Its bond rating is sinking deep into junk bond territory with a negative outlook. One of its premier state enterprises, the ship builder Vinashin, is functionally bankrupt and unable to make interest payments on its external debt — debt that the lenders thought had official backing. Inflation is officially running at 1 per cent a month but was probably more like 15–20 per cent last year. Why is Vietnam, a nation with a bright outlook and a record of rapid growth, so troubled?

There are several reasons. One is that the Party has a policy of state enterprises having a ‘leading role’ in development. In practice, this has meant giving them near-monopoly power, cheap land, credits and government contracts in varying combinations. About half of all enterprise capital increases since 2004 have gone to state enterprises, but they accounted for only a quarter of output growth and had employment fall by several hundred thousand jobs. This waste of capital has been compounded by pouring money into dubious infrastructure projects that are often premature, overly expensive or just not needed. These bad choices were somewhat easier to take when debt was low and low-cost donor funds made the lack of productivity less painful.

Since Vietnam has become a ‘middle income’ nation, it is getting less super-cheap aid loans and its borrowing has risen each year. In addition, domestic credit has grown at an astonishing 30 per cent a year since 2000, doubling every 30 months. A lot of this credit has found its way into real estate and development loans. Land in Hanoi recently changed hands at $10,000 a square metre, higher than in Beijing. Land is a preferred investment for money ‘earned’ in dubious ways, as it is not taxed after it is purchased nor is it centrally listed. It seems safer to many Vietnamese than bank accounts with negative interest rates or a stock market that is less than half now than it was in 2007. Land rental or sales also help provinces with revenue for local expenses — so even an honest provincial chief likes high land prices. But high land prices distort urban growth and the lack of a real estate tax means that cities are chronically short of funds for needed services or investments like subways — which are needed because the high land prices push developers to build tall buildings, which generate traffic.

The lack of trust of ordinary Vietnamese in their own currency shows up in ‘errors and omissions’ in the balance of payments. They sell dong and buy gold or dollars when they can — that entry was $9 billion in 2009 and probably higher last year. Shaky estimates put private gold and dollar holdings in the tens of billions of dollars. The upside of this is that there is plenty of capital if the government institutes sensible policies and rebuilds trust. The downside is that people are cynical and the government seems to ‘forget’ about stability once things calm down and returns to its inflationary practices. Because a slowdown in credit growth would pressure many developers and banks that extended loans with over-priced land as collateral, there is some serious prospective pain in staying with a low-inflation course. On the other hand, with both foreigners and its own people becoming less willing to extend credit, there are diminishing returns from printing money. With credit at 130 per cent of GDP (it was only 30 per cent in 2000), the game is nearly up. Either credit grows only a little faster than real GDP or it creates inflation.

The path ahead is not clear. Some still do not see how deep a hole has been dug and want to keep digging. The state enterprises, banks and emerging plutocrats do not want to stop dancing and they have immense influence. An IMF loan with real conditions is one option. A loan from Asian neighbours (perhaps through the ill-defined Chiang Mai accord) is another. But the days of the government being able to create credit, use it poorly and persuade others to give it the benefit of the doubt are over.

Professor David Dapice is an Economist in the Vietnam Program in the Ash Center for Democratic Governance and Innovation at John F. Kennedy School of Government, Harvard University and an Associate Professor of Economics at Tufts University.