Weak Legal Environments in Asia - Essay Example

 Weak Legal Environments in Asia Many countries of Asia and other developing markets suffered because of weak legal environments and poor governance systems1. Countries with weak legal protections suffered greater exchange rate depreciation and this led to severe stock market declines during the crisis. During the crisis when the managers have more control rights than ownership rights, the firm’s perform poorly. Many Asian countries suffered during the 1997 Asian financial crisis but South Korea has come closes to seeing history repeat itself. The government is not willing to accept that they are in the midst of another financial crisis and they attribute the situation to the malicious financial analysts2. While in 1977 the economic crisis was triggered by the Thai baht, this time the crisis began on Wall Street. Many South Koreans are of the opinion that their economy is vulnerable to western market panic and destabilization because it is more transparent and open to foreign capital than its neighbors3. This is the reason that countries like Japan and China have not been as seriously affected by the global crunch as South Korea has been. However the reason behind South Korea being affected is that the Korean banks have huge foreign debts unlike the neighboring nations and as the global credit market dried up, the banks were in trouble as they needed dollars to repay the maturing foreign currency loans. What added to the pressure was that the foreign banks refused to roll over the existing loans. Before the 1997 crisis occurred in the Asian countries, the corporate sector in Korea showed very high debt-equity ratios and low profitability and they were still expected to yield high profitability.4 Such crises do not occur overnight and in Korea even ten years before the actual meltdown took place, the return on capital fell short of the oppurtunity cost. Profitability declined even after control of firm-specific and industry-specific factors and the macro-economic conditions. The rate of return on assets (ROA) was much lower in Korea than in other countries. The corporate governance in Korea was very weak as the system failed to provide sufficient monitoring and discipline. The larger firms did not face exit threats and the Korean laws protected incumbent controlling shareholders.5 Because of the Korean family structure, in the chaebols or the business groups, ownership is heavily concentrated to the extent that an individual has almost total control over all the firms within the group.6 The average rate of return on equity was often lower than the prevailing interest rates for loans, according to Joh. Owner-managers have expropriated other investors by investing the firm’s resources to maximize their own or the group’s welfare.7 Such firms started showing discrepancy in cash flow rights and voting rights which led to severe agency problems between the controlling and minority shareholders. This is line with Joh’s contention that the accounting and management system in Korea was not transparent which prevented the banks and investors from receiving accurate information. The internal governance system was also not right because controlling shareholders had the right to select the board of directors. The non-performing loans had started to show up even before the currency crisis because six of the thirty largest business groups (chaebols) went bankrupt before the crisis. These non-performing loans weakened the banks and provoked the liquidity crisis. According to Borensztein and Lee, weaknesses in financial institutions and corporate borrowers may in fact explain much of the credit contraction.8 Banks had to increase their capital ratios in line with Basle standards without which they were not in a position to expand credit to their customers. The financial reforms also changed the economic incentives for the banks and the corporations and this also affected the demand and supply of credit. The “credit crunch” according to the authors, may have been the outcome of the structural changes in the financial sector rather than of a general monetary contraction. This is support by Joh’s findings that institutional shareholders did not monitor firm activity despite owning 40% of the shares. Banks were virtually controlled by the government and they held about 10% of the listed firm shares while the other financial institutions such as the insurance companies, the security firms and investment trust companies owned more than 10 percent. The financial institutions were not allowed to vote on firm decisions. The non-financial institutions held more than 20% of the shares and the investors protected the incumbent controlling shareholder from potential outside threats. There was also divergence between the cash flow rights and the control rights in the Korean firms.9 Pyramid ownership structures and cross holding among firms allowed the controlling shareholders to exercise full control over a firm, even though they held only a small portion of the cash flow rights. This study found that firms with large equity by foreign investors and firms with higher disclosure quality and alternative sources of external financing suffer less compared to the chaebol firms where power lies in the hands of the owner-managers. This has also been confirmed by Joh who says that the chaebol firms registered lower profitability and this had started manifesting much before the crisis. According to Joh it is not the weak corporate governance system that can be held responsible but the controlling shareholder’s expropriation of minority shareholders. South Korea was one of the most globalized nations and perhaps this is the reason they were hit the hardest. During the 1997 crisis the IMF loans and some other loans had saved the nation but the loans required that the country open up its stock market and banks to foreign investors, lift constraints on currency trading and reduce corporate debts10. This weakened the legal system and the country had to change its labour laws also. This also forced South Korea to be more globalized and open its market to foreign investors and loans, much more than other Asian countries. Another significant reason for the business downturn in South Korea is that politicians are close to business. It is troubling in a country where chaebol industrial giants have their hands into everything around11. Both the leaders and the businessmen are prone to corruption. Its legal institutions are weak and the politicians corrupt. Dictatorship and authoritarian governments are the norm in South Korea. This it can be seen that because of the loans taken in 1997, they were forced to open up their economy and remove constraints. However, it appears that it was the cumulative effect of several factors that triggered the financial crisis in 1997. The chaebol firms tried to invest the firm resources in their individual or the group’s welfare and since these firms were closely held, the minority investors suffered. The institutional investors could not have controlling rights and the non-financial institutions protected the incumbent shareholders. As the corporate governance within the country was weak, there was no monitoring which allowed the firms to run as they wanted to. Since the internal governance too was weak and the accounting and management was not transparent, the banks and the investors could not receive accurate information. The chaebols were so mismanaged that the problems started to show up even before the currency crisis actually occurred. As the firms that had drawn loans could neither repay the loans nor service the interest, it weakened the banks that provoked the liquidity crisis. Hence it is a mix of weak corporate governance by the leaders as well as no monitoring by the intuitional shareholders that led to the financial crisis of 1997 in South Korea. Bibliography Baek, JS Kang, JK & Park, KS 2004, Corporate governance andfirm value: evidence from the Korean financial crisis, Journal of Financial Economics, vol. 71, pp. 265-313 Borensztein, E & Lee, JW 2002, Financial crisis and credit crunch in Korea: evidence from firm-level data, Journal of Monetary Economics, vol. 49, pp. 853-875 Fackler, M 2008, South Koreans reliving nightmare of last financial crisis, retrieved online June 9, 2009 from http://www.nytimes.com/2008/10/24/business/worldbusiness/24iht-24won.17217405.html Joh, SW 2003, Corporate governance and firm profitability: evidence from Korea before the economic crisis, Journal of Financial Economics, vol. 68, pp. 287-322 Park, J & Lee, S 2009, Global Financial Crisis: Background, Prospects, and Its Impacts on Korea, Seoul Journal of Economics, vol. 22, no. 1, pp. 77 Pilling, D 2009, Fear and self-loathing in South Korea, Financial Times. London (UK): May 28, 2009. pg. 13 Ramstad, E 2009, Koreans Take Pay Cuts to Stop Layoffs, Wall Street Journal. (Eastern edition). New York, N.Y.: Mar 3, 2009. pg. A.1 The Economist, 2008, Second time around, retrieved online June 9, 2009 from http://www.economist.com/displaystory.cfm?story_id=12470531 Read More