The government wants to help faltering companies stay in business. But what has caused this wave of defaults? Mahmoud Mohieddin* explains News of major defaulters has, for the past few weeks, made for interesting headlines, and even lively debate on various chat shows. Even in faraway coastal resorts, long nights have been whiled away discussing loans, defaulters and corporate corruption. Indeed, some of the country's largest defaulters were part of Egypt's "jet-set" social scene. They threw lavish parties, wining and dining the rich and powerful. Small wonder, then, that they had become such big news. The problem of non-performing loans is sizeable. The total indebtedness of defaulters now stands at LE50 billion, or 14 per cent of the LE360 billion (a figure close to Egypt's annual GDP) lent by Egyptian banks to private industry, households and the public sector. Several notes merit attention in this regard. Firstly, the aforementioned figure of non-performing loans (LE50 billion) includes a range of critical, watch-list and doubtful loans in addition to the bad ones. Secondly, part of the LE50 billion figure are public sector loans implicitly guaranteed by the government. Third, over the past couple of years, it has been announced that loan-loss provisions for bad and doubtful loans have exceeded 80 per cent. Adequacy for these provisions and the appropriate calculation method, however, are still under debate. Although high by international standards, the size of Egypt's non-performing loans are not unusual for a developing country. A recent study investigating the safety of the Egyptian banking system and its ability to absorb financial shocks, be they credit quality, foreign exchange and interest rate risks in addition to liquidity problems, has shown that the Egyptian banking sector has not reached a crisis situation yet. However, if conditions continue to deteriorate, more serious difficulties might ensue. One of the banking system's problems lies with the weak capital adequacy ratio of some banks. This requires recapitalising banks with the aim of restoring an adequate capital ratio that takes into account the level of provisions in addition to other prudential requisites. Probity aside, inefficient financial managers who have failed to prove their competence will have to be replaced. Additionally, the current structure of the banking system renders the level of competition low. Despite the large number of banks now working in the Egyptian system the four major public sector banks still dominate; they control almost half of the banking sector in addition to their participation in joint ventures. The many foreign banks operating in Egypt merely focus on activities dealing with a limited number of, low-risk, high return, clients. Why, then, have our borrowers defaulted on such a scale? In my opinion there are four main reasons. First, the inappropriate implementation of the financial liberalisation policy of the early 1990s. The performance of credit departments of many banks was less than adequate. During deregulation, the Central Bank gave up control over bank lending policies, let the banks set their own interest rates, and removed restrictions that were previously imposed on lending to various sectors. Since then, banks have been free to make their own lending decisions, a practice abandoned for decades. Unsurprisingly, they developed little of the expertise required to make the right decisions. Furthermore, high interest rates on the Egyptian pound, and a "stable" exchange rate, caused a surge in deposits. This put pressure on banks to expand their lending operations. Many banks became careless with their loans. The problem increased, but remained unnoticed during the "bull" market. As soon as the economy began to slowdown, problems surfaced. What happened next was a classical case of liquidity and financial problems. The banking system had overextended itself during the period of strong economic growth. This has happened in other countries before. When a similar set of events occurred in Britain in the mid-1970s, and again in the late 1980s, the Bank of England adopted a new policy that came to be termed the 'London Rules'. According to these rules the Bank of England initiated a program of debt-rescheduling for viable borrowers. That is, bank clients whose repayment problems were due to economic reasons, not fraud. Second, bank internal audit and control departments, which supervised the granting of loans and follow-up repayments, were inefficient. These departments were often staffed with ill- trained personnel who performed tasks in a largely perfunctory manner. In one bank, service in the internal audit department was considered a disciplinary measure for employees. The Central Bank has since become aware of this problem and established guidelines for audit committees. Third, at an early stage the Central Bank did not adopt strict measures for the supervision of credit operations. It did not use its information about clients and their credit profiles to limit high risk credit until late 1998. For a long time, bankers assumed that faltering businesses would eventually recover and resume regular repayments. As the slowdown continued, this hope began to fade. Fourth, investors miscalculated and adopted a herd mentality; following each other into economic activities. The liquidity crunch of late 1997-1998, coupled with three external shocks (the fall in oil prices, tourism revenues and the decline in foreign investments following the emerging markets financial crises) have adversely affected the real estate and tourism sectors and some assembly plants. These were the first to be hit by economic recession. As recession took hold, a number of investors began borrowing to pay off their older debts. To do so, they, inter alia, overvalued their assets or used the same collateral more than once. Such acts of fraud merely exacerbated the problem. Benefiting from the experiences of other countries, the government introduced a new initiative to keep "serious" investors solvent. This new programme is designed in tandem with international recognised rules, similar to the "London Rules". Its general framework is as follows: Advising banks to reschedule debts without writing off any of the borrowers outstanding obligations, including the original debts and accruing interest. Freezing any legal action by the banks against the borrowers during the rescheduling period. Stopping all credit to new projects, but continuing to provide credit for operational needs and additions to capital. Restructuring and consolidating companies with outstanding debts, instructing them to focus mainly on their core activities. This approach may be sufficient to resolve some default cases. But there is a need for assertive intervention in the management of assets. One way would be to create an agency with national "AAA" credit rating, with the necessary guarantees, to oversee regulations concerning bankruptcy, solvency, and receivership. This agency should run the assets of companies in receivership and pay back the banks, employees, and tax departments, according to a given timetable. The agency should also use risk-calculation methods to restructure companies placed under receivership. Finally, it should be allowed to borrow by virtue of its financial strength and the assets under its control. Defaulters have unused production capacity in addition to assets that deteriorate over time. This complicates the issue of solvency. We should judge the companies which are worthy of support on the basis of their ability to remain solvent and viable in the future. Yet, we must also appreciate that some companies will be insolvent, despite the intended help. The banking system should not waste valuable resources on such companies. Once they have folded, these companies would be making way for a new generation of businesses to emerge, ones that operate on sounder economic and financial principles. Indeed, in a market economy, exit rules are as important as entry procedures. * The writer is a member of the General Secretariat and chairman of the Economic Committee of the National Democratic Party .
