KEY RATING DRIVERS

Vietnam's ratings reflect strong growth performance and prospects, persistent current account surpluses, manageable debt service costs and sustained foreign direct investment inflows. The ratings also reflect a high public debt ratio, low foreign-exchange reserve buffers, macro-prudential and banking sector risks and some structural indicators being weaker than those of peers, including per capita income and human development standards.

The revision of the Outlook to Positive reflects the following key rating drivers:

Vietnam is building a record of policy-making focused on macroeconomic stability. This approach, which includes greater exchange-rate flexibility and an increasing focus on inflation stability, has supported consistently strong levels of foreign direct investment (FDI) and helped maintain robust economic growth. Vietnam's real GDP expanded by 6.2% in 2016, taking the five-year average real GDP expansion to 5.9%, against the 'BB' median of 3.4%. Growth remains supported by the country's export-oriented manufacturing sector and steady expansion in services, despite weakness in the mining and quarrying sectors from the ongoing oil and gas industry downturn. Fitch expects real GDP growth to improve gradually over the forecast period, to 6.3% in 2017 and 6.4% in 2018, supported by continued FDI inflows into the manufacturing sector and strong private consumption expenditure.

Vietnam's foreign-exchange reserves continued to improve, rising to USD37.0 billion by end-2016, from USD28.6 billion at end-2015. This improvement was supported by the adoption of a new exchange-rate mechanism in early 2016, which aims at greater exchange-rate flexibility, alongside a strong current account surplus and continued robust FDI inflows. However, the new regime, in which the central bank sets a daily trading range on either side of the reference rate, could be tested in a stronger dollar environment that results in currency weakness among emerging economies dependent on foreign capital flows.

Vietnam's 'BB-' rating also reflects the following key rating drivers:

Government debt is above the 'BB' median and has continued to rise. Based on preliminary estimates of the authorities, government debt/GDP rose to 53.4% at end-2016, from 50.1% at end-2015. A broader definition of overall public debt that includes explicit government guarantees reached 63.7% at end-2016, just short of the official 65% debt ceiling. The authorities have reaffirmed their commitment to remain within the ceiling through fiscal measures and limits on guarantee issuance. Fitch expects the authorities to avoid breaching the debt ceiling using a combination of these measures. Proceeds from the 2016-2020 equitization programme could also help contain debt over the forecast period.

Fitch estimates a decline in the 2016 fiscal deficit to 5.7% of GDP (on the agency's adjusted deficit, which is more closely aligned with Government Finance Statistics criteria), from 6.2% at end-2015 as fiscal revenues are estimated to have outperformed. The authorities have reinforced their commitment to lower deficit and debt levels under their 2016-2020 budget plan. Fitch expects the deficit to remain close to 5.7% of GDP over 2017-2018, absent major revenue reforms.

Vietnam's rankings on a range of governance indicators have improved over the previous few years, including on all six dimensions of the World Bank's worldwide governance indicators from 2014 to 2015. Nevertheless, the country's ranking on the composite governance metric is at the 39th percentile, still below the 'BB' median's 50th percentile. On the Ease of Doing Business Index, Vietnam is close to the 'BB' median. Vietnam's per capita income and human development indicators remain weaker than the peer median: per capita income was USD2,172 at end-2016, ranking at the 37th percentile on the UN Human Development Index, compared with the USD5,058, or 58th percentile, for the 'BB' median.

Vietnam's current account remains in surplus, averaging around 4% of GDP for the five years ending 2016. Although Vietnam's reserve coverage of current external payments is below that of its peers, at 2.3 months against 4.2 months of the 'BB' median, a still-high share of concessional debt supports its external liquidity position. External debt service as a percentage of current external receipts was 4.9% at end-2016, against the 'BB' median's 12.9%, although this advantage is likely to start declining in 2017 when Vietnam is scheduled to graduate from the World Bank's International Development Association eligibility criteria, leading to higher funding costs. The sovereign has been increasing its share of domestic debt financing to prepare for the reduced access to concessionary financing.

Although Fitch's banking sector outlook for Vietnam is stable, some challenges remain. The agency believes the large stock of non-performing loans (NPLs) is likely to take time to resolve due to legal impediments, and the 2.5% reported system NPL ratio at end-2016 understates actual asset quality issues. In addition, structural systemic weaknesses remain, as evident from thin capital buffers and weak profitability. We believe recapitalisation needs of the banking sector remain a risk for the sovereign. Further, while improving economic performance is likely to support lower NPL formation, a rapid and sustained increase in credit growth poses a risk to financial stability in the medium term. Overall credit growth at end-2016 was around 18% (2016 target: 18%-20%) and the official credit growth target for 2017 has been capped at 18%.