Thursday, June 23, 2016

Government role in corporate debt restructuring

First published in The Korea Herald.

The hot topic in Korean corporate circles today is undoubtedly the moves by the government and state-run policy banks to bail out the ailing shipbuilding and shipping companies.

Given the importance of these sectors in Korea and their prolonged financial distress, it is understandable that the government has pushed the panic button. The process of bailing them out has been set in motion with some sort of consensus reached between the Finance Ministry and Bank of Korea.

BOK Gov. Lee Ju-yeol has cautioned against the central bank mobilizing its power to print money in the ongoing corporate restructuring. He was echoing the sentiments of critics, who have raised worries over the government’s possible misuse of the money-issuing authority.

The current crisis in the shipping and shipbuilding industries is very much evident. Once regarded as the backbone of Korea’s economic growth and job creation, they have been reeling from mounting losses caused by an industry-wide slump and increased costs.

Hanjin Shipping and Hyundai Merchant Marine -- the major South Korean shipping companies -- face trouble with mounting losses and have applied for creditor-led debt restructuring.

The top three shipbuilders have also failed to clinch a single deal in April, according to latest data.

They only managed to win five construction deals over the first four months of this year, which is only around 5 percent of the average amount posted in previous years.

Daewoo Shipbuilding & Marine Engineering and Hyundai Heavy Industries, failed to win any deals in April. Samsung Heavy Industries has not earned any orders this year for the first time.

Given this dismal situation, it is important to ask: Is active government involvement in corporate debt restructuring really advisable?

No doubt, corporate debt restructuring is an important step toward recovery. But what are the limits to which the government should stick to without putting a burden on other sectors and more importantly tax payers?

Given the interlinkages between corporate debt problems on one hand and the recovery of the financial system and overall economy on the other hand, several governments across the world in the past have introduced measures to help facilitate the process of corporate debt resolution.

However, there are a number of complications involved.

Corporate debt problems have often created real risks of disruption of activity as companies have difficulties meeting their working capital needs to secure production. This in some cases led to weaker capacity to service existing debt and further deteriorated their balance sheet.

The slowdown of activity has contributed to unemployment and the nonperforming loans have endangered the already weakened banking system and further reduce the ability of banks to extend credit, slowing down the recovery.

As experts have noted, debt overhang becomes self-perpetuating as corporations are unable to deleverage by retaining earning or issuing equity because of recession, but recession is also being prolonged by the high level of debt.

The government’s rescue efforts of embattled corporates typically entail direct fiscal costs and may have increased the contingent risk in the future due to moral hazard. The resolution of corporate debt problems thus became an important part of the recovery strategies across a range of countries affected by the crisis.

A past IMF Working Paper, “Government Involvement in Corporate Debt Restructuring: Case Studies from the Great Recession” is worth noting here, and should be mandatory reading for Korea’s Finance Ministry officials at this time.

The paper surveys corporate debt restructuring episodes in Latvia, Russia, Spain, UAE, Ukraine, and the United States and provides a comparison of modalities of government.

It notes that in cases in which the number of troubled corporations is small, their potential macroeconomic importance is limited and the financial system is sound, the rationale for government’s involvement in corporate debt workouts is weak.

“In contrast, when corporate debt problems are widespread, with potentially sizable macroeconomic consequences, and market failures inhibit debt workouts on the required scale, a comprehensive approach involving government could be warranted. In these cases, however, the framework of such involvement needs to be carefully defined.”

That choice typically involves weighing the costs of intervention against the need for a speedy restructuring. The costs are not limited to the direct financial ones, and include indirect economic costs that could eventually appear from both action and inaction of the government.

Governments’ specific role in an effective corporate debt restructuring process typically includes provision of: appropriate legal foundations; mediation and incentives for out-of-court resolutions; direct financing; and facilitation of restructuring.

Large-scale debt workouts may require an overhaul of the legal framework and corresponding enforcement mechanisms.

Direct government financial assistance to facilitate debt restructuring is generally observed in cases in which debt problems are pervasive and impose negative externalities on the economy.

The incentives may include compensation to creditors for lengthening maturities or providing guarantees for corporate loans. Sometimes, such support also includes direct lending to companies that are viable but are unable to access markets on their own.

In addition to direct assistance to corporations, governments may provide indirect support to the corporate sector via assistance with bank recapitalization and liquidity provision.

This approach is being tried in Korea now.

The IMF paper notes that country experiences with wide-scale corporate debt restructuring in the past have been mixed and have involved lengthy and difficult processes.

“While outcomes varied by country, the past experience indicates that a properly designed strategy would generally make the best use of limited fiscal resources, target interventions where needed most, leverage market-based solutions and private resources, bolster credit enforcement and insolvency laws, and preserve credit culture.”

Tailoring a corporate debt restructuring strategy to individual country circumstances is a complex process involving attention to a number of key factors -- including policy coordination, analysis of data to assess the dimensions of the debt problem, reform of the legal and institutional framework for enforcement of credit, particularly the corporate insolvency law, identifying the rationale for government financing and coordination with financial sector restructuring, particularly with respect to banks.

“The direct financial costs of government interventions varied significantly across countries. While the fiscal and contingent costs in corporate debt restructuring episodes are somewhat smaller compared to the costs of financial sector support, they ranged from zero (where no fiscal resources were deployed) to 10 percent of GDP,” the IMF study notes

“However, it should be noted that contingent risks built up in the years before the crisis due to corporate sector debt have in some cases already translated into fiscal costs.”

In what should be positive for the Korean government at this stage, in general, the debt restructuring and related measures have helped avoid large-scale corporate insolvencies in the sample countries. These measures provided confidence to the markets and stabilized expectations.

However, they also came at a direct and indirect cost to the taxpayer. These interventions weakened the governments’ balance sheets as they accepted assets of questionable financial value in exchange for new resources that had ample alternative use in crisis times.

That is something that the Korean policymakers will have to monitor and work out as they race to bailout the ailing firms.

Amending retail price maintenance rules

First published in The Korea Herald.

The Korea Fair Trade Commission is all set to take a decision on amending the “Guidelines for Review of Resale Price Maintenance” as the public comment period has just concluded.

Resale price maintenance, or RPM, is a system in which the manufacturing firm determines and enforces the price at which distributors resell its products. Hence, it is also known as vertical price-fixing, price protection, or the practice of imposed prices.

Until now, RPM has been deemed illegal in Korea, and companies that are caught engaging in this practice are fined heavily by the antitrust agency because it is considered anticompetitive.

The proposed amendments will allow RPM under certain conditions, more specifically if it “enhances consumer welfare.” It will still be generally illegal; firms need to prove that it does indeed help consumers if they want to get permission for the practice.

The FTC guidelines prescribe specific review criteria for the enforcement of Article 29 (1) of the Monopoly Regulation and Fair Trade Act on resale price maintenance, or RPM. For this purpose, it received public comments for about three weeks from May 23 to June 13.

The current guidelines treat minimum RPM as illegal per se regardless of whether there are justifiable reasons for using it, such as consumer welfare enhancement.

“The proposals state that the minimum RPM is highly likely to be deemed illegal as a matter of principle. However, when the consumer welfare enhancing effect of the minimum RPM concerned outweighs its anticompetitive effect, the minimum RPM can be permitted as an exception,” the agency has noted.

“The burden of proving reasons to justify the minimum RPM, such as consumer welfare enhancing effect, is on the (concerned) enterprise.”

Following the FTC’s move, there are some questions that need to be asked: Should RPM continue to remain illegal? And what will be the impact of the proposed amendments?

For many years, until antitrust agencies across the world struck it down, RPM used to be a common practice for manufacturers to set a minimum price for retailers to sell their goods. It ensured a minimum price of resale and avoided price competition.

Globally, public policy toward RPM has taken various forms.

It has been prohibited in Canada since 1951 as a restrictive practice against the public interest. In the United States resale price maintenance is authorized in some but not all the states, and also in interstate commerce between “fair-trade” states. In Sweden the practice has been prohibited since 1953. In the United Kingdom legislation introduced in 1964 prohibits RPM, except for classes of goods specifically exempted by a special court.

There are quite a few criticisms of RPM, which led it to being termed illegal.

It is argued that the system artificially inflates prices. Consumers lose out as they have less discretionary income to spend on other goods. Moreover, it is also allocatively inefficient as the price is likely to be above marginal cost.

By setting high prices, manufacturers will have no incentive to remain internationally competitive. RPM enables an easy profit margin in domestic markets, but the result is that inefficient manufacturers may stay in business and lose the market incentive to cut costs and become more efficient.

It also seems out of place today when the culture of shopping around on the Internet for the cheapest products is so widespread.

The likelihood of collusion is high, particularly in a market gravitating toward either manufacturers or retailers. By making RPM illegal, it prevents the formation of cartels.

On the other hand, the supporters of RPM say that it helps retailers to be more profitable. Manufacturers may also prefer it, because if the retailers are profitable then more of their goods will be sold.

It also prevents price wars among retailers as they will not start undercutting each other.

It has also been argued that RPM provides help for smaller retailers, who cannot buy in bulk, to remain profitable. On the other hand, it enables manufacturers to reward shops who promote their products through advertising. This will help firms invest more in future products.

Consumers benefit because they don’t have to waste time searching around for the best deal. They know the price will be the same regardless of where they buy it.

Moreover, its supporters note that minimum RPM is different from price-fixing by cartels. Classic price-fixing is typically referred to as horizontal price-fixing, as they are arrangements between competitors operating at the same level of distribution. On the other hand, vertical arrangements are those between businesses operating at distinct levels of distribution.

In price-fixing, the initiators are competitors who realize that they will be better off if they minimize group competition. With minimum RPM, a single manufacturer influences downstream retailers’ behavior through an increased markup, so they will compete more aggressively on nonprice dimensions, even as competition among manufacturers is not affected. This enhances intra-brand nonprice competition and overall inter-brand competition.

They note that minimum RPM is a business practice that can benefit companies and consumers in stark contrast to price-fixing conspiracies.

Incidentally, in recent years, there is increasing recognition of the potential competition benefits of RPM arrangements and many antitrust agencies are relaxing the rules to make them more flexible.

In 2007, the United States moved away from the per se prohibition. In December 2014, the Australian Competition and Consumer Commission authorized an RPM agreement for the first time, recognizing that the supplier had limited market power and that the arrangement benefited consumers. The European Union guidelines also state that parties to an RPM agreement have the “possibility to plead an efficiency defense” under certain circumstances. In a number of jurisdictions in the region, RPM agreements are not singled out, but are subject to the same test as other vertical agreements.

South Korea is also now moving in the same direction, and it remains to be seen how flexible the FTC amendments will be.