and GRDP was an estimated D 77.441 ­ trillion (US$3.6 billion). Province officials project population growth to continue at about 1.25 percent per year. Gross regional domestic product GRDP is a simple proxy that reflects the strength of the economic base. It is an important indicator because of the implied correlation between GRDP and the potential revenue that can be collected by the province. In this analysis, provin- cial authorities were optimistic about the province’s growth potential, basing their expectations on its growing trade with China and its mining and tourism potential. Quang Ninh officials projected strong provincial growth of around 15 percent, with the exception of 2014–15, when GRDP data as provided by the province indicated lower growth (figure 2.2). That drop was apparently caused by the conversion to a different base year and not by an economic decline. The predicted growth rates were used in the assessment of sustainable debt; how- ever, debt may not increase given the national average GRDP growth rate of 6–7 percent annually. Revenues The ratio of revenue to GRDP is important because it indicates the extent to which revenue is optimized. The ratio normally would follow the GRDP trend (figure 2.3). The projected economic growth rate exceeds the annual population growth rate, which averages 1.25 percent. That growth again implies a relatively sharp rise in GDP per capita and will probably result in an increase in the quality of services demanded as disposal income increases. The estimates provided by Quang Ninh, however, show the proportion of reve- nue collected declining relative to GRDP and do not reflect the strong GRDP growth. Revenue growth as shown in figure 2.4 remains relatively flat around FIGURE 2.2 Projected Gross Regional Domestic Product Growth, Quang Ninh Province 300,000 30 250,000 20 200,000 10 D, billions % GRDP 150,000 0 100,000 –10 50,000 –20 0 –30 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 GRDP in D, billions GRDP growth, % Source: Quang Ninh Province. 40 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.3 Ratio of Actual and Projected Revenue to Gross Regional Domestic Product, Quang Ninh 25 20 % revenue to GRDP 15 10 5 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual Projected Source: Quang Ninh Province. FIGURE 2.4 Actual and Projected Revenue, Quang Ninh 18,000 16,000 Revenue, D, billions 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual Projected Source: Quang Ninh Province. 5 percent, compared with the strong 15 percent GRDP growth shown in figure 2.2. If the estimates are correct, they would indicate either that tax rates have decreased or efficiency has increased or that the fiscal approach adopted is very conservative. In addition, the sharp drop in GRDP observed in 2015–16 does not affect the reve- nue. Figure 2.3 shows a conservative approach to estimating revenue. Recurrent expenditure Recurrent expenditure is an important dimension because it determines the proportions of revenue that are committed and those that are discretionary figure 2.5). Increases in recurrent expenditure are a normal occurrence as local (­ governments mature and aging infrastructure requires more maintenance. The decrease in actual recurrent expenditure from 2012 to 2014 reflects the rise in revenue, with the expenditure remaining relatively steady. However, the sharp rise in the percentage of recurrent expenditure in later years is disturbing and will negatively affect the province’s creditworthiness. When recurrent expendi- tures reach 80 percent of GDP, the potential for new borrowing will be lowest. Budgeted capital program The projected capital expenditure indicates a decline after 2015. This estimate may be a function of the province’s underdeveloped future planning capacity, A Demand-Side Analysis of the Provincial Governments | 41 FIGURE 2.5 Ratio Recurrent Expenditure to Revenue, Quang Ninh 90 Recurrent expenditure to total budget, % 80 70 60 50 40 30 20 10 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual ratio Budget ratio Source: Quang Ninh Province. FIGURE 2.6 Actual and Budgeted Capital Expenditures, Quang Ninh 7,000 350 6,000 300 5,000 250 D, billions D, billions 4,000 200 3,000 150 2,000 100 1,000 50 0 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual 5,740 6,036 4,944 n.a. n.a. n.a. n.a. n.a. n.a. Capital investment in D, billions Planned n.a. n.a. 4,944 6,329 3,210 3,182 3,143 3,117 2,996 Actual 267 281 230 n.a. n.a. n.a. n.a. n.a. n.a. US$, millions Planned n.a. n.a. 230 294 149 148 146 145 139 Source: Quang Ninh Province. Note: n.a. = not applicable. its wait-and-see attitude, or a decreasing capital budget due to the increasing recurrent expenditure (figure 2.6). The planned investments program is estimated at D 21.977 trillion (US$1.022 billion). It is based on the master plan prepared by McKinsey, consultants who generated a list of priority projects that have a total value of D 227.505 trillion (US$10.5 billion), or 10 times the value of the planned investment program. The master plan includes 69 economic projects (casinos, golf courses, a commercial complex, and industrial parks) of D 158.140 trillion (US$7.3 billion) that would generate income. Those income-generating projects would be funded through PPPs, a local development investment fund, SOEs, and private developers, which together would reduce the capital expenditure needed to D 69.365 trillion (US$3.2 billion). 42 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 2.2  Capital Expenditures for 204 Infrastructure Projects, Quang Ninh PROJECT EXPENDITURES D, MILLIONS US$, MILLIONS Total 20,370,143 964 Average 103,139 4.97 Maximum 1,198,128 55 Minimum 1,316 0.06 Source: Quang Ninh Province. The project list submitted by the province still amounts to D 20.37 FIGURE 2.7 billion (US$964 million), and the plan is to fund that amount mostly Composition of Capital Program, Quang Ninh from the province’s own resources, with some borrowing. The prov- ince’s emphasis on economic projects probably implies that some of Transport, 29% them will also eventually be undertaken as PPPs or by developers. The analysis also notes that the province’s projected decline and sta- bilization of expenditure after 2016 are also not realistic for a growing province. However, the lack of more realistic estimates is ascribed to the fact that planning probably has not progressed to a level at which Health, detail could be recorded in the budgets. Economic, 0.5% Unfortunately, the information submitted gave no indication of Education, 69.5% longer-term planning incorporating all services. Also, details of the 1% services to be delivered by the SOEs could not be obtained. The pro- vincial authorities indicated that projects in housing and municipal Source: Quang Ninh Province. infrastructure would be done by developers, with no estimate of an impact on the province’s financial situation. The characteristics of the projects are shown in table 2.2. and figure 2.7. Borrowing history Quang Ninh’s experience borrowing for capital projects includes borrowing from the VDB for rural infrastructure. The province has also issued bonds for highway construction of D 800 billion (US$37 million), with a 3-year maturity to 2016, and for the construction of a hospital of D 150 billion (US$7 million). The bond issuance shows that the province has some experience dealing with banks and bond issues. Quang Ninh has also planned further debt and bond issues as shown in table 2.3. Quang Ninh authorities indicated that they requested the central govern- ment to provide a guarantee to the water utility but that the central govern- ment will not provide subsidies.4 That condition should have created a contingent liability that will affect the province’s creditworthiness and debt absorption capacity. However, it was not possible for the analysis to establish the extent of the contingent liabilities, and they have not been considered in the quantification of debt absorption capacity. However, the central govern- ment indicated that the contingent liability rests with the central govern- ment and not with Quang Ninh province. Projected debt absorption according to the free cash flow approach Using the FCF approach, the analysis calculated the debt and capital program for Quang Ninh province as shown in figure 2.8. The initial variations are largely due to existing loan redemptions. The total cumulative sustainable debt amounts to D 57.168 trillion (US$2.658 billion) with capacity of D 4 trillion (US$186 million) in 2016. A Demand-Side Analysis of the Provincial Governments | 43 The debt in the case of Quang Ninh is restricted by the statutory ceiling and not by affordability. The revenue projections show an initial decrease in revenue and then a relatively slow growth of 5 percent that materially affects the borrow- ing capacity, especially in later years. Additional criteria used by the commercial banks and capital market investors to assess credit exposure include (a) debt coverage ratio of revenue ­ TABLE 2.3  Planned Borrowing by Quang Ninh, D, billions YEAR 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Vietnam Borrowing by facility 20 40 250 60 100 100 100 100 100 100 Development Actual withdrawals 20 40 210 100 n.a. n.a. n.a. n.a. n.a. n.a. Bank Repayment 18 20 30 83 83 83 83 83 83 83 Outstanding balance 55 75 255 273 290 308 325 343 360 378 (planned) State Treasury Loan facility (planned) 300 400 200 300 300 300 300 300 300 300 Actual withdrawals 300 400 200 300 n.a. n.a. n.a. n.a. n.a. n.a. Repayment 51 256 259 355 n.a. n.a. n.a. n.a. n.a. n.a. Outstanding balance 250 400 350 300 300 300 300 300 300 300 (planned) Issue of Bonds Planned issues n.a. n.a. 950 0 0 1,000 0 0 1,000 0 Interest repayment n.a. n.a. n.a. 82 82 1,032 100 100 1,100 100 Capital repayment n.a. n.a. n.a. n.a. n.a. 950 0 0 1,000 0 Planned outstanding n.a. n.a. 950 950 950 1,000 1,000 1,000 1,000 1,000 balance Source: Quang Ninh Province. Note: n.a. = not applicable. Numbers are rounded. FIGURE 2.8 Debt Profile, Quang Ninh 7,000 6,000 5,000 4,000 D, billions 3,000 2,000 1,000 0 –1,000 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Cumulative outstanding debt Capacity next year Total statutory limit Source: World Bank calculations. 44 | Mobilizing Finance for Local Infrastructure Development in Vietnam to debt servicing, (b) liquidity ratio, (c) working ratio, and (d) solvency ratio. The debt coverage ratio remains in acceptable limits (minimum 1.2) and never gets below 6. The other ratios are tested using the DSA. The capital program and sustainable debt capacity is defined by the statu- tory limitations imposed by the SBL, conditions set by the SBV on commercial banks, real economic growth, inflation, the collection of all potential revenue, the right balance between income-generating and socially orientated pro- grams, and the ability to curtail recurrent expenditure. The provision of infrastructure can be accelerated by borrowing instead of using only the province’s own resources to directly invest in infrastructure. However, it is important to note that repayments will have to be generated using the province’s own resources. Borrowing accelerates the creation of infrastruc- ture but does not create new resources. Creation of new resources can be done only by increasing rates and taxes, decreasing operational costs, or using resources more efficiently. Projected debt capacity using the debt sustainability analysis approach In applying the DSA approach, the analysis assumes that the requirement of the balanced budget approach will still apply, and in the testing of the fiscal space it makes no provision for borrowing for operational purposes to achieve a bal- anced budget (no budget deficits or surpluses). In practice, however, such provi- sions are not always the case, with substantial carryovers or shortfalls being the norm. Like the FCF methodology, the DSA approach aims to establish sustainable debt levels by developing a baseline scenario using macroeconomic indicators and acceptable ratios. Similar to the FCF analysis, the DSA does not take into account short-term bridging loans from the central government and ODA. It was assumed that cash flow management challenges would be bridged by short-term borrowing from the central treasury. The macro debt indicators used in the Ho Chi Minh City analysis (World Bank 2014b) are also used in this analysis to ensure a degree of consistency in the setting of sustainable debt levels. The indicators and ratios are mainly used to test the assumptions and confirm the FCF model. The indicators include (a) the solvency ratio, with debt to GRDP not to exceed 25 percent; (b) debt service to local revenue, preferably not to exceed 25 percent; (c) statutory lim- itations, with the SBL 2015 requirement such that total debt stock may not exceed 30 percent of the previous year’s revenue; (d) a liquidity test, with interest payments as a percentage of recurrent expenditure, preferably not to exceed 25 percent; (e) a budget deficit of 0 percent (no deficit); and (f ) existing debt similar to the FCF, short term and expected to be redeemed by the time new debt is considered Quang Ninh remains comfortably within the financial norms but breaches the preferred solvency ratio in 2016 and 2019 (figures 2.9–2.11). The total debt was not adjusted to bring the ratio to the recommended levels because, over time, it returns to an acceptable level, and the substantial breach occurs in the period when there is considerable doubt about the integrity of the GRDP and revenue data. The projected 2019 breach can be managed by good cash management. According to the provisions of the SBV, the recommended acceptable debt level for the province should be 30 percent of revenue, indicating a maximum A Demand-Side Analysis of the Provincial Governments | 45 FIGURE 2.9 Debt Sustainability Analysis Indicators: Liquidity Ratio, Quang Ninh 30 25 Liquidity ratio, % 20 15 10 5 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Interest to recurrent Preferred maximum limit Source: World Bank calculations. FIGURE 2.10 Debt Sustainability Analysis Indicators: Solvency Ratio, Quang Ninh 60 50 Solvency ratio, % 40 30 20 10 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Debt to GRDP Preferred maximum level Source: World Bank calculations. FIGURE 2.11 Debt Sustainability Analysis Indicators: Debt Service to Revenue, Quang Ninh 30 Ratio debt service to revenue, % 25 20 15 10 5 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Interest to revenue Preferred maximum Source: World Bank calculations. 46 | Mobilizing Finance for Local Infrastructure Development in Vietnam initial debt level of D 4 trillion (US$186 million), rising to D 6 trillion (US$279 ­ million). Higher realized levels of revenue will increase this substan- tially because considerable fiscal space exists on all the other parameters except the solvency test. In this regard, the ratio of revenue to GRDP levels is relatively high compared with the other provinces, and the increase in revenue also will have to be based on an increase in the GRDP. Potential capital program Quang Ninh would be able to borrow on the order of D 4 trillion (US$186 million) and accelerate its capital program, but the province would have to ­ carefully monitor the allowable total debt stock. A more realistic smoothed capital program conforming to the expected statutory norm is shown in figure 2.12, in which it is compared with the projected planned capital program. The lumpiness of the capital program budgeted in 2016 will have to be smoothed by combining the resources available in 2016 and 2017. The ceiling is derived from the revenue estimates, which were conservative relative to GRDP growth, although reducing the percentage of revenue to GRDP would assist in a better credit profile and compliance with solvency criteria. According to the provin- cial authorities, the entire projected capital program can be funded and some further capital programs accelerated (though this assessment does not refer to the project list). Constraints and summary Quang Ninh is in a healthy financial position and, from a financial perspective, is able to borrow. The ability to borrow is probably understated as a result of a very conservative revenue growth projection compared with the predicted GRDP growth. Borrowing capacity in 2016 is indicated as D 4 trillion (US$186 million). Quang Ninh also has a borrowing plan as well as a detailed list of priority projects. FIGURE 2.12 Capital Program with and without Borrowing, Quang Ninh 7,000 320 6,000 280 240 5,000 US$, millions 200 D, billions 4,000 160 3,000 120 2,000 80 1,000 40 0 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Budgeted capital program, 4,028 4,020 4,156 6,329 3,210 3,182 3,143 3,117 2,996 3,146 3,303 3,468 D, billions Capital program with borrowing, 4,028 4,020 4,692 4,239 6,464 3,804 4,197 3,969 3,754 4,312 3,952 4,121 D, billions Budgeted capital program, 187 187 193 294 149 148 146 145 139 146 154 161 US$, millions Capital program with borrowing, 187 187 218 197 301 177 195 185 175 201 184 192 US$, millions Source: World Bank calculations. A Demand-Side Analysis of the Provincial Governments | 47 In conclusion, the province has the ability to borrow and the need and the willingness to borrow, and it has the knowledge that the effective demand will be a function of the terms of any financing facility. The increase in size of the capital program is such that insufficient capacity is unlikely to be a factor. It is also clear that a substantial amount of preparation has been undertaken. A long-term concern is whether recurrent expenditure will increase faster than revenue, which in the long term will inhibit borrowing. However, this potential has to be viewed against the conservative predictions about revenue increases. Dong Nai province analysis Dong Nai is adjacent to Ho Chi Minh City (map 2.1) and enjoys a spillover from the economic growth of that city into its thriving industrial and construction sectors. The province aimed for a GRDP on the order of D 57 trillion (US$2.6 ­ billion) in 2014, and it aims to grow this by 10–11 percent per year (World Bank 2015). Currently it is also the preferred destination of foreign direct investment (FDI) in Vietnam, attracting over D 36 trillion (US$1.66 bil- lion) in 2014 (Smetts 2014). A substantial project to construct an airport as a regional hub is also being considered by the National Assembly. The approval of this project could have a substantial positive economic impact on Dong Nai. However, it also would put additional strain on the infrastructure to support such a hub, despite the indications that the regional airport itself would be funded by national funds. Gross regional domestic product Provincial authorities were optimistic about the province’s growth potential, basing their expectations on the high level of foreign fixed investment and the historic economic performance (figure 2.13). Dong Nai projects a strong annual GRDP growth of around 15 percent, compared with a national target of around FIGURE 2.13 Gross Regional Domestic Product Growth, Dong Nai 900,000 25 800,000 700,000 20 600,000 15 D, billions % GRDP 500,000 400,000 10 300,000 200,000 5 100,000 0 0 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 GRDP growth, D GRDP growth, % Source: Dong Nai Province. 48 | Mobilizing Finance for Local Infrastructure Development in Vietnam 6–7 percent. In light of the historic performance, this projection seems to be realistic; however, it should be noted that, as the overall economic base expands, ­ the maintenance of high growth rates becomes more challenging. Revenue The ratio of revenue to GRDP is important because it indicates the extent to which revenue is optimized, which would normally follow the GRDP trend. The estimates provided by Dong Nai, however, show the revenue collected declining relative to GRDP (figure 2.14). The province’s revenue, which is growing at an average 10 percent per year, is more realistic for future planning, although lower than the GRDP growth (figure 2.15). FIGURE 2.14 Actual and Projected Revenue to Gross Regional Domestic Product, Dong Nai 8 7 Ratio of revenue to GRDP, % 6 5 4 3 2 1 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual revenue ratio Projected revenue ratio Source: Dong Nai Province. FIGURE 2.15 Actual and Projected Revenue, Dong Nai 35,000 30,000 25,000 20,000 D, billions 15,000 10,000 5,000 0 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Actual Projected Source: Dong Nai Province. A Demand-Side Analysis of the Provincial Governments | 49 Recurrent expenditure Recurrent expenditure is an important dimension because it determines the proportions of revenue that are committed and those that are discretionary (­figure 2.16). Increases in recurrent expenditure are a normal occurrence as local governments mature and aging infrastructure requires more maintenance. However, the sharp rise in percentage of recurrent expenditure in the case of Dong Nai is disturbing and will negatively affect its creditworthiness. Despite the predicted revenue growth of 10 percent and strong GRDP growth, the level of recurrent expenditure relative to revenue is predicted to reach 95 percent, a level which not only will affect future borrowing ability but also will be seen as a risky area in credit assessments. Future revenue increases could remove this concern if recurrent expenditure does not also increase. Budgeted capital program The projections show a smooth rise in capital expenditure (figure 2.17). province’s capital investment program amounts to D 9,213,945 million The  ­ FIGURE 2.16 Recurrent Expenditure to Revenue, Dong Nai 100 90 Recurrent ratio, % 80 70 60 50 40 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Budgeted recurrent ratio Actual recurrent ratio Source: Dong Nai Province. FIGURE 2.17 Actual and Budgeted Capital Expenditure, Dong Nai 7,000 315 6,000 280 245 5,000 210 US$, millions D, billions 4,000 175 3,000 140 105 2,000 70 1,000 35 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Actual 1,315 2,069 2,271 2,685 2,947 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Capital investment in D, billions Planned n.a. n.a. n.a. n.a. 2,947 3,647 3,388 3,659 3,952 4,268 4,609 4,840 5,082 5,336 5,603 5,883 Actual 61 96 106 125 137 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. US$, millions Planned n.a. n.a. n.a. n.a. 137 170 158 170 184 199 214 225 236 248 261 274 Source: Dong Nai Province. Note: n.a. = not applicable. 50 | Mobilizing Finance for Local Infrastructure Development in Vietnam (US$428 million) over 5 years, with plans to fund it from the province’s own resources. Given the need to address the already severe congestion on the transport routes and the need to expand, this estimate seems conservative. Unfortunately, this analysis could not obtain any indication of longer-term planning that incorporates all services and the services to be delivered by the SOEs. The relative amounts committed to capital program areas are shown in figure 2.18. Borrowing history Dong Nai has both borrowed from banks and issued bonds. Dong Nai officials concluded two loans with VietinBank of D 200 billion (US$9 million) and D 1 trillion (US$46.5 million) in 2014. Both have an interest rate of 7 percent. In addition, they have a loan of D 400 billion (US$18.6 million) from the Bank for Investment and Development of Vietnam (BIDV) with an interest rate at percent and a tenor of 2 years. It is interesting to note 6 ­ FIGURE 2.18 that the loans were used  for nonincome-generating Composition of Capital Program, Dong Nai infrastructure projects and that no collateral was pro- vided. In addition to these loans, the province previously 0ther, used a bond that has since matured and been repaid. The 27% debt profile of Dong Nai over the next 10 years is shown in figure 2.19. Total transport, 45% Projected debt capacity according to the free cash flow approach Municipal, The debt coverage ratio remains in acceptable limits 14% (­minimum 1.2) and never gets below 7. (The other ratios are tested in the DSA.) To a large degree the capital program Buildings/ Education, and sustainable debt level will be defined by the statutory administration, 11% limitations imposed by the SBL, conditions set by the SBV, 3% real economic growth, inflation, the collection of all poten- Source: Dong Nai Province. tial revenue, the right balance between income-generating and socially orientated programs, and the ability to curtail FIGURE 2.19 Debt Profile, Dong Nai 9,000 8,000 7,000 6,000 D, billions 5,000 4,000 3,000 2,000 1,000 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Cumulative outstanding debt Capacity next year Total statutory limit Source: World Bank calculations. A Demand-Side Analysis of the Provincial Governments | 51 recurrent expenditure. The provision of infrastructure can be accelerated by borrowing instead of using only provincial resources to directly invest in infrastructure. Projected debt capacity using the debt sustainability analysis approach In the DSA approach, the analysis assumes that the requirements of the bal- anced budget approach will still apply. When testing the fiscal space, no provision is made for borrowing for operational purposes to achieve a bal- anced budget (no budget deficits or surpluses). In practice, however, that approach is not always the case; instead, substantial carryovers or shortfalls are the norm. Like the FCF methodology, the DSA approach aims to establish sustainable debt levels by developing a baseline scenario using macroeconomic indicators and acceptable ratios. Similar to the FCF analysis, the DSA has not taken into account short-term bridging loans from treasury and ODA. It was assumed that cash flow management challenges would be bridged by short-term borrowing from the central treasury. Dong Nai remains comfortably within all the financial ratios of the DSA approach (figures 2.20–2.22). Therefore, it is recommended that the acceptable FIGURE 2.20 Debt Sustainability Analysis Indicators: Liquidity Ratio, Dong Nai 30 25 Liquidity ratio, % 20 15 10 5 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Interest to recurrent Preferred maximum limit Source: World Bank calculations. FIGURE 2.21 Debt Sustainability Analysis Indicators: Solvency Ratio, Dong Nai 30 25 Solvency ratio, % 20 15 10 5 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Debt to GRDP Preferred maximum level Source: World Bank calculations. 52 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.22 Debt Sustainability Analysis Indicators: Debt Service to Revenue, Dong Nai 30 Debt service to revenue, % 25 20 15 10 5 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Interest to revenue Preferred maximum Source: World Bank calculations. debt level for the province be accepted as 30 percent of revenue, indicating a maximum initial level of debt capacity of D 4.94 trillion (US$230 million), rising to D 7.65 trillion (US$356 million), and a cumulative level of total debt of D 59.772 trillion (US$2.78 billion). Potential capital program Dong Nai would be able to borrow on the order of D 3.347 trillion (US$155 million) in 2016 after accounting for existing debt. The province can accel- erate its capital program but would have to carefully monitor the allowable total debt stock. A realistic smoothed capital program conforming to the expected statutory norm is shown in figure 2.23. The comparison with the budgeted projected capital program indicates that the budgeted capital pro- gram plus some additional projects can be undertaken. The ceiling is deter- mined by the revenue and, as discussed, the projections indicate a very conservative estimate of future revenue despite the high projected GRDP growth rate. In reality, the actual revenue and the consequential debt cap are expected to be higher. Constraints and summary Dong Nai is in a healthy financial position and, from a financial perspective, is able to borrow. The ability to borrow is probably slightly understated as a result of a conservative revenue growth projection compared with the pre- dicted GRDP growth. Borrowing capacity in 2016 is indicated as D 4.94 tril- lion (US$230 million), but new debt will be restricted to D 3.347 trillion (US$155 million). In summary, the province has the ability, experience, and willingness to borrow. Effective demand is most likely to be constrained by the terms of  any potential additional borrowing. Although factors such as access to  land and other planning issues may present short-term constraints, the increase of the annual capital program with borrowing is not so great as A Demand-Side Analysis of the Provincial Governments | 53 FIGURE 2.23 Budgeted versus Potential Capital Program with Borrowing, Dong Nai 9,000 400 8,000 350 7,000 300 6,000 US$, millions 250 D, billions 5,000 200 4,000 150 3,000 2,000 100 1,000 50 0 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Budgeted capital program in D, billions 2,947 3,647 3,388 3,659 3,952 4,268 4,609 4,840 5,082 5,336 5,603 5,883 Capital program with borrowing in D, billions 2,947 3,385 4,094 4,503 4,954 5,449 5,994 6,294 6,609 6,939 7,286 7,650 Budgeted capital program in US$, millions 137 170 158 170 184 198 214 225 236 248 260 273 Capital program with borrowing in US$, millions 137 157 190 209 230 253 279 293 307 323 339 356 Source: World Bank calculations. to be substantial, and it is likely that the full capacity could be used. Therefore, Dong Nai is likely to have a total debt capacity of D 4.94 trillion (US$230 million). Bac Ninh province analysis overspill Bac Ninh is next to Hanoi in the Red River valley and as such enjoys an ­ from the economic growth of Hanoi (map 2.1). It has thriving industrial and con- struction sectors based on virtual export harbors and export credit zones. It is a fairly recently formed province that is rapidly converting from a rural economy to an industrial economy. Currently industrial activity is dominated by Samsung and its dependent suppliers, which provide some 60 percent of the province’s GRDP, posing a serious systemic risk for the province. Gross regional domestic product The provincial authorities were optimistic about the growth potential of the Bac Ninh economy, basing their expectations on the historical growth, the projected growth of 14 percent per year, and the fact that Bac Ninh lies on a number of transport corridors. The impact of Samsung’s activities is illustrated by the drop in GRDP growth when it reached production capacity in 2013 (figure 2.24). It is notable that the high increases in 2010–13 were from a relatively low base. Revenue The important ratio of revenue to GRDP indicates the extent to which revenue is optimized and would normally follow the GRDP trend. As in the two other provinces, the revenue shows a declining trend in GRDP that is contrary to intu- itive expectations and indicates a conservative approach was taken in estimating future revenue growth (figure 2.25). 54 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.24 Gross Regional Domestic Product Growth, Bac Ninh 600,000 60 500,000 50 400,000 40 D, billions % GRDP 300,000 30 200,000 20 100,000 10 0 0 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 GRDP growth, D GRDP growth, % Source: Bac Ninh Province. FIGURE 2.25 Actual and Projected Revenue to Gross Regional Domestic Product, Bac Ninh 8 7 6 Revenue to GRDP, % 5 4 3 2 1 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual Projected Source: Bac Ninh Province. The delayed impact of Samsung’s declining operations is also reflected in the revenue growth. Despite its past high growth, the province now is projecting an annual growth rate in revenue of around 10 percent on average, which can be viewed as reasonable and compares well with the predicted GRDP growth rate of around 12 percent (figure 2.26). Recurrent expenditure Recurrent expenditure is an important dimension because it determines the proportions of revenue that are committed (recurrent) and those that are A Demand-Side Analysis of the Provincial Governments | 55 FIGURE 2.26 Actual and Projected Revenue, Bac Ninh 18,000 16,000 14,000 12,000 D, billions 10,000 8,000 6,000 4,000 2,000 0 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Actual Projected Source: Bac Ninh Province. discretionary (figure 2.27). In the case of Bac Ninh the percentage used for recurrent expenditure is projected to be stable around 65 percent of revenue, allowing a substantial discretionary buffer, which will be viewed favorably in  a credit rating if prudent debt levels are maintained. The drop in the ­ percentage in 2012 was a result of recurrent expenditure growing more slowly than revenue. Budgeted capital program The province’s investment program amounts to D 8.137 trillion (US$378 million) over 5 years, with the funding to come from the province’s own resources figure 2.28). Investment in transport dominates, which is understandable for a (­ province that is undergoing rapid industrialization and that needs to use the quality of its transport routes to attract investors. Unfortunately, the provincial information gave no indication of longer-term planning that would incorporate all services or say what services were be delivered by the SOEs. The size of the projects in the budgeted capital program varies from small to substantial, as shown in figure 2.29. Borrowing history Bac Ninh has a loan of D 252 billion (US$11.7 million) with the VDB and a loan of D 100 billion (US$4.65 million) from the state treasury. The province has issued two municipal bonds of D 100 billion (US$4.65 million) and D 300 billion (US$13.95 million) at issue rates of 9.65 percent and 6.59 percent, respectively. The start and maturity dates are 2013–18 and 2014–19, respectively. Thus, Bac Ninh has experience in borrowing, and officials are confident about managing cash flows. 56 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.27 Ratio of Recurrent Expenditure to Revenue, Bac Ninh 70 Recurrent expenditure to revenue, % 65 60 55 50 45 40 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Budget recurrent ratio Actual recurrent ratio Source: Bac Ninh Province. FIGURE 2.28 Actual and Budgeted Capital Expenditure, Bac Ninh 3,500 160 3,000 140 120 2,500 US$, millions 100 D, billions 2,000 80 1,500 60 1,000 40 500 20 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Actual 946 1,421 1,567 1,767 n.a. n.a. n.a. n.a. n.a. n.a. n.a. Capital investment in D, billions Planned n.a. n.a. n.a. n.a. 1,510 2,243 2,075 2,296 2,449 2,739 2,973 Actual 44 66 73 82 70 n.a. n.a. n.a. n.a. n.a. n.a. US$, millions Planned n.a. n.a. n.a. n.a. 70 104 97 107 114 127 138 Source: Bac Ninh Province. Note: n.a. = not applicable. Projected debt capacity according to the free cash flow approach Similar to the other two provinces studied, the constraining element for Bac Ninh is not the ability to service debt, but the 30 percent previous debt ceiling. This constraint indicates an allowable D 2.843 trillion (US$132 m illion) in  2016 and a maximum debt level of D 4.817 trillion (US$224 ­ ­ million in 2025). Cumulative capacity is D 37.642 trillion (US$1.751 billion) (figure 2.30). Projected debt capacity using the debt sustainability analysis approach In applying the DSA approach, the analysis assumes that the requirement of the balanced budget approach will still apply. When testing the fiscal space, no provision is made for borrowing for operational purposes to achieve a A Demand-Side Analysis of the Provincial Governments | 57 balanced budget (no budget deficits or surpluses). In FIGURE 2.29 practice, however, that approach is not always the case; Composition of Planned Capital Program, Bac Ninh instead, substantial carryovers or shortfalls are the norm. Education, Building/public, 7% Like the FCF methodology, the DSA approach aims 22% to establish sustainable debt levels by developing a baseline scenario using the macroeconomic indica- tors and acceptable ratios. Similar to the FCF analysis, this approach has not taken into account short-term Health, 2% bridging loans from the treasury and  ODA. It was Transport, assumed that cash flow management challenges 59% Municipal, would be bridged by short-term borrowing from the 10% state treasury. Bac Ninh remains comfortably within all the financial ratios of the DSA approach (­ f igures 2.31–2.33). Source: Bac Ninh Province. FIGURE 2.30 Debt Profile, Bac Ninh 6,000 5,000 4,000 D, billions 3,000 2,000 1,000 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Cumulative outstanding debt Capacity next year Statutory limit Source: World Bank calculations. FIGURE 2.31 Debt Sustainability Analysis Indicators: Liquidity Ratio, Bac Ninh 30 25 Liquidity ratio, % 20 15 10 5 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Interest to recurrent Preferred maximum limit Source: World Bank calculations. 58 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.32 Debt Sustainability Analysis Indicators: Solvency Ratio, Bac Ninh 30 25 Solvency ratio, % 20 15 10 5 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Debt to GRDP Preferred maximum level Source: World Bank calculations. FIGURE 2.33 Debt Sustainability Analysis Indicators: Debt Service to Revenue, Bac Ninh 30 Debt service to revenue, % 25 20 15 10 5 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Preferred maximum limit Interest to revenue Source: World Bank calculations. Potential capital program Bac Ninh province has greater scope to accelerate the capital program by ­borrowing, mainly because of its lower recurrent expenditure. Figure 2.34 shows a smoothed potential capital program versus the budgeted capital program, which indicates that substantial acceleration is possible. Constraints and summary Bac Ninh is in a healthy financial position and, from a financial perspective, is able to borrow. As a rapidly developing province, it needs to develop its transport infrastructure to remain an attractive investment area. The prov- ince can sustainably borrow D 2.843 trillion (US$132 million) in 2016. This will escalate to D 4.817 trillion (US$224 million) in 2025, with total borrowing estimated at D 37.643 trillion (US$1.751 billion). Total borrowing substantial leverage on its capital because the prov- will give the province ­ ince will be able to maintain a low ratio of recurrent expenditure to total revenue. The initial increase in the capital program is not substantial, and physical or planning constraints are not expected to have a significant delaying influence. A Demand-Side Analysis of the Provincial Governments | 59 FIGURE 2.34 Capital Program with and without Borrowing, Bac Ninh 6,000 300 5,000 250 4,000 200 US$, millions D, billions 3,000 150 2,000 100 1,000 50 0 0 2014 2015 2016 2017 2018 2019 2020 Budgeted capital program, D, billions 1,510 2,243 2,075 2,296 2,449 2,739 2,973 Capital program with borrowing, D, billions 946 1,421 3,129 4,090 5,414 5,193 5,398 Budgeted capital program, US$, millions 70 104 97 107 114 127 138 Capital program with borrowing, US$, millions 44 66 146 190 252 242 251 Source: World Bank calculations. In summary, the province has the need, ability, and willingness to borrow, and the conversion of need into effective demand will be influenced more by the  terms of access to borrowing than by interest rates and other terms. However, there is some concern about creditworthiness because of the prov- ince’s dependence on a single contributor, Samsung, for nearly 50 percent of the its revenue. Bac Ninh was projected to have a demand for new debt up to D 2.843 trillion (US$132 million) in 2016. All provinces contributing to central government revenues This study considered eight more provinces that contribute to the central government budget. The sharing ratio, which is not the same across the prov- inces, varies from 40 percent to 91 percent. Economic growth and population growth also vary considerably, as does the relationship between capital investment programs and recurrent cost. The variation makes it quite diffi- cult to extrapolate from that result with a reasonable degree of accuracy without doing an individual assessment. However, the data for individual assessments were not readily available. Thus, given the objective of this study—namely, to establish what effective market demand would be—the analytic approach aggregated the available data and collectively determined the effective demand of all 11 provinces. A comparison of the provinces shown in figure 2.35 shows about equal popu- lations and widely diverging total retained income profiles, but it shows substan- tially less divergence in discretionary income as a result of the transfers to and from the central government. That result suggests that the demand for infrastructure funding would not be too divergent among provinces. However, substantial differences can be seen in economic growth (though calculation of GRDP was inconsistent across provinces, and therefore is unavailable), population growth, and capital i ­nvestment needs. Another important step in assessing demand is to consider the current 60 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.35 Comparison of 11 Provinces Participating in Revenue Sharing, 2013 50,000 D, billions, and population, thousands 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Ba Ria- Bac Bing Can Da Nong Hai Khant Quang Quang Vinh Vung Tau Ninh Duong Tho Nang Nai Phong Hoa Ninh Ngai Phuc Total population, in thousands 1,087 1,085 1,869 1,272 981 2,752 1,945 1,215 1,213 1,231 1,045 Total revenue in D, billions 11,417 10,718 31,400 7,235 11,678 33,070 46,448 12,367 31,450 33,840 17,498 Total retained income in D, 11,615 6,228 11,500 5,895 12,151 5,945 8,847 6,761 10,120 9,298 9,571 billions Source: Vietnam Statistical Office. Note: There is a slight discrepancy between the figures provided by Dang Nai and by the Statistical Office, but not to the extent that it will materially influence the conclusion. relationship between capital expenditure and recurrent expenditure, as this defines the discretionary income available for potential loan servicing. The rela- tive recurrent expenditures of the provinces (figure 2.36) averages about 70 per- cent, indicating that all provinces have fiscal space that enables them to borrow under current conditions. Aggregated provincial borrowing Aggregated retained revenue for all 11 provinces contributing to central govern- ment revenues in 2013 is estimated as D 100 trillion (US$4.65 trillion), according to MOF estimates. The analyses of the three pilot provinces indicate that, even with high recurrent costs, the total debt stock will most likely be determined by the cap of 30 percent of revenue and not by the affordability of loans or the ability to service loans from the discretionary portion. Given this likeli- hood, the aggregated initial ceiling on borrowing would be D 33 trillion (US$1.535 billion). Assessment of provincial demand The only way to assess the actual funding need for the 11 provinces is to make ­ certain subjective assumptions and to use different approaches to estimate each province’s potential capacity to absorb debt. The results of the different approaches must then be viewed with the understanding that the capacity will be used only if the other constraints are overcome. However, the conversion of capacity to effective demand will depend finally on how beneficial the provinces deem the terms. A Demand-Side Analysis of the Provincial Governments | 61 FIGURE 2.36 Provincial Recurrent Costs, 2013 100 90 Recurrent costs, % 80 70 60 50 40 30 20 10 0 Ba Ria- Bac Bing Can Da Dong Hai Khank Quang Quang Phuc Vung Ninh Duong Tho Nang Nai Phong Hoa Ninh Ngai Vinh Tau Vietnam Provinces Source: Vietnam Statistical Office. Aggregated revenue of provinces and debt ceiling The analysis of 11 provinces assumed that the additional projects to be funded by debt would materialize over 5 years, given the lengthy process of being included in the budget, planning, and so on. Employing the total debt ceiling and a percent ratio of recurrent debt to revenue and the aggregated revenue of all 70 ­ the provinces, the analysis put demand at between D 6.6 trillion (US$307 ­million) in 2016 and D 33 trillion (US$1.535 billion) in 2021. Extrapolated demand The total debt capacity of the three provinces was estimated to be D 10.19 trillion (US$474 million), given an average of D 3.397 trillion (US$158 million). Extrapolating to the 11 provinces would result in a total demand of D 37.363 trillion (US$1.738 billion). Although the three target provinces all have had ­ exceptional GRDP growth and have clearly geared up their implementation capacity to support the rapid economic development, condition is unlikely to be true of all the provinces, especially the more rural ones. Not all provinces expe- rience GRDP growth rates as high as the three selected provinces, as indicated by the national average of around 6 percent, and they probably do not experience the same demand for infrastructure spending. In addition, the more rural ­ provinces, especially, have probably not built up the planning and implementa- tion capacity required to rapidly accelerate the additional infrastructure spend- ing to this level. To allow for the need to ramp up infrastructure projects across all provinces, the analysis assumes that potentially 20 percent of the total spend- ing commitment could materialize. The demand would then be between D 7.473 trillion (US$348 million) and D 37.363 trillion (US$1.738 trillion). Current capital expenditure and project size Capital expenditure in 2013 in all provinces was estimated at D 33 trillion (US$1.535 billion), indicating that substantial implementing capacity was avail- able. If the analysis assumes that this capacity could potentially increase by 20 percent, a borrowing demand of D 6.6 trillion (US$307 million) would not be unreasonable, with a 40 percent borrowing maximum. Thus, the demand could go up to D 13.2 trillion (US$614 million). 62 | Mobilizing Finance for Local Infrastructure Development in Vietnam In the three target provinces, the average project size after eliminating the outliers would be on the order of D 200 billion (US$9.3 million). If the analysis assumes that the other eight provinces can increase their planning and imple- mentation capacity to undertake two more projects, the additional ­ funding  need  would be D 4.400 trillion (US$204 million). An additional two projects per province would increase the funding need by D 9.680 trillion (US$450 million). Ministry of finance project list The MOF has also compiled a partial list of capital projects to be funded from provinces’ own resources and ODA over the period 2015–20 (figure 2.37). The list indicates a total need of D 17.610 trillion (US$819 million) for project imple- mentation from domestic resources and a request for ODA of D 62.317 trillion (US$2.89 billion). The result is a provincial project implementation capacity of D 79.927 trillion (US$3.7 billion) over 5 years and a capacity of D 15.985 trillion (US$743 million) per year in addition to the current capital programs of D 33.000 trillion (US$1.535 billion). In summary, the provinces can be assumed to have the capacity to undertake a substantial number of additional projects. The calculations indicate that despite the still-heavy dependence on and preference for ODA, Vietnam’s changing status toward being a middle-income country could render its reliance on ODA unrealistic. In addition, there is a sub- stantial need for project capital funding. Thus, if the ODA component is elimi- nated, the total from domestic resources could be D 17.610 trillion (US$819 million) for nine provinces, and D 1.956 trillion (US$91 million) per year over a 5-year period. However, should the ODA be substantially less than it is now, funding for higher-priority projects may be obtained from borrowing. If analysis assumes that this approach doubles the demand for borrowing, the total could be D 3.912 trillion (US$182 million). Provinces’ stage of readiness to borrow and the availability of a project pipeline will play a major role in determining the maximum effective demand ­ for borrowing. However, provinces will need better budget and financial FIGURE 2.37 Projects Identified by Provinces, 2015–20 45,000 40,000 35,000 30,000 D, billions 25,000 20,000 15,000 10,000 5,000 0 Bac Quang Thai Hai Hung Dong Thai Long Long Binh Quang Hai Thanh Da Ninh Nam Nguyen Durong Yen Nai Binh An Son Thuan Ninh Phong Hoa Nang Domestic sources 368 674 266 98 275 4,155 3,271 612 1,924 2,150 n.a. n.a. 3,817 n.a. ODA requests 3,363 2,696 1,066 3,453 3,943 22,138 1,630 132 19,686 n.a. 5,110 n.a. n.a. n.a. Total planned investments 3,731 3,370 1,332 3,551 4,218 26,294 4,901 745 12,629 2,150 n.a. 12,034 38,174 25,120 Source: Vietnam Ministry of Finance. Note: n.a. = not available; ODA = official development assistance. A Demand-Side Analysis of the Provincial Governments | 63 management practices before they can be considered creditworthy borrowers. Also, most projects need a preparation period, so analysts can assume that the provinces’ borrowing ability will not be fully utilized. More research is needed to determine how much of the maximum allowable borrowing could effectively be used. Nevertheless, a summary based on the different approaches to determine provinces’ readiness to borrow is shown in table 2.4. Using the FCF and DSA approaches discussed earlier, the study therefore estimates realistic maximum demand for the debt needed to take on other projects in addition to the existing capital program to be about D 6.700 trillion (US$311 million) in 2016. Effective demand Although the demand and capacity of D 6.700 trillion (US$311 million) is deemed to be within the absorption and additional implementation capacity of the 11  provinces, that demand will be influenced by the regulatory reform and the promptness of amendments as well as by the commercial banks’ appetite for lending. It is also suggested (as discussed later in this chapter) that any TABLE 2.4  Debt Capacity Approaches ESTIMATION 2016 IN MAXIMUM 2016 REALISTIC IN REALISTIC IN UNDERLYING ASSUMPTIONS NOTES METHOD D, BILLIONS IN US$, MILLIONS D, BILLIONS US$, MILLIONS Total debt cap per 33,000 1,535 6,600 307 Based on aggregate Will increase Amended State revenue of provinces in annually with Budget Law 2016; assuming that it will increase in aggre- take up to 5 years to reach gate revenue debt cap due to the need Based on for smoothing capital assumption that expenditure on additional all debt would be projects not budgeted used for addition- al projects Extrapolated from 37,363 1,734 7,473 347 Discounted to 20% for Based on three provinces capacity constraints assumption that all debt would be Based on average (US$158 used for addition- million) of 3 provinces al projects extended to all 11 Based on current 13,200 614 6,600 307 Ability to increase by 20% Additional capital expenditure projects Based on average 19,360 900 9,680 450 Average size of the projects Additional project size planned in the three projects provinces, analyzed with 2–4 additional projects Ministry of Finance 3,912 182 1,956 91 Also assuming a 5-year Assumed to project list period reflect unfunded projects The recommended 22,533 5,240 6,695 311 Based on underlying potential demand assumption that all as an average of additional accelerated the different infrastructure funding will be approaches by way of private-sector debt, though in reality, some of the additional projects could be funded from provinces’ own resources Source: World Bank calculations. 64 | Mobilizing Finance for Local Infrastructure Development in Vietnam borrowing initiative should be accompanied by capacity building in financial management, which will take time. The biggest factor in converting need or demand into effective demand will be the borrowing terms, especially consider- ing the benefits of establishing interest-free access to the VDB. One of the most important considerations in assessing effective demand will be the loan duration, or tenor, as illustrated by figures 2.38 and 2.39. Figure 2.38 indicates the repayment on a D 100 loan over a 10-year period and the impact it has on affordability. Figure 2.39 illustrates the changes in amounts that can be borrowed by a fixed installment of D 100 over a 10-year period. Both graphs FIGURE 2.38 Projected Effect of Loan Period on Annual Installments 120 Annual installment on a D 100 loan 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 Term of loan, years Interest rate: 6% Interest rate: 8% Interest rate: 10% Source: World Bank calculations. FIGURE 2.39 Effect of Loan Period on Amount Borrowed with Fixed Installments 800 Loan amount with fixed installment of D 100 700 600 500 400 300 200 100 0 1 2 3 4 5 6 7 8 9 10 Term of loan, years Interest rate: 6% Interest rate: 8% Interest rate: 10% Source: World Bank calculations. A Demand-Side Analysis of the Provincial Governments | 65 show that tenor has a greater effect on the potential amount of borrowing than interest rates do. Note that even if the amount borrowed reaches the prescribed debt ceiling, any reduction in the annual installments will leave a bigger portion of the discretionary, uncommitted revenue available for direct capital invest- ment. Therefore, one can conclude that the most critical reforms for provincial borrowing would be to (a) amend the restriction on the duration of loans from commercial banks and (b) develop the capital markets to allow bonds of longer tenor to be issued. Comparison and conclusion In conclusion, all three provinces analyzed are financially healthy, and the ceil- ing on debt should be the 2015 SBL ceiling on provincial debt, which took effect in 2017. In the case of two provinces, sharp increases in the ratio of recurrent expenditure to revenue may become an issue in the future. Further, the increase in the implementation of additional projects would not constitute a barrier to changing demand into effective demand, given the substantial current capital programs already being managed by the provinces. In most instances, these car- ryovers reportedly are a result of accrual accounting with services or goods ren- dered but not yet paid for. It is unclear whether this could also be a sign that implementation capacity is insufficient. The realization of effective demand will depend on capacity building, needed regulatory reform, the appetite of the banks, and the attractiveness of the terms of the financing facility. This analysis determined that the amount needed to launch a CIFF and have an impact and leverage to support the reform program is about D 6.6 trillion (US$307 million). Provinces receiving grants from the central government The fact that most of the provinces are still dependent on transfers from the central government does not rule those provinces out as potential, credit- worthy borrowers. Intergovern­ mental transfers that occur on a dependable and predictable basis in many cases form an integral part of a province’s over- all planning and its capital investment planning. However, this observation is made with the condition that such transfers should not be subject to short- term arbitrary or interpretive decisions. Instead they should be formula driven and based on firm agreements derived from the overall intergovernmental fiscal framework. In assessing creditworthiness, such transfers are included as “other income,” although one of the risk criteria would be grant dependency, which would create other thresholds to borrowing. In Vietnam, the SBL and the annual state budget, when taken together with the 5-year stability periods, have created this certainty and have made all provinces, in theory, potentially creditworthy and able to qualify for borrowing, depending on the individual financial analysis. Although a high-level analysis of the needs and financial capacity of the provinces is necessary to generate a quantitative indication of the potential ­ demand, it should be understood that any financing facility represents a potential borrowing demand. That demand is likely to increase as Vietnam’s economy develops and more provinces become contributors rather than recipients of ­ transfers. A facility may also be used to create market access for these provinces. 66 | Mobilizing Finance for Local Infrastructure Development in Vietnam Water sector Although the water utilities are officially independent, in practice they are subject to provincial authorities that set tariff levels and govern operational ­ investments (Smetts 2014); thus, they should be regarded as potential direct or indirect borrowers. The financial investments needed by the rural and urban  water and sanitation sector are extensive, about D 55.685 trillion (US$2.59 ­ billion) a year, of which approximately D 13.975 trillion (US$650 ­million) will be provided by households and private resources. Approximately 87 percent of this need is in urban areas and represents about 2.5 percent of GDP. About 60 percent of the investment in the urban system is for replacing, rehabilitating, and refurbishing, so no new income will be generated. Therefore, incorporating this expenditure in revised higher tariffs to help the sector break even is difficult. The potential need of the water sector is excluded from the current analysis because a separate dedicated facility has been put in place by the Asian Development Bank, and drawdowns are cur- rently limited. Local development investment funds The local development investment funds (LDIFs) in principle could be potential clients, and the need for their investments in revenue-generating projects is also substantial. However, substantial demand is not likely in the near future. The LDIFs are constrained by the requirement of an equity component, which only 17 LDIFs have achieved. Expansion of the existing LDIFs would have to be  matched with further equity investments, which could limit the effec- tive demand. The LDIFs therefore are not considered in this analysis, although some demand may manifest itself over time beyond that already being provided through ODA and their access to markets. State-owned enterprises SOEs play an important role in Vietnam because they have access to the capital markets. At the same time, they could represent substantial contingent liabilities to the national government. According to international standards, which are not yet adopted in Vietnam, those credit risks should be taken into account. There may be advantages to regarding SOEs as potential direct clients of the provinces, especially in the smaller provinces. Doing so could remove the contingent liability aspects. Recent experience in China is an example of the issues that can arise when virtually off-balance-sheet lending by SOEs is not being coordinated in an integrated way (Lu and Sun 2013).5 SOE participa- tion would depend on whether the terms are more favorable than direct access to the markets would be. For the purposes of this study their potential demand, whether indirect or direct, is not taken into account as an immedi- ate reality. This approach may be reconsidered, depending on future devel- opments to boost the size of bond issues. Constraints affecting access to debt financing Provinces hoping to borrow funds and estimate effective demand face chal- lenges, both in the provinces and in the overall intergovernmental system, that will affect their access to financing. How well provincial authorities meet those challenges could determine the banks’ willingness to take on pro- vincial credit risks and could slow borrowing. Banks need information if they are to make prudent and sound credit decisions. This section outlines the A Demand-Side Analysis of the Provincial Governments | 67 types of information that provinces must have and must make available to financing facilities. Information should be readily accessible and accurate enough for banks to perform credit appraisals. First, because data are collected from multiple sources, the data often are inconsistent and may raise fundamental integrity concerns. Second, given long budget cycles and lack of final audited figures (which are not available often until 18–20 months after the fiscal year-end), actual figures are useless as a management tool or as a basis for assessing creditworthiness. Financial statements often do not present a full picture for the following reasons: (a) ODA is regarded as off budget. (b) Debt is not reflected in financial ­ statements. (c) The statements do not show the activities of SOEs and public sector enterprises that have various degrees of autonomy. (d) Carryovers are not formally reflected, with no limit or transparency on the carryovers. (e) On-bill financing can be as high as 5–20 percent of the budget (World Bank 2014a). (f ) Contingent liabilities are not transparent. Several factors indicate provinces’ lack of financial management and insufficient management information systems. Provinces tend to underesti- mate revenue, to consistently overspend on capital, and to under- or over- spend against budgets (figure 2.40 illustrates this for two provinces). Also, substantial year-to-year swings in projected data and a consequential loss of FIGURE 2.40 Budget Deviations in Dong Nai and Quang Ninh Provinces a. Dong Nai Province 100 80 60 % of budget 40 20 0 –20 –40 2010 2011 2012 2013 2014 b. Quang Ninh Province 60 50 % of budget 40 30 20 10 0 2012 2013 2014 Capital budget Recurrent budget Sources: Dong Nai and Quang Ninh Provinces. 68 | Mobilizing Finance for Local Infrastructure Development in Vietnam predictability make any degree of integrity in credit assessments impossible. Moreover, provinces have a tendency to disregard the development plan and regularly vary the allocations. For example, a policy of allocating excess reve- nue to salary reform and capital expenditure increases fixed recurrent costs in the long term and can threaten long-term sustainability. Both the provin- cial and central levels need to improve their budget, debt, and cash flow man- agement capacity (World Bank 2014a). The preparation, planning, and coordination in project conception need improvement. Reforming intergovernmental relations by allowing further fiscal decentral- ization would enable provincial credit risk to be perceived and legally differenti- ated from the central government debt repayment responsibility. This reform would be a crucial element in a structure that supports accountability and transparency. The regulatory framework on lending needs to be clearly articulated to create certainty regarding the relationship between borrowers and lenders, especially as far as default and recourse measures are concerned. Many of the constraints can be mitigated and the quantum of the potential sustainable debt can be substantially increased by an increase in revenue, that is, by faster increases in the tax rate, higher economic growth that increases the tax base, or decreased operational expenditure through reductions in recurrent costs, such as by reducing staff. For example, provinces collect only 60 percent of their potential revenue, on average, and they have no control over the struc- ture of taxes and only limited authority over the quantum of taxes and tariffs. Most of these issues are not new and have been highlighted in a World Bank report, “Assessment of PFM Arrangements at the Provincial Level” (World Bank 2011). General creditworthiness considerations in provinces In a unitary budget system, there is a perception that all credit risk at the local level effectively migrates to the central government and becomes part of the public debt. One objective of creating the CIFF is that of making a clear distinction between central and provincial debt. Provinces should start preparing for this separation of obligations by considering the follow- ing actions: • Use sinking funds • Quantify contingent liabilities • Improve the management of recurrent expenditure (especially future commitments) • Introducing cost recovery principles • Concentrating on improved collections • Making SOEs financially independent • Developing stronger cash and debt management systems • Developing default procedures with the central government to remove any ambiguity in how to deal with a local government default • Improving data availability and reliability • Building relationships with the commercial banks and capital market. The World Bank has developed weeklong academies in a number of countries to strengthen the creditworthiness process at the local government level. These workshops help provinces become good credit risks and strengthen and develop good planning, management, and governance practices, which are preconditions A Demand-Side Analysis of the Provincial Governments | 69 for becoming creditworthy. The government of Vietnam should consider work- ing with the World Bank to arrange this type of academy. Risk for an entity like the potential city infrastructure financing facility A province that is considering whether to work with an entity such as a CIFF or other instrument must conduct a high-level review of potential risks to such an entity. Provinces should note that credit risk depends on the structure of a CIFF as it concerns lending to the commercial banking sector, the provinces, or both. The CIFF should have a credit assessment system that allows prudent credit decisions, thus reducing the possibility of default. Further, CIFFs must have clear rules on how to deal with defaults and the consequential likely workouts.6 Other countries have made provisions granting substantial powers to an administrator appointed by the central government to oversee the financial rehabilitation of a defaulting local government if it cannot make an agreement for rescheduling payments with the creditors. Other potential risks include (a) the lack of demand for the facility, (b) ­rejection of the terms or conditionality, (c) demand for the facility that is too high, (d) no accompanying reform program, (e) statutory limitation of debt, (f ) total public sector debt exceeding safe limits, (g) lack of financial and credit management capacity in banks and provinces, (h) liquidity risk for CIFF due to delayed payments or nonpayments, (i) defaults and consequential loss, ( j) inability to ­ raise additional finance, and (k) fraud and mismanagement. Provincial governments’ willingness to participate in pilot city infrastructure financing facility Consultations with the surveyed provinces on the need for future debt require- ment and lending terms with key provincial government officials determined that the three provinces were willing to participate in a pilot CIFF. Key consid- erations for the establishment of CIFF include the following aspects: • Long-term financing. The provinces are willing to borrow for infrastructure development, but currently long-term financing for infrastructure projects is not available. Provinces have shown preference and need for loans with a 10–15-year tenor, which would typically match the project life cycle period. • Preferential mechanism for CIFF. As per SBL 2015, provincial governments are allowed to mobilize capital from all legal fund sources. However, for prov- inces, commercial banks may still be the last sources to tap for financing under the current market conditions. Without preferential mechanisms such as better interest rates or term conditions, provincial governments would not be interested to borrow from CIFF. • Interest rates. Most provinces currently approach State Treasury or VDB for loans for infrastructure development. Provinces wish the interest rate appli- cable to commercial bank loans under the pilot CIFF program to be matched with that offered by the State Treasury and VDB. • Vietnamese dong-denominated loans . The provinces have expressed their  ­preference for Vietnamese dong-denominated loans rather than US ­dollar-denominated or any other foreign currency denominated loans, as they do not want the risk of foreign exchange to be passed onto them. • Moratorium period. Against the current practice of fixed grace period, the provinces wish the loans to be of flexible grace period for each loan along with scope for pre-payments to be made by provincial governments. 70 | Mobilizing Finance for Local Infrastructure Development in Vietnam Conclusions on effective demand The financial analysis of the assessed provinces shows that all three are finan- cially healthy. The debt ceiling that is imposed by the new SBL will determine the total debt exposure, not the ability to afford and service debt. However, the analyses show that the provinces have considerable room to improve manage- ment without substantial regulatory changes, which could increase the debt limits over time. ­ Some long-term trends that are of concern, such as the sharp rise in recurrent costs in some provinces, will need attention if the government is to achieve its goal of using substantial amounts of private sector debt sustainably. The short- term analysis shows an effective and realizable demand for long-term b ­ orrowing. Although the analysis could not derive definitive quantitative results, if the terms are attractive to the provinces in 2016, borrowing can realistically be expected to be D 3.3 trillion to D 6.6 trillion per year per province (US$153 ­million to US$307 million). However, the limited availability of timely and accurate data may restrict the provinces’ access to finance. Currently provinces have enough fiscal space to allow borrowing with only cursory credit assessments, but as recurrent costs increase with new debt, that opportunity will be diminished unless provinces streamline their access to data for submission to financing facilities. The central government and provinces therefore can consider the following interventions to improve the quality of financial management of the provinces to enhance creditworthiness. In the short term: • Prepare a sector-wise capital investment plan with clearly identified projects. The provinces should consider preparing medium- to long-term capital investments with clear sector-wise investments required, as well as taking into account the national and provincial priorities and bankability. • Standardize budgeting, accounting, and financial reporting by provincial governments to bring transparency and uniformity into financial ­reporting. This can be built into the capacity building support in a pilot CIFF program. • Identify training and capacity building requirements for officials on project identification, project preparation, procurement, and management, to help identify projects that are of national and provincial priority and at the same time are financially viable and bankable. • Streamline the regulatory framework for provincial borrowing from ­ commercial banks, allowing provinces to borrow from commercial banks as an eligible source of debt financing and defining payment security and a recourse mechanism. In the long term: • Implement reforms to improve the revenue income for provinces to meet the debt-service obligations. For instance, the provinces may undertake various tariff reforms and align taxes, user charges, and other levies to market or com- mercial levels, moving toward full cost recovery. • Obtain credit ratings for provincial governments. To provide comfort to the commercial banks under a pilot program like a CIFF, the provinces may consider getting a domestic credit rating, international credit rating, or both. A Demand-Side Analysis of the Provincial Governments | 71 Those conclusions, from the limited work conducted for this book, is reinforced by previous work by the World Bank—that governments hoping to ­ receive any private sector financing at scale and for relatively long term need to upgrade their financial management systems. If countries expect the private sector to take on the full risk of infrastructure financing, as is the eventual objective, then the timeliness, availability, and accuracy of their data must meet the needs of the potential lender. INTERNATIONAL CREDITWORTHINESS APPROACHES AT THE SUBSOVEREIGN LEVEL National and central governments Most governments adopt rules to manage and control subsovereign borrowing because of the need to prevent subsovereign debt defaults, which can damage the overall financial system and even jeopardize the central government’s own rating. Thus governments face a delicate task in balancing autonomy and decentralization principles with the controls to be imposed. It is clear that there ­ is no perfect set of rules. Creditors often believe that a national or central government will not allow cities and provincial utilities to fail financially, creating a “moral ­hazard,” in which one party takes more risks because another party bears the cost of those risks. In this view, the risk for governments is that proper credit assessments are not undertaken by creditors and excessive credit is granted, with subsovereign entities borrowing far beyond their means on the premise that risk will be t­ ransferred. The risk is exacerbated if creditors lack timely financial information, adequate controls, monitoring, and management of subsovereign debt. However, decentralization policies also permit decision making at the ­interface with constituents, allowing local governments to use subsover- eign ­ borrowing to address backlogs and fund infrastructure for growth. Most ­ governments embarking on decentralization have found it necessary to place some restrictions on subsovereign borrowing with the following goals. First, restrictions prevent individual local governments from suffering financial distress as a result of borrowing and a potential consequential default ­ on debt obligations. Defaults could lead to bailouts by central governments, which essentially defeats the goals of local autonomy and responsibility. There is  also a real fear that one bailout, irrespective of how necessary it is, may undermine autonomy and financial discipline on a countrywide scale. ­ Second, aggregating overborrowing at the local government level can n egatively affect the national macroeconomic environment. In extreme ­ cases, it can even negatively influence a country’s credit rating. An example is the overborrowing by local governments in China in the past few years, which necessitated sharp intervention by the Chinese government to curtail and manage the overborrowing by subsovereign entities. The government adopted measures to protect the solvency of local governments. However, such circumstances are changing as the central government moves to encour- age deleveraging in the financial system, and protections on local debt may have been withdrawn (Financial Times 2017). 72 | Mobilizing Finance for Local Infrastructure Development in Vietnam Restrictions on local government debt and borrowing A number of controls and restrictions with respect to borrowing by local govern- ments are used by both local and central governments: • Political restrictions are enacted in some local governments, sometimes through a local referendum, so that no long-term borrowing can occur with- out the approval of the citizens. • Direct control entails consideration and approval of borrowing on a case-by- case basis. Direct control—although good to manage and control debt and bor- rowing—has a severe downside in that the credit risks in the case of default are seen to migrate to the approving authority. The central government’s approval of individual spending and borrowing initiatives of subsovereign governments introduces an implicit guarantee of local and regional public debt. Having granted permission, the central government may find it more difficult to refuse a bailout later on, should the local government run into trouble. • Administrative and numerical restrictions comprise fiscal rules and regula- tions controlling the amount of new or overall debt levels. • Self-imposed restrictions are approved by the central government. • Market-based control provides clarity that the central government will not intervene and that local governments will be allowed to go bankrupt. The financial markets therefore must carry out diligent credit assessments similar to the credit assessments applied to private companies. One rule that is virtually uniform is the prohibition on borrowing to cover operational costs, although short-term bridging loans are allowed. In addition, it is common practice to prohibit or require central government approval for ­ borrowing in foreign currency. Most of those measures are self-explanatory, and the different approaches and the continuum are illustrated in figure 2.41, but the range of measures used in the administrative control environment of other countries are shown in table 2.5). Administrative controls are seldom based on a thorough credit analysis to determine sustainable debt levels; in most cases they take the form of empirical formulas such as: x% of y. The following are the most common empirical formulas used: • A percentage of budgeted revenue or previous year revenue (Brazil, the Philippines, Poland) • A percentage of budget or previous year’s expenditure (Belgium, Germany) • Debt service as a percentage of revenue (Brazil, Japan, the Republic of Korea, Spain) • A percentage of the total property valuation (common in the United States) • A fixed amount (the United Kingdom, £500,000 local) • A percentage of capital program (Denmark, Vietnam) • Total debt (Hungary) • Overall budget deficit (Austria, Spain) • New debt (Croatia, Lithuania). Table 2.6 indicates some of the values adopted by different countries. In some countries, dual constraints have been adopted that restrict two components, such as overall debt level and annual debt service. The most common constraints involve restricting total debt and annual debt service; linking the restrictions expenditure or the capital program is less common. Administrative and numer- ical fiscal rules are attractive because they are clear, transparent, and relatively A Demand-Side Analysis of the Provincial Governments | 73 FIGURE 2.41 Types of Controls over Local Government Borrowing Numeric No No control Direct restrictions restrictions, with or approval No Self-imposed and no but without on an ad borrowing guidelines approval approval approval hoc basis required required • Debt limits • Serving limits TABLE 2.5  International Types of Control over Subsovereign Borrowing TYPE COUNTRIES COMMENT Local autonomy, no Finland, France, Japan, Netherlands, New Zealand, Policy of no bailout is clearly articulated. ­restrictions/market-based South Africa, Switzerland No restrictions, approval Argentina (province), Brazil (local), Peru (local), Self-discipline is required. required Turkey (local), United Kingdom (local) Negotiated limits Austria, Germany (regions), Spain (regions) Debt ceilings are negotiated on the basis of fiscal targets. Numeric control Brazil (local), Croatia, Denmark, Estonia (local), Canada allows each province to set controls Philippines, Poland, Spain, United States, Vietnam and uses virtually all types of restrictions. Direct control Bolivia, China, India (state), Thailand (local) From unrestricted, China has now adopted a quota system. Self-imposed Argentina, Australia (state) The subsovereign borrowers and their association have adopted guidelines. Prohibition on borrowing Cambodia (local), Indonesia, Latvia, Mexico (state), Latvia and Indonesia adopted central Nigeria (state external) borrowing. easy to manage and monitor. Appropriate rules also improve the credibility of fiscal policy. They have the drawback that they lack flexibility and do not nor- mally distinguish between purposes or qualities, for example, income genera- tion, project or general obligation borrowing, size of city, and other specific considerations such as investment in infrastructure to service a new economic activity such as a new mining development. One serious drawback to numerical rules, though, is that because they are not flexible, users can find loopholes and circumvent the purpose of the imposed controls. Local governments find it easy to create other vehicles to borrow and so bypass the controls, effectively negat- ing the objectives. Therefore, even at the local government level, contingent lia- bilities should be tracked. 74 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 2.6  Sample of Numeric Control Measures Used Globally BORROWING AS DEBT SERVICE PERCENTAGE OF TOTAL PREVIOUS YEAR TOTAL PROPERTY ANNUAL CAPITAL PERCENTAGE OF CURRENT REVENUE: PREVIOUS OR EXPENSES (%) VALUATION (%) PROGRAM (%) REVENUE CURRENT Philippines: 20% of Croatia: 30% of Ontario, Canada: debt United States: various Denmark: 25% of capital regular income previous year expenses service not to exceed common 40% of program for year 25% of revenue property valuation Poland: 12–15% of Albania: debt service less Prince Edward Island, Vietnam: 30–100% of recurrent revenue than 20% of average Canada: 10% of capital program revenue for 3 years property value Nova Scotia, Canada: Czech Republic: debt 30% of own source service less than 30% of revenue revenue Uganda: 10% of France: debt service recurrent revenue 50% of operating without approval, 25% revenue with approval Albania: 77% of Italy: debt service less recurrent revenues than 15% of total annual revenue Hungary: less than Brazil: debt service less 50% of own revenue than 11.5% of current revenue South Africa and Spain have been at pains to announce that they will not financially bail out subsovereign entities that default; instead they would place offenders under administrative rules to “work out” the entity’s debt and to restore it to sound financial standing. Nonetheless, despite a central govern- ment’s efforts to prevent even psychological credit risk migration, in practice, bridging loans and other means are still sometimes considered. Vietnam’s current creditworthiness approach Under the 2002 SBL, provincial borrowing was set annually at 30 percent of the annual capital budget, with exceptions made for Hanoi and Ho Chi Minh City, which were allowed up to 100 percent. Under the 2015 SBL, it has changed to a formula based on the previous year’s revenue as in the following examples: • Uses 60 percent of previous year’s revenue for Hanoi and Ho Chi Minh City • Uses 30 percent of previous year’s revenue for the second tier of provinces that contribute to the central budget • Uses 20 percent of previous year’s revenue for provinces that generate at least 50 percent of their own budget The adoption of this new formula would bring Vietnam more in line with global practice. Additional clauses in the 2015 SBL also stipulate “[u]sing the state budget fund at a State Treasury beyond the budget estimate approved by a competent authority, except for the case of temporary funding or advance funding from next year’s budget prescribed in Article 51 and Article 57 of this Law” (Article 18, Clause 11). Also, “Budget expenditures may only be realized after the budget A Demand-Side Analysis of the Provincial Governments | 75 estimate is approved by a competent authority; the standard, and expenditure limits imposed by competent authorities, must be complied with” (Article 8, Clause 4). Where some defaults did occur in Vietnam in the past, they were handled not through the courts, as in many other countries. but administratively, essentially by employing the reserves at provincial level and using bridging support from the central government. The new approach under the 2015 SBL should facilitate borrowing within the affordability limitations and create more flexibility to deal with multiyear projects. However, it is also essential that the SOEs, which in principle pose a contingent liability to local government, be brought under the net. Creditworthiness criteria of local government No government uses the actual creditworthiness or debt absorption capacity of local governments when setting borrowing limits. However, commercial lenders that are taking a credit risk on provincial government have their own credit processes—most of them proprietary—that can vary from extremely rigorous to ­ cursory, depending on their knowledge and risk perception of the sector. Globally a number of specialized intermediaries and local and regional development institutions specialize in subsovereign lending. All of them have over time devel- oped their own credit assessment processes, which also vary from cursory to sophisticated. Some private intermediaries—such as Dexia in France (a privat- ized SOE, now a commercial bank), with 26,000 municipal clients—have devel- oped an automated and very sophisticated credit assessment system to allow the setting of risk premiums. Similarly, INCA in South Africa has developed a sophis- ticated appraisal methodology allowing the determination of capital adequacy requirements and risk premiums as well as other conditions and loan caveats. Most of these credit processes are confidential and proprietary, but in general they follow the broad methodology applied by the rating agencies, although on a more informal basis. Contractual savings institutions tend to rely more heavily on formal credit ratings, especially where exposure is through bond issue. They use the ratings to continually balance the portfolio to maintain the desired weighted credit quality. Monitoring the client, which is part of the formal rating procedure, is also more important to them than to the banking sector, which tends to undertake monitoring by regular client reports as one of the condition- alities. Contractual savings institutions often employ the caveats in the loan agreements, with punitive breach of contract conditions and default clauses to force regular reporting. The sizes of the provinces in Vietnam and the potential volume of borrowing and bond issues indicate that it is probably time for credit rating agencies to start playing a more prominent role, and that formal credit ratings in due course may be considered as a precondition above a certain level of borrowing. Basic approach to credit rating The basic approach to rating of subsovereign entities is always based on the sov- ereign rating as a benchmark and ceiling, and it will follow a cascading approach in determining the risk and the eventual rating (figure 2.42). Ratings have often been described as part science and part art, and they use the past to look into the future to predict the possibility of default and the likely 76 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 2.42 The Cascading Approach of Risk Evaluation Country Sector Region/province (if applicable) Entity severity if a default occurs. The approaches of the three big rating agencies are fundamentally the same and follow this sequence7: • Performing an in-depth study of documentation provided by the entity being rated (client) • Performing in-depth and penetrating interviews • Drafting the rating report • Allowing the client to confirm the correctness of the information • Submitting information to a rating committee for allocation of a rating • Publishing the rating (if the client agrees) • Regularly monitoring and issuing early warnings if required. The actual aspects analyzed at the provincial level will differ from sector to sector but normally will focus on the long term and have both qualitative and quantitative focus. At the subsovereign level the approach will normally consist of an assessment and analysis of the following: • The economic base in its area of jurisdiction. This step will cover aspects such as potential GRDP growth, unemployment rates, poverty indexes, concentra- tion risk in a single client and industry, vulnerability to volatile inputs such as energy costs and other fixed costs. • Financial performance and stability. This step will cover past performance and predicted future performance. Issues covered will be strength of the balance sheet, cash flow, and profitability as well as a number of semistandard finan- cial ratios measuring solvency, liquidity, working ratio, debt-to-equity, or approximation in the case of a statutory entity, debt coverage, reserves, con- tingent liabilities, and operating revenues. • The experience and quality of management. Although sometimes relatively subjective, this step will be based on an impression of whether management is a winning team or not. Specific items considered are succession planning, qualifications, experience, and training programs. • Operational performance. This step looks at the efficiency and effectiveness of the entity with substantial reliance on peer comparisons. • Autonomy and transparency. This step considers aspects such as the right to appoint management, the right to determine taxes and tariffs, the right to borrow, and so on. A slightly contradictory but substantial issue is also the A Demand-Side Analysis of the Provincial Governments | 77 question of government support and, where subsidies are involved, the predictability and dependability of such transfers. ­ • Risks. The rating also includes a frank discussion of the external or internal risks faced by the entity. This step will cover aspects such as political and legislative changes, economic stress testing, and vulnerability to global events. Ratings and shadow ratings At the subsovereign level, where getting formal ratings is expensive, a prelimi- nary step often is to conduct a private shadow rating process as a precursor to a formal rating. A shadow rating is a less in-depth assessment of an entity follow- ing the same basic methodology but usually carried out by a nonaccredited rat- ing entity. This could be the institution itself, a bank, a consultant, or even a rating agency. A shadow rating has the advantage that it is cheaper, identifies the areas where improvement is needed before resorting to a formal rating, and can be easily adjusted to serve a specific purpose. For example, Afcapconsult in South Africa has developed Municat/Watercat,8 a municipal water credit assess- ment tool that can be used as a model for municipalities and water utilities. Key outputs include shadow credit rating, benchmarking, trend analysis, and reform agendas. The Municat/Watercat tools are to be used by the following stakeholders: • The municipality and utility, to identify performance improvement areas and to compare with their peers • The donor community, to identify common areas in which technical assis- tance can have a substantial effect on a number of entities • The regulator and government, to monitor performance • The financial institution, to identify potential borrowing clients and to get comfortable in an unknown sector. SUGGESTED CRITERIA FOR PROVINCES IN VIETNAM General criteria The study did not require the design of a detailed credit framework but instead involved the high-level identification of potential creditworthiness compo- nents. The list is not exhaustive but, as discussed in the assessment of the three provinces, it includes information that must be available and have a high level of integrity and dependability. Aspects that must be considered are presented in table 2.7. If a borrowing support initiative is to be implemented, participation should be subject to meeting certain criteria. First, enough information must be com- piled for banks to undertake a credit appraisal, and second, project preparation should be at an advanced stage ready for investment. Initial credit risk assessment of provinces The process of obtaining full creditworthiness at the provincial level will unfold over a number of years. However, that doesn’t mean that development of a provin- cial debt market would be held in abeyance until full creditworthiness is achieved. Whereas full creditworthiness remains the long-term goal, provinces should be formally rated by accredited credit rating agencies to ascertain whether they 78 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 2.7  Criteria for Creditworthiness of Provinces ECONOMIC LEGISLATIVE POLITICAL STABILITY AND GOVERNANCE OPERATIONAL EFFICIENCY • Likelihood of support from Statutory limits imposed by • Autonomy •  • Collection efficiency the central government the SBL and MOF • Predictability and dependability of (capability to collect • Ability to impose taxes and Recourse mechanisms and •  transfers billed accounts) collect tariffs default procedures • Clarity of roles, responsibilities, and • Billing efficiency • GRDP and growth projections Compliance with regulations •  authority (capability to bill for • Unemployment ratio Authority to borrow •  services rendered) • Future challenges • Staff costs per function • Dependency on grants • Maintenance expenditure • Concentration on servicing a • Quality of management single industry client, or information systems group of clients • Use of private sector • Future potential, such as in • Customer complaint mining, export, or tourism resolution norms FINANCIAL PERFORMANCE HUMAN RESOURCES RISKS • Collateral and reserves • Management quality and experi- • Changing legislation • Operating surplus and deficit ence • Economic volatility • Percentage of cost recovery on trade services • Appropriateness of staff qualifica- • Interest rate volatility • Solvency and liquidity ratios tions • Political interference in • Debt service ratio (the proportion of annual revenue spent on • Quality of multiyear planning and day-to-day decisions servicing principal and interest obligations) budget • Loss of financial control • Debt service coverage (the amount of cash available to meet • Succession planning over SOEs principal and interest obligations) • Training programs • Working ratio (the ability to recover operating costs from operating revenues • Cash reserves as a share of annual operating income (expressed as months of operating expense) • Consumer bad debt provision (cash provision for bad and doubtful debt) • Operating cost cover ratio • Interest cover • Debt maturity concentration • Potential revenue not collected • Ability to remain within budget • Contingent liabilities • Ring-fencing of revenue and expenditure for different functions and SOEs meet initial minimum conditions for access to CIFF support. The following are the suggested conditions for rating: • Compliance with the criteria in the SBL as far as maximum debt limits are concerned • Compliance with all legislative and regulatory requirements • Operational and debt coverage ratio to be at least 1.3 (total unearmarked revenue divided by recurrent expenditure plus debt services) ­ • Actual deviations from budget to be within a specified norm (an initially acceptable 10 percent maximum deviation, gradually decreasing to 5 percent; partially as a proxy objective measurement of management capacity and skill) • A satisfactory skills development plan to address project preparation and financial management that is to be developed and implemented • Long-term recurrent expenditure projections not to exceed 90 percent of unearmarked revenue • Liquidity cash reserves of at least 3 months to be maintained A Demand-Side Analysis of the Provincial Governments | 79 • If financing is a bond issuance, an external sinking fund to be created • At least a medium-term, climate-friendly development plan with the sup- porting capital investment plans to be developed and incorporated in the budgets. These suggestions would apply in both retail and wholesale environments. In the wholesale environment, banks would also be free to apply their own credit criteria and would be expected to do so. For the commercial banks to participate and benefit in CIFF activities, they would be required, at minimum, to apply these conditions and credit principles. Creditworthiness criteria of financial institutions The assessment of banks to be used by the CIFF will be decided in consultation with the SBV. Basic high-level considerations in determining the creditwor­thiness of a bank are (a) earnings before interest, taxes, depreciation, and amortization; (b) liquidity; (c) capital adequacy; (d) solvency; (e) debt-equity ratio; (f ) nonper- forming loans; (g) asset quality; (h) portfolio diversification (sector, client, area); (i) fee to margin income; ( j) management quality; (k) risk management systems; and (l) financial performance and ratios. A rating approach would also consider aspects such as the regulatory environment and economic prospects; however, because those factors will be common for all banks and other financial intermedi- aries to a large degree, it is not critical to take them into account. CONCLUSIONS The conclusion from this high-level assessment of the provinces’ potential ­ effective demand for access and support from a new financing facility is that demand is likely to be substantial but will take time to unfold. The three prov- inces assessed in this chapter are all financially healthy, and their debt will be capped by the new SBL prescription that total debt stock must be capped at 30 percent of the previous year’s revenue rather than by the ability to service the debt. The detailed analysis of the three provinces indicates that the provinces must have considerable fiscal space for borrowing before the ceiling is reached or before the ability to service debt becomes an issue. The assessment raised some concerns that the recurrent expenditure trends in some provinces are ris- ing to levels that can be regarded as curtailing fiscal flexibility; thus policy mak- ers should initiate attempts to constrain the growth. The chapter showed that the 11 second-tier provinces have the ability, capac- ity, and willingness to incur debt. Implementation capacity is not likely to pres- ent a challenge in most provinces, given the relatively small increase in capital investments. Therefore, the assessment concluded that provinces will have a substantial demand for access and support from a new financing facility to pro- mote more borrowing and longer-term loans. Regulatory constraints and the financial attractiveness of the facility, however, will determine the effective demand. That demand will depend on the facility’s conditions of such support and the degree to which reforms promote more autonomy, enhance revenue, and improve financial management capacity. If capacity building is efficient, if the regulatory environment is enabling, and if the conditions and terms are attrac- tive, the effective demand by end-2016 is estimated to be between D 3.3 trillion 80 | Mobilizing Finance for Local Infrastructure Development in Vietnam (US$153 million) and D 6.7 trillion (US$311 million) and to remain at around D 6.45 trillion (US$300 million) for the next 5 years. Another conclusion noted that promoting sustainability and creditwor- thiness required that a credit evaluation system be introduced and that certain minimum parameters be articulated to allow access to support from ­ the potential CIFF. Under the approach being considered—involving the private sector and structuring the support program for the private sector to ­ take at least some real credit risk, even if partial—the commercial banks and capital markets will have limited appetite for the approach if timely and accurate information is not available. The lack of information from borrow- ers could prove to be more of a constraint than the availability of properly prepared projects, not in itself, but as a symptom of the inadequacy of prov- inces’ financial management capabilities, management information systems, and budget skills. In light of these considerations, this chapter recommends that the CIFF initiative require, as a precondition, that participants in the borrowing support system and take part in a program to enhance financial management capacities at the provincial level. NOTES 1. “The World Bank in Vietnam,” World Bank country overview, http://www.worldbank.org​ /­en/country/vietnam/overview. 2. Category 2 here means second-tier provinces that are net contributors to revenue of the government of Vietnam. Category 3, third-tier provinces, depend heavily on the central government’s transfers and have very limited creditworthiness. 3. Ratios are generally accepted measurements used by commercial lenders to assess an ­ entity’s financial health and will typically include (a) debt service cover ratio, which is the ratio of cash flow available to service debt; (b) operating cost cover ratio, which indicates the operating costs as a ratio to total operating income; (c) liquidity ratio, which measures the short-term ability to meet obligations; and (d) loan life cover ratio, which measures the long-term ability to service a loan. ­ ational 4. The MOF stated that this is not a provincial contingent liability but a charge on the n budget. 5. Since Beijing heavily restricted local governments’ borrowing, local government financing vehicles were created to borrow on local governments’ behalf. Such borrowing, which totaled over US$4 trillion in this IMF analysis, was responsible for one-quarter of the ­ buildup in China’s overall domestic debt since 2008. 6. A workout is the process whereby a debtor meets a loan commitment by satisfying altered repayment terms. This is often managed by an independent administrator and may consist of some radical interventions such as reducing staff. 7. The more detailed Moody’s approach to credit rating can be obtained at https://www​ .moodys.com/researchdocumentcontentpage.aspx?docid=PBC_147779. 8. For more details of the assessment tool, please refer to “Presentation on Credit Assessment & Benchmarking Tools Developed (Watercat & Municat),” available at UN-HABITAT website: http://mirror.unhabitat.org/list.asp?typeid=54&catid=270. REFERENCES Albrecht, David, Hervé Hocquard, and Philippe Papin. 2010. Urban Development in Vietnam: The Rise of Local Authorities: Resources, Limits and Evolution of Local Governance. Paris: Agence Française de Développement. Financial Times. 2017. “Rising Risk in Chinese Local Government Debt.” FT Confidential Research. June 26. A Demand-Side Analysis of the Provincial Governments | 81 Fitch Ratings. 2014. “Vietnam: Full Rating Report.” Fitchratings.com, November 17, 2014. Government of Vietnam. 2012. State Budgets 2002 and 2013. Unpublished documents. Hanoi: Government of Vietnam. IMF (International Monetary Fund). 2014. Vietnam: 2014 Article IV Consultation—Staff Report; Press Release; and Statement by the Executive Director for Vietnam. Country Report 14/311. Washington, DC: International Monetary Fund. Lu, Yinqiu, and Tao Sun. 2013. “Local Government Financing Platforms in China: A Fortune or Misfortune?” IMF Working Paper 13/243, International Monetary Fund, Washington, DC. Smetts, Susanna. 2014. “Water Supply and Sanitation in Vietnam: Turning Finance into Services for the Future.” UNDP Water and Sanitation Program. Washington, DC: World Bank. UNDP (United Nations Development Programme). 2013. 2013 Human Development Report. New York: United Nations Development Programme. World Bank. 2011. Vietnam: Assessment of PFM Arrangements at the Provincial Level. Washington, DC: World Bank. ———. 2013. Assessment of the Financing Framework for Municipal Infrastructure in Vietnam. World Bank, Washington, DC. ———. 2014a. Making the Whole Greater than the Sum of the Parts: A Review of Fiscal Decentralization in Vietnam. Washington, DC: World Bank. ———. 2014b. Subnational Debt Management Performance Assessment: Ho Chi Minh City, Vietnam. Washington, DC: World Bank. ———. 2015. Vietnam Socio-Economic Development Plan, 2010 to 2020. Washington, DC: World Bank. http://www.worldbank.org/en/country/vietnam/overview. 3 A Supply-Side Analysis of the Vietnamese Banking Sector The Vietnamese banking industry has shown impressive growth in the past decade along with the country’s economy. Since the 1990s, the government of Vietnam has launched a series of restructuring and liberalization reforms to strengthen the banking sector as part of the country’s shift to a more market-driven  economy. These reforms also have paved the way for the ­ diversification of commercial banks in the country (box 3.1). Overall, total assets of the commercial banks in Vietnam have been rapidly expanding, and forecast to increase from US$267 billion in 2015 to US$422 billion by 2019 (figure 3.1). The Vietnamese banking industry is highly concentrated in the four state- owned commercial banks (SOCBs),1 which control around 45 percent of total assets (Schmittmann et al. 2017). The remaining assets, held by 89 banks, are highly fragmented. Those banks are mainly composed of joint-stock com- mercial banks (JSCBs), joint-venture banks, and branches of foreign banks (figure  3.2). SOCBs dominate the market in terms of loans and depos- its,  although their share has been eroding since the 1990s, decreasing to 70 percent in the early 2000s and later to 45 percent in 2017. Traditionally, SOCBs have been the instrument of government policy lending, which often includes programs that focus on state-owned enterprises (SOEs). SOCBs continue to be the main funding source for SOEs. The majority of the income for SOCBs is from interest-based rather than fee-based products. More spe- cialized segments, such as project financing and investment banking, have a limited presence in Vietnam. The non-SOCBs, especially JSCBs and the wholly owned foreign banks, have increasingly imposed competitive pressure onto the traditional players in the banking sector (tables 3.1 and 3.2). Together, the non-SOCBs account for more than half of total assets in the sector. JSCBs have shown aggressive growth in recent years and have emerged as an important competitor for the SOCBs. They have more diversified shareholding structures, with both pub- lic and private shareholders. They focus on small and medium enterprises (SMEs) and on the retail segment. The foreign banks, which differentiate themselves with their global industry knowledge, expand rapidly into the retail market.  83 84 | Mobilizing Finance for Local Infrastructure Development in Vietnam BOX 3.1 Vietnam Banking Reform Timeline Over the past 65 years, various banking reforms in commercial loans could be used to finance local Vietnam have brought the sector to the point at which ­infrastructure projects. FIGURE B3.1.1 Vietnam Banking Reform Snapshot By 2008, formal licenses were Restructuring granted to 100% foreign- and Establishment of four large Deregulation invested banks, namely HSBC, consolidation state-owned commercial of domestic Standard Chartered Bank, of banking banks (SOCBs)-VBARD interest rates Hong Leong Bank, sector through (AgriBank), BIDV, (1996–2002) Shinhan Bank, and ANZ mergers and Incombank, and Vietcombank (Sacombank). acquisitions 1951 1991 2005 2007 2011 2013 Establishment Financial liberalization paved Government’s Since April 1, 2007, 100% New law Vietnam Asset of the State the way for the establishment decision in foreign-owned banks are on credit Management Bank of Vietnam, of commercial joint-stock May 2005 to allowed to be established institutions company was successor of the banks, joint-venture banks, restructure in Vietnam as part of took effect established in July Vietnam branches of foreign banks, and equitize World Trade Organization on January 2013, to clean up National Bank credit cooperatives, SOCBs by commitment. Newly 1, 2011. bad debt from the people’s credit funds, 2010 established banks had to banking system and finance companies have a minimum- and allow domestic over the next decade. chartered capital of D 1 banks to undergo trillion and reach D 3 much-needed trillion by December 12, restructuring. 2011. FIGURE 3.1 Total Assets of Vietnamese Commercial Banks 450 400 350 300 US$, billions 250 200 150 100 50 0 2012 2013 2014 2015 2016 2017 2018 2019 Total assets Client loans Client deposits Source: “Vietnam Commercial Banking Report Q2/2015,” BMI Research. Note: Data for 2014 are estimated; 2015–19 data are forecast. A Supply-Side Analysis of the Vietnamese Banking Sector | 85 FIGURE 3.2 Chartered Capital and Number of Banks per Category 10,000 50 8,959 9,000 46 45 8,000 40 7,000 33 35 Number of banks 5,777 US$, millions 6,000 30 5,000 25 4,000 20 3,000 2,469 15 2,000 10 1,000 980 5 4 5 0 0 SOCBs JSCBs Wholly owned Foreign bank foreign banks branches Total chartered capital (US$, millions) Numbers of banks Source: State Bank of Vietnam. Note: SOCB = state-owned commercial bank; JSCB = joint-stock commercial bank. TABLE 3.1  Key Groups of Banks by Market Focus and Strengths STATE-OWNED JOINT-STOCK FOREIGN BANK WHOLLY OWNED JOINT-VENTURE POLICY BANK COMMERCIAL BANKS COMMERCIAL BANKS BRANCHES FOREIGN BANKS BANKS 4 BANKS 33 BANKS 46 BANKS 5 BANKS 4 BANKS 1 BANK Characteristics • Dominate Vietnam’s • Have a shorter history • Are constrained by • Differentiate • Use joint-­ • Provides market in terms of of operations than the regulation themselves by venture funds to assets, loans, deposits, SOCBs. limiting the offering contracts for carry out the and distribution capacity to operate innovative capital policy-­ • Focus on SME and network. as local banks. products that contributed directed retail segment, with reflect their by one or lending of • Traditionally focus on a • Historical focus on emphasis on banking global industry more the govern- certain segment. For servicing multina- products and services. knowledge. Vietnamese ment. example, Agribank tional customers in • Had aggressive growth banks and focuses on the Vietnam, but with • Expand in recent years in one or more agricultural sector; increasing focus on aggressively into terms of branch foreign banks. Vietcombank specializ- larger Vietnamese retail market. network and deposit es in trade finances, companies. • Are tradition- mobilization. • Have a limited foreign exchange, and ally focused • Have key strengths branch network. international payments.• Are strategic foreign on relations in terms of capital, investors. Most of the with corporate • Provide main source of experience, and top JSCBs have large customers, funding for SOEs. technological international strategic primarily expertise. • Have a good reputation investors, such as export with domestic HSBC (Techcombank), companies depositors. ANZ Bank from the (Sacombank), and foreign ACB (Standard joint-venture Chartered Bank) bank’s country. continued 86 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 3.1, continued STATE-OWNED JOINT-STOCK FOREIGN BANK WHOLLY OWNED JOINT-VENTURE POLICY BANK COMMERCIAL BANKS COMMERCIAL BANKS BRANCHES FOREIGN BANKS BANKS 4 BANKS 33 BANKS 46 BANKS 5 BANKS 4 BANKS 1 BANK • Includes an extensive • Are under pressure to • Have a limited • Announce their • Have a limited • Has a limited branch network with restructure. Many small number of presence by branch branch over 1,000 branches or JSCBs (such as Ocean branches, each buying stakes in network. network. transaction offices Bank, GP Bank) with requiring a local joint-stock • Have • Does not across Vietnam. poor performance and separate license. players, such as difficulties have to high NPLs are under HSBC expanding, • Are geographically compete restructuring through (Techcombank), given local concentrated in with mergers and acquisi- ACB (Standard partners’ urban areas. commercial tions. Chartered limited banks. Bank), and ANZ resources, (Sacombank). thus requiring that joint-­ venture banks maintain their original capital structure between foreign and local partners. Note: State-owned commercial banks include majority state-owned joint-stock bank (VietcomBank). Wholly owned foreign banks include ANZ (Sacombank), HSBC, ACB (Standard Chartered Bank), Hong Leong, and Shinhan Bank. JSCB = joint-stock commercial bank; NPLs = nonperforming loans; SME = small and medium enterprises; SOE = state-owned enterprise; HSBC = The Hongkong and Shanghai Banking Corporation; ANZ = Australia and New Zealand Banking Group. TABLE 3.2  Products of Key Groups of Banks in Vietnam STATE-OWNED JOINT-STOCK COMMERCIAL FOREIGN BANK WHOLLY OWNED JOINT-VENTURE POLICY BANK COMMERCIAL BANKS BANKS BRANCHES FOREIGN BANKS BANKS Major players • Agribank • Techcombank • ABN Amro Bank • HSBC • Indovina Bank • Vietnam Bank • Vietcombank • Sacombank • Bank of China • Standard • Vietnam- for Social • VietinBank • ACB (Standard • Citibank Chartered Bank Russia Bank Policies • BIDV Chartered Bank) • Deutsche Bank • ANZ Bank • VID Public • Military Bank AG Vietnam • Hong Leong Bank • Maritime Bank Bank • Vina Siam • LienVietPostBank • Shinhan Bank Product focus • Have an industry • Focus on individual • Focus on sophisti- • Focus on retail • Focus on • Focus on focus but are consumers and SMEs if cated products banking through products for lending to expanding into large. Large JSCBs also for foreign-­ automobile and foreign-­ poor personal and SME offer corporate banking, invested housing loans, invested households, products. Some still treasury, and capital mar- companies and Internet banking companies disadvantaged focus on serving the ket products, such as large state-owned services, as well investing and students, traditional industry foreign exchange companies. as international doing business overseas customer groups transactions, derivative credit card in Vietnam, workers, • Have select (such as Agribank trading, options, services. such as ethnic products for for rural and securities, leasing subsid- export-import minority foreign and • Have introduced agricultural financial iaries, and trade finance. finance, households, high-income new products to markets), while • If smaller JSCBs, have overseas and other Vietnamese retail the Vietnamese others are increasing limited product remittances, social customers, market, such as their focus on diversification with a project development including mortgage catering to the focus on SMEs. finance, as purposes, international services and needs of individual well as export such as job • Are starting to offer payment services, medium-term consumers and and import creation and more innovative deposit foreign currency certificates of SMEs. support environmental products to boost capital trading, and deposit. services. protection. mobilization. remittances. Note: State-owned commercial banks include majority state-owned joint-stock banks (Vietcombank). Wholly owned foreign banks listed were granted licenses for 100 percent foreign-owned subsidiary banks in 2008. BIDV = Bank for Investment and Development of Vietnam; JSCB = joint-stock commercial bank; SME = small and medium enterprises; HSBC = The Hongkong and Shanghai Banking Corporation. A Supply-Side Analysis of the Vietnamese Banking Sector | 87 BANKING INDUSTRY ISSUES Asset liability mismatch A major constraint facing commercial banks’ capability and appetite for lending to provincial governments is the mismatch between short-term capital and long- term loans. Because the primary sources of funding for commercial banks are the customers’ deposits, which are short- to medium-term in nature, the banks’ assets will always have shorter tenor compared with the long-term financing needs of infrastructure. Commercial banks are able to mobilize only a small amount of long- term capital: less than 4 percent of the total liabilities in four of the banks discussed here. However, a relatively significant portion of their loan portfolios (on average more than 20 percent) is allocated to long-term loans to clients (see later section, “Rapid Assessment of Performance of Selected Commercial Banks”). Thus com- mercial banks are exposed to the liquidity risk of using too much short-term capi- tal for long-term lending (table 3.3 and figure 3.3). The ratio of long-term liabilities to long-term assets is generally lower than 16 percent, except for VietinBank, with 26 percent. In current conditions, further long-term loans to provincial govern- ments could increase the gap between long-term assets and liabilities. TABLE 3.3  Characteristics of Selected Commercial Banks ASSETS AND LIABILITIES, D, MILLIONS VIETCOMBANK LIENVIETPOSTBANK MARITIME BANK VIETINBANK Long-term assets 27,762,105 18,680,940 4,529,183 90,853,242 Long-term liabilities 2,017,282 2,872,705 182,515 23,366,272 Long-term liquidity gap 25,744,823 15,808,235 4,346,668 67,486,970 Long-term liabilities as share of long-term assets, % 7.27 15.38 4.03 25.72 Long-term liabilities as share of total liabilities, % 0.32 2.87 0.20 3.23 Source: Annual reports for 2015 of Vietcombank, LienVietPostBank, Maritime Bank, and VietinBank. FIGURE 3.3 Liquidity Risks Facing Selected Commercial Banks 100,000,000 80,000,000 60,000,000 D, millions 40,000,000 20,000,000 0 Vietcombank LVPB MSB Vietinbank Long-term assets Long-term liabilities Long-term liquidity gap Source: Annual reports for 2015 of Vietcombank, LienVietPostBank (LVPB), Maritime Bank (MSB), and VietinBank. Note: LVPB = LienVietPostBank; MSB = Maritime Bank. 88 | Mobilizing Finance for Local Infrastructure Development in Vietnam Credit slowdown Another constraint in the Vietnam banking industry is the slowdown of credit growth, which affects commercial banks’ lending capability (figure 3.4). Vietnam’s banking sector has shown impressive growth in both loans and deposits since 2000. In the period 2000–2012, total loans and deposits also grew at a compound annual growth rate of 28.3 percent and 28.9 percent, respectively. The fastest growth rate took place in the period 2002–07, when total loans and deposits grew at a compound annual growth rate of 35.8 percent and 37.5 percent, respectively. That growth peaked in 2007, when loans grew at 53.9 percent and deposits grew at 51.5 percent. Since 2013, both loan and deposit growth rates have been lower than they were earlier. The slowdown in loan growth has largely resulted from a large number of bad debts in Vietnam’s banking sector, which have reduced the willingness of banks to lend. With room for policy easing, the State Bank of Vietnam (SBV) is expected to cut rates further to spur credit growth in the country in the short term. Nonperforming loans Dealing with high percentages of nonperforming loans (NPLs) is a top priority for banks in Vietnam. Banks must ensure that lending to provincial governments does not lead to a possible increase in NPLs. Reliable NPL data are difficult to obtain because of a big gap between Vietnamese bank practices and interna- tional standards on reporting NPLs (figure 3.5). However, according to the SBV, reporting of NPLs across the banking sec- tor has been increasing since 2009 and peaked at 4.1 percent in December 2012 (figure 3.6). Independent rating agencies as well as other economists believe ­ the unreported number to be much higher. Many think that the 3.3 percent of FIGURE 3.4 Growth of Loans and Deposits in the Banking Sector 60 50 40 % growth 30 20 10 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Deposit Credit GDP Source: State Bank of Vietnam. Note: GDP = gross domestic product. A Supply-Side Analysis of the Vietnamese Banking Sector | 89 FIGURE 3.5 Estimates of Nonperforming Loans NPLs reported by banks (October 2012) State Bank of Vietnam surveillance estimates (February 2013) Fitch Ratings estimates (October 2012) 0 2 4 6 8 10 12 14 % of total lending Source: State Bank of Vietnam and Fitch Ratings. Note: NPL = nonperforming loan. FIGURE 3.6 Changes in Nonperforming Loan Rate of Commercial Banks 4.5 4.1 4.0 3.6 NPL rate, % of total credit 3.5 3.2 3.5 3.0 3.4 3.0 3.3 2.5 2.9 2.6 2.0 2.2 2.0 1.5 1.0 0.5 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Year-end Source: State Bank of Vietnam. Note: NPL = nonperforming loan. NPLs in 2014 does not reflect the true troubled status of the Vietnamese banking industry or of the credit quality of bank lending. The SBV has issued many mea- sures to control and manage NPLs at commercial banks, such as issuing Circular 02 on loan reclassification (effective June 2014) and establishing the Vietnam Asset Management Company in July 2013 to repurchase banks’ NPLs. As a result, the NPL rate decreased from 3.6 percent in 2013 to 3.3 percent in 2014. State-owned enterprises SOEs currently account for more than half of the banking sector’s NPLs ­(figure 3.7). Sour loans (in which interest is overdue and recovery of principal is uncertain) in the property sector are another main source of NPLs. Small banks have an overwhelming exposure to real estate loans and individual loans, resulting in highly skewed and risky loan portfolios. 90 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 3.7 Allocation of Credit and Nonperforming Loans a. Total credit allocation b. Total nonperforming loan allocation Real estate, Real estate, 12.0% 10.3% Stock Stock market, market, 5.6% 6.5% Others, 14.1% State-owned Others, State-owned enterprise, 25.5% enterprise, 56.0% 70.0% Source: Bank Reform Report 2011. The relatively high proportion of NPLs in local commercial banks reduces the availability of domestic debt capital and, therefore, the potential for com- mercial banks to join syndicated loans for infrastructure projects. In addi- tion, high bad debt levels in local commercial banks make it difficult for international investors (funds and banks) to on-lend through these local banks. Under the current circumstances, commercial banks are hesitant to lend to provincial governments because such lending may lead to an increase in NPLs, which have limited or no recourse mechanism. Commercial banks need to learn how to properly manage credit risks specific to provincial government borrow- ing, knowledge that should be required both by commercial banks’ policies and SBV regulations. MACROECONOMIC INSTABILITY AFFECTS GOVERNMENT CREDITWORTHINESS The track record of macroeconomic instability in recent years threatens the credibility of the government at both the central and provincial levels. That record could potentially affect the creditworthiness of provincial government borrowers. Moreover, the high level of government debt could trigger a fiscal crisis, undermining confidence in the ability of the banking sector to lend to pro- vincial governments. Falling inflation Falling inflation provides room for further rate cuts, making borrowing from commercial banks more affordable for provincial government borrowers. Although economic growth has been sustained, headline inflation continues to fall, providing room for continued monetary easing. Consumer price inflation rose 4.1 percent on average in 2014, marking a significant decline from the A Supply-Side Analysis of the Vietnamese Banking Sector | 91 6.6 percent recorded in 2013. Easing price pressures in turn FIGURE 3.8 have led to a recent rise in the real policy rate. Real interest Proportion of Banking Industry’s Short-, rates came in at 4.8 percent in 2014, suggesting that current Medium-, and Long-Term Loans monetary policy is not terribly loose.2 Long-term (>5 years), 17% Domination of short-term loans More than 60 percent of Vietnamese commercial banks’ out- standing loans were short term, while the entire banking Medium-term Short-term sector’s total long-term loans (more than 5-year tenor) were (1–5 years), (≤1 year), estimated at US$31 billion by the end of 2012 (figure 3.8). In 22% 61% general, more than 85 percent of the Vietnamese commer- cial banks’ total liabilities are due in less than 1 year; for some banks, that rate is up to 98 percent. Those percentages Source: Vietnam banking survey 2013, KPMG. reflect a mismatch of financing tenor caused by provincial governments’ long-tenor infrastructure projects and the short-term nature of commercial bank deposits. The SBV set a limit, effective February 2015, allowing commercial banks to provide medium- and long-term loans up to 60 percent of their short-term fund- ing mobilization.3 The new regulation has increased the medium- and long-term lending capability of the commercial banks. However, many commercial banks believe that the credit market can neither function as nor replace the debt mar- ket; that is, they cannot provide the long-tenor loans to the allowable limit because of the tenor mismatching and the liquidity issue. The Vietnamese bank- ing system does not want to repeat the recent painful experience with high NPLs and the liquidity crisis. In general, the new circular has some positive regulatory impact, but it has little effect on technically promoting long-term lending by commercial banks. Less attractive government bonds Within this macroeconomic context, yet another trend is that government bonds are becoming less attractive to the banking system. For many years, issuing a government bond was a traditional way that the Vietnamese government dealt with its fiscal deficit. However, the government has been very unsuccessful with its bond issuing plans recently, and in May 2015 issuing of government bonds reached a low point. Several factors explain this situation. First, in 2015 the economy improved and credit grew higher than the pre- vious year. As a result, the commercial banks can find better opportunities to lend, and they have shifted their portfolios to focus more on business sectors and less on government bonds. Second, the interest rates offered by govern- ment bonds with maturity in 5 and 10 years are 5.5 percent and 6.3 percent, respectively. Those interest rates are far below the market rate for commercial banks’ medium- and long-term loans, which are 9.0–11.0 percent. Third, the SBV circular 36/2014/TT-NHNN set ceilings for government bond buying. JSCBs are not allowed to buy government bonds in excess of 35 percent of their short-term mobilization funds, and the ceiling for SOCBs is 15 percent. Some commercial banks have reached their ceiling and cannot buy more ­government bonds. According to Resolution 78/2014 of the National Assembly, the government will not issue bonds with a maturity of less than 3 years. One reason is that the 92 | Mobilizing Finance for Local Infrastructure Development in Vietnam government is in the process of restructuring its debts and reducing capital costs; for example, bond proceeds are not yet disbursed to projects, but bond repay- ment is already due. Since April 2015, the government has issued only bonds with maturity of 5, 10, and 15 years, but bonds with the shortest maturity of 5 years account for 60 percent of total bonds issued. Since liquidity is still a big issue, buying long-maturity government bonds will be limited under the current bank- ing business conditions. EXPLORING NEW MARKET SEGMENTS Ongoing restructuring in the banking sector and in SOEs may have improved commercial banks’ strengths and credit assessment capability, giving the sector a fresh start in tapping into new market segments, such as lending to provincial governments. The Vietnamese government aims to speed up the process of pri- vatizing SOCBs, which will help modernize the banking industry. SOCBs will play a smaller role in lending to provincial governments, and the risks associated with state-directed lending will decrease over time. The government has already taken steps to address the high level of NPLs in the banking sector, which constituted 4.67 percent of total loans in 2013, accord- ing to the SBV. While it is expected that progress on this front will be gradual, the government’s strengthening of the banking sector is a step in the right direction to secure the country’s long-term growth prospects. Ongoing banking reforms by the government are expected to help strengthen the sector and encourage bank lending, although it is notable that progress on this front will likely proceed at a gradual pace. The government established the Vietnam Asset Management Company in July 2013 to clean up bad debt from the banking system and to allow domestic banks to undergo much-needed restruc- turing and strengthening of their credit assessment mechanism. Meanwhile, the government also aims to speed up the reform of SOEs, which accounted for more than half of the bad debts in the banking sector, in a bid to improve operational efficiencies and reduce their need to borrow to finance their losses. In the gov- ernment’s latest efforts, the SBV will look to consolidate the banking sector through mergers and acquisitions and will seek to dissolve weak financial insti- tutions that have little chance of recovery. ASSESSMENT OF COMMERCIAL BANKS THAT LEND TO PROVINCIAL GOVERNMENTS Some provincial governments have borrowed directly from commercial banks for their infrastructure projects. Commercial banks can lend directly to provin- cial governments with tenor up to 2 years if the source of repayment is the pro- vincial budgets. A recent example is Dong Nai province. It is one of the 13 net contributors (including Hanoi and Ho Chi Minh City) to the state budget that signed two separate credit contracts with VietinBank in 2014 for loans of D 200 billion and D 1 trillion (US$ 46.5 million). The two contracts have 2-year tenor and the same annual interest rate of 7 percent. At the same time, Dong Nai prov- ince has also directly borrowed from the Bank for Investment and Development of Vietnam (BIDV); the loan for D 400 billion (US$ 18.6 million) has a 2-year tenor and annual interest rate of 6 percent. All of Dong Nai’s infrastructure A Supply-Side Analysis of the Vietnamese Banking Sector | 93 TABLE 3.4  Commercial Banks’ Direct Lending to Provincial Governments PROVINCIAL LOAN AMOUNT PROJECTS AND LOAN AMOUNT LENDER BANKS GOVERNMENT (US$, MILLIONS TENOR (YEARS) INTEREST (%) LOCAL ENTITIES (D, MILLIONS) BORROWERS EQUIVALENT) VietinBank Ho Chi Minh City Thu Thiem Tunnel 8,000,000 372.0 2 — Project Management Unit VietinBank Dong Nai Nonrevenue 1,200,000 55.8 2 7 province infrastructure projects BIDV Dong Nai Nonrevenue 400,000 18.6 2 6 province infrastructure projects LVPB Thai Nguyen Land development 80,000 3.7 2 7 province fund Sources: Commercial banks VietinBank, BIDV, and LVPB. Note: BIDV = Bank for Investment and Development of Vietnam; LVPB = LienVietPostBank; — = not available. TABLE 3.5  State-Owned Commercial Bank Lending Rates, by Recipient CENTRAL GOVERNMENT (THROUGH LOCAL LENDING TERMS CORPORATIONS INDIVIDUALS GOVERNMENT BONDS) GOVERNMENTS Interest rate (%) 4.08 (5-year bond) 6.00–8.70 9.00–10.00 (short-term) 9.00–15.00 6.19 (10-year bond) 7.05 (15-year bond) 10.5–12.0 (long-term) Collateral No No Yes Yes; creditworthiness Tenor 3–15 years 2 years 1–10 years 1–5 years Source: Selected state-owned commercial banks. projects that are funded by such commercial borrowings are non–revenue gen- erating. As reported by the lending banks, the provincial government borrowers have made their repayments as scheduled. SBV documents that regulate lending to provincial governments by com- mercial banks are Decision 1627/2001/QD-NHNN of 2001 and Letter 576/ NHNN-CSHT of 2005. In the SBV regulations, commercial banks are allowed to lend to provincial governments for infrastructure projects (tables 3.4 and 3.5). In general, all identified existing loans to provincial governments by commer- cial banks have more favorable lending terms—lower interest rates and no col- lateral required—than those of other corporate and individual clients. However, the SBV set a limit on the amount of lending to each provincial gov- ernment based on the capital gap between a provincial capital expenditure bud- get, with a 30 percent limit, and the total updated and planned commercial capital mobilization of provincial government during the year. The maximum tenor for provincial government lending is 2 years, and commercial banks take the full credit risk of lending to them. There is no implicit provision of a recourse mechanism and commercial banks are encouraged to work with provincial gov- ernments on their own loan repayment supervision. Borrowing by provinces to issue municipal bonds Provincial governments can borrow from the bond market by issuing municipal bonds. According to the Vietnam Bond Market Association, four provincial governments—Ho Chi Minh City, Hanoi, Dong Nai, and Da Nang—have ­ 94 | Mobilizing Finance for Local Infrastructure Development in Vietnam successfully issued municipal bonds with total par value of about D 17 trillion (US$790 million), with maturity ranging from 1 to 15 years. Many of the bonds have expired on maturity and no case of default has been reported. Moreover, some smaller provinces have also issued municipal bonds to selected commer- cial banks in private arrangements. The common tenor of provincial bonds is 3 to 5 years. However, in 2005 and 2006 Ho Chi Minh City was able to sell in Vietnam its 15-year bonds of about D 325 billion (US$15 million) and D 425 billion (US$20 million), respec- tively. The province’s ability to sell 15-year bonds demonstrates that under certain conditions, commercial financing in Vietnam can match the long-term tenor needs of provincial infrastructure investment projects. Because Ho Chi Minh City is the richest province in Vietnam, and buyers believe that the city’s bonds carry the implicit support of the Ministry of Finance, Ho Chi Minh City ­ onsidered “too big to be allowed to fail.” Provinces that are not as well is c known to investors may have a harder time finding buyers than those rela- tively wealthy provinces that have already issued bonds. The assumption of some buyers that the Ministry of Finance will stand behind the bond issuers has not been tested. The municipal bond buyers are dominated by SOCBs (Vietcombank, BIDV, VietinBank, Agribank); some JSCBs (VP Bank, Maritime Bank, Military Bank, Techcombank, Ocean Bank, LienVietPostBank); and insurance companies (AIA Vietnam). The commercial banks take the full credit risk in lending to provincial governments through bonds or loans within the current legal and market conditions, but they have little risk mitigation in such transactions. In fact, none of the existing loans to provincial governments by commercial banks have been ­ provided with proper collateral or guarantee. The commer- cial banks have ­ conducted some technical and risk assessment in lending to provincial governments, but even those assessments have taken shortcuts within their internal risk management procedure. And, in the absence of a recourse mechanism, the lender banks have been exposed to a great deal of credit risk, with very little risk  mitigation in such lending to provincial governments. Contingent liabilities of provincial governments Many provincial governments have their own enterprises or hold the majority of  shares. Those entities get loans from commercial banks, especially from SOCBs. Because the government is privatizing SOCBs, what the banks’ risk strat- egy will actually be after such equitization is unclear, nor is it clear how the approach will affect their willingness to lend to provincially owned companies. Equitization may lead to more stringent lending criteria and somewhat reduce commercial funding access by provincial governments’ infrastructure corpora- tions. However, even after equitization, the central government is expected to retain a controlling interest in the large commercial banks. In such circum- stances, the provincial governments may continue to retain some influence on directed lending to their own enterprises. Current SBV regulations set a limit on the longest tenor of 2 years on the loans to provincial governments by commercial banks. As a consequence, long-term commercial bank lending is not available to provincial governments’ infrastruc- ture projects, which often require long-term capital. A Supply-Side Analysis of the Vietnamese Banking Sector | 95 Local capital markets and other financing sources As in other countries, commercial financing to provincial governments in Vietnam can take many forms. It can come through projects that involve a degree of private management and private risk, such as public-private partnerships, joint-stock companies, build-operate-transfer (BOTs), and similar arrange- ments. Vietnam has had a number of BOTs and joint ventures in infrastructure (for example, the Phu My power plant, Thu Duc water treatment plant, and oth- ers). Such projects require both equity and debt. However, under Vietnam’s current conditions, debt is more difficult to arrange than equity. The equity markets in Vietnam are still in the early stages of development, but the debt markets are even more undeveloped. For infrastructure financing, debt is far more important than equity because debt is needed to make equity work, and commercial debt also is required for public sector projects when such projects are not commercially viable, par- ticularly infrastructure that does not generate revenue. The sources of long- term financing available to provincial governments for infrastructure investment are very limited, mostly because debt capital markets in Vietnam are undeveloped. Directed lending and government-guaranteed lending Over the years, SOCBs have been lending, often directly, to provincial govern- ments and SOEs to finance their investments. In addition, the commercial banks have three common forms of financing for infrastructure projects. First, some commercial banks have been appointed by the government as servicing banks for infrastructure projects that are considered official development assistance (ODA) projects. The banks are not responsible for project appraisal and, there- fore, are not exposed to credit risks. In such cases, commercial banks simply collect fees for their bank services. Second, commercial banks can provide on-lending with original funding from ODA sources. And third, the banks can work with international financial institutions that make loans for long-term projects or to government entities that are secured with explicit government guarantees. In all cases, commercial banks in Vietnam are exposed to very little credit risk in dealing with provincial governments. By comparison, provincial governments are currently not qualified to ­borrow from institutional investors and foreign banks. So far, no institutional investors and foreign banks have bought municipal bonds or provided loans to provincial governments. The simple reason is that provincial govern- ments have no credit ratings, and neither their bond issuance nor commer- cial loans are backed by well-known financial institutions or the central government. COMMERCIAL BANK CONSTRAINTS IN LENDING TO PROVINCIAL GOVERNMENTS The current law is not completely silent on the possibility of provincial govern- ments borrowing from commercial banks. However, as noted earlier, the longest allowed tenor of commercial bank loans to provincial governments is 2 years, 96 | Mobilizing Finance for Local Infrastructure Development in Vietnam making it impossible for the banks to provide long-term lending directly to pro- vincial governments. Another limitation is the SBV regulation that prevents any bank from lending more than 15 percent of its shareholders’ equity to any single client, or more than 25 percent of its shareholders’ equity to a client and its associate organizations and individuals.4 Exemptions for such restrictions may be applied for on-lending from government and financial institutions. The regulation can be a constraint for large infrastructure projects, because the capital base of local banks is still relatively small; therefore, local syndication may be required, which limits the lending capability. When calculating weighted risk of assets, banks consider the riskiest types of assets to be securities and real estate. How provincial governments’ assets should be classified is unclear, both from a general regulatory standpoint and for inter- nal risk procedure classifications within banks. Tenor mismatching and liquidity risks Because commercial bank deposits are short term, financing from commercial banks is not available at the long tenors needed for infrastructure projects. Generally, more than 85 percent of the total liabilities of Vietnam’s commer- cial banks are due in less than 1 year; for some banks, the rate is as high as 98 percent. The Vietnamese banking system suffered from an adverse liquidity crisis in 2011, when the interbank lending market was very active. As a result, Vietnamese commercial banks generally view liquidity risks as one of the key risks in their risk management system. In that regard, commercial banks will have some lim- itations, both in their lending capability and in their appetite for long-term lend- ing to provincial governments, whether direct or indirect (for example, buying municipal bonds). No recourse mechanism and high credit risks The so-called self-budget balancing of provincial governments does not guar- antee that provincial governments can repay their commercial borrowing. Some current loans to provincial governments are not fully market driven. In the absence of a clear recourse mechanism—leaving banks without any repay- ment guarantee from the government or international financing institutions— many Vietnamese commercial banks are unlikely to finance provincial governments because they view lending to them for infrastructure projects as too risky. Historically, loans to government infrastructure projects at the central and provincial levels were covered with central government guarantees for repayment. Typically, those loans or lines of credit were neither tied to nor collateralized by any specific revenue source. More recently, a full credit risk guarantee is often required to reassure the lenders in the event govern- ment borrowers fail to make good on their debt service payments. As with any lending to provincial governments, banks have a difficult time under- standing the financial condition of the borrowers (in this case, provincial governments) and the ability and willingness of the borrowers to make the required payments. A Supply-Side Analysis of the Vietnamese Banking Sector | 97 No credit ratings for provincial governments The majority of commercial banks in Vietnam have their own credit rating system for local clients. However, this is not the case with provincial govern- ­ ments as clients. Market-driven lending to provincial governments is unprece- dented for many of the banks. As a result, no credit rating system is available for provincial government borrowers. In addition, the quality of provincial govern- ments’ financial and budget information is very poor and unreliable because of the limited capacity at the local level and low accounting standards for pre­ paring financial statements. Those conditions make it impossible for the com- mercial banks to assess the creditworthiness of provincial governments based on available information. Poor project preparation and lack of accountability of provincial governments Provincial government projects can be classified into two types: revenue gener- ating and non–revenue generating. Commercial banks considering lending for projects of the first type will take a cautious approach to the project’s credit appraisal by evaluating the provincial government on the basis of its cash flow. However, the poor quality and lack of transparency in the documents the provin- cial government submitted for appraisal may reduce the commercial banks’ interest in evaluating such projects. Regarding the second type, non-revenue-generating projects, some commer- cial banks view lending to provincial governments as grant funding from state or provincial budgets. Therefore, lending to this type of project will require some form of central government guarantee or tangible collateral. Although the repay- ment by provincial governments is not legally and financially mandated by com- mercial banks’ policies, commercial banks likely will only act as agents to serve disbursements of government grant funding or on-lending if it is permitted. Commercial banks are not inclined to sue provincial governments that fail to meet their repayment obligations, however, because it would potentially damage their business operations in provincial governments’ territories. Maintaining a good relationship with government at all levels is extremely important for com- mercial bank operations. Reasons that banks are not inclined to buy municipal bonds Buyers and potential buyers of municipal bonds, including commercial banks, have indicated that the interest rate (coupon) offered was not compet- itive; that is, alternative commercial fixed-term investments were available at more favorable rates. Central government bonds are preferred to munici- pal bonds because they are considered more trusted value assets. Another reason that banks avoid government projects is that provincial governments’ disclosure and documentation before the sale of bonds were insufficient for municipal bonds and far below international standards and the banks’ credit assessment requirements. When those conditions are not met within the commercial banks’ internal credit analysis, the appetite for buying municipal bonds will be weaker. 98 | Mobilizing Finance for Local Infrastructure Development in Vietnam Reasons that provincial governments are not inclined to borrow from commercial banks Under current economic circumstances, many provincial governments are not motivated to seek commercial financing for their own investment projects. Provincial governments still compete with each other for the limited state bud- get, ODA, and favorable borrowings from the Vietnam Development Bank and the state treasury for their infrastructure investment projects. From the perspec- tive of the provincial government, commercial rates are high compared with the favorable rates of the Vietnam Development Bank or state treasury. Thus, many provincial governments look at commercial borrowing only as an option of last resort to finance their infrastructure investment projects. Another factor that hinders many provinces from issuing municipal bonds is that the procedures for issuing bonds are time consuming and cumber- some. They entail relatively high fixed costs, such as costs of documentation, advertising, and payment to securities companies, among others. Therefore, issuing municipal bonds is worthwhile only if a relatively large bond sale is being contemplated. Many provinces have borrowing needs below the eco- nomic cutoff point; thus, the high fixed cost of bond issuance means that this method will continue to be impractical for many provinces. INCENTIVES FOR COMMERCIAL BANKS TO LEND TO PROVINCIAL GOVERNMENTS Most commercial banks have expressed interest in entering a new market seg- ment and lending to provincial governments, if they could know that market conditions would continue to improve. The following sections describe condi- tions that may act as incentives that would interest commercial banks in lending to provincial governments. Entry into new market segments Market-based lending to provincial governments is still new to the Vietnamese banking industry. However, commercial banks will be more willing to enter a new market segment if the government puts in place the balancing principle that addresses risk and return in lending to provincial governments. The commercial banks would prefer having the low-risk model in tandem with other financial mechanisms and instruments because, although their approach to such lending is cautious, they still need to diversify their bank portfolios. In addition, in 2013, the whole banking system had a large amount of unemployed capital—about D 200 trillion (US$9.3 billion). Although the unemployed capital was believed to be a short-term surplus, it indicated that the banking system was not short of capital during some periods. When the economy is stagnant and investment demand and individual consumption are decreasing, commercial banks often can more easily mobilize capital than they can lend or fund business activities. This has been the situation in recent years in Vietnam; thus, buying bonds is still the com- mon practice of Vietnamese commercial banks to deal with the unemployed cap- ital. However, in the long run, commercial banks are looking for new clients and funding opportunities to ensure their profitability. If market conditions improve, lending to provincial governments would be a new opportunity to use the unem- ployed capital of commercial banks. A Supply-Side Analysis of the Vietnamese Banking Sector | 99 Short-term lending to provincial governments As a general principle, provincial governments should be free to borrow from the source that best matches their particular needs at a given time, which are not always for the long term. Provincial governments sometimes need to borrow short term for short-lived assets or short-term budget deficits. Also, they may have short-term cash management needs. Such short-term lending is an oppor- tunity for commercial banks, which would be appropriate sources of funds needed on a short-term basis. Other lending services needed by provincial governments Many commercial banks believe they should be given an opportunity to earn additional profits by developing other business relationships with the provincial governments, including deposits, cash management, and wealth management. Changes in Vietnam’s economic and market conditions that have raised it to a lower-middle-income country have made obtaining traditional ODA for funding infrastructure projects more difficult. Thus, such funding requires government at all levels to find ways to fill the financing gaps. The banking system and capital market will play a vital role in resolving this matter. Many provincial governments have realized that overreliance on ODA and the state budget can lead to expensive and often inefficient infrastructure proj- ects when contractors are appointed by ODA sponsors without international competitive bidding. In such cases, the positive effect of low interest rates can be superseded by significantly higher capital costs. In another scenario, waiting for funds from the central budget or ODA can lead to delays in infrastructure devel- opment and continued poor infrastructure services. With more autonomous power in provincial government budget planning, provincial governments that are not dependent on central budget support are expected to use their strong revenue streams to finance their investment needs. Some provincial govern- ments have tried to improve simultaneously their business environment, to attract foreign direct investment, and their capability and accountability in infra- structure investment planning and budgeting. Those provinces will move ahead of other competing provinces and will be able to develop a sustainable business relationship with the banking sector. New State Budget Law The amended State Budget Law (SBL) of 2002 was approved in May 2015 and went into effect in January 2017. Accordingly, the debt ceiling of provincial gov- ernments has been set at a higher level. In the previous SBL, total outstanding borrowing could not exceed 30 percent of the provincial budget’s total annual domestic capital investment. However, some important changes within the new SBL set the ceiling of outstanding borrowing as a percentage of the total provin- cial income. The changes affect the following: • Special cities of Hanoi and Ho Chi Minh City, where the ceiling is 60 percent of city income • Provinces whose actual income exceeded the budget in the previous year and that have repayment capability, which are allowed 30 percent of provincial income • Remaining provinces that have an allowable 20 percent of provincial income. 100 | Mobilizing Finance for Local Infrastructure Development in Vietnam The SBL also sets debt repayment as a priority in that it clearly requires pro- vincial governments’ annual budgets to include loan repayment. Improved risk management and operations Vietnamese commercial banks have improved their risk management capability tremendously over the past years, and many of them have adopted a rigorous and effective credit risk appraisal process. The overall operation of the banks has also been substantially improved. The greater accountability has made the commer- cial banks more confident in tapping a new segment of lending to provincial ­ governments and project financing. Provincial governments’ preference for borrowing in local currency Provincial governments that secure long-term debt through the central govern- ment find funding is more available in foreign currencies because these financial markets are more developed than those in Vietnam and interest rates are lower. But borrowing in foreign currencies increases the risk to the government, even with managed exchange rates, because it can increase the central government’s vulnerability to external economic shocks and changes in the real exchange rate. One of the government’s objectives in the medium term should be to increase the use of domestic savings to finance infrastructure improvements. Such an approach would lower the real cost of debt instruments available in Vietnamese dong. Provincial governments that fund investment projects from their own budgets also will require access to long-term private finance. To be sustainable, such funding should increasingly be denominated in Vietnamese rather than foreign currencies. Thus, commercial funding for provincial government proj- ects would be better served by Vietnamese commercial banks. SUMMARY OF KEY FINDINGS The current status, key constraints, and incentives of commercial lending by Vietnamese commercial banks to provincial governments of Vietnam are sum- marized in table 3.6. RAPID ASSESSMENT OF PERFORMANCE OF SELECTED COMMERCIAL BANKS This section reports on this study’s rapid assessment review of five banks that are potential candidates for the city infrastructure financing facility (CIFF) mechanism. The five banks, which are broadly assessed in a rapid assessment, include two SOCBs (the state-owned commercial banks Vietcombank and VietinBank); two JSCBs (the joint-stock commercial banks LienVietPostBank and Maritime Bank); and one foreign bank (HSBC Vietnam). The assessment is based on their performance, including balance sheets, NPLs, local government lending portfolios, corporate governance, and credit and risk management sys- tem. The analysis can help provide an initial idea of the size of the CIFF and qualification criteria during the CIFF design phase. A Supply-Side Analysis of the Vietnamese Banking Sector | 101 TABLE 3.6  Key Findings on Lending to Provincial Governments by Commercial Banks CURRENT STATUS KEY CONSTRAINTS AND HINDRANCES KEY INCENTIVES 1 Commercial banks can lend directly to provincial Prudent banking regulations. Entry into new market segment. governments without guarantees or collateral. Repayment is based on the provincial governments’ annual budgets. The longest tenor of lending to provincial governments is two years. 2 Provincial governments’ lending portfolios consist Tenor mismatching and liquidity Unemployed capital in banking mainly of municipal bonds. risks. system. 3 Commercial banks take full credit risk in lending to No recourse mechanism and high Offer of other services to provincial governments under the current legal and credit risks. provincial governments through market conditions, but they have unclear risk lending to provincial govern- mitigation strategies. ments. 4 Provincially owned enterprises’ borrowing raises the No credit ratings for provincial Short-term lending to provincial contingent liabilities of provincial governments. governments and lack of reliable governments. information to assess creditworth­ iness of provincial government borrowers. 5 Long-term commercial bank lending is not available Poor project preparation and Changes in economic and market to provincial governments. accountability of provincial conditions. governments. 6 Commercial financing to provincial governments is Unattractiveness of municipal bonds The State Budget Law and the prevailing, but local capital markets are undevel- for some commercial banks. possibility of introducing a oped. recourse mechanism. 7 Directed lending and lending with government Insufficient motivation of many Improvement of risk management guarantees are common. provincial governments to borrow capability and overall operations from commercial banks. of commercial banks. 8 Provincial governments are currently not qualified as Preference of provincial govern- borrowers for institutional investors and foreign ments to borrow in Vietnamese banks. dong than in foreign currencies. Although the banks consulted in the assessment have a limited appetite for lending to local governments now, they have expressed interest in such lending when the CIFF mechanism is in place. The local commercial banks generally view wholesale and credit enhancement options as low-risk and high-risk mod- els, respectively, and the first option would be more favorable from the local banks’ perspectives because the source of capital is secured by the CIFF. However, the foreign bank would be more interested in the credit enhancement option because it may reduce credit risks for the bank. Vietcombank Established in 1963 as a state-owned commercial bank, the Bank for Foreign Trade of Vietnam (Vietcombank) is the oldest commercial bank for external affairs in Vietnam. It was the first bank in the country to have a centralized cap- ital management structure and the first commercial bank to deal in foreign cur- rencies. After more than half a century in operation, the bank has more than 400 branches, transaction offices, representative offices, and affiliates, both in Vietnam and abroad. Its Vietnamese offices include a head office in Hanoi, one operation center, one training center, 89 branches, and over 350 transaction offices all over the country. The bank also has three subsidiaries in Vietnam, two subsidiaries in other countries, one representative office in Singapore, and six 102 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 3.7  Key Financial Information for Vietcombank 2014 2015 Indicators in D, billions Total assets 576,996 674,395 Loan portfolio 316,254 378,542 Deposits 422,204 500,528 Shareholder funds 43,473 45,172 Profit after tax/net income 4,585 5,332 Return on assets, % 0.88 0.85 Return on equity, % 10.76 12.03 Source: Vietcombank Annual Report 2015. joint ventures. In addition, Vietcombank has developed an automatic banking system with 2,100 automated teller machines and 49,500 points of sale nation- wide. The bank’s operations are supported by a network of more than 1,800 cor- respondent banks in 155 countries and territories. Vietcombank expanded from its original role as North Vietnam’s foreign trade bank to become one of the country’s largest universal banks. It is also an investor in a number of other financial institutions, including Vietnam Export Import Commercial Joint Stock Bank (CJSB), Saigon Industrial and Commercial CJSB, Gia Dinh CJSB, Military CJSB, International Commercial CJSB, Oriental CJSB, Chohungvina Bank, Petroleum Insurance Company, and Golden Insurance Company. In 2015, Vietcombank increased its charter capital from D 55 billion (US$2.6 million) to D 265 billion (US$12.3 million). The bank has been expanding its assets volume and it reached D 674 trillion (US$31.4 billion) in 2015 (table 3.7). Balance sheet assessment As figure 3.9 shows, the three main components of Vietcombank assets in 2013 were loans and advances to customers (56 percent), placement with and loans to other financial institutions (20 percent), and investment securities and other financial assets (16 percent). The majority of total outstanding loans are lending for SOEs, and 20 percent is for retail loans (figure 3.10). In January 2015, the governor of the SBV said that Saigonbank would merge with Vietcombank as part of restructuring in the sector, resulting in the follow- ing shareholder structure: government (77.1 percent); Mizuho Corporate Bank Ltd., Japan (15.0 percent); and other shareholders (7.9 percent). As shown in figure 3.11, Vietcombank’s lending balance concentrates on man- ufacturing and processing (32 percent); trading (27 percent); and agriculture, forestry, aquaculture, and mining (8 percent). By far, the majority of its lending is for loans of less than a year (figure 3.12). Exposure of lending to provincial governments Vietcombank also lends to provincial governments as follows: • Municipal bonds. Vietcombank has bought about D 1.839 trillion par value of Hanoi and Ho Chi Minh City’s municipal bonds with 3- to 5-year tenors and coupon rates of 7.2–10.7 percent. • Direct lending to provincial governments. So far, Vietcombank has not lent to any provincial governments, but it has lent to two major cities (table 3.8). A Supply-Side Analysis of the Vietnamese Banking Sector | 103 FIGURE 3.9 FIGURE 3.10 Vietcombank Asset Portfolio Customer Shares of Vietcombank’s Cash, gold, and Loan Portfolio gemstones, Other assets, 1% Balance at State 4% Bank of Vietnam, Others, 3% 27% Investment Placement securities with and loans and other to other FIs, financial 20% assets, SOE, 16% 53% Loans and advances Retail, to customers, 20% 56% Source: Vietcombank Annual Report 2015. Source: Vietcombank Annual Report 2015. Note: FI = financial institution. Note: SOE = state-owned enterprise. FIGURE 3.11 FIGURE 3.12 Vietcombank’s Loan Portfolio, by Industry Length of Terms in Loan Shares of Agriculture, forestry, Vietcombank’s Loan Portfolio aquaculture, and mining, Others, 8% 15% Long term Manufacturing (> 5 years), and processing, 29% 32% Transportation, logistics, and communications, 6% Short term (< 1 year), 60% Trading, Medium term 27% (1–5 years), Electricity, petroleum, 11% Construction, and water, 5% 7% Source: Vietcombank Annual Report 2015. Source: Vietcombank Annual Report 2015. • Experience of lending to infrastructure projects (including provincial government projects). Vietcombank has taken lending exposure to road and seaport projects undertaken by private companies and SOEs under the BOT route. The bank has also provided loans to subcontractors of the Ministry of Finance for big infrastructure projects. For such infrastructure projects, the tenor is 2–15 years, and interest rates are 10–10.5 percent. Liquidity Vietcombank has traditionally maintained a reasonable level of liquidity, and this has become even more important in view of economic instability and some 104 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 3.8  Vietcombank’s Direct Loan Transactions with Vietnam’s Two Biggest Cities: Hanoi and Ho Chi Minh City LOANS D, MILLIONS Provincial government bonds 1,838,889 Hanoi 688,889 Ho Chi Minh City 1,150,000 Direct loans to provincial governments None Total provincial government portfolio 1,838,889 Total loan portfolio 378,542,000 Total assets 674,395,000 Direct loans to provincial governments as a share of the total loan 0 portfolio, % Total provincial government portfolio as a share of total assets, % 0.2 Source: Vietcombank Annual Report 2013. FIGURE 3.13 Vietcombank Liquidity Ratios 90 80 70 60 50 Percent 40 30 20 10 0 Loan/deposit ratio Cash ratio Liquidity ratio Year 2013 Year 2014 Year 2015 Source: Vietcombank Annual Report 2015. tightening of liquidity in the local market. Though the bank’s liquidity ratio declined from 41 to 33 percent from 2013 to 2015 (figure 3.13), it is still well above Vietnam’s industry average liquidity ratio of 16 percent and the global industry average liquidity ratio of 15 percent, indicating a relatively solid liquidity posi- tion. The bank has been deploying customer deposits toward interest-earning assets, with a loans-to-deposits ratio above Vietnam’s industry average (67 per- cent) and the global average (70 percent). Most of the liability is for less than a year (table 3.9 and figure 3.14), whereas around two-thirds of the loans are short to medium term in nature. The bank is focusing on developing new deposit products with a particular emphasis on lengthening the maturity profile of its A Supply-Side Analysis of the Vietnamese Banking Sector | 105 TABLE 3.9  Vietcombank’s Net Liquidity Gap (as of June 2016), D, millions OVERDUE NOT OVERDUE OVER UP TO UP TO 1 TO 3 TO 12 1 TO OVER TOTAL 3 MONTHS 3 MONTHS 1 MONTH 3 MONTHS MONTHS 5 YEARS 5 YEARS Total assets 7,633,387 30,688,618 241,387,271 152,311,043 152,683,160 71,279,890 27,762,105 683,745,474 Total liabilities n.a. 12,607,781 383,547,432 111,817,968 111,954,885 7,276,950 2,017,282 629,222,298 Net liquidity gap 7,633,387 18,080,837 (142,160,161) 40,493,075 40,728,275 64,002,940 25,744,823 54,523,176 Source: Vietcombank Annual Report 2015. Note: n.a. = not applicable. deposit portfolio, a strategy that is important in view of the FIGURE 3.14 current mismatch. Length of Total Liability of Vietcombank Over 5 years, Nonperforming loans From 2% 1 to 5 years, The level of NPLs at Vietcombank reached 2.7 percent in 2013 5% and decreased to 1.8 percent in 2015, well below the Vietnam industry and global industry NPLs average of 2.5 percent. An increase in the amount of bad debts in 2013 was entirely due to the higher proportion of lending to SOEs in the bank’s loan portfolio. Corporate governance The system of bank governance and control in Vietnam is some- what different from most other countries, which have a clear definition of roles and responsibilities and a clear separation of powers between board and management. They also have an Less than 1 year, 93% internal audit function and a board audit committee that serve as a key mechanism in this overall governance and control struc- Source: Vietcombank Annual Report 2015. ture. The board of directors of Vietcombank is a full-time board appointed by the government, which is a shareholder. In addi- tion to the government-appointed members, the board has a rep- resentative from the Mizuho Corporate Bank Ltd., Japan. A supervisory board independent of the board of directors also reports to the general assembly of shareholders. The supervisory board is mainly responsible for o ­ perational control and internal audit of bank operations. However, the internal audit func- tion differs from the standard international practice. In Vietnam, an internal control function reports to the supervisory board and is actively involved in the control and compliance process. In addition, a State Audit Bureau carries out audit work on all SOEs, including the state banks. The supervisory board currently has four members, all of whom are full-time employ- ees of the bank. The supervisory board meets monthly and reports to the bank’s board of directors on a regular basis. The supervisory board also monitors the implementation of long-term strategies and goals at the bank, as well as ensures that the accounting systems at Vietcombank are in line with current regulations and principles. Credit and risk management The bank adopted a centralized management system for reducing credit risk that is structured procedurally into risk management, sales, and operations. The objective of separating the three types of functions is to minimize risks and 106 | Mobilizing Finance for Local Infrastructure Development in Vietnam take advantage of credit officers’ expertise. The bank credit manual sets out pro- cedures for credit policy, the credit management process, and credit assessment and control. The procedures are important because the bank has delegated authorities at the branch level for lending up to a certain amount. The board of directors, which has the highest responsibility for the bank’s overall risk man- agement, promulgates risk management policies and strategies for each period, establishes secured business limits, and directly approves high-value business transactions in accordance with both legal and internal requirements. LienVietPostBank In operation since 2008, Lien Viet Post Joint Stock Commercial Bank, or LienVietPostBank (LVPB), formerly known as LienVietBank, is a Vietnamese retail bank that provides banking products and services through its own transac- tion points across 42 cities and provinces and 1,031 postal transaction offices nationwide. By the end of 2015, LVPB had 4,023 employees. The founder shareholders include Him Lam Joint Stock Company, Saigon Trading Group, and Southern Airports Service Company. In 2011 Vietnam Post Corporation became the LVPB’s biggest shareholder by contributing capital to the bank equal to the value of the Vietnam Postal Savings Service Company, including cash. The merger was one of the most notable in Vietnam at that time and is a milestone in the development of the bank. The LVPB then changed its name to Lien Viet Post Joint Stock Commercial Bank and became the first postal bank in Vietnam. The bank focuses on developing banking products for households and SMEs and on expanding its activities to rural and remote areas using the post office network. The chartered capital by December 2015 was D 6,460 billion (US$300 million). In 2015, the total assets of LVPB reached D 107 trillion (US$ 5.1 billion), putting the bank among top 15 largest JSCBs in Vietnam (table 3.10). Balance sheet assessment As figure 3.15 shows, the three main components of LVPB assets in 2015 were loans and advances to customers (52 percent), investment securities and other financial assets (30 percent), and placement with and loans to other financial institutions (5 percent). TABLE 3.10  Key Financial Information for LienVietPostBank 2014 2015 Indicators in D, billions Total assets 100,801 107,587 Loan portfolio 40,815 55,470 Deposits 77,820 77,629 Shareholder funds 7,391 7,600 Profit after tax 466 350 Return on assets, % 0.46 0.33 Return on equity, % 6.31 4.60 Source: LienVietPostBank Annual Report 2015. A Supply-Side Analysis of the Vietnamese Banking Sector | 107 FIGURE 3.15 FIGURE 3.16 LienVietPostBank Asset Portfolio Customer Shares of LienVietPostBank Loan Cash, gold, Portfolio and gemstones, 0% Balance at State Bank of Vietnam, Other assets, 2% Retail, 11% Placement with 16% SOE, and loans to 16% other FIs, Foreign invested 5% enterprise, 1% Investment securities and other Loans and financial advances assets, to 30% customers, 52% Corporate, Source: LVPB Annual Report 2015. 67% Note: FI = financial institutions. Source: LVPB Annual Report 2013. Annual report of 2015 has no available data on customer shares. Note: SOE = state-owned enterprise. FIGURE 3.17 FIGURE 3.18 LienVietPostBank Loan Portfolio, by Industry Length of Terms in Loan Shares of Household Agriculture, forestry, LienVietPostBank Loan Portfolio services, aquaculture, and mining, Other 7% 10% Long term services, (> 5 years), 8% 29% Manufacturing Short term and processing, (≤ 1 year), 15% 24% Trading, 15% Electricity, petroleum, and water, <1% Construction Medium term and real estate, (1–5 years), 45% 47% Source: LVPB Annual Report 2013. Annual report of 2015 has no available data on sector shares. Source: LVPB Annual Report 2015. Shareholder structure is Vietnam Post (13 percent); Him Lam (15 percent); individual and institutional shareholders (72 percent). LVPB’s lending balance was concentrated in corporations (67 percent), retail (16 percent), and SOE (16 percent) (figure 3.16). LVPB’s lending balance concentrated on construction and real estate (45  ­p ercent), trading (15 percent), and manufacturing and processing percent) (figure 3.17). Most of the loans are short to medium term in nature (15 ­ (figure 3.18). 108 | Mobilizing Finance for Local Infrastructure Development in Vietnam Exposure of lending to provincial governments As table 3.11 shows, LVPB also lends to provincial governments as follows: • Municipal bonds. LVPB has bought D 780 billion par value of Hanoi and Ho Chi Minh City’s municipal bonds with 3- to 5-year tenors and coupon rates of 6–7 percent. • Direct lending to provincial governments. So far LVPB has only lent to Thai Nguyen province through the Thai Nguyen provincial land development fund with the loan amount of D 80 billion, tenor of 2 years, and interest rate of 9 percent. The repayment is a bullet repayment at the end of the project, and the source is assumed to be the provincial budget. • Experience in lending to infrastructure projects. LVPB has experience in lending to roads and bridge projects (via the BOT route) through bilateral loans, syndicated loans, and subscription to government bonds. The bank also extends loans to subcontractors for the Ministry of Finance’s large infrastruc- ture projects. Liquidity The bank’s liquidity ratio decreased from 31 percent in 2013 to 22 percent in 2015, and cash ratio decreased from 57 percent to 31 percent, mainly due to a greater allocation of customer deposits to fund customer loans and other interest earning assets (figure 3.19). While this may reflect that the solvency ­ position of the bank has been deteriorating, the liquidity ratio for the bank is still well above the Vietnam industry average (16 percent) as well as the global industry average (15 percent). The vast majority of liability is less than 1 year (figure 3.20), however nearly half of the loans are medium term. The bank may consider paying more attention to addressing its potential asset liability mis- match problem. Nonperforming loans The level of reported NPLs declined from 2.5 percent in 2013 to less than percent in 2015. That decline was completely due to the increase in the 1 ­ loan portfolio. The bank’s NPLs were mainly from bad debts in construction TABLE 3.11  LienVietPostBank’s Lending to Cities and Provinces LOANS D, MILLIONS Provincial government bonds 780,000 Hanoi 580,000 Ho Chi Minh City 200,000 Direct loans to provincial governments 80,000 Thai Nguyen province 80,000 Total provincial government portfolio 860,000 Total loan portfolio 55,470,000 Total assets 107,587,000 Direct loans to provincial governments as share of total loan 0.01 portfolio, % Total provincial government portfolio as share of total assets, % 0.80 Source: LVPB Annual Report 2015. A Supply-Side Analysis of the Vietnamese Banking Sector | 109 FIGURE 3.19 FIGURE 3.20 LienVietPostBank Liquidity Ratios Length of Total Liability of 100 LienVietPostBank From 1 to 5 years, 2% 80 60 Percent 40 Less than 1 year, 20 98% Source: LVPB Annual Report 2015. 0 Loan/deposit ratio Cash ratio Liquidity ratio Year 2013 Year 2014 Year 2015 Source: LVPB Annual Report 2015. TABLE 3.12  LienVietPostBank’s Net Liquidity Gap (as of June 2016), D, millions OVERDUE NOT OVERDUE OVER UP TO UP TO 1 TO 3 TO 1 TO OVER TOTAL 3 MONTHS 3 MONTHS 1 MONTH 3 MONTHS 12 MONTHS 5 YEARS 5 YEARS Total assets 404,743 139,812 24,736,775 8,991,710 15,205,108 40,479,159 18,680,940 108,638,247 Total n.a. n.a. 44,417,669 19,624,480 25,129,414 7,942,597 2,872,705 99,986,865 liabilities Net liquidity 404,743 139,812 (19,680,894) (10,632,770) (9,924,306) 32,536,562 15,808,235 8,651,382 gap Source: LVPB Annual Report 2015. Note: n.a. = not applicable. and real estate industries, which account for around 45 percent of LVPB’s lending portfolio. Corporate governance LVPB has a good corporate governance structure in place with a clear separation of duties between the board of directors and management, although there are no members of management on the board. The board has three committees, each with a number of councils with different responsibilities. The three committees are the Strategy, Technology, Business, and International Relations Committee; the Human Resources, Credit, and Cost Management Committee; and the Asset-Liability, Risk Management, and Anti-Money Laundering Committee. The supervisory board includes an internal audit division and departments of backup, periodical audit, and regular supervision as well as a Postal Transaction Office audit. This board is inde- pendent of bank management. Overall, the bank has a strong organizational struc- ture with a clear identification of the main functions and responsibilities. 110 | Mobilizing Finance for Local Infrastructure Development in Vietnam Credit and risk management The credit and risk management process of LVPB is not as straightforward as corporate governance. Credit and risk management seem to be both fragmented and duplicated among subcommittees and functional councils. Therefore, the bank implemented credit monitoring and centralized debt resolution at the head office in 2013, while enhancing credit granting monitoring at business units by promulgating internal regulations in compliance with the board’s guidance and direction. In addition, in 2013 the bank also revised its organizational structure to enhance the effectiveness of credit risk management. Maritime bank Vietnam Maritime Commercial Joint Stock Bank (Maritime Bank) was established in 1991 in Hai Phong City. It opened for business right after the Ordinance on Joint Stock Banks, Credit Cooperatives, and Finance Companies took effect, and it became one of the first JSCBs in Vietnam. In 2015, the bank was one of the five larg- est JSCBs in the country, with chartered capital of D 11,750 billion (US$547 ­million), a branch network of nearly 300 offices nationwide, and 3,268 employees. Maritime Bank has been selected by the World Bank as one of six commercial banks in the two-phased Banking System Modernization Project.5 It has bene- fited from the project and built a modern banking operational system meeting international standards. The total assets of the bank maintained at around D 104 trillion (US$ 4.9 billion) in 2014 and 2015 (table 3.13). Balance sheet assessment As figure 3.21 shows, the three main components of Maritime Bank assets in 2015 were investment securities and other financial assets (47 percent), loans and advances to customers (26 percent), and placement with and loans to other financial institutions (11 percent). Main shareholders were the Vietnam Post and Telecommunication Group (6.1 percent), the Phuc Tien Investment LLC (6.5 percent), and others (87.4 percent). Maritime Bank’s lending balance is highly concentrated in corporate sectors (79 percent), retail (12 percent), and SOE (9 percent) (figure 3.22). The ­ loan portfolio is relatively balanced, both by industry and by length of loan (­figures 3.23 and 3.24). TABLE 3.13  Key Financial Information for Maritime Bank 2014 2015 Indicators in D, billions Total assets 104,369 104,311 Loan portfolio 22,967 27,490 Deposits 63,219 62,616 Shareholder funds 9,446 13,616 Profit after tax 143 116 Return on assets, % 0.14 0.11 Return on equity, % 1.51 0.85 Source: Maritime Bank Annual Report 2015. A Supply-Side Analysis of the Vietnamese Banking Sector | 111 FIGURE 3.21 FIGURE 3.22 Maritime Bank Asset Portfolio Customer Shares of Maritime Bank Cash, gold, and gemstones, 2% Balance at State Bank of Vietnam, Others, <1% Other assets, 2% SOE, Retail, 8% 12% Placement with 12% and loans to other FIs, 11% Loans and advances Investment to securities and customers, other financial 26% assets, 47% Source: Maritime Bank Annual Report 2015. Corporate 79% Source: Maritime Bank Annual Report 2015. Note: SOE = state-owned enterprise. FIGURE 3.23 FIGURE 3.24 Maritime Bank’s Loan Portfolio, by Industry Length of Terms in Loan Shares of Maritime Bank’s Loan Portfolio Shipping business, 8% Long term Light industry and (> 5 years), consumer goods, 32% Short term 4% (≤ 1 year), 30% Others, Property and 52% infrastructure, 35% Other services, Medium term 1% (1–5 years), 38% Source: Maritime Bank Annual Report 2015. Source: Maritime Bank Annual Report 2015. Exposure of lending to provincial governments Maritime Bank has not been lending to provincial governments but has been buying some municipal bonds. The bank has not disclosed data about outstand- ing municipal bonds. Liquidity The bank may consider further improving its solvency position to manage fiscal risk. Its liquidity ratio and cash ratio are low compared with the Vietnam indus- try averages (figure 3.25), which are 16 and 21 percent respectively. The loans to deposits ratio is declining and well below the Vietnam’s average of 67 percent and the global industry average of 70 percent, indicating that there is still liquid- ity margin for the bank to cover unforeseen funding requirements. Because the 112 | Mobilizing Finance for Local Infrastructure Development in Vietnam bank is deploying most of its deposits (short-term in nature) to provide short- to medium-term loans, the bank is less likely to face asset liability mismatch prob- lems (figures 3.25 and 3.26, and table 3.14). Nonperforming loans The bank has been improving its asset quality. The level of NPLs at Maritime Bank declined from 2.7 percent in 2013 to 2.6 percent in 2015, around the industry average in Vietnam. The increasing amount of bad debts during 2012 to 2013 was mainly due to the high proportion of lending to the troubled shipping industry. Corporate governance Maritime Bank has a good corporate governance structure in place, with a clear separation of duties between the board and management. The bank’s board of directors does not have any members of management on the board. The board has six committees: credit and investment board, board risk handling commit- tee, board risk management committee, human resources committee, strategy committee, and audit committee. The supervisory board has an internal audit function in place that reports to the shareholders and is independent of the bank management. FIGURE 3.25 FIGURE 3.26 Maritime Bank Liquidity Ratios Length of Total Liability of 100 Maritime Bank From 1 to 5 years, 80 2% 60 Percent 40 20 0 Loan/deposit Cash ratio Liquidity ratio Less than 1 year, ratio 98% Year 2013 Year 2014 Year 2015 Source: Maritime Bank Annual Report Source: Maritime Bank Annual Report 2015. 2015. TABLE 3.14  Maritime Bank’s Net Liquidity Gap (as of June 2016), D, millions FREE OF UP TO 1 TO 3 TO 1 TO OVER OVERDUE TOTAL INTEREST 1 MONTH 3 MONTHS 12 MONTHS 5 YEARS 5 YEARS Total assets 4,287,125 16,981,986 39,366,852 5,472,341 15,043,764 20,161,719 4,529,183 105,842,970 Total n.a. 2,767,891 33,827,211 22,102,512 25,323,225 3,136,680 182,515 90,844,456 liabilities Net liquidity 4,287,125 14,214,095 5,539,641 (16,630,171) (10,279,461) 17,025,039 4,346,668 14,998,514 gap Source: Maritime Bank Annual Report 2015. Note: n.a. = not applicable. A Supply-Side Analysis of the Vietnamese Banking Sector | 113 Credit and risk management The bank has developed an internal rating system and credit policies that apply to specific customer segments: SMEs, large corporate and financial institutions, and retail and community. VietinBank The Vietnam Bank for Industry and Trade (VietinBank), formerly the Industrial and Commercial Bank of Vietnam, was established in 1988 when it was separated from the SBV. It became a state-owned corporation in 1993. As one of the four largest SOCBs in the country, VietinBank’s total assets account for a significant part of the market share of the whole Vietnamese banking system. VietinBank’s capital resources have continued to increase over the years and have risen substan- tially since 1996, with annual average growth of 20 percent. In December 2008 the bank carried out an initial purchase offer, and the shares were subsequently listed on the Ho Chi Minh Stock Exchange in July 2009. The shareholder structure is 64.5 percent SBV, 19.7 percent Bank of T­ okyo-Mitsubishi, 8.0 percent International Finance Corporation (IFC), and 7.8 percent, others. The bank has an extensive network of 150 branches and over 1,000 transaction offices throughout the country, employing 21,024 personnel. In 2015 the bank’s charter capital was D37,234 billion (US$1.73 billion). The bank is particularly strong in certain sectors, such as the oil and gas industry, coal, and food processing and supply, and it has a strong relationship with many state-owned companies in these sectors. The asset size of VietinBank remained the largest in the local bank- ing system, with a volume of D779 trillion (US$36.3 billion) in 2015 (table 3.15). Balance sheet assessment As seen in figure 3.27, the three main components of VietinBank’s Assets in 2015 were loans and advances to customers (68 percent), investment securities and other financial assets (15 percent), and placement with and loans to other finan- cial institutions (8 percent). VietinBank’s corporate lending accounted for nearly a half of total outstand- ing loans, and about 17 percent of outstanding loans were for SOEs (figure 3.28). VietinBank’s lending balance concentrates on manufacturing and processing (29 percent); trading (28 percent); and construction (11 percent) (figure 3.29). Its loan portfolio is more than half short-term loans (figure 3.30). TABLE 3.15  Key Financial Information for VietinBank 2014 2015 Indicators in D, billions Total assets 661,242 779,483 Loan portfolio 435,502 533,530 Deposits 424,181 492,960 Shareholder funds 55,259 56,109 Profit after tax 5,726 5,716 Return on assets, % 0.87 0.73 Return on equity, % 10.36 10.19 Source: VietinBank Annual Report 2015. 114 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 3.27 FIGURE 3.28 VietinBank Asset Portfolio Customer Shares of VietinBank’s Loan Portfolio Cash, gold, and gemstones, 1% Other assets, Balance at SBV, 6% 2% Placement with and Others, SOE, Investment loans to other FIs, 16% 17% securities, 8% and other financial assets, 15% Retail, Other 21% limited companies, Loans and 19% advances to customers, 68% Other joint Source: VietinBank Annual Report 2015. stock companies, Notes: SBV = State Bank of Vietnam; FI = financial institution. 27% Source: VietinBank Annual Report 2015. Note: SOE = state-owned enterprise. FIGURE 3.29 FIGURE 3.30 VietinBank’s Loan Portfolio, by Industry Length of Terms in Loan Shares of VietinBank’s Loan Portfolio Others, Manufacturing Long term 18% and processing, (> 5 years), 29% 33% Real estate, Short term 8% (< 1 year), Electricity, 56% fuel gas, and hot water 6% Medium term Wholesale and Construction, (1–5 years), retail trade, 11% 11% 28% Source: VietinBank Annual Report 2015. Source: VietinBank Annual Report 2015. Exposure of lending to provincial governments VietinBank also lends to provincial governments (table 3.16) as follows: • Municipal bonds. VietinBank bought D 2.75 trillion par value of munici- pal bonds from four provinces: Hanoi, Ho Chi Minh City, Quang Ninh, and  Bac Ninh, with the longest tenor of 10 years and coupon rates of 7.2–8.7 percent. • Direct lending to provincial governments. VietinBank lent to two provincial governments. The first direct provincial government loan of D 8 trillion was granted to Ho Chi Minh City’s Provincial People’s Committee for its Thu Thiem Tunnel Project Management Unit. The second direct provincial ­ government loan was to Dong Nai province for D 1.2 trillion, with a 2-year tenor and interest rate of 7 percent for non-revenue-generating infrastructure projects. The repayment source was assumed to be the provincial ­ budget. The typical source of funding for these loans has been the short-term deposits of the bank. A Supply-Side Analysis of the Vietnamese Banking Sector | 115 TABLE 3.16  VietinBank’s Portfolio of Lending to Provincial Governments LOANS D, MILLIONS Provincial government bonds 2,750,000 Hanoi 1,000,000 Ho Chi Minh City 550,000 Quang Ninh province 800,000 Bac Ninh province 400,000 Direct loans to provincial governments 9,200,000 Ho Chi Minh City 8,000,000 Dong Nai province 1,200,000 Total provincial government portfolio 11,950,000 Total loan portfolio 533,530,000 Total assets 779,483,000 Direct loans to local governments/total loan portfolio 1.7 Percent total provincial government portfolio/total assets 1.5 Source: VietinBank Annual Report 2015. Liquidity The bank is operating on a liquidity ratio at par with the Vietnam industry aver- age liquidity ratio (16 percent) and slightly above the global average level (15 per- cent). The bank needs to focus on maintaining a strong liquidity position, especially because the loan/deposit ratio of the bank stood at a very high level (nearly 100 percent). An ambitious credit growth plan will also put pressure on the liquidity of the bank. The bank may consider improving its solvency position by increasing the deployment of deposits toward liquid assets. Given that the majority of the bank’s deposits are deployed to provide short- to medium-term loans, the bank is less likely to face asset mismatch problems (figures 3.31, 3.32 and table 3.17). Nonperforming loans The level of NPLs at VietinBank was 0.8 percent in 2013 further down to percent, much lower than the overall market level. Part of the reason for 0.7 ­ the  improvement was the strong growth in the portfolio during this period. The other cause was that VietinBank had sold its bad debts at their book value to the Vietnam Asset Management Company. Corporate governance The system of bank governance and control is somewhat different in Vietnam than in most other developed countries, which have a clear definition of roles and responsibilities and a clear separation of powers between board and man- agement, as well as an internal audit function and board audit committee as a key mechanism in this overall governance and control structure. The board of direc- tors of VietinBank is a full-time board appointed by the government as share- holder. In addition to the government-appointed members, representatives also come from the Bank of Tokyo-Mitsubishi and the IFC. There is also a supervi- sory board independent of the board of directors that reports to the general assembly of shareholders. One of the main functions of the supervisory board is to manage and control the internal audit function. However, this function differs 116 | Mobilizing Finance for Local Infrastructure Development in Vietnam FIGURE 3.31 VietinBank Liquidity Ratios 120 100 80 Percent 60 40 20 0 Loan/deposit Cash ratio Liquidity ratio ratio Year 2013 Year 2014 Year 2015 Source: VietinBank Annual Report 2015. FIGURE 3.32 from the more standard international practice. In Vietnam an Length of Total Liability of VietinBank internal control function reports to the supervisory board, which Over 5 years, is actively involved in the control and compliance process. In 3% addition, a state audit bureau does auditing of all state-owned From 1 to 5 years, entities, including the state banks. The supervisory board has 12% five members who are full-time employees of the bank. The supervisory board meets monthly and reports to the board of directors on a regular basis. The supervisory board also monitors the implementation of long-term strategy and goals at the bank, as well as ensures that the accounting systems at VietinBank are in line with current regulations and principles. Credit and risk management VietinBank has a well-developed credit and risk process that is Less than defined in a detailed sequence of steps, from the application for a 1 year, loan through the decision-making process. The bank has sepa- 85% rated the customer relationship role from the risk management Source: VietinBank Annual Report 2015. function by segregating those functions at branch level. It then established about nine centers for risk management to cover the whole country. At that step, the risk management committee is responsible for the credit assessment and appraisal of all larger business loans. The committee operates independent of the customer relationship staff, who have the primary responsibility for developing and expanding the business. That segregation is an important step in enhancing the credit and risk management capabilities at VietinBank. The bank’s risk management committee has overall responsibility for risk management, particularly with regard to credit, the major risk for VietinBank. The committee issued instructions that restrict and curtail the lending for sec- tors identified as higher risk in the current economic environment. The bank A Supply-Side Analysis of the Vietnamese Banking Sector | 117 TABLE 3.17  VietinBank’s Net Liquidity Gap (as of June 2016), D, millions OVERDUE NOT OVERDUE OVER UP TO UP TO 1 TO 3 TO 1 TO OVER TOTAL 3 MONTHS 3 MONTHS 1 MONTH 3 MONTHS 12 MONTHS 5 YEARS 5 YEARS Total assets 4,942,240 3,211,051 156,849,755 142,977,725 217,181,110 169,913,467 90,853,242 785,928,590 Total n.a. n.a. 211,577,410 169,112,861 232,792,667 86,508,512 23,366,272 723,254,165 liabilities Net liquidity 4,942,240 3,211,051 (54,727,655) (26,135,136) (15,611,557) 83,508,512 67,486,970 62,674,425 gap Source: VietinBank Annual Report 2015. Note: n.a. = not applicable. instituted a customer rating system based on qualitative and quantitative criteria developed by the bank over a number of years. All customers are rated by this system and must exceed a certain rating to be considered for a loan. The compre- hensive risk management structure is designed to manage the bank’s exposure to credit, market, and operational risks to the highest standards. HSBC Vietnam London-based Hongkong and Shanghai Banking Corporation (HSBC) opened its first office in Saigon (now Ho Chi Minh City) in 1870. In August 1995 the bank opened a full-service branch in Ho Chi Minh City and a second branch in Hanoi and established a representative office in Can Tho City in 2005. The chartered capital of the bank was D 7,530 billion (US$ 350 million) in 2015. In 2009 HSBC became the first foreign bank to incorporate in Vietnam. The  new  entity, HSBC Bank (Vietnam) Ltd., is 100 percent owned by the Hong  Kong SAR, China and Shanghai Banking Corporation Limited. HSBC  Bank  (Vietnam) Ltd. is also the first wholly foreign-owned bank to operate both branches and transaction offices in Vietnam. HSBC is currently ­ one of the largest foreign banks in Vietnam to serve onshore and offshore clients. The bank provides a comprehensive range of banking services, including retail banking and wealth management, commercial banking, global banking, global markets, global payments and cash management, global trade, and receiv- ables finance and securities services. Because detailed information on loan portfolio (by borrowers, tenor, and so on) was not available during the study, the analysis of HSBC focuses on the avail- able financial information (table 3.18 and figures 3.33 and 3.34) and the gover- nance structure of the bank. Balance sheet assessment As figure 3.33 shows, the three main components of HSBC Vietnam assets as of December 31, 2015, were loans and advances to customers (38 percent), place- ment with and loans to other financial institutions (32 percent), and investment securities and other financial assets (15 percent). Customer deposits account for a major portion of total liabilities, and the majority of the customer loans are short to medium term. The maximum tenor for U.S. dollar-dominated loans can be up to 10 years, while maximum tenor for Vietnamese dong-dominated loans ranges between 5 and 7 years. The funding sources for dong-dominated loans of HSBC are the local deposits of the bank, while long-term loans advanced by the bank are generally funded by long-term funds from the international markets. 118 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE 3.18  Key Financial Information of HSBC Vietnam 2014 2015 Indicators in D, billions Total assets 84,293 72,215 Loan portfolio 32,790 27,085 Deposits 65,841 57,957 Shareholder funds 10,294 9,986 Profit after tax 814 935 Return on assets, % 0.97 1.29 Return on equity, % 7.91 9.36 Source: Financial statements of HSBC Vietnam 2015. FIGURE 3.33 Exposure of lending to provincial governments HSBC Vietnam Asset Portfolio HSBC Vietnam currently does not regard provincial gov- Cash, gold, ernments as qualified borrowers. Therefore, the bank has and no provincial government portfolio and has neither bought gemstones, Investment 1% municipal bonds nor lent directly to any provincial govern- Others, ments. The bank is experienced in lending to infrastruc- securities Balance at State 1% and other Bank of ture projects, mainly including loans to private sector and financial Vietnam, assets, SOEs. The typical sources of finance for the Vietnamese 13% 15% dong loans are the local deposits. For U.S. dollar loans the funds are mostly from the international market, which has longer tenor. Placement with and loans to Liquidity other Fls, 32% HSBC Vietnam has been improving its solvency position Loans and by deploying more funds toward liquid assets. The bank’s advances loan-to-deposits ratio decreased from 100 percent in 2014 to customers, 38% to 48 percent in 2015, indicating that the bank has suffi- cient liquidity to cover unforeseen funding issues Source: Financial statements of HSBC Vietnam 2015. (figure  3.34). The cash ratio for the bank also reached Note: FI = financial institution. 115  percent in 2015, implying that the bank has good liquidity to absorb credit losses. Because the bank is deploying short-term local deposits to fund short- and medium-term loans, while using international market to finance long-term loans, the bank is less likely to face asset liability mismatch problems. Nonperforming loans HSBC Vietnam’s NPL rate reached 3.4 percent in 2013, due partly to the decreased outstanding loans in 2013. The rate decreased to 1.1 percent in 2015, well below the Vietnam industry average and the global industry average. Corporate governance As one of the world’s largest banks, HSBC is committed to the high standards of corporate governance set by the code for the industry and its shareholders. The Board of Directors of HSBC Holdings, led by a group chairman, is respon- sible for overseeing the management of HSBC globally. The authority of the A Supply-Side Analysis of the Vietnamese Banking Sector | 119 FIGURE 3.34 HSBC Vietnam Liquidity Ratios 120 100 80 Percent 60 40 20 0 Loan/deposit ratio Cash ratio Liquidity ratio Year 2014 Year 2015 Source: Financial statements of HSBC Vietnam 2015. board directors is exercised by collective action at the board meetings. The board sets the risk management strategy for the group and approves capital and oper- ating plans presented by management. The board committees are the Group Risk Committee, Group Audit Committee, Group Remuneration Committee, Nomination Committee, Group Management Board (GMB), Financial System Vulnerabilities Committee, Code and Value Committee, and Chairman’s Committee. Members of the board comprise a majority of independent nonexec- utive directors to ensure that no individual or small group can dominate its decision making. The board delegates the day-to-day management of HSBC Holdings to a GMB; heads of global business units or holding global functions and the chief executive officer of each region attend GMB meetings. The GMB is a key ele- ment of HSBC’s management and reporting structure such that all line opera- tions are accountable either to a member of GMB or directly to group chief executive officer, who in turn reports to the group chairman. HSBC Vietnam’s management team includes 12 members under the lead- ership of the first Vietnamese chief executive officer. More than half of the management team are foreigners who are the heads of the key business func- tions of the bank. There is no local board, but the management team of local business is under the delegation and supervision of the GMB and the global business and function. As a subsidiary of the global business group, the local business operations are aligned with the group strategy, principles, and objectives. Credit and risk management HSBC Vietnam has adopted a strong credit and risk management frame- work that meets the international standards and the HSBC Group’s guidance and policies. 120 | Mobilizing Finance for Local Infrastructure Development in Vietnam Key considerations by the five banks on participating in a city infrastructure financing facility Consultation with the five banks assessed revealed that the banks are receptive to the concept of a CIFF and consider it as an opportunity for a new business segment of provincial lending. Having limited exposure to provinces and per- ceiving high provincial credit risks, the banks note that their key considerations on potential participation in a CIFF are the following: • Interest margin and terms. The banks intend to earn an interest margin on provincial lending under a pilot CIFF program in line with the credit risk associated with the provincial governments that are under consideration. The banks are also willing to extend medium-term to long-term loans to pro- vincial governments, depending on the tenor of available CIFF funding. • General obligation versus project finance. The banks have been providing project-specific loans to provinces rather than general obligation loans, and ­ they would prefer to provide project-specific loans to provinces because the lack of transparency and standardization in budgeting and financial reporting procedures makes it difficult for banks to assess the strength of provincial governments’ balance sheets. For general obligation loans proposed under the CIFF program, the free cash flows available with the provincial govern- ments from their overall operations may be escrowed for repayment to improve the debt security. • Capacity. Commercial banks possess inadequate capacity for credit appraisal, risk management, and pricing of provincial loans. The banks have highlighted the need for support for building capacity in budgeting and financial manage- ment procedures followed by provincial governments, in analysis of provin- cial accounts and records, and for appraisal, pricing, risk management, and monitoring of provincial loans. • Currency denomination. The banks prefer the provincial loans under a CIFF program to be denominated in Vietnamese dong, however they also indicated that they are open to receiving the CIFF funding in foreign currency. The banks would either pass on the risks to the provincial governments by includ- ing an appropriate foreign exchange risk premium, or they would hedge their exposure to the risks by using appropriate derivatives instruments. CONCLUSION AND RECOMMENDATIONS The banking sector in Vietnam has shown impressive growth with its ongoing restructuring and liberalization reforms. The sector is gradually recovering from the global financial crisis, and the commercial banks have just recently addressed the substantial NPL overhang. With substantial untapped capital sitting in the industry, the commercial banks are exploring new funding opportunities. Participating in the potential CIFF program may help commercial banks address issues such as asset liability mismatch, high provincial credit risks, and limited experience in undertaking credit assessment on the provinces, thus allowing provinces to use commercial banking resources in the short to medium term. More importantly, developing a CIFF program may also improve provincial gov- ernments’ debt management and borrowing practice, thus ultimately building up a credit culture and enhancing their capacity to tap into the capital market for local infrastructure financing in the long term. A Supply-Side Analysis of the Vietnamese Banking Sector | 121 A rapid assessment of a sample of commercial banks in Vietnam was carried out to assess the potential of commercial banks to participate in the CIFF pro- gram. The SOCBs such as Vietcombank and VietinBank are among the largest commercial banks in Vietnam, with the greatest size of total assets, loans, and chartered capital, as well as a good business base across various sectors of the economy. These banks have made significant investments in infrastructure and have had considerable experience in lending directly and indirectly to provincial governments. Other smaller domestic commercial banks (LVPB, Maritime Bank) have built a provincial government portfolio but have some limitation in terms of lending capability. Finally, a foreign bank (HSBC Vietnam) is improving its sol- vency position and indicates sufficient bandwidth for provincial lending. Further assessment should be carried out thoroughly to identify a list of qualified com- mercial banks to participate in the CIFF program, once the program is launched. The selected commercial banks have experience in providing loans at longer tenors. On average, four of the five selected banks used approximately 31 percent of their assets to make loans at tenors greater than 5 years (figure 3.35). FIGURE 3.35 Average Loan Tenor of Four Vietnam Commercial Banks 31% Short term (≤ 1 year) Medium term (1–5 years) 55% Long term (> 5 years) 14% 100 24 29 33 32 80 60 11 29 Percent 47 38 40 56 47 20 30 24 0 LVPB Vietinbank Maritime VietcomBank Selected commercial banks Short term (≤ 1 year) Medium term (1–5 years) Long term (> 5 years) Sources: Bank for Foreign Trade of Vietnam (Vietcombank); Lien Viet Post Bank (LVPB); Maritime Bank; Vietnam Bank for Industry and Trade (VietinBank), as of December 31, 2015. 122 | Mobilizing Finance for Local Infrastructure Development in Vietnam This suggests that the banks have the ability to lend at longer tenors and could possibly do so for provincial governments, if the appropriate regulations were put in place to authorize it. However, commercial banks would need to balance any expansion of long-term lending to provincial governments with the poten- tial increase in liquidity risk, given existing conditions in which extensive mis- matches already exist between long-term assets and long-term liabilities. Hence, the availability of a refinancing window through which the banks could obtain longer-term capital to fund long-term loans to provincial governments would potentially serve as a key market stimulant for commercial banks. Overall, the banks still have limited exposure to provincial lending, given that banks still associate provincial lending with high risks and regulatory ambiguity. Bank officials have expressed their willingness to participate in a pilot program like the CIFF, provided that they are able to obtain sufficient information to assess the creditworthiness of the provinces. To do so would essentially require improved transparency of financial reporting by the provincial governments, as well as building the capacity of provincial governments to streamline financial reporting. Proposed qualification criteria for selecting participating banks Proposed qualification criteria for the selection of participating banks for the CIFF mechanism may include both qualitative and quantitative criteria (box 3.2). To propose appropriate qualification criteria under the local business environment, decision makers will have to consult with the SBV and Ministry of Finance in the later stage. Once qualification criteria are established, the study team can conduct a detailed bank assessment for selecting banks to participate in the CIFF program. Recommendations for commercial banks under a pilot city infrastructure financing facility Because commercial banks have limited experience in provincial lending in gen- eral, the following actions would be important for commercial banks planning to participate in a potential CIFF: Business pipeline development. The commercial banks currently adopt a cor- porate relationship banking approach focused on private sector entities and BOX 3.2 Qualifications for Banks to Participate in a City Infrastructure Financing Facility Program for Provincial Lending At the preliminary stage, proposed qualification • Liquidity ­ criteria could include the following: • Solvency • Asset quality • Risk and portfolio diversification • Size of bank in terms of assets, loans, and • Credit and risk management capability ­chartered capital • Financial performance • Capability to assess project financing • Nonperforming loans • Bank strategy and risk appetite • Capital adequacy • Management capability A Supply-Side Analysis of the Vietnamese Banking Sector | 123 SOEs for lending across various sectors. With their entry into provincial financ- ing, the commercial banks would need to deal with a customer segment that will be more regionally dispersed and that will require cost-effective ways of busi- ness network expansion and of developing loan deals with provinces. Appraisal procedures. Since commercial banks have very limited exposure to provinces currently, the credit appraisal procedure would need to be customized to adequately assess the provinces on various financial and institutional aspects. The appraisal procedure should consider and adequately price all the risks asso- ciated with the provincial governments. Risk management function. Commercial banks would need to develop a rating tool, risk register, and risk control matrix for provincial government loans and integrate them into the wider organization risk management and decision-­ making process for better portfolio monitoring and management from the risk perspective. Internal audit. More active internal audit processes and system automation, review of portfolio, and capacity building to adopt international best practices would be needed. Capacity building. Banks would have to train staff and officials on various aspects related to the assessment of provincial loan proposals, including techni- cal assessment, financial assessment, environmental and safeguards assessment, risk management aspects, and other related aspects. Regulatory issues to be considered for the supply side As the next chapter will discuss in detail, some fundamental weaknesses in the current legal and regulatory framework of provincial borrowing constrain prov- inces in efficiently and effectively using private capital to narrow the funding gap in public infrastructure investments. Here we highlight key regulatory consider- ations on the supply side. First and foremost, the legal framework should clearly specify that commer- cial banks can lend to provincial governments and should provide guidelines for advancing and accounting of provincial government loans by commercial banks. The central government may also need to modify the SBV guidelines to allow commercial banks to lend to provinces for a longer tenor, compared with the existing maximum tenor allowed of 2 years. More important, the current legal framework lacks a clear recourse mechanism, making commercial banks and other creditors perceive that provincial lending is too risky. Thus, the legal framework should provide a clear recourse mechanism for the case of a provin- cial government’s default or insolvency. As the five selected banks highlighted, debt security related to provincial lending needs to be enhanced. The legal framework should allow provincial gov- ernments to service their debt through escrow accounts and collateralization agreements. The selected banks also highlighted the need for the legal frame- work to emphasize standardization of and transparency in the budgeting, accounting, and financial reporting procedures followed by provinces. NOTES 1. The SOCBs are the partially privatized Bank for Foreign Trade of Vietnam (Vietcombank), Vietnam Bank for Industry and Trade (VietinBank), Bank for Investment and Development of Vietnam (BIDV), and Vietnam Bank for Agricultural and Rural Development (Agribank). 124 | Mobilizing Finance for Local Infrastructure Development in Vietnam 2. “Real Interest Rate,” World Development Indicator, World Bank, https://data.worldbank​ .org/indicator/FR.INR.RINR?end=2016&start=2015. 3. Circular 36/2014/TT-NHNN issued by the State Bank of Vietnam, November 20. 4. Article 128 of the Credit Institution Law. 5. Phase I (P036042) of the project was to implement the international standard core banking solutions (CBS) and modules of banking operation systems to six participating commercial banks to improve their operational practice and capacity; phase II (P082627) of the project was a response to the urgent needs of expanding the core banking solutions to mitigate the risk of running both the new and legal systems in parallel. REFERENCES Vietcombank. 2016. Vietcombank Annual Report 2015 . http://vietcombank.com.vn​ /­upload/2016/06/09/20160613_AR_VCB_2015_EN.pdf?27. LienVietPostBank. 2016. LienVietPostBank Annual Report 2015. https://www.lienvietpostbank​ .com.vn/sites/default/files/file_download/ANNUAL_REPORT_LPB_2015.pdf. Maritime Bank. 2016. Maritime Bank Annual Report 2015. http://static2.vietstock.vn/data​ /­OTC/2015/BCTN/VN/MSB_Baocaothuongnien_2015.pdf. Vietinbank. 2016. Vietinbank Annual Report 2015. https://www.vietinbank.vn/web/export​ /­sites/default/en/annual/annual-report-2015.pdf. HSBC Bank Vietnam. 2016. Summarized Financial Statements. http://www.about.hsbc.com​ .­vn/-/media/vietnam/en/hsbc-in-vietnam/financial-information/finance-report-2015-en​ .­pdf. Schmittmann, J., Corvino, D., and Katagiri, M., 2017. Vietnam: Selected Issues. IMF Country Report 17/191, International Monetary Fund. https://www.imf.org/~/media/Files​ /­Publications/CR/2017/cr17191.ashx. 4 An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam Provincial governments in Vietnam have their respective rights, duties, and responsibilities established in laws, including those related to the local bud- get and capital ­mobilization. Budgets of provincial governments are prepared and submitted to the central government through a bottom-up process in which local legislatures review and appropriate the local budgets before ­ submitting them to the upper tiers of ­ government. The National Assembly ultimately adopts a budget for the entire country, which is a consolidation of ­ the central and local b­ udgets. Provincial budgets are an integral part of this unitary budget, but with a high level of spending d ­ ecentralization. As discussed in previous chapters, for provinces to effectively leverage their budget surpluses to obtain private sector capital to finance public infrastruc- ture investments, a comprehensive legal and regulatory framework is needed to address constraints on both the demand and the supply s ­ ide. This chapter provides a detailed review of the legal and regulatory framework for provincial financing in Vietnam to help identify the key legal and regulatory constraints to the establishment of the city infrastructure financing facility (CIFF) and the adjustments needed to launch the potential ­ program. VIETNAMESE JURIDICAL FRAMEWORK FOR CAPITAL MOBILIZATION BY PROVINCIAL GOVERNMENTS This section presents an assessment of Vietnam’s juridical framework for ­capital mobilization by the provincial ­governments. It analyzes the legal frame- work governing the capital mobilization capability of the provincial govern- ments, including the provincial governments’ borrowing from commercial banks, the Vietnam Development Bank’s (VDBs) lending, and provincial ­ governments’ bond i ­ssuance. The findings from that assessment helped the report team in making final recommendations for this ­ chapter.  125 126 | Mobilizing Finance for Local Infrastructure Development in Vietnam Capital mobilization capability of provincial governments Under Vietnamese law provincial governments comprise the provincial People’s Council (PPCo) and the provincial People’s Committee (PPC), which are organized in administrative units at the provincial, district, and commune ­levels.1 The provincial governments have their respective rights, duties, and responsibilities as provided by law, including those related to the local budget and capital ­mobilization. The current capital mobilization capability of the provincial governments is mostly governed by the State Budget Law and the public debt management laws, the former related to management of the ­provincial government’s budget and the latter to the debt management of the provincial ­governments. State budget laws The principal legislation or backbone of the legal framework governing the state budget is the Law on State Budget (or State Budget Law, SBL),2 which constitutes the overall legal framework for the budgeting and financing of national and provincial ­ infrastructure. The law not only stipulates the budget formulation process and the definition of revenues and expenditures, but also sets forth the framework for the provincial governments’ capital ­mobilization. The provincial committees and councils (the PPCs and PPCos) constitute the main level of local government and have responsibility for defining the provincial budget—the estimated revenues and expenditures for the district ­ and ­commune levels that fall under their ­ jurisdiction. Although the SBL empowers provincial governments with certain budget- ary autonomy, all of the budgets must be integrated into a unitary state b ­ udget. The budget process starts with the lowest level of provincial government and progresses through the different administrative stages until it reaches the National Assembly for final ­ approval. At the provincial levels, all the budgets of communes and districts under provincial administration are compiled into a single budget, which, once approved by the PPCo, is submitted to the Ministry of Finance (MOF) at the national ­ level. The National Assembly approves the integrated state budget and distributes the results to the provin- cial governments and to treasury offices around the country, which are responsible for recording the r ­ evenues and expenditures of the local govern- ments under their ­ jurisdiction. According to the SBL, revenues available for provincial budgets include tax revenues that are fully assigned to local governments, tax revenues that prov- inces have to share with the central government, other revenues assigned to local governments by the central government, and domestic b ­ orrowing.3 The SBL also provides a “list of spending tasks” associated with provincial budgets, with broad definitions for capital and recurrent e ­ xpenditures. Such capital expenditures include investments in the construction of socioeconomic infrastructure projects and investments in state enterprises, economic organi- zations, and financial i­ nstitutions. The provincial governments also are allowed to mobilize domestic capital, so although the former law, SBL 2002, indicates that, in principle, provincial budgets should be balanced,4 it also contemplates domestic borrowing for investment in infrastructure projects that are included in provincial budgets and are part of the 5-year plan of the P ­ PCos. The former law, SBL 2002, limited the amount of capital mobilized, which must not exceed 30 percent of the annual investment capital for capital construction included in the provincial budget (with an exception allowing ­ An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 127 100 ­percent for Hanoi and 150 percent for Ho Chi Minh C ­ ity).5 In that regard, the former law, SBL 2002, is further guided by Decree 60/2003 and Circular 59/2003,6 which state that when demand exists for mobilization of investment capital for the construction of infrastructural works (covered by the provincial budget), the PPC must prepare the investment capital mobilization plan and submit it to the PPCo for a ­ pproval. After PPCo approval, the plan must then be reported to the Ministry of Planning and Investment (MPI) and the MOF for supervisory ­purposes. The new budget law, SBL 2015, raises the borrowing limit to 30 percent of provincial revenues for provinces that are net contributors to the national ­budget.7 Provincial governments are allowed to borrow to offset their local budget deficit and to repay the principal of d ­ ebts. The borrowing can be in the form of bond issuance, on-lending of a provincial government’s foreign loan, or loans from other sources in accordance with the ­ laws. Generally, the annual budgeting process of local government considers the balancing capacity of the local budget, the borrowing balance limit, and the demand for development investment ­capital. The PPC bases the estimate on local deficit, borrowing, and repayment of debt, then submits it to the PPCo for ­ approval. Once approved, it is submitted to the central government for ­ approval. The government of Vietnam is required by the SBL to prescribe in detail cases in which the local budget deficit is permitted so as to ensure the debt repayment capacity of localities and suit the total deficit of the state b ­ ­ udget.8 This assessment noted that the SBL and its guiding legislation are silent on a recourse mechanism, including in its detailed p ­ rocedures. Such a mecha- nism would ensure that, in the case of local government default, the lenders or financiers could recover the funds from the provincial b ­ udget. The recourse mechanism would play an important role in credit enhancement for local gov- ernments by providing financiers with the necessary security currently absent in the market in ­ Vietnam. The study found that the absence of the recourse mechanism in the SBL is one of the legal barriers that discourages the credit institutions from lending money to the provincial g ­ overnments. For example, a 2-year limitation on lending by commercial banks to provincial governments was established by the State Bank of Vietnam (SBV) Official Letter 576/ NHNN-CSTT, and the inability of commercial banks to access the govern- ment’s foreign loans for subsequent on-lending or lending to provincial governments was due to a restriction in Decree ­ ­ 78/2010. Public debt management laws The purposes of provincial government borrowing are defined in Article 37 of the Law on Public Debt M ­ anagement.9 Those purposes include (a) non-­ revenue-generating projects for socioeconomic development within the provincial budget spending task under the SBL and (b) revenue-generating ­ projects capable of recovering ­ capital. Articles 37 and 38 of the Law on Public Debt Management defines the forms of domestic borrowing and introduces the possibility of ­ i ndirect international financing through the central government. Local borrowing potentially could be in the form of bonds or ­ loans from other legitimate ­ sources. However, the law does not specifically define the other legitimate sources—it just generally states that those other legitimate sources must be in accordance with the l ­ aws. One could therefore interpret that capital mobilization by provincial governments from credit institutions (as further assessed in the next ­section) is not contrary to the Law on Public Debt ­ Management. 128 | Mobilizing Finance for Local Infrastructure Development in Vietnam Conditions for domestic borrowing by provincial governments (under public debt management laws) Regarding borrowing by the provincial governments for investment in non-­ ­ revenue-generating projects, Article 3 ­ 9.1 of the Law on Public Debt Management states that the following conditions must be ­ satisfied. First, the project must have completed investment procedures under the investment law and other relevant laws and must be on the investment list under the 5-year plan already decided by P­ PCos. Second, bond issuance schemes and plans for use of loans and debt ­payment must have been adopted by the PPCo and approved in writing by the ­MOF. Third, the value of the domestic borrowings must be within the provincial budget’s borrowing limits under the ­SBL. And fourth, for on-lend- ing of the government’s foreign loans, the conditions specified in Articles ­ 24.3 25.5 of the Law on Public Debt Management must be ­ and ­ satisfied. With regard to borrowing by the provincial governments for investment in revenue-generating projects, the Law on Public Debt Management10 states that the following conditions must be satisfied: First, the projects must have com- pleted investment procedures under the investment law and relevant laws and must have been determined by competent agencies as capable of recovering capital, and second, schemes on issuance of bonds for project investment must have been evaluated and approved in writing by the ­ MOF. Borrowing limits by provincial governments (under public debt management laws) According to the Law on Public Debt Management and its guiding legislation, based on the state budget laws, the PPCs must set borrowing limits for provincial budgets that they report to PPCos and submit to the prime minister for a ­ pproval.11 Consequently, borrowings of, and bonds issued by, provincial governments must be made within the approved borrowing l ­imits. However, the legislation makes it possible for a provincial government’s limits to exceed the approved limit, pro- vided that the PPC submits a specific plan to the MOF for its appraisal and for reporting to the prime minister for a ­ decision. In that regard, it is noted that, according to Resolution 10/2011 of the National Assembly and Decision 958/2012 of the prime minister, the public debts (including the government debts, the debts guaranteed by the government, and the provincial governments’ debts) may not exceed 65 percent of gross domestic product (GDP) by 2020 and 60 ­percent of GDP by ­ 2030.12 According to Article 19 of Decree 79/2010, in accordance with the borrowing limits under the SBL, the capacity to balance provincial budgets for debt pay- ment, the projects’ implementation schedule, and the projects’ needs for funds of loaned projects, the PPC must elaborate the annual detailed plan on borrowing and the annual detailed plan on debt payment and must submit them to the PPCo for ­approval. The first plan, the borrowing plan, must elaborate borrowing sources (bond issue, other lawful financial sources, and borrowing from foreign on-lending of a government loan), and it must show the funding being used for the declared p ­ urposes. The second plan must elaborate debt repayments from the provincial budget and from capital recovery of ­ projects. The plan on debt repayment is to be made and approved by the PPC only on a year-by-year basis, even for revenue-generating ­ projects. Thus, the assessment determined that for medium- and long-term financing of infrastructure development projects, the SBL may cause credit institutions providing such financing to be concerned and ­ uncomfortable. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 129 This requirement also seems to be one of legal barriers discouraging credit institutions from lending to the provincial governments, because it means that provincial governments have a higher risk of not meeting repayment terms for their medium- and long-term ­ financing. Implementation of provincial government debt payment (under public debt management laws) The Law on Public Debt Management (Article 42) provides a debt payment principle that states that the provincial governments’ sources for repaying ­ debt are provincial budgets and funds recovered from the investment projects locality. Guiding this law, Decree 79/2010 (Article 21) establishes prin- of the ­ ciples for the repayment of provincial government debts; that is, where loans are included in the budget, repayment must come from provincial budget funds, and when loans are used for programs and projects, repayment must first come from revenues generated by the p ­ rojects. When such revenues are insufficient for debt repayment, provincial budget funds must be allocated to repay the outstanding ­ debts. Management of provincial government debts (under public debt management laws) According to Decree 79/2010 (Article ­21.1), the PPC must borrow money and pay provincial governments debts according to approved borrowing limits and ­plans. The MOF is assigned to supervise provincial governments for both borrowing and debt ­ payment. For the purposes of administration and supervision, under Decree 79/2010 (Article ­21.3) the PPC must direct provincial departments and functional sectors to closely monitor the use of funds from loans for programs and projects and must report on its borrowing and debt payment in accordance with the l ­ aws. The owners of programs and projects are responsible for reporting quarterly to the PPC on the implementation, fund withdrawal, disbursement, and debt payment of programs and ­ projects. On-lending of the government’s foreign loans According to Article 23 of the Law on Public Debt Management, the MOF must directly provide or authorize a financial or credit institution to provide ­on-lending. The on-lending beneficiaries include the following: (a) financial and credit institutions borrowing for further lending to users under credit programs or credit components of programs and projects using foreign loans; (b) enter- prises borrowing for investment in programs and projects capable of recovering part or all of the loans; and (c) provincial governments borrowing for investment in socioeconomic development within the provincial budget spending t ­ ask. According to Article 18 of Decree 78/2010, (a) the MOF must directly provide on-lending for provincial governments and for financial and credit institutions for implementation of credit limits or programs that are not subject to specific conditions and (b) the MOF must authorize financial and credit institutions to act as on-lending agencies in certain ­ cases. The first case is on-lending to enter- prises for execution of specific investment programs or projects, and second is implementation of credit limits or programs subject to conditions on borrowers, areas, sectors, on-lending interest rates, and other relevant c ­ onditions. Further, in case of on-lending of the government foreign loan to the provincial governments, the decree states: (a) the MOF must evaluate the debt repayment 130 | Mobilizing Finance for Local Infrastructure Development in Vietnam capacity of the provincial governments (Article 1 ­ 9.5 of Decree 78/2010), (b) the on-lending interest rate must be the same as the foreign loan interest (Article ­7.3 of Decree 78/2010), and (c) the on-lending currency must be the orig- inal foreign currency in which the foreign loan has been borrowed (Article 4 ­ .3 of Decree ­ 78/2010). The research team therefore offers an interpretation that, for on-lending of the government foreign loan to the provincial governments, the on-lending agency is always only the MOF ­ itself. Thus, the study highlights the need to clarify those stipulations or to make an appropriate amendment to Decree 78/2010 to clarify that ­ point. Without that clarification or amendment, a model of a CIFF with wholesale function (that is, having two tiers of lending as described later in this chapter), which proposes to use the government’s foreign loan, may not ­ work. The recommendations in the final section of this chapter reflect this interpretation, though the MOF would have to agree with ­ it. Further, for provincial governments to be eligible to benefit from central gov- ernment on-lending, they must fulfill the following conditions: (a) be permitted by competent authorities to borrow the government’s foreign loans, (b) have socioeconomic development investment projects within the local budget spend- ing task that have completed investment procedures under the investment law and other relevant laws, and (c) have a provincial budget with sufficient capacity to repay the ­debt.13 The MOF’s Department of Debt Management and External Finance (DDMEF) must sign the on-lending contracts on behalf of the ­ MOF.14 That means that the DDMEF may play a similar retail-like role within the CIFF, as discussed later in this c ­ hapter. In addition, according to Decree 78/2010, the fol- lowing conditions must be ­ met. First, before approving the loan, the MOF must evaluate the provincial budget plan for the year in which the foreign loan agree- ment is signed and the loan use and payment plan are approved by the P ­ PC.15 Second, provincial governments have certain advantages relative to other eligi- ble subborrowers; for example, (a) they are not charged an on-lending charge fee by the government or the MOF (Article 10), (b) the on-lending interest rate is the same as the foreign loan interest rate (Article 7), and (c) no security is required or applicable (Article ­ 12). With regard to on-lending interest rates that are applicable to official development assistance (ODA) loans provided to organizations other than provincial governments, Article 7 of Decree 78/2010 stipulates the following: First, in the case of “on-lending in the original foreign currency,” the on-­ lending interest rate is equal to two-thirds of the commercial interest refer- ence rate corresponding to the on-lending c ­ onditions. If two-thirds of the ­ commercial interest reference rate is lower than the foreign lending interest rate, then the on-lending interest rate is equal to the foreign lending inter- est ­rate. In case of on-lending in foreign currency without a commercial interest reference rate, then the on-lending interest rate is equal to the for- eign lending interest ­ rate. Second, in the case of “on-lending in Vietnam dong,” the on-lending interest rate is determined as equal to the foreign currency lending interest rate ­previously specified, plus the exchange rate risk ratio between the relevant for- eign currency and the Vietnam ­ dong. The MOF (in coordination with the SBV) shall be calculating and announcing the exchange rate risk ratio between the Vietnam dong and three major foreign currencies, namely US ­ dollars, euros, and Japanese y ­ en. In the case of major fluctuations on the foreign exchange An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 131 market, the MOF may announce another exchange rate risk ratio during the applicable ­ period. If the original foreign currency in the loan agreement is different from the three foreign currencies, the exchange rate risk ratio is the ­ one applicable to US ­ dollars. Third, a number of trades and sectors are eligible for the preferential interest rate, which is equal to 30 percent of the corresponding foreign currency or Vietnam dong on-lending interest rate; however, the preferential interest rate must not be lower than the foreign lending interest ­ rate. Given those conditions, the study determined that such provision on the on-lending rates in Vietnamese dong should be taken into account for proposing a CIFF with a wholesale ­function. ­ .3 of Decree 78/2010, in the case of on-lending Further, according to Article 4 to a PPC, the on-lending currency is the original foreign currency in which the foreign loan has been b­ orrowed. That implies that any on-lending of a govern- ment foreign loan to the provincial governments under a CIFF model should be made only in foreign currency (that is, not in Vietnamese dong) to comply with the ­ decree. The recommendations at the end of this chapter will reflect that ­implication. Capital mobilization by provincial governments from commercial banks Organizational forms and permissible operation of commercial banks According to Article 6 of the Law on Credit Institutions, credit institutions include, but are not limited to, (a) domestic commercial banks, established and organized in the form of a joint-stock company; (b) state commercial banks, established and organized in the form of a single member limited liability com- pany (LLC) that is wholly owned by the state; and (c) joint-venture credit insti- tutions and the wholly foreign-owned credit institutions established and organized in the form of a LLC that comprises a single member LLC and a mul- timember ­LLC. The permissible operation of commercial banks, which includes receiving deposits, extending credits, and providing payment services through the account, must be specified by the SBV in the license issued to each commercial bank. Extension of credit seems to be the current major source of revenue of ­ commercial banks, which could be made in the form of (a) loans, (b) discounts and ­rediscounts of negotiable instruments and other valuable papers, (c) bank guarantees, (d) issuance of credit cards, (e) domestic factoring, or (f ) interna- tional factoring applicable to banks authorized to conduct international ­payment ­services. Credit assessment and risk mitigation For its purposes of assessment and approval to extend credit, the commercial bank must, on principle, require its client to provide data proving that the client has (a) a feasible plan on the use of its capital and financial capability, (b) a law- ful capital use purpose, and (c) measures to secure the loan before the credit institution makes a decision on extension of ­ credit.16 Further, in extending the credit, the commercial banks are required to comply with the relevant provi- sions of the Vietnamese laws to ensure the security of the credit institutions’ operations regarding the limits on extension of credit,17 the prudential ratios,18 and the reserves for risks occurring during their ­ operation.19 132 | Mobilizing Finance for Local Infrastructure Development in Vietnam With respect to credit assessment and risk mitigation, the SBV issued Circular 36/2014, which stipulates minimum safety limits and ratios for transactions per- formed by credit institutions and branches of foreign banks that must be con- stantly maintained to ensure security during their ­ operation. Those limits include (a) minimum capital adequacy ratio, (b) credit limit, (c) solvency ratio, (d) maximum ratio of short-term capital sources used as the medium- and long- term loans, (e) limit on capital contribution and stock purchase, and (f ) loan-to- deposit ­ratio. Specifically with regard to the use of short-term capital sources, credit institutions (including commercial banks) are entitled to use short-term cap- ital sources for providing medium- and long-term loans in Vietnamese dong (including foreign currencies converted into Vietnamese dong) at a certain permissible percentage (60 ­ percent).20 Credit institutions also are entitled to purchase and invest in government bonds at the maximum rate of 15 percent (state-owned commercial banks) or 35 percent ( joint-stock commercial banks, joint-venture banks, and wholly foreign-owned ­ banks). Investment in government bonds may include entrusted credits granted to other organiza- tions to purchase and invest in government bonds, but it excludes credits used to purchase and invest in government bonds by means of entrusted capital derived from other ­ organizations. Further, the SBV has also issued Circular 02/2013 (as amended by Circular 09/2014) on classified assets, levels and methods of setting up of risk provisions, and use of provisions against credit risks in the banking activity of credit institu- tions and foreign bank b­ ranches. The circular classifies the debts into five groups: group 1, standard debts; group 2, debts that need attention; group 3, substandard debts; group 4, doubtful debts; and group 5, potentially irrecoverable ­ debts. The debts are classified following quantitative and qualitative methods, and they are generally based on the capability of the borrowers to pay obligations and the performance of the borrowings in paying their debt o ­ bligations. Of the debt groups, groups 3, 4, and 5 are nonperforming ­ loans. Accordingly, credit institu- tions (including commercial banks) are required to set up provisions, including specific provisions for each customer and general provisions, in accordance with the ­laws. Thus, regarding the use of the CIFF model with a wholesale function, this study determined that the SBV must promulgate specific guidance or regulations on the assessment of credit risks relating to the loans to be pro- vided by commercial banks to provincial ­ governments. Taking into account the lack of detailed regulation on the matter and the lack of experiences of commercial banks in assessing the loans to provincial governments, such promulgation would support the credit assessment process used by the commercial banks when they are assessing whether to provide loans to pro- vincial ­governments. Borrowing from commercial banks Generally, according to the Law on Credit Institutions, credit institutions (including commercial banks) will have autonomy in the conduct of business operation and will be liable for the results of their business their ­ operation. On one hand, no organization or individual will be permitted to ­ ­ntervene in the business operation of credit i illegally i ­nstitutions. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 133 On  the  other  hand, credit institutions will have the right to refuse any request  for extension of credit  or for ­ provision of other services if they consider that conditions are ­ ­ neither fully satisfied nor inconsistent with the ­laws. Regulations on lending by credit institutions (including commercial banks) to clients that are not credit institutions21 apply the following rules: Borrowers or c­ lient. 22 The client could be Vietnamese or foreign organizations or individuals that are capable of repayment and that have demand for funds to perform investment projects; have a plan of production, business, and service activity or investment projects; and have a plan of domestic and overseas living standard ­improvement. Borrowing ­principles. 23 The client must (a) use the loan capital for the correct purpose agreed to in the credit contract and (b) repay the loan principal and contract. interest on time as agreed to in the credit ­ Borrowing ­conditions.24 The client will be required to satisfy all of the prescribed conditions, which include the f ­ ollowing. (a) It has the civil legal capacity and capacity for civil acts and bears civil responsibility as stipulated by the applicable ­laws. (b) It must have a lawful purpose for using the loan c ­ apital. (c) It must have the financial capacity to ensure repayment of the loan within the time limit undertaken. (d) It must have an investment project or plan for production, busi- ­ ness, and services that is feasible and effective, or it must have an investment project or a feasible plan to service living conditions that complies with the ­laws. (e) It must comply with the regulations of the government and the guidelines of the SBV on security for ­ loans. term.25 The loan could be (a) a short-term loan (with a duration Loan types and ­ up to 12 months), (b) a medium-term loan (with a duration over 12 months up to ­ onths). 60 months), or (c) a long-term loan (with a duration over 60 m Loan interest ­rates.26 The loan interest rate shall be agreed in the loan contract in accordance with the regulations of the ­SBV. Lending ­method.27 It is permissible to use lending to provide loans to an invest- ment project for development of production, business, and services or an invest- conditions. ment project for servicing living ­ Although Decision 1627/2001 and its subsequent amendments do not have a specific clause on credit institutions’ lending to provincial governments, the study team could see from the description of types of clients (as noted earlier) that commercial banks are allowed to extend credit to provincial governments provided that provincial governments are “capable of repayment and have demand for funds to perform investment ­ projects.” Further, according to Decision 1627/2001, in the case of lending in foreign currency, (a) credit institutions must be licensed for foreign exchange activities, and (b) the credit institutions and the client must strictly comply with the government regulations and the SBV guidelines on foreign exchange ­ ­ control. SBV Circular 43/2014 stipulates that on foreign currency loans provided by 134 | Mobilizing Finance for Local Infrastructure Development in Vietnam credit institutions and branches of foreign banks for clients who are residents, commercial banks may only provide the foreign currency loans to meet borrowers’ specific capital demands that are permissible, which include the ­ following: • Short-term, mid-term, and long-term loans used as outward remittance for payments on imported goods or services, if the borrowers’ foreign currency derived from their operating revenues is sufficient to repay such loans • Short-term loans granted to key petroleum importers who are given quotas on petroleum imports in 2015 by the Ministry of Industry and Trade to repay foreign debts incurred from such importing, if the borrowers lack operating revenues in foreign currency required to repay such loans • Short-term loans used to meet the domestic enterprise’s demands for capital needed to implement its plans to manufacture and trade goods exported through Vietnam’s border gates and that the borrower’s foreign currency derived from the export turnover is sufficient to repay • Loans used as direct outward investments regarding important national proj- ects that are subject to investment decisions made by the National Assembly, the government, or the prime minister, and the offshore investment certifi- cate granted by the ­MPI. In addition to the specified capital demands of the borrowers mentioned earlier, subject to the prior approval of the SBV, commercial banks are permitted to consider lending decisions on foreign currency loans if the ­ demands for capital are regarded as a priority and fulfill policy incentives to develop production and business as prescribed in resolutions, decrees, deci- sions, directives, and other documents of the government and the prime ­minister. Under the CIFF wholesale model, lending by the commercial banks to the provincial governments may need the prior approval of the SBV, in case the loan is in foreign ­ currency. In compliance with Decision 1627/2001, in 2002 the SBV issued an official letter guiding lending to support provincial budgets for infrastructure development. In 2005, at the request of the MOF, the SBV sent its official letter ­ to the commercial banks,28 which guides commercial banks’ lending to provin- cial governments, with the following main specifications: • Purpose for b­ orrowing. Loans are used for the construction of infrastructure works that are in the provinces’ investment portfolio, included in the 5-year investment plan, and within the scope of the provincial budget that ensures the payment (as approved by the ­ PPCo). • Loan amount and ­ limits. The maximum lending limit (of commercial banks) to a provincial budget (as of the signing date of the loan agreement) is equiv- alent to the difference between 30 percent of total annual domestic capital investment of the provincial budget and the total mobilized capital of the pro- vincial budgets, including (a) the actual mobilized capital (at the date of sign- ing the loan contract) and (b) the amount of capital expected to be mobilized in accordance with the plan (as approved by the ­ PPCo). (Actual mobilized capital includes borrowings from commercial banks and investment bonds issued in compliance with the provisions of the government and borrowings from other legitimate funding ­ sources.) • Loan ­term. The maximum loan term is 24 ­ months. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 135 • Loan ­contracts. The loan contracts are entered into between commercial banks and the relevant PPC (or the provincial departments of finance and PPC). pricing, if so authorized by the ­ • Loan ­disbursement. The whole amount will be disbursed into the accounts of treasury. the provincial budgets at state ­ • Loan use supervision Commercial banks will agree with the PPC on the appli- cation of measures for checking and supervising the loans in compliance with budget. the Vietnamese laws on lending and the state ­ According to the Law on Promulgation of Legislation, any official letters of state agencies in general, and the SBV Official Letter 576/NHNN-CSTT in particular, are not regarded as a type of ­ legislation. Though from a legal per- spective this type of letter has only guiding power, not binding power, practi- cally all the commercial banks seem to strictly follow the SBV guidance in the official letter to avoid any subsequent ­ consequences. That explains why the commercial banks have not provided medium- and long-term loans to finance the infrastructure development projects of the provincial ­governments. Thus the study team determined that a new SBV circular needs to be drafted that would facilitate the commercial banks’ medium- and long- term lending to provincial governments and would invalidate the application 576/NHNN/CSTT. of Official Letter ­ Both SBL 2015 and public debt management law have given regulation on the authority of the local governments incur debt, but the regulation has not yet clearly specified the form of bank loan as one eligible source, which could lead to interpretation that provincial borrowing from commercial banks is not fully legally ­supported. This perception is further sustained given the exis- tence of the prime minister’s Instruction 25 issued in 2014, which forbids ­provinces from borrowing from commercial banks to cover the expenditure of local ­ budgets. In order to create an enabling subnational borrowing environ- ment, it would be important to clarify the effectiveness of prime minister’s Instruction 25 and specify that commercial bank loans are a legal lending source to provincial/local ­ governments. Capital mobilization by provincial governments from the Vietnam development bank The VDB was established by Decision 108/2006 of the prime minister as part of reorganizing the Development Assistance Fund (DAF) (established under Decree 50/1999) to implement the state’s policies on development investment credit and export credit, regulated in Decree ­75/2011. The VDB, which will be assessed later, offers loans with favorable terms to provincial governments, including longer tenor, but only under national target programs approved by the ­government. For instance, one of the national target programs was the program for solidifying and rebuilding the canals to develop rural transport roads, infrastructure for aquaculture, and infrastructure for craft villages in rural ­ areas, during the period ­ 2009–15.29 According to the decision, the VDB is responsible for providing loans to provincial governments, and the provincial governments are responsible for repaying the debts to the VDB when d ­ ue. For the repayment of the debts, the provincial governments must use the domes- tic development investment capital sources (including investment capital 136 | Mobilizing Finance for Local Infrastructure Development in Vietnam sources from the collection of land use fees) that are allocated in the annual budget balance of the locality to repay the ­ d ebts. The canal rebuilding program was further guided by Circular 156/2009, which stipulates that the ­ loans are made through the VDB once approved by the MOF, and the loan agreements are signed between the VDB branch in the locality and the ­ provincial Department of Finance and ­ Pricing. Capital mobilization by provincial governments from local government bonds As noted earlier, the Law on Public Debt Management authorizes provincial governments to issue bonds to finance local investment projects that meet certain ­conditions. Guiding the Law on Public Debt Management on this legal matter is Decree 01/2011, which consolidated the regulations for the issuance of both domestic and international government bonds, and Circular ­81/2012.30 Decree 01/2011 defines local government bonds as debt securities that are issued by the PPC to raise funds for local investment works and ­ projects. The local government bonds can be issued to fund investment in (a) socioeconomic development projects that are included in the provincial budgets, both under the spending task, according to the SBL, and under the investment portfolio defined in the 5-year plan decided by the PPCo; or (b) “local repayable projects” identi- ­ PCo.31 The PPCs are responsible for arranging for the payment of fied by the P interest and principal on the bonds when ­due. The PPCs are required to ensure repayment of debt obligations coming from the provincial budget and from local revenue-generating ­projects. Local government bonds are issued under bond issuance plans prepared by the PPCs, accepted by the PPCo, and approved by the M ­ OF. Article ­25.1 of Decree 01/2011 stipulates that bond issuance plans must include (a) the bond issuance objective and information on the projects to be funded; (b) capital sources of project and capital demand on bond issuance; (c) projected ­ volume, term, interest rates, and method of bond issuance; and (d) a repay- ment plan and the projected amount, maturity, and interest rate on the b ­ ond. Local government bonds have to be registered and deposited at the Vietnam Securities Depository and listed and traded on a stock exchange following the guidelines established by the M ­ OF. Local government bonds are issued through tendering, underwriting, or bond issuing agents and must be issued with maturities of 1 year or ­more. For the issuance of local government bonds, the following conditions are required under Article 24 of Decree 01/2011: • The local government bonds must be for investment in (a) projects of social and economic development, which are under the duties of the provincial budget in accordance with the SBL and the portfolio of the 5-year plan decided by the PPCos; or (b) projects determined by the PPCos as being able to meet capital recovery r­ equirements. Such projects must complete the investment procedures prescribed by the investment laws and the relevant provisions of the Vietnamese ­laws. • They must have a bond issuance scheme, with the required contents,32 approved in writing by the PPCos and appraised and approved in writing by the ­MOF.33 An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 137 • The maximum total capital raised by issuing bonds must be within the debt limit from funds mobilized annually from the provincial budget in accor- dance with the SBL and guiding ­ legislation. • Regarding projects that are able to meet capital recovery requirements, the total value of the loan, including the issuance of bonds to invest in such a ­ roject. project, must not exceed 80 percent of the total investment of that p Also, according to Article 7 of Decree 01/2011, the bond buyers (including buyers of local government bonds) generally could be Vietnamese organizations and individuals and foreign organizations and i ­ ndividuals. However, Vietnamese organizations are not permitted to use funds allocated by the state budget to buy bonds, including local government b ­ onds. This means that under the current legal framework, commercial banks, including the state-owned commercial banks, are allowed to use their mobilized capital (for example, saving deposits) to buy local government ­ bonds. The local government bondholders have such rights and obligations as provided by Article 8 of Decree ­ ­ 01/2011. In particular, the local government bondholders, on one hand, are guaranteed full payment in due time when the principal and interest of bonds come to maturity, or the local government bondholders can use the bonds for transfer, donation, inheritance, and mort- gage discount in civil and credit relations in accordance with the current regulations or l ­ ­aws. On the other hand, local government bondholders are obliged to pay tax (that is, institutions pay corporate income tax and individu- als pay personal income tax) for interest income arising from local government bonds and income arising from transfer of the local government bonds (as a kind of income arising from securities transfer) in case of transfer of such bonds, in accordance with the tax ­ laws. OVERVIEW OF PAST AND CURRENT CREDIT AND FINANCIAL INSTITUTIONS This section is an overview of the past and current credit and financial institu- tions (including VDB, formerly the DAF) that have functions, with certain lim- itations, of wholesale, retail, and credit enhancement similar to what will be set up in the ­CIFF. Those credit institutions share characteristics in areas such as establishment, capital mobilization sources, managerial organization tasks, and borrower eligibility, among ­others. The characteristics were used as a reference by the study team to assess optional legal structures and to make recommenda- section. tions at the end of this ­ Development assistance fund The DAF, now reorganized as the VDB, was established under Decree 50/1999/ ND-CP, dated July 8, ­ 1999. Its purposes were to mobilize medium- and long- term capital, and to receive and manage the state’s capital sources used for devel- opment investment credit to implement the state’s development investment support ­policy. The DAF was structured as a state financial organization that operates as a n­ onprofit. It had status as a legal person; it had charter capital, a financial balance, and its own seal; and it was entitled to open its accounts at the state treasury and banks in Vietnam and ­ overseas. 138 | Mobilizing Finance for Local Infrastructure Development in Vietnam Charter capital and capital mobilization sources The DAF’s charter capital was D 3 trillion (equivalent to US$136 million) derived from the existing charter capital of the National Investment Support  Fund34 and annual supplementary state budget a ­ llocations. Any change of the charter capital of the DAF was subject to the approval of the prime ­minister. Decision 231/1999 of the prime minister stated that the DAF could mobilize capital from the following sources: (a) state budget, (b) loans from other funds (for example, post savings, social insurance fund, and so on), (c) government bonds, (d) foreign loans used for on-lending, (e) trust capital, and (f ) other ­sources.35 Managerial organization of the development assistance fund The DAF was composed of the Management Council, the Board of Supervision, the general director, the deputy general directors, and the professional bureaus and ­sections. The appointment, dismissal, commendation, and discipline of Management Council members, the head of the Board of Supervision, the gen- eral director, and the deputy general directors of the DAF were as decided by the prime minister at the proposal of the head of the Government Commission for Organization and ­ Personnel. The Management Council of the DAF comprised five members (two full-time members, the chairman and vice chairman-cum-general director; and three part-time members representing the MOF, MPI, and ­SBV). The council had the following tasks and powers: • Submit to the prime minister for approval any supplements or amendments of the DAF charter, as well as matters concerning the development invest- jurisdiction. ment credits that were beyond its ­ • Adopt the operation orientations, financial plans, and final settlement reports DAF. of the ­ • Perform tasks and exercise powers as stipulated in the DAF c ­ harter. • Supervise and inspect DAF operations according to the DAF charter and decisions of the Management ­ Council. • Scrutinize reports of the Board of Supervision, settle complaints, and report cases beyond its jurisdiction to the prime minister for consideration and ­settlement. The Board of Supervision of the DAF was responsible to the DAF Management ­ AF. The board had the following Council for supervision of all operations of the D tasks and powers: • Inspect and supervise the observance of the guidelines, policies, and profes- sional regimes and rules in DAF operations to raise their efficiency and ensure the safety of the state’s property and the DAF’s ­assets. • Report to the DAF Management Council on the inspection and supervision results and propose the measures to resolve any ­ issues. • Carry out its work independently according to the program already adopted by the DAF Management ­ Council. • Present its reports or recommendations on the inspection and supervision results and/or report on financial settlement evaluation at meetings of the Management Council (but not entitled to ­ vote. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 139 • Consider and submit to the competent authorities for settlement all com- plaints about DAF operations that were lodged by capital lending organiza- tions, investors, credit institutions undertaking the entrusted loan provision, and other organizations and ­ individuals. The general director was the DAF’s legal representative who took responsi- bility before the prime minister, to the DAF Management Council, and before the law for the entire operations of the D­ AF. The general director’s tasks and powers complied with the provisions of the DAF’s c ­ harter. The general director was assisted by the deputy general directors and an assisting ­ apparatus. The general director was responsible for setting up and dissolving professional bureaus and sections, branches, and transaction offices, as well as appointing and dismissing heads and deputy heads of bureaus and s ­ ections. Directors and deputy directors of branches and transaction offices were decided by the general director after obtaining consent of the Management ­ Council. Eligible borrowers Decree 43/1999, on development investment credit, stipulates that eligible bor- rowers will be development investment projects of different economic sectors that are capable of capital recovery in a number of areas, including the transport and water sector and some socialization projects in education, health, culture, and ­sports.36 However, the decree does not make clear whether revenue-­ generating projects carried out by provincial governments, such as by a project management unit (PMU) or a sectoral department, are eligible borrowers or ­not. As for non-revenue-generating or insufficient-revenue-generating projects, pro- vincial governments could not get financing from the DAF, except for programs and projects approved by the prime ­ minister. Development assistance fund tasks According to Article 5 of Decree 50/1999, the DAF had the following tasks: • Mobilize medium- and long-term capital and receive the state’s capital sources (including domestic and overseas capital) for implementation of the state’s development investment support ­ policy. • Use its capital sources efficiently and for the right p ­ urposes. • Provide investment loans and recover ­ debts. • Provide postinvestment interest rate ­ support. • Provide guaranty for investors to borrow investment capital to reguarantee, and to undertake the reguarantee for investment ­ funds. • Entrust or take the entrusted provision of investment ­ loans. • Perform other tasks assigned by the prime ­ minister. • Strictly abide by the state’s laws and other regulations concerning its ­operation. • Observe the regime of periodical reports to the prime minister and the con- cerned ministries and branches as ­ prescribed. Note that (a) the DAF had no function to provide on-lending loans to commercial banks for lending to provincial governments, and (b) the DAF could provide eligible investors with guarantee services (that is, a type of credit ­enhancement). However, it is uncertain whether those investors could be provincial governments (via a PMU or sectoral ­department). 140 | Mobilizing Finance for Local Infrastructure Development in Vietnam Taxation regime Article 2 of Decree 50/1999/ND-CP states that the DAF is exempted from taxes and state budget remittances in order to reduce its lending interest rate and guaranty ­f ee. The DAF was assigned the centralized economic cost-accounting and financial regime decided by the prime minister at the MOF. proposal of the ­ Vietnam Development Bank The VDB was established pursuant to Decision 108/2006/QD-TTg of the prime minister, dated May 19, 2006, to reorganize the DAF and to implement the state’s policies on development investment credit and export ­ credit. The VDB has legal person status, charter capital, and a ­ seal. It is allowed to open accounts at the SBV, the state treasury, and domestic and foreign commer- cial banks and to join the system of payment with banks and provide payment services according to the provisions of ­laws. The VDB took over all the rights and responsibilities of the ­ DAF. The VDB operates on a not-for-profit b ­ asis. Its compulsory reserve ratio is 0 percent. The VDB is not required to buy deposit ­ ­ insurance. The VDB’s payment government. capacity is guaranteed by the ­ Charter capital and capital mobilization sources VDB’s charter capital is D 5 trillion (US$227 million), which comes from the previous charter capital of the D ­ AF. Adjustments to the charter capital of the VDB depend on its specific requirements and tasks, ensure the capital adequacy ratio, and are considered and decided by the prime ­ minister. According to Decision 108/2006 (Article 3) and Decision 110/2006 (Article 21), the capital sources of the VDB are as follows: • State budget sources, including (a) the charter capital of the VDB, (b) state budget capital allocated to projects according to annual plans, and (c) ODA capital assigned by the government) • Mobilized capital, including (a) issuing of bonds and deposit certificates according to the provisions of laws; (b) loans from the Postal Savings, the Social Insurance Fund, and domestic and overseas credit and financial institutions) • Receipt of entrusted deposits of domestic and overseas institutions • Nonrefundable capital voluntarily contributed by individuals; economic, financial, and credit institutions; sociopolitical organizations; and domestic and overseas associations, societies, and organizations • Receipt of entrusted capital from local governments; economic organizations; sociopolitical organizations; and domestic and overseas associations, societ- ies, and organizations for granting and lending • Other capital sources as provided by ­ law. Further, pursuant to Decisions 108/2006 and 110/2006, the prime minister issued Decision 44/2007, dated March 30, 2007, promulgating the Regulations on Financial Management of the VDB, according to which, for its operation cap- ital, the VDB could mobilize capital from the following sources: • Issuing of the government bonds, bonds guaranteed by the government, bonds of the VDB, bills (of exchange) of the VDB, deposit certificates An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 141 • Borrowing from Vietnam Social Insurance, the domestic financial credit institution • Borrowing from foreign financial and credit organizations • State budget provisions for postinvestment assistance • ODA funds as authorized by the MOF to provide on-lending loans • Receipt of entrusted deposits from domestic and foreign organizations • Mandated capital (for releasing to projects and collecting debts from clients) of domestic and foreign organizations through the mandate contract between the VDB and mandate organizations • Volunteered and nonrefunded capital from individuals; economic, financial, and credit organizations; as well as sociopolitical organizations, associations, and domestic and foreign nongovernmental organizations • Capital provided by the state budget to fulfill the mission on investment and credit, export credit, and objectives and programs of the g­ overnment. Managerial organization of the Vietnam Development Bank The managerial organization of the VDB is stipulated in Decision 110/2006, according to which the VDB must be composed of the Board of Management, the Board of Supervision, and the executive ­apparatus. The appointment or dis- missal of members of the Board of Management and the general director of the VDB are to be decided by the prime minister (at the proposal of the minister of home affairs after consulting the MOF and relevant a­ gencies). The appointment or dismissal of deputy general directors, the head of the Board of Supervision, and the chief accountant shall be decided by the Board of ­ Management. The  appointment or dismissal of other managerial tittles of the VDB shall be decided by the general ­director. The Board of Management of the VDB has five members, including full-time members and part-time members, of which, the chairman of the Board of Management and general director are full-time members, and the leaders of the MOF, MPI, and SBV are part-time m ­ embers. The Board of Management of the VDB has the following powers: • Manage the VDB in compliance with stipulations of Decision 108/2006, its charter, and other related ­ regulations. • Decide on the development plan and operational direction of the V ­ DB. • Approve the VDB’s yearly business plan based on the proposal of the general ­director. • Ratify the establishment, division, separation, mergence, and dissolution of operations centers, branches, and representative offices in domestic and for- ­ irector. eign locations based on the proposal of the general d • Decide appointment or dismissal for the VDB’s management titles, including deputy general director, controller-general of the Board of Supervision, and chief accountant based on the proposal of the general d ­ irector. • Ratify the appointment scheme and the general director’s appointment or dismissal of the director of a department at the head office, and directors of branches, operations centers, and representative offices domestic and ­abroad. • Issue documents on such matters as (a) general regulations on the operation of the Board of Management and Board of Supervision, (b) general regula- tions on the professional operations of the VDB, and (c) guidance documents to implement the state ­ regulations. 142 | Mobilizing Finance for Local Infrastructure Development in Vietnam • Examine and supervise the executive apparatus in implementing the govern- ment’s regulations on the development of investment credit, export credit of the state, the VDB charter, and related decisions of the Board of ­Management. • Approve the Board of Supervision activity plan and consider its supervision report. result report and financial liquidation appraising ­ • Approve the annual performance report, financial statement, and cleared-­ balance sheet of the ­VDB. • Report to the minister of internal affairs for submission to the prime minister to appoint or dismiss the chairperson of the Board of Management, its general director, and ­members. • Write a proposal to the MOF for submission to the prime minister to do the following: (a) amend or supplement policies on the development of invest- ment credit and export credit, (b) amend or supplement the charter on the operation and organization of the VDB, and (c) amend or supplement the general regulation of financial management of the ­ VDB. • Fulfill the other rights and missions of the VDB in accordance with the l­ aws. • Be responsible before the prime minister for the Board of Management’s ­decisions. The Board of Supervision of the VDB has a maximum of seven full-time ­members. The controller-general is appointed or dismissed by the Board of Management, and other members of the Board of Supervision are appointed or dismissed by the chairperson of the Board of Management based on the proposal of the controller-general. The Board of Supervision of the VDB is empowered to ­ accomplish the following: • Examine the abidance of guidelines, policies, laws, and resolutions of the Management. Board of ­ • Examine the financial activities and abidance of accounting mechanisms, the ­ DB. operation of internal inspections, and the audit system of the V • Review the annual financial statement and, if necessary, examine in detail each item related to the VDB’s financial activities in order to report to the Board of Management, the MOF, and other relevant ­ agencies. • Report to the Board of Management about the accuracy, honesty, and legality of recording and filing of accounting records, as well as preparation of accounting books and financial statements; and about the operation of the internal inspection and audit system of the ­VDB. • Approve controlling tasks and proposals submitted to the Board of Management for measures to amend, supplement, and improve the VDB’s operation in accordance with the ­ laws. • Use the VDB’s internal inspection and audit system for implementing its ­missions. • Fulfill other assigned missions and use designated p ­ owers. • The general director of the VDB is the legal representative of the VDB, responsible before the Board of Management, the prime minister, and the law for all management of the VDB’s operation with the assistance of deputy general directors and the chief a ­ ­ ccountant. The general director has the ­following powers: • Organize and execute the missions that the government and the prime minis- VDB. ter assigned to the ­ • Manage the VDB’s activities, decide issues related to the VDB’s activities in compliance with the laws and resolutions of the Board of Management, and be responsible for performance of the ­ VDB. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 143 • Regulate the decentralization to the VDB’s affiliates in carrying out opera- tions of state investment and export credit, postinvestment support, guaran- tee, and the other operations in compliance with the l ­ aws. • Decide the lending interest rate and deposit interest rate of the VDB in accor- dance with the regulations of the state development investment credit and export ­credit. • Receive capital and other resources given by the ­ government. • Approve an independent audit institution to audit the VDB’s a ­ ctivities. • Decide the appointment and dismissal of the directors of departments at the head office, and directors of branches, operations center, and representative offices domestic and abroad (after getting approval of the Board of ­Management). • Decide on the appointment and dismissal of the other positions of the VDB, including (a) deputy director of the operations center, branches, and repre- sentative offices; (b) managers and deputy managers of divisions, and direc- tor and deputy director of head office departments; and (c) other positions under the general director’s authority as stipulated by the Board of ­Management. • Issue documents on (a) general regulations on the operation and activity of the operations center, branches, and representative offices and (b) regula- tions on the organization and operation of internal inspection and audit in compliance with the ­ laws. • Submit to the Board of Management documentation for (a) approval of the VDB’s yearly business plan; (b) reporting to the minister of finance to submit to the prime minister for decisions on the amendment or supplementation to the charter on organization and operation of the VDB and general regulations on the financial regime; (c) establishment, division, separation, mergence, or dissolution of the branches and representative offices of operations centers and branches and representative offices of the VDB; (d) appointment and dis- missal of the deputy general directors and chief accountant; and (e) deciding of commission rate, fee, and fines applicable to customers in compliance with the ­laws. • Be the legal representative of the VDB before the law in procedure, dispute, liquidation, dissolution, and international relations related to the VDB’s ­activities. • Exert authority in case of emergency (such as natural calamities, enemy-in- flicted destruction, fire, breakdown) to decide on measures, to be responsible for such decisions, and to report immediately afterward to the Board of ­Management. • Sign documents, agreements, contracts, and certificates of the VDB in the activities of internal affairs and foreign affairs in compliance with the l ­ aws. • Be responsible before the Board of Management and state competency authority for the implementation of the authority’s executive missions in accordance with the ­ laws. • Report to the Board of Management and other state competency agencies as stipulated in the charter and other regulations related to the VDB’s o­ perations. • Exercise other rights and missions according to the regulations of the law and the Board of ­Management. Eligible borrowers Decision 44/2007 (Article 7) states that the VDB could use its operating cap- ital for implementing the state policy on development investment credit and 144 | Mobilizing Finance for Local Infrastructure Development in Vietnam export credit in accordance with the regulation of the g ­ overnment. In this regard, the government issued Decree 75/2011 on state investment credit and export credit (as amended by Decree 54/2013/ND and Decree 133/2013), according to which (Article 5) eligible borrowers are investors having invest- ment projects on the list of projects eligible for investment credit attached to Decree ­75/2011. Examples include the investment projects on building works to treat wastewater and garbage in urban areas, industrial parks, economic zones, export-processing zones, high-tech parks, hospitals, and craft-village industrial complexes, all of which fall under groups A and B projects accord- ing to the laws on ­ c onstruction. Taking into account the definition of investors  in Article 1 ­ ­ .2 of Decree 75/2011, in which investors are enter- prises, economic organizations, and self-accounting and revenue-generating state agencies, the researchers found that a provincial government and its subordinate departments (via their PMUs) could not be eligible borrowers of VDB loans, except in the case of the programs and projects approved by the prime minister, as further noted in the next ­ section. Tasks of the Vietnam Development Bank According to Decision 108/2006 (Article 4), the VDB has the following tasks: • Mobilize and receive capital of domestic and overseas organizations to pro- vide state credits for development investment and export under the regula- government. tions of the ­ • Implement policies on development investment credit, including (a) granting of loans for development investment, (b) postinvestment support, and (c) investment credit ­guarantee. • Implement policies on export credit, including (a) granting of loans for export, (b) export credit guarantee, and (c) guarantee for bidding participa- tion and for implementation of export ­ contracts. • Accept entrusted management of ODA capital on-lent by the government and accept entrusted provision of loans for investment and collection of debts for domestic and overseas organizations through entrustment contracts between the VDB and entrusting ­ organizations. • Entrust financial and credit institutions to carry out credit transactions of the  VDB. • Provide payment services for clients and join domestic and international pay- ment systems to serve the VDB’s operations under the provisions of l ­ aw. • Perform international cooperation tasks concerning development invest- ment credit and export ­ credit. ­ ime. • Carry out other tasks assigned by the prime minister, from time to t With regard to carrying out prime minister’s assigned tasks, it is worth noting an example of Decision 13/2009 of the prime minister37: assigning the VDB to provide loans to provincial governments for solidifying the canals and develop- ing rural transport roads, infrastructure for aquaculture, and infrastructure for craft villages in rural areas for the period 2009–15, as mentioned e­ arlier. The study team has noted that (a) the VDB has no function to provide on-­ lending loans to commercial banks for lending to provincial governments and (b) the VDB could provide eligible investors with guarantee services (that is, a type of credit enhancement), although they are not provincial governments (via a PMU or sectoral d ­ epartment). In other words, the VDB seems not to have a wholesale and credit enhancement function as the CIFF d ­ oes. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 145 Risk mitigation methods The VDB may set up risk provision funds for dealing with risks caused by insol- importers. The VDB’s debt classifica- vency of investors, exporters, or overseas ­ tion must follow regulations of the ­SBV. The prime minister decides on levels of deduction for setting up and using risk provision funds in the financial mecha- ­ DB. According to Decision 44/2007 of the prime minister (Article 8), nism of the V the annual fund extraction rate of the risk provision fund will be equal to 0.5 ­ ­ percent of the average balance of loans for investment, export credit loans, investment credit, export guarantee, tender bond, and performance b ­ ond. Taxation regime According to Decision 108/2006 of the prime minister (Article 2), the VDB is exempt from taxes and state budget contributions applicable according to the law. provisions of ­ LEGAL ASSESSMENT AND RECOMMENDATIONS FOR SETTING UP A CITY INFRASTRUCTURE FINANCING FACILITY Fundamental weaknesses constraining provincial borrowing Vietnam currently has a weak enabling environment for providing subnational governments with access to debt finance for local public i ­nfrastructure. The existing regulations are incomplete, inconsistent, and scattered among different legal ­documents. Some regulations are established on a temporary basis for deal- ing with specific contexts without regard for the longer-term consequences of the ­regulations. Fundamental weaknesses in the current regime include the following: Lack of legal clarity in borrowing a­ uthority. Generally, the regulation on the authority of subnational governments to incur debt has to be given by both the SBL and public debt management ­ legislation. However, these regulations have not yet clearly specified the form of bank loan as one the sources of subnational debt, an omission that could lead to the interpretation that borrowing by prov- inces from commercial banks is not fully legally s­ upported. ­ erms/maturities. Currently there is no restriction on the Restriction on debt t maximum term of borrowing ­ instruments. However, the maximum term of a bank loan to subnational governments is interpreted to be restricted to 24 months because of the provision of an official State Bank of Vietnam Letter (576/NHNN-CSTT). In practice, commercial banks strictly interpret the ­ provision as applying to all types of lending so as to avoid any subsequent ­ legal ­consequences. government. Currently, the require- Moral hazard of implicit guarantee of central ­ ment that subnational borrowing must be approved by the MOF on a transac- tional basis may create the moral hazard of an implied central government ­guarantee. ­ ecurity. The presence of a mechanism that ties revenues of Unspecified debt s subnational entities pledged to creditors in case of debt insolvency is ­ ­ critical. 146 | Mobilizing Finance for Local Infrastructure Development in Vietnam However, the current legal framework has not yet specified any means of debt borrowing. security that provinces could use for their ­ Inadequate standards of ­ disclosure. Currently, formal principles and require- ments on reporting and disclosure of subnational debt are not yet sufficiently in place, despite the existing provisions on disclosure of national public debt information. Potential lenders thus do not (a) have adequate information for ­ credit evaluation, (b) feel confident in making decisions on credit provision, and (c) appear able to monitor and manage the loan uses and repayments by ­provinces. Inadequate standards of default and ­ insolvency. At present, no provisions in the current legal framework on the mechanisms and procedures are available in the governments. event of default or insolvency of local ­ Importantly, the government of Vietnam has already begun adopting regula- tory reforms to improve the legal framework for subnational debt, including the new SBL of ­ 2015. However, the legal and regulatory framework should be fur- ther upgraded to meet the government’s financial objective, including setting up a financing facility to jumpstart the subnational debt m ­ arket. Specific legal considerations for setting up a city infrastructure financing facility pilot The proposed CIFF with a wholesale function (which proposes to use the gov- ernment’s foreign loans) may not work without clarification or an appropriate amendment to Decree ­78/2010.38 That is because the interpretation of the provi- sions of Decree 78/2010 is that for on-lending of the government foreign loan to the provincial governments, the on-lending agency is always only the MOF ­itself. Thus, for a CIFF to be legally established, the government must (a) clarify or amend Decree 78/2010 to allow the establishment of a CIFF with wholesale function, (b) sign an international loan treaty with an international donor, such as the World Bank, that allows the establishment of a CIFF with credit enhance- ment function, or (c) combine the establishment of a CIFF with a wholesale function with a treaty that allows for a CIFF with a credit enhancement ­function. It is assumed that a CIFF with wholesale and credit enhancement functions would be ­ established. To avoid any unexpected conflict and overlap between these two functions, any reforms should establish two separate entities (or two separate units within one entity) for performing each of those functions ­ separately. Subject to further discussion and determination by the stakeholders, such entities could be established within the MOF—such as a department or a PMU of the MOF—or outside the MOF—such as a new separate entity or unit outside the MOF—pursuant to a relevant decision of the MOF, a decision of the prime minister, or a decree of the government, ­ respectively. As discussed earlier in this chapter regarding the Law on Public Debt Management and Decree 78/2010, the MOF’s DDMEF could provide on-lending of government foreign loans directly to provincial governments, such as by pro- viding a retail function similar to that of the ­CIFF. However, that approach would not contribute much to the development of the debt market of the provincial governments, nor would it attract or mobilize the participation of the private sector in providing capital for the provincial governments for city infrastructure An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 147 investment, as ­ contemplated. Thus, subject to further determination by stake- holders, the CIFF with a wholesale function or credit enhancement function would likely meet the twin objectives of mobilizing more funds for provincial governments for infrastructure development while developing the debt market for provincial ­ governments. The SBL and all its guiding legislation are silent on a recourse mechanism, including detailed procedures to ensure that in the case of provincial govern- ment default, the lenders and financiers receiving loans from the CIFF with a wholesale function could recover the funds from the provincial b ­ udget. Therefore, subject to the further determination by the stakeholders, the govern- ment must stipulate a recourse mechanism when establishing the ­ CIFF. The MOF and the SBV could guide the establishment of such a mechanism in accor- dance with their state management authority in a new circular (box 4 ­ .1). Vietnam’s laws currently have no specific regulations or guidance regarding the assessment of credit risks related to the loans to be provided by commercial banks to the provincial g ­ overnments. In practice, commercial banks’ own expe- rience is in assessing credit risk of corporate or individual customers rather than of provincial ­governments. Thus, the SBV will need to provide specific guidance or regulations on the CIFF with a wholesale function, subject to the further determination by ­ stakeholders. To some extent, such guidance will support the commercial banks’ credit assessment process for providing loans to provincial ­governments. BOX 4.1 City Infrastructure Financing Facility Recourse Mechanism Purpose of a Recourse Mechanism Main Contents and Provisions of the Recourse The purpose of the CIFF recourse mechanism is to Agreement encourage the commercial banks to provide loans to For the benefit of both the lending commercial bank the ­ PPCs. The mechanism would allow the com- and the PPC, the recourse agreement should contain mercial banks to secure the loans by requiring that the following main provisions: the PPC set up a special account at a commercial • The recourse account is in the name of the PPC, bank for receiving part the annual revenue of the as account holder, and is opened at the lending PPC. Such revenues might be from the provincial ­ commercial ­bank. budget revenue sources or from a transfer from the • The recourse account is an interest-bearing central government and would belong to budget account in which the earned interest belongs to items used for repayment of borrowing by provin- the ­PPC. g overnments. The lending commercial bank cial ­ • The money balance in the recourse account would have a senior right to intercept revenue if the should be maintained at least at a level equal to defaults. debt service ­ the outstanding liability or debt (that is, the loan interest and partial principal) of the PPC to be Proposed Recourse Arrangement paid or repaid in the payment period (for exam- The proposed CIFF recourse mechanism is shown in ple, on a quarterly, semiannual, or annual basis) figure ­B4.1.1 to the lending commercial ­ bank. continued 148 | Mobilizing Finance for Local Infrastructure Development in Vietnam Box 4.1, continued FIGURE B4.1.1 City Infrastructure Financing Facility Recourse Mechanism Revenue PPCs Loan agreement Recourse State treasury agreement Commercial banks Legend: Loan Repayment Revenue sources ­ ommittees. The loan agreement is to be signed by and between Note: PPCs = provincial People’s C a PPC and a commercial ­ bank. The recourse agreement is a tripartite agreement among a PPC, a commercial bank, and the state ­ treasury. The lending commercial bank has an irrevocable is met, the state treasury will then transfer partial right to deduct from the recourse account any inter- revenue of the PPC to the recourse account, using, for est and principal due if the PPC fails to pay or repay example, part of the provincial budget revenue or a on the date payment is ­ due. After such a deduction transfer from the central government from a budget and upon receipt of a written request by the lending item assigned to repayment of borrowing by provin- commercial bank, to ensure that the required balance cial ­governments. As discussed earlier, the SBV Official Letter 576/NHNN-CSTT, dated ­ overnments. June 10, 2005, guides lending by commercial banks to provincial g It stipulates a maximum loan term of 24 months, although infrastructure investments normally are medium to long ­ term. Thus, subject to further determination by stakeholders, the SBV must issue a new circular that would facilitate the commercial banks’ medium- and long-term lending to provin- cial governments and would invalidate the application of Official Letter ­576/ NHNN-CSTT. RECOMMENDATIONS ON THE LEGAL STRUCTURE AND SETUP OF A CITY INFRASTRUCTURE FINANCING FACILITY The recommendations on legal structures and preliminary roadmaps proposed 4.1. for setup of the CIFF are provided in table ­ An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 149 TABLE ­4.1  Legal Structure and Considerations for a City Infrastructure Financing Facility ISSUES RECOMMENDATIONS NOTES, REMARKS, ASSUMPTIONS, AND LEGAL ADJUSTMENTS Legal basis CIFF may be set up under a For a CIFF with wholesale function, it is necessary to have a clarification to or an for establish- decision of the MOF, a appropriate amendment of Decree 78/2010, allowing the establishment of a CIFF ment of a decision of the prime with wholesale ­function. CIFF minister, or a decree of the For a CIFF with credit enhancement function, or a CIFF with both wholesale and ­government. credit enhancement functions, it is necessary (a) to have a clarification to or an appropriate amendment of Decree 78/2010, allowing the establishment of a CIFF with wholesale function; and (b) to have in place an international loan treaty (to be signed by the government or the MOF, and an international donor, such as the World Bank), allowing the establishment of a CIFF with credit enhancement ­ function. In this regard, the recommendation is to set up a CIFF in a pilot period (under a decision of the MOF or the prime minister, or a decree by the government), to be set on the basis of an international loan treaty (for example, between the World Bank and the government of ­ Vietnam). The pilot period could be three to five years and would be aimed at investigating the market, the operation, and other ­matters. Some provincial governments and commercial banks would be ­ selected. Legal form To be further discussed and Assuming that a CIFF with wholesale and credit enhancement functions would be ­determined. established, in order to avoid any unexpected conflict and overlapping between these two functions and to assess the performance of each, one entity would be established with two separate units for performing each function of wholesale and enhancement. Subject to further decision by the government and the relevant credit ­ international loan treaty to be signed by the government or the MOF, and an international donor, such entity could be established within the MOF (for example, as a department or project management unit of the MOF) or as a new separate entity outside the MOF, pursuant to a relevant decision of the MOF or prime minister, or decree of the government, depending on the entity to be ­ created. Functions of To be further discussed and From the legal perspective, the CIFF could be established with all three ­ functions. a CIFF: ­determined. However, now the MOF (via its DDMEF) could provide a retail function similar to the wholesale, function. That function would not contribute much to the develop- CIFF with retail ­ credit ment of the debt market of the provincial governments, nor would it attract or enhance- mobilize the participation of the private sector in providing capital for the provincial ment, and governments for city infrastructure investment, as ­contemplated. Thus, subject to retail further discussion and determination by the stakeholders, the CIFF with wholesale function, with credit enhancement function, or both would meet the twin objectives of mobilizing more funds for provincial governments for infrastructure development, while developing the debt market for provincial ­ governments. Financing To be further discussed and Generally, the CIFF should aim to provide medium- and long-term loans to commer- period ­determined. cial banks and provincial governments and/or provide credit enhancement for medium- and long-term loans provided by commercial banks to provincial ­governments. It is proposed that the SBV would issue a new circular that would facilitate the commercial banks’ medium- and long-term lending to provincial governments and 576/NHNN/CSTT. Such a circular would invalidate the application of Official Letter ­ could be issued by the SBV after or even before the establishment of the ­ CIFF. Potential There may be such issues as For a CIFF with wholesale function, it is necessary to have a clarification to or an roadblock the following: appropriate amendment of Decree 78/2010, allowing the establishment of a CIFF with wholesale ­function. • No clear stipulations under the Vietnamese laws on the For a CIFF with credit enhancement function, or a CIFF with both wholesale function establishment of entities and credit enhancement function, it is necessary to (a) have a clarification to or an CIFF. like a ­ appropriate amendment of Decree 78/2010, allowing the establishment of a CIFF with wholesale function; and (b) have in place an international loan treaty to be signed by the government or the MOF, and an international donor (for example, the World Bank), allowing the establishment of a CIFF with credit enhancement ­ function. continued 150 | Mobilizing Finance for Local Infrastructure Development in Vietnam TABLE ­4.1, continued ISSUES RECOMMENDATIONS NOTES, REMARKS, ASSUMPTIONS, AND LEGAL ADJUSTMENTS • No clear stipulations under Subject to further discussion and determination by the stakeholders, the recourse the Vietnamese laws on a mechanism should be mentioned and stipulated in the relevant decision of the MOF recourse mechanism, or the prime minister (or decree of the government) on establishment of the CIFF as including its detailed noted ­previously. The mechanism would be further guided by the MOF and the SBV procedures, which could in accordance with their state management authority in the new ­circular. ensure that in the case of a provincial government’s default, the lenders or financiers could recover the funds from the provincial ­budget. • No specific guidance or Subject to further discussion and determination by the stakeholders, regarding the regulations under the CIFF with wholesale function, it is necessary to have specific guidance or regulations Vietnamese laws regarding from the SBV on this matter, which will, to a certain extent, support the credit the assessment of credit assessment process by the commercial banks for providing loans to the provincial risks relating to loans that ­governments. would be provided by com- mercial banks to the provincial ­governments. • Limitation on the maximum Subject to the further discussion and determination by the stakeholders, in order to loan term of 24 months for facilitate lending by the commercial banks to the provincial governments under the loans provided by model of a CIFF with wholesale function and credit enhancement function, it is commercial banks to necessary to have the SBV’s new circular, which would facilitate the commercial provincial ­governments. banks’ medium- and long-term lending to provincial governments and would ­ 005. invalidate the application of Official Letter 576/NHNN-CSTT, dated June 10, 2 • Lack of support from the Key decision makers must be given information that explains and proves the positive makers. key decision ­ impacts of the CIFF with wholesale and credit enhancement functions to enable them to make the decision to support the ­CIFF. ­ reparation: The following issues need to be further discussed and defined with all stakeholders in the potential project p regime • Financial and tax ­ • Charter of organization and operation of the CIFF • Financial regulations of the CIFF • Possible limitations to capital structure and financial instruments used to raise the capital of the CIFF • Minimum capital requirement • Reporting duties and accounting • Relevant supervisory agency • Requirements related to asset management • Requirements related to risk management clients. Wholesale facility: the eligible borrowers are • Possible limitations that could apply to sector financing or to types of ­ commercial banks that directly borrow from the CIFF and then provide on-lending loans to provincial governments for infrastruc- investment. Credit enhancement facility: the eligible clients are the provincial g ture ­ ­ overnments. • Governance requirements and minimum staff requirements entity • Average time needed to set up such ­ Notes: CIFF = city infrastructure financing facility; MOF = ministry of finance; DDMEF = Department of Debt Management and External Finance; SBV = State Bank of ­ Vietnam. NOTES 1. According to the Constitution and the Local Government Organization Law 2015 (which replaced the People’s Councils and People’s Committees Organization Law in 2016), in addition to the provincial, district, and commune-level councils, a “special administrative-​ ­ economic unit” may be established by the National ­ Assembly. 2. The former SBL was approved by the National Assembly on December 16, 2 ­ 002. current revised SBL was approved in 2015 and became effective in January 2 The ­ ­ 017. An Assessment of the Legal Framework for a City Infrastructure Financing Facility in Vietnam | 151  3. Under the SBL 2015, total borrowing of the provincial government budget comprises funds for (a) covering the deficit of the provincial government budget and (b) repaying the prin- cipal of the provincial government ­ budget.  4. Under the SBL 2015, in addition to the deficit spending of the central budget, a deficit spending of the provincial budget is also a ­ llowed. Such deficit spending of the provincial budget is (a) used only for investment in projects under midterm public investment plans as decided by the PPCo and (b) aggregated with the state budget deficit and decided by the National ­ Assembly. The deficit of the provincial budget could be covered by domestic borrowing sources (from the local government bonds issuance, on-lending loans from the ­ government, and other domestic borrowings permissible by the l ­ aws).  5. Exceptions are stipulated in (a) Article 5 ­ .3 of Decree 123/2004 (for Hanoi), and (b) Article 5.3 of Decree 124/2004, which was amended by Decree 61/2014 (for Ho Chi Minh C ­ ­ ity).  6. Articles ­ 26.2, and ­ 26.1, ­ 26.3 of Decree 60/2003 and Section ­ II.1.3.4 of Circular ­ 59/2003.  7. Article ­ 7.6 of the SBL ­ 2015. For Hanoi and Ho Chi Minh City, the limit is 60 ­ percent. For localities that have an amount of revenue lower than recurrent expenditure of local budgets (third-tier provinces), the limit is 20 ­percent.  8. Article ­ 7.5.c of the SBL ­ 2015.  9. This book was prepared before the new Law on Public Debt Management (LPDM) was approved. The LPDM 2017 will be in effect in July, 2018; therefore, the main discussion is focused on LPDM 2009. Draft LPDM 2017 was reviewed in the preparation of this book, and did not substantially affect the discussion on the regulatory framework. 10. Article ­39.2 of the Law on Public Debt ­ Management 2009. 11. Article 18 of Decree ­ 79/2010. 12. Resolution 10/2011 of the National Assembly and Decision 958/2012 of the prime m ­ inister. 13. Article ­24.3 of the Law on Public Debt ­ Management. 14. Article 2 of Decision 2328/2014 of the MOF on functions, duties, and powers of the Depart- ment of Debt Management and External ­ Finance. 15. According to Article 1 ­ 9.5, Decree 78/2010 of the Law on Public Debt M ­ anagement. Further advantages given to provincial governments under the decree are in Article 10, regarding lending fees; Article 7, on interest rates; and Article 12 on security r ­ equirements. 16. Article ­94.1 of the Credit Institution ­Law. 17. Article 128 of the Credit Institution Law states that the total balance of loans made to a single client shall not exceed 15 percent of the equity of the commercial bank, and the total balance of loans made to a single client and related persons shall not exceed 25 percent of the equity of the commercial ­ bank. 18. Article 130 of the Credit Institution Law relates to the prudential ratios: the solvency ratio, the minimum capital adequacy ratio of 8 percent or a higher ratio as stipulated by the SBV from time to time, the maximum ratio of short-term funds used to provide medium- and long-term loans, status of current foreign currency and gold over equity, the ratio of loan balance over total monies deposited, and the ratios of medium- and long-term deposits over total medium- and long-term loan ­ balances. 19. Article 131 of the Credit Institution ­Law. 20. Article 17 of Circular 36/2014 of the ­SBV. 21. Decision ­ 1627/2001. Amendments to SBV Decision 1627/2001 include Decision 688/2002, Decision 28/2002, Decision 127/2005, Decision 783/2005, and Circular 3 ­ 3/2011. 22. Article 2 of SBV Decision 1627/2001 (as amended from time to t ­ ime). 23. Article 6 of SBV Decision 1627/2001 (as amended from time to t ­ ime). 24. Article 7 of SBV Decision 1627/2001 (as amended from time to t ­ ime). 25. Articles 8 and 10 of SBV Decision 1627/2001 (as amended from time to t ­ ime). 26. Article 11 of SBV Decision 1627/2001 (as amended from time to t ­ ime). 27. Article 16 of SBV Decision 1627/2001 (as amended from time to t ­ ime). 28. In accordance with its Decision 1627/2001, the SBV issued Official Letter ­No. 1354/NHNN- CSTT, dated December 4, ­2002. The MOF’s Official Letter ­No. 4761/TC/TCNH dated April 21, 2005, requested the SBV to send an Official Letter 576/NHNN-CSTT, dated June 10, ­2005. 29. Decision 13/2009 of the prime minister (as amended by Decision 56/2009 of the prime ­minister). 30. Decree 01/2011 consolidated and replaced the regulations contained in Decrees 141/2003 and ­53/2009. 31. Article 4 of Decree ­ 01/2011. 152 | Mobilizing Finance for Local Infrastructure Development in Vietnam 32. Contents must include (a) the purpose for bond issuance and other information on the project regarding the bond issuance capital source; (b) investment capital structuring of the project and the capital need from bond issuance; (c) expected volume, term, interest rate, form, and plan for bond issuance; (d) plan for allocation of payment source of principal and interest of bonds upon maturity; and (f ) commitments of the issuing entity to bond ­buyers. 33. According to Circular 81/2012 (Article 8), within 30 working days from the date of receipt of the scheme of bond issuance (as approved by the PPCos) from the PPC, the MOF shall assess and notify in writing to the PPC requesting that it implement the bond issuance (if the conditions for bond issuance are ­satisfied). 34. The National Investment Support Fund was established under Decision 808-TTg, dated 09/12/1995, of the prime minister to raise funds and grant loans to the development investment projects in different branches and occupations under the preferential policy and in the areas with difficulties as defined by the g ­ overnment. 35. Decision 231/1999/QD-TTg dated 17/12/1999 of the prime minister on approval of the DAF. charter of the ­ 36. Decision 231/1999 (Article 13) of the prime minister states that the eligible borrowers are stipulated in Decree 43/1999 on development investment c ­ redit. Article 8 of Decree borrowers. 43/1999 stipulates those ­ 37. As amended by Decision ­ 56/2009. 38. See descriptions of wholesale, retail, and credit enhancement functions in chapter 1 in the section, “Proposed CIFF ­Structures.” Appendix A List of Key Legal Documents CONSTITUTION 1. The Constitution of the Socialist Republic of Vietnam, dated November 28, 2013 (“Constitution”). 2. Resolution No. 64/2013/QH13, dated November 28, 2013, of the National Assembly, on the implementation of the Constitution of the Socialist Republic of Vietnam. GOVERNMENT, MINISTRY OF FINANCE, STATE BANK OF VIETNAM, AND LOCAL GOVERNMENTS 3. Law on government organization, dated December 25, 2001 (“Government Organization Law”), which was replaced by the Government Organization Law 2015, dated June 19, 2015 (effective January 1, 2016). 4. Law on the People’s Councils and the People’s Committees organization, dated November 26, 2003 (“People’s Councils and the People’s Committees Organization Law”), which was replaced by the Local Government Organization Law 2015, dated June 19, 2015 (effective January 1, 2016). 5. Law on State Bank of Vietnam, dated June 16, 2010 (“Law on State Bank of Vietnam”). 6. Decree No. 36/2012/ND-CP, dated April 18, 2012, of the government, on defining the functions, tasks, and organizational structures of ministries and ministerial-level agencies (“Decree 36/2012”), as amended by Decree No. 48/2013/ND-CP, dated May 14, 2013, of the government, amending and sup- plementing a number of articles of decrees relating to control of administra- tive procedures (“Decree 48/2013”). 7. Decree No.215/2013/ND-CP dated December 23, 2013, of the government stipulating function, task, power, and organizational structure of the Ministry of Finance (“Decree 215/2013”). 8. Decision No.2328/QD-BTC dated September 9, 2014, of the MOF stipulating function, task, power and organizational structure of the Department of Debt Management and External Finance (“Decision 2328/2014”).  153 154 | Mobilizing Finance for Local Infrastructure Development in Vietnam 9. Decision No.2338/QD-BTC dated September 9, 2014, of the Ministry of Finance stipulating function, task, power, and organizational structure of Department of Banking and Financial Institutions (“Decision 2338/2014”). LEGISLATION PROMULGATION 10. Law on legislation promulgation, dated June 3, 2008 (“Law on Legislation Promulgation”), which was replaced by the law on legislation promulgation, dated June 22, 2015 (effective July 1, 2016). PUBLIC INVESTMENT AND PUBLIC DEBT MANAGEMENT 11. Law on public investment, dated June 18, 2014 (“Law on Public Investment”). 12. Law on public debt management, dated June 17, 2009 (“Law on Public Debt Management”). 13. (Amended) Law on public debt management, November 23, 2017. The law will be effective in July, 2018. 14. Resolution No.10/2011/QH13, dated November 8, 2011, of the National Assembly, on economic-social development plan for five years from 2011 to 2015 (“Resolution 10/2011”). 15. Decision No.958/QD-TTg, dated July 27, 2012, of the prime minister, on approval of the public debt and national foreign debt strategy in the period of 2011–20 and the orientation toward 2030 (“Decision 958/2012”). 16. Decree No.78/2010/ND-CP, dated July 14, 2010, of the government, on on-lending of government’s foreign loans (“Decree 78/2010”). 17. Decree No.79/2010/ND-CP, dated July 14, 2010, of the government, on pub- lic debt management operation (“Decree 79/2010”). 18. Decree No.15/2011/ND-CP, dated February 16, 2011, of the government, on provision and management of government guarantee (“Decree 15/2011”). 19. Decree No.01/2011/ND-CP, dated January 5, 2011, of the government, on issuance of government bonds, government-guaranteed bonds, and local government bonds (“Decree 01/2011”). 20. Circular No.81/2012/TT-BTC, dated May 22, 2012, of the Ministry of Finance, guiding the issuance of local government bonds in local markets (“Circular 81/2012”). STATE BUDGET 21. Law on State Budget 2002, dated December 16, 2002. 22. Law on State Budget 2015, dated June 25, 2015, and effective from January 2017. 23. Law on Thrift Practice and Waste Combat, dated November 26, 2013 (“Law on Thrift Practice and Waste Combat”). 24. Decree No.60/2003/ND-CP, dated June 6, 2004, of the government detail- ing and guiding the implementation of the State Budget Law (“Decree 60/2003”). List of Key Legal Documents | 155 25. Decree No.123/2004/ND-CP, dated May 18, 2004, of the government, stipu- lating a number of particular financial and budgetary mechanisms applica- ble to Hanoi capital (“Decree 123/2004). 26. Decree No.124/2004/ND-CP, dated May 18, 2004, of the government, ­ stipulating a number of particular financial and budgetary mechanisms applicable to Ho Chi Minh City (“Decree 124/2004), as amended by Decree No.61/2014/ND-CP, dated June 19, 2014, of the government, on amendment and supplement of a number of articles of Decree 124/2004 (“Decree 61/2014”). 27. Circular No.59/2003/TT-BTC, dated June 23, 2003, of the Ministry of Finance, guiding the implementation of Decree 60/2003 (“Circular 59/2003”), as corrected by Official Letter No.12725/TC-VP, dated December 4, 2003, of the Ministry of Finance, on correcting Circular 59/2003 (“Official Letter 12725/2003”). 28. Circular No.51/2004/TT-BTC, dated June 9, 2004, of the Ministry of Finance, guiding the implementation of Decree No.123/2004 (“Circular 51/2004”), as corrected by Official Letter No.6616TC/NSNN, dated June 16, 2004, of the Ministry of Finance, on correcting Circular 51/2004 (“Official Letter 6616/2004”). 29. Circular No.52/2004/TT-BTC, dated June 9, 2004, of the Ministry of Finance, guiding the implementation of Decree No.124/2004 (“Circular 52/2004”), as corrected by Official Letter No.6617TC/NSNN, dated June 16, 2004, of the MOF, on correcting Circular 52/2004 (“Official Letter 6617/2004”). 30. Circular No.86/2004/TT-BTC, dated August 25, 2004, of the Ministry of Finance, guiding the management of mobilized capital for infrastructure investment of budget of provinces and municipalities within central authority (“Circular 86/2004”). 31. Circular No.107/2008/TT-BTC, dated November 18, 2008, of the Ministry of Finance, providing supplemental guidance on a number of matters on management and operation of State Budget (“Circular 107/2008”). 32. Circular No.128/2008/TT-BTC, dated December 24, 2008, of the Ministry of Finance, guiding collection and management of State Budget revenues through State Treasury (“Circular 128/2008”). 33. Circular No.161/2012/TT-BTC, dated October 2, 2012, of the Ministry of Finance, stipulating the regime of control and payment of state budget expenditures through the state treasury (“Circular 161/2012”). 34. Circular No.162/2012/TT-BTC, dated October 3, 2012, of the Ministry of Finance stipulating advanced payment fund from the state treasury (“Circular 162/2012”), as amended by Circular No.62/2015/TT-BTC, dated May 5, 2015, of the Ministry of Finance, on amendment and supplement of a number of articles of Circular 162/2012 (“Circular 62/2015”). 35. Circular No.61/2014/TT-BTC, dated May 12, 2014, of the Ministry of Finance, guiding registration and usage of the account at the state treasury in the con- dition of applying budget and treasury management information systems (“Circular 61/2014”). 36. Official letter No.576/NHNN-CSTT, dated June 10, 2005, of the State Bank of Vietnam, on lending to support the provincial budget for infrastructure works investment (“Official Letter 576/NHNN-CSTT”). 156 | Mobilizing Finance for Local Infrastructure Development in Vietnam 37. Official letter No.1354/NHNN-CSTT, dated December 4, 2002, of the State Bank of Vietnam, guiding the lending to support provincial b udget  for  infrastructure works investment (“Official letter 1354​ ­ /­NHNN-CSTT”). CREDIT INSTITUTIONS 38. Law on Credit Institutions, dated June 16, 2010 (“Law on Credit Institutions”). 39. Circular No.36/2014/TT-NHNN, dated November 20, 2014, of the State Bank of Vietnam, stipulating minimum safety limits and ratios in activities of credit institutions, branches of foreign banks (“Circular 36/2014”). 40. Circular No.02/2013/TT-NHNN, dated January 21, 2013, of the State Bank of Vietnam, on providing on classification of assets, levels and method of set- ting up risk provisions, and use of provisions against credit risks in the bank- ing activity of credit institutions, foreign banks’ branches (“Circular 02/2013”), as amended by Circular No.09/2014/TT-NHNN, dated March 18, 2014, of the State Bank of Vietnam, on amending and supplementing a num- ber of articles of Circular 02/2013 (“Circular 09/2014”). 41. Circular No.43/2014/TT-NHNN, dated December 25, 2014, of the State Bank of Vietnam, on foreign currency loans provided by credit institutions and branches of foreign banks for clients being residents (“Circular 43/2014”). 42. Circular No.28/2012/TT-NHNN, dated October 3, 2012, of the State Bank of Vietnam, on the bank guarantee (“Circular 28/2012”). 43. Decision No.1627/2001/QD-NHNN, dated December 31, 2001, of the State Bank of Vietnam, issuing regulation on lending by credit institutions to cus- tomers (“Decision 1627/2001”), as amended by Decision No.688/2002/ QD-NHNN, dated July 1, 2002, of the State Bank of Vietnam, on overdue debt transfer of customers’ loans at credit institutions (“Decision 688/2002”), Decision No.28/2002/QD-NHNN, dated January 11, 2002, of the State Bank of Vietnam, on amending Article 2 of Decision 1627/2001 (“Decision 28/2002”), Decision No.127/2005/QD-NHNN, dated February 3, 2005, of the State Bank of Vietnam, amending, supplementing a number of articles of Decision 1627/2001 (“Decision 127/2005”) as amended by Decision No.783/2005/QD-NHNN, dated May 31, 2005, of the State Bank of Vietnam, on amendment and supplement of Article 1.6 of Decision 127/2005 (“Decision 783/2005”), amended by Circular No.33/2011/TT-NHNN, dated October 8, 2011, of the State Bank of Vietnam, on amendment and supplement of a number of articles of No. 13/2010/TT-NHNN dated May 20, 2010, of the State Bank of Vietnam issuing regulation on minimum safety ratio in activi- ties of credit institution and regulations on lending of credit institutions to the clients promulgated by Decision 1627/2001 (“Circular 33/2011”). CIVIL CODE 44. Civil Code, dated June 14, 2005 (“Civil Code”). 45. Decree No.163/2006/ND-CP, dated December 29, 2006, of the government, on secured transaction (“Decree 163/2006”), as amended by Decree List of Key Legal Documents | 157 No.11/2012/ND-CP, dated February 22, 2012, of the government, on amend- ment and supplement of a number of articles of Decree 163/2006 (“Decree 11/2012”). INVESTMENTS AND ENTERPRISES 46. Law on investment, dated November 29, 2005 (“Investment Law of 2005”); replaced by Law No.67/2014/QH13, dated November 26, 2014, on invest- ment (“Investment Law of 2014”), which was effective from July 1, 2015. 47. Law on enterprises, dated November 29, 2005 (“Enterprise Law of 2005”), as amended from time to time; replaced by Law No.68/2014/QH13, dated November 26, 2014, on enterprises (“Enterprise Law of 2014”), which was effective from July 1, 2015. TAX 48. Law on corporate income tax, dated June 3, 2008 (“Corporate Income Tax Law”), as amended in 2013 and 2014. 49. Law on personal income tax, dated November 21, 2007 (“Personal Income Tax Law”), as amended in 2013 and 2014. DEVELOPMENT INVESTMENT CREDIT AND POLICY CREDIT 50. Decree No.75/2011/ND-CP dated August 30, 2011 of the government on credit investment and export credit of the state (“Decree 75/2011”); as amended by Decree No.54/2013/ND-CP dated May 22, 2013, of the govern- ment supplementing Decree 75/2011 (“Decree 54/2013”); as amended by Decree No.133/2013/ND-CP dated October 17, 2013 of the government amending, supplementing Decree 54/2013 (“Decree 133/2013”). 51. Circular No.35/2012/TT-BTC dated March 2, 2012, of the Ministry of Finance, guiding a number of articles of Decree 75/2011 (“Circular 35/2012”). 52. Decision No.13/2009/QD-TTg dated January 21, 2009, of the prime minister on usage of the development investment credit fund of the state to continue the implementation of solidifying channels and canals, development of rural traffic road, infrastructure for raising and planting aquatic products and infrastructure of trade village in countryside in the period of 2009–15 (“Decision 13/2009”); as amended by Decision No.56/2009/QD-TTg of the prime minister amending, supplementing a number of articles of Decision 13/2009 (“Decision 56/2009”). 53. Circular No.156/2009/TT-BTC, dated August 3, 2009, of the Ministry of Finance guiding mechanism of state development investment credit borrowing to the implementation of solidifying channels and canals, ­ ­ development of rural traffic road, infrastructure for raising and plant- ing aquatic products, and infrastructure of trade village in countryside (“Circular 156/2009”), as corrected by Decision No.2326/QD-BTC, dated September 25, 2009, of the Ministry of Finance (“Decision 2326/2009”). 158 | Mobilizing Finance for Local Infrastructure Development in Vietnam 54. Decision No.03/2011/QD-TTg, dated November 10, 2011, of the prime min- ister issuing regulation on guarantee for small- and medium-size enterprises borrowing loans from commercial banks (“Decision 03/2011”).1 VIETNAM DEVELOPMENT BANK 55. Decision No.108/2006/QD-TTg, dated May 19, 2006, of the prime minister, on establishment of the Vietnam Development Bank (“Decision 108/2006”). 56. Decision No.110/2006/QD-TTg, dated May 19, 2006, of the prime minister, approving the charter of Vietnam Development Bank’s organization and operation (“Decision 110/2006”). 57. Decision No.44/2007/QD-TTg, dated March 30 2007, of the prime minister, on issuance of regulation on financial management for the Vietnam Development Bank (“Decision 44/2007”). 58. Circular No.111/2007/TT-BTC, dated September 12, 2007, of the Ministry of Finance guiding the implementation of financial management mechanism (“Circular 111/2007”). LOCAL DEVELOPMENT INVESTMENT FUNDS 59. Decree No.138/2007/ND-CP, dated August 28, 2007, of the government, on organization and operation of local development investment funds (“Decree 138/2007”), as amended by Decree No.37/2013/ND-CP, dated April 22, 2013, of the government, on amendment and supplement of a number of articles of Decree 138/2007 (“Decree 37/2013”). 60. Circular No.28/2014/TT-BTC, dated February 25, 2014, of the Ministry of Finance, guiding the financial management mechanism of local develop- ment investment funds (“Circular 28/2014”). 61. Circular No.42/2014/TT-BTC, dated April 8, 2014, of the Ministry of Finance, issuing standard charter of local development investment funds (“Circular 42/2014”). POLICY BANK 62. Decree No.78/2002/ND-CP, dated October 4, 2002, of the government, on credit for poor people and other policy beneficiaries (“Decree 78/2002”). 63. Decision No.131/2002/QD-TTg, dated October 4, 2002, of the prime minis- ter on establishment of social policy bank (“Decision 131/2002”). DEVELOPMENT ASSISTANCE FUND 64. Decree No.43/1999/ND-CP, dated June 29, 1999, of the government, on development of investment credit of the state (“Decree 43/1999”) (no longer applicable). 65. Decree No.50/1999/ND-CP, dated July 8, 1999, of the government, on orga- nization and operation of development supporting fund (“Decree 50/1999”) (no longer applicable). List of Key Legal Documents | 159 66. Decision No.231/1999/QD-TTg, dated December 17, 1999, of the prime min- ister, approving charter of organization and operation of development sup- porting fund (“Decision 231/1999”) (no longer applicable). 67. Decision No.232/1999/QD-TTg, dated December 17, 1999, of the prime min- ister, issuing regulation on financial management of development support- ing fund (“Decision 232/1999”) (no longer applicable). 68. Decision No.59/2005/QD-TTg, dated March 23, 2005, of the prime minister, issuing regulation on financial management for development support fund (“Decision 59/2005”) (no longer applicable). DRAFT LEGISLATION 69. Draft (amended) Law on State Budget. 70. Draft circular of the Ministry of Finance, guiding the capital mobilization of the local governments. 71. Draft (amended) Law on Public Debt Management. NOTE 1. Replacement for the old ones being Decision No.14/2009/QD-TTg, dated January 21, 2009, of the prime minister, issuing regulations on guarantee for enterprises borrowing loans from commercial banks (“Decision 14/2009”), as amended by Decision No.60/2009/QD​ -​ TTg, dated April 17, 2009, of the prime minister, on amendment and supplement of a num- ber of articles of Decision 14/2009 (“Decision 60/2009”). ECO-AUDIT Environmental Benefits Statement The World Bank Group is committed to reducing its environmental footprint. In support of this commitment, we leverage electronic publishing options and print- on-demand technology, which is located in regional hubs worldwide. Together, these initiatives enable print runs to be lowered and shipping distances decreased, resulting in reduced paper consumption, chemical use, greenhouse gas emissions, and waste. We follow the recommended standards for paper use set by the Green Press Initiative. The majority of our books are printed on Forest Stewardship Council (FSC)–certified paper, with nearly all containing 50–100 percent recycled content. The recycled fiber in our book paper is either unbleached or bleached using totally chlorine-free (TCF), processed chlorine–free (PCF), or enhanced elemental chlo- rine–free (EECF) processes. More information about the Bank’s environmental philosophy can be found at http://www.worldbank.org/corporateresponsibility. V ietnam stands out as one of the most dynamic emerging countries in the East Asia and Pacific region. Since major reforms in the 1990s, the country has experienced an annual average growth rate of 6–7 percent, and the extreme poverty rate has fallen from over 50 percent to 3 percent. Yet, the rapid growth and decentralization processes have brought significant pressure on provincial governments in terms of local infrastructure investments and urban services delivery. With an annual shortfall of US$9 billion in funding for local infrastructure investments, provincial governments in Vietnam need to move toward a more market-driven financing model. This transition will require enhanced financial and technical capacity of local governments, as well as an enabling environment for subnational borrowing. Mobilizing Finance for Local Infrastructure Development in Vietnam explores the development of a pilot financial instrument that could catalyze the subnational borrowing market in Vietnam. It presents the findings of three assessments that focused on (a) the borrowing capacity and creditworthiness of selected provincial governments; (b) the capacity of the commercial banking sector to invest in provincial governments; and (c) the status of Vietnam’s regulatory framework. These findings will provide policy makers in Vietnam with an understanding of the key issues associated with a shift toward a more affordable and efficient local infrastructure financing model, and present a preliminary roadmap for development of a pilot instrument. Policy makers in transition countries facing similar challenges will be interested in this book, too. PPIAF provides technical assistance to governments to support the creation of a sound enabling environment for the provision of basic infrastructure services by the private sector. PPIAF also supports the generation and dissemination of knowledge on emerging practices on matters relating to private sector involvement in infrastructure. The production of this book was funded by PPIAF. For more information, visit www.ppiaf.org. ISBN 978-1-4648-1287-3 SKU 211287