Defusing A Debt Bomb

Can Chen clean up the troubled banking sector?

As a former U.S. Senator and Republican Vice-President, Dan Quayle is no stranger to Taiwan. As an Asian security flash point, the island has long been a darling of American conservative politicians. When Quayle visited Taiwan in late November as a representative of the private sector, the focus again was the island's vulnerability--but this time to a financial crisis. Quayle's employer: Cerberus Capital Management, the world's largest investor in distressed debt, which has been active in crisis-stricken Thailand, South Korea, and Japan.

The descent of the global-finance vultures on Taiwan shows how serious the country's troubles have become. While the government says nonperforming loans are a manageable 5% of total bank lending, independent estimates range up to 15%--nearly at the level other Asian countries were before their currencies crashed in 1997. "Nobody knows the true scope of the problem," says Quayle, who is helping Cerberus find local partners to set up an asset management company to buy and sell problem loans.

GLUT. Taiwan should be strong enough to avert a full-blown crisis. But as worries mount, and its currency and stock markets steadily drop, the embattled government of President Chen Shui-bian is scrambling to restore confidence. On Nov. 25, he got the opposition-dominated legislature to pass a law laying the groundwork for reform. It removes legal obstacles that have made bank mergers near impossible. It also makes it easier for banks to dispose of bad loans.

That could set off a badly needed consolidation of the financial sector, now glutted with 53 commercial banks and some 360 credit cooperatives serving a population of 23 million. Taiwan "probably has more bank branches than bakeries," quips Neal Stovicek, Taipei-based advisor to National Securities Corp. The competitive frenzy has contributed to reckless lending.

The bill also is viewed as a badly needed victory for Chen. Since taking office in May, the President has been hit with a recall campaign by legislators angry over his cancellation of a nuclear plant and has been under intense fire from business for not paying enough attention to the economy.

Cleaning up the mess won't be easy. And the economic fallout could grow more severe. The roots of the problem are lax government oversight, poor disclosure, and Taiwan's reluctance to defuse a debt bomb that's been ticking for a decade. In 1992, the government granted 16 new banking licenses as part of a financial liberalization. Many of these banks proceeded to lend with abandon, often to conglomerates and overambitious property developers tied to the Kuomintang, then the ruling party. Even more dangerous, many Taiwanese banks include stocks in their asset base--a practice that backfired disastrously in Japan--and accept them as collateral. In 1998, serious problems began to surface. Big companies such as Chinese Automobile Co. and Kuoyang Construction Co. defaulted and lenders had to reschedule the huge debts of conglomerates such as textile maker Tuntex Group.

But rather than forcing banks to solve the problem by booking loan losses, regulators urged them to roll over loans. Or banks failed to report problem loans. Such sloppy practices continue. "Everyone is hiding the bad loans," says Jeffrey L. Koo Jr., president of Chinatrust Commercial Bank, Taiwan's largest private bank. Koo says Chinatrust, one of the few to be rated creditworthy by international firms such as Moody's Investors Service, plans to raise up to $600 million to fund takeovers.

PROPS. The government has compounded the problem by intervening repeatedly in the stock market, hoping higher prices would prop up struggling companies. When Asian markets failed to recover from the 1998 crash, the strategy stopped working. Even under Chen, who had promised in his campaign to dismantle the KMT business empire and clean up the banks, Taipei has kept pumping money into the stock market, down 40% since May. And it recently asked banks to give weak companies another six months to repay principle.

Now the pain is being felt in the rest of the economy. Because banks have so much capital and collateral tied up in equities, lower prices mean that even if they seize the shares of a deadbeat borrower, they may not recover the cost of a loan. Property pledged as loan collateral has dropped in value as much as 50% since the mid-1990s. Meanwhile, dud loans are piling up. Officially, they have risen from 3.7% of commercial bank debt at the end of 1997 to 5.4%--or $22 billion--at the end of September, 2000. The government figures there's another $6 billion in bad loans at nonbank institutions, such as farmer credit cooperatives, where bad debt levels are as high as 50%. However, Salomon Smith Barney puts the bad debt figure at $60 billion, roughly 20% of gross domestic product, and UBS Warburg says at least 13 commercial banks would have a negative net worth if they wrote off all bad loans. "Of course, we are very concerned," says Edward Lai, deputy director general of bank examination at Taiwan's central bank. The resulting credit pinch is especially hard on small and midsize businesses, the economy's backbone. Bank lending grew just 0.4% in the third quarter.

Taiwan is not on the brink. It has $110 billion in foreign reserves, a healthy trade surplus, and low government debt. Many leading electronics companies have kept their debt in check. "We don't have a problem in maintaining the foundation for sustained economic development," says Finance Minister Yen Ching-chang. The next step, he adds, is to set up asset-management corporations to buy bad debt at a discount, and then try to recover the loans.

But Chen has his work cut out to fix the system. KMT-linked companies would surely go under--and Chen can't afford to rile his rivals too much because he lacks a legislative majority. Also, Taipei hasn't set aside funds to cover bad loans from banks forced to restructure. "Somebody has got to cover the loss, and only the government can," says National Chengchi University banking professor Norman Yin. Sooner or later, the price for years of recklessness must be paid. Taiwan need only look around Asia to see what will happen if it waits too long.