Liberalization of domestic banking combined with weak supervision can boost the quantity but undermine the quality of bank lending to the corporate sector (Dooley, 1997 and Krugman, 1999a). Of course, bank lending can enhance growth by financing higher levels of corporate investment. However, liberalization combined with lax bank supervision or implicit or explicit deposit guarantees can also ratchet up the riskiness of bank loan portfolios. This combination does seem to be an important factor contributing to the vulnerability of the corporate sectors in East Asia (Krugman, 1998). Also, state-owned banks or bank lending directed by governments can result in the misallocation of credit to corporations, which seemed to have been the case in Chile, Mexico, and the transition countries (Velasco, 1987; Lubrano, 1996; Begg, 1996). The level of overall domestic bank credit in developing countries has been on an upward trend since the late 1980s (Figure 1, top panel).
Underdeveloped domestic nonhank capital markets concentrate risk by limiting the number of options for corporate financing. Small or nonexistent corporate bond, commercial paper, and equity markets lead to overreliance on bank financing. The absence of derivative markets prevents corporations from hedging against the risk of exchange rate devaluation. Domestic bank and foreign portfolio financing can finance growth in the good times, but the absence of alternative financing and derivative markets can also result in excessive vulnerability of the economy to a bad shock or bad news regarding the corporate sector.
The limited data on the corporate financial structure of emerging market countries suggest a correspondence between vulnerability to crisis and hank dominance of the financial system. Gross financial flows to the corporate sector for the six of the nine crisis episodes that are reported in Kamin et al. (1999) are quite high relative to industrial countries, suggesting countries at their stage of development may be inherently more vulnerable to financing shocks (Table 2). Bank loans account for about half of gross financial flows to three fourths of the corporate sector for the crisis countries, which is higher than for Singapore, the U.S. and the U.K., about the same as for Germany (with its system of bank cross ownership). In Japan, which has its own slow-burning systemic corporate sector problems, bank loans account for fully three fourths of corporate financing. In addition, Claessens et al. (2000), concluded that external financing mostly from banking systems is inherent to East Asian corporate sectors.
to the Nonfinancial Corporate Sector, 1992-94
Volatile capital inflows can increase vulnerability to crisis. Capital inflows have accelerated sharply in recent years (Lopez Mejia, 1999 and Adams et al., 1998; Figure 1, middle panel). Further, their volatility has increased in line with the shift in external financing from international banks to other private sources (Figure 1, bottom panel). These inflows can go to corporations directly (Indonesia) or indirectly via domestic banks (Mexico in 1995 or Korea). Again, capital inflows toward high (risk adjusted) rate of return projects is beneficial to investors and corporations alike and can boost economic growth. However, herd behavior on the part of international investors may set the stage for a sudden reversal of capital inflows (Calvo and Mendoza, 1998). These reversals can be especially harmful when external liabilities are mostly of short-term liabilities, as in the case of Korea in 1997 (Lane et al., 1999). Capital inflows rose sharply beginning seven or eight years before the crises in each of the nontransition countries examined here (Figure 2).
Poor corporate governance is the other side of the buildup of vulnerability. Corporate governance practices cover shareholder rights, creditor rights, accounting and disclosure, and ownership and control. Certainly, governance was a problem in countries emerging from a icentrally planned system, either due to direct state control of corporations or to a faulty privatization process (World Bank, 1996). Several studies have concluded that governance in East Asia was poor owing to a high degree of ownership concentration (Claessens et al., 1998b).
Finally, the vulnerability of highly leveraged balance sheets can be further increased by rigid macroeconomic policies. In several east Asia countries rigid adherence to a fixed exchange rate raised the price of nontradable goods and assets relative to tradables (World Bank, 1999). The overvalued exchange rate lulled corporations into a false sense of security regarding the costs of external debt servicing, leading to continued external borrowing, and a shift of investment to nontradables and, thereafter, to asset market bubbles. (World Bank, 1999; Lane et al., 1999). In addition, if world interest rates are below domestic interest rates banks have reason to borrow abroad and onlend to domestic corporations, leaving banks with a large open foreign currency position. Domestic bank lending denominated in foreign currency, in contrast, shifts foreign exchange risks to corporations, who have little experience in managing such risk.