Asian financial crisis: A credit perspective

Abstract

A year after the beginning of the Asian Financial Crisis, its economic impact on the global economy is still not fully revealed. Furthermore, it does not appear that the Crisis is approaching the end of its course.

To steer their companies through the crisis, corporate executives must gain a proper perspective of the factors leading to the crisis. In doing so, this paper offers an alternative explanation to the causes of the crisis. From our analysis, we find that a key factor leading to the crisis is the role of credit. Prior to the crisis, while signs of deteriorating financial situations were present in these Asian countries, macroeconomic factors such as budget deficits, foreign debts owned by governments and trade deficits were not out of line in comparison to other emerging markets.

Our analysis indicates that a key contributor to the financial problem in Asia was the lacking of well-developed credit markets providing the necessary liquidity for companies to finance their long-term working capital requirements for growth. As a result, companies needing the financing would have to resort to short-term loans. What made the situation worse was the fact that most of these loans were denominated in foreign currencies such as US dollars. With a number of defaults by key corporations in Thailand and Korea in early 1997, creditors reassessed the risk of lending to these countries, and decided to reduce their loan exposure in the region by refusing to renew these short-term loans upon maturity. This, in turn, created tremendous pressure on the currencies leading to further credit tightening and, eventually, the financial crisis.

This paper begins by examining the broad characteristics of the financial crises in Southeast Asia. The paper then considers factors contributed to the crisis, especially the role of credit and its management by private companies in the crisis. This should allow corporate executives to develop a proper perspective to lead the company out of the crisis.

Background

Asia was a region with the most potential in the global business scene in recent decades. Gross Domestic Products (GDP) growth of most countries in the region was higher than that of industrialized countries. Table 1 displays the comparative GDP growth rates of these countries.

The Asian miracle was abruptly halted in 1997 when financial problems in a number of key companies in Thailand triggered off a round of exchange turbulence that spread to neighbor countries. By the end of the year, currencies of these countries were significantly depreciated with high interest rates and slowing economic activities. Table 2 displays the changes for equity and currency rates

What caused the Thai crisis?... How did this affect other Asian countries? Prior to the crisis, there were signs of changes in economic fundamentals in these countries. Historically, the fast growth of these Asian countries was supported by superior growth in exports Since the early 1990s, export growth of these countries were slowing (see table 3).

However, these early signs of trouble were mostly undetected by these countries which continued to increase investment in production capacities financed with short-term credit. As a result, production capacities were not utilized in the most efficient manner. The inability for these projects to generate sufficient cash flow to meet debt obligations when they come due resulted in a number of key defaults leading to the crisis.

In Thailand, financial problems could be seen before the crisis:

February 1997, Somprasong defaulted its foreign debt payment;

May, 1997, Finance One, Thailand's largest finance company failed;

In Korea, early signs of problems emerged before the crisis occurred also:

January 1997, Hanbo Steel, the 14th largest chaebol sought court receivership

March 1997, Sammi Steel, the main firm of the 26th chaebol was also in court receivership

April 1997, the Jinro Group, the 19th chaebol defaults on its loan payment.

These events have exposed the potential cash flow problems experienced by these firms to their creditors.

Due to the lack of a developed domestic credit market, most of the loans to these companies were short-term loans denominated in foreign currencies. The defaults led to significant non-renewal of loans by creditors upon maturity. The withdrawal of credit facilities by these creditors under such circumstances led to significant pressure on the domestic currency as these companies scrambled for foreign currencies to settle their loans.

In addition to the lack of a developed credit market, governmental policies also contributed to the heavy use of short-term financing for investment capital. First, most of these countries have their currencies tied to the US dollar, while capital flows were allowed to go in and out of these countries freely. This combination of capital account liberalization and fixed exchange policy results in a situation whereby arbitrage opportunities are created for market participants.

When domestic countries experience adverse economic changes such as an increase in inflation or lower productivity, these changes would lead to a decrease in value of the country's assets. Thus the country's currency will decline. However, when the government fixes its exchange rate, the country's currency value will stay at the same level due to government interventions regardless of the adverse changes in economic fundamentals. Thus, a fixed exchange rate in this case will not reflect its true economic values. When exchange rates are overpriced because of the imposed restrictions by the government, distortion of the exchange rates will generate massive capital flows to capture the arbitrage opportunities.

Furthermore, the fixed exchange regime also resulted in high domestic interest rates as the governments used high interest rates to maintain their overvalued currencies. With the high domestic interest rates the cost of raising domestic capital was increased. Hence, companies were attracted to finance their investments with foreign debt at a lower rate. While this exposed the companies to possible exchange rate risk, this risk was perceived to be minimal given the fact that exchange rates were fixed by the government.

To add to the risk, most of the foreign financing obtained was short-term in nature. Short-term debts are more subjected to the risk of non-renewal by creditors. When non-renewal occurs, borrowers are forced to come up with a large amount of cash flow for the payment of principal and interest. Table 4 reports short-term debt to foreign reserve ratios of these Asian countries. A ratio exceeding one indicates that the country has more short-term debt than foreign reserves. A ratio less than one indicates that the country has more foreign reserves than their debts. Two observations are noteworthy. First, the short-term debt to reserve ratios of these countries have increased significantly from 1994. Second, several countries have their ratio exceeding one, indicating their economic vulnerability to potential withdrawal of credit facilities.

This financing arrangement by Asian countries was not as problematic when their economies were growing at a healthy pace. However, evidence of slowing economic growth was present since mid 1990s. To compensate for the slow growth rates, these countries increased investments in projects of higher risks. Political pressures to increase capital accumulation to sustain their economic growth further enforced the desire for growth. As a result, there was evidence indicating excessive investment in risky, but low profitability projects. In addition, large flows of Japanese capital were rushed in to get higher returns for their capital because of the low interest rate in Japan.

The problem of excessive investment was well illustrated by a standard measure of investment efficiency -- the incremental capital output ratio (ICOR). ICOR is defined as the ratio between the rate investment as a percent of GDP and the rate of economic growth. The higher is the ICOR, the lower the investment efficiency. The low productivity of these excessive investments (measured by ICOR) is demonstrated in Table 5. Further, to ensure higher returns, some of the funds were invested in speculative land and real estate properties along with purchases of equity.

The combination of the lack of a developed and stable source of funds from the credit market, and a slowing of profit and excessive risky investments caused creditors to review their credit policies, imposing a rush by corporations to obtain foreign currencies to pay their debt obligations. This, in turn, exerts pressure on local currencies forcing significant depreciation.

Foreign Investment and Opportunities for U.S. Companies

As illustrated above, a key contributor to the Asian crisis was the lack of a developed stable source of credit and poor credit management. While the problem of financing long-term investments with short-term borrowing is well understood by the credit community, the maturity matching principle for assets and liabilities was grossly neglected by these companies in these markets.

Given the attractive growth potential of these Asian countries along with sound long-term fundamentals such as a high saving rate, quality workforce and high education levels (Table 6), there is no reason why the impressive historical growth rates cannot be extrapolated once these countries recover from the crisis.

U.S. companies with expertise in credit management and access to stable long-term financing are in a good position to take advantage of the Asian economic situations. Given the depreciated value of these companies compounded with the depreciated value of the exchange rates of these countries, it may be time for U.S. corporations to formulate strategies that can penetrate into these Asian markets.

In general, the factors that plagued these countries leading to the crisis were primarily credit related. The consequences were also very predictable from a credit perspective. Improvement in credit management in these companies would be critical in avoiding a future crisis. Conclusion

As can be seen from the discussion above, in the center of the Asian crisis is the role of credit and its management. For Asian countries to return to their former health, the governments need to open their economies and allow foreign direct investments into all economic sectors. Over the longer term, Asia needs to develop a debt market to provide companies access to stable long-term financing. For Asian companies, a need to develop sound credit policies and practices is a top priority.

Although Asian countries are still in economic troubles, it is likely that they will bounce back given sufficient time because the economic fundamentals in these countries are sound. These factors are important indicators of strong economic performance in the long run and should be considered by U.S. corporations.

References:

Corsetti G., P. Pessenti and N. Roubini, "What caused the Asian Currency and Financial Crisis?" working paper, March 1998.

Radelet S. and J. Sachs, "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," working paper, April 1998. Harvard Institute for International Development.

Dr. Chung is the Special Project Consultant, Treasury Management Association and Dr. Fung is the Dr. Y.S Tsiang professor of Chinese Studies, the University of Missouri-St. Louis. We would like to thank Daniel Cheung for useful comments.

Copyright Credit Research Foundation Third Quarter 1998
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