CORPORATE AND FINANCIAL SECTOR REFORM 21 Corporate and Financial Sector Reform: Progress and Prospects This chapter examines and appraises the corporate and financial sector reforms undertaken so far in the crisis-affected economies in Southeast Asia and East Asia. It considers what must be done—both in the short and medium term—to create vibrant and healthy corporate and financial sectors. The chapter concludes that sustainability of the region’s short-term recovery, as well as its long-term economic prospects, depends largely on how effectively and comprehensively the corporate and financial sectors are restructured. T he 1997-1998 Asian financial crisis was the biggest economic and social shock to befall the region since the Great Depression. After decades of Fortunately, 1999 brought a clear shift from crisis toward recovery. As current account balances im- proved while inflation remained subdued, investor rapid growth, output plummeted. In little over a confidence returned. This allowed the region’s cur- year, the five crisis countries—Indonesia, Republic of rencies to stabilize and interest rates to fall, which in Korea (henceforth referred to as Korea), Malaysia, turn fueled recovery in output. Estimates indicate that Philippines, and Thailand—saw their combined eco- all the crisis countries except Indonesia saw substantial nomic loss reach approximately 30 percent of gross GDP growth in 1999, ranging from 3.2 percent in the domestic product (GDP). As a result, once again, the Philippines to around 10.7 percent in Korea. unemployment and poverty problems came to the fore. The improvement in financial market conditions In Korea, for instance, where unemployment and has been particularly impressive. Most of the region’s poverty were almost nonexistent before the crisis, the currencies have appreciated dramatically. The unemployment rate almost tripled in 1998, while urban Indonesian rupiah and the Korean won, for instance, poverty incidence more than doubled at the peak of strengthened by 35 and 25 percent, respectively, the crisis. Such a devastating economic shock, in against the dollar between early 1998 and the end of turn, precipitated substantial social turmoil. The crisis- 1999 (see figure 1.8). Malaysia, which introduced capi- affected countries experienced food riots and tal controls in September 1998 and maintains a fixed labor unrest, and in Indonesia a dramatic political exchange rate, is the exception. Yield spreads on upheaval occurred. international bonds issued by the crisis countries have 22 ASIAN DEVELOPMENT OUTLOOK 2000 fallen sharply (see box 1.4). Domestic short-term in Korea, 10 percent in Malaysia, and 32 percent interest rates have also fallen. With the exception of in Thailand. Indonesia, where higher inflation and greater politi- The main problem is the overhang of corporate cal uncertainty have kept rates high, interest rates in debt. Burdened with an enormous stock of nonper- crisis countries are in line with their precrisis aver- forming loans (NPLs), banks are undercapitalized and ages. Stock markets have soared. Since the fourth reluctant to lend. Saddled with heavy debt burdens, quarter of 1998, stock prices in these countries have many firms are technically insolvent. Private sector increased, on average, by 50 percent in local currency financial analysts estimate that as many as 60-85 per- terms. With currencies also appreciating, the rise has cent of loans in Indonesia are nonperforming, com- been even larger in dollar terms (see figure 1.9). pared with 20-30 percent in Korea and Malaysia and Market capitalization in most crisis countries is now 50-70 percent in Thailand (see table 1.2). Compari- approaching or even exceeding its precrisis level. sons between countries must be made cautiously, be- This recovery, while impressive, masks sub- cause the definition and measurement of NPLs differ stantial problems, particularly in the corporate and considerably. Official estimates of the share of NPLs financial sectors. Distress in the financial sector and are much lower, but even these indicate a dramatic restructuring costs have proved far larger than anti- increase since the onset of the financial crisis. cipated. One estimate suggests that total financial Overall, the sheer size of NPLs reflects the poor restructuring costs for the four worst-hit countries health of the corporate sector. However, all firms did will reach 58 percent of GDP in Indonesia, 16 percent not suffer equally. In general, export-oriented CORPORATE AND FINANCIAL SECTOR REFORM 23 Box 1.4 Improved International Confidence in Crisis Countries The yield spread of a government bond is the difference between the yield on that bond and the yield on a “safe” instrument of similar maturity (usually US Treasury notes). The size of the yield spread represents the degree of international investor confidence in a country’s economy: the higher the yield spread, the lower the investor confidence. Tracking yield spreads over time is therefore a useful gauge of how investor confidence shifts. Yield spreads tend to have an inverse relationship with GDP growth, so lower yield spreads suggest an improved economic outlook. The government of the Republic of Korea issued two foreign currency bonds in April 1997 to mobilize foreign exchange: a five-year $1 billion bond and a ten-year $3 billion bond. At that time the spreads of these bonds over US Treasury notes of the same maturity were 3.35 percent and 3.55 percent per year, respectively. The yield spreads reached a peak of 7.2 percent in the third quarter of 1998 following Russia’s debt moratorium. Since then, the Republic of Korea’s yield spreads have been on a broad downward trend. The same pattern is true for sovereign bonds in other crisis countries. Yield spreads peaked in the third quarter of 1998—16 percent for Indonesia, and 7 percent for both Philippines and Thailand—but have dropped significantly since. In the fourth quarter of 1999, yield spreads over comparable US Treasury notes for the Republic of Korea and Thailand were around 1.8 percent, while those for the Philippines and Indonesia stood at 3.1 and 5.5 percent, respectively. companies fared better than those that produce restructuring. A variety of vested interests, including nontraded goods and services, and, except in Korea, financial institutions, business corporations, labor small firms were hit harder than large firms. In unions, and politicians have exerted pressure to slow Malaysia, for instance, about 75 percent of the NPLs and limit structural reform. are to firms in the nontradable sector. In Thailand, small firms and households account for 50 percent of CORPORATE FINANCIAL AND CORPORA TE the NPLs. RESTRUCTURING Each of the crisis countries has embarked on comprehensive restructuring strategies to deal with Plummeting currencies, collapsing confidence, and this financial and corporate distress. While consider- financial system paralysis characterized the early phase able progress has been made, the magnitude of NPLs of the financial crisis. Uncertainties about the likely suggests that much remains to be done. The risk is behavior of depositors and foreign creditors and fears that economic recovery will dull the momentum for about the financial health of borrowers led banks vir- 24 ASIAN DEVELOPMENT OUTLOOK 2000 tually to stop lending. To prevent a complete collapse for bank recapitalization by ensuring that government in bank intermediation, financial reform strategies ownership increase commensurately with the infusion initially focused on measures to restore market confi- of public recapitalization; (b) maximizing the partici- dence and attract capital inflows. The most popular pation of the private sector by providing fiscal and method was government guarantees, and in the early administrative incentives; and (c) ensuring that the stages of the crisis, governments gave broad guaran- restructuring process was comprehensive and covered tees both to foreign creditors and depositors. the institutional, legal, and regulatory aspects of the As the crisis deepened and the extent of corpo- banking sector as well as its financial health. Banks rate and financial insolvency became clear, the reform were mandated to meet international standards of strategy shifted toward restructuring in the financial capital adequacy, loan classification, loan-loss and corporate sectors. The goals were twofold: to provisioning, accounting, and disclosure. escape from the crisis and to address the structural Similar goals drove corporate restructuring ef- weaknesses that had helped trigger the financial col- forts. It was necessary to find quick and effective ways lapse. The focus was on restructuring insolvent finan- of allocating losses and facilitating asset mobility to cial institutions by closure, merger, or recapitalization; remove the paralyzing debt overhang that stymied the improving corporate governance; reducing labor mar- corporate sector. Developing an efficient bankruptcy ket rigidities; and deregulating domestic markets. regime and modernizing corporate governance were In all the crisis countries, three broad principles also critical. governed financial restructuring: (a) minimizing the Again, strategies were broadly similar across the risk of moral hazard associated with using public money crisis countries. All countries developed new out-of- CORPORATE AND FINANCIAL SECTOR REFORM 25 Table 1.2 Nonperforming Loan Ratios and Fiscal Costs of Restructuring, Crisis Countries (percent) Share of nonperforming loans to total loans Official estimate Unofficial Fiscal costs of estimate, restructuring as Country End of 1997 End of 1998 September 1999 peak level share of GDP Indonesia — — — 60-85 58 Korea — 7.6 6.6 20-30 16 Malaysia — 18.9 17.8 20-30 10 Philippines 5.4 11.0 13.4 15-25 — Thailand 19.8 45.0 44.7 50-70 32 — Not available. Note: NPLs are measured on a three-month basis, and the unofficial estimate includes assets carved out for sale by the asset management companies. Sources: Central banks and financial supervisory agencies; World Bank (1999a); Deutsche Bank (1999); J.P. Morgan (1999); Bank of America (1999); staff estimates. court systems to restructure the debts of large firms, in restructuring their corporate and financial sectors, variants of the London approach to corporate restruc- but with different approaches. Korea adopted tight turing (see box 1.5). Indonesia set up the Jakarta macroeconomic policies under an International Initiative, Korea and Malaysia set up corporate debt Monetary Fund (IMF) program and aggressively restructuring committees, and Thailand used a closed, merged, or suspended insolvent financial in- corporate debt-restructuring advisory committee. Tax stitutions. Malaysia declined an IMF rescue plan, opt- incentives encouraged out-of-court workouts, while ing for capital controls, and closed no financial regulatory obstacles that hindered mergers and debt- institutions. After dramatically downsizing the finan- equity swaps were removed. Simultaneously, the crisis cial sector by closing virtually all its finance compa- countries strengthened domestic bankruptcy laws to nies, Thailand adopted a more gradual, market-based accelerate resolving bankruptcy cases, protect credi- approach to restructuring, with banks allowed to raise tors’ rights, and discipline managers. Policies to im- equity capital over a long period through phased-in prove corporate governance included attempts to reduce requirements for loan provisioning. Indonesia lags ownership concentration, increase market competition, behind the other three countries, and has only re- reduce government monopolies, strengthen the rights cently taken steps to deal with banking problems and of minority shareholders, and increase the transpar- corporate distress. As a less severely affected economy, ency of financial reports and transactions. the Philippines adopted a market-led reform process, with the government and the central bank focusing An Individual Look at Crisis Countries on reforming the supervisory systems. Though the broad principles of financial and corpo- Indonesia. Indonesia’s first step toward structural re- rate restructuring have been similar in the crisis coun- form in the financial sector was to create new institu- tries, the details and rates of progress have varied tions. The Indonesian Bank Restructuring Agency was considerably. Korea and Malaysia have gone furthest formed in January 1998 as an independent body to 26 ASIAN DEVELOPMENT OUTLOOK 2000 Box 1.5 Models of Corporate Restructuring There are three popular approaches to During this period, more than equal treatment for all creditors of corporate sector restructuring: 160 British companies used the a single category centralized, decentralized, and the London approach, in which creditor • The possibility of penalties if the London approach. financial institutions and indebted agreements are not adhered to. In the centralized approach, the firms work under the close To be successful, this approach government plays a leading role. This coordination of a government demands strong confidence in the is effective when the size of institution (in the British case, the official mediating institution. In the problematic debts is small, corporate Bank of England), but outside the British case, the parties concerned structure is simple, and the formal judiciary process. The London held the Bank of England in high government enjoys high levels of approach includes regard, a crucial ingredient for confidence. Sweden in the early 1990s • Full information sharing between success. and Hungary in the mid-1990s used a all parties involved in a workout Superficially, the corporate debt centralized approach to corporate • Collective decision making workouts under government restructuring. among creditor banks on whether coordination in Indonesia, Korea, At the other extreme, interested and on what terms a company and Thailand resemble the London parties use a decentralized approach should be given a financial lifeline approach. However, the Asian to reach voluntary restructuring • Standardized agreements between countries lacked the equivalent of the agreements. This is considered more debtors and creditors and among Bank of England, a government useful than the centralized approach creditors themselves institution with high credibility. They if the bad debts are large and the • A clear timetable to achieve also suffered a lack of mutual trust corporate structure is complex. timely resolution and confidence between financial Corporate restructuring in the United • Binding agreements between institutions. This process is now States tends to follow this model. banks and firms to participate in gradually changing, as both financial The London approach evolved and honor the restructuring institutions and corporations become in the United Kingdom when agreements more confident in the ability of numerous firms faced bankruptcy in • The principle of “shared pain” in government to oversee corporate the recession of the early 1990s. the allocation of losses, meaning debt restructuring. restructure troubled banks and their assets. Within system and 90 percent of its negative net worth. this agency, a specific Asset Management Unit was Unfortunately, the restructuring of these state banks created in April 1998 to acquire NPLs from troubled has just begun. By some estimates, around 80 percent banks. By the end of 1999, it held around two thirds of all outstanding loans are nonperforming. As a re- of all NPLs. So far, however, the Indonesian Bank sult, most Indonesian financial institutions remain in- Restructuring Agency has done little to recover these solvent or undercapitalized, and lending operations assets, although the legal, organizational, and regula- are severely curtailed. tory framework is in place. One of the major causes of the collapse of the Greatest progress has been made in restructur- banking system was the absence of an effective bank ing private banks. At the end of July 1997, before the supervision system. Realizing this weakness, Indonesia onset of the crisis, Indonesia had 160 private banks. has taken steps to improve prudential regulations, bank In September 1998, all private banks were classified supervision, and enforcement capabilities. Never- into categories of A, B, or C, based on their capital theless, bank supervision remains limited because of adequacy. All group C banks and nonviable group B weak enforcement capacity and a lack of trained staff. banks were closed in March 1999. In the span of one As in the financial sector, Indonesia’s efforts at year, 66 banks were closed and 12 taken over by the corporate reform initially focused on creating new state. Consequently, the state banking system accounts institutions and improving legislation. First, the gov- for 75 percent of the liabilities of Indonesia’s banking ernment set up the Indonesian Debt Restructuring CORPORATE AND FINANCIAL SECTOR REFORM 27 Agency in July 1998 to help restructure foreign debt. Commission was created to monitor and supervise This agency allows debtors and creditors to insure all financial institutions. During the crisis, however, it themselves against exchange risks, once they have focused on financial and corporate restructuring, ac- reached rescheduling agreements. Indonesia then celerating the reform process. created the Jakarta Initiative for out-of-court corpo- In early 1998, two of Korea’s largest banks, Korea rate settlements, following the example of the London First Bank and Seoul Bank, were recapitalized with approach to corporate workouts. Legislation to im- public funds and effectively nationalized. Korea First prove corporate governance included new bankruptcy Bank was subsequently sold to a foreign consortium. and anticorruption laws. In August 1998 a new bank- On 29 June 1998, the Financial Supervisory Commis- ruptcy law was introduced, which modernized the legal sion announced that five insolvent commercial banks infrastructure for bankruptcy and facilitated the rapid would be closed and absorbed by healthier banks. resolution of commercial disputes. In 1999 a law Mergers involving the five largest banks have been against corruption, collusion, and nepotism was passed. completed. Two years after the crisis, the number of Despite this comprehensive legal and institu- banks has been reduced from 33 to 23 through clo- tional framework, the progress of corporate restruc- sures and mergers. The government has also closed turing has been disappointing. The Indonesian Debt down or suspended 21 of 30 merchant banks, and 22 Restructuring Agency has registered little debt. By the other financial institutions. end of June 1999, only 80 bankruptcy cases had been The public sector contribution to this restructuring registered, although almost half of Indonesian corpo- has been huge. At the beginning of the crisis, the govern- rations were insolvent and experiencing increased dif- ment earmarked W64 trillion ($53.3 billion) in public ficulties in meeting debt service obligations. One of funds to support financial sector restructuring. By the the biggest constraints on the speed of corporate debt end of 1999, the government had used the entire allo- restructuring has been the lack of financial system cation of funds to purchase W20.5 trillion ($17.1 billion) reform. Weak undercapitalized banks lack the re- in NPLs from banks and secondary financial institutions sources or technical skills to resolve corporate debts through the Korea Asset Management Corporation. within the framework of the Jakarta Initiative. Another It also provided W43.5 trillion ($36.2 billion) in recapi- constraint is the enormity of Indonesia’s foreign debt. talization and deposit repayment support through the Without relief from foreign creditors, including Japan, Korea Deposit Insurance Corporation. Indonesia probably cannot service this debt, in par- Korea has taken a three-pronged approach to ticular the $36 billion owed to foreign banks. reforming the corporate sector. First, the four largest chaebols (conglomerates of corporations), known as Korea. Korea’s financial sector strategy initially focused the Big Four, were restructured through specific plans on restoring market confidence with government to improve capital structure. These required the four guarantees to prevent a run on the banks. However, chaebols to reduce their debt-equity ratios to below once the situation stabilized, priority shifted to re- 200 percent by the end of 1999, remove existing cross- structuring or closing insolvent financial institutions guarantees between subsidiaries in different lines of and rehabilitating viable ones. At the same time, business, and consolidate businesses by exchanging adoption of international standards of regulation noncore businesses with other chaebols, a process and supervision was emphasized, as well as capital known as “Big Deals.” market development. Second, the mid-ranking chaebols and other In December 1997 , the Korean Parliament large corporations have been subject to out-of-court passed 13 financial reform bills, and streamlined bank- workouts with their designated lead creditor banks, ruptcy law. In January 1998, the government, corpo- based on the London approach. rations, and unions agreed on a national council to Third, the restructuring of small- and medium- discuss economic restructuring. A legal framework for size enterprises (SMEs) has been left to the creditor corporate sector restructuring was created in February banks and largely postponed. To prevent insolvency 1998. In April 1998 the powerful Financial Supervisory and preserve employment, these firms were allowed 28 ASIAN DEVELOPMENT OUTLOOK 2000 easy access to working capital loans. In Korea, com- for its subsidiaries, caused bank losses estimated at pared with other crisis countries, SMEs account for a $10.4 billion. The requirement that the Big Four re- relatively small fraction of outstanding bank loans. duce their debt-equity ratio to less than 200 percent While this justifies the delay in restructuring SMEs, a by the end of 1999 also led to debt write-downs and comprehensive program to work out these debts is debt-equity swaps that cut the earnings of major com- urgently needed. mercial banks. The restructuring of the Big Four and out-of- These costs made it difficult for Korean banks court workouts of other large corporations have had to build the capital and loan-loss provisioning needed mixed results. The lead banks have been accused of to absorb the losses from further corporate including firms that should have been immediately liq- restructuring. Some progress has been made, however. uidated. Given their financial fragility, the banks have The average capital adequacy ratio of the commer- been reluctant to absorb losses, and are trying to keep cial banks reached 10.5 percent by the end of 1999. many troubled firms on their balance sheets that in Nonetheless, estimates suggest that the Korean gov- fact are unlikely to survive the crisis. The lead banks ernment will need additional public funds besides the have also been unable to devise a comprehensive set W64 trillion ($53.3 billion) already used for reforming of workout criteria involving debt-equity swaps, debt the financial sector. write-downs, and debt rescheduling. The absence of comprehensive criteria has raised concerns about the Malaysia. Malaysia’s experience of financial restruc- fairness and effectiveness of using differential mea- turing differed from the other crisis countries in two sures to support different firms in various industries. crucial aspects. First, Malaysia began with a stronger Disagreements over loan-loss provisioning, disputes financial sector. Before the crisis it had developed more over asset valuation, and managers’ resistance to los- effective bankruptcy and foreclosure laws, as well as a ing control all have further complicated the process. stronger supervisory capacity. The banking sector was Consequently, many firms are likely to fail to meet also well capitalized, with capital-asset ratios exceed- their obligations to their lead banks. ing 10 percent. Second, Malaysia altered its macro- The restructuring impact of the Big Deals is also economic course in September 1998, choosing to mixed. Whether or not the excess capacity problems impose capital controls rather than accept an IMF that plagued Korea’s chaebols have been solved is not rescue package. clear. Evidence is also mixed on whether the Big Four However, like the other countries, Malaysia has fulfilled its commitments to improve corporate began its financial and corporate restructuring effort governance and slim down to a few core businesses. by creating new institutions. In June 1998, the authori- Most of the banks, including restructured ones, ties set up Danaharta, an asset management company have seen substantial improvement in the quality of (AMC) to acquire nonperforming bank loans. In their assets and profitability of their operations. Their August 1998, Danamodal was created to recapitalize lending capacity also has increased, supporting the financial institutions whose capital adequacy ratios ongoing economic recovery. However, financial re- fell below 9 percent. In the same month the Corporate structuring is far from over. The Financial Supervisory Debt Restructuring Committee was established to Commission has been struggling to restructure the facilitate the out-of-court restructuring of corporate three largest investment trust companies, which hold debt. many corporate bonds issued by corporations engaged Both Danaharta and Danamodal made signifi- in out-of-court workouts. Many nonbank financial cant progress in restructuring banks. Danamodal institutions, including life insurance companies, also injected $1.6 billion into ten financial institutions, need rehabilitation. while Danaharta purchased 50 percent of outstand- The banks have faced major losses from the cor- ing NPLs, about the same ratio as Korea. The level of porate workouts. For instance, the restructuring of NPLs appears to have peaked in mid-1999 at over Daewoo, Korea’s second-largest chaebol until domes- 20 percent of total loans. The total fiscal cost of the tic creditors decided on a debt-rescheduling program restructuring is estimated at around 10 percent of GDP . CORPORATE AND FINANCIAL SECTOR REFORM 29 In an effort to accelerate the rationalization and Its major reform elements included (a) strengthening consolidation of the banking system, instead of closing the prudential and supervisory systems overseeing the affected institutions as in Korea and Thailand, financial sector, (b) adopting an early intervention Malaysia continued to encourage financial institutions system to deal effectively with problem banks and keep to merge and consolidate. The central bank approved the banking system sound, (c) strengthening and the formation of ten banking groups and the selection modernizing state banks through privatization, of the anchor banks and their respective partners in (d) reducing the intermediation costs of financial January 2000. Accordingly, 54 domestic banking in- institutions, and (e) improving the legal and regula- stitutions—reduced from 88 at the end of 1997—will tory framework. be further consolidated. With a relatively sound legal To improve the supervisory framework, the system and a good institutional framework for finan- central bank required banks to set up 2 percent general cial restructuring, the prospects for Malaysia success- loan-loss provisions, as well as increasing specific fully restructuring its financial system seem bright. loan-loss provision on individual loans, which reached Before the crisis, Malaysia’s corporations were 2 percent by 1 October 1999. The central bank also less heavily indebted than firms in other crisis coun- limited banks’ exposure to the real estate sector to tries in East Asia. Consequently, corporate distress in 20 percent of total loans, and reduced the allowable Malaysia was less acute than elsewhere, although firms loan value of real estate security from 70 to 60 per- were hit hard by the rise in interest rates because of cent. It imposed a 30 percent liquid cover on all foreign heavy dependence on bank financing. Malaysia’s exchange liabilities from foreign currency deposits. troubled firms are concentrated in the real estate, con- To deal more effectively with problem banks, the struction, and infrastructure sectors. central bank adopted an early warning system that Nonetheless, debt workouts and operational re- included formalizing sanctions on undercapitalized structuring through the Corporate Debt Restructuring banks. To strengthen and modernize state banks, the Committee have been slow, partly because of a lack government concentrated on selling shares to private of adequately trained staff. To address the problem, investors. Statutory reserve requirements were re- the government has established agencies to deal with duced from 10 to 8 percent in May 1998 to reduce the corporate restructuring: the Loan Monitoring Unit of costs of financial intermediation. the central bank assists small corporate borrowers in Regulatory improvements have been significant. restructuring, a rehabilitation fund helps viable SMEs The central bank has proposed major revisions to key restructure, and the Finance Committee on Corpo- banking laws to (a) limit the ability of universal and rate Governance works on reforming corporate gov- commercial banks to invest in firms; (b) redefine the ernance practices. functions, authority, and minimum capitalization of trust entities; (c) adopt the Basle Capital Accords, a Philippines. While the Philippines was affected by set of standards for measuring capital adequacy; the Asian crisis, it suffered significantly less than the (d) strengthen provisions to guard against bank over- other four crisis economies. No broad banking crisis exposure to risky assets; (e) guard against credit occurred and no emergency rescue assistance from the concentration among borrowers; (f) grant the central IMF was needed. The country was resilient because it bank the right to examine banks once a year; and had virtually no short-term foreign currency borrow- (g) authorize the central bank to issue regulations ing, its banks were well-capitalized after two decades requiring bank subsidiaries and affiliates to maintain of financial sector reform, and its manufacturing sector a balanced position in foreign exchange transactions. was smaller and less leveraged than the other economies. These reforms contributed to the early recovery The mildness of the Philippines’ crisis affected of financial markets. Nonetheless, problems remain. the scope and nature of the country’s financial and First, many of the new prudential norms and interna- corporate reforms. Compared with the four worst-hit tional standards are poorly implemented. Second, crisis economies, the Philippines followed a market- banks still hold many real estate NPLs, which con- led reform process with less government involvement. tinue to curtail banking sector operations and stall 30 ASIAN DEVELOPMENT OUTLOOK 2000 overall economic activity. The illiquidity of property By January 2000, only four banks had accepted the markets also means that loan-loss provisioning may government’s recapitalization scheme, and most banks not reflect all real losses. Informal loan-for-property limited new lending and resorted to complex private swaps without formal legal foreclosure proceedings arrangements to raise capital. The level of NPLs in pose an additional problem. commercial banks is so high—as much as 50 percent of total loans or more—that for banks to recapitalize Thailand. Like other crisis countries, Thailand began through normal business operations seems impossible. structural reform in the financial sector by creating Thailand’s strategy for corporate restructuring, new institutions. In October 1997, three months after like that of the other countries, consisted of new in- the onset of the financial crisis, the government stitutions, better incentives, and improvements in the established the Financial Sector Restructuring legal framework. In August 1998, the government cre- Authority to organize the workout of failed finance ated the Corporate Debt Restructuring Advisory companies, and the Asset Management Company to Committee. It also endeavored to create an effective buy nonperforming assets and recover them. In legal framework for recovering debt through bank- December 1997, the Financial Sector Restructuring ruptcy legislation, and provided tax and other incen- Authority closed 56 of 58 suspended finance compa- tives to encourage corporations and banks to nies, and since then has been disposing of their assets. restructure bad debt. The Asset Management Company purchased its first Progress has been made, and the results of the NPLs at a Financial Sector Restructuring Authority corporate restructuring account for about 25 percent auction in March 1999. of NPLs. The growth of NPLs has outpaced the rate of After closing the finance companies, to help re- corporate restructuring completion. SMEs account for gain investor confidence the government adopted a more than two thirds of this aggregate corporate market-based approach to restructuring and recapi- debt, which makes restructuring complex: transactions talizing the remaining financial institutions. By gradu- are small, costly, and diffuse, with firms scattered ally introducing stricter loan classification and over the country. Banks have also been reluctant loan-loss provisioning requirements, the Thai authori- to deal with the debts of SMEs, preferring to scale ties hoped to give private investors the incentive— back lending. and time—to provide fresh capital. Thailand has made greater progress in im- However, this strategy did not succeed because proving the supervisory and regulatory framework private investors had little incentive to invest in those surrounding the financial sector. The authorities are banks and in other financial institutions that were enforcing new loan classifications and provisioning amassing large numbers of NPLs because of continu- requirements, and the supervisory functions of the ing recession. The government shifted to a more in- Bank of Thailand are being strengthened. All finan- terventionist approach in August 1998, announcing a cial institutions have signed a memorandum of new comprehensive financial restructuring package. understanding that describes their plans to raise This package allowed viable financial institutions to capital. The more stringent provisioning requirements recapitalize using public funds under clear safeguards. for nonperforming assets are being phased in from the It offered incentives for accelerating corporate debt second half of 1998 until the end of 2000. The Bank restructuring and promoting new lending to the private of Thailand also began implementing a moderniza- sector. It also created a legal basis for establishing tion program aimed at redesigning the bank’s organi- private AMCs and clear resolution strategies for fi- zational structure, streamlining work processes, and nancial institutions in line with the government’s long- improving corporate governance. As part of these term objective of strengthening the financial system. efforts, experts from some central banks of industrial Even this interventionist approach faced prob- countries have offered recommendations on lems. Thai bank owners remain as reluctant to take strengthening central banking and bank supervision. advantage of public funds as they were determined to The Bank of Thailand has also set up a school for maintain ownership and control of their institutions. bank examiners. CORPORATE AND FINANCIAL SECTOR REFORM 31 Assessment of Reforms with more stable and efficient financial sectors than before (see box 1.6). Almost three years after the onset of the Asian crisis, Unfortunately, it is too early to be certain of such financial and corporate restructuring is best seen as a success. Despite continuing pressure from interna- work in progress. All the crisis countries have begun tional financial institutions, corporate and financial to lay the foundations for stronger financial and cor- reform has slowed, and backtracking is evident in some porate sectors. Throughout the region, new account- cases. Moreover, it is an open question whether some ing standards, improved disclosure requirements, and crisis countries had sufficient political leadership and better rules for corporate governance were introduced. institutional capacity to implement such massive and However, effective implementation and enforcement complex structural reforms within a short time. Insti- of these rules are still lacking. tutional weaknesses have been the main obstacle to Similarly, all the crisis countries have made rapid and efficient implementation of reform programs progress in the immense task of financial and corpo- in Indonesia and Thailand. rate restructuring, but much remains to be done. Banks Though much remains to be done, it is not too remain undercapitalized and still hold large amounts early for a critical appraisal of the region’s reform ef- of NPLs on their balance sheets. The ratio of NPLs to forts. With hindsight, the crisis countries obviously did total loans remains well above 20 percent in all the not have a well-designed road map to guide their fi- crisis countries, far higher than in any previous major nancial and corporate restructuring. The reason is emerging-market banking crisis. Public sector involve- clear: with the crisis deepening daily, these countries ment has been much higher than anticipated: while did not have the luxury of spending months designing restructuring, governments nationalized many weak an optimal reform program. Nonetheless, there are financial institutions. Although all the region’s gov- several lessons to be learned. ernments have placed a high priority on divesting state-owned banks and assets, willing and qualified Synchronizing Restructuring Efforts. In every crisis buyers have been scarce. Consequently, the restruc- country, the restructuring process began with banks. turing process will likely require a further infusion of Balance sheets were cleaned up and capital bases public money (see table 1.3). strengthened so these banks could take charge of re- The strength of the crisis countries’ public com- structuring ailing firms. Unfortunately, this strategy did mitment to structural, financial, and corporate reform not work, as banks were ill-prepared to lead the cor- may have contributed to their economic recovery. porate restructuring efforts. Their main priority was Market confidence—and hence the return of foreign to avoid a further deterioration of their assets by direct and portfolio investment—has been boosted by becoming more conservative in lending and asset the expectation that Asia will emerge from the crisis management and sharply scaling back normal inter- Table 1.3 Fiscal Costs of Recapitalization, Selected Crisis Countries, Mid-October 1999 (percent of 1998 GDP) Cost Indonesia Korea Malaysia Thailand Estimated recapitalization cost 58.3 16.0 10.0 31.9 Funds disbursed 10.6 12.5 4.2 23.9 Expected additional costs 47.7 3.6 5.8 8.0 Source: World Bank (1999a). 32 ASIAN DEVELOPMENT OUTLOOK 2000 Box 1.6 Trend of Foreign Direct Investment in Crisis Countries Foreign direct investment (FDI) has been abolished, allowing foreign now also allowed to distribute their long been an important source of investors to buy as much as products domestically. external finance in developing Asia. 100 percent of a local firm. The In Malaysia, restrictions on It also proved to be much more Foreign Investment Promotion Act foreign holdings in new export- stable than other forms of capital provides comprehensive legal oriented manufacturing projects have flows during the crisis. In been suspended until 2000 1998 and 1999, net FDI and foreign ownership flows into the five worst- limits have also been hit countries—Indonesia, relaxed. Indonesia has just Korea, Malaysia, begun implementing new Philippines, and incentives to attract Thailand—slightly foreign investors, increased from the 1997 increasing the maximum level of $17.5 billion. foreign ownership of banks However, individual to 99 percent, while the countries fared differently. authorities have provided FDI inflows into Korea a clearer legal framework were $2.8 billion in 1997, for the conversion of $5.5 billion in 1998, and bonds issued locally into $8.5 billion in 1999. FDI equity. inflows into Malaysia for Since the financial the same years were crisis, cross-border mergers $5.1 billion, $3.7 billion, and acquisitions, as and $3.8 billion. This opposed to greenfield difference, in large part, investments, have become reflected different the most important mode attitudes by the crisis- of FDI in the five crisis affected countries toward countries. Cross-border the role that FDI should majority-owned mergers play in corporate and and acquisitions reached financial reform. an annual average value of FDI can be important $12 billion in 1998 and in financial and corporate 1999, as compared with restructuring. By investing $1 billion annually in 1994- in, or acquiring, distressed 1996. Opportunities for companies or banks, cheap acquisitions and a foreign investors provide crucial new protection for foreign investors in more liberal environment for FDI capital as well as managerial Korea. Thailand also allows foreign have attracted foreign investors. In resources. Several countries in the investors to hold as much as 100 addition to strengthening the rights region have made specific efforts to percent equity in domestic banks and of foreign investors, the crisis- attract FDI, with Korea and finance companies for as long as ten affected countries have tried to Thailand the most prominent. Korea years, while 39 industrial sectors have simplify procedures for mergers and has opened several sectors to foreign been opened to increased foreign acquisitions, revamped their investors, including property, participation. Majority foreign-owned bankruptcy laws, introduced short- securities dealing, and other financial companies (with the foreign investor term tax measures to facilitate asset businesses. Restrictions limiting holding more than 50 percent of the transfer, and improved accounting foreign ownership of equity have voting securities of the business) are standards to ease asset valuation. CORPORATE AND FINANCIAL SECTOR REFORM 33 mediary operations. This retrenchment created a vi- stroyed, this information is difficult to recreate. Simi- cious circle in which heavily indebted but viable firms larly, corporations embody organizational and social could not get credit. This, in turn, led to still more NPLs. capital that is also difficult to recreate quickly. Thus, In some countries stricter regulatory and super- to the extent possible, it is important to avoid dam- visory standards made matters even worse. In age to the credit system during bank restructuring and Thailand, for instance, banks became even more re- to minimize the erosion of social capital during cor- luctant to lend as regulatory standards were tightened. porate restructuring. Mergers and acquisitions are This exacerbated the credit crunch, creating more preferable to outright bank closure, and workouts are business failures and deepening the recession. Regu- better than outright insolvency. latory changes in equity markets worsened the prob- The crisis countries, however, did not adhere lem. Thailand’s stock exchange introduced stringent to these principles. Many financial institutions were requirements for new entrants, such as a minimum closed in the early months of the crisis without ad- number of shareholders and minimum profits for sev- equate thought about how this would affect the credit eral consecutive years, which most SMEs were un- system. Similarly, institutional and supervisory im- able to meet. Simultaneously, access to commercial provements, although well intentioned, further en- banks and finance companies was drastically reduced. dangered the credit system by making it more difficult Not only did the failure to synchronize the re- for banks to function. The countries did not, for in- structuring of banks and corporations worsen the stance, follow reform policies that would encourage region’s recession, but it also left banks extremely frag- mergers by liberalizing domestic laws to make foreign ile. The balance sheets of recapitalized banks could takeovers easier. In several cases, reform efforts un- easily deteriorate again, depending on the outcome dermined the rights of secured creditors. of corporate workouts. Although identifying all troubled firms and accurately forecasting how many Considering Local Circumstances. All the crisis coun- will be able to survive the crisis are difficult, a com- tries relied heavily on voluntary, out-of-court settle- prehensive restructuring strategy based on a clear as- ments for corporate restructuring, the hallmark of the sessment of the corporate and financial sectors would London approach. Given the absence of well- avoid the costs of repeated bank restructuring. functioning bankruptcy courts, this was perhaps in- evitable. Within this framework, however, the Articulating Methods and Goals. While financial sec- government was expected to play the role of mediator, tor restructuring efforts benefited from a clear body facilitating an orderly resolution, while banks, as of international experience, few precedents were creditors, managed the workout. Given their available for corporate restructuring of the scale and undercapitalization and the heavy burden of NPLs, type necessary. As a result, the process was confused. banks did not play their part, particularly in Indonesia Policymakers did not understand why the so-called and Thailand. The large role played by foreign-based London approach was deemed appropriate for work- accounting firms, consulting agencies, and investment ing out corporate debt, why it was so critical to re- banks also complicated matters. Naturally, these firms duce debt-equity ratios in the short term, or why followed international standards for accountancy and certain corporate structures were considered supe- due diligence, which were often more stringent than rior. For instance, the breakup of the chaebols was traditional local standards. The new and tougher deemed desirable, but reformers could not recom- criteria made it difficult for the lead banks and mend what industrial organization should replace corporations to reach agreement on debt workouts. Korea’s chaebol-dominated system. As a result, the London approach had only mixed success, and corporate reform has been slow. Minimizing Damage to Credit System. A properly functioning credit system is the nerve system of an Using Intermediary Institutions. The crisis countries economy. It contains the most important financial and had few intermediary institutions, such as investment industrial information of the private sector. Once de- banks, to facilitate mergers and acquisitions. Instead 34 ASIAN DEVELOPMENT OUTLOOK 2000 commercial banks, which specialized in providing institutions. Little attention, however, has been paid short-term working capital, led the corporate restruc- to disposing of those bad assets that were bought by turing effort. Not surprisingly, results were disappoint- or transferred to AMCs. The short-term reform agenda ing. Instead of evaluating project viability and needs to focus on AMCs and disposing of their assets. debt-service capability, commercial banks were more It also needs to foster further improvements in the inclined to recover as much of their loans as possible, related regulatory environment. if necessary by foreclosing on assets clients had pledged All the crisis economies except Thailand estab- as collateral. If they could not recover collateral, the lished centralized government-supported AMCs, to commercial banks kept the NPLs on their books and which NPLs were transferred. By the end of 1999, two continued to provide short-term emergency financ- thirds of NPLs in Indonesia had been transferred to ing to avoid further losses. its Asset Management Unit. In Korea and Malaysia, the share was 50 percent. However, the proportion of Participating in Reform. Beyond these specific les- NPLs actually resolved or disposed of is far lower (see sons for financial and corporate restructuring, broader table 1.4). In Korea less than 5 percent of NPLs held lessons for reform can be learned. Perhaps the most by the Korea Asset Management Corporation have important is the need for reforms to be “owned” by been resolved, and the share is less than 1 percent in countries themselves. Only when a country owns a Indonesia and Malaysia. The vast majority of the NPLs reform program does it act in a cost-effective manner are still carried on the government’s books, at sub- that bears results. Korea stands out as a country whose stantial fiscal cost. reform program bore the hallmarks of ownership: com- Improving the regulatory framework can speed mitted and strong political leadership, inclusiveness, the resolution of the AMCs’ portfolios. The purchase, broad participation, and democratic decisionmaking. transfer, management, and sale of assets must be easier. In particular, rules surrounding transfer taxes and THE NEXT STEPS: recognizing losses from the sale need improvement. TASKS SHORT–TERM T ASKS A second approach is to increase private sector parti- cipation in restructuring. This helps reduce the The crisis countries have made significant, if inter- government’s fiscal obligation and ensure that the mittent, progress toward financial and corporate re- AMCs are as commercial as possible. At the very least, form. However, there is much more to be done. The operations need to be market-driven, efficient, and biggest risk facing the region is complacency. As mar- kets recover and foreign investors return, the momen- tum for further reform is weakened. With the growing opposition from vested interests, the risks of backtrack- Table 1.4 Operations of Asset ing are high. Management Companies, Selected Slowing or halting the reform process would have Crisis Countries, January 2000 serious consequences: it would erode investor confi- dence, waste the enormous resources already ex- pended, lose an invaluable opportunity to modernize NPLs to AMCs % NPLs disposed of Asia’s financial and corporate sectors, and reduce the Country % total % GDP by AMC region’s growth potential. The region has much to do, including strengthening the ongoing reforms and im- Indonesia 66 35 0.7 proving the governance process. Korea 50 20 4.7 Malaysia 50 14 0.1 Strengthen Ongoing Reforms AMC Asset management company. NPL Nonperforming loan. The focus of the restructuring effort so far has been Source: Staff estimates. on resolving NPLs and recapitalizing weak financial CORPORATE AND FINANCIAL SECTOR REFORM 35 transparent. Encouraging direct private participation reforms take time, however, as their goal is an entirely in AMCs would also be useful. All the AMCs increas- new corporate framework and culture. ingly are employing the expertise of private firms to With the assistance of multilateral financial in- value assets and develop disposal strategies. Malaysia stitutions, notably the Asian Development Bank, the is considering contracting out a proportion of its IMF, and the World Bank, the crisis countries have nonperforming assets to private management. In 1999, focused reform actions on increasing the transparency the Korean Asset Management Corporation of economic and financial data, strengthening corpo- announced plans to establish joint ventures with for- rate disclosure requirements, increasing accountabil- eign investors to dispose of nonperforming assets. Each ity to shareholders, strengthening competition laws, joint venture has about W300 billion in assets, with privatizing state-owned enterprises, dismantling state- the foreign share at 65 percent. However, even with supported monopolies and cartels, and restructuring this foreign participation, asset disposal has been opaque corporate relations. extremely slow. The crisis countries have made significant Many aspects of the region’s regulatory frame- progress toward improving corporate and financial work need further improvement. The most crucial is governance. Rights of minority shareholders and providing mechanisms that give early warning of pend- broader stakeholders are better protected, and share- ing trouble in financial institutions. Laws should re- holders, including minority ones, are treated more quire supervisory agencies to provide effective early fairly. Active cooperation between stakeholders and warning mechanisms and take prompt corrective ac- corporations is encouraged. Emphasis has been re- tions to minimize the risk of financial crisis. For ex- newed on the responsibility of the board to give stra- ample, when a bank’s capital adequacy ratio declines, tegic guidance, monitor management effectively, and the bank should automatically fall under greater regu- provide accountability to stakeholders. Disclosure of latory scrutiny with tight restrictions on its activities. information, for instance, on a firm’s financial status, More broadly, prudential standards need im- performance, and ownership structure is now quicker provement because they are well below international and more accurate. In Korea, firms must provide con- norms. Bankruptcy and foreclosure laws need to be solidated financial statements. In Malaysia, individu- amended to facilitate seizing debtors’ assets and re- als are restricted to a maximum of ten directorships in duce the need to resort to the judicial process. Bank publicly listed companies, and firms are required to secrecy laws may need loosening to increase financial provide quarterly financial statements. transparency and discourage the flow of corrupt funds Despite this progress, more efforts are needed into the region’s financial centers. Given that finan- to establish a modern legal and regulatory framework, cial and corporate activities are increasingly interre- reduce the risk of bureaucratic and corruption-prone lated, an integrated approach to supervisory functions administrative procedures, reform the ownership is needed. structure of large business groups, adopt modern finan- cial management techniques, and reduce corruption. Improve Governance Corruption is a serious systemic problem in some countries. It can involve either monopolistic “crony It is now widely recognized that poor governance was capitalist” firms or the rent-seeking bureaucracies that a major weakness in the region’s financial and corpo- extract bribes, called rents, in return for licensing privi- rate sectors. Symptoms include intricate formal and leges. Crony capitalist firms are best addressed through informal relationships between governments, financial a well- designed privatization program. The institutions, and corporations; inadequate disclosure rent-seeking corruption is more entrenched and more requirements; and widespread corruption and favor- difficult to eradicate, and ill-planned efforts to do so itism. A major focus of the reform effort has been could increase inefficiency. To mitigate these risks, gov- strengthening governance by improving market disci- ernance reforms should be carefully formulated and pline and corporate governance, as well as introduc- implemented. Reforms must take into account a ing anticorruption and competition policies. Such country’s individual circumstances—its legal, judiciary, 36 ASIAN DEVELOPMENT OUTLOOK 2000 and civil service systems; regulatory standards; cor- Philippines, deficits are unlikely to deteriorate further porate governance; and industrial organization—as if domestic interest rates remain low and economic well as its capacity to implement changes. recovery continues. Nonetheless, existing fiscal imbalance must be SOLVING SOLVING PROBLEMS: remedied over the medium term. Otherwise, economic THE L ONGER-TERM T ASKS LONGER- ONGER-TERM TASKS recovery will be stymied as private investment is crowded out and debt-servicing requirements impede Before the onset of the financial crisis, the region’s the public sector’s infrastructure development. Thus, economies enjoyed strong fiscal positions, and budget the countries should place high priority on reducing surpluses were the norm. When the crisis first hit, fis- fiscal imbalances as soon as possible. They could gen- cal policies were kept tight, but that has changed. All erate additional revenues by privatizing nationalized the crisis-affected countries have spent massive fiscal banks and state-owned enterprises, and selling finan- resources on financial restructuring, including buying cial assets in the publicly owned AMCs. Attracting NPLs, recapitalizing insolvent banks, and protecting more domestic and foreign private investment into depositors and creditors. Public spending also has in- the ailing financial and corporate sectors also will help creased to stimulate economic recovery and provide alleviate the fiscal burden. So, too, will more consis- social safety nets for the poor and vulnerable. Fiscal tent efforts to recover defaulted bank loans through deficits have risen substantially and public debt has systematic investigations into corporations’ uses of accumulated (see table 1.5 and box 1.7). such loans. To ensure equitable distribution of the Reduce Fiscal Imbalances restructuring burden, costs should be allocated to reflect the division of responsibility for the problem. Debt accumulation was greater in Indonesia, If a financial institution’s problems are due largely to Korea, and Malaysia, where the financial restructuring government intervention in directing credit to was government-led, than in Thailand, which adopted particular borrowers, then the government should bear a market-based approach. Indonesia and Thailand, a larger part of the costs. If, however, banks’ losses are where restructuring is still at a relatively early stage, largely due to their own commercial mistakes, bank are likely to suffer large fiscal deficits in 2000 com- shareholders and managers should absorb most of pared with precrisis levels. In Korea, Malaysia, and the costs. Table 1.5 Fiscal Balance Before and After the Crisis: Crisis Countries, 1994-2000 (percentage of GDP) Country 1994 1995 1996 1997 1998 1999 2000 Indonesia 0.4 0.6 0.2 0.0 -3.7 -2.3 -5.0 Korea 0.4 0.3 0.3 -1.5 -4.2 -2.9 -2.8 Malaysia 2.3 0.8 0.7 2.6 -1.5 -3.8 -2.0 Philippines 1.0 0.6 0.3 0.1 -1.8 -3.6 -1.8 Thailand 1.9 3.0 2.4 -0.9 -3.4 -3.0 -3.0 Note: Figures for 1999 and 2000 are staff estimates. Source: Statistical Appendix. CORPORATE AND FINANCIAL SECTOR REFORM 37 Box 1.7 Fiscal Deficits, Public Debt, and Development Policies A history of prudent the existence of higher fiscal policy meant that Fiscal Balance and Money Supply Growth interest rates and a Asia’s developing of Developing Countries, Ranked by Inflation Rates, crowding-out effect in the countries entered the Various Years (percent) bond market. financial crisis with Second, if the extremely low public Average fiscal Average money government bond market debt. The ratios of Economy balance/GDP supply (M2) growth is not developed (as in public debt to GDP in Asia’s crisis countries), the crisis countries were Developing countries: 1983-1989 high level of public debt around 20-30 percent 28 countries with less than can impair the at the end of 1997, 6% inflation (average 3.2%) -4.8 9.8 development of the 31 countries with 6-15% inflation compared with an (average 9.3%) -5.5 15.4 financial markets. Because average of 70 percent 29 countries with more than Asian bond markets are at for Organisation for 15% inflation (average 84.8%) -6.9 81.9 their early stages, Economic Co-operation Selected DMCs: 1980-1998 governments might be 5 countries with less than and Development tempted to try to force 6% inflation (average 4.3%) 0.3 16.5 member countries. 11 countries with 6-15% financial institutions to Since then, however, inflation (average 9.6%) -5.0 20.8 purchase government the size of public debt 5 countries with more than bonds at higher prices. has surged. Korea’s 15% inflation (average 37.1%) -5.8 60.3 Such financial repression public debt almost DMCs Developing member countries. can restrict the portfolios tripled from W37 trillion Note:Selected DMCs exclude the Central Asian republics and the Pacific of financial institutions to W94 trillion between DMCs. and distort the market Sources: IMF (1990); ADB data. 1997 and 1999, even interest rate structure. though it remained at a Third, government’s relatively modest 19 percent of development effort could be GDP. In Thailand, the public Fiscal Balance and Development crippled. Interest payments on a debt-to-GDP ratio jumped from Performance of Selected Economies, large stock of public debt could 6.3 percent in 1997 to 21 1981-1999 (percent) constrain fiscal expenditure, and percent at the end of prevent governments from Fiscal GDP Inflation September 1999. Public debt balance/GDP growth rate rate focusing on the improvement of was relatively stable in public services and investments in Malaysia, although at a NIEs 0.7 7.1 5.0 physical and social infrastructure. somewhat higher level of India -6.7 6.0 9.1 Moreover, a rising interest burden 38 percent at the end of Pakistan -6.8 5.4 8.5 can easily allow public debt to September 1999. By contrast, Sri Lanka -11.2 4.7 11.6 spiral out of control. It was this in Indonesia and Philippines, Argentina -2.3 2.1 414.1 realization that led the major the debt-to-GDP ratio is Brazil -7.3 2.5 602.2 industrial countries to make fiscal expected to reach 95 and 58 Mexico -4.8 2.7 45.2 consolidation a priority when percent, respectively, by the NIEs Newly industrialized economies. their ratios of fiscal deficit to GDP end of 2000 and 1999. Note: The three Latin American countries cover 1980-1998; reached 5-10 percent and ratios of Excessive accumulation of their fiscal balance/GDP covers 1980-1997. public debt to GDP Source: ADB data. public debt can affect financial reached 50-60 percent. markets and government’s Compared with developed development effort adversely in countries, the ratios of public debt three ways. First, if the central to GDP in Asian crisis countries bank monetizes fiscal deficits, concluded that countries with higher are, on average, still low. However, this inflationary expectations and market fiscal deficits and public debt should not be a reason for complacency. interest rates will increase. Based on a experienced higher monetary Instead, each government should plan study of 88 developing countries, the expansion and inflation (1990). Borio to initiate a fiscal consolidation International Monetary Fund and McCauley (1996) also confirmed exercise as quickly as possible. 38 ASIAN DEVELOPMENT OUTLOOK 2000 Develop Financial Markets tion and market orientation in the financial sector by increasing operational efficiency, developing human It is generally agreed that one of the major causes of resources, maximizing synergy between various sub- the region’s financial crisis was excessive reliance on sectors, and facilitating resource mobilization. It should short-term bank loans from abroad to facilitate long- cover the banking sector, nonbank credit institutions, term investments at home and abroad. Asian finance insurance sector, capital markets, and newer financial has traditionally been overwhelmingly bank-based, institutions such as venture capital entities. Thailand and that must change (see figure 1.10). An important has begun working on a long-term blueprint for the lesson from the crisis is that it is urgent to develop structure of the overall financial sector. domestic financial markets that can efficiently allo- All types of long-term financial markets— cate domestic savings to long-term projects. There- equity, bond, and insurance—need to be fostered. fore, the crisis countries need to modernize and However, bond markets deserve particular attention develop their capital markets, particularly bond mar- because they have long been neglected, while efforts kets, and maximize the efficiency with which long- at developing equity markets began long before the term savings are channeled into profitable industrial crisis. Bond markets were underdeveloped for several and infrastructure projects. reasons: persistent government surpluses meant that A financial sector development strategy is a use- the region’s countries had little, if any, outstanding ful way to prepare for this kind of fundamental change. government debt. Therefore, there was no benchmark The strategy should aim to ensure greater diversifica- yield curve of returns on safe government debt, mak- CORPORATE AND FINANCIAL SECTOR REFORM 39 ing it difficult to price other bonds. The investor base should follow, and corporate bond markets will for bonds was limited; the market infrastructure was develop. In 1999, Asia-Pacific Economic Cooperation inadequate. Moreover, weak corporate governance provided guidelines to facilitate the development and underdeveloped regulatory and supervisory ar- of domestic bond markets in member countries rangements reduced the attractiveness of corporate (see box 1.8). bonds. As a result, the markets for corporate bonds and asset-backed securities were particularly stunted. CONCL USION CONCLUSION According to a 1999 survey by the Asia-Pacific Economic Cooperation Council, outstanding bonds The financial sector was the weakest link in Asian in member countries, excluding Japan and the United economies. Excessive government intervention, over- States, on average represented only 34 percent of GDP. reliance on banks, and pervasive crony capitalism Once Japan and the United States were included, the hampered innovation and distorted incentives. average rose to 105 percent. Sustainability of the region’s short-term recovery, as Given the rudimentary nature of domestic bond well as its long-term economic future, rests largely on markets, a gradual approach is desirable. First, the how effectively and comprehensively the financial and market for primary government securities issues must corporate sectors can be restructured. This will first be developed. Then a secondary market for these issues entail cleaning up from the crisis. Corporate restruc- Box 1.8 Recommendations for Developing Bond Markets In August 1999, Asia-Pacific Economic approach to the bond market regulatory regime and risk- Cooperation presented policy development. management procedures, and provide recommendations for the On the regulatory framework, the relevant information to participants development of domestic bond report emphasized several issues: on a timely basis. To ensure the markets, which focused on five key (a) full, timely, and accurate disclosure liquidity of domestic bonds, it is areas: government policies, of information; (b) objective criteria to crucial to have accurate and reliable regulatory framework, market differentiate between public offering benchmark yield curves, transparency infrastructure, liquidity, and risk and private placement and to in the primary and secondary management. Government policies distinguish sophisticated institutional markets, low transaction costs, were to emphasize these elements: investors from other investors; diverse groups of market participants, (a) striking a balance between (c) good governance principles for and the gradual creation of sovereign debt management policy institutional investors and contractual derivatives markets. and a strategy for domestic bond savings institutions; (d) clarity in the To promote effective risk market development; (b) developing roles, responsibilities, and objectives management, the report proposed a comprehensive bond market of the regulatory authorities; identifying risks of the bond development strategy; (c) creating a (e) transparency in trading and program, maintaining a debt profile, sound legal framework; (d) ensuring price reporting; and (f) sound risk sharing between government a level playing field with consistent criteria for external credit and private issues, ensuring sound tax policies for all financial assessment institutions. investment and risk management instruments and market The report made important policies by bond investors, participants; (e) maintaining suggestions on market infrastructure, preventing issuance through consistency between the bond liquidity, and risk management. To unregulated channels, avoiding market development strategy, fiscal develop market infrastructure, it is overreliance on credit rating, and monetary policies, and the essential to ensure clear rules and keeping credit rating agency financial sector development procedures that can be legally assessments, and keeping credit strategy; and (f) using a phased enforced, create an effective rating agencies credible. Source: APEC (1999). 40 ASIAN DEVELOPMENT OUTLOOK 2000 turing, especially, must be accelerated, while setting regulatory standards, but it should not become nonperforming assets must be disposed of. At the same directly involved in allocating capital. A diverse and time, the crisis countries must pay more attention to largely private financial system within a well- the foundations of their future financial system. A 21st constructed regulatory and supervisory framework century financial system requires a different role for allocates resources most efficiently and safely. The government. The public sector can and must play an region’s prosperity depends on how quickly and effec- important role in overcoming coordination failures and tively such a financial system can be created.
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