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Non-performing Loan Issue Crucial to Asia's Economic Resurgence

Sakura Institute of Research, Inc.
Kenichi Takayasu, Yosie Yokoe

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Summary

A year and nine months have passed since the onset of the currency crisis in July 1997. Though the currency situation and financial conditions have stabilized, the expansion of non-performing loans continues unabated in major Asian economies. This article focuses on Thailand, South Korea, Malaysia and Indonesia. The Thai, South Korean, Malaysian and Indonesian governments have made the required improvements in their institutions and legal systems and provided injections of public funds. Yet, bank credit growth rates continue to stagnate, restricting the vital flow of funds needed for economic reconstruction.

Thailand has worked to restructure its banking system under IMF supervision. In August 1998, the government announced the Financial Sector Restructuring Package. This plan aims to encourage the consolidation of financial institutions and boost bank lending through the injection of public funds. However, financial institutions have been slow to respond to these financial restructuring measures, and the non-performing loan ratios have continued to rise. In addition, due to factors that include the delayed restructuring of corporate debt and the prolonged stagnation of real economic activity, the government may be forced to formulate additional measures.

In South Korea, problems in the financial sector were already beginning to emerge before the onset of the currency crisis. South Korea has been working to rebuild its financial system under the leadership of the Financial Supervisory Commission, which was established in April 1998. There was a quick completion of the evaluation of banks' financial positions and the selection of banks capable of survival, paving the way for subsequent processes which include the acquisition of non-performing loans and injections of public funds. While South Korea has made relatively good progress toward the disposal of non-performing loans, the problem of credit contraction has not yet been overcome. Financial institutions now need to focus on efforts to help themselves, instead of depending on public funds. In addition, corporate reform must be encouraged. One source of concern is the effect of the present situation on the government's fiscal position.

Malaysia's preparations for financial reconstruction included the establishment of two agencies: Danaharta to purchase non-performing loans, and Danamodal to inject public funds. In addition, a major restructuring program has been drawn up for the finance companies. Unfortunately, these measures are not sufficient to bring about a radical resolution of the non-performing loan problem. And there is a risk that delays in the disposal of non-performing loans will increase the final cost of the disposal process.

Indonesia established the Indonesian Bank Restructuring Agency in January 1998. This agency is aggressively promoting the consolidation of banks. In addition, there are plans for injections of public funds into banks with potential for rehabilitation. However, the pace of financial reconstruction in Indonesia has been slower than in other Asian economies, and there is concern about the implications of this on the fiscal resources and political and social stability.

In all four economies examined in this article, governments have already formulated policy packages for the disposal of non-performing loans and the actual disposal process has begun. However, many issues still stand in the way of financial system reconstruction. For example, private sector financial institutions have been slow to respond to non-performing loan disposal measures, and overcoming the non-performing loan problem at the national level is likely to take some time. Moreover, governments also need to develop long-term visions for the reconstruction of their financial systems.

As seen from the perspective of restructuring of financial systems, it is possible to identify a number of features in Japan's support for Asian economies. For example, features of the New Miyazawa Initiative include the large scale of the plan, which is valued at US$30 billion; the inclusion of systems to guarantee the credit of Asian governments; and recognition that restructuring of corporate debt is a vital prerequisite for the disposal of non-performing loans.

Judging from the financial situation, a considerable period of time is needed for financial institutions to set definite timetables for the complete disposal of non-performing loans and restoration of their financial intermediation functions, and for the Asian economies to return to a growth track. Unless the credibility of financial institutions is restored, there will be no improvement in financial intermediation capabilities and financial measures will not be fully effective despite efforts to facilitate the disposal of non-performing loans through changes in economic systems.

Foreword

With the arrival of the new millennium just months away, the Asian economies are struggling to overcome the effects of the currency crisis and claw their way back to growth. However, the funds needed for economic reconstruction cannot be supplied efficiently in the present environment, and urgent steps are needed to rebuild financial systems and encourage inflows of foreign funds.

In this article, we will examine the position with non-performing loans for Thailand, South Korea, Malaysia and Indonesia from this perspective, and analyze their government measures and the response of private sector financial institutions. We will also discuss the role of Japanese support for Asia with reference to the financial sector.

I. Deepening Non-preforming Loan Crisis

1. Stagnant Bank Lending

A year and nine months have elapsed since the onset of the currency crisis in July 1997. Evidence of improving financial conditions in the economies hit by the crisis began to emerge from around mid-1998, including the stabilization of exchange rates, falling interest rates, and an improvement in stock prices. The external credibility of Asian countries has also started to improve. This is apparent in a higher credit rating for South Korea and the reduction of the yield gap between Asian sovereign bonds and U.S. government bonds.

Yet, the Asian economies continue to stagnate. In order to stimulate economic performance, it will be necessary first to ensure that bank credit is efficiently supplied. The growth rate for bank lending has fallen in all four economies studied in this article (Fig. 1). In Thailand, Malaysia and South Korea, lending has fallen below the level for the previous year.

2. Non-preforming Loan Explosion

It is not unusual for currency and financial (banking system) crises to strike a developing economy at the same time.(1) What is unusual about the latest crisis is the fact that, in many Asian economies, the non-performing loan problems of the banking sector have continued to expand even after the restoration of currency stability (Table 1).

Before the onset of the currency crisis in mid-1997, Thailand and Malaysia had introduced measures to limit lending on real estate. However, the non-performing loan problems in their banking sectors were not especially serious. Indonesia's non-performing loan ratio (non-performing loans/ total loan balance), though the highest among the economies surveyed, was still only 10%, and the ratios for the other seven economies were all in single figures. (China did not publish data for 1997.)

Non-performing loan levels have risen sharply, however, since the second half of 1997. Government statistics now show non-performing loan ratios of 50.1% for Thailand (end of January 1999), 25% for Indonesia (April 1998), 14.6% for Malaysia (December 1998), and 7.4% for South Korea (December 1998).

The gravity of the situation is apparent enough from figures published by governments, but analyses by private sector financial institutions paint an even worse picture. In January 1999, the American securities company Goldman Sachs released figures indicating that non-performing loan ratios for all economies except Hong Kong would reach double-digit peaks, which are significantly higher than recent government forecasts; they are as high as 60% for Indonesia, 26% for South Korea, and 19% for the Philippines. In the case of Thailand, the actual non-performing loan ratio was already above the level projected in January 1999.

Moreover, non-performing loan ratios are still rising in all major Asian economies.(2) Hong Kong and Singapore are both affected not only by domestic factors, but also by the high levels of outstanding loans to neighboring countries. The collapse of the Guangdong International Trust and Investment Corporation (GITIC) of China has hurt Hong Kong banks, while Indonesia's problems have impacted on banks in Singapore. Problems with non-performing loans have become a major focus of concern even in the Philippines, where the real estate market did not become especially overheated, and in China, which has been able to avoid a devaluation of its currency. The stability of the banking system has also become a policy priority in Taiwan, which appears to have been affected relatively little by the currency crisis.

The disposal of non-performing loans will require huge sums of money. The cost is defined as the sum of the shortfalls in the equity and bad debt reserves of the financial institutions relative to the expected loan losses, and the amounts of new money needed to meet capital ratio requirements. Current estimates are US$192.1 billion (20% of nominal GDP) for China, US$23.5 billion (28% of nominal GDP) for Indonesia, and US$19.5 billion (18% of nominal GDP) for Thailand.

Thus far, we have studied the situation of non-performing loans in Asia. The following discussion focuses on Thailand, South Korea and Indonesia, which have accepted financial support from the IMF, and on Malaysia, which has followed its own strategy.

Yet, it is only in Malaysia where lending to the real estate sector (including the construction industry) is clearly high as a percentage of total outstanding bank lending (35.3%). The ratios for Thailand (13.7%) and South Korea (8.7%) are not especially high. (There are no published data for Indonesia.) What is significant is the extent to which loans to sectors other than real estate have turned bad under the recessionary conditions that have existed since the start of the currency crisis. In Thailand, the non-performing loan ratio reached 50.1% (as of the end of January 1999).

The growing gravity of the problem with non-performing loans can be attributed to over-lending by private sector banks before the start of the currency crisis (Table 2). This phenomenon, which occurred in many Asian economies, is apparent first of all from increases in the ratio of bank lending to nominal GDP. By the second quarter of 1997, immediately before the onset of the currency crisis, the ratios for Thailand and Malaysia had reached the incredibly high levels of 142.9% and 138.5%, respectively. A second indicator of over-lending is a rise in the loan-deposit ratios (loans/ deposits) of banks. In many economies, banks were lending more than they could raise through deposits. When the currency crisis occurred, the ratios were 121.2% in Thailand, 108.5% in Indonesia, and 103.1% in South Korea. Even Malaysia's ratio was close to 100%, at 96.1%.

One reason why most Asian banks now have enormous amount of non-performing loans is their inability to disperse risk because they have limited scope for portfolio management. In developing countries, banks are often unable to obtain adequate information about their borrowers, while the number of companies in promising industrial sectors tends to be limited. These factors are reflected in a tendency for bank lending to be concentrated into a limited range of industries or companies. In the 1990s, another three factors emerged in the Asian economies. First, increased financial interaction with other countries brought massive inflows of foreign money. Despite this, banks apparently chose to increase their lending to existing borrowers instead of finding new borrowers.

Second, financial internationalization enabled borrowers with good credit ratings to raise funds cheaply overseas or through offshore markets. Having lost this business to foreign financial institutions, domestic financial institutions seem to have been forced to turn their attention to borrowers with lower credit ratings. Third, the "crowding-in" effect in economies with positive fiscal balances, such as Thailand, forced banks to increase their lending to private sector borrowers.

II. Thailand: Rebuilding of Banking System a Long process

1. Slow progress on Banking System Reform

Thailand was hit by both the currency crisis and a financial crisis simultaneously. In 1999, 18 months after the onset of the currency crisis, the non-performing loan ratio still continues to rise. During the 1990s, the rapid liberalization of Thailand's financial markets and the adoption of an open-door policy produced a range of problems, including an expanding real estate bubble, excessive capital investment in the manufacturing sector, and a non-performing loan burden for financial institutions. With the collapse of the system that pegged Thailand's currency against the U.S. dollar in July 1997, these problems suddenly came to the fore. Asset prices continued to fall, and economic performance deteriorated rapidly. The loan portfolios of financial institutions deteriorated quickly in this environment, leading to a serious decline in their financial intermediation capabilities.(3)

An analysis of the responses of the Thai government, the International Monetary Fund (IMF), the World Bank, and other organizations in the period since the start of the currency crisis suggests that the intended timetable was to deal first with the problems of the finance companies and then to undertake a radical reform of the banking system itself. In December 1997, it was decided to close 56 of the 91 finance companies. Unfortunately, this approach had the effect of delaying the reform of the banking system. It was not until 1999, following the government's announcement in August 1998 of the Financial Sector Restructuring Package, that locally-owned commercial banks began to make significant efforts to recapitalize.

Thailand's non-performing loan ratio rose rapidly between the end of June 1997 and the end of January 1999, which is the latest period for which statistics were available (Table 3). In the space of just 18 months, the non-performing loans of locally-owned commercial banks increased by 7.5 times, from 305 billion bahts (loans in arrears by 12 months or more) to 2,289.6 billion (loans in arrears by three months or more). The non-performing loan ratio rose by a massive 41.8 points, from 8.3% to 50.1%. In Thailand, commercial banks (locally-owned and foreign) account for 69.2% of total public and private sector lending by all financial institutions (as of the end of 1997). Moreover, locally-owned commercial banks account for 81% of the loan balance of the commercial banking sector as a whole, including foreign banks. The non-performing loan problem has had a major impact, therefore, on the economy.

The disposal of non-performing loans by commercial banks is expected to accelerate, due to the passage of an economic reform bill and moves to restructure corporate debt. The real problem here, however, is the size of the final losses that will be incurred when commercial banks begin the process of purposeful disposal of their non-performing loans and remove them from their balance sheets. From this perspective, it is interesting to observe the outcome of an auction of finance company assets conducted by the Financial Sector Restructuring Authority (FRA) on December 15, 1998. The auction covered the loan portfolios of 56 companies selected for closure in December 1997. The auction was said to be the biggest in the world in terms of the items put on sale in a single day, with 45 asset tranches amounting to a total of 384 billion bahts on offer.

Yet, there were only 15 actual sales, equivalent to just 41% of the nominal price.(This includes additional sales on December 18.) Apparently, some of the 30 unsold asset tranches attracted bids that were rejected by the FRA as low. The remaining asset tranches were auctioned again on March 19, 1999, this time with the participation of the Asset Management Corporation (AMC), an institution established to buy the non-performing assets of finance companies. On average, successful bids amounted to only 18.2% of the nominal value of the assets.

The real estate market seems unlikely to recover quickly in the present environment. Supply-side pressure is still strong. Of the 248,100 properties put on sale between 1995 and 1997, over half (139,599) remain unsold. In 1997, a total of 21,215 properties were sold. Assuming that this is indicative of the level of demand in the foreseeable future, it will take six or seven years to dispose of unsold properties from the 1995-97 period, even if no new properties are put on the market. If commercial banks respond to the enactment of the 11 economic reform laws by stepping up their disposal of non-performing loans, it is possible that real estate prices will slump further.

For these reasons, there is little hope of a dramatic reduction in the non-performing loan ratio in the short-term. However, the ratio should be discounted to reflect the following factors. First, it is estimated that about 20% of the non-performing loans are "strategic non-performing loans" to borrowers who are not making repayments despite having the ability to do so. Second, some of the non-performing loans are covered by bad debt reserves. (Commercial banks are required to provide for at least 20% of the required amount of bad debt reserves by the end of 1998, at least 60% by the end of 1999, and 100% by the end of 2000.) Third, when the economy recovers, it will be possible to reclassify some of the non-performing loans as normal loans.

When these and other factors are taken into account, it becomes apparent that the final loss, incurred when banks begin to dispose of their non-performing loans in earnest, will be significantly lower than that indicated by the non-performing loan ratio. Moreover, the non-performing loan ratio will be reduced on paper if the restructuring of corporate debt can be accelerated, allowing these loans to be removed from balance sheets.

2. Developments Since the Announcement of Financial Sector Restructuring Package

On August 14, 1998, the Thai government announced the Financial Sector Restructuring Package. The main components of the plan are (1) the consolidation of commercial banks and finance companies that are unable to recover through their own efforts, and (2) injections of public funds to facilitate recapitalization by financial institutions.

(1) Restructuring of Financial Instiutions

The consolidation of financial institutions in Thailand began to accelerate after the large-scale closure of finance companies in December 1997. The Financial Sector Restructuring Package announced in August 1998 specified the disposal methods for the four commercial banks nationalized in January and February 1998, the two commercial banks nationalized in August, and finance companies nationalized during 1998.

Of the six banks that were nationalized in 1998, the First Bangkok City Bank and the Bangkok Bank of Commerce (sound assets taken over, non-performing assets transferred to the Asset Management Corporation established for the Bangkok Bank of Commerce) were absorbed by the government-affiliated Krung Thai Bank; the Laem Thong Bank by the state-owned Radanasin Bank; and the Union Bank of Bangkok by the state-owned Bank Thai (formed from Krung Thai Thanakit, a finance company affiliated to the Krung Thai Bank; 12 closed finance companies; and the Union Bank of Bangkok) (Fig. 2). The Financial Institution Development Fund (FIDF) provided injections of funds for five banks, including the three state-owned banks which were used as recipients for this process and the nationalized Bangkok Metropolitan Bank and Siam City Bank.

The number of finance companies has been reduced from 91 before the currency crisis, to 24 as of March 1999. Meanwhile, consolidation have cut the number of commercial banks from 15 to 13 (including the Radanasin Bank, which took over the sound assets of the 56 finance companies targeted for closure at the end of 1997).

In Thailand, a key question in relation to the consolidation of financial institutions is the extent to which foreign financial institutions will be interested in acquiring nationalized commercial banks and locally-owned commercial banks. The government has already amended the foreign investment law to allow majority foreign ownership of financial institutions for up to ten years.

So far, foreign investors have acquired majority stakes in only two cases. The ABN Amro Bank of the Netherland has acquired the Bank of Asia by buying approximately 70% of its stocks, while the Development Bank of Singapore (DBS) decided to acquire the Thai Danu Bank in 1998 and is expected to take its shareholding from 50.27% to the maximum 77-78% in 1999. Foreign financial institutions are currently in the midst of negotiations over the acquisition of the Bank of Ayudhya and the Nakornthon Bank.

(2) Recapitalization of Commercial Banks

The use of injections of public money to recapitalize commercial banks is another key component of the Financial Sector Restructuring Package, as a way of facilitating new lending. Thus far, preparations have been made for the support measures valued at a total of 300 billion bahts. This is made up of 200 billion bahts in support for basic equity items (Tier 1) through a swap of government bonds for preferential stocks, and 100 billion bahts in supplementary (Tier 2) equity support through a swap of government bonds for subordinated bonds.

Following the announcement of the Financial Sector Restructuring Package, commercial banks tended to reject this kind of support. This was especially true for the Tier 1 program, which involves an examination of management and shareholder responsibilities. However, several commercial banks have since adopted a more positive stance toward applications for public funds. There are several reasons for this change of attitude. First, the amount of non-performing loans has continued to rise. Second, many commercial banks would not be able to recapitalize through their own efforts in the market. Third, one of the measures included in Thailand's Sixth Letter of Intent to the IMF in December 1998 called for an exchange of memorandums by January 31, 1999 between the central bank and commercial banks and finance companies, in relation to measures for recapitalization.

As of March 1999, the Siam Commercial Bank had applied for support under both Tier 1 and Tier 2 schemes, the Nakornthon Bank under the Tier 1 scheme, and the Bank of Asia under the Tier 2 scheme. Other banks, including the Thai Military Bank and the Thai Danu Bank, are reportedly considering applications. The government wants more commercial banks to apply for injections of public funds. At present, however, the larger commercial banks, especially those owned by ethnic Chinese, are reluctant to apply for this kind of support because of the focus this will bring to management responsibilities.

3. Stagnant Bank Lending

Despite the announcement of the Financial Sector Restructuring Package and an improvement in the financial environment, the growth rate for lending by commercial banks has fallen dramatically since the second half of 1998. The decline in the balance of commercial bank lending as a whole continues unabated, with growth of -4.2% in October 1998, -5.3% in November, -9.7% in December, and -13.0% in January 1999 (relative to the same months of previous year). Even if offshore lending through the Bangkok International Banking Facility (BIBF) is excluded, there is still a rapid fall in the growth rate for lending, from +4.4% in October 1998, to +3.3% in November, +1.2% in December, and +0.3% in January 1999.

In December 1998, Thailand and the IMF agreed that the target real economic growth rate for 1999 should be +1%. The central bank believes that the achievement of this growth rate will require a yearly increase of 4-8% in the lending balance of commercial banks in 1999. Yet, it seems unlikely that restructuring and management modernization efforts will be sufficient to bring about an immediate increase in lending by commercial banks. There are several reasons for this view. First, the non-performing loan ratio is still rising. Second, the corporate debt restructuring process has been delayed. Third, banks need to adapt to global standards by increasing their bad debt reserves and tightening their definition of non-performing loans. Fourth, commercial banks are operating at a loss, even before provision for bad debt reserves. Moreover, if corporate debt restructuring begins in earnest, commercial banks may not want to give new loans to companies after they have written off loans to them.

Aside from the supply of funds, the future level of demand will be another issue influencing growth in lending by commercial banks. The capacity utilization ratio for the manufacturing sector is extremely low, and both consumption and investment remain stagnant. These factors appear to rule out the emergence of new demand in all but a few industries.

The government has repeatedly called on commercial banks not only to increase lending, but also to reduce their lending rates. Officials have pointed out that since market rates have fallen sharply, lending rates should fall by a similar margin, and that there has been no reduction in the margin between deposit rates and lending rates. As far as the first issue is concerned, reductions in the fund raising cost of commercial banks (deposit rates) began to be reflected in the reduction of lending rates with a time lag. Regarding the second issue, however, there seems to be little room to reduce interest spreads when the various cost factors affecting commercial banks are taken into account.

These include FIDF contributions, the business consumption tax,(4) the need to provide bad debt reserves and funds to cover loan write-offs, and the high ratios for general expense to deposits. Any reduction in interest rates spreads would require an easing of the restrictions on bad debt reserves to remove the requirement to allocate 1% of normal loans to reserves. It would also depend on a cut in the deposit reserve rate and the easing of regulations so that normalized non-performing loans can be included with normal loans.

4. System Improvement to Facilitate Non-performing Loan Disposal

Corporate debt restructuring and the disposal of non-performing loans are two aspects of the same process. The key requirements, with reference to the facilitation of non-performing loan disposal by private sector financial institutions, are tax incentives, improvement of related laws, and the establishment of intermediary institutions which facilitate debt restructuring through measures to reconcile the interests of lenders and borrowers.

To speed up the disposal of corporate debt, it was first necessary to pass the 11 economic reform laws which included laws relating to bankruptcy, the exercise of mortgage rights, commercial banking, and foreign investment (including real estate ownership). According to the Fifth Letter of Intent, which became public in August 1998, the necessary amendments were supposed to be passed by Thailand's Parliament by the end of October 1998. However, strong resistance from some members of the Parliament delayed the process, and it was not until March 1999 that the bills finally passed the Upper House and were put into law.

In 1998, the central bank (the Bank of Thailand) established the Corporate Debt Restructuring Advisory Committee (CDRAC). This group has since acted as an intermediary and facilitator in debt restructuring negotiations between financial institutions (creditors) and companies. As of early March 1999, it was involved in debt restructuring for 293 companies and had already disposed of loans belonging to 56 companies. The loans amounted to 120 billion bahts, or 18% of the total amount of debt in value terms. The CDRAC is currently considering measures to increase eligibility for negotiations from 351 companies in 200 groups, to around 600 companies.

On March 19, the central bank drew up an agreement defining the conditions to be applied when financial institutions enter into repayment negotiations with companies that have fallen behind on their loan repayments. The major financial institutions have formally accepted and signed this agreement. The agreement states that a repayment plan that was approved by the majority of a company's creditors and by financial institutions holding more than 75% of the company's total debts must be accepted, even by financial institutions that do not approve of the plan. The agreement includes penalties for non-conformance.

5. Priorities for the Future

(1) New Approaches to Recapitalization

Since early 1999, locally-owned commercial banks have been using new methods for recapitalization. The capital ratio required in Thailand is 8.5%. Financial institutions, especially the major locally-owned commercial banks, have sought to avoid official intervention in their management as a concomitant of injections of public funds. To this end, some of them have issued stapled limited interest preferred stock (SLIPS) or capital guaranteed preference (CAPS) unit trusts.

These trusts, which consist of subordinated bonds and preferential stock, can be included in equity, and are sold to institutional investors and individuals by investment trust companies. Commercial banks are increasingly adopting this method for recapitalization. The Thai Farmers Bank and the Bank of Ayudhya has already issued them, and the Bangkok Bank and the Thai Danu Bank are reportedly planning issues. These products provide investors with returns of about 11% even if the issuer continues to make a loss, and the maximum of around 22% if the issuer goes into the black. With domestic deposit interest rates falling rapidly, the issues have attracted the attention of both institutional and individual investors. With this practice, commercial banks can recapitalize while avoiding official interference in their affairs. Unless the banks can improve their earnings, however, the issues could become a heavy burden in the future.

(2) Eatablishment of Non-performing Loan Purchasing Institutions

The process of separating the sound assets of commercial banks from their non-performing assets, and the transfer of the non-performing assets to asset management institutions, has proceeded more slowly in Thailand than in South Korea or Malaysia. An Asset Management Corporation has been established to acquire the non-performing assets of the 56 finance companies that were closed in December 1997. As discussed earlier in this article, this organization has participated in asset auctions. However, the full details of plans for AMCs for commercial banks have yet to be made public, and many questions remain unanswered.

What is the timetable for the establishment of AMCs, and what will be the ultimate disposal method for non-performing loans purchased by the AMCs? Will separate AMCs be established for each bank, or will there be one AMC for the whole of the banking sector? Will the AMCs purchase non-performing assets from healthy banks? What action will be taken if secondary losses are incurred after the purchase of the loans?

(3) Privatization of Natioanlized Banks

Another difficult issue is the privatization of the locally-owned commercial banks nationalized since January 1998, and the government-affiliated Krung Thai Bank. At the end of January 1999, these five banks accounted for 28% of the total outstanding assets of the banking sector and 42% of the non-performing loans. Their non-performing loan ratio was 66%.

A privatization framework was finally approved by the Cabinet in March 1999. The first step will be to devise a privatization method for the Radanasin Bank, which took over the sound assets of 56 closed finance companies and absorbed the Laem Thong Bank in August 1998. At present, all stocks are held by the FIDF which is under the jurisdiction of the central bank, but there are plans to reduce the holding to 24-49% after privatization. In terms of the methods used to sell assets, sound assets will probably be sold to investors, while non-performing assets will probably be sold to AMCs owned by the FIDF. If investors also buy non-performing assets, other questions will need consideration. To what extent will the government provide guarantees against secondary losses? If the prices of non-performing assets rise, how will the proceeds be distributed? The privatization scheme used for the Radanasin Bank may well become the template for the privatization of other nationalized banks.

(4) The Fiscal Burden

The economic crisis and restructuring of the financial system are also having a deleterious effect on government finances. Until the onset of the currency crisis, Thailand had, for many years, consistently achieved budget surpluses. In the 1998/99 fiscal year, however, the deficit is projected to reach 5% of GDP, reflecting the cost of measures to stimulate the economy, the need to establish social safety nets, and the erosion of tax revenue due to the economic downturn. In addition, according to the Sixth Letter of Intent, the cost of financial system reform is expected to amount to 3% of GDP. This means that economic reform and the restructuring of the financial system will involve fiscal expenditure equivalent to as much as 8% of GDP.

In 1998, the government drastically shifted the focus of its economic stance from a policy mix based on defense of the baht, fiscal retrenchment and monetary tightening, to a position based on stabilization of the baht, fiscal expansion and monetary easing. Other positive signs include an improvement in the market environment for global bond issues, which had been a source of concern since 1998, and the availability of foreign assistance, including Japan's New Miyazawa Initiative.

However, the solution of the non-performing loan problem is likely to be a long and costly process. It is still possible that the government will be forced to formulate additional supplementary measures (including the provision of additional public funds, the easing of conditions for injections of public money, and the provision of investment incentives to foreign financial institutions) to back up the Financial Sector Restructuring Package announced in August 1998.

III. South Korea

1. Proliferation of Chaebol Bankruptcies Accompanied by the Expansion of Banks' Non-performing Loans

Unlike the other three economies examined in this article, the non-performing loan problem in South Korea was not triggered directly by the currency crisis. The problems in the South Korean financial sector were already becoming apparent before the July 1997 devaluation of the Thai baht. Those problems included a proliferation of bankruptcies among the chaebol (conglomerates), notably Hanbo, Jinro and Kia, and a deterioration in the financial positions of the principal banks for these groups, such as the Korea First Bank and the Seoul Bank.

Historically, the government has intervened heavily in South Korean banks' affairs, and the financial sector has had a reputation for bureaucratic control. The government's strategy has been to use its strong influence over financial institutions to ensure that funds are distributed to priority industries and to use the chaebol to achieve economic growth. Government wishes were reflected in the allocation of funds, the setting of interest rates, and other conditions for bank lending, even in appointments to the boards of financial institutions. This situation is now being blamed for resulting in the lack of improvements in the management capabilities and credit assessment skills in the financial institutions. In addition, some observers believe that the efficient allocation of funds was hindered by the government's failure to take profitability into account in its decision-making.(5)

As borrowers, companies - and in particular, the chaebol - have consistently placed an emphasis on quantitative expansion of their operations ahead of improvements in profitability. The chaebol companies were able to secure credit by cross debt guarantees. This mechanism allowed them to undertake aggressive expansion of their operations, but it also created several problems, including high debt ratios. By the end of 1997, the average debt ratio had reached 450% for the 143 listed companies belonging to the 30 largest chaebol. This is more than double the average for other listed companies (210%).(6)

In November 1997, the value of the won plummeted. This was followed by a rapid deterioration in the quality of the assets held by financial institutions (Fig. 3, Table 4). According to the Financial Supervisory Commission, non-performing loans held by commercial banks increased from 12 trillion won (3.9% of total loans provided) at the end of 1996 to 21 trillion won (5.8% of total loans provided) at the end of 1997, and to 29 trillion won (8.6% of total loans provided) at the end of June 1998.

The definition of non-performing loans was tightened since July 1998, which was extended from "loans in arrears by six months or more" to "loans in arrears by three months or more." Despite this, loan purchases by government-affiliated institutions reduced the total amount of non-performing loans to 22 trillion won at the end of September 1998. The non-performing loan ratio also declined to 7.1%. The total still stood at 22 trillion won at the end of 1998, but although the rate of increase had been abated, a drop in the total amount of loans provided caused the non-performing loan ratio to rise again to 7.4%.

On the surface, the non-performing loan position appears to have stabilized. A strong body of opinion suggests, however, that the actual non-performing loan ratio is higher than that indicated by the figure published by the Financial Supervisory Commission. For example, J.P. Morgan of the United States puts the non-performing loan ratio at 25-30% (April 1998), while Lehman Brothers estimated in September 1998 that the non-performing loan ratio will reach a peak of 33%. In addition, in January 1999, Goldman Sachs published an estimate that placed the peak ratio at 26%. All of these figures are two or three times higher than the figure published by the Financial Supervisory Commission.

2. Progress toward Development of Non-performing Loan Disposal Schemes

South Korea's financial sector is now undergoing restructuring under the guidance of the Financial Supervisory Commission, which was established in April 1998. As shown in Fig. 4, the main components of the restructuring scheme for the banking sector are (1) consolidation, (2) the purchase of non-performing loans, and (3) recapitalization.

The first stage of the process was the classification of South Korea's 26 commercial banks into four categories: (1) relatively sound banks, (2) those conditionally capable of survival, (3) those incapable of survival alone, and (4) those to be nationalized. The deterioration in the financial positions of the Korea First Bank and the Seoul Bank proved especially grave, and in January 1998, steps were taken to nationalize these two banks. The remaining 24 commercial banks were classified as (1) relatively sound banks, which were defined as banks with capital ratios of at least 8% at the end of 1997, and (2) problem banks with capital ratios lower than 8%. The 12 problem banks were directed to report rehabilitation plans.

On the basis of those plans, seven banks were judged conditionally capable of remaining in business, and the remaining five as incapable of survival on their own. The banks that made up the latter group were the Donghwa Bank, the Dongnam Bank, the Daedong Bank, the Chungchong Bank, and the Kyungki Bank. These will be purchased by the Shinhan Bank, the Housing and Commercial Bank, the Kookmin Bank, the Hana Bank, and the Koram Bank, respectively, all of which were deemed to be relatively healthy.

The seven banks judged conditionally capable of staying in business were the Cho Hung Bank, the Korea Exchange Bank, the Hanil Bank, the Commercial Bank of Korea, the Kangwon Bank, the Chungbuk Bank, and the Peace Bank of Korea. The conditions set down for the continuing operation of these banks included the change in management, recapitalization and mergers, capital reductions, cost reductions, and the prevention of accumulation in non-performing loans.

These decisions, which covered the first stage of the process, were made by June 1998, just four months after the February inauguration of Kim Dae-Jung as South Korea's new president. As the assessments of the banks' financial positions were completed relatively quickly, South Korea was able to hasten the transition to subsequent processes, such as the acquisition of non-performing loans and the recapitalization through injection of public funds.

In consultation with the IMF, the South Korean government decided to privatize the two nationalized banks, the Korea First Bank and the Seoul Bank, through a bid by November 15, 1998. This led to a decision to sell the Korea First Bank to a consortium led by the American investment company Newbridge Capital, and to Seoul Bank to the British financial group HSBC Holdings. Memoranda covering the sales were exchanged between the South Korean government and the investors in December 1998 and February 1999, respectively.

Banks that had capital ratios above 8% at the end of 1997 and the conditionally approved banks were set goals related to the disposal of their non-performing loans and recapitalization, in order to achieve and maintain the status of sound banks.

The Korean Asset Management Corporation (KAMCO) is the main organization for the purchase of non-performing loans. KAMCO was originally established in 1962 as an institution for the disposal of non-performing loans. It was reorganized in November 1997, to enhance its ability to cope with the present crisis. The model for that reorganization was the Resolution Trust Corporation (RTC), which was created in the United States. KAMCO plans the purchase of non-performing loans using funds raised through issues of government-guaranteed bonds and other mechanisms. It will acquire all the non-performing loans held by the problem banks and 50% of the non-performing loans held by the sound banks. In September 1998, KAMCO announced that it had already purchased over 60% of the target amount of non-performing loans from the banking sector. The average purchase price was approximately 40% of face value.

Injections of public funds are the principal tool used in achieving the other goal, the recapitalization. The government is making public funds available so that banks can attain and maintain capital ratios of 10%. Recipients include the five aquiring and merged banks (such as that of the Hanil Bank and the Commercial Bank of Korea) and the two nationalized banks (Korea First Bank, Seoul Bank). Banks need to recapitalize and strengthen their business foundations in order to dispose of their non-performing loans and to improve their future competitiveness. However, there is a limit to the extent to which they can rely on public funding, and financial institutions will also need to recapitalize through their own efforts, such as through the attraction of funds, including foreign capital, from private sector investors.

The government predicts that the restructuring of the financial sector will require 64 trillion won in public funds. In the period of just over one year from November 1997 to December 1998, capital injections amounted to 40.9 trillion won, or slightly more than 60% of the predicted total. (As shown in Table 5, this sum consisted of 19.9 trillion won used by KAMCO to purchase non-performing loans; 6.3 trillion won used for the recapitalization of banks, including those targeted for mergers; 6.9 trillion won in loss coverage; and 7.8 trillion won in deposit repayments.)

Private sector financial institutions have also been working to overcome the crisis. The South Korean government made injections of public funds conditional on bank efforts to help themselves, including mergers and reorganization. Following the announcement of mandatory P&As in June 1998, several banks announced their own plans for four mergers. The mergers in question are between the Hanil Bank and the Commercial Bank of Korea, between the Hana Bank and the Boram Bank, between the Kookmin Bank and the Korea Long-Term Credit Bank, and between the Cho Hung Bank, the Kangwon Bank, and the Hyundai International Merchant Banking Corporation.

The Hanil Bank and the Commercial Bank of Korea reportedly agreed to merge under strong pressure from the government, and the two banks have received injections of public funds totaling 3.3 trillion won for recapitalization. The Cho Hung Bank and the Kangwon Bank were both deemed conditionally capable of remaining in business, when banks were assessed in June in 1998. The proposed merger is part of their rehabilitation plans. The Hana Bank and the Boram Bank have relatively healthy financial structures, as do the Kookmin Bank and the Korea Long-Term Credit Bank.

They appear to have opted for mergers as a way of strengthening their business foundations. The merger between the Hanil Bank and the Commercial Bank of Korea was completed in January 1999. The merger resulted in the creation of the Hanvit Bank, which has since reached agreement on a normalization plan with the Financial Supervisory Commission. Key components of the plan include the reduction of redundant staff, branch network, and subsidiaries; the disposal of non-performing loans by December 2000; the installation of an internationally acceptable non-performing loan classification system by January 2000; the appointment of a financial advisor to recapitalize; achieving a capital ratio of 10% by 2000; and the appointment of external experts to establish a dedicated unit for risk management and to set up new risk management policies and procedures.

The restructuring of South Korea's financial system has focused primarily on the banking sector. However, the restructuring of the non-bank sector will be another crucial priority. In recent years, this sector has taken advantage of lax regulations and achieved rapid growth in its share of lending and deposits. The "merchant banks" are one type of such non-banks. Of the 30 merchant banks, 16 have been closed because of deteriorating financial problems. The surviving companies are expected to achieve capital ratios of 8% by the end of June 1999. Under an agreement with the IMF, these companies will, from January 1999, become subject to the same rules as commercial banks with regard to connected lending, such as lending to major shareholders or their subsidiaries. Such lending is limited to 25% of equity.

South Korea has made better progress toward the disposal of non-performing loans than other Asian economies. It earned praise from the IMF for completing the first stage of its financial reform process in September 1998. Throughout 1998, however, the rate of increase in the balance of bank lending fell fairly consistently relative to the same months of 1997, and negative figures have been recorded in each of the five months since September. The statistics have yet to show any easing in this credit contraction (Fig. 5). In the following, we will examine some of the issues and concerns that surround the restructuring of the financial system.

3. Issues and Concerns

First, an improvement in the capacity of private sector financial institutions to help themselves is needed more than ever, especially among those who are directly involved in the restructuring of the financial system. To date, the disposal of non-performing loans has been implemented through government initiatives. As discussed below, however, expenditure on the restructuring of the banking system has become a major drain on fiscal resources, and in the future, financial institutions will be expected to rely on their own efforts, rather than on injections of public funds.

Injections of public funds have been conditional on the implementation of restructuring measures, including the consolidation of financial institutions and reductions in job numbers. However, there is a risk that restructuring will be impeded by opposition from labor organizations. According to media reports, following the announcement of P&A plans for five banks in June 1998, settlement systems were temporarily paralyzed when employees of the banks targeted for liquidation adopted various courses of action, including the destruction of computers.(7)

Second, the government has taken the initiative in the disposal of non-performing loans because of the need to resolve this problem quickly to restore the credit generating functions of the financial institutions and to revive the economy. In other words, South Korea needs its financial institutions to function as financial intermediaries. Unfortunately, however, whether South Korean financial institutions will be able to shoulder this burden in the short term is questionable, as they areregarded as lacking in credit assessment capabilities after decades of operation under bureaucratic control.

Banks must dispose of the negative legacy of the past in the form of non-performing loans, and at the same time, they must improve their management capabilities and credit assessment systems. One effective solution to these problems would be to draw on the knowledge and knowhow of foreign companies. In this regard, the successful sales of the Korea First Bank and the Seoul Bank to foreign investors are highly significant.

Third, there are the problems with borrowers, as the other parties to the non-performing loans. To end its credit crunch and revive its economy, South Korea must focus not only on the problems with the financial institutions that made the loans, but also on the closely associated problems with the borrowers. In South Korea, the onset of the currency crisis was triggered in part by a series of bankruptcies among chaebol companies. Thus, reform of the chaebol will be an essential prerequisite for any lasting solution to the non-performing loan problem.

Corporate reform is one of the conditions for IMF support. The agreement reached in December 1998 placed requirements such as the following on the major chaebol. Firstly, they must focus on their core business sectors and streamline their other operations. Secondly, they must improve their capital structures through such means as recapitalization, acceptance of foreign investment, and asset sales, with a view to achieving debt to equity ratios below 200% by the end of 1999. Thirdly, cross debt guarantees within the chaebol groups must be eliminated by March 2000. Fourthly,corporate governance and transparency must be improved. There has been some progress toward the elimination of cross guarantees.

The total for the 30 main chaebol was halved from 27 trillion won in April 1998 to 12 trillion won at the end of that year. However, the directors of the chaebol have reportedly shown little enthusiasm for measures affecting other activities, such as business swaps. In addition, there has been fierce opposition from workers faced with job uncertainty and other concerns. President Kim exerted considerable influence over the business swap plan, but doubts have been expressed from the market with reference to the real benefits of the plan in terms of efficiency gains and other factors.

Fourth, the government has its own problems, including the impact of the crisis on fiscal policy and the need to find additional financial resources. As stated earlier in this article, the government estimates the total sum required to dispose of non-performing loans at 64 trillion won. This is equivalent to three-quarters of the government's total budget.

Financial reform has been accorded a high priority in the draft budget for FY1999. The problem is placing considerable strain on government finances. For example, approximately 7.8 trillion won, equivalent to almost one-tenth of total expenditure, has been allocated to interest payments on government bonds issued to cover deposit insurance and other requirements. However, the task of raising funds overseas should be easier for South Korea than for other Asian economies, as its credit rating has been raised by major rating agencies, including Fitch IBCA and S&P.

Another issue with implications for fiscal policy is the accuracy of the non-performing loan figures used as a base for the decisions to inject public funds. As noted earlier, there is a considerable gap between the figures released by the government and estimates made by private sector financial institutions. If the volume of non-performing loans has been underestimated, then there has been less progress toward the purchase of non-performing loans than is suggested by the 60% figure cited by government. Moreover, if the slow pace of corporate reform causes the economy to remain stagnant, then there will be further rises in the amount of non-performing loans and the cost of their disposal.

Finally, there are questions as to the way in which the non-performing loans should be disposed of once they have been purchased. Ultimately, KAMCO will have to recover the non-performing loans it has purchased through liquidation of the assets of borrowers. The alternative is for it to sell the loans to investors through auctions or other means. Only then will it be able to recoup the funds used to buy the loans and the associated costs. The fiscal burden will increase if this final process is delayed, or if the final sale price is pushed down, or if no buyers are found and the government is left to carry the losses.

In December 1998, KAMCO signed a contract with the American real estate company Loan Star Fund covering the purchase of 565 billion won of property-secured non-performing loans that it had acquired from financial institutions. Problems still remain, however, as KAMCO made a 37.6 billion won loss on the 201.2 billion won deal with the Lone Star Fund after paying 238.8 billion won to financial institutions for the loans.(8)

IV. Malaysia

1. Banking Sector Hit by Dramatic Rise in Non-performing Loans

The balance of bank lending in Malaysia has grown by 25-30% per annum since 1995. This rate of increase is considerably higher than the nominal annual growth rate for GDP, which was 10-15% over the same period. As a result, the balance of bank lending rose from 69% of GDP in 1994 to 99% in 1997. This ratio of lending to GDP is slightly lower in Malaysia than in Thailand, where it is 106%, but substantially higher than the 65% for South Korea and the 56% in Indonesia.

In the lead up to the onset of the currency crisis, banking trends in Malaysia were characterized by a rapid rise in lending and the concentration of loans in such areas as property and the stock market. In June 1997, before the beginning of the currency crisis, lending in the three areas of property, consumption credit, and the purchase of securities accounted for over 45% of total lending. If the construction sector is included, this share rises to around 55%. Loans to the manufacturing sector represented only 15% of total lending. The central bank sought to curb excesses in the supply of property by imposing ceilings on lending to the property sector and securities purchasing. From April 1997, lending for properties was limited to 20% of total loans, and lending for securities purchasing was limited to 15% (30% in the case of merchant banks) of the total. Despite these measures, lending continued to expand in both areas.

Since the summer of 1997, the collapse of the currency and stock prices, economic stagnation caused in part by a tighter monetary policy, and the suspension of major development projects have all impacted severely on the property and securities sectors. Bank assets have been eroded by the slump that has affected their principal areas of lending (Fig. 6, Table 6).(9)

The value of non-performing loans held by banks quadrupled from 15 billion ringgits (non-performing loan ratio of 3.7%) in June 1997 before the currency crisis, to 60.5 billion ringgits (non-performing loan ratio of 14.6%) in December 1998. (In October 1997, the definition of non-performing loans was extended from "loans in arrears by six months or more" to "loans in arrears by three months or more." In September 1998, the definition was relaxed once again to "loans in arrears by six months or more.") Some analysts believe that the actual ratio for non-performing loans is higher than the figure published by the central bank and that this ratio is really over 20%. Though the value of non-performing loans has risen sharply in Malaysia, its ratio to total lending is relatively low when compared with the ratios recorded in Thailand and Indonesia.

2. Financial Restructuring Measures Focusing on Economic Stimulation

In 1998, the currency and economic crisis in Malaysia was becoming increasingly serious. The central bank responded with taking the initiative in implementing decisive measures for financial reform.

As in Thailand, these measures focused first of all on the finance companies. At the end of 1997, there were 39 finance companies with loan portfolios equivalent to about one-quarter of the lending balance of the entire banking sector (consists of commercial banks, finance companies, and merchant banks). Their main area of business was small-scale consumption credit, and the percentage of lending to non-productive sectors was especially high when compared with other areas in the banking sector.

A breakdown of the lending balance as of June 1997 shows that the property sector accounted for 20% of lending, consumption credit (especially loans for purchases of passenger cars) for 33%, and loans used to buy securities for 10%. Finance company assets were subject to considerable erosion in the wake of the currency crisis because of this lending mix. By December 1998, non-performing loans held by finance companies amounted to 18.2 billion ringgits, or around 30% of the total for the entire banking sector. Their non-performing loan ratio had climbed to 19.7%, compared with 14.6% for the banking sector as a whole.

The structural reform measures adopted for the finance companies focus on (1) consolidation and (2) tighter regulation. Though there are 39 finance companies, the top five or six companies control over 70% of the market. Given the small scale of their operations and their inadequate business structures, it seemed unlikely that the small- and medium-sized finance companies would be able to restructure through their own efforts.

In early 1998, the central bank announced that the industry should be reorganized to leave just five or six companies by the end of March. On the set deadline of March 31, it was announced that all companies had agreed to this restructuring. The plan called for an industry amalgamation to leave six major finance companies capable of acting as anchor firms, and mergers with commercial banks within the same group or with other banking groups. Ultimately, all finance companies were to be amalgamated into eight companies. The financial system stabilization package announced in March 1998 included regulatory changes designed to strengthen their financial positions. The minimum risk-weighted capital ratio was raised from 8% to 9% at the end of 1998 and will be increased to 10% at the end of 1999. The minimum capital funds will be raised from the present level of 5 million ringgits to 300 million ringgits at the end of June 1999, and to 600 million ringgits by the end of 2000.

On the other hand, there has been little consolidation activity among the commercial banks, which account for around 70% of total banking sector lending. The only significant events have been the announcements of two large mergers. The first merger, announced in March 1998, involved the acquisition of the Sime Bank, which was experiencing increasingly serious financial problems. It posted a pre-tax loss of 1.8 billion ringgits for the half-year which ended December 31, 1997. It was acquired by a major financial group, Rashid Hussain Bhd., and merged with a member of that group, the RHB Bank.(10) The RHB Bank is Malaysia's third-ranked bank. The other merger involved the government-affiliated Bank Bumiputra Malaysia, the second largest in Malaysia in terms of total assets.

With its financial situation deteriorating as a result of mounting non-performing loans, this bank decided to merge with the Commerce Asset-Holdings, a major finance group. The preliminary agreement was reached in September 1998.(11) In both cases, the government and the central bank appear to have provided strong, behind-the-scenes guidance as part of their financial restructuring efforts. There are plans to inject public funds amounting to 1.5 billion ringgits into the RHB Bank and the Sime Bank, and 1.1 billion ringgits into the Bank Bumiputra Malaysia.

The consolidation process of financial institutions has been paralleled by the use of public funds to purchase non-performing loans and to recapitalize. This strategy is expected to rebuild the financial intermediation function of the financial institutions by removing the dead weight of non-performing loans from their balance sheets and using injections of public funds to strengthen their equity positions. Two quasi-governmental institutions, Pengurusan Danaharta Nasional Berhad and Danamodal Nasional Berhad, have been established for this purpose.

Danaharta was created to acquire the non-performing loans of financial institutions. It commenced business in June 1998 and receives advice from Arthur Andersen and J.P. Morgan. By December 1998, just over six months from the establishment, it had reached agreement on the purchase of non-performing loans totaling 8.1 billion ringgits. This amount consisted mainly of loans made to the broad property sector which includes construction, or for the purchase of securities. In addition, Danaharta manages 11.6 billion ringgits in non-performing loans held by two financial institutions, including the Sime Bank.

Non-performing loans disposed of to date amount to 19.7 billion ringgits. This is equivalent to about one-third of the total of banking sector non-performing loans, which amounted to 60.5 billion ringgits in December 1998 (Fig. 7). The average discount rate is 61%,(12) and the financial institutions have received 3.1 billion ringgits in payment. This includes 2.7 billion ringgits in government-guaranteed zero-coupon bonds with a face value of 3.8 billion ringgits, and 400 million ringgits in cash.

Furthermore, Danaharta plans to issue government-guaranteed bonds with a face value of 15 billion ringgits to cover the disposal of non-performing loans. Assuming this issue will be made under terms similar to those for previous issues, and with a discount rate of 40-60%, this means that Danaharta plans further purchases of non-performing loans amounting to 13-20 billion ringgits.

Danamodal was established in August 1998 under central bank ownership to deliver the injections of public funds. It is advised by Salomon Smith Barney and Goldman Sachs. In October, it announced that funds totaling 3.3 billion ringgits would be made available to ten financial institutions. For the financial institutions concerned, these funds will raise the average capital ratio from 9.75% at the end of August to an estimated 14.06%. It is anticipated that capital injections totaling 16 billion ringgits will be needed to maintain the capital ratios of all domestic banks at a minimum level of 9%. In October, a zero-coupon bond issue with a total face value of 11 billion ringgits was issued through allocations to financial institutions. Financial institutions bought the bonds using funds released to the market through the reduction in the statutory reserve requirement in September 16.(13)

The emphasis on extremely realistic measures targeted toward economic recovery, rather than on strengthening the financial system as a whole (Table 7), has been the feature of financial restructuring in Malaysia. Initially, Malaysia focused on the application of international standards and the reinforcement of various systems as a basis for restructuring, as was the case in Thailand and South Korea. In October 1997, it extended the definition of non-performing loans from "loans in arrears by six months or more" to "loans in arrears by three months or more."

Similarly, among the measures included in the financial system stabilization package announced in March 1998 were the aforementioned tightening of the capital ratio and minimum capital requirements for finance companies, a quarterly disclosure requirement for data relating to capital ratio and non-performing loans, and the lowering of the ceiling for large loans to a single customer from 30% of total capital to 25%.

The government changed its policy stance, however, when these measures failed to halt the deterioration of Malaysia's economic situation. In September 1998, it eased a number of restrictions. To help the property sector, it exempted lending for the construction or purchase of residential properties worth 250,000 ringgits or less from the rule limiting the broad property sector lending to no more than 20% of total loans. (In January 1999, controls on lending for development of properties were tightened in order to restrict the supply of real estate. A ban was imposed on loans for the development of residential properties and shophouses where the individual unit costs more than 250,000 ringgits each.) The ceiling for loans from commercial banks and finance companies for use in the purchase of stocks and unit trust funds was raised from 15% to 20% of total lending.

The definition of non-performing loans was eased from "loans in arrears by three months or more" to "loans in arrears by six months or more." Also, the continuous repayment period required before loans could be reclassified as performing loans was reduced from 12 months or more to six months or more. On September 1, the statutory reserve requirement was lowered from 8% to 6%, and on September 16, it was further reduced to 4%.(14) The central bank estimates that the reduction of the statutory reserve requirement on September 16 released 6-8 billion ringgits into the market. Most of this money appears to have been used to buy the aforementioned Danamodal bonds.

One response to the non-performing loan problem has been the implementation of measures relating to corporate debt. In Malaysia, there has been an increase in the number of companies seeking protection under Section 176 of the Companies' Act. When such protection is approved, the company concerned is granted a repayment moratorium for a specific period to allow it to formulate a restructuring plan. However, there has been considerable criticism of this mechanism as it is seen simply as a way in which companies can avoid their obligations or play for time. The government responded to this criticism with the establishment of the Corporate Debt Restructuring Committee (CDRC) as an intermediary to facilitate debt negotiation between companies and financial institutions. By October 1998, it had received over 20 applications. However, the CDRC has no legal power, and debtor companies and the financial institutions to which they owe money voluntarily agree to abide by the guidelines that it formulates.

3. Issues Relating to Restructruing of Financial System

A framework for the restructuring of the financial system was assembled quickly in Malaysia. Elements of that framework include the consolidation of financial institutions, and the disposal of non-performing loans and injections of public funds through governmental institutions. Unfortunately, the growth rate for bank lending fell consistently, from 16.9% in March 1998 to 10.2% in June, 4.5% in September, and -1.6% in December (when compared with the same months of 1997). Putting an end to this credit contraction has, thus far, proved impossible. The following discussion traverses some of the issues affecting financial system reform in Malaysia.

The first problem is funding. Danaharta allocates government-guaranteed bonds to financial institutions in exchange for their non-performing loans. Accordingly, additional funds are not required at the time of purchase. As the bonds are guaranteed by the government, however, government finances will eventually come under pressure if the recovery of funds through disposal of those non-performing loans purchased does not go according to plan. As stated earlier, Danamodal is using funds released into the market through a reduction in the statutory reserve requirement. So far, it has raised only 11 billion ringgits of the 16 billion ringgits needed, and it has not revealed its plans for raising further funds.

Malaysia had planned to raise funds through an issue of global bonds in the summer of 1998, but was forced to cancel this issue when its credit rating was lowered. Unlike South Korea, which has seen its credit rating raised by several major international rating organizations, Malaysia's rating has yet to be reviewed.(15) This means that attracting private sector foreign investment remains problematical. Domestic funds in the form of employee pension funds, which amount to around 140 billion ringgits, are available as a recourse of last resort.

The second problem relates to the implementation of plans for restructuring. As discussed earlier in this article, a wide-ranging restructuring plan was developed for the finance companies under strong guidance of the government and the central bank. In January 1999, however, MBf Finance Bhd. and Kewangan Berusatu Bhd. were placed under the central bank's control, leading to the concern that the position of finance companies might have deteriorated more than had been anticipated. It is conceivable that plans for restructuring may need some revision or additional measures.

As far as commercial banks are concerned, the pace of restructuring has been slow. To date, merger plans have been announced in only two cases. The role of foreign capital in the consolidation of financial institutions will remain limited for as long as Malaysia maintains its 30% ceiling on foreign ownership.(16) Also, while the government has predicted that Danaharta would complete the disposal of non-performing loans six months ahead of schedule, by June 1999, it has to balance its non-performing loan purchases from financial institutions with efforts to recover the funds through the final disposal of loans through measures such as sale to investors.

The top priority, among measures to restructure the financial system in Malaysia, is to forestall the impending risk of an economic downturn. The government has moved to reduce the amount of non-performing loans held by banks by relaxing its definition of non-performing loans, but it has not implemented measures adopted in other countries, such as the forced consolidation of financial institutions. Of course, it is debatable as to whether or not a uniform tightening of regulations would be appropriate at a time of prolonged economic stagnation and increasingly serious problems with non-performing loans in the banking sector.

While Malaysia's approach is worthy of study in this respect, it has yet to produce benefits in terms of increased bank lending. By delaying the disposal of non-performing loans, the government may exacerbate the problem and increase the ultimate cost. Moreover, even if Malaysia is able to overcome its present problems with non-performing loans through its own unique approach, it will still need to develop a longer-term vision for its financial system. The consolidation of financial institutions is likely to prove an effective way of strengthening the financial system. Yet, if Malaysia is forced to seek foreign investment to support this process, it will also need to gain foreign approval through the adoption of global standards.

V. Indonesia

1. Fragile Financial System

As part of the structural adjustment measures in 1980s which were intended to reduce its dependence on oil, Indonesia has undertaken two major programs of financial reform, in 1983 and 1988. After first liberalizing deposit and loan interest rates, it subsequently implemented a series of deregulatory measures which included the removal of the prohibition on the new establishment of private national banks. The government also eased the standards governing branch establishment, and allowed foreign banks to move into the Indonesian market through joint ventures.

These banking reforms led to dramatic increases in the number of banks and branches and the value of lending and deposits, especially among private sector institutions. Between 1988 and 1997, the number of commercial banks (the total of state banks, private national banks, and foreign banks and joint banks) rose from 111 to 222, and the number of branches from 1,728 to 6,308. The balance of lending surged from 42 trillion rupiahs to 378 trillion rupiahs.

Unfortunately, improvements in credit investigation and management capabilities of banks and the supervisory capabilities of the authorities failed to keep pace with this rapid process of liberalization. Even before the currency crisis, a number of problems were becoming apparent. Banks lacked credit assessment capabilities. Some were lending predominantly to related companies, such as members of the same corporate group, while others, especially state banks, were making loans under pressure from powerful politicians and on the basis of personal contacts. In addition, there was widespread criticism over a lack of transparency and inadequate financial reporting, and the ineffective central bank supervisory and regulatory systems. Moreover, in recent years, banks increased their lending in the area of real estate development.

Many of the loans made within this fragile framework became suddenly unrecoverable when the currency crisis led to the crash of the rupiah, soaring interest rates, and an economic dive. Following the onset of the currency crisis, bank finances came under pressure, as deposit rates rose above lending rates and spreads turned negative (Fig. 8).

A statement issued by the governor of the central bank in June 1998 reported that the non-performing loan ratio for banks had risen from 10% in April 1997 to 25% in April 1998.(17) Non-performing loan ratio statistics are not published periodically in Indonesia. On the basis of subsequent economic trends, however, the non-performing loan problem seems likely to have deteriorated quite considerably. The American company Goldman Sachs has predicted that Indonesia's non-performing loan ratio will reach a peak level of 60%. On December 23, 1998, the Jakarta Post reported an estimate by local consultants that state banks had non-performing loans amounting to 150 trillion rupiahs, and that non-performing loans held by private national banks had reached 175 trillion rupiahs. Based on estimates by the local consultants, these figures represented non-performing loan ratios of 55-60% and 80%, respectively.

2. Restructuring of the Banking System

Indonesia's banking system is currently undergoing restructuring under the leadership of the Indonesian Bank Restructuring Agency (IBRA) established in January 1998. The principal technique used is the consolidation of banks.

In November 1997, immediately after Indonesia had concluded an agreement with the IMF on financial support, 16 private national banks were closed. The IMF stipulated that financial reform was one of the conditions for its assistance, and these bank closures were the first step in that process. As deposit protection was initially limited to 20 million rupiahs, however, the closures sparked increased unease about the banking sector. This caused deposits to flow from private national banks into state banks and foreign banks. As a result, the financial system plunged into crisis (Fig. 9). Immediate action was needed, and the central bank provided approximately 140 trillion rupiahs in liquidity to support the banks that were experiencing liquidity deficit. In January 1998, the government moved to provide full protection for deposits and credits, and to establish IBRA, as part of the financial system restructuring process.

Fig. 10 illustrates the process of consolidation of banks by IBRA. First, the 54 problem banks were placed under IBRA supervision. In April 1998, seven out of the 54 banks that had received the central bank's liquidity support that amounted to in excess of 500% of their paid-up capital, or 75% of their total assets, were suspended their operations. Another seven banks that had received liquidity support in excess of 500% of their paid-up capital and amounting to more than 2 trillion rupiahs were placed under the IBRA management. Among the banks placed under the IBRA management were the state-owned Bank Ekspor-Impor Indonesia (Bank Exim) and the second-ranked private national bank, Bank Danamon. Of the remaining 40 banks, eight have been removed from the IBRA supervision for various reasons, including the achievement of a capital adequacy ratio in excess of 5% following improvements in their financial positions.

In August, three of the seven banks under the IBRA management suspended operations. The government also announced the nationalization of four banks. One of these was the biggest private national bank, Bank Central Asia (BCA), which had been under the IBRA supervision since May. Four state banks, including Bank Exim, were merged to create the new Bank Mandiri.

In Indonesia, bank restructuring is being driven by the government using its powers of compulsion. To begin with, the government pursued a restructuring policy which promoted bank mergers. There was a series of announcements of voluntary mergers by private national banks in early 1998, in line with this approach. Subsequently, however, the government changed its policy stance, and IBRA began to suspend bank operations or to deprive them of their license. As these measures also targeted banks that had already announced mergers, one merger plan after another was canceled.

In September 1998, the government announced a recapitalization program involving the use of public funds. To some extent, this has established a framework for financial restructuring through a combination of consolidation measures for banks that cannot be rehabilitated, and rescue measures for those that can. Under the program, which targets banks with capital adequacy ratios that lie within the range of |25%-+4%, the government provides 80% of the funds needed to attain a 4% capital adequacy ratio. The banks must find the remaining 20% through their own endeavors. The program will be funded by government bond issues.

The first injection of public funds, amounting to 4.29 trillion rupiahs, was to be distributed among 12 banks, with Bank Lippo receiving 3.75 trillion. However, the fact that the owner of Bank Lippo is closely associated with President Habibie prompted criticism about a lack of transparency in the decision-making process, and the plan was canceled.

In March 1999, the government announced a package of measures targeting private national banks (Fig. 11). The package combines consolidation with injections of public funds. Of the 128 private national banks, 38 will be closed and seven nationalized. Another nine will receive injections of public funds, while 73 had a sufficient level of capital and will not need recapitalization by the government. (The single remaining bank is still under assessment.)

The Asset Management Unit (AMU) was established within IBRA as the official agency responsible for the purchase of non-performing loans. The assets of closed banks are transferred to the AMU, which will sell them on. In general, however, there has been little progress with these asset disposals.

Related systems are also under review. The minimum capital adequacy ratio, set at 4% until the end of 1998, will be tightened to 8% at the end of 1999, and then to 10% by the end of 2000. A ceiling has been lowered on banks' net open foreign exchange, and financial reporting requirements have been strengthened. The banking law has been revised to allow 100% foreign ownership. In reality, however, the banking sector will not be able to attract foreign investment until other changes are made, including the restoration of political and social stability, an improvement in information disclosure by banks, and the achievement of greater transparency in the government's administration of the banking sector. While there has been some progress with financial system reform, many issues still need to be tackled if these changes are to be effective.

In relation to private sector corporate debt, the government has amended the much criticized bankruptcy law. The changes are expected to speed up procedures for the exercise of rights and to bring greater transparency to the process. Nevertheless, problems remain. At present, the only commercial court is in Jakarta (though there are plans to establish such courts in other locations, such as Ujungpandang and Medan), and there is a need for the recruitment and training of personnel who can administer the law.

In addition, the government has announced the "Jakarta Initiative" as a mechanism that will complement the bankruptcy laws. This arrangement is designed to avoid bankruptcy procedures by encouraging out-of-court settlements through mediation between creditors and debtors.

The disposal of external debt by private sector companies is another major issue. This amounts to US$64.5 billion (March 1998) and is equivalent to almost half of Indonesia's total external debt of $138 billion. The purchase of U.S. dollars to repay debt was one of the factors that drove down the value of the rupiah. Following negotiations with a consortium of foreign creditor banks, the government established the Indonesian Debt Restructuring Agency (INDRA) and secured an eight-year deferral. Participation in this scheme is voluntary, however, and the repayment terms are such that neither debtors nor creditors derive major benefits from participation. For these reasons, it appears that there has been little progress with the disposal of debt under the scheme.

3. Long List of Issues

Indonesia's non-performing loan problem is significantly more serious than the difficulties faced by the other three economies examined in this article. It has been slow to deal with the problem, and the effectiveness of the measures announced to date is doubtful.

One source of concern is the impact on government finances and the ability of the government to fund the measures. It is estimated that injections of public funds totaling more than 300 trillion rupiahs will be needed for recapitalization of banks. The government plans to raise the necessary funds through bond issues, but the amount required is equivalent to approximately 30% of GDP and exceeds total annual government expenditure. Interest payments on the bonds will reach an estimated 34 trillion rupiahs. The government has set aside 18 trillion rupiahs for this purpose in its budget for FY1999 (April 1999-March 2000). Sources for the remaining 16 trillion rupiahs include the sale of assets transferred to the AMU from closed banks. It is not certain, however, that the sale process will proceed as planned.

There has also been public anger over the government's decision to shoulder the massive cost of financial restructuring.(18) Clearly, expenditure on financial restructuring has reduced the government's ability to spend funds on such things as social safety nets at a time when the rapid economic decline is causing increasingly serious unemployment and poverty. Moreover, the 300 trillion rupiahs will be used entirely for recapitalization, and the way in which the crucial task of disposing of non-performing loans is to be approached is less than clear.

If the disposal process is to be carried out by individual banks using funds injected by the government, it may be difficult to find buyers, acquire the necessary knowledge and experience, or recruit qualified personnel. If the loans are purchased by the AMU, the fiscal cost will increase still further. While international financial support (or, in some cases, increased support) is another possible option for purchasing the loans, that approach would also impose a heavy burden on government finances because of future repayment obligations.

The implementation of recapitalization plans is a second area of concern. Even the nine banks that will receive injections of public funds will need to borrow 20% of the funds required to recapitalize on its own efforts. However, it will be difficult to find investors in Indonesia or overseas at a time of deep recession in the domestic economy and continuing social and political unrest. Moreover, the current capital threshold of 4% is inadequate by global standards, and banks must raise their capital ratios to 8% by the end of 1999.

Also, the measures announced in March 1999 apply only to Indonesian private national banks. However, while the role of state banks is tending to decline in Indonesia, they still occupy an important position. For example, they account for 45% of total commercial bank lending (November 1998). The only action in relation to state banks has been the announcement of a merger between four banks. The government will need to formulate and implement further restructuring measures, including recapitalization measures.

A third problem is the continuing political and social unrest with the approach of the general election and the presidential election. This situation is hindering the adoption and implementation of measures to reform the financial system. In addition, it will have a negative effect on foreign investment.

Finally, the financial restructuring measures have little credibility. There is still no regular publication of non-performing loan statistics in Indonesia, and the government has been slow to disclose information about such items as the terms and schedule for injections of public funds and schemes for the disposal of non-performing loans. The inconsistency of government policy is another issue, as evidenced by frequent changes in the capital ratio rules.(19) The government has also attracted criticism because of the lack of transparency in the decision-making process that led to the selection of Bank Lippo as a recipient of public funds. It is to be hoped that the government will formulate and steadily implement restructuring measures that will be seen as credible in both Indonesia and overseas.

‡Y. Evaluation of Non-performing Loan Disposal Policies

Fig. 12 shows the banking system restructuring process with particular emphasis on the disposal of non-performing loans. The disposal process is divided into (1) the emergence of the non-performing loan problem, (2) recognition of the problem by governments and private sector financial institutions, (3) ascertaining the real extent of the non-performing loan problem, (4) developing policy packages, (5) implementing policy packages, and (6) reaction by private sector banks.

The four countries examined in this article are already on track toward the establishment of related institutions (deposit insurance corporations, non-performing loan purchasing institutions) and the enhancement of their functions. They have also made considerable progress with the development of schemes to recapitalize through injections of public funds, and with improvements to their legal systems in relation to the disposal of non-performing loans. In these countries, the non-performing loan disposal process has now reached the implementation stage. The pace and extent of the process will probably be influenced considerably by such factors as political leadership and the extent to which the required funds can be raised domestically.

There are three key issues in relation to the disposal of non-performing loans and the future restructuring of the banking system. First, in the four countries discussed in this article, private sector financial institutions have generally been slow to react to non-performing loan disposal measures.(20) As discussed at the start of the article, the growth rate of bank lending has fallen continuously, and there has been little progress toward mergers or tie-ups instigated by private sector banks.

Second, it will take a considerable period of time to resolve each country's entire non-performing loan problem. Unless governments play a direct role in the disposal of non-performing loans, it will not be possible to break out of the vicious circle of expanding corporate debt, declining real economic performance, and shrinking bank credit. From a national perspective, however, the acceptance of non-performing assets from private sector banks by non-performing loan purchasing agencies merely shifts the non-performing loan problem from the private sector to the public sector. The non-performing loan problem will not be truly resolved until the process in the public sector is completed.(21)

Third, in addition to the disposal of non-performing loans and conformance with global standards,(22) it will also be necessary to develop a long-term vision for the restructuring of the financial system. For example, how can profitability of banks be improved? What kind of financial structure should be created to include foreign financial institutions? How should financial and capital markets be fostered? There are many other questions to be answered in relation to financial system restructuring.

In South Korea, extremely low ROA ratios are a feature of its banks. (ROE is higher because capital ratios are low.) Interest margins are extremely low compared with those achieved in other countries, and it appears that South Korean banks were lending on extremely narrow spreads. Moreover, internal growth rates of capital were low, and capital bases were inadequate.

In Asia, conditions are not adequate for this radical approach for a number of reasons. First, there are few investors or intermediaries (with high risk tolerance) willing to undertake active acquisition of non-performing loans. Second, Asian countries have been slow to develop the legal systems and the mechanisms, such as courts, needed for the disposal of non-performing loans. Third, some governments restrict ownership of real estate by foreigners. Fourth, governments cannot afford to provide non-performing loan purchasing agencies with adequate funds.

There is debate about whether developing countries introducing global standards should apply regulations that are stricter than those standards. (See Rojas-Suarez [1997], pp.35-43.) Broadly speaking, the debate is between those who believe that regulations should be stricter, since Asian banks are exposed to greater risk than their counterparts in developed countries, and those who advocate looser regulation as way of encouraging increased bank lending and achieving rapid economic growth.

Thailand, which is currently under IMF supervision, has tightened its definition of non-performing loans and introduced bad debt reserve requirements as strict as those applied in the United States. However, these measures have caused a further decline in the lending capacity of banks. In addition, Thailand eased its ceiling for foreign ownership of financial institutions (from less than 25% to a majority shareholding over a ten-year period) because it needed the support of foreign financial institutions to drive the consolidation of its banks.

In contrast, Malaysia has given priority to the stimulation of its economy. In September 1998, the Malaysia's definition of non-performing loans was eased from "three months in arrears" to "six months in arrears." Malaysia is not under IMF supervision, its non-performing loan problem is smaller than that of Thailand, and the funds required to dispose of non-performing loans are generally being raised within Malaysia. There is little need for Malaysia to accept the support of foreign financial institutions in the restructuring of its domestic banks. For this reason, there seems to be little incentive for Malaysia to ease its restrictions on foreign ownership of financial institutions or to promote itself overseas as conforming to global standards.

In any case, global standards are not a universal panacea. They need to be used in conjunction with a variety of complementary indicators (early warning signs), including deposit-loan ratios, foreign currency borrowings, lending to specific industries and companies, the ratio of short-term borrowing, indicators of bank financial positions, corporate debt trends, interest rates, and exchange rates.

VII. Financial System Restructuring and Support from Japan

The Japanese government has provided huge amounts of economic assistance to Asia since the onset of the Asian currency crisis. In October 1998, Finance Minister Miyazawa announced a financial assistance scheme totaling US$30 billion. The scheme consists of $15 billion in medium- to long-term assistance to facilitate real economic recovery in Asian countries, and $15 billion to cover any demand for short-term funds during the economic reform process. Known as the "New Miyazawa Initiative," this scheme is extremely significant for the restructuring of financial systems in Asian countries.

First, the substantial size of the scheme makes it attractive to Asian countries, which have seen increasing limitations on their access to funds. During 1998, international syndicated lending to the ten major Asian economies (the NIEs, the ASEAN-4, China, and India) amounted to US$33.2 billion, a decline of 66% from the previous year's level. Similarly, fund raising through international bond issues declined by 71.9%, to US$11.3 billion. The only government that has been able to arrange foreign currency-denominated bond issues since the start of the currency crisis is that of South Korea (US$4 billion). Funds received in the form of financial assistance will have a significant positive effect on economic recovery, provided that the money is applied to public investment, social safety nets (albeit indirectly), and financial system restructuring.

Second, the scheme prepares to back up the credit status of Asian countries. Under the scheme, the Export-Import Bank of Japan will guarantee borrowings from private sector financial institutions by Asian countries. It will also guarantee sovereign bonds issued by Asian governments (though this will require a legislative amendment). In addition, the scheme will provide trade insurance coverage for those loans to Asian countries by private sector financial institutions. Plan has also been made for the establishment of an interest subsidy fund. This will allow the subsidization of interest on those loans provided to Asian countries by the Export-Import Bank, private sector financial institutions, and other organizations, in cooperation with the Asian Development Bank.

Third, the New Miyazawa Initiative also calls for the provision of support for measures to rebuild financial systems and restructure corporate debt. Such support is essential if Asian countries are to be able to break out of the vicious circle of simultaneous financial system reform, restructuring of corporate debt, and declining real economic performance. On a practical level, there are many issues that need to be tackled. In some Asian countries, however, the problems are now so serious that financial system reform and corporate debt restructuring would not be possible without injections of public money from other countries. (In such cases, companies must be selected carefully and monitored closely.) Financial support for the restructuring of corporate debt is linked to the question of which companies and industries should be helped to survive. Accordingly, support must be coordinated with the industrial policies of the governments concerned.

Fourth, the New Miyazawa Initiative has also raised expectations about the creation of conduits for the supply of funds to local companies. Since the start of the currency crisis, there has been an increasing emphasis on policy finance concepts based on the assumption that funds will be targeted toward such areas as agriculture, exporters, and small- and medium-sized companies. This is not limited to the New Miyazawa Initiative. In order to supply funds to target companies in such areas, it will be necessary to establish and expand related institutions, such as small industry finance corporations and credit guarantee associations.

It will also be necessary to establish monitoring agencies and other organizations capable of providing objective assessments of companies' financial positions and business plans. Technical assistance from private sector financial institutions will also be needed. The argument that conduits should be created to supply funds efficiently to local companies is not a new one, and had been put forward even before the onset of the currency crisis. As part of present efforts to provide financial and technical assistance to Asia, conduits should be established to channel domestic and foreign public funds into local companies.

Conclusion

There has been continuous debate over the reasons for the spread of the currency crisis to so many Asian countries. The focus of discussion now should be on the fact that the "non-performing loan contagion" had spread so widely through the Asian countries, including to those that were not forced to devalue their currencies. From a financial perspective, it seems inevitable that a considerable period of time will be required before definite timetables can be established for the radical disposal of non-performing loans, the financial intermediation functions of financial institutions can be restored, and the Asian economies can return to substantial growth performance.

In the four economies examined in this article, private sector financial institutions cannot afford to meet the cost of dealing with the non-performing loan problem. For this reason, governments are taking an active role in efforts to dispose of non-performing loans. If the governments concerned cannot solve the problem, the only alternative will be an approach based on a regional or international framework. The IMF can only supply funds in response to international balance of payments crises, and it cannot provide the funds needed to restructure banking systems and, in particular, to dispose of non-performing loans.

Since the onset of the Asian currency crisis, there have been calls for the establishment of an "Asian Monetary Fund" to stabilize exchange rates. Yet, the problem now facing Asia is not currency stability, but financial system restructuring. That is why Japanese support for Asia is so important. The New Miyazawa Initiative and other forms of support for Asia are expected to be effective in restoring the credibility of financial systems in Asian countries.

In addition to the issues discussed in this article, such as improvements to various systems and injections of public funds, the restoration of credibility is also absolutely vital in terms of rebuilding banking systems and restoring financial intermediation functions. In 1996, net inflows of capital into private sector banks in Thailand, which was the first country affected by the currency crisis, amounted to US$5 billion. Subsequently, however, the direction of the flow changed. Funds totaling 8.3 billion flowed out in the second half of 1997, and the outflow reached $13.6 billion during 1998 (Table 8).

Though the baht began to stabilize after February 1998, its credibility with various institutions and sectors, including IMF economic restructuring measures, private sector companies, the banking system, the governments, and banks in developed countries, has not yet been restored. Unless credibility can be restored, the restoration of financial intermediation functions will not be possible, regardless of improvements in economic systems (such as the creation of agencies or legal systems for the disposal of non-performing loans), and financial policies will not be fully effective.

End Notes

1. The non-performing loan problems currently affecting the Asian economies are more serious than those experienced in the past by economies in other regions. An analysis of non-performing loan ratios recorded during banking crises in developed countries and Latin American nations reveals that even the all-time high, recorded in Mexico at the end of September 1994, was just 10.6%. As shown in Table 1, the Asian economies have recorded significantly higher ratios, which include 50.1% for Thailand (end of January 1999, government figure) and around 60% for Indonesia (an estimate, published in January 1999 by Goldman Sachs).
2. The weakness of the banking sector is reflected in growing concern about loan losses on real estate lending. With the exception of South Korea, financial authorities in the economies studied in this article were concerned about real estate-related lending before the onset of the currency crisis. For example, Thailand imposed limits on the expansion of bank credit in 1995, while Malaysia introduced restrictions on real estate-related lending in the first half of 1997.
3. See Takayasu [1998] for a discussion of trends in the banking sector from times about the onset of the currency crisis to March 1998.
4. Taxed on interest income.
5. Suzuki [1993], Fukagawa [1997], and Kwon [1998].
6. The Korea Times, March 24, 1998.
7. Nihon Keizai Shimbun, July 10, 1998.
8. The Korea Times, December 23, 1998.
9. The prolonged duration and the increasing gravity of the economic crisis have also been reflected in the dramatic rise in non-performing loans to the manufacturing sector.
10. Business Times (Malaysia), March 11, 1998.
11. Business Times (Malaysia), September 18, 1998.
12. There was a case in which a major loan in excess of 3 billion ringgits was purchased for only 4 ringgits. If this is excluded, the discount rate falls to 37%.
13. Danamodal home page ("Danamodal Inaugural Bond Issue of RM11 billion")
14. The statutory reserve requirement was also reduced in February and July of 1998.
15. On March 31, 1999, S&P upgraded its outlook of Malaysia from "negative" to "stable".
16. On the subject of limitations on foreign ownership, Prime Minister Mahathir has ruled out any easing of the restriction on bank ownership by foreigners in the foreseeable future. However, he has also said that the stock ownership ratio could be raised if there is a pressing need for funds.
17. Jakarta Post, June 17, 1998.
18. Jakarta Post, January 6, 1999.
19. In February 1998, the minimum paid-up capital requirement was suddenly raised from 150 billoin rupiahs for foreige exchange banks and 50 billion rupiahs for non-foreign exchange banks; banks were required to raise their paid-up capital to I trillion rupiahs by the end of 1998, to 2 trillion rupiahs by the end of 1999, and to 3 trillion rupiahs by the end of 2003. Later, the deadline for reaching the level of 2 trillion rupiahs was extended to the end of 2000 (in February 1998). Also, the level that sound banks were required to attain by the end of 1998 was reduced from 1 trillion rupiahs to 250 billion rupiahs (April 1998). Othrer changes included a decision to exempt existing banks from the 250 billion rupiah requirement(June 1998).
20. Do Asian banks have the resilience to withstand external shocks such as the currency crisis and the dramatic shifts in macroeconomic indicators that follow in their wake? The fragility of the business bases of Asian banks is apparent from their financial indicators. The return on assets (ROA) and the return on equity (ROE) of commercial banks in Thailand were deteriorating even before the onset of the currency crisis. Their deposit-loan ratios (loans/deposits) surpassed the 100% level while their quasi-liquid asset ratios were low.
21. The disposal of non-performing loans is taking a long time because conditions in Asia are not conducive to radical disposal. As shown in Fig. 13, banks not only lose interest incomebut must also provide for bad debt reserves if they reclassify their normal loans as non-performing loans, after principal and interest payments have been in arrears for a certain period, or when loans are deemed to be unrecoverable. Normally, in such cases, non-performing loans remain on balance sheets as loans (= indirect write-downs. Final losses are not yet confirmed at this point.) On the other hand, radical disposal through direct write-downs results in the removal of non-performing loans from balance sheets and their inclusion in P/L statements as a loss. While this approach confirms the loss, the fact that the loans are removed completely from the balance sheet benefits banks by reducing maintenance costs and improving capital ratios through the reduction of assets.
22. The present banking system restructuring process is characterized by strong awareness of the need to conform to global standards. Global standards cover such areas as (1) prudential regulations (capital ratio requirements, definitions of non-performing loans, bad debt reserves) and those relating to the soundness of bank management, (2) disclosure and those relating to corporate governance, (3) those related to the transparency of financial administration, and (4) those related to legal systems and commercial practices.

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