Information about Asia and the Pacific Asia y el Pacífico
Chapter

VII Corporate Performance and Reform

Author(s):
Yougesh Khatri, Il Lee, O. Liu, Kanitta Meesook, and Natalia Tamirisa
Published Date:
August 2001
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Corporate sector vulnerabilities and governance issues are increasingly seen to have played key roles in the Asian crisis. Recent economic literature has gone so far as to place these at the center of the crisis. While the debate as to the main causes of the crisis will no doubt continue, it is clearly important to be able to identify the main corporate sector vulnerabitities and to ensure that sufficient reforms are undertaken in order to avoid future crises stemming from the corporate sector and to ensure that this sector can withstand financial crises, whatever the cause.

This section provides a brief overview of the corporate sector in Malaysia; discusses possible links between the corporate sector and the recent crisis; examines corporate performance before, during, and after the crisis; and assesses progress with corporate reform. Various indicators provide evidence of a deterioration in corporate performance before the crisis, a significant negative impact on the sector with the onset of the crisis, and strong signs of recovery in 1999. There is clear evidence of progress with reforms, although this progress has been somewhat uneven; debt restructuring has proceeded well under the Corporate Debt Restructuring Committee and Danaharta; some operational restructuring has taken place through the resolution by Danaharta of its nonperforming loans portfolio; and there have been concerted efforts made to adopt the proposals of the Finance Committee’s Report on Corporate Governance. These reforms with take time to complete and become effective, but momentum should not be lost in the face of either an improving or deteriorating environment.

Key Features of the Corporate Sector1

The Malaysian corporate sector is large and for most of the last decade has been characterized by rapid growth, mainly driven by increasing stock prices and a high level of new equity issues and privatizations (relative to the region). The Malaysian corporate sector is highly concentrated both in terms of ownership and control. The “insider” system of corporate governance applies and, together with an overreliance on bank financing, the sector has some innate vulnerabilities.

Capital Market Structure

The Malaysian capital market and underlying corporate sector are large by any standard. The total capitalization of the Kuala Lumpur stock exchange, including financial and nonfinancial corporations on the main and second boards, amounted to RM 424 billion ($112 billion) or 125 percent of GDP at end-2000. At its peak in 1993, market capitalization reached 360 percent of GDP. The International Finance Corporation’s Emerging Stock Markets factbook 1999, ranked Malaysia’s market capitalization at end-1998 as the twenty-third largest in the world; its total value traded was twenty-ninth highest in the world; and, by number of listed companies, Malaysia ranked fifteenth in the world.

The corporate sector was characterized by rapid growth throughout the 1990s. The number of listed companies in Malaysia increased to 795 from 285 in 1990 by the end of the decade (Figure 7.1). The number of listed companies grew on average by 11.6 percent a year throughout the 1990s, and by 14 percent for the period 1990–96. Compared to the other crisis countries, this was relatively rapid; Indonesia averaged a 10 percent annual growth in the number of listed companies throughout the decade, but that was from a much lower base (122 in 1990); Korea averaged only 1 percent annual growth, but from a much higher base (669 listed companies in 1990);2 Thailand averaged over 7 percent annually for the decade, but 13.6 percent in the 1990–96 period. Market capitalization in Malaysia grew by an average rate of over 40 percent in the 1990–96 period and by an average of nearly 30 percent for the decade. This was not unusual for the region; Indonesia and the Philippines had more rapid growth rates but from a much lower base.

Figure 7.1.Selected Asian Countries: Capital Market Overview

Sources: IMF, World Economic Outlook; Asia and Pacific Department core database, and CEIC Data Company Limited.

The growth in market capitalization in Malaysia was driven mainly by increases in stock prices, but also by new equity issues and privatization. Stock prices increased by a factor of over 2.4 between 1990 and 1996, and by a factor of 5 for the Philippines, compared to between 1 and 1.5 for the other crisis countries. In the precrisis period, only Korea raised more funds through the equity market in absolute terms than Malaysia. Malaysia was at the forefront of Asian privatization, and Malaysian privatizations, which accounted for a large portion of total new equity raised in the country, also constituted around one-third of total revenue from privatization in the region (Harvey and Roper, 1999).3

While the amount of new equity raised was large by regional comparison, Malaysia was still highly dependent on bank financing. New financial flows to corporations in the period prior to the crisis (1995–97) were mainly from the domestic banking system, representing nearly 60 percent of net funds compared to around 15 percent from equity. 11 percent from domestic debt markets, and 16 percent raised through external borrowing (World Bank, 1999a). The authorities, however, are attempting to develop the domestic bond market and are encouraging corporations to diversity their sources of funding.

Box 7.1.The Insider and Outsider Systems of Corporate Governance

Corporate governance relates to ways in which investors and owners (principals) oversee managers who run the firms (agents). There are essentially two main systems of corporate governance, referred to as the insider and outsider systems.

The outsider system refers to the Anglo-American system where typically ownership of firms is widely dispersed and control is delegated to professional managers; the number of listed companies is large; the process of acquiring control is market oriented (i.e., there is a liquid capital market with frequently traded ownership and control rights); there are few interlocked patterns of ownership; and there are few major controlling shareholders, which are rarely associated with the corporate sector itself.

The insider system is characterized by the Following features; there is a high concentration of ownership; the corporate sector has controlling interests in itself; the number of listed companies is relatively small; the capital market is it liquid because controlling blocks are held by a few major shareholders, and these are held rather than traded; there are a large number of holding or interlocked companies acting to deter outsiders from acquiring control; and major shareholders typically also play an active role in management and have the decisive vote in major decisions.

To illustrate the contrast between the outsider (mainly the United Kingdom and the United States) and insider systems (most other countries, including continental Europe and Asia), Crama and others (1999) find that the largest owner in the median U.K. listed company in 1998 had a stake of less than 15 percent, and less than 5 percent in the median U.S. listed company; compared with over 80 percent of listed non-financial companies in continental Europe that had shareholders with a blocking minority (at least 25 percent) and where around half the companies had one shareholder with an absolute majority. La Porta, Lopez-de-Silanes, and Shleifer (1998) find the average share of common stock owned by the largest three shareholders in the largest companies to be 54 percent in Malaysia, 46 percent in Thailand, 20 percent in Korea, and 18 percent in Japan, compared to less than 15 percent in the United Kingdom and the United States.

Both systems have relative strengths and weaknesses that are typically analyzed in a principal-agent framework. Some of the main issues are summarized below (mainly from Crama and others, 1999).

Ownership and Voting Power: Structures and Consequences
A: Dispersed ownership and dispersed voting power (United Kingdom, United States)B: Dispersed ownership and concentrated voting power (Countries where a stake holder con collect proxy votes and shareholder coalitions are allowed)
Advantages: Portfolio diversification and liquidity; takeover possibilityAdvantages: Portfolio diversification and liquidity; monitoring of management
Disodvontoges; Insufficient monitoring and free-riding problemDisadvantages: Violation of one-share-one-vote principle; reduced takeover possibility
Agency conflicts; Management vs. shareholdersAgency conflicts: Controlling block holders vs. small shareholders
C: Concentrated ownership and dispersed voting power (Any company with voting right restrictions)D: Concentrated ownership and concentrated voting power (continental Europe, Asia, and any company after a takeover)
Advantages: Protection of minority holders’ rightsAdvomoges: High monitoring incentives; more focused strategicdirection, restructuring, and long-term commitment
Disadvantages: Violation of one-share-one-vote principle; low monitoring incentives; low portfolio diversification possibilities; low liquidity; higher cost of capital: reduced takeover possibilitiesDisadvantages: Low portfolio diversification possibilities: low liquidity; reduced takeover possibilities
Agency conflicts: Management vs. shareholdersAgency conflicts; Controlling block holders vs. small shareholders
The Asian crisis economies (which fall under type D) are characterized by highly concentrated ownership and control, and thus the classic agency problem (between management and shareholders) becomes irrelevant. Another agency conflict arises, however, between insiders (major shareholders) and outsiders (small shareholders), and the main problem of corporate governance becomes how to ensure that the insiders do not exploit (expropriate) the assets of outsiders.
The Asian crisis economies (which fall under type D) are characterized by highly concentrated ownership and control, and thus the classic agency problem (between management and shareholders) becomes irrelevant. Another agency conflict arises, however, between insiders (major shareholders) and outsiders (small shareholders), and the main problem of corporate governance becomes how to ensure that the insiders do not exploit (expropriate) the assets of outsiders.

Malaysia, like the other crisis countries, is characterized by the insider system of corporate governance (Box 7.1), in which there is a high degree of ownership concentration, cross holdings, and participation of owners in management. A few large corporations account for a significant proportion of financial assets and productive capacity in the country.4 Concentration also occurs at the level of stock ownership, which, given the large capitalization, is in the hands of relatively few institutional and corporate investors. Another layer of concentration occurs in terms of control, where “pyramiding” or cross-holding of share ownership magnifies the actual control of a few individuals or entities well beyond their actual level of ownership in each company.

The Development path of the corporate sector has resulted in some innate vulnerabilities. First, the Development of the private sector under the activist industrial policies of the government has resulted in close ties between government and large corporations. Second, the cross-holding structures can create incentives for double leveraging and thus create a multiplier effect in the sensitivity of corporate wealth to changes in the equity market (Kochhar and others, 1999, Chapter IV). Third, the concentration of shareholding can lead to poor governance because a small group can exercise control over a firm and pursue the objectives of the insiders at the cost of the outsiders or small shareholders (Claessens, Djankov, and Lang, 1999; and Box 7.1). An interesting feature of corporate ownership in Malaysia was the prevalence of nominee accounts. Nominee accounts at end-1997 were the largest type of shareholders in the top five shareholders of listed companies, and about half the beneficial owners of the nominee accounts were foreigners. A recently issued set of rules by the Kuala Lumpur stock exchange requiring securities accounts to be opened in the name of the beneficial owner means that nominee accounts can be expected to be phased out soon.

Legal and Institutional Structure

The non-financial corporate sector in Malaysia is mainly governed by three acts: the Companies Act, 1965; the Securities Industry Act, 1983; and the Securities Commission Act, 1993.5 The Kuala Lumpur stock exchangers listing requirements and rules also play an important role in regulating investors, brokers, and issuers. The Companies Act deals with the pre-in-corporation, incorporation, operations, and duties of companies and their directors, as well as the rights and obligations of shareholders and directors. The Securities Industry Act and Securities Commission Act make up the legislative and regulatory frameworks of Malaysia’s capital markets, under the authority of the Ministry of Finance. The powers of the Kuala Lumpur stock exchange were recently strengthened through amendments to the Securities Industry Act, such that the exchange may now take action against directors and any person involved with its listing requirements.6

Malaysia has comprehensive laws relating to corporate governance, and the laws governing creditor rights are comparable to those of OECD countries (Table 7.1). While accounting standards are also good, enforcement and actual practice have been weaker. The Financial Reporting Act of 1997 was designed to address this issue by giving the force of law to (i.e., requiring all companies to comply with) the accounting standards approved by the national accounting body, the Malaysian Accounting Standards Board. Most of the accounting standards approved by this board are based on international accounting standards. While progress with improving standards and adopting international best practices has been notable, the accuracy of financial data needs to be improved by bringing financial disclosure requirements in line with international best practices. The broader legal and institutional environment is strong, although transparency and accountability in the public sector need more attention (World Bank, 1999b).

Table 7.1.A Comparison of Legal Protection, Accounting Standards, Institutions, and Enforcement in Various Countries
Shareholder Protection1Creditor Protection1Degree of Judicial Enforcement2Accounting Standards3
Malaysia3.047.776
Korea2.036.762
Thailand3.035.964
Latin America42.516.253
United States5.019.571
United Kingdom4.049.478
Japan3.029.465
Germany1.049.462
Source: La Porta, lopez-de-Silanes, and Shleifer (1998).

On a scale from 1 (weakest) to 5 (strongest).

On a scale from 1 (lowest) to 10 (highest).

The higher the measure, the higher the standard.

Average of Argentina, Brazit, Chite, and Mexico.

Source: La Porta, lopez-de-Silanes, and Shleifer (1998).

On a scale from 1 (weakest) to 5 (strongest).

On a scale from 1 (lowest) to 10 (highest).

The higher the measure, the higher the standard.

Average of Argentina, Brazit, Chite, and Mexico.

There are a number of alternatives for dealing with distressed corporations. The Companies Act allows creditors to petition the high courts to wind up a company if that company defaults on debt payments, and allows debtors to petition for court protection under Section 176 unitl a group of creditors (representing three-fourths of the outstanding debt) agree to a reorganization plan.7 Companies and creditors can also opt for voluntary out-of-court restructuring of the debt or. for companies with debt exceeding RM 50 million and having more than three creditors, the voluntary out-of-court restructuring can be done through the Corporate Debt Restructuring Committee.8

Corporate Sector and Financial Crises

There are two main branches of economic literature that link the corporate sector with financial crises. The main literature on crises has been at the macroeconomic level focusing on macroeconomic fundamentals or self-fulfilling crises (modeled on bank runs), and has only recently (in a model by Krugman) included explicitly the corporate sector as a central element. The other branch of the literature is more microeconomic based, looking at either firm-level data to investigate the role of the corporate sector in the crisis or focusing on the role of institutional factors and corporate governance.

Macroeconomic Approaches

Standard Models of Financial Crises

The literature on financial crises has a long history and extends well beyond the scope of this section.9 The main prevailing theories have been classified by Eichengreen as “first generation” and “second generation” models. First generation models are associated with the seminal paper by Krugman (1999) and generally explain crises as a result of a deterioration in fundamentals. The main feature of second generation models (following Obstfeld, 1986) is self-fulfilling speculative attacks, although even for these some perceived weakness in fundamentals seems to be the key trigger for the speculative attack.10” The Development of the second generation models followed the breakdown of the exchange rate mechanism in 1993 and the Mexican crisis in 1994, as aspects of these crises were hard to reconcile with the first generation models. This was mainly because the decisions to abandon pegs were not related to the exhaustion of reserves in defending the currency and, in some cases, were not easily explicable at all from the point of view of economic fundamentals.

The Asian crisis seemed to consolidate the consensus toward the second generation models as representing more recent crises. Krugman (1999) suggests, however, that for the major crises in the Asian countries, neither of these models seems to have much relevance.11” The fiscal positions, by conventional measures, were strong, and there were not really the clear trade-offs between employment and exchange rate stability (e.g., as faced by the United Kingdom in 1992), Krugman suggests the need for a “third generation” of crisis models and is skeptical about the current bank-centered candidates (Corsetti, Pesenti, and Roubini, 1998; or Chang and Velasco, 1998).12 Krugman acknowledges that these models capture some aspects of the crisis, but outlines an alternative candidate that emphasizes factors not formally included in previous models, namely, the role of companies’ balance sheets in determining their ability to invest and the role of capital flows in affecting real exchange rates.

Krugman’s Proposed Third Generation Model

Reliance on the moral hazard argument, according to Corsetti, Pesenti, and Roubini, is discounted as a key feature by Krugman, who argues that there was ample evidence of significant investment in the Asian crisis countries prior to the crisis, including in direct foreign purchases of equity and real estate, which clearly were not protected by any form of implicit guarantee. Krugman does, however, accept the existence of multiple equilibria as a necessary element in modeling the crisis, although not the mechanism implicit in the Diamond-Dybvig type approach. The Krugman model incorporates three key elements:

  • contagion:

  • the transfer problem:13 A huge change is needed in the current account as a counterpart to the reversal in capital flows, which is evidently central to the crisis yet has not been explicitly included in previous models; and balance sheet problems: Most descriptive accounts of the crisis place significant emphasis on the role of firms’ balance sheets, but this had not been featured as a central element in the crisis literature.14

The model is characterized by multiple equilibria, where a loss of confidence, for whatever reason, can lead to a self-fulfilling collapse; the mechanism differs from the Diamond-Dybvig approach in that the main mechanism is the transfer problem. Very roughly speaking, the loss of confidence leads to the transfer problem, and to achieve the required current account reversal, the country must experience a large real depreciation and/or output decline, either of which adversely affects the balance sheets of domestic firms. This validates the initial loss of confidence, i.e., moving from the high expected investment equilibrium to the low expected investment equilibrium. According to the model, the factors that make such a crisis possible (i.e., reinforce the feed-back loop between investment, real exchange rates, and balance sheets) are high leverage, low marginal propensity to import, and large foreign currency debt relative to exports.

Microeconomic and Institutional Approaches

A number of studies have used firm level data to investigate (in a comparative context) the corporate performance of the crisis countries during the 1990s, including Claessens, Djankov, and Lang (1998), Pomerleano (1998), Harvey and Roper (1999), and Claessens, Djankov, and Xu (2000). These studies provide new evidence suggesting that the causes of the Asian crisis may lie in firm-based decisions.

Claessens, Djankov, and Xu summarize the literature on the role of the corporate sector, in both performance and financing, in the Asian crisis and identify four main possible links, summarized briefly below.

First, the weak corporate performance after the crisis was related largely to the shocks experienced by the Asian countries, including declines in aggregate demand, reversal of capital flows, sharp depreciations, and increases in interest rates (Furman and Stiglitz, 1998). As yet, there is little empirical work assessing the importance of aggregate shocks to corporate performance. There is some evidence from survey data, such as the results of a survey of that industrial firms reported in Dollar and Hallward-Driemeier (2000).15 that indicates these shocks played an important but not exclusive role in the performance of these firms during the crisis.

Second, the poor performance of the corporate sectors during and after the crisis reflects previous fundamental weaknesses (Corsetti, Pesenti, and Roubini, 1998). This view implies that the performance of firms was not adequately monitored by shareholders and investors, and/or firms were not subject to sufficient competition, thus poor performers or riskier firms were not forced to fully adjust and increase their rates of return to compensate investors for higher risk. This view may also imply that profitability was overstated by firms; thus the lack of transparency, relatively weak accounting practices in the region, and weak corporate governance may have hidden the extent of the problems and delayed the onset of the crisis.16 A number of studies indicate that ownership structure may induce risky behavior. The insider system (Box 7.1) prevails in the Asian countries; the extensive links and cross-holdings of shares, particularly between corporations and banks, are likely to have disforted the market allocation of resources and resulted in excessive and nontransparent risk. These ownership links clearly played a significant role in Korea and Indonesia. Government involvement—through direct participation in bank ownership and through links with corporations and banks—is also likely to weaken the allocation of resources because a political dimension is introduced into the allocation decisions.

Third, aggregate arid financial shocks to the financial sector may result in a credit crunch, constraining lending to viable corporations with profitable investment and trading opportunities. Shocks—financial, real, or regulatory—may cause a real or perceived shortage of capital for banks and lead to their curtailing credit for investment or trade, thus impairing the performance of firms. A credit crunch may result from weak financial institutions or from a change in the regulatory and supervisory environment. Increased uncertainty regarding whether and at what price loans with be available may also result in a shortfall of loanable funds (Stiglitz and Weiss, 1981. The balance sheet problem (Bernake and Gertler, 1995) may exacerbate the effect of a shock; in the presence of asymmetric information and principal-agent relationships, the corporation’s net worth or wealth becomes an important determinant of the amount it can borrow, as assumed in the Krugman model, rather than the prospects of the project for which the borrowing is undertaken. Thus, a decline in the wealth of a firm (e.g., through depreciation that reduces the domestic value of foreign assets) can reduce the credit available even for viable new projects.

Fourth, the efficiency of debt-resolution mechanisms with determine, in part, the extent of the impact of financial and other shocks. It has long been recognized that the institutional framework is important in avoiding and resolving systemic financial crises and that exceptional mechanisms, such as Fund programs, may be required during periods of systemic crisis. This broad area of literature spans economic principles for optimal workouts to the importance of creditor rights to enforce claims and seize collateral, both in the context of domestic and external borrowing, as seen in the review by La Porta, Lopez-de-Silanes, and Shleifer (1999).

Corporate Performance

Financial ratios, which are commonly used to analyze corporate performance, have the advantage of being simple to compile and are broadly understood, but they have some major drawbacks. Simple financial ratios generally give a partial indication of performance in a particular dimension. Financial ratios can also be misleading (e.g., looking at rates of returns rather than risk-adjusted rates of return). Economic measures based on concepts of efficiency—measured relative to other Finns—or total factor productivity—measured for a firm over time—provide more comprehensive measures of performance, but require detailed production (input-output) data. Generally, only accounting data are readily available on a consistent basis between firms and over time, and thus an analysis of corporate performance has generally employed a financial ratio analysis.

Below, performance is analyzed based on financial ratios, but also on approximations to the economic measures of efficiency and productivity using accounting data. This provides evidence that performance in the Malaysian corporate sector, and in the corporate sector of the other crisis countries, deteriorated prior to the crisis, but deteriorated even more dramatically with the onset of the crisis. The evidence is consistent with a number of the possible links identified above, although no formal tests were conducted.

Financial Indicators of Corporate Performance and Risk

Performance, as measured by the net profit margin, seemed relatively healthy in Malaysia and did not appear to diminish markedly before the crisis (Table 7.2). The net profit margin compared favorably with those of the other crisis countries, and prior to the crisis was only surpassed by that of Indonesia (Table 7.3).17 Unlike the other crisis countries, the Malaysian corporate sector in aggregate was still profitable in 1997; thus, Malaysia appears to have entered the crisis later or fared better going into it. There were, however, signs of increasing corporate distress going into the crisis, as indicated by the percentage of firms not able to cover interest expenses from operational cash flows.

Table 7.2.Financial Ratios for Listed Non-financial Companies in Malaysia(In percent, unless otherwise indicated)
19951996199719981999
Profit (after tax)/Turnover (net profit margin)10.510.17.5-3.7-1.1
Return on shareholder’s funds11.010.87.64.9-2.4
Return on assets5.34.62.9-1.8-0.8
Earnings yield (equals I/Net price-earnings ratio)4.33.94.2-4.4-1.6
Net dividend yield1.51.11.52.11.8
Current ratio (equals current assets/current liabilities)1.21.11.11.01.0
Total debt-to-equity ratio0.50.70.91.01.1
Number of companies included in calculating these ratios473541627664325
Source: Kuala Lumpur stock exchange data provided in April 2000
Source: Kuala Lumpur stock exchange data provided in April 2000
Table 7.3.Operational Performance of Publicly Traded Corporations and Share of Distressed Corporations in Selected Asian Countries(In percent)
19951996199719981999

(First half)
Net profit margin
Indonesia12.413.9-3.6-13.3-8.9
Korea2.70.4-0.3-2.62.7
Malaysia12.212.06.9-2.81.3
Thailand7.15.1-3.62.24.8
Firms unable to cover interest expenses from operational cash flows
Indonesia12.617.940.358.263.8
Korea6.511.224.333.826.7
Malaysia3.45.617.134.326.3
Thailand6.710.432.630.428.3

While Malaysia appears to have fared comparably well going into the crisis, it did no better than the other countries during the crisis or the recovery period. Lack of a differentially superior post-crisis performance, given the more favorable starting conditions, may reflect either the lag with which the crisis affected Malaysia or the later pickup in domestic demand compared with the other countries (see Section II). Also, because Malaysia has a significantly larger market capitalization relative to GDP, the stock market declines during the crisis are likely to have resulted in a larger loss of wealth and an increase in leverage, thus enhancing corporate stress. An alternative explanation is suggested below (see Corporate Performance and Links to the Crisis).

An alternative measure of corporate performance is the return on assets, which has the advantage of not being affected by the liability structure of a firm. While providing a measure of return on capital,18 The return on assets in Malaysia tell a similar story to net profit margins, although there is a more obvious decline in the return on assets just prior to the crisis (Table 7.2). Claessens, Djankov, and Xu (2000) compare real return on assets, which they define as return on assets less the inflation rate, in a sample of Asian countries and the United States and Germany. The findings reveal that the average real return on assets for the precrisis period of 1988–96 in Thailand, the Philippines, and Indonesia were the highest among the sample of 36 countries (that report to World-scope) at 9.8 percent, 7.9 percent, and 7.1 percent, respectively. Malaysia’s average for the same period was not far behind at 6.3 percent—ranking eighth in the sample of 36—and greater than that of either the United Stales (5.3 percent) or Germany (4.7 percent). Korea had one of the lowest real return on assets for the period in the sample at 3.7 percent. Indonesia, Thailand, and Korea had declining trends in real return on assets between 1990 and 1996, with Korea measured from an already low base, While Malaysia had an increasing trend between 1988 and 1993, but a declining one there after through 1996. Thus, return on assets—measured in real terms and over a longer period—seems to indicate declining corporate performance in the precrisis period.

A number of risk indicators worsened prior to the crisis, Measures such as the proportion of distressed corporates (Table 7.3), leverage (Table 7.4), and the maturity structure of debt clearly indicate that risk was increasing in the run-up to the crisis.19 Higher returns would normally be required to justify this increased risk. In effect, accounting returns, although generally high, were declining, and implicit risk-adjusted returns were declining even more rapidly.

Table 7.4.Debt/Equity Ratios in Selected Economies(In percent)
1990199119921993199419951996
Hong Kong SAR1.82.01.81.82.32.01.6
Indonesia1.92.12.11.72.11.9
Japan2.92.02.02.12.22.42.4
Korea3.13.23.43.63.53.83.5
Malaysia1.00.60.60.71.01.01.2
Philippines0.81.21.21.11.21.3
Singapore0.90.90.91.10.91.01.0
Taiwan Province of China0.70.90.90.90.80.8
Thailand2.22.01.81.92.12.22.4
Germany1.61.61.51.51.51.51.5
United States0.91.01.11.11.11.11.1

Summary statistics on the distribution of firm-level, indicators of non-financial corporate performance reported by Harvey and Roper also suggest that corporate performance in the Asian countries—but also in other emerging markets—deteriorated in the run-up to the Asian crisis. Harvey and Roper report statistics on the entire distribution of returns on equity and returns on invested capital from firm-level ratios for a number of emerging markets. They determine that the median of these indicators had early declined in Indonesia and Thailand, and less clearly so in Korea, the Philippines, and Malaysia.20” More generally, the reported medians of a series of corporate performance indicators—namely return on equity, return on invested capital, total debt to common equity, and interest payments relative to earnings before interest and tax—show a deterioration in the main Asian and Latin American emerging markets between 1992 and 1996, with the clear exception of Mexico, for which three out of four Indicators improved.

A related form of return measure is that on stock market investment, Harvey and Roper estimate the buy-and-hold returns accruing to investors between January 1990 and December 1996 for various countries and conclude that returns in the Asian crisis countries declined prior to the crisis and that risk-adjusted returns were relatively poor in Asia. Only Malaysia and the Philippines outperformed the World Morgan Stanley Capital Index over the period, while the U.S. Morgan Stanley Capital Index had both a higher return and lower volidity (or risk) than all of the Asian countries (Table 7.5). Throughout Asia, Harvey and Roper also find that returns in individual markets deteriorated well before the onset of the crisis. Although the buy-and-hold investment strategy is a naive one, after considering alternative dynamic strategies Harvey and Roper still find that Asian returns failed to outperform either U.S. or world dynamic strategies.

Table 7.5.A Comparison of Stock Market Returns and Risk in Selected Economies(During period of January 1990-December 1996)
Buy and HoldAverage Annualized Monthly ReturnAnnualized Standard Deviation
Indonesia11.103.09103.55
Korea-17.33-9.5295.47
Malaysia127.1311.8085.02
Philippines118.139.55109.07
Taiwan Province of China-42.894.26151.92
Thailand29.563.12111.48
United States184.1413.9639.76
World78.557.6046.20

A popular measure of liquidity, the current ratio (see Table 7.2) indicates that liquidity in Malaysia’s corporate sector declined slightly before and during the crisis. Negative profits during and immediately after the crisis imply that cash reserves and other liquid assets likely had declined. New borrowing for investment declined significantly with the onset of the crisis, and new investment was partly financed from retained earnings, further decreasing current assets relative to current liabilities.

Leverage in the corporate sector, measured as the ratio of total debt to equity, was rising rapidly in Malaysia in the precrisis period, but has since stabilized (Table 2.1 and Table 7.5). Harvey and Roper note that the entire distribution of leverage ratios at the firm level shifted right or worsened between 1992 and 1996. Reporting the distribution by quartiles, they find that in 1992, a quarter of the firms had leveraged 2.1 percent of the common stock, hall had reported a leverage ratio of 18.9 percent or less, and three-quarters of the firms had stated their leverage ratio was less than 50 percent. By 1996, the corresponding values for the first, second, and third quarlites had increased to 12 percent, 58 percent, and 112 percent, respectively.

Economic Measures of Corporate Performance

Efficiency and productivity are the main economic measures of performance. Technically efficient firms use the least combinations of inputs, such as labor and capital, to produce a unit of output at a given point in time and for a given environment, such as technological and institutional infrastructure. The firms using the least inputs to produce output define the production frontier, which relates output to inputs, or. equivalently. the efficient unit isoquant, the efficient input combinations that can produce one unit of output. Firms not on the production frontier (i.e, not on the unit isoquant) are said to be inefficient; the level of inefficiency can be measured by the “distance” from the frontier.21 Shifts in the production frontier—and, correspondingly the unit isoquant—can be thought of as technological change but with generally reflect changes in the exogenous environment in the broad sense of all factors exogenous to the firm. Total factor productivity conflates efficiency changes with technological change and broader changes in the exogenous environment and is thus a residual catch-all measure.

Ideally, to calculate efficiency economic measures of inputs and outputs would be used, but as these are not available accounting data are used as proxies. Crude approximations of output (using total sales or turnover), capital (using total assets), and labor and other inputs (using total expenses = turnover - earnings before interest and tax) are derived from the published balance sheets and income statements for the 29 largest nonfinancial corporates for the period 1995–99.22 Dividing the two input measures (total assets and total expenses) by output (turnover or total revenue), a scatter plot can be derived of the input combinations, of which the lower boundary formed by the points furthest south and/or west is indicative of a unit isoquant. The larger the scatter, the less the implied relative efficiency, and thus the scalier plots for the 1995–99 period (Figure 7.2) indicate a worsening of relative efficiency for these large corporations between 1995 and 1998, but it is unclear from the scatter plots whether efficiency improves or worsens in 1999.

Figure 7.2.Malaysian Corporate Sector: Total Assets and Expenditures Relative to Total Revenue

The Malmquist index23 (Malmquist, 1953; and Fare, Grosskopf, and lovell, 1994) allows us to jointly derive measures of technical efficiency (distance from the frontier) and exogenous change (i.e., shifts of the frontier that are often attributed to technological change) (Figure 7.3). The derived indices of technical efficiency and exogenous change, using the 29 firms for which 1999 data were already available, indicate that average efficiency declined during 1995–99. While exogenous factors, such as technological change, institutional and regulatory factors, and macroeconomic and international variables, deteriorated somewhat but were strongly positive contributors to total factor productivity in 1999, Figure 7.3 plots chained indexes of changes in average measured efficiency for firms and shifts in the frontier. Bearing in mind the significant reservations with respect to the data expressed earlier, there are indications that technical efficiency and, more strongly, total factor productivity, declined prior to the crisis. This provides further evidence of a deterioration of fundamentals in the corporate sector and in the environment in which corporations operated prior to the crisis. The continued decline in efficiency in 1999 is consistent with the view that the benefits from any restructuring were not likely to be manifested immediately because of transition costs and the dynamics of adjustment. The deterioration in exogenous factors—a shift of the frontier away from the origin—is consistent with the initial deterioration in factors external to the firms, such as increases in interestrates, the large real depreciation, and a decline in aggregate demand, because these with have affected costs for all firms and thus with have shifted the efficient frontier. As these external factors improved, however, it is also possible that the initial pressure to improve efficiency diminished.

Figure 7.3.Indices of Efficiency, Exogenous Change, and TFP

(1995 = 100)

The deterioration in corporate sector performance is also evident from the aggregate data on listed non-financial corporations. Aggregating total revenue, total assets, and total expenditure for the whole corporate sector in Malaysia (see Table 7.2 for the number of firms included for each year) similar indicators of performance, which combine efficiency and shift in the efficient frontier, can be plotted at an aggregate level over time (Figure 7.4). The aggregate indicators clearly demonstrate a deterioration in the corporate sector’s use of total assets (i.e., an increase in the total assets/total revenue ratio) in the run-up to the crisis. In 1997, performance in both dimensions is weaker, and in 1998 a major deterioration occurs in the dimension of expenses relative to revenue, possibly due to a significant shift in the frontier relating to the various exogenous shocks that are discussed further, below.

Figure 7.4.Malaysian Corporate Sector: Performance Indicators

Corporate Performance and Links to the Crisis

The evidence of deterioration in corporate performance in Malaysia and within the region is consistent with various aspects of the links discussed above. What emerges from the returns measures, particularly when adjusted for risk, and from the economic performance Indicators is that performance in the Malaysian corporate sector did indeed deteriorate before the crisis, and there is thus support for the fundamentals-based theories. The evidence, however, is also consistent with Krugman’s model if the deterioration in precrisis corporate performance is considered insufficient to have warranted the externt of the crisis. Contagion, together with the deterioration in fundamentals, could have acted as the trigger by causing the change in sentiment that resulted in a shift from high to low equilibrium and ultimately in the full-blown crisis. This view provides another possible explanation as to by Malaysia went into the crisis in a stronger position and yet, with the onset of the crisis, its performance was similar to the other crisis countries.

Relating to the first link discussed above, associating corporate performance to stocks, there is ample evidence from the accounting and economic measures of corporate performance in Malaysia of a significant deterioration in performance with the onset of the crisis. Measures of net profit margins, return on assets, the number of distressed firms, and firm-level and aggregate efficient measures all deteriorated in 1997 and significantly more so in 1998. The survey evidence in Dollar and Hallward-Driemeier (2000) identifies aggregate shocks as a major, but not the sole cause of the deterioration in performance of manufacturing firms in Thailand. The measure of a shift in the efficient frontier from the Malmquist index provides another indicator of the impact of exogenous factors in explaining a deterioration in corporate performance.

Although not immediately evident from the accounts-based financial ratios, there is evidence of a decline in corporate performance in Malaysia and the other Asian countries before the crisis and thus the second potential link.24 The accounting measures are only partial indicators and do not adjust for risk. The evidence indicates that stock market returns in the Asian countries adjusted for risk (volatility) were well below those in other equity markets in the 1990s (Harvey and Roper, 1999); that returns in the Asian stock markets declined well before the onset of the crisis (Harvey and Roper); and that returns on assets were declining in all the crisis countries in the run-up to the crisis, and even more rapidly if adjusted for the increasing risk associated with higher leverage, increasing external debt, and an increasing share of short-term debt. Scatter plots and Malmquist indices show some deterioration in efficiency of the largest Malaysian corporation before the crisis. Thus there is some evidence that appropriate market discipline on firms was missing, but there does not appear to be a problem with misreporting of profitability, and accounting standards appear to be stronger than in other countries in the region. Other factors, such as the ownership structure and government involvement, clearly could also be contributory factors to the increased risk in the corporate sector that did not result in a correspondingly higher required return.

Performance indicators say little about whether or not there has been a credit crunch nor do they indicate whether the real effects of the financial and other shocks were related to the efficiency of debt-resolution mechanisms, the third and fourth possible links. It appears that slow growth in the private sector credit is due to a lack of demand for funds rather than a lack of supply, which is consistent with the overinvestment story (see also Section VI), Ghosh and Ghosh (1999) find that, for Korea and Thailand, the binding constraint was slowing demand rather than an inadequate supply of funds.

With respect to debt resolution, the mechanisms available were inadequate at the onset of the crisis, but Malaysia took decisive and effective steps to deal with the emerging problems by creating institutions to deal with nonperforming loans and debt restructuring, as discussed in Section VI and below. Overall, the country has fairly strong legal and institutional frameworks and laws relating to corporate governance, and those governing creditor and shareholder protection are comparable to those of OECD countries (La Porta, Lopez-de-Silanes, and Shleifer, 1998; Table 7.1).

Malaysia is characterized by a high prevalence of collateral-based bank lending, and thus the rapid asset and equity price inflation is likely to have contributed to an increase in bank lending. The roles of contagion, leverage (corporate balance sheets), and the transfer problem are clear in Malaysia, and all of these are central to the Krugman model. The asset price collapse, with the reversal of capital flows and its impact on net wealth, however, was probably a more important factor than the currency depreciation in the feedback loop that resulted in the crisis, but such a collapse is not an explicit part of the Krugman model.25

Progress with Corporate Reforms

Corporate reforms can be classified as relating to debt restructuring, operational restructuring, and improvements in corporate governance. The progress achieved by Malaysia with debt restructuring has been significant, and the proactive approach adopted by the authorities seems to have paid off. The extent of progress with operational restructuring is less clear, and the adoption of measures to improve corporate governance with need to be applied evenly before their benefits become apparent.

Debt Restructuring

Debt restructuring in Malaysia has taken a number of forms. The Corporate Debt Restructuring Committee provides a platform—based on London rules—to achieve out-of-court corporate debt restructuring (see Section VI). Restructuring is also occurring on an out-of-court basis and outside of the formal Corporate Debt Restructuring Committee or Danaharta framework. As of end-March 2000, more than 192 companies had filed for court protection under Section 176 of the Companies Act. Of these, 18 percent of the applications relate to the first quarter of 2000; thus the rate of applications does not appear to be slowing. Firms in the sectors described as finance, insurance, property, or trading have dominated, representing nearly 40 percent of annual, as well as total, applications. Over 1,000 petitions to liquidate companies have been submitted, and there has also been an increase in mergers and acquisitions.26

Of The Asian crisis countries, Korea and Malaysia have made the most progress in restructuring debt, achieved mainly out of court. By August 1999, the two countries had completed restructuring of about one-third of the debt registered under their respective programs.

Operational Restructuring

Operational restructuring of Malaysian corporations has proceeded partly through the resolution by Danaharta of its acquired nonperforming loans accomplished by rehabilitation of businesses and liquidation and foreclosure of collateral, and through the elimination of non-core businesses as part of debt-restructuring agreements coordinated by the Corporation Debt Restructuring Committee. By end-2000, Danaharta had appointed special administrators to oversee the management of more than 80 companies under its control to assist in their stabitization and restructuring.

Another important aspect of operational restructuring in the crisis countries has been reductions in labor, which have been the main source of improvement in operational cash flows (Claessens, Djankov, and Klingebiel, 1999). Average labor shedding in publicly listed companies resulted in a 34 percent decrease in payrolls in mid-1999 compared to mid-1997 for Korea, a 12 percent decrease for Thailand, but only a 7 percent decrease for Malaysia. The use of foreign workers in the latter meant that, although there was evidence of labor boarding (Bank Negara Malaysia, 1999), the flexibility to dismiss foreign workers helped to cushion the domestic labor force from the full impact of the crisis.

Corporate Governance

Significant progress has been made in implementing the recommendations of the Finance Committee’s Report on Corporate Governance. The report was made public in March 1999, and the Finance Committee established an Implementation Project Team, consisting of the Ministry of Finance, the Securities Commission, the Registry of Companies, the Kuala Lumpur stock exchange, the Federation of Public Limited Companies, Bank Negara Malaysia, and Malaysian Exchange of Securities Dealing and Automated Quotation. Implementation of the recommendations is taking the form of updating of laws, regulations, and rules in line with international best practices; amendments to the listing requirements of the Kuala Lumpur stock exchange; and Development of accreditation programs for existing directors of listed companies. Malaysia also led the Asia-Pacific Economic Cooperation (APEC) finance ministers’ initiative on corporate governance; in May 1999, a report was submitted to the APEC finance ministers entitled “Strengthening Corporate Governance in the APEC Region.” Most recently, a monitoring body on corporate governance was set up, the Minority Shareholders Watchdog Group, to monitor corporations, provide advice on best practices, and eventually to offer other services like proxy voting. While there has been a concerted effort to improve the corporate governance environment, a few high-profile cases of poor governance relating to companies with political links have undermined market sentiment. Thus it with be important to apply the new code of governance evenly.

Summary and Conclusions

The analysis indicates that corporate performance in Malaysia deteriorated notably prior to the crisis and recovered somewhat in 1999, Some accounting measures of performance, such as financial ratios, indicate a relatively stable performance immediately prior to the crisis. Increasing risk—indicated by higher leverage, an increase in the proportion of distressed firms, and the lower proportion of long-term to total debt—meant, however, that risk—adjusted returns were deteriorating. Stock market returns in individual markets in the crisis countries declined as well in the run-up to the crisis. Measures of efficiency also indicate that corporate performance worsened in the precrisis period. The indicators point to some role for the decline to corporate-level fundamentals, such as performance and sustaitiability, in explaining the crisis, particularly in Korea and Thailand. More recently, the corporate sector in Malaysia has benefited from a strong economic recovery and lower interest rates, and the accounting measures of corporate performance show significant improvement in 1999, although measures of efficiency have not improved.

An assessment of corporate reforms shows that significant progress has been achieved with debt restructuring, and concerted efforts have been made toward improving corporate governance. There is, however, less evidence of operational restructuring over and above labor shedding, and efficiency measures—adjusting for changes in exogenous circumstances—suggest that the benefits of operational restructuring have not yet led to increases in firm efficiency.

While an analysis of corporate performance in Malaysia finds a number of possible links between the corporate sector and the crisis, the failure of corporate governance is an underlying theme. As in other Asian countries, the net worth of a firm—rather than the profit potential of a particular undertaking—is an important determinant of how much a firm can borrow in Malaysia. Such a mechanism is likely to lead to an inefficient allocation of funds and to the balance sheet problem, both of which may exacerbate the effects of a shock that reduces the wealth of a firm. Also, evidence indicates that corporations in Malaysia, and in the other Asian countries, were increasing leverage despite their declining profitability, referred to as the “Asia Bet” by Harvey and Roper (1999). Increasingly, corporations were tapping short-term and foreign debt markets, effectively betting that exchange rates would remain stable; they lost both bets. The close links between the corporate sector and the financial sector and the lack of a well-developed corporate bond market also led to overreliance on bank lending.

Thus, it could be argued that the system of corporate governance led to inefficient allocation of funds, created innate vulnerabilities in the corporate sector, and failed to discipline managers and contain the risks they assumed. The importance of good governance is clear, and to achieve it requires better monitoring of managers, improved information quality and availability, and transparency in corporate management. Adoption of the recommendations of the Finance Committee’s Report on Corporate Governance is proceeding well and, if fully implemented and adhered to in spirit, with significantly enhance corporate governance in Malaysia. These reforms with take time to implement and become effective, but momentum should not be lost because of improving or deteriorating corporate and general economic performance.

There is significant evidence of a deterioration in corporate sector performance, but it does not appear to be commensurate with the resulting crisis. If the decline in corporate fundamentals did not justify the extent of the crisis in Malaysia, then the role of contagion, the balance sheet problem, and the transfer problem suggest the type of crisis described by the model in Krugman (1999). The implications for avoiding such crises are similar to those suggested above. A more specific implication is the reduction in the reliance on short-term debt and external deht—both are key to the feedback mechanism—to reduce susceptibility to sudden losses of confidence, resulting in self-fulfilling crises. Once such a crisis is under way, it is clear that sufficiently large funds from a lender-of-last-resort could restore confidence and avoid a downward spiral and protracted crisis. In reality, the amounts needed are very large and their availability may create moral hazard.

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The number of firms listed on the Korean stock exchange and its overall capitalization may be misleading as the KOSDAQ (similar to the NASDAQ in the United States) has been growing rapidly, and this growth is not reflected by the stock exchange figures.

In early 1991, Malaysia released its privatization master plan, which had the objective of privatizing key industries, and proceeded with Tenaga Nasional, the national electricity company—one of the largest privatizations to date in Asia at $1.2 billion. Between 1992 and 1992 privatization revenue averaged 3 percent of annual GDP.

The International Finance Corporation produces an indicator of this type of concentration derived from the ten largest stocks in the IFC global indices for each country relative to the total International Finance Corporation Global market Capitalization for each country. At end-1998, this measure of concentration was 31.5 percent for Malaysia compared with 61.5 percent for Indonesia, 37.9 percent for Korea, 55.4 percent for the Philippines, and 45.8 percent for Thailand.

Also relevant to the Financial corporations and the broader legal and institutional environment in which corporations operate are: the Futures Industry Act of 1993, the Banking and Financial Institutions Act of 1989, and the Malaysian Code on Takeovers and Mergers of 1987, all of which were supplemented by guidelines such as those of the Kuala Lumpur stock exchange (mentioned above) and the Foreign Investment Committee.

For more details on the legal and institutional environment governing corporations, see the forthcoming publication. Malaysia: Corporate Governance Assessment by the World Bank.

In response to certain weaknesses identified in the Companies Act, key provisions of Section 176 were tightened after the onset or the crisis in an attempt to prevent misuse of the Act as a means to delay adjustment.

For a fuller discussion of the problems with enforcement of laws, autonomy of regulators, transparency in exercising existing regulation, and confusion over jurisdictional boundaries, see Kochhar and others (1999), Chapter IV.

See, for example, the survey in Berg and others (1999) and the references therein.

A crude caricature of the first generation model is one in which a budget deficit is financed by “printing money.” which results in the eventual collapse of a fixed exchange rate. In second generation models, the crisis results from a conflict between a fixed exchange rate regime and the desire to pursue a more expansionary monetary policy: investors bet that the authorities with let the peg go rather than compromise on another front, such as employment, and this bet is self-fulfilling.

Note that Krugman (1999) has a somewhat different view from that of Krugman (1998).

Two major views have emerged in the postcrisis literature. The first view (Corsetti, and Roubini, 1998) suggests that the apparent soundness of macroeconomic policy was misleading because a large hidden subsidy via implicit government guarantees to banks and corporations led to moral-hazard lending and implied a hidden government deficit. Thus the apparent soundness of the macroeconomic policy was an illusion. The second view, associated with Radelel and Sachs (1998), may be characterized by the idea that there was not a major problem with the policies pursued by the crisis countries and that investments were basically sound: at most, the countries suffered from “financial fragility” and were thus vulnerable to self-fulfilling pessimism on the part of international lenders (see models by Chang and Velasco, 1998).

The transfer problem—discussed by Keynes, among others—refers to the difficulty in transferring large quantities of capital from one country to other countries. The problem relates to the burden of making the transfer, but also to the burden associated with the resultant change in exchange rates and relative prices.

The role of firms’ balance sheets in the crisis has most often been related to the impact of massive exchange rate depreciations on the domestic value of the foreign currency-denominated debt of these firms, which had been accumulating prior to the crisis. Balance sheets were further weakened by declining sales and high interest rates. These problems in turn led to the increase in non-performing loans, but this view implies that the problem was not price a banking system problem.

The survey found that 60 percent of firms said that the substantial decline in domestic demand and higher input costs relating to the depreciation were the primary sources of difficulty. Only one-third of the firms cited access to capital as a major problem, although mine cited the cost of Capital as a problem.

Weak corporate governance and a lack of transparency are the central factors in explaining the Asian crisis according to Johnson and others (1998), But, as Furman and Stiglitz (1998) point out, countries with few problems in terms of corporate governance and transparency have still experienced crises (e.g., Sweden).

The net profit margin reported by Claessens, Djankov, and Lang (1999) in this table differs from that derived using the Kuala Lumpur stock exchange data in Table 7.2. This may be due to a different sample (Table 7.2 is limited to non-financial corporations) or different definitions. Also, the net profit margin in Table 7.2 is defined as earnings before interest and tax less tax relative to turnover.

The return on assets is nevertheless a partial measure of performance because it only takes into account returns with respect to capital and not other factors, such as labor.

The ratio of long-term debt to total debt was relatively low in the region and declined steadily in Malaysia to average less than one-third for the period 1988-96. The ratios for the same period were 34.1 percent in Indonesia, 43.7 percent in Korea, 52.2 percent in the Philippines, and 30.9 percent in Thailand. These are low compared to the average U.S. and German long-term-to-total debt ratios for the same period: 55.3 percent for Germany and 75.9 percent for the United States (Claessens, Djankov, and Xu, 2000).

For Indonesia, the median return on equity declined to 12.5 percent in 1996 from 15 percent in 1992, while for Thailand, it declined more markedly to 7.7 percent from 19.4 percent over the same period.

In addition, allocative efficiency requires that the firm not only be on the unit isoquant but also at the point where the budget line or surface determined by the relative input prices is tangential to the unit isoquant.

The Kuala Lumpur stock exchange kindly provided accounting information on the top 40 firms, of which only 29–representing around 40 percent of total market capitalization–had complete accounts through 1999. There are of course Significant problems in this analysis, not the least of which are the use of accounting variables as proxies for economic variables, the problem of comparing companies across industries, the aggregation of inputs into only two groups, and the use of only a subset of firms his analysis should thus the taken as indicative.

The Malmiquist indices of efficiency and total factor productivity reported here were estimated by Jenifer Piesse of Birkbeek College, University of London.

Of course, this can be considered consistent with the previous link to the extent that there was evidence of a deterioration in corporate performance before the crisis, but the main decline followed the onset of the crisis and the various shocks.

Kochhar and others (1999) estimate a relative wealth shock the to changes in the stock market capitalization in Malaysia during the financial crisis, of 155 percent of GDP, compared to the impact on net wealth of the exchange rate depreciation (at its peak) of only 14 percent of GDP.

The number of company liquidations increased from 681 in 1996 to 1,898 in 1997 (an increase of 179 percent) and to 4,800 in 1998 (an increase of 152 percent). Comparing liquidations between January and September 1999 of 3,778, with those between January and September 1998 of 3,438, we see a much smaller increase.

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