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Balancing risks and returns in Asia

By Chrisopher Lingle

Sunday, Jun 01, 2003, Page 9

ILLUSTRATION: YU SHA

With so many uncertainties relating to rising public and private debt and terrorism and military reprisals, the global picture for economic growth has become increasingly murky. Among the wider imponderables are the effects of a spike in oil prices or a steep fall in the dollar or a stalled US economic recovery.

As investors scour the planet in search for a reasonable balance of risks and returns, attention is again focusing on Asian economies and stock markets. Many analysts have begun to observe that Asia, outside of Japan, holds considerably more promise than other parts of the world. A report prepared by J.P. Morgan estimates that economic growth in Asia will average 5.6 percent this year. The figures suggest that China will top the league with 7.5 percent, followed by South Korea at 6.2 percent and India at 5.8 percent. And it is expected that China's performance will help boost intraregional trade in such a manner that there is less dependence on export markets like North America and Europe.

Despite this rosy picture, Asia economies have shown a tendency of volatility arising from poorly planned expansion associated with excessive borrowing causing over-capacity and bubbles. Figures from Morgan Stanley Capital Index (MSCI) reveal much about the scale of the turmoil that hit much of East Asia in 1997 to 1998.

During that period, shares on Indonesia's market shed 90 percent of their value while those in Malaysia lost 74 percent. Stocks traded on Thailand's main indexes saw 73 percent go up in smoke while their counterparts in Singapore, the Philippines and South Korea lost from 56 percent to 67 percent. Even stocks traded in the safe haven of Hong Kong lost 51 percent of their market capitalization. Along with the collapse of capital markets, the unmanageable burden of US dollar-denominated debts caused banks and insurers to become insolvent while corporate empires disintegrated.

Of course, lessons were learnt from burnt fingers during that episode leading to changes in the composition of companies traded on these markets and in overall economic activity. In particular, there has been a shift away from a concentration on property developers and supportive industries (eg, concrete) toward manufacturing and technology.

On several measures, Asian stocks are attractive. They trade, on average, at just over 10 times their prospective earnings and paying average dividend yields that are half again as large as payments on stocks traded in the US.

Yet, just as there are global uncertainties, there are many problems relating to the region. For example, there are elections scheduled for next year in Taiwan, South Korea, the Philippines, Indonesia, India and Malaysia that could lead to some surprise changes in policy. And then there is the potential destabilizing effect of tensions between North Korea and its various antagonists.

Another reason for prudence before committing investment funds in Asia is the ratio of non-performing loans (NPLs) held in the banking sector. Consider that banks are generally healthy if no more than 2 percent of their loans are non-performing and ratios below 5 percent are acceptable. However, NPLs that exceed 10 percent are considered to be problematic while rates over 20 percent are deemed to be dangerous.

Official data for the Philippines suggests that the non-performing loan rate is just over 16 percent. According to Fitch, these numbers do not reflect foreclosures on real estate that would raise the NPL rate closer to 26 percent. And in Indonesia, despite considerable success at reducing the amount of non-performing loans, most of the banks that were nationalized in 1997 remain under government control.

Japan's banking system is struggling under the weight of 40 percent of outstanding loans to be non-performing with official figures valuing bad debt at 52.4 trillion yen. Data from McKinsey on non-performing loans by country estimates that China has a bad loan ratio of 44 to 55 percent of GDP. The ratio in Taiwan is 20 to 27 percent while in South Korea it is 7 to 14 percent.

More of Asia's financial institutions must recapitalize or close or merge. The simplest way out would be to relax restrictions on foreign ownership of banks. However, many countries still prohibit foreigners from majority control of a domestic bank. A temporary solution was introduced in Thailand to allow foreign control of its banks through majority foreign ownership, but it was limited to 10 years.

Even so, many of the problem banks are not solvent enough to attract foreign buyers. At the same time, the slump in the region's economies means that it is equally difficult to attract domestic capital. In many instances, there are inadequate reserves set aside to cover losses. Inevitably, there must be substantial consolidation of Asia's banking industry.

Aside from capital infusions, foreign banks will introduce much-needed innovation while expanding customer services. As it is, most Asian financial institutions paid low interest to depositors while providing cheap loans to large corporate borrowers and made little credit available to small and medium-sized enterprises. It would also help if banks move away from relying almost exclusively upon property-based collateral. Restructuring Asia's banks require more than recapitalization that involves lowering costs and waste. There must also be better legal protection of contract and property rights within a system of competent, unbiased judges and regulators. Outdated accounting systems also need to be modernized to meet international standard and to provide greater transparency and accountability.

These changes involve radical changes that would weaken the arbitrary use of power by politicians and bureaucrats throughout Asia. Until there is greater reliance upon the rule of law along with improvements in banking and capital market standards, foreign investors should exercise extreme caution before placing their funds in Asia.

Christopher Lingle is professor of economics at Universidad Francisco Marroqu in Guatemala and Global Strategist for eConoLytics.com.
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