The onset of the Asian Financial Crisis
Twenty years ago, in July 1997, the Bank of Thailand withdrew from intervening (pegging Thai Baht to USD) to defend the Thai Baht when its foreign reserves dropped to just effectively USD 7.5 billion after taking into consideration off balance sheet obligations of USD 23.4 billion. Therefore, it simply became untenable for Bank of Thailand to continue defending the Thai Baht. Arguably, that was the “official” start of the Asian Financial Crisis (AFC). Twenty years on, it is an interesting story to share especially when told by those privileged to serve our country when we were given an opportunity to formulate and execute the solutions during that period.
Causes of the crisis
The cause(s) of the Asian crisis will probably be long debated even after this 20th anniversary by economist and political analysts. The underlying reasons range from fixed exchange rates, current account deficits, reckless lending, currency speculation to crony capitalism.
For example, one end of the spectrum lays the blame squarely on crony capitalism in the emerging market economies of East Asia and the other on foreign party’s hell bent on destroying the Asian economies creating a new dawn for neo colonialism.
The two extremes aside, aspects such as managing trade balances, sound credit practices in the banking industry and realistic exchange rates are generally accepted as matters which the governments are responsible to adhere to, to avoid future crises and these are perhaps settled conclusions.
However, there are claims that the weakness was due to a “directed economy” and “capital allocated” based on government influence enabling high growth achieved by the East Asian economies pre-AFC, but they remain debated by economists.
Similarly, the argument for a free unfettered flow of capital and unrestricted trading practices, including short selling to derive profit, championed by the advocates of capitalism against the proponents who argue for the rights of the nations to safeguard the welfare of their citizens vide regulations and restriction on capital will continue to be debated.
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Reaction to the crisis
Once the crisis started, the reactions and approach taken to best resolve the crisis differed. Though many were ready to acknowledge the crisis, some still were in denial and continued to insist that stress tests undertaken by the regulators on banks still showed a sound financial system.
Moreover, some of the measures such as the establishment of Danaharta were deemed merely as pre-emptive. However, a more likely scenario was that the weakness in the banking system existed pre-crisis and the exchange rate decline was a mere trigger to the full-blown credit crisis.
The renowned Professor Altman pointed to back testing data for the three other Asian crisis countries by the World Bank which proved such weaknesses in the banking system existed pre-crisis. Perhaps those in the know in Malaysia would concur a similar view on Malaysia’s situation.
Indeed, the combined level of NPLs, including those acquired by Danaharta, reported by banks and those under CDRC at the peak of the crisis in 1998 was 18.6%, which exceeds the 10% NPL ratio synonymous with the benchmark on what is recognised a credit crisis.
Noteworthy during a lunch at the Lake Club to introduce the newly formed management team of Danaharta to senior central bankers, discussion on concerns of a lost decade ensued.
For many of us, young, probably foolish and still brimming with the confidence of Malaysia in the 1990s and the “can do” attitude, never doubted for a moment our ability to turn around the situation. Regrettably more likely a case of foolish bravado rather than deep intellectual insights on the situation or intuition of evolving the right solutions.
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Learning from others
At the beginning of the crisis, uncertainty prevailed when deciding on strategies and tactics moving forward. Indeed, advice from global consultants were sought and to be fair, in some aspects, their inputs were invaluable.
For example, Arthur Andersen contributed to the legal team’s efforts in drafting the Danaharta Act. Other advice proved to be polite, and was less than effective. Yet, some foreigners genuinely helped by sharing their real-world experiences they had from earlier Credit Crises such as that in Sweden.
An excellent example was that there was no need to raise USD dollar debt, or for that matter any new “money” to acquire the NPLs. The approach to raise USD dollar debt was originally planned to be undertaken by a large global investment bank which would have enjoyed substantial fees had the bonds been issued.
These multibillion USD borrowings based on commercial rates were was considered necessary to maintain Malaysia’s financial policy independence by shoring up reserves with USD funds raised converted into Ringgit then used to acquire NPLs. This negated the need to approach IMF and allowed Malaysia to manage its financial matters independently.
However, borrowing USD at commercial rates on the international debt market would have been a disastrous undertaking given Malaysia’s sovereign rating had fallen to just one notch above junk status.
The former CEO of Securum pointed out that an NPL is a funded position and does not need new funding. As such, the Asset Management Company (AMC) merely needs to borrow from the bank, i.e. existing lender to acquire the NPL. The lesson learnt that an NPL is a funded position proved to be invaluable. Like many other foreign ideas we borrowed, this idea was adapted and enhanced with Malaysian innovations.
To this end, Danaharta’s zero coupon bonds were created, tied in with a novel incentive programme for the banks which sold their NPLs to share on the upside as well as provide a window for liquidity vide Bank Negara Malaysia (BNM). This not only resolved the funding issue but sped up the carve out of NPLs which then accelerated commercial banks’ return to its critical lending activities which had all but ceased at a substantial number of financial institutions with the onset of the credit crisis.
That idea of revamping an existing workable model was not only applied to Danaharta but also when Danaharta’s chairman and management were subsequently requested to chair and seconded to operate CDRC.
CDRC was originally set up based on the London Approach towards debt resolution and the first model operated using rotating chairman picked from amongst the lenders, and implementation was on consensus view. However, what became apparent was that senior bankers, with front line responsibilities for their own bank, could not dedicate their time nor consistently apply policies and decisions compared to what a dedicated full-time chairman of lenders meeting could perform.
Therefore, one of the key improvements was centralising the chairman of the creditors meeting. Moreover, the new team tightened and enhanced its procedures on achieving milestones and also introduced greater “persuasion” from the Central Bank in respect of reaching consensus and coordination with Danaharta on the possibility of using the Danaharta Act to reduce the majority required to approve a Schemes of Arrangement.
BNM vide its press release on July 23, 2009 stated that “CDRC was first established during the 1998 financial crisis and was successful in resolving 57 cases with a total outstanding debt of RM45.8bil, helping to accelerate the country’s economic recovery.”
During the crisis, the policy trilemma from an economic perspective was truly understood. The policy trilemma, also known as the impossible or inconsistent trinity, states a country must choose between free capital mobility, exchange-rate management and monetary autonomy (the three corners of the triangle in the diagram).
Source: The Economist
The point was reiterated by Noble prize-winning economist Paul Krugman in 1999 “you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain – or Canada); or it can choose to leave capital free and stabilise the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina, or for that matter, most of Europe today)”.
Businesses in Malaysia required stable exchange rates as Malaysia continued to have an open trading economy which had large imports and exports denominated in USD. It was clear that interest rates could not influence exchange rates in a crisis without severe repercussions as previously proven elsewhere in the world, e.g. the pound crisis during the departure from the Exchange Rate Mechanism (“ERM”). Early attempts in increasing interest rates proved disastrous. The increase in interest rates had several severe impacts, including higher unsustainable cost of debt, fall in demand, and decline in asset values.
It should have been clear to all and sundry that the policy by the IMF and World Bank to advise on the concept of increase in interest rates was flawed and would worsen the crisis. Only when currency and capital controls were established, could interest rates be brought down significantly, insulating monetary policy from volatility due to fluctuating currency. This allowed businesses to breath, increased confidence, provided stability and caused asset prices to rise.
Moreover, in respect of asset price rising, residential property prices could increase as interest rates began to fall and new products such as Base Lending Rate (BLR) plus zero financing began to emerge in response to falling interest rates.
Also, the pegged exchange rate was set at a mark that people were confident that the Ringgit was undervalued and there was no hurry to take out the monies through the black market, etc. Further, the strong trade surplus that followed ensured that the exchange rate could be sustained. Fortunately for Malaysia, the policy misstep with regards to increased interest rates adopted at the onset of crisis was brief and did not have the debilitating effect on the economy it had in other Asian crisis countries.
Source: Kanitta Meesook, II Houng Lee, Olin Liu, Youngest Khatri, Natalia Tamirisa, Michael Moore, and Mark H. Krysl; Malaysia: From Crisis to Recovery, pg 27, Figure A.2.9
The following graph from a book by Dominic Barton, Gregory Wilson, Roberto Newell entitled Dangerous Market, Managing in Financial Crisis shows the comparisons between country performances in the period relevant to the Asian crisis. As seen by several of the measures, Malaysia outperforms those countries which followed the IMF prescription.
Source: Dangerous Markets: Managing in Financial Crisis
One of the reasons for this success is the coordinated effort by the National Economic Action Council (NEAC) and BNM with specialist agencies created during the crisis with specific roles.
“Malaysia has achieved considerable progress in implementing these reforms in comparison to other crisis countries. The approach adopted by Malaysia (and also Korea) in resolving bad loans problems and restructuring banks involved a high degree of government involvement, which had the advantage of speed and coherence …” (excerpt from Malaysia: From Crisis to Recovery by Kanitta Meesook, II Houng Lee, Olin Liu, Youngest Khatri, Natalia Tamirisa, Michael Moore, and Mark H. Krysl, pg 74)
Whether or not exchange control played a significant role is still debated because at that time, a fair degree of stability had been established in the region and there was consensus that the Ringgit was undervalued.
However, unorthodox approaches to crisis resolution has gained wider acceptance. Iceland is a more recent example of a crisis country that implemented unorthodox solutions and posted better results compared to Ireland which, at the onset of the Global Financial Crisis, did not have as severe a problem as Iceland.
The graph below compares the growth in Gross Domestic Product (GDP) between Ireland and Iceland, followed by between Iceland and Greece.
Source: The Washington Post
Source: Allianz Global Investors
Iceland sharply reduced spending, more than Ireland, and increased interest rates up to 18% to rein in inflation, it allowed its banks to go bust (did not repay foreigners for their reckless lending) and let its currency collapse whilst putting capital controls in place.
Certainly, Iceland’s economy has outperformed Greece which remains beleaguered with economic malaises and severe hardship for its people. It takes bravery to force an economic reset that addresses the underlying issues but Greece cannot pull the same trick because Greece’s currency is the Euro.
It is acknowledged that significant financial and balance sheet reform took place in Malaysia following the Asian crisis. Weaker banks were merged with stronger banks rather than being liquidated and domestic financial institutions were recapitalised, thus reducing the catastrophic events associated with bank closures.
This lesson was learnt from the crisis in the 1980s and thus the option of bank mergers was pursued rather than bank closures unlike in other Asian Crisis countries. Infrastructure-related privatisation were brought into government fold and corporations balance sheet were improved.
However, the criticism was that whilst restructuring did take place it was mainly financial but not so much on critical operational restructuring. However, the criticism is perhaps unfair, corporate exercises such as mergers and acquisitions arose following the aftermath of the AFC, which led to the revamped AirAsia, merger of various banks in Malaysia forming CIMB, formation of SapuraCrest and later with Kencana Petroleum, forming Sapura Kencana, are some of today’s leading corporations in Malaysia.
There are also cases of foreign ownership which had benefited the country, and companies with stronger balance sheet were able to grow successfully. It was pointed out by a leading economist from an investment bank recently that following the AFC, the efforts in the 1990s at expanding infrastructure and investment into manufacturing and reformation of the financial sector, spurred economic growth and paid dividend in the 2000s, i.e. the economy did grow well in the period following the tech bubble bust right up to the Global Financial Crisis without large growth in credit expansion or high oil prices.
Total Public Debt over GDP have been increasing for the first few years post-AFC as corporate investment increased along with fiscal stimulus plans by the Government. Subsequently, Total Public Debt over GDP have been fairly consistent post-2005, suggesting macroeconomic stabilisation (steady growth in credit).
Source of data: Malaysia Economy in Three Crises by Prema-chandra Athukorala, October 2010 & World Bank
For completeness and as a useful conclusion, some of the lessons learnt are set out below:
- No doubt the leadership provided by the government was instrumental in managing the crisis successfully, in particular after the initial stage of being decisive, focused, demonstrating the ability to adapt and being steadfast on the direction once it was clear. Strong government facilitated passing of important legislation during the time such as the Danaharta Act which was an important factor in debt resolution.
- The presence of strong “Economic Institutions” such as NEAC, MOF, BNM (CDRC, Danaharta and Danamodal coordinated by BNM) and the Securities Commission enabled the policies and approaches to be implemented effectively with credibility and instilled investor confidence.
- Debt was substantially denominated in Ringgit and not in foreign currency. Even foreign currency debt can be a manageable problem if it is not sovereign-related (or implied sovereign guaranteed), i.e. private sector-related as in the case of Iceland.
At worst, debt of domestic corporations denominated in foreign currency can be written off once assets were foreclosed and the losses would be limited and shared by foreign lenders. However, if debt is in foreign currency and sovereign-related, the implication of default is severe as foreign banks and bond holders leverage on this point at the expense of the nation. Argentina, and more recently Mongolia, are examples of countries with high levels of sovereign debt denominated in foreign currency, when they defaulted.
- The driving force of the economy are entrepreneurs. Therefore, the preservation of genuine entrepreneurs is critical and this is also positive for banks and lenders. Entrepreneurs are the people best placed to turn around the business even in distress as they know the business, have the entrepreneurial drive, risk appetite and above all willingness to put risk capital into the business. Contrast this with liquidators who despite being professional have diametrically opposite characteristics. In any case, supporting the entrepreneur is also in the best interest of lenders which is well known to most bankers in bank recovery divisions and restructuring specialists. Danaharta provided comprehensive data in their final annual report which supports this proposition.
Source: Danaharta Annual Report 2005
- The importance of bottom up analysis on credit markets and capital deployed so far indicated that “back testing” some of the Asian Crisis hit countries by the World Bank showed that financial weaknesses could be clearly identified before the crisis. The exchange rate crisis was a mere trigger which set off what was already an existing weakness in the economy and quality of credit. We understand similar analysis also indicated Greece and US exhibited the same characteristics prior to the Global Financial Crisis.
Source: Managing Corporate and Sovereign Credit Risk in a Global Environment by Professor Edward I. Altman, 16 November 2015
- Having the right people remains one of the most important factors. During that time, a great number of bright people were drafted to serve the country. They not only were highly talented individuals, they also had the capacity to learn quickly, adapt and innovate. Rising above all challenges during the time, they worked well as team of Malaysians that produced exemplary results. This was well acknowledged and many went on to advise other countries facing a financial crisis or keen on setting up their own AMC.
- Probably the most important lessons are what the late chairman Tun Raja Mohar Raja Badiozaman advised us at Danaharta, i.e. to work diligently and with integrity. Moreover, he emphasised that we should keep proper records of deliberations and decisions made as he mentioned once we are all gone, only the records remain. To him, these records eventually will be the only things available to stand up to the scrutiny by third parties. No doubt that many should be named for their contribution during that time but special mention is made only of Tun Raja Mohar because he was an immense pillar of integrity and reason during the darkest days of the crisis and the ensuing political crisis.
Ravindran Navaratnam is the Managing Director and Co-Founder of Sage 3 Capital, a specialist advisory firm advising on distress resolutions for major corporations in Malaysia and Singapore. He was formerly the General Manager responsible for strategy and corporate finance at Danaharta, Malaysia’s asset management company at the height of the Asian Financial Crisis, at its inception. Ravi’s views have been sought by senior Government officials via his role as advisor for major national initiatives to restructure Non-Performing Loans. In this respect, he has had invitations from government agencies in China, Thailand, Vietnam, Dubai, Ireland and Indonesia to advice on the matter.