The last strategy response from the Asian countries which we will look at briefly - and subsequently in a later chapter in substantially more detail - is that of microeconomic reform and restructuring. In contrast to the Latin American debt crisis of 1995 which undoubtedly had major microeconomic effects, but whose roots were macroeconomic, the very root cause of the Asian crisis lay in the micro-economy. Consequently, a key strategy for dealing with the worst effects of the crisis and for reviving Asia’s shattered and bruised economies had to deal with microeconomic management and reform. Here, one has to say that the record in 199 7-98, while fine in theory, was poor in practice, in the implementation of that theory.
Some progress was made however. Since the onset of the Asian crisis, several Asian countries have sought to improve their regulatory frameworks for domestic financial institutions, forcing increases in bank CAR ratios and the improvement of standards on loan provisioning and loan classification.
In addition, the governments of Korea, Indonesia and Thailand sought to varying degrees to put in place an institutional and legal framework for the resolution of debt restructuring. Finally, all three countries increased foreign investor access to their markets, companies and banks through the raising of foreign investor ownership ceilings and the reduction or elimination of rules inhibiting such access. Korea, for example, fully liberalised foreign purchases of domestic Korean won bonds and abolished most ownership restrictions for foreign investors, key elements in the task of re-liquifying the Korean financial and economic system. In the financial sector, to recall, Thailand closed 56 finance companies, while Korea closed more than half of its merchant banks. In addition, it closed two commercial banks, re-capitalised them and sought to resell them to domestic and foreign investors. The governments of Korea and Thailand announced the issuance of domestic bonds worth up to 15 of the GDP, placing these with domestic financial institutions in order to put a floor under the balance sheet of their respective banking systems.
All sound measures and proof indicated that the efforts of the IMF and World Bank were not wasted and that progress was made at the micro-economic as well as the macroeconomic level. That said, one should not under-estimate the damage caused at the micro-economic level by the crisis and thus the remaining problem. The World Bank in its report East Asia: The Road to Recovery’, said that it was estimated that as a result of the crisis two-thirds of Indonesian firms suffered losses exceeding their equity, while for Korea this figure was two-fifths and for Thailand one quarter.5 Higher interest rates, plunging capital bases, a collapse in available domestic bank credit as banking systems sought first to repair their own balance sheets combined to produce a ruinous result for many Asian corporations. In the go-go days of Asian economic growth, the fundamental weaknesses of many of these companies, including small capital and equity bases and over-leverage on cheap, in many cases governmentinduced credit, had been hidden by strong top line growth in the P&L. Diminishing total returns was a warning prior to the crisis, a warning
which went unheeded at all levels.
High debt-equity ratios was however the natural product of the Asian growth model, itself founded on consensus and co-operative rather than competitive economics. Asian governments had sought to expand deliberately the strategic export sectors. In order to do so, they provided, directly or through their banking systems, cheap, directed credit, subsidised loans and tax breaks. Insufficiently deep Asian equity and bond markets required that the Asian corporates rely for most of their external funding on bank loans. In the early 1990s, many Asian governments removed or reduced borrowing limits, particularly on foreign currency borrowing, but failed simultaneously to strengthen banking, corporate regulation and supervision. When I arrived in Asia at the start of 1996, before I joined the banking sector, many of its markets and economies felt like a Gold rush precisely because there was insufficient control or supervision of bank lending or corporate borrowing. It was the ‘Wild East” in that just about anything went. Cheap credit was available and deals were done whatever it took. Corporate governance played a part also in that corporate borrowing was in many cases hugely excessive relative to its potential for driving the bottom line. As a result, a substantial part of corporate profit went into paying interest costs, thus making corporations especially vulnerable to domestic interest rate rises. For example, by 1997, according to the World Bank, more than two thirds of all profits of listed Thai companies went to cover the interest costs.
In addition, excessively cosy relationships between domestic bank loan officers and many corporations led to increased loans to firms with high debt leverage and low profitability. Political pressure from the top to make loans to favoured or strategic companies had an eventual cost and in 1997 and 1998 that cost was high - and remains high to this day. As stated in Asia Falling, it is all about incentive. Banks had little incentive for ensuring that their loans were creditworthy, while corporations had little incentive to ensure that their loans were needed in the first place since they would get them anyway. The market pricing mechanism was thus significantly distorted. What we have seen subsequently is not only the result of that but effectively an attempt by “the market” to achieve a greater degree of pricing mechanism equilibrium. In the 1960s and 1970s, many Asian countries privatised banks and corporations, however in many cases they retained a heavy hand in their financial running. As an economist, it is my profound view that the state is inherently inefficient from a profit perspective in running companies and banks, a condition brought about by the fact that profit is not the only or in some cases even the major motive. Interlocking relationships between the government, banks and corporations thus reduced the ability of the market mechanism to function, thus inexorably leading to ever diminishing returns and the consequent need for ever increasing credit just to maintain those returns. Cronyism” was a factor behind the Asian crisis. To anyone with any common sense, this is merely stating the obvious, but to some apparently it has to be said. Granted, that same cronyism or contact- or consensus- capitalism depending on how one terms it was also a key plank of the Asian growth story for at least two decades, but such practices, lacking the discipline of a free market which focuses only on the bottom line eventually led to major price distortion, such distortions inevitably being corrected, albeit after a substantial period of time and at the expense of a regional crash.
Inadequate domestic asset markets and more specifically the infrastructure of those asset markets, namely zealous and INDEPENDENT regulators and deep and broad institutional investor bases were also a key reason for the lack of true market discipline which pervaded in Asia in the 1990s. For instance, in 1996, the mutual fund industry represented under 1000 of the total Stock Exchange of Thailand (SET) trading. Outside of Singapore, many Asian countries had weak or minimal pension fund industries. Finally, the very organisational structure had a part to play in the eventual Asian crisis, characterised most commonly by a diversified conglomerate structure whose shares were closely held by a family. Given the lack of development of the Asian equity markets and the lack of minority shareholder rights, these owners again did not have sufficient incentive to make their corporations efficient. They simply did not have to.
The result of all this was that the crisis caused wholesale bankruptcy in countries which had these fundamental microeconomic flaws. Indonesia was easily the hardest hit, followed by Korea and Thailand. The extent of the damage reached systemic proportions in all IMF programme member countries. Solving this crisis at the microeconomic level always necessitated a comprehensive and cooperative strategy involving international creditors, domestic banks and corporations, domestic governments and the influence of multilateral organisations to prod proceedings along in the right direction. Using the incentive rule, such strategies oniy work if they have to, if they are forced to. This implies the breaking up of those cosy relationships between banks, corporations and governments. There is a key lesson from the Japan crisis (1991-and still counting) in this. Bank restructuring in particular works most effectively if it is enforced by the government, creditors or shareholders, rather than at the agreement of cosy agreements. This was a key reason why the Japanese government attempts at bank restructuring - however belated, however pitiful - have so far failed to achieve what most in the West see as the desired result - a profitable, healthy bank. Instead of this, Japan has gradually been nationalising its financial system, a strategy which is doomed to ever diminishing returns and ultimate failure. When faced with the painful choice between propping up institutions (and those cosy relationships) or biting the bullet and letting such institutions go or be forcibly restructured, no matter what the short term cost to prices or market confidence, Japan chose the easy way out.
It has yet to be confirmed that Thailand, Korea and Indonesia have avoided this route. If they have not, that will have dire consequences for the medium- and long-term growth prospects of their economies. The alternative to the approach of bank-led restructuring is theoretically and has been practically that of government-led restructuring. Under this model, the government creates an asset management company to reduce and restructure bank non- performing loans, taking over and restructuring bad debts and replacing these assets with bond issues, thus the banking system is re-capitalised. While governments may prefer voluntary negotiations between bank creditors and corporate debtors, without appropriate balancing mechanisms in order to avoid social structure damage, this is rarely the most appropriate way of achieving an efficient result. What seems clear is that there must be an element of enforceability of this restructuring by the authorities and equally a degree of submission to market pricing discipline. On the latter, this means, whatever price the market currently supports is the price you get for your distressed assets, not the price you or your government might want. However, those distressed assets need domestic as well as foreign buyers. More has to be done to democratise the Asian equity markets, increasing the rights of minority shareholders, developing strong mutual and pension fund industries which in turn can help enforce corporate and bank restructuring - or throw out directors and CEOs through the creation of emergency shareholder meetings - a source of much humour in Japan for some time and look at the cost of that. Disclosure and accounting standards have to be improved (or in some cases created). Remember, things don’t improve if they don’t have to improve. The message to Asia is a clear, if an uncomfortable one: the Asian capitalist model does not work anymore. It has passed its sell by date. This is not to say that Asia should necessarily and automatically adopt a U.S. version. It is to say that Asian governments and financial authorities should create true market places, which might or might not mimic their U.S. counterparts, but which focus on creating free and fair trade, strong regulatory and supervisory standards and the institutional investor structure to support deep and liquid asset markets. The pricing mechanism used must be the market rather than the relationship. Why? Not because that is the U.S. model (it is questionable whether or not it is in fact given trade subsidies which both the U.S. and Europe provide), but because it is the most efficient model, providing the soundest base for long-term sustainable growth. That, surely, must be the aim.
The emphasis on the market pricing mechanism must not be at the expense of ignoring the importance of creating a sufficient legal framework, a crucial element in any country’s infrastructure, as important as ports and roads, as electricity, housing and education. In the case of a debt and currency crisis, the first priority in this regard must be to provide an adequate bankruptcy law framework to encourage new investors to pick through the rubble of distressed assets. Only when this occurs will there be sufficient incentive not to become distressed in the first place. In the wake of what appears to be strong recoveries in Asia, this may no longer seem relevant, but it most assuredly is. Without sufficient microeconomic reform and restructuring, those recoveries will most assuredly prove fleeting, the result of temporary fiscal and monetary stimulus which when removed in order to avoid renewed inflation results in a sharp pullback in domestic demand. Generally speaking, there are three types of resolving bankruptcy or insolvency: liquidation, rescue or agreed restructuring or “work out” involving informal relationships outside of the court’s mandate. Both liquidation and rescue necessitate the presence and active involvement of the formal court procedure, the first leading most likely to a sale of assets to a third party (the company and the court being the first two parties), the second involving the administered rescue of a company as a viable and going concern through public infusion or in the private sector case most likely debt-equity swaps. The dependency in Thailand, Korea and Indonesia on the Asian model of consensus rather than market capitalism led to an initial emphasis on informal work outs after the crisis, despite the emphasis by the IMF on the strengthening of the institutional infrastructure framework. Issues such as “loss of face” and the necessity to maintain business and banking relationships have proved to be strong obstacles to the initial creation and then the enforcement of efficient bankruptcy laws. However, it is wrong to say that culture is an inevitable obstacle to this process. The Singapore bankruptcy code, shaped by the UK 1985 Insolvency Act is a case in point, involving supposed Western legal enforcement with an Asian emphasis on compromise and negotiation, a potential model for others in the region to follow. Extending that example, it is no coincidence whatsoever that Singapore has an exceptionally strong corporate legal framework and zealous and independent regulatory bodies, and at one and the same time its corporate and banking systems are relatively low geared - as befits PROFIT necessity - and have survived the Asian crisis for the most part healthy and intact. There are no doubt strong relationships between banks and corporations in Singapore, but they are not allowed to be the founding premise for debt creation.
Outside of Singapore, in crisis countries where the relationship became the essence of the pricing mechanism, rather than the market, is where the Asian model eventually broke down when it was forced to compete with the unfettered forces of the global freemarket system. The Asian model does not have to be scrapped wholesale, but the driving force and the incentive for economic growth have to be altered in favour of the market. Strong relationships can and should still exist. That need not change, but they cannot be the primary motivating force behind economic expansion. Not anymore. The alternative is to reject the global system and turn inwards, but that is not a realistic option for any but the foolhardy. The “emerged’ nations chose that alternative in the 1930s, in favour of trade and capital market protectionism. The Great depression was the result.
Going forward, Asia, now more than ever, will need access to great amounts of liquidity. In the short term it might get that from asset managers seeking short-term returns. However, to rely on those is to ignore many of the key lessons of the crisis, not least that over- reliance on short-term capital flows is a perilous policy choice - and that is exactly what is, a policy choice. There is an alternative, and that is to create a more viable platform for foreign direct investment in the cases of some, institutional infrastructure for others, recapitalising their financial systems not only with money but with the legal and supervisory framework to encourage investors to the view that the crisis will not re-occur.
So much for what has not happened at the level of microeconomic reform, what is needed, what is to come - or not. This is not to take anay from the fact that 1999 saw a dramatic recovery in Asian economies, one which surprised many. The length of that recovery will, as we have seen, depend crucially on the extent of microeconomic reforms which Asian countries attempt to achieve. That said, IF such reforms are imposed, it is a recovery which has some chance of continuing into 2001 and beyond, depending of course on how the external environment, not least in the U.S., pans out. The next chapter looks at this issue of Asian economic recovery, how it was created, the recovery’s first symptoms and why macroeconomic dynamics suggest it will continue at least in the short term.
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