One of globalization's most sweeping effects has been to transform closed, government-controlled financial systems into free markets open to foreign investors. Over the past two decades, surging capital flows have reduced funding costs for corporations and enabled investors to reap higher risk-adjusted returns. But unfettered capital markets have a downside: increasingly frequent economic breakdowns, particularly in emerging economies. More than 65 serious financial crises have erupted over the past ten years - almost one and a half times the number recorded during the 1980s.
Last year alone, Argentina suffered a bank shutdown and a severe devaluation when it defaulted on its government debt, and a long-smoldering crisis flared in Turkey after one of the country's largest banks went under, causing confidence to crumble. Industrialized countries are also vulnerable, as Sweden found in 1992, when a real-estate-market bubble burst, plunging banks into the red and causing the value of the krona to plummet.
Yet no matter how real the threat of national financial meltdown might be, and no matter how devastating the consequences, many companies seem disinclined to safeguard themselves -- even though, in our experience of dozens of such events over the past 15 years, managers can take many precautions. Obvious measures include monitoring potential warning indicators, maximizing cash, and restructuring debt. To be more thorough still, companies can minimize their key operational risks, run crisis scenario analyses, and devise explicit plans for crisis management.
The better prepared a company may be, the more likely it is to survive a crisis. It might even position itself to prosper from the chaos. Consider the case of the Ayala Group, one of the oldest conglomerates in the Philippines. Ayala has traditionally been more fiscally cautious than its peers, keeping larger amounts of cash on hand and holding less debt than might seem efficient (exhibit). But this prudence has enabled the company to withstand numerous difficulties in its 165 years. During the 1997 crisis that swept through Asia, for example, while competitors were putting the brakes on their capital expenditures, Ayala went on aggressively building out the country's first digital wireless network on the Global System for Mobile Communication (GSM) standard. The Ayala subsidiary Globe Telecom is now the top wireless company in the Philippines. In the banking industry, Ayala acquired one of its major competitors (which was in distress), thereby boosting its own Bank of the Philippine Islands from the country's fifth- to second-largest bank in terms of assets.
Readiness has a price, however: management not only must constantly be ready to engage in battle but also must moderate the usually intense focus on quarter-to-quarter financial results. In strong economic times, analysts have chided the Ayala Group for its conservative balance sheet. But in most cases, careful planning greatly improves the odds of surviving financial crises, though the worst of them -- those that spark political furors, such as the 1998 crisis in Indonesia and the 2001 - 02 crisis in Argentina -- can bring down the best-prepared companies.
See the Warning Signs
Amid the instantaneous and fickle movements of information and money in borderless capital markets, corporate executives can rely on no one but themselves to spot the next crisis welling up. Stanley Fischer, former first deputy managing director at the International Monetary Fund, once commented wryly that "The IMF has [privately] predicted 15 of the last 6 crises. If we went out and started predicting [publicly], we would bring on many crises." Indeed, the problem of self-fulfilling prophecies puts severe constraints on all public watchdogs, and managers thus cannot depend on the IMF or ratings agencies to sound the alarm.
The good news, though, is that warning signs can be spotted well in advance if managers take the time to look. Most observers focus on macroeconomic variables such as exchange rates and fiscal deficits. Macroeconomic conditions certainly matter -- smart managers regularly review the country reports put out by bank analysts and well-informed journals -- but these signs are usually the last to flash red before a crisis breaks. It is in the real economy and the banking system, where the roots of crises develop, that the first indications of trouble to come can be seen.
Indeed, warnings abound: companies fail to earn their cost of capital or to maintain enough cash flow to cover interest payments comfortably, for example, while commercial banks go on lending sprees, often doling out funds to increasingly unstable corporations. Ultimately, these problems show up in the banks' profitability and nonperforming-loan portfolios. Foreign lenders may add to the credit binge with short-term foreign-currency loans. Asset price bubbles, often in real estate or the stock market, inflate collateral values and put banks at risk. When several of these indicators start heading in the wrong direction at once, trouble is sure to be brewing.
Symptoms of Argentina's crisis, for example, were visible long before it erupted in December 2001. The economy of Argentina had been shrinking for the past four years, and its companies' return on invested capital for some time had been lower than the cost of capital. Depositors had been moving funds offshore for more than a year and stepped up the pace sharply in the six months before the crisis erupted. Meanwhile, Argentina's fiscal deficit had ballooned, placing the country on an unsustainable borrowing binge. The writing was on the wall.
Conserve Cash and Restructure Debt
When the storm breaks, revenue streams and credit lines dry up and interest rates skyrocket. After Brazil's sharp devaluation in 1998, interest rates soared to 65 percent and stayed there for more than three months. In Argentina, interest rates rose to 74 percent in November 2001 -- just before the government froze deposits and banks stopped lending money altogether. Under such circumstances, companies that lack adequate cash flows or bear a heavy burden of indebtedness soon develop liquidity problems and often descend rapidly into insolvency.