Corruption Asia

Corporate Governance and Finance in East Asia
A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand

VOLUME TWO
Country Studies
Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank
Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term country does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines
iii
Contents
List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51
2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance
53 53 55 55 60 62 65
iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214
v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226
4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References
229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277
vi
List of Tables
1. Indonesia Table 1.1 Growth of the Banking Sector, 1993-1999 Table 1.2 Foreign Capital Flows, 1990-1998 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies, 1992-1997 Table 1.4 Growth Performance of Publicly Listed Companies by Sector, 1992-1997 Table 1.5 Financial Performance of Publicly Listed Companies by Sector, 1992-1997 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies, 1992-1995 Table 1.7 Growth Performance of the Top 300 Conglomerates, 1990-1997 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies, 1993-1997 Table 1.9 OwnershipConcentrationofPubliclyListedCompanies by Sector, 1997 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates, 1988-1996 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1.12 CharacteristicsoftheBoardofDirectors Table 1.13 Presence of Board Committees in Listed Companies Table 1.14 Banking Sector Outstanding Loans, 1992-1999 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization, 1992-1999 Table 1.16 FinancingPatternsofPubliclyListedNonfinancial Companies, 1986-1996 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.18 GDP Growth by Sector, 1996-1999 Table 1.19 DER and ROE of Publicly Listed Companies by Sector, 1996-1998 Table 1.20 ROE of the Banking Sector, 1992-1997 Table 1.21 Nonperforming Loans by Type of Bank, 1996-1998 2. Republic of Korea Table 2.1 Listed Firms with Positive Economic V alueAdded, 1992-1998 Table 2.2 KeyMacroeconomicIndicators Table 2.3 Subsidiaries of the 30 Largest Chaebols Table 2.4 Development of the Stock Market, 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41
54 56 61 63
vii Table 2.5 Table 2.6 Table 2.7 Table 2.8 Table 2.9 Table 2.10 Table 2.11 Table 2.12 Table 2.13 Table 2.14 Table 2.15 Table 2.16 Table 2.17 Table 2.18 Table 2.19 Table 2.20 Table 2.21 Table 2.22 Table 2.23 Table 2.24 Table 2.25 Table 2.26 Table 2.27 Table 2.28 Table 2.29 Table 2.30 Private Capital Flows to Korea, 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector, 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies, 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size, 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols, 1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio, 1995-1997 Ownership Composition of Listed Companies, 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry, 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size, 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type, 1997 Ownership Composition of Listed Firms in Selected Countries, 1997 Ownership Concentration ofAll Listed Firms, 1992-1997 OwnershipConcentrationofListedNonfinancialFirms, 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry, 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size, 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms, 1999 InternalShareholdingsofthe30Largest Chaebols, 1987-1997 FlowofFundsoftheNonfinancialCorporateSector, 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector, 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies, 1994-1998 Financing Patterns of the Top 30 Chaebols, 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols, 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127
viii Table 2.31 Table 2.32 Table 2.33 Net Profit Margins of Chaebols, 1985-1997 Number of Firms with Dishonored Checks, 1986-1998 Nonperforming Loans of General Banks, 1990-1998 131 137 138 158 159 160 161 163 164 166 173 175 176 180 184 191 201 203 204 205 206 207 208 209 212 235 236
3. The Philippines Table 3.1 GDP Growth of SoutheastAsian Countries, 1990-1999 Table 3.2 Growth and Financial Performance of the Top 1,000 Companies, 1988-1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct, 1988-1997 Table 3.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type, 1988-1997 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure, 1988-1997 Table 3.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size, 1988-1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry, 1988-1997 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector, 1997 Table 3.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies, 1997 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector, 1997 Table 3.11 TotalandPerCompanySales,SectorOrientation, Flagship Company, andAffiliated Banks of Selected Business Groups, 1997 Table 3.12 Control Structure of the Top 50 Corporate Entities, 1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.14 Philippine Stock Market Performance, 1983-1997 Table 3.15 Financing Patterns of the Corporate Sector, 1989-1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType,1989-1997 Table 3.17 Composition ofAssets and Financing of the Publicly Listed Sector, 1992-1996 Table 3.18 Financing Patterns by Control Structure, 1989-1997 Table 3.19 Financing Patterns by Firm Size, 1989-1997 Table 3.20 Financing Patterns by Industry, 1989-1997 Table 3.21 OwnershipConcentration,Profitability andFinancial , Leverage Table 3.22 Foreign Investment Flows, 1995-1998 4. Thailand Table 4.1 Public Companies Registered, 1978-2000 Table 4.2 Public Offerings of Securities, 1992-1999
ix Table 4.3 Table 4.4 Table 4.5 Table 4.6 Table 4.7 Table 4.8 Table 4.9 Table 4.10 Table 4.11 Table 4.12 Table 4.13 Table 4.14 Table 4.15 Table 4.16 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand, 1993-1999 Key Financial Ratios of Publicly Listed Companies, 1985-1996 Average Key Financial Ratios by Company Size, 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand, 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability, Leverage, Ownership Concentration, and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand, 1990-1998 Merger and Acquisition Activities, 1993-1999 Size and Composition of the Thai Financial Sector, 1992-1999 Offerings of Debt Securities, 1992-1999 Common-Size Statements for Companies Listed in SET, 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration, 1990-1996 Financial Ratios of All Listed Firms, 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration, 1990-1996 External Debt, 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies, 1985-1999
237 238 239 241 242 243 251 252 256 258 259 260 261 262 264
List of Figures
Figure 1.1 Figure 1.2 Figure 3.1 Figure 3.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197
Foreword
Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADBs financialsectorworkinitsdevelopingmembercountries.
Arvind Panagariya ChiefEconomist
xi
Preface
Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaa of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldaaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.
xii
Abbreviations
ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholdersmeeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter
xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
1 Indonesia
Saud Husnan1
1.1
Introduction
The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesias monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation
1
Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
Corporate Governance and Finance in East Asia, Vol. II
rate reached 58.5 percent. All sectors, except utilities, posted negative growth. The construction sector was the worst hit, contracting by 36.5 percent, followed by finance (-26.6 percent) and trade (-18 percent). The scale of the financial crisis exposed weaknesses of the countrys corporate sector. The highly concentrated and family-based ownership structure of corporate groups and companies resulted in a governance structure where corporate decisions lie in the hands of controlling families. In many instances, these controlling families had political connections that allowed their companies to enjoy special privileges. Foreign creditors, no doubt, placed a high premium on these political connections in assessing the chances of being repaid. To facilitate even easier access to credit, the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. These banks were allowed to operate even if they violated minimum capital adequacy requirements. In this setup, short-term loans were used to finance long-term investments. Lending activities of affiliate banks that were not sufficiently backed by owners equity and the reliance by foreign lenders on the strength of political connections paved the way for risky investments. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. On the other hand, prior to the financial crisis, the Indonesian economy seemed to be in generally good shape. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. However, the currency composition and term structure of corporate foreign indebtedness were causes for concern. Foreign debt reached more than $100 billion. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea, Malaysia, or Thailand, this left the Indonesian economy extremely vulnerable. When the crisis hit the country, highly leveraged companies, particularly those with large foreign loans, were the ones most affected. This study reviews the Indonesian corporate sectors historical development, regulatory framework, patterns of ownership and control, patterns of financing, and responses to the financial crisis. It analyzes the weaknesses of corporate governance in Indonesia, how it has affected corporate financial performance and financing, and how it contributed to the crisis. The study also identifies family-based companies and corporate groups, and analyzes their importance to the corporate sector in Indonesia. Section 1.2 presents an overview of the Indonesian corporate sector. Section 1.3 looks at patterns of corporate ownership and control, and
Chapter 1: Indonesia 3
profiles the corporate sectors governance characteristics. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.2 Section 1.4 analyzes corporate financing patterns. It also examines the statistical relationship between corporate performance and corporate governance characteristics. Section 1.5 examines the corporate sector during the financial crisis in terms of its role, how it was affected by the crisis, and its response. Section 1.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector.
1.2 1.2.1
Overview of the Corporate Sector Historical Development
The marked permeability between the State and business in Indonesia goes back to the countrys struggle for independence. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies, in the course of the fight for nationhood from 1942 to 1950. Up until the mid-1960s, while Chinese and indigenous entrepreneurs ran some large businesses in trading, textiles, and tobacco industries, medium- and large-scale companies were dominated by state-run industrial concerns. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968, a gradual shift in public investment away from manufacturing took place. Subsequently, substantial volumes of private investment entered the scene. In the early 1970s, the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. The industries that emerged were highly import-dependent and reliant on tariff protection. Despite the oil revenues,
Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. However, only 40 companies replied39 are private companies and one state-owned company (Bank BNI). Not all items in the questionnaires were answered by the respondents.
the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. During this period, a distinct industrial elite started to emerge. These were families with strong links to the political elite of the New Order. In the 1980s, the Government shifted its industrial policy toward the promotion of labor-intensive exports. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. By 1987, exports of nonoil products (particularly textiles and footwear, wood, and related products) had shares in total exports that were rapidly increasing. In 1992, the value of manufactured exports overtook the value of oil and gas exports for the first time. Partly as a result of various government policies, the Indonesian industrial sector was quite diverse. While most of the companies were small, produced consumer goods, and employed the bulk of the industrial labor force, there were also many rapidly growing large-scale companies and business groups or conglomerates, which dominated their respective sectoral outputs and markets. 1.2.2 The Capital Market
The Government reactivated the stock exchange in 1977. A number of underwriters emerged, mostly nonbank financial institutions and stockbrokers. But until the end of 1988, the number of firms quoted in the stock market was only 24. The equity market remained largely unappealing due to a number of factors. First, many founding owners of companies were reluctant to go public and dilute their corporate ownership. Generally speaking, the dilution of corporate ownership, even when new shareholders do not threaten the control exercised by the original owners, potentially subjects companies to greater regulatory scrutiny. Second, the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. Third, investors were reluctant to supply funds to the stock market because they did not know whom to trust and the mechanisms that could protect small investors and shareholders against expropriation by controlling shareholders were underdeveloped. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. Last, the Capital Market Executive Agency and National Investment Trust tried to attract small investors to the stock market by setting prices and preferring small orders in initial public offerings (IPOs). But these proved counterproductive because they limited the potential for capital gains to prospective investors.
At the end of 1988, the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. Thus, companies could no longer enjoy low-interest credit from state banks. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market, which were previously constrained to 4 percent per day. The Government also allowed foreign investors to buy up to 49 percent of listed shares. Consequently, the number of listed companies in the stock exchange increased substantially, from 24 in 1988 to more than 300 in 1997. During this period, the capital market played an increasing role in raising long-term funds needed by the corporate sector. Conglomerates carried out 210 out of 257 IPOs, with a total value of Rp16.5 trillion. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). Since 1977, six SOCs had issued equities in the market, with a total value of more than Rp8 trillion. However, to date, the controlling shareholder of these SOCs is still the State. 1.2.3 The Banking Sector
Despite the development of the stock market, the banking sector has been and still is the major source of credit for the corporate sector. Through the years, the banking sector has undergone many reforms. However, the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. The initial banking sector reform was introduced in 1983. Interest rate regulations on state banks and credit ceilings in general were removed. The banking sector, which up to then was channeling oil revenues to priority sectors, began to face competition. The dominance of state banks started to erode. However, priority credits still enjoyed subsidized interest rates and funding from the Central Bank. In 1988, more significant reforms were introduced. These included the opening of the banking industry to new entrants, reduced restrictions on foreign exchange transactions, and increased access of domestic banks to international financial markets. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. Partly as a result of these reforms, the number of private domestic banks increased. Table 1.1 shows that from 1994 to 1998, private domestic banks dominated the sector in terms of number and total assets. But in terms of assets per bank, state-owned banks were still among the biggest.
Table 1.1 Growth of the Banking Sector, 1993-1999

Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks
Source: Bank Indonesia.
1993 100.6 7 7.9 10 11.8 29 6.5 27 88.2 161 214.0 234
1994 104.5 7 9.2 10 14.3 30 7.9 27 113.8 166 248.1 240
1995 122.6 7 12.3 10 17.9 31 9.8 27 147.5 165 308.6 240
1996
1997
1998
1999
141.3 201.9 304.8 391.5 7 7 7 5 15.8 10 19.8 31 10.7 27 37.8 10 37.4 34 12.3 27 51.1 10 47.6 34 14.5 27 66.4 10 35.9 39 18.8 27
200.9 248.7 351.9 291.6 164 144 130 92 387.5 528.9 762.4 789.4 239 222 208 173
Assets and liabilities were concentrated in the top 10 banks. In terms of assets, private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group), Bank Danamon (ranked 7th), and Bank International Indonesia (ranked 9th). The other banks among the top 10 were state banks. Among private domestic banks, the 10 largest were all affiliated with major business groups. Of these, BCA, Bank Danamon, and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA), while BUN has been closed down by the Government. Both BCA and BUN have shareholders linked to the former President Suharto. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector. But the banking system proved incapable of performing its intermediation function. Because regulation was weak, banks could earn profits even when they did not gather and process information about risk.
Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way. In effect, there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. 1.2.4 Foreign Capital
The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs), initially from Japan and the Republic of Korea. But FDIs were only one form of foreign capital inflows to Indonesia. In the 1990s, there was a phenomenal growth in direct borrowings by Indonesian corporations. Until the onset of the crisis, foreign creditors were eager to provide financing to Indonesia, especially through bank loans. Between 1990 and 1996, Indonesia received capital inflows averaging about 4 percent of GDP. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP), they still amounted to a large sum for the economy to absorb. From the mid-1980s until July 1997, when the financial crisis hit Indonesia, FDI flows were strong. Most FDIs came in through joint ventures with business groups having strong political connections. Net FDI flows increased to $5.59 billion in 1996, as shown in Table 1.2. Successive policy deregulation facilitated FDIs in various light manufacturing industries, such as metal goods, textiles, and footwear. Increasingly, foreign investment also had a strong presence in the services and infrastructure sectors. In 1994, the Government allowed foreign investors to own 100 percent of an Indonesian company, except in certain strategic sectors. Table 1.2 Foreign Capital Flows, 1990-1998 ($ billion)
Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998
1.09 1.48 1.78 2.00 2.11 3.74 5.59 4.50 (0.40) (0.09) (0.01) (0.09) 1.81 3.88 4.10 5.01 (2.63) (1.88) 8.87 7.33 (13.15)
= not available. Source: IFS CD-ROM, IMF, September 2000; Joint BIS-IMF-OECD-World Bank Statistics on External Debt, November 2000.
Up until the late 1980s, participation in the Indonesian stock market was exclusive to domestic investors. The Government relaxed this restriction in 1988, allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. Consequently, foreign investors began to dominate daily trading, increasing the total trading value from Rp8 trillion in 1992 to Rp120.4 trillion in 1997. In September 1997, with the onset of the Asian crisis, the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. Between 1989 and 1992, the average foreign ownership of listed companies was 21 percent. This increased to 30 percent by the end of 1993, but declined to an average of 25 percent during 19951997. In the 1990s, foreign banks became a significant source of financing for the corporate sector. By the end of 1997, more than 50 percent of total Indonesian private debt and 60 percent of total foreign exchange debt were owed to 175 foreign banks and other foreign financial institutions. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. Private borrowers preferred foreign loans since these were relatively cheaper, especially the short-term ones. From 1987 to 1996, the average borrowing rate for dollar loans was 9 percent, plus 4 percent for the depreciation of the rupiah. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 devaluation under the managed floating system. In November 1998, total corporate debt reached nearly $118 billion. Domestic corporate debt was about $50 billion equivalent, of which two thirds were rupiah-denominated. The external corporate debt owed to foreign commercial banks was $67 billion. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. 1.2.5 Growth and Financial Performance
While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis, an interesting question is whether standard measures of corporate profitability and performance also indicated the same. The following section looks at the growth and financial performance of the corporate sector. Due to data constraints, the analysis focuses only on publicly listed companies, state-owned companies (SOCs), and conglomerates.
Publicly Listed Companies Table 1.3 shows the growth and financial performance of Indonesian publicly listed companies. During 1992-1997, total sales of listed companies grew at an annual average rate of 31 percent, while total assets grew at 43 percent. Despite such rapid growth, publicly listed companies as a group contributed less than 10 percent to GDP, although the contribution increased over time. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996, but turned negative in 1997. The growth of listed companies was sustained by continuing investments. Table 1.3 Growth and Financial Performance of Publicly Listed Companies, 1992-1997 (percent)
Item Growth Indicators Sales Growth Share of Value Added in GDPa Asset Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb 1992 3.7 250.0 12.6 3.4 38.4 1993 45.1 4.6 48.5 240.0 12.5 3.5 37.6 1994 50.3 6.0 64.8 220.0 12.0 3.5 34.2 1995 37.8 6.9 37.1 220.0 11.3 3.5 34.4 1996 18.2 7.0 33.8 230.0 10.7 3.2 30.4 1997 7.0 6.4 31.9 310.0 1.1 0.6 24.7
= not available. Note: The number of firms is not identical for each year. In 1997, there were 204 firms; 1996, 248 firms; 1995, 246 firms; 1994, 250 firms; 1993, 226 firms, and 1992, 174 firms. a Value added was assumed to be 30 percent of total sales. b Asset turnover is defined as sales over assets. Source: JSX Monthly (several publications).
Average return on equity (ROE) of listed firms was 11.8 percent between 1992 and 1996, but dropped to 1.1 percent in 1997 when the crisis began to buffet Indonesia. Return on assets (ROA) was also relatively stable during 1992-1996, averaging 3.4 percent, but declined to 0.6 percent in 1997. Asset turnover was above 30 percent until 1996, but fell to 24.7 percent in 1997. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines, ranging from 220 to 250 percent between 1992 and 1996. When the crisis battered Indonesia in 1997, the average DER increased to 310 percent from 230 percent the
10
previous year. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. Overall, it appeared that the performance of listed companies was quite satisfactory prior to the crisis, although asset turnover was slow. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture; mining; basic industry and chemicals; miscellaneous industry; consumer goods; property, real estate, and building construction; infrastructure; finance; and trade, investment, and services. In terms of sales and asset levels in 1997, the dominant sector was the finance sector. However, in terms of growth of sales and assets, the mining sector ranked first, followed by agriculture (Table 1.4). In terms of share of value added to GDP, only two sectors (mining and finance) showed a consistently increasing trend from 1992. The finance sectors contribution to GDP, meanwhile, increased from 0.73 percent in 1992 to 1.64 percent in 1997. Table 1.5 presents the financial performance of listed companies by sector. From 1995, the mining sector had the lowest DER, indicating its reliance on equity to support growth. The finance; trade, investment, and services; and property, real estate, and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. For instance, when the property sector was booming during 1993-1997, the banks eagerly provided credit to property development companies. The same applied to the trade sector. Before the crisis, the mining sector had the highest ROE, averaging 21.3 percent between 1992 and 1996. But the sectors ROE fluctuated a lot, due mainly to the domination of the International Nickel Company of Canada, which operated in nickel and copper mining in 1992 and 1993. During those years, the fluctuation in nickel and copper prices contributed to the oscillation of ROE. The consumer goods sector ranked second in terms of ROE, averaging 17.7 percent during 1992-1996. This sector was less affected by the crisis, still posting a positive but lower ROE, helped in part by the relatively strong demand for consumer goods. Also, the companies in the sector did not operate with a high leverage. Meanwhile, the property sector was severely affected by the crisis, with ROE falling to -11.2 in 1997. When interest rates increased, ROE fell drastically because the sector had one of the highest DERs. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. ROA of all sectors dropped in 1997. Four sectors (basic industry and chemicals, miscellaneous industry, property, and trade) even posted
Table 1.4 Growth Performance of Publicly Listed Companies by Sector, 1992-1997 (percent)
Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services
= not available. Source: JSX Monthly (several publications).
1992 0.1 0.0 0.8 1.1 0.6 0.1 0.0 0.7 0.4
1993 155.0 64.1 32.6 26.3 31.7 11.5 95.4 103.5 23.7 21.5 13.0 68.8 62.1 39.6 85.8 50.0 (28.6) 25.2 11.6 51.6 22.7 36.7 90.0 0.3 0.1 0.9 1.2 0.6 1.3 0.4 0.7 0.6
1994 (75.3) 53.1 42.0 43.4 64.8 (76.7) 26.5 61.7 40.8 66.1 16.4 31.1 67.2 59.5 92.1 35.6 83.8 51.6 133.3 340.0 16.9 64.9 123.4 170.4 43.5 68.7 (82.8) 0.1 0.1 1.0 1.5 0.9 0.3 0.4 1.0 0.7
1995 51.4 38.8 29.4 30.1 23.8 24.7 24.7 62.9 54.4 44.9 36.2 41.3 17.2 35.8 32.3 31.2 41.9 53.1 71.4 77.3 51.7 34.6 28.6 15.1 28.7 54.0 24.6 0.1 0.1 1.1 1.6 0.9 0.3 0.5 1.3 1.0
1996
1997
58.5 45.2 5.9 54.9 14.1 (11.4) 8.2 13.0 31.5 (8.4) 6.0 (20.5) 6.5 9.9 31.8 28.4 21.6 (0.6) 119.7 112.8 27.6 135.7 17.5 53.7 28.9 59.0 22.1 0.9 25.9 8.0 18.2 14.7 43.6 24.4 30.5 28.7 133.3 92.9 (7.7) (27.8) (12.7) (113.5) 13.4 (149.5) 49.6 (41.6) 19.0 (192.0) 46.5 (11.3) 39.1 (41.7) 17.3 (203.2) 0.1 0.1 1.1 1.5 1.0 0.3 0.4 1.5 1.0 0.1 0.1 0.8 1.5 0.8 0.2 0.4 1.6 0.9
Table 1.5 Financial Performance of Publicly Listed Companies by Sector, 1992-1997 (percent)
Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure Finance Trade, Investment, and Services
Source: JSX Monthly (several publications).
1992 20.0 50.0 110.0 120.0 120.0 150.0 90.0 560.0 380.0 8.8 44.7 12.4 13.2 15.7 13.3 17.1 11.0 11.4 6.9 4.7 5.5 4.2 6.7 4.2 8.7 1.3 38.2
1993 130.0 80.0 100.0 130.0 190.0 150.0 180.0 650.0 160.0 19.2 7.7 12.7 10.6 18.7 8.8 20.5 11.8 11.8 5.1 2.7 5.7 4.1 6.0 3.2 7.3 1.2 39.1
1994 80.0 80.0 100.0 120.0 110.0 140.0 70.0 680.0 120.0 15.5 17.7 10.8 9.3 18.7 10.6 13.2 11.9 10.3 7.1 10.3 5.1 4.1 8.4 4.5 7.7 1.1 4.4 71.4 46.0 46.7 61.1 89.4 20.4 35.7 12.3 64.5
1995 80.0 70.0 100.0 150.0 110.0 170.0 80.0 650.0 140.0 17.6 19.1 10.0 8.4 17.1 10.2 13.4 13.1 7.6 8.5 13.5 5.5 4.7 8.0 3.9 7.6 1.2 3.6 74.7 46.9 42.8 67.8 81.5 19.3 33.9 14.1 65.1
1996 100.0 70.0 110.0 160.0 110.0 180.0 110.0 630.0 160.0
1997 230.0 110.0 190.0 220.0 180.0 190.0 100.0 700.0 210.0
14.2 23.9 17.1 (5.8) 8.2 (4.0) 7.1 (3.6) 18.3 7.8 8.6 (11.2) 15.0 12.1 13.4 5.4 6.1 1.1 9.0 9.7 4.1 4.1 9.8 3.7 9.4 1.2 3.2 53.9 38.9 41.5 56.9 87.8 16.2 30.6 13.0 60.6 8.1 3.0 (0.4) (1.3) 5.7 (3.2) 7.3 0.6 (2.6) 36.8 25.6 23.9 40.4 79.8 11.9 29.3 13.4 46.8
382.8 479.7 26.4 35.0 39.5 43.1 63.7 71.2 111.0 86.6 14.8 168.3 73.9 38.3 17.5 14.0 66.0 69.4
Chapter 1: Indonesia
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negative ROA. Trade had the highest ROA of 39.1 percent in 1993, but dropped dramatically to 4.4 percent the following year. The finance and miscellaneous industry, and basic industry and chemicals sectors had relatively stable ROA before the crisis. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. State-Owned Companies At the end of 1995, there were 165 state-owned companies (SOCs)3 in Indonesia. SOCs actively operated in various sectors4 under the supervision of technical departments. For instance, the Department of Finance supervised 30 SOCs, which collectively had the largest assets. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. This was due to large sales by the National Oil Company (Pertamina). Just like private companies, SOCs diversified into many businesses. By 1995, there were 58 SOCs with subsidiaries and affiliates. Taken together, the subsidiaries and affiliates number 459 with total assets of Rp343.3 trillion. SOCs sales growth fluctuated during 1990-1996, registering an average annual rate of 10 percent. Similarly, growth of net profits and assets was erratic, averaging 24 and 31 percent, respectively, between 1993 and 1995. These growth rates were low compared to those for listed companies during the same period. Assuming a fixed ratio of value added to sales, the SOCs value added as a percentage of GDP ranged from 6 to 8.7 percent. This was relatively high compared to the 3.7 to 7 percent for publicly listed companies. However, the ratio decreased from 8.7 percent in 1990 to 6 percent in 1996, indicating SOCs declining contribution to GDP. SOCs ROE ranged from 6.6 to 8.8 percent between 1992 and 1995 (Table 1.6), much lower than that of companies listed in the stock exchange. The DER was slightly higher than for listed companies, but it continuously declined from 370 percent in 1992 to 250 percent in 1995. ROA had been at high levels from 1992 to 1995, increasing from 21.1 percent in 1992 to 28.3 percent in 1995. Asset turnover rates were lower relative to those of publicly listed companies. While asset turnover rates of publicly listed
3
SOCs are those in which the State has at least a 51 percent equity interest. Six SOCs were listed in the Jakarta Stock Exchange. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies); banks (seven companies); insurance (11 companies); and finance company (four companies).
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companies consistently declined over time, SOCs asset turnover rates showed a downward trend from 32.4 percent in 1992 to 28.6 percent in 1994, but climbed to 30.5 percent in 1995. Table 1.6 Growth and Financial Performance of State-Owned Companies, 1992-1995 (percent)
Indicator Growth Indicators Sales Growth Share of Value Added in GDPa Assets Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb
= not available. a Value added was assumed to be 30 percent of total sales. b Asset turnover is defined as sales over assets. Source: Indonesian Data Business Center.
1992 7.2 370.0 8.8 21.1 32.4
1993 16.4 7.2 23.1 310.0 7.0 24.1 30.7
1994 (9.1) 5.7 (2.6) 260.0 6.6 28.0 28.6
1995 25.1 6.0 17.3 250.0 8.6 28.3 30.5
Conglomerates This study used available data on the top 300 conglomerates in Indonesia. In 1997, these conglomerates owned 9,766 business units, mostly private companies. Their total sales increased from Rp90.1 trillion in 1990 to Rp234 trillion in 1997. Assuming a constant ratio of value added to sales, the contribution of conglomerates to GDP increased from 12.8 percent in 1990 to 13.4 percent in 1994, but dropped to 11.2 percent in 1997 (Table 1.7). Table 1.7 Growth Performance of the Top 300 Conglomerates, 1990-1997 (percent)
Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 17.1 19.4 16.7 16.2 18.1 12.5 3.0 12.8 12.7 13.4 13.4 13.4 13.3 12.8 11.2
= not available. a Value added was assumed to be 30 percent of total sales. Source: Indonesian Data Business Center.
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1.2.6
Legal and Regulatory Framework
During the 1990s, the Government promulgated a number of laws and regulations to protect investors. By international standards, however, the legal and regulatory framework of the corporate sector was far from adequate. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. The law replaced an earlier statute that was based on the Dutch system. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC), tasked with supervising the firm; and the board of directors (BOD), tasked to provide direction to the company. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. The actual responsibilities of BOCs vary by company and are stipulated in the companys charter. For instance, the decision to use certain company assets as collateral for bank credit might need BOC approval. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. This guards against shady intercompany dealings within a group of companies. For instance, a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. The law also holds the directors and commissioners jointly responsible for decisions made by the company. The BOC, as representative of shareholders, is the only shareholder mechanism for monitoring and controlling the BOD. If the BOC does not perform well, shareholders lose control. The law also specifies that the highest institution in the limited company is the shareholders meeting. The meeting decides on important issues, such as the appointment (or replacement) of directors, commissioners, and the accountant. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation); acquisitions, mergers, and consolidations; and declaration of bankruptcy. The company charter details the issues that need shareholder meeting approval. In general, an approval needs the majority (50 percent plus one) vote, except in strategic issues stated in the law. For example, the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting, and the attendance should at least be two thirds of total shareholders. For mergers,
16
acquisitions, consolidations, and bankruptcy, the decision should be approved by three fourths of the shareholders present, and the attendance should at least be three fourths of total shareholders. Because of such requirements, some listed companies sell no more than a small proportion of shares to the public in order to retain the freedom of the founders to make strategic decisions. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge; (ii) proxy voting; (iii) proxy voting by mail; (iv) cumulative voting for directors; (v) preemptive rights on new share issues; (vi) one share one vote; (vii) the right to call an emergency shareholders meeting; (viii) the right to make proposals at the shareholders meeting; (ix) mandatory shareholders approval of interested transactions; (x) mandatory shareholders approval of major transactions; (xi) mandatory disclosure of transactions by significant shareholders; (xii) mandatory disclosure of connected interests; (xiii) mandatory disclosure of nonfinancial information; (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees; (xv) mechanisms to resolve disputes between the company and shareholders; (xvi) independence of auditing; (xvii) mandatory independent board committee; and (xviii) severe penalties for insider trading. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange, delineating the tasks and responsibilities of the Capital Market Supervisory Agency. It regulates the requirements of investment companies, securities companies, underwriters, brokers, investment managers, investment advisors, and other supporting agencies, such as custodian banks and the securities registration bureau. It also regulates reporting and auditing procedures, transparency requirements, insider trading (including market rigging and manipulation) investigation, and administrative and legal punishment. The law is supplemented by Government regulations, decrees of the finance minister, and guidelines promulgated by the head of capital market supervision. Examples in the area of corporate governance are guidelines for situations that can potentially lead to conflicts of interest and for acquisitions of substantial shares of listed companies. An important rule is the requirement for independent shareholders approval for arrangements that might lead to conflicts of interest. Controlling shareholders have no vote on the matter. A tender offer is also required for acquisitions of up to 20 percent of listed shares.
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Bankruptcy Law Despite loan covenants, creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. The old bankruptcy law based on the Dutch system was biased in favor of debtors and made it almost impossible for creditors to seek court resolution when debtors defaulted. A new bankruptcy law was passed in August 1998. It aimed to protect creditors by providing easier and faster access to legal redress. Unsecured creditors could proceed against a debtor in default based on loan covenants and through the legal process of collection against the latters assets. A Commercial Court was also set up to deal with bankruptcy cases. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. For instance, the Banking Law (1992), amended in October 1998, states that a bank is not allowed to provide credit without collateral. However, the collateral could take the form of nonphysical assets (e.g., the viability of a project). Banking regulations also set lending limits, net open positions, capital adequacy, etc.
1.3
Corporate Ownership and Control
This section looks at the ownership structure of the corporate sector and reports the results of an ADB survey on corporate management and control of publicly listed companies. Discussions on corporate ownership cover listed companies and conglomerates. 1.3.1 Corporate Ownership Structure
Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). The two most important elements of ownership structure are concentration and composition. Ownership concentration is usually measured by the proportion of shares owned by the top one, five, or 20 shareholders. It reveals characteristics of controlling shareholders, for instance, whether they are individuals, families, holding companies, or financial institutions.
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Publicly Listed Companies Table 1.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. On average, the five largest shareholders owned 68.9 percent of total outstanding shares. The percentage owned by each of the five largest shareholders was 48.6, 13.6, 3.9, 2, and 0.8, respectively. The pattern of ownership concentration changed little over this period. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. This preserves the pro rata share of existing shareholders. When a company makes a rights issue, the controlling shareholders usually act as standby buyers. Table 1.8 Ownership Concentration of Publicly Listed Companies, 1993-1997 (percent)
Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.5 16.6 3.0 2.1 0.5 72.7 1994 48.1 13.7 3.9 2.0 0.6 68.3 1995 47.9 14.1 4.0 1.9 0.8 68.7 1996 48.5 12.0 4.2 1.8 1.0 67.5 1997 48.2 11.6 4.4 2.1 1.2 67.5 Average 48.6 13.6 3.9 2.0 0.8 68.9
Source: The Indonesian Capital Market Directory.
Table 1.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture, mining, consumer goods, and basic industry and chemicals sectors than in others. Meanwhile, ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). This is because a few companies in the transportation sector issued high proportions of shares to the public. Zebra Nusantara (taxi services), for instance, issued 93.4 percent, Rig Tenders Indonesia (shipping services) issued 51.6 percent, and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.5 percent. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997, about two thirds of publicly listed companies outstanding shares were owned by corporations that were directly or indirectly controlled by families. When a company goes public, the founder usually continues to own the majority of shares through a
19
fully-owned limited liability company (Perseroan Terbatas). Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals. Table 1.9 Ownership Concentration of Publicly Listed Companies by Sector, 1997 (percent)
Sector Agriculture Mining Basic Industry and Chemicals Misc. Industry Consumer Goods Industry Prop., Real Estate, and Bldg. Constn. Infrastructure, Util., and Transportation Finance Trade, Investment, and Services Average
Source: The Indonesian Capital Market Directory.
First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.5 58.9 50.9 44.4 54.9 44.4 44.2 46.3 36.3 48.2 15.6 9.4 11.3 14.1 13.2 10.6 8.7 9.7 13.1 11.6 2.5 1.4 4.0 5.1 1.5 4.3 0.7 6.8 14.7 4.4 1.3 0.7 1.9 3.6 0.1 2.2 0.1 2.4 6.2 2.1 1.1 0.6 1.3 2.9 0.1 2.1 0.1 1.1 1.9 1.2
This is confirmed in Claessens et al. (1999), which shows that in 1996, two thirds (67.1 percent) of Indonesian publicly listed companies were in family hands, and only 0.6 percent were widely held. In fact, Indonesia has the largest number of companies controlled by a single family. In terms of capitalization, the top family controls 16.6 percent of total market capitalization while the top 15 families control 61.7 percent of the market. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. Claessens et al. (1999) also found, in a cross-country study, that the correlation between the share of the largest 15 families in total market capitalization, on the one hand, and the efficiency of the judicial system, the rule of law, and corruption, on the other, is strong. The findings suggest that the concentration of corporate control in the hands of few families is a major determinant of the evolution of an inefficient legal and judicial system, as well as the existence of corruption. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in
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the small number of families and the tight links between companies and the Government. If the role of a limited number of families in the corporate sector is so large and the Government is heavily involved in and influenced by business, the legal system is less likely to evolve in a manner that protects minority shareholders. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Coordination is easier because informal communication channels exist. But these benefits are few and often dubious compared to the high costs of concentration. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988, foreign ownership increased to 21 percent. In 1993, it rose to 30 percent, but later declined and steadied at around 25 percent. In September 1997, the Government allowed foreign investors to buy up to 100 percent of listed shares. However, the onset of the crisis negated this development, resulting instead in a decline in the proportion of foreign investor ownership.5 Conglomerates Table 1.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment, ethnicity, political affiliation, and family origin. Among the top 300 conglomerates, most were established during the New Order Government, numbering 162 in 1988 and 170 in 1996. This may indicate that the New Order Government, with all its regulations, was able to create a favorable environment for business development. However, conglomerates established before 1969 dominated in terms of sales, accounting for 64 percent of total conglomerate sales in 1988-1996. In Indonesia, there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. Indigenous businesspeople include the Javanese, Sundanese, Batak, and Padang. The nonindigenous businesspeople are usually Chinese, Indian, or other ethnic groups. During 1988-1996, nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. From 193 in 1988, their number increased to
In 1997, the proportion of foreign ownership declined from 27.55 percent in August to 25.42 percent in December.
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Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates, 1988-1996

Item Number of Groups Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily Sales (Rp trillion) Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily 1988 1989 1990 1991 1992 1993 1994 1995 1996
13 125 162 86 193 21 260 40 176 124
13 125 162 83 196 21 259 41 175 125
13 123 164 80 196 24 260 41 171 129
13 120 167 76 199 25 260 40 174 126
13 118 169 76 198 26 262 38 172 128
12 122 166 71 201 28 263 37 171 129
12 122 166 69 205 26 262 38 172 128
11 120 169 71 204 25 260 40 177 123
10 120 170 68 204 28 259 41 175 125
9.4 31.2 23.2 12.8 38.6 12.4 48.9 14.9 35.0 28.8
12.3 36.8 28.4 15.1 46.4 16.0 58.4 19.1 42.6 34.9
13.3 43.2 33.6 17.6 54.4 18.0 58.4 31.7 49.1 41.0
15.8 49.7 40.0 18.7 64.5 22.3 80.7 24.8 57.2 48.3
20.4 59.1 46.5 21.2 76.7 28.1
21.9 73.1 52.1
25.2 30.1 33.4 86.1 103.0 116.4 59.8 68.9 77.4
22.8 25.2 29.0 31.1 87.3 101.5 120.9 137.4 37.0 44.4 52.1 58.7
95.6 114.3 134.2 159.1 179.8 30.4 32.8 36.9 42.9 47.4 68.4 57.6 77.4 69.7 89.5 106.3 120.4 81.6 95.7 106.8
Source: Indonesian Business Data Centre, Conglomeration Indonesia 1997.
204 in 1996. Their total sales also increased from Rp38.6 trillion in 1988 to Rp137.4 trillion in 1996, due to their go public activities. For instance, sales of the Bakrie group before it went public in 1990 were only Rp369.9 billion. In 1996, its sales reached Rp1.9 trillion, more than five times its 1988 level. Meanwhile, the number of mixed groups declined from 86 in 1988 to 68 in 1996. While they supplied 20.1 percent of total
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sales in 1988, their contribution declined to 13.7 percent in 1996. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Conglomerates were also classified into nonofficial- and officialrelated groups. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). Most of the top 300 conglomerates were established by ordinary citizens. Only about 13 percent were formed by official or ex-official families, or have resulted from alliances between entrepreneurs and officials. The well-known official-business alliances are those between Sudwikatmono (former President Suhartos cousin) and Soedono Salim, Djuhar Soetanto, and Ibrahim Risyad of the Salim group. More recent alliances were between Bambang Trihatmodjo (former President Suhartos son) and Johannes Kotjo, Bambang Rijadi Soegomo, and Wisnu Suhardhono of Apac-Bhakti Karya. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. In 1996, average sales of official-related conglomerates reached Rp1.2 trillion, compared with the less than Rp700 billion of a nonofficial-related conglomerate. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. Banks owned by groups or conglomerates typically act as a cashier that provides credit to companies within the group. Prudential credit analysis tends to be ignored. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. In November 1997, most of the 16 liquidated banks had violated the legal lending limit set by the central bank, Bank Indonesia. In 1997 and 1998, banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). In 1996, there were 175 groups that originated from a family business. Some of them later became public companies by listing in the stock market. But listed companies within conglomerates were few. The Salim group, for instance, which is the largest conglomerate in Indonesia, owns four groups with many subsidiaries and affiliate companies. Out of 174 companies, 117 are jointly owned by the family and 57 are owned by individual family members. But only a handful of these companies are listed in the market, including Indofood Sukses Makmur (food industry), Indocement Tunggal Prakarsa (cement industry), and Fast Food (restaurants). The Suharto family is the largest stockholder in Indonesia, collectively controlling
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assets worth $24 billion (Claessens et al., 1999). The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children, as well as other relatives and business partners, many of whom, besides Suharto himself, served in some government function (see Figure 1.1). The Salim Group is also in part controlled by the Suharto family. The families retain control of the companies through ownership, management, or both. Although some groups employ professional managers, families mostly manage the groups and make strategic decisions themselves. The BOC chairperson often represents the controlling party of the company. He or she could either be the biggest shareholder, or someone very close to and trusted by the controlling shareholders. If the family members cannot actively manage the companies as directors, they maintain their position as commissioners. Although they are not actively involved in the daily operations of the companies, they still control the work of the directors. Some of the groups related to officials have a unique share ownership structure. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. In so doing, the controlling shareholders are able to maintain their special relationship with officials, and hence, continue receiving some kind of protection and special treatment. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain. Indonesian law allows cross-shareholdings, with no restrictions. But it is difficult to obtain data on cross-shareholding among firms. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. In 1996, for instance, Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). Both are listed companies and members of the Salim group. Cross-holdings between financial and nonfinancial firms potentially create more serious problems. This is because cross-owned banks had to consider not only their own interests, but those of the entire group. Cases in point are the Bank Papan Sejahtera and Bank Niaga, which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company, Semen Cibinong. While the source of the
Figure 1.1 The Suharto Group

Usaha Mulia Group (cousin Hasim) Cemen Cibinong Hanurata Group Suharto Family Citra Lamoro Group (daughter Mbak Tutut) Bank Yama Bob Hasan Group (Mohamad Hasan) Gatari 22 firms with control over 20% Citra Marga Persda Tollroad Trias Sentosa Bank Central Indomobil Mercu Buana Group (step brother Probo) 11 firms with control over 20% Kedaung Indah 14 firms with control over 20% Kedaung Group (Agus Nursalim) 18 firms with control over 20% Tirtamas 21 firms with control over 20%
262 firms with control over 20%
Salim Group (friend Soedono)
Sempati Air Humpuss Group
Bank Utamar
Bimantara Group (son Bambang)
TPI
Andromed
Tripolita
Kabelindro Kiani Murmi Sakti
Source: Stijn Claessens, Simeon Djankov, and Larry H. P. Lang, (Feb. 1999). Who Controls East Asian Corporations? Financial Economics Unit, Financial Sector Practice Department, World Bank.
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problem is inconclusive, one possibility is that legal lending limits had been violated. 1.3.2 Management and Internal Control
A companys internal organizational structure determines how shareholders control management. The typical structure of a publicly listed company in Indonesia is shown in Figure 1.2. Shareholders are at the top of the organization, both controlling and minority. The BOD leads the company and makes strategic and operational decisions. The managers execute the BODs decisions and lead employees in their departments. As the owners representatives, the BOC supervises the work of directors. Therefore, the BOC has the right to obtain any information concerning the firm, seek an audience with directors, and, if necessary, request a shareholders meeting. This is based on the Dutch system. Figure 1.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia
Shareholders
Board of Directors
Board of Commissioners
M a n a g e r s Employees
The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed companies, including the boards, the directors, management and managerial compensation, role and protection of minority shareholders, and accounting and auditing procedures. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange.
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Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the companys founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
27
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
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Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
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provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., directors fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
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1.3.3
External Control
Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtors assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Governments political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors confidence in Indonesias legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were
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external acquisitions. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. One famous takeover was Bank Papan Sejahtera, which was acquired by Yopie Wijaya in 1995. Wijaya and his friends bought shares of the bank on several occasions until they gained control. They then replaced the BOD and later sold the bank, at a large profit, to Hashim Djojohadikusumo, the owner of Tirtamas group.6 In this case, the acquiring interest was apparently seeking economic profits. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo, who was acquiring his second commercial bank. However, the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. In these two latter cases, the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. Control by the Government Government control could be in the form of state ownership, appointment of management, restrictions on market entry, or direct subsidies. Most Indonesian state companies are 100 percent owned by the Government, except for publicly listed SOCs. State ownership for listed SOCs ranges from 25 to 35 percent. The Government appoints the BOD and BOC of these firms. Before the financial crisis, it was common for the Government to invest in certain private companies. For instance, with the ministers approval, a state-owned insurance company may invest its funds in a private firm. The Government is thus able to appoint some officials to be members of the private firms BOD or BOC. This used to be a common practice in companies associated with the Suharto regime. In the massive restructuring of the banking sector that commenced after the crisis, the Government took over NPLs and put them under IBRA management. Since the NPLs reached up to Rp300 trillion, IBRA found itself tasked with managing large amounts of assets in the private sector.
Later in March 1999, the bank was liquidated. The bank was reported to have high NPLs and had broken the legal lending limit. In April 1999, Bank Niaga was under a recapitalization program.
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1.4 1.4.1
Corporate Financing Financial Market Instruments
Prior to 1977, bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. Since then, new instruments have been introduced to the corporate sector, including bonds, stocks, and others offered by nonbank financial institutions or finance companies. Bank loans, however, remain the major financing instrument for the corporate sector. Bank Credit As shown in Table 1.14, bank credit surged from Rp122.9 trillion in 1992 to Rp487.4 trillion in 1998. Private national banks and state-owned banks were the biggest domestic creditors, jointly providing almost 90 percent of loans until 1997. Data from Bank Indonesia show that from 1994 to 1997, private national banks overtook state banks as the dominant credit source. From 34.4 percent in 1992, the share of private national banks in outstanding total loans increased to 44.6 percent in 1997. Table 1.14 Banking Sector Outstanding Loans, 1992-1999 (Rp trillion)
Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total
1992 1993
1994
1995
1996
1997
1998
1999
68.2 71.5 80.0 93.5 108.9 153.3 9.3 14.7 18.4 24.2 27.6 48.6 3.0 3.6 4.2 5.2 6.5 7.5 42.3 60.4 86.3 111.6 150.0 168.7 122.9 150.3 188.9 234.6 292.9 378.1
220.7 112.3 66.7 50.0 6.6 6.8 193.4 56.0 487.4 225.1
Equities In 1977, when the Government reactivated the stock exchange, equities became available to the corporate sector. However, because of the restrictions discussed below, this market was not well developed. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates), companies considered alternatives to bank loans.
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Some companies went public, thus increasing the role of the capital market in raising long-term funds. In 1988, when foreign investors were not yet allowed to purchase listed shares, funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. The ratio reached 8.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms shares, but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. It gradually increased again starting in 1991, shooting up to 18.7 percent in 1997. Overall, the stock market has gained a bigger role in corporate sector financing (Table 1.15). Table 1.15 Value of Stocks Issued and Stock Market Capitalization, 1992-1999 (Rp trillion)
Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization
1992 1993 11.2 16.1
1994 26.5
1995 35.4
1996 1997 1998 50.0 70.9
1999
76.0 206.7
9.1 10.7 14.0 15.1 17.1 18.7 15.6 91.8 48.6 123.4 207.6 310.9 406.6 301.5 333.6 859.5
Financing by Finance Companies Finance companies first emerged at the end of 1980, offering services such as leasing, factoring, credit cards, and consumer credit. They were not, however, allowed to accept deposit accounts from the public. Prior to 1995, the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.g., legal lending limit, capital adequacy ratio, and net open position). Most banks therefore set up subsidiary finance companies to circumvent banking regulations. During the 1990s, finance companies were increasingly used as channels for the inflow of foreign loans. In 1995, the Government issued regulations to supervise and promote prudential practices in finance companies, i.e., limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. The ratio of funds raised by finance companies to credit disbursed by the banking sector has been increasing from about 5 percent in 1992 to 13 percent in 1996.
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Commercial Papers Commercial papers, which are unsecured negotiable promissory notes with a maximum maturity of 270 days, have been popular in Indonesia since 1990. While banks had some exposure to these instruments, they were not rated by a rating agency. Thus in November 1995, Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments), otherwise it would be classified as a loss in the banks books. 1.4.2 Patterns of Corporate Financing
Table 1.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. In the second half of the 1980s, publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings), averaging 26.5 percent and 36.8 percent, respectively. This is in contrast to the lower share of borrowings during the same period. In terms of composition, short-term borrowings were greater than long-term debts, at 81 percent of total borrowings. Table 1.16 Financing Patterns of Publicly Listed Nonfinancial Companies, 1986-1996 (percent)
Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.8 17.3 14.0 3.2 26.5 26.5 11.8 7.6 100.0 1991-1996 16.0 39.3 16.7 22.6 23.3 (0.1) 23.4 8.4 13.0 100.0 1986-1996 17.3 37.9 16.5 21.4 23.5 (0.1) 23.6 8.6 12.6 100.0
= not available. Source: Authors estimates based on the Pacific-Basin Capital Markets (PACAP) Databases, PACAP Research Center, 1996.
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In the 1990s, the pattern changed. Corporate debts grew over time, rising from Rp54.4 trillion in 1993 to Rp112.9 trillion in 1996. This amount doubled in 1997, reaching Rp229.2 trillion. Of the various financing sources, corporate debts accounted for 39.3 percent during 1991-1996, with longterm debts increasing rapidly. These liabilities grew significantly because corporate expansion was largely financed by debt. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. For instance, Indofood registered losses of almost Rp1.2 trillion (mostly foreign exchange losses), while Semen Cibinongs losses reached Rp2.9 trillion. Two telecommunications companies, Indosat and Telekom, also suffered from foreign exchange losses but managed to post profits of Rp0.6 trillion and Rp1.1 trillion, respectively. All companies in the cement industry suffered from foreign exchange losses, except Semen Gresik (an SOC), which managed to post significant profits due to low exposure to dollar-denominated loans. Hence, the corporate sectors high leverage, as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997, was due largely to a rapid rise in long-term debts, which was masked by the rapid growth in investments. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Note that the corporate sectors high leverage existed side by side with sizable equity capital raised from the capital market. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. Bank loans also surged when the banking sector was liberalized in 1988. 1.4.3 Corporate Financing and Ownership Concentration
It has been suggested, in the context of Indonesia and some other countries, that ownership concentration may be associated with heightened risk-taking by companies. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. They also do not want to dilute corporate control and are more likely to finance growth with debt. Table 1.17 compares the DER of listed firms by degree of ownership concentration. The results indicate that firms with higher ownership concentration tend to have a higher DER. The analysis of ownership patterns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares. Most corporate charters require commissioners to approve debt issues or sign debt agreements.
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However, since commissioners represent the controlling party, decisions on debt are made with the implicit endorsement of owners. Controlling parties rely on external financing to maintain their equity share and, ultimately, to maintain control of the company. Table 1.17 DER of Listed Companies by Degree of Ownership Concentration (percent)
Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699.0 1,358.0 351.0 386.0
Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. The test of the difference between the two means found the t-value of 1.56 significant at the 10 percent level. Source: Authors estimates.
1.5 1.5.1
The Corporate Sector in the Financial Crisis Causes of the Financial Crisis
Many intertwined factors led to the crisis. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inadequacy of the regulatory framework under the financial liberalization, heavy reliance of companies on bank credits to finance investments, and high ownership concentration among families with political affiliation. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sectors access to domestic and foreign private capital. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom. Between 1987 and 1996, the private sector borrowed heavily in unhedged dollars. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. In addition, the free capital flow system allowed private companies to borrow dollars offshore without any restriction. As a result, the borrowings swelled, aided
37
by the lack of an existing mechanism to supervise and monitor foreign transactions. The removal of entry barriers in the banking sector caused the number of private national banks to soar from only 65 in 1988 to 144 in 1997. The supervising agency was caught unprepared. A director at Bank Indonesia revealed that in 1995, the level of corporations foreign debt could not even be ascertained. It was doubly difficult to exercise supervision when groups with political clout owned the banks. Conglomerates that had difficulty in getting loans (i.e., those with high DERs) established their own banks. The banks served as a cashier that provided easy credit to nonfinancial companies within the group. This often led to the violation of prudential credit management practices. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. They were, after all, only created to serve the companies to which they lent. As a result, large amounts of credit were directed to the companies within the group, and the negative net open position (short position in dollars) continuously rose to precarious levels. The Government later specified the legal lending limit and the net open position that banks had to follow. However, to circumvent these banking regulations, conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. It was only in 1995 that some regulations on the activities of finance companies were contemplated. It is not known if these regulations had an effect on nonbank intermediaries. Heavy Reliance on Bank Credits to Finance Investments Companies relied heavily on bank loans to finance rapid corporate expansion because internal financing was insufficient and the capital market was not developed. There was also a smaller demand for equity compared to external debt financing since controlling shareholders preferred the latter to maintain their control of the companies. In the process, many firms became highly leveraged. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. The large supply of foreign funds, averaging about 4 percent of GDP, did finance many viable ventures. However, substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers close political connections. A lot of short-term foreign funds were used to finance long-term investment projects. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans.
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By mid-1997, $35 billion of Indonesias foreign debt owed to private foreign banks was about to mature in less than one year. In early 1998, total private sector foreign debt stood at $72.5 billion, of which $64.5 billion was owed directly by corporations. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families, there was also almost universal confidence that the economic growth would continue indefinitely. Corporations were certain that they could roll over short-term loans when these fell due, as they had done so in the years before the crisis. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. Families retain control by keeping the majority percentage of outstanding shares. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership, and in the process maintain control of the company. They enhance their control over companies through cross-shareholdings, by setting up their own banks, and investing shares among nonfinancial companies within the group and in other groups companies. Collusion between big businesses and the political elite was widespread in Indonesia. This was often the case in the banking industry, where private banks are usually in the hands of big businesses, politicians, or both. In many cases, banks did not lend on the basis of the soundness of the project, but on the basis of who the borrower was. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. This fact was usually not disclosed in financial statements, partly because they used nominee accounts to register ownership rather than set up a holding company. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. Projects involving massive capital investments and long-term operating deals (in telecommunications, toll roads, and power generation) require huge capital. Since the Government could not afford to undertake these projects, contracts were granted to the private sector, most often to people who were close to the ruling regime.
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1.5.2
Impact of the Financial Crisis on the Corporate and Banking Sectors
Impact on the Corporate Sector Table 1.18 shows that growth in most sectors significantly fell in 1997. This continued in 1998, when all sectors, except utilities, posted negative growth rates. The construction sector was the worst hit, followed by the finance and trade sectors. Table 1.18 GDP Growth by Sector, 1996-1999 (percent)
Sector Agriculture, Livestock, Forestry, and Fisheries Mining and Quarrying Manufacturing Electricity, Gas, and Water Supply Construction Trade, Hotels, and Restaurants Transport and Communications Financial, Real Estate, and Business Services Other Services GDP 1996 3.1 6.3 11.6 13.6 12.8 8.2 8.7 6.0 3.4 7.8 1997 1.0 2.1 5.3 12.4 7.4 5.8 7.0 5.9 3.6 4.7 1998 (0.7) (2.8) (11.4) 2.6 (36.5) (18.0) (15.1) (26.6) (3.8) (13.0) 1999 2.1 (1.7) 2.6 8.2 (1.6) (0.4) (0.7) (8.1) 1.8 0.3
Source: Central Bureau of Statistics (Biro Pusat Statistik, BPS).
The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.24 trillion for the first six months of 1998; 53 companies reported negative equity of Rp6.58 trillion (meaning their losses were greater than the paid-up capital); and 128 companies reported a total loss of Rp46.52 trillion. Only 86 companies reported profits. Using the financial statements as of 30 June 1998 of 161 publicly listed companies, DER and ROE were calculated per sector, as shown in Table 1.19. The average DER was found to be 1,370 percent, much higher than the 307 percent registered in December 1997. Sectors with lower ROE generally had higher DER. The consumer goods industry reported the lowest ROE, followed by property, real estate, and building construction. Most sectors showed significant increases in leverage, indicating a rapid rise in
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Table 1.19 DER and ROE of Publicly Listed Companies by Sector, 1996-1998 (percent)
DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.0 65.0 111.0 158.0 108.0 177.0 105.0 631.0 163.0 229.0 1997 234.0 108.0 193.0 219.0 177.0 191.0 97.0 697.0 205.0 307.0 1998 186.0 72.0 635.0 1,097.0 2,271.0 864.0 92.0 1,395.0 2,625.0 1,370.0
a
ROE 1996 1997 1998a
14.2 23.9 12.8 17.1 (5.8) 36.5 8.2 (4.0) (78.1) 7.1 (3.6) (115.4) 18.3 7.8 (373.4) 8.6 (11.2) (264.6) 15.0 12.1 30.2 13.4 5.4 (6.7) 6.1 1.1 (92.0) 10.7 1.1 (124.1)
Note: DERs were calculated for only 161 companies (out of 214) that had positive equity. a Actual data for 1st semester only, but annualized to approximate full year values. Source: JSX Monthly, several publications.
rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. The huge losses suffered by most companies were caused by three factors. First, losses in operation were due to declines in sales and increases in the cost of imported inputs. Second, interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999. Third, foreign exchange losses came about with the use of unhedged foreign debt. Impact on the Banking Sector Table 1.20 reveals that the banking sectors ROE decreased significantly in 1997. Mostly suffering from a liquidity squeeze, private banks posted negative ROEs in the same year. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits, small foreign banks enjoyed the highest profits. As the rupiah weakened and interest rates increased, the NPL ratio rose to 25.5 percent in April 1998, from only 8.8 percent in 1996. This figure further increased to 47.7 percent in July 1998, as shown in Table 1.21. Financial and banking analysts estimate that by September 1998, the NPL ratio had reached more than 60 percent, and would have kept on increasing if interest rates had not declined.
41
Table 1.20 ROE of the Banking Sector, 1992-1997 (percent)

Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total
= not available. Source: The National Banking Association.
1992 7.06 20.34 16.91 21.45 21.45
1993 15.84 27.72 16.47 20.07 13.12 15.07
1994 14.73 30.69 14.37 19.44 15.24 15.70
1995 7.25 22.2 8.81 13.67 8.50 9.68
1996
1997
8.28 5.89 27.15 20.86 11.30 5.39 13.09 11.43 10.09 (11.38) 11.24 (4.20)
Table 1.21 Nonperforming Loans by Type of Bank, 1996-1998 (Rp trillion)

State-Owned Banks 140.1 198.1 274.2 19.3 22.0 129.6 13.8 11.1 47.3 Private National Banks 179.8 187.5 222.2 8.6 6.5 128.6 4.8 3.5 57.9 Regional Foreign and Development Joint Venture Banks Banks 9.2 10.8 14.6 1.1 1.2 1.9 11.9 11.1 13.0 32.2 48.7 106.7 1.5 2.2 37.0 4.7 4.5 34.7
Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998
Total 331.3 361.3 445.0 622.7 29.1 30.5 31.9 297.2 8.8 8.4 7.2 47.7
= not available. Source: Infobank, July No. 227/1998 and October No. 230/1998.
State-owned banks initially had the highest NPL ratio. In July 1998, however, private national banks overtook State-owned banks when their NPL ratio jumped to 57.9 percent. The high and increasing NPLs, coupled with negative spreads (deposit rate was higher than the credit rate), put pressure on the banking sector.
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1.5.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997, the Government and private sector formed a committee to help corporates deal with the crisis, particularly in terms of debt resolution. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Corporate debt accounted for 46.7 percent ($64.6 billion) of Indonesias total external debt in March 1998. In addition, the corporate sector had more than Rp600 trillion ($75 billion at Rp8,000/$1) in debt from domestic commercial banks. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring), about 80 percent of which was private. More than two thirds of private debt was short-term and the average maturity of all private debt was estimated to be only 18 months. In June 1998, IBRA was formed to offer Mexican-style resolution for private sector foreign debt. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. However, by mid-September 1998, none of the 2,000 eligible firms had signed up for the scheme. Aside from being described as overly complicated, few companies were in a position to resume interest payments. Thus, the scheme failed. On 9 September 1998, the committee launched the Jakarta Initiative, a more comprehensive scheme to tackle domestic and foreign corporate debt. The scheme encourages negotiation between creditors and debtors, assembling the legal and policy framework to facilitate corporate restructuring. One premise of the initiative was that creditors should agree to a standstill for a certain period (creditors would desist from exercising their claims on a distressed companys assets) to allow debtors to operate normally after obtaining fresh financing. Since September 1998, a number of prominent companies, such as Garuda (a national flag carrier), Astra International (automotive), and Ciputra (property business), have been subject to restructuring deals under the initiative. In November, Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.2 billion debt. By end-November, the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.4 trillion of domestic debt and $6.7 billion of foreign exchange debt. While the process of restructuring was in progress, companies were not servicing their debts. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. Unfortunately, only a
43
few companies reached agreement with their creditors on this. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. In the banking industry, Bank Bali agreed on a debt-to-equity swap with its creditor, Standard Chartered, under which the latter would become one of the banks shareholders. Bank Niaga also negotiated with some of its creditors, i.e., Rabobank and Citibank, for equity infusion. Meanwhile, some companies attempted to restructure their businesses on their own. When credit from the banking sector became unavailable and interest rates increased significantly, the companies financial performance deteriorated, forcing them to cut costs, lay off workers, consolidate business units, and sell noncore businesses or nonoperating assets. For instance, Astra International, a publicly listed company operating in the automotive industry, focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors, plantations, mining, and mining equipment. Some listed companies with relatively rich shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). Bankruptcy Reform The Bankruptcy Law was passed in August 1998, aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings, especially in preventing unjustifiable delays in the adjudication of bankruptcy. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. Moreover, limitations will be imposed on the ability of secured creditors to foreclose on their collateral during bankruptcy proceedings (as is provided for in the bankruptcy laws of most other countries), with the requirement that adequate compensation and protection will be provided to such creditors during that period. A Commercial Court was set up to handle corporate restructuring and debt settlements, as well as general commercial disputes. Debtors, who fail to reach agreements with creditors in out-of-court workouts under the Jakarta Initiative or fail to gain the requisite creditor support for the workout plan can resort to the Commercial Court. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process
44
to achieve liquidation of the company. In the longer term, it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. The significance of a sound bankruptcy system cannot be understated as it provides a backdrop for negotiations in the workout and restructuring process against which parties often gauge their legal rights. However, the Courts early record has been a disappointment, with only 17 cases filed as of November 1998. The Court has also declared only two companies bankrupt. The bias in favor of debtors has retarded the pace of corporate restructuring. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. To push bankruptcy reforms, legislation against corruption, collusion, and nepotism (anti-KNN) was signed in 1999. There will be changes in the implementation of the bankruptcy law, including procedures for handling operational issues and processing bankruptcy cases. The Government, in consultation with IMF and the World Bank, is also reviewing the Bankruptcy Law. Capital Market Reform In the capital market, the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. Previously, companies were allowed to sell shares only by issuing stock rights. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. However, since the market reflects the condition of the economy, the measure had only a minimal impact. The Government has also been concerned with the issue of capital controls. Realizing that they undermine investors confidence, the Government did not impose restrictions nor did it attempt to regulate capital flows. Rather, the monitoring system for foreign exchange transactions will be strengthened to improve transparency and better assess the credit exposure of the corporate and banking sectors. Banking Sector Reforms The Governments banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks; (ii) the resolution of nonviable private banks; (iii) the merger, reform, and recapitalization of state banks; (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia; and (v) a strengthened banking supervision system.
45
In 1997, the Government established IBRA to supervise problem banks. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. To obtain a clearer picture of the banking sector, the Government required banks to be audited by international external auditors. In October 1998, Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. A new central banking law, providing Bank Indonesia with substantially enhanced autonomy, was enacted in 1999. The Bank Indonesia 21st package includes recapitalization, improvement of rules and prudential regulations, and follow-up action on bank restructuring. Bank Indonesia has announced a recapitalization program for potentially viable private banks. Banks deemed ineligible for recapitalization will be closed, merged, or sold (after transferring NPLs to the AMU). However, depositors will be fully protected by the Government. Liquidity support given to troubled banks should be repaid in four years. The four state banks (BDN, BEII, BBD, and Bapindo) will be merged into one bank named Bank Mandiri. The merger process will be finished within two years. Other Regulatory Reforms To push corporate restructuring further, the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. It has also drafted regulations to remove obstacles for converting debt to equity. The importance of this legislation may need to be emphasized. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. In particular, it is doubtful whether pure holding companies are able to enter into swaps. To overcome these problems, regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans.
1.6 1.6.1
Summary, Conclusions, and Recommendations Summary and Conclusions
Corporate Ownership and Structure Most of Indonesias top conglomerates were established as family businesses. Some 175 groups that originated from family businesses controlled
46
53 percent of total assets of the top 300 Indonesian conglomerates. However, not all of the conglomerate-affiliated companies are publicly listed. Among those listed in the Jakarta Stock Exchange, the majority remains family-controlled. On average, families control 67.1 percent of publicly listed companies in Indonesia, while a single family controlled 16.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61.7 percent. These figures show the extent of power wielded over the corporate sector by a small number of families. The restructuring and resolution of financial distress may, however, put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. Financing Patterns Controlling shareholders opted to use debts to finance expansion, allowing them to maintain their equity shares and, thus, retain ownership control of companies. As a result, corporate debts grew over time. Rapid growth in investments masked the corporate sectors increasing leverage. Companies preferred to borrow in dollars because interest rates of foreign loans were lower than for domestic loans and the exchange rate was relatively stable. But because foreign creditors were reluctant to lend long term, Indonesian companies borrowed short term. Foreign creditors, meanwhile, lacked the information necessary to allow them to assess projects risks and chances for success. Companies relied heavily on bank credit. However, banks were unwilling to provide credit to highly leveraged companies. Therefore, when barriers to entry in the banking sector were lifted, conglomerates set up their own banks to serve as cashiers providing credit to companies within groups. These banks also obtained cheap offshore funds. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. When the Government regulated the legal lending limit and the net open position of banks, conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. On the one hand, this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion
47
without diluting their control. On the other hand, it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. Impact of the Financial Crisis Prior to the crisis, the corporate sector was in quite good shape in terms of growth and profitability. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. Sales of conglomerates as well as those of publicly listed companies were increasing, although at a declining rate. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. When the crisis hit Indonesia, the highly leveraged companies, particularly those with large short-term foreign loans, were the most adversely affected. Total profits of publicly listed companies dropped to Rp3.1 trillion in 1997 from Rp13.21 trillion in 1996, and registered a net loss of Rp39.24 trillion in the first half of 1998. DER increased to 307 percent in 1997 and further surged to 1,370 percent in 1998. ROE dropped from 1.1 percent in 1997 to -124.1 percent in 1998; the consumer goods industry was the worst hit, followed by the property sector. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts, the high domestic interest rates that prevailed from 1998, and the rapid decline in equity due to losses. The financial crisis led to the closure of several dozen banks. As the rupiah weakened and interest rates increased, NPLs rose and capital adequacy ratios fell. At the height of the crisis, Bank Indonesia extended emergency loans to many banks, financed by issuing nearly $80 billion worth of bank restructuring bonds. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. The Government and the private sector responded with measures to mitigate the negative effects. The Government introduced reforms to improve bankruptcy procedures, facilitate debt restructuring, and strengthen prudential regulations and supervision of the financial sector. To restructure the corporate sector, the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). Meanwhile, corporate-initiated debt restructuring
48
measures included internal business restructuring (e.g., cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. 1.6.2 Policy Recommendations
The Government should introduce measures to address the weaknesses in corporate governance identified in this study. Specific recommendations include protecting the rights of minority shareholders, improving the legal and regulatory framework for bank supervision, and protecting creditors rights. Protecting Minority Shareholders Rights The Corporate Law provides sufficient rights and protection for all shareholders, but inadequate protection to minority shareholders from the dominance of large shareholders. In particular, minority shareholders have not been able to oppose controlling shareholders decisions to invest in unprofitable projects financed by unhedged foreign currency debts. If the role of a limited number of families in the corporate sector is so large and the Government is either heavily involved in or influenced by business, the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. Amendments should include (i) empowering minority shareholders by raising the majority percentage of votes required on critical corporate decisions and mandating minimum representation of minority shareholders on the board; (ii) delineating the functions of the board of directors and commissioners; and (iii) strengthening transparency and disclosure requirements. Most companies claim to have adopted international standards of accounting and auditing procedures, but it is not clear whether in practice these standards are in place. The Government should ensure that all laws and regulations are effectively enforced. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector, the regulatory environment was not prepared to supervise the increasing number of banks and nonbank
49
financial institutions. In the first place, the banking regulatory framework was inadequate in regulating banks dealings with affiliated nonfinancial companies. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. Consequently, most of banks NPLs resulted from credit to companies within the same group. The regulatory framework was also weak in supervising and monitoring foreign transactions. When finance companies were used to channel offshore loans in lieu of commercial banks, the Government lost monitoring and control powers over foreign fund flows. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. One way is to set limits on lending activities by banks to affiliated nonfinancial companies, with necessary legal sanctions for violations. The Government should also continue strengthening the monitoring system for foreign exchange transactions. Banks should be required to provide data on such transactions and charged penalties for noncompliance. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. Because foreign creditors are faced with more information asymmetries than domestic creditors, it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. Protecting Creditors Rights To protect creditors rights, a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. However, the Court has been slow and ineffective in processing bankruptcy suits. Further, in contrast to the Republic of Korea and Thailand, the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts, it has been difficult to implement standstills, orderly restructuring, recapitalization, and liquidation of corporate assets. With credit being coursed through the domestic banking system rather than directly to numerous local corporations, the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. This is a significant factor in
50
explaining the greater depth of the crisis in Indonesia, despite the smaller level of capital inflows (as a percentage of GDP). The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing. Only when creditors have the confidence that their rights are protected will they resume financing companies.
51
References
ADB Programs Department (East). 1996. Indonesia: Sustaining Manufactured Export Growth. Manuscript. Bank Indonesia, Economic and Financial Statistics, various publications. Claessens, Stijn, Simeon Djankov, and Larry H. P. Lang. 1999. Who Controls East Asian Corporations? Financial Economics Unit, Financial Sector Practice Department, World Bank. Conny Tjandra Rahardja. 1995. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. Unpublished thesis MMUGM, Yogyakarta. Delhaise, P. F. 1998. Asia in Crisis: The Implosion of the Banking and Finance System. John Wiley and Sons. Forest, Jonathan, Michael Krill, and Richard Turtil. 1999. Indonesia: An Emerging Market. Working Paper #58, Center for International Business Education and Research, University of Maryland, Maryland. Indonesian Business Data Centre. 1997. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Indonesian Business Data Centre. 1998. The Private Debt Anatomy. Indonesian Central Bureau of Statistics. 1996. Large and Medium Manufacturing Statistics. Institute for Economic and Financial Research. Indonesian Capital Market Directory 1992-1998. Jakarta Stock Exchange. JSX Monthly Statistics, various publications. Keasey, K., and M. Wright. 1997. Corporate Governance: Responsibilities, Risks, and Remuneration. John Wiley and Sons. Embassy of Indonesia. 1995. Economy of Indonesia. Embassy of Indonesia Homepage. Letter of Intent of the Government of Indonesia to the IMF, 14 May 1999. The Economist Intelligence Unit. Indonesia Country Profile, various publications. The Economist Intelligence Unit. Indonesia Country Report, various publications.
2 Republic of Korea
Kwang S. Chung and Yen Kyun Wang1
2.1
Introduction
The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth, Korea) in November of that year. As the Korean currency, markets, and corporates were sent reeling, the Government and business sector had good reason to reflect on the causes of the crisis. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. A national consensus is emerging that a democratic system based on free market principles should be firmly established to promote more intense competition in every sector of the economy. The countrys winners would then emerge based only on economic efficiency, timely exit of poor performers from the market, and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2.1). Business managers and controlling shareholders were maximizing firm size at the expense of profits, a practice that was not checked by creditors, internal control mechanisms, or capital market discipline. This has been the crux of the corporate governance problem in Korea. Further, banks as major creditors had governance problems of their own and failed to monitor or exercise the control rights generally afforded to lenders via loan agreements.
Professors, Department of Economics, Chung-Ang University, Seoul, the Republic of Korea. The authors wish to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Korea Stock Exchange for its help and support in conducting company surveys, and Graham Dwyer for his editorial assistance.
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Table 2.1 Listed Firms with Positive Economic Value Added, 1992-1998
Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35.4 1993 513 174 33.9 1994 531 165 31.1 1995 560 163 29.1 1996 561 163 29.1 1997 518 104 20.1 1998 490 164 33.5
Note: The EVAs are calculated as: EVA = NOPAT WACC, where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. The EVAs are the same as the economic profit as explained in T. Copeland, T. Koller, and J Murrin (1995). Source: Korea Stock Exchange, June 1999.
Weaknesses in the overall corporate governance system in Korea had many ramifications. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. Self-dealings by controlling shareholderscrosssubsidization and cross-guarantees among member firms within a chaebol (a conglomerate/large business group)and the lack of transparency hindered the development of an efficient capital market capable of mobilizing low-cost equity funds. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Government reform goals for the corporate sector include enhancement of corporate transparency, accountability of controlling shareholders and boards of directors, capital market discipline, and improvement of bankruptcy procedures. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms, especially chaebols. This study collects and analyzes data on the Korean economy, the corporate sector, and individual companies, aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. This study also reviews the legal and
2
The survey was conducted mainly through the Korea Stock Exchange, which distributed and collected the questionnaire. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. Many firms left some questions unanswered.
Chapter 2: Korea 55
regulatory framework for the corporate sector and reform measures taken after the crisis. This chapter is composed of six sections. Section 2.2 presents an overview of the corporate sector. It traces the countrys economic development, reviewing government policies responsible for the development of the modern corporate sector. Section 2.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols, which account for a substantial portion of the Korean economy. It reviews such elements as shareholders rights, the board of directors system, corporate control by the Government, creditors, and employees and their role in shaping corporate governance practices. Section 2.4 contains analyses of corporate financing and its relationship to performance. Section 2.5 describes the state of the corporate sector in the financial crisis and draws on the results of the foregoing sections to outline the causes of the crisis. Section 2.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. It then presents recommendations for further reform in corporate governance and financing.
2.2 2.2.1
Overview of the Corporate Sector Historical Development3
The development of the Korean corporate sector is closely related to the progress of the economy. The evolution of the modern Korean economy can be divided into four periods. Major economic indicators for some of these periods are shown in Table 2.2. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Koreas industrial capacity. From 1948 to 1961, the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. The Government tried to produce food, clothing, and other necessities domestically, and naturally adopted an import substitution policy. In the period 19481961, the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent.
3
The review of historical development of the Korean economy draws substantially from the book by Sohn, Yang, and Yim (1998).
56
Table 2.2 Key Macroeconomic Indicators Annual Average (percent, unless otherwise indicated)
Indicator GNP Growth Rate Inflation Rate Savings Rate Investment Rate Manufacturing/GDP Interest Rate on Time Depositse Exchange Rate (won/$) Export Growth Rate Import Growth Rate Trade Balance (million $) Current Account (million $) Capital Account (million $) 1962-1971 1972-1979 8.7 14.9 21.1a 21.5 250.5 38.8 24.8 (724.0) (297.0) 492.1 9.1 15.4 24.4 29.0 27.9b 15.2 452.0 41.2 32.4 (1,949.5) (1,265.9) 1,447.2 1980-1989 8.3 8.4 29.2 30.7 30.7c 11.2 757.8 15.8 12.2 314.2 1,855.2 31.4 1990-1997 7.2 6.1 35.7 37.1 29.1d 9.9 794.4 10.6 11.8 (8,332.9) (7,102.5) 8,753.1
= not available. a Refers to 1971. b Refers to 1979. c Refers to 1989. d Refers to 1997. e For maturities of one year or more. Source: Bank of Korea, Economic Statistics Yearbook; IMF, International Financial Statistics.
However, the Government was not successful in solving the problems of slow growth, high unemployment and inflation, and large current account deficits, largely because of political instability, lack of strong drive, and inconsistent economic policies. Large amounts of aid in the form of agricultural goods from the US kept prices of local goods low and discouraged efforts to increase agricultural production. Export Drive: 1962-1971 Between 1962 and 1971, the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966). In the Plan, the Government called for an unprecedented average annual economic growth rate of 7.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries, modernizing the industrial structure, and implementing new budget and tax measures. This goal required very high savings and investment rates. The Government tried
Chapter 2: Korea 57
to meet its targets by borrowing large amounts of foreign capital on the one hand, and maximizing mobilization of domestic savings on the other. In 1963-1964, Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. During the first five-year plan period, the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. In 1964, the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system, and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. The exchange rate system was a kind of crawling peg until 1974. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. Exports increased sharply from $41 million in 1961 to $2.2 billion in 1972. The average growth rate of the economy from 1960 to 1964 was 5.5 percent, a modest improvement over the 4.3 percent average between 1954 and 1959; but the average growth rate for 1965-1969 shot up to 10 percent. The well-educated, abundant, and cheap labor force was well utilized by the export-led growth strategy, which laid a solid foundation for a steady growth path. During this period, the Government tried to provide exporting firms with a free trade environment. However, due to continuous current account deficits, imports of consumer goods and luxury items were highly restricted. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT), but tariff rates were raised to 40 percent in the 1960s, up from 30 percent in the late 1950s. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. This change raised the import liberalization rate from 9.3 percent to 60.4 percent. But the liberalization trend turned out to be short lived as current account deficits continued. In 1971, the import liberalization rate was 55 percent, while the average tariff rate was 39 percent. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent, resulting in high real interest rates. Bank deposits increased rapidly, channeling funds from curb markets into the banking sector. The interest rate reform enabled banks to allocate large funds to the industrial sector and reduced the high inflationary pressure that had built up in the economy. Also, the growth of gross domestic product (GDP) raised domestic savings, boosting internal investment resources.
58
Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976), the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). By promoting HCIs, it tried to substitute imports and export high value-added HCI products. There were three reasons for the switch: first, the Government felt the need to strengthen the defense industry. Second, the emergence of competition of other low-wage, less developed countries forced Korea to adjust its industrial structure. Third, the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. The Government targeted six industriessteel, nonferrous metal, machinery (including automobiles), shipbuilding, electronics, and chemicalsas future core industries, investing a total of $9.6 billion between 1973 and 1981 into these sectors. In 1972, in the face of a world economic slump, the domestic economy was stagnant and many businesses, overburdened with debts and high interest rates, faced the danger of bankruptcy. The Government took emergency measures, announcing rescue packages for businesses and banks. These included rescheduling business debts, reducing or exempting debts of farmers and fishermen, and giving low interest rate loans to banks from the central bank. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. These practices contained an implicit government guarantee that large businesses and banks could never fail, becoming a seed of the economic crisis in 1997. The HCI promotion policy was much more comprehensive than past economic development plans. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation. The Government encouraged a variety of business projects, and assigned them to specific chaebols. It promoted HCIs by supplying massive capital for construction and development, and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. Unlike the previous system, where preferential export credit was given to almost every exporter, this new strategy had the Government explicitly allocating credit only to those firms deemed vital to HCIs in the form of below-market interest rates
Chapter 2: Korea 59
through state-controlled banks. Firms that followed the Government expanded greatly, with many turning into the now well-known chaebols. New start-up firms, however, met increased difficulty. Such an approach gave the Government increased control over the economy, as it had to control only a few large chaebols. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. The severe world recession caused by the second oil shock, coupled with political uncertainty due to the assassination of President Park in 1979, exacerbated the overcapacity problem. This required industrial restructuring by the Government, including forced liquidations and mergers and acquisitions (M&As). Evaluations of HCI promotion policies are mixed. The plan of the 1970s was thought to be successful in the long run, since during the second half of the1980s many of the promoted firms became world-class competitors and exporters, and their utilization ratios were very high. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2.2). However, the policy wasted substantial amounts of resources in the short and medium terms, such as widespread underutilization of capacities of HCIs and related plants, especially between 1979 and 1985. Meanwhile, light manufacturing and service industries were weakened by disadvantages such as a lack of credit. Cheap credit and distorted prices resulted in overexpansion in the HCIs. Macroeconomic policies became hostages of the industrial strategy. Economic Liberalization and Globalization: 1980-1997 In 1979, faced with high inflation, a heavy foreign debt burden, and the large excess capacity of HCIs, the Government adopted comprehensive measures to promote economic stabilization. The growth rate of the money supply was reduced drastically, fiscal expenditure maintained zero growth, imports were further liberalized while tariff rates were lowered, price controls were abolished, and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. Meanwhile, the Government restructured some large businesses through forced liquidation and M&As. The incentives available became more market-based. In order to improve economic efficiency, various measures to increase competition were taken. The two important ones were import liberalization and deregulation of the financial sector, including denationalization of banks. In 1986-1989, Korea recorded current account surpluses and rapid economic growth due to the three lows: low value of the US dollar, low
60
world interest rates, and low oil prices. The low value of the dollar led to a low won and high yen, while continuous and large current account surpluses saved Korea from the foreign debt problem. In 1988, Korea became a signatory country to the International Monetary Fund (IMF) Article VIII, giving up its foreign exchange controls related to the current account, and declaring that it would follow Article XI of GATT, further increasing its pace of import liberalization. In 1993, the import liberalization ratio reached 98.1 percent and average tariff rates 8.9 percent. In 1990, Korea adopted a market average exchange rate system, in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. The official rate fluctuated within a band, which gradually widened. Korea began participating in many multilateral trade negotiations during the Uruguay Round, joined the Asia Pacific Economic Cooperation (APEC) Group in 1993, and acceded to the World Trade Organization (WTO) in 1994. The Government tried to adjust economic policies and regulations to meet global standards. Industrial and trade policies were modified to be consistent with WTO. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996, the Government committed itself to further liberalization of the goods and capital markets, but it chose to liberalize gradually. Meanwhile, the importance of chaebols was increasing, with the 30 largest in the total economy in 1997 standing as follows: value-added, 13.1 percent; total assets, 46.3 percent; total debts, 47.9 percent; total sales, 45.9 percent; and total workforce, 4.2 percent. 2.2.2 Rise of the Large Business Groups (Chaebols)4
The Korean Fair Trade Act defines a business group as a group of companies, whose business activities are controlled by an identical person. A large-scale business group is called a chaebol. The most important element characterizing chaebols is the concentration of ownership, where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. The birth of chaebols can be traced to the selling of Japanese colonial properties that were reverted to the Korean Government after World
4
The historical review of chaebols draws substantially from the paper of Lee and Lee (1996).
Chapter 2: Korea 61
War II. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. Since the 1960s, the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. The Government provided subsidies, financial assistance, and tax breaks to key industries to promote exports and industrial upgrading. This policy contributed greatly to the expansion of chaebols. In the mid-1970s,when the Government put a great deal of emphasis on development of the HCIs, large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. From the standpoint of the Government, it was more effective to deal with a small number of companies to secure tangible outcomes. This galvanized the fast growth of chaebols. Since the Government controlled most business activities, chaebols that maintained a close relationship with the political authorities were able to grow fast. Chaebols have a history of substantial concentration of ownership. One reason for this controlling power is inter-company shareholding among subsidiaries. Table 2.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993, reaching 669 in 1996. However, after the financial crisis, the number of subsidiaries declined drastically due to corporate restructuring. Important managerial decisions are made primarily by owners. In this sense, the ownership and management of a chaebols subsidiaries are not separate. Chaebols are also excessively diversified. Subsidiary companies of chaebols are subject to fleet-type management in that they are controlled by the overall managerial system of chaebols, and they are aided and supported by one another. Table 2.3 Subsidiaries of the 30 Largest Chaebols, 1993-1996
Year 1993 1994 1995 1996 No. of Subsidiaries 604 616 623 669 Average No. of Subsidiaries per Chaebol 20.1 20.5 20.8 22.3
Source: The Fair Trade Commission.
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Theoretically, chaebols can benefit from synergies, including the economies of organizational size inherent in multi-product and multiplant firms, in addition to the usual economies of scale. Since chaebols are engaged in many different businesses, they can reduce uncertainties and dilute risks through sharing of information and diversification. This could ensure their stable growth and enhance their investment abilities. On the other hand, there are many negative assessments of organizational structures and practices of chaebols. For example, internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms, which may ultimately lead to the decline of social efficiency. Diversification may raise chaebol profitability but could also work to eliminate more efficient competitors because bigger chaebols have a higher capability to enforce unfair methods of competition. Meanwhile, diversification can make chaebols stable through the portfolio effect. However, if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries, the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. 2.2.3 Role of the Capital Market and Foreign Capital
In the 1960s, the Governments efforts to develop the stock market culminated in the Capital Market Development Act of 1968. In the early years after the enactment of the law, listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms, and were allowed extra depreciation charges for tax purposes. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. Under this law, the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. They had to meet certain requirements in terms of firm size, years since establishment, profitability, etc. The law also contained provisions to afford tax and other benefits to firms that went public and to impose tax-related penalties on those that refused to comply with government recommendations. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act.
Chapter 2: Korea 63
During the 1980s and 1990s, several important policy measures were implemented to promote the development of the stock market. First, the Government announced the gradual opening of the capital market to foreign investors in January 1981. In this regard, a country fund, The Korea Fund, Inc., was established to invest in domestic shares beginning in September 1985. Second, the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. Also that year, Korean firms were allowed for the first time to issue in international financial markets equity-related securities such as convertible bonds (CBs) and depository receipts. Third, in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. The policy to expand the size of the stock market, mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues, continued until 1989. Beginning 1990, however, the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies, especially those paying small or no dividends. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. Because of government policies and the booming economy, the stock market grew rapidly during the 1980s. As shown in Table 2.4, the number of firms listed on the Korea Stock Exchange almost doubled in the five-year period from 1985 (342 firms) to 1990 (669 firms). The aggregate
Table 2.4 Development of the Stock Market, 1985-1998

No. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.9 918.6 747.0 965.7 934.9 833.4 654.5 406.1 Market Capitalization (W billion) 6,570 95,476 79,020 151,217 141,151 117,370 70,989 137,798 Market Capitalization as a Ratio to GDP (%) 8.0 79.2 44.0 49.4 40.1 30.1 16.9 34.6
Year 1985 1989 1990 1994 1995 1996 1997 1998
Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.
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market value of all listed firms represented only 8 percent of GDP in 1985, but increased sharply to 79.2 percent by 1989. The relative size of the stock market diminished to 44 percent in 1990, due to declining stock prices, and stayed at the 30-40 percent level up to 1996. The growth in the number of listed firms also slowed in the 1990s. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis. The aggregate market value of listed shares bottomed at 16.86 percent of GDP in 1997, but rose again to 34.59 percent in 1998 and to more than 50 percent in the early months of 1999. Korean companies borrowed substantial amounts of foreign capital due to the excess of investments over savings and chronic current account deficitsexcept in the period 1986-1989, and 1993. However, foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries. Table 2.5 shows net FDIinward investments by foreigners less outward investments by Koreansin the period 1985-1998.
Table 2.5 Private Capital Flows to Korea, 1985-1998 ($ million)

Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total
a b
313 (9) 696 809 147 (808) (115) (311) (832) (2,264) (3,008) (3,017) 1,123 3,742 (3,534)
1,737 (333) (297) (607) (2) 218 2,338 4,953 10,553 8,149 13,875 21,183 12,287 (340) 73,714
1,453 (2,339) (9,852) (2,542) (1,414) 5,500 7,001 4,924 (1,455) 13,642 21,450 24,571 2,800 (7,413) 56,326
1,650 (1,433) (9,658) (3,870) (1,910) 2,150 5,085 2,583 25 10,817 16,239 19,347 3,785 (1,942) 42,868
(518) (418) 63 1,352 471 3,440 1,255 2,126 (1,694) 2,858 4,141 4,546 (2,296) (6,944) 8,382
Permit basis. Other investments include loans, trade credits, currency and deposits, and other liabilities. Source: Balance of Payments, Bank of Korea.
Chapter 2: Korea 65
Complicated government regulations, weak incentives for attracting FDI, and high production costs were the main reasons for low FDI in Korea. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. In addition to FDI, other net private capital inflows amounted to $130 billion during 1985-1998. Of this, portfolio investments amounted to $73.7 billion and loans $42.9 billion. Between 1986 and 1989, Korea had substantial current account surpluses and experienced net private capital outflow. Net private capital inflow, excluding FDI, increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2.5). 2.2.4 Growth and Financial Performance
This section looks at the performance of (i) the aggregate corporate sector; (ii) listed firms; and (iii) chaebols. This would lay the foundation for evaluating the effect of corporate governance on performance. The same categories will be analyzed in later sections. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. The contribution of the corporate sector to GDP was 73.2 percent in 1987, increasing to 76 percent in 1997. The growth rates of total assets, equity, and sales of the aggregate sector during this period were very high (Table 2.6). However, the growth rates of equity and sales dropped sharply in 1996 and 1997. Corporate sector net proft margins increased from 1993 to 1995, but dropped in 1996 and were negative by 1997. Return on equity (ROE) and return on assets (ROA) showed similar patterns. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424.6 percent in 1997, following the sharp depreciation of the won. This indicates that a substantial proportion of debt was denominated in dollars. Profit rates of Korean firms were relatively low compared to those of Taipei,China and the US. Table 2.7 compares the ratio of ordinary income to sales of Koreas manufacturing sector with those of Japan; Taipei,China; and US. The ratio is generally in the same range for Japan and Korea, but between 1988 and 1993, Japans was consistently higher. The dismal performance of the Korean corporate sector compared to the
Table 2.6 Growth and Financial Performance of the Nonfinancial Corporate Sector, 1990-1997 (percent)
Growth Performance Year Total Assets Equity Sales Financial Performance Net Profit Margin DER ROE ROA
1990 1991 1992 1993 1994 1995 1996 1997
23.8 22.2 13.3 11.9 18.2 19.7 15.8 21.3
14.9 16.0 10.7 15.9 16.2 18.2 9.8 1.4
19.3 21.0 13.4 10.3 17.3 21.2 13.9 13.4
1.4 1.5 1.2 1.2 1.9 2.0 0.5 (0.8)
297.1 6.2 1.6 318.0 6.7 1.7 325.1 5.5 1.3 312.9 5.4 1.3 308.1 8.1 2.0 305.6 9.1 2.3 335.6 2.5 0.6 424.6 (4.2) (0.9)
DER = debt-to-equity ratio, Net profit margin = ratio of net income to sales, ROA = return on assets (ratio of net income to total assets), ROE = return on equity (ratio of net income to stockholders equity). Source: Bank of Korea, Financial Statement Analysis Yearbook.
Table 2.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent)
Year Korea US Japan Taipei,China
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
2.5 3.6 3.6 4.1 2.5 2.3 1.8 1.5 1.7 2.7 3.6 1.0 (0.3)
5.9 5.8 2.8 8.3 6.9 3.7 3.7 4.0 4.0 7.5 7.9 8.3
3.9 2.8 3.7 4.5 4.7 4.3 3.4 2.6 1.9 2.4 2.9 3.4
6.0 8.0 13.6 13.9 18.4 4.5 4.0 3.4 2.9 4.9 5.1
= not available. Note: Ratio of ordinary income to sales = (ordinary income/sales). Ordinary income = operating income + nonoperating income (from financial activities) nonoperating expenses (from financial activities). Source: Bank of Korea, Financial Statement Analysis Yearbook.
Chapter 2: Korea 67
other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. This preference of Korean firms has its roots in the structure of corporate governance. Performance followed similar patterns across different industries (Table 2.8). Growth rates of total assets are generally high, with the wholesale and retail trade sector and the construction sector having the highest figures. Profit rates of most industries are also quite low, the exception being the electricity, gas, and steam supply industry. This may be related to its having the lowest DER. The other financial ratios follow the general pattern of the aggregate corporate sector. All sectors experienced a sharp decline in equity and sales growth in 1997, with equity in wholesale and retail trade even contracting. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. The manufacturing, construction, trade, and transport sectors recorded negative profit rates in 1997. It is notable that the construction sectors profit rate began its decline in 1995, a year ahead of the other industries. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2.9). In most years, the sales growth of listed firms was higher than that of the aggregate sector (see Table 2.6). In 1997, sales of listed firms grew 18.5 percent while the aggregate sector recorded only 13.4 percent. The superior performance of listed firms in terms of sales growth may be due to large firms easy access to credit and the inclusion of financial firms in the listed firms category. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. However, both ROA and ROE were lower for the listed firms compared to the latter. A comparison of performance by firm size reveals some interesting results. The growth performance of large firms for the 1988-1997 period was better than that of medium- and small-scale firms (Table 2.10). Again, this may be an indication of the bias toward large firms in terms of access to credit. However, the average ROE was lowest for large firms, while their average net profit margin was lower than that of medium firms, but higher than that of small firms. Net profit margins, ROEs, and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. Small listed firms were hardest hit by the financial crisis, followed by mediumsized firms and large ones.
Table 2.8 Growth and Financial Performance of Selected Industries (percent)

Growth Performance Year Assets Equity
a
Financial Performance NPM

b
Sales
DER
ROE
ROA
Manufacturing 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 13.0 15.2 20.4 15.8 24.0 23.8 22.6 12.3 11.2 16.9 19.3 15.0 22.4 17.8 10.3 15.0 24.9 31.0 37.8 16.8 16.3 8.6 17.6 14.1 21.4 5.8 1.1 17.0 9.8 16.8 22.6 15.8 7.0 18.8 17.4 10.3 10.0 18.2 20.4 10.3 11.0 15.0 1.1 2.0 1.9 2.0 1.6 1.4 1.4 1.0 1.1 2.0 2.8 0.5 (1.0) 1.4 348.4 350.9 340.1 296.0 254.3 285.5 306.6 318.7 294.8 302.5 286.7 317.1 396.2 315.2 5.8 10.9 10.7 10.2 6.4 5.6 5.6 3.7 4.2 7.6 11.0 2.0 (4.2) 6.1 1.3 2.4 2.4 2.5 1.7 1.5 1.4 0.9 1.0 1.9 2.8 0.5 (0.9) 1.5
Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.4 4.0 5.3 8.2 24.8 34.5 30.9 16.7 17.0 24.8 24.9 14.5 14.3 18.3 8.0 (0.1) (3.2) 22.8 35.5 28.5 23.1 20.0 22.7 30.6 12.4 9.2 5.9 16.6 1.5 (5.7) 2.9 16.2 18.9 29.2 36.2 16.0 5.5 13.7 16.1 16.5 16.3 14.1 0.9 (0.3) (1.1) 0.5 1.0 1.1 1.5 1.4 2.0 2.1 0.6 0.1 (0.5) 0.7 520.5 569.4 740.9 538.4 458.5 473.4 474.8 461.5 432.6 375.2 423.8 562.6 655.7 514.4 5.2 (1.6) (6.6) 3.2 5.5 6.4 10.3 8.8 12.3 10.4 3.2 0.7 (3.0) 4.2 0.9 (0.2) (0.8) 0.5 1.0 1.1 1.8 1.6 2.3 2.1 0.6 0.1 (0.4) 0.8
Real Estate, Renting, and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.4 12.2 15.3 13.6 24.7 22.8 14.0 12.1 10.9 25.6 17.3 15.3 14.6 16.1 7.7 (0.2) 15.3 25.1 22.6 14.9 10.8 23.2 2.2 6.6 7.8 13.5 5.8 12.0 16.0 16.0 21.2 25.8 32.5 27.7 21.3 15.7 9.1 27.3 31.1 28.6 14.0 22.0 7.5 3.9 5.6 6.7 7.0 3.4 2.4 2.2 0.5 1.1 1.0 (0.0) 0.8 3.2 241.5 270.3 288.7 228.0 245.5 338.5 483.8 526.8 616.5 239.4 291.1 290.9 428.8 345.4 14.5 6.8 14.5 19.0 19.2 12.9 13.4 10.8 2.8 2.8 3.4 (0.1) 3.9 9.5 4.3 1.9 3.7 5.5 5.6 3.0 2.3 1.7 0.4 0.9 0.9 (0.0) 0.8 2.4
Table 2.8 (Contd)

Growth Performance Year Assets Equitya Sales NPMb Financial Performance DER ROE ROA
Wholesale/Retail Trade 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.3 23.6 14.1 11.1 21.7 20.5 16.9 18.3 19.7 14.4 21.0 14.4 13.8 14.1 16.1 17.3 (2.2) 13.6 17.6 21.9 18.5 13.3 17.5 26.6 18.1 15.2 18.6 0.8 0.5 0.7 0.4 0.4 0.4 0.4 (0.7) 0.4 448.5 462.9 456.5 539.3 524.3 543.7 510.5 612.6 512.3 10.4 6.9 9.6 6.1 6.8 6.6 6.1 (11.1) 5.2 2.0 1.3 1.7 0.9 1.1 1.0 1.0 (1.1) 1.0
Transport, Storage, and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.9 17.4 11.4 6.9 10.5 14.8 12.8 12.4 10.4 16.1 15.7 15.3 34.5 14.9 (10.7) (4.8) (12.5) 22.5 47.6 (2.2) 9.5 14.6 12.0 21.0 14.9 4.6 1.8 9.1 (0.3) 11.7 11.4 12.9 8.2 14.6 20.4 14.4 15.5 15.6 19.2 14.7 19.0 13.6 (2.4) (1.1) (0.0) 1.6 1.5 2.4 3.3 3.0 2.3 4.2 3.3 0.5 (2.8) 1.2 698.3 740.4 1,062.0 921.4 633.4 341.5 344.9 332.9 321.1 323.5 307.4 367.5 482.8 529.0 (15.9) (8.0) (0.3) 15.2 10.8 6.9 10.6 9.7 7.8 14.5 11.4 1.9 (11.3) 4.1 (2.3) (1.1) (0.0) 1.4 1.3 1.7 2.4 2.2 1.8 3.4 2.8 0.4 (2.2) 0.9
Electricity, Gas, and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.7 2.6 0.3 0.6 4.0 7.7 16.2 18.9 12.7 12.1 15.5 30.4 30.6 12.6 8.4 9.5 12.2 18.9 12.6 9.1 11.2 11.4 7.5 15.1 14.6 34.3 2.4 12.9 7.6 6.6 9.7 11.3 4.3 12.5 14.3 18.7 14.3 18.8 15.9 17.2 15.1 12.8 7.3 8.7 11.6 19.6 16.2 10.8 11.2 10.0 5.1 8.8 8.1 4.9 3.9 9.7 187.4 169.2 143.0 106.0 89.2 90.0 98.3 112.2 122.7 116.5 117.8 111.6 172.3 125.9 6.2 7.3 9.6 15.5 11.6 8.3 8.9 8.5 4.6 8.4 7.8 4.4 3.5 8.0 2.2 2.6 3.7 7.0 5.9 4.3 4.6 4.1 2.1 3.8 3.6 2.0 1.4 3.7
= not available. a New equity does not include capital surplus. b NPM denotes net profit margin. Source: Calculated using data from Bank of Korea, Financial Statement Analysis Yearbooks.
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Table 2.9 Growth and Financial Performance of Listed Companies, 1985-1997 (percent, unless otherwise indicated)
Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.9 11.3 20.9 26.4 22.5 19.6 23.3 15.2 9.6 22.8 24.9 21.0 18.5 19.7 Net Profit Margin 0.6 0.8 0.6 2.3 2.9 2.9 2.1 1.7 1.4 2.2 2.4 0.6 (1.4) 1.5 ROE 3.5 5.0 3.2 9.2 6.8 6.8 5.3 4.6 3.9 6.1 6.9 1.7 (5.1) 4.5 ROA 0.3 0.5 0.4 1.4 1.6 1.4 1.0 0.9 0.7 1.1 1.2 0.3 (0.7) 0.9
Source: Constructed using data from Korea Investors Service, Kis-Fas, 1998.
Performance of Chaebols This section uses available data on the top 30 chaebols. The criteria for selection of largest chaebols have changed a few times, but the number of designated groups has been fixed at 30 since 1993. In 1995, the largest chaebol, Hyundai Group, had 46 member companies, of which 16 were publicly listed (Table 2.11). The number of Hyundai member companies rose to 57 in 1997. The smallest group had 16 members in 1995, of which four were listed. Generally, it is the chaebols large firms that are listed. Chaebols have been the most important actors and engines of growth in the Korean economy. In 1997, the 30 largest chaebols accounted for 13.1 percent of the economys total value added (excluding the financial sector), and close to half of total assets (46.3 percent), debts (47.9 percent), sales (45.9 percent), and net profits (46.7 percent) of the corporate sector. Between 1993 and 1997, the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.6 and 2.12). The top five chaebols registered the highest growth rates, followed by the top 6-10 (Table 2.12). It should also be noted that when the financial crisis struck in 1997, the top 11-30 chaebols experienced a decline of
Table 2.10 Growth and Financial Performance of Listed Companies by Size, 1988-1997 (percent)
ROE Large 9.8 6.9 6.6 5.5 5.0 4.4 6.6 7.3 1.8 (5.1) 5.0 15.1 8.6 3.9 6.3 6.0 6.2 7.1 11.6 2.0 (4.8) 6.8 16.0 10.8 6.9 5.6 3.2 2.7 (1.0) 0.9 (0.9) (6.3) 5.6 1.6 1.4 1.2 0.9 0.8 0.7 1.0 1.1 0.3 (0.6) 0.8 3.9 2.4 2.0 1.6 1.5 1.6 2.8 0.9 0.5 (1.0) 1.7 4.2 3.2 2.0 1.5 0.8 0.6 (0.2) 0.2 (0.2) (1.5) 1.4 Medium Small Large Medium Small ROA Growth Performance Large 17.2 13.0 19.5 25.4 16.3 9.7 18.9 25.0 16.5 17.8 17.3 Medium 14.3 11.3 15.0 17.2 12.2 13.9 14.9 22.8 10.6 13.3 15.2 Small 13.5 5.2 10.0 1.4 5.6 6.6 8.4 11.8 7.4 3.6 9.5
Net Profit Margin
Year
Large
Medium
Small
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average
2.5 3.1 2.9 2.2 1.9 1.7 2.5 2.6 0.6 (1.4) 1.7
3.7 2.6 2.4 1.9 1.8 1.9 2.3 3.8 0.7 (1.5) 1.9
3.4 3.1 2.1 1.6 0.9 0.7 (0.3) 0.3 (0.2) (1.8) 1.2
Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion. Others are medium firms. Source: Korea Investors Service, Kis-Fas, 1998.
Table 2.11 Features of the 30 Largest Chaebols

Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43,743 40,761 31,395 31,313 14,501 13,929 12,246 11,427 9,158 7,090 6,423 5,756 5,364 5,147 5,117 4,766 3,574 3,433 3,303 3,129 2,995 2,990 2,935 2,924 2,873 2,475 2,180 2,158 1,996 1,853 1997 53,597 351,651 38,376 35,455 22,927 16,457 14,309 14,287 10,967 7,774 7,486 6,370 6,177 6,458 6,640 4,131 3,956 3,951 3,910 3,445 4,346 3,677 3,690 3,398 2,599 2,798 No. of Member Companies 1995 46 55 49 25 32 23 24 16 31 28 27 26 18 21 16 17 16 16 14 19 22 19 24 11 14 8 8 11 18 16 1997 57 80 49 30 46 25 24 28 31 30 26 25 21 19 18 18 17 24 24 24 6 8 2 15 7 18 No. of Listed Companies 1995 16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4
= not available. Source: Fair Trade Commission.
Table 2.12 Growth and Financial Performance of the 30 Largest Chaebols, 1993-1997 (percent)
Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.9 20.0 31.9 17.2 20.3 11.8 18.5 27.5 32.4 12.7 10.6 18.1 27.1 10.4 (2.0) 12.3 19.4 30.1 19.3 14.8 Assets 12.5 19.3 27.0 19.4 38.2 11.7 15.6 19.8 27.5 20.3 15.3 16.6 25.7 15.6 4.7 13.0 17.9 24.9 20.4 26.6 Financial Performance Net Profit Margin 1.5 2.7 4.0 0.8 0.3 1.0 1.3 1.2 0.2 (2.5) (0.5) (0.1) (0.1) 0.1 (3.2) 1.0 2.0 2.7 0.5 (0.7) ROE 5.3 9.9 18.0 2.3 0.4 0.9 3.3 3.1 (1.4) (14.1) (1.5) (0.2) (2.3) 0.2 (16.0) 3.0 6.7 10.7 1.2 (5.0) ROA 1.9 3.5 5.6 1.0 0.3 0.9 1.2 1.2 0.2 (2.2) (0.4) (0.1) (0.1) 0.1 (2.4) 1.1 2.2 3.2 0.6 (0.7)
Source: Bank of Korea.
74
2 percent in their sales and a very low 4.7 percent growth in total assets. Only the top five chaebols registered a positive net profit margin in 1997. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. Their worst year was 1997 when ROE hit -15.95 percent. The better showing of the top five chaebols was a direct result of their dominance in human resources, technology, and access to credit. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. However, except for 1995, the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. There has been a wide range in DER among chaebols, from 190 to 3,765 percent (Table 2.13). By the end of 1997, the average DER of the 30 largest chaebols reached 519 percent. In general, chaebols had a higher average DER than the corporate sector as a whole. The absence of a well-developed equity market and the provision of subsidized credit, coupled with weak corporate governance, resulted in the chaebols excessive leverage.
2.3
This section looks at the key aspects of corporate governance in Korea. Ownership patterns, internal and external control mechanisms, and government intervention interacted through a set of laws and regulations to bring about the existing structure. The Commercial Code stipulates the basic governance framework and applies to all corporations. However, loopholes and inconsistent policies spawned strategic behavior and agency problems, and led to a high concentration of ownership, weak corporate control, and vulnerable balance sheets. Attempts to rectify the corporate structure were halfhearted and it was only after the onset of the crisis that many of the most serious reforms were instituted. 2.3.1 Patterns of Corporate Ownership
The ownership of most Korean listed firms is highly concentrated.5 Founding families are mostly still the largest shareholders and, more important, a pyramidal structure of corporate ownership is prevalent.
5
While ownership concentration can be defined and measured differently in different contexts, in this instance, it refers to the degree of concentration and shareholdings in the hands of an identical person. This identical person, in Koreas legal and regulatory framework, includes the largest shareholder, his/her relatives, and the companies that are under the control of the largest shareholder.
Table 2.13 The Top 30 Chaebols Debt-to-Equity Ratio, 1995-1997 (percent)

Chaebols 1995 1. Hyundai 2. Samsung 3. LG 4. Daewoo 5. Sunkyung 6. Ssangyong 7. Hanjin 8. Kia 9. Hanwha 10. Lotte 11. Kumho 12. Doosan 13. Daelim 14. Hanbo 15. Dongah Construction 16. Halla 17. Hyosung 18. Dongkuk Steel 19. Jinro 20. Kolon 21. Tongyang 22. Hansol 23. Dongbu 24. Kohap 25. Haitai 26. Sammi 27. Hanil 28. Kukdong Construction 29. Newcore 30. Byucksan 1996 1. Hyundai 2. Samsung 3. LG 4. Daewoo 5. Sunkyung 6. Ssangyong 7. Hanjin 8. Kia 9. Hanwha 10. Lotte 11. Kumho 12. Halla 13. Dongah 14. Doosan 15. Daelim 16. Hansol 17. Hyosung 18. Dongkuk Steel 19. Jinro Debt-to-Equity Ratio 376.4 205.8 312.8 336.5 343.3 297.7 621.7 416.7 620.4 175.5 464.4 622.1 385.1 674.9 321.5 2,855.3 315.1 190.2 2,441.2 328.1 278.8 313.3 328.3 572.0 506.1 3,244.6 936.2 471.2 924.0 486.0 436.7 267.2 346.5 337.5 383.6 409.4 556.6 516.9 751.4 192.1 477.6 2,065.7 354.7 688.2 423.2 292.0 370.0 218.5 3,764.6
Table 2.13 (Contd)

Chaebols 20. Kolon 21. Kohab 22. Dongbu 23. Tongyang 24. Haitai 25. Newcore 26. Anam 27. Hanil 28. Keopyong 29. Miwon 30. Shinho 1997 1. Hyundai 2. Samsung 3. Daewoo 4. LG 5. SK 6. Hanjin 7. Ssangyong 8. Hanwha 9. Kumho 10. Dongah 11. Lotte 12. Halla 13. Daelim 14. Doosan 15. Hansol 16. Hyosung 17. Kohab 18. Kolon 19. Dongkuk Steel 20. Dongbu 21. Anam 22. Jinro 23. Tongyang 24. Haitai 25. Shinho 26. Daesang 27. Newcore 28. Keopyong 29. Kamgwon Industrial 30. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.8 590.5 261.8 307.8 658.5 1,225.6 478.5 576.8 347.6 416.9 490.9 578.7 370.9 472.0 505.8 468.0 907.8 399.7 1,214.7 944.1 359.9 216.5 (1,600.4) 513.6 590.3 399.9 465.1 472.1 433.5 323.8 338.4 1,498.5 (893.5) 404.3 1,501.3 676.8 647.9 1,784.1 438.1 375.0 419.3 347.5 386.5 519.0 305.6 335.6 424.6
Sources: aFair Trade Commission. bBank of Korea, Financial Statement Analysis Yearbook.
Chapter 2: Korea 77
When controlling shareholders hold a very small percentage of the shares, an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders, that is, the ownership structure can bring about an incentive effect. However, large ownership can also bring about the entrenchment effect, i.e., an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. Theoretically, with a given range of managerial shareholdings (for instance, 10 to 30 percent), the entrenchment effect outweighs the incentive effect. Beyond that range, the incentive effect once again dominates. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding, managerial entrenchment becomes more likely. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. The controlling shareholders of chaebols hold comparatively smaller percentages of shares, resorting to extensive use of pyramiding to maintain control. Thus, the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. Composition of Ownership Among listed companies, including banks and other financial firms, the individual ownersthe portfolio investors as well as the controlling shareholders and their family membersformed the largest shareholder group (Table 2.14). The next important group was other corporations, followed by banks. The pattern of distribution changed little through 1992-1997. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992, but their shares declined to 21.7 percent by 1997. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies stock portfolios declined. The percentage of shares owned by other corporations, foreigners, and insurance companies increased during the period, while those owned by banks, the Government, and state-owned companies and securities companies declined. Among listed nonfinancial companies, individuals were also the largest shareholder group. However, the extent of ownership by these individuals declined gradually after 1988, the year the stock market was in a frenzy due to buying sprees. From 69.1 percent, the percentage of holdings by individuals slipped to 60.6 percent by 1997. The holdings of financial institutions, including investment trust companies, fluctuated widely during the period, and then steadily declined after 1993. The reduction can be
Table 2.14 Ownership Composition of Listed Companies, 1988-1997 (percent)

Financial Institutions Securities Firms Total 28.0 28.0 27.3 26.9 26.1 21.7 9.7 14.7 18.2 17.9 19.1 21.3 18.5 16.9 15.6 13.8 17.4 14.3 17.4 18.6 16.5 12.4 13.6 16.1 17.6 19.1 18.8 17.2 18.1 18.6 20.6 22.8 4.1 8.7 9.1 10.1 11.6 9.1 3.3 1.9 1.8 2.2 3.2 5.0 5.3 5.2 5.0 4.8 5.2 4.7 3.6 2.9 2.2 2.1 4.3 5.5 7.5 7.2 7.7 7.0 8.0 5.5 4.9 4.9 1.3 1.2 1.5 1.5 1.8 2.1 1.9 2.1 2.3 2.4 5.9 5.8 5.4 5.7 6.5 6.4 Insurance Firms Other Corporations Foreigners Individuals 39.9 37.6 36.9 36.4 34.3 39.8 69.1 68.5 62.0 60.8 59.0 59.1 60.8 59.7 59.5 60.6
Year
No. of Firms
The Statea
Banks, etc.b
A. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775
9.2 8.6 8.7 8.0 7.4 6.6
16.9 17.5 18.3 18.3 17.4 13.2
B. Listed Nonfinancial Companiesd 1988 406 0.5 1989 498 0.7 1990 531 0.6 1991 505 0.5 1992 508 2.2 1993 511 2.3 1994 521 1.8 1995 548 2.3 1996 570 2.4 1997 551 1.7
4.1 8.0 9.2 9.2 9.6 12.2 8.6 9.3 8.5 6.5
Note: Ownership is based on number of shares. a The State covers the Government and state-owned companies. b Banks, etc. includes commercial banks, merchant banks, investment trust companies, mutual savings, and finance companies. c Data from Korea Stock Exchange. d Constructed from data files of the Korea Listed Companies Association.
Chapter 2: Korea 79
ascribed to prudence in staying away from the stock marketas part of their risk management strategyas the stock market was in doldrums throughout the 1990s. The holdings of other corporations are mainly equity investments in affiliate companies. Corporate holdings averaged 16 percent throughout 1988-1997. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. Before such liberalization, foreign holdings were derived from purchases through country funds and direct capital investments. Compared with its holdings in all listed companies, government ownership in nonfinancial companies was remarkably smaller and more concentrated. In most instances, the Government was the sole owner. This trend can be explained by government ownership, whether partial or absolute, of some banks. In 1998, the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. Individuals held the majority of the shares in all industries except in telecommunications, electricity, and service of motor vehicles (Table 2.15). In general, financial institutions had more shares in the manufacturing sector than in primary industries. Over the years, other corporations holdings shifted toward service industries, indicating their increased investments particularly in the service industries with high growth rates. The Governments and state-owned institutions (including some banks) ownership was generally small except in the power sector, with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. The ownership distribution in listed nonfinancial firms, categorized into large, medium, and small companies, did not vary significantly (Table 2.16). One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms, indicating their heavier reliance on inter-firm financing investments. When independent companies are distinguished from firms affiliated with the 30 largest chaebols, there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2.17). However, a more detailed breakdown of the data on majority shareholdings in the next section shows significant differences in the two groups composition and level of majority shareholdings. Institutional investors, as distinguished from individual and foreign investors, held 26.8 percent of listed shares in 1997. This is low compared with those in Japan, UK, and US (Table 2.18). However, the holdings of institutional investors were expected to increase significantly with the Governments introduction of US-type investment companies in 1998 and
Table 2.15 Ownership Composition of Listed Nonfinancial Firms by Industry, 1990 and 1997 (percent)
Financial Institutions The Statea 0.2 0.2 0.4 1.3 0.5 1.0 39.5 0.0 0.2 0.1 0.4 0.3 0.5 0.6 3.8 6.1 8.9 4.4 7.1 8.2 9.3 10.5 12.0 10.9 10.6 11.2 22.5 4.3 11.0 9.1 27.9 8.8 7.2 17.8 7.3 13.0 9.2 9.3 2.4 8.6 5.3 9.3 6.4 8.1 7.2 9.0 9.5 7.8 7.7 2.5 6.0 7.3 7.8 8.0 8.0 9.8 7.6 8.7 6.2 7.5 0.6 1.2 0.5 0.9 1.9 1.2 1.4 0.3 1.7 2.1 0.2 0.5 0.2 1.8 7.0 1.8 3.4 8.9 0.3 2.4 1.5 3.7 2.9 16.7 14.7 20.9 19.6 18.7 22.6 24.1 10.7 14.7 20.8 5.8 3.0 20.7 17.4 14.9 15.5 19.7 22.9 23.1 19.5 17.4 Banks, Etc.b Securities Firms Insurance Firms Other Corporations Foreigners 0.3 1.0 0.0 2.4 2.3 0.2 2.1 4.8 1.5 0.1 0.4 5.2 0.3 4.1 0.7 1.6 2.1 1.8 Individuals 83.1 88.7 64.8 73.4 62.2 64.9 59.2 54.9 52.9 66.7 59.4 56.7 29.5 85.9 55.7 63.3 38.1 65.3 57.9 42.9 60.4 56.3 62.0
Industry
1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood, Paper, and Printing Pulp, Paper, and Printing Chemicals, Rubber, and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics, Elecl Mach., and App. Motor Vehicles Electricity, Gas, and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average
1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood, Paper, and Printing Pulp, Paper, and Printing Chemicals, Rubber, and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics, Elecl Mach. and App. Motor Vehicles Electricity, Gas, and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.0 1.8 0.9 1.2 1.3 0.9 2.1 1.8 0.8 2.5 1.3 1.2 7.6 0.2 0.8 3.2 1.4 1.6 2.1 1.4 1.7 2.8 6.8 5.0 4.4 0.9 5.3 7.0 7.9 5.4 6.6 7.3 8.4 4.0 8.6 3.5 7.8 11.2 6.6 6.1 1.5 6.8 2.3 6.5 3.6 1.7 4.4 3.9 7.9 7.6 5.8 5.0 5.7 2.2 5.0 6.1 4.5 3.2 3.5 3.7 2.4 4.7 5.1 9.1 3.1 25.5 4.9 1.0 3.3 1.8 2.2 0.9 0.9 2.4 2.4 1.1 2.6 2.4 2.5 0.9 2.7 1.2 4.2 8.1 2.4 2.6 2.5 3.5 2.4 9.9 6.9 20.3 15.8 12.6 14.9 18.6 18.8 27.2 13.7 17.6 20.3 31.1 9.5 12.9 20.7 23.1 18.4 20.0 43.2 23.0 11.7 19.1 0.9 6.7 2.9 1.2 4.7 6.3 6.2 5.5 4.6 6.1 3.0 6.4 16.4 1.9 2.2 4.3 2.8 4.6 0.5 5.1 6.2 4.78 81.9 78.6 60.9 69.6 75.3 65.8 57.9 57.8 54.4 68.0 60.4 58.4 45.6 59.4 76.4 58.2 49.5 63.5 59.4 43.3 57.1 54.3 60.6
= not available. Note: Ownership is based on number of shares. a The State covers the government and state-owned companies. b Banks, etc. includes commercial banks, merchant banks, investment trust companies, mutual savings, and finance companies. Source: Constructed from data files of the Korea Listed Companies Association.
Table 2.16 Ownership Composition of Listed Nonfinancial Firms by Size, 1997 (percent)
The Stateb Foreigners 4.9 4.4 5.4 4.8 1.2 1.4 2.4 1.7 6.8 6.4 5.1 6.5 4.8 4.9 5.8 4.9 2.4 2.5 2.1 2.4 21.5 18.6 16.5 19.3 Banks, etc.c Securities Firms Insurance Firms Other Corporations Individuals 58.4 61.5 62.6 60.4
Firm Sizea
No. of Firms
Large Medium Small Total
211 208 80 499
Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion. Others are medium firms. The State covers the government and state-owned companies. c Banks, etc. includes commercial banks, merchant banks, investment trust companies, mutual savings, and finance companies. Source: Constructed from data files of the Korea Listed Companies Association.
Table 2.17 Ownership Composition of Listed Nonfinancial Firms by Control Type, 1997 (percent)
The State 1.7 0.7 1.5 8.7 8.1 8.5 6.0 6.3 6.1 Banks, etc. Securities Firms Insurance Firms 2.0 1.8 2.0 Other Corporations 16.4 17.5 16.7 Foreigners 4.8 3.7 4.5 Individuals 60.4 61.8 60.7
Control Type
No. of Firms
Independent Firms Affiliates of 30 Largest Chaebols Total
316 117 433
Source: Constructed from data files of the Korea Listed Companies Association.
Chapter 2: Korea 83
Table 2.18 Ownership Composition of Listed Firms in Selected Countries, 1997 (percent)
Country Japan Korea Taipei,China United Kingdom United States
Source: Stock Exchange of Korea.
Institutional Investors 42.4 26.8 10.3 54.5 45.6
Individuals 23.6 39.8 56.5 20.3 47.6
Foreigners 9.8 9.1 8.7 16.3 6.1
financial institutions establishment of corporate pension fund accounts. At the moment, only closed-end investment companies and traditional investment trust companies are allowed. The more popular open-end investment companies (mutual funds) were expected to come into existence by the end of 1999 with the Governments deregulation of the capital market. Foreign holdings of Korean shares were 9.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder, including those of the largest shareholder, his/her family members, and the companies under the control of the largest shareholder; minority shareholders, defined as those holding less than 1 percent of shares; and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. Generally, the majority shareholder group in all listed companies consists of the corporate, rather than the individual, investors (Table 2.19). In 1997, for example, corporations held 70 percent of the controlling blocks of shares, while family members accounted for only 30 percent. This has had profound implications for corporate governance and the market for corporate control in Korea. Among nonfinancial listed firms, the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.20). The majority shareholder groups shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. But these may
Table 2.19 Ownership Concentration of All Listed Firms, 1992-1997 (percent)

Majority Shareholders Corporation 15.1 14.3 18.7 16.1 15.7 18.7 7.9 7.7 6.9 6.1 5.8 8.1 23.0 22.0 25.6 22.1 21.6 26.8 Individual Subtotal Other Shareholders Corporation 3.4 3.9 2.6 2.9 3.1 4.9 Individual 2.0 1.2 2.0 2.2 2.3 2.3 Subtotal 5.4 5.0 4.6 5.1 5.4 7.2
Minority Shareholders Subtotal 71.6 73.0 69.8 72.8 73.0 66.0
Year
Corporation
Individual
1992 1993 1994 1995 1996 1997
41.5 43.1 37.7 44.6 46.9 33.3
30.0 29.9 32.1 28.2 26.1 32.7
Note: The majority shareholder includes the largest shareholder, his/her family members, and the companies under the control of the largest shareholder. Minority shareholders are those holding less than 1 percent of shares. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group. Source: Stock Exchange of Korea.
Chapter 2: Korea 85
Table 2.20 Ownership Concentration of Listed Nonfinancial Firms, 1988-1997 (percent)

Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.8 57.6 57.6 58.5 60.3 62.0 58.8 54.1 50.9 48.8 Majority Shareholders 27.8 28.9 29.4 28.9 27.9 25.8 25.4 23.5 23.3 25.9 Other Shareholders 18.5 13.5 12.9 12.6 11.8 12.2 15.7 18.0 22.0 20.4
Source: Constructed from data files of the Korea Listed Companies Association.
have been underestimated because it was widely believed that the largest shareholder often had hidden shares registered in the names of relatives and subordinates of the company. The practice of hidden shares seems to have been less prevalent in recent years. Besides, hiding shares offers no additional tax or other benefits. Meanwhile, minority shareholders, which held less than 1 percent of a companys outstanding shares as of 1997, collectively owned less than 50 percent of an average firm. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average. Across industry, utility companies have a relatively higher degree of ownership concentration with the majority shareholder owning nearly 45 percent of an average company (partly because these companies were owned solely by the Government before their privatization [Table 2.21]). In such cases, the Government has retained a large number of shares. Majority ownership is also high in the chemicals, rubber and plastics, and mining categories. In most industries, the majority owner held more than 20 percent of an average firm. In telecommunications, ownership was relatively diffused due to government regulation. Ownership concentration tended to be lower in large compared to medium and small listed firms. It was highest in medium-sized firms before 1993 and, thereafter, in the small firms. The percentage of shares held by minority owners (with less than 1 percent of outstanding shares) was highest for large firms at more than 55 percent (Table 2.22).
Table 2.21 Ownership Concentration of Listed Nonfinancial Firms by Industry, 1997 (percent)
Number of Firms 3 2 43 49 12 16 90 39 31 71 34 8 9 49 40 15 1 10 29 551 36.8 51.1 43.5 44.8 31.5 52.9 44.5 47.6 50.4 53.6 53.7 36.0 51.8 55.1 49.0 39.0 54.6 34.2 46.2 48.8 25.6 38.0 30.7 27.8 29.2 26.2 37.9 26.6 19.8 21.7 26.8 44.8 24.5 23.5 21.1 19.9 10.7 24.7 29.6 25.9 Minority Shareholders Majority Shareholders Other Shareholders 12.4 11.0 21.5 16.3 39.3 19.1 17.4 16.3 26.2 22.2 19.5 19.2 23.7 17.7 21.5 41.2 34.8 41.2 20.5 20.4
Industry
Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood, Paper, and Printing Pulp, Paper, and Printing Chemicals, Rubber, and Plastics Basic Metal Fabricated Metal and Machinery Electronics, Elecl Mach., and App. Motor Vehicles Electricity, Gas, and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total
Source: Constructed from data files of Korea Listed Companies Association.
Table 2.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size, 1988-1997 (percent)
Year Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Medium 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Large 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 No. of Firms 66 81 72 76 80 67 78 102 134 115 148 197 219 212 210 217 216 216 215 215 165 213 220 217 218 217 227 230 231 221 Minority Shareholders 53.8 52.0 55.3 55.6 55.9 56.8 52.4 51.2 50.4 47.1 48.5 51.2 52.9 55.7 57.0 59.2 56.9 53.8 50.5 49.7 57.1 58.9 60.8 62.6 65.0 66.6 62.6 59.8 56.2 55.2 Majority Shareholders 26.4 30.1 27.6 27.7 28.5 27.9 28.3 27.2 26.7 31.4 30.5 33.2 32.6 31.4 30.8 27.9 26.5 26.3 26.4 29.6 24.8 28.5 28.0 26.0 24.2 21.2 21.2 21.4 21.3 25.5 Other Shareholders 19.8 17.9 17.1 16.7 15.6 15.3 19.3 21.7 22.9 21.5 21.1 15.7 14.5 12.9 12.2 12.9 16.5 19.9 23.1 20.7 17.5 12.6 11.2 11.5 10.8 11.7 16.2 18.9 22.5 19.2
Source: Korea Listed Companies Association.
88
Ownership Concentration and Financial Performance J. H. Kim (1992) and Kim, Hong, and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. Both studies used Tobins Q (TQ) for the value of a firm as an index of financial performance, and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. If TQ is higher than 1, it means the firm creates value; if TQ is lower than 1, the firm destroys value. J. H. Kim (1992) found the relation between TQ and SCS to be nonlinear. If SCS is below 10 percent, TQ increases as the SCS increases. If SCS reaches 10 percent, TQ has a maximum value. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. If SCS is below the range of 20-25 percent, TQ is above 1, thus a firm creates value. If SCS is above 20-25 percent, TQ is below 1, thus a firm destroys value. The study by Kim, Hong, and Kim (1995) reached a similar conclusion. They analyzed firms in which controlling shareholders participate as managers. The relationship between TQ and SCS shows a similar pattern. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork, Shleifer, and Vishny, 1988), although turning points in the value of firms are different. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. The Code prohibits a subsidiary company from owning shares of its parent company, which is the company holding more than 40 percent of outstanding shares of its subsidiary. Where direct cross-shareholding is not allowed, one company can still place equity investments in another, which can then pass the equity capital to a third. This type of inter-firm investment, called pyramiding commonly (though incorrectly) known as indirect cross-shareholding is prevalent in Korea. One of the merits of pyramiding, from the standpoint of the controlling shareholder, is effective control of a certain group of companies even with a smaller investment. In Korea, affiliated companies have been able to conduct inter-firm transactions, often at terms unfair to one of the transacting parties. For example, one company from a chaebol group could obtain debt payment
Chapter 2: Korea 89
guarantees from other members of the group at no cost. Thus, firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. Until recently, neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. The extent of pyramiding can be seen in some of the previous tables. In Table 2.14, for example, corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. In many instances, financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. These shares should be added to the control block although the financial institutions belonging to the 30 largest chaebols are prohibited from exercising their voting rights in the member firms of the chaebol. The fact that corporations, not individuals, dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. For the whole sample, the top five shareholders consisted of 2.5 corporations and two individuals, together owning an average of 38.5 percent of shares. Among chaebol affiliated firms, 62 percent (16 out of 26) had a corporation as the largest shareholder. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3.4 corporations, together owning an average of 37.9 percent of shares. Of the 81 respondents, 59 were parent firms with one or more subsidiaries, together having a total of 292 domestic subsidiaries, or about four firms each, and 319 foreign subsidiaries, or about five subsidiaries each. Twenty-two of the 81 respondents were independent, standalone setups. Partial results are shown in Table 2.23. Among the 81 listed firms in the ADB survey, 59 parent companies collectively had investments in 759 firms, or an average of 13 firms per company. Among the subsidiaries or firms receiving investments, 53 percent were domestic nonfinancial firms, 34 percent were foreign companies, and about 11 percent were domestic financial institutions. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. Thus, there are instances of direct cross-shareholding in Korean firms, although they are likely to be insignificant. In the case of the 30 largest chaebols, the average shareholding of the controlling owners and their families was 8.5 percent as of 1997. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. For the same year, the top 30 chaebols shareholding by subsidiaries was 34.5 percent. If we define the internal shareholdings of a
Table 2.23 Ownership Concentration in the Survey Sample of 81 Listed Firms, 1999
Five Largest Shareholders No. of Firms Largest Shareholders Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total
Classification
Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is
CEO an Individual a Firm
CEO an Individual a Firm
81 55 31 10 14 26 3 7 16
20.4 21.5 24.0 21.7 19.4 18.0 13.5 18.8 18.5
2.0 2.5 2.6 3.0 1.4 1.1 3.0 1.7 0.5
2.5 2.1 1.5 1.6 3.6 3.4 2.0 3.0 3.9
21.2 25.8 31.5 31.8 8.4 11.4 25.1 22.5 4.0
17.3 12.9 5.7 5.6 34.3 26.5 4.6 16.9 34.8
38.5 38.7 37.2 37.4 42.8 37.9 29.7 39.4 38.8
Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only. a Number of shareholders. A few companies reported less than five largest shareholders. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.
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chaebol as the shareholdings of the controlling family and the member companies of the group, the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. Table 2.24 shows the average internal shareholdings in the 30 largest chaebols. The family and member companies shareholdings have been declining over time. As of 1997, the controlling families owned 8.5 percent and member companies, 34.5 percent. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols firms are still privately held. Table 2.24 Internal Shareholdings of the 30 Largest Chaebols, 1987-1997
Type of Shareholding Internal Shareholdings Family Member Companies
Source: Korea Fair Trade Commission.
1987 56.2 15.8 40.4
1990 45.4 13.7 31.7
1992 46.2 12.8 33.4
1993 43.4 10.2 33.2
1994 42.7 9.6 33.1
1997 43.0 8.5 34.5
Judging from the historical record, it appears that the chaebol families have had a strong desire to expand their business bases. Thus it can be inferred that their strategy in designing the ownership structure of their business groups was to minimize the financial resources required to maintain their grip on the management of the member firms while maximizing their control. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. Hattori (1989) identified three patterns based on data in the early 1980s.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. Based on these studies, the ownership patterns can be described as follows.
6
Hattori, Tamio. 1989. Japanese Zaibatsu and Korean Chaebols. In Korean Managerial Dynamics, edited by K. H. Chung and H. C. Lee, pp. 79-95. New York: Praeger. Lee, Jae Woo. 1997. Is the Fair Trade Policy Fair? Korea Economic Research Institute. Ungki Lim. 1998. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Paper presented at the Annual Conference of Financial Management Association, Chicago, 15 October 1998.
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The first (Type A) is called direct family ownership. A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. The Hanjin Group, consisting of eight listed and 16 privately held firms as of 1997, is an example of this type. The second (Type B), called the indirect control via base company, shows a simple pyramidal structure. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. Investments between the lower level subsidiaries are rare. The Hanwha Group can be classified as such a company. It consists of seven listed and 24 privately held firms. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. The third (Type C) is indirect control via complex shareholding. Here the family directly controls a base company and a nonprofit foundation, which then make investments in the subsidiaries. The family itself holds shares in some subsidiaries, which in turn hold shares in some of the other subsidiaries. The Hyundai Group exemplifies this. As of 1997, it had 18 listed and 39 private companies. The controlling family has sizable investments in two base companies and smaller investments in many others. A nonprofit foundation under the familys control is the largest shareholder of one of the base companies. The two base companies have investments in three other base companies. Also, subsidiaries have extensive investments in other subsidiaries. Thus, the family controls the groups member companies by its own shareholdings, investments made by the base companies, holdings of the nonprofit foundation, and subsidiaries equity participation. The fourth type (Type D) is management control. Under this type of ownership pattern, there is no controlling shareholder. The Kia Group was about the only management-controlled group but was out of existence by 1999, completely dissolved under financial distress. Most of its member firms were acquired by, or merged into, other firms. For example, Hyundai Motors acquired Kia Motors via an international auction. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. But the former chief executive officer (CEO), Sun Hong Kim, and his management team exercised full control over the group without much interference from major investors. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting, financial, and business activities. One of the
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pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter, the Fair Trade Act). Initially, the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. However, direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. These amendments prohibited holding companies and direct cross-shareholding, and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets. This limit was also applicable to banks and insurance companies. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. The prohibition of holding companies was also abolished in 1999. Until the end of 1998, only operating holding companies were allowed to be established. An operating holding company is defined by the Fair Trade Act as one whose investment in others does not exceed 50 percent of its total assets. This was the reason why chaebols chose to employ pyramidal structures. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. One condition requires that the DER of the holding company should not exceed 100 percent. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. A third disallows multiple layering of holding companies. The Government is also considering whether to allow consolidated taxation for pure holding companies. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. At this early stage, following the amendment of the law, there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. It remains to be seen whether they will adopt the holding company structure in the future. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. Existing guarantees had to be resolved by March 2000. Also, the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones, thus hurting the shareholders of stronger firms. They hindered early exits (liquidation, bankruptcy reorganization,
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etc.) of nonviable member firms and helped afford a disproportionate advantage to chaebols in obtaining favorable bank loans because (it was generally believed) the Government would not let large chaebols go bankrupt. The Fair Trade Commission has been deeply involved in promoting managerial transparency by exercising its power to investigate and levy penalties on unfair internal transactions among member firms of chaebols. Since the economic crisis, the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. The 30 largest chaebols are now required to publish combined financial statements, which put together the accounts of all members of a chaebol, unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. In 1998, chaebols dismantled their planning and coordination offices or chairmans offices under pressure from the Government. These offices were legally informal and functioned as the headquarters of chaebols. The staff of these organizations were employees of member firms. Their operating costs were borne by the member companies rather than by the controlling shareholder, who is universally called the group chairman. The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity, even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. The chairmans office had its own chief executive officer, usually in the rank of a company president. The office established strategies for the group as a whole, planned for capital raising and allocation on a groupwide basis, and transferred funds generated by one firm to another. It also acted as the secretariat for the unofficial presidential meeting of the member firm presidents. Some chaebols operated group management boards attended by top executives (presidents or chairpersons) of larger member firms. Despite chaebols decision to dismantle the chairmans offices, there have been no significant changes. Some chaebols have disintegrated or shrunk in size, but the larger and stronger ones still operate their newly named restructuring headquarters under the control of the group chairperson. Chaebols maintain that the restructuring headquarters will exist only for a limited period, until urgent restructuring is complete. 2.3.2 Internal Management and Control
Monitoring of corporate management by shareholders, boards of directors, and the capital market was almost nonexistent until the recent reform
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efforts. There are many reasons for this. The Governments policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. This policy managed to hamper any monitoring initiatives from the capital market. Legal provisions to protect investors were limited, the concept of fiduciary duty of managers was not well established, and takeover codes were not accommodative to active monitoring. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. Meanwhile, creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. Loan agreements and debt indentures did not include strict covenants. Even when the covenants were violated, the creditors did not declare defaults. Banks, as the major creditors, had their own governance problems. Under such circumstances, only the Government could play an effective role in monitoring corporations. However, this was complicated by the prevailing attitude that large companies, especially chaebols, were too big to fail. Board of Directors General Characteristics of the Boards Under the Commercial Code, corporations should have a board of directors consisting of at least three members. Directors are elected at the general shareholders meeting for a term not exceeding three years. The board elects one or more representative directors from among the board members. Most companies have one representative director, but some large ones have two or more. In most listed companies, except for banks, the controlling shareholder is officially the representative director and the CEO, or at least acts as the de facto CEO. As of 1997, the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. With few exceptions, the representative director was also the chairperson of the board. Even where the largest shareholder is not the representative director, he or she generally approves major decisions made by the management. Thus, in most Korean firms, control is not separate from ownership. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders.
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When the Commercial Code first introduced the corporate board system in the 1960s, members of the board, other than the representative director(s), were supposed to be outside directors. However, it has been common practice that candidates for directorship are handpicked by the controlling shareholder/CEO from among the senior managers and are automatically approved at the general shareholders meeting. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. With the boards consisting only of insiders, they were virtually under the full control of the CEOs and in practice functioned only as management councils without any decision-making powerat least until 1998. A few large companies had more than 50 directors, all of whom were managers. Recent Reform Efforts on the Board System In 1997, the listing rules of the Korea Stock Exchange were revised to require that listed companies have one or more independent outside directors by the 1998 annual shareholders meeting. The rules further require that the number of outside directors be not less than a quarter of the size of the board by the annual shareholders meeting in 1999. Moreover, the listing rules restrict the eligibility of independent outside directors to those who have no family ties with the managers and no significant business transactions with the company. Despite the qualification requirements, there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. In order to address this concern, the stock exchange recently amended the listing rules to require that companies disclose a detailed profile of the candidate and the person who made the nomination. Further, companies have to disclose in their annual reports the frequency of board meetings, the attendance rate of outside directors, and their positions (accept or reject) on matters voted on in board meetings. The exchange is also expected to recommend company charters to have provisions that allow for information demanded by outside directors to be promptly supplied to them. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. However, cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. In the 1999 annual shareholders meetings, almost all companies succeeded in adopting cumulative voting.
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The committee structure of the board as found in the US has not yet been adopted by listed companies, although some banks recently have established board committees. This is because most banks, having no controlling shareholders, are required to have a majority of outside directors. The controlling shareholder of some banks is the Government, which had extended financial support in their recent recapitalization efforts. In March 1999, a blue-ribbon committee, the Corporate Governance Reform Committee, was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. In September of the same year, this committee adopted the Code of Best Practice in Corporate Governance. Meanwhile, the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. Among others, the Korean Code recommends that large listed firms should have at least three independent directors, who would comprise at least 50 percent of the boards, an audit committee, and a nominating committee. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. The average board had 8.4 directors. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. Among the firms with no outside directors, 88 percent had plans to hold elections in the near future. These results are in accordance with the new listing rules introduced in 1998. On average, inside directors owned 16.1 percent and outside directors 1.1 percent of outstanding shares of a listed company. In 78 percent of the responding firms, the chairperson of the board was also the CEO and on average held 10.5 percent of the shares. Where the chairperson was not the CEO, he or she held 6.2 percent and the CEO 14.9 percent on average. Where the two were separate, they had a parent/child relationship in 20 percent of the cases. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). Directors were also chosen on the basis of their relationship with the controlling
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shareholder (30 percent). Less frequently, election of directors was based on shareholdings (7 percent) and status as founder (7 percent). Most frequently, the management nominated director candidates (64 percent of the directors). Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms), relationship with controlling shareholders (21 percent), and shareholding (10 percent). In some instances, founders of the company acted as the chairperson (22 percent). In 91 percent of the sample firms, the board had no committees. In a very small number of firms, the board had a nomination and an audit committee. These were established only recently. As discussed earlier, most firms just began to elect a small number of outside directors to meet a new requirement in the listing rules and thus have no experience in the AngloAmerican type of board processes. In most firms, the term of appointment of directors and board chairpersons is three years. The current chairperson has been in office for 6.2 years on average. This rather long tenure must be due to their status as controlling shareholders in most firms. About five directors per firm have been in office for more than one term. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms; and fixed fees plus performance-related pay, including stock options, in 23 percent. According to the Commercial Code, compensation for directors must be approved by the annual shareholders meeting for each fiscal year. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. The board or the management then determines compensation packages for individual directors. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. In 13 percent, the management determines the remuneration. However, in some firms, the package for the chairperson is directly proposed at the annual shareholders meeting either by the board (31 percent of the firms) or by the management (9 percent). In 1997, among the 81 sample firms, a total of 562 directors were sitting on two or more corporate boards. In one case, one person was sitting on nine boards and this person was the CEO of a chaebol firm. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards.
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Management CEO In the survey sample, 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. According to the survey, CEO is also the founder in 52 percent of the firms. In 21 percent of cases, CEO was given shares by the family; and in another 21 percent CEO bought shares in the market. In the 25 firms where CEO was not the chairperson of the board, he or she was selected on the basis of professional expertise in 15 firms, shareholding in three firms, and was appointed by the Government in five firms. When CEO is not the chairperson, compensation is by fixed salary in 74 percent of the firms; fixed salary plus net profit-related bonus in 9 percent; and fixed salary plus performance-related pay including stock options in 13 percent. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. In 20 percent, it was proposed by CEO and approved by the board. In a handful of sample firms, in which there is no controlling shareholder, CEO generally has the ultimate power to decide on corporate affairs. In cases where CEO is not the largest shareholder and chairperson, he or she does not enjoy much power. However, the survey tells a slightly different story than is generally believed in Korea. It indicates that CEO, who is not the chairperson, decides on important matters on his/her own in 13 out of the 44 firms. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. In 4 percent of the cases, CEO simply follows the orders of the chairperson. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. In the survey, CEOs have been in their positions for an average of 9.2 years. In less than 20 percent of the firms, CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. In such cases, the payment is about five times the CEOs annual salary. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. A smaller number of firms consider maximization of a companys market share and looking after the interests of such stakeholders as creditors and employees as very important. Ensuring that a company serves the public interest is considered a less important responsibility of CEO.
100 Corporate Governance and Finance in East Asia, Vol. II
Senior Executives In the past, it was common for all senior executives to be elected as directors at the shareholders meeting. Senior managers were even often called directors although they were not official members of the board. The term of appointment of executives did not have any real meaning because they had to leave the company if and when the controlling shareholder demanded. Usually CEO suggests the maximum amount of all the directors compensation at the shareholders meeting to get approval and then sets the base salary and bonus for individual executives. The bonus is supposed to be linked to company performance, but in practice is fixed and understood as part of a fixed salary. Korean firms have rarely used shares for executive compensation. However, executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO, in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. Incentive stock options have become a popular compensation method since the Securities and Exchange Act was amended in 1996 to allow the issuance of stock options to managers and other employees. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings, but as of March 1999 only 27 firms actually had given stock options to their executives or employees. Transparency and Disclosure Accounting Standards The Financial Supervisory Commission (FSC) was established in April 1998 to take charge of supervising the financial markets and institutions. The commission has played an active role in introducing new rules on corporate governance, disclosure, and accounting standards. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. This action was in response to calls by international investors and, in particular, from IMF and the World Bank. Penalties for fraudulent financial reports were increased. Reforms in accounting standards since May 1998 have proceeded in several areas: (i) revision of financial accounting standards that are primary sources of the Korean Generally Accepted Accounting Principles; (ii) establishment of accounting standards for financial institutions; and
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(iii) establishment of accounting standards for combined financial statements of chaebols. The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. Thus, financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current years income statement. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current years financial statements. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. Consolidated reporting was introduced before the outbreak of the crisis. In the ADB survey, 41 percent of the companies believed that they have followed some international accounting standards, but 49 percent confessed that they have not followed international standards at all. Only 10 percent of the respondents have followed all international accounting standards. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. Under the Commercial Code, they also have the power and duty to monitor the activities of executive directors. In practice, however, they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. Notwithstanding a regulation limiting the votes of the largest shareholder to a maximum of 3 percent of the outstanding voting rights in selecting an internal auditor, the internal auditor is considered to be a subordinate of the
controlling shareholder/CEO. In order to increase independence, the relevant laws and regulations were changed after the Asian crisis to require at least one of the internal auditors to be full time and to recommend that listed firms have outside (independent) auditors. Listed and registered corporations must publish financial statements audited by external accounting firms. Previously, the board of directors had the power to appoint an external auditing firm, but since 1998 a committee consisting of internal auditors, outside directors, and creditors selects it. Responsibilities of the External Auditors Committee include recommending a selection to the annual shareholders meeting and ensuring that external auditors conform to new transparency standards. External auditors are selected for a term of three years. If the company changes its external auditor for reasons that are not listed in the relevant regulation, then the Securities and Futures Commission can appoint a new one. In the ADB survey, almost all firms affirmed that the external auditor is independent from the company. Big Korean accounting firms are affiliated with US accounting firms. The current external auditors have been associated with the surveyed companies for an average of 4.6 years. In the past, however, there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing, underdeveloped market discipline for accounting firms, and lack of strong professional ethics in the accounting profession. The internal auditor in the Korean corporate system can be argued to be inferior to the Anglo-American audit committee and the German supervisory board. This is because the auditor, as a monitor of management in the Korean (and also the Japanese) system, does not have the power to hire and fire the managers. If the status of internal auditors is elevated to that of independent board members, this problem will largely disappear. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. But this problem can be mitigated if auditors function under the umbrella of the board. Accepting these arguments, the Korean Code of Best Practice also recommends that large firms adopt the audit committee structure with two thirds of its members consisting of independent directors. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. The Securities and Exchange Act will also be revised to require an audit committee for large listed companies with total assets equal to or exceeding W2 trillion. About 100 listed firms will be subject to this requirement.
2.3.3
Shareholder Rights
Voting Rights and Practices Under the Commercial Code, corporations cannot issue common shares without voting rights. One common share should have one vote. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. About one fifth of the listed firms issued nonvoting preferred shares. The Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally. However, the Depository is subject to shadow voting, meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. Thus, the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. However, voting by the Depository can influence the outcome of votes because an ordinary resolution of the general shareholders meeting requires a majority of the votes attending and one quarter of total votes outstanding. A special resolution requires two thirds of the votes attending and one third of total votes outstanding. Approval of mergers and major divestitures, charter amendments, and dismissal of directors and internal auditors require a special resolution. The survey shows that the Korea Securities Depository holds 69.21 percent of total shares issued. A total of 326 shareholders per firm, or 10.79 percent of the shareholders, attended the last annual general meeting, representing 62.77 percent of the shares. The Depository represented 20 percent of the shares attending the meetings. The above results indicate that, in general, small shareholders do not attend the annual meeting and that, for some firms, the Depository is instrumental in getting resolutions passed. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). These voters represented only 5.93 percent of the shareholders but 26.53 percent of the total shareholdings. This shows that a relatively larger number of shareholders send in their proxies. The management is the most important proxy. The securities companies and banks are the second and third, respectively. Citizens coalitions sometimes solicit proxies in order to file lawsuits against a management. No companies have so far introduced voting by mail, Internet, or telephone. Under the Commercial Code, amendments of the articles of incorporation require a special resolution. Companies can increase the number
of votes required for a resolution to amend the articles. Changes in the authorized capital require an amendment of the articles of incorporation. However, the board of directors decides on issues of shares within the limit of the authorized capital. Shareholders have preemptive rights, but these can be waived by an amendment of the articles of incorporation. Proposals put forward by management are rarely rejected at the general meetings. Only two out of 62 respondents to this question have had cases in which proposals were rejected. Those that are most likely to be rejected relate to election of directors, dividend proposals, mergers and acquisition plans, and major investment projects (only five firms answered this question). In four out of 62 respondents, the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. Shareholder Protection Before the economic crisis, laws and regulations were generally very loose in protecting the rights of minority shareholders. Various measures have since been taken to improve investor protection. In February 1998 and again in March, the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0.01 percent. For recommendations for dismissal of directors and internal auditors, the requirement was lowered from 1 to 0.5 percent, and for access to unpublished accounting books and records, from 3 to 1.0 percent. Due to the changes in rules for investor protection, an activist citizens coalition has brought shareholder derivative suits against several large listed firms. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. This citizens coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. It also attended the shareholders meeting of several companies to present the views of outside shareholders, demand changes in business policy, or block charter amendments considered harmful to minority shareholders. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. As an example, the Tiger Fund, an institutional investor based in the US, was able to force a change in the charter of SK Telecom. The amendment included a provision requiring the company management to get prior approval of shareholders to undertake major investments and raise capital in international markets. The company also agreed to the right of the fund
to recommend two directors to the corporate board. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. After the economic crisis, controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. This has strengthened the accountability of controlling shareholders as de facto CEOs. The Commercial Code has a new clause that regards the controlling shareholder as a de facto director if he or she uses personal influence to affect business decisions of the management. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management. Before the amendment, managers were considered to be subject to the duty of care, but it was not entirely clear whether they had the duty of loyalty as well. For further protection of investors, the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. However, it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. The laws and regulations of the country protect shareholders from interested transactions, affiliated lending or guarantees, loans to directors, mergers and acquisitions, and transactions with major shareholders. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. 2.3.4 Control by Creditors
Role of Creditors in Corporate Monitoring Traditionally, creditors did not interfere with the management of a debtor. The covenants in loan agreements and bond indentures were very loose, simple, and not strictly enforced. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. As for bond issues, underwriting securities firms acted also as trustees. Thus, there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. In fact, bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. Banks have played some limited role in monitoring the investment activities of chaebols. In 1974, the Government introduced the Credit Management Regulation system whereby chaebols were required to seek the approval of their main banks prior to undertaking large investments,
acquisitions, and purchases of real estate. In 1994 the approval requirement was abolished. In 1996, the main bank system was introduced and has been applied to the 51 largest business groups to which banks extended more than W250 billion in loans and payment guarantees. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. However, there have been concerns that the Government might use the system to intervene in the management of the business groups. Under the system, a main bank is charged with collecting and analyzing financial information of the firm and delivering its opinion on various applications and matters requiring consultation among lenders to the firm. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. Purchase of real estate should be financed by equity capital and not by borrowed funds. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. In turn, the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. Besides the setting up of an External Auditors Committee by firms, as discussed earlier, creditors now have a bigger say in court proceedings for receivership and composition. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. However, this proposal has only a slim chance of being accepted by the Government or legislature. The view that is more popular among theorists is that creditors would pursue goals that are not in harmony with value maximization and the decision-making role should be bestowed on the shareholders as residual claimants. On the other hand, recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors, including, on average, 11 banks, 10 nonbank
financial institutions (NBFIs), and 17 nonfinancial corporations. Most of the financial institutions are not affiliates of the borrowing company, whereas seven of the 17 nonfinancial corporations are. The borrowers relationship with most banks has lasted for more than five years. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. Among the creditors, banks are most likely to require collateral. NBFIs infrequently ask for collateral. With respect to the types of loans, collateral is more likely to be required of loans for working capital than for fixed investments. Most firms feel that requirements for collateral have been tightened since the crisis started. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. For more than half of such firms, renegotiation took place after the crisis. When loans could not be repaid on time, payments were usually rescheduled through negotiation without any penalty. For a small number of firms, penalty was involved in rescheduling, collateral was taken away, or creditors filed for receivership. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. More than half of the firms think that creditors have no influence on their management and decision making, while a third think that creditors have weak influence. Only a few feel that creditors have very strong influence. Creditors usually exercise their influence through covenants relating to the use of loans. A few creditors exercise influence through covenants relating to major decisions by the company, or through their shareholdings. One tenth of the firms received assistance from the Government in loan applications, most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. The assistance came from, in order of importance: affiliated companies, holding companies, subsidiaries, controlling shareholders, and other financial institutions. Relationships with affiliated companies providing guarantees or collateral include ownership of each others shares, holding shares of another company by both the borrower and the guarantor, mutual guarantee agreements, and purchase or supply of raw materials. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees, 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance), 16 percent
by other affiliated companies, 4 percent by subsidiaries, 2 percent by holding companies, and 1 percent by the Government. Role of Creditors in the Corporate Restructuring Process In the current process of business restructuring and workouts of an unprecedented number of firms under financial distress, banks and other institutional lenders are playing more important roles than ever before. Behind these new strengthened roles of creditors is the newly set-up FSC. The new ways through which creditors, especially banks, will get involved in the restructuring and workout processes, and in continued monitoring of debtors, are summarized below. First, major creditors, including commercial and merchant banks, have been the driving forces for restructuring activities of the largest 64 chaebols. In this connection, the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. Second, the main vehicle for implementing the workout concept (or the London Approach) is the Corporate Restructuring Agreement (CRA) signed by 210 financial institutions in July 1998. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. In cases where the creditors are unable to reach an agreement on a workout plan, the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. This committee was set up in accordance with the provisions of the CRA. Separate from but emulating the CRA, a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. Third, the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. Under a contract signed between the creditors and the debtor, the delegation has the right to approve wide-ranging financial activities of the firm. 2.3.5 The Market for Corporate Control
Government Policy Toward Hostile Takeovers Until 1994, the Korean Government maintained a policy of protecting the incumbent management of listed companies. Representative of the policy was the stipulation under the Securities and Exchange Act that no one can accumulate more than 10 percent of the voting shares of a listed company
unless he or she obtains prior approval of the Securities and Exchange Commission. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Stock purchases by tender offer were also exempted. It was generally believed that the securities authority would use its power to review and order revisions of the tender offer statement to halt any hostile takeover attempt. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. The policy to protect the incumbent owners/managers was formally dropped when the Securities and Exchange Act was amended in 1994 to abolish the 10 percent limit. As far as institutional arrangements are concerned, it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. A company cannot issue new shares to a third party without first amending the corporate charter. Privately placed CBs cannot be converted into shares in one year. Publicly issued CBs require three months before their owners can convert them to shares. Unlike the UK, Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998, an acquirer of shares wishing to own more than 25 percent of the issued shares was required to make a tender offer to buy at least 50 percent). Unlike Germany, corporations cannot limit the voting rights of large shareholders to a given maximum. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992, but were completely eliminated in 1998. Takeover Activity As soon as the Act was amended, hostile takeovers by tender offers began to appear in the capital market. Between 1994 and 1997, a total of 13 hostile takeover attempts occurred. However, more than half of these attempts failed. The reasons for failure are diverse. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs, turning to white knights, and announcing competitive tender offers by the controlling shareholder. In one case, the outside shareholders did not want to sell shares because the share price went above the offer price due to a share repurchase by the target and anticipation of a competitive bid from a third party. For takeover defense, listed firms rely mainly on shareholdings by the largest shareholder. Companies have also utilized share repurchases.
The Securities and Exchange Act was revised in 1998 to abolish the 10 percent limit on share repurchases and the Government simultaneously eliminated the limit on foreign ownership of shares of listed firms. Charter amendments have also been employed by some firms to limit the maximum number of directors. In their charters, some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. Golden parachutes are almost unknown in Korea because the total amount of director compensation has to be voted on at the general shareholders meeting each year. Hostile takeovers in Korea will be rare in the future. One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26.7 percent on average as of the end of 1997 for nonfinancial listed firms). Many of the takeover targets in the past did not have a controlling shareholder (group). Some had two or more large shareholders who had joint control of the firm but could not cooperate. It is harder now to find such firms. Another reason is that many listed firms belong to chaebols. Firms affiliated with a large group are generally regarded as difficult targets as the other members of the group will come to the rescue or act as white knights. As of February 1999, 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. 2.3.6 Control by the Government
State-Owned Enterprises Government ownership of listed companies is very limited. As of the end of 1997, a steel company, an electric power company, and a bank had government ownership. In 1998, the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. In 1999, Korea Telecom, in which the Government still holds the largest ownership, was newly listed. The Government-owned listed companies, except for the banks, are designated as public companies, which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. Currently the limit is 3 percent. For the steel company, the limit will be eliminated when it is fully privatized in two years. For the others, it is not certain whether the Government will ever fully privatize them and whether it will hold a golden share in the case of a complete sale of Government-held shares.
The Government used to appoint a few public officials to the boards of state-owned corporations. But this rule, as applied to four large corporations, was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. The Governments right to send public officials to the boards was eliminated. Beginning in 1999, more state-owned corporations became subject to this new board structure. The nonexecutive directors are now recommended by a committee, nominated by the minister in charge of the company in question, and approved by the Chairperson of the Planning and Budget Commission. Control Over Private Companies One of the pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols (see 2.3.1). Meanwhile, the main bank system, which was introduced in 1996, is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. The Government has frequently imposed restrictions on the use of capital markets by large companies, especially those belonging to chaebols. For example, the Government, administering through a self-regulatory committee of the securities industry, controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. It was abolished before the economic crisis but another regulation, which limits the total amount of bonds issued by the five largest chaebols, went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. In addition, only qualified firms could issue new shares. There were also limits on the amount raised and the number of issues per year. Further, each of the 10 largest chaebols was allowed to raise funds no more than 4 percent of the total market capitalization of the member firms. 2.3.7 Employee Participation in Corporate Governance
Employee participation in corporate governance is very limited. Labor is not represented in corporate boards. There is no active debate or discussion going on about this potentially difficult issue. Even where employees hold
shares of their companies through employee stock ownership plans, they delegate their voting rights to plans representatives. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. The relevant regulation was amended recently in order to facilitate voting by individual employees. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Under the Capital Market Development Act of 1968, employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. Under another law enacted in 1972 to induce private companies to go public, these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices, which were generally much lower than estimated values. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. In 1987, the subscription rights given to employees when a company goes public and when a listed company issues shares were increased to 20 percent of the new shares. The percentage of shares held by the employee stock ownership plans in listed companies was 1.9 in 1980, 2.5 in 1990, and 2.1 in 1997. Under the Labor Management Council Law, employers are required to meet with representatives of labor unions at least once every three months. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. In actuality, the council meetings have been superficial. Trade unions are organized on an enterprise basis. Local unions in the same industry have established industrial labor federations. At the national level, there are two federations of labor unions. The typical collective bargaining agreement has a one-year duration. Collective bargaining is, in principle, carried out at the enterprise level. The respondents of the ADB survey had 2,654 employees per firm on average, of which 2 percent were senior managers, 32 percent technicians and professional staff, and 66 percent manual workers. Two thirds of the respondents had an organized union. In these firms, union members account for 54 percent of the employees. In 70 percent of the firms with organized unions, the management usually consults the union on major issues relating to the management, operation, and development of the company. About half of these firms considered the influence of the union on the management of the company to be weak, but 27 percent of them felt that it was strong. The union had no influence on the management in 17 percent of the firms.
2.4 2.4.1
Corporate Financing7 Overview of the Financial System
The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7
The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.
counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.
Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump
after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the
total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage
Interest Rate Deregulation Plan, implementing the first stage in November 1991. The Government adopted a cautious approach, opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. In addition, entry barriers to banks and NBFIs were lowered in an attempt to promote competition, which resulted in the establishment of a number of new banks, short-term finance companies, mutual savings, finance companies, etc. With the privatization of nationwide commercial banks, the Government simplified various directives and instructions regulating personnel management, budget, and organization of commercial banks. Also, the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3.5 percent in November 1981. Some policy loans were also abolished. Moreover, the business scope of financial institutions was greatly widened from the early 1980s. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2.2.1). Meanwhile, as a first step toward liberalization of capital account transactions, the Government announced a plan in 1981 that substantially improved foreign investors access to the domestic capital market. Since 1985, Korean firms have been allowed to issue CBs in international financial markets. In June 1993, the Korean Government announced its Financial Liberalization and Market Opening Plan. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. It included such important issues as interest rate deregulation, revision of the credit control system, development of the money market, and liberalization of foreign and capital transactions. The capital market, especially the domestic bond market, was liberalized drastically in 1998 after the financial crisis. 2.4.2 Patterns of Corporate Financing
Corporate Financing Practices In this section, flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector, listed companies, and the 30 largest chaebols. On the basis of flows of funds, the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. Internal funds include retained earnings, depreciation,
and net capital transfers from the Government, but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. Equity capital represents the shareholders commitment to the business. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. It measures the degree of financing growth in total assets by additional debts. The use of additional debt to finance growth increases financial risks as the company may not be able to pay interest during periods of recession or high interest rates. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders equity to change in total assets or 1-IDFR. It measures the degree of financing growth in total assets by additional equity, comprising internally generated capital (retained earnings, capital surplus, depreciation, and allowances) and new equity capital. Financing Patterns of the Aggregate Corporate Sector Table 2.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. The share of external financing, including all sources other than retained earnings, depreciation, and government transfers, on average, was 71 percent during the period. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. Before 1988, the corporate sectors most important source of external finance was bank borrowings, particularly in the short term. In 1988 when the stock market boomed, the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. Securities finance became a more important source from 1988 onwards, except in 1991, 1994, and 1997. In securities finance, financing by corporate bonds and CPs was more significant than by new equity, except for the stock market boom of 19871988. Meanwhile, the proportion of foreign borrowings in total finance rose steadily, particularly in the 1990s in response to the liberalization of the capital market; but it remained less than 10 percent of total financing. Table 2.26 shows the four measures of corporate financing calculated from Table 2.25. The SFR averaged 28.4 percent in the precrisis period 1988-1997. This means that internal funds after dividend payment were insufficient to finance growth in total assets. The corporate sector used
Table 2.25 Flow of Funds of the Nonfinancial Corporate Sector, 1988-1997 (percent)
1988 43.8 56.2 13.6 9.6 4.0 1.5 2.5 29.5 2.6 3.0 3.7 7.1 3.0 3.2 9.9 0.1 3.2 28.4 71.6 25.4 10.6 14.8 4.9 9.9 38.6 2.0 9.5 9.2 15.4 2.4 0.3 8.0 (0.1) 4.1 27.1 72.9 28.0 11.5 16.5 2.7 13.8 30.9 2.1 2.7 15.7 8.6 1.7 4.7 9.4 (0.1) 4.8 26.7 73.3 30.7 14.5 16.1 1.7 14.4 27.8 1.8 -2.8 17.7 8.4 2.6 3.0 8.6 0.2 6.4 28.7 71.3 25.9 10.8 15.1 (0.3) 15.3 27.7 2.3 5.4 8.6 9.3 2.0 5.1 12.6 0.7 6.3 30.0 70.0 22.0 9.1 12.8 1.7 11.2 34.4 2.4 9.7 10.2 10.3 1.8 1.1 2.6 0.0 0.4 (2.0) 12.6 (0.1) 6.3 6.4 27.3 72.7 32.4 15.1 17.3 3.2 14.2 26.5 0.3 3.6 10.3 10.8 1.6 4.8 1.2 1.5 0.4 1.6 9.0 0.2 5.0 3.8 27.9 72.1 23.0 10.7 12.2 0.4 11.9 34.7 (0.7) 11.6 11.1 10.4 2.2 6.1 1.2 2.1 0.7 2.1 8.4 0.1 3.6 4.7 1989 1990 1991 1992 1993 1994 1995 1996 22.6 77.4 21.7 10.9 10.8 (0.3) 11.1 36.6 0.2 13.5 13.8 8.5 0.6 8.1 1.7 2.7 1.0 2.6 11.1 (1.6) 5.3 6.0 1997 26.9 73.1 27.7 10.0 17.7 1.3 16.4 27.1 0.4 3.0 16.6 5.3 1.7 4.5 2.4 1.3 1.2 (0.4) 13.8 0.9 6.3 6.6
Sources of Funds
Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl. and Public Bonds Commercial Paper Corporate Bonds Stock Issuesb Equity Other than Stock Foreign Loans Foreign Current Bonds Trade Credit Direct Investment Others Others Government Loans Business Credit Other Financial Debts
= not available. a Includes retained earnings, depreciation, and net capital transfers from the Government. b Includes capital surplus, which is the excess of current value over issue value of stock. Source: Understanding Flow of Fund Accounts, Bank of Korea, 1994; and Flow of Funds, Bank of Korea.
Table 2.26 Financing Patterns of the Nonfinancial Corporate Sector, 1988-1997 (percent)
Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average
a
SFRa 43.8 28.4 27.1 26.7 28.7 30.0 27.3 27.9 22.6 26.9 28.4
NEFRa 20.1 17.8 10.3 11.0 11.4 12.1 12.3 12.7 9.0 5.5 12.2
IDFR 36.1 53.8 62.6 62.3 60.0 57.9 60.3 59.5 68.3 73.3 59.4
IEFR 63.9 46.2 37.4 37.7 40.0 42.1 39.7 40.5 31.7 26.7 40.6
Excludes capital surplus. Source: Calculations from Understanding Flow of Fund Accounts, Bank of Korea, 1994; and Flow of Funds, Bank of Korea.
additional equity to finance 12.2 percent of the growth in total assets. The balance, an average of 59.4 percent, was financed by additional debts. Incremental financing from equity was 40.6 percent over the 10-year period. There were significant time trends. In periods of high economic growth such as in 1988, SFR peaked at 44 percent. It dropped to 28 percent the following year, declining to 26.9 percent by 1997 when net profit margins were negative. NEFR registered 20.1 percent in 1988 during the stock market boom, but plunged to 5.5 percent in 1997. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years, but also continuously fell, dropping to 26.7 percent in 1997. While SFRs, NEFRs, and IEFRs were declining, the corporate sector relied heavily on external financing for its expansion. IDFR reached 73.3 percent in 1997, indicating a high financial risk position. Across industry, in the manufacturing sector, average SFR was 37.5 percent, higher than the aggregate 28.4 percent (Table 2.27). On average, 45.2 percent of incremental asset growth was financed by equity, higher than the aggregate 40.6 percent. Manufacturing financed 54.8 percent of its total asset growth through debts, and the total debt ratio was much higher in 1996 and 1997 at 62.5 and 76.4 percent, respectively. Lower income diminished the industrys equity position toward crisis year 1997. Its IEFR and NEFR dropped to 23.6 percent and 1.6 percent, respectively.
The construction industry showed the most cyclical pattern in annual asset growth. It had the highest average SFR in 1988 at 31.9 percent, which decreased to 8.8 percent in 1990, then increased to 20.2 percent in 1993, and fell to about 10 percent in 1997. Equity financed an average 25.1 percent of total asset growth for the period; from 17.7 percent in 1996, this dropped further to 15.8 percent in crisis year 1997. Total debt financed an average 74.9 percent of asset growth, with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. Since 1992, the proportion of short-term borrowings in total financing has been high, explaining partly the collapses of several construction companies in 1995, one year ahead of the other industries. Financing patterns of the wholesale, retail, and hotels sector and realty/renting/business activities sector were similar. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. On the other hand, the utilities (electricity, gas, and steam) and the transportation, storage, and communication sector had relatively high incremental equity ratios, and low total debt and short-term borrowing ratios. In 1997, the two sectors also had low equity financing ratios and high debt financing ratios. Categorized according to company size, large firms showed more cyclical patterns in these financing ratios than small- and medium-sized firms. Since large firms were more profitable, their average SFR was higher.
Table 2.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent)
Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.0 42.3 28.1 29.6 37.7 47.6 37.8 50.0 30.2 21.7 37.5 NEFRa 9.5 7.2 5.4 3.8 4.9 6.0 3.6 3.2 3.5 1.6 4.9 IDFR 34.4 46.4 63.2 62.6 53.0 42.6 54.3 52.6 62.5 76.4 54.8 IEFR 65.6 53.6 36.7 37.4 47.0 57.4 45.7 47.4 37.5 23.6 45.2
Table 2.27 (Contd)
Year
SFRa
NEFRa
IDFR 53.4 62.8 81.7 78.6 71.1 66.7 78.5 76.8 76.5 87.6 73.4
IEFR 46.6 37.2 18.3 21.4 28.9 33.5 21.5 23.2 23.5 12.4 26.7
Wholesale/Retail Trade, Household Goods, Hotels 1988 33.6 9.7 1989 26.6 8.0 1990 12.8 4.1 1991 14.3 4.0 1992 24.4 2.5 1993 22.3 7.8 1994 15.3 4.2 1995 16.2 4.3 1996 16.9 2.7 1997 8.9 1.9 Average 19.1 4.9
Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average
31.9 20.3 8.8 9.6 14.5 20.2 20.0 10.3 10.2 10.9 15.7
15.7 6.6 9.6 7.9 9.2 8.6 8.0 4.2 5.2 3.7 7.9
52.8 70.7 80.9 80.8 74.1 69.5 70.1 84.0 82.3 84.2 74.9
47.2 29.3 19.1 19.2 25.9 30.5 29.9 16.0 17.7 15.8 25.1
Trasport, Storage, and Communication 1988 64.9 1989 63.0 1990 50.8 1991 51.9 1992 56.9 1993 63.7 1994 53.4 1995 53.5 1996 42.6 1997 29.2 Average 53.0
3.6 4.3 (9.4) 2.8 2.9 1.0 1.9 1.6 2.0 0.5 1.1
25.9 29.8 54.0 40.0 34.8 29.6 37.7 42.3 47.0 68.7 41.0
74.1 70.2 46.0 60.0 65.2 70.5 62.3 57.7 53.0 31.1 59.0
Table 2.27 (Contd)

Year SFRa NEFRa 6.0 (0.4) 3.0 1.5 8.3 7.4 7.6 7.8 17.3 3.4 5.9 IDFR 31.0 56.7 70.5 77.1 54.7 69.0 79.0 67.0 53.9 65.3 62.4 IEFR 69.0 43.3 29.5 22.9 45.3 31.0 21.0 33.0 46.1 34.7 37.6
Real Estate, Renting, and Business 1988 51.1 1989 34.8 1990 19.6 1991 18.2 1992 18.8 1993 11.7 1994 8.6 1995 17.7 1996 18.6 1997 23.8 Average 22.3 Electricity, Gas, and Steam Supply 1988 118.6 1989 118.6 1990 82.1 1991 56.0 1992 51.1 1993 55.4 1994 72.4 1995 62.4 1996 45.0 1997 24.9 Average 75.6
1.0 0.4 0 0 0 0 1.4 1.0 0.4 0.1 0.4
(107.8) (35.8) 7.1 35.1 42.8 36.7 18.9 28.4 47.1 70.7 14.3
207.8 135.3 92.9 64.9 57.2 63.3 81.1 71.6 52.9 29.3 85.6
IDFR = incremental debt financing ratio, IEFR = incremental equity financing ratio, NEFR = new equity financing ratio, SFR = self-financing ratio. a Excludes capital surplus. Source: Calculated using data from Bank of Korea, Financial Statement Analysis Yearbooks.
Their average IEFR was also higher and IDFR smaller. The trend was reversed in 1996-1997, however, when large firms had much lower equity financing ratios and higher debt financing ratios than small- and mediumscale firms. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this. The large firms had a higher proportion of external financing in 1996-1997. Long- and short-term borrowings of these firms shot up in that period.
Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2.28). The average IEFR and IDFR were 10.3 and 89.7 percent, respectively, for listed companies, compared with the entire corporate sectors 35 percent and 65.4 percent. The debt financing ratio of listed companies was high since they relied more on external financing. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies, and were large borrowers. The proportion of their short-term financing averaged 72.5 percent and their total external financing, 91.6 percent. In 1997, the IDFR of listed companies increased to 93.8 percent. Financing Patterns of Chaebols For chaebols, the average SFR was 28.2 percent, about the same as that of the corporate sector as a whole, and higher than that of listed companies (Table 2.29). The average IEFR of the top 30 chaebols of 29.5 percent is lower than that of the corporate sector in general, but higher than that of listed companies. Group-member firms borrowed less, at an average 70.6 percent of total asset growth, compared with 89.7 percent for all listed companies. The chaebols drive to expand their empires resulted in heavy borrowings. They were able to borrow easily from banks by issuing corporate bonds and CP, and using cross-payment guarantees among affiliated companies. All of the top 30 chaebols relied heavily on short-term borrowings. In 1996-1997, the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. The largest borrowers were the top 11-30 chaebols. Their shortterm borrowings accounted for 86.8 percent of their total finance in 1997. External financing reached 94.7 percent. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. Cross-payment guarantees have been declining since 1993 and reached 91.3 percent of their equity capital in 1997 (Table 2.30). In 1997, the top 11-30 chaebols had the highest guarantees commitments at 207.1 percent of their equity capital; the top 6-10 chaebols, 153.9 percent; and the top five chaebols, the lowest ratio of 58.9 percent. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.
Table 2.28 Financing Patterns of Listed Companies, 1994-1998 (percent)

SFRa IDFR 85.4 88.5 91.1 93.8 89.7 12.1 8.9 7.3 5.5 8.5 2.5 2.6 1.6 0.7 1.9 NEFRa IEFR 14.6 11.5 8.9 6.2 10.3
Year
1994 1995 1996 1997 Average
a Excludes capital surplus. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.
Table 2.29 Financing Patterns of the Top 30 Chaebols, 1994-1997 (percent)

SFRa 41.2 36.8 22.4 12.3 28.2 NEFRa 1.2 1.4 1.3 1.1 1.3 IDFR 57.6 61.8 76.3 86.6 70.6 IEFR 42.4 38.2 23.7 13.4 29.5
Year
1994 1995 1996 1997 Average
Excludes capital surplus. Source: Calculated using data of Seung No Choi, Largest Business Groups in Korea, Korea Federation of Industries.
Table 2.30 Cross-Payment Guarantees of the Top 30 Chaebols, 1993-1997 (as percentage of equity capital)
Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469.9 1994 258.1 1995 161.9 1996 105.3 64.7 150.3 200.0 1997 91.3 58.9 153.0 207.1
= not available. Source: Fair Trade Commission and the Federation of Korean Industries.
Factors Influencing Corporate Financing Choices Until recently, Korean firms preferred debt financing (bank and nonbank borrowings). There were several reasons for this. First, more than half of bank loans were priority loans with low interest rates, so that the firms engaged in lobbying to gain access to them. Further, the Korean economy was plagued with high inflation, especially in the 1970s when real interest rates of bank loans were negative. Second, poor financial and corporate governance resulted in overlending by banks, inefficient investment and excessive diversification of corporations, and underdevelopment of the stock market. Third, the Government provided implicit guarantees on bank lending and large businesses. Fourth, chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. Financial institutions did not strictly screen their loan projects and monitor their debtors, and extended loans based on cross-payment guarantees. And fifth, the Government applied high tax rates on net profits of corporations. Interest payments on debts were considered a loss when calculating taxes. According to the ADB survey, company preferences in financing investment projects before the crisis were, in order of ranking, loans from banks, bond issues, rights issues, and reserves and retained earnings. Few firms ranked loans from NBFIs as their first preference. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. These are followed by loans from banks, bond issues, and loans from NBFIs. Firms now prefer internal funds and new equity capital. This change implies that firms now give more attention to financial risks.
In seeking external financing, the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. This preference has changed little after the crisis. According to the survey, in selecting financing sources, firms give their first consideration to minimization of transaction and interest costs. Other factors include, in order of importance, ensuring the liquidity of the company, maintenance of the existing ownership structure, and reduction in tax burden. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. For these firms, the percentage of foreign currency denominated debt in the portfolio was 14.5 percent at the end of 1997. The most important reasons why they chose to borrow foreign currency denominated loans were that terms of foreign loans were more favorable and/or these loans were considered cheaper. Only a few firms sought foreign loans because domestic loans were not available. Among the responding companies that had foreign currency denominated loans, more than half (53 percent) hedged against exchange rate fluctuations. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21.36 percent on average for these companies. Among those that never hedged against exchange rate risks, many firms (or 42 percent) never considered hedging; some (36 percent) thought that a hedging facility was not available or not working properly; and others (29 percent) expected the local currency to appreciate in value. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Korea now provides a better environment for financial risk management. A futures exchange launched in 1999 trades foreign exchange options, and futures and other financial derivatives. 2.4.3 Financial Structure, Diversification, and Corporate Performance
Corporate Performance and Financial Structure Many chaebols were vulnerable to unfavorable cyclical shocks such as the business downturn at the end of 1995 and the terms of trade shock in 1996. Nonetheless, even with a heavy debt burden, they survived for two to three
years before collapsing at the time of the 1997 financial crisis (2.2.3, Table 2.13). The extremely high leverage and the ability of chaebols to survive for several years with huge debts are evidence of poor internal governance of both the corporate and financial institutions, as well as lax financial supervision (Nam et al., 1999). In order to determine the relationship between financing patterns and corporate performance, Nam et al. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. Among the main findings were the following. (i) In terms of total borrowings to total assets, the top five chaebols and the top 6-70 chaebols had similar ratios, but the ratios of independent firms were much lower. (ii) In terms of net income to total assets, the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period, except in 19931995 when semiconductor prices were extraordinarily high. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols, except in 1991. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. They were also higher than those of the top five chaebols until 1992. However, the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. The ratios of the top five chaebols were similar to those of the top 6-70 chaebols until 1991 when the top five chaebols ratios shot up. (iv) In terms of EBITDA to total assets, the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. They were also higher than those of the top five chaebols until 1991. But since 1992, the top five chaebols ratios were much higher. These findings indicate that independent firms have had a lower leverage and performed better financially.
Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas, its profit rate declined. During 1985-1997, the degree of diversification was highest in the top five chaebols, second highest in the top 6-30, and lowest in the top 3172 chaebols. The differences in the degrees of diversification among the three groups are substantial. The diversification of the top five chaebols remained at about the same level within the period; the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. The degree of diversification of chaebols that fell into default, court receivership, and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. The diversification of chaebols under workout was much lower than that of the top 6-30. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings, debt guarantees for free, or outright transfer of resources due to poor corporate governance practices. In terms of the net profit margin (the ratio of net profits to sales revenue), the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992, then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. Meanwhile, net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30, except in the recession years of 1996-1997. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2.31). Their subsidiaries, however, had easier access to credit than the top 31-72 chaebols. The more diversified top five chaebols performed better than the less diversified top 6-30 because they were better established in most business areas and have superior personnel and technology, larger research and development expenditure, and easier access to cheap credit.
2.5
The Corporate Sector in the Financial Crisis
This section looks at the various causes of the crisis in 1997. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. Government intervention, too, had a significant role. Indicators such as increasing debt-to-equity ratios, rising nonperforming loans (NPLs) and falling
Table 2.31 Net Profit Margins of Chaebols, 1985-1997

Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default, Court Receivership, and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.1 0.3 1.0 1.3 0.5 2.1 0.3 1.0 1987 1.4 1.3 1.6 1.8 (0.1) 2.6 1.2 1.6 1989 1.6 1.7 3.2 1.2 (0.1) 2.2 1.3 1.8 1990 0.9 0.7 1.6 0.6 0.6 1.1 0.7 1.0 1992 1994 1.1 1.3 1.1 1.2 1.1 0.8 (0.2) 1.1 2.3 1.2 4.8 3.3 0.9 1.2 (0.1) 1.2 1995 3.4 2.6 7.0 4.5 1.1 1.9 (0.3) 0.4 1996 0.8 0.3 0.2 1.0 1.1 1.3 (0.7) (0.8) 1997 0.1 (0.0) 0.4 (0.8) 0.3 0.7 (4.2) (4.6)
0.1 0.2 (1.2) 1.3 1.5 (0.4) (1.4) (6.7) 0.4 1.9 0.6 1.3 (0.1) 0.9 1.5 1.1 0.5 (4.0) 0.9 8.4 (1.9) (1.6) 0.9 0.3 3.5 4.6 0.6 0.7 0.6 (10.9) 2.2 (0.1) (1.7) (1.8) 0.2 1.6 3.0 6.4 1.1 1.4 (1.6) 0.6
0.7 1.5 (0.3) (1.8) 0.8 1.7 1.3 1.0 (0.3) 1.1 1.7 (0.5) (1.4) (1.1) (1.9) 2.1 (9.3) 0.6 5.6 0.5 1.0
0.4 (0.6) (0.8) 1.9 0.4 (0.4) (1.4) (4.8) (3.4) (0.2) (0.2) 1.4 0.0 (7.5) (7.8) 2.5 1.1 0.8 0.8 1.8 0.1 1.1 4.7 2.6 0.7 0.6 0.8 0.7 (1.0) 0.3 (0.8) (1.1) (2.0) (0.3) 0.3 0.1 (3.3) 12.6 (0.9) 0.7 0.4 0.9 1.3 1.4 0.5 0.5 1.1 (4.1) (6.6) (12.3) (0.6) (0.0) (0.3) 0.8 3.4 (2.9) 2.2 0.4 1.1 0.8 0.9 1.3 1.4
(1.0) (3.2) (13.7) (0.5) (0.9) (8.1) (5.5) (2.6) (12.8) (0.8) (1.5) (2.8) (4.9) (9.8) (37.3) 0.7 0.7 (0.1) 1.1 (4.5) 0.3 (0.2) (13.3) 0.1 (1.8) (20.8) 0.2 (17.6) (20.6) 0.1 0.3 (3.1) 0.2 (0.2) (4.2) 2.5 (0.2) (3.2) 0.5 (0.2) (0.7) 0.7 0.7 (0.4) (2.3) (0.3) (12.2) (4.0) (4.8) (11.2) 2.0 0.8 (0.3) 1.3 1.0 (2.8) 0.4 0.5 (6.3) 0.7 0.6 (0.1)
= not available. Source: Whan Whang, 1998, Background and Task of Structural Adjustment, Beyond the Limit, Management Research Institute, Chung Ang University, p.11.
corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. A remote trigger in the Thai crisis was all that took to push the economy over the edge. 2.5.1 Weaknesses in Corporate Governance
Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. Along with government policies to protect the status quo, this has led to entrenched management. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. They were then almost automatically elected at the general shareholders meeting. Internal and External Control Concentration of ownership has been and will be the major obstacle to the independence of the board of directors from management, and to the development of the market for corporate control. Until 1997, the boards of all listed companies were composed of insiders only. But in 1998, after the crisis, the Korea Stock Exchange introduced listing rules requiring that listed firms elect independent outside directors to comprise not less than a quarter of the board members. Moreover, the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. Ownership concentration also had ramifications on corporate transparency. Until 1997, a firms board of directors had the power to appoint an external auditor. Thus, the independence and objectivity of the external auditor were often questioned. Now, a committee composed of internal auditors, outside directors, and creditors should select (recommend) the external auditor. Meanwhile, the controlling shareholder or CEO generally selects the internal auditor despite a legal provision limiting the votes of the largest shareholder to a maximum of 3 percent. Thus, internal auditors cannot be expected to perform their function independently of management. The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system.
There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. These included restrictions of shareholdings of institutional investors, restrictions of voting rights of shares of institutional investors, a large issuance of preferred stocks with no voting rights, regulatory and practical difficulty in implementing proxy voting, and restrictions on hostile takeovers. Traditionally, the Government maintained a policy of protecting the incumbent management of a listed company. The purpose was to increase the size of the stock market by having financially sound private firms go public with an assurance that they would not be taken over. Representative of the policy was the stipulation under the Securities and Exchange Act that no one other than founders could accumulate more than 10 percent of the voting shares of a listed company unless he or she obtained prior approval of the Securities and Exchange Commission. Meanwhile, corporate accounting information was not reliable due to the lack of independence of external auditors, prevalent window dressing practices, and some differences in Koreas generally accepted accounting principles from international standards. In this situation, individuals, as well as institutions, participated in the stock market as short-term traders rather than long-term investors. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. Many changes were introduced to promote M&A in the 1990s. However, hostile takeovers in Korea will likely be rare in the future. One reason is that the percentage of inside shareholdings for an average listed firm is very high. Many of the takeover targets in the past did not have a controlling shareholder. Another reason is that firms affiliated with a chaebol are generally regarded as difficult targets as the other members of the group will come to the rescue or act as a white knight. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder, usually a member of the founding family. There were no effective monitoring mechanisms for its management. Under the direction of the controlling shareholder, profitable firms within a chaebol tended to subsidize unprofitable firms. These internal dealings made strong firms weak and helped marginal firms survive. Diversification can reduce chaebols risks through the portfolio effect; however, when a large diversified chaebol, as a whole, has an unsound capital structure and
strong financial links among its member firms through investments and cross-guarantees, the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. Such problems may eventually cause ripples through the entire economy. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. As mentioned earlier, the typical chaebol firm had an extremely high DER, while (non-chaebol) independent firms had much lower borrowing ratios. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms, as the latter are well established in most business areas. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins, although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. 2.5.2 The Role of Government Intervention
Strong government intervention in the early stages of economic development was useful for overcoming inefficiencies in financial and capital markets and for managing high investment risks. However, the intervention later resulted in the accumulation of adverse side effects: underdeveloped product, capital, and other individual markets; prevalence of rent-seeking and morally hazardous behavior by economic decision makers; and a high degree of inefficiency in the economy. The Governments supervision and regulation of financial institutions were poor. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. Further, the authorities did not properly check on banks lending practicesbanks did not screen the lending projects and evaluate the creditworthiness of corporations properly. 2.5.3 Manifestations of Weak Corporate Governance and Government Intervention
Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis, financing choices of listed firms in order of preference were bank loans, bond issues, share issues, and internal funds. Financing preferences changed drastically after the crisis. The new preference ordering is as
follows: internal funds, share issues, bank loans, and bond issues. This change implies that firms are now more attentive to financial risk and inefficient investment financed by external funds is less likely to recur in the future. The foremost reason why listed companies preferred debt financing over issues of new shares lies in the largest shareholders desire to keep control of the management by preventing dilution of their ownership. Other factors also contributed to this preference. Bank loans, which were the most important financing source until 1987, consisted of high proportions of policy loans. Nonpolicy loans were also considered to be cheap because of interest rate regulations. The poor state of corporate governance in the banking and financial sectors was responsible for overlending by banks and NBFIs through perfunctory screening of loan applications. Implicit guarantees by the Government on bank loans to large businesses, as evidenced by occasional, large-scale bailouts of financially distressed firms, obviously contributed to overlending and aggravated the situation. The lending practices of banks, which generally required guarantees or collateral, were advantageous to chaebols because they were in an ideal position to meet the loan requirement through cross-guarantees among their member firms. As of the end of 1997, the top 30 chaebols showed a DER of 519 percent, which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand, the size of the stock market was not adequate to digest all the potential supply of new shares to finance the rapid growth of corporations. The preference for debt finance also led to a relatively large foreign debt. At the end of 1996, total foreign debt amounted to $157.5 billion, 63 percent of which was short-term. The ratio of external debts to GDP reached 48 percent at the end of 1998. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. After the financial crisis erupted in Indonesia and Thailand, overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. In the international financial market, won/dollar nondeliverable forward rates increased rapidly, signaling a bearish speculative move on the won. However, the Government and the Bank of Korea defended the currency, reducing foreign exchange reserves to a dangerous level. In November 1997, the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea.
Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms, regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding, has given rise to various types of self-dealings by the controlling shareholder, and the pursuit of growth through excessive diversification and inefficient investment. Moreover, legal and other barriers prevented the exit of financially nonviable firms. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and too big to fail legacies to large businesses. The banks and merchant banks lent to large businesses, especially chaebols, without strictly evaluating the creditworthiness of businesses and the profitability of projects. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. The inevitable result of inefficient investment was a fall in corporate profits. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11,000 per year starting 1992. It jumped to 17,200 in 1997, then 20,000 during January-September of 1998. The monthly number reached more than 3,000 from December 1997 to February 1998, decelerated from March 1998, and returned to about 1,000 in September 1998 (Table 2.32). Meanwhile, the ratios of net profits to sales, total assets, and shareholders equity of all industries, excluding the financial sector, were low in 1996 and 1997. In 1997 they became negative. Before the crisis, a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. Further, nine out of the 30 top chaebols failed. The Government could hardly help them because of the number and magnitude of business failures. Financial Sector Vulnerability Because of financial losses in the corporate sector, the NPL ratio8 of banks and other financial institutions began to increase. The bank supervisory
8
NPLs of banks comprise fixed (substandard) and doubtful loans, and estimated losses. Fixed loans are those for which interest is not received for six months or longer, and there is collateral. Doubtful loans are those for which interest is not received for six months or longer, and there is no collateral. These were the definitions until 30 June 1998. However, starting 1 July 1998, they are defined as loans for which interest payments are overdue by three months or more. According to the six months definition, the NPL ratio of commercial banks increased rapidly from 4.1 percent in 1996, reaching highs of 6 percent in 1997 and 8.6 percent in June 1998. Following the three months definition, the NPL ratio reached 7.7 percent in 1997.
Table 2.32 Number of Firms with Dishonored Checks, 1986-1998

Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4,890 4,754 3,573 3,238 4,107 6,159 10,769 9,502 11,255 13,992 11,589 171,69 20,027 Manufacturing 1,114 811 706 696 866 1,657 3,259 2,850 3,133 3,553 3,855 6,856 7,673 Construction 380 354 242 195 294 585 1,131 1,135 1,210 1,751 1,544 2,472 2,985 Services 3,244 3,457 2,517 2,250 2,859 3,759 6,053 5,265 6,647 8,386 5,637 6,979 8,417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952
Note: 1998 figures cover only January-September. Source: Bank of Korea.
authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action. In 1990-1993, the ratio reached 7-8 percent, and declined to 4-6 percent in 1994-1996 (Table 2.33). The difference between the Korean and Western definitions of NPLs left foreign investors with suspicions that the size of NPLs in Korea might be much larger than the government-announced magnitude. This speculation was said to be one of the causes of the financial crisis in Korea. Meanwhile, ROEs and ROAs of Korean and Japanese banks were low compared with those of the US, European countries, and Taipei,China. Compared to ROAs and ROEs of domestic branches of foreign banks, those of domestic banks were lower in the 1990s. This was mainly due to the high ratios of NPLs, low efficiency, and large government-directed loans. 2.5.4 Shortcomings in Macroeconomic Policy
The macroeconomic framework also contributed to the crisis in 1997. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries. As a result they had largely overvalued currencies, and continuous and large current account deficits. The current account deficits in terms
Table 2.33 Nonperforming Loans of General Banks, 1990-1998 (W billion)

Year 1990 1991 1992 1993 1994 1995 1996 1997 1998
a
Total Loans 90,556 118,475 143,705 160,520 194,739 241,827 289,649 375,832 337,584
Fixed (A)a 5,310 6,176 7,736 8,997 9,537 10,190 9,430 12,562 18,192
Doubtful (B)b 952 1,170 1,584 2,116 1,639 1,910 1,954 9,600 10,237
Estimated Loss (C) 958 920 840 816 213 385 490 490 648
NPL (A+B+C) 7,221 8,266 10,160 11,929 11,390 12,484 11,874 22,652 29,077
NPL Ratio (%) 8.0 7.0 7.1 7.4 5.8 5.2 4.1 6.0 8.6
Fixed loans are those requiring collateral and for which interest is not received for six months or longer. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. Source: Bank of Korea.
of percentage of GDP were as follows: Malaysia -8.6 percent (1995); Thailand -8.1 percent (1995); Korea -4.8 percent (1996); and Indonesia -3.6 percent (1995). It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997, and 30 percent in 1996, judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. In addition to the overvaluation of the won, the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997, which led to large corporate losses. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable. Related to this, the ratio of short-term debt to foreign reserves was very high. Meanwhile large businesses could not legally lay off workers, even in times of economic slowdown, because of the rigid labor market. Businesses served as a social safety net. Mass layoffs became legally possible only after the economic crisis. The main result of the rigid labor market was a high-cost and lowefficiency economy. In 1997, the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei,China, although per capita income in Korea was much lower. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei,China. Land prices and real estate rents were also high compared to trading partners.
2.6 2.6.1
Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities
Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness. However, the immediate objective centered on restoring the international investment communitys confidence in the Korean economy. To achieve this, the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. Nonviable firms and financial institutions, including banks, had been forced into bankruptcy proceedings or merged into healthier entities. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. The FSClater called the Financial Supervisory Service (FSS) which is in charge of prudential regulation of financial institutions, has been actively utilizing its influence to motivate institutions to coordinate debtor firms restructuring activities. Corporations, which were laden with huge amounts of debt and were on the verge of bankruptcy, embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. Voluntary Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. They have been pressured to stop such practices as providing loan guarantees, and subsidizing money-losing units. They have also been urged to divest themselves of strategically ill-fitting businesses and sell equity holdings of attractive business units to foreign firms to reduce debts. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. Downsizing by curtailing employment has been prevalent, although efforts to lay off thousands of blue-collar employees at Hyundai Motors encountered fierce opposition from labor and ended up in mediation after intervention by politicians from the ruling coalition.
Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. The reasons are manifold. Locally, sellers could not find buyers as almost all domestic firms struggled to raise cash for debt reduction and for working capital needs while there was a severe credit crunch following the outbreak of the crisis. Internationally, potential foreign buyers waited for the price of acquisition targets to come down further. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. In many cases, banks and other creditors were reluctant to absorb losses realized by debt compositions, or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. The process of voluntary debt recontracting by creditors was prolonged because Korean lending organizations lacked experience and expertise when it involved a multitude of creditors. More important, they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. Data collected by the Korean Chamber of Commerce and Industry show that the number of potential domestic and foreign buyers in the M&A market increased by about 50 percent over the six-month period from April to October 1998. This number was at 779 firms in April and grew to 1,138 by the end of October. More than 59 percent of potential buyers were foreign firms. On the other hand, the number of potential sellers decreased somewhat from 2,281 in April to 2,045 in October. The data also show that about 24 percent of acquisition negotiations ended up in actual deals, while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. Banks did not have the incentive to force financially nonviable firms to liquidate, because liquidation of debtor firms would exacerbate the banks already weak balance sheets. Noticing this disincentive, FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. A debtor whose liquidation value was estimated to be greater than its going concern value was subject to exitmeaning the creditors would altogether stop lending and not allow renewal of the existing debt. In their first review, the creditor
banks selected 55 firms as targets for exit. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms, the results thus far have not entirely been as desired. Among the 55 firms selected, 24 were liquidated, 11 were merged into other group members, three filed for courtsupervised bankruptcy reorganization, and 12 were sold off to other firms. Among the sell-offs, two were acquired by newly organized employee stock ownership plans. A second round of review to select more firms for exit was conducted by the Major Creditors Council organized for each of the top five chaebols. These chaebols submitted plans for restructuring to improve their respective capital structures. Based on these plans, the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. Negotiations were then held between the chaebols and the creditors councils to finalize the financial structure improvement plans. The plans were put into action immediately following finalization. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. Corporate Workouts Workouts in the forms of debt rescheduling, interest reductions, write-offs, and/or conversion of debt into equity have been applied to those firms that are considered to be viable in the long run and have voluntarily entered into negotiations with creditor banks. The workout plans were completed for most firms by early 1999. FSC has been monitoring the processes from a prudential regulation standpoint. A portion of the Technical Assistance Loan of $33 million, provided by the World Bank, was allocated to the six largest banks for them to employ outside experts as advisors, not only for the design of corporate workout programs but also their implementation. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. Also, workouts are being applied to non-chaebol firms identified as financially weak, but viable, by their creditors. By the end of 1998, creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols, and 16 non-chaebol corporations that had been selected as possible workout candidates. Upon completion of the evaluation,
creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. Big Deals Ever since the outbreak of the economic crisis, the Government has been urging the largest chaebols to strike big deals or business swaps among themselves to consolidate overlapping manufacturing facilities. These deals could eliminate excess capacity in such industries as semiconductors, automobiles, railroad cars, power plant facilities, vessel engines, aircraft, oil refineries, and petrochemicals. Big deals would, it is hoped, enable chaebols to streamline their overly diversified operations and focus on several core business areas. Big deals have been elevated to the status of the most important means of effective corporate restructuring. On 3 September 1998, chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. As of April 1999, most of the big deals have entered their final stages of negotiation. In the case of automobiles, Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. In the early days after the outbreak of the crisis, inducement of foreign direct investments was considered to be the most effective means of achieving that end. Thus, Korea adopted and implemented policies to open its capital market completely. Restrictions on foreign ownership of land were also abolished. Foreign investmentin the form of acquisition of controlling interests, purchase of divested assets, and equity participationreached about $8.5 billion on agreement basis during the 10-month period after December 1997. This figure contrasts sharply with the total of $700 million for all of 1997. However, some of the acquisition agreements have been discarded for various reasons. In one case, the foreign buyer demanded specific protections against adverse developments in the business environment. In another, labor union demands of the seller were not acceptable to the transacting parties. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. First, uncertainty over the future
course of the Korean economy remains high. Second, many of the potential buyers believed that prices asked by sellers were still too high and there would be opportunities to buy assets on fire sales in the future. With this in mind, some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers point of view. Third, foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. Fourth, local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. Fifth, foreign buyers were concerned with the inflexibility of the labor market. Sixth, many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. Seventh, the widespread practice of cross-guarantees of loans and the lack of corporate transparency could potentially give rise to contingent liabilities to the buyer and this has posed a bottleneck problem to the speedy consummation of deals. 2.6.2 Policy Measures for Corporate Reform
Goals and Policy Measures for Reform in the Corporate Sector Based on their assessments of what caused the economic crisis in Korea and what needs to be done to overcome it, the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. As set forth in the agreement, these goals were: (i) to enhance managerial transparency; (ii) to remove cross-guarantees of loans among group members; (iii) to reduce financial leverage; (iv) to focus on a small number of core businesses; and (v) to improve the accountability of controlling shareholders and the board. Overhaul of Bankruptcy Procedures In February 1998, legal procedures pertaining to corporate rehabilitation and bankruptcy filings were simplified to expedite rulings on the exit of nonviable firms and to ensure better representation of creditor banks in the resolution process for court receivership or court-supervised composition. In effect, the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. Not only does this represent progress in terms of an improved institutional framework for market competition, but it also has important implications with respect to corporate workouts. The presence of
an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. Also, the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. The changes in the reorganization procedures can be summarized as follows. First, if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership, the court may annul its previous decision and force the firm into immediate liquidation. The purpose of this rule is to shorten the reorganization planning period. In the past this stage usually extended for as long as two to three years. Also, the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. Second, the new rules made it clear that a court receivership order is available only when the going concern value of the firm under consideration is greater than its liquidation value. Third, a Management Committee, comprised of experts in the legal, accounting, and economics professions should be organized to provide for expeditious proceedings in court. Fourth, the right to revoke court receivership is allowed to the creditors. The creditors can form a Creditors Committee among themselves to allow them to participate in the decision processes in court. Fifth, the Composition Act was amended to narrow the eligibility of applying for court-supervised composition, thereby preventing abuses by controlling shareholders/managers of financially distressed firms. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets, number of creditors, etc. Improving Transparency and Corporate Governance9 Transparency and accountability in corporate governance will be promoted by the following measures: (i) consolidated financial statements are required beginning 1999; (ii) legal changes have been made so that domestic accounting practices conform to international standards; (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0.01 percent in May 1998; (iv) restrictions on institutional investors voting rights were eliminated in June 1998; (v) all listed companies are required to appoint outside directors beginning 1998
This and the following two subsections draw on the Ministry of Finance and Economy, Koreas Economic Progress Report, October 1998.
(as of the end of May 1998, 514 listed companies had appointed 677 outside directors); (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms; (vii) by the end of March 1998, crossdebt guarantees totaling about W10 trillionabout 30 percent of the total guarantees among the 30 largest chaebolswere dissolved; and (viii) as of 1 April 1998, financial institutions could no longer require cross-debt guarantees. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. These new standards are and will continue to be strictly enforced. A recent case in point is the penalty imposed by the Fair Trade Commission on chaebol subsidiaries found to be involved in unfair transactions among group members, including financial subsidization. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. Capital Market Liberalization Since 1998, Korea has rapidly liberalized the capital market by adopting the following measures: (i) the ceiling on foreign equity ownership was completely eliminated in May 1998. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions; (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages, beginning on 1 April 1999; (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998; (iv) during April and May 1998, 21 industries were further liberalized or newly opened to FDI (now, only 31 out of 1,148 industries remain closed, either partially or fully, to FDI); (v) by the end of May 1999, an additional nine industries will be opened or further liberalized; and (vi) all current laws related to FDI have been streamlined and incorporated into a single legal framework represented by the Foreign Investment Promotion Act, which was passed in August 1998. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. According to the law, administrative procedures for FDI will be dramatically simplified and made transparent. As for promotion, the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. In addition, various supporting measures, including tax exemptions and reductions, have been instituted for FDI:
(i)
(ii)
(iii)
Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries, such as the high-tech industry, for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. The law allows rental cost exemptions and reductions for FDI. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. The location of the FIZ will be determined at the request of foreign investors. Various support measures, including infrastructure and tax support, will be provided to foreign firms in the FIZ.
Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market. These liberalization measures, however, are not risk-free. To minimize potential risks, the Korean Government is strengthening prudent regulations and market monitoring, as well as building an early warning system. Also, the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Koreas bond market. It aims to establish a benchmark by consolidating various government bonds. Three-year government bonds will be used to establish a benchmark. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. These bonds will be issued
monthly. If interest rates stabilize at a low level, and the demand for longerterm bonds increases in the future, the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. In order to promote a greater market demand for government bonds, a primary dealers system will be introduced for healthy financial institutions. Prior to the introduction of this system, commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. The Government established specific qualification criteria and selected the primary dealers in 1999. It also opened the credit rating service market to foreign competition, and is promoting joint ventures between foreign and domestic agencies. In August 1998, Moodys signed a joint venture contract with Korea Investors Service. Investment Companies Korea has developed an institutional framework for closed-end investment companies so that they function as a key instrument for long-term financing. Related legislation was put into effect in September 1998. It is now easy for private investors, both domestic and foreign, to establish closed-end investment companies. No qualification requirements are being imposed on investors who are sponsoring new mutual funds, with only minor standard exceptions. Mutual funds (or open-end investment companies) will be allowed starting 2001. As a pilot program, a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. Twenty-five domestic financial institutions, including the Korea Development Bank, invested a total of W1.6 trillion in these funds: W0.6 trillion for the debt restructuring fund, and W1 trillion divided equally between the three balanced funds. These are expected to operate for the next three years, but may be extended as required. To ensure transparency and efficiency of the fund operations, they will be managed by foreign investment management companies. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. This law will not only provide an effective institutional environment for the disposal of NPLs, but it will also help improve financial institutions risk management. According to the law, financial institutions
and qualified public corporations, such as the Korea Asset Management Corporation (KAMCO), can utilize ABS. More important, foreign business corporations with good credit standing are now also permitted to issue ABS. 2.6.3 Policy Recommendations
Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. However, this can only be a temporary measure. As markets become more efficient, the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. Selfdealings, cross-subsidization, and other unfair internal transactions among affiliated companies should be stopped primarily by improving rules on corporate governance rather than by boosting the Governments policing role. A good governance system is essential for the healthy growth of corporations and financial institutions. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. There must be stronger rules to control agency problems. For instance, the role of the board of directors as the internal control mechanism must loom large in corporate governance. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. The Government has restored a previously abolished regulation that imposes a ceiling on the total amount that a chaebol company can invest in other firms. However, unless the limit is tight and binding, this regulation may not be effective in curtailing pyramidal structures. On the other hand, when the limit is binding, which is the case for many chaebols, then the regulation will inhibit efficient investment of firms. In principle, greater efforts to improve corporate governance are preferable to regulation of interfirm investment. However, there is another view that placing a maximum limit on interfirm investments, as stipulated by the government measure, is inevitable, considering that there is no other effective way to limit circular investments among chaebol affiliates (e.g., A investing in B, B investing in C, and C investing in D, etc.) and the level of interfirm investments is very high. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional
investors or their trade associations. Companies could also invite nominations from such organizations as the Korea Listed Companies Association or citizens coalitions that have been active in monitoring corporate management through proxy solicitations. The annual shareholders meetings could also elect reputable monitoring companies to recommend director candidates (Latham, 1997).10 Other means to improve independence of the boards include mandating that independent outside directors form the majority; using audit, governance, and other committees; and requiring that all directors hold shares of their companies. The Government has already announced that it intends to amend the Commercial Code to introduce Anglo-American type audit committees as an alternative to the current internal auditor system. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. Listing rules may recommend that all or large listed companies adopt an audit committee. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. Further, the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders, thereby helping to strengthen board independence and enlisting boards more active involvement in monitoring corporate management. Since the economic crisis, various measures have been implemented to promote investors rights. One action that has yet to be taken is the introduction of an act to facilitate class action suits against corporate directors and internal and external auditors for their wrongdoings. If and when the law is introduced, it will have to include making self-dealings by directors and officers, and also negligence of external (independent) auditors actionable. Class action suits are an efficient means for corporate monitoring. Institutional investors will play an increasingly important role in corporate governance. There has recently been a general shift in individual investor preference from direct personal stock trading to investing in traditional investment trust companies and the newly introduced (closed-end) investment funds. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. One way of motivating institutions to do this is to
10
M. Latham, 1997. Proposed: A Governance Monitor, The Corporate Board, September/ October 1997, pp. 23-26.
provide comprehensive guidelines for their actions in matters related to corporate governance. The institutions respective trade associations, such as the Korea Investment Trust Association, could prepare such guidelines. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting, reviewing independence and expertise of candidates for outside directors, objecting to certain defensive measures proposed by the management, strengthening incentive compensation schemes for executives, etc. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. Many of the larger investment trust companies, insurance companies, securities companies, and other NBFIs are subsidiaries of chaebols especially the five largest ones. Also, important pension funds including public employee funds and teacher funds seem to have their own governance problems because their top management and portfolio management policies are controlled by the Government, and thus cannot be expected to be actively involved in monitoring portfolio firms. In the coming years, the Government will have to come up with appropriate policy measures to solve these problems. Measures that are being implemented or introduced will require that the management of institutional investors be closely monitored by a board consisting of a majority of independent outside directors, an audit committee, and compliance officers. Rights of minority shareholders should also be strengthened for these institutions. Another measure, more drastic in nature, is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and, possibly, by all nonfinancial companies (or industrial capital). An efficient means to control problems arising from ownership of financial institutions by industrial capital is to strengthen the accountability and fiduciary duty of the very management of these institutions. The Government can also lower the limits on investments in affiliated companies, strengthen its supervisory activities, and impose stronger penalties on violations of the rules on portfolio investments. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. The Government recently proposed the revision of bankruptcy-related laws. One issue that is being debated is the necessity of the court ordering a firm into bankruptcy once it is found to be nonviable during deliberation on composition or receivership. Another concerns whether the court-appointed receiver should be given the power to convene board and shareholder meetings and also to replace directors and officers with court approval.
There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. In turn, the banks have great leverage over the management of debtor firms. This means that the Government can control the banks and, through them, private firms. In order to minimize government intervention in bank and corporate management, bank managers should be made accountable to shareholders but not to the Government. For this, the limit on ownership of bank shares will have to be eased so that strategic investors (shareholders) can act as true effective monitors of bank management. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. Banks should adopt strong incentive compensation schemes for management. Bank boards also need to be made more independent from management. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. The Government should substantially reduce the proportion of policy loans from bank loans. Many concepts regarding good corporate governance are still new to a lot of market players in Korea, and thus full-scale education programs should be developed. The public and corporations should be taught or fully informed of the best practices in corporate governance. Chaebols are overly indebted, excessively diversified into nonrelated business areas, and consistently show low profit rates. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date, to concentrate instead on a small number of core businesses, and stop unfair internal transactions. Such measures include providing an effective corporate governance system; reduction of protection of domestic markets and entry barriers; the elimination of implicit guarantees for financial support to chaebols, large firms, and financial institutions; lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends), and introducing disincentive schemes for excessive borrowings, such as application of higher interest rates by banks to chaebols with higher DERs. Many corporations are burdened with excessive debt and, therefore are vulnerable to economic shocks. The Government should put more efforts into developing the capital market, which could provide alternative sources of long-term corporate finance. To facilitate the development of the Korean stock market, the important issues to be addressed are: (i) improvement of the corporate disclosure system; (ii) provision of reliable accounting information; and (iii) a good corporate governance system to protect investors. The current obligatory system of disclosure that emphasizes hard
information on past performance needs to be transformed into a system in which corporations voluntarily announce soft information on future prospects. Currently, penalties on violations of disclosure rules are not effective enough to have a significant impact. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. One of the significant changes in the bond market after the economic crisis is that most corporate bonds are now issued nonguaranteed and on the basis of credit quality of the issuer. Policies are needed to help develop more reliable services by bond rating agencies. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. These should be lengthened to make them a source of stable long-term funds. The development of the OTC bond market requires a well-developed dealer system. The function of securities companies as dealers of bonds should be improved. At the same time, the information system of the bond market should be better organized to transmit, on a real time basis, data on quotations and trading volumes. The network should cover not only the exchange market but also OTC transactions of investors and dealers. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts. In determining optimal exchange rates, profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates, wage rates, and labor productivity should be considered. Prevalent corruption, especially among business people, politicians, and bureaucrats, is considered to be one of the major causes of the economic crisis. Without successfully addressing this problem, no economic reforms will be effective. The establishment of a Corruption Prevention Institute will be helpful in this regard. Future research could include causes of corruption, reasons for different degrees of corruption in various countries, and measures to reduce corruption.
References
Bank of Korea. Economic Statistics Yearbook, various issues. Bank of Korea. Financial Statement Analysis Yearbook, various issues. Bank of Korea. 1993. Koreas Financial System. Bank of Korea. 1994. Understanding Flow of Fund Accounts. Cho, D. S. 1997. Koreas Chaebol. Maeil Daily Economic Newspapers, September 1997. Choi, S. N. 1998. Koreas Large Conglomerates, 1995, 1996, 1997, and 1998 issues. Center for Free Enterprise, September 1998. Chon, I. W. 1996. Determinants of Diversification of Korean Business Groups. Korea Economic Research Institute, KERI. Chon, I. W. 1996. Market Concentration and Diversification of Business Groups. Korea Economic Research Institute, KERI. Chung, K. H., and H. C. Lee (eds.). 1989. Korean Managerial Dynamics, pp. 7995. New York: Praeger. Hattori, Tomio. 1989. Japanese Zaibatsu and Korean Chaebols, in Korean Managerial Dynamics, edited by K. H. Chung and H. C. Lee, pp. 79-95. New York: Praeger. International Monetary Fund, International Financial Statistics, various issues. Jua, S. H. 1999. Evolutionary Chaebol. Bibong Publishing Co. Kang, H. S., S. K. Kwon, W. H. Lee, and J. Y. Cho. 1998. Corporate Restructuring. Hong Moon Sa, September 1998. Kim, Ju Hyun. 1992. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. Financial Studies. Kim, W. T., C. D. Hong, and K. S. Kim. 1995. An Empirical Evidence on Value of a Firm and Ownership Structure. Financial Studies. Korea Development Bank. Survey of Facility Investment Plan, various issues. Latham, M. 1997. Proposed: A Governance Monitor. The Corporate Board, September/October 1997, pp. 23-26. Lee, Jae Woo. 1997. Is the Fair Trade Policy Fair? Korea Economic Research Institute, KERI.
Lee, K. U., and J. H. Lee. 1996. Business Groups in Korea: Characteristics and Government Policy. KIET Occasional Paper No. 23, Korea Institute for Industrial Economics and Trade, November 1996. Lee, Y. S. 1996. A New Trade and Industrial Policy in the Globalization of Korea. Korea Institute for International Economics and Trade. Lim, Ungki. 1998. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Annual Conference of Financial Management Association, Chicago, October 1998. Lim, Ungki. 1999. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols, 2nd Sangnam Forum, Yonsei University, Seoul, March 1999. Ministry of Finance and Economy. 1998. Koreas Economic Progress Report, October 1998. Nam, I. C., J. K. Kim, Y. J. Kang, S. W. Joh, and J. I. Kim. 1999. Corporate Governance in Korea. Conference on Corporate Governance in Asia: A Comparative Perspective. Korea Development Institute and World Bank. Sohn, C. H., J. S. Yang, and H. S. Yim. 1998. Koreas Trade and Industrial Policies: 1948-1998. KIEP Working Paper 98-05, Korea Institute for International Economic Policy, September 1998. Wang, Y. K. 1995. Capital Liberalization, Real Exchange Rate and Policy Measures. Korea Finance Institute, January 1995. Whang, Whan. 1998. Background and Task of Structural Adjustment, Beyond the Limit. Management Research Institute, Chung Ang University.
3 The Philippines
Cesar G. Saldaa1
3.1
Introduction
In recent years, the Philippine corporate sector has played a leading role in the governments efforts to get the country on track toward sustainable economic development. This has come about following a political and economic upheaval from 1983 to 1987, about a decade before the recent Asian crisis. Issues such as State ownership of businesses, state-sanctioned monopolies, and government subsidies were tackled during that period, aiming at eventually limiting the Governments role to economic policy setting and allowing the private sector to conduct most economic activity. The Government pursued the privatization of various state-owned corporations as part of its financial rehabilitation programs sponsored by the World Bank and the International Monetary Fund (IMF). The lifting of the debt moratorium in 1991, after the completion of debt negotiations with the IMF and Paris Club, allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. Companies of other Asian countries were already using these markets to finance investment and growth. When the Asian crisis erupted in 1997, the Philippine economy and corporate sector were in a relatively sound financial position. From 1993 to 1996, healthy profits from the previous five years and new equity raised through successful initial public offerings (IPOs) in a robust stock market allowed the corporate sector to accelerate investments and borrowings. The Asian financial crisis revealed that, overall, the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments.
1
Principal, PSR Consulting, Inc., the Philippines. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the PSR Consulting, Inc. staff, in particular Francisco C. Roble, Denise B. Pineda, and Liza V. Serrana, for their research assistance, the Philippine Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
Still, the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. Corporate financing relies excessively on bank loans. Companies finance long-term investments with short-term debt, usually with the acquiescence of bank creditors. Banks have significant presence as members of affiliated business groups, which leads to their easing of due diligence and monitoring standards when lending to group members. This study reviews the Philippine corporate sector in terms of its historical development, regulatory framework, patterns of ownership, control by internal and external governance agents, patterns of financing, and responses to the financial crisis. It analyzes the impact of corporate governance on company financial performance and financing, on family-based and controlled conglomerates, and on the financial crisis.
3.2 3.2.1
During the 1950s and 1960s, nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. To implement these policies, the Government overvalued the local currency and imposed high import tariffs. Companies were profitable because of protection from foreign competition. But protectionist policies made labor relatively more expensive and, therefore, companies were necessarily large and capital-intensive. While new manufacturing industries were successfully established, their growth could not be sustained. An industrial elite, composed mostly of families previously in trading businesses, emerged to influence industrial policies. These early industrialists naturally opposed any initiative to reduce tariffs, yet they did not risk new capital required for modernizing and expanding manufacturing capacity. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. Government interventions under the notion of master planning for economic and social development characterized the 1970s and early 1980s. The policy was crafted by the martial law regime at that time. The Board of Investments (BOI) was created to draw up an investment priorities
Chapter 3: Philippines 157
plan (IPP) to encourage private sector investments by offering tax and other incentives. The Government signaled through the IPP its intent to shape the future industrial landscape, organizing industries into sectors and picking winners. No strategic industry could take off without the Governments participation in its management and operations. Foreign ownership was allowed only in industries with high technological and market barriers, i.e., the pioneer industries identified in the IPP. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. Exports were not competitive because of the high costs of imported materials. Following government initiatives in the control of the infrastructure and utilities sectors, the State took over the generation and distribution of electricity, assumed ownership of the largest petroleum refining company, and initiated the development of alternative energy sources in response to the oil crises. The 1980s were marked by a peaceful transition of political power. Reforms in policies, including the reduction of tariffs, quantitative restrictions, and import licensing requirements, clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. Starting in 1981, the Government continuously revised the enabling law of BOI so that incentives were reduced in number, made less associated with capital investments, and oriented toward exports. Nevertheless, BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. In the early 1990s, the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. In 1991, the legislative body passed the Foreign Investment Act (FIA). The FIA allowed foreign equity investment in many areas and at the same time provided a transparent, advance notice of areas where the country disallowed or restricted foreign investment. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sectors high degree of concentration, dominance by large companies, and orientation toward domestic markets. In many industries, the top three companies accounted for a disproportionately large share of total sales and assets. The high industrial concentration led to practices of price leadership and output restrictions and the rise of industry lobby groupscommon features of an oligopolistic
market. With economic reforms introduced in the 1980s and 1990s, however, competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. A comparison of the Philippines economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sectors performance in context. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.1). Its growth rate began to catch up with others in 1996, only to be unsettled by the crisis of 1997. Table 3.1 GDP Growth of Southeast Asian Countries, 1990-1999 (percent)
Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.0 8.9 7.2 7.3 7.5 8.2 7.8 4.7 (13.2) 0.2 Korea, Rep. of 9.5 9.1 5.1 5.8 8.3 8.9 6.8 5.0 (6.7) 10.7 Malaysia 9.7 8.6 7.8 8.3 9.2 9.8 10.0 7.5 (7.5) 5.4 Philippines 3.0 (0.6) 0.3 2.1 4.4 4.7 5.8 5.2 (0.5) 3.2 Thailand 11.2 8.5 8.1 8.3 9.0 8.9 5.9 (1.7) (10.2) 4.2
Source: ADB, Key Indicators of Developing Asian and Pacific Countries 2000.
3.2.2
Growth and Financial Performance
Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1,000 corporations, which was taken as a representation of the Philippine corporate sector.2 During 1988-1997, net sales of the top 1,000 Philippine companies grew 17.5 percent per year (Table 3.2). This rate of growth was sustained by a comparable 18.8 percent growth in fixed
2
The SEC-BusinessWorld Annual Survey of the Top 1,000 Corporations covers financial and nonfinancial companies. In this section, only nonfinancial companies were used.
Table 3.2 Growth and Financial Performance of the Top 1,000 Companies, 1988-1997
1989 519.1 33.6 290.2 707.1 468.7 238.4 63.1 197 14.1 4.7 73 6.5 887 0.6 896 0.7 903 0.8 902 1.0 900 1.1 181 11.5 4.1 73 5.6 149 12.2 4.9 78 6.3 121 12.8 5.8 77 7.5 119 12.1 5.5 72 7.6 102 16.4 8.1 66 12.3 898 1.3 107 13.1 6.3 60 10.6 900 1.6 109 12.8 6.1 54 11.4 898 1.9 629.6 35.2 378.4 861.4 555.3 306.1 95.8 741.3 862.3 46.5 64.8 411.9 480.9 952.6 1,123.5 570.1 615.3 382.5 508.2 136.4 188.6 954.1 72.9 617.2 1,317.1 714.4 602.7 218.0 1,177.6 144.4 776.9 1,781.2 900.1 881.2 338.0 1,394.0 148.3 941.2 2,341.1 1,209.7 1,131.4 411.7 1,697.5 193.5 1,191.4 3,160.1 1,647.5 1,512.7 443.6 1990 1991 1992 1993 1994 1995 1996 1997 1,978.9 96.5 1,225.9 3,893.9 2,332.4 1,561.5 446.9 149 6.2 2.5 51 4.9 896 2.2 Compound Growth (%) 17.5 14.6 18.8 22.7 20.8 26.2 27.2 Average 146 12.6 5.3 68 7.9 898 1.2
Indicators
1988
Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders Equity Retained Earnings
464.7 28.4 260.8 618.6 426.5 192.1 51.4
Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin
222 14.8 4.6 75 6.1
Other Indicators No. of Companies Sales per Company (P billion)
899 0.5
Leverage = total liabilities/stockholders equity, net profit margin = net income/net sales, return on assets (ROA) = net income/total assets, return on equity (ROE) = net income/ stockholders equity, turnover = net sales/total assets. Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines.
assets. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997. Total assets grew at an average annual rate of 22.7 percent. Asset growth was funded by debt that grew at an average of 20.8 percent per year, and by equity that grew at a higher average annual rate of 26.2 percent. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. Return on equity (ROE) and return on assets (ROA) averaged 12.6 percent and 5.3 percent, respectively, for the 10-year period. These rates of return are high compared with other Asian countries. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. This is high compared with developed countries but compares favorably with other Asian countries. Further, leverage increased from 109 percent in 1996 to 149 percent in 1997, but the extent of the increase was not as dramatic as in other Asian countries, indicating that the corporate sectors exposure to foreign currency-denominated loans was not as significant as in other countries. Net profit margins for the top 1,000 companies averaged 7.9 percent for the period. The growth rates of corporate sales for the period 1988-1997 exceeded those of the countrys GDP for the same period (Table 3.3). Assuming
Table 3.3 The Corporate Sector and Gross Domestic Product, 1988-1997
Top 1,000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%)
a
GDP (P billion) 799 925 1,077 1,248 1,352 1,474 1,693 1,906 2,172 2,427 13.1
Net Sales (P billion) 465 519 630 741 862 954 1,178 1,394 1,697 1,979 17.5
Ratio of Estimated Value Addeda to GDP (%) 17.5 16.8 17.5 17.8 19.1 19.4 20.9 21.9 23.4 24.5
Value-added is assumed to be 30 percent of net sales. Sources: ADB, Key Indicators of Developing Asian and Pacific Countries 1999; and the SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, various years.
a constant ratio of value added to sales, these figures suggest a significant and increasing contribution of the corporate sector to GDP. A study of company performance by ownership type, size, corporate control structure, and industry reveals further structural characteristics of the growth and financial performance of the corporate sector. The premise is that these variables have a direct bearing on corporate performance and growth. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed, (ii) foreign-owned, (iii) Government-owned, and (iv) privately owned. Averaging 42.8 percent of the corporate sectors total sales between 1988 and 1997, privately owned companies constituted the largest group (Table 3.4). The foreign-owned companies were the
Table 3.4 Growth and Financial Performance of the Corporate Sector by Ownership Type, 1988-1997
Indicators Publicly Listed Privately Owned Rate, %) 17.3 22.0 28.4 28.5 27.0 31.8 2.9 158 13.0 5.2 103 5.3 42.8 606 0.8 ForeignOwned 21.8 3.9 26.3 22.8 22.9 22.7 22.0 142 22.2 9.3 146 6.3 27.9 196 1.5 GovernmentOwned 4.0 4.3 9.8 14.1 12.9 17.0 5.4 190 5.7 2.1 22 10.3 11.5 23 4.8
Growth Indicators (Compound Annual Growth Net Sales 20.0 Net Income 19.4 Fixed Assets 19.6 Total Assets 29.4 Total Liabilities 26.4 Stockholders Equity 32.5 Retained Earnings 30.1 Financial Ratios (%) Leverage 89 ROE 15.1 ROA 8.0 Turnover 53 Net Profit Margin 15.5 Other Indicators Share of Sales (%) 17.8 No. of Companies 73 Sales per Company (P billion) 2.5
Source: SEC-BusinessWorld Annual Survey of the Top 1,000 Corporations in the Philippines, various years.
second largest at about 27.9 percent, followed by publicly listed ones. Publicly listed companies had a minor though steadily increasing share in total sales. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE), or 38 percent, were among the top 1,000 companies in 1997, meaning that the remaining 62 percent were relatively small in sales and assets. However, while there were few of them, these companies were comparatively large, selling an average of P4.1 billion per company in 1997, compared with P2.75 billion per company for foreign-owned companies. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. Governmentowned companies in the top 1,000 list, although small in number, registered the largest per company sales at about P9 billion in 1997. These were mostly large public utilities. The compound annual sales growth rate was 21.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997, exceeding the 17.5 percent average growth rate of the entire corporate sector. Privately-owned and Government-owned companies grew at slower rates. With an average leverage ratio of 142 percent, a level high by Western standards but at par with those of other Asian countries, foreign-owned companies borrowed more than publicly listed ones. But by being most efficient in employing assets, they generated the highest return on investments, with an average ROE of 22.2 percent and ROA of 9.3 percent. Publicly listed companies had the lowest leverage at 89 percent, the highest net profit margin of 15.5 percent, reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income, the second best ROE and ROA, and the second lowest asset turnover. The government-owned companies had the highest leverage at 190 percent but lowest ROA and ROE because these are primarily public utilities and companies in the energy sector where turnover is low, the asset base is large, and low return on investment is the norm. It should also be added that the profit margin of Government-owned companies is distorted by the presence of holding companies such as the Philippine National Oil Company, Bases Conversion Development Authority, and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. The privately-owned companies had a high average leverage ratio of 158 percent. Their ROA and ROE were both more than twice as high as those of government-owned companies, but lower than those of foreignowned and publicly listed companies.
Performance by Control Structure By control structure, a company can be a member of a conglomerate or independent. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997, compared with 32.3 percent for the conglomerates. But the conglomerates were larger measured in sales per company, grew faster, had a lower leverage ratio, and achieved higher returns on invested assets than independent companies (Table 3.5). Table 3.5 Growth and Financial Performance of the Corporate Sector by Control Structure, 1988-1997
Indicators Group Member Independent 18.7 2.0 25.2 23.0 22.4 24.6 26.0 166 15.8 6.1 124 5.0 55.6 715 0.8
Growth Indicators (Compound Annual Growth Rate, %) Net Sales 20.2 Net Income 21.2 Fixed Assets 25.7 Total Assets 32.3 Total Liabilities 30.7 Stockholders Equity 34.1 Retained Earnings 32.3 Financial Ratios (%) Leverage 98 ROE 15.8 ROA 8.0 Turnover 67 Net Profit Margin 12.3 Other Indicators Share in Sales (%) 32.3 No. of Company 159 Sales per Company (P billion) 2.1
Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, various years.
Performance by Firm Size By firm size, the corporate sector is divided into large, medium, and small companies, depending on assets and sales. Sales and resources of the
Philippine corporate sector are highly concentrated among the large companies, which, for this study, are defined as the largest 100 companies in the top 1,000 list. Sales per company in this group averaged P13.4 billion in 1997. Medium-sized companies, defined in this study as the next 200 largest companies in the top 1,000 list, averaged a far less P3 billion in per company sales, while small companies, referring to the remaining companies in the list, averaged only P920 million in per company sales during the same year. Large companies accounted for 56.1 percent of the total sales of the corporate sector, although they comprised only 8.8 percent of the total number of companies in the list (Table 3.6). However, sales of mediumsized companies grew faster than large companies. Medium-sized companies also performed better in terms of ROE, averaging 16 percent, indicating that they deployed resources more efficiently than large and small companies.
Table 3.6 Growth and Financial Performance of the Corporate Sector by Firm Size, 1988-1997
Indicators
Large Medium 19.6 47.2 29.9 32.5 25.6 49.6 36.0 156 16.0 7.1 81 9.5 12.9 89 1.6 Small 19.9 26.2 25.4 28.1 25.0 32.7 44.5 128 10.1 4.5 73 6.6 31.0 730 0.5
Growth Indicators (Compound Annual Growth Rate, %) Net Sales 15.7 Net Income 1.3 Fixed Assets 15.5 Total Assets 18.4 Total Liabilities 18.2 Stockholders Equity 18.9 Retained Earnings 13.9 Financial Ratios (%) Leverage 158 ROE 13.1 ROA 5.3 Turnover 65 Net Profit Margin 8.2 Other Indicators Share in Sales (%) 56.1 No. of Companies 79 Sales per Company (P billion) 7.3
Small companies, although the largest in number, showed the lowest ROE, averaging 10.1 percent. Poor returns appear to have been caused by the low profit margin at 6.6 percent, compared with 9.5 percent for medium-sized companies and 8.2 percent for large ones. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. The Asian financial crisis affected large companies most severely, with their ROE dropping to 3.8 percent in 1997, from 14.8 the previous year. ROE dropped from 10.7 percent in 1996 to 8.7 percent in 1997 for medium-sized companies. For small companies, ROE dropped to 7.4 percent in 1997 from 11.7 percent a year earlier. Leverage was the highest for large companies, at 158 percent on average during 1988-1997. Mediumsized companies leverage level was slightly lower, at 156 percent. But small companies leverage was significantly lower, at 128 percent for the period. Large- and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997, unlike their counterparts in other Asian countries. Performance by Industry This study also looked at corporate performance by industry, specifically those industries least and most affected by the financial crisis. The growth and financial performance of selected industries, i.e., manufacturing, utilities, real estate, and construction, are shown in Table 3.7. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales. The sector showed consistent growth in sales, profits, assets, and equity up to 1996, but suffered its largest decline in net profits in 1997, as indicated by the negative annual growth, at -12.8 percent, of net income. Net income declined from P54.1 billion in 1996 to P4.2 billion in 1997 for this sector. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector, but lower than that of construction, and utilities and services sectors. Growth of sales, net income, and assets was much higher for the real estate and property, and the construction sectors than for the manufacturing, and utilities and services sectors, reflecting to some extent a bubble phenomena in the former two sectors, especially during the period 1994-1996. The real estate and property sector also suffered significantly in sales, net income, and profitability in 1997 when the crisis started. Sales revenue and net income declined from P76.7 billion and P35.8 billion in
Table 3.7 Growth and Financial Performance of the Corporate Sector by Industry, 1988-1997
Utilities Real Estate and and Services Property 39.2 37.8 48.2 45.7 52.8 41.7 28.6 69 16.7 10.1 24 42.4 3.0 31 0.7
Indicators
Manufacturing
Construction 27.3 55.9 23.0 23.0 25.7 19.0 21.7 192 9.1 2.7 83 2.9 2.2 28 0.6
Growth Indicators (Compound Annual Growth Rate, %) Net Sales 16.9 17.7 Net Income (12.8) 17.3 Fixed Assets 20.5 12.4 Total Assets 19.4 19.6 Total Liabilities 18.3 20.8 Stockholders Equity 21.4 16.3 Retained Earnings 17.1 10.6 Financial Ratios (%) Leverage 142 181 ROE 13.9 5.7 ROA 5.9 2.0 Turnover 112 24 Net Profit Margin 5.2 8.5 Other Indicators Share in Sales (%) 82.2 12.6 No. of Company 454 17 Sales per Company (P billion) 1.3 5.4
1996 to P56.9 billion and P24.7 billion in 1997, respectively. As a result, the sectors ROE dropped from 15.7 percent to 10.4 percent. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector, and was also much more limited compared with the property sectors in other Asian countries. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1,000 companies total sales on average during 19881997. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997, it does not appear to have been excessively exposed to foreign currency-denominated loans. The sectors buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.
The utilities sector had the second highest leverage during 19881997 at 181 percent on average, reaching up to 313 percent in 1997. The currency devaluation bloated the foreign currency-denominated loans of these companies. Overall, the leverage of all four industries was low, unlike in neighboring countries hit by the Asian crisis. 3.2.3 Legal and Regulatory Framework
The Corporation Code of 1980 is the main law governing the corporate sector. Two other pertinent laws are Presidential Decree (PD) 902-A, which is also the organic law governing the operations of SEC, and the Insolvency Law. For publicly listed companies, the Revised Securities Act (RSA) and PSEs public listing requirements also apply. The General Banking Law, which regulates banks and nonbank financial institutions except insurance companies, contains some provisions affecting corporations dealings with banks. Corporation Code of 1980 Supplanting the old Corporation Law of 1906, which was based on American corporate law, the Corporation Code of 1980 is a compilation of important juridical rulings, administrative regulations, and recognized rules on corporate practices. It provides the basic constitutional structure for the organization, operation, and dissolution of corporations. It specifies the minimum information to be indicated in the articles of incorporation,3 which serve as the companys declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. Under the Code, the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. Amendments to the articles of incorporation require approval by a majority of the board of directors and a two-thirds vote of outstanding capital stock. One month after registration, the Code requires a corporation
3
A companys articles of incorporation should include: (i) corporate name; (ii) purpose of the corporation; (iii) principal office; (iv) term of existence; (v) number of directors (not less than five nor more than 15); (vi) names, nationalities, and residences of incorporators and directors; (vii) number, par value, and amount of authorized capital stock; and (viii) names, nationalities, and residences of original subscribers, and amount subscribed and paid by each. The articles of incorporation may also include other matters such as waiver of preemptive right and classes of shares such as founders or redeemable shares describing their rights, privileges, and restrictions.
to adopt a code of bylaws or rules for its internal governance. To be valid, the bylaws must be consistent with the law, the corporations articles of incorporation, and public policy; must be general, uniform, and reasonable; and should not impair vested rights.4 Philippine corporate law distinguishes between management decisions that require only a majority vote of the board and major decisions that require a two-thirds majority vote of shareholders. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. However, shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. Its mandate is to supervise corporations in order to encourage investments and protect investors. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders, directors, or officers. In 1976, PD 902-A expanded SECs mandate to include absolute jurisdiction, supervision (regulatory), and control (adjudicative) of all corporations. In addition, PD 902-A also granted SEC the exclusive jurisdiction to hear and decide cases involving: (i) complaints about devices or schemes employed by the board of directors and officers amounting to fraud and misrepresentation that may be detrimental to the interest of the public or shareholders; (ii) controversies arising out of intra-corporate relations, among shareholders, between the shareholders and the corporation, and between the corporation and the State concerning its franchise or right to exist; (iii) controversies in the election or appointments of directors and officers of corporations; and (iv) petition of corporations to be declared in a state of suspension of payments in cases when their assets cover all debts but they cannot pay these debts when they fall due.
4
Some of the items that a corporation may provide in its bylaws are the following: (i) time, place, and manner of calling and conducting regular or special meetings of the directors and shareholders; (ii) required quorum in shareholders meetings, manner of voting, and forms of proxies and manner of voting them; (iii) qualifications, duties, and compensation of directors, officers, and employees; (iv) time for holding annual election of directors and manner of giving the election notice; (v) manner of election or appointment and term of office of all officers other than directors; (vi) penalties for violation of the bylaws; and (vii) manner of issuing certificates in the case of stock corporations.
The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for suspension of payments to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the countrys facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a self-regulated organization. Thus, PSE now
has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchanges rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks voting shares.
Regulations on the single borrower limit (SBL) put a ceiling on the maximum amount that a bank can lend to a debtor. SBL rules limit the total liabilities of any borrower of a commercial bank to 15 percent of the banks unimpaired capital and surplus, and an additional 15 percent for adequately secured loans, to a maximum 30 percent (unimpaired capital and surplus refers to the total paid-in capital, surplus, and undivided profits, net of valuation reserves of a bank). SBL limits exclude risk-free loans such as Government-guaranteed loans and loans secured by cash deposits. Total corporate liabilities include all liabilities of the debtors and their majorityowned subsidiaries. The Monetary Board may prescribe the consolidation of the liabilities of subsidiaries with the parent corporation under certain conditions. Central Bank (Bangko Sentral ng Pilipinas [BSP]) regulations do not prohibit loans by the bank to its directors, officers, shareholders, and other related interests, known as DOSRI. However, they are subject to certain prudential requirements under banking laws, as follows: (i) a director or officer of a bank can only borrow or become a guarantor, endorser, or surety for loans from the bank with the written approval of all other directors of the bank (i.e., excluding the director concerned); (ii) the amount of outstanding credit accommodations that a bank extends to its shareholders shall be limited to an amount equal to the sum of their unencumbered deposits and book value of their paid-in capital contributions; and (iii) loans and advances given to officers in the form of fringe benefits shall not form part of liabilities under DOSRI.
3.3 3.3.1
Corporate Ownership and Control Patterns of Corporate Ownership
The historical development of Philippine corporate ownership is rooted in the countrys colonial past, the industrial policies of the Government, and the recent emergence of industrialists and an entrepreneurial class. During the Spanish and American period up to World War II, a small number of families acquired land and owned large businesses. These families built and preserved their businesses over several generations. Many of them became controlling shareholders of family-based corporations and business groups that are major players in the present-day Philippine corporate sector. Ownership is a key element in corporate control and governance. Public listing rules of PSE require that a minimum of 10 to 20 percent of
outstanding shares, depending on the size of the company, be available for trading in the stock exchange. As companies usually only issue the minimum required number of shares, large blocs of controlling shareholders often dominate corporate decision making in publicly listed companies. Public investors and minority shareholders are not in a position to influence management. Moreover, the presence of large controlling shareholders makes takeovers by other companies difficult. For these reasons, the resolution of conflicts between the interests of controlling shareholders, minority shareholders, public investors, and creditors in Philippine companies depends very much on the effectiveness of internal control systems. Ownership Concentration of Listed Companies This study measures ownership concentration in terms of shareholdings by the top one, five, and 20 shareholders.5 Table 3.8 shows that the top shareholder owned 40.8 percent of the market value of an average nonfinancial company. The shareholding of the top shareholder varied across sectors. It was highest for the property sector at 54.8 percent, followed by holding companies (as a sector) at 53 percent. One shareholder held majority control of an average company in these two sectors. The average shareholding of the largest shareholder was less than 25 percent only in sectors with large market capitalization, such as power and energy, and transportation, and in sectors with high risks, such as oil exploration and mining. These figures suggest that for publicly listed companies, a single shareholder often has substantial or even dominant control. Combined, the holding of the top five shareholders in an average company was about 65.3 percent for the nonfinancial sector and 59.2 percent for the financial sector. The five largest shareholders held majority control over an average Philippine publicly listed company, except in three sectorstransportation; food, beverage, and tobacco; and oil exploration. Ownership by the five largest shareholders was on average most concentrated among holding companies (78.4 percent), and in construction (74 percent), property (69.8 percent), manufacturing and trading (68.4 percent), and communications (67.3 percent).
The study derived ownership data for 194 (169 nonfinancial) companies out of 221 (190 nonfinancial) listed on the Philippine Stock Exchange as of 1997. Shareholdings by the top one, five, and 20 shareholders were estimated for each company and averaged by using the market capitalization of each company as a weight.
Table 3.8 Ownership Concentration of Philippine Publicly Listed Companies by Sector, 1997
Sector Financial Institution Banks Financial Services Average Shareholdingb Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food, Beverage, and Tobacco Holding Companies Manufacturing, Distribution, and Trading Hotel, Recreation, and Other Services Property Mining Oil Average Shareholdingb
a
Top 1 26.9 41.3 27.2 35.4 21.5 23.8 47.7 22.7 53.0 37.4 28.9 54.8 23.4 19.9 40.8
Top 5 59.2 63.2 59.2 67.3 55.4 48.4 74.0 44.1 78.4 68.4 55.3 69.8 56.0 45.1 65.3
Top 20a 76.4 65.8 76.2 76.9 72.1 69.2 86.2 69.7 86.0 42.6 68.0 74.5 51.9 64.3 75.9
Information on the top 20 shareholders is not available for five holding companies, 10 manufacturing companies, and two property companies. b Weighted by market capitalization. Source: PSE databank.
The shareholding of the 20 largest shareholders in an average company was 75.9 percent for the nonfinancial sector and 76.2 percent for the financial sector. In 12 out of 13 sectors, the top 20 shareholders owned more than 50 percent of the voting shares of an average company. In 10 out of 13 sectors, the top 20 shareholders held more than a two-thirds majority control of an average company. Ownership Concentration at Critical Levels of Control PSE listing rules require that a minimum of 10 to 20 percent of outstanding shares of a company be issued to the public, depending on its size. An interesting question is whether in reality Philippine publicly listed companies issue enough shares to be truly widely held or whether they barely meet this minimum requirement. The answer to this can be gleaned from an
analysis of the number of companies in which the top one, five, or 20 shareholders owned more than 50 percent (signifying operating control), 66 percent (signifying strategic control), or 80 percent (only nominally publicly listed) of outstanding shares. Table 3.9 shows that in 44 companies, or about 30 percent of the total, a single shareholder held operating control of a company. In 21 companies, or 14 percent of the total, a single shareholder held two-thirds majority control. In four companies, or 3 percent of the total, a single owner owned more than 80 percent of outstanding shares. In 111 companies, or almost 75 percent of the total, the top five shareholders owned more than 50 percent of the voting shares. In 76 companies, or 51 percent of the total, the top five shareholders held more than two-thirds majority control of a company. In 116 companies, or 78 percent of the total, the top 20 shareholders collectively owned a majority of a companys shares. With such high levels of ownership concentration, minority shareholders are unlikely to be able to influence the strategic and operating decisions of a company without the support of one or more large shareholders. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. The shares of publicly listed companies are thinly traded and illiquid, and share prices are sensitive to movements of foreign funds. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. Who are the top one, five, and 20 shareholders? In Table 3.10, the top five controlling shareholders were classified into eight groups. The largest group is nonfinancial corporations, including pure holding companies, controlling an average of 52.1 percent of publicly listed companies in the Philippines in 1997. In four of 11 nonfinancial sectors, nonfinancial corporations held majority control. Individuals did not constitute a significant shareholder group among the top five shareholders, holding only an average of 2.2 percent of outstanding shares of publicly listed companies. Nonfinancial corporations with controlling shareholdings are likely to be holding companies, which are mostly privately owned and controlled by family-based shareholder blocs. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. There are advantages to establishing pure holding companies. Through these, large and family-based shareholders pool the familys ownership over many
Table 3.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies, 1997
% of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 13 7 2 3 Top 5 40 33 50 28 27 50 28 30 Top 20a 60 67 64 20 47 50 43 36 45
Sector
Communication Construction Food, Beverage, and Tobacco Manufacturing, Distribution, and Trading Holding Power Transportation Property Total
= not available. a Data for top 20 shareholders were not available for five holding companies, 10 manufacturing companies, and two companies in the property sector. Source: PSE databank.
Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector, 1997 (percent)
Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company
Sector
Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food, Beverage, and Tobacco Holding Companies Manufacturing, Distribution, and Trading Hotel, Recreation, and Other Services Property Mining Oil Average Shareholdinga 33.9 6.6 33.5 53.5 26.3 37.2 59.4 29.8 66.0 45.9 36.7 67.3 26.8 21.9 52.1 8.5 12.6 0.0 1.3 12.3 0.2 0.8 0.0 0.2 1.7 0.0 4.7 3.9 0.2 3.2 3.0 1.5 4.2 5.6 5.7 0.7 3.9 0.4 2.4 0.0 0.0 5.1 6.6 0.4 5.5 4.3 5.3 1.0 0.4 8.5 2.2 0.0 5.7 0.0 0.6 0.0 1.7 0.3 0.0 0.1 5.8 0.0 1.3 0.2 10.7 0.0 1.2 0.0 0.0 0.3 0.0 0.0 5.0 0.0 1.4 1.3 0.0 1.2 3.0 10.2 3.1 9.1 7.6 9.0 5.4 19.3 5.6 2.3 1.0 2.3
2.6 18.6 2.8 0.6 0.0 2.6 1.5 0.0 0.8 11.0 7.6 0.6 12.5 13.7 1.1
1.7 0.0 1.6 0.6 0.0 0.2 0.1 0.0 0.1 0.2 0.0 0.0 0.0 0.5 0.1
Weighted by market capitalization. Source: PSE Databank.
companies and share in the risks and profits of the group. They can also better manage their income taxes because income from affiliated companies passes through a holding company. Such advantages have contributed to the popularity of holding companies among publicly listed companies. Holding companies as a sector had the largest market capitalization in PSE in 1997, accounting for P258.6 billion or 26.7 percent of market capitalization of the nonfinancial publicly listed companies. Holding companies were themselves 66 percent owned by other nonfinancial corporations. Privately-owned pure holding companies own a majority of shares and exercise control of publicly listed holding and operating companies through a multilayered pyramid structure. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies, while still allowing the public to own minority shares. As a group, financial institutions did not have a significant ownership in nonfinancial corporations, with an average of only 7.2 percent in 1997. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4.7 percent of shareholdings), commercial banks (1.3 percent), securities brokers (1.1 percent), and insurance companies (0.1 percent). The 7.2 percent shareholding by the financial institutions was even inflated to some extent because securities brokers held trading portfolios for their clients rather than long-term investments. Insurance companies were very minor investors in the stock market because prudential regulations prevent them from investing significant amounts even in equities of large companies. Investment trust funds were the most important institutional investors. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). Funds of SSS and GSIS consist mainly of compulsory contributions from members of the countrys private sector and government workforce, respectively. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications, Petron and MERALCO in power and energy, and San Miguel Corporation (SMC) in food and beverages. The investment funds presence in these sectors ranged from 8.5 to 12.6 percent of market capitalization in 1997. Because of limited ownership by institutional investors, there was no real market for investment information. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.
Family-Based Ownership and Business Groups The Asian Development Bank (ADB) survey of publicly listed companies conducted for this study reveals that about one third of responding companies started out as family businesses. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies), suggesting that most publicly listed companies are parts of business groups. Most family businesses that went public did so because they wanted to raise capital and to gain the prestige associated with being a public company. However, many companies in family-owned groups are not publicly listed. To understand the ownership and governance characteristics of family-owned business groups, the study put together a list of prominent business groups, identified the companies belonging to each of these groups, and tracked the financial performance of each company from 1992 to 1997, using data on the Philippines top 1,000 companies.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3.11). Family-based groups have larger companies since their total sales were about 33.4 percent of the top 1,000 corporations sales, but they comprised only 23.8 percent of total companies in number. All major industries were represented, suggesting that business groups are common in all major markets. Some 20 financial institutions were affiliated with these groups, including 16 commercial banks. This is significant considering that there were only 31 local commercial banks in the country in 1997.7
6
The study used publicly available shareholder information and published reports. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1,000 Corporations in the Philippines. A common feature of corporate ownership of a business group is the centrality of a commercial bank. Large shareholders and their families own these banks directly or through their controlled companies. Commercial banks hold the largest share, about three fourths, of the financial resources in the country. Corporate financing depends on intermediation by banks. For this reason, a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. The Central Bank deregulated interest rates and foreign exchange, liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks, and increased the capital requirements for all types of banks. Prudential regulations, including SBL and DOSRI rules, remain in force to control excessive lending of banks to insiders. Still, the Central Banks reforms are probably changing the conduct but not necessarily the structure of the banking system. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector, so far limiting their involvement to selected products. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks.
Compared with other Asian countries, an average group in the Philippines has fewer member companies. Together, the top 10 family-based business groups had only 119 companies in the top 1,000 companies, or an average of about 12 per group. The main constraint may be the availability of family members that could be drawn for top management positions. In terms of number of companies, the largest family-based business group was the Ayala Corporation Group, with 27 affiliated companies in the top 1,000. In terms of sales, the largest was the Eduardo Cojuangco group, the principal owner of SMC, the biggest private company in the Philippines. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities, including business groups and independent companies, ranged according to their sales (Table 3.12). These corporate entities accounted for 53.6 percent of the total sales of the top 1,000 corporations in 1997. Significantly, the three largest entities were family-based groups, namely, Cojuangco, Lopez, and Ayala. Also, 25 out of the 50 top corporate entities were familybased groups. Family-based business groups are most dominant in sectors such as manufacturing, real estate, construction, and banking. Foreign-owned companies mainly serve the export markets. Interlocking Relationship between Financial and Nonfinancial Firms Although financial institutions as a whole did not own directly significant proportions of shares of nonfinancal corporations in the Philippines, as discussed in previous sections, the two were closely related through their affiliations to business groups. Commercial banks are often affiliated to a particular business group. To show this, the study used the four largest business groupsAyala, Gokongwei, Lopez, and Henry Syas examples. In 1997, nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. For the Ayala group, the nonfinancial sector was real estate (60.4 percent of the groups 1997 profits); for the Gokongwei Group, it was manufacturing (36.2 percent); for the Lopez group, broadcasting (49.8 percent); and for the Henry Sy group, retail merchandising (69.1 percent). In the meantime, for each of these groups, a substantial proportion of group profits came from its financial subsidiaries. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group, and more than 20 percent for the Lopez group and Henry Sy group. It is also noteworthy that, with the exception of Banco de Oro, which was majority-owned by the Henry Sy group, in most
Table 3.11 Total and Per Company Sales, Sector Orientation, Flagship Company, and Affiliated Bank of Selected Business Groups, 1997
Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6
Major Sector Orientation
Estimated No. of Affiliated Companies Total Sales (P billion) 123.7 98.8 84.5 49.4 48.5 47.5 46.5 44.0 26.5 26.0 17.5 17.2 16.3 15.5 13.0 13.0
Average Sales Per Company (P billion) 6.5 6.6 3.1 4.1 4.0 5.3 11.6 7.3 2.4 6.5 2.2 1.9 3.3 3.9 2.6 2.2
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.
Beverages, food, coconut oil, and packaging Power distribution and mass communications Real estate, food, and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines, beverages, agriculture, and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution
12. 13. 14. 15. 16. 17.
Real estate, telecom, and personal care prods Shipping, power, and food Food, beverages, and dairy products Investments, construction, and mining Management, real estate, and tourism Credit card
18.
Eduardo Cojuangco Lopez Family Group Ayala Corp. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M. Consunji 4 3
Food and dairy products Construction and mining
10.4 10.1
2.6 3.4
19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 4 238 1.1 805.6
Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication, distribution, and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore, mining, and real estate Department store Mining Construction Telecommunication Shipyard and power
4 7 5 2 4 4 3 2 5 7 5 5 2 3 2 3 2 2 2 2
8.5 8.3 7.9 7.8 6.9 6.2 6.0 5.6 5.4 5.2 4.7 4.4 3.7 3.4 3.3 2.5 2.0 1.8 1.4 1.1
2.1 1.2 1.6 3.9 1.7 1.6 2.0 2.8 1.1 0.7 0.9 0.9 1.9 1.1 1.7 0.8 1.0 0.9 0.7 0.6 0.3 2.8
Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. P. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Ramos Gaisano Family Group Felipe Yap Felipe F. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepea/ Fil-Estate Group Total
Real estate
Sources: PSE Databank, SEC-BusinessWorld Annual Survey of Top 1,000 Corporations (1997), and various company annual reports.
Table 3.11 (continuation) Total and Per Company Sales, Sector Orientation, Flagship Company, and Affiliated Bank of Selected Business Groups, 1997
Business Group
Size Classa Flagship Company
Affiliate Bankb UCPB PCIBank BPI Metrobank/Global Bank PCIBank Banco de Oro Allied Bank Bank of Commerce Asian Bank PDCP Bank Union Bank Consumer Bank (Savings Bank) RCBC Asian Bank Equitable Banking Corp.
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21.
Eduardo Cojuangco Lopez Family Group Ayala Corp. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go W. Uytengsu/General Milling Group David M. Consunji Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group
Large Large Medium Medium Medium Large Large Large Medium Large Medium Medium Medium Medium Medium Medium Medium Medium Medium Small Small
San Miguel Corporation MERALCO Ayala Corporation Toyota Motors Robinson Shoe Mart Philippine Airlines Phil. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. Alaska Milk Corporation DM Consunji, Inc. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement
East-West Bank International Exchange Bank
Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp.
22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. Keppel-Monte Bank
Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. P. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Ramos Gaisano Family Group Felipe Yap Felipe F. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepea/Fil-Estate Group
Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small
Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. F. Cruz & Co., Inc. PT&T Corp. Kepphil Shipyard Inc. Fil-Estate Development Inc.
Size class is measured in terms of sales: Large = greater than P4.48 billion; medium = P1.65 billion to P4.48 billion; small = less than P1.65 billion. Refers to commercial banks, unless otherwise indicated. Sources: PSE Databank, SEC-BusinessWorld Annual Survey of Top 1,000 Corporations (1997), and various company annual reports.
Table 3.12 Control Structure of the Top 50 Corporate Entities, 1997

Sales (P billion) Control Structure Major Industrial Orientation 123.7 98.8 84.5 77.1 60.8 53.2 49.4 48.5 47.5 46.5 44.0 38.0 37.6 26.5 26.0 24.8 22.4 19.6 18.1 17.5 17.2 16.3 15.5 15.2 Business Group Business Group Business Group Government- and Foreign Jointly Owned Business Group Business Group Business Group Government-Owned Publicly Listed/Foreign-Owned Foreign-owned Business Group Business Group Business Group Business Group Business Group Foreign-Owned Foreign-Owned Business Group Business Group Foreign-Owned Privately-Owned Publicly Listed/Foreign-Owned Privately-Owned Business Group
Corporate Entity
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.
Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. Texas Instruments (Phils.), Inc. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.), Inc. Fujitsu Computer Products Corp. of the Phils. Philippine National Bank Mercury Drug Corp. First Pacific/Metro Pacific Group
21. 22. 23. 24.
Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp.
Beverages, food, coconut oil, and packaging Power distribution, mass communications, and bank Real estate, bank, food, and car manufacturing Power Refined petroleum products Refined petroleum products Banking, car manufacturing, and real estate Banking, food, and telecommunications Department store and banking Airlines, beverages, agriculture, and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate, telecommunication, and personal care products Shipping, power, and food Food, beverages, and dairy products Investments, banking, construction, and mining Gold and other precious metal refining
25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 9.8 9.6 9.5 8.5 8.4 8.3 8.2 7.9 7.9 7.8 6.9 6.0 5.6 1,290 53.6 Foreign-Owned Foreign-Owned Foreign-Owned Business Group Foreign-Owned Business Group Privately-Owned Government-Owned Business Group Business Group Business Group Business Group Business Group
La Suerte Cigar and Cigarette Factory Land Bank of the Philippines Procter and Gamble Philippines Andres Soriano Family Group George Go Hitachi Computer Products (Asia) Corp. National Steel Corporation National Food Authority Phil. Amusement and Gaming Corporation Mitsubishi Motors Phils. Corp. W. Uytengsu/General Milling Group David M. Consunji Uniden Philippines Laguna, Inc.
14.9 14.7 13.3 13.0 13.0 12.6 12.0 11.5 10.7 10.7 10.4 10.1 9.8
Privately-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned Government-Owned Government-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned
38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50.
EAC Distributors Inc. Philip Morris Philippines, Inc. Philips Semiconductors Phils., Inc. Jollibee Foods Citibank N.A. Luis Lorenzo Family Group United Laboratories Development Bank of the Philippines Alcantara Family Group Bienvenido Tantoco Elena Lim Brimo Family Group Andrew Tan Total Share in Top 1,000 Companies Sales (%)
Cigarettes Bank Soap and detergents Management, real estate, and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay, corn (unmilled), and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters, and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment, radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines, including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate
Sources: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations (1997), PSE Databank, and various company annual reports.
publicly listed commercial banks affiliated to these groups, business groups had only minority ownership. However, although public investors held a majority of shares, these were dispersed shareholdings. Actual control of the banks was still held by the groups. 3.3.2 Corporate Management and Shareholder Control
The main mechanisms by which shareholders control corporate management are the board of directors, appointment and compensation of senior executives, shareholder voting in general meetings and legal protection of their rights, accounting and auditing, and financial disclosure. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study.8 The Board of Directors As the representative of shareholders in a company, the board of directors plays a crucial role in corporate governance. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs, such as amendments of the articles of incorporation, issuance of corporate bonds, sale or disposition of a substantial portion of corporate assets, investments of corporate funds in other companies or purposes, issuance of stocks, corporate mergers or consolidations, voluntary dissolution, approval of management contracts, amendments in the bylaws, determination of compensation to board members, removal of directors, and declaration of cash dividends. The Corporation Code holds members of the board of directors liable, jointly and individually, to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. They are likewise liable if they pursue financial interests that conflict with their duty as directors. Shareholders have the right under the Code to file derivative suits against directors and officers and other third parties to redress any wrongdoing committed against the corporation for which the board refuses to sue or to remedy. Of course,
8
The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies).
actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions; protecting shareholder interests; appointing senior management; ensuring that a company follows legal and regulatory requirements; and determining remuneration for board directors and senior management, in a descending order. Making day-to-day management decisions was not regarded as an important board responsibility. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31.9 percent), or percentages of shareholdings (28.7 percent). But professional expertise is also an important criterion (28.7 percent). In a few cases, board directors were the founder of a company, appointed by the Government, or representatives of creditors. More than half of respondents indicated that board directors were elected during the shareholder general meetings. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management, or the Government without approval by shareholder general meetings. According to the ADB survey, a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average, with a maximum of 36 percent. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. In practice, the average number of years of holding office was 6.6 for board chairpersons and 7.5 for board members. The longest was 27 years for board chairpersons and 14 years for board directors. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents), a fixed fee plus performance-related bonuses (30 percent), or a per diem for meetings (18 percent).
Compensation for the chairperson was determined either by the board (54 percent of respondents), the parent company or company bylaws (21 percent), or management (15 percent). The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. Ninetythree percent of the respondents had one or more outside directors. But the independence of these outside directors is often doubtful. It is also not clear whether the outside directors were elected before or after the financial crisis. In some companies, owners brought prominent political or civic leaders into their boards with the intention of improving the visibility of the corporation rather than improving the quality of board decisions. Companies may set up special board committees to strengthen due diligence procedures.9 In practice, however, large shareholder-dominated companies often view such committees as unnecessary formalities. In the ADB survey, only 35 percent of responding companies have set up board committees. About half of the active committees were audit committees and the other half nomination committees. These committees were established only recently. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. The ADB survey shows that in 41 percent of the responding companies, the chairperson of the board was also the chief executive officer (CEO). A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents), relationship with controlling shareholders (35 percent), or amount of shareholding (15 percent). This suggests that large shareholders control CEOs by means other than shareholdings, namely, by tenure and compensation. Unlike in Western corporate models, CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. When the CEO was not the chairperson, the CEO
9
The three most common board subcommittees are the compensation, audit, and nomination committees. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. The nomination committee searches and reviews candidates for key management positions. The audit committee selects external auditors, negotiates the audit fees and scope of audits, and reviews the findings of external audits.
was not related to the chairperson by blood or marriage in all of the cases except one. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEOs most important responsibility. But about 27 percent viewed it to be ensuring steady growth of the company. A substantial number of respondents also considered looking after interests of other stakeholders and the general public as among the important responsibilities of the CEO. An overwhelming 70 percent of respondents said a CEO who was not the chairperson of the board could make key decisions only after consulting the chairperson or the entire board. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. The golden parachute was apparently not a common feature of CEOs compensation packages. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation, equal to three years pay, if the CEOs contract was preterminated. The average service length of CEOs was 5.2 years. The longest service rendered was 27 years. Shareholder Rights and Protection Under the Corporation Code, shareholders enjoy a number of rights and protection. Among others, first, to help ensure the representation of minority interests in the board, the Corporation Code allows cumulative voting for directors, and prohibits the removal, without cause, of directors representing minority shareholders. Second, shareholders may exercise appraisal rights, i.e., the rights to demand payment for shares of those who do not agree with the boards decisions when a company (i) amends the articles of incorporation; (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets; (iii) invests in another company for a purpose different from that of the corporation; or (iv) enters into a merger or consolidation with another corporate entity. Third, shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. They can vote through proxy, including electronic means. Companies are not allowed to issue shares with different voting rights. Fourth, the Corporation Code requires that the following types of transactions involving potential conflict of interest between shareholders and management be reviewed and approved by the board: (i) dealings of a company with directors or officers; (ii) contracts with companies linked through interlocking directorship; and (iii) involvement of directors in businesses that compete with the company. Fifth,
shareholders are allowed to inspect a companys stock and transfer books. Regardless of the amount of shares held, a shareholder could file a derivative suit against a director to redress a wrongdoing. Sixth, in cases of corporate takeovers, potential buyers are required to make a tender offer to minority shareholders at a price equal to the offer it is making to controlling shareholders. Last, the Revised Securities Act has strict provisions designed to deter insider trading. In practice, because of poor compliance and enforcement as well as some loopholes in corporate laws, minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. Few minority shareholders actually exercised their appraisal rights. Those who did were usually offered below-market values for their shares. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. During annual general meetings where minority shareholders could exercise their rights, because of the dominance of large controlling shareholders, there were often no real discussions of board proposals or actions. There was little chance that a proposal from minority shareholders could ever get approved. In the case of preemptive rights, the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. Although transactions involving potential conflict of interest need to be reviewed and approved by the board, there are no requirements for disclosing such transactions to shareholders under the Corporation Code. Consequently, it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. Being appointees of controlling shareholders, board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. In cases of derivative suits against directors for wrongdoings or actions against insider trading, SEC proceedings were costly and time-consuming. In the past, no one has been successfully prosecuted for insider trading. There was only one case, that of Interport Resources Corporation, where SEC made substantial progress in investigation. But an action by the regular court on a petition by the companys owners/officers prevented SEC from pursuing the investigation. The company was dissolved before indictment. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. However, in the Philippines, hostile takeovers are not common because in most companies ownership is concentrated
in a few controlling shareholders and families. Nevertheless, the successful hostile takeover by First Pacific Group of PLDT, a company that is widely held but has a large shareholder, demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. The ADB survey provides further evidence on shareholder rights, protection, and their activism in the corporate sector. The responding companies had on average 43,522 shareholders each. Nominees held about 45 percent of the outstanding shares. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. About 333 shareholders per company voted by proxy, representing 3.4 percent of shareholders but 58 percent of outstanding shares. The brokers or securities companies were the most important proxy voters, followed by management and banks. An average of about 4,900 shareholders per company did not vote during the last annual general meeting, representing about 24 percent of outstanding shares. Table 3.13 summarizes rights that the shareholders of the responding companies enjoyed. Table 3.13 ADB Survey Results on Shareholder Rights
Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings
Source: ADB Survey of Philippines Publicly Listed Companies, 1999.
Yes 100.0 51.4 70.0 36.8 56.8 92.7 43.2 69.4
No 0.0 48.6 30.0 63.2 43.2 7.3 56.8 30.6
Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor, appointed either by the board or shareholders during the annual general meetings. About 93 percent of the respondents contracted
their annual audit to an international auditing firm. On average, the responding companies have been associated with their present auditors for 13 years, with the longest being 50 years. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. Because of such long relationships, independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. Nevertheless, independent audits do not guarantee the absence of questionable accounting practices. In two celebrated cases, a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp., a bankruptcy case) or hid a large amount of liabilities and losses (PLDT, a hostile takeover case). Disclosure and Transparency The disclosures required by the Corporation Code are achieved through shareholders inspection of a companys books and an information statement that companies should regularly issue to shareholders. The Code grants a shareholder the right to inspect business records and minutes of board meetings. Meanwhile, the information statement transmitted to every shareholder should contain the audited financial statements, a management discussion of the business, and an analysis of financial statements. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. From publicly listed companies, the agency also requires reports on important details about their operations and management, imposing penalties on violators. In practice, financial reporting standards allow room for interpretation by independent auditors. An auditor can choose among three alternative sets of GAAP, namely, the local standard (i.e., as practiced in the Philippines), the international accounting standard, or the accounting standard of a specific developed country (for example, the US GAAP). These different versions of GAAP, although closely related, vary in their evaluation of some major accounts such as securities and other liquid assets, long-term leases, investments in subsidiaries, revaluation of fixed assets, foreign currency-denominated liabilities, intangible assets, intra-company receivables and payables, and consolidation policy. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. Most major international auditing firms operate in the Philippines. Nevertheless, there are many cases of poor financial reporting by large companies.
Many small- and medium-sized businesses did not have quality financial statements. Publicly available financial information was often of low quality, arguably, because of the highly concentrated ownership of Philippine corporations, as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. Even for widely held public companies, the authorities, namely SEC and the Philippine Institute of Certified Public Accountants (PICPA), sometimes did not penalize independent auditors for poorly prepared audited financial statements. Corporate Control by Controlling Shareholders As in many other Asian countries, controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups, which are usually controlled by holding companies. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the groups management. They allow risk pooling and can achieve economies of scale in management, marketing, and financing. However, they also make it easier for controlling shareholders to expropriate interests of minority shareholders. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. When control rights exceed cash flow rights, large shareholders can use their control to transfer wealth from a company in a business group where they have low cash flow rights to another where they have high cash flow rights, e.g., from a minority-controlled to a majority-owned subsidiary. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258.6 billion, they formed the largest group of corporate entities in the Philippine stock market in 1997, accounting for 27 percent of the total stock market capitalization that year. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). Family-based controlling shareholders use them as vehicles for controlling business groups. Pure holding companies can be privately owned, which are closely held by large shareholders and family members, and publicly listed, which are controlled by large shareholders with public investors in a minority position. Selective public listing is a strategy of many business groups for channeling funds from public investors to member companies. Controlling shareholders usually select member companies that require large
equity investment for public listing. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. Some holding companies are not pure holding companies. They are operating companies but at the same time have majority or minority share ownership in other operating companies. In cases of minority ownership, controlling shareholders of a parent company hold these shares as strategic investments that they could increase or reduce depending on business opportunities. These investments can be classified according to the role of the controlling shareholders in the management of the invested company, namely, active minority or passive minority holdings. In an active minority-owned operating company, the parent company plays an active role in management. Depending on the performance of the company, controlling shareholders of the parent company may eventually increase their shares to a majority position. In a passive minority-owned operating company, controlling shareholders of the parent company do not participate in management. They may have a representative in the board. Controlling shareholders gain additional leverage in management control over minority-owed companies. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. Minority-owned companies may also need access to resources of the group, especially its management, financing, and customers. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate, Ayala Corporation, as an example (Figure 3.1). Ayala Corporation is a publicly listed pure holding company. It is majority-owned by Mermac, Inc., a family-owned pure holding company, with 59 percent of shares. Public investors collectively hold a minority of 41 percent. Ayala Corporation then holds a sufficient number of shares to achieve various degrees of control in two types of holding companies and two types of operating companies. It has a majority control at 71.1 percent of Ayala Land, minority control at 42.4 percent of Bank of the Philippine Islands, an active minority share at 44.6 percent of Globe Telecom, and a passive minority investment at 15 percent in Honda Cars (Philippines). The first three companies are publicly listed while the fourth, Honda Cars (Philippines), is privately owned. Ayala Corporations majority- and minority-controlled operating companies are also holding companies. Ayala Land fully owns Makati Development Corporation and holds a minority stake, at 47.2 percent, of Cebu Holdings (a publicly listed government-owned company).
Figure 3.1 Corporate Control Structure: The Case of Ayala Corporation
Family Members 100% Mermac, Inc. (58.96%) Privately-Held Pure Holding Company
Public Investors
(41.04%) <50% Ayala Corporation
>50%
Publicly Listed Pure Holding Company
>50% MajorityControlled Operating and Holding Company Ayala Land (71.06%)
<50%
>15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.6%)
<15% Passive MinorityOwned Pure Operating Company Honda Cars Phils., Inc. (15%)
MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.44%)
>50% MajorityControlled Pure Operating Company Makati Development Corporation (100%)
<50% MinorityControlled Pure Operating Company Cebu Holdings, Inc. (47.2%)
>50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%)
<50% MinorityControlled Pure Operating Company
Note: Data as of 31 December 1998.
Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank, a privately owned company. The control of companies through indirect corporate shareholdings, defined as control by large shareholders of an operating company through minority ownership by several companies, is illustrated in the Lopez Group (Figure 3.2). Being in the public utilities sector, companies in the Lopez Group are large and minority-controlled. MERALCO, Rockwell Land, and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company, Benpres Holdings, and a minority-controlled holding company, First Philippine Holdings Corporation. The Lopez Family owns a significant portion of shares of these companies if these indirect shareholdings are summed up and attributed to the beneficial owners. Generally, however, indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector.10 The Ayala familys control rights over BPI was 1.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group.11 The Lopez familys control rights over MERALCO was 5.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.12 These examples show that even when large shareholder groups are minority shareholders, they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. The situation offers large shareholders tremendous incentive to move resources
10
For details, see the World Bank research papers by Stijn Claessens, Simeon Djankov, and Larry H. P. Lang: 1999a, The Separation of Ownership and Control in East Asian Corporations; 1999b, Expropriation of Minority Shareholders: Evidence from East Asia; and 1999c, Diversification and Efficiency of Investment by East Asian Corporations. See also Stijn Claessens, Simeon Djankov, Joseph P. H. Fan, and Larry H. P. Lang, 1998, Who Owns and Controls East Asian Corporations? 11 Ibid. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.44%] / [58.98% x 42.44%] = [42.44%] / [25%] = 1.7 times Ibid. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1.64% +37.5%] / [(88.3% x 1.64%) + (37.5% x 14.76%)] [39.14%] / [1.3% x 5.5%] [39.14%] / [6.8%] 5.7 times
12
Figure 3.2 Corporate Control Structure: The Case of Lopez Group

Public Investors
Family Members
Lopez, Inc.
Privately-Held Pure Holding Company 88.3%
11.7%
62.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation
Benpres Holding Corporation
Majority-Controlled Publicly Listed Pure Holding Company
Manila Electric Company
1.64%
MinorityControlled 14.76% Operating Company MinorityControlled 24.5% Operating Company MajorityControlled Operating Company
Rockwell Land Corporation
24.5%
First Philippine Industrial Corporation
50%
50%
Note: Data as of 31 December 1998.
from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. 3.3.3 The Role of Creditors in Corporate Control
This study examines the role of creditors in corporate control by looking at (i) how corporate borrowers perceive the control power of their creditors, and (ii) how the legal framework protects creditor interests and rights. Control by Creditors According to the ADB survey, a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. The average company, the data suggest, accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans, whether for working capital or capital expenditure. However, it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. The survey results also revealed that creditors did not intervene in the management of borrowing companies and wanted to maintain business relationships with corporate borrowers even when they were in trouble. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management, while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. Suspension of Payments of Debts Under PD 902-A, SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan
agreement. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. There are two modes of suspension of payments under PD 902A. The first mode is for simple suspension of payments, under which, a companys assets are of sufficient value to cover all of its debts; the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. Under this mode, it is not clear whether the corporate borrowers assets are of sufficient value to cover its liabilities. An impending conflict between the two parties could result in dissipation of assets of the company due to creditors action to liquidate the companys assets they hold as collateral. Under such circumstances, SEC could intervene to avoid asset dissipation. The borrower will propose a rehabilitation plan to SEC, which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. There are no legal or practical limits to the time period of suspension of payments. The law on suspension of payments envisions resetting the corporations business for a temporary period to prevent its irreversible collapse. In practice, the litigation process, including the rehabilitation of the corporation, could take an indefinite period. For example, SEC and the court required that the creditors of BF Homes, Inc., a real estate-based business group, wait for 14 years from the time the company petitioned for suspension of payments in 1984. The corporation continued to be under rehabilitation receivership as of June 1999.
3.4 3.4.1
Corporate Financing The Financial Market and Instruments
The Philippine financial market has remained underdeveloped compared with other countries in the region. Commercial banks hold about three fourths of the resources of the financial system. Consequently, bank credit is the main source of corporate financing. Markets for equity and debt instruments are small and there are serious structural problems that discourage large, profitable companies from going public. Publicly listed companies do not represent a cross section of the Philippine corporate
sector. Of the 221 companies listed in the Philippine Stock Exchange in 1997, only 84 had sales large enough to be placed in the top 1,000 companies. Most publicly listed companies issue only up to 20 percent of total shares to the public, the minimum required to qualify as a public corporation. As a result, most listed companies are controlled by their five largest shareholders. The Philippine stock market is not a liquid market. Table 3.14 shows that the average volume of daily trading in 1997 stood at P2.4 billion (or $59 million using the average exchange rate). Foreign funds were wary of the Philippine stock market because of its limited liquidity. They invested in only a few large companies whose shares were relatively liquid. The market capitalization of the Philippine stock market in August 1997, about the size of Thailands, was one of the smallest in the region at $47.7 billion, compared with Malaysia ($186 billion), the Republic of Korea (henceforth, Korea) ($143 billion), and Indonesia ($61.5 billion). The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e.g., Korea and Thailand). Malaysia, however, is far ahead of the flock. Interest rates, inflation, and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. From the 1970s up to the early 1990s, the country experienced double-digit inflation. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills, while interest rates were at high levels and volatile. The stock market was depressed up to the early 1990s. Rising stock prices during the Ramos administration reflected to some extent the business optimism. The period 1993-1997 was one of lower inflation and declining lending rates. Equity financing through IPOs was active. However, the collapse of the stock market during the Asian financial crisis suggested that the earlier stock price surge in part reflected the bubbles common to other stock markets in the region. The crisis affected the Philippine corporate sector, but not to the same extent as it did in other Asian economies. In part, this is because, compared with other economies, Philippine companies were less leveraged, less exposed to foreign debt, especially short-term debt, and less engaged in risky investments. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. Foreign portfolio investments also remained small. Even in the real estate sector, companies expanded only at a moderate pace. Equity instruments include common stocks, preferred stocks, and convertible securities. The corporate sector raised a substantial amount of
Table 3.14 Philippine Stock Market Performance, 1983-1997

Daily Trading Volume (P million) 129.5 72.7 207.9 114.3 158.3 314.4 728.7 1,445.6 1,515.9 2,686.0 2,373.2 ($ million) 6.2 3.4 9.3 4.1 5.9 12.5 26.3 59.2 57.8 102.2 59.4 Ratio of Market Capitalization to GDP 0.1 0.0 0.0 0.1 0.1 0.1 0.3 0.2 0.2 0.3 0.7 0.8 0.8 1.0 0.5
Year 369.1 524.5 571.9 608.9 682.8 799.2 925.4 1,077.2 1,248.0 1,351.6 1,474.5 1,692.9 1,906.3 2,171.9 2,421.3
Market Capitalization (year end, P billion)
Gross Domestic Product (current prices, P billion)
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
19.5 16.5 12.7 41.2 61.1 88.6 261.0 161.2 297.7 391.2 1,088.8 1,386.5 1,545.7 2,121.8 1,251.3
= not available. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986. Source: PSE databank.
equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. From 1988 to 1997, about 127 companies went public with a total value of offerings of about P134.6 billion, of which 85 percent was raised from 1993 to the first half of 1997. Because existing shareholders wanted to retain their proportionate control over their companies, the rights issue was a popular way of raising equity capital. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. Debt instruments include negotiated credits and debt securities. Negotiated credits, which were the principal source of corporate financing in the Philippines, include bank credits, asset-backed credits, leases, discounting of receivables, and inventory financing. Debt securities include commercial papers and corporate bonds. Only a few large companies floated commercial papers because of the limited market, tight regulations, and high transaction costs. Under SEC regulations, issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc., which ultimately influences the pricing of commercial paper issues. The underwriter, which in most cases is an affiliate of the issuing company, sells these commercial papers through brokers. The largest buyers have been commercial banks, which buy commercial papers either for their own account or for their clients. Corporate bonds are another type of debt securities. However, corporate bond issuing was even more limited. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. The corporate bond market was stunted, moreover, by volatile interest rates and the absence of a secondary market. The picture of the financial system that emerges is thus one of limited capital markets, lack of competition among financial institutions, and the dominance of large commercial banks. Capital markets cannot provide the market discipline that corporate investors need. Only the commercial banks, by virtue of their large stakes in the financial system, are in a position to provide such discipline. However, because business groups often own large commercial banks, a strong regulatory system for bank supervision is imperative. 3.4.2 Patterns of Corporate Financing
The study looked at retained earnings, new equity, and debt as sources of corporate financing by using flow of funds analysis. The measures used in the analysis are:
(i)
(ii)
(iii)
(iv)
(v)
Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets. It measures a companys capacity to finance growth in fixed assets by internally generated funds; Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. It measures a companys capacity to finance asset growth by internally generated funds; New equity financing ratio (NEFR): ratio of changes in stockholders equity (excluding retained earnings) to changes in total assets; Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. It measures a companys reliance on borrowings in financing asset growth; Incremental equity financing ratio (IEFR): ratio of changes in shareholders equity inclusive of retained earnings to changes in total assets. It measures a companys capacity to finance asset growth by equity capital. By definition, it is one minus IDFR.
All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines from 1988 to 1997. As shown in Table 3.15, during this period, the average SFRF was high at 109 percent. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector. On the other hand, the SFRT was low at Table 3.15 Financing Patterns of the Corporate Sector, 1989-1997
Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.1 0.1 0.4 0.5 0.5 0.4 0.2 0.2 0.6 0.4 1.4 0.5 0.4 0.2 0.8 0.9 0.3 0.4 0.3 0.7 0.5 0.2 0.3 0.5 0.5 0.9 0.3 0.3 0.4 0.6 0.9 0.1 0.3 0.6 0.5 0.8 0.0 0.4 0.5 0.5 2.8 0.0 0.1 0.9 0.1 Average 1.1 0.2 0.3 0.5 0.5
Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, 1988-1997.
only 19 percent, implying that internal funds were far from sufficient to finance growth in total assets. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. There were significant year-to-year variations. In periods of an economic crunch such as in 1989, 1991, and 1997, the SFRF was higher. Companies financed fixed assets from internal sources in hard times. In all the years, internal funds were not a significant source of financing growth in total assets, except in 1991, when it financed 45 percent of it. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. In 1997, retained earnings declined and few new equity investments flowed into the corporate sector. Total assets grew by 23 percent that year, with debt providing 93 percent of the financing requirements. As a result, the level of corporate leverage increased. It can also be observed that the relative importance of stockholders equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997. This was mainly caused by the declining contribution from retained earnings, suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. Corporate Financing by Ownership Type As shown in Table 3.16, for all three types of companiespublicly listed, privately- and foreign-owned, debts were the most important source of financing. Retained earnings were the least important, except for foreignowned companies that had a negative new equity financing ratio, reflecting the capital flight caused by political instability in the early 1990s. On Table 3.16 Corporate Financing Patterns by Ownership Type, 1989-1997
Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa
a
Publicly Listed 1.3 0.3 0.3 0.5 0.5
Privately-Owned 0.8 0.2 0.3 0.6 0.5
Foreign-Owned 1.7 0.2 (0.0) 0.9 0.1
Excludes negative balances. Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, 1988-1997.
average, publicly listed companies relied more on new equity financing than privately- and foreign-owned companies. Foreign-owned companies relied more heavily on debt financing, contributing 90 percent of growth in total assets, compared with 47 percent for publicly listed companies and 55 percent for privately-held firms. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.17. It presents a composition analysis of assets and financing sources for the period 1992-1996. The sector built up its short-term debts, especially bank loans, significantly Table 3.17 Composition of Assets and Financing of the Publicly Listed Sector, 1992-1996 (percent)
1992 Assets Cash and Temporary Investment Accounts Receivable Inventory Other Current Assets Total Current Assets Investment Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Debt Other Long-Term Debt Other Long-Term Liabilities Total Liabilities Stockholders Equity Total Liabilities and Stockholders Equity 14.7 13.5 12.7 2.4 43.3 10.2 42.3 4.2 100.0 12.2 12.2 3.5 27.9 16.8 0.0 6.8 51.6 48.4 100.0 1993 14.0 13.3 11.7 2.4 41.3 12.5 41.8 4.4 100.0 10.9 12.2 3.6 26.8 17.6 0.1 7.2 51.6 48.4 100.0 1994 19.3 12.0 9.4 2.6 43.4 12.9 38.9 4.8 100.0 9.4 10.4 3.7 23.5 16.5 0.0 8.3 48.3 51.7 100.0 1995 1996
13.7 13.3 12.1 13.0 10.5 9.8 3.4 2.8 39.8 38.9 16.9 16.0 38.6 37.7 4.7 7.4 100.0 100.0 9.3 10.9 3.9 24.1 15.8 0.1 9.1 49.1 50.9 100.0 9.3 13.8 3.8 26.8 16.9 0.1 10.0 53.8 46.2 100.0
Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, 1988-1997.
in 1996 and became more vulnerable to the financial crisis in 1997. The traditional measure of liquidity, the current ratio,13 was at 1.45 in 1996, indicating that many publicly listed companies were likely to be in a tight liquidity position. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets, their inherent ability to pool risks, the easier access to external credit, and economies of scale in fund raising. As shown in Table 3.18, the average SFRF of business groups was higher compared with that of independent companies. On average, retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups, as opposed to 94 and 30 percent, respectively, for independent companies. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. Table 3.18 Financing Patterns by Control Structure, 1989-1997
Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa
a
Group Member 1.1 0.2 0.3 0.5 0.6
Independent Company 0.9 0.3 0.3 0.5 0.5
Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, 1988-1997.
Group companies financed an average of 45 percent of growth in total assets by debt, compared with an average of 54 percent for independent companies. Group companies were generally more profitable than independent companies. Further, group companies usually financed their investment in member companies by equity rather than debt. For these two reasons, group companies were less reliant on debt financing than
13
Defined as total current assets divided by total current liabilities. The normal standard liquid position is a current ratio of 2 or higher.
independent companies. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. Corporate Financing by Firm Size SFRF was highest for medium-sized companies, with an average of 3.06. The corresponding ratio was 0.76 for small companies and 0.88 for large companies (Table 3.19). The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets. With assets growing at a fast pace during this period, medium-sized companies used more debts, averaging 61 percent of growth in total assets, compared with 55 percent for large companies and 47 percent for small ones. Table 3.19 Financing Patterns by Firm Size, 1989-1997
Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa
a
Large 0.9 0.2 0.3 0.6 0.5
Medium 3.1 0.3 0.2 0.6 0.4
Small 0.8 0.2 0.3 0.5 0.5
Excludes negative balances. Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, 1988-1997.
The medium-sized companies high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. These years were 1991 with 110 percent, 1993 with 96 percent, and 1997 with 131 percent. Large companies IDFR of 0.55 was substantially higher than the small companies 0.47. Large firms consistently increased their reliance on debts from 1994 to 1997. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.08 and SFRT of 0.50 (Table 3.20). On average, equity financed 42 percent of incremental asset growth. There was also increased reliance on debt financing. Excluding
1991, when debts declined, the manufacturing industry financed 57 percent of its total asset growth by debt. While this level is considered prudent, the total debt ratio was much higher in 1996 at 0.79 and in 1997 at 0.91. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. Table 3.20 Financing Patterns by Industry, 1989-1997
Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1.1 0.5 0.4 0.6 0.4 Construction 0.5 (0.2) 0.7 0.5 0.5 Utilities and Real Estate Services and Property 0.3 0.3 0.3 0.6 0.4 3.6 0.3 0.4 0.4 0.6
a Excludes negative balances. Source: SEC-BusinessWorld Annual Survey of Top 1,000 Corporations in the Philippines, 1988-1997.
The real estate industry financed its growth by substantial equity funds. Up to 1997, the industry generated internal funds, achieving an average SFRF of 3.58 and SFRT of 0.27. Equity financed an average of 62 percent of total asset growth. During the crisis year, debt financed about 78 percent of asset growth in real estate. In the eight years preceding the crisis, the incremental equity ratios of the industry were high, ranging from 41 to 118 percent. Equity financed the rapid expansion in the industrys assets in the period 1994 to 1997. Since the real estate boom coincided with that of the stock market, many of the leading real estate companies successfully went public during that time. The construction sector was a heavy user of debt financing. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. The utilities sector showed weaknesses in internal fund generation in 1989-1994, with an SFRF as low as 0.04. The situation improved beginning 1994, increasing to 0.47 two years later. Excluding 1997 when fixed assets declined, SFRF for the sector averaged 0.32, while SFRT averaged only 0.29. The effects of the crisis of 1997 were adverse. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. Incremental equity financing amounted to an average of 44 percent of total asset growth. The sector had the highest leverage among all industries that year.
3.4.3
Ownership Concentration, Financial Leverage, and Performance
Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.14 Large shareholders may borrow excessively to undertake risky projects, knowing that if an investment turns out to be successful they could capture most of the gain; while if it fails, creditors bear the consequences. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. Using the PSE database, the degree of ownership concentration, measured by the percentage of shareholdings of the largest five shareholders, was regressed against measures of profitability and of financial leverage. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA, ROE, and leverage, alternatively, as the dependent variable. As shown in Table 3.21, the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. ROE, ROA, and financial leverage are all positively and significantly related to the degree of ownership concentration. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and, at the same time, more profitable.
Table 3.21 Ownership Concentration, Profitability, and Financial Leverage

Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.00056 1.769 0.004 3.130 ROA 0.00036 2.287 0.008 5.230 Leverage 0.00125 2.421 0.009 5.860
Leverage = the ratio of total assets to total equity, ownership concentration = the total shareholdings of the top five shareholders, ROA = return on assets, ROE = return on equity. Source: Authors estimates based on the PSE databank, 1992-1996.
14
See for example Michael Jensen (1993), The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, Journal of Finance 48: 831-880.
3.5 3.5.1
The Corporate Sector in the Financial Crisis The Financial Crisis: Causes and Manifestations
A devaluation of the local currency signaled the arrival of the financial crisis in 1997. The Government explained that the country had sound economic fundamentals but that the problems were caused by contagion. The Governments judgment that economic fundamentals were strong was based on stable growth rates, which averaged 4.5 percent per year from 1992 to 1997. Although much lower than those of other Asian countries, the countrys GDP growth pace indicated that it did not have a bubble economy, that is, an overexpansion of capacities. The costs of an economic correction brought about by the regional financial crisis were thought probably to be low due to the sound structure of the real economy and the strong position of the financial sector. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. The largest contributors to GDP were services at 43 percent, industry at 34 percent, and agriculture at 21 percent. Exports were growing at about 20 percent per year in the three years preceding the crisis. Manufactures accounted for about 85 percent of exports, with commodities accounting for the balance. The export sector had a very narrow breadth. In 1997, more than half (52 percent) of exports were semiconductors. Garments was the second largest export sector at about 9 percent, but its share had been declining by 4 percent per year since 1995. Commercial and industrial activities in the country were largely oriented to domestic markets. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment), raw materials, and intermediate goods. Net trades in goods and services averaged a deficit of 4.8 percent of GDP from 1995 to 1997. The country experienced balance of payments surpluses but these were due to transfers, notably remittances of overseas workers. In sum, the economy still showed vestiges of its import-dependent and substituting character, with a narrow exporting industry base. Compared to other East Asian crisis-affected countries, the country was less dependent on foreign private capital. Net investment inflows were $3.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. Historically, foreign investments in the country have been low, their growth gathering momentum only beginning in 1992. Because of limited local capital, the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. After a
long period of debt moratorium and restructuring that started in 1983 and ended in 1991, the Government sought stability and achieved this in 19921997. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. Eventually, the Government restructured its debts into longer tenors with a maximum of 25 years. During this time, the country and the corporate sector had no access to foreign currency debts from the international financial market, unlike their counterparts in the region. The lessons from debt restructuring became the basis for the Governments economic policies. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3.5 percent, an average inflation rate of 7.8 percent, an average Treasury bill rate of 13.1 percent, a government fiscal surplus from 1994 to 1997, a positive balance of payments from 1992 to 1996, and a relatively healthy banking system. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors, adjustments were focused on the quantity and quality of the banking systems corporate loans, which, in turn, depended on the quality of the corporate sectors investments. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10.6 billion as of March 1997. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. In the Philippines, the discipline of the loan moratorium and the restructuring of the countrys loans to long-term maturity kept this ratio below 100 percent up to September 1997. After hovering in the range of 100 to 127 percent, the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin, resulting in stability in the short-term debt to reserves ratio. The corporate sector was in a relatively stable financial condition around the time of the crisis. Profitable operations since 1992 had allowed it to build equity, fueled also by successful IPOs during the stock market boom of 1993-1996. Total debts were only 52 percent of assets or 108 percent of equity. From 1988 to 1996, average ROE was 13.3 percent. Closer analysis, however, shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. From 1993 to 1997, assets grew at a compound annual rate of about 31 percent, while sales grew by only 20 percent per year.
The corporate sector indeed overexpanded after 1993 like its counterparts in the region, but to a lesser degree. Debts financed a large part of this expansion, growing by about 34 percent per year from 1994 to 1997. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. Most of this leverage happened during the boom years in the region. These patterns in investment and financing are similar to those of other countries in the region. In sum, the countrys economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive contagion effect of optimism by investors and creditors about the region. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative contagion. 3.5.2 Impact of the Crisis on the Corporate Sector
Aside from the foreign exchange adjustment, the other immediate impact of the crisis was that on foreign investment flows. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.22). Foreign investments in the Philippines have not been as high as the inflows to other Asian countriesand this, precisely, mitigated the effects of the pullout and liquidation of investments in the aftermath. Net foreign portfolio investment amounted to $1.5 billion in 1995, or 114 percent of net foreign direct investment (FDI). It rose to $2.101 billion or 196 percent of net FDI in 1996. In 1997, net FDI remained stable at more than $1 billion. It financed 26 percent of corporate capital growth. But portfolio investment amounting to $406 million flew out of the Philippines. Table 3.22 Foreign Investment Flows, 1995-1998
Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1,609 1,300 1,485 145,303 23.0 1996 3,517 1,074 2,101 92,718 30.4 1997 762 1,073 (406) 121,749 26.0 1998 739 555 328 69,650 32.7
Note: Peso-dollar exchange rates used are: 1995 = 25.71; 1996 = 26.22; 1997 = 29.47; 1998 = 41.06. Data for 1998 cover only January-August. Sources: Bangko Sentral ng Pilipinas and SEC.
Corporate financial performances and conditions deteriorated during 1997. Net profit margins were at a 10-year low at 4.9 percent, ROE at 6.2 percent was barely above inflation rate, and leverage increased to 149 percent compared with 109 percent in 1996. Companies deferred investments in new fixed assets. Because of weak internal fund generation, new borrowings financed asset growth. With the increase in borrowings and reduced liquidity, the corporate sector became vulnerable to loan calls and high interest rates. Loan calls, in turn, depended on the liquidity and capital position of commercial banks, which held about 75 percent of the assets of the financial system in 1997. The resources of the financial system that year totaled P3,369 billion, with commercial banks holding P2,513 billion. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. By March 1988, the commercial banking sectors capital remained strong at 17.3 percent of assets. A number of small banks closed but they represented less than 1 percent of the financial systems total resources. The real problem of the corporate sector during the crisis was the rise in interest rates. Because commercial banks were strongly capitalized, they were willing to restructure and renegotiate existing loans by corporate borrowers, albeit at current market interest rates. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. The interest rates on Treasury bills, meanwhile, ranged from 11 to 13 percent from 1993 to July 1997, then rose to a high of 22.7 percent in January 1998, sparking a rise in interest rates on corporate loans. Average bank lending rates climbed to their peak of 25.2 to 28.2 percent in November 1997. Lending rates were well above the 20 percent level from July 1997 to March 1998. Although corporate borrowers were not highly leveraged, they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. When the Treasury bill rates eased in March 1998, lending rates also came down, suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. The combined effects of shrinking demand and high interest rates reduced the corporate sectors demand for loans. Loans outstanding of commercial banks declined by the first quarter of 1998, in varying degrees for each sector. By October 1998, the sectors with the highest outstanding loans had reduced their credit exposures. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels; and the wholesale and
retail trade sector, by 12 percent. However, loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. These figures show that adjustment problems were industry-specific and that the real estate industry, as with its counterparts in other Asian countries, was a problem sector. In March 1997, real estate loans averaged 11.9 percent of bank loan portfolios. These peaked at 14.3 percent in December 1997, and subsequently went down to 13.6 percent in June 1998. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. As for nonperforming loans (NPLs), the ratio increased to a high of 11.5 percent by September 1998. But the Philippine banking system had gone through worse crises in the past, and its experience of low, single-digit NPL ratios began only since 1989. Still, the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the countrys last major banking crisis in 1984-1986. 3.5.3 Responses to the Crisis
Government Responses The Governments policy and regulatory responses to the crisis focused on monetary and credit issues, the fiscal position, and the financial system. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts, set limits on overbought/oversold foreign exchange positions of banks, and set up a hedging facility for borrowers with foreign currency-denominated loans. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. The Central Bank also moved to control inflation and bring down domestic interest rates by reducing the statutory reserve requirement by 3 percentage points and raising the liquidity reserve ratio by the same amount. The move retained the liquidity position of banks but lowered their cost of reserves, thereby reducing overall intermediation costs. This allowed the Central Bank to convince the banks, through the Bankers Association of the Philippines, to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1.5-6 percent. This voluntary agreement partly explains why the loan spreads of banks were within the range of recent experience. The Central Bank adopted other measures to strengthen the financial system, including (i) a regulatory limit of 20 percent on banks loans to the
real estate sector; (ii) shortening the period for classifying unpaid loans as past due from three months to one month; (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts; (iv) increasing banks capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks; (v) improving disclosure requirements on the financial position of banks; and (vi) issuing guidelines on duties and responsibilities of banks boards of directors for improved quality of bank management. The policy directions and actions taken by the Government appear to have ushered in recovery. The economy avoided a recession in 1998 and achieved 3.6 percent growth in 1999. With prudent monetary management, the Government kept inflation below 10 percent. Average Treasury bill rates have cooled since mid-1998. In response to calls for lower bank intermediation costs, bank loan rates have also come down. The real estate portfolio of commercial banks also declined and was well below the Central Banks regulatory ceiling by March 1998. Responses of the Corporate Sector The corporate sectors financial position, its accessibility to foreign capital, and the legal framework for reorganization and liquidation conditioned its response to the crisis. With its weakened financial position, the corporate sector dealt with the crisis as any company facing a recession and drying up of credit wouldcompanies cut costs by reducing staff, changing technologies, subcontracting and outsourcing, consolidating business units, and giving up noncore businesses. Financially strong companies were able to survive the crisis by effecting such internal restructuring. Large companies with heavy loan exposures such as Philippine Airlines Inc. (PAL), the countrys flag carrier, took more action. PAL, which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership, came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. In the case of PLDT, the largest telecommunications setup in the Philippines, the Asian crisis opened a unique opportunity for foreign investors. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. The acquiring company, First Pacific Corporation, was known to have a policy
of investing to control companies that are dominant players in their industries. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. One mode was the outright purchase of shares in the open market. Consequently, the stock price of PLDT was buoyant during the takeover period. A second method was to purchase the shares of other large minority shareholders. PLDTs large minority shareholders such as the SSS and First Philippine Fund publicly announced their willingness to offer their entire holdings in a block sale at a premium. A third method was to make a formal tender offer to PLDTs controlling minority shareholders, the Cojuangcos, at a premium over the market price to reflect the value of management control. First Pacific, using some or all of these means, eventually took over PLDT and announced a restructuring plan for the entire group of companies. SMC is another widely-held company managed by a minority shareholder, the Soriano family. In a legal process that ended in his takeover of management, Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. Although considered the prime industrial company in the Philippines, SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. Its stock price and returns to shareholders had stagnated. When Cojuangco took over, he restructured the company toward its core brewery business and sold off local and foreign subsidiaries.
3.6 3.6.1
The Philippine corporate sector has been shaped by the countrys economic and industrial development policies. Ownership is highly concentrated and a few dominant players control major industries. Corporate governance is conditioned by the high ownership concentration of these large companies. When companies are highly profitable, controlling shareholders can capture these profits by excluding public investors from ownership. By itself, concentrated ownership of companies is not equivalent to weakness in corporate governance. It may even solve agency problems that a separation of control and ownership could precipitate because large shareholders have an incentive to closely oversee management. The question, however, is whether there are sufficient safeguards to prevent controlling shareholders from
expropriating the wealth of minority shareholders through aggressive and risky investment. With large shareholders in control, minority shareholders need to be protected by external control mechanisms. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders, oligopolistic market structures, an underdeveloped capital market, ownership of banks by business groups, an ineffective insolvency system, passive independent auditing, and the lack of market for corporate control. The result is that corporate governance depends only on internal controls. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. Returns to capital exceeded inflation rates. Leverage was within Asian norms but above developed country standards. By ownership structure, foreign companies were the most profitable but highly leveraged. Privately-owned companies, the most numerous in the corporate sector, were the least profitable. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. By control structure, companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. By size, medium companies showed higher profitability than large and small ones. Performance was, to some extent, influenced by industry characteristics, with the real estate and public utilities industries standing out for their pronounced cyclical patterns. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. Ownership of publicly listed companies is highly concentrated. The five largest shareholders have majority control of an average publicly listed company, while the largest 20 shareholders control more than 75 percent of shares. Financial institutions are not significant shareholders. Forming business groups appears to be a viable means of competing because this allows for more efficient organization and utilization of resources of large controlling shareholders. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings. Analysis of corporate financing by ownership
type gave similar results, with the foreign-owned companies found to rely more on borrowed funds. After controlling for industry effects, statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. ROA, ROE, and leverage were all positively related to the degree of ownership concentration. The positive relationship between financial leverage and ownership concentration is consistent with the hypothesis that controlling shareholders prefer to use debt financing in order to avoid ownership dilution. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. Publicly listed companies were responsive to investors requirements for prudent use of debts. Ownership concentration was positively related to both returns and leverage. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. Large companies owned or controlled by business groups tend to dominate their industries. A business group is an effective business organizational model for achieving leadership in industries, superior profitability, and sustained growth. A commercial bank is an important part of most business groups. Even in cases where the group owned only a minority share of a commercial bank, the bank usually accounted for a large share of each groups net profits. Large, family-based shareholders gain control by such means as the setting up of holding companies, selective public listing of companies in the group, and centralized management and financing. The pyramid model is useful for centrally managing smaller companies, as typified by the Ayala Group. Business groups with pyramiding structures heighten the issue of corporate governance. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. The difference between management control and ownership rights is usually substantial. Larger disparities in control over cash flow rights imply higher incentives for large shareholders to (i) expropriate wealth of shareholders not belonging to the controlling group and (ii) invest in empirebuilding and high-risk projects. The extent of governance problems depends on internal control policies of the controlling shareholders, the amount of pressure from stock market investors and PSE (for publicly listed companies in the group), and the extent of supervision of outside institutions such as independent auditors and SEC.
The financial crisis came when the Philippine economy was in a relatively strong financial position, with recently restructured public debt, a strong international reserves position, low inflation, the government budget in surplus, and a market-oriented policy environment. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years, strong capital position built on IPOs in a buoyant stock market, and sound overall creditworthiness. The corporate sector accessed the foreign debt market only in the mid-1990s because of the countrys long-drawn debt moratorium. Still, there was a sharp rise in borrowings and decreasing productivity of investments a few years before the crisis in a pattern similar to that of Asian crisis countries. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates, adversely affecting companies operations and financial position. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. As the crisis wore on in 1998, there were sharp rises in the number of bankruptcies and petitions for debt relief, mostly by highly leveraged companies and speculative investors in real estate. The Central Bank imposed strict limits on real estate lending, resulting in the banks accelerated restructuring of troubled debts in this sector. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. This law is flawed in concept because it supplants a market-based credit agreement with a political process. That is, SEC officials, rather than the banks that lent millions of pesos, decide on the financial future of a troubled debtor. Under the new Securities Regulation Code enacted in 2000, SECs quasijudicial functions, including suspension of payments, are to be removed and transferred to courts. 3.6.2 Policy Recommendations
The Government should address weaknesses in corporate governance identified in this study by introducing reforms in the policy and regulatory framework and promoting the development of markets. Specific actions recommended are described below. Promoting a Broader Ownership of the Corporate Sector The highly concentrated ownership of the publicly listed corporate sector should be a concern of SEC and PSE. There are systemic risks involved in highly concentrated ownership. For example, decisions by large sharehold-
ers often cause wide volatility in stock prices and invite reaction from creditors. The following recommendations involve amendments to the Corporation Code that will improve transparency of ownership and address the current high level of ownership concentration in Philippine business: (i) require disclosures of underlying ownership of shares held by nominees and holding companies; (ii) require disclosure of material changes in ownership; and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent, depending on the size of the company, to 25 percent. The adjustment should be made over a fixed period of time. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. Clear legal accountability is a precondition for successful shareholder activism. Another measure would be to impose a statutory limit on the number of directorships that one can accept. This may limit current practices of appointing prominent individuals and family members as directors. To strengthen the board, the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. Because independent directors tend to adopt the perspective of minority shareholders in board decisions, they serve to curb the powers of controlling shareholders. To help ensure this, PSE Listing Rules should specify criteria and a selection process that will help ensure that the nominees for the position are truly independent and qualified. Strengthening Minority Shareholder Rights An issue that concerns minority shareholders is whether they have instrumentslegal or ethicalthat can prevent controlling shareholders from expropriating their wealth through risky investment and financing, inadequate disclosures, insider information, and self-dealing. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. It has suffi-
cient case history that can be used as a basis for tightening its disclosure requirements. Minority shareholders have failed to use traditional venues such as the annual general shareholders meetings to discipline controlling shareholders that expropriate their wealth. They need legal empowerment such as higher majority voting requirements, e.g., raising the current two-thirds majority to a three-fourths majority. For example, current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. Because ownership is generally concentrated in five shareholders, the board can easily muster the needed majority to approve the deal. By requiring sufficient disclosure and a 75 percent majority vote on such decisions, the board will be compelled to initiate a thorough discussion of the merits of the proposed related-party deals that will require the participation of minority shareholders. Finally, the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks, and of banks in nonfinancial companies in order to avoid connected lending; (ii) set strict limits on lending by banks to affiliated companies, officers, directors, and related interests. Impose severe penalties for any attempt by banks to circumvent this regulation; (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards; (iv) require banks to follow international financial accounting, reporting, and disclosure standards; and (v) closely monitor, limit, or prohibit cross-guarantees by companies belonging to affiliated groups. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines, in particular, in areas of supervisory functions of the central bank, prudential measures and regulations, fit and
proper rule, foreign ownership of banks, transparency, and lending to DOSRI. Reforming the Legal and Regulatory Framework for Investment Funds and Venture Capital Owners of Philippine publicly listed companies consist of controlling shareholders and investors that hold trading portfolios. This investor profile has a missing middlelong-term investors who intend to participate in longterm growth of a company and who also trade shares depending on company performance. Investment and venture capital funds meet this description. In developed capital markets, institutional investors lead public investors in providing market signals to companies. This way, institutional investors can be a driving force in providing market discipline to management. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. Presently, SEC appears to be taking a primarily regulatory posture in the operation of investment funds. Its priority is to protect prospective fund investors from unscrupulous fund managers. By supporting the establishment and operation of institutional investors, SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. Institutional investors impose market discipline by voting on strategic corporate decisions. If institutional investors are present, an active financial analyst community can begin to form. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. Promoting Shareholder Activism Promoting shareholder activism to encourage small shareholders to actively monitor management is an approach that has not been tried out in the Philippines. Two measures should be adopted to promote shareholder activism. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors, management, and external auditors. The current law should expand class action suits to include management and
auditors. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders, their directors and management, and the external auditors. Legal provisions for class action suits should cover self-dealing by directors, compensation contracts, information disclosures, and dividend decisions. SEC should allow minority shareholders to be represented by activist groups. These groups have an incentive to gather technical expertise, leadership, and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders wealth. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. SEC should take steps to simplify the process of class action suits and provide an avenue for out-of-court settlements similar to practices in the US, where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. Expanding Debt Securities Financing The Philippine corporate sector relies on bank loans because controlling shareholders do not want to dilute their control by issuing equities. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. And by issuing Government Treasury securities in longer tenors, the Government could develop the market for future issues of corporate bonds. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. There are existing institutions such as Dun and Bradsreet, and Credit Information Bureau that can be the starting point of this effort. Securities market development efforts should coincide with strict regulation of the commercial banking sector. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies, guarantees, entry
and exit barriers, and various other forms of protection. The Governments competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. The Government should also continue to improve infrastructure, so that small- and medium-scale companies can become more competitive relative to large companies. Efforts to reduce graft and corruption, improve enforcement of the rule of law, and provide quality basic services should also be heightened. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance, there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. Many large companies remain privately owned, and publicly listed companies trade barely the minimum number of shares required for public listing. Lack of liquidity deters institutional investors. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. PSE and SEC need to build a liquid and efficient market. PSE should campaign for top-tier companies to go public and work with SEC in encouraging publicly listed companies to expand their share offerings to the public. SEC should require that a larger percentage of publicly listed companies shares be sold to the public. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. Audited financial statements contain basic information about a companys financial position and performance. Many of the problems associated with auditing and disclosure stem from the tendency of SEC and PICPA to be satisfied with replicating what their counterparts in the US require by way of audit standards and disclosures. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. Current disclosure requirements of SEC are not rigorous enough for public investors. Penalties for poor conduct of auditing by independent
auditors and the mechanism for imposing them are weak. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors, SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. Instead, violators were made to pay only nominal penalties. SEC and PICPA need to formulate more specific disclosure standards, review the system of penalties on professionals involved in a companys violation of disclosure rules, and implement those standards and penalties rigorously. Improving the Legal Framework for Suspension of Payments, Reorganization, and Liquidation. Reforming the legal framework for suspension of payments, reorganization, and liquidation of troubled companies should be made a priority of the Government. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. The law is obviously not in line with the Governments policy of allowing market mechanisms to work and not intervening in private sector business. The law on suspension of payments replaces a market-oriented solution with a political process. For that matter, it creates a moral hazard problem. Although the new Securities Regulation Code enacted in 2000 has removed some of SECs quasijudicial functions, including the resolution of intracorporate disputes, suspension of payments and private damage actions, and transferred these to courts, the new law needs to be effectively implemented and enforced.
References
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4 Thailand
Piman Limpaphayom1
4.1
Introduction
In May to July 1997, the Thai baht came under pressure from speculative attacks, heralding not only a financial crisis in the country, but also the stalling of East Asias economic miracle. After mounting an aggressive defense of the currency, the Thai Government conceded and adopted a floating exchange rate regime. Thailands crisis exposed similar vulnerabilities in other East Asian economies, with the currencies of Indonesia, Republic of Korea (henceforth, Korea), Malaysia, and Philippines all depreciating significantly. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. But it also laid bare weaknesses in both the financial and corporate sectors. The banking system, poorly regulated and sheltered from competition, had been plagued with prudential problems for a long time. It was inefficient in financial intermediation. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector, the banking system merely validated the financial risks. The corporate sector also contributed significantly to the crisis, with Thai corporations overutilizing short-term foreign currency-denominated loans. For the period 1994-1996, annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). In the prelude to the 1997 crisis, short-term private debt obligations grew to about 60 percent of total private sector debts. The majority of these debts were not properly hedged. As a result, Thai corporations were collectively overexposed to exchange rate risks. The fixed exchange rate policy, coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system, magnified the impact of these problems on the economy when the crisis hit.
1
Associate Professor, Faculty of Business, Asian University of Science and Technology, Chonburi, Thailand. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Stock Exchange of Thailand for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
There is now a consensus that weak governance was partly responsible for the corporate sectors poor financing and investment practices. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework, lack of transparency and adequate disclosure, and a family-based corporate ownership structure. This study examines these and other factors that might have weakened corporate sector governance in Thailand, focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). Section 4.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans, its growth and financial performance, as well as its legal and regulatory framework. Section 4.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. Section 4.4 provides an overview of Thailands financial markets and examines patterns of corporate financing and investment in the years prior to the 1997 crisis. Section 4.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. The study then considers policy recommendations with emphasis on corporate governance improvement.
4.2 4.2.1
The corporate sector has long been considered the engine of Thailands economic growth, with government policy providing support but avoiding direct interference. The country initiated national economic development planning in 1961 when the economy was growing rapidly. The National Economic and Social Development Board was created to plan the countrys economic and social development. The First and Second Plans (1961-1971) Under the first two plans, the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. Import tariffs on machinery and heavy equipment were removed. To protect domestic industries, the Government increased tariffs on products that could be produced locally, while new industries were encouraged to reduce the need for imports.
Chapter 4: Thailand 231
During this period, gross national product grew by about 7 percent per year, with the agricultural sector the major contributor. Industrial sector growth was also rapid and many industries (tires, textiles, chemicals, canned foods, processed steel, and automobile assembly) emerged. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. However, capital inflows, especially foreign aid from the United States, helped offset these deficits. Inflation levels were low, averaging 1.6 percent per year. Consequently, the value of the baht remained stable. The Third, Fourth, and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. External factors, including a weakening of the dollar, and increases in world food and oil prices, resulted in increases in the current account deficit, leaving the Government no choice but to resort to overseas borrowings. Budget deficits also increased throughout the Fourth Plan. Thus, the governments debt burden escalated. Inflation reached 15.5 percent in 1973 and 24.3 percent in 1974, remaining high until 1981. The Government had to shift emphasis to restoration of economic stability, using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. At the same time, it proceeded with its development plan for the industrial sector. As a result, the industrial sector grew at a faster rate than the agricultural sector. Unemployment, however, became a major problem as domestic investment declined. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. The focus shifted to export promotion, with the devaluation of the baht in 1984 a major step in this direction. The results were increased exports, an improved trade balance, and reduced current account deficits. The decline in imports was steady. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry, the current account registered a surplus in 1986. Budget deficits remained a major problem during the Fifth Plan, however. The average budget deficit reached an all-time high of $2.15 billion per year or 4.4 percent of GDP. To close the fiscal gap, the Government borrowed $6.4 billion from overseas and increased taxes on numerous items, including luxury goods. Average growth for the period was 4 percent per year, lower than anticipated due to a worldwide economic recession.
The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period, while exports expanded considerably. From 1989, the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. Growth rates during 1987-1991 ranged from 9.5 to 13.2 percent per year, averaging 10.5 percent. The manufacturing sector became a dominant force in the economy, increasing its share in total export value from 42 to 76 percent. The country also attracted a large amount of foreign direct investments (FDIs), reaching an annual inflow of $2 billion in 1991. Most of the FDIsoriginating mainly from Japan; United States; Singapore; Europe; and Hong Kong, Chinawent to export-oriented manufacturing industries. The exchange rate was steady at around B25 to the dollar. The Seventh Plan (1992-1996) The economys performance from 1992 to 1996 generally met the targets of the Seventh Plan. Average annual growth in real GDP was 8 percent, compared with the 8.2 percent target. Private sector investment grew at an average annual rate of 7 percent, lower than the target of 8.8 percent. Growth of exports and imports averaged 14.2 and 13.6 percent, respectively, compared with the 14.7 and 11.4 percent targets. Inflation was 4.8 percent, better than the 5.6 percent target of the Seventh Plan. Thailands rapid growth up to the mid-1990s made the country one of the worlds fastest-growing economies. Key to this growth performance was the governments adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. The countrys high ratings in the international capital market, combined with its liberal financial policies, invited a deluge of capital seeking profitable investments. Thailand became a debtors market, with private foreign debt reaching $92 billion by the end of 1996, from only $31 billion in 1992. On top of its predominantly borrowed nature, the bulk of domestic investments went to speculative ventures such as real estate, property development, and the stock market, rather than to productive activities. By 1995, an oversupply of housing emerged. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates, compounded by a slump in property sales, the property sector began to collapse in 1996.
Toward the end of the Plan period, the signs of an economy about to falter were there. Exports went into a tailspin, with growth shrinking from 23.8 percent in 1995 to 1.3 percent in 1996, on account of an overvalued baht that weakened export competitiveness. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. The deficits caused the Government to rely on even more external borrowing, which raised the debt service ratio. 4.2.2 Development of Capital Markets
Although the corporate sector has long been the governments main tool for economic development, the capital markets didnt play a significant role until 1975. Included in the Second Plan (1967-1971) was a proposal to establish the countrys first authorized and regulated securities market. Its most crucial role was to help mobilize funds to support Thailands industrialization and economic development. In 1969, a former Chief Economist from the US Securities and Exchange Commission, Sidney M. Robbins, prepared a comprehensive report entitled A Capital Market in Thailand, which later became the master plan for the development of the Thai capital market. In his report, Robbins recommended an overhaul of the existing informal stock market established earlier by a group of local brokers in favor of a centrally regulated institution. In 1972, the Government amended the Announcement of the Executive Council No. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare, extending its control and regulatory powers to the finance and securities companies operating freely at the time. In May 1974, the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. SET officially became the Stock Exchange of Thailand in 1991. In 1978, the Government passed the Public Limited Company Act, placing all publicly listed companies under regulation. However, many companies considered the Act too restrictive and a hindrance to growth. Before the capital market emerged, the corporate sectors main source of funding was the banks. And because the Government considered the banking system vital to the development of the economy, its policy had always been to protect domestic banks. Foreign banks were barred from competing directly with domestic banks, a policy that held throughout the first six economic development plans. Under the 1962 Commercial Banking Act, which was amended in 1979 and 1985, the Bank of Thailand and
the Ministry of Finance had full authority to supervise all commercial banks. At the end of the Sixth Plan, there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. With the liberalization of financial markets, Thai banks gained access to a variety of funding sources from around the world. The resulting availability of funds propelled the corporate sectors growth through the early part of the 1990s. However, the financial and banking laws were generally ineffective. The regulatory measures were inadequately designed and poorly enforced. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. While the Bank of Thailand had the regulatory power to influence business practices, it usually relied on moral suasion. The Government also granted financial institutions overly generous bailouts, creating a moral hazard problemthe perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. In the 1990s, Thailands capital market entered a new era with improved legislation and regulation, increased financial market activities, and new financial instruments. Laws were enacted to stimulate growth of the corporate sector. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws, while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. The introduction of these two laws came just after the Governments signing of Article VIII of an Agreement with the International Monetary Fund (IMF) in May 1990 to deregulate and liberalize financial markets. Thailand discarded controls on foreign exchange transactions and capital flowsa turning point for the Thai corporate sector. A number of internal and external factors contributed to the Thai Governments acceptance of the IMFs Article VIII agreement. Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Externally, the Government was under international pressure to deregulate the financial sector. Earlier, the World Bank had recommended such a move, and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. The pressure dovetailed with the Governments intention to make Bangkok one of the financial centers of the region, to cater specifically to its
fast-growing neighbors. Financial deregulation and liberalization were key to realizing that vision. The Bangkok International Banking Facility (BIBF) was thus established to facilitate international borrowings and encourage capital flows as a means of financing the current account deficit. The stock market boom from 1991 until the financial crash of 1997 reflected international investors response to Government policies. The result was a corresponding growth and development in Thailands capital markets. Worldwide, the country became recognized as an economic development model for other emerging economies. 4.2.3 Growth and Financial Performance
Since the 1978 enactment of the Public Limited Company Act, about 661 companies with total registered capital of B2.1 trillion and paid-up capital of B1.3 trillion have been registered with the authority (Table 4.1). The majority of the companies are in manufacturing, finance, and wholesale/ retail trade and restaurant/hotel sectors, in that order. In terms of capital, however, the financial sector is the largest, with B1.4 trillion in registered capital and B791 billion in paid-up capital. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4.1 Public Companies Registered, 1978-2000
Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.9 16.6 350.1 30.9 34.5 111.0 110.9 1,394.5 50.6 2,101.0 Paid-up Capital (B billion) 1.2 11.9 261.0 19.6 23.3 83.1 78.5 791.0 21.6 1,291.2
Type of Business Agriculture, Hunting, Forestry, and Fishing Mining and Quarrying Manufacturing Electricity, Gas, and Water Construction Wholesale and Retail Trade, and Restaurants and Hotel Transport, Storage, and Communication Financing, Insurance, Real Estate, and Business Service Community, Social and Personal Service Total
Note: The data for 2000 is as of October 2000. Source: Department of Commercial Registration, Ministry of Commerce, Thailand.
B261 billion. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. The development of the corporate sector closely followed the development of capital markets. After the passage of the SEA of 1992, the value of public offerings rose steadily, reaching a precrisis peak in 1996 (Table 4.2). Debt market activities also increased significantly with the establishment of the Bond Dealers Club (BDC) in 1994. Domestic and offshore debt issues reached B54.7 billion and B27.8 billion, respectively, from only B20.5 billion and B1 billion the previous year. Table 4.2 Public Offerings of Securities, 1992-1999 (B billion)
Type of Securities Equity Debt Instrument Domestic Offering Offshore Offering Hybrid Instrument Domestic Offering Offshore Offering Total Funds Raised 1992 1993 1.2 5.1 6.4 34.0 20.5 1.0 1994 82.1 54.7 27.8 1995 64.6 39.3 31.3 1996 1997 65.2 40.4 51.9 1998 1999
15.7 136.4 277.2 12.2 25.9 31.1 286.8 26.5
1.6 7.5 39.3 22.4 96.3 194.6
8.7 5.7 7.9 37.8 151.8 201.0
0.3 6.7 9.1 2.5 56.6 174.1 599.6
= not available. Source: Key Capital Market Statistics, Securities and Exchange Commission of Thailand.
The 1997 crisis battered the primary market for securities, reducing the value of offerings to a little more than a quarter of the previous years level. While a rebound was apparent beginning in 1998, this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together, the capital market became instrumental in the rapid growth and development of the corporate sector. The signing of Article VIII with the IMF, moreover, allowed Thai financial institutions and corporations to obtain funds overseas. These peaked at B89.7 billion in 1996, the year before the crisis struck. The stock market also became an invaluable source of funds for corporations. The number of listed companies and securities steadily increased until 1996 (Table 4.3). Market capitalization, meanwhile, reached
Table 4.3 Statistical Highlights of the Stock Exchange of Thailand, 1993-1999

Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index
a
1993 1994 1995 1996 1997 1998 1999

a
347 408
389 494
416 538
454 579
431 529
418 494
392 450
3,325 3,301 3,565 2,560 1,133 1,268 2,193 2,201 2,114 1,535 1,303 930 855 1,610 1,683 1,360 1,281 832 373 356 482
Due to listing requirements and other reasons, not all public companies are listed on the SET. Source: Securities and Exchange Commission of Thailand.
its high point in 1995 at B3.6 trillion. Foreigners accounted for an increasing proportion of SETs turnover value, their share rising from 17 percent in 1993 to 43 percent in 1997. Side by side with this surge of financing for corporate growth, however, was the ominous deterioration in the key financial ratios of publicly listed companies. Throughout the 1990s, corporate profitability had been declining. But instead of shifting to a low gear, the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. The key financial ratios of all companies listed on SET bear this out (Table 4.4). Corporate profitability, as measured by return on assets (ROA), return on equity (ROE), and gross profit margin, had been on the rise throughout the 1980s. The upward trends for ROE and ROA continued through 1989, then stalled in 1990. Meanwhile, gross profit margin rose until 1991 before falling in 1992. By the early 1990s, the averages for all three profitability ratios took a downswing all the way until 1996. ROA dipped from 10.3 percent in 1989 to 3.4 percent in 1996. ROE similarly fell from 21.4 percent to 5.8 percent. While the decline in gross profit margin was not as sharp, in the end, the companies could not generate enough net returns from their assets and equity, resulting in their inability to fulfill debt obligations. From 10.5 at its peak in 1987, the average times interest earned (TIE) was down to 5.1 by 1996. The financial leverage of all companies declined until 1994, pulled down by active public offering activities. The trend reversed in 1995, however, when long-term debt grew as Thai corporations began to borrow heavily to finance growth. The plunge in profitability and asset turnoverfrom 117 percent in 1985 to 65 percent in 1996 for the lattercast doubts on the
Table 4.4 Key Financial Ratios of Publicly Listed Companies, 1985-1996

LongTotal Term Total Return Return Gross Debt Debt Debt on on Profit Times to to to Assets Equity Margin Interest Equity Equity Assets (%) (%) (%) Earned (%) (%) (%) 3.7 4.9 8.1 9.3 10.3 8.9 7.2 6.7 5.8 5.3 4.4 3.4 7.6 12.7 15.7 20.7 21.4 18.5 15.8 14.2 10.2 10.0 7.7 5.8 25.4 24.9 27.2 27.4 28.0 29.5 30.2 27.7 27.6 27.7 27.4 26.0 3.4 4.2 10.5 9.4 9.8 8.4 5.9 7.6 7.4 7.7 5.8 5.1 242.2 215.6 168.2 161.0 139.9 144.8 151.6 138.4 139.6 125.9 140.0 145.7 59.4 47.9 39.6 36.7 35.4 34.6 41.7 34.2 35.5 38.1 44.4 44.0 63.1 60.8 54.7 54.5 51.5 50.8 51.4 51.9 51.2 49.5 52.1 52.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.4 12.7 12.3 12.7 12.8 11.7 12.7 12.4 12.9 14.1 16.1 16.0 117.4 119.0 125.1 120.1 114.3 91.8 88.7 80.9 77.9 66.5 63.2 64.6
Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island, US.
practice of heavy borrowing. Despite the availability of the equity market, these companies opted for debt. A major reason for this was the rapid rise in asset prices, resulting in higher collateral values for borrowers. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations. The downtrend in corporate profitability, which was particularly significant in the two years preceding the crisis, was felt across industries, but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. Severely affected by global competition throughout the decade, the textiles, clothing, and footwear industries also experienced losses. Hotels and travel showed the highest ROE of 15 percent while textiles, clothing, and footwear had the lowest at 11 percent. Among the crisis-hit countries, Korea and Thailand had the highest debt-to-equity ratios. Thailands ROE, which fell from 16 percent in 1991 to just under 6 percent in 1996, was also distinct in the region. Overall, large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.5). They were generally more efficient in managing their assets and
Table 4.5 Average Key Financial Ratios by Company Size, 1985-1996

Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6.5 6.2 12.6 12.8 26.3 23.8 6.5 7.2 121.3 135.0 20.1 29.3 43.3 49.6 7.7 10.5 94.3 88.6 5.9 13.3 25.7 6.3 176.8 62.3 52.2 18.0 83.1 Small Medium Large 5.1 6.8 10.1 13.6 30.1 25.1 5.4 8.2 134.8 142.6 30.6 31.8 47.0 48.6 10.2 10.6 61.5 87.8 6.7 14.9 20.6 6.3 164.3 49.4 52.3 15.4 116.7
capital despite the higher gross margins of small companies. They also tended to use more financial leverage than small companies as their total DERs show. During the 1990s, the overall activities of listed companies, measured by total asset turnover, also deteriorated. Although stable in the 1980s, total asset turnover declined after 1989. In sum, although the performance of listed companies in the late 1980s was strong, by the 1990s, weaknesses became evident. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. 4.2.4 Legal and Regulatory Framework
Before 1992, the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies. However, some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public. For instance, the law disallowed cumulative voting. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness. Cumulative voting, it was thought, could lead to a high turnover in the board, which would be disruptive to company management. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.
Another issue was the proportion of shareholding by top shareholders. The law prohibited the largest shareholders, as a group, from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. The provision discouraged original family owners from registering their companies. The Public Company Act of 1992, adopted to promote the development of publicly listed companies, relaxed the contentious provisions of the 1978 Public Limited Company Act. Cumulative voting was made optional, the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares, and the punishment for management misconduct was also lightened considerably. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. However, the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. As the succeeding sections point out, the exit of these provisions appears to have contributed to the 1997 financial crisis. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. This will be discussed in Section 4.5.
4.3
Ownership and control of corporations in Thailand are highly concentrated, a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. The protection of minority shareholders was inadequate under the Public Company Act of 1992, and external monitoring and control of corporations were also weak. An Asian Development Bank (ADB) survey conducted for this study shows, for instance, that creditors had generally little influence on the management of corporations.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. As it turned out, concentrated ownership, coupled with weak corporate governance, played an important role in bringing about the financial crisis.
ADB survey questionnaires were sent to all Thai listed companies in early 1999. Fortysix companies responded, but not all questions were answered.
4.3.1
Patterns of Corporate Ownership
A World Bank study covering nine Asian countries finds that firms in Japan and Taipei,China have the least concentrated ownership, with the largest shareholder on average controlling 10.3 percent and 18.9 percent of shares of a company. In contrast, Thai; Indonesian; and Hong Kong, China firms have the highest single shareholder ownership concentration at 35.3 percent, 33.7 percent, and 28.1 percent of control rights, respectively. Most large Thai corporations listed on SET started out as family businesses. The Public Company Act of 1992 allowed ownership and control of these companies to remain with the founding families even as they became increasingly dependent on nonfamily resources. In the past, these companies obtained funding solely from banks or from their own retained earnings. But with their increased reliance on new varieties of equity and debt instruments, one would expect the public, creditors, and minority shareholders to stake their claim in the control and regulation of these companies. Unfortunately, this was not the case. Ownership Concentration Between 1990 and 1998, the top five shareholders of each of publicly listed Thai companies held, on average, 56.4 percent of outstanding shares, with the top three shareholders accounting for almost 50 percent (Table 4.6). This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. Across industries, there were only slight variations in the pattern. Ownership was most concentrated in the packaging, Table 4.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand, 1990-1998
Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five
a
28.1 12.0 7.4 5.2 4.0 56.4
26.2 11.4 6.6 4.9 3.9 52.4
26.3 11.4 6.8 5.0 3.9 52.4
26.8 11.0 7.1 5.2 4.0 53.8
32.3 16.5 9.9 6.4 4.6 68.9
26.4 10.7 6.9 4.9 3.9 52.6
27.7 11.3 7.0 5.0 3.9 54.3
28.1 11.7 7.1 5.1 3.9 55.6
28.5 28.9 11.7 12.1 7.3 7.3 5.1 5.2 4.1 4.2 56.6 57.5
Average for 1990-1998 period. Source: Comprehensive Listed Company Information Database, Stock Exchange of Thailand.
agribusiness, and building and furnishing industries, with a top-five ownership concentration of at least 60 percent. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. Based on a regression analysis, there is no statistically significant relationship between ownership concentration (measured by percentage of shares owned by the top five shareholders) and profitability of Thai publicly listed companies (Table 4.7). On the other hand, results show a significant positive relationship between ownership concentration and financial leverage, as measured by debt-to-equity and debt-to-asset ratios. These are consistent with the hypothesis that companies with more concentrated ownership tend to engage in higher debt financing because their controlling owners do not want to dilute their control by bringing in new equity holders. Company size is significantly related to ROE and leverage. Table 4.7 Statistical Relationships between Corporate Profitability, Leverage, Ownership Concentration, and Company Size
Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.058* ROE (0.116) Debt-to-Equity (1.533)*** Debt-to-Assets (0.072)
(0.001) 0.003 0.029 3.037
0.001 0.022*** 0.031 3.090
0.005** 0.169*** 0.080 6.800
0.001*** 0.034*** 0.115 9.647
Note: The regression included dummy variables for industry, year, and ownership types. * Denotes significance at the 10 percent level; ** at the 5 percent level; *** at the 1 percent level. Source: Authors estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island, US.
Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies, owning 26.7 percent of outstanding shares on average (Table 4.8). It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. Through these holding companies, founding families maintain effective control of entire groups, including those that are publicly listed
Table 4.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand, 1990-1998
Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.3 27.6 25.4 22.8 23.3 27.3 27.8 28.6 28.5 26.7 Bank 2.1 1.8 1.6 1.6 1.4 1.2 1.5 1.3 1.6 1.5 NBFIsa 6.9 7.2 7.5 2.9 6.5 5.1 4.7 5.6 5.2 5.5 Individuals 13.9 15.2 18.0 17.9 18.9 19.4 20.0 19.3 20.0 18.5 Government Other 0.7 0.5 0.8 0.7 1.3 1.3 1.2 1.5 1.4 1.1 1.1 0.9 0.7 1.3 0.5 0.5 0.4 1.0 3.3
= not available. a NBFIs denotes nonbank financial institutions, including finance and investment companies. Source: Comprehensive Listed Company Information Database, Stock Exchange of Thailand.
in SET. Although holding companies set up affiliate firms, the affiliate firms rarely hold shares of their parent companies, unlike in Japan where crossshareholding is common. The ADB survey indicated that listed companies held shares in an average of 11 companies. Individual family members also hold a significant amount of outstanding shares, averaging about 18.5 percent. These individuals usually hold important management positions in concerned companies. Typically, founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares. This practice is illustrated by Central Pattana, a company listed in the real estate sector of SET. Established in 1980 with a registered capital of B300 million, the company, a joint venture among three families, operates five of the most successful shopping malls in Thailand. In 1994, the company increased its registered capital and became a public company listed in SET. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. The largest shareholder is Central Holdings Company, owned by the Chirathivat family, one of the founding members, with 29.3 percent of outstanding shares. In addition, individual members of the Chirathivat family aggregately hold 25.6 percent of outstanding shares. The top 10 shareholders include a holding company owned by the Tejapaibul family,
another of the companys founding members. In effect, the top 10 shareholders consist predominantly of members of founding families and their holding companies. By owning 62 percent of voting shares, these shareholders are able to control the company. Across industries, the predominance of individual family members and holding companies in the top shareholder list remains valid. Except in the hotel and travel service sector, holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. Although the list of top shareholders of publicly listed companies includes financial institutions, they exercise limited influence in operations because of the restricted size of their shareholdings. On average, commercial banks account for only 1.5 percent of total outstanding shares of listed companies. Moreover, only one tenth of listed companies have commercial banks on their top-five shareholder list. Nonbank financial institutions hold an aggregate 5.5 percent of total outstanding shares. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. The Government holds, on average, 1.1 percent of total outstanding shares of listed companies. Only a handful of companies have the Government among their large shareholders. In such cases, the Government owns the majority of the shares. For example, Thai Airways International Plc. has the Ministry of Finance as its only large shareholder with 92.9 percent of outstanding shares. Another example is Bangchak Petroleum Plc., where the top three shareholders are the Ministry of Finance, the Petroleum Authority of Thailand, and a state bank. Together, they account for 80 percent of total outstanding shares. There was a trend of rising government shareholdings throughout the period 1990 to 1998. However, with the envisioned privatization master plan, the Governments role in public companies is expected to decline. 4.3.2 Corporate Management and Control3
Board of Directors The Public Company Act of 1992 stipulates the appointment process, qualification, roles, duties, and responsibilities of directors of public companies.
3
Discussions in this section are based on results of company surveys by SET and ADB, both conducted in 1999.
Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. Unless stipulated in public companies articles of association, directors shall be elected at the annual general shareholders meetings (AGSMs). In their business conduct, directors are required to act with care and honesty for the companys best interest, and to comply with the laws and articles of association. If found in violation of these provisions, directors may be imprisoned or fined. In addition, directors could be compelled to compensate the company for damages arising from their misconduct. Many companies have a formal policy on corporate governance and business ethics. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter, while 30 percent of respondent companies held board meetings monthly. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. Most companies (83 percent) satisfied SETs requirement of having two independent board members, while 15 percent of respondents went beyond the requirement. Meanwhile, the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. Chair of the Board and Chief Executive Officer The SET survey showed that about 73 percent of listed companies had a separate executive (management) board. Generally, an executive board consists of senior management and some main board members. Some companies (36 percent) had five to six main board members holding seats in their executive boards. The ADB survey indicated, meanwhile, that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. Nineteen companies stated that selection was based on professional qualifications. In five other companies, selection was based on relationships with controlling shareholders. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies, but not in 22 others. Three companies indicated that the CEO and the chair were close relatives. Although 28 percent of the chairpersons came from the ranks of independent outside directors, the majority (71 percent) had board chairs who were also members of top management teams.
Compensation of Directors, Chair, and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. Where different, these were attributed to variations in the extent of duties and responsibilities assumed by those directors. Half of the companies in the SET survey had a separate remuneration committee. However, the work of this committee was often considered part of the executive boards responsibilities, not an independent assignment. Also, the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. These committees were mainly responsible for determining compensation for senior and regular staff. The directors compensation was determined largely by the Board of Directors except in 19 percent of the companies surveyed where a remuneration committee was in charge. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. In 25 companies, the remuneration packages had to be approved during AGSMs. Three companies allowed their management to determine the chairs compensation package. Audit Committees and Accounting Standards Since January 1999, all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. Companies already with audit committees did not have independent outside directors as audit committee members. SETs attempts to bring accounting practices to international standards have included requiring listed companies to consolidate all liabilities including those on off-balance sheetsin their financial statements beginning June 1998. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards, while 19 companies observed only some of them. All respondents confirmed the use of external auditors, with 41 firms admitting the use of services of international auditing firms. In one company, however, the auditor is not
independent from the company. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. Relationships between firms and external auditors are generally long-term, averaging about 14 years. However, the corporate sector lacks a strong self-regulatory body to compel compliance with these standards, although recently, the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. SETs rules and regulations closely follow this Act. For instance, shareholders can claim compensation in cases of negligence or dishonesty by management. The Act also holds directors liable for any damage to shareholders, including false statements to conceal information about the financial condition and operations of the company during the sale of shares, debentures, or other financial instruments. The Act, likewise, stipulates the proper conduct of shareholder meetings, as well as the registration and holding of shares. While safeguards are in place, there are also significant gaps in the system of shareholder protection. (i) No standards are enforced in the content and timing of notices for shareholder meetings. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. (ii) The prudential role of outside directors is limited by the noncompulsory character of their participation in key decision-making bodies such as the audit, remuneration, and executive committees. (iii) Because the chair is frequently also part of the top management team, there is the danger that top management may be capable of unduly influencing the boards decisions. (iv) The roles and responsibilities of the major government agencies regulating shareholder rightsthe Ministry of Commerce, SEC, SET, and the Bank of Thailand are not clearly defined. As a result, the institutional machinery is not fully responsive to complaints about violation of shareholder rights. According to the ADB survey, most responding companies have rules and regulations intended to protect shareholders. In the majority of these companies (38 out of 46 respondents), shareholders have access to reliable information at no cost. Forty-four companies indicated that they had proxy voting in place, with 13 companies allowing proxy voting through mail. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. At least 28 responding companies had the following
mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions; and mandatory disclosure of related interests and significant shareholders transactions. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing, takeover of the company, and insider trading. On paper, minority shareholders are assured adequate legal protection. In practice, however, such protection has been insufficient. Written law and its enforcement diverge partly because of a provision that shareholders who take action against erring directors must have at least 5 percent of the total number of shares. But with the ownership concentration of Thai companies, it would be difficult for minority shareholders to gather the shares needed to take action. In theory, minority shareholders may also appoint an outside inspector to examine the companys operations and financial condition, and call an extraordinary session. But the exercise of these rights requires even higher shareholding levels. In effect, the only group of shareholders that can exercise rights is the top five shareholders. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. Only a small number of shareholders attended the latest AGSMs. Although the attendees held, on average, 66 percent of total outstanding shares, they comprised only 8 percent of total shareholders. Almost 82 percent of shareholders, representing only about 28 percent of shareholdings, did not vote in previous AGSMs. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. These problems appear to be partly a result of the relaxation of the rules and regulations in the original Public Limited Company Act of 1978. While stimulating the growth of the sector, the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. 4.3.3 External Control
Control by Creditors The fact that insider control in Thai companies is very strong should compel a search for alternative external control and monitoring mechanisms. Banks would be obvious candidates to implement these mechanisms, given their importance in providing finance and their stake in companies.
Historically, Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. However, creditors do not always require project feasibility studies or business plans in granting loans. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. Apparently, a companys reputation and its long-term relationship with creditors sufficed in many instances, as the ADB survey confirmed. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral, 17 indicated that only some of their creditors had such a requirement, while 18 said none of their creditors required collateral. Most companies reported that banks were more likely to require collateral, while loans for fixed investment were also more likely to be supported by collateral. The presence of collateral usually diminishes banks incentives for screening project feasibility and monitoring project implementation. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected, 11 experienced rejection after the crisis started. For 20 of the 46 responding companies, creditors collateral requirements were tightened after the crisis. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. In the end, however, the majority believed that creditors had little influence on company management and decision making. Only three companies thought otherwise. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. Normally, when insiders want to expand their companys operations without losing control, they resort to borrowing. Leverage allows the assets and operations of the company to grow without diluting corporate control. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. Under a weak bankruptcy system, such as that seen in Thailand before the crisis, borrowers seldom lose control to creditors even when they default and become insolvent. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. There were many options, other than losing control, to solve debt repayment problems. Debtors had many handles to stall the bankruptcy process, including procedural disputes, which could cause a delay by at least a year. Actual bankruptcy proceedings took more than five years on average.
The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. Such efforts would serve to strengthen external discipline on controlling owners. It will take years, however, before the extent to which the bankruptcy framework has been strengthened becomes clear. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. SEC was later made responsible for regulating corporate takeovers. According to the SEA of 1992, there are two categories of merger and acquisition activities with associated regulatory measures. The first category is the acquisition of shares in the open market. In this case, a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition, if the purchase of shares implies a change in the directors or business activities. The second category is the tender offer, which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. There are detailed requirements regarding such notification, whether directly or indirectly, of shareholders: (i) all shareholders must receive tender offers; (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days; and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. SEC has no authority to either approve or reject tender offers; its main role is to ensure transparency and fairness. Recently, the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. The market for corporate control has not been active in Thailand, and failed to provide managers with strong incentives to perform efficiently. Since the introduction of the Public Limited Company Act of 1978, only a limited number of successful mergers of public companies have taken place. In 1994 and 1995, there were 41 cases of tender offers, with a total tender offer value of B42.3 billion (Table 4.9). In 1996, there were only six tender offers, with a significantly lower total tender offer value of B8.3 billion. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. Although merger and acquisi-
Table 4.9 Merger and Acquisition Activities, 1993-1999

Year 1993 1994 1995 1996 1997 1998 1999
a
Tender Offer Valuea (B billion) 5.4 23.1 19.2 8.3 6.2 7.7 11.0
B billion 4.6 17.3 11.2 6.9 3.5 6.2 6.7
Purchase Value Number of % of Tender Offer Value Companies 84.1 75.1 58.1 84.0 55.8 81.3 60.8 8 27 14 6 9 13 23
Tender offer value refers to the minimum offer value. Source: Securities and Exchange Commission of Thailand.
tion activities increased after 1997, most of these were forced mergers or related to rescue packages. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. But instead of opting for an active role in the market for corporate control, they have mostly been concerned with short-term gains. While the Thai mutual fund industry compares well to those in other developing countries in the region, it remains small. Since 1994, trading by mutual funds in SET represented less than 10 percent of total trading. Pension funds are perhaps even weaker in Thailand. Provident funds for government workers and workers in public enterprises have been established only recently. Employee Participation in Corporate Governance There has been little, if any, employee participation in corporate governance in Thailand. Few companies offer employee stock option plans (ESOPs). Even when companies offer ESOPs, employees regard the plans as monetary incentives, not with a view to becoming involved in actual management. Because of the current crisis, employees are even less willing to accept common shares as a form of compensation or benefit. Eleven of the 46 responding companies in the ADB survey offer ESOPs, but employees have never been represented in the board of directors since their shareholdings are minimal. Twenty-nine firms indicated that employees held shares of their companies, but the average shareholding is smaller than 1 percent of total outstanding shares.
4.4 4.4.1
Corporate Financing Overview of the Financial Sector
A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.10) shows that Thailand is a highly bank-dependent economy. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. The bond market played only a marginal role in corporate financing, although its role increased in the wake of the crisis. Table 4.10 Size and Composition of the Thai Financial Sector, 1992-1999 (B billion)
Outstanding Loans from All Financial Institutions 2,906.1 3,663.4 4,775.1 5,979.6 6,912.0 8,171.1 7,360.5 6,477.5 Outstanding Loans from Commercial Banks 2,161.9 2,669.1 3,430.5 4,230.5 4,825.1 6,037.5 5,372.3 5,119.0 SET Market Capitalization 1,485.0 3,325.4 3,300.8 3,564.6 2,559.6 1,133.3 1,268.2 2,193.1 Domestic Debt Securities Outstanding 215.2 262.0 339.0 424.4 519.3 546.8 941.4 1,390.4
Year 1992 1993 1994 1995 1996 1997 1998 1999
Source: Stock Exchange of Thailand, Thai Bond Dealing Centre, and Bank of Thailand.
The Banking System Until recently, the banking sector was highly concentrated; there were 29 commercial banks, 15 of which were domestic banks. Competition from foreign banks was limited as they were not allowed to engage in full branch operations. In 1996, total assets of commercial banks amounted to B5.5 trillion. The share of domestic banks in the banking systems total assets was 80 percent. The countrys largest bank, Bangkok Bank Ltd., accounted for 28 percent of the banking sectors total assets; the next four largest banks accounted for 63 percent. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.
The Government was also a major figure in the banking system, owning 70 percent of the countrys second largest bank. Banking activity peaked in the mid-1990s. The Government removed controls on capital and dividend repatriation in 1991, and almost all capital account transactions were deregulated. In 1993, the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. Licenses were granted to 15 Thai banks, 12 existing foreign banks, and 20 new foreign banks. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. Because borrowers carried the exchange rate risk, the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. BIBF banks also enjoyed tax incentives on their operations and profits. In contrast, hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. The Equity Market During the first few years of its operations, SET was not very active. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. Easy access to commercial bank loans by family business groups, due to their close ties, also made it unattractive to raise capital from the equity market. The lack of supply of quality shares was a big problem for SET at that time. SET is organized into 32 major industries. Through the years, banking, finance, and property have accounted for the bulk of trading volumes. Benefiting from rapid economic and industrial growth, the stock market entered its first boom period in 1986. Despite the worldwide market crash in 1987, SET immediately recovered due to the strength of the Thai economy. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. After that, the market rose steadily and reached a record high in the fourth quarter of 1993. Turnover value reached B2.2 trillion. The number of listed companies also quadrupled between 1981 and 1993. Some 347 companies were listed in the same year with a total market capitalization of B3.3 trillion. In the following years, the SET index declined, reaching 355.8 in 1998. In 1995, an over-the-counter market, the Bangkok Stock Dealing Center (BSDC), was set up by 74 members with an initial capital of B500 million. BSDC is a nonprofit, self-regulatory organization under the
jurisdiction of SEC. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. Only one security was listed in BSDC in 1995 and two more in 1996. Turnover value was B1.8 billion in 1996, but dropped the following year to B122 million. In 1998, turnover value was negligible and the BSDC Index remained flat throughout 19961998. Consequently, the BSDC was dissolved in 1999. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. It separated the primary and secondary markets to promote more flexible and effective supervision of both. The primary market is supervised by SEC, which has a legal mandate to examine a companys financial status and operations before allowing it to issue securities to the public. After initial public offerings, securities can be traded in the secondary markets, which consist of SET and BSDC. According to the SEA of 1992, SETs primary functions are to serve as a center for the trading of listed securities and to provide the essential systems needed to facilitate securities trading. SET, however, also acts as a clearinghouse, securities deposit center, and securities registrar, among other functions approved by SEC. Before 1993, there were two kinds of companies in SETlisted and authorized companies, with each facing different listing requirements. Listed companies were those that had (i) paid-up capital of at least B20 million, and (ii) a minimum of 300 shareholders, each holding no more than 0.5 percent and collectively owning at least 30 percent of paidup capital. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. In 1996, the two classifications were merged, so now only listed companies are traded in SET. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds, financial projections, and pro forma balance sheet and income statements. In July 1990, SET established new requirements for initial public offerings. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. Company applicants must have an established history of operating under substantially the same management. The company should then appoint a financial adviser, approved by SET, to assist in the public offering process. The listing application should be submitted concurrently to SEC and SET. If approved by SEC and the SET Board of Governors, stock trading can commence within five days. The allocation procedure is nondiscretionary. If the issue is oversubscribed, lottery drawing must be used to ensure fairness.
The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. In 1996, it accounted for a small share of the entire financial sector, at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. To gain some perspective of the size of the bond market in Thailand, in 1994, it represented only 9 percent of GDP, compared to 110 percent in the US and 74 percent in Japan in the same year. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. The bond market in Thailand started in 1933, the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. Upon its founding in 1942, the Bank of Thailand assumed responsibility for regulating the bond market. Beginning 1961, the Government issued more bonds to finance industrial development projects and perennial deficits. The budget surpluses of the 1990s eliminated the need for new bond issuance, and the Government did not issue new bonds during 1990-1997. The recent financial crisis, however, led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4.11). However, the market for these bonds has been slow owing to the change in the Governments original policy of requiring the use of state-guaranteed bonds as legal reserves. The corporate sector played a limited role in the bond market in the early years because of the complicated rules and regulations in effect at that time. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. Investors had limited knowledge of debt instruments. A turning point of the corporate debt market was the enactment of the SEA of 1992, which encouraged limited companies and public companies to issue debt instruments. Four years after the passage of the SEA, the size of the corporate debt market rose to B132.9 billion. The Thai Rating Information Services, the first bond rating agency in Thailand, was also instrumental to the growth of the corporate debt market. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent, while secured debt instruments accounted for just above 10 percent. The proportion of domestic convertible debt instruments increased until 1995,
Table 4.11 Offerings of Debt Securities, 1992-1999 (B billion)

Item Government Bonds Treasury Bills State Enterprise Bonds Guaranteed Nonguaranteed Other Government Bonds Corporate Bonds Domestic Secured Unsecured With Warrant Convertible Short-Term Offshore Secured Unsecured With Warrant Convertible Total 1992 1993 1994 1995 1996 1997 1998 1999
400.0 333.7 77.0 27.0 60.4 57.1 55.2 57.4 49.3 46.7 95.2 50.8 55.2 43.1 41.3 46.7 90.1 6.3 14.3 8.0 5.1 29.5 138.8 191.5 55.0 5.1 61.4 110.0 86.7 132.9 40.9 37.1 315.9 5.1 21.1 59.8 47.5 43.1 12.5 37.1 289.3 3.5 5.5 10.7 0.0 0.0 33.7 5.1 10.8 31.9 30.3 29.7 7.3 13.1 107.4 9.6 19.3 3.5 0.0 17.3 140.6 0.7 5.1 8.2 2.7 0.3 6.0 7.7 4.9 0.7 40.3 50.2 39.2 89.7 28.4 26.5 3.1 6.0 5.4 1.0 26.2 28.2 45.9 20.5 1.6 0.0 26.5 39.3 22.4 7.9 37.8 2.5 32.1 121.8 167.1 141.9 329.0 281.7 538.7 821.8
Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.
then declined substantially in 1996 and 1997. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts. Total offshore debt offerings peaked in the run-up to the financial crisis. However, by the end of 1997, the year the crisis unraveled and the baht was floated, total offshore debt offerings had plunged by 68 percent to a mere B28.4 billion. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities. By 1995, turnover value had reached B51.5 billion. The following year, this had climbed to B200.6 billion, a surge attributed to capital inflows encouraged by high returns on Thai bonds,
compared with investment in equities. In 1997, turnover value plummeted to B106.2 billion as a result of the default of debentures due to the Asian crisis. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. Turnover fell further to B72.1 billion in 1998. In the same year, BDC was renamed the Thai Bond Dealing Centre following its status upgrade to a bond exchange. 4.4.2 Patterns of Corporate Financing
An examination of financing patterns among Thai companies listed in SET shows that on the asset side, listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4.12). The proportion of accounts receivable also declined steadily. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. In any case, overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. Thailands publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. At lower than 5 percent of total liabilities, the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. From 1990 to 1996, short-term loans accounted for more than 40 percent of total liabilities, a trend most apparent in the leap between 1991 and 1992. Longterm loans accounted for about 20 percent of total liabilities, steadily easing up between 1990 and 1996. Equity financing remains an important part of listed companies long-term financing, with equity levels remaining high despite an increase in debt. Retained earnings accounted for about 30 percent of total equity financing. There was also little change in the trend in retained earnings within the seven-year period. Across industries, significant variations can be noted. Construction and property development industries tended to have high proportions of long-term loans and debentures. For the construction industry, these accounted for 33 percent of total liabilities, while for the property development industry, these comprised 31 percent. The average for all industries was only 22 percent. Companies in construction and property development seemed unable to generate internal funds, judging by their relatively low levels of retained earnings, cash balances, and marketable securities holdings. In addition, they also had a relatively small proportion of equity and
Table 4.12 Common-Size Statements for Companies Listed in SET, 1990-1996 (percent)
Item All Years 1990 1991 1992 1993 1994 1995 1996 2.3 2.2 3.2 2.9 2.4 2.2 1.7 1.9 0.8 3.3 1.6 0.5 0.7 0.6 0.6 0.3 12.9 16.2 15.0 13.6 13.1 13.0 10.9 12.0 15.2 17.9 14.6 15.9 14.9 14.7 14.9 15.0 12.4 6.8 9.0 10.2 12.0 14.6 14.8 14.2 43.8 46.4 43.5 43.2 43.2 45.2 42.9 43.6 36.1 36.5 37.8 37.6 38.8 34.2 34.3 34.8 20.2 17.1 18.8 19.3 17.9 20.6 22.6 21.6 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 6.9 10.8 9.8 6.9 6.1 5.9 6.3 6.2 22.2 17.6 18.8 25.3 25.4 21.8 21.3 21.8 7.8 10.5 9.4 8.0 7.4 7.6 6.7 7.7 36.9 38.8 37.9 40.3 38.8 35.3 34.2 35.6 10.1 7.8 8.5 9.6 8.7 9.6 11.6 12.0 2.2 2.2 1.6 0.2 2.1 2.9 3.2 2.5 1.5 1.3 1.6 2.0 1.8 1.2 1.5 1.3 50.7 50.1 49.7 52.0 51.4 49.1 50.6 51.4 17.3 18.3 18.2 17.9 17.1 17.7 16.2 16.8 17.7 16.7 17.7 18.2 16.9 18.4 17.9 17.4 14.3 14.9 14.5 11.9 14.5 14.7 15.3 14.4 49.3 49.9 50.3 48.0 48.6 50.9 49.4 48.6 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity
were highly leveraged. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industrys total liabilities, compared with the 44 percent general average. Printing and publishing companies had lower financial leverage than companies in other industries. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high, medium, and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.13). The level of total liabilities for the group characterized by high ownership concentration
Table 4.13 Common-Size Statements of Public Companies by Ownership Concentration, 1990-1996

Degree of Ownership Concentration Item Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity High 2.6 0.6 14.6 15.5 11.1 44.4 35.7 19.9 100.0 7.2 22.2 8.4 37.8 12.2 0.9 2.1 53.0 16.3 16.0 14.6 47.0 100.0 Medium 2.3 1.2 11.9 16.5 13.2 45.1 36.0 19.0 100.0 6.6 22.9 7.8 37.3 8.6 2.4 1.4 49.7 17.1 18.2 14.9 50.3 100.0 Low 1.9 0.7 12.4 13.8 13.0 41.9 36.5 21.6 100.0 6.9 21.4 7.3 35.6 9.4 3.3 1.1 49.5 18.4 18.8 13.4 50.5 100.0
was 53 percent of total assets compared with 49.7 percent for medium ownership concentration companies and 49.5 percent for low ownership concentration companies. For the high ownership concentration group, common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.
Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing, followed by bank loans, bond issues, and rights issues. After the crisis, however, bond issues overtook loans from commercial banks as the second preference. Generally, the choice of financing is determined by the companys liquidity considerations, minimization of transaction and interest costs, and maintenance of the existing ownership structure. An overall picture of SET-listed companies financing and investment patterns in the 1990s shows a steady rise in the use of financial leverage (Table 4.14). The ratio of total debt to total assets increased from 50.8 percent in 1990 to 52.7 percent in 1996. Short-term debt accounted for most of the increase, especially from 1994 to 1996. Public companies relied more on short-term debt financing in the period before the financial crisis. More important, however, was the headlong deterioration of firms ability to meet their interest payment obligations. The TIE ratio declined from its peak of 7.7 in 1994 to 5.1 in 1996. Such deterioration of financial positions during the period was a common feature of listed companies. Table 4.14 Financial Ratios of All Listed Firms, 1990-1996
Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) 1990 1991 1992 1993 1994 1995 1996 8.4 5.9 7.6 7.4 7.7 5.8 5.1 144.8 151.6 138.4 139.6 125.9 140.0 145.7 34.6 41.7 34.2 35.5 38.1 44.4 44.0 50.8 51.4 51.9 51.2 49.5 52.1 52.7 11.7 12.7 12.4 12.9 14.1 16.1 16.0 25.1 23.7 28.1 31.3 31.1 31.0 28.9 63.3 61.7 66.2 68.8 65.8 65.1 64.3
Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island, US.
The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.15. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. While further detailed investigations are necessary, it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. As a result, these firms more easily increased their leverage, thus rendering them more vulnerable.
Table 4.15 Financial Ratios of Listed Companies by Ownership Concentration, 1990-1996

Degree of Ownership Concentration Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) Low 6.5 126.5 34.2 49.4 13.4 27.4 63.8 Medium 7.2 124.6 30.8 49.6 11.8 29.8 66.1 High 6.5 148.3 42.4 52.8 14.8 28.0 64.3
Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island, US.
4.5 4.5.1
The Corporate Sector during the Financial Crisis Impact of the Financial Crisis on the Corporate Sector
The financial crisis came after a period of rapid growth in the Thai economy. The corporate sector contributed significantly to the crisis because of its rising levels of leverage, unhedged foreign exchange liabilities, and a preponderance of short-term debt liabilities. The proportion of nondebt-creating capital flows, such as direct equity and portfolio investment, continued to slide from 1985 to 1997. Their average annual growth rate declined from 28.5 percent between 1985 and 1990 to 8.7 percent from 1991 to 1996. This decline was accompanied, on the other hand, by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF. From 45 percent of total net capital movements in 1985, debt-creating capital inflows rose to 65 percent in 1990, peaking in 1994 at 84 percent. The proportion of external debt as a percentage of GDP consequently increased from 42.2 percent in 1986 to 251.9 percent in 1997. The composition and term-structure of this debt, however, is even more telling. From only 34 percent in 1986, private debt accounted for 84.5 percent of external debt in 1996 (Table 4.16). Nonbank private debt increased from 27.4 percent to 46 percent during the same period. Additionally, the proportion of short-term debt increased from 15.8 percent in 1986 to 52 percent in 1995.
Table 4.16 External Debt, 1986-1999 ($ billion)

Private Nonbank Long-Term Short-Term 3.1 2.8 3.0 4.6 7.3 10.0 11.5 12.7 13.7 23.9 31.2 32.1 34.8 31.6 1.9 1.7 2.3 2.9 6.2 10.5 12.8 12.3 7.4 18.6 18.8 13.9 10.9 10.4 1.4 3.0 3.8 10.7 10.9 6.9 5.3 6.4 15.1 23.7 20.5 19.2 14.9 7.8 0.3 0.3 0.3 0.3 0.3 0.3 0.7 1.3 3.5 4.4 2.3 3.9 3.9 3.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.9 1.2 2.2 2.8 3.9 4.1 5.5 4.0 6.4 10.0 8.4 5.2 2.5 1.6 Total 18.3 20.0 21.1 22.9 29.3 37.9 43.6 52.1 64.9 100.8 108.7 109.3 105.1 95.6
Government
Year
Long-Term Short-Term
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
12.0 13.9 13.0 11.9 11.3 12.1 12.5 14.2 15.5 16.3 16.7 24.1 30.9 35.9
0.1 0.1 0.3 0.2 0.3 0.7 0.6 0.2 0.1 0.1 0.0 0.2 0.1
Source: Bank of Thailand.
This shows that although banking and finance companies suffered most because of their short-term exposure, nonfinancial companies also experienced severe liquidity problems as a result of the bahts devaluation. With easy access to foreign funds, large Thai companies had actively borrowed at low interest rates from foreign financial institutions. The ADB survey conducted for this study confirms this: 35 of the 46 respondents indicated that they took out foreign-denominated loans mostly from foreign banks. On average, foreign currency-denominated debts constituted 55 percent of their total debt portfolio. Most of these foreign debts were not properly hedged, exposing the companies to disaster when the baht started tumbling on 2 July 1997. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings; (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms; and (iii) bankruptcies, closures, and drastic decline in the number and capital of newly registered companies. The value of public offerings sank in 1997 to B56.6 billion from the 1996 level of B201 billion. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998, reaching 45 percent of total outstanding credit in December, based on the three-month past due definition. Aside from the problem of NPLs, according to the Bank of Thailand, outstanding credit also declined throughout the second half of 1998. If lending rates remained high, banks would be recording more of such NPLs. Similarly, the liquidity problems faced by the corporate sector are likely to continue for some time. Due in part to liquidity problems on the one hand, and poor business confidence on the other, the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4.17). Meanwhile, from its peak in 1995, the number of newly registered companies dropped to a 10-year low in 1998. The effects of the crisis were felt across all industry sectors. SETs dismal performance is indicative of the extent of the setback suffered by the Thai capital market. Foreign investors retreated from the market, leaving domestic investors with large capital losses. Even before the crisis, trading activity at SET had been on the downturn. At the end of 1994, the SET Index stood at 1,360. After that, the index declined to 1,281 in December 1995 and to 831.6 in December 1996. It hit a 10-year low in the second quarter of 1998. Trading volume has since been thin, suggesting that serious investors have not returned to the market.
Table 4.17 Number of Newly Registered and Bankrupted/Closed Companies, 1985-1999

Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10,777 11,095 14,066 19,096 22,312 25,933 25,052 36,134 31,288 35,915 37,410 37,407 28,904 20,201 24,677 Bankrupted/Closed 2,797 4,410 5,105 4,307 4,902 3,218 3,224 4,334 4,112 9,695 3,792 7,080 9,925 12,409 6,977
Source: Department of Commercial Registration, Ministry of Commerce, Thailand.
The price-to-earnings (P/E) ratio deteriorated from 19.5 at the end of 1994 to 12 in 1996 and further to 6.6 in 1997. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. A steady price decline over the past few years has dragged down the ratio of market price to book value. It also explains the higher dividend yield ratio. 4.5.2 Responses to the Crisis
Initially, the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. But when assistance from other sources did not materialize, the Government was left with no choice. The IMF financial package was a credit facility of $17.2 billion for balance of payments support and buildup of the countrys reserves. As part of the assistance package, IMF required Thailand to meet a set of performance criteria and implement various restructuring measures. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.
The terms of the agreement required the Government to maintain tight monetary and fiscal policies. In early 1998, IMF relaxed these key conditions. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence, increase profitability, and restore solvency. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. As it turned out, only two companies emerged intact from the suspension. The assets of the other companies were liquidated by auctions. The Bank of Thailand also improved banking standards. Strict loan classifications, loan provisioning, and income recognition were implemented. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. Regulatory Response by the Government The IMF program, drawn up with World Bank and ADB assistance, also aimed at institutionalizing legal and regulatory reforms. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. These include repeal of the Commercial Bank Act, the Civil and Commercial Code, and the Act Regulating the Finance, Securities, and Credit Foncier Businesses. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments, and worked on revisions to the Secured Transaction Law. Under the old bankruptcy laws, creditors seldom succeeded in obtaining payment against bankrupt borrowers. There were many options for solving debt repayment problems. Creditors could negotiate to reschedule debt repayments, and if necessary, follow through with a civil or bankruptcy suit. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. The old law allowed only creditors to file bankruptcy suits, and did not recognize debtor-initiated bankruptcy declarations. While no definition for insolvency could be found in the bankruptcy law, it was widely interpreted as having debts more than assets. Creditors thus bore the burden of proving a debtors insolvency before the courts. By invoking procedural loopholes, however, debtors could drag out the process for many years. Many believed that the process was inefficient. For example, secured creditors had to obtain the courts approval before starting proceedings
for the recovery of debt through the realization of any collateral. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. To make matters worse for creditors, any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. In 1999, the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. The amendment added reorganization provisions to the Bankruptcy Act of 1940, thereby allowing court-supervised corporate restructuring. The original Bankruptcy Act dealt only with liquidation and composition. The amended legislation also includes voluntary bankruptcy as a new feature. Under the old Bankruptcy Act, creditors always had to contend with the threat of disruptions in a delinquent borrowers business. The new law is designed to prevent bankruptcy due to temporary liquidity problems by allowing an insolvent debtor to file a reorganization plan with the court. The amended law also introduced the concept of automatic stay, which means that a debtor could continue in business while the reorganization program was being implemented. In effect, a remedy beneficial to borrowers and creditors is made possible through a business reorganization that should improve the borrowers debt position and ensure its continued operations. The reorganization process is successful if (i) the debts shall have been discharged; (ii) management of the company reverts to the borrower; (iii) shareholders regain their legal rights; and (iv) the debts shall have been settled within a five-year period. If the process fails to revive the business, the company shall be declared bankrupt and liquidation of assets shall follow. The model for Thailands amended bankruptcy law was the US Chapter 11, the main purpose of which is to assist in the rehabilitation process so that a company can repay its debt and still retain its assets while remaining in business. Chapter 11 is the main tool in restructuring bankrupted companies in the US, but it is a complicated, time consuming, and expensive process. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts time. In Thailand, the judges and court officers have yet to learn and master the new bankruptcy procedure. Enforcement of the new law is bound to be ponderous and lengthy. There are other potential problems. For one, the amended law limits the rights of secured creditors. But more important, it covers only the court-supervised reorganization of distressed companies. Companies need
to solve the problems (e.g., corporate governance) that caused the bankruptcy in the first place. Without the necessary corporate restructuring, the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. Under the new law, the test for insolvency still uses the balance sheet criterion, namely liabilities exceed assets, as opposed to the more appropriate criterion of ability to pay when the debt falls due. The Foreclosure Act Amendment was likewise passed in 2000. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. The new foreclosure law cuts short the procedures required under the Civil and Commercial Code for petty or simple cases dealing with mortgage defaults: (i) submission by the drafting committee of a default judgment bill within a week, and (ii) processing of default cases within four to six months of filing of a court claim. The amendment also remedies the slow process of executing or disposing of assets in a public auction. Still pending Parliament approval is the amendment to the Secured Transaction Law, which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. In the past, only tangible assets were the norm. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. SEC also examined the possibility of an amendment to the Public Company Act of 1992. Replacing the Public Limited Company Act of 1978, the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. The result, however, has not been satisfactory. Most important, minority shareholders rights are not adequately protected. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. Minority shareholders also have to absorb the costs related to their actions because the 1992 Act does not allow them to be reimbursed by the company. Consequently, questions have been raised regarding the appropriateness of the 1992 Act. There have been proposals to lower the minimum shareholdings required for a minority group to request the board of directors to call an extraordinary general meeting at any time. In case the board of directors does not comply, the court, after determining the legitimacy of the request, shall have the power to call the extraordinary general meeting. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting.
Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. This may be true in countries where publicly traded companies are widely held. But as demonstrated, this is not so in publicly traded companies in Thailand. Because of high ownership concentration, the controlling shareholders have the exclusive domain to appoint or exercise management, and determine voting results on virtually any matter. The textbook separation between owners who sit in the companys board and professional managers who run the company does not apply in Thailand. But because this is the assumption embedded in the regulation, the main problem is overlooked, i.e., the dominance of controlling shareholders, who are also the managers, vis-a-vis the minority shareholders. Consequently, there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders value. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company, subject only to approval by the board of directors. In addition, it permits directors, with the approval of the board, to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. Directors enjoy unusual protection under the 1992 Act in that they can be pardoned by shareholders in the annual general shareholders meeting for any violation of fiduciary duties. The only reason Thai investors placed their money in stock issues despite these legal cracks was the rapid increase in stock prices in the 1990s. In the absence of such a stock market boom now, minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. Where equity will come forward, it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. The radically changed circumstances after 1997 offer the possibility that firms and their controlling shareholders will be under greater pressure to concede to the exercise of minority rights. Otherwise, they face the prospect of being unable to compete for the scarce funds available in the equities market. The regulators are drafting a proposal to amend the provisions on related transactions. The proposal clearly delineates duties of care and loyalty for directors of public companies. The 1992 Act only prescribesnot requiresthe use of the cumulative voting procedure. Most companies decide against cumulative voting, claiming that it creates fragmentation in the board of directors, which, in turn, disrupts the companys management and decision making. However, without cumulative voting, minority shareholders have no chance of being represented in the board. The proposal for the amendment of the Public
Company Act of 1992 includes a recommendation to require all public companies to use cumulative voting to ensure that the board of directors consists of representatives from all groups of shareholders. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy, contributing to the unprecedented rise in the corporate sectors bad debt. In response, the Government introduced debt restructuring-related measures to help resolve bad debts. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies, methods, and procedures for debt restructuring. Considerable progress has been achieved on this front. By October 2000, 322,764 debt restructuring cases involving B1.8 trillion had been completed. Commercial banks initiated 74 percent of these cases, accounting for B1.1 trillion of outstanding credit. Another 77,068 cases involving B475 billion are undergoing restructuring. In addition, a Corporate Debt Restructuring Advisory Committee (CDRAC) was established in 1998 to map out debt restructuring measures in support of efficient negotiations between the private sector and financial institutions. As of November 2000, CDRACs target debtors comprised 10,767 cases involving outstanding credit of B2.6 trillion. However, only 7,147 cases (B1.6 trillion) have agreed to cooperate with CDRACs restructuring process. Some 82 percent of these cases have been successfully restructured, accounting for B1.1 trillion in outstanding credit, with the majority of the debtors coming from the commerce, personal consumption, and manufacturing sectors. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. Cases for which negotiations were unsuccessful, as well as those that did not cooperate with CDRACs restructuring process, will be settled by the courts. The first bankruptcy court in Thailand opened on 18 June 1999. Within three months, the court had more than 80 cases for disposition, although since then, the number of cases has abated. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. In particular, where bankruptcy procedures are swift and effective, the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. This point is crucial because compared with
Malaysia, Philippines, and even Indonesia, Thailand is coming from a situation where excessively high leverage became the norm because firms could obtain finance without having to concede a measure of control to outsiders. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. It required listed companies to establish their own audit committees by the end of 1999. Financial information from listed companies will also soon be required to conform to International Accounting Standards. The exchange has already required that listed companies quarterly reports be directly comparable with annual statements. Such improvements in disclosure standards are part of the efforts of SET and SEC, despite the weakness of their disciplinary powers, to push companies to harmonize their accounting with international standards.
4.6 4.6.1
This study has provided an overview of the corporate sector and governance in Thailand. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. The study covers the period 1985 to 1996, a time span that includes the onset of financial liberalizationthe turning point of Thai economic development in the last decadeand represents the decade preceding the Asian financial crisis of 1997. Examination of corporate ownership, behavior, and performance during this period helps understand the causes of the crisis. The economic development of Thailand took off with the implementation of a series of National Economic and Social Development Plans beginning with the first medium-term plan for 1961 to 1966. In the next three decades, the Thai Government managed its economy with the corporate sector as the main engine of growth and development. For this reason, the Government protected certain corporate sectors through tariffs and regulation, and promoted key industries through incentives. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. The
importance of bank financing continued throughout the 1990s, even after the development of capital markets. In 1992, the corporate sector entered a new era with the enactment of two major pieces of legislation, the Public Company Act of 1992 and the SEA of 1992. Subsequently, there was a marked increase in the number of public corporations. The SEA of 1992 also marked the beginning of an active bond market in Thailand. After 1992, the number and value of public offerings of securities accelerated. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. In 1995 and 1996, the profitability of publicly listed companies abruptly declined and their financial leverage increased. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. At the onset of the 1997 financial crisis, the overall corporate sector was seriously affected. The number of newly registered companies in 1997 dropped by almost 10,000 from the previous years level. At the same time, the numbers of bankruptcy cases and company closures reached alltime highs. Meanwhile, the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. The impact of the crisis was felt across all industries. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. During 1992-1997, foreign debt in the Thai corporate sector increased continuously, reaching its peak in 1996. Nonbank private corporations accounted for most of the increase. Although there was a decline in short-term foreign debt, the increase in long-term debt more than compensated for the drop. Because most of these debts were not hedged, Thai companies were vulnerable to exchange rate risks. Consequently, the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations, at a time when most of them were already experiencing declining profits and high leverage. The study examined the impact of ownership structure on corporate governance and financing patterns. One of the major findings is the high ownership concentration among Thai companies listed on SET. On average, the top five largest shareholders hold about 56 percent of total outstanding shares. Although there are some variations across industries, the overall pattern of ownership concentration seems to have been stable for the past 10 years. This implies that the control of an average Thai company is typically in the hands of a few persons (founders or their associates) who own a majority of total outstanding shares. Minority shareholders,
although larger in number, hold only a small portion of total outstanding shares. Consequently, they have little influence over management decision making and control. Among the five largest shareholders of Thai companies listed on SET, holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. Individuals and insiders hold the second largest proportion at about 19 percent. Financial institutions hold a very small proportion; commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. The investing public holds the rest of the outstanding shares, averaging 46 percent. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies, through the use of holding and affiliated companies. The implications of ownership structures that are concentrated to such a high degree are serious. The absence of external market controls on the management of publicly listed corporations is dangerous. With financial institutions playing limited roles in the capital market, there is a clear lack of outside monitors for these publicly listed but family-controlled companies. Institutional investors in Thailand, foreign and domestic, are not active. In the past, the government pension fund was the only major institutional investor. Recently, the mutual fund industry has entered the picture but with limited roles and activities. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. All these, along with a highly concentrated ownership structure, contribute to the lack of external controls on the corporate sector through the capital markets. Thus, publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. It remains to be seen how reforms in bankruptcy proceduresincluding the increased threat of creditor controlcould shift the incentives of controlling shareholders toward greater acceptance of equity finance and its consequent accession of control to new shareholders. The highly concentrated ownership structure weakens the protection of minority shareholder rights. Nominally, the existing legal and regulatory framework suggests otherwise. The key laws, the Public Company Act of 1992 and the SEA of 1992, protect the interests of all shareholders of public companies. These laws stipulate rules and regulations concerning the activities of all public companies. The rules in both Acts governing
minority shareholders participation in decision making and in initiatives against management conform to international standards. However, the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions, because there is no separation between ownership and management. In view of this, the main challenge is not how the board can control management to maximize shareholder value. Rather, because there are shared interests between the controlling shareholders and key management personnel, the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. For instance, before the crisis, laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. Certain provisions, moreover, posed formidable barriers in the minority shareholders exercise of their rights. For example, the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings, a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders protection in this regard. The ownership structure of Thai listed companies also significantly affects company behavior. Ownership concentration appears to have little impact on corporate profit performance, but is significantly related to financing patterns. Specifically, the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. Consequently, these companies tend to become overleveraged, making them vulnerable to economic shocks. 4.6.2 Policy Recommendations
There are three major policy issues and recommendations that could improve corporate governance in Thailand. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. The second issue involves the protection of shareholder rights, an aim that can be achieved mostly through legal reforms. The third issue involves creating external market controls through better regulation and development of the capital markets. In this third area, key reforms that will strengthen the regulation of financial institutions,
encourage market competition, activate the market for corporate control, and increase the participation of institutional investors are imperative. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. Under the current system, three major government organizations (the Ministry of Commerce, SET, and SEC) are involved in corporate supervision. This is due to the historical development of the Thai corporate sector: before 1975, the Ministry of Commerce had the sole supervisory responsibility; in 1975, SET was mandated to supervise listed companies; and after the enactment of the SEA in 1992, SEC was established as another supervisory agency. Consequently, the supervisory system is fragmented and not as effective as it should be. It is important that the roles and responsibilities of each agency are clearly defined to the public. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. Only then will these agencies be able to act promptly and effectively. The best approach may entail establishing a single, unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. Once the roles and responsibilities are clearly defined, the supervisory agencies also need to be empowered to enforce the laws. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. There is also supposed to be separation of ownership and control, with control delegated to professional managers. The owners of a firm rely on a board of directors to supervise the managers, voting only on major decisions. If this were the situation, the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. The board therefore plays a pivotal role. In reality, in most of Thailands publicly traded firms, the principal shareholder typically plays a key role in management and often serves as the chief executive officer. If the principal shareholder is in fact chair of the board, he/she often has the decisive vote. In this setting, the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. As in other crisis economies in the region, this is a problem in Thailand.
There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. The situation prompts two specific recommendations. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. This includes prescribing ways to empower minority shareholders without disrupting the companys operations. SEC is exploring the possibility of amending the law toward this direction. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders, increasing penalties for directors engaged in misconduct, requiring cumulative voting for the election of directors, and a prohibition of connected transactions by directors or management. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. The second recommendation is to dilute ownership concentration through the use of regulatory power. Through an amendment in the Public Company Act, the Government can change the shareholding limit for controlling shareholders. This move is expected to be unpopular among founding family members and original owners. There is also a need for legislation dealing with nominee or holding companies because they are the institutional means that founding family members use to maintain control. The Government does not have an effective way of monitoring the financial activities of these companies even as it is widely believed that a large amount of funds is being channeled through them. Because these holding companies control a number of large public companies in Thailand, they should be monitored and regulated. To ensure a level playing field, regulators must increase transparency and step up enforcement. Since the Asian financial crisis, there has been much progress in this area. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. The slow improvement in the legal framework has likewise obstructed progress in this area. SEC has been trying to lay the foundations of good corporate governance by espousing fairness, transparency, accountability, and
responsibility among companies. However, the SECs disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. Accounting standards have also been under review. Capital Market Development and Regulation Another important issue concerns the development of capital markets. Without a strong and efficient capital market, it will be difficult to improve corporate governance in Thailand. In the stock market, for instance, there is a need to increase market disciplinary power through market competition. In an environment of highly concentrated ownership, the power of the capital market to discipline inefficient management is almost nonexistent. One way the Government can improve the current situation is to require publicly listed companies to trade a higher proportion of outstanding shares in the secondary market. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. The Bank of Thailands enforcement of prudent lending practices among Thai financial institutions, aimed at ensuring that banks finance only creditworthy projects, will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. The same goes for improvements in the bankruptcy system. Because the financing of Thailands corporate sector is predominantly bank-based and will remain so for a long while yet, it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. This may not be possible without reforms in the banking sector itself, especially in the area of connected lending. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. The first step is to establish an active secondary Government bond market, which, in turn, will lead to the emergence of a reference yield curve. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. A well-developed domestic debt market will provide corporations with an alternative to bank financing, while a strong domestic debt market will also offer protection from foreign exchange risk. Further, a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies.
References
Annual Report. 1997. The Securities and Exchange Commission of Thailand. Bank of Thailand Monthly Bulletin. 1995-1999. Bank of Thailand. Bank of Thailand Quarterly Bulletin. 1995-1999. Bank of Thailand. Bond Market Development in Thailand. 1998. The Thai Bond Dealing Centre. Department of Commercial Registration Database, Ministry of Commerce, Thailand. Fact Book. 1995-1999. The Stock Exchange of Thailand. Key Capital Market Statistics. 1997-1999. The Securities and Exchange Commission of Thailand. PACAP-Thailand Database, Pacific-Basin Capital Markets Research Center, The University of Rhode Island, Kingston, US. Thai Accounting Standards. 1995. The Stock Exchange of Thailand. The Stock Market in Thailand. 1997. The Stock Exchange of Thailand.

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Corporate Governance and Finance in East Asia

A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand

Arvind Panagariya ChiefEconomist

Note: In this volume, $ refers to US dollars, unless otherwise stated.

Corporate Governance and Finance in East Asia, Vol. II

Overview of the Corporate Sector Historical Development

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Table 1.1 Growth of the Banking Sector, 1993-1999

1993 100.6 7 7.9 10 11.8 29 6.5 27 88.2 161 214.0 234

1994 104.5 7 9.2 10 14.3 30 7.9 27 113.8 166 248.1 240

1995 122.6 7 12.3 10 17.9 31 9.8 27 147.5 165 308.6 240

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

1992 7.2 370.0 8.8 21.1 32.4

1993 16.4 7.2 23.1 310.0 7.0 24.1 30.7

1994 (9.1) 5.7 (2.6) 260.0 6.6 28.0 28.6

1995 25.1 6.0 17.3 250.0 8.6 28.3 30.5

Legal and Regulatory Framework

Corporate Governance and Finance in East Asia, Vol. II

Corporate Ownership and Control

Corporate Governance and Finance in East Asia, Vol. II

Source: The Indonesian Capital Market Directory.

Corporate Governance and Finance in East Asia, Vol. II

Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates, 1988-1996

13 125 162 86 193 21 260 40 176 124

13 125 162 83 196 21 259 41 175 125

13 123 164 80 196 24 260 41 171 129

13 120 167 76 199 25 260 40 174 126

13 118 169 76 198 26 262 38 172 128

12 122 166 71 201 28 263 37 171 129

12 122 166 69 205 26 262 38 172 128

11 120 169 71 204 25 260 40 177 123

10 120 170 68 204 28 259 41 175 125

20.4 59.1 46.5 21.2 76.7 28.1

21.9 73.1 52.1

25.2 30.1 33.4 86.1 103.0 116.4 59.8 68.9 77.4

Source: Indonesian Business Data Centre, Conglomeration Indonesia 1997.

Corporate Governance and Finance in East Asia, Vol. II

Figure 1.1 The Suharto Group

262 firms with control over 20%

Salim Group (friend Soedono)

Sempati Air Humpuss Group

17 firms with control over 20%

Bimantara Group (son Bambang)

8 firms with control over 20%

Kabelindro Kiani Murmi Sakti

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Corporate Financing Financial Market Instruments

1992 1993 11.2 16.1

1996 1997 1998 50.0 70.9

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Corporate Governance and Finance in East Asia, Vol. II

Impact of the Financial Crisis on the Corporate and Banking Sectors

Source: Central Bureau of Statistics (Biro Pusat Statistik, BPS).

Corporate Governance and Finance in East Asia, Vol. II

ROE 1996 1997 1998a

Table 1.20 ROE of the Banking Sector, 1992-1997 (percent)