Financing Southeast Asia's economic development in Southeast Asia 9789812301819, 981230181X

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Financing Southeast Asia’s Economic Development

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg >

ii

The Institute of Southeast Asian Studies (ISEAS) was established as an autonomous organization in 1968. It is a regional research centre for scholars and other specialists concerned with modern Southeast Asia, particularly the many-faceted issues and challenges of stability and security, economic development, and political and social change. The Institute’s research programmes are Regional Economic Studies (RES, including ASEAN and APEC), Regional Strategic and Political Studies (RSPS), and Regional Social and Cultural Studies (RSCS). The Institute is governed by a twenty-two-member Board of Trustees comprising nominees from the Singapore Government, the National University of Singapore, the various Chambers of Commerce, and professional and civic organizations. An Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute’s chief academic and administrative officer.

© 2003 Institute of Southeast Asian Studies, Singapore

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Financing Southeast Asia’s Economic Development Edited by

Nick J. Freeman

INSTITUTE OF SOUTHEAST ASIAN STUDIES, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

iv

First published in Singapore in 2003 by Institute of Southeast Asian Studies 30 Heng Mui Keng Terrace Pasir Panjang Singapore 119614 Internet e-mail: [email protected] World Wide Web: http://bookshop.iseas.edu.sg All rights reserved. No part of this publication may be reproduced, translated, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 2003 Institute of Southeast Asian Studies, Singapore

The responsibility for facts and opinions in this publication rests exclusively with the editor and contributors and their interpretations do not necessarily reflect the views or the policy of the Institute or its supporters. ISEAS Library Cataloguing-in-Publication Data Financing Southeast Asia’s economic development / edited by Nick Freeman. Papers presented originally at the ASEAN Roundtable on Financing Sustained Economic Development in Southeast Asia, 22-23 October 2001, Singapore, organized by the Institute of Southeast Asian Studies and supported by Konrad Adenauer Stiftung. 1. Finance—Asia, Southeastern—Congresses. 2. Debt, External—Asia, Southeastern—Congresses. 3. Banks and banking—Asia, Southeastern—Congresses. 4. Investments, Foreign—Asia, Southeastern—Congresses. 5. Venture capital—Asia, Southeastern—Congresses. 6. Stock exchanges—Asia, Southeastern—Congresses. 7. Capital investments—Asia, Southeastern—Congresses. I. Freeman, Nick J. II. Institute of Southeast Asian Studies. III. ASEAN Roundtable (2001 : Singapore) HC441 A843 2001 2003 sls2002020280 ISBN 981-230-181-X Typeset by Stallion Press (India) Pvt. Ltd. Printed in Singapore by Seng Lee Press Pte. Ltd.

© 2003 Institute of Southeast Asian Studies, Singapore

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Contents

List of Tables List of Figures Acknowledgements Contributors 1 External Financing under Financial Globalization: An East Asian Perspective Akira Kohsaka 2 Managing the Debt Burden in Southeast Asia Homi Kharas and Sudarshan Gooptu 3 Commercial Bank Lending and Restructuring in the ASEAN-5 Countries Sakulrat Montreevat and Denis Hew 4 The Challenges of Microfinancing in Southeast Asia John D. Conroy 5 Opportunities and Trends in the ASEAN Project Finance Environment Gary S. Wigmore and Giles Kennedy 6 Developing the Role of Venture Capital in Southeast Asia Khalili Khalil

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60 97

162 176

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Contents

7 Reviving Foreign Direct Investment Inflows in Southeast Asia Hafiz Mirza

195

8 Developing the Fledgeling Debt Securities Markets in Southeast Asia Mario B. Lamberte

208

9 Developing and Deepening the Equity Markets of Southeast Asia Nick J. Freeman

245

10 Regional Financial Integration in Southeast Asia Ngiam Kee Jin

281

11 The Role of Multilateral Lending and Development Agencies in Southeast Asia Santi Chaisrisawatsuk and Wisarn Pupphavesa

315

Appendix 1: Project Finance in Southeast Asia’s Water and Sanitation Sector Eric Teo

343

Appendix 2: Financing Electricity and Gas Supply in Southeast Asia: The Role of Intergovernmental Co-operation Andrew Symon

349

Index

365

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List of Tables

1.1 Net Capital Inflows to Emerging Markets 1.2 Pre-Crisis Macroeconomic Situation 1.3 Maturity Composition of External Debt

12 16 17

2.1 Public Debt as a Share of GDP

37

3.1 ASEAN-5 Bank Loans, Bonds, and Equities, as a Percentage of GDP, 1996–2000 3.2 ASEAN-5 Outstanding Loans of Commercial Banks, 1996–2000 3.3 ASEAN-5 Percentage Share of Bank Loans, by Economic Sectors, 1995–2000 3.4 Number of Commercial Banks in ASEAN-5, 1996–2000 3.5 Supply-Side Indicators of Unwillingness to Lend of Commercial Banks in the ASEAN-5 Countries, 1996–2000 3.6 Demand-Side Indicators of a Slowdown in Bank Lending in the ASEAN-5 Countries, 1996–2000 3.7 Measures Employed to Alleviate the Credit Slowdown in the ASEAN-5 Countries 3.8 Systemic Banking Crises in Selected ASEAN Countries, 1998

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62 63 64 65

67 68 71 72

List of Tables

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3.9 3.10 3.11

3.12 3.13 3.14 4.1 4.2 6.1 6.2 6.3 7.1 7.2 7.3 7.4 7.5 8.1 8.2

Singapore Domestic Banking Sector, after the Bank Mergers Capital Adequacy Ratio (CAR) in Thailand, Malaysia, and the Philippines, 1997–2001 Non-Performing Loan Levels (Excluding Transfers to Asset Management Companies) in Indonesia, Malaysia, Thailand, and the Philippines, 1998–2001 Financial Restructuring Measures in ASEAN-4 Countries Asset Resolution Strategies in Select Southeast Asian Countries Bank Foreign Ownership Ceiling and Business Differentiation

76 77

80 81 82 83

World Outreach of Microcredit Indonesia: Regulated Financial Institutions and Microfinance, 2000

100 120

Malaysian VCCs’ and Asian VCCs’ Perspectives Compared Types of Exit by Venture Capitalists (U.S. Study) Critical Success Factors for VCCs in the K-Economy

182 188 192

Growth in Real GDP per Capita, 1982–2001 Inward Foreign Direct Investment in South and East Asia, 1980–99 Percentage of Global FDI Share of Selected Developing Countries Top Ten Investors in ASEAN: Balance of Payments Flow Data, 1995–2000 Priority Policies to Encourage Foreign Direct Investment Into and Within ASEAN

196

Indonesia: Maturity Structure of Government Bonds Indonesia: Corporate Bonds Maturity Structure, December 2000

219

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197 199 200 204

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List of Tables

8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10a 8.10b 8.11a 8.11b 8.12

9.1 9.2 10.1 10.2

10.3 10.4 10.5

Malaysia: Outstanding Malaysian Government Securities Classified by Original Maturity Malaysia: Outstanding Private Debt Securities Classified by Original Maturity Philippines: Issuance of Government Securities, 1995–2000 Philippines: Issuance of Commercial Papers Thailand: Maturity of Government Bonds under the 500 Baht B Programme Thailand: Maturity Structure of Corporate Bonds Indonesia: Major Issuers of Corporate Bonds, 1996–2000 Malaysia: New Issues of Private Debt Securities (Excluding Cagamas Bonds) by Sector Malaysia: Share of New Issues of Private Debt Securities (Excluding Cagamas Bonds) by Sector Philippines: Short-Term Commercial Paper Issues Philippines: Long-Term Commercial Paper Issues Thailand: Values of Corporate Bonds Issued During 1995–2000, Classified by Industry MSCI Weightings for Southeast Asia Compared (Mid-2001) Top Ten Multinational Enterprises, Ranked by Size of Foreign Assets, 1999 Summary of Current and Capital Account Liberalization in the ASEAN-5 Countries Major Regulations on Offshore Use of Currencies in Selected Asian Countries, 31 December 2000 ASEAN-4: Net Capital Flows, 1990–97 International Bank Lending to Emerging Asian Economies, 1996–98 Inflow of Foreign Direct Investment into ASEAN-5, 1985–99

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220 221 222 223 223 225 226 227 227 228 229 232

259 261 284

286 290 291 291

List of Tables

x

10.6 10.7 10.8

Singapore: Capital Flows, 1996–2001 Absolute Covered Interest Differential Sources of Intra-ASEAN Outward Direct Investment Flows, 1995 to June 1999 10.9 Sources and Recipients of Net Intra-ASEAN Direct Investment, 1995 to June 1999 10.10 Malaysia: Net Portfolio Investment 10.11 Malaysia: Flow of Funds through External and Special External Accounts, 15 February to 2 June 1999 11.1 11.2 11.3 11.4 11.5 11.6

Cumulative World Bank and ADB Lending, GNI per Capita, and GDP Growth, by Country Cumulative ADB Lending and Technical Assistance to Southeast Asia, as at End 2000 Cumulative World Bank Lending to Southeast Asia, by Sector Gross Domestic Savings, Capital Formation, and Resource Gap in Southeast Asia Change in Consumer Prices, 1995–2000 Spearman’s Rank Correlation Coefficients

© 2003 Institute of Southeast Asian Studies, Singapore

292 295 299 299 302 303 324 325 327 329 331 333

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List of Figures

1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8

Net Capital Flows, by Region, 1970–99 Net Capital Flows in East Asia Net Private Financing, by Region, 1992–2000 Gross Private Financing to Emerging Markets, 1995–2000 Real Effective Exchange Rates Exchange Rate Regimes and Foreign Exchange Controls Gross Capital Flows Degrees of Capital Account Liberalization

2.1

Conventional Deficits Only Partially Explain Changes in Public Debt Changes in Public Debt in Cambodia, Laos, and Vietnam The Buildup of Public Debt Has Been Mainly Due to Domestic Debt Issuance Primary Balances in ASEAN Countries, 1995–2000 Sovereign Risk and Devaluation Risk Premiums, January 2000 to April 2001

2.2 2.3 2.4 2.5 6.1 8.1a

5 6 9 10 14 18 24 25 40 41 44 45 50

Self-Reinforcing Cycle of Economic Prosperity: The Bay Area Experience

178

ASEAN-5: Outstanding Total Debt Securities

212

© 2003 Institute of Southeast Asian Studies, Singapore

List of Figures

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8.1b ASEAN-5: Total Gross Issuance of Debt Securities, 2000 8.2a ASEAN-5: Ratio of Total Outstanding Debt Securities to GDP 8.2b ASEAN-5: Ratio of Total Gross Issuance of Debt Securities to GDP, 2000 8.3a ASEAN-4: Distribution of Outstanding Debt Securities 8.3b ASEAN-5: Distribution of Gross Issuance of Debt Securities, 2000 8.4 Ratio of Outstanding Debt Securities to GDP by Major Issuers 8.5 Distribution of Outstanding Debt Securities by Major Issuers 9.1 9.2 9.3 9.4 9.5 9.6 9.7

9.8

Number of Listed Companies in Southeast Asia’s Main Equity Markets, 1990–2001 Market Capitalization of the Southeast Asian Equity Markets, 1990–2001 Capitalization of Southeast Asian Markets and Select U.S. Corporates, as at 25 September 2001 Market Capitalization of Southeast Asia and Hong Kong Compared, 1990–2001 Relative Performances of the Main Equity Market Indices in Southeast Asia, 1987–2001 Relative Performances of the Main Equity Market Indices in Southeast Asia, 1994–2001 MSCI’s All Country World Free Index Weightings for Southeast Asia, Before and After the New Free Float Component MSCI’s All Country Asia-Pacific Free Ex-Japan Index Weightings for Southeast Asia, Before and After the New Free Float Component

10.1 Singapore: Foreign Equity Investment 10.2 Thailand: Foreign Equity Investment

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212 213 213 215 215 216 218 248 249 251 251 253 254

261

262 301 301

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Acknowledgements

Creating this book has been a team effort. I wish to express my sincere appreciation to all the chapter contributors for their support in generating this volume, and for dealing with my incessant e-mail messages with such good humour. I am also very grateful to the Konrad Adenauer Stiftung (KAS) for its financial support of the ASEAN Roundtable 2001, on the topic of “Financing Sustained Economic Development in Southeast Asia”, from which this book directly emanates. Initial versions of the chapters in this volume were first presented as papers at the Roundtable in October 2001, and subsequently benefited from insightful comments made by discussants and other participants. I would like to thank all those who participated in the Roundtable, and particularly the paper discussants for their valuable comments on the papers presented. I also wish to thank the experts who took time out of their busy schedules to share their thoughts and experiences in a stimulating panel session on project finance in Southeast Asia. In addition to the chapter writers cited in this book, the following people provided very valuable inputs and insights during the Roundtable gathering, which undoubtedly helped strengthen and enrich this book: George Abonyi of Asia Strategy Forum in Bangkok, Charles Adams of the IMF in Tokyo, Marie-Anne Birken of Orrick Helen Yeo in Singapore, Soedradjad Djiwandono of ISEAS, Do Thi Kim Hao of the Hanoi Banking College, Kathryn Kerle of Moody’s in Singapore, Leeber Leebouapao of the National Economic

© 2003 Institute of Southeast Asian Studies, Singapore

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Acknowledgements

Research Institute in Vientiane, Worapot Manupipatpong of the ASEAN Secretariat, Wolfgang Moellers of KAS, Mya Than of ISIS in Bangkok, Hadi Soesastro of CSIS in Jakarta, Peter Stephens of the World Bank in Singapore, Bambang Subianto of AABS in Jakarta, Andrew Symon of Petroleum Argus in Singapore, Leslie Teo of the Monetary Authority of Singapore, Jean-Pierre Verbiest of the Asian Development Bank, and Vo Tri Thanh of the Central Institute of Economic Management in Hanoi. My sincere thanks also go to the staff at the Institute of Southeast Asian Studies for their sterling work in both helping to organize the Roundtable and preparing this volume for publication. Nick J. Freeman June 2002

© 2003 Institute of Southeast Asian Studies, Singapore

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Contributors

John D. Conroy is Special Consultant at the Foundation for Development Cooperation, Brisbane. Nick J. Freeman is Senior Associate Fellow of the Institute of Southeast Asian Studies, Singapore. He is also a Senior Advisor to Mekong Capital Ltd. Sudarshan Gooptu is Senior Economist, Poverty Reduction and Economic Management Sector Unit, East Asia and Pacific Region, at the World Bank. Denis Hew is Fellow at the Institute of Southeast Asian Studies, Singapore. Giles Kennedy is an associate in Milbank, Tweed, Hadley & McCloy LLP’s Singapore office and a member of its global corporate finance team. Khalili Khalil is Associate Professor, and Special Tasks Officer in the Office of the Deputy Vice Chancellor (Academic), Universiti Teknologi Malaysia. Homi Kharas is Chief Economist, East Asia and Pacific Region, at the World Bank.

© 2003 Institute of Southeast Asian Studies, Singapore

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Contributors

Akira Kohsaka is Professor of Economics at the Osaka School of International Public Policy, Osaka University, Japan. Mario B. Lamberte is President, Philippine Institute for Development Studies (PIDS), Manila. Hafiz Mirza is Professor of International Business at the Bradford University School of Management, United Kingdom. Sakulrat Montreevat is Fellow at the Institute of Southeast Asian Studies, Singapore. Santi Chaisrisawatsuk is at the School of Development Economics, National Institute of Development Administration (NIDA), Thailand. Ngiam Kee Jin is Senior Fellow at the Institute of Southeast Asian Studies, Singapore. Andrew Symon is the Singapore-based editor of Argus Asia Gas & Power, published fortnighly by the U.K. group, Energy Argus. He is also a research associate of the South Australian Centre for Economic Studies at the University of Adelaide. Eric Teo is Managing Director of Savoir Faire Corporate Consultants, and Council Secretary, Singapore Institute of International Affairs. Gary S. Wigmore is the managing partner of Milbank, Tweed, Hadley & McCloy LLP’s Singapore office and is head of the firm’s Asian Project Finance Practice. Wisarn Pupphavesa is Dean, Graduate School of Development Economics, National Institute of Development Administration, Thailand.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > 1

1. External Financing under Financial Globalization: An East Asian Perspective

1

External Financing under Financial Globalization: An East Asian Perspective Akira Kohsaka

1. Introduction

In the 1990s, capital account transactions expanded far beyond current 1 account counterparts, across both developed and developing economies. This new “financial globalization” trend has been produced by two recent 2 developments: financial liberalization and financial innovation. Both trends tend to blur distinctions in existing financial institutions, instruments, and transactions, and so shift the roles of government authorities from discretionary direct intervention in markets to rulebased indirect supervision and surveillance. Under these trends, however, net private — as well as total — capital inflows to the financial crisisaffected countries in East Asia turned negative, and remained so since 1997. And at this moment, we see no sign of their becoming positive in

© 2003 Institute of Southeast Asian Studies, Singapore

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Akira Kohsaka

the near future. As such, a series of financial crises have made clear that international capital flows carry risks as well as benefits. Indeed, since the early 1990s, views on the impact of international financial integration on developing economies have changed significantly. Financial globalization, or capital market integration, is forcing the policymakers of developing economies (and particularly “emerging market” countries) and international communities to cope with new policy challenges. Indeed, since the Asian financial crises, various efforts have been launched in a range of areas in pursuit of a more robust domestic as well as international financial system (International Monetary Fund [2000c]). Some areas are said to enhance transparency and accountability, better assess standards and codes, and more clearly identify financial sector vulnerabilities. Generally, they are intended to contribute to better-informed lending and investment decision-making. Other areas include capital account liberalization, alternative exchange rate regimes, and involving the private sector in crisis resolution. They are intended to harmonize the new reality of jumped-up capital movements within domestic — as well as international — settings, and to restructure domestic and international institutions, and help them adapt to this new reality. The purpose of this chapter is to give some thought to this area. More concretely, based on our painful experiences of the financial crises of the 1990s, we should search for realistic policy principles, particularly in the field of macroeconomics, balancing the benefits of financial globalization with the costs of intrinsic market failures. Specifically, given the apparent intrinsic defects of capital markets in general, this chapter emphasizes the importance of a second-best mix of policy tools in developing countries with respect to exchange rate regimes, prudential regulations, and capital controls. The 1990s was a decade when a wide range of capital transactions was deregulated, along with financial globalization. In developing countries, particularly emerging market countries, capital account liberalization was vigorously promoted through expanding access to international capital markets, with the aim of reducing capital costs and enlarging alternative sources of external finance. As a consequence of rapidly accumulated external debt, and then a reversal of these flows (especially short-term flows), a series of currency and

© 2003 Institute of Southeast Asian Studies, Singapore

1. External Financing under Financial Globalization: An East Asian Perspective

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financial crises occurred in East Asia. Accordingly, it is quite natural to ask what was wrong with capital account liberalization, its pace, and its sequencing. We should note here that it is inappropriate to discuss capital account liberalization independently of macro-management frameworks and microeconomic structures in the context of individual economies. Macroeconomic frameworks, such as exchange rate regimes, obviously affect capital movements. Microeconomic structures of financial institutions, as main actors in the international capital markets, also significantly affect capital movements. And, vice versa, capital movements affect both macro and micro institutions. Therefore, in discussing capital account liberalization, we must have a comprehensive perspective, including both macroeconomic policies and microeconomic structures in East Asia. That said, how can we make efficient use of capital markets despite their intrinsic failures? In this respect, actual policy choices must be based on a strong grasp of the institutional infrastructure in individual economies. In order to identify feasible policy choices, we must distinguish between realistic responses necessary for the time being and desirable policy courses in the long run, with knowledge of the institutional infrastructure that has supported both policy management and financial markets. The next section of this chapter briefly overviews patterns and components of international capital flows to emerging markets, highlighting diversities across periods, as well as across regions and individual economies. In Section 3, we briefly review policy lessons learnt from our experiences of the financial crises in the 1990s. Inflexible exchange rate regimes, volatile short-term capital flows and vulnerable financial systems are found to be some of the usual suspects. Section 4 pursues possible policy choices to cope with the fragilities associated with volatile capital flows to those economies. We emphasize the nonexistence of a unique all-weather solution, and the necessity of finding tailor-made prescriptions for individual economies. Policy issues related to capital account liberalization are re-examined in Section 5, focusing on potential benefits of external financing on the economic growth of emerging market countries. We argue that unconditional capital account liberalization could be very dangerous, and requires a variety of pre-

© 2003 Institute of Southeast Asian Studies, Singapore

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Akira Kohsaka

conditions for full-fledged liberalization, which are not necessarily common among individual economies, and should be pursued in each historical as well as socio-political context. In the concluding section of the chapter, the remaining agenda will be briefly touched upon. 2. Patterns and Compositions of Capital Flows in East Asia

Before discussing possible policy choices to cope with these increasing, but periodically volatile, international capital flows, this section briefly overviews patterns and components of international capital flows to emerging East Asian markets, highlighting diversities across periods, as well as across regions and individual economies. In the past three decades we have witnessed twin peaks in capital flows to developing economies (see Figure 1.1). The first was in the early 1980s, and the second was in the mid-1990s. Both peaks were followed by abrupt reversals of capital, from inflows to outflows, on a massive scale. But capital flows are not homogeneous and their behaviour can be different. Generally, foreign direct investment (FDI) is far more stable than other flows, such as portfolio investment and loans. Indeed, the first surge of capital flows to developing economies consisted mainly of debt flows, especially bank loans. Once they subsided, the more recent upsurge of flows was led by non-debt flows (that is, FDI), next by portfolio investments (that is, bond and equities issuance), and then by the recovery of bank and other loans. Before the Asian financial crisis in 1997, there were significant differences in the compositions of capital flows across regions. In the case of East Asia and the Pacific, the role of bank loans was relatively larger than other developing regions, such as Latin America, while both regions had in common the most important component: FDI (see Figure 1.2). Even these regional characteristics in capital composition, however, could obscure the differences among individual economies within each region. In Asia, one reason is the existence of China as a big absorber of foreign capital flows (Figure 1.2), largely in the form of FDI. For China, the role of bank loans and portfolio investment is relatively secondary, although both are also large in absolute terms. Thus, it is not surprising to see that Southeast Asia’s economies have experienced very different capital compositions. In Indonesia, bank and other loans led the capital

© 2003 Institute of Southeast Asian Studies, Singapore

Figure 1.1 Net Capital Flows, by Region, 1970–99

1. External Financing under Financial Globalization: An East Asian Perspective

5

Developing Countries 400,000 350,000

US$ Millions

300,000 250,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

200,000 150,000 100,000 50,000 0 1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

1988

1990

1992

1994

1996

1998

1990

1992

1994

1996

1998

East Asia and the Pacific 180,000 160,000 140,000

US$ Millions

120,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

100,000 80,000 60,000 40,000 20,000 0 1970

1972

1974

1976

1978

1980

1982

1984

1986

Latin America and the Caribbean 160,000 140,000 120,000

US$ Millions

100,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

80,000 60,000 40,000 20,000 0 1970 -20,000

1972

1974

1976

1978

1980

1982

1984

1986

1988

Source: World Bank, Global Development Finance, CD-ROM (2000). © 2003 Institute of Southeast Asian Studies, Singapore

Figure 1.2 Net Capital Flows in East Asia Indonesia 25,000 20,000 15,000

Short-term debt flows Total long-term debt flows Portfolio equity flows

US$ Millions

Foreign direct investment 10,000

Grants

5,000 0 1970 -5,000

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

1986

1988

1990

1992

1994

1996

1998

1986

1988

1990

1992

1994

1996

1998

-10,000 -15,000

Philippines 10,000 8,000

US$ Millions

6,000 4,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

2,000 0 1970 -2,000

1972

1974

1976

1978

1980

1982

1984

-4,000

Malaysia 20,000

US$ Milions

15,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

10,000

5,000

0 1970 -5,000

1972

1974

1976

1978

1980

1982

1984

Figure 1.2 (continued) Thailand 25,000 Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

20,000

US$ Millions

15,000 10,000 5,000 0 1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

1986

1988

1990

1992

1994

1996

1998

1986

1988

1990

1992

1994

1996

1998

-5,000

Korea 50,000 40,000

US$ Millions

30,000 20,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

10,000 0 1970 -10,000

1972

1974

1976

1978

1980

1982

1984

-20,000

China 80,000 70,000

US$ Millions

60,000 50,000

Short-term debt flows Total long-term debt flows Portfolio equity flows Foreign direct investment Grants

40,000 30,000 20,000 10,000 0 1970

1972

1974

1976

1978

1980

1982

1984

Source: World Bank, Global Development Finance, CD-ROM (2000).

8

Akira Kohsaka

upsurge, rather than FDI, which was also the case in Thailand (including huge short-term loans) until 1997. Malaysia observed FDI playing a leading role in ballooning capital inflows, while the Philippines’ experience was somewhere in-between these four Southeast Asian economies. Then came the Asian currency, financial, and economic crises of 1997 and after. The three capital components showed very contrasting developments during the crises (see Figure 1.3). The largest contraction was found in loans, but FDI either remained the same or showed a little increase, while portfolio investment flows were somewhere in-between. One of the interesting differences between the East Asian and Latin America experience is the rebound of portfolio flows to the former, which was is not the case for the latter. One reason again is the China factor. On the other hand, as far as bank and other loans are concerned, the inflow reversals were severe, and damaged real economies in the region, because of their heavy reliance on loans in the past. The sharp reduction of loans is particularly visible in charts depicting gross financing flows 3 to East Asia (see Figure 1.4). The rise and fall of bank loans can be attributed to a number of factors. High rates of return on assets, mechanisms to reduce information asymmetries, enhanced contract enforcement and moral hazard would be part of the explanation. Inevitably, however, bank loans tend to be pro-cyclical and are prone to reverse contagion, stemming from large exposures to emerging markets. Portfolio investment flows also share some of the same pro-cyclical and contagious characteristics as bank loan flows. For the time being, net capital inflows to Southeast Asia will remain negative or close to zero (see Table 1.1). One reason is that heavily indebted economies in the region still have to repay their external debts. The other is that declines in FDI inflows to Southeast Asia are being offset by larger FDI inflows to China. Net flows in bank loans will remain negative, and those in portfolio investment close to zero, against the background of the present unfavourable global financial situation. This situation is driven by such external factors as the global economic slowdown (including the technology sector), weakening growth in Europe and Japan, as well as such domestic factors as lacklustre structural reforms and political uncertainties.

© 2003 Institute of Southeast Asian Studies, Singapore

Figure 1.3 Net Private Financing, by Region, 1992–2000

1. External Financing under Financial Globalization: An East Asian Perspective

9

Emerging Markets 250

foreign direct investment portfolio investment bank loans and other

200 150

US$ Billions

100 50 0 1992 -50

1993

1994

1995

1996

1997

1998

1999

2000

-100 -150 -200

Asia 150

foreign direct investment portfolio investment bank loans and other

100

US$ Billions

50

0 1992

1993

1994

1995

1996

1997

1998

1999

2000

1999

2000

-50

-100

-150

Latin America 80 60

US$ Billions

40 20 0 1992

1993

1994

1995

1996

1997

1998

-20 -40

foreign direct investment portfolio investment bank loans and other

-60

Source: International Monetary Fund, International Capital Market (August 2001). © 2003 Institute of Southeast Asian Studies, Singapore

Figure 1.4 Akira Kohsaka Gross Private Financing to Emerging Markets, 1995–2000

10

All Emerging Markets 300

US$ Billions

250 200

Loans Equities Bonds

150 100 50 0 1995

1996

1997

1998

1999

2000

Asia 140 Loans

120

Equities Bonds

US$ Billions

100 80 60 40 20 0 1995

1996

1997

1998

1999

2000

1998

1999

2000

Latin America 100 90 80 US$ Billions

70

Loans Equities Bonds

60 50 40 30 20 10 0 1995

1996

1997

Source: International Monetary Fund, International Capital Market (August 2001).

© 2003 Institute of Southeast Asian Studies, Singapore

1. External Financing under Financial Globalization: An East Asian Perspective

11

3. Lessons from Financial Crises in the 1990s

In this section, we briefly review policy lessons learnt from our experience of the financial crises in the 1990s. After the 1994 currency crisis of Mexico, there was a lot of debate on policy management in emerging 4 markets. There we can find a number of consensus perceptions: • •

•

•

Inflexible exchange rates tend to lead to a currency crisis. In particular, a large real appreciation is likely to lead to currency speculation. Large current account deficits also tend to lead to crisis, through an expected currency depreciation. This holds true whether the deficit is due to fiscal deficits or to private over-spending. Short-term capital flows, including portfolio investment, can be volatile as well as destabilizing. Therefore, the issuance of foreign currency–denominated, short-term national bonds to defend currency values can be fiscally, and also socially, very costly. The banking sector should be carefully surveyed and supervised. A vulnerable banking sector tends to lead to contagion with a collapse of confidence in the banking system, and may deepen currency and financial crises by constraining strong tightening policies.

To what extent could we make use of these lessons for the Asian crisis of 1997? And can we also apply these lessons in the context of East Asia? This author believes that the answer to both questions is: “No, not fully.” Table 1.2 endorses this answer, summarizing pre-crisis macroeconomic situations in Mexico before 1994 and East Asia before 1997. First of all, until the crisis, we do not see substantial swings in real effective exchange rates throughout the 1990s in East Asia (see Figure 1.5). Except for China and Hong Kong, East Asia had never seen more than 20 per cent real currency appreciation. Even in Thailand, its real appreciation immediately before the crisis was no more than 15 per cent from its historical trend of the 1990s, so that it could have hardly ignited expectations for immediate currency depreciation. Second, while current account deficit was persistent and large, capital account surplus larger than the current deficit did matter more in Thailand and other crisis economies. Despite differential paces of capital account liberalization, capital inflows, particularly those of short term, increased explosively in East Asia in the first half of the 1990s (Figures 1.1 and 1.2 and Table 1.3).

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

Private capital flows, netb Private direct investment, net Private portfolio investment, net Other private capital flows, net Official flows, net Change in reservesc Memorandum Current accountd

1.2. Other Asian emerging markets

Private capital flows, netb Private direct investment, net Private portfolio investment, net Other private capital flows, net Official flows, net Change in reservesc Memorandum Current accountd

1.1. Crisis countries f

1. Developing Asia e

34.1 38.2 7.5 −11.6 2.5 −51.6 18.3

–7.2

−23.2

−13.5

21.6 26.4 0.9 −5.7 8.2 −16.8

35.0 6.5 13.3 15.2 1.1 −6.5

1994

30.8 6.7 25.0 −0.8 3.2 −20.0

1993

8.0

36.5 39.6 2.1 −5.2 −3.7 −25.4

−39.1

54.9 10.3 18.6 26.0 8.6 −18.0

1995

14.9

49.8 45.6 3.5 0.6 −7.9 −41.6

−53.0

74.1 11.7 27.6 34.7 −4.4 −5.3

1996

51.1

22.3 49.6 −0.1 −27.2 −7.2 −46.8

−25.5

−5.9 10.2 8.8 −25.0 14.1 39.4

1997

41.5

37.9

8.9 43.0 0.7 −34.8 2.1 −38.7

62.9

69.7

−14.1 48.5 −6.3 −56.2 0.2 −16.8

−18.3 8.9 13.1 −40.3 −3.3 −39.3

1999

−31.9 11.4 −9.0 −34.3 17.3 −46.9

1998

Table 1.1 Net Capital Inflows to Emerging Markets (US$ Billions)

41.5

4.3 41.8 −3.3 −34.2 −9.3 −25.8

46.0

−19.8 5.1 6.9 −31.9 1.8 −23.9

2000

27.2

6.6 44.5 −6.2 −31.6 −2.5 −28.4

31.6

−28.9 6.6 −4.5 31.0 1.0 −0.2

2001

16.0

11.6 43.8 1.9 −34.1 1.6 −27.2

28.6

−15.1 6.0 0.3 −21.5 −2.7 −8.1

2002

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Akira Kohsaka

2. Western hemisphere 42.4 23.2 63.7 −44.4 7.8 4.0 −52.0

37.4 12.2 45.5 −20.3 30.4 −20.7 −45.9 −37.1

41.6 24.9 3.4 13.2 17.8 −23.3 −39.8

63.8 40.5 39.7 −16.4 5.8 −29.0 −66.8

68.3 56.5 25.4 −13.6 16.0 −13.8 −90.4

72.7 60.8 17.7 −5.8 15.1 8.7 −56.3

44.6 63.4 10.8 −29.6 7.0 7.6 −48.6

36.7 62.8 5.1 −31.2 8.1 −3.1 −57.9

39.0 67.2 6.7 −34.9 11.2 6.0

−62.4

57.8 54.5 11.8 −8.5 6.2 −2.9

Source: International Monetary Fund, World Economic Outlook (October 2001, table 1.2, p. 7).

Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. Emerging markets include developing countries, countries in transition, Korea, Singapore, Taiwan Province of China, and Israel. b Because of data limitations, “other net investment” may include some official flows. c A minus sign indicates an increase. d The sum of the current account balance, net private capital flows, not official flows, and the change in reserves equals, with the opposite sign, the sum of the capital account and errors and omissions. e Includes Korea, Singapore, and Taiwan Province of China. f Includes Indonesia, Korea, Malaysia, the Philippines, and Thailand.

a

Private capital flows, netb Private direct investment, net Private portfolio investment, net Other private capital flows, net Official flows, net Change in reservesc Memorandum Current accountd

1. External Financing under Financial Globalization: An East Asian Perspective

© 2003 Institute of Southeast Asian Studies, Singapore

13

’98 ’99 August

1994

’99 August

© 2003 Institute of Southeast Asian Studies, Singapore

’98 ’99 August

1994

’95

’96

’97

’98

’99 August

60 1994

1994

’95

’95

’97

’96

’97

Thailand

’96

Indonesia

Source: International Monetary Fund, World Economic Outlook (October 1999, figure 2.6, p. 56).

’97

60

’96

60

’95

80

120

80

1994

’98

80

Korea

’97

100

120

’96

100

Malaysia

’95

100

120

’97

60

’96

60

’95

60

1994

80

80

120

80

Hong Kong SAR

100

120

100

China

100

120

Figure 1.5 Real Effective Exchange Rates (June 1997 = 100)

’98

’98

’99 August

’99 August

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15

Again, we may be able to add some consensus perceptions, this time from the Asian perspective, as follows: •

•

Inflexible exchange rates tend to lead to a currency crisis, not necessarily because of overvaluation, but because they tend to give wrong signals to the market, and induce excess risk-taking such as huge external short-term borrowing. Even without persistent and large current account deficits, largescale reversals of capital flows can trigger currency crises, that is to say, a current account imbalance is not a necessary condition for a crisis.

The point made clear by the above two additional lessons is that the Asian crisis was a “new” type of crisis, so that it would not have been predicted beforehand. Indeed, Furman and Stiglitz (1998) suggested that the Asian crisis was novel when they tried to predict crises using three representative models, and found that none of them could predict 5 the occurrence of the crisis well. The important issue here is in what sense the Asian crisis was new. Is every financial crisis different? Was this crisis purely accidental? Or, one may be able to say that it was not a “real” financial crisis until October 1997, but became so due to mismanagement in the months immediately after July 1997. At the least, we are able to say that the Asian policy frameworks prior to the crisis did not appear to match well with the new global economic environment, and more specifically the process of financial globalization. 4. How to Cope with the Volatility of Capital Flows

In this section we examine possible policy choices to cope with the fragilities associated with volatile capital flows to economies. One may have in mind the use of capital controls on volatile capital movements. In fact, controls on short-term capital were said to play a significant role in maintaining autonomy of macroeconomic policy in Chile and Colombia in the 1990s (Ariyoshi et al. 2000). Or, if we would wish to focus on allocative efficiency of intermediated funds, we may want to strengthen supervision of the banking sector, which was a main player in financial intermediation. Further, if excess capital inflows resulted from inflexible exchange rates, we may have to look for an alternative

© 2003 Institute of Southeast Asian Studies, Singapore

Dollar peg Dollar peg Dollar peg Managed float Crawling peg

Country

Mexico (1994) Thailand (1997) Malaysia (1997) Korea (1997) Indonesia (1997)

© 2003 Institute of Southeast Asian Studies, Singapore

Source: Rodrik (1999, table 1).

b

1990–94. 1992–94. c 1994. n.a. = Not available.

a

Exchange Rate Regime

Current Account Deficit (% of GDP, 1994–96) 6.5%b 7% 7% 3% 2%

Real Appreciation (% Change, 1994–96) 30%a 10% 10% 0% 5%

Table 1.2 Pre-Crisis Macroeconomic Situation

37%c 39% 30% 63% 31%

Short-Term Debt (% of Total Debt, 1996)

n.a. 13% 10% 8% 13%

Financial Vulnerability (NPL/Total Assets, 1996)

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Table 1.3 Maturity Composition of External Debt (Percentages) 1990

1992

1994

1996

Asia-Pacific Short-term (banks) Short-term (others) Long-term

18.7 6.0 75.2

22.0 5.4 72.5

22.4 4.7 72.9

29.2 4.2 66.6

Latin America Short-term (banks) Short-term (others) Long-term

8.9 9.4 81.7

10.3 12.7 77.0

12.4 12.4 75.2

15.0 6.9 78.1

Source: Rodrik (1999, table 1).

exchange rate arrangement, including a free float system. In this section we will discuss policy options for exchange rate arrangements, the strengthening of prudential controls, and the effectiveness of capital controls, one by one. 4.1. Exchange Rate Regimes

Figure 1.6 shows the number of economies (between 1975 and 1998) with flexible exchange rate regimes, the share of economies with convertible currencies for current account transactions, and a summary measure of foreign exchange controls. Generally, developing economies have been increasing the flexibility of exchange rates and improving convertibility in current account transactions. In fact, the share of developing economies with flexible exchange rates gradually rose from 10 per cent in 1975 to 50 per cent in 1995, and those with convertibility in current account transactions doubled from 40 per cent in the 1980s to 80 per cent in the 1990s. As for capital account transactions, however, the pace of deregulation has been relatively slow (see Figure 1.6). The crises in the 1990s suggest that it is difficult for emerging market countries to maintain single-currency pegging, so they should move towards more flexible exchange rate regimes. Indeed, a combination of a fixed exchange rate and a vulnerable financial system would induce excessive capital inflows and inefficient resource allocation and, through constraining monetary policies, would magnify and deepen economic crises. It might be wrong, however, to abandon one exchange rate regime

© 2003 Institute of Southeast Asian Studies, Singapore

Akira Kohsaka

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Figure 1.6 Exchange Rate Regimes and Foreign Exchange Controls 100

60 Summary measure of restrictions (right scale)

50

90 80 70

40 Flexible exchange rate regime (left scale)

60

30

50 Countries with convertible currencies for current account transactions (right scale)

20 10

40 30 20 10

0 1975

1978

1981

1984

1987

1990

1993

0 1996 1998

Source: Jadresic, Masson, and Mauro (1999, figure 1).

only because it is vulnerable to rather infrequent crises. For there is no guarantee that a flexible exchange rate regime will not become misaligned, or volatile, or both. In the context of such small open economies as emerging market countries, both misalignment and volatility of exchange rates are likely to be larger than in developed economies. Accordingly, a pure free float might not be a realistic choice of exchange rate regimes. In fact, the pre-conditions for a free float that are often identified6 are: • • • •

a high degree of integration with international capital markets; a high diversification of partners in current account transactions; a high priority placed on monetary autonomy, due to independent supply and demand shocks; well-developed domestic capital and foreign exchange markets, equipped with such functions as risk diversification and risk management.

But how many emerging market countries can meet all four of these criteria? Being aware of huge differences among developing economies with

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respect to their development stages and economic environments, we would not be able to recommend one unique optimal exchange rate regime applicable to developing economies in general. Even an optimal exchange rate regime for one country might become sub-optimal as its environment changes. Having said this, however, we can draw some policy implication for the choice of exchange rate regimes of emerging markets, in the context of financial globalization: •

•

•

In order to maintain both monetary autonomy and free access to international capital markets, pegging to a single major currency is simply not a viable choice. More flexible exchange rate regimes, including a free float, should be chosen. Somewhat tautologically, if we give up monetary autonomy and happen to be equipped with such institutional pre-conditions as independent monetary authorities, ample foreign exchange reserves, and a robust domestic financial system, an economy may be able to maintain a single currency peg.7 With comparatively underdeveloped domestic capital markets, if you can maintain monetary and fiscal discipline, and command some degree of effective control on capital account transactions, some broader (that is, not single) range of pegging — such as a basket peg, peg within a band, a crawling peg, and so forth — could be considered.

4.1.1. Prudential Regulations Revealing exchange rate risks, more flexible exchange rates would help improve the private sector’s risk management with international capital movements, thereby contributing to sound macroeconomic management. Likewise, strengthening prudential regulations on domestic and foreign financial institutions would alleviate potential macroeconomic risks. For, financial institutions are central in international capital transactions, and it is their excess risk-taking and their partners’ sudden shifts of sentiment which cause and trigger financial and currency crises. In other words, if prudential controls enhance risk management of financial institutions in international capital transactions, it could moderate the volatility of international capital movements. Risk management of international capital transactions is not totally different

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Akira Kohsaka

from that of domestic counterparts. A framework of regulations and supervision for domestic transactions should be extended and adapted. In the case of international capital transactions, however, additional risk factors — such as exchange rate risks and differences in national institutions — come into view. Accordingly, while prudential criteria should be common across markets in order to exclude opportunities for regulatory arbitrage, it would not be easily attained in reality. On the creditors’ side, developed countries should supervise investors and financial institutions located within their jurisdictions, and discourage them from taking excessive risks in international transactions. Due to their relative size, even slight, but sudden, portfolio shifts could generate excess capital inflows or sudden outflows to small, open emerging market countries, which the latter would find difficulty in absorbing. Why this sudden reversal of capital flows? This is because, first, investors and financial institutions in developed countries often do not recognize differences in economic performance, nor differences in asset compositions, among economies in the same region. Secondly, they tend to run like a herd towards a country, or countries in a region, exactly as they would towards a bank or some banks, which is rational individually, but certainly not globally. On the borrowers’ side, in order to establish and implement prudential criteria, we require such elements as supervision and regulation of public authorities, internal governance of private financial institutions, and market discipline. Since qualities of these elements depend on development stages of markets and institutions across countries, we cannot expect much even in emerging markets among developing countries. Weaknesses often mentioned in Indonesia include: relatedparty lending, loan concentration, weak legal frameworks and levels of governance, a lack of disclosure systems, and weak supervisory authorities. But we can see similar phenomena beyond emerging market countries. In Korea, for example, the capital shortages of banks were not well recognized nor well handled. Though the Bank for International Settlements (BIS) capital adequacy rule had been introduced in 1992, the rule itself tended to underestimate risks relating to short-term loans, defective domestic rules on provisioning, stock valuation, and asset classification, inadequate accounting standards, and distorted prudential

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evaluation. In other words, the pre-conditions for capital account liberalization were not adequately satisfied (Shin and Wang 1999). As such, in those emerging market countries without strong supervision, the crisis fully exposed a lack of skills and ability for risk management in private financial institutions. Can we overcome these defects overnight? To be realistic, we have no choice but to resolve them over time, in the longer-run perspective of economic development. If this is the case, programmes for capital liberalization, which should presuppose a robust banking system and an adequate public supervisory 8 regime, cannot but become a piece of good-looking but inedible cake.

4.1.2. Capital Controls Capital controls can be justified only when malfunctions exist which prevent markets from allocating capital efficiently. Imperfect information problems, such as an asymmetry between borrowers and lenders, and uncertainty for the future, could cause excessive risk-taking, as well as inefficient investment. Furthermore, sentiment-driven disinvestment, or a reversal of capital flows, could lead to macroeconomic instability and huge economic and social costs, as in the case of emerging markets in the 1990s. Thus, capital controls can be regarded as second-best precautionary measures against these market failures and their resulting external diseconomies. Accordingly, to assess the effectiveness of capital controls, we must examine to what extent they contribute to policy objectives related to macroeconomic stability, through restraining capital movements, especially those of short-term capital flows. Capital controls, changing the size and composition of capital flows, would affect interest rate differentials and the foreign exchange market, thereby influencing the effectiveness of monetary policies. Also, we must consider at what cost capital controls can be implemented. They can distort resource allocation, and require additional administrative costs to enforce regulations. They might undermine efforts to improve the infrastructure of domestic capital markets, as in the case of other protectionist measures, and adversely 9 affect international investors’ confidence in the financial market. In the 1990s, emerging markets imposed controls on short-term capital inflows prior to financial crises, and on outflows in the process of

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Akira Kohsaka

22 10

crises. Cases of the former (that is, controls on short-term inflows) include Brazil (1993–97), Chile (1991–98), Colombia (1993–98), Malaysia (1994), and Thailand (1995–97). There, capital controls were used to maintain macroeconomic stability against rapid increases in capital inflows in the early 1990s. Together with sterilization, and other policy measures — such as deregulation on capital outflows, more flexible exchange rates, strengthened prudential controls and fiscal tightening — some countries appeared successful in containing capital inflows, and others were successful in increasing the maturity composition of the inflows. Cases of the latter (that is, controls on capital outflows) include Malaysia (1998) and Thailand (1997), with experiences that had mixed results in attaining exchange rate stability. It would be difficult to draw any general lessons from the above experiences on the effects of capital controls. Since policies and their environments change together, we cannot identify the effects of capital 11 controls per se. Nevertheless, we may be able to suggest the following: • • •

•

There is no unique instrument for capital controls which are effective any time, anywhere; Selective controls on specific transactions (for example, short-term capital transactions) are effective in the short run; The choice and effectiveness of capital controls depends on the degree of development in administrative capacity and the domestic financial markets; To be effective, capital controls must be comprehensive. Yet, the more comprehensive, the more distortionary and costly capital controls then become.

5. The Quest for Appropriate Capital Account Liberalization

The recent trend of financial globalization has shown us the opportunities and risks of capital account liberalization in developing economies. Opportunities include increasing investment possibilities, creating technology spillovers, and deepening domestic capital markets. Risks include increasing instability of small open economies, more exposed to outside shocks, such as sudden reversals of foreign capital flows. In such cases, these economies may face serious difficulties in not only macroeconomic management, but also their financial systems as a whole.

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1. External Financing under Financial Globalization: An East Asian Perspective

23

In fact, these small and open developing economies have never been so open as developed economies. Figure 1.7 shows the relative size of gross capital flows to gross domestic product (GDP) across regions. Because of steady increases in FDI and other capital flows, we can see an enhanced reliance on foreign capital flows by developing economies as a whole. The current situation is, however, not comparable to that of developed economies yet, in terms of levels, nor of trends. It is obvious from Figure 1.7 that developing economies, as well as those in Asia, have been far less open than developed economies, relative to GDP levels. Then, to what extent are developing economies less open than developed ones? IMF (2001b) shows two complementary measures of capital account liberalization. The restriction measure is based on the number of restrictions on capital flows, as reported to the IMF by national authorities. However, this measure cannot capture adequately the degrees of liberalization. The other measure, the openness measure, is based on gross stocks of foreign assets and liabilities, as a ratio to GDP. This is a counterpart concept of domestic financial depth. Degrees of capital account liberalization, measured by these two means (that is, the restriction measure and openness measure), are illustrated in Figure 1.8. One notable fact that can be seen in Figure 1.8 is that while developed economies show parallel movements in the two measures, towards more openness in their capital accounts, they diverged over time in developing economies. Particularly in recent periods, the openness continued to be enhanced, despite unchanged restriction measures. Particularly in Asia, this must partly reflect the opening up of China, and the rapid growth of East Asia. Moreover, this may suggest that either the restrictions are not necessarily effective or updated, or that the exogenous pressures of capital flows are very strong, or both. Either way, this indicates the need for institutional rearrangements and/or catching-up of institutional abilities in capital flow management within the context of accelerating global financial integration. As is always the case, market liberalization per se does not guarantee that market mechanisms will consistently function well. This is particularly so in the case of capital markets, which are often characterized by incomplete and asymmetric information problems. Indeed, various studies show mixed evidence across economies on whether simple capital

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Akira Kohsaka

24

20

Figure 1.7 Gross Capital Flows (Percentage of GDP) 20 Developing Countries Advanced Economies

15

15

10

10

5

5

0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

20

Africa

Developing Countries by Region 20

15

15

10

10

5

5

Asia

0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98 20 Middle East and Europe

0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98 20 Western Hemisphere

15

15

10

10

5

5

0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

Gross

FDI

Portfolio and banks

Source: International Monetary Fund, World Economic Outlook (October 2001, figure 4.1, p. 147).

© 2003 Institute of Southeast Asian Studies, Singapore

1. External Financing under Financial Globalization: An East Asian Perspective

0.0

Figure 1.8 Degrees of Capital Account Liberalization 1.5 0.0 Advanced Economies Developing Countries

25

0.5

0.2

1.2

0.2

0.4

0.4

0.0

0.4

0.3

0.6

0.6

0.6

0.2

0.8

0.3

0.8

0.1

0.0 1.0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

0.0 1.0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

Developing Countries by Region 0.5

0.5

0.0

0.2

0.4

0.2

0.4

0.4

0.3

0.4

0.3

0.6

0.2

0.6

0.2

0.8

0.1

0.8

0.1

0.0

Africa

0.0 1.0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

Asia

0.0 1.0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

0.5

0.0

0.2

0.4

0.2

0.4

0.4

0.3

0.4

0.3

0.6

0.2

0.6

0.2

0.8

0.1

0.8

0.1

0.0

Middle East and Europe

0.0 1.0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

Western Hemisphere

0.5

1.0 0.0 1970 ’74 ’78 ’82 ’86 ’90 ’94 ’98

Restriction measure (left scale, inverted)

Openness measure (right scale)

Source: International Monetary Fund, World Economic Outlook (October 2001, figure 4.2, p. 148).

© 2003 Institute of Southeast Asian Studies, Singapore

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Akira Kohsaka

account liberalization can generate economic growth, either through increased domestic investment, spillovers from technology transfers, or 12 deepened domestic financial markets. These results suggest that the impact of capital account liberalization on economic growth appears to be crucially dependent on the initial conditions and policies in the individual economy. In other words, for the liberalization to obtain expected beneficiary results, with minimal costs, we are required to improve institutional conditions in ways which may not be adequately spelt out in more general debates. In the long run, the globalization of financial markets could expand opportunities, such as more efficient resource allocation and better risk diversification. Emerging market countries, however, are only marginal in the global capital markets, so they tend to be more exposed and vulnerable to large swings in international investor sentiment, and subject to herd behaviour and contagion. The IMF (2001a) pointed out the “on-off ” nature of international investors in emerging market financing. This is not news at all, but has been well recognized as intrinsic to international capital markets. Further, at present “increased asset price volatility in matured markets and the prospects of a slowdown in global growth combined with market turbulence in key emerging markets” will make it difficult for emerging market countries — including East Asian economies — to tap external finance in the form of either portfolio investment or loans, as much as they did in the early 1990s. The international capital market failure is intrinsic to capital markets in general. In domestic markets we have devised a variety of safety nets, such as the central bank as the lender of last resort to deposit insurance schemes. Yet, we are not yet equipped with similar safety nets in the international financial markets. Obviously, an adequate safety net scheme to protect against a systemic crisis, as in the recent Asian financial crisis, is out of reach of individual monetary authorities in developing economies. This is one reason why a new international financial architecture is desperately needed. Of course, short run benefits from bail-outs, and long-run costs and risks of moral hazard come into view when devising any new safety net schemes. Keeping in mind this tradeoff, however, we must proceed on two fronts: debt workouts in the short run, and crisis minimization

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in the long run. In the debt workouts, it is necessary not only to work out debts — case by case — with some element of debt relief, but also to establish rules for risk sharing between private debtors and creditors. Crisis prevention would need action in three areas: •

•

•

The first step is to strengthen supervision, with respect to both debtors and creditors. International co-operation would be necessary on this front. Expanded liquidity provision or stand-by arrangements would be helpful in containing sudden capital reversals, at least to some extent. Remembering the relatively gradual process of crisis spillovers in the Asian crisis, the idea of an Asian Monetary Fund might have utility if the timing is right. Increasing transparency and enhancing disclosure of the private, as well as the public, sector would be of some use in lessening uncertainties, though we must recognize that the process would take time, and should go hand in hand with the institutional evolution of individual economies.13

6. Concluding Remarks

In order to prevent future financial crises, multilateral financial institutions and developed countries governments have emphasized the importance of more sound macroeconomic policies, of stronger supervision, and of more transparent domestic financial markets. It is easy, however, to blame mismanagement on the side of emerging market countries, such as inadequate regulation and supervision of financial institutions, and inflexible macroeconomic policies. Furthermore, there is less consensus than it may seem on what are sound macroeconomic policies, and less confidence on whether well-written codes can be implemented in practice. As noted earlier, for example, there is no unique solution for an optimal exchange rate regime for individual emerging markets, or developing countries in general. The choice would depend on the functions and governance of their foreign exchange markets, domestic financial markets and, furthermore, market institutions as a whole — including public policy authorities. It is important to strengthen market discipline, as well as the supervision and regulation of public authorities, in a bid to avoid moral hazard. Yet, whether they work well

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Akira Kohsaka

in practice depends on the functions and governance of judicial and political systems, and market institutions as a whole. We need not be unduly cynical though. Indeed, there are adequate reasons to support the taxation of short-term foreign borrowing, more flexible exchange rate adjustments, and higher reserve requirements on short-term foreign exchange deposits (Calvo, Leiderman, and Reinhart 1995). To cope with existent capital market failures, capital controls — especially on short-term capital — can be a second best and complementary option to other macroeconomic (more flexible exchange rates) and microeconomic (stronger prudential regulations) policy instruments. Any exchange rate policies, prudential regulations and capital controls alone, however, cannot be a panacea, but rather are at most a second best option. In addition, the effectiveness of capital controls themselves depend on the functions and governance of markets and public policy authorities. Therefore, the authorities in emerging market countries should concentrate on how they design and combine their available policy instruments, in the context of their own institutional infrastructure, with some outside assistance if it is available. At the beginning of the twenty-first century, we finally appear to have reached a consensus view that international financial market liberalization can have both favourable and adverse effects. Even multilateral financial institutions such as the IMF have become very cautious these days. They say, correctly, that emerging market countries should, as a pre-condition to capital account liberalization, create institutions that strengthen the positive aspects of financial integration, and that other developing economies should make capital account liberalization the ultimate goal, to be attained only over time with various paces (IMF 2001b). NOTES 1. In the former, cross-border transactions in portfolio investments, such as equities and bonds, rose from 70 to 240 per cent of GDP during the period 1990–96, while the ratio of exports and imports to GDP remained a little less than 50 per cent during the decade before 1996 (IMF 1999b). The same can be said for developing economies, in that the increase in capital transactions has tended to

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exceed those in the current account. Namely, the annual average increase in exports of those economies was a little less than US$100 billion during the decade before 1997, while net capital inflows amounted to US$150 billion annually during 1991 through 1996. 2. The former consists of a series of deregulations in domestic financial markets, crossborder capital transactions and external trade, and foreign exchange controls. The latter comes from the information technology (IT) revolution, which has cut down transaction costs of collecting, processing and operating information in the financial sector, thereby enabling sophisticated pricing strategies through new financial instruments, and enhancing their utility in risk management. 3. Kawai and Liu (2001) examined the determinants of bilateral bank loan flows to developing economies, and have attempted to explain the different lending behaviour among European Union, Japanese, and U.S. commercial banks. 4. The literature includes Sachs, Tornell, and Velasco (1996); Calvo and Mendoza (1996); Edwards (1997); and Journal of International Economics (1996). Also, the views of economists of multilateral institutions are found in Burki (1997) for the World Bank, Loser and Williams (1997) for the IMF, and the OECD (1995). 5. Those are models in Frankel and Rose (1996); Kaminsky, Lizondo, and Reinhart (1998); and Sachs, Tornell, and Velasco (1996). 6. See, for example, Isard (1995); Obstfeld and Rogoff (1995); Eichengreen et al. (1998). 7. In 1983, Hong Kong substituted a free-float system for the present pegged system under a currency board. Even for Hong Kong as an international financial centre, however, it is not an easy strategy to maintain nominal exchange rate stability against the U.S. dollar, whilst guaranteeing free capital movements. In fact, in each episode of currency attack, including the recent crisis, Hong Kong reformed and upgraded its currency board system to accommodate destabilizing shocks to domestic financial markets. Accordingly, the system would be hardly transferable to other economies. See Jao (1998) and Meredith (1999). 8. As pointed out by Leslie Teo at the ASEAN Roundtable 2001 on Financing Sustained Economic Development in Southeast Asia, Singapore, October 2001, we will need a new design for prudential controls, due to the increasingly blurred demarcation between various types of financial institutions. A more forward-looking, harmonized, and integrated approach to prudential controls and supervision of the financial system is necessary to address unsupervised risks, as well as overlaps and gaps in the conventional regulatory framework. 9. Concrete measures for implementing capital controls are diverse. Broadly, there are two types. One is direct controls, including discretionary interventions, quantitative controls and licensing. The other is indirect controls, to increase the transaction costs of specific items (taxation, unremunerated reserve requirement

© 2003 Institute of Southeast Asian Studies, Singapore

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[URR], multiple exchange rates, provisioning for foreign currency positions, asymmetric position controls, differential reporting obligations, and so forth). 10. The effectiveness of capital controls are not necessarily symmetric between those on inflows and outflows. But we will not discuss the distinction in this chapter. 11. One of the difficulties in measuring the effects of capital controls is that we cannot obtain objective indicators of their strength. In some prior studies, they divide capital transactions into a number of categories, check existences of controls in each category, and regard the number of categories with controls as a proxy for the strength of controls (for example, see IMF 2001b). 12. See IMF (2001b) and the references therein. 13. One might claim the need for establishing a robust credit and risk management “culture”, which would also take time to develop. Increasing competition with foreign financial institutions might help accelerate the process of changing the “culture”.

REFERENCES Ariyoshi, Akira, Karl Habermeier, Bernard Laurence, Inci Otker-Robe, Jorge Ivan Canales-Kriljenko, and Andrei Kirilenko. Country Experiences with the Use and Liberalization of Capital Controls. Washington, D.C.: International Monetary Fund, January 2000. Burki, Shahid J. “A Fate Foretold: The World Bank and the Mexican Crisis”. In Mexico 1994, edited by S. Edwards and M. Naim. Washington, D.C.: Carnegie Endowment, 1997. Calvo, Guillermo and Enrique Mendoza. “Petty Crime and Cruel Punishment: Lessons from the Mexican Debacle”. American Economic Review, May 1996. Calvo, Guillermo, Leonardo Leiderman, and Carmen Reinhart. “Capital Inflows to Latin America with Reference to Asian Experience”. In Capital Controls, Exchange Rates and Monetary Policy in the World Economy, edited by S. Edwards. Cambridge: Cambridge University Press, 1995. Edwards, Sepastian. “The Mexican Peso Crisis? How Much Did We Know? When Did We Know It?” National Bureau of Economic Research Working Paper no. 6334. Cambridge, M.A.: National Bureau of Economic Research, 1997. Eichengreen, Barry, Paul Masson, Hugh Bredenkamp, Barry Johnston, Javier Hamann, Esteban Jadresic, and Inci Otker. Exit Strategies: Policy Options for Countries Seeking Greater Exchange Rate Flexibility. IMF Occasional Paper no. 168. Washington, D.C.: International Monetary Fund, 1998. Frankel, Jeffrey A. and Andrew K. Rose. “Currency Crashes in Emerging Markets: An Empirical Treatment”. Journal of International Economics 41, no. 3–4 (1996): 351–66.

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Furman, Jason and Joseph E. Stiglitz. “Economic Crises: Evidence and Insights from East Asia”. Brookings Paper on Economic Activity, no. 2, 1998. International Monetary Fund (IMF). World Economic Outlook. Washington, D.C.: International Monetary Fund, October 1999b. . “Report of the Acting Managing Director to the International Monetary and Financial Committee on Progress in Reforming the IMF and Strengthening the Architecture of the International Financial System”. IMF Homepage (accessed 12 April 2000c). . International Capital Market. Washington, D.C.: IMF, August 2001a. . World Economic Outlook. Washington, D.C.: IMF, October 2001b. Isard, Peter. Exchange Rate Economics. Cambridge University Press, 1995. Jadresic, Esteban, Paul Masson, and Paolo Mauro. “Exchange Rate Regimes of Developing Countries: Global Context and Individual Choices”. Mimeographed. International Monetary Fund, November 1999. Jao Y.C. “The Working of the Currency Board: The Experience of Hong Kong 1935–1997”. Pacific Economic Review 3, no. 3 (October 1998). Journal of International Economics, 1996. Kaminsky, Graciela, Saul Lizondo, and Carmen M. Reinhart. “Leading Indicators of Currency Crises”. IMF Staff Papers 45, no. 1 (1998). Kawai, Masahiro and Li-Gang Liu. “Determinants of International Commercial Bank Loans to Developing Countries”. Paper presented at the Autumn Convention of the Japan Economic Association, Hitotsubashi University, Tokyo, 7–8 October 2001. Loser, Claudio M. and Ewart S. Williams. “The Mexican Crisis and Its Aftermath: An IMF Perspective”. In Mexico 1994, edited by S. Edwards and M. Naim. Washington, D.C.: Carnegie Endowment, 1997. Meredith, Guy M. “Liquidity Management under Hong Kong’s Currency Board Arrangements”. Paper presented at the “International Workshop on Currency Boards: Convertibility, Liquidity Management and Exit”, Hong Kong, 9 October 1999. Obstfeld, Maurice and Kenneth Rogoff. “The Mirage of Fixed Exchange Rates”. Journal of Economic Perspectives 9, no. 4 (1995). Organization for Economic Co-operation and Development (OECD). OECD Economic Surveys: Mexico. 1995. Rodrik, Dani and Andres Velasco. “Short-Term Capital Flows”. National Bureau of Economic Research Working Paper no. 7364. Cambridge, M.A.: National Bureau of Economic Research, September 1999. Sachs, Jeffrey D., Aaron Tornell, and Andres Velasco. “Financial Crises in Emerging

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Markets: The Lessons from 1995”. Brookings Papers on Economic Activity, no. 1, 1996. Shin, Inseok and Yunjong Wang. “How to Sequence Capital Market Liberalization: Lessons from the Korean Experience”. Paper presented at the conference on How Open Should Capital Market Be? Fine Tuning Regulation and Deregulation, Friedrich Ebert Stiftung, Frankfurt, Germany, 7–8 December 1999. World Bank. Global Development Finance. CD-ROM. 2000, 2001.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg >

2. Managing the Debt Burden in Southeast Asia

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2

Managing the Debt Burden in Southeast Asia Homi Kharas and Sudarshan Gooptu

1. Introduction

Despite a reputation for being fiscally conservative, governments across the Southeast Asian region have seen rapid increases in their debt to gross domestic product (GDP) ratios over the last few years. More than half the countries have debt/GDP ratios that exceed the 60 per cent Maastricht criterion, considered to be a threshold for fiscal stability in a developed country. For the developing countries of Southeast Asia it may be prudent to consider a lower threshold. By that standard, the debt burden is high for all the Southeast Asian countries, except Myanmar, whose government has had no access to credit for some time. The issue is all the more acute because the recent trend in the debt/ GDP ratio has shown a rapid rise. Whether that is the result of one-shot factors and will quickly reverse, or whether the higher debt levels have put countries on a trend path towards ever growing debt burdens, is a

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Homi Kharas and Sudarshan Gooptu

crucial question for policymakers to mull over. How did this come about in a region where macroeconomic stability has for many decades been the cornerstone of the development strategy? What are the implications of a high debt burden for economic management? What institutional issues arise in managing public debt? This chapter seeks to shed some light on these questions. By and large, Southeast Asian countries have taken a short-term approach to debt management. They have tried to ensure that cash flows are available to finance current debt service payments and they have tried to maintain fiscal deficits within reasonable bounds of available finance. This is a short-term approach because it only considers financial flows in a given year. In an environment of rapid growth, the debt burden as measured by the debt/GDP ratio shrinks naturally, so a short-term approach can be consistent with longer-term fiscal sustainability. But the recession of 1997/98, large currency depreciations, and substantial budget funds needed to recapitalize the banks, coupled with a prognosis of slower medium-term growth, have clearly shown that factors other than the fiscal deficit have been major drivers of debt dynamics. A narrow focus on the deficit can be misleading. Indeed, a growing strand of economics literature argues that currency and banking crises have not been driven by fiscal deficits, as was the case in the first round of sovereign debt crises (Krugman 1979), but by broader considerations of fiscal and macroeconomic risks when these are not be handled in a consistent fashion (Furman and Stiglitz 1998; Eichengreen, Rose, and Wyplosz 1996). The governments of the richer Southeast Asian countries have accessed private capital markets, both domestically and abroad, for a substantial portion of their debt. The secondary market trading in these instruments provides real time pricing of fiscal risks, and gives important information on what is happening to intangibles such as “investor confidence”. For Thailand, the Philippines, and Indonesia, these signals showed considerable volatility in 2000 and 2001, with marked spikes clearly evident during periods of important political events (involving leadership in all three countries), and key economic events such as the conclusion of the International Monetary Fund (IMF) agreement with Indonesia. The links between such “confidence” measures, fiscal policy,

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and debt dynamics can change in an environment of open capital markets. For example, expansionary fiscal policy may stimulate the economy in a normal Keynesian way if the economy is closed. But with open capital markets and high debt, fiscal expansion could also trigger higher domestic interest rates, and greater devaluation risk, thereby undermining domestic investment spending. Unlike countries in Latin America, Southeast Asian countries have been able to quickly adapt fiscal policy to changing economic circumstances because a considerable portion of spending has been discretionary, especially development projects. One legacy of high debt is that the inflexible portion of the budget (debt service, interest payments, and mandated transfers to sub-national governments) has started to rise. There are two consequences: achieving fiscal deficit targets becomes harder if there are unanticipated shocks; and priority setting and expenditure efficiency become more important determinants of delivery of important public services, especially in the so-called social areas of education, health, and livelihood programmes. Following the 1997 crisis, it has become conventional to claim that Southeast Asian countries must develop their domestic bond markets as an alternative to commercial bank financing. That policy conclusion is made even more imperative by the growing stock of domestic public debt in many economies. The institutional development of bond markets and the associated need to “professionalize” the management of government bonds are long-term projects. Fortunately, several countries have already embarked on such a course, establishing new Public Debt Laws and setting up public Debt Management Offices with clearly defined accountabilities. This chapter first looks at the growth of public debt in seven Southeast Asian countries — the middle-income economies of Indonesia, Thailand, the Philippines, and Malaysia, and the low-income economies of Cambodia, Laos, and Vietnam. It then decomposes the growth of debt into core components using the accounting identities derived in Kharas and Mishra (2001). It further assesses the macroeconomic impact of a growing public debt, and the use of market signals as important information on the adequacy of the debt management strategy. The next section introduces a broader discussion of fiscal risks and their

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Homi Kharas and Sudarshan Gooptu

management, and the final section offers some concluding remarks. 2. Public Debt Is Growing in Southeast Asia

The dramatic rise in public debt that has taken place in several Southeast Asian countries since the East Asian financial crisis is putting severe fiscal pressures on their governments, through macroeconomic adjustments and through contingent liabilities associated with the systemic crises in the financial and corporate sectors. These, in turn, have generated fiscal strains that have led to increased budget deficits and which are squeezing public spending. Part of the deterioration in budget balances can be attributed to the natural consequence of the trough in the business cycle that inherently leads to declining revenues as the tax base shrinks (for income, value added, and import taxes). Meanwhile, there have been growing calls from the citizens of Southeast Asian countries for their governments to assume more responsibility for protecting low-income groups from the adverse impact of the crisis. The mode of financing of the increased budget deficits (between debt and money) has determined whether countries have racked up high debt burdens or not, and whether public spending can be maintained in a fiscally sustainable fashion. Over the past three years since the crisis, most of the Southeast Asian countries except Cambodia, Indonesia, and Laos have been pursuing an expansionary fiscal policy in order to stimulate their economies. Public debt levels (central government) have also risen sharply in some countries (Table 2.1). Currency devaluations precipitated balance sheet losses on government books, and the interest burdens on their outstanding foreign claims rose. Since 1996, public debt as a share of GDP has more than tripled in Indonesia and Thailand, and has risen sharply in Malaysia, primarily due to the sharp increase in domestic debt that resulted from financial sector bail-outs. By the end of 2000, public debt/GDP was over the 60 per cent Maastricht criterion in four Southeast Asian countries. Even though overall budget deficits have been increasing during the post-crisis period, the share of the budget that has had to go towards the inflexible components of the government’s budget (such as interest payments on their respective external and domestic public debts, wages

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2. Managing the Debt Burden in Southeast Asia

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Table 2.1 Public Debt as a Share of GDP (Percentages)

Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam

1990

1995

1996

1997

1998

1999

2000e

0.0 41.9 n.a. 79.5 18.9 n.a. 77.4 14.9 131.1

0.0 33.2 n.a. 41.1 5.9 71.7 73.2 10.2 43.6

0.0 26.9 n.a. 35.3 5.2 64.7 73.7 9.4 37.9

66.0 61.5 282.8 54.6 6.1 79.1 72.9 36.3 37.5

75.0 66.5 120.0 61.3 6.8 77.0 83.1 45.2 39.7

70.9 87.4 n.a. 64.1 n.a. 85.6 87.4 55.9 38.3

n.a. 99.1 n.a. 61.4 n.a. 91.1 84.5 57.3 46.6

Note: “Public debt” consists of public and publicly guaranteed Central Government debt, sub-national debt and borrowings by state-owned enterprises that have an explicit sovereign guarantee. Domestic and foreign currency-denominated debts are included. e = Preliminary estimate. n.a. = Not available. Source: World Bank.

and salaries, and mandated transfers to sub-national governments) has also been increasing in most Southeast Asian countries. High public-sector debt, and associated increased call on fiscal resources of the governments for debt service payments, has diminished their capacity to respond to another shock through fiscal means. During 1997–2000 the share of interest payments on public debt in total government spending has increased significantly in Cambodia, Indonesia, Laos, Thailand, and Vietnam. Most notably, in Indonesia, interest payments on public debt accounted for about 21 per cent of total expenditures on average between 1997 and 2000, up from an average of 9.5 per cent immediately preceding the crisis (1995–96). In Thailand, interest payments on public debt have increased from a pre-crisis average of about 1 per cent of total government expenditures (1995–96) to almost 7 per cent of total government expenditures in the post crisis (1997– 2000) period. The extent of these inflexible components of the fiscal budgets of high-debt Southeast Asian countries will be a drag on their respective medium-term growth prospects. It is important to note that the above public debt figures may not

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Homi Kharas and Sudarshan Gooptu

reflect all the governments’ obligations, since they exclude contingent liabilities that pose serious fiscal risks. These include future additional needs of financial sector resolution and debts of troubled state-owned enterprises, among others. In some Southeast Asian countries, such as Indonesia, one also faces the challenge of fiscal decentralization which can expand fiscal deficits unless managed prudently. Hence, looking at “conventional deficits” will not suffice if one wants to identify the fiscal risks inherent in an economy and how these “deficits” reflect the actual change in the government’s liabilities (that is, its public debt situation and its sustainability). Burnside, Eichenbaum, and Rebello (1999) have argued that while the East Asian countries had budget surpluses ex-ante, they also had large prospective deficits which, if realized, would imply large deficits ex-post. So the monetization of deficits (sometimes ex-ante expectations and other times ex-post) may still be contributing to an exchange rate crisis, but one may not observe any systematic relationship between deficits and crises by simply looking at data on “conventional deficits”. In countries with weak governance structures and poor regulatory and supervisory conditions, these hidden deficits may be even larger than reported figures would suggest. For instance, Bambang Subianto has noted that the accumulation of contingent liabilities in Indonesia was rooted in the lack of governance 1 in almost all sectors, accumulating over decades. The accumulated losses over several decades had not been reported completely in the balance sheets of the corporations prior to the crisis (the book value of firms’ assets did not represent their true market value). The crisis forced corporations to book these losses and correct their balance sheets. As a result, the quality of the loan portfolio of commercial banks that had lent funds to these corporations deteriorated sharply. Associated blanket guarantees by the Indonesian government on the financial sector were called, and the contingent liabilities of the government were realized. Hence, the actual fiscal situation of a country would be better estimated if one can deduce how much of contingent liabilities will be realized in the future, and what will be the impact of future exchange rate movements and domestic price levels on the stock of foreign and domestic debt respectively. At a bare minimum, this can be empirically estimated by looking at the “actuarial deficits” (using the Kharas and

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Mishra 2001a approach) which includes all expenses, including financial assistance for bank restructuring and other capital account transactions, which directly affect the government’s stock of liabilities, and deficits of the central bank and public corporation. Using this approach, the factors that went behind the observed change in the cumulative debt profile of Southeast Asian countries since the 1997 East Asian crisis was estimated in this chapter. The change in debt-output ratio was broken down into its contribution from: • • • • • •

real output growth real exchange rate changes domestic inflation reported deficit seigniorage revenue extra-budgetary activities

Figures 2.1 and 2.2 report on the results of this analysis. This approach explicitly recognizes the fact that budget deficits and surpluses constitute only a small portion of changes in the debt burden measured as the ratio of government liabilities to GDP. The contribution of other factors, such as realization of contingent liabilities, changes in exchange rates, domestic prices, and quasi-fiscal costs on government liabilities, sometimes exceed the contribution of the budget deficit to the debt (Kharas and Mishra 2001a). Kharas and Mishra (2001a) also find that the size of these “hidden deficits” are systematically linked to currency crises. These increase around crisis periods and decrease in tranquil periods. Thus, having a small budget deficit or surplus is only part of a successful public debt management strategy; other elements include timely provision for contingent liabilities, minimization of the effect of cross-currency valuations, avoidance of large quasi-fiscal cost through sterilization, financial bail-outs and so on. The Indonesian experience illustrates that when a crisis hits and contingent liabilities begin to be realized, the process of dealing with it becomes more and more complex with time. As events progressed and the recession became deeper in Indonesia, speedy implementation of possible countervailing measures was prevented by social and political constraints. Lack of common agreement and understanding among

© 2003 Institute of Southeast Asian Studies, Singapore

Figure 2.1 Conventional Deficits Only Partially Explain Changes in Public Debt Malaysia

Indonesia 20

50

15

40

10 30 5 20 0 10 (5) 0 (10) (10)

(15)

(20)

(20) 1995

1996

1997

1998

+ Real output growth + Domestic inflation - Base money (M1)

1999

2000

1995

+ Real exchange rate + Conventional deficit + Residual

1996

1997

1998

+ Real output growth + Domestic inflation - Base money (M1)

Philippines

1999

2000

+ Real exchange rate + Conventional deficit + Residual

Thailand 20.0

15 10

15.0

5 10.0 0 5.0

(5)

0.0

(10) (15)

(5.0)

(20) (10.0) (25) (15.0)

(30)

(20.0)

(35) 1995

1996

1997

+ Real output growth + Domestic inflation - Base money (M1)

1998

1999

2000

+ Real exchange rate + Conventional deficit + Residual

1995

1996

1997

+ Real output growth + Domestic inflation - Base money (M1)

1998

1999

2000

+ Real exchange rate + Conventional deficit + Residual

Note: The change in debt is derived using the methodology provided in Kharas and Mishra (2001). Sources: International Financial Statistics and International Monetary Fund Statistical Annexes; World Bank staff estimates.

Figure 2.2 Changes in Public Debt in Cambodia, Laos, and Vietnam Lao PDR

Cambodia

150.0

70.0 60.0

100.0

50.0 40.0

50.0 30.0 20.0

0.0

10.0 0.0

(50.0)

(10.0) (100.0)

(20.0) 1995

1996

1997

+ Real output growth + Domestic inflation - Base money (M1)

1998

1999

1995

2000

+ Real exchange rate + Conventional deficit + Residual

1996

+ Real output growth + Domestic inflation - Base money (M1)

1997

1998

1999

2000

+ Real exchange rate + Conventional deficit + Residual

Vietnam 20.0

10.0

0.0

(10.0)

(20.0)

(30.0)

(40.0)

(50.0) 1995

1996

+ Real output growth + Domestic inflation - Base money (M1)

1997

1998

1999

2000

+ Real exchange rate + Conventional deficit + Residual

Note: The change in debt is derived using the methodology provided in Kharas and Mishra (2001). Sources: International Financial Statistics and International Monetary Fund Statistical Annexes; World Bank staff estimates.

42

Homi Kharas and Sudarshan Gooptu

policymakers and other stakeholders on the factors leading to the buildup of public debt prevented formation of a consensus on how to deal with the debt problem. And thus a strong commitment to concerted reform became difficult to achieve. As bank restructuring progressed, the government’s liability increased. Public debt grew through the issuance of government bonds. In the case of the four Southeast Asian countries affected by the crisis (namely, Indonesia, Malaysia, the Philippines, and Thailand), the role of contingent liabilities that were realized (ex-post) was a significant factor leading to the growth of public debt. This is embodied in the “residual” term shown in Figure 2.1. In the same spirit, declines in public debt have been associated with privatization/asset sales (in the Philippines in 1995 and Malaysia in 1999). In Indonesia, the increase in public debt due to the real exchange rate effect (in 1997) and financial sector–related contingent liabilities that were realized and resulted in domestic bond issues (in 1999), can be clearly observed in the decomposition shown in Figure 2.1. In the non-crisis countries, Cambodia, Laos, and Vietnam, the size of the “hidden deficit” is negative (that is, a reduction in the stock of debt), primarily due to the restructuring (including forgiveness) of debts that were owed to their respective Paris Club creditors (1995–97) and the Soviet bloc in 2000. For these low-income countries — Cambodia, Laos, and Vietnam — almost all their public debts are owed to official 2 creditors and on concessional terms (Figure 2.2). The positive spike in debt levels in Cambodia in 1997 is because of the discovery of previously unrecorded Russian debt. 3. Macroeconomic Impact of Growing Public Debt

The last five years since the East Asian crisis have seen a change in the focus of debt management policymaking, from looking merely at public debt levels and external debt, to issues related to the vulnerability of a country to the risks inherent in its public debt portfolio. Public debt management is now concerned with both external and domestic liabilities of the government, and with fiscal risks emanating from its contingent liabilities. Under these changed circumstances, where comprehensive public debt management is associated with prudent use of public funds, a situation of high and

© 2003 Institute of Southeast Asian Studies, Singapore

2. Managing the Debt Burden in Southeast Asia

43

unmanageable public debt burdens is translated into more critical sovereign risk assessments by market participants (and higher credit risk and exchange rate premiums). In some cases, such as Indonesia, the Philippines, and Thailand, domestic interest rates have had to have a premium to attract investors into holding local currency assets. Even with the premium, capital outflows continued to be observed in Indonesia through 2001. With the ongoing global slowdown, and the 11 September terrorist attacks, the risks of further economic instability (and hence risks of interest rate and exchange rate variations) remain. Prudent public debt management has thus become all the more urgent. Globalization has impacted debt management as well. The East Asian crisis has brought with it a change in the focus of debt management policy from external debt management and its sustainability to managing public debt (external and domestic) and fiscal risks. Domestic debt instruments account for a significant proportion of East Asian government liabilities (Figure 2.3). This has important implications on the pace of reforms in their domestic bond markets. The late 1990s has seen a significant increase in the number of developing countries with internationally rated domestic bond issues. 4. Debt Management and Macroeconomic Management

Co-ordination between debt management and macroeconomic management policy is imperative. Corporations manage financial risks by matching the currency composition and maturity of their assets with those of their liabilities in an integrated manner. The situation with sovereigns is different. Typically, the management of sovereign assets and liabilities cannot be co-mingled. A government debt portfolio is often the largest financial portfolio in the country. It may contain complex and risky financial structures that can expose the government to substantial risk to the government’s balance sheet and the country’s financial stability. Under these circumstances, debt management and monetary policy co-ordination are key. Governments are often reluctant to raise interest rates to control inflationary pressures, as this would adversely affect the debt service on its domestic (variable interest rate) liability portfolio. Others may be tempted to inflate away some of the value of nominal debt, or to inject liquidity in the market prior to debt refinancing, to keep interest rates down. But higher inflation can also

© 2003 Institute of Southeast Asian Studies, Singapore

Figure 2.3 The Buildup of Public Debt Has Been Mainly Due to Domestic Debt Issuance (Changes in the Stock of Total External Debt, 1994–99) Malaysia

Indonesia 25%

10%

20%

8%

15%

6%

10%

4%

5%

2%

0%

0%

-5%

-2%

-10%

-4% 1994

1995

1996

1997

1998

1999 -6%

Residual Cross-currency valuation Net change in interest arrears * Net flows on debt

1994

1995

* Owed to private creditors.

Indonesia: Domestic and External Public Debt Stock (US$ billions) 1,500 Domestic

1,000 500 External 1995

1996

1997

1997

1998

1999

Malaysia: Domestic and External Public Debt Stock (US$ billions)

2,000

0 1994

1996

Residual Cross-currency valuation Net flows on debt

1998

1999

120 100 80 60 40 20 0 External 1994 1995

Philippines

Domestic

1996

1997

1998

1999

Thailand

10%

25%

8%

20%

6% 15%

4% 2%

10%

0%

5%

-2% 0%

-4% -6%

-5% 1994

1995

1996

1997

1998

1999 -10%

Residual Cross-currency valuation Debt forgiveness or reduction Interest capitalized Net flows on debt

1994

External 1996

1997

1997

1998

1999

Thailand: Domestic and External Public Debt Stock (US$ billions)

Domestic

1995

1996

Residual Cross-currency valuation Net flows on debt

Philippines: Domestic and External Public Debt Stock (US$ billions) 2,000 1,500 1,000 500 0 1994

1995

1998

1999

2,000 1,500 1,000 500 0 1994

Domestic External 1995

1996

Source: World Bank, Global Development Finance 2001.

1997

1998

1999

Figure 2.4 Primary Balances in ASEAN Countries, 1995–2000 Indonesia

% of GDP 4.5% 4.0% 3.5% 3.0%

5.0% Primary Balance

4.0%

Primary Balance

2.5% 2.0% 1.5%

3.0% 2.0% 1.0% 0.0%

1.0% 0.5%

-1.0%

0.0%

-2.0% 1995

1996

1997

1998

1999

2000

1995

5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

1996

% of GDP 4.0%

Philippines

% of GDP

1997

1998

1999

2000

Thailand

3.0% Primary Balance

2.0% 1.0% 0.0%

Primary Balance

-1.0% -2.0% -3.0%

1995

1996

1997

1998

1999

1995

2000

Cambodia

% of GDP 0.0%

1996

-1.0%

1997

1998

1999

2000

1998

1999

2000

Laos

% of GDP 0.0%

-0.5%

1995

1996

1997

-2.0%

-1.0%

-3.0%

-1.5% -2.0%

Malaysia

% of GDP 6.0%

-4.0% Primary Balance

-5.0% Primary Balance

-6.0%

-2.5%

-7.0%

-3.0% 1995

1996

1997

1998

1999

Vietnam

% of GDP 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0%

-8.0%

2000

Primary Balance

1995

1996

1997

1998

1999 2000 prel.

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have substantial negative effects on debt dynamics through lowering growth rates, depreciating the currency and increasing contingent liabilities in the banking system. Debt management and fiscal policy are also intertwined. Figure 2.4 shows the primary balance of Southeast Asian countries during recent years. What is remarkable is that even in 1997 and 1998, the period of major contraction in GDP, Indonesia, Malaysia, and the Philippines were running primary surpluses, while Thailand’s primary deficit was small by international fiscal standards. These very conservative fiscal positions may be appropriate given high debt levels, but they also indicate that the interaction between debt, policy, and macroeconomic management is not well understood within the region. Most analysts have found that during the 1990s, fiscal policy in these four middle-income countries has been significantly pro-cyclical. Fiscal surpluses did not rise rapidly enough to cool aggregate demand during the early 1990s, and deficits did not expand fast enough during the downturn and period of weak economic growth in 1997 and 1998. Today, again, governments across the region are reacting to the economic slowdown by announcing expansions in public spending. But the effectiveness of such measures is unclear, both in terms of the timing of the fiscal stimulus and in terms of its impact. There are several reasons why it proved difficult to run an expansionary fiscal stance and give a positive fiscal stimulus to economic growth in 1998. Most observers point to the administrative delays in translating government policy pronouncements into actual expenditures, especially when key safety-net programmes — the priority area for public spending — were relatively underdeveloped. In most cases, it took well over nine months to a year before the funds started to disburse in significant quantities, even in Malaysia where public administration is relatively strong. Furthermore, fiscal structures in many countries do not automatically adjust to current economic conditions. Revenue collections (for example, income taxes) are often deferred, relative to the time when the taxable event occurs, while cyclical expenditure items, such as unemployment insurance, are mostly absent. Thus, all the burden of cyclical fiscal adjustment falls on policy changes which take time to develop and

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implement, and which are therefore hard to align with economic cycles. To some extent, this may be a blessing in disguise. In open economies with high savings and import rates, the traditional Keynesian fiscal multiplier is likely to be small. Keeping fiscal policy consistent with long-term growth determinants may be more important than trying to manage short-run cycles with fiscal policy. The experience of the Organization for Economic Co-operation and Development (OECD) (Box 2.1) is instructive in this regard. In euro economies with high debt levels, fiscal expansion has not generated an output response even in the short run. The low-income economies of Cambodia, Laos, and Vietnam have also had modest fiscal deficits relative to other developing countries at similar stages of development. In these countries, access to concessional finance is the critical determinant of the fiscal stance. It would be imprudent to attempt a proactive fiscal policy using money finance or non-concessional debt to fund additional public expenditures. Some governments have resorted to issuing short-term debt solely because it demands lower interest rates — and a smaller call on the fiscal budget. However, such a strategy has often led to higher refinancing costs ex-post. Similarly, issuing foreign currency debt with lower interest rates than domestic borrowing, if not managed prudently, may expose a country to high exchange rate risk. As shown in the previous section, budget deficits/surpluses constitute only a portion of the changes in total government liabilities since “hidden deficits” may exist as well. Thus, issuing high interest rate zero coupon long-term domestic bonds may lead to high future deficits that need to be accounted for in debt management policy. The central bank’s daily management of liquidity of the country’s foreign currency debt service in the foreign exchange market may also conflict with its intervention policy. These transactions could be perceived by financial markets as having a signalling effect on its foreign exchange policy, thereby undermining its effectiveness. It will also have an impact on exchange rate risk premia. Examining readily available market signals can assist macroeconomic policymakers and public debt managers with an “early warning indicator” of impending crises with some degree of analytical precision. Using the familiar interest rate parity condition one can decompose the interest

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Box 2.1 Fiscal Consolidation and Macroeconomic Performance: Homi Kharas and Sudarshan Gooptu Lessons from the OECD Countries

The experience of the Anglophone OECD countries and those in the euro area suggests that while there is widespread agreement that a sound fiscal position is conducive to improved economic performance over the medium to long term, the a impact of fiscal consolidation on output in the short term is an area of some dispute. The standard Keynesian analysis suggests that fiscal contraction will result in lower employment and output over the short term, as it reduces aggregate demand (partly offset by the decline in real interest rates and by the anticipation of a reduction in the future tax burden). A more recent economic literature (often labelled “non-Keynesian”) has emphasized the distortions arising from government intervention. In this view, the short-term macroeconomic impact of fiscal consolidation can be positive under the same circumstances that help make such adjustments successful — when they occur with high initial levels of public debt or are expenditure-based. As high public debt raises interest rates and enhances expectations of future increases in taxation or possible default (especially if certain thresholds of public debt are perceived as unsustainable), a reduction in public debt can increase aggregate demand of the b private sector via wealth effects. Reductions in public expenditure and the associated public wage compression (which can impact private sector wages) can reduce production costs, which raises profitability and competitiveness, thus stimulating c investment and exports. Reducing public spending can also raise the confidence of the business sector, to the extent such consolidations are perceived as more successful. Considering the experience of the past twenty years, there is some evidence for the United States suggesting that in the short term the standard Keynesian effect may dominate, with fiscal contractions (achieved through either a reduction in expenditure or an increase in taxes) estimated to have had a negative effect on output, d although the multipliers are generally small. This result plausibly reflects the relative stability of fiscal policy and government debt in the United States and the limited role of government in the economy, characteristics that are shared by other Anglophone countries — at least over recent years. Even in these countries, however, one part of the non-Keynesian story does appear to hold, namely, reductions in government e spending have a strong positive effect on investment spending. The evidence for other countries is more mixed, with several authors finding evidence that some fiscal contractions can be associated with somewhat higher growth even in the short term, particularly if the contraction is associated with falls in government f spending. Most of these cases occur in OECD euro area countries characterized by high levels of government debt and large governments, where non-Keynesian effects are likely to be more important. Although governments remain large in many OECD euro area countries, recent reductions in government debt ratios and fiscal deficits, and the associated improvements in the long-term fiscal outlook, may have reduced the effectiveness of non-Keynesian channels. a

Hemming, Kell, and Mahfouz (2000); World Economic Outlook (May 1996, chapter 3). See, among others, Perotti (1999, pp. 1399–1436). c See, for example, Alesina, Ardanga, Perotti, and Schiantarelli (1999). d See Blanchard and Perotti (1999). Small multipliers are also a property of the IMF’s large econometric model (MULTIMOD) when monetary policy is assumed to primarily stabilize inflation. e This result has also been found for other countries. See Alesina, Ardanga, Perotti, and Schiantarelli (1999). f For a survey, see Alesina, Perotti, and Tavares (1998, pp. 197–266). b

Source: International Monetary Fund, World Economic Outlook (May 2001, box 3.3, p. 97).

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rate to arrive at estimates of default risk and devaluation risk (Kharas, Pinto, and Ulatov 2001b). Figure 2.5 shows this breakdown for the four crisis countries — Indonesia, Malaysia, the Philippines, and Thailand — for the period January 2000 to August 2001. For these countries, the sovereign risk (denoting pure “country risk” due to market fundamentals) is measured by the spread paid by the government over a risk-free asset, in this case one-year U.S. Treasury bills. Sovereign risk premia tend to be relatively stable compared with devaluation risk premia, because the former reflects long-term fundamentals. The devaluation risk (er) pemium is derived as d * the residual in the interest parity condition: (1) er = i − i − sr − ee where d er is the devaluation risk, i is the domestic, one-year government bond * rate, i is the one year U.S. treasury bill rate (sr) is the sovereign risk premium and ee is expected devaluation, taken from Consensus Forecasts. High devaluation risk premia (as observed, for instance, in Indonesia in July 2000, the Philippines in November/December 2000, and Thailand in July 2000 and April to May 2001 in Figure 2.5) are often signs of growing political instability as perceived by market participants. In Indonesia, for instance, the announcement about the completion of the third review of the IMF Extended Fund Facility arrangement in August 2001 led to a sharp drop in the devaluation risk premium. Default risk has not changed at all, indicating the difficulty of changing perceptions about long-term fundamentals involving structural reform performance and possible concern about the size of public debt (especially domestic debt that has shown a rapid increase). Malaysia, on the other hand, has shown a continuous decline of the devaluation risk premium, which suggests that fears of an imminent ringgit realignment are not warranted. 5. Managing Public Debt Prudently

A government’s public debt management policy will have important macroeconomic linkages. Marcoeconomic policy will impact on corporate and government revenues, which in turn will affect their respective repayment capacities, asset values, and collateral valuations. It will impact on the trade balance and on the composition of capital (that is, debt and non-debt flows). Conversely, the mode of financing

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Figure 2.5 Sovereign Risk and Devaluation Risk Premiums, 2000 to AprilGooptu 2001 50 HomiJanuary Kharas and Sudarshan Indonesia 25 20

Devaluation risk premium

15 10 5 0

Sovereign risk premium

-5 -10

Ja n00 Fe b00 Ma r-0 0 Ap r-0 Ma 0 y-0 0 Ju n00 Ju l-0 0 Au g00 Se p00 Oc t-0 0 No v-0 0 De c-0 0 Ja n01 Fe b01 Ma r-0 1 Ap r-0 Ma 1 y-0 1 Ju n01 Ju l-0 1 Au g01

-15

Philippines 8.00 6.00

Sovereign risk premium

4.00 2.00 0.00 -2.00 -4.00

Devaluation risk premium

Ja n00 Fe b00 Ma r-0 0 Ap r-0 Ma 0 y-0 0 Ju n00 Ju l-0 Au 0 g0 Se 0 p00 Oc t-0 No 0 v-0 0 De c-0 0 Ja n01 Fe b01 Ma r-0 1 Ap r-0 Ma 1 y-0 1 Ju n01 Ju l-0 Au 1 g01

-6.00

Malaysia Sovereign risk premium

Devaluation risk premium

Ja n0 Fe 0 b00 Ma r-0 0 Ap r-0 Ma 0 y-0 0 Ju n00 Ju l-0 Au 0 g0 Se 0 p00 Oc t-0 No 0 v-0 De 0 c-0 0 Ja n01 Fe b0 Ma 1 r-0 1 Ap r-0 Ma 1 y-0 1 Ju n01 Ju l-0 Au 1 g01

3 2 1 0 -1 -2 -3 -4 -5 -6

6 5 4

Thailand Devaluation risk premium

3

Source: Authors’ computations based on monthly data from Datastream 2 Inc.1 and Consensus Forecast, Sovereign risk premiumInc. 0 -1 Ja n00 Fe b00 Ma r-0 0 Ap r-0 0 Ma y-0 0 Ju n00 Ju l-0 0 Au g00 Se p00 Oc t-0 0 No v-0 0 De c-0 0 Ja n01 Fe b01 Ma r-0 1 Ap r-0 1 Ma y-0 1 Ju n01 Ju l-0 1 Au g01

-2

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adopted (that is, the financing mix) will have important implications for a country’s future debt-servicing profile, and sustainability of its public investment programme, and thereby on the flexibility of macroeconomic policy. Prudent debt management entails making informed decisions by the authorities, on an ongoing basis, of the degree of concessionality of their existing and future debt portfolio, and whether there are debt service “humps” in the horizon. Maintaining open channels of communication with creditors (both official and private) will facilitate the authorities of a country to remain well informed about their creditworthiness, and the considerations that different sources of financing would take into account. A stable macroeconomic environment and efficient public expenditure management have been seen to go a long way in maintaining favourable creditor perceptions and inflows of non-debt flows (such as foreign direct investment). Macroeconomic strategies that have involved keeping investors and creditors positively engaged (including privatization programmes and orderly debt restructuring arrangements) have facilitated continued access of financing at reasonable costs. Official debt relief and increasing concessional assistance from external creditors, such as the Paris Club and the World Bank/IMF Heavily Indebted Poor Country’s (HIPC) Debt Reduction Initiative, have been conditional on good macroeconomic (and fiscal) management by its borrowing countries. An assessment of the fiscal accounts of the Southeast Asian countries in this chapter shows growing inflexibility in the budget, due to rising debt service payments and a growing wage bill, which divert resources away from social sector expenditures. Prudent public debt management will require that fiscal sustainability be maintained over a medium-term time horizon. To this end, a more strategic approach towards public debt management policy (rather than short-term cash management that remains the practice in several countries in East Asia) is warranted. Comprehensive budget reporting and monitoring to include fiscal risks due to contingent liabilities would significantly facilitate this process. The debt burden must be evaluated on a medium-term basis. The forward-looking estimation of debt-supporting capacity should be undertaken by the public debt managers with due consideration to a medium-term funding strategy that is consistent with the medium-term

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objectives of the debt management office. For instance, the risks arising from debt financing include: interest rate risk on variable interest rate debt; refinancing and rollover risk on fixed rate debt; currency risk due to mismatches in currency of inflows and revenues; and/or commodity price risk (for example, on assets [reserves], liabilities, export earnings and import expenses). These give rise to fiscal risks that need to be managed (see Box 2.2). Improvements in public budget management are concurrently underway in several countries, including Thailand, Indonesia, and the Philippines, with the urgency of this having increased significantly since the Asian financial crisis. The eventual move from cash accounting and budgeting to accrual accounting and budgeting is being considered by some of the countries in the region in the context of getting a better handle on fiscal risks due to public contingent liabilities. In theory, fiscal sustainability and public debt management can be considered on the basis of the “Balance Sheet Approach” which views “sustainability” from the point of “solvency”, that is, assets should cover liabilities, and takes into account all current and future assets and liabilities (that is, a comprehensive public sector balance sheet). This is, however, difficult to estimate in practice. Hence, a “Fiscal Rules Approach” is often used, which involves deriving conditions under which the debt to GDP ratio does not rise over time, or if it does, rises and stabilizes to levels that are comfortable over time. Under this approach, the fiscal stance cannot be sustained if the growth rate of the economy is less than that of the stock of debt. Ex-post trends on this are relatively easy to estimate in practice, but systematic ex ante analysis is needed to identify changes in these trends in the future. Another key task of public debt managers is to continuously monitor fiscal vulnerability. This involves having continuous access to information on the stock of international reserves of the monetary authorities, and the extent of the government’s access to international markets (as highlighted by borrowing spreads from different potential creditors — both foreign and domestic); managing the maturity profile of the public debt and sources of vulnerability of government revenues and expenditures (including the effect of devaluation on the budget); and monitoring the inflation rate which eats away the real value of non-

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Box 2.2 Risks Encountered in Sovereign Debt Management Risk

Description

Market/refunding (or rollover) risk

Risks associated with changes in interest rates and/or exchange rates. On debt denominated in domestic currency, changes in interest rates affect debt service costs on new issues, making short-duration debt more risky than long-duration debt. Debt denominated in foreign currency is similarly subject to the effects of changes in foreign currency interest rates, including changes in credit spreads; it is also subject to changes in interim and final cash flows (coupon payments and principal) when converted into the domestic currency, owing to exchange rate movements. The risk that debt will have to be rolled over at an unusually high cost, or in certain cases that it cannot be rolled over at all, can be particularly important for emerging markets.

Liquidity risk

There are two types of “liquidity risk”. One refers to the cost or penalty investors face in trying to exit a position when the number of transactors has markedly decreased or because of the lack of depth of a particular market. The other form of liquidity risk, for a borrower, refers to a situation where the volume of liquid assets can diminish quickly in the face of unanticipated cash flow obligations and/or a possible difficulty in raising cash through borrowing in a short period of time.

Credit risk

The risk of non-performance by borrowers on loans or other financial assets or by a counter-party on financial contracts. This risk is particularly relevant in cases where debt management includes the management of liquid assets. It may also be relevant in the acceptance of bids in auctions of securities issued by the government as well as in relation to contingent liabilities, and in derivative contracts entered into by the debt manager.

Settlement risk

Refers to the potential loss that the government could suffer as a result of failure to settle, for whatever reason other than default, by the counter-party.

Operational risk

This includes a range of different types of risks including transaction errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls, or in systems and services; reputation risk; legal risk; security breaches; or natural disasters that affect business activity.

Source: International Monetary Fund and World Bank, Guidelines for Public Debt Management (2001).

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indexed debt, as well as tax revenues. There are also associated risks of foreign exchange volatility in a country’s public debt portfolio that need to be managed. In addition, the depth of the domestic financial market will influence the degree of refinancing risk, maturity, and yield curve a government is exposed to. More efficient debt markets in turn can strengthen the transmission and implementation of monetary policy, including the achievement of monetary targets or inflation objectives, and enable the use of market-based monetary instruments. Well-functioning domestic debt markets reduce or eliminate the need for direct and potentially damaging monetary financing of the deficit. Hence, sound debt management policies should lower borrowing costs in the long term and reduce the budgetary impact of deficit financing, and contribute to debt sustainability. In determining an appropriate funding strategy, solvency versus creditworthiness considerations are critical. A country may be solvent in the eyes of creditors but not necessarily creditworthy at any particular point in time. The latter is influenced by market perceptions about a government’s willingness to pay, and their continuous assessments of sovereign risk (that, in turn, affects their willingness to lend). Concerns about debt overhang influence investor and market confidence. To this end, the creditor composition and concessionality of a country’s existing debt will influence future debt management policy and borrowing strategy. Once the public sector borrowing requirements are determined, prudent debt management will require appropriate attention to issues such as: how to minimize “liquidity” and “rollover” risks; the trade-off between foreign exchange and interest rate risk to be borne by the government; the trade-off between price and refinancing risk; external versus domestic borrowing decisions; real exchange rate movements and the extent of “natural hedge” there may be in a country’s foreign exchange inflows and outflows. In March 2001, the World Bank and the IMF issued a set of Guidelines for Sound Practices in Sovereign Debt Management (henceforth called the Guidelines) that are designed to assist policymakers in considering reforms to strengthen the quality of their public debt management and reduce their country’s vulnerability to international financial shocks. Cross-country experiences suggest that vulnerability is often greater for smaller and emerging

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market countries because their economies may be less diversified, they have a smaller base of domestic financial savings and less-developed financial systems, and are more susceptible to financial contagion through the relative magnitudes of capital flows. Irrespective of whether financial shocks originate within the domestic banking sector or from global financial contagion, prudent government debt management policies, along with sound macroeconomic policies, are essential for containing the human and output costs associated with such shocks. The World Bank/IMF Guidelines cover both domestic and external public debt, and encompass a broad range of financial claims on the government. They seek to identify areas in which there is broad agreement on what constitutes sound practices in public debt management generally. The Guidelines endeavour to focus on principles applicable to a broad range of countries at different stages of development and with various institutional structures of national debt management. They should not be viewed as a set of binding practices or a rigid prescription, nor suggest that a unique set of sound practices exists, which would apply to all countries in all situations. Building capacity in sovereign debt management can take several years, and country situations and needs vary widely. The Guidelines are mainly intended to assist policymakers by disseminating sound practices adopted by member countries in conducting debt management operations, and for which there is a record of experience. Multi-year capacity building programmes on the lines of these debt management Guidelines are under way in Indonesia and Thailand, while seminars and workshops are frequently being held in the other Southeast Asian countries on demand. These programmes are supported by several official donors and agencies, such as the Asian Development Bank, Australian Agency for International Development (AusAID), Japan, U.S. Treasury, IMF, and World Bank, among others. Given the complex nature of implicit contingent liabilities in reality, especially where governance is weak, the debt management Guidelines may be construed as being too narrow. With the same groups (or “families”) owning a range of businesses in the financial, corporate, and insurance sectors, the monitoring of these contingent liabilities becomes all the more difficult. The need for processes and mechanisms that allow for group supervision and corporate governance becomes all the more important. Understanding the social and political linkages in the

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economy is crucial to understanding the motivations of policymakers to bail out an entity in the face of a crisis. The key issue is how the losses of a crisis are to be apportioned among different stakeholders in the economy (private, public, domestic, or foreign). In the face of weak governance and ineffective rule of law, political debate over apportioning losses may lead to unnecessary delays in implementing crisis resolution measures, and asset stripping by bad debtors may emerge. The dynamics of the crisis thus may fuel the realization of an even greater value of contingent liabilities and further increase the public debt beyond sustainable levels. Each country’s capacity-building needs in sovereign debt management will be shaped by the capital market constraints it faces, its exchange rate regimes, the quality of its macroeconomic and regulatory policies, its institutional capacity to design and implement reforms, its credit standing in international markets, and its objectives for public debt management. Nevertheless, all governments face policy choices concerning debt management objectives, their preferred risk tolerance, which part of the government balance sheet the government debt managers should be responsible for, and how to establish sound governance for public debt management. On many of these issues, there is increasing convergence on what are considered prudent sovereign debt management practices that can also reduce vulnerability to contagion and financial shocks. These include: recognition of the benefits of clear objectives for debt management; the separation and co-ordination of debt and monetary management; a limit on debt expansion; the need to carefully manage refinancing risk and the interest costs of debt burdens; and a sound institutional structure, including clear delegation of responsibilities and associated accountabilities among government agencies involved in debt management. Prudent public debt management must also be carefully co-ordinated and consistent with reforms in overall public financial management, involving improvements in liquidity and cash management, audit, and accounting practices in Southeast Asian countries. Monitoring subnational borrowing transactions, issuance of sovereign guarantees and contingent liabilities can be better understood and implemented if undertaken in the context of overall public financial management reforms.

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6. Concluding Remarks

High levels of public debt have largely arisen from the need to recapitalize banks in an environment of slow growth, currency devaluation, and, in some instances, high domestic interest rates. The debt dynamics illustrated by these numbers suggests that a narrow focus on fiscal deficits as the key policy issue with which to address debt sustainability is too narrow. Fiscal policymakers must consider debt dynamics in a much broader context of growth, exchange rate volatility, contingent liability management, and, indeed, overall political stability. This is a more complex task than was the case in the past — not only are Southeast Asian countries more heavily indebted today than they were before the Asian financial crisis of 1997, but they also live in a world with more underlying volatility. Combined, these forces suggest a change in focus to one of fiscal risk management from one of debt sustainability analysis. Given strong fundamentals, the levels of indebtedness are still manageable, even in Indonesia, the most heavily indebted of the Southeast Asian countries. Doubtless, high debt levels will constrain delivery of public services and the adaptability of fiscal policy, but at current levels there is ample scope for policy to bring the debt/GDP ratio onto a stable trajectory. From this perspective, the management of debt is as much a function of government microeconomic policy as it is of government macroeconomic policy. The former is what will dictate the level of contingent liabilities, guarantees, and efficiencies in managing expenditure reductions on delivery of public services. It may also have a strong bearing on medium-term growth and currency movements, which in the longer term are key drivers of debt dynamics. One encouraging conclusion is that the market-oriented Southeast Asian countries seem to have overcome the nervousness of financial markets that an unexpected sudden devaluation may occur. That will help keep domestic real interest rates low, improving public debt dynamics directly through lower interest payments on domestic debt, and indirectly through higher growth rates. Given the importance and size of domestic public debt, there is a substantial institutional programme that needs to be developed to manage public debt. Government domestic bond markets remain underdeveloped and thin, with little secondary market trading. This limits the capacity

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of governments to manage their debt actively to take advantage of periods when market conditions are more favourable to reduce the long-term cost of debt. In the past, bond market development was impeded in part because, with fiscal surpluses being the norm, there was no benchmark issue off which to gauge risk of a domestic currency– denominated liability. Equally, the legal and institutional underpinnings of a bond market were underdeveloped with no pressing urgency for such a market to develop. This in turn contributed to the excessive reliance of the corporate sector on commercial bank financing. Conditions have now changed. Bond market development is needed both for the smooth refinancing of public sector domestic debt and to help corporates shift to a more balanced financial structure away from commercial loans. As the bond markets develop, a more professional public sector debt management capacity could pay dividends in reducing the overall cost of public sector debt. To conclude, the reforms required to manage Southeast Asian public debt levels so as to minimize the overall economic cost are broad. They encompass both microeconomic policy reforms, greater attention to fiscal risk management and broader institutional reforms to gain a better understanding of market perceptions of risk and to provide tools for managing such risk. Although policymakers would prefer to believe that fiscal sustainability can be assured by macroeconomic policy decisions which are fully under their control, they must recognize that they are living in a world where markets absorb and interpret a very broad array of data. Markets can, to use Guillermo Calvo’s term, simply be “unforgiving” if any aspect of policy or politics strays beyond the norm. And the punishment is usually meted out in foreign and domestic financial markets, for credits and bonds. NOTES 1. Discussant’s comments by Dr Bambang Subianto at the ASEAN Roundtable 2001 on Financing Sustained Economic Development in Southeast Asia, Singapore, October 2001. 2. Concessionality being determined by a “grant element” calculation, which is based on the OECD-DAC methodology, and employs a 10 per cent discount rate.

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REFERENCES Alesina, Alberto, Roberto Perotti, and Jose Tavares. “The Political Economy of Fiscal Adjustments”. Brookings Papers on Economic Activity 1 (1998). Alesina, Alberto, Silvia Ardanga, Roberto Perotti, and Fabio Schiantarelli. “Fiscal Policy, Profits, and Investment”. NBER Working Paper no. 7207. Cambridge, M.A.: National Bureau of Economic Research, July 1999. Blanchard, Olivier and Roberto Perotti. “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output”. NBER Working Paper no. 7269. Cambridge, M.A.: National Bureau of Economic Research, July 1999. Burnside, Craig, Martin Eichenbaum, and Sergio Rebello. “Prospective Deficits and the Asian Currency Crisis”. World Bank Staff Working Paper no. 2174, 1999. Easterly, William. When Is Fiscal Adjustment an Illusion? Washington, D.C.: World Bank, 1998. Eichengreen, Barry, Andrew K. Rose, and Charles Wyplosz. “Contagious Currency Crises”. Scandinavian Journal of Economics 98, no. 4 (1996): 463–84. Furman, Jason, and Joseph E. Stiglitz. “Economic Crises: Evidence and Insights from East Asia”. Brookings Papers on Economic Activity 2 (1998): 1–114. Hemming, Richard, Michael Kell, and Selma Mahfouz. “The Effectiveness of Fiscal Policy in Stimulating Economic Activity — A Review of the Literature”. Mimeographed. Washington: International Monetary Fund, March 2000). International Monetary Fund. World Economic Outlook. Washington, D.C.: May 1996, May 2001. International Monetary Fund and World Bank. Guidelines for Public Debt Management. 21 March 2001. Kharas, Homi and Deepak Mishra. “Fiscal Policy, Hidden Deficits and Currency Crisis”. In World Bank Economists’ Forum, edited by Shantayanan Devarajan, F. Halsey Rogers, and Lyn Squire. Washington, D.C.: World Bank, 2001a. Kharas, Homi, Brian Pinto, and Sergei Ulatov. “An Analysis of Russia’s 1998 Meltdown: Fundamentals and Market Signals”. Brookings Papers on Economic Activity 1 (2001b): 1–68. Krugman, Paul R. “A Model of Balance-of-Payments Crises”. Journal of Money, Credit and Banking 11, no. 3 (1979): 311–25. Perotti, Roberto. “Fiscal Policy in Good Times and Bad”. Quarterly Journal of Economics 114 (November 1999): 1399–436. World Bank. Global Development Finance 2001. Washington, D.C.: World Bank, May 2001. World Bank and the International Monetary Fund. Guidelines for Sound Practices in Sovereign Debt Management. 2001.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > Montreevat and Denis Hew 60 Sakulrat

3

Commercial Bank Lending and Restructuring in the ASEAN-5 Countries Sakulrat Montreevat and Denis Hew

1. Introduction

A number of works in the literature establish the existence of a causal link between finance and growth and development. For example, see Beck and Levine (2001), Gourinchas et al. (2001), Rajan and Zingales (1998), and Levine and Zervos (1998). In addition, a growing body of economic literature reveals a lending boom as a key element of banking and balance-of-payment crises in developing countries (Gourinchas et al. 2001). The 1997 Asian crisis was characterized by large capital outflows, weak financial systems, a massive contraction of bank credit, and a sharp economic recession. See Chan-Lau and Chen (1998), Lindgren et al. (1999), Noble and Ravenhill (2000), and Jomo (2001). The lending function of commercial banks in financing the economy

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has been widely criticized, especially in bank-based financial systems. Disyatat (2001) described the relationship between a bank’s role and the real economy as follows: When the banking sector is healthy, the standard Keynesian effect applies — output increases as monetary policy is eased and real factor costs decline, but when banks are weak, a devaluation will bring about contractions in the real economy. An economy whose banks are weak, in terms of low net worth, high exposure to currency risk, and bad quality assets, is much more vulnerable to output collapse in the wake of a currency crisis. (Disyatat 2001, p. 3)

Southeast Asian banks’ capacity to lend has been questioned in the postcrisis period, at a time when alternative forms of corporate finance are still in the process of being developed. This chapter focuses on bank lending in the post-crisis ASEAN-5 countries (Indonesia, Malaysia, the Philippines, Singapore, and Thailand), bank restructuring and corporate debt restructuring, and the development of financial safeguards to strengthen the domestic financial system. The chapter is organized as follows. Section 2 profiles the role of banks, and a set of stylized facts on credit contraction in the post-crisis ASEAN-5 countries. Factors on both demand and supply sides of bank credit are analysed. Progress made in bank and corporate debt restructuring is examined in Section 3. Financial safeguards to strengthen the domestic financial system are discussed in Section 4. Concluding remarks are provided in Section 5. 2. The Role of Commercial Banks and Bank Lending

The primary role of a commercial bank is to act as a financial intermediary, by mobilizing and allocating resources, through deposit taking and lending. Recently, the scope of bank activities has developed to cover a wider range of financial services, including investment banking and fund management. In much of Southeast Asia, banks perform an important role as domestic lenders, as evidenced by the size of loans to the gross domestic product (GDP) in the ASEAN-5 economies (see Table 3.1). However, the size of bank loans has tended to decline since the Asian financial crisis. Malaysia and Singapore have actively tapped the bond and equity markets in the late 1990s. There is an increasing trend of bond financing in Malaysia, Singapore, and Thailand, and of equity market financing in the Philippines. Yet the capital markets of

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Table 3.1 ASEAN-5 Bank Loans, Bonds, and Equities, as a Percentage of GDP, 1996–2000 Indonesia Year

Bank Loans

1996 1997 1998 1999 2000

55.0 60.2 51.0 20.3 20.8

Malaysia

Equity Market Bonds Capitalization 1.8 2.5 1.5 1.4 1.7

40.6 25.6 18.4 40.7 20.1

Year

Bank Equity Market Loans Bonds Capitalization

1996 1997 1998 1999 2000

90.0 102.8 109.5 108.0 101.4

Philippines Year

Bank Loans

1996 1997 1998 1999 2000

51.6 58.4 50.3 45.5 44.0

317.1 133.4 132.2 184.0 130.4

Singapore

Equity Market Bonds Capitalization 0.3 0.2 0.6 0.9 1.1

46.9 47.3 49.0 57.3 62.1

97.7 51.6 51.3 65.1 78.1

Year

Bank Equity Market Loans Bonds Capitalization

1996 1997 1998 1999 2000

99.1 102.2 110.3 103.6 96.9

20.2 22.1 23.3 30.3 31.1

201.5 229.9 173.5 298.1 252.9

Thailand Year

Bank Loans

Bonds

Equity Market Capitalization

1996 1997 1998 1999 2000

105.0 127.8 113.2 111.2 94.2

11.2 11.5 20.3 30.1 33.4

53.1 23.1 26.8 43.8 26.2

Source: CEIC Database.

the ASEAN-5 economies, except Singapore, are not well developed. Most of the region’s stock markets are characterized by poor transparency, low liquidity, thin trading, high volatility, and underdeveloped market infrastructure (Asian Development Bank 2000). Meanwhile, the corporate bond markets are relative small and largely underdeveloped (Yoshitomi and Shirai 2001a). Besides domestic bank borrowing, larger Thai corporations are able to borrow directly from foreign banks in the offshore market. Meanwhile,

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Table 3.2 ASEAN-5 Outstanding Loans of Commercial Banks, 1996–2000 Growth in Bank Lending (Nominal % Change) Year

Indonesia

Malaysia

Philippines

Singapore

Thailand

1996 1997 1998 1999 2000

24.9 29.1 28.9 −53.8 19.5

30.5 24.5 32.9 7.2 6.5

51.9 26.5 −4.8 0.4 7.2

16.5 12.8 5.9 −2.9 4.7

14.2 24.8 −13.6 −2.0 −10.3

Growth in Bank Lending (Real % Change) Year

Indonesia

Malaysia

Philippines

Singapore

Thailand

1996 1997 1998 1999 2000

15.7 21.6 −18.4 −61.7 15.1

16.9 19.9 −2.2 0.5 4.9

40.7 16.0 −10.1 −5.8 2.7

14.9 10.6 6.9 −2.9 2.5

7.9 18.2 −20.0 −2.3 −11.6

Sources: CEIC Database and Bank Negara Malaysia.

small- and medium-sized enterprises (SMEs) in Thailand rely heavily on domestic bank credit. In Indonesia, if banks are not owned by the government, they are commonly owned by large business groups, or politicians, or both. A bank owned by a group usually provides credit to the companies in that same group (ADB 2000). In the Philippines, most creditors are domestic commercial banks. Half of domestic commercial banks are linked through ownership to non-financial business groups. In contrast, only a few commercial banks in Malaysia are part of conglomerates (ADB 2000). Although Singapore has a large offshore market, regulations have prevented corporations from borrowing offshore in domestic currency. Given Singapore’s ample savings and low interest rates, offshore foreign currency borrowing by corporations remains very small. In Southeast Asia, Malaysian and Singaporean corporations have tended to rely more on bond and equity financing (Dekle and Kletzer 2001). A sharp contraction in lending growth of commercial banks in the ASEAN-5 countries was observed during 1998–99 (see Table 3.2). However, the contraction now seems to have peaked. In the case of Thailand, the sharp decline in outstanding loans, especially in 2000, was due to substantial debt write-offs, credits transferred to asset management companies (AMCs),

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Table 3.3 ASEAN-5 Percentage Share of Bank Loans, by Economic Sectors, 1995–2000 Indonesia

Malaysia

Year

Agri.

Mnfg.

Others

Year

Agri.

Mnfg.

Others

1995 1996 1997 1998 1999 2000

06.6 06.0 06.9 08.1 10.6 07.3

30.7 26.9 29.5 35.2 37.4 39.7

62.7 67.1 63.6 56.7 52.0 53.1

1995 1996 1997 1998 1999 2000

2.2 2.1 2.0 2.0 2.4 2.9

24.2 22.0 20.1 18.8 18.6 18.2

73.6 75.9 77.9 79.2 79.0 78.9

Philippines

Singapore

Year

Agri.

Mnfg.

Others

Year

Agri.

Mnfg.

Others

1995 1996 1997 1998 1999 2000

8.1 5.7 5.0 4.7 4.3 4.3

34.4 32.3 29.9 26.5 28.2 27.8

57.5 62.1 65.1 68.8 67.4 67.9

1995 1996 1997 1998 1999 2000

0.1 0.1 0.1 0.1 0.1 0.1

10.1 09.6 08.7 08.1 07.9 07.5

89.8 90.3 91.2 91.8 92.0 92.3

Thailand Year

Agri.

Mnfg.

Others

1995 1996 1997 1998 1999 2000

3.7 3.4 2.7 2.8 2.6 2.6

25.8 27.1 30.9 30.7 30.1 28.7

70.4 69.6 66.4 66.5 67.3 68.7

Agri. = Agriculture. Mnfg. = Manufacturing. Sources: CEIC Database and Bank Negara Malaysia.

and continued Bangkok International Banking Facility (BIBF) debt repayments. It has been suggested that if debts written off and credits transferred to AMCs were discounted, commercial bank credit gradually improved marginally from the second half of 1999, recording a growth rate of 0.6 per cent in 2000 (Bank of Thailand 2000). By economic sector, the share of bank lending to the manufacturing sector has been on a declining trend for all the ASEAN-5 countries,

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Table 3.4 Number of Commercial Banks in ASEAN-5, 1996–2000 Year

Indonesia

Malaysia

Philippines

Singapore

Thailand

1996 1997 1998 1999 2000

239 222 222 173 164

37 35 35 33 31

49 54 53 52 47

146 152 154 142 140

15 15 13 13 13

Source: CEIC Database.

except Indonesia (see Table 3.3). In 2000, only 8 per cent of bank lending went to manufacturing in Singapore, compared with 18 per cent in Malaysia, 30 per cent in both the Philippines and Thailand, and 40 per cent in Indonesia. In the post-crisis environment, there has been some concern expressed as to the ability of commercial banks to perform the role of domestic lenders, especially among the bank-based financial systems found in Indonesia, the Philippines, and Thailand. Both supply and demand shifts have simultaneously influenced bank lending in the ASEAN-5 economies after the 1997 crisis. Closures and ongoing mergers of banks have become a negative factor on credit availability (see Table 3.4). Customers of closed banks and other financial intermediaries encountered difficulties in establishing a credit relationship with other banks during the middle of the Asian financial crisis. Meanwhile, banks became extremely risk-averse in lending (Lindgren et al. 1999). When banks merge their operations, temporary increases in costs usually occur, and it takes time for mergers to produce anticipated cost reductions (Takayasu 2001). In such cases, the banks then tend to avoid other costs that may occur in credit release. Although the banking sector of Singapore was relatively untouched by the crisis, the government is determined to improve efficiency in the sector through consolidation. However, market forces have not delivered a faster consolidation process in the financial sector of Singapore (International Monetary Fund 2001a). At the onset of the crisis, severe depreciation in domestic currencies deteriorated the balance sheets of many domestic firms and banks in Southeast Asia, and inflicted substantial losses, resulting in a massive accumulation of non-performing loans (NPLs) in some countries.

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Consequently, banks have subsequently been more cautious in granting loans. Also, banks with lower capital adequacy ratios have curtailed lending activities. The reallocation of their asset portfolios away from loans was evident in banks in all the ASEAN-5 countries (see Table 3.5). Moreover, with stringent bank capital adequacy and loan classification rules of the crisis-affected economies, a capital-induced bank credit slowdown has been identified. As observed, banks are inclined to keep relatively risk-free assets, such as government securities, in their asset portfolios (Table 3.5). Based on a decreasing loan-deposit ratio and an increasing deposit growth of commercial banks in all ASEAN-5 countries, liquidity preferences have deterred banks from extending credit (Table 3.5). Meanwhile, the financial intermediation functions of banks have not yet been fully restored. The “spreads” between lending and deposit rates have increased in all countries, except the Philippines. And profitability, as measured by return on assets (ROA), has slightly improved for banks in Indonesia, Malaysia, and Thailand (Table 3.5). In addition, the corporate sectors of crisis-hit economies have yet to recover. The corporate debt-equity ratios at the end of 2000 were still above the levels of 1996. Especially for Indonesia and the Philippines, the ratios were greater than the peak levels of 1997 (Table 3.5). A lack of improvement in corporate debt-equity ratios reflects the amount of debt financing going to weak corporations, as well as difficulties faced by some corporations in servicing their debt (ADB 2001b). Banks are therefore understandably reluctant to extend new loans to corporations with already high debt-equity ratios. On the demand side, the growth of bank lending seems to be occurring in tandem with industry and GDP as a whole (see Table 3.6). Because of the tight fiscal and monetary policies in the crisis-affected economies in the wake of the financial crisis, a sudden decline in output demand and production caused a severe contraction in demand for bank credit. Indeed, many companies closed down. For viable enterprises, rapid expansion in production capacity during the pre-crisis years resulted in weakened credit demand for new investment after 1997, due to excess production capacity. Indonesia was the hardest hit on production capacity utilization, falling by nearly 21 per cent between 1996 and 1998. The Philippines suffered least, with its capacity utilization contracting by just 9 per cent (Asiaweek, 1999). Thailand suffered a major decline in capacity utilization, dropping almost 20 per cent during the same period

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Supply-Side Indicators of Unwillingness to Lend of Commercial Banks in the ASEAN-5 Countries, 1996–2000 (Percentages) Indonesia

Malaysia

Philippines

Loans/total assets (%) 1996 75.6 60.5 56.6 1997 71.5 57.5 56.0 1998 63.9 63.3 54.6 1999 27.6 59.7 50.6 2000 27.3 59.2 47.5 Government securities/total assets (%) 1996 4.2 7.4 n.a. 1997 4.1 5.9 n.a. 1998 3.4 6.5 n.a. 1999 35.3 6.4 n.a. 2000 45.1 6.9 n.a. Loan-deposit ratio (%) 1996 104.0 93.4 94.9 1997 105.7 91.9 96.5 1998 85.0 82.9 88.5 1999 36.0 83.9 80.2 2000 37.3 83.6 76.1 Deposit growth (%) 1996 31.2 38.8 28.1 1997 26.9 48.7 30.2 1998 60.4 5.0 6.3 1999 9.1 21.4 10.9 2000 15.1 19.7 9.6 Spread (lending rate – deposit rate; %) 1996 2.5 1.9 2.0 1997 5.5 1.0 1.6 1998 10.1 2.3 1.3 1999 0.2 2.8 0.3 2000 3.4 2.7 0.4 Return on assets (ROA; %) 1996 n.a. n.a. n.a. 1997 n.a. 1.4 n.a. 1998 −19.9 −0.6 0.8 1999 −9.1 1.2 0.4 2000 1.0 1.5 0.4 Corporate debt-equity ratio (listed companies) 1996 2.6 2.4 1.7 1997 4.2 2.6 2.0 1998 3.4 2.6 1.8 1999 3.7 2.7 2.0 2000 4.4 2.5 2.1

Singapore

Thailand

50.2 49.5 48.9 45.1 44.8

47.4 48.0 46.2 44.6 41.6

4.6 4.2 5.9 6.0 6.6

1.3 1.1 5.2 8.2 11.1

107.4 115.4 93.4 84.4 89.9

134.5 143.3 115.4 110.2 94.3

8.6 5.0 30.7 7.5 −1.8

16.4 17.0 8.8 −0.3 5.2

2.3 2.3 2.7 3.3 3.4

3.8 4.0 4.5 4.3 4.5

n.a. n.a. n.a. n.a. n.a.

1.6 −0.7 −5.0 −4.9 −1.5

n.a. n.a. n.a. n.a. n.a.

4.5 7.0 6.1 6.0 6.3

ROA = Return on assets. n.a. = Not available. Sources: CEIC Database; annual reports of central banks (various issues); ADB (2001b).

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Table 3.6 Demand-Side Indicators of a Slowdown in Bank Lending in the ASEAN-5 Countries, 1996–2000 (Percentages) Indonesia Growth in industry sector 1996 10.7 1997 5.2 1998 −14.0 1999 1.9 2000 5.5

Malaysia

Philippines

Singapore

Thailand

14.4 7.5 −10.9 8.0 14.7

6.4 6.1 −2.1 0.9 3.6

7.4 7.6 0.6 7.1 10.2

7.0 −1.9 −13.6 9.8 7.1

GDP growth 1996 7.8 1997 4.7 1998 −13.1 1999 0.8 2000 4.8

10 7.3 7.4 5.8 8.5

5.8 5.2 −0.6 3.3 3.9

7.6 8.5 0.1 5.9 9.9

5.9 −1.7 −10.3 4.2 4.3

Lending rate 1996 1997 1998 1999 2000

9.18 10.33 8.04 6.79 6.78

14.84 16.28 16.78 11.78 10.91

6.26 6.30 7.49 5.80 5.83

19.22 21.82 32.15 27.66 18.46

13.40 13.60 14.42 8.98 7.83

Source: CEIC Database.

(Bank of Thailand 2000). In addition, Thailand’s high interest rate policy in the wake of the crisis caused a reduction in the ability of borrowers to repay loans, and thereby a weakening in their demand for new credit. On the equilibrium principle, the lending rate is an indicator of the balance between the supply and demand for bank credit. Lending rates of all ASEAN-5 economies have declined since mid-1998, and are still below their pre-crisis levels (Table 3.6). This implies that excess credit demand has been met. Various attempts at determining whether the contraction in bank lending after the 1997 financial crisis stemmed from the supply or demand sides have provided mixed results. The World Bank conducted a survey of 3,710 manufacturers in the five Asian crisis countries during November 1998 to February 1999. According to the summary report, 67.9 per cent of all firms cited weak domestic demand as the primary cause of their difficulties; and only 37.9 per cent experienced illiquidity

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problems. The report concluded that inadequate liquidity was not generally perceived to be a major problem, and the existence of a credit 1 crunch could not be confirmed. However, Thailand reported the largest proportion of firms in short liquidity (56.8 per cent), followed by Indonesia (34.8 per cent). The Philippines reported the largest proportion of firms citing high interest rates as causing a decline in capacity utilization (55.5 per cent), followed by Thailand (53.7 per cent) and Indonesia (51.3 per cent) (Yoshitomi and Ohno 1999). Based on the same survey data, Dwor-Frecaut et al. (1999) concluded that the recovery of firms in Indonesia, Malaysia, the Philippines, and Thailand was constrained by the availability of bank credit and domestic demand was low. In particular, SMEs had experienced a harder time obtaining credit from the banking systems. Lamberte (1999) studied whether there had been a credit crunch in the Philippines since the onset of the Asian financial crisis. Based on both macro- and firm-level data, the results do not support the existence of a credit crunch. It was concluded that the decline in bank loans could be largely attributed to a decrease in demand for credit, due to the economic downturn. By using a causality test, the results indicated that declines (increases) in the GDP growth rate preceded or caused the declines (increases) in bank loans during the first quarter of 1982 to the second quarter of 1999, but not the other way round. From the banks’ perspective, Domac and Ferri (1999) found that the decline in growth of loans in Indonesia, Malaysia, and the Philippines could be attributed to: (a) heightened corporate risks and uncertainty about the path of corporate debt workouts; and (b) a capital crunch, as bank capital has been widely wiped out. The liquidity crunch, induced by monetary tightening at the beginning of the Asian financial crisis, was found in Indonesia. To curb the excessive credit growth, the monetary authorities of Malaysia directed banks to reduce credit extension. Domac and Ferri also found evidence of a disproportionate contraction in loans to SMEs in Indonesia, Malaysia, and Philippines during the same period. Based on econometric techniques, Ghosh and Ghosh (1999) estimated supply and demand for bank credit, and found evidence of a credit crunch in Indonesia in late 1997, as the banking crisis deepened, and the supply of real credit declined. Thereafter, the decline in credit

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demand, due to the wider economic recession, was the major constraining factor. In the case of Malaysia, Gan and Soon (2001) estimated loan demand and supply, with supplementary survey data on the lending behaviour of banks. They identified a credit-crunch phenomenon during the period July 1997 to March 1998, and thereafter a decline in demand for credit as the economy slowed down. Tight monetary policy, together with the erosion of banks’ capital base, were mainly responsible for the retrenchment in the supply of loans, thereby creating a condition of excess credit demand for the period. The Monetary Authority of Singapore (MAS 1999) raised concerns over whether there was a liquidity 2 crunch, or a credit crunch, or both, during early 1998. Based on estimated money demand, compared with actual money supply, the MAS study found there had not been any liquidity crunch in the first half of 1998. The study also found that while estimated loan demand in Singapore had moderated in line with slowing economic growth, the actual loans supplied had also fallen. In line with Singapore banks’ heightened cautiousness, the decline in the supply of credit was most significant for vulnerable sectors, such as the commerce sector, nonbank financial institutions, and professional and private individuals. The report concluded that there was some credit rationing by Singapore banks, reflecting their rational reaction in the midst of an adverse economic environment. The issue of a credit crunch is not unique to Singapore. Ito and Silva (1999a) used aggregate monetary data and Japan Export-Import Bank (JEXIM) survey data on banks to confirm the existence of a credit crunch in Thai commercial banks following the floating of the Thai bath in July 1997. Banks’ preference for liquidity and asymmetric information were found to impede credit extension by banks. With a higher level of deposits, large banks did not increase their lending, indicating their prudent behaviour and their preference for keeping more liquid assets on their balance sheets. Small- and medium-sized banks, however, had a liquidity shortage. Based on a regression method, the findings in the later study by Ito and Silva (1999b) confirmed that supply-side “credit crunch” problems affected banks’ lending behaviour in the early stages of the crises in both Thailand and Indonesia. An empirical study by Thubdimphun (2000) showed that a capital crunch caused the decline in lending of eight

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Thai commercial banks during 1997–99. The regulations on loan classification, provisioning, and capital adequacy put downward pressure on bank capital, causing a reduction in their lending to asset ratio. Agenor et al. (2000) estimated demand for excess liquid assets by commercial banks. The results for Thailand indicated that the contraction in bank lending accompanying the crisis was derived from supply factors. These analyses confirm that there were several simultaneous factors, from both the demand and supply of bank credit taking place in the ASEAN5 countries during and after the Asian financial crisis. These bring about important implications for policymakers. To alleviate the credit slowdown, some direct measures were imposed, such as special credit facilities for SMEs, credit guarantees, and mandated credits, as well as moral suasion on banks Table 3.7 Measures Employed to Alleviate the Credit Slowdown in the ASEAN-5 Countries Measures Indonesia

Credit facility to SMEs; allow negative interest rate spreads; export credit guarantee scheme; purchases of NPLs; recapitalization assistance.

Malaysia

Moral suasion on banks to lend; lower interest rates (or interest margins); lower reserve and liquid asset requirements; mandated targets on lending to the private sector; purchases of NPLs; recapitalization support.

Philippines

Suspended the general provisioning requirement for loans in excess of outstanding stock at the end of March 1999; lower reserve requirements.

Singapore

Lower interest rates; provide financing scheme to local companies by government co-sharing the credit risks with banks; lower Tier 1 CAR; credit derivatives (capital treatment for three main credit derivative products: credit default swap, total rate of return swap, and credit-linked note).

Thailand

Special credit facility for SMEs and exporters; low interest rates; moral suasion on lending rates; credit scheme for residential housing at low-interest rates and long payment period; recapitalization support; establish private and central asset management corporations.

Sources: Lindgren et al. (1999); annual reports of central banks (various issues).

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Table 3.8 Systemic Banking Crises in Selected ASEAN Countries, 1998

Country Indonesia Malaysia Thailand Philippines

Peak Fiscal Cost of Peak NPL Real Change in in Real Acquiring NPLs Levels (as % GDP Exchange Interest (as % of GDP) of Loans) Growth Rate Rates 50.0 16.4 32.8 0.5

65-75 25-35 33 20

−15.4% −12.7% −5.4% −0.8%

−57.5% −13.9% −13.7% −13.0%

3.3% 5.3% 17.2% 6.3%

Decline in Real Asset Prices −78.5% −79.9% −77.4% −67.2%

NPLs = Non-performing loans. Source: Claessens et al. (2001).3

to lend and keep interest margins low (see Table 3.7). The 1997 financial crisis has left banks, corporate firms, and economies in Southeast Asia less able to respond to real growth opportunities. Bank restructuring and corporate debt restructuring should accelerate, so as to resolve problems faced on the supply side of bank lending. Meanwhile, accommodative fiscal and monetary policies should be implemented to boost the economies through the demand — as well as the supply — side of bank lending. 3. Bank Restructuring

The systemic banking crisis that occurred in several ASEAN countries during the late 1990s has led to a significant corporate debt overhang, which continues to impede full economic recovery in the Southeast Asian region. It is therefore critical for governments in these countries to develop strategies to restructure their banking sectors, and implement policies that would strengthen their domestic financial systems. Lindgren et al. found that a broad-based bank restructuring strategy should achieve three main economic objectives: •

•

Restore the viability of the financial system as soon as possible so that it can efficiently mobilize and allocate funds. This would mean that a core banking system must be in place to preserve the integrity of payment systems, capture financial savings and ensure essential credit flows to the economy. Provide an appropriate incentive structure through the process of

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reviving the financial system to ensure effectiveness and avoid moral hazard for all market participants (including bank owners and managers, borrowers and depositors and creditors, asset managers and government agents involved in bank restructuring and supervision. Minimize the cost of the government managing the process efficiently and ensuring an appropriate burden sharing (by distributing losses to existing shareholders) (Lindgren et al. 1999, p. 29).

After reviewing the existing literature on financial and bank restructuring (especially applied to emerging markets), Claessens et al. (2001, p. 3) highlighted three phases of bank restructuring, as shown in the box below. Phase 1: Short-term containment phase. The financial crisis is still unfolding at this phase. Governments tend to implement policy measures that are aimed at restoring public confidence with the domestic financial system. This is to minimize the negative consequences of a loss of confidence by depositors and other investors in the financial system. Phase 2: Restructuring and rehabilitating weak financial institutions. Restructuring would include the following processes: recognizing and allocating financial losses; restructuring financial claims of financial institutions and operational restructuring of financial institutions. This phase also includes corporate debt restructuring. Phase 3: Structural reforms which, among other things, include changes in the legal and regulatory frameworks, privatizations of any nationalized financial institutions and corporations.

Using Claessens’ three phases of bank restructuring, the crisis-affected ASEAN countries — such as Indonesia, Thailand, Malaysia, and the Philippines — have completed phase 1 and are currently undergoing phase 2. Furthermore, these countries appear to have more or less adhered to the three economic objectives itdentified by Lindgren et al. (1999). The four main bank restructuring measures that have been implemented in the Southeast Asian region are as follows: • • •

closing down of non-viable banks, merging existing banks, and the nationalization of others; recapitalization of financially viable banks; setting up asset management companies (AMCs), and undertaking asset resolution strategies;

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opening up of the domestic banking sector to foreign financial institutions, as a means to obtain new capital and improve competitiveness.

These main bank restructuring measures, and others, are discussed in more detail below. 3.1. Bank Closures, Mergers, and Acquisitions

In Indonesia, the Indonesian Bank Restructuring Agency (IBRA) which was set up by the government in January 1998, has played a major role in the restructuring of Indonesia’s banking sector. IBRA closed down banks that were not financially viable (seventy out of 237 banks) and rehabilitated the remaining banks through nationalization, mergers, and recapitalization. In August 1998, IBRA nationalized four banks, and closed down three banks that were under its control. In July 1999, the government merged four state banks into Bank Mandiri, making it the country’s largest commercial bank. The following year, nine private banks that were taken over by IBRA were merged with Bank Danamon. In Thailand, four commercial banks collapsed during the crisis, leaving thirteen banks as at the end of year 2000. The Thai government also closed down one commercial bank and merged three banks and twelve finance companies. The government also established the Financial Restructuring Authority (FRA) in October 1997 to review the rehabilitation plans of fifty-eight suspended finance companies and to oversee their liquidation (fifty-six of these fifty-eight finance companies were subsequently closed down). Mergers and closures reduced the number of Thai finance companies significantly, from ninety-one (before July 1997) to twenty-two (by the end of 1999). In Malaysia the government did not close down any commercial banks. However, the government did take control of Malaysia’s largest finance company, MBf Finance, when it collapsed in 1998. During that year, ten finance companies were merged. There were also two commercial bank mergers that took place in 1999: •

Bank of Commerce Berhad absorbed the assets and liabilities of Bank Bumiputra Malaysia Berhad, and was renamed BumiputraCommerce Bank Berhad. The merged bank became the second largest commercial bank in Malaysia.

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RHB Bank absorbed the assets and liabilities of Sime Bank, to become the third largest commercial bank in Malaysia.

Frustrated by the slow pace of bank consolidation, Bank Negara Malaysia announced an accelerated bank merger programme in 1999 that would merge fifty-four domestic financial institutions (twenty-two of which were commercial banks) into ten anchor banks. By June 2001, nine out of the ten anchor banks had completed their merger plans. The remaining anchor bank, Arab-Malaysian Holdings, was expected to complete its acquisition of MBf Finance by the end of 2001. In the Philippines, there were twenty-two bank closures in 1998, which consisted of one commercial bank, six thrift banks, and fifteen rural banks. However, the impact on the financial system was minimal, as the combined asset size of these closed banks was only 0.4 per cent of total banking assets. Also during that year, the Philippine government adopted a comprehensive banking sector reform programme, with the aim of strengthening the bank’s capacity to withstand external shocks, and enhancing regulators ability to deal with financially troubled banks. This programme was designed with the collaboration of the World Bank and the IMF. There was also a second bank reform plan, to deal with strengthening the financial position of the Philippines’ second largest bank (46 per cent owned by the government), the Philippine National Bank (PNB), which came under financial distress during the regional crisis. Bank restructuring in the Philippines has been mainly undertaken by the private banking sector, where there has been several voluntary mergers of private banks over the past few years, as a means to strengthen competitiveness. Merger activity has recently increased with the General Banking Law of 2000, which allows listed commercial banks with universal banking status to acquire total ownership of other banks with the same status. Singapore has also experienced an increase in bank merger and acquisition activity in 2001, involving the following domestic commercial banks: •

•

In early 2001, Singapore’s largest commercial bank, the Development Bank of Singapore (DBS) acquired Dao Heng, Hong Kong’s fourth largest bank, for US$5.7 billion. In June 2001, Singapore’s third largest bank, Oversea-Chinese Banking

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Table 3.9 Singapore Domestic Banking Sector, after the Bank Mergers

Total assets (S$ billions) Total loans (S$ billions) Total deposits (S$ billions) Total shareholders’ funds (S$ billions) No. of branches ATMs

DBS*

UOB + OUB

OCBC + KCH

111.0 54.2 92.8

113.7 61.5 96.6

83.0 50.4 71.1

8.4 107 900

13.1 93 426

8.3 74 381

DBS — Development Bank of Singapore. UOB — United Overseas Bank. OUB — Overseas Union Bank. OCBC — Oversea-Chinese Banking Corporation. KCH — Keppel Capital Holdings. *Excludes Dao Heng Bank. Source: Business Times (Singapore).

•

Corporation (OCBC), successfully acquired Keppel Capital Holdings (KCH), which owns Singapore’s smallest bank, Keppel TatLee Bank. In August 2001, Singapore’s second largest bank, United Overseas Bank (UOB) succeeded in merging with Overseas Union Bank (OUB), and therefore overtook DBS as the largest bank in Singapore.4

3.2. Recapitalization and the Capital Adequacy Ratio (CAR)

In Indonesia, a total of US$67.8 billion of sovereign bonds have been issued as liquidity support to the banking sector. From this amount, US$44.8 billion has been used to recapitalize four state banks, four nationalized banks, seven private banks, and twenty-seven regional banks. The balance of funds raised by the bond issue has been used for general liquidity support. The government’s recapitalization programme was officially completed in October 2000. IBRA has assisted in the recapitalization of seven banks, with an average capital adequacy ratio (CAR) at just below 11 per cent, as at June 2001. However, other banks in Indonesia have reported lower CARs (some below 4 per cent). From negative capital in 1999, the banking system’s capital base has been gradually improving. The government had set an average CAR target of 8 per cent for the entire banking system by the end of 2001.

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In Malaysia, Danamodal — the government agency responsible for recapitalizing the banking sector — has injected US$1.6 billion into ten financial institutions. As at the end of January 2001, eight banks had repaid their loans, leaving an outstanding balance of capital injection of US$0.97 billion. The average CAR for Malaysia’s banking system has been above 11 per cent since 1998 (12.8 per cent as at the end of December 2001). In Thailand, much of the capital injection into banks has been sourced privately. Since the crisis, private banks have raised US$10 billion in new capital through various hybrid capital instruments, and also public capital support through the Tier-1 scheme. Headline CARs for private banks have ranged between 12 to14 per cent since the crisis. Most of the state-owned banks remain in a negative capital position, reflecting the large level of losses yet to be recognized on these banks’ balance sheets. The Philippine banking system came under severe pressure during the crisis, and central bank emergency lending increased from 4.5 billion pesos at the end of 1997 to peak at 14.3 billion pesos in May 1998. However, past bank reforms strengthened the banking system, and major bank failures managed to be avoided during the crisis (Rodlauer et al. 2000). Nevertheless, the Philippines’ second largest bank, PNB, came under severe financial stress during the crisis, as 35 per cent of its total loans were in foreign currency. In 2000 the Bangko Sentral ng Pilipinas Table 3.10 Capital Adequacy Ratio (CAR) in Thailand, Malaysia, and the Philippines, 1997–2001

Thailanda Malaysia

b

Philippinesb a b

1997

1998

1999

2000

2001

9.3

10.9

12.4

12.0

13.9

10.5 (10.3)

11.8 (11.7)

12.5 (12.6)

12.4 (12.2)

12.8 (12.6)

16.0

17.6

17.5 (17.0)

16.2 (15.6)

15.8 (15.4)

Thailand’s CAR values relate to commercial banks only. Figures within parenthesis are the CAR values for commercial banks only.

Sources: Asian Development Bank; Bank Negara Malaysia; Bangko Sentral ng Pilipinas; Bank of Thailand.

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(BSP) and the Philippine Deposit Insurance Corporation (PDIC) extended financial assistance to the Philippine National Bank (PNB), with 15 billion pesos and 10 billion pesos respectively. The Philippine banking system is significantly better capitalized than most of its neighbours. As at the end of 1998, the average CAR was 17.6 per cent, well above the minimum regulatory requirement of 10 per cent. In 2001, Philippines’ CAR remains one of the highest in Southeast Asia, at about 16.7 per cent (June 2001). 3.3. Asset Resolution Strategies

The pace of asset disposal in Indonesia has been extremely slow. By September 2001, only about 5.6 per cent of NPLs that IBRA has acquired from banks had been disposed of. (IBRA raised 18.9 trillion rupiah from asset recoveries in FY2000.) IBRA has managed to outsource the management and collection of about 50 per cent (16.3 trillion rupiah) of its holdings of commercial loans to several banks, including Bank Danoman, Bank BNI, Bank Bukopin, and Ban Artha Graha. IBRA aimed to accelerate its asset disposal activities to meet its asset recovery targets for FY2001 (27 trillion rupiah in cash and 10 trillion rupiah in bond swaps). There has been suggestions that IBRA should hasten the pace of resolving, or auctioning off, small and medium sized loans, so that it can focus on dealing with larger debtors (total debts outstanding in excess of 50 billion rupiah), which accounts for 84 per cent of bank loans that IBRA controls (Pangestu et al. 2001). Danaharta (Malaysia’s centralized asset management company) had acquired 44 per cent of NPLs in the banking system by December 2000. Its acquisition phase has since been completed, and the AMC is currently at the asset management and disposal phase. By September 2001, Danaharta had successfully restructured 83 per cent of loans under its portfolio with expected recoveries of 57 per cent. Although Danaharta has made significant progress in resolving non-performing loans, the pace of future asset resolution will probably slow down, as it deals with smaller and more difficult loan cases. Unlike the centralized asset management approach adopted in Indonesia and Malaysia, Thailand’s private banks have set up their own private AMCs. However, the progress made by state banks in

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debt restructuring has been slower than private banks. According to the IMF (2001b), private banks have restructured 45 per cent of base period NPLs, compared with 30 per cent by state banks. Currently, about 50 per cent of Thailand’s systemic distressed assets are derived from state banks. The Thai Asset Management Corporation (TAMC) was set up in June 2001 to deal with the substantial number of unresolved NPLs, particularly in state banks. By the end of 2001, the TAMC had plans to acquire up to 1.1 trillion baht from state banks, and 250 billion baht from private banks. This represented about half of the total banking systems’ NPLs (100 per cent of state banks NPLs, and 25 per cent of private banks NPLs). The TAMC will exchange Financial Institutions Development Fund (FIDF) guaranteed bonds for the acquired NPLs. The Thai parliament has recently passed a law providing the TAMC with special executive powers to resolve and manage distressed loans. The Philippines did not set up any AMCs during the Asian financial crisis. Several banks have proposed that a government-owned AMC should be established to deal with the rising NPL problem (17 per cent as at June 2001). So far, the government has not displayed any interest in undertaking such an initiative, because of fiscal constraints and moral hazard concerns. It is more likely that the government will favour a decentralized private AMC approach, rather like that of Thailand. 3.4. Key Concerns: Slow Pace of Restructuring and Rising NPLs

The pace of financial and corporate restructuring slowed down in 2001, due to the regional economic downturn and depressed asset prices. Sociopolitical considerations have also been a factor (for example, selling assets either too cheaply, and/or to foreign investors). There are also concerns as to whether AMCs can really expedite the corporate debt restructuring process. Klingebiel (2001) found that AMCs can often delay, rather than expedite, corporate restructuring, and that asset disposal using AMCs are quicker in advanced countries where there are suitable ingredients, such as professional management, political independence, adequate bankruptcy, and foreclosure laws, good management and information systems. Among the crisis-affected countries, the pace of

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Table 3.11 Non-Performing Loan Levels (Excluding Transfers to Asset Management Companies) in Indonesia, Malaysia, Thailand, and the Philippines, 1998–2001 1998

1999

2000

2001 Q1

2001 Q2

2001 Q3

2001-Q4 or Latest

Indonesia

49.2

32.9

18.8

18.1

16.6

14.7

12.1

Malaysia

13.6 (10.3)

11.0 (8.8)

9.7 (8.3)

10.6 (9.3)

11.4 (10.3)

11.7 (10.7)

11.5 (10.5)

Thailand

45.0 (42.9)

38.9 17.7 (38.6) (17.7)

17.4 (17.4)

12.6 (12.6)

12.8 (12.9)

10.4 (10.5)

Philippines

11.0 (10.4)

12.7 14.9 (12.3) (15.1)

16.6 (16.6)

17.0 (17.0)

17.4 (17.9)

16.9 (17.3)

Note: Figures within parentheses are the NPL ratios for commercial banks. Sources: World Bank; Asian Development Bank; CEIC Database.

restructuring has been observed to be the fastest in Malaysia, and slowest in Indonesia. The pace of asset disposal has been extremely slow in Indonesia for various reasons, including the poor quality of assets held by IBRA, and political considerations (for example, resistance towards selling assets to foreigners). According to the ADB, the financial environment in Southeast Asia becomes more worrying once the substantial amount of NPLs that were transferred to AMCs are taken into account. This is clearly evident when aggregate NPLs (which includes NPLs that were transferred to AMC) are calculated: • • • •

Indonesia: 55.2 per cent in June 2001; Thailand: 25 per cent in July 2001; Malaysia: about 17 per cent in June 2001; Philippines: there are no AMCs, but NPLs have risen to about 17 per cent.

Moreover, slow progress in asset disposition, and the re-entry of previously resolved loans as NPLs, may lead to rising bad loan levels in the near term. In fact, NPLs have been recently creeping up in both Malaysia and the Philippines (see Table 3.11).

© 2003 Institute of Southeast Asian Studies, Singapore

Indonesia

© 2003 Institute of Southeast Asian Studies, Singapore

Many weak commercial banks

— Weak banks still — in the system

Sources: World Bank (27 March 2001); authors.

14 foreign banks (about 30% of total bank assets)

None

— Majority foreign — ownership of banks

Weaker banks taken over as part of merger programme

Danamodal injected US$1.6 billion into 10 banks

4

50 out of 54 financial institutions were merged into 10 banking groups by the end-2000 deadline 1

None None

US$9.2 billion (13% of GDP)

Malaysia

Bank recapitalization strategies — Public funds for US$44.8 billion — recapitalization

— Banks that are — temporarily — nationalized

Financial distress resolutions — Bank closures 70 of 237 — Closure of other None — financial institutions — Mergers 9 nationalized banks and 4 state banks have been merged

Initial government response — Liquidity support US$21.7 billion (18% of GDP)

Action

Some weak public and private banks

US$1.7 billion into private banks and US$12 billion into state banks 4 completed, 2 pending

4

1 of 15 59 of 91 finance companies 3 banks and 12 finance companies

US$24.1 billion (20% of GDP)

Thailand

Table 3.12 Financial Restructuring Measures in ASEAN-4 Countries

14 foreign banks, 3 foreign banks acquired universal bank status Bank reform plan to strengthen Philippine National Bank

14.3 billion pesos (central bank emergency loans)

None

1 comm. bank 6 thrift banks 15 rural banks Voluntary Mergers by some private banks

4.5 billion pesos (central bank emergency loans)

Philippines

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Debt and business restructuring, outsourcing, and foreclosure.

Yes. AMC fully operational within IBRA on April 1998. IBRA has accumulated about US$57.8 billion in assets.

Indonesia

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Assets transferred to AMC Assets disposed of as a % of total assets under its control

85.2% total NPLs in the banking system. 5.6%. 44% total NPLs in the banking system. 83%.

Loans larger than RM5 million and mostly loans secured by property or shares.

Private auction, tenders, securitization, business restructuring.

Yes. Danaharta was set up in June 1998 and has accumulated US$10.3 billion in assets.

Malaysia Thailand

No AMC established.

Proposal to set up private AMC is being considered. Recent rise in NPLs have resulted in calls by several banks for a state-owned AMC.

Philippines

All assets of failed finance companies No AMC established. transferred to FRA. TAMC plans to acquire 100% of state banks’ NPLs and 25% of private banks’ NPLs by end 2001. For private banks, loans greater than 5 milion baht and with collateral are eligible for transfer. TAMC: Up to 50% of total NPLs in the banking system. 70% of closed finance company assets. TAMC: Minimal so far.

TAMC: debt and business restructuring, outsourcing, and foreclosure.

Established Financial Restructuring Agency (FRA) on 24 October 1997 to liquidate failed finance companies. Government established centralized Thai Asset Management Company (TAMC) in June 2001.

Sources: World Bank (27 March 2001); Asian Development Bank (2001b); authors.

AMC = Asset management company. NPL = Non-performing loan.

— — — — — —

Asset transfer and disposal — Type of assets Assets of frozen — transferred banks and worst assets.

Nature of AMC — Asset disposition, — restructuring, and — management

Centralized AMC — Set up centralized — AMC to which the — banking system’s — NPL are — transferred

Strategy

Table 3.13 Asset Resolution Strategies in Select Southeast Asian Countries 82

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Table 3.14 Bank Foreign Ownership Ceiling and Business Differentiation

Country

Pre-Crisis Ownership Ceiling

Current Ownership Ceiling

Malaysia

30%

Unchanged

Indonesia

49%

99%

Thailand

25%

100%

Philippines

30%

60%

Singapore

40%

*

Business Differentiation Only one licence issued since 1983 (Bank of China). Restrictions exist on opening new branches, including ATMs. World’s 200 biggest banks rated higher than “A” are allowed to open branches in Jakarta. None The new General Banking law allows this limit to increase to 100% over a seven-year period. Foreign banks may set up branches with full banking authority. Various business restrictions, including opening of new branches and ATMs.

* In 1999, the Monetary Authority of Singapore (MAS) introduced an intermediate level of 12 per cent of shareholdings as a new threshold. MAS approval is still required before a single individual can increase his/her shareholding in a domestic bank above the existing 5 and 20 per cent thresholds. ATM = Automated teller machines. Sources: Casserley and Gibb (1999); Gochoco-Bautista et al. (2000); various government sources.

3.5. Foreign Bank Ownership and Participation in the Domestic Banking Sector

Foreign ownership limits in Indonesian banks were raised from 85 per cent to 99 per cent in May 1999. The acquisition of a stake in Bank Bali by Standard Chartered Bank collapsed when a scandal broke out involving alleged side-payments by Bank Bali to a government-linked company, in order to participate in the joint-recapitalization programme (Enoch et al. 2001). Since the scandal, there has not been any new foreign capital invested in Indonesia’s domestic banking sector. Foreign ownership of local Thai banks, which was restricted to 25 per cent before the crisis, was raised to 100 per cent in 1997. As a result, four locally owned commercial banks (Bank of Asia, Thai Danu Bank, Nakornthorn Bank, and Radanasin Bank) were acquired by foreign

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financial institutions. Foreign institutions were primarily motivated to conduct these acquisitions as a means to gain access to the branch networks and customer bases of the local banks. Although, the Malaysian government has not increased its foreign ownership ceiling of 30 per cent, locally incorporated foreign banks — such as the Hong Kong and Shanghai Banking Corporation (HSBC), Standard Chartered, and Citibank — were believed to have increased their market share, particularly in retail business, as local banks have been preoccupied with both the merger exercise (see above) and NPL recoveries. In Malaysia, there are thirteen foreign banks operating, which together represent about 30 per cent of total commercial bank assets. Foreign banks’ branch expansion is limited. In the Philippines, there has been an increase in foreign players in the domestic banking sector. The recent General Banking Law of 2000 has allowed the foreign ownership ceiling (for foreign banks) to increase from the existing limit of 60 per cent to 100 per cent, over a seven-year period. At the same time, the limit for bank ownership, by foreign individuals or non-bank corporations, has risen from 30 to 40 per cent. The MAS had awarded six Qualifying Full Bank licences (QFBs) to foreign banks in the 1999–2001 period. The foreign banks were ABN Amro Bank, Banque Nationale de Paris (BNP), Citibank, Standard Chartered Bank, HSBC, and Maybank. Each QFB will have additional branches, off-premise ATMs, and ATM sharing facilities as privileges. Moreover, the QFBs will be able to share ATMs among themselves, resulting in a QFB network of ninety or more locations in Singapore. 3.6. Corporate Debt Restructuring

Any discussion of financial restructuring in Southeast Asia is not complete without also looking at corporate debt restructuring. As discussed earlier, the Asian financial crisis led to a huge corporate debt overhang that still needs to be resolved. The progress made to date in corporate debt restructuring in Indonesia, Malaysia, and Thailand is discussed below. According to a recent quarterly survey by the Jakarta Initiative Task Force (JITF), total corporate debt in Indonesia amounted to US$119 billion, as of December 2000. Of this amount, 48 per cent (US$57 billion) is owed to offshore creditors, and the other 52 per cent (US$62 billion) to domestic

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creditors. About 62 per cent (US$37.3 billion) of the onshore corporate debt is classified as non-performing. IBRA holds 80 per cent (US$29.9 billion) of all onshore distressed loans. Significant progress had been made in corporate debt restructuring by the JITF — about 58 per cent of corporate debt referred to the JITF had been resolved by October 2001. However, current requirements for financial institutions to sell converted equity within two to five years is worrying, since debt/equity conversions are important features in Indonesian corporate restructuring transactions. The World Bank has recommended that financial institutions be allowed to hold converted equity indefinitely, but to insist on maintaining the most conservative accounting procedures on such equity. As at the end of 2001, Malaysia’s Corporate Debt Restructuring Committee (CDRC) had successfully resolved about 60 per cent of corporate debt under its portfolio. The CDRC had resolved thirty-seven cases amounting to RM34.5 billion. Out of a total of eighty-six applications with total debts of RM66.8 billion, twenty-three cases were withdrawn (or rejected) and eleven cases were transferred to Danaharta. This leaves twelve outstanding cases with debts amounting to RM18 billion, which have yet to be resolved. A new chairman was appointed to the CDRC in August 2001, Datuk Azman Yahya (who is the former head of Danaharta), to take charge of speeding up corporate debt restructuring in Malaysia. A lack of clear guidelines has been identified as one of the main reasons for the slow pace of debt restructuring. Therefore, new initiatives were unveiled by the CDRC in early August 2001 to hasten the corporate debt restructuring process in Malaysia. These new initiatives included: •

•

•

the establishment of a fixed time-frame of one year, beginning with the formation of a creditor’s steering committee, to fully resolve the outstanding corporate debt of RM30 billion; to accelerate the debt restructuring process, financially distressed companies will be given three months to sign debt restructuring agreements, if 75 per cent of their debtors give approval (previously a 100 per cent agreement was required); for new cases, assistance will only be considered by the CDRC for financially troubled companies with a minimum aggregate borrowings of RM100 million (previously RM50 million);

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the borrower must have exposure to at least five creditor banks (previously two creditor banks).

Thailand’s Corporate Debt Advisory Committee had resolved 45 per cent of corporate debt under its control by January 2001. However, the pace of Thailand’s corporate debt restructuring had slowed down considerably. The completion rate of corporate debt restructuring has decelerated from an average of 86 million baht per month for the first six months of 2000 to an average of 61 million baht for the last six months of 2000. For the first quarter of 2001, the completion rate has slowed to an average of 47 million baht per month. According to the Thailand Economic Monitor (World Bank, July 2001), this decline in completion rate is due to the following reasons: • • •

Viable cases have been restructured, but the remaining cases are more complex, and will take a much longer time to reach an agreement. An increasing number of distressed loans have been transferred to private AMCs, where they are not counted in the completion rate. Creditors and debtors were waiting for the TAMC to begin operations, in the hope that debt workouts will be more favourable when loans are transferred to the state-owned AMC.

As of October 2001, about 48 per cent of corporate debt had been restructured, a mere 3 percentage point increase from January 2001. The recently formed TAMC has been given special legal powers to speed up corporate debt restructuring in Thailand. However, there are concerns as to whether the TAMC will effectively implement corporate debt workouts, by enforcing co-operation among debtors. Moreover, most debt restructuring of NPLs belonging to private banks will be outside the framework of the TAMC. Current estimates indicate that less than half the proposed 250 billion baht in NPLs from private banks will be transferred to the TAMC. 4. Financial Safeguards to Strengthen the Domestic Financial System

A country-wide banking panic can depress the output of an economy. The macroeconomic effect tends to be more severe in developing countries than in industrial advanced economies, as commercial banks

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dominate the financial sectors in the former. Consequently, there are fewer alternative channels of obtaining credit or raising capital in emerging economies (Eichengreen and Rose 1998). Therefore, financial safeguards should be put in place to strengthen the infrastructure of the domestic financial systems in Southeast Asia, in a bid to prevent a systemic banking crisis from occurring in the future. Some of these financial safeguards are discussed below. 4.1. Strengthen Banking Supervision and Regulation

Banking supervision should involve improved monitoring, inspection, and examination of banks, to assess their ability to comply with relevant banking laws and regulations. It is important to strengthen banking supervision and regulation, to limit moral hazard, and to ensure that financial intermediaries have the incentive to allocate resources and perform their other functions in a prudent manner (Finance for Growth). The adoption of regulations that provide public disclosure of banks’ financial conditions should enable depositors to distinguish between good and bad banks, should reduce asymmetric information flows, and therefore limit the occurrence of financial panic that can spread rapidly through the system (that is, systemic risk). 4.2. Market-Based Regulation: Subordinated Debt

In countries where there is weak supervision, a market-based system of regulation can be used to avoid moral hazard. Such a market-based system would require banks to issue subordinated debt to the private sector. This creates a situation where the debt holders are unlikely to be “bailed out”, but instead are “bailed in”, as they become stakeholders in the banking system. The issue of subordinated debt also contributes to the development of a private debt securities market, and thereby helps diversify the financial sector in a country. 4.3. Improvements in Risk Management

Folkerts-Landau and Lindgren (1998) and Johnston and Otker-Robe (1999) identify three types of risk which banks need to better manage: credit risk, market risk, and liquidity risk. Johnston and Otker-Robe (1999) propose several measures to better manage credit risks, as follows:

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a limit on credit concentration in particular sectors of the economy; a foreign exposure limit on loans; an increase in the capital adequacy requirements for banks with large international business operations; an incorporation of various elements of cross-border risk in loan classification and provisioning requirements; close monitoring of banks’ foreign currency–denominated, or indexed, loans extended to domestic borrowers.

To deal with interest rate risk (which is a type of market risk), the maturity structure of interest-sensitive assets and liabilities in each currency should be closely monitored, in an attempt to limit the occurrence of maturity mismatches. Exposure to derivatives transactions should be included in the bank’s balance sheet, to better manage this form of market risk. Liquidity risk can be better managed by imposing liquidity requirements on banks. In the United States, bank examiners have recently been evaluating the soundness of bank management in controlling risk. Since 1996, the Federal Reserve and the Comptroller of the Currency have been assessing risk management processes at banks they supervise (Mishkin 2001). Central banks in Southeast Asia might be well advised to adopt similar measures to achieve best practices in risk management. 4.4. Strengthen the Ownership Structure

There should be more operational restructuring of banks, where the ownership structure of banks moves away from family- or individualcontrolled businesses, to one owned by multiple institutional investors. There are some positive advantages of more institution-orientated bank ownership structures, which include: • • • •

access to substantially more capital; professionally managed, with focus on maximizing shareholders’ riskadjusted returns; no interference by external parties in management and credit risk assessment; easier to merge with other banks (which can enhance the overall efficiency of the banking sector).

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The number of state-owned banks should also be reduced, to promote efficient allocation of economic resources. Governments and government-owned enterprises (including banks) tend not to be driven by profits, and may channel credit to borrowers that may not necessarily generate high economic growth (Mishkin 2001). Also, the lack of a profit incentive will mean that state-owned banks are less likely to adopt risk management practices, or operate efficiently (to minimize costs and maximize revenue). 4.5. Financial Safety Net: An Explicit Deposit Insurance Scheme

A deposit insurance scheme can reduce the likelihood of bank crises, and also contribute to financial deepening in a developing country (Cull 1998). The scheme is normally designed to protect both the stability of the banking system and individual depositors (particularly small depositors). If the scheme is so designed, it can boost the confidence of depositors in the banking sector, by alleviating uncertainty, and contribute to increased deposits. Garcia (1999) calls for a deposit insurance scheme that encourages all parties that are directly or indirectly affected by the scheme to maintain a sound financial system. He highlighted several conditions for an insurance deposit scheme to be established: • • • •

the scheme should be explicitly and clearly defined in law and regulation, in order to enhance transparency; there must be effective supervision and regulation of the banking system; membership of the scheme must be compulsory, and insurance premiums must be risk-adjusted to mitigate adverse selection; the scheme should be well-funded, accountable to the public, and free from political interference.

4.6. Development of the Equity and Bond Markets

There is a wide range of financial instruments potentially available to raise capital for investment. The development of bond and equity markets would reduce the reliance on commercial banks as the dominant source of financing. After the Asian financial crisis, there is a need for some Southeast Asian countries to move further away from bank finance, and to rely more on capital markets as a source of funding (particularly

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corporate bond markets). However, Asian corporate bond markets are largely underdeveloped: the size of bond issues tend to be small; maturity is concentrated in the short to medium term; and secondary markets are highly illiquid. It may take some time for Southeast Asian countries to develop viable corporate bond markets, and a policy to quickly develop domestic bond markets may not be feasible (Shirai 2001). A two-prong approach, where the banking system is strengthened, while at the same time, corporate bond and equity markets are being developed, is probably a more realistic option. Moreover, bank loans and corporate bonds are likely to be complementary to each other for financing economic development (Yoshitomi and Shirai 2001a). 5. Concluding Remarks

Banks still perform an important role of domestic lending in the ASEAN-5 countries. However, the size of bank loans in the Southeast Asian economies tended to decline after the 1997 financial crisis. A sharp contraction in the lending growth of commercial banks in the ASEAN-5 countries was found during the period 1998–99. Nevertheless, the contraction seems to be bottoming out. The share of bank lending to the manufacturing sector has been on a declining trend for all the ASEAN-5 countries, except Indonesia. Meanwhile, there is an increasing trend of bond financing in Malaysia, Singapore, and Thailand after the crisis, and of equity market financing in the Philippines. Both supply and demand factors are found to determine the behaviour of bank lending in the ASEAN-5 economies. On the supply side, closures and ongoing mergers of banks have become a negative factor for credit availability. Meanwhile, balance sheet deterioration and liquidity preferences have deterred banks from extending credit. On the demand side, the growth of bank lending seems to be in tandem with that of industry sectors and the GDP as a whole. As an indicator of the balance between supply and demand for bank credit, lending rates of all ASEAN-5 countries have shown a declining trend. This implies excess demand for bank credit in the economies has been met. Many previous studies have attempted to answer whether the contraction in bank lending after the 1997 financial crisis resulted from the supply or demand sides,

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or both. Based on macro- and micro-level data on both firms’ and banks’ perspectives, the studies provided mixed results. Beside the different types of data, the definition of a credit crunch itself is not uniform, and varies among the studies. Evidence of the credit crunch phenomenon is not conclusive, although there seems to be grounds for a case in Indonesia and Thailand. Whatever the definition of a credit crunch is, the analyses confirm that there have been several simultaneous factors, from both the supply and demand for bank credit, taking place in the ASEAN-5 economies during and after the crisis. Implicitly, financial and corporate restructuring should accelerate to resolve problems on the supply side of bank lending. Simultaneously, accommodative fiscal and monetary policies should be implemented in a bid to boost the economies through the demand side of bank lending. The slow progress made in bank and corporate restructuring continues to impede full economic recovery in the region. Moreover, there is no “one-size-fits-all” strategy to bank restructuring. In fact, the ASEAN-5 countries have implemented different bank restructuring measures — where differing nuances depend on their socio-economic and political circumstances. Malaysia and Singapore are well ahead in bank restructuring, and both are in the midst of consolidating their banking sectors through mergers and acquisitions. In practice, policymakers will not be able to achieve all the economic objectives of bank restructuring without sacrificing at least one of the three objectives identified by Lindgren (1999). Hence, striking an appropriate balance is the key to a successful bank restructuring strategy. Opening up the banking sector to foreign financial institutions would bring benefits, such as new capital, financial innovation, best management practices, and greater financial disclosure and transparency. However, financial liberalization and deregulation has to be properly sequenced, as poor financial sequencing has devastating consequences to the real economy, as observed during the Asian financial crisis. Therefore, the domestic banking sectors need to be strengthened through bank restructuring and consolidation, so that local banks are better prepared to compete with new entrants, such as foreign financial institutions and non-bank domestic institutions (such as stockbroking companies). Besides the banking sector, authorities should also encourage

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the consolidation of their domestic stockbroking and insurance companies, so as to enhance competitiveness in the financial services industry. As in the United States, the Southeast Asian region will probably see an increase in merger activities between banks and non-banks. Financial liberalization and financial deepening will have long-term positive effects on economic development in Southeast Asia. However, in the short term, governments might be well advised to adopt a gradual approach to the opening-up of their domestic financial systems. It is important to have adequate “breathing space” to strengthen the domestic financial infrastructure, putting in place the necessary financial safeguards, in a bid to avoid another financial crisis in the future. NOTES 1. A credit crunch is primarily a supply phenomenon. It can be defined as an abrupt change in lending behaviour by banks, which modifies the relationship between credit availability and interest rates. There are at least two identifiable transmission channels that can worsen a crunch: (a) the borrowers’ balance sheet channel; and (b) the bank balance sheet channel. See Ito and Silva (1999, pp. 5–7). 2. A liquidity crunch arises when monetary policy is too tight, leading to insufficient loanable funds in the banking system to support economic activities. A credit crunch, on the other hand, reflects either banks’ inability or unwillingness to extend credit to customers. See MAS (1999, pp. 38–39). 3. Data sources: the fiscal cost as a percentage of GDP was taken from Honohan and Klingebiel (2000); peak NPLs as a percentage of loans is from Caprio and Klingebiel (1999); the change in exchange rate is the percentage change in exchange rate against the U.S. dollar during the first quarter of 1998; the “real interest rate spike” equals the peak in the real money market during the crisis year; for the Philippines, the real discount rate was reported instead of the money market rate, due to data unavailability; the real growth in asset prices is the largest drop on a monthly basis in the stock market index during the crisis year, compared with the level of the stock market index in January 1997; and GDP data, exchange rate data, interest rate data is from the IMF’s International Financial Statistics. 4. In June 2001, the DBS made an unsuccessful hostile takeover bid for the OUB. REFERENCES Agenor, P.R., J. Aizenman, and A. Hoffmaister. “The Credit Crunch in East Asia: What Can Bank Excess Liquid Assets Tell Us?” World Bank Working Paper

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2483. 2000 . Ariff, M. and A.M. Khalid. Liberalization Growth and the Asian Financial Crisis: Lessons for Developing and Transitional Economies in Asia. Cheltenham: Edward Elgar Publishing Limited, 2000. Asiaweek. “Production after the Meltdown”, 16 April 1999. Asian Development Bank (ADB). Corporate Governance and Finance in East Asia: A Study of Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. Volume One (A Consolidated Report). 2000. . . Asia Recovery Report. March, June, and September 2001a. . . Asia Economic Monitor. December 2001b. . Asian Policy Forum Report. Policy Recommendations for Preventing Another Capital Account Crisis. ADB Institute, 7 July 2000. Bank Indonesia. Annual Report 2000. . Bank Negara Malaysia. Annual Report. 1997, 1998, 1999, 2000. . The Central Bank and the Financial System in Malaysia: A Decade of Change. Bank Negara Malaysia, 1999. Bank of Thailand. Annual Report 2000. Bangkok: Bank of Thailand . Bangko Sentral ng Pilipinas. Annual Report. 1998, 1999, 2000. . Beck, T. and R. Levine. “Stock Markets, Banks, and Growth: Correlation or Causality”. World Bank Working Paper. July 2001. . Caprio, J. and D. Klingebiel. “Episodes of Systemic and Borderline Financial Crises”. Mimeographed. World Bank, October 1999. Casserley, D. and G. Gibb. Banking in Asia: The End of Entitlement. Singapore: John Wiley & Sons, 1999. Chan-Lau, A. and Z. Chen. “Financial Crisis and Credit Crunch as a Result of Inefficient Financial Intermediation — With Reference to the Asian Financial Crisis”. IMF Working Paper WP/98/127. August 1998. Claessens, S., D. Klingebiel, and L. Laeven. “Financial Restructuring in Banking and Corporate Sector Crises: What Policies to Pursue?” National Bureau of Economic Research Working Paper 8386. Cambridge, M.A.: National Bureau of Economic Research, 2001. . Cull, R. “The Effect of Deposit Insurance on Financial Depth: A Cross Country Analysis”. Mimeographed. 1998.

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Dekle, R. and K. Kletzer. “Domestic Bank Regulation and Financial Crises: Theory and Empirical Evidence from East Asia”. IMF Working Paper WP/01/63. May 2001. . Demirguc-Kunt, A., E. Detragiache, and P. Gupta. “Inside the Crisis: An Empirical Analysis of Banking System in Distress”. World Bank Research Policy Paper no. 2431. August 2000. . Ding, W., I. Domac, and G. Ferri. “Is There a Credit Crunch in East Asia?” World Bank Working Paper no. 1959. August 1998. . Disyatat, P. “Currency Crises and the Real Economy: The Role of Banks”. IMF Working Paper WP/01/49. May 2001. . Domac, I., and G. Ferri. “The Credit Crunch in East Asia: Evidence from Field Findings on Bank Behavior and Policy Issues”. Mimeographed. World Bank, November 1999. Dwor-Frecaut, D., M. Hallward-Driemeier, and F.X. Colaco. “Asian Corporates’ Credit Needs and Governance”. Chulalonglorn University–World Bank Knowledge Management Project. Eichengreen, B. and A. Rose. “Staying Afloat When the Wind Shifts: External Factors and Emerging Banking Crises”. In Money, Capital Mobility and Trade: Essays in Honor of Robert A. Mundell, edited by G. Calvo, R. Dornbusch, and M. Obstfeld. Cambridge: MIT Press, 1998. Enoch, C., B. Baldwin, O. Frecaut, and A. Kovanen. “Indonesia: Anatomy of a Banking Crisis, Two Years of Living Dangerously, 1997–99”. IMF Working Paper, May 2001. Finance for Growth. World Bank Policy Research Report. Washington, D.C.: World Bank, 2001. Folkerts-Landau, D. and C. Lindgren. “Towards a Framework for Financial Stability”. IMF World Economic and Financial Survey, January 1998. Gan, W.B. and L.Y. Soon. “Credit Crunch During a Currency Crisis: The Malaysian Experience”. ASEAN Economic Bulletin 18, no. 2 (2001): 176–92. Garcia, G.H. “Deposit Insurance: A Survey of Actual and Best Practices”. IMF Working Paper WP/99/54, 1999. Ghosh, S.R. and A.R. Ghosh. “East Asian Aftermath: Was There a Crunch?” World Bank Working Paper WP99038, October 1999. Gochoco-Bautista, M.S., S. Oh, and S.G. Rhee. “In the Eye of the Asian Financial Maelstrom: Banking Sector Reforms in the Asia-Pacific Region”. Asian Development Bank, 2000. Gourinchas, Pierre-Okiveier, Rodrigo Valdes, Oscar Landerretche. “Lending Booms: Latin America and the World”. National Bureau of Economic Research Work-

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ing Paper 8249. Cambridge, M.A.: National Bureau of Economic Research, April 2001. . Honohan, P. and D. Klingebiel. “Controlling the Fiscal Costs of Banking Crises”. World Bank Policy Research Working Paper 2441, 2000. International Monetary Fund. “World Economic and Financial Survey: International Capital Markets Developments, Prospects, and Key Policy Issues”. July 2001a. . . “Thailand: Selected Issues”. IMF Country Report, August 2001b. Ito, K. and L.P. da Silva. “The Credit Crunch in Thailand During the 1997–98 Crisis: Theoretical and Operational Issues with the JEXIM Survey”. World Bank, March 1999a. . . “New Evidence of Credit Crunch in Thailand and Indonesia and Its Policy Implications”. World Bank, November 1999b. . Jomo, K.S. Malaysian Eclipse: Economic Crisis and Recovery. London: Zed Books Ltd., 2001. Johnston, R.B. and I. Otker-Robe. “A Modernised Approach to Managing the Risks in Cross-Border Capital Movements”. IMF Policy Discussion Paper, 1999. Klingebiel, D. “The Role of Asset Management Companies in the Resolution of Banking Crisis”. In Resolution of Financial Distress, edited by Stijn Claessens, Simeon Djankov, and Ashoka Mody. Washington, D.C.: World Bank Institute, 2001. Lamberte, M.B. “Credit Crunch! Credit Crunch! Credit Crunch?” PIDS Policy Notes no. 99-08, August 1999. . Levine, R. and S. Zervos. “Stock Markets, Banks, and Economic Growth”. American Economic Review 88, no. 3 (June 1998): 537–58. Lindgren, Carl-Johan, T.J.T. Balino, C. Enoh, A.M. Gulde, M. Quintyn, and L. Teo. “Financial Sector Crisis and Restructuring: Lessons from Asia”. IMF Occasional Paper 188, 1999. . Mishkin, F.S. “Financial Policies and the Prevention of Financial Crises in Emerging Economies”. World Bank Working Paper no. 2684, October 2001. Monetary Authority of Singapore (MAS). Annual Report 1998/1999. Singapore: MAS, 1999. . Morgan, J.P. “Asia-Pacific Outlook”. 26 September 2001. Noble, G.W. and J. Ravenhill. The Asian Financial Crisis and the Architecture of Global Finance. Cambridge: Cambridge University Press, 2000. Pangestu, M. and M.S. Goeltom. “Survey of Recent Developments”. Bulletin of Indonesian Economic Studies 37, no. 2 (2001): 141–71. Rajan, R. and L. Zingales. “Financial Dependence and Growth”. American Economic Review 88 no. 3 (June 1998): 559–86.

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Rodlauer, M., P. Loungani, V. Arora, C. Christofides, E.G. De La Piedra, P. Kongsamut, K. Kostial, V. Summers, and A. Vamvakidis. “Philippines: Towards Sustainable and Rapid Growth”. IMF Occasional Paper no. 187, 2000. Shirai, S. “Overview of Financial Market Structures in Asia: Cases of the Republic of Korea, Malaysia, Thailand and Indonesia”. ADB Institute Research Paper 25, September 2001. Takayasu, K. “Bank Restructuring in Asia”. RIM Pacific Business and Industries II, no. 1 (2001). Thubdimphun, S. “The Impact of the Deterioration in the Thai Banks’ Balance Sheets on Bank Lending”. Masters thesis, Faculty of Economics, Thammasat University, May 2000. Yoshitomi, M. and K. Ohno. “Capital Account Crisis and Credit Contraction: The New Nature of Crisis Requires New Policy Responses”. ADBI Working Paper, May 1999. Yoshitomi, M. and S. Shirai. “Designing a Financial Market Structure in Post-Crisis Asia: How to Develop Bond Markets”. ADB Institute Research Paper 15, March 2001a. . Technical Background Paper for Policy Recommendations for Preventing Another Capital Account Crisis. ADB Institute, 7 July 2001b. World Bank. “Special Focus: Financial and Corporate Restructuring: An Update”. World Bank, 27 March 2001. . . “Indonesia”. World Bank, 28 March 2001. . . “Malaysia: Social and Structural Change Update”. World Bank, 29 March 2001. . . “Thailand Economic Monitor”, July 2001. .

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Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > 97 4. The Challenges of Microfinancing in Southeast Asia

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The Challenges of Microfinancing in Southeast Asia John D. Conroy 1. Introduction

This chapter examines the circumstances of seven Southeast Asian countries in which institutional microfinance has developed to some significant degree. The treatment is broad-brushed, since it is written as a contribution to a wide-ranging discussion of the capacity of financial systems in Southeast Asia to finance the recovery of regional economies from financial crisis, rather than an attempt to update existing studies which describe microfinance comprehensively in the countries 1 concerned. This chapter aims to paint some details into the big picture with which this book is concerned. They are minor details, and might be regarded as trivial in financial terms, in the sense that the transactions described would scarcely register in the consolidated balance sheets of the financial sectors of any country in the region. However, these transactions are significant in the lives of millions of poor people who

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are not served by formal financial institutions. And while accepting that growth is essential for poverty alleviation, this chapter asserts that the participation of the poor in economic recovery and growth will be facilitated by their access to microfinancial services. The crude “trickledown” analogy for the diffusion of the benefits of growth may be discredited. But if, for heuristic purposes, we were to adopt that analogy and pursue its implications, microfinancing could be described as a process by which capillary systems are opened to enable the benefits of growth to flow to the poor, and to facilitate their participation in it. The financial service needs of the poor are simple, but their satisfaction can be life-enhancing. The poor need access to convenient, liquid, and safe deposit services which are protected against inflation by positive real rates of interest. With savings in reserve, the poor are able to smooth their consumption expenditures in the face of uncertain income streams. Savings provide a shield against catastrophic events which, by forcing the vulnerable to divest productive assets, would otherwise tip them over the dividing line between meagre sufficiency and poverty. “Micro”-insurance is a related financial product with potentially profound welfare benefits. Similarly, the poor — who make their living in a myriad of activities in the informal sectors of the region, many of them either landless or with insufficient agricultural land — need access to credit to increase the productivity of their labour, or to free them from exploitative financial relationships. 1.1. Defining Microfinance

Having established the significance of the subject, we proceed to definition. “Microfinancing” is the provision of financial services to poor and low-income households without access to formal financial institutions. In most of the countries to be considered in this chapter, such households form a clear majority. Given the book’s concern with Southeast Asia, it is appropriate to adopt the definition of microfinance used in the Asian Development Bank’s microfinance development strategy for the Asia-Pacific region (ADB 2000a, p. 1): Microfinance is the provision of a broad range of financial services such as deposits, loans, payment services, money transfers, and insurance to poor and low-income households and their micro-enterprises.

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The ADB’s definition is a good deal more inclusive than those 2 adopted by many practitioners, who would apply strict criteria for loan size and targeting of clients, excluding from consideration the supply of services to “low-income” people. Many would take such a stand even in a situation where (say) 75 per cent of a population are beyond the reach of regulated financial institutions, and where the population below the poverty line is (again, say) only 25 per cent. A more restrictive definition, while useful for some purposes, would prevent us from discussing here several significant regulated financial institutions, which are international leaders in their fields, and whose methods of operation have much to teach microfinance practitioners. Having said that, it is nonetheless important to remember that there is a clear distinction between the economic activities and financial service 3 needs of the small and medium enterprise (SME) sector, and those of the clients of microfinance institutions. The latter operate on a much smaller scale and exclusively in the informal sector of the economy. While there may be some overlap between the bottom end of the SME sector and the poor and lower-income people who form the constituency of microfinance, it is the needs of the latter to which this chapter is directed. “Microfinance” encompasses access to savings and other financial services, as well as credit. The term has come into greater currency since the early 1990s, and has largely (but not entirely) supplanted the term “microcredit” in the professional literature. The latter term is now recognized as unfortunate because its use has focused attention on a single aspect of microfinancial services, lending to the poor, and diverted attention from the need to develop systems of financial intermediation to which the poor have access. Savings is often described, in a memorable phrase, as “the forgotten half of rural finance” (Vogel 1984). Using the term “microcredit” perpetuates this amnesia. Microfinance institutions (MFIs) are developing forms of “microinsurance” to protect the vulnerable from misfortunes, such as ill health, which can tip them over the edge into poverty. Estimating the potential demand for insurance services by the poor as quite substantial, Kunkel and Seibel (1997) refer to microinsurance as “the forgotten third of microfinance”. In addition, microfinance practitioners are working to introduce newer services, such as money transfers (given the high

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degree of spatial mobility of the working poor, and the difficulties and expense they may experience in remitting funds to their families). 1.2. The Outreach of Microfinance

The Microcredit Summit, a U.S.-based movement which supports the growth of MFIs targeting the poor, collates data submitted by MFIs concerning the outreach of their programmes. Self-reporting is a dubious basis for recording the achievements of grant-seeking organizations, many of which are not subject to audit in their own countries. The Summit attempts to have independent monitors assess the claims of the organizations concerned. On that basis, the Microcredit Summit reports a world-wide increase in the outreach of microcredit programmes responding to its surveys, as shown in Table 4.1. On a regional basis, the Summit Secretariat notes that Asian programmes reported 23.6 million clients at the end of 2000, of whom 10.5 million were classified as “poorest”. From this it appears that the centre of gravity of the world microfinance movement is located in Asia. Looking at the country data, we see that Bangladesh houses a number of “mega-institutions”, of which the Grameen Bank — with 2.4 million clients in the “poorest” category at the end of 2000 — is the leader. Other major institutions in Bangladesh include BRAC, with 1.6 million “poorest” clients, ASA with 1.01 million and PROSHIKA with 0.89 million. In the case of Bangladesh, it can be said that the level of donor interest and monitoring is such that the reported figures for these major institutions carry some credibility. Institutions in Southeast Asia do not feature prominently in the tables. From Indonesia, the BRI Units Table 4.1 World Outreach of Microcredit Date End 1997 End 2000

No. of Programmes

No. of Clients

No. of “Poorest” Clients

618 1,567

13.5 million 30.7 million

7.6 million 19.3 million

Source: Microcredit Summit.

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(discussed at some length below) are shown as having 2.7 million clients, of whom 0.125 million are among the “poorest”. The table does not acknowledge the achievement of BRI in having some 25 million deposit accounts, of which more than 16 million are savings accounts with balances averaging US$85. This may not be “microcredit” but it is certainly microfinance. The high profile achieved by microfinance in international development circles in the last ten or twelve years is due, more than any other factor, to publicity accorded the successes of the Grameen Bank of Bangladesh and the other Bangladeshi non-governmental organizations (NGOs) mentioned above, some of which are also multi-faceted social and economic institutions. Broadly speaking, these have in common a basic organizational principle, the use of groups of women borrowers to overcome the problem of their lack of collateral. The donor community recognized the potential of microfinance as a tool for poverty alleviation with the formation of an international consultative group, the CGAP (Consultative Group to Assist the Poorest) in 1995, to which all major multilateral and bilateral donors have subscribed. The World Bank and certain bilateral agencies, notably USAID and GTZ, have a track record in the field dating back at least to the 1980s, or even further if one includes efforts to improve rural financial systems. The CGAP identifies and disseminates standards for the measurement and analysis of MFI operations, “best practice” modes of operation, and other information for microfinance practitioners and donors. Certain major donors, such as the ADB, have drafted microfinance strategies to guide their own efforts and those of member governments and MFIs (ADB 2000a, www.adb.org/documents/policies/ microfinance). This has occurred in response both to CGAP’s influence and the broader trend to explicit incorporation of poverty alleviation into programme criteria (notably in the PRSP, the “Poverty Reduction Strategy Paper” process, which the World Bank and the International Monetary Fund [IMF] now enjoin upon recipient governments). 1.3. Models of Microfinance

Among the proliferation of microfinance institutions (MFIs) in developing and even some industrial countries, a number of distinguishable

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models have emerged. The Grameen Bank model, referred to above, has been applied in many countries in a wide variety of settings. The Grameen model requires careful targeting of the poor through means tests, usually with a focus on women, and intensive fieldwork by staff, to motivate and supervise the borrower groups. Groups normally consist of five members, who guarantee each other’s loans. Some compulsory saving requirements are imposed, but in general quite limited voluntary saving occurs. Sustainability is achieved by increasing the scale of operations, and by decentralizing control and carefully managing costs. While some other models have as their goal the creation of autonomous institutions, this is not expected of the individual borrower groups. In Bangladesh, where the greatest numbers of Grameen-inspired institutions exist, considerable innovation is occurring; only the basic model is described here. The Village Bank is a widely replicated model, found mainly in Latin America and Africa, but with substantially less total outreach than the many Grameen Bank replications. Typically, an implementing agency establishes individual village banks with between thirty and fifty members, and provides capital (called the “external account”) for onlending to individual members. Individual loans are repaid at weekly intervals over sixteen weeks, at which time the village bank returns the principal with interest to the implementing agency. A bank repaying in full is eligible for subsequent loans, with loan sizes linked to the performance of village bank members in accumulating savings. Peer pressure operates to maintain full repayment, thus assuring further injections of loan capital, and also encourages savings. Savings accumulated in a village bank can be loaned out to members (the “internal” account). The standard business plan calls for a village bank to accumulate sufficient capital in its internal account to enable “graduation” after three years, by which time loan capital has been accumulated entirely from internal sources. Hence village banks are intended to become autonomous institutions. Somewhat less structured than village banks (and a good deal less so than Grameen banks) are Credit Unions (CUs). These are democratic, non-profit financial co-operatives, owned and controlled by their members. CUs mobilize savings, provide loans for productive and

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provident purposes, and have memberships which are generally based on some common bond. The memberships of CUs are likely to be more heterogeneous than that of Grameen banks, although various CUs differ in the extent to which they include poorer and low-income households. CUs generally relate to an apex body that promotes primary credit unions and provides training, while monitoring their financial performance. In Asia, rural credit unions have been successful in some countries, both in terms of sustainability and of reaching out to the poor (notably in Sri Lanka). But they have been less successful in most other countries of the region. A fourth model, based on “self-help” groups (SHGs), is somewhat similar to the village bank concept, although less structured. Most prominent in India, SHGs have around twenty members who should be relatively homogeneous in terms of income. Their primary principle is the lending of members’ savings, but SHGs also seek external funding to supplement internal resources. The terms and conditions of loans differ among SHGs, depending on the democratic decisions of members. Typical SHGs are promoted and supported by NGOs, but the objective (as with village banks) is for them to become free-standing institutions. Some NGOs act as financial intermediaries for SHGs, while others act solely as “social” intermediaries, seeking to facilitate linkages of SHGs with either licensed financial institutions or other funding agencies. The SHG model is a good platform for combining microfinance with other sectoral activities and their implementing agencies (maternal and child health and adult literacy, among others). However, the relatively loose structure of groups makes rapid expansion of outreach and tight monitoring of performance more difficult than, say, with the Grameen Bank model. In a quite different category from the four models discussed above, each of which has strong voluntary elements involving the action of NGOs or community-based entities, is what might be called a rural financial systems approach. As practised in Indonesia, this model exhibits a diversity of regulated financial institutions providing rural financial services. These range from a national-level institution with substantial outreach and extensive networks to small local institutions occupying particular market niches. Also, depending on the regulatory environment

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in a particular country, it may be possible for an NGO to transform a successful MFI into a regulated financial institution. The rural financial systems approach to microfinancing will be discussed below, with particular reference to Indonesia. The “transformation” process in which NGOs evolve to become regulated financial institutions will also be described, in the context of Cambodia and the Philippines. 2. Microfinance within Southeast Asia: Light and Shade

Within Southeast Asia, there is considerable diversity between countries in the degree to which systems of microfinancing have emerged, and in the institutional forms developed or adapted for them. Before proceeding to a country-by-country discussion, it may be useful to suggest in broad terms the scope of this diversity. For the purposes of this chapter, it is convenient to categorize countries in Southeast Asia as either “market” economies, differing in the degree to which they have modernized their financial sectors, or “transitional” economies, differing in the extent to which they have accepted the challenge of adopting market principles.4 Among the “market” economies of ASEAN, there are considerable differences, both in the incidence of poverty, which might stimulate microfinance initiatives as a response to disadvantage, and in the balance between private and public involvement in the process. For example, Malaysia and Thailand have considerably higher levels of per capita income than either Indonesia or the Philippines. In Malaysia, in particular, absolute poverty was (at least until the financial crisis from 1997) regarded as a residual and diminishing problem which could be eliminated early in this current century. The official Malaysian approach to eliminating poverty, and to the provision of microfinancing services as an element in that process, has been essentially “social-welfarist”. Microfinance services for people without access to conventional financial institutions have been seen within the framework of a redistributive social policy involving substantial subsidies. In the case of Thailand, elements of subsidy (and implicit redistribution) have also been present in financial policy for lower-income rural people. However, for reasons which will be discussed below, there are marked differences between Malaysia and Thailand in microfinance

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policy and practice. One such difference is that, whereas the voluntary or NGO sector of financial service provision is relatively undeveloped in Thailand, an NGO with strong political backing is the major actor in Malaysia. And in Thailand, a government financial institution has primary responsibility for microfinancing, and has become both an international leader in its field and an integral part of the Thai financial system. Indonesia and the Philippines also provide some marked contrasts, both with one another and with Malaysia and Thailand. Indonesia has adopted a model of microfinance service provision based very largely on the operations of regulated financial institutions, whereas NGOs are of relatively limited significance. The emergence of sustainable and effective models of microfinancing within the formal financial system, many of them privately owned and operated, has been more a by-product of Indonesia’s efforts at financial sector development than of any conscious policy to stimulate microfinance, per se. And by contrast, Indonesia also provides some examples of mass “microcredit” programmes involving NGOs and other community organizations (especially in the late Soeharto era), which were politically driven and not at all concerned with sustainability. Microfinancing in the Philippines has followed a more conventional course, based primarily on the energies of a burgeoning NGO community. The influence of Grameen Bank methods of service delivery has been very strong in that NGO community and the Philippines also has a regulatory environment favourable to the operation of small regulated banks suitable for microfinance. The Philippine government has explicitly incorporated microfinance into its poverty alleviation strategies, has encouraged NGOs to develop sustainable microfinance programmes, and is beginning to promote the transformation of successful microfinance NGOs into regulated financial institutions. In the “transition” economies there is a range of experiences and some marked contrasts. In terms of overall economic and financial sector development, Laos has made least progress, and its economic activities retain a substantial non-monetized component. In terms of developing a microfinance sector, it lacks important institutional and policy prerequisites. The cases of the other transitional countries discussed here,

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Cambodia and Vietnam, provide some instructive contrasts. In many senses, Vietnam is experiencing a more difficult transition to financial liberalization, given the continuity provided by a militarily undefeated socialist institutional and governmental structure, and the resistances to change within it. Also, an autonomous NGO movement, as distinct from mass organizations set up by the state, is still substantially lacking (though this could be seen as simply more evidence of continuity in the political culture of Vietnam). In Cambodia, however, the history has been one of abrupt discontinuity; the period of turmoil and uncertainty from the time of withdrawal of Soviet influence in 1989 appears to have left less entrenched resistance to change. Simultaneously, a governmental vacuum opened opportunities for the “INGOs”, the international NGO movement (which was the vehicle for much bilateral development assistance in the early period). Among many innovations introduced as part of an INGO-led reconstruction effort in the early 1990s were “microcredit” projects. Some of these have flourished as indigenous NGOs, and have embraced financial intermediation functions. These successful institutions are now being incorporated into an explicit legal and regulatory framework for microfinance; the “transformation” process described above. 3. Country Case Studies 3.1. Malaysia

Malaysia has a modern financial system with a diverse range of institutions, both private and public, including Islamic banks. Public institutions include development financing institutions — a development bank and an agriculture bank (Bank Pertanian), as well as the Credit Guarantee Corporation (CGC) which provides guarantees on lending by other financial institutions to SMEs. At the lower end, CGC has a credit guarantee scheme for “hawkers and petty traders”, but loan sizes for this scheme suggest it is operating at a level somewhat above conventional microfinance. The smaller loans guaranteed by CGC would, however, qualify in terms of the ADB definition with which this chapter commenced. There are also urban credit co-operatives, but these serve a salaried clientele, while rural credit co-operatives have minuscule

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outreach, and the co-operative movement as a whole is in a weak condition, with government now attempting to revitalize it. Essentially the only institutions engaging in microfinance are drawn from the NGO community, where there is one dominant MFI and a handful of minor operators. Among other factors, interest rate controls may have played some part in keeping commercial banks out of microfinance. McGuire, Conroy, and Thapa (1998, p. 185) noted that Bank Negara, the central bank, restricted the spread between base and maximum lending rates in the commercial banking system to 4 per cent, less than would be required to cover the extra costs associated with microfinance lending. In the case of some loans guaranteed by CGC, the permissible spread was only 2 per cent, reinforcing this effect. There has been some engagement by regulated financial institutions with microfinance in other ways, however, and this is described below. Malaysia is the wealthiest country discussed in this chapter, and the only one classified as an upper middle income country by the World Bank. This is an important factor in the approach taken to poverty alleviation through microfinance in Malaysia, an approach deriving from the New Economic Policy (NEP) which operated from 1971 to 1990. The NEP was directed to reducing poverty and income disparities between ethnic groups, and particularly to improving the position of the bumiputera, the indigenous peoples of Malaysia.

3.1.1. Amanah Ikhtiar Malaysia: The Dominant Institution Malaysia’s dominant MFI, Amanah Ikhtiar Malaysia (AIM), was established in 1987. Up to 1998, it had made some 103,000 loans and disbursed a total of RM328 million (around US$86 million at the current exchange rate, considerably more if contemporary exchange rates are applied). Some 80 per cent or more of all funds loaned were for economic purposes, the remainder for “social” purposes (Sukor Kasim 2000). AIM’s activities have been directed almost entirely to the alleviation of poverty 5 among poor Malays. It was set up with a charter “to disburse small loans on reasonable terms exclusively to the very poor households to finance additional income-generating activities” (Gibbons and Sukor Kasim 1990), but for all practical purposes has confined its attention to the bumiputera. This is evident from its outreach data, rather than from its charter.

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Believing that while the NEP had successfully reduced the number of households in poverty, the persistence of hardcore poverty required a new approach, AIM adopted the Grameen Bank model, with some modifications to suit the Malaysian context. An official survey in 1989 indicated that some 94,600 households, or 2.2 per cent of the total population, were classified as “hard core poor”, with incomes below half the level of the official poverty line. The indigenous Malay community was disproportionately represented among these poor households. AIM, intent on targeting the poorest among the poor, used the official periodic Household Income Survey as a guide and developed its own means test to identify the hardcore category. By August 1994, AIM had some 6,100 Grameen groups in operation, with a total membership approaching 30,000 borrowers. Assuming that its procedures to identify the poor were both effective and consistently applied, this is quite impressive coverage of the target population, achieved in seven years. As discussed below, outreach might have been higher, but for political considerations. Total loans disbursed at that time amounted to RM37.9 million (US$14.8 million) and, reflecting the relative priorities accorded savings and credit, total savings were US$1.8 million. Some 28 per cent of lending was for agriculture, 46 per cent for trade, 15 per cent for animal husbandry, and 10 per cent for other activities (Conroy, Taylor, and Thapa 1995, p. 20). In Malaysia, because of the sensitivities of its Muslim clients and sponsors, AIM levied “service charges” on loans, rather than interest expressed in percentage terms. If calculated as interest on the principal involved, however, these charges were well below rates in the Malaysian commercial banking sector. For example, the average loan size for borrowers taking a third loan in 1994 was RM1,044 (US$427), for which the service charge equated to around 4.7 per cent flat, over the usual one-year loan term. Service charges on larger loans were somewhat higher in percentage terms, but these were only a small proportion of total advances; for all classes of loans service charges covered only a portion of AIM’s lending costs (Conroy, Taylor, and Thapa 1995, p. 21). Some 60 per cent of AIM’s operational costs between 1989 and 1995 were covered by a Malaysian government grant, while the state governments granted additional support of up to 40 per cent annually. In consequence,

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AIM had limited stimulus to strive for self-sufficiency in its early years (McGuire, Conroy, and Thapa 1998, pp. 178–79). Loan capital was provided by central government grants, supplemented by soft loans from CGC and some commercial banks, especially those with a majority government shareholding. However, from 1992 a constraint on expansion of outreach operated, due to a government decision to channel a grant of US$7.3 million, intended for loan capital, over the period 1991–95, through YPEIM, an Islamic foundation. YPEIM, however, decided to programme the disbursement over a much longer period, a decision which according to a recent evaluation of AIM’s programme, caused a serious cashflow problem, and undermined AIM’s plans for expansion and the achievement of viability (Sukor Kasim 2000).

3.1.2. A Loss of Direction Soft loan financing from regulated financial institutions, mentioned in the previous paragraph, tided AIM over cashflow difficulties from 1992, and indeed permitted an increase in loan ceilings from 1994, after the departure of the founding management. According to a recent evaluation, the average loan size jumped by 400 per cent between 1994 and 1998, and this was accompanied by an increase in portfolio at risk (Sukor Kasim 2000, p. 307). AIM’s expansion from 1994, at which time it had reached some 50 per cent of its target group in peninsular Malaysia (Sukor Kasim 2000, p. xii), appears to have been more in terms of value of loans outstanding than increased outreach to the hardcore poor. The evaluation notes that the restoration by central government of loan capital funding in 1997 sparked a further upward revision of loan ceilings, coinciding with a blowout in operational costs. An increase in the number of “dropouts” from the programme, especially among poorer members, was noted from 1994, as loan sizes increased, a trend which accelerated from 1997. Citing “blatant disregard of the fundamental Grameen principles”, Sukor drew attention to leakage [of loans] to the “not so poor” and the “non poor”. … It is vital for [AIM] to relay the message that their outreach is women who are at the bottom two-thirds of the poverty household level as the author uncovered that due to relaxation on means testing, the less poor and the non-poor are motivated to become [AIM’s] members. (2000, p. 324)

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He is particularly critical of two loan programmes introduced after 1997. The first was given the name “SPIN”. The SPIN was directed to men in the fishing industry. The second was titled SP-IT, for “single mothers” (female heads of households). Participants were offered an unprecedentedly high first loan of RM10,000 (US$2,650). With the diversion of AIM’s attention to larger loans and better-off borrowers, the evaluator was also concerned about the implications of this development for credit discipline and portfolio quality. Whether the inclusion of larger borrowers is a problem per se is largely a matter of perception. Other MFIs might do so to diversify risk and improve overall sustainability, but the evaluator took the view that, in terms of AIM’s charter, larger loans amounted to “mission drift”. And there may be particular political circumstances affecting the choices made for AIM. In the event, the admission of people to the programme who are out of sympathy with its objectives has had a corrosive effect on sustainability. By the end of 1998, portfolio at risk (PAR) had risen to 3 per cent (Sukor Kasim 2000, p. xviii); not too serious as an end-point, but certainly a warning as a trend indicator. But by the end of 2000, the PAR of the whole AIM programme, with RM100 million outstanding, had increased to 10 per cent, with SPIN at 60 per cent PAR and SP-IT at 36 per cent (Sukor Kasim, personal communication, October 2001). These are levels which indicate grave problems for the AIM programme. In 1997, AIM decided to break with its early practice, by raising the interest rate on loans to a uniform 19 per cent. Not only was this a substantial increase, it also expressed borrowing cost as a percentage of principle for the first time. The evaluation suggests this accelerated the loss of poorer clients from the programme, not just because an increase in costs would depress demand, but because many of the poorest are devout, and would find the interest charge unacceptable. While management’s decision to increase charges is understandable, as being consistent with a movement away from subsidies, and progress towards financial sustainability for AIM, it does raise an important issue in the particular circumstances of Malaysia. An earlier discussion of funding policy, set in a comparative context (McGuire, Conroy, and Thapa 1998, p. 186) made the judgment that the then official policy of subsidizing microfinance was appropriate in the circumstances of Malaysia. It would

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still be appropriate to do so now, given the relatively small numbers of the hardcore poor and the relative prosperity of Malaysia, provided that AIM settles on an objective set of targeting principles, without hint of political considerations, and concentrates on running a lean and cost-effective operation. At the end of 1998, AIM had forty branches and six area offices, serving some 39,000 borrowers and almost 56,000 members. The evaluation refers to the need for “a major and expensive rehabilitation exercise”. The more recent trends in portfolio at risk appear to underline the correctness of this judgement. 3.2. Thailand

Several studies (McGuire, Conroy, and Thapa 1998; Meyer and Nagarajan 2000) have noted that specialized microfinance services are not important in Thailand. Meyer and Nagarajan explain this in terms of a relatively prosperous economy and comparatively minor poverty problems. On the eve of the financial crisis in 1997, official estimates of the incidence of poverty in Thailand were between 10 and 15 per cent, depending on the measure used, and the poor were concentrated in the provinces of the north and northeast (McGuire, Conroy, and Thapa 1998, p. 287). Meyer and Nagarajan also credit the large outreach achieved by BAAC (the state agricultural bank, discussed below) with having reduced the need for specialized MFIs. They note the geographic concentration of Thai poverty, and that cash and in-kind transfer payments support the poor in affected regions, and that they also benefit from government credit schemes. Perhaps for the reasons suggested by Meyer and Nagarajan, NGO involvement in the provision of microfinance services is extremely limited. McGuire, Conroy, and Thapa (1998) could find only one, relatively small, organization that was exclusively engaged in microfinance, as well as some multi-purpose NGOs which also operated microfinance programmes as an adjunct to their main activities. The lack of involvement of NGOs as creators and operators of MFIs — as seen, for example, in the Philippines and even Indonesia, and most particularly in South Asia — is striking. Among government-inspired schemes, as mentioned by Meyer and Nagarajan, which provide some financial services to the poor, there is a mixture of government and non-government activity. Government agencies

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operate three main programmes, those of the Community Development Department (CDD), the Government Savings Bank (GSB) and the Urban Community Development Office (UCDO). McGuire, Conroy, and Thapa (1998, p. 302) describe the CDD programme as “very much government driven, with a government department establishing revolving funds at the village level to be managed by local government authorities”. The programmes of GSB and UCDO are described as “managed by independent boards, [which] operate by extending loans to co-operatives and community organizations, which are mainly non-government bodies owned by their members”. Erhardt (1999, p. 11) gives a figure of some 1,200 thrift and credit co-operatives in Thailand in 1997, with almost 2 million members, but notes that they experience severe payment problems. For the rural sector as a whole, Meyer and Nagarajan (2000, p. 319) report a pattern of market segmentation which is somewhat stylized because of the lack of national survey data on rural financial services. They posit a scenario in which commercial banks serve large farms and agro-industries; BAAC largely serves small and medium farms, co-operatives, and associations; the poor and landless are served mainly by informal finance and a few government programs and NGOs. Agricultural co-operatives and village-level credit unions may also reach poorer segments of the rural population.

A study of financial services available to poor and low-income entrepreneurs in Chiang Mai province, northern Thailand (Erhardt 1999), describes the modes of financing available in terms of a continuum, with formal, regulated institutions at the “high”, or formal end. Most formal in this sense are the commercial banks, which, while they dominate the financial sector overall, have great difficulty dealing with micro or small entrepreneurs with limited or no collateral, who have no reliable records and whose requested loan size is below bank thresholds. Further along the continuum are the branches of BAAC, the agricultural bank, which is closer to the rural areas in terms of its branch network, and closer still in terms of its adoption of joint-liability lending for small loans to groups of small farmers. Less formal are the cooperatives, which include both agricultural co-operatives and thrift and credit co-operatives, and which occupy the next position on the continuum. Further along still are licensed pawnshops, at the margin of the regulated, formal financial sector. After this we cross over into an informal financial zone

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occupied by traders who extend credit, by means including hire purchase, then money lenders, Rotating Savings and Credit Association (ROSCAs), and finally — at the informal end of the continuum — a host of personal arrangements involving family and friends. It is worth noting that this account of financing options available in sample locations in Chiang Mai province makes no mention either of NGOs or of the various government-sponsored schemes mentioned above.

3.2.1. BAAC: The Bank for Agriculture and Agricultural Co-operatives The principal formal financial institution of relevance to low-income rural people in Thailand, referred to by Meyer and Nagarajan, is the Bank for Agriculture and Agricultural Co-operatives (BAAC), established in 1966. It has been the subject of a number of detailed studies (including Sacay, Randhawa, and Agabin 1996; Muraki, Webster, and Yaron 1998; Meyer and Nagarajan 2000). This chapter’s account of the operations of BAAC relies primarily on the most recent of these studies, together with the conclusions of an earlier exploration by the Foundation for Development Cooperation (McGuire, Conroy, and Thapa 1998). The most remarkable thing about BAAC is the degree of its market penetration. As Meyer and Nagarajan (2000, pp. 321–23) report: The penetration of BAAC in rural areas is more significant than any other single rural financial institution in Asia. Some 4.7 million of the country’s five million plus farm households are registered for its services, although in any one year not all have loans. In 1996, 3.4 million households (72 per cent) were registered as individual branch clients, while the remaining 28 per cent were registered as members of 877 agricultural co-operatives and 295 farmers’ associations that borrowed from BAAC. Therefore, directly or indirectly, it reached about 90 per cent of the country’s farmers.

In terms of depth of outreach, the reach to the lower income groups, Meyer and Nagarajan (2000, p. 324) infer from the incidence of relatively small loans that “BAAC must be reaching fairly poor clients, if not the poorest of the poor. Moreover, the co-operatives and associations that 6 on-lend BAAC funds possibly reach members who may be even poorer.” A somewhat sterner, if still tentative, conclusion was reached by McGuire, Conroy, and Thapa (1998, pp. 290–91), who decided that:

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BAAC does not specifically target the poor, and some commentators suggested that it may not reach the poorest farm families. Moreover, the poorest people are often without land and therefore are not farmers. These people are not eligible to receive loans from BAAC, by virtue of its mandate as stipulated in its charter … Therefore, while BAAC has huge outreach in the rural areas, it may not reach the poorest households.

McGuire et al. pointed out that the original BAAC charter restricted it to providing loans to farmers for on-farm activities. This was amended in 1992 to allow limited lending to farmers for agriculturerelated activities. Further amending the charter to allow lending for non-agricultural activities in rural areas has often been debated, and some progress occurred in 1999, as discussed below. However, McGuire et al. speculated that even if this were to occur: it is unlikely the bank will increase its poverty lending. While there is some pressure for it to do so, its cost structure and interest rate structure mean that it is unlikely that it could engage in poverty lending on a commercial basis.

Background data supporting this judgement are documented by Meyer and Nagarajan (2000, p. 333). Despite efficient internal operations, BAAC has maintained spreads between deposit and lending rates which are rather low. It also cross-subsidized smaller borrowers at the expense of larger ones, has been subject to political direction on interest rates, and has discounted its wholesale loans to co-operatives and associations rather generously by comparison with the rates charged for individual loans. The other side of this coin is the bank’s degree of subsidy dependence. BAAC receives subsidies in several ways. These include soft loans from donors, preferential rediscount facilities granted by the central bank, and exemptions the central bank has granted from reserve requirements on deposits, among others. A calculation for BAAC in 1995, of a “Subsidy Dependence Index” associated with Jacob Yaron, suggested that the bank could have managed without these subsidies by raising its average yield on portfolio from 11.0 to 14.9 per cent (Muraki, Webster, and Yaron 1998). This is a highly creditable performance by comparison with most agricultural development banks in the developing world. Apart from these subsidies, BAAC received a very helpful boost from the government

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from 1975, when a direction was given to commercial banks to lend in the agricultural sector. This obligation could be satisfied by the banks’ depositing any shortfall in their lending quotas with BAAC, where they earned a relatively low return on the funds. To a large extent this relieved the agricultural bank of the more expensive course of mobilizing savings in its rural constituency. Commercial bank deposits represented more than 70 per cent of BAAC’S deposits in the 1980s. This proportion (and the absolute amount involved) declined substantially in the 1990s, while BAAC’s savings mobilization performance improved considerably. In 1995 some 3.4 million of its savings accounts (of a total of 4.1 million) held balances below US$201, which Meyer and Nagarajan suggest shows that poor people must have held some of these small accounts. They note also that the bank’s deposit accounts in 1997 outnumbered its loan accounts by about one million. This is encouraging, but should be compared with the even better performance of Bank Rakyat Indonesia (BRI), discussed below in the section on Indonesia. Indeed, the achievements of BRI may provide a benchmark for BAAC in its efforts to rebuild after losses suffered during the financial crisis from mid1997. Meyer and Nagarajan (2000, p. 347) sum up the weaknesses of BAAC. Those of particular relevance to BAAC’s capacity to engage in microfinance include the fact that rural savings mobilization is still not a high priority, that BAAC is still subsidy-dependent, and that its lowinterest policy “is a disincentive for searching more aggressively for ways to make smaller loans efficiently”. Finally, its policies and charter constrain BAAC from serving the rural non-farm sector fully (although legislation in 1999 did authorize it to offer a wider range of financial services in rural areas). In October 1998, BAAC came under the banking supervision of the central bank. Maurer et al. (2000, p. 5) note that with this change, “the bank has become subject to prudential regulation, such as capital adequacy and loan loss provisioning”. In a decidedly upbeat forecast, they suggest that “[m]ore stringent rules and performance standards may be painful in the short term but they will help BAAC in its struggle for financial viability and self-sustainability in the long run”.

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They further suggest that, shielded by its obligations to the central bank, BAAC will be better able to resist political interference in its lending and loan-recovery operations in future. In addition, recent changes permitting BAAC to open a “non-farm window” will revitalize the bank’s operations and foster its transition from the status of “specialized agricultural lending institution” to “universal rural bank” in coming years. Another view of the role of BAAC, which is surprisingly tolerant of its redistributive functions, comes from the 7 IMF. Robert Townsend, working on rural survey data from Thailand, has put forward the hypothesis that BAAC may be operating a “risk contingency system” for farmers. In times of crisis this system yields welfare gains for which the state pays by means of fiscal transfers to the bank. This is in many ways a troubling proposition; it surely cannot mean that the flow of fiscal resources to an agricultural bank should be taken as prima facie evidence that it is indeed performing the risk contingency function. If that were the case we could rewrite the history of every politicized agricultural development bank in the world. The judgement that a bank is performing risk contingency functions, sufficient to justify subsidies and the occasional recapitalization, would have to be made on careful case-by-case analysis, if at all. It will be interesting to see whether Townsend feels able to make that case for BAAC after further study. Townsend is more concerned about other measures currently being applied in Thailand. He refers to: social safety net programs put in place to help the poor in the crisis … village funds and village banks are being promoted throughout the countryside and funded by government expenditure without hardnosed evaluation of the role of these institutions that are supposed to help the poor … [while] the government sets up a small business credit guarantee fund, which I fear … has close to 100 per cent guarantee of small business loans. (IMF 2001c)

The Thaksin government, elected in January 2001, has “prioritized fiscal measures to boost rural incomes, including suspending farmers’ debts and creating village revolving funds” in response to an increase in the numbers of the poor by three million during the crisis (ADB 2001, www.adb.org/ documents/CSPs/THA/2001/csp0100.asp). Debt forgiveness measures often have corrosive effects, both on the balance sheets of financial institutions

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and on the credit culture in which they operate. And the creation of revolving funds simply as conduits for government money is seldom the most effective way to build rural financial institutions serving the poor. These measures suggest a more populist approach, which may employ the rhetoric of microfinance without absorbing the lessons of its experience. 3.3. Indonesia

The pattern of microfinance service provision in Indonesia differs from that observed in almost all other countries in which the sector has achieved any significant outreach.8 There are two major differences. The first is that certain regulated financial institutions in Indonesia, both public and private, have been able to extend sustainable financial services deep into the countryside, reaching many of the poor. The second, closely related, difference concerns the role and status of NGOs, which in other countries underpin much microfinance activity. In Indonesia, prior to the fall of the New Order government in 1998, the Department of Home Affairs and its line agencies operated a comprehensive system of local administration. This gave the central government considerable capacity to implement its policies and programmes in the provinces. Coupled with the suspicions harboured by officials at all levels about NGOs, this meant that there was less scope in Indonesia for the spontaneous emergence of private NGO initiatives than in, say, the Philippines. The position of NGOs changed substantially in 1998, when in the wake of the financial crisis, the Habibie government and the international community gave responsibility for relief and reconstruction under the “Social Safety Net” programme to the Indonesian NGO community. NGOs continue to enjoy a more positive status, although the Indonesian NGO movement is still a minor player in the provision of microfinance services. Methods of delivering microfinance services found in Indonesia cover a wide range. Solidarity group-based lending approaches are commonly used by NGOs. However, most microfinance services are delivered on an individual basis, due to the dominance of the sector by regulated financial institutions, following normal banking practice. The poor also manage their own financial service provision using arisan, traditional

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ROSCAs which are very common in Indonesia. Co-operatives also provide financial services to their members, traders provide credit for the poor as an element in transactions, and the state operates pawnshops. Patron/client financing relationships are widespread and tenacious outside the formal sector.

3.3.1. Bank Indonesia: The Central Bank Bank Indonesia (BI) has regulatory oversight of most of the major institutions engaged in microfinance, and has participated actively in shaping them. In this it is unlike its counterparts in other countries with strong microfinance sectors, such as Bangladesh, for example, where the central bank has been largely irrelevant to microfinance. Following the emergence of the New Order government, a new central bank law was enacted in 1968. This law gave BI a strong “developmental” mandate. However, in 1983 a process of financial sector deregulation and liberalization commenced. A longer-term consequence of these reforms was the successful turnaround of the villagelevel financial operations of BRI, the state bank whose primary focus was the agricultural sector. The Pakto financial deregulation “package” in 1988 continued the liberalization process. Among other measures, it freed up entry of new banks to the so-called “rural bank”, or BPR, sector. A new central banking law was enacted in 1999 by the Habibie government (Law No. 23 of 1999 on BI) at the urging of the IMF. Among other measures, BI’s previous role as an “agent of development”, responsible for channelling credit to priority sectors and groups, was abolished. These credit functions were to be transferred to other entities. The continuation of credit subsidies, thus transferred, was to be timebound, and the costs of continuing credit subsidies were to be approved as part of the government budgetary process, rather than being funded by BI. During the short presidency of Abdurrahman Wahid, political opposition to the new law began to swell. There was some support for reviving the role of BI as an “agent of development”, together with calls for the restoration of liquidity financing by the Bank. Under IMF pressure, in 2001 the matter was referred by the new government of President Megawati to an independent expert panel for advice. A “Letter of Intent” transmitted by the government to the IMF, in August 2001 (IMF 2001) committed the government to “maintaining a strong, independent and accountable central bank”.

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3.3.2. The Banking System The banking institutions regulated by BI are the commercial banks and the BPRs, or “rural banks”. Among commercial banks we give particular attention to BRI and its Units, and also consider the Regional Development Banks (BPDs). This account also considers the several categories of BPRs (Bank Perkreditan Rakyat, literally, people’s credit banks). The BPRs are generally very much smaller than commercial banks, and offer a more restricted range of services. As is well known, the Indonesian commercial banking system was devastated by the financial crisis. With few exceptions, commercial banks were little involved in microfinancing prior to the crisis. They are even less inclined to become so under current circumstances. However, under the New Order government, a number of commercial banks were involved as channelling agencies in official credit schemes implemented by BI. To some extent, the rhetoric of these official schemes included microfinance, but their performance in outreach to the poor did not match the rhetoric. A number of commercial banks have been involved in another government microfinance programme, the PHBK (Programme Linking Banks with Self-Help Groups). Prior to the crisis, some larger commercial banks had begun to explore the market potential of lower-end financial services, by means including the acquisition of small banks (BPRs) and setting up their own microbanking divisions. The financial crisis put an end to this tentative expansion of financial services to low-income people. However, several small commercial banks had developed niche activities in microfinance, and which have continued unabated. They have strong microfinance customer bases, although their outreach is small. 3.3.3. Bank Rakyat Indonesia (BRI) At the other end of the scale, Bank Rakyat Indonesia (BRI) is one of the largest commercial banks. Here we are concerned specifically with BRI’s Unit division, which operates at a retail level in rural areas, and has successfully encompassed elements of microfinance. Units offer a restricted range of services, tailored to the needs of small rural customers, including the Simpedes savings account and the Kupedes loan. BRI’s Unit (formerly Unit Desa) system, operating at village or sub-district

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Table 4.2 Indonesia: Regulated Financial Institutions and Microfinance, 2000

Institution

No. of Loan Accounts (Millions)

Mean Balance Outstanding per Account

No. of Deposit Accounts (Millions)

Mean Balance per Account

BRI Units BPRs BKDs LDKPs

2.60 1.68 0.70 1.30

Rp2.55m/US$340 Rp1.94m/US$260 Rp0.22m/US$29 Rp0.28m/US$35

16.7 4.6 0.6 n.a.

Rp0.65m/US$85 Rp0.25m/US$33 Rp0.05m/US$7 n.a.

Notes: Data for Bank Rakyat Indonesia relate to the Kupedes (loan) and Simpedes (deposit) accounts. Term deposits are excluded. Various dates during 2000. BRI = Bank Rakyat Indonesia. BPR = People’s Credit Bank. BKD = Village Credit Body. LDKP = NBFI Savings and Credit Institutions. Source: Bank Indonesia and Bank Rakyat Indonesia.

level in rural areas, performed strongly throughout the Asian financial crisis, with its Kupedes borrowers continuing to make over 97 per cent of the instalments that fell due in the period from mid-1997 to mid1999. Savings mobilized through the Units grew dramatically over this period, doubling from 8.3 trillion rupiah at the end of October 1997 to 17.7 trillion rupiah at the end of June 1999. The BRI Unit division’s performance in the face of the crisis put the seal on its reputation as one of the most efficient rural financial institutions in the developing world. Its strong repayment performance occurred at a time when the commercial banking system as a whole had non-performing loans estimated at 60 per cent of total loan portfolios. Indeed, BRI’s deposittaking operations, serving small and micro clients through the Unit network, provided the lifeblood of liquidity for the bank as a whole throughout the crisis. This helped to prop up BRI in the face of heavy losses incurred by its corporate lending division. In mid-2000, some 3,600 BRI Units had about 2.6 million Kupedes loans outstanding (see Table 4.2), with an unpaid balance of 6.7 trillion 9 rupiah (US$0.89 billion). The average outstanding loan balance was 2.55 million rupiah (US$340) and the twelve-month loss rate on the loan portfolio was at the extremely low level of 1.37 per cent. Studies of

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the size distribution of loans, and the characteristics of borrowers, indicate that at the lower end of the lending range the BRI Units do indeed reach the ranks of the poor. However, the outreach of the BRI Units to low-income and poor people appears quite variable from place to place. Moreover, Kupedes loans are secured by collateral, most commonly some certification of land ownership, and are made in respect of established economic enterprises, not start-ups. These requirements constrain the capacity of Units to lend to the very poor, although less stringent requirements for loans below 1 million rupiah (US$130) are being piloted. On the other side of the balance sheet, the Units had 24.9 million savings accounts. These included 16.7 million Simpedes savings accounts (see Table 4.2) with a mean balance of around 650,000 rupiah (US$85). Again, this suggests that many depositors are likely to be poor. Clearly, lack of liquidity is not a constraint on the lending of the BRI Units. With a loss rate close to 1 per cent, the Units could be considered too conservative in their lending practices.

3.3.4. Regional Development Banks (BPDs) Another category of Indonesian commercial bank is of particular significance to microfinance. They are the BPDs (Regional Development Banks), one in each province, owned by the respective provincial governments. While they have a mandate to act as bankers to their governments, they also perform some functions analogous to those of so-called “Second-Tier Institutions” operating in microfinance in some other Asian countries (for example, PCFC in the Philippines). Some BPDs (seven out of twenty-six) have responsibility for supervision of certain small formal financial institutions operating within the provinces. Their regulatory and supervisory responsibilities appear likely to increase as governmental devolution takes place in Indonesia. 3.3.5. BPRs (Rural Banks or BPR non-BKD) The term “BPR” (people’s credit bank, but often translated simply as rural bank) is used in the Banking Act of 1992 and elsewhere to describe two categories of small regulated financial institution. The first is the “BPR non-BKD”, most commonly called simply “BPR”. There were around 2,400 of these small banks in mid-2000. Recently, a number of

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BPRs practising banking under Islamic (syariah) principles have emerged. The second category is called, formally, BPR-BKD, or simply, “BKD” (Village Credit Body). There were 5,345 BKDs in mid-2000. They date back to the late nineteenth century, and were formed under Dutch rule on Java and Madura islands as pioneer microcredit institutions. For simplicity, in this chapter the two categories of institutions will be called simply BPRs and BKDs. BKDs are very much smaller institutions than BPRs. Both are subject to the Banking Act, and are in principle regulated and supervised by BI. Under the 1992 Banking Act, BPRs may accept time and savings deposits, and provide credit. Most are limited liability companies in private ownership, operated for profit. Some are in chains associated with commercial banks or NGOs. Some are registered as cooperatives, others are organized on Islamic principles (BPR Syariah). In mid-2000, BPRs had 1.677 million accounts (see Table 4.2) with outstanding loans of 3.256 trillion rupiah (US$430 million) and a mean outstanding balance of around 1.94 million rupiah (US$260) per account. The comparable figure for the BRI Kupedes, as noted above, was US$340. There were almost 4.6 million demand deposit accounts, totalling some US$230 million, with a mean balance of around 250,000 rupiah or US$33 (compared with the BRI Simpedes average of US$85) as well as fixed deposits totalling 1.675 trillion rupiah (US$220 million). Loan-to-deposit ratios were typically around 80 per cent, and the average BPR had assets of perhaps 1,800 million rupiah (US$240,000). The mean loan and deposit balances of the BPRs suggest they are, in general, serving a lower-income stratum of the population than the BRI Units. In May 1999, BPRs accounted for 0.65 per cent of credit outstanding in the banking system and their deposits were some 0.25 per cent of all deposits. While this is almost trivial if the chosen numeraire is a financial one, the number of clients who benefit from access to BPRs (almost 1.7 million borrowers) is far from trivial. Typical loans offered by a BPR are short-term microloans for petty traders ranging from 100,000 to 3 million rupiah, with three- to six-month maturities, daily instalments, and flat rates of interest in the range 2 to 4 per cent per month. The BPR system withstood the crisis, in general much better than the commercial banks. BI strengthened

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prudential supervision in 1999 and liquidated seventy-two BPRs, while the 10 overall level of non-performing loans rose to 37 per cent. Bank Indonesia and GTZ have begun a project (ProFI or Promotion of Small Financial Institutions) to address the weaknesses of the BPR system.

3.3.6. BKDs (Village Credit Bodies, or BPR BKD) BKDs commenced operations more than a century ago, and their status as banking institutions was affirmed by legislation in the colonial parliament in 1929. They were never subject to BI interest rate restrictions, which enabled them to set interest rates at sustainable levels well before the financial sector reforms of the 1980s. The 1992 Banking Act brought them under the supervisory jurisdiction of BI. They are supervised by BRI on behalf of BI. Some 5,400 of these small locally based institutions served more than 700,000 borrowers in mid-2000. They are found primarily in the provinces of East and Central Java. They do not offer the same levels of service of the BPRs, and are normally open only one day a week, in association with local market days. In mid-2000, BKDs had loans outstanding of 152 billion rupiah (US$20 million) — (see Table 4.2) — with an average loan size of 217,000 rupiah (US$29). BKDs focus almost exclusively on credit provision, although a portion of each loan is held in a mandatory deposit. These mandatory balances totalled 32 billion rupiah in mid-2000, with more than 600,000 accounts and an average balance of around 50,000 rupiah, or US$7. These savings and loans figures suggest genuine microfinance. Most BKD loans have a twelve-week term, with weekly instalments and an effective annual interest rate of 43 per cent. Management of each BKD is in the hands of a committee drawn from the village government. Loans are approved primarily on the basis of character and “bankability”. An itinerant bookkeeper employed by the district government and paid for by the BKDs serves five or six BKDs, each of which opens on a rota, determined by village market days. All record-keeping is manual. 3.3.7. Non-Bank Financial Institutions NBFIs are a heterogeneous group, but a common characteristic they share (besides their activity in microfinance) is that they are not subject to BI regulation. For the purposes of microfinance in Indonesia, they

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include small community-based financial institutions (LDKPs), pawnshops, and the savings and credit co-operatives.

3.3.8. The LDKPs: Community-Based Non-Bank Financial Institutions The acronym “LDKP” is applied generically to a range of small savings and credit institutions which exist, with variations, in a number of provinces. A total of 2,272 LDKPs (see Table 4.2) were operating in mid-2000, serving more than 1.3 million borrowers, with loans outstanding of some 360 billion rupiah (US$48 million), with a mean balance outstanding of 275,000 rupiah (US$35). The level of savings mobilized by the LDKPs (334 billion rupiah) was almost as great as the loans outstanding. As with the BKDs, this also suggests genuine microfinance. A mean loan size (balance outstanding) of US$55 for LDKPs puts them on roughly the same social level as the BKDs (US$43), and on a very much lower level than the BPRs (US$390) and the BRI Units (US$510). The lending procedures of one type of institution within the LDKP category, the BKKs of Central Java, give a sense of the nature of these small village-based institutions. BKKs apply the now typical instruments of microcredit: loans are unsecured and character-based, relying on references from local officials rather than based on feasibility studies. Initial loans are small and gradually increased, based on repayment performance. This mechanism functions as the primary repayment incentive. Loans are paid in equal instalments, carrying maturities from twenty-two days to twelve months, according to six different repayment plans, with monthly effective interest rates ranging from 2.2 to 10.8 per cent. Savings are mandatory for every loan, and are treated as cash collateral, becoming accessible only after full loan repayment (BI and GTZ 1999). 3.3.9. Savings and Credit Co-operatives Co-operatives were a primary instrument of state policy under Soeharto and independent initiatives were discouraged. Essentially the only cooperatives in rural areas were those within the official KUD (Village Co-operative Unit) system. A new co-operative law in 1992 attempted

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to entrench the official co-operatives in certain areas of the economy. However, since 1998, independent entities are now free to obtain licences under the Act of 1992 to set up KSP (Savings and Credit Co-operatives). Some NGOs have taken advantage of the new situation to set up financial services co-operatives. Islamic self-help savings and loan groups (the BMT) are in many cases adopting the co-operative legal form, while a long-running government microfinance programme (P4K) is working towards having its self-help groups adopt co-operative status. There is also a proliferation of unregistered co-operatives, and some moneylenders have adopted these (referred to as Kosipa) as a front for their high-cost lending. Many USPs which originated within the KUD movement continue actively, although less tightly linked into the official system than before. Some 36,000 co-operative savings and loan entities were registered in Indonesia in October 2000. These comprised around 1,200 KSPs and some 5,200 USPs (the latter rural, and associated with the KUD co-operative system). In addition there were some 29,600 urban USPs, mostly associated with workplace arrangements. The KSPs had perhaps 0.7 million members and the rural and urban USPs around three million and seven million, respectively. A Bank Indonesia/GTZ assessment of the credit union activities of the USP Units of the KUD is that: [they] have so far played a minor role as financial intermediaries due to repressive regulation and excessive government interference under the New Order regime of former President Suharto. However, the more than 5,335 government-sponsored KUDS are established throughout the country and would in fact possess a tremendous microfinance potential if properly stimulated and regulated.

3.3.10. Informal Financial Institutions NGOs conducting microfinance require no permission to extend credit, and there are no reporting requirements or supervisory arrangements for such activities. However, they are forbidden to mobilize the savings of members, unless these are deposited directly in a regulated financial institution. In practice, some savings mobilization appears to be tolerated as long as the amount is small. Some larger NGOs have set up their own BPRs to overcome the problem. Also, the new freedom to set up savings and loan co-operatives under the Act of 1992 offers another solution to

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this problem. However, for NGOs unable to take either of these paths, the inability to mobilize even compulsory savings in conjunction with lending is a constraint on their activities. NGOs have been involved in mass poverty alleviation programmes of the government, which involve elements of microfinance, especially the IDT (or “backward villages” programme, of 1993–97). Their function in such schemes has been to act as social intermediaries, preparing “self-help groups” of the poor to participate. Relatively few NGOs in Indonesia are specialist microfinance providers. Most have microfinance as only one among a range of development activities. By contrast, Grameen replications have not been particularly successful in Indonesia, and the outreach of this category of NGO is insignificant. Self-help groups (SHGs) are completely informal organizations. Hundreds of thousands of informal SHGs with savings and credit activities exist in Indonesia. Many are spontaneous groupings, based on traditional forms of association, such as the arisan. This is the Indonesian version of the ROSCA. Many other SHGs have been founded by government and community organizations, in connection with government programmes, or have been created by NGOs, and some are organized on syariah principles. An unknown number of SHGs continue in operation, on the basis of revolving funds which they have been able to preserve from one or another of the mass programmes, operated by government from time to time (described in the next section). As many as 400,000 groups were formed during the 1990s in connection with one programme or another, involving perhaps 10 million individual members, and touching the lives of perhaps another 40 million family members. This is enormous outreach, mostly to the poor and very poor, but financial sustainability has been elusive.

3.3.11. The Role of Government Since the advent of the New Order government, successive governments, acting through the central bank and a number of line departments, have supported activities now categorized as microfinance. Initiatives have been dedicated either to financial sector development in some broader sense, or to nurturing particular microfinance projects. There has often been significant donor involvement in these activities, and the overall

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record — as exemplified by the performance of BRI — has been good. Initiatives styled specifically as “microcredit” or “microfinance” became more important over time during the Soeharto period, as the overall incidence of poverty fell, and the need was felt for a more targeted approach to eliminating the residual. To some extent this reflected a realization by the New Order government that, despite the successes of BRI Units and small bank and non-bank financial institutions in extending sustainable financial services to lower strata of the population, there remained a core group of the poor untouched by this progress.

3.3.12. Mass Poverty Alleviation Programmes By contrast with the government’s achievements in financial sector development for the benefit of lower-income and rural people, there was a parallel development of mass credit schemes, in which neither institutional sustainability nor financial sector development have been objectives. Indeed, these have often operated at odds with the sustainable programmes already described. These mass schemes reflected political concern with the problem of the hardcore poor. The first was the IDT (presidential instruction relating to backward villages), which commenced in 1993. A second, the UEDSP (village economic activities with savings and loans), commenced in 1995, also with the benefit of presidential funding. A third campaign, the Prosperous Family Programme, was introduced as an emergency measure in 1996. Donors have avoided entanglement in unsustainable mass schemes of the government, although they did support microfinance in the context of “social safety net” programmes, as a response to the crisis. Some sense of the character of these mass government programmes may be gained by considering the most meteoric scheme of this genre, the “Prosperous Family Programme”. In 1996, as an emergency response to political concerns about income inequality, President Soeharto launched this programme, using the National Family Planning Co-ordinating Board (BKKBN) as the implementing agency. Some 9.8 million Indonesian families received highly subsidized funding under this programme in just twelve months. The programme was financed by a levy of 2 per cent on the incomes of corporations and high-income individuals, channelled through a Soeharto family foundation. It became one of the “social safety net” programmes

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after the commencement of the crisis in 1997. Cumulative disbursements by the various microcredit programmes implemented by the Family Planning Board rose from 317 billion rupiah in December 1997 to 768 billion rupiah in December 1998, and 900 billion rupiah in March 1999. This last figure is equivalent to approximately US$100 million, at an exchange rate of 9,000 rupiah. The Prosperous Family and other programmes in this category, such as the UEDSP, were retrogressive in their influence on financial sector development in Indonesia. They often acted to undercut legitimate microfinance institutions attempting to achieve sustainability with realistic interest rates, and they were a negative influence on the rural credit culture. 3.4. Philippines

There are three categories of MFI in the Philippines, each of which answers to a different regulator. These are rural and thrift banks, NGOs which provide microfinancial services, and credit unions or co-operatives. Of these three institutional types, the rural banks appear to deal with somewhat higher-income clients and make larger loans than the microfinance NGOs. Many of the NGOs have adopted variants of the Grameen Bank model and in general, group organization of one sort or another is their most common mode of service delivery. The assets of these three types of MFIs were equivalent to only about 4 per cent of the assets of the commercial banking system in 1996. However, as Llanto (2000, p. 252) points out, “the combined number of MFI offices, at 7,855 outlets, is more than twice the number of commercial bank offices”. A characterization of microfinance NGOs in the Philippines (Llanto 2000a, pp. 254–55) suggests that: • • • •

their capital consists substantially of donated funds; they have engaged in very limited borrowing from commercial sources; they have typically mobilized only small amounts of savings from their members, but; they employ innovative lending techniques.

Most microfinance NGOs are financed by foreign donors, or by domestic philanthropists or foundations. As non-stock, non-profit organizations, they have difficulty accessing loan capital from commercial sources.

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Further, they are not legally permitted to mobilize deposits from the public or even (strictly speaking) from their members. Hence their capacity to fund lending through savings mobilization is quite limited. As against this, NGOs are quite innovative in their design of loan products and in overcoming their clients’ lack of hard collateral. Despite this, Llanto remarks that most credit NGOs in the Philippines are neither viable nor sustainable: While credit NGOs effectively target and reach poor clientele, they are neither effective nor efficient credit intermediaries because of their weak institutional capacity and financial position. These institutions seem capable of delivering financial services to the poor only because of their access to grants and concessional loans. (Llanto 2001, p. 255)

3.4.1. The Microfinance Council: An Instrument for Self-Regulation Leading Philippine NGOs are concerned to improve this situation. Microfinance NGOs have been active in dialogue with the National Credit Council (discussed below) and in self-regulation. The Microfinance Coalition for Standards (now the Microfinance Council), set up in 1996 with USAID assistance, is an organization of MFIs and other microfinance stakeholders (including the central bank) which documents best practice and sets benchmark standards for MFI performance, as well as conducting training activities. Commercial banks have had limited engagement with microfinance in the Philippines; only government-owned financial institutions have had any substantial involvement. The Development Bank of the Philippines, the LandBank, and the People’s Credit and Finance Corporation (PCFC) have provided wholesale loans to MFIs for on-lending to microfinance clients. In this way they have financed rural banks, co-operatives, and NGOs to serve as conduits for credit. However, this involvement has often been on unsustainable terms, with subsidized credit delivered at government direction. Private commercial banks, on the other hand, have been extremely tentative in their approach to microfinance. A study of The Role of Commercial Banks in Microfinance (Goodwin-Groen 1998) discusses the quite limited record of commercial bank microfinancing in Asia and the Pacific. While there is a long

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tradition of government subsidized loans channelled through banking systems, microfinance conducted as a profitable business is comparatively rare. Goodwin-Groen identified BRI and another small private commercial bank in Indonesia, together with one small private commercial bank each in Sri Lanka and India, as comprising the four commercial banks in the Asia-Pacific region which treat microfinance as a profitable core business. In the Philippines, Goodwin identified some cases where private commercial banks have made lines of credit available to particular MFIs. However, in one case this occurred at a sub-market rate of interest and in another the bank concerned channelled the money through its charitable foundation to allow for a tax write-off, should the loans fail. Good performance by certain NGOs had encouraged the bank to convert this lending to a fully commercial basis, but the crisis in 1997 cut short this experiment. At that time, a single NGO — TSPI Development Corporation — had eight loans from three leading commercial banks, and its financial performance was exemplary. Despite this, interviews suggested that personal relationships between board members of TSPI and senior bank executives were the primary motivation for these arrangements (Goodwin-Groen 1998, p. 27). The experience of this and several other well-performing NGOs in the Philippines suggests that there are barriers of culture and perception in the banking community, which must crumble before traditional bankers will consider funding even the best-performed of MFIs. This has led some MFI leaders to conclude that the only feasible path to expansion and mobilization of the funding necessary to meet the demand for microcredit is to transform their organizations into small regulated banks. Several MFIs have followed the “transformation” strategy so far, including CARD Bank and Opportunity Microfinance Bank.

3.4.2. The Potential of Small Banks Among regulated financial institutions in the Philippines are some smaller banks, including thrift banks, rural banks, and co-operative banks. These banks offer a smaller range of services than commercial banks, and typically serve a community or a limited geographic area. They have much lower minimum capital requirements than the commercial banks,

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and these are lower, depending on the size of the urban centre in which they are located. This is a provision favourable to NGOs, such as CARD and the APPEND group of NGOs, seeking to obtain bank licences for their microfinance business. They are quite widespread throughout the provinces. Concerning the small local banks, McGuire, Conroy, and Thapa (1998, p. 237) note that: Of all the banks it is the rural banks that are best placed to engage in microfinance. Rural banks are established to meet the credit needs of borrowers who are often outside the catchment areas of commercial banks and/or who may be considered poor risks by other banks … In addition co-operative banks may be organized to perform banking and credit services for the cooperatives. Most rural and co-operative banks do not have means-tested programs targeted to poor borrowers, and it is understood that most of their clients are people in the rural areas who are slightly better off.

Despite this, there are a number of rural banks actively providing small loans to the poor, and several operate microfinance programmes employing group methods. The World Bank (1996) identified a particular model of rural bank, the co-operative rural bank, as having the potential to reach the poor, without the necessity to set up new specialized institutions for the purpose. Certainly a rural bank license is one option for an MFI looking to “scale up” its operations. Co-operatives and credit unions are supervised by the Co-operative Development Authority. McGuire et al. note that of some 42,000 cooperatives registered under the Co-operative Code in 1997, half were nonoperative. The co-operatives accept fixed deposits from members which cannot be withdrawn unless the member resigns. They also offer savings and time deposits which are “withdrawable”. Consequently, the co-operatives have a larger resource base for lending than the NGOs. Co-operatives have been promoted in the past by the government to support “livelihood” programmes, under which LandBank employed them as funding conduits. Llanto notes of the co-operative movement that it has demonstrated its potential for mobilizing deposits and providing financial services to small savers and borrowers, and that it has been able to finance its lending from share capital and deposits, quite apart from its role as a conduit for government funding. Well-run co-operatives in the Philippines show positive financial performance and are sustainable, although limited financial

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reporting required of them by the regulatory authority and the laxness of supervision make it difficult to arrive at firm conclusions on what proportion of institutions performs at a high level.

3.4.3. PCFC The People’s Finance and Credit Corporation (PCFC) was set up in 1995 as a specialized institution for lending to the poor. PCFC is a registered finance company and its articles provide for it to be privatized. PCFC funds microfinance institutions, defined broadly, including NGOs, rural banks, co-operatives, and other intermediaries as conduits for on-lending to the poor. These intermediary organizations are required to operate in a self-sustaining and operationally viable manner. In 1997 the Congress of the Philippines passed the Poverty Alleviation Act, which: promotes the adoption of a market-based approach in addressing the demands for financial services of the poor. It specifically mentions the promotion of a viable and sustainable financial market and the adoption of market-based interest rates in the provision of credit services to the poor as key elements of the policy and strategy for microfinance in the country. (Llanto 2001, p. 260)

PCFC was identified as the primary vehicle for the delivery of financial services to the poor, acting as an apex or second-tier institution. It commenced operations by taking over the capital and loan portfolio of LandBank, under an earlier anti-poverty initiative, the National Livelihood Support Fund. It has also received ADB/IFAD funding for on-lending to MFIs, in particular those following the Grameen model. PCFC also has a supervisory role. As lender to a wide range of small MFIs, it has a legitimate concern to safeguard its resources by requiring their adherence to appropriate accounting and reporting standards and operational methods. In addition, it has a concern for capacity-building among its client organizations. In this sphere, it co-operates with the People’s Development and Trust Fund, which was created specifically for capacity-building of MFIs. PCFC is a member of the Microfinance Council, and maintains dialogue with the MFIs and with external agencies, such as the Washington-based CGAP, which is influential in defining performance standards for MFIs.

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3.4.4. Policies for Microfinance In 1994, the government established a National Credit Council (NCC), with the objectives of rationalizing government lending programmes and developing a national credit delivery system capable of addressing issues of poverty. The Council’s focus has been exclusively on small credit and microcredit, and one early task was for it to draft and disseminate a set of guidelines — Policy Guidelines for Credit for the Poor — for government agencies undertaking lending programmes. In 1997 the NCC published a National Strategy for Microfinance. Thus is set a framework emphasizing the role of the private sector, including MFIs, and the need for an enabling policy environment. Given the pervasive use of subsidized credit in government programmes at that time, it emphasized the need for market interest rates to apply to loans and deposits. It further proposed that government line agencies should withdraw from the implementation of credit and guarantee programmes, in favour of specialized lending agencies (McGuire, Conroy, and Thapa 1998). These recommendations were taken up in a law, signed in August 1999, which provided for the phasing out of all subsidized credit programmes in the agriculture sector over a four-year time span. An Executive Order (no. 138 of 1999) also required government nonfinancial agencies to terminate all non-agricultural credit programmes and transfer their funding to government financial institutions. An administrative order empowered the NCC to rationalize directed credit programmes in all sectors, and to formulate policy guidelines. An inventory of eighty-six such programmes, implemented by twenty-one executing agencies, was drawn up. The government financial institutions to which these programmes were to be transferred were further instructed, by Executive Order, to make credit decisions in these programmes “based on market conditions and the creditworthiness of private credit conduits” (Llanto 2000a, p. 260). However, Llanto (2001) notes that despite the support of the central bank and the Finance Ministry for this policy, in practice government financial institutions have yet to comply fully, and credit subsidies persist in some government programmes. More recently, changes to banking legislation embodied in the

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General Banking Law of 2000 have provided a more conducive regulatory environment for microfinance among regulated banking institutions (Credit for the Poor 2000). Provisioning requirements, which had operated to penalize institutions lending to microfinance clients, have been modified. Banks may now conduct microfinance lending based on clients’ cash flow, rather than on traditional collateral criteria. Repayment schedules may also be tailored to the cash flow patterns of microfinance clients, with daily repayment if necessary. Such lending must now be market-based, in the sense that interest rates must be constructed to recover all the transaction costs associated with such lending. Llanto (2000a) had previously identified some unconscious regulatory bias against microlending, in central bank provisioning and other requirements, and these legislative changes make some improvement in this situation. The changes are thought likely to increase pressure for MFIs to follow the “transformation” path, although a moratorium on the establishment of new banks during 2000 prevented early action on this front. Microfinance in the Philippines is conducted in a generally supportive policy environment, and within a substantially liberalized financial system. Its strengths include regulatory provisions which make possible the establishment of small banks with modest minimum capital requirements and an energetic NGO sector, leading elements of which display awareness of the need to define and employ best practice operating procedures. Many NGOs, however, are still locked into a dependent relationship with donors, and have yet to develop the necessary standards of professionalism. In pursuit of high standards and a modality for funding and supervising a diverse range of MFIs, the Philippines has established a second-tier financial institution, PCFC. It has the resources and the mandate to use a “carrot and stick” approach to improving the financial performance of MFIs. 3.5. Cambodia

Cambodia has a population of 11.8 million people and a GNP per capita of US$260, placing it among the world’s twenty poorest nations. It is a postconflict economy, which suffered enormous loss of human and physical

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capital during twenty-five years of turmoil. Some 85 per cent of Cambodians live in rural areas, and agriculture constitutes half of the country’s GDP. The incidence of poverty is estimated at 36 per cent nationally, and 40 per cent for the rural areas (World Bank ). Despite the importance of the rural economy, rural financial services are ill-developed. Some 40 per cent of the rural population live in provinces without a commercial bank branch, and in those where branches exist, services are confined to principal towns. Only about 4 per cent of outstanding commercial bank credit is for agriculture-related activities. In the absence of commercial provision, the demand for financial services is met by NGOs and moneylenders, as well as family, friends, and agricultural traders (ADB 2000b). In Cambodia, as mentioned in the introduction to this chapter, the international NGO community played a key role in the introduction of microfinance from the early 1990s. While UNICEF set up the first revolving fund in 1989, international NGOs soon followed, including EMT/GRET, a French NGO, from 1991. A number of foreign agencies set up MFIs, which have subsequently become independent Cambodian entities. The largest, ACLEDA, was established in 1993 as the “Association of Cambodian Local Economic Development Agencies”, with UNDP and (later) IFC support. While the commercial banks service only urban areas, by 2000 there were some seventy local and international NGOs operating in microfinance in twenty-four provinces and municipalities throughout the country. Some fifty of these reported on their activities to the NBC, the central bank. The value of credit outstanding, as reported to the NBC at end 2000, was approximately US$29 million. According to one source (Son Koun Thor 2001, p. 2) this benefited some 370,000 households, or around 21 per cent of the total rural population. The ADB (2000b) reported only 11 per cent coverage, and US$21 million outstanding to 255,000 households, at a sightly earlier date, but the apparent discrepancy may be due to a combination of rapid growth and improved data collection. For the voluntary sector to achieve outreach of 21 per cent in a decade would be a considerable achievement. As an indicator of the broader significance of the NGO movement for provision of services, it is worth noting that

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NGOs currently disburse about US$75 million annually for a wide range of activities, an amount greater than 20 per cent of the annual government budget (ADB 2000b, p. 5). In parallel with the development of an MFI sector, reforms to the Cambodian banking system created separate commercial banks and a central bank (the National Bank of Cambodia, NBC). Private commercial banks commenced operations from 1991, as a legislative framework was put in place. Interest rate liberalization commenced, with banks free to set their interest rates from 1995. A more comprehensive law on banking and financial institutions was enacted in 1999. Apart from the NBC, which has twenty provincial branches, there are thirty-one commercial banks and a specialized financial institution, the Rural Development Bank (RDB). Most transactions of the formal financial institutions are still conducted in U.S. dollars. There is a substantial interest rate margin quoted for loans in riel, the local currency.

3.5.1. A Policy Framework for Microfinance Cambodia has developed a policy, regulatory, and supervisory regime for microfinance which provides a marked contrast with other countries in the region, in the extent to which it assigns a formal status and role to MFIs, and has created an institutional framework for their operation. This perhaps reflects the particular circumstances of the parallel development of the microfinance and formal financial sectors in the reconstruction period from 1989, and the relative vigour of the NGOs, compared with the halting start of the commercial banking system. An important step in the evolution of a distinctive Cambodian policy regime was a decree, in 1995, setting up the Credit Committee for Rural Development, supported by the UNDP and a French agency. The committee was given a mandate to design a legal framework for rural credit in which MFIs would be recognized and facilitated, to formulate a savings mobilization policy, to facilitate rural access to financial services, including money transfers, and to deal with donors in support of these objectives. The next important element in the regulatory and supervisory system for microfinance was the Supervision Office for Specialized Banks and MFIs, set up in the Bank Supervision Department of the NBC in 1997. It receives financial and technical support from the French agency

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AFD, and is responsible for collecting financial information on the microfinance sector, and for capacity-building and assuring the compliance of MFIs with regulatory, accounting, management, and prudential standards.

3.5.2. The Rural Development Bank Under the policy framework for microfinance, a key initiative of the government is to support and strengthen microfinance services in rural areas through the Rural Development Bank, established in 1998. The policy calls for: Support and strengthening of micro finance services in rural areas through the Rural Development Bank and national and international micro finance operators … for provision of credit services in support of agriculture and rural economy based on free market for development, efficiency and sustainability. (Son Koun Thor 2001, p. 1)

The RDB is under the financial control of the Ministry of Economy and Finance, and is supervised by the NBC. Licensed as a commercial bank, RDB engages in rural finance, solely at the wholesale level. RDB functions as a second-tier institution, wholesaling loans to licensed financial institutions (LFIs). Its responsibilities include: • • • • • •

financing and refinancing MFIs and commercial banks in support of the rural economy; negotiating with donors for funding; encouraging the mobilization of deposits by the public; co-operating with financial institutions in providing agricultural credit; conducting wholesale banking activities; and training staff of MFIs funded by donors or government.

RDB’s charter calls for it to provide capital to licenced MFIs and other microfinance providers, and to local and foreign investors willing to contribute to rural development in Cambodia. The bank has granted loans for on-lending to a number of leading Cambodian MFIs at concessional rates (Son Koun Thor 2001). Following the enactment of a Banking Law in 1999, a regulation (Prakas) on the licensing of MFIs was issued by the NBC in January 2000. According to the CEO of the Rural Development Bank, this

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provides [an] opportunity to national and international financial organizations, credit operators to transform themselves into MFIs and to join the formal banking system. Moreover, it also gives them access to financial resources from national and international institutions, especially from the RDB. (Son Koun Thor 2001, p. 6)

Requirements under the Prakas include: • • •

•

•

applicants for an MFI licence must be incorporated as a limited liability company or a co-operative; licensed MFIs must have minimum registered capital of KR250 million (US$65,000); MFIs must maintain a minimum capital adequacy ratio of 20 per cent between eligible capital and weighted risks, and there are liquidity ratio and large loan exposure requirements; all other entities not satisfying the licensing requirements, but which provide credit services to individuals or groups, must register with the NBC; and all microfinance operators, whether licensed or not, are excluded from a range of financial sector activities — including leasing, derivatives, gold, and commodities dealing — and the provision of cheque facilities and swap or forward dealing in foreign currencies.

3.5.3. ACLEDA The licensed financial institutions (LFIs) eligible for funding which are, or soon will be, eligible for RDB funding include ACLEDA, the major Cambodian NGO which has achieved the status of a specialized rural bank, and a number of licensed MFIs (EMT and HK). A number of other NGOs are in the process of achieving licensed MFI status, including CCB, Prasac Credit Association, and ANS. As mentioned, the most significant financial institution to emerge from the NGO sector is ACLEDA, which at the end of 1999 had loans outstanding of KHR52 billion (US$13.7 million) to some 58,000 borrowers. This loan portfolio was 65 per cent (by value) and 23 per cent (by numbers of clients) of the total portfolios of twenty-five large NGO credit providers reporting to the central bank (ADB 2000b, Table A3.1). ACLEDA was licensed as a specialized rural bank in October 2000, and issued capital in the company is held by ACLEDA (45 per cent), ACLEDA staff (6 per cent), and four

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foreign investing entities, including the International Finance Corporation (IFC). Its outstanding loan portfolio at the end of March 2001 was some US$19.6 million, with loans averaging US$296 to more than 66,000 clients, of whom almost 80 per cent are women (www.bellanet.org/partners/mfn/acleda). ACLEDA Bank has more than a 50 per cent market share of microcredit in Cambodia, and employs some 551 staff in sixty-one offices, spanning fourteen provinces. It is working to expand savings mobilization and to develop money transfer services. With regard to savings, the ADB (2000b, p. 4) notes that the domestic savings rate in Cambodia in 1997 was only 5 per cent of its GDP; the lowest in Southeast Asia. The ADB believes there would be a strong demand for savings among rural communities, if appropriate facilities were available. While most NGOs have emphasized credit before savings, the existence of substantial capacity for savings is shown by the success of a savings mobilization project conducted in Battambang province by CARE Cambodia. Within less than two years, CARE established seventy-five “Savings Banks” in seventy-two villages, serving more than 6,000 active savers, some 4,000 of whom were women. Total savings mobilized amounted to US$51,000. Some 2,300 members had loans outstanding from the Savings Banks amounting to US$87,000. The mean savings and loan balances are US$8.50 and US$$37.00, respectively, and portfolio at risk was only 0.35 per cent. An evaluation report (Mehrtens and Cornford 2001) notes that “members are very aware that the money they are borrowing is the money that they and their neighbours have saved”. CARE provides continuing subsidies for staff costs, and the project has some way to go towards financial sustainability. Nonetheless, the experience of the Battambang project in savings mobilization is encouraging. During the early, pilot phase of the project, the Savings Bank paid 3 per cent per month for voluntary savings, later reduced to 2 per cent per month. From April 2001, this rate has been reduced drastically, to 8 per cent per annum, in an effort to cut costs and increase self-sufficiency. It will be interesting to see how this affects the availability of deposits. Concerning microfinance industry practices, RDB reports (Son Koun Thor 2001) that where MFIs make individual loans, collateral is

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required. A typical micro-enterprise loan with a term of less than one year or less may be in the range US$100 to US$500 (substantially more in the case of ACLEDA). ACLEDA’s rate for such loans is 4 per cent per month on a flat basis. Group lending by NGOs for the rural poor does not require collateral because of the joint liability arrangement. Loans are made to the individual in amounts usually from US$20 to US$100 dollars, and interest rates range from 3 to 6 per cent per month, depending on the policy of each operator. Higher monthly rates may be calculated on a declining balance. Most programmes require compulsory deposits as a condition for obtaining loans. Interest rates on deposits range from 1 to 3 per cent per month, and savings are available for lending to members, upon agreement by the group. However, relatively few programmes place as much emphasis on savings as the Battambang project described above. Among leading MFIs in Cambodia, the most successful in savings mobilization is the local affiliate of CRS (Catholic Relief Services), which has mobilized savings equivalent to 30 per cent of a loan portfolio valued at US$1.34 million dollars, as at the end of 2000. EMT is the third largest MFI in Cambodia in terms of loans outstanding. At the end of 2000, its portfolio totalled US$2.8 million dollars, compared with more than US$17 million dollars at ACLEDA Bank. However, EMT had some 73,000 borrowers, compared with ACLEDA’s 61,000, giving mean loan sizes of US$38 and US$280, respectively. Besides targeting a poorer clientele, EMT is also innovative in having established an autonomous health insurance project in 1998. EMT reached break-even point in 1998 with its solidarity group lending, and decided to test a health insurance system. The experiment has revealed some difficulties and is proceeding (GRET 2000). Cambodia has adopted what might be called a “transformation” model of microfinance service provision. This is one where microfinance services originate in the voluntary sector and the government’s role is seen as providing an appropriate policy and regulatory environment and financial infrastructure (specifically, a second-tier institution, the RDB, to act as a wholesaler for and nurturer of MFIs). Microfinance institutions are then expected to follow a linear path on which they transform themselves from informal revolving funds to NGOs to licensed MFIs, and then to specialist microfinance banks. Only ACLEDA has made

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the transition to bank status, and at present only a couple of institutions are licensed MFIs, although more will become so in the next year or two. The ability to incorporate a small specialist bank — such as ACLEDA Bank — under Cambodian law is an essential part of the supportive regulatory environment. Cambodia is one of a relatively small number of countries in the Asian region (Indonesia and the Philippines being others) where this is possible. 3.6. Vietnam

Despite considerable progress in poverty reduction during the 1990s,11 Vietnam remains one of the poorest countries in the world. Among many elements in a poverty reduction strategy, the government has focused on the financial service needs of the poor, particularly in rural areas. Government efforts in the field have involved central bank regulation of interest rates, and direction of the state banking system to provide subsidized credit to target groups. In addition, international agencies and NGOs have drawn the government’s attention to the potential of microfinance to alleviate poverty, and have supported a number of projects trialling imported models of microfinance service provision.12 These developments have occurred while Vietnam has been moving to establish the institutional framework for a modern financial system and to introduce elements of liberalization as possible and appropriate. The movement away from a socialist mono-banking system in Vietnam has proceeded since the late 1980s, beginning with the establishment of the Vietnam Bank for Agriculture and Rural Development (VBARD), as a separate entity in 1988. VBARD is a state “policy” bank, responsible for “directed” lending to agricultural and rural sector lending, and with a brief to develop lending to individuals and households, by contrast with the earlier pattern of financing state-owned enterprises and communes. For these purposes it enjoys government subsidies and access to central bank credits. More recently, in 1995, another policy bank was established within the corporate structure of VBARD to perform specialized lending to poor households unable to meet VBARD’s credit criteria. This is the Vietnam Bank for the Poor (VBP). The central bank, the State Bank of Vietnam (SBV), has regulatory oversight of formal financial institutions. The formal financial sector now includes, besides the SBV, VBARD, and VBP, a number

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of government-owned commercial banks. There are in addition almost a thousand People’s Credit Funds (PCFs), a much smaller number of credit co-operatives, around fifty small “shareholder banks”, and a number of foreign and joint-venture banks. Of these institutions, VBARD, VBP, and the PCFs are relevant to microfinance, while a small number of rural shareholder banks appear to have potential in the field (Llanto 2000b). There is also a semi-formal sector, not regulated by the SBV, consisting of the microfinance operations of mass organizations (including those for women, veterans, farmers, and youth) which are instruments of the state. These organizations are represented at every level, from the national to the provincial, and down to the commune level, and are able to disburse government-funded loans under a range of programmes. Within this semi-formal sector there is also a relatively small amount of microfinancing conducted by NGOs. These are still primarily foreign in funding and management, due to the limited development of indigenous NGOs independent of the mass organizations. Finally, there is an informal sector in which finance is available from family and friends, as well as moneylenders, and in which traditional Vietnamese ROSCAs, known as choi hui or choi ho, are common. Informal financing mechanisms were until recently the most important sources of credit in rural areas, although the rapid expansion of VBARD’s operations, and then more recently the advent of VBP, have wrought substantial structural changes in rural credit markets (McCarty 2001).

3.6.1. Rapid Change in Rural Financial Markets National household surveys were conducted in 1992–93 and 1997–98, with results indicating that in the former period private moneylenders and individuals provided 73 per cent of loan funds in rural areas, and government banks 23 per cent. By the latter period, after only five years, government banks had increased their share of rural lending to 40 per cent. At the same time, the share of moneylenders had fallen from 33 to 10 per cent. This change “reflected the rapid growth of VBARD lending and a “crowding out” of the informal sector” (McCarty 2001, p. 5). Aggregate data for 1998, cited by Llanto (2000b, p. 337), suggest even greater state bank coverage, and are perhaps consistent with a pattern of very

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rapid growth in outreach. Some 5.9 million rural households (about 49 per cent of the total) had loans from regulated financial institutions, with mean loan sizes of US$290 (VBARD) and US$110 (VBP). Of this number, 2.7 million loans were made to “low-income households”, said to be 40 per cent of all such households in the rural sector. This suggests the possibility of at least some continuing unsatisfied demand for credit among the poor. McCarty (2001, p. 5) judges that “the extension of the formal banking system to rural Vietnam is the most remarkable achievement of microfinance in Vietnam since 1996”. Indeed rural households appear more likely to be borrowing from banks than urban households. The household survey data indicate that in 1997–98, 7 per cent of rural households reported loans due to the VBP (compared with 4 per cent in urban areas), and 26 per cent reported loans with VBARD and other government banks (as against 9 per cent in urban areas). Such a “rural bias” is highly unusual, in the region or indeed anywhere. Llanto describes VBARD as innovative in its efforts to reach people at the commune or grassroots level, where its representation is thin. It has introduced mobile banking units to increase the outreach of its credit and deposit services, and has also developed joint liability groups. These act as intermediary organizations for borrowers unable to offer conventional collateral. It also lends to individuals who are members of “guarantee groups” under the auspices of one or another of the mass organizations, for example, for women or farmers. The bank works closely with these mass organizations. Such measures have contributed to rapid growth, in line with VBARD’s mandate to reach as many households with subsidized credit as possible. However, Llanto (2000b, pp. 337–8) comments that VBARD has limited outreach to poor communes in isolated and mountainous regions, where poverty is found in the highest concentrations. He also points to a contradiction between its role as a source of subsidized credit and its function of providing commercial credit to non-poor entities. The VBP was, as mentioned above, established to compensate for VBARD’s shortcomings as a lender to the poor. It has a specific mandate to provide subsidized credit to poor households, using VBARD’s branch network and field staff. It does not mobilize savings, and is dependent

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primarily on government for funding. According to McCarty (2001, p. 6), by the end of 1999 some 2.3 million poor households had gained VBP loans totalling US$276 million, at an interest rate of 0.7 per cent per month. The maximum loan term was thirty-six months, the maximum loan size around US$170, and the mean size around US$120. Llanto suggests (2000b, p. 338) that the long-term viability of VBP is problematic. This is because its lending interest rate, although subsidized, is not high enough to cover costs. Also, it is dependent on external sources for loanable funds (the government), and staff and physical facilities (VBARD). Its joint liability system of loan management seems not to be effective, as evidenced by repayment problems. Finally, its policy of lending only to farm-based households prevents it from financing an expansion of rural non-farm economic activity, which would be a highly appropriate form of microfinancing.

3.6.2. The People’s Credit Funds People’s Credit Funds (PCFs) are savings and credit co-operatives operating at the commune level and have the most widespread network of any financial institutions in Vietnam. They were created in the early 1990s with foreign NGO assistance, and erected atop the wreckage of an earlier credit cooperative system which collapsed in the late 1980s. They operate under the co-operatives law and lend only to members, although they mobilize savings from members and non-members alike, and are permitted by the SBV to set deposit and lending rates above those of VBARD and VBP. In 1998 they served some 0.6 million rural households, perhaps 5 per cent of the total. About half of loans went to “low-income” households, although the mean loan size (at US$300) was slightly above that for VBARD’s subsidized lending. While the volume of PCFs’ lending was less than that of VBP and much below that of VBARD, the PCFs appear to be relatively more successful in deposit mobilization. This is because of their physical accessibility, their higher interest rates, more attractive savings products and the security offered by deposit insurance on longer-term deposits (Llanto 2000b, pp. 338–40). This last point is important to a clientele which remembers losing savings in the collapse of the predecessor co-operative system. Llanto judges the PCFs to have considerable potential as microfinance institutions, although at present they discourage the poorest by their shareholding requirement,

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and are inexperienced in microcredit methods, including dealing with women and joint liability groups. He also mentions the Rural Shareholders Banks as having some promise as a model of microfinance provision, by virtue of their legal status, despite their small numbers and limited resources. This review of microfinance in Southeast Asia has noted the good performance in several countries, including Indonesia and the Philippines, of small regulated banks with strong links into local communities.

3.6.3. Semi-Formal Microfinance: Mass Organizations and NGOs Outside the formal financial sector, there is the semi-formal sphere of microfinance activity, involving various mass organizations and NGOs, often acting as agents of one or another government programme. These may be directed to specific objectives, such as job creation, re-greening or resettlement, and have in common their reliance on heavily subsidized government funding and low interest rates. Mass organizations also provide their members with facilities for solidarity group microfinance, where resources may be channelled from VBARD or VBP. For example, the Vietnam Women’s Union (VWU) has 11 million members and some 80,000 women’s savings and credit groups (Llanto 2000b, p. 341). However, McCarty describes as a “myth” the suggestion that much rural microfinance is channelled to women and their organizations. He states that this “is only the case for many of the small NGO schemes, an uncertain percentage of informal lending, and for some VBARD lending. The vast majority of rural loans are, however, made to men” (McCarty 2001, p. 22). Microfinancing by NGOs is for the most part conducted as an activity ancillary to some primary objective, in fields such as education, health, or livestock rearing. Here microfinance is likely to be viewed more as an entry point to the villages. In practice there is a range of situations, with one or two international NGOs attempting to introduce international best practice, emphasizing savings mobilization and setting interest rates for sustainability, while the others act out the “microfinance-as-charity” role. McCarty’s generalization of NGO behaviour is based on a survey of seventy-six such microfinance schemes in mid-2000. Only two Vietnamese NGOs could be identified for this survey. Data for a group of nine of the larger international NGOs show total loans outstanding of less than US$18 million; minute in

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relation to the volumes of subsidized credit channelling via the state banks. Lending interest rates charged by these schemes were generally in line with VBARD rates, and savings mobilization was “either zero or modest”. All these larger schemes integrated microfinance with other activities and objectives McCarty 2001, p. 15). Informal sector lending, involving relatives, friends, and neighbours, the professional moneylenders, and traditional ROSCAs, continues to be of great importance in rural Vietnam. According to McCarty (2001, p. 11), “the main reason for an ongoing strong informal sector is that the formal sector can meet demand for loans at the low interest rate only for the most credit-worthy households”. In this sense, rural Vietnam is a “repressed financial system” where a significant proportion of households get little or nothing from the formal sector. Formal loan conditions (and maybe informal ones) act as the “rationing mechanisms” that exclude households. These mechanisms include collateral requirements prescribing how loans must be used and setting loan sizes and terms not suitable for the needs of the poor. For example, only about 30 per cent of all rural households can provide the documents required to pledge land against credit. The reference to “informal” criteria being applied may suggest some politicization or favouritism in official lending. Certainly, Llanto (2000b, p. 345n) implies that international NGOs active in microfinance are sceptical of the official lists of the poor eligible for credit from official sources.

3.6.4. The Neglect of Savings Mobilization Leaving aside issues connected with the provision of credit, there is an even more serious deficiency in Vietnamese microfinance: the neglect of savings mobilization among poor and lower-income households. This is a weakness of VBARD, set up to be the principal financial services provider in rural areas, and still more of VBP, set up to serve the poor, but which does not collect savings at all. The minimum deposit accepted by VBARD branches is 50,000 Vietnamese dong (around US$3.30) and 100,000 dong in commercial bank branches (McCarty 2001). This is an obstacle to savings accumulation by the poor in a country with an average per capita income of US$400. The source of VBARD’s and other banks’ deposits is overwhelmingly

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urban, and the interest rate structure and limited range of savings products do not encourage rural deposits. However, McCarty (2001, p. 20) notes that VBARD’s savings performance is “very erratic”, varying greatly across the country. Thus savings, as a percentage of loans, is as high as 92 per cent and as low as 2 per cent across nine provincial branches. While the poorest provinces appear to have the lowest savings ratios, international experience of aggregate savings behaviour provides no evidence to suggest that this should be so. Examining the reasons for such wide variations in performance and, in particular, case studies of successful savings mobilization by VBARD branches, could prove instructive. In this regard, the experience of the PCFs might also provide some lessons. Their comparative success in mobilizing savings appears to flow from the ability to offer higher deposit rates and to design products better matching the needs of low-income and poor people, as well as their accessibility to the poor. NGOs, on the other hand, appear to take their cue from the government financial institutions, and to share their limited appreciation of the value of savings, either for institutional viability or for the welfare of the poor. Consequently, they have pursued a microcredit rather than a microfinance orientation.

3.6.5. The Policy and Regulatory Environment Gilbert Llanto (2000b, p. 346), surveying the state of microfinance in Vietnam in 1999, described the major unresolved issues as being: • to find a proper role for the state-owned banks; • to agree to an appropriate interest rate policy for the central bank; • to implement a positive approach to savings mobilization; • to achieve a competitive, market-oriented environment for microfinance and for the financial sector more broadly; • and to institute appropriate regulation and supervision for MFIs. As is usually the case in transitional economies, many of the problems constraining the development of sustainable microfinance can only be resolved in the context of broader financial sector reform, including movement towards a commercialized banking system. Short of full interest rate liberalization, it may be feasible to allow progressively greater latitude in setting interest rates to particular institutions. This is happening with respect to PCFs and other non-bank credit institutions,

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for instance, along with some loosening of interest rate ceilings and the SBP’s move to a “base rate” method of setting rates in 2000. A trend towards positive real interest rates over the last three years, in consequence of price stability, has also been helpful to institutional sustainability and financial sector development. A number of other reforms and clarifications have occurred in recent years, including greater flexibility now given to commercial banks in deciding loan guarantee requirements. Rights and obligations with regard to borrowing and lending have been clarified in the Civil Code, registration for non-credit institutions conducting banking activities has been introduced in a Law on Credit Institutions, and a co-operatives law which provides a framework for the development of credit cooperatives has been enacted. Also, in 2000, a politburo directive called for a review of the PCF system, to achieve its consolidation and improvement, and to provide for supervision (McCarty 2001, p. 12). The Asian Development Bank evidently feels the time is ripe to assist the government to develop a policy and legal framework conducive to the development of microfinance in Vietnam. A loan for technical assistance is to be made in 2002 to assist the SBV with the conceptual framework for a national policy on microfinance, with the possibility of drafting specific legislation for the sector. Particular attention will be given to drafting prudential regulations for MFIs, with a view to legitimating and expanding their savings mobilization. The ADB also intends to assist in improving the functioning and coverage of the Deposit Insurance Agency to support savings mobilization. It aims to assist in crafting a regulatory framework within which MFIs can evolve into formal regulated financial institutions. The ADB thus appears to have a “transformation” scenario in mind for MFIs, perhaps similar to that in Cambodia, discussed elsewhere in this chapter. McCarty (2001, p. 3) describes the microfinance market in Vietnam as “segmented”, and suggests that “the most useful breakdown is to divide households into those who can access the Vietnam Bank for Agriculture (VBARD) and those who cannot”. He comments that the poor are mostly unable to access subsidized credit from VBARD. While some may access VBP credit (perhaps 40 per cent, according to data cited above) it is not clear whether this will prove a sustainable source. Otherwise, poor

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households must turn to relatives or private lenders. He suggests that for the poor, access to credit on a sustainable basis, at interest rates closer to those charged by informal lenders, would be a boon. McCarty describes the NGOs as “trapped in a microfinance-as-charity vision”, dependent on subsidies and taking their lead on interest rates from subsidized government institutions rather than moving to compete with high-cost providers in the informal sector. 3.7. Laos

Laos has the least-developed microfinance sector of any country considered in this chapter, and is classified both as least developed and as an HIPC (heavily indebted poor country). Sparsely populated, it has a pattern of small, dispersed settlements, unfavourable for the delivery of all services, not least microfinance. The continuing importance of non-monetized subsistence activities is another constraint on financial sector development, and there is an apparent absence of significant traditional ROSCA activities and even of a well-developed system of professional village moneylending (Kunkel and Seibel 1997). By contrast, these practices are commonplace in neighbouring countries as well as throughout the region more generally. However, sample survey evidence cited by Kunkel and Seibel (from which single source most of my information is drawn) seemed to them to suggest an incipient demand for microfinancial services in the rural economy, especially for savings deposits. This judgement was based on evidence concerning household holdings of cash, gold, and silver. Laos commenced its transition from central planning in 1986, with a series of reforms under the “New Economic Mechanism”. From 1990 the government turned its attention to the financial sector, carving the former state mono bank into a central bank and a number of commercial banks. Private sector banks were permitted to operate in urban areas, and interest rate liberalization commenced. Kunkel and Seibel note that in the financial sector “progress has been impeded by the reluctance of administrative and institutional decision makers to fully implement national policy decisions at the local level”. By 1996, six state banks served the rural sector and the largest of these, the Agricultural Promotion Bank (APB), had sixteen branches and some ninety sub-branches, serving

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a total of eighteen provinces and 133 districts. The APB was established in 1993 to be the primary agricultural lender and to achieve national outreach. The five lesser banks had only twelve branches. Kunkel and Seibel record that perhaps only 15 per cent of households in Laos had access to formal financial services by 1996. Operating outside the formal financial sector, the Lao Women’s Union (LWU), an official mass organization, had 650,000 members, some 50 per cent of the female adult population. With a staff of some 20,000 women and volunteers in virtually all villages, the LWU had the greatest potential for outreach in microfinance of any institution in Laos. Income generation and improved access to credit are among the multiple objectives of the LWU, which between 1990 and 1996 established some 1,650 “Lao Village Credit Associations” (LVCAs) focusing on women and the poor. Kunkel and Seibel describe the LVCAs as located in target villages selected by local government, in association with donors. Among other innovations and reforms likely to support the development of sustainable MFIs in Laos, Kunkel and Seibel saw the need for the LVCAs to be transformed into financial intermediaries. Then they could provide sustainable financial services to their communities, instead of focusing primarily on subsidized credit, with little attention to savings. As they operated at the time Kunkel and Seibel studied them, the LVCAs were not primarily MFIs, but rather groups focusing on some primary concern (such as livestock raising or education and training) with a revolving credit fund attached. Some thirteen projects operated by INGOs with the LCVAs, and a smaller number funded by multilaterals, served perhaps 14 per cent of all villages in the country, disbursing US$6 million between 1992 and 1996, with loan sizes typically between US$10 and US$50. French agencies are active in the field. While interest rates varied, most were at around 10 per cent per annum, around the preferential rate charged by state commercial banks. A Lao economist comments that in a nonmonetized economy such as Laos, where the poor have relatively little experience of trading, the livestock loan is a particularly effective form of microcredit. This is because it enables people to build on

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their existing knowledge, skills, and resources, rather than encouraging them to embark on less familiar and riskier enterprises.

3.7.1. Damaging Impact of the Asian Crisis During the financial crisis from 1997, inflation in Laos peaked at an annualized rate of 167 per cent early in 1999, although this was brought down to 10 per cent by the end of 2000 (IMF 2001a). Many Lao women must have been glad they had allocated wealth to gold and silver rather than cash or bank deposits. For the financial sector, macroeconomic instability was very damaging. Negative real interest rates, high inflation, and expectations of devaluations … undermined confidence in the financial sector, keeping savings rates low and limiting monetary depth. (Okonyo-Iweala et al. 1999)

The three state commercial banks sustained very high levels of nonperforming loans over the period and are still described as “deeply insolvent” (IMF 2001a). The current Letter of Intent (LOI) from the Lao government (IMF 2001a) imposes strict restraints on credit growth for all financial institutions, pending substantial restructuring and reform of the financial system, to include the phase-out of the state commercial banks. Although externally financed projects (including donor-assisted MFIs) are not affected by this credit stricture, economic conditions during the past four years cannot have been favourable to the further growth and development of MFIs. In its draft Poverty Reduction Strategy Paper (PRSP) filed with the IMF in April 2001 (IMF 2001b), the Lao government gives priority to the agriculture/forestry, education, road infrastructure, and health sectors for strategic interventions to reduce poverty levels, and singles out rural development as an inter-sectoral priority. Under that latter heading, there is specific reference to financial sector reform and to needed improvements in rural financial services, but no reference to microfinance, per se. More broadly, donor reservations about Lao government policies for the resettlement of ethnic minorities, which are 70 per cent of the population and a greater proportion of the poor, impede the full commitment of external resources to rural development (Jerve 2001). Given that poverty is

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Impact of the Asian Financial Crisis on Microfinance in Southeast Asia, as at November 1998

Not surprisingly, the crisis has had a much greater impact on microfinance in Indonesia than in any other country. The value of loans outstanding by BRI Unit desa and the rural banks have fallen by between one-quarter and one-half in constant price terms since the onset of the crisis. These institutions are supporting a much reduced level of activity among small entrepreneurs, at the same time as living standards are falling significantly. Moreover, at least in aggregate, the rural banks are running down the real value of their capital stock at an alarming rate. There are also signs of growing fragility in government schemes such as P4K and PHBK, which call for renewed commitment of resources to assist them to survive the crisis. By comparison, the crisis has had a more moderate effect in other countries. While it has impacted on MFIs in the Philippines, Malaysia, and Thailand, in most cases it has served to reduce the rate of growth in their outreach, rather than reduce outreach in absolute terms. There is also increasing evidence that the crisis is having a greater effect on institutions serving small business clients than on specialist MFIs serving the poor. In the Philippines this seems to be a robust conclusion. Evidence from a number of quarters suggests that programmes focusing solely on the poor appear to have withstood the crisis better so far, in terms of client numbers and repayment rates, than programmes not specifically targeted at the poor. This seems to be the case even where such programmes are run by the same institution, such as TSPI. In Malaysia, too, AIM has maintained high repayment rates among poor 13 borrowers while other institutions catering to higher-income borrowers have reportedly experienced increased arrears. Another more tentative conclusion is that microfinance appears to have suffered most where it is linked into the formal financial system. This is not surprising as the crisis has been first and foremost a financial one. As noted above, the rural banks in Indonesia, which are a major supplier of microfinancial services, are facing a very difficult situation. In the Philippines, it appears that thrift banks and possibly rural banks have suffered more than specialist MFIs, with reduced deposits forcing the thrift banks to reduce their loan portfolios. And MFIs in the Philippines and Malaysia have found it very difficult to maintain linkages with commercial banks, because of increased interest rates and more cautious lending policies. On the other hand, MFIs which rely on government and donor agencies rather than the formal financial system for resources appear to have fared better. This does not imply that microfinance should not become more integrated into the formal financial system. Such linkages are critical if microfinance is to reach large numbers of poor people on a sustainable basis. Nevertheless, they may make the microfinance sector more prone to cyclical fluctuations. The findings also suggest that much greater attitudinal change is necessary within the formal financial system about the scope for commercial engagement with microfinance. It is instructive that in the Philippines, individual loan officers at the commercial banks have acknowledged that MFIs are very good clients, but have been obliged to follow bank policy to reduce lending that is perceived as “risky”. There is a need to further educate senior bank management about the scope for profitable linkages with MFIs, and the need to avoid blanket lending policies which inadvertently work against such linkages (McGuire and Conroy 1998).

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concentrated in the rural areas, this reticence on the part of donors has significant implications for the full range of anti-poverty interventions in Laos, including microfinance. 4. Impact of the Asian Financial Crisis on Microfinance in Southeast Asia

In 1998, the Foundation for Development Cooperation surveyed MFIs in a number of Asian countries, to examine the impact on their operations of the Asian financial crisis, from mid-1997. Countries surveyed included Indonesia, the Philippines, Malaysia, and Thailand. The conclusions of this survey included the fact that MFIs in general fared better than the commercial banking systems in most of the countries concerned, that the crisis appeared to have more severe impacts on institutions serving small business clients than on specialist MFIs serving the poor, and that microfinance appeared to have suffered worst in those countries where it was linked most closely into the formal financial system. Microfinance programmes, including Grameen Bank replications, which most stringently targeted the poorest were least affected. A summary of the conclusions of this study (McGuire and Conroy, November 1998) is given in the text box on the preceding page. 5. Conclusion

This book is concerned with issues of financial sector development, considered in the light of the set-back to growth and development from events in the region in the late 1990s. Its terms of reference include consideration of financing for recovery, how further financial deepening may be achieved, and the need to develop new financing mechanisms and vehicles, while managing the process of liberalization better in future. The challenges of corporate and bank restructuring, the appropriate role for development assistance and the public/private balance are other considerations. Further, we are asked to consider how the financing needs of SMEs can be met more effectively, and whether microfinancing has the capacity to make credit available to a wider spectrum of people. It is necessary to repeat here a point made in the introductory section of this chapter, that there is a clear distinction between the economic

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activities and financial service needs of the SME sector and those of the clients of microfinance institutions. The latter operate on a much smaller scale. While there may be some overlap between the bottom end of the SME sector and the poor and lower-income people who form the constituency of microfinance, it is the needs of the latter to which this chapter has been directed. It should be clear from the country case studies in this chapter that financial liberalization supports the development of effective microfinancing mechanisms and institutions. Freedom to set interest rates is essential for sustainable microfinance. Such freedom may be conferred by government fiat (as in Indonesia after 1983) or exist by default, because MFIs are simply able to take matters into their own hands (as in Bangladesh since independence) because of the weakness of the regulatory authority. Issues of financial sector deepening give rise to considerations of equity and participation, at least from a microfinance perspective. Extending the outreach of microfinancial services is a contribution to financial deepening, although more important qualitatively than quantitatively. This is because, to repeat a point made several times in this chapter, the money value of microfinance assets and liabilities is not likely to become a significant element in the consolidated balance sheets of financial sectors in the region. However, there is a yardstick, other than the monetary one, which has relevance to the issue of financial deepening. That other yardstick should measure the impact financial deepening has on the number of people who are drawn in to participate in the financial system, by virtue of their gaining access to financial services which meet their needs. The search for new financial instruments and platforms for the provision of financial services has its counterpart in the world of microfinancing. The country studies in this chapter have attempted to convey something of the diversity of models and institutions, some of them imported, some of them home-grown, which are being applied in Southeast Asian countries. A diversity of approaches is appropriate; narrow prescriptions concerning “the” model appropriate to the region or to any single country within it are unlikely to be helpful. It is better

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to set operational performance standards as benchmarks against which the various models in operation can be measured. The need for financial sustainability is increasingly understood by the voluntary sector agencies which have entered microfinance, while the high standards of certain formal regulated institutions, notably BRI and BAAC, have demonstrated to governments the possibility of sustainable rural sector financing. It is also interesting to note the relative resilience of many MFIs in the face of the Asian crisis. The challenges confronting microfinance in Southeast Asia, then, include the need to achieve operational and financial sustainability for MFIs, and to achieve this while integrating the institutions which practise microfinance within the broader financial system, as part of a financial deepening process. They include the need to achieve good governance within MFIs serving constituencies of the poor, and to avoid the politicization of financial service delivery. And they include the need to achieve good governance at the system level, by instituting appropriate policy regimes and forging effective systems of regulation and supervision for microfinance service providers. With regard to the role of donors, experience noted in the country case studies indicates their best function may be to assist with forms of financial sector development which increase the access of poor and lowincome people to financial services delivered on a sustainable basis. This suggests the need for intervention at the system level, to assure an appropriate policy and regulatory environment for sustainable microfinance to flourish. At the firm level, it suggests the desirability of support to assure the creation and piloting of institutional models of MFI which can achieve outreach to unserved or underserved strata of populations in a sustainable fashion, and which can function as organic entities within the broader financial system. This formulation implies a role for the private sector in such provision, but does not imply that private investors should be responsible for all the costs of establishing such systems and the institutions within them. Subsidies or external assistance, however, are best directed to establishment and capacitybuilding costs; financial self-sufficiency in routine operations is a separate and essential goal for all microfinancing institutions.

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ACRONYMS/ABBREVIATIONS USED ACLEDA ADB AIM APB BAAC BI BKK BKKBN BMT BPD BPR BRI CDD CGAP CGC GOI CU GSB GTZ IDT IFAD IFC IMF INGO KSP KUD KUPEDES LDKP LVCA LWU MFI NBC NCC NEP NBFI NGO PAR PCF PCFC PHBK Pro-Fi

Association of Cambodian Local Economic Development Agencies Asian Development Bank Amanah Ikhtiar Malaysia Agricultural Promotion Bank (Laos) Bank for Agriculture and Agricultural Co-operatives Bank Indonesia Category of NBFI (Indonesia) National Family Planning Co-ordinating Board (Indonesia) Islamic Savings and Credit Group (Indonesia) Regional Development Bank (Indonesia) People’s Credit Bank (Indonesia) Bank Rakyat Indonesia Community Development Department (Thailand) Consultative Group to Assist the Poorest Credit Guarantee Corporation (Malaysia) Government of Indonesia Credit Union Government Savings Bank (Thailand) German Development Assistance Agency Presidential Program for Backward Villages (Indonesia) International Fund for Agricultural Development International Finance Corporation International Monetary Fund International NGO Savings and Credit Group (Indonesia) Village Co-operative Unit (Indonesia) BRI Microfinance Lending Programme (Indonesia) NBFI Savings and Credit Institutions (Indonesia) Lao Village Credit Association Lao Women’s Union microfinance institution National Bank of Cambodia National Credit Council (Philippines) New Economic Policy (Malaysia) non-bank financial institution non-governmental organization portfolio at risk People’s Credit Fund (Vietnam) People’s Credit and Finance Program (Philippines) Programme Linking Banks with Self-Help Groups (Indonesia) Promotion of Small Financial Institutions project (Indonesia)

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Poverty Reduction Strategy Paper Agriculture Ministry Microfinance Program (Indonesia) Rural Development Bank (Cambodia) Rotating Savings and Credit Association State Bank of Vietnam self-help group BRI Microfinance Savings Program (Indonesia) small and medium enterprise Credit Program for Fishermen (Malaysia) Credit Program for Female Household Heads (Malaysia) Urban Community Development Office Village Economic Activities and Finance Project (Indonesia) U.S. Agency for International Development Credit and Savings Unit (Indonesia) Vietnam Bank for Agriculture and Rural Development Vietnam Bank for the Poor Vietnam Women’s Union Foundation for the Development of the Malaysian Islamic Economy

NOTES * I am grateful to my colleague Paul McGuire for his comments on an earlier draft, and also to Dr Leeber Leebouapao for his comments on the Laotian material. Dr Sukor Kasim was most generous in making available material which underpins the section on Malaysia. Ms Nina Nayar was most helpful in regard to Cambodia while Ms Michiko Katagami and Dr Nimal Fernando assisted me with materials on that country. None of these people should be held responsible for my final interpretations. Also, I thank Dr Nick Freeman of ISEAS for his patience and good humour. 1. Relatively few studies of countries in the region deal with microfinance in a national perspective, as distinct from case studies of particular institutions or sub-regions. McGuire, Conroy, and Thapa (1998) contains relevant studies of Indonesia, Malaysia, the Philippines, and Thailand, while Asian Development Bank (2000c) includes studies of Indonesia, the Philippines, and Vietnam. Indonesia is the bestdocumented country, with recent material including Robinson (2001), Steinwand (2001), and Holloh (1998), although each of these has its own institutional focus. Meyer and Nagarajan (2000) is primarily a study of rural finance, but deals with microfinance in Indonesia and Thailand incidentally. There is a dearth of material dealing with the transition economies. 2. In this the ADB is supported by Robinson (2001). 3. A glossary of acronyms used can be found at the end of this chapter. 4. Among the ASEAN members, Singapore, Brunei, and Myanmar will not be

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discussed here. The first two are wealthy countries. This does not mean there is not scope for forms of alternative financial service delivery to benefit disadvantaged groups in their populations. However, discussion of these is outside the scope of this chapter. In the case of Myanmar, circumstances — including limited information, the closed nature of its economic system, limited donor activity and limited opportunity for NGO initiatives — all suggest that Myanmar might best be treated in a separate country study. 5. For discussion of the emergence of AIM in the context of the New Economic Policy, see McGuire, Conroy, and Thapa (1998), pp. 175–78. 6. However, “possibly” and “may” are qualifiers which may, just possibly, indicate a certain lack of confidence in this judgement. 7. More accurately, from a scholar participating in an IMF panel discussion of IMF-supported research. 8. This section draws extensively on Conroy (2000) and McGuire, Conroy, and Thapa (1998). The writer also benefited from participating in an AusAID review of the Indonesian microfinance sector in January 2001, in company with Dr Kieran Donaghue and Dr Sumantoro Martowijoyo. Mr Dominique Gallman of the GTZ/ Bank Indonesia Pro-Fi project has been a most helpful correspondent. 9. A rate of Rp7,500 is used for many currency conversions in this chapter, and where other rates are used this is evident from the text. In a situation of extreme exchange rate instability, such as in Indonesia since mid-1997, it is often misleading to convert to other currencies when discussing changes in rupiah values. 10. Data for the BPR sector in mid-1999, based on CAMEL ratings, showed 42.5 per cent of BPRs as “sound”, with 14.7 per cent “fairly sound”, and 28.1 per cent “unsound”. 11. The proportion of people under a “total poverty line” dropped from 58 per cent in 1992–93 to 37 per cent in 1997–98, while the proportion under a “food poverty line” fell from 25 to 15 per cent (Vietnam Development Report 2000). 12. Published materials on microfinance in Vietnam are sparse. Two recent country overviews are available (Llanto 2000b; McCarty 2001) and are the primary sources for this chapter. 13. This conclusion was based on information received from the then management of AIM in 1998, and is not entirely consistent with the conclusions of the review of AIM (Sukor Kasim 2000) cited above.

REFERENCES Adams, D.W., D.H. Graham, and J.D. Von Pischke, eds. Undermining Rural Development with Cheap Credit. Boulder: Westview Press, 1984.

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Asian Development Bank (ADB). Finance for the Poor: Microfinance Development Strategy. Manila: Asian Development Bank, 2000a. . Report and Recommendation of the President to the Board of Directors on the Proposed Loan to the Kingdom of Cambodia for the Rural Credit and Savings Project. RRP: CAM 30237. Manila: Asian Development Bank, 2000b. . The Role of Central Banks in Microfinance in Asia and the Pacific: Country Studies. Manila: Asian Development Bank, 2000c. . Thailand, Country Strategy and Program Update 2002–2004. Manila: Asian Development Bank, 2001 Conroy, J.D. “Indonesia”. In The Role of Central Banks in Microfinance in Asia and the Pacific. Vol. 2, Country Studies. Manila: Asian Development Bank, 2000. Conroy, J.D., K.W. Taylor, and G.B. Thapa. Best Practice of Banking with the Poor. Brisbane: Foundation for Development Cooperation, 1995. Credit for the Poor. “Philippines Central Bank Encourages NGOs to Reinvent Themselves as Banks”, no. 29, December 2000, pp. 7–8. Erhardt, Wolfram. Credit for Poor and Low-Income Entrepreneurs in Urban and Rural Northern Thailand. Discussion Paper no. 99/4. Stuttgart: Institute of Agricultural Economics and Social Sciences in the Tropics and Sub-Tropics, University of Hohenheim, 1999. Gibbons, David and Sukor Kasim. Banking on the Rural Poor. Penang, Malaysia: Centre for Policy Research, Universiti Sains Malaysia, 1990. Goodwin-Groen, Ruth. The Role of Commercial Banks in Microfinance: Asia-Pacific Region. Brisbane: Foundation for Development Cooperation, 1998. GRET. Experimenting with a Micro-Health Insurance System in Cambodia: The EMT Example. CGAP Microfinance Gateway. 2000. . Holloh, Detlev. Microfinance in Indonesia: Between State, Market and SelfOrganisation. Hamburg: Lit Verlag, 1998. International Monetary Fund (IMF). Lao PDR Letter of Intent and Memorandum on Economic and Financial Policies, March 2001. . Interim Poverty Reduction Strategy Paper of the Lao PDR. 2001b. . . “Panel Discussion on Macroeconomic Policies and Poverty Reduction”. Washington, D.C.: 2001c. . Jerve, Alf Morten. “Laos”. In Choices for the Poor: Lessons from National Poverty Strategies, edited by Alejandro Grinspun. New York: United Nations Development Programme, 2001. Kunkel, Carmen R. and Hans Dieter Seibel. “Microfinance in Laos: A Woman’s Business?” Working Paper no. 1977-1, Development Research Center, University of Cologne, 1997.

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Llanto, Gilbert M. “The Philippines”. In The Role of Central Banks in Microfinance in Asia and the Pacific: Country Studies, pp. 247–77. Manila: Asian Development Bank, 2000a. . “Viet Nam”. In The Role of Central Banks in Microfinance in Asia and the Pacific: Country Studies, pp. 334–56. Manila: Asian Development Bank, 2000b. . “Sustainable Rural Finance: Policy and Design Issues”. In Policy Notes, no. 4/2001. Manila: Philippine Institute for Development Studies, 2001. Maurer, Klaus, in collaboration with Shyam Khadka and Hans Dieter Seibel. “Agricultural Development Bank Reform: The Case of The Bank for Agriculture and Agricultural Cooperatives, Thailand”. Rural Finance Working Paper, no. B.6. Rome: IFAD, 2000. McCarty, Adam. Microfinance in Vietnam: a Survey of Schemes and Issues. Hanoi. DfID (Department for International Development, U.K.) and State Bank of Vietnam, 2001. McGuire, Paul B. and John D. Conroy. Effects on Microfinance of the 1997–1998 Asian Financial Crisis. Brisbane: Foundation for Development Cooperation, November 1998 . McGuire, Paul B., John D. Conroy, and Ganesh B. Thapa. Getting the Framework Right: Policy and Regulation for Microfinance in Asia. Brisbane: Foundation for Development Cooperation, 1998. Mehrtens, Grahame and Robyn Cornford. CARE Cambodia, Savings Mobilisation Project, Battambang Province: Mid-Term Evaluation Report. Brisbane: Foundation for Development Cooperation, 2001. Meyer, Richard L. and Geetha Nagarajan. Rural Financial Markets in Asia: Policies, Paradigms, and Performance. A Study of Rural Asia, vol. 3. Manila: Asian Development Bank, 2000. Muraki, Tetsutaro, Leila Webster, and Jacob Yaron. Thailand, BAAC — The Thai Bank for Agriculture and Agricultural Cooperatives. Case Studies in Microfinance: Sustainable Banking with the Poor. Washington, D.C.: World Bank, 1998. Okonyo-Iweala Ngozi, Victoria Kwakwa, Andrea Beckwith, and Zafar Ahmed. “Impact of Asia’s Financial Crisis on Cambodia and the Lao PDR”. Finance and Development 36, no. 3 (1999). Robinson, Marguerite, S. The Microfinance Revolution: Sustainable Finance for the Poor. Lessons from Indonesia. Washington, D.C.: World Bank and Open Society Institute, 2001. Sacay, O., B. Randahawa, and M. Agabin. The BAAC Success Story: A Specialized Agriculture Bank under Government Ownership. Washington, D.C.: Financial Sector Development Department, World Bank, 1996. Son Koun Thor. The Implementation of the Royal Government Policy Program in Social Development for Poverty Alleviation: Rural Credit in Cambodia. Phnom Penh:

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Rural Development Bank of Cambodia and AFD, 2001. Steinwand, Dirk. The Alchemy of Microfinance: The Evolution of the Indonesian People’s Credit Banks (BPR) from 1895 to 1999 and a Contemporary Analysis. Berlin: VWF (Verlag fur Wissenschaft und Forschung), 2001. Sukor Kasim. Impact of Banking on Rural Poor in Peninsular Malaysia: Final Report of External Impact Evaluation Study on AIM Active Borrowers, NonBorrowing Members, Dropouts and Non-Participating Poor. Penang: Centre for Policy Research, Universiti Sains Malaysia, 2000. Vietnam Development Report, Attacking Poverty. Joint Report of the GovernmentNGO-Donor Working Group, Consultative Group meeting for Vietnam, 1999. Vogel, Robert, C. “Savings Mobilisation: The Forgotten Half of Rural Finance”. In Undermining Rural Development with Cheap Credit. Boulder: Westview Press, 1984. World Bank. A Strategy to Fight Poverty: The Philippines. Washington, D.C.: World Bank, 1996.

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Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > Wigmore and Giles Kennedy 162 Gary S.

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Opportunities and Trends in the ASEAN Project Finance Environment Gary S. Wigmore and Giles Kennedy

1. Introduction: Project Financing Opportunities in ASEAN Prior to 1997

Prior to 1990, project financing did not play a significant role in the raising of capital for infrastructure projects in the ASEAN countries (or indeed, in any of the countries in East Asia). Historically, sponsors and developers of East Asian infrastructure projects had either relied on traditional forms of commercial bank loan financing (generally with full recourse to the sponsor or developer), or had obtained sovereign guarantees to backstop the credit risk associated with the project. The Singapore government, for example, fully funded the development and construction of both underground mass rapid transit (MRT) light rail

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system and Changi International Airport. In this environment, opportunities for highly structured project-financed transactions were rare. However, as a result of the boom years of the 1980s, the record high economic growth rates that many ASEAN countries experienced caused a dramatic increase in the demand for new infrastructure projects. By the end of that decade, the continued ability of ASEAN governments to fund the required infrastructure developments was being severely tested. Many governments simply did not have the ability or the reserves to support additional infrastructure projects through the issuance of sovereign debt guarantees and were reluctant to increase domestic borrowing to fund such projects directly. This environment created the opportunity for alternative methods of financing to emerge and the structured project finance model was soon seen to offer a viable alternative to the traditional forms of financing Asian infrastructure projects. By the early 1990s, strong interest in the project finance model had developed throughout East Asia (mirroring a similar trend in other parts of the world) as sponsors recognized that the structured financing arrangements utilized in project financing could provide a useful mechanism to both leverage investment capital and reduce residual longterm risk exposure. Developers in diverse infrastructure sectors such as telecommunications, mining and minerals, power, transportation, petrochemicals, water, oil, and gas soon began courting project finance investors and financial institutions. By the mid-1990s, almost every ASEAN country had infrastructure projects under development that were financed using the project finance model. Privately sourced funding provided through project-financed transactions allowed many Asian countries, including Indonesia, Thailand, and the Philippines, to rapidly implement projects that would not otherwise have been possible or economically viable. 2. The 1997 Economic Crisis and Its Effect on Project Financing Opportunities

Through the mid-1990s, enthusiasm across East Asia continued to grow as project financing techniques were successfully utilized to raise debt

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for a wide range of infrastructure projects, most notably in the power sector. In 1996, international lending institutions closed a record number of project-financed infrastructure deals in ASEAN countries. So heady was the optimism of developers that among the many projects being proposed was the world’s longest bridge — a 95-kilometre (60-mile) tollway linking the island of Sumatra and peninsular Malaysia across the Straits of Malacca. President Soeharto’s daughter Siti — whose interests led a consortium of sponsors — announced that the developers were confident that much of the US$3 billion cost of the bridge’s construction could be funded by raising capital on the international market, using the project finance model. During the second half of 1997, the situation changed quickly and dramatically. As various East Asian countries were affected by the spreading monetary crisis, exchange rates fell against the U.S. dollar, economic growth rates plummeted, and countries around the region sunk into recession. As a result, a wide range of infrastructure projects were delayed, with most of those ultimately cancelled. Within the first few months of the crisis, sponsor and investor enthusiasm for projectfinanced development waned. In Indonesia alone over US$10 billion of power plant development (some 15,000 MW) was suddenly put on hold. In September 1997, development work on Malaysia’s US$5.5 billion, 2.4-gigawatt Bakun hydroelectric project was suspended. By late 1997, the Thai government cancelled Hopewell Holdings’ contract for the Bangkok Elevated Road and Train System, a US$5 billion to US$7 billion project on which Hopewell had already spent US$500 million. During the ensuing two-year period, many financial institutions and investors suffered heavy losses, and the continuing political and economic instability resulted in a greatly reduced appetite for developing country infrastructure projects world-wide. Most notably impacted were projects in Indonesia, India, China, Vietnam, Brazil, Russia, and the ex-Soviet Union states and Pakistan, where investors had been hit hardest. In many ASEAN countries, investors’ reluctance to pursue new infrastructure development was attributable to a perception that the risks associated with investing in the region had greatly increased, with no attendant enhancement in economic returns. Many ASEAN countries were increasingly viewed as politically and economically unstable,

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possessed of uncertain legal systems susceptible to external manipulation. In addition, developers found that a high-profile local partner could quickly become a liability with a sudden change of government. Political machinations and domestic political considerations often took priority over the actual infrastructure needs of a country. Particularly troubling situations arose in Indonesia, China, and Pakistan, where off-takers began to renege on contractual obligations by demanding lower tariffs and other concessions or refused to pay the amounts that had been agreed in the off-take agreements. By refusing to fulfil contractual obligations until signed agreements were renegotiated on terms more favourable to the government, the very basis of the project finance model — contractual risk allocation and sharing — was undermined. While the booming U.S. economy of the late 1990s greatly assisted East Asian economies in recovering from the 1997 currency crisis, it had the exact opposite effect on Asia’s infrastructure sector. As the United States and Europe deregulated their power industries, large amounts of U.S.- and Europe-based generation and transmission assets were placed on the market for the first time, and greenfield and start-up opportunities suddenly became plentiful. In addition, deregulated telecommunications markets and the Internet bubble created tremendous investment opportunities in broadband, cable, and fibre optic networks. While competition in the United States and Europe was intense, the general political and economic situation in Asia made investments in developed countries highly attractive to investors who had become increasingly risk-averse. The politically stable and economically strong markets of the industrialized West were on the whole seen to offer a more acceptable risk/reward relationship than was available in the ASEAN region. By mid-1999 — two years after the currency crisis began in Thailand — new greenfield infrastructure development in Asia had seen a dramatic decline, and in many sectors it had all but ground to a halt. Almost all sponsors, banks, investment banks and law firms that had been involved in project-financed projects had either substantially scaled back or closed their project finance departments altogether. A steady stream of developers, investors, and other professionals departed East Asia to work on infrastructure projects in the United States, Europe, and the Middle East.

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3. Project Financing Opportunities: The Current Environment

While the years 2000 to 2002 saw steady improvement in the environment for Asian infrastructure projects, the number of greenfield projects under active development (which had provided a large portion of project finance opportunities prior to mid-1997) remained relatively few in number. This was primarily due to continuing economic uncertainty and in some cases oversupply. Since 1997, the contraction of regional economies has left many countries with significantly slower growth rates than was originally forecast, resulting in excess electrical-generation capacity. Thailand and Indonesia, for example, are projected to have no new electrical capacity demand until after 2005, and the Philippines is not expected to require additional power plants until at least 2004. Analysts have noted that the market for project-financed debt has slowly but steadily improved over the past two years. The number of project finance deals completed in 2000 increased significantly from 1999, along with greater liquidity in the secondary market. Such signs of renewed activity are similar to those that appeared in the United States following the 1997 downturn, when project finance market analysts identified a period of reassessment and consolidation before a broader return to economic activity began. Today, signs of a recovery in project finance opportunities are perhaps most evident in Singapore and the Philippines. This is probably most attributable to the power sector privatization processes that have been under way for some time in both countries. In the Philippines, the Philippine Electric Power Industry Reform Act was finally passed into law in June 2001, committing the country to the privatizing of National Power Corporation’s generating assets and the deeper involvement of the private sector in the electricity-generation industry. The impending privatization of the Philippine power market has caught the attention of many independent power producers (IPPs), who recognized that the Reform Act creates a myriad of opportunities in the Philippine’s electricity generation, transmission, and supply sectors. Mirant — the largest investor in the Philippine power sector with over US$2.5 billion in total investments to date — has publicly announced that in connection with the ongoing privatization, it expects to make a significant number of

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new investments in the Philippines in the period prior to 2007. Unfortunately, despite such optimism, many of the ghosts of 1997 continue to haunt the Philippine project finance market today. In late 2001 development work on the Bulacan Biomass 36 MW power project in the Philippines was halted after the withdrawal of Enron, its lead sponsor. The cancellation came just weeks after Manila was rocked by terrorist bombings, mass urban protests, and the ousting of the country’s president amid charges of corruption. Equally troubling, the Reform Act contains language that many interpret as a signal that the Philippine government intends to renegotiate existing IPP electricity off-take agreements. In addition, Philippine President Gloria Macapagal-Arroyo issued Administrative Order 14, which requires a “thorough review” of all IPP contracts held by the state-owned National Power Corporation. The spectre of contract renegotiation will likely be an issue for sponsors and investors seeking to raise funds on international capital markets for all future Philippine projects. In Singapore, the government has established the Singapore Electricity Pool, with PowerGrid and Power Supply, the owners of the transmission and distribution networks respectively, having already been corporatized. While there are still significant steps that must be taken to fully privatize the Singapore power sector, including the sale of generation assets, these critical first steps have established Singapore as East Asia’s leader in electricity sector privatization and have been important in signalling new opportunities in project finance in all ASEAN countries. Approximately 6,000 MW of stateowned generating capacity is to be transferred as part of the privatization in a process that will remove all state ownership from the power-generation sector. Although the finer details of the privatization process have yet to be made publicly available, the Singapore government has indicated that foreign ownership will not be restricted. Further, the market mechanism to be employed for the setting of power prices will allow the full pass-through of fuel-related generating costs, and will loosely resemble other power tariffsetting mechanisms employed in Britain and New Zealand. Exactly how the power market in Singapore will function is unknown, given the changes to the market rules that are to be implemented before privatization and the high reserve margins on the Singapore power grid (in excess of 70 per cent at present). However, the political stability of Singapore and the efficiencies

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of the city-state are likely to be attractive to foreign developers and utilities. At the time of writing, the Singapore privatization has been delayed but is still expected to be completed in late 2003 or 2004. Other ASEAN governments are also seeking to privatize power infrastructure assets, particularly Thailand, where the National Energy Policy Office has signalled its intention to establish a more competitive electricity industry by 2003 and to sell generating assets, including the 4,600 MW Ratchaburi plant. Unlike the Philippines, in Thailand the initial reforms have centred on the generation sub-sector, including the enactment of the Small Power Producer Programme, which established the Independent Power Producer Programme and placed a premium on the use of renewable energy resources, such as bagasse and rice hulls. In May 1998 the Thai government issued a policy statement setting forth its future objectives, including the divestiture of the generation assets of the Electricity Generating Authority of Thailand and its transformation into a transmission company. 4. Current Trends in Project Financing

With early signs of economic recovery in the ASEAN region, and the re-emergence of opportunities for sponsors, developers, and investors, several identifiable trends are discernible. 4.1. Changed Focus towards Acquisition Activity

In the absence of greenfield opportunities around East Asia, many project developers have focused on the few opportunities created by the events of 1997, notably the acquisition of existing infrastructure assets. Sponsors who have made a long-term commitment to Asia have used merger and acquisition (M&A) opportunities created by the currency crisis to take advantage of economies of scale and integration, and to consolidate holdings as many developers have exited the market. The effect of acquisition activity over the last few years, coupled with the reduced number of new projects, has been increased market concentration around the region, such as the numerous purchases of generation assets by Tractebel in Thailand (making it one of that country’s largest IPPs). In addition, companies such as Texaco and Singapore Power have been

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actively acquiring power assets in Korea, confirming the trend by developers to grow by acquisition rather than building new assets. 4.2. Restructuring of Existing Projects

A new specialty area of Asian project finance that has emerged from the events of 1997 is the financial restructuring of existing assets, with several major projects in the region already going through a reorganization and/ or refinancing. Restructuring activity may take the form of renegotiation of financing documentation and/or underlying project documentation. Restructuring is being considered in many cases, either because the project as originally structured is no longer economically viable, or because project payments are in default. Indonesia in particular has seen most of its pre-1997 IPP projects face the prospect of renegotiated contracts with lower tariffs that are not tied to the U.S. dollar. Numerous power projects in Indonesia are in default and in the process of evaluating various restructuring options, including Paiton I, Jawa Power, and at least three geothermal power projects. Prior to the 11 September 2001 terrorist attacks in the United States, the sponsors of Paiton I power project, the largest and most noteworthy of the projects, had expected to announce a restructured tariff with Perusahaan Listrik Negara (PLN), the state electricity company in Indonesia, leading to a financial restructuring with its lenders within a matter of months. The Paiton I power project reached a settlement with PLN in 2002 and is expected to conclude a financial restructuring with its creditors in early 2003. As the first and largest IPP in Indonesia, the Paiton I restructuring represents a significant step towards rebuilding confidence in the viability of infrastructure financing in Indonesia. With its restructuring, Paiton I is expected to pave the way for other successful restructurings and eventually refinancings and new financings in Indonesia. Current investor sentiment within the ASEAN region appears to reflect a consensus that there is significantly less risk involved in restructuring an existing infrastructure project than investing in new development. With so many projects around the region in default, project restructurings are likely to increase in number. Furthermore, other projects that are now only partially completed will require some form of

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restructuring before they can attract the new capital investment required for completion. Early in 2001 PLN signed an agreement to resume construction of the 1,320 MW coal-fired Tanjung Jati B IPP project, now planned for completion in 2004. This project, which was suspended by Hopewell Holdings in 1998 when the plant was only partly constructed, is expected to be a litmus test of the return of badly needed foreign infrastructure investment in Indonesia. Project restructuring of the type currently being proposed is a new concept to many parts of East Asia, where restructuring traditionally has concentrated only on liquidation and bankruptcy processes. Restructuring laws and processes in many jurisdictions provide only conservative, often expensive and inefficient mechanisms. This is particularly true in countries where the legal system is based on English precedent, such as Thailand and Malaysia. Many ASEAN countries have already publicly acknowledged that legal reform is required. In Thailand, for example, the Bankruptcy Law of 1940 (which had previously governed all formal restructuring processes) was amended by the Bankruptcy Law of 1998 (passed in April of that year). Such reform should have the effect of encouraging and facilitating restructuring of existing projects in Southeast Asia. Combining the trends of increased M&A activity, restructuring, and regulatory changes was Sithe Asia’s 1999 acquisitions of generating assets from two companies affiliated with the Hyundai group; one of Korea’s largest chaebol that was in the process of restructuring in response to the regional economic crisis. These transactions represented the first two foreign IPPs to achieve financial close in Korea, and were only possible due to recently enacted regulatory changes that for the first time allowed a foreign-owned company to hold a power plant operating licence in Korea. Following the current period of restructuring of existing projects, a renewed emphasis on new infrastructure development is expected. As opportunities to restructure dwindle, developers, sponsors, and investors will look to new project finance structured investment products. This is likely to involve the development of greenfield projects, as well as construction of new assets at existing sites. While many parts of the ASEAN region may not have significant greenfield opportunities for some time, the first signs of new asset developments are expected shortly.

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4.3. Privatization of Public Infrastructure Assets

M&A activity is not only occurring in the private sector, but it is also occurring as a result of the privatization of public infrastructure assets. Governments around the region are selling infrastructure assets such as toll roads, water, waste water treatment, and waste and refuse collection. Privatization of existing public infrastructure assets is likely to continue for some time, given the pressure that governments and local authorities in many ASEAN countries face in operating and managing existing infrastructure. Privatization is also driven by the need for governments to raise revenues and reduce debt. In addition to energy sector privatization in the Philippines and Singapore (as discussed above), other East Asian countries pursuing privatized electric power sectors include Japan, Korea, China, and Malaysia. Continued privatization of infrastructure assets in the region should greatly increase project financing opportunities, and continue the trend towards greater private sector involvement in infrastructure development, financing, operation, and management. While Asian-based power developments accounted for approximately 50 per cent of project-financed deals (by value) in the first six months of 2002, other industries, including telecommunications, transportation, and water, are expected to compete for a greater share of project financing resources in the future. Examples of recent non-power industry project-financed deals include the North Luzon Expressway and the Mayniland water project in the Philippines. 4.4 Use of Local Currency

Fluctuating exchange rates of Asian currencies against the U.S. dollar have had a significant impact on the viability of many ASEAN regionbased projects, with declining local currency valuations exacerbating already high debt service levels. Since 1997, there has been a noticeable shift away from supporting Asian infrastructure projects with U.S. dollar– denominated debt. This is due to both an increased risk premium being demanded by international lenders and a greatly reduced willingness of government off-takers to index tariffs to the U.S. dollar or other foreign currencies. As a result, developers have sought to fund projects with local currencies in an effort to reduce foreign exchange risk and overall project costs. On the financing side, a notable example of the movement towards funding projects in local currency is Tri Energy’s 750 MW

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gas-fired power plant in Thailand, where the off-shore sponsors attempted to refinance a portion of its existing U.S. dollar–denominated debt with funding in Thai baht in an effort to lower financing costs and reduce foreign exchange exposure. Although the Tri Energy refinancing was not ultimately implemented for unrelated reasons, this trend is likely to continue. 4.5. Higher Levels of Base Equity

Another trend that has emerged since 1997 is the requirement imposed by lenders for greater amounts of base equity to be contributed to projects, especially where the project is required to bear market/demand risk. This is a change from the traditional situation, in which only minimal base equity was required up front and reflects clear lender sentiment as to the risks and ultimate viability of projects in the post-1997 environment of the ASEAN region. 5. Current Issues Facing Project Financing in ASEAN 5.1. Governmental Role in Legal Reform

As noted above, legal reform is a key concern to project finance lenders, and an area that has been the focus of much attention during the last few years. Given the general investor and sponsor perception that certain ASEAN countries are politically and economically risky, it is increasingly important that governments in the region are seen to be implementing predictable and transparent legal systems. One example of such reform was enacted by Vietnam in March 1999. This law, Measures to Encourage Foreign Investment Activities in Vietnam, or “Decision 53”, was designed to cut the costs and hassles of doing business in Vietnam for foreign-owned enterprises. Central to the effectiveness of Decision 53 was a measure aimed at reducing or eliminating the higher prices that foreign-owned enterprises were required to pay for some goods and services under then-existing dual-pricing policies. Starting in July 1999, utility charges, land rents, and minimum wages were all officially reduced, and a “road map” for further reductions and eliminations was provided. While foreign investors have welcomed the enactment of Decision 53, most agree that it was only a small step forward in solving Vietnam’s foreign investment problems, and that it

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has made only a marginal impact on development in the country. One lesson learnt during the past decade of project development in East Asia is that it is critical for regulations to be made as clear, concise, and as conducive as possible to encourage investment. In particular, in order to encourage new infrastructure, governments must assist developers of greenfield projects in identifying and acquiring access to appropriate sites. An excellent example of such co-operation is Sithe Asia’s San Roque project in the Philippines, where the government has undertaken the obligation to acquire all land rights necessary for the construction of a 345 MW dam, and the developers and lenders to the project have agreed to advance all of the funds needed by the government to carry out such obligations. 5.2. Political Risk Insurance

The importance of political risk insurance has increased recently and is becoming a crucial element for attracting investment into the region. Transactions within the ASEAN region now routinely include full political risk coverage. Where this has not been provided, deals have involved either local financing or pricing of the transaction at a premium. In September 2001, The Economist published a survey in which it ranked the “riskiest” countries in the world in which to do business (based upon economic and political stability, debt structure, and government policy). The top five countries consisted of Myanmar, Zimbabwe, Pakistan, Russia, and Indonesia. The fact that two ASEAN countries are in the top five demonstrates that political risk is a very significant factor in East Asia, and one that must be considered when developing, financing, or operating infrastructure projects developments in the region. The potential benefits of political risk insurance have become evident in the last few years. In 1999, OPIC paid US$290 million to MidAmerican Holdings (formerly CalEnergy) as compensation for PLN’s failure to honour a supply contract for the 400 MW Dieng and Patuha geothermal power projects in Indonesia. One other notable Asian power project with political risk insurance coverage and financial support from Overseas Private Investment Corporation (OPIC) is Dabhol Power Company’s US$2.9 billion, 2,184 MW power project in India. One new trend emerging is the use of political risk insurance from

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private insurers, rather than insurance from the traditional sources of government and export credit agencies, including Multilateral Investment Guarantee Agency (MIGA), Japan Bank for International Cooperation (JBIC), Nippon Export and Investment Insurance (NEXI), ExportImport Bank of the United States (U.S. Exim), OPIC, HermesKreditversicherungs-AG, and others. In early 2001, the CBK hydroelectric project in the Philippines became the largest project financing to rely solely on private political risk insurance for 100 per cent of principal and interest owing to commercial lenders. Other projects are expected to turn to the private insurance market in future, given relatively competitive costs (compared with government-provided political risk insurance) and the speed with which coverage can be underwritten (it may take only three to four months to secure private insurance, compared with twelve months or more for government agencies). 5.3. Use of Development Banks, Multilateral Organizations, and Export Credit Agencies

Given the continuing political and economic concerns in ASEAN countries, multilateral and export credit agencies are expected to play a greater role in project financings in the region. Such agencies provide direct loans as well as credit support in terms of political risk coverage and guarantees to private lenders. The active participation of multilateral and export credit agencies should ultimately create some of the confidence for private sector lenders to re-enter the financing market. There are numerous agencies which are active in ASEAN countries and are, in fact, looking for well-structured deals to finance, including the International Finance Corporation (IFC), OPIC, the Netherlands Development Finance Company (FMO), NEXI from Japan, the Islamic Development Bank, U.S. Exim, Export Development Corporation (EDC) from Canada, and others. 6. Conclusion: Prognosis for the Future

Given ASEAN’s steadily increasing population and continued (if dramatically slowed) economic growth, there will continue to be a demand for new infrastructure products well into the future. In 1997

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the World Bank estimated that between US$1.2 trillion and US$1.5 trillion would need to be spent on infrastructure in the developing countries of Southeast Asia before 2007. This suggests that for the region to meet its infrastructure requirements, the use of project financing structures is likely to increase. Project financing will also become increasingly important as the trend towards privatization of public assets in the region picks up pace, and as the region emerges from its economic crisis. If, for example, Singapore, a country which has traditionally relied on its cash-rich central government to fund its infrastructure needs, is turning to project finance, it is likely most ASEAN countries will continue to rely heavily on private capital markets to fund future development. As East Asian markets continue to recover from the events of 1997, the use of project finance techniques to finance infrastructure will almost certainly increase, but will likely be somewhat different from those that offshore investors were accustomed to in the mid-1990s. As one project finance commentator noted in an issue of Euromoney, “the fundamental problem with project finance in Asia is the huge leap of faith required by banks in a market which may operate in very different ways”. Governments in the region can do much to close the gap by addressing these fundamental issues stemming from the economic events of 1997 and thus ease the way for the use of project financing in the future.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at 176 Khalili Khalil < http://bookshop.iseas.edu.sg >

6

Developing the Role of Venture Capital in Southeast Asia Khalili Khalil

1. Introduction

The development of the venture capital (VC) industry in Southeast Asia is at various stages: from the quite mature stage of Singapore, to the developing stage of Malaysia, Thailand, and some others countries in the region. In addressing this topic, the chapter primarily examines the Malaysian experience of venture capital, as well as referring to some elements of Singapore’s world-class experience. Malaysia was chosen because of the author’s knowledge of the VC industry in this country, whilst Singapore provides an advanced benchmark. However, Malaysia offers a more appropriate case study for most of the other countries in Southeast Asia, and many of the comments made about Malaysia’s VC industry are equally pertinent to Indonesia, the Philippines, and Thailand. The development of Malaysia’s VC industry has been one of slow

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growth, although there has been no lack of funds or target companies. With a total fund size of RM1 billion (about US$265 million), the industry lags significantly behind Singapore’s US$5 billion (1999 figures), despite the fact that both industries started at around the same time. A wide range of factors, such as restrictive investment criteria, entrepreneurs’ attitudes to venture capital, poorly communicated business plans and low public awareness, have all been offered as causes of the lethargic Malaysian VC industry. 2. Achieving a Self-Reinforcing Cycle of Economic Prosperity: New Growth Theory, K-Economy, and Venture Capital

In 1986, Stanford economist Paul Romer developed the New Growth Theory in an attempt to explain the causes of long-term economic growth; a situation which traditional economics had difficulty explaining (Romer 1986, 1990). The cornerstone of the New Growth Theory is the premise that economic growth does not just happen. Rather, it is driven by the accumulation of knowledge, which in turn encourages technical advancement. New Growth theorists regarded investment in technological advancement as very crucial in sustaining long-term growth, because it creates a non-competitive (and hence, monopolistic) platform from which a country can leapfrog in terms of productivity and efficiency. With the help of the economic multiplier, a technological paradigm shift could raise economic growth permanently when commercialized via a process widely known as “innovation” (Aghion 1998; OECD 1996a, 1996b; World Bank 1999). A recent comparative study on the highly successful San Francisco Bay Area/Silicon Valley has shown that the benefits of technological progress tend to put an economy into a self-reinforcing cycle of economic prosperity (Figure 6.1). Venture capital is shown to be an important element in this cycle, as one of the components that will promote outstanding business performance. The ideas behind the knowledge economy (k-economy) are not new, and are based on the model advocated by the New Growth Theory. Similarly, the knowledge economy model is based on the proposition that knowledge generation and technological advancements will achieve greater and sustainable economic growth. When technology is

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Figure 6.1 Self-Reinforcing Cycle of Economic Prosperity: The Bay Area Experience

• Outstanding graduate

• High per capita income • Favourable distribution of income • Positive resident perceptions • Vibrant cultural environment

WEALTH CREATING INFRASTRUCTURE AND ENVIRONMENT

HIGH QUALITY OF LIFE

and research programs

• Strong research productivity

• High private sector SUSTAINED ECONOMIC PROSPERITY AND HIGH PER CAPITA GDP GROWTH

investment

• Highly educated workforce

OUTSTANDING BUSINESS PERFORMANCE

• Extremely strong shareholder returns • Large venture capital flows • Robust employment growth over comparative regions

Source: Adapted from Barry et al. (1999, p. 9).

commercialized — innovation — it creates a non-competitive platform from which a country can enjoy permanent growth. Technological breakthroughs are achieved through research and development (R&D) that are costly and long term. Therefore the ability to obtain long-term risk-bearing capital, or venture capital, for successful commercialization is critical. So, what is venture capital? VC financing is the provision of longterm risk-bearing capital, usually in the form of equity participation, to companies with high-growth potential. In the Silicon Valley experience, VC financing has spewed forth a whole plethora of success stories, from IBM to Intel to Apple. According to data supplied by Venture Economics Information Services (1998), there were 616 venture-backed initial public offerings (IPOs) on the NASDAQ between 1989 and 1997. Venture capital is a necessary component in financing and spurring innovation and thus, technological progress for the following reasons: •

Innovation comes with uncertainty (Levy 1998). It is the paradox of innovative companies that the very essence of being on the frontier

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•

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of a pioneering technological breakthrough comes with severely limited subject familiarity. These essentially block any prospect of obtaining traditional sources of bank funding. Companies targeted by venture capitalists are predominantly smaller and younger in their early stage, when new products or services are being developed. Again, the risks inherent in this early stage of the corporate life-cycle make them generally unacceptable customers to traditional commercial lending institutions. Venture capital target firms normally do not possess collateral, which is often required by traditional credit providers, nor the track record of an established company. Given the early stage of their development, these companies would rarely have attained a breakeven situation, nor the size that would make them suitable for direct investments by larger corporations.

All these special characteristics call for equally special financing arrangements, whereby relatively higher risk-taking is encouraged through equity-related arrangements that allow for exceptionally favourable participation outcomes (that is, high risk and high returns). It is basically the demand for this form of financing which venture capital attempts to satisfy. 2.1. The History of Venture Capital Financing in Malaysia

The first VC fund in Malaysia was set up in 1984, when Arab Malaysian Berhad (AMMB) and South East Asia Ventures of Singapore (SEAVI) formed Malaysian Ventures Berhad, with an initial fund size of RM13.8 million. In 1990 the government liberalized regulations for venture capital companies (VCCs) by allowing companies investing up to a maximum 75 per cent in high-technology and risky projects to qualify for tax holidays or pioneer status. By that time, there were six VCCs managing total funds worth RM92.8 million. By 1992, the number of VCCs had doubled to twelve, and the total fund size had grown significantly, to RM350.3 million, with the setting up of the Malaysian Technology Development Corporation (MTDC). As at end 1998, a Bank Negara Report (1999) indicated that there was a total of twenty-three active VCCs in the country, which had funded 246 investee companies, with total funds mobilized at just over RM1 billion, and total investments of RM952.1 million.

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2.1.1. The Malaysian Technology Development Corporation The Malaysian Technology Development Corporation Sdn Bhd (MTDC) was established by the government of Malaysia in March 1992. MTDC commenced operations in October of the same year. It is jointly owned by the Malaysian government (22.1 per cent) and sixteen large Malaysian corporations (77.9 per cent). The objectives of MTDC are two-pronged: •

•

To commercialize technological research from universities and research institutions in order to develop indigenous technology and facilitate technology transfer to the private sector. To encourage the growth of technology-based companies through the provision of venture capital and management consultancy services. MTDC is also responsible for introducing new technological processes to industries by forming strategic alliances with leading global technology companies.

As at end 1998, MTDC’s total assets were close to RM1 billion. In addition, it had successfully established three world-class universityaffiliated incubators and a Science Park. As at the end of January 2000, approximately fifty-five Malaysian companies had benefited from its Technology Acquisition Fund, thirty-five from its Commercialization of R&D Fund, and another thirty-six young companies were enjoying the incubator facilities at its three locations. MTDC has also recently launched a fund for women entrepreneurs and there have been six recipients thus far. 3. Issues Confronting the Venture Capital Industry in Malaysia

There have been very few research studies undertaken on the VC industry in Malaysia. Among the handful construed as having provided such pioneering work are Chia and Wong (1989), whose work focused on the VC industry in Singapore, and Aylward (1998), who studied the trends in VC financing for developing countries. Some of the issues considered most important to VCCs and the VC industry as a whole in Malaysia are discussed below. There are eight issues Malaysian VCCs

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felt were most important, and another two were obtained as feedback from the ASEAN Roundtable held in October 2001 in Singapore. 3.1. Eight Issues Most Important to VCCs

In our study, eight issues were identified as being the most important to Malaysian VCCs: investment philosophy/criteria of VCCs; government policies and incentives; attitudes of entrepreneurs towards VC financing; difficulty in deal structuring; low level of public awareness; availability and accessibility of exit mechanisms; poorly written business plans; and availability and accessibility to informal venture capital.

3.1.1. Investment Philosophy/Criteria of VCCs Examples of restrictive criteria with which venture capitalists have to evaluate proposals include: •

•

•

•

High hurdle rates. This criterion was more prevalent in VCCs that depended on bank financing or had a high cost of funds. For example, a common investment policy may require that the management give a verbal undertaking that the target companies can be listed over the next three to five years. This essentially meant that such a VC fund would only invest in companies either in the expansion or later stages of development. The target company’s new products must demonstrate market acceptance. This implied that such target companies were at least in the early stages of expansion, that is, first round financing. The target company must be able to furnish at least three years’ projected profit and loss, or cashflow, in its business plan. While this appeared to be a sound and reasonable request, the dilemma of most innovative companies is that the potential impact for their product may be too distant to assess (hidden usefulness) or difficult to conceptualize. Indeed, even giants like IBM initially failed to see the potential of the personal computer in every home. Management of the target company must have a relevant track record. This meant that several of today’s innovative companies set up by young entrepreneurs may not qualify. This is an important criteria that must be addressed, as there is a trend of Internet startups managed by young “Netpreneurs” in their mid-twenties.

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Table 6.1 Malaysian VCCs’ and Asian VCCs’ Perspectives Compared

Criteria

Mean Rating Tidd’s Findings from this Based on Ratings Study by Asian VCCs

Entrepreneur able to evaluate and react to risk Entrepreneur capable of sustained effort Entrepreneur familiar with market Entrepreneur demonstrated leadership ability* Entrepreneur has relevant track record* Product prototype exists and functions Product demonstrated market acceptance Product proprietary or can be protected* Product is “high technology” Target market has high growth rate Venture will stimulate an existing market Little threat of competition within three years Venture will create a new market Financial return >10 × within 10 years Investment is easily made liquid (i.e. via IPO or acquisition) Financial return >10 × within 5 years

4.0 3.7 4.0 2.0 4.0 3.0 2.0 2.0 1.0 3.3 2.0 2.0 2.0 3.3 3.0

3.5 3.7 3.6 3.0 2.9 2.9 2.8 2.6 1.4 3.2 2.5 2.4 2.2 2.9 2.7

2.3

2.1

Ratings: 1 = Irrelevant; 2 = Desirable; 3 = Important; 4 = Essential. * Denotes a difference of more than 0.5 level between the two ratings. Source: Adapted by Tidd, Bessant, and Pavitt, based on the framework in Khalil and Bayraktar (1998, pp. 574–83).

To put the above findings in another context, a comparison was done between the Malaysian VCCs’ perspective versus Asian VCCs’ perspectives. The results are shown in Table 6.1. From the comparison above, it is evident that the mean ratings of Asian VCCs did not differ significantly from Malaysian VCCs, with the exception of the following, which differed by more than 0.5 in mean ratings: •

•

Malaysian VCCs rated the entrepreneur’s demonstrated leadership abilities as being “desirable”, whereas Asian VCCs surveyed by Tidd ranked this criterion as being “important”. Malaysian VCCs rated entrepreneurs’ track record as “essential”, against Tidd’s findings which was rated as “rather important” (mean rating: 2.9).

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In addition, Malaysian VCCs were not so concerned about the ability to protect or patent the product, and hence rated this criterion as “desirable”. On the other hand, Asian VCCs in Tidd’s survey rated this as “quite important” (mean rating of 2.6).

3.1.2. Government Policies and Incentives Sagari and Guidotti (1992) have asserted that pro-active government polices and regulations are crucial factors in promoting growth in the VC industry. In Singapore, Chia and Wong noted that various generous tax incentives, loans and grants for small to medium-sized industries, and aggressive infrastructure development provided a major impetus for the growth of VC financing in Singapore after 1986. Similarly, the liberalization of investment guidelines by pension funds in the United States saw a significant mobilization of funds to the VC industry from 1983 onwards. In Malaysia the main problem cited from interviews with VCCs pertained to the lack of government tax incentives that would help stimulate various fund pools — for example, employees provident fund (EPF), pension funds, mutual funds, cash-rich corporations and high net-worth individuals — to invest their money in VC funds. 3.1.3. Attitudes of Entrepreneurs towards Venture Capital Financing What do entrepreneurs expect from venture capitalists? An important point that is often overlooked by venture capitalist and target companies alike is the chemistry in the investor-investee relationship. In a survey conducted by Bovaird (1990) on ninety-three investee firms in the United Kingdom, it was shown that to an entrepreneur, commitment, patience, and trust were notable hallmarks of a venture capitalist, as opposed to the commonly cherished attributes of track record, financial strength, efficiency, and reputation. Another factor that does not particularly endear a venture capitalist to an entrepreneur is the high rates of return required by the venture capitalist. According to Sahlman (1994), it is usual for venture capitalists to demand a return in excess of 30 per cent per year. Failing this, the entrepreneur is contractually bound to either buy back a portion of the venture capitalist’s stake in the company, or address the shortfall by issuing more shares to the venture capitalist. Apart from buy-back guarantees, anti-dilutive clauses are also common in VC financing agreements. These clauses limit the investee

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company’s ability to raise more funds via additional share issues. It is thus hardly surprising that venture capitalists are also popularly known as “vulture capitalist”. The following examples of how entrepreneur attitudes towards venture capital could affect the VCCs were derived from interviews with Malaysian VCCs: • •

•

Entrepreneurs were reluctant to give up a significant stake (defined as being greater than 20 per cent), and hence control, to an outsider. Malaysian entrepreneurs generally could not resist the temptation to “shop around”. Hence, it is usual for entrepreneurs to be talking to more than one VCC at any one time, particularly after a first VCC has shown willingness to give the business plan a second look. Entrepreneurs did not appreciate the fact that apart from providing financing, VCCs could also be a source of value-added professional advice. Thus, VCCs were sometimes seen as “greedy bankers”.

Conflict of interests can also arise when the incentives and compensation of the VC managers get in the way of giving good advice to investee companies (Grompers 1995). This is likely to occur when sound long-term strategic advantages, such as plant modernization or downstream diversification plans, are sacrificed for short-term quick fixes, and thus a good year-end bonus for the venture fund manager.

3.1.4. Difficulty in Deal Structuring The ability to successfully structure a mutually beneficial deal is vital in the VC process. This is because the working relationship, and ultimately the success of the investee company, is more likely to remain intact or enhanced if venture capitalist and entrepreneur both believe that a winwin situation exists. However, this can be scuttled by the lack of, or limited availability of, relevant industry information inherent for new, innovative processes or products. This may in turn affect the valuation of the target company, and hence pricing (Sagari and Guidotti 1992). Thus, such difficulty in deal structure can affect the growth of VC financing, as VCCs prefer to avoid companies on the cutting-edge of technology and concentrate instead on financing more established, lowrisk industries. This is indeed a paradox in venture capital, as the very

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essence of being on the frontier of pioneering innovation normally goes hand-in-hand with limited subject familiarity. In Malaysia, some of the factors that were said to make deal structuring difficult were mainly linked to the ability to value, and hence price, the target companies efficiently. A lack of information on the industry was the most cited problem. Other less major problems were product novelty, and difficulty in assessing market acceptance. This is because potential users may have latent needs or requirements that they cannot articulate. This essentially meant that VCCs tend to shy away from investing in “seed” or “startup” companies, particularly the ones operating in high-technology areas.

3.1.5. Low Level of Public Awareness Low awareness was one of the major factors highlighted by Malaysia’s Ministry of International Trade and Industry and Malaysian Technology Development Corporation. In fact, the problem seems to be not so much a lack of awareness per se ; but rather a lack of understanding as to what venture capital really is. Findings from a recent survey showed that whilst 100 per cent of respondents had heard of the term venture capital, only 40 per cent were able to give a reasonably accurate description of VC financing. 3.1.6. Availability and Accessibility of Exit Mechanisms The ability to divest, or sell-out, its stake in an investee company is an important criterion for VCCs (Venture Capital Journal, Fall 1998). Hence, one of the factors that can affect the growth of the VC industry is the availability and accessibility to such exit mechanisms. In Malaysia, the official stock exchange for the listing of VCCs is Malaysian Exchange of Securities Dealing and Automatic Quotation, or MESDAQ. MESDAQ commenced operations in April 1999, with its maiden — and only IPO to date — of Supercomal Berhad. Prior to the setting up of MESDAQ, Malaysian VCCs generally divested by (a) listing eligible investee companies on the Kuala Lumpur Stock Exchange, or (b) selling-out to other interested third-parties, or (c) selling back the stake to the entrepreneur owners or major shareholders of the investee company (a share buy-back). Interestingly, a study by Lin and Smith (1998) have shown that an

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initial public offering or stockmarket listing is seldom the final exit point for VCCs. This is supported by the data from Venture Economics, which showed that approximately 85 per cent of U.S. VCCs continue to remain invested in companies after the latter has been listed on the NASDAQ. Hence, it is conceivable that the easy accessibility to an official stock exchange is partly regarded by VCCs as more of a provider of investment comfort than an actual exit mechanism.

3.1.7. Poorly Written Business Plans To venture capitalists, business plans represent a snapshot of a prospect. This is an important point, because the business plan is normally the first formal contact between a company and the venture capitalist. Accordingly, a poorly written business plan is not likely to incite or induce any further interest, particularly if the entrepreneur is “coldcalling” (that is, the venture capitalist and the entrepreneur do not know each other). According to Aylward, an average of only two out of every ten business plans submitted are appraised in detail. And among the major factors cited for such a high average drop rate — the ratio of approvals to investments — is poorly written or presented business plans. Nonetheless, an important observation that was made by several venture capitalists, on business plans from target companies, was that it was common for Malaysian companies seeking venture capital to have their business plans written by their professional advisers. Whilst this would certainly provide the business plan with a professional finish, it may lack the enthusiasm and passion for the product that only an entrepreneur writing the plan could project. This is most important for start-ups looking for venture capital to finance a new, untested product or service. 3.1.8. Availability and Accessibility to Informal Venture Capital Informal venture capital commonly comes in the form of borrowings from immediate family, relatives, and friends to set up a business. Whilst there is a limit to the amount or the number of times that one can borrow from friends and relatives, informal venture capital can pose serious competition to the formal markets, especially if these sources represent comparably large amounts. Such large sources of informal

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venture capital are generally provided by “angel investors”. In venture capital jargon, “angel investors” are high net-worth individuals or private groups who invest in a company without taking on the consulting role of venture capitalists (Harrison and Mason 1996). According to Barry (1990), informal venture capital is often more important than formal markets in developing countries. This trend tends to be more pronounced in young, emerging market economies. From interviews conducted in Malaysia, venture capitalists attributed the lack of participation from informal venture capital to there being no organized network of “business angels” in the country, unlike in the United Kingdom and the United States. Thus, the sources of informal venture capital tended to come from savings of parents, relatives, spouse, and close friends.

3.1.9. Two Additional “Growth Inhibitors” for the VC Industry Firstly, is a stock market a prerequisite for the establishment and development of the VC industry in Malaysia and other countries in Southeast Asia? The relatively recent history of the VC industry and the paucity of research work in this area makes it difficult to conclusively answer this question. Undoubtedly the performance of the stock market greatly affects VC liquidity. This could be seen in the United States in 1983, 1986, and again in 1998, with the boom periods, as well as the crashes of 1988/89 and 2001. VC activity reflected these situations in the stock market, with corresponding bursts of start-ups and IPO activities during stock market boom periods, and conversely the closure of start-ups and falls in IPO numbers during crash periods. As a result of the volatility of U.S. stock markets, the VC industry in the United States has been able to adapt itself to this reality, and evolved new exit strategies. These have included exits in the form of acquisitions by private and public companies. In fact, private and public acquisitions outpaced IPOs from 1984 to 1990 (Venture Capital Journal, May 1990 and May 1991). Foreign investors from Japan, Germany, and Britain provided the major source of exits for U.S. venture capitalists. But acquisitions are only one form of alternative exit to the traditional IPO. A 1992 study found the following types of exits, and their frequencies, in a sample of 442 investments from 1970 to 1982 (see Table 6.2). In summary, therefore, the setting up of a stock market is

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Table 6.2 Types of Exit by Venture Capitalists (U.S. Study) (Percentages) Type of Exit Initial public offerings Acquisitions Company buybacks Secondary sales Liquidations Write-offs

Frequency 30 26 6 9 6 26

Sources: Bygrave and Timmons (1992).

not an essential pre-requisite for a VC industry. Secondly, are the characteristics of the family-based firm an additional key constraint to the development of an efficient VC industry, or more broadly, is Southeast Asian business culture at odds with VC development? The issue here is the unwillingness of many family-based companies to share ownership, for fear of losing power and control over their operations. Yet VC funding necessitates giving up a certain amount of control of the firm. However, almost by definition, VC funds tend to focus on high-tech and high-risk start-up ventures, and high-tech and high-risk start-ups generally do not fit the description of family-based Asian businesses. That being the case, it is unlikely that the two — family-based businesses and VCs — will often cross paths. However, the issue of unwillingness of entrepreneurs to give up a percentage of their ownership of a company is real. Entrepreneurs tend to look for commitment, patience, and trust as key attributes in VCCs; and not track record, financial strength, efficiency, and reputation. 4. Addressing the Growth Inhibitors

Focusing on the top three growth inhibitors, let us now examine ways in which they might be overcome. 4.1. Restrictive VCC Investment Criteria

By comparing what VCCs regarded as restrictive in their investment policies and what they regarded as important attributes in assessing

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investment criteria, it can be observed that in both cases, the VCC’s preference for risk-aversion was prevalent. Hence, making the investment criteria less restrictive may only answer part of the problem. Instead, VCC’s may have to change their mindset, and make more of an effort to learn and understand the innovation process, as well as the broader technology and business issues and developments. Some of the ways in which this could be done include: •

•

•

Encouraging VCCs to attend intensive training courses involving technology management. A number of universities in Singapore and Malaysia, such as the National University of Singapore and Universiti Teknologi Malaysia already offer such courses. Recruiting analysts who are conversant and comfortable in dealing with high technology. VCCs could also recruit “knowledge workers” from the IT industry as part of their investment teams. Start thinking in terms of innovation. In addition to the due-diligence checklist, greater use of the Innovation Audit, which has been developed by the Department of Trade and Industry (United Kingdom), might be of utility.

4.2. The Lack of Government Incentives

In one survey, government policies and incentives were ranked by Malaysian VCCs as the second most important factor inhibiting growth. Some incentives relevant to the industry might include the following: •

• •

Encourage other fund pools, such as pension funds, insurance funds and mutual funds, to invest either in managed VC funds or as direct investments in private equity; Grant tax holidays, double deductions, lower tax rates for VCCs, particularly those involved in early stage financing Changes in bankruptcy laws that allow innovative companies to fail. Presently, the rigid bankruptcy laws and the risk-averse VC industry has meant there is no incentive for inventors to go out on a limb and innovate.

The Venture Capital Association of each Southeast Asian country could study the prevailing VC industry-related incentives in the United States and Singapore, and look for ways to recommend the similar measures at

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home. In their book, Chia and Wong attributed the significant leap in the VC growth in the United States and Singapore to the various generous incentives provided by the government in 1983 and 1986 respectively. On the other side of the coin, are government policies prone to over-protect the VC industry? This writer believes that the issue here is not “over-protection” per se, but rather “intervention” which some may perceive as excessive (although this tends to depend on which aspect one is looking at). If we were to look at this issue from the aspect of national economic development, we may see the rationale behind government involvement in this area. We may also see that the concern of the government is not, in the final analysis, a thriving VC industry. Rather, a healthy VC industry is just a means to an end. The true objective is economic development through technology development. This point has been emphasized in connection with the k-economy, in the first part of this chapter, where knowledge generation and technological advancements are expected to achieve greater and sustainable economic growth. Getting technology development funded is a problem. Traditional financial institutions shy away from funding technology startups because of its complexity, the long wait for returns and difficulties in evaluating intellectual properties. In the circumstances government like Singapore and Malaysia have taken the initiative in the form of a number of actions that will encourage a strong VC industry. When the government appears to be supporting the VC industry, it is not actually making a specific initiative for the VC industry. Rather, the bigger picture is the government supports high-tech entrepreneurship. Bygrave and Timmons (1992) make a very strong case for the government role: [The government] plays many crucial roles in high-tech entrepreneurship. It funds research and development in university and government laboratories; it is a customer; it supports education; it passes laws that fosters entrepreneurship.

In the case of Malaysia, there is a lack of government incentives, and the lowering of capital gains tax would be welcomed. Other government initiatives might include: tax support for R&D venture incubators, more research grants, strengthening of intellectual property laws, and revision of the country’s bankruptcy laws.

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4.3. Attitudes of Entrepreneurs towards Venture Capital Financing It has been suggested that this problem may only be confined to entrepreneurs seeking venture capital for the first time. It could therefore be argued that VCCs could allay such concerns, particularly on the concept of exchanging equity for cash, by the following two measures. First, hosting informal meetings, whereby entrepreneurs who are already enjoying the backing of VCCs are invited to talk to other entrepreneurs who are seeking venture capital for the first time. Secondly, explaining the concept of venture capital in simple terms. It can be quite frightening for an entrepreneur to learn that in return for VC funding, he or she has to issue a “convertible, redeemable loan stock with a put option exercisable at a mutually agreed price” to the venture capitalist. 4.4. Other Factors That VCCs Consider Are Growth-Inhibiting In a recent Malaysian study, VCC respondents brought up two other factors that they felt were slowing down the growth of the VC industry. First, the difficulties of attracting talent. This was a recurring theme, regardless of the stage of VCC industry development in the world (IFC Report 1998). In Malaysia, VCCs not only had to be contented with a limited pool of experienced analysts who were conversant with venture capital, but the industry had to compete with the stockbroking industry for talent. A frustrating point for VCCs was the fact that stockbroking firms were paying an investment analyst with four years working experience a monthly salary of between RM6,000 and RM8,000, whereas those with VCCs were generally paid between RM3,500 and RM5,000 per month. Whilst it may be difficult to compete head-on with stockbrokers in terms of pay, VCCs can attract talent by (a) giving share options in the venture fund, (b) giving share options in a specified investee company, or (c) by successful branding. On this score, VCCs might seek to adapt the “McKinsey Professional Services Model” in generating a self-reinforcing cycle of attracting talent. Secondly, encouraging the diffusion of innovation. VCCs in Malaysia stated that access to specific information, especially on the latest technology, was vital in evaluating target companies. Yet there is currently no centralized information databank for key innovations where VCCs can verify or benchmark the “newness” of products.

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

Innovative companies are by definition, riskier.

VCCs need to review investment criteria to accept higher risks or to contain riskier investments so as not to affect their overall performance. VCCs have to learn and understand the innovation process well as the broader technology and business issues and developments.

Possible implications for investment policies of Malaysian VCCs

Innovation Uncertainty Factor

Key differences between companies in the k-economy and traditional economy

Critical Success Factor

VCCs may find this to be very different from people management in the past when technical skills rather than creativity were emphasized. VCCs may have to evaluate target companies on criteria other than the relevant track record of the entrepreneurs.

Managing creativity in highly skilled knowledge workers is an important factor in a k-economy.

Human Factor

VCCs must be able to cope with the “insecurity” that knowledge in an innovative firm rests in the minds of a few who must be continually motivated. VCCs may have to play a more active role in managing the organization and reward structure of investee companies as they move from one stage to another.

In a k-economy learning most often comes while doing; the knowledge of an organization tends to be tacit in nature.

Organization Factor Management Competence Factor

In a k-economy, the VCC may not be able to depend on past experiences in problem-solving. VCCs may have to ensure and invest on continuous learning.

Problems in innovative firms tend to be conceptual in nature, for example, generating revenue from Net portals which customers expect for free.

Table 6.3 Critical Success Factors for VCCs in the K-Economy

VCCs may have to change their investment policies to take on a more active role as champions and ensure complete ownership of an innovation. They may also need to invest in startups early so as to remain competitive.

Innovative companies need to change constantly: to anticipate and create future uses for their innovations to remain competitive.

Know-How and Know-Why Factor

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5. Conclusion: The Future 5.1. Challenges for VCCs in the K-Economy

The business model in the k-economy is likely to be radically different from the one VCCs are familiar with (OECD 1996a, 1996b). This means that VCCs would benefit greatly from ideas that address VCCs’ management of investee companies and assessment of target companies in a k-economy environment. To analyse the implications of the new economic environment there is a need for a comprehensive framework. This was found in Levy’s “5 Critical Success Factors” that he used to address similar issues; namely, the successful management of innovation in the future. The analysis is summarized in Table 6.3. 5.2. Impact of the Internet on the Landscape of Venture Capital Industry

The advent of the Internet can be seen as both a boon and a bane for VCCs. With the Internet, VCCs are able to access information quicker, cheaper, and easier. For example, they are able to obtain the latest information on a new technology, or new valuation method for internet business models, or new ways of doing business. These could potentially alleviate the problems of information gathering for the purpose of deal structuring. But the benefits of the Internet can also work the other way: target companies seeking venture capital could potentially bypass risk-averse local VCC players in search of international VC suppliers who are more risk-tolerant. This could radically change the landscape for the VC industry. International VCCs can also seek indigenous target companies without the need to be physically in that particular country. Another potential competitor to the local VCCs are foreign internet companies themselves. Such companies are likely to set their sights on local target companies, once the subscription boom in their home markets start to flag. REFERENCES Aghion, Philippe et al. Endogeneous Growth Theory. Cambridge, M.A.: MIT Press, 1998. Aylward, A. “Trends in Venture Capital Finance in Developing Countries”. IFC Discussion Paper (Washington), no. 36, 1998. Bank Negara Report. Kuala Lumpur: Ministry of Finance, 1996, 1999.

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Barry, C.B. et al. “The Role of Venture Capital in the Creation of Public Companies: Evidence from the Going Public Process”. Journal of Financial Economics, October 1990. Bay Area Council. The Bay Area: Winning in the New Global Economy – A Profile of Comparative Economic Performance. The Bay Area Economic Forum Publications, San Francisco, 1999. Bovaird, C. Introduction to Venture Capital Finance. London: Pitman Publishing, 1990. Bygrave, W.D. and J.A. Timmons. Venture Capital at the Crossroads. Boston: Harvard Business School, 1992. Chia, R., and K.C. Wong. Venture Capital in the Asia Pacific Region, with Specific Reference to Singapore. Singapore: Toppan, 1989. Grompers, P.A. “Optimal Investment, Monitoring and Staging of Venture Capital”. Journal of Finance, December 1994. Harrison, R. and C. Mason, eds. Informal Venture Capital: Evaluating the Impact of Business Introduction Services. United Kingdom: Woodhead-Faulkner, 1996. Khalil, T.M. and B.A. Bayraktar, eds. Management of Technology III: The Key to Global Competitiveness. Georgia: Industrial Engineering and Management Press, 1998. Levy, N. Managing High Technology and Innovation. New Jersey: Prentice Hall, 1998. Lin, T.H. and R.L. Smith. “The Unwinding of Venture Capital Investments: Insider Selling during Equity IPOs”. Journal of Corporate Finance 4 (1998): 241–63. Organization for Economic Co-operation and Development (OECD). The Knowledge Economy: Science, Technology and Industry Outlook. Paris: OECD, 1996a. . Venture Capital and Innovation. Paris: OECD, 1996b. Romer, Paul. “Increasing Returns and Long-Run Growth”. Journal of Political Economy 94, no. 5 (1986): 1002–37. . “Endogenous Technological Change”. Journal of Political Economy 98, no. 5 (1990): 71–102. Sagari, S. and G. Guidotti. “Venture Capital: Lessons from the Developed World for the Developing Markets”. IFC Discussion Paper (Washington), no. 13 (1992). Sahlman, W. “Insights from the Venture Capital Model of Project Governance”. Business Economics 29, no. 3 (July 1994). “Venture Capital Secondaries Hold Steady”. Venture Capital Journal 38, no. 9 (Fall 1998). Venture Economics Information Services. Report on Venture-Backed IPO on Nasdaq. 1998. World Bank. World Development Report 1998/99: Knowledge for Development. Washington, D.C.: World Bank, 1999.

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Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > 195 7. Reviving Foreign Direct Investment Inflows in Southeast Asia

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Reviving Foreign Direct Investment Inflows in Southeast Asia Hafiz Mirza

East Asia, including Southeast Asia, emerged as the primary success story, albeit nuanced, of the later part of the last century. Rapid rates of growth — in country after country, from Singapore and Malaysia to Korea and China — have led to vast numbers of people (the most ever in a single period of history) being lifted out of poverty. Table 7.1 shows that some of these economies — Hong Kong, Singapore, South Korea, and Taiwan — have grown so fast that their per capita incomes have converged towards those of the existing “advanced economies”. In a recent reclassification of world economies, these regional countries have recently been incorporated into the advanced economies group by the Bretton Woods institutions, and are now referred to as newly industrialized Asian economies (NIAEs). Moreover, it is also clear from the table that other Asian economies — notably much

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Table 7.1 Growth in Real GDP per Capita, 1982–2001 (Percentage Change) Ten-Year Averages 1982–91

1992–2001a

Advanced economies Newly industrialized Asian economies (NIAEs)b

2.5 6.9

2.2 4.5

Developing economies Asiac

2.0 5.0

3.8 6.0

Analytical Group

a

Estimated. Hong Kong SAR, South Korea, Singapore, and Taiwan. c East and South Asia. b

Source: International Monetary Fund, World Economic Outlook (May 2001).

of Southeast Asia and China — have also been enjoying rapid rates of growth. Sometimes this growth has outstripped even that of the NIAEs; and certainly it has been more rapid (despite a few recent blips) than the average of other developing countries or advanced economies. Many factors can be adduced to explain this historically unprecedented economic expansion of an entire region, ranging from the common (such as the role of the developmental state in most economies, and the intra-regional networks of Chinese and other capitalists) to the more context-specific (such as the locations of Singapore and Hong Kong in relation to their respective Southeast Asian and Chinese hinterlands). Most importantly, perhaps, East Asia, especially Southeast Asia, was “ready and willing” when the world economic crisis of the 1970s induced the irruption of Japanese and Western transnational corporations (TNCs) into the developing countries. Initially, many of these TNCs were seeking cheap labour, but increasingly, especially in Southeast Asia, they found skilled human resources, large national and regional markets, the opportunities inherent in infrastructural development, and a range of other inducements. Table 7.2 indicates the scale of foreign direct investment (FDI) by TNCs in East Asia. Although as a determinant of “globalization”, FDI has generally grown more rapidly than trade and most other international capital flows over the last decade,

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

9

61

7

71

155,552

4,252 1,667

55,588 14,135 13,413 5,864 9,735

95,712 26 38,883 14 14,117 173 2,098 32,355 7,980 66 Neg.

1990

47

13

360,478

10,088 4,528

180,462 128,959 21,769 10,478 15,736

169,848 62 50,755 206 38,453 937 6,852 55,491 16,775 397 307

1995

Source: UNCTAD, World Investment Report (1996, 2000, 2001).

East Asia’s share of world total (%) Southeast Asia’s share of FDI in East and South Asia (%)

35,518

2,178 1,177

South Asia India

Total

8,098 — 1,729 1,140 2,405

25,242 19 10,724 2 6,078 5 1,225 6,203 981 7 Neg.

ASEAN Brunei Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam Cambodia

Other East Asia China Hong Kong South Korea Taiwan

1980

Region/Country

Accumulated Stock

30

20

93,518

4,759 3,577

61,112 44,236 11,368 3,088 2,248

27,647 5 4,677 86 6,513 387 1,249 8,085 3,732 2,745 168

1997

22

12

87,158

2,877 2,635

64,786 43,751 14,776 5,215 222

19,495 4 −356 45 2,700 315 1,752 5,493 7,449 1,972 121

1998

17

11

96,148

3,043 2,168

76,916 40,400 23,068 10,349 2,926

16,189 5 −3,270 79 3,532 300 737 6,984 6,078 1,609 135

1999

Annual Inflow

10

11

137,348

3,037 2,315

120,427 40,772 60,448 10,186 4,928

13,884 19 −4,550 72 5,542 240 1,489 6,390 2,448 2,081 153

2000

Table 7.2 Inward Foreign Direct Investment in South and East Asia, 1980–99 (US$ Millions)

23

19

1,183,952

33,170 18,971

884,218 346,694 469,776 42,389 24,165

266,564 n.a. 60,638 659 54,315 2,408 12,688 89,250 27,924 17,956 758

Stock 2000

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its expansion in Asia was even more rapid. In consequence, Asia’s share of world stocks of FDI rose from 7 per cent in 1980, to 13 per cent in 1995, to nearly 20 per cent just after the Asian crisis (investment into China and Hong Kong continued to grow). Since then, the proportion of annual world FDI going to Asia has reduced, as Table 7.2 shows. Although in some years the absolute level of FDI flows to Asia may have been up (it varies by economy), proportionally the amount of FDI in developing countries (and hence Asia) has declined (UNCTAD 2001). The situation is far worse for Southeast Asia: total FDI inflows into the region have declined markedly over the last four years, from US$27.7 billion in 1997, through US$19.4 billion in 1998 and US$16.6 billion in 1999, to only US$10.7 billion in 2001. Although, a large part of the overall decline can be explained by divestments from a small number of economies in the region, primarily Indonesia (ibid.), it is nevertheless a grim fact that a region which was once the premier developing recipient of FDI now receives barely 10 per cent of total FDI destined for East Asia (Table 7.2). The situation for Southeast Asia looks grimmer if a “competitor analysis” is conducted. Table 7.3 shows that the Southeast Asian “ascendancy” of the 1980s has increasingly been overtaken by the (re-)arrival of China, Brazil, and Mexico — among others — on the scene, as well as a very large number of potential competitors among the developing and emerging economies. One particular area of concern is that major past investors have been reducing their absolute and proportional investment in Southeast Asia in recent years. For example, Table 7.4 shows that Japan was not one of Southeast Asia’s top ten investing economies in the year 2000 — an extraordinary turnaround from the 1980s and 1990s, albeit probably a temporary one. A number of “obvious” reasons for the recent decline of FDI in Southeast Asia, both proportionally and in absolute amounts, can be suggested, including shifting technological/trade patterns, the burgeoning lure of China, the liberalization of other emerging economies, and the dampening effect of the Asian crisis. However, this chapter will try to focus on longer-term issues, particularly in the context of three pieces of research conducted by the author and colleagues since 1995. Focusing on longer-term issues allows us to glean fundamental factors at work in

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

17%

25%

Sources: UNCTAD, World Investment Reports; ASEAN FDI Database.

26,091

12,634

130,455

— — 0.11 — — — — 0.61

Average annual FDI to all developing countries (US$ millions) Share of FDI to developing countries as a % of global flows

— 0.01 0.13 — — — — 0.49

Potential competitors Czech Republic Hungary Poland Romania Russian Federation Slovakia Ukraine India

10.93 6.77 2.59 3.78 3.65 6.05 0.88 9.99 0.61

75,804

5.68 4.29 0.78 1.46 4.11 15.63 1.68 10.54 0.88

Existing competitors China Hong Kong Republic of Korea Taiwan Argentina Brazil Chile Mexico Venezuela

26.55

1986–90

Total FDI to all developing countries (US$ millions)

23.10

1980–85

ASEAN share of FDI to developing countries

Country

35%

87,861

527,166

1.22 2.49 2.41 0.24 1.24 0.18 0.26 1.23

29.00 5.46 1.36 1.49 4.62 4.37 2.34 8.20 1.31

20.62

1991–96

Table 7.3 Percentage of Global FDI Share of Selected Developing Countries

28%

188,630

565,889

1.61 1.09 3.32 0.74 2.17 0.20 0.33 1.48

22.69 8.70 3.29 0.95 6.79 13.89 3.37 6.06 2.22

11.20

1997–99

19%

240,000

240,000

— — — — — — — —

— — — — — — — — —

4.17

2000

7. Reviving Foreign Direct Investment Inflows in Southeast Asia 199

© 2003 Institute of Southeast Asian Studies, Singapore

Japan USA Netherlands Singapore United Kingdom Hong Kong Taiwan (ROC) South Korea (ROK) Germany France

1 2 3 4 5 6 7 8 9 10

13,400

2,826 2,759 1,790 1,443 1,166 918 842 643 547 465

Value USA Netherlands Bermuda Japan United Kingdom France Singapore Canada Hong Kong Germany

Country

1999

11,391

2,960 2,833 1,355 762 742 655 629 489 483 482

Value USA United Kingdom Bermuda Taiwan (ROC) France Germany Singapore Hong Kong Malaysia South Korea (ROK)

Country

2000

8,720

2,320 1,493 889 802 772 696 684 611 273 180

Value

Japan USA United Kingdom Singapore Netherlands Hong Kong Taiwan (ROC) Germany France South Korea (ROK)

Country

1995–2000

84,398

19,194 17,975 9,654 9,241 8,141 5,602 4,454 3,685 3,456 2,996

Value

Source: ASEAN Secretariat: ASEAN FDI Database. Data compiled from the respective ASEAN Central Banks and Central Statistical Offices. Data not available for Cambodia. Data not available for Lao PDR for the period 1995–98.

Total

Country

No.

1998

Table 7.4 Top Ten Investors in ASEAN: Balance of Payments Flow Data, 1995–2000 (US$ Millions)

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the decline of FDI to Southeast Asia, as well as suggesting ways of reviving FDI flows to the region. 1. Are Transnational Corporations Dedicated Followers or Fashion, or Are Fundamental Factors Involved?

The first of the three pieces of research referred to above was conducted primarily in 1996 and early 1997, when the issue of declining FDI trends in Southeast Asia first came to the fore. This research was a comprehensive survey (Mirza, Bartels, Hiley, and Giroud 1997), which involved about 300 companies from all the major source countries. The data collected was analysed using rigorous statistical methods, including factor analysis. It was clear that the TNCs were not simply followers of fashion (bandwagons to China notwithstanding), but more fundamental forces were involved. The results implied that Southeast Asia’s best strategy to attract nonASEAN FDI to Southeast Asia was to facilitate intra-ASEAN FDI flows. This made, and still makes, sense on a number of levels. First, Southeast Asia is a region which is having to compete with other regions and growth zones, including Mercosur, “Greater China”, and India in the developing world alone. It therefore needs to stress its critical mass as a community of closely co-operating economies, as opposed to a club of individual and individualistic nation-states. Secondly, Southeast Asia — or at least parts of Southeast Asia — is maturing, and represents a growing market to which TNCs are responding, often by taking advantage of the regional division of labour: this is a natural process and needs to be encouraged. Thirdly, as Southeast Asia matures, so do its home-grown TNCs which, apart from also pursuing a regional division of labour, are potential targets or partners for non-Southeast Asian TNCs or their subsidiaries in the region. These tendencies explain the success of the ASEAN Free Trade Area (AFTA); they still require that the ASEAN Investment Area (AIA) must provide the broad physical and commercial infrastructure within which intra-Southeast Asian trade and investment may occur. Table 7.5 shows a suggested strategic framework to encourage FDI in ASEAN, which emerged from the comprehensive survey. Five types of policies and measures were identified, ranging from general ones related to regional stability, to specific ones designed to create an enabling 1 environment. These policies could be applied at the host, intra-ASEAN

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or trans-ASEAN level, and the table suggests orders of relevance at each level. In the original report (replicated in Table 7.5) the findings were incorporated into a threefold “prioritization” of policies, indicated by the number of “pluses”. These priorities were then consolidated into a set of recommendations (other research and activities were involved), which ultimately fed into the planning for the ASEAN Investment Area at the ASEAN Secretariat. The comments in the last column in Table 7.5 refer to the current situation, and we will return to these comments below. The fieldwork for the second research study (Mirza, Giroud, and Koster 2001), on technology transfer to East Asian — including Southeast Asian — economies has only just finished and the analysis is not yet fully complete. The design of the study was posited on the recognition that most growth in such economies has since the 1980s (that is, the commencement of the so-called “Asian Miracle”) emanated from an expansion of capital — including FDI, foreign portfolio investment, international bank loans — and labour, and it is not clear to what extent Southeast Asian economies have actually improved their technological competencies (including business culture, skills, and expertise). The findings of the study underline the fact that in the growth years, many — but not all, and not entirely — Southeast Asian countries “forgot” about improving the fundamental technological base of their own companies, as well as the work-force. This feeds into the “creation of an enabling environment for FDI” in Table 7.5. But, of course, the issue is really one of an enabling environment for Southeast Asian economies and companies. TNCs can be a useful route for transferring relevant knowledge to Southeast Asian companies (and through the training of workers, they are often doing a big service), but this transfer is not automatic, and the biggest problem lies in the low absorptive capacity (that is, the ability to absorb knowledge) of Southeast Asian companies, including suppliers to TNCs. Significantly more effort should be placed into improving the absorptive capacity of local firms. The final research study has only recently commenced, and is looking at the specific mechanisms whereby FDI feeds into the reduction of poverty, especially in the regional context (in order to see how countries such as Vietnam and Cambodia can learn from the experience of older

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3

ASEAN member countries). Among the issues being assessed in the questionnaire-based survey are those initially raised in the “comprehensive survey” mentioned earlier. Thus, although the new study has yet to be completed, the initial findings, gleaned from discussions with some forty TNCs in Malaysia, Singapore, and Thailand, have allowed the updating of Table 7.5 (specifically the comments in the final column). The findings of the technology transfer survey have also been incorporated into the updating of Table 7.5. Having done this, we can now return to the issue of reviving FDI inflows in Southeast Asia. 2. Reviving FDI Inflows in Southeast Asia

The specific suggested policies for trying to revive FDI inflows in Southeast Asia are given under “comments” in Table 7.5, and relate to five broad areas: political and economic stability, trade-related measures, the reduction of restrictions to FDI in ASEAN, the creation of an enabling environment for FDI, and incentives. However, a number of contextual issues are crucial in understanding how FDI might be revived in Southeast Asia. First, it is absolutely essential to recognize that the vast majority of the “usual suspects” where FDI is concerned — that is, large and diversified TNCs, emanating from the triad economies of North America, Japan, and Europe — are already established in Southeast Asia. Reviving FDI inflows therefore involves three interwoven strands of policy: • •

•

encouraging local and regional re-investment by these TNCs, which is why the issue of regional integration is so important; preventing the departure of TNCs already based in Southeast Asia, especially where they have operations in, say, both China and Southeast Asia (in this respect China normally has a cost advantage over existing operations in ASEAN4 which can be overcome in a number of ways, including productivity gains — that is, knowledge transfer and utilization — and the relocation of labour-intensive product processes to newer member countries with lower wages); and very careful targeting of new FDI sources, such as smaller TNCs, TNCs in industries not yet represented in Southeast Asia or in countries with little investment to date (interestingly, China is emerging as a more significant investor in Southeast Asia5).

© 2003 Institute of Southeast Asian Studies, Singapore

+++

+++

— National treatment for foreign firms

Creation of an enabling environment for FDI — Establish good-quality support industries

+++

+++

++ +++

++

+++

+

++

+++

++ +++

++

+

+

+

++

+ +

++

Host Intra-ASEAN Trans-ASEAN Level Level Level

— Ease restrictions on outward FDI (especially for domestic firms)

Reduction in restrictions on foreign investors — Removal of barriers on participation by foreign corporations

Trade-related measures — Extension of AFTA — Attack on non-tariff barriers

Policies to ensure regional political and economic stability

Policies and Measures

Policies Applicable at the

This remains a serious issue in virtually all ASEAN economies. TNCs are crying out for support in this, especially because of competition from China. The knowledge or technology base of ASEAN firms needs a considerable boost; TNCs can assist in technology transfer.

Not a big concern because of liberalization and the ASEAN Investment Area (AIA), but an issue in a few ASEAN countries. The AIA time-frame has been shortened considerably. This assists both ASEAN and non-ASEAN TNCs with subsidiaries in the region; procedures have been streamlined. Remains an issue, but mostly for ASEAN companies. No longer a big concern, except in a few cases/countries (as per AIArestricted industries list). Many countries now allow 100 per cent foreign ownership in industries, such as banking, in which there was considerable protection previously.

Almost completed. Utilized by TNCs already based in ASEAN. Remains an issue in some ASEAN countries.

There are grave concerns about some countries and the general regional scenario.

Comments: Current Situation

Table 7.5 Priority Policies to Encourage Foreign Direct Investment Into and Within ASEAN

+++ ++

+++

++

++

++

+

++

+++

++

+

+

++

+++

+++

++ +++

++

+++

+

+

+

Note: +++ = High priority; ++ = Medium priority; + = Low priority or unnecessary.

— ASEAN-wide arbitration and other services — Tax concessions, grants, and other incentives for inward and outward FDI — Complementary ASEAN FDI regimes/schemes

+++ +++

+++

+++

+++ +++

++

— Harmonization of ASEAN corporate laws and regulations

Incentives for FDI — Information and technical services — Assistance in finding partners and contacts — Enhanced ASEAN schemes (AICO and so forth) — Joint promotion of FDI

+

+

+++

— ASEAN-wide harmonization of FDI policies

+++

+++

— Predictability and transparency of laws and rules — Develop good-quality manpower

+++

+++

— Establish good physical and communication infrastructure

Useful as part of an industrial policy for the region.

Only needed on a limited, specific basis.

ASEAN Investment portal yet to be completed. Some good databases exist, for example, on suppliers, but there is a lack of awareness among TNCs and so forth. This must be improved. There is not a big case for these. Fundamentals are more important than such schemes and incentives. This is especially significant for encouraging interest from TNCs unfamiliar with ASEAN. However, needs careful targeting — most of the “usual suspects” are already here! Many countries should really put more effort into encouraging reinvestments by established foreign subsidiaries. There is no longer a pressing need for these.

Remains a crying need, especially in terms of engineering and managerial skills. There has been some amelioration of this situation because of redundancies, but this is the time to plan and avoid future bottlenecks. AIA measures which encourage this will help, especially because the size of ASEAN economies means that “industrial clusters” must cross boundaries. Beneficial for newer ASEAN member countries. Helps integration of operations across ASEAN. Ditto.

Some improvements can be made in physical infrastructure. Some way to go in terms of legal and commercial infrastructure. But better than most developing economies, including China. Needs improvement, especially in some countries.

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Secondly, Southeast Asian countries and the ASEAN Secretariat should continue to refine their system for collecting and reporting FDI data. In particular, a key measure of FDI inflow — re-invested earnings — is not yet systematically collected in Southeast Asia. In other words, Southeast Asian countries may be targeting the “wrong solutions”. Indeed, there is some evidence to suggest that the FDI situation in the region is not as bad as the existing numbers might suggest. A considerable amount of re-investment is being made by TNCs already based in Southeast Asia (The ASEAN Investment Review 2001). Thirdly, to be fair to Southeast Asian economies, many of the policies suggested in Table 7.5 (or implied by the comments) have already been implemented in the region, or are in train. This is because many of the fundamental issues were identified before the current malaise (including by our comprehensive survey), but the policies took a while to put in place — and have yet to be fully realized or appreciated. This is because Southeast Asia has been buffeted by the recession in the world economy, especially since the region is heavily dependent on a number of volatile international industries, chiefly electronics (hence the huge decline in overall Japanese FDI in a region where Japanese TNCs have substantial existing capacity and therefore little need for more). With the rebound in electronics world-wide, especially the semiconductors industry in the United States, the revival of FDI flows to Southeast Asia — and other parts of Asia — looks more likely (“Asia: Is This the Rebound?” Business Week, 25 March 2002). Of course, Southeast Asia has to ensure that any revival has to be in a diversified range of industries and sectors. Finally, the quandaries of the current world economy notwithstanding, it must be recognized that Southeast Asia’s problems in attracting FDI today are largely the results of past successes. For example, as a pioneering region, Southeast Asia led the way in showing other developing countries that FDI could be used to good effect. Consequently, Southeast Asia could never hope to permanently retain its place as the developing region with the highest level of proportional or even absolute levels of FDI. However, as a relatively large, integrated, mature region and market (hopefully politically stable), Southeast Asia can expect a revival of FDI. Moreover, success has led to higher levels of income in the older member countries, and thence to higher

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wages and competition with countries such as China and Mexico. Solutions have to be found, or rather encouraged on the part of TNCs and Southeast Asian firms, through appropriate policies. This situation — the perils of success — has always been a dilemma faced by relatively developed economies. NOTES 1. Investment within Southeast Asia, emanating from other Southeast Asian economies, by both non-ASEAN and ASEAN TNCs. 2. Investment across Southeast Asia, emanating from outside Southeast Asia, for example, where decisions are made for regional operations across the region by non–Southeast Asian parent companies. 3. The relevant part of this study, funded by the Department for International Development (DfID) in the United Kingdom, is being conducted jointly by this author and Axèle Giroud. 4. Many companies we have interviewed to date in our current survey have an interesting internal dialogue being conducted by their operations in China and Southeast Asia. In some cases “intra-TNC competition” is intense. On the whole, however, most TNCs are not “putting all their eggs in one basket”, and are maintaining a presence in both Southeast Asia and China. Of course, many have existing sunk costs in Southeast Asian economies, which they do not propose to forgo. 5. For example, in 2000 and 2001, Chinese companies were the largest investors in Cambodia. See The ASEAN Investment Review 2001.

REFERENCES International Monetary Fund. World Economic Outlook.º May 2001. Mirza, Hafiz, Frank Bartels, Mark Hiley, and Axèle Giroud. The Promotion of Foreign Direct Investment Into and Within ASEAN: Towards the Establishment of an ASEAN Investment Area. Jakarta: ASEAN Secretariat, 1997. Mirza, Hafiz, Axèle Giroud, and Kathrin Koster. “Transnational Corporations and the Upgrading of Technological Competencies of ASEAN Economies”. Report presented to the Japan Bank for International Co-operation, Tokyo, 2001. The ASEAN Investment Review 2001. Jakarta: ASEAN Secretariat, 2001. UNCTAD. World Investment Report 2001: Promoting Linkages. New York and Geneva: United Nations, 2001.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > 208 Mario B. Lamberte

8

Developing the Fledgeling Debt Securities Markets in Southeast Asia Mario B. Lamberte 1. Introduction

ASEAN economies have long recognized the importance of developing a deep and broad domestic debt securities market to complement the banking 1 system in efficiently mobilizing and allocating financial resources. However, it was only in the early 1990s that they started to make bold steps to build a vibrant domestic debt securities market. For instance, in 1990 Malaysia implemented the electronic inter-bank funds transfer and scripless bookentry system, and in 1992 mandated the rating for all issuance of domestic debt securities by a newly established domestic rating agency. In Thailand, the passage of the Securities and Exchange Act of 1992 ushered in a new era for the development of the domestic bond market. This inspired the establishment of a local rating agency and an organized over-the-counter (OTC) market. In the Philippines, the private sector in co-operation with the government formed the Capital Markets Development Council in the

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early 1990s, to identify regulatory and institutional impediments to the development of the capital market and recommend measures to reduce, if not completely eliminate, those impediments. Many of the recommendations of the Committee found their way into the recently passed Securities Regulation Code. The Bureau of the Treasury started in 1995 to conduct electronic auctions of government securities. The Indonesian government encouraged the establishment of a rating agency in 1994. The following year, a law was passed to clearly delineate the role of the Ministry of Finance in regulating the domestic capital market. The East Asian financial crisis has further strengthened the resolve of ASEAN member countries to accelerate the development of their domestic debt securities markets and reduce reliance on bank lending. It is a sure way for them to redeem their countries from the so-called 2 “original sin”. One view that emerged in the wake of the Asian financial crisis is clearly summarized by Herring and Nathporn (2000) in the following manner: Viewed from a broader perspective, the economy is at risk of crisis due to excessive reliance on bank lending. Because banks are highly leveraged institutions, the economy is much more vulnerable to a financial crisis than if more corporate borrowing had taken place in the bond market and the claims were held in well-diversified portfolios.

An interesting observation was that ASEAN countries had high domestic savings rates even before the Asian financial crisis, yet they had to borrow a lot from financial institutions abroad to fund new projects and expand existing ones. Due to the undeveloped fixed-income securities, these savings might have been invested abroad and came back to the region in the form of short-term bank credit, which foreign financial institutions quickly withdrew at the height of the crisis. Had the region been served by a wellfunctioning fixed-income securities market, the situation could have been different. As Rhee (2000) has pointed out, “domestic savings as well as foreign exchange reserves in the region could have remained in Asia, mitigating the severity of the financial crisis caused by the reversal of capital flows”. He is actually toying with the idea of developing not only domestic bond markets, but also a regional bond market for East Asia. The interest in developing the domestic debt securities markets in the region has been fuelled further by the miserable state of the banking

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system subsequent to the Asian financial crisis. In fact, some of the major lending financial institutions of severely crisis-hit countries collapsed, while the remaining ones have had difficulties restarting their lending programmes due to high non-performing loans and much more stringent prudential regulations. In view of this situation, corporations that used to heavily depend on bank credit have explored sourcing funds from the domestic debt securities markets, while investors seeking higher returns on their savings than those offered by bank deposit rates have started to take notice of the attractive opportunities provided by the domestic bond market. This gives a sense of urgency to capital market reforms, to sustain the incipient enthusiasm of both the potential issuers and buyers of fixed-income securities. While the enthusiasm for developing the domestic debt securities markets has been running high in the wake of the financial crisis, Yoshitomi and Shirai (2001) have reminded us that the domestic debt securities markets in developing economies cannot be quickly developed. Even the debt securities markets in some developed economies took a long time to develop. Given the dominance of the banking system in the financial system of Asian economies, relentless efforts should be made to strengthen banking institutions, while simultaneously initiating the development of the domestic debt securities market. This is because in the transition from a heavily bank-dependent to a capital market– dependent economy, the private debt securities market and the banking system are likely to be complementary to each other rather than substitutes. For instance, banks will become the major issuers and investors of debt securities during the initial stages of the development of the domestic debt securities market. This interim financial structure certainly calls for a new regulatory framework for the banking system in developing economies that are going to be exposed to new types of risks, 3 as they intensely participate in the debt securities market in various capacities. The remainder of this chapter will tackle three topics. Section 2 presents the present profile of the debt securities markets in Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Section 3 keeps stock of the recent efforts of these five ASEAN economies to accelerate the development of their domestic debt securities market. The last section discusses some remaining tasks that need to be accomplished to support

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the development of the fledgeling domestic debt securities markets in these economies. 2. Profile of the Debt Securities Markets in ASEAN

This chapter deals with debt securities markets, which consists of shortterm securities (that is, with a maturity of one year or less) and mediumto long-term securities (that is, with a maturity of more than one year). Normally, bonds refer to the latter. However, some countries in the region (for example, Thailand and Indonesia) also treat securities with one year maturity as bonds. 2.1. Size and Structure

First, we describe the size and structure of the domestic securities market of each of the five ASEAN economies using the latest available data. Figure 8.1a shows the total outstanding debt securities of the five ASEAN economies, in U.S. dollars, as of December 2000 (except for Thailand, where data is only available up to December 1999). The size of the outstanding debt securities differs significantly among the five economies. Indonesia appears to have the largest quantity of outstanding debt securities, amounting to about US$90 billion. This includes both corporate bonds and the recently issued government bonds, namely: indexed bonds, variable rate bonds, fixed rate bonds, and hedge bonds. Malaysia’s outstanding debt securities stood at US$53 billion. This consists of government bonds, which include the Malaysian government securities (MGS), government investment issues (GII), Malaysian savings bonds and Khazanah bonds, and private debt securities (PDS), which include Danaharta bonds, Danamodal bonds, Cagamas bonds and other private debt securities (Norashikin Abdul Hamid and Mahani Zainal Abidin 2001). The Philippines’ outstanding debt securities amounted to US$26.1 billion. This includes government securities consisting of Treasury bills, and bonds and private securities consisting of short- and long-term commercial papers (CPs). In the Philippines, the long-term commercial paper market is the de facto bond market. For lack of data on outstanding private debt securities, Singapore’s outstanding debt securities shown in Figure 8.1a include only government T-bills and bonds, which stood at US$23.5 billion. Thailand’s outstanding debt

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212

Figure 8.1a ASEAN-5: Outstanding Total Debt Securities (US$ Millions)*

100,000 80,000 60,000 40,000 20,000 0

Indonesia

Malaysia

Philippines

Singapore

Thailand

* Latest available data. Figure 8.1b ASEAN-5: Total Gross Issuance of Debt Securities, 2000 (US$ Millions)

20,000 15,000 10,000 5,000 0

Indonesia

Malaysia

Philippines

Singapore

Thailand

securities amounted to US$30.7 billion as of December 1999. This consists of government securities, such as government bonds, state enterprise bonds, Bank of Thailand (BoT)/Financial Institutions Development Fund (FIDF)/ Property Loan Management Organization (PLMO) bonds, and T-bills and corporate bonds, including those issued abroad. Figure 8.1b shows the gross issuances of debt securities, in U.S. dollars, of the five economies during 2000. Thailand issued about US$17 billion of

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Figure 8.2a ASEAN-5: Ratio of Total Outstanding Debt Securities to GDP (Percentages)

Percentage

80 60 40

70.5 50.9

20 0

32.1

Indonesia

Malaysia

Philippines

27.2

Singapore

30.1

Thailand

Figure 8.2b ASEAN-5: Ratio of Total Gross Issuance of Debt Securities to GDP, 2000 (Percentages)

Percentage

20 15 10

16.7

15.0

5

8.1

6.2

4.0

0

Indonesia

Malaysia

Philippines

Singapore

Thailand

debt securities in 2000. It is followed by Singapore whose total issues — which include government and private securities — amounted to about US$14 billion. Malaysia issued about US$10 billion and Indonesia, about US$8 billion. The Philippines had the smallest issuance, amounting to about US$6 billion. Figure 8.2a shows the size of the debt securities of the five ASEAN countries, relative to the size of their economies. Malaysia’s outstanding debt securities comprised 70.5 per cent of GDP, while that of Indonesia about 60 per cent. The Philippines and Thailand

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had about the same size of their outstanding debt securities relative to GDP, at around 30 per cent. The size of Singapore’s outstanding securities relative to GDP was 27.2 per cent. (As mentioned earlier, this refers only to government securities. Thus, if private debt securities were included, the relative size of Singapore’s debt securities market will surely appear much higher than what was shown above.) In terms of gross issuance of debt securities (see Figure 8.2b), Singapore issued debt securities in 2000 equivalent to about 17 per cent of its GDP. It is followed by Malaysia at 15 per cent. The Philippines’ and Thailand’s gross issuances of debt securities were 8.1 per cent and 6.2 per cent of GDP, respectively. The smallest was Indonesia, at 4 per cent of its GDP. Figure 8.3a gives the distribution of outstanding debt securities by major issuers. It shows the overwhelming dominance of government securities in the ASEAN economies’ debt securities market. The exception is Malaysia, where outstanding corporate bonds comprised more than half of the total. Interestingly, at least half of the gross issuance of debt securities in 2000 came from the private sector (Figure 8.3b). An exception to this pattern is the Philippines, where almost all of the new issues in 2000 came from the government. Thus, in terms of total outstanding and gross issuance of debt securities in U.S. dollars, the Philippines appears to have the smallest debt securities market among the five ASEAN economies. 2.2. Trends

Let us now turn to the trends in the domestic debt securities market of the five ASEAN economies during the period 1995–2000. Indonesia’s total outstanding debt securities were less than 3 per cent of GDP, up until 1999, when it suddenly shot up to 39.4 per cent, and further rose to 51 per cent in 2000 (Figure 8.4). The sharp rise in the ratio can be attributed mainly to new large issues by the government, aimed at raising funds for bank recapitalization and banking guarantee. Malaysia had a relatively large domestic debt securities market even before the Asian financial crisis. From 46 per cent of GDP in 1995, the outstanding debt securities gradually rose to 48 per cent in 1997, then rose sharply in 1997 to 56 per cent. It further increased to 67 per cent in 1999 and to

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Figure 8.3a ASEAN-4: Distribution of Outstanding Debt Securities (Percentages)

100

3.6

4.9

90

29

80

55.5

Percentage

70 60 50

96.4

95.1

40

71

30

Private Government

44.5

20 10 0

Indonesia

Malaysia

Philippines

Thailand

* Latest available data. Figure 8.3b ASEAN-5: Distribution of Gross Issuance of Debt Securities, 2000 (Percentages)

0.4

100 90 80

Percentage

70

56.3

54.6

60.9

49.8

60 99.6

50 40 30 20

43.7

45.4

39.1

10 0

Indonesia

Malaysia

Philippines

Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

50.2

Private Government

Thailand

Figure 8.4 Ratio of Outstanding Debt Securities to GDP by Major Issuers Mario B. Lamberte (Percentages)

216

60

Percentage

50 40

Indonesia

total government private

30 20 10 0

Percentage

1995 80 70 60 50 40 30 20 10 0

1997

1998

1999

2000

1998

1999

2000

Malaysia

total government private

1995

Percentage

1996

1996

40 35 30 25 20 15 10 5 0

1997

Philippines

total government private

1995

1996

1997

1998

1999

2000

1998

1999

2000

1998

1999

2000

30 Percentage

25 20

Singapore

total government private

15 10 5 0 1995

1996

1997

35

Percentage

30 25

Thailand

total government private

20 15 10 5 0 1995

1996

1997

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70.5 per cent in 2000, mainly due to the significant growth in the outstanding private debt securities. The Philippines’ ratio of outstanding debt securities to GDP was quite high at 36.5 per cent in 1995, but it gradually declined to about 32 per cent since 1997. In the case of Singapore, the ratio of outstanding government securities to GDP was flat at about 16 per cent during the period 1995–97. Beginning in 1998, however, it consistently rose by a significant amount, reaching 27.2 per cent in 2000. The growth in the size of Thailand’s debt securities since 1995 has been phenomenal — from 10 per cent of GDP in 1995 to 30 per cent in 1999. This was largely due to the significant rise in outstanding government securities, although private debt securities also made a significant contribution to that rise in 1999. The shares of outstanding government and private debt securities of the five ASEAN economies are shown in Figure 8.5. Up until 1999, Indonesia’s debt securities mainly comprised of corporate securities. In 1999, the government issued 425.1 trillion rupiah. More large issues were made in the following year, bringing the outstanding government debt securities to 634.2 billion rupiah. As Shidiq and Suprodjo (2001) have pointed out, the government bond market in Indonesia was born by accident, because of the urgent need of the government to recapitalize failing banks. Malaysia’s case is quite interesting. The shares of government and private debt securities had moved in opposite directions, indicating a faster rise in outstanding private debt securities than government debt securities. In particular, private debt securities increased fourfold over the six-year period, to reach RM137.2 billion in 2000. It is to be noted that in 1998, Danamodal Nasional Bhd. was established to facilitate restructuring of financial institutions (Rhee 2000). Another financial institution, Pengurusan Danaharta Nasional Bhd., was created to acquire non-performing assets from financial institutions. Together, they issued RM21.3 billion in five-year bonds. In contrast, government securities rose by only 45 per cent during the same period, reaching RM103 billion in 2000. In the Philippines, the share of private debt securities was no more than 8 per cent during the period 1995–2000. Outstanding government debt securities rose from 667.3 billion pesos in 1995 to 1,013.9 billion pesos in 2000, whereas that of the private sector increased

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Figure 8.5 Distribution of Outstanding Debt Securities by Major Issuers

Mario B. Lamberte

120

Indonesia

Percentage

100 80 60 40 20

government private

0

Percentage

1995

1996

80 70 60 50 40 30 20 10 0

1998

Malaysia

1995

1996

120

1997

1999

2000

government private

1998

1999

2000

Philippines

100 Percentage

1997

80 60

government private

40 20 0 1995

1996

120

1998

1999

2000

Singapore

100 Percentage

1997

80 60 40

government private

20 0

Percentage

1995

1996

90 80 70 60 50 40 30 20 10 0

1997

1998

1999

Thailand

1995

1996

1997

2000

government private

1998

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1999

2000

8. Developing the Fledgeling Debt Securities Markets in Southeast Asia

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from 28.9 billion pesos to 44.6 billion pesos during the same period. In Thailand, government debt securities accounted for more than 60 per cent between 1995 and 1997, and rose to more than 70 per cent in 1998 and 1999. According to Jantaraprapavech (2001), the government issued government bonds in 1998 and 1999 for the first time in a decade, under the 500 billion baht programme to finance the liability of the Financial Institution Development Funds. Thus, outstanding government securities doubled in 1998 to 712.5 billion baht, and rose further to 986.6 billion baht in 1999. Private debt securities, on the other hand, saw a significant increase in 1999 to 403.8 billion baht, from only 177.6 billion baht in 1998. Although the past trends in the domestic debt securities market in the region are quite encouraging, one cannot be too optimistic about future trends. This is because excess production capacity currently plagues Southeast Asian economies. Once refinancing exercises in Thailand, Indonesia, and Malaysia end, bond issuance is likely to fall. It may require other measures, such as those recently adopted by Singapore, to sustain 4 the rise in the supply of bonds. 2.3. Maturity Structure

There is a great variation in the maturity structure of debt securities issued in the five ASEAN economies. In Indonesia, 79 per cent of the total government securities issued in 1999 and 2000 had a maturity period of five years or more (Table 8.1). As regard corporate bonds, roughly 70 per cent of the issues during the period 1998–2000 concentrated in the 4 to 5 year maturity period (Table 8.2). In Malaysia, government securities issues with a maturity period of more than fifteen Table 8.1 Indonesia: Maturity Structure of Government Bonds Maturity 1–5 years 5–10 years Above 10 years

Value (Rupiah Billions)

% of Total Value

133,558,975 282,340,304 218,315,594 634,214,873

21.06 44.52 34.42 100.00

Source: Shidiq and Suprodjo (2001).

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69

Total

17,990.46

642.10 12,452.50 4,895.86

Value (Rupiah Billions)

© 2003 Institute of Southeast Asian Studies, Singapore 53

3 36 14

No. of Issuers

11,998.46

292.10 8,360.50 3,345.86

Value (Rupiah Billions)

1.5 1.5 1.5 2.6 5.0 7.9 3.1 6.0 9.0 9.2 11.3 13.5

2 4 6 7 9 12

4–5 Years

16.9 20.9 17.9 19.7 20.0 27.0

11 14 12 15 16 24

6–10 Years

Source: Norashikin Abdul Hamid and Mahani Zainal Abidin (2001).

1995 1996 1997 1998 1999 2000

As a percentage of the total

1995 1996 1997 1998 1999 2000

1 1 1 2 4 7

2–3 Years

Value (RM billions)

Year

100.00

3.57 69.22 27.21

%

1999

100.00

2.43 69.68 27.89

%

42

— 32 10

No. of Issuers

9,816.50

0.00 7,341.50 2,475.00

Value (Rupiah Billions)

1998

21.5 19.4 19.4 19.7 18.8 13.5

14 13 13 15 15 12

11–15 Years

56.9 52.2 52.2 48.7 45.0 38.2

37 35 35 37 36 34

>15 Years

Table 8.3 Malaysia: Outstanding Malaysian Government Securities Classified by Original Maturity

– = No issuer. Source: Shidiq and Suprodjo (2001).

5 45 19

No. of Issuers

0–3 years 4–5 years ≥6 years

Term

2000

Table 8.2 Indonesia: Corporate Bonds Maturity Structure, December 2000

100.0 100.0 100.0 100.0 100.0 100.0

65 67 67 76 80 89

Total

100.00

0.00 74.79 25.21

%

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Mario B. Lamberte

2–3 Years

— — — — 500 —

© 2003 Institute of Southeast Asian Studies, Singapore

0.0 0.0 0.0 0.0 1.5 0.0 55.2 66.7 45.0 30.4 5.3 4.0

2,466 5,711 3,987 1,080 1,765 480

4–5 Years

9.0 1.2 45.9 69.6 90.3 23.8

400 106 4,072 2,475 30,277 2,845

6–10 Years

Source: Norashikin Abdul Hamid and Mahani Zainal Abidin (2001).

— = No outstanding securities being reported.

1995 1996 1997 1998 1999 2000

As a percentage of the total

1995 1996 1997 1998 1999 2000

Value (RM billion)

Year

0.0 0.0 9.1 0.0 2.9 0.0

— — 808 — 987 —

11–15 Years

35.8 32.1 0.0 0.0 0.0 72.1

1,600 2,750 — — — 8,610

>15 Years

Table 8.4 Malaysia: Outstanding Private Debt Securities Classified by Original Maturity

100.0 100.0 100.0 100.0 100.0 100.0

4,466 8,567 8,867 3,555 33,529 11,935

Total

8. Developing the Fledgeling Debt Securities Markets in Southeast Asia 221

© 2003 Institute of Southeast Asian Studies, Singapore

—

—

D. Notes**

E. 10-year land bank bond

—

—

8

0.03

14 7 7 — — — —

12.84

13.83 14.98 — — — —

15.01 11.89 12.73 13.57

Yield (%)

—

495

—

—

79,795 38,530 19,680 19,585 2,000 — —

— 61,491 82,983 118,797

263,271

343,661

Pesos Millions

—

0.14

—

—

23.23 11.21 5.73 5.70 0.58 — —

— 17.90 24.15 34.58

76.63

100.00

Share (%)

1996

—

13.99 14.59 15.18 16.00 — —

— 12.35 12.82 13.36

Yield (%)

68

—

—

56,485 31,189 7,500 5,537 10,259 2,000 —

— 58,340 63,440 86,249

208,029

264,582

Pesos Millions

0.03

—

—

21.35 11.79 2.83 2.09 3.88 0.76 —

— 22.05 23.98 32.60

79

100.00

Share (%)

1997

—

—

14.18 12.75 17.19 16.96 14.20 —

— 13.11 13.81 14.34

Yield (%)

6,773

—

—

—

42,983 21,986 10,000 5,551 5,446 — —

— 78,854 71,054 70,516

220,424

270,180

Pesos Millions

2.51

—

—

15.91 8.14 3.70 2.05 2.02 — —

— 29.19 26.30 26.10

82

100.00

Share (%)

1998

—

—

17.75 19.28 19.63 19.00 14.20 —

— 15.00 16.21 17.39

Yield (%)

* Mostly issues by government agencies (MWSS, municipal bonds, and so forth). ** Mostly composed of floating rate treasury notes with interest rates ranging from 50 to 75 basis points above the 91-day Treasury-bill rate. CMB = Cash Management Bills. MWSS = Manila Waterworks and Sewerage System.

24,860

97

44,527 23,430 21,000 — — — —

1 25 26 27

2,000 81,258 82,563 85,936

C. Bonds*

B. Fixed-rate treasury bonds 1. 2-year 2. 5-year 3. 7-year 4. 10-year 5. 20-year 6. 25-year 7. 30-year par bond

78

100

Share (%)

251,757

321,144

Total issues

A. Treasury bills 1. CMB (35 to 63 days) 2. 91-day 3. 182-day 4. 364-day

Pesos Millions

Particulars

1995

1,266

—

—

—

56,634 22,310 9,620 10,576 14,128 — —

— 60,600 62,233 63,756

186,589

244,489

Pesos Millions

Table 8.5 Philippines: Issuance of Government Securities, 1995–2000

0.52

—

—

23.16 9.13 3.93 4.33 5.78 — —

— 24.79 25.45 26.08

76

100.00

Share (%)

1999

—

—

12.32 13.81 14.78 16.35 14.20 —

— 9.98 10.49 11.05

Yield (%)

870

—

—

93,258 26,102 19,954 23,005 18,911 — 5,286

22,460 44,705 49,226 55,436

171,827

265,955

Pesos Millions

0.33

—

—

35.07 9.81 7.50 8.65 7.11 — 1.99

8.45 16.81 18.51 20.84

65

100.00

Share (%)

2000

—

12.50 14.16 14.71 14.98 14.20 17.98

15.50 9.93 11.06 12.03

Yield (%)

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Table 8.6 Philippines: Issuance of Commercial Papers Long-Term CPs

Short-Term CPs

Year

Total

Pesos Millions

% of Total

Pesos Millions

% of Total

WAIR

1994 1995 1996 1997 1998 1999 2000

24,256 30,882 30,115 24,585 8,057 8,716 1,171

6,200 12,065 15,550 11,400 750 6,700 —

25.6 39.1 51.6 46.4 9.3 76.9 —

18,056 18,817 14,565 13,185 7,307 2,016 1,171

74.4 60.9 48.4 53.6 90.7 23.1 100.0

12.622 11.579 12.524 12.665 15.539 n.a. n.a.

Short-term: Tenor of one year or less. Long-term: Tenor ranging from one to five years. CP = Commercial paper. WAIR = Weighted average interest rate. n.a. = Not available. Source: Securities and Exchange Commission.

Table 8.7 Thailand: Maturity of Government Bonds under the 500 Baht B Programme Original Maturity (Years)

1999 (June)

1998 Baht Millions

%

Baht Millions

%

1 2 3 4 5 6 7 8 10 12 15

150,000 20,000 50,000 — 60,000 — 50,000 20,000 50,000 — —

37.50 5.00 12.50 — 15.00 — 12.50 5.00 12.50 — —

— — — 30,000 — 30,000 — — — 20,000 20,000

— — — 30.00 — 30.00 — — — 20.00 20.00

Total

400,000

100.00

100,000

100.00

— = No activity. Source: Bank of Thailand.

© 2003 Institute of Southeast Asian Studies, Singapore

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Mario B. Lamberte

years have been dominant during the period 1995–2000. However, its share has been declining during the period 1995–2000 as an increasing number of issues have fallen within the four to ten-year maturity period (Table 8.3). With respect to private debt securities, there seems to be a shift away from short-term to long-term bonds, with a maturity period of more than five years, especially in the wake of the Asian financial crisis (Table 8.4). In the Philippines, short-term government securities have maturities of 91, 180, and 364 days. On the other hand, long-term securities consist of two-, five-, seven-, ten-, and twenty-year bonds. Short-term securities comprised at least 65 per cent of the total issuances of government securities during the period 1995–2000 (Table 8.5). Among the long-term securities, the two-year bonds appear to be the most popular among investors. With regard to private debt securities, long-term commercial papers with tenor ranging from one to five years comprised a fairly high proportion of total issuances of commercial papers up until the East Asian financial crisis struck (Table 8.6). In 2000, no private enterprise issued a long-term commercial paper due to the uncertain political and economic conditions. Singapore’s government securities consist of three-month, one-, two-, five-, seven-, and ten-year securities. According to Tan (2000), the maturity mix is a good spread across different years, up to nine to ten years. In Thailand, about half of the government bonds under the 500 billion baht programme had a maturity period of less than five years (Table 8.7). In contrast, most of the corporate bond issues had maturity of five years or more. After the Asian financial crisis, however, the share of corporate bonds with a maturity period of less than five years rose substantially, to one-third in 1998 and 1999, and eventually to about half in 2000 (Table 8.8). 2.4. Major Issuers of Corporate Debt Securities

The two consistently large issuers of corporate bonds in Indonesia were the property and banking sectors (Table 8.9). However, the banking sector’s share significantly dropped in 1997 and since then has not recovered. In the case of the property sector, its share substantially declined only in 2000. Against these was the significant rise in the share of wood-based and infrastructure sectors. In Malaysia, the large issuers of corporate bonds before the Asian financial crisis were the

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

27.72 —

67.64

Total 35.71

8.68 5.67

17.43

3.93

1997a

36.26

1.81 — 22.35 — — 0.05 —

2.75 1.98 7.31

1998b 1.70 22.30 35.14 2.81 19.81 26.66 3.20 — — 3.27 3.17

2000b (Sep.)

214.98 118.07

5.60 26.98 35.24 8.01 61.24 0.41 43.35 9.88 — 11.53 12.76

1999b

100.00

8.78 2.37 46.32 — 1.55 — — 40.98 —

1995a

48.81 — — — — 24.31 15.87

11.01

1997a

5.00 — 61.64 — — 0.14 —

7.58 5.46 20.17

1998b

Source: Securities and Exchange Commission, Thailand.

b

2.60 12.55 16.39 3.73 28.49 0.19 20.16 4.59 — 5.36 5.93

1999b

1.44 18.89 29.76 2.38 16.78 22.58 2.71 — — 2.77 2.68

2000b (Sep.)

100.00 100.00 100.00 100.00 100.00

0.61 4.93 2.04 12.12 — 2.66 — — 56.49 21.16

1996a

Percentage of Total

Data of 1995–97 are approved public offering values and approved offering values in overseas market. Data of 1998–2000 are actual public offering and private placement values. — = No issuance of bonds.

a

64.75 24.26

1.05

114.64

3.05

5.94 1.60 31.33

1996a

0.70 5.65 2.34 13.89

1995a

1 2 3 4 5 6 7 8 9 10 >10

Maturity (Years)

Value of Issues (Baht Billions)

Table 8.8 Thailand: Maturity Structure of Corporate Bonds

8. Developing the Fledgeling Debt Securities Markets in Southeast Asia 225

4

22

Others

Total

36

7

5

1

1

8

3

11

39

6

5

3

2

8

4

11

Source: Shidiq and Suprodjo (2001).

41

7

7

1

2

—

Consumer goods

8

Financial

6

Banking

4

1

2

13

Infrastructure

8

Property

49

9

7

4

4

8

6

11

1996 1997 1998 1999 2000

Wood-based and agro industries

Industry

No. of Issuers

3,260.0

1,550.0

275.0

300.0

2,419.7

1,150.0

3,585.0

1997

3,260.0

1,314.6

275.0

300.0

2,419.7

800.0

3,585.0

1998

4,284.7 12,539.7 11,954.3

1,380.0

200.0

—

—

1,169.7

400.0

1,135.0

1996

12,450.3

674.1

1,386.3

2,225.0

400.0

2,669.7

1,800.0

3,295.2

1999

Value (Rupiah Billions)

17,990.5

1.721.0

2,036.3

2,173.0

2,400.0

3,050.0

3,300.0

3,310.2

2000

Table 8.9 Indonesia: Major Issuers of Corporate Bonds, 1996–2000

32.2 — 100.0

4.7

—

—

27.3

9.3

26.5

1996

26.0 — 100.0

12.4

2.2

2.4

19.3

9.2

28.6

1997

11.1

17.9

3.2

21.4

14.5

26.5

1999

27.3 5.4 — — 100.0 100.0

11.0

2.3

2.5

20.2

6.7

30.0

1998

Percentage

9.6 — 100.0

11.3

12.1

13.3

17.0

18.3

18.4

2000

22,258.6

Total

214.1 0 3,604.2 2,069.1 2,236.7 2,260 3,923.8 0 120

1997 0 0 125 1,473.3 529 0 7,704.5 1,000 0

1998 0 0 1,114.5 9,011 63.8 20 2,258.8 0 660

1999 42.5 0 1,133.1 1,868.6 4,564.1 7,320.3 5,237 0 2,130.8

2000

27,341.9 31,951.1 12,493.4 19,594.6 28,233.5

12,383.9 14,427.9 10,831.8 13,128.1 22,296.4 14,958 17,523.2 1,661.6 6,466.5 5,937.1

0 0 3,244.5 2,598.2 1,017.2 2,886 319.4 436.4 1,882.2

1996

Source: Norashikin Abdul Hamid and Mahani Zainal Abidin (2001).

100.00

1.79 0.00 9.55 20.46 16.63 26.35 13.59 0.27 11.36

Agriculture, forestry, and fishing Mining and quarrying Manufacturing Construction Electricity, gas, and water Transport, storage, and communications Finance, insurance, real estate, and business services Government and other services Wholesale, retail trade, hotels, and restaurants

Total

1995

Sector

100.00

0.00 0.00 26.20 20.98 8.21 23.30 2.58 3.52 15.20

1996

100.00

1.48 0.00 24.98 14.34 15.50 15.66 27.20 0.00 0.83

1997

100.00

0.00 0.00 1.15 13.60 4.88 0.00 71.13 9.23 0.00

1998

100.00

0.00 0.00 8.49 68.64 0.49 0.15 17.21 0.00 5.03

1999

100.00

0.19 0.00 5.08 8.38 20.47 32.83 23.49 0.00 9.56

2000

Table 8.10b Malaysia: Share of New Issues of Private Debt Securities (Excluding Cagamas Bonds) by Sector (Percentages)

9,200.7 13,057.9

165 0 878.4 1,882.5 1,530.4 2,424 1,250.4 25 1,045

Agriculture, forestry, and fishing Mining and quarrying Manufacturing Construction Electricity, gas, and water Transport, storage, and communications Finance, insurance, real estate, and business services Government and other services Wholesale, retail trade, hotels, and restaurants

Sub-total Government bonds

1995

Sector

Table 8.10a Malaysia: New Issues of Private Debt Securities (Excluding Cagamas Bonds) by Sector (RM Millions)

100.0

3.9

18,869

—

1,277

15,407

839

499

—

847

Pesos Millions

—

6.5

81.9

4.4

2.7

—

4.5

% of Total

100.0

1995

15,135

1,469

394

10,675

803

571

—

1,223

Pesos Millions

100.0

9.7

2.6

70.5

5.3

3.8

—

8.1

% of Total

1996

* Short-term commercial papers have a tenor of one year or less. Source: Securities and Exchange Commission.

18,056

700

Real estate

Total

720

4.0

51.3

9,256

Business services

Finance

11.2

2,002

16.9

3,054

0.3

12.4

% of Total

Transportation/ communications

57

2,247

Pesos Millions

Wholesale trade

Utilities

Manufacturing

Sector

1994

3.0

1.8

65.6

13.8

4.1

—

11.8

% of Total

13,185 100.0

395

236

8,645

1,825

534

—

1,550

Pesos Millions

1997

7,307

533

64

5,629

—

468

—

613

Pesos Millions

100.0

7.3

0.9

77.0

—

6.4

—

8.4

% of Total

1998

Table 8.11a Philippines: Short-Term Commercial Paper Issues

2,016

1,748

36

202

—

—

—

30

100.0

86.7

1.8

10.0

—

—

—

1.5

Pesos % of Millions Total

1999

8.4

1.5

90.1

—

—

—

—

1,171 100.0

99

17

1,055

—

—

—

—

Pesos % of Millions Total

2000

—

Transportation/ communications

6,200

100

—

65

4,000

—

—

—

21

—

—

—

15

% of Total

12,065

—

3,000

—

1,400

1,000

—

—

6,665

Pesos Millions

1995

100

—

25

—

12

8

—

—

55

% of Total

20,250

—

6,050

—

9,400

1,000

—

—

3,800

Pesos Millions

100

—

30

—

46

5

—

—

19

% of Total

1996

* Long-term commercial papers have a tenor of one to five years. Source: Securities and Exchange Commission.

Total

Community, social, and personal services

Real estate

Business services

1,300

—

Wholesale trade

Finance

—

900

Pesos Millions

Utilities

Manufacturing

Sector

1994

11,400

—

6,000

—

1,100

1,500

—

300

2,500

Pesos Millions

100

—

53

—

10

13

—

3

22

% of Total

1997

750

—

—

—

—

—

—

—

750

Pesos Millions

100

—

—

—

—

—

—

—

100

% of Total

1998

Table 8.11b Philippines: Long-Term Commercial Paper Issues

6,700

—

4,000

—

—

1,000

—

—

1,700

100

—

60

—

—

15

—

—

25

Pesos % of Millions Total

1999

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

Pesos % of Millions Total

2000

230

Mario B. Lamberte

manufacturing, construction, and transport sectors (Tables 8.10a and 8.10b). During the height of the crisis, the finance sector became the single largest issuer of corporate bonds. In 2000, about 75 per cent of the issues were shared by the transport, finance, and electricity sectors. In the Philippines, the finance sector has been the largest issuer of short-term commercial papers (Table 8.11a). This mostly consisted of finance companies, which raised short-term funds for re-lending at longer terms, and for maintaining liquidity (Saldana 2000). As regards long-term commercial paper, the largest issuers before the crisis were the manufacturing, finance, and real estate sectors (Table 8.11b). But this market dried up in the wake of the Asian financial crisis. There was a brief resurgence in 1999, led by the real estate, manufacturing, and transport sectors, but again it dried up in 2000. In Thailand, the commercial banking sector was the largest issuer of corporate bonds even before the Asian financial crisis. Its share even rose in 1998 and 1999 as some commercial banks issued large chunks of corporate bonds (Table 8.12). In 2000, the building and furnishing materials sectors became the largest issuer of corporate bonds. 2.5. Investor Base

The investor base for debt securities in the five ASEAN countries appears to be limited. In Indonesia, the banking sector cornered more than 60 per cent of government bonds and corporate bonds. In Malaysia, the provident fund (EPF) had been the largest investor of government securities, accounting for 62 per cent of the total during the period 1995–2000. The second largest investor was National Savings Banks, at 17 per cent. EPF together with insurance companies, was also the major investor in corporate bonds, cornering about 73 per cent of the total outstanding corporate bonds, as of November 2000. Commercial banks held 17 per cent of the total. In the Philippines, the Central Bank, banks and government-controlled pension funds accounted for about 77 per cent of total outstanding government securities. The Central Bank uses government securities for its open market operations, while banks and pension funds hold securities to meet statutory reserve and mandatory liquidity requirements. The rest are held by non-financial entities, including individuals and insurance companies. Banks are also

© 2003 Institute of Southeast Asian Studies, Singapore

8. Developing the Fledgeling Debt Securities Markets in Southeast Asia

231

the largest holders of commercial papers, followed by institutional investors and high net-worth individuals. The Central Provident Fund (CPF) of Singapore has been the largest investor in government debt securities, accounting for about two-thirds of the total outstanding government securities in 1998. Commercial banks gobbled up 30 per cent. Interestingly, the share of commercial banks in the total outstanding government securities doubled within a span of eleven years, at the expense of CPF and other investors. In Thailand, commercial banks were the largest investors in government debt securities, although their share declined from a high of 60 per cent in 1995 to 43 per cent, as of the first half of 2000. Banks were also the major investors in corporate bonds (Jantaraprapavech 2001). 2.6. Secondary Market

The secondary market for both government and private debt securities has been thin for the five ASEAN economies. Most of the securities are traded in OTC markets, and only very few are listed on exchanges. In Indonesia, the turnover ratio of government bonds for recapitalization and banking guarantees was low, at 42 per cent, while that of corporate bonds ranged 5 from 34 to 48 per cent (Shidiq and Suprodjo 2001). In Malaysia, secondary trading of MGS has improved significantly since 1998 (Norashikin Abdul Hamid and Mahani Zainal Abidin 2001). It accounted for 73 per cent and 41 per cent of the total trading volume in 1998 and 1999, respectively. The turnover ratio of MGS improved significantly from a mere 6 per cent in 1995 to 93 per cent in 2000. In contrast, the total trading volume of private debt securities was small, and the turnover ratio averaged only 34 per cent during the period 1995–99. In the Philippines, the secondary market is mainly dominated by government securities. In 1999, the turnover ratio for T-bills averaged 44 per cent, while that for two- and five-year T-bonds, which are most heavily traded, was 60 and 49 per cent, respectively (Saldana 2000). The turnover ratios for all tenors of T-bonds increased significantly between 1997 and 1999. On the other hand, private debt securities have been largely illiquid. In Singapore, the daily trading volume of government securities (T-bills and bonds) has increased significantly in recent years. For instance, average daily turnover in 2000 reached S$816 million, which was more

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore 7,922 — 5,333 24,886 400 — 16,896 11,652 — — — 1,524 — — 1,016 — — 3,682 3,047 — — —

2,497 18,526 18,526 —

4,296 — 26,213 6,187

325 — — 120 — — — — — — — — — 8,098 — 2,497 1,373 —

70,130 117,495

1. Agribusiness 2. Banking — Commercial banks — Non-commercial banks 3. Building and furnishing materials 4. Chemicals and plastics 5. Commerce 6. Communication 7. Electrical products and computer 8. Electronic components 9. Energy 10. Finance and securities 11. Foods and travel services 12. Healthcare services 13. Hotels and travel services 14. Household goods 15. Leasing 16. Machinery and equipment 17. Others 18. Packaging 19. Printing and publishing 20. Property development 21. Pulp and paper 22. Textiles 23. Transportation 24. Vehicles and parts

Total 35,710

— — 3,961 — — — — — 17,427 — — — — — 4,722 — — —

— — 3,933 5,667

— — — —

1997a

— — 12,930 5,157 2,400 — 900 — 350 — 22,558 — 500 1,421 — 1,700 1,000 1,717

56,800 1,600 12,570 4,500

5,200 184,557 168,455 16,102

125,606

900 — 11,810 5,202 264 2,000 1,700 3,152 17,500 370 2,575 — 500 5,001 — — — —

41,300 700 — 10,000

7,249 15,384 9,244 6,140

2000 1999b (Jan.–Sep.)b

36,257 315,859

— — 237 1,281 — — — — — — — — — 309 — — — —

— 500 — 6,420

— 27,510 20,000 7,510

1998b

100

0.46 — — 0.17 — — — — — — — — — 11.55 — 3.56 1.96 —

6.13 — 37.38 8.82

3.56 26.42 26.42 —

1995

b

Data of 1995–97 are approved public offering values and approved values of bonds offered overseas. Data of 1998–2000 are actual public offering and private placement values. Source: Securities and Exchange Commission, Thailand.

a

— 41,138 41,138 —

1995a

Industry

1996a

Value of Corporate Bonds (Baht Millions)

100

0.34 — 14.38 9.92 — — — 1.30 — — 0.86 — — 3.13 2.59 — — —

6.74 — 4.54 21.18

— 35.01 35.01 —

1996

100

— — 11.09 — — — — — 48.80 — — — — — 13.22 — — —

— — 11.01 15.87

— — — —

1997

100

— — 0.65 3.53 — — — — — — — — — 0.85 — — — —

— 1.38 — 17.71

— 75.87 55.16 20.71

1998

100

— — 4.09 1.63 0.76 — 0.28 — 0.11 — 7.14 — 0.16 0.45 — 0.54 0.32 0.54

17.98 0.51 3.98 1.42

1.65 58.43 53.33 5.10

100

0.72 — 9.40 4.14 0.21 1.59 1.35 2.51 13.93 0.29 2.05 — 0.40 3.98 — — — —

32.88 0.56 — 7.96

5.77 12.25 7.36 4.89

2000 1999 (Jan.–Sep.)

% of Total Corporate Bonds

Table 8.12 Thailand: Values of Corporate Bonds Issued During 1995–2000, Classified by Industry 232

Mario B. Lamberte

8. Developing the Fledgeling Debt Securities Markets in Southeast Asia

233

than twice the turnover in 1997. However, it is still low, accounting for less 2 per cent of total outstanding amount of government securities in that same year. In Thailand, government debt securities have dominated the secondary market since 1998, accounting for about 90 per cent of the total trading value at the Thai Bond Dealing Centre (Jantaraprapavech 2001). Its turnover ratio rose significantly from 44 per cent in 1999 to 125 per cent in the first three-quarters of 2000. With regard to corporate debt securities, its turnover ratio peaked at 150 in 1996, but dropped sharply as the Thai economy went through a severe crisis. It started to recover in 1999 and reached 36 per cent in the first three-quarters of 2000. 3. Addressing Major Factors Affecting the Development of the Debt Securities Markets

Recognizing the need to accelerate the development of the debt securities markets, the five ASEAN countries have attempted to address major impediments to such development. This section discusses recent major initiatives taken by the five ASEAN economies to stimulate their domestic debt securities market. At the outset, we may say that Singapore and Malaysia have already gone quite far in terms of providing a wholesome environment for developing the domestic debt securities market. At the tail end are the Philippines and Indonesia. 3.1. Benchmark Reference Rate

Benchmark securities are important in pricing instruments, both on the primary and secondary markets. Having a lower risk and high liquidity profile, government securities can very well serve as benchmark instruments. They should, however, be available in various tenors, and in sufficient quantity. Since 1998, Singapore has been implementing several measures to improve the benchmark yield curve, such as increasing the issuance of SGS bonds, re-opening of existing ones, and extending the SGS maturities to ten years. In 2000, the average yields for the SGS were as follows: three-month T-bills — 2.48 per cent; one-year T-bills — 2.57 per cent; two-year bonds — 2.90 per cent; five-year bonds — 3.44 per cent; seven-year bonds — 3.78 per cent; ten-year bonds — 4.09 per cent. Singapore is currently considering extending further the SGS maturities to fifteen years. In 1997, the Malaysian government

© 2003 Institute of Southeast Asian Studies, Singapore

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Mario B. Lamberte

mandated Khazanah, a wholly owned government corporation, to issue benchmark bonds on a regular basis (that is, four issues a year at intervals of three months [Tan 2000]). As of 1999, Khazanah bonds accounted for 10 per cent of total outstanding government bonds. As of midOctober 2001, the market indicative yields of Malaysian government securities with the corresponding remaining years to maturity were as follows: one year — 2.921 per cent; two years — 3.018 per cent; three years — 3.145 per cent; four years — 3.266 per cent; five years — 3.359 per cent; six years — 3.574 per cent; seven years — 3.775 per cent; eight years — 3.894 per cent; nine years — 4.019 per cent; ten years — 4.150 per cent; and fifteen years — 4.856 per cent. The Philippines first experimented with floating-rate notes to introduce the market to long-term government securities. Then, in the second half of the 1990s, it replaced the floating-rate notes with fixedrate T-notes and bonds, and gradually extended the maturities to twentyfive years. However, the market lacks the appetite for the twenty- and twenty-five-year bonds. In 2000, fixed-rate T-notes and bonds comprised 43 per cent of the total outstanding government securities, compared with only 8 per cent in 1995. The average yields of government securities when issued were as follows: 91-day T-bills — 9.93 per cent; 182-day Tbills — 11.06 per cent; 364-day T-bills — 12.03 per cent; two-year bonds — 12.50 per cent; five-year bonds — 14.16 per cent; seven-year bonds — 14.71 per cent; and ten-year bonds — 14.98 per cent. In Thailand, the re-issuance of government bonds under the 500 billion baht programme in late 1998 has paved the way for the development of a benchmark for pricing securities. Developed by the Thai Bond Dealing Centre, the yield curve currently spans over the range of zero to fifteen years. It is based on a bidding yield of all government bonds quoted by nine primary dealers (Jantaraprapavech 2001). A set of government bonds with maturity close to one, two, five, seven, and ten years are also selected to represent as benchmark bonds. Indonesia has just started to issue government bonds for bank recapitalization, which can hardly be used as benchmark bonds. 3.2. Supply of Debt Securities

At the initial stages of the development of the debt securities market,

© 2003 Institute of Southeast Asian Studies, Singapore

8. Developing the Fledgeling Debt Securities Markets in Southeast Asia

235

the government plays a key role as a reliable supplier of debt securities. The Monetary Authority of Singapore (MAS) conducts auctions of three-month T-bills weekly, and issues one-year T-bills, two-, five-, sevenand ten-year bonds according to a pre-announced issuance calendar. The issue size ranges from S$2.4 billion to S$3.6 billion. Not only did the government increase the issuance of SGS, but it also exhorted statutory boards to raise funds from the bond market, to increase the supply of high-quality bonds in the market, rather than to continue to depend on bank credit. This is a bold move on the part of the Singaporean government, considering the fact that statutory boards have been able to access bank loans easily and at reasonable rates. Thus, as of the first quarter of 2001, statutory boards had already issued a total of S$4.8 billion, with maturities ranging from five to fifteen years. Singapore has also liberalized its policy on the non-internationalization of the Singapore dollar in the past three years. Between 1998 and the first quarter of 2001, foreign entities issued bonds worth S$6.6 billion, with maturities ranging from two to ten years. In view of these reforms, the total Singapore-dollar and non-Singapore dollar-denominated corporate debt issuance rose markedly, from S$8.5 billion in 1997 to S$50.5 billion in 2000. In March 2000, the Malaysian government started to announce the securities auction calendar, to inform the public that it will be issuing MGS on a regular basis. It also enlarged the size of MGS, and consolidated existing MGS issues into fewer larger issues, with issue sizes ranging from RM3 billion to RM5 billion, and maturities from three to ten years. To increase the supply of private debt securities, the Securities Commission became the sole regulator of all fund-raising activities — a move that should speed up and reduce the costs of issuance of securities. The Commission recently introduced measures to facilitate the approval of private debt securities issues, such as waivers of minimum rating requirements, the mandatory underwriting requirements, and the minimum shareholders’ funds. The government has granted a waiver from stamp duty for all instruments relating to the issue and transfer of private debt securities, issues of which have been approved by Bank Negara Malaysia or the Securities Commission. In the Philippines, the Bureau of the Treasury conducts a weekly

© 2003 Institute of Southeast Asian Studies, Singapore

236

Mario B. Lamberte

auction of T-bills. The auction for the two-year bond is done once a month and for the five-, seven-, and ten-year bonds once every quarter. The issue size ranges from 1 billion pesos to 3 billion pesos. Most recently, the government issued a ten-year zero coupon bond and, in view of the positive reception of the market, it plans to issue it on a regular basis. The Philippines has so far not seriously addressed major impediments to the supply of private debt securities. For instance, the existing Corporation Code requires the approval of corporate CP issues only by the issuer company’s board of directors, but requires a two-thirds majority of stockholders for bond issues. All issuances of CPs need to be registered with the Securities and Exchange Commission (SEC). One of the requirements for issuing a short-term CP is that the issuer should secure a credit line from commercial banks equivalent to at least 20 per cent of its aggregate CP outstanding at any time. This definitely raises the cost of issuing CPs. In the case of long-term CPs, which are considered by the market as de facto bonds, issuers are not required to obtain a credit line from banks, but they must satisfy certain stringent requirements imposed by the SEC. In Thailand, the government has recently restarted issuing T-bills, partly to create a short-term benchmark for the bond market, and also to rationalize the auction of government securities by coming up with auction schedules. Thus, T-bills and government bonds are auctioned every Monday and Wednesday, respectively, and state enterprise bonds, every other Tuesday. The law that prohibits the government from issuing bonds unless it runs into a deficit will be a major constraint on the part of the government to deepen and broaden the market for government securities. Indonesia has yet to formulate a programme for developing government debt securities beyond what it is doing now to recapitalize ailing banks. 3.3. Demand for Debt Securities

Investors are naturally attracted to investment instruments that have high yields relative to other instruments, given the same risk profile. Fiscal incentives can make debt securities attractive to investors. To stimulate demand for debt securities, Singapore does not impose a capital gains tax on SGS. The series of tax reforms introduced in 1998 and

© 2003 Institute of Southeast Asian Studies, Singapore

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1999 have been designed to give concessionary tax rates to investors of debt securities. For instance, interest income earned by financial institutions and corporations in Singapore from eligible debt securities is taxed at a concessionary rate of 10 per cent. Non-residents holding SGS issued between 28 February 1998 and 27 February 2003 are exempt from withholding tax. As part of its effort to broaden the investor base of Singapore’s debt securities market, from December 2000 the government has allowed non-residents to borrow Singapore dollars freely to invest in Singapore dollar financial assets including SGS, and Singapore dollar bonds. Malaysia has also provided tax incentives to encourage investors to invest in debt securities. More specifically, it provides tax exemption on interest earned by individuals investing in bonds issued by public companies listed on the Kuala Lumpur Stock Exchange, on interest earned by individuals investing in bonds issued by companies rated by Rating Agency Malaysia Berhad or Malaysian Rating Corporation Berhad, and on interest income received by unit trusts and listed closedend funds from corporate bonds. Withholding tax for foreign investors on interest earned has been reduced from 20 to 15 per cent since October 1994. More recently, the government has granted a waiver of stamp duty for all instruments relating to the issue and transfer of private debt securities approved by Bank Negara Malaysia or the Securities Commission. In contrast, Thailand and the Philippines retain a complicated tax system that tends to reduce the returns on investing in debt securities. In Thailand, for instance, individual investors are subject to a 15 per cent withholding tax on interest income and on capital gains. In the Philippines, there is a 0.15 per cent documentary stamp tax on issuance/ acquisition of securities, and a 20 per cent withholding tax on interest income on bond investments. 3.4. Market Infrastructure

The market infrastructure for developing the debt securities market is pretty well in place in Singapore. There are twelve approved primary dealers in the SGS market that provide liquidity to the market by quoting two-way prices under all market conditions and underwriting the issuance

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of SGS auctions. In addition to the twelve primary dealers, there are twenty dealers representing various financial institutions and seventytwo banks that maintain book-entry SGS accounts with MAS for their own trading. To support the market-making activities of primary dealers, the government has recently established a repo facility for primary dealers. Since 1998, profits generated by primary dealers from trading in SGS have been exempt from tax. An efficient clearing and settlement system supports the SGS market. The MAS maintains a register of all SGS, and transactions are cleared T+1 on a DvP basis over the MAS electronic payment system and MAS’ SGS book-entry clearing system. Same day settlement can be made if transactions are entered before 3:30 p.m. To provide the market with up-to-date information about the debt securities market and enhance transparency of the market, MAS posts daily the SGS closing and high-low prices on its website. Malaysia introduced much earlier a Principal Dealer System, in which market makers were appointed for certain types of debt securities. The principal dealers are to provide broadly continuous two-way price quotations for these papers to individuals, institutional clients, and Bank Negara Malaysia (BNM). However, Horashikin Abdul Hamid and Mahani Zainal Abidin (2001) have pointed out that principal dealers are reluctant to make markets because of the high cost of holding and the lack of paper. Also, there is an existing regulation against shortselling and there is no infrastructure for bond lending. In short, principal dealers are not prepared to make two-way quotes unless they are willing to take additional risks. Malaysia has put in place other infrastructure for both the primary and secondary market for government securities. In particular, it automated its primary auction process for government securities in 1996. This is supported by a real time gross settlement (RTGS) system called RENTAS, which in 1999 replaced an earlier netting system for settlement of trades in securities. The government set up a Bond and Information and Dissemination System (BIDS) in 1997 to promote awareness of the bond market and enhance the transparency of the OTC market. An important measure made by BNM for the primary corporate bond market was the mandatory rating for all issuances of domestic debt securities. Malaysia has currently two credit rating

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agencies. To improve the efficiency of secondary trading of PDS, BNM has required that all unlisted PDS be issued scripless, with clearing and settlement executed electronically via the RENTAS. Like Malaysia, the Philippine government, through the Bureau of the Treasury, conducts auctions of Treasury bills and bonds using an electronic system, supported by a book-entry registry system. However, settlement is not on a DvP system, but on a same day netting system. It has more than forty accredited government securities dealers, who are not required to make two-way quotes. There currently exists two credit rating agencies in the Philippines, but the government does not mandate issuers to have their issues rated. In Thailand, T-bills, BoT, and FIDF bonds are issued in scripless form and are transferred by book entries, all handled by the Bank of Thailand (Ganjarerndee 2000). Similarly, corporate bonds are issued in scripless form and transferred by book entry, but cleared and settled at Thailand Securities Depository Co. The creation of the Thai Bond Dealing Centre (TBDC) is an important step towards developing the secondary market for bonds. Dealers are required to report to TBDC all traded transactions, so as to provide the market with information on prices. A similar effort was made in Indonesia with the creation of the Over-the-Counter Fixed Income Service (OTC-FIS), located in the Surabaya Stock Exchange. But in Indonesia traders are not required to report their trading transactions to the OTC-FIS. Scripless trading of securities has been available in Indonesia since 1998, and rating of commercial paper and bond issues is mandatory, which is performed by two approved credit rating agencies. 4. Remaining Tasks

The description and analysis above suggests four things. First, the domestic debt securities markets in the five ASEAN economies are still at their infant stage. Private and state enterprises’ easy access to both domestic and foreign bank credit, and a long history of budget surpluses — with the exception of the Philippines — were some of the main reasons why governments in these countries did not pay much attention to the development of the domestic debt securities market. Secondly, the private debt securities market

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cannot flourish without a well-developed market for government securities. Benchmark bonds are needed to establish a yield curve that can serve as a basis for the pricing of other securities. This, therefore, requires a strong commitment on the part of the government to issue securities of various tenors at regular intervals, regardless of its fiscal position. Thirdly, appropriate policies can stimulate the supply of, and demand for, debt securities. And fourthly, the government must ensure that adequate market infrastructure be put in place to reduce transaction costs and settlement risks, as well as enhance the transparency of trading in securities. Although ASEAN economies have already shown a strong commitment towards nurturing their fledgeling debt securities market and have started to remove some of the major impediments, some tasks remain ahead. Obviously, those that so far have done little in reforming their debt securities market have more to do to spur the development of the domestic debt securities market, and they can profit from the initiatives recently undertaken by other economies in the region in this respect. We discuss these below. 4.1. Benchmark Yield Curve

Singapore’s efforts in developing benchmark yield curves deserve to be given a serious look. Maturities are well spaced and lot sizes auctioned for each tenor are sufficiently large. Auctions are made in accordance with a pre-announced calendar. The Philippines has made similar efforts but has achieved little in establishing a reliable yield curve of risk freeinterest rates, for two reasons. One reason is that whenever a conflict between developing a robust market for benchmark bonds and minimizing the cost of borrowing emerges, the government usually opts for the latter. Thus, the government rejects bids especially for longer tenors whenever it thinks the bid rates are unreasonably high. This has prompted the private financial institutions to create an alternative reference rate — the Phibor. The other reason is that lot sizes auctioned for each tenor are relatively small. Another thing worth noting is the emergence of a swap market in Singapore. Although swap rates are not risk-free rates, corporations may consider them as alternative benchmarks for bond rates. This only underlines the importance of developing hedging mechanisms that can help in appropriately pricing debt instruments.

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4.2. Primary Dealer System

Both Singapore and Malaysia have established a primary dealer system for government debt securities, in which the primary dealers make twoway prices under all market conditions. Their experience suggests that this system should be supported by a securities-lending facility for primary dealers to facilitate their market-making activities. So far, only Singapore has established a securities-lending facility for dealers. To deepen and broaden the market for government securities, other ASEAN economies might be well advised to adopt a primary dealer system supported by facilities for the repurchase market and securities lending. 4.3. Tax Incentives

To develop debt securities during the initial stages of development, appropriate tax incentives must be introduced. Both Singapore and Malaysia are way ahead in these efforts. In other ASEAN economies, taxes on debt securities are not only high but also distortionary, making debt securities less attractive than other financial instruments. Here again, the government should make a clear choice between raising revenues and nurturing a debt securities market. In designing a tax incentive system for debt securities, care must be exercised in such a way that it does not favour one class of investor over another, and that it does not artificially create different classes of debt securities within the same market. This has been one criticism cited against Singapore’s tax incentive system for SGS (Tan 2000). 4.4. Mandatory Investment in Government Securities and Mandatory Credit

The demand for government securities in the Southeast Asian region looks big at first blush. However, a large chunk of it is due to the fact that some institutions, notably banks, provident and pension funds, and insurance companies, are mandated to invest a sizeable portion of their resources in government securities. This undermines the pricing and liquidity of government securities, since these institutions normally hold on to those securities until maturity. This policy needs to be re-examined in light of the need to develop an efficient financial market. Given ASEAN economies’ current emphasis on inflation targeting,

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indirect monetary tools will be more effective in attaining that objective than direct monetary tools, such as imposing relatively high reserve requirements on bank deposits. More generally, governments in the region must let the market allocate financial resources efficiently. Mandatory credit allocation to certain industries weakens corporate governance and reduces incentives of favoured industries to access the debt securities market for funds. 4.5. Role of Institutional Investors

Institutional investors, such as pension funds, mutual funds, and insurance companies, have an important role to play in the development of debt securities markets in the region. Apart from providing funds to the bond market, they are also an important source of market discipline. However, pension funds, mutual funds, and insurance companies should be given enough flexibility to manage their investment portfolios so that they can fully develop and attract more funds for the debt securities market. Appropriate intermediation taxes can also help in developing institutional investors. 4.6. Good Corporate Governance

One of the issues that clearly emerged during the Asian financial crisis is the need to institute good corporate governance in the region. Corporations wanting to issue bonds must convince potential buyers that they have a professional management team able to protect the interests of all stakeholders, including bondholders. They must follow internationally accepted accounting and auditing standards and regularly disclose to the public their performance. The presence of independent members on the boards of corporations can enhance corporate governance. Also, adequate protection of minority shareholders and a clear bankruptcy law are effective instruments for strengthening corporate governance. 4.7. Rating of Corporate Debt Securities

Mandatory rating of corporate debt issues can enhance the marketability and increase the proceeds of debt security issues. However, passing a minimum rating requirement should not be made a pre-condition for

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issuance of debt securities. The mandatory rating requirement should be combined with the upgrading of the quality of domestic credit rating agencies, or allowing foreign rating agencies to compete with local rating agencies in rating issues. 4.8. Market Infrastructure

An efficient clearing and settlement system and information system are important infrastructure for developing the domestic debt securities market. Settlement risk must be minimized, if not completely eliminated, so that both the primary and secondary markets for debt securities can function well. Countries in the region that have not yet established an RTGS system for clearing and settlement need to accelerate the implementation of such system and link it with a central depository system. Unlike equities, debt securities are traded mostly OTC. An information system, like the BIDS in Malaysia or the one developed by TBDC in Thailand, which includes a requirement that traders report their trading transactions, can enhance the transparency of the OTC market, and provide the general public with up-to-date information on prices of securities. Finally, there is a need to reconsider the policy against short-selling of securities in the region, and develop a repo facility to support the market-making activities of primary dealers, as Singapore has done. NOTES * The author is grateful to Ms Juanita E. Tolentino and Ms Merle G. Galvan for their excellent research assistance. 1. For the purposes of this chapter, ASEAN refers only to the ASEAN-5 countries, namely Indonesia, Malaysia, the Philippines, Singapore, and Thailand. 2. According to Eichengreen and Hausman (1999), original sin “is a situation in which the domestic currency cannot be used to borrow abroad or to borrow long term, even domestically. In the presence of this incompleteness, financial fragility is unavoidable because domestic investments will have either a currency mismatch (projects that generate pesos will be financed with dollars) or a maturity mismatch (long-term projects will be financed with short-term loans”. Crisis-hit countries in East Asia experienced severe double mismatch, that is, currency and maturity mismatch, and an imbalance between short-term foreign debts and international reserves, prior to the onset of the financial crisis.

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3. In the long run, banks must be prepared to deal with the challenges posed by a vibrant bond market by competing fiercely for corporate credit and by looking for alternative sources of revenue (for example, consumer credit). 4. These measures are discussed in Section 3. 5. The turnover ratio is computed by dividing the volume of transactions by the total amount of bonds listed.

REFERENCES Eichengreen, Barry and Ricardo Hausmann. “Exchange Rates and Financial Fragility”. National Bureau of Economic Research Working Paper no. 7418. Cambridge, M.A.: National Bureau of Economic Research, November 1999. Ganjarerndee, Siri. “Development of Government Bond Markets in DMCs – Thailand”. Paper presented at the ADB Conference on Government Bond Markets and Financial Sector Development in Developing Asian Economies, 28–30 March 2000. Herring, Richard J. and Nathporn Chatusripitak. “The Case of the Missing Market: The Bond Market and Why It Matters for Financial Development”. ADB Institute Working Paper 11, ADBI (July 2000). Jantaraprapavech, Sureeporn. “The Bond Market in Thailand”. Mimeographed. 2001. Norashikin Abdul Hamid and Mahani Zainal Abidin. “Ringgit Bond Market: Development and Challenges”. Mimeographed. 2001. Rhee, S. Ghon. “Regionalized Bond Markets: Are the Region’s Markets Ready”. Mimeographed. September 2000. Saldana, Cesar G. “Development of Government Bond Markets in DMCs — Philippines”. Paper presented at the ADB Conference on Government Bond Markets and Financial Sector Development in Developing Asian Economies, 28–30 March 2000. Shidiq, Akhmad Rizal and Urip Suprodjo. “The Development of Indonesian Corporate Bond Market”. Mimeographed. 2001. Tan Kok-Hui. “Development of Government Bond Markets in DMCs — Singapore”. Paper presented at the ADB Conference on Government Bond Markets and Financial Sector Development in Developing Asian Economies, 28–30 March 2000. Yoshitomi, Masaru and Sayuri Sirai. “Designing a Financial Market Structure in PostCrisis Asia”. ADB Institute Working Paper 15, March 2001.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at 245 9. Developing and Deepening< the Equity Markets of Southeast http://bookshop.iseas.edu.sg > Asia

9

Developing and Deepening the Equity Markets of Southeast Asia Nick J. Freeman

1. Introduction

Lessons to be learnt from the Asian financial crisis that struck much of Southeast Asian in 1997–98 are numerous and have now been fairly well rehearsed. One of these lessons is that an over-reliance on just one or two principal sources of financing can pose potential problems for an economy. Throughout much of Southeast Asia, commercial bank lending remains the dominant source of funding for domestic corporates seeking capital for their development. Looking ahead, it would seem sensible that Southeast Asian countries seek to better diversify their sources of corporate sector funding, particularly for long-term investment needs. Some options would entail embracing what are relatively new or underdeveloped funding sources in Southeast Asia’s experience, such as the corporate bond market, venture

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capital, and so on. Other options, such as the equity markets and project financing, would necessitate further developing and deepening what are already relatively developed funding sources, and taking them to the next level. This chapter seeks to address the issues confronting Southeast Asian countries in developing and deepening their equity markets, and how they might go about reaching that next level. The chapter is divided into three main parts: past, present, and future. The first part briefly profiles the recent history of Southeast Asia’s equity markets, and charts their burgeoning over the last few decades, notably with regard to foreign portfolio inflows. The second part attempts to identify the main challenges and dilemmas that currently face Southeast Asia’s equity markets, as evidenced by their relatively poor performance since the Asian financial crisis of 1997. The third part of the chapter seeks to discern some of the policy options that might be available to the region’s equity markets in any bid to revive their fortunes. The chapter focuses its attention on the principal five equity markets in Southeast Asia: Indonesia (Jakarta’s JSX), Malaysia (Kuala Lumpur’s KLSE), the Philippines (Manila’s PSE), Singapore (the SGX), and Thailand (Bangkok’s SET). Brunei, Cambodia, and Laos do not yet have equity markets operating. Myanmar piloted a single-stock equity market in the mid-1990s, but this project was not subsequently developed. Vietnam opened its first equity market in July 2000, and by mid-2001, six former state-owned enterprises were listed on the Ho Chi Minh City stock exchange. But with an aggregate capitalization of around US$85 million and average daily trading volumes of just US$350,000 (as at midSeptember 2001), the Vietnam equity market remains very small — less than 0.01 per cent the capitalization of Jakarta’s JSX, the smallest of Southeast Asia’s five main equity markets. 2. Southeast Asia’s Equity Markets Past: A Brief Profile of Their Pre-1997 Performance and Pertinence The large capital inflows into emerging markets in the 1990s were predicated on, and helped to strengthen, the perception that emerging markets represented a near-mainstream asset class that was suitable for many investors.1

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2.1. Global Emerging Market Trends and Regional Equity Markets History

Although commercial bank lending (from both foreign and domestic banks) remains the predominant source of capital funding for firms in Southeast Asia, the region’s equity markets have developed quite substantially in the last quarter century, and have acted as fairly significant conduits for long-term capital raising by the region’s corporate sector. It is certainly true that the growth of Southeast Asia’s equity markets has occurred at a greater pace than its fledgeling corporate bond markets. The burgeoning of Southeast Asia’s equity markets has been part of a global trend that has seen stock markets open and develop across the developing world over the last twenty years or so. Forty-three countries opened stock markets between 1980 and 1998, helping drive — as well as being driven by — the flow of portfolio capital to emerging markets, which rose from effectively zero in 1980 to US$100 billion in 1993 (the 2 big “bull market” year for emerging market equity investors). The thirtytwo “developing country” markets within the IFC’s global composite index saw their aggregate capitalization grow from US$67 billion (or 2.5 per cent of global capitalization) in 1982 to US$2.1 trillion (or 8.9 3 per cent of global capitalization) in 1997. As Weber and Davis (2000) note, this trend has created an important “channel for investment capital from wealthy industrial nations to “emerging markets” as well as a 4 mechanism for institutional change in local economies”. Buoyed by the end of the Cold War, and a trend of privatization across many developing economies, the 1990s witnessed a significant increase in private capital flows to global emerging markets, including Southeast Asia, peaking around 1993–94. Indeed, the emerging markets became a 5 new, mainstream “asset class” for portfolio investors during the 1990s. The history of formal equity markets in Southeast Asia dates back over seventy-five years, but they have only become a well-established feature of the region’s economic landscape over the last twenty-five years. The oldest bourse in Southeast Asia is the Manila stock exchange, originally established in 1927. The KLSE in Kuala Lumpur has its roots in the Malayan Stock Exchange, founded in 1960. Between 1965 and 1973, the stock exchanges in Kuala Lumpur and Singapore continued to operate as a common exchange — the Stock Exchange of Malaysia and Singapore. Only in 1973 was the

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Figure 9.1 Number of Listed Companies in Southeast Asia’s Main Equity Markets, 1990–2001

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independent Stock Exchange of Singapore formally incorporated. The SET in Thailand was established in late April 1975. The Jakarta stock exchange is the youngest of the “big five” equity markets in Southeast Asia, having only commenced operations in 1977. Most recently, in July 2000, Vietnam unveiled its first attempt at a secondary market for trading both equity and 6 fixed-income securities, located in Ho Chi Minh City. The following subsections will attempt to sketch out a brief profile of Southeast Asia’s equity market development during the 1990s. 2.2. Listed Firms

As Figure 9.1 shows, the aggregate number of companies listed on Southeast Asia’s five main equity markets rose considerably during the 1990s, from 800 in January 1990 to slightly over 2,100 in mid-2001 — a 2.6-fold increase. Notably, the Asian financial crisis of 1997–98 did not cause the cummulative number of companies listed in Southeast Asia to drop (for example, through the de-listing of bankrupted firms), although there was a discernible levelling-off in initial public offerings

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Figure 9.2 Market Capitalization of the Southeast Asian Equity Markets, 1990–2001 (US$ Millions)

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(IPOs) in the 1998–2000 period. In the three-year period between January 1998 and December 2000, the regional picture was quite mixed, with the number of companies listed in Jakarta increasing by just four, Manila had a net increase of nine listed firms, Bangkok’s SET actually contracted by fifty-one companies, eighty-three more companies were listed in Kuala Lumpur, and ninety-three firms in Singapore. Relative to other major stock markets during the 1990s, the increase in the number of companies listed on Southeast Asia’s equity markets was fairly commendable. The number of firms listed in Hong Kong increased from just under 300 in January 1990 to 740 by mid-2001 (a 2.5-fold increase); Japan increased from 2,024 to 2,578 listed firms over the same period (a 25 per cent increase); and the NYSE increased

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from 1,723 to 2,817 (a 63 per cent increase). And the same post-1997 plateau of IPOs is apparent across all these equity markets. Even the NASDAQ in New York, which enjoyed a significant increase in the performance of its index during the later part of the 1990s, saw the number of companies listed on its market contract from 5,466 to 4,436 (a contraction of 19 per cent), partly as a result of vigorous merger and acquisition (M&A) activity in the ICT sector. 2.3. Market Capitalizations and Trading Volumes

In terms of their market capitalizations (that is, the total value of all the shares listed on the equity market), Southeast Asia’s stock markets have also witnessed some fairly commendable increases during the last decade or so, as shown in Figure 9.2. The aggregate capitalization of Southeast Asia’s five main equity markets increased from around US$122 billion in January 1990 to US$444 billion in December 2000 — a 3.6-fold increase. However, the cumulative capitalization of these five markets actually peaked in February 1997, shortly before the Asian financial crisis commenced, at US$837 billion — 47 per cent higher than where they “fetched up” at the end of 2000. Put another way, the market capitalizations of Southeast Asia’s equity markets have almost halved in 7 the years since the Asian financial crisis, in U.S. dollar terms. Over the same period (that is, between January 1990 and December 2000), the market capitalization of the Hong Kong equity market increased by slightly more than eightfold, the NYSE by 4.4-fold, and Japan’s market capitalization actually decreased by 25 per cent. When we look to see how Southeast Asia’s combined market capitalization compares with some of the major global equity markets, the results are fairly humbling. As at mid-2001, the five main equity markets of Southeast Asia had a combined market capitalization that was 46 per cent smaller than Hong Kong alone, an eighth the size of Japan, 3 per cent of the NYSE, and 12 per cent of NASDAQ’s market capitalization (or 2.5 per cent of the NYSE and NASDAQ combined). Clearly, in global terms, the Southeast Asian markets combined are a very small “blip” on the global asset allocation “radar screen”; and individually, at least three of these Southeast Asian equity markets (Bangkok, Jakarta, and Manila) are bordering on insignificance in global

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Capitalization of Southeast Asian Markets and Select U.S. Corporates, as at 25 September 2001

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terms. Indeed, a number individual companies listed in the United States have capitalization figures that exceed those of entire Southeast Asian equity markets, as illustrated in Figure 9.3. As at late September 2001, General Electric had a market capitalization that was 56 per cent greater than the market capitalizations of all five major Southeast Asian 9 equity markets combined. Even in the regional context, Southeast Asian markets have lost ground relative to Hong Kong (see Figure 9.4), notably since late 1999, having had a higher aggregate market capitalization than Hong Kong until the onset of the Asian financial crisis. A broadly similar pattern is apparent with regard to trading volumes on Southeast Asia’s equity markets; they have broadly increased during the 1990s, yet they remain substantially smaller than in the major markets. Whilst sometimes overlooked, the issue of providing adequate trading volume in emerging markets is an essential one for most institutional investors, who tend to shun illiquid markets (and by default, shun companies with shares listed on illiquid markets, regardless of the 10 fundamental qualities of such companies). 2.4. Indices

As Figure 9.5 shows, the performance of the Southeast Asian market indices in the decade prior to the Asian financial crisis appears to also have been fairly commendable. In the ten years prior to January 1997, the Southeast Asian market indices were all up by between 2.5- and 9.8-fold, suggesting that if investors had “bought the index” in January 1987, they would have enjoyed acceptable returns a decade later. That said, a considerable proportion of the rises in the Southeast Asian indices were recorded during the first half of the 1990s (most notably in the emerging markets “bull run” of 1993–94), and their performances since 1994 have been markedly less impressive, as shown in Figure 9.6. This is particularly evident when one compares how the Southeast Asian equity market indices have performed relative to some other equity indices in the period between 1987 and 1994. Since 1987, their aggregate index performance has been below those of Hong Kong, the FTSE in London, and all the major U.S. indices (for example, Dow Jones Industrial, S&P 500, and NASDAQ Composite); only performing better than Japan’s Nikkei Stock Average 225. And since 1994, the relative performance of

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the Southeast Asian equity market indices has been even worse. As an asset class, Southeast Asian listed equities have not performed at all well in comparison with other global equities for at least seven years. 3. Southeast Asia’s Equity Markets Present: Post-1997 Challenges and Dilemmas “Poor old Southeast Asia. There are no fundamental reasons that its stock markets are declining — it’s just that no one’s really that interested any more …” Mark Matthews, ING Barings, AsiaTalk, 19 November 1999 “Unfortunately, almost everything south of Hong Kong is looking like a nogo region and seems set to stay that way.” Charles Wheeler, Standard & Poor’s, Guan Xi, 20 September 2001 “In this world you have value investors and growth investors, but these markets [Indonesia, the Philippines, and Thailand] really don’t offer much in either category.” 11 Markus Rosgen, ING Barings

Having provided a brief profile of Southeast Asia’s equity markets and their development during the 1990s, let us now turn to the major challenges and dilemmas that currently face these markets in the post-1997 context. 3.1. Challenges of Perception The old notion of a national stock exchange as a natural monopolycum-utility has become not just antiquated but actively harmful. The Economist, 26 May 2001, p. 11

As the SGX in Singapore has noted, increasingly “issuers and investors are migrating to markets that provide the greatest liquidity and best execution. The traditional value of an exchange is being eroded by the proliferation of electronic communications networks which are positioning themselves as virtual exchanges, and providing a single 12 electronic access to multiple markets.” The ability of policymakers to embrace these sorts of developments, and position their respective equity markets to take advantage (or at least not be victims of ) these changes requires a change in mindset. It can be argued that equity markets, particularly in developing countries, have been “invested” with more

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than just capital in the past; but also with national pride and political collateral. Equity markets are sometimes perceived by policymakers rather like oil refineries, hydropower projects, and even currencies, as totems of a country’s current economic strength and its future aspirations. More than just any old public utility, the stock market is regarded as a national symbol, and the performance of its index regarded as a measure of a country’s health and its corporate pulse. Given such perceptions, it may be difficult for policymakers to take the sort of action that is necessary to ensure the long-term future of a country’s equity market, if it requires divesting some of this non-financial collateral. For example, one could liken perceptions of equity markets to those of national airlines, as “national flag carriers”. This may explain in large part why the airline industry and equity markets have both been slow to engage in the sort of cross-border M&A activity that we have seen in most other industries in recent years, primarily due to resistance by policymakers. Instead, airlines and equity markets have made attempts to create strategic alliances, which aim to derive advantages from nonequity consolidation (for example, code sharing and cross-listing), without making the bolder step of actually merger, and thereby diluting their national identity. This is despite the fact that equity markets and airlines are faced with exactly the same sorts of forces — global over-capacity, increasing global competition, advances in technology and communications — that are driving businesses in other industries to consolidate across borders. There is also the danger of disconnect between the perceptions of policymakers towards their home country equity market and the perceptions of institutional investors. While the former have a tendency to view their domestic equity market in terms of its role within the national economy, the latter (as discussed in a later section of this chapter) increasingly regard all equity markets — and the companies listed on them — within a global context. If policymakers in Southeast Asia are to keep their domestic equity markets vibrant and relevant to the international financial industry, they need to be aware of the methods institutional investors use to conduct their work, and the prisms through which they perceive the world.

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3.2. Challenges of Global Asset Allocation, Diversification, and Benchmark Indices

It has been conventional wisdom in asset management for some time that diversifying one’s funds across different asset classes and countries is a sensible practice, providing some degree of protection from sudden events in one particular location or investment. However, global asset allocation methods have been undergoing gradual change in the 1990s. One change has been the increasing emphasis placed on asset allocation according to business sectors, as opposed to countries. As discussed below, the rise of multinational enterprises means that the utility of dividing up one’s investment portfolio according to the home country headquarters of each company (or the country where the company is listed, if different) is much less clear. In other words, the merits of portfolio allocation according to geographic diversification are becoming much less convincing. Far better to diversify one’s portfolio according to business sectors, investing in industries with differing business cycles, across a spectrum of companies, responsive to differing external conditions: growth stocks, momentum stocks, high-yield stocks, 13 defensive stocks, and so forth. There are a number of reasons for this gradual shift of asset allocation methods from countries to sectors. However, a major factor has been what Brooks and Catao (2000) see as a “growing conviction in the investment community … that globalization and the new economy are raising the importance of global industry effects in explaining return variation, at the expense of country-specific 14 factors”. Analysis recently conducted by Brooks and Catao suggest there is “clear evidence that industry sectors are becoming more important 15 in diversifying portfolio risk”. The financial industry has not been immune from the forces of globalization that have impacted on many industries in recent years. The “gravitational pull” of the major equity markets is becoming more apparent in emerging markets, with equity markets in Southeast Asia often taking 16 their opening cue from the direction of U.S. markets the night before. As capital flows across borders become easier, thanks in part to developments in communications as well as regulatory liberalization, it appears that contagion effects between markets are becoming more and more evident, and therefore the extent to which allocating assets across countries provides

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some degree of protection looks less and less convincing. If so, the utility of investing in some emerging markets, such as those in Southeast Asia — primarily as a hedge against the major equity markets — is lessened. Rather, these emerging equity markets must attract capital on their own merits, providing a conduit through which foreign capital can invest in domestic corporates offering relatively attractive risk-adjusted rates of return. And if institutional investors increasingly look at the equity universe through the prism of business sectors, then this only reinforces the need for Southeast Asian corporates to compare themselves, not with other companies listed in the same country, but other firms in the same business listed across the globe. When it comes to stock picking by institutional investors, Siam Cement in Thailand will increasingly be compared with Cemex in Mexico and Italcementi in Italy, not with Bangkok Bank or Thai International. The capital market industry itself has been going through considerable change in recent years, including consolidation within the fund management business. Increasingly large pools of capital are being managed by single asset management firms. Whilst there will always be a role for specialized boutique investors, including those focusing on Southeast Asia, the major global investors are reaching a scale that rivals the markets in which they trade and invest. As the Bank for International Settlements noted in its 1998 annual report, even a relatively marginal portfolio adjustment by some of the largest fund managers can be a “first order-event” for some of the 17 emerging markets in which they invest. But as some Southeast Asian equity markets have seen their market capitalizations shrink to low levels, resulting in very small index “weightings” (see the next paragraph), some global fund managers are becoming increasingly reluctant to expend time and resources conducting fundamental research on the spectrum of companies listed in 18 the region. For what are regarded as peripheral equity markets, institutional investors often find it more efficient to simply adopt an index-tracking investment strategy. Whilst index-tracking is an established investment strategy that is quite common in the developed equity markets, it poses some particular problems for Southeast Asia’s equity markets. The various global indices — such as the MSCI (Morgan Stanley Capital International), S&P (Standard & Poor’s), FTSE International, and Dow Jones indices — have tended to broadly benchmark their recommended asset allocations (or “weightings”) on the capitalizations of companies and aggregate capitalizations of whole

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markets. But as we have seen, Southeast Asia’s market capitalizations have contracted substantially since 1997, particularly in U.S. dollar terms, and are minute in comparison with the major equity markets. As a result, their recommended “weightings” have become equally small, prompting some major brokerage houses to even “zero weight” much of Southeast Asia in 19 recent years. In mid-2001, for example, the MSCI weighted Southeast Asia’s equity markets thus: Table 9.1 MSCI Weightings for Southeast Asia Compared (Mid-2001) Standard ACWI (All Country World Index) Free Index20 Singapore Malaysia Thailand Philippines Indonesia

0.38% 0.29% 0.08% 0.05% 0.03%

Japan Hong Kong Korea Taiwan India China

10.71% 0.93% 0.58% 0.69% 0.35% 0.35%

Hong Kong Korea Taiwan India China

18.1% 11.3% 13.7% 6.8% 6.7%

All Country Asia-Pacific Free Ex-Japan Index Singapore Malaysia Thailand Philippines Indonesia

7.6% 5.9% 1.6% 0.9% 0.6%

Source: MSCI Press Release, 19 May 2001.

For Southeast Asia, the index challenge has been compounded by changes currently under way amongst the providers of most major global indices to reconfigure their weightings, to take account of the number of company shares available for trading (the so-called “free float”). In the case of the MSCI, by mid-2002 the recommended weightings for listed companies will be based on their free float, rather than purely their aggregate capitalization. For listed companies that are closely held, either by the company’s founding family, or by the host country government, or though complex cross-shareholding agreements — of which there are a substantial number in Southeast Asia — their 21 recommended weightings will be reduced, or even dropped altogether. This will also have adverse knock-on effects for Southeast Asian equity market weightings, as shown in Figures 9.7 and 9.8. As the use of various

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indices grows within the asset management industry, it may become increasingly difficult for emerging equity markets to get back on institutional investors’ radar screens when their recommended weightings fall below a certain point. But does inclusion in these various indices matter ? It is estimated that approximately US$3 trillion in institutional funds is currently benchmarked against the various MSCI indices alone, of which US$500 billion is directly tracking the indices.22 As a result, “equity indices have become staggeringly influential on market behaviour”.23 3.3. Challenges of Sectoral Biases in Southeast Asia’s Equity Markets

The increasing emphasis on asset allocation according to sectors leads us to another challenge confronting Southeast Asia’s equity markets; their own sectoral imbalances. Whilst local banks, brokerage houses, finance companies, property developers and some other business sectors are often very well represented on Southeast Asia’s equity markets, companies in some other sectors of the real economy are much less visible. This constrains institutional investor appetite in Southeast Asia’s markets, when the range of sectoral exposure they are looking for is not provided by the spectrum of companies listed on the local equity markets. Clearly, it is not feasible for a national stock market to fully and accurately reflect the corporate profile of the host country’s real economy, nor can it contain listed companies in those sectors where the host economy has little or no activity. And nor should a stock market seek to follow investor fashion by seeking to bring to market companies in the most attractive business sectors of the day. However, a national stock market should try to ensure that it is not unduly tilted towards one or two business sectors, and should consider ways to encourage a diversity of stocks. When a local equity market is dominated by banks and finance companies, this market can become a virtual “no-go” area for institutional funds during a downturn in the financial industry business cycle. Unable to “rotate” into other sectors, portfolio investors have no choice but to pull their capital out of the equity market altogether. As one brokerage report commented wryly in late 1999, “people want exposure to something big that has a conveyor belt in Southeast Asia, not just property and 24 banks”.

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Figure 9.7 MSCI’s All Country World Free Index Weightings for Southeast Asia, Before and After the New Free Float Component

0.4 0.35

% Weighting

0.3 0.25 0.2 0.15 0.1 0.05 0 Singapore

Malaysia Standard

Thailand

Philippines

Indonesia

With new free float component

Source: MSCI, May 2001.

Table 9.2 Top Ten Multinational Enterprises, Ranked by Size of Foreign Assets, 1999 (Percentages)

Company General Electric ExxonMobil Corp. Royal Dutch Shell General Motors Ford Motor Co. Toyota Motor Co. Daimler Chrysler AG Total Fina SA IBM BP

Listed

Foreign Assets as % of Total Assets

Foreign Sales as % of Total Sales

USA USA UK/Netherlands USA USA Japan Germany France USA UK

34.8 68.8 60.3 24.9 — 36.3 31.7 — 51.1 74.7

29.3 71.8 50.8 26.3 30.8 50.1 81.1 79.8 57.5 69.1

Source: Percentage figures calculated from figures provided in UNCTAD Press Release, TAD/INF/PR29 (18 September 2001).

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Figure 9.8 MSCI’s All Country Asia-Pacific Free Ex-Japan Index Weightings for Southeast Asia, Before and After the New Free Float Component

8 7

% Weighting

6 5 4 3 2 1 0 Singapore

Malaysia Standard

Thailand

Philippines

Indonesia

With new free float component

Source: MSCI, May 2001.

3.4. The Challenge Posed by Multinational Enterprises

Another challenge facing emerging equity markets, including those of Southeast Asia, is the rise of multinational enterprises (MNEs). Often listed on the major equity markets of the United States, Japan, or Europe, major multinational firms have operations that span the globe, often through vertically integrated equity ownership structures. As a result, portfolio investors can gain global exposure to an industry (and sometimes multiple industries) through a listed MNE, without the need to invest directly in numerous emerging markets. Indeed, they may even be able to gain adequate exposure to “peripheral economies” purely through investment in some global MNEs. According to UNCTAD’s World Investment Report 2001, some of the world’s largest MNEs have substantial overseas assets and sales, as a proportion of total assets and sales (see Table 9.2). Further, if such MNEs have direct subsidiaries and equity-related

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affiliates operating in the economies of Southeast Asia, then there is relatively less chance that these local companies will have the desire to list their operations in the host country, as the lead company within the MNE should be able to provide adequate (and possibly cheaper) funding sources. In this way, MNEs have the potential to indirectly constrain emerging equity markets, both in terms of investors wishing to invest and companies wishing to list. This is particularly true in Southeast Asia, where the presence of foreign-based MNEs, through several decades of substantial FDI activity, is fairly considerable. Returning to the issue of sectoral imbalances within Southeast Asia’s equity markets, part of the problem may stem from the fact that some local industries are dominated by the presence of foreign MNEs (through wholly or majorityowned subsidiaries and affiliates), which have scant need to make use of the host country’s equity market. In this regard, Southeast Asia’s wellestablished strategy of providing a conducive host environment for FDI may not be wholly compatible with its attempt to develop its equity markets. One recent development that might reverse this trend, however, is the perceived increase in more “open” (that is, less equity-based and vertically integrated) international production networks in Asia, as depicted by Borrus, Ernst, and Haggard (2000). Such a trend might be expected to see the emphasis on securing sources of investment funding shift back towards companies in host countries, without recourse to the lead company of a conventional MNE, and thereby promote the use of local equity markets as a means of long-term capital raising. 3.5. If You Can’t Beat Them …

As Schmukler and Vesperoni (2000) note, “equity trading is shifting 25 from local domestic markets to international markets”. This is happening for a number of reasons. First, the sorts of challenges confronting Southeast Asia’s equity markets — and numerous other emerging markets — discussed above are becoming apparent to corporates seeking to enact IPOs, and prompting them to consider the alternatives to a domestic listing. As listing regulations are gradually relaxed, companies from the developing world are seeking to enact IPOs on more attractive equity markets; closer to the bigger pools of portfolio 26 funds and trading on more liquid markets. For example, in the case of

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both the NASDAQ and NYSE in New York, a number of Southeast 27 Asian companies have either a single or dual listing. Another option for the larger Southeast Asian firms is to consider issuing American 28 Depository Receipts (ADRs) or Global Depository Receipts (GDRs). Whilst such a strategy might well be in the best interests of the pertinent companies, it is probably not in the best interests of the domestic equity market, which may see its “best and brightest” listed firms depart as part of a gradual “hollowing out” process. Evidence suggests that even ADRs and GDRs can reduce liquidity in the domestic equity market and be detrimental to the development of equity markets in developing countries (Moel 2000). Secondly, returning to an issue discussed above, technological and communications advances are driving changes in the way equity securities are traded, with companies offering brokerage services that span borders. For example, in September 2001, Hong Kong-based Boom.com — one of Asia’s leading Internet stockbrokers — launched a pan-Asian online trading platform, spanning twelve exchanges in ten Asian countries, plus three exchanges in the United States. Clients of the company have online 29 access to all the equity markets through a single account. Clearly, if domestic stock markets fail to keep up with these sorts of developments, they run the real risk of ultimately being overtaken by these “new upstarts”. Having surveyed some of the principal challenges currently confronting Southeast Asia’s equity markets, let us now consider how some of these challenges could be addressed through future policy options. 4. Southeast Asia’s Equity Markets Future: Policy Options for Strengthening and Deepening the Region’s Stock Markets 4.1. Changes to the Ownership Structures and Managerial Approach of the Equity Markets

Established in December 1999, Singapore Exchange (SGX) is East Asia’s first demutualized, integrated securities and derivatives exchange in the Asia-Pacific. It was formed through the merger of the Stock Exchange of Singapore (SES) and the Singapore International Monetary Exchange

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Limited (SIMEX), and then demutualized. In November 2000, SGX subsequently listed one billion of its own shares on the SGX — another first in East Asia. This restructuring of the equity market in Singapore positions SGX fairly well to take advantage of current developments and trends in the global financial industry. No longer a mutual organization owned by its stockbroker members, SGX can develop its business like any other listed corporate, more flexibly and promptly responding to (sometimes rapid) changes in the external environment, and able to consider participating in strategic alliances and M&A deals. Its diversified range of services also allows it to spread its business risks and sources of earnings. For example, there was a fairly marked decline in equities trading on the SGX in mid-2001. However, the recent terrorist attack on New York prompted a sharp increase in derivatives trading (for example, Eurodollar futures), which helped mitigate against the 30 reduction in equities-related transactions. For SGX, derivatives trading acts as a hedge on securities trading, and vice versa. Making the transition from a mutual society to a company (whether listed or not) would not be an uncharted exercise for Southeast Asia’s equity markets. Australia (in 1999), Hong Kong (in 2000), Manila (in 31 2001), and Singapore have all made the transition, as has the London Stock Exchange, the Deutsche Boerse, and Euronext (the merged entity of the Paris, Brussels, and Amsterdam bourses), amongst others. In late September 2001, the Tokyo stock exchange announced that it too would demutualize, and aims to list its own shares shortly. Under Malaysia’s ten-year Capital Market Masterplan, unveiled in February 2001, Kuala Lumpur anticipates listing the KLSE in 2003. And Thailand has declared an intention to “corporatize” the SET, although it has no plans yet for listing. Clearly, demutualizing and eventual listing is becoming the trend 32 for equity markets, not the exception to the rule. There have also been recent initiatives to develop new equity markets in Southeast Asia, better tailored for small- and medium-sized enterprises, particularly in the technology sector, modelled in part on the Growth Enterprise Market (GEM) market in Hong Kong, launched in 1999. Thailand has unveiled its Market for Alternative Investments (MAI), whilst Malaysia has launched the Labuan International Financial Exchange (LFX), following the lacklustre Malaysian Exchange of

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Securities Dealing and Automated Quotation (MESDAQ) initiative. However, these new markets do not appear to have been particularly successful, with very few IPOs recorded thus far. And even if these new markets ultimately do prove to be successful, they actually run the risk of “cannibalizing” the established equity markets of the region, and inadvertently adding to the liquidity problem and “hollowing out” problems discussed earlier. 4.2. Potential for “Dovetailing” between the Equity Markets and Other Financing Sources

In seeking ways to strengthen and deepen Southeast Asia’s equity markets, there is the potential for greater “dovetailing” of these efforts with other elements of the financial and investment industry in the region. Work to develop the region’s fledgeling corporate bond markets, for example, could be conducted in parallel with the equity markets, possibly sharing some elements of the trading infrastructure. The distinction that is commonly made between foreign direct investment (FDI) and foreign portfolio investment is also becoming increasingly redundant when looking at ways to develop Southeast Asia’s corporate sector.33 Conventional FDI activity — such as greenfield projects, bringing new production capacity — has been fairly scarce in Southeast Asia since 1997. Conversely, recent years have seen a marked increase in the number of cross-border M&A deal flow within the region (Zhan and Ozawa 2001), and the enactment of such M&A deals often entails the use of the equity market in cases where the domestic company is listed. Indeed, the increasing complexity and demands of foreign direct investors is necessitating that host countries provide a sufficiently robust platform of financial services to support such activity, including equity markets. A valid argument can be made that developing a robust equity market can be good for FDI activity in a host country, and vice versa. In building up the region’s equity markets with diverse portfolios of listed companies across the spectrum of business sectors, perhaps greater emphasis should be placed on encouraging more foreign-invested enterprises to seek listings in Southeast Asian host countries. And, as Southeast Asia gradually moves towards more “open” forms of transnational production networks (TPNs), there should be increased portfolio investor appetite for

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equity securities in these local firms. The burgeoning of the TPNs may mean that foreign investors will gain increasingly less exposure to TPNs through the shares of lead companies of MNEs headquartered (and often listed) in the major financial centres, and therefore seek to acquire shares in local firms participating in these TPNs. In other words, foreign investor appetite for local companies listed in Southeast Asia may increase, particularly if the introduction of the ASEAN Free Trade Area (AFTA) creates a more conducive regional environment for local firms to participate in what are becoming increasingly complex (and less equity-based) TPNs — what one commentator has described as the increasing “slicing up” of production 34 activity in Asia. 4.3. The Need to Develop a Robust Financial “Hinterland”

As Singapore has discovered in recent years, it can be quite difficult to build up one’s capital markets if the surrounding hinterland does not provide a conducive environment to support its development. Good deeds in one specific location can be discounted by unwanted distractions in the surrounding region. Conversely, the development of Hong Kong’s equity market during the 1990s has been considerably buoyed by the “injection” 35 of mainland Chinese corporates. The same applies to the financial industry itself. It can be quite difficult to develop a robust domestic equity market beyond a certain scale if there is not a supporting industry “hinterland” of fund managers, pools of domestic savings, an equity investment “culture”, and various other elements of a financial industry around to provide a supporting platform. It can therefore be argued that any attempt to develop and deepen Southeast Asia’s equity markets necessitates that parallel efforts are made to develop the region’s own retail savings and asset management services and capabilities. Such a process has been evident in Singapore in recent years, with fund managers encouraged to establish a presence in the country. A major attraction for fund managers has been the possibility of managing some of Singapore’s very substantial savings, parts of which are now being “farmed out” to private asset managers. For other Southeast Asian countries, where such substantial pools of money are not available to help entice asset management expertise, a more long-term exercise entails educating local savers — and retail stock market “punters” — on the merits of investing through open-ended funds and other investment vehicles.

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4.4. “Spring Cleaning” and Bringing New Companies to Market

Although equity market regulators cannot be held responsible for the poor performance of listed companies in the “real economy”, they do have the ability to influence the behaviour of these firms in the market. For example, companies that fail to meet various existing minimum criteria can be temporarily or permanently de-listed. And the criteria themselves can be gradually improved, notably on issues like transparency, financial reporting, treatment of minority shareholders, and so on. Institutional investors have expressed their concern at what they perceive to be insufficient protection of minority shareholder rights in Southeast Asia since 1997, notably with regard to restructuring of firms after the crisis, conducted in ways that may have benefited the majority / founding shareholders. Stock market regulators in the region might therefore examine ways in which they could tighten up — and enforce — regulations aimed at better protecting minority shareholders of listed companies in Southeast Asia. Where they still exist in Southeast Asia, distinctions made between foreign and local shares should also be phased out, as should ceilings on aggregate or individual shareholdings held by foreign entities. Various initiatives could be enacted to encourage more companies to enact IPOs and list on the domestic exchanges. For example, Thailand is providing tax holidays for companies that decide to list on either the SET or the 36 fledgeling Market for Alternative Investments (MAI). Similarly, Vietnam is offering a number of incentives to encourage “equitized” firms to list on its new equity market (albeit without much success so far). The ongoing process of state sector divestment in several Southeast Asian countries could also support an increase in the quantity, quality and diversity of equity paper traded on Southeast Asia’s equity markets. The privatization of state firms, or reductions in governments’ holdings of already listed companies, could bring more equity on to the relevant market, in those cases where such divestments are not solely conducted as trade sales. IPOs of state firms should help in developing Southeast Asian equity markets’ “sectoral breadth” as well as their general “volume depth”. In March 2001, the Thai government announced that it had

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intentions to privatize eighteen state-owned firms, including Thai International, the Petroleum Authority of Thailand, the airport and port authorities, the Government Housing Bank, Krung Thai Bank, the telephone organization and the communications, electricity, and 37 waterworks authorities. Further rights issues and public share sales by already listed companies might also be expected to help in improving weightings in indices where “free float” considerations are an increasingly important factor. Although the increasing importance of benchmark indices is posed as a challenge in this chapter, it could also be regarded as an opportunity, or at least a wake-up call. As Winkler (2000) points out: Adjusting indices to reflect free float constraints … should encourage governments to think long and hard about ways to keep their markets on the foreign investment map. … Outperforming markets will see their regional weightings rise due to net portfolio inflows into the region: under-performing markets will see their relative weightings crumble further.

4.5. The Merits of Creating a Single Trading Platform for Southeast Asian Equities Whether exchanges forge alliances or go it alone, the challenges of attracting and retaining liquidity will prove formidable. Cheaper technology allows trading systems to multiply. Traders can look instantly for the best prices. Orders can swiftly be re-routed. That means that exchanges with with an apparently impregnable franchise can lose it almost overnight — something that no longer makes for sound sleeping for those who run them.38

Another policy option that might help develop and deepen Southeast Asia’s various equity markets would be to consolidate them into a single trading platform for equity securities in the region. The primary aim of such a project would be to create a degree of critical mass (of capitalization, trading volumes, and business sectors), in a bid to prevent the region’s stock markets becoming a backwater for institutional investors and marginalized from major portfolio capital flows. The notion of creating a single equity trading platform in Southeast Asia first gained serious attention in May 2000, when the central bank governor of Thailand at that time (Chatumongol Sonakul) floated the idea of fully integrating the stock markets of Bangkok, Kuala Lumpur, and Singapore.

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However, the idea did not seem to catch on, with observers pointing to the various logistical hurdles that would have to be overcome first, including: the differing trading systems (for example, quote-driven or order-driven); the differing payment, clearing, and settlements procedures; differing listing regulations; differing corporate governance and reporting practices; differing fee and commission structures; differing regulatory codes; differing currencies and foreign exchange regimes; incompatible hardware and software systems at present, and so on. Whilst such an argument is wholly valid, it is also true to say that each of the Southeast Asian equities markets are individually confronted with the need to up-grade their systems in the face of technological change, and that a collaborative approach to these challenges might ultimately reduce the costs entailed. And in some areas, such as listing criteria, they have all been moving in the same direction, towards a much more flexible regulatory framework, and the actual differences between countries are not as great as one might first imagine. In addition to the logistical difficulties likely to be encountered, there would also be various psychological issues to confront, including where to physically locate such a market. Given both these logistical and psychological hurdles, it might be necessary to consider erecting a wholly new system, rather than graft a regional system on to an existing equity market in the region. Proprietary claim to any new trading platform could be equally or proportionally shared by the participating countries. Clearly, any regional equity market initiative would need the full approval of all major participants, and could not be envisaged as a unilateral initiative by one country. The case of the Central Limit Order Book (CLOB) in Singapore, which traded a significant number of Malaysian stocks prior to 1998, illustrates the tensions that can arise if one country feels uncomfortable about overseas trading of its companies’ shares. With regard to the vexing issue of currency (perhaps the biggest challenge facing any regional equity market initiative), one option might be to consider some form of standard derivative, perhaps along the lines of ADRs, which if traded in a single currency might also be expected to reduce portfolio investors’ foreign exchange risks in the region. Any attempt at a regional trading platform could be enacted incrementally,

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perhaps commencing with just the fifty largest listed firms in the region, and developed from there. A regional platform for trading equity securities (and possibly other types of securities and financial paper) in Southeast Asia would not be wholly unprecedented, in two respects. First, with specific regard to Southeast Asia, the region has already developed parallel arrangements for trade (the ASEAN Free Trade Area) and for direct investment (the 39 ASEAN Investment Area). Both these initiatives aim to provide a single market, for traders and direct investors respectively, and a similar arrangement for portfolio investment might be a logical extension. Secondly, with specific regard to the equity markets industry, a number of full-blown mergers and strategic alliances have already been enacted between stock markets. For example, Euronext is a merger of the Paris, Brussels, and Amsterdam bourses (with Lisbon expected to join in the near future). In mid-2001, trading in Switzerland’s major companies migrated from Zurich to a new exchange (located in London) called 40 Virt-x, which is also trading 600 of Europe’s “blue chip” stocks. There 41 are also plans for a single Caribbean equities market. Indeed, there is even talk of a global trading platform, trading around the clock in the shares of major multinational enterprises, stemming from an alliance between major equity markets in differing time zones, including: NYSE, Euronext, ASX (Sydney), TSE (Tokyo), Toronto, Hong Kong, and Sao 42 Paolo. As a precursor, it is worth noting that in September 2000, FTSE Global 100 launched a “real time” global index for the world’s 100 largest multinational firms, running twenty-four hours each day, and the MSCI followed in February 2001 with a more comprehensive real time index 43 running twenty-three hours each day. What tangible benefits might a pan-regional equity market in Southeast Asia bring? First, by aggregating their current capitalizations, it should help keep Southeast Asian equities on the radar screen of global fund managers and the increasingly influential benchmark indices. Secondly, it might also be expected to improve trading volumes in the shares of some larger companies, and make it less likely that they gravitate to the major overseas markets. Thirdly, by joining together in some form, it might also be expected that Southeast Asia’s equity market regulators could work together towards improving and standardizing various

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regulatory and listing requirements, thereby gradual creating a much better environment for portfolio investors. Fourthly, a pan-regional equity market might also be expected to improve aggregate trading volumes on Southeast Asia’s equity markets, and thereby reassure institutional investors that have been concerned by the lack of liquidity that has sometimes been apparent. Fifthly, the creation of a single trading platform should also reduce the costs for institutional investors to trade, clear and 44 settle their shares in the region. And finally, it would give the Southeast Asian markets a greater voice in negotiating with other equity and capital markets, in what looks like a global consolidation process in the years ahead, which may ultimately lead to just one or two global equity markets, trading twenty-four hours a day. There might also be some indirect benefits to be derived from a single trading platform, including positive repercussions for FDI activity in the region, particularly with regard to 45 cross-border M&A activity. 5. Conclusion

Could the economies of Southeast Asia simply do without one or more vibrant equity markets? Whilst equity markets may not be an essential prerequisite for sustained economic development of a host economy, evidence suggests that they can be “an important engine of economic 46 growth in developing countries”. And during the 1990s they have developed into a relatively important conduit for the allocation of longterm funds from institutional investors in the advanced economies to the domestic corporate sectors of emerging markets. Equity markets can also provide a vehicle for the investment of domestic savings, and act as an important pillar of any financial industry seeking to mobilize and harness local funds. Whether or not they also act as a symbolic statement of a developing country’s aspirations for modernity, equity markets also perform a number of other non-financial roles. In particular, they can have a positive impact on general corporate governance and transparency levels in a country, through the regulations imposed by stock market regulators on listed firms, and thereby also setting a benchmark for unlisted companies. Stock markets can also provide a useful “private sector” early warning indicator (if anyone is looking properly) as to the general health of the corporate sector in a country,

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as well-resourced investment analysts apply relatively rigorous — and consistent — analytical tools to the companies that they track. In the case of Thailand, the analytical ratios applied by investment analysts clearly indicated that the Thai corporate sector was in trouble long before mid-1997, and explains in large part why the SET index had been trending down for some 47 considerable time prior to 2 July 1997, as institutional investors kept away. Therefore, equity markets probably do serve a useful purpose, and can play a role in financing the sustained economic development of Southeast Asian countries. Clearly, any revival in the fortunes of Southeast Asia’s equity markets depends in large part on a revival of the individual corporate sectors that lie behind these markets. In this respect, the region’s equity markets share a similar fate to Southeast Asia’s banks, whereby a full resolution of the latter’s difficulties cannot be enacted without some improvement in the vibrancy of the domestic corporate sector. That said, the future of the region’s equity markets are not exclusively at the mercy of their corporate sectors, and there are initiatives that can be taken to improve their prospects, in conjunction with efforts to rebuild and strengthen the domestic companies that are currently listed — and hopefully are yet to list — on these markets. Crucially, these initiatives must be tailored to conform with significant changes under way within the financial industry, and how institutional funds are allocated and managed around the globe. Failure to do so runs the very real risk that Southeast Asia’s equity markets (along with numerous other emerging equity markets) will become an irrelevance. As the “producers” of equity securities, companies may seek to raise long-term financing by other means, or list on equity markets beyond the region; and as the main “consumers” of equities, institutional investors may seek to avoid shares traded in what they regard to be unattractive markets. In other words, the equity markets of Southeast Asia could be steadily hollowed out. And the notion of a national equity market becoming redundant and defunct is not an academic one; both the Budapest and Prague stock exchanges have seen their daily trading volumes drop in recent years to levels (below US$10 million, in a handful of stocks) 48 where their demise is now being contemplated. Ultimately, institutional investors and “the market” will decide which equity markets survive in the long term, based on their need for liquid markets providing efficient and cheap trading. Equity markets and regulators

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that provide this standard of service have a far better chance of surviving than those who do not, and this reality is just as valid for Southeast Asian markets as for those in Europe and the United States. Whilst a large part of the answer lies in being cognizant of how portfolio capital is allocated and managed, and adopting policies tailored to conform with changes currently under way in the financial industry, some of the strategies enacted to revive the region’s equity markets could evolve from concepts already piloted within Southeast Asia itself. In particular, the examples of the ASEAN Free Trade Area and the ASEAN Investment Area could provide inspiration for a new ASEAN Securities Area initiative. If nothing else, an ASEAN-wide coordinated effort to revive the fortunes of the region’s equity markets would give out the right “signals to the market”, that Southeast Asia’s policymakers are cognizant of the need to improve the business environment for portfolio investors. And it may also provide one part of the tangible solution, in “bulking up” what have become largely peripheral and illiquid markets into a more robust regional platform for the buying and selling of Southeast Asian equities. However, this is certainly not to suggest that a single equity market for all of Southeast Asia would wholly solve the challenges and weaknesses that currently confront the JSX, the KLSE, the PSE, the SET, and the SGX. There are clearly other issues and initiatives that can be pursued in tandem, if the corporate sectors of Southeast Asia are going to be able to continue raising equity funding for their long-term investment needs on local markets, and thereby support the sustained economic development of the region. Rodolfo Severino, Secretary-General of ASEAN, made the following observation in 1999: Leaps in information, transportation and communications technology have made national barriers to trade and capital flows … more and more counterproductive and even destructive. It has become clear that, if individual economies are to thrive or even survive in an increasingly and unavoidably competitive world, they have to coordinate, cooperate and integrate as regions. This means states have to cooperate regionally, economies have to integrate regionally, and the business community has to operate regionally.49

This is no less true of capital flows and equity markets. The path-breaking efforts that Southeast Asia has already displayed in the field of trade and direct investment to create a single regional market may now need to be emulated in the field of portfolio investment.

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NOTES 1. International Monetary Fund, International Capital Markets 1999, p. 63. 2. Weber and Davis (2000, p. 4). Prior to 1950, there were just forty-nine countries in the world with stock markets, of which twenty-four were in Europe and thirteen were in current or former British colonies. Just fourteen stock markets were opened in the twenty years between 1960 and 1980 (ibid., pp. 7, 28). See also Aylward and Glen (1999, pp. 4–5). 3. Naughton (1999, p. 23). 4. Weber and Davis (2000, p. 2). According to Weber and Davis, the term “emerging markets” was first coined by an economist at the International Finance Corporation, who was seeking a more up-beat term to replace “Third World” (ibid., p. 8). 5. For some of the principal factors driving this trend in the 1990s, see Claessens (1995, pp. 3–5). 6. Vietnam is the first of France’s former colonies in Southeast Asia to open a formal stock market. Although the reasons for the late development of equity markets in Indochina may be very specific to the three countries of the sub-region, it is interesting to note that former French colonies across the globe have a reputation for being less likely to develop equity markets. Weber and Davis note that between 1980 and 1998 just one equity market was opened in a former French colony (Lebanon), prompting them to speculate that it is “as if French colonial history were an innoculation against stock markets” (Weber and Davis 2000, p. 36). 7. The low point for Southeast Asia’s equity markets was August 1998, when their aggregate capitalizations dropped to just US$241 billion. 8. For example, in mid-2001, Jakarta’s market capitalization was less than 0.2 per cent of the NYSE. For Bangkok, the equivalent figure was 0.26 per cent, and 0.36 per cent for Manila. 9. On 25 September 2001, General Electric’s capitalization was US$352.6 billion, compared with US$226 billion for all five main equity markets in Southeast Asia. Microsoft’s capitalization was US$276.1 billion. 10. Fund managers tend to have differing ways by which they judge if trading volume levels are adequate. These include average daily trading volume of a stock over a fixed period, or a ratio dividing the minimum daily turnover of a stock by the size of their investment in the company, or an ability to complete a divestment within a certain number of days, and so forth. 11. Quoted in “Indonesia, Thailand, the Philippines Are Tough Markets for Investors to Like”, Asian Wall Street Journal, 8 August 2000. 12. Quote taken from the SGX website .

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13. Of course, there are limits to the utility of any kind of portfolio diversification within the same broad asset class (in this case, equities). A sudden and substantial downward correction in the U.S. equities market, for example, can probably not be avoided by investors that remain fully invested in stocks in Asia, prompting them to diversify into other large asset classes (for example, bonds, commodities, currencies, derivative instruments, and so forth). 14. Brooks and Catao (2000, p. 3). 15. Brooks and Catao (2000, p. 17). This analysis seems to broadly support the notion that “because companies are going global and national stock markets are increasingly correlated, diversifying across countries no longer offers investors the same amount of protection it once did” (ibid., p. 4). 16. In terms of this “gravitational pull”, it is interesting to note that the correlation between the S&P 500 and MSCI Europe–Asia–Far East indices increased substantially in the last decade, from 25 per cent in 1995 to 78 per cent in 2000 (Brooks and Catao 2000, p. 3). 17. Bank for International Settlements (1998, p. 90). 18. “Together taking up only a 4.1 per cent weighting in the MSCI AC Asia Free exJapan index, Indonesia, the Philippines, and Thailand have become so diminished in the financial universe that it is no longer cost-effective for most fund managers to follow them very closely”. See “Indonesia, Thailand, the Philippines Are Tough Markets for Investors to Like”, Asian Wall Street Journal, 8 August 2000. 19. In July 2000, ING Barings — an emerging markets-oriented investment bank — put a zero recommended weighting on Indonesia, the Philippines, and Thailand. Malaysia was added to that list a few months later, leaving just Singapore with a recommended weighting in Southeast Asia. As at September 2001, Indonesia, Malaysia, and the Philippines remained zero-weighted by this securities firm. 20. The MSCI’s Standard ACWI Free Index represents forty-nine equity markets around the world, with an aggregate market capitalization of US$18.76 trillion in mid2001. 21. For companies with a free float below 15 per cent, they will generally be excluded from future MSCI indices. 22. See “MSCI Introduces Coming Changes for Index Family”, Asian Wall Street Journal, 11 December 2000. MSCI claims that 90 per cent of institutional equity assets in Asia are benchmarked to its indices. 23. Schwartz (2000, p. 30). 24. ING Barings, AsiaTalk, 4 November 1999. 25. Schmukler and Vesperoni (2000, p. 1). 26. As a result, the manager of an investment fund that has an emerging markets mandate

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can find that some of the companies into which he/she is investing may actually have their shares listed in the developed equity markets of the United States or Europe. Also see Doidge et al. (2001). 27. In August 2000, there was one Indonesian, one Philippines, and six Singapore companies listed on the NASDAQ. The NYSE has three Indonesian, two Philippines, and four Singapore companies listed. Over 400 foreign firms are now listed in the United States, either as common stock or ADRs. 28. ADRs and GDRs are certificates issued by financial intermediaries, in lieu of an overseas equity security, which are then listed in the United States or Europe, and traded like normal shares. Dividends are paid in the currency of the country in which they are traded (for example, U.S. dollars for ADRs). 29. See Boom.com’s press release of 19 September 2001. The exchanges in its panAsian trading platform include: ASX in Australia, Shenzhen, and Shanghai, HKEx in Hong Kong, JSX in Indonesia, TSE and OSE in Japan, KSE in Korea, PSE in the Philippines, SGX in Singapore, TSE in Taiwan, SET in Thailand, and NASDAQ, NYSE, and AMEX in the United States. 30. ING Barings, “AsiaTalk”, 24 September 2001, p. 8. In August 2001, securities trading volumes on SGX were reported to be down 24 per cent year-on-year. However, average daily trading volumes on SGX’s derivatives market increased by between 50 and 100 per cent immediately following the terrorist attacks in the United States. 31. No date has yet been set for the listing of the PSE in Manila, following its recent demutualization. However, this seems unlikely before 2002. 32. See “The Battle of the Bourses”, in Peet (2001, pp. 15–20). Also see “Incorporating to Compete” by Lotte Chow, in Far Eastern Economic Review, 8 March 2001, pp. 48–49. 33. Also see Dunning and Dilyard (1999). 34. Abonyi (2000). 35. The HKSE has actively worked to attract mainland China firms to list in Hong Kong. A critical issue for the HKSE in the years ahead will be in establishing some form of complementary relationship with the mainland equity markets, if it is to survive in the long term. 36. Companies listing on the SET are eligible to have their income tax rate reduced from 30 to 25 per cent for five years after listing. Companies listing on the MAI can see their income tax level drop to 20 per cent for the same period (Johnson 2001, p. 68). 37. Johnson (2001, pp. 66–68). 38. The Economist, 28 July 2001, p. 66.

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39. The relatively new “e-ASEAN” initiative also aims to “harmonise policies, regulations and standards in information and communications technology within ASEAN”. A single equity market trading platform could also come under this umbrella aim, perhaps as a tangible pilot project for e-ASEAN. Quote taken from a speech by Rodolfo Severino, Secretary-General of ASEAN, on “Building Knowledge Societies: ASEAN in the Information Age”, in Kuala Lumpur, 26 January 2000. 40. “Hunting Where the Ducks Are”, The Economist, 30 June 2001, p. 68. 41. “Island-Hopping”, The Economist, 2 June 2001, p. 71. 42. See “Exchanges to Create Global Equities Market”, Financial Times, 7 June 2000. Also see “Paper Tigers” in Peet (2001, pp. 21–23). 43. See MSCI press release, 27 February 2001. Also see “FTSE Launches 24-Hour Global Index”, eFinancial News, 1 September 2000. 44. Adequate liquidity levels and low trading costs can be critical for an equity market’s long-term survival, particularly where there is competition. The chairman of the NYSE believes that “The real battle between exchanges … is no longer about electronics, still less about floors against screens: it is about liquidity and price.” (Peet 2001, p. 11). “Merging exchanges allows liquidity to be pooled; it also offers the means for more efficient clearing and settlement” (“The Hunt for Liquidity”, The Economist, 28 July 2001, pp. 65–66). 45. M&A deals can be much easier to enact if both companies have their shares traded on the same equity market. 46. Filer et al. (1999, p. 15). 47. Indeed, the SET index peaked at around 1,700 in mid-1994 (Abonyi 1999). 48. See “Exchanges Near the End of the Line”, Emerging Markets Week, 23 July 2001, p. 2. 49. “A Regional Outlook for ASEAN Business”, Speech by Rodolfo Severino, in Singapore, 22 July 1999.

REFERENCES ABN-AMRO Rothschild. “US Listing or Bust?” Asiamoney, December 2000 to January 2001, pp. 86–89. Abonyi, George. “Thailand: From Financial Crisis to Economic Renewal”. ISEAS Working Paper on Economics and Finance no. 3. Singapore: Institute of Southeast Asian Studies, 1999. . “Linking Asia Together”. Asian Wall Street Journal, 5 December 2000. Aylward, Anthony and Jack Glen. “Primary Securities Markets: Cross Country Findings”. IFC Discussion Paper no. 39 (June 1999).

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Bank for International Settlements (BIS). 68th Annual Report. Basel: BIS, 1998. Brooks, Robin and Luis Catao. “The New Economy and Global Stock Returns”. IMF Working Paper (WP/00/216), 2000. Borrus, Michael, Dieter Ernst, and Stephan Haggard, eds. International Production Networks in Asia: Rivalry or Riches? London: Routledge, 2000. Claessens, Stijn. “The Emergence of Equity Investment in Developing Countries: Overview”. World Bank Economic Review 9, no. 1 (1995): 1–17. Claessens, Stijn, Simon Djankov, and Larry Lang. “Who Controls East Asian Corporations — and the Implications for Legal Reform”. Public Policy for the Private Sector Note no. 195, September 1999. Doidge, Craig, G. Andrew Karolyi, and Rene M. Stulz. “Why Are Foreign Firms Listed in the US Worth More?” National Bureau of Economic Research Working Paper 8538. Cambridge, M.A.: National Bureau of Economic Research, October 2001. Dunning, John and John Dilyard. “Towards a General Paradigm of Foreign Direct and Foreign Portfolio Investment”. Transnational Corporations 8, no. 1 (April 1999): 7–52. Field, Graham. “The 24-Hour Market Myth”. Global Investor, October 2000, pp. 39– 40. Filer, Randall, Jan Hanousek, and Nauro Campos. “Do Stock Markets Promote Economic Growth?” William Davidson Institute Working Paper no. 267, September 1999. International Monetary Fund (IMF). International Capital Markets 1999. Washington, D.C.: IMF, September 1999. Johnson, Mark. “Thailand Strives to Restore Market Glory”. Asiamoney, September 2001, pp. 66–68. Moel, Alberto. “The Role of American Depository Receipts in the Development of Emerging Markets”. Paper dated 1 September 2000. Naughton, Tony. “The Role of Stock Markets in the Asia-Pacific Region”. Asian-Pacific Economic Literature 13, no. 1 (May 1999): 22–35. Peet, John. “Rise and Fall. A Survey of Global Equity Markets”. The Economist, 5 May 2001. Pomerleano, Michael and Xin Zhang. “Corporate Fundamentals and Capital Markets in Asia”. Paper presented at the Conference on Preventing Crisis in Emerging Markets, New York, 26–27 March 1999. Schmukler, Sergio and Esteban Vesperoni. “Globalization and Firms’ Financing Choices: Evidence from Emerging Economies”. Paper dated 4 May 2000. "William Davidson Institute Working Paper No. 388, May 2001.

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Schwartz, Stephanie. “Racing to Embrace Free Floats”. Global Investor, October 2000, pp. 30–31. Weber, Klaus and Gerald F. Davis. “The Global Spread of Stock Exchanges, 1980–1998”. William Davidson Institute Working Paper 341, October 2000. Wilcox, Jarrod. “An Investor’s Perspective on the Asian Crisis”. Paper presented at the Conference on Preventing Crisis in Emerging Markets, New York, 26–27 March 1999. Winkler, Eve. “Keeping the Fund Managers Interested”. Asian Wall Street Journal, 31 October 2000. Zhan, James and Terutomo Ozawa. Business Restructuring in Asia: Cross-Border M&As in the Crisis Period. Copenhagen: Copenhagen Business School Press, 2001.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at 281 10. Regional Financial Integration in Southeast Asia < http://bookshop.iseas.edu.sg >

10

Regional Financial Integration in Southeast Asia Ngiam Kee Jin

1. Introduction

For trade in goods, Southeast Asia is effectively a free trade area. When the Agreement for the CEPT (Common Effective Preferential Tariff) Scheme, leading to the ASEAN Free Trade Area (AFTA), first came into effect in 1993, ASEAN countries gave themselves fifteen years to bring all tariffs down to 5 per cent or less.1 In 2002, after only eight years, 95 per cent of regional trade of the ASEAN-6 (Brunei, Indonesia, Malaysia, the Philippines, Singapore, and Thailand) are already at tariff rates of 0 to 5 per cent. The four new ASEAN members (Vietnam, Laos, Myanmar, and Cambodia) are scheduled to reduce tariffs to no more than 5 per cent from 2006. Despite their efforts in boosting regional trade, intra-ASEAN trade accounts for only about 20 per cent of the region’s annual total trade of more than US$700 billion. ASEAN’s major trading partners are the United States, the European Union, and Japan.

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While ASEAN countries have been actively pursuing greater trade integration among themselves, they have not exhibited the same kind of zeal for closer integration in other spheres. For example, the progress in boosting investment flow between ASEAN members has been relatively slow. The ASEAN Investment Area (AIA), which would see countries granting the same investment rights to firms from other ASEAN countries as their own companies, is only due to come into effect in 2003. Nevertheless, investment flows from one member country to another have grown in response to proximity and competitive advantage. The Southeast Asian region is unique, as the countries are at different and extreme stages of development. To exploit their comparative advantage, local firms and multinational corporations (MNCs) have to diversify their production processes and stages of production across various countries in the region. Good examples of this are the electronic industries operating in the ASEAN countries, and in the so-called “Growth 2 Triangles”. Another striking feature of ASEAN is that liberalization of services among the members has never been on its agenda. Yet ASEAN countries cannot be internationally competitive in manufacturing if their services are not competitive. Manufacturing efficiency depends on an economy’s total efficiency, and services contribute a major part to that total efficiency. To be fair, the Southeast Asian countries have been liberalizing their financial services, at least until the Asian financial crisis (henceforth referred to as “the crisis”), that began in July 1997. This should lead both to greater financial integration with the rest of the world, and amongst Southeast Asian countries, as it involves the increasing interaction of their national financial markets. However, in the aftermath of the crisis, some ASEAN countries have moved backward, by resorting to various means to impede the flow of international capital. This chapter will focus on the extent of financial integration among the Southeast Asian countries. It will examine the movements of capital within the region, and the integration of their financial markets. Knowing the extent of their financial integration can throw light on many interesting policy issues. The first is whether financial integration (or lack of it) was the cause of the contagion that afflicted the financial markets of this region during the crisis. The second is whether the

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Southeast Asian countries should co-operate or pool their resources to repel speculations against their currencies. The third is whether savings or investment flows within the region are allocated optimally. Last, but not least, the knowledge obtained might help provide some clues as to whether the region forms an optimum currency area. This chapter is organized as follows. Section 2 discusses the policies of the Southeast Asian countries towards financial integration. Section 3 provides a measure of the extent of financial integration of each Southeast Asian country with the rest of the world. Section 4 analyses the pros and cons of financial integration. Section 5 assesses whether the Southeast Asian countries are more integrated among themselves than with the rest of the world. Section 6 considers a case for closer financial integration among the Southeast Asian countries. Section 7 examines some mechanisms to achieve greater financial integration among ASEAN members. Finally, Section 8 gives some concluding remarks and suggestions. 2. Policies towards Financial Integration

Financial integration involves the increasing interaction of national financial markets. It can occur through the removal of capital controls and liberalization of financial services. Before the crisis, most of the Southeast Asian countries had taken measures to liberalize their capital accounts. Liberalization had generally been pursued in times of macroeconomic stability, in order to minimize possible destabilization to the domestic financial markets. According to de Brouwer (1999), the catalysts for reforms had been the recognition of potential gains to economic growth from a more sophisticated and open financial system, the need to remain competitive as a location for foreign direct investment (FDI), and as a response to changes in world trading rules regarding 3 financial liberalization. However, upon the onset of the crisis, Thailand, Malaysia, and Indonesia made a U-turn of their financial policies by reverting to controls on capital movements. 2.1. Pre-Crisis Policies

The development of controls on the current and capital accounts for the Southeast Asian economies prior to the Asian financial crisis is summarized in Table 10.1. The first column indicates whether a country

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Table 10.1 Summary of Current and Capital Account Liberalization in the ASEAN-5 Countries

Indonesia (o) Malaysia (o) Philippines (r) Singapore (o) Thailand (r)

Current Account Restrictions

Capital Account Restrictions

1980 1990 1996

1980 1990 1996

— — a — —

— — a — —

— — — — —

— — a — a

— — a — a

— — a — a

Surrender Export Receipts 1980 a a a — a

1990 1996 — a a — a

— a — — a

Notes: o = Open capital account. r = Restrictions on capital account. a = Application of restrictions. — = No restrictions. Source: de Brouwer (1999).

is relatively open (o) or restricted (r), based on the existence of legal restrictions. Before 1997, Singapore and Indonesia could be considered as having “free capital markets”, followed by Malaysia and Thailand with relatively free capital accounts, while the Philippines was the only country in the region with a relatively high degree of control over capital movements. This is consistent with the assessment of Kim (1993). Singapore scored very well because it had always been one of the most open economies in the world. There were no trade barriers or exchange controls in Singapore. Indeed, Singapore had completely liberalized its exchange controls as early as June 1978. Since then, Singaporeans have been allowed to borrow and lend freely in all currencies, as well as to deal freely in foreign exchange. Non-residents 4 have been allowed to make direct and portfolio investments in Singapore. The liberal exchange control regime provided a conducive environment for the development of Singapore as an international financial centre. Among the other four Southeast Asian economies, Indonesia seems to have had the most open capital account before 1997, as it had been employing a liberal exchange regime with minimal controls since August 5 1971 (de Brouwer 1999). The offshore use of the rupiah was partly regulated prior to the crisis, principally through the long-standing

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prohibition of bank lending in rupiah to non-residents, and limits on exports and imports of rupiah banknotes. However, the existence of a 6 number of unrestricted channels, and the ineffective enforcement of the existing regulations, permitted the development of an active offshore market in rupiah in Singapore. In Malaysia, cross-border transactions in 7 ringgit had been liberal until late 1998. The authorities had liberalized most capital outflows, except for corporations with domestic borrowing, and had adopted a liberal approach towards portfolio inflows. The country had also allowed offshore over-the-counter (OTC) trading in equities and bonds listed on Malaysian securities exchanges. As a result, an OTC market in Malaysian stocks, as well as an offshore market in ringgit, had developed in Singapore. In Thailand, cross-border transactions in baht were quite liberal prior to the Asian financial crisis. Non-residents were free to obtain baht credit from domestic banks and operate in well-developed spot and forward markets. Controls were applied only to a few transactions, including exporting baht banknotes and issuing of debt securities abroad by residents. Outward direct, portfolio, and property investments by residents were also controlled. The Philippines maintained a wide range of controls on its current and capital accounts (Kim 1993). FDI must be registered, and approval is required for outward investment over US$1 million and for foreign borrowing. However, there had been substantial easing of its controls since 1991. As a result, foreign exchange receipts could be retained and residents were allowed to deposit foreign currencies abroad. 2.2. Post-Crisis Policies8

However, the Asian financial crisis proved to be the turning point for Indonesia, Malaysia, and Thailand as they resorted to various kinds of capital controls to ease pressures on their currencies. Singapore took a different policy path by liberalizing the use of the Singapore dollar. There was no major policy changes in the Philippines, as it was not seriously affected by the crisis, and it had already imposed tight controls over its capital account. Table 10.2 provides a glimpse of the situation in the post-crisis period. The cross-country comparison reveals that all the Southeast Asian

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

Approval Restricted

Prohibited Largely prohibited Approval

Prohibited Approval Approval Approval

Restricted Largely prohibited Quantity limit

Restricted Largely prohibited Quantity limit Approval

Approval

Free

Restricted

Restricted

Quantity limit

Restricted

Restricted

Approval

Restricted

Free

Free

Free Free Free

Singapore

Restricted

Free

Approval

Largely prohibited

Approval Approval Mostly prohibited Restricted

Philippines

Approval Approval

Malaysia

Approval Approval Prohibited

Indonesia

Approval/ prohibition

Restricted

Approval

Largely prohibited

Restricted

Largely prohibited

Mostly prohibited

Restricted

Free Quantity limit Free

Thailand

Note: Based on Ishii et al. (2001, table 1). The categories refer to the key element of restrictions, and do not reflect full details which can be found in the original table. The category “Restricted” often involves requirements of prior approval or consultation on selected transactions, and thus are more lightly regulated than the category “Approval” which requires prior approval on a broad spectrum of transactions. Source: Kochhar et al. (2001).

Imports of domestic currency Exports of domestic currency Use of domestic currency in settlement of trade transactions Non-residents’ holdings of or transfers between/from domestic currency accounts Residents’ domestic currency deposits abroad Domestic currency lending from residents to non-residents Banks’ derivative transactions in domestic currency with non-residents Domestic currency lending to residents from non-residents Non-residents’ issue/sale of domestic currency assets locally Non-residents’ purchase of domestic currency assets locally Residents’ issue/sale of domestic currency assets abroad

Nature of Transaction

Table 10.2 Major Regulations on Offshore Use of Currencies in Selected Asian Countries, 31 December 2000

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countries, with the exception of Singapore, had maintained tight controls of their currencies towards the end of 2000. Singapore went out on a limb by further liberalizing the use of its currency in August 1998, despite the ongoing Asian financial crisis. The measures introduced by Singapore included allowing its banks to lend out Singapore dollars to residents for use outside Singapore, and to non-residents to finance designated 9 economic activities in Singapore. Before August 1998, banks were required to consult the Monetary Authority of Singapore (MAS) before granting Singapore dollar loans in excess of S$5 million to non-residents for financing their investments in Singapore, and were not allowed to provide Singapore dollar loans to non-residents for use outside of 10 Singapore. Banks were even required to obtain MAS approval if they wanted to grant Singapore dollar loans to residents for use outside Singapore. Faced with persistent speculative pressures on its currency, Thailand imposed a number of selective exchange and capital controls in May 1997. Unless supported by underlying trade or investment activities in Thailand, banks were required to suspend their baht transactions with non-residents. They were also prohibited from extending baht loans to non-residents. Furthermore, they were not allowed to buy baht in the spot market from non-residents. In January 1998, the prohibition of baht loans to non-residents was replaced with a quantitative limit of 50 million baht for each counterparty, and the ban on the spot purchase of baht by banks was lifted. However, banks were required to submit daily reports of all foreign exchange transactions with non-residents to the central bank, and to maintain documentary evidence supporting such transactions. Nonetheless, the controls were less comprehensive than that of Malaysia, as they did not apply to current account transactions. On 1 September 1998, Malaysia imposed a comprehensive set of controls on cross-border ringgit transactions. It stopped the free convertibility of its currency to punish short-sellers of ringgit during the height of the crisis. It also ordered that no ringgit payments could be affected between external accounts, and that all offshore ringgit must be repatriated by the end of the month. In one fell swoop, these measures 11 caused the offshore ringgit market in Singapore to disappear overnight. However, the controls exempted FDI projects so as to target only

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speculative investment activities. To prevent a massive capital outflow following the restrictions, controls were introduced on outward investments by residents and on export proceeds (which must be paid in foreign currencies and repatriated to Malaysia). The controls also covered the repatriation of ringgit funds by non-residents. When the controls were first introduced, non-residents had to wait for one year to repatriate ringgit funds from the sale of Malaysian assets. This rule was subsequently replaced by a graduated exit levy in February 1999, and a flat levy in September 1999, on profits from portfolio investment. In February 2000, the levy on profits for portfolio investment retained in Malaysia for more than one year was abolished. During the height of the crisis in late 1997, the Indonesian authorities also tightened controls on the use of rupiah, by imposing a US$5 million limit (per bank and per customer in a given day) on the forward purchase of rupiah by banks from non-residents. Trade and investment-related transactions were, however, exempted from this ruling. On 15 January 2001, more restrictive restrictions were imposed, including reducing the limit on forward transactions with non-residents. Moreover, Indonesian banks were prohibited from holding rupiah funds offshore, from transferring rupiah funds to banks offshore, and from purchasing rupiah securities issued by non-residents. 3. Measuring the Extent of Financial Integration

Based on the policies of the Southeast Asian countries towards financial integration, one would expect Singapore to be the most financially integrated with the rest of the world. The recent liberalization of its rules relating to the use of the Singapore dollar can be expected to intensify the integration of its financial markets with those in the region and the rest of the world. Although the economies of the other Southeast Asian countries can be considered as fairly open before the crisis, they are not expected to be as financially integrated with the rest of the world when compared with Singapore. In any case, the crisis-hit countries of Indonesia, Malaysia, and Thailand are expected to be less financially integrated with the world, as they resorted to various kinds of capital controls in the years since the crisis. Quantifying the extent and trend of financial integration is a difficult task. Be that as it may, integration of

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financial markets usually implies an increase in capital flows, and a tendency for the integration of asset prices across countries. 3.1. Cross-Border Flows of Capital

Although no comprehensive measure of gross cross-border financial flows in Southeast Asia exists, there is little doubt that the flows have increased over the past two decades, at least until the onset of the crisis in July 1997. As shown in Table 10.3, net private capital flows to the ASEAN-4 economies (Indonesia, Malaysia, the Philippines, and Thailand) in the years before the crisis constituted a very high percentage of their gross domestic product (GDP). In fact, Thailand, Malaysia, and Indonesia were among the ten largest emerging market recipients of net private capital flows during the first half of 1990s (Lopez-Mejia 1999; World Bank 1997). It is interesting to note that the “other net investment” component constituted a large share of overall capital flows into Indonesia, Philippines, and Thailand. As bank lending had been found to be the most volatile component in the balance of payments account, these three economies tended to be most prone to a currency crisis. In contrast, FDI formed a major share of total capital inflows to Malaysia. This should make Malaysia more resilient against currency attacks, as FDI had been considered to be the most stable form of external financing (Bird and Rajan 2000; World Bank 1999; Samo and Taylor 1999). However, capital flows into ASEAN appear to have fallen since the crisis. This was due to a sharp reversal in international bank lending to the “Asia-5” crisis economies of Malaysia, Thailand, Indonesia, the 12 Philippines, and Korea between 1997 and 1998 (Table 10.4). International bank lending to the “Asia-5” economies remained buoyant at almost US$50 billion in the first half of 1997, but swung into negative territory (of –US$135 billion) in the second half of 1997, and then averaged close to –US$100 billion for the two successive half years that followed. Apparently, international banks became less willing to “roll over” existing short-term debts to these crisis-hit countries during and after the crisis. Interestingly, FDI inflows into Malaysia, the Philippines, 13 and Thailand remained relatively stable even after the crisis (Table 10.5). Only Indonesia experienced an outflow of FDI in 1988 and 1999. Singapore’s situation is unique, as it is an exporter of capital and a

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

2.5 1.2 0.0 1.4 1.1 –3.0 15.1 8.9 0.0 6.2 –0.1 –11.3 2.0 1.3 0.1 0.6 1.9 –1.5 8.7 1.4 0.5 6.8 0.1 –2.8

4.6 1.2 0.0 3.5 1.1 –2.4 11.2 8.3 0.0 2.9 0.4 –2.6 1.6 2.0 0.3 0.2 3.3 –2.3 10.7 1.5 0.0 9.2 1.1 –4.3

1992

8.4 1.1 3.2 4.1 0.2 –3.2

2.6 1.6 –0.1 1.1 2.3 –1.1

17.4 7.8 0.0 9.7 –0.6 –17.7

3.1 1.2 1.1 0.7 0.9 –1.3

1993

a

Note: The minus sign in the table denotes a rise, and vice versa. 1989 to 1996. b Estimates. Source: International Monetary Fund (1997).

Indonesia Private capital flows Direct investment Portfolio investment Other investment Official flows Changes in reserves Malaysia Private capital flows Direct investment Portfolio investment Other investment Official flows Changes in reserves Philippines Private capital flows Direct investment Portfolio investment Other investment Official flows Changes in reserves Thailand Private capital flows Direct investment Portfolio investment Other investment Official flows Changes in reserves

1991

8.6 0.7 0.9 7.0 0.1 –3.0

5.0 2.0 0.4 2.5 0.8 –1.9

1.5 5.7 0.0 –4.2 0.2 4.3

3.9 1.4 0.6 1.9 0.1 0.4

1994

12.7 0.7 1.9 10.0 0.7 –4.4

4.6 1.8 0.3 2.4 1.4 –0.9

8.8 4.8 0.0 4.1 –0.1 2.0

6.2 2.3 0.7 3.1 –0.2 –0.7

1995

9.3 0.9 0.6 7.7 0.7 –1.2

9.8 1.6 –0.2 8.5 0.2 –4.8

9.6 5.1 0.0 4.5 –0.1 –2.5

6.3 2.8 0.8 2.7 –0.7 –2.3

1996

Table 10.3 ASEAN-4: Net Capital Flows, 1990–97 (Percentage of GDP)

11.5 1.6 1.4 8.5 0.1 –4.3

4.1 1.8 0.2 2.1 2.0 –1.8

10.2 7.2 0.0 2.9 0.0 –5.1

5.1 1.7 0.5 3.0 0.7 –1.7

Simple Averagea

–10.9 1.3 0.4 –12.6 4.9 9.7

0.5 1.4 –5.3 4.5 0.8 2.1

4.7 5.3 0.0 –0.6 –0.1 3.6

1.6 2.0 –0.4 0.1 1.0 1.8

1997b

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Table 10.4 International Bank Lending to Emerging Asian Economies, 1996–98 (US$ Billions) 1997 1996 Asia* China Asia-Five

First Half

1998

Q3

Q4

First Half

Q3

Q4

80

74

−8

−109

−103

−94

−32

13 58

13 49

21 −39

−1 −96

−6 −96

−25 −59

4 −43

* Excluding regional financial centres of Hong Kong and Singapore. Source: Bank for International Settlements (1999).

Table 10.5 Inflow of Foreign Direct Investment into ASEAN-5, 1985–99 (US$ Billions)

Singapore Indonesia Malaysia Philippines Thailand

1985–89

1990–94

1995

1996

1997

1998

1999

2.4 0.4 0.8 0.4 0.7

5.2 1.7 4.2 0.8 1.9

7.2 4.3 4.2 1.5 2.1

9.0 4.7 6.5 1.2 3.7

8.1 4.7 6.5 1.2 3.7

5.5 −0.4 2.7 1.8 7.4

7.0 −3.2 3.5 0.7 6.1

Source: Asia Recovery Information Centre (2001).

regional financial centre. As can be seen in Table 10.6, Singapore traditionally attracted large inflows of FDI. In the early years, Singapore depended heavily on FDI (averaging 10 per cent of GDP during 1965– 14 85) to build up its industrial capacity. Although a major exporter of capital in recent years, it still continued to enjoy a net positive inflow of FDI. However, Singapore experienced a large net outflow of portfolio investment, due mainly to overseas investment of the huge domestic savings by the Government of Singapore Investment Corporation (GIC), and by cash-rich companies and individuals. Unlike the other ASEAN economies, Singapore did not borrow from overseas, and thus avoided the problem of reversal of international bank lending during the crisis. As the “host” to the Asian dollar market (ADM), which is the Asian counterpart to the Eurodollar market, Singapore banks only acted as

© 2003 Institute of Southeast Asian Studies, Singapore

© 2003 Institute of Southeast Asian Studies, Singapore

Source: Kochhar et al. (2001).

Official reserves (net) Special drawing rights Reserves position in the IMF Foreign exchange assets

Net errors and omissions

Financial account (net) Direct investment Inflow Outflow Portfolio investment Assets Liabilities of which, equity securities Other investment Assets Banks Other sectors Liabilities Banks Other sectors

Capital flows (including errors and omissions) Capital and financial account balance Capital account (net)

–10,407 –9 2 –10,399

–674

–6,803 4,998 14,625 9,627 –16,480 –17,802 1,322 1,339 4,678 –19,089 –4,981 –14,108 23,767 11,325 12,442

–7,673 –6,999 –196

1996

–11,856 –38 –136 –11,682

1,793

–16,298 5,356 19,254 –13,898 –19,310 –19,433 122 125 –2,344 –61,905 –18,385 –43,521 59,561 27,746 31,815

–14,762 –16,555 –275

1997

–4,981 –112 –50 –4,819

7,834

–36,506 9,642 10,570 –928 –11,728 –12,848 1,120 1,111 –34,420 –5,949 3,711 –9,660 –28,471 –21,401 –7,070

–29,050 –36,884 –378

1998

Table 10.6 Singapore: Capital Flows, 1996–2001 (S$ Millions)

–7,321 12 –294 –7,039

1,764

–30,984 5,400 12,198 –6,798 –12,009 –15,642 3,633 3,637 –24,375 –35,720 –18,077 –17,643 11,345 5,441 5,904

–29,544 –31,308 –324

1999

–11,835 –30 41 –11,846

–5,809

–19,651 3,645 11,017 –7,371 –23,889 –20,300 –3,590 –3,588 593 –9,122 2,284 –11,406 9,715 12,799 –3,085

–25,741 –19,932 –281

2000

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intermediaries for the cross-border flow of funds. A closer examination of the assets and liabilities of Singapore banks reveals that their ADM business was large, but highly volatile. 3.2. International Asset Price Integration

As financial markets became more integrated, asset prices will tend to adjust in anticipation of capital flows to exploit any arbitrage opportunities. Indeed, it is possible to have a perfectly integrated international market in which capital never actually flows from one market to another. Instead, market participants would adjust the equilibrium prices in response to new information. They would not be acting rationally if they were to conduct transactions at the old prices. If prices did not diverge from equilibrium levels, then no arbitrage activities (and hence capital flows) would take place. Hence, the cross-border flows of capital might not accurately reflect the extent of financial integration. Other ways of evaluating the extent of financial integration are needed. One way is to measure the extent of international asset price integration. According to Herring and Litan (1995), there are at least three measures of asset price integration: (a) covered interest parity (CIP), where capital flows equalize the forward premium (or discount) to the interest rate differential between currencies; (b) uncovered interest parity (UIP), where capital flows equalize expected rates of returns on countries’ assets; and (c) real interest parity (RIP), where capital flows equalize real 15 interest rates across different countries. The problem with testing of UIP and RIP is that they require expected exchange rates and expected inflation rates, respectively, which are unobservable. As such, the test of UIP or RIP is really a test of joint hypothesis. For example, failure of the data to support UIP can be explained by the fact that UIP does not hold (probably because of the existence of a risk premium), or that the assumptions about exchange rate expectations are at fault, or both. Similarly, it is difficult to ascertain the reasons for departures from RIP because the relationship depends on expected inflation rates, which are not directly observable. Since all the data required for measuring CIP are directly observable and are readily available, only the CIP for the Southeast Asian economies can be reported and discussed. If capital is perfectly mobile, CIP should hold. The only barriers

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that prevent free movement of capital to attain CIP are transaction costs, capital controls and other institutional barriers, such as regulations and taxes. As such, the CIP is often viewed as the most unalloyed criterion of capital mobility and financial market integration. One way of testing for the validity of CIP is to find out whether the following inequality is satisfied: (1)

|(R – R*) – (F – S)| < C

where C is the cost of carrying out the transactions, and the left-hand side of the equation is the covered interest differential (CID), which is the absolute difference between the domestic interest rate (R) and the foreign interest rate (R*), adjusted for the forward premium or discount (F – S). The F and S (defined as the price of foreign currency in terms of domestic currency) are in log form. It is clear that a non-zero CID does not necessarily imply that the CIP does not hold, and hence risk-free arbitrage opportunities are available. Arbitrage profits arise only if the CID is greater than the transaction cost. Table 10.7 shows the key results of the CID for the various countries in Southeast Asia, using monthly data from DataStream. Notice that the Eurodollar (or offshore) rate is used for the foreign interest rate, while the onshore rates are used for domestic interest rates. Column 3 of the table reports the mean of the CID for the whole sample period and for three sub-periods (pre-crisis period, crisis period, and post-crisis period). As onshore interest rates for the Southeast Asian countries are used, great care has to be taken in choosing the “correct” onshore interest rates and in interpreting the results (Ngiam 1996; MAS 2000). This is because, unlike the offshore rates, the onshore interest rates are distorted by the presence of taxes and statutory reserve requirements in the 16 domestic markets. Nevertheless, the change in the mean of the CID from one sub-period to another should provide an indication as to whether individual financial markets in Southeast Asia have become more integrated or more segmented with the rest of the world over time. The results obtained are consistent with a priori expectations. Among the five countries, Singapore stands out as having the lowest CID, which reflects the fact that its financial market is one of the most open and most integrated with the rest of the world. Singapore’s financial market has also become more integrated with the rest of the world over time, as

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Table 10.7 Absolute Covered Interest Differential (CID) Sample Period

Mean CID

Standard Deviation

Singapore

Full sample Pre-crisis Crisis Post-crisis

1986:04 1986:04 1997:07 1999:01

– 2002:01 – 1997:06 – 1998:12 – 2002:01

0.009663 0.006951 0.039928 0.004835

0.020093 0.010118 0.050522 0.004859

Malaysia

Full sample Pre-crisis Crisis Post-crisis

1993:09 1993:09 1997:07 1999:01

– 2000:05 – 1997:06 – 1998:12 – 2000:05

0.1363378 0.0655919 0.3096142 0.1442985

0.1817808 0.1060768 0.2507346 0.1361718

Indonesia

Full sample Crisis Post-crisis

1997:02 – 2001:12 1997:07 – 1998:12 1999:01 – 2001:12

1.069961 0.091016 1.158956

1.135214 0.049776 1.145011

Philippines

Full sample Crisis Post-crisis

1997:01 – 2001:12 1997:01 – 1998:12 1999:01 – 2001:12

0.067419 0.097086 0.047639

0.086847 0.111257 0.059785

Thailand

Full sample Pre-crisis Crisis Post-crisis

1995:12 1995:12 1997:07 1999:01

0.287669 0.069647 0.678457 0.191123

0.398187 0.149092 0.575446 0.153246

– 2001:11 – 1997:06 – 1998:12 – 2001:11

its CID is lower during the post-crisis period than during the pre-crisis period. On the other hand, the CID for all the other ASEAN countries is much higher than for Singapore, with Indonesia exhibiting the highest deviation, followed by Thailand, Malaysia, and the Philippines. Interestingly, the CID for Malaysia and Thailand is higher in the postcrisis period than in the pre-crisis period. This may reflect the fact these two countries have imposed tighter controls on the outflow of funds during and after the crisis. Unfortunately, pre-crisis data for Indonesia and the Philippines are unavailable. But the limited data available seems to suggest that the CID for these two countries is higher after the crisis than during the crisis. 4. Pros and Cons of Financial Integration

Global financial integration has been a mixed blessing for many economies. On the one hand, financial integration leads to greater

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allocative efficiency, as free international movement of capital allows for a more optimal allocation of global resources. On the other hand, surges and drastic reversals in capital flows can create new sources of systemic risks. These tensions were experienced by several of the Southeast Asian countries during the crisis, and might help explain their recent change in attitude towards capital account liberalization. 4.1. Benefits

Benefits of financial integration are based on growth, inter-temporal optimization, risk-sharing through portfolio diversification and efficiency gains. With global financial integration, one would expect the financial markets to channel capital to countries with the highest risk-adjusted returns on capital. In theory, capital will flow from one country to another until the marginal productivity of capital across countries is equalized. In such an idyllic world, global world welfare is maximized. For an individual country, foreign capital inflows can contribute to its growth by increasing the rate of capital accumulation, and by spurring technological innovation. In terms of inter-temporal optimization, free capital flows allow a country in a recession to borrow from the rest of the world to smoothen its consumption and income streams. It can help the country to dampen its business cycles and increase its welfare. The problem with many borrowers (including the United States) is that they tend to borrow continuously in order to sustain their high consumption or investment. This raises the question of whether persistent borrowing by a country is sustainable in the long run. With financial integration, countries are supposed to be able to make cross-border investments to diversify their assets. But the benefits of diversification are not going to be permanent. As cross-border financial flows accelerate, national financial markets will eventually become more highly correlated, significantly reducing the benefits of international diversification. Indeed, the correlation between the United States and non-U.S. stock markets is generally higher today than it was during the 17 1970s. Finally, financial integration is generally supposed to enhance micro-economic efficiency, and thereby productivity growth. Efficiency gains can be achieved through various sources, including the transfer of technology, increased competition among the financial service providers, and efficient allocation of resources through financial deepening.

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4.2. Costs

The potential costs of financial integration include the overheating of the economy due to capital surges, the collapse of the economy from a reversal of capital flows, and increasing volatility in prices and exchange rates due to volatile movements of capital flows. While sudden inflows of capital can cause problems to the economy (such as high inflation and excessive consumption), a reversal of capital flows on a large scale is probably more damaging, as several of the Southeast Asian countries found out during the crisis. To guard against the vagaries of capital movements, a country should try to attract more “good capital”. FDI is normally considered “good capital”, as it cannot easily be repatriated during a crisis. The worst type of capital inflow is probably short-term, foreign currency loans. Too much reliance on such loans can cause the output of a country to contract when its currency collapses during a crisis (Rajan 2001). This is because when the domestic currency collapses, domestic firms or financial institutions that have taken out such loans will suffer a deterioration of net-worth (the so-called “balance-sheet effect”). But the exchange rate depreciation can also provide a boost to the export sector (the “competitive effect”). Thus, the impact on output from a local currency depreciation depends on the relative magnitude of these two effects. Even without a financial crisis, financial market volatility can have a deleterious effect on economic performance. To be sure, increased volatility and contagion have certainly made the world a more unstable place. But lack of stability does not necessarily imply worsening economic trends. It may simply mean that there are larger fluctuations around the trend. However, volatility and contagion can lead to changes in behaviour that can result in the deterioration in trend performance. For example, financial volatility increases risk which, in turn, can discourage longterm private investment. It can also make the public sector adopt a more conservative stance, in which financial stability is an objective superior to the objective of growth and high employment. 5. Financial Integration among Southeast Asian Countries

The extent of financial integration among the Southeast Asian countries can be roughly gauged by examining the flows of direct and portfolio

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(or equity) investment within the region. Such information should provide an answer to the question whether tighter controls on capital movements imposed by some Southeast Asian countries in the aftermath of the crisis have slowed down capital flows within the region. According 19 to a recent report by the ASEAN Secretariat, intra-ASEAN direct investment constituted about 15 per cent of the total FDI flows into the region between 1995 and 1998. With the progress made in regional arrangements such as AFTA and the AIA, intra-ASEAN investment flows in the future can be expected to grow, but are unlikely to reach the scale of European Union intra-regional investments. Interestingly, intra-ASEAN direct investment did not decline in 1997, which was the year the crisis started. In fact, the total increased by about 18 per cent from US$2.48 billion in 1996 to US$3.01 billion in 1997 (Table 10.8). However, the impact of the crisis was felt in 1998, when many ASEAN firms were having problems with debt servicing and corporate restructuring. As a consequence, intra-ASEAN investment flows dropped drastically to US$278 million in 1998; a decline of 91 per cent from the previous year. This was attributed mainly to large net disinvestments or repatriations of US$1.72 billion in Brunei Darussalam. In addition, Singapore, being the region’s largest investor, divested US$103 million in 1998, compared with its total investment exposure in the region of US$2.2 billion in 1997. Intra-ASEAN direct investment exhibited two opposing patterns. On the one hand, Singapore and Malaysia were the two major regional investors in ASEAN (Table 10.9). From 1995 to the first half of 1999, Singapore and Malaysia accounted for 49 per cent and 34 per cent, respectively, of outward intra-ASEAN investment flows in the region. During that period, Singapore was the largest ASEAN investor in Malaysia (64 per cent), Indonesia (63 per cent), and Thailand (93 per cent). Singapore moved so fast into the region that by 2001 it became 20 the second largest foreign direct investor in Thailand, after Japan. Given the geographical proximity and social ties, it is perhaps not surprising that 64 per cent of ASEAN direct investment into Singapore came from Malaysia. On the other hand, in terms of the host or recipient country perspective, the distribution of intra-ASEAN investment flows was well spread out, with as many as four countries accounting for a 75.5 per

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Table 10.8 Sources of Intra-ASEAN Outward Direct Investment Flows, 1995 to June 1999 (US$ Millions) 1995

1996

1997

1998

First Half of 1999

Total

Brunei Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam

52.66 101.5 1.9 6.31 142.95 31.41 4.2 4.1 2,227.47 524.9 — (0.67) 46 34.15 2,151.86 1,425.09 170.01 348.09 0.37 0.5

0.6 28.08 110.98 1.2 199.38 — 22.98 2,209.53 435.94 2.04

(16.10) 1.6 29.6 1.7 231.35 0.2 5.36 (103.24) 123.15 5.3

5 1.1 5.79 0.6 84.4 — (1.96) (895.69) 20.06 0.4

143.66 38.99 320.73 11.8 3,267.5 (0.47) 106.53 4,787.55 1,097.25 8.61

Total

4,797.42 2,475.38

3,010.73

278.92

(780.30)

9,782.15

Figures within parentheses are disinvestments. Source: ASEAN Secretariat: ASEAN FDI Database.

Table 10.9 Sources and Recipients of Net Intra-ASEAN Direct Investment, 1995 to June 1999 Sources of Intra-ASEAN Investment

Recipients of Intra-ASEAN Investment

Brunei Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam

Brunei Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam

Total

1.47% 0.31% 3.00% 0.12% 34.00% 0.00% 1.09% 49.00% 11.00% 0.09% $9,782.15 million

Total

−21.10% 22.70% 8.20% 1.50% 30.40% 8.00% 3.80% 8.10% 20.60% 17.80% $9,782.15 million

Note: The percentages may not add up to 100, due to rounding. Source: ASEAN Secretariat: ASEAN FDI Database.

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cent share of the total inward intra-ASEAN investment. These counties were Malaysia (25 per cent), Cambodia (19 per cent), Thailand (17 per cent), and Vietnam (15 per cent). Indonesia and Singapore received a mere 6.7 per cent each of intra-ASEAN investment flows between 1996 and the first half of 1999. The extent of intra-ASEAN equity and portfolio investment is harder to deduce, as such data are not easily available and are fragmented. Figure 10.1 shows foreign equity investment in Singapore. Note that foreign equity investment in Singapore was dominated by the European Union, followed by the United States, Japan, and the ASEAN countries. The amount of equity investment in Singapore by ASEAN members has been flat throughout the 1990s. Figure 10.2 shows foreign equity investment in 21 Thailand. The picture in Thailand is quite different from that of Singapore. Foreign equity investment in Thailand by the ASEAN countries had been increasing rapidly in the past decade, especially after the crisis in 1997. In 2000, Singapore was the third largest foreign portfolio equity investor in 22 Thailand, after Japan and the United States. In that year, Singapore companies pumped 14.5 billion baht (S$567 million) into the Thai equity market. The financial linkages between Malaysia and Singapore are interesting and deserve some elaboration. Before Malaysia imposed capital controls in September 1998, the equity and banking markets in the two countries were closely intertwined. Both countries operated a joint stock exchange until 1973, when Malaysia terminated the “inter-changeability” 23 between the ringgit and the Singapore dollar. As a consequence, the two countries set up their own stock exchanges. However, the two separate exchanges continued to list the other country’s stocks until 1989, when Malaysia decided to de-list Malaysian companies from the Singapore bourse. Singapore responded by trading Malaysian stocks on CLOB International, which is an over-the-counter market. Apart from trading in Malaysian stocks, Singapore was also playing host to a large offshore 24 ringgit market. By declaring, on 1 September 1998, that any ringgit outside the country was no longer legal tender, the trading of Malaysian stocks on CLOB International and the offshore trading of ringgit could no longer be sustained. Singapore promptly terminated the trading of Malaysian stocks on CLOB International and the trading of offshore

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Singapore: Foreign Equity Investment 60,000 EU

50,000

S$ Millions

40,000 30,000 Japan

20,000

USA

ASEAN

10,000 Hong Kong

0 1990

1991

1992

1993

1994

1995

1996

1997

1998

Source: Singapore Department of Statistics, Yearbook of Statistics (various issues).

Figure 10.2 Thailand: Foreign Equity Investment 60,000 USA

50,000

EU

Baht Millions

40,000

Japan

30,000 20,000 ASEAN

10,000 0 1990

1991

1992

1993

1994

1995

1996

1997

1998

Source: Bank of Thailand, Quarterly Bulletin (various issues).

© 2003 Institute of Southeast Asian Studies, Singapore

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Table 10.10 Malaysia: Net Portfolio Investment (RM Millions) Period

Net Portfolio Investment

1997 July August September October November December Total

–3,932 –5,347 –7,038 –3,158 –4,198 1,521 –29,067

1998 January February March April May June July August September October November December

213 4,092 1,179 –1,261 –571 1,463 –1,382 –387 –1,899 –366 –398 43

Total

–2,206

Source: Haggard (2000). 25

ringgit. Such controls could be viewed as an attempt by Malaysia to decouple the financial markets in the two countries. Singapore claimed that the closure of CLOB International was not a big loss to its financial centre, although the curbs constituted a step backward in ASEAN’s efforts 26 to liberalize trade and investment. The impact of capital controls on portfolio flows in Malaysia can be seen in Table 10.10. Net portfolio investment in Malaysia was already negative in the second half of 1997. It continued to be negative in the later part of 1998 despite the controls, albeit at a much reduced pace. According to Ariff and Yap (2001), there was hardly any foreign portfolio inflows into Malaysia between September 1998 and February 1999. The Malaysian government was, however, conscious of the harmful effects

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Table 10.11 Malaysia: Flow of Funds through External and Special External Accounts, 15 February to 2 June 1999 (RM Millions) Date

Net Cumulative Portfolio Inflow

5 March 10 March 17 March 24 March 31 March 7 April 14 April 21 April 28 April 5 May 12 May 19 May 26 May 2 June

−22 19 21 37 74 62 398 424 554 1,089 1,436 2,064 2,373 2,831

Source: Haggard (2000).

of the controls and took actions to ease the rules on foreign capital in the course of 1999, and the National Economic Action Council (NEAC) of Malaysia was able to report a rebound of portfolio inflows into Malaysia (Table 10.11). 6. A Case for Closer Financial Integration within Southeast Asia

With the emergence of China as an economic powerhouse absorbing most of the FDI flowing into East Asia, Southeast Asian countries may have no choice but to co-operate with each other on all fronts, including financial co-operation, so as to recapture global interest in the region as an investment destination. In fact, nations that lagged behind in the process of integration could seek regional financial integration as a first step towards global financial integration. The rest of the world is unlikely to object, as regional co-operation in financial matters (unlike most kind of regional trade co-operation) is generally less prone to discrimination and diversion of economic activities away from third parties.27 The

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principal expected benefits from greater financial integration within Southeast Asia are improved allocative efficiency, and the increase in trade and investment within the region. Greater financial integration should help channel funds from the surplus-savings countries in the region (such as Singapore) to the deficit-savings countries (such as Thailand). Singapore, as an international financial centre, could also play a more effective role in channelling funds from the industrial countries for development in the region. With regional financial integration, MNCs operating in the region would also be encouraged to make their forays into the neighbouring countries. The above observation suggests that regional financial integration should lead to a greater intra-ASEAN flow of trade and investment. A greater integration of the national financial markets in the region could help prevent the marginalization or disappearance of some of the financial markets in the region. Currently, all the stock markets (including the second board markets) in the Southeast Asia region are relatively small and suffer from low liquidity. There is also a trend for big companies in emerging economies to list on bourses in the United States, in the form of stocks or American Depository Receipts (ADRs). Trading in these stocks will migrate to markets where the price recovery and liquidity is greatest. In 2000, non-U.S. stocks traded on the New York Stock Exchange (NYSE) accounted for about 10 per cent of the total NYSE 28 trading volume. In addition, the rise of Internet trading and the development of electronic stock-trading systems — such as the Electronic Communication Networks (ECN) — is posing new challenges to all securities exchanges, including those in the Southeast Asian region. In the United States, the ECNs now act as mini-exchanges. However, greater regional financial integration can raise the risk of financial instability, as shocks are transmitted more quickly from one financial system to another. To minimize such a risk, countries should open up their economies to regional (or international) financial transactions, only if prudential supervision is first upgraded, the moral hazard created by too generous a financial safety net is limited, corporate governance and creditor rights are strengthened, and transparent auditing and accounting standards and equitable bankruptcy and insolvency procedures are adopted.

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7. Mechanisms to Attain Greater Regional Financial Integration

There are four possible dimensions, along which greater financial integration within Southeast Asian countries could take place: strengthening of regional co-operative arrangements, consolidating financial markets and institutions, regulatory co-operation and harmonization, and helping in the growth of financial activities in the country where it can be done most efficiently. 7.1. Strengthening Regional Co-operative Arrangements

Apart from AFTA, ASEAN members have also co-operated in various ASEAN industrial projects, including ASEAN Industrial Project (AIP) scheme, ASEAN Industrial Complementation (AIC) scheme, ASEAN Industrial Joint Venture (AIJV) scheme, and ASEAN Industrial Co29 operation (AICO) scheme. Most of these projects were unsuccessful. However, the ASEAN Investment Area (AIA) scheme, which is aimed at promoting investment within ASEAN, has made good progress. For manufacturing, agriculture, forestry, mining and farming, and the services incidental to them, ASEAN members have agreed to grant national treatment to all ASEAN companies, including companies partly owned by non-ASEAN investors. When this scheme comes into operation in 2003, it is hoped that ASEAN would make it a success, so as to spur intra-ASEAN investment flows. On the monetary front, ASEAN countries have agreed to provide credit facilities to each other in times of currency speculations. In March 1997, five ASEAN member countries — Indonesia, Malaysia, the Philippines, Singapore, and Thailand — set up a currency swap arrangement, under which a central bank exchanges domestic currency for U.S. dollars, but agrees to buy back the domestic currency with U.S. dollars after a pre-determined period. The swap transaction period is for up to three months, although this can be extended to a maximum of six months. Unfortunately, the amount of money agreed upon under the ASEAN Swap Arrangement is only a modest US$100 million (but later expanded to US$200 million), which could hardly act as an effective 30 deterrent against currency speculators. Unless the amount which can be drawn is enlarged, ASEAN countries will focus on implementing the

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so-called Chiang Mai Initiative (CMI). Under the CMI, which was signed in Chiang Mai in May 2000, the ten ASEAN countries, together with Japan, China, and South Korea, agreed to expand their web of bilateral swap agreements. For example, the bilateral agreement between Japan and South Korea allows each country to swap its local currency for up to US$5 billion in cash with its counterpart. While a common currency can also boost trade and investment (Rose 2000), it is still a long way off for ASEAN. Apart from increasing trade and investment, a common currency can also result in building a more credible exchange rate system, strengthening the defence mechanism against currency attacks, and obviating the need for competitive devaluation (Ngiam and Yuen 2001). The major cost is the relinquishing of an independent exchange rate policy. However, this should not stop the ASEAN members from working towards a common currency. One practical approach would be for ASEAN to work towards the goal of a common currency in the following 31 stages: (a) A Brunei-Malaysia-Singapore currency arrangement; (b) the inclusion of other ASEAN countries in the arrangement; and (c) a common ASEAN currency. The first stage towards an ASEAN currency goal could begin by extending the existing Brunei-Singapore currency arrangement to 32 Malaysia. In fact, in June 1967, Malaysia had a currency interchangeability arrangement with Brunei and Singapore. Under that arrangement, the currency of one country was circulated in the other countries as “customary tender”, and accepted at par with the country’s own currency. In 1973, Malaysia decided to opt out of that arrangement. Brunei chose to maintain the arrangement with Singapore. Both Brunei and Singapore have benefited from the arrangement, as they enjoy more stable currencies and an increase 33 in their bilateral trade and investment. 7.2. Consolidation of Financial Markets and Institutions

On the global scene, there is a growing trend towards consolidation of stock exchanges and banks. ASEAN stock markets individually lack critical mass compared with stock markets in the United States, Europe, and Japan. By linking up with each other, each stock exchange can enlarge its investor base and enhance the liquidity for individual stocks. Around the world, banks are also seeking economies of scale and scope through mergers and acquisitions. To be sure, cross-country tie-ups are more

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prevalent among stock exchanges than among banks. For stock exchanges, the classic case involves the merger of the Paris, Amsterdam, and Brussels bourses into Euronext. In the case of banks, the merger between Deutsche Bank and Bankers Trust is well known. After the decoupling of the two stock exchanges in Singapore and Malaysia in September 1998, there is no more formal linkage between any of the bourses in Southeast Asia. Currently, Singapore and Thailand are discussing plans to get their companies to dual-list their stocks on 34 each other’s stock market. Singapore and Australia already have a cotrading link, which started in December 2001. There is a possibility of tie-ups among the second boards (which cater mainly to start-up companies) of Malaysia, the Philippines, and Singapore, in order to boost their trading volume. Right now, all these boards are having problems with low liquidity, which led Singapore to even consider scrapping its 35 second board. Cross-border consolidation among banks would be more difficult to achieve, as it could have wider implications, ranging from financial stability to issues of macroeconomic management and customer protection. Still, Thailand managed to sell a majority stake in Thai Danu Bank to DBS Bank of Singapore. However, Indonesia failed in its attempt to sell Bank Bali to the London-based Standard Charted Bank in 1999, as Indonesian employees protested. As the encroachment by foreign banks can be a sensitive issue, banks in Southeast Asia should find alternative ways of working closely together. One way out for them might be to establish strategic alliances with suitable partners in the region. 7.3. Regulatory Co-operation and Harmonization

To speed up the process of consolidation of their financial markets and institutions in the region, countries in Southeast Asia should participate actively to harmonize their regulations and policies. Right now, it is difficult to develop a regional capital market, as countries in this region have differing levels of development, and different policies on the openness of the capital accounts. As a result, different countries may benefit differently from (or feel threatened by) the establishment of a regional capital market. To enable participating markets to fully benefit from a regional capital

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market or a cross-listing of stocks, cross-border flows of capital in these markets must first be liberalized. For example, if a Thai investor cannot buy stock on the Singapore bourse freely, but Singapore and other investors are given a free rein, then the full reciprocal benefits cannot be realized. In this case, opportunities for price arbitrage accrue only to non-Thai investors, while Thai investors trade only in their national market. That is why the president of the Stock Exchange of Thailand (SET) was less than enthusiastic about the proposal to have dual-listing 36 of its stocks on the Singapore Exchange (SGX), and vice versa. In any case, Singapore companies may not be interested in listing on the Thai bourse, as they are currently required to seek approval from the Thai central bank for the transfer of their funds in and out of Thailand. To encourage the exchanges in the region to merge or form alliances, a move towards a demutualized structure for the exchanges would be 37 helpful. In December 1999, Singapore decided to demutualize its 38 bourse, and also made it a public-listed company. This has made it easier for the SGX to forge cross-border strategic alliances. Indeed, the SGX quickly went on to have a co-listing of stocks with the demutualized Australian Stock Exchange (ASX), and has been pursuing a similar tieup with the only other demutualized exchange in Asia, the Hong Kong Stock Exchange (HKSE). 7.4. Mutual Help

It is inevitable that ASEAN members will continue to compete with each other in a number of financial services. But this is not a zero-sum game, as they can grow and profit together. However, countries should learn to accept the fact that certain countries have a comparative advantage in producing certain kinds of financial services, and this should be nurtured by all ASEAN members. After all, it is in their interest to retain more financial businesses in this region, rather than losing them to countries outside the region, as financial institutions operating in the region are more likely to outsource their services to neighbouring countries. Whether the ASEAN members have the political will to support one another, even if the economic arguments for doing so are sound, is beyond the scope of this chapter. Although Singapore is the premier financial centre in the region, it

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does not make sense for it to grab all the financial businesses. There should be opportunities for all the countries in the region. Perhaps a more acceptable approach for Southeast Asian countries is the adoption of the European model, which has an active hub in London, with strong nodes in Frankfurt, Paris, and other markets. For example, Singapore could consolidate its position as a regional hub for the Eurocurrency market, foreign exchange trading, and corporate listing. Brunei and Malaysia could establish financial centres which offer Islamic financial facilities and services. Other countries could consider becoming centres for other activities, which might include, among others, the trading of financial derivatives based on regional financial instruments, a regional bond market, and a regional “second board” market. 8. Concluding Remarks and Suggestions

Before the crisis in 1997, the Southeast Asia countries were well known for having some of the most liberal financial policies among all the emerging economies. As a result, they were able to attract a large flow of direct, portfolio, and bank lending into their economies. Unfortunately, the crisis and the subsequent downturn of the regional economies led several countries in the region to impose controls on capital flows. Hopefully, these countries should be able to ease controls on their capital accounts, once their financial markets have stabilized and their economies have recovered from the doldrums. Singapore took an opposing path by liberalizing its financial services sector despite the crisis. In view of the competitive threat from China, the ASEAN countries have been pushing hard for trade liberalization. For trade in goods, the Southeast Asian region is already a free trade area. To effectively counter the challenges from China, the ASEAN economies will also need to cooperate in other spheres such as the business and financial services. This is because the ASEAN economies cannot be internationally competitive in manufacturing if their services (business or financial) are not competitive. To be sure, financial co-operation is much harder to achieve than trade co-operation, as it is inextricably linked to other policies, such as those towards the capital account and the exchange rate system. But if ASEAN countries want the region to be taken seriously as a base for foreign investment, they will have no choice but to consider removing

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the impediments to further financial integration amongst themselves. While acknowledging that financial co-operation may test ASEAN countries’ political will to the fullest, there are two principles, which if followed, should help considerably. The first principle is that all ASEAN countries must benefit from financial integration, so that they will have the incentive to co-operate and work together. The spirit of give-andtake must prevail if financial integration within ASEAN is to become a reality. The second principle is that ASEAN should adopt an evolutionary approach to financial integration, based on co-operative effort and mutual interest. Given the diversity of the economies in the region, and at different stages of development, financial co-operation in ASEAN should proceed with flexibility, and at a pace that is comfortable for all those wishing to take part.

NOTES 1. ASEAN (the Association of Southeast Asian Nations), was formed in 1967. Its founding members were Indonesia, Malaysia, the Philippines, Singapore, and Thailand. All ten Southeast Asian countries are now members of ASEAN. 2. Growth triangles are sub-regional economic zones, where all participating players can benefit. The three growth triangles in Southeast Asia are: the SIJORI Growth Triangle which covers Singapore, the Johor state of Malaysia and the Riau Islands of Indonesia; the Indonesia-Malaysia-Thailand Growth Triangle (IMT-GT); and the Northern Growth Triangle, which includes north Sumatra, the northern states of peninsular Malaysia and southern Thailand. 3. de Brouwer (1999, p. 43). 4. Government approval is required, however, for foreign investment in residential properties which are of less than six storeys high, and in other properties that have been zoned for industrial and commercial uses. 5. The various control measures used by the other four Southeast Asian countries before 1997 are reported extensively in de Brouwer (1999). 6. These included: bank and non-bank residents’ holding of rupiah accounts offshore, rupiah credit facilities by non-bank residents to non-residents, the setting up of rupiah accounts by non-residents, the use of rupiah for trade settlements, and the free buying and selling of rupiah assets by non-residents. 7. However, the authorities would not hesitate to impose restrictions on foreign exchange markets whenever the ringgit came under pressure, as happened in 1986 and in 1993–94.

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8. This sub-section draws heavily on the work by Ishii et al. (2001). 9. In addition, foreign entities are allowed to come to Singapore to issue Singapore dollar bonds. However, they must convert or swap the Singapore dollar proceeds into a foreign currency. 10. The MAS’s policy on the internationalization of the Singapore dollar was previously set out in a MAS notice to banks, “MAS 621”. In August 1998, MAS 621 was replaced by “MAS 757”, which marks the first phase of liberalization on the use of the Singapore dollar. 11. Malaysian controls also led to the termination of trading of Malaysian stocks in the over-the-counter (OTC) market in Singapore, known as the Central Limit Order Book (CLOB). 12. Unfortunately, the Bank for International Settlements (BIS) does not provide separate figures for each country. But knowing that Malaysia imposed capital controls in September 1998, and that it attracted mostly FDI inflows, separate data would most likely show that the country did not suffer from a reversal of international bank lending. 13. However, Mody and Negishi (2001) have argued that much of the capital inflows into Malaysia, Thailand, and Indonesia, after the crisis, were due primarily to the rapid increase in merger and acquisition (M&A) activities (mostly in the service sectors), rather than in new manufacturing capacities for exports. 14. Monetary Authority of Singapore (1997). 15. The Feldstein and Horioka criterion has also been used to measure the degree of financial integration. According to Feldstein and Horioka (1980), there should be no relation between domestic savings and domestic investment, if there is perfect world capital mobility. 16. For example, the correct interest rate for Singapore is not the domestic interbank rate (IR), but rather the effective cost (EC) of funds. This is because the EC is used by foreign exchange dealers to calculate the Singapore to U.S. dollar forward exchange rate or the swap points. The EC can be obtained by adding the reserve cost to the IR, which is the cost of funds for many Singapore banks. See Ngiam (1996) for the actual calculation. 17. Shapiro (1999, p. 661). 18. An investment is considered a portfolio investment when investors do not have effective control over the firms. Equity investment normally refers to the paid-up capital held by investors. 19. ASEAN Investment Report 1999: Trends and Developments in Foreign Direct Investment. Note that ASEAN here refers to all ten Southeast Asian countries. 20. Bank of Thailand Quarterly Bulletin, December 2001.

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21. In Thailand, equity investment is defined as investments of 10 per cent or more in stocks, while portfolio investment is defined as purchases of less than 10 per cent stakes in Thai firms. 22. Business Times (Singapore), 22 August 2001. 23. For a full background of the currency interchangeability arrangement between Malaysia and Singapore, see Chan and Ngiam (1992). 24. The gross size of the market was estimated to be around RM25 billion. See “Bank Wins Ringgit Case on Landmark Banking Rule” in Business Times (Singapore), 8 March 2002. 25. For a good account of the impact of Malaysia’s capital controls on Singapore, see Haggard (2000). 26. Straits Times, 13 October 1998. 27. This view was also expressed by Garnaut (2000). 28. Trairatvorakul (2001). 29. This is the assessment of Lim (2001). 30. Actually, the amount that a member can borrow is very small. Under the arrangement, each country agrees to contribute US$40 million to the scheme, and is entitled to withdraw only up to twice this amount in times of need. 31. For an elaboration of this sequencing idea, see Ngiam (2000). 32. For Malaysia to join the arrangement, two major obstacles must first be overcome. First, Malaysia has to lift its capital controls. Second, the three countries must agree to a common exchange rate policy. 33. For a cost-benefit analysis of the currency interchangeability arrangement between Brunei and Singapore, see Chan and Ngiam (1992). 34. “Singapore, Thailand Keen on Dual Listing”, Business Times (Singapore), 20 February 2002. 35. “SGX to Study Role of Sesdaq”, Straits Times, 13 March 2001. 36. “SGX will Gain More from Dual Listing, Says Thai Bourse Chief ”, Business Times (Singapore), 5 March 2002. 37. Basically, a demutualized structure involves the separation of members (who are owners) from the users of the exchange. This should reduce the potential conflict of interest between the two parties. 38. Singapore also took the opportunity to merge its stock and derivative exchanges. REFERENCES Ariff, Mohamed and M. Yap. “Financial Crisis in Malaysia”. In From Crisis to Recovery:

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East Asia Rising Again? edited by T.S. Yu and D. Xu. Singapore: World Scientific, 2001. Asia Recovery Information Center. Asia Recovery Report 2001, March 2001 . Bank of International Settlements. 69th Annual Report, Basle: BIS, 1999. Bank of Thailand. Quarterly Bulletin. Bangkok: Bank of Thailand, various years. Bird, Graham and R. Rajan. “Restraining International Capital Flows: What Does It Mean”. Global Economic Quarterly 1 (2000): 57–80. de Brouwer, Gordon. Financial Integration in East Asia. United Kingdom: Cambridge University Press, 1999. Chan, K. and K.J. Ngiam. “Currency Interchangeability Arrangement between Brunei and Singapore”. Singapore Economic Review 37 (1992): 21–33. Feldstein, M.S. and C. Horioka. “Domestic Savings and International Capital Flows”. Economic Journal 90 (1980): 314–29. Garnaut, Ross. “East Asia Financial Cooperation: Which Way Forward”. Paper presented at the Conference on Financial Markets and Policies in East Asia, Canberra, 2000. Haggard, Stephen. The Political Economy of the Asian Financial Crisis. Washington, D.C.: Institute for International Economics, 2000. Herring, Richard J. and R.E. Litan. Financial Regulation in the Global Economy, Washington, D.C.: Brookings Institution, 1995. International Monetary Fund (IMF). World Economic Outlook: Interim Assessment. Washington, D.C.: IMF, 1997. Ishii, Shogo, Inci Otker-Robe, and Li Cui. “Measures to Limit the Offshore Use of Currrencies: Pros and Cons”. Working Paper 01/43. Washington, D.C.: International Monetary Fund, 2001. Kim, Sun Bae. “Do Capital Controls Affect the Response of Investment to Savings? Evidence from the Pacific Basin”. Economic Review 1 (1993): 23–39. Kochhar, K., A. Senhadji, J. Lee, and Y. Nishigaki. “Singapore: Selected Issues”. IMF Country Report no. 01/77. Washington, D.C.: International Monetary Fund, 2001. Lim Chong Yah. Southeast Asia: The Long Road Ahead. Singapore: World Scientific, 2001. Lopez-Mejia, Alejandro. “Large Capital Inflows: A Survey of the Causes, Consequences, and Policy Responses”. IMF Working Paper no. 99/17. Washington, D.C.: International Monetary Fund, 1999. Mody, Ashoka and S. Negishi. “Cross-Border Mergers and Acquisitions in East Asia”. Finance and Development. Washington, D.C.: World Bank, 2001.

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Monetary Authority of Singapore (MAS). “Current Account Deficits in the ASEAN3”. MAS Occasional Paper no. 1. Singapore: MAS, 1997. . Financial Market Integration in Singapore: The Narrow and the Broad Views, MAS Occasional Paper no. 20. Singapore: MAS, 2000. Ngiam Kee Jin. “Comments”. In Financial Deregulation and Integration in East Asia, edited by T. Ito and A.O. Krueger, pp. 354–57. Chicago: University of Chicago Press, 1996. . “Singapore”. In A Common Currency for East Asia: Dream or Reality? edited by K. Bashar and W. Mollers, pp. 243–50. Kuala Lumpur: Asian Institute for Development Communication, 2000. Ngiam Kee Jin and H. Yuen. “Monetary Cooperation in East Asia: A Way Forward”. Singapore Economic Review 46 (2001): 211–46. Rajan, R. “Collapse and Recovery in East Asia: International Financial Flows and Regional Financial Safeguards”. Paper presented at the APEC Roundtable and APIAN Workshop, Singapore, 2001. Rose, A. “One Money, One Market: The Effect of Common Currencies on Trade”. Economic Policy 30 (2000): 7–46. Samo, Lucio and Mark Taylor. “Hot Money, Accounting Labels and the Performance of Capital Flows to Developing Countries: An Empirical Investigation”. Journal of Development Economics 59 (1999): 337–64. Shapiro, Alan. Multinational Financial Management. 6th edition. New York: John Wiley, 1999. Singapore Department of Statistics. Yearbook of Statistics (various issues). Singapore: Department of Statistics, various years. Trairatvorakul, Prasarn. “What Are the Prospects for a Regional Capital Market in East Asia?” Paper presented at the Forum on East Asian Financial Co-operation, Hong Kong, 2001. World Bank. Private Capital Flows to Developing Countries: The Road to Financial Integration. New York: Oxford University Press, 1997. . Global Economic Prospects and the Developing Countries. New York: Oxford University Press, 1999.

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Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at http://bookshop.iseas.edu.sg > 11. The Role of Multilateral 343 Appendix 1

Appendix 1 Project Finance in Southeast Asia’s Water and Sanitation Sector ERIC TEO

Water and sanitation are crucial utilities of public good, with an important social value. They are, in fact, even more important today against the backdrop of two present trends: the current economic slowdown; and the anti-globalization backlash. The economic slowdown has forced many governments to shift their economic strategies towards Keynesian pump-priming and public spending. To cushion the harsh realities of globalization, there is a dire need for big business and capital to be more involved with governments in alleviating poverty and in bridging the social inequity gap that is perceived to have widened with globalization. Water and sanitation are prime examples of essential public works of great social value, which could be better developed during this period

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of economic slowdown, although private capital is urgently needed to finance such projects. (See the Annex below, for an assessment of East Asia’s needs in water and waste management.) The need for private capital is especially crucial because of three present factors in Asia today, namely, the Asian crisis; the decentralization process and greater accountability to the people via democratization; and the rise of civil society. Public authorities have been greatly impoverished thanks to the Asian crisis and public budgets for public works, amenities, and utilities have dried up. The decentralization process has transferred the responsibility of providing such services to local authorities, which unfortunately in most cases do not have the technical, managerial, and financial resources to do so. Lastly, owing to the democratization process, the rise of civil society and a greater accountability of the public authorities to the people (at both central and local levels), voters are expecting high-quality services from the authorities, which can now only deliver them with private sector input and resources. In fact, there are two related issues that must be equally addressed when we talk about water and sanitation, and especially in Southeast Asia. These are: (a) better water resource management (at source, the conservation of watersheds, and the protection of aquifers from environmental pollution through wanton discharge of waste water); and (b) the management and distribution of raw water for agriculture and irrigation. These two areas are normally outside the purview of private capital, although Southeast Asian countries should start thinking of urgent ways to involve and harness private capital here too. Perhaps, funding from multilateral organizations and development banks could be found. Project financing in the water and sanitation sectors must now fully integrate the social aspect as much as possible. Such a scheme should bring together the state (central or local authorities), the market (private sector), and the consumer (civil society, unions, NGOs, environmental and lobby groups) in a partnership, which could be none other than the Public Private Partnership (PPP). This PPP concept is in opposition to the partial failure of privatizing outright the water and sanitation sector, as it has been demonstrated to a huge extent in the United Kingdom. (The privatization model has, however, been more successfully used in

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the electricity sector.) There are four essential factors that must be considered in a package when discussing the PPP in water and sanitation. Firstly, in the PPP concept, the assets (raw water, water or waste water production facilities, and the distribution network) belong to the state, which also sets the overall developmental strategy and regulatory framework for the private sector to work within. The private sector would build and operate the utilities facilities, so as to deliver these services efficiently and effectively, according to its best technical, financial, and managerial practices. The most developed form of PPP is the full concession, where the private sector manages the full water production and distribution chain (or full waste water treatment chain), from intake of raw water at source right to the taps, and including the collection of water bills or taxes from the consumers. This partnership should establish the quality of service (quality of potable water or waste water treatment) provided, the pricing formula, future tariff increases, and the duration of the concession or contract (ideally for twenty-five to thirty years). It should fix a fair and reasonable water and sanitation tariff for the consumer (for social and political reasons), whilst ensuring that the private sector operator gets a reasonable and fair profit margin over the duration of the concession or contract. This tariff should also take into account all the valid perimeters, which affect potable water or waste water treatment pricing, and cater for the tariff increases by integrating all these factors in a pre-determined and acceptable formula. The attractiveness of this concessionary formula is the possibility for the concessionaire to recoup its capital investments in the mid-term, usually starting from the seventh to the twelveth year, depending on the capital outlay which it has to provide in the project. By fixing a long concessionary period, the private sector partner can seek to plan and achieve reasonable capital returns within a public sector guaranteed framework. However, it is to be noted that the greatest obstacle to a successful PPP in this region will come from the existing low water tariff, owing to heavy subsidies in the past, for either social or ideological reasons. Secondly, to satisfy the projected supply-versus-demand curve over the duration of the concession or contract, there is a need to ensure that the private concessionaire or operator abide by his commitment to

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expand the supply (or the water and sanitation facilities) through planned and staged investments throughout the duration of the concession, commensurate with projected demand. If this planned expansion of supply is not complied with, the authorities would levy a penalty on the operator, except in case of force majeur, which must be proven legally. On the other hand, if the authorities modify the concession contract (for example, over tarification, cost of raw water, change of framework or regulations, and so forth), which inexorably affect cost of supply, the operator should also be entitled to a fair compensation. Thirdly, financing the expansion of the services (according to supply versus demand) must be factored into the overall project over the duration of the concession, so as to allow the operator a maximum predictability and utmost certainty in managing the finances of the concession over the pre-determined duration. This involves a long-term commitment over the partnership by both the public and private sectors, which is the key to a PPP. Project financing will involve both equity and debt financing (usually at a ratio of 30:70) at each and every stage of expansion/ investments in the concession. As cost and revenue for the operations are calculated and controlled at each stage of the concession/investments, there is certainty and transparency for all parties concerned, namely, the authorities, operator, banks, insurance, as well as the consumer. Lastly, regulatory frameworks must be clear and transparent. The appointed regulator must be fair and neutral, so as to be clearly credible in the eyes of the authorities and the operator. The transparency and fairness of the regulatory framework and the regulator are of utmost importance for the project, in order to help lower the political risks as much as possible. This is especially so for long-term concessions of this nature, with a social value and a public good. It is where developmental banks, multilateral organizations and export credit agencies will have to come in to provide some confidence to private capital and operators. There would hence be better risk allocation with such organizations and agencies playing a key intermediary role here and within a clear and transparent PPP framework. With the rise of the civil society (consumer lobbies, NGOs, unions, and environmental groups), against the backdrop of mounting antiglobalization sentiments world-wide and in this region, it is becoming

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imperative for the authorities and the private sector to co-operate fully in delivering the best services of water and sanitation to the population at the fairest and lowest price (and even if need be, by subsidizing perhaps the tariff levied on the poorest sectors of the population, at least in the initial phases of operation), whilst ensuring the financial viablity of the operator or concessionaire over the whole period of the concession. The PPP should bring all the principal actors in the community to jointly finance and operate such a social amenity and a public good. ANNEX East Asia’s Needs in Water and Waste Management

The World Bank has estimated that infrastructure investment requirements in the East Asian economies could be as high as US$1.5 trillion for the period 1995–2004. This massive demand should continue as the region recovers from, and will grow after, the 1997 economic crisis. Based on the above factors, regional governments and local authorities have now recognized that the public sector does not have all the sufficient financial resources to meet the infrastructural investment requirements. As a result, the infrastructural and utilities sectors are being gradually opened up to private sector participation. It was estimated by Environmental Business International Inc. that the market for water and waste management in five major Asian economies — Hong Kong, India, South Korea, and Taiwan — was a startling US$14 billion in 1995. These two infrastructure sectors grew at an average of 7 per cent per annum, to reach US$16 billion in 1997. For the period between 1995 and 2005, the East Asian region will require an estimated US$292 billion in investments to meet the growing demand for water and waste management facilities and services. An awareness of the utmost importance in water management is to satisfy the growing needs of the urban population, in terms of clean potable water to drink, and the effective treatment and disposal of waste water, has been highlighted last year by the International Water Forum in the Hague, Netherlands. Water needs in East Asia are also linked to the increasing agricultural and irrigational needs of many Asian countries, as well as the harnessing of hydraulic power for the generation of electricity, especially in China and the countries of the Greater Mekong

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Environmental Technology Market Size for Some Regional Countries (US$ Millions) 3,500 1993 2000

3,000 2,500 2,000 1,500 1,000 500

C hi na Si ng ap or e

In do ne si a

Ta iw an

ay si a Ph ilip pi ne So s ut h Ko re a Th ai la nd

al

In di a M

H on g

Ko ng

0

Source: Regional Institute of Environmental Technology (RIET).

Sub-Region. It is therefore becoming imperative in Asia to focus more attention on water resource management, as the scarcity of water has wreaked havoc in Northeast Thailand and the Klang Valley (Malaysia), whereas floods have devastated vast areas along the Mekong River, including Cambodia and the Mekong Delta in southern Vietnam.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at < http://bookshop.iseas.edu.sg > 349 Appendix 2

Appendix 2 Financing Electricity and Gas Supply in Southeast Asia: The Role of Intergovernmental Co-operation ANDREW SYMON

Introduction

If the countries of Southeast Asia are to prosper, and further raise the living standards of their peoples, then there will need to be a very large, if not massive, increase in electricity supply. The expansion of power supply raises the question of fuel choice, and the extent to which individual countries will be able to rely on their own resources. Natural gas is an attractive choice, given the region’s generous endowment of this resource, and the less damaging environment impact of gas combustion when compared with coal. The scale of future power and associated fuel needs, and its

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implications for finance, make it imperative that governments in Southeast Asia co-operate as far as possible, so that demand can be met as efficiently as possible. The geographical distribution of gas and other primary energy reserves in the region is uneven. So is the electricity and gas supply infrastructure. Some countries or areas may have a surplus, while nearby regions are hungry for energy. There is clear potential for extensive cross-border electricity and gas trade. Even where a country may have abundant electricity capacity and gas, distant parts of the country might be served more cheaply by imported supply from immediate neighbours. Efficient development should also minimize environmental costs. Inter-governmental co-operation is necessary if governments wish to promote the use of natural gas as the main fuel for power generation. Fuller use of natural gas will require more cross-border pipelines. But bringing gas to market is not a simple task, given its high capital costs and the regulatory issues associated with cross-border gas supply. An obstacle to the development of cross-border gas and power transmission is government concerns over the security of supply. Governments are cautious about relying on energy supplies that can be easily interrupted. There may therefore be merits in an ASEAN Energy Treaty, whereby governments make legally binding commitments to common principles supporting the regional transit of gas and power. This would give comfort both to governments and investors that there would not be arbitrary interference with energy transit. Power Demand Outlook

To realize the scale of this region’s potential power demand, it is useful to compare Southeast Asia with Western Europe. This comparison also serves to introduce the idea of a co-operative approach among governments to achieve their energy goals. Both Southeast Asia and Western Europe are made up of different sovereign states, which cover a coherent geographical area. Economic co-operation, including co-operation in the energy sector, is pursued in both regions. Europe, through the fifteen1 member European Union (EU), now has well-established political institutions and legal frameworks for economic co-operation. These are less advanced in the Southeast Asian region. But progress nevertheless is

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being made in developing and implementing regional and sub-regional approaches, through the Association of Southeast Asian Nations 2 (ASEAN) and the Asian Development Bank (ADB)–assisted Greater 3 Mekong Sub-Region programme (GMS). There would seem a substantial possibility for deepening this work through energy sector co-operation. The ten countries of Southeast Asia occupy a landmass of four million square kilometres, have a total population of roughly 525 million, and an average annual per capita income of less than US$900. The fifteenmember EU occupies a land mass of 2.5 million square kilometres, has a population of around 300 million, and an average per capita income over twenty times greater, at US$22,000. Differences in the two regions’ economic development are underlined by the levels of electricity and gas infrastructure. Southeast Asia has an installed generation capacity of approximately 90 gigawatts (GW), or 90,000 megawatts (MW). In 2001, gross electricity production was 750 kWh per capita, and total regional output was 2.5 per cent of world output. More than 190 million people in the region do not have access to electricity. In contrast, the EU has an installed capacity of 585 GW. In 2001, gross electricity production was 8,750 kWh per capita, and total output was 17 per cent of world output. As far as gas infrastructure is concerned, Western Europe has 1.2 million kilometres of gas transmission and distribution lines, whereas Southeast Asia has about 12,000 kilometres (see Tables 1 and 2). In other words, taking into account that Southeast Asia has oneand-three-quarter times the population of the EU, the region would need eleven times its current power capacity to match that of Western Europe, if that is what it takes — among other things — to achieve a standard of living comparable to the EU today. Such an assertion may be a little simplistic. But this broad comparison does indicate the order of magnitude of the region’s needs for power infrastructure and associated fuel supply in the coming decades. The scale of investment required will be huge, bearing in mind today that 1,000MW of generation capacity alone costs about US$500 million to US$800 million, depending on whether it is a gas-combined cycle or coal-fired thermal unit (with the capital costs of the former being cheaper). Then there are the transmission and distribution costs. Added to these costs are those

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Table 1 Andrew Symon Southeast Asia and European Union: Economic and Power Supply Indicators, 2001a Population (million)

GNI per Capita (US$)b

Installed Capacity (MW)

Brunei Cambodia Indonesia Laosc Malaysia Myanmar Philippines Singapore Thailand Vietnam Total

0.3 13.1 213.5 5.3 23.3 51.1 80.1 4.1 62.9 78.9 532.6

24,000 260 570 290 3,380 250 1,040 24,740 2,000 390 1,065

707 40 20,909 644 14,778 1,173 13,409 7,657 22,035 8,478 89,830

EU15

304

21,730

585,000

World

6,100

Output (Twh) 2.5 0.5 112 1.5 72 5 47 29 101 31 401.5

Per Capita Output (Kwh) 8,333 38 525 283 3,090 98 587 7,073 1,606 392 754

2,661

8,750

15,684

2,571

GNI = Gross national income. MW = Megawatts. Twh = Terrawatt hours. Kwh = Kilowatt hours. a Refers to power for the public grid and therefore does not include “captive” generation for dedicated use for factories, hotels, and so forth. b Data for the year 2000. b 70 per cent of output sold to Thailand. Sources: World Bank; Asian Development Bank; International Energy Agency; BP Statistical Review of World Energy; author’s estimates.

Table 2 Access to Electricity in Southeast Asia, 2000 Electrification Rate (%) Brunei Cambodia Indonesia Malaysia Myanmar Philippines Singapore Thailand Vietnam

99.2 15.8 53.4 96.9 5.0 87.4 100.0 82.1 65.8

Total

Population Without Electricity (Million) 0.003 10.3 98.0 0.7 45.3 9.5 0.0 10.9 19.0 193.7

Source: International Energy Agency.

© 2003 Institute of Southeast Asian Studies, Singapore

Population With Electricity (Million) 0.3 1.9 112.4 22.6 2.4 66.1 4.0 49.8 59.5 319.0

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for fuel supply infrastructure. And of all fuels, the upfront investment cost of natural gas infrastructure is the most expensive. Power development on this scale may also have large environmental costs. Fuel Choice and Natural Gas

The expansion of power supply leads to the question of fuel choice. Southeast Asia’s most abundant primary energy source is natural gas. There were proven reserves of 216 trillion cubic feet at the end of 2001, and production in 2001 of about 17,000 million cubic feet per day, 8,000 million cubic feet per day of which was used to produce liquefied natural gas (LNG) for export to Japan, Taiwan, and South Korea (see Table 3). There are also extensive coal resources, mostly in Indonesia. Indonesia has 5.3 billion tons of proven coal reserves. In 2001, Indonesia produced 96 million tons, and exported 70 million tons, almost all of which went to other Asian countries. Vietnam also produces significant quantities of coal, and smaller amounts are mined in the Philippines 4 and Thailand. There is potential for greater use of hydropower, especially in the northern Mekong region. But greater reliance on large-scale hydropower projects is controversial because of its environmental impact. There is a great deal of concern already that planned dams in the upper reaches of the Mekong River will damage the downstream life of the river and communities living along its banks. Oil is an option only when there is no other fuel source. The region’s own oil supply is limited. Southeast Asia is a net importer of oil, and it is an expensive fuel for power generation. New and sustainable forms of energy for power generation — such as wind, biowaste, and solar power — should be drawn on to a greater extent for small-scale generation. This could be of importance for rural electrification programmes, where individual demand centres are small and dispersed. But overall, the contribution will still be small relative to total power demand. An exception could be geothermal energy, which may be a significant source of energy or power in the Philippines and Indonesia. Nuclear power is rarely put forward by planners in Southeast Asia. Natural gas is an attractive fuel. But there are economic, commercial, and political difficulties in harnessing gas to the maximum extent. Southeast Asia’s natural gas supply industry remains at an embryonic stage outside of Malaysia and Thailand. Gas fields, often distant from

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market, require high capital cost infrastructure for extraction, processing, and shipment, by either pipeline (often across borders), or in the liquefied form (LNG) by ships. This is turn means that gas producers need longterm contracts so that they can secure financing. Unlike the situation in North America and Europe, where gas infrastructure is well developed, much of the Southeast Asian gas supply industry is still at the project development stage. A result of this lack of infrastructure is that there is no gas market. Gas is not a traded commodity, unlike coal or oil. From the point of view of power-generation development, gas may simply not be an option because there is no available supply. But once gas is available, it can be a very economic choice. Gas-fuelled combined cycle plants are very efficient; significantly more so than coal-fuelled plants. And once the gas supply infrastructure is in place, with the necessary anchor consumers, additional gas can be supplied at a very low marginal cost. Gas prices can drop markedly over the long run. The challenge for gas in Southeast Asia is financing the initial infrastructure. Coal, in contrast, needs far less investment in infrastructure. Coal is a very cheap fuel, and contractually simple to obtain under spot or term contract conditions. Therefore, despite concerns over its environmental impact — which can to some extent be mitigated by various clean coal technologies — coal remains a favoured fuel among power plant developers and government planners. Over the long term, just how adequate the Southeast Asian region’s primary energy resources are compared with the future scale of power demand is a moot point. Local resources may come to be supplemented by coal supplies from Australia and South Africa, two of the world’s largest exporters. There could also be LNG supply from northern Australia and the Middle East Gulf, where there are huge gas reserves that will never be fully needed by local markets (Table 3). Cross-Border Power and Gas Supply

Given the scale of power needs, and to maximize the use of local energy resources, governments in Southeast Asia will need to encourage greater cross-border supply of electricity and natural gas. The geographical distribution of energy resources in the region is uneven. So is electricity and gas supply infrastructure. Some countries or areas may have a surplus, while nearby regions are hungry for energy. There is clear potential for cross-

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Table 3 Natural Gas Reserves and Production in Southeast Asia, Australia and the Pacific, and the Middle East, 2001 Proven Reserves (Tcf)a Brunei Cambodiac Indonesia Laos Malaysia Myanmar Philippines Thailand Vietnam Total Australia Papua New Guinea Middle East World

Gas Production (mmcf/d)b

13.8 0 92.5 0 75.0 12 3.0 12.7 6.8

1,133 0 7,690 0 5,534 637 13d 1,900 145

215.8

17,052e

90.0 12.2

3,141 319

1,974.6 5,476.7

22,050 238,299

a

Trillion cubic feet, as proven at end 2001. Million cubic feet per day. c Cambodia has possible reserves of 3 trillion ft 3 in offshore waters; in the offshore overlapping claims area with Thailand, there may be 11 trillion ft 3 of gas. d Since 2002, 110 million ft 3 per day with the coming onstream of the Camago-Malampaya field. e About 8,000 million ft 3 per day is for export LNG production in Malaysia, Indonesia, and Brunei. b

Sources: Governments; BP; and author’s estimates.

border electricity and gas supply. Even where a country may have abundant electricity capacity and primary energy resources, distant parts of the country might be served more cheaply by imported supply from immediate neighbours. In the case of power supply, for example, costs of production can be lower when an inter-connection is used to offset production from expensive peaking plants. Since the peak portion of the load can be met by power purchased through the inter-connections, the existing plants can be

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Possible Southeast Asian Gas Grid

LA

O

MYANMAR

S

THAILAND

CA M BO DI VI A ET NA M

PHILIPPINES

M A L AY S I A BRUNEI

SINGAPORE

Existing pipelines INDONESIA

Planned and proposed pipelines

Source: ASEAN Centre of Energy, Jakarta.

run on a base load scheme. This results in lower generating costs. The ability to share spinning reserves (immediately available capacity) means that individual countries may operate at a lower reserve margin than would be the case otherwise. They would be able to defer investment in new plants, but still meet load demand with high reliability and security of supply. Efficient development should also minimize environmental costs. Some gas and power trade already takes place. Myanmar exports gas to Thailand, and there is talk of increasing volumes. Laos has been exporting power to Thailand for many years, and this is to increase. Thailand also has memoranda of understanding (MoU) for imported

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power from Myanmar and China’s Yunnan province. Inter-connections are planned by 2005 between Vietnam and Cambodia, and Thailand and Cambodia. Further south, there are two power connections between southern Thailand and northern Malaysia. There are also power and gas connections between Malaysia and Singapore. In terms of future gas supply links, Thailand and Cambodia are working together to establish a joint development zone for oil and gas production in very prospective waters in the Gulf of Thailand, subject to overlapping maritime border claims, the origins of which date back to the French colonial period. Gas from the area could support much needed power development in Cambodia, as well as be supplied to Thailand. Pipelines could connect Cambodia with the already wellestablished Thai system. Further to the southeast, in Vietnamese waters, gas fields are earmarked for supply to the Mekong delta region. Not too distant too are pipeline links between Thailand and Malaysia. These two countries have the region’s most developed gas infrastructure. In the southern Gulf of Thailand, a pipeline should be in place by 2004, from the offshore joint development area (JDA) between Thailand and Malaysia, to northwest Malaysia across the Kra Isthmus. There are also proposals to take gas from the JDA system into the northern Thai system by 2010, or just after. To the east of the JDA, in the Commercial Agreement Area (CAA) in the South China Sea between Malaysia and Vietnam, a gas pipeline is also to be built to the Mekong delta. The area is also to supply gas to the Malaysian peninsular, adding to the existing supply from Malaysian fields offshore the peninsular. Malaysia, in turn, is linking its transmission system to fields in Indonesia. A short pipeline link from Indonesian fields in the West Natuna Sea, northwest of Borneo island and west of peninsular Malaysia, was completed in August 2002. These already supply Singapore. Proposed also is a link from South Sumatra to the west coast of the peninsular, in addition to the planned pipeline to Singapore to be in operation in 2003. The idea of piping gas from Indonesia’s East Natuna or Natuna D Alpha fields to Thailand has also resurfaced. Role of Inter-Governmental Co-operation

Co-operation among governments to foster cross-border grids has been on

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the agenda for some time now. Apart from bilateral negotiations and arrangements, a regional approach is pursued under the auspices of ASEAN. In 1986, members signed an agreement for co-operation in the efficient development and use of all forms of energy. Under the umbrella of ASEAN, national oil companies meet as the ASEAN Council on Petroleum (Ascope), and power authorities meet as the Heads of ASEAN Power Utilities (Hapua). Both groups have teams working on policy and masterplans for regional grids. Complementing initiatives under the ASEAN umbrella, the Mekong countries (including China’s southern Yunnan province) also pursue energy sector co-operation — and joint approaches in other matters — through the Greater Mekong Sub-Region programme, assisted by the Asian Development Bank. A particular focus of this programme is the development of a regional Mekong power grid. So what can Southeast Asian governments in fact do to accelerate development? To what extent can cross-border electricity and gas supply be encouraged by governments on a regional multilateral basis? Or is this too difficult a task at this stage of the region’s economic development? Will more immediate advances take place if governments focus on bilateral agreements? Is it better that they concern themselves with ways of removing obstacles to electricity and power trade with their immediate neighbours, rather than worry about grand regional plans and agreements? Certainly, one might argue that bilateral agreements are most relevant now for project development. Inter-connections that so far exist have been formed between two countries when specific project economics have made sense. And this is likely to be the pattern of most development for some time to come. But there are first steps also being taken towards supplies from one country to two or more countries. As noted above, Malaysia began taking gas from Indonesia's West Natuna fields in August 2002, which also began supplying Singapore in January 2001. And there is also talk that the planned pipeline from Indonesia’s Sumatra to Singapore will have a spur to Malaysia’s west coast, as a result of Malaysia's state-owned petroleum company, Petronas, becoming a partner in the pipeline operation with Indonesia's state-owned Perusahaan Gas Negara in September 2002. Plans to link Sumatran fields with Java, Indonesia’s most urbanized and industrialized area, are also advanced.

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A result of various inter-connections between pairs of countries will be links between systems of three or more countries. In gas supply, by the end of the decade it is possible to envisage a pipeline corridor stretching from Myanmar to Thailand to peninsular Malaysia, Singapore, and Indonesia’s Sumatra and Java. There will be a mixture of demand and production centres. There are also pipelines planned from the Malaysia-Vietnam CAA. One is to pipe gas south to Malaysia and another possibly to Vietnam's Mekong delta in the north. So Vietnam could be linked to the Malaysian system. There is also the possibility of a link by then between the Thai system and a yet-to-be born Cambodian system, through the joint development of the offshore overlapping claims. Could there also be the prospect of Vietnam being linked to the Thai system? The proposed development of piped gas from fields in Vietnamese waters in the eastern Gulf of Thailand to the Mekong delta could perhaps lead to a connection from these fields to the Thai system. Links between three and more countries open up the possibility of cross-border supply of gas and power to countries not sharing mutual borders. For example, a producer in south Sumatra could sell gas to an “off-taker” in Thailand. Gas would be placed into the Malaysian system and an equivalent amount — although different molecules — taken by Thailand from Malaysia. And a similar situation could occur for power. Diverse energy trade along these lines would clearly be in the interests of a more complete and efficient use of the region’s energy resources. Governments therefore do need to take a regional approach to power and gas infrastructure development. They will need to reach agreement as to how they can best foster this multi-country trade. Some policy questions that seem important now follow. Gas Pipelines or Electricity Transmission

Gas grids should not compete with electricity grids. Given that the predominant use of gas in Southeast Asia is for power, it may make more economic sense to take gas across borders in the form of electrons, rather than molecules. That is, instead of a gas pipeline, it may be better to generate power in some centres and export that to neighbouring countries.

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Role of the Private Sector

Given the scale of investment required for power and gas development, there is a strong argument to encourage a much more extensive role for the private sector in the power and gas supply industries. Thus far, the main agents for gas and power in the region have been state-owned companies. The private sector has been able to operate in the upstream petroleum segment for many years, usually contracted to state-owned companies. In recent years, power generation has also been opened to the private sector. Some countries, such as Singapore, the Phillipines, Thailand, and Indonesia, intend to further liberalize their industries. But this is likely to be a gradual process. State companies will continue to be key agents in Southeast Asia, the most prominent of which will be Malaysia's Petronas. Existing cross-border sales contracts are between state companies, although the producers may be private companies alone, or in consortia with state-owned companies. This is the case, for example, of gas sales from Indonesia to Singapore and Myanmar to Thailand. To what extent will private producer companies be able to engage in trade directly with customers? Can private companies build and operate connecting infrastructure? Can private sector consumers of gas and power deal directly with producers? This leads to questions about price regimes, and to what extent governments intervene, and to what extent they are market-based. The answers depend to a very large extent on governments’ own domestic energy policies. Open Access to Infrastructure

This is intertwined with the issue as to what role is envisaged for the private sector. Open access should accelerate greater cross-border energy trade. Markets would expand as gas and power are delivered at lower prices. There would be more incentive for exploration and development of otherwise marginal gas fields. Investors, produers, and transmission operators will see the potential for power or gas sales beyond their initial contracted buyers. Transmission facilities will therefore be built of sufficient capacity to cater for expanded flows. Without open access, the danger is that transmission will only be built with limited capacity matching the initial bilateral contracts.

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Independent System Regulator

Provision for greater private sector participation and open infrastructure access makes it necessary for independent regulation, to ensure that this is being provided for, and that common carrier tariffs are appropriate. Tariffs must not be discriminatory. Independent System Operator

The complications of balancing gas or power supplied to one part of a system, with what must be delivered from another part of the system to the suppliers’ customers, would demand an independent operator. For example, an Indonesian producer might agree to sell gas of certain heat content over a period of time to a customer in Thailand. The operator would have to ensure that the Malaysian gas supplied on behalf of the Indonesian producer was of the same heat content, or was of sufficient volume, to match the total Indonesian heat content. Legal Uniformity and Standards

Countries would need to strive for uniformity in legal and fiscal requirements, conditions affecting the operation of cross-border infrastructure, and gas and power sales contracts. They would need to establish common technical, safety and environmental standards. A Distant Vision

More cross-border gas and power transmission links are likely to be the start of the road towards common gas and electricity markets in Southeast Asia. But this is a distant vision. Governments in the region have different views as to the role of the state, private sector, and market in energy. Some are establishing or pursuing the development of liberalized and competitive power and gas supply industries. But there are also second thoughts about liberalization in light of doubts stemming from the the crisis experienced in the United States with the well-publicized failures of California's deregulated power and gas markets in 2000 and 2001, and the later corporate scandals at Enron and other energy traders, along with allegations that they manipulated energy prices. Malaysia is very cautious about the extent and rate of liberalization. Indonesia is in the very early stages of industry restructuring. Vietnam has only started to entertain more

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extensive private sector participation under closely administered conditions. It is unlikely, therefore, that there will be any rapid evolution of integrated and liberalized gas and power markets in Southeast Asia. Given both the different levels of economic development of the various countries and the different policy positions, development will be gradual and conservative. It is worth noting that in Western Europe, where there is agreement among the EU member states to create integrated and competitive power and gas markets, realization is still proving to be a slow process. Electricity traded across borders only represents 8 per cent of total electricity consumption. In Southeast Asia, nevertheless, the ASEAN governments do endorse the idea of comprehensive cross-border gas and power links. A memorandum of understanding promoting trans-ASEAN gas transmission was signed by regional energy ministers in July 2002. The governments agreed to pursue common policies, laws, and regulations supporting cross-border pipeline development. Among other things, the ministers endorsed the principle of third party or open access. In power, the Mekong countries, Thailand, Laos, Myanmar, Cambodia, and Vietnam, signed in November 2002 a formal inter-governmental agreement on power trade within their sub-region. An ASEAN Energy Treaty?

The region’s long-term energy needs do require governments to work together to foster cross-border gas and power supply. But governments are understandably cautious about entering into cross-border energy agreements if they fear it is leaving them vulnerable to supply interruptions. No government anywhere in the world wants to be overreliant on foreign energy supply, if it can be possibly avoided. This is especially so if the predominant supply of power or gas is coming from a single source from one other country, or through one country only. In contrast, importing coal can seem a much better option from the point of view of security of supply. International coal supply is plentiful and competitive. Coal is cheap and easy to procure under spot or term contracts. This indeed is what proponents of coal argue in Thailand. But opposition to coal can be strong, as events in Thailand show. In May 2002 the government, in the face of long-standing protest, postponed development by independent power producers of 2,100MW of planned coal fired capacity. Perhaps a solution could be the

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introduction of LNG imports alongside of piped gas supply. This will then help achieve a competitive supply, with gas from several sources. In Western Europe this role is emerging for LNG, where there are now eight import and regassification terminals. To accelerate the development, some argue now for an ASEAN energy treaty similar to the 1994 international Energy Charter Treaty. This was instigated primarily to facilitate cross-border energy trade in Europe, but has expanded its coverage to include countries beyond Europe, such as Japan and Australia. It covers most forms of energy, and not just power and gas. The Treaty came into effect in 1998 and has now been ratified by more than fifty signatories. An ASEAN energy treaty, or the inclusion of ASEAN member countries in the Energy Charter would represent a legally binding commitment by governments to common principles supporting the transit of gas and power from place to place. This would advance existing ASEAN agreements relevant to energy. It would also give comfort to both investors and member countries that there would not be arbitrary interference by governments in the transit of gas and power. Such an energy treaty would complement ASEAN’s strong progress towards creating a free mechanized 5 trade area. Despite the various caveats as to how quickly progress can be made, energy sector co-operation can further strengthen ASEAN as a regional institution. Necessary tasks, where all can easily agree on the goals, can be the most effective way of creating bonds between states, even if achieving them is a slower process than some may think. After all, the EU had its origins in a 1951 treaty between France, the then West Germany, Italy, Luxembourg and the Netherlands over practical co-operation in the production of coal and steel. Grand visions of Southeast Asian gas and power transmission systems and markets are easy to put forward. But they are much harder to realize. It is a bit like people a century ago imagining how far railway networks could stretch, linking once-isolated countries. In fact, trans-ASEAN railways with links to China are back on the agenda. Perhaps this gives a bit of romance to gas and power as it does to railways. It is easy to draw lines on maps. But despite the various caveats as to how quickly progress can be made, the building blocks for more comprehensive cross border links and eventually more integrated markets are appearing.

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NOTES 1. The EU currently consists of Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and the United Kingdom. 2. ASEAN was established in 1967, in Bangkok, by Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Brunei joined in 1984, then Vietnam in 1995, Laos and Myanmar in 1997, and Cambodia in 1999. The ASEAN Declaration states that the purpose of the association is to accelerate the economic growth, social progress and cultural development in the region through joint endeavours in the spirit of equality and partnership in order to strengthen the foundation for a prosperous and peaceful community of Southeast Asian nations, and to promote regional peace and stability through abiding respect for justice and the rule of law in the relationship among countries in the region and adherence to the principles of the United Nations Charter. 3. In 1992, Cambodia, Laos, Myanmar, Thailand, Vietnam, and the Yunnan province of China, with the assistance of the ADB, entered into a wide-ranging programme of economic co-operation, known as the Greater Mekong Sub-Region programme. There is also the Mekong River Commission, established in 1995 by Cambodia, Laos, Thailand, and Vietnam, which seeks to ensure sustainable use of the resources of the Mekong River. It replaced an original Mekong Committee established in 1957. 4. To give an idea of what these figures mean for power development, 1,000MW of power can be supported by about 130 million cubic feet per day of gas, or about 2.5 million tons per year of coal. The decision to use coal or gas for power is a longrun decision, that is, at the time of planning for a new power station. Gas and coal cannot be substituted for each other once a power plant is built, because of the different technologies of gas-combined cycle and conventional coal combustion plants. 5. The ASEAN Free Trade Area (AFTA) programme was launched in 1992 with the aim of creating a regional market free of tariff barriers. Tariffs on goods traded within ASEAN, which meet a 40 per cent ASEAN content requirement, are being cut to 0 to 5 per cent by the year 2002/03 for Thailand, Indonesia, Singapore, Malaysia, the Philippines, and Brunei, and by 2006 for Vietnam, 2008 for Laos and Myanmar, and 2010 for Cambodia. Zero tariff rates on virtually all imports are targeted by 2010 for the original members, and 2015 for the four newer ASEAN members.

© 2003 Institute of Southeast Asian Studies, Singapore

Reproduced from Financing Southeast Asia’s Economic Development, edited by Nick J. Freeman (Singapore: Institute of Southeast Asian Studies, 2003). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at 365 < http://bookshop.iseas.edu.sg > Index

Index

A Abdurrahman Wahid, President 118 ABN Amro Bank 84 accounting and auditing standards 242 Agricultural Promotion Bank (APB) 149 Amanah Ikhtiar Malaysia (AIM) 107–10 American Depository Receipts (ADRs) 135, 264, 304 angel investors 187 Arab Malaysian Berhad (AMMB) 179 Arab-Malaysian Holdings 75 ASEAN Council on Petroleum (Ascope) 358 ASEAN Free Trade Area (AFTA) 201, 267, 271–74, 281, 298 ASEAN Industrial Co-operation (AICO) 305 ASEAN Industrial Complementation (AIC) 305 ASEAN Industrial Joint Venture (AIJV) 305 ASEAN Industrial Project (AIP) 305 ASEAN Investment Area (AIA) 201, 271–74, 282, 298, 305 ASEAN Swap Arrangement 305 Asian crisis 11–15 Asian Development Bank (ADB) 55, 98, 135, 148, 315, 321, 351 Asian dollar market (ADM) 291 Asian Monetary Fund 27

asset allocation 257–60 asset management 257–58 asset management companies (AMCs) 63, 79 asset price integration 293 Association of Cambodian Local Economic Development Agencies (ACLEDA) 135–38, 140 asymmetric information 23 auditing and accounting standards 304 Australian Agency for International Development (AusAID) 55 Australian Stock Exchange (ASX) 308 B baht 285 Bakun hydroelectric project 164 Bambang Subianto 38 Ban Artha Graha 78 Bangko Sentral ng Pilipinas (BSP) 78 Bangkok Elevated Road and Train System 164 Bangkok International Banking Facility (BIBF) 64 Bangladesh 100–2 Bank Bali 83, 307 Bank BNI 78 Bank Bukopin 78 Bank Bumiputra Malaysia Berhad 74 Bank Danamon 74

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366

Bank for Agriculture and Agricultural Co-operatives (BAAC) 112–16 Bank for International Settlements (BIS) 20, 258 Bank Indonesia (BI) 118, 123–25 Bank Mandiri 74 bank mergers 74 Bank Negara Malaysia 75, 107, 235–38 Bank of Asia 83 Bank of Commerce Berhad 74 Bank of Thailand (BoT) 212, 239 Bank Perkreditan Rakyat 119 Bank Pertanian 106 Bank Rakyat Indonesia (BRI) 101, 115– 20 bank restructuring 39, 42, 61, 72, 91 Bankers Trust 307 banking supervision 87 bankruptcy law 170, 242 Banque Nationale de Paris (BNP) 84 Battambang 139 benchmark bonds 240 benchmark securities 233 benchmark yield curves 240 BKD (Village Credit Body) 120 BKKs, Indonesia 124 Bond and Information and Dissemination System (BIDS) 238, 243 bond markets 35, 43, 57, 58, 61, 89 bonds 11, 61, 89 Boom.com 264 boutique investors 258 BPR (People’s Credit Bank) 119–22 Brazil 22, 164, 198 Bretton Woods 195, 320 brokerage houses 259 Brunei Darussalam 298, 306 Bulacan Biomass 167 Bumiputra-Commerce Bank Berhad 74 C Cagamas bonds 211 Cambodia 36, 37, 42, 47, 106, 134, 202, 335 capacity building 323, 326 capital account 285 capital account liberalization 2, 22, 23, 26, 28

capital adequacy ratio (CAR) 76 capital controls 15, 21, 28, 302 capital market integration 2 Capital Market Masterplan 265 capital markets 34, 89 capitalization 247, 250 CARD Bank 130 CARE Cambodia 139 Catholic Relief Services 140 central depository system 243 Central Limit Order Book (CLOB) 270, 300 Central Provident Fund (CPF) 231 CEPT (Common Effective Preferential Tariff) 281 Chiang Mai 112, 113 Chiang Mai Initiative (CMI) 306 Chile 15, 22 China 4, 8, 164, 165, 198, 203, 207, 303, 309, 347 Citibank 84 clearing and settlement system 243 closed-end funds 237 co-operative banks 118, 130 Co-operative Development Authority 131 Colombia 15, 22 common currency 306 Community Development Department (CDD) 112 community-based financial institutions (LDKPs) 124 concessional finance 47 Consultative Group to Assist the Poorest (CGAP) 101, 132 contagion 8, 26, 257, 297 contingent credit lines (CCL) 319, 337 corporate bond markets 90, 247 corporate bonds 90, 211, 224, 237 Corporate Debt Restructuring Committee (CDRC), Malaysia 85 Corporate Debt Advisory Committee, Thailand 86 corporate debt restructuring 61, 72, 79, 84 corporate governance 242, 270, 272, 304 corporate restructuring 91 covered interest differential (CID) 294

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Index covered interest parity (CIP) 293 credit co-operatives 106, 112 Credit Committee for Rural Development 136 Credit Guarantee Corporation (CGC) 106 Credit Program for Fishermen (SPIN), Malaysia 110 credit rating agencies 239, 243 Credit Unions (CUs) 102 creditor rights 304 cross-border financial flows 289 cross-listing 256 currency crisis 11 currency depreciation 297 currency speculation 11 currency swap arrangement 305

Enron 167 entrepreneurs 183, 188 equity markets 61, 89, 246 Eurodollar futures 265 Eurodollar market 291 Euronext 265, 271 exchange controls 284 exchange rate regimes 2, 27, 171 exchange rate risks 20 Export Development Corporation (EDC) 174 Export-Import Bank of the United States (U.S. Exim) 174

D Danaharta 78, 85, 211, 217 Danamodal 77, 211, 217 Dao Heng Bank 75 debt burden 33, 34, 36 debt management 34, 46, 58 debt markets 54 debt securities markets 210 debt workouts 27 debt/GDP 33, 57 decentralization 344 Deposit Insurance Agency 148 deposit insurance scheme 89 derivatives 265, 309 Deutsche Bank 307 Deutsche Boerse 265 Development Bank of Singapore (DBS) 75, 307 Development Bank of the Philippines 129 Dow Jones 252, 258 drawing rights 332 dual-pricing 172

F Financial Institutions Development Fund (FIDF) 79, 212 financial liberalization 92, 283 financial linkages 300 financial restructuring 169 Financial Restructuring Authority (FRA) 74 financial safeguards 61, 87 financial service providers 296 fiscal decentralization 38 fiscal deficits 34 fiscal policy 35, 46 Fischer, Stanley 319 fixed exchange rate 17 fixed-income securities 209 flexible exchange rate 17 foreign direct investment (FDI) 4, 8, 196, 203, 206, 263, 266, 272, 283, 289, 297, 318, 336 Foreign ownership limits 83 Foundation for Development Cooperation 113, 153 free float 17, 18, 259 FTSE 252 FTSE Global 100, 271 FTSE International 258

E Electricity Generating Authority of Thailand 168 Electronic Communication Networks (ECN) 304 emerging markets 247, 257, 272 energy sector 331

G General Electric 252 Global Depository Receipts (GDRs) 264 globalization 43, 257, 338, 343 governance 56, 323, 329, 337 government bonds 42 Government Housing Bank 269

© 2003 Institute of Southeast Asian Studies, Singapore

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368

Government of Singapore Investment Corporation (GIC) 291 Government Savings Bank (GSB) 112 government securities 217 Grameen Bank 100, 105, 108, 153 Greater China 201 Greater Mekong Sub-Region 347, 351 greenfield investment 165, 166, 170 Growth Enterprise Market (GEM) 265 Growth Triangles 282 GTZ (German Development Assistance Agency) 101, 123 Guidelines for Sound Practices in Sovereign Debt Management 54 H Habibie, B.J., President 117, 118 Heads of ASEAN Power Utilities (Hapua) 358 Heavily Indebted Poor Country’s (HIPC) Debt Reduction Initiative 51 hedging mechanisms 240 herd behaviour 26 Hermes-Kreditversicherungs-AG 174 HIPC (heavily indebted poor country) 149 Hong Kong 249 Hong Kong and Shanghai Banking Corporation (HSBC) 84 Hong Kong Stock Exchange (HKSE) 308 Hopewell 164, 170 Horst Kohler 319 I income distribution 335 incubator facilities 180 independent power producers (IPPs) 166 index-tracking 258 India 103, 130, 164, 201 Indonesia 20, 34, 36, 37, 38, 39, 42, 43, 46, 49, 52, 57, 63, 65, 66, 69, 74, 76, 78, 80, 84, 103, 105, 117, 164, 165, 169, 173, 211, 284, 335 Indonesian Bank Restructuring Agency (IBRA) 74, 76, 78, 85 Informal Financial Institutions 125 informal venture capital 186

infrastructure projects 162, 163 initial public offerings (IPOs) 178, 187, 249, 263, 268 institutional investors 242, 256, 258, 268, 272, 273 insurance companies 241, 242 interest payments 37 interest rates 43, 147 International Bank for Reconstruction and Development (IBRD) 321, 332 international capital flows 4 International Development Association (IDA) 321 International Finance Corporation (IFC) 135, 139, 174 international financial architecture 26 International Monetary Fund (IMF) 28, 34, 54, 55, 75, 101, 116, 118, 151, 315, 318, 338 international production networks 263 International Water Forum 347 Internet 193 intra-ASEAN direct investment 201, 298 investment portfolios 242 investor appetite 260, 266 Islamic banks 106 Islamic Development Bank 174 J Jakarta Initiative Task Force (JITF) 84 Japan 55, 198, 249 Japan Bank for International Cooperation (JBIC) 174 Japan Export-Import Bank (JEXIM) 70 Jakarta Initiative Task Force (JITF) 84, 85 K k-economy 193 Keppel Capital Holdings (KCH) 76 Keppel TatLee Bank 76 Khazanah bonds 211, 234 knowledge economy (k-economy) 177 Korea 170 Kosipa 125 Krung Thai Bank 269 KSP (Savings and Credit Co-operatives) 125

© 2003 Institute of Southeast Asian Studies, Singapore

369

Index Kuala Lumpur Stock Exchange 185, 237, 246, 247, 265 KUD (Village Co-operative Unit), Indonesia 125 Kupedes loans 119, 121 L Labuan International Financial Exchange (LFX) 265, 266 LandBank 129, 131, 132 Lao Village Credit Associations (LVCAs) 150 Lao Women’s Union (LWU) 150 Laos 36, 37, 42, 47, 105, 149, 335 LDKP (NBFI Savings and Credit Institutions) 120, 124 legal reform 172 lender of last resort 330 lending allocation 334 lending boom 60 listing criteria 270 listing regulations 270 loan conditionalities 337 London Stock Exchange (LSE) 265 M Macapagal-Arroyo, Gloria, President 167 mergers and acquisitions (M&As) 168, 250, 256, 265, 266, 272 Malaysia 22, 36, 39, 42, 46, 49, 61, 63, 65, 66, 69, 70, 74, 80, 84, 85, 106, 176, 208, 284 Malaysian Exchange of Securities Dealing and Automated Quotation (MESDAQ) 185, 266 Malaysian government securities (MGS) 211 Malaysian Rating Corporation Berhad 237 Malaysian savings bonds 211 Malaysian Technology Development Corporation (MTDC) 180, 185, 179 Malaysian Ventures Berhad 179 Market for Alternative Investments (MAI) 265, 268 Mass Poverty Alleviation Programmes 127 mass rapid transit (MRT) 162

Maybank 84 Mayniland 171 MBf Finance 74, 75 Megawati Soekarnoputri, President 118 Mekong River 348, 353 Mercosur 201 MESDAQ 185, 266 Mexico 11, 198, 207 MGS 235 micro-insurance 98 microcredit 99, 147 Microcredit Summit 100 Microfinance Council129 microfinance institutions (MFIs) 99, 101 mini-exchanges 304 minority shareholders 242, 268 Monetary Authority of Singapore (MAS) 70, 235, 238, 287 moral hazard 8, 87 MSCI 258, 259, 271 multilateral development banks (MDB) 320 Multilateral Investment Guarantee Agency (MIGA) 174 multilateral lending 317, 335 multinational corporations 196, 201, 203, 262, 267, 282, 304 mutual funds 242 Myanmar 33, 246 N Nakornthorn Bank 83 NASDAQ 178, 186, 250, 252, 264 National Bank of Cambodia (NBC) 136 National Credit Council (NCC) 133 National Economic Action Council (NEAC) 303 National Livelihood Support Fund 132 National Power Corporation 167 National Savings Banks 230 National University of Singapore 189 Netherlands Development Finance Company (FMO) 174 Netpreneurs 181 New Economic Policy (NEP) 107 New Growth Theory 177 Nippon Export and Investment Insurance (NEXI) 174

© 2003 Institute of Southeast Asian Studies, Singapore

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370

non-bank financial institutions 123 non-performing loans (NPLs) 65, 79 North Luzon Expressway 171 NYSE 249, 264, 304 O open-ended funds 267 Opportunity Microfinance Bank 130 Organization for Economic Cooperation and Development (OECD) 47 over-the-counter (OTC) markets 208, 231, 238, 243, 285 Over-the-Counter Fixed Income Service (OTC-FIS) 239 Overseas Private Investment Corporation (OPIC) 173, 174 Overseas Union Bank (OUB) 76 Oversea-Chinese Banking Corporation (OCBC) 75, 76 P Pakistan 164, 165 Paris Club 42, 51 pawnshops 112, 118 pegging 19 pension funds 242 People’s Credit and Finance Corporation (PCFC) 129 People’s Credit Funds (PCFs) 142, 144, 147 People’s Development and Trust Fund 132 People’s Finance and Credit Corporation (PCFC) 132 Perusahaan Gas Negara 358 Perusahaan Listrik Negara (PLN) 169 Petroleum Authority of Thailand 269 Petronas 358, 360 PHBK (Programme Linking Banks with Self-Help Groups) 119 Phibor 240 Philippine Deposit Insurance Corporation (PDIC) 78 Philippine Electric Power Industry Reform Act 166 Philippine National Bank (PNB) 75, 77, 78

Philippines 34, 42, 43, 46, 49, 52, 61, 63, 65, 66, 69, 75, 77, 80, 84, 105, 128, 166, 208, 211, 284 policy-based lending 331 political risk insurance 173 portfolio capital 247, 269 portfolio investment 4, 202, 247, 262, 266, 302 poverty 339, 343 poverty alleviation 98, 127, 336 primary dealer system 241 Principal Dealer System 238 private capital flows 247, 319, 336, 339, 344 private debt securities (PDS) 211, 217 private sector 339 privatization 166, 167, 171, 175, 247 project financing 166, 246, 337, 344 Property Loan Management Organization (PLMO) 212 Prosperous Family Programme 127 provident and pension funds 241 prudential regulations 19 public debt 35, 36, 42, 49, 51, 55 Public Private Partnership (PPP) 344 public spending 35, 36, 46 public works 343 R R&D venture incubators 190 Radanasin Bank 84 Ratchaburi 168 Rating Agency Malaysia Berhad 237 recapitalize banks 34, 57 regional bond market 209 Regional Development Banks (BPDs) 119, 121 regulatory liberalization 257 RENTAS 238 repurchase market 241 reserve requirements 294 RHB Bank 75 ringgit 49, 285, 300 risk allocation 346 risk management 19 risk-adjusted rates of return 258, 296 risk-bearing capital 178

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371

Index Rodolfo Severino 274 Rotating Savings and Credit Association (ROSCAs) 113, 118, 146 RTGS system 243 rupiah 284, 288 rural banks 130, 131 rural credit markets 142 Rural Development Bank (RDB), Cambodia 136–39 Rural Shareholders Banks 145 Russia 164 S S&P 500 252 San Roque 173 savings and credit co-operatives 124 Savings Bank 139 Securities Commission 235 securities lending 241 self-help groups (SHGs) 103, 125, 126 SGS 233, 235, 237, 238 short-selling 243 Silicon Valley 178 Sime Bank 75 Simpedes savings accounts 119, 121 Singapore 61, 63, 65, 70, 75, 84, 162, 166, 167, 175, 214, 233, 267, 284, 306 Singapore dollar 285, 300 Singapore Electricity Pool 167 Singapore Exchange (SGX) 246, 255, 264, 308 Singapore International Monetary Exchange Limited (SIMEX) 265 Singapore Power 168 small and medium enterprise (SME) 63, 69, 99, 106, 153, 154 Soeharto, President 124, 125, 127 South East Asia Ventures of Singapore (SEAVI) 179 sovereign risk 49 sovereign bonds 76 special structural adjustment loan (SSAL) 332, 337 Sri Lanka 103, 130 Standard & Poor’s 258 Standard Chartered Bank 83, 307

start-ups 186 State Bank of Vietnam (SBV) 141, 144 Stern, Nicholas 328 Stock Exchange of Thailand (SET) 246, 248, 265, 268, 273, 308 stockbroking 191 strategic alliances 265 structured financing 163 subsidized credit 143 Summers, Lawrence 319 Supercomal Berhad 185 supplemental research facility (SRF) 319 Surabaya Stock Exchange 239 Swap market 240 systemic crisis 26 T TAMC 86 tax incentives 237, 241 technical assistance 323, 337 Technology Acquisition Fund 180 technology transfer 202, 203 Texaco 168 Thai Asset Management Corporation (TAMC) 79 Thai Bond Dealing Centre (TBDC) 233, 234, 239, 243 Thai Danu Bank 83, 307 Thai International 269 Thailand 22, 34, 36, 37, 42, 43, 46, 49, 52, 61, 63, 65, 66, 68, 69, 70, 74, 77, 80, 86, 104, 111, 168, 208, 234, 284, 318 Thailand Securities Depository Co 239 Thaksin Shinawatra, Prime Minister 116 thrift banks 130 transnational production networks (TPNs) 266 Tracktebel 168 Treasury Bills (T-bills) 211, 236 Tri Energy 172 TSPI Development Corporation 130 U UEDSP (Village Economic Activities and Finance Project), Indonesia 128 uncovered interest parity (UIP) 293

© 2003 Institute of Southeast Asian Studies, Singapore

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372

United Nations Development Program (UNDP) 135, 136 United Nations Children’s Fund (UNICEF) 135 unit trusts 237 United Overseas Bank (UOB) 76 Universiti Teknologi Malaysia 189 Urban Community Development Office (UCDO) 112 U.S. Agency for International Development (USAID) 101, 129 U.S. Treasury 55 V venture capital companies (VCCs) 179 Venture Economics 186 Vietnam 37, 42, 47, 106, 141, 164, 172, 202, 246, 268 Vietnam Bank for Agriculture and Rural Development (VBARD) 141–46, 148

Vietnam Bank for the Poor (VBP) 141, 144 Vietnam Women’s Union (VWU) 145 Village Bank 102 Village Co-operative Unit 124 Village Credit Body 122 Virt-x 271 virtual exchanges 255 volatility 19, 297, 332 W women entrepreneurs 180 World Bank 54, 55, 75, 85, 101, 131, 315, 320 Y yield curve 240 YPEIM (Foundation for the Development of the Malaysian Islamic Economy) 109

© 2003 Institute of Southeast Asian Studies, Singapore