The Implications of the Next Phases of the Crisis

The Prospects of the Financial Sector. The IMF's Regional Economic Outlook: Asia and Pacific (IMF 2009b) argues that the risk of corporate defaults is unusually high, but much lower than that which prevailed during the Asian crisis. Therefore, the report concludes that the impact of the crisis on the corporate and banking sectors is likely to be significant but manageable. It estimates that losses to creditors (excluding shareholders) from defaults in Asia as a whole could amount to about 2% of GDP, while bank losses could amount to about 1.3% of their assets. The main reason the risks are manageable is that the corporate sector entered the crisis in robust health, with low leverage ratios and high profitability. These findings, however, are based on a scenario in which Asia's economy stabilizes and then recovers gradually. In any event, a decisive start is needed to address the banking problems and corporate restructuring.

Credit Slowdown. It is important to realize that the consequences of the crisis will be with us for a long time. For instance, the IMF (2009b) forecasts that the Asian economy as a whole will grow 1.3% this year, a marked decline from previous years. It is also important to remember what happened in Indonesia, Korea, and Thailand during the crisis in 1997. An IMF study of 40 episodes of financial crisis puts the average fiscal costs associated with resolving financial crises at 16% of GDP (Laeven and Valencia 2008). In Indonesia, for example, the share of nonperforming loans at the peak was 32.5%; the gross fiscal cost of the crisis was 56.8% of GDP; the output loss was 67.9% of GDP; the minimum real GDP growth rate was -13.1%. The initial nonperforming loan recovery effort was weak. While I am not suggesting that a crisis is likely in East Asia, the current global crisis will have consequences for East Asia. In a recent seminal paper, Reinhart and Rogoff (2008: 3) found:

that the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate climbs an average of 7 percentage points over the down phase of the cycle, which lasts, on average, more than four years. Output falls (from peak to trough) an average of more than 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than the duration of unemployment. Third, the real value of government debt tends to explode, rising an average of 86% in the major post– World War II episodes.

Following on Reinhart and Rogoff's (2008) methodology in examining the impact of crises, I examined the evolution of private sector credit in the aftermath of a crisis along three aspects: the time it took for credit growth to resume, the time it took the nominal value of credit to exceed the level preceding the crisis (based on local currency value), and the time it took the ratio of credit to GDP to recover to the pre-crisis level (Table 11 [ PDF 11.6KB | 1 page ]). On average, it took 14.5 quarters or more than three and a half years, for credit to resume growing. In 8 of 15 countries studied, the ratio of credit to GDP never recovered to the pre-crisis level. For example, in the US, it took 60 quarters (15 years) for the ratio of credit to GDP to recover to the level preceding the second quarter of 1990, which was the last quarter of sustainable growth. The result seems to suggest that, if a country suffers a sustainable decline during a crisis period, then nominal credit is going to take many quarters or years to recover to the level prior to the crisis, and the time for the ratio of credit to GDP (depth) to recover will be even longer, if ever. If history is any guide, worldwide credit will not recover anytime soon.

Are Nonbank Financial Institutions Capable of Picking Up the Slack in Banking?

In a now famous speech, "Lessons from the Global Crises," Alan Greenspan (Greenspan 1999) said,

With the benefit of hindsight, we have been endeavoring for nearly two years to distill the critical lessons from the global crises of 1997 and 1998. … Before the crisis broke, there was little reason to question the three decades of phenomenally solid East Asian economic growth, largely financed through the banking system, so long as the rapidly expanding economies and bank credit kept the ratio of nonperforming loans to total bank assets low. The failure to have backup forms of intermediation was of little consequence. The lack of a spare tire is of no concern if you do not get a flat. … East Asia had no spare tires. The United States did in 1990 and again in 1998. Banks, being highly leveraged institutions, have, throughout their history, periodically fallen into crisis. Where there was no backup, they pulled their economies down with them.

Banks are a major source of debt finance, but relying solely on bank loans is neither sufficient nor desirable for meeting long-term financing. Equity and debt markets also need to provide long-term finance. In this context, it is instructional to review the capacity of the nonbank financial institutions to pick up the slack in the banking system. This section reviews each major segment of East Asia's nonbank financial institution sector—notably, the supply side (equity and bond markets) and the demand side (mutual funds, pension funds, and insurance companies)—to assess the state of the segment, the role it plays, and its capacity to supply credit. The conclusions are that only Korea has a vibrant nonbank financial institution sector, with adequate demand and supply. Only Malaysia and Thailand have a mutual fund industry with adequate depth.

Supply Side. Private sector-led economic growth requires well-functioning equity and corporate bond markets as a source of risk capital to encourage entrepreneurship and provide the corporate sector with an alternative to bank finance. Sound capital markets also reduce the vulnerability of the economy to stresses in the banking sector. With some exceptions, however, the capital markets in East Asia are not a major source of risk capital (Table 12 [ PDF 11KB | 1 page ]).The equity markets offer limited opportunities to issuers in the domestic market. Investors struggle with limited information and low liquidity in the securities markets.

Only Korea demonstrates a sustained ability to mobilize new capital, mobilizing 8.8% in 2007. Other countries in the region—the PRC (1.8%), Indonesia (0.1%), Malaysia (0.6%), and Thailand (3.0%)—do not have the same capacity to mobilize fresh equity capital (Table 13 [ PDF 11KB | 1 page ]).

Demand Side. Institutional investors such as mutual funds, pension funds, and insurance companies are a critical source of demand for bonds.

Despite its recent growth, Asia's mutual fund industry has weak fundamentals and is small compared with regional and global markets (Table 14 [ PDF 9.9KB | 1 page ]). Mutual fund assets (as a % of GDP), however, are large in Thailand (21.1%) and in Malaysia (24.7%). In Thailand, there is an evident deepening of the market, from 8.7% in 2000 to 21.1% in 2007. The market in Malaysia also has grown rapidly from 18.4% in 2004 to 24.7% in 2007. While governments in the region have established regulatory structures, the absence of enforcement to protect investors causes problems, such as the mutual funds crisis in Indonesia. Despite extensive rules, disclosure is inadequate in the areas of investment policy and the calculation of net asset value, sales procedures are poor, and the valuation of linked products has no governing rules. Many of the largest mutual funds do not follow international norms of valuation (e.g., Indonesia).

The pension industry in Asia is small (Table 15 [ PDF 9.9KB | 1 page ]). Pension assets constitute only 2.3% of GDP in Indonesia and 5.2% in Thailand. Two notable exceptions are Korea and Malaysia, where pension assets constitute 24.4% and 51.2% of GDP, respectively. If governments in the region would make a concerted effort to reform the industry and promote pension funds, then the potential to mobilize domestic resources would be great.

The insurance sector is small as well (Table 16 [ PDF 12.4KB | 1 page ]). Again, the two notable exceptions are Korea, where pension assets are 40.1% of GDP, and Malaysia, where they are 20.9%. In Indonesia, for instance, they are 5.8% of GDP, 10 firms control more than three-quarters of assets, and five life insurers serve 48% of the population. Many small insurers are undercapitalized and likely to withstand losses in the future. For example, in Indonesia more than half of new sales replace business lost during the year, and of the business lost, close to 95% of terminations are due to lapses in payment and surrenders. Indonesia's insurance business does not offer products that consumers want, and Indonesian consumers lack confidence in long-term commitments.

The IMF (2009b) warns that corporate defaults are likely to increase in emerging markets. Emerging economies have US$1.8 trillion in corporate debt that must be rolled over in 2009, and the threat of defaults is rising to "dangerous levels." According to the IMF report, "Dealing with corporate bankruptcies will be a major challenge in the advanced economies, but an even greater threat lies in the corporate sector in emerging economies." (IMF 2009b) Not only has the global financial crisis constrained bank lending, but these countries have been hurt by hedge funds and other investors who have pulled money out of emerging markets, either to lower their own exposure to risk or to raise cash to meet redemption requests. While Asia has been less reliant on external financing than some other regions, reversals are evident in countries such as Korea. Similarly, the IMF (2009b) points out considerable corporate risks arising from the global financial crisis, although the impact on corporate sector finances in Asia is not known. The data in the available databases, such as Worldscope or Amadeus, are not timely enough to assess the impact on the corporate sector. However, many countries in the region, such as Korea and Malaysia, undertook significant corporate financial restructuring after the 1997 crisis. In Korea, Malaysia, and Thailand, based on the financial indicators, the corporate sectors are robust. There has been a marked transformation in financial practices in East Asia. These sounder corporate financial practices bode well for financial stability.

In this context, it is important to remember the past in order not to be condemned to repeat it. Amid all the discussion today about fragility in the global banking sectors, few are discussing the role that corporate restructuring must play in restoring health to both the real economy and the financial sector. Yet this is one of the key lessons that should have been learned from the record of earlier crises over the last couple of decades. It should come as no surprise that, during recessions, the declines in output and corporate profitability will likely spread, leading to corporate distress and possible insolvencies. The banking sector is a mirror image of the corporate sector, and the quality of assets in the banking system can not be better than the quality of liabilities in the corporate sector. To the extent that the corporate sector is fragile—i.e., overleveraged and unprofitable—the assets of the banking sector are poor. Therefore, corporate distress is both a symptom as well as a cause of economic weakness. There is a risk that the recent recapitalization of the banking sector will fail to achieve its intended objectives, because none of the measures addresses the depth of corporate distress.

For example, corporate financial fragility preceded the Asian financial crisis. There is no easy remedy to cure systemic corporate distress. Coping with it requires a host of simultaneous measures, such as financial engineering techniques (massive debt/equity swaps and loan haircuts), tax incentives for restructuring, policy approaches to the disposal of bad debts (such as the creation of "good bank/bad bank" structures), effective bankruptcy courts, and the establishment of procedures for out-of-court workouts. In particular, countries need to gear up for large-scale corporate restructuring under a government-sponsored or industry-sponsored out-of-court process—the so-called London approach.⁵

During the Asian crisis, government interventions in corporate restructuring were very effective in restoring the corporate sector to stability in the aftermath of a crisis. For example, Korea's enforcement of benchmarks for corporate deleveraging stipulated that banks could not lend to corporations that did not meet these targets or to government agencies that purchased nonperforming loans, which thereby became creditors of bankrupt companies and perforce involved in their restructuring. In this context, the government strategy for dealing with corporate restructuring is critical to the prospects for the recovery from a systemic crisis. Similarly, Malaysia's demonstrated success during the Asian crisis is a good model to follow for tackling corporate and bank restructuring in unison. The National Economic Action Council in Malaysia, created in January 1998 as a high-level consultative body (including the Prime Minister and Governor of the Central Bank), formulated an agenda for comprehensive restructuring of the banking and corporate sectors. Three agencies— Danaharta, Danamodal Nasional Berhad (Danamodal), and the Corporate Debt Restructuring Committee (CDRC)—were established with these planned roles: Danaharta was established as an asset management company with functions similar to those of the US Resolution Trust Corporation; Danamodal was established to recapitalize the banking sector, especially to assist banks whose capital base had been eroded by losses; and the CDRC was established to reduce stress on the banking system and to repair the financial and operational positions of corporate borrowers. These three agencies linked their efforts effectively. A bank in trouble because of a huge amount of bad loans on its books could ask Danaharta to sell its nonperforming loans. Thereafter, if the bank was still in financial trouble and the shareholders could not recapitalize, the bank could seek financial assistance from Danamodal, in return for a stake in the company. Effectively, new money would be injected into the bank, diluting the original shareholders. This meant that Danamodal could facilitate consolidation of the sector by selling its stake to a stronger bank and thereby fostering mergers. Meanwhile, CDRC acted as an informal mediator, facilitating dialogue between borrowers and their creditors to achieve voluntary restructuring schemes. If CDRC could achieve this, then nonperforming loans would be resolved voluntarily. If not, Danaharta would take over the bad loans.

Unfortunately, in several countries, including Indonesia, Malaysia, and Thailand, the entire corporate restructuring infrastructure was dismantled after the crisis. It might be desirable to consider this experience going forward.

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