The interest rates offered by finance companies must be lowered and forced mergers and acquisitions completed before the finance sector can achieve a reasonable level of stability. Vatchara Charoonsantikul and Thanong Khanthong report.

The distorted interest rate structure of the finance sector has emerged as a major policy concern.

As part of the first step to restore stability to the industry, Thirachai Phuvanatnaranubala, the Bank of Thailand's director of financial institutions supervision and development, is developing measures to force finance companies to quote uniform interest rates for their promissory notes (P/N). Short-term rates must be brought down, even forcibly, if there is to be any chance that long-term rates can be lowered to give the cash-strapped financial system and the economy a break.

A host of troubled finance companies are offering a P/N call rate of 21 per cent a year, a level significantly higher than their lending rate. This means that they are losing heavily for every baht they take in as a roll-over to offset the withdrawals from their nervous P/N holders or creditors.

Since the Financial Institutions Development Fund is guaranteeing all of the Bt1.43 trillion worth of promissory notes in the system (as of March 1997), these troubled finance companies have found solace in the disastrous pyramid game they are playing ­ only to find themselves the most vulnerable players.

A US investment banking firm defines a financial crisis as a generalised loss of confidence in the financial system, a breakdown in the payments system and a contraction of the gross domestic product (GDP) to the level supported by the amount of cash in the economy. ''The financial crisis is developing from a protracted deterioration in asset quality resulting from high real interest rates and a slowdown in economic growth," the firm said.

Since finance companies rely mainly on short-term capital for their funding, they are susceptible to financial shocks or sudden outflows of deposits. Of the total Bt1.43 trillion P/N in the finance sector, Bt369.54 billion was accounted for by call rates (a P/N holder gets his money back the day after he redeems his call), Bt698 billion by three-month rates, Bt207.4 billion for less than 12 month rates, Bt72.3 billion for one year rates and Bt81.24 billion for rates beyond one year.

With the collapse of the bubble economy, finance companies are reeling under the burden of non-performing loans, which are threatening to tear apart the financial system. The US investment banking firm estimates that finance companies' non-performing loans increased from 3 per cent at the end of 1995 to an estimated 12 per cent at the end of 1996, and are expected to peak at 20 per cent in mid-1998.

Since their total loans reached Bt1.45 trillion, their non-performing loans may reach almost Bt300 billion by the middle of next year.

Nervousness over the collapse of the financial system, resulting from high real interest rates and a sharp economic downturn, led to a speculative attack on the baht last month and to the severe credit crunch that followed.

Finance companies and corporations are being squeezed by the tight liquidity, particularly after the shutdown of the foreign exchange swap market as a way to punish foreign currency speculators.

Interbank deposit rates have climbed to 16.5 per cent for one month, 13 per cent for six months and 11.75 per cent for one year. For a capital deficit country like Thailand, a sudden outflow of capital or a currency attack would have far-reaching consequences for the financial system.

No one is certain whether the liquidity crunch is temporary in the aftermath of the baht attack or whether the shutdown of the swap market is being countered by foreign investors keeping their capital, which would have flowed back into Thailand, in offshore markets.

Some officials have said the central bank cannot keep the swap market closed for too much longer because the country needs short-term capital to finance its balance of payments. A prolonged shutdown might also scare off foreign investors.

In the meantime, to raise funds, local corporations have no choice but to sell their blue-chip stocks, which just adds to the financial crisis. Bangkok Bank, Thai Farmers Bank or Siam Commercial Bank have been repeatedly pounded because they are the core holdings of the corporations, who are now being forced to raise money by selling everything they can get their hands on.

Finance Minister Amnuay Viravan and central bank Governor Rerngchai Marakanond realise that they will not be able to turn the economy around if interest rates are kept high to defend the currency, but they cannot lower the rates either, unless they develop a credible package for easing the uncertainty in the finance sector.

So they are now adopting a two-pronged strategy to deal with the financial sector crisis. First, distortions in the interest rate structure of the finance sector must be ended by moving the finance rate closer to the commercial bank rate. The normal gap is about 2 percentage points. The high cost of funds for finance companies has been in turn punishing businesses, which are being charged exorbitant interest rates.

To do so, financially sound finance companies will have to be distinguished from financially bereft ones. There is a growing consensus among the banking authorities that finance companies that are beyond salvaging should be allowed to go under. The cost of bailing out all of the troubled companies would be beyond their capability. Finance One Plc is lucky to have received an official bail-out because it is the largest finance company in the country and too big to fail.

Reports over the weekend that the regulators were pondering forced mergers among the finance companies have been confirmed. The ones that cannot be salvaged will go under by the weight of market forces, while the rest will be forced into mergers and acquisitions by being given incentives to become banks.

There is going to be wholesale change in the finance sector and a departure from the outdated Life Boat Scheme. It is going to be a major political fight because most shareholders and managers of finance companies have strong political connections. They will all selfishly demand a government bail-out.

The wave of mergers and acquisitions will be difficult. It will be nearly impossible to ask six or seven finance companies to merge on equal terms. Troubled finance companies must completely write down their debts and be forced to either become takeover targets or to merge at the expense of their shareholders. Blood will flow in the boardrooms, not champagne.

If the merger push is successful, the remaining finance companies would then operate under a new interest rate structure allowing them to access funds at a lower cost. This would set the stage for the general interest rate reduction needed to boost the economy.

More importantly, a climate of lower interest rates will provide a window of opportunity for banking regulators to adopt a more flexible foreign exchange regime.

The US investment banking firm says any modification of the exchange rate regime should aim at permitting greater flexibility in the conduct of monetary policy and to bring domestic interest rates down ­ not to enhance external competitiveness.