National Markets and Institutions to Support Financial Development in East Asia Gordon de Brouwer, Masahiro Kawai and Jay Rosengard* 1. Introduction The experiences of the past few years have highlighted the importance of getting the basic institutional features of a country’s organisations and markets right. This is particularly important for financial institutions and markets because they play a key intermediation role in the economy in general. Poorly developed financial markets and institutions impose a constraint on economic development. And weaknesses in financial markets and institutions make an economy vulnerable to domestic and international adverse economic shocks. The pressure for robust markets and institutions has increased in recent years (CMCG Working Group of the 2003). The East Asian financial crisis, ongoing crises in Latin America, serious corporate governance problems in industrialised economies, and the focus on the ‘security agenda’ have combined to heighten investor sensitivity to country risk and led to a greater centralisation of decision-making on foreign investment within firms. Competitive pressures in East Asia have increased. China’s accession to the WTO in 2001 is seen as a firm commitment to reform, marketise and internationalise its economy, which, along with sustained economic growth, poses a serious challenge to similar markets to attract foreign capital and keep domestic capital. The aim of the paper is to talk through some of the issues policymakers face at the national level in thinking about financial markets, institutions, and systems. We start in Section 2 by reviewing the evidence on the importance of well-functioning markets and institutions in general. At the heart of this is the adequate provision of ‘market and institutional infrastructure’ – the rule of law, well-functioning bureaucratic and regulatory processes, and control of corruption. In Section 3, we look at recent developments in the region’s financial markets. While the demographics and production possibilities in East Asia offer huge opportunities, financial markets in the region are relatively poorly developed. There is scope for substantial improvement in equity, bond, foreign exchange, and derivatives markets. This would enable firms and households to diversify their saving and investment opportunities, as well as provide the means to better manage financial risk. More openness in financial markets might also be helpful in improving the efficiency of markets. In Section 4, we review recent developments in financial institutions in the region. While some progress has been made in dealing with problem and bad loans, post-crisis
*
Gordon de Brouwer is Professor of Economics, Asia Pacific School of Economics and Government, Australian National University; Masahiro Kawai is Professor of Economics, University of Tokyo; and Jay Rosengard is the Director, Financial Sector Program, Center for Business and Government, John F. Kennedy School of Government, Harvard University. Comments are welcome to
[email protected],
[email protected] and
[email protected].
adjustment is still incomplete. And financial institutions face new risks, not least in terms of dealing with the effects of business cycle variability and asset price bubbles. This poses a new set of challenges for firm management and supervisors alike. In Section 5, the focus of the paper shifts to microfinance. Many East Asian countries are still low-income emerging and transition economies. In these economies, banking and other formal financial services tend to be directed at more established firms and households in higher income groups, and not the small low-income independent business operator (like street vendors, unregistered maintenance workers, and handicraft producers). Low-income workers in emerging economies typically have no access to the financial system, and so microfinance institutions offer substantial benefits as a potential savings and lending vehicle. There is evidence to show that microfinance can be a profitable business for banks. The challenge is for banks to recognise this and develop the products, processes, and systems to deliver these financial services. Section 6 concludes the paper. 2. The Quality of Infrastructure in Markets and Institutions For financial markets and institutions to develop and function effectively, they need to be supported by adequate and appropriate ‘infrastructure’. At its most basic level, ‘infrastructure’ refers to the rule of law and the clear definition and protection of private property rights. In recent years there has been a surge in the study of legal and governance frameworks that underpin and support the development of markets and institutions, including with respect to the financial sector. Examples include the sets of papers written around La Porta La Porta, Lopez de Silanes, Shleifer and Vishny (1998) and Kaufman and Kray (2002). The literature argues that the quality of infrastructure can be judged by a number of key factors: an effective legal framework, reliable accounting and disclosure standards, an efficient and reliable clearing and settlement process, and reliable and easily accessible information (La Porta, et al. 1998; Herring and Chatusripitak 2000). How does East Asia perform? Based on La Porta et al. (1998), Herring and Chatusripitak (2000) set out a collection of tables assessing countries by the quality of their financial infrastructure, creditor rights, judicial systems and information systems. These are replicated in Table 1 for the region’s four relatively developed markets (Japan, Singapore, Hong Kong and Australia), six emerging markets (Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand); the United Kingdom and the United States are included as reference markets. As set out in Herring and Chatusripitak (2000), the quality indicators set out in Table 1 include contract realisation (the converse of the risk of contract modification by government through repudiation, postponement, or scaling down), lack of corruption (special payments or bribes to officials), rule of law (a tradition of law and order), bureaucratic quality, accounting standards (based on inclusion and omission of key items in a large sample of company reports), and press freedom (repressive actions and laws on the press). Press freedom is included on the grounds that it gives business people and investors a sense of the degree to which they can get full, reliable and easy access to information relevant to their investment choices. These are obviously qualitative
2
subjective assessments. While the exact ordering of economies may vary slightly, the general placement of the ordering is robust to the inclusion of other factors or exclusion of included factors.
Table 1: Indicators of Quality of Financial Infrastructure 0 to 10 scale, higher is better Total score Australia Hong Kong Indonesia Japan Korea Malaysia Philippines Singapore Taiwan Thailand
9.06 7.75 3.52 8.67 6.73 6.55 4.14 7.58 7.50 6.50
Contract realisation 8.71 8.82 6.09 9.69 8.59 7.43 4.80 8.86 9.16 7.57
Reference markets United Kingdom United States
8.93 8.99
9.63 9.00
Lack of corruption 8.52 8.52 2.15 8.52 5.30 7.38 2.92 8.22 6.85 5.18
Rule of law
Accounting standards 8.0 7.3 n/a 7.1 6.8 7.9 6.4 7.9 5.8 6.6
Press freedom
10.00 8.22 3.98 8.98 5.35 6.78 2.73 8.57 8.52 6.25
Bureaucratic quality 10.00 6.90 2.50 9.82 6.97 5.90 2.43 8.52 n/a 7.32
9.10 8.63
8.57 10.00
10.00 10.00
8.5 7.6
7.78 8.72
Source: adapted from Herring and Chatusripitak (2000), based on LaPorta et al. (1998)
The differences between markets are striking. The four developed markets of Japan, Singapore, Hong Kong and Australia stand out as the high quality markets, with Australia and Japan on a par with the quality of infrastructure in the UK and US financial markets. Singapore is disadvantaged by its relative lack of freedom of access to information. The emerging East Asian markets as a whole are below developed market quality but there are two clear sets: Taiwan, Korea, Malaysia and Thailand in the middle, and the Philippines and Indonesia at the bottom. This breakdown should come as no surprise. It largely matches sovereign debt ratings, as shown in Table 2. There is room for improvement in all markets, and this is most compelling for the less well developed economies of the region. To us, this implies that there is enormous scope for cooperation between countries in the region to build up capacity. Table 1 has a number of shortcomings. It does not include China or other transition economies, and it does not give a sense of the changes that have occurred in the region over the past five years since the East Asian crisis. There have been substantial changes to the laws concerning corporate and general governance in the region since the crisis, although there are concerns about the enforcement of these changes (OECD 2003). We examine this in two ways. The first way uses the result that the various measures of governance examined in papers on this issue – voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption – are highly correlated with each other. This is useful because there are adequate time series for some of these variables, especially corruption. To this end, Figure 1 plots Transparency International’s estimate of corruption for a number of economies from 1995 to 2003.
3
9.12 6.72 2.86 7.92 7.36 3.90 5.54 3.44 7.16 6.02
Table 2: S&P Foreign Currency Sovereign Credit Rating Long Term AAA BBB A+ CCC+ AABBB+ AA+ BB+ AAA AAABBBBB-
Australia China Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore South Korea Taiwan Thailand Vietnam
Ratings Outlook stable stable stable stable negative stable stable negative stable stable stable positive stable
Short Term A-1+ A-3 A-1 C A-1+ A-2 A-1+ B A-1+ A-2 A-1+ A-3 B
Source: Standard & Poors website. Notes: ratings as at 3 March 2003; the highest long-term rating is AAA and lowest is C.
Figure 1: Corruption 10
New Zealand Singapore
9
Canada
Australia
8
Hong Kong
United States
7
Japan
6
Malaysia
5
South Korea
4
China
3
Thailand Philippines
2 Indonesia
1 0 1995
1996
1997
1998
1999
2000
2001
2002
2003
Source: Transparency International
The second way draws on Kaufman and Kray (2002) who provide estimates of ‘governance’ for two time periods, 1997/98 and 2000/01. Figure 2 plots the results for selected regional economies for these two years for the ‘rule of law’, which measures such things such as incidence of crime, effectiveness and independence of the judiciary, and enforcement of government contracts on a rising scale of –2.5 to +2.5. Economies below (above) the 45-degree line are ones where the score has risen (fallen). The standard errors in their estimates are large, so these changes are seldom statistically significant. Nevertheless, while imperfect, they are some indication of how things have changed.
4
Figure 2: ‘Rule of Law’, 1997/08 and 2000/01 2.5 Sg
2.0 1.5
NZ
above the 45 degee line means a deterioration
SK
1997/98
1.0
H
Tw
Jp US
Myl
0.5
Th Ph
0.0 -0.5 Myn -1.0
Vn Nk Id
Chn Cm below the 45 degee line means an improvement
Lao
-1.5 -2.0 -2.5 -2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
2000/01
Source: Kaufmann and Kray (2002)
There are two sets of results from these figures. First, there is substantial diversity in governance between economies in East Asia and the measures provide a fairly consistent profile. Japan, Singapore, Hong Kong and Australia tend to be among the economies with strong market, legal and governance infrastructure, while Cambodia, Indonesia, Laos Myanmar, North Korea, the Philippines and Vietnam tend to have the weakest. Second, not much has changed for most economies; the implication is that deep change seldom occurs quickly. But there has been some change. Notable improvers over the past five years are China and Laos, albeit from a low base, while Indonesia and the Philippines seem to have deteriorated (and in the case of the Philippines, this is after a period of improvement in the second half of the 1990s).1 3. Recent Developments in Financial Markets The potential for financial market development in East Asia is huge. On the supply side, the rapid economic growth that has characterised many countries in the region over the past three decades offers many potentially high-return long-term investments in productive infrastructure and services. On the demand side, a combination of relatively young populations and increasingly broad coverage of mandatory insurance and retirement programs has led to a sharp growth of insurance and pension funds. This creates a rapidly accumulating stock of long-term funds in search of attractive investment opportunities. The challenge is to develop the appropriate investment instruments and institutions, together with an enabling legal and regulatory environment, to match these long-term funds with long-term investment opportunities.
1
When Kaufman and Kray’s estimate of ‘regulatory frameworks’ is plotted instead of ‘rule of law’, there is a substantial deterioration for Indonesia in 2000/01 from 1997/98.
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3-1. Stock markets Given that they are relatively developed (compared to other financial markets in the region) and accessible by foreign investors, there is considerable focus on East Asia’s stock markets. Regional stock markets have had a mixed performance in the post crisis period, although much of this reflects uncertainty caused elsewhere by the collapse of the US technology bubble and the effects of the US slowdown, terror attacks and war in Iraq. The region as a whole now comprises over 10 per cent of the global stock market indices; Table 3 show recent developments in the S&P Global Index. Japan tends to dominate the region but it is waning, with the South Korean and Australian markets recording the largest rises in index share over the past five years. Table 3: East Asian Equity Market Capitalisation Shares, S&P Global 1200 Index 1997 1998 1999 2000 2001 Australia 1.17 1.14 1.12 1.03 1.19 China 0.06 0.04 0.11 0.14 0.13 Hong Kong 0.74 0.53 0.58 0.63 0.56 Japan 7.30 6.16 8.93 7.27 6.11 Malaysia 0.05 0.04 0.04 0.04 0.04 New Zealand 0.02 0.01 0.01 0.01 0.00 Singapore 0.17 0.13 0.22 0.19 0.22 South Korea 0.04 0.11 0.25 0.19 0.46 Taiwan 0.25 0.17 0.38 0.28 0.40 Total 9.8 8.33 11.64 9.78 9.11 Total ex Japan 2.5 2.17 2.71 2.51 3.00 Reference item USA 59.7 61.6 58.3 58.8 60.1 Source: S&P 2002 Review Global Indices. Notes: China represents Chinese stocks traded in HK.
Serious problems in market microstructure and efficiency also remain that impede solid recovery. De Brouwer and Smiles (2002), for example, examine differences in East Asian stock markets with other markets in the United Kingdom and United States. They report that there are substantial microstructural differences between East Asian equity markets and those elsewhere, especially in terms of size, number of stocks, extent of foreign listings, and trading hours. The US, Japanese and UK markets are the largest in terms of capitalisation, number of listed stocks, and market turnover. The Malaysian, Indonesian, Taiwanese and Thai markets tend to be at the lower end of the spectrum. The investor base is narrow in the equity markets of most economies in East Asia. These economies are associated with restricted and highly regulated contractual savings systems, underdeveloped mutual funds, a highly regulated asset management industry, and a limited role for insurance companies in capital markets. US and UK markets have higher proportions of listed foreign stocks, Japan has a substantially lower share of foreign stocks while Singapore has a very high share. Malaysia, Indonesia, Taiwan and Thailand have either no foreign listings or virtually no foreign listings. The markets also have diverse sectoral weightings, although these do not seem to be related to geography or level of development. They also look at high-frequency (five-minute) equity returns in 2000. They report that price formation in East Asian equity markets differs from the major markets in two respects. First, market opening price variability is relatively larger in East Asian equity
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2002 1.38 0.13 0.55 7.00 0.06 0.01 0.25 0.67 0.34 10.39 3.39 59.3
markets. It appears that much of the global price action that matters to equity markets occurs in New York and London, and all this information needs to be incorporated into domestic equity prices. This conforms with the general assessment that stock prices in East Asia are heavily influenced by developments in US markets, especially in the short term.2 The other key difference is in the level of relative market efficiency. The weak-form test of market efficiency — testing whether past returns contain information about current and future movements in returns — does not hold in any equity market on high frequency data like five-minute returns.3 But past information matters considerably less for the large US and UK markets than for all equity markets in East Asia, including Japan but apart from Singapore. At one extreme, for example, information beyond one hour is irrelevant for US, UK, Hong Kong and Singaporean stocks. At the other extreme, only information beyond five days is irrelevant for China’s Shanghai A (domestic) stocks. This is a substantial gap, with the other East Asian equity markets lying somewhere in between. There is still room for development in East Asian equity markets, including in longer trading hours and wider foreign listing and participation in stock markets. 3-2. Foreign exchange markets Almost a quarter of the world’s foreign exchange market activity takes place in East Asia, but this is highly concentrated in the regional financial centres in Japan, Singapore, Hong Kong and Australia (Table 4).4 Most trading in Hong Kong and Singapore is in G3 currencies, not the local currency. In a number of regional economies, non-resident access to the domestic foreign currency market is tightly regulated, even in economies whose currencies are convertible on the capital account (like Indonesia, Korea, Malaysia, Singapore, Taiwan and Thailand). While this is designed to limit destabilising speculation,5 it is a substantial impediment to the development of local foreign currency markets. A notable feature of regional foreign exchange markets is increased concentration among the firms doing foreign exchange business, although this is also characteristic of other foreign exchange markets like that in the United States, and reflects narrowing margins, increased competition, and the global consolidation of financial institutions. The concentration of activity has increased and the number of players in the markets has generally declined, in some cases very substantially (Table 5).
2
See, for example, de Brouwer (2002) and Park (2002).
3
This is tested by including past 30 minute, hourly and daily returns and variances in GARCH(1,1) specifications of 5-minute changes in regional equity prices. 4
The Singapore figures for foreign exchange trading are regarded by some as artificially high. Sheng (2001, 2002) argues that the limited foreign exchange trading in much of East Asia shows the region’s lack of financial sophistication and influence. 5
See de Brouwer (2001) for an analysis of these issues.
7
Table 4: Foreign Exchange Market Turnover in East Asia Australia China HK Indonesia Japan Korea Malaysia NZ Philippines Singapore Taiwan PoC Thailand East Asia US Total
1989 29
1992 29
49
60
111
120
4
Amount, US$ billion 1995 1998 40 47 0 90 79 2 161 136 4 1 7 7 1 105 139 5
55
74
244 115 718
287 167 1,076
403 244 1,572
2001 52 0 67 4 147 10 0.1 4 1 101 4
3 2 424 392.1 351 254 1,969 1,618 Source: BIS (2002a)
1989 4.0 6.8 15.5
7.7
34.0 16.0 100.0
Percentage share of total 1992 1995 1998 2.7 2.5 2.4 0.0 5.6 5.7 4.0 0.1 11.2 10.2 6.9 0.2 1 0.4 0.4 0.4 0.1 6.9 6.7 7.1 0.3
2001 3.2 0.0 4.1 0.2 9.1 0.6 0.1 0.2 0.1 6.2 0.2
0.2 21.5 17.9 100.0
0.1 24.2 15.7 100.0
26.7 15.5 100.0
25.6 15.5 100.0
Table 5: BIS Foreign Exchange Market Survey Australia China HK Indonesia Japan Korea Malaysia NZ Philippines Singapore Taiwan PoC Thailand Reference US
Number of banks covering 75 per cent 1995 1998 2001 10 9 10 22 24
5 25
20
1992 72
26 5 19 21 5 4 10 23 24
14
375
17 14 9 4 10 18 20
330
12
11
20
208
13
180
Number of participonats 1995 1998 75 66 -426 376 366 -25 345 356 -99 -5 8 6 -51 218 206 -49
2001 56 272 15 342 71 9 5 42 192 53
--
33
35
130
93
79
Source: BIS (1996, 1999, 2002a)
The fact that Japan has the most foreign exchange market activity in East Asia does not mean that much of the trading activity in the region is done directly in the yen. The dollar-yen is the second most common transaction in foreign exchange markets, after the dollar-euro.6 But there is very little direct trade of local East Asian currencies with the yen. As shown in Table 6, local East Asian currency trade with the yen is largely done indirectly, through local currency-dollar and dollar-yen trades (and vice versa). Daily average turnover in 2001 of domestic currency trade in non-Japan East Asia with the dollar was $77,084 million, compared to $630 million with the yen and $455 million with the euro. A minuscule 0.3 per cent of local-currency foreign-exchange transactions in East Asian countries are done with the yen as the direct counterpart. For Southeast Asia, the value of direct yen foreign currency trade has even fallen over time.
6
The dollar-euro currency pair accounted for 30 per cent of global turnover in April 2001, compared to 20 per cent for the dollar-yen and 11 per cent for dollar-sterling (BIS 2002a: 2).
8
Table 6: Local Currency Foreign Exchange Turnover, US$ million, daily average
16,327
1995 - of which dollar euro 15,667 167
15,305
14,286
Total Australia China HK Indonesia Japan Korea New Zealand Philippines Singapore Taiwan PoC Thailand Total East Asia United Kingdom United States Total
yen 205
130,810
121,929
6,689
n/a
3,959
3,675
39
41
5,881
5,545
32
65
172,282 74,167 211,072 693,078
161,102 53,147
6927 15,471 84,819 158,142
311 3,240 49,316 57,961
373,220
23,600
1998 - of which dollar euro 22,462 196
18,711 972 124,045 2,289 4,928 492 17,644 1,720 2,574 196975 114,817 315,872 919,930
17,484 935 113,275 2,222 4,702 488 17,210 1,592 2,485 182855 88,692 n/a 502,952
Total
1 6,478 14 28 0 22 22 7 6768 21,270 103,183 163,879
yen 339
26,839
2001 - of which dollar euro 25,641 265
17 n/a 34 25 1 104 63 63 646 1,466 78,541 86,426
24,578 579 109,708 8,416 2,794 459 11,600 2,647 1,520 189140 122,852 236,436 835,380
24,260 568 101,634 8,297 2,517 454 11,345 2,525 1,477 178718 102,152 n/a 518,924
Total
Source: BIS (2002a); Notes: in 1995 and 1998, the euro is estimated as the sum of German mark and French franc reported daily average turnover; n/a indicates not applicable.
3-3. Bond markets Bond markets comprise two sets of assets – long-term government securities and longterm private securities, or corporate bonds. Bonds are typically an important financial asset in many developed economies but bond markets in East Asia are typically relatively poorly developed. This reflects a number of factors, namely borrower and lender preference for bank intermediation and generally low government debt associated with a strong policy aversion for fiscal deficits. But the decline in directed lending in the 1990s and the severe recessions of the past few years have changed this in many countries. Table 7: Domestic Debt Securities (per cent of GDP) Government Government Banks Banks Corporates Corporates Dec 1997 Dec 2002 Dec 1997 Dec 2002 Dec 1997 Dec 2002 Australia 27.8 17.2 12.5 18.9 7.3 13.8 China 7.4 16.2 9.7 16.2 0.6 0.8 HK 7.5 9.2 14.1 15.1 1.9 2.9 Indonesia 24.0 40.1 ----Japan 62.3 115.8 34.6 27.7 12.5 18.0 Malaysia 26.7 35.8 23.2 11.1 28.7 40.0 NZ 29.7 27.4 ----Philippines 30.3 27.4 ---1.4 Singapore 15.6 36.6 10.0 20.8 2.8 6.8 S. Korea 9.4 19.0 19.3 26.6 19.8 30.0 Taiwan 11.0 24.5 6.7 6.4 17.0 19.2 Thailand 0.2 22.9 6.3 9.4 2.7 5.1 Source: Brown, Skully and Batten (2003), except Indonesian debt figure which is central government debt taken from the ADB’s ARIC website, http://www.aric.adb.org.
There are now many calls for developing broad and deep bond markets in East Asia.7 The argument is straightforward: a broader set of financing provides greater opportunity for risk-pooling and risk-sharing for borrowers and lenders, boosting financial and economic efficiency and reducing individual and collective risk. Banks remain an 7
See, for example, Herring and Chatusripitak (2000) and Asian Policy Forum (2001).
9
3 6,225 32 53 1 75 17 9 6680 17,104 84,395 119,724
yen 391
3 n/a 57 44 2 53 57 23 630 1,666 62,145 75,127
essential element in this because they perform many of the underwriting, issuance, settlement and investment functions in these markets. The development of corporate bond markets is likely to become more important over time, as FDI investors look to domestic capital markets to help fund their FDI. This is especially important in countries in which FDI is directed to providing goods and services for the domestic market, like China (CMCG Working Group of the 2003). But with only a few exceptions, notably Malaysia, Korea, Japan Australia, and Taiwan, regional bond markets in East Asia, especially corporate bond markets, are weak and poorly developed. The development of government bond markets also depends on the degree to which institutions, like banks, insurance companies and pension funds, are forced to acquire bonds and thereby finance government spending or obligations. While forced acquisition of government securities may have an initial appeal as a device to reduce fiscal costs, it tends to retard the development of bond markets because it seriously hinders the growth of secondary markets. There is also a problem in the way bond markets are growing in the region, notably as the by-product of fiscalisation of the East Asian financial crisis. For example, in Indonesia the government issued Rp 740 trillion (US$87.1 billion) in bonds, equal to two-thirds of 1999 GDP (when most of the bonds were issued) and one-half of 2001 GDP. These bonds cover three components of the cost of Indonesia's financial crisis: compensation to Bank Indonesia for the liquidity support it provided to banks at the peak of the crisis; compensation to banks that assumed the liabilities of banks closed by the government; and recapitalization of undercapitalized banks that have remained open. These bonds have created two severe problems: an extremely heavy fiscal burden to service a debt now equal to about 70 percent of GDP; and crowding out of private sector borrowing – the income of many banks is dominated by interest earned on government bonds rather than interest from loans made to businesses and consumers. Furthermore, while the recapitalization bonds help the balance sheet of banks, they do not provide much liquidity, which could constrain the capacity of banks to respond to credit demands should markets strengthen. Finally, the government is now issuing bonds to refinance the earlier bonds, euphemistically termed ‘debt reprofiling.’ In short, we have a bit of a paradox: yes, we need to develop domestic bonds, but they also need to be the right kind of bonds. 3-4. Derivatives markets Derivatives, including swaps, forwards and options, are an essential part of risk management for firms, financial institutions and governments. Table 8 provides a snapshot of the depth of derivatives markets in East Asia. As for foreign exchange trading, derivatives trading is concentrated in the region’s financial centres - Japan, Singapore, Hong Kong and Australia. Over the counter derivatives trading elsewhere in the region is negligible, and reflects the limited ability of firms and households to manage financial risk.
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Table 8: OTC Derivatives Market Activity in East Asia average daily turnover, US$ billion, net of local inter-dealer double counting Total April 1998 31.6
Australia China HK Indonesia Japan Korea Malaysia NZ Philippines Singapore Taiwan Thailand East Asia Reference UK US Total
51.4 1.0 120.6 1.1 0.8 5.4 0.4 90.7 1.6 2.2 306.8
April 2001 50.7 0.0 52.0 0.5 131.7 4.0 0.9 3.4 0.6 72.5 1.8 1.3 319.4
591.2 293.8 1,681.7
628.1 284.7 1,862.2
Foreign exchange April 1998 April 2001 28.8 40.9 0.0 48.9 49.4 1.0 0.5 89.0 115.9 1.0 3.9 0.8 0.9 5.0 3.1 0.4 0.6 85.4 69.3 1.5 1.7 2.2 1.3 264.0 287.5 468.3 235.4 1,338.1 Source: BIS (2002a)
Interest rate April 1998 April 2001 2.8 9.8 0.0 2.4 2.6 0.0 0.0 31.6 15.8 0.0 0.1 0.0 0.0 0.4 0.3 0.0 0.0 5.3 3.2 0.1 0.1 0.0 0.0 42.6 31.9
390.3 169.1 1,186.1
122.9 58.4 343.6
237.8 115.7 676.1
Figure 3: Derivatives Trade in East Asia (Gross) Foreign exchange derivatives Interest rate derivatives 160,000
20,000
18,000 140,000 16,000 120,000 14,000 100,000 US$ million
US$ million
12,000
80,000
10,000
8,000 60,000 6,000 40,000 4,000 20,000 2,000
0
0 Australia
HKSAR
Indonesia
Japan
Korea
Malaysia
New Zealand
Philippines
Singapore
Taiwan
Thailand
Australia
HKSAR
Indonesia
Japan
Korea
Malaysia
New Zealand
Philippines
Singapore
Source: BIS (2002a)
The region largely holds its own in terms of foreign exchange derivatives: East Asia’s share of foreign exchange derivatives was about 24 per cent in April 2001, on par with its share of world foreign exchange trading. But East Asia is particularly weak when it comes to interest-rate derivatives, with only 4.7 per cent of the world market. These derivatives are simple – only 6 per cent are options with the rest just swaps (68 per cent) and forwards (26 per cent). They are largely concentrated in US dollar interest rates; yen interest rate derivatives have been declining. There is a striking difference between regional financial centres in this regard, while Australia’s economy is less than one-tenth the size of that of Japan’s, interest rate derivatives trading in Australia is almost as large as that in Japan. (Figure 3). The general implication from the low interest rate derivatives activity is that East Asia is poorly developed in its financial risk management. This is becoming an impediment to financial development and growth in emerging East Asia because the lack of domestic derivatives markets is acting as a constraint on domestic financing of FDI and hence is emerging as a barrier to new FDI (CMCG Working Group of the 2003).
11
Taiwan
Thailand
4. Recent Developments in Commercial Banks 4-1. Trends in bank credit Trends in commercial bank credit to the private sector provide information on the degree of banking sector activity in an economy. Figure 4 depicts commercial bank credit as a ratio of GDP for crisis-affected East Asian countries, including Japan, during the period 1985-2003. The figure indicates different patterns across countries. The commercial bank credit to GDP ratio in Japan reached its peak in 1990 and has since declined steadily. The ratios in Thailand, Indonesia and the Philippines reached their peak in 1997 and have since declined as a trend. The ratio in Malaysia reached its peak in 1998 and has been virtually flat since then. Despite a severe crisis, bank credit as a ratio of GDP in Korea has continued to rise even during the crisis period. The real value of commercial bank credit, reported in Figure 5, also reveals different patterns across countries. In the post-crisis period, real bank credit (adjusted for the CPI) has recovered fairly quickly in Korea and Malaysia. In the first half of 2003, the stock of real bank credit to the private sector is about 87% higher than the 1997 levels in Korea and 12% higher in Malaysia. There is some sign of recovery in Thailand and Indonesia, but their levels are still lower than the 1997 levels. In Japan and the Philippines, real bank credit continues to be sluggish. These statistics suggest that the Korean banking sector—at least its financial intermediation function—appears to have recovered, and Malaysia is following Korea. Thailand appears to be getting out of its worst situation, though the level of bank credit is still much lower than the 1997 level. On the other hand, the banking sectors in Japan, Indonesia and the Philippines continue to have difficulties in generating new credit flows to the economy. 4-2. Banking sector restructuring and consolidation Japan, Thailand, Indonesia, Korea and Malaysia experienced systemic banking sector crises in 1997-98. In Japan, the economic impact was not drastic, but price deflation and economic stagnation were firmly embedded. In the latter four countries, massive capital outflows took place, equity and currency markets collapsed, banking and corporate sectors were severely distressed, and output eventually declined sharply. The International Monetary Fund stepped in to rescue Thailand, Indonesia and Korea. Institutional frameworks Frameworks were created to resolve systemic crises in the financial and corporate sectors in these countries, including Japan (Table 9). These frameworks were put in place with the recognition that financial sector restructuring requires resolution of bank nonperforming loans (NPLs) and, hence, of non-repayable corporate debt. Without corporate debt restructuring, financial sector health would not be restored.
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Table 9. Institutional Frameworks for Banking and Corporate Sector Restructuring Major Support Institution
Agency for Bank Recapitalization
Asset Management Company
Agency for Voluntary Corporate Restructuring
Indonesian Bank Restructuring Agency (IBRA) [June 1998] Financial Supervisory Services (FSS)
Direct from Bank Indonesia (BI) or via IBRA
Indonesian Bank Restructuring Agency (IBRA)
Korea Deposit Insurance Corporation (KDIC)
Korea Asset Management Corporation (KAMCO)
Malaysia
Bank Negara Malaysia (BNM)
Danamodal [August 1998]
Danaharta [June 1998]
Corporate Debt Restructuring Committee (CDRC) [August 1998]
Thailand
Bank of Thailand (BOT)
Financial Restructuring Advisory Committee (funded by the Financial Institutions Development Fund)
FRA to take assets of closed finance companies; unsold assets moved to AMC and good assets to RAB.(b) TAMC for commercial banks [July 2001]
Corporate Debt Restructuring Advisory Committee (CDRAC) [June 1998]
Indonesia Korea
Jakarta Initiative Task Force (JITF) (a) [September 1998] Corporate Restructuring Coordination Committee (CRCC) [July 1998]
Financial Services Deposit Insurance RCC and IRC(c) None. Oversight by FSA Agency (FSA) Corporation (DIC) Notes: (a) Based on the Frankfurt Agreement for debts to foreign commercial banks, the Indonesian Debt Restructuring Authority (INDRA) was created to guarantee access to foreign exchange, but was closed due to its ineffectiveness. (b) FRA refers to the Financial Sector Restructuring Authority; AMC refers to the Asset Management Corporation; RAB refers to Radanasin Bank; and TAMC refers to the Thai Asset Management Corporation. (c) RCC refers to the Resolution and Collection Corporation and IRC refers to the Industrial Revitalization Corporation. Source: Kawai (2000a,b).
Japan
Despite some similarities in basic frameworks, actual approaches to restructuring have varied across countries, reflecting differences in the magnitude of the problem, initial conditions of the economy, the nature of the corporate system, the extent of political commitment to the restructuring and reform, and the institutional capacities of financial authorities. Korea and Malaysia undertook decisive policies to recapitalize banks and to guide corporate debt restructuring, while Thailand and Indonesia initially pursued a market-based approach. After experiencing inadequate results, the latter two countries shifted to more aggressive policies to facilitate NPL resolution and corporate restructuring. For example, Thailand decided to set up an official asset management company, called the Thai Asset Management Corporation (TAMC), in July 2001 in order to actively work on NPL problems of Thai banks. Malaysia’s framework has been one of the most coherent for addressing financial and corporate restructuring. Box 1: Government-led Approach vs. Market-based Approach to Restructuring An advantage for a government-led approach is that it can deliver quick results in reducing non-performing loans (NPLs) in the banking sector, recapitalizing viable institutions and effectively inducing restructuring through financial support, tax and regulatory changes, and framework setting. The greater the coordination failure in the markets and the larger the scale of the problem, the more a government-led approach makes sense. At the same time, however, the approach entails risks. It places a substantial fiscal burden on taxpayers and may effectively bail out negligent creditors and debtors, thereby creating potential for a future moral hazard and inviting a recurrence of reckless behavior.
13
In contrast, a market-based approach has several advantages. First, by relying on private rather than public resources to facilitate restructuring, it helps contain fiscal costs and mitigate problems of moral hazard. Second, it generally works better in recovering NPLs than a bureaucratically administered system under a public asset management corporation (AMC). Finally, it provides better incentives for restructuring, leading to efficiency in the banking and corporate systems, and greater safety. Financial sector restructuring As a result of proactive policy response to banking sector problems, significant progress was made to contain and overcome the systemic crises in the financial sector. Measures were put in place to resolve insolvent financial institutions—including closure, merger and temporary nationalization—, to carve out NPLs from the balance sheet of financial institutions, to recapitalize weak, but viable financial institutions using public resources, and to dispose of or restructure NPLs. Many of these measures have been accompanied by the debt and operational restructuring of highly indebted corporations. Governments initially injected liquidity into the banking sector to avert runs on individual banks and subsequently guaranteed all deposits and often other financial liabilities as well, thereby taking responsibility for bank losses. Many non-viable and insolvent financial institutions were either closed, merged with healthier institutions, or temporarily nationalized; some bad loans of closed or weak (but viable) financial institutions have been transferred to public (and private) asset management companies (AMCs); and many weak but viable institutions received public funds for recapitalization.8 In all countries NPLs have declined over the past five years except in the Philippines where there has been a steady rise since 2000 (Table 10). The NPL ratios in the balance sheets of banks are now below 2 per cent in Korea, 8 per cent in Malaysia and Indonesia (excluding those NPLs transferred to IBRA), and 16 per cent in Thailand and in the Philippines. These figures compare quite favorably with those at the peak of the Asian financial crisis. The resolution of NPLs and injection of capital, both public and private, have restored capital adequacy to levels that are on the average above the minimum standard of the Bank for International Settlements (BIS), except in Indonesia. The latest available data for banking sector capital adequacy ratios range from about 8 per cent in Indonesia, more than 11 per cent in Korea, to 13-17 per cent in Malaysia, Thailand and the Philippines.9 However, some individual banks have yet to achieve the 8 per cent threshold. Corporate restructuring Corporate sector restructuring is the other side of the process of financial sector restructuring, because the substantial overhang of bank NPLs was largely a consequence of distressed corporate performance.
8
Bank recapitalization adds incentives for banks to successfully renegotiate on the restructuring of their claims on highly indebted firms. An adequately capitalized bank can objectively recognize the economic value of its loans and, if necessary, reduce the face value of its claim to resolve the NPL problem. 9 Asian Development Bank, Asian Economic Monitor (February 2003).
14
[insert Table 10 here]
15
Governments introduced three frameworks to resolve corporate debt overhang. First, court-based insolvency procedures were strengthened, including bankruptcy, reorganization and foreclosure laws, legal protection of creditor rights, and the establishment of functioning judiciary systems. Second, formal frameworks for voluntary, out-of-court debt negotiations were developed under the “London rules” arrangement. Third, official AMCs were empowered to restructure distressed debts and corporations, in addition to disposing of acquired assets. The presence of a well functioning judicial/legal system and an effective court-based insolvency procedure can be a credible threat to both debtors and creditors, which can encourage a less costly, voluntary negotiation for corporate restructuring. Some progress has been made in corporate debt and operational restructuring through these three channels. Progress has been made on corporate debt restructuring under voluntary workout schemes. In Indonesia, as of December 2002, the Jakarta Initiative Task Force (JITF) had worked out about US$18.9 billion out of the total US$29 billion in distressed corporate debt that it had been tasked to help restructure. JITF now has a year left to complete restructuring the remaining US$10 billion of distressed debt, as the agency’s mandate is scheduled to expire by the end of 2003. In Malaysia, the Corporate Debt Restructuring Committee (CDRC) officially ceased operation in August 2002, after having restructured 47 cases or 98 per cent of those it accepted, worth RM43.97 billion in face value. In Thailand, by the end of November 2002, the Corporate Debt Restructuring Advisory Committee (CDRAC) had successfully restructured 10,303 cases worth B1,372 billion out of 15,385 cases of target debtors with credits outstanding of B2,625 billion in face value. The remaining 4,994 cases worth B1,287 billion were still in the process of restructuring or subject to court litigation.10 Similarly in Korea, significant progress has been made in restructuring the chaebols and non-chaebol firms. The progress in debt resolution by public AMCs has varied across countries.11 In Malyasia, Danaharta had resolved all NPLs in its portfolio by September 2002, with an expected recovery rate of 57 per cent. In Korea, as of November 2002, the Korea Asset Management Corporation (KAMCO) had resolved 57 per cent of the face value of NPLs purchased from financial institutions since 1997, with an expected recovery rate of 47 per cent. In Thailand, as of December 2002, the Thai Asset Management Corporation (TAMC) had resolved 67 per cent of the total book value of B759 billon in impaired assets it had acquired, with an estimated recovery rate of 45 per cent. TAMC expects to complete the restructuring of all assets in its portfolio by the end of 2003. In contrast, debt resolution by the public AMC has been slow in Indonesia. As of December 2002, the Indonesian Bank Restructuring Agency (IBRA) had disposed of only about 20 per
10
At the same time, from 1998 to October 2002, Thai financial institutions themselves successfully restructured 538,468 cases worth B2,665 billion in face value, while 40,142 cases worth B125 billion were still under the restructuring process. 11
Unlike the other crisis-affected countries, the Philippines did not establish a public AMC in the aftermath of the crisis, relying instead on individual banks to restructure their own NPLs. In 2002, in response to the rising level of NPLs, the government proposed a bill for the creation of specially designed AMCs or special purpose vehicles (SPVs). The SPVs are expected to acquire, turn around, and resell the financial sector’s distressed assets, estimated at P500 billion or about 27% of the total loans of the banking system.
16
cent of the total assets under its management, while another 19 per cent had reached the stage of signing an MOU or implementing restructuring proposals. Consolidation of financial institutions. Together with bank restructuring, significant consolidation of the banking sectors has been underway. As a result of closure and merger, the number of commercial banks has been reduced. When insolvent banks were temporarily nationalized, they were often sold to foreign stakes. These consolidations moves are expected to make the banking industry more competitive, efficient and profitable. In Japan, there were 10 city banks and 3 long-term credit banks in 1997, and by 2003 they had been consolidated to 5 groups and 2 banks one of which is now foreign owned. In Korea, there were 33 commercial banks in 1997, whose number has been reduced to 22 of which 3 banks are foreign owned and 4 banks have large foreign stakes. In Thailand, there were 15 commercial banks which were all domestically owned before the crisis, and the number of commercial banks has been reduced to 13 of which only 6 are domestically owned and 4 are foreign owned (while the remaining 3 banks are either state owned or temporarily nationalized). In Malaysia, there were 58 domestic financial institutions (21 domestic banks, 12 merchant banks and 25 finance companies) in July 1999, which have been consolidated to 10 groups by the end of 2002. 4-3. Reforms of the regulatory and supervisory frameworks While financial restructuring is needed to restore financial system health, more important is to address shortcomings in prudential regulations and supervision and to enhance accounting, auditing and legal standards in the banking sector. This is essential because of the need to improve the quality and efficiency of financial intermediation through the banking system. Each of the crisis-affected countries has adopted measures to improve prudential control (Table 11), while tolerating some degree of forbearance in the transition to recovery.12 Table 11. Changes in Prudential Standards in East Asia Indonesia Loan classification (days elapsed before considered past due) Loan loss provisioning
No change—180 days
Korea Lowered from 180 days to 90 days
From 20/75/100 (Backward looking) to 20/50/100 (forward looking) Reduced from up Reduced from up to 6 Interest accrual to 6 months to up months to up to 3 to 3 months; months; with no clawback clawback Source: World Bank, East Asia: Recovery and Beyond (2000, p. 82).
Substandard/doubtful/loss
From 0/50/100 to 10-15/50/100
12
Malaysia
Thailand
No change—180 days
Lowered from 360 days to 90 days
No change—0/50/100
From 0/50/100 to 20/75/100
No change, up to 6 months; with clawback
Reduced from up to 6 months to up to 3 months; no clawback
Achieving the BIS capital adequacy standards and loan classification and provisioning standards instantly is hardly a credible approach when the banking system cannot comply.
17
Korea has perhaps gone the furthest in terms of strengthening bank supervision. The newly created FSC has consolidated regulatory functions that were previously shared between the finance ministry and central bank, enhancing its regulatory credibility. Most of the prudential measures will take time to implement, not least because of a lack of human resources. Even with highly sophisticated prudential, accounting and regulatory frameworks in place, banks could still fail because of the difficulty of identifying their problems at an early stage. Furthermore, the effectiveness of prudential standards—as well as efforts to improve the protection of outside investors—is closely intertwined with corporate ownership structures, which in turn reflect the preferences of the dominant forces within government and the private sector—and may be slower to change. The traditional triangle among corporations, banks and governments has been shaken by the crisis, and the manner in which it is rebuilt will have significant implications for the effectiveness of prudential standards. Two challenges remain with regard to prudential regulation and supervision: to strengthen the implementation of the rules that have been put in place and to ensure that the supervision is complemented with adequate incentives for both owners/managers and depositors to reduce the kind of moral hazard risks that led to overlending before the crisis. In view of the fact that the authorities of crisis-affected countries provided blanket guarantees of deposits and other bank liabilities to stabilize the banking system, they need to move to a rule-based deposit insurance system. The design of limited deposit insurance schemes that protect the vulnerable but do not undermine incentives will be an important challenge. 4-4. Improving corporate governance of financial institutions The need to improve corporate governance, in particular that of financial institutions, is another important agenda item that the East Asian economies face. Disclosure, accounting and auditing standards are weak, the role of the board of directors is not clearly defined and minority shareholders are not adequately protected. Since business organizations mirror the underlying business culture, improvements in corporate governance require changes in business organization.13 Technological developments and increased exposure to competition will aid such fundamental changes. For instance, rapid developments in information and communications technology are expected to require the streamlining of business operations, and greater competition coming from capital market development is likely to impose greater discipline on the way financial institutions are run. Recent studies of corporate governance have documented large differences across countries in ownership concentration in publicly traded firms, in the breadth and depth of capital markets, and in the access of firms to external finance. One explanation for these differences is the level of legal protection of outside investors, both shareholders and creditors, from expropriation by the managers and controlling shareholders of firms; 13
One of the features of the East Asian economies has been the prevalence of business transactions based on relationships between banks and firms and between non-bank firms or on trust. While lowering the transactions and agency costs that come about from asymmetric information, trust is not enough to sustain complex operations in an increasingly global market, and arm’s length relationships need to be developed.
18
although political factors that affect the degree of compliance may be more important to financial development than legal systems per se. The East Asian economies do not rank appreciably below other emerging markets in terms of equity protection or creditor rights, although deficiencies in the enforcement of investor rights reflecting judicial shortcomings are often identified. Moreover, the valuations of firms controlled by inside shareholders are far below those of comparable firms, suggesting the expropriation of outside investors may be significant (Claessens, Djankov and Lang, 1998). Table 12. Equity Rights, Creditor Rights, and Judicial Efficiency, mid-1999 Equity rights One-share one-vote Proxy by mail Shares not blocked Cumulative voting Equity rights score (sum) Improvement over 1996 Creditor rights Restrictions on reorganizations No automatic stay on assets Secured creditors first paid Management does not stay on in reorganizations Creditor rights score (sum) Improvement over 1996 Judicial efficiency Timetable to render judgement Existence of a specialized bankruptcy code Judicial efficiency score (sum) Improvement over 1996
Indonesia
Korea
Malaysia
Thailand
0 0 0 0 0 None
1 0 +1 0 2 +1
1 0 0 0 1 None
0 0 +1 1 2 +1
1 +1 0 +1 3 +2
1 0 1 1 3 None
1 0 1 1 3 None
1 1 0 1 3 None
+1
+1
0
+1
+1 2 +2
1 1 +1
0 0 None
0 0 +1
Note: A 1 denotes that equity and creditor rights are in the law, that there are time limits to render judgement, and that specialized bankruptcy courts exist. A + indicates and improvement over the law in place before the crisis, that is, in 1996. Sources: World Bank (2000, p. 84).
Most assessments have pointed to the need to strengthen the rights of outside investors, and there has been some progress on this front (Table 12), although the effectiveness of enforcement remains an issue. In most countries effective enforcement of recent and prospective changes will require sustained effort to improve the quality of the judiciary. Enhancing transparency through more stringent (and enforced) disclosure requirements using international accounting and auditing standards will be an essential complement to the effort to strengthen investor protection. Credit-rating agencies, securities analysts, professional watchdogs and the financial media can play key roles in enhancing transparency. While there may be powerful vested interests protecting the status quo, the pressure from foreign investors for a convergence of regulatory standards should not be underestimated as capital markets continue to integrate. The crisis has certainly increased consciousness about the importance of corporate governance. Countries and corporations unable or unwilling to address investor demands risk becoming increasingly ostracized, which itself can be an important motivator for reform.
19
If countries are successful in improving the protection of outside investors, the rationale for interlocking ownership structures and financing arrangements will diminish, as the benefits of greater choice in trade and finance begin to outweigh the comfort of traditional relationships. Continued integration of trade and capital flows will loosen these relationships further. A growing body of recent work has characterized the East Asian conglomerate as one in which a large number of firms, typically including one or more bank and non-bank financial institution, are controlled by a single family. Family control can reach very high levels even for publicly traded firms. Control is often enhanced and further concentrated through pyramid structures and a deviation from one-share-one-vote rules (Claessens, Djankov and Klingebile, 1999), and members of company boards tend to have allegiance to the controlling family. Such conglomerates account for large shares of overall market capitalization and have had access to credit because of their relationship with and ownership of financial institutions. The top ten families in Indonesia and the Philippines were found to control more than half of the listed corporate sector, and nearly half in Thailand, with the concentration of ownership lower in more developed economies. Legal and regulatory systems have been influenced by the concentration of corporate resources and the links large firms have to the government, suggesting that prospective reforms in these areas will also be influenced by changes in ownership structures. At the same time, it is important to recognize that the structure of corporate ownership in East Asia—both the dominance of conglomerates and the close relationships among the group bank and firms—has evolved in response to the business environment, the concentration of wealth, the quality of the legal framework and the judiciary, the modus operandi of dealing with government officials, and even ethnic factors. 5. Development of Microfinance Institutions, Instruments, and Delivery Systems 5-1. The unbanked majority As dependent as most Asian economies are on banks for financial intermediation, these banks still serve a very small segment of domestic businesses and households, especially in lower-income emerging market economies (Rosengard 2002). Most banks pursue clients at the tip of a nation’s economic pyramid, “blue chip” firms and consumers, neglecting most businesses and households in the country. They provide commercial savings, credit, and fee-based services for their privileged, relatively high-income citizens and businesses; they fail to serve the below-median income “unbanked majority” of households and enterprises (see Levine, Loayza, and Beck 2000 for macro level measurement of financial sector development in terms of outreach and coverage by geographic region and economic stratum, and Microcredit Summit Campaign 2002 for a detailed worldwide listing of microfinance institutions and a description of their client bases). Most formal lending goes to either large corporations or urban consumers. Medium, small, and micro enterprises have limited or no access to bank loans, with credit availability declining by business size and distance from urban centers. Savings mobilization and fee-based activities by banks do not have much better coverage. Banks discourage, either directly or via high fees and large minimum balance 20
requirements, small-scale deposits, and most banks do not have offices beyond the district capital. Thus, most rural households and low-income urban households do not have access to either basic savings services or funds transfer and payment services. For example, in China, all microfinance programs together still had less than 70,000 loans outstanding at the end of 2000, excluding the Rural Credit Cooperatives (Sun 2003). Even in the region’s country with the most extensive rural banking system, Indonesia, coverage is still quite limited. In a recently completed nationwide sample survey, 67.7 percent of the respondents did not have credit from any formal or informal financial institution, and 61.9 percent of the sample did not have a savings account in any formal or informal financial institution (see Table 12 in Rosengard et al 2001c for a more detailed breakdown of these figures). 4-2. The role of the microenterprise sector and household savings Whether measured by number of businesses, number of employees, or value of output, microenterprises are the foundation of most economies around the world. Asia is no exception, where informal employment comprises 65 percent of non-agricultural employment, of which 59 percent is comprised of self-employment in informal enterprises (see Chen 2002 for a comprehensive description of the informal economy). We are not talking about the poorest of the poor, with no assets and minimal income generation, but rather, the “working poor,” sometimes referred to as the “economically active poor.” These are owners and operators of unlicensed, unregistered, non-tax paying family or extended family businesses: trading kiosks, food stalls, home industries, simple agro-processing, maintenance and repair services, handicraft production, and the like. Untapped potential for funds mobilization refers to community-based household savings. While individual transactions tend to be small, the poor do indeed save, and experience has shown that they welcome alternatives to traditional modes of savings like cattle and jewelry, in the form of a safe and accessible place to deposit their money (see Bass and Henderson 2001 for a review of micro savings mobilization). 5-3. Importance of sustainable microfinance for national development 14 Sustainable microfinance institutions ensure the long-term provision of essential services for those who are usually not clients of formal financial institutions. They serve as formal business financing sources for microenterprises; offer communities safe and remunerative depositories for household savings; and provide complementary financial services such as the transfer and payment of funds. If structured effectively, microbanking institutions are financial intermediaries for lowincome citizens, integrating formal financial markets with informal real markets and delivering financial services to previously unbanked entrepreneurs and communities. They allow the “working poor” to accumulate assets via either savings mobilization or
14
See Rosengard (2000b) for a more detailed review of this topic and Morduch (1999) for an examination of key issues in microfinance today.
21
the productive investment of loan capital, and thus, to contribute to national economic development through income growth, job creation, and improved living standards. The microfinance institutions that have the largest and longest-term impact are those that are financially sustainable. This means that they can cover all of their costs, including operational expenses, the cost of funds, and loan losses. They should also be able to generate a modest surplus for reinvestment in new products, delivery systems, and technology. The emphasis on sustainability promotes economic efficiency, decreases dependency on external resources, and creates the principal positive incentive for savers to deposit their funds (trust that their savings are secure) and borrowers to repay their loans (continued access to capital). (Mis)perceptions of Banks Despite considerable documentation to the contrary, most commercial banks believe that microenterprises are not a significant component of development. Furthermore, they believe that it is impossible to make money lending to microenterprises, and even if possible, it is immoral to make a profit on microenterprise lending (Fischer 1995 and Salloum 1995). Likewise, in spite of evidence demonstrating otherwise, most commercial banks believe that poor households do not and cannot save, as they have neither the desire nor the means to accumulate funds. Banks conclude that small-scale savings mobilization is not financially viable, due to the effort it would take to teach the poor to save, coupled with the small amount of savings these efforts would generate (Vogel and Burkett 1986). Given these misperceptions, commercial banks tend to either refrain from microfinance completely or engage in microfinance only as a social service or for political expediency. Rather than viewing microfinance as a new business opportunity to generate significant profits, banks believe they are on a social mission or a drive to deflect political pressures. Consequently, most commercial banks do not make money on microfinance operations, and cease these activities once financial losses exceed social or political benefits (Versluysen 1999). Common mistakes of commercial banks that commence microfinance activities for nonbusiness objectives include: inappropriate loan and savings products and delivery systems; underpricing of credit instruments; inefficient and ineffective lending methodologies; cumbersome, centralized organizational structures; and field staff with profiles and career objectives incompatible with successful microfinance institutions (Valenzuela 2002). Microfinance Market Realities There is some factual basis to the above-summarized misperceptions of commercial banks. Microenterprises are indeed different from larger firms, and micro loans are not simply smaller versions of conventional business loans. The mobilization of small-scale household savings also requires modification of traditional ways of raising funds (see Drake and Rhyne 2002 for a collection of essays on the commercialization of microfinance).
22
Credit Microenterprises are family owned and managed, with very informal organizational structures and operations. Their businesses are cash based and often entail irregular cash flow, being either cyclical or seasonal. Business records at best might include a cash book – income statements and balance sheets are non-existent. Microenterpreneurs usually do not have credit histories with formal financial institutions, nor do they have conventional bank collateral such as land and buildings with clear legal title in their name. Microenterprises are also highly diverse sectorally and highly dispersed geographically. Thus, if banks do not adapt their lending approaches to the unique characteristics of microenterprises, they will incur an operating loss because of high transaction costs, as well as encounter significant risk of non-repayment due to inadequate assessment and management of credit risk. Given the above characteristics of microenterprises, banks must change the way they make loans if they are to tap this market profitably: • The design of loan products must meet the business needs and projected cash flow of prospective borrowers, especially loan repayment terms and conditions. • Loan processing must be swift and decentralized, so that disbursement is timely, credit risk is accurately assessed, and sufficient loan volume can be generated. • Staff must be familiar with local markets and communities, and receive appropriate initial and refresher/upgrading training. • Loans must be priced to cover all financial, operational, and default costs and to produce enough surplus (profit) to pay for both employee incentives and reinvestment to improve bank efficiency, effectiveness, and competitiveness. • Accounting, reporting, and supervision systems must consistently reveal the true financial performance of microbanking activities, and affirm that reported profits upon which bonuses will be paid are indeed real profits. Savings Low-income households save for a variety of reasons, for example to: cover unforeseen emergencies, such as illness or death; smooth out irregular cyclical or seasonal income flows; make long-term family investments in education or home improvement; take advantage of unanticipated business opportunities; pay for social or religious obligations; and finance retirement or disability expenses. These savings tend to be a relatively stable source of long-term loanable funds for banks, in contrast to the volatile “hot” investment funds of larger depositors whose primary concern is achievement of the highest return. Banks should design their savings instruments for low-income households to address the needs of this clientele. The primary concern of low-income savers is a safe, accessible place to put their money; they tend to be less interest-rate sensitive than large-scale depositers. Unlimited withdrawals and no minimum balance or monthly account fees in a sound bank are more important to low-income savers than high interest rates. Lotteries for savers have also proven attractive to low-income households.
23
Transfers and Payments Transfer and payment services are essential for low-income households to: send money from rural to urban areas, for example to support students studying in cities; send money from urban to rural areas, for example to support parents who remained in villages after their children migrated to cities; and to send money from abroad, perhaps from “guest workers” to their families back home. 5-4. An example from East Asia15 Appropriate adaptation of banking methodologies to the microfinance market can produce impressive cases of commercial banks that have “done well while doing good,” that is, have both made money and provided essential financial services to microenterprises and low-income households. One such example is Bank Rakyat Indonesia (BRI), the most successful commercially based microfinance institution not only in East Asia but worldwide (see Patten and Rosengard 1991 for the history of BRI’s microbanking activities). As of 31 August 2003, BRI had: 3.2 million KUPEDES (General Rural Credit) micro loans outstanding, totaling Rp. 13.6 trillion (U.S.$1.6 billion); and 29.6 million savings accounts, totaling Rp. 25.3 trillion (U.S.$3.0 billion). During the month of August 2003, BRI made 186,323 loans totaling Rp. 1.5 trillion (U.S.$171 million), while portfolio quality remained excellent: the twelve-month loss ratio16 was 1.68 percent, and the portfolio status17 was 2.28 percent. BRI’s microbanking profits for the previous year (per 31 December 2002) were Rp. 1.7 trillion (U.S.$195.7 million) (Bank Rakyat Indonesia 2003). As an indication of the resiliency of BRI’s microbanking operations, BRI’s micro credit program actually improved its already excellent loan repayment rates while maintaining portfolio size during the East Asian financial crisis: KUPEDES borrowers continued to pay back more than 97 percent of everything that had fallen due, and the twelve-month loss ratio declined steadily during the crisis, remaining below 2 percent since November 1998. In fact, the larger the loan, the worse the performance, even within the same financial institution (Patten, Rosengard, and Johnston 2001). Four key factors seem to account for these results: 1) the installment repayment design of KUPEDES loans means they are much less leveraged than other types of loans, making KUPEDES borrowers less vulnerable to external disturbances; 2) most KUPEDES borrowers are engaged in the purchase and sale of domestically-produced essentials, and thus tend to benefit when consumers forego imported products and go downmarket during hard times; 3) rural areas are less affected by a monetary crisis – the drought which hit a bit earlier hurt the rural community much more; and 4) KUPEDES borrowers had developed a professional relationship with BRI that they tried to maintain 15
For a comparative perspective, see Rosengard (2001a) for an overview of financial intermediation for the poor in Africa and Rosengard et al (2001b) for an example of successful commercially based microfinance in Africa.
16
The total amount due during the last 12 months but not paid, including everything that has been written off, divided by the total amount that has fallen due during the last 12 months.
17
The total amount overdue divided by the total amount outstanding.
24
so they would continue to have access to BRI’s credit facilities (Patten, Rosengard, and Johnston 2001). 5-5. Prospects for the future of microfinance in East Asia Microfinance in East Asia will only have a major development impact if it is done through formal financial institutions. While other microfinance models, such as membership-based organizations (cooperatives and credit unions) and non-profit organizations (foundations and donor or government sponsored projects) are also important and fill key market niches, their impact tends to be limited and unsustainable. These efforts must be complemented by commercial banks with the infrastructure, expertise, and retail distribution networks to have long-term, nation-wide impact (see Rosengard 2000a for a more complete discussion of the future of microfinance via regulated financial institutions). There are several examples of successful commercially-oriented microfinance institutions in East Asia, most of them in Indonesia. In addition to BRI (see Rosengard et al 2001c for a recently completed impact evaluation and market survey of BRI’s microbanking services), there are also well-developed systems of provincially-based microfinance institutions, and a system of approximately 4,500 active village banks (BKDs, Bank Kredit Desas) in Java and roughly 1,200 village banks (LPDs, Lembaga Perkreditan Desa) in Bali (see Patten, Rosengard, Johnston, and Kusomo 2003 for a comprehensive review of these institutions). Hopefully, several regional trends will serve as a catalyst for commercial banks to look more creatively and aggressively at new domestic markets and business segments to increase their earnings. Deregulation of financial institutions, liberalization of financial markets, and globalization of financial services have lowered barriers to entry, increased competition, and contributed to market saturation. Perhaps necessity will motivate commercial banks to seek profits from serving the “unbanked majority.” 6. Conclusion Finance is an important element in sustainable economic development and stable economic growth. It is essential to develop the right sort of legal and business infrastructure to support the development of financial markets, institutions and systems in a manner compatible with the financing needs and aspirations of individuals and firms. In this paper, we have argued that more can be done at the national level to create, develop and strengthen markets and institutions. In particular, there is scope for developing domestic bond, derivatives and equity markets. Despite progress, there is an ongoing need to renew and restructure financial institutions so that they are resilient to new domestic and international pressures. And, given that many people in many countries in the region lack access to financial services and systems, it is timely for financial institutions to consider the opportunities provided by microfinance services.
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