David Hale: ASIA NEEDS TO OPEN BANKS, REIN IN FAMILY CONTROL

Date: 01-26-2001

David Hale, global chief economist, Zurich Financial Services in Chicago, and speaker at the East-West Center's Asia Pacific Executive Forum on "Doing Business in a Changing Asia: A Strategic Vision" held Jan. 16-19. Topic: "Corporate Restructuring after the Asian Crisis"

ASIA NEEDS TO OPEN BANKS, REIN IN FAMILY CONTROL
China Economy Likely To Become More Open Than Japan, Korea

The Asian financial crisis will "go down in the history books as the harbinger of massive structural change in the region's economic system, not just a cyclical correction after several years of robust growth." The crisis "was unique in the modern history of emerging market economies" because it resulted from microeconomic problems, not traditional cyclical imbalances such as large fiscal deficits or higher inflation. Poor banking regulation, government industrial policy and cronyism between bankers, companies and politicians were at the heart of the problem.

As a result, Thailand, Korea and Indonesia have opened their banking systems to foreign investment for the first time. Thailand has sold several medium-sized banks, Korea one major bank and large shareholdings in other banks, and the Indonesian government will probably try to sell local banks to foreign banks in the future because the cost of the domestic bank rescue has doubled the ratio of public debt to GDP.

These countries must open their financial systems because local banks continue to have a high level of non-performing loans: in Thailand, about 23 percent of the total; Indonesia 17 percent; and Korea 13 percent.

Other trends are clear: a general recognition that corporations must be "more transparent and more protective of the rights of minority shareholders"; and there will be greater reliance on funding companies through capital markets rather than just banks. The total value of corporate IPOs in East Asia was more than $18 billion last year compared to $8.5 billion in 1999. Countries are also opening more to foreign direct investment. Korea has seen FDI triple in the past five years from $9.5 billion in 1995.

Korea, with the "most interventionist industrial policies of any non-communist country in the region" prior to the crisis, has seen the most dramatic corporate restructuring reforms. The government permitted several major banks to go bust and then recapitalized them with state funds while permitting foreign banks to invest for the first time. It allowed Daewoo to go bankrupt and Hyundai is in the midst of restructuring to divest major assets. The government has also banned corporate cross-guarantees of lending. The upsurge of bankruptcies has led to a sharp rise in the level of unemployment and weakened the power of Korea's trade unions.

In 1999, Korean firms took advantage of a resurgent stock market to raise a great deal of equity capital. The long-term challenge will be to establish insurance companies and investment management organizations that are "truly autonomous from the industrial sector and allocate capital on the basis of enterprise profitability."

Indonesia has purchased $80 billion of bad loans and is trying to sell off assets to the private sector. But powerful Chinese families are trying to regain control of their firms while there is political pressure to sell assets cheaply to indigenous business groups.

The critical corporate governance problem in the Southeast Asian countries is the dominant corporate control of the family firm, controlling 81 percent of Indonesia's stock market capitalization, 50 percent in Thailand and 44 percent in Malaysia. As Hugo Restall explained in a Wall Street article: "'The family benefits at the expense of minority shareholders because the publicly listed companies pay paltry dividends while directing the lion's share of the profits back to the privately owned portion of the group through preferential pricing. Related-party transactions are subject to great public scrutiny in Europe. But in Asia they pass under the radar screen. In many companies where the family's ownership stake in the company is small, shareholders apparently don't even realize they are being fleeced.'"

Large debts can leave the shareholders holding the bill; and if the group acquires its own bank, companies can borrow more freely for speculative investments. If anything goes wrong, the government will be expected to protect those creditors from losing their money. "If Asian firms now depend more heavily upon capital markets than banks, there will have to be major changes in the relationship between management and shareholders."

Another factor which could encourage such a change is the rise of information technology in Asian equity markets. Both Hong Kong and Korea have created new specialized equity markets for technology companies. Moreover several Asian companies have also used NASDAQ to obtain capital.

"Ironically, the country which is now pursuing the most radical reforms in capital market structure, corporate governance and other financial practices is the one which was least affected by the Asian crisis -- China...These reforms could result in China having the largest equity market in Asia within 20 years while also boasting a far more open economy than either Japan or Korea have even today." One of the objectives that China should set for its next stage of economic development is the creation of a stock market with a capitalization of more than $1 trillion.

China re-established domestic stock markets in 1991 while many Chinese companies have obtained listings in Hong Kong, New York and other foreign markets during recent years. The aggregate value of all these companies is about $500 billion. A new Internet company, China.Com, went public last June and now has a market capitalization of over $6 billion while NASDAQ hopes that another six will come to market this year.

With goals of a 7-8 percent steady growth in GDP, expansion of China's stock market could help private companies raise capital while permitting the government to promote further privatization of state enterprises.

China faces many challenges: 30-40 percent of all loans are non-performing while the stock of loans is equal to about 100 percent of the $1 trillion GDP. Since 75 percent of all loans are to state owned enterprises, it will be difficult for the government's bank restructuring agencies to extract value from the troubled loans unless there is a stock market to encourage privatization or create some form of secondary market for assets. At present, about half of China's economy is privately owned but the revival of the banking system will probably require the government to expand this ratio to 70-80 percent.

Second, China has a weak revenue collection system. The total stock of government debt is still a modest 21 percent of GDP. But since tax receipts are only about 13 percent of GDP compared to 20 percent in other developing countries, it will be far more difficult for China's government to sustain a rising ratio of debt to GDP. "The government could use the stock market to reduce borrowing until it has more time to create an effective tax system."

Third, China has a rapidly aging population that will require the development of pension funds in order to finance retirement. In 2045, more than half of China's population will be over the age of 50. The development of pension funds will require a parallel growth of capital markets to provide an outlet for the investment of retirement savings.

Fourth, the growth of the stock market could help China's private sector to expand more rapidly and bolster employment at a time when many state enterprises are shedding labor. In 1989, the enterprises laid off 5.6 million workers.

Finally, the emergence of the stock market as an important vehicle for allocating capital would help to lessen the risk of China experiencing future financial crises comparable to those that gripped East Asia during the late 1990s.

The great question that the government must resolve is the role of foreign investors. They are not permitted to purchase A shares, but they can invest in B shares as well as companies listed in Hong Kong, New York or other foreign markets. Meanwhile, China's own citizens have no opportunity to invest in some of the country's most exciting new technology and telecommunications companies because they are listed in Hong Kong and New York.

"China has attempted to maintain a rigidly segmented securities market because of concern about exchange controls. But there are many examples of how a country can regulate capital inflows without completely denying foreigners access to the local stock market."

China has already enjoyed tremendous success in attracting foreign direct investment. The current stock of FDI in China is $350 billion or the third largest in the world after the U.S. ($1.1 trillion) and Britain ($550 billion). Some Hong Kong brokerage firms are projecting that membership in WTO will boost China's FDI to levels as high as $100 billion per annum by 2005. With such high levels, China should be attracting at least $10-20 billion per annum of portfolio investment. In fact, during 1999, China used both the global and local capital markets to finance $12.9 billion of new IPOs or two-thirds the total for all of East Asia less Japan.

"A new system of one unified equity market with ownership ceilings on foreign investors would produce far superior outcomes for everyone than the current system of one country/multiple markets."

David Hale can be reached at 312-537-1960 or debra.hamilton@kempter.com

This is an East-West Wire, copyright East-West Center