In 1986, the government of Vietnam implemented a program of political and economic reforms called Doi Moi, which were geared towards creating what the government termed a socialist-oriented market economy. Efforts to collectivize key economic sectors were abandoned, privatization began in the commodities sector and relations with Western states were vastly improved.

Those reforms ushered in an era of prosperity for Vietnam, with average annual per capita income rising from about USD100 to USD1,300. Over the past decade, the poverty rate in the country has fallen from almost 60 percent to just 12 percent, according to the latest government statistics.

But 2011 proved a challenging year for Vietnam, as inflation spiked to 23 percent and its trade deficit widened, prompting the government to tighten its monetary policy. It also launched another period of rapid reform, to reduce the government’s role in the financial sector.

The country’s efforts were initially met with nearly unparalleled success as measured by the Vietnamese equity market, which gained more than 30 percent from the beginning of this year into early May. As inflation nosedived and the bank modernization scheme moved apace, market confidence was palpable.

However, that confidence cooled along with the global economy, as manufacturing in the country slowed and gross domestic product (GDP) growth became tepid.

Confidence also suffered a body blow in late August when two prominent bankers, including the country’s wealthiest banker Nguyen Duc Kien, were arrested on corruption charges. While the exact nature of his crimes hasn’t been disclosed (so far he’s accused only of improper lending), he is one of the first of the nation’s private business tycoons to be arrested for financial crimes.

By necessity, corruption must be rooted out for any modernization to be effective; otherwise nothing is accomplished beyond applying a veneer. And the charges against Nguyen don’t seem to be trumped up. The chairman and two executives at Asia Commercial Bank (Hanoi: ACB), of which Nguyen is a founder, have resigned.

It’s also become apparent that Vietnamese banks may be awash in bad debt, with an estimated 10 percent of all outstanding loans considered questionable. A recently report from Barclays suggests that as much as 20 percent of loans might be bad and as much as USD16 billion would be needed to keep the system solvent. While that might not sound like much to Americans, who have become accustomed to hearing about “trillions” in recent years, in Vietnam that’s nearly 12 percent of GDP.

Regardless of who is right about the severity of the situation, the banking system likely requires a recapitalization. Unfortunately, there are doubts that the government has either the desire or the ability to do that effectively. This political reality has chipped away at investor sentiment and put a lid on foreign direct investment, with flows into Vietnam off by more than a third this year.

While the markets are clearly concerned about these developments, supranational organizations such as the International Monetary Fund (IMF) aren’t too concerned yet. GDP growth is expected to come in at about 5 percent this year and foreign currency reserves remain high, signs that the broader economy is holding up well and the risk of a broad bank crisis is low. Standard & Poor’s has also reported that it believes the Vietnamese government has a solid handle on the situation.

While I don’t look for a crackdown on banking executives in Vietnam, I wouldn’t be surprised to see at least a few more arrests made. It is believed that improper lending became rife under the country’s stimulus programs in 2008 and 2009, which were valued at about USD8 billion. The government will be eager to see atonement for those crimes.

I also don’t believe that the wholesale collapse of Vietnam’s banking sector is in the offing. Many question the validity of the data released by Vietnamese banks, but it’s reasonably accurate and a number of Western banks hold stakes in these institutions. Given those relationships, quite a few Western eyes are on Vietnamese banks, making it tough for them to pull one over.

That said, I would avoid sinking any money into Vietnam, for the time being. About a third of the Ho Chi Min Index’s constituents are banking businesses whose shares are likely to remain under pressure for some time.

Instead, I would focus on more promising markets such as Thailand, Malaysia, Indonesia and the Philippines for now. Vietnam would warrant another look, once it puts this mess behind it.