The Asian currency crisis with the debacle of the Baht in July 1997 brought about unprecedented turmoil in the region. Many finance companies and other entities went bankrupt and resultantly, bankers lost huge amount of money.

The key question is: are there any lessons to be learnt from this crisis? Duff and Phelps Credit Rating Co. (DCR) believes that there are lessons to be learnt from this crisis. In a special report titled DCR Examines Credit Lessons From theAsian Currency Crisis, published in January 1999, DCR has highlighted the lessons that credit managers should learn.

The report is significant in that it demolishes a number of myths both relating to the crisis as also related to traditional credit analysis.

The Myth of the Liquidity ratios

Traditional financial analysis would tend to give a good score to a company that carries high cash balances (cash plus short-term investments). However, DCR feels that one should not be misled by such companies that apparently look cash rich. On the other hand, a careful investigation of their financial statements should be carried out in order to ascertain whether:

 The high cash balances is the result of new debts rather than healthy operations;

 Whether, as detected in some cases by DCR, cash was already pledged to cover the shareholders or the group companies’ banking facilities. DCR found that the pledge agreements were often not disclosed in the financial statements of the owner companies.

Over-financing is as much as cause of concern as undercapitalisation – an unfailing message one gets from the Asian crisis. The reason for the accumulation in cash and related debt was partly due to the availability of cheap and lenient financing during the boom days in Asia. Many companies were tempted to take unnecessary financing offers that had been aggressively provided by bankers, the proceeds of which were invested in the local capital market’s high-yield instruments, without clear investment policy.

DCR would caution a credit analyst to not get misled by a high liquidity ratio but to explore the source of the liquidity, as to whether it emanates from the core operations of the company or is only a reflection of borrowing that could not be gainfully utilised. Besides, the quality of the near-cash investment and off-balance-sheet claims thereon should also be investigated, which may be difficult as not normally disclosed on the balance sheet.

Beware of Inter-company Lending and Cross Guarantees

The practice of inter-company lending and cross guarantees arises as groups take advantage of the borrowing capacity of their flagship companies, which in most cases are the strongest within the group and enjoy a wide access to cheap and lenient financing from capital and banking markets. The flagship companies would guarantee their sister companies/affiliates’ debts and/or would directly give loans to their sister companies/affiliates.

These were common practices among the Korean Chaebols (Korean business groups), which had been expanding their businesses aggressively over the last 10 years.

Lending to the flagship companies with significant exposure to its sister companies/affiliates results in indirect exposure to additional risks—sometimes including sovereign risk—in which the sister companies/affiliates are operated. For, in such cases, the risk is the composite of the risk in the parent company and all the several diversified business risks guaranteed or supported by it.

The experience from Korea in particular proves that lending to flagship companies was riskier than it seemed because in most cases the flagship companies acted, as indirect financing vehicles for their groups expansions. Thus, credit analysis of such cross-linked business groups should be focused not only on the borrower’s business, but also on the overall operation of the group’s businesses.

The degree of financial exposure to the groups’ non-core operations, which in most cases were loss-making operations, should be taken into consideration.

The fallacy of EBITDA analysis

One of the most common financial ratios that is used to measure a company’s ability to service interest payments is EBITDA divided by interest expense, also known as interest coverage ratio. EBITDA [earnings before tax (EBT) plus interest expense plus depreciation and non-cash charges] has been popularly used as a proxy of cash flow from operations available to service interest/coupon payments. The simple rule of traditional ratio analysis is – higher the interest cover, the better.

A problem with the EBITDA, as defined above, is that it includes income from non-core operations such as interest income from lending to affiliates and short-term investments.

The Asian crisis revealed that whereas the interest cover was substantially good prior to the crisis, it just failed to protect the lenders during the crisis period. The reasons are obvious today – the cash flow incorporated non-core incomes which were recurring and accounted for a substantial percentage of total earnings. Income earned from arbitraging activities and lending to group companies were sometimes 3-5 times higher than income from its core operation. In some cases, deteriorating income from core operation was covered up by an increasing amount of interest income generated from lending to group companies.

Basically, many Asian companies became “multi-finance and investment” companies in addition to their core operations. A multi-finance company is a popular Indonesian term, meaning companies engaged in financing factoring and multiple financial products.

During the crisis period, earnings from group companies dried down. At the same time, pressures on working capital mounted as inventory build up accompanied the recession and suppliers were reluctant to finance the same. Thus, the sound-enough credits of the yesteryears started defaulting as interest cover turned adverse.

A lesson to be learned is that EBITDA divided by interest expense ratio should be carefully interpreted because EBITDA is not always a good proxy of cash flow from operations. For a “quick and dirty” indicator, Net operating funds flow (NOFF) from core operations may be a better indicator than EBITDA to estimate a company’s ability to service its interest/coupon payments.

Financing State-run enterprises – a bad credit remains a bad credit

Prior to the crisis, there was a belief that it was acceptable to lend money to state-owned entities with weak financials, even without legal guarantees from the government since the government would eventually bail them out. After all, the governments would lose credibility if they did not bail these entities out of their debts. Some of them were considered to be “too big to fail.”

DCR feels that this assumption was relegated to a myth, as even large state-owned entities were allowed to fail under financial stress. Among these were large state-owned entities such as GITIC (Guangdong International Trust & Investment Corporation), Garuda Indonesia (Indonesia’s National Air Carrier), as well as less strategic concerns such as Hutama Karya and Wijaya Karya (both are Indonesia’s state-owned construction companies).

The collapse of a state-owned company without any bailout from the respective government is actually not new to the financial market. In 1989, following the share market crash in 1987 and economic recession in 1988, a state-owned development finance corporation (DFC) in New Zealand went bankrupt without any rescue from the ‘AAA’-rated New Zealand government.

By contrast, in the case of South Korea, the government gave its financial and administrative assistance to a large section of the private sector, such as KIA Motors, Seoul Bank and Korea First Bank. The government has also encouraged main credit banks to grant bailout loans to the ill-fated companies.

DCR believes that one should not entirely ignore the tangible value of government support, but not to an extent where such implicit support itself becomes the basis of the credit analysis of the borrower. As a broad “first-cut,” a government will have strong incentives to honor such implicit support if the state-companies are:

(i) strategic industries such as defense, energy or utility; (ii) major GDP/tax contributors; (iii) major employers; and (iv) national champion of the country’s long-term focus. In these cases, implied support from the government may ultimately ensure recovery of some debt obligations.

Character: The Forgotten C of Credit:

Remember the five Cs (capital, collateral, cash flow, condition and character) of credit analysis? Although it is commonly learned on the first day of a credit training class, many analysts bankers in the region did not spend much time assessing their borrowers’ character in their daily business transactions.

The crisis has taught us that character also plays a very important factor—especially in countries where the economic crisis hit the most. Though it is a non-quantifiable attribute, there should be a careful assessment of the borrower’s character (integrity, track record, etc.) at the onset, and sufficient time should be dedicated to gather market information on the controlling figure or family before analyzing the borrower’s financial and business positions.

It is worth noting that many Asian business groups are still majority family-owned. DCR considers management’s commitment to credit quality as one of the key qualitative considerations in the rating determination. The assessment of management’s commitment to credit quality is subjective and often hard to evaluate.