Information about Asia and the Pacific Asia y el Pacífico
Chapter

II Vulnerabilities

Author(s):
Leslie Teo, Charles Enoch, Carl-Johan Lindgren, Tomás Baliño, Anne Gulde, and Marc Quintyn
Published Date:
January 2000
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Information about Asia and the Pacific Asia y el Pacífico
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The Asian financial crisis involved several mutually reinforcing events, starting with the devaluation of the Thai baht in July 1997, and followed by devaluations of other currencies, the attack on the Hong Kong dollar in October 1997, a rapid withdrawal of foreign private capital, bank runs, sovereign downgrades, and a dramatic decline in real economic activity.3 A combination of financial system and corporate sector vulnerabilities and weaknesses contributed to the crises and magnified the negative impact of exchange rate devaluations and foreign capital withdrawals on financial institutions. This section highlights some of these vulnerabilities, which were present in all the crisis countries, albeit differing in specific aspects.

Macroeconomic and Financial Weaknesses

A key vulnerability arose from the large capital inflows—especially those deriving from foreign borrowing. These inflows were equivalent to 3.5 percent of GDP annually in Indonesia, 2.5 percent in Korea, and 10 percent in Thailand during 1990–96 (Figure 1). They were encouraged by high economic growth, low inflation, and relatively healthy fiscal performance (Tables 1 and 2, and Figure 2), financial sector and capital account liberalization, integration into global capital markets, formal or informal exchange rate pegs (Figure 3), and various incentives created by the government.4 Capital flows also reflected conditions in the global financial system, including low interest rates and weaknesses in risk management by lenders in industrialized countries. The bulk of these inflows reflected direct borrowing by banks (Korea and Thailand) and corporations (Indonesia): this was especially evident in Thailand right before the crisis.5 In contrast, in Malaysia, inflows of foreign direct investment were larger than direct borrowing and portfolio inflows, while capital inflows in the Philippines (particularly portfolio inflows) had only recently become significant.

Figure 1.Balance on Capital and Financial Account/GDP

(In percent)

Source: IMF, World Economic Outlook.

Table 1.Selected Economic Indicators(In percent or ratios)
19901991199219931994199519961997199819991
Indonesia
Real GDP growth9.08.97.27.37.58.28.04.6−13.6−3.9
Inflation7.89.47.59.78.59.47.96.660.725.4
Current account balance/GDP−2.8−3.4−2.2−1.5−1.7−3.3−3.2−3.0−0.12.8
Central government balance/GDP1.340.04−1.15−0.710.010.771.16−0.67−4.46−6.48
Broad money growth29.724.622.621.121.826.727.027.461.715.6
Private sector credit/GDP46.145.845.548.951.953.555.461.051.6
Korea
Real GDP growth9.59.15.15.88.68.97.15.5−5.52.0
Inflation8.69.36.24.86.34.54.94.47.51.8
Current account balance/GDP−0.8−2.8−1.30.3−1.0−1.9−4.7−1.813.17.1
Central government balance/GDP−0.67−1.62−0.490.640.320.350.280.28−3.78−5.12
Broad money growth17.221.914.916.618.715.615.814.125.2
Private sector credit/GDP52.552.853.354.256.857.061.869.873.6
Malaysia
Real GDP growth9.68.67.88.39.39.48.67.7−7.5−1.6
Inflation2.82.64.73.53.73.43.52.75.33.8
Current account balance/GDP−2.1−8.8−3.8−4.8−7.8−10.0−4.9−5.112.38.7
Central government balance/GDP−3.08−2.480.130.521.451.301.072.58−1.91−6.05
Broad money growth18.224.418.123.815.818.223.79.61.36.1
Private sector credit/GDP71.475.374.374.174.684.889.8100.4108.7
Philippines
Real GDP growth3.0−0.60.32.14.44.75.85.2−0.52.3
Inflation14.118.79.07.69.18.18.46.09.78.5
Current account balance/GNP−5.8−1.9−1.6−5.5−4.6−4.3−4.4−5.11.82.1
Central government balance/GNP−3.80−2.40−1.30−1.60−1.70−1.30−0.60−0.70−2.60−2.70
Broad money growth15.515.511.024.626.525.315.820.97.415.0
Private sector credit/GNP20.518.921.527.230.038.250.057.650.546.9
Thailand
Real GDP growth11.68.18.28.58.68.85.5−0.4−8.01.0
Inflation6.05.74.13.45.15.85.95.68.10.5
Current account balance/GDP−8.3−7.5−5.5−5.0−5.4−7.9−7.9−1.912.28.8
Central government balance/GDP4.604.142.531.981.982.491.04−1.62−2.88−3.84
Broad money growth26.719.815.618.412.917.012.616.49.54.7
Private sector credit’GDP64.567.772.279.890.997.5100.0116.3109.5
Sources: IMF, International Financial Statistics; World Economic Outlook; and national authorities.

1999 IMF estimates.

Sources: IMF, International Financial Statistics; World Economic Outlook; and national authorities.

1999 IMF estimates.

Table 2.Selected Indicators of Vulnerability(Period ended December 1996)
IndonesiaKoreaMalaysiaPhilippinesThailand
Macro indicators
Inflation >5%
Fiscal deficit >2% of GDP
Public debt >50% of GDP
Current account deficit >5% of GDP
Short-term flows >50% current account deficit1
Capital inflows >5% of GDP
Ratio of short-term debt to international reserves >1 2
Financial sector indicators
Recent financial sector liberalization
Recent capital account liberalization
Credit to the private sector >100% of GDP
Credit to the private sector, real growth >20%
Emphasis on collateral when making loans
Estimated share of bank lending to the real estate sector >20%3
Stock of nonperforming loans >10% of total loans
Stock market capitalization (as percent of GDP)40303109856
Source: IMF, International Financial Statistics; World Economic Outlook; World Bank and IFC.Note: The cutoff points are based on the relevant literature that attempts to predict currency and banking crises (Kaminsky, Lizondo, and Reinhart, 1997, for currency crisis; and Hardy and Pazarbaşjoğlu, 1998, for banking crisis).

Defined as the sum of net portfolio and other investments in the financial accounts.

As of June 1997.

At the end of 1997, Includes indirect exposure through collateral

Source: IMF, International Financial Statistics; World Economic Outlook; World Bank and IFC.Note: The cutoff points are based on the relevant literature that attempts to predict currency and banking crises (Kaminsky, Lizondo, and Reinhart, 1997, for currency crisis; and Hardy and Pazarbaşjoğlu, 1998, for banking crisis).

Defined as the sum of net portfolio and other investments in the financial accounts.

As of June 1997.

At the end of 1997, Includes indirect exposure through collateral

Figure 2.Real GDP Growth

(In percent)

Source: IMF, World Economic Outlook.

Note: Data for 1999 are IMF staff estimates.

Figure 3.Real Effective Exchange Rate

(June 1997 = 100)

Source: IMF, International Financial Statistics.

Inflexible exchange rate regimes complicated macroeconomic management and increased vulnerability. The nominal exchange rate had depreciated in a predictable manner in Indonesia, and was closely linked to the U.S. dollar (or a basket of currencies) in Korea, Malaysia, the Philippines, and Thailand. The broadly stable exchange rate created incentives for borrowing in foreign exchange as borrowers underestimated the risks associated with foreign currency exposure.6 Lenders, meanwhile, ignored the fact that lending in foreign exchange involved substantial credit risk. Maturity mismatches in banks’ portfolios, and currency mismatches on corporations’ balance sheets aggravated the problem. A long history of stable exchange rates also undermined incentives to introduce adequate prudential rules on, and monitoring of, foreign currency exposures. The three crisis countries were especially vulnerable to capital outflows and exchange rate devaluations because of the significant amount of short-term foreign currency debt, which was mostly unhedged. Furthermore, the growth of this debt outpaced growth in usable foreign exchange reserves during most of the 1990s, making these countries increasingly susceptible to a deterioration in market sentiment and large capital outflows.7 In addition, material adverse change clauses in debt contracts shortened the effective maturity of long-term debt, increasing vulnerability to negative events.8 Malaysia was less vulnerable because foreign currency borrowing was lower due to a requirement of official approval above a certain limit.

The capital inflows helped fuel rapid credit expansion that led to strains—asset price inflation and excessive risk taking—which increased the vulnerability of the financial systems. In Korea, Malaysia, and Thailand private sector credit in nominal terms expanded rapidly during the 1990s, at an average rate of 15 to 20 percent compared to inflation rates of 3 to 10 percent (Figure 4). Total commercial bank and near-bank assets grew from between 50 and 100 percent of GDP in 1992 to between 150 and 200 percent of GDP at the end of 1996 (Box 3). As a comparison, deposit money banks held assets equal to 30 percent of GDP in Mexico, 48 percent in Brazil, 80 percent in the United States, 136 percent in the European Union, and 300 percent in Japan.9 The Asian economies were in a self-reinforcing cycle—growth in credit reinforced the investment booms, which in turn encouraged further capital inflows and lending. This growth also led to asset price inflation (especially in Malaysia and Thailand), which encouraged lending to the real estate sector and inflated collateral values. Meanwhile, banks were increasingly exposed to credit and foreign exchange risks and to maturity mismatches, to the extent that foreign borrowing was short term and domestic lending long term, thus increasing the countries’ vulnerability to outflows.10 Rapid growth also strained banks’ capacity to assess risk adequately.

Figure 4.Nominal Credit Growth to the Private Sector

(In percent)

Source: IMF, International Financial Statistics.

Box 3.Structure of the Financial System at the End of 1996

Commercial banks dominated the financial system in Indonesia. Out of a total of 238 commercial banks, there were 7 state-owned banks, 27 regional government banks, 160 private banks, 34 joint-venture banks, and 10 foreign banks. In addition, there were approximately 9,200 rural banks. Nonbank financial institutions included 252 finance companies, 163 insurance companies, about 300 pension and provident funds, and 39 mutual fund companies. Total assets of the system were equivalent to about 90 percent of GDP. Commercial banks held 84 percent of total assets while rural banks held about 2 percent. The remaining assets were held by finance companies (7 percent of total assets), insurance companies (5 percent), and other nonbank financial institutions (2 percent).

Korea’s financial system was the most differentiated among these countries, with 26 commercial banks, 52 branches of foreign commercial banks, 7 specialized and development banks, 30 merchant banks, 30 investment trust companies, 33 life insurance companies, 17 nonlife insurance companies, 56 securities companies, 19 investment advisory companies, 230 mutual savings companies, 2 credit guarantee funds, and approximately 6,000 credit unions, mutual credit facilities, and community credit cooperatives. Total assets of the system were close to 300 percent of GDP. Commercial banks alone accounted for 52 percent of total assets, while specialized and development banks accounted for 17 percent.1 Merchant banks held a further 5 percent; insurance companies 7 percent; while the remaining 19 percent were held by other types of institutions.

In Malaysia, the financial system included 35 commercial banks, 39 finance companies, 12 merchant banks, 7 discount houses, 4 pension and provident funds, 62 insurance companies, 6 unit trusts, 7 development institutions, and a savings bank. Total assets of the system were equivalent to 300 percent of GDP. Commercial banks accounted for 70 percent of total assets of the banking system (comprising the commercial banks, finance companies, and merchant banks), and merchant banks and finance companies for 30 percent of total assets.

Although the financial sector in the Philippines included different types of banks and nonbanks, the sector was dominated by commercial banks. At the end of 1996, there were 49 commercial banks, 3 specialized government banks, 109 thrift banks, approximately 800 rural banks, 129 insurance companies, 12 nonbank financial institutions with quasi-banking functions, and a large number of small nonbank institutions without quasi-banking functions. The number of foreign banks that operate wholly owned branches in the Philippines is currently capped at 14. Total assets of the system were equivalent to 115 percent of GDP. Commercial banks held 82 percent of total assets, thrift banks accounted for 9 percent, rural banks 1 percent, and non-banks the remaining 8 percent.

In Thailand, the financial system included 29 commercial banks, 91 finance and securities companies, 7 specialized state-owned banks, approximately 4,000 savings and agricultural cooperatives, 15 insurance companies, 880 private provident funds, and 8 mutual fund management companies. Out of the 29 commercial banks, 14 were branches of foreign banks. In addition, 19 foreign banks were established under the offshore Bangkok International Banking Facilities, which lent to residents in foreign currency. Total assets of the system amounted to the equivalent of 190 percent of GDP. Commercial banks alone accounted for 64 percent of total assets, while finance companies accounted for 20 percent of total assets. State-owned specialized banks accounted for a further 10 percent.

In all countries, except Indonesia, banks were mostly private, with many of the larger private banks publicly listed. The degree of ownership concentration differed across countries; in Korea, a single ownership limit of 4 percent meant that banks were owned by diverse groups of individuals, while in Thailand, despite a similar rule, several of the large banks were owned or controlled by family groups. Similarly, in Indonesia, Malaysia, and the Philippines, banks were owned or controlled by corporate conglomerates.

At the same time, a significant part of the banking sector was owned by the public sector, especially in Indonesia where public sector banks accounted for over 40 percent of total assets of the financial system. In Korea and Thailand, state-owned institutions represented about 15 percent of total assets. In Malaysia one large commercial bank was government-owned.

There were also foreign banks (branches or subsidiaries) with substantial stakes (5–20 percent of total banking system assets) in the domestic financial system in all five countries, although the degree of financial openness in each country differed, with Korea, Malaysia, and Thailand being the most restrictive and the Philippines the least. In Indonesia, foreign banks were allowed to own up to 85 percent of a joint venture.

1 Assets include trust accounts, which are a significant share of commercial bank assets (about 40 percent). Trust accounts have grown rapidly and are subject to weaker regulation and fewer restrictions than regular bank accounts.

In most countries, the growing nonbank financial institutions held riskier assets and more volatile financing than commercial banks, which made them increasingly vulnerable to a decline in asset quality and to a change in investor and depositor sentiment.11 Nonbank financial institutions had grown very rapidly in recent years; they were favored by the easier licensing requirements (Thailand) and less stringent regulations, including lower capital requirements (Korea and the Philippines) than those applied to commercial banks.12 Merchant banks in Korea and finance companies in Thailand were the first institutions to face liquidity shortfalls, and many became insolvent and had to be closed.13

The corporate sector in Korea and Thailand was highly leveraged, a factor that, in combination with the pervasive nature of the corporate crisis, significantly deepened the banking crisis. Average debt to equity ratios of listed companies were around 400 percent in both countries at the end of 1996. By contrast, ratios in Indonesia, Malaysia, and the Philippines were about 150 to 200 percent.14 With the exception of Indonesia, corporate leverage had increased significantly over the 1990s.15 The high corporate leverage in Korea was largely the outcome of government policies that emphasized aggressive export-oriented growth and included measures such as directed credit, subsidized loans, and explicit or implicit credit guarantees that biased funding in favor of borrowing rather than equity placements. In Thailand, corporate borrowing reflected optimistic growth projections and a push to gain market share. At the same time, equity markets in the three crisis countries were undeveloped, since large family-controlled corporations were hesitant to raise funds through equity financing lest their control be diluted. In Malaysia, the stock market was particularly highly developed (with a capitalization of over 300 percent of GDP at the end of 1996; see Table 2), reducing the need for bank financing.

Structural Vulnerabilities

Bank lending practices in the five countries have traditionally relied on collateral rather than credit assessment and cash flow analysis, making banks especially vulnerable to excessive risk taking and declines in asset values. For example, during the years of high economic growth, credits were increasingly used to fund investments that turned out to be economically unsound. When the exchange rate devaluation and contraction in demand rapidly eroded companies’ repayment capacity (see footnote 10), banks and supervisors were suddenly faced with sharply increasing nonperforming loans, loan–loss provisioning needs, declines in collateral values, and eroding capital bases. Other inadequate lending practices including connected lending, high exposure to individual clients, and excessive sectoral concentration of loans, aggravated the problem.

In addition, ineffective market discipline allowed excessive risk taking. Inadequate accounting and disclosure practices (see Box 4) and implicit government guarantees weakened market discipline. A tradition of forbearance and “lifeboat” schemes for nonviable institutions instead of firmer corrective action or government intervention encouraged excessive risk taking, increased moral hazard, and prevented market agents from exerting discipline. As a result, risk premiums, credit ratings, and analyst reports, including reports of international financial institutions, indicate that market participants did not identify the weaknesses and did not predict crisis.

Box 4.Weaknesses in Disclosure Practices in the Asian Crisis Countries

The following shortcomings in accounting and disclosure practices undercut market discipline and fueled the crisis.

  • High corporate leverage was hidden by related-party transactions and off-balance sheet financing.
  • High-level foreign exchange risk exposure by corporations and banks resulting from large, short-term borrowing in foreign currency was not evident.
  • Disclosure of loan classification, loan-loss provisioning, and accrual of interest was weak. Although most banks disclosed the accounting policy for loan-loss provisioning, they did not disclose in the balance sheet the aggregate amount of loans and advances for which they had stopped accruing interest.
  • In Korea, the practice of cross-guarantees made it hard to assess the solvency of the largest borrowers.
  • Consolidation of accounts was generally absent.
  • Detailed information on sectoral concentration was largely absent, even though all countries had large exposure limits in place.
  • Disclosure regarding derivative financial instruments was weak.
  • Contingent liabilities of the parent of a conglomerate, or of financial institutions, for guaranteeing loans (particularly foreign currency loans) were generally not reported.

In the crisis countries, prudential regulation and supervision had serious deficiencies. These deficiencies included lax prudential rules, or application of rules, particularly on connected lending, loan concentration, cross guarantees, and foreign currency mismatches. A significant problem was the lack of strict loan classification criteria and weak rules on loan provisioning and interest suspension. In addition, financial sector regulators and supervisors lacked autonomy, making them susceptible to political and industry pressure. Supervisors frequently waived prescribed limits, a significant problem in Korea and Thailand.16 The prudential framework also failed to keep up with the developments in the system. For example, in some countries prudential rules on foreign currency exposures failed to limit excessive foreign open positions or maturity mismatches. More broadly, building up supervisory capacity was not a priority during the boom years.

Weaknesses in supervision were compounded by the close links between governments and financial institutions. The government’s interference in credit allocation in Indonesia and Korea (through directed credits) circumvented the need for thorough risk assessment by the banks, made the governments co-responsible for the quality of banks’ assets, and provided an implicit government guarantee on banks’ liabilities. Furthermore, given the governments’ historic role of promoting investment through policy loans and guarantees to corporations, supervisors were constrained in their ability to penalize banks for making bad loans.

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