VIETNAM, on the back of strong economic growth in recent years, has been attracting record levels of foreign direct investment (FDI) through 2006 and

While its cost competitiveness in manufacturing is drawing in foreign investment, JUSTIN KEAN and ANDREW BROWN look at how Vietnam can boost its attractiveness to move up the value chain

VIETNAM, on the back of strong economic growth in recent years, has been attracting record levels of foreign direct investment (FDI) through 2006 and 2007.

Its entry into the World Trade Organisation and continued government commitment to deregulation has encouraged more foreign firms to invest and operate there. The effect of the accession has resulted in robust demand for office, retail and industrial space.

The question remains, however, whether this is part of an overall strategy by multinational firms to diversify out of existing markets or simply a labour arbitrage, with firms looking for the next low-cost location? Also, why are international firms choosing Vietnam over other low-cost locations in Asia?

There has been much discussion about the ‘China Plus 1′ scenario. At first glance, the logic seems clear. A firm operating in China becomes over-dependent on a single country and looks to diversify. This seems to be the case with Japanese garment manufacturer Uniqlo Co. Previously, the firm was producing 90 per cent of its garments in China. Now, this has been reduced to some 70 per cent. There is an intention to have 30 per cent of production in South-east Asia by 2009. However, although there is an advantage in the resulting diversification, this is often not a key driver.

Anecdotal evidence suggests that this need to expand to cheaper locations is one of the main drivers behind Vietnam’s FDI flows. Taiwanese investment into China, for example, has been trending down for some time, as has Singaporean investment. Firms, therefore, are not exactly pulling out of China. Instead, they are expanding elsewhere. The Taiwanese motorcycle firm Kymco, for example, owns assembly lines in China and Indonesia and is turning next to Vietnam; its rival, San Yang, decided on Indonesia.

Seoul-based Kookmin Bank, which during the 1990s assisted many Korean firms in establishing operations in the Pearl River Delta, is now seeing third- and fourth-generation operational expansions focusing on Vietnam.

The driving factor appears to be cost. It is well-known that the operational costs in China’s east coast cities have increased significantly in recent years. Producers there, many of whom have eagerly invested in China through the 1990s and 2000s, are looking to expand. However, the super profits that were previously readily available in China’s special economic zones no longer exist, with rising wages and rising land prices eating into margins.

When margins are eroded, producers are largely faced with two choices: move to China’s hinterland to access lower wages but place a logistical hurdle between them and their traditional port-based distribution channels. Or set up the next stage of their operations in another low-cost location.

When we look at FDI into Vietnam by sector type, we can see that much of it has been invested to take advantage of the cost arbitrage opportunity that is offered by Vietnam’s low-cost base.

As at end 2006, 68.7 per cent of all investment in Vietnam was in the industrial sector. This is typically the sector where investment decisions are most sensitive to labour rates and set-up costs. Of that industrial investment, only 17.1 per cent found its way into the light industrial sector, which is typically where the most tangible value-add can come from.

FDI into other key value-creating sectors, such as banking and finance, hotel and tourism, and transport and telecom, has remained in single digits in terms of portions of total FDI.

Vietnam clearly has a role to play in the roll-out strategies of MNCs investing in the Asia-Pacific region.

We need to ask, however, for what functions and business processes is Vietnam a favoured location, and for which activity is it still likely to take some time before Vietnam becomes a suitable choice?

Analysis undertaken around this topic shows that Vietnam is ideally suited to low-cost manufacturing where the key components are labour costs and availability. When MNCs look to move up the value chain by undertaking more complex activities, especially ones that rely on high-quality human capital, Vietnam falls behind its competitors in the region.

That is not to say that MNCs have not been able to establish value add production facilities in the country. In fact, there are several case studies of firms that have taken highly complex processes to Vietnam. However, we note that in doing so, there has been considerable work involved in training local workers and bringing suppliers and real estate providers up to speed so that they deliver at the service level required.

In addition to the evolution of a skilled workforce, education of suppliers and development of supply chains in Vietnam, there are other areas that will need improvement. Significant work remains before there is an improvement in English penetration, tertiary qualification levels, the rule of law, security of private real estate ownership and deregulation of Vietnam’s commerce - especially in the areas of banking and finance.

Some progress has, of course, already been made. However, more needs to be done. As our experience in China proved, eventually wage rates will rise and MNCs will look to relocate. In China, however, as low-cost manufacturers have looked elsewhere to produce, constant investment in both hard and soft infrastructure has meant the country continues to be an attractive location.

Research and development, high-technology manufacturing and pharmaceuticals continue to see significant inflows of investment, even as foreign interests look elsewhere to make a quick dollar. That’s a lesson Vietnam seems ready to learn.

Justin Kean is associate director of Asia-Pacific occupier research, Jones Lang LaSalle; Andrew Brown is managing director,Jones Lang LaSalle Vietnam

Source : Business Times - 27 Sep 2007