December 29, 2000

East Asia: Recovery and Restructuring

Ramon Moreno

Pacific Basin Notes. This series appears on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies within the FRBSF’s Economic Research Department.

More than three years have passed since the collapse of the Thai baht triggered a wave of currency and financial crises in East Asia. After experiencing sharp economic contraction in 1998, East Asian economies have rebounded strongly, buttressed by rapid growth in their exports to the United States. While the early recovery is laudable, questions still remain about whether it will last and, in particular, whether a number of these economies will be able to weather external shocks, such as a slowdown in high-tech exports to the U.S. market. One factor that will influence the resilience of these economies is the progress made in financial sector restructuring following the crises of 1997. To shed light on this question, this Economic Letter briefly describes the features of East Asia’s recovery and its financial restructuring.

Crisis and recovery

The 1997 crises in East Asia were followed by recessions of unprecedented severity. Output declined sharply in several economies in 1998, ranging from 7% in Korea to 13% in Indonesia. However, output growth rebounded in 1999 and, according to recent Asia Pacific Consensus Forecasts, is expected to average over 7% in 2000, typical of pre-crisis growth rates.

The rapid recovery of East Asian economies is in some ways a surprise. The disruptions to the financial sector effectively wiped out the capital of many borrowers and their bank lenders. As a result, there was a severe credit crunch in which even borrowers with good projects could not get financing. Given the shortage of credit, it seemed that restoring growth and spending would require a lengthy process of repairing the financial sector by improving the balance sheets of lenders and borrowers. Instead, growth was restored relatively quickly, even before all the problems in East Asian financial sectors had been addressed.

Two explanations may be offered for the region’s rapid recovery. First, and most important, robust global demand, notably in the United States, contributed to strong export growth and the replenishment of foreign reserves. For example, in Korea, exports in U.S. dollars fell over 5% in 1998 (Q4/Q4), but then grew nearly 17% in 1999 and accelerated to 22% in the second quarter of 2000, compared to a year earlier. Foreign reserves rose from $20.4 billion at the end of 1997, when the Korean won collapsed, to $92.5 billion in September 2000.

The second stimulus to growth has been expansionary fiscal policies. In an effort to repair the financial sector and attenuate the social impact of the crises, budget balances have switched from surpluses to very large deficits, leading to dramatic increases in the public debt. For example, between 1997 and 2000, the government budget in Thailand switched from near balance to a projected deficit of 7% of GDP, while the ratio of public sector debt to GDP rose from 27% to 66% (of which 21% is foreign). The estimated increase in public debt has been even higher in Indonesia, from less than 25% in 1996, to over 90% in 2000 (World Bank, 2000).

Although the recent performance of many East Asian economies has been impressive, concerns remain about how a slowdown in external demand would affect the region’s economic performance. This will depend in part on how policy responses adopted since the crises affect the operation of the financial sector. One question is the extent to which balance sheets of lenders and borrowers that were disrupted by financial crises have been put on a sounder footing, thus restoring the normal flow of credit. In particular, has the overhang of nonperforming loans been reduced? The second question is the extent to which certain institutional practices have been reformed so as to discourage risk-taking while encouraging market adjustment and competition. The answers to these questions will influence the durability of the ongoing recovery and the resilience of East Asian economies to future economic shocks.

Repairing balance sheets

The goods news is that East Asian governments have made progress in cleaning up balance sheets. Nonperforming loans have been taken off the books of banks, thus strengthening their financial position in an effort to encourage them to resume lending. These nonperforming loans have either been absorbed by the government or sold to private investors. A recent report by the World Bank (2000) provides data on the adjustment process.

Governments also have encouraged lenders and borrowers to enter negotiations to restructure existing debts or to adopt measures that facilitate foreclosure. For example, in Korea at the end of March 2000 there were 76 firms under workout programs, managing debt amounts equivalent to 9% of Korean GDP (43 trillion won). A system of prepackaged bankruptcies has been introduced, so that companies undergoing workout programs may be forced into receivership if half of the creditors agree or if creditors reach no consensus within a certain time.

Private investors also have acquired or injected capital in banks or weak borrowers. In Thailand, 314 billion baht (over US$7 billion at recent exchange rates) of private (tier 1) capital had flowed into banks by 2000. Some of the mergers or acquisitions have been particularly noteworthy, such as the takeover of a major South Korean bank by a foreign investor.

However, the adjustment process is not complete. According to the World Bank (2000), the share of nonperforming loans still held by the banking sector in Indonesia earlier this year was about 40% of total loans, compared to 9% when the crisis broke out. Another 20% of the bad loans have been absorbed by the government. In Thailand, bad loans were at 32% of total loans or higher, while in Korea they were estimated at 12%, about double what they were around the time the Korean won collapsed in 1997. Some banks in the region also face capital constraints, which reduces their ability to lend.

Financial systems in the region also remain vulnerable to poor performance and liquidity problems of heavily indebted borrowers. In Indonesia, the restructuring of corporate debt only took off this year, and borrowers are still heavily exposed to the debt denominated in foreign currency that was a major factor in the Indonesian crisis. In Korea, corporate debt-to-equity ratios have fallen significantly, but there is evidence of continued financial sector vulnerability.

Reforming institutional practices

It can be argued that while East Asia’s financial arrangements in the past contributed to rapid growth, they also provided a safety net to lenders and borrowers that reduced incentives for risk management. Risky investments in domestic property markets in Thailand, exposure to currency risk by the Indonesian corporate sector, and a highly leveraged corporate sector in Korea are examples of behavior that contributed to the widespread bankruptcies and the financial crises that beset the region in 1997 and 1998.

Ongoing efforts to improve the quality of bank supervision and regulation through institutional reforms (such as the creation of independent financial supervision entities with stronger enforcement powers and the training of regulators) are important steps in enhancing risk management. However, significant obstacles remain because traditional arrangements at times protect borrowers from the consequences of poor investment decisions.

One difficulty is that policymakers face an ongoing dilemma in dealing with firms that experience financial difficulties. The traditional response in East Asia is for the government to step in to support such institutions, for example, by encouraging lenders to roll over financing. While such measures may support economic activity in the short run, they effectively reduce the penalties for risk-taking. Indeed, the East Asian crisis revealed that the resulting imbalances may prove too large for the economic system to manage.

Another difficulty is that borrowers defaulting on their obligations have significant advantages over their creditors. A tradition of forbearance implies that creditors are expected to be patient in attempting to secure payment from borrowers. In line with this, there is a perception in a number of countries in the region that bringing bankruptcy petitions to court is not desirable or cost-effective. Through December 1999, only 37 bankruptcy liquidation or rehabilitation petitions had been filed in Thai courts out of 400,000 nonperforming debtors. In part this reflects difficulties in ensuring debtor accountability; before bankruptcy reform was enacted, defaulting debtors could avoid judgment in Thai courts simply by not showing up. Even in those cases when bankruptcy petitions have been brought to court, until recently, success by creditors in some legal jurisdictions has been limited.

There are also obstacles to full market adjustment in the process of taking over weak firms or consolidation. While some major domestic firms have been taken over, in a number of widely publicized instances serious investors have withdrawn their bids after studying the books of the takeover candidate more carefully. This suggests both a lack of transparency in the information initially made available and sale prices that are too high. In some cases, firms experiencing financial difficulties are reluctant to relinquish control or to dilute ownership and are nevertheless able to survive because of institutional arrangements that allow them to do so. They may also have ample say about the terms under which they will divest assets. In other cases, governments are holding these assets, and they appear to be reluctant to allow investors–particularly foreign ones–to acquire them at what are perceived as bargain prices. The temptation to hold on to nonperforming assets or to delay adjustment has been particularly strong in the recent past, because improved economic growth creates expectations that asset prices will eventually recover.

One consequence of this gradual adjustment is that weak firms and their creditors remain vulnerable to sudden collapse. For example, the failure of the Korean conglomerate Daewoo in 1999 forced the Korean government to intervene to preserve the stability of the Korean bond market and of investment companies that held large amounts of Daewoo debt. More recently, liquidity problems experienced by other conglomerates in Korea (such as affiliates of Hyundai, and Ssangyong) have led to fund withdrawals from investment trust companies with exposure to these firms. The large increases in public debt in some East Asian economies partly reflect the costs of delayed adjustment.

These experiences illustrate the difficulties of transition. In East Asia, requiring financial institutions or large business groups to take corrective measures involves a major reassessment of the relationship between government and business, and achieving political consensus for such drastic change is difficult. As in many instances of financial reform throughout the world, change has taken place only as awareness of the rising costs of the status quo has increased.


Since July 1997, when the Thai baht collapsed, East Asia has experienced an unprecedented economic contraction and dramatic recovery. Although adjustment is not complete, there has been significant progress made in repairing balance sheets disrupted by recent financial crises. Steps also have been taken to improve supervision and regulation. However, the biggest challenge facing East Asian policymakers is to decide how much of certain traditional institutional practices to keep, and how much to discard in favor of the systems in place in advanced market economies. This traditional system was associated with decades of rapid growth, but it also contained implicit or explicit guarantees that led to risky lending and excessive leveraging. Meeting this challenge successfully will significantly enhance the durability of the region’s ongoing recovery.

Ramon Moreno
Senior Economist


The World Bank. 2000. East Asia Brief (September).

Pacific Basin Notes are published occasionally by the Center for Pacific Basin Studies. Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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