FRBSF Economic Letter
2000-38; December 29, 2000
East Asia: Recovery and Restructuring
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.
Conclusions
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
Reference
The World Bank. 2000. East Asia Brief (September).
Opinions expressed in this newsletter 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. Editorial
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