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However, Korea had the legal framework to deal with the chaebol problems. Creditors have been able to use the courts to put the chaebol into receivership. Though the Daewoo crisis did not come to the fore until mid-1999, its creditors negotiated rate reductions, grace periods and debt – equity conversions to stabilise its debt of $80 billion, then proceed with the break-up and sale of its assets. Other chaebol have been stabilised, after debt restructuring agreements with bankers. The state also intervened, requiring gearing ratios to be reduced to at least 200%, and prohibiting cross-guarantees of chaebol members’ debt.21

The situation is quite different in Indonesia and Thailand, where corporate restructuring has been hampered by the absence of clear legal guidelines on issues such as foreclosure, the definition of insolvency and the legal rights of creditors.

žExchange rate regimes: these countries had all adopted some type of US dollar peg.22 In the absence of any serious inflation, real effective exchange rates were stable, with only a slight rise in 1995 – 96. Trade weighted exchange rates were also stable. Once the Thai baht came under pressure, and floated in July 1997, it depreciated rapidly. The other countries responded by widening their fluctuation bands (depending on the system of pegging), but the runs continued, forcing them, with the exception of Malaysia,23 to float their respective currencies. The Indonesia rupiah was floated in August; the Korean won in December. All of these governments had used their central banks to defend the currency, exhausting much of their foreign exchange reserves24 and pushing up domestic interest rates.

The financial sector

žAll of the Asian economies were bank dominated, with underdeveloped money markets. Between 1990 and 1997, bank credit grew by 18% per annum for Thailand and Indonesia, 12% for Korea. By way of contrast, credit growth averaged 4% per annum for the G-10, and was just 0.5% for the USA. By 1997, bank credit as a percentage of GDP for Thailand, Korea and Indonesia was, respectively, 105%, 64% and 57% – amounts that were close to, or in the case of Thailand above, those for developed countries. The rapid increase in the supply of credit, in the absence of the growth of profitable investment opportunities, caused interest margins to narrow (to the point that they were roughly equal to operating costs), even though riskier business loans were being made, largely in construction and property. Property was also used as collateral – soaring property prices fooled the banks into thinking the risk they faced from property-backed loans was minimal.

21This account comes from Scott (2002), pp. 61, 63.

22Hong Kong was the only economy in the region with a currency board. Ferri et al. (2001), using data on SME borrowers (1997–98), show that during a systemic banking crisis, relationship banking with the banks that survive has a positive value because it reduced liquidity problems for SMEs, and therefore made bankruptcy less likely.

23Prime Minister Mahathir of Malaysia blamed speculators for the run on the ringgit and refused to float the currency, though the band was widened.

24For example, foreign exchange reserves in Thailand amounted to about $25 billion pre-crisis, but by the time the baht was floated, the central bank had issued about $23 billion worth of forward foreign exchange contracts.

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developers. The figure for Indonesia was 25 – 30%. The problem was compounded by the use of collateral, mainly property. The loan to collateral ratios stood between 80 and 100%, creating a collateral value effect, that would further destabilise banking sectors once property (and equity) prices began to decline. The role of collateral and collateral values in models of shocks and money transmission has been emphasised by Bernanke and Gertler in various papers.28

žSome government policies could inadvertently contribute to the problem. For example, the Thai government introduced the Bangkok International Banking Facility (BIBF) in 1993, to promote Bangkok as a regional banking sector and encourage the entry of international banks. The BIBF was also used by domestic banks to diversify into international banking intermediation by obtaining offshore funds for domestic or international lending. Unfortunately, they gave Thai banks29 a new way of borrowing from abroad, using BIBF proceeds to invest heavily in property and related sectors.

žAsian banks borrowed in yen and dollars from Japan and the west, and on-lent to local firms in the domestic currency. There was little use of forward cover against the currency risk arising from these liabilities because of the relative success of the peg, up to 1997. For example, the Thai baht had not been devalued since 1984, with only slight fluctuations around the exchange rate (BT25.5:$1). Rising interest rates and a collapsing currency proved lethal. Firms could not repay their debt, and banks found it increasingly difficult to repay the principal and interest on the dollar debt. Non-performing loans as a percentage of total loans soared, especially in Thailand and Indonesia. As Table 8.7 shows, by 1998, the percentage of non-performing loans was just under 40%.

žA tradition of forbearance towards troubled banks, and the widespread impression that governments would support the banking sector – through either implicit or explicit guarantees. For example, in Indonesia, the costly and protracted closing of Bank Summa in 1992 resulted in a policy of no bank closures in the years prior to the crisis.30 Similar attitudes prevailed in all these countries. An added problem was that even if the authorities had wanted to close insolvent banks, an inadequate legal framework in most of these countries made it very difficult to force firms into insolvency.

žRegulation of the financial sector was nominal, for several reasons. First, named as opposed to analytical lending, i.e. it was the individual’s connections with the bank that mattered. There was little in the way of assessment of the feasibility of proposed projects, nor was the risk profile of the borrower evaluated. Together with a lack of staff training and expertise, it meant no modern methods of risk assessment were used by the banks. In Korea political interference meant some financial institutions were subject to unfair audits and penalties.31

žIn Thailand, the same group of top officials moved back and forth between business, the banking sector and government. Offices were run to enhance an official’s future standing,

28See for example, Bernanke and Gertler (1995).

29In December 1996, 45 financial firms were licensed to handle BIBFs, or, effectively, engage in offshore activities.

15were Thai banks and 30 were foreign banks or bank branches. The Thai banks used their BIBFs to borrow from abroad and lend locally.

30Batunaggar (2002), p. 5.

31Casserley and Gibb (1999), p. 325.

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entry, with 21 foreign banks in 1997. However, their activities were severely constrained because each one was only allowed a few branches.

žIn the Korean financial sector, activities were strictly segmented by function. Specialised banks provided credit to certain sectors, for example, the Housing and Commercial Bank, development banks (e.g. the Korea Long Term Credit Bank and the Export Import Bank), and nation-wide/regional banks. By 1997, there were eight national banks, serving the chaebol and the retail sector. Ten regional and local banks offered services to regional (or local) business and retail clients. Government influence was all pervasive. Not only did they own shares in some banks, but all executive appointments were political. There was directed lending – the government would pressure a bank to grant specific amounts of credit to firms. Political connections, not creditworthiness, was the determining factor in many bank loan decisions.

žThere were also investment institutions, which held about 20% of total assets in 1997. They were made up of merchant banks, securities firms and trusts. Merchant banks had no access to retail markets, raising their funding costs. Using funds raised by commercial paper issues, overnight deposits and US dollar loans, they invested in relatively risky assets, including risky domestic loans and Indonesian and Thai corporate bonds. Once these economies collapsed, these banks faced mounting losses. Depositors panicked, especially those who held US dollar accounts. Loan rollovers were also terminated, which forced these banks to buy US dollars.

The central bank tried to defend the won but by late 1997, had used up all of their foreign exchange reserves. An application for IMF standby credit was agreed by early December. It amounted to $21 billion over 3 years, with just under $6 billion for immediate disbursement. A few days later, the won was floated – in 6 weeks it lost 50% of its value against the US dollar.

Indonesia’s banking sector aggravated the crisis in that country. It was unique among the countries in allowing foreign bank participation. Foreign banks could own up to 85% of joint ventures. Major banking reforms came into effect in 1988, and between 1988 and 1996, the number of licensed banks grew from 20 to 240. Branch networks grew and new services were offered by banks. This stretched the supervisory services, and banks began to engage in questionable practices. There was intense competition among banks. This contributed to the rapid expansion of credit, much of it named or ‘‘connected’’, 25 – 30% of it going to the property sector, especially developers.

In 1991, prudential regulation was tightened by Bank Indonesia. Banks had to meet capital ratios, and were rated. Mergers were encouraged, but did not take place, and banks used their political connections to escape the tough new measures. From 1990, Indonesia’s private corporate (non-bank) sector borrowed heavily from overseas, with most of the debt denominated in dollars.34 By 1997, it had grown to $78 billion, exceeding the amount of sovereign external debt by close to $20 billion. Lack of confidence in the banking and corporate sectors caused the currency crisis to deepen, even after the rupiah was floated.

34 The government had stopped banks from taking on much external debt.

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8.3.2. The Contagion Effect

The Asian crisis provides a classic example of contagion. The previous section illustrates how each country had unique problems which made them prime contagion targets following the rapid decline of the currency and financial markets in Thailand. There were two dimensions: positive feedback mechanisms within each country and rapid geographical spread across national boundaries. Initially, the currency markets bore the brunt of the contagion: the currency crisis spread from Thailand to Indonesia, Malaysia, the Philippines and Korea because investors tended to group these countries together. Table 8.5 shows a degree of correlation between Thai equity prices and those in other Asian markets. The exception is Korea, where, pre-crisis, the correlation was slightly negative. Post-crisis, the correlation strengthens, especially in Korea, where it jumps to just under 60%.

Table 8.5 suggests that overseas investors will have believed that asset returns in these economies would remain positively correlated to a high degree. The currency crisis spread rapidly because of the high substitutability of many of each other’s exports, the absence of capital controls, and the perceived similarity of financial conditions. Since these countries competed with each other in world export markets to a high degree, a fall in the value of the Thai baht would mean the other currencies would have to decline to remain competitive. Traders reacted accordingly, selling these currencies in anticipation of their inevitable depreciation. The surprise depreciation wrecked the balance sheets of banks and companies with unhedged foreign exchange liabilities. High interest rates and a deteriorating economic outlook caused a steep decline in the property and equity markets. The hitherto sound loans suddenly looked problematic, causing concern about the viability of the banks with high percentages of non-performing loans, backed by collateral, the value of which was collapsing.

For these reasons, the contagion spread from the foreign exchange markets to the bank sectors very quickly. Indonesia had a history of bank problems, as was illustrated in Chapter 6.

In the absence of bank guarantees, runs on banks quickly follow and include:

žWithdrawals by depositors.

žA run on off-balance sheet products, for example, closing trust accounts, mutual funds.

žCuts in domestic and international interbank funding.

žBorrowers run down credit lines, in anticipation of not being able to do so in the future.

žFinancial assets such as equity, bonds and mutual funds are sold and any proceeds withdrawn from domestic banks.

Table 8.5 The Correlation Coefficients: Thai and Other Asian Equity Markets (weekly equity price movements)

Source: BIS (1997), table VII.7.

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Table 8.7 The Korean Banking Sector: pre/post-crisis

Source: Lindgren (1999), p. 76.

Market share: % share of assets.

Banks with majority government ownership; the state had a minority interest in six other banks.

to encourage restructuring, which was successful. Staff costs were reduced by 35%, and the number of branches by 20%.

Foreign banks were permitted 100% ownership and in December 1999, Korea First Bank was sold to a US financial holding company, Newbridge Capital. Deutsche Bank was hired to prepare Seoul Bank for privatisation and sale to foreign investors in June 2001. However, despite a respectable bid from an American group, 70% of it was sold to Hana Bank in late 2002.

Non-performing loans were disposed of more successfully than in other countries. The Korean Asset Management Company (KAMCO) had been established in 1962. For a fee, it collected non-performing loans from banks. In 1997, a special fund was set up within KAMCO to purchase all impaired loans from firms covered by the Korean Deposit Insurance Corporation. It was funded by the Korean Development Bank, the Korean Deposit Insurance Corporation, special government guaranteed bonds and the commercial banks. This special fund is, effectively, a ‘‘bad bank’’, discussed earlier in the chapter. It purchased the NPLs at 45%, 3% for unsecured loans, and disposed of collateral. KAMCO sold some of the NPLs to international investors and others at public auction, foreclosed and sold the underlying collateral, and collected on loans. As of June 1999, 7 trillion won was collected from loans with a face value of 17 trillion, or 41% of the face value.37 By global standards, this is a reasonably successful recovery rate.

As shown in Table 8.7, restructuring cut the number of merchant banks by 60% and the number of private merchant banks by half. The five commercial banks that were state owned in mid-1999 were to be re-privatised by 2002, in accordance with the terms of Korea’s agreement with the IMF. At the time of writing, some progress had been made. Of the five state owned commercial banks in Table 8.7, as of 2003:

37 Source: Lindgren (1991), p. 72.