The devaluation of the Thai baht in July 1997 set off a series of shock waves throughout Asia. To provide insights on the state of the Asian economy today, Working Knowledge recently brought together a panel of four scholars with a long-standing interest and expertise in the region. Professor Yoshino, one of the School's Directors of Research, also served as moderator.

Michael Yoshino: We represent different disciplines, but we have all been looking at various aspects of the Asian economic crisis for almost two years. It spread quickly from Thailand to Malaysia, Indonesia, the Philippines, and South Korea. Japan was already in deep recession. The overall situation, though improved, remains a focal point of interest and concern. This forum gives us an opportunity to discuss some of what we've learned from our research. Krishna, let's begin with you.

Krishna Palepu: There is a bottleneck in Asia among the institutions that are supposed to facilitate financing, regulation, and governance of corporate activity--the result of growth that has overrun the institutional capacity of these countries. The banking problem in Japan, including major defaults on loans, provides clear evidence of this. I see a need to reexamine the key players in these economies at the corporate, institutional, and public policy levels.

Walter Kuemmerle: In many ways, this crisis has been in the making for a long time. In terms of an institutional perspective, it was predictable that at some point something had to break down. But at the same time, I think the so-called Asian contagion has actually created additional long-term opportunities for multinational corporations [MNCs] and private equity firms. For example, MNCs understood early on that there were some institutions lacking in the countries in which they operate, and so they had to recreate parts of these institutions by establishing their own research and development infrastructure. Several MNCs invested in local R&D sites, for example, to support their local manufacturing operations. In some cases, these investments eventually triggered the insight among governments that a national science infrastructure was a necessity. Recently, foreign private equity players have also become aware of investment opportunities.

Yasheng Huang: I echo these sentiments, and I think the institutional map in Asia in the past has also provided opportunities for MNCs to play a role that they would not otherwise play. China, for example, has a very high savings rate; yet it imports large amounts of direct investment every year. One reason is institutional underdevelopment. Since the banks didn't provide efficient financial intermediation, MNCs took advantage of the opportunity.

Palepu: My research with [HBS associate professor] Tarun Khanna is compatible with the finding that business groups play an important role in filling institutional voids. Much of the debate regarding the restructuring process in the Asian economy concentrates on the evils of, say, the South Korean chaebols and the damage they have done as huge and powerful industrial webs. In reality, however, because governments have not paid enough attention to building institutional infrastructure, it's the business groups that have filled the void and helped sustain the economies of Korea, China, Japan, and the rest of Asia. If governments want to promote entrepreneurship, rather than decry the role of multinationals and business groups, they should focus more on creating market institutions that make it easy for entrepreneurs to gain access to private equity and other forms of capital. Through that process, they would make the role of MNCs and business groups less important.

	Deregulation has been one of the major problems sweeping through Asia. Many saw it as a great opportunity, but there have been more negatives than anticipated. Michael Yoshino

Kuemmerle: Governments need a lot of education to become more informed about what market mechanisms can do and how science and technology influence a country's welfare. I've found that when multinationals in the electronics and pharmaceutical industries established R&D sites in China and some other Asian countries, governments were concerned that these labs were creating things that would be taken out of the country, rather than benefit it.

Palepu: I've also noticed a confusion in the minds of government officials and corporate managers between deregulation and market development. If you have a field of grass with a fence around it, and you remove the fence, that doesn't make it into a championship-quality golf course. You still need to develop the property and attract top players. Deregulation allows people to play, but in many ways the grounds themselves aren't ready. The result is that experience prevails, and existing players with access to other institutions like MNCs have an advantage. In fact, our research shows that in many of these countries, the advantage to business groups and multinationals increases when there is deregulation.

Yoshino: Deregulation has been one of the major problems sweeping through Asia. Many saw it as a great opportunity, but there have been more negatives than anticipated. Institutions have indeed failed to keep up with growth, but we also ought to look at an institutional inability to change in order to meet new requirements. In almost every Asian country you look at, institutions did work effectively at one time. Japan certainly produced great results in the fifties, sixties, and seventies with the same institutional framework--including powerful keiretsu groups--that is now a problem.

Huang: Policymakers in less developed parts of Asia such as China and India face a real dilemma. They want to develop competitive companies within their own nations, but they view competition with MNCs as a threat to this objective. As a result, they erect trade barriers and put in capital to nurture their own firms. The problem is that this insularity has, in fact, weakened their enterprises by reducing the competitive landscape of their economies and providing such a degree of comfort to policymakers that they don't have an incentive to undertake hard policies. It's the competition that comes from foreign banks and MNCs that forces changes in institutions and ownership. Determining an optimal sequence of reforms is a major issue.

Kuemmerle: There's an interesting analogy in the science and technology system. Here, too, it's better to address the problem at the roots, but it's not all that obvious what the roots are. Several Asian governments have been trying to establish high-technology parks like Silicon Valley or North Carolina's Research Triangle. The thought was, if they could attract one or two key researchers working in other countries and have them team up with some native graduate students, miracles would happen. It took a number of years to realize the need for a fundamental change in the educational system, with an emphasis on creativity, not rote learning. And to complement that, you need sophisticated venture capitalists willing and able to fund risky investments. The whole idea of staged equity commitments, which is ubiquitous in Silicon Valley, didn't exist in the minds of Asian financial institutions, and so it's taken governments quite awhile to understand this process as well.

Palepu: On the other hand, it's also true that chaebols have realized this for a long time. Since its founding more than thirty years ago, Daewoo has acted as a major venture capitalist in South Korea. There's actually a lot of knowledge in these countries, but it's inside the companies themselves. The question is, how do you preserve the institutional capabilities of major corporations in a Japan, Korea, or India but also improve their governance and create the right incentives for them to take advantage of these capabilities? Their goal should not be just to promote growth but to create value. I think that's the real challenge now, since so much of the debate has focused on developing external institutions.

Kuemmerle: It's also interesting to see how governments have reacted to the crisis. Immediately after it occurred, obviously everybody tried to extinguish the fires. But when you're doing that and dealing with the IMF and other supernational institutions, it's easy to lose sight of what the target should be in the long run. You suddenly become so focused on firefighting that you forget what you need to do to replant the forest in a way that won't catch fire again. I'm concerned that this is the state of affairs in some of the Asian economies.

Huang: I agree that governments ought to address specific market failures rather than break up these business groups. But the Koreans believe that the continuing existence of the chaebols perpetuates their problems and that they have to break them up to correct some of their market inefficiencies. As for the chaebols themselves, they have no incentive to move to a different system in which they will play a diminished role.

Palepu: But you can make certain reforms to give them the incentive. For example, developing the market for corporate control establishes the mechanism that advanced markets use in motivating managers. In the West, managers know that shareholders have the tools to replace them if they are dissatisfied with corporate performance. There is also the threat of hostile takeover by other management teams that can promise better returns to shareholders. This realization motivates managers to pay attention to shareholder value creation.

Kuemmerle: This is where foreign private equity firms can have a huge influence and, if they play their cards right, gain access to assets that will later serve as role models of how an economy can be restructured or how restructuring can be supported. I'm actually quite optimistic that this is happening over time. There's an illustrative case study in International Entrepreneurial Finance, the MBA elective course I've developed. The case, "QI-Tech," deals with a Chinese high-tech company founded as a 50-50 joint venture between a Western corporation and a Chinese state-owned enterprise [SOE]. It was clear that in order for this firm to succeed beyond China, it needed more technology than the Western joint-venture partner could provide, so the Western partner decided to sell to a major worldwide player in the industry. But the negotiations were not well prepared, and when the first bidder showed up, the Chinese partner said they wouldn't relinquish control. The deal fell through. Only then did the Western partner comprehend how much more education was needed to make the Chinese partner understand the value of bringing in a majority owner. By the time another potential buyer made an offer two years later, the SOE was much more open to the idea, and the deal succeeded.

Yoshino: What's especially interesting to me about that story, Walter, is the experimentation that the parties are going through. That's exactly what has to happen. Government cannot institute a framework in which these kinds of transactions happen smoothly. If you look at the history of venture capital in this country, it took time to gain momentum in a perfect environment. When it's transferred to places like Korea or China or India, you can imagine the obstacles that lurk around every corner

Palepu: An important part of this involves changing mindsets. The notion that you're not obligated to own a business from generation to generation is something that many Asians haven't grappled with.

Yoshino: On a similar note, the Japanese are still preoccupied with protecting their employees first. Banks and shareholders come way down on their list of priorities, even though shareholder equity is now much more important.

Huang: There's also the matter of the role of government in creating and implementing regulations and policies when it comes to resolving the tension between control and access to capital. In Asia, government regulations and policies play a big part in affecting how managers and shareholders think about this issue.

Kuemmerle: I see a real need for creating functioning markets where institutions take care of aberrations, not government intervention. Another important piece in all this is the development of reliable auditing capabilities.

Palepu: And people have to appreciate that this is a long and arduous process. It starts with education and a variety of other institutions that are all linked. To create good auditors, you need good accounting schools. To have good accounting schools, you need good secondary schools and so on.

Yoshino: I second that. I see the current crisis on two different levels. A great deal of restructuring is going on, including divestments, layoffs, and reorganizations, and these will occur over the next three to five years. But the kind of restructuring Krishna is talking about is much more fundamental to reform. Unfortunately, I don't think it receives enough attention. It's also worth remembering that the U.S. economy developed over several centuries. The Asian economies are switching out of a catch-up, top-down mode in a very compressed time frame.

Huang: That's definitely a very important element in understanding Asia. Policymakers and business managers there have been eager to be as successful as their Western counterparts, but they've had to work within a much shorter time frame. Given that, they were apt to make mistakes, and they have.

Palepu: Looking ahead, let me direct some advice to MNCs seeking opportunities in Asia. It's very important for them not to base their strategies for emerging markets on what has worked well in their home country. What flies in New York or London or Berlin might not make it in Shanghai.

Huang: I also think multinationals must distinguish between two kinds of demand for their product or technology. One is created by government policies, regulations, and subsidies. The other is the underlying market demand for the product. MNCs should focus only on the latter. One Japanese company I've looked at invested billions of dollars in the production of high-end VCR components for sale in China--a decision not justified by the market. Although this equipment was too expensive and too advanced for most Chinese households, the product was strongly supported financially and politically by the government. Bottom line: the company lost a lot of money.

Yoshino: If I may have the last word, I'd like to underscore the importance of professional leadership in times of trouble. Many of the corporate groups in countries such as Thailand, Indonesia, the Philippines, and Malaysia are run by families who founded and control the organization. When the crisis hit, some of these entrepreneurial families didn't know what to do. And their indecisiveness reverberated through the ranks of upper and middle managers, who were immobilized without the usual marching orders for them to obey and implement. In the face of this slow response from the top and the domino effect that ensued, problems grew worse. In contrast, there are some Asian companies that have purposely invested a substantial amount of time and money educating and building a strong group of professional top executives. These firms seem to have been able to restructure much more quickly and effectively. I think they provide the model for the Asian organization of the new millennium.

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