Asia’s Bad Old Ways: Reforming Business by Reforming Its Environment

Hilton L Root. Foreign Affairs. Volume 80, Issue 2. March/April 2001.

Having rebounded more quickly than expected from the financial crises of 1997, East and Southeast Asian governments today appear to be models of fiscal responsibility. South Korea has won praise for its timely delivery of financial information to the public; Thailand has introduced tougher bankruptcy laws; Indonesia has taken steps to clean up bad loans and recapitalize its banking system. Yet despite such accomplishments and a remarkable revival of GDP growth in these Asian countries, many Western critics warn that the progress has been too slow and that the underlying weaknesses that led to the crisis remain.

The critics fear that most East and Southeast Asian businesses have gone as far as they are willing to go in restructuring operations-but that this isn’t nearly far enough. The greatest concerns center on heavily concentrated business ownership and closed systems of production. Continued economic dominance by a few families and a few firms, the critics contend, reinforces flawed Asian market systems and keeps new global economic opportunities at bay. The original owners maintain control over bankrupt companies and resist the sale of their non-core operations, while promising ventures have trouble competing for investment against “crony capitalists” who use their political clout to attract scarce funds.

But if the bad old ways that critics point to were all that bad, then why did they work so well at first? Why was Asia the fastest-growing emerging market in the world from 1960 to 1997? What the critics disregard is that Asian businesses have responded rationally to particular social and institutional contexts. Their practices led to growth in the past and in some situations could continue to permit short-term growth. If these firms have not adopted Westernstyle reforms, it is not because they don’t understand them; the reforms just have not made sense under the circumstances.

Certainly, the deficiencies in Asia’s economic organization are real and will have to be corrected if the region is to prosper in an increasingly globalized world. But the real problems stem less from poor business practices than from the difficult business environment, which lacks, for example, effective contract– enforcement mechanisms and the principle of neutral government intervention. Rectifying these deeper problems will require not just economic policy reforms, but major social and political changes. To offer truly constructive advice, critics must understand the histories of these countries’ financial systems. In the short term, hectoring and putting conditions on aid will only make the situation worse.

Rational Sins

Three years ago, the collapse of the Thai baht dragged East and Southeast Asia through a default spiral as exchange rates plunged and equity and property values collapsed. The international financial bailout that helped revive these economies came with scathing criticism of their basic economic structures. The hardest-hit nations were accused of bringing the problems on themselves by tolerating cronyism, corruption, weak legal structures, corporate opacity, and poor business ethics.

These days, despite some superficial changes, many of these factors remain. Japan drifts from one ineffective reform package to another: its leaders fail to follow through on announced plans, continue to protect obsolete sectors, and renege on pledges to reveal and clean up nonperforming bank loans. In South Korea, Indonesia, Malaysia, Thailand, and the Philippines, private cartels still dominate, insolvent banks continue to operate, bankruptcy laws remain generally inadequate, and bank supervision falls below international standards. Governments have been slow to enact reforms, so nationalized financial assets have not been restructured, definitions of nonperforming loans are a sham, independent regulators do not enforce stock market rules, and litigation still accomplishes too little.

Among the changes that Western critics want to see are protections for minority shareholders, corporate transparency, external auditing, transparent legal frameworks enforced by capable judiciaries, and meaningful distinctions between the regulators and the regulated. These goals are reasonable and rational, but the criticisms lack a broad historical perspective. Blaming Asia’s recent economic failures on cronyism, for example, misses the point that many of the sins committed by Asian businesses were economically rational responses to an inherently uncertain business environment.

In the United States, financial transactions typically take place among a large number of independent contractors. Trades are conducted anonymously or at arm’s length, with each side aware that its risk is minimized by a legal safety net of enforceable contracts. But this kind of trade is difficult in East and Southeast Asia, where inconsistent contract enforcement has forced firms to internalize risks by dealing only through closed production systems.

In addition, Asian firms have been reluctant to disclose profits for fear of having to surrender them to arbitrary governments, while outside financiers remain unwilling to invest without adequate protection against embezzlement. To cope with these risks, firms have acquired substantial “organizational capital”-business relationships dependent on family ties, trust, reputation, and repeated dealings. These relationships allow firms to raise money informally from within their networks of family and acquaintances, without having to go to a bank and show collateral for the loans. In the past these social assets helped firms grow, but in today’s highly competitive global trading system they may be excess baggage.

Trapped In the Network

Different parts of the region face somewhat different problems. In East Asia, capital is allocated according to the notion that a strong state’s proper role is to help coordinate the flow of external financing to companies. Bureaucratic interventions have nurtured and sustained powerful industrial conglomerates, whose subsidized strength has compensated for weaknesses in the capital markets. Similarly, firms in Japan and South Korea react to external market uncertainty by forming internal networks to take direct control over their suppliers and distribution systems. Thus Japan’s keiretsu and South Korea’s chaebol (business groupings) have established vertical ties with small-scale domestic producers and horizontal ties with one another. This strategy brings a wide range of transactions into a more controllable, closed system, reducing companies’ exposure to the risks of opportunism and fluctuations in transaction prices in an unpredictable market. These large networks have evolved into industrial conglomerates, typically including a main bank, that allow intensive sharing of information and internal capital generation.

The Japanese and South Korean examples stand in contrast to much of Southeast Asia-most notably Thailand, Indonesia, and the Philippines—where predatory or weak states discourage industrial development. Operating without the institutional frameworks needed for arm’s-length exchanges, and fearing arbitrary and oppressive state intervention, businesses in the region have quite reasonably gravitated toward a distinctive trading style based on personal relationships-in other words, crony capitalism.

In Indonesia, for example, Chinese trading networks dominate the privatesector economy. These Chinese traders are loosely bound together by implicit contracts and depend on personal or communal sanctions, rather than the law, to enforce contract compliance. Guanxi, for example, is a personal relationship built on trust in an individual’s ability to follow through on promises. This trust is acquired through repeated good performance and cannot be transferred to someone hired from the outside. The relationship also implies a responsibility to implement one’s promises but does not include any formal obligation.

Networks built on relationships such as guanxi therefore lack the formal ties needed to band together and be sold to an outside investor-indeed, any such loosely grouped network would have difficulty borrowing funds from outsiders in its own name. Murky ownership rights and the presence of unincorporated businesses acting with undefined liability mean that assets cannot be turned into capital. Instead, they can be traded only within narrow circles of acquaintances. It should thus be no surprise that of the countries that fell into crisis in 1997, Indonesia is having the greatest difficulty recovering.

The failure of Southeast Asian states to enforce contracts prevents the personal networks that dominate those economies from evolving into more open systems of production. Unlike their East Asian counterparts, therefore, few Southeast Asian businesses have transformed themselves into modern, complex corporations. Yet given the commercial environment they have been facing, those businesses would not have been able to prosper in the first place without these extensive and effective personal networks.

Out With the Old?

Although critics are frustrated by the slow pace of institutional reform, Asian businesses have valid reasons for not wanting to abandon the strategies that served them well in the past-at least not until underlying weaknesses in the business environment are corrected. Business transparency, for example, is dangerous in the present environment because firms that disclose profits can still be subject to arbitrary government audits and expropriations. And relying on internal transactions and closed production systems allows firms to be sure of the accuracy and timeliness of the financial and other information they receive, which might otherwise be in doubt.

In both East and Southeast Asia, moreover, small or new companies have had difficulty breaking into the market. In the 196os and 1970s, efficient business management was rare and highly concentrated in the region, so governments and individuals pushed capital toward the few capable firms. These companies were able to exploit economies of scale and scope, gaining significant advantage vis-a-vis new entrants and developing crucial links abroad. For smaller and less well established firms in the region to now flourish against such competition, they will need a free flow of capital, especially from external investors. But investors are unlikely to direct their funds toward fresh and promising economic opportunities in the absence of a better legal framework, setting up a Catch-22 situation: foreign investors demand accountable owners who fully disclose relevant information, but looser traditional business practices will continue to make sense as long as contract enforcement remains inefficient.

Asian policymakers learned from the 1997 crisis that closed production systems are inflexible and that opening up requires stronger external legal systems and less state favoritism. But what no one has yet been able to design is a smooth transition from the concentrated, closed systems of today to more fluid and well-regulated alternatives. The future clearly favors the model of market-based financing that has supported U.S. economic growth in recent years. Furthermore, the ability to easily assess and disseminate financial information via the Internet can only expedite change. Nevertheless, it is still unclear how quickly an open model can be adopted in Asia and whether the shift can be accomplished without stifling economic growth, at least initially.

Measuring the success of reform in terms of growth rates, in fact, may perpetuate just the sort of cronyism that critics want to eliminate-because the quickest and easiest way to grow is to rely on the old and familiar practices that have served so well in the past. South Korea, for example, has experienced 40 years of strong economic growth but is still missing many of the essential ingredients of an open economy. It lacks a dependable legal system, which requires a judiciary that can enforce and carry out the intent of the law, a government able to interpret laws in a way that reflects social consensus, and a middle class with a vested interest in enforcing the law. Ultimately, a social revolution may be necessary to move the locus of decision-making away from chaebol owners, whose concentrated control of South Korea’s means of production affords them great political and social clout.

A professional middle class can ensure the enforcement of contracts and the objective operation of the state if there is a code of conduct in place that separates their private interests from their professional activity. This group would derive its status from professional expertise rather than clientele or geography and would have an interest in managing the state in a businesslike manner. Yet most Asian nations have not provided the conditions for large numbers of individuals to make the transition from low-status servants of a clientalist political system to high-status professionals. In effect, Asia is facing a dilemma that requires broad social and political change, not just policy reform, to solve.

The Indirect Approach

Rather than pressing directly for policy reforms in the short term, which might provoke resentment without spurring lasting changes, Washington should put its faith in more indirect forces. A healthy U.S. and global economy and increased trade openness, as well as an affirmed U.S. commitment to East and Southeast Asian regional security and integration, will create the external conditions necessary for broad internal changes. U.S. officials can accomplish more in dealing with their Asian allies by putting aside the big stick-America’s disproportionate clout in international lending institutions-than by brandishing it.

Asian businesses understand the pro-competition, liberalizing economic rationalism that makes Western firms efficient, but the domestic political and social institutions that could facilitate such efficient business practices are still in development. In such a situation, patronizing lectures are both inappropriate and potentially counterproductive, because they risk needlessly offending sensitivities and impeding constructive progress. Reactions against modernization and liberalization in East and Southeast Asia will claim that the West is foisting change on the region for its own benefit.

Western critics who believe that change is not coming fast enough can draw solace from the fact that globalization will continue to lap at the shores of Asia’s economies. The conglomerate and family models of business organization today still make it difficult for Asian companies to adopt the preferred business model for global competition. But capital is global nowadays, and businesses depend on foreign investment. East and Southeast Asian firms must learn to better manage the risks inherent in the international economy, without depending on favoritism and government bailouts. Even the giants who grew up in Asia’s past, such as South Korea’s Daewoo, will fail if they resist global forces and refuse to take on new risks.

The elites of the old regime who hope to ride out the slump and return to the good old days will face one major problem: they will find that globalization has changed the rules of the game. Firms’ inability to raise money will ultimately force them to change; access to capital markets will impose checks and balances on business behavior. The profits and productivity growth of those firms that are able to adapt will be the best argument, and support, for true reform.