Sound financial system key to Asian sustained growth

By Vincent Lingga

HONG KONG, China (JP): An inadequate financial system could threaten the foundation of Asian economic growth, financial analysts, International Monetary Fund (IMF) and World Bank executives here warn.

Almost all reports and analyses issued here regarding the currency crisis in Thailand which began in early July and the subsequent financial turbulence that hit Indonesia, Malaysia and the Philippines put much of the blame on their weak financial system, notably the banking sector.

The World Bank and IMF economists, here for their annual meetings, showed how these countries had to pay the costs for being late in responding to the new challenges to their macroeconomic discipline brought about by the influx of private capital.

But they remain bullish that robust growth will return to these countries after a temporary slowdown.

"I am sure they will do well again after the hiccup in the financial sector," World Bank president James D. Wolfenshon said here yesterday.

The seeds of the currency turbulence were sown when the bulk of the huge private capital flows since the early 1990s, attracted by Southeast Asia's economic boom, entered through the banking system, according to the advance copy of the IMF's World Economic Outlook report which will be published next month.

Banks which were poorly managed and inadequately supervised excessively expanded lendings without much regard to risks and this led to a boom in domestic consumption and real estate speculation and development. It also resulted in appreciating exchange rates and a widening current account deficit.

But all banking systems in the world are potential victims of the risk perception of the international financial community.

As the international financial community perceived, imminent problems emerged due to unsustainable credit growth and external imbalances. The market perception shifted, setting off a sudden reversal of capital flows through the dumping of local currencies and sharply reducing liquidity and credit.

Currency turmoil and the weakness of the real estate market, all conspired to test the banks' creditworthiness at a time when the support of the authorities has become less certain.

A World Bank study prepared after the currency crisis in Thailand recounts that when the governments were forced to raise short-term interests to defend the national currencies from speculative attacks, they risked knocking out the banking system.

This is because many banks in emerging markets often fund short and lend long in the absence of long-term funding instruments.

"We have detected structural deficiencies in the Thai financial sector and we have told them so," IMF Director Michael Mussa told a seminar on Asia and the IMF here yesterday.

The two multilateral institutions highlight some deficiencies in East Asia's financial system.

Their reports note that implicit state support has maintained the creditworthiness of many rotten institutions, with credit ratings dependent, to a large extent, on the quality of expected state support rather than the quality of banks' balance sheets and profitability.

Insolvency

Some countries which experienced bank insolvencies have often tried to correct them by providing blanket coverage for liabilities and imposing regulatory forbearance, according to the reports.

"If they (Thailand) had acted early enough, the damages would not have been as great. Even now, we would like them to move faster on policy adjustments and structural reform," Wolfenshohn said.

President of the Asian division of bank rating agency Thomson BankWatch, Philippe Delhaise, came to a similar conclusion.

Delhaise observed in the latest BankWatch assessment of banks in Asia that in many countries there are several state banks operating under close government guidance. Such banks usually exhibit performance ratios which are largely artificial, essentially because their asset quality is abysmal.

The state banks are used as conduits for government development and fiscal policies. Loan classification and provisioning rules are largely inadequate.

In the pure private sector, according to BankWatch, reasonably good asset quality can only be found in Hong Kong and Singapore, with the Philippines and Malaysia at a distance. In those countries, regulatory authorities enjoy, to various degrees, the best reputation.

Banks in Hong Kong, Singapore and the Philippines also have very high capital ratios. At the other extreme , banking systems in Korea, Japan, China, Thailand, Indonesia and India suffer from poor asset quality, the BankWatch study said.

The IMF, World Bank and BankWatch studies expressed similar concerns on excessive lending to real estate.

They cautioned real estate problems hit banks in various ways. Real estate is used as collateral in most types of lending, compounding problems.

BankWatch cited an unfortunate pawnshop mentality among many bankers. Loans are extended on the strength of collaterals without much regard for the ability of the borrower to repay principals and interest from its main line of activities.

Low liquidity, as often as fraud or bad luck, has historically been responsible for bank failures.

Liquidity is the key to survival. A bank can be bankrupt, unprofitable and at the lower end of the asset quality spectrum, but it can still survive if authorities give it enough liquidity and some leeway to "cook the books".

The three institutions believe reform of the banking sector is critical because in most developing countries, where the financial market still lacks depth and the debt market has a limited number of instruments, the banking system controls most new financial flows.

But the IMF, supposed to be the guardian of exchange stability for its 181 member countries, did not want to be blamed for not giving early warnings on the problems which led to Southeast Asia's currency crisis.

It said it had warned Thailand as early as June last year, Indonesia in July and Malaysia in August of the same year.

Claim

The IMF backed up its claim in its latest annual report, issued last week, which also carries summaries of the IMF consultations with its member governments last year.

For example, the summary on consultation between the IMF board of directors and the Indonesian government in July, 1997 reveals the IMF's concern over Indonesia's banking sector.

The report also praises Indonesia for its prudent macroeconomic management and steady reform.

Some excerpts from the IMF Directors-Indonesia consultation: "Directors urged the authorities to address weaknesses in the banking sector, and in particular to act decisively to resolve the problems of insolvent banks and recover nonperforming loans. They consider these actions critical in reducing the vulnerability of the economy to shock and to lessen moral hazard.

"More generally, they strongly urged greater transparency in policy implementation, especially a regulatory framework and tax system that provides a level playing field."

But like in Thailand and Malaysia, it apparently took time for the message to get through in Indonesia.

The Indonesian government announced on Sept. 3 a new package of reform measures which include more vigorous efforts to bring the financial sector under control by, if necessary, closing down insolvent, poorly managed banks and finance companies.