Restoring East Asia's Dynamism 9789812305800

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Restoring

East Asia's Dynam1sm

Nomura Research Institute, Ltd. (NRI), established in 1966, is Japan’s largest and most comprehensive private-sector research organization. It offers a wide range of services, including public policy research, investment and financial research, management consulting, contract research and regional planning. The company is also Japan’s leading supplier of systems consulting, integration and operating services. NRI has a staff of 2,700 and operates globally through offices in Tokyo, Yokohama, Osaka, New York, Washington, D.C., San Francisco, London, Frankfurt, Paris, Zurich, Sydney, Hong Kong, Singapore, Taipei and Seoul. NRI also manages the Nomura School of Advanced Management, one of Japan’s foremost centres for management training, and is affiliated with the Tokyo Club Foundation for Global Studies, a non-partisan foundation supported by Japanese industry to promote better understanding in Japan of world issues. 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 multifaceted problems of stability and security, economic development, and political and social change. 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. A ten-man Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute’s chief academic and administrative officer.

© 2000 Institute of Southeast Asian Studies, Singapore

Restorin~

ynam1sm

[dlted by

Seiichi Masuyama Donna Vandenbrink Chi a Siow Yue

NRI

Nomura Research Institute Tokyo

I5EA5

Institute of Southeast Asian Studies Sln'lapore

Published jointly by Institute of Southeast Asian Studies 30 Heng Mui Keng Terrace Pasir Panjang Singapore 119614

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Nomura Research Institute New Otemachi Building 2-2-1 Otemachi Chiyoda-ku, Tokyo 100-0004, Japan

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the Institute of Southeast Asian Studies. © 2000 Tokyo Club Foundation for Global Studies ISEAS Library Cataloguing-in-Publication Data Restoring East Asia’s dynamism / edited by Seiichi Masuyama, Donna Vandenbrink, Chia Siow Yue. Papers originally presented at an AT10 Researchers’ Meeting on Restoring East Asia’s Dynamism, Tokyo, 28–29 January 1999, organized by the Nomura Research Institute. 1. Financial crises—East Asia—Congresses. 2. Finance—East Asia—Congresses. 3. Business cycles—East Asia—Congresses. 4. Business enterprises—East Asia—Congresses. 5. East Asia—Economic conditions—Congresses I. Masuyama, Seiichi. II. Vandenbrink, Donna. III. Chia, Siow Yue. IV. AT10 Researchers’ Meeting (1999 : Tokyo, Japan) V. Nomura Research Institute. HC412 R43 2000 sls2000037172 ISBN 981-230-105-4 (soft cover) ISBN 981-230-106-2 (hard cover) ISEAS on the Internet: http://www.iseas.edu.sg/pub.html The responsibility for facts and opinions in this publication rests exclusively with the authors and their interpretations do not necessarily reflect the views or the policy of the Institutes or their supporters. Typeset by Superskill Graphics Pte Ltd Printed in Singapore by Seng Lee Press Pte Ltd

© 2000 Institute of Southeast Asian Studies, Singapore

Contents List of Tables List of Figures Acknowledgements List of Contributors Foreword Seiichi Masuyama Introduction 1 From Currency to Economic Crisis Yoopi Abimanyu 2 The Banking System and the Savings Rate in the Philippines Victor A. Abola, Emilio Neri, Jr., and Richard Supangan 3 Corporate Governance in Thailand: From Crisis to Recovery Deunden Nikomborirak and Somkiat Tangkitvanich 4 Exports and Economic Recovery: A Malaysian Perspective Ong Hong Cheong 5 Reform of China’s State-owned Enterprises in Face of the Asian Financial Crisis Hu Jiangyun 6 Regaining International Competitiveness: Hong Kong after the Asian Financial Crisis Edward K.Y. Chen and Raymond Ng 7 Singapore’s Response to the Challenge of the Asian Crisis and Globalisation Chia Siow Yue 8 The Past and Future Role of Small and Medium-sized Enterprises in Taiwan’s Economic Development Jiann-Chyuan Wang 9 The Role of Japan’s Direct Investment in Restoring East Asia’s Dynamism: Focus on ASEAN Seiichi Masuyama

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Case Study: Japan’s Direct Investment and the Electronics Industry in ASEAN Hisami Mitarai Case Study: Impact of the Crisis on the Automobile Industry in ASEAN and Outlook for the Future Y. Iwasa 10 A Re-Evaluation of Asian Values Phillip Wonhyuk Lim The Editors

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284 297 320

List of Tables 1.1 1.2 1.3 1.4 1.5 2.1 2.2 2.3 2.4 2.5 2.6 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8

Phillips-Perron Unit Root Test OLS Regression Estimates of Equation 2 Percentage Change in the Consumer Price Index and its Components Balance of Payments, FY 1996/97–1997/98 Selected Interest Rates, January 1997–September 1998 Ratio of NPLs to Total Assets and Total Loans Total Assets of the Financial System by Type of Institution, 1980–97 Currency in Circulation (CC) as a Percent of M1, M2, and M4 Money Supply 500 Largest Banks in East Asia, by Country Minimum Capital Requirements by Type of Bank Loan-Loss Provisioning Requirements of the BSP and the World Bank Ranking of Selected Countries on Corporate Governance Factors Corporate Ownership Concentration in East Asia, 1991–97 Average Foreign Acquisition of Listed Domestic Corporations Composition of Top Five Shareholders of the 150 Largest Listed Companies, by Type of Investor, 1997 Characteristics of Top Five Shareholders of the 150 Largest Listed Companies, by Industry Protection of Minority Shareholders’ Rights Direction and Composition of Malaysia’s Exports, 1997 Comparative Advantage of Malaysia’s Major Export Categories, 1993–94 Productivity Indicators by Sub-sector, 1996 Growth Rates of Selected Major Export-oriented Industries Comparative Depreciation of East Asian Currencies Real Effective Exchange Rates for Selected Currencies, 1997–June 1998 Contribution to GDP Growth Rate, 1991–98 Financial Indicators of Economic Recovery, Q1 1997–Q2 1999

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13 13 15 18 22 33 39 40 49 50 56 72 75 76 78 80 82 95 97 99 100 100 101 103 108

4.9 5.1 5.2 5.3 5.4 5.5 6.1 6.2 6.3 6.4 6.5 6.6 6.7

7.1 7.2 7.3 8.1 8.2 8.3 8.4 8.5 9.1 9.2

Major Real Indicators of Economic Recovery, Q1 1997–Q2 1999 Fixed-asset Investment by SOEs, 1992–97 Value of Industrial Output, Total and SOE Contribution, 1978–97 Workers in Cities and Towns, Total and at SOEs Combined Profits and Losses of SOEs under the Independent Accounting System, 1992–97 Small and Medium-sized Enterprises’ Share of the SOE Sector, 1997 Growth in Real GDP and its Components, 1991–98 Growth in Domestic Exports by Destination, 1995–98 Growth in Re-exports by Main Destinations, 1995–98 Growth in Visitor Arrivals by Origin, 1995–98 Growth in Receipts from Visitors by Origin, 1995–98 Ratio of R&D Expenditures to GNP in Selected Economies, 1990–96 Ratio of Education Expenditure to Total Government Expenditures and GDP in East Asian Emerging Economies, 1990–96 Macroeconomic and Financial Indicators for Singapore, 1970–98 Imports and Exports by Direction, 1997 Inward and Outward Foreign Investment, 1990 and 1995 SMEs’ Share of the Manufacturing Sector by Number of Firms, Employees, Sales, and Exports, 1982–97 Comparison of SMEs’ Position in Selected Economies Distribution of SME Firms and Sales in the Manufacturing Sector by Industry, 1997 Comparison of Manufacturing Firms with 5–99 Employees in Selected Economies Production, Growth Rate, and Market Share of Taiwan’s Seven Top Suppliers of Notebook-PCs Amount and Composition of Japan’s FDI Outflows by Region Amount and Share of Japan’s Direct Investment in Asian Economies and Selected Regions

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109 121 121 122 123 130 136 137 138 139 140 147 152 165 167 169 195 196 198 199 207 217 219

9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14 9.15 9.16 9.17 9.18 9.A1 9.A2 9.A3 9.A4 9.A5

Amount and Composition of Inward FDI in East Asia and Selected Regions Japan’s FDI in the ASEAN-4 Countries, Balance of Payment Basis Factors Inducing and Restraining Japan’s FDI in ASEAN Economies Amount and Distribution of Japan’s FDI in the Manufacturing Sector by Industry Impact of Currency Movements on Profitability of Export- and Domestic Market-oriented Firms Impact of Currency Movements on Balance Sheets of Export- and Domestic Market-oriented Firms Performance of ASEAN-4 Subsidiaries of Japanese Manufacturers, FY 1998 Local Sales of ASEAN-4 Subsidiaries of Japanese Manufacturers, by Industry Comparison of Investment-related Costs in Major East Asian Cities Survey Responses on the Impact of Currency Depreciation on Price Competitiveness, by Industry FDI Measures Adopted since mid-1997 in the Five Countries Most Affected by the Asian Financial Crisis Areas of Increasing Investment by Japanese Firms in the Medium Term Reasons for Expected Decrease in Investment by Japanese Companies, by Area Japanese Companies’ Average Evaluation of Investment Results, by Area Most Frequently Cited Deterrents to Medium-term Investment in Selected Asian Economies Future Agenda for Promoting Japan’s FDI in East Asia Electronics Industry Production in ASEAN, 1994–98 Output of Electronic Equipment in ASEAN by Product, 1993–99 Output of Electronic Components in ASEAN by Product, 1993–99 Development of Electrical and Electronics Industry Functions in ASEAN Economies ASEAN Electrical and Electronics Industry Development over the Next Decade, by Country

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220 221 222 229 234 235 237 238 240 241 244 250 251 252 254 255 260 262 263 265 266

9.A6 9.A7 9.A8 9.B1 9.B2 9.B3 9.B4

Overseas Operations of Japanese Companies in the Electronics Industry, by Product and Region Investment Conditions in ASEAN Now and in Ten Years, by Factor Response of Japanese Companies to the Changed Business Conditions from the Asian Currency Crisis Sales of Passenger Cars and Commercial Vehicles in the ASEAN-4 Countries, 1993–98 Planned Investment in the ASEAN-4 by Japanese Automobile Companies Relative to 1997 Level Incentives and Conditions of AICO and CEPT Schemes Comparison of Automobile Markets in the ASEAN-4 and Five Major Asian Countries, 1996

267 278 282 285 289 293 295

List of Figures 1.1 1.2 1.3 1.4 1.5 2.1 2.2 2.3 3.1 5.1 5.2

Exchange Rate of the Rupiah against the U.S. Dollar, 9/96–12/97 Indonesian, Korean, and Thai Daily Stock Market Indices, 7/1/97–3/10/98 Daily Exchange Rates of Baht, Won, and Rupiah versus U.S. Dollar Timing of Political Announcements and Movements in the Rupiah Exchange Rate Monthly Rate of CPI Inflation, 1/97–1/98 Year-on-Year Growth in Savings plus Time Deposits, 1993–98 Summary of Banking System Reforms Highlights of the (Proposed) Revised General Banking Act Real Estate Sector Exposure of Commercial Banks and Finance Companies 1990–96 Growth Rate of Total Exports and Exports to East Asia, July 1997–December 1998 Composition of Fiscal Revenues by Category of Enterprise, 1978–95

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3 7 8 10 16 41 42 52 81 116 120

7.1 7.2 7.3 7.4 9.1 9.2 9.3 9.4 9.A1 9.A2 9.A3 9.A4 9.A5 9.A6 9.B1 9.B2 9.B3 9.B4

Index of Singapore Dollar Exchange Rate versus Selected Currencies Singapore Stock Market Index, 1995–99 Singapore Property Price Index, December 1988– December 1998 Summary of Singapore’s Responses to the Regional Financial Crisis Japan’s FDI Outflows, 1982–98 Profitability of Japan’s FDI in the Manufacturing Sector by Receiving Region Yen Exchange Rate, Japan’s FDI, and Asian Economic Growth Corporate Profitability in Japan, Germany, and the United States ASEAN Share of the World Market for Electronic Equipment and Components Yen Exchange Rate and Japan’s FDI by Sector, 1987–98 Regional Distribution of Japan’s FDI in the Electronic and Electrical Equipment Sectors, 1987–98 Yen Exchange Rate and Japan’s Direct Investment in the Electronic and Electrical Equipment Sectors in Asia Japan’s Direct Investment in ASEAN Cumulative to 1997 Japan’s Direct Investment in ASEAN by Country, 1989–98 Monthly Automobile Sales in ASEAN-4 Countries, 1997 Japan’s Direct Investment in the ASEAN-4 Automobile Industry Structural Problems of the ASEAN Automobile Industry Measures to Improve the Structure of the Automobile Industry in ASEAN and Revitalise the Economies

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173 174 175 180 216 223 231 232 261 268 269 270 271 272 286 288 291 292

Acknowledgements The publication of this book was made possible through the generous funding of the Tokyo Club Foundation for Global Studies. The editors would like to thank Mr. Shozo Hashimoto, President of the Tokyo Club, for writing the foreword. Many people associated with Nomura Research Institute (NRI) and the Institute of Southeast Asian Studies contributed in different ways to this publication. The editors express appreciation for their input and support.

© 2000 Institute of Southeast Asian Studies, Singapore

List of Contributors Yoopi Abimanyu Victor A. Abola Edward K.Y. Chen Chia Siow Yue Deunden Nikomborirak Hu Jiangyun Y. Iwasa Phillip Wonhyuk Lim Seiichi Masuyama Hisami Mitarai Emilio S. Neri, Jr. Raymond Ng Ong Hong Cheong Somkiat Tangkitvanich Richard Supangan Jiann-Chyuan Wang

Center for Policy and Implementation Studies, Jakarta University of Asia and the Pacific, Manila Centre for Asian Pacific Studies, Lingnan University, Hong Kong Institute of Southeast Asian Studies, Singapore Thailand Development Research Institute, Bangkok Development Research Center of the State Council, Beijing Nomura Research Institute, Tokyo Korea Development Institute, Seoul Nomura Research Institute, Tokyo Nomura Research Institute, Tokyo University of Asia and the Pacific, Manila Centre for Asian Pacific Studies, Lingnan University, Hong Kong Institute of Strategic and International Studies (ISIS) Malaysia, Kuala Lumpur Thailand Development Research Institute, Bangkok University of Asia and the Pacific, Manila Chung-Hua Institution for Economic Research, Taipei

© 2000 Institute of Southeast Asian Studies, Singapore

Foreword In the wake of the Asian financial and economic crisis of 1997–98 an enormous amount of energy has been expended to stabilise and restart the East Asian economies. Moreover, the post-crisis environment for longterm economic growth in East Asia looks to be significantly different from and far more complex than before the crisis. The profound transformation in financial systems that occurred in the process of solving the crisis, for example, will have a far-reaching impact on corporate governance. At the same time, the paradigm shift from manufacturing technology to information technology that is spreading around the world along with increasing economic globalisation appears poised to take effect in East Asia. These environmental changes will require East Asian economies to make significant structural adjustments. With these issues in mind, in the spring of 1998, the Tokyo Club Foundation for Global Studies asked the ten leading think tanks in East Asia (the AT10) to research the problem of re-establishing the dynamism of the region’s economies. The AT10 researchers grappled with a variety of issues pertinent to their respective economies. They came together in late January 1999 to present their papers and exchange ideas. The papers collected here are the revised versions of those efforts. I am delighted that the Tokyo Club, with the co-operation of ISEAS and NRI, can make them available. In the past year, the East Asian economies as a whole have rebounded from the crisis almost beyond expectations, showing remarkable resiliency. Some economies, however, are still plagued with the after-effects, and even those that have done relatively well have found their future growth path less certain because of the newly evolving environment. Looking forward East Asian economies need both to tackle their immediate problems and to undertake the structural changes necessary to put them on a desirable path for long-term development. The papers in this volume address issues that are critical to defining a new paradigm for East Asian economic growth. I hope that they will contribute to the emerging debate. Shozo Hashimoto President Tokyo Club Foundation for Global Studies

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INTRODUCTION Seiichi Masuyama In spring 1998 in the midst of the Asian crisis, the Tokyo Club Foundation for Global Studies asked ten East Asian think tanks (AT10) to study the problem of restoring the region’s economic dynamism. The papers in this volume are the result of those studies. They were presented for discussion at a conference in Tokyo on 28 and 29 January 1999 and modified thereafter. Although the papers cover a wide range of subjects, they are by no means comprehensive. The issues they do consider may be divided into three categories: strategies to cope with the crisis; policy responses to rectify weaknesses that might have induced or aggravated the crisis; and structural problems to be resolved in order to bring East Asian economies back firmly to a path of long-term growth. Before specifically taking up these issues, most authors assessed, if only briefly, the causes and magnifiers of the East Asian economic crisis. CAUSES AND MAGNIFIERS OF THE ASIAN FINANCIAL CRISIS

Although the primary cause of the financial crisis is generally thought to be the failures of global capital markets rather than the defects of East Asian socio-economic systems, there is a general recognition that too hasty financial liberalisation made the region’s financial systems vulnerable to sudden reversals in international capital flows. Since the outbreak of the crisis the Asian value system has been deluged with allegations that it is prone to corruption and cronyism, but these criticisms are over-exaggerated and lack historic perspective (Chapter 10). Nevertheless it is true that the structural problems of East Asian economies increased their vulnerability to the financial crisis and magnified its scale and reach. Rigidity in many East Asian economic systems had made these economies vulnerable to the external shocks. The rigid exchange rate regime under a dollar-peg system adopted by many East Asian economies is generally blamed for the accumulation of unsustainable imbalances. Hong Kong’s currency board arrangement and linked exchange rate regime limited the ability of monetary policy to cushion the economy from major

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external shocks (Chapter 6). Inflexible factor markets also increased the vulnerability of the region’s economies to external shocks. In Hong Kong the limited supply of public land and the government’s tolerance of oligopoly in the property sector restricted the economy’s ability to adjust to changed circumstances and reduced its international competitiveness by raising business costs (Chapter 6). The weak crisis management capability of some East Asian governments aggravated the crisis. Inconsistent government policy announcements in Indonesia contributed to the spread of the crisis by undermining investor confidence. Empirical analysis of the contagion emanating from initial financial crisis in Thailand found that announcements by the Indonesian government, rather than movements of the baht exchange rate, led to the instability and depreciation of the rupiah exchange rate in late 1997 and early 1998 (Chapter 1). Inefficient financial systems in East Asia misallocated the inflow of foreign capital and these systems either became extremely unstable or totally collapsed when international capital suddenly flowed out. Insider transactions and a lack of transparency plague banking systems, the mainstay of the financial systems in the region. Implicit government loan guarantees have created moral hazard (Chapters 2 and 10). Owing to its transitional economy, the banking system in China has accumulated a dangerous amount of non-performing loans even without liberalisation of capital flows, by lending to inefficient state-owned enterprises (SOEs, Chapter 5) The inefficiency of financial systems is closely intertwined with the slow development of modern corporate governance in East Asia. A lack of transparency is thought to have weakened the confidence of international as well as domestic investors in the region’ s financial systems, thus aggravating the scale of the crisis. As the contributors from Thailand observed: “Although it is far-fetched to attribute this crisis to bad corporate governance per se, weaknesses in governance certainly rendered the Thai economy more vulnerable to imbalances ” (Chapter 3). Concentration of corporate ownership among a few families resulted in the prevalence of connected-lending in countries such as Thailand and the Philippines (Chapters 2 and 3). The state-owned enterprise system in China has a three-faceted corporate governance problem: inadequate incentives for management, an inadequate mechanism of external discipline, and inadequate control over enterprise managers by boards of directors. This has resulted in rampant administrative interference in enterprise affairs and insider control (Chapter 5).

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The heavy dependence of many East Asian economies on foreign direct investment (FDI) was both positive and negative. FDI proved to be the most stable form of international capital flow. Most export-oriented investments were resilient to the shock of the crisis, as they are efficient and benefited from the devaluation of local currencies (Chapter 9). On the other hand, the crisis has slowed down inflows of green-field investments, although this has been offset to a large extent in Korea and Thailand by a sharp increase in M&As. As the net inflow of M&A capital is probably more cyclical than green-field investments, East Asian economies are likely to be forced to draft a new growth strategy that depends less on FDI. STRATEGIES TO COPE WITH THE IMPACT OF THE CRISIS

East Asian governments have responded to the negative impacts of the crisis with a variety of polices. The main responses are first, adopting macro-economic stabilisation policies and, in the exceptional case of Malaysia, re-instituting capital control; second, restructuring the financial sector with improved transparency; third, reducing operating costs for businesses; and fourth, strengthening social safety nets. Macroeconomic Stabilisation Policy and Exceptional Capital Control

The initial IMF prescription for a tight fiscal and monetary policy mix has been widely recognised as counter-productive in the strong deflationary environment at the height of the Asian financial crisis. As a result, many East Asian governments have modified their macroeconomic policy mix to adopt a more stimulative stance. China, which has maintained capital control, pursued stimulative fiscal and monetary policies to alleviate the deflationary impact (Chapter 5). Malaysia had a reasonable degree of success introducing capital controls as an emergency measure in conjunction with relaxing fiscal and monetary policy (Chapter 4). Indeed, capital control is becoming recognised as an acceptable means for less developed economies to avoid the destabilising impact of oscillating flows of short-term capital. Indonesia, on the other hand, was forced to tighten monetary policy to compensate for its deteriorating fiscal balance due to the additional expenditures needed to address the grave social consequences of the crisis. The policy that Indonesia formulated with the help of international organisations also seems to have stabilised the exchange rate (Chapter 1).

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Restructuring Financial Institutions and Improving Financial System Transparency

Since the deteriorating quality of financial systems in the crisis-affected economies has had severe negative consequences on the real economy, the restructuring of financial institutions has become the top priority. Chapter 1 explains the efforts of the Indonesian government to restructure insolvent Indonesian banks and Chapter 2 describes the reform agenda for the Philippine banking system. The Philippine paper suggests that requiring a higher equity ratio for financial institutions may restrain excessive risktaking. It may even be reasonable to require higher equity ratios for financial institutions in developing economies than in developed economies because of the riskier environment. The author also argues for maintaining a relatively low limit on deposits covered by insurance to prevent moral hazard problems on the side of depositors and stricter central bank policies toward bank failures to prevent moral hazard problems on the lender side. Such restructuring of the financial system will have a significant longterm impact on economic performance through better allocation of resources and improved corporate governance. Reducing Business Operating Costs

Singapore and Hong Kong, which were not forced to make large currency devaluation, had to cope with the weakened cost competitiveness of locally based businesses. To improve its competitiveness against countries that experienced major devaluation, Singapore instituted cost-cutting measures including an income policy that reduced government wages by 5 to 8 percent (Chapter 7). Strengthening Social Safety Nets

The traditional social safety net systems of East Asian economies proved grossly inadequate to cope with the significant economic dislocation that resulted from the Asian financial crisis. For example, Indonesia had to increase its expenditures on social safety net programs to address the scale of problem (Chapter 1). Strengthening social safety nets is not only a short-term measure to cope with crisis. It will be necessary in the long-term as well. Structural reforms to improve efficiency and international competitiveness involve reducing protection of industries, and this means that governments will have to take over some social policy functions, such as maintaining

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employment and providing housing and medical care, that had been imposed on corporations. The task of reform is particularly significant in China’ s transitional economy in which SOEs are a major provider of social welfare functions. China has embarked on such reform (Chapter 5). POLICIES TO REDUCE VULNERABILITY TO EXTERNAL SHOCKS

Apart from direct responses to the negative impacts of the Asian financial crisis, East Asian governments need to improve their economies’ capacity to absorb large-scale external shocks to prevent the repetition of the crisis. The papers in this volume suggest two areas for improvement: first, enhancing the crisis management capability of governments and second, increasing the flexibility of factor markets. Enhancing Government Crisis-management Capability

The experiences of the Asian financial crisis call for the improved ability of East Asian governments in crisis management. There is a need for consistency of government policy announcements and transparency in policy formulation. This is true not only with governments of crisis-hit economies such as Thailand, Indonesia, and Korea but also with some other governments such as Hong Kong. The authors of Chapter 6 think that “the Asian financial crisis highlighted the need for the Hong Kong government to enhance ability to take the initiative capacity of crisis management” in response to a currency attack. They argue that the Hong Kong government should be more transparent about how the pegged exchange rate regime and currency board system work. Increasing the Flexibility of Factor Markets

A lesson from the Asian financial crisis is that East Asian governments need to enhance the flexibility of factor markets in order to strengthen the economies’ adaptive capabilities to large shocks and to increase and maintain international competitiveness. The rigidity in the property market together with a fixed exchange rate system in Hong Kong has resulted in a loss of competitiveness as explained before. The Hong Kong government had announced a long-term strategy to increase the supply of housing just before the crisis, but it reversed the policy and froze the sale of land and scaled back the building of subsidised housing. The authors of Chapter 6 argue that the government instead should have adhered to the policy of

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expanding the supply of land and housing and rectifying the oligopolistic structure of the property industry. Labour markets in East Asia seem to have had a fairly high degree of flexibility, except in economies such as Japan, Korea and China. In China, labour market reform is a necessity to implement SOE reform, and such measures as publicity campaigns, vocational training, and opening of re-employment service centres have been taken (Chapter 5). AGENDA FOR LONG-TERM DEVELOPMENT

As East Asian economies have shown a remarkable ability to rebound from the crisis, of which they were more a victim than perpetrator, it is easy to fall into complacency. Indeed, it is also crucial for the future longterm development of East Asian economies to preserve the factors that aided their past ‘miraculous’ growth. Asia ’s cultural tradition, which places a high value on education and saving, should be preserved with some modification such as more orientation to innovation in education to support the relatively high growth rates targeted by East Asian economies. The outward-looking economic policy needs to be maintained as well with some modification such as pragmatic control of capital flows. Continued attraction of foreign direct investment will be crucial. Government involvement to correct market failures also continues to be necessary, again with some modification such as more indirect intervention than in the past, so as to foster independent entrepreneurship in the private sector. However, even before the crisis, East Asian economies were approaching a crossroads in their development path. Some possible constraints to sustainable economic development had become apparent. The front-running developing economies such as Malaysia and Thailand had begun experiencing a shortage of skilled human resources, which could have constrained their industrial upgrading. Imbalance between the protected and inefficient domestic market sectors such as the financial sector and the more open and competitive export-oriented manufacturing sector had become too large to sustain balanced economic growth in most East Asian economies, with the possible exceptions of Hong Kong and Singapore. Thus, East Asian economies, particularly as they continue on the path of development, need to resolve bottlenecks to sustainable development. They need to maintain outward-looking economic policies and to develop industrial diversity by steadily upgrading toward a knowledge-based industrial structure and developing an efficient and competitive financial sector. Such a broad and upgraded industrial structure depends on skilled

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human resources and efficient corporate organisations. Efficient and competitive financial and corporate sectors are predicated on the establishment of a well-functioning corporate governance system. To maintain a robust and competitive economy in an environment of globalisation, East Asian economies need to enhance regionalisation of the economic and industrial structure. Maintaining Outward-looking Economic Policies

It is crucial that East Asian governments continue their outward-looking economic policies to maintain competition and to enjoy the merits of economic globalisation. East Asian governments have rightly even further liberalised FDI policies in response to deteriorating FDI inflows (Chapter 9). Although the Malaysian government tightened capital control, the selective capital control seems to be justified as a measure to cope with the consequence of the market failures of global capital markets. This should not be seen as the reversal of the outward-looking economic policies in the region. Broadening the Industrial Base

The development of a more broadly based infrastructure to reduce concentration on either the manufacturing sector or the service sector is necessary to increase competitiveness and to diversify risk. An efficient service sector is becoming more and more important for East Asian economies since, aided by the development of information technology, corporations world-wide have pursued total efficiency throughout all stages of the value chain, from research and development to production, logistics, marketing, sales, and finance. Moreover, many East Asian economies need to develop an efficient service sector to avoid concentration on the manufacturing sector. In Hong Kong, on the other hand, there is a recognition that “the economy’s extreme service- and outward-orientation greatly concentrated business risks” (Chapter 6). Moreover, to reduce the over-dependence on foreign firms, the development of domestic firms is increasingly recognised as crucial. Singapore aspires to build world-class companies (Chapter 7). Upgrading to a Knowledge-based Industrial Structure

In order to broaden industrial structure, upgrading to a knowledge-based industrial structure is increasingly necessary as East Asian economies

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climb the development ladder. Singapore acknowledges a need to have “an advanced and globally competitive knowledge economy within the next decade,” which requires “a strong technological capability and a vibrant entrepreneurial culture” (Chapter 7). It is also obvious that Hong Kong needs “to promote high value-added industry, based on knowledge centred on technology” (Chapter 6). For that purpose investment in physical as well as human capital and in knowledge-creating activities is desirable. Moreover, the acute need to expand and upgrade university education and research capability is clearly recognised. Developing a knowledge-based industrial cluster may call for proactive government involvement. The authors of Chapter 6 claim that “fiscal incentives and reduced land costs for targeted industries could be justified by positive externalities emanating from these knowledge-generating industries.” At the same time, government involvement should be indirect so as not to kill entrepreneurship in the private sector. The Hong Kong government established the Commission for Innovation and Technology in 1998 to examine the problems for the creation of knowledge-based industries and to formulate necessary polices, recognising Hong Kong’s lagging behind other NIEs in R&D expenditures relative to the economy’s size (Chapter 6). This is a significant modification of its traditional laissez faire economic policy. The IT industry has been targeted by most East Asian governments to spearhead the transformation to a more knowledge-based industrial structure. The Hong Kong government proposed a HK$13 billion “Cyberport” project, funded mostly by private investment, to develop an infrastructure for information service industries (Chapter 6). Developing an Efficient and Competitive Financial Sector

Upgrading the relatively underdeveloped financial sector is critical for the long-term economic development of East Asian economies as they become more sophisticated. The sector plays a key role in a market-oriented resource-allocation base for modern corporate governance and venture capital finance. Liberalisation is the basic policy direction, but proactive government policy is also required to develop the basic infrastructure. Singapore is liberalising its financial sector to compete with more liberalised Hong Kong. Singapore is de-mutualising and merging the Stock Exchange of Singapore and the Singapore Monetary Exchange. It continues to develop the asset management industry (Chapter 7). The underdeveloped local

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currency bond market is recognised to have led to the increased financial risk as evident in the Asian financial crisis with the heavy dependence on the banking system and concentration of financial risk in the short-term debt markets (Chapter 6). The conservative fiscal policies pursued by East Asian governments until the Asian financial crisis limited the supply of government bonds, which play a catalytic role in the development of bond markets as benchmarks. The Hong Kong Monetary Authority started to issue Exchange Fund Bills and Notes for that purpose (Chapter 6). Venture capital markets are becoming recognised as necessary infrastructure to support the development of local firms, which could help broaden the industrial structure. Developing Human Resources and Networking

Abundant supply of skilled human resources is the key to upgrading to the knowledge-intensive industrial structure that is needed for sustainable economic development. While attracting foreign professionals is a shortterm solution, development of local talent is the long-term objective. East Asian economies must place high priority on investment in education, particularly higher education, and training. Recognising the limited supply of skilled financial personnel as a bottleneck to the development of its financial sector Singapore is accelerating the training of local personnel and attracting more foreign talent (Chapter 7). The Hong Kong government urgently needs to attract overseas professionals and “serious consideration should be given to dealing with related issues such as immigration rules, living environment, and social life” (Chapter 6). An interesting idea to overcome the constraint on innovative human resources in a single economy is to network research activities among the large pool of human resources in the community of Chinese-speaking economies. For example, Hong Kong could specialise in applying and commercialising research results that are generated at institutions in Mainland China (Chapter 6). This implies a need for further regionalisation of economies and industries about which more is said below. Developing Efficient Corporate Organisations

In order to achieve sustainable industrial development, it is essential to develop efficient corporate organisations. After all, applying increasing knowledge to increasing capital and labour creates economic wealth. The way it is applied is crucial for the growth of productivity. The traditional

© 2000 Institute of Southeast Asian Studies, Singapore

xxiv SEIICHI MASUYAMA

heavy dependence of many East Asian economies on FDI is due to the inadequacies of domestic corporate organisations in addition to the lack of technology. While East Asian economies must attract sufficient FDI to maintain industrial strength and spur domestic corporations, they must also generate efficient and competitive domestic corporations in order to develop a broader, more balanced industrial structure. Despite the imperative to develop domestic firms, the papers in this volume have not raised the traditional cry for infant industry protection. I think this is because the detrimental effects of protectionist policies on competition and entrepreneurship have been increasingly accepted. Instead of infant industry protection they make the case for generating a favourable environment for the development of small and medium-sized enterprises and argue for government to take a role as a venture capitalist. For East Asian developing economies encouraging small and mediumsized enterprises (SMEs) seems to be a more natural and viable approach to fostering domestic enterprises than pursuing large national champions. The Korean economy, which was oriented to large conglomerates known as chaebol, proved to be highly vulnerable to the large-scale shock of the Asian crisis, while the Taiwanese economy, which depended to the highest degree on SMEs, was highly resilient. To the extent that development of SMEs in Taiwan owes to its cultural and social background, or “ the closely knit Chinese family and kinship structure” (Chapter 8) its experience is not necessarily directly transferable to other economies. However, to the extent that government’s restraint against direct interference in business affairs contributed to the development of its SMEs (Chapter 8), Taiwan’ s experience challenges other East Asian governments to modify their more interventionist industrial policies. It is noteworthy that industrial development in interventionist Singapore focused largely on multinational corporations and that Singapore’s domestic enterprises are still relatively underdeveloped. Business efficiency often seems to depend on entrepreneurial independence together with networking capability rather than on the economies of scale typically pursued under interventionist industrial policies. Again, Taiwan is a case in point. The strong networking capability of Taiwan’s SMEs seems to compensate to some extent for their lack of economies of scale. Moreover, ease of entry and exit and involvement of most SMEs in highly competitive export markets has preserved a competitive environment. For example, “Taiwan ’s simple bankruptcy procedures facilitated the exit of inefficient firms” (Chapter 8). In industries such as the IT manufacturing sector with vertical production characteristics,

© 2000 Institute of Southeast Asian Studies, Singapore

INTRODUCTION xxv

Taiwan’s SME networks have been reorganised to form centre-satellite contracting relationships, which are often more efficient and flexible than the large firm-oriented systems of Japan and Korea (Chapter 8). Taiwan’s centre-satellite contract networks offer a potential corporate model suitable to the information age. Still, SMEs are often handicapped by a lack of economies of scale in R&D, human resources, and management capability. Corporate efforts and indirect government policy support will be necessary. In this context, East Asian governments are taking on a role as venture capitalists to develop a knowledge-based industrial structure. The Hong Kong government, for instance, set up a HK$5 billion Innovation and Technology Fund to support innovation and the commercial application of technologies (Chapter 6). The development of efficient corporate organisations is a particularly challenging task in China’s transitional economy because of the inefficiency of many SOEs. The priority of the SOE reform program is on reform of large state enterprises. The government has introduced such measures as allowing SOEs to re-capitalise by swapping debt for equity and allowing the healthiest enterprises to raise funds in domestic and international capital markets, encouraging large and medium-sized SOEs to merge unprofitable SOEs, and converting SOEs to shareholding organisations. Moreover, the government is forcing restructuring of the textile industry, which is plagued with oversupply and weak profitability (Chapter 5). It remains to be seen whether such mandatory restructuring operations to rescue inefficient enterprises may not cause adverse selection or undermine the competitive environment necessary for organisational efficiency. The government’s policy of forming SOEs into large enterprise groups in order to increase economies of scale may not pay enough attention to the necessary environment of competition. Establishing Effective Corporate Governance Systems

There is growing recognition that corporate governance systems are in need of comprehensive reform in order to develop a well-functioning financial sector and to develop efficient and competitive corporate organisations. The problem of concentrated corporate ownership among a small number of family empires is now being resolved with the restructuring process in the aftermath of the Asian financial crisis in countries such as Thailand and Korea. The massive sale of subsidiaries to keep parent corporations afloat should dramatically alter the ownership structure of Thai corporations (Chapter 3). Apparently the same applies to Korean

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xxvi SEIICHI MASUYAMA

corporations as well. The Philippines needs to address the problems of interlocking directorates and connected-lending in the private sector. The latter may be helped by improvement of transparency and increased presence of foreign financial institutions (Chapter 2). In China diversifying corporate ownership amounts to the wholesale reform of SOEs. While this reform is ongoing, China has begun to strengthen internal accounting and auditing procedures and implement a special governmental inspection system as steps toward improving enterprise governance (Chapter 5). Enhancing Regionalisation

The regionalisation of East Asian economies will increase their growth opportunities as well as their resiliency. Regionalisation continues to be a pillar of Singapore’s development strategy despite some criticism that the strategy has made the city-state vulnerable to external shocks such as the Asian financial crisis. The Stock Exchange of Hong Kong already lists 41 China incorporated enterprises and the authors of Chapter 6 argue that Hong Kong should continue to develop its fund-raising role for Mainland China. Crucial trends to deepen regional ties in East Asia are for ASEAN to maintain the liberalisation drive exemplified in AFTA and for the integration of Chinese-speaking economies to proceed further. Moreover, recent moves towards formation of free trade areas between Singapore and Japan and between Korea and Japan are steps in this same direction. Redefining the Role of Government

As East Asian economies move from the early stages of development to become more complex, government’ s role also needs to be transformed. East Asian governments have scaled back or ceased their direct intervention in business operations. With economic progress based on innovation, individual initiative becomes more important than co-operation with authoritarian directions. The Asian, or Confucian, value placed on accepting authoritarian rule needs to be modified to accommodate more democratic behaviours. In the words of Korea’s President Kim Dae Jung: “in order for Asian nations to foster innovation and to make a successful transition from input-driven growth to productivity-driven growth, Asia would have no other practical alternative to democracy” (Chapter 10). This does not necessarily mean that East Asian people share the instant democratisation often advocated by the Western people. Chapter 10 considers Asian values in relation to regional economic development, and contemplates the role of government in this context.

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INTRODUCTION xxvii

As it makes the transition to a market economy China needs to lessen the direct intervention of government in economic affairs. In a first step in a program to improve the business environment, China reduced the number of central government departments and commissions from 40 to 29. Most of the reduction came by eliminating industrial departments that interfered in enterprise operations (Chapter 5). While taking a less authoritarian and less interventionist stance toward the economy, governments in East Asia must also work to create an environment that is conducive to industrial upgrading. This is evident in Hong Kong where the laissez-faire policy that contributed so significantly to economic growth in the past is recognised as inadequate for the industrial upgrading that is necessary for future growth. The authors of Chapter 6 argue that “governments should become proactive in projecting future market developments and in shaping industrial policies accordingly in order to shift their competitive advantage.” They say that this can be implemented by “designing a tax regime and allocating public and financial resources to favoured sectors as well as investing in the supply-side economy to promote long run economic growth.” These are the areas through which East Asian governments can support the long-term sustained development of their economies.

© 2000 Institute of Southeast Asian Studies, Singapore

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FROM CURRENCY TO ECONOMIC CRISIS

1

1 From Currency to Economic Crisis1 Yoopi Abimanyu INTRODUCTION

From August 1997 the Indonesian rupiah was profoundly shocked by currency fluctuation. As of the first quarter of 1998, the rupiah had depreciated much further than other currencies in the region. This currency shock was unanticipated (Radelet and Sachs 1998 b). At its onset, the depreciation of the rupiah was widely viewed as contagion from other Asia-Pacific countries, as Indonesia’s macroeconomic fundamentals were considered sound (Chan 1997). According to this view, the behaviour of the rupiah was mostly due to the movement of other Asia-Pacific currencies. Announcements by public officials that added to domestic political uncertainty exacerbated the depreciation of the rupiah. The currency crisis led to economy-wide deterioration. By late 1998 Indonesia ’s economic condition had stabilised somewhat due in part to steps taken in the fiscal, monetary, and banking sectors and to the government’s efforts to maintain a stable exchange rate. This chapter aims to document the currency and economic crises that stand in the way of Indonesia’s return to dynamic economic growth. First, it describes the unfolding of the currency crisis in Indonesia and investigates the empirical connection of contagion and political announcement effects to the drastic fall in the rupiah. Then, it describes Indonesia’ s macroeconomic crisis in terms of negative growth, high inflation, and balance of payments problems, and the economic conditions in the fiscal and monetary sector, the banking sector, and the exchange rate.

© 2000 Institute of Southeast Asian Studies, Singapore

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THE CURRENCY CRISIS The Currency Shock

For the past several decades, prudent macroeconomic policies and continuing deregulation kept Indonesia on a path of rapid economic development. Since the 1970s, economic growth averaged 7 percent per annum, raising Indonesia’s GDP per capita to the level of middle income countries by the mid-1990s. Broad-based, labour-intensive growth, together with sustained improvements in basic education and health services, dramatically lowered the incidence of poverty—from over 60 percent in the late 1960s to 11 percent by the mid-1990s. 2 Indonesia’s economic structure diversified. Dependence on the oil sector declined as an exportoriented manufacturing base emerged, led by a dynamic private sector and fuelled by high domestic savings and large inflows of foreign direct investment. Indonesia maintained macroeconomic balance: the budget was balanced; inflation was contained; current account deficits were relatively low; and international reserves were built up to a comfortable level, pushed by 10.4 percent export growth in 1996. Despite these sound macroeconomic conditions, the rupiah was profoundly shocked by currency fluctuation from August 1997. Until July 1997, the rupiah had been considered one of the stable currencies in the Asia-Pacific region. From September 1996 to July 1997 the currency depreciated only 3.83 percent, from 2,342 rupiah per U.S. dollar to 2,432 rupiah per U.S. dollar (Figure 1.1). However, from July to November 1997 it depreciated about 47 percent and it fell another 35 percent in December 1997 alone, for an overall decline of 67.1 percent from July to December 1997.3 The rupiah fell much further in value than did the other currencies in the region. The Indonesian government responded to the initial shock by abandoning the crawling peg exchange rate regime and letting the currency float to seek its market-determined level from 14 August 1997. At the same time, it tightened the money supply, thereby raising domestic interest rates as a means of defending the currency. The aim was to maintain interest parity in order to avoid a massive depreciation of the rupiah.4 In November 1997 the government signed agreements with the International Monetary Fund (IMF) for Stand-by Loan Arrangements in the amount of US$43 billion to strengthen the country’s foreign exchange reserves.

© 2000 Institute of Southeast Asian Studies, Singapore

FROM CURRENCY TO ECONOMIC CRISIS

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FIGURE 1.1 Exchange Rate of the Rupiah against the U.S. Dollar, 9/96–12/97 rupiah/US$

6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500

1996

12/31

12/15

11/27

11/11

10/8

10/24

9/4

9/22

8/1

8/19

7/16

6/30

6/12

5/9

5/27

4/7

4/23

3/4

3/20

2/14

1/29

1/13

12/26

12/10

11/6

11/22

10/3

10/21

9/17

8/30

2,000 1997

Source: Dow Jones. http://djinteractive.com

Unanticipated Shock

Radelet and Sachs (1998b) argue that the currency shock was unanticipated. They found no prior sign of looming crisis among market participants or market analysts. The ongoing assessment of credit risk in the domestic market by rating agencies such as Standard and Poor’s, Moody’s, and other independent agencies was a positive and stable outlook. Even forecasters at the IMF and World Bank gave only a slight indication of macroeconomic risk in the region. The real exchange rate appreciation was thought to be a short-term phenomenon and not a sign of impending crisis. The initial shock to the rupiah was widely viewed as contagion from other Asia-Pacific countries, particularly Thailand, as Indonesia’s macroeconomic fundamentals were considered sound (Chan 1997; Nasution 1997; and Fratzscher 1997). The general view was that the actual behaviour of the rupiah was mostly due to the movement of other currencies in the region. After the initial shock, the Indonesian financial market plummeted

© 2000 Institute of Southeast Asian Studies, Singapore

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YOOPI ABIMANYU

in late 1997, despite the small current account deficit, relatively little bank debt, no significant corporate bankruptcies, and the steady growth of the stock market. One indication of the mounting economic consequences arising from the exchange rate depreciation came from the financial sector. In early November 1997, domestic financial markets suffered a severe liquidity shortage.5 The liquidity shortage was apparently caused by three factors: a run on certain private banks, a disruption of the interbank money market, and government interventions in the foreign exchange market that were not completely sterilised. Currency in circulation stood at roughly 25 trillion rupiah on 31 October 1997 and it had increased by 4.5 trillion rupiah to 29.5 trillion rupiah on 4 November, the second business day after the government announced the closure of sixteen banks. The amount of currency in circulation remained high through 17 November and then declined by around 5 trillion rupiah during the last two weeks of November. The interbank money market was disrupted beginning in November. Banks with excess reserves were hesitant to make loans to banks short of reserves, even overnight interbank loans, because of the possibility that other private banks might be closed. (Lists of additional banks to be shut were circulating.) Some banks were forced to turn to the central bank for 6 support in the face of a severe liquidity crunch. The government’s intervention in the foreign exchange market during early November absorbed a large amount of liquidity. The decline in net foreign assets of the banking system was partly offset by an expansion of other central bank instruments, but this did not fully offset the contraction. Mounting Crisis

The withdrawal of foreign funds created a chain reaction that quickly developed into a financial panic. The depreciation of the rupiah resulting from the flight of foreign capital sparked a renewed withdrawal of foreign exchange, as domestic borrowers with un-hedged currency positions rushed to buy dollars. Only a few Indonesian firms had hedged their foreign exposures, since most believed that the government would maintain the crawling-peg exchange rate regime with predictable, gradual depreciation. As the currency depreciated, foreign lenders became more concerned over the debt levels of their clients. Given Indonesia’s lack of clear bankruptcy laws and workout mechanisms, they started to call in loans, which reinforced the depreciation. The withdrawal of foreign funds also set off a liquidity squeeze and a sharp rise in interest rates that made it difficult for firms to operate and created problems in the business environment.

© 2000 Institute of Southeast Asian Studies, Singapore

FROM CURRENCY TO ECONOMIC CRISIS

5

The banking system started to bend under the intense pressure. Nonperforming loans rose quickly and there were more runs as depositors rushed to make withdrawals either out of concern over the safety of the banking system or in order to meet pressing foreign exchange obligations. The capital base of the banks eroded, adding to the pressure. As anxiety about the financial position of banks mounted, the public began to withdraw deposits at an increasing rate. While the amount of currency in circulation increased hardly at all during the third quarter of 1997, it rose by 17 percent during the fourth quarter. And in the first three weeks of January 1998 alone, it increased an alarming 24 percent. Despite the central bank’s growing provision of funds to enable the system to continue operating, commercial banks were having increasing difficulty performing their usual functions: • With a shrinking deposit base, banks had fewer and fewer funds available to lend to the corporate sector at time when corporations’ need for credit was intensifying. • Foreign banks were no longer accepting letters of credit from Indonesian banks, forcing companies to pay 100-percent of the cost of imports in foreign exchange, even before goods were delivered. • Domestic banks were refusing to lend to each other. Since banks no longer trusted the financial condition of other banks, they would lend only for very short terms at very high interest rates. In order to keep the system afloat, the central bank had stepped in to the interbank market to recycle funds from banks with ample funds to those short of liquidity. It offered swap facilities for exporters to entrust their dollars to commercial banks and schemes to help exporters obtain letters of credit. However, the problems steadily mounted while confidence continued to dissipate. Finally, to solve the underlying problems of the commercial banks and to rescue the banking system, in January 1998 the government introduced a comprehensive guarantee for all depositors and creditors of commercial banks. It also charged a new agency, the Indonesian Banking Restructuring Agency (IBRA), with restoring the banking system to financial health. By putting its full faith and credit behind commercial banks, the government expected that the public’s fear would subside and foreign creditors would be convinced to rollover external loans. Also, the IBRA would insulate the central bank from the political consequences of restructuring and from the difficult decisions about which banks should be taken over, re-capitalised, or merged. To reduce pressure on the foreign exchange market, the government required domestic borrowers to report their loans. Outstanding private

© 2000 Institute of Southeast Asian Studies, Singapore

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YOOPI ABIMANYU

domestic debt was disclosed at US$78.2 billion as of February 1998. The government also set up a small team called the Indonesian Debt Restructuring Agency (INDRA) to consolidate negotiations between domestic borrowers and foreign creditors. On 4 June 1998, this team succeeded in rescheduling a private sector foreign loan in Frankfurt, Germany for eight years with a three-year grace period. Political Uncertainty

As the economic crisis took hold at the end of 1997 its causes became as much political as they were economic. Economic and political issues fed on one another, exacerbating the crisis. There were signs that former President Suharto’s health was weakening and he had no apparent successor. There was growing discomfort with the economic role played by Suharto’s family and its business-as-usual attitude in the midst of the economic crisis gripping the nation. There were riots preceding the campaign for the March 1998 presidential election. All these were indicators of growing domestic political uncertainty (Radelet and Sachs 1998 b). Contagion and Political Effects

Thus, Indonesia’s predicament has been viewed as a case of contagion, augmented by political issues, leading to unnecessary economic contraction. The rupiah’s depreciation immediately after July 1997 has been attributed to uncertainties spilling over from the collapse of other currencies in the region and its continued slide into early 1998 is attributed to uncertainty over the domestic political situation. This interpretation can be tested empirically as a contagion effect and a political announcement effect on the exchange rate. Contagion Effect

According to Fratzscher (1997) contagion occurs because open economies that are connected through trade, geography, common external shocks, or similar economic structures also have integrated financial markets. When one country is hit by a financial crisis, investors may flee the other countries as well, either because they want to adjust their investment holdings and raise cash (‘constitutional’ contagion) or because they fear the spread of the crisis to the connected countries (‘herding’ contagion, p. 13). The more financially integrated one country is with a country

© 2000 Institute of Southeast Asian Studies, Singapore

FROM CURRENCY TO ECONOMIC CRISIS

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where a currency crisis begins, the more likely it is that the crisis will spread and the more severe the crisis will be in the infected country. Most Asian countries, including Indonesia, were financially integrated with Thailand. The weekly returns on their stock markets were closely correlated. Most of these stock markets declined significantly after the crisis struck Thailand in early July 1997 (Fratzscher 1997, pp. 13, 14, 40). The similarity in the movement of stock market indexes and exchange rates in Korea, Thailand, and Indonesia between July 1997 and March 1998 suggests that there was a contagion effect running from Thailand to the others (Figures 1.2 and 1.3). Political Announcement Effect

Weaknesses such as lack of transparency in policy decisions, crony capitalism, corruption, monopoly power, and growing short-term indebtedness existed in Indonesia before the shock, but after the shock the FIGURE 1.2 Indonesian, Korean, and Thai Daily Stock Market Indices, 7/1/97–3/10/1998 Index 850 Jakarta Stock Exchange Composite Index 750

Stock Exchange of Thailand (SET) Index KOSPI Composite

650

550

450

350

250 7/1

8/1

9/1

10/1

11/1

12/1

1997

Source: Dow Jones. http://djinteractive.com.

© 2000 Institute of Southeast Asian Studies, Singapore

1/1

2/1

1998

3/1

8

YOOPI ABIMANYU

FIGURE 1.3 Daily Exchange Rates of Baht, Won, and Rupiah versus U.S. Dollar Baht/$, Won/$ Index 7/1/97 = 100

Rupiah/$ Index 7/1/97 = 100

240

700

220

600

Baht/$ Index Won/$ Index Rupiah/$ Index

200

500 180 400 160 300 140 200

120

100

100 7/1

8/1

9/1

10/1

11/1

12/1

1997

1/1

2/1

3/1

1998

Source: Dow-Jones Interactive, http://djinteractive.com.

sense of political uncertainty was heightened. Inconsistent responses of the Indonesian government to the evolving crisis added to the sense of uncertainty. For example, first the government postponed the large infrastructure investment projects, then it reinstated them, and then it postponed them again. The distrust created by such inconsistency was compounded by the fact that certain banks had close connections with government officials. Two of then-President Suharto’s relatives publicly balked and threatened to sue the government when their banks were ordered closed, even though senior government officials strongly asserted that the decision was final and would go forward. In this climate of uncertainty, the movement in the rupiah exchange rate appears to reflect the market’s evaluation of the government’s efforts with respect to the crisis. For example, the rupiah strengthened immediately when Indonesia signed its first agreement with the IMF on 3 October 1997. It was up 10.65 percent by 3 November after large concerted

© 2000 Institute of Southeast Asian Studies, Singapore

FROM CURRENCY TO ECONOMIC CRISIS

9

interventions by Japan and Singapore. This strength was very short lived, however. Numerous times from December 1997 to January 1998 the currency weakened sharply. Moreover, the drops in the rupiah occurred seemingly in response to particular official statements or actions (Figure 1.4). For example, • the rupiah depreciated 11.94 percent on 10 December 1997 after a statement that then-President Suharto was ill and needed total rest, and it declined 24.02 percent the next day. • the rupiah depreciated by 37.14 percent, 13.75 percent, and 11.36 percent on 2, 3 and 4 January 1998 following the end-December announcement by IndoSuez Carr Securities that Indonesia’s short-term foreign debt (commercial paper, convertible bonds, and promissory notes) reached US$200 billion • the rupiah plummeted by 31.09 percent in the first week of January when Suharto delivered the draft for the government budget speech, • the market registered no reaction on 15 January 1998 when Suharto signed the IMF Letter of Intent, which included a stringent 50-point reform program and established the Financial and Economic Defence Board. • the rupiah depreciated by 7.64 percent and 13.31 percent on the two days after Suharto lifted the credit facility for the national car project (MOBNAS) and the national aerospace industry (IPTN) and announced that these projects would be supported by the people’s fund and foreign investment respectively • the rupiah depreciated 17.95 percent in the third week of January 1998 when the news broke that Suharto agreed to run for re-election and that Habibie would be Vice President. • the rupiah went down by another 26.21 percent two days later on the news that Suharto and Habibie would be elected and the release of the details of the revised government budget, and • the rupiah depreciated by 22.44 percent when it was announced that the IMF and the World Bank, particularly the IBRD, disagreed with the government’s controversial proposal for a currency board system. This string of events suggests that certain movements in the rupiah were tied to specific public announcements—the so-called political announcement effect. With confidence in the government lacking and uncertainty about the political situation mounting such announcements compounded the rupiah depreciation.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

August

1997

September

October

November

16 banks being liquidated Nov. 1

IMF package Oct. 31

December

Rumours around Suharto’s health 2nd week of Dec.

1998

January

February

March

Currency board system agreed by DPR Feb. 11

IMF delayed US$1 bil. loan

IMF opposed the CBS Feb. 16

Suharto signed agreement with IMF Jan. 15

Negative reaction to 1998/99 draft budget Jan. 7-8

Sentiments around private foreign debt Jan 2-4

Suharto and Habibie elected Pres. and V.P. Jan 20

April

Sporadic rioting in Jakarta May 14

May

Harmoko asked Suharto to resign May 19

Suharto resigned May 21

June

6 students killed at Trisakti May 12

BCA under IBRA supervision

Rate peak Rp 16,700 Capital control rumours and private debt maturity June 17

1 9 17 25 4 12 20 28 5 15 23 1 9 17 27 4 12 20 1 9 17 26 6 14 22 2 10 18 26 6 16 24 1 9 20 28 6 14 22 1 9 17 25

July

Projects rescheduled Sept. 16

Source: Asian Wall Street Journal and Reuters.

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

13,000

14,000

15,000

16,000

17,000

18,000

19,000

20,000

Rupiah/U.S. dollar

FIGURE 1.4 Timing of Political Announcements and Movements in the Rupiah Exchange Rate 10 YOOPI ABIMANYU

FROM CURRENCY TO ECONOMIC CRISIS

11

The Model

To evaluate the hypothesis that contagion and a political announcement effect explain the depreciation of the rupiah in 1997 –98 we conducted a regression analysis involving the value of the rupiah, the exchange rates of other regional currencies, and official announcements concerning the Indonesian government. The model is based on Frankel and Wei’s model of the contagion effect (1992, pp. 2–3). In that model, the dependent variable measures changes in the value of a country ’s currency relative to the currency of a control country and the independent variables measure changes in the values of the currencies of countries with which the subject country is financially integrated. We ted this model to test the political announcement effect as well as the contagion effect by including a dummy variable. Thus, our model is: (1)

 Rp  d  t = α +  FC t 

∑ (βi dE it ) i =1

+ γDt + ε t

where: d indicates the first-difference and Rp/FCt = exchange rate of rupiah relative to a control currency, FC α = intercept βi = parameter Eit = nominal exchange rate of country i relative to FC γ = parameter Dt = dummy variable representing certain political announcements εt = error term. The parameter βi indicates the influence of the currency of country i on the currency in question and the parameter γ indicates the impact of the political announcements. We hypothesise that during the latter half of 1997 and early 1998 the movement of the Indonesian rupiah was affected by contagion from the Thai baht and the Korean won as well as by adverse political announcements. Empirical Analysis

We tested the above model on daily data for the period 1 July 1997 to

© 2000 Institute of Southeast Asian Studies, Singapore

12 YOOPI ABIMANYU

11 March 1998, a total of 173 observations. The currency rates came from Reuters. The ordinary least-squares regression estimating equation is: (2)

∆log(Rp/£) = α + ∆1log(baht/£)t + θ2∆log(won/£)t + θ3∆log(HK$/£)t + θ4∆log(US$/£)t + θ5Dt

The dependent variable is the exchange rate of the rupiah against the British pound. The independent variables include the exchange rates of the Thai baht, the Korean won, the Hong Kong dollar, and the U.S. dollar visà-vis the British pound. As discussed earlier, Indonesia appears to be financially integrated with both Thailand and Korea, the countries hardest hit by the crisis (Radelet and Sachs 1998 a). The dummy variable, D, measures the political announcement effect and has the value 1 on days when official announcements were made and a value of 0 otherwise. Empirical Results7

Time-series Properties. Before estimating the regression in Equation 2 we analysed the time-series properties of the exchange rate variables (Table 1.1). The Phillips-Perron test is the appropriate test for stationarity, since Indonesian central bank intervention in the foreign exchange market created a change in the series (Hill 1996).8 According to the test, we reject the null hypothesis that a unit root exists for each variable. Apparently each of the exchange rate series is integrated on order zero; in other words, it is stationary. OLS-Regression Results. The OLS-regression of Equation 2 does not support the hypothesis of a contagion effect on the rupiah during the period of analysis. Estimated coefficients on both the baht variable and the won variable were not statistically different from zero (Table 1.2). Neither did the movements of the U.S. dollar or the Hong Kong dollar significantly affect the movement of the rupiah. To test whether the number of observations was too few for OLS regression to identify a significant relationship between the other crisisaffected Asian currencies and the rupiah, we also estimated an Autoregressive Distributed Lag (ADL) model of the relationship among the exchange rate variables. 9 The ADL model, using several lags and deleting all insignificant independent variables, yielded results for the currency variables similar to those from the OLS regression. Hence,

© 2000 Institute of Southeast Asian Studies, Singapore

FROM CURRENCY TO ECONOMIC CRISIS

13

TABLE 1.1 Phillips-Perron Unit Root Test t-statistic Constant ∆ log ∆ log ∆ log ∆ log ∆ log

(rupiah/pound)t (baht/pound)t (won/pound)t (HK dollar/pound) t (US dollar/pound) t

–12.713*** –14.948*** –9.373*** –11.859*** –11.831***

Constant and No constant or trend trend –12.698*** –15.028*** –9.689*** –11.845*** –11.819***

–12.555*** –14.767*** –9.682*** –11.893*** –11.865***

Notes: Daily data for 1 July 1997 to 11 March 1998, a total of 173 observations. *** denotes rejection of the null hypothesis at the 1% MacKinnon critical value.

TABLE 1.2 OLS Regression Estimates of Equation 2 Dependent variable: log (rupiah/pound) Estimated Coefficient Constant ∆ log (baht/pound)t ∆ log (won/pound)t ∆ log (HK dollar/pound) t ∆ log (US dollar/pound) t Dummy R-squared D-W Statistic Ljung-Box Q-statistic (–9) ARCH (–9) LM (–9) Number of observations

–0.005 (–1.212) 0.0264 (1.800) –0.047 (–0.475) 5.512 (0.672) –4.489 (–0.544) 0.164 (11.478)* 0.489 2.032 18.176 21.882 15.723 173

Notes: Daily data for 1 July 1997 to 11 March 1998. t-statistics are shown in parentheses. * indicates significance at the 97.5% critical level (one-sided test).

© 2000 Institute of Southeast Asian Studies, Singapore

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contagion from the Thai and Korean currencies does not appear to explain the depreciation of the rupiah. On the other hand, the OLS regression did lend some support to the hypothesis of a political announcement effect on the rupiah. The estimated coefficient on the dummy variable is significantly greater than zero on a one-tailed test (Table 1.2). This indicates that the government announcements shown in Figure 1.4 had a positive effect on the rupiah/ pound exchange rate (thereby depreciating the rupiah). Thus, our empirical analysis does not support the claim that the sharp depreciation in the rupiah in the second half of 1997 was due to contagion from the currency crises in Thailand or Korea. On the other hand, it did support the view that certain official announcements contributed to the instability and depreciation of the rupiah exchange rate in late 1997 and early 1998. ECONOMIC CRISIS10

The currency crisis has led to the deterioration of the whole Indonesian economy. This part of the chapter describes the mounting consequences of the currency crisis on Indonesia ’s real economy. Negative Growth

The financial and exchange rate turbulence has negatively influenced economic activity in Indonesia, resulting in the deceleration of GDP growth to 4.7 percent in 1997 from 8.0 percent in 1996. A deeper contraction of real output was anticipated for 1998 due in part to social unrest in mid May 1998 that disrupted production and distribution triggering inflationary pressure in the real sector. By the first half of 1998, economic growth had contracted by 16.5 percent. Almost all sectors, except some agricultural and public utilities sectors, experienced negative growth. The greatest declines in output were in the construction, commerce, financial services, and manufacturing industries. High Inflation

The passthrough effect of the rupiah depreciation, the May 1998 riots that disrupted the distribution system, and the domestic supply shortage led to sharp increases in the prices of food and other essential items which contributed to high inflation in 1998 (Table 1.3 and Figure 1.5).

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

2.37 0.43 0.11 0.45 0.32 0.12 0.11 0.22 0.35 0.31 1.11 1.68

5.14 15.95 7.15 7.68 6.07 5.42 9.58 8.70 2.96

10.55 18.41 5.65 5.91 3.89 7.07 12.16 9.10 8.61

Prepared Foods

2.80 2.57 –0.67 –0.04 0.06 –0.81 1.42 1.58 1.85 3.57 3.30 2.81

Source: Central Bank of Indonesia.

1997 January February March April May June July August Sept. Oct. Nov. Dec. 1998 January February March April May June July August Sept.

Foodstuffs

5.52 8.34 4.32 2.29 4.13 1.59 5.58 4.48 1.57

0.68 0.22 0.38 0.68 0.80 0.34 0.61 0.49 1.17 0.72 –1.41 0.95

Housing

15.12 14.01 11.20 4.34 4.53 10.95 12.26 2.96 –0.23

0.91 0.51 0.21 –0.02 0.09 0.17 –0.08 0.66 1.04 2.47 –0.12 3.34

Clothing

8.79 19.93 4.63 5.29 2.40 2.33 8.40 6.21 3.28

2.33 0.82 0.26 1.87 0.12 0.43 0.24 0.33 0.40 1.34 1.45 1.70

Health

3.72 8.42 2.18 1.50 1.41 1.55 6.82 6.47 1.24

1.94 0.22 –0.07 0.73 0.04 0.18 3.02 3.08 2.02 0.79 0.35 1.17

Education

5.85 5.81 1.59 4.94 17.25 2.07 3.45 2.74 2.10

1.32 0.05 –0.02 0.09 0.10 0.03 0.06 0.18 0.27 0.20 0.57 0.52

Transport

TABLE 1.3 Percentage Change in the Consumer Price Index and Its Components, January 1997–September 1998

7.17 12.67 5.27 4.70 5.24 4.64 8.56 6.30 3.75

1.70 0.76 0.03 0.40 0.31 –0.04 0.80 0.92 1.09 1.39 0.79 1.72

General

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16 YOOPI ABIMANYU

FIGURE 1.5 Monthly Rate of CPI Inflation, 1/97–9/98 percent 14 12 10 8 6 4 2 0 Jan. -2 1997

March

May

July

Sept.

Nov.

Jan. 1998

March

May

July

Sept.

Source: Central Bank of Indonesia.

Cumulative inflation through the first half of 1998 reached 39.69 percent and by the end of the second quarter, year-on-year inflation was 54.55 percent. After rising 19.84 percent in the first two months of 1998 (and 29.81 percent in the first quarter), the increase in the Consumer Price Index slowed somewhat to 24.74 percent for the second quarter of 1998. Although the second quarter figure is a significant improvement over the first quarter of 1998, it is markedly higher than the year-earlier figure, when prices rose by only 1.99 percent. CPI inflation was 33.19 percent for the first half of FY 1998/99 and 58.30 percent through the first nine months of calendar year 1998. Monthly data present a slightly more optimistic picture of recent inflation. Inflation peaked at 12.67 percent per month in February 1998. Since then, each month except May has recorded lower inflation than the previous month. Even the 5.24 percent inflation rate for May was surprisingly low given the dramatic hike in fuel and energy prices, the political unrest that renewed panic-buying and generated temporary shortages in some markets, and the continuing weakness of the rupiah.

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The consumer price index rose by 3.75 percent in September 1998, (the July and August inflation rates were 8.56 percent and 6.30 percent, respectively). The rate in September would have been even lower had average food prices not increased 8.61 percent over the previous month. Data from other sources suggest that much of this increase in food prices actually occurred in late August, and that food prices were probably about as stable as all of the other CPI categories in September. This means that official statistics probably understate inflation for August, and overstate actual price increases in September. The slowdown in inflation is probably due to consumers’ low purchasing power, their stopping to build up stocks and beginning to consume from existing household supplies, and to the recent appreciation of the rupiah, which should ease inflationary expectations. It remains a question whether more credible government policies contributed to the decline in inflation. Policymakers should aim to achieve credibility—by not saying one thing, and then doing another—in order to further reduce inflation. Balance of Payments

For many years prior to the onset of the financial crisis in mid-1997, Indonesia ran large current account deficits offset by large capital account surpluses. The situation changed greatly in 1997 and 1998, however. The current account deficit shrank from US$8 billion in FY 96/97 to an estimated US$1.7 billion in FY97/98 (Table 1.4). The turnaround in the current account came mainly in the second half of FY96/97 (between October 1997 and March 1998). During the first half of FY97/98 the current account deficit stood at a relatively high US$2.49 billion, although it was down considerably from the level a year earlier. In the third quarter of FY97/98, however, the current account deficit shrank to just US$202 million, the lowest quarterly level since the third quarter of 1994, and in the final quarter of FY97/98 the current account recorded a large (estimated) surplus of US$1 billion. The drop in total imports caused the turnaround in last year ’s current account. Oil and gas exports actually declined and the deficit on the services account increased, due entirely to an increase in the oil/gas services deficit. The turnaround in the current account was mirrored by an even more dramatic turnaround in the capital account (Table 1.4). The net capital account collapsed in FY97/98 to negative US$7.62 billion after growing more than two-and-a-half times from FY94/95 to FY96/97 to reach

© 2000 Institute of Southeast Asian Studies, Singapore

Current Account Merchandise Exports, fob Non-oil/gas Oil & gas Oil LNG LPG Imports, fob Non-oil/gas Oil & gas Oil LNG Services, net Non-oil/gas Net income Oil & gas Oil LNG

–8,069 6,219 52,038 39,267 12,771 7,513 4,686 572 –45,819 –41,126 –4,693 –4,423 –259 –14,288 –10,747 –6,095 –3,541 –1,831 –1,710

Q1

FY 1996/97 Q2 Q3 Q4 Q1

FY 1997/98 Q2 Q3

–1,699 –2,588 –2,166 –1,053 –2,302 –1,102 –1,395 –202 13,458 910 1,343 2,529 1,437 3,482 2,176 2,979 56,162 12,528 12,816 13,732 12,962 14,737 14,364 14,234 45,924 9,771 9,965 10,073 9,458 11,980 11,782 11,356 10,238 2,757 2,851 3,659 3,504 2,757 2,582 2,878 5,854 1,687 1,709 2,147 1,970 1,650 1,527 1,624 3,980 960 1,012 1,348 1,366 976 967 1,126 407 110 130 164 168 131 88 131 –42,704 –11,618 –11,473 –11,203 –11,525 –11,255 –12,188 –11,255 –38,619 –10,795 –10,410 –9,822 –10,099 –10,168 –11,157 –10,023 –4,085 –823 –1,063 –1,381 –1,426 –1,087 –1,031 –1,232 –3,814 –756 –995 –1,313 –1,359 –1,019 –963 –1,164 –271 –56 –68 –68 –67 –68 –68 –68 –15,157 –3,498 –3,469 –3,592 –3,739 –4,584 –3,571 –3,181 –10,522 –2,700 –2,623 –2,681 –2,743 –3,446 –2,404 –1,932 –6,596 –1,398 –1,627 –1,555 –1,515 –,811 –1,513 –1,493 –4,635 –798 –846 –901 –996 –1,138 –1,167 –1,249 –2,109 –442 –428 –466 –495 –549 –516 –546 –2,526 –356 –418 –435 –501 –589 –651 –703

Fiscal Year 1996/97 1997/98

TABLE 1.4 Balance of Payments, FY 1996/97–1997/98 (US$ million)

1,000 4,821 12,827 10,806 2,021 1,053 911 57 –,006 –7,271 –735 –668 –67 –3,821 –2,740 –1,779 –1,081 –498 –583

Q4

18 YOOPI ABIMANYU

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

12,668 –820 5,298 4,857 250 441 –6,118 13,488 6,546 6,942 4,599 –701 –3,898

Source: Central Bank of Indonesia.

Capital Account Official capital, net Inflows IGGI Transfers Non-IGGI Debt repayments Private capital, net Direct investment Other Total Errors & omissions, net Monetary movements –7,629 4,199 8,294 7,417 200 877 –4,095 –11,828 1,833 –13,661 –9,328 –693 10,021

Fiscal Year 1996/97 1997/98 1,993 –434 1,103 1,088 24 15 –1,537 2,427 1,024 1,403 –595 1,103 –508

Q1 2,839 7 1,409 1,004 16 405 –1,402 2,832 1,640 1,192 713 –781 68 3,868 56 1,493 1,478 101 15 –1,437 3,812 1,540 2,272 2,815 –105 –2,710

FY 1996/97 Q2 Q3

TABLE 1.4 – continued

3,968 –449 1,293 1,287 109 6 –1,742 4,417 2,342 2,075 1,666 –918 –748

Q4 2,226 362 1,084 1,078 0 6 –722 1,864 1,267 597 1,124 1,119 –2,243

Q1 1,790 –191 1,143 1,141 0 2 –1,334 1,981 1,392 589 395 –1,691 1,296

–5,442 3,158 4,074 4,068 200 6 –916 –8,600 –324 –8,276 –5,644 –496 6,140

FY 1997/98 Q2 Q3

–6,203 870 1,993 1,130 0 863 –1,123 –7,073 –502 –6,571 –5,203 375 4,828

Q4

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20 YOOPI ABIMANYU

US$12.66 billion. In other words, capital outflows greatly exceeded capital inflows for FY97/98. This turnaround on the capital account happened even though net inflows of official capital increased sharply, with inflows rising from US$5.29 billion to US$8.29 billion and government debt repayments falling from US$6.11 billion to US$4.09 billion. The improvement in the official capital account was swamped by the enormous deterioration on the private capital account, which moved from a surplus position of US$13.48 billion to a deficit position of US$11.82 billion. Most of this reversal in the private capital account was caused by the flight of portfolio capital. Net private portfolio investment flowing into Indonesia amounted to US$6.94 billion in FY96/97 (more than three times the amount two years earlier), but in FY97/98 net outflows of portfolio investment from Indonesia reached US$13.66 billion. The entire deterioration in portfolio investment took place during the second half of fiscal 97/98. Foreign direct investment into Indonesia also collapsed in the second half of FY97/98. During the first half of the fiscal year (April –September 1997), realised net foreign direct investment (FDI) into Indonesia was as high as it had been a year earlier. However, net FDI became negative in the third quarter of FY97/98. Since it is unlikely that Indonesian direct investment overseas surged during this period (October to December 1997), net outflow of FDI must be attributed to a huge drop in foreign direct investment in Indonesia. However, the Capital Investment Coordinating Board does not indicate such an enormous drop in realised FDI during the last three months of 1997. Balance of Trade

World oil and commodity prices continued to fall due to reduced demand following the Asian crisis and a general slowdown in the world economy, and there is little immediate prospect of a reversal of this trend. In terms of balance of trade, Indonesia’s non-oil exports grew at their lowest rate in more than a decade during the first nine months of 1998 and they actually declined in both August and September (Table 1.4). It is somewhat difficult to explain this decline in non-oil exports in August and September since exports should have benefited from the continued depreciation of the rupiah, which still averaged more than Rp11,000 per US dollar in August and September. Throughout 1998, the positive impact of exchange rate depreciation on exports has been masked by a decline in export prices (as shown by the much larger growth in

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exports by volume than by value). However, there is no indication of a precipitous decline in export prices in August and September. Consequently, the fall in exports during these two months must be attributed largely to a fall in volume rather than to a fall in price. A decline in foreign orders in the wake of the May disturbances could explain this fall in export volume. Given a two- or three-month time lag between when orders are placed and when goods are shipped, a decline in orders in mid-May would show up as reduced export shipments in August. Other factors, such as random events, a lack of trade finance, or declining world demand for Indonesian goods, could also explain this recent downturn in non-oil exports. PRESENT ECONOMIC CONDITION Fiscal Sector

Considering the condition of the economy and the agreement signed with the International Monetary Fund (IMF), the government of Indonesia revised its assumptions for the budget for fiscal year 1998/99 The government fully understands the need to find the right balance between containing the budget deficit and mitigating the impact of the economic crisis on the poor. The government has decided to reinforce the social safety net and extend subsidies to ensure sufficient supply of foodstuffs, basic essential commodities, and medicine at affordable prices. The subsidy program would be targeted at the most vulnerable groups of people. With a social safety net program accounting for about 7.5 percent of GDP, of which about 6 percent is earmarked for food, fuel, electricity, and medicine, an increase in the fiscal deficit is unavoidable The budget deficit for fiscal 1998/99 is expected to be largely, if not entirely, financed from foreign sources. Given the difficulty in introducing new tax measures under present economic circumstances, the government is considering steps to enhance the efficiency of tax collection as well as to introduce non-tax measures. Monetary Sector

Indonesia implemented a tight monetary policy to stabilise the rupiah and safeguard against inflationary pressure. This was done to compensate for the impact of the social safety net on the budget deficit. Also, to dampen the effect of massive withdrawals of public funds from the banking system, the central bank provided expanding liquidity support. As a result, base money increased by 17.6 percent from January to the end

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22 YOOPI ABIMANYU

of August 1998. The enormous runs on banks increased currency in circulation quite sharply, almost doubling it from Rp28.4 trillion at the end of 1997 to Rp52.1 trillion by the end of July 1998. Accordingly, the annual growth rate of the money supply (M1) jumped from 22.2 percent to 57.2 percent during the same period. Monetary tightening is carried out by raising interest rates. The rate on one-month Sertifikat Bank Indonesia (SBI) was raised sharply from 22 percent in January 1998 to 45 percent on March 23, 1998 (Table 1.5). Further increases in SBI rates to 50 percent and 58 percent respectively took place on 21 April and 7 May 1998. Subsequently, commercial bank

TABLE 1.5 Selected Interest Rates, January 1997–September 1998 (Annual Percentage Rate, End of Period) Credit 1-Month SBIs 1997 January February March April May June July August Sept. Oct. Nov. Dec. 1998 January February March April May June July August Sept.

1-Month Working Capital Time Deposits Investment

12.00 11.70 11.10 10.60 10.50 10.50 10.70 30.00 21.00 20.50 20.00 20.00

14.30 14.30 14.10 13.90 13.80 13.80 13.80 16.90 18.50 21.40 20.00 19.60

19.10 19.00 18.90 18.80 18.00 18.80 18.60 25.10 26.40 26.80 26.40 25.40

16.40 16.40 16.40 16.40 16.30 16.20 16.00 19.70 20.30 28.10 19.80 18.90

22.00 22.00 45.00 50.00 58.00 58.00 65.20 70.40 64.70

25.70 28.60 44.50 50.60 56.10 49.90 52.90 60.70 63.30

25.60 25.60 27.80 29.50 33.20 33.80 34.10 35.00 35.70

19.00 19.20 20.20 21.60 22.80 22.70 23.40 24.20 24.90

Source: Harvard Institute for International Development, Jakarta Office.

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deposit rates for all maturities also rose substantially to between 50 percent and 60 percent. September witnessed divergent interest rate developments. The SBI rate declined by around six percentage points from 70.4 percent to 64.7 percent and overnight inter-bank rates eased during September. Although commercial bank deposit rates kept increasing from 60.7 percent to 63.3 percent, the pace of increase slowed somewhat in September and seems to have come to a stop by the end of the month. Assuming that the SBI rates continue to decline, deposit rates in the banking system can be expected to stabilise at the prevailing level or even decline in the near future since banks will try maintain a positive spread between deposit and SBI rates. Investment in SBIs appears to be the main risk-free alternative since banks maintain limited ability and/or willingness to engage in new lending to the real sector. The lowering of the open market rate does not necessarily indicate a shift towards an expansionary monetary policy. Instead, it might reflect the central bank’s attempt to lower the cost of the high-interest-rate regime on the financial sector, including the central bank. Given the stable exchange rate and somewhat lower inflation rate, a further gradual reduction of interest rates seems to be the most prudent monetary policy choice. Banking Sector

The banking sector has been hit hardest by the economic crisis. The currency depreciation has affected the capacity of the corporate sector to service foreign loans, which, in turn, has contributed to a growth in nonperforming loans. Tight monetary policy, aimed at stabilising the currency, has contributed to negative interest spreads and thereby eroded the equity position of banks and severely reduced the availability of credit. The combination of all these factors has resulted in widespread insolvency among the commercial banks and had adverse consequences on the economy. The government has achieved some noteworthy policies to restructure the banking sector. The Indonesian Bank Restructuring Agency (IBRA) and its Asset Management Unit (AMU) were made fully operational under a Presidential Decree, which provides a legally based charter of rights and responsibilities for the IBRA. Several banks whose operations were frozen in April 1998 will be liquidated soon after all their assets are transferred to the AMU. In the meantime, ownership of the rest of the ailing banks whose operations were

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24 YOOPI ABIMANYU

frozen in April last year will be taken over by the government in proportion to the capital restructuring implemented by these banks. As part of the re-capitalisation program, all banks will be reviewed to identify financial problems. Banks which are considered in need of recapitalisation and whose business plans are considered feasible can obtain capital investment from the government. The first-phase financial review has been implemented at national private banks and state-owned banks. The government will continue to provide a guarantee scheme on deposits and other liabilities of locally incorporated banks. Four state banks (Bank Exim, Bapindo, Bank Bumi Daya, and Bank Dagang Negara) are to be merged into one bank. The government is also undertaking to improve prudential regulation, particularly by bringing the coverage of asset-quality and loan-loss provisions into line with international standards and by preparing guidance on debt-restructuring. The Banking Act No. 7 of 1992 had been amended to bring about some major changes, such as transferring bank licensing from the Ministry of Finance to Bank Indonesia; increasing opportunities for foreign investors to become shareholders in domestic banks; and narrowing the definition of bank secrecy which previously covered all asset and liability information to cover only information related to depositors and deposits. Exchange Rate

To stabilise the rupiah, the authority has tightened domestic monetary conditions by pushing interest rates upward. The weakness in the exchange rate, shown in its volatile movements, reflects the government ’s commitment to implement the economic stabilisation and reform measures. Recently, market players have responded positively to some policy measures including • • • •

the central bank policy to raise the rate on SBIs; the IBRA’s move to clean up banks; government attempts to resolve the private sector debt problem; the government’s success in obtaining US$14 billion assistance from the IMF, the World Bank, the Consultative Group on Indonesia (CGI), and other international organisations; and • the cancellation of the Currency Board System implementation. The exchange rate appreciated somewhat as a result of these steps as well as some external factors such as low interest rates in the United States.

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From June 1998 until the first week of September 1998, the rupiah appreciated about 28.02 percent (from Rp14,900/US$ to Rp10,725/US$). During November, the rupiah continued to appreciate, gaining about 3 percent in value. On 30 November the currency traded at Rp7,425/US$, compared to Rp7,650/US$ at the end of October. Although over the entire month the rupiah strengthened, at the beginning of the month it exhibited occasional weaknesses. For the first of November, the rupiah fell through the Rp8,000/US$ level to reach Rp8,700/US$. Later on, the rupiah recovered and traded around Rp8,000/US$. The strength and relative stability of the exchange rate during the latter half of November 1998 was surprising given the political climate of social tension and repeated violent clashes between demonstrators and security forces during and following the Parliament session. At the beginning of November the rupiah recei ved support from the IMF loan disbursement. This probably helped the exchange rate to appreciate below the Rp8,000/ US$ level. However, the continued strength and stability of the rupiah throughout the remainder of the month is more difficult to explain. There seems to be a market perception that the rupiah was supported by dollar sales through state banks or even state-owned companies during the latter part of the month. Although the central bank stated that it was not directly intervening in the market, market participants in offshore trading centres insisted that the monetary authority had been actively selling the US dollar to stabilise the rupiah. The exchange rate is expected to appreciate further as a result of the restructuring of private debt and increased intervention by the central bank in the very thin foreign exchange market, among other things. Regarding the foreign exchange reserves, net international reserves increased from US$13.5 billion on 31 August 1998 to US$14.0 billion on 30 September 1998. This appears to be consistent with apparent IMF targets on reserves. The weekly fluctuation in net international reserves may reflect the reconciling of inflows of multilateral assistance and outflows as these funds are disbursed (sold) to importers. Net foreign assets reported in rupiah remained relatively unchanged because the strengthening of the rupiah closely offset the moderately higher dollar amount of foreign exchange. CONCLUSION AND SUMMARY

This chapter described the currency and economic crisis in Indonesia. Regression analysis failed to detect a significant contagion effect on the

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26 YOOPI ABIMANYU

Indonesian rupiah from the currencies of Thailand, Korea, Hong Kong, or the United States in the short-run. However, the regression analysis did find a statistically significant political announcement effect, suggesting that announcements by the government may have contributed to the overshooting of the depreciation of the rupiah. The currency crisis has led to the deterioration of the whole economy, resulting in the deceleration of GDP growth in 1997 and a deeper expected contraction for 1998 exacerbated by social unrest in mid-May and high inflation. Indonesia experienced a huge deterioration on the capital account. Net capital inflows were negative in fiscal year 1997 –98, probably due to the flight of portfolio capital. Foreign direct investment into Indonesia also collapsed in the second half of fiscal 1997–98, recording negative amounts in the last two quarters of the fiscal year (Table 1.4). Non-oil exports have grown at their lowest rate in more than a decade due to the collapse of commodity prices and a general slowdown in the world economy. The government has revised assumptions underlying the budget for fiscal year 1998 –99 to reflect realistically the present economic crisis facing Indonesia. The government also has decided to reinforce the social safety net and extend subsidies for the public and it is considering steps to enhance the efficiency of tax collection as well as implementation of nontax measures. To help stabilise the rupiah and reduce inflationary pressure, tight monetary policy has been implemented by raising interest rates to compensate for the large budget deficit due to the social safety net program. The government has implemented several policies to restructure the banking sector through mergers, liquidation, and re-capitalisation. In addition, the government is improving prudential regulations and introducing major changes in the Banking Act. The combination of all these policies has helped stabilise the exchange rate to some extent.

Notes 1

The author gratefully acknowledges the contributions of Dr. Djunaedi Hadisumarto, Dr. Imron Husin, and Winang Budoyo of the Center for Policy and Implementation Studies, Dr. Bambang Subianto, Dr. Susiyati B. Hirawan, and Dr. Sahala L. Gaol of the Ministry of Finance of Indonesia, Marzuki Usman MA, Prof. Dr. Anwar Nasution, and Widjanarko MA of the Indonesian Economist Association, Dr. Joseph Stern, Dr. Peter Rosner, and Dr. Stephen Radelet of the Harvard Institute for International Development, and Prof. Suzuki, Dr. Eric D. Ramstetter

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3 4

5

6

7

8

9

10

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of the East Asian Economist Association, and Professor Chia Siow Yue of ISEAS and the other participants in the AT10 Researchers Meeting. International Monetary Fund, Press Release No. 97/50, 5 November 1997. Asian Wall Street Journal, various issues. This policy approach used to be called “leaning against the wind” (Levi 1996, p. 300). Although the liquidity shortage developed following the closure of 16 private banks in early November, it is difficult to establish empirically that the closures caused the liquidity shortage. Some analysts suggested that Indonesia might be caught in a liquidity trap. During a certain period (particularly around the end of 1997) the banking system might have had sufficient liquidity but was reluctant to lend because of extreme concern about the credit worthiness of borrowers. All calculations reported in this paper were performed using Eviews version 2.0. For discussion of the Phillips-Perron test refer to Holden and Perman 1994, Christiano 1992, Chu and White 1992, Perron and Vogelsang 1992a, Perron and Vogelsang 1992 b, Perron 1990, Perron 1989. See Athukorala and Menon 1994, p. 275; Banerjee et al. 1993, pp. 48 – 51; Davidson and MacKinnon 1993, pp. 680 –84. This section follows the format of theEconomic Report, Harvard Institute for International Development, Jakarta Office, various issues.

References

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Christiano, Lawrence J. 1992. “Searching for a Break in GNP”. Journal of Business and Economic Statistics 10, no. 3 (July): 237 –50. Chu, Chia-Sang James and Halbert White. 1992. “A Direct Test for Changing Trend”. Journal of Business and Economic Statistics 10, no. 3 (July): 289–99. Cuthbertson, Keith, Stephen G. Hall, and Mark P. Taylor. 1992. Applied Econometric Techniques. Hertfordshire: Harvester Wheatsheaf. Danareksa. 1998. Macroeconomic Monthly Review: Recent Developments. Jakarta: PT Danareksa. August. Davidson, Russel and James G. MacKinnon. 1993.Estimation and Inference in Econometrics. New York: Oxford University Press. Dickey, David A. and Wayne A. Fuller. 1981.“Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root ”. Econometrica 49, no. 4 (July): 1057–72. Djiwandono, J. Sudradjad. 1998. “The Rupiah—One Year After the Float”. The Indonesian Quarterly XXVI, no. 3: 170 –77. Edwards, Sebastian. 1991. Real Exchange Rates, Devaluation, and Adjustment: Exchange Rate Policy in Developing Countries. Cambridge, Massachusetts: MIT Press. Enders, Walter. 1995. Applied Econometric Time Series. New York: John Wiley & Sons. Frankel, Jeffrey A. and Shang-Jin Wei. 1992. “Yen Bloc or Dollar Bloc: Exchange Rate Policies of the East Asian Economies ”. Birmingham International Finance Group. University of Birmingham Global Finance Lecture, 14 October. Fratzscher, Marcel. 1997. “Why are currency crises contagious? A comparison of the Mexican crisis of 1994 and the Thai crisis of 1997”. Advanced Studies Program in International Economic Policy Research. Kiel Institute of World Economics. 20 December. Greene, William H. 1993. Econometric Analysis, 2d ed. New York: Macmillan Publishing Company. Government of Indonesia. “Explanation on the Amendment of the Law Number 3 Year 1998 on the Government Budget Fiscal Year 1998/ 1999”. Government of Indonesia. Harvard Institute for International Development. 1998. Economic Report. Harvard Institute for International Development (HIID): Jakarta Office. Hill, Hal. 1996. The Indonesian Economy Since 1966. Cambridge: Cambridge University Press. Holden, Darryl and Roger Perman. 1994. “Unit Roots and Cointegration for the Economist ”. In Cointegration for the Applied Economist, ed. B. Bhaskara Rao. New York: St. Martin ’s Press.

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Levi, Maurice D. 1996. International Finance. Singapore: McGraw-Hill. Maddala. G. S. 1992. Introduction to Econometrics. Singapore: Macmillan. Murinde, Victor. 1996. Development Banking and Finance. Hant, England; Avebury, Ashgate. Nasution, Anwar. 1997. “The Recent Financial Crisis in Indonesia”. Paper for Conference on Money and Financial Markets in Asia: A Challenge to Asian Industrialization. Federal Reserve Bank of San Francisco and American Committee on Asian Economic Studies (ACAEAS). September. San Francisco. ______. 1997. “Notes on Monetary Policy Instruments ”. 20 June. Perron, Pierre. 1994. “Trend, Unit Root and Structural Change in Macroeconomic Time Series ”. In Cointegration for the Applied Economist, ed. B. Bhaskara Rao. New York: St. Martin ’s Press. ______. 1990. “Testing for a Unit Root in a Time Series With a Changing Mean”. Journal of Business amd Economic Statistics 8, no. 2 (April): 153–62. ______. 1989. “The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis”. Econometrica 57, no. 6 (November): 1361 –401. ______ and Timothy J. Vogelsang. 1992a. “Short Communications: Testing for a Unit Root in a Time Series with a Changing Mean ”. Journal of Business and Economic Statistics 10, no. 4 (October): 467 –70. ______. 1992b. “Nonstationary and Level Shifts with an Application to Purchasing Power Parity”. Journal of Business and Economic Statistics 10, no. 3 (July): 301 –20. Phillips, Peter C. B. and Pierre Perron. 1988. “Testing for a unit root in time series regression”. Biometrika 75, no. 2: 335 –46. Radelet, Stephen and Jeffrey Sachs. 1998 a. “The East Asian Financial Crisis: Diagnosis, Remedies, Prospects ”. Paper prepared for the Brookings Panel, Washington, D.C. March. ______. 1998b. “The Onset of the East Asian Financial Crisis ”. Harvard Institute for International Development (HIID). 10 February. Wardhana, Ali. 1998. “Overcoming the Current Economic Downturn ”. The Indonesian Quarterly XXVI, no. 3: 178 –82.

© 2000 Institute of Southeast Asian Studies, Singapore

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30 ABOLA, NERI AND SUPANGAN

2 The Banking System and the Savings Rate in the Philippines Victor A. Abola, Emilio Neri, Jr., and Richard Supangan In some of the afflicted countries, the recent Asian currency crisis has turned into a banking crisis that has put full economic recovery a few years farther away. This study tries to determine whether the currency crisis degenerated into a banking crisis in the Philippines. Since the country relies heavily on the banking system as a conduit for savings, a weak banking system may negatively impact the savings rate over a number of years and may thus impede economic recovery. A previous study by one of the authors (Abola 1999) noted the striking feature of the Philippines that it has the lowest savings rate in East Asia. Many analysts contend that the Philippines’ low propensity to save could put a damper on stronger long-term growth. The present study also looks into the nature of recent banking and financial system reforms and evaluates their impact in making the Philippine financial system more capable of fulfilling its traditional role of efficient intermediation. IMPACT OF THE ASIAN CURRENCY CRISIS ON THE FINANCIAL SYSTEM AND THE SAVINGS RATE

We first trace the impact of the Asian currency crisis (ACC) on the banking system in the Philippines to determine whether a banking crisis has occurred or whether one may occur in the near future. Then we try to examine how the weakness of the banking system may have affected the rate of savings.

© 2000 Institute of Southeast Asian Studies, Singapore

THE PHILIPPINES 31

Impact of the ACC on the Banking System

A banking crisis can lead to a currency crisis, and a currency crisis can provoke a banking crisis. The direction of causation is not well established. What is better established is that in Asia a currency crisis seems to have emerged first, and the banking crisis was a logical consequence. This is not to say that the banking system did not have its weaknesses. As Kaminsky and Reinhart (1998) point out, “while banking crises often precede BOP crises, they are not necessarily the immediate cause of currency crises, even in the cases where a frail banking sector puts the nail in the coffin of what was already a defunct fixed exchange rate system”. The ACC exposed and exacerbated the banking system’s fragility, leading to its eventual collapse. This sequence is consistent with Kaminsky and Reinhart’s conclusion that “the peak of the banking crisis most often comes after the currency crash, suggesting that existing problems were aggravated or new ones created by the high interest rates required to defend the exchange rate peg or the foreign exchange exposure of banks”. In the present instance, the affected Asian countries had liberalised their capital accounts and attracted huge amounts of foreign capital in the form of both direct and portfolio investments for a good number of years. Relatively stable exchange rates and high domestic interest rates contributed to the continuing inflow of short-term money. Relatively high local interest rates also led firms to borrow in foreign currency, often on short tenors. A large portion of these funds went to real estate investments. Thus, when foreign capital stampeded out, the exchange rates had to depreciate substantially. As monetary authorities tried to stem the outflow with even higher interest rates, property prices collapsed. The double whammy— depreciation of the exchange rate on foreign borrowings and higher interest rates on domestic borrowings—made it difficult for firms to repay their bank loans. Thus, a banking crisis ensued. The Philippines was no exception to this general pattern. Although there was no wholesale closure of banks as there was in Thailand and Indonesia, the banking sector in the Philippines was afflicted by surging non-performing loans. The key questions are whether the currency crisis in turn caused a banking crisis in the Philippines and, if not, whether a banking crisis is likely to occur in the next two years or so. To answer these questions, we need first to define a banking crisis. Caprio and Klingebiel (1996) maintain that “there is no objective, generally accepted definition of when a problem in the banking sector becomes systemic.” But as these authors and others have tried to trace the causes or

© 2000 Institute of Southeast Asian Studies, Singapore

32 ABOLA, NERI AND SUPANGAN

warning signals of banking crises, they have adopted working definitions in each case. We refer to these definitions of systemic banking crisis. Did Losses Wipe Out Bank Capital?

Caprio and Klingebiel (1997) defined a systemic banking crisis as a situation in which the net worth of the banking system is almost or entirely eliminated. They found as many as eighty-six episodes in sixty-nine countries that met this definition of a banking crisis. In order to evaluate the Philippine banking system under this definition, we first have to estimate the banking system ’s loan losses. Official data tend to understate losses, because banks have the ability to make loans look better than their actual state (Caprio and Klingebiel 1997, p. 81). Nonetheless, the usual starting point is the amount of non-performing loans of the banking system. In the Philippines, non-performing loans used to be defined as loans on which no payment of principal or interest had been received for the past six months. However, the classification was made more strict under Circular 143 issued in October 1997 by the central bank, Bangko Sentral ng Pilipinas; the non-payment period was reduced to three months starting from April 1998.1 The amount of non-performing loans (NPLs) is related to the total loan portfolio to obtain the nonperforming loan ratio. We work back from the NPL ratio to compute the amount of bad loans and loan losses. The NPL ratio in the Philippines trended downwards after the currency and banking crisis in the early 1980s, bottoming out at 3.5 percent in 1996 (Table 2.1). Thereafter, it resumed its rise, climbing more steeply from June 1997. The ratio had risen to 5.4 percent by the end of 1997. It reached 11.97 percent in October 1998 and stood slightly lower at 10.37 percent in December 1998. Industry watchers expected the NPL ratio to hit a peak of 15 percent some time during the first half of 1999. Applying this 15 percent NPL ratio to the aggregate loan portfolio for September 1998, we derive an estimate for the peak volume of bad (i.e., non-performing) loans, about 238 billion pesos. Assuming that 50 to 60 percent of this amount represents losses that are not covered by collateral because of the fall in real estate values, we obtain an estimate of effective loan losses totalling between 119.0 and 142.8 billion pesos. Finally, we deduct from the effective loss amount, the total loan-loss provision of the banking system, which was 55.8 billion pesos in September 1998, to arrive at an estimate of between 63.2 and 87.0 billion pesos of net unrecognised losses for the Philippine banking system. The aggregate capital of the

© 2000 Institute of Southeast Asian Studies, Singapore

THE PHILIPPINES 33

TABLE 2.1 Ratio of NPLs to Total Assets and Total Loans (Percent)

1992 1993 1994 1995 1996 1997 March June Sept Dec. 1998 March June Sept. Dec.

NPLs/Assets

NPLs/Loans

3.49 2.93 2.71 2.45 2.29 2.53 2.73 3.10 3.43 5.15 6.10 7.28 6.55e

6.84 5.27 4.71 3.98 3.51 3.95 4.03 4.76 5.41 8.17 9.65 11.52 10.37

Loan Loan Provisions/Loans Provisions/NPLs 3.27 2.55 2.03 1.72 1.39 1.42 1.39 1.51 2.28 2.66 2.82 3.15 4.04

47.77 48.34 43.01 43.14 39.50 36.04 34.56 31.73 41.97 32.55 29.17 27.35 38.33

Notes: e – estimate. Source: Bangko Sentral ng Pilipinas (BSP).

banking system was about 409 billion pesos as of September 1998. Thus, for the Philippines, estimated unrecognised loan losses amounted to about 15 to 21 percent of bank capital. While this rate of losses indicates that the ACC inflicted significant damage on the banking system, it is still far too low to suggest that the system is insolvent. Hence, we can conclude that the Philippines has not experienced a systemic banking crisis under the Caprio-Klingebiel definition. Moreover, this conclusion holds even if we count the total amount of effective loan losses without deducting the provisions for losses. In comparison, the Philippines did suffer a systemic crisis according to this definition during the years 1981–87. In 1986 the assets and loans of distressed government banks were transferred to the national government for disposal. The amount transferred alone totalled P107.4 billion or 37.1 percent of total bank assets. At that time, the stockholders’ equity of banks, which totalled P40.2 billion, comprised only 13.9 percent of assets. Therefore, even if the government later recovered 40 percent of the value of the transferred assets, the P64.4 billion in lost capital (P107.4 transferred assets × 60%) still represented 160.2 percent of stockholders’ equity. In that instance, the banking system was clearly insolvent.

© 2000 Institute of Southeast Asian Studies, Singapore

34 ABOLA, NERI AND SUPANGAN

Multiple Criteria for Banking Crisis

Demirguc-Kunt and Detragiache (1998) proposed an alternative definition of a banking crisis by which we can also evaluate the Philippine situation. According to these authors a full-fledged crisis requires that at least one of the following four conditions be met: (1) The ratio of non-performing assets to total assets in the banking system exceeds 10 percent. (2) The cost of rescue operations is at least 2 percent of GDP. (3) Banking sector problems result in a large-scale nationalisation of banks. (4) Extensive bank runs take place or emergency measures such as deposit freezes, prolonged bank holidays, or generalized deposit guarantees are enacted by the government in response to the crisis. We know that the recent experience of the Philippines did not meet criterion (3) and (4), but we need to investigate whether either of the first two criteria was met. Over the past twenty years, loans have usually comprised 47 to 65 percent of total bank assets. Taking the earlier figure of 15 percent as the maximum probable ratio of non-performing loans to total loans, we expect non-performing assets would reach 8.5 percent of total assets in 1999. While this ratio is high, it is still below Demirguc-Kunt and Detragiache’s (DKD) 10-percent threshold for a full-fledged banking crisis. On the other hand during the mid-1980s, the non-performing asset ratio in the Philippines did exceed 10 percent. We turn to DKD ’s second criterion, the cost of the rescue operations. Strictly speaking, there has been no government rescue in the Philippines. However, the Bangko Sentral ng Pilipinas (BSP) and the Philippine Deposit Insurance Corporation (PDIC) have provided emergency loan financial assistance to distressed banks. As of year-end 1998, their combined cumulative assistance had reached P19 billion, constituting only 0.7 percent of 1997 GDP, which is considerably under the DKD benchmark. The extent of government assistance would appear even smaller if we deducted the P3.4 billion that such advances averaged from 1994–96. We can conclude from these estimates of the non-performing asset ratio, the cost of government assistance, and bank solvency that the weakness in the Philippine banking system has not reached an extent that justifies the label ‘ crisis’ as defined by the leading researchers on bank crises. Yap (1998) supports this conclusion. Following Kaminsky and Reinhart (1998) he developed indices to predict BOP and banking crises in the Philippines. He found that signals of crisis in the Philippines were “intermittent and rather weak especially when compared with the 24 months prior to the 1983 crisis”. Thus, Yap’ s indices as well as our

© 2000 Institute of Southeast Asian Studies, Singapore

THE PHILIPPINES 35

calculations all suggest that the present distress of the Philippine banking sector should not be called a systemic banking crisis. Could a Crisis Still Develop?

Even though the situation in the Philippines does not reach the established crisis benchmarks calculated on current data, a banking crisis could still emerge if relevant variables turn sour. To evaluate the possibility of a banking crisis occurring in the near future we estimated a logit model of the probability of a banking crisis and a regression model of the NPL ratio and forecasted them up to the year 2000. We first constructed a logit model of the probability of a banking crisis in the Philippines based on the behaviour of other macroeconomic variables. Although logit methodology is commonly used for cross-section or panel data, we applied it to analyse time-series data, specifically annual data for 1981 to 1998. For this investigation, we defined a banking crisis as a year in which the number of failed banks reaches 20 or more and assigned the dependent variable the value 1 in these years. All other times the dependent variable had the value 0. Using the number of failed banks as the criterion actually identifies the peak of a crisis rather than its inception. According to this definition, banking crises occurred seven times from 1981 to 1998—in the years 1981, 1984–87, 1990, and 1998. Although we concluded in the previous section that the Philippines is not now experiencing a banking crisis, since more than 20 Philippine banks failed in 1998 it qualifies as a crisis year according to the logit-model definition. It should be noted, though, that most failed banks were tiny rural banks. By and large, for all years, the closed banks’ share of total banking system deposits never exceeded 1.5 percent. Except for the truly severe years of 1984–86, the share was normally much lower than even 0.2 percent. If we had instead defined a crisis year according to closed banks’ share of total deposits, with a cut-off of, say, 0.8 percent, the only crisis years would have been 1984–87. This shows that our failed-banks definition of a banking crisis is rather stringent. The independent variables were the current inflation rate, the ratio of currency to money supply (M1), the reserve requirement for the previous year, and the GNP growth rate lagged two years. The first two variables are expected to have a positive effect on the number of bank failures, since higher inflation makes it more difficult for borrowers to repay loans, and a higher currency ratio (an increase in cash holdings) ordinarily implies less public confidence in the banking system. The second two variables

© 2000 Institute of Southeast Asian Studies, Singapore

36 ABOLA, NERI AND SUPANGAN

should have negative signs. Higher reserve requirements mean that banks must hold a greater percentage of cash and are therefore less able to lend, leading to fewer bank failures. A higher GNP growth rate means that borrowers have more wherewithal to repay bank loans. The GNP growth rate is lagged two years to account for the tendency among both local managers and government authorities to delay biting the bullet after serious problems emerge. The estimated coefficients of this logit model had the expected signs and t-statistics were all significant between 8 percent and 18 percent (Appendix 2.1).2 According to the model, the probability of a crisis (twenty or more bank failures) was above 50 percent in five of the years from 1981 to 1998. It was particularly high during the years 1984–87 and it was below 50 percent in both 1981 and 1998. Thus, in a sense, the results from the logit model support the earlier conclusion that there is no real banking crisis in 1998. 3 From the estimated coefficients and forecast values of the independent variables we calculated the probability of a banking crisis occurring in 1999 or 2000 (Appendix 2.1). In general the values of the independent variables suggest a moderate economic recovery starting 1999, with inflation easing by roughly 1.5 percent each year, reserve requirements declining, and a normalisation of the currency ratio to 48 percent by 2000. Given these assumptions, the forecasted probability of a banking crisis occurring in 1999 is quite low, at 10.9 percent, but it rises sharply to 46.8 percent in 2000. GNP growth slowed down considerably in 1998 from 5.8 percent to 0.1 percent. But the delayed effect of this slowdown was not enough to raise the probability of a bank crisis above the critical level of 50 percent in the year 2000. Thus, consistent with the findings using other criteria, the logit analysis suggests that there is presently no crisis in the usual sense. But this analysis also indicates that the Philippine banking system is not yet out of the woods. The years 1999–2000 will be a critical time in which to clean up and consolidate the system in order to avert a real crisis. To get a deeper sense of the possibility of a banking crisis in the near term we also estimated a regression on the NPL ratio for the same period covered by the logit model (Appendix 2.1). The independent variables were the contemporaneous GNP growth rate, the previous year’s reserve requirement, and the NLP ratio lagged one year. The t-statistics on the estimated coefficients were all acceptable, but using the DH test we could not reject the null hypothesis that the error terms are not autocorrelated. Using the estimated regression coefficients and forecasted values of the independent variables we calculated an NPL ratio for the Philippine banking

© 2000 Institute of Southeast Asian Studies, Singapore

THE PHILIPPINES 37

system of 14.48 percent for 1999 and 14.94 percent for 2000. These NPL ratios imply non-performing loans close to 10 percent of total assets, the percentage that DKD defined as the threshold for a banking crisis. Thus, these regression results are consistent with the conclusion we reached above—although there is no systemic banking crisis at present, the weakness in the banking system is significant enough to require a number of years to overcome. Impact of Banking System Weakness on the Savings Rate

Given the importance of raising the propensity to save in order to improve the Philippines’ development prospects, we investigated whether the current fragile state of the banking sector has restrained the rate of savings. Neither the national savings rate nor the household savings rate declined in 1997. After all, the impact of the currency crisis was not felt in that year, when GDP still grew by 5.1 percent. In fact, the savings rate predicted from our model of household savings (Abola 1999) was quite close to the actual savings rate for 1997. The full effects of the currency crisis were not felt until 1998. Although official savings data are not yet available for 1998, we can use preliminary GNP data, which do not include detailed breakdowns of savings, to obtain a general indication of savings behaviour in 1998. We estimate national savings by deducting personal consumption expenditure (PCE) and government consumption expenditure (GCE) from GDP. This estimate of national savings is biased downward, because GDP omits net factor income from abroad, a large component of GNP due to the many Filipinos working overseas. According to this method the savings rate declined substantially from 1997 to 1998 . In current prices the estimated savings rate for 1998 was 12.3 percent, down from 14.3 percent in 1997, and in constant prices it stood at 12.4 percent, down from 15.6 percent in 1997. We speculate that the decline was due mainly to lower savings by general government and business and corporate enterprises and that household savings was not severely affected by the currency crisis. This expectation is based on our econometric model of household savings, in which the coefficients on the real effective exchange rate (REER) and the GNP growth rate have opposite signs (Appendix 2.2). According to the BSP, the REER declined by 17.9 percent in 1998. Based on our model, this decline should have boosted household savings by more than enough to offset the negative impact of the slowdown in GDP growth.

© 2000 Institute of Southeast Asian Studies, Singapore

38 ABOLA, NERI AND SUPANGAN

Indicators from the Banking System

We now examine some financial system indicators for possible signs of negative savings. First, the banking system’s share of total financial assets increased from 80 percent in 1996 to 82 percent in September 1998, while the share of non-bank financial institutions declined. During the same period there has been a “flight to quality” within the banking system, i.e., an increase in the share of commercial banks vis-à-vis the share of smaller thrift banks and rural banks (Table 2.2). Second, we look at the currency ratio (currency in circulation as a percentage of money supply in its different definitions, M1 to M4). 4 A rising ratio would suggest declining public confidence in the banking system. There has been a long-term slide in the currency ratios since the banking crisis of the 1980s (Table 2.3). This trend continued until 1997. In 1998, however, the currency ratios rose on a monthly basis, particularly in the first half-year, and then returned to levels more attune with 1997. Although this increase in cash-holding in the Philippines coincided with the worsening second wave of the Asian crisis (South Korea and Indonesia), it is probably best attributed to the heavy need for cash during the combined national and local elections in May 1998. The year-on-year growth rate of savings and time deposits continued to decelerate during 1998 (Figure 2.1). The slowdown worsened from July 1998, with growth in savings plus time deposits down to a single digit by November. This slowdown can be attributed to the income effect of the currency crisis as well as to weakness in the banking sector. Thus, available financial data, such as the banking system ’s share of total financial sector assets and the currency ratio, do not indicate that the weakening banking system has led to a significant decline in the savings rate. Nevertheless, the decline in savings and time deposit growth could still point to trouble. Threats to Recovery of the Savings Rate

Given the economic outlook for 1999 and 2000, we see two possible threats to a recovery of the savings rate based on our econometric model of household savings in the Philippines (Appendix 2.2). The first potential threat to the savings rate comes from expectations about the real effective exchange rate (REER). A preference for a strong REER on the part of the monetary authorities could put a damper on the savings rate. The bias of the monetary authorities towards a strong peso created the weaknesses in the economy prior to the 1997 debacle. This bias could rear its head again.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

34.1c 65.9c

23.8a

73.3b 5.6b 18.1b 3.0b

76.2

a

502.5 90.4

60.6 46.7

107.3

283.3 15.1 88.0 8.8

395.2

Share Amount

1985

56.5c 43.5c

21.4a

71.7b 3.8b 22.3b 2.2b

78.6 a

801.3 74.3

107.8 84.0

191.8

539.7 37.6 18.5 13.7

609.5

Share Amount

1990

56.2c 43.8c

23.9a

88.5b 6.2b 3.0b 2.2b

76.1 a

2,030.0 103.6

277.2 157.2

434.4

1,347.4 143.3 68.2 36.7

1,595.6

Share Amount

1995

63.8c 36.2c

21.4a

84.4b 9.0b 4.3b 2.3b

78.6 a

2,636.2 116.6

277.7 249.0

526.7

1,876.2 185.1 0.2 48.0

2,109.5

Share Amount

1996

52.7c 47.3c

20.0a

88.9b 8.8b 0.0b 2.3b

80.0

a

3,369.3 133.3

313.7 276.7

590.3

2,513.0 208.4 0.0 57.6

2,779.0

Share Amount

1997

53.1c 46.9c

17.5a

90.4b 7.5b 0.0b 2.1b

82.5a

Share

Notes: From February 1996 specialised government banks include only Al-Amanah Islamic Investment Bank of the Philippines (AAIIBP) an d from 1997 the remaining specialised government banks consolidated with commercial banks. a Share of grand total. bShare of banking system total. cShare of non-bank financial institutions total. Source: BSP Statistical Bulletin, various issues.

247.7 101.6

20.1 38.8

Government Private

Total Total Assets/GNP (%)

58.9

138.4 10.6 34.2 5.6

188.8

Non-bank financial institutions

Commercial banks Thrift banks Specialised gov’t banks Rural banks

Banking system

Amount

1980

TABLE 2.2 Total Assets of the Financial System by Type of Institution, 1980–97 (Billion pesos and Percent)

THE PHILIPPINES 39

40 ABOLA, NERI AND SUPANGAN

TABLE 2.3 Currency in Circulation (CC) as a Percent of M1, M2, and M4 Money Supply (Percent) 1992 1993 1994 1995 1996 1997 1998 Jan. Feb. March April May June July Aug. Sept. Oct. Nov. Dec.

CC/M1

CC/M2

CC/M4

64.21 61.20 60.10 57.17 52.59 50.07

18.22 17.30 15.72 13.85 12.72 11.97

14.68 13.36 12.21 10.77 9.52 8.63

52.35 51.90 52.38 54.37 53.24 50.38 50.84 49.55 49.27 50.83 50.99 51.89

12.34 12.25 12.11 13.06 12.86 11.81 11.62 11.09 11.12 11.64 11.89 12.83

8.56 8.66 8.67 9.30 9.26 8.34 8.03 7.54 7.55 8.09 8.34 9.13e

Notes: e – estimate. Annual averages. Source: CEIC, BSP.

Instead of recognising the advantages of a weak REER both for exports and for poorer households with overseas workers, the authorities may remain complacent to a rising REER. Such a policy would once again deter savings. Fortunately, the economists in charge of public finance do not share the bias for a strong REER. They have publicly expressed their preference for a truly competitive peso and for lower interest rates, and their preference can keep the REER in its proper place. Nonetheless, the REER should be watched closely, since exports have been the main engine of growth in past years. A second potential threat to savings is the outlook for income. If the growth rate in GNP per capita does not rebound to positive territory in 1999, permanent income may slide. This would have a longer term negative impact on savings. Fortunately, the main factor that made GDP per capita decline in 1998 was the estimated 6.6 percent decline in the agriculture

© 2000 Institute of Southeast Asian Studies, Singapore

THE PHILIPPINES 41

FIGURE 2.1 Year-on-Year Growth in Savings plus Time Deposits, 1993–98 60.0%

50.0%

40.0%

30.0%

20.0%

10.0%

0.0% J M 1993

S

J M 1994

S

J M 1995

S

J M 1996

S

J M 1997

S

J M 1998

S

Source: CEIC.

sector, which was the worst performance in the post-war period. Agriculture experts expect a recovery to at least 3.0 percent growth for 1999. The economy, and hence income growth and savings, will still be vulnerable on two other fronts: weakening exports and continued inability of the banking system to consolidate and renew its lending activities. Of these two, the present study is only directly concerned with the latter. Nevertheless we can say that, although the growth rate of Philippine exports slowed in 1998, at 17 percent this rate was still the highest in the region by a wide margin. The outlook for the banking system’s ability to mobilise savings, on the other hand, depends on the success of recent reforms to strengthen the system and restore confidence on the part of savers. Evaluation of these reforms is the focus of the remainder of this chapter. ANALYSIS OF BANKING SYSTEM REFORMS

The banking sector dominates the financial system, accounting for 83 percent of its assets. A strong banking system is necessary in order to provide the institutional channel for robust savings growth. We examine how well the Philippine banking system serves the goal of mobilising savings in terms of the information and incentive relationships between

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

Issued 3/19/98 effective immediately

Issued 3/19/98 effective immediately

Issued 5/6/97 effective immediately

Minimum Capital Requirement Circular 156

Debt Securities/Marketable Equity Securities Circular 161

Exposure to the Real Estate Sector Circular Letter to all Commercial Banks

Issued 3/19/98 effective 12/98

• Limit on appraised value of real estate to secure loans reduced from 70% to not more than 60%

• All investments in debt and marketable equity securities governed by mark-to-market rules and regulations

• Raised minimum capital requirements for existing banks, newly authorized but not yet operating banks, or banks with complete but pending applications (see Table 2.5).

• All banks listed on the Philippine Stock Exchange required to disclose in their quarterly published Statement of Condition: (1) amount of non-performing loans and ratio to total loan portfolio; (2) amount of classified loans and other risk assets; (3) general loan-loss reserves; and (4) specific loan-loss reserves

• Increase access to information • Improve legal framework and judicial capability to expedite receivership/liquidation

Proposal

BANKS AND USERS OF FUNDS Disclosure of Quarterly Information Circular 157

• Insured deposits increased from P10,000 to P100,000 • Banks’ contribution increased from 1/12 of 1% of deposits to 1/5 of 1% of deposits

12/92

BANKS AND PROVIDERS OF FUNDS PDIC Compulsory Insurance Scheme

Summary of Reform

Date

Object of Reform

FIGURE 2.2 Summary of Banking System Reforms

Amendment to Resolution No. 477 4/28/97

Amendment to Manual of Regulations for Banks and Other Financial Intermediaries

Pursuant to Monetary Board (MB) Resolution No. 405 3/18/98

Tied to World Bank Financial Sector Loan Assistance

Compulsory insurance scheme instituted in 1969

Remarks

42 ABOLA, NERI AND SUPANGAN

© 2000 Institute of Southeast Asian Studies, Singapore

Issued 6/6/97 effective immediately

Guidelines Circular 130

ACCOUNTING, DISCLOSURE, AND LEGAL FRAMEWORK Stricter Classification of Past Due Issued 10/1/97 Loans effective Circular 143 immediately

Issued 5/27/97 effective immediately

• Classification of past due loans depends on the mode of payment and total outstanding loan balance. • Loans with monthly instalments require a minimum of 3 payments in arrears while loans with quarterly, biannual, and annual instalments require only 1 payment in arrears. • When amount in arrears reaches 20% of the outstanding balance of the loan/receivable, the total outstanding balance considered past due, regardless of the number of instalments in arrears.

• Guidelines on basic responsibilities and duties of the board of directors of banks/quasi-banks

• MB approval required before bank officers with rank of Senior Vice President and up can assume appointed positions

• Banks required to develop and implement a compliance system and to appoint/designate a compliance officer to oversee its implementation (see Circular 181 Annex A-2)

• Require banks to disclose to the public information on their aggregate exposure to DOSRI

Proposal

Issued 10/2/97 banks given two months to comply

• Loans to DOSRI borrowers from their banks limited to 50% of the market value of the stocks they would use to secure the loan

• Limit on real estate loans reduced to not more than 20% of total loan portfolio • Banks exceeding 20% given one year within which to comply

Summary of Reform

Issued 1/26/99 effective immediately

Date

Appointment of Officers Circular 129

SUPERVISORY REGIME Compliance System Circular 145

Connected-lending Circular Letter

Object of Reform

FIGURE 2.2 – continued

Pursuant to MB Resolution 1266 10/1/97

Pursuant to MB Resolution No. 491 4/30/97

Pursuant to MB Resolution No. 135 8/13/97

Remarks

THE PHILIPPINES 43

44 ABOLA, NERI AND SUPANGAN

banks and the providers of funds, the users of funds, and the supervisory regime. We also analyse the governing accounting, disclosure, and legal framework under which Philippine banks operate. Finally we evaluate the prospects for the system given the reform measures carried out since the onset of the Asian crisis. (Major reforms are summarised in Figure 2.2.) Banks and the Providers of Funds

Banks’ two main sources of funds are stockholders and depositors. Stockholders provide capital to banks and banks return dividends and enhanced asset value, as well as financial and other information. Depositors put their funds in banks in return for interest and for information that should enable them to assess the risk of forfeiting their capital and interest in the future. Here, we focus on the incentive system for depositors. Later on, we discuss stockholder incentives in conjunction with banks and the users of funds, since the amount of capital put in by stockholders affects banks’ risk-taking activities. The main policy issue affecting the relationship between banks and depositors is whether to insure depositors against losses in case of bank failure. The benefit to depositors of protecting their capital must be weighed against the potential adverse consequences of deposit insurance and guarantees for the banking system. When their deposits are insured, depositors have less incentive to monitor banks and take precautions against excessive risk-taking by banks. Thus, the existence of deposit insurance—whether implicit or explicit—may weaken the banking system. The Philippines has had a compulsory deposit insurance scheme since 1969 when depositors were insured up to P10,000 and banks were required to contribute 1/12 of 1 percent of deposits to the insurance scheme. After an intermediate increase in 1985, these amounts were further increased in 1992 to P100,000 and 1/5 of 1 percent of deposits, respectively. The insurer is a government corporate entity called the Philippine Deposit Insurance Corporation (PDIC). Given the system ’s fixed maximum level of insured deposits, the proportion of deposits covered by the scheme has slid naturally from 36.5 percent in 1992 to 19 percent in 1997. In addition to deposit insurance, central bank policies toward bank failure offer a kind of deposit guarantee. The BSP claims that it does not have an explicit “too-big-to-fail” policy, but certain of its policies that imply support from the BSP may encourage banks to take excessive risks. For example, a bank under receivership may resume operations within 90 days subject to approval and evaluation of the proposal to be submitted by

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the previous owners. A failed bank that voluntarily declares a bank holiday, on the other hand, may be reopened either through the infusion of capital by an investor, or with the assistance of the PDIC through the purchase of the bank’s assets (BSP 1998). The reopening of Banco Filipino mandated by the Supreme Court has opened the door for recklessness among Philippine banks. It could cause existing banks to take excessive risks given the good chance of their losing nothing should they become insolvent. Excessive risk-taking by Philippine banks was observed in the currency and financial crises both in the mid-1980s and in 1997. Given the adverse incentives inherent in deposit insurance schemes, the first-best option to strengthen the banking system might be to remove all forms of guarantee that could lead to moral hazard. Such a doctrine would imply scrapping the PDIC, which provides an explicit, though partial, guarantee of bank deposits. The complete elimination of deposit insurance is not appropriate for a number of reasons, however. First, excessive-risk taking by banks cannot be attributed solely to the presence of PDIC and implicit guarantees. Other factors such as connected lending and macroeconomic conditions may have been more important determinants of the lending boom in real estate and the excessive risk-taking by banks in both these episodes. Moreover eliminating deposit insurance completely is unrealistic considering the low level of development and limited economic literacy of the Philippines. A majority of Filipinos are small depositors who have very little understanding of their need or ability to monitor and assess the creditworthiness of banks. Correcting the externalities of underdevelopment justifies the existence of some form of guarantee to Philippine depositors. Indeed, despite its size and wealth, even the United States has retained a deposit insurance system to protect its economy from the negative consequences of bank runs (Goldstein and Turner 1996). Finally, the existing insurance system in the Philippines maintains a strong incentive to monitor, since depositors are only partially guaranteed. The PDIC argues that the “best protection for depositors is knowledge of the true condition of the banks through timely and accurate reports and disclosures” (Leung 1998). This position is counter to the interests of some players who sought to raise the maximum amount covered by deposit insurance, especially after the recent crisis. Conscious of the moral hazard problem, the PDIC is batting for reforms to (1) ensure greater access to information and (2) to improve the legal framework and judicial capability to expedite the receivership and liquidation processes. Legislative

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46 ABOLA, NERI AND SUPANGAN

changes are in the pipeline to address these needs. They are tied to a Financial Sector Assistance Loan granted by the World Bank. Banks and the Users of Funds

Banks are expected to lend to worthy borrowers capable of repaying loans and providing interest income to the bank. These transactions have to reflect the best use of the funds corresponding to the level of risk that the bank is willing to take. Widespread government involvement, connectedlending, and excessive risk-taking can distort banks ’ utilisation of funds, resulting in large losses and even collapse. Strengthening the banking system must involve reducing these practices. Government Involvement

A bank regulatory framework must preclude inappropriate government involvement in order to instil confidence among savers. Governments that intrude on bank operations to pursue political objectives or personal interests often bring about loss of profitability and efficiency (Goldsteinand Turner 1996). The recent Asian crisis revealed the problem of connected-lending involving high-ranking government officials and well-placed political figures throughout Asia. Painful lessons about government involvement learned in the financial crisis of the 1980s have made the Philippine banking system less prone to this potent contributor to banking crises. One indicator of this is that the participation of government-run financial institutions in the industry has decreased in since 1985. For instance, in 1985 two government financial institutions, the Development Bank of the Philippines (DBP) and the Philippine National Bank (PNB), together accounted for nearly one-half of national banking assets. As of end-1996, these two banks accounted for less than 20 percent of total bank assets. The Philippines initiated reforms to rehabilitate and privatise government financial institutions during the second half of the 1980s. PNB is already technically considered a private bank although its largest shareholder is still the government. The government retains control of the Land Bank of the Philippines (LBP) and the DBP in order to address some of the basic market failures that still exist in the banking system. These two banks through which funding by multilateral agencies is channeled now serve mainly as conduits of special credit programs for the agricultural and

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industrial sectors (Lamberte and Llanto 1995). There is some fear that crony capitalism may intensify once again under the current administration. Connected-lending

While political interference in credit decision-making has been reduced substantially, connected-lending continues to be prevalent among private entities.5 Many Philippine conglomerates still have their own banks and have encountered problems of loan concentration. This situation exists despite the long-standing limits on lending to directors, officers, stockholders, and related interests (DOSRI). The existence of interlocking directorates among large businesses may have stimulated the aggressive projects that contributed so significantly to the financial crisis and rendered the BSP unable to restrict the lending boom to speculative undertakings despite improvements in its supervision and examination powers after 1993 when it acquired a new charter. While privatisation and rationalisation of public banks helped improve the efficiency of savings mobilisation, to avoid discouraging long-term savings the Philippines needs to address the fragility caused by interlocking directorates and connected-lending in the private sector. One measure to strengthen the system against the consequences of connected-lending is to improve bank disclosure and transparency. If banks were required to disclose the percentage of DOSRI loans to total loans, then depositors could react appropriately to the risks of lending to related businesses. Expectation of depositors’ reaction might curb banks’ tendency to undertake aggressive risks simply because of connections with borrowers. The BSP is evaluating a proposal to require such disclosure. Increasing competition from foreign banks should also help strengthen the system against the problems resulting from connected-lending. Entry of foreign banks into the loan market should bring lower interest-rate spreads and innovative attempts to attract bank-affiliated, top-100 domestic corporations as loan customers. In this more competitive environment, local banks will have to stop rationing credit to non-affiliates and start lending to the “middle-market” firms that are not typically connected to domestic banks and their conglomerates. An added benefit is that competition with foreign banks will force local banks to offer more attractive rates to depositors and provide new value to their customers. Now that the macroeconomic environment is more conducive to competition than it was during the peso ’s unsustainable peg against the U.S. dollar, these reforms have a better chance of succeeding. 6

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48 ABOLA, NERI AND SUPANGAN

Excessive Risk-taking

Bank lending can present a problem where “the borrower has incentives to engage in activities that are undesirable from the lender ’s point of view because they make it less likely that the loan will be paid back ” (Mishkin 1997). Requiring bank owners to increase their equity is the typical means to counter this moral hazard problem. With a larger capital stake in the bank, the owners face higher costs if the bank fails and hence they are less likely to engage in high-risk undertakings. Capital Adequacy. The principle underlying capital adequacy requirements is similar to the rationale for general provisioning and specific loan-loss provisioning. Banks with inadequate capital have less cushion against rising bad debts and potential loan losses. Because financial environments are more volatile in developing countries than in developed countries, it seems imperative that developing countries adhere to higher or more conservative capitalisation standards. Currently, local Philippine banks have an informal agreement with the BSP to maintain a capital-to-risk-asset ratio of at least ten-percent at all times. Philippine banks deserve high marks compared to the rest of the region in terms of the bank capitalisation requirement. According to an informal survey conducted by the BSP in March 1998, bank capitalisation has remained consistently above 14 percent, despite the enduring effects of the financial crisis, with a conservative estimate of 0.24 capital-to-loans ratio for 1998. As of end-September 1998, commercial banks ’ average capital-to-risk-asset ratio stood at 15.8 percent which is 50 percent higher than the PDIC’s 10-percent statutory requirement (Merrill Lynch 1998). While Philippine banks are usually recognised for complying with and even far exceeding the Bank for International Settlements (BIS) capitalisation standards, these high capitalisation ratios may lead to a reversal of what was a favourable trend of declining market concentration in the domestic banking industry. Minimum Capital Requirement. Philippine banks ’ capital adequacy ratios are relatively high because since 1993, they have been required to submit quarterly reports on capitalisation to the BSP. The minimum capital requirement for banks has been steadily increased over time to bring stability to the banking system. For example, the minimum for universal banks has been increased three times from P500 million in 1980 to P4.56 billion in 1996 (to be met by 1999). The increase in the minimum capital requirement helped banks weather financial volatility and improved confidence in the system.

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Yet, despite admirable capital ratios, Philippine banks are still small in absolute size compared to their counterparts in the East Asia region. Of the 35 domestic commercial banks only 23 were among Asiaweek’s list of the 500 largest Asian banks in 1998 (Table 2.4). The average asset-size of these Philippine banks was only US$2.2 billion. The Philippines ranked along with Indonesia at the bottom in terms of the average assets of its largest banks. The BSP continued to push for higher capitalisation levels after the onset of the latest crisis. In March 1998, the BSP required an increase of 20 to 60 percent in minimum bank capitalisation, depending on the type of bank, from the prescribed end-1998 levels. The increase is to be completed in three tranches by end-December 2000 (Table 2.5). This move implies an additional capitalisation of around P24.5 billion or 8.1 percent of the total capital accounts of commercial banks alone as of 30 June 1998. New capital infused will be less than that amount to the extent that mergers or buyouts occur and profits are registered from the reference date. The higher minimum capitalisation requirement is expected to encourage mergers and consolidations among banks, which will foster stability in the banking system. It will enable banks to build a buffer against probable losses. Higher capitalisation is also expected to rationalise the industry by

TABLE 2.4 500 Largest Banks in East Asia, by Country Number of Banks in Top 500

Assets US$ billions

Assets/Bank

China Japan Hong Kong South Korea Singapore Taiwan Thailand Malaysia Indonesia Philippines Other countries

23 150 26 28 12 37 15 32 50 23 104

1,379 6,682 367 395 153 445 127 136 108 51 727

60.0 44.5 14.1 14.1 12.8 12.0 8.5 4.3 2.2 2.2 7.0

Total

500

10,570

21.1

Source: Asiaweek, 11 September 1998.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

4,500 2,000 250 40 20 10 5 3 2

200 40 20 10 5 3 2

12/24/98

3.9 2.6

6.5

26 13

325 52

4,950 2,400

12/31/99

4.8 3.2

8.0

32 16

400 64

5,400 2,800

12/31/00

Revised Requirements with Complianced by:

3,500 1,625

Note: 1/ Existing banks only. No new banks are allowed at present. Source: Bangko Sentral ng Pilipinas.

Expanded Commercial Banks Commercial Banks Thrift Banks Within Metro Manila Outside Metro Manila Rural Banks in: Metro Manila1/ Cities of Cebu and Davao 1/ Class 1–3 cities & Class 1 municipalities Class 4 –6 cities & Class 2–4 municipalities Class 5–6 municipalities

Requirements Until 12/24/98

TABLE 2.5 Minimum Capital Requirements by Type of Bank (Million Pesos)

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weeding out the weak banks and banks that are not financially viable. Moreover, by promoting joint ventures with foreign banks it will force domestic banks to become more globally competitive (BSP 1998). All told, this capital strengthening should improve the confidence of ordinary depositors in the banking system. The stability brought by raising capitalisation standards comes at some cost. Increasing capitalisation may sacrifice profitability, as it reduces the funds available for lending. Higher capitalisation also affects competitive forces since it usually means higher barriers for prospective entrants (Lamberte 1993). Fears that raising capital standards might sustain if not expand connected-lending and interlocking directorates, and thus prolong the effects of the financial crisis, complicate the textbook principle of its prudential benefits. The Philippines has put in place several measures other than capitalisation to reduce excessive risk-taking by banks. In May 1997, just before the outbreak of the crisis, it limited real estate loans to 20 percent or less of the loan portfolio. In June 1997 it raised the professional standards of bank officials and defined the duties and responsibilities of the board of directors. In March 1998 it adopted the mark-to-market rule for trading and equity portfolios to take effect in September 1998 (BSP Circular No. 161). Besides all these measures, banks may simply be required to list a greater percentage of their shares in the stock market in order to bring the discipline of the market to bear on their risk-taking decisions. A final measure to curb excessive risk-taking is to make loanprovisioning more stringent. More stringent loan provisions result in a more conservative asset valuation, which is transmitted to a conservative capital account. With this, the bank can place less money in risky assets, as discussed in detail below. Banks and the Supervisory Regime

The Philippines would not have suffered from the financial crisis if the level of supervision and examination were compatible with the high degree of capital adequacy and domestic financial liberalisation. Indeed, very few Asian countries would have passed the test for adequate supervision and examination, except probably Hong Kong and some would argue that even Hong Kong has not been able to avert the problem of asset inflation. Setting prudential norms and supervising compliance are complex tasks involving the accumulation and evaluation of information on complicated

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52 ABOLA, NERI AND SUPANGAN

transactions from institutions that may have an incentive to obfuscate their financial positions. They also require a stable and skilled cadre of experts in the public sector (Gavin and Haussman 1997). Recognising its limited resources to adequately supervise and regulate a highly open financial system, Malaysia decided to reverse its commitment to further capital account liberalisation. In contrast, government officials in the Philippines seem committed to retaining an open capital account and they have focused on the difficult task of bringing levels of supervision and examination up to international standards (Figure 2.3). 7 The limited extent of government involvement in the Philippine banking system and the high degree of independence of the BSP do not prevent pressure on bank supervisors for regulatory forbearance. Supervisors and examiners are not immune to lawsuits. For instance, officials of Orient Bank—the sole commercial bank closed since the start of the Asian financial crisis—filed a suit against BSP officials. Furthermore, it seems

FIGURE 2.3 Highlights of the (Proposed) Revised General Banking Act • Authorizes BSP to supervise quasi-banks, trust entities, and other financial institutions • Requires assessment of bank’s ownership structure, directors and senior management, operating plan, internal controls, projected financial condition and capital base for bank licensing • Reduces minimum Filipino ownership of new banks to 60% from 70% • Limits total foreign equity in a bank to 60% of total voting stock • Allows bank holding corporations to own up to 100% of the equity in banks but limits their investing to only the extent and the enterprises allowed to the investee bank • Gives MB authority to review and reject proposals to transfer significant ownership or controlling interest in existing banks to other parties • Permits MB to exempt voting stockholdings in banks from the application of prescribed ceilings on stockholdings in banks • Permits MB to remove or suspend a duly elected or appointed bank director or officer • Permits MB to authorize foreign banks to acquire up to 100% of a distressed bank • Establishes MB criteria for reviewing major acquisitions or investments by a bank • Extends DOSRI limitation to cover bank exposure in general • Has MB require banks to have a system for accurately measuring and monitoring market risks • Restrains owners of banks placed under receivership from doing business on behalf of the bank or from causing any more dissipation of bank assets • Empowers BSP to obtain more information, data, and statistics about global financial markets and the global operations of banks operating in the country

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to be widely accepted that while the Philippines has adequate regulations on the books, supervision and examination standards are not implemented uniformly and efficiently in the interests of bank depositors and savers. Neither the imposition of corrective measures nor the prompt closure of insolvent banks can be carried out efficiently in the Philippines because of the clout of domestic banks. Restrictions on bank behavior typically face strong reaction from the Bankers Association of the Philippines (BAP). Indicative of this strength is the fact that whenever the BSP has lowered bank reserve requirements at the same time it has aggressively “mopped up” liquidity through open market operations. 8 How can the BSP force banks to close down if it actually implements policies that encourage them to increase leverage? All in all, however, it can be said that the Philippines has sound prudential rules that are above average compared to the rest of the region. Supervisory procedures in the Philippines, which include reporting requirements and examination, are regular, comprehensive, and thorough (Nascimento 1991). For instance, the reporting system covers every item on banks’ balance sheets, and information such as credit to DOSRI is even reported daily. Bank examiners are tasked with examining all books, documents, papers, records, cash, and available assets to ascertain the financial condition of banks, their subsidiaries, and affiliates (BSP 1998). On-site examinations and inspections patterned after the U.S. system focus on the quality of bank assets, which are classified accordingly (Nascimento 1991). The BSP has been augmenting manpower resources in its supervisory department and has mandated the setting up of a compliance system within banks, supervised by a compliance supervisor. Supervisory staff undergo continuous training and they co-ordinate closely with their regional counterparts regarding new demands generated by developments in international banking. Bank examinations are conducted on a consolidated basis (i.e., head office, branches, and financial subsidiaries and affiliates) to assess the financial condition of the bank in its entirety. One area that needs improvement is off-site examinations (Box 2.1). The BSP’s operational arm for bank supervision and examination —the Supervisory Reports and Special Studies Office of the Supervision and Examination Section—has over emphasised on-site supervision (Intal and Llanto 1998). Besides, the BSP is seeking the revision of the General Banking Act to provide for (1) more inspection and punitive powers for BSP, (2) more freedom for banks to hold non-allied investments, and (3) the implementation of a BIS –style capital ratio.

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54 ABOLA, NERI AND SUPANGAN

Nevertheless, while the wish list of desirable reforms may be long, it must be kept in mind that the information and expertise available to regulators are limited. Proponents of applying the ‘best practice’ in supervision need to be realistic. No country has been able to reform bank supervision and examination sufficiently before reaching a certain level of development. Accounting, Disclosure, and Legal Framework

Proper accounting standards require strict asset classification and adequate provisioning practices and disclosure of relevant information, while the legal infrastructure must enable economic agents (banks, depositors, creditors, and regulators) to carry out their roles effectively. Assessment of Asset Quality

Philippine banks’ aggressive lending to the property and stock markets and other undertakings that neither earned nor saved dollars showed the weakness in their assessment of risk. Bank lending in these markets rose sharply in the few years before the crisis, although as a late starter, the Philippines never reached the top of the region ’s list of overexposure in these sectors. Some observers argue that the Philippines would have been less exposed to the crisis if reporting on asset quality had met international standards. Others dismiss this criticism as hindsight because it was rarely voiced even well into the speculative boom in securities and property markets, which started as early as 1994. The BSP did not monitor asset quality in terms of exposure by sector or industry; it did not review loan allocations of banks to the real estate sector until 1996. Only when Thailand began to show vulnerability to capital reversals, did the BSP specially survey banks about their exposure to the real estate sector. But the BSP was not solely to blame. Since no other central bank in Southeast Asia found the urgency to monitor real estate exposure, the Philippine Monetary Board (MB) also saw no need at that time to conduct these expensive surveys. A large real estate loan portfolio seemed perfectly natural, given the huge profits that were made in property investing during the boom years of 1994 to 1997. Another weakness of the regulatory framework is the loose rules on loan and deposit classification. Although the law caps bank lending to certain sectors, bank management has considerable discretion in classifying loans (Folkerts-Landau 1995). The practice of window-dressing by logging

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regular liabilities under the contingent liability account is rampant. Some banks are also able to evade ceilings on lending to certain sectors (e.g., real estate) by selling loans to other banks or to trust funds (Gochoco-Bautista 1998). Until October 1997, demand loans were considered past due if payment was not received within six months of a written demand. For loans payable in instalments, the determining factor was the number of payments in arrears, which varied with the repayment schedule of the loan (monthly, quarterly, semi-annually, or annually). 9 In practice, banks differed considerably in their treatment of overdue loans (Folkerts-Landau 1995). Conservatively managed banks generally placed loans on a non-accrual status more promptly than the BSP schedule, not necessarily out of conservatism but in order to avoid the tax on gross revenues; other banks followed looser practices, especially as they began facing financial distress (Nascimento 1991). Thus, while some banks always maintained safety and prudence, other banks ignored elementary norms of prudence. Classification System. The Philippines was one of the earliest in the region to adopt a prudential classification system for loans and deposits. Banks are required to classify their loans into “Special Mention”, “Substandard”, “Doubtful”, or “Loss” categories and to provide valuation reserves in accordance with BSP rules and regulations. The BSP confirms the classification and the adequacy of valuation reserves during on-site examinations (BSP 1998). The BSP updated the classification system after the crisis broke out. From April 1998 the window for past due loans was shortened to three months (see note 1). Real estate held for less than five years is classified as substandard for purposes of provisioning. For real estate held more than 5 years, the loss provision requirement increases by 10 percent each year held, so that property held 10 or more years carries a reserve requirement of 50 percent. Similar rules apply to personal property acquired except that the cut-off holding period is three years. Portions of the law still have to be updated to account for technological and financial innovations and for institutional changes. Also, the system of annual reviews conducted by bank supervisors is deficient for prudential purposes. Loan-Loss Provisions and Reserves. Both general provisions and specific provisions for loan-losses provide a buffer to protect depositors from the risk of default created by the doubtful accounts of bank borrowers. The BSP required banks to make allowances for specific loan accounts and also to set aside a general provision for loan losses not linked to individually identified uncollectable accounts (2 percent of the gross loan portfolio, net

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of interbank loans that are considered non-risk under existing regulations). These provisioning requirements for Philippine banks are in line with the requirements of the World Bank (Table 2.6). Observers have noticed that actual write-offs of local banks have not kept pace with the rate of default declaration, and this may add to the difficulties of some mid-sized banks in meeting the increased minimum capital requirement (Table 2.5). As might be expected the deficiency in provisioning is even greater for dollar loans. But considering that levels of provisioning in the Philippines are on a par with those in the rest of the region, Philippine banks are in comparatively better shape. The fact that it requires provisioning for secured non-performing loans suggests the somewhat greater conservatism of the Philippines compared to the other crisis-hit countries. Legal Framework

The least that a government can do for savers is to assure that the rights of depositors, creditors, and borrowers are well enforced. Without such

TABLE 2.6 Loan-Loss Provisioning Requirements of the BSP and the World Bank (Percent) BSP1/ Loan Classification General3/ Standard Unclassified Classified Special mention3/ Substandard Collateralised3/ Uncollateralised Doubtful Loss

Before 12/31/98

Effective 12/31/98

Effective 4/15/99

World Bank2/

— — —

— — —

2 — —

— 1 —

0

2.6

0 25 50 100

12.5 25 50 100

5.0 25 25 50 100

— 20 — 50 100

Notes: 1/ Allowance for bad loans as a percent of total amount of loans. 2/ Allowance for bad assets as a percent of outstanding balance. 3/ Full compliance required by 1999. Source: Bangko Sentral ng Pilipinas, World Bank.

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credibility, instability in the financial system could cause dis-saving. Indeed, one of the main components the World Bank deemed indispensable to an international institutional framework is that governments avoid legislative or administrative action that stands in the way of the basic functioning and enforceability of financial contracts (Honohan and Vittas 1996). The Philippine legal-regulatory framework undermines confidence in the banking system on two fronts. On one hand, it does not sufficiently protect the rights of creditors (banks). At the same time, it overly protects banks from the negative consequences of their own mistakes. The system’s deficiency in protecting the rights of creditors has several aspects. Inadequate Protection of Creditors’ Rights. A recent World Bank study (Alba, Claessens, et al. 1998) found that the Philippines and Indonesia are exceptions to the general rule that judicial enforcement of property rights is stronger in Asia than in Latin America. The Philippine Civil Code favours foreclosure over rehabilitation. When debtors default, the Civil Code provides for the enforcement of creditors’ contractual rights through foreclosure. At the same time, banks may actually be encouraged to hide bad accounts rather than pursue foreclosure because the creditor is required to pay transfer and documentary stamp taxes immediately, even if there is a good chance that it might lose the default case. Moreover, the law requires that banks hold the foreclosed assets in question for one year, since debtors have the legal right to work on repayment and asset recovery within that time. Limited Room for Restructuring. The narrow range of securities available in the Philippines also explains why debt restructuring is prone to foreclosure. The fact that some types of assets, such as inventories and receivables, are not commonly collateralised limits the options of banks to rehabilitate distressed borrowers. (This is also a major constraint on small and medium-sized enterprises in obtaining bank loans.) Creditors are not encouraged to take charge of assets because they cannot continue the operations of the debtor enterprise. If it is not possible to reach an agreement on debt restructuring in cases of default, the lender ’s only option is to foreclose. Therefore, illiquid but viable companies may be subject to cannibalisation. Foreclosure of Insolvent Firms . The procedures for foreclosure of insolvent firms are deficient and hamper banks in resolving claims. Although legally empowered, the Securities and Exchange Commission (SEC) has had no general framework for approving suspension of loan payments and it has limited institutional capacity to resolve cases involving illiquid or insolvent companies rapidly.

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Forbearance Problem The legal and regulatory systems create a moral hazard problem by giving banks too much leeway to rehabilitate their balance sheets, even to the detriment of depositors. The weak judicial system means that the process of bank closure is protracted. 10 Savers can have more faith in the banking system if the legal system ensures that borrowers cannot escape their obligations to banks and that banks cannot escape their obligations to depositors. The Philippines needs to revise its legal and regulatory framework with these objectives in mind. A dedicated bankruptcy court should be established to absorb the quasijudicial functions of the SEC. The policy framework and institutional structure for loan payment suspensions must be strengthened in order to protect the contractual rights of creditors and to promptly resolve liquidity and solvency problems, as well as to encourage orderly debt workouts for entities experiencing financial distress (Lim and Woodruff 1998). Information Disclosure, Accounting, and Auditing Standards

Accounting and auditing standards in the Philippines are considered to be on a par with those in the rest of the region (Merrill Lynch 1998). Local banks adhere generally to the accepted accounting and auditing standards and provide information reflecting their true financial condition (Lamberte and Llanto 1995). The disclosure statements for audited annual accounts required of banks are consistent with International Accounting Standard No. 30, Disclosures in the Financial Statements of Banks and Similar Financial Institutions. Banks are required to publish the names and designations of the members of the Board of Directors, President, Executive Vice Presidents, and Senior Vice Presidents in a quarterly un-audited Statement of Condition. Generally speaking accounting and financial information is quite sufficient for sorting out healthy and unhealthy banks. Accounting Standards and Audits. Philippine accounting standards are based fundamentally on the United States’ Generally Accepted Accounting Principles (USGAAP). However, updates since the early 1990s have been based on the slightly less stringent framework of the International Accounting Standards Committee (IASC). It is desirable to return to closer adherence to USGAAP. The Board of Accountancy publishes an official gazette to update practitioners on changes in standards. Meanwhile, the Accounting Standards Council (ASC) drafts accounting standards for the SEC. The Philippines probably has the most certified public accountants (CPAs) per capita in the region. Latest estimates place the number of

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accountants in the Philippines at about 80,000. But some studies (Alba, Battcharhaya, et al. 1998) have found that the manpower requirements for the accounting and auditing profession are still not adequately met. Umbrella groups of accounting professionals are not sufficiently organised and do not follow the ethical standards necessary to pass for an internationalised financial system. For instance, the Board of Accountancy, which is the body responsible for the supervision of accountants, has yet to exercise its power to suspend or revoke charters, despite numerous reported cases related to lack of professionalism. It is even rarer for creditors or investors to seek legal action against auditors. Despite a long history of self-regulation in the accounting and auditing profession, there is room for improvement. Quality of Information and Sanctions. Despite the overall good quality of financial information in the Philippines, there is a consensus among users that financial statements do not provide enough data on bank loan portfolios, especially on delinquencies, problem assets, foreign exchange position, off-balance sheet commitments, and other risk areas. Also, auditors in the Philippines have limited power to examine company records and depend heavily on clients to provide the necessary information. Clients who supply incorrect information face no penalty. In addition, the use of dummy and multiple accounts is prevalent (Gochoco-Bautista 1998). Relevant information on banks ’ real estate exposure in this latest boom came too late for authorities to be able to step in to avert a crisis. Smaller Philippine banks also have been poor in filing annual financial statements required by the regulatory bodies. The penalty for not submitting financial statements to the SEC and other governing bodies is too light to encourage compliance. The lack of key data caused by banks ’ failure to file may hamper analysis of credit risk. This could be aggravated by the absence of a credible credit rating agency in the Philippines. The effectiveness of the sole credit rating agency, the CIBI has been called to question by a recent Asian Development Bank study (ADB 1997). Overall Assessment

Overall, the Philippine banking system does provide the proper incentives for the relationship between banks and their sources of funds (mainly depositors). A stronger system requires maintaining a relatively low limit on deposits covered by insurance. This insurance is meant to address the market failure among the segment of depositors who are unlikely to know or understand the risks of different banks based on typical disclosure of information. The rest of depositors are better protected by improved

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60 ABOLA, NERI AND SUPANGAN

disclosure requirements than by more extensive deposit insurance. The Philippine system of implicit and explicit guarantees appears well designed to support stability. As far as the relationship between banks and the users of funds, the Philippine banking system appears to have overcome earlier problems with government involvement in lending decisions. Also, it has implemented stringent regulations on connected-lending in the private sector since the mid-1980s. Although these regulations could be tightened further, stronger surveillance is a greater need than tighter policy. Finally, incentives for excessive risk-taking by banks have been curbed through higher minimum capital requirements, higher capital adequacy ratios, limits on property loans, mark-to-market valuations, more stringent criteria for asset classifications, higher loan-loss provisioning, and reduced incentives for foreign loans, among other things. Most of these measures have been in place since 1997 and should be viewed as making a net positive contribution to bank stability. Insofar as supervision (auditing, monitoring, early intervention capability) is concerned, new supervision methodologies have been introduced that emphasise matters other than simply portfolio quality, such as risk management capacity, funding vulnerabilities, and systems that assure asset quality. Again, the policies are in place and the supervisory staff is undergoing training. The loopholes that have to be addressed by legislation are to increase the authority of supervisors and provide for their protection from legal action. Overall, supervisory reforms have, at the very least, had a neutral effect on bank stability in the Philippines. There is still a lot of room for improvement in the legal framework, particularly in failure resolution, the receivership-liquidation process, accounting and disclosure standards, and severity and effectiveness of sanctions for violations. Many of these matters require legislative action, which will take some time to accomplish. The authorities appear to recognise what needs to be done, but they will not be able to fully address all these issues in the next couple of years. Hence, deficiencies in the legal framework may remain a sword of Damocles that threatens the continued health of the banking system. On balance, there is reason to believe that the reforms put in place so far will strengthen the banking system and should encourage savers to have greater confidence in the system up to the medium-term. The weaknesses of the legal-accounting framework and supervisory capability must be addressed more diligently, if the positive impact of the other measures is not to wear off over the longer time horizon.

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THE PHILIPPINES 61

APPENDIX 2.1 SUMMARY OF LOGIT AND REGRESSION ANALYSES OF BANKING CRISES LOGIT analysis of Banking Crises, 1981–98

BC = 0.539 INFL – 0.825 RR(–1) + 20.608 CUM1 – 0.561 GNPGR(–2) (1.75) (–1.62) (1.42) (–1.83) Log likelihood = –6.194 where

BC

= 1 if banking crisis 0 otherwise INFL = inflation rate RR(–1) = reserve requirement ratio (lagged one year) CUM1 = ratio of currency to money supply (M1) GNPGR(–2) = annual growth rate of real GNP (lagged two years)

Least-Squares Regression Estimates of Non-performing Loan Ratio, 1981–98

NPL = 16.624 – 0.658 GNPGR + 0.753 NPL( –1) – 0.581 RR(–1) (5.00) (–7.18) (11.38) (–3.72) Adj R2 = 0.93 where

SEE = 1.59

F = 79.04

DH = –0.98

NPL

= non-performing loan ratio (non-performing loans as % of total loans) GNPGR = annual growth rate of real GNP NPL(–1) = non-performing loan ratio (lagged one year) RR(–1) = reserve requirement ratio (lagged one year) Forecast Values of Independent Variables

INFL CUM1 RR GNPGR

1998

1999

2000

8.9 0.51 16.33 0.1

7.5 0.50 16.00 2.8

6.0 0.48 15.00 5.0

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62 ABOLA, NERI AND SUPANGAN

APPENDIX 2.2 ECONOMETRIC MODEL OF HOUSEHOLD SAVINGS FOR THE PHILIPPINES

The ordinary least squares regression results below are the best estimates for our model of annual household savings rates based on time series data for the Philippines for the period 1980 –96.11 (1) SAVHH = –273.675 + 0.00498 PCY(–1) + 0.480 GNPGR t-values (–8.17) (3.916) (3.002) + 383.372 DRATIO – 0.299 REER (7.882) (–3.370) Adj R2 = 0.833 SEE = 2.357 F = 21.03

DW = 1.606

(2) SAVHH = 275.13 + 0.00575 PCY5 + 0.00489 PCYTRANS t values (8.12) (2.40) (4.057) + 383.372 DRATIO – 0.309 REER (6.614) (3.196) Adj R2 = 0.83 SEE= 2.378 F = 20.61

DW = 1.53

where: SAVHH PCY (–1) GNPGR DRATIO

= = = =

Households savings as % of GDP Per capita GDP lagged one year Growth rate of GNP (% per year) Dependency Ratio (total population – employed)/total population REER = Real Effective Exchange Rate Index (1980 = 100) PCY5 = Average per capita GDP last 5 years (measure of permanent income) PCYTRANS = Transitory per capita GDP (actual PCY – PCY5) Notes 1

The classification of past due loans depends on (1) the mode of payment and (2) the total outstanding loan balance. Monthly payments require a minimum of three months of installment in arrears while quarterly,

© 2000 Institute of Southeast Asian Studies, Singapore

THE PHILIPPINES 63

2

3

4

5

6

semestral and annual payments require only one installment in arrears. However, when the total amount in arrears reaches twenty percent of the total outstanding balance of the loan/receivable, the total outstanding balance of the loan/receivable shall be considered as past due, regardless of the number of installment in arrears. (Bangko Sentral ng Pilipinas Circular No. 143.) We used the maximum likelihood estimation (MLE) method, which is asymptotically normal and has desirable asymptotic properties. The logit model by definition contains a heteroskedastic error term, and although the MLE does not correct for it, MLE is a consistent estimator. Given that the independent variables do not use grouped data, no estimate of the variance for each observation could be obtained, and so the weighted least squares method could not be applied. See Pyndick and Rubinfeld (1998), pp. 309, 313. The results should be taken with some reservations because the sample size is quite small (n=18) and MLE estimation requires a large sample size to assume normality. M4 is M3 plus the peso-equivalent of residents’ deposits in the foreign currency deposit units (FCDU) of banks. The latter are not usually considered as part of domestic monetary aggregates. Ownership of the Philippine corporate sector is highly concentrated. The same groups that own and control major parts of the manufacturing and services sectors also control most of the major banks. Sixty to 90 percent of most publicly listed companies is owned by the top 20 stockholders, with the top 5 shareholders owning more than 50 percent. In addition, cross-shareholdings is extensive. The highly concentrated ownership and the tight linkage between the corporate and banking sectors have led to a significant concentration of loans outstanding. For instance, the top 100 corporate borrowers in the Philippines account for $10.7 billion or 30 percent of loans outstanding from the banking system (Lim and Woodruff 1998). Skeptics question the validity of this strategy, since entry liberalization in 1994 did not lead to significantly more competition from foreign banks despite their growing share in total loans (Abola 1998). We believe that foreign banks were kept from competing head-on with local banks by such factors as macroeconomic policy. In particular, the strategy of the monetary authorities to combine an exchange rate peg with a fairly open capital account policy may have limited competition. The virtual currency peg encouraged foreign banks to source (dollar) funds from their offices abroad and place them in risk-free government

© 2000 Institute of Southeast Asian Studies, Singapore

64 ABOLA, NERI AND SUPANGAN

7

8

9 10

11

securities such as T-bills. Increasing the allocation of deposits to “risk– free” government securities instead of to speculative real estate loans (even if they yielded very high returns) seemed to make more sense on the basis of an asset portfolio strategy (e.g., risk-return tradeoff). Assuming the monetary authorities avoid these macroeconomic policy mistakes in the future, foreign banks should become more competitive. The new element of exchange rate risk will likely encourage foreign banks to reallocate their funds out of government securities and other money market funds into loans, which will generate greater interest spreads. This will surely discourage most banks to fund their loans from dollar liabilities. Although the BSP has been using the Basle standard for monitoring banks since 1993, a law requiring the standards has yet to be enacted. The Revised General Banking Act (GBA) proposed by the BSP includes this provision. (The major proposed revisions to the GBA are highlighted in Figure 2.3.) This implies that the BSP would rather lower reserve requirements than accommodate capital inflows. This, in turn, fuels a lending boom, which we have tagged as a main determinant of banking crises (DKD 1998). Refer to note 1. “When a bank faces protracted liquidity or solvency problems, the MB may appoint a conservator in order to protect depositors and other creditors. If the conservator is unable to restore the viability of the bank, the bank is declared insolvent. The MB then appoints a receiver to take charge of all assets and liabilities of the bank, and forbids the bank from doing business. Within 60 days, the MB decides whether to liquidate the bank or to recognize it to permit the resumption of business. In the former case, CBP appoints a liquidator to carry out the decision, provided no court challenges the decision ” (Nascimento 1991). The model and results are discussed in more detail in Abola 1999. The downward trend in the simple dependency ratio during the period of analysis may explain the unexpected positive sign on DRATIO.

References

Abola, Victor A. 1998. “Bank Liberalization Since 1994: Boon or Bane?” CRC Economic Policy Papers No. 6. Pasig, Metro Manila: Center for Research and Communication Foundation, Inc.

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THE PHILIPPINES 65

______. 1999. “Evolution of the Philippine Financial System ”. In East Asia’s Financial Systems: Evolution and Crisis , ed. S. Masuyama, S.Y. Chia, and D. Vandenbrink. Singapore: ISEAS and Nomura Research Institute. ADB Institute-ASEAN Economic Forum on Current Asian Financial Developments. 1998. Executive Summary. InAsia: Responding to Crisis. Tokyo: Asian Development Bank Institute. ADB Institute-IFMP Workshop on Current Financial Developments in East Asia (APEC Round). 1998. Executive Summary. In Asia: Responding to Crisis. Tokyo: Asian Development Bank Institute. Alba, Pedro, Amar Bhattacharya, et al. 1998. “Volatility and Contagion in a Financially Integrated World: Lessons from East Asia ’s Recent Experience.” Policy Research Working Paper 2008. Washington, D.C.: The World Bank. ______, Stijn Claessens, and Simeon Djankov. 1998.“Thailand’s Corporate Financing and Governance Structures: Impact on Firms ’ Competitiveness”. Policy Research Working Paper 2003. Washington, D.C.: The World Bank. May. Antonio, Emilio, Emilio Neri, Jr,. and Teresa Taningco. 1998. “Capital Inflows and the Philippine Economy: Issues and Policy Options ”. In Coping with Capital Flows in East Asia, ed.C.H. Kwan, S.Y. Chia, and D. Vandenbrink. Singapore: Institute for Southeast Asian Studies and Nomura Research Institute. Asian Development Bank. 1997. “Promoting Financial and Capital Market Development: Voluntary Principles and Collaborative Initiatives ”. Background paper for the Fourth APEC Finance Ministers Meeting, Kuala Lumput, 4–6 April. Bangko Sentral ng Pilipinas (BSP). 1998. “The Philippines: Onward to Recovery”. Manila: Bangko Sentral ng Pilipinas. July. Bandiera, Oriana, Gerard Caprio, Jr., and Fabio Schiantarelli. 1998.“Does Financial Reform Raise or Reduce Savings?” Boston College, September. Unpublished manuscript. Berg, Andrew, and Catherine Pattillo. 1998. “Are Currency Crises Predictable? A Test”. Working Paper WP/98/154. Washington, D.C.: International Monetary Fund. November. Caprio, Gerard Jr. 1998. “Banking on Crises: Expensive Lessons from Recent Financial Crises ”. Policy Research Working Paper 1979. Washington, D.C.: The World Bank. June. ______ and Daniela Klingebiel. 1997. “Bank Insolvency: Bad Luck, Bad Policy, or Bad Banking? ” In Annual World Bank Conference on

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66 ABOLA, NERI AND SUPANGAN

Development Economics 1996, ed. Michael Bruno and Boris Pleskovic. Washington, D.C.: The World Bank. Coronado, Julia Lynn. 1997. “The Effects of Social Security Privatization on Household Saving: Evidence form the Chilean Experience”. Finance and Economics Discussion Series 1998 –12. Washington, D.C.: Board of Governors of the Federal Reserve. February. Demirguc-Kunt, Asli and Enrica Detragiache. 1998.“The Determinants of Banking Crises in Developing and Developed Countries ”. IMF Staff Papers 45, no. 1 (March): 81 –107. Folkerts-Landau, D. et al. 1995. “Effect of Capital Flows on the Domestic Financial Sectors in APEC Developing Countries”. In Capital Flows in the APEC Region, ed. M.S. Khan and C.M. Reinhart. Occasional Paper 122. Washington, D.C.: International Monetary Fund. Gavin, Michael and Ricardo Haussmann. 1997.“Make or Buy? Approaches to Financial Market Integration ”. Working Paper 337. Washington, D.C.: Inter-American Development Bank. ______, Ricardo Haussmann, and Ernesto Talvi. 1997. “Saving Behavior in Latin America: Overview and Policy Issues ”. Working Paper 346. Washington, D.C.: Inter-American Development Bank. May. Gavin, Michael, Ricardo Haussmann, and Leonardo Leiderman. 1995. “The Macroeconomics of Capital Flows to Latin America: Experience and Policy Issues ”. Working Paper 310. Washington, D.C.: InterAmerican Development Bank. October. Gochoco-Bautista, Maria Socorro. 1998. “Prospects and Adjustment Imperatives for Philippine Capital Markets”. Background Paper Series No. 12. Pasig, Metro Manila: National Economic and Development Authority. February. Goldstein, Morris and Philip Turner. 1996. “Banking Crises in Emerging Economies: Origins and Policy Options ”. BIS Economic Papers No. 46. Basle: Bank for International Settlements (BIS). October. Hardy, Daniel C. and Ceyla Pazarbasioglu. 1998. “Leading Indicators of Banking Crises—Was Asia Different? ” Working Paper WP/98/91. Washington, D.C.: International Monetary Fund. June. Gibsonk Scott. 1996. Philippine Banking Sector Review. Manila: Hoare Gorett (HG) Asia, Philippines, Inc. 4 Dec. Honahan, Patrick and Dimitri Vittas. 1996. “Bank Regulation and the Network Paradigm: Policy Implications for Developing and Transition Economies”. Policy Research Working Paper 1631. Washington, D.C.: The World Bank.

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Intal, Ponciano S. Jr. and Gilberto M. Llanto. 1998. “Financial Reform and Development in the Philippines, 1980 –1997: Imperatives, Performance and Challenges”. PIDS Discussion Paper Series No. 9802. Manila: Philippine Institute for Development Studies (PIDS). January. Kaminsky, Graciela L. 1998. “Currency and Banking Crises: The Early Warnings of Distress ”. International Finance Discussion Papers No. 629. Washington, D.C.: Board of Governors of the Federal Reserve System. October. ______ and Carmen M. Reinhart. 1996. “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems ”. International Finance Discussion Papers No. 544. Washington, D.C.: Board of Governors of the Federal Reserve System. March. Khan, Mohsin S. and Carmen M. Reinhart, eds. 1995.Capital Flows in the APEC Region. Occasional Paper 122. Washington, D.C.: International Monetary Fund. March. Lamberte, M. 1993. “Assessment of Financial Market Reforms in the Philippines, 1980–1992”. Journal of Philippine Development 20, no. 2 (Second Semester): 231–59. ______ and G. Llanto. 1995. “A Study of Financial Sector Policies: The Philippine Case”. In Financial Sector Development in Asia: Country Studies, ed. S.N. Zahid. Manila: Asian Development Bank. Leung, Ernest. 1998. “Bank Deposit Insurance System in the Philippines”. Paper presented at the Federal Deposit Insurance Corporation International Conference on Deposit Insurance, Workshop on Structuring a Deposit Insurance System. Washington, D.C., 11 September. Levine, Ross. 1996. “Foreign Banks, Financial Development, and Economic Growth”. In International Financial Markets, ed. Claude E Barfield. Washington, D.C.: AEI Press. Lim, Cheng Hoon and Charles Woodruff. 1998. “Managing Corporate Distress in the Philippines—Some Policy Recommendations”. Working Paper WP/98/138. Washington, D.C.: International Monetary Fund. Mishkin, Frederic S. 1997. “Understanding Financial Crises: A Developing Country Perspective”. In Annual World Bank Conference on Development Economics 1996, ed. Michael Bruno and Boris Pleskovic. Washington, D.C.: The World Bank. Moreno, Ramon, Gloria Pasadilla, and Eli Remolona. 1998. “Asia’s Financial Crisis: Lessons and Policy Responses ”. In Asia: Responding to Crisis. Tokyo: Asian Development Bank Institute.

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68 ABOLA, NERI AND SUPANGAN

Nascimento, J.C. 1991. “Crisis in the Financial Sector and the Authorities’ Reaction: The Philippines”. In Banking Crises: Cases and Issues, ed. V. Sundararajan, V. and T. Balino. Washington, D.C.: International Monetary Fund. Pindyck, R.S. and D. L. Rubinfeld. 1998. Econometric Models and Economic Forecasts. Boston: McGraw-Hill. Yap, Josef T. 1998. “Developing an Early Warning System for BOP and Financial Crises: The Case of the Philippines ”. Paper presented at the Sixth Convention of the East Asian Economic Association, Kitakyushu, Japan, 4–5 September.

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THAILAND 69

3 Corporate Governance in Thailand From Crisis to Recovery Deunden Nikomborirak and Somkiat Tangkitvanich INTRODUCTION

Besides cronyism, corruption, and nepotism, the fall of the East Asian economies has been ascribed to “bad corporate governance ”. One cannot help but wonder whether the issue of governance is only a convenient scapegoat for the unexpected collapse of the once dynamic East Asian economies, or whether it is in fact a serious underlying defect of the economy that is only recently exposed because of economic malaise. Until the crisis, corporate governance was a rather unfamiliar issue in Thailand. Even now, there is no single Thai word that properly conveys the idea of “governance”. There are at least three versions in use at the moment. To be able to deal with the issue of corporate governance, it is necessary first to define what we mean by the term. Corporate governance is the responsibility that directors and managers have to a company’s other stakeholders, including shareholders, creditors, employees, the government, the society-at-large, the environment, and consumers. Managers are responsible for conducting the business in a way that maximises value to owners or shareholders; directors are responsible for monitoring that managers do so. Both are jointly responsible for servicing debt, ensuring the well-being of employees, providing reliable services to customers, and taking responsibility in environmental concerns. Balancing responsibilities to these diverse groups can be complicated indeed.

© 2000 Institute of Southeast Asian Studies, Singapore

70 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

CORPORATE GOVERNANCE AND THE CRISIS

The East Asian crisis has been attributed, in part, to bad corporate governance which includes reckless lending by commercial banks, risky investment by managers, expropriation of company funds by directors, managers, and large shareholders, shady business deals, and poor audits. It would be far-fetched to attribute this crisis to bad corporate governance per se, but weaknesses in governance certainly rendered the Thai economy more vulnerable to imbalances. The bubble in the real estate and property sector would not have been as large if banks and finance and securities companies had been more cautious about their lending. The Bank of Thailand and the Stock Exchange of Thailand would have been better able to implement timely corrective measures had financial accounting and auditing properly exposed the dire financial straits of most banks and companies. But it is moot to talk about what could have happened. What is more interesting is that fact that all of a sudden the Thai economy is shouldering the cost of inherent weaknesses in its corporate governance. Fire sales of leasing businesses taken over from the finance companies that were closed in the midst of the crisis are fetching only 25–30 percent of their face value due to unreliable accounting.1 Poor accounting also poses a major obstacle to the on-going debt restructuring process. Unreliable financial data have created distrust among creditors and debtors. Lack of transparent management, weak internal corporate control, and lack of effective monitoring also made foreign investors hesitant to buy minority shares in Thai businesses. Hence, re-capitalisation has been slow in coming. To help boost inflows of foreign capital to the ailing financial sector, the government has abolished the 25-percent cap on foreign shareholding in banks and finance and securities companies. Caps on other sectors are currently being reviewed by Parliament. While the conceptual and theoretical framework of corporate governance has been developed rather extensively, there are few quantitative surveys of the quality of governance across countries. The World Competitiveness Yearbook published by International Institute for Management Development (IMD), an independent, non-profit organisation located in Switzerland, provides a few indicators related to governance. The IMD compiles rankings of various aspects of national competitiveness, such as government, finance, infrastructure, management, and technology, based on a questionnaire survey of 2,500 chief executives and economic leaders in forty-six countries. In the area of corporate governance, the survey ranks the extent to which

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THAILAND 71

• • • • • • • • •

rights and responsibilities of shareholders are adequately specified legal regulation of financial institutions is adequate for financial stability companies enjoy public trust corporate boards prevent improper practices in corporate affairs managers are efficient to generate value for shareholders insider trading is uncommon in the market managers give adequate attention to their responsibility towards society relations between managers and employees are generally productive domestic companies adequately emphasise customer satisfaction

The IMD’s rankings for selected East Asian and developed countries are shown in Table 3.1. South Korea, Thailand, and Indonesia, the three countries most severely affected by the crisis, are also the three countries with the worst overall rankings. South Korea’s greatest weakness in corporate governance lies in inadequate protection of shareholders’ rights and lax regulation of financial institutions. South Korea ranked next to last, 45 out of the 46 countries surveyed, in these two categories. Boards’ ineffectiveness in deterring improper corporate practices and relations with labour are other weaknesses of governance in South Korea. Nevertheless Korean firms rank near the top in customer-orientation. This may explain the country’s impressive success in industrialisation and export. While Thailand and South Korea had the same average rank; Thailand ranked above Korea in shareholders’ rights and financial regulations and well below Korea in social responsibility and customer-orientation. Indonesia, which had the worst average in the sample, ranked rather unfavourably in all categories and was 44 out of 46 in insider trading. In contrast, Malaysia placed significantly above its neighbours in overall quality of corporate governance as well as in most individual categories. Taiwan, the East Asian Tiger that escaped relatively unscathed from the crisis, also ranked relatively favourably in overall corporate governance, although it was weak in financial regulation and control of insider-trading. Among the four selected developed economies, Japan’s overall standing was the worst. Japanese corporate governance offers little benefit to shareholders due to inadequate protection of shareholders’ rights and management’s inability or failure to generate shareholder value. However, Japan’s corporate sector draws strength from its ability to satisfy customer demand, in which it is ranked number one, and maintenance of good industrial relations, in which it is ranked fourth. These rankings offer some evidence linking weaknesses in corporate governance and the victims of the economic crisis. In the next section, we

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

10 18 26 18 9 13 33 12 16 17.22

8

15

25 22 4 17 19 23 2 15.00

United Kingdom

21 24 30 8 26 14 34 20.89

5

26

Germany

15 28 45 9 25 4 1 23.56

39

46

Japan

Note: Figures show each country’s rank out of a total of 46 countries surveyed. Source: IMD, World Competitiveness Yearbook, 1998.

Rights and responsibilities of shareholders Legal regulation of financial institutions Corporate credibility Corporate boards Shareholder value Insider trading Social responsibility Industrial relations Customer orientation Average ranking

United States

24 43 36 25 18 41 5 31.33

45

45

South Korea

29 40 21 32 38 31 28 31.33

32

31

Thailand

4 16 13 34 15 7 20 15.22

19

9

Malaysia

TABLE 3.1 Ranking of Selected Countries on Corporate Governance Factors

38 39 33 44 37 34 36 37.33

37

38

Indonesia

19 27 18 42 28 20 10 26.33

38

35

Taiwan

72 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

THAILAND 73

examine in detail the defects in Thai corporate governance that may have contributed to the spectacular fall of the economy. While this is a case study of Thailand, the analysis can be extended to apply to other countries within the region, which share similar governance problems. CORPORATE STRUCTURE IN THAILAND Corporate Ownership

The pillar of corporate governance is corporate ownership. Ownership implies control; and control, to a great extent, determines the structure and the behaviour of the board and management. Ownership of a company may be dispersed or it may be concentrated in the hands of institutional investors (banks, mutual funds, pension funds, or insurance companies), the government, corporations, or individuals. There are pros and cons to concentration of ownership. While concentrated ownership offers relative stability, effective monitoring, and continuous relations with suppliers, creditors, and customers, it puts small shareholders at risk of being marginalised. Thus, concentrated ownership must go hand-in-hand with adequate protection of minority shareholders’ rights. Such rights include the ability to nominate, appoint, and dismiss directors and managers through cumulative voting, to call emergency shareholders’ meetings, to make proposals at meetings, and to have access to relevant information (mandatory reporting by large shareholders, mandatory disclosure of non-financial information) and reliable financial statements.2 Firms with widely dispersed shareholding encounter a different problem. While inequitable treatment of large and small shareholders may not be an issue, the separation of ownership and control poses a serious principalagent problem. Without a major stakeholder, corporate control falls largely to management. Shareholders must then rely on the elected board of directors to represent their interests by monitoring the potentially unruly management. The dispersed shareholding structure typical of U.S. corporations makes managerial control exceptionally strong. Thus, selfinterested management practices, such as excessive compensation and provision of “golden-parachutes” (deals managers make to protect themselves in case of merger or acquisition) are top issues in American corporate governance code of conduct. Corporate ownership in Thailand is highly concentrated, even compared with neighbouring countries. Concentration is measured as the proportion of ownership that is held in blocks of 5 percent or more of total shares

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74 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

belonging to one owner. According to this measure, ownership concentration of Thai corporations averaged 72.9 percent during 1991–97, highest of all the East Asian countries (Table 3.2). Most blocks were held by other corporations (28.13 percent) and by financial institutions (32.93 percent). The proportion of blocks held by individuals was much greater in Thailand (6.20 percent) and Indonesia (6.21 percent) than in other countries in the region. The Thai corporate sector has been dominated by the family-run management style pioneered by Chinese merchants. Many families have prospered and built empires that cut across several industries, in particular banking, finance and securities, agribusiness, and telecommunications. The Sophonpanich family (Bangkok Bank), the Lam Sam family (Thai Farmers Bank), the Techapaiboon family (Sri Nakorn Bank), the Chearavanont family (Chareon Phokaphand Conglomerate), and the Chirativat Family (Central Department Store and hotel chains) have been prominent in the Thai corporate landscape. Although some of their businesses have been listed publicly, the founders have managed to keep a controlling share within the family. This situation may change with the current crisis, however. Struggling to emerge from the massive debt burden created by the sharp depreciation of the baht and the burst of the economic bubble, many of these family-run business empires have had to shed subsidiaries to keep their core businesses afloat. Other less fortunate ones have had to sell off a large ownership share of their core business. Families involved in banking for generations saw their ownership evaporate with a stroke in the government-mandated capital write-downs, while others in finance and securities lost entire businesses through the mandatory shutdown and subsequent nationalisation of fifty-six finance companies. Most of those that survived had to surrender a large (and sometimes controlling) equity share to foreign companies. Indeed, the current crisis has had an unprecedented impact on Thailand’ s corporate ownership structure and its impact on ownership will continue to be significant into the future. The emerging corporate ownership structure is less family-oriented and more dominated by the government and foreign investors. Subsequent to the nationalisation of commercial banks, the government has become the largest equity owner in the banking industry. A significant increase in foreign shareholding is also expected in many sectors, particularly those most affected by the crisis including banking, finance and securities, and insurance, as well as public utilities such as energy and telecommunications (Table 3.3). With the pending revision of the Alien Business Law to allow

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

53.20 67.19 26.08 26.35 53.82 56.54 61.47 14.89 72.90 31.90 10.03 1.84 1.78 6.12 2.32 1.79 4.72 2.55 4.46 2.59

Management 3.61 6.21 1.59 5.69 2.45 3.73 2.50 3.69 6.20 2.10

Individuals 30.78 52.51 18.00 10.33 27.57 40.26 28.17 7.19 28.13 20.06

Corporation

8.29 2.68 4.43 3.22 17.91 10.77 25.91 1.25 32.93 6.55

Institutions

0.49 3.94 0.28 0.99 3.68 0.00 0.16 0.00 0.60 0.58

Other

Notes: Concentration refers to cumulative shareholding greater than 5%. Management ownership includes ownership by officers and dire ctors. Individual ownership includes ownership by persons who are not employees, officers, or directors. Financial institutions include banks, insurance companies, mutual funds, and pension funds. Other includes government, employees, and unclassified. Source: Claessens, Stijn et al. 1998.

Hong Kong Indonesia Japan Korea Malaysia Philippines Singapore Taiwan Thailand All countries

Financial Concentration

Type of Blockholder

TABLE 3.2 Corporate Ownership Concentration in East Asia, 1991–97 Average (Percent of total shares)

THAILAND 75

Entertainment Finance & Securities

Commerce Energy

• • • • • • • • • • • • • • • • • • • • • • •

Agri-business Banking

Advanced Agro Bangkok Bank Ltd Bank of Ayudhya Thai Danu Bank Bank of Asia KrungThai Bank Thai Farmers Bank Siam Makro PCL The Co-generation Electricity Gen PCL PTT Explor. & Prod. United Broadcasting S-one Securities Nava Finance Asia Credit (SG Asia Credit) Bangkok Investment (AIG Finance) Union Securities Sri Thana DBS Securities Ekachart Securities TISCO Keitnakin Asia Securities Trading (ABNAMRO Asia) • Nat’l Finance & Securities

Company

Industry

45.06 59.83 44.90 32.16 43.17 48.12 NA NA 78.79 100 100 NA 51.77 28.8 38.62 41.50

NA NA 0.0 41.97 3.8 0.0 25.00

12.64

17.00 35.97 32.61 30.00 20.00 12.17 5.92 1.25 22.06 15.63

37.04 48.78 7.74

11/98

29.38 25.00 23.19

02/97

Foreign Share

TABLE 3.3 Foreign Acquisition of Listed Domestic Corporations

© 2000 Institute of Southeast Asian Studies, Singapore

GIC 6.5%

Indosuez WI Carr 100% DBS Securities 100% BNP PrimeEast 70% Bankers Trust 75% KEB, Bank of Tokyo, etc 17.8% ABN-AMRO 35.3%

Yuanta, Taiwan, 49% Societe General Cosby 51% AIG Group 70%

Multichoice Int’l Holding

Sithe Pacific

GIC 15.1%

DBSa 50.27% share (3/98) ABN-AMRO 75% share (3/98)

Enso Co., USA Government of Singapore

Investor-share Details

76 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

© 2000 Institute of Southeast Asian Studies, Singapore

25.00 15.38 23.09 44.17 45.43 20.66 35.00 15.24

02/97 30.00 22.49 25.91 85.17 86.39 25.00 47.63 24.76

11/98

Investor-share Details

Notes: Figures in italics are calculated by the authors based on SEC data. Foreign ownership share excludes foreign holdings smaller than 0.5% and thus may slightly understate the true foreign share. Source: 2/97 from HSBC James Capell: Thailand Investment Strategy , March/April 1997 and 11/98 from Capital Nomura, Monthly Review, November–December 1998.

Communications

Building and Furnishing

Electronic Components

• • • • • • • •

Property Chemicals & Plastics

Land and House National Petrochemicals Thai Plastic GSS Tech Hana Microelectronics Siam City Cement Siam Cement Shinawatra Satellite

Company

Industry

Foreign Share

TABLE 3.3 – continued

THAILAND 77

78 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

more foreign equity holding, Thai corporations could witness much greater foreign ownership. Corporate Control

Given the concentrated ownership structure, Thai corporations are controlled primarily by large shareholders who are unchallenged by other stakeholders such as smaller shareholders or creditors. Through majority shareholding, the owners have the power to appoint directors and managers, to make major corporate decisions that require majority-share approval, to approve interested business transactions, and even to change the corporate charter. The key question is who controls the Thai corporate ? Taking the top five shareholders of each of Thailand’ s 150 largest listed companies as a group and examining its composition gives an indication of the type of investors who are in control. Most prominent are private companies or holding companies, which comprise 38 percent of this group of top shareholders, followed by individuals, who comprise 21 percent (Table 3.4). Moreover, many of these private and holding companies are socalled “captive companies,” which are unlisted companies that serve the interests of a single individual or family. Such companies can be easily identified as they are often named after the individual or the family. Thus, individuals and families appear to wield considerable control over the corporate sector.

TABLE 3.4 Composition of Top Five Shareholders of the 150 Largest Listed Companies, by Type of Investor, 1997 (Percent) Type of Investor Private companies and holding companies Individuals Foreign banks (including securities and nominees) Domestic banks Finance and securities companies Insurance companies Other

Share of the 750 Top Investors 38.38 21.38 15.41 5.18 5.84 2.00 11.81

Source: Authors’ calculations from Stock Exchange Commission data.

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Corporate control varies widely across industries. Individual control is particularly prominent in two sectors: property and finance and securities (Table 3.5). In the property sector, almost half of the top five shareholders are individuals. Interestingly, these two sectors have had poor track records. The former is teetering on the brink of bankruptcy as a result of reckless borrowing and the latter is deeply mired in bad debt as a result of reckless lending. Control by other than private companies and individuals is relatively insignificant. Government ownership is limited to the banking and finance industries. This does not reflect a conscious policy on the part of the government. Rather, it is the consequence of the government policy to bailout insolvent banks and finance and securities companies by injecting new capital. Foreign investment banks are numerous among the five largest shareholders in several industries, including banking, finance and securities, energy, telecommunications, and electronics. 3 However, since local law restricts banks to holding no more than 10 percent of non-financial company shares, their corporate control is normally limited. In only a few cases is a bank the largest shareholder. Domestic banks’ stake in other corporations is confined largely to the insurance and finance and securities sectors, where banks are allowed unlimited ownership. This pattern by no means implies that local banks have no interest in non-financial industries. Investment records of Thai commercial banks reveal extensive investment in unlisted non-financial companies. As most local banks are still family-run, many of these businesses are part of the family’s business empire. Tight cross-ownership among financial institutions has rendered the financial system in Thailand rather fragile. During the bubble era, much of the reckless lending was negotiated by finance and securities companies as the latter, especially ones not listed in the SET (Stock Exchange of Thailand), were subject to less stringent regulations than banks. A large part of the credit extended by finance and securities companies found its way into the bubble sector, namely real estate. By the mid-1990s finance companies’ exposure to the real estate sector in absolute terms was almost equal to that of commercial banks, despite the fact that total loan extensions by finance companies were less than one-third those of banks (Figure 3.1). Such reckless lending led to the eventual government-mandated shutdown of fifty-six finance companies despite the attempt by affiliated banks to bail them out by both credit and equity injection. Undoubtedly, the event severely crippled the entire banking

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

2 1

2

1 10 9 18 5 7 2 3 11 8 3 3 0 15 3 3 5 1 2 2

Foreign Banks

1 2 0 0 0 0 4 0 0 1 0 1 1 1

17 5 0 3 1 1 1 3 0 0 0 1

3 1 1

1

1 3

Insurance Companies

0 1

Thai Banks

2 1

12 3 0 5 2 0 3 0 0 0 0 1 1 4 2 2

3 3

Finance Companies

1 3 3 12 15 1

19 25 15 43 14 16 15 16 7 25 4 21 6 5 8 2 13

Companies

5 3

8 1 5 42 3 4 26 5 3 6 1 3 6 6 5 8 14 2 5

Individuals

1

2 2

5 1 1 2 2 4 0 2 8 0 0 0

1 14

Gov’t

2

1

1 0 0 1 0 0 2 0 0 1 0 0

1 5

Funds

2

1

1

1 3 1 5 2 2 1 1 4 1 0 0 0 4 1

Centre

35 65 30 144 35 30 55 30 30 50 13 35 14 30 20 15 40 5 10 5 7 5 20 25 5

Total

Notes: Figures indicate the number of each type of investor in the group of the top five shareholders in the 150 largest listed corporations. Government shareholding includes shares held by the Crown Property, the Ministry of Finance, the Financial Institute Development Fund, state-owned ente rprises, and other government agencies. Centre denotes shares deposit centre. Source: Authors’ calculation based on Stock Exchange of Thailand data.

Agriculture Banking Commerce Finance Insurance Construction Property Hotels Energy Telecommunications Transportation Chemicals Electric Electronics Vehicles Entertainment Food Housing Machinery Other Packaging Printing Pulp and paper Textiles Mining

Industry

TABLE 3.5 Characteristics of Top Five Shareholders of the 150 Largest Listed Companies, by Industry (Number of Shareholders) 80 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

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FIGURE 3.1 Real Estate Sector Exposure of Commercial Banks and Finance Companies, 1990–96 billion baht

5,000 4,500 4,000 3,500 3,000 2,500

Total Loans Real Estate Loans by banks

2,000

by banks

by finance companies

by finance companies

1,500 1,000 500 0 1990

1991

1992

1993

1994

1995

1996

Source: Bank of Thailand.

sector. As the health of the banking sector deteriorates, the ripple effect is now beginning to take its toll on some insurance companies affiliated with commercial banks. To conclude, in Thailand many listed companies, including commercial banks, are still family-run. Corporate governance among such companies lacks transparency and accountability to minority shareholders as well as to other stakeholders such as employees. Bad governance, particularly in the finance and securities and property sectors, certainly contributed to the present financial crisis. How can such bad corporate governance be expunged? The next section focuses on corporate governance in Thailand. Do laws and regulations or the local culture facilitate good corporate governance? Can western prescriptions for good governance help solve the problems affiliated with concentrated corporate ownership and control?

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CORPORATE GOVERNANCE IN THAILAND Protection of Shareholder’s Rights

Although large shareholders can exercise corporate control merely through majority vote, there are several governance procedures that can help ensure transparency, accountability, and equity of corporate affairs by facilitating effective monitoring by small shareholders. The concept of a shareholder’s rights and duties as a corporate owner is relatively new to Thailand. It was only in 1993 that relatively comprehensive protection of basic shareholders ’ rights was introduced with the Public Company Act B.E. 2535 (Table 3.6). However, the minimum number of shares required for shareholders to exercise some of these rights tends to be somewhat high. For example, Thailand requires 20 percent of total eligible votes to call an emergency shareholders ’ meeting whereas the requirement in most other countries is only 10 percent. What the law seriously lacks is mandatory shareholder approval of interested transactions.

TABLE 3.6 Protection of Minority Shareholders’ Rights Availability Quorum for shareholders’ meeting

yes

Right to call emergency shareholding Right to dismiss directors

yes yes

Right to audit firm ’s financial statement and directors’ management Right to make proposals at shareholder meetings Right to sue directors for negligence of fiduciary duty Mandatory shareholder approval of interested transactions

yes

Pre-emptive rights on new stock issues Mandatory shareholder approval of major transactions Proxy voting Cumulative voting Mandatory independent board committees Mandatory report by large shareholders Insider trading penalty

yes yes no

yes yes yes yes yes yes yes

Source: Authors’ summary of Public Company Law B.E. 253.

© 2000 Institute of Southeast Asian Studies, Singapore

Minimum Share Requirement • • • • • • • • •

1/3 of all votes 1/2 of all voters 1/5 of all votes 3/4 of voters present 1/2 of votes present 1/3 of all voters 1/5 of all votes 1/3 of all votes 5% of all votes

• Transaction must be approved by board of directors • 3/4 of votes present • 3/4 of votes present

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Expropriation of corporate funds by insiders is most frequently and most conveniently negotiated through interested transactions (such as transfer pricing). The other provisions of the Public Company Law for the protection of small shareholders do appear adequate, however. The rule of law is a necessary but not sufficient condition for solving governance problems. Without a willingness among shareholders to coordinate their moves and to participate in meetings, legal rights are meaningless. In the past, these rights have rarely been exercised, as few Thai shareholders were aware of their rights and duties as corporate owners. Moreover, during the boom years most retail investors, driven mainly by speculative motives, were looking for the opportunity to make a quick profit and few paid attention to corporate fundamentals such as governance. As long as money kept flowing in, there was little incentive to monitor management. Apathy on the part of small shareholders gives insiders license to misappropriate corporate funds. If minority shareholders do not show up at the general shareholders’ meeting, a single block holder with a mere 20 percent ownership share can easily dominate the meeting ’s outcome— perhaps with a little help from his friends. Furthermore, there are also ways around the regulations to protect the rights of small shareholders.For example, in case the required quorum is not met, prepared decisions are made and recorded. To validate these decisions, management can call upon proxy brokers to ask them to get their (shareholder) clients to send backdated letters authorising their proxy votes. But this may not be sufficient, as the law also requires support by a minimum of one-half of the shareholders present at the meeting. To get around this rule, large shareholders simply hand over single shares to their friends, families, and employees and ask them to show up at the meeting. As a result of these regulatory loopholes, corporate decisions are rarely made at general shareholders ’ meetings. The minutes are often drafted prior to the meeting and can take up to one year to be circulated. Thus, small shareholders are minimally involved in corporate decision-making and very poorly informed of corporate decisions. There is little sense in closing these loopholes, however, unless small shareholders become more active. Without shareholder activism, there is little that the law can do to help. On an optimistic note, the present crisis may have given birth to shareholder activism in Thailand. When funds dry up, it becomes fingerpointing time. Shareholders are now demanding accountability for corporate failures on the part of management and directors. News reports of small

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shareholders protesting at general shareholders ’ meetings have begun to appear. This nascent activism should be nurtured not only by provisions to protect shareholders’ rights, but also by guaranteeing their access to accurate corporate information. Accounting and Auditing

Regulators, policymakers, investors, and shareholders all rely on a company’s financial statements to assess its performance and financial standing. Yet, corporate accounting is often more a work of art than a work of mathematics. Inaccurate financial reporting can work to the advantage of corporate insiders but it can be very costly for other stakeholders, such as small shareholders and creditors. It also undermines the market mechanism and may debilitate state regulatory supervision. Without accurate financial information, small shareholders are not able to detect suspicious transactions. Creditors are not able to assess a borrower’s ability to service debt. Investors are not able to make efficient investment decisions. Thus, badly run firms are not penalised, while well managed ones are not rewarded. Regulators fail to detect companies ’ financial weaknesses and to undertake timely corrective preventive measures. Accounting in Thailand is notorious for its creativity and imagination. Most companies keep two sets of accounts: one for management, another for authorities such as the Department of Revenue or the Stock Exchange Commission. Unlisted companies may maintain three versions: one for the owner, another for the business partner, and a third one for the tax collector. Poor accounting standards can be attributed to insufficient regulatory supervision and mild penalties for violations. The major weakness in Thai accounting is the method of valuation. Vague rules concerning the method by which assets can be valued represent a large loophole through which accountants can jiggle around numbers to make financial reports look good. For example, many financial institutions re-value their assets so that they appear solvent in order to avoid intervention from the Bank of Thailand. A public utility that initially failedto convince the Cabinet of the need for a price increase simply re-valued its assets to inflate depreciation and, hence, cost. Without clear rules and regulations regarding valuation of assets, insiders will always be able to manipulate the numbers. Auditing is not any better. Auditors are known to close accounts for their customers. The profession suffered further damage to its already

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tarnished reputation when the SET temporarily withdrew professional certification of two widely known auditors from two reputable auditing firms, one Thai and the other foreign. While the penalty may not have been so severe in itself, the social sanction proved quite caustic. 4 Auditing, like credit rating, suffers from potential conflict of interest. Auditors often develop close business relationships with their client companies and thus become unwilling to report potentially damaging oddities. To promote an arms-length relationship between auditors and the companies that they audit, a system utilising a pool of certified auditors has been proposed. Each year, the regulator would allocate several auditors to each company through lottery. A company could choose from among the allotted auditors only. Such a scheme requires a relatively large pool of qualified auditors, which Thailand does not currently have. Nevertheless, it is worth considering as a model for the future. While clearer valuation rules and stiffer penalties for professional negligence are required to elevate the existing accounting and auditing standards, self-regulation offers a medium-term solution to the problem of audit quality. Many businesses voluntarily seek external audits by reputable organisations in order to enhance the transparency of their corporate governance. In other countries, professional associations of accountants or auditors establish industry-wide standards to which members must comply. Self-regulation is not born of ethics but of economics. A company will regulate itself only if it pays to do so. American companies establish and advertise their corporate code of conduct because multibillion-dollar institutional investors, such as the California Public Employee Retirement System (CalPERS), set corporate governance standards for the companies in which they will invest. Credit-rating agencies also rate a company ’s corporate governance. Therefore, for self-regulation to be realised, investors will have to demand it. Independence and Accountability of the Board of Directors

While provision of shareholders’ rights and access to accurate and timely corporate information can improve the ability of shareholders to monitor corporate behaviour, a small shareholder has little incentive to perform the monitoring alone, as his stake in the company is insignificant. Moreover, the minority shareholders are by nature so dispersed that it is often impossible to co-ordinate their activities. As a result, minority shareholders must rely on elected representatives that will act to protect their interests. These representatives are the company ’s board of directors.

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86 DEUNDEN NIKOMBORIRAK AND SOMKIAT TANGKITVANICH

The board of directors is supposed to be accountableto shareholders for properly monitoring management. Since monitoring requires an arm ’s length relationship, directors should be independent from management. In a company where a large controlling shareholder is present, however, the board is often neither independent from management nor accountable to small shareholders. This is because through majority rule the controlling shareholder can appoint board members without the approval of other small shareholders. Consequently, both directors and managers represent only the interests of the large shareholder, rendering the designed internal corporate control ineffective. The literature on corporate governance refers to several measures, including mandatory independent directors, to promote independence of the board. The Cadbury Codes of the UK recommend at least three nonexecutive directors. The SET requires that at least two directors be independent directors, but the term ‘independent’ excludes only managers, employees, and their relatives. It cannot exclude directors who have close personal ties with the large shareholders or who are executives of affiliated companies. Thus, boards of directors are often staffed not with qualified professionals who would monitor company management, but rather with friends and family of the controlling shareholder(s) who would not oppose management. When a single shareholder has effective control of both the board and management, increasing the number of independent directors is unlikely to improve corporate governance. The more serious problem concerning corporate boards is the accountability of the directors. The law states clearly that directors are jointly responsible for violations of the law including falsifying documents such as shareholders’ meeting minutes or the company ’s financial statement, concealing vital information from authorities, breaking the rules regarding distribution of dividends, and extending loans to directors. When it comes to board fiduciary accountability, however, the law is very vague. It states that directors are jointly responsible for “performing their duty according to the law, the objectives and rules of the company and the decisions made at shareholder’s meetings, with honesty to protect the interest of the company.” Short of fraud and violations of the written rules and regulations, under this vague wording it is difficult to prove that a director has failed to perform his duty adequately and in good faith to protect the interests of the company. The court has had limited experience in dealing with such cases; much is subject to interpretation. Since the beginning of 1999 charges have been brought against several executives of defunct finance companies and a bankrupt electronics company, but no one has been

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convicted so far. These cases will set a precedent with respect to the legal interpretation of the scope and scale of a board ’s accountability to shareholders. Promotion of Institutional Investors

If small shareholders cannot depend on the board of directors to monitor management when a large shareholder takes control of the corporation , a potential alternative is for them to invest in mutual funds and rely on the fund managers to watch over the portfolio. Similarly, individuals invest indirectly in corporate equity through bank deposits, insurance plans, and pension plans. Compared to holding shares directly, with these investments the individual is guaranteed a fixed return, while financial institutions bear the investment risk. That is why institutional investors are the ideal candidates to perform the monitoring function. Countries with relatively good corporate governance often have institutional investors as prominent blockholders, such as commercial banks in Germany, mutual funds in the United States, or pension funds in the UK.5 Promoting institutional investors to serve this function in Thailand has two drawbacks, however. First, Thai institutional investors themselves do not have good corporate governance. After all, was it not reckless lending by financial institutions that brought on today’s crisis? How could we expect these institutions to raise the standard of corporate governance? Moreover, why were Thai commercial banks—as large stakeholders—not more involved in monitoring the companies to which they lent extensively, in the way that house banks in Germany and Japan often act as corporate monitors? One reason is that a large part of the loans extended by Thai commercial banks was secured through personal connections. Thai banks rarely scrutinise the feasibility of projects. Instead, they rely on personal relationships and the reputation of the owner or the company. That is why most bank loans are either unsecured or secured only by personal guarantees. A second reason for Thai banks’ failure to monitor is that during the 1990s bank lending was extremely competitive. Everyone was willing to hand out credit. Thus, if one bank imposed too many loan conditions, a company could easily take its business elsewhere. During the period of euphoria, prudence seemed unnecessarily costly. With insufficient regulatory supervision and inadequate internal control, there was a race to the bottom in terms of quality of loans extended. Reckless lending was contagious. The second drawback with relying on Thai institutional investors as monitors of corporate behaviour is that they often have vested interests in

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the companies in which they invest. In June 1998, the Stock Exchange Commission temporarily withdrew professional licenses from four executives of the oldest mutual fund in Thailand. Two charges were laid: one for investing with “conflict-of-interest”, and the other for imprudent investment. In sum, until the governance of financial institutions and other institutional investors markedly improves neither the board of directors nor institutional investors appear likely to adequately promote the interests of small shareholders in Thailand. Thus, after a lengthy analysis, we are back to square one—after all, shareholders themselves may have to exert greater effort in monitoring corporations. Long-term debt holding will have to be promoted in order to encourage shareholders to become more involved in a company ’s management. This includes the introduction of corporate debentures and corporate bonds. Thailand’s bond market is still underdeveloped because the government maintained a fiscal surplus for almost a decade prior to the crisis. However, now that the government has come to rely heavily on debt issues to raise funds to rehabilitate and stimulate the economy, the potential for the development of such a market has increased significantly. Laws and Regulations against Misappropriation of Corporate Funds

The single most serious corporate governance problem in Thailand is abusive behaviour by insiders. This behaviour includes interested transactions such as transfer pricing (buying products or services at a high price from a company which the insider owns), insider-trading (buying up shares before a stock-split or dumping shares before an unfavourable announcement of corporate performance), subjective allocation of a company’s resources (lending to friends and families), and downright fraud, such as embezzlement of company funds. Without good accounting and auditing, misappropriation of funds cannot be detected easily and verified. Thus, improved accounting and auditing standards are a prerequisite to stamping out such abusive behaviour by insiders. Other regulations regarding disclosure requirements such as mandatory reports of financial engagement of large shareholders and of interested transactions can also help. However, without effective punitive measures, exposing abusive behaviour can only do so much to change corporate governance. This is where law and enforcement come into play. At the moment, individuals

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suspected of engaging in such behaviour can be charged under either criminal or civil law, depending on the nature of the misconduct or violation. And should the act be carried out by a nominee —e.g., if the executive director asks his sister-in-law to buy or sell shares for him—the instigator can not be charged with insider trading. The sister-in-law will also not be charged for exploitation of misappropriated information, as she would be under the American insider-trading law, which stipulates that appropriation of information from an insider is also a crime. The Thai legislature is preparing to pass a new law on money laundering. Although the initial focus of the law was money from drugs, prostitution, and corruption, its potential implications for corporate governance are enormous. Under the new law, the origin of any large sum of money deposited at any financial institution must be traced and verified. All individuals involved in the transfer and laundering of misappropriated funds can be charged with a criminal offence. Unfortunately, the law is likely to be watered down significantly by the House of Representatives, many of whose members could be adversely affected by the proposed law in its current form. CONCLUSION

The path towards good corporate governance is arduous. The crisis exposed the inherent weaknesses in the governance of the Thai corporate sector, but it gave no clear direction about how to strengthen corporate governance. Policy prescriptions from the experiences of developed countries are of limited applicability as they are based on different assumptions regarding institutional and legal framework, corporate structure, and local culture. At the heart of good governance is information. Without adequate and accurate data, we cannot penetrate the corporate veil. Thus, accounting should be the very first target for reform. Good or bad accounting is not a question of ethics, but of economics. Gresham ’s Law of the bad chasing out the good accurately applies to accounting as well as to money. When one company can get away with manipulating or falsifying financial reports, then there is no incentive for any company to submit a valid report that may make it look worse than the competition. Bad accounting must be penalised so that it pays for companies to adopt good accounting practices. Regulatory supervision must be strengthened and penalties for professional liability made harsher. Once good accounting systems are in place, inappropriate behaviour by insiders—the most serious problem of Thai corporate governance —will

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be more easily detected. The next step should be to ensure that abusers are held responsible for their misconduct. At this point, the Insider Trading Law, the Public Company Law, and the Money Laundering Law must be strengthened to deter undesirable corporate misconduct. The judiciary process must also become more efficient. Cumbersome court procedures can undermine law enforcement, as they do in Thailand. Indeed, there are numerous other measures to promote good corporate governance, including fostering board independence, ensuring the rights of shareholders, and developing a long-term equity market. These are also important but they are secondary to upgrading accounting systems and penalising malfeasance. Bad corporate governance will no longer pay once proper accounting systems and effective legal punishments are established. Notes 1

2

3

4

5

In a recent bid for leasing contracts, a (well-informed) foreign consulting company, which also performed an advisory role to the government in the fire sale, submitted a bid to purchase the contracts at 50 percent of face value. Bids made by other competitors did not exceed 30 percent of face value. The 20 percentage point discrepancy is a crude reflection of the cost of unreliable financial data. Non-financial information may include governance arrangements, management structures, and compensation and pay procedures. Foreign investment banks became prominent in the finance and securities industry after the cap on foreign shareholding was lifted. The revised auditing law, currently being scrutinized by the parliament, imposes harsher penalties. German banks exercise corporate control through custodianship of shares deposited therewith.

References

CalPERS Shareowner Forum. 1997. “Governance Principles. International Corporate Governance”. http://www.calpers-governance.org/ Claessens, Stijn, Simeon Djankov, and Larry H.P. Lang. 1999. “Who Controls East Asian Corporations? ” Policy Research Working Paper No. 2054. Washington, D.C.: The World Bank. February. __________. 1998. “Ownership Structure and Corporate Performance in East Asia”. The World Bank.

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Davis Global Advisor. 1998. Corporate Governance 1998: An International Comparison. Newton, MA: Davis Global Advisor. Fukao, Mitsuhiro. 1995. Financial Integration, Corporate Governance, and the Performance of Multinational Companies. Washington, D.C.: Brookings Institution. International Institute for Management Development (IMD). World Competitiveness Yearbook 1998. Lausanne, Switzerland: IMD. Jensen, Michael. 1986. “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers”. American Economic Review 76. Johnson, W. Bruce, Robert Magee, Nandu Nagarajan, and Harry Newman. 1985. “An Analysis of the Stock Price Reaction to Sudden Executive Deaths: Implications for the Management Labor Market ”. Journal of Accounting and Economics 7. Lanoo, Karel. 1996. “Future Directions of Corporate Governance in Europe”. Http://www.ecu-activities.be/1996_1/lannoo.htm. La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Schleifer. 1998. “Corporate Ownership Around the World”. NBER Working Paper Series W6625. Washington, D.C.: National Bureau of Economic Research. June. ______ and Robert Vishny. 1998. “Law and Finance”. Journal of Political Economy 6, no. 106, pp. 1113 –55. Lewellen, Wilbur, Claudio Loderer, and Ahron Rosenfeld. 1998.“Mergers Decisions and Executive Stock Ownership in Acquiring Firms”. Journal of Accounting and Economics 7. Organisation for Economic Cooperation and Development (OECD). 1998. Corporate Governance; Improving Competitiveness and Access to Capital in Global Markets. Paris: OECD. Pedro, Alba, Stijn Claessens, and Simeon Djankov. 1998. “Thailand’s Corporate Financing and Governance Structures: Impact on Firm ’s Competitiveness”. Paper presented at Conference on Thailand ’s Dynamic Economic Recovery and Competitiveness, Bangkok, Thailand, 20–21 May. Price-Waterhouse. 1998. Corporate Governance Survey in Thailand . Schleifer, Andrei and Robert W.Vishny. 1996. “A Survey of Corporate Governance”. NBER Working Paper Series W5554. Washington, D.C.: National Bureau of Economic Research. May. Trairatvorakul, Prasarn. 1998. “The Importance of Governance Reforms in the Recovery from Financial Crisis: Viewpoints from Thailand ”. Paper presented at the Asia Development Bank Institute ’s Conference on Managing Asia’s Financial Sector Recovery: The Role of Competition Policy and Corporate Governance, Singapore, 9 –10 November.

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Walkling, Ralph and Michael Long. 1984. Agency Theory, Managerial Welfare, and Takeover Bid Resistance, Rand Journal of Economics 15. World Bank. 1998. Corporation in Distress. In East Asia: The Road to Recovery. Washington, D.C.: The World Bank. Zhuang, Juzhong. 1998. “Strengthening Corporate Governance in Asia: Some Conceptual Issues and the Role of ADB”. Paper presented at the Asia Development Bank Institute ’s Conference on Managing Asia ’s Financial Sector Recovery: The Role of Competition Policy and Corporate Governance, Singapore, 9–10 November.

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4 Exports and Economic Recovery A Malaysian Perspective 1 Ong Hong Cheong INTRODUCTION

The Asian financial crisis of 1997 brought Malaysia to the brink of economic collapse. The economy plunged into its worst-ever recession with GDP contracting by 7.5 percent in 1998, the ringgit devalued by onethird, the stock-market plummeting by 7.6 percent to a nine-year low, and the banking sector confronted by a serious threat of bank failures and rising non-performing loans (NPLs). According to the government, Malaysia lost seven years in terms of standard of living gains as a result of the currency devaluation. Amid a widening global and often acrimonious debate on the causes of the regional financial crisis and the need for a new international financial architecture, the most pressing concern for Malaysia was to contain the rapidly deteriorating financial and economic situation and to revive the economy. This posed the interesting question of how important a role the export sector would play in Malaysia’s economic recovery. Also, with government spending accounting for one-quarter of GDP, how would the government, as both policymaker and actor, rise to the challenge of stimulating and reflating the economy in the context of ‘Malaysia Incorporated’? This paper assesses the contribution of exports and government to Malaysia’s economic recovery. It first considers exports as an engine of past growth, then looks at the place of exports in the National Economic Recovery Plan, and finally assesses the economic recovery through the first half of 1999. 2

© 2000 Institute of Southeast Asian Studies, Singapore

94 ONG HONG CHEONG

EXPORTS: GROWTH ENGINE FOR MALAYSIA

A singular characteristic of Malaysia’s robust economic development over the past few decades is the openness of the economy to international trade and investment. This has led the export sector to be conventionally described as an important growth engine. Between 1978 and 1997, the nominal value of gross exports grew at an average annual rate of 14 percent, providing the momentum for 7.2 percent annual real growth and increasing in size from 45 percent of GDP to 80 percent. There were years when exports collapsed because of recession in the external environment. Nevertheless, the number of consecutive years of high exports and high growth were good enough to transform a developing economy into a middle-income industrialising economy, widely recognised as a noteworthy member of the so-called “East Asian Miracle”. According to the World Trade Organization (WTO) Malaysia was the world’s eighteenth largest exporter in 1997, with gross exports of US$78.9 billion or about 1.4 percent of global exports. The export sector is equivalent to 80 percent of GDP and manufactured exports represent 80 percent of total exports (Table 4.1). These high ratios indicate the openness of Malaysia’s economy and its relatively advanced level of industrialisation. There are two noteworthy features of Malaysian exports. The first is the fact that manufactured exports are largely FDI-driven and the second is the dominance of electronics and electrical goods, which account for slightly more than half of total exports. Historical data reveal that this is the fastest growing export segment. In the 24 years since Malaysia began to export electronics and electrical products in 1975, exports of these products have risen more than 300-fold. In particular, between 1978 and 1998 electronics exports, comprising mainly semiconductors, increased annually by 21 percent compared with annual growth of 6.2 percent for exports of agricultural and other primary commodities. Given the global trend towards information technology and knowledge-based products, the competitiveness and dynamism of electronics exports should allay concerns over the risks of Malaysia ’s high export concentration. Traditionally, the major export markets for Malaysia were Singapore, primarily because of proximity, and the United States and Japan, because they provide effective demand and liquidity to countries in the AsiaPacific region. The 15 countries of the revitalised European Union accounted for only 16 percent of Malaysian exports in 1998. Trade with countries in the South remained low, hampered by problems of finance and the need to set up Bilateral Payment Arrangements between Bank Negara Malaysia and the central banks in these countries. To date, Bank Negara Malaysia

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TABLE 4.1 Direction and Composition of Malaysia’s Exports, 1997 Composition Principal Exports

Direction % of Total Exports Principal Export Markets

Manufactured Goods of which: Semiconductors Electronic equipment & parts Electrical machinery & appliances Textiles, clothing, footwear Chemicals & chemical products Wood products Metals Transport equipment Rubber products

80.8

Agricultural Products of which: Rubber Saw logs Sawn timber Palm oil

10.5

18.4 18.1 17.2 3.4 3.7 2.9 2.6 2.2 1.8

1.3 1.1 1.3 4.9

Minerals of which: Crude oil LNG Tin

3.2 3.0 0.2

Other

1.7

Total Value % of GDP

7.0

ASEAN of which: Singapore Thailand Indonesia Philippines Vietnam Brunei North East Asia of which: Japan China Hong Kong SAR Chinese Taipei Korea Australasia Australia New Zealand North America United States Canada European Union of which: Netherlands United Kingdom Germany Belgium France Ireland Rest of World

100.0% Total US$78.9 bil Value 80.4

% of Total Exports 27.4 20.0 3.6 1.6 1.5 0.4 0.3 27.8 12.4 2.4 5.5 4.3 3.2 2.0 1.7 0.3 19.3 18.6 0.7 14.4 3.9 3.3 2.9 1.0 0.9 0.4 9.1 100% US$78.9 bil

Source: Department of Statistics, Bank Negara Malaysia. 1998 Annual Report.

has 26 such arrangements providing credit and deferred terms for trade financing. Some may argue that Malaysia ’s dependence on only three markets to absorb about half its exports is a structural weakness. On the other hand, Malaysia would be even more vulnerable if it depended on weaker, lower income economies to absorb its exports, rather than on some of the world’ s richest economies.

© 2000 Institute of Southeast Asian Studies, Singapore

96 ONG HONG CHEONG

Export Competitiveness and Comparative Advantage

Malaysia’s export competitiveness can be examined in a number of ways. One is according to the theory of comparative advantage developed by Ricardo in 1817, which postulates the ability to produce for export at a lower opportunity cost. Porter’s (1990) argument for a new concept of “competitive advantage” that emphasises industry structure and government policy is akin to Krugman’s (1994) advocacy of strategic and managed trade, which is the model followed by Japan. Balassa (1965) suggests indices of revealed comparative advantage (RCA) as a measure of export competitiveness. RCA compares the share of a country’ s exports in a given sector to that sector ’s share of world exports. UNIDO uses the ratio of a country’ s net exports to its total trade to indicate export competitiveness. The simplest and clearest index, the world economic share (WES) used by UNCTAD, compares the value of a country’s exports of a commodity to total world exports of the same commodity. According to data for 1993–94 Malaysia’ s share of world exports in vegetable oil (palm oil), natural rubber, and veneer and plywood was relatively large in 1994, suggesting that it holds a comparative advantage in these commodities (Table 4.2). More recent data would likely show little change in these categories of comparative advantage. In addition, Malaysia appears to have a competitive advantage in semiconductors and electronics equipment and parts. In 1993–94 Malaysia supplied 7.94 percent of total world exports of transistors and valves (SITC-776), 10.57 percent of world exports of sound recorders (SITC-763), and 16.51 percent of radio receivers (SITC-762). In 1997 Malaysia’s exports of electronic products totalled US$28.8 billion (Table 4.1). Electronics Trends of San Jose, California estimated the world-wide electronics market at US$1.0 trillion for 1998 and projected that it would increase to US$1.38 trillion by the year 2001 ( New Straits Times , 10 December 1998). It attributed the strong growth mainly to new products demanded by mobile consumers, resulting in a convergence of personal computers, communication devices, televisions, and the Internet. The prospect for strong growth in world demand for electronics products bodes well for Malaysia’s exports in this sector into the early part of the next century. To take advantage of the growth in demand Malaysia needs to preserve the favourable supply conditions on which its competitive advantage is based. The dynamic electronics industry in Malaysia has an estimated 850 established companies and employs more than 400,000 workers.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

Fixed vegetable oil Natural rubber Radio broadcast receivers Veneers, plywood, etc. Sound recorders, etc. Wood shaped, sleepers Transistors, valves, etc. Television receivers Headgear, textiles, clothing Office, adp machines, parts Gas, natural and manufactured Telecom equipment, parts Electric power machinery, NES Gold, silverware, jewellery Heating and cooling equipment Undergarments, not knit Furniture, parts, etc. Switchgear, etc., parts, NES Fish, preserved and prepared Crude petroleum Toys, sporting goods, etc. Outwear knit Electric distributors equip. Automatic data processing equip. Articles of plastic, NES Ships, boats, etc.

424 232 762 634 763 248 776 761 848 759 341 764 771 897 741 844 821 772 037 333 894 845 773 752 893 793 2.7 1.0 2.5 1.5 1.9 2.0 8.4 1.5 0.7 3.0 1.1 2.7 0.5 0.5 0.7 0.2 0.7 0.8 0.1 2.9 0.4 0.4 0.2 1.0 0.3 0.2 5.04 1.84 4.66 2.76 3.66 3.73 15.86 2.81 1.36 5.69 2.09 5.07 0.89 0.88 1.40 0.39 1.26 1.57 0.23 5.39 0.68 0.77 0.46 1.80 0.58 0.43

% of Malaysian Exports

Source: UNCTAD. Handbook of International Trade and Development Statistics. 1995.

Export Item

SITC

Value US$ billion 47.35 21.58 16.51 11.29 10.57 8.33 7.94 7.77 6.77 4.49 3.30 3.20 2.99 2.61 2.60 1.85 1.81 1.75 1.59 1.58 1.43 1.41 1.16 1.03 0.82 0.70

WES % of World Exports

TABLE 4.2 Comparative Advantage of Malaysia’s Major Export Categories, 1993–94

MALAYSIA 97

98 ONG HONG CHEONG

Competitive labour costs, productivity, and strategic location for both sourcing and marketing have attracted the world’s top electronics corporations to locate subsidiaries in Malaysia. These companies include Advanced Micro Devices, Hewlett Packard, Intel, Motorola, Seagate, Integrated Device Technology, Dell, Acer, Fairchild, Siemens, Sony, and Toshiba. Malaysian-controlled electronics companies are basically assemblers that use imported components and act as suppliers for the MNCs. As the present import content of the electronics and electrical industry is about 60 to 80 percent, there is potential to increase local sourcing. To sustain competitive advantage there is a continuous need to shift into higher technology. This creates additional pressure to attract major fabrication companies to locate in Malaysia on a joint-venture basis to produce wafers, memory chips, microprocessors, application-specific integrated circuits, and other components. According to FDI statistics released by the Malaysian Industrial Development Authority (MIDA), electronic and electrical industry projects still comprise the largest number of applications for new direct investments. Approved capital investments could easily exceed US$15 billion. Studies conducted by the National Productivity Corporation in Malaysia indicate continuing manufacturing efficiency in the electronics and electrical sector. For example, in 1996 value added per employee rose by 12 percent while unit labour cost declined by 8 percent (Tables 4.3 and 4.4). Currency Depreciation and Export Competitiveness

According to theory, currency depreciation or devaluation enhances a product’s export competitiveness. By various measures, Malaysia experienced a considerable devaluation as a result of the Asian financial crisis. Exports from Malaysia should benefit accordingly from an improved price advantage. From 2 July 1997 to 29 December 1998 the ringgit depreciated by 33.6 percent against the US dollar (Table 4.5). As calculated by Hussain and Radelet (1999) the Real Exchange Rate depreciated by 37.6 percent, putting the ringgit back at its 1990 competitive level . According to the IMF, the Real Effective Exchange Rate of the ringgit declined by 27 percent (Table 4.6). This is perhaps the most accurate assessment of the enhancement in Malaysia’s export competitiveness as a result of the crisis. In the real world certain factors may limit the actual gain in export business from such a depreciation. Changes in bargaining power may accompany the decrease in currency value. In Malaysia, for example,

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

24.2 5.9 17.5 16.4 –9.0 6.7 –0.2 24.5 12.1 –4.5 26.5 4.2 –8.3 7.7 3.5 8.3

Electrical and Electronics 7.8 –1.1 2.0 –0.7 –0.1 8.6 3.8 6.8

Fabricated Metal Products

Source: National Productivity Corporation. Malaysia: International Trade and Industry Report 1997/1998 .

Value added per employee Value added content Process efficiency Value added per labour cost Unit labour cost Labour cost per employee Value added per fixed asset Fixed assets per employee

Textiles

TABLE 4.3 Productivity Indicators by Sub-sector, 1996 (Percent Growth)

4.9 –4.2 6.0 –3.8 –0.4 9.1 –0.9 5.8

Wearing Apparel

4.1 –10.3 20.7 –4.2 –6.4 8.6 –5.8 10.5

Food Manufacturing

MALAYSIA 99

100

ONG HONG CHEONG

TABLE 4.4 Growth Rates of Selected Major Export-oriented Industries (Percent) GDP Industrial production index Manufacturing index Electronics and electrical products Textiles and apparel Wood and wood products

1990

1991

1992

1993

1994

1995

1996

1997

8.6 12.2 15.6

7.8 11.1 13.9

8.3 8.7 10.5

9.2 9.6 12.9

9.4 12.4 14.0

8.6 13.1 15.1

7.7 11.0 12.3

–4.8 10.6 12.4

32.1 9.7 14.3

31.0 3.7 5.3

13.7 11.4 10.8

13.4 19.5 22.0

21.7 9.1 4.2

20.7 5.3 5.7

8.8 — 11.4

13.6 5.3 –0.2

Source: Department of Statistics, Bank Negara Malaysia. October 1998.

Monthly Statistical Bulletin .

TABLE 4.5 Comparative Depreciation of East Asian Currencies

RM/US$ S$/US$ Baht/US$ Rupiah/US$ Peso/US$ Won/US$ NT$/US$ Yen/US$

2 July–31 Dec 1997

2 July 1997– 29 Dec 1998

–34.9 –14.6 –37.2 –52.2 –33.9 –43.9 –14.6 –11.9

–33.6 –13.9 –21.0 –69.0 –32.6 –26.7 –13.6 —

Source: Telerate, Asian Wall Street Journal .

manufacturers and timber exporters report losing export earnings because foreign buyers would pay them only according to the new U.S.-dollar value of their products. Moreover, manufacturing companies that are operating at full capacity cannot expand production to benefit from the depreciated ringgit. The Export Sector’s Contribution to Growth

The concepts of “contribution to economic growth” and “export-led growth” require some clarification. The Dictionary of Modern Economics defines “export-led growth” as:

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

134.7

124.5

101.4

Peso

Yen

US$

113.8

104.8

119.5

137.9

128.4

115.3

105.8

120.4

139.9

127.3

114.6

107.2

117.6

140.9

127.8

105.0

123.9

138.8

126.6

113.0

May

103.4

120.9

139.1

126.7

111.9

Jun

104.5

121.9

135.0

126.7

110.6

Jul

107.1

120.9

128.9

125.8

106.2

Aug

107.0

116.3

117.0

125.8

97.1

Sep

Note: RM = Malaysian ringgit; S$ = Singapore dollar; Peso = Philippine peso. Source: IMF. International Financial Statistics.

111.1

127.1

RM

S$

Apr

106.5

114.4

110.5

123.9

90.1

Oct

109.3

107.2

113.3

124.0

88.4

Nov

112.0

104.7

109.8

125.2

82.9

Dec

113.5

105.6

98.3

123.4

74.3

Jan

Mar

Jan

Feb

1998

1997

86.3

Mar

86.0

Apr

84.8

May

99.6

65.7

—

—

—

Jun

112.6 113.3 114.2 114.9 117.4

105.6 105.6 102.9

102.9 106.6 108.8 107.8

126.6 129.1 129.6 127.9

84.4

Feb

TABLE 4.6 Real Effective Exchange Rates for Selected Currencies, 1997–June 1998 (1990 =100)

MALAYSIA 101

102

ONG HONG CHEONG

The expansion of an economy, which is stimulated by a rising volume of exports. Such a source of growth not only has real linkage effects and multiplier effects on the rest of the economy but also ensures that growth will not be constrained or halted by balance of payment difficulties, since it makes available any foreign exchange necessary to pay for additional imports required for expansion. In the national income accounts, the term ‘ exports’ refers to both merchandise trade and non-factor services exports with the latter mostly freight and insurance. Whether ‘ net exports of goods and non-factor services’ (the value of exports minus the value of imports) is positive or negative indicates whether the export sector on balance adds to or detracts from overall GDP growth. There were six years between 1991 and 1997 when Malaysia’s net exports were negative, mainly because of large annual payments for freight and insurance exceeded the merchandise trade balance (Table 4.7). Thus, for these years the export sector was a ‘detractor ’ rather than a ‘contributor’ to economic growth. In such years, GDP growth is technically attributed to growth of domestic aggregate expenditure or domestic demand rather than to growth of foreign demand. In 1997, for example, even though total exports of goods and services amounted to US$94 billion at current market prices, or 93 percent of GDP, imports were larger and the resulting negative net export balance took 0.2 percentage points off of the GDP growth rate. The story was different for 1998. Without the contribution from the export sector, GDP would have declined much more than the actual 7.5 percent. Net exports added 19.6 percentage points to GDP growth, although this was not enough to offset the negative contribution due to declines in private investment (–19.8 percentage points), private consumption (–5.0 percentage points), and government spending (–1.3 percentage points). The large positive contribution of the export sector came almost entirely from a contraction in imports rather than an increase in exports. The dramatic collapse of real imports in 1998 is attributed to three major factors: (1) the one-third increase in the cost of imports because of the ringgit devaluation and falling consumer demand, (2) the sharp decline in imports of capital goods because of recession, business uncertainty, and high inventory, and (3) the cuts in trade credit by domestic as well as foreign banks. Thus, Malaysia’s experience in the Asian financial crisis suggests that reducing imports can make a substantial contribution toward economic recovery from the technical perspective of the national accounts. Moreover, during a recessionary crisis it is easier to reduce imports than to increase exports. © 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

7.8 4.1 1.5 — 1.8 0.4 5.1 –4.7

8.6 3.9 4.7 4.8 2.3 –7.1 11.2 –18.3

1992

2.8 2.2 4.2 0.3 –1.2 14.2 –15.4

8.3

1993

1.4 4.5 6.8 1.0 –4.5 20.0 –24.5

9.2

1994

2.2 4.4 7.2 0.4 –4.8 17.5 –22.3

9.4

1995

0.1 2.8 4.4 2.0 –0.7 7.6 –8.3

8.6

1996

1.8 2.1 2.9 1.1 –0.2 11.3 –11.5

7.7

1997

Notes: a Goods and non-factor services. b 1998 based on new GDP series, constant 1987 prices. Source: Author’s estimates based on data from Bank Negara Malaysia Monthly Statistical Bulletins.

Percent change in GDP Percentage point contribution of: Government spending Private consumption Private investment Change in capital stock Net exports Exportsa Importsa

1991

TABLE 4.7 Contribution to GDP Growth Rate, 1991–98

–1.3 –5.0 –19.8 –1.0 19.6 … 19.6

–7.5

1998b

MALAYSIA 103

104

ONG HONG CHEONG

Export Performance in 1998

Recently released trade data show Malaysia’s gross exports rising by 30 percent in 1998 compared with the corresponding period of 1997. However, because of the 33.6 percent ringgit devaluation exports shrank in U.S. dollar terms. The contraction in exports appears even larger if exports are valued according to the average exchange rate for the period, which was RM3.9229 to the U.S. dollar, rather than the exchange rate for 1997, which was RM2.8123. In nominal ringgit value, exports to the United States grew sharply by 51 percent, supporting the view that, as one result of the Asian financial crisis, the United States has assumed the role of “importer of last resort”. Exports by the European Union expanded by 45 percent. Exports to Japan and Singapore grew nominally by 10 percent. The main export categories that showed encouraging performance during 1998 were electronic and electrical products and palm oil. Exports of electronic and electrical products increased 36 percent in nominal value. Palm oil exports rose by 6 5 percent, possibly reflecting also Indonesia’ s ban on palm oil exports.

EXPORTS AND THE NATIONAL ECONOMIC RECOVERY PLAN

The Malaysian government responded initially to the devastating impact of the Asian financial crisis on the economy by adopting the IMF-advocated solutions of making fiscal cuts, hiking interest rates to support the weakening ringgit, curbing private spending and credit growth, and shortening the classification period for non-performing loans (NPLs) from six to three months. These austerity measures only worsened the deteriorating financial and economic situation as reflected in a liquidity crunch, increasing corporate debt, and rising NPLs in the banking system. The threat of systemic bank failures was real, as was the loss in public confidence made worse by capital flight to Singapore where foreign banks reportedly offered ringgit deposit interest rates of 30 to 40 percent. At the same time, there was great concern that the Singapore over the-counter market, CLOB, was involved in heavy short-selling of Malaysian equities that continued to de-stabilise the financial sector. To cope with the financial and economic distress and with a sense of great urgency, a National Economic Action Council (NEAC) was set-up in January 1998 as a consultative body to the government. On August 4, a comprehensive framework for economic recovery called the National

© 2000 Institute of Southeast Asian Studies, Singapore

MALAYSIA 105

Economic Recovery Plan (NERP) was unveiled to stabilise the ringgit, restore stock market confidence, maintain financial stability in the banking system, strengthen economic fundamentals, continue equity and socioeconomic agenda, and restore adversely affected sectors of the economy. It became clear to the NEAC that excessive currency volatility and uncertainty, as much as capital volatility, was the trigger-point for the financial and economic turmoil; the ringgit was floating wildly without a supporting floor. Thus, achieving currency stability along with more stable capital movement would be the critical linchpin for economic recovery. As a result, on 1 September 1998, the day when the Malaysian stock market plummeted to a nine-year low, the Malaysian government rejected economic orthodoxy and introduced a set of selective exchange and capital controls to save the economy. Reprehended around the world as destructive and retrogressive and against the global trend of financial liberalisation, these controversial new measures included: • Pegging the ringgit at RM3.80 to the US dollar; • Declaring the ringgit inconvertible and untradeable offshore; • Locking-in foreign portfolio investments in Malaysia for a one-year minimum; • Declaring that the trading of Malaysian equities would only be legally recognised if done in Malaysia and not offshore; and • Limiting foreign exchange to be taken out by a traveller to the equivalent of RM10,000. By effectively de-linking the exchange rate of the ringgit from domestic interest rates, the first two measures allowed the central bank to regain its “monetary independence”. As a result, the government was able to reduce domestic interest rates to a historically low level to create more stable conditions conducive to business revival. An asset management company, Danaharta, was set up in September to strengthen the banking system by purchasing NPLs from ailing banking institutions. According to latest reports it had acquired one-third of the NPLs in the banking system. A special-purpose vehicle called Danamodal was established to re-capitalise troubled banks, finance companies, and merchant banks, injecting US$2 billion in ten banking institutions. Another new agency, the Corporate Debt Restructuring Committee (CDRC) was set-up to resolve the bad debts of 23 Malaysian companies and reduce any market risk being transmitted to the major creditors, the banking institutions. A National Infrastructure Fund was also established to revive stalled infrastructure projects and it has reportedly awarded contracts amounting to US$5 billion.

© 2000 Institute of Southeast Asian Studies, Singapore

106

ONG HONG CHEONG

To deal with banks’ excessive concern with protecting the loan asset quality in their balance sheets, over and above reasons of lack of business confidence or lack of new viable business ventures, the central bank directed commercial banks to meet a loan growth target of 8 percent for 1998. The latest news is that bank loans contracted by 2 percent in 1998. To reflate the economy would require a considerable amount of fiscal pump priming. The total financing requirements for the National Economic Recovery Plan (NERP) are estimated at RM62 billion or US$16.3 billion. Even though domestic funding sources such as provident, pension, and insurance funds and oil revenues could provide US$21 billion, the Malaysian government applied for foreign financial assistance from bilateral and multilateral sources, but not from the IMF. According to official reports, the total foreign funding amounted to US$5 billion and the major foreign lenders were the World Bank (US$0.7 billion), Japan Eximbank (US$1.0 billion), a Sumitomo/Nomura loan (US$0.7 billion), Japan Overseas Economic Cooperation Fund (US$1.0 billion), and the Consortium of Foreign Banks in Malaysia (US$1.0 billion). The NERP addressed the close link between exports and economic growth as part of the general action plan to strengthen the balance of payments. Recommended measures were: • To promote resource-based industries and activities with low import content; • To accelerate backward linkages for non-resource based industries and more local sourcing; • To enhance R&D and product innovation of capital goods; • To study export-competitiveness for manufactured goods; • To study the cost-benefit of the electronics and electrical sectors, with the potential to increase local content. Other measures related to improving the services account by saving on foreign payments for freight and insurance and consultancy services, increasing tourism receipts, and making Malaysia a regional centre of educational excellence. In an article entitled “Challenges, Prospects for Economic Recovery” the new governor of Bank Negara Malaysia, Tan Sri Ali Abul Hassan Sulaiman, emphasised the need to find more practical solutions to overcome the crisis of deep recession with severe strain on the banking sector because it would be impractical to rely solely on the export sector:

© 2000 Institute of Southeast Asian Studies, Singapore

MALAYSIA 107

Malaysia realizes that it cannot rely solely on the export sector because of several downside risks in the external environment. Growth in 1999 will necessarily be domestic-driven. Hence, the need for a fiscal deficit and an accommodative monetary policy. On the fiscal side, the government needs to press ahead with spending on infrastructure and social projects, while the corporate sector reorganizes itself. This should not be seen as inappropriate spending but rather as necessary investments to facilitate economic recovery. AN ASSESSMENT OF ECONOMIC RECOVERY, JANUARY – JUNE 1999

An assessment of economic recovery must inevitably raise questions regarding how to define economic recovery, what appropriate indicators and criteria to use, and which period is relevant and meaningful for comparison. While economic recession is conventionally defined as ‘ two consecutive quarters of negative growth’, there appears to be no agreedupon definition for economic recovery. The Malaysian government has announced that a one-percent GDP growth rate as officially forecast for 1999, would be sufficient confirmation of economic recovery. But not all sectors of the economy would recover at the same time and speed. Logically, the concept of “full economic recovery” should mean a state when all sectors of the economy have restored their expected dynamism. In particular, for a free market economy, where the private sector comprising private consumer spending and private business investment is the engine of growth, then “full recovery” is achieved when there is a strong positive rebound in private consumer spending and investment. The leading indicators for Malaysia’ s incipient recovery are the Kuala Lumpur Stock Exchange (KLSE) index, KLSE market capitalisation, and external reserves (Table 4.8). All three show robust growth beginning in the fourth quarter of 1998, affirming the benefits of the policy of selective exchange and capital controls. Industrial production and manufacturing still show negative growth in the first quarter of 1999 (Table 4.9). So do private consumption and investment. The negative contribution of domestic demand to GDP growth more than offset the positive contribution from external demand, or the almost 11 percent increase in net exports.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

Q2 Q3 Q4 Q1

1999 Q2

19.3 30.2 33.1 3.4 — — — 21.8 32.4 34.0 3.6 — 3.7 — 20.1 34.8 33.5 3.7 — — — 18.5 21.3 26.5 4.1 — 5.9 10.3 13.7 14.0 16.9 7.0 — 9.1 11.0

7.3 6.0 10.2 8.9 — 12.6 11.2

4.0 3.4 4.5 8.1 12.8 17.8 10.6

2.7 –4.9 –1.8 8.0 13.2 18.9 11.8

3.9 1.6 –4.2 7.9 14.2 19.8 12.3

7.5 4.7 1.7 7.9 12.7 19.0 12.7

2.4790 2.5235 3.1975 3.8883 3.6430 4.1750 3.8000 3.8000 3.8000 3.8000 1,203.1 1,077.3 814.6 594.4 719.5 455.6 373.5 586.1 508.1 811.1 844.5 744.5 584.5 375.8 452.9 285.9 249.1 374.5 317.9 532.0 29.1 28.0 19.3 15.2 15.7 13.9 21.5 26.2 27.7 31.1 40.8 45.6 45.0 43.9 42.9 41.6 0.1 42.0 42.0 42.3 3.2 2.2 2.3 2.9 5.1 6.2 5.5 5.3 3.0 2.1 7.36 7.71 7.65 8.60 10.91 11.07 7.75 6.48 5.70 3.30 9.24 9.50 9.61 10.33 11.96 12.27 8.89 8.04 8.04 7.24

Source: Bank Negara Malaysia publications and KLSE. Investors Digest.

Leading Indicators Ringgit/US$ Kuala Lumpur Composite Index KLSE market capitalisation (MR bil) International reserves (US$ bil) External debt (US$ bil) CPI (94=100) yoy % change 3-month KLIBOR (%) Base lending rate Banking Indicators M3 (annual % change) Total deposits Total loans Net NPLs 6-months (%) Net NPLs 3-months (%) Gross NPLs/Total loans (5) Risk-weighted capital ratio (%)

Q4 Q1

Q3

Q1 Q2

1998

1997

TABLE 4.8 Financial Indicators of Economic Recovery, Q1 1997–Q2 1999

108 ONG HONG CHEONG

© 2000 Institute of Southeast Asian Studies, Singapore

11.5 13.5 24.6 8.4 20.1 –11.7 1.8 –13.5 32.3 6.7 15.2 13.4 1.8 13.5 1.2 19.4 18.2

11.6 13.8 23.3 8.6 5.5 3.1 8.6 –5.5 5.0 2.6 14.6 1.3 8.8 5.2 1.1 19.4 18.3 6.8 7.0 0.5 20.3 19.8

9.6 11.7 22.0 7.7 8.3 –0.6 6.5 –7.1 7.9 6.4 –8.1 19.6 4.5 –2.3 1.4 18.7 17.3 2.6

10.2 10.9 21.5 5.6 –1.0 6.6 4.2 2.4 –0.1 2.0 12.8 2.4 –1.4 –10.0 3.1 18.1 15.0

–0.1 –1.8 3.1 –3.1 –11.9 8.8 –1.4 10.2 –11.6 –5.4 –16.8 –23.6

Source: Department of Statistics publications. National Economic Action Council publications.

Industrial Production Index (93=100) Manufacturing Index (93=100) Semiconductors, electronic growth GDP growth rate (%) Domestic demand External demand (net) Exports of goods and services Imports of goods and services Growth of domestic demand Private consumption Government consumption Gross investment Growth rate in external demand Exports of goods and services Imports of goods and services Net exports (US$ billion) Merchandise exports Merchandise imports Unemployment rate (% labour force)

Q4 Q1

Q3

Q1 Q2

1998

1997

–1.0 –24.9 4.5 17.3 12.8

–6.0 –8.9 –1.5 –5.2 –33.2 28.0 0.9 27.1 –28.7 –8.9 3.1 –42.7

Q2

–2.9 –23.6 5.0 17.9 12.9

–10.4 –14.5 –11.3 –10.9 –32.4 21.5 –2.1 23.6 30.0 –14.9 2.3 –56.4

Q3

TABLE 4.9 Major Real Indicators of Economic Recovery, Q1 1997–Q2 1999 (Annual percent change)

2.5 –18.0 5.9 19.5 13.6 3.2

–10.9 –14.7 –6.0 –10.3 –28.2 17.9 2.3 15.6 –29.0 –13.8 –17.9 –45.0

Q4

1.2 –10.6 4.2 18.3 14.1 4.5

–2.3 –3.1 6.7 –1.3 –12.2 10.9 1.2 9.7 –13.3 –4.1 22.4 –22.9

Q1

1999

12.5 6.2 4.7 20.4 15.7

3.0 8.7 –8.6

6.2 9.5 14.1 4.1 –3.5 7.6 12.9 –5.3

Q2

MALAYSIA 109

110

ONG HONG CHEONG

It is beyond dispute that the Malaysian economy has shown substantial recovery by the second quarter of 1999. There was robust expansion in industrial production (including a 14-percent rebound in the production of semiconductors and other electronics components), a revival in private consumer spending, and positive growth in government consumption. Full-fledged recovery has yet to be achieved, however, as gross investment reflecting largely private investment remained negative. Of special interest is that in the second quarter of 1999 (Table 4.9), the export sector including exports of services contributed 12.9 percentage points to GDP growth, three times the overall 4.1 percent GDP growth rate for the quarter. To a large extent this reflected a fortuitous rise in electronics exports and the pick-up in world demand for electronics products. Another important factor was the continuing economic boom in the United States, which enabled it to buy more and enlarge its market share of Malaysian exports. The conclusion is clear and indisputable: it is fully appropriate to characterise Malaysia’s second quarter 1999 real GDP growth as exportdriven. Stated differently, exports, helped by the benign effects of the socalled controversial selective capital controls, have effectively pulled the Malaysian economy out of recession. The outlook is also encouraging. Two sets of financial and real sector indicators confirm that the momentum of higher economic output is getting stronger, raising expectations that a full economic recovery can be achieved in the year 2000. Notes 1

2

The views expressed in this paper are personal and do not necessarily reflect the views of ISIS Malaysia. This paper was first presented at the Tokyo Club Foundation for Global Studies Researchers’ Meeting in Tokyo on 28–29 January 1999 and then revised in October 1999.

References

Aghevli, Bijan B. 1999. “The Asian Crisis —Causes and Remedies”. Finance and Development. June. Ali Abul Hassan Sulaiman. 1998a. “Challenges and Prospects for Economic Recovery in Malaysia”. Keynote Address, MIER 1998 National Outlook Conference, Kuala Lumpur, 1–2 December.

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______. 1998b. “Challenges, Prospects for Economic Recovery”. The Edge. 7 December. ______. 1999. “Asian Financial Turmoil and Its Implications—The Malaysia Experience So Far”. Malaysia-Japan Economic Association 21st Joint Conference, Kuala Lumpur, 9–10 March. Balassa, Bela. 1965. “Trade Liberalization and ‘ Revealed Comparative Advantage”. The Manchester School, no. 32, pp. 99–123. Bank Negara Malaysia. 1999. “ Economic and Financial Development— Malaysian Experience in the Second Quarter of 1999”. Press Release, 25 August. Calomiris, Charles W. 1998. “The IMF’s Imprudent Role as Lender of Last Resort”. Cato Journal 17, no. 3 (February). Chang, Roberto and Andres Velasco. 1998. “The Asian Liquidity Crisis”. National Bureau of Economic Research Working Paper 6796, November. Credit Suisse. 1999. “Malaysia Strategy”. Equity Research. 7 February. Crinius, Wolfgang, and Gunter Weinert. 1999. “Slow Recovery in World Trade”. Intereconomics, May/June. Daim Zainuddin, Tun. 1999a. “Economic Turmoil: Lessons for Malaysian Businessmen”. National and International Chamber of Commerce and Industry Conference, Kuala Lumpur, 8 July. ______ 1999b. “Past the Storm, Second Quarter, 1999”. New Voice of Asia. Glick, Reuven, and Andrew Rose. 1998. “Contagion and Trade: Why Are Currency Crises Regional?” NBER Working Paper 6806, National Bureau of Economic Research. November. Guitian, Manuel. 1999. “Economic Policy Implications of Global Financial Flows”. Finance and Development. March. Guttsman, Janet. 1999. “World Bank heretic begins to win mainstream backing”. Business Times. 4 June. Gonzalez-Hermosillo, Brenda. 1999. “Developing Indicators to Provide Early Warnings of Banking Crisis”. Finance and Development. June. Hussain, Mumtaz, and Steven C. Radelet. 1999. “Exports and Asia’s Recovery”. In The Asia Competitiveness Report . Geneva: World Economic Forum. Katushiro, Nakagawa. 1999. “The Impact of the Asian Economic Crisis on Trade”. Journal of Japanese Trade and Industry . 1 January. Krugman, Paul. 1994. The Myth of Asia’s Miracle. Foreign Affairs. 73 (November): 62–78. Mahathir Mohamad, Dato Seri. 1999 a. Speech at the World Economic Forum. Davos, Switzerland. 29 January.

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______. 1999b. “Why Malaysia’s Selective Currency Controls are Necessary and Why They Have Worked”. Symposium on the First Anniversary of Currency Controls, Kuala Lumpur, 2 September. Mahbob, Sulaiman. 1999 a. “The Need to Strengthen the Economic Recovery Process”. National Economic Action Council (NEAC) Press Release, 23 March. ______. 1999b. “Economic Recovery under Fixed Exchange Rate and Capital Control Environment”. National Economic Action Council (NEAC) Press Release, 9 June. Malpass, David. 1998. “The Road Back From Devaluation”. Asian Wall Street Journal. 21 January. Mertens, Brian. 1998. “Asia’s Exports Miss the Boat”. Asian Business. October. Miche, Jonathan. 1999. “Damping Down Speculation”. New Voice of Asia. Second Quarter. National Economic Action Council (NEAC). 1998. “National Economic Recovery Plan—Agenda for Action”. NEAC/Economic Planning Unit. Kuala Lumpur. August. NEAC-MTEN. 1999a. “Status of Implementation–NERP Recommendations”. National Economic Action Council (NEAC) Press Release, 14 June. ______. 1999b. Bank Negara Malaysia Meeting with Fund Managers and Analysts. National Economic Action Council (NEAC) Press Release, 19 August. Porter, Michael. 1990. The Competitive Advantage of Nations. New York: Free Press. Sachs, Jeffrey, and Wing Thye Woo. 1999. “The Asian Financial Crisis: What Happened, and What is to be Done.”In The Asia Competitiveness Report. Geneva: World Economic Forum. Selgin, George. 1998. “Godfathers of Easy Money”. Financial Times. 21 October. Sharma, Sunil. 1999. “The Challenge of Predicting Economic Crises”. Finance and Development. June. Stiglitz, Joseph. 1998. “Restoring the Asian Miracle”. Asian Wall Street Journal. 2 February. Tsang, Donald. 1997. “The Asian Debt Market: How the Region Can Harness Savings to Head Off Crises”. Asiaweek. 19 December. United Nations Commission on Trade and Development (UNCTAD). 1995. Handbook of International Trade and Development Studies.

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Wade, Robert. 1998. “The Asian Crisis and the Global Economy: Causes, Consequences and Cure”. Current History. November. Wee, Victor. 1999. “Malaysia’s Experience in Dealing with the Financial Crisis”. NEAC Speech at Joint Seminar, Securities Association of China and Asian Securities Analyst Federation, Dalian, 28–30 June.

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5 Reform of China’s State-owned Enterprises in Face of the Asian Financial Crisis1 Hu Jiangyun INTRODUCTION

After China set a socialist market economy as its goal, reform of stateowned enterprises (SOEs) became a top priority and a key to the country’s structural economic reform. The Fifteenth National Congress of the Communist Party of China (CPC) held in September1997 established new targets for the reform of SOEs, including getting large SOEs on a sound economic footing by the year 2000. The withering of China ’s external market caused by the Asian financial crisis and the weakness of domestic demand due to tight macroeconomic policies presented new challenges for the SOEs. The government is sticking to its original 1997 targets despite these adverse conditions and has recently increased investment and expanded domestic demand in order to create a better economic environment for SOE reform. It has also begun specific steps to reorganise, transform and restructure, and improve the management of SOEs.

IMPACT OF THE ASIAN FINANCIAL CRISIS

Through the domino effect the Asian financial crisis that occurred in July 1997 involved the financial community throughout the world. When exchange rates dropped drastically in the emerging market economies, China committed not to devalue the renminbi, and suffered a heavy loss as a result. In particular, this commitment had an adverse impact on the external climate for SOE reform.

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Impact of the Crisis

Drop in Exports led to Economic Slowdown

China’s export growth slowed in 1998 as a result of the decline in imports by other crisis-struck Asian economies. The growth rate of total exports fell to 0.5 percent for 1998, and it even became negative from August through November (Figure 5.1). The growth rate of total exports followed the pattern of exports to East Asia. Comparing 1998 with 1997, exports were down 31.3 percent to Korea, 13.6 percent to ASEAN, 6.7 percent to Japan, and 11.5 percent to Hong Kong. The fall in exports had a direct effect on industrial production. First, the prices of bulk export commodities plunged sharply in 1998. The average price of export goods declined 5.5 percent in the January–September period compared with the same period a year earlier, and prices of coal, oil, and oil products fell by 10 to 30 percent. Likewise, export prices for machine tools, electronics, paper, TV sets, and other products fell by 7 to 25 percent. Second, the decline in export demand slowed the growth of industrial output. The decrease in the value of exports led to a 2.1 percentage point fall in the growth rate of industrial production for the first half of 1998 and a decline of one percentage point for the entire year. Finally, the fall in industrial production in turn reduced the growth rate of GDP by one percentage point. Decrease in Inward Investment from Asia

In 1998 approvals for establishing foreign-funded enterprises decreased 5.7 percent to 19,846, while approved foreign direct investment contracts were up 2.2 percent, for a total of US$52.13 billion. Total foreign direct investment utilised in 1998 fell 0.67 percent, to US$45.58 billion after increasing 5.4 percent from 1996 to 1997. From 1997 to 1998 investment into Mainland China from ten economies of the Asia region (including Hong Kong, Macao, and Taiwan) fell 13.40 percent causing Asia’s share to decline by 9.74 percentage points. At the same time, in-place capital investment into the Mainland from the Asia region fell 9.27 percent, and Asia’ s share contracted by 7.46 percentage points. For 1998 in-place capital investment from Indonesia declined 16.15 percent, from Korea it was down 28.78 percent, from Japan it fell 27.01 percent, and from the Hong Kong SAR it was off 8.93 percent from the previous year.

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FIGURE 5.1 Growth Rate of Total Exports and Exports to East Asia, July 1997–December 1998 Percent

30 25 Total Exports

20 15 10 5 0 -5 -10

Exports to East Asia

-15 -20 -25 July 1997

Sept.

Nov.

Jan. 1998

Mar.

May

July

Sept.

Nov.

Source: China Customs Statistics, 1996–1998.

Pressure on Foreign Exchange Reserves

Given a sustained trade surplus, with a cumulative increase of 7.8 percent from January to December 1998 and the stable renminbi exchange rate, China’s foreign exchange balance was under great pressure due to the external financial crisis. Foreign exchange reserves increased a mere 3.6 percent at the end of 1998 over their level at the end of 1997. The slower increase in foreign exchange was mainly due to four factors: • Some Asian countries deferred payments to China or were even unable to make payment. • Foreign parties to some foreign-funded enterprises remitted profits abroad due to difficult operations of the parent companies, with some enterprises even transferring external debts into renminbi liabilities.

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• Expectations of renminbi devaluation triggered illegal procurement and flight of foreign exchange. As a result, foreign exchange deposits by individuals increased US$12.1 billion by the end of 1998 over the previous year; and • The decline in international market prices stimulated smuggling into China. Smugglers accumulated a huge amount of foreign exchange by illegal means. Despite these negative factors, the foreign exchange balance is improving as a result of a crackdown on smuggling and strengthened exchange controls. Lessons from the Asian Financial Crisis

Reform of the Financial System and Reinforcement of Regulation

With expanding economic exchanges among countries as a result of regionalisation and globalisation, the world-wide daily turnover of foreign exchange transactions has reached US$1,500 billion and short-term hot money has topped US$7,500 billion, almost 20 percent of world GDP. In such an economic environment, if a country’s financial system is weak, its banking system vulnerable due to poor regulation, and its financial market opened at the wrong time, financial turbulence is apt to occur, affecting the regional economy and even involving the entire world. The recent financial crisis in Asia is a typical example. China’s financial system exhibits some problems similar to those in other Asian countries. The authorities have become concerned over the large volumes of foreign exchange fleeing China and being purchased illicitly. They recognise the dangers of rashly allowing financial liberalisation when regulatory and banking systems are not complete and the market mechanism is not sound. Since the crisis, all Asian countries have begun reforming their financial systems and strengthening financial regulation. China is also speeding up the reform of state-owned banks and the establishment of a sound financial regulatory system. The experiences of its Asian neighbours will provide a guide for China in guarding against and eliminating financial risks. Consummation of Corporate Governance

The Asian financial crisis has also revealed deficiencies in governance among East Asian companies. Some tycoons exercised highly centralised control with close ties with government officials, banks, and other

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corporations. Relying heavily on support from the government and banks, they expanded their scale of business and diversified operations without considering the reality of their financial condition. This pushed up liabilityasset ratios, exposed them more heavily to risks and losses, and ultimately cornered them into insolvency. In the past, China used the take-off experience of other Asian countries as reference point. Following the Asian model, China concentrated on establishing conglomerate enterprises not on corporate governance, offering few incentives and placing few restrictions on managerial personnel. Now, China has begun to pay attention to the restructuring of enterprises that is occurring in other Asian countries and to revise its policy on the formation of large enterprise groups.

Structural Reform

Emerging market economies have typically undertaken structural reform in the course of transition from government-direction to market-orientation. Imperfect commodity, capital, and labour markets have caused structural imbalances in high-growth environments and resulted in bubble economies. The Chinese government has realised the importance of structural reform to the reform of the state sector. In order to create a better macroeconomic environment for enterprise reform, it is cultivating the market mechanism and setting up a social security system. It recognises that adjustment of the industrial structure must be carried out in light of domestic and overseas market trends and competitive pressures, so that China can fully benefit from its comparative advantage. At the same time, the fiscal, distribution, investment, and financial systems should be reformed to create a new structural framework that prevents violent fluctuations in economic development.

PROCESS AND STATUS OF SOE REFORM Process of SOE Reform

Under the planned economy, SOEs were not independent economic entities but affiliates of the government, and their economic activities were carried out according to the state plan. Since 1978 the government has adopted various reforms to the state sector. These reforms may be divided into three stages.

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1978–1984: Decentralisation

Initial reform of the state-owned enterprise sector covered two main areas. Administrative control over most enterprises was decentralised to the local government, and enterprises were given more decision-making power and permitted to retain a portion of their profits. These measures to increase economic incentives benefited some 36,000 SOEs. 1984–1992: Contractual Responsibility System

In October 1984 China adopted the new concept of a planned market economy based on public ownership and between 1984 and 1992 more than 95 percent of SOEs were brought under the so-called Contractual Responsibility System (CRS). The contractual responsibility system was actually a continuation of the process of decentralisation. Under this system, the state entrusted the operation of public property to the managerial personnel of enterprises. Contracts could be negotiated between SOEs, on behalf of the government, and contractors. The contracts specified how much the contractor would turn over to the enterprise as well as the proportion of the surplus over the contracted commitment that would be distributed to the contractor and the proportion that would be distributed to the enterprise. One aim of this system was to encourage enterprises to turn a profit and pay taxes each year. The CRS suffered from four problems. First, enterprises bore no responsibility for operating losses. Second, contracts were not standardised, so unfair competition could result if different enterprises negotiated different contract terms. Third, the rigid economic structure of the enterprises hindered their structural readjustment and optimisation. Fourth, the system encouraged enterprises to seek short-term gains and made them reluctant to undertake long-term investments in product development or technological advancement. 1992 to Present: Establishing a Modern Enterprise System

In October 1992 China adopted the goal of building a socialist market economy and recognised that the market allocation system should be allowed to operate and that the state sector should be reformed to establish a modern enterprise system. In 1997 the Fifteenth National Congress of the CPC went further in proclaiming the strategic readjustment of the state sector, the deepening of enterprise reform, and the importance of the nonstate sector as a component of the socialist market economy.

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Position of SOEs in the National Economy

SOEs continue to play a prominent role in China’s national economy in terms of government revenues, taxes, fixed asset investment, employment, and other areas. • SOEs make a significant contribution to fiscal revenues. Although their share has decreased since 1988, it has remained above 70 percent, far larger than the share of revenues contributed by other enterprises (Figure 5.2). • SOEs are responsible for over half of China’s total fixed-asset investment, although the proportion fell from 68.1 percent in 1992 to 53.0 percent in 1995 (Table 5.1). • SOEs still accounted for over one-fourth of total industrial output in 1997, even though their share had fallen year after year since 1978 (Table 5.2).

FIGURE 5.2 Composition of Fiscal Revenues by Category of Enterprise, 1978–95 100.0 Other Enterprises 90.0 80.0

Collective Enterprises

70.0 60.0 SOEs

50.0 40.0 30.0 20.0 10.0 0.0 1978

1980

1982

1984

1986

1988

Source: China Statistical Yearbook 1998, p. 272.

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TABLE 5.1 Fixed-asset Investment by SOEs, 1992–97

1992 1993 1994 1995 1996 1997

Amount RMB billions

Share of Total Investment %

549.87 792.59 961.50 1,089.82 1,200.62 1,309.17

68.1 60.6 56.4 54.4 52.4 52.5

Source: China Statistical Yearbook 1998, p. 186.

TABLE 5.2 Value of Industrial Output, Total and SOE Contribution, 1978–97

1978 1980 1985 1990 1991 1992 1993 1994 1995 1996 1997

SOE Industrial Output

Total Industrial Output bil. RMB

Amount bil. RMB

Share of Total %

423.7 515.4 971.6 2,392.4 2,662.5 3,459.9 4,840.2 7,017.6 9,189.4 9,959.5 11,373.3

328.9 391.6 630.2 1,306.4 1,495.5 1,782.4 2,272.5 2,620.1 3,122.0 2,836.1 2,902.8

77.63 75.98 64.86 54.10 56.16 51.52 46.95 37.33 33.97 28.48 25.52

Source: China Statistical Yearbook 1998, p. 433.

• Over half (54.7 percent) of urban workers in 1997 were employed by SOEs, although the proportion was down from 63.2 percent in 1992 (Table 5.3). Of the 11.51 million workers laid off in cities and towns by the end of 1997, 68.4 percent, or 7.87 million were from SOEs. Over three-quarters of the workers laid off from SOEs, 6.1 million people, had been at small-sized enterprises. Thus, despite recent declines, SOEs still hold an important position. This importance depends upon three factors: their profits are the major

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TABLE 5.3 Workers in Cities and Towns, Total and at SOEs Number of Workers in Cities and Towns

1992 1993 1994 1995 1996 1997

Total 10,000

At SOEs 10,000

Share of Workers in Cities and Towns Employed at SOEs %

17,241 17,589 18,413 19,093 19,815 20,207

10,889 10,920 11,214 11,261 11,244 11,044

63.16 62.08 60.90 58.98 56.74 54.65

Source: China Statistical Yearbook 1998, p. 130.

source of treasury revenues; they employ a great number of people; and they have a huge amount of assets. Therefore, the successful reform of SOEs will have a critical bearing on China’s economic development. Major Problems

Irrational Industrial Structure

The structure of the state-owned enterprise sector is irrational in many aspects. First, the organisational makeup of SOEs is irrational. On average, SOEs are too small to realise economies of scale. Average capital per enterprise is only 10 million yuan. Because they are involved in too many industries and their number is too large, their investments are too widely dispersed. Second, SOEs carry a heavy burden of social-welfare obligations. For example, they run more than 18,000 primary schools with 6.1 million students and 600,000 teachers and staff. Their annual spending on these schools is as high as 4.5 billion yuan. At the same time, SOEs also manage over 3,700 hospitals and medical care units with beds, accounting for about one-third of China’s total hospital beds. Third, the output of SOEs is irrational. They do not necessarily supply products or services that are in demand so they usually operate below capacity. The disparity between the industrial structure and the demands of society is due to administrative interference of central and local governments in investment and construction decisions. In addition, SOEs

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were slow to shift out of traditional industrial sectors that lost market share or competitive edge. Fourth, SOEs suffer because of irrational location decisions. In the past, local governments designated sites for SOEs without regard to what was suitable to the particular business. As a result, they have extremely high costs for transportation, environmental protection, and infrastructure that greatly reduce their competitiveness. Inefficiency and Heavy Losses

The inefficiency of SOEs is evident from their low input-output ratios and low rates of capacity utilisation. State-sector enterprises possess about two-thirds of China’s economic resources and their share of fixed-asset investment exceeds 50 percent, but they account for only one-quarter of industrial output value. SOEs generate only 2.7 yuan in profit per 100 yuan of inputs, while township enterprises yield 7.2 yuan in profits from the same amount of inputs. According to a survey of producers of more than 900 main industrial products, over half of SOEs were operating below 60-percent capacity in 1995. Losses being incurred by SOEs have three dimensions. First, the number of loss-making enterprises is on the increase. In 1991 only 29.7 percent of SOEs suffered losses, but the share shot up to 39.2 percent in 1997 and to 49 percent in 1998. 2 Second, the total losses of loss-making enterprises have been spiralling year after year while the total profits of enterprises turning a profit have been declining (Table 5.4). In 1996 and 1997 the total losses exceeded the total profits. According to a survey by responsible TABLE 5.4 Combined Profits and Losses of SOEs under the Independent Accounting System, 1992–97 (Billion yuan) Year

Total Losses

Total Profits

1992 1993 1994 1995 1996 1997

36.927 45.264 48.259 63.957 79.068 83.095

53.510 81.726 82.901 66.560 41.264 42.783

Source: China Statistical Yearbook 1998, p. 461.

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government departments, more than 50,000 small-sized SOEs reported a net loss of 6.6 billion yuan in 1997. Third, the increase in the number of money-losing enterprises led a rise in the number of cases of insolvency. The number of SOEs that went bankrupt in 1996 alone (6,443 enterprises) was more than triple the number that went bankrupt during the entire period 1991 to 1995 (1,520 enterprises). Overdue Bank Loans

According to the China State Property Administration, the liability-asset ratio of SOEs ballooned from 18.7 percent in 1980 to 71.7 percent in 1993. It climbed to 75.1 percent among 124,000 such enterprises after verification in 1994. Among 302,000 SOEs surveyed in 1997, 51,000 had liabilityasset ratios of at least 100 percent, and among enterprises with a ratio below 100-percent, 61,000 had bad debts in excess of their capital assets. The 112,000 enterprises in these two categories comprised 37.2 percent of the SOEs in the survey. As suggested by their high liability-asset ratios, some SOEs were deeply indebted to banks and this in turn caused some banks to have an unreasonably high ratio of non-performing loans. According to the China State Property Administration by the end of 1995, non-performing loans of state-owned banks accounted for 22.3 percent of the total and total liabilities of SOEs amounted to 5,812.63 billion yuan. According to the latest official estimates, the ratio of non-performing loans of Chinese banks is as high as 25 percent, of which 2 percent represents bad debt that cannot be recovered at all and 3 percent represents loans past due for more than two years. MAJOR MEASURES FOR FURTHER ENTERPRISE REFORM

External demand is slack due to the Asian financial crisis and domestic demand is weak due to four years of tight policy. China’ s rate of growth and prices are falling, whereas the unemployment rate is rising. The Chinese government has instituted countermeasures to cope with this severe situation, including revised macroeconomic policies, successive interest rate cuts, a substantial increase in government investment, and expansion of domestic demand. At the same time, the government has realised that macroeconomic policy management is not sufficient and that efficiency must be improved on a microeconomic level as well. Despite worsening market conditions, China is pushing ahead with the

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re-organisation, transformation, and restructuring of state-owned enterprises. Measures to Improve the Business Environment

Drawing on the experience of other Asian countries, the Chinese government has adopted a number of policies to improve the overall environment in which state-owned enterprises operate. The first step was to reform government organisations. In 1998 the number of departments and commissions of the State Council was reduced to 29 from 40, eliminating mainly those industrial departments that interfered directly in enterprise operations. Second, the government has pursued a strong fiscal policy and an active monetary policy. In mid-1998 the government issued an additional 100-billion yuan of special state bonds to provide financial support for infrastructure construction. As a result, the 2,845.7 billion yuan total investment in fixed assets for the year was two percent above the plan amount and 14.1 percent greater than in the previous year. In 1998 fixed asset investment in the public sector reached 2,110.2 billion yuan, an increase of 21.2 percent over 1997. Interest rates were lowered twice during 1996, and since the onset of the Asian financial crisis the central bank increased the money supply and lowered the interest rate four times, while banks injected more loans into infrastructure construction projects. All of these steps were aimed at expanding domestic demand. Third, the government has begun to reform the financial system. The central bank was reorganised, replacing the system of provincial branches with nine trans-regional branches to free the activities of central bank branches from administrative interference by local governments. A new standard for classifying assets into five grades was adopted to facilitate liquidation of non-performing assets. The government adopted standards for securities market operations and began to supervise the activities of non-bank financial institutions. The central bank cracked down on illegal foreign exchange activities. Government interference in allocating investments has been reduced and state-owned banks have been given autonomy in lending decisions. Fourth, the government has made further improvements in the social security system. Pension, medical insurance, and social welfare systems are being established through a combination of public planning and individual accounts. In 1998 the central and local governments planned to spend 17.5 billion yuan on workers laid-off from SOEs, a net increase of 14 billion yuan over the previous year’s figure. The government established

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a minimum standard of living for workers who had been laid off from SOEs in urban areas in order to guarantee their basic needs and to encourage local governments to put priority on the re-employment of laid-off workers. From the second half of 1998 the government began replacing the system of providing free housing to state workers. Although such housing was supposed to revert to the enterprise when workers left state enterprises, in practice many laid-off workers continued to live in these houses. Under the new system workers are able to pay for their housing and occupy it independent of their employment. Fifth, the government has launched a re-employment program. According to our analysis China has nearly 20 million excess workers. Many SOEs could operate with only two-thirds the number of workers they currently employ and some may require only half the current number of workers. The government took three active employment measures in 1998. First, it began a publicity campaign through the press to alter people’ s notions about employment possibilities and to encourage laid-off workers to find suitable new jobs. Second it drew up a vocational training program, and third it opened re-employment service centres and more labour markets to provide job information for unemployed and laid-off workers. In 1998 more than 99 percent of laid-off workers entered such re-employment centres and more than 92 percent received the minimum standard-ofliving subsidy. In the meantime 50 percent of all laid-off workers, 6.09 million people, found new employment. 3 Stepping up Reform of SOEs

The reform of SOEs must take into account both the specific nature of the state-owned sector in China and the unique conditions of certain types of enterprises. China is a large, developing country and it had a planned economy for a long time. As a result, the state sector encompasses a large number of enterprises and employees, and it is involved in many different industries in many places. Moreover, SOEs differ widely in terms of location, industry, productivity, technology, and management level. Therefore, no single pattern of reform can apply across-the-board to all state enterprises. At present the government is pursuing a number of different approaches to bring about reform of the state-owned sector. These include re-organisation, transformation, restructuring, introduction of shareholding and shareholding co-operative systems, conglomeration, merger, acquisition, leasing, contracting, bankruptcy, and auction. Recent steps taken by the government include:

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Increasing Capital of SOEs

• transferring a portion of the outstanding loans and accrued interest of banks into government investment in SOEs. Such capital increments amounted to at least 50 billion yuan in 1997 and exceeded 70 billion yuan in 1998. • encouraging SOEs to enlarge their capital base by raising funds in the market. Priority is given to key enterprises and members of large enterprise groups that comply with state industrial policies and have sound operations and management. These enterprises are allowed to list their shares and raise funds in domestic and international capital markets. Of the 512 super-large enterprises selected for reform, 183 have listed their stocks on the market over the past ten years. In 1998 thirty large listed SOEs raised a total of 16.3 billion yuan. • issuing special government bonds to provide capital for stateowned banks. On 18 August 1998 the government issued 270 billion yuan in special state bonds exclusively saleable to the Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and China Construction Bank. At the same time, the amount of required reserves deposited with the central bank was reduced. Funds from these sources were earmarked to increment the capital of the four state-owned banks. Encouraging Mergers, Bankruptcy, and Downsizing

The government is encouraging large and medium-sized SOEs to merge with enterprises that have been in the red for three years running. The surviving entities are allowed five to seven years to repay over-due loans and accrued interest is waived, but they must take over all the liabilities of the merged enterprises and redirect their personnel. Surplus labour should be laid off to find new jobs through re-employment centres. For loss-making enterprises with readily marketable products but a heavy burden of debt, the government is offering reductions or exemptions in interest payments on the condition that the enterprises link their level of employment to their level of output and lay off surplus workers. On the other hand, it is requiring enterprises that have been operating at a loss for a long time without hope of turnaround be sold at auction after their assets are appraised. Part of the proceeds from the sale of these enterprises is to be used to redirect their surplus workers and to pay off their bad bank loans.

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These three measures have been financed from the bad-debt reserves of state-owned banks. By the end of 1997 a total of 675 failed SOEs in 111 cities had been liquidated, 1,022 had been merged with other enterprises, 4 and 1.69 million workers had been laid off and channelled to other sectors. To accomplish this, in 1998 state-owned banks used a total of 40 billion yuan of bad-debt reserves, which was 10 billion more than the previous year. Textile Industry Retrenchment

The government is requiring the textile industry, which has the largest number of loss-making enterprises and the greatest amount of losses, to destroy all obsolete machinery and reduce staff. In 1998 the number of spindles was reduced by some 5.12 million, staff was reduced by 660,000 workers, and losses were cut by 2.6 billion yuan, exceeding the planned reductions of 4.8 million spindles and 600,000 personnel. According to the plan for 1999, 9.50 million spindles and 1.10 million personnel are to be eliminated in order to cut losses by three billion yuan. The government is providing a three-million yuan subsidy for each10,000 spindles destroyed. Advancing the Shareholding System

Among the 2,500 enterprises selected by the central and local governments for an experiment with the shareholding system, 1,989 were turned into shareholding companies between 1993 and the end of 1997. 5 Of these, 1,562 were medium- and large-size SOEs with assets totalling 2,178 billion yuan and comprising over one-third of the total number of enterprises under the independent accounting system. 6 Implementation of the shareholding system continued into 1998. Establishing Large Enterprise Groups

In 1998 China stepped up efforts to encourage the establishment of large enterprise groups as one pattern for enterprise reform (see Cases 1 and 2). Typically, these are conglomerates that operate across several industries in several geographic regions and compete internationally.

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Case 1 Oil and Chemical Group Companies China Natural Gas Group and China Petroleum and Chemical Industrial Group were formed by reorganising subsidiaries of the China Natural Oil and Gas Exploration and Development Corp. and China Petrochemical International Co. These former entities, along with the Ministry of the Chemical Industry, had comprised the State Administration of Petroleum and Chemical Industries, which operated under the State Economic and Trade Commission. The two new groups were formed as trans-regional, integrated industrial chains, with domestic and foreign trade, production, and marketing. As a result, each can compete effectively with such rivals as China Marine Oil Corp. In 1998 the restructured China Natural Gas Group attained net profits of 4.0 billion yuan and paid taxes of 25.75 billion yuan.

Case 2 Shanghai Baogang Group Company Shanghai Baogang (Baoshan Iron and Steel) Group Company was formed on 17 November 1998 by combining the assets of Shanghai Baoshan, Shanghai Metallurgy, and Meishan Group. The net assets of the new group company amount to 70.5 billion yuan and its fixed assets make up 20 percent of the industry total. The former Shanghai Baogang was an efficient producer mainly of high quality thin plates and seamless steel tubes in large quantities; Shanghai Metallurgy had been known for its many varieties and specifications of specialty steel products; and Meishan had been a provider of ore materials. The combination of these three in a single large enterprise group will give full play to their respective strengths, improve product quality, and increase variety. The new group is China’s largest producer of high-grade iron and steel.

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A number of factors shaped China ’s approach to establishing large enterprise groups. These included the failure of national champions in some other countries, the world-wide trend away from conglomerate mergers and toward mergers involving companies in the same industry, and the recognition that formation of large enterprise groups should be carried out under specific guidelines. In particular, steps must be taken to ensure that mergers do not result from interference by central government departments and local governments to compel enterprises to form new groups. Instead, enterprises should be encouraged to merge according to market conditions and their own best interests. In addition, mergers that seek only diversification, expansion, or access to unfamiliar areas should be discouraged. Diverse Reforms for Small- and Medium-sized SOEs

Generally speaking, the contribution of small- and medium-sized SOEs to state-sector sales and output is in proportion to their share of state-owned enterprise assets or capital (Table 5.5). There are, however, big differences by region, sector, and enterprise. As a result, the government has had to adopt various approaches to reform small- and medium-sized enterprises, including re-organisation, combination, merger, introduction of shareholding, introduction of the shareholding co-operative system, leasing, contractual operation, and auction. During the 1990s the shareholding co-operative system spread rapidly among smaller SOEs. This system has four characteristics: 1. Enterprise staff are both capital contributors and labourers, sharing risks jointly. TABLE 5.5 Small- and Medium-sized Enterprises’ Share of the SOE Sector, 1997 (Percent)

Small enterprises Small and mediumsized enterprises

Share of Enterprises

Share of Assets

Share of Capital

Share of Sales Income

Share of Output Value

81.0

16.1

17.3

16

17.5

94.4

35.2

34.5

35

37.0

Source: State Economic and Trade Commission. 1998.

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2. Enterprise management is democratic with decisions made at the general shareholders meeting, the supreme authoritative organ, on the basis of one vote for one person or one share. This system also establishes a reasonable corporate governance structure. 3. Enterprises should operate to protect the owners ’ interests and shareholders’ responsibility is limited by their capital contribution. The enterprise takes on limited liability for its debt. 4. Enterprises distribute profits according to work and capital contribution. According to a survey of 60,000 industrial enterprises, 23 percent had been reorganised as shareholding companies or as shareholding cooperatives by the first half of 1998. In some localities almost half of the surveyed enterprises, and in a few localities over 80 percent, had completed this restructuring. The government observed, however, that simply restructuring SOEs could not solve the problem of low efficiency. As small- and mediumsized SOEs are primarily located in cities and towns, many of them operate at a loss, leading to an increase in the number of laid-off workers in these localities. In order to reduce employment pressure, the government has refocused its attention on the development of these enterprises. In 1998 the State Economic and Trade Commission set up a Small- and Medium-Sized Enterprise Department and the central bank required stateowned banks to set up special departments to arrange loans for these enterprises. In addition, interest rates are permitted to fluctuate by a wider margin on such loans. Improving SOE Management

Management of SOEs has been improved on two fronts. First, the accounting system has been improved. Internal accounting and auditing procedures have been strengthened and practices of public accounting firms as intermediaries have been standardised. The Ministry of Finance has decreed that 105 certified public accounting firms that had been subject to local governments should be appraised and spun off in order to form an independent public accounting system. Second, a special inspection system has been implemented. The central government has dispatched inspectors to key large SOEs to examine their financial condition, evaluate the administrative achievements of the management, and submit a true, accurate, and objective report. These inspectors do not participate in or interfere with the operations or management of the enterprises.

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Problems with the Reform of State-owned Enterprises

Inadequate Corporate Governance

Turning SOEs into shareholding companies does not completely solve the problem of corporate governance. The Development Research Centre of the State Council identified three major corporate governance issues from a 1997 survey of managers of SOEs. First, SOEs do not provide adequate incentives to management. Over seventy-eight percent of managers of state-owned enterprises deemed it necessary to set up a system to base a manager’s ownership share on the performance of the enterprise. Second, SOEs lack an adequate mechanism of external discipline. Only 20 percent of managers agreed that external discipline is more effective than internal controls. Third, boards of directors have little control over enterprise managers. Only 27.6 percent of enterprise managers thought that the board could exert normal control. These responses clearly indicate the need to improve corporate governance. Corporate governance problems in China are similar to those in other East Asian countries. Administrative interference is serious; insider-control is apparent; the number of outside and expert directors on the board is too small and they cannot function effectively; and the capital market and banks do not exert adequate control over enterprises. Deficiencies in Bankruptcy Procedures and Auctioning of Small Enterprises

There are at least three major problems with procedures for bankruptcy and auctioning of small SOEs. First, lack of transparency in the auction process and failure of some local intermediaries to appraise assets uniformly have resulted in large amounts of state-owned assets being siphoned off to individuals or the private sector. Second, false declarations of bankruptcy by enterprises attempting to escape their debts have contributed to a sharp rise in banks’ non-performing assets. Third, through abuse of power some local officials and enterprise executives have embezzled enterprise assets at the expense of employees. Despite the many possible ways to reform small- and medium-sized SOEs, in some regions they were simply sold and all their debts wiped out. Such haphazard selling has caused a number of problems, including loss of state assets, difficulties in recovering bank debt and taxes, and harm to the interests and rights of creditors and workers. The central government has prohibited random selling of smaller state enterprises and required

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sales of small- and medium-sized SOEs to be conducted according to statutory procedures. The government is in the process of formulating and modifying laws and regulations to ensure that capital markets operate according to standard procedures and to ensure that the interests of property owners, creditors, and employees are protected at the time of bankruptcy, auction, and liquidation. CONCLUSION

In the face of the Asian financial crisis the Chinese government has realised that reliance merely on macroeconomic policies cannot maintain long-term and efficient economic development. This is particularly true since China’s structural readjustment is delayed, its market mechanism is imperfect, both its financial controls and banking system are fragile, and economic efficiency is low. Hence, in addition to adopting strong macroeconomic policies to stimulate domestic demand and avoid deflation, the government has intensified its efforts to restructure industry and reform SOEs. The state sector plays a critical role in the national economy and its complicated problems pose a great challenge to reform. The goal for the first stage of the SOE reform is to make most large state-owned enterprises viable by the year 2000. Successful reform of state-owned enterprises will be conducive not only to China’s economic growth but also to the economic rehabilitation and stability of Asia as a whole. Notes 1

2

3 4 5 6

The author is indebted to Dr. Zhang Xiaoji for valuable materials and ideas that he contributed to this paper. China Statistical Abstract 1998, p. 12 and People’s Daily, 20 March 1998, p. 1. People’s Daily, 22 January 1999, p. 1. Economic Daily, 5 March 1998; People’s Daily, 7 March 1998, p. 4. People’s Daily, 7 March 1998, p. 4. Financial News, 14 October 1998, p. 1. The independent accounting system requires enterprises to set up their own settlement accounts at banks, to prepare their own financial statements and to calculate their own profits or losses.

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6 Regaining International Competitiveness: Hong Kong after the Asian Financial Crisis Edward K.Y. Chen and Raymond Ng The Asian financial crisis triggered by currency speculation in July 1997 resulted in region-wide economic meltdown. Most developing countries in East Asia have experienced sharp currency depreciation, reversal of capital flows, widespread insolvency of financial institutions and businesses, shattered financial markets, falling economic growth, and rising unemployment. The unprecedented scale and severity of the crisis, as well as its contagious and self-reinforcing nature, took policymakers and researchers by surprise. There is an urgent need to identify the fundamental factors underlying the outbreak and the worsening of the crisis with a view to reducing the risks of similar occurrences in the future. It is equally crucial to formulate and implement adjustment and reform measures to address the key weaknesses of the affected countries, to restore market stability and investor confidence both at home and abroad, and, above all, to rebuild the foundation for smooth, sustained economic growth. Success will depend on the commitment and ability of the authorities concerned to take the necessary steps to resolve the institutional and structural weaknesses widely implicated in the crisis. Despite its strong economic fundamentals, sound financial systems, and prudent monetary and fiscal disciplines, Hong Kong was unable to remain aloof from the contagious financial turmoil. So far, Hong Kong has managed to defend its exchange rate peg against currency speculation. Nevertheless, disruptions in the interbank market and interest rate volatility caused the stock and real estate markets to tumble and, coupled with a slowdown in the external sector, consumption fell and general economic activity slowed considerably. The Asian crisis posed a major challenge to the Hong Kong economy, especially to its capacity to accommodate

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adverse external economic shocks and sudden shifts in investor sentiment. The crisis has also revealed the strengths and weaknesses of Hong Kong’s apparently robust economic and financial systems. Since the crisis, the government has introduced several measures to strengthen the self-restoring mechanism of the linked exchange rate regime and to ease the strain on interbank liquidity and bank credit. In October 1998 it announced an ambitious plan to boost Hong Kong’s long-run economic growth by promoting high technology and value-added industries. This chapter examines the strengths and weaknesses of the Hong Kong economy in light of the Asian financial turmoil and evaluates policy measures—those already adopted and those being recommended—to restore international competitiveness and achieve balanced, sustainable economic growth. ADVERSE IMPACTS OF THE ASIAN FINANCIAL CRISIS ON THE HONG KONG ECONOMY

According to official statistics, economic growth in Hong Kong reached a record low of negative 7 percent for the third quarter of 1998 (Table 6.1).1 The unemployment rate averaged a historic high of 5.8 percent for October– December 1998. Hong Kong’s economic downturn is to a large extent the result of drastic contraction of both internal and external demand that stemmed in one way or another from the Asian financial crisis. On the external side, domestic exports for 1998 fell 10.9 percent from 1997 to HK$188.5 billion (Table 6.2). The decline in domestic exports was concentrated among regional economies weakened by the Asian crisis. While domestic exports to the United States (the largest destination) were down by 0.4 percent, those to China (the second largest destination) dropped by 12.2 percent and exports to Japan and Singapore fell even more sharply, by 39.5 percent and 39.3 percent respectively. Total reexports dropped 6.9 percent to HK$1,159.2 billion in 1998 (Table 6.3). Re-exports to the United Kingdom still grew 8.2 percent and re-exports to the United States declined only 0.6 percent, but those to Korea, Japan, Singapore, China, and Taiwan fell by 36.6 percent, 17.4 percent, 12.8 percent, 8.2 percent, and 7.5 percent respectively. Moreover Hong Kong’s service exports decreased an average of 5.5 percent over the first three quarters of 1998, while service imports reported positive growth of 1.7 percent during the same period. Tourist arrivals for 1998 fell by 8 percent and total tourist spending for the same period dropped sharply by 24.1 percent (Tables 6.4 and 6.5). Specifically, spending by tourists from China

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

5.4 6.4 5.8 2.5

–2.6 –5.1 –6.9 –5.6

1997 Q1 Q2 Q3 Q4

1998 Q1 Q2 Q3 Q4

–2.5 –5.0 –9.9 –9.0

4.0 8.2 10.6 2.4

8.6 8.5 7.5 6.7 1.6 4.7 6.2 –6.7

Private Consumption Expenditure

2.0 –5.4 3.6 2.4

4.6 5.6 –0.1 –0.3

7.7 7.2 2.2 3.9 3.2 4.0 2.4 0.6

Government Consumption Expenditure

–8.6 –1.9 –21.1 –26.0

18.5 7.2 20.9 5.8

9.3 9.2 3.7 15.7 10.7 10.8 12.8 –14.3

Gross Domestic Fixed Capital Formation

1.4 –0.5 –7.0 –9.6

4.0 6.2 4.4 9.6

17.3 19.8 13.5 10.4 12.0 4.8 6.1 –4.3

Exports of Goods

–1.7 –1.8 –10.5 –13.5

6.4 6.9 7.1 8.2

19.0 22.2 12.7 14.0 13.8 4.3 7.2 –7.2

Imports of Goods

Source: Hong Kong Census and Statistics Department. Hong Kong Monthly Digest of Statistics . Various issues.

5.1 6.3 6.1 5.4 3.9 4.6 5.0 –5.1

1991 1992 1993 1994 1995 1996 1997 1998

Gross Domestic Product

TABLE 6.1 Growth in Real GDP and its Components, 1991–98 (Percent)

–10.1 –11.5 –4.7 –0.3

–5.4 3.0 –2.9 –5.0

4.7 10.6 8.0 6.5 4.8 8.5 –0.1 –6.6

Exports of Services

1.2 1.6 –2.7 –2.0

4.5 0.2 6.3 4.9

11.3 9.7 5.8 8.8 2.1 2.5 4.0 –0.6

Imports of Services

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TABLE 6.2 Growth in Domestic Exports by Destination, 1995–98 (Percent) Mainland China U.S.A. U.K. Japan Germany Singapore Taiwan Total 1995 1996 1997 1998

4.2 –3.0 3.6 –12.2

–0.3 –12.1 2.3 –0.4

6.3 –3.1 1.2 –6.2

13.6 –4.6 –6.1 –39.5

–4.9 –6.5 –9.4 –5.0

Source: Hong Kong Census and Statistics Department. Statistics. Various issues.

0.1 –18.2 –16.0 –39.3

31.2 –15.9 4.8 –7.1

4.3 –8.4 –0.4 –10.9

Hong Kong Monthly Digest of

fell by 8.5 percent and by those from Taiwan, Japan, and Southeast Asia fell yet more sharply, by 14.8 percent, 43.5 percent, and 43.0 percent respectively. At the same time, contagion from the regional financial turmoil and the attempts to defend the currency caused excessive volatility in the interbank money market. The strained money market and the ensuing surge in interest rates and credit crunch caused the collapse of internal demand and triggered a drastic slowdown in domestic economic activity. The Hong Kong dollar interbank (12-month) offer rate jumped from 7.2 percent in August 1997 to 12.09 percent in January 1998. For the period October 1997 to September 1998 the rate averaged 10.06 percent, significantly higher than the 5.88 percent average for 1996 and 7.47 percent average for 1997. The best lending rate for the same period averaged 9.87 percent. Between July 1997 and June 1998, stock and real property values fell by an estimated HK$4.3 trillion, more than triple GDP for 1997. Each household was estimated to have lost about HK$2 million (Standard Chartered Bank 1998a). Equity and real property assets also lost liquidity, as banks were reluctant accept them as collateral for loans or credit in face of the tumbling markets. This exacerbated the negative wealth effect, thus depressing consumer spending. The higher interest rates increased mortgage payments, reducing household purchasing power for consumer spending. A serious credit crunch emerged as adverse movements in the asset markets and increasing credit risks stemming from the deteriorating economy made banks more cautious with lending. The sharp decline in property prices in particular restricted bank credit since most bank loans are secured against real property collateral. In addition, banks maintained a higher liquidity position because volatile interest rates made interbank

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

19.0 8.8 6.3 –8.2

10.0 4.9 7.9 –0.6

U.S.A.

28.0 14.4 –3.0 –17.4

Japan 10.0 3.2 –1.9 –9.0

Germany 18.1 11.6 8.5 8.2

U.K. 23.8 –4.0 11.0 –7.5

Taiwan 27.8 9.1 3.5 –12.8

Singapore

17.0 4.1 –3.9 –36.6

Republic of Korea

Source: Hong Kong Census and Statistics Department. Hong Kong Monthly Digest of Statistics . Various issues.

1995 1996 1997 1998

Mainland China

TABLE 6.3 Growth in Re-exports by Main Destinations, 1995–98 (Percent)

17.4 6.6 5.0 –6.9

Total

138 EDWARD K.Y. CHEN AND RAYMOND NG

© 2000 Institute of Southeast Asian Studies, Singapore

15.4 3.0 –0.6 13.1

5.8 3.4 –2.1 1.7

Taiwan

17.4 40.9 –42.5 –30.9

Japan 5.5 14.4 –7.4 –22.7

Southeast Asia –0.3 4.0 –9.9 –12.5

Europe –3.5 0.3 6.6 –3.4

U.S.A.

4.4 11.6 –5.9 –5.8

Australia & New Zealand

Source: Hong Kong Census and Statistics Department. Hong Kong Monthly Digest of Statistics . Various issues.

1995 1996 1997 1998

Mainland China

TABLE 6.4 Growth in Visitor Arrivals by Origin, 1995–98 (Percent)

–5.7 –5.0 7.3 9.2

Canada

9.3 14.7 –11.1 –8.0

Total

HONG KONG 139

© 2000 Institute of Southeast Asian Studies, Singapore

29.3 10.6 2.4 –8.5

9.2 –9.1 –8.3 –14.8

Taiwan

16.0 31.1 –50.2 –43.5

Japan 14.7 9.3 –10.1 –43.0

Southeast Asia 11.3 13.3 –11.8 –27.1

Europe 2.7 9.3 3.1 –16.7

U.S.A.

11.6 13.4 –10.6 –27.2

Australia & New Zealand

Source: Hong Kong Census and Statistics Department. Hong Kong Monthly Digest of Statistics . Various issues.

1995 1996 1997 1998

Mainland China

TABLE 6.5 Growth in Receipts from Visitors by Origin, 1995–98 (Percent)

14.0 7.7 4.8 –3.4

Canada

16.7 13.1 –15.2 –24.1

Total

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borrowing expensive and unpredictable, and, more importantly, because the availability of last-resort liquidity from the Liquidity Adjustment Facility (LAF) was uncertain. Hong Kong dollar loans and advances fell by 3.9 percent in 1998, a drastic decrease compared with annual growth of 24.4 percent in 1997 and 17.1 percent in 1996. As a result of the credit crunch and high interest rates, combined with the negative wealth effect, consumption and investment spending declined drastically bringing about a significant economic contraction. This put further pressure on the asset markets, giving rise to a vicious circle of liquidity and credit crunch, falling asset values, negative economic growth, rising unemployment, and loss of confidence. The volume of retail sales dropped by 16.7 percent in 1998. Economic growth fell to negative 4.9 percent during the first three quarters of 1998 from an average of 6.2 percent during the same period in 1997 (Table 6.1). Growth in private consumption expenditure fell yet more sharply, from an average of 8.1 percent during the first three quarters of 1997 to negative 5.9 percent during the same period in 1998. The unemployment rate soared from 2.2 percent in August 1997 to a record high of 5.8 percent in December 1998. The extreme volatility in Hong Kong financial markets resulted from repeated speculative attacks on the Hong Kong dollar during 1997–98, most notably in October 1997 and August 1998. In the first instance, speculators allegedly took profits from shorting in the futures and foreignexchange forward markets. They appeared to be taking advantage of the close connections between the spot and forward foreign exchange markets and the equity and futures markets, on the one hand, and the Hong Kong Monetary Authority’s (HKMA) use of high interest rates to defend the peg, on the other hand. The HKMA stepped in to prevent those banks involved in the currency attacks from obtaining liquidity. It imposed punitive interest rates on banks that were repeatedly using the LAF. This caused chaos and uncertainty in the interbank market. On one occasion the overnight lending rate soared to 289 percent and the three-month Hong Kong dollar lending rate reached 50 percent. Financial disintermediation resulted, as banks with excess funds were no longer willing to lend their excess liquidity and banks needing liquidity were reluctant to turn to the LAF and had to go to the interbank market regardless of the cost. Bank lending almost came to a halt, as did the economic activities that were supported by bank loans or credit lines. In the August 1998 instance, speculators launched a full-scale attack on the Hong Kong dollar and the stock and futures markets. They allegedly had accumulated huge short positions in the futures market before selling

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around HK$31 billion (borrowed from international organisations that had raised Hong Kong-dollar debt in Hong Kong) in the spot market. They were aiming to push up interest rates, while shorting in the Hong Kongdollar forward and equity markets (particularly in constituent shares of the Hang Seng Stock Index) to push the futures index down further. In a desperate attempt to prevent financial disaster and collapse of the peg, the HKMA resorted to intervention in the foreign exchange spot, futures, and equity markets to counteract the speculators. It purchased around HK$120 billion worth of constituent shares, mostly in the last two days before settlement of the futures contract for August, and about 50,000 futures contracts for August (Hong Kong Economic Times, 31 August 1998). WEAKNESSES IN HONG KONG’S ECONOMIC AND FINANCIAL SYSTEMS

Hong Kong is well known for its strong economic growth and sound economic fundamentals, well-built infrastructure, prudent monetary and fiscal policies, sizeable accumulation of fiscal and foreign reserves, and liberalised and well-developed financial sector under sound regulation and supervision. It also has a highly flexible market-oriented economy, a welleducated and dynamic workforce, and a linked exchange rate regime backed by huge reserves of foreign currency. Certainly, Hong Kong did not suffer from an accumulation of foreign debt and liabilities that put the exchange rate under pressure. Nevertheless, the economy was not entirely without problems. The Asian crisis revealed certain structural and institutional weaknesses in Hong Kong’s economic and financial systems. First among these was the excessive orientation of the economy toward the service sector. In 1997 the service sector’s share of overall output was 85.2 percent whereas the industrial sector’ s share was only 14.7 percent. Within a short period of time services came to dominate Hong Kong’s economy following the relocation of much of its manufacturing industry to China, particularly during the 1980s. The rapid expansion of outward processing activities, coupled with the robust trade and economic growth of China, created a huge demand for transportation and other commercial and financial services. In addition, financial and property development interests dominated the stock market. In December 1997, seven of the twenty leading companies (in terms of market capitalisation) listed on the Hong Kong Stock Exchange were either banks or property developers. These seven accounted for 67.5 percent of the capitalisation of the top 20 companies and 35 percent of overall market capitalisation. Finance and

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property companies together accounted for 54.2 percent of the total market capitalisation of all listed companies in December 1996, not counting the many other companies also involved in real property development or with assets invested in real estate. The dominance of the property and finance sectors increased the concentration risk in the economy, making it highly vulnerable to adverse external shocks and making the eventual economic adjustment more painful than in a better balanced economy. 2 A second weakness was the structure of the financial system, in particular the underdevelopment of the Hong Kong dollar debt market. Because of a lack of debt alternatives, most long-term financing in Hong Kong, such as mortgage loans, was funded by short-term bank deposits. As a result, volatility in short-term interest rates spread to longer-term finance markets and to the real economy. Thus, the absence of a well-developed debt market exacerbated the economic disruption caused by the currency speculation and high interest rates. A third source of weakness was Hong Kong’s linked exchange rate system and currency board arrangement. The linked exchange rate regime seemed to have deviated from orthodox reliance on the intrinsic selfrestoring mechanism. Specifically, the supposedly intrinsic ‘cash arbitrage’ could not function properly due to high transaction costs and to the fact that a February 1994 reform restricted such arbitrage to the three noteissuing banks (NIBs). That reform allowed non-note-issuing banks to obtain bank notes from NIBs at the market exchange rate, rather than the pegged rate. Instead of relying on the self-restoring mechanism, the HKMA tended to intervene to support the Hong Kong dollar and relied solely on high interest rates to attract capital inflows to defend the peg. The linked exchange rate became somewhat confused with a fixed exchange rate system and suspicion arose over whether the HKMA was committed to maintaining the peg, despite the fact that the currency is supported by well in excess of 100-percent foreign reserves. During the 1997 episode, high interest rates did not induce the anticipated capital inflows, perhaps because of the high risk-premium on holding Hong Kong dollars and because of the expectation of exchange rate depreciation. Defending the peg was made more difficult by the close links among foreign exchange markets, interest rate movements, and equity and futures markets. Speculators were able to take profits from their short positions in the HK dollar forward, futures, or equity markets by heavily short-selling the Hong Kong dollar to push interest rates up. The punitive interest rates imposed by the HKMA in October 1997 on financial institutions repeatedly using the LAF brought further uncertainty to the

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money market, more volatile interbank interest rates, and financial disintermediation. The integration of global financial markets, the growth of aggressive portfolio capital flows, and the expansion and increasing sophistication of derivatives trading have weakened the conventional currency board system’s ability to tackle speculative attacks while containing short-term interest rate volatility. Moreover, the HKMA had gradually taken on more functions in addition to that of a currency board. These included managing government reserves and funds, issuing securities, supervising financial institutions, influencing interest rates and, more recently, intervening in the stock and futures exchange markets. Because the HKMA had exercised these typical central bank functions, speculators may have expected that it would also exercise the discretion of a central bank to abandon the linked exchange rate regime or devalue, particularly when defending the peg became excessively costly. MEASURES TO REGAIN COMPETITIVENESS AND PROMOTE LONG-TERM GROWTH

Hong Kong has few macroeconomic policy options to address what was perhaps the worst economic downturn in its recent history. The small size of the public sector limits the government’s capacity to use fiscal policy to boost aggregate demand and the linked exchange rate regime rules out expansionary monetary policy, as the primary policy objective is to maintain exchange rate stability. In lieu of these conventional measures Hong Kong must put priority on containing the disruptions in the financial markets and alleviating the credit crunch to restore monetary order. At the same time the government must find ways to diversify the economy and better position it for sustainable long-run growth. Restore Monetary and Macroeconomic Stability

To restore stability to the economy and monetary order in the short run the government needs to address the fundamental weakness of the existing linked exchange rate regime and currency board arrangement. In view of the increasing aggressiveness, severity, and persistence of speculative attacks and the ineffectiveness of the existing mechanism for defence of the exchange rate regime, in September 1998 the HKMA introduced a package of measures to modify the linked exchange rate system. All licensed banks were allowed to convert the Hong Kong dollars in their clearing accounts at the Exchange Fund into U.S. dollars at a fixed exchange

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rate. (Previously, only legal tender in circulation had been guaranteed such convertibility.) Banks were also allowed to use their holdings of Exchange Fund papers as collateral for repurchase agreements to obtain repeated overnight liquidity from the Discount Window (formerly the Liquidity Adjustment Facility) at the Base (previously Offer) Rate. After the change, banks were restricted to using only Exchange Fund papers and the existing eligible papers to obtain overnight liquidity from the discount window. To ensure that additional papers issued were fully backed by foreign reserves, the HKMA stipulated that new Exchange Fund papers could only be issued against the inflow of funds. It also started daily publication of information on its foreign currency assets and the monetary base, which includes bank notes and coins issued and the interbank balance, and on Exchange Fund papers outstanding. These measures were aimed at enhancing the self-restoring cash arbitrage of the currency board by extending it to ‘reserve currency’ arbitrage. They were also intended to increase the availability and accessibility (with certainty) of interbank liquidity to reduce interest rate volatility caused by the conjunction of currency attacks and market manipulation. The new restriction on the issuing of Exchange Fund papers should reinforce the currency board discipline by making theentire monetary base fully backed by foreign reserves. In addition to the steps it has taken so far, the government should also consider separating the currency board (the Exchange Fund) from the existing HKMA structure. The latter could focus on the typical central bank functions, except note-issuing, which would be left to the currency board and would be fully backed by foreign reserve assets. The government could go yet further and enact a statute requiring the currency board to manage foreign assets and to maintain the peg and 100-percent back-up for currency issued. Such a mandate would eliminate all suspicion that the HKMA could at its discretion devalue or abandon the peg. Furthermore, the government should explain fully to the public and business community how the pegged exchange rate regime and currency board system work. Increasing transparency would help restore the confidence of the public and local and foreign investors on which maintenance of the regime depends and this would allow the self-restoring mechanism to operate. To restore macroeconomic stability the government also needs to improve its policies affecting the property market. The government’s long-standing policy has been to support high land prices as a major source of fiscal revenue. It has been suggested that the government’s slow response to increase the supply of land and public rental housing, along with expanding

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demand for housing, was in large part responsible for the asset bubble and inflation during the 1990s. Surging demand from investors and speculators, in addition to actual end-users of property, fuelled the bubble, and altered the structure of demand for real property. Investors were seeking physical assets rather than financial assets to hedge rising inflation, which reached almost 10 percent in both 1989 and 1990. Confidence in the linked exchange rate regime further supported strong demand for property, particularly as Hong Kong experienced persistent balance of trade surpluses until 1995 (averaging 9.4 percent of GDP during 1986–90). 3 The real estate market overheated and property prices and land rentals surged, reinforced by the highly inelastic supply curve due to oligopoly among property developers and the policy stance of the government. Just before the financial crisis in 1997, the government did announce a long-term strategy to increase the overall supply of housing to 85,000 units per year and to have 70 percent of households owning their own homes by 2007. However, when real property prices collapsed during 1998 the government reversed this new policy, put a hold on land sales until early 1999, and scaled back the building of subsidised housing. It cancelled the so-called ‘Sandwich Class Scheme, although it continued to provide subsidised loans for the middle class to purchase property from private developers.4 The government was right to give up its long-standing bias in favour of high land prices by moving to increase the supply of housing. This move would enhance competitiveness by reigning in surging property prices and rents, a factor in Hong Kong’s high operating costs. However, the government’s subsequent policy reversal created inconsistencies that in turn caused further uncertainty and chaos in the already troubled property market. Instead, the government should have adhered to the policy to increase the supply of land and housing units and at the same time adopted measures to address the oligopolistic structure of the property market in order to prevent developers from earning monopoly profits and make the supply of housing more elastic. Promote High Value-added, Knowledge-content, Technology Industries

Hong Kong could reduce the excessive orientation toward the service industry and create a more diversified economic structure by adopting policies to encourage the expansion of manufacturing. However, given Hong Kong’s high labour and other factor costs, a preferred strategy for

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long-term growth is to promote high value-added industry based on high knowledge content or technology and enhance the economy’s competitiveness by raising factor productivity. Many new views on long-term economic growth sprouted to explain the remarkable performance of the emerging economies in East Asia. 5 Despite differences over development strategy, these theories all suggest that long-term economic growth is largely concerned with the supply side of an economy and is determined by technological change, which is endogenous and can be affected by economic policy. In particular, in the ‘new growth theory’ the important determinants of sustainable long-term growth are the stock of knowledge, innovation and the creation of new technology and ideas, and the learning-by-doing and dynamic spillover effects on human capital from the production of technology-intensive products. New knowledge and innovation are created through the R&D activities of scientists and engineers and as by-products of knowledge-generating activities and learning-by-doing. Hong Kong has lagged behind other NIEs in devoting resources to R&D (Table 6.6). For example, Hong Kong TABLE 6.6 Ratio of R&D Expenditures to GNP in Selected Economies, 1990–96 (Percent) Australia Canada China Hong Kong Indonesia Japan South Korea Malaysia Mexico New Zealand Philippines Singapore Taiwan Thailand U.S.A.

1990

1991

1992

1993

1994

1995

1996

1.37 1.46 0.68 — — 3.04 1.87 — — — — 0.86 1.66 — 2.82

— 1.51 0.66 — — 3.00 1.93 — — — — 1.04 1.70 — 2.84

1.57 1.55 0.63 — — 2.95 2.08 0.38 — — — 1.18 1.78 — 2.78

— 1.59 0.57 — — 2.88 2.30 — 0.24 — — 1.08 1.76 — 2.64

— 1.57 0.48 — — 2.84 2.58 0.33 — — — 1.11 1.80 — 2.54

— 1.52 0.49 —

1.38 1.64 0.48 0.26 0.08 3.33 2.81 0.23 0.26 0.90 0.14 1.35 1.85 0.11 2.42

Source: Australian National University (quoted from p. 74).

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2.69 — — — — 1.15 1.81 — 2.45

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did not have any measurable R&D expenses until 1996, when they accounted for only 0.26 percent of GDP. Korea, Singapore, and Taiwan have been investing larger and larger shares of their GDP in R&D activities over the years. Since technology and new knowledge are public goods that diffuse through various channels across the economy, investment in physical and human capital and in knowledge-creating activities yields large external benefits. When such investment allows the workforce to become more adaptable and efficient in using advanced technology through learning-bydoing, it may raise the overall level of labour quality and productivity. This argument suggests that the government should take the initiative to improve Hong Kong’s capacity to create and absorb new technology. At the same time, countries should focus on the comparative advantage arising from their resource endowment or stock of technology, and then specialise in creating knowledge and producing goods with high knowledge or technology content. With the increasing globalisation of commodity markets, exports have enormous potential for stimulating economic growth. An economy can grow by creating new or differentiated products that are not perfect substitutes for existing brands. Such products occupy a market niche and this oligopoly position generates high marginal profits for the economy, at least temporarily. A country should aim to accumulate the physical and human capital to shift its comparative advantage toward the creation of such differentiated products. Innovation involves not only creating new technology, products, and services, but also adopting more cost-efficient production techniques and value-adding processes, such as differentiating products and services, improving product quality and design, and finding new ways of packaging and marketing and new supplies of raw materials and semi-manufactures. Hong Kong has begun to take steps to reorient the economy toward growth based on innovation, knowledge, and technology. In March 1998 the government established a Commission for Innovation and Technology to investigate the potential for developing high knowledge-content and technology industry in Hong Kong and to formulate and implement policy to this end. The government policy address for 1998 laid out an ambitious long-term plan to develop Hong Kong into a knowledge and innovationoriented and technology-intensive economy. The plan aims to facilitate the development and commercialisation of innovative ideas and technology with a focus on the areas of information technology (especially electronic commerce and software engineering), design and fashion, multimediabased information and entertainment services, and health-food and pharmaceuticals based on Chinese medicine. To accomplish these goals,

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the government committed resources to establish an applied science and technology research institute and a research institute on Chinese medicine and to build a science park in three phases over the next 15 years. It also proposed to set up a HK$5 billion Innovation and Technology Fund to support innovation and the use of technology in the industrial or commercial sectors and a HK$100 million Film Development Fund to promote creativity and the use of technology in film production. A Venture Board at the Hong Kong Stock Exchange will also be established to facilitate fund-raising for small emerging companies. In March 1999 the government proposed developing a ‘Cyberport’ at Telegraph Bay in Pokfulam to promote the cyber industry by providing the infrastructure essential to support a strategic cluster of information services companies. The Cyberport would also enhance Hong Kong’s competitiveness in technology-based industry by expanding the pool of talent and expertise. Smaller local companies would benefit from proximity to market leaders, for instance through exchanging ideas and expertise and sharing information on the latest technological and market trends. The Cyberport will be developed in phases starting in 2002 and cost HK$13 billion, most of which will be funded by private investment. Hong Kong has taken a step in the right direction by adopting these policies to promote the high-tech industry and the application of more advanced technology in existing industries. Particularly significant are the investment in R&D and knowledge-generating activities and establishment of channels for emerging companies to raise funds. Nevertheless, the government should be careful not to overlook policies that might have more immediate impact on the economy’s competitive position. Historically Hong Kong has not encouraged, and it currently lacks, the technological base and human capital for high-tech industries and these industries are rather underdeveloped in Hong Kong. The long-term goal should be to build up or shift the stock of knowledge and technology (and comparative advantage) smoothly toward high-tech industry by investing in human and physical capital in knowledge-generating and innovation activities. But the first priority should be to encourage industries in which Hong Kong still has a comparative advantage and in which it has an accumulated stock of production knowledge and marketing expertise to adopt more advanced technology. The government can immediately strengthen existing research on and funding support for high-technology development and eventually incorporate these projects into the planned research institutes as they are set up. It can also devote resources directly to enlarge the research capacity

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of universities, particularly to support applied science projects carried out in conjunction with industry and commerce. By supporting such projects Hong Kong will be able to train more researchers and engineers with exposure to industry. Funding should be based on the practical application and industrial contribution of each project. Academics and universities in Hong Kong can use their established contacts and connections with other research institutes as the foundation for expanding research co-operation. For example, in co-operation with Mainland China, Hong Kong could specialise in the scientific and industrial application and commercialisation of results that are generated by research institutions in the Mainland. Until sufficient numbers of scientists and engineers are trained locally, the government needs to adopt policies to attract overseas professionals to work in Hong Kong. In addition to competitive salary packages, other factors that are important in attracting professionals include immigration rules, living environment, and social life. Hong Kong should establish a special programme (quota) giving preference to immigrants with higher education (such as masters and doctoral degrees) and relevant qualifications, especially those from the Mainland or Taiwan. It should make every effort to offer quality housing with a good living environment at reasonable cost and other facilities such as schools and sports and leisure centres. The government should accelerate the completion of the proposed Science Park, which is to have self-contained housing, schools, and other social and recreational facilities. The government can also adapt the policy on industrial estates to provide private companies with subsidised land on which they can build plants, housing, and other social or recreational facilities. These should in turn help to attract skilled professionals from abroad to work in Hong Kong. Over the longer term, Hong Kong should invest in the infrastructure and human capital that would make it a desirable production base for hightech industry. This would attract FDI, which would bring in not only capital but also new ideas and technology that could be diffused to other sectors and industries. Fiscal incentives and reduced land costs for targeted industries could be justified by the positive externalities emanating from knowledge-generating industries. The appropriate strategy for human capital development is discussed below. Enhance the Quality and Dynamism of Hong Kong’s Workforce

Investment in human capital and human resource development is important for long-term economic growth, especially for Hong Kong, which has few

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natural resources. Hong Kong has devoted fewer resources to education than other emerging Asian economies, although expenditure on education has been increasing as a share of government spending and as a share of GDP (Table 6.7). From 1990 to 1996 the ratio of education spending to total government spending averaged 17.3 percent in Hong Kong, which is below the 19.0 percent in South Korea, 19.3 percent in Taiwan, 20.4 percent in Malaysia, 21.1 percent in Thailand, and 21.9 percent in Singapore. During the same period Hong Kong devoted an average of 2.9 percent of GDP to education, compared with 3.1 percent in the Philippines, 3.2 percent in Thailand, 3.3 percent in South Korea, 4.0 percent in Singapore, 5.3 percent in Malaysia, and 5.7 percent in Taiwan. Furthermore, according to Low (1998), in 1995/96, in Hong Kong mean years of schooling for those over age twenty-five was 8.8 for males and 5.5 for females compared with 10.9 and 10.7 years for males and females in Japan, 11.6 and 7.1 years in South Korea, and 9.3 and 7.9 years in Taiwan. Investment in human capital will not only enhance labour productivity but also enlarge the stock of knowledge and technology and generate positive externalities for various industries and sectors. The Hong Kong government should therefore expand its investment in education and post-school vocational training that would otherwise be under-invested. To complement the government’s policy to develop Hong Kong as a knowledge-based economy and to promote knowledge- and innovationled growth, it should undertake a thorough review of the education system and curriculum and evaluate how it can strengthen the creative and innovative ability of the future workforce. Hong Kong needs a comprehensive education strategy to encourage creative, innovative, and analytical thinking and to equip students with the skills to acquire and adapt new knowledge. Enhancing students’ language and communication skills is also of utmost importance to creating a capable labour force. Equally important is the need to increase the manpower engaged in R&D and knowledge-generating activities. For the longer term, the government should encourage Hong Kong’s younger generations to pursue the study of science and technology, particularly postgraduate research and careers in R&D. In addition, it needs to provide post-school training to enable workers to keep up with rapid advances in production technology. The Vocational Training Council, Open University of Hong Kong, and other continuing education institutes should become more active in offering on-the-job-training and post-secondary training. Such training programmes, workshops, and seminars would especially benefit small- and mediumscale enterprises that do not have adequate resources of their own to

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0.169 0.174 0.175 0.164 0.174 0.176 0.180 0.173

0.028 0.028 0.028 0.028 0.029 0.031 0.033 0.029

0.195 0.158 0.159 0.214 0.204 0.205 0.199 0.190

0.031 0.026 0.027 0.036 0.036 0.036 0.037 0.033

Republic of Korea E/G E/GDP 0.189 0.187 0.188 0.199 0.222 0.217 0.228 0.204 0.057 0.055 0.055 0.052 0.053 0.048 0.050 0.053

Malaysia E/G E/GDP 0.169 0.161 0.150 0.159 0.145 0.180 0.197 0.166 0.033 0.031 0.030 0.029 0.027 0.032 0.036 0.031

Philippines E/G E/GDP 0.199 0.229 0.223 0.247 0.226 0.189 — 0.219 0.042 0.049 0.044 0.043 0.031 0.030 — 0.040

Singapore E/G E/GDP 0.201 0.202 0.211 0.218 0.214 0.218 0.211 0.211

0.028 0.029 0.032 0.035 0.035 0.034 0.034 0.032

Thailand E/G E/GDP

0.198 0.207 0.195 0.193 0.200 0.172 0.187 0.193

0.054 0.061 0.062 0.061 0.060 0.052 0.050 0.057

Taiwan E/G E/GDP

Source: United Nations, Statistical Yearbook for Asia and the Pacific 1997 ; Council for Economic Planning and Development, Taiwan. Taiwan Statistical Data Book 1998 .

1990 1991 1992 1993 1994 1995 1996 Average

Hong Kong E/G E/GDP

TABLE 6.7 Ratio of Education Expenditure (E) to Total Government Expenditure (G) and GDP in East Asian Emerging Economies, 1990–96

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devote to staff training. Improvement in labour efficiency and productivity would in part justify rising labour costs. Develop Hong Kong as a Financial Centre for China and the Asia-Pacific Region

Hong Kong is a leading international banking and financial centre, and the banking and finance industry accounts for a significant share of Hong Kong’s overall domestic output. Hong Kong’s favourable business environment, stable currency with no foreign exchange and capital account controls, liberalised financial sector, excellent infrastructure, well-educated and trained workforce, as well as its location as a gateway to China and in a time zone that compliments London’s and New York’s all contribute to this position. The government has also invested in such financial infrastructure as a sound regulatory and supervisory framework and a Real Time Gross Settlement system, which provides delivery-versus-payments and payment-versus-payments services to reduce transaction and settlement risks. The Asian financial crisis focused attention on two aspects of Hong Kong’s financial markets that need to be improved— the underdeveloped debt market and the domination of the equity market by real estate and financial interests. To solidify its position as a financial centre for China and the Asia-Pacific region Hong Kong is stepping up efforts to improve long-term financing and to strengthen and diversify the equity market. Long-term Financing Development

Hong Kong’s debt market is quite small compared to the markets in other countries. In 1995 outstanding debt amounted to about 10 percent of GDP in Hong Kong compared to 74 percent in Japan, 52 percent in Malaysia, 54 percent in Singapore, and 110 percent in the United States (Sheng 1997). Without an active and liquid debt market, longer term investments (such as mortgage loans) have to be financed by short-term funds, while longterm savings must be invested in short-term bank deposits or in the equity market, which carries higher risk. Thus, the underdevelopment of the debt market increases maturity risks and causes allocative inefficiency. Developing the debt market is all the more necessary because of expected increased demand for debt paper as a result of the booming insurance industry and the coming implementation of the mandatory provident fund as well as increasing demand for long-term finance to fund proposed investments in infrastructure, housing projects, and perhaps the hightechnology industry.

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To date, Hong Kong has taken a number of steps to boost the development of the debt market. The HKMA has issued Exchange Fund Bills and Notes which provide benchmarks for interest rates of various maturities and it built the Central MoneyMarket Unit system to facilitate the transaction and settlement of debt paper trading. In addition, in October 1997 the government established the Hong Kong Mortgage Corporation (HKMC), which should facilitate the securitisation of mortgage loans and the development of the debt market by supplying more debt instruments to the market. Importantly, by providing a more direct channel for funding mortgage loans with longer-term financial resources it may promote fixed-rate mortgage loans backed by fixed-rate debt paper. The availability of fixed-rate mortgages would, in turn, help protect mortgage borrowers, the banking industry, and the economy as a whole from short-term interest rate volatility. The HKMC launched a HK$20 billion Note Issuance Programme targeted at financial institutions in January 1998 and a HK$20 billion Debt Issuance Programme designed for institutional investors in June 1998. For the latter issue in particular, it appointed primary dealers with good connections to institutional investors as underwriters and market makers for the programme, and it appointed selling-group members to assist with the distribution of the debt papers. If these appointments help widen and internationalise participation in the local debt market, the market will deepen and become more liquid. The HKMA also plans to list and trade Exchange Fund papers in the Stock Exchange of Hong Kong by mid-1999. The government could also consider issuing debt papers to fund such infrastructure projects as the West Rail and the MTR Tseung Kwan O Extension and issuing treasury notes or bills to fund public housing and highway projects and even the fiscal deficits arising from a temporary drop in government revenues. In view of the surging demand for long-term funds in Asia, Hong Kong should take more positive steps to develop itself as a regional bond centre, especially for governments, international institutions, and creditworthy trans-national corporations. The World Bank projected that the proportion of fixed capital investment in the region funded by debt papers would increase from 9 percent in 1994 to 26 percent by 2004 (World Bank 1995). Currently the bond market is valued at only 80 percent of GDP in Asia, (only 35 percent if Japan is excluded), while its value is about 150 percent of GDP in North America and 110 percent in Europe (Bank of East Asia 1998).6

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Equity Market Diversification

Hong Kong has begun to both strengthen its equity market and broaden its scope. In March 1999 the government announced a comprehensive plan for reform of the securities and futures market, including upgrading financial market infrastructure, strengthening the regulatory framework, and reorganising existing exchanges and clearinghouses. Creation of a single clearing arrangement for securities, stock options, and futures transactions will increase efficiency while reducing risk and cost. A new Securities and Futures Bill will rationalise and consolidate the 12 existing securitiesrelated ordinances, clarify regulatory objectives, strengthen the supervisory and investigative power of the Securities and Futures Commission (SFC), and introduce regulation of Internet trading. The two existing stock exchanges and their associated clearinghouses are to be de-mutualised and merged into a new holding company that will ultimately be listed as a publicly traded company. With the reorganisation, equity trading will operate under a new constitution and a new set of corporate governance rules, and trading rights will be separated from ownership rights. The new entity will provide for increased access to trading and clearing facilities, and it will have broader, more balanced representation of market users and the general public on its board. As part of the strategy to diversify the stock market, Hong Kong should expand its efforts to list qualified enterprises from Mainland China. As of November 1998, already forty-one China-incorporated enterprises were listed and traded on the Stock Exchange of Hong Kong (SEHK). The SFC and the SEHK should co-operate and co-ordinate with China’s two stock exchanges and supervisory authority in order to accommodate discrepancies in accounting, legal, and regulatory and supervisory standards for instance. Hong Kong should also continue to develop its role as fund raiser, or even fund manager, for Mainland China. China will have a great need to tap international capital, particularly in view of its robust economic growth and strong demand for financial resources to build infrastructure and production capacity and to reform state enterprises and fuel the expansion of private enterprises. Locally, the government should explore seriously the privatising and listing of the Mass Transit Railway, Kowloon-Canton Railway, the post office, the airport, and other public entities on the stock market. Privatisation of utilities would benefit the equity market by diversifying and broadening the scope of issues traded. At the same time, it would help the utilities raise funds to fuel expansion and, supposedly, improve their management

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and production efficiency. The Venture Board, which is soon to be established at the Stock Exchange, will add an extra dimension to the scope of the stock market, extending participation to emerging technology companies. Banking Sector Reform

To secure its position as an international financial centre Hong Kong should also undertake reforms that would further enhance the efficiency of its already highly liberalised and competitive banking sector. This could be achieved by ending the remaining Interest Rate Agreement of the Hong Kong Association of Bankers, removing limitations on lending and receiving deposits for restricted-licence banks and deposit-taking companies, and eliminating the one-branch restriction on foreign banks licensed after 1979. Eliminating the one-branch restriction would both encourage foreign banks already in Hong Kong to expand their operations and also attract more foreign banks to Hong Kong. These reforms would enhance competition in the banking industry and increase the efficiency of financial resource mobilisation. Savings would be attracted to those banks (and to investment activities) that generate higher returns and are able to offer higher interest rates to compete for deposits. The gap between deposit and lending rates would also narrow. To maintain profitability, banks would have to enhance their efficiency and to diversify their businesses, perhaps by expanding their non-interest earning products and services, such as merchant or private banking and fund management. Restore Government Credibility, Reliability, and Efficiency

In the traditional view, the economic role of government is limited to providing basic infrastructure and public goods (such as law and order, health care, social security, and a well-developed financial sector to facilitate financial resource mobilisation) and to maintaining macroeconomic stability through prudent monetary and fiscal policies. East Asia’s experience with rapid economic growth suggested that government should also have a concrete development strategy to predict future market directions and shape industrial policy to shift comparative advantage accordingly. In the aftermath of the Asian financial crisis it appears that government must take on yet another role—to continually review and modify foreign exchange and financial systems in light of current global financial and economic conditions. This role is especially critical in a small, open

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economy with the presence of international banks and portfolio investors such as Hong Kong. The global integration of financial markets and sophistication of trading techniques (combined with the increasing volume and aggressiveness of portfolio and speculative capital) ensure that any weaknesses will eventually be exposed and corrected by market forces, at a potentially high cost. The contagious and self-fulfilling nature of crises such as recently gripped Asia impels the Hong Kong government to enhance both its ability to take the initiative and its capacity to manage financial crises, speculative attacks, and other external shocks. Hong Kong should set up a crisis-management facility to track current local and international market developments and to analyse market trends, the extent and nature of risk, and the likely impacts on the local and regional economy. It should also consider developing a contingency facility that would be continually adjusted according to the latest market conditions so that the government is prepared to adopt appropriate measures to cope with external shocks and to reduce the disruption to the economy if such shocks cannot be avoided. Existence of a contingency facility would ensure that prompt, decisive action can be taken before a crisis causes widespread worry and panic in the market and shakes market confidence too badly. Timely action is particularly important in today’s financial markets where sentiment and expectation play a significant role. The need for a proactive government stance was highlighted by Hong Kong’s experiences of the past two years. The government should have been aware of such unusual patterns as occurred in 1997–98 when speculators moved to profit from the HKMA’s reliance on high interest rates to defend the peg. By keeping abreast of these developments, the Hong Kong authorities could have stepped in to strengthen the currency board arrangement and to stop the excessive and illegitimate short selling, and thereby avoided the desperate intervention in the spot and futures markets in August 1998. 7 In addition to building up its capacity to confront crisis, the government must also rebuild its credibility, particularly on financial and economic policies. Credibility is a crucial element in successful and effective formulation and implementation of macroeconomic policies. When information is imperfect and the public are not well informed or do not understand how and why decisions are made, they may become suspicious or sceptical about the government’s motivation and the appropriateness of policy. Public scepticism makes policy less effective and increases the risk of market turbulence. It requires a lot of effort to repair the damage to

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credibility when the government adopts the wrong policies or makes mistakes. To regain credibility, the Hong Kong government should increase the transparency of its policies and it should brief and consult the business community and the general public when it formulates new policies. The more the public and investors know about and understand policy objectives, the more readily they can accept that the policies are sound and in the best interests of the economy, and the more effective policy will be. CONCLUSION

The severity and contagious nature of the Asian financial crisis have forced policymakers and researchers to think seriously about the destabilising effects of rapid, adverse capital flows across borders. That Hong Kong is a small, open, and extremely outward-looking economy rendered it particularly vulnerable to adverse external economic and financial shocks, despite its strong underlying economic fundamentals. The domestic economy will continue to slow down and prices adjust downward in the face of the weakening external sector until prices reach a level that restores Hong Kong’s international competitiveness or the external sector begins to pick up again. Certain weaknesses in the economy could have caused the persistent currency speculations and exacerbated the disruptive effects of the speculative attacks on the Hong Kong dollar. The economy had become overly oriented to the service sector and risk was concentrated in the stock and property sectors, which experienced bubbles after 1990. Lacking a well-developed debt market, the financial sector did not adequately match long-term and short-term supply and demand for financing. The impaired self-restoring mechanism of the currency board system and the HKMA’s intervention to drive up interest rates to support the peg (and punish speculators) caused market uncertainty, financial dis-intermediation, the bursting of the asset bubbles, and the choking-off of economic activity. Furthermore, the increasing complexity and sophistication of financial markets and the close connections among the foreign exchange, equity, and futures markets made the defence of the peg more difficult and disruptive than expected. To restore financial order and macroeconomic stability the HKMA adopted reforms that strengthened the self-restoring mechanism of the pegged exchange rate regime, increase the availability of interbank liquidity (with absolute certainty and transparency) to prevent market manipulation, and strengthen the commitment to and transparency of the currency board.

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The currency speculations would not have been as disruptive and painful if these reforms had been put in place earlier. In formulating long-term economic policy, Hong Kong needs to identify the “engine” for smooth sustainable growth and to achieve a more balanced and diversified economic structure. The government has committed itself to promoting high-technology and value-added industries and to investing heavily in the required infrastructure and human capital. Urgent and serious consideration should be given to promoting mid- to lower stream applied technology research and to the formulation of policy to attract overseas scientists and engineers to work in Hong Kong. These measures would upgrade Hong Kong’s technological level, thereby increasing production capacity and efficiency. Simultaneously, the government should further develop and capitalise on Hong Kong’s comparative and locational advantages in the finance industry by widening the scope and diversifying the structure of the equity market, particularly in view of the future fund-raising needs of China and the region. The financial sector could be strengthened by attracting more good quality companies from the Mainland and even from other countries to list or raise debt in Hong Kong, by further developing the Hong Kong dollar debt market, and by seeking to develop as a regional bond market for Asia. Hong Kong should aim to become a truly “international” financial centre with companies from the region (at the least) listing shares or raising debt in Hong Kong and with international institutional investors widely and actively investing or managing funds in Hong Kong. The government should also reconsider its strategy for human resource development, as it has become clear that knowledge, innovation, and human capital investment are key factors in international competitiveness today. Finally, there is also an urgent need for the government to restore credibility by enhancing its reliability, responsibility, transparency, and consistency. As confidence and expectations have played a crucial role in the determination of macroeconomic aggregates (e.g., investment and consumption) and in financial markets, a lack of confidence undermines the effectiveness of government policy, regardless of the intention or appropriateness of the policy. Notes 1

The year-on-year growth rate of negative 7 percent for the third quarter of 1998, which is widely seen as a sign of further weakening of the economy, is somewhat misleading. For the first three quarters of 1998

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2

3

4

5

6

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the rates of growth of GDP over the previous quarter are –11.6 percent, 0.84 percent, and 6.4 percent respectively. These rates show an improvement over the rates in the first three quarters of 1997 (–7.2 percent, 3.5 percent and 8.4 percent respectively). The difference between the quarterly growth rates of 1998 and 1997 narrows from –4.3 percentage points in the first quarter to –2.7 percentage points in the second quarter, and further to –2 percentage points in the third quarter. The distortion of the economy toward the property sector was likely even greater than already suggested to the extent that companies in other industries invested in real property development or related activities. Furthermore, real property overvaluation since 1990 probably raised the returns to property investment relative to investment in other industries such as manufacturing, misallocating even more resources toward real property development and away from, for instance, hightechnology manufacturing. The relocation of manufacturing industry to China contained the prices of tradable goods and enabled Hong Kong to maintain its overall international competitiveness. The Sandwich Class Scheme was a subsidised homeownership scheme for middle-income earners that was developed by the Hong Kong Housing Authority. These include the “new”, “endogenous”, “structuralist” or “revisionist” growth theories, and the like. Without mature and active bond markets to channel long-term funds, most businesses in Asia rely heavily on bank loans, which are mostly short-term and subject to higher interest-rate and exchange-rate risk, despite the high saving ratios in many East Asian countries. The investment company formed to manage the HK$120 billion worth of shares purchased by the government in this intervention has no explicit policy or schedule for handling the shares or for dealing with its obligations and rights as a significant shareholder in some companies (which comprised a significant proportion of the shares trading in the market). The lack of a clear policy, particularly regarding the schedule and method for putting these shares back on the market, adds uncertainty to the equity market and further complicates the functioning of the stock market especially when it comes to business decisions on such matters as takeovers or mergers.

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References

Adams, F. Gerard, and IngerMarie Davis. 1994. “The Role of Policy in Economic Development: Comparisons of the East and Southeast Asian and Latin American Experience”. Asian-Pacific Economic Literature 8, no. 1 (May): 8–26. Balls, Edward. 1997. “Open Macroeconomics in an Open Economy”. Occasional Paper 13. Centre for Economic Performance, London School of Economics, November. Capital. 1998. “The Future of Hong Kong’s High Technology Industry” (in Chinese). August. Chen, Edward K.Y. 1997. “The Total Factor Productivity Debate: Determinants of Economic Growth in East Asia”. Asian-Pacific Economic Literature 11, no. 1 (May): 18–37. Commission of Innovation and Technology, Hong Kong SAR Government. 1998. First Report. September. Council for Economic Planning and Development. 1998.Taiwan Statistical Data Book 1998. Taipei: Republic of China. Dalla, Ismail. 1995. The Emerging Asian Bond Market. Washington, D.C.: The World Bank. Bank of East Asia. 1998. “Medium-term Development of Hong Kong Securities Market”. Economic Analysis. November. Grossman, Gene M., and Elhanan Helpman. 1990. “The ‘New’ Growth Theory: Trade, Innovation and Growth”. American Economic Association Papers and Proceedings 80, no. 2 (May): 86–91. Hang Seng Bank. 1998 a. “The Hong Kong Economy in a Year of Adjustment”. Hang Seng Economic Monthly. July. ______. 1998b. “The Linked Exchange Rate System: A New Regime”. Hang Seng Economic Monthly. September/October. Hong Kong Census and Statistics Department.Hong Kong Monthly Digest of Statistics. Various issues. Hong Kong Monetary Authority (HKMA). 1998. “Strengthening of Currency Board Arrangement in Hong Kong”. HKMAQuarterly Bulletin 17, pp. 7–11. Hong Kong SAR Government. 1998. The 1998 Policy Address . Printing Department, Hong Kong SAR Government. Hongkong Bank. 1998. “Hong Kong’s Growth and Cost Adjustments— Where They Stand”. Economic Report. August. Low, Linda. 1998. “Human Resource Development in the Asia-Pacific”. Asian-Pacific Economic Literature 12, no. 1 (May): 27–40.

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Ng, Raymond and Edward K.Y. Chen. 1998. “The Role of Monetary Policy under a Linked Exchange Rate Regime: The Case of Hong Kong”. In Coping with Capital Flows in East Asia , ed. C.H. Kwan, D. Vandenbrink and S.Y. Chia. Singapore: Institute of Southeast Asian Studies and Nomura Research Institute, pp. 136–70. Schuler, Kurt. 1998. “A Contingency Plan for Dollarizing Hong Kong”. Hong Kong Centre for Economic Research, HKCER Letters, No. 52. September. Sheng, Andrew. 1997. “The Scenarios for the Future: Electronic Payments in Asia”. HKMA Quarterly Bulletin 12 (August): 92–97. Smith, Heather. 1995. “Industry Policy in East Asia”. Asian-Pacific Economic Literature 9, no. 1 (May): 17–39. Standard Chartered Bank. 1998a. “The Asian Crisis”. Viewpoints 13 (June). ______. 1998b. “Hong Kong’s Competitiveness”. Viewpoints 14 (August). ______. 1998c. “Hong Kong’s Economic Prospects: Light at the End of the Tunnel?” Viewpoints 15 (October). Tanzi, Vito and Howell H. Zee. 1997. “Fiscal Policy and Long-Run Growth”. IMF Staff Papers 44, no. 2 (June): 179–209. United Nations. 1998. Statistical Yearbook for Asia and the Pacific 1997. Bangkok: Economic and Social Commission for Asia and the Pacific. Warr, Peter G. 1994. “Comparative and Competitive Advantage”. AsianPacific Economic Literature 8, no. 2 (November): 1–14.

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7 Singapore’s Response to the Challenges of the Asian Crisis and Globalisation Chia Siow Yue INTRODUCTION

In recent decades, country after country in East Asia has embraced globalisation, as opening up of economies to foreign trade and foreign capital has brought increased economic resources, improved efficiency, and higher economic growth and standards of living. The currency and financial crisis that erupted in Thailand in July 1997 and swept through the East Asian region put an abrupt end to the East Asian Miracle and exposed the region’s vulnerability to the downside of globalisation. The “crisis countries” are the ASEAN-4 (Indonesia, Malaysia, Philippines, and Thailand) and South Korea. Other countries in the region have been less severely affected either because they have sound macroeconomic and financial fundamentals, as in Hong Kong, Singapore, and Taiwan, or because they do not have open capital accounts, as in the transitional economies of China, Cambodia, Laos, Myanmar, and Vietnam. Exchange rates stabilised by late 1998 and stock and property asset prices have bottomed out. Nevertheless, the crisis deepened in the sense that it spread to the real economy as growth rates in all countries were either much lower or negative for 1998 and as the social impact was increasingly felt. This chapter examines Singapore’s macroeconomic and financial indicators prior to the onset of the regional financial crisis, the impact of the crisis on the Singapore economy, and Singapore’s responses to the crisis as well as to the longer term challenges of globalisation.

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MACROECONOMIC AND FINANCIAL INDICATORS Key Features of the Singapore Economy

Singapore is one of the smallest nation states in the world, with only 650 square kilometres of land and 3.7 million population. However, the citystate is not that small in economic size. The World Development Report for 1998 ranked Singapore ’s 1997 nominal GNP of US$102 billion the thirty-fourth largest in the world and the 3rd largest in ASEAN (after Indonesia and Thailand). It is the largest trading nation in Southeast Asia, the world’s eleventh largest exporter, and the twelfth largest importer. It is also one of the largest recipients of foreign direct investment and plays host to large numbers of foreign multinational corporations (MNCs) in manufacturing and services. Economic growth in the past three decades has been led largely by exports and foreign investment. The dynamism of the Singapore economy is reflected in its average GDP growth rate of 7.4 percent for 1980–90 and 9.0 percent for 1990–97 (Table 7.1). By 1997, GNP per capita had reached US$32,940, the fourth highest in the world, after Switzerland, Japan, and Norway. Adjusted for purchasing power parity Singapore’s per capita GNP of US$29,000 ranked first in the world (World Bank 1998). Of course, Singapore’ s ranking in inter-country comparisons is helped by the fact that it is a city-state without any rural drag. On a city-to-city comparison, Singapore’s growth performance and relative income level would appear more modest. High GDP growth in Singapore has been accompanied by price stability and employment creation. The Consumer Price Index showed an average annual rise of 2.7 percent in the 1980s and 2.4 percent for 1990–97. The unemployment rate has declined progressively since the mid-1960s and averaged 2.4 percent for 1990–97, but the rate is trending upwards because of the impact of the regional crisis. On the other hand, Singap ore has become increasingly dependent on foreign labour across the spectrum of skills and it is estimated that before the onset of the regional financial crisis, foreigners exceeded 20 percent of the labour force. Indicators of Globalisation and Regionalisation

Singapore is one of the world’s most open economies, with extensive global trade and investment links. It is also the hub of Southeast Asia, with close regional transportation, trade, and financial links.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

39,310 8.0

1997

1.8 231,122 157.3 254,864 173.5 14.8 119,617 7.3

143,244

99,216 81.4 48,498 33.2

1995

S$ million

9.0 48.5 34.7

1990–97

557,182

7.4 34.2 42.2

1980–90

S$ % % % % S$ million % of GNP S$ million % of GNP % of GNP S$ million % GNP S$ million % GNP S$ million % GNP S$ millin 9.4 19.3 32.2

1970–80

Source: Singapore Ministry of Trade and Industry. Economic Survey of Singapore 1998 .

Asian Dollar Market assets Bank loans and advances to nonbank customers

Stock of outward foreign equity investment

Stock of inward foreign equity investment

Current account balance Official foreign reserves

Exports of goods & services

Percapita GNP GDP growth rate Gross national savings/GNP Gross fixed capital formation/GNP Unemployment rate % Imports of goods & services

Unit

TABLE 7.1 Macroeconomic and Financial Indicators for Singapore, 1970–98

151,637

503,558

20.0 124,584

38,170 1.5 52.1 35.4 3.2

1998

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Trade Linkages

Total external trade in goods and services reached 331 percent of Singapore’s GNP in 1997, with an export/GNP ratio of 174 percent and an import ratio of 157 percent. The trade ratio is the highest among the 133 countries listed in the World Development Report, and reflects Singapore’s role as an entrepôt and regional hub, the high export-orientation of its manufacturing sector, and the high import content of its consumption and production. First, Singapore has been the entrepôt of Southeast Asia for centuries, historically exporting the region’s primary produce to the West, without or after processing, and importing western manufactures for redistribution to the region. In recent decades, as the regional economies engaged in direct trading of primary commodities and embarked on industrialisation, the Singapore entrepôt exported the manufactures, parts, and components of the region, within the region and to the rest of the world. Thus, entrepôt trade increasingly comprises intra-industry trade and intra-firm trade arising from the growth of production networks across the region. In the 1990s, entrepôt exports continued to account for over 40 percent of Singapore’s total merchandise exports. Second, Singapore embarked on industrialisation in the early 1960s, with foreign MNCs from the United States, western Europe, and Japan spearheading export manufacturing. The export/total sales ratio of the manufacturing sector has averaged over 60 percent in the past two decades. Third, Singapore has a very high import content in consumption and production, including water and energy. As a result, any positive effect that exchange rate devaluation has on exports could be neutralised by its negative effect on higher import costs. This explains Singapore’s reluctance to use the exchange rate as a policy instrument to improve competitiveness. Asia dominates Singapore’s merchandise trade, accounting for 61.5 percent of Singapore’s total trade in 1997, with 63.2 percent for imports and 59.8 percent for exports, followed by America and Europe, which together accounted for 30.8 percent of imports and 32.4 percent of exports (Table 7.2). The Asian share would be even larger if trade with Indonesia, a major trading partner, is included. (Published trade statistics do not include Singapore’s bilateral trade with Indonesia.) Among the Asian countries, Japan is the largest source of imports and Malaysia the largest market and second largest source.

© 2000 Institute of Southeast Asian Studies, Singapore

© 2000 Institute of Southeast Asian Studies, Singapore

235,316 47,688 14,484 23,629 11,539 16,575 2,337 na 61,953 7,335 18,613 3,281 60,574 53,436 74,227 67,135 8,878 3,223 382,218

124,271 34,564 8,447 5,780 6,056 8,208 271 na 29,548 2,954 10,080 807 31,944 27,485 36,297 33,017 3,111 982 196,605

Imports

111,045 13,125 6,038 17,848 5,483 8,368 2,067 na 32,405 4,382 8,532 2,473 28,630 25,952 37,929 34,118 5,767 2,241 185,613

Exports 55,036 7,956 3,599 10,536 2,767 4,223 405 na 13,997 2,208 4,041 1,251 19,360 18,287 29,193 26,849 3,004 943 107,535

Domestic Exports

Source: Singapore Department of Statistics. Yearbook of Statistics 1997.

Asia Japan China Hong Kong South Korea Taiwan Brunei Indonesia Malaysia Philippines Thailand Vietnam Europe EU America US Oceania Africa Total

Total

Amount S$ million

56,009 5,169 2,439 7,312 2,716 4,145 1,662 na 18,408 2,174 4,491 1,222 9,270 7,661 8,736 7,269 2,763 1,298 78,078

Reexports 61.57 12.48 3.79 6.18 3.02 4.34 0.61 na 16.21 1.92 4.87 0.86 15.85 13.98 19.42 17.56 2.32 0.84 100.00

Total 63.21 17.58 4.30 2.94 3.08 4.17 0.14 na 15.03 1.50 5.13 0.41 16.25 13.98 18.46 16.79 1.58 0.50 100.00

Imports

TABLE 7.2 Imports and Exports by Direction, 1997

59.83 7.07 3.25 9.62 2.95 4.51 1.11 na 17.46 2.36 4.60 1.33 15.42 13.98 20.43 18.38 3.11 1.21 100.00

Exports

Distribution %

51.18 7.40 3.35 9.80 2.57 3.93 0.38 na 13.02 2.05 3.76 1.16 18.00 17.01 27.15 24.97 2.79 0.88 100.00

Domestic Exports

71.73 6.62 3.12 9.37 3.48 5.31 2.13 na 23.58 2.78 5.75 1.57 11.87 9.81 11.19 9.31 3.54 1.66 100.00

Reexports

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Investment Linkages

Singapore has extensive two-way investment linkages with the region and world. Foreign direct investment (FDI) has a strong presence in Singapore. According to the World Investment Report 1998, FDI inflows into Singapore averaged US$3.6 billion annually in the 1986–91 period, the highest among developing countries. Singapore accounted for 12.3 percent of FDI flows to all developing countries and 21.8 percent of flows to developing Asia. For the period 1992–97, FDI inflows rose to an annual average of US$7.2 billion, but among developing countries Singapore’s ranking fell behind China’s and Mexico’s. FDI penetration in Singapore is among the highest in the world, as measured by the ratio of inward FDI flow to gross fixed investment and the ratio of inward FDI stock to GDP. The flow ratio averaged 37.6 percent for 1986–91 and 25.4 percent for 1992– 96 and the stock ratio averaged 68.8 percent for 1980–96. The major sources of FDI to Singapore are the triad of the EU, Japan, and the United States, reflecting the ownership advantages of firms from these countries (Table 7.3). Inward FDI is concentrated in manufacturing and financial services, corresponding to Singapore’s dual role as a manufacturing platform and a financial centre. Singapore has been a net exporter of capital since the mid-1980s but outward direct investment is on a smaller scale than inward direct investment. The outward flow ratio averaged 6.9 percent in 1986–91 and 12.2 percent in 1992–96 as compared to 14.9 percent and 50.8 percent for Hong Kong during the same two periods. Official Singapore statistics show that by 1995 the outward stock of FDI reached S$36.9 billion (43.4 percent of the stock of inward FDI) and 30.2 percent of GNP. In contrast to inward FDI, which comes mainly from the United States and Europe, outward FDI is largely confined to Asia, particularly to the ASEAN region. This pattern reflects the ownership advantage of investing in firms largely at the regional level only, and is dominated by investments in financial services and manufacturing. Macroeconomic and Financial Fundamentals

Notwithstanding Singapore’s very open economy, the regional contagion in both the current and capital accounts has not been as severe as in less open economies in the region. This was due to Singapore’s sound macroeconomic and financial fundamentals. • The government has always practised fiscal prudence, with budgetary surplus achieved over not only operating expenditures but also

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TABLE 7.3 Inward and Outward Foreign Investment, 1990 and 1995 1990 Inward stock of foreign direct equity investment Total (S$ million) By country of origin United States European Union Asia Japan ASEAN Hong Kong By industry Manufacturing Financial services Outward stock of foreign direct equity investment Total (S$ million) By destination Asia ASEAN Hong Kong China Europe United States Australia By industry Manufacturing Financial services

1995

49,830.6 84,267.0 % of total 17.2 16.9 21.2 20.6 34.7 33.7 21.4 20.1 6.0 6.7 6.6 4.6 39.7 43.2

36.3 45.4

13,622.0 36,866.0 % of total 51.5 58.3 26.2 33.8 16.6 13.8 1.8 6.6 8.0 10.4 5.1 5.5 3.9 3.0 17.6 66.3

25.6 60.3

Source: Singapore Department of Statistics. Yearbook of Statistics 1997.

development expenditures. The budget surplus amounted to over 5 percent of GNP in 1995–97. • Singapore has one of the highest savings rates in the world, averaging over 50 percent of GNP in 1995–97. • Singapore’s current account was consistently in surplus during the 1990s, averaging about 16 percent of GNP in 1995–97 and rising to 20.9 percent in 1998. • Official foreign reserves stood at S$107.8 billion (US$76.4 billion) at end-1996 S$119.6 billion (US80.6 billion) at end-1997 and S$124.6 billion (US$74.4 billion) at end-1998, among the largest in the world. This sizeable resource available to the Monetary Authority of Singapore (MAS) acts as a deterrent to concerted speculative attacks by currency

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speculators. Based on Singapore’s strong official reserves position, the Singapore dollar has been trending upwards over the past decades from S$3.09 to the U.S. dollar in 1970 to S$1.48 in 1997. • Singapore’s external debt stood at only US$37 million in 1990 and there has been no official external debt since 1994. Based on data from the Bank of International Settlements, private external debt in the form of external bank claims and non-bank credits stood at US$10.4 billion in mid-1997 and US$9.9 billion by end-1997. Thus, total external official and private debt was only 12.3 percent of official foreign reserves. • Capital inflows to Singapore comprised mainly direct investments rather than portfolio investments and bank loans. FDI is much more stable, contributes to the creation of productive capacity, and involves transfers of technology and managerial and marketing know-how while flows of portfolio investment and bank loans are more short term and volatile. Over and above these quantitative indicators, Singapore has a sound banking system, with the Monetary Authority of Singapore (MAS) maintaining strict prudential and supervisory controls. IMPACT OF THE REGIONAL CRISIS

Two channels and phases of regional contagion may be distinguished, namely the contagion of financial markets and the contagion of economic recession. First, Thailand was a “wakeup call” for international investors and creditors in the region and precipitated reassessment of the economic and financial fundamentals of individual economies and corporate borrowers. Several economies were found to have large current account deficits, export slowdowns, over-capacity in key sectors, falling investment quality and productivity, asset bubbles in equity and property markets, overexposure to short-term capital inflows, financial sectors with poor prudential supervision and high non-performing loans, and high corporate debt-equity ratios. Successful attacks on the Thai baht triggered similar attacks on other currencies, leading to a region-wide competitive devaluation. Likewise, tumbling stock prices in one market triggered falls in other markets within the region. Second, the real economies of the region are linked through trade and direct investment flows and the economic recession in Thailand that followed the currency and financial crisis there was translated into falling demand for the goods and services produced by other East Asian economies. The knock-on effects led to a downward spiral of regional demand. In the process, economies with sound fundamentals also succumbed to the regional contagion. © 2000 Institute of Southeast Asian Studies, Singapore

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Impact on Singapore’s Economic Growth, Price Level, and Employment

Singapore’s economic growth performance felt the impact of the regional financial crisis strongly in 1998. The economy had been growing healthily since the 1985–86 recession and growth was a buoyant 8 percent in 1997. Earlier official forecasts of 2.5 to 4.5 percent growth for 1998 had to be revised downwards to 0.5 percent or –1.0 percent as the environment in the region worsened over the course of the year. The economy actually achieved an overall growth rate of 1.5 percent for 1998, but it was technically in recession in the second half as the growth rate decelerated from 6.2 percent in the first quarter to negative growth in the last two quarters. The economic outlook for 1999 remained uncertain, as the regional crisis persisted, financial problems emerged in Russia, China, and Latin America, and an economic downturn was expected for the United States and the EU. The official forecast was for growth of between plus 1 percent and minus 1 percent. However, the regional economic downturn bottomed out sooner than expected and Singapore ended 1999 with a growth rate of 5.1 percent. The 1998 economic downturn reflects the contraction of external demand and to a lesser extent that of domestic private investment demand. Exports of goods and services account for over two-thirds of Singapore’s final demand. External demand fell 4.9 percent, as exports of both merchandise goods and services shrank due to three key factors: 1) weakened demand for consumer and capital goods due to economic downturns and deepening recessions in East Asian economies; 2) erosion of Singapore’s costcompetitiveness with the sharp devaluation of other regional currencies versus the moderate depreciation of the Singapore dollar against the U.S. dollar; and 3) cyclical downturn in the global electronics industry, which affected Singapore’s exports to developed countries as well as its exports of parts and components to markets in the region. Excluding the oil trade, domestic exports of merchandise to the region fell 10 percent and reexports to the region fell 13 percent. Hub-services with high regional exposure, such as commerce, tourism, transport, and financial services were more severely affected than sectors and companies with markets mainly in the United States and Europe. As a result of the deflationary trend, consumer prices fell in 1998, by 0.3 percent, for the first time since the recession of 1985–86. Consumer prices also fell because of the lower prices of imports from other countries in the region following devaluation of their currencies and because of weak international oil and commodity prices. The 3-month interbank interest rate rose sharply from an average 3.32 percent in the first half of 1997 to a high of 9 percent at end-January 1998 © 2000 Institute of Southeast Asian Studies, Singapore

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as the regional crisis spread and deepened, but the rate declined to only 1.75 percent by end-1998 as domestic liquidity conditions eased. In parallel with the interbank rates, the average prime-lending rate fell from a high of 7.8 percent for May–August 1998 to 5.9 percent by end-1998. The poor performance of GDP impacted negatively on employment. For the first time since the 1985–86 recession, total employment declined and the unemployment rate rose, reaching 3.2 percent in 1998, up from 1.8 percent in 1997. The number of retrenched workers reached an all-time high (28,300) and tripled the number in 1997. Most jobs lost were in the manufacturing sector, particularly in electronics. In the service sector, the bulk of the job losses were in commerce, real estate, and finance. According to the Ministry of Manpower more than 40 percent of workers were displaced due to industrial downturn and business failures, one-third were laid off as a result of industry restructuring, and one-quarter were retrenched because of high business and labour costs (Ministry of Trade and Industry 1998). Impact on the Exchange Rate

The Singapore dollar did not come under intense speculative attack and it did not experience drastic devaluation as most other regional currencies in 1997–98. The Singapore dollar depreciated about 13 percent against the U.S. dollar, but it appreciated sharply against regional currencies, especially the Indonesian rupiah (210 percent), Korean won (32 percent), Malaysian ringgit (25 percent), and Thai baht (20 percent) (Ministry of Trade and Industry 1998, Figure 7.1). The depreciation of the Singapore dollar visà-vis the U.S. dollar reflects two opposing forces. The declining interest of international investors in Asian currency exposure following the devaluation of the baht, rupiah, ringgit and won tended to weaken the currency, while the safe-haven role played by the Singapore dollar tended to strengthen its exchange rate. Against a trade-weighted basket of currencies of major trading partners, the Singapore dollar appreciated, which put pressure on exporters. Tan and Chen (1999) show that the export-weighted effective exchange rate rose by 9.8 percent in 1998, while the import-weighted effective exchange rate fell by 4.7 percent. Singapore’ s real effective exchange rate (REER) and overall competitiveness remained relatively stable due to the low rate of inflation. The Monetary Authority of Singapore (MAS) continued a policy of flexible management against a trade-weighted basket of currencies so as to maintain price stability; the low inflationary pressure enabled MAS to

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FIGURE 7.1 Index of Singapore Dollar Exchange Rate versus Selected Currencies Index: 1/1/96 = 100 190 170 150 S$/Won S$/Baht S$/Ringgit

130 110

S$/Yen S$/Yuan S$/US$

90 70 50 Jan Apr 1996

Jul

Oct

Jan Apr 1997

Jul

Oct

Jan Apr 1998

Jul

Oct

Jan 1999

Source: Monetary Authority of Singapore (MAS). Monthly Statistical Bulletin.

achieve this objective. However, the increased volatility and uncertainty of financial markets necessitated allowing a wider band of the tradeweighted exchange rate. In early October 1998, the Deputy Prime Minister and Chairman of MAS reiterated that Singapore would not restrict the movement of short-term capital but would continue to maintain careful watch over the currency to ensure that there were no hot money flows that could upset the exchange rate. Impact on Stock and Property Markets

Heavy investments in the stock and property markets in Singapore led to sub-optimal allocation of capital resources. Stock and property prices peaked in mid-1996 and were already on a downtrend before the regional crisis erupted, but the crisis accelerated the downward movement. Falling asset prices and the negative wealth effect adversely affected consumer and investment spending.

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At end-August 1998 the stock price index, which had risen by some 145 percent during 1990–96, reached a low of 856, which was two-thirds off its peak (Figure 7.2). Foreign and local investors alike withdrew funds from the Singapore stock market. Concern was growing over the softening of the local property market, the impact of the region’s financial difficulties on local banks, and the impact of the economic downturn as well as bad debts on corporate balance sheets and profitability. Property stocks were worst hit, falling by around 75 percent from their peak. Due to lower prices, turnover on the Stock Exchange of Singapore fell 14 percent in 1998, even though the volume of transactions grew 43 percent. The stock market index rebounded in the closing months of 1998 and early 1999. During the boom from mid-1990 to mid-1996, property prices in Singapore nearly tripled. In May 1996 the government introduced measures to cool the private residential property market and prices eased (Figure 7.3). The regional crisis exacerbated the downtrend. By end-1998, the URA Price Index for residential properties had fallen by 45 percent from its mid-1996 peak. Likewise, office rental prices fell 39 percent from their peak in the third quarter of 1996. Falling asset values hurt the balance

FIGURE 7.2 Singapore Stock Market Index, 1995–99 Index: 1975=100 700 600 500 400 300 200 100 0 Jan Apr 1995

Jul

Oct

Jan Apr 1996

Jul

Oct

Jan Apr 1997

Jul

Oct

Source: China Economic Information Centre. CEIC Database.

© 2000 Institute of Southeast Asian Studies, Singapore

Jan Apr 1998

Jul

Oct

Jan 1999

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FIGURE 7.3 Singapore Property Price Index, December 1988–December 1998 Index 1990=100 350 300 250 200 150 100 50 0 Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec 88 89 90 91 92 93 94 95 96 97 98

Source: China Economic Information Centre. CEIC Database.

sheets and profitability of property developers and exposed the Central Provident Fund (CPF), the Housing and Development Board (HDB), and other financial institutions to the risks of lower property values and mortgage loan defaults. Property market analysts believed that prices bottomed out by end-1998 and increased property market transactions were evident in early 1999. Impact on the Financial and Corporate Sectors

Singapore has a large financial sector, reflecting its role as a regional financial centre. At end-1998 there were 145 banks, 74 merchant banks, and 17 finance companies. Growth of financial services fell from 15.3 percent in 1997 to –0.5 percent in 1998. As investors and lenders lost confidence in the regional economies, offshore lending fell drastically. The assets/liabilities of the Asian Dollar Market (ADM) contracted 9.8 percent in 1998, after growing 6.0 to 14.9 percent per year from 1995 to 1997. Loans and advances (including bills) to non-bank customers fell 24 percent, while interbank

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lending remained stable. Some recovery in ADM lending activity was observed in the last quarter of 1998. Domestic lending also turned cautious, as loans and advances to non-bank customers grew at only 5.9 percent in 1998 as compared to double-digit growth of preceding years. Average daily volume of major foreign exchange trading fell 15 percent in 1998 to US$142 billion, after registering 31 percent growth in 1997. This decline reflected the lower risk appetite of international investors, dampened regional foreign exchange demand, and capital controls imposed by Malaysia. In contrast, trading in financial futures on the Singapore International Monetary Exchange (SIMEX) rose as firms increasingly used derivatives to hedge against price volatility. The average daily trading volume of SIMEX rose by 16 percent in 1998 to a record of 108,961 contracts. The regional crisis and falling domestic asset prices have weakened domestic financial institutions, as they are confronted with rising nonperforming loans (NPLs). Initially, the concern was more with the regional exposure of local banks as the Singapore economy was still healthy. In February 1998, the Deputy Prime Minister disclosed to Parliament that the regional exposure of local banks “was not alarmingly high ”, and local banks had made provision for their regional loans. At end-December 1997, local banking groups (DBS, OCBC, UOB, OUB, KTB) had loans and investments in the five crisis countries amounting to S$37.2 billion. This comprised 16 percent of their total assets. Two-thirds of these loans and investments were in Malaysia and 15 percent in Indonesia. Classified loans (loans graded as substandard, doubtful, or bad) amounted to S$2 billion or 5.7 percent of these loans as of mid-January 1998. The local banking groups set aside S$1.8 billion in specific and general provisions from their 1997 earnings. The NPLs of the five local banking groups more than trebled from S$5.4 billion in December 1997 to S$18.4 billion in December 1998, as banks more stringently classified loans as substandard, doubtful or outright loss. The ratio of NPLs to total non-bank loans for the local banking groups rose to the 7.9 –17.2 percent range. These banks set aside S$3.2 billion as provisions for 1998, much higher than the provisions made in 1997. Total cumulative provisions reached S$8.1 billion, providing a 44 percent cover for reported NPLs. With these hefty loan provisions, net profits plunged 32 percent, from S$1.8 billion in 1997 to S$1.2 billion in 1998. Even so, the Singapore banks ’ balance sheets and their ability to lend have not been impaired, unlike the situation for many banks in the region, which require re-capitalisation. Capital adequacy ratios (CAR)

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were in the 15.6 –20.4 percent range, substantially above the 8 percent minimum specified by the Bank for International Settlements. The regional crisis also heavily damaged corporate profitability. The 193 companies listed on the Stock Exchange of Singapore with financial year ending in March reported 1998 earnings down 88.9 percent, from S$4,568 million to only S$507.9 million. Only 50 companies reported higher profits, while 63 companies reported losses ( Business Times, 1 April 1999). A growing number of companies made record provisions for NPLs, while others experienced a fall in the value of investments and potential losses on projects. The three major property companies wrote off S$3.1 billion in property values. Most companies appear to have taken the opportunity to clean up their balance sheets as much as possible. The corporate sector was also adversely affected by tight liquidity conditions up to mid-1998. Because of the regional shortage of funds, the domestic prime lending rate, which had been steady at 6.3 percent since August 1995, began rising in November 1997 and reached 7.8 percent in May 1998. At the same time, financial institutions tightened loan criteria out of concern over NPLs, resulting in a credit crunch. Since the third quarter of 1998, however, interest rates have been on a downward trend and liquidity has improved markedly. Impact on Trade and the Balance of Payments

Singapore’s total trade shrank 7.5 percent in 1998 after it grew 5.7 percent in 1997. This was the first contraction since the 1985–86 recession and the worst in decades. Non-oil trade fell 6.1 percent and oil trade fell 22 percent, primarily due to the sharp fall in international oil prices. Imports fell 13.6 percent, a combination of price and demand effects. The fall in imports was much steeper than the fall in exports, reversing Singapore ’s usual merchandise trade deficit. Total exports fell 1 percent in 1998 versus their 5.3 percent growth in 1997 and domestic exports of oil fell 15 percent, while re-exports and nonoil domestic exports remained relatively stable. The regional crisis has several implications for Singapore ’s export performance. First, regional demand for Singapore ’s exports declined, particularly from the crisis countries, where import demand plunged because of higher import prices, foreign exchange shortage, and economic recession. Japan, South Korea, Hong Kong, Malaysia, and Thailand traditionally absorbed almost half of Singapore’s exports. Export performance is actually worse than these data indicate because they exclude merchandise exports to

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Indonesia and exports of services to the region, both of which fell sharply in 1998. Second, as the East Asian crisis contributes to slower economic growth in the United States and Europe through the trade effect, Singapore ’s exports to these countries will slow down. Third, Singapore ’s export competitiveness will increasingly be challenged as the crisis countries recover their export capabilities and take advantage of their devalued currencies. Apart from the impact of the regional crisis, Singapore ’s export performance is also dependent on the recovery in the global electronics industry. Electronics products and parts and components accounted for almost two-thirds of Singapore ’s non-oil domestic exports in 1998. Notwithstanding the impact of the regional financial crisis on Singapore’s economic growth, the current account surplus has improved, reaching S$29.5 billion and 20 percent of GNP in 1998, against S$22.3 billion and 15 percent in 1997. The surplus in merchandise rose sharply from S$1.7 billion in 1997 to S$24.6 billion as imports fell 13 percent. The economic slowdown, resulting from both the regional financial crisis and the global electronics downturn, had led manufacturers to delay imports and run down inventory in the face of weakening demand and uncertain economic conditions. Conversely, the normally much larger services surplus contracted sharply from S$16.5 billion in 1997 to a mere S$0.6 billion in 1998 because of weak regional demand for Singapore ’s tourist, financial, and professional services. The capital and financial account saw the net outflow of funds escalate from S$6.0 billion in 1997 to S$29.9 billion in 1998 (20 percent of GNP). This reflected the dramatic S$80.1 billion reversal in the flow of bank and other liabilities, from an inflow of S$53.6 billion in 1997 to an outflow of S$26.5 billion in 1998. With limited access to local funds, foreign banks in Singapore have traditionally relied on funding their Singapore and regional credit activity from their head offices and the Asian Dollar Market. Such funding has been scaled back due to the contraction in credit activity in Singapore and the region as well as heightened credit risks. Apart from the outflow of bank funds, there was also a net repayment of offshore loans, such as those with the Asian Dollar Market. In consequence of the developments in the capital and financial account, the balance of payments surplus fell from S$11.7 billion in 1997 to S$5 billion in 1998 and growth in official foreign reserves slowed. At year-end 1998, reserves reached a total of S$125 billion, providing cover for 8.8 months of imports.

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RESPONDING TO THE CHALLENGES OF REGIONAL CRISIS AND GLOBALISATION

Singapore’s current predicament has two aspects for policymakers: the short-term problems brought on by the financial and economic turmoil in the region and the longer term issue of how Singapore can meet intensifying competition due to the globalisation of trade, finance, and information flows. Singapore’s history as a small city-state has been a history of continuing responses to changes in the global and regional environments. In November 1996, well before the onset of the regional crisis, the government announced the need to review Singapore ’s economic competitiveness over the next decade, and in May 1997 it convened the Committee on Singapore ’s Competitiveness (CSC). 1 The CSC ’s report, which was released to the public in November 1998, laid out a programme for how Singapore should position itself to meet the challenges of globalisation and also proposed specific responses to the immediate regional crisis. In addition, since the formation of the Financial Sector Review Group in late 1997, the government has been undertaking to further liberalise the financial sector in response to the slowdown in Singapore ’s development as a financial centre. Responding to the Regional Financial Crisis

Singapore felt the impact from the regional crisis in two ways. One was the fall in demand from neighbouring economies, which, along with a fall in demand for electronics, was the primary cause of the 1998 recession. The other was the significant erosion in Singapore ’s international competitiveness as a result of the relatively larger depreciation of the other currencies in the region compared to the Singapore dollar. Stimulating domestic demand would have had only a limited effect against the recession, particularly given the high import leakage of Singapore ’s consumption and investment demand. Rather than resorting to devaluation to restore its competitive position, Singapore chose to implement measures to cut domestic costs and to provide fiscal and financial relief for businesses, households, and individuals. This policy response reflects the influence of the CSC and its recognition of the longer-term implications of the regional crisis for Singapore. Although Singapore’s neighbours have been preoccupied with the financial crisis and ensuing domestic economic, political, and social problems they pose an emerging challenge. The CSC report noted: “The regional economic

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crisis, which started in July 1997, has altered the economic landscape. The sharp currency realignments have eroded our cost competitiveness. Before the crisis, regional countries have expanded their infrastructure rapidly. With financial reform and economic restructuring, regional countries will eventually recover and become even more competitive. We have to take decisive action to regain our competitiveness and strengthen our capabilities to prepare for future growth ” (p. 20). The CSC argued against devaluing the Singapore dollar, noting that the strength of the currency reflects market confidence that the economy is fundamentally sound. Instead, it proposed six strategic responses to ride out the crisis: • reducing business costs (including wage costs) to help tide viable companies through the crisis and minimise unemployment; • ensuring that the broad economic framework continues to function effectively, including maintaining a strong and sound financial system and corporate access to working capital; • maintaining investor confidence in the economy; • accelerating capability-building and economic restructuring to keep ahead of the competition; • diversifying beyond the region, seeking out new markets and niches; and • leveraging on market opportunities in regional economies to form strategic partnerships. During 1998, even before the public release of the CSC report in November, the government introduced three packages that implemented the first strategy of cutting Singapore ’s business and labour costs (Figure 7.4). The February 1998 fiscal budget announcement included tax incentives and rebates for business as well as rebates on income taxes,

FIGURE 7.4 Summary of Singapore’s Responses to the Regional Financial Crisis February 1998 Budget Measures

Tax incentives and tax changes for business: • Tax incentives for fund management, bond market, unit trusts, syndicated offshore credit and underwriting facilities, general provisions made by banks and merchant banks, SIMEX, venture capital, transport and logistics, exhibition organisers, approved cyber-traders, employing talent from abroad, industrial noise and chemical hazard control.

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SINGAPORE 181 Tax changes for individuals: • Rebate on income tax • Rebate on Housing and Development Board (HDB) service and conservancy and rental charges • Rebates on utility rates June 1998 Off-budget Package

November 1998 Cost-reduction Package

Business cost reduction: • Additional property tax rebate • Rental rebates by Jurong Town Corporation, Housing and Development Board, and Civil Aviation Authority of Singapore Economic restructuring and capacity-building assistance: • Speeding up of public sector development projects • Expanded grants for Skills Redevelopment Program, Local Enterprise Financing Scheme, Economic Development Board’s Economic Development Scheme, trade promotion and facilitation by Trade Development Baord Stabilisation of specific sectors: • Suspension of government land sale stamp duty on uncompleted properties, reassignment of government land sale parcels, extension of project completion period • Tax deduction for bank provision • Tax allowance for refurbishment of hotels Labour cost: • 10 percentage point reduction in CPF contribution by employers, for 2 years • 5–8% reduction in wages recommended by National Wage Council Taxes: • Corporate tax rebate • Property tax rebate and property tax exemption for land under development • Suspension of stamp duty suspension on share transactions Government rates and fees: • Reduced foreign worker levy • Rental concessions • Rental reductions by JTC and HDB • Reduced charges for land, sea, and air transport and telecommunications • Rebate on utility tariffs Personal and household rebates: • Extension of rebates on HDB rentals and maintenance charges, rebates on utility charges • Rebates on public transport • Reduced hospital charges

Source: Singapore Ministry of Trade and Industry. Economic Survey of Singapore 1998 .

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utility charges, and public housing maintenance fees and rents for households and individuals. In June 1998, as the deteriorating external environment necessitated downward revision of the growth forecast for the year, the government announced a S$2 billion off-budget package of additional measures to cut business costs and stimulate the economy. Finally, as the Singapore economy slipped into recession for the second half-year, in November 1998 the government announced a further S$10.5 billion package of cost-reduction measures to provide relief to businesses and households. A major feature of these cost-cutting measures is the cut in wages and benefits. The amount that employers are required to contribute to the Central Provident Fund (CPF) was halved (to ten percent of employees ’ salaries) for 2 years effective from January 1999, saving businesses an expected S$7.5 billion in salary-related costs.2 In addition, the government accepted the National Wage Council ’s recommendation to reduce wages by 5 to 8 percent. Together these steps amount to a 15-percent reduction in wage costs. A second measure aimed at cutting labour costs was to reduce the levy for skilled and unskilled foreign workers in the manufacturing and services sectors and for skilled foreign workers in the construction sector by S$50–S$100 per month. Other measures adopted by the government included: • cuts of up to 40-percent in industrial land and factory rentals by Jurong Town Corporation and the Housing and Development Board, following CSC recommendations to lower land and factory rents to early 1990s levels in line with current depressed market conditions; • lower electricity and telecommunications tariffs (by up to 40 percent for IDD calls), lower port tariffs for harbour craft, and 10-percent rebate on airport landing fees following the CSC ’s call to lower government user charges for electricity, telecommunications, and port services • cuts in customs and excise duties for cars (from 41 percent to 31 percent) and petroleum (from 46 percent to 40 percent) and an increase in road tax rebate from S$50 to S$250 in response to the recommendation by the CSC to reduce vehicle-related customs duty and petrol/diesel duty to reflect the policy shift from restraining car ownership to restraining car usage; • tax relief including a 55-percent property tax rebate, a 10-percent corporate income tax rebate, and suspension of stamp duties on share transactions. • reducing rates or extending rebates on corporate and personal income taxes.

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Together these measures are projected to reduce business costs by about S$10 billion or 15 percent, amounting to 7 percent of GDP. To maintain corporate access to working capital, the second short-term strategic focus after cost cuts, the CSC recommended that the government use the existing Local Enterprise Finance Scheme in addition to access to commercial bank loans. It suggested raising the cap on eligible fixed-asset investments from $30 million to $50 million and widening the coverage to include manufacturing-related service companies and long-term loan financing for used machinery. The CSC ’s recommendations for building capabilities over the longer term included: repositioning the Skills Development Fund to encourage employers to train workers in certifiable skills; establishing a National Skills Recognition System to promote skills upgrading; and elevating the Skills Redevelopment Programme to a national programme with greater support and funding from government and employers. The CSC’s specific recommendations on diversifying the market to offset the fall in regional demand focused on ways to help local companies explore and penetrate new markets. They included enhancing trade development incentives for overseas investments, establishing overseas marketing offices, undertaking international marketing programmes such as franchising, direct marketing, licensing and branding; and increasing funding for companies that participate in trade missions and approved fairs. To retain and attract investors to Singapore the CSC recommended increasing funding of promotional agencies to intensify international marketing activities and creating an incentive package to attract foreign companies to undertake the entire value chain of key services in Singapore. Restructuring the Financial Sector

Singapore’s stringent system of prudential regulation and supervision helped bring its financial sector through the 1997 –98 crisis relatively unscathed compared to the financial systems of neighbouring East Asian economies. Nevertheless, market concerns that the financial sector is overregulated, particularly compared to the more laissez faire Hong Kong, have slowed down Singapore’s development as a financial centre and led to recognition that Singapore needs to liberalise further if it is to retain its competitive position in this sector. The Financial Sector Review Group formed in August 1997 made wide-ranging recommendations to ease the regulatory environment and provide for improved financial disclosure. The Monetary Authority of Singapore is implementing changes to give its policy framework a more

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flexible stance, “shifting its emphasis from regulation to supervision … . [This] will give better-managed institutions more leeway to assume risk profiles they are comfortable with” (MAS Annual Report 1997/98, p. 10). MAS also aims to “raise information disclosure standards, to enable investors to make informed decisions,” as well as to promote the financial sector more actively in a bid to “develop Singapore as a world class financial centre.” As a cumulative result, and the “regional turmoil notwithstanding, the MAS has embarked on a fundamental review of its approach to regulating and developing the financial sector in Singapore ” (p. 9). Since the end of 1998, commercial banks have been instructed to report their hidden reserves and loan portfolio by country and industry. The investment guidelines for CPF-approved unit trusts have been revised to give fund managers greater flexibility, and the minimum amount of shareholder funds necessary to establish an investment advisory business has been reduced from US$500 million to US$100 million. In November 1998, MAS announced that it will place S$10 billion of its funds with private sector fund managers over the next three years, beginning with US$2.5 billion in 1999 ( Business Times, 12 February 1999). This is in addition to an on-going drive to develop the asset management industry in Singapore by encouraging government-linked companies (GLCs) and statutory boards to place excess funds with private sector fund managers. MAS issued its first 10-year bonds in mid-1998. The S$1.5 billion issue is expected to act as a benchmark against which MAS and other statutory boards as well as major corporations will issue more debt paper in the future. To develop the bond market, foreign banks and companies may also be permitted to issue debt paper in currencies other than the Singapore dollar. For commercial banks, the minimum cash balance requirement has been lowered from 6 percent to 3 percent, and the capital adequacy ratio (CAR) requirements are to be made less stringent, albeit still within the guidelines set by the BIS. Various studies are underway to examine bringing a greater degree of competitiveness into the securities industry in Singapore; these will include an initiative by the MAS announced in November 1998 to both de-mutualise and merge the Stock Exchange of Singapore (SES) with the Singapore International Monetary Exchange (SIMEX). Regulations on brokerage commission rates are also to be revised to permit greater competition, the settlement period lessened, and foreign companies will see a relaxation in some of the listing requirements for the SES. The SES may also move to end the distinction between local and foreign share tranches.

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MAS has been reviewing existing restrictions pertaining to commercial banking in the domestic retail sector. Liberalisation measures may include: relaxing current limits on the number of off-site ATM machines and permitting shared ATMs; possible upward revision in local currency lending limits; establishing additional foreign bank branches; possibly revising the terms on offshore licences for reputable foreign banks to allow greater access to the domestic market. These changes will bring the level of competition in the domestic retail commercial banking sector more in line with the levels of foreign competition allowed in wholesale commercial banking, investment/merchant banking, treasury services, and offshore banking. Currently, foreign banks account for about one-third of total resident deposits and almost half of resident loans, with a market share that exceeds that of foreign banks in other East Asian countries except Hong Kong. These measures are intended to strengthen the domestic banking sector so that it can withstand the competitive challenges of globalisation. The government is also pressuring local banks to become more effective regional players by merging to improve their asset base and competitiveness. Two bank mergers took place in 1998—DBS Bank merged with the Post Office Savings Bank and Keppel Bank with Tat Lee Bank. The government would like to see more mergers, until the number of local banking groups has been reduced from the existing five to only two. MAS has been asked to take on the added responsibility of promoting Singapore’s financial services. The government has identified key growth areas in fund management, risk/treasury management, stock market, general debt, venture capital, insurance and reinsurance and cross-border electronic banking. The supply of skilled financial personnel remains a serious bottleneck and this is being addressed by accelerating the training of local personnel and attracting more foreign talent. Meeting the Longer-Term Challenges of Globalisation

Looking beyond the immediate crisis, the CSC expected Singapore would have “an advanced and globally competitive knowledge economy within the next decade … where the basis for competitiveness will be the capabilities and intellectual capital to absorb, process and apply knowledge … have a strong technological capability and a vibrant entrepreneurial culture … be an open cosmopolitan society, attractive to global talent and connected with other global knowledge nodes … be a critical mass of Singaporeans who are risk-taking entrepreneurs, innovators and arbitrageurs. … To realise this vision, we require a quantum jump in

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capabilities, while managing our cost competitiveness” (CSC 1998, p. 6). The CSC recommended eight key strategies to move Singapore toward this vision: • • • • • • • •

maintaining manufacturing and services as twin engines of growth; strengthening the external wing; building world-class companies; strengthening local small and medium-sized enterprises; developing human and intellectual capital; leveraging on science, technology and innovation; optimising resource management; and using government as a facilitator of business.

Manufacturing-Services Nexus

Manufacturing and services will remain the twin engines of growth for Singapore. This strategy involves exploiting the linkage between the two sectors, reducing vulnerability by providing a broader economic base, and balancing a globally oriented manufacturing sector with a regionally oriented services sector. Manufacturing contributes significantly to Singapore ’s GDP, employment, and foreign exchange earnings as well as being a key to technological progress, productivity improvements, and entrepreneurship. The costcompetitiveness of the manufacturing sector has been a growing problem and the 1997–98 currency realignments have aggravated the situation. The short-term cost-cutting measures to restore competitiveness were discussed earlier. In the longer term, however, to remain competitive in manufacturing, Singapore will have to move beyond competition based primarily on cost advantage to competition based on capability. This requires moving up the value-chain into research and development (R&D) and design, and down the value-chain into logistics, marketing, and sales, positioning as a critical base for the manufacture of high value-added products, and providing manufacturing-related services to companies based in Singapore and in the region. To ensure Singapore ’s role as a manufacturing base the CSC recommended: maintaining cost competitiveness; having a balanced mix of manufacturing activities; building strong manufacturing capabilities in niche areas; strengthening competitiveness in other parts of the value chain; applying science and technology more widely; embracing innovation; providing an entrepreneurial environment; grooming world-class companies; positioning Singapore as a premier regional hub; developing a strong external wing; and integrating Singapore into the global economy.

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As to the other growth engine, the services sector, Singapore is positioning itself as a regional financial centre and a regional services hub. It needs to strengthen its existing hub services including financial services, international trading, international exhibition, transport and logistics, and tourism. It may promote such new high growth services as health care, education, media, communications and information technology (IT) services, and electronic commerce. The CSC recommended three main measures: monitor closely cost competitiveness and leverage on Singapore’s strategic location, good infrastructure, and talent pool; enhance the international orientation and profile of Singapore’s hub services capabilities; exploit IT and telecommunications to expand and strengthen international linkages. Outward Investment and Regionalisation

In 1993 Singapore adopted the strategy to regionalise its economy by building an external economy that was strongly linked to and that would enhance the domestic economy. This strategy was driven by three factors. First, it would help Singapore overcome its shortages of land, natural resources, and labour. Second, the booming regional economies would provide business opportunities for investors from Singapore. Third, it would enable Singapore to forge closer ties with its neighbours to enhance its economic and political security. Regionalisation has not led to a hollowing out of the domestic economy. Even as factor income from abroad has increased, the contribution of foreign operations to value-added in the Singapore economy actually fell from 12 percent in 1993 to 11.3 percent in 1996. In addition, S$5.1 billion or 20 percent of total sales of overseas manufacturing affiliates was shipped back to Singapore in 1996. This is equivalent to 2.8 percent of Singapore’s total imports and indicates that these affiliates were already forging linkages with companies in Singapore. Nevertheless, the regionalisation strategy has come under criticism since the Asian financial crisis. Critics note that Singapore businesses that have expanded into the region have been badly affected by the contraction of demand in host markets, currency volatility, and non-performing loans and that some companies have had to trim or even shut down their regional operations. Outward investment, however, is crucial for Singapore ’s continuing development, to enable Singapore to expand beyond the confines of the city-state and tap the region ’s resources and markets. The local private sector remains weak and developing a critical mass of indigenous

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world-class companies with a global reach will take more time. Hence, regionalisation must remain a strategic pillar to sustain Singapore ’s economic growth and local firms need to position themselves to exploit economic opportunities when neighbouring economies begin to recover. Both government-linked companies (GLCs) and private companies that still have the resource capacity are encouraged to continue investing in the regional economies. Opportunities are beckoning as these economies have liberalised their policies toward foreign direct investment, by opening up formerly closed sectors and by allowing mergers and acquisitions as they seek to re-capitalise their financial and corporate sectors. Practical strategies that the CSC recommended for pursuing these opportunities include: • generating linkages from overseas affiliates to Singapore through trade flows; • consolidating Singapore’s headquarters, high-tech operations, and R&D functions in Singapore; • pooling resources in overseas ventures by forming clusters and tie-ups to maximise collective leverage; • promoting strategic flagship projects; • promoting tripartite co-operation, enhancing Singapore’s role as a partner for investors from outside the region; • developing globally and regionally minded managers and investors; and • tapping foreign talent to overcome domestic manpower constraints. World-Class Companies and Vital SMEs

Singapore’s aspirations to achieve the economic depth and resilience of developed-country status depend on producing indigenous world-class companies with core competencies. Such companies are needed to enable Singapore overcome its small size and develop an external wing that is capable of exploiting opportunities and competing effectively in regional and global markets. World-class companies need skilled manpower, financial resources, technological capacity, market networks, and an entrepreneurial spirit. Although Singapore plays host to thousands of foreign multinational corporations (MNCs), it has no indigenous MNC in the category of the Fortune Global 500. Singapore ’s earlier industrial policy focused on attracting and retaining foreign MNCs and it did not devote much attention to nurturing domestic enterprises. Despite more than three decades of industrialisation, Singapore ’s numerous local small

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and medium-sized enterprises (SMEs) continue to play a secondary role to foreign MNCs and they have limited capacity to venture abroad. Since the mid-1980s, however, the Economic Development Board (EDB) has been more proactive in promoting local SMEs in supporting industries and linking them with foreign MNCs to facilitate technology transfer and market networking, particularly in the electronics industry. On their part, SMEs have not always been forthcoming because of concern that partnerships with large foreign MNCs or GLCs would dilute their control. The CSC recommended the following strategies to strengthen local enterprises: • consolidate and pool resources among local enterprises to achieve synergy and competitiveness, such as through linking private sector companies with GLCs that have advantages of size, financial resources, core capabilities, and experience in venturing abroad; • improve the supply of engineering and managerial manpower through expanded education and training facilities; • promote innovation and technology, such as through government provision of funding and facilities and incentives for commercialisation of innovation, acquisition of technology, and technological upgrading; • build indigenous products and brand names; and • increase international and regional orientation. Human Resource Development, Foreign Talent, and R&D

In some ways, lack of land and natural resources has been a blessing for Singapore, forcing it to focus on developing human resources. However, Singapore’s pool of human talent remains limited, due to its small population base as well as the colonial legacy of neglect of education and training and the government’s limited financial resources after independence in the 1960s and 1970s. As a result, even by the 1990 population census, only 25 percent of Singapore ’s non-student population had completed secondary education and only 14 percent had upper secondary or tertiary education. The educational flow has improved quite dramatically recently. By 1999, 60 percent of the college-age cohort was receiving polytechnic or university education. To position itself as a competitive knowledge-based economy, Singapore has adopted a two-pronged strategy involving upgrading its own pool of human resources and importing foreign talent. Financial resources for education and training have grown rapidly in the past two decades, covering primary to tertiary education, continuing education, and training at all

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levels of the skill spectrum. In particular, government expenditure on education tripled and enrolment in polytechnics and universities more than doubled in the 1987 –97 period. In recent years foreign labour has accounted for over 20 percent of the Singapore labour force, as a result of a general shortage of labour and the shortage of specific skills. For technological upgrading, a systematic policy of recruiting foreign talent to augment the domestic pool has been put in place. The Economic Development Board is tasked not only with promoting inflow of foreign direct investment but also with promoting inflow of foreign talent. The CSC recommends that government create the most conducive environment through appropriate incentives and infrastructure to attract, develop, and retain the best talents locally and from around the world. The growing emphasis on recruiting foreign talent has met with resistance from some segments of the citizenry who are concerned that the“crowding out” effect will reduce Singaporeans to second-class workers and professionals. The government has gone to great lengths to explain its rationale, which is that the foreign talent pool will enable Singapore to remain competitive and that the larger pie it makes possible means an absolute gain for Singaporeans. Policy makers recognise that Singapore has reached a stage of economic development in which competitiveness will have to be based on capabilities rather than costs. Heretofore Singapore has depended heavily on foreign MNCs introducing advanced and sophisticated technology and know-how through the process of FDI; now it must also develop its own science, technology, and innovative capabilities. Singapore launched its first National Technology Plan in 1991. This plan included the developing of technology infrastructure, encouragement of R&D activities by the private sector as well as the formulation of a human resource plan to complement the science, technology, and innovation needs of Singapore. In 1996, the second National Science and Technology Plan (NSTP 2000) was launched. The NSTP maintained the core strategies of the first plan with particular improvements noted in terms of the strategic development of research institutes and centres, the gross expenditure on R&D (GERD), the number of research scientists and engineers, and number of patents introduced. Its focus on science and technology is indicated by the characteristics of student admissions into polytechnics and universities. In 1997, over half of student admissions were into science and engineering courses. Singapore ’s ratio of R&D expenditure to GDP rose from a mere 0.8 percent in 1990 to 1.5 percent by

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1997. Likewise, the R&D manpower/labour force ratio jumped from 0.28 percent to 0.60 percent. Notwithstanding these sharp improvements, absolute numbers are very small compared to those of bigger economies, reflecting Singapore’s smaller demographic base, and the ratios are still behind those of South Korea and Taiwan and many advanced industrial countries. Hence, Singapore faces the need to recruit foreign talent, encourage inward FDI by foreign MNCs, and at the same time encourage outward investment. The CSC described a number of ways for Singapore to leapfrog into the next stage of R&D. These include: focusing on research areas in which Singapore already has reasonable world standing; focusing funding on providing continued competitive capabilities to industry; promoting transfer of technology, spin-off, and start-up companies as well as technology acquisition; nurturing indigenous high-tech enterprises; enhancing links to other technology centres to facilitate technology transfer; using governmentbased venture capital as seed money to promote investments in technologybased industries and create networking links with overseas technology companies; designing human resource development programmes to encourage R&D and innovation activities; and creating an innovative environment conducive to intelligent risk-taking and entrepreneurship. Singapore is also pushing for further development in Information Technology (IT) as a business enabler, particularly as it aspires to be an IT hub for the Asia-Pacific region. For a start, Singapore would focus on developing IT in three areas: communications and media, e-commerce, and IT innovation. A recent study called, “Information Society Index”, by International Data Corp and World Times Inc. notes that by the year 2002 Singapore will be the world’s second most dominant information economy, behind only the United States (Business Times, 8 April 1999). The study tracks 55 countries that account for 97 percent of global GDP and 99 percent of global IT expenditures. Currently Singapore ranks first in Internet usage and infrastructure, third in computer usage, and tenth in access to information. CONCLUSION

A key question is when can East Asia ’s economic dynamism be restored. The spread and severity of the regional financial crisis were unexpected, resulting in tremendous loss of confidence. It is important that confidence returns, particularly among investors. Many of the fundamentals and strengths which contributed to the East Asian Miracle have remained

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largely intact in most countries —the work ethic, thrift and savings, education and skills development, and social cohesion. The downside which the regional crisis has exposed is slowly being addressed —the vulnerability of dependence on short-term volatile capital flows, weakness of domestic financial and banking systems, and shortfalls in economic management and corporate governance. The volatility of short-term capital flows should be taken up by reform of the international financial architecture so that globalisation can be a boon and not a bane for individual economies. Despite strong macroeconomic and financial fundamentals, Singapore has been sucked into the regional financial crisis. General business and consumer sentiment in Singapore’s domestic economy has been adversely affected by the regional downturn and Singapore ’s growth rate plummeted in 1998. Nonetheless, unlike other regional governments that must engage in “fire fighting” tasks, the Singapore Government has been able to focus attention on a longer-term strategy to maintain competitiveness in an increasingly globalised world. A key component of this strategy is to ensure Singapore’s competitive edge over regional countries when they emerge from the crisis with more competitive financial and corporate sectors. Measures are being put in place to strengthen Singapore’s position as a regional services hub and particularly as a financial centre. On the threshold of the twenty-first century, Singapore has come a long way. It has achieved political stability, social cohesion, a high quality of life, and a highly competitive economy. It has been driven by a strong sense of political and economic vulnerability arising from its geopolitical position in Southeast Asia and its physical limitations. The pursuit of a stakeholder society and good governance have enabled Singapore to achieve its goals. For the next lap, with globalisation providing intense competition, Singapore ’s continuing economic prosperity will largely depend on its ability to compete on capabilities rather than costs. The vision is a knowledge-based economy. Many strategies and policies are being developed and implemented to achieve this objective, including a large continuing role for foreign MNCs and a growing importation of foreign talents to enable Singapore to grow beyond the limits of its small physical size and small demographic base. The political leadership and policy makers have the challenging task of convincing the Singaporean business community and the Singaporean workforce that this is a shared vision and a positive-sum game as well as convincing highly mobile international investors and international professionals to put their stakes in Singapore.

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Notes 1

2

This was a follow-up to the 1986 Economic Committee Report that was targeted at pulling Singapore out of the 1985 recession and the 1991 Strategic Economic Plan that charted economic strategies for the 1990s. Required CPF contributions had also been reduced to expedite economic recovery from the 1985 recession.

References

Chia Siow Yue. 1997. “Singapore: Advanced Production Base and Smart Hub of the Electronics Industry ”. In Multinationals and East Asian Integration, ed. Wendy Dobson and Chia Siow Yue. Ottawa and Singapore: IDRC and Institute of Southeast Asian Studies. ______. 1998. “The Asian Financial Crisis: Singapore ’s Experience and Response”. ASEAN Economic Bulletin 15, no. 3 (December). Reprinted in Southeast Asia’s Economic Crisis , ed. H. W. Arndt and Hall. Singapore: Institute of Southeast Asian Studies, 1999. Committee on Singapore ’s Competitiveness (CSC). 1998. Report. Singapore: Ministry of Trade and Industry. November. Department of Statistics. 1998. Yearbook of Statistics, Singapore 1997 . Singapore: Department of Statistics. Economic Committee. 1986. The Singapore Economy: New Directions. Singapore: Ministry of Trade and Industry. Economic Planning Committee. 1991. The Strategic Economic Plan: Towards a Developed Nation. Singapore: Ministry of Trade and Industry. Ministry of Trade and Industry. 1999. Economic Survey of Singapore 1998. Singapore: Ministry of Trade and Industry. Tan Khee Giap and Chen Kang. 1999. “Economic Outlook for Singapore: Forecasting the Singapore Economy for 1999 –2000”. Paper presented at the 1999 Regional Outlook Forum, organised by the Institute of Southeast Asian Studies. Singapore. 8 January. United Nations Conference on Trade and Development (UNCTAD). 1998. World Investment Report 1998: Trends and Determinants . Geneva: UNCTAD. World Bank. 1988. World Development Report 1998/99: Knowledge for Development. New York: Oxford University Press.

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8 The Past and Futur e Role of Small and Medium-Sized Enterprises in Taiwan’s Economic Development Jiann-Chyuan Wang INTRODUCTION

Taiwan’s economy is predominantly composed of small and mediumsized enterprises (SMEs). In fact, some 98 percent of local enterprises are classified as SMEs. 1 In the past forty years, SMEs have played a crucial role in Taiwan’s economic development in terms of job creation, export share, and increased value-added. Although SMEs are typically prevalent in developing countries, Taiwan’s smaller firms remained unusually competitive alongside larger firms as its economy developed. What accounts for the economic success of Taiwan ’s SMEs and will these enterprises maintain their significance in the face of current economic challenges? After describing the position of SMEs in Taiwan’s economy, this chapter examines the factors behind the rise of SMEs in Taiwan and their role in the country’s economic development after the 1980s. It argues that the unique division of labour that developed between SMEs and large enterprises provided the economy with considerable manoeuvrability to adjust to the Asian financial crisis. Nevertheless, technological change and weak export demand in the wake of the crisis pose challenges for the future of Taiwan’s SME sector. Statistical Picture of Taiwan ’s SME Sector

SMEs have played an important role in the Taiwan economy at least since the 1980s. Although the definition has changed, SMEs have consistently comprised over 95 percent of firms since 1983 (Table 8.1). 2 SMEs have also accounted for over 78 percent of Taiwan’s total employment since the 1980s. © 2000 Institute of Southeast Asian Studies, Singapore

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TABLE 8.1 SMEs’ Share of the Manufacturing Sector by Number of Firms, Employees, Sales, and Exports, 1982–97 (Percent) SME Share of Manufacturing Sector

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Firms

Employees

Sales

Exports

— 98.54 98.34 98.49 98.15 97.60 97.72 97.39 97.16 97.05 96.79 94.49 96.26 97.97 97.95 97.81

— — — — — — 78.21 77.97 78.11 78.65 78.68 78.65 79.18 79.75 78.64 78.43

— — — — — 38.99 36.87 33.32 34.51 34.34 33.66 33.98 32.20 35.97 34.29 32.11

75.53 66.90 62.53 64.59 70.05 70.77 63.33 64.83 60.49 64.04 59.02 57.81 55.47 53.45 52.51 51.47

Notes: Before 1995, SMEs in Taiwan were defined as firms with capital registration below NT$40 million or with sales below NT$60 million. Source: Kuo (1998).

SMEs comprise a comparable share of total firms in Taiwan, South Korea, the United States, and other Asian countries (Table 8.2). However, SMEs account for a larger share of total employment in Taiwan than in most other countries. The employment share of SMEs in Taiwan is somewhat higher than in Hong Kong, Europe, South Korea, and Japan and it is considerably higher than in the United States, Australia, and the ASEAN countries.3 There is a much greater difference among countries in terms of the contribution of SMEs to exports. SMEs in Taiwan produced 55.4 percent of exports, which is well ahead of their export share in South Korea (42.8 percent) or Japan (12.6 percent). The larger export role of SMEs in Taiwan may have something to do with the country’s absorptiontype export-oriented networks that are described in the next section. Despite their importance, the position of Taiwan ’s SMEs has been declining. Their share of total manufacturing sales decreased steadily from 39 percent in 1987 to 32 percent in 1997 (Table 8.1). Sales of large

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TABLE 8.2 Comparison of SMEs’ Position in Selected Economies (Percent) SMEs’ Share of Firms

Employees

Sales

Exports

Taiwan (1994)

98.0

79.2

38.5

55.5

Hong Kong (1994) Indonesia (1993) Malaysia (1988) Philippines (1998) Singapore (1992) South Korea (1994) Japan (1994)

98.4 97.0 92.6 98.9 92.0 99.2 99.1

63.3 — 40.2 50.0 44.0 71.5 78.0

— — 19.6 26.3 27.0 53.9 —

— — — — 4.7 42.8 (1993) 12.6 (1993)

Australia (1994)

95.7

39.6

54.6 (1993)

Europe (1995) United States (1995)

99.8 99.7

66.5 52.7

64.9 47.3

— — 29.0 (1993)

Notes: SMEs defined as follows (by number of employees). Japan: