Financial Restructuring in Asia: Issues and Opportunities
Tom Pepper and Ian Giddy
1. Current Situation
-The Asian financial crisis beginning in 1997 has left most Asian companies in need of financial restructuring.
2. Origins of the crisis
-The crisis stemmed primarily from excessive or otherwise inappropriate borrowing to finance continued high growth.
-By 1997, high growth had come to seem "only natural," as one after another Asian company developed systems for profitably exporting lower cost manufactured products to Western, and in recent years, Japanese markets.Concurrently, the emergence of new consumer groups in every Asian country seemed to confirm the "natural" condition of high growth and continuing prosperity.
-Heavy use of debt to finance business expansion also seemed "only natural," as newly-established companies lacked an equity base and business-friendly governments were supplying low-cost debt that, on the one hand, appeared easy to service in an overall environment of high growth and, on the other hand, could also be rolled over relatively easily.Problems would obviously arise if the above conditions no longer applied, but till then company owners felt no pressure to change to a less expansionist approach.
-Such equity as appeared to be required was typically generated "internally," from reinvested earnings, related companies, or individual relatives.This "minimal" level of equity enabled the dominant owners of a company or group of related companies to retain management control over their businesses, but imposed no cost-of-capital constraints on the amount or type of business expansion.As long as sales growth exceeded growth in expenses, business expansion appeared cost "free" and became, in turn, the main measure of business success.
-In this environment, family-dominated business owners -- or, as in Japan, surrogate family business executives -- saw no need to share information or control with outsiders, foreign or domestic.Moreover, with no apparent cost-of-capital constraints, company owners and executives also saw no need to monitor how efficiently they were using their capital. Assets that elsewhere might have been sold off or at least securitized, thereby freeing up capital to be deployable in higher return businesses, remained less-than-optimally utilized in existing businesses and on existing companies' balance sheets regardless of their underlying worth if they had been subjected to independent valuation.
3. Foreign exchange complications
-Unlike export-oriented manufacturing firms, whose foreign currency earnings gave supportive policy makers a rationale for minimizing concerns about over-borrowing, various non-exporting borrowers also took on high debt levels.If, as often happened, these borrowings were in foreign currencies, the borrowing firms -- and, as events later showed, even national treasuries -- were left disproportionately exposed to adverse exchange rate movements.
-In particular, property developers in Thailand, Indonesia, and Korea, whose currencies were pegged to the U.S. dollar, found it advantageous to undertake arbitrage plays, borrowing in dollars at lower interest rates than in their home markets, converting these dollars into local currencies, and simply assuming they could rely on their countries' pegged exchange rates to be able to service dollar-denominated debt in later years.Such interest arbitrage plays generated attractive short-term profits (in some cases stimulating further borrowing to finance still more speculative property development).
-As foreign-based currency traders outside Asia noticed this borrowing pattern emerging, some reasoned that they, too, could undertake arbitrage plays, and short sell what they considered vulnerable Asian currencies in an expectation the exchange values of these currencies would fall.Beginning with the collapse of Thai baht in July 1997, and spreading during the course of the year to the Indonesian rupiah, Korean won, and Malaysian ringgit, this in varying degrees is what happened.
-As local currency values depreciated, local companies that had borrowed in foreign currencies could no longer service debt payments.As confidence fell, so did domestic demand, then employment, then overall growth.Strapped companies could no longer service even domestic currency debt.
4. Government-stimulated recoveries
-Deficit spending by governments, supported in Thailand, Indonesia, and Korea by IMF loans, sought to stimulate recovery.
-In line with now standard macroeconomic theory, these stimulative efforts have worked fairly well, though economists remain typically more cautious than business leaders, officials, or politicians on grounds the affected economies still need extensive microeconomic reform to insure against repeated instances of excessive borrowing.
5. Pending Corporate Finance Issues:Increased Need for Equity
-Even as overall growth among Asian economies recovered during the ensuing two years -- a result of both government stimulus and fortuitous export growth based on extraordinary growth in the U.S. economy -- most individual companies in Asia are still left with over-leveraged balance sheets.
-For such companies to achieve self-sustaining financial strength, they need increased equity to reduce debt levels.This need for increased equity raises important issues not previously faced in Asia:
-Where is such equity to be found?
-Will existing owners accept new equity providers?
-What will be the effects on corporate control of raising new equity?
-The issue of growth vs. control arises not only in Asia, but anywhere:Increased equity is needed to enable a business to grow beyond the limits set by its debt servicing capabilities and/or retained earnings; yet increased equity is often anathema in family-owned businesses that are a prevalent pattern for new ventures and especially prevalent in Asia.Thus, while well-known traditions of arms-length business relationships in the U.S., U.K., and associated Commonwealth countries make publicly available equity (and/or financing from private equity funds) easier to raise and accept in these countries than in most Asian countries, the underlying business issues are identical.
-Unexpectedly, in light of the "base case" reliance on debt rather than equity in the financing of business expansion in Asia, equity may now be in increasing demand in markets in which traditional financial institutions are reluctant to continue lending at the same pace and/or using the same "friendly" criteria as before.Faced with a stark choice between accepting outside equity or being unable to obtain debt financing to support expansion, Asian business owners are likely to show "flexibility" andaccept new equity.Correspondingly, financial institutions that can identify and sponsor equity investors willing to accept minority positions in Asia-based companies will themselves be in great demand.Hence, the sudden and recent appearance in Asian markets of Western-based private equity funds.
6. Global Pressures for Increased Use of Equity
-Various by-products of globalization are also increasing the importance of equity in Asian corporate finance.
-Government- directed or subsidized debt financing -- effectively a system of credit allocation -- requires protectionism, both from foreign-based lenders, lest the previously stronger capital structures of these "outsiders" enable them to offer local borrowers even better terms than the government permits, and from bankruptcy, lest borrowers take on more debt than they prudently should and run into trouble servicing this debt.But such protectionism is now tolerated by other countries less than before.As Asian countries have grown richer, they can no longer claim to be so poor as to deserve special treatment.On an opportunity cost basis, such protectionism is also increasingly expensive, i.e., relative to alternative uses of public funds or lower taxes as a percent of GDP; too much subsidization produces a crowding-out effect and/or higher interest rates.
-A government-directed credit allocation system also effectively pre-empts development of a risk-based credit culture:Lacking systems of credit analysis and price differentiation, banks over-lend; in the absence of market-determined interest rates, neither borrowers nor lenders catch signals to slow down existing expansion; a Japanese-type situation arises, in which the borrowing companies keep seeking sales growth to the point of over-capacity (and resulting low or negative profitability), while the lending banks are stuck with under-performing loans they typically roll-over to maintain nominal asset values.Escaping from or avoiding altogether such over-lending implies a need to employ more equity-based financing than traditionally used in Asia.
-As previous systems of government-subsidized and/or government-allocated credit come under increasing pressure, the weight of excessive debt levels is felt by both borrowing companies and governments.As in Japan for the past decade, a downward spiral ensues:Companies can no longer service their debt (or find new debt to pay off the old); as loan repayments decline, banks' liabilities exceed their assets; temporarily, some banks "survive" through direct government support, as in recent nationalizations in Japan, Korea, Thailand, Indonesia, and Malaysia; but government finances themselves also come under strain and the nationalized banks are put up for sale in a privatization process (in which, in many recent cases, foreign-based buyers have taken control, as only they have the available equity to purchase assets at prices the selling governments and their publics consider fair or at least defensible). 
-A global market in equity returns has limited the segmentation that Asian financial markets had previously considered "natural."The relentless search by equity providers for ever-higher returns, coupled with Asian companies' need for increased equity, leads to an increased emphasis on profitability (i.e., return on equity), vs. the previous emphasis among Asia-based companies on sales growth, market share, or net profit after taxes.
-As long as subsidized debt financing made the cost-of-capital unimportant, Asian companies could afford to ignore it.Once increased equity is needed, however, savvy equity investors will insist that proposed uses of their money earn a net-positive return and a return higher than known alternative uses.In these circumstances, equity is no longer "free."In effect, such arms length-supplied equity has a cost that Asia's traditional "equity" financing didn't have.This change in the criteria through which equity is supplied in turn changes the basis of corporate governance, as well as requiring Asian companies to build considerations of cost-of- capital into business planning.
7. Nascent Market for Corporate Control
-As demand for arms-length/third-party equity financing gradually takes shape in Asia -- at least complementing and in due course replacing the traditional family- or surrogate family-based providers of equity -- an arms-length market for corporate control will also take shape.
-This is not yet an immediate issue, in the sense of such a market's becoming "hot."For cultural reasons, mergers and acquisitions in Asia will remain predominantly "within the family."Divestitures, particularly in the form of management buy-outs, will occur more frequently, however, as companies seeking to raise their returns on equity will look for ways to divest slow growing sub-divisions and subsidiaries.
-From a proliferation of divestiture proposals will come a necessary response in terms of merger and acquisition possibilities.Previously "un-heard of" proposals to buy or sell companies will in due course appear "normal."

March 14, 2000
Ian Giddy
Tom Pepper