Financial Sector Reform in Malaysia by yul68574


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									                                  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

                                              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
   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.
              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 PROBLEMS:                                      remedied over the medium term. Otherwise, economic
               THE L ONGER-TERM T ASKS
                     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
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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